The limits of disclosure regime: Penalising industry, confusing investors

Across the world, financial market regulation is largely built on the edifice of a disclosure regime. Regulated entities are mandated to make periodic and event-based disclosures. This is surely a time-tested and sound practice — after all, more sunlight is always welcome. 

 

The disclosure system, combined with the principle of caveat emptor — or “let the buyer beware,” which implies that the buyer purchases at their own risk — is also comforting for regulators. In a way, prescribing disclosures gives them a certain satisfaction of a job well done. This column examines the efficacy of the much-touted disclosure regime in regulating the financial sector in India.

 

The world over, “greed and fear” dictate investor behaviour in financial markets. The marketplace is often chaotic, making the regulator’s task both tough and challenging. This is even more so in emerging markets like India, due to a lack of awareness and inherent information asymmetry among market participants. Balancing the interests of all stakeholders — and striking the right balance between “ease of doing business” and appropriate regulation — can often prove to be a tricky affair.

 

The situation could prove to be rather trying in the event of an episode that affects the interests of a large number of stakeholders, or one likely to have systemic impact. Suddenly, the regulator faces an onslaught of criticism from various quarters — including some unexpected ones.

 

Like any other organisation facing public outcry, perception management becomes the regulator’s foremost priority. More often than not, this is typically achieved by adding clauses to the existing regulations and prescribing additional disclosures. What often gets lost in the milieu is the possibility of over-regulation of the market.

 

Let’s examine the disclosure regime from the perspectives of both investors and the regulated entities mandated to make the disclosures.

 

When someone argues that enhanced disclosures are meant to protect the interests of investors, they generally have in mind minority shareholders and individual investors. Institutional and large investors typically conduct their own due diligence and aren’t wholly dependent on the disclosed information, as they have the resources to carry out detailed analysis.

 

As for individuals, they tend to go by media reports and any analysis available in the public domain. They may not have the capability or time to examine the nuances of the disclosures. For example, the mandated disclosures under various Securities and Exchange Board of India (Sebi) regulations, such as the Listing Obligations and Disclosure Requirements (LODR) and the Issue of Capital and Disclosure Requirements (ICDR), run into hundreds of pages. It would be a challenging task for individuals to thoroughly review them and keep up with the changes. In a way, voluminous disclosures only lead to information overload for investors. What is worse is that this may result in some vested interests driving investor behaviour —an unintended and undesirable consequence.

 

As for the regulated entities, more disclosures imply increased compliance costs. Most of these disclosures are broad-based and apply uniformly across the spectrum, including to those entities that play by the rule book. Smaller entities feel the pinch more acutely. Though the regulator at times prescribes lighter norms for them, that doesn’t help the system. In fact, it could prove counterproductive —many violations occur in smaller entities that often operate below the radar. 

 

Now, let’s address the all-important issue of enforcement. While it is a common-sense conclusion that regulatory prescriptions without an effective oversight and enforcement mechanism are meaningless, it is a fact that the relatively poor enforcement has been the Achilles’ heel not only for financial sector regulators in India but also for regulators in other sectors.

 

The regulatory laws allow regulators to either impose civil penalties on wrongdoers or prosecute them in criminal courts for serious offences. Even if one were to take a generous view of the regulators’ civil adjudication performance, it is undeniable that their record in taking serious matters to criminal courts, let alone securing any convictions, has been dismal. For instance, in the securities market, insider trading is considered a serious offence. While insider trading regulations have been amended umpteen times over the last decade, with additional disclosures prescribed, not a single case has been deemed fit for prosecution in a criminal court. The securities market regulator could perhaps draw some comfort from the fact that the performance of other regulators has been even worse!

 

Filing a charge sheet in a criminal court requires a lot of hard work, besides the intent to do so. In a criminal case, the charges must be proven “beyond reasonable doubt,” whereas in a civil proceeding, the standard is “preponderance of probability”. Naturally, the quality of investigation as also the evidence presented must be of much higher standard for criminal prosecution. Do the regulators have the capacity to do this? More importantly, given the constant fire-fighting they face, what priority do the regulators give to this task?

 

The regulators need to use their enforcement capabilities tactfully. Instead of spreading their resources thin over a large number of cases, they should focus on the serious ones. “Risk-based supervision” isn’t a buzz word; regulators must adopt this principle in its true spirit.

 

The disclosure requirements should vary based on a thorough and objective analysis of risk perception, not on gut feeling. Rigorous and timely enforcement, including prosecution in serious cases, would serve as a far greater deterrent than prescribing dozens of new disclosures. Why penalise the whole industry, and confuse investors, by imposing more disclosures instead of going after the main culprits? Regulators should reflect on this, and dedicate quality time to investigation and enforcement.

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The author is distinguished fellow at the Observer Research Foundation, and former chairman of Sebi