Archives For corporate law

The Forgotten Strand of the Anti-Monopoly Tradition in Anglo-American Law

Ben Sperry —  13 January 2021

Admirers of the late Supreme Court Justice Louis Brandeis and other antitrust populists often trace the history of American anti-monopoly sentiments from the Founding Era through the Progressive Era’s passage of laws to fight the scourge of 19th century monopolists. For example, Matt Stoller of the American Economic Liberties Project, both in his book Goliath and in other writings, frames the story of America essentially as a battle between monopolists and anti-monopolists.

According to this reading, it was in the late 20th century that powerful corporations and monied interests ultimately succeeded in winning the battle in favor of monopoly power against antitrust authorities, aided by the scholarship of the “ideological” Chicago school of economics and more moderate law & economics scholars like Herbert Hovenkamp of the University of Pennsylvania Law School.

It is a framing that leaves little room for disagreements about economic theory or evidence. One is either anti-monopoly or pro-monopoly, anti-corporate power or pro-corporate power.

What this story muddles is that the dominant anti-monopoly strain from English common law, which continued well into the late 19th century, was opposed specifically to government-granted monopoly. In contrast, today’s “anti-monopolists” focus myopically on alleged monopolies that often benefit consumers, while largely ignoring monopoly power granted by government. The real monopoly problem antitrust law fails to solve is its immunization of anticompetitive government policies. Recovering the older anti-monopoly tradition would better focus activists today.

Common Law Anti-Monopoly Tradition

Scholars like Timothy Sandefur of the Goldwater Institute have written about the right to earn a living that arose out of English common law and was inherited by the United States. This anti-monopoly stance was aimed at government-granted privileges, not at successful business ventures that gained significant size or scale.

For instance, 1602’s Darcy v. Allein, better known as the “Case of Monopolies,” dealt with a “patent” originally granted by Queen Elizabeth I in 1576 to Ralph Bowes, and later bought by Edward Darcy, to make and sell playing cards. Darcy did not innovate playing cards; he merely had permission to be the sole purveyor. Thomas Allein, who attempted to sell playing cards he created, was sued for violating Darcy’s exclusive rights. Darcy’s monopoly ultimately was held to be invalid by the court, which refused to convict Allein.

Edward Coke, who actually argued on behalf of the patent in Darcy v. Allen, wrote that the case stood for the proposition that:

All trades, as well mechanical as others, which prevent idleness (the bane of the commonwealth) and exercise men and youth in labour, for the maintenance of themselves and their families, and for the increase of their substance, to serve the Queen when occasion shall require, are profitable for the commonwealth, and therefore the grant to the plaintiff to have the sole making of them is against the common law, and the benefit and liberty of the subject. (emphasis added)

In essence, Coke’s argument was more closely linked to a “right to work” than to market structures, business efficiency, or firm conduct.

The courts largely resisted royal monopolies in 17th century England, finding such grants to violate the common law. For instance, in The Case of the Tailors of Ipswich, the court cited Darcy and found:

…at the common law, no man could be prohibited from working in any lawful trade, for the law abhors idleness, the mother of all evil… especially in young men, who ought in their youth, (which is their seed time) to learn lawful sciences and trades, which are profitable to the commonwealth, and whereof they might reap the fruit in their old age, for idle in youth, poor in age; and therefore the common law abhors all monopolies, which prohibit any from working in any lawful trade. (emphasis added)

The principles enunciated in these cases were eventually codified in the Statute of Monopolies, which prohibited the crown from granting monopolies in most circumstances. This was especially the case when the monopoly prevented the right to otherwise lawful work.

This common-law tradition also had disdain for private contracts that created monopoly by restraining the right to work. For instance, the famous Dyer’s case of 1414 held that a contract in which John Dyer promised not to practice his trade in the same town as the plaintiff was void for being an unreasonable restraint on trade.The judge is supposed to have said in response to the plaintiff’s complaint that he would have imprisoned anyone who had claimed such a monopoly on his own authority.

Over time, the common law developed analysis that looked at the reasonableness of restraints on trade, such as the extent to which they were limited in geographic reach and duration, as well as the consideration given in return. This part of the anti-monopoly tradition would later constitute the thread pulled on by the populists and progressives who created the earliest American antitrust laws.

Early American Anti-Monopoly Tradition

American law largely inherited the English common law system. It also inherited the anti-monopoly tradition the common law embodied. The founding generation of American lawyers were trained on Edward Coke’s commentary in “The Institutes of the Laws of England,” wherein he strongly opposed government-granted monopolies.

This sentiment can be found in the 1641 Massachusetts Body of Liberties, which stated: “No monopolies shall be granted or allowed amongst us, but of such new Inventions that are profitable to the Countrie, and that for a short time.” In fact, the Boston Tea Party itself was in part a protest of the monopoly granted to the East India Company, which included a special refund from duties by Parliament that no other tea importers enjoyed.

This anti-monopoly tradition also can be seen in the debates at the Constitutional Convention. A proposal to give the federal government power to grant “charters of incorporation” was voted down on fears it could lead to monopolies. Thomas Jefferson, George Mason, and several Antifederalists expressed concerns about the new national government’s ability to grant monopolies, arguing that an anti-monopoly clause should be added to the Constitution. Six states wanted to include provisions that would ban monopolies and the granting of special privileges in the Constitution.

The American anti-monopoly tradition remained largely an anti-government tradition throughout much of the 19th century, rearing its head in debates about the Bank of the United States, publicly-funded internal improvements, and government-granted monopolies over bridges and seas. Pamphleteer Lysander Spooner even tried to start a rival to the Post Office by appealing to the strong American impulse against monopoly.

Coinciding with the Industrial Revolution, liberalization of corporate law made it easier for private persons to organize firms that were not simply grants of exclusive monopoly. But discontent with industrialization and other social changes contributed to the birth of a populist movement, and later to progressives like Brandeis, who focused on private combinations and corporate power rather than government-granted privileges. This is the strand of anti-monopoly sentiment that continues to dominate the rhetoric today.

What This Means for Today

Modern anti-monopoly advocates have largely forgotten the lessons of the long Anglo-American tradition that found government is often the source of monopoly power. Indeed, American law privileges government’s ability to grant favors to businesses through licensing, the tax code, subsidies, and even regulation. The state action doctrine from Parker v. Brown exempts state and municipal authorities from antitrust lawsuits even where their policies have anticompetitive effects. And the Noerr-Pennington doctrine protects the rights of industry groups to lobby the government to pass anticompetitive laws.

As a result, government is often used to harm competition, with no remedy outside of the political process that created the monopoly. Antitrust law is used instead to target businesses built by serving consumers well in the marketplace.

Recovering this older anti-monopoly tradition would help focus the anti-monopoly movement on a serious problem modern antitrust misses. While the consumer-welfare standard that modern antitrust advocates often decry has helped to focus the law on actual harms to consumers, antitrust more broadly continues to encourage rent-seeking by immunizing state action and lobbying behavior.

