A Proposed Framework to Reduce Asymmetric Information in Equity Offerings

Abstract

Abstract The security offering literature shows that firms offering their shares for sale to the public generally manage their earnings upwards around the offering to raise investor demand for the firm’s shares and increase their sale price. In addition, the literature demonstrates that earnings management around the offering increases the information asymmetry between the issuers and outside investors, thereby increasing the issue flotation costs. Markedly increased flotation costs imply, inter alia, a reduced demand for, and pricing of, the new shares offered – the opposite result of that sought by the issuing management. To date, mechanisms to prevent issuing firms from managing earnings opportunistically are non-existent. I address this current gap in the literature by proposing a disclosure-based framework for issuing firms aimed at reducing the extent of information asymmetry between them, outside investors and underwriters. Specifically, I present a mechanism where firms add a voluntary “honest disclosure” section in their issue prospectuses, in which they provide information that reduces uncertainty about their financial reports. I demonstrate that such voluntary disclosures by firms create a reality that encourages truthful reporting around the offering and results in a more effective capital market. The proposed framework does not require a change in current institutional mechanisms. Furthermore, as an integral part of the prospectus, the SEC will scrutinize the disclosure. Last but not least, the new section should not add significant cost to the issuer.