Research Paper

Accounting
Leakage of Information: Its effect

on stock price and firm

performance
Abstract:

The paper presents information about the different kinds of news which are

leaked out of a company and how they affect the performance and stock

market liquidity. Information leakage is when a person or a group of persons

reveal specific data about some precious information. Leakage can be

voluntary or involuntary and it can have a good or a bad effect on the firm

position. The most efficient mode of transmission is rumours (also called

word of mouth) and actual facts and figures involuntarily leaked out of the

firm. This knowledge affects the decision making of the trader. Our paper

briefly highlights the behavior of an early informed trader. This change in

decision making alters the firm performance as well as creates a shift in

stock prices occasionally. If the rumours stay present they are bound to

produces a price run up in stocks. We have discovered that the Securities

and Exchange Commission has tried to account for this problem and its RFD

(regulation fair disclosure) aims to serve the purpose of its prevention to the

lowest possible.

Contents
Abstract:.....................................................................................................................2

INTRODUCTION:..........................................................................................................3

LITERATURE REVIEW:.................................................................................................5

METHODOLOGY:.........................................................................................................7

Ways of leaking information:...........................................................................................7

Rumours:....................................................................................................................8

Word of mouth communication:....................................................................................9

Mass communication:.................................................................................................9

How does a rumour become strong?...............................................................................9

Lay-off Rumours:....................................................................................................10

Takeover Rumours:..................................................................................................12

Bailout Rumours:....................................................................................................13

Security and Exchange Commission:...............................................................................14

CONCLUSION:...........................................................................................................15

REFERENCE:.............................................................................................................16

REFERENCE:

INTRODUCTION:

“Rumour…speed lends her strength and she wins vigour as she goes, clinging to the false and

wrong yet heralding truth.”__ Vergil Aeneis, Book IV.

In an ideally perfect market all investors will receive information at the appropriate time with all

the recipients getting the information at the same time. In reality, however, the corporate insiders
and their favoured parties can receive premonitions about the upcoming happenings before it is

revealed to the public.

Information leakage is when a system’s internal knowledge, initially closed to an outsider is

somehow revealed to unauthorized persons. Information leakage does not always involve a

breach in security; rather it can be a means to give the receiver a benefit to exploit the

information to his own advantage. Information is disclosed by variable sources which might

sometimes be the company itself and there are times when it is revealed by the unauthorized

personals to the outsiders. Information leakage has one basic aim _ to inform the trader

beforehand and create a change in stock prices in return. Information leakage affects the stock

market liquidity causing it to either benefit or harm the company. Information is leaked by means

of rumours either voluntarily or involuntarily. Rumours cover a number of information which

might have an impact on the stock prices. Managers disclose information about their firm if it is

likely to increase the value of stocks and withhold the information which might harm the stocks.

Takeover rumours, Layoff-off rumours, bail-out rumours and write-down rumours are most

commonly spread around. They lead to some sort of change but the intensity of effect depends

upon the strength of the rumour. A rumour grasps strength when it is repeatedly heard from a

variable number of sources. Despite the increase or decrease of stock prices caused by leakage of

information, there is always a long term investment cost to the investor and an economic cost to

the firm. In the early 1990’s the company disclosed information about its stocks to the investors

which was utilized by them for decision making. Later on internet started to gain popularity in

spreading information about the firm’s financial position. This mode has now been exploited to

such a vast extent that now information is disclosed in the shortest time if intended. The

Securities and Exchange Commission, the regulatory agency tried to take steps to minimize these

effects. The leakage of information was not considered up until a long time, however their
importance has been recently acknowledged by economists on account of its effects on firm

performance and stocks. SEC has passed rules and regulations and it is mandatory to follow them

in order to have a sound reputation in the market. Regulation Fair disclosure RFD is now passed

by the SEC to improve the observation of rules in business and ensure the fair buying and selling

of shares. It prohibits the companies from revealing information earlier to analysts and traders.

