An attempt to protect small investors has the unintended effect of
driving firms to debt market
The
US Securities and Exchange Commission in 2000 adopted Regulation Fair
Disclosure, a rule requiring firms to provide investors equal access to
information about companies. The goal of Regulation Fair Disclosure intended to
curb insider information and protect small investors. But this well-intentioned attempt to
level the playing field has had the unintended effect of causing companies to
take on significantly heavier debt burdens, according to MIT Sloan School
Assistant Professor Reining Chen.
The regulation prompted companies to change
how they raise capital, according to Chen, who analyzed 10 years of data on
over a thousand publicly traded firms affected by the rule. Instead of selling
stock, which would require public disclosure, many firms avoided the release of
detailed company information by going to banks or other lenders for their
capital needs, Chen discovered.
"The SEC wanted to affect the
information environment for companies," says Chen. "While the agency
may have done so, it actually affected the capital structure of companies as
well. It had the effect of making companies more leveraged."
Regulation Fair Disclosure, adopted in
a 3-1 vote in August 2000, ended the practice of selectively disclosing
information, typically to favored analysts or institutional investors. Advocates
for small investors praised the new rule, which they said would promote
democratization of investing and restore confidence in the integrity of the
market.
To unravel the effect of the ruling on
the capital structure of firms, Chen analyzed data from the SEC filings of
firms listed on the New York Stock Exchange for five years before and five
years after the rule went into effect. The companies most affected by the
disclosure rule were those that had the greatest imbalances in buy and sell
orders for their stocks after the rule went into effect, Chen determined.
Companies hurt by the regulation tended
to borrow money when they needed capital, rather than sell stock, she
discovered. Some public disclosure is required for borrowing, but it is not as
detailed as the disclosure required for selling stock.
Companies may fear public disclosure
for several reasons, according to Chen. Sometimes firms are protecting
information that could help competitors, she says. "Also when a company
discloses something that is complicated, the general public may not be able to
understand it and that will create volatility in the stock price."
The regulation has been more of a
burden for small companies than large companies, according to Chen. Large
companies have many analysts following them, and information about big firms
comes out one way or another. Small companies, on the other hand, get less
attention from analysts, and these firms have trouble conveying information
accurately to the public.
"The bigger companies actually
benefited from this rule," says Chen. "Their information environment
in the equity market improves. It does not improve for smaller firms."
One way the SEC might have avoided this
problem is by having different regulations for companies of different sizes,
she says.
In some ways the regulation helped
large investors at the expense of small investors, according to Chen. When
companies go to the debt market, they avoid public disclosure, but analysts and
investors still need to know about the firms.
"Big institutional investors have
more resources than small investors do to search for undisclosed information,
so the large investors benefit," says Chen. "That is an unintended
consequence of the regulation."
Chen does not pass judgment on whether
Regulation Fair Disclosure was good or bad for the investment world. But she
says her research shows that regulators need to be aware that simple rules can
have far-reaching effects.
"Regulators may have good
intentions, but when making rules, they need to have a broader
perspective," she says.
Subscribe