Today I’d like to talk about capital formation—one part of the Commission’s tri-partite mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. There is much to be said about the Commission’s efforts to facilitate capital formation. But because I’m an economist, today I will focus in particular on some of the economic fundamentals that I believe can be considered when thinking about capital formation.
Posts Tagged ‘Craig Lewis’
In our paper, Do Fraudulent Firms Engage in Disclosure Herding?, which was recently made publicly available on SSRN, we present two new hypotheses regarding the strategic qualitative disclosure choices of firms involved in potentially fraudulent activity. First, these firms have incentives to herd with industry peers in order to escape detection. Second, these firms have incentives to locally anti-herd with the same peers on specific aspects of disclosure consistent with achieving fraud-driven objectives. We use text-based analysis of firm disclosures and compare disclosures across firms involved in SEC enforcement actions to benchmarks based on industry, size and age, and also to each firm’s own disclosure before and after SEC alleged violations.
We hypothesize that firms involved in potentially fraudulent activity face tensions when providing qualitative disclosures to the Securities and Exchange Commission, the agency tasked with enforcing anti-fraud laws. Our focus is on the Management’s Discussion and Analysis section of the 10-K, which is where managers have a high level of discretion to describe the key issues facing their firms and to describe their performance in detail. A primary motive is to escape detection, and managers who assume that the SEC is less likely to scrutinize disclosures that resemble industry peers, or that such disclosure is less likely to raise red flags, have incentives to herd with industry peers. On the other hand, the same objectives that lead managers to commit fraud may also provide incentives to anti-herd in their disclosure from industry peers. However, these latter incentives are likely more localized, and anti-herding would be predicted only on disclosure dimensions that might help managers to achieve these objectives.
The mission of the SEC is both straightforward and broad: To protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Though none of these objectives exists in isolation-and indeed, they interact and reinforce each other-today I thought I would focus on our primary mission of protecting investors. Specifically, I would like to discuss the role of economic analysis in furthering the Commission’s mission to protect investors and how the public can help the Commission craft regulations that effectively accomplish that goal.
Economic Analysis in Support of Commission Rulemaking
The Division of Risk, Strategy, and Financial Innovation (or “RSFI”) supports the Commission in a variety of ways, but the one that perhaps most directly impacts the investing public is the Division’s role in providing economic analysis in support of Commission rulemaking. And I believe that the economic analysis provided by RSFI is one of the essential elements of how the Commission works to fulfill its mission to protect investors.
The Division of Risk, Strategy and Financial Innovation, or “RSFI”, was formed, in part, to integrate rigorous data analytics into the core mission of the SEC. Often referred to as the SEC’s “think tank,” RSFI consists of highly trained staff from a variety of backgrounds with a deep knowledge of the financial industry and markets. We are involved in a wide variety of projects across all Divisions and Offices within the SEC and I believe we approach regulatory issues with a uniquely broad perspective.
Because my Division has a slightly cumbersome name – which is why you might hear us colloquially called “RiskFin” (though I prefer the more inclusive and accurate “RSFI,” as you can see) – today in my remarks I thought I’d focus on one word in our magisterial title: “Risk.” Risk, particularly as relates to the financial markets, can be a capacious term, and my Division certainly touches on many of those various meanings. But we are particularly focused on developing cutting-edge ways to integrate data analysis into risk monitoring.
I would like to talk about economic analysis in support of Commission rulemakings, and, in particular, the role of economists from the Division of Risk, Strategy, and Financial Innovation (or “RSFI”) and the recently issued guidance on economic analysis.
Background on the Division of Risk, Strategy, and Financial Innovation
Without going into a description of the history of RSFI — which would not take long in any event, as the Division is only three years old — it may be useful to set the stage for how, in my mind, the Division fits into the overall structure of the Commission.
First, who are we? Often referred to as the SEC’s “think tank,” RSFI consists of highly trained staff from a variety of academic disciplines with a deep knowledge of the financial industry and markets. For example, we currently have over 35 PhD financial economists on staff, and hope to hire more this fall. We also have statisticians, financial engineers, programmers, MBAs, and other experts, including individuals with decades of relevant industry experience.
In our forthcoming Journal of Financial and Quantitative Analysis paper, Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers, we analyze shareholder initiated class action lawsuits and the associated stock price reaction. Our analysis uses a comprehensive sample obtained from the Securities Class Action Lawsuit Clearinghouse (see here) at Stanford University (which tracks federal securities class action lawsuits since 1996). This service reports that 1,915 class action lawsuits were filed over the period 1996 through 2003 with litigation peaking in 2001 when 493 suits were filed. Not only do we examine price reactions on the lawsuit filing date, but we consider the possibility that these lawsuits signal that comparable firms are susceptible to similar lawsuits. If true, we expect these comparable firms to have negative stock price reactions that are significantly related to the probability of being sued.
We develop an econometric model for the propensity to be sued based on both firm and industry-specific factors. We show that shareholder wealth losses on the date that the filing of a lawsuit is announced are understated because investors partially anticipate these lawsuits and capitalize part of the losses in advance. In this regard, our methodology is consistent with the literature on conditional event study methods that emphasizes the role of explicitly conditioning for the expected information (i.e., partial anticipation of lawsuits) in estimating announcement effects, and suggests that the probability of an event (i.e., of being sued) is, as we find in this study, significantly related to the event date announcement effect. While other studies have examined whether investors partially anticipate corporate events, such as acquisitions and debt offerings, they are based only on firm-specific information. In contrast to these studies, we incorporate spillover effects based on industry specific information, such as the litigation environment, to determine both the propensity of a firm to be sued and the associated shareholder losses. We focus on the relation between investor reactions and the probability of being sued and demonstrate that prior expectations about the likelihood of being sued are significant determinants of the anticipated losses prior to the filing of an actual lawsuit and on the lawsuit filing date.
Our main findings are as follows. First, we find that investors partially anticipate lawsuits based on firm-specific and industry-specific information and capitalize losses prior to the filing of a lawsuit. Second, we show that filing date effects understate the magnitude of shareholder losses on average by approximately a third. Finally, we demonstrate that prior expectations about the likelihood of being sued are important determinants of the losses that investors capitalize in anticipation of being sued and of the losses on the lawsuit filing date. In particular, we show that the more likely a firm is to be sued, the larger is the partial anticipation effect (shareholder losses capitalized prior to a lawsuit filing date) and smaller is the filing date effect (shareholder losses measured on the lawsuit filing date). Our evidence suggests that previous research that typically focuses on the filing date effect understates the magnitude of shareholder losses, and such an understatement is greater for firms with a higher likelihood of being sued.
The full paper is available for download here.