Private Intermediary Innovation and Market Liquidity: Evidence from the Pink Sheets® Market

In 2007, Pink Sheets LLC assigned each Pink Sheets^® company to a disclosure tier and on its website affixed a colorful graphic to its stock symbol signifying the company's public disclosure level. This unique innovation allows us to investigate the impact of increased salience of disclosure practices on liquidity. Using a difference‐in‐difference design, we find evidence that firms classified into the Current Information category experienced an increase in liquidity while firms classified into the No Information category experienced a decrease in liquidity, both relative to other unclassified over‐the‐counter firms. This suggests that increases in the salience of disclosure practices via assignment to disclosure tiers affect investors’ attention, leading to changes in trading behavior that ultimately translate into liquidity changes. We also provide evidence that some investors anticipated the resulting liquidity changes because stock returns around a key event date leading up to the release of the disclosure tiers are positively associated with subsequent liquidity changes.     

Auditor Fees and Fraud Firms

The issue of whether auditor fees affect auditor independence has been extensively debated by regulators, investors, investment professionals, auditors, and researchers. The revised Securities and Exchange Commission (SEC) requirements that resulted from the implementation of the Sarbanes‐Oxley Act (2002) limit nonaudit services (NAS) and mandate NAS fee disclosure. The SEC's requirements are based on the argument that auditor independence could be impaired—and hence audit quality may be reduced—when auditors become economically dependent on their clients or audit their own work. Economic bonding leads to reduced independence, which can lead to reduced audit quality. We study a sample of firms sanctioned by the SEC for fraudulent financial reporting in Accounting and Auditing Enforcement Releases (SEC‐sanctioned fraud firms) and examine whether there is a relationship between auditor fee variables and the likelihood of being sanctioned by the SEC for fraud. We use SEC sanction as a measure of audit quality that has not previously been used in the auditor fee literature and is more precise than some of the other proxies used for flawed financial/auditor reporting. We find, in univariate tests, that fraud firms paid significantly higher (total, audit, and NAS) fees. However, in multivariate tests, when controlling for other fraud determinants and endogeneity among the fraud, NAS, and audit fee variables, we find that while NAS fees and total fees are positively and significantly related to the likelihood of being sanctioned by the SEC for fraud, audit fees are not. These findings suggest that higher NAS fees may cause economic bonding, thereby leading to reduced audit quality. Our findings of significantly higher NAS fees and total fees in fraud firms hold after controlling for latent size effects and other rigorous testing. These results contribute to the literature that examines the SEC's concerns regarding NAS and can be used by policy makers for additional consideration.     

The liquidity of the London capital markets, 1825–70†

This article examines the liquidity of the London capital markets in the decades following the liberalization of UK incorporation law. Using comprehensive stock and bond data, we calculate a measure of market liquidity for the period 1825–70. We find that stock market liquidity trended upwards but bond market liquidity did not increase over the sample period. Stock market liquidity during our sample period was partially influenced by the bond market, rather than fluctuations in economic output. In our analysis of the cross‐sectional determinants of individual stock liquidity, we find that firm size and the number of issued shares were important determinants of liquidity.  Finally, we find little evidence of an illiquidity premium, which is consistent with the view that investors did not price liquidity in this nascent market.     

Are Investors Misled by “Pro Forma” Earnings?*

This paper uses stock market data to investigate the popular claim that investors are misled by the “pro forma” earnings numbers conspicuously featured in the press releases of some U.S. firms. We first document the frequency and magnitude of pro forma earnings in press releases issued during June through August 2000, and describe the 433 firms that engaged in this financial disclosure strategy. Our test period predates public expressions of concern by trade associations and regulators that pro forma earnings may mislead investors and the subsequent issuance of guidelines and rules on the disclosure of pro forma earnings numbers. We use two complementary approaches to determine whether the share prices that investors assign to pro forma firms are systematically higher than the prices assigned to other firms. Our market‐multiples tests for differences in price levels find some evidence suggesting that pro forma firms may be priced higher than firms that do not use the disclosure strategy. This apparent overpricing is not, however, related to the pro forma earnings numbers themselves. Our narrow‐window stock returns tests reveal no evidence of a stock return premium for pro forma firms at the quarterly earnings announcement date. Collectively, the results cast doubt on the notion that investors are, on average, misled by pro forma earnings disclosures despite the widespread concern expressed in the financial press and by regulators.     

