Summary Disclosure and the Efficiency of the OTC Market: Evidence from the Recent Pink Sheets Experiment

Abstract

This paper uses a natural experiment to shed light on several key questions in securities law - the value of disclosure rules, the beneficiaries of disclosure, and the extent to which low-disclosure markets may deviate from semi-strong market efficiency. On November 6, 2006, the Pink Sheets announced that in May 2007, it would introduce a new classification system: each company would receive a simple sign, reflecting its level of disclosure (including “skull and bones” for firms investigated for fraud; a “stop” traffic sign for firms with no disclosures; a “premier” sign for highly-disclosing firms). The new system would not generate any new information - it would merely summarize already public information in one sign. In the event study of stock market returns, I find that the firms that in May 2007 were assigned into “low-disclosing” categories experienced significant negative returns (7% to 16% decline) following the November 2006 announcement of the upcoming classification, relative to OTC firms that received a “transparent” sign. I also analyze non-disclosure-based predictors of the Pink Sheets classification, and the extent to which investors may have relied on such indirect proxies in their trading. Overall, these results suggest that: (1) prominent summaries of public information can affect stock prices of OTC companies; (2) sophisticated investors predicted subsequent placement of firms into categories and thus were aware of existing levels of disclosure; (3) sophisticated investors expected the new summary disclosure system to affect decisions by unsophisticated investors; (4) sophisticated investors did not expect the new classification to significantly affect the behavior of firms’ insiders; and (5) disclosure by self-regulatory organizations can significantly affect financial markets. This evidence also indicates that prior to the new system, “dark” firms’ prices departed significantly from semi-strong efficiency.