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Monday, July 17, 2006

Disclosure Adds Shareholder Value: Lessons from Sarbanes-Oxley's Predecessor

This opinion editorial appears in today's issue of Stanford Knowledgebase, the monthly electronic newsletter published by the Stanford Graduate School of Business, http://www.gsb.stanford.edu/news/knowledgebase.html.

The convictions of the late Kenneth Lay and Jeffrey Skilling on charges of fraud and conspiracy in the Enron trial are important reminders that corporate executives don't always operate in the best interests of shareholders. A natural impulse is to turn to government to devise regulations to force executives to operate the corporations they manage in the interests of shareholders and the employees. But what do we know about the success of these regulations?

o understand whether shareholders value government regulation in financial markets, we recently completed an analysis of the effects of the 1964 Securities Acts Amendments. The 1964 Amendments extended the disclosure requirements that have applied to firms traded on the New York and American Stock Exchanges (NYSE and AMEX) since 1934 to large over-the-counter (OTC, now known as NASDAQ) firms. The relatively lax disclosure requirements for OTC firms prior to 1964 meant that shareholders were generally on their own in obtaining reliable information on the functioning of their companies and in devising methods to penalize management for failures to maximize shareholder value.

The 1964 Amendments dramatically changed the disclosure requirements for large OTC firms. Specifically, large OTC firms were newly required to: (1) register with the Securities and Exchange Commission (SEC); (2) provide regular updates on their financial position, such as audited balance sheets and income statements; (3) issue detailed proxy statements to shareholders; and (4) report on insider holdings and trades. Our study tested how the 1964 Amendments affected the stock returns and operating performance of the newly covered OTC firms, relative to unaffected NYSE and AMEX firms.

We found that OTC firms that were newly required to begin complying with all four forms of mandatory disclosure had substantial one-time gains in stock value relative to comparable NYSE/AMEX firms that were unaffected by the legislation. Our estimates of the higher returns range from 11.5 percent to 22.1 percent and imply that the 1964 Amendments created $3.2 billion to $6.2 billion of value for shareholders of the OTC firms we studied.

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