Why Antifraud Provisions Are Not Enough: The Significance of Opportunism, Candor and Signaling in the Economic Case for Mandatory Securities Disclosure
Joseph A. Franco
Suffolk University Law School
Columbia Business Law Review, Vol. 2002, pp. 223-362
Even in the face of recent evidence of pervasive market failure in issuer disclosure, many continue to argue that U.S. securities markets have experienced merely a problem of antifraud enforcement and that mandatory disclosure as a policy is largely irrelevant to these events. This article challenges the view that market incentives, supplemented by government enforcement of antifraud prohibitions alone, are sufficient to lead issuers to choose voluntarily socially optimal levels of disclosure. Informational asymmetry between issuers and investors impairs economic efficiency by enabling less candid issuers to impose a negative externality on the disclosure of candid issuers. This problem is not plausibly redressed by antifraud prohibitions alone because investors generally will be unable to infer the true state of affairs based solely on an issuer's voluntary disclosure. The financial economics literature reveals that the conditions necessary to support unraveling or invertability (i.e., the ability to infer the true informational state of affairs based merely on observed voluntary disclosure) are not present in securities markets. Mandatory disclosure provides a useful remedy to some aspects of this asymmetry problem. Mandatory disclosure requirements, like antifraud prohibitions, establish a mechanism by which candid issuers are better able to signal their candor so that investors value candid issuers' disclosure more highly. Unlike antifraud prohibitions that promote issuer credibility by enhancing the accuracy of affirmative issuer representations, mandatory disclosure is aimed at making disclosure more candid by limiting issuer discretion to conceal information. These considerations provide support for why mandatory disclosure as a signaling mechanism is superior to private signaling (or issuer choice) mechanisms, such as issuer self-signaling, collective private-ordering arrangements, or jurisdictional competition. In jurisdictions with comprehensive disclosure requirements, such as the United States, mandatory disclosure requirements are generally qualitatively superior than voluntary disclosure schemes because they more effectively constrain issuer discretion in the disclosure process. Although mandatory disclosure may be more costly than issuer choice methods, the disparity in cost is frequently overstated and misunderstood. If costs are properly formulated, the social gains from enhanced credibility under mandatory disclosure will likely outweigh the additional disclosure costs. This article also examines other economic justifications for mandatory disclosure based on the existence of positive informational externalities or excessive private information gathering by investors and concludes that the justification based on the corrosive effects of informational asymmetry on issuer credibility is more compelling.
Number of Pages in PDF File: 138
Keywords: Securities, Mandatory disclosure
JEL Classification: K22, G18, G28, D82Accepted Paper Series
Date posted: November 21, 2002
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