Liberty And Disclosure: A Framework for Securities Regulation

The late Larry Ribstein explores the principles of a liberty-oriented securities regulatory regime.

The federal securities laws comprise one of the most important categories of regulation in the U.S.  Particularly since Sarbanes-Oxley and Dodd-Frank, this regulation has been blamed for inhibiting innovation and imposing a significant regulatory tax on business activity.  This essay considers some general principles for ensuring that securities regulation stays within limits that are consistent with a free and productive society.  My central principle is that regulation should go only as far as necessary to protect market actors’ freedom to raise capital and invest in productive business ventures.

It is important to emphasize at the outset that regulation of disclosure and fraud can support rather than restrict liberty.  Securities regulation promotes entrepreneurial activity by enabling investors to trust small and young firms that otherwise might not have an opportunity to develop public reputations.  Firms in countries that lack these mechanisms may need to rely on family ties.  This sharply limits the potential for large-scale business activities.  Robust securities regulation is arguably one reason why this country has long had the world’s strongest capital markets.  Thus it is important not simply to banish securities regulation because it can be costly, but focus on reasonable regulation that encourages productive business activity.

The core principle underlying securities regulation is the prohibition of fraud.  Fraud is costly in part because it forces buyers to go to the trouble of investigating the truth and sellers to give buyers costly assurances.  The government can reduce these costs by providing a credible enforcement mechanism that encourages firms and sellers to tell the truth.  This is especially important for securities.  In contrast to tangible goods whose qualities are apparent from inspection, securities often merely promise future rewards from the efforts of unseen promoters.

An important question in developing principles for securities regulation is how far this regulation should go beyond simply ensuring that the seller is not lying.  In other words, why should not the law simply stop with the common law of fraud, as it did a century ago?

The simple answer to this question is that mandating disclosure saves investors the costs of digging up the information for themselves, and issuers the cost of providing assurances that their disclosures are trustworthy.  But this simply explains why disclosure is a good idea, not why government needs to require it.  If disclosure is useful we ordinarily can expect the market to provide it as it does for other goods and services.  Although firms have incentives to simply keep silent rather than risking penalties for fraud, firms that choose this course may find it hard to raise money from skeptical investors. Therefore, we need to go further to justify the restrictions on individual liberty imposed by mandatory disclosure laws.

If the law only prohibited fraud, firms and sellers might decide that they risk more from potential fraud liability than they stand to gain from voluntary disclosure.  Moreover, as Judge Frank H. Easterbrook and Professor Daniel R. Fischel explained in Mandatory Disclosure for the Protection of Investors, 70 Virginia Law Review 669 (1984), investors need disclosures that facilitate comparisons across companies.  Comparisons are possible only if there is a common format for disclosures. Yet private market actors cannot easily reap all of the social benefits of developing rules delineating what must be disclosed.  The government therefore may need to prescribe a socially desirable amount of disclosure. It follows that regulation may be necessary in order to support the liberty-enhancing role of robust capital markets.

But disclosure can be mandated by private organizations, particularly including stock exchanges, as well as by government.  Private regimes could be enforced by contracts, such as listing agreements between issuers and exchanges supported by listing fees.   The government’s role could be limited to enforcing these contracts. The question, then, is not whether we need mandatory disclosure, but whether we need government promulgation and enforcement of a costly mandatory disclosure regime. 

Even if some government-supplied mandatory disclosure may be efficient, there is an additional general question of which government should regulate securities that are traded nationally and internationally.  Should securities be regulated in the U.S. at the state or federal level? To what extent should a single country, such as the U.S., regulate global transactions?  From the standpoint of balancing government’s liberty-enhancing and liberty-reducing roles, the question is the extent to which investors should be able to choose the applicable regulatory regime.

Easterbrook and Fischel argue that federal regulation of securities was warranted in the 1930’s despite the existence of state securities laws because states were imposing regulatory costs outside their borders.  A corporation that has shareholders in several states may have to comply with the most stringent and not necessarily the most efficient rule.  State competition was not working the way it is supposed to work in an idealized model of state law.

