This blog post continues our expert analysis of complex investments.
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”. (Emphasis added)
Table 1. Readability and Other Selected Statistics of DJIA Component Companies
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”.
In the Handbook, investor Warren E. Buffett wrote the preface, stating:
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:
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:
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:
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…”
- 2006; SEC Proxy Statement Disclosure rules; “We are also adopting a requirement that disclosure under the amended items generally be provided in plain English.”
- 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”.
Somewhat ironically, the SEC itself is subject to the Plain Writing Act (“PWA”) of 2010. The PWA requires the SEC (and other federal agencies) to:
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., CFA, Tom Brakke, CFA, Gerry Guild, CFA, and John Duval, Sr.
You can find our complete roster of securities experts here.
 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.
 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.
 “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.
 Id. at 1.
 Id. at 3.
 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.
 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.
 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.
 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.
 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.
 SEC Plain Writing Initiative; (Effective October 1, 1998) Available at http://www.sec.gov/plainwriting.shtml; Accessed May 29, 2014.
 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.