In Amazon, Antitrust & Competition, Constitutional Law, Corporate & Securities Law, Economic Theory, Google, Intellectual Property, Law & Economics, Monopolization, Patent, Platforms, Truth on the Market , , , , , , , , , , , ,
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Buyback Backlash: Is the Ban Non-binding?

Eric Fruits —  27 March 2020

[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.

This post is authored by Eric Fruits, (Chief Economist, International Center for Law & Economics).]

The Wall Street Journal reports congressional leaders have agreed to impose limits on stock buybacks and dividend payments for companies receiving aid under the COVID-19 disaster relief package. 

Rather than a flat-out ban, the draft legislation forbids any company taking federal emergency loans or loan guarantees from repurchasing its own stock or paying shareholder dividends. The ban lasts for the term of the loans, plus one year after the aid had ended.

In theory, under a strict set of conditions, there is no difference between dividends and buybacks. Both approaches distribute cash from the corporation to shareholders. In practice, there are big differences between dividends and share repurchases.

  • Dividends are publicly visible actions and require authorization by the board of directors. Shareholders have expectations of regular, stable dividends. Buybacks generally lack such transparency. Firms have flexibility in choosing the timing and the amount of repurchases, subject to the details of their repurchase programs.
  • Cash dividends have no effect on the number of shares outstanding. In contrast, share repurchases reduce the number of shares outstanding. By reducing the number of shares outstanding, buybacks increase earnings per share, all other things being equal. 

Over the past 15 years, buybacks have outpaced dividend payouts. The figure above, from Seeking Alpha, shows that while dividends have grown relatively smoothly over time, the aggregate value of buybacks are volatile and vary with the business cycle. In general, firms increase their repurchases relative to dividends when the economy booms and reduce them when the economy slows or shrinks. 

This observation is consistent with a theory that buybacks are associated with periods of greater-than-expected financial performance. On the other hand, dividends are associated with expectations of long-term profitability. Dividends can decrease, but only when profits are expected to be “permanently” lower. 

During the Great Recession, the figure above shows that dividends declined by about 10%, the amount of share repurchases plummeted by approximately 85%. The flexibility afforded by buybacks provided stability in dividends.

There is some logic to dividend and buyback limits imposed by the COVID-19 disaster relief package. If a firm has enough cash on hand to pay dividends or repurchase shares, then it doesn’t need cash assistance from the federal government. Similarly, if a firm is so desperate for cash that it needs a federal loan or loan guarantee, then it doesn’t have enough cash to provide a payout to shareholders. Surely managers understand this and sophisticated shareholders should too.

Because of this understanding, the dividend and buyback limits may be a non-binding constraint. It’s not a “good look” for a corporation to accept millions of dollars in federal aid, only to turn around and hand out those taxpayer dollars to the company’s shareholders. That’s a sure way to get an unflattering profile in the New York Times and an invitation to attend an uncomfortable hearing at the U.S. Capitol. Even if a distressed firm could repurchase its shares, it’s unlikely that it would.

The logic behind the plus-one-year ban on dividends and buybacks is less clear. The relief package is meant to get the U.S. economy back to normal as fast as possible. That means if a firm repays its financial assistance early, the company’s shareholders should be rewarded with a cash payout rather than waiting a year for some arbitrary clock to run out.

The ban on dividends and buybacks may lead to an unintended consequence of increased merger and acquisition activity. Vox reports an email to Goldman Sachs’ investment banking division says Goldman expects to see an increase in hostile takeovers and shareholder activism as the prices of public companies fall. Cash rich firms who are subject to the ban and cannot get that cash to their existing shareholders may be especially susceptible takeover targets.

Desperate times call for desperate measures and these are desperate times. Buyback backlash has been brewing for sometime and the COVID-19 relief package presents a perfect opportunity to ban buybacks. With the pressures businesses are under right now, it’s unlikely there’ll be many buybacks over the next few months. The concern should be over the unintended consequences facing firms once the economy recovers.

In Banking, Corporate & Securities Law, COVID-19, Financial Regulation, Google, International Center for Law & Economics, Platforms, Regulation, The Law, Economics, and Policy of the COVID-19 Pandemic, Truth on the Market , , , , , , ,
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SUPREMES PRESERVE FRAUD ON THE MARKET (AND BAIL OUT CLASS ACTION PLAINTIFFS) – TIME FOR CONGRESS TO KILL IT

Alden Abbott —  25 June 2014

On June 23 the Supreme Court regrettably declined the chance to stem the abuses of private fraud-based class action securities litigation.  In Halliburton v. EPJ Fund (June 23, 2014), a six-Justice Supreme Court majority (Chief Justice Roberts writing for the Court, joined by Kennedy, Ginsburg, Breyer, Sotomayor, and Kagan) reversed the Fifth Circuit and held that a class action certification in a securities fraud case should be denied if the defendants produce evidence rebutting the presumption that defendants’ misrepresentations had a price impact. EPJ Fund filed a class action against Halliburton and one of its executives, alleging that they made misrepresentations designed to inflate Halliburton’s stock price, in violation of Section 10(b)(5) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5. In Basic v. Levinson (1988), the Supreme Court held that: (1) investors could satisfy the requirement that plaintiffs relied on defendants’ misrepresentations in buying stock by invoking a presumption that the price of stock traded reflects all public, material information, including material misrepresentations; but that (2) defendants could rebut this presumption by showing that the misrepresentations had no price impact.  Halliburton argued that class certification was inappropriate because the evidence it introduced to disprove loss causation also showed that its alleged misrepresentations had not affected its stock price, thereby rebutting the presumption. The district court rejected Halliburton’s argument and certified the class, and the Fifth Circuit affirmed, concluding that Halliburton could use its evidence only at trial. Although the Court rejected Halliburton’s arguments for overturning Basic, it agreed with Halliburton that defendants must be afforded an opportunity to rebut the presumption of reliance before class certification, because the fact that a misrepresentation has a price impact is “Basic’s fundamental premise.”

Justice Thomas, joined by Scalia and Alito, concurred in the judgment, but argued that the “fraud on the market” (FOTM) theory embodied in Basic should be overruled, based on logic, economic realities (“market efficiency has . . . lost its luster”), and subsequent jurisprudence clarifying class certification requirements.  Significantly, the Thomas dissent points to a variety of well-recognized motives for the purchase of securities that have nothing to do with a presumption (key to the FOTM theory) that the market accurately reflects the value of a stock in light of all public information:  “Many investors in fact trade for the opposite reason—that is, because they think the market has under- or overvalued the stock, and they believe they can profit from that mispricing. . . .  Other investors trade for reasons entirely unrelated to price—for instance, to address changing liquidity needs, tax concerns, or portfolio balancing requirements. . . .  In short, Basic’s assumption that all investors rely in common on price integrity is simply wrong.”  [citation omitted]

Thomas, Scalia, and Alito are right – the Court’s majority missed a major opportunity to rein in class action opportunism by failing to consign Basic to the graveyard of economically flawed Supreme Court precedents, where it belongs.  Given the costs and difficulties inherent in rebutting the presumption of reliance at the class action stage, Halliburton at best appears likely to impose only a minor constraint on securities fraud class actions.

