Blog: Would a shift to semiannual reporting really affect short-termism?

by Cooley LLP
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You remember, of course, that last month, the president, on his way out of town for the weekend, tossed out to reporters the idea of eliminating quarterly reporting.  (See this PubCo post.) The president said that, in his discussions with leaders of the business community regarding ways to improve the business environment, Indra Nooyi, the outgoing CEO of Pepsico, had suggested that one way to help business would be to trim the periodic reporting requirements from quarterly to semiannually. The argument is that the change would not only save time and money, but would also help to deter “short-termism,” as companies would not need to focus on meeting analysts’ expectations on a quarterly basis at the expense of longer term thinking. “We are not thinking far enough out,” he added. (For more on saving time and money through semiannual reporting, see this PubCo post.) But how much impact would a shift to semiannual reporting really have on short-termism?

According to the WSJ, the issue had been raised during a meeting with a group of executives.  Apparently, Nooyi “broached the idea of making the U.S. reporting system more like Europe’s, in which companies are required to report some financial information only twice a year…. ‘Most agree that a short-term only view can inhibit long-term strategy’” Ms. Nooyi said in a statement. ‘My comments were made in that broader context….In the end, all companies have to balance short-term and long-term performance.’”

In response to the president’s comment, SEC Chair Jay Clayton issued a statement:

“The President has highlighted a key consideration for American companies and, importantly, American investors and their families—encouraging long-term investment in our country.  Many investors and market participants share this perspective on the importance of long-term investing. Recently, the SEC has implemented—and continues to consider—a variety of regulatory changes that encourage long-term capital formation while preserving and, in many instances, enhancing key investor protections. In addition, the SEC’s Division of Corporation Finance continues to study public company reporting requirements, including the frequency of reporting. As always, the SEC welcomes input from companies, investors, and other market participants as our staff considers these important matters.”

But how much does quarterly reporting really contribute to short-term thinking?  In this article on CNN.com, an NYU professor argues that it does have an impact. While the transparency of quarterly reporting “seems like a good thing,” as it turns out,

“quarterly reporting has evolved into a system of managing primarily for the quarterly numbers, with a net result of distorting financial performance negatively, much in the way teaching students solely to perform well on a standardized test distorts their learning. The focus on quarterly results has brought us unprecedented share buybacks which artificially boost stock prices, non-strategic cost-cutting, less investment in longer-term basic and applied research (versus product development), as well as an unhealthy pressure on labor costs. Additionally, a study published in The Journal of Accounting and Economics found that 78% of CFOs would sacrifice long-term value to make their quarterly earnings targets. The study found they would cut spending, delay starting a beneficial project, or book revenues ahead of time just to meet short-term earnings expectations.”

And, the professor contends, studies have shown that “for long-term oriented companies, average market capitalization was 58% higher, average company profit was 81% higher, average company earnings were 36% higher, and average company revenue was 47% higher. They also created 132% more jobs.”  (For more on the adverse impact of short-termism and the beneficial impact of a long-term strategic view, see, e.g.this PubCo post and this PubCo post.) In addition, the author points out, the importance of long-term thinking has been promoted by a number of institutional investors, such as Blackrock and Vanguard. (See, e.g., this PubCo post.)  At the end of the day, although she acknowledged that it was “unclear if moving to semi-annual reporting will cure corporate short-termism,” nevertheless, she viewed it as “a step in the right direction.”

But how much of a step is it? And, commentators ask, would that step be worth the sacrifice of transparency? While it’s certainly arguable that the pressure to report earnings on a quarterly basis can lead companies to manage their businesses to meet quarterly analyst expectations, the real question is whether a change to semiannual reporting would have much effect on short-termism?  That is, wouldn’t the same 78% of CFOs who would sacrifice long-term value to make their quarterly earnings targets also make the same sacrifice to achieve their semiannual earnings targets? As one investment strategist quoted in this Reuters article characterized the concept, it’s a “cockamamie idea. For starters, what’s the difference between six and three months? … Either way we’re talking about a very short-term period.”

And one law professor cited in this article in the WSJ maintained that a switch to semiannual reporting would actually exacerbate the potential for manipulation: “‘If companies report only every six months, then there could be more damage, not less,’ [according to the professor.]  Without quarterly updates, ‘the stock price could drift even farther out of whack from fundamentals, and then the temptation for management to distort earnings could potentially be even greater.’”

What’s more, according to a CFA Institute study assessing the actual impact of the frequency of company reporting on public companies in the UK—which moved to  require quarterly reporting in 2007, but then no dropped the requirement in 2014—

“the initiation of required quarterly reporting in 2007 had no material impact on the investment decisions of UK public companies…. By contrast, the initiation of mandatory quarterly reporting in 2007 was associated with significant changes in other areas. An increasing number of companies published more qualitative than quantitative quarterly reports and gave managerial guidance about future company earnings or sales. At the same time, there was an increase in analyst coverage of public companies and an improvement in the accuracy of analyst forecasts of company earnings. When quarterly reporting was no longer required of UK companies in 2014, less than 10% stopped issuing quarterly reports (as of the end of 2015). Again, there was no statistically significant difference between the levels of corporate investment of the UK companies that stopped quarterly reporting and those that continued quarterly reporting. However, there was a general decline in the analyst coverage of stoppers and less of such decline for companies continuing to report quarterly.”

