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The Impact of Regulation Fair Disclosure: Trading costs and
Information asymmetry
Venkat R. Eleswarapu *
Rex Thompson *
and
Kumar Venkataraman *
First Draft: October 2001
This Draft: February 2003
• Eleswarapu,
veleswar@mail.cox.smu.edu
, Thompson,
rex@mail.cox.smu.edu
and Venkataraman,
kumar@mail.cox.smu.edu
, Edwin L. Cox School of Business, Southern Methodist University, P.O.Box
750333, Dallas, TX 75275-0333. We thank Hank Bessembinder, Selim Topaloglu, Wanda Wallace, and
seminar participants at the Frank Batten Young Scholars Conference, the 2002 Financial Management
Association Meetings, Texas Christian University, Texas Tech University and Southern Methodist University
for their comments and Zhu Liye for research assistance. We are especially grateful to an anonymous referee
and to Paul Malatesta, the Editor for many helpful suggestions. Also, we acknowledge the use of the analysts’
data from IBES. Thompson is the Collins Professor of Finance and acknowledges the financial support of his
chair.
 The Impact of Regulation Fair Disclosure: Trading costs and
Information asymmetry
Abstract
In October of 2000, the Securities and Exchange Commission (SEC) passed Regulation
Fair Disclosure (FD) in an effort to reduce selective disclosure of material information by firms
to analysts and other investment professionals. We find that the information asymmetry reflected
in trading costs at earnings announcements has declined after Regulation FD, with the decrease
more pronounced for smaller and less liquid stocks. Return volatility around mandatory
announcements is also lower but overall information flow is unchanged when mandatory and
voluntary announcements are combined. Thus the SEC appears to have diminished the advantage
of informed investors, without increasing volatility.
Keywords: Trading costs, Information asymmetry, Regulation Fair Disclosure, Return volatility
I. Introduction
Effective October 23, 2000, the Securities and Exchange Commission (SEC) passed
Regulation Fair Disclosure (Regulation FD) that prohibits selective disclosure of material
information to analysts and other investment professionals. Under the regulation, any intentional
disclosure of material non-public information by firms to analysts or other parties must be
simultaneously released to the general public. Unintentional disclosures must be disclosed
publicly within 24 hours
1
. Both proponents and critics expect the rule to have far-reaching
effects on the efficiency of financial markets and the structure of the financial services industry.
The intended objective of the regulation was to provide equal access to firm disclosures.
If equal access is improved, then the amount of asymmetric information in the securities market
should decline subsequent to the regulatory adoption. Our investigation attempts to measure
changes in the amount of asymmetric information, as reflected in the adverse selection
component of trading costs, for a sample of NYSE firms that traded both before and after the
regulation. To enhance the power of the investigation, we focus on trading days surrounding the
release of earnings information, where information asymmetry is elevated. As an adjunct, we
also examine the regulatory impact on total information flow through an investigation of stock
return volatility.
Parallel research into the total impact of the regulation is building. For example, Heflin,
Subramanyam and Zhang (2003) look at return variability around earnings announcements and find
an apparent reduction due to the regulation. Agarwal and Chadha (2002), Janakiraman,
Radhakrishnan and Szwejkowski (2002) and Zitewitz (2002) look for changes in analyst forecast
accuracy with mixed results. Topaloglu (2002) finds that institutional trading activity after earnings
1
Details about what constitutes a violation of Regulation FD as well as remedies and penalties are summarized, for
example, in Bellezza, Huang and Spiess (2002).
1
announcements is relatively higher after Regulation FD than before. Sundar (2002) finds evidence
of a decrease in information asymmetry around conference calls for firms that employed restricted
disclosure practices before the regulation. Straser (2002) finds mixed results for changes in the
probability of informed trading. Bellezza, Huang and Spiess (2002), using data from the period
before the regulation, find no evidence of selective disclosure around voluntary earnings
announcements, thus casting a vote against any impact of regulation.
Our tests for changes in the adverse selection component of trading costs indicate a
decline after the adoption of Regulation FD. Thus we conclude that the regulation appears to
have reduced the degree of preferential access to material information around earnings
announcements. In cross-section, the results suggest that uninformed traders in less liquid firms
obtain the greatest benefit from reductions in asymmetric information and trading costs. Our
analysis of stock return volatility indicates no material change in total information released
through announcements when both mandatory and voluntary earnings announcements are
combined. This supports the SEC’s conjecture that increased public disclosures along with
recent technological advances in web communications allow firms to effect the same information
flow as before regulation
2
. In further corroboration, market model residual variance shows no
significant change, either in non-announcement periods or across all trading days.
This paper is organized as follows. Section II provides a brief model of how asymmetric
information costs due to Regulation FD can be isolated. Section III presents measures of trading
costs and information asymmetry, while Section IV contains the sample description. Empirical
results for trading costs are presented in Section V. Section VI describes results for stock return
volatility and information flow, while section VII concludes.
2
Recent surveys suggest that companies are now more frequently “web-casting” important information releases and
analyst meetings as well as using an open conference call format (See Sundar (2002)).
2
II. Modeling the Impact of Regulation FD
It was reportedly a common practice before Regulation FD for corporate officials to
discuss the future outlook of their companies and provide guidance on earnings forecasts to
select groups of analysts and large shareholders through meetings, conference calls and phone
conversations. Specific examples of such selective disclosure are summarized in the final report
of the regulation (SEC(1999)). Also, it was alleged that companies were providing material
information to analysts as a reward for obtaining favorable ratings and recommendations. The
analysts could trade on this information or exchange it to large clients for brokerage business.
The trading advantages attendant to these selective disclosure processes, if accurately depicted in
the claims, contributes to the asymmetric information costs faced by uninformed traders.
Regulation FD was intended to reduce the extent of such informed trading by forcing firms to
either disclose information to everyone or disclose less information.
In opposition, if the regulation causes less information disclosure as suggested in recent
surveys by the Securities Industry Association (SIA) (2001) and the Association for Investment
Management and Research (AIMR) (2001), then it can result in less informative prices and a
greater trading advantage for those able to discover the information through other channels. For
example, less disclosure might give a greater informational advantage to corporate insiders,
managers of competitors, as well as the most resourceful analysts and investors. Since the
asymmetric information component of trading costs captures the combined effects of the
likelihood of encountering an informed trader and the extent of his or her informational
advantage, the regulation could either increase or decrease trading costs. Our investigation is
designed to differentiate between these alternatives.
3
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