Ultimately, the questions of the value of foundational, corporate, and secu- rities laws requires empirical testing of the benefits and costs of the laws.
Such laws have theoretical advantages and disadvantages, and practice enables us to ascertain which category of effects prevail. Chapter 5 of this book will review the growing empirical literature on the cross-country com- parisons of different legal regimes and their effect on economic growth and capital markets and present our own empirical analyses of this effect. Other types of studies have been conducted on the consequences of securities law, though, ranging from historical analyses on the origin of this law to the use of this law by foreign firms. This chapter concludes by briefly reviewing these categories of empirical findings.
There have been some historical studies of the economic effects of some aspects of securities law that focused on the effect of the first introduction of the law. One famous early study questioned the value of the securities law, after finding that the passage of the Securities Act had no apparent effect on the average return earned by investors in new stock issues.76While this study is often cited as evidence that the securities laws did not provide any benefit, it might also be noted that it also calls into question the claims of critics that these laws were harmful. However, it is not clear that the study’s measure, the average return on new issues, is the proper test for the effect of securities laws, as the effect of greater information should be a reduction in opportunistic behavior, which would appear as a difference in the dispersion of returns from new issues. When this issue was more recently studied, the research found that the new issues after the adoption of the Securities Act did not significantly affect the average return of New
York Stock Exchange issues, but found a dramatic effect for issues not traded on the NYSE which were often overpriced prior to the Securities Act’s effect.77Moreover, the dispersion of returns and associated risk was lower after the Securities Act for all groups of shares studied, included those traded on the NYSE. The results indicated that the “information effects of securities regulation should be reflected in the risk borne by investors, and not the average risk-adjusted returns.”78
The mandatory disclosure rules also have seen some historical study.
George Benston studied the reaction of the market to the passage of the 1934 Exchange Act, by testing the subsequent results of firms which had previously made required disclosures of sales against those which had not.79He found no material effect from the legislation. The study has seen significant criticism,80though, and its implications are uncertain.81Even Benston’s results indicated that the 1934 Act improved pricing accuracy in the market. Several studies found that the mandatory disclosure provisions
“of the 1933 and 1934 Acts reduced underwriter costs and that the disclo- sure programs increased investor confidence and led directly to a large increase in investor participation in the stock markets.”82A more recent study, however, found that the laws’ passage did not markedly increase public disclosures.83 We will examine this historical evidence further in Chapter 4. Any such historical analysis is somewhat constrained by limits on available data, but the record can provide some information.
These studies from the era surrounding the adoption of the securities laws may be expected to underestimate the value of those laws in today’s world. As noted above, a new law takes some time to establish its market credibility and yield its positive effects. Moreover, the SEC and its rules were still relatively embryonic at the time period studied in this research (prior to 1953 or even earlier). Thus, a lack of effect immediately after passage of the laws does not mean much about the current operation of those laws. It seems reasonable to expect that the Commission’s rules and enforcement activities have improved over time, as its staffhas gained more expertise and experience with implementing the laws. Any positive benefits of securities law would also grow as private parties became more familiar with the regime and associated network effects affiliated with the law. The true benefits from the law increase as it establishes its reliability and credi- bility and compliance becomes routinized and therefore cheaper. In the process, heuristics of trust develop that increase market efficiency.
The historical empirical measurements of securities law may inevitably underestimate its benefits, because they test only the federal securities laws.
Before the nation had a federalized Securities Act or Securities Exchange Act, the states had written their own securities legislation, called “blue sky”
laws. These state laws had some significant limitations, which provoked the
demand for uniform federal legislation. However, the state laws surely offered some portion of the potential economic benefits from securities laws, so that studies of the federal laws would only capture a portion of the benefit from such laws, rather than representing a comprehensive measure.
Some international research also sheds light on the economic virtue of securities laws. Corporate takeovers can help promote the efficient alloca- tion of capital, by displacing ineffective management. Acquirers typically pay a material premium over the market price of a stock, which is under- valued. The presence of such acquisitions evidences some shortcomings in internal corporate governance, suggesting that public shareholders are either unaware of managerial shortcomings or unable to do anything about them in corporate elections. The ability of outside acquirers to take over a company, through devices such as tender offers, can thus enhance efficiency beyond that achievable by existing shareholders.84Incidentally, the threat of a takeover may also influence managers to perform better and save their jobs. The overall effectiveness of acquisitions in promoting this efficiency, though, depends on a variety of factors, including transaction costs, agency costs, information problems, etc. Not all takeovers are efficient—the acquirer’s managerial decision is also influenced by agency opportunism risk, but the presence of acquisitions can help discipline the market and enhance efficiency.
One test for the economic value of corporate and securities law is to observe its effect on the market for corporate control through acquisitions.
