The Effect of Relaxed SEC Regulations on Market Liquidity
“If you’re going to buy a used car and you don’t have information about the car—if you can’t get the history of the car or the accident report—are you going to buy that car?” asked Lin Cheng, assistant professor of accounting at the Eller College. His recent paper, “The Commitment Effect versus Information Effect of Disclosure—Evidence from Smaller Reporting Companies,” published in the Accounting Review, discusses the same principle—the trust of the buyer—but in a different context.
One reason people trust firms enough to invest in them is because of public filings, such as the 10-K, that firms are required to make by the SEC. A 10-K filing is similar to an annual report, which contains a business description, the discussion of current year operations, and the financial statements. It is a status report that makes transparent the business decisions of the firm. If the firm fails to convey this information accurately and adequately, the firm can be penalized by the SEC. The 10-K filings “give the investor the impression that the disclosure policy year after year is credible because penalties are associated if they don’t follow the disclosure regulations,” said Cheng. Therefore, public disclosure regulations are considered a “credible commitment mechanism.”
Recently, however, the SEC has changed the regulations and as a result, some smaller companies are given the choice of disclosing or not disclosing certain information in their 10-K reports. Cheng and his coauthors have examined the effect of this regulation relaxation. They have found that there is decreased market liquidity for companies that have chosen to reduce their disclosure. Market liquidity reflects how quickly a company’s stock can be sold without having to reduce its price by much. Decreased market liquidity means a reduced stock price. “If you don’t have much information about the company, you won’t buy shares in it,” Cheng concluded.
“The punch line,” he said, “is that we also find a reduction of market liquidity for smaller companies that maintain their disclosure level.” Why would people choose not to invest in companies who still disclose the same amount of information as they did before the change in requirements? Cheng explained, “The firm can choose to reduce the level of disclosure at any moment. If you’re looking for a long-term investment and you’re not sure if next year the company will give you enough information, you won’t invest.”
When people do not trust companies, the market loses liquidity. Likewise, if investors cannot trust that they will have access to key information in the future, they will not buy shares. If this is the case, why did the SEC relax the requirements for small businesses to begin with? According to Cheng, the relaxation of financial reporting requirements can save the firm money by reducing the compliance costs. However, the unintended consequence is the reduction in market liquidity, which shrinks the pool of potential investors.
“Overall, this study suggests that mandatory disclosure regulations provide a credible commitment mechanism that cannot be fully replaced by voluntary disclosure,” said Cheng. “The idea is to inform policy setters and to provide evidence why mandatory disclosure regulation is necessary.”