UNDERSTANDING THE ECONOMIC CONSEQUENCES OF THE SEC’S “ELIGIBLITY RULE”: A DISCUSSION

1. Federal Reserve Bank of Atlanta Financial Markets Conference April 15, 2004 UNDERSTANDING THE ECONOMIC CONSEQUENCES OF THE SEC’S “ELIGIBLITY RULE”: A DISCUSSION Edward J. Kane Boston College

2. The strength of the Bushee-Leuz Analysis is threefold: • Its clever use of Revealed Preference to classify firms; • Its recognition of the need to compare the benefits of compliance with the costs of avoidance; • Its careful use of the event-study method.

3. It is instructive to liken the Burden of the “Eligibility Rule” to that of a tax. This particular tax is interesting because it falls unequally on the profits of different firms and/or on the returns of different stockholders.

4. This perspective suggests that the uncertainty generated and resolved at different event dates concerns both the incidence and the size of the tax. It also suggests the possibility that the compliance decision may reveal something about whether managers are willing to act in the best interests of stockholders even if their compensation is tied to accounting profits (agency costs).

6. Using this tax perspective, the authors’ three types of firms can be reinterpreted as follows: Already Compliant Firms = Zero incremental tax rates for firms and stockholders. Freshly Compliant Firms = Firm pays an incremental profits tax (TFC); stockholders may receive implicit benefits (BFC). Noncompliant Firms = Firms pay zero profits tax; stockholders pay an implicit tax (TNC) due to loss of trading data and liquidity.

7. The Main Value of the tax perspective is that it allows us to dispense with the idea that stockholders in “Already Compliant Firms” benefited from undefined “externalities.” They benefited because net returns to stockholders in the other two classes of firm are being taxed and the market prices on the three types of securities needed to move to establish equal after-tax total returns.

8. To show this simply, let us suppose that stock in all three types of firms initially promise to earn and pay out $1 per year forever and that all three stocks are priced at $1/r.

9. Once the tax is imposed, the shares temporarily offer different returns: Already Compliant Firms still offer: $1 Freshly Compliant Firms (“FC”) offer: $1 – TFC(+ BFC) Non Compliant Firms (“NC”) offer: $1 – TNC Mutual Fund records would probably show that Funds moved from the taxed to the untaxed stocks, driving up the price of AC firms and driving down the price of FC and NC firms. Flows from NC to FC stocks would soften the net effect on FC firms.

10. At the equilibrium new prices, the firms would promise to pay the same after-“tax” returns going forward. Of course, at each particular event date, only some of the tax effect would emerge.

11. This suggests a way to re-read the evidence in the last panel of Table 4. • At most event dates, price adjustments are less than one percent away from the benchmark of OTCBB firms. The major exception is the event of SEC approval, which appears to have resolved a considerable amount of uncertainty. • Mean cumulative deviations of raw returns from OTCBB benchmarks are: AC FirmsFC FirmsNC Firms +3.4% -.2% -3.3%

12. The conclusions I draw are: • Stockholders of FC firms were not significantly harmed: The concern for shareholder interests shown by conforming reduced the agency-cost allowance in discount rates enough to largely offset the value of the profit tax TFC. • The decline in NC stock prices may reflect increased stockholder concern about agency costs associated with the decline in transparency generated by the now-increased difficulty of tracking intraday price movement.