Stock market response to regulatory reports of deceptive advertising: The moderating effect of omission bias and firm reputation

Whereas a growing body of research has examined the consumer-related implications of deceptive advertising, the stock market consequences stemming from the regulatory exposure of such infractions remain largely unexplored. In a step to address this gap, the current research examines the effect of regulatory reports of misleading ads on firm stock prices. Results from an event study, focusing on the pharmaceutical industry as the empirical context, show an average abnormal return of -0.91% associated with regulatory reports of deceptive advertising. Analysis of the abnormal returns, however, reveals that the stock market response to these reports is shaped by omission bias, in that investors penalize commission violations more than omission violations. Furthermore, firm reputation is found to moderate the penalty for commission violations. In addition, two experiments examine the effect of such violations on investor beliefs. The first helps elucidate the process mechanism underlying the observed stock market effects and the second provides insights regarding the reputation-omission bias interaction for firms committing repeat violations. Overall, our findings provide important theoretical, managerial, and public policy implications regarding the role of financial markets in regulating deceptive ad practices.