Optimal Disclosure Policy Research Articles

Investment Behavior under Uncertainty in Number of Competitors

One explanation for why investors crowd into a given strategy, as in the Quant Crisis of 2007, even when they understand its negative implication is that they are often simply not aware of the extent of crowding. In this paper, we build a simple model that formalizes this intuition. To derive excessive crowding, our model relies on two ingredients: (i) an investor’s investment decision imposes a negative externality on other investors, and (ii) investors are uncertain about the amount of competing capital at play. The model then allows us to analyze regulations regarding disclosure of capital committed to a strategy. Interestingly, we nd that it is suboptimal to disclose the amount of capital perfectly to the investors to mitigate the crowding, and that there is a case for strategic blocking of the information. We show that the implementation of the optimal disclosure policy requires a commitment device without which there occurs a policy trap.

Outside Directors, Litigation Environment, and Management Earnings Forecasts

AbstractThis study examines whether outside directors factor in litigation costs for the firm while monitoring optimal disclosure policy. It investigates the association of management earnings forecast disclosure and the proportion of outside directors across two regimes with unequal litigation costs, the United States and Canada. I find that the positive association between forecast frequency/ precision and the proportion of outside directors is stronger in Canada. This suggests that outside directors are more likely to encourage disclosure in less litigious Canada. I also find that firm‐level governance mechanisms such as outside directors and country‐level litigation environment act as governance substitutes in determining unbiased forecasts. Specifically, the negative association between forecast bias and the proportion of outside directors is stronger in Canada. I also revisit the effect of legal regime on forecast disclosure in a non‐U.S. context. Recent legislation has increased the likelihood of class‐action lawsuits in Canada. The passage of these laws has decreased the precision in forecasts by Canadian firms.

A Theory of Multidimensional Information Disclosure

This paper studies the optimal disclosure policy of multidimensional information when the sender can commit ex ante to the policy. By controlling the information available to an uninformed receiver, the sender controls the distribution of the receiver’s posterior expectations. Assuming quadratic preferences, we derive an upper bound of the sender’s ex ante utility based on semidefinite programming, and show that a linear transformation of the state is optimal if it is normally distributed. In addition, we examine extensions in which the receiver has private information and there are multiple senders. Applications of our theory include information sharing in an oligopoly.

Interim Performance Feedback in Multistage Tournaments: The Optimality of Partial Disclosure

Workers competing in a tournament for a prize (e.g., a promotion) often perform sequentially in multiple stages. When the firm is privately informed about the workers’ performance, it can sharpen incentives by strategically disclosing the intermediate results. But the policies that enhance final-stage effort may dampen incentives at the intermediate stage. In our model, the optimal disclosure policy has a simple form: disclose only if all workers perform poorly. This result offers a novel justification for partial disclosure in performance feedback. Also, it contrasts with the existing literature that focuses on the extreme policies of full disclosure and no disclosure.

Informational Feedback Effect, Adverse Selection, and the Optimal Disclosure Policy

Trading in a secondary stock market not only redistributes wealth among investors but also generates information that guides subsequent investment. We provide a positive theory of disclosure that reflects both functions of a secondary market. By making private information public, disclosure reduces private information acquisition and levels the playing field. However, a leveled playing field has two opposite effects on firm value. On one hand, it ameliorates adverse selection among investors and improves the liquidity of firm shares. On the other hand, it could also impede investment efficiency because less information is produced by the market and used by decision makers. This trade-off determines the optimal disclosure policy. Our theory generates new testable predictions and reconciles disclosure with other parts of securities regulation that encourage private information production.

Optimal Disclosure Policy and Undue Diligence

Optimal Disclosure Policy and Undue Diligence

Optimal Disclosure Policy and Undue Diligence

While both public and private financial agencies supply asset markets with large quantities of information, they do not necessarily disclose all asset-related information to the general public. This observation leads us to ask what principles might govern the optimal disclosure policy for an asset manager or financial regulator. To investigate this question, we study the properties of a dynamic economy endowed with a risky asset, and with individuals that lack commitment. Information relating to future asset returns is available to society at zero cost. Legislation dictates whether this information is to be made public or not. Given the nature of our environment, nondisclosure is generally desirable. This result is overturned, however, when individuals are able to access hidden information - what we call undue diligence - at sufficiently low cost. Information disclosure is desirable, in other words, only in the event that individuals can easily discover it for themselves.

Contract Litigation as Information Revelation Channel and its Implications on Reputation (Dis)Incentives

We examine how the reputation concern of contracting parties affects contractual incentives if information is transmitted to the public through contract litigation. In a career concern framework, the performance of the long-lived seller is revealed to future buyers only if contractual disputes are litigated. We show that the seller's reputation concern acts like an additional legal cost which induces her to settle privately. A strong reputation concern effectively voids the incentive contract and eliminates all incentives. Finally, we apply the model to discuss the optimal information disclosure policy of courts.