LITERATURE REVIEW:

Our findings are divided on whether the company reveals information voluntarily or is it leaked

out unconsciously. This paper can be considered as an amalgamation of a number of researches

on this topic and our own final interpretation from it.

Micheal Kosfeld| (2001), Aditya Goenka (2000), Sara Fisher (2007), Wallace (2007), Eva

Sletten (2006) are our basic source of information. Apart from these we have found other papers

on the related issues as well. Most of them deal with rumours and its impacts.

Although rumours are well-known in real life they are almost absent in economic theory. Only in

recent years economists have started to look at rumours, from a quantitative as well as qualitative

aspect. e.g. Koenig (1985), Kapferer (1989), Pound and Zeckhauser (1990), Banerjee (1993) and

Zivney et al (1996) an early exemption is Rose (1951). Our paper aims to tell about the

qualitative aspect of rumours and their effects however.

Micheal Kosfeld(2001) says that rumours produce a price rup-up causing an increase in stock

prices. Price run-ups related to rumours have been observed in an early study by Rose (1951) and

more recently by Pound and Zeckhauser (1990) and Zivney et al. (1996). Our paper supports this

point and research shows that rumours lead to price run ups in the market.

Dye (1985) and Verrecchia (1983) suggest that managers reveal news about firm value which

favorably affects the stock price and withhold the information which has a bad effect on it.

A trader receiving some information about the some forthcoming event can exploit it twice, first

when he receives it and next when it is publicly revealed. (Marcus K. Brunnermeier)

Pound and Zeckhauser (1990) have examined the effects of takeover rumours on stock prices.

We have analyzed the effects of takeover rumours its pros and cons, along with a case study to

support our point.

The functions of Security and exchange Commission have been discussed in detail in a number

of papers as well as in online encyclopedia. Our paper quotes their rules and regulations in order

to show its stance on the matter.

METHODOLOGY:

We have tried to use variable number of sources for the content of the paper. Our primary source

remains the internet. Apart from the internet we have gone through a detailed analysis of the

research work of various scholars and economists. For the case studies we have browsed through

the Business Recorder Pakistan for cases concerned with the national market and for the

international case studies we have sifted through the PAGE, Business week, Newsweek and

Bizweek. The Companies covered by us include Walls, Polka, Barclays, Dechert and Tapal (pvt)
ltd. The encyclopedia used for the keywords and concept grasping has been Investopedia and

Wikipedia online. For the definitions and keyword explanation online dictionaries have been

used. (Merriam Webster and Oxford Dictionary) .

Ways of leaking information:

There are two types of financial information leaked out about a firm on which the investors are

dependent. They are

i) Voluntary

ii) Involuntary

Both have an effect on the stock prices of the firm and eventually the rise or fall of the prices

affects the company’s performance.

Voluntary information is leaked out by a company itself. The information disclosed can either be

a rumour or an actual fact. The information usually is good news used by the managers as a

means to increase the price of the company’s stock. The company can circulate information

through national press or through official media. At the same time they withhold the information

that is going to have an adverse effect on the company. As a result the share price after the

information has been leaked out is higher than the price before the information leakage. This

helps the company to prosper as the price run-up has a positive effect on the company’s

performance. In some cases the managers also disclose bad news early in order to inform the

loyal customers about the future risks.

Involuntary information is a category of information leakage which is usually a rumour created

by people outside the company and sometimes by the workers of the company. The main aim is
to harm the company’s reputation by creating misconceptions about the company. However

sometimes they can have an effect otherwise.

Rumours:

Rumours have an impact on different economic variables, such as market demand and

equilibrium prices.

