Law, share price accuracy, and economic performance: the new evidence.

• Author: Fox, Merritt B.

TABLE OF CONTENTS INTRODUCTION I. THE EXISTING LEGAL DEBATE A. The Traditional Consensus and Its Collapse B. Share Price Accuracy and Economic Efficiency 1. The Irrelevance Position 2. The Relevance Position 3. Empirical Studies C. Mandatory Disclosure and Share Price Accuracy 1. The Ineffectiveness Position 2. The Effectiveness Position II. SHARE PRICE ACCURACY, SHARE PRICE INFORMEDNESS AND THE [R.sup.2] METHODOLOGY A. Share Price Accuracy 1. Precise Definitions of "Actual Value" and "Share Price Accuracy 2. The Core Determinants of Share Price Accuracy: The Existence of Information and Its Reflection in Price 3. "Speculative Noise" Versus "Fundamental Information" B. Share Price Informedness 1. The Concept 2. Relationship of Share Price Accuracy to Price Movement C. The [R.sup.2] Methodology 1. Overview 2. Indirect Evidence That [R.sup.2] Is a Good Inverse Proxy for Share Price Accuracy 3. Direct Test of [R.sup.2] as a Proxy for Share Price Accuracy III. SHARE PRICE ACCURACY AND EFFICIENCY IN THE REAL ECONOMY A. Cross-Country Comparisons B. Cross-Industry Comparisons C. An Answer to the First Big Question IV. MANDATORY DISCLOSURE AND SHARE PRICE ACCURACY A. History of the Enhanced MD&A Requirements B. Test Design and Procedures: Hypothesis H1 1. Assumption Driving Test Design 2. Implications 3. Testable Hypothesis 4. Advantages of the Test Design 5. The Sample 6. The Calculations 7. The Basic Statistical Test of Hypothesis H1 8. Multivariate Regression Analysis of Hypothesis H1 9. Test of Whether Recession Prompted Bad-News Firms to Disclose Sooner 10. Robustness Tests C. Test Design and Procedures: Hypothesis H2 1. Assumptions and Implications 2. The Testable Hypothesis 3. The Test of Hypothesis H2 CONCLUSION TABLE II TABLE III TABLE IV TABLE V TABLE VI TABLE VII TABLE VIII INTRODUCTION

Mandatory disclosure has been at the core of U.S. securities regulation since its adoption in the early 1930s. For many decades, this fixture of our financial system was accepted with little examination. Over the last twenty years, however, mandatory disclosure has been subject to intensifying intellectual crosscurrents. Some commentators hold out the U.S. system as the standard for the world. They argue that adoption by other countries of a U.S.-styled system, with its greater corporate transparency, would enhance their economic performance. (1) Other commentators, in contrast, insist that the U.S. mandatory disclosure regime represents a mistake, not a model. (2) These crosscurrents are reflected as well in the actions and words of policymakers. On the one hand, Congress, responding to the recent spate of corporate scandals, enacted the Sarbanes-Oxley Act, (3) which amended the U.S. securities laws to require what is probably the greatest increase in disclosure since their inception. On the other hand, the Council of Economic Advisors, in its discussion of these reforms in the 2003 Economic Report of the President, agnostically stated that "whether SEC-enforced disclosure rules actually improve the quality of information that investors receive remains a subject of debate among researchers almost 70 years after the SEC's creation." (4)

Most debate between these contending positions has been at the level of theory. (5) The surprisingly small amount of empirical research brought to bear on the issues involved is relatively equivocal in its implications. (6) This Article introduces to the legal debate important new empirical evidence based on recent research of the authors and others that, while not definitively settling the overall question of mandatory disclosure's desirability, helps resolve two central, highly disputed questions:

--Is the efficiency of the real economy (the actual production of goods and services) enhanced when share prices become more accurate?

--Do rules mandating that issuers make public disclosures actually increase share price accuracy? (7)

Contrary to the arguments advanced by opponents of mandatory disclosure, the empirical evidence presented here suggests that both of these questions should be answered in the affirmative.

