Financial regulation and IPOs: Evidence from the history of the Italian stock market
Abstract
In different conditions, financial regulation has different impacts on the development of public equity markets. By covering the population of 879 IPOs from the unification of Italy (1861) to today, this is the first paper that examine the effects of different regulatory regimes on thesurvival ofIPOsin a long run perspective. We find that when the demand for investor protection is high, the stricter listing requirements increase IPO survival. In presence of a high demand for easier capital formation on the financial markets, survival of newly listed firms is shorter, but the number of firms going public does not grow.
Key words:
IPOs; Regulation; Survival;Investor protection; Italy
1
- Introduction
The number of firms going public has declined over the last decade. This has generated an intense debate, involving academics, as well as policy-makers and stock exchange officials. The drop in number of IPOs has been attributed to a regulatory overreach, in which regulatory changes, such as the Sarbanes-Oxley Act of 2002 (SOX) and SOX-like provisions in Europe, are blamed responsible. The increased compliance costs that these tighter regulations imposed on publicly traded firms, meant to prevent the repeat of corporate scandals (e.g. Enron, WorldCom, Parmalat),reduced the attractiveness of being public[*].Gao, Ritter and Zhu (2013) propose a different explanation. In recent years, the number of IPOs declined as a private firm is much more likely to be acquired than to go public, due to the higher importance of fast time-to-market and to the higher economies of scope that can be achieved through a merger with a strategic, establishedacquirer. However, they also agree that regulatory changes could help in restoring a higher number of IPOs.On the other side, the financial crisis comes with an increased demand for regulation, meant to counteract the destruction of trust which stops trades and investments (Sapienza and Zingales 2012). In financial critical conditions, indeed, regulatory interventions could be away to curb widespread distrust among investors and foster the functioning of the financial markets (Glaeser and Shleifer 2003).
The effectiveness of regulation is controversial (Shleifer 2005; Zingales 2009). Recent IPO studies find that the level of uncertainty is lower for IPOs issued after tightening regulatory changes (Johnston and Madura 2009; Ekkayokkaya and Pengniti 2012; Shi et al. 2012). Akyol at al. (2012) show that the effects of SOX-like provisions adopted by EU Member States have been effective in reducing the uncertainty surrounding valuations in regulated markets. In contrast, the average level of underpricing of IPOs on the exchange-regulatedmarkets, primarily the London Stock Exchange’s Alternative Investment Market(AIM), which were not affected by the new rules, did not decline after the adoption of thecorporate governance codes. From an historical perspective, Chambers and Dimson (2009) highlight that regulations has been less effective than market forces at reducing information asymmetry in UK IPOs. Two studies investigate the relationship between of regulation and IPO survival. Simon (1989) finds that the US Securities Act of 1933 did not the failure rate of firms listed NYSE. Burhop et al. (2012) find that the IPO failure rate was similar on the Berlin and the London financial markets at the beginning of the twentieth century, even if they were characterized by two different levels of regulation. However, these studies refer to concise periods of time, up to 15 years). Our paper is the first to evaluate the impact on IPO survival of the evolution of the regulatory framework on financial markets over time.
We contribute to the debate drawing upon the political economy of finance to study the consequences of regulatory interventions occurring under dissimilar market conditions on financial development.This theory offers a clue to identify when and why one can expect financial regulation to change over time, evaluating financial reforms and their feasibility (Pagano and Volpin 2001). Specifically, through the guidance of the public and private interest theories, we entail explaining the effects of regulatory changes taking place in different conditions. Examining the extent to which public and private interests may influence the design of new regulatory interventions, we analyze the implications of regulation for financial development.
