New York, NY – This past week, the Atlanta Federal Reserve Bank held its 2008 Financial Market’s Conference, entitled Financial Market Reforms: Taking Stock at Sea Island Georgia. The focus of this year’s conference was evaluating various market developments, including regulations that have been passed in recent years, to ascertain what we might be able to learn about the effectiveness and consequences of these rules.
One of the regulations discussed at this year’s conference was Regulation Fair Disclosure, approved by the Securities and Exchange Commission on August 10, 2000. The panel discussing this topic was moderated by Charles I. Plosser, President of the Federal Reserve Bank of Philadelphia. Panelists included Paul M. Healy, James R. Williston Professor of Business Administration, and Head, Accounting and Management, Harvard Business School; Michael W. Mayhew, Chairman and Global Director of Research of Integrity Research Associates, LLC; and Louis M. Thompson Jr., Managing Director of industry consultancy Kalorama Partners.
Professor Healy initiated the discussion by reviewing the results of a new paper he authored in which he conducted an extensive review of all of the academic studies in recent years to determine how Regulation Fair Disclosure (and the Global Research Analyst Settlement) impacted the U.S. capital markets. The following extract includes the introduction to Professor Healy’s paper on this topic.
How did Regulation Fair Disclosure Affect the US Capital Market? A Review of the Evidence
Between 2000 and 2003, two significant new regulations, Regulation Fair Disclosure and the Global Settlement, were adopted in the US to improve the quantity and quality of information available to investors. This paper’s primary purpose is to review prior research on the effects of the first of these changes, Regulation Fair Disclosure (Reg FD). However, it also briefly discusses and provides preliminary evidence on the impact of the Global Settlement on sell-side equity research.
Reg FD was approved the U.S. Securities and Exchange Commission (SEC) on August 10, 2000. Under the new rules, which became effective on October 23, 2000, firms were prohibited from providing private disclosure of material information to particular analysts or investors. If management unintentionally provided such information, it was required to publicly disclose the information within 24 hours.
The rule was motivated by SEC concern about potential loss of investor confidence in the integrity of capital markets resulting from management selectively providing valuable information on future earnings and business fundamentals to favored Wall Street analysts and large investors. The SEC argued that selective disclosure enabled some investors to “make a profit or avoid a loss at the expense of those kept in the dark.” As a result, “investors who see a security’s price change dramatically and only later are given access to the information responsible for that move rightly question whether they are on a level playing field with market insiders.”
In addition to increasing investor confidence, the SEC contended that the new rules would limit managers’ ability to use access to private information as a way of rewarding analysts who recommended their stock or made favorable earnings forecasts, and of penalizing analysts who were critical of the company. Finally, the SEC noted that technological advances facilitated broader dissemination of information than previously possible. “Whereas issuers once may have had to rely on analysts to serve as information intermediaries, issuers now can use a variety of methods to communicate directly with the market. In addition to press releases, these methods include, among others, Internet webcasting and teleconferencing. … Technological limitations no longer provide an excuse for abiding the threats to market integrity that selective disclosure represents.”
Opponents of the new rule, which included the Securities Industry Association and the Association for Investment Management and Research argued that it “would have a chilling effect on the disclosure of information by issuers.” Their concern focused on the difficulty in determining when a disclosure would be “material” (and therefore subject to the regulation). As a result of this ambiguity, opponents predicted that the new rule would lead managers to stop any informal communications with the outside world altogether and that this gap would not be filled by increased public disclosure of comparable information.
To investigate the competing hypotheses about the effects of Reg FD, studies have examined management and (to a lesser extent) analyst responses to the new regulation. Studies of management responses investigated whether public access to information increased following Reg FD via forecasts of earnings and more open access to conference calls. In addition, many studies have examined the regulation’s impact on trading volume and liquidity, the capital market’s processing of earnings information, and the performance of financial analysts.
As discussed in section 2, researchers face three challenges in assessing the impact of Reg FD. First, they must develop hypotheses on the expected impact of the new regulations and identify dependent variables to test the hypotheses. Second, the post-FD period was a particularly turbulent one in US capital markets, making it difficult for researchers to infer whether findings can be attributed to Reg FD per se, or to other concurrent events. Finally, since it is difficult to identify which particular firms provided selective disclosure and which analysts benefitted from the practice, researchers typically estimate the average impact on all firms and analysts, reducing the power of their tests.
Section 3 summarizes the findings of Reg FD research. Studies of manager responses to the new rules find an increase in managers’ voluntary disclosure post-FD. Expanded disclosure arises from manager decisions to make closed conference calls, previously available only to select analysts and investors, open to all investors. There is also evidence of an increase in the frequency of management earnings forecasts, but it is more difficult to interpret these results because they do not control for potentially confounding events.
The increased access to conference calls by retail investors is accompanied by a modest increase in retail investor trading activity at the time of the call. Finally, financial analysts’ earnings forecasts and stock recommendations appear to be less newsworthy post-FD, consistent with there being a decline in their access to private information.
There is no consistent evidence that Reg FD was accompanied by a change in analysts’ earnings forecast accuracy or forecast dispersion, suggesting that there was no change in information available to analysts post-FD. This is perhaps not surprising given the observed increase in public disclosure by management to offset the decline in private disclosure. Finally, aside from the modest increase in retail trading volume during conference calls, there is no consistent evidence of a change in market liquidity or efficiency.
Overall, the findings suggest that Reg FD was accompanied by an increase in public disclosure by managers and a decline in the value of sell-side analyst information. However, there was little discernible change in investor behavior. The findings therefore suggest that regulator concerns about weakened investor confidence from selective management disclosure and critics concerns about the impact of the new rules on market information were both over-stated.
As noted above, Reg FD was not the only new regulation that affected the quantity and quality of information provided to US investors early in the 21st century. In 2003-4, twelve of the largest investment banks agreed to a settlement with regulators following an investigation of the effect of investment banking practices on equity research. The Global Settlement sought to improve the reliability of analyst research by regulating the use of investment banking to support sell-side research, and by requiring banks to provide independent research to clients to supplement their own reports. Preliminary evidence on the Settlement’s effects on equity research, reported in Section 4, suggests that it was accompanied by a decline in sell-side research funding and sell-side analyst employment, particularly at the punished banks. Prior evidence indicates that research quality at these banks was actually higher than at less renowned investment banks, brokerage firms, and buy-side firms where fired sell-side analysts were likely to find new employment, raising questions for future research about whether the Settlement improved the quality of equity research in US capital markets.
 SEC (2003), p. 1.