The Securities Litigation Expert Blog

The "Plain English" Disclosure Documents of Complex Investments

Posted by Jack Duval

May 30, 2014 6:14:00 AM

This blog post continues our expert analysis of complex investments.

Keep_Calm_-_Plain_English

 

Twenty-six years ago the SEC adopted a rule that required securities issuers to write certain section of their disclosure documents in “plain English”. Alas, disclosure documents remain, for the most part, exceedingly hard to decipher.  Indeed, there is evidence that they have become even more complex.

As we have discussed here and here, the typical annual report is replete with legalese, industry jargon, and written at a very high level. In the table below, we have measured the readability of the 2013 annual report risk disclosure sections of all 30 Dow Jones Industrial Average (“DJIA”) component companies.

This is especially pertinent because the SEC Plain English Disclosure rule “requires issuers to write the cover page, summary, and risk factors section of the prospectuses in plain English”.[1] (Emphasis added)

 

Table 1.  Readability and Other Selected Statistics of DJIA Component Companies[2]

Company

Automated Readability Index - Grade Level

Percent Difficult Sentences

Percent Complex Words

Percent Dale-Chall Unfamiliar Words

MMM 3M Co

19

67.4%

31.2%

38.1%

AXP American Express Co

19

69.2%

27.9%

34.4%

T AT&T Inc

19

56.5%

32.4%

44.4%

BA Boeing Co

17.6

45.3%

28.2%

36.4%

CAT Caterpillar Inc

19

55.1%

27.9%

37.0%

CVX Chevron Corp

19

77.6%

32.1%

37.8%

CSCO Cisco Systems Inc

19

70.5%

26.2%

35.2%

DD E I du Pont de Nemours and Co

19

56.5%

33.9%

40.3%

XOM Exxon Mobil Corp

18.2

45.3%

28.6%

41.5%

GE General Electric Co

19

62.8%

27.2%

35.2%

GS Goldman Sachs Group Inc

19

73.5%

26.9%

36.8%

HD Home Depot Inc

19

66.7%

29.0%

37.8%

INTC Intel Corp

16.6

52.2%

24.8%

35.8%

IBM International Business Machines Co...

19

74.5%

31.4%

33.8%

JNJ Johnson & Johnson

19

73.7%

31.9%

40.4%

JPM JPMorgan Chase and Co

19

76.6%

27.0%

35.2%

MCD McDonald's Corp

19

66.3%

27.4%

37.2%

MRK Merck & Co Inc

18.5

50.8%

27.6%

33.7%

MSFT Microsoft Corp

17.1

44.3%

27.2%

37.5%

NKE Nike Inc

19

57.1%

26.1%

37.2%

PFE Pfizer Inc

19

65.4%

27.1%

36.3%

PG Procter & Gamble Co

18

53.0%

28.2%

37.2%

KO The Coca-Cola Co

19

63.6%

26.7%

35.5%

TRV Travelers Companies Inc

19

64.1%

28.9%

37.1%

UTX United Technologies Corp

19

59.2%

29.6%

37.5%

UNH UnitedHealth Group Inc

19

72.9%

29.6%

35.9%

VZ Verizon Communications Inc

18.6

58.3%

28.1%

35.4%

V Visa Inc

16.9

48.0%

25.8%

35.0%

WMT Wal-Mart Stores Inc

19

72.3%

25.8%

35.1%

DIS Walt Disney Co

19

63.5%

26.2%

35.4%

Averages

18.65

62.07%

28.36%

36.87%

 

The average annual report risk disclosure section was written at slightly under the Ph.D. level, contained a majority of difficult sentences, and a significant number of complex and unfamiliar words.

Needless to say, such documents are not written in “plain English”. In addition, as we have discussed above, annual reports have continued to get longer, with many now in excess of 400 pages.

These facts are disappointing in light of the long time period that filing companies have had to refine their reporting, and the regulatory emphasis on “plain English” writing.

Background of "Plain English" Disclosure

In August 1998, the SECs Office of Investor Education and Assistance issued guidance on how issuers should write disclosure documents. This document was called “A Plain English Handbook:  How to create clear SEC disclosure documents”.[3]

In the Handbook, investor Warren E. Buffett wrote the preface, stating:[4]

For more than forty years, I’ve studied the documents that public companies file. Too often, I’ve been unable to decipher just what is being said or, worse yet, had to conclude that nothing was being said… There are several possible explanations as to why I and others sometimes stumble over an accounting note or indenture description.  Maybe we simply don’t have the technical knowledge to grasp what the writer wishes to convey.  Or perhaps the writer doesn’t understand what he or she is talking about.  In some cases, moreover, I suspect that a less-than-scrupulous issuer doesn’t want us to understand a subject it feels legally obligated to touch upon.  (Emphasis added)

SEC Chairman Arthur Levitt gives the motivation for plain English disclosures:[5]

Investors need to read and understand disclosure documents to benefit fully from the protections offered by our federal securities laws.  Because many investors are neither lawyers, accountants, nor investment bankers, we need to start writing disclosure documents in a language investors can understand: plain English.