The FOTM presumption that has enabled a substantial rise in securities class action litigation over the last quarter century makes no economic sense, according to the scholarly consensus.  What’s more, it imposes a variety of social harms on the very groups that were supposed to benefit from this doctrine, as described in a recent study of the political economy of FOTM.  Specifically, longer-term shareholders end up bearing the cost of class action settlements that benefit plaintiffs’ trial lawyers, and to the extent paying and receiving shareholders are fully diversified, FOTM is a wash in terms of compensation that turns into a net loss when costs including attorneys’ fees are included.  Moreover, FOTM’s utility as a fraud deterrent is “much muted” because payments are made by the corporation and its insurer, not the individual culpable agents.  In short, “[w]hen the dust settles, FOTM not only fails to meet its stated goals, it does not even try.”

Not included in this litany of FOTM’s shortcomings is the serious issue of error costs, and in particular the harmful avoidance of novel but efficient behavior by corporate officials that fear it will incorrectly be deemed “fraudulent.”  This largely stems from the fact that “fraud” is not precisely defined in the securities law context, which has led to “at least three costs: public and private actions are not brought on behalf of clearly specified regulatory objectives; the line between civil and criminal liability has become unacceptably blurred; and the law has come to provide at best a weak means of resolving vital public questions about wrongdoing in financial markets.”

In light of these problems, Congress should eliminate the eligibility of private securities fraud suits for class action certification.  Moreover, Congress should require a showing of specific reliance on fraudulent information as a prerequisite to any finding of liability in a private individual action.  What’s more, Congress ideally should require that the SEC define with greater specificity what categories of conduct it will deem actionable fraud, based on economic analysis, as a prerequisite for bringing enforcement actions in this area.

Public choice insights suggest this wish list will be difficult to obtain, of course (but not impossible, as passage of the Class Action Fairness Act of 2005 demonstrates).  Public support for reform might be sparked by drawing greater attention to the fact that class action securities litigation has actually tended to harm, rather than help, small investors.

What about even more far-reaching securities law reforms?  Asking Congress to consider decriminalizing insider trading undoubtedly is unrealistic at this juncture, but it is interesting to note that even mainstream journalists are starting to question the social utility of the SEC’s current crackdown on insider trading.  This focus may lead to a serious case of misplaced priorities.  Notably, as leading Federal District Court Judge (SDNY) and former Assistant U.S. Attorney (AUSA) Jed Rakoff has stressed, AUSAs avoid pursuing far more serious frauds arising out of the 2008 Financial Crisis in favor of bringing insider trading cases because the latter are easier to investigate and prosecute in a few years’ time, and, thus, best enhance the AUSAs’ marketability to law firms.  (Hat tip to my Heritage colleague Paul Larkin for the Rakoff reference.)

In Antitrust & Competition, Corporate & Securities Law, Error Costs, Securities , , , , ,
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Meese and Oman Spank the Corporate Law Prof Amici in Hobby Lobby

Thom Lambert —  2 June 2014

The Religious Freedom Restoration Act (RFRA) subjects government-imposed burdens on religious exercise to strict scrutiny.  In particular, the Act provides that “[g]overnment shall not substantially burden a person’s exercise of religion even if the burden results from a rule of general applicability” unless the government can establish that doing so is the least restrictive means of furthering a “compelling government interest.”

So suppose a for-profit corporation’s stock is owned entirely by evangelical Christians with deeply held religious objections to abortion.  May our federal government force the company to provide abortifacients to its employees?  That’s the central issue in Sebelius v. Hobby Lobby Stores, which the Supreme Court will soon decide.  As is so often the case, resolution of the issue turns on a seemingly mundane matter:  Is a for-profit corporation a “person” for purposes of RFRA?

In an amicus brief filed in the case, a group of forty-four corporate and criminal law professors argued that treating corporations as RFRA persons would contradict basic principles of corporate law.  Specifically, they asserted that corporations are distinct legal entities from their shareholders, who enjoy limited liability behind a corporate veil and cannot infect the corporation with their own personal religious views.  The very nature of a corporation, the scholars argued, precludes shareholders from exercising their religion in corporate form.  Thus, for-profit corporations can’t be “persons” for purposes of RFRA.

In what amounts to an epic takedown of the law professor amici, William & Mary law professors Alan Meese and Nathan Oman have published an article explaining why for-profit corporations are, in fact, RFRA persons.  Their piece in the Harvard Law Review Forum responds methodically to the key points made by the law professor amici and to a few other arguments against granting corporations free exercise rights.

Among the arguments that Meese and Oman ably rebut are:

  • Religious freedom applies only to natural persons.

Corporations are simply instrumentalities by which people act in the world, Meese and Oman observe.  Indeed, they are nothing more than nexuses of contracts, provided in standard form but highly tailorable by those utilizing them.  “When individuals act religiously using corporations they are engaged in religious exercise.  When we regulate corporations, we in fact burden the individuals who use the corporate form to pursue their goals.”

  • Given the essence of a corporation, which separates ownership and control, for-profit corporations can’t exercise religion in accordance with the views of their stockholders.

This claim is simply false.  First, it is possible — pretty easy, in fact — to unite ownership and control in a corporation.  Business planners regularly do so using shareholder agreements, and many states, including Delaware, explicitly allow for shareholder management of close corporations.  Second, scads of for-profit corporations engage in religiously motivated behavior — i.e., religious exercise.  Meese and Oman provide a nice litany of examples (with citations omitted here):

A kosher supermarket owned by Orthodox Jews challenged Massachusetts’ Sunday closing laws in 1960.  For seventy years, the Ukrops Supermarket chain in Virginia closed on Sundays, declined to sell alcohol, and encouraged employees to worship weekly.  A small grocery store in Minneapolis with a Muslim owner prepares halal meat and avoids taking loans that require payment of interest prohibited by Islamic law.  Chick-fil-A, whose mission statement promises to “glorify God,” is closed on Sundays.  A deli that complied with the kosher standards of its Conservative Jewish owners challenged the Orthodox definition of kosher found in New York’s kosher food law, echoing a previous challenge by a different corporation of a similar New Jersey law.  Tyson Foods employs more than 120 chaplains as part of its effort to maintain a “faith-friendly” culture.  New York City is home to many Kosher supermarkets that close two hours before sundown on Friday and do not reopen until Sunday.  A fast-food chain prints citations of biblical verses on its packaging and cups.  A Jewish entrepreneur in Brooklyn runs a gas station and coffee shop that serves only Kosher food.  Hobby Lobby closes on Sundays and plays Christian music in its stores.  The company provides employees with free access to chaplains, spiritual counseling, and religiously themed financial advice.  Moreover, the company does not sell shot glasses, refuses to allow its trucks to “backhaul” beer, and lost $3.3 million after declining to lease an empty building to a liquor store.