Taking firms to the stock market: IPOs and the importance of large banks in imperial Germany, 1896–1913

Large universal banks played a major role in Germany's industrialization because they provided loans to industry and thereby helped firms to overcome liquidity constraints. Previous research has also argued that they were equally important for the German stock market. This article provides quantitative and qualitative evidence that although the market for underwriters was dominated by a small oligopoly of six large banks, there was still perceptible competition, which kept fees and short‐run profits low. Another interesting finding presented here is the absence of a signalling effect to investors. Neither underpricing nor the one‐year performance was different for the IPOs issued by one of the Big Six. Thus, although the German IPO business was in the hands of a small oligopoly, investors did not benefit from the lack of competition. One explanation is that the quality of IPOs on the German stock market of the time was very good in general as a result of the competition between underwriters, but also as a result of the tight regulation of underwriting, which ensured the quality of all firms on the German stock market.     

Market liquidity,private information,and the cost of capital: Market microstructure studies on family firms in Japan

We investigate cost of capital, information asymmetry, and market liquidity of listed family firms vs. non-family firms in Japan. First, we find that the cost of debt is lower and the cost of equity is higher for family firms than non-family firms, but the differences are not significant. The WACC of family firms becomes higher than that for non-family firms and the difference is significant probably because family firms in Japan use less leverage. Next, we find that the stocks of family firms are traded with higher information asymmetry than non-family firms. As for information asymmetry and illiquidity measures, we utilize the variables Adjusted PIN and Probability of Symmetric Order Flow Shocks (PSOS). Concomitantly we also estimate alternate conventional measures of market liquidity as a robustness check. Overall, the evidence on liquidity is somewhat mixed, while we find family firms show higher information asymmetry, which may affect cost of equity. As a final policy implication, we recommend family firms in Japan conduct more voluntary and timely disclosure, in particular, for the benefit of general stock investors, and may want to increase leverage to reduce the WACC.     

噪声交易与股票流动性:兼对“正(负)相关”理论的评析及“流动性黑洞”现象的解释

噪声交易与股票流动性都是行为金融研究的重点，但二者的相关性问题学界一直未能达成一致，"正负之争"不休。文章改进Kyle （1985）的假设，构建符合中国实际的流动性数理模型，模型表明：噪声交易与流动性负相关，且相关关系受信息不对称、风险厌恶度等因素的影响。进一步，文章以中国沪深300指数的成分股数据证实了"噪声交易-流动性"关系，发现其存在显著的月历效应和市场行情效应。文章对"正（负）相关"理论进行了梳理和评析，为争论的清晰化、明朗化做出贡献。     

Independence in Appearance and in Fact: An Experimental Investigation*

In this study, we use experimental markets to assess the effect of the Security and Exchange Commission's (SEC's) new independence rule on investors' perceptions of independence, investors' payoff distributions, and market prices. The new rule requires client firms to disclose in their annual proxy statements the amount of nonaudit fees paid to their auditors. The new disclosure is intended to inform investors of auditors' incentives to compromise their independence. Our experimental design is a 2 3 between‐subjects design, where we control the presence (unbiased reports) or absence of auditor independence in fact (biased reports). While independence in fact was not immediately observable to investors, we controlled for independence in appearance by varying the public disclosure of the extent of nonaudit services provided by the auditor to the client. In one market setting, investors were not given any information about whether the auditor provided such nonaudit services; in a second setting, investors were explicitly informed that the auditor did not provide any non‐audit services; and in a third setting, investors were told that the auditor provided nonaudit services that could be perceived to have an adverse effect on independence in fact. We found that disclosures of nonaudit services reduced the accuracy of investors' beliefs of auditors' independence in fact when independence in appearance was inconsistent with independence in fact. This then caused prices of assets to deviate more from their economic predictions (lower market efficiency) in the inconsistent settings relative to the no‐disclosure and consistent settings. Thus, disclosures of fees for nonaudit services could reduce the efficiency of capital markets if such disclosures result in investors forming inaccurate beliefs of auditor independence in fact ‐ that is, auditors appear independent but they are not independent in fact, or vice versa. The latter is the maintained position of the American Institute of Certified Public Accountants (AICPA), which argued against the new rule. Further research is needed to assess the degree of correspondence between independence in fact and independence in appearance.     

