Disclosure laws are enacted to protect individuals when they become active on financial markets. In the case of a public securities offering, US regulation requires filing of a Form S-1 with the Securities and Exchange Commission (‘SEC’) prior to the offer’s commencement. The European Union has a similar legal framework in place where a prospectus is published that has to be ‘complete’, ‘consistent’ and ‘understandable’ (Prospectus Directive 2003/71/EU) before the national competent authority approves it.
In addition to the development of statutory disclosure, firms devote substantial resources to marketing to create product and brand awareness. Revenues of banks and other financial firms are derived from the origination of loans or the management of financial assets. In capital market transactions, advertising is an important tool to increase awareness for the firm among prospective investors and successfully raise capital. Advertisements for public offerings are regulated under Article 15 of the European Prospectus Directive. The rationale their regulation is that advertisements, besides attracting attention, can also lead to an alteration of product and risk perceptions and might be influential to decision-making behavior.
Not all information included in advertisements is informative for the decision to be made. According to economic theory, an investment decision should reflect a trade-off between risk and returns, and disclosure that is not informative of either of these factors should in principle be irrelevant to a rational decision maker. An extensive stream of behavioral research shows, however, that non-informative content does affect decision-making. Consider, as an example, past return information: the efficient markets hypothesis postulates that past returns are uninformative for future returns, but research shows that investors tend to rely heavily on this information.
In our paper ‘The Effects of Risk Framing, Balanced Information and a Regulatory Seal of Approval’, we examine how the translation of informative statutory disclosure into advertisements affects investor decision-making. We focus on advertisements since research conducted by the SEC shows that the complexity of disclosure spurs investors to rely on accessible forms of disclosure, such as advertisement. Psychological research also shows that effects arising from saliency and framing of attributes can have significant consequences for the outcome of the decision process.
Using an experimental survey, we document that the balance in risk and return disclosure significantly affects investor willingness to consult other information besides the advertisement. Additional information can be obtained from annual reports or the prospectus. The mechanism that underlies this effect is unclear, but might be attributable to investors no longer being interested to invest in a proposition once they have a clear picture of the downside risks at the initial information stage. We also find that the explicit exposition of risks increases the risk perception and decreases the willingness to consult other information.
The setup of the experiment also allows us to test how referral to supervisory oversight affects decision outcomes. Article 15(2) of the Prospective Directive requires advertisements to state that ‘a prospectus has been or will be published’. In practice, however, this requirement has been translated into a statement of the availability of an approved prospectus. Especially the word ‘approved’ might induce a certification effect on decision makers. Given that the scrutiny and approval of the prospectus is not informative of the likelihood that the returns will be realized, theory suggests this information to be irrelevant for a rational decision maker.
We show, however, that referring to regulatory approval increases investors’ willingness to invest by more than 10 percent, while it decreases the perceived risks by almost 6 percent. Our evidence also suggests this relation is causal, since large increases or decreases in willingness to invest are explained by the presence or absence of regulatory-referencing.
To conclude, externalities of regulatory oversight have received limited (academic) attention although they are relevant to policy and regulatory discussions. Unregulated referencing to supervisors runs the risk of degrading their role to an undesirable sales argument. Moreover, it is conceivable that this certification effect arises more broadly, for example, when regulators are responsible for licensing firms. Awareness for these mechanisms is important to better achieve regulatory objectives.
Ruben Cox is an Assistant Professor of Finance at Erasmus University Rotterdam and with the Netherlands Authority for the Financial Markets. Peter de Goeij is an Associate Professor of Finance at Tilburg University. The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the official view, policy or position of the Netherlands Authority for the Financial Markets or its Board of Directors.