As these examples illustrate, the assertion by lower courts that “for-profit, secular corporations cannot engage in religious exercise” is just empirically false.

  • Allowing for-profit corporations to have religious beliefs would create intracorporate conflicts that would reduce the social value of the corporate form of business.

The corporate and criminal law professor amici described a parade of horribles that would occur if corporations were deemed RFRA persons.  They insisted, for example, that RFRA protection would inject religion into a corporation in a way that “could make the raising of capital more challenging, recruitment of employees more difficult, and entrepreneurial energy less likely to flourish.”  In addition, they said, RFRA protection “would invite contentious shareholder meetings, disruptive proxy contests, and expensive litigation regarding whether the corporations should adopt a religion and, if so, which one.”

But actual experience suggests there’s no reason to worry about such speculative harms.  As Meese and Oman observe, we’ve had lots of experience with this sort of thing:  Federal and state laws already allow for-profit corporations to decline to perform or pay for certain medical procedures if they have religious or moral objections.  From the Supreme Court’s 1963 Sherbert decision to its 1990 Smith decision, strict scrutiny applied to governmental infringements on corporations’ religious exercise.  A number of states have enacted their own versions of RFRA, most of which apply to corporations.   Thus, “[f]or over half a century, … there has been no per se bar to free exercise claims by for-profit corporations, and the parade of horribles envisioned by the [law professor amici] has simply not materialized.”  Indeed, “the scholars do not cite a single example of a corporate governance dispute connected to [corporate] decisions [related to religious exercise].”

  • Permitting for-profit corporations to claim protection under RFRA will lead to all sorts of false claims of religious belief in an attempt to evade government regulation.

The law professor amici suggest that affording RFRA protection to for-profit corporations may allow such companies to evade regulatory requirements by manufacturing a religious identity.  They argue that “[c]ompanies suffering a competitive disadvantage [because of a government regulation] will simply claim a ‘Road to Damascus’ conversion.  A company will adopt a board resolution asserting a religious belief inconsistent with whatever regulation they find obnoxious . . . .”

As Meese and Oman explain, however, this problem is not unique to for-profit corporations.  Natural persons may also assert insincere religious claims, and courts may need to assess sincerity to determine if free exercise rights are being violated.  The law professor amici contend that it would be unprecedented for courts to assess whether religious beliefs are asserted in “good faith.”  But the Supreme Court decision the amici cite in support of that proposition, Meese and Oman note, held only that courts lack competence to evaluate the truth of theological assertions or the accuracy of a particular litigant’s interpretation of his faith.  “This task is entirely separate … from the question of whether a litigant’s asserted religious beliefs are sincerely held.  Courts applying RFRA have not infrequently evaluated such sincerity.”

***

In addition to rebutting the foregoing arguments (and several others) against treating for-profit corporations as RFRA persons, Meese and Oman set forth a convincing affirmative argument based on the plain text of the statute and the Dictionary Act.  I’ll let you read that one on your own.

I’ll also point interested readers to Steve Bainbridge’s fantastic work on this issue.  Here is his critique of the corporate and criminal law professors’  amicus brief.  Here is his proposal for using the corporate law doctrine of reverse veil piercing to assess a for-profit corporation’s religious beliefs.

Read it all before SCOTUS rules!

In Corporate & Securities Law, Health Care, International, Regulation, Supreme Court, United Kingdom , , , , , , , , ,
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So What’s Going to Happen to Securities Fraud Class Actions? Some Thoughts on Halliburton

Thom Lambert —  7 March 2014

On Wednesday, the U.S. Supreme Court heard oral argument in Halliburton v. Erica P. John Fund, a case that could drastically alter the securities fraud landscape.  Here are a few thoughts on the issues at stake in the case and a cautious prediction about how the Court will rule.

First, some quick background for the uninitiated.  The broadest anti-fraud provision of the securities laws, Section 10(b) of the 1934 Securities Exchange Act, forbids the use of “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe….”  The Commission’s Rule 10b-5, then, makes it illegal “to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”

Although Section 10(b) doesn’t expressly entitle victims of securities fraud to sue for damages, the Supreme Court long ago inferred a private right of action to enforce the provision.  The elements of that judicially created private right of action are: (1) a material misrepresentation or omission by the defendant, (2) scienter (i.e., mental culpability worse than mere negligence) on the part of the defendant, (3) a connection between the misrepresentation or omission and the purchase or sale of a security, (4) the plaintiff’s reliance upon the misrepresentation or omission, (5) economic loss by the plaintiff, and (6) loss causation (i.e., the fraud, followed by revelation of the truth, was the proximate cause of the plaintiff’s investment loss).

For most individual investors, the economic loss resulting from any instance of securities fraud (and, thus, the potential recovery) is not enough to justify the costs of bringing a lawsuit.  Accordingly, 10b-5 suits seem like an appropriate context for class actions.  The elements of the judicially created cause of action, however, make class certification difficult.  That is because most securities fraud class actions would proceed under Federal Rule of Civil Procedure 23(b)(3), which requires that common issues of law or fact in all the plaintiffs’ cases predominate over plaintiff-specific issues.  Because the degree to which any individual investor relied upon a misrepresentation (element 4) requires proof of lots of investor-specific facts (How did you learn of the misrepresentation?, How did it influence your investment decision?, etc.), the reliance element would seem to preclude Rule 10b-5 class actions.

In Basic v. Levinson, a 1988 Supreme Court decision from which three justices were recused, a four-justice majority endorsed a doctrine that has permitted Rule 10b-5 class actions to proceed, despite the reliance element.  The so-called “fraud on the market” doctrine creates a rebuttable presumption that an investor who traded in an efficient stock market following a fraudulent disclosure (but before the truth was revealed) “relied” on that disclosure, even if she didn’t see or hear about it.  The theoretical basis for the fraud on the market doctrine is the semi-strong version of the Efficient Capital Markets Hypothesis (ECMH), which posits that securities prices almost instantly incorporate all publicly available information about the underlying company, making it impossible to earn above-normal returns by engaging in “fundamental analysis” (i.e., study of publicly available information about a listed company).  The logic of the fraud on the market doctrine is that publicly available misinformation affects a security’s price, upon which an investor normally relies when she makes her investment decision.  Thus, any investor who makes her investment decision on the basis of the stock’s price “relies” on the “ingredients” of that price, including the misinformation at issue.

In light of this logic, the Basic Court reasoned that a defendant could rebut the presumption of reliance by severing either the link between the misinformation and the stock’s price or the link between the stock’s price and the investor’s decision.  To sever the former link, the defendant would need to show that key market makers were privy to the truth, so that the complained of lie could not have affected the market price of the stock (in other words, there was “truth on the market”…great name for a blog, no?).  To sever the latter link, the defendant would need to show that the plaintiff investor made her investment decision for some reason unrelated to the stock’s price—say, because she needed to divest herself of the stock for political reasons.

