The half-hidden paternalism of disclosure mandates: Have we gone too far?

The unravelling principle is one of the most influential concepts in financial reporting theory. The principle examines the problem of a seller aware of material facts that may be reported to the buyers or withheld for greater gain. In the classic market for lemons, George Akerlof observed that lack of transparency may cause markets to break down because potential buyers anticipate that those goods put for sale are likely to feature more severe withheld issues. The beauty of the unravelling principle is to prolong this intuition and turn its conclusion upside down. Some withholding sellers realize that they are being perceived at an average quality across all other withholding sellers, even though their facts are better than this average quality. In turn, disclosures must unravel like falling dominos as, one after another, withholding sellers with better information choose to be forthcoming and report their information.

Unfortunately, in practice, the unravelling principle does not appear to operate as seamlessly as theory would predict. Experimental evidence unquestioningly shows that individuals are too trusting and imperfectly correct for lies by omission. These potential losses can be large, with studies showing that buyers making of ranging from 20 and 25 percent relative to rationally forming their expectations following a non-disclosure.

Disclosure mandates also seem to matter in environments where unravelling should apply. In 1998, Los Angeles County required restaurants to exhibit hygiene cards on their windows. Many restaurants were previously withholding low inspection scores; in response to the disclosure requirement, food poisoning decreased. In 2010, the Dodd-Frank Act required imminent dangers and injuries in mining industries to be reported in financial statements, where they would be easily accessible to a wide investor base. These incidents were known to firms but—for the most part—omitted from annual reports despite their relevance to investors as well as current and potential employees.

Since its creation, the Securities and Exchange Commission (SEC) adopted a worldview consistent with this evidence. Among many other examples, the SEC requires public issuers to follow generally accepted accounting rules, hire an external auditor, and file periodic financial statements. If questioned, an SEC commissioner would probably say that the Commission was founded to discipline markets after the stock market crash of 1929 showed that many small investors were irrationally exuberant about public securities. In fact, the mission of the SEC is explicit in this regard: “to promote a market environment that is worthy of the public’s trust.” Put more bluntly, investors should not be expected to apply the sort of cynical logic that drives unravelling.

I refer to this view as paternalism. It is a philosophy where the individual makes errors that can be prevented with regulations that place restrictions on behavior. In the context of financial reporting, paternalism is concerned with investors’ inability to adequately evaluate the strategic rationale behind a lack of transparency. By mandating disclosure, the regulator is shielding investors against losses due to a misunderstanding of strategic incentives. 

In a recent study, I argue that it is precisely the most successful paternalism that may cause the greatest market failures. Investors insulated from losses cannot learn from experience and will not form sufficiently skeptical responses to withholding. Regulators cannot control the continuous process of financial and transactional innovations which accounting standards are not equipped to regulate in real time. Hence, paternalism only works to a degree. Investors induced to optimism by repeated experiences of successful paternalism will fail to exert adequate caution when new innovations arise. Excessive optimism coupled with a lack of transparency will cause even greater investor harm than if investors had learnt to expect strategic withholding. In the long run, an indiscriminate application of paternalism contributes to the very problem it intends to solve.

Through this mechanism, paternalistic regulations can unwittingly sustain continuing cycles of asset bubbles and crashes. These cycles begin with investors forming trusting expectations as they observe markets being regulated effectively and attribute occasional lack of transparency to random factors that do not indicate serious issues. Then, a new financial innovation is developed which allows some firms to bypass regulatory requirements. We have an extensive historical record of these: from Enron’s off-balance sheet financing schemes to unreported employee stock option valuations. Investors fail to apprehend the true significance of withheld information and misprice firms’ equity, causing a period of financial turmoil. Prices drift down during the turmoil, leading to renewed calls for regulation and starting another cycle with more effective regulations and a build-up in investor trust.

In simulations of a decision-theoretic model, below, I illustrate how the optimal paternalism, captured by a parameter in the horizontal axis, varies as a function of the regulator horizon or the likelihood of transactional innovations. Laissez-faire is the only policy that, in the long run, trains investors not to form excessively optimistic investor beliefs when new transactions occur. As regulators become patient or innovations likely, the optimal regulation converges to pure laissez-faire economics.

There is a quote attributed to Confucius that best summarizes the trade-off: “By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest.” The quote also inspires a practical regulatory question over the appropriate scope for experience, especially what criteria guide a proper application of paternalism or—to put it simply—when should laissez-faire markets be trusted to solve the problem?

The theory suggests a five-point conceptual framework intended to define conditions under which laissez-faire economics or paternalistic regulations should be given the function to discipline disclosure.

  1. Given that paternalism impairs long-term investor learning, the horizon of the marketplace is a critical aspect for the scope of paternalism. Paternalism should be applied more cautiously to early-stage markets where investors should be given opportunity to learn about all risks.
  2. The costs of investor optimism are greatest when regulators are unable to keep pace with financial innovations and, consequently, laissez-faire will be more desirable in those situations where future transactions are difficult to forecast.
  3. The damage is greatest when there are value-decreasing investment decisions that are affected by optimism. Paternalism may then become desirable to reveal irrational exuberance in periods of high undue optimism.
  4. Large harms call for greater paternalism than small harms; by contrast, small harms serve a social role in disciplining investor optimism and should not be subject to same regulatory scrutiny.
  5. Unique circumstances or matters that cannot be easily generalized to future events or other firms, may tolerate greater levels of regulator intervention as the harm from future optimism will be muted.

This conceptual framework can be used to organize the scope of regulatory intervention. In summary, not all investor losses are detrimental, and some serve the purpose of building experience to avoid greater future losses.

These questions have become even more important in the context of the proliferation of non-traditional financial assets, of which cryptocurrencies and non-fungible tokens are the most recent examples. These markets may be particularly obscure to small investors, featuring decentralized disclosures and record-keeping, as well as a complex and asset-specific set of issuance and custody rules. Issuers in these markets have resisted interference by regulators, noting that regulation may stifle innovation and most investors are aware of the risks and rewards.

Regulators across the world have, for now, tacitly taken a laissez-faire approach that is consistent with the points 1 to 5 raised in the framework. These markets are young, highly innovative, rarely serve to finance physical investments, feature small positions for most investors, and seem to exhibit disclosure problems unique to the industry. Yet, with continuing growth and the development of decentralized finance, these characteristics are already changing and draw the industry closer to the role of traditional investments. It remains to be seen how regulators will adjust their disclosure mandates to these new classes of assets.

Jeremy Bertomeu is an Associate Professor of Accounting at the Washington University in St. Louis Olin Business School.

This post is adapted from his paper, “Disclosure Paternalism” available on SSRN.

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