COLUMBIA LAW SCHOOL’S BLOG ON CORPORATIONS AND THE CAPITAL MARKETS
What Really Drives “Short-Termism”?
Earlier this month, the CEO of Pepsi Co. suggested to President Trump that eliminating quarterly reporting (and shifting to biannual reporting) would reduce the pressure on managers to focus on the short-term. As impulsive as Elon Musk, the president bought this view hook, line, and sinker and tweeted his proposed shift to the world (and a probably startled SEC).
But what will be the actual impact? Those who have a law and economics orientation will predictably respond that widening reporting frames will present investors with greater uncertainty and risk, with the result that stock prices should decline (and the cost of capital should increase). Some corporate managers will point to offsetting cost savings from reduced reporting, but cost savings are trivial in comparison with even a small stock price decline. Nonetheless, the argument that moves more managers is that, under six-month reporting, they can focus more on the long-run. Yet, this argument may be precisely backwards; that is, the shift to six-month reporting is more likely to exacerbate than alleviate this problem.
The empirical research in this area (while limited) tends to show that financial managers will indeed sacrifice long-term shareholder value in order to meet a quarterly earnings forecast. In a well-known study, three respected financial economists surveyed 401 senior financial executives and posed a hypothetical problem to these executives: If they saw they were likely to fall short of a quarterly earnings target, would they cancel or delay an investment or project with a positive net present value (“NPV”)?(1) The majority conceded that they would. In addition, more than three-quarters of the surveyed executives agreed that they would sacrifice shareholder value (by deferring NPV investments) to smooth earnings—apparently because they believe that missing the earnings target (or experiencing earnings volatility) will cause a stock price drop.
So, there is a problem (which my neoclassical friends in the law and economics field tend to ignore). But does a shift to less frequent reporting help or hinder? If we shift to six-month reporting, financial managers may face even greater pressure to meet their earnings target (or the consensus forecast). After all, impatient investors will have waited longer and faced greater uncertainty. The failure to “meet your forecast” would cast even a greater cloud on management’s reputation and competence.
Consider the problem this way: If it were possible to report earnings on a monthly basis (or—and this is sheer fantasy—a weekly basis), missing the monthly or weekly target would not mean that much. A short fall in one week could be offset by a compensating gain in the next week. But a failure to meet a six-month forecast could not be corrected until the annual audited results were posted some eight or nine months later (when the issuer filed its Form 10-K). Thus, self-interested managers will be even more incentivized to sacrifice NPV projects to meet the earnings target.
Ironically, logic thus suggests that the narrower the reporting frame, the less that the long-run will be subordinated to the short-run. To be sure, nothing here is certain. The UK moved from six-month reporting to quarterly reporting in 2003, and then moved back to six-month reporting in 2013. No one has detected any measurable change in capital investments on either of these shifts. Still, cultures and pressures may be different on opposite sides of the Atlantic, and there is both much greater use of incentive compensation in the United States and much greater pressure from activist hedge funds focused on the short-run. These factors may incline managers in the U.S. to focus more on the short-run to please the market.
Some other impacts do seem more certain. Under a six-month reporting cycle, information asymmetries will increase, and this will make insider trading even more profitable (and probably even more predictable). Stock volatility seems also likely to increase in the face of greater uncertainty.
So what should be done? Probably the simplest and best answer would be for financial managers to give less guidance about future earnings. Once a financial manager makes a forecast, he has effectively pledged his reputation and needs to protect it by manipulating earnings. Hence, less in the way of earnings forecasts implies less pressure on managers. The SEC and the stock exchange could discourage forecasting in a variety of incremental ways, but, of course, they cannot prohibit forecasts.
Can the SEC simply shift from quarterly to six-month reporting? This is a legal question that may cause the SEC to assert its powers under Section 36 of the Securities Exchange Act of 1934. Section 36 (“General Exemptive Authority”) authorizes the SEC to “exempt any person, security, or transaction, or any class or classes of persons, securities or transactions, from any provision or provisions of this title or of any rule or regulation thereunder…” But exercise of this authority requires the SEC to find “that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.” To date, the SEC has used this provision only sparingly. Suppose then that such an exemption is granted by the SEC, based on cost savings justifications and the claim that it will protect investors from short-termism. Suppose next that a large group of institutional investors (including the Council of Institutional Investors) sues, claiming that the SEC’s exemption is very inconsistent with the “protection of investors.” How much deference should the SEC get?(2) Indeed, does this exemption even qualify for Chevron deference? This is a short column that will not attempt to resolve the current status of Chevron deference, but my bet would be that a conservative Supreme Court would back a conservative SEC.
But maybe I am just a pessimist.
John C. Coffee, Jr., is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.
(1) See John R. Graham, Campbell R. Harvey and Shivaram Rajgopal, The Economic Implications of Corporate Financial Reporting, (available at https://ssrn.com/abstract=647705 (2005). This study later appeared in the Journal of Accounting and Economics in 2005).
(2) If one wishes to read more on this topic, see Daniel T. Deacon, Administrative Forbearance, 125 Yale L.J. 1548 (2016); Lesley Chen, The SEC’s Forgotten Power of Exemption: How the SEC Can Receive Deference in Favor of Internal Whistleblowers Even When the Text is Clear, 67 Emery L. J. 1043 (2018).