Measuring the costs and benefits of regulation:

Conceptual issues in securities markets

J. Harold Mulherin

,1
Terry College of Business, University of Georgia, Athens, Georgia 30602, United States
Received 6 February 2007; received in revised form 26 February 2007; accepted 27 February 2007
Available online 10 April 2007
Abstract
This paper reviews the economic theory of regulation and surveys the empirical evidence on its
application to past and recent changes in U.S. securities regulation. The theory provides multiple potential
motives for regulation and cautions the empirical researcher against nave modeling of the costs and
benefits of regulatory change. Moreover, the nature of the regulatory process compounds the standard
pitfalls of empirical analysis such as endogeneity and confounding events. Productive empirical techniques
include the development of cross-sectional predictions of the effects of regulation as well as the use of
unregulated control samples. An important avenue for future research is a more refined estimation of the
extent to which regulation has unintended consequences.
2007 Elsevier B.V. All rights reserved.
JEL classification: G14; G28; G38; K22
Keywords: Regulation; Public interest; Special interest; Unintended consequences
1. Introduction
Measuring the costs and benefits of regulation is an important but challenging task for
economic analysis. A critical conceptual issue is that there are several economic theories of
regulation ranging from public interest to special interest that influence the structure of
hypotheses and the interpretation of results. Empirical analysis is further affected by the nature of
regulatory events which typically react to economic conditions and are drawn out over extended
Journal of Corporate Finance 13 (2007) 421437
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E-mail address: mulherin@terry.uga.edu.
1
I thank Bill Brown, Sabine Doeschl, Jeff Netter, Annette Poulsen, and seminar participants at Claremont McKenna
College for comments on prior drafts.
0929-1199/$ - see front matter 2007 Elsevier B.V. All rights reserved.
doi:10.1016/j.jcorpfin.2007.02.005
periods of time. These aspects of regulatory events compound the standard pitfalls of empirical
analysis such as endogeneity, confounding events, specification sensitivity, and statistical power.
In this paper, I review the body of theory and evidence on the economic study of regulation.
My goal is to draw on the extant literature to better shape the future estimation of the costs and
benefits of regulation. My emphasis will be on the regulation related to the U.S. Securities and
Exchange Commission (SEC). In addition to being consonant with the theme of this edition of the
Journal of Corporate Finance, there are particular reasons to devote attention to the SEC. Contrary
to world trends in privatization and deregulation (Shleifer, 1998), the powers of the SEC appear to
be expanding. For example, the SarbanesOxley Act moved the SEC beyond the simple
provision of disclosure to the more active mandate of actual corporate policy (Romano, 2005).
In juxtaposition to this expansion of the scope of the SEC, however, the courts continue to
monitor the decisions made by the agency. For example, recent decisions by the U.S. Court of
Appeals have tempered the SEC's efforts to impose broader governance requirements on the
mutual fund industry. Justice Ginsburg remanded the rulemaking back to the SEC for failing
adequately to consider the costs mutual funds would incur in order to comply with the conditions
and by failing adequately to consider a proposed alternative (Chamber of Commerce v. SEC, 366
U.S. App. DC 351 (June 21, 2005)). The tone of this ruling remarkably resembles the admonition
of SEC policymaking by George Stigler (1964a, pp. 117118) more than 40 years ago, where he
posed an essential research question: how does the [SEC] show that the changes it recommends
(a) will improve the situation, and (b) are better in some sense than alternative proposals?
Following Stigler's (1964a) call for research, a substantial literature has arisen on the
economics of regulation, including a large body of analysis of the SEC. Section 2 reviews the
central conceptual and measurement issues that have been raised by the regulation literature.
Section 3 then frames the various ways to model the specific regulation of the SEC. Section 4
surveys the historical studies of the costs and benefits of SEC regulation and Section 5 considers
some of the ongoing research on the current regulatory efforts of the SEC. Section 6 provides a
summary and conclusion.
2. Conceptual and measurement issues in the study of regulation
2.1. The underlying theory and testable hypotheses
George Stigler was the original advocate for the systematic study of the costs and benefits of
regulation. He called for the development of testable hypotheses on regulatory policies followed
by scientific analysis of pertinent data. See, for example, Stigler (1964a,b, 1971, 1972, 1974) and
Stigler and Friedland (1962).
To develop testable hypotheses, one must have a model of regulation. Economists have
developed at least two distinct regulatory models, which can be labeled the public interest theory
and the special interest theory. The public interest theory is the traditional statement that regulation
responds to market failure as an attempt to improve social welfare (for a critique, see Chapter 25 of
Alchian and Allen (1964)).
The special interest theory, by contrast, argues that regulation responds to various political
support groups. The motivation for this alternative depiction of regulation was the observation that
many regulations appear aimed not at consumer protection but instead at producer protection
(Stigler, 1971). Moreover, regulations also often appear to have differential effects on small versus
large firms in an industry (Stigler, 1974). The basic economic theory of regulation was extended
from a simple capture hypothesis to a broader special interest hypothesis by Posner (1971, 1974)
422 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
and Peltzman (1976). In a review of the empirical evidence, Peltzman (1989) compares and
contrasts the relevance of the public interest and special interest models of regulation. Hazlett
(1998) applies the different regulatory models to his query, Why did FCC license auctions take
67 years?