The optimal disclosure policy when firms offer implicit contracts

The observability of history is crucial for the sustenance of implicit (or relational) contracts. When a firm hires a sequence of short-lived workers, turnover adversely affects the observability of history—the old worker may leave the firm before communicating the history to the young. However,turnovercanalsoenhanceprofitsifmatchinggainscanbeextractedupfront.Disclosure of the workers’ productivity information affects turnover by mitigating adverse selection. Thus, the optimal disclosure policy trades off matching efficiency with the sustainability of implicit contracts. I show that (i) opaqueness can be optimal only for firms with moderate reputation concerns, and (ii) an opaque firm’s profit may decrease with its reputation concern.

On disclosure policy in contests with stochastic entry

We study how a contest organizer who seeks to maximize participant effort should disclose the information on the actual number of contestants in an imperfectly discriminatory contest with stochastic entry. When each potential contestant has a fixed probability of entering the contest, the optimal disclosure policy depends crucially on the properties of the characteristic function H(⋅)=f(⋅)/f′(⋅), where f(⋅) is the impact function. The contest organizer prefers full disclosure (full concealment) if H(⋅) is strictly concave (strictly convex). However, the expected equilibrium effort is independent of the prevailing information disclosure policy if a linear H(⋅) (Tullock Contest) applies.

Outside Directors, Litigation Environment and Management Earnings Forecasts

This study examines whether outside directors factor in litigation costs for the firm while monitoring optimal disclosure policy. It investigates the association of management earnings forecast disclosure and the proportion of outside directors across two regimes with unequal litigation costs - U.S. and Canada. I find that the positive association between forecast frequency/precision and the proportion of outside directors is stronger in Canada. It suggests that outside directors are more likely to encourage disclosure in less litigious Canada. I also find that firm-level governance mechanisms such as outside directors and country-level litigation environment act as governance substitutes in determining unbiased forecasts. Specifically, the negative association between forecast bias and the proportion of outside directors is stronger in Canada. I also revisit the effect of legal regime on forecast disclosure in a non-U.S. context. Recent legislation has increased the likelihood of class-action lawsuits in Canada. The passage of these laws has decreased the precision in forecasts by Canadian firms.

Sustaining implicit contracts when agents have career concerns: the role of information disclosure

Firms often augment career concerns incentives with implicit incentive contracts. I formalize the interaction between these two incentives, and highlight its implications on a firm's decision to disclose its workers' productivity information. Disclosure enhances career concerns but inhibits implicit contracts. I show two main results. First, implicit contracts weaken (i.e., substitute) career concerns if the prior belief about the worker's ability is low, and vice versa. Second, when these incentives are substitutes, the optimal disclosure policy follows a cutoff rule: patient firms are opaque, and transparent firms never offer implicit contracts. These results need not hold if the incentives are complements.

Value creation with Dye’s disclosure option: optimal risk-shielding with an upper tailed disclosure strategy

Dye [J Account Res 23 (1985) 123] showed that the optimal disclosure policy, when a manager is randomly endowed with perfect private information, is upper tailed, i.e., the manager only discloses firm value above an appropriate cutoff level. We interpret this strategically as an optimal exercise by management of the embedded formal option to report value. Given any disclosure cutoff level, we value the corresponding option using contingent claims analysis. It is shown that the Dye disclosure cutoff value maximizes the formal option value. We find it to be the minimum possible conditional valuation (conditioned by non-disclosure) which is thus consistent with the intuition that investors should value conservatively. We show how the Dye cutoff can be interpreted as a strike price in a ‘protective put’ which offers a shield against risk of disclosure of low value. The strategic analysis is further extended by allowing the probability level that the manager is informed to be a choice variable. We show that the manager will never choose to be perfectly endowed with information, and is likely to be more endowed than unendowed. We also present a simple worked example which shows how the total value of the firm changes once the Dye option is formally incorporated.

The Optimal Disclosure Policy When Firms Offer Implicit Contracts

Firms often motivate their workers with implicit incentive contracts. Since these contracts are sustained through the threat of future retaliations by the workers, their sustenance hinges on the worker's observability of the game's history. When a long-lived firm hires a sequence of short-lived workers, the coexistence of old and young generation of workers facilitates the observability of history. The old communicates the history to the young. Turnover adversely affects the observability of history, because the old worker may leave the firm before communicating the history to the young. But if workers are better matched with their prospective employers, efficient turnover can also enhance profit by maximizing the matching gains available for up front extraction. Disclosure of the workers' productivity information to outside labor market affects turnover by mitigating adverse selection in turnover. Thus, the optimal disclosure policy trades off matching efficiency in turnover with the sustainability of implicit contracts. I formalize this trade-off, and characterize the optimal disclosure policy. There are three main results: (i) opaqueness can be strictly optimal only for the firms with moderate reputation concerns, (ii) in equilibrium, an opaque firm's profit may decrease with its reputation concern, and (iii) opaqueness is less likely to be the optimal policy when the matching gains are high.