Share portfolios in the early years of financial capitalism: London, 1690–1730

The dramatic expansion of public and private financial markets in the aftermath of the Glorious Revolution has received extensive attention. Despite this, little is known about how ordinary individual investors managed risk within this framework. Using a newly constructed dataset of share ownership for those joint‐stock companies listed in the financial press of the day, we reconstruct individual portfolio holdings for investors in these companies. We examine individual portfolio holdings first for the decade after the Glorious Revolution and then for the years around the South Sea Bubble. Despite a fivefold increase in the number of unique individuals in the market between the 1690s and the 1720s, we find that in each period roughly 80 per cent of those active in the equity market held shares in only one company, even though many shareholders had the capacity or wealth to diversify share portfolios. These outcomes suggest diversification against idiosyncratic liquidity risk. Overall, however, there is limited evidence that individuals were using their financial portfolios to protect against diversifiable shocks. For many, we argue, company‐specific voting and firm governance rules drove market activity.     

Disclosure Policy and Market Liquidity: Impact of Depth Quotes and Order Sizes*

This paper investigates the relation between disclosure policy and market liquidity. Our tests examine two key aspects of market liquidity, the effective bid‐ask spread and quoted depth, and how they relate to financial analysts' ratings of firms' disclosure policies. We introduce a method of combining order sizes and depth quotes to yield more precise estimates of effective spreads on trades likely constrained by quoted depth. We find that while firms with higher rated disclosures are charged lower effective spreads, they are also quoted lower depth, consistent with the notion that better disclosures reduce information asymmetry but also cause some liquidity suppliers to exit the market. Therefore, a simple examination of spreads and depths yields ambiguous inferences on the relation between disclosure policy and market liquidity. We resolve this ambiguity by estimating depth‐adjusted effective spreads, and find that firms with higher rated disclosures have lower depth‐adjusted effective spreads across all trade sizes. Consequently, our results reveal a robust inverse relation between disclosure ratings and effective trading costs. This implies that a policy of enhanced financial disclosure is related to improved market liquidity.     

The Switch-Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters

The SEC has long asserted that earnings management practices result in adverse consequences for investors. We examine whether SEC oversight affects firms' accounting quality in terms of earnings management trade-offs. We expect that increased firm-specific regulatory scrutiny, in the form of an SEC comment letter, will induce management to switch from accrual-based earnings management (AEM), which is a main focus of the SEC, to real-activities-based earnings management (REM), which is not likely to be commented on in the SEC's review process. Consistent with our predictions, we find that AEM is lower and REM is higher following the receipt of a comment letter, relative to non-comment-letter years and a propensity-score-matched sample of non-comment-letter firms. However, we do not find a significant difference in total earnings management (i.e., the sum of AEM and REM), suggesting that the higher REM acts as a substitute for lower AEM activity. We further find that our results are driven by accounting comments relating to estimates and accruals and not by classification-only comments, which suggests that a comment letter that does not question specific issues associated with estimates and accruals is not a strong enough signal to induce the firm to change earnings management behavior. Additionally, the shift to REM is attenuated for firms with high institutional ownership. These results collectively suggest that the comment letter process effectively constrains AEM but has the unintended consequence of firms, on average, switching to REM.     

Regulatory Oversight of Financial Reporting: Securities and Exchange Commission Comment Letters

The Securities and Exchange Commission (SEC) reviews company filings (10‐Q, 10‐K, S‐1, etc.) submitted to them. If a review identifies potential deficiencies, the SEC staff sends the company a comment letter seeking clarification, additional information, and ultimately, perhaps, revision of the filing or future filings. We examine the content, resolution, and ensuing informational consequences of SEC comment letters. The content analysis shows that nearly half of all comments involve accounting application, financial reporting, and disclosure issues. More than 17 percent of our sample cases result in immediate amended filings to resolve the issue(s) arising from the comment letters, and financial statements and/or footnotes are frequently revised. Following comment letter resolution, the adverse selection component of the bid‐ask spread declines and Earnings Response Coefficients (ERCs) increase. Our results provide little support for the conjecture that the market interprets the receipt of a comment letter as a signal that the firm has poor reporting quality. Finally, we find no evidence that comment letter firms increase the quantity or change the type of voluntary disclosure, thereby eliminating a possible competing explanation for the improved information environment. We conclude the SEC's oversight has beneficial informational effects.     