The contrasting underpinnings of the public interest and special interest models of regulation
have important implications for empirical research. Analysis of regulation faces a joint-hypothesis
problemsimilar to Fama's (1991) observations about tests of market efficiency. Any assessment of
the effects of regulation must be jointly tested with a model or models of regulation.
There are a number of reasons why it is important to be cognizant of the differing models
regarding the underlying basis for regulation. Certainly the predicted effects of a new regulation or
regulatory change will be fashioned by one's underlying model a public interest viewpoint
would likely have a different and possibly opposite prediction on the effects of a regulation on
firms in an affected industry than would the special interest theory. Similarly, the perception of a
regulatory policy that, say, inhibited entry would also be influenced by the assumed model of
regulation. The public interest model might view the entry barrier as excluding fraudulent firms
while the special interest model would pose such a barrier as an inhibition of competition. Overall,
the underlying model can position the burden of proof and the statistical power of empirical tests of
regulation. If one finds that a regulation has benefits that are not measurably different than the
costs, one's policy prescription on whether to maintain the regulation would be influenced by
one's priors formed by either the public interest or special interest framework.
The framing of the underlying model is particularly important when determining whether
regulation has unintended consequences. Peltzman's (1975) analysis of automobile safety reg-
ulation illustrates the classic example of unintended consequences. He found that the mandatory
provision of seatbelts reduced fatalities to drivers but had the offsetting effect of faster driving and
more pedestrian deaths. Peltzman (1975, p. 717) interpreted the results to contrast sharply with
the apparent intent of safety regulation.
Other analyses of safety regulation, however, offer greater ambiguity in inferring unintended
consequences. Peltzman's (1973) analysis of consumer protection in the drug industry found that
the legislation reduced innovation and raised prices. Was this an unintended consequence of
public interest legislation? Or was this instead consistent with a special interest model that
benefited incumbent firms in the drug industry at the expense of potential new entrants?
As another example, research of the 1971 federal ban on cigarette advertising on television
indicates that the regulatory change actually increased the shareholder wealth of U.S. tobacco
companies (Mitchell and Mulherin, 1988). Was this an unintended consequence of public-
minded, anti-smoking advocates such as the American Cancer Society? Or was the mandated
reduction in advertising instead a solution to a prisoner's dilemma faced by the special interests of
the tobacco companies? The queries related to these dichotomous perspectives persist in the
current congressional debate on tobacco ads (Martin, 2007). And as will be discussed below,
similar questions about the intended or unintended consequences of regulation also apply to the
securities industry.
2.2. General measurement issues in the study of regulation
There are also a number of measurement issues faced when studying the costs and benefits of
regulation. Many of these are standard factors such as endogeneity, confounding events, and
imprecision in data that occur in any empirical study. But these estimation issues are often
compounded by the lengthy and noisy nature of the regulatory process.
423 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
As predicted by theory, regulation is endogenous (Demsetz, 1967) and responds to economic
conditions (Peltzman, 1976). This makes it difficult to disentangle the effects of regulatory change,
especially at the aggregate level. These estimation difficulties reflect the issues in performing
counterfactual analysis (Fogel, 1962; McAfee, 1983). One prescription for regulatory endogeneity
is to include a control group not subject to the regulatory change (Stigler and Friedland, 1962).
Alternatively, a model based on a particular regulatory theory might generate cross-sectional
predictions of the expected effects (Posner, 1974; Watts and Zimmerman, 1978).
A related issue is that regulation often occurs at the time of confounding events. For example,
deregulation in industries such as banking and telecommunications has occurred amid tech-
nological change. Separating the effects of regulatory change fromtechnological change is thereby
difficult. However, temporal differences in regulatory change can often be used to parse the effects
of deregulation that is responding to technology. For example, Kroszner and Strahan (1999) use the
timing of banking deregulation across the 50 states to support special interest theory in the banking
industry. Mahoney (2003) uses a similar approach in studying the origin of state blue-sky laws.
2.3. Regulatory event studies
The prevalent use of the event study technique in the analysis of regulation gives rise to further
estimation issues. Event studies use securities prices to infer the changes in value due to an event
and are widely employed in financial economics (Fama, 1991).
Some care, however, is required when applying event studies technique to regulatory cases.
One aspect of regulatory change is that it often affects a number of firms at the same time, violating
the assumption of independence that gives power to event studies. A prescription is to conduct the
analysis at the portfolio level (Schwert, 1981). A related procedure is to develop tests of the cross-
sectional effects of a regulatory event (Mitchell and Netter, 1989).
