Opinion
Research by
Michael Greenstone
3M Associate Professor of Economics
Department of Economics, Massachusetts Institute of Technology
Paul Oyer
Associate Professor of Economics
Stanford Graduate School of Business
Annette Vissing-J¿rgensen
Associate Professor of Finance Kellogg School of Management Northwestern University
FOR FURTHER INFORMATION: Helen K. Chang, 650-723-3358, Fax: 650-725-6750
Disclosure Adds Shareholder Value: Lessons from Sarbanes-Oxley's Predecessor
July 2006
STANFORD GRADUATE SCHOOL OF BUSINESS—The convictions of the late Ken Lay and Jeffrey Skilling on charges of fraud and conspiracy in the Enron trial are important reminders that corporate executives don't always operate in the best interests of shareholders. A natural impulse is to turn to government to devise regulations to force executives to operate the corporations they manage in the interests of shareholders and the employees. But what do we know about the success of these regulations?
For decades, some economists and business people have argued that regulatory oversight of corporate executives is not necessary. They say that private contracts combined with the possibility of litigation should be enough to prevent corporate fraud. That is, shareholders can band together to sue executives that mismanage firms and the threat of these suits will cause the executives to act in shareholders' best interests.
On the other hand, it can be costly for shareholders to obtain information about the executives' performance, lawsuits are costly, and an unregulated market could suffer from a free-rider problem if no individual shareholder has a sufficient stake in the company to pursue litigation on his or her own.
To understand whether shareholders value government regulation in financial markets, we recently completed an analysis of the effects of the 1964 Securities Acts Amendments. The 1964 Amendments extended the disclosure requirements that have applied to firms traded on the New York and American Stock Exchanges (NYSE and AMEX) since 1934 to large over-the-counter (OTC, now known as NASDAQ) firms. The relatively lax disclosure requirements for OTC firms prior to 1964 meant that shareholders were generally on their own in obtaining reliable information on the functioning of their companies and in devising methods to penalize management for failures to maximize shareholder value.
The 1964 Amendments dramatically changed the disclosure requirements for large OTC firms. Specifically, large OTC firms were newly required to: (1) register with the Securities and Exchange Commission (SEC); (2) provide regular updates on their financial position, such as audited balance sheets and income statements; (3) issue detailed proxy statements to shareholders; and (4) report on insider holdings and trades. Our study tested how the 1964 Amendments affected the stock returns and operating performance of the newly covered OTC firms, relative to unaffected NYSE and AMEX firms.
We found that OTC firms that were newly required to begin complying with all four forms of mandatory disclosure had substantial one-time gains in stock value relative to comparable NYSE/AMEX firms that were unaffected by the legislation. Our estimates of the higher returns range from 11.5 percent to 22.1 percent and imply that the 1964 Amendments created $3.2 billion to $6.2 billion of value for shareholders of the OTC firms we studied.
We also found that the affected OTC firms had greater income and sales growth than unaffected NYSE/AMEX firms after the law's passage. Thus, the increases in market value appear to have been justified by improved operating performance.
These results suggest that, contrary to critics' call for deregulation, a weakening of such federal oversight is unlikely to be beneficial for U.S. equity markets. At the same time, these results imply that the introduction of disclosure regulations similar to the 1964 Amendments in the scores of developed and developing equity markets with less stringent requirements is unlikely to be harmful and, in fact, is likely to be beneficial.
The 1964 disclosure requirements that we studied are less strict than those specified in the Sarbanes-Oxley Act of 2002, so the results are not directly informative about that legislation. Our results do not imply that, had Sarbanes-Oxley been in force before 2002, the Enron collapse would have been avoided.
However, the recent crop of corporate scandals might have been worse if the SEC's older mandatory disclosure rules had not been in place.
—Michael Greenstone, Paul Oyer, and Annette Vissing-J¿rgensen
Related Information
Mandated Disclosure, Stock Returns, and the 1964 Securities Acts Amendments, Michael Greenstone, Paul Oyer, and Annette Vissing-Jørgensen, Quarterly Journal of Economics, May 2006