Probabilistic Disclosures for Corporate and other Law (by Saul Levmore)

Posted on behalf of Saul Levmore as part of the Legal Discontinuities Online Symposium:

Corporate law is a striking area where probabilistic information ought to be made widely available. This information often has elements of continuity and discontinuity, but it is at present withheld because disclosure is accompanied by the risk of liability when it is later discovered to have provided an inaccurate particle of information. It is not simply that corporate and securities law make use of continuous as well as discontinuous rules. For example, continuously defined controlling shareholders are subject to a strict fiduciary obligation, while discontinuously defined acquirers must make the government and the world aware of their holdings of more than 5% (depending on the jurisdiction, but almost all countries have such categories) of the stock of a corporation. Many areas of law are peppered with such contrasts. But corporate law, like the law governing products liability, medical malpractice, and other areas where disclosure is law’s centerpiece, is also home to rules that encourage vague information of limited usefulness. Ironically, disclosure rules discourage better disclosure. Much as a surgeon is encouraged to disclose that there is “some chance” that an operation will lead to death, corporations are encouraged to say things like “a lawsuit that has been brought against us presents some risk that our profits will decline.” In both cases, the better-informed insider could more usefully offer a series of probabilities, but current law discourages such disclosures. 

When law requires disclosures, the product is often categorical. Investors might prefer probabilistic information, but it is often easier to make disclosures in binary form, though this is of little use to the audience. The key point here is that more useful disclosure opens the disclosing party to claims of misrepresentation because it is easier to err when revealing a great deal of probabilistic information than it is when making vague categorical information. 

In 2019, Senator Elizabeth Warren, while attempting to be the Democratic candidate in the 2020 U.S. presidential elections, suggested that corporations should be required to disclose the fact that climate change might have an adverse effect on their projected earnings. Admittedly, the idea was not to inform shareholders about their investments, but to raise interest in climate change and to encourage greater political support for laws aimed at this problem. If shareholders thought that unmitigated climate change would affect their investments, they might be more inclined to pay higher taxes or sacrifice short-term profits in order to enjoy a more secure future. Warren’s idea was consistent with many disclosure requirements, as the suggested disclosures provided less information than they might have. A corporation is required to disclose knowledge of factors that might have a significant impact on the value of the firm. For example, firms regularly reveal the presence of lawsuits, and usually report (accurately, let us assume) that management does not expect the litigation it describes in its annual statements to have a significant impact on projected profits. The disclosure is not unlike that found to avoid products liability or to protect against claims brought against health-care providers for failing to disclose risks. There are risks, but disclosures often do not contain much information; firms issue vague warnings when they could disclose more useful information that they can easily obtain. For instance, a firm has probably calculated the risk attached to each lawsuit it faces, in order to decide how much to spend on defense or whether to settle a case on some terms. An optimist might say that present disclosures inform motivated recipients to investigate further, but usually the point of disclosure is, or ought to be, to lower the overall cost of information acquisition by placing the burden on the better-informed party, and especially so if this is likely to avoid duplicative information gathering by other, dispersed parties. The reality is that most disclosures are sensibly made as vague as possible in order to comply with the law, while avoiding ex post judgments that they were misleading or knowingly incomplete. “This product may contain peanuts” is much less useful than the information actually available to the producer of foodstuff, and the same sort of thing is true in corporate law.

Accounting practices, in particular, often provide less information than is actually available. An accountant might say that corporate disclosures were verified in compliance with generally accepted accounting standards, but this is presumably inferior to the accountant’s disclosure that “We investigated the corporation’s report of income and based on statistical sampling, we think it is 30% likely that the disclosure is accurate, 50% likely that income is somewhat greater than reported, but has been under-reported perhaps to avoid future lawsuits, and 20% likely to have been overstated (10% by an amount greater than $1 million).” If the corporation is later accused of misrepresentation, it will normally be safe if it adhered to “generally accepted accounting principles.” The corporation needs to fear litigation only if it intentionally misrepresented or held back information from the market or from the accountants. The reliance on accounting conventions is striking. In some cases, like the reporting of interest expenses, the accounting information is precise and readily compared to that produced by other companies and their accountants. But other information is vaguely specific. It is not surprising that a party considering the purchase of a company will investigate assets and past performance, and will rarely rely on accountants’ previous reports. Better information is plainly available to the prospective acquirer, but law seems satisfied or more comfortable with the (unnatural but available) demarcations provided by accounting conventions.

One solution would be for law to promise that so long as the information disclosed was as informative as that found in minimally compliant documents or announcements, then disclosing parties would find themselves in a safe harbor, protected from future litigation and discoveries that some pieces of information were inaccurate. The market might then encourage the provision of useful information. Similarly, I would prefer that my doctor tell me that an operation has a .04% chance of killing me and a 1% chance of requiring a blood transfusion, rather than being told “This procedure can lead to death or a need for a blood transfusion.” Indeed, I might like to see a curve representing the likelihood of various outcomes. There is, to be sure, the danger that the information provided will be inaccurate, through error or misbehavior by a subordinate, but the idea is for the disclosure to be protected so long as it provides more information than that offered in the familiar vaguely specific form. In the corporate context, a corporation would be within this safe harbor if, for instance, it gave probabilistic information about projected sales and costs so long as this information was superior to “We do not expect lawsuits against us to significantly affect our future, and the numbers offered here are reported according to accepted financial standards.” Accounting firms could be in the business of certifying that the probabilistic information revealed, even with inevitable mistakes, was at least as useful as the vague information that would comply with the law.

In short, there are areas where more information is available, and where investors and consumers could be given more useful information. They will receive this information if the provider is protected by a rule that recognizes that although more information is likely to contain more errors, it is still more useful than the vaguely specific statements that currently comply with law. Corporate (and securities) law is a good place to start experimenting with this idea for more useful disclosures. 

This post is adapted from a draft paper to be published in a forthcoming symposium issue in Theoretical Inquiries in Law. The papers were part of the Legal Discontinuities conference held at Tel Aviv University Law School’s Cegla Center in December 2019.