In October 2000, when the U.S. Securities and Exchange Commission adopted Regulation Fair Disclosure (“Reg FD”), it was trying to give smaller investors a break by ending “selective disclosure” – the practice of companies giving material information only to a few analysts and institutional investors before disclosing it publicly. But a recently released research paper by two Wharton faculty members and a PhD student raises some serious questions about the costs of the regulation.

Concern over the possible negative effects of the regulation is nothing new: In May 2001, soon after Reg FD’s passage, a subcommittee of the U.S. House of Representatives met to examine whether it hurt or helped investors (the session was adjourned without reaching a decision).

When Reg FD was first crafted, the SEC commissioners may have been thinking of President Franklin D. Roosevelt, who first proposed the legislation that created the SEC. He is said to have introduced the concept with a letter to Congress stating that “the purpose of this legislation is to protect the public with the least possible interference to honest business.”

But in their paper, SEC Regulation Fair Disclosure, Information, and the Cost of Capital, Wharton finance professors Armando Gomes and Gary Gorton and PhD student Leonardo Madureira suggest that Reg FD may have in fact brought about just such interference – at least for small firms – without delivering much in the way of additional information to investors. Small firms are defined here as those with an average market value of $71 million.

“The adoption of Reg FD was extremely controversial,” note the researchers. “While proponents argued that selective disclosure was unfair and undermined the integrity of capital markets, opponents warned that that there would be a ‘chilling effect’ on communication between firms and investors, and that information transfer between companies and investors would deteriorate.”

According to the authors, the adoption of Reg FD caused a “significant reallocation of information-producing resources” that effectively raised the cost of capital for smaller firms. Additionally, the loss of the “selective disclosure” channel for information flows could not be completely replaced with other information transmission channels, such as conference calls or webcasts and other electronic communication forums.

But any examination of the circumstances behind Reg FD should consider the fact that the SEC was under significant pressure to take action back when it first proposed and then passed the measure. “Three reasons were given by the SEC for the adoption of Reg FD,” explain the authors. First, it was argued that selective disclosure leads to a loss of investor confidence. If small investors fear that insiders will regularly profit at their expense, they will not be nearly as willing to invest. The second was the perception that information was used by management as a bribe, perhaps to gain or maintain favor with particular analysts or investors. Finally, the SEC stated the view that technological advances have eliminated selective disclosure as a requirement for market efficiency.

Has it though? A July 16, 2004, article in, titled Ana lyst (Un)coverage Hurting Small Firms, cites a study from the National Bureau of Economic Research which concluded that “the decline in analyst coverage of small companies has cost those businesses roughly 138 basis points per year.”

The main finding of the Wharton researchers is that “there was a reallocation of information-producing resources and that this reallocation had asset pricing effects. Our results suggest that Reg FD had unintended consequences and that ‘information’ in financial markets may be more complicated than current finance theory admits. To a degree, smaller firms have regained traction through webcasts and other ‘new media’ outlets, but the effects are still statistically significant.”

Gomes, Gorton, and Madureira document that in the wake of Reg FD, “small firms on average lost 17% of their analyst following and big firms increased theirs by 7%, on average. Moreover, while big firms are almost twice as likely to make voluntary earnings announcements (pre-announcements), small firms did not increase their pre-announcements significantly.”

The researchers also note that a 2001 survey conducted by the American Bar Association found that 67% of respondents believed that Reg FD had a greater impact on small and mid-cap companies than on large-cap companies. According to another survey that year by the National Investor Relations Institute, the fraction of firms responding that “less information was being provided post-FD” was higher for small-cap firms when compared to the group of mid- and large-cap firms. Furthermore, the fraction of firms that “perceived a decrease in analyst following post-FD” was higher for the group of small-cap firms, while the percentage of firms that perceived an increase in analyst following was higher for the group of large-cap firms.

In addition, the Wharton co-authors point to existing literature suggesting that small firms may need selective disclosure of information to maintain or attract analyst following. “Small firm liquidity may be so low that the costs of obtaining private information may be higher than the gains from selling or trading on private information.”

The authors state that information can be transmitted from firms to markets through four channels:

  • Firms, in addition to mandatory disclosures, can disclose information to the public voluntarily, such as through earnings pre-announcements;
  • Firms can selectively disclose information through such mediums as phone calls or one-on-one meetings;
  • So-called “sell side” analysts can produce research that is released to the public as analysts reports or other correspondence; and
  • Private information can be produced by outsiders, “informed traders,” who then trade on the basis of their information.

    The Wharton researchers argue that Reg FD sought to eliminate the second channel of information flow, selective disclosure, under the implicit assumption that the same information would still flow into markets through other channels, particularly voluntary and mandatory disclosures. “But Reg FD also affects the ‘sell side analyst’ channel, because the biggest impact of Reg FD is on analysts,” according to Gomes, Gorton, and Madureira. “Research suggests that Reg FD has made most analysts stock-guessers rather than stock-pickers because they do not receive that wink and nod from company management.”

    Is Reg FD a desirable public policy? The answer may not be as simple as yes or no; in fact it may be looked upon as a choice between the lesser of two evils – keeping the market efficient but knowing that some investors may have early access to inside knowledge, or reducing the efficiency of the capital markets to some degree in the name of fairness.

“Clearly, it is difficult to assess notions of ‘fairness,’ even if that is interpreted to mean social welfare,” conclude the researchers. “Our view is that some assessment is warranted in order to understand public policies with regard to disclosure in securities markets, in particular, Reg FD. Essentially, we’re not trying to judge the efficacy of Reg FD – but we wanted to point out that with measures like this, there may be unintended results.”