Rumours are a part of everyday life. We hear rumours everywhere, sometimes about a strong

political leader other times about some policy of government, some secret activities and yet

there are times when we hear rumours about the national and international market. The

importance of rumours in economics was absent for a long time, up until recently, when the

economists started to acknowledge the significance of rumours. Rumours can be spread through

many ways. Mostly through:

i) Word of mouth communication

ii) Mass communication

Word of mouth communication:

This type of communication is initially spread through a casual exchange of words, however, if

the source is persistent and strong enough, it eventually becomes believable. This can have a

significant effect on the stock prices and produces a price run up. Thus these rumours take the

form of beliefs and these beliefs later on diffuse within a market economy hereby affecting the

outcomes.

Mass communication:

Mass communication involves the spread of information either through the print media or

through the electronic media1. It is the strongest of all sources of communication. Investors
greatly rely on this mode of communication for buying and selling stocks. The spread of rumours

can have an adverse effect on the company’s stock value. Therefore, it is the moral and ethical

responsibility of the journalists and other communicators to respect the privacy of the firm and

not disclose information until and unless it is from a fairly reliable source.

How does a rumour become strong?

Sell on the rumour, buy on the news. That is the Wall Street journals adviced for individual

investors. However for the institutional investors they say sell when the company officials tell

you, buy when they tell everyone else.

The more the number of communicators the greater is the credibility of the rumour. Thus every

other person who communicates a rumour becomes an infectious agent and helps to strengthen

the rumour. The word of mouth communication grasps hold in this way e.g. increase in the price

of the good i.e. share of some well known company together with a rumour about the takeover of

that company will make the communicator have a stronger belief in the rumour. To support our

findings we have the example of the entrance of Unilever in Pakistan’s ice cream industry. There

were four well known ice cream brands in Pakistan in the early 1990’s namely; IGLOO,

POLKA, ROCCO and YUMMY. However, in 1995 Lever Brothers, a multi-national company

entered the ice cream industry of Pakistan as Wall’s and purchased all assets of Polka ice cream

which was the only large competitor to Wall’s at that time. According to an estimate the takeover

of Polka by Unilever Pakistan Limited under the subsidiary branch of Wall’s would result in an

increase of 64.45% in the stock sector. Therefore the rumours about a possible takeover were

leaked out beforehand to favour the stock run up.

There are many kinds of rumours and information leakages including the lay-off rumours,

takeover rumours, and rumours about increase in share prices of the firm. Apart from these there

are many other types of information which can be exchanged through rumours and gossip1.

Lay-off Rumours:

Lay-off rumours2 of several firms and agencies have been reported recently which can create a

negative impact on the firm. This is illustrated by an example below.

Dechert, an international law firm of more than 1000 lawyers, having top ranked practices in

various legal services operates throughout USA and Europe. Rumours about the lay-off of

several of its agents have been revealed. The rumours claim that the lay-offs are not performance

related (some of the people affected were given good performance reviews a few months ago),

rather they are economy related. According to the rumours, stealth lay-offs are occurring

whereas no official lay-offs have taken place giving rise to further suspicion. The news claim

several associate lay-offs ranging from 13-18 and even more across several months since March.

These rumours are having a negative impact on the firm and its reputation has been tarnished

greatly. It has left many lawyers unemployed. Lay-offs without solid reason have led to distrust

and discontent among attorneys and the already employed are looking for alternative jobs.

However finding jobs is becoming increasingly difficult.

The Dechert Chairman Barton J.Winokur disclaims any allegations saying that “Lay-off rumours

are bull” however the damage already done is irreparable.

1 Market prices, Inflation rates, Growth rates, Share indices, layoffs, inside trading, theft and fraud, financial statements, annual
reports, management, employee reviews about a company, financial resources, obligations, and activities of the economic entity

(either an organization or an individual), purchases and sales of the business enterprise.

2 To dismiss an employee temporarily/permanently because of slack business.

Lay-offs should be a well guarded secret, until the official announcement itself includes as many

as the firm feels necessary. The firm should later on ensure the remaining staff about it position

and future motives to create a feeling of amity and trust.