Basic thus set up a scheme in which the class plaintiff bears the burden of establishing that the stock at issue traded in an efficient market.  If she does so, her (and similarly situated class members’) reliance on the misinformation at issue is presumed.  The defendant then bears the burden of rebutting the presumption by showing either that the misrepresentation did not give rise to a price distortion (probably because the truth was on the market) or that the individual investor would have traded even if she knew the statement was false (i.e., her decision was not based on the stock’s price).

The Halliburton appeal presents two questions.  First, should the Court overrule Basic and jettison the rebuttable presumption of reliance when the stock at issue is traded in an efficient market.  Second, at the class certification stage, should the defendant be permitted to prevent the reliance presumption from arising by presenting evidence that the alleged misrepresentation failed to distort the market price of the stock at issue.

With respect to the first question, the Court could go three ways.  First, it could maintain the status quo rule that 10b-5 plaintiffs, in order to obtain the reliance presumption, must establish only that the stock at issue was traded in an efficient market.  Second, it could overrule Basic wholesale and hold that a 10b-5 plaintiff must establish actual, individualized reliance (i.e., show that she knew of the misrepresentation and that it influenced her investment decision).  Third, the Court could tweak Basic by holding that plaintiffs may avail themselves of the presumption of reliance only if they establish, at the class certification stage, that the complained of
misrepresentation actually distorted the market price of the stock at issue.

My guess, which I held before oral argument and seems consistent with the justices’ questioning on Wednesday, is that the Court will take the third route.  There are serious problems with the status quo.  First, it rests squarely upon the semi-strong version of the ECMH, which has come under fire in recent years.  While no one doubts that securities prices generally incorporate publicly available information, and very quickly, a number of studies purporting to document the existence of arbitrage opportunities have challenged the empirical claim that every bit of publicly available information is immediately incorporated into the price of every security traded in an efficient market.  Indeed, the winners of this year’s Nobel Prize in Economics split on this very question.   I doubt this Supreme Court will want to be perceived as endorsing a controversial economic theory, especially when doing so isn’t necessary to maintain some sort of reliance presumption (given the third possible holding discussed above).

A second problem with the status quo is that it places an unreasonable burden on courts deciding whether to certify a class.  The threshold question for the fraud on the market presumption—is the security traded in an efficient market?—is just too difficult for non-specialist courts.  How does one identify an “efficient market”?  One court said the relevant factors are:  “(1) the stock’s average weekly trading volume; (2) the number of securities analysts that followed and reported on the stock; (3) the presence of market makers and arbitrageurs; (4) the company’s eligibility to file a Form S-3 Registration Statement; and (5) a cause-and-effect relationship, over time, between unexpected corporate events or financial releases and an immediate response in stock price.”  Others have supplemented these so-called “Cammer factors” with a few others: market capitalization, the bid/ask spread, float, and analyses of autocorrelation.  No one can say, though, how each factor should be assessed (e.g., How many securities analysts must follow the stock? How much autocorrelation is permissible?  How large may the bid-ask spread be?).  Nor is there guidance on how to balance factors when some weigh in favor of efficiency and others don’t.  It’s a crapshoot.

The status quo approach of presuming investor reliance if the plaintiff establishes an efficient market for the company’s stock is also troubling because the notion of a “market” for any single company’s stock is theoretically unsound.  An economic market consist of all products that are, from a buyer’s perspective, reasonably interchangeable.  For example, Evian bottled water (spring water from the Alps) is a very close substitute for Fiji water (spring water from the Fiji Islands) and is probably in the same product market.  From an investor’s perspective, there are scores of close substitutes for the stock of any particular company.  Such substitutes would include all other stocks that offer the same package of financial attributes (risk, expected return, etc.).  It makes little sense, then, to speak of a “market” consisting of a single company’s stock, and basing the presumption of reliance on establishment of an “efficient market” in one company’s stock is somewhat nonsensical.

With respect to the second possible route for the Halliburton Court—overturning Basic in its entirety and requiring individualized proof of actual reliance—proponents emphasize that the private right of action to enforce Section 10(b) and Rule 10b-5 is judicially created.  The Supreme Court now disfavors implied rights of action and, to avoid stepping on Congress’s turf, requires that they stick close to the statute at issue.  In particular, the Court has said that determining the elements of a private right of action requires “historical reconstruction.”  With respect to the Rule 10b-5 action, the Court tries “to infer how the 1934 Congress would have addressed the issue had the 10b-5 action been included as an express provision of the 1934 Act,” and to do that, it consults “the express causes of action” in the Act and borrows from the “most analogous” one.  In this case, that provision is Section 18(a), which is the only provision in the Exchange Act authorizing damages actions for misrepresentations affecting secondary, aftermarket trading (i.e., trading after a public offering of the stock at issue).  Section 18(a) requires a plaintiff to establish actual “eyeball” reliance—i.e., that she bought the security with knowledge of the false statement and relied upon it in making her investment decision.  There is thus a powerful legal argument in favor of a full-scale overturning of Basic.

As much as I’d like for the Court to take that route (because I believe Rule 10b-5 class actions create far greater social cost than benefit), I don’t think the Court will go there.  Overruling Basic to require eyeball reliance in Rule 10b-5 actions would be perceived as an activist, “pro-business” decision:  activist because Congress has enacted significant legislation addressing Rule 10b-5 actions and has left the fraud on the market doctrine untouched, and pro-business because it would insulate corporate managers from 10b-5 class actions.

Now, both of those characterizations are wrong.  The chief post-Basic legislation involving Rule 10b-5, the 1995 Private Securities Litigation Reform Act, specifically stated (in Section 203) that “[n]othing in this Act shall be deemed to … ratify any implied private right of action.”  As Justices Alito and Scalia emphasized at oral argument, the PSLRA expressly declined to put a congressional imprimatur on the judicially created Rule 10b-5 cause of action, so a Court decision modifying Rule 10b-5’s elements would hardly be “activist.” Nor would the decision be “pro-business” and “anti-investor.”  The fact is, the vast majority of Rule 10b-5 class actions are settled on terms where the corporation pays the bulk of the settlement, which largely goes to class counsel.  The corporation, of course, is spending investors’ money.  All told, then, investors as a class pay a lot for, and get very little from, Rule 10b-5 class actions.  A ruling eviscerating such actions would better be characterized as pro-investor.

Sadly, our financially illiterate news media cannot be expected to understand all this and would, if Basic were overturned, fill the newsstands and airwaves with familiar stories of how the Roberts Court continues on its activist, pro-business rampage.  And even more sadly, at least one key justice whose vote would be needed for a Basic overruling, has proven himself to be exceedingly concerned with avoiding the appearance of “activism.”  A wholesale overruling of Basic, then, is unlikely.

