SEC fair disclosure rule causes companies to borrow more, MIT Sloan professor finds

Professor Reining ChenProfessor Reining Chen

An attempt to protect small investors has the unintended effect of driving firms to debt market

CAMBRIDGE, Mass., Oct. 29, 2009 — The US Securities and Exchange Commission in 2000 adopted Regulation Fair Disclosure, a rule requiring firms to provide investors equal access to information about companies. The goal of Regulation Fair Disclosure intended to curb insider information and protect small investors.

But this well-intentioned attempt to level the playing field has had the unintended effect of causing companies to take on significantly heavier debt burdens, according to MIT Sloan School Assistant Professor Reining Chen.

The regulation prompted companies to change how they raise capital, according to Chen, who analyzed 10 years of data on over a thousand publicly traded firms affected by the rule. Instead of selling stock, which would require public disclosure, many firms avoided the release of detailed company information by going to banks or other lenders for their capital needs, Chen discovered.

"The SEC wanted to affect the information environment for companies," says Chen. "While the agency may have done so, it actually affected the capital structure of companies as well. It had the effect of making companies more leveraged."

Regulation Fair Disclosure, adopted in a 3-1 vote in August 2000, ended the practice of selectively disclosing information, typically to favored analysts or institutional investors. Advocates for small investors praised the new rule, which they said would promote democratization of investing and restore confidence in the integrity of the market.

To unravel the effect of the ruling on the capital structure of firms, Chen analyzed data from the SEC filings of firms listed on the New York Stock Exchange for five years before and five years after the rule went into effect. The companies most affected by the disclosure rule were those that had the greatest imbalances in buy and sell orders for their stocks after the rule went into effect, Chen determined.

Companies hurt by the regulation tended to borrow money when they needed capital, rather than sell stock, she discovered. Some public disclosure is required for borrowing, but it is not as detailed as the disclosure required for selling stock.

Companies may fear public disclosure for several reasons, according to Chen. Sometimes firms are protecting information that could help competitors, she says. "Also when a company discloses something that is complicated, the general public may not be able to understand it and that will create volatility in the stock price."

The regulation has been more of a burden for small companies than large companies, according to Chen. Large companies have many analysts following them, and information about big firms comes out one way or another. Small companies, on the other hand, get less attention from analysts, and these firms have trouble conveying information accurately to the public.

"The bigger companies actually benefited from this rule," says Chen. "Their information environment in the equity market improves. It does not improve for smaller firms."

One way the SEC might have avoided this problem is by having different regulations for companies of different sizes, she says.

In some ways the regulation helped large investors at the expense of small investors, according to Chen. When companies go to the debt market, they avoid public disclosure, but analysts and investors still need to know about the firms.

"Big institutional investors have more resources than small investors do to search for undisclosed information, so the large investors benefit," says Chen. "That is an unintended consequence of the regulation."

Chen does not pass judgment on whether Regulation Fair Disclosure was good or bad for the investment world. But she says her research shows that regulators need to be aware that simple rules can have far-reaching effects.

"Regulators may have good intentions, but when making rules, they need to have a broader perspective," she says.

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