Why Antifraud Prohibitions are Not Enough: The Significance of Opportunism, Candor and Signaling in the Economic Case for Mandatory Securities Disclosure

Tuesday, January 1st, 2002 at 12:00 am by Joseph A. Franco
Joseph A. Franco, Why Antifraud Prohibitions are Not Enough: The Significance of Opportunism, Candor and Signaling in the Economic Case for Mandatory Securities Disclosure, 2002 Colum. Bus. L. Rev. 223

The cataclysmic collapse of Enron Corporation in the fall of 2001 jolted America’s financial markets and spawned public denunciations regarding corporate disclosure practices and independent auditors unprecedented in post-New Deal annals. Slowly and inexorably, evidence has emerged indicating possible fraud in disclosure and serious gaps in the current system of mandatory disclosure for public issuers. Criminal and S.E.C. investigations are proceeding against Enron, its officers, and its independent auditor, Arthur Andersen LLP. Arthur Andersen has been indicted for obstruction of justice and is teetering on the verge of collapse.

In response, Congress has launched a series of hearings. Securities markets and the SEC have manifested widespread concern about the accounting practices of other public companies, particularly in the telecommunications and energy industries. Indeed, Global Crossing, a major telecommunications corporation, has already sought protection from creditors in bankruptcy and is itself the subject of law enforcement investigations and congressional hearings. A task force from a leading financial executives group has urged its members to improve financial management and the quality of financial reporting. Individual public companies have responded with enhanced disclosure in order to engender greater financial transparency and to ward off the adverse repercussions of its less savory brethren’s seeming lack of candor. Only last October, the new Chairman of the S.E.C. optimistically told a gathering of accounting industry executives about a new spirit of cooperation between regulators and the accounting industry. Within three months, the pleas for accommodation gave way to calls for dramatic and far-reaching reform.

Enron is much more than a problem of individual, or even collective, misconduct or corporate malfeasance. It poses important questions about the effectiveness of disclosure policies in practice and, in particular, why disclosure requirements failed so badly in this case. These immediate concerns in the aftermath of Enron, of course, are currently in the hands of prosecutors, regulators and Congress. But it is also important to ask at a more general level how massive disclosure failures of this sort can be reconciled with an overarching theory of disclosure regulation and, in particular, what should be the roles of government and markets in promoting socially efficient disclosure by issuers. This article pursues this more general avenue of inquiry.

The regulatory theory of disclosure is hardly a novel issue for legal scholars, although current trends in scholarship provide something of an ironic counterpoint to the reality of the unfolding financial events post-Enron. As discussed below, the trend in recent years among legal scholars has challenged the need and utility of imposing mandatory disclosure requirements on issuers of securities. Instead, it is argued that markets create adequate incentives for issuers voluntarily to provide socially optimal levels of firm-specific disclosure. Both sides of the debate can find some anecdotal ammunition from recent financial events. However, popular perception, judged by expressions of congressional and journalistic outrage, would appear to favor a more pro-regulatory approach toward disclosure. Certainly the consequences of Enron, if nothing else, attest to the high stakes associated with fashioning appropriate disclosure policies.

In theory, disclosure regulation under the federal securities laws seeks to promote socially efficient levels of issuer disclosure of firm-specific information. Broadly speaking, disclosure regulation can be divided into antifraud prohibitions and mandatory disclosure requirements. The former prohibitions are principally designed to eliminate deception in disclosure, while the latter requirements are principally intended to increase the amount of disclosure and, as I will argue, the overall candor of disclosure. Antifraud prohibitions enhance the integrity of disclosure by prohibiting materially false and misleading representations. They do not impose affirmative content-based disclosure obligations, but rather mandate accuracy.

Antifraud principles contrast in this respect with the other primary form of disclosure regulation, mandatory disclosure requirements. Under the securities laws, mandatory disclosure requirements regulate the dissemination of particular kinds of information to investors and markets and arise in two different contexts. The requirements are triggered by an issuer’s offering of securities to the public. In addition, federal law imposes continuing mandatory disclosure requirements–so-called periodic disclosure requirements–on issuers of exchange-traded or widely-held securities. These provisions compel disclosure of information that would not necessarily be voluntarily disclosed by an issuer. Such information-forcing requirements promote greater candor by establishing a content floor for an issuer’s disclosure.

