Fraud on the Market: A Relational Investment Approach

Abstract:     
Fraud on the Market (FOMA) has been one of the most popular topics of discussion among American legal scholars over the last two decades. The focus of scholarship has been placed mainly
on the effect of FOMA on the efficiency and on the fairness of the American stock market. This paper takes a different approach: it highlights and compares the effects of three liability regimes on corporate governance and, in particular, on the relational investment structure of a publicly held firm. The three liability regimes I examine are the traditional common law regime, the Reliance regime and the Fraud on the Market regime.

The first part of the paper examines the effect of liability on monitoring. In particular, I argue that the traditional Common Law regime, which conditions liability on proximity, manifests and fosters the monitoring role institutional-investors play in England. The American deviation from the traditional rule, in the form of the Fraud on the Market regime, discourages such relational investment and encourages shareholder passivity.

The second part of the paper adopts an (almost) opposite agency model: whereas the first part treats the collective body of shareholders as principals concerned with their manager-agent performance, in the second part the manager-principal circulates information in the market for the purpose of soliciting feedback from informed investors-agents. Whereas monitors are inspecting the managers' hidden actions, thereby diminishing the firm's agency costs, feedback providers are actually informing managers, thereby enabling the latter to run the firm more efficiently. I show that each liability regime provides a different set of incentives to investors and, therefore, facilitates the operation of a different feedback mechanism.

Accepted Paper Series