Disclosures about acquisitions – empowering investors?

The Securities and Exchange Commission recently voted to propose rule amendments to improve the information that investors receive regarding the acquisition and disposition of businesses.  

As the SEC Chair put it in a press release:

  • “The proposed rules are, first and foremost, intended to ensure that investors receive the financial information necessary to understand the potential effects of significant acquisitions or dispositions…The staff’s work on the proposed rule amendments reflects years of experience.  Their work to eliminate unnecessary costs and burdens of the current rules – which in some cases have been significant and frustrated otherwise attractive transactions – while at the same time improving the disclosures investors receive should be applauded.”

In a nutshell, when one company acquires another, the financial history of the acquiree may be as relevant as that of the acquirer itself to assessing the ongoing prospects of the combined company; regulators in the US and in other countries have rules to ensure this information is made available to users. Of course, some acquisitions are more material than others, so the rules include various “significance” tests to determine when such financial information is or isn’t necessary, and perhaps to address the necessary degree of detail, and also to address the need for pro forma statements. Needless to say, this rapidly becomes a monumentally arbitrary reporting cookbook. The SEC’s proposals would tweak various aspects of this, without changing the basic premise. For example, in some high-significance circumstances, the SEC currently requires three financial years of statements for the acquired entity; under the proposal, two years would always be sufficient.

As is sometimes the case with IASB proposals, the most diverting aspect of this comes from a statement by one of the five commissioners. While he approved the issuance of the proposal for public comment, he found plenty of things to criticize. Here are some extracts:

  • Mergers and acquisitions offer substantial benefits for public companies and investors, creating economies of scale and scope that make firms more efficient. But research has long shown that they can also be used by executives to build empires, even if giving management more domain is not in investor interests. Our disclosure rules should balance these benefits and costs, requiring information after mergers close that allows investors to hold management accountable for their mistakes. The prospect of that accountability makes management more likely to pursue only those mergers that make long-term sense for investors.
  • In two ways, today’s proposal ignores evidence on how corporate insiders use mergers to extract private benefits at investor expense. First, our rules historically have required certain disclosure related to the acquisition of “significant” businesses—that is, those with sufficiently large implications for the firm’s financial future to make more detailed disclosure necessary. For decades, we have determined the “significance” of the merger by reference to the audited value of the acquirer’s assets according to its last-filed annual financial statements. Today’s proposal would, among other things, determine a deal’s significance based upon the market value of the acquirer’s equity.
  • The problem with this change is that it could result in less disclosure about acquisitions made by companies whose market value is significantly different from their book value. The evidence shows that those are the mergers that are more likely to be bad deals—precisely the type of mergers for which we should require the most transparency. That’s especially true in light of evidence suggesting that managers prefer to hide information about underperforming mergers in order to avoid accountability to investors…
  • Second, the economic analysis in the release reflects a troubling trend of one-sided thinking in our rulemakings. To justify today’s changes, the economic analysis goes on at length about the benefits of rolling back certain disclosures. But it says nothing about the foundational theory or evidence showing that mergers also come with substantial agency costs. The failure to grapple with these costs suggests that our regulatory choices reflect one-sided advocacy rather than sound economic analysis.
  • For example, the release describes the obvious fact that target companies receive a substantial premium when they’re acquired. But the release ignores the other half of this well-known equation: that acquiring companies’ stocks tend to take a hit upon the announcement of a merger. Looking at the performance of the combined company, which is more logically—and economically—sound, shows that many mergers are not in investors’ long-term interests …

Leaving aside whether these criticisms are all valid in the context of the proposals, they seem implicitly to argue more broadly against our tired assumptions about disclosure and its virtue: when the rules as they stand have facilitated such consistently mediocre deal-making (I’ve cited in the past a Harvard Business Review finding that 60% of mergers destroy shareholder value), why would these modest amendments do any better? In expressing a hope for “detailed ideas about how this proposal can be improved in ways that will empower investors to hold executives accountable—particularly for those mergers that harm investors over the long run,” he seems to be indicating that the information provided subsequent to the transaction may be as important as what came before it (as I wrote here, similar ideas are floating around in the context of IFRS reporting), and perhaps looking beyond that, to a less complacent approach to shareholders’ rights, or perhaps a more interventionist approach by regulators, or better, by politicians. Whether the focus is on mergers, or executive compensation, or financial reporting as a whole, the capacity of traditional disclosure alone to provide the sunlight that serves as the best disinfectant (to cite the excruciatingly tired cliché) is surely tapped out…

The opinions expressed are solely those of the author

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