While the need for antifraud principles is universally conceded by scholars, the same cannot be said regarding mandatory disclosure requirements. This state of affairs is surprising. Mandatory issuer disclosure has commanded broad political support for almost seventy years. Moreover, until recently, the consensus among legal scholars, with certain exceptions, had generally affirmed the desirability of such regulation. In recent years, however, the pendulum has begun to swing in the direction of academic critics of mandatory disclosure. These critics question the value of mandatory disclosure. In their view, mandatory disclosure is costly and results in little valuable information to securities markets that issuers would not otherwise disseminate as a matter of economic self-interest. This development represents a nearly complete reversal of academic fortune for proponents of mandatory disclosure in less than two decades.

This article reconsiders the mandatory disclosure debate from an economic efficiency perspective. Economic arguments for mandatory disclosure depend in part on so-called market-failure arguments. The common germ in these arguments is that certain factors related to the production and distribution of firm-specific information cause the private profit-maximizing calculus of issuers to diverge from firm-specific disclosure policies that would be socially optimizing. There are three fundamental economic arguments for mandatory disclosure: one based on informational asymmetry between issuers and investors, and the other two based on the positive informational externalities arising from issuer disclosure and the potential of private investors to engage in excessive information gathering.

This article contends that the informational asymmetry rationale for mandatory disclosure not only provides a compelling economic justification, but also is more important than the other proffered justifications, yielding greater practical insights for policymakers concerning the design of disclosure standards. The article’s thesis rests on two distinct arguments: first, that mandatory disclosure is a preferred solution to the problem of informational asymmetry, and second, that the informational asymmetry justification is superior to other justifications that have been advanced for mandatory disclosure.

The first argument occupies the bulk of the article (Sections II-V) and is directed largely at critics of mandatory disclosure. The argument rests on three propositions: (i) a disclosure regime consisting only of antifraud principles would not lead issuers to provide optimal levels of firm-specific disclosure; (ii) mandatory disclosure redresses a number of the deficiencies of a purely antifraud-based disclosure regime; and (iii) mandatory disclosure is superior to issuer-choice disclosure regimes in which antifraud regulation is augmented by private signaling mechanisms selected by issuers.

Section II discusses the first of these propositions and describes the problem of informational asymmetry as a source of economic inefficiency. In brief, I argue that informational asymmetry makes opportunistic disclosure strategies and other forms of disclosure bias viable because investors will face obstacles in distinguishing between candid issuers (issuers that provide fair and honest disclosure) and opportunistic issuers (issuers whose disclosure is distorted by self interest and other bias inducing factors). Unless investors can reliably distinguish between candid and opportunistic issuers (or alternatively, candid issuers can distinguish themselves as candid in the eyes of investors), investors will tend to discount all issuers’ disclosure (whether candid or opportunistic) to reflect the risk of disclosure bias. This discount, as applied to candid issuers, is in essence a negative externality imposed on candid issuers by opportunistic issuers. The externality impairs economic efficiency by making non-candid issuers appear more valuable than they really are and candid issuers appear less valuable.

Candid issuers undoubtedly have incentives to distinguish themselves from their less candid counterparts and will engage in some degree of signaling – giving rise to a process known as incentive signaling. Incentive signaling is most clearly effective when it leads to ‘unraveling‘ – the disclosure of sufficient amounts of information by issuers to permit investors to infer accurately the quality of issuers’ disclosure solely from the content and amount of information that each issuer discloses. Those issuers that remain silent will be perceived by investors as issuers who are withholding information for very predictable reasons (i.e., issuers who have bad news and who do not wish to share it). Antifraud prohibitions perform a critical function in this scheme by ensuring that when an issuer discloses information, the disclosure is accurate or truthful. But there are significant limitations to the incentive-signaling model as applied to securities issuers. Antifraud prohibitions alone will fall considerably short of inducing issuers to disclose at levels consistent with complete unraveling. As explained below, there are a number of confounding factors that make it impossible to infer from issuer silence that the sole reason for the silence by an issuer is possession of bad news.

Section III makes the affirmative case for mandatory disclosure as a remedy for informational asymmetry. The implausibility of issuer unraveling (corroborated by the significant withholding of material firm-specific information by issuers) reveals how mandatory disclosure serves to promote more socially efficient disclosure policies by issuers. Mandatory disclosure compensates for deficiencies in voluntary disclosure governed by antifraud provisions alone not only by increasing the amount of information disclosed, but by functioning as a signaling mechanism itself. This signaling function of mandatory disclosure is analogous to the signaling function performed by antifraud prohibitions, but it has a different purpose. Whereas antifraud rules are aimed at promoting credibility by enhancing the accuracy of affirmative issuer representations, mandatory disclosure is aimed at making disclosure more candid by limiting issuer discretion to conceal information.