That leaves the third route, modifying Basic to require that class plaintiffs first establish a price distortion resulting from the complained of misrepresentation.  I have long suspected that this is where the Court will go, and the justices’ questioning on Wednesday suggests this is how many (especially Chief Justice Roberts and Justice Kennedy) are leaning.  From the Court’s perspective, there are several benefits to this approach.

First, it would allow the Court to avoid passing judgment on the semi-strong ECMH.  The status quo approach—prove an efficient market and we’ll presume reliance because of an inevitable price effect—really seems to endorse the semi-strong ECMH.  An approach requiring proof of price distortion, by contrast, doesn’t.  It may implicitly assume that most pieces of public information are instantly incorporated into securities prices, but no one really doubts that.

Second, the third route would substitute a fairly manageable inquiry (Did the misrepresentation occasion a price effect?) for one that is both difficult and theoretically problematic (Is the market for the company’s stock efficient?).

Third, the approach would allow the Court to eliminate a number of the most meritless securities fraud class actions without appearing overly “activist” and “pro-business.”  If class plaintiffs can’t show a price effect from a complained of misrepresentation or omission, then their claim is really frivolous and ought to go away immediately.  The status quo would permit certification of the class, despite the absence of a price effect, as long as class counsel could demonstrate an efficient market using the amorphous and unreliable factors set forth above.  And once the class is certified, the plaintiffs have tons of settlement leverage, even when they don’t have much of a claim.  In short, the price distortion criterion is a far better screen than the market efficiency screen courts currently utilize.  For all these reasons, I suspect the Court will decide not to overrule Basic but to tweak it to require a threshold showing of price distortion.

If it does so, then the second question at issue in Halliburton—may the defendant, at the class certification stage, present evidence of an absence of price distortion?—goes away.  If the plaintiff must establish price distortion to attain class certification, then due process would require that the defendant be allowed to poke holes in the plaintiff’s certification case.

So that’s my prediction on Halliburton.  We shall see.  Whatever the outcome, we’ll have lots to discuss in June.

In Corporate & Securities Law, Economic Theory, Financial Regulation, Regulation, Securities , , ,
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Contemplating Disclosure-Based Insider Trading Regulation

Thom Lambert —  15 June 2012

TOTM friend Stephen Bainbridge is editing a new book on insider trading.  He kindly invited me to contribute a chapter, which I’ve now posted to SSRN (download here).  In the chapter, I consider whether a disclosure-based approach might be the best way to regulate insider trading.

As law and economics scholars have long recognized, informed stock trading may create both harms and benefits to society.  With respect to harms, defenders of insider trading restrictions have maintained that informed stock trading is “unfair” to uninformed traders and causes social welfare losses by (1) encouraging deliberate mismanagement or disclosure delays aimed at generating trading profits; (2) infringing corporations’ informational property rights, thereby discouraging the production of valuable information; and (3) reducing trading efficiency by increasing the “bid-ask” spread demanded by stock specialists, who systematically lose on trades with insiders.

Proponents of insider trading liberalization have downplayed these harms.  With respect to the fairness argument, they contend that insider trading cannot be “unfair” to investors who know in advance that it might occur and nonetheless choose to trade.  And the purported efficiency losses occasioned by insider trading, liberalization proponents say, are overblown.  There is little actual evidence that insider trading reduces liquidity by discouraging individuals from investing in the stock market, and it might actually increase such liquidity by providing benefits to investors in equities.  With respect to the claim that insider trading creates incentives for delayed disclosures and value-reducing management decisions, advocates of deregulation claim that such mismanagement is unlikely for several reasons.  First, managers face reputational constraints that will discourage such misbehavior.  In addition, managers, who generally work in teams, cannot engage in value-destroying mismanagement without persuading their colleagues to go along with the strategy, which implies that any particular employee’s ability to engage in mismanagement will be constrained by her colleagues’ attempts to maximize firm value or to gain personally by exposing proposed mismanagement.  With respect to the property rights concern, deregulation proponents contend that, even if material nonpublic information is worthy of property protection, the property right need not be a non-transferable interest granted to the corporation; efficiency considerations may call for the right to be transferable and/or initially allocated to a different party (e.g., to insiders).  Finally, legalization proponents observe that there is little empirical evidence to support the concern that insider trading increases bid-ask spreads.

Turning to their affirmative case, proponents of insider trading legalization (beginning with Geoff’s dad, Henry Manne) have primarily emphasized two potential benefits of the practice.  First, they observe that insider trading increases stock market efficiency (i.e., the degree to which stock prices reflect true value), which in turn facilitates efficient resource allocation among capital providers and enhances managerial decision-making by reducing agency costs resulting from overvalued equity.  In addition, the right to engage in insider trading may constitute an efficient form of managerial compensation.

Not surprisingly, proponents of insider trading restrictions have taken issue with both of these purported benefits. With respect to the argument that insider trading leads to more efficient securities prices, ban proponents retort that trading by insiders conveys information only to the extent it is revealed, and even then the message it conveys is “noisy” or ambiguous, given that insiders may trade for a variety of reasons, many of which are unrelated to their possession of inside information.  Defenders of restrictions further maintain that insider trading is an inefficient, clumsy, and possibly perverse compensation mechanism.

The one thing that is clear in all this is that insider trading is a “mixed bag”  Sometimes such trading threatens to harm social welfare, as in SEC v. Texas Gulf Sulphur, where informed trading threatened to prevent a corporation from usurping a valuable opportunity.  But sometimes such trading creates net social benefits, as in Dirks v. SEC, where the trading revealed massive corporate fraud.

As regular TOTM readers will know, optimal regulation of “mixed bag” business practices (which are all over the place in the antitrust world) requires consideration of the costs of underdeterring “bad” conduct and of overdeterring “good” conduct.  Collectively, these constitute a rule’s “error costs.”  Policy makers should also consider the cost of administering the rule at issue; as they increase the complexity of the rule to reduce error costs, they may unwittingly drive up “decision costs” for adjudicators and business planners.  The goal of the policy maker addressing a mixed bag practice, then, should be to craft a rule that minimizes the sum of error and decision costs.

Adjudged under that criterion, the currently prevailing “fraud-based” rules on insider trading fail.  They are difficult to administer, and they occasion significant error cost by deterring many instances of socially desirable insider trading.  The more restrictive “equality of information-based” approach apparently favored by regulators fares even worse.  A contractarian, laissez-faire approach favored by many law and economics scholars would represent an improvement over the status quo, but that approach, too, may be suboptimal, for it does nothing to bolster the benefits or reduce the harms associated with insider trading.

