Are foreign issuers complying with Regulation Fair Disclosure?

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Abstract

Regulation Fair Disclosure (RFD) requires that any release of material information be made to the general public rather than to select individuals. The regulation represents an attempt by the Securities and Exchange Commission to restore a level of fairness to the market. Foreign issuers, however, are currently exempt from this rule. We examine liquidity changes around earnings announcements of American Depository Receipts (ADRs) before and after the introduction of RFD. We find that market makers have adjusted spreads to reflect the new, less information asymmetric environment for U.S. issues, but the same changes are not observed for our ADR sample. Similarly, the decline in activity measures of U.S. issues is not observed in our ADR sample. Our results suggest that investors and market makers are not yet convinced that foreign issuers are complying with RFD.

Introduction

On 23 October 2000, the Securities and Exchange Commission (SEC) implemented Regulation Fair Disclosure (RFD), prohibiting corporations from making selective disclosure of material, non-public information to analysts, institutional investors and other parties that may trade on the basis of the information. The proposed rule1 dictated that the regulation applies to all issuers that are registered under Section 12 of the Exchange Act, which includes U.S. and non-U.S. entities. However, after considering comments received on the proposal, in order to narrow the scope of the regulation, in the SEC's final rule foreign issuers are exempt from the regulation.

Although not required to comply with the disclosure stipulations of RFD, there has been anecdotal evidence that some foreign issuers voluntarily adopted fair disclosure practices. For example, Alcatel, a French American Depository Receipt (ADR) listed on the NYSE, has indicated that although it continues to hold one-on-one meetings with analysts, material issues are only discussed in the broadest terms.2 This change in disclosure policy is a direct consequence of the perceived importance of adhering to RFD.

In spite of the RFD-related compliance costs3 that will be incurred, these issuers feel that it is important to follow the guidelines of the regulation for a number of reasons. First, U.S. investors expect and demand the same level of disclosure by all firms. Second, there is the possibility that the SEC will extend the regulation to include foreign issuers. Third, disclosure regulations may become globally harmonized. Fourth, ADR initiators are being urged by parties that establish ADR programs to comply with RFD in order to be truly competitive with their U.S. peers.

The objective of this study is to examine the changes in various liquidity proxies for ADRs surrounding information events around the implementation of RFD. Bertin et al. (2005) provide the basis for categorizing empirical proxies for liquidity as either measures of friction or activity, allowing a clear interpretation of changes in liquidity proxies. Friction measure classifications follow Demsetz (1968), Grossman and Miller (1988) and Stoll (2000), where friction is identified as the price concession for immediacy. In contrast, activity measures reflect the extent of trading. Both of these dimensions are relevant since the cost of transacting as well as the extent of the trading may independently change around information releases.

The flow of information from public companies to investors following RFD may become discontinuous or discrete. As analysts no longer act as intermediaries between public companies and investors in the transmission of information, the continuous communication that may be the norm prior to RFD would no longer be representative of the flow of information. This change in information flow may be evident in securities’ liquidity. Specifically, during periods without information releases, the cost of trading or the ability to trade may change. In fact, the restructuring of information into discrete bursts may be observable in liquidity changes around these bursts.

However, this change in information flow would also be consistent with the argument put forth by proponents of RFD that prior to the regulation selective disclosure practices resulted in differential information knowledge among market participants. Therefore, one would expect to find information leakage prior to announcements that would be reflected in liquidity. This is especially relevant for earnings announcements where guidance may be given to analysts preceding an announcement. Earnings announcements are thus an excellent example of an information event that might be expected to have some early disclosure before the implementation of RFD.

After RFD, pre-earnings announcement information asymmetry would no longer be a concern of market participants and therefore we would expect that liquidity proxies would be distinctly different before and after the implementation of RFD. In studies of information asymmetry measures of U.S. firms, estimated measures are generally dependent on a specific microstructure model. A more general analysis of liquidity proxies may provide more clues about the changes following RFD. In addition, we posit that similar changes in liquidity for ADRs around earnings announcements would suggest that market participants believe that foreign firms are RFD compliant.

This paper contributes to the literature by revealing a difference in activity measures between the control and ADR samples. Specifically, the decreased levels of volume and transaction size around earnings announcements after the implementation of RFD for the control sample are consistent with greater retail investor confidence and lower information asymmetry. However, we do not find similar significant changes for our ADR sample.

This paper is organized in the following way. In Section 2, we provide a brief overview of RFD including the changes in disclosure requirements as well as empirical evidence on the impact of the regulation. In Section 3, we discuss the institutional features of ADRs and the benefits and costs in complying with U.S. disclosure standards. We describe our data and empirical methodology in Section 4. Results are presented in Section 5 and Section 6 concludes.

Section snippets

Regulation Fair Disclosure

RFD rules are a result of SEC concern about the selective disclosure practices by U.S. corporations to certain parties, such as analysts and institutional investors. These parties, that have access to information prior to its release to the general public, could take advantage of this information for profit, or to gain an informational edge over other market participants. Corporations could use these disclosures as leverage against analysts to pressure them into providing favourable reports.

American Depository Receipts

ADRs are the predominant method by which foreign companies shares are listed on U.S. exchanges and the ADR shares represent claims on foreign shares. From the company's perspective, an ADR listing provides a number of advantages. It can broaden the company's shareholder base and increase trading volume. ADRs can also be used to raise the awareness of U.S. investors to their products.

Although ADRs are currently not required to comply with the new disclosure requirements, there are a number of

Data and methodology

Our sample consists of all NYSE-listed ADRs for which earnings announcements are reported by First Call7 between January 2000 and April 2001. We define our earnings window as the 4-day window

The impact of RFD prior to earnings announcements

We report changes in liquidity proxies categorized as friction measures in Table 1 across the three regimes, before-RFD, after-RFD/pre-decimalization and after-RFD/post-decimalization, in the pre-earnings announcement period. The results for ADRs are presented in Panel A and for the control firms in Panel B. We find that dollar quoted spreads and dollar effective spreads significantly decrease after the implementation of RFD for ADRs. However, percentage quoted and effective spreads are

Conclusion

In a market environment where investor confidence about management practices has deteriorated dramatically, Regulation Fair Disclosure represents an attempt by the SEC to restore a level of fairness to the market. The regulation requires that any release of material information be made to the general public rather than to select individuals. This rule, however, only applies to U.S. firms; foreign issuers are currently exempt.

Using changes in liquidity before and after the implementation of RFD,

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