Sections IV and V extend the case for mandatory disclosure by addressing the counterarguments of the critics of mandatory disclosure. These critics contend that mandatory disclosure is not an effective means of redressing the inefficiency associated with the problem of informational asymmetry. Instead, critics have proposed a number of so-called issuer-choice alternatives to mandatory disclosure (described in Section IV) such as the supplementation of issuer self-signaling through the use of gatekeepers and reputational investments, collective private-ordering arrangements and jurisdictional competition. A common feature among the alternatives is the heavy reliance on issuer discretion or choice. According to issuer-choice advocates, candid issuers using these more sophisticated signaling strategies will have adequate incentives to provide efficient levels of disclosure as a matter of self-interest and without (or with less) intrusive government intervention.

Section V shows that the current system of mandatory disclosure is likely to be a superior mechanism for remedying informational asymmetry than the private signaling mechanisms of issuer-choice advocates. In jurisdictions with comprehensive disclosure requirements, such as the United States, mandatory disclosure requirements are generally qualitatively superior because they require more disclosure, engender greater standardization and more effectively constrain issuer discretion in the disclosure process. Although mandatory disclosure may be more costly than issuer-choice methods, the disparity in cost frequently is overstated and misunderstood. If costs are properly formulated, the social gains from enhanced credibility under mandatory disclosure will outweigh the relatively small additional disclosure costs entailed by mandatory disclosure.

The second fundamental argument advanced in the article is directed at proponents of mandatory disclosure who have relied principally on grounds other than the problem of informational asymmetry when defending mandatory disclosure. I argue that a justification based on informational asymmetry is both more compelling and realistic than other proffered justifications for mandatory disclosure.

While proponents of mandatory disclosure have generally noted the problem of informational asymmetries, they have attached greater significance to efficiency arguments based upon other factors, or have treated the informational asymmetry concern as a fairness rather than as an efficiency concern. In particular, proponents have attributed greater economic importance to the issuers’ failure to internalize positive informational externalities accruing to third parties and the potential of mandatory disclosure to reduce social costs associated with excessive information gathering by private investors.

The principal advantage of the informational asymmetry justification is that it strengthens the link between the theoretical justification for mandatory disclosure and its implications in designing mandatory disclosure requirements. Proponents of mandatory disclosure who primarily emphasize the positive informational externalities from issuer disclosure are unable to establish a clear relationship between the proffered economic justification for mandatory disclosure and the kinds of disclosure standards imposed under federal law. Divorcing the economic justification for mandatory disclosure and the design of disclosure policy creates doubts as to the utility of the existing scheme of mandatory disclosure. In contrast, the signaling approach advanced here carries clear normative implications for the design of disclosure standards. Specifically, it serves to explain the critical and largely neglected role of standardization in promoting socially optimal levels of issuer disclosure.

The signaling rationale for mandatory disclosure has another significant explanatory advantage over the other economic arguments for mandatory disclosure. It reveals more clearly how the rationale for mandatory disclosure relates to the justification for antifraud disclosure regulation. The signaling theory of mandatory disclosure is properly viewed as both an extension of and an important supplement to the rationale for antifraud regulation. Mandatory disclosure requirements significantly raise the costs of non-candid (or selectively incomplete) disclosure for opportunistic issuers, just as antifraud prohibitions increase the costs of false and misleading disclosure. Mandatory disclosure also serves to supplement antifraud regulation. In particular, it offsets the disclosure-suppressing effects of antifraud regulation.

As argued here, the principal justification for mandatory disclosure is an economic one: disclosure requirements promote more socially optimal levels of disclosure by issuers. Many proponents of mandatory securities regulation contend that disclosure regulation advances goals other than economic efficiency such as fairness, investor protection, and social transparency. While these goals are undoubtedly important and may provide alternative justifications for mandatory disclosure, they also implicate distributional objectives on which there is little consensus. Emphasizing such arguments, in my view, may lead proponents of mandatory disclosure to unnecessarily and erroneously concede the economic efficiency aspect of the debate. Hence, I have adhered to the narrower concerns of economic efficiency in the analysis below.

Author Information

Associate Professor of Law, Suffolk University Law School