The Next Epidemic: Bubbles and the Growth and Decay of Securities Regulation

Abstract

This article explores how speculative bubbles undermine the effectiveness of securities regulations and spawn epidemics of securities fraud. A brief historical survey demonstrates that stock market bubbles almost invariably coincide with epidemics of securities fraud, and provides a compelling argument that the outbreak of fraud in the Enron era did not stem merely from factors unique to the 1990s, but from the dynamics of an asset price bubble as well.

Drawing on perspectives from securities law practice and economic theory, the article argues that bubbles dilute the deterrent effect of antifraud rules and promote deregulation. Both effects alter the calculus of securities law compliance for public companies and market intermediaries. In turn, diluted regulations and deregulation further fuel a bubble's expansion.

The article creates a basic model for how bubbles promote deregulation. During the formation a bubble, three interrelated cycles - the business cycle, the cycle of investor confidence and the regulatory cycle - generate feedback for each other (by stimulating excessive economic growth, investor trust in the integrity of the market and deregulation). When a bubble bursts, these three cycles reverse and generate negative feedback (through recession, a collapse of investor trust and re-regulation). The interaction of these cycles creates the potential for a perverse pattern of under-regulation or deregulation as bubbles form - the moment when more oversight is needed - and re-regulation in the aftermath of a bubble - once the economy and investor trust have already been damaged.

The article also explores how the dynamics of a bubble can undermine the deterrent effect of anti-fraud rules on securities issuers and market intermediaries by distorting the rational calculus of compliance, potentially exacerbating behavioral biases and raising information and agency costs.

Keywords: securities law, securities regulation, bubble, fraud

JEL Classification: K22, K42, G12, G18, G38, N20, N40