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Abstract:
One of the underlying questions in the aftermath of the Enron and comparable scandals is whether securities regulation failed, and if so, what kind of fix is appropriate. To answer that, we have to confront an apparent expectations gap in what the law can accomplish. Some investors (and politicians) seek greater confidence than is practicable and the SEC has the political incentive to contribute to a mythology of market integrity - and then manage the fallout when corruption surfaces. This paper explores the SEC's political situation and then moves on to discuss various reforms - including some in the recently enacted Sarbanes Oxley Act - designed to improve investor protection. While some reforms do indeed improve securities regulation at the margin, an expectations gap remains.

Enron, Corporate Governance, Securities Law, Securities Regulation, Corporate Law, Sarbanes-Oxley

Abstract:
One of the underlying questions in the aftermath of the Enron and comparable scandals is whether securities regulation failed, and if so, what kind of fix is appropriate. To answer that, we have to confront an apparent "expectations gap" in what the law can accomplish. Some investors (and politicians) seek greater confidence than is practicable, and the SEC has the political incentive to contribute to a mythology of "market integrity" - and then manage the fallout when corruption surfaces. This paper explores the SEC's political situation, and then moves on to discuss various reforms - including some in the recently enacted Sarbanes-Oxley Act - designed to improve investor protection. While some reforms do indeed improve securities regulation at the margin, an expectation gap remains.

Abstract:
Recent empirical work has puzzled over the lack of a positive correlation between the presence of a majority of outside directors on a corporate board and measures of firm performance. Drawing on work in social psychology and group behavior, this paper extends previous work to offer plausible explanations for the value-enhancing contributions of a "balanced" board. These possibilities include insider countering of outsider biases, the promotion of internal middle management interests, and the reduction in CEO influence activities that distort communications and interfere with trust. The paper then turns to use these same (and related) insights to point out some unintended behavioral consequences of recent efforts to increase the liability exposure of directors and make them more accountable. The paper concludes by addressing the connection between its analysis and the current "law versus norms" debate in corporate and securities law.

Abstract:
One of the many places where firms confront the difficulty of monitoring their agents is with respect to legal compliance. A firm wants its agents to be sensitive to legal requirements in order to minimize the threat of legal sanction and reputational harm that it faces when a violation occurs. For a variety of reasons, however, agents have a different set of compliance incentives. Recent years have brought an abundance of scholarly and practical literature on the task of organizational compliance. Firms are under increasing pressure to engage in aggressive "command and control"-style monitoring, which in turn raises questions about the net pay-offs from these efforts. Some critics say that greater attention to social institutions such as norms, culture and trust would actually produce better incentive compatibility, and higher rates of compliance, than high-pressure supervision. Thus, scores of articles advocate a more ethics or "integrity"-based effort at building compliance cultures within firms. But this remains a contested field, and diligent monitoring is still the baseline for most compliance initiatives.

My specific interest in this paper is in what work in social and cognitive psychology - the stuff of contemporary behavioral law and economics - has to say about the task of compliance and this contest between hard and soft monitoring strategies. To be sure, the psychological work touching on this subject is tentative, often contestable, and always highly context-dependent, making it difficult to articulate strong, confident predictions about behavior in this setting. My aim, however, is slightly less ambitious. Most of the legal discourse on supervision and compliance today makes behavioral predictions while ignoring this body of research entirely. I am content to think about what normative conclusions might follow if it turns out that these psychological predictions are robust within firms.