In the Plain English Disclosure rule release, the SEC’s executive summary states:[6]

Full and fair disclosure is one of the cornerstones of investor protection under the federal securities laws. If a prospectus fails to communicate information clearly, investors do not receive that basic protection. Yet, prospectuses today often use complex, legalistic language that is foreign to all but financial or legal experts. The proliferation of complex transactions and securities magnifies this problem.  A major challenge facing the securities industry and its regulators is assuring that financial and business information reaches investors in a form they can read and understand.
In response to this challenge, we undertake today a sweeping revision of how issuers must disclose information to investors. This new package of rules will change the face of every prospectus used in registered public offerings of securities.  Prospectuses will be simpler, clearer, more useful, and we hope, more widely read.
First, the new rules require issuers to write and design the cover page, summary, and risk factors section of their prospectuses in plain English.  Specifically, in these sections, issuers will have to use: short sentences; definite, concrete, everyday language; active voice; tabular presentation of complex information; no legal or business jargon; and no multiple negatives.  Issuers will also have to design these sections to make them inviting to the reader.  In response to comments, the new rules will not require issuers to limit the length of the summary, limit the number of risk factors, or prioritize risk factors.
Second, we are giving guidance to issuers on how to comply with the current rule that requires the entire prospectus to be clear, concise, and understandable.  Our goal is to purge the entire document of legalese and repetition that blur important information investors need to know. (Emphasis added)

On January 22, 1998, the SEC adopted Rule 421(d) – The New Plain English Rule and amended Rule 421(d). Both rules took effect on October 1, 1998.  In staff Legal Bulletin No. 7 (CF), the SEC summarized the new rule and amendments as follows:[7]

Companies filing registration statements are required to:

  • write the forepart of these registration statements in plain English;
  • write the remaining portions of these registration statements in a clear, understandable manner; and
  • design these registration statements to be visually inviting and easy to read.

Since 1998, the “plain English” language has been incorporated into a number of SEC Rules and other laws, including:

  • 2002; The Sarbanes-Oxley Act in Section 409, Real Time Issuer Disclosures.  “Each issuer reporting under section 13(a) or 15(d) shall disclose to the public on a rapid and current basis such additional information concerning material changes in the financial condition or operations of the issuer, in plain English…”[8]
  • 2006; SEC Proxy Statement Disclosure rules; “We are also adopting a requirement that disclosure under the amended items generally be provided in plain English.”[9]
  • 2010; Amendments to Form ADV. “Investment Advisors are required to provide new and prospective clients with a brochure and brochure supplements written in plain English”.[10]

Somewhat ironically, the SEC itself is subject to the Plain Writing Act (“PWA”) of 2010.[11] The PWA requires the SEC (and other federal agencies) to:[12]

write documents in plain writing, which the Act defines as writing that is “clear, concise, well organized, and follows other best practices appropriate to the subject or field and intended audience.” Plain writing avoids jargon, redundancy, ambiguity, and obscurity.

Investors Are Relying on their Financial Advisors

The state of most investment disclosure documents today is that they are a nexus of “jargon, redundancy, ambiguity, and obscurity.”  This defeats the purpose of disclosure, one of the bedrock principals of investor protection.  If disclosure documents are written in such a way that only a highly trained professional can understand them, then investors won’t even know what questions to ask. In such cases, investors are forced to rely on their advisors.

I believe this is good cause for a uniform fiduciary standard for all registered representatives and investment advisors.

__________

The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.

Notes

[1]                 17 CFR Parts 228, 229, 239, and 274, Release Nos. 33-7497 and 34-39593, 1. Available at http://www.sec.gov/rules/final/33-7497.txt; Accessed May 28, 2014.

[2]                 DJIA 2013 component company annual reports are available at http://www.sec.gov/edgar/searchedgar/companysearch.html; All annual reports were accessed on May 28, 2014.  The entire risk disclosure section of each component company’s annual report was used for this analysis.

[3]                 “A Plain English Handbook:  How to create clear SEC disclosure documents”; SEC Office of Investor Education and Assistance; Available at http://www.sec.gov/pdf/handbook.pdf; Accessed May 28, 2014.

