Comparisons among firms play a major role in securities analysis. This Article asks if this fact justifies the mandatory nature of securities regulation. Once a firm approaches the public securities markets, federal securities regulations compel it to disclose financial information to the public. A seminal theory argues that firms would not otherwise commit to maintain optimal disclosure levels, since a disclosing firm bears all disclosure costs but does not gain all disclosure benefits.
This Article examines the robustness of this argument in relation to disclosure benefits, which arise from comparisons among firms. Financial data of peer firms allows shareholders to measure and monitor the relative performance of their own firm. The ability to make such comparisons is a benefit that each disclosing firm provides to its peers; it may have great social value but allegedly no private value to the disclosing party which bears the full cost of such disclosure. One might, therefore, call for addressing this market failure with a mandatory disclosure requirement.
Interestingly, while the above description might justify a mandatory disclosure requirement for private firms (a requirement which does not exist in practice), it does not automatically justify requiring disclosure by public firms. If comparison benefits accrue only after public shareholders or securities analysts have had a chance to review the data of all the relevant firms (which is the case for all public firms), each individual firm cannot enjoy comparison benefits without exposing its own statements. In other words, if one firm must make its financials public in order to incur comparative disclosure benefits-which is normally the case with public firms since their public investors process financial data outside the boundaries of the firm-then public firms would tend to disclose information regardless of the fact that such information benefits their peers. This voluntary mutual disclosure phenomenon, which helps firms capture comparative disclosure benefits, mitigates the fear that disclosure might be sub-optimally produced without the intervention of the regulator. Nevertheless, if a material piece of information confers significant comparative benefits when reviewed by corporate insiders and not by the public shareholders, one cannot count on voluntary mutual disclosure to occur, and mandatory federal intervention might be in order.
The justifications for the mandatory nature of federal securities disclosure regulations have been thoroughly examined in the literature, during a long lasting debate which has recently reignited.1 Interestingly, the often-praised properties of the federal disclosure system cannot easily serve as a justification for its mandatory nature.2 Simply put, if the regime governed by the securities and Exchange Commission (SEC) benefits the shareholders of a given firm, then such a firm would opt for this regime when going public, since it would maximize the value of its shares. To compel firms to adopt the disclosure regulations is unnecessary.
This notion is part of the now classical view that pre-initial public offering (IPO) shareholders will either commit to optimal corporate governance terms at the public offering stage, or else the market will penalize them with a discount on the value of their shares.3 This hypothesized voluntary commitment to adopt the SEC regulation, if it is indeed optimal, also allows one to disregard the distorted managerial interests of mature firms that might lead firms to leave the SEC system or refrain from adopting its everchanging features. Even in the absence of mandated disclosure, the incorporation documents could simply state that once committed to the SEC system in the IPO, managers and directors must adhere to the disclosure regulation system thereafter.
Against the backdrop of such an optimistic understanding, Frank H. Easterbrook and Daniel R. …