Rules typically need complementary enforcement to be effective (Leuz and Wysocki 2008) and their effects should be evaluated as a whole. A long-run perspective is therefore required to consistently evaluate the effects of regulation on the capital markets (Levine 2011). With reference to the entire population of IPOs in Italy since its unification in 1861, we investigate the impact of major changes in regulation on the number of firms going public per year and on their survival profile. IPO-firms’ survival is often considered a measure of capital market development (Fama and French 2004; Burhop et al. 2012) and laws have been intended to ensure its growth (La Porta et al. 2002). As suggesting by the “law and finance literature”, better regulated capital market develops corrective mechanisms and remedies to address information asymmetries increasing thesurvivalof firms going public (La Porta et al. 1997a, 1998).
The population 879 IPOs in the period 1861-2011 offers the opportunity to examine the evolution of the Italian regulatory framework along the political and economic changes occurred over a long time period. The Italian context here represents an ideal framework to investigate the evolution of regulation, because Italy has been characterized for a long time by a weak protection for both shareholders and creditors (La Porta et al. 1998), andrecently evolved into one of the developed countries in terms of shareholder protection (Enriques 2003).We investigate the effects of the long-run evolutionof regulation occurred in Italy, focusing on the impact of fourdifferent regulatory regimes (1861-1935, 1936-1973, 1974-1997, and 1998-2011)that we identified adapting the classification of the Italian legal framework provided by Aganin and Volpin (2005).
We find a significant increase in the IPO survival when regulatory interventions occur in periods of higher demand for investor protection, while a decrease is registered when a demand for regulation aimed to enhance capital formation. The aim of capital formation are not reached, if measured in terms of number of firms going public. Controlling for macroeconomic variables, the shorter survival profile of firms going public after restricting regulatory changes is not accompanied by an increase in the number of IPOs per year, scaled by GDP.
This paper is organized as follow. Section 2 develops the testable hypotheses. Section 3 describes the evolution of the Italian regulatory framework identifying different regulatory regimes over time. Section 4 presents the data, the sample and the methodology. Section 5 reports the results and Section 6 concludes.
- Literature review and testable hypotheses
Regulators face indeed difficulties to strike the right balance between investors protection and an effective capital raising strategy (Ritter 2013). IPO markets offer an interesting setting in which to calibrate the effectiveness offinancial regulation, testing whether new regulatory interventions are able to explain IPO market development. Regulation is an inevitably dynamic issue and is driven by external conditions. In practice, how regulation evolves in time and its effects on the financial markets is still an unexplored issue. We aim to address this issue considering the impact of regulatory regimes that develop when different conditions and interests are in place. According to two competing views, the public and the private interest motives for regulation, we elaborate two sets of hypotheses explaining how the demands for regulation arises.
The need to correct market failures and protect investors from harm is one of the basic fundamentals of government regulatory interventions (Joskow and Noll 1981). The literature on political economy of finance suggests that in these cases regulation calls in “public interest”, law interventions are meant to provide more stability to the financial system as a whole (Pagano and Volpin 2001). However, interventions cannot occur without costs, such as the amount of resources to comply with new laws, and the burden imposed to firms that should not have been regulated, but nevertheless, are subject to it (Zingales 2004). This is why regulation is expected to come when its benefits outweigh the costs of implementation.
In periods of corporate scandals or financial crises, regulatory intervention could represent a way to curb and prevent distrust, coherent with a higher demand for regulation to protect investors. An increase in the demand for regulation is indeed expected when people perceive unfairness of existing social order (Glaeser and Shleifer 2003, Djankov et al. 2003). Distrust, defined as a poor propensity of players to cooperate for socially optimal solutions (La Porta et al. 1997b), represents the real source of such disorder (Aghion et al. 2010). In critical economic conditions, the more stringent interventions of regulators aim to reduce problems of distrust that grips potential investors and undermines the efficient functioning of the capital markets. Regulation might be a successful screening device to select firms entering the markets, although it does not always represents the optimal solution.