Abstract:
Politics aside, the question of whether the EU should create an SEC is about the trade-offs between scale and accountability. This paper considers that trade-off in the U.S. context, with specific attention the SEC's apparent role as a "global" securities regulator on matters relating to issuer disclosure. The principal claim is that in making enforcement decisions, there will likely be a "home bias" toward domestic enforcement actions that makes extraterritorial actions less likely, thus reducing the incentives to comply. To the extent that this is typical of regulatory behavior, then there may be lessons for Europeans considering the question of institutional design. More broadly, the paper also considers some of the institutional features that make SEC enforcement policy what it is, which may or may not be exportable (or which policy makers in Europe may not want to import) to the European context.

securities regulation, enforcement, fraud, Securities and Exchange Commission

Abstract:
Recent advances in behavioral finance and economics have offered fascinating, albeit tentative, suggestions that may be useful to securities law policy-makers, especially in the aftermath of Enron and similar scandals. Because of the tentative nature of the findings, however, strong incorporation seems premature. After reviewing some of the literature, I look at three different problem areas - internet fraud, selective disclosure and the measurement of damages in class actions - where this literature might at least provoke creative ideas on how to respond, even if it doesn't generate a clear-cut solution.

Abstract:
Section 404 of the Sarbanes-Oxley Act has generated a firestorm of controversy. This essay, part of a retrospective on Robert Clark's classic volume, Corporate Law, tries to explain the controversy as the natural product of indeterminacy with respect to both the benefits and costs of internal controls. The indeterminacy has led a variety of groups that benefit from an inflated construction of the liability threat (accountants, lawyers, consultants, IT professionals) to try to capture the interpretation of the requirement in a self-serving fashion. Much of the behavior in the aftermath of the new internal controls standards - especially the emphasis on expensive bottom up detail - is consistent with this account. Though significant benefits have also been generated, the risk is that internal controls resources have not been put to their best use, and that a statutory provision that makes a good deal of sense if thoughtfully administered misses the real reason why internal controls are important: countering the strategic incentives that managers have to hide information and allow information flow to be distorted.

Abstract:
Since its adoption in 2002, the legitimacy of the Sarbanes-Oxley Act has been heavily contested. This paper first examines criticism of the Act from an economic perspective: how likely is it that investors are well or poorly served? Concluding that there is more ambiguity here than either proponents or critics acknowledge, it then turns to the social construction of Sarbanes-Oxley, i.e., how it is perceived, and why. The debate could be simple politics and rent-seeking, or reflect deeper ideological beliefs about the legitimacy of corporate governance and its regulation. To this end, the paper suggests that the Act may have been partially motivated by a desire to move the proper boundaries between the public and private domains in corporate governance, and may be construed in such a light. It then turns to current issues under Sarbanes-Oxley such as the authority of independent directors and the scope of the Act as applied to smaller companies and foreign issuers and considers how various interest groups and other "interpretive communities" (including employees and the financial media) might negotiate its proper meaning regarding those issues.

Sarbanes-Oxley Act, securities regulation, auditing, corporate governance

Abstract:
The recent mutual fund scandals in the United States have generated both public and private litigation, forcing renewed attention to the nature and scope of private remedies that seek compensation for fiduciary misbehavior. This paper analyzes the difficulties in pursuing such claims as derivative action, insofar as the courts have given the fund's independent directors considerable discretion to recommend the termination of such suits. It criticizes this move as a misapplication of corporate law theory generally, showing that corporate governance in mutual funds cannot be viewed through the same lens as with respect to other kinds of firms. It also argues that an ideology of consumer sovereignty displaces fiduciary responsibility with respect to many agency cost problems in the fund industry. To the extent that independent directors adopt that ideology (or are selected because they have already adopted it), they will be suboptimal shareholder representatives.

Mutual fund scandals, compensation, fiduciary responsibility, derivative actions

Abstract:
This paper considers whether the prevailing liability structure under Section 11 of the Securities Act of 1933 makes sense as applied to large capitalization issuers. This, in turn, requires an evaluation of whether the alternative structure for liability, that under Rule 10b-5 and the periodic disclosure requirements of the Securities Exchange Act of 1934, is sufficient or deficient in terms of promoting adequate disclosure. The paper suggests some fine-tuning under the '34 Act designed to bring better external certification, particularly by accountants, into the picture. More radical reforms are justified under the '33 Act, including the essential abandonment of underwriter due diligence liability.

