Disclosure policy choices under regulatory threat

• Author: Jacco L. Wielhouwer,Jeroen Suijs
• DOI: http://doi.org/10.1111/1756-2171.12260
• Date: 01 March 2019
• Published date: 01 March 2019

RAND Journal of Economics

Vol.50, No. 1, Spring 2019

pp. 3–28

Disclosure policy choices under regulatory

threat

Jeroen Suijs∗

and

Jacco L. Wielhouwer∗∗

This article shows that firms “voluntarily” increase their disclosures in response to the threat

of more stringent disclosure regulations. These disclosures are mostly just sufficient to deter

regulation. However, when investment risk is low, both managers and investors might strictly

preferthe regulation deterring equilibrium. Wefurther find that in many cases, regulation can only

be deterred by asymmetric disclosurebehavior of the firms. This suggests that coordination issues

and free-riding may be important reasons why self-regulation may fail. The results also indicate

the importance of considering political pressure and regulatory threats to explain observed

symmetric and asymmetric voluntary disclosure behavior.

1. Introduction

In resolving inefficiencies in the market, regulation by government or any other authority is

a costly solution which consumes much time and resources. Alternatively, threatening to regulate

may be sufficient to induce the desired behaviorby market participants. In this article, we develop

a model to study the disclosure behavior of firms when they face the threat of more stringent

regulation. Such threat may induce market participants to self-regulate their industry. Firms can

try to avert regulation by “voluntarily” moving toward the desired behavior.

These tensions between desired and current behavior are abundantly present in corporate

disclosure, where managers’ potential benefits of information asymmetry and investors’ infor-

mation needs conflict. Consider, for example, the discussions on insufficient transparency of the

hedge fund industry. In 2007, former Securities and Exchange Commission (SEC) head Harvey

Pitt stated in a conference of Certified Public Accountants (CPAs)that “Regulation of hedge funds

is on the horizon. The only question is whether that regulation will come from the government or

∗Erasmus University Rotterdam; suijs@ese.eur.nl.

∗∗Vrije Universiteit Amsterdam; j.l.wielhouwer@vu.nl.

The authors would like to thank the Editor, three anonymousreviewers, Miles Gietzmann, Philip Joos, Roland Koenigs-

gruber, Harold Houba, and participants of the EIASM workshop on Accounting and Economics 2010 in Vienna for their

helpful comments and suggestions.

C2018 The Authors. The RAND Journal of Economics published by Wiley Periodicals, Inc. on behalf of The RAND

Corporation.

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial License, which

permits use, distribution and reproduction in any medium, provided the original workis properly cited and is not used for

commercial purposes. 3

4/THE RAND JOURNAL OF ECONOMICS

from hedge funds themselves.”1Although a so-called self-regulatory organization (SRO) under

government oversight is an option to make regulation more efficient (GAO, 2011), hedge funds

failed to avert regulation by increasing their transparency and disclosure (e.g., Dodd-FrankAct in

the United States and the Alternative Investment Fund Managers Directive[AIFMD] in Europe).

Executive compensation presents another example. Investors have long since asked for more

information on executivecompensation packages, but fir ms havefailed to provide this information

in a sufficient manner. In the United States, this has led to ever-increasing disclosure regulation

by the SEC. Starting in 1992 with a mandatory report justifying the firm’s compensation policies,

several amendments prescribing additional mandatory disclosures have followed over time, with

the most recent one being the SEC’s proposal on pay-for-performance disclosures.

Regulatory threat has proven partly effective in other settings, though. In the early 1990s,

environmental liability disclosures did improve under regulatory threat by the SEC. However,

the disclosures remained insufficient and additional regulation was introduced in 1996 (for more

details, see, e.g., Barth, McNichols, and Wilson, 1997; Alciatore, Callaway Dee, and Easton,

2004). Other examples include corporate governance codes and corporate social responsibility

disclosures. Corporate governance codes havebeen a product of self-regulation in many countries.

Also, until now, most corporate social responsibility disclosures are voluntary and initiatives with

respect to integrated reporting are self-regulated. The industry has kept off regulation so far.

This article analyzes whether firms, when facing a threat of disclosure regulation, can fore-

stall government regulation by voluntarily increasing disclosure and thereby increasing investor

welfare. Contrary to several related articles (e.g., Leland, 1979; Gehrig and Jost, 1995; DeMarzo,

Fishman, and Hagerty, 2005), we do not consider an SRO but focus on sustainable equilibrium

strategies without active enforcement by the industry itself.

This article considers a setting in which firms may have an incentivenot to disclose infor ma-

tion, whereas potential investorsbenefit from more disclosure. Firms have many reasons for not or

only partly disclosing relevant information (see, e.g., Verrecchia, 1983; Dye, 1985; Penno, 1997;

Pae, 2005). The reason for nondisclosure or partial disclosure in this article is investor response

uncertainty as, for example, in Dye (1998), Dutta and Trueman (2002), and Suijs (2007).2The

setting that we employ to achieve nondisclosure or partial disclosure in an unregulated setting is

comparable to Suijs (2007). The misalignment of interests between firms and investors creates a

demand for disclosure regulation.3

We model a financial market with two investment opportunities, for example, mutual funds

or firms, who compete for the investors’ capital. The investors can choose between investing

in the firms or in some outside investment opportunity (e.g., risk-free asset). To attract capital,

firms may voluntarily disclose (noisy) information about their future return. Each investment

opportunity can be either a success or a failure. In the unregulated setting, equilibrium strategies

exist in which no or little information is disclosed in equilibrium, but disclosure regulation, which

we assume to be costly, can increase investor welfare. We show that in such circumstances, a

threat of regulation may induce firms to disclose more information. For high-risk investments,

that is, investments with a relatively low probability of success, we find that firms’ disclosure

policies are just informative enough to avert disclosure regulation, that is, the additional increase

in investors’ welfare of disclosure regulationcancels out against the cost of disclosure regulation.

In the aforementioned conference of CPAs,Harvey Pitt said: “If the hedge fund industry is able to

realize that the benefits of self-regulation outweigh their costs, for a few dollars more the industry

can protect itself from unwelcome government intervention. Absent any concrete suggestions

from hedge funds . . . legislators and regulators will be happy to propose their own solutions, no

1www.reuters.com/article/idUSN1626114020070517 : “Former SEC head urges hedge funds to self-regulate,”

May 17, 2007.

2See Beyer, Cohen, Lys, and Walther (2010) for more details on this reason for the unraveling argument not to

hold.

3Forstudies that focus on the demand for disclosure regulation, see, for example, Dye (1990), Suijs and Wielhouwer

(2014), or Vives (1984).

C

The RAND Corporation 2019.