Over the last years capital markets around the world have been shaken by a series of dramatic events. Corporate scandals, banking failures, and over-leveraged firms and nations made the news headlines in the last decade. These events have triggered a public demand for strict regulation on corporations (BusW_2001,Merkel_2010).Voicing the demands, the US regulators has recently issued important rules affecting firms’ financial reports. The aim of these rules is to promote efficient capital markets. However, regulation is costly. Regulators are often unaware of firms’ incentives and lack the means to enforce the rules (Coase_1960).

The aim of this project is to investigate whether these regulatory interventions result in net capital markets benefits. Particularly we study three regulatory interventions in firms’ financial reporting: rules directing the Securities and Exchange Commission(SEC) to review regularly firm’s financial reports (SOX408_2002); bankruptcy rules that mandate firms that emerge from bankruptcy to apply fresh start accounting-FSA (FASB852_2009); and rules requesting firms to disclosure internal control weaknesses (ICW) in their financial reports (SOX302_2002,SOX404_2002).

We test whether the introduction of these rules help capital markets agents in their economic decisions, namely: 1) whether institutional investors disinvest in firms that have been identified by the SEC reviews as having deficiencies in financial reports; 2)whether the post-bankruptcy performance of firms that apply FSA is better than the post-restructuring performance of firms that do not apply FSA; 3)whether investors incorporate information about internal control problems in their long-run investment decisions.

While these regulatory interventions have generated intense debate among practitioners and academics in the US, research on the topics is scarce, mainly in the first two cases. One of the reasons is the lack of ready-to-use data. We take advantage of that and hand-collect unique data to perform the following empirical studies.

The first study collects data on SEC letters sent to firms when the SEC review teams detect problems in their reports. The letters were confidential until recently so our study is one of the few on the topic (other is Johnston&Pet_2012). We study the institutional investors’ reaction to the issuance of the SEC letters. Institutional investors are sophisticated agents capable of monitoring firms and interested in the quality of financial reports (Chen et al_2007). As the aim of the SEC letters is to identify weaknesses in financial reports, institutional investors may perceive the letter as bad news and consequently disinvest in the firm. This reaction could be interpreted as a beneficial capital market effect of the SEC review regulation in the sense that it facilitates efficient allocation of resources.

The second study uses hand-collected data to compare the post-bankruptcy performance of firms that apply FSA when they reorganize under court supervision, with performance of firms that negotiate with creditors out-of-courts. The only published study on FSA (Lehavy_2002) shows that

ex-post performance vary with managerial discretion over FSA estimates. A related study identifies the relative power of debtholders as an important factor affecting firm reorganization value (Harner&Marincic_2011). Thus, we explore how these two factors affect ex-post firm performance. If FSA regulation contributes to efficient capital markets, we expect better ex-post performance for firms going through court reorganization and applying FSA vis-à-vis firms that restructure debt privately and do not apply FSA.

The third study investigates changes in institutional investors’ holdings in firms that report, and subsequently solve (or do not solve), internal control weaknesses (ICW). Differently from other studies (Asbaugh et al_2009, Munsif_2011) we explore the long-term effects of ICW reporting on investment decisions, and how investors’ decisions vary with the nature and severity of ICW. We expect that institutional investors react negatively to the reporting of ICW, but later re-adjust their investments positively if the firm solves the problems. That evidence would be consistent with the view that regulation on ICW reporting assists capital market participants to make better informed investment decisions.

Our findings are useful to regulators. Given the costs of regulation policymakers must decide on a mix of rules and market-based measures to solve information asymmetries in the economy (Jensen&Meckling_1976). Understanding to which extent financial reporting regulation promotes efficient capital markets can assist regulators in that decision. Our results are also useful to investors and other agents in assessing the effects of regulation in their valuation and investment decisions.

The research team has previously worked together and has the skills to develop the project successfully.

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With the objective to increase the research activity directed towards the achievement of the United Nations 2030 Sustainable Development Goals, the possibility of associating scientific projects with the Sustainable Development Goals is now available in Ciência_Iscte. These are the Sustainable Development Goals identified for this project. For more detailed information on the Sustainable Development Goals, click here.