My new book chapter proposes a disclosure-based approach that would help reduce the sum of error and decision costs resulting from insider trading and its regulation.  Under the proposed approach, authorized informed trading would be permitted as long as the trader first disclosed to a centralized, searchable database her insider status, the fact that she was trading on the basis of material, nonpublic in­formation, and the nature of her trade.  Such an approach would (1) enhance the market efficiency benefits of insider trading by facilitating “trade decod­ing,” while (2) reducing potential costs stemming from deliberate misman­agement, disclosure delays, and infringement of informational property rights.  By “accentuating the positive” and “eliminating the negative” conse­quences of informed trading, the proposed approach would perform better than the legal status quo and the leading proposed regulatory alternatives at minimizing the sum of error and decision costs resulting from insider trading restrictions.

Please download the paper and send me any thoughts.

In Amazon, Antitrust & Competition, Corporate & Securities Law, Error Costs, Financial Regulation, Platforms, Regulation, Securities , , , , ,
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UCLA Law’s Lowell Milken Institute Law Teaching Fellowship Now Accepting Applications

Josh Wright —  20 December 2011

I’m pleased to pass along the following information from the Lowell Milken Institute for Business Law and Policy at UCLA School of Law:

 

Introduction

  • The Lowell Milken Institute for Business Law and Policy at UCLA School of Law is now accepting applications for the Lowell Milken Institute Law Teaching Fellowship.
  • This fellowship is a full-time, year-round, one or two academic-year position (approximately July 2012 through June 2013 or June 2014).  The position involves law teaching, legal and policy research and writing, preparing to go on the law teaching market, and assisting with organizing projects such as conferences and workshops, and teaching.  No degree will be offered as part of the Fellowship program.

Eligibility

  • Fellowship candidates must hold a JD degree from an ABA accredited law school and be committed to a career of law teaching and scholarship in the field of  business law and policy.  Applicants should have demonstrated an outstanding aptitude for independent legal research, preferably through research and/or writing as a law student or through exceptional legal experience after law school. Law Teaching Fellowship candidates must have strong academic records that will make them highly competitive for law teaching jobs.

Fellowship Requirements

The Fellowship program is year-round, over one or two academic years, during which time the Fellow will:

  • complete at least one substantial scholarly publication and present the publication as a work-in-progress to the UCLA School of Law faculty;
  • teach at least one class per academic year of the appointment;
  • work closely with a faculty mentor in order to observe and participate in teaching, as well as to complete a publishable scholarly piece;
  • assist the Institute’s Executive Director with other projects relating to the Institute’s work, including organizing conferences and other events,  research, publications, public education and outreach efforts;
  • permit the Institute to publish any article(s) resulting from the Fellowship—as long as such publication will not interfere with the Fellow’s ability to publish such articles in a law journal; and
  • acknowledge the Institute’s assistance in any published work that is facilitated by the Fellowship.

Fellowship Benefits

The unique features of this Fellowship include opportunities to:

  • develop expertise in business law and public policy;
  • work with a faculty mentor;
  • develop expertise in business law teaching;
  • complete a published piece of research before entering the law teaching market;
  • obtain faculty recommendations and support for law teaching jobs;
  • participate in the rich mixture of scholarly symposia, invited lectures, and conferences of the Lowell Milken Institute for Business Law and Policy; and
  • participate in UCLA School of Law’s rich interdisciplinary scholarly symposia, lectures, and conferences.

Application Material and Deadlines

To apply for the 2012-2013 Lowell Milken Institute Law Teaching Fellowship, please submit the following materials by March 1, 2012:

  • A cover letter summarizing your qualifications for the fellowship;
  • A current resume, including a list of published works;
  • An official law school transcript;
  • Contact information for three references, including at least one from a law school professor familiar with your scholarly potential;
  • A detailed research proposal, no longer than five single-spaced pages in length; and
  • A description of teaching interests (course abstract and plan for class or seminar preferred)

Interested candidates should submit materials as a single PDF or Word.doc file to estrada@law.ucla.edu.

Equal Opportunity Employer

The University of California is an affirmative action/equal opportunity employer, and seeks candidates committed to the highest standards of scholarship and professional activities and to a campus climate that supports equality and diversity.

In Corporate & Securities Law ,
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Abolishing corporate personhood: still stupid

Larry Ribstein —  13 December 2011

Doug Mataconis criticizes efforts in Congress to overrule Citizens United by abolishing corporate personhood (HT Bainbridge).

I’ve already addressed this issue, noting among other things that “the loss of personhood would not have the slightest effect under Citizens United” because that case reasoned that the speaker’s identity is irrelevant.  In any event, I pointed out that “if personhood matters at all under Citizens United and subsequent decisions, the loss of personhood actually could be a constitutional boon to corporations.” That’s because “the post-Bellotti cases on corporate political speech showed that it is easier to deny First Amendment rights if the speech is attributed to an artificial person.”

In general, as I noted in my earlier post, this attempted sneak attack around CU crosses St. Hubbins-Tufnel fine line between clever and stupid.

In Constitutional Law, Corporate & Securities Law, First Amendment
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The jurisprudential significance of blogs

Larry Ribstein —  11 November 2011

Gordon Smith notes that this issue came up at a Columbia conference on Delaware law and courts.  He observes that the Glom gets a plug on a speaker’s slide.  So I’ll mention that above the Glom on the pictured slide we find. . . Truth on the Market.

In Corporate & Securities Law
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The emerging venue battle in El Paso/Kinder Morgan

Larry Ribstein —  22 October 2011

T-R’s Alison Frankel writes (HT Pileggi) about dueling suits in Texas and Delaware challenging the El Paso/Kinder Morgan merger: Three class actions in Texas state court and two class actions and a shareholder derivative suit in Delaware Chancery.

It looks like this merger may bring to a head the “escape from Delaware” phenomenon I discussed a year ago.

In Corporate & Securities Law, Jurisdictional Competition ,
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Debating the business judgment rule

Larry Ribstein —  5 October 2011

Alison Frankel gripes about a NJ judge’s ruling throwing out a shareholders’ derivative suit seeking to hold the J & J board accountable for problems concerning the company’s Rispardal drug. Frankel thinks the bad faith standard the court applied is not high enough.

Ted Frank responds that the fact that the company had settled criminal allegations doesn’t mean the board was irresponsible given big companies’ exposure to prosecutorial overreaching (here’s my thoughts on the problems with prosecutors).  He notes that given huge potential penalties and legal costs “even a risk-neutral set of executives would refuse to go to trial on criminal charges that they had a 95% chance of winning.”  As Ted says:

The issue is this: first, any corporate law is going to have to balance false negatives (valid suits against directors being thrown out prematurely) and false positives (invalid suits against directors costing tens of millions of dollars in time and money to resolve). Any opening up of the courtroom doors to challenge directors will reduce false negatives at the expense of more false positives; any increase in the burden to bring suit will reduce false positives at the expense of more false negatives.

Anyway, Ted continues, shareholders of NJ corporations can decide to invest in firms incorporated elsewhere if they think NJ law is too lenient on directors, aptly citing my and O’Hara’s The Law Market.

