How Enforcement Affects Disclosure

The ability of disclosure rules to provide investors, consumers, and the public with useful information depends largely on how well the rules are enforced. Strong enforcement helps ensure the provision of information and increases companies’ desire for mandatory disclosure. In a new article, we offer a model of mandatory disclosure regulation and enforcement and analyze four essential questions the model raises.

Which firms are willing to disclose voluntarily in the absence of mandatory disclosure?

In his famous article, “Market for Lemons,” Akerlof (1970) argues that markets can collapse because of information asymmetry. Persistent information asymmetry where, for example, no seller discloses its product’s quality ultimately results in market failure because buyers protect themselves against potentially obtaining low-quality products.

A decade later, Grossman and Hart (1980) published a fundamental disclosure theory. It states that all sellers except the one with the worst product quality will disclose voluntarily. The driving force behind this result is intuitive: Absent any disclosure, potential buyers cannot distinguish between products based on quality and offer a price reflecting the average product quality in the market. The seller with the best-quality product will not accept the price for just the average product and will distinguish itself from the other sellers by disclosing its product’s superior quality. By disclosing voluntarily, the information asymmetry about the seller’s product is resolved, and buyers offer an adequate price for its product. For the remaining products, the buyers now offer a lower average price because the average quality in the pool of products decreases. This results in an iterative process in which the sellers of higher quality products continue to separate until everyone, but the seller of the lowest-quality product voluntarily discloses.

The same logic applies to corporate disclosure: It is in the best interest of high-quality firms to separate from low-quality firms through voluntary disclosure. But the principle relies on assumptions that might not always hold: Disclosure cannot come at a cost (including proprietary cost), all firms possess information that is relevant to investors, and reactions to the disclosure must be anticipated perfectly. Several models loosen the initial assumptions. For instance, Dye (1985) or Jung and Kwon (1988) assume that not all firms have relevant information to disclose. Thus, investors cannot distinguish between firms that intentionally remain silent and those that have no information to disclose. Assuming that the latter firms are not fundamentally different from the other firms in the market, their expected firm value equals the average firm value.

It is this group of non-disclosing firms that provides incentives to low-quality firms to remain silent. Because investors cannot distinguish between firms without information and firms that deliberately remain silent, all non-disclosing firms are assigned the same average value. Thus, low-quality firms endowed with non-favorable information, i.e., indicating a firm value below the non-disclosure price, will remain silent; consequentially they are pooled with the more valuable non-endowed firms unable to disclose. In contrast, high-quality firms endowed with favorable information, i.e., indicating a firm value above the non-disclosure price, will disclose voluntarily to distinguish themselves. As a result, high-quality firms disclose voluntarily, and low-quality firms and non-endowed firms do not disclose. Low-quality firms that do not make enough disclosure are a common argument in favor of mandatory disclosure (e.g., Beyer et al., 2010).

How do voluntary and mandatory disclosure interact in the presence of enforcement?

Suppose we add an asymmetric mandatory disclosure regime to the voluntary disclosure setting, meaning the disclosure regime follows the common principle of conservative accounting (e.g., Goex, 2009). Firms that possess non-favorable information and fall short of a threshold that triggers disclosure obligations must disclose. In contrast, firms possessing favorable information are not required to disclose but can disclose voluntarily.

An important assumption underlying Grossman and Hart (1980)’s result is that firms that disclose must tell the truth. Einhorn (2005) considers the interplay of mandatory and voluntary disclosure, but without considering enforcement. Suppose we relax the truth-telling condition and introduce a weaker version. A firm disclosing under the mandatory disclosure regime must state its firm value correctly, but it can illegally remain silent. Thus, the firm’s true value becomes publicly known only if it is caught failing to disclose by enforcement. The guilty firm receives a penalty proportional to its misconduct and restates its disclosure.

We show that a partial disclosure equilibrium exists under probabilistic enforcement, i.e., firms are caught with a certain probability. Low-quality firms below a compliance threshold reveal their type according to the disclosure regulation in equilibrium. Firms with a quality above the compliance threshold but below the mandatory disclosure threshold illegally remain silent to pool with non-disclosing firms of higher quality. For the illegally silent firms, the incentive effect of enforcement designed to induce truthful disclosure is not sufficiently strong to deter misconduct. Further, our model still includes voluntary disclosure, meaning that firms at the top of the value distribution opportunistically separate themselves. These results resemble empirical findings concerning firms’ disclosure behavior around implicit or explicit thresholds. Our model allows for investigating the incentive effect of enforcement on both firms’ mandatory and voluntary disclosure choices.

How do enforcement intensity or punitive damages affect disclosure incentives?

Altering enforcement – changing the probability of a firm getting caught or the severity of penalties – has two effects on firms’ disclosure incentives. Under imperfect enforcement, the mandatory disclosure threshold is no longer the line that separates disclosing and non-disclosing firms. Some firms will have incentives to pool with firms of higher quality and try to illegally remain silent in the hope of avoiding enforcement. This results in the compliance threshold introduced above. The higher a firm’s probability of getting caught or the higher the potential penalties, the more firms at the bottom fulfill their mandatory disclosure obligations. However, stronger enforcement also reduces high-quality firms’ desire to separate themselves, making voluntary disclosure less valuable, i.e., the voluntary disclosure threshold increases. Enforcement triggers a substitution effect, where more low-quality firms disclose but medium-quality firms stop disclosing voluntarily.

Which mandatory standards are favored by firms given enforcement?

So far, we assume an exogenous mandatory disclosure regime with a given disclosure rule that is subsequently enforced. However, regulation is largely the outcome of political processes. It is reasonable to assume that firms can shape disclosure rules, while enforcement is usually firmly in the hand of regulators.

Given that assumption, we show that enforcement creates a feedback effect that drives firms’ attitudes toward disclosure regulation. Our model rationalizes a positive relationship between enforcement and mandatory disclosure regulation, which is also observed in empirical studies. Essentially, stronger enforcement reduces the number of non-compliant, low-value firms and in turn the opposition of high-value firms to more mandatory disclosure.

Overall, both firms’ private information and enforcement intensity drive their preferences toward disclosure regulation. Enforcement connects firms of different qualities and their mandatory and voluntary disclosure decisions by altering the costs and benefits of remaining silent. The incentive effect of enforcement affects firms’ disclosure choices by determining not only firms’ compliance behavior under the mandatory disclosure regime, but also the attractiveness of voluntary disclosure. More intense enforcement encourages more low-value firms to disclose, increasing the potential price of not disclosing and making separation by voluntary disclosure less attractive.

This post comes to us from professors Benedikt Franke at the University of Würzburg and Dirk Simons at the University of Mannheim. It is based on their recent article, “Enforcement and Disclosure” available here

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