Abstract:
In securities-fraud cases, courts routinely admonish plaintiffs that they are not permitted to rely on allegations of "fraud by hindsight." In effect, courts disfavor plaintiffs' use of evidence of bad outcomes to support claims of securities fraud. Disfavoring hindsight evidence appears to tap into a well known, well-understood, and intuitively accessible problem of human judgment of "20/20 hindsight." Events come to seem predictable after unfolding, and hence, bad outcomes must have been predicted by people in a position to make forecasts. Psychologists call this phenomenon the hindsight bias. The popularity of this doctrine among judges deciding securities cases suggests that judges actively seek techniques that enable them to correct for psychological biases that might otherwise affect their decision-making.

This paper assesses the hypothesis that judges have adopted the "fraud-by-hindsight" doctrine so as to avoid erroneous judgment infected with the hindsight bias. We find that although judges have identified a real problem in human judgment, they are not developing a doctrine to remedy the influence of hindsight on judgment. Rather, they are using this problem of human judgment as the justification for expanding their authority to manage the complex, high-stakes securities cases that come before them. The result provides judges with the greater case-management authority they seek, but leaves the securities litigation without a meaningful doctrine to ameliorate the influence of hindsight on judgment.

Abstract:
The SEC is often praised or criticized for the law it makes. But relatively little scholarly effort has gone into trying to understand how or why it acts as it does. Indeed, critics of the SEC tend to adopt one of two fairly inconsistent behavioral theories: either that the Commission is readily captured by external political interests or that it behaves with a great deal of internal slack so that its decisions reflect judgmental biases and heuristics. On the other hand, those more inclined to support SEC rulemaking have not adequately explained how or why the Commission would likely make good law in the face of either external pressure or internal heuristics. My paper is an effort to stimulate a richer institutional understanding of the work of the SEC by looking more closely at both the external and internal accounts, and considering some possibilities for synthesis. The recent mutual fund corporate governance rulemaking is examined as a useful case study into how the Commission tries to balance costs and benefits in the face of considerable uncertainty.

Abstract:
Twenty years after being decided, Basic Inc. v. Levinson is being interpreted and applied in interesting, sometimes jarring, ways. This paper looks at Basic's presumption of reliance in fraud-on-the-market cases and the ways in which contemporary courts are addressing such issues as (1) the level of efficiency that is necessary for the presumption to apply; (2) the role of market price distortion and loss causation in the class certification decision; and (3) the connections between materiality and reliance (Basic's two separate issues) in both class certification and on the merits. Basic set in motion much of the resulting confusion by making more of reliance - and market efficiency - than was needed, and then paying too little attention to the joint risks of indeterminacy and disproportionality in the liability threat created by fraud-on-the-market lawsuits. Had it taken a different route, or better explained the route it was taking, we might have seen early on that class recovery is better suited as a deterrence mechanism than a compensatory device. That makes a stringent approach to reliance, causation or class certification unnecessary, but also calls into question the idea that each investor has a "right" to recovery by trading at a distorted price. Instead, the law headed in precisely the opposite direction.

securities regulation, securities litigation

Abstract:
Recent research in corporate governance points to the importance of transparency as a device for controlling agency costs, among other functions. That speaks to a long-standing issue in American securities regulation: whether there is (or should be) a conceptual separation between federal securities law and state corporation law on matters of managerial accountability, or whether the disclosure orientation of the federal law should be expansive enough to pursue accountability without undue concern with jurisdictional divisions. This paper explores the ways that the SEC confronts the apparent constraints on its ability to act aggressively in this area. It first revisits the law, showing that many of the restrictive holdings dealing with fiduciary responsibility under the securities law are really about the affirmative duty to disclose rather than any overarching federalism principle. Because the SEC has so much unused authority over duty to speak, this indicates that the doctrinal constraint is less than the rhetoric of some of the case law suggests. The paper then turns to other, more powerful, constraints: resources, remedies and human nature's resistance to the kinds of legal incentives often employed by the SEC. It ends with a look at the SEC's use of rhetoric and symbols in the face of the constraints on its ability to act in this sphere.