Of course Frankel might argue that the business judgment rule that the court used to decide the case is ubiquitous, leaving plaintiffs with little choice. Indeed, the only significant dissent is Nevada which is, if anything, even easier on directors than NJ.   Frankel might also argue that this indicates state corporation law is rigged for managers and that we would do better under federal law.  Perhaps what we need is a super Dodd-Frank/SOX on steroids that preempts state law and exposes managers to suits like the one NJ dismissed.

I would respond that the universal acceptance of the business judgment rule represents the market’s rejection of Frankel’s position.  If Frankel wants to complain that the market for corporate law is imperfect,  she would need to persuade me that shareholders are better off in the clutches of Congress.

In Amazon, Corporate & Securities Law, Federalism, Jurisdictional Competition, Platforms , ,
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SEC Organizational Reform Hearing

J.W. Verret —  14 September 2011

The semester is off to a bang.  I arrived at Stanford Monday to start teaching in the Law School and begin a research fellowship at the Hoover Institution.  Yesterday I hiked in the mountains overlooking the SF Bay.  Today I am flying back to DC (and blogging in flight, how cool is that) to testify Thursday before the House Committee on Financial Services alongside SEC Chairman Schapiro, former Chairman Pitt, and former Commissioner Paul Atkins on proposed legislation from Congressman Scott Garrett and Chairman Spencer Bachus to reform and reshape the SEC.

Part of the hearing, titled “Fixing the Watchdog: Legislative Proposals to Improve and Enhance the Securities and Exchange Commission” will deal with the study on SEC organizational reform mandated by the Dodd-Frank Act and conducted by the Boston Consulting Group.  Frankly, I found it full of quotes from the consultant’s desk manual, with references to “no-regrets implementation,” “business process optimization” and “multi-faceted transformation.”  I believe the technical term is gobbledy-gook.

The remainder of the hearing will involve a discussion of the SEC Organizational Reform Act (or “Bachus Bill”) and the SEC Regulatory Accountability Act (or “Garrett Bill”).  The Bachus Bill proposes a number of organizational reforms, like breaking up the new Division of Risk, Strategy, and Financial Innovation to embed the economists there back in to the various functional divisions.  The Garrett Bill seeks to strengthen the guiding principles originally formulated in the NSMIA amendments by elaborating on how the agency can meet its economic analysis burden in rule-making.

I thought I would give TOTM readers a sneak peak at my testimony.  I aim to make two key points.  First, sincere economic analysis is important.  SEC rules have consistently done a poor job of meeting the mandate of the NSMIA to consider the effect of new rules on efficiency, competition, and capital formation, and they will continue to do a poor job until they hire more economists and give them increased authority in the enforcement and the rule-making process.  Second, the SEC’s mission should include an explicit requirement that it consider the effect of new rules on the state based system of business entity formation.

Here’s a sneak peak at my testimony for TOTM readers:

Chairman Bachus, Ranking Member Frank, and distinguished members of the Committee, it is a privilege to testify today.  My name is J.W. Verret.  I am an Assistant Professor of Law at Stanford Law School where I teach corporate and securities law.  I also serve as a Fellow at the Hoover Institution and as a Senior Scholar at the Mercatus
Center at George Mason University.  I am currently on leave from the George Mason Law School.

My testimony today will focus on two important and necessary reforms.

First, I will argue that clarifying the SEC’s legislative mandate to conduct economic analysis and a commitment of authority to economists on staff at the SEC are both vital to ensure that new rules work for investors rather than against them.  Second, I will urge that the SEC be required to consider the impact of new rules on the state-based system of business incorporation.

Every President since Ronald Reagan has requested that independent agencies like the SEC commit to sincere economic cost-benefit analysis of new rules.  Further, unlike many other independent agencies the SEC is subject to a legislative mandate that it consider the effect of most new rules on investor protection, efficiency, competition and capital formation.

The latter three principles have been interpreted as requiring a form of cost-benefit economic analysis using empirical evidence, economic theory, and compliance cost data.  These tools help to determine rule impact on stock prices and stock exchange competitiveness and measure compliance costs that are passed on to investors.

Three times in the last ten years private parties have successfully challenged SEC rules for failure to meet these requirements.  Over the three cases, no less than five distinguished jurists on the DC Circuit, appointed during administrations of both Republican and Democratic Presidents, found the SEC’s economic analysis wanting. One
failure might have been an aberation, three failures out of three total challenges is a dangerous pattern.

Many SEC rules have treated the economic analysis requirements as an afterthought. This is in part a consequence of the low priority the Commission places on economic analysis, evidenced by the fact that economists have no significant authority in the rule-making process or the enforcement process.

As an example of the level of analysis typically given to significant rule-making, consider the SEC’s final release of its implementation of Section 404(b) of the Sarbanes-Oxley Act.  The SEC estimated that the rule would impose an annual cost of $91,000 per publicly traded company.  In fact a subsequent SEC study five years later found average implementation costs for 404(b) of $2.87 million per company.

That error in judgment only applies to estimates of direct costs.  The SEC gave no consideration whatsoever to the more important category of indirect costs, like the impact of the rule on the volume of new offerings or IPOs on US exchanges.

In Business Roundtable v. SEC alone the SEC estimates it dedicated over $2.5 million in staff hours to a rule that was struck down.  An honest commitment by the SEC to empower economists in the rule-making process will be a vital first step to ensure the mistakes of the proxy access rule are not replicated in future rules.

I also support the goal in H.R. 2308 to further elaborate on the economic analysis requirements.  I would suggest, in light of the importance and pervasiveness of the state-based system of corporate governance, that the bill include a provision requiring the SEC to consider the impact of new rules on the states when rule-making touches on issues of corporate governance.

The U.S. Supreme Court has noted that “No principle of corporation law and practice is more firmly established than a state’s authority to regulate domestic corporations.”

Delaware is one prominent example, serving as the state of incorporation for half of all publicly traded companies.  Its corporate code is so highly valued among shareholders that the mere fact of Delaware incorporation typically earns a publicly traded company a 2-8% increase in value.  Many other states also compete for incorporations, particularly New York, Massachusetts, California and Texas.

In order to fully appreciate this fundamental characteristic of our system, I would urge adding the following language to H.R. 2308:

“The Commission shall consider the impact of new rules on the traditional role of states in governing the internal affairs of business entities and whether it can achieve its stated objective without preempting state law.”

The SEC can comply by taking into account commentary from state governors and state secretaries of state during the open comment period.  It can minimize the preemptive effect of new rules by including references to state law where appropriate similar to one
already found in Section 14a-8.  It can also commit to a process for seeking guidance on state corporate law by creating a mandatory state court certification procedure similar to that used by the SEC in the AFSCME v. AIG case in 2008.

I thank you again for the opportunity to testify and I look forward to answering your questions.

In Corporate & Securities Law, Economic Theory, Financial Regulation, Securities, Truth on the Market , , , ,
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