Published November 6, 2009

Too much disclosure can sometimes be bad

By R SIVANITHY

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MOST people place their faith in the disclosure-based model which says that the more information financial advisers and companies are made to tell the public, the better. This is the rationale behind Regulation Full Disclosure (RFD) in the US and the Sarbanes-Oxley Act of 2002, and is the preferred regulatory approach that has evolved over the past decade in tandem with deregulated markets.

However, in light of just how inadequate this model has proven to be in the banking collapse of the past two years, it is necessary to rethink the wisdom of this approach. There may be a need for greater official intervention, monitoring and policing - especially when one ponders the disturbing possibility that more disclosure may not always be good.

Consider, for example, the results of a 2003 experiment conducted by behavioural economists at Carnegie Mellon University (The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest by Cain, Moore & Lowenstein, subsequently published in the Journal of Legal Studies, January 2005).

In the experiment, people were asked to estimate the number of coins in jars and were paid according to the accuracy of their estimates. This group was only allowed to view the jars from a distance of one metre and for around 10 seconds each time.

They were advised by a group of advisers who were allowed to examine the jars closely, prepare an advisers' report, but were paid according to how accurate or how high, relative to actual value, the estimators' guesses were.

In other words, it was in the advisers' interest to ensure their 'clients' overpaid and thus it was in their interest to offer misleading advice. Not surprisingly, the estimators, under advice from the biased advisers, consistently over-guessed the number of coins.

But what makes things most interesting was that even when the bias was revealed to the estimators, it made no difference - they continued to listen to the misleading advice and made overly high estimates. Increased disclosure did not lead to increased scepticism.

What conclusions might be drawn from this? As the authors noted, 'disclosure may increase bias because advisers feel morally licensed and strategically encouraged to exaggerate their advice even further from the truth'.

'As for those receiving the advice, proper use of disclosure depends on how the conflict of interest biased the advice and how that advice impacted them. Because people lack this understanding, disclosure can fail to solve the problems created by conflicts of interest and may sometimes make matters worse'.

In other words, if advisers are compelled to make full disclosure, they then see this as releasing them from responsibility and thus granting them free rein to make even more biased recommendations which then tends to be accepted by an ignorant and ill-equipped public.

As a result, the advice from the researchers was not to be too quick to believe in the benefits of disclosure. For it to have proper use, it appears that it's essential the reader/recipient have full understanding of how the conflict of interest has influenced/biased the adviser and also, the reader/ recipient must be able to correct for that bias.

The problem, however, is that most people simply don't have the necessary wherewithal or know-how. It's like a doctor telling a patient that he has a life-threatening disease and has to take medication X, then telling the patient that X's manufacturers sponsor the doctor's research. The patient may have no expertise or means to obtain a second opinion, and even if he did, may lack the expertise to weigh the two.

Similarly, in the investment world, even if the use of disclaimers were prohibited and brokers and banks forced to reveal all their conflicts of interest, would such disclosure be of any use to readers? For example, if a broker has recently completed a major corporate finance deal for a company and then issues a 'strong buy' on that company's shares, would revealing this connection make any difference to most readers?

When it comes to stocks, there is also an added complication founded on the hypocritical nature of markets. Cynics could well argue that often, biased advice is exactly what investors want since they secretly believe bias increases their chances of making money. They might publicly extol the virtues of objective recommendations and claim to want to make their own investment decisions, but privately, if they believe that following biased or crooked advice can be profitable, they may very well welcome it.

How should regulators then handle the complex issue of disclosure, given that strict adherence to the previously accepted model may not be appropriate? The answer is not to abandon the model, but to recognise its failures and modify it accordingly. One way is to prominently highlight risks instead of just returns by forcing advisers to classify their products/advice into various risk categories such as low, medium and high. At the extreme, it may be necessary to ban outright the sale of complex, derivative-based products to retail investors. Use of plain and simple English must be compulsory and harsher penalties are also needed, instead of the slaps on the wrist recently administered to sellers of failed structured products.

What's therefore needed is a more realistic, 'cleverer' approach to disclosure that acknowledges that although disclosure is a good thing, too much of a good thing can sometimes be bad.