The duty to disclose financial information is a fundamental feature of life as a public company. And while some firms might view their disclosure obligations as little more than a necessary evil, some recent research shows why tough rules can be good for them. And why, perhaps, the obligations should be even tougher in Canada.

The struggle over corporate disclosure essentially pits investors against management. More comprehensive, useful and timely disclosure benefits investors by putting them in a better position to make informed decisions. Management may resist these demands, however, because disclosure is time-consuming, expensive and may expose management to unwelcome scrutiny from competitors and shareholders. It can mean more pressure to perform, resistance to excessive executive compensation or challenges to management’s strategic aspirations.

The latest data from the Canadian Securities Administrators seem to support the view that many companies treat their disclosure obligations as an unwelcome chore. According to a report on the CSA’s continuous disclosure reviews for the past fiscal year, involving 854 CD reviews, only 39% companies passed with flying colours, meaning no remedial action was necessary. Another 36% of issuers were asked to make changes in future filings; 19% were required to refile a portion of their disclosure; 5% were referred to enforcement; and 1% were so bad that regulators issued a cease-trade order.

The CSA states that a significant share of the problems it found involved deficiencies in the management discussion and analysis portion of the disclosure, including inadequate disclosure of liquidity and capital resources, accounting policy changes, related-party transactions, and risks and uncertainties that could affect future performance. The CSA reviews also found problems with issuers’ revenue recognition practices, executive compensation disclosure and cash-flow statements.

Despite the relatively low level of complete compliance with the disclosure rules, the CSA pronounced itself “satisfied” with the results. But should your clients or, for that matter, issuers be pleased with the quality of corporate disclosure?

Some new research suggests that they should not. A new working paper from the U.S. National Bureau of Economic Research, by professor René Stulz of the department of finance at Ohio State University, looks at the role that securities laws play in corporate valuations.

The paper suggests that entrepreneurs looking to take a company public and investors both want strong disclosure laws, whereas insiders of companies already public prefer weaker requirements. For entrepreneurs and pre-initial public offering companies, tougher disclosure rules are valuable because they commit such firms to a level of openness to shareholder scrutiny they might not otherwise choose if the decision was left up to the company. As a firm probably couldn’t, by itself, convince investors that it would provide adequate disclosure without a law forcing it to do so, it would receive a lower valuation.

“The problem the entrepreneurs face is that they cannot credibly commit to take actions in the future that are valuable to outside shareholders but are not optimal for themselves,” the paper states. “After the IPO, the firm’s insiders would like to disclose less than they committed to disclose before the IPO.”

But if investors know that a firm is subject to tough disclosure rules, the firm can maximize its IPO proceeds. “Disclosure is valuable because the information disclosed can be used to force the firm to take actions that maximize shareholder wealth,” the paper explains. “The usefulness of securities laws depends heavily on the extent to which they lead to credible disclosure and that outside shareholders or the state can act on the information disclosed to force the firm to pursue a course of action that is valuable to outside shareholders.”

In other words, it’s not just the existence of tough rules that is important, but also that the enforcement of those rules is robust and that the legal environment is favourable to shareholders.

“We show that mandatory disclosure through securities laws can decrease agency costs between corporate insiders and minority shareholders,” says Stulz in the paper, “but only provided the investors can act on the information disclosed and the laws cannot be weakened too much through lobbying by corporate insiders.”

Of course, the value of robust CD rules doesn’t evaporate once a company completes its IPO. Investors may be the most obvious beneficiaries of effective CD, but it also matters to the company because it affects its ongoing cost of equity.

@page_break@Another recent study suggests that Canadian companies face a higher cost of equity than their U.S. counterparts. In a recent working paper, Jonathan Witmer of theBank of Canada’s financial markets department estimates that the cost of equity in Canada is between 20 and 40 basis points higher than in the U.S. And, the paper suggests, better disclosure regulation could narrow that gap.

The BofC paper observes that the amount by which analyst forecasts miss the mark is positively related to the cost of equity. In other words, the bigger these misses, the higher a firm’s cost of equity. The theory is that if analysts don’t have a great handle on the earnings a firm is likely to report, disclosure is probably lacking, and that is reflected in a higher cost of equity.

The BofC study tested this theory across various countries using the World Bank’s investor protection indices, which measure the level of investor protection in self-dealing transactions by corporate insiders based on the stringency of disclosure requirements, the degree of director liability and the ability of shareholders to sue directors; the test controlled for factors such as differences in accounting standards and other variables. The paper found that Canada’s cost of equity is statistically different from a handful of countries.

“Canada is not the best-performing country, according to these indices,” the paper states, “which makes it easier to argue that improvements can be made to the cost of equity in Canada, and better reflects the widely held belief of problems in enforcement in Canada.”

Moreover, it argues, narrowing the gap between the cost of equity in Canada and the U.S. could benefit the economy, because this achievement “would have large economic benefits, given the size of Canada’s capital markets.” IE