Regulation Fair Disclosure and the Cost of Equity Capital

Regulation Fair Disclosure (hereafter, Reg FD) was adopted by the SEC in 2000 to prohibit the selective disclosure of material information. The SEC was concerned that selective disclosure enables a privileged few, who are privy to the information, to profit at the expense of the investing public and that this unequal access to information will inevitably lead to individual investors’ loss of confidence in the integrity of the capital markets. The SEC believed that Reg FD would increase investor confidence in market integrity and thus “encourage continued widespread investor participation in our markets, enhancing market efficiency and liquidity, and more effective capital raising” (SEC 2000). In our forthcoming Review of Accounting Studies paper Regulation Fair Disclosure and the Cost of Equity Capital, we empirically investigate the effect of Reg FD on the cost of equity capital.

We use two approaches to estimate the ex ante or implied cost of equity capital for all U.S. firms with required data. The first approach simultaneously estimates the cost of capital and long-term growth for a portfolio of firms at a particular point in time (Easton and Sommers 2007). The second approach estimates the cost of capital for a firm at a particular point in time using assumed long-term growth (Gebhardt, Lee, and Swaminathan 2001; Claus and Thomas 2001; Gode and Mohanram 2003). These two approaches complement each other. Using the portfolio-specific cost of capital estimates, we find some evidence that the cost of capital declines after Reg FD, on average, for a broad cross-section of U.S. firms and that the reduction in the cost of capital is significant for medium and large firms but is not significant for small firms. Our findings based on the firm-specific cost of capital estimate are stronger and generally consistent with those based on the portfolio-specific cost of capital estimates.

We further examine whether the reduction in the cost of capital in the post-FD period relative to the pre-FD period is systematically related to firm characteristics indicative of selective disclosure prior to Reg FD. We find that the reduction in the cost of capital post Reg FD, in general, is more pronounced for firms with low book-to-market ratios, positive R&D expenditures or high levels of institutional ownership, i.e., firms that tend to provide more selective disclosure before Reg FD. This cross-sectional variation in the reduction in the cost of capital post Reg FD increases our confidence in attributing the observed decrease in the cost of capital to Reg FD rather than to unknown confounding factors.

We also examine the change in the cost of capital for a sample of American Depositary Receipts and U.S. listed foreign firms (hereafter, ADRs). ADRs are legally exempt from Reg FD. We find little evidence that the cost of capital is significantly decreased post Reg FD for ADRs but continue to observe some evidence of a significant decrease in the cost of capital for a matched sample of U.S. firms. This further increases our confidence in attributing the observed decrease in the cost of capital post Reg FD for U.S. firms to Reg FD. To summarize, our results do not support a conclusion in recent studies that the cost of capital has increased post Reg FD and, if anything, suggest the opposite.

The full paper is available for download here.