In the IPO setting, regulation can be effective in limiting agency problems. Information asymmetry would ideally disappear if regulation required insiders to fully disclose their private information. In practice, by introducing more stringent listing requirements a tighter regulation should discourage and limit the access to the capital markets to “lemon” firms. We therefore expect that firms going public in compliance with stronger regulations aimed to restore investor protection might be of higher quality, increasing their survivability on the financial markets.
At the same time, tighter regulationsmight limit the number of firms going public.Recently, there has been an increase in the numberof foreign firms delistings fromUS markets to list elsewhere. Doidge et al. (2010) argue that this happens also because of the passage of the SOX, with firms escaping the newly imposed obligations. Firms can indeed avoid the constraints of their home country’s rules and regulations. This has generateda debate in the US (Gao et al. 2013, Doidge et al. 2013), which led to a new law in 2012, the Jumpstart Our Business Startups (JOBS) Act, designed to stimulate economic growth by improving access to the public capital markets for emerging growth companies. The undesired consequence of restricting laws aimed to restore investor protection is indeed a reduction in the attractiveness of listing avenues, and therefore a drop in IPO volumes.
Hypothesis 1a. Regulatory interventions occurringin periods of higher demand for investors protection lead to an increase in the survival of firms going public
Hypothesis 1b. Regulatory interventions occurringin periods of higher demand for investors protection lead to a decrease of the IPO activity.
Regulatory interventions have different aims when taking place in favorable conditions.In these periods, regulatory changes are typically aimed to increase the possibilities of capital formation, making it easier to go public and, in general, lowering the restrictions in raising funds. For instance, the “financial accelerator” effect (Bernanke et al. 1999), that arises when collateral values increase and firms are able to gain easier access to external financial sources, can amplify and propagate economic and financial cycles. However, it might also lead to a socially suboptimal outcome, that of financial instability. Indeed, while risk is overestimated in recessions, leading to a prudential behavior, it is often underestimated in economic booms (Borio et al. 2001). Among the numerous side effects, this contributes to excessive rapid credit growth, inflated collateral values, artificially low lending spreads, and to financial institutions holding relatively low capital and provisions. In the meanwhile, few investors care about the transparency of firms when capital markets grow (Wagenhofer 2011).
In expansion periods, regulators are affected by a reduced demand for regulation, as a diffuse pressure exerted by financial markets’ agents to implement less restrictive interventions and increase as much as possible capital formation. The private interest theory of regulation (Stigler 1971), also called the economic theory of regulation, predicts that regulators cannot work independently from the existing forces operating on the financial markets. While pressure can take different forms, from the coercive power of the state used by groups to achieve their own interests (Becker 1983;Peltzman1989;Rajan and Zingales 2003), to the widespread sentiment of agents demanding more financial openness to promote markets’ growth by reducing the cost of capital and increasing its availability for the borrowers (Chinn and Ito 2006), governments are inevitably influenced when designing law interventions.Decreasing the compliance costs firms have to bear, the regulators’ aloof behavior may increase the probability that lemon firms enter the capital markets. In this case, the development of financial markets is negatively influenced by the expected lower survivability of firms joining it.
Hypothesis 2a. Regulatory interventions occurring in periods of higher demand of reduced requirements for capital formation lead to an decrease in the survival of firms going public.
Hypothesis 2b. Regulatory interventions occurring in periods of higher demand of reduced requirements for capital formation lead to an increase of the IPO activity.
- The regulatory framework and the evolution of the IPO market in Italy
The first IPO on the Milan Stock Exchange, the railway company SocietàdelleStrade Ferrate Lombardo Veneto,took place in the year of the unification of Italy, 1861.Examining the evolution of the IPO market from its foundation makes possible to uncover long-term patters in the effectiveness of regulatory interventions in fostering the development of the financial markets. We identify specific regulatory regimes, each of them characterized by several law interventions, but with a common design in terms of principles, shareholders’ rights, and requirement for access to the market. The set of regulations provide the structure, while the period in which there are implemented establishes the character of what can be labeled a regulatory regime (Hood et al. 2001).
