The Lemons Problem: How Less Disclosure Affects Risk Perceptions by Knowledge@Wharton
When the JOBS (Jumpstart Our Business Startups) Act became law in 2012, one provision allowed firms to reduce the amount of information that they provide to investors before an IPO. This was meant to make it easier for smaller firms to get outside investors. Research co-authored by Wharton accounting professor Daniel Taylor finds that those shortcuts have had some unintended — and costly — consequences. The paper, “The JOBS Act and Information Uncertainty in IPO Firms,” was authored by Taylor, Mary E. Barth of Stanford University’s Graduate School of Business and Wayne R. Landsman of the University of North Carolina’s Kenan-Flagler Business School.
In this interview with Knowledge@Wharton, Taylor discussed the impact of that increased information uncertainty, both on investors and the companies seeking to go public.
An edited transcript of the conversation appears below.
The Cost of Easier IPOs:
In our research, we looked at the IPO market — firms that aren’t publicly traded yet, but are going public on the New York Stock Exchange or the NASDAQ. We look at the price that they go public at, their future returns, and the volatility or risk associated with those companies. And then we correlate those measures with the amount of disclosure that the firm has at the time of its IPO.
There was a rule that came out back in 2012 called the JOBS Act. The JOBS Act allowed firms to reduce the amount of information that they provide to investors. A lot of your viewers or your readers are probably familiar with SEC filings. You’ve got to file several financial statements with the SEC, income statements, balance sheets, etc., and disclosures relating to things like management compensation [before going public].
“When you observe a firm scale back its disclosure, they’re doing that for a reason.”
[One thing] the JOBS Act did was reduce the amount of information that the firm is required to provide to the equity market before going public. And a natural question is, when you reduce the amount of information, are you increasing the risk of [investing in] the company? How do investors respond to that? We try to answer that question by looking at what actually happened after regulation.
What we end up finding in the study is that after the JOBS Act, the IPOs that are going public and reducing their disclosures are actually substantially riskier. Just think about a world in which the SEC requires all IPOs to go through a screening process and provide these mandatory disclosures. And then, the legislative branch of government comes along and says, “Well, let’s actually scale that back. Let’s only require them to do two years’ worth of screening as opposed to the prior three years.”
You can imagine that’s going to have the effect of potentially bringing different companies to the market. The analogy would be, [if] you go to a used car lot: Suppose the government requires that when you purchase a used car, the car dealer had to give you basically a spec sheet on what the car’s been doing, what the car’s life was.
Then the government comes along and says, “Well, we’re not going to require that anymore. Car dealers can do it voluntarily.” Now when you go to the car dealer, some cars have the spec sheet and other cars don’t have the spec sheet. What do you infer about the cars that don’t [have them] — or the car dealers that don’t offer you the spec sheets? This is what we call a “lemons problem” — where you have companies that aren’t disclosing as much anymore. And the question is: Why are they not disclosing much anymore?
We find that those companies that don’t disclose are indeed much, much, much riskier. That’s sort of the key punch line of the study: When you observe a firm scale back its disclosure, they’re doing that for a reason. And investors become more uncertain, and that generates risk for the company.
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