[4]                 Id. at 1.

[5]                 Id. at 3.

[6]                 17 CFR Parts 228, 229, 239, and 274, Release Nos. 33-7497 and 34-39593. Available at http://www.sec.gov/rules/final/33-7497.txt; Accessed May 28, 2014.

[7]                 Staff Legal Bulletin No. 7 (CF); “Plain English Disclosure”; September 4, 1998; Available at http://www.sec.gov/interps/legal/slbcf7.htm; Accessed May 28, 2014.

[8]                 Sarbanes-Oxley Act of 2002, Section 409, Real Time Issuer Disclosures; (Generally effective after August 29, 2002)  Available at http://www.sox-online.com/soxact.html; Accessed May 29, 2014.

[9]             SEC Executive Compensation and Related Person Disclosure; 17 CFR Parts 228, 229, 232, 239, 240, 245, 249, and 274; Release Nos. 33-8732A, 34-54302A, IC-27444A; 191.  (Effective November 7, 2006)  Available at http://www.sec.gov/rules/final/2006/33-8732a.pdf;  Accessed May 29, 2014.

[10]               SEC Amendments to Form ADV; 17 CFR Parts 275 and 279; Relase No. IA-3060; 1; (Effective October 12, 2010) Available at http://www.sec.gov/rules/final/2010/ia-3060.pdf;  Accessed May 29, 2014.

[11]               SEC Plain Writing Initiative; (Effective October 1, 1998)  Available at http://www.sec.gov/plainwriting.shtml; Accessed May 29, 2014.

[12]               Report on Implementing the Plain Writing Act of 2010; U.S. Securities and Exchange Commission; April 11, 2014.  Available at http://www.sec.gov/plainwriting/plainwritingplan.pdf; Accessed May 29, 2014.

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Financial Advisor Licensing for Complex Investments

Posted by Jack Duval

Mar 6, 2014 1:29:00 PM

This blog post continues our expert analysis of complex investments.

In yesterday's blog post, we examined how different regulatory licensing exams have undergone relatively little change.  Another way to evaluate the licensing requirements for financial advisors is to compare their respective work and education requirements and length of time it takes to prepare for the tests. 

Table 4.  Comparison of Requirements and Test Preparation for Designations

 

Designation

Description

Work Requirement

Education Requirement

Time to Complete Test Preparation Courses

Series 7 License[1]

Registered Representative

0

0

3-5 weeks

Series 65 License[2]

Investment Advisor

0

0

3-5 weeks

Life Insurance License[3]

Life Insurance Sales

0

0

4 days

CLU[4]

Chartered Life Underwriter

3 years

0

2 years

CFP[5]

Certified Financial Planner

3 years

College degree

9 months

CFA[6]

Chartered Financial Analyst

4 years

College degree

4 years

 

This analysis reveals a wide disparity in work, education, and course preparation time required to earn various licenses and designations.  Most striking are the lack of education and work requirements for securities and insurance licenses. Those, coupled with the very short preparation times required to pass their respective tests, imply a narrow scope of examination.

The low rate of adaptation of test content to changes in the investment landscape, and the narrow scope of securities licensing exams, points to serious deficiencies in the training of financial advisors.  As we have discussed here and here, the  ubiquity of ETFs, hedge funds and other alternative investments, structured products, and securitizations has led to an explosion of investment complexity.

The investment of retail and institutional funds is a serious undertaking which can have irreversable consequences.  Those that sell complex products should be trained accordingly.

__________

The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.

Notes

[1]                 Individual broker-dealers may have work and education requirements, but FINRA does not. Various web forums recommend three to five weeks of reading before taking the exam preparation courses.  However, the Kaplan University Series 7 traditional live class is only four days, 9am to 5pm. Available at http://www.kfeducation.com/securities/series-7?state=ny; Accessed March 6, 2014. 

[2]                 Individual Registered Investment Advisory firms may have work and education requirements, but the states and the SEC do not.  Various web forums recommend three to five weeks of reading before taking the exam preparation courses.  However, the Kaplan University Series 65 traditional live class is only two days, 8:30am to 5:30pm. Available at http://www.kfeducation.com/securities/series-65?state=ny; Accessed March 6, 2014.

[3]                 Individual insurance companies may have work and education requirements, but the states to not. Most states have a 20-hour life-only pre-licensing requirement.  Kaplan University Life Only traditional live class, four days, 9am to 5pm. Available at http://www.kfeducation.com/insurance-lic/state/ny/?level=LH; Accessed March 6, 2014.

[4]                 The American College; Available at http://www.theamericancollege.edu/the-college-experience/getting-started; Accessed March 6, 2014. Phone conversation with American College representative “C.J.” at 8am on March 6, 2014.