A thornier issue in implementing regulatory event studies is that regulatory change occurs via a
lengthy and uncertain process making it difficult to pinpoint when the market responds to the new
regulation (Binder, 1985). The event window of a regulatory change from the initial development
in a congressional sub-committee to actual passage and implementation can encompass many
months or even several years. Such lengthy windows can make the estimates of the effects of
regulatory events very sensitive to the underlying model of expected returns, similar to the
observations of Fama (1998) in his critique of long-run performance studies. The concerns about
the appropriate estimation model are further compounded by the fact that theory (Peltzman, 1976)
posits that regulatory change can alter the risk of the affected firms.
One response to the problems raised by lengthy event windows is to attempt to specify the key
dates in the regulatory process. But this procedure remains sensitive to the ambiguity in isolating
what the key dates actually are. Not surprisingly, studies of a given regulatory event often reach
contrasting conclusions due to differences in the method of choosing key dates and in the
procedure for computing abnormal returns. Compare, for example, the analysis of OSHA cotton
dust standards by Maloney and McCormick (1982) that uses a broad event windowwith later work
by Hughes et al. (1986) that uses specific key dates.
Given the estimation issues inherent in regulatory event studies of shareholder wealth effects, a
useful supplement is to also measure operational data. For example, Gallet (1999) found that both
the advertising expenditures of U.S. tobacco companies and the level of competition in the
industry fell following the 1971 television advertising ban. This is consistent with the positive
wealth effects to the shareholders of the tobacco companies that had been reported by Mitchell
and Mulherin (1988).
424 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
3. Framing SEC regulation: public interest or special interest?
The fundamental role of the SEC is to induce publicly traded companies to provide disclosure
of material information. The Securities Act of 1933 applies to primary equity markets and
requires issuing companies to register the offerings with the SEC and to provide a prospectus
(Blum, 1938). The Securities Exchange Act of 1934 applies to secondary market trading and
requires publicly traded companies to produce regular filings and to disclose executive
compensation and insider trading (Benston, 1973; Jaffe, 1974). The 1934 Act originally applied
only to firms trading on organized exchanges (NYSE, Amex and regional exchanges) but was
extended to the over-the-counter market in 1964 (Greenstone et al., 2006) and the OTC Bulletin
Board in 1999 (Bushee and Leuz, 2005). The SEC also oversees the mutual fund industry
(Bosland, 1941a,b), proxy contests (Note, Harvard Law Review, 1956), and stock exchange
operations (Jarrell, 1984; Macey and Haddock, 1985).
One way to frame SEC regulation is a public interest model which motivates the existence of
the SEC by pointing to perceived market failures. Proponents of regulated disclosure argue that
without the SEC there would be a sub-optimal level of information provided to investors (Coffee,
1984). Much of the motivation for the SEC comes from the perceived flaws in securities markets
leading up to the Great Crash of 1929 (Seligman, 1983), although calls for federally mandated
disclosure to reduce fraud and tame insider trading were made many years earlier (Untermyer,
1915).
Of course, the disclosure requirements of the SEC are not without critics. Easterbrook and
Fischel (1984) concur with the regulatory proponents that the central issue is the impact of
information asymmetry on securities investors. But they question whether the federal mandates of
the SEC protect investors better than alternatives such as actions at the state level against fraud,
rules adopted by stock exchanges, and reputational forces in the marketplace. Their analysis
echoes Hayek's (1945, p. 522) observation that the method by which such knowledge can be
made as widely available as possible is precisely the problem we have to answer.
Consistent with the skepticism of Easterbrook and Fischel (1984), several authors suggest a
special interest rather than a public interest impetus for SEC regulation. Mahoney (2001) argues
that the SEC rules as to how and when information on securities offerings is disclosed subtly
created entry barriers that benefited the special interests of incumbent investment banks. Schwert
(1977) finds that the creation of the SEC had a significant, negative effect on the seat prices of the
NYSE and concludes that neither a nave public interest model nor a simple capture model
accurately depicts SEC regulation. In a political support model derived from Peltzman (1976),
Jarrell (1984) explains the deregulation of NYSE commission rates as a function of the interaction
between securities brokers, institutional investors, and small investors. Similarly, Haddock and
Macey (1987) model the evolution of insider trading laws in a political support framework that
includes insiders, market professionals, and outside investors.
The dichotomous public-interest and special-interest perspectives on information asymmetry
and federally-mandated disclosure can be cogently synthesized by comparing the views of two
Nobel laureates who have studied the economics of information: Joseph Stiglitz and George
Stigler. Stiglitz (2002) considers the private provision of information to be fraught with pervasive
market failures. From his information asymmetry models, he considers the SEC to be in the public
interest and infers support for SEC policies such as Regulation Fair Disclosure because the lack of
full disclosure undermines investor confidence (Dillon, 2001).
Stigler (1964b) is more skeptical of the mandated disclosure policy of the SEC. He points out
(p. 420) that information costs money, and no society is rich enough to get all the available
425 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
information. More importantly, Stigler (1964b) emphasizes that information can be provided
through many mechanisms in both the government and the private sector and that it is important to
compare the costs and benefits of such information mechanisms. Hence, the resolution of whether
the SEC is best framed in the public interest or by special interests is an empirical question. This
emphasis by Stigler on empirical analysis also cautions against falling into a Nirvana trap where a
positive-cost market setting is conceptually compared to an ideal, zero-cost regulatory world (see
Demsetz (1969) as well as Barzel (1977) and Coase (1974)). The next section considers the
empirical literature that has been spawned by Stigler's call for a costbenefit analysis of the SEC's
disclosure policies.
