NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

SEC Regulation FD Raises the Cost of Capital for Small Firms

"Increases in the costs of producing information affected the asset prices of small firms; in particular, the stocks of small firms that lost analyst coverage after the adoption of Regulation FD experienced significant increases in the costs of capital."

Well-functioning capital markets depend heavily on the free and efficient flow of economic and financial information between firms and investors, analysts, and the public. From this perspective, the Securities and Exchange Commission's Regulation Fair Disclosure (FD) of 2000, which aims to stop the practice of "selective disclosure" by firms of material information to only a few analysts and institutional investors before disclosing it publicly, would have seemed a welcome move. Yet, its adoption was highly controversial. Supporters argued that selective disclosure was unfair and undermined the integrity of financial markets, while detractors asserted that the flow of information between firms and investors would deteriorate without it.

In SEC Regulation Fair Disclosure, Information, and the Cost of Capital (NBER Working Paper No. 10567), co-authors Armando Gomes, Gary Gorton, and Leonardo Madureira examine the impact of Regulation FD on the production and transmission of information in financial markets, on security prices, and the cost of capital; they also ask whether these effects differ according to the size of the firms in question. The authors use quarterly NYSE and NASDAQ firm data between for the 1997-2002 period, and break it down into small, mid-sized, and large firms. They analyze the effects of Regulation FD on various market variables (analyst following, firms' use of pre-announcements, and forecast errors and volatility at earnings announcements).

Before highlighting their findings, the authors explain how information traditionally flows from firms to markets. Beyond mandatory firm disclosures, information flows in four main ways: 1) firms can provide information voluntarily to the public; 2) firms can selectively disclose information (for example, through telephone calls or one-on-one meetings; 3) "sell-side analysts" produce reports which are released to the public; 4) outsiders produce private information and then trade on that basis. Regulation FD sought to curb the second channel under the assumption that the same information would flow to the market through other channels, particularly channel 1.

"Our main finding," explain the authors, "is that there was a reallocation of information-producing resources and that this reallocation had asset-pricing effects." Specifically, they found that on average small firms lost 17 percent of their analyst following after the adoption of Regulation FD, while large firms increased their following by 7 percent. They also found that large firms became almost twice as likely to make voluntary earnings announcements, whereas small firms did not significantly increase their voluntary announcements. Also, after the adoption of Regulation FD, small firms experienced higher forecast errors and more volatile market responses to their earnings announcements -- consistent with a greater information gap -- whereas large firms did not experience a significant increase in these categories. "These results suggest that big firms were able to replace the loss of channel (2) with channels (1) and (3), but that small firms were not able to do so."

Gomes, Gorton, and Madureira show that increases in the costs of producing information affected the asset prices of small firms; in particular, the stocks of small firms that lost analyst coverage after the adoption of Regulation FD experienced significant increases in the costs of capital. The authors cite possible underlying reasons: first investors tend to demand a higher return on stocks where more private (and less public) information is available; second, improved disclosure might reduce information asymmetries between well informed and uninformed investors, so that overall investors are more confident that stocks will trade at a "fair" price.

Why does the impact of Regulation FD differ according to firm size? Surveys seem to confirm the authors' findings. A 2001 survey of members of the securities bar of the American Bar Association found that 67 percent of respondents believed regulation FD had a greater impact on small and mid-cap companies than on large-cap companies; and a 2001 survey by the National Investor Relations Institute found that more firms believed that small firms were providing less information following Regulation FD, as compared to small and mid-sized firms. Theoretically, economists have argued, large firms have greater incentives to create better disclosure policies, and because the production of information involves fixed costs, the costs per unit of size become smaller as firms become larger.

The authors also find that more complex firms -- as measured by their level of intangible assets -- are more adversely affected by Regulation FD than less complex firms, suggesting that complex information is better delivered in one-on-one interaction rather than through broad public pronouncements. However, they find no significant difference in the regulation's impact on firms according to the quality of their governance when assessing pre-announcements, forecast errors, volatility, and the cost of capital.

Following the adoption of Regulation FD, the authors summarize, "some small firms just completely stopped being followed by analysts, and... the cost of capital increased for those firms." They conclude that different information channels (such as public announcements versus private one-on-one communication) are hardly perfect substitutes. "Overall, our results suggest that Regulation FD had unintended consequences and that 'information' in financial markets may be more complicated than current finance theory admits."

-- Carlos Lozada


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