We adoptthe classification of the Italian legal framework provided by Aganin and Volpin (2005), identifying four sub-periods, or regulatory regimes, in the evolution of the Italian stock market: 1861-1935, 1936-1973, 1974-1997, and 1998-2011[†].
1861-1935: Lack of financial market regulation
At the birth of the Reign of Italy, the Italian stock market was almost totally self-regulated. In those years, firms could issue shares with multiple votes using cross-shareholdings with no limits, banks were often not concerned about the quality of listings firms (Vivante2003). Such loose existing legal framework did not formalize any requirement in terms of information disclosure for listed firms.
1936-1973: Post-29 financial market reforms
As a response to the crisis of the 1929, a dramatic change in the Italian legal framework occurred in 1936, when the Law 375/36 (Bank Law) was approved with the aimto overcome the disorder and to restore trust among investors (Aganin and Volpin 2005). Laws implemented primarily aimed to satisfy the existing demand for investor protection imposing important innovations in disciplinating markets’ agents. The stock market regulation improved dramatically, with the Bank Law establishing a clear separation between short term and medium-to-long term financing and with the Civil Code (Royal Decree 262/42) imposing thatall shareholders acquired the right to vote at the annual shareholder meetings.
1974-1997: Alignment to the international markets
The important legal improvements that occurred since 1974 allow to identify this year as the beginning of a new regulatory regime. Specific disclosure requirements were set to ensure the quality of issuersand, more importantly, the government delegated part of the supervision of the financial markets to a commissions equivalent of the US SEC. Notwithstanding the establishment of CONSOB (CommissioneNazionale per le Società e la Borsa), the regulatory interventions in this period contained loopholes (Aganin and Volpin 2005), and shareholders were more likely to be expropriated by controlling blockholders (La Porta et al. 1998).
1998-today: Investor protection reforms
The latest major regulatory change took place in 1998. The Legislative Decree 58/98 (Draghi Reform) represented a “cornerstone” (Mallin 2011), because it explicitly focused on strengthening minority shareholders’ protection. This law changed the process of capital market offerings and takeovers, the functioning of audit firms, as well as minority shareholders’ rights, increasing minority shareholders’ protection through a wider application of the right to withdrawal from the company. Later, the EU Takeover Directive (2004/25/EC), containing requirements for the bidders in M&As, and the Savings Law (Law 262/05) signed a further progress in favor of a greater investor protection in avoiding corporate frauds. The regulatory regime starting in 1998 was characterized by a conspicuous demand for investor protection.
- Methodology and data
4.1 Data and sources
In this paper, we analyse the population of 879 Italian IPOs that went public over the full history of Italy since its foundation, in 1861, until December 2011, on the Milan Stock Exchange.Different datasets were used to obtain the information. The listing and delisting dates, the establishment and failure years, the industry identification, and the delisting reasons were collected referring to three sources: a publication by Mediobanca (2012), the historical collection of De Luca (2002), which integrates the primary source of Mediobanca by punctually describing the history of each listed firm, and the EURIPO database[‡]. Macroeconomic and financial variables are taken from the publications of three institutions. We refer toSiciliano et al. (2011) for the data on the market return index, to Mediobanca (2012) for the number of firms listed per year, and to the national statistical agency (ISTAT) for the value of GDP, population and the number of insolvency per year. Since our primary source of data contained the full population of listings in the Milan stock exchange, our first task consisted in identifying IPOs. Similarly to Chambers and Dimson (2009) we excluded introductions, new listings by firms with a dispersed and broad prior stockholder base, transfers of listings from other markets, the cross-listings of companies quoted on another exchange, IPOs of closed-end-funds commonly known as investment trust.For each IPO firm we assessed the survival time after the listing, defined as the time elapsed from the IPO up to the suspension, liquidation or any other event leading to the delisting from a stock exchange, with the exception of transfers to another market.