4. Historical analysis of the costs and benefits of SEC regulation
4.1. Analysis of the creation of the SEC
Analysis of the effects of SEC regulation dates nearly back to the creation of the agency itself.
Several papers written in the 1930s aim to empirically measure the impact of the creation of the
SEC on stock market liquidity. Dolley (1938) concluded that the SEC impeded markets as
evidenced by a reduction in market liquidity measured by dividing aggregate trading volume by
overall market returns. This research sparked critiques by Sweezy (1938) and Beach (1939) who
questioned Dolley's estimates of liquidity as well as the presumption that more liquidity was
preferred to less.
The systematic analysis of the costs and benefits of SEC regulation originated in the 1964
paper by George Stigler (1964a). In a biting piece on the 1963 Special Study of the SEC (US SEC,
1963), Stigler (1964a) chastised the commission for its lack of rigorous analysis of the issues
facing securities markets. Stigler (1964a, p. 120) labeled the SEC study a promiscuous collection
of conventional beliefs and personal prejudices rather than an objective treatment of testable
hypotheses. He argued (p. 124) that it is possible to study the effects of public policies, and not
merely assume that they exist and are beneficial.
The basic test that Stigler (1964a) proposed, was, as he noted (p. 120), simplicity in itself.
His primary research question (p. 120) was how did investors fare before and after the SEC was
given control over the registration of new issues? To conduct his experiment, Stigler studied the
post-issue performance of public offerings in the 19231928 pre-SEC period with offerings in the
19491955 post-SEC period. To control for overall market factors, he measured the ratio of
individual issue performance relative to market indexes. His results (p. 120) indicated that In
both periods it was an unwise man who bought new issues of common stock. In both the pre-and
post-SEC periods, investors in new issues lost roughly the same amount of money in the two
years following the offering. From these results, Stigler (1964a, p. 124) concluded that grave
doubts exist whether if account is taken of costs of regulation, the SEC has saved the purchasers
of new issues one dollar. Subsequent analysis by Jarrell (1981) and Simon (1989), which use
broader data and more sophisticated models of expected returns such as the capital asset pricing
model and arbitrage pricing theory, report similar results on no improvement in mean new issue
performance following the creation of the SEC.
Stigler (1964a) also found (page 122) that the variance of post-issue performance was greater
in the pre-SEC period. Jarrell (1981) and Simon (1989) report similar results. Stigler (1964a)
noted that this might simplistically be interpreted to say that the SEC reduced volatility, an
interpretation made by Friend and Herman (1964). But Stigler states (1964a, p. 122) that a more
plausible explanation lies in the fact that many more new companies used the market in the 1920s
426 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
than in the 1950s fromone viewpoint a major effect of the SECwas to exclude newcompanies.
Jarrell (1981, p. 668) concurs that a likely effect of the SECwas to raise the costs of relatively risky
new issues and Simon (1989) suggests that this led to the growth of new issues being placed on the
unregulated over-the-counter market. More recent analysis by Mahoney and Mei (2006) of the bid-
ask spreads and volatility of NYSE-listed securities finds no evidence that the creation of the SEC
reduced information asymmetry.
The contribution of Stigler (1964a) and subsequent analysis is its guidance in doing rigorous
analysis of the costs and benefits of regulation. A possible shortcoming, however, is its focus on a
broad before/after analysis of a major regulatory event which effectively treats the pre-regulatory
period as the control sample. The SEC came after the 1929 crash (May, 1939), an endogenous
response not unlike the impetus of other major securities legislation (Banner, 1997). It is
problematic to study variables such as risk and return before and after such an endogenous event.
Indeed, Officer (1973) measures aggregate market volatility in the period between 1897 and 1969
and concludes that any decline in market volatility subsequent to the creation of the SEC was a
normal reversion to the mean rather than stemming from the SEC itself.
An improvement over the simple before/after analysis is to have a control sample that is not
directly affected by the regulatory event. As noted by Stigler and Friedland (1962, p. 1), Whether
the statutes really have an appreciable effect on actual behavior can only be determined by
examining the behavior of people not subject to the statutes. As an example, Smith (1981, p. 681)
suggests comparing the newly-regulated U.S. market with the unregulated Canadian market in the
period surrounding the creation of the SEC.
Several studies have attempted an analysis of an unregulated control group around the creation
of the SEC. Benston (1973) studies the effect of the disclosure requirements of SEC regulation by
contrasting firms that did and did not disclose accounting information, namely sales data, prior to
the creation of the SEC in 1934. He found that the change in return volatility following the
creation of the SEC was no different for the firms that had previously disclosed sales information
than from the firms that had not previously disclosed information. From these results, Benston
(1973, p. 149) concluded that the disclosure provisions of the '34 Act were of no apparent value
to investors. Such conclusions were contested by Friend and Westerfield (1975) who questioned
whether a control group based on the pre-SEC disclosure of sales adequately separated firms that
would or would not have been affected by the creation of the SEC.