A study at the European Corporate Governance Institute found that the volume of merger and acquisition activity from 1999 to 2002 was much greater in countries that had stronger shareholder protection and higher accounting standards.85In addition, hostile takeovers are more frequent in countries with greatest investor protection, the premium paid to share- holders is greater in these countries, and cross-border mergers are more likely if the target company is governed by stronger investment protection laws. While these investor protections themselves add costs to acquisition activity (such as mandatory disclosure requirements and restrictions on how the takeover is structured), they apparently offer much greater coun- tervailing economic benefit and consequently enhance the market for cor- porate control.
Evidence for the economic benefits of the securities law can also be seen from a natural experiment involving foreign issuers of securities. Foreign companies cross-list their securities, in the form of certain categories of American Depository Receipts (ADRs), on US markets, thereby sub- jecting themselves to some of the restrictions of this country’s securities laws. Doing so has the economic benefit of providing more direct access to US capital, but given the globalization of financial capital markets,
cross-listing is not vital to accessing US capital. Some countries, to encour- age cross-listing on their markets, have advertised corporate-friendly legal rules, though the United States has maintained its strict securities law requirements. These stricter rules may well have enhanced cross-listing in the United States, implicitly demonstrating the economic advantages of its securities regulation.
John Coffee and others have suggested that such cross-listing in the United States is a form of “bonding” by foreign companies, in which they accept the relatively rigorous requirements of US securities law in order to demonstrate the quality of their company and credibility of their disclo- sures.86Cross-listing may take different forms but typically requires foreign firms to materially increase their disclosures. US securities laws can lend credibility to the cross-listing companies that enhances their investment appeal. Companies from countries with lesser legal requirements may reduce the agency risk costs of investment by binding themselves to tighter standards.87The existence of cross-listing provides another natural experi- ment regarding the value of US legal governance of corporate securities.
The phenomenon of cross-listing has been extensively investigated by financial economists. Much of the research shows a distinct benefit to cross-listing. An investigation of hundreds of cross-listings found that the process significantly reduced a company’s cost of capital, and that the benefit was greater as the increased government regulation from cross- listing was greater (that is, as the home governance was weaker and when the cross-listing was with an American exchange that exercised greater supervisory power).88A study of Canadian firms found that cross-listed firms traded at a higher price than did their purely domestic counterparts.89 Other studies have shown that cross-listings increase firms’ market values.90 The benefit is greatest for minority shareholders, as might be expected, because of their vulnerability to opportunism.91More specific accounting research demonstrates that the value from the US securities laws comes from the disclosure requirements, which enable more accurate projections of the company’s prospects.92
Some additional research has found that firms from weak investor pro- tection nations were less likely to cross-list in the United States, but that companies from those nations who did cross-list issued more equity.93 While this result has been used to question the bonding hypothesis, it is con- sistent with the possibility that agency problems prevent even efficient bonding through cross-listing. The cross-listing test thus has some theoret- ical imperfections, because the individuals who choose to cross-list, a company’s officers, are the very individuals whose opportunism is regulated by US securities laws. Hence, the firms that might most benefit from bonding may be the least likely to undertake the process. Perhaps for this
reason, the empirical evidence on the bonding rationale for cross-listing is not entirely consistent, but the evidence gives substantial support for the claim that the costs of compliance with US securities laws are more than overcome by the benefits of such compliance.
The significance of the cross-listing research should not be exaggerated, many companies do not voluntarily cross-list (for reasons that may involve efficiency or managerial agency problems or some other factor). The pres- ence of cross-listing simply provides evidence of the potentially empower- ing value of restrictive national laws, as foreign companies voluntarily choose to bind themselves with restrictions in order to gain the benefits of this action. Indeed, the research on the value of regulation for cross-listing could well understate the true effects of strict regulation, because the cross- listing decisions are made by managers who may have some self-interest to the contrary. The positive results for cross-listed companies further testify to the value of the SEC requirements. Other research has found that firms providing more disclosures have a lower cost of capital,94but again this research is limited to voluntary disclosures. Evidence of such benefits of voluntary disclosure could overstate the value of mandatory rules (which might require inefficient excessive disclosure) or understate their value (because agency problems make voluntary disclosure insufficient and inefficient).
Some international evidence supports the economic value of compulsory provisions of securities laws. When the developing market economies of the Czech Republic, Hungary, and Poland created rules for their economies, the latter two countries adopted strong investor protection securities laws with an independent regulator, while the Czech Republic did not do so.95 Some argued that the Czech approach was superior and that the securities regulations would “suffocate” the developing equity markets of Hungary and Poland.96In reality, the Hungarian and Polish markets outperformed the Czech market, even though the latter nation’s privatization strategy should have enhanced the development of stock markets.
These studies are limited in scope but clearly support the economic value of securities regulation. It seems that US legal governance enhances the efficient market for corporate control via acquisitions. US legal governance appears to provide considerable value to firms, as evidenced from the eco- nomic value of cross-listing and bonding with federal securities laws. The small test of emerging East European nations generally supports greater securities legislation. The available evidence suggests that US laws are eco- nomically beneficial, even when they appear to restrain private choice.
Chapter 5 will contain much broader cross-country studies of the associa- tion of various legal restrictions and market development, and this research will demonstrate the economic value of securities regulation.