Disclosure, Investment and Regulation

This paper provides a general model of voluntary and mandatory disclosure. In the present incomplete contract setting, disclosure determines the probability that the cash flow is verifiable. While disclosure is necessary to secure new financing, it provides existing claimholders with a windfall gain. Typically, the optimal voluntary disclosure level is below the socially optimal level. A mandatory standard improves welfare by reducing the deadweight loss of expropriation and by increasing investment efficiency. As complete mandatory disclosure may curtail investment, a partial standard can be superior. Furthermore, the model shows that better legal shareholder protection goes together with higher disclosure standards and that harmonization of disclosure standards may be detrimental.