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

Edward J. KaneEdward J. Kane 11

UNDERSTANDING THE UNDERSTANDING THE ECONOMIC CONSEQUENCES ECONOMIC CONSEQUENCES

OF THE SEC’S “ELIGIBLITY OF THE SEC’S “ELIGIBLITY RULE”: A DISCUSSIONRULE”: A DISCUSSION

Edward J. KaneEdward J. Kane

Boston CollegeBoston College

Federal Reserve Bank of AtlantaFinancial Markets ConferenceApril 15, 2004


The strength of the Bushee-Leuz The strength of the Bushee-Leuz Analysis is threefold:Analysis is threefold:

1.1. Its clever use of Revealed Its clever use of Revealed Preference to classify firms;Preference to classify firms;

2.2. Its recognition of the need to Its recognition of the need to compare the benefits of compliance compare the benefits of compliance with the costs of avoidance;with the costs of avoidance;

3.3. Its careful use of the event-study Its careful use of the event-study method.method.


It is instructive to liken the Burden It is instructive to liken the Burden of the “Eligibility Rule” to that of a of the “Eligibility Rule” to that of a tax. This particular tax. This particular taxtax is is interesting because it falls interesting because it falls unequally on the unequally on the profitsprofits of of different different firmsfirms and/or on the and/or on the returnsreturns of different of different stockholdersstockholders..


This perspective suggests that the This perspective suggests that the uncertainty generated and resolved at uncertainty generated and resolved at different event dates concerns both different event dates concerns both the the incidenceincidence and the and the sizesize of the tax. of the tax.

It also suggests the possibility that the It also suggests the possibility that the compliance decision may reveal compliance decision may reveal something about whether managers something about whether managers are willing to act in the best interests are willing to act in the best interests of stockholders even if their of stockholders even if their compensation is tied to accounting compensation is tied to accounting profits (agency costs).profits (agency costs).


Using this tax perspective, the authors’ Using this tax perspective, the authors’ three types of firms can be reinterpreted three types of firms can be reinterpreted as follows:as follows:

Already Compliant Firms = Zero incremental Already Compliant Firms = Zero incremental tax rates for firms and stockholders.tax rates for firms and stockholders.

Freshly Compliant Firms = Firm pays an Freshly Compliant Firms = Firm pays an incremental profits tax (Tincremental profits tax (TFCFC); stockholders ); stockholders may receive implicit benefits (Bmay receive implicit benefits (BFCFC).).

Noncompliant Firms = Firms pay zero profits Noncompliant Firms = Firms pay zero profits tax; stockholders pay an implicit tax (Ttax; stockholders pay an implicit tax (TNCNC) ) due to loss of trading data and liquidity.due to loss of trading data and liquidity.


The Main Value of the tax perspective The Main Value of the tax perspective is that it allows us to is that it allows us to dispense withdispense with the idea that stockholders in “Already the idea that stockholders in “Already Compliant Firms” benefited from Compliant Firms” benefited from undefined undefined “externalities“externalities..””

They benefited because net They benefited because net returns to stockholders in the returns to stockholders in the other other two classes of firm are being two classes of firm are being taxed taxed and the market prices on and the market prices on the the three three types of securities types of securities needed to move needed to move to establish to establish equal after-tax total equal after-tax total returnsreturns..


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


Once the tax is imposed, the shares Once the tax is imposed, the shares temporarily offer different returns:temporarily offer different returns:

Already Compliant Firms still offer: $1Already Compliant Firms still offer: $1Freshly Compliant Firms (“FC”) offer: Freshly Compliant Firms (“FC”) offer:

$1 – T$1 – TFCFC(+ B(+ BFCFC))Non Compliant Firms (“NC”) offer: Non Compliant Firms (“NC”) offer:

$1 – T$1 – TNCNC

Mutual Fund records would probably show Mutual Fund records would probably show that Funds moved from the taxed to the that Funds moved from the taxed to the untaxed stocks, driving up the price of AC untaxed stocks, driving up the price of AC firms and driving down the price of FC and firms and driving down the price of FC and NC firms. Flows from NC to FC stocks NC firms. Flows from NC to FC stocks would soften the net effect on FC firms.would soften the net effect on FC firms.


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


This suggests a way to re-read the evidence This suggests a way to re-read the evidence in the last panel of Table 4.in the last panel of Table 4.

1.1. At most event dates, price adjustments At most event dates, price adjustments are less than one percent away from the are less than one percent away from the benchmark of OTCBB firms. The major benchmark of OTCBB firms. The major exception is the event of SEC approval, exception is the event of SEC approval, which appears to have resolved a which appears to have resolved a considerable amount of uncertainty.considerable amount of uncertainty.

2.2. Mean cumulative deviations of raw returns Mean cumulative deviations of raw returns from OTCBB benchmarks are:from OTCBB benchmarks are:

AC FirmsAC Firms FC FirmsFC Firms NC NC FirmsFirms +3.4%+3.4% -.2% -.2% -3.3% -3.3%


The conclusions I draw are:The conclusions I draw are:

1.1. Stockholders of FC firms were not Stockholders of FC firms were not significantly harmed: The concern for significantly harmed: The concern for shareholder interests shown by shareholder interests shown by conforming reduced the agency-cost conforming reduced the agency-cost allowance in discount rates enough to allowance in discount rates enough to largely offset the value of the profit tax largely offset the value of the profit tax TTFCFC..

2.2. The decline in NC stock prices may The decline in NC stock prices may reflect increased stockholder concern reflect increased stockholder concern about agency costs associated with the about agency costs associated with the decline in transparency generated by the decline in transparency generated by the now-increased difficulty of tracking now-increased difficulty of tracking intraday price movement.intraday price movement.

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

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