Chow (1983) performs analysis of the imposition of the SEC disclosure requirements that
more distinctly controls for regulated and unregulated firms by studying both newly regulated
NYSE-listed firms as well as a control sample of unregulated over-the-counter firms. Using event
study analysis around key regulatory dates, Chow (1983) finds that the 1933 Securities Act had
negative wealth effects on the shareholders of newly-regulated NYSE firms vis--vis the
unregulated OTC firms. The effect appeared to be inversely related to firm size, which Chow
(1983, p. 514) suggested was due to increased out-of-pocket compliance costs.
4.2. Extension of SEC disclosure requirements
More recent research has studied the effects of SECdisclosure policy by analyzing the extension
of SEC regulation to firms trading over-the-counter in 1964 and to firms trading on the over-the-
counter bulletin board in 1999. As noted by Ferrell (2003, pp. 45) such analysis has several
potential advantages over the studies of the original imposition of SECdisclosure requirements. For
one, the newSEC authority was granted in time periods that were less economically severe than the
1929 Crash and subsequent depression. Second, the regulated firms on organized exchanges
427 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
provide a natural control group for the newly-regulated firms in the over-the-counter market.
Further, the new disclosure laws did not affect all over-the-counter firms equally.
Greenstone et al. (2006) study the extension of SEC disclosure requirements to the over-the-
counter market in 1964. A novel contribution of their analysis is the use of a database of the
weekly stock returns of 1196 OTC securities in the 1963 to 1966 period that was hand-collected
from Barron's. They perform an event study over the January 1, 1963, to November 15, 1965,
period over which the legislation extending the SEC authority was debated and implemented.
They contrast the abnormal returns of the OTC firms most affected by the new regulation with a
control sample of NYSE/AMEX firms that were already subject to disclosure regulation.
Greenstone et al. (2006) find that the most affected OTC firms had significant, positive returns
during the regulatory event period. Not surprisingly, given the nearly three-year event window,
they report (p. 403) that the significance of the difference between the OTC firms and the control
group of NYSE/AMEX firms is sensitive to the method of computing abnormal returns.
Ferrell (2003) performs related analysis of the 1964 regulatory changes on a sample of 762
OTC firms taken from Barron's. He finds that the volatility of the returns of the OTC firms fell
relative to a control sample of exchange-listed companies.
Bushee and Leuz (2005) analyze the extension of SEC disclosure requirements to the OTC
Bulletin Board (OTCBB). They contrast OTCBB firms that were already compliant with the new
regulations with those that were not. For key dates around the passage of the regulation, Bushee
and Leuz (2005) find that the already compliant firms had positive abnormal returns while the
non-compliant firms suffered a wealth lost. Consistent with the stock return data, they also find
that the already compliant firms experienced an increase in liquidity while the non-compliant
firms suffered a reduction in liquidity. Indeed, a large majority of the non-compliant firms chose
to leave the OTCBB and trade on the less active Pink Sheets, an effect that Bushee and Leuz
(2005, p. 261) compare to the initial imposition of SEC disclosure requirements in the 1930s.
4.3. Summary of the historical analysis
The review in this section of the historical analysis of SEC regulation attests to the difficulty in
estimating the costs and benefits of regulation. The noisy, lengthy regulatory process gives rise to
endogenity issues, confounding events, selection concerns, and other obstacles. Hence, there are
still many questions from the historic analysis as to whether the benefits of the disclosure polices
of the SEC outweigh the costs. In many respects, the estimation obstacles inherent in the analysis
of regulation resemble those described by Lyon et al. (1999) in their review of methods for testing
long-run abnormal returns, analysis which they label as treacherous.
Stigler (1972) acknowledges the difficulty in constructing tests that isolate the effects of
regulation. But he strongly argues that the difficulty of such analysis does not provide an excuse
for refraining from such efforts. He states (1972, p. 7) that we can isolate the effects of policies
with improving precision and with further study the conclusions can be made more definite and
more reliable. The following section reviews the efforts in current research to surmount the
difficult estimation issues so as to learn more about the costs and benefits of SEC regulation.
5. Current topics in SEC regulation
There are a number of important, current topics related to SEC regulation including the impact
of the SarbanesOxley Act, SEC regulation of mutual funds, and the effect of Regulation Fair
Disclosure. This section reviews the literature on these topics with an eye toward the obstacles
428 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
facing the analysis of these new regulations, the methods used to overcome such obstacles, and
suggestions for future research.
5.1. The SarbanesOxley Act
The SarbanesOxley Act of 2002 has significantly expanded the authority of the SEC in
regulating corporate governance. As described by Romano (2005), a notable feature of the Act is
that it went beyond the traditional disclosure requirements of securities regulation to actual
mandates of the structure of corporate governance. Specific mandates contained in the new
regulation include the requirement that corporations have independent audit committees, the
prohibition of corporate loans to officers, and the requirement of executive certification of financial
statements (Karmel, 2005).
