From Documents to Data: The New World of Risk Disclosure

Online research used to be about navigating massive, discursive document landscapes. At some level, this kind of research served merely to extend traditional analog methods for research and analysis of printed materials. However, documents are only containers. They are not themselves information.

More recently, sophisticated use of databases and the transition to XML has begun to liberate data within documents, creating new possibilities for how we imagine, encounter, manage, and manipulate information. At Knowledge Mosaic, our general business strategy has been to develop data parsing methods that allow us to build deep reservoirs of data mined from documents and then transport and deliver this data dynamically and in multiple formats to multiple platforms. All nearly in real-time.

In the past year, as part of this effort, Knowledge Mosaic has plunged into the dark and uncertain world of risk disclosure. Companies historically have been required to list risk factors associated with their business when they issue new securities. More recently (since early 2006), the SEC has mandated that public companies include risk factor disclosures in their 10-K annual report.

Now, many people assume that risk factor disclosures are like fresh, shiny paint on rotten wood - or perhaps old, crappy paint on fresh wood - but that in either case lawyers recycle and slap together risk disclosure language to dissemble, not to enlighten. And there may be some truth to that view.

But here's the deal. Risk is not generic. It varies by industry and it varies by business segment. Risk for software companies is not the same thing as risk for companies that manufacture chemicals or drill for oil or sell groceries or manage investments. Risk pre-Sarbanes-Oxley is not the same as risk post-Sarbanes-Oxley and it will be different yet again post-Bear Stearns. Directors and officers face different kinds of risk, as do engineers and salespeople.

Our SM Risk website currently contains 1,074,598 risk factor statements parsed from 57,213 filings filed since May 26, 2000. We have classified these risk factor statements using a taxonomy that includes more than 30 master categories (such as competition risk, environmental risk, experience risk, governance risk, and legal risk) and more than 1,000 minor categories (such as accounting charges, hazardous waste, patent infringement, product liability, and senior indebtedness).

What we have learned in developing this risk disclosure research platform is that it is definitely a terrific environment for instantly finding useful precedent language when preparing risk disclosure statements. However, SM Risk also reveals the nuance and texture in risk disclosure, with rich implications for how we understand the meaning of risk in different industries, business segments, regions, and time periods. One of our exciting opportunities in the coming months will be to start analyzing and mapping that nuance and texture.

But for now, here are two interesting illustrations of risk disclosure, one concerning experience and one involving earthquakes.

No Experience. It turns out many companies admit they have no experience in the activity for which they are trying to raise money. Just two days ago, Accential Pharmaceuticals Inc. - which is trying to raise nearly $9 million to commercialize BiovaxID, a non-Hodgkins lymphoma vaccine - conceded in a risk factor statement that "we have no experience manufacturing BiovaxID or any other immunotherapies for the number of patients and at a cost that would enable widespread commercial use."

Back in February, Refinery Science Corporation, a company with virtually no revenue, tried to raise $10 million, while conceding that "We are a development stage, independent petroleum processing technology company, with no experience in the market, and failure to successfully compensate for this inexperience may adversely impact our operations and financial position." Wouldn't this be useful information to have at your fingertips before investing?

Earthquake Faults. Many companies operate facilities that sit on or near earthquake faults. Of the 1,949 risk factor disclosures that mention earthquake risk, 920 (or 47 percent) are from companies headquartered in California. If you want to know which of these California companies faces risk to manufacturing facilities from an earthquake, a simple text query (earthquake manufacturing) returns 239 risk factors from 165 companies.

Wouldn't it to be good to begin benchmarking California companies with manufacturing facilities in similar industries that do not address this potential for disaster in their risk factor disclosures? For example, 57 of these risk factors are reported by 34 companies in the semiconductor industry (SIC 3674). Intel is not one of them. Why not? Indeed, Intel only mentions the word "earthquake" in two of its 1,516 filings - one a 1999 8-K referring to the major earthquake in Taiwan and one an S-4 from 1999 that does refer to risk to Intel's critical business operations from earthquakes in California. Doesn't this disclosure gap seem odd? Does it matter? In the event of a major earthquake that destroyed major parts of Intel's facilities, some investors (and their attorneys) might think it did.

We are not currently licensing SM Risk, except as a data feed. Later this year, when we release our new business law platform, we will incorporate SM Risk into this platform. For now, if you are interested in exploring this risk landscape in more fine-grained detail, you can use the SM Risk website free of charge. Please feel free to contact me for more information on signing up. My email address is pschwartz@knowledgemosaic.com.