Regulation Fair Disclosure (“Reg FD”) is commonly believed to prohibit managers from disclosing information about their firm to select shareholders. But managers are in fact allowed to do so in several circumstances. Specifically, Reg FD exempts communications to shareholders who will not trade on the information and to companies’ customers, suppliers, and strategic partners. In a new article, we exploit an understudied setting where large shareholders and firms enter into bilateral contracts that entitle the shareholders to receive specific information privately from management. We find that, after the execution of such contracts, firm performance improves and the amount of public disclosure drops.
From a theoretical perspective, our findings are consistent with delegated monitoring theories of disclosure that predict that, when public disclosure is costly, monitoring by a large stakeholder leads management to supply more private information to that stakeholder and less public information to other similarly aligned investors who free-ride off the monitor (Admati et al., 1994; Diamond, 1984). We also take steps to ensure that our results are not driven by the firm’s poor performance or any expropriation by the shareholder.
Shareholder contracts specifying private information rights are released publicly through SEC filings and, despite their visible presence, are largely ignored in the literature (Schoenfeld, 2020). We analyze 3,456 of these contracts using 13D filings from 1996 to 2018. We observe that the two main types of shareholders in this setting are corporate shareholders, who invest in firms to facilitate specific business projects, and activist shareholders, who profit from investing in, fixing, and divesting from firms. From a theoretical perspective, both types of investors have the appealing institutional feature that they are not short-term traders. Rather, these shareholders use their private information to monitor and guide management. Of the 3,456 shareholder contracts in our sample, 1,110 or about 32 percent specify information rights for shareholders.
Our first analysis provides descriptive evidence on what information shareholders can acquire from firms in this setting. We find that shareholders can gain access to a variety of information from a target firm, including financial forecasts beyond what firms often release publicly, appraisals of a firm’s assets and liabilities, production schedules, access to physical premises, trade secrets, and accounting ledgers and the right to ask questions of the firm’s employees, directors, and auditors. Consistent with Reg FD, information rights are often accompanied by covenants that prohibit shareholders from trading on any information obtained from these sources, further supporting our argument that these information rights serve primarily as a way for shareholders to monitor firms.
Consider, for example, the following excerpt from the shareholder contract executed in 2016 between investor Apollo Global Management and Miller Energy Resources:
The Company [Miller Energy] shall furnish to the Shareholder [Apollo] the following information… a report setting forth, for each calendar month during the then current Fiscal Year to date, the volume of production and sales attributable to production… within 30 days after the end of each month, a report setting forth, for each calendar month during the fiscal year to date, the volume of production and sales attributable to production on a well by well basis… on the tenth Business Day of each calendar month, a six-month forecast of cash flows of the Company its Subsidiaries on a monthly basis… on or before the end of each Fiscal Year, an updated appraisal of all hard assets of the Company and its Subsidiaries… during normal business hours and upon reasonable notice, reasonable access at all reasonable times to its officers, employees, auditors, properties, offices, plants and other facilities and to all books and records.
In our second analysis, we find that information rights in shareholder contracts are more common for corporate investments and in settings where access to information is important for shareholders given the potential for agency problems. Specifically, the prevalence of information rights is significantly positively associated with geographic distance between a firm and a shareholder, which is a widely used proxy for information asymmetries between management and investors. Information rights are also significantly positively associated with contract complexity, which is a construct used by prior studies as a proxy for the extent of relationship-specific investments, a setting where agency problems can be more severe. We also find that information rights in shareholder contracts are positively associated with the total dollar value of a shareholder’s investment, a setting where shareholders are likely to monitor management more.
Our first concrete evidence that the large shareholders in our sample monitor the firm instead of expropriate from other investors is based on our finding that the market reacts favorably to the filing of shareholder contracts with information rights. The mean (-5, +5 day) market-adjusted return to shareholder contracts with information rights, centered on their filing dates, is +1.2 percentage points and statistically significant. These positive announcement returns are supported by our evidence on overall improved operational performance at the target firms. On average, from the year before to two years after the execution of a shareholder contract with information rights, EBITDA/assets and EBITDA/sales significantly increase in a difference-in-differences (D-in-D) manner by 2.82 and 3.49 percentage points at the targets, respectively. Both of these changes are relative to performance-matched control firms. Consistent with the setting assumed in models of delegated monitoring, these findings further suggest that large shareholders use information rights not to expropriate from other investors, but to monitor the firm in a manner that benefits all shareholders.
Having established that our setting represents a delegated monitor who acquires private information, we next test whether management reduces public disclosure. We find that, on average, from the year before to the year after the execution of a shareholder contract with information rights, target firms’ annual management guidance and 8-K filing frequencies significantly decrease by about 1.5 to 2.0 disclosures per year relative to control firms. Both of these changes are relative to disclosure-matched control firms. These findings on improved performance and reduced disclosure support the predictions of delegated monitoring theories and are inconsistent with theories that predict that information rights would result in reduced disclosure due to investors expecting poor performance from the firm.
Our study makes several contributions to the literature. In many economics models of disclosure, investors do not enter directly into contracts for release of information to meet their needs but rather build price-based mechanisms into compensation contracts to induce managers to make disclosures that maximize the stock price (e.g., Verrecchia, 1983). However, prior studies argue that some sophisticated shareholders have expertise in monitoring managers and, as part of their monitoring process, likely have special information needs beyond what is provided by mandated disclosures such as the annual report (e.g., Admati et al., 1994). In such situations, shareholders may use their ownership-control rights to contract with a firm to meet these needs. This study provides some of the first evidence on this mechanism that shareholders use to fulfill their monitoring role.
Our study also highlights circumstances in which Reg FD allows managers to provide shareholders with selective access to information, which is a feature of Reg FD that has received limited research attention. Our finding that information rights can facilitate beneficial monitoring is contrast with Reg FD’s main premise that selective disclosure harms investors.
Admati, A. R., Pfleiderer, P., Zechner, J., 1994. Large Shareholder Activism, Risk Sharing, and Financial Market Equilibrium. Journal of Political Economy 102, 1097-1130.
Diamond, D. W., 1984. Financial Intermediation and Delegated Monitoring. Review of Eco- nomic Studies 51, 393-414.
Schoenfeld, J., 2020. Contracts between firms and shareholders. Journal of Accounting Research 58, 383-427.
Verrecchia, R., 1983. Discretionary Disclosure. Journal of Accounting and Economics 5, 179-194.
This post comes to us from professors Venky Nagar at the University of Michigan’s Ross School of Business and Jordan Schoenfeld at Dartmouth College’s Tuck School of Business. It is based on their recent article, “Shareholder Monitoring and Discretionary Disclosure,” available here.