Dechert has publicized its revenue. It has shown an increase in its profit per equity partner by an

18.1% from $1.99million in 2006 to $2.35million in 2007. This is a contradiction to the rumours

creating confusion among the audience and raising questions as to who is sharing in the firm

success and how is the profit being measured. The legal industry is already in a bad crisis and

these unconfirmed reports are further creating concerns among the industry leaders about the

possible associate lay-offs.

The profit reports along with the lay-off rumours is creating suspicion and confirming the

rumbling of something about to go down at Dechert LLP.

Takeover Rumours:

News of a company takeover bid influences the share prices. Takeover3 rumours often decrease

the share prices instantly because there is less demand for shares in the market. Takeover

rumours can lead to over-reaction therefore careful consideration should be given before any

news is passed on. Takeover rumours sometimes favour the stock prices of the target company.

This is due to the fact that investors tend to risk the possibility of future investment benefits.

Thus these rumours can sometimes be voluntarily leaked out of a firm in order to serve the

required purpose.

A false takeover rumour can cause a monetary cost to the company. This is illustrated by an

example.

3 To acquire the control of a corporation by stock purchase or exchange, either hostile or

friendly.
Tapal takeover rumours by it prime competitor Unilever are recently being circulated around the

market. However, these rumours are declared as false and baseless by Y.H.Thara, Executive

Director & Company Secretary Tapal. These rumours have been believed to be spread by proper

planning in order to affect the company’s performance. These rumours are meant to demoralize

the employees and also lead to the weakening of distribution networks of Tapal Pvt. Ltd. Since

Tapal today enjoys over 17 per cent or 22 million kilogram share of the total tea market

annually up from 10 million kilogram in 1990. Tapal's envious growth has come at the expense

of its multinational competitors, Brooke Bond and Lipton brands, whose combined market share

has shrunk from 60 million kg to 45 million kg during the same period, General Manager

Finance and Corporate Services of Tapal Y.H. Thara told PAGE

(http://www.pakistaneconomist.com/issue2000/issue46/i&e1.htm)

This explains that these rumours might have been circulated intentionally by its market rivals.

Bailout Rumours:

Bailout is an act of loaning or giving capital to a failing business in order to save it from

bankruptcy, insolvency, or total liquidation and ruin.

(The New Oxford American Dictionary, First Edition, Elizabeth J. Jewell and Frank R. Abate)

Barclays Bank, one of the UK’s high street banking giants, has seen its share prices fall to their

lowest level in two and a half years.

Rumours about the financial problems of the bank have been spread across UK. These rumours

originated in August 2007 when the bank took two overnight loans from the Bank of England.

Barclays borrowed £1.6bn from the bank of England. This confirmed the speculations that the

bank is currently unable to settle the debts of other banks during daily trades.
However these rumours have been regarded as baseless by Bob Diamond, the president of

Barclays plc. Barclays shares dropped 9% on Nov 9th, 07. The shares even got suspended due to

rumours of a £4.8bn ($10bn) exposure to bad debts in the US. However, a Barclays spokesman

denied the rumours saying "There are no liquidity issues in the U.K markets. Barclays itself is

flushed with liquidity."

These rumours have now been dispelled but the share prices have closed with a sharp lowering.

Security and Exchange Commission:

The Securities and Exchange Commission is the regulatory agency that prevents corporate

abuses relating to the offering and sale of securities and corporate reporting. SEC has the

powers to inflict punishment on those who are found guilty of accounting frauds, spreading false

information about any company and indulging in inside trading. Under the disclosure

requirement of SEC, a company must inform the market as soon as there is any news likely to

have a material effect on share prices.

Regulation Fair Disclosure (RFD) is an SEC ruling passed in 2001 in an effort to prevent

selective disclosure by public companies to market professionals and certain shareholders.