Recent work has attempted to estimate the overall effect of the SarbanesOxley Act on the
shareholder wealth of publicly traded corporations in the U.S. As discussed earlier, this is an
extremely difficult task. The Act reacted to a sequence of collapsing firms including Enron in
November/December 2001 and Worldcom in June 2002. Moreover, as is typical of legislation,
the Act evolved through Congress over a lengthy period, ranging from a number of con-
gressional hearings in the first half of 2002 to the signing of the Act by the president at the end of
July 2002.
The reactive nature of the regulation and the lengthy period over which it evolved makes it
difficult to determine when the market absorbed the news about the passage of the Act. Due to this
uncertainty in determining the specific timing of the market reaction, Chhaochharia and Grinstein
(2005) used a lengthy window from November 2001 to October 2002 to capture all of the news
related to the regulation. By contrast, Jain and Rezaee (2005), Li, Pincus and Rego (2006), and
Zhang (2005) determine the key dates on which the market became aware of the regulation,
although these studies differ as to what these key dates are.
Given the ambiguities in the dating of the markets reaction to the SarbanesOxley Act, it is not
surprising that the studies do not produce consistent results. Zhang (2005) reports that the Act had
an overall negative impact on the U.S. stock market. By contrast, Chhaochharia and Grinstein
(2005), Jain and Rezaee (2005), and Li, Pincus and Rego (2006) report that the Act had an overall
positive effect. Moreover, even the studies that report the same overall effects of the Act, reach
different conclusions on the cross-sectional effects of the new legislation. For example, Jain and
Rezaee (2005) report that the Act tended to enhance the value of the firms already in compliance
with the mandates of the Act, while Chhaochharia and Grinstein (2005) report that the Act
increased the value of the firms that were not in compliance with the Act.
Several papers have taken steps to mitigate the ambiguity in the analysis of the overall impact
of the SarbanesOxley Act on shareholder wealth. A primary difficulty in determining the overall
effects of the Act is one that plagues any counterfactual study, the lack of a control sample. Litvak
(2007-this issue) surmounts this problem by studying the effects of the SarbanesOxley Act on
cross-listed, non-U.S. ADRs that were subject to the Act. As a control sample, Litvak (2007-this
issue) uses matched firms based on country, industry and size. She performs an event study of 14
key dates during the passage of the Act and finds that, relative to the matched firms, the regulated
ADRs experienced negative abnormal returns. Smith (2006) performs similar analysis and
concludes that for cross-listed firms the anticipated costs of SarbanesOxley outweigh the
benefits.
Another improvement over the aggregate studies is to formally model the anticipated cross-
sectional effects of the constraints imposed by the new regulation. Wintoki (2007-this issue)
429 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
considers the portion of the SarbanesOxley Act that mandates greater independence in corporate
board structure. He argues that this one-size-fits-all approach to corporate governance will
conflict with the endogenous governance response by corporations to information and transaction
costs (Demsetz and Lehn, 1985). He separates firms into portfolios based the costs and benefits of
outside monitoring and then studies these portfolios in calendar time over the period from January
15, 2002, to August 15, 2002, during which the Act was originated and passed. He finds that the
portfolio of firms with high outside monitoring costs and low outside monitoring benefits suffered
a wealth loss from the SarbanesOxley Act. He interprets his results to say that the Act imposes
net costs on young, small growth firms.
A useful supplement to the event study analysis of regulation is to look beyond stock prices to
actual operational effects. Linck et al. (2007) perform such analysis by estimating the effects of
the SarbanesOxley Act and other governance mandates of the era on the supply and demand of
directors. Using data from the 1990 to 2004 period, they find that following the Act, corporate
boards are bigger, more independent and meet more often. Correspondingly, governance costs
such as director pay and director and officer insurance has risen, with smaller firms affected
disproportionately. While the greater board independence documented by Linck et al. (2007)
appears to be an intended consequence of the legislative mandates, it is not clear that such
independence has improved corporate performance. Moreover, their research raises the question
as to whether higher director pay and larger boards were the intended results of the architects of
the new governance standards.
Future work in this area might consider the political economy of the SarbanesOxley Act. Was it
quack corporate governance (Romano, 2005)? Did it have unintended consequences (Linck et al.,
2007)? Or was it a response to special interests and, if so, to which such political support groups?
Recent research by Hochberg et al. (2006) moves in this direction by studying the wealth effects of
the SarbanesOxley Act as a function of whether the insiders of a particular corporation lobbied
against the Act.