The problem lay in the choice-of-law rules for selecting the applicable state law.  State securities laws apply to local transactions and investors. This is what forces national firms to comply with many states’ laws. The problem would not exist if investors could choose the state disclosure regime the way they choose state governance law — that is, by choosing where to incorporate.  If this were the applicable choice-of-law rule, state law may well be superior to federal law because it offers the potential for shareholder choice.  Although shareholders would have to evaluate many different state regimes, they can delegate this task to efficient securities markets where market prices can reflect the applicable law along with securities’ other characteristics.

There are analogous issues at the global level.  Because securities trade all over the world regardless of where their issuers are based, the U.S. securities laws have potentially international reach.  The U.S. Supreme Court held in Morrison v. National Australia Bank, Ltd, 130 S.Ct. 2869 (2010), that foreign plaintiffs who transacted in foreign shares on a foreign exchange could not sue under U.S. anti-fraud law.  This rule effectively lets investors choose not to have the protection of U.S. securities laws by engaging in transactions like the one in Morrison.  As with states in U.S.-based transactions, Morrison forces the U.S. to compete for global investments.

With these general considerations in mind, six principles are important in squaring the extent of federal securities regulation with free markets.

1.  Choice of law rules should enable investors to choose the applicable disclosure regime.  Competition among securities regulators can constrain excessive regulation, enable investors to tailor regulation to their needs, and provide a laboratory for experimenting with different rules. See O’Hara & Ribstein, The Law Market (Oxford University Press, 2009).  Choice is critical given the difficulty of determining the right balance between individual liberty and regulation.

2.  As long as appropriate choice-of-law rules are in place, securities regulation should be imposed at the lowest government level — e.g., state rather than federal — that is consistent with sustaining efficient securities markets.  A corollary of this principle is that the higher the level at which securities regulation is imposed, the more regulators should take to conform to the additional principles below.

3. The law should permit truthful speech.  While banning fraud and mandating disclosure may be necessary to support robust capital markets, the same justifications may not apply to prohibitions of truthful speech.  Prohibiting truthful speech may reduce liberty without protecting markets.  This principle would, for example, support eliminating the prohibition under the Securities Act of 1933 on “gun-jumping,” or pre-registration disclosures.

4. The law should provide for sunset or periodic review.  Such provisions would take account of the dynamic nature of securities markets and thereby ensure that regulation disappears when changing conditions make it obsolete.

5.  Firms should be able to opt out of regulation unless there is substantial reason to believe that mandatory law is necessary to protect investors.  Note that imposing regulation at the lowest possible government level consistent with the first principle above can achieve the benefit of optional rules by letting investors and issuers choose the applicable law.  Optional rules may be appropriate even given compliance with the first principle where it makes sense to enact a coherent regime at the federal level but where investor choice is appropriate for some individual provisions.

6. The law should apply only to disclosure rather than providing substantive fiduciary or voting rules.  This is consistent with the rationale offered by William O. Douglas & George E. Bates for the federal securities laws when they were enacted (The Federal Securities Act of 1933, 40 Yale Law Journal 704 (1933) — to require firms to do no more than tell the truth about securities and let investors decide what to invest in based on these disclosures.  This comports with the basic principle of accommodating the need for regulation with liberty. This principle is also an important practical consideration where firms with different governance systems may trade in the same global markets.  While a single disclosure law might reasonably apply to different firms, it may be costly to try to superimpose U.S. federal governance rules on top of the governance rules to which non-U.S. issuers are subject in their home country.  This became an important consideration in trying to apply Sarbanes-Oxley’s provisions regulating the board of directors to European corporations with supervisory boards.  See Larry E. Ribstein, Cross-Listing and Regulatory Competition, Review of Law & Economics, Vol. 1, No. 1, Article 7.

7. Even laws that comply with all the above principles may go too far by imposing regulation that is justified only for some of the transactions or investors to which they apply.  This calls for applying the principle of “nuanced” regulation — that is taking account of differences among firms and investors as to the need for regulation and the costs of compliance. For example, even if federal regulation of internal controls disclosures is warranted, the regulation should be tailored to account for the greater burden these controls impose on smaller companies. See Kamar, Karaca-Mandic, and Talley, Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-Country Analysis (December 1, 2008),.

These simple principles can help shape securities laws that support liberty rather than undermine free markets.  Keeping these principles in view might help check the periodic regulatory frenzies that occur when bubbles pop. See Ribstein, Bubble Laws, 40 Houston Law Review 77 (2003).