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
Edward J. Kane
1
The strength of the Bushee-Leuz
Analysis is threefold:
1. Its clever use of Revealed
Preference to classify firms;
2. Its recognition of the need to
compare the benefits of compliance
with the costs of avoidance;
3. Its careful use of the event-study
method.
Edward J. Kane
2
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.
Edward J. Kane
3
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).
Edward J. Kane
4
Edward J. Kane
5
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.
Edward J. Kane
6
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.
Edward J. Kane
7
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.
Edward J. Kane
8
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.
Edward J. Kane
9
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.
Edward J. Kane
10
This suggests a way to re-read the evidence
in the last panel of Table 4.
1.
2.
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 Firms
FC Firms
NC Firms
+3.4%
-.2%
-3.3%
Edward J. Kane
11
The conclusions I draw are:
1.
2.
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.
Edward J. Kane
12
Edward J. Kane
13