Analyst Following and Market Liquidity*

This paper investigates the relation between analyst characteristics (number of analysts following a firm and their forecast dispersion) and market liquidity characteristics (bid‐ask spreads and depths and the adverse‐selection component of the spread). Prior research has found contradictory results on the relation between analyst following and market liquidity and has offered differing theories on how analysts affect liquidity. While prior research has posited analysts as proxies for privately informed trade or as signals of information asymmetry, I hypothesize that analysts provide public information, implying that analyst following (forecast dispersion) should have a positive (negative) association with liquidity. Cross‐sectional simultaneous estimations provide support for this hypothesis. The results are both statistically significant and economically important. Granger causality tests indicate that analyst characteristics lead market liquidity characteristics. These results clarify the role of analysts in providing information to financial markets and highlight benefits of increased analyst following.     

Empirical Study on Information Asymmetry Based on Chinese Forward Exchange Rate Market

Many published studies have considered information asymmetry between domestic and foreign investors about local assets in the stock market, particularly in developed markets. The present study proposes a new perspective to address the issue in the case of China's forward exchange rate market. Following the framework of Clarida and Taylor (1997), the term structures of exchange rates in the domestic forward and the non‐deliverable forward markets are constructed and then applied to predict future spot exchange rates based on a vector equilibrium correction model. By comparing the forecast accuracy on the basis of the root mean square error and the mean absolute error, it is shown that dynamic out‐of‐sample forecasts of the domestic forward market are superior to those of the non‐deliverable forward market, suggesting that domestic investors are better informed than foreign investors. The result has several important policy implications, especially for exchange rate determination.     

The Paris financial market in the nineteenth century: complementarities and competition in microstructures1

This article sets out to explain why the Paris Bourse was highly successful in the nineteenth century in spite of the supposedly inefficient monopoly of the official market, the Parquet. The literature argues that the official monopoly was sidelined by a free, innovative market known as the Coulisse, but it fails to explain how the Coulisse emerged despite the monopoly and how the two markets persisted alongside each other during the entire century. We provide a detailed history of how these two markets emerged and interacted. The Parquet increasingly developed as a high‐end market, providing security, transparency, and effective settlement‐delivery to unsophisticated investors trading on the spot market. The Coulisse provided liquidity, immediacy, and opacity to professional investors trading mostly forward. In line with recent theoretical developments, we argue that the juxtaposition of heterogeneous organizations had important virtues for market participants, since it allowed the exchanges to specialize in different investors and services and made the exchanges complementary to each other. We demonstrate our claim by looking at both the formal rules and the actual functioning of the Parquet, drawing on its archives which we have recently classified.     

The Effect of Humanizing Robo‐Advisors on Investor Judgments*

We examine the effect of humanizing (naming) robo‐advisors on investor judgments, which has taken on increased importance as robo‐advisors have become increasingly common and there is currently little SEC regulation governing key aspects of their use. In our first experiment, we predict and find that investors are more likely to rely on the investment recommendation of an unnamed robo‐advisor, whereas they are more likely to rely on the investment recommendation of a named human advisor. Theory suggests one reason that naming a robo‐advisor may have drawbacks pertains to the complexity of the task the robo‐advisor performs. We explore the importance of task complexity in our second experiment. We predict and find that investors are less likely to rely on a named robo‐advisor when the advisor is perceived to be performing a relatively complex task, consistent with our first experiment, and more likely to rely on a named robo‐advisor when the advisor is perceived to be performing a relatively simple task, consistent with prior research on human‐computer interactions. Our findings contribute to the literature examining how technology influences the acquisition and use of financial information and the general literature on human‐computer interactions. Our study also addresses a call by the SEC to learn more about robo‐advisors. Lastly, our study has practical implications for wealth management firms by demonstrating the potentially negative effects of making robo‐advisors more humanlike in an attempt to engage and attract users.     

