Disclosure and Financial Market Regulation

The following post comes to us from Luca Enriques, Allen & Overy Professor of Corporate Law at University of Oxford, Faculty of Law, and Sergio Gilotta of University of Bologna.

In our recent paper, Disclosure and Financial Market Regulation, we provide a critical overview of the role of disclosure in financial market regulation.

We begin by discussing the goals of disclosure regulation, which we identify in investor protection, agency cost reduction and price accuracy enhancement. Disclosure protects investors because (a) it gives them the information that is needed in order to make correct investment decisions, (b) it prevents them from being “exploited” by traders having superior information, and (c) it constrains managers’ and controlling shareholders’ opportunistic behavior. In this last respect, the goal of investor protection equates that of agency cost reduction.

Disclosure acts as a curb on agency costs because it facilitates the enforcement of core substantive rules (e.g., directors’ fiduciary duties) and, on more general grounds, because it contributes to shareholder empowerment in corporate governance.

Last but not least, disclosure serves the purpose of enhancing the accuracy of market prices in reflecting value-relevant information. In this respect, it is an instrument for improving market efficiency.

Next, we turn to the reasons why governments impose disclosure. Acknowledging the many benefits that disclosure brings about does not amount to claiming that mandatory disclosure is necessary and/or desirable. If information is so valuable for investors, why should not market forces be spontaneously providing it in optimal amounts? The large body of literature devoted to addressing such issue provides many explanations why this may not be the case: private incentives may be too weak, due to free-riding and externality problems bearing on the public-good like nature of information; managers’ and controllers’ self-interest may lead firms to systematically shy away from the disclosure of significant (and especially negative) information. Further, mandatory disclosure may be needed to achieve standardization in the information disclosed and in order to subsidize the activity of informed traders.

We then address the limits and the costs of mandatory disclosure. Contrary to regulators’ beliefs, disclosure-based techniques may not always prove effective. Lack of effectiveness may originate from flaws affecting the regulatory and enforcement process (policymakers and enforcement agents may be captured by interest groups and may suffer from cognitive biases), and from investors’ own cognitive biases and bounded rationality.

Especially when used as “stealth substantive regulation” (e.g., with a view to inducing a desired course of action), disclosure may have unintended negative consequences. Enhanced disclosure of managerial compensation, for instance, may have the effect of increasing, rather than decreasing, average pay, and could also alter the compensation structure in ways that are detrimental to shareholder interests.

Disclosure-based regulatory techniques entail further costs. First, because the direct costs of mandatory disclosure (the costs of drafting, printing and mailing the documents, and those of ensuring compliance with the regulation) are in large part fixed, they tend to be comparatively more burdensome for small issuers, putting them at a competitive disadvantage vis-à-vis larger ones. Any one-size-fits-all approach to corporate disclosure is thus (at least) in this respect misguided.

Second, mandatory disclosure increases issuer liability risk. The risk of being held liable for affirmative misstatements tends to rise as the amount of information disclosed and the frequency of disclosures increase. In order to minimize this risk, firms may adopt a formalistic and bureaucratic approach to compliance, which may have the effect of reducing the overall amount of useful information released.

Last but not least, mandatory disclosure may distort investment decisions, inducing firms to forgo profitable projects, and may eventually stifle private incentives for investment in innovation.

We conclude by pointing to two issues that in our view are particularly representative of today’s regulatory challenges in the area of mandatory disclosure. First, mandatory disclosure systems are inherently expansive: they often rely on general standards (think of the materiality principle), and general standards are expansive by their very nature. Expansion is further fueled by the fact that implementation and enforcement are left to specialized public bodies institutionally leaning toward increasing, rather than decreasing, mandated disclosure. Thus, mandated disclosure may easily become excessive and especially small, newly-established firms may find it too costly to access public securities markets, with negative consequences for an economy’s dynamic efficiency.

Second, in parallel to the unceasing expansion in scope and reach of disclosure duties, communication channels between issuers and investors are shrinking. Both in the US and the EU, listed firms are no longer permitted to selectively communicate value-relevant information to the marketplace. That may have the effect of reducing the overall amount of information conveyed to the market, at the detriment of its efficiency.

The paper is a draft chapter for a forthcoming volume, The Oxford Handbook on Financial Regulation, edited by Eilís Ferran, Niamh Moloney, and Jennifer Payne, (Oxford University Press), and can be found in full text here.

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