Mandatory disclosure and individual investors: evidence from the JOBS Act.

• Author: Honigsberg, Colleen
• Position: Jumpstart Our Business Startups Act - New Directions for Corporate and Securities Litigation

ABSTRACT

One prominent justification for the mandatory disclosure rules that define modern securities law is that these rules encourage individual investors to participate in stock markets. Mandatory disclosure, the theory goes, gives individual investors access to information that puts them on a more equal playing field with sophisticated institutional shareholders. Although this reasoning has long been cited by regulators and commentators as a basis for mandating disclosure, recent work has questioned its validity. In particular, recent studies contend that individual investors are overwhelmed by the amount of information required to be disclosed under current law, and thus they cannot--and do not--use that information to analyze the companies that they own.

Using a recent change in the law that allows firms to disclose less information before their initial public offering ("IPO"), we examine whether reduced disclosure leads to less trading by individual investors. Our results show that, immediately following the IPO, individual investors are less likely to trade in the stocks of the firms that provide less disclosure--but that this difference disappears after two weeks of trading. Our findings have important implications for the lawmakers now examining whether, and how, to change the mandatory disclosure rules that have served as the basis offederal securities law for generations.

Table of Contents INTRODUCTION I. MANDATORY DISCLOSURE AND INDIVIDUAL INVESTORS A. The Optimal Role of Individual Investors in Modern Stock Markets B. Individual Investors and Mandatory Disclosure 1. Disclosure and "Leveling the Playing Field" 2. Disclosure and "Information Overload" II. DATA AND EMPIRICAL RESULTS A. The JOBS Act 1. Reductions in Disclosure Available to EGCs 2. Previous Work on the JOBS Act B. Descriptive Statistics C. Key Variables of Interest 1. Disclosure Index 2. Measure of Individual Participation D. Research Design E. Empirical Findings 1. Linear Regression 2. Modified Propensity Score Matching 3. Analysis Beyond the First Day of Trading III. IMPLICATIONS FOR LAWMAKERS AND COMMENTATORS A. Mandatory Disclosure at the IPO Stage B. Experimental Design and Changes to Mandatory Disclosure Law IV. CONCLUSION APPENDIX INTRODUCTION

Mandatory disclosure is the cornerstone of federal securities law. (1) One oft-cited justification for requiring disclosure (2) is that it is necessary to provide individual investors with equal access to securities markets. (3) But whether the mandatory disclosure rules we have today actually achieve this goal is theoretically ambiguous and hotly debated. Some argue that disclosure facilitates individual investor participation in securities markets by reducing information asymmetry among different types of investors-that is, by leveling the playing field between sophisticated institutional shareholders and invididual investors. (4) More recent work, however, has suggested that individual investors suffer from "disclosure overload"--and that increasing the amount of information disclosed under federal securities law does not benefit these investors, who are unable to extract relevant information from increasingly complicated securities filings. (5) But there is surprisingly little empirical evidence on whether and how the quantum of information required to be disclosed under federal securities law actually affects individual investor participation in securities markets. (6)

In this Article, we provide evidence on the effects of disclosure on individual investors from a unique setting provided by a recent law: the Jumpstart Our Business Startups Act of 2012 ("JOBS Act"). (7) The JOBS Act allows certain firms conducting an initial public offering ("IPO") to provide fewer disclosures to investors. (8) This setting allows us to provide unique insights into the relationship between mandatory disclosure rules and individual investor participation for two reasons. First, most firms that conduct an IPO after the passage of the JOBS Act are allowed to provide reduced disclosure in one or more different areas in which disclosure is typically mandated; (9) this provides variation that allows us to study how individual investors respond to varying levels of disclosure. Second, because investors generally have limited information about firms before an IPO, disclosure is especially relevant to investors at the IPO stage. (10) Thus, our setting provides a unique opportunity to test the importance of mandatory securities disclosures to individual investors at a time when securities law is an important source of information--indeed, sometimes the only source of information--for those investors.

Our evidence shows that reducing the information that firms are required to disclose before an IPO leads to a statistically and economically significant decrease in individual investor participation in the IPO. Importantly, however, this effect is substantially reduced during the week of trading following the IPO--and disappears completely after two weeks. Our findings are consistent with theory predicting that individual investors who are at an informational disadvantage to other investors will be less likely to participate in securities markets. But our evidence also shows that, while this disadvantage can be addressed by mandating disclosure, such mandates are not the only mechanism available to address these information asymmetries. (11)

Our findings have important implications for the regulators now considering the costs and benefits of proposed changes to the disclosures currently mandated by federal securities law. (12) In particular, the evidence indicates that policymakers concerned about the effects of such changes on individual investors might turn their focus to firms that are already public--rather than firms at the IPO stage, where the effects of reduced disclosures are likely to be largest for individual investors. Our findings also suggest that lawmakers should emphasize experimental approaches to modifying the law in this area--as the SEC has done in the past--so that regulators and researchers can better understand the effects of these changes on investors of all kinds.

The remainder of the Article proceeds as follows. Part I provides theoretical background on the relationship between mandatory disclosure rules and individual investors' participation in stock markets. Part II provides empirical evidence that individual investors participate less in the IPOs of firms that disclose less under the JOBS Act--but that this effect disappears during the two weeks of trading that follow the offering. Part III describes the implications of our findings for lawmakers and commentators. Part IV concludes.

1. MANDATORY DISCLOSURE AND INDIVIDUAL INVESTORS

   Ever since the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934, commentators have offered myriad justifications for the federal laws that require public corporations to disclose certain information to investors. (13) In this Article, we study one frequently cited justification for mandatory disclosure laws: that mandatory disclosure is beneficial because it entices individual investors to participate in securities markets.

   This claim has been hotly debated for decades, with commentators emphasizing two objections. First, observers dispute whether individual investors should be encouraged to participate in equities markets at all. As we explain in Part I.A below, some have argued forcefully that social welfare might be enhanced by excluding--or at least discouraging--individual investors from participating in stock markets. Despite these arguments, however, securities regulators today emphasize individual investor participation as an important policy objective of modern securities law. (14)

   Because regulators continue to pursue mechanisms for encouraging individual investors to participate in stock markets, in Part I.B we consider whether, in fact, providing individuals with more information about public companies encourages them to invest. Significant recent work has questioned that notion, arguing that, because individuals are unable to process the overwhelming quantum of information provided in modern securities disclosures, mandatory disclosure mies likely have little effect on individual investor participation in markets. As we explain below, although some previous work has attempted to examine that claim empirically, in this Article we use a rare setting to evaluate the relationship between mandatory disclosure and individual investor participation in modern stock markets.

   1. The Optimal Role of Individual Investors in Modern Stock Markets

      Virtually since the conception of the modern federal securities regulation apparatus, policymakers have argued that the protection of individual investors should be among its principal goals. (15) The legislative history of both the 1933 and 1934 Acts themselves suggest that Congress intended both statutes to serve that objective. (16) Nor is the notion antiquated. Current SEC Chair Mary Jo White has frequently worried that today's securities regulation regime may not give individual investors sufficient protection. (17)

      Recent scholarship, however, has argued forcefully that individual investor protection should not be the central goal of securities regulation. For example, Zohar Goshen and Gideon Parchomovsky have persuasively argued that the objective of securities law should be to maximize social welfare, and that to do so, lawmakers should design securities regulation for sophisticated institutional investors rather than individuals. (18) More recently, finance scholar Luigi Zingales has suggested that regulators should discourage individual investors from participating in securities markets because protecting this relatively small group of unsophisticated investors causes a significant increase in regulatory costs--without offsetting social-welfare benefits. (19)

      By...