A Behavioral Framework for Securities Risk
| Publication year | 2010 |
| Citation | Vol. 34 No. 02 |
Introduction
The most difficult tasks for firms involve forecasting, managing, and disclosing risks. In the wake of the financial crisis, a serious examination of risk and risk management at publicly traded firms has occurred. After the crisis, much of the focus has been on new regulatory agencies and additional powers for existing regulators,(fn1) while little energy has been expended on examining and improving the efficacy of the current securities risk-disclosure framework, which was intended to serve as a bulwark for investors.(fn2) The landmark Dodd-Frank Wall Street Reform and Consumer Protection Act created the Consumer Protection Financial Bureau and expanded the powers of the Securities Exchange Commission, yet in 2,319 pages of legislation, no provision was included to enhance risk disclosures.(fn3) This Article seeks to fill that void by providing the first critical analysis and redesign of the existing risk-disclosure framework in light of new understandings in the interdisciplinary field of behavioral law and economics. This Article contends that enhanced risk disclosures based on the behavioral tendencies of actual investors, not theoretically rational investors, can serve as a powerful, complementary risk-management tool in the modern financial-regulatory landscape.
More specifically, this Article examines risk disclosures in the security filings of public firms, particularly those disclosures in the
In order to better capture the advantages of disclosure-based risk regulations given the behavioral tendencies of investors, this Article proposes a behavioral framework for Risk Factors built on (1) the relative likelihood of the risks and (2) the relative impact of dynamic risks. This framework makes risk disclosures more accessible and meaningful to investors and would serve as the new default for public firms. An important feature of the new default is that firms will be able to opt out of the new framework if they believe that the existing Risk Factors requirements are more appropriate. But these firms would need to explain to investors why they opted out. This new default framework would be spatially, optically, and substantively superior to the current framework for investors.(fn6)
(Spatially, the proposed framework would require Risk Factors to appear as the first substantive item after the cover page or table of contents of any prospectus, quarterly report on Form 10-Q, and annual report on Form 10-K. Taking into account the heuristic of "anchoring," the Risk Factors will serve as an anchor in the minds of investors as they read a firm's later rosier disclosures.(fn7)
Optically, Risk Factors will be presented in a standardized, menulike format based on relative likelihood and relative impact.(fn8) Studies on framing effects suggest that this new menu-like framework would offer the investing public a form of risk disclosure that is easier to comprehend relative to the existing regime.(fn9) Additionally, in order to better convey the dynamic nature of risk, the proposed framework would require that new or changed disclosures be underlined to make it easier for readers to identify amended disclosures.
Substantively, the new default framework would require that Risk Factors be categorized in terms of relative likelihood and impact.(fn10) Firms that choose to adhere to the new default framework would have to classify their disclosed significant risks in terms of relative likelihood and impact based on three tiers for each metric. Additionally, in order to better ensure the timeliness of risk disclosures, existing senior executive officer certifications will include specific language attesting to the "freshness" of the disclosed Risk Factors under the proposed framework.
From the firm's perspective, the new framework will also change a firm's disclosure-drafting mindset. Firms under the new framework would have to consider their risks more carefully because they would have to rank their disclosures. This ranking would likely shift their drafting emphasis away from a litigation-avoidance posture to an informational posture, which will create disclosures that are more meaningfully compliant. Disclosure then becomes more than a regulatory chore to be completed: it becomes a meaningful risk-management tool for firms.(fn11) Under the new framework, disclosure may also lead managers to rethink or avoid actions that will generate highly negative disclosures or riskier classifications.(fn12) If done appropriately, the reconfigured framework can lead to better information for investors and better risk management for firms.(fn13)
Structurally, the Article proceeds as follows: Part I provides an overview of the current Risk Factor framework and its underlying rationales. Part II challenges the bedrock securities law assumption of the reasonable investor being a rational person by reintroducing the reasonable investor as a predictably irrational person through a discussion of common cognitive limitations: biases, heuristics, and the framing effect, and how these affect risk assessment. Part III critiques and describes key shortcomings of the current risk-disclosure framework. Part IV proposes a behavioral framework configured around relative likelihood and relative impact of dynamic risks, and describes its key elements. Part V examines how the behavioral framework would (1) lead to a better capture of securities disclosure; (2) create a more balanced appeal to the underlying rationales for Risk Factors; (3) simplify transparency and increase financial literacy; (4) lower information costs for investors by requiring companies to enhance their publicly available risk disclosures; and (5) improve financial arbitrage. The Article closes with a brief conclusion.
I. The Current Risk-Disclosure Framework
The current federal securities disclosure framework was created when Congress enacted the Securities Act of 1933(fn14) (the Securities Act) and the Securities Exchange Act of 1934(fn15) (the Exchange Act) in response to the excesses and ruins of the Roaring Twenties and the Great Depression.(fn16) The articulated intent of those landmark Acts was to "substitute a philosophy of full disclosure for the philosophy of
The objective of the Securities Act is to ensure "full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof."(fn18) The Securities Act mandates, with exceptions, the registration of any securities offerings that use any "means or instruments" in interstate com-merce.(fn19) Pursuant to its mandated registration process and its antifraud provisions, the Securities Act attempts to ensure that investors receive accurate and meaningful information about the offered securities and their issuing firms.(fn20)
The Exchange Act, in turn, governs the subsequent trading of those securities in secondary markets.(fn21) Like the Securities Act, the Exchange Act attempts to ensure that investors in those secondary markets receive accurate and meaningful information about the offered securities and their issuing firms.(fn22) The Exchange Act works to achieve this purpose by requiring periodic reporting filings(fn23) and by imposing a broad anti-fraud provision in Section 10.(fn24)
As a result of both Acts, firms are required to make timely disclosures and periodically update them for the "proper protection of the investors and to insure fair dealings in the security."(fn25) These timely disclosures consist of information such as a firm's key contracts, employee headcounts, financial statements, and material risks. These Acts also require firms' disclosures to be timely, topical, periodically updated, and in "plain English."(fn26) But, in reality, disclosures regarding a firm's risks are often stale, vague, uninformative, and in need of improvement.
Under the Securities Act, most firms offering securities to the public are required to file a registration statement. This filing requires the disclosure of certain risks relating to the firm and of the offered securi-ties.(fn27) Following the Securities Offering Reform of 2005, the Exchange Act required similar Risk Factors to be included in a public firm's annual reports on Form 10-K and quarterly reports on Form 10-Q.(fn28) In theory, Risk Factors are intended to inform investors of each firm's deepest fears and gravest vulnerabilities.(fn29) The guidelines for such Risk Factors under the Securities Act and the Exchange Act are identical and spelled out in Item 503(c) of Regulation S-K as follows:
To continue reading
Request your trial