A trio of Wharton professors has published a paper asserting that Regulation Fair Disclosure has caused an increase in the cost of capital for small companies.

“We find that the adoption of Reg. FD caused a significant reallocation of information-producing resources, resulting in a welfare loss for small firms, which now face a higher cost of capital,” the authors concluded. “The loss of the ‘selective disclosure’ channel for information flows could not be compensated for via other information transmission channels ... Our results suggest that Reg. FD had unintended consequences and that ‘information’ in financial markets may be more complicated than current finance theory admits.”

The study is considered so important it will most likely wind up among the topics discussed at the Securities and Exchange Commission’s upcoming annual Government-Business Forum on Small Business Capital Formation, scheduled for Sept. 20. “The Staff of the Commission is aware of the study and is considering the issues being raised,” acknowledges an SEC spokesman.

Gomes

Gorton

Madureira

The 58-page paper was co-authored by Armando Gomes, Gary Gorton and Leonardo Madureira, all of the University of Pennsylvania’s Wharton School.

The authors note in their report that in general, information can be transmitted from firms to markets via four channels:

In addition to mandatory disclosures, firms can disclose information to the public voluntarily through such channels as earnings pre-announcements.

Firms can selectively disclose information via phone calls, or one-on-one meetings.

“Sell side” analysts can produce research which is released to the public through research reports.

Private information can be produced by outsiders, which the authors call “informed traders,” who then trade on the basis of their information.

Impact Depends On Company Size

While trying to determine Reg. FD’s effects on security prices and the resulting allocation of resources, the authors note their main empirical strategy is to explore various cross-sectional differences among firms pre- and post-Reg. FD. “In this regard, our prior belief is that there are important cross sectional differences with regard to firm size,” they add.

There are two reasons they believe that Reg. FD has had different impacts on firms of different size. First, they point to a few surveys. For example, they note a 2001 survey of members of the securities bar by the American Bar Association found that 67 percent of respondents believed that Reg. FD had a greater impact on small and mid-cap companies than on large-cap companies.

In addition, a 2001 survey by the National Investor Relations Institute found that the percentage of companies claiming that less information was being provided post-FD was higher for small-cap firms when compared to the group of mid- and large-cap firms. The survey also found that the percentage of companies perceiving a decrease in analyst following post-FD was higher for the group of small-cap firms. Conversely, the percentage of companies perceiving an increase in analyst coverage was higher for the group of large-cap firms, according to the Wharton trio.

They also point out what they deem to be theoretical reasons for believing there is a link between firm size and the amount of information produced. For example, they note one 1990 study argued that large firms have better disclosure policies because the incentives for private information acquisition are greater in their case.

The authors cite a 1993 study that argued that production of information entails fixed costs, and thus disclosure costs per unit of size are more likely to decrease with size.

On the relationship between size and analyst following, they cite a 2001 study that argues that small firms may need selective disclosure of information to maintain and/or attract analyst following, because—for small firms—liquidity may be so low that the costs of obtaining private information may be higher than the gains from selling or trading on private information.

“Our main finding is that there was a reallocation of information-producing resources and that this reallocation had asset pricing effects,” the study asserts. For example, the authors found that small firms on average lost 17 percent of their analyst following, and big firms increased theirs by seven percent, on average.

“Moreover, while big firms are almost twice as likely to make voluntary earnings announcements [pre-announcements], small firms did not increase their pre-announcements significantly,” they add. “We find consistent effects of this reallocation on earnings forecast errors and market responses to earnings announcements: small firms experience higher forecast errors and volatility at earnings announcements, consistent with a higher information gap; no significant increases occur for big firms.”

These results suggest that big firms were able to replace the loss of channel no. two, mentioned above—namely, phone calls, or one-on-one meetings—with channels one and three—earnings pre-announcements and sell-side analyst reports—but that small firms were not able to do so. “We demonstrate that this reallocation resulted in a higher cost of capital for small firms [and no significant change for big firms],” the report adds.