Abstract:
The last thirty years or so have brought a rapid shift toward institutionalization in the financial markets in the U.S., i.e., investment by mutual funds, pension funds, insurance companies, bank trust departments and the like. This paper focuses on the institutional role of the SEC as a seventy-five year old agency in a capital marketplace far different from that of the 1930's. A baseline question about the future of financial regulation in the U.S. is whether the SEC, with such a long and weighty legacy of law-making from a time when public markets were retail markets, is competitively fit to act as a regulator in a capital marketplace that is now so institutional and global. Part I asks whether there is a coherent theory or approach to retail investor protection in today's marketplace, either in terms of enforcement intensity or rule-making. This Part considers two very different contemporary challenges to SEC's orthodoxy: the emergence of the British "light touch" to securities industry regulation, which favors informal suasion to heavy-handed enforcement, and the expansion of knowledge about consumer and investor behavior from research in behavioral economics. Neither, it argues, maps well onto the SEC's mission. Part II then moves to the institutional marketplace for issuer securities and engages in a thought experiment about whether, as many assume, markets that have no appreciable retail participation should properly be governed as "antifraud only." This Part considers what antifraud-only means, and again expresses some skepticism about whether we can expect to see the development of private markets, largely free of regulation, that substitute for the public ones we observe today. Finally Part III takes up whether the SEC's regulatory orthodoxy is stable enough as markets become not only institutional but global. It suggests, contrary to what many believe, that globalization leads to increasingly territorial (rather than listings) based exercise of regulatory jurisdiction over issuer disclosure. It also places the SEC's recent initiatives toward mutual recognition in this context. The unifying theme in all three Parts stems from a long-standing interest in studying the behavior of the SEC: why it acts as and when it does and (often more importantly) what limits it imposes on itself or has imposed from outside.

securities regulation, retail investors, behavioral economics

Abstract:
There is a lively debate about the relative merits of entity versus individual liability in cases involving securities fraud. After reviewing this debate in the context of both private securities litigation and SEC enforcement, this paper considers whether the legal tools available against individual executives are adequate, and if not, what changes might be made. The main focus is on equitable remedies, especially rescission and restitution, under both state and federal law. As to the former, Vice Chancellor Strine's opinion in In re Healthsouth offers an interesting template, although there are limits on the usefulness of derivative suits to police aggressively in this area. Federal law probably offers the more powerful tools, which could be used more effectively than they are at present.

Securities Regulation, Corporate Law, Corporate Governance

Abstract:
The role of technological evolution as a potential causal factor in the recent financial scandals has not yet been fully explored. This paper looks at technology-induced changes in the issuers' marketplace environment, in the trading behavior of investors and in the tools employed by technology-oriented firms to make the case that motive, opportunity and the potential for rationalization of less-than-candid financial reporting were intensified by these trends. In particular, these forces suggest that some sizable portion of financial misreporting was not selfish on the part of managers but a predictable feedback loop generated by competitive forces. If so, there are important lessons to be learned with respect to the appropriate forms of (and forums for) deterrence, as well as with respect to on-going debates about the philosophy of financial reporting.

Abstract:
This essay introduces and comments on three articles in the Virginia Law & Business Review that address important questions of international competitiveness and U.S. securities regulation: the evolution of the Rule 144A market as a way for foreign issuers to tap U.S. capital without submitting to a mandatory disclosure regime; the emergence of international accounting standards to which the SEC seems eventually ready to submit; and "best execution" differences between trading platforms in the U.S. and the E.U.

securities markets, international competition

Abstract:
This paper considers what research in cognitive psychology and behavioral economics has to say about one of the basic state of mind constructs in the law of fraud: scienter. It takes a clinical approach, examining the securities fraud case that never happened against Martha Stewart. In granting a judgment of acquittal in Stewart's favor on the securities fraud charge, the court seemingly misunderstood the law of scienter, which turns on awareness rather than purpose. But that simply provides an opportunity to think about what awareness means in the context of financial transactions. From publicly available sources, interesting inferences can be drawn about what Martha Stewart was thinking (and feeling) during the events at issue.

