Vicarious Liability for Bad Corporate Governance: Are We Wrong About 10b-5?

Abstract:     
I formulate a rational expectations signaling model of vicarious liability for securities fraud, particularly the much-criticized "fraud on the market" private class action arising under Rule 10b-5. I show that fraudulent misreporting by managers occurs in the absence of managerial moral hazard -- i.e., where managers simply maximize shareholder payoffs -- and that vicarious liability can serve as an appropriate deterrent, creating separating equilibrium. I then show that the particular remedy under Rule 10b-5 can perfectly deter fraud and perfectly compensate purchasers, and that Rule 10b-5 class actions may function better than critics claim.

Number of Pages in PDF File: 42

working papers series