Home Country Investor Protection,Ownership Structure and Cross‐Listed Firms' Compliance with SOX‐Mandated Internal Control Deficiency Disclosures

We examine whether home country investor protection and ownership structure affect cross‐listed firms' compliance with SOX‐mandated internal control deficiency (ICD) disclosures. We develop a proxy for the likelihood of cross‐listed firms' ICD misreporting during the Section 302 reporting regime. For cross‐listed firms domiciled in weak investor protection countries, we have three main findings. First, firms whose managers control their firms and have voting rights in excess of cash flow rights are more likely to misreport ICD than other firms during the Section 302 reporting regime. Second, there is a positive association between the likelihood of ICD misreporting and voluntary deregistration from the SEC prior to the Section 404 effective date. Third, for firms that chose not to deregister, there is a positive association between the likelihood of ICD misreporting and the reporting of previously undisclosed ICDs during the Section 404 reporting regime. We do not find similar evidence for cross‐listed firms domiciled in strong investor protection countries. Our findings are consistent with the hypothesis that, for cross‐listed firms domiciled in weak investor protection countries, managers who have the ability and incentive to expropriate outside minority shareholders are reluctant to disclose ICDs in order to protect their private control benefits. The results of our study should be of interest to regulators who wish to identify noncompliant firms for closer supervision, investors who wish to identify ex ante red flags for poor financial disclosure quality, and researchers who wish to understand the economic forces governing cross‐listed firms' financial disclosure behavior.     

Institutional Investors' Trading in Speculation: Evidence from China

The trading behaviour of institutional investors has attracted much attention. However, many issues related to their trading behaviour cannot be addressed without high‐frequency changes in institutional ownership. Based on a measure of the trading behaviour of institutional investors by using an institutional account dataset from China, we find that (i) active institutions trade speculatively by taking advantage of individual investors; (ii) individuals buying high and selling low offer liquidity only on average; (iii) foreign investors do not show significant patterns in speculation; and (iv) trading of active institutions significantly affects price. This study casts doubt on the conventional wisdom that institutional or sophisticated investors improve market efficiency by correcting mispricing, and provides direct evidence for institutional investors' speculation behaviour and their destabilising effect on the stock market. Results suggest that regulators in emerging markets should monitor institutions' speculation to bring fairness and justice to the stock market.     

Multi‐Market Competition,R&D,and Welfare in Oligopoly

We investigate a multi‐market Cournot model with strategic process research and development (R&D) investments wherein a multi‐market firm meets new competitors that enter one of the markets. We show that entry can enhance the total R&D expenditures of the multi‐market firm. Moreover, the incumbent's profit nonmonotonically changes as the number of entrants increases. Depending on the fixed entry costs and R&D technologies, both insufficient and excess entry can appear. Our results imply that diversification of their products can be a useful strategy for firms.     

Are Risk Factor Disclosures Still Relevant? Evidence from Market Reactions to Risk Factor Disclosures Before and After the Financial Crisis

The SEC's Disclosure Effectiveness Initiative (December 2013) highlights a difference between accounting regulators and academics in their perceptions of Item 1A risk factor disclosure effectiveness. Because most academic evidence relies on pre‐financial crisis data, we compare changes in risk factor disclosure informativeness before and after the crisis as a possible explanation for this disconnect. We further explore this discrepancy by considering (i) three classes of market participants, (ii) new, discontinued, and repeated disclosures, and (iii) nonmarket outcomes. Our results confirm previous findings but indicate that those results no longer hold in the subsequent period. Specifically, we find that although equity, option, and bond markets react to unexpected risk factor disclosures in the period leading up to the financial crisis (2006–2008), the market reactions decline significantly in the post‐crisis period (2009–2014). Perhaps surprisingly, the documented changes in informativeness are not driven by disclosures repeated from one year to the next but instead result from new disclosures initiated in the current year and, in the option and debt markets, also from disclosures discontinued from the previous year. Finally, using the Altman Z‐score as an objective bankruptcy risk measure, we find that the association between risk factor disclosures and companies’ future bankruptcy risk declines significantly in the post financial crisis period. Taken together, these findings contribute to the current disclosure effectiveness debate by highlighting that risk factor disclosures, which were informative in the preceding period, become less reflective of the underlying economic risks and thus less informative to investors in the post‐crisis period. La déclaration des facteurs de risque est‐elle toujours pertinente ? Données tirées des réactions du marché à la déclaration des facteurs de risque avant et après la crise financière