(But compare those results with another recent study, “Frequent Financial Reporting and Managerial Myopia,” which appeared in the March 2018 issue of The Accounting Review.  That study concluded that, “when new regulatory mandates forced companies to increase the frequency of their financial reporting, they reduced their annual capital investments by about 1.5% or 1.9% of their total assets, depending on how capital investments are defined.” It also reported that the level of reduction should be considered in light of the fact that “the average annual capital investments of these firms amounted to about 9% of assets.”) In addition, according to this article, it turned out that many companies in the UK continued to put out quarterly reports, egged on by investors, analysts and portfolio managers.

Moreover, pressure from Wall Street to increase quarterly EPS is just one of the many factors that have been identified as contributing to short-termism (see this PubCo post). Blame has also been attributed to, among other things, executive compensation (see this PubCo post and this PubCo post), traders’ compensation (see this article in The Atlantic), the “legal underpinnings” of capital markets regulation and the business model and prevailing culture of the investment management industry (see this PubCo post), caselaw regarding directors’ fiduciary duties (see this PubCo post), and, perhaps most significant, hedge fund activism.  As suggested in this NYT DealBook column, the activist playbook is certainly not limited to buybacks and dividends: “[a]s activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.” See this PubCo post.

When companies focus on long-term strategy, they’re typically talking about a time horizon of three to five years or longer, not six months. In fact, some have argued that a better approach to deterring short-termism would be to focus on companies’ incentive structures. As discussed in this PubCo post, some consultants have suggested that companies interested in encouraging a long-term view consider changing the performance periods in their incentive plans from three-year to five-year performance periods, “which may provide a better balance between executives’ reluctance to wait to receive compensation and shareholders’ concerns that equity awards should reward long-term value creation.”

And, in June, investor Warren Buffett and JPMorgan CEO Jamie Dimon wrote a WSJ op-ed  urging companies to move away from quarterly guidance.   Their contention was that it’s not quarterly reporting that creates “an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability,” it’s quarterly guidance. In fact, they reaffirmed their support for quarterly reporting:

“Our views on quarterly earnings forecasts should not be misconstrued as opposition to quarterly and annual reporting. Transparency about financial and operating results is an essential aspect of U.S. public markets, and we support being open with shareholders about actual financial and operational metrics. U.S. public companies will continue to provide annual and quarterly reporting that offers a retrospective look at actual performance so that the public, including shareholders and other stakeholders, can reliably assess real progress.”

The Council of Institutional Investors agreed that public companies should continue to report quarterly on their financial performance, but should move away from quarterly earnings guidance.

Some commentators have observed that a shift to semiannual reporting could compound other problems.  For example, some commentators have suggested that, with a shift to semiannual reporting, the risk of making selective disclosures could increase as investors privately seek additional information. In this article, professors from Wharton and Georgetown, discussing the issue of quarterly reporting, contend that a shift to semiannual reporting could increase the risk of insider trading and put investors at more of an information disadvantage, noting that quarterly reports are about more than earnings: they also update risks and caution investors when results may no longer be indicative of future results. Information asymmetry can also reduce market liquidity, they suggest, raising concerns that U.S. markets could lose their premier status.

And this academic paper considered whether the frequency of financial reporting affects investors’ reliance on alternative sources of earnings information. The authors looked at investors in companies that reported only semiannually and concluded that they were prone to looking to quarterly earnings announcements of industry peers that were viewed as bellwethers to provide alternative sources of earnings news. The authors found

“that the returns of semi-annual earnings announcers are almost twice as sensitive to the earnings announcement returns of US industry bellwethers for non-reporting periods compared to reporting periods. Strikingly, these heightened spillovers are followed by return reversals when investors finally observe own-firm earnings at the subsequent semi-annual earnings announcement. This indicates that investors periodically overreact to peer-firm earnings news in the absence of own-firm earnings disclosures arising from low reporting frequency.”

But interestingly, in this article, former Treasury Secretary Lawrence Summers argues that the concern with systemic short-termism is overblown—for example, he contends, the presence of unicorns—“almost all of which have little or no profits… suggests that investors are happy to buy into compelling long-run corporate visions.”  With regard to quarterly reporting, he contends that “[r]educing the frequency of corporate profit reporting would make major surprises and drastic market moves more likely. It would also allow managers to wait longer before they revealed major problems….Less-frequent reporting would also favor professional investors who are in constant touch with management over others whose information would be even more limited than it is today. In an age of big data and transparency, moving toward less information would be a very odd step.”

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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