Firms Gone Dark

I have just posted on SSRN a revised version of a paper that focuses on firms that exit the mandatory disclosure system even though their shares remain publicly traded and may be held by thousands of investors, Firms Gone Dark. It will be published shortly in the University of Chicago Law Review.

The paper begins by explaining how firms go dark. The securities laws currently permit a firm to exit the mandatory disclosure system if certain conditions are met, one of which is that the firm not have any class of securities outstanding with three hundred or more “holders of record.” This “record holder” test would appear to prevent any firm with three hundred or more shareholders from exiting mandatory disclosure. However, the test currently does not define a “holder of record” as the real (or “beneficial”) owner of the firm’s stock, but rather as the party “identified as the owner” of the security on the firm’s records. Most shares in publicly traded firms are held by nominees, such as banks and brokerage houses, not by the beneficial owners themselves. Each nominee, in turn, holds its shares on behalf of dozens, hundreds, or even thousands of institutional and individual investors. Thus, a reporting company can easily have fewer than three hundred “holders of record” and thus be eligible to exit mandatory disclosure even though the company may have thousands of beneficial shareholders. Hundreds of publicly traded firms have taken advantage of this rule to exit mandatory disclosure in recent years. Such exiting firms are said to “go dark” because they subsequently provide little information to public investors. The paper also describes the characteristics of firms that go dark and the stock market’s sharply negative reaction to going-dark announcements.

I then examine the disclosure practices of firms that have gone dark and explore their implications for the longstanding debate in securities regulation over whether mandatory disclosure is needed. Critics of mandatory disclosure argue that insiders can be counted on voluntarily to provide the “firm-optimal” level of disclosure—that which maximizes the joint wealth of insiders and public investors. Defenders of mandatory disclosure disagree, arguing that insiders often have an incentive to provide less than the firm-optimal level of disclosure. The disclosure practices of gone-dark firms, I show, cast doubt on the claim of mandatory disclosure’s critics. Only a small fraction of firms that go dark provide any financial information publicly to their hundreds or thousands of public investors. I explain why it is highly unlikely that, for the vast majority of these gone-dark firms, the firm-optimal level of disclosure is zero. The fact that stock prices drop substantially when firms announce they will exit mandatory disclosure provides further reason to be skeptical that post-exit disclosure levels are generally firm-optimal.

The paper concludes by addressing the question of how exits from mandatory disclosure should be regulated. It begins by explaining that when insiders can unilaterally decide to exit mandatory disclosure, they may have an incentive to exit even when such exit reduces firm value. The SEC is currently considering a proposal to prohibit firms with three hundred or more beneficial shareholders from exiting mandatory disclosure. Adoption of this proposal, I show, would decrease value-reducing exits but not eliminate them. I then put forward a new approach to regulating exits from mandatory disclosure: requiring public investor approval before insiders can turn off the lights. Such an approach would prevent a firm from exiting mandatory disclosure as a publicly traded company unless such exit increases firm value.

The current draft of the paper is available here.

As I am continuing to work on projects related to firms’ choice of disclosure arrangements, any comments would be most welcome.