5.2. Mutual fund governance
In addition to implementing the new regulations on the governance of public traded
corporations mandated by SarbanesOxley, the SEC has also been attempting to mandate new
governance standards for mutual funds. Specifically, the SEC aimed to mandate that mutual funds
have independent chairmen and that the fraction of independent directors on the boards of
directors of mutual funds be increased to 75% (US SEC, 2005). The SEC's oversight of mutual
fund governance traces back to the Investment Company Act of 1940 which prescribed for
investment companies a comprehensive and intricate guide to their future conduct (Bosland,
1941a p. 477) including registration with the SEC and a mandate that the board of directors of an
investment company be composed of at least 40% outside directors (Bosland, 1941b). Like the
SarbanesOxley Act, the recent SEC's actions regarding mutual fund governance came after
reported market malfeasance including late trading and market timing (Mahoney, 2004).
The U.S. Court of Appeals has remanded the newly proposed rules on mutual fund governance
back to the SEC for further consideration. A main reason given by the court was that the SEC
failed to consider adequately the costs of the new rules and had also failed to adequately consider
a proposed alternative that would simply require disclosure of mutual fund governance (Chamber
of Commerce v. SEC, 366 U.S. App. DC 351 (June 21, 2005)). The court also noted that the
chairman of the SEC had shown a dismissive attitude toward the value of empirical data in
policymaking (Brewster et al., 2005).
430 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
Indeed, there is far from conclusive evidence in support of the SEC's call for greater board
independence at mutual funds. Tufano and Sevick (1997) find that board independence is
associated with lower fees in a sample of open-end mutual funds in 1992 and Del Guercio et al.
(2003) find a similar result for closed-end funds in 1996. However, in more recent data from
2002, Ferris and Yan (2007-this issue) find that fund fees are related neither to board
independence nor the presence of an independent chairman. Similarly, in data from 2003,
Meschke (2005) finds no relation between fees and board independence, especially after
controlling for the endogenous factors that determine board composition in the first place.
In a report related to mutual fund governance (US SEC, 2005), the SEC acknowledged the lack
of a consensus of any effects of mutual fund governance on fund performance or fees, but stated
(p. 2) that it's new rules were aimed at providing oversight and preventing scandals rather than at
performance or fees. Yet the research by Ferris and Yan (2007-this issue) finds no relation
between recent scandals and board or chairman independence.
From a more methodological perspective, the SEC (US SEC, 2005 pp. 7173) acknowledges
that the analysis of mutual fund governance, fund performance and fees is sensitive to both
sample and specification. Yet the SEC concludes (p. 73) that, Finding no relation in the data does
not confirm that no economically significant relation exists between fund governance and
performance. The triple negative in this sentence is not only grammatically poor but is also
statistically vacuous. The tone of this conclusion is exactly the type of analysis criticized by
Stigler (1964a,b) in his path breaking analysis. Rather than follow Stigler (1964b, p. 416) and
present explicit hypotheses and test them by developing techniques of the social sciences, the
SEC in the area of mutual fund governance has relied upon the a priori case for protecting
investors plus the scandals revealed Presumably the recent admonition by the courts will
prompt the SEC to be more rigorous in its approach to policymaking.
Future research on mutual fund regulation might attempt to discern the potential winners and
losers under the governance structure proposed by the SEC. Writing in 1971, George Stigler (p. 5)
conjectured that newly proposed SEC regulation would inhibit entry in the mutual fund industry
to the benefit of large, incumbent funds. Are such forces at play in the current debate on mutual
fund governance?
5.3. Regulation fair disclosure
In 2000 the SEC adopted Regulation Fair Disclosure (FD). The stated aim of the regulatory
change was to end the practice of selective disclosure whereby certain stock market analysts were
said to gain privileged access to information on U.S. corporations. The new regulation required
that firms release information on data such as earnings either broadly to all interested market
participants or not at all, a sort of information socialism. In some respects, the underpinnings of
this regulation parallel that of insider trading rules where insiders must either disclose or abstain
from trading. In both cases, disclosure is not mandated, but instead there cannot be selective gain
from non-disclosed information.
Research on Regulation FD has addressed the effects of the new regulation on proxies for
information asymmetry such as stock return volatility, trading volume, and bid-ask spreads. The
research has also studied the changes in the response by the stock market to earnings forecasts and
other analyst announcements. Hence, in contrast to much of the analysis of the SarbanesOxley
Act which has focused on the wealth effects of the new regulation, the analysis of Regulation
FD has focused on the effects of the regulation on the information environment in the stock
market.
431 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
One impediment to discerning the effects of Regulation FD is that it came at the time of
significant confounding events including stock market decimalization. Regulation FD became
effective on October 23, 2000 while the NYSE and AMEXfully decimalized on January 19, 2001,
and NASDAQ fully decimalized on April 9, 2001. Because a reduction in tick size has been
shown to affect observed measures of information asymmetry such as volatility and bid-ask
spreads (Bessembinder, 2003; Ronen and Weaver, 2001), the contemporaneous decimalization
of U.S. stock markets makes it difficult to perform before and after studies of the effect of
Regulation FD.
There is some evidence that Regulation FD lessened the information advantage of analysts.
Both Heflin et al. (2003) and Gintschel and Markov (2004) report a reduction in the price impact of
analysts forecasts. Eleswarapu et al. (2004) report a reduction in the adverse selection component
of the bid-ask spread around earnings announcements.
