Behavioral Finance and Investor Governance
Lawrence A. Cunningham
George Washington University
Washington & Lee Law Review, Vol. 59, p. 767, 2002
The efficient market hypothesis is a special case in finance. It explains only tiny fractions of observed phenomena. Perhaps its major contribution is a formal definition of an ideal market world, to which policy formulations may be directed and against which they can be measured. Indeed, it seems unlikely that the infirmities of market action ever will be so minuscule as to render the EMH more than a special case, though it may explain more in the future than it does now. However things evolve, during the evolutionary course the shackles of the EMH should be unloosed from corporate and investing culture.
Part I presents behavioral finance as to how prices of stocks are formed?including a theoretical framework, empirical evidence, and psychological explanations. It integrates these materials into a model of market and investor behavior that can be used as a lens through which to analyze a wide variety of legal rules and policies bearing on market regulation and corporate governance. Part II is a series of prescriptions on the implications of this account relating to investor governance. It starts with a proposal to promote and expand investor education concerning the cognitive biases behavioral finance exposes. It proceeds to introduce and propose reforms in three critical areas of law and policy that this model impacts: (1) the market regulatory environment in which investors participate, including suitability and churning rules and policies relating to day trading, margin trading, and circuit breakers; (2) the legal duties of boards of directors in making capital allocation decisions such as equity offerings, dividend distributions and stock acquisitions; and (3) issues in corporate and securities litigation, principally the reliance requirement in securities fraud cases and the stock market exception to the appraisal remedy in cash out mergers.
The efficient market idea turns out to be an aspiration worth pursuing, but one never likely to be realized. These proposals and prescriptions therefore operate both to push the reality toward the ideal and to deal with the gap that will persist. The article has a major public policy subtext too, at stake in the discussion of how prices are formed is the overarching question of capital allocation. Society is better off in terms of aggregate wealth when its resources are allocated to those best able to deploy them. Investors allocating capital based on rational calculation will produce that result, while those allocating based on sentiment will not.
A word on methodology concludes the piece concerning where the piece fits in the bourgeoning legal literature drawing on behavioral social science. Throughout the intellectual history and genealogy of behavioral finance, legal scholars with a social science inclination have drawn on various strands of thought pioneered in these fields, importing the work of the cognitive psychologists, principally behavioral decision theory (which they call BDT). Concerns of the lead importers center on the usefulness of BDT to legal scholarship and policymaking generally include whether all it will do is furnish criticism of law and economics and fail to offer its own positive theories of law or normative prescriptions. Whatever power BDT has for legal scholarship in general, this Article should leave no doubt that it furnishes a positive theory of market behavior quite different than that of efficiency (imported and promoted by some law and economics devotees) and that this theory carries with it substantial normative implications for law and legal policy in the fields of securities and corporate law.
Number of Pages in PDF File: 64
Keywords: Author's note: Please ignore the disclaimer against citing or quoting this paper that accompanies the electronic text available here and feel free to cite or quote the article, a final version of which appeared at 59 Washington & Lee Law Review 767-837 (2002).
Date posted: January 23, 2001