Abstract:
This essay, part of a symposium on narrative in corporate law, considers various portrayals of the complicity of the SEC in the Bernard Madoff scandal - including the Commission's own Inspector General's report issued in September 2009. It considers possible explanations (revolving door problems, incompetence and sloth, etc.) but suggests that the story is deeper and more frustrating, arising out of the relative poverty in which the SEC operates, which in turn leads to habits of thought and action that leave too much unnoticed and undone. The interesting question, then: why the poverty? The essay concludes with a political explanation. While by no means meant to excuse the neglect in the Madoff matters, the essay suggests the possibility of a more sympathetic portrayal of the work-a-day world of securities regulation.

securities fraud, Madoff, narrative

Abstract:
In Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., the Supreme Court addressed whether third-party participants in a fraudulent scheme engineered by a corporate issuer face liability in a private securities lawsuit for harm caused by the issuer’s false and misleading corporate disclosures. Though this would seem to be a matter of determining whether their deceptive behind-the-scenes conduct by itself constituted a “primary” violation of the antifraud prohibition found in SEC Rule 10b-5, the Court answered by interpreting reliance element of plaintiffs’ cause of action. It says that there is no reliance, and hence no liability, when the link between the third party’s actions and the resulting misrepresentation is too remote or attenuated. This paper offers a novel reading of Stoneridge. The choice of reliance as the crucial element suggests the Court’s comfort with different liability outcomes in 10b-5 cases depending on whether the action is SEC or criminal enforcement (where reliance is not a required showing) or private litigation (where it is). Why might such a distinction make sense? One possible answer comes by looking at the extraordinary nature of the remedy granted in private fraud-on-the-market cases - the aggregate out of pocket claims of all those who bought or sold from the time of the alleged primary misrepresentations to the date of corrective disclosure, a figure that can be staggeringly large and disconnected from any meaningful requirement of reliance-in-fact. Especially when the particular defendant is a secondary actor, there can be a sense of severe disproportion, even if the underlying conduct was wrongful. My main argument is that in its emphasis on remoteness and attenuation applied solely in the context of private securities litigation, Stoneridge reinvigorates duty as a limitation on liability to open market investors in order to constrain the unique liability risk that defendants face. It shows how this applies to a wide range of cases, and often generates pro-plaintiff outcomes where liability is well-deserved. The paper concludes with a proposal for legislative reform that would restore aiding and abetting liability but with a better system of proportionate fault.

securities fraud, litigation, class actions

Abstract:
William Cary's opinion in the Cady, Roberts case is seminal in the development of modern insider trading regulation. This paper revisits three ideas that were important to the decision and that remain contested today. First, it explores the "why regulate?" question, to which Cary replied (as Justice Ginsburg recently did once again in O'Hagan) in terms of the familiar investor confidence rationale. The paper considers, in a not unsympathetic way, the role of insider trading regulation as a useful myth within the structure of seccurities regulation. Second, it revisits the "possession versus use" question raised in Cady, Roberts and so many cases since. Third, it addresses the question of why insider trading regulation for so long has avoided definition and rulemaking in favor of open ended standards.