Part I of this Article briefly reviews the debate in the existing legal literature concerning these two questions. Part II sets out the basic concepts needed to understand the new empirical evidence: the ideas of share price accuracy and share price informedness, and the relatively new technique called the [R.sup.2] methodology, which we use to measure share price accuracy. Part III discusses studies utilizing the [R.sup.2] methodology recently published in the finance literature by authors of this Article and others, which strongly suggest that greater share price accuracy does lead to enhanced efficiency in the real economy. Part IV presents the results of a new study that we have conducted utilizing the [R.sup.2] methodology that suggest that mandatory disclosure does in fact increase the amount of meaningful information reflected in share prices. The study examines the effects of the change in disclosure rules, adopted in December 1980, that enhanced the requirements concerning management discussion and analysis of issuer financial condition and operating results (the "MD&A" requirements). This change for the first time effectively requires managers to disclose any material information that suggests that the issuer's most recent results are not necessarily indicative of future operating results or future financial condition. Our study suggests that share prices did in fact become more informed as a result of the enhanced MD&A requirements.

1. THE EXISTING LEGAL DEBATE

   1. The Traditional Consensus and Its Collapse

      For the first three decades following passage of the Securities Act of 1933 ("Securities Act") and the Securities Exchange Act of 1934 ("Exchange Act"), most securities law commentators took the desirability of mandatory disclosure as a given. These commentators believed that the primary purpose of the securities laws is to promote fairness. (8) In their view, price accuracy promotes fairness because it is unfair for a purchaser to pay more for a share than it is really worth. To them, mandatory disclosure is beneficial because it clarifies the value of the share and therefore makes such unfair overpayment less likely. (9)

      This consensus began to break down as discussion of securities law started to be infused with financial economics. Financial economics suggests that disclosure is not necessary to protect investors against unfair prices. The efficient market hypothesis ("EMH") (10) holds that the price of a thickly traded stock is unbiased--i.e., on average equal to the stock's actual value (11)--and this is true whether there is a great deal of information available about the issuer or only a little. (12) Thus, a law requiring issuers to disclose more information than they would otherwise voluntarily disclose is unnecessary to protect ordinary investors from buying shares at prices that are unfair in the sense of being on average greater than their actual values. (13)

      Attention thus shifted from the effects of mandatory disclosure on fairness to its effects on economic efficiency. Here opinions among financial economists have varied. (14) Mandatory disclosure's effect on efficiency has also been a matter of intense debate among the economics-oriented members of the legal academy. As the discussion below indicates, the two questions this Article addresses empirically--whether an increase in share price accuracy enhances the performance of the real economy and whether mandatory disclosure increases share price accuracy--are at the center of this debate. (15)

   2. Share Price Accuracy and Economic Efficiency

      Do more accurate share prices enhance economic efficiency? Some legal scholars think not and embrace what we call the "irrelevance position." Others think the level of share price accuracy is relevant to economic efficiency.

      1. The Irrelevance Position

         Some scholars embrace the irrelevance position based on a simple application of first principles derived from the widely accepted theories forming the foundations of the capital asset pricing model ("CAPM") and the EMH. These commentators believe that these principles can be used to demonstrate the impossibility of more informed prices enhancing efficiency. (16) The view of these theoretical skeptics, including Professors Barbara Banoff and Roberta Romano, starts with the proposition that the EMH assures that prices will be unbiased and hence fair. They then go on to argue that any improvements in share price accuracy resulting from increased disclosure affect only firm-specific risk, which can be diversified away. Under CAPM, a change in the level of firm-specific risk has no effect on the market value of its shares. This is because a security with higher firm-specific risk will not be priced in the market to produce a higher expected return since there is no need to provide an extra reward to induce the holding of risks that can be diversified away. These scholars thus believe that any improvement in share price accuracy that mandatory disclosure may bring about cannot justify its cost, since improved share price accuracy will not increase the market value of the shares involved. As a result, they oppose mandatory disclosure.

         Other scholars embracing the irrelevance position, including Professor Lynn Stout, acknowledge the theoretical argument that share price accuracy could enhance economic efficiency by helping to better guide capital to the most promising proposed investment projects, but dismiss the importance of this effect in the real world. (17) These writers point to the institutional reality that the vast majority of new real investment is not funded by public offerings of equity. These institutional skeptics believe, therefore, that share prices can have at most only a small effect on the functioning of the real economy. (18) As a result, they believe in the inherent weakness of any argument...