Optimal Disclosure and Litigation Rules Around IPOs and SEOs
In recent years, there have been a number of reforms of the legal and regulatory framework governing disclosures and litigation around initial public offerings (IPOs) and seasoned equity offerings (SEOs): the most prominent of these are the JOBS Act of 2012 and the Securities Offering Reform of 2005. In our paper, we develop a theoretical analysis of the optimality of allowing firms to disclose various kinds of information prior to IPOs and SEOs, and of alternative rules to govern private securities litigation. In our model, firm insiders, with private information about variables affecting their future firm performance, may make disclosures (claims) about their future realization prior to selling new equity to outsiders. The issue price of firms' equity is affected by their disclosures; by the demand for equity from institutional investors, who may conduct costly (and noisy) verifications of firm disclosures; and by the demand from retail investors, who do not have access to such an informative verification technology. There may also exist an agency with the power to regulate firm disclosures; and private securities litigation, as a result of which the courts are able to penalize firms ex post for making optimistic disclosures without a strong basis in fact.
The first implication of our model relates to the self-regulatory incentives of firms to make conservative disclosures in the absence of any regulatory agency or ex post litigation. Our results imply that such incentives exist only in markets where a large proportion of the demand for new equity issues arises from institutional (sophisticated) investors, who are able to verify the claims made by firms effectively, and at a low cost. On the other hand, if the offering size is small relative to potential market size, the firm is able to raise a relatively large proportion of the required external financing from retail investors (unable to independently verify the claims made, unlike institutional investors). In this case, the firm has an incentive to ‘hype’ the equity offering by making tall claims, since any market-imposed costs of hyping the offering will be small.
When there is an agency regulating allowable disclosures, our theory has implications for the kinds of disclosures that it may be beneficial to allow prior to new equity issues. If the proportion of institutional investors in the equity market is relatively large, and if the claims made by the firm can be verified by institutions with sufficient precision at a relatively low cost at the time of the offering, then it is beneficial (from the point of view of minimizing information risk faced by uninformed investors) to allow the information to be disclosed. However, even in settings where the proportion of institutional investors is large, disclosures which are very costly to verify should be restricted. Further, such restrictions on disclosure need to be more stringent in equity market settings where the participation rate of retail investors in the equity issue is greater.
Our paper shows that when it is easy for investors to file lawsuits against firms for making inaccurate forward-looking statements and win large penalties, and the litigation regime is rather uninformative, firms issuing new equity will be deterred from making disclosures. However, when penalties are moderate, and the litigation regime is such that court verdicts are informative (ie, insiders with better grounds for making a particular forward-looking statement are found liable and penalized less often), private securities litigation will not have a stifling effect on disclosure. In such a litigation regime, the potential for private securities litigation makes disclosures more credible to investors, thus promoting disclosure.
The article is available here.
Onur Bayar is Associate Professor at the Department of Finance, University of Texas at San Antonio, Thomas Chemmanur is Professor of Finance and Hillenbrand Distinguished Fellow at Boston College and Paolo Fulghieri is Macon G. Patton Distinguished Professor and Area Chair of Finance at UNC Kenan-Flagler Business School.
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