Abstract:
The concept of the "half-truth" -- the idea that the truth can be misleading if some important qualifier has been concealed -- has not been given much theoretical attention by either courts or commentators. Rather, the potentially misleading character of something that is by itself technically true is simply treated as a fact question. This paper is an effort to explain the half-truth doctrine, and show why courts apparently apply it more restrictively in securities cases than in common law fraud cases. The key insight comes from situating the half-truth roughly half way between the true misstatement and the failure to speak at all, and seeing the "normative" issue as one of what inferences a listener or reader should draw in light of background norms about how forthcoming the speaker is reasonably expected to be on a particular topic. The background norm in securities cases includes an ability to conceal (though not actively lie about) proprietary matters such as research and marketing initiatives. In this environment, in contrast to the settings in which many of the common law cases arise, a narrow use of the doctrine is appropriate. This leads to a theory of corporate discourse for fraud purposes that can be employed in other related subjects, such as the duty to update and the treatment of "general expressions of optimism."

Abstract:
The standard rational actor model of organizational behavior leads one to question why corporations would mislead the investing public when neither the company nor its managers were trading in securities. After a brief investigation of answers to this problem in traditional economic terms, this article seeks to use modern institutionalist theory on organizational behavior to argue that corporate belief systems can become "unrealistic" (and hence the source of possible corporate misrepresentations about its risks and future prospects) because of predictable distortions in information flow and, more importantly, perceptual biases among managers. The potentially adaptive role of bias in corporate cultures is considered, along with possible implications for securities law. The article then extends the account based on these cognitive and informational forces to other forms of socially harmful corporate behavior.

Abstract:
Disputes involving the sale of risky securities to apparently sophisticated customers arise frequently, and pose vexing legal problems. This article draws from the literature on psychology and economics to develop a rich descriptive account of investment decision-making by both individual and institutional investors, and analyzes the temptations that brokers face to exploit individual cognitive and motivational slack and (in institutional settings) moral hazard problems that may also be subject to denial and rationalization. It then turns to normative questions involving issues such as the treatement of brokers as fiduciaries, the duty to read, and the nature of the brokers' risk disclosure obligations.

Abstract:
This paper considers the relationship between increased technological sophistication in investing and the quality of risk disclosure by issuers. For a variety of reasons, the need for high quality risk disclosure may well increase in a noisier informational enviroment, thus prompting the question of whether we have an adequate policy for when issuers must disclose known risks. While the prevailing standards under the Securities Act may well be adequate, there is no coherent policy under the Securities Exchange Act -- a troublesome thought given the increasing emphasis on '34 Act disclosures in an era of shelf registration, integrated disclosure, etc. The paper proposes that the SEC develop a requirement that EDGAR files be updated promptly to reflect changes in the companies "risk discussion and analysis" -- a narrative discussion of prevailing material investment risks known to management. At the same time, the SEC must then recognize a privilege of nondisclosure of risk-related information (e.g., bad news) that would likely cause a significant competitive injury through the exposure of a business strategy, plan or secret. Such a balanced policy would be a notable improvement on the existing standards -- for instance, the half-truth doctrine, the duty to update and the duty to correct -- which are highly uncertain and indeterminate, and do not explicitly recognize any competitive injury privilege.

Abstract:
Invoking recent research on organizational behavior, this paper explores the lawyering difficulties associated with coming to "know" a corporate client, with special attention to preparing corporate filings and publicity in compliance with the federal securities laws. Research on social cognition and organizational perception emphasizes that companies may develop internal cultures and belief systems that deflect awareness of risks and dangers, even though less biased observers might well sense their presence. In particular, corporate belief systems that have an optimistic bias may well be adaptive generally, notwithstanding this tendency to obscure certain kinds of risks. To the extent that managers are affected by these biases, corporate disclosure is apt to reflect it unless some third party is able to offset them. This paper suggests that the key difficulty facing corporate lawyers is the need to be "cognitively independent" while maintaining a position of access to managerial inference. Illustrations are drawn from a number of recent cases. The final portion of the paper explores the relevance of bias to a number of questions, such as the proper structure of securities litigation policy, the development of corporate and securities firm compliance programs, and the problem of lawyer service on client boards of directors.