[5]                 Wake Forest University Online CFP Certification Program.  Available at http://wfu.course-central.com; Accessed March 6, 2014.

[6]                 CFA Institute. Available at http://www.cfainstitute.org/programs/cfaprogram/charterholder/Pages/index.aspx; Accessed March 6, 2014.

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Are Financial Advisors Being Trained for Complex Investments?

Posted by Jack Duval

Mar 5, 2014 10:16:00 AM

This blog post continues our expert analysis of complex investments.

One reason why financial professionals have trouble understanding complex investments is that they are not trained properly for them.  In particular, the licensing requirements for Registered Representatives and Investment Advisors have not evolved significantly while the investment landscape has.

Text Mining of Keywords

One way to quantify how much the licensing requirements have changed is to use a simple text mining analysis of keywords between documents.  This technique excludes prepositions and articles of two texts and compares the remaining keywords between them.  A simple "percentage similarity" statistic is generated based on keywords. The higher the percentage, the higher the similarity between the texts.

Most texts, even if on the identical subject, have very low similarity.  For example, stories about the Russian military involvement in the Ukraine filed on the same day by the New York Times and the Wall Street Journal had a similarity of 12 percent. Likewise, two stories filed by the New York Times and the Washington Post about President Obama’s budget proposal had a similarity of 18 percent.

Pages_from_Series_7_Study_Guide_-_2012

Remarkably, the training topics for Registered Representatives (Series 7) and Investment Advisors (Series 65) have remained similar over time.  For example, the NASAA Series 65 Exam Specifications had a similarity of 27 percent from 2004 to 2010; and the NYSE Series 7 Study Guide had a similarity of 33 percent from 1995 to 2012.

One exception is the CFA Exam, which is under constant review and revision to keep up with the changing investment landscape.[1] From 1969 to 2010, the CFA Topic Outline had only a 10 percent similarity.  These findings are summarized in Table 3, below:

Table 3.  Similarity Between Topics on Regulatory Exam Topics and Other Texts

Document

Publish Date

Comparative Document

Publish Date

Similarity of Keywords

Obama Budget - NYTs

3/4/14

New York Yankees - NYTs

3/4/14

4%

Russia-Ukraine - NYTs

3/4/14

Russia-Ukraine - NYTs

3/4/14

12%

Obama Budget - NYTs

3/4/14

Obama Budget - WaPo

3/4/14

18%

CFA Topic Outline

1969

CFA Topic Outline

2010

10%

NASAA Series 65 Exam Specifications

2004

NASAA Series 65 Exam Specifications

2010

27%

NYSE Series 7 Study Guide

1995

NYSE Series 7 Study Guide

2012

33%

Lack of Evolution

This evidence points to a lack of evolution in the training of Registered Representatives and Investment Advisors. The investment landscape has undergone wholesale changes in the last 20 years and continues to evolve at a faster pace.

As we have discussed here, the world of finance has seen an explosion in both investment complexity and the number of investment options available.  If licensing exams are not keeping up with these developments, then investors (and their advisors) are at great risk.

Ignorance and investments don’t mix well, and typically end badly.

__________

The Accelerant roster of complex investment experts includes:  Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.

Notes

[1]                 See The CFA Program Candidate Body of Knowledge: The Past Decade, 2000-2010; Available at http://www.cfainstitute.org/programs/cfaprogram/Documents/cfa_program_curriculum_evolution.pdf; accessed March 5, 2014.  Also see the Institute of Chartered Financial Analysts: A Twenty-Five Year History; available at http://www.cfapubs.org/doi/pdf/10.2469/op.v1987.n1; accessed March 5, 2014.

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Ph.D-Level Disclosure Documents for Complex Investments

Posted by Jack Duval

Mar 3, 2014 8:07:00 AM

This blog post continues our expert analysis of complex investments.

In research that is forthcoming from Accelerant and summarized below, we have found that almost all investment disclosure documents are written on the graduate or professor level.  That is, they are written for individuals who have obtained or are pursuing graduate degrees or Ph.D.'s.

Needless to say, this puts these documents beyond the readability of the typical investor.

A sampling of public disclosure documents of common and preferred stocks, open and closed-end mutual funds, and ETFs show that they are almost all written at the graduate or Ph.D. level, are replete with long sentences, and have significant amounts of complex and/or unfamiliar words.  This makes them very difficult for the general public (and even industry experts) to understand.

