How the SEC allows issuers to play “Where’s Wally?” with investors

The stated objective of the US SEC is to require issuers to provide “full disclosure” of all “material facts” about securities sold to the public or traded on exchanges.

In fact, many relevant facts are indeed disclosed and are held in SEC files available to anyone via the Internet.

However, it’s not always easy to find these material facts because the SEC allows issuers to play “Where’s Wally” with investors.

Where’s Wally? is a series of children’s books created by the British illustrator Martin Handford. The books consist of a series of complex full-page illustrated pictures of hundreds of tiny people doing various things. The purpose is to find a character called Wally among the group, which can be difficult as he is always well hidden.
from Wikipedia


How facts are concealed in plain sight

Most registration statements, company reports, and other mandatory SEC disclosure documents are drafted by lawyers.

The required content of these documents is specified in SEC rules. However, lawyers are paid to comply with these rules without highlighting information that an issuer may wish not to be generally known.

Thanks to the slow minds of SEC officials, this is easier to do than one might think.

Here are just some of the tricks of concealment:

  • Bury embarrassing facts in a list of possible risks: There are usually hundreds of risks that might befall a company, causing loss to investors, from a meteorite landing on their headquarters to war to plague and famine. Most prospectuses today are larded with pages of risk disclaimers, covering almost everything imaginable. It’s all true, so it must be disclosed. However, by mixing remote, obvious risks (like war or revolution), with specific, more likely imminent risks (like an Auction Rate Bond becoming illiquid), and toning the language, just so, most investors and security analysts will technically have been informed, without anything having registered on their brains.
  • Incorporate facts “by reference”: Yielding to pressure from issuers who pretend to want to lower costs to investors, the SEC allows certain facts to be reported only once and then “incorporated by reference” in future reports. What this means is that an investor must have the time, patience, and inclination to seek out the reference document in order to understand the document under scrutiny. Needless to say, most investors are too lazy to do this and, consequently, the facts “incorporated by reference” are never understood.
  • Load documents with detailed description of irrelevancies: For example, a closed-end fund may be authorized to conduct a long-list of revenue enhancement or risk abatement techniques, while, in fact, only one of these methods is actually employed. By filling documents with descriptions of all these techniques, while only mentioning the actual use of one of these methods somewhere else in the document, the investor is skillfully diverted from understanding the real nature of the issuer’s business.
  • Play the “each fact in the proper document” game: Issuers are required to send a long list of forms to the SEC, each with a cryptic label (like 10K, F-1, or CB) and with specific content rules. As long as information is disclosed in the proper place, the SEC doesn’t seem to care if the investor ever sees it. For example, the precise terms and conditions of a security are usually described in the registration statement of initial issuance, but not subsequently. Therefore, an investor reading an annual report or auditor’s notes to a financial statement, may never be aware that a particular issue is, in fact, “toxic”. Sometimes the security may have been issued years before and in subsequent documents there are no notes even “incorporating by reference” prior material information.

Analysts must have a structured check-list

Too often, investors and analysts assume that either the SEC or some other analyst has checked out issuer’s documentation carefully. Usually this is not the case.

The only way a security analyst can be reasonably sure that he or she has thoroughly examined an issue is to start with a check-list, indicating topics to be covered and questions to be answered.

Typeical outline format

With the complexity of modern capital markets, such a check-list can be long, complex, and difficult to construct.

A practical solution is to use outlines provided on Capital Market Wiki under the structure of Capital Market Taxonomy.

The box (right) shows an outline used for preferred stock.

There are ready-to-go outlines for over 70 different capital market topics, from questions involving jurisdictions, to instruments, to institutions of all types, to operations, rules, and techniques.

The advantage of using topical outlines to guide securities research is that when information is missing or not found, this is evident.

The casual analyst, trying to make sense of an annual report or SEC required document, may easily be misled by the “Where’s Wally” ploy of those drawing up these sources of information — especially when analysis is done on-the-fly, without an outline.

Check out the Capital Market Wiki ready-to-use free outlines .


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