Career Concerns and Optimal Disclosure Policy

When a worker is raided, his initial employer is often better informed about his quality than the raiders. If the worker has career concerns and matching influence productivity, the initial employer can strategically disclose this information to influence incentives and matching efficiency. If the initial employer can use long-term complete contracts, perfect competition in the raider market ensures full disclosure. In contrast, an optimal short-term contract induces full disclosure if i) worker is risk neutral, ii) worker does not face any liquidity constraints, and iii) raider market is perfectly competitive. By relaxing any of the above conditions, one can find situations where full disclosure is no longer optimal.

Sustaining Implicit Contracts when Agents have Career Concerns: The Role of Information Disclosure

Firms often combine career concerns based incentives with incentives created through relational performance contracts. In this context, disclosure of worker's productivity information enhances career concerns based incentives, but may reduce the firm's ability to sustain relational contracts. The latter effect originates as upon reneging on the relational contract the firm can continue to rely on the career concerns based incentives. Thus, stronger is this incentive the larger is the punishment payoff of the firm. I consider an environment where a long-run firm faces a sequence of short-run workers, who can subsequently get raided (poached). The disclosure policy of the firm determines how much information about the worker's productivity it will share with the potential raiders. I provide a characterization of the optimal disclosure policy. When relational contracts substitutes career concern incentives, the optimal disclosure policy follows a cut-off rule where the more patient firms always opt for opaqueness. Also, the firm never combines the two forms of incentives when they are substitutes. Both of these results need not hold if the incentives are complements. I further show that in presence of firm specific matching gains, the set of discount factor that supports transparency is increasing in the size of the matching gain.

The Governance Role of Institutional Investors and Outsider Directors on the Properties of Management Earnings Forecasts

This paper investigates the relation between institutional ownership and board of directors' composition and the properties of management earnings forecasts. A firm's optimal disclosure policy is determined by a trade-off between costs and benefits of disclosure. Managers acting in their self-interest may have incentives to distort disclosure policy. Governance mechanisms, to the extent they are effective in protecting the interests of the providers of capital, should mitigate these distortions. We find evidence that institutional ownership and outsider directors are favorably associated with the properties of earnings forecasts. Firms with greater institutional ownership and outside directorship are more likely to issue a forecast and do so consistently. Further, these forecasts tend to be more specific and accurate. The governance measures also mitigate managers' tendency to issue optimistic forecasts.

Optimal Disclosure Policy in Oligopoly Markets

This paper examines the private and social optimality of full disclosure of private information in a two‐period oligopoly model. An incumbent firm is privately informed about the market demand and its production cost after operating as a monopolist in the first period, and then competes against an entrant in the second period. Two main results are derived. First, it is shown that the incumbent is best off by pre‐committing to disclose both the demand and cost information. By disclosing full information, the incumbent nullifies its self‐defeating intertemporal incentives, which arise whenever it has private information about the market demand, its cost efficiency, or both. In addition, the equilibrium output variance is the largest under full disclosure, which benefits the incumbent ex ante. Second, the paper shows that the incumbent’s full disclosure of the demand and cost information may or may not be desirable from a social efficiency standpoint. In particular, the correlation between the firms’ production costs is crucial to the rank of disclosure policies in terms of their impact on social efficiency.

Conservatism, Optimal Disclosure Policy, and the Timeliness of Financial Reports

We develop a theory of the relation between biases in financial reporting and managers' incentives to issue timely voluntary disclosures. We find that firms with relatively more conservative accounting are less likely to make timely voluntary disclosures than firms with less conservative accounting. Therefore, price is more timely in reflecting the news of firms with less conservative accounting. Prior research has assumed that the timeliness by which news is impounded in price is uncorrelated with the nature of accounting earnings and has ascribed a concave earnings-return relation to the accounting system reporting bad news on a more timely basis than good news. In our theory, a concave relation is not necessarily attributable to a difference in the way the accounting system reports good vs. bad news. Rather, our prediction stems from how biases in mandatory financial reports determine which firms optimally choose to make voluntary preemptive disclosures and which do not. Hence, our theory provides an alternative explanation for the empirical findings and cautions against interpreting them as evidence that accounting is conservative. Finally, we identify means of empirically distinguishing between the alternative explanations.

Forcing Firms to Talk: Financial Disclosure Regulation and Externalities

In this paper we analyze a model of voluntary disclosure by firms in financial markets. We focus on externalities that arise when firm values are correlated and the disclosures made by one firm affect the valuation of other firms. In our model, firms can choose the precision of their disclosure, and disclosure, which is costly, has social value. In the case of one firm, we uncover interesting economies of scale in the value of the disclosure, which lead to discontinuities in the optimal disclosure policy as parameters of the model change. For example, the optimal precision may jump from zero to a positive level when the prior precision regarding the firm's value is at a threshold level. For the case of multiple firms, we show that because of the externality in the firms' valuation, the Nash equilibrium disclosure policies are often socially inefficient. Thus, there is scope for disclosure regulation to improve welfare. We study the possibilities of mandating a minimal precision level for the disclosure or setting a system of subsidies that reduce the perceived cost of disclosure. While both methods can sometimes improve welfare, for each method there are cases (where firms differ in their cost or other parameters) where welfare is not improved. Neither of these methods of regulation dominates the other in all situations.