While the evidence around analyst forecasts and earnings announcements suggests a leveling of
the playing field, the question remains as to whether Regulation FD actually improved the
information flow to investors. Irani and Karamanou (2003) and Moharanram and Sunder (2003)
report a decline in analyst coverage following Regulation FD. Bushee et al. (2004) report a decline
in conference calls by firms that had held closed conference calls prior to Regulation FD.
Other research argues that much of the reported effects of regulation FD on the information
environment stems from confounding events. Bailey et al. (2003) report no significant change in
the price impact of earnings releases after controlling for the effects of decimalization. Similarly,
Collver (2007-this issue) reports a decline in measures of informed trading following Regulation
FD but attributes the bulk of these effects to decimalization rather than the regulation itself.
Francis et al. (2006) use a control sample of ADRs that were exempt from the new regulation and
conclude that Regulation FD had no unique effects on the information environment of U.S.
corporations.
As in the case of the SarbanesOxley Act, there is some evidence that Regulation FD had
disproportionate effects on small firms. Agrawal et al. (2006) find that Regulation FD led to less
accurate analyst forecasts, especially for small firms. Gomes et al. (2007-this issue) report that
Regulation FD reduced information production and had a disproportionate effect on small firms
conveying complex information. Ahmed and Schneible (2007-this issue) report that the quality of
information for high technology firms deteriorated after Regulation FD.
Future research might consider the political economy of these differential effects of regulation.
Should the disproportionate effects on small firms be considered unintended consequences, as
suggested by a public interest model, or should the effects be considered a direct result of
competing special interests? In particular, how might the effects of Regulation FD affect the
competitiveness of new entrants vis--vis incumbent firms?
Another topic with promising returns is the impact of Regulation FDon the various competitors
in the provision of information. Cornett et al. (2005) report that Regulation FD has reduced the
advantage of analysts affiliated with investment banks. Jorion et al. (2005) find that Regulation FD
has increased the information advantage for credit rating agencies that are excluded from the
regulation. Future research might consider more broadly the effect of Regulation FDon the various
special interests that provide information on publicly traded firms.
6. Summary and conclusion
The basic question related to measuring the costs and benefits of securities regulation is posed
by Alchian (1977, p. 227): Though we know securities regulation is what securities regulators
432 J. Harold Mulherin / Journal of Corporate Finance 13 (2007) 421437
do, we may not know the why. One may wonder why we insist that all public, corporate firms
reveal information. Developing analysis to address this fundamental query is a challenging task.
However, prior and ongoing research on the SEC and regulation in general provide important
lessons to guide future studies.
An essential starting point is that there are multiple models of regulation ranging from public
interest to special interest. The public interest model relies on market failure to motivate policy
changes. However, the apparent market failures motivating the creation of the SEC, the now-
repealed Glass Steagall Act, and other securities regulation have been hard to detect in actual
empirical scrutiny (Bosland, 1941a; Kroszner and Rajan, 1994; Mahoney, 1999). The lack of
evidence of market failure, and the absence of identifiable regulatory corrections, suggests that
regulation can serve special interests rather than the public interest.
Because of the multiple motivations for regulation, researchers should avoid the Nirvana
fallacy (Demsetz, 1969) that conceptually compares a positive cost market with a zero-cost
government. This caution is particularly relevant for the regulation of corporate governance such
as the SarbanesOxley Act which aims to solve the agency costs of corporate management via
apparently benevolent agents within the government.
The multiple possible motives for government regulation also create ambiguity in determining
whether government regulation has unintended consequences. Several studies of the Sarbanes
Oxley Act and Regulation FD conclude that the new regulation had the unintended consequence
of disproportionately imposing costs on small firms. But while such an effect might be deemed
unintended in a public interest framework, it is often a direct prediction of a special interest model
(Stigler, 1974) in which regulators are captured by incumbent firms.
In addition to the issue of whether the consequences of regulation are unintended, an
important question is whether different components of regulation can act at cross purposes? For
example, the SarbanesOxley Act has aspired to improve corporate monitoring while Reg-
ulation FD has aimed at reducing the advantages of informed investors. Recent research by
Gaspar and Massa (2007), however, emphasizes that informed investors can play any important
monitoring role. Roe (1990) more generally elucidates the tension in U.S. securities law
between investment constraints and corporate governance. Hence, an important contribution of
future research can be to jointly study the effects of seemingly disparate pieces of recent
securities legislation. In particular, might any leveling of the playing field caused by Regulation
FD have detrimentally affected the monitoring that Sarbanes Oxley sought to bolster?
Finally, both regulation and the research on its effects should avoid a one-size-fits all
approach (Mulherin, 2005). As observed by Diamond (1999, p. 157), We tend to seek easy,
single-factor explanations of success. For most important things, though, success actually
requires avoiding many separate causes of failure. In terms of the United States and its
securities markets, is success tied to the specific disclosure policy of the SEC or instead due to a
more general avoidance of failure in the economy, monetary policy, and the court system?
Certainly this essential question should be part of any costbenefit analysis of securities
regulation.
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