Should Size Matter When Regulating Firms?

The following post comes to us from Deniz Anginer, Financial Economist in the Development Research Group at the World Bank; M. P. Narayanan, Professor of Finance at the University of Michigan; Cindy Schipani, Professor of Business Law at the University of Michigan; and H. Nejat Seyhun, Professor of Finance at the University of Michigan.

In our paper, Should Size Matter When Regulating Firms? Implications from Backdating of Executive Options [15 N.Y.U. J. Legis. & Pub. Pol’y (forthcoming Winter 2011)], we present a data point relevant to significant issues of policy concerning areas of law where small firms have either been granted exemption from regulations or not investigated for violations of laws that, on their face, apply to them. Whether small firms should be exempted is an empirical question the answer to which depends on the likelihood of such firms violating regulations.

There are numerous instances in the law where small firms have been granted exemptions from regulatory restrictions. The major justification offered by the proponents for this exemption of small firms is the claim that regulation has a disproportionate effect on these companies. For example, in the area of securities law, regulation of small firms has drawn criticism throughout the years. It has been lamented that “the [Securities Exchange Commission] SEC [has] never . . . understood small businesses, their capital needs, their importance to our economy, and the special circumstance they face…” Similarly, since its enactment in 2002, the Sarbanes-Oxley legislation (SOX) has been highly criticized for the level of expense it has imposed upon firms’ efforts to comply with the legislation. In order to decide if regulation should be lenient towards small firms, we need to first understand what types of firms are likely to be engaged in illicit activity. If we knew that small firms are also likely to violate laws, as a matter of public policy, should we continue to exempt firms from regulatory scrutiny solely due to size? That is, should size matter in regulatory policy decisions? Furthermore, should size be a factor when prosecutors target firms for investigation?

Policy makers, however, face an unavoidable endogeneity problem when addressing the question of optimal regulation. First, if certain groups of firms are not carefully scrutinized, then we cannot be certain that they are abiding by the regulations. Second, if small firms are statutorily excluded from regulatory compliance, it is quite possible that exclusion will lead to socially harmful actions by these firms, yet such actions may not be detected because they are not covered by regulations. Third, regulatory authorities may systematically target large and visible firms either due to their greater perceived deterrent value or greater chance of financial recovery. Finally, regulatory authorities may also pursue larger firms to further their personal career prospects, even if these targets do not provide the best chance of recovery or deterrent value. Thus policy makers would be advised to exercise caution before relying on prosecutions or investigations to decide which types of firms are engaging in illicit activity and thus worthy of regulation or investigation. While this endogeneity problem is easy to understand, it is difficult to document. After all, we typically do not know if certain firms are violating a statute unless they are caught doing it.

This paper provides a data point relevant to this policy discussion by using the options backdating context to circumvent the endogeneity issue discussed above. The backdating scenario provides a unique opportunity to predict which firms are likely to have engaged in illegal backdating activity. By examining the timing of option grants and the stock price patterns, we can compute a statistical likelihood of backdating regardless of whether a firm is ever identified as a possible back-dater. In most circumstances, this kind of ex-ante likelihood of engaging in an illicit activity is not available. Typically, there is some suspicion of illicit activity, which leads to an investigation, which is then followed by resolution. If there is no investigation, there can be no estimate of the probability of the illicit activity.

However, using our complete options grant database, we can establish the likelihood that a firm is engaging in illicit activity independently of whether the firm is ever investigated. We are then able to compare the size of firms likely to have engaged in the illicit activity with the general population of firms to determine if smaller firms are overrepresented in the illicit activity sample. We find that this is indeed the case that smaller firms are overrepresented in the sample. We then compare the size of firms in the illicit activity sample with the size of firms that were investigated, while holding constant other determinants of likely options backdating. Here we find firms that were investigated for engaging in illicit options backdating practices are likely to be, on average, larger compared to firms that have been engaging in options backdating but were not investigated. This finding suggests that prosecutorial motives might be driving the types of firms that are being subjected to investigations. This in turn implies that policy decisions regarding the type of firms to regulate should not be based on observed investigations or prosecutions. Our results therefore raise significant implications for the public policy debate on the level of regulation that should apply to smaller firms.

The full paper is available for download here.

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