Automated Readability Index

To analyze these documents, we have used the Automated Readability Index (“ARI”), which was designed for the U.S. Air Force to gage the readability of technical reports and manuals. The ARI was created by two Ph.D.’s, E. A. Smith and R.J. Senter, in 1967 and they describe the motivation behind its creation as follows:[1]

The Air Force makes extensive use of written materials such as manuals, reports, staff studies, training documents, letters, etc.  The readability of a document greatly influences the time required to extract needed information from the document.  Likewise, it influences the probability that the information extracted will be correctly understood and used.

Certainly the world of finance also makes “extensive use of written materials”.  Those materials include research reports, investment presentations, investment contracts, and disclosure documents.

However, the finance industry has not taken the same efforts as the U.S. Air Force to simplify their documents.  As can be seen in Table 2, below, almost all of the documents sampled are written at the graduate or Ph.D. level.

Table 2.  Readability Statistics of Typical Financial Disclosure Documents[2]

 

Date Accessed

Document

Investment Type

Automated Readability Index

Percent Difficult Sentences

Percent Complex Words

Percent Dale-Chall Unfamiliar Words

2/26/14

General Electric Annual Report

Common Stock

17.5

56.00%

23.30%

31.00%

2/28/14

KKR Annual Report

Common Stock

19

72.20%

28.50%

34.30%

2/26/14

Twitter S-1

IPO Filing

16

55.20%

25.30%

29.20%

2/26/14

BlackRock Basic Value Fund Registration Statement

Mutual Fund - Domestic Equity

18.8

59.40%

25.30%

29.20%

2/26/14

BlackRock Enhanced Dividend Achievers Trust Registration Statement

Closed-end Fund - Equity Covered Call Strategy

17.3

57.50%

20.60%

27.80%

2/26/14

Merrill Lynch PreferredPlus Trust Certificates

Trust Originated Preferred Stock -Backed by Qwest Notes

17.7

61.10%

25.90%

29.90%

2/26/14

Merrill Lynch Capital Trust I

Trust Originated Preferred Stock -Backed by Merrill Lynch Notes

19

62.20%

23.90%

24.80%

2/27/14

PowerShares DWA NASDAQ Momentum Portfolio

Equity ETF

15.9

51.90%

25.90%

28.90%

2/28/14

Direxion Daily Mid Cap Bull 3X Shares

3X Leveraged ETF

15.5

55.40%

20.00%

24.80%

There can be no doubt that Wall Street benefits from complexity.  When investments are complex, clients need help understanding them and tend to pay more for them. For example, a simple stock trade can be executed for a few dollars at a discount brokerage firm, however, structured products have commissions ranging from one to eight percent.

Back to Schema Theory

In the discussion section of their paper Smith and Senter contemplate what would later be a major field of study – schema theory, which we have discussed previously here.  They write:[3]

There are many factors involved in applying any readability index.  A major consideration especially relevant when considering the adult reader is his background in the content area.  If the written material is in his area of competency, readability would be less important than if it were in a subject matter area with which he had had little previous contact… An economist may be able to read most written material dealing with his specialty, yet, have difficulty reading comparatively introductory texts in electronics.

This certainly applies to financial documents.  Even highly intelligent and very well educated people can find typical disclosure documents impenetrable if they are not familiar with business, economics, finance, and accounting, among other domains.  This means that both retail and institutional investors are relying on their financial advisors to understand the product’s risks and rewards, interaction with their other investments, and its suitability.

__________

The Accelerant roster of complex investment experts includes:

Steve Pomerantz, Ph.D.Tom Boczar, Esq., CFATom Brakke, CFAGerry Guild, CFA, and John Duval, Sr.

You can find our complete roster of securities experts here.

Notes

[1]                 E. A. Smith and R.J. Senter, Automated Readability Index; (1967); 1.  Available at: http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0CDYQFjAB&url=http%3A%2F%2Fwww.dtic.mil%2Fcgi-bin%2FGetTRDoc%3FAD%3DAD0667273&ei=k7wQU9W5HO-u0AH464DwBA&usg=AFQjCNExZ8a2RTg8GucWY2IUXB2LN1ezrg&sig2=He5j3DAUr_YXsYQKoR_PQQ&bvm=bv.61965928,d.dmQ; Accessed February 28, 2014.

[2]                 The Automated Readability Index gives the grade level equivalent of the document: 16 is a college senior; 18 is someone who is two years into a graduate degree, such as an MBA; and 19 is a Ph.D. student.  The longer a sentence is, the more difficult it is considered; the longer a word is, the more complex it is considered, Dale-Chall Unfamiliar Words are words that do not appear on a list of 3,000 common worlds that are known to most 4th-grade students.

[3]                 See supra note 1, at 13.

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