Bad news travels fast: comment letters, investor trading behavior, and stock liquidity
Shouyu Yao, Chaoshin Chiao, Chunfeng Wang, Feiyang Cheng, Pan HuangPurpose
This study investigates the effect of real-time disclosed regulatory comment letters on corporate stock liquidity and explores the underlying driving factors, using a unique sample from the Chinese stock market. Leveraging the timely nature of comment letter issuance and the subsequent reply mechanism in China, the paper aims to unambiguously identify the market consequences of comment letters and the associated mechanisms. Specifically, we focus on the role of different investor groups' trading behaviors, particularly retail net-sells and investor sentiment, in mediating the liquidity changes. Ultimately, this research provides new insights into the market monitoring effect of comment letters and regulatory enforcement in emerging markets.
Design/methodology/approach
We manually collected a sample of comment letters and their real-time replies issued by the Shenzhen Stock Exchange (SZSE) from 2014 to 2018. We employ event study methodology and Difference-in-Differences (DiD) models to analyze the changes in inquired firms' stock liquidity, measured by the Quoted Spread (QS) and Effective Spread (ES), following the comment letter disclosure. We proxy retail investor trading behavior using net sell volumes of small transactions and examine the driving role of retail net-sells and negative retail sentiment in the observed liquidity decline. This design leverages the unique institutional setting of real-time disclosure in the Chinese market.
Findings
The findings demonstrate that the stock liquidity of inquired firms significantly declines immediately after the comment letter disclosure. However, this decline does not significantly recover after the firms issue their subsequent replies. The short-term deterioration in liquidity is mainly driven by intense retail net-selling activities and heightened negative retail sentiment. Furthermore, the liquidity exhibits only a partial recovery over a longer period, extending up to 60 days post-disclosure. Finally, the negative effect of comment letters on stock liquidity is more pronounced for firms characterized by higher information uncertainty and greater corporate governance deficiencies.
Originality/value
This study uses the real-time disclosure mechanism of comment letters in the Chinese market to examine their impact on the trading behavior of different investor groups, particularly retail investors, thus mitigating concerns about insider trading. It confirms a significant regulatory effect of comment letters as a non-punitive regulatory tool in the capital market, filling a gap in the literature regarding their efficacy. By focusing on the unique emerging market context of China, this research enriches the global understanding of comment letters' impact and offers important practical implications for improving regulatory instruments worldwide.