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Economic Consequences of SEC Disclosure Regulation. Brian J. Bushee and Christian Leuz. Motivation. Disclosure regulation and enforcement of these rules are viewed as cornerstones of U.S. capital markets Success of U.S. markets is often attributed to strict disclosure rules
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Economic Consequences of SEC Disclosure Regulation Brian J. Bushee and Christian Leuz
Motivation • Disclosure regulation and enforcement of these rules are viewed as cornerstones of U.S. capital markets • Success of U.S. markets is often attributed to strict disclosure rules • US accounting scandals • But there is little evidence on economic consequences of SEC disclosure regulation • Recent regulatory event in OTCBB market allows us to examine firm-specific costs and benefits of disclosure regulation: • Prior to 1999, firms with fewer than 500 owners or less than $10 million in total assets did not have to file with the SEC • After 1999, “Eligibility rule” forces OTCBB firms to comply with the reporting obligations under the 1934 Securities Exchange Act
What are the costs and benefits? • Potential benefits of disclosure regulation • Improved liquidity and lower cost of capital • Improved transparency and corporate governance • Potential costs of disclosure regulation • Direct costs of preparing information for SEC filings • Proprietary costs and litigation risk • Increased public scrutiny • But couldn’t firms simply choose to increase their disclosure to reap these benefits? • Disclosure regulation can provide a commitment device • Externalities of disclosure regulation
Research Design • The eligibility rule created 3 major groups of firms: • Noncompliant firms: removed from OTCBB • Newly Compliant firms: adopted filing to remain on OTCBB • Already Compliant firms: filed with the SEC before rule • Three groups allow us to study the impact of SEC disclosure regulation on firms • Noncompliant and Newly Compliant firms: • When is compliance too costly for firms? • What is the channel through which benefits arise? • Already Compliant firms • Are there externalities from disclosure regulation?
OTC Bulletin Board • Electronic quotation medium for OTC securities • Operated and regulated by NASD • Distinct from the Pink Sheets (published by NQB) • No listing requirements, only a sponsoring market maker • Prior to 1999, firms that did not file under Section 12(g) or Section 15(d) had to comply with Rule 15c2-11 • For these firms, one market maker was required to have current financial statements at the time of quote initiation • 65% (or 3503) firms on OTCBB did not file with the SEC
Eligibility Rule • “Eligibility Rule” (NASD Rule 6530) requires OTCBB firms to comply with the reporting obligations under the 1934 Securities Exchange Act • Rule was approved by SEC on January 4, 1999 • All new issues must comply before being quoted • Existing issues had to comply by assigned phase-in date: • Phase-in period: July 1999 and June 2000 • Phase-in dates were determined by ticker symbol • Issuers were reviewed 30 days prior to phase-in date (60 days for banks and insurance companies) and had an “E” appended to their ticker symbol if they did not yet comply
Hypotheses • Listing choices • Should reflect firms’ net costs or benefits • Should be associated with firm characteristics (size, ownership structure, financing needs, profitability) • Stock Returns • Measure of firms’ net cost or benefits • Announcement: Already > Newly ≥ Non • Liquidity Measures • Long-term shifts: Newly = ++, Non = – , Already = +/– • Benchmark with NASDAQ Small Cap Time trends
Listing Choices • 76% of OTCBB firms not previously filing with the SEC become noncompliant and are removed from the OTCBB • Data availability is particularly severe for noncompliant firms • Results have to be interpreted very carefully • Results likely to understate differences between groups • Evidence that Newly Compliant firms are: • Have a higher market capitalization, • More leverage, and • Lower profitability than Noncompliant firms
Summary Return Results • Already Compliant firms experience positive returns around the announcement dates • Consistent with the existence of positive externalities • Other firms experience lower returns at announcement dates • Consistent with being forced to second-best alternative • Noncompliant firms exhibit negative returns • Consistent with net costs from the regulatory change • There are significant returns around the phase-in dates • Newly Compliant experience negative returns when “E” is appended and positive returns when they comply • Noncompliant firms experience negative returns • Consistent with residual uncertainty about firms’ response to rule • Could indicate price pressures and a downward sloping demand curve
Summary Liquidity Results • Already Compliant firms • Reduced spreads and higher turnover after the rule change • NASDAQ Small Cap • consistent with positive externalities • Newly Compliant firms • Exhibit largest reduction in spreads & increases in trading activity • Newly Compliant firms “catch up” with Already Compliant firms • consistent with significant liquidity benefits from disclosure • Noncompliant firms • Exhibit increased spreads and lower turnover & days traded • consistent with significant liquidity costs due to rule change • Liquidity changes occur around the phase-in of the eligibility rule
Conclusions • Imposition of SEC disclosure requirements had significant economic consequences for OTCBB firms • It pushed a significant number of smaller firms with lower outside financing needs into a less regulated market • Significant costs to a one-size-fits-all approach • “Crowding out” effects It is important to consider firms’ responses and avoidance strategies • Pink Sheets market played an important role in this regard • Its existence probably prevented firms from going private • But it made also more harder to compel firms to disclose • Pink Sheets today look much like the OTCBB 5 years ago
Conclusions • Eligibility rule did compel about 25% of the firms to adopt filing with the SEC to avoid removal from OTCBB • There are substantial liquidity benefits for these firms • But, overall, the regulation appears costly to these firms • Evidence on existence of positive externalities • Positive returns and liquidity benefits • Enhanced market reputation and liquidity spillovers • Liquidity is an important mechanism through which disclosure regulation affects firms
Relevant SEC Rules • Section 12(g) of 1934 Act • Issuers with less than $10 million in total assets or fewer than 500 shareholders at fiscal year end are exempt from SEC filing required under Sections 13 and 15(d) of 1934 Act • Section 15(d) of 1934 Act • Issuers with security offerings under the 1933 Act have to comply with reporting obligations under Section 15(d) • Rule 15c2-11 • Market maker must have current financial statements on file to initiate quotation of a security • After 30 days, “Piggyback” exemption One dealer needs statements once • Rule 504 under 1933 Act • Exempt from registration under 1933 Act for one $1 million offering per year • Avoids reporting obligations under Section 15(d)
