Joel Seligman examines the historical debate surrounding the Securities and Exchange Commission’s mandatory corporate disclosure system, focusing on George Stigler’s influential 1964 critique and subsequent discussions. While acknowledging Stigler’s role in sparking important questions about regulatory necessity, Seligman argues that critics often underestimated the historical evidence of securities fraud and the need for public market confidence, ultimately defending the continued relevance of mandated disclosure in securities regulation.
Editor’s note: In the year of the 90th anniversary of the Securities and Exchange Act, we aim to examine the historic record of the Act, the debates that ensued among economists, and its relevance to today’s corporate governance environment. You can read the articles part of this series here.
In 1964, George Stigler published his much-cited Public Regulation of the Securities Markets, the first serious critique of the Securities and Exchange Commission’s mandatory disclosure system. Stigler questioned the need for any compulsory disclosure system and inspired several subsequent critiques including works by George Benston, Henry Manne, Gregg Jarrell, Homer Kripke, Michael Jensen & William Meckling, Frank Easterbook, and Daniel Fischel.
Much of this criticism of the mandatory disclosure system has been based on the efficient market hypothesis, portfolio theory, agency theory and theory of the firm. In 1983, I published an article, The Historical Need for a Mandatory Corporate Disclosure System, arguing that many of the critics of this system ignored or underestimated the evidence concerning securities fraud, excessive underwriters’ or insiders’ compensation, and the need for public confidence in the securities markets. This work persuaded Congress in recent years to create and expand mandated disclosure and civil and criminal sanctions for violations of the Federal Securities laws.
Historically, the proponents of mandatory securities have advanced five principal arguments to justify the system. First, in the absence of a compulsory disclosure system, some issuers will conceal or misrepresent information material to investors. Second, in the absence of a compulsory system, underwriting costs and insiders’ compensation would be excessive. Third, without the compulsory system, there would be less public confidence in the securities markets. Fourth, neither state laws nor private associations such as the stock exchanges historically had ensured adequate levels of corporate disclosure.
Fifth, in the absence of compulsory disclosure, civil and criminal actions also could not ensure optimal levels of corporate disclosure. Stigler assembled empirical evidence to advance the argument that the corporate disclosures compelled by the SEC’s mandatory system were unnecessary. Stigler’s study purported to demonstrate that the 1933 Securities Act’s new issue registration requirements “had no important effect on the quality of new securities sold to the public.” In a single “simple” test, Stigler compared how well investors fared before and after the SEC was given power to regulate new issues. His study examined the five-year price history of all new industrial stocks with a value exceeding $2.5 million introduced in the 1923-1928 period and of all new industrial stocks with a value exceeding $5 million introduced in the 1949-1955 period. To eliminate the effects of general market conditions, Stigler measured stock prices relative to market averages. “Thus if from 1926 to 1928 a common stock rose from $20 to $30, the price ratio is 150 (percent) or an increase of 50 percent, but relative to the market, which rose by 68.5 percent over this two-year period, the new issue fell 12 percent.”
Two types of measurements could be obtained from such a test. First, the variance of new securities prices relative to the price variance of the overall market could be calculated. A decline in price variance of the overall market could be calculated, and such a decline in price variance would imply that investors were receiving material information in the post-SEC (1949-1955) period that they had not received in the pre-SEC (1923-1928) period. As Stigler himself memorably wrote in a 1961 article entitled The Economics of Information, “[p]rice dispersion is a manifestation – and, indeed, it is a measure – of ignorance in the market.” Analogously, new securities prices were more likely to vary from market prices if investors were unable to initially, accurately value new securities because of material data deficiencies than if investors initially had received complete and accurate material investment data. Stigler, however, dismissed the significance of findings from his study that the variance of price ratios had, in fact, declined after the SEC began administering its compulsory disclosure system, conjecturing that it was the result of SEC exclusion of risky companies rather than a positive benefit of disclosure.
A more plausible interpretation of these data was offered by Irwin Friend and Edward Herman, who stated, “[w]ith full disclosure we would expect less drastic shifts in estimates of expected profitability of a given issue as a result of the greater initial level of economic information (and, presumably, the reduction in the possibility of surprises from this source. . . .” . That fewer “risky” issues were floated in the post-SEC period, Friend and Herman urged, “was the result of improved disclosure of the degree of risk and a consequent greater reluctance by investors to buy risky new issues.”
The second type of measurement that can be obtained from Stigler’s test is the change in new issue prices relative to the market average between the pre-SEC (1923-1928) and post-SEC (1949-1955) periods. A finding that new issue prices relative to the market were unchanged would suggest that the SEC’s mandatory new issue disclosure requirements had no material effect. A finding that new issue prices relative to the market were superior in the post-SEC period, by contrast, would suggest that the mandatory disclosure requirements had prevented investors from being overcharged when purchasing new securities.
It is, however, unclear whether Stigler’s research design was sufficiently sophisticated to effectively measure price performance results. Today it is conventional to assume that a security’s price varies, in part, because of the degree of sensitivity of the security to overall market price changes (the so-called beta co-efficient). To accurately test whether new issue securities prices had changed relative to the market before and after the operation of the SEC’s mandatory corporate disclosure system, Stigler should have selected securities with equivalent sensitivities to market changes. He did not do so. Similarly, Stigler ignored dividend income. Securities paying out a larger percentage of their earnings as dividends should achieve smaller long-term price appreciation than securities paying a lesser percentage of their earnings. Unless the sample of firms in both of Stigler’s test periods pursued identical dividend policies, different price effects would be predictable.
But putting to one side those weaknesses in study design and ignoring the substantial number of computational errors which Stigler acknowledged appeared in the initial publication of his test results, Stigler’s conclusion may be rejected on the more fundamental ground that it is not supported by the results of his own test. Friend and Herman corrected the data errors in Stigler’s tabulation of results and found that on average new common stock prices relative to the market in each of the five years after issue from the 1949-1955 period were superior to the comparable results from the 1923-1928 period. Stigler, recomputing his own tabulations, similarly found the average of common stock prices relative to the market superior in four of the five post-SEC years. While the margin of superiority in some of the post-SEC years was not statistically significant, the corrected results at least suggested that mandatory disclosures by new issues had improved price performance.
Stigler’s study nonetheless deserves a place in the securities law literature. He raised legitimate questions about the need for the mandatory disclosure system which have remained perennial questions to this day. While the debate in recent decades largely has shifted from do we need a mandatory disclosure system at all to second-order debates about whether the system’s costs and complexity can be justified, Stigler was the intellectual pioneer. He deserves credit for that.
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