The Regulation FD rule reads as follows: "Whenever an issuer, or any person acting on its

behalf, discloses any material nonpublic information regarding that issuer or its securities to

[certain enumerated persons], the issuer shall make public disclosure of that information...

simultaneously, in the case of an intentional disclosure; and... promptly, in the case of a non-

intentional disclosure."

(http://www.investopedia.com/terms/r/regulationfd.asp)
The RFD aims to even the playing field between the individual investors and institutional

investors, since an early institutional investor often acquires the information beforehand and

uses it to his benefit as he knows the inside information about the company. Companies used to

release important information through brokers during meetings and conference calls which gave

the institutional investor an edge over the general public and share holders. Later on, with the

advancement in electronic media online discount brokers also started to work for timely

reporting to traders. This way the Internet placed an encyclopedia of rich research information

into the hands of investors. Buyers and investors grew hungrier for more information thus the

online brokers started to exploit this mode of information to enable the investors to make more

efficient investment decision. The RFD serves to ensure uniform transmission of information to

everyone. The RFD was strongly opposed initially by the institutional investors because they

were accustomed to benefitting from selectively disclosed material information. However in

October 2000, the SEC ratified Regulation FD which is now working efficiently.

CONCLUSION:

Financial accounting information basically assists the investors and creditors to decide about the

placement of their resources for investment. These decisions help the general public to

determine which company is successful these days and help them to invest their scarce sources

of cash. The share market is a constantly running business and it is starved for any kind of

available information. Investors and creditors aim to fulfill their respective purposes i.e.

investors are interested in the return on share whereas the creditors are interested in the return of

share. Therefore no matter which kind of news is achieved whether economic, political or

scientific, if it is likely to have an expected effect on the stock prices, it will get circulated and is

highly valued by the investors. This flow of information though efficient and informative, tends
to affect some agent in a bad way. Rumours cause a unidirectional trend where one might get

benefit but at the expense of harm to another. SEC’s ruling RFD is trying its best to minimize

this trend, but apart from the authorities it is the moral and ethical responsibility of every agent

within an economy to avoid the spread of unconfirmed news and follow a regular pattern of

annual or quarterly disclosure.

REFERENCE:

• M.Kosfeid/Journal of Mathematical Economics (2005); Rumours and markets

• Sara Fisher and Wallace P.Mullin (Oct,2007): Gradual incorporation of information into

stock prices

• Aditya Goenka (Dec, 2000); Informed Trading and the leakage of information

• Marcus K. Brunnermeier (Princeton university) ; Information leakage and market

efficiency

• Fateh Lakhan Institut de Recherche en Gestion, Université de Paris XII-Val de Marne,

Créteil, France ; Stock market liquidity and information asymmetry around voluntary
earnings disclosures
• http://www.investopedia.com/terms/s/sec.asp

• http://en.wikipedia.org/wiki/U.S._Securities_and_Exchange_Commission

• http://www.pakistaneconomist.com/issue2000/issue46/i&e1.htm

• http://www.topix.com/business/law/2008/10/dechert-chairman-layoff-rumors-are-bull

• http://abajournal.com/news/new_spin_on_dechert_layoffs/
• http://www.abovethelaw.com/2008/02/nationwide_layoff_watch_decher_1.php

• http://www.law.com/jsp/article.jsp?id=1202425437818

• http://www.telegraph.co.uk/finance/markets/2819147/Barclays-denies-$10bn-rumour-as-

shares-slide.html

• http://www.telegraph.co.uk/finance/markets/2818780/Barclays-rumours-knock-shares.html

• http://news.bbc.co.uk/2/hi/business/7087451.stm

• http://www.brecorder.com/index.php?

id=714824&currPageNo=1&query=&search=&term=&supDate=

• http://www.businessweek.com/

• http://www.investopedia.com/terms/r/regulationfd.asp

• http://www.sec.gov/answers/regfd.htm

• http://en.wikipedia.org/wiki/Regulation_Fair_Disclosure