The Case for Individual Audit Partner Accountability

Despite repeated regulatory interventions, accounting failures continue to persist in companies around the world. In this Article, I explain why regulatory oversight, private enforcement, and firm-level reputational sanctions are unlikely to induce accountants to take optimal levels of care when auditing corporate financials. Instead, our best chance for improving audit quality lies in establishing a market for individual audit partners’ brands—a market that can hold individual auditors responsible for their mistakes. The Article begins by identifying four key benefits to this approach. First, forcing auditors to be publicly associated with any audit failures occurring on their watch will induce them to increase their effort in order to avoid the stigma of failure. Second, now that a significant portion—frequently more than half—of audit hours are performed overseas, holding a single individual publicly accountable for any audit failures will improve monitoring of auditors in other jurisdictions. Third, in light of significant evidence of variation in the quality of audit partners—even partners within the same firm—exposing that heterogeneity will empower members of audit committees and investors to choose auditors more carefully. Finally, commoditizing individual auditors could increase industry competition without the need for aggressive regulatory action. The Article then argues that, in order to spur the development of a market in auditor reputation, lawmakers should encourage the development of Auditor Scorecards. To do so, regulators should require the disclosure of additional auditor-level information and ensure useful information is provided through enforcement actions. Although there are costs to these changes, those costs are likely to be outweighed by giving investors the information they need to develop a common Scorecard for auditor quality. Such Scorecards will help boards and investors make better use of the legal tools already at their disposal to hold auditors accountable when they fail in their gatekeeping function

Quieting the Sharholders\u27 Voice: Empirical Evidence of Pervasive Bundling in Proxy Solicitations

The integrity of shareholder voting is critical to the legitimacy of corporate law. One threat to this process is proxy “bundling,” or the joinder of more than one separate item into a single proxy proposal. Bundling deprives shareholders of the right to convey their views on each separate matter being put to a vote and forces them to either reject the entire proposal or approve items they might not otherwise want implemented. In this Paper, we provide the first comprehensive evaluation of the anti-bundling rules adopted by the Securities and Exchange Commission (“SEC”) in 1992. While we find that the courts have carefully developed a framework for the proper scope and application of the rules, the SEC and proxy advisory firms have been less vigilant in defending this instrumental shareholder right. In particular, we note that the most recent SEC interpretive guidance has undercut the effectiveness of the existing rules, and that, surprisingly, proxy advisory firms do not have well-defined heuristics to discourage bundling. Building on the theoretical framework, this Article provides the first large-scale empirical study of bundling of management proposals. We develop four possible definitions of impermissible bundling and, utilizing a data set of over 1,300 management proposals, show that the frequency of bundling in our sample ranges from 6.2 percent to 28.8 percent (depending on which of the four bundling definitions is used). It is apparent that bundling occurs far more frequently than indicated by prior studies. We further examine our data to report the items that are most frequently bundled and to analyze the proxy advisors’ recommendations and the voting patterns associated with bundled proposals. This Article concludes with important implications for the SEC, proxy advisors, and institutional investors as to how each party can more effectively deter impermissible bundling and thus better protect the shareholder franchise

The Surprising Benefits of Mandatory Hedge Fund Disclosure

Regulators have long disagreed whether regulation would reduce hedge funds’ financial misreporting. On the one hand, critics have stated that hedge funds are unlikely to misreport because their investors are highly sophisticated financial players who can detect and deter financial misconduct. On the other hand, recent changes in the composition of hedge funds’ investors have led many to question this argument. In this paper, I test whether hedge fund regulation reduces misreporting by using a quasi-natural experiment in which a subset of hedge funds was regulated, deregulated, and then regulated again. Unique features of the setting permit me to study not only whether hedge fund regulation reduces financial misreporting—but, if so, why the regulation reduces misreporting. The results show that regulation reduces misreporting at hedge funds and that the imposition of disclosure requirements, even without other concurrent changes in regulation, can reduce hedge funds’ misreporting. The result seems surprising, because hedge funds’ investors are commonly thought to have access to far more information than is required by disclosure rules. Further inquiries suggest that disclosure requirements led funds to make changes in their internal governance, and that these changes in governance induced funds to report their financial performance more honestly and accurately

Mandatory Disclosure and Individual Investors: Evidence From the Jobs Act

One prominent justification for the mandatory disclosure rules that define modern securities law is that these rules encourage individual investors to participate in stock markets. Mandatory disclosure, the theory goes, gives individual investors access to information that puts them on a more equal playing field with sophisticated institutional shareholders. Although this reasoning has long been cited by regulators and commentators as a basis for mandating disclosure, recent work has questioned its validity. In particular, recent studies contend that individual investors are overwhelmed by the amount of information required to be disclosed under current law, and thus they cannot—and do not—use that information to analyze the companies that they own. Using a recent change in the law that allows firms to disclose less information before their initial public offering (“IPO”), we examine whether reduced disclosure leads to less trading by individual investors. Our results show that, immediately following the IPO, individual investors are less likely to trade in the stocks of the firms that provide less disclosure—but that this difference disappears after two weeks of trading. Our findings have important implications for the lawmakers now examining whether, and how, to change the mandatory disclosure rules that have served as the basis of federal securities law for generations

Petition for Rulemaking on Short and Distort

Today, some hedge funds attack public companies for the sole purpose of inducing a short-lived panic which they can exploit for profit. This sort of market manipulation harms average investors who entrust financial markets with their retirement savings. While short selling serves a critical function in the capital markets, some short sellers disseminate negative opinion about a company, inducing a panic and sharp decline in the stock price, and rapidly close that position for a profit prior to the price partially or fully rebounding. We urge the SEC to enact two rules which will discourage manipulative short selling. The petition for rule-making on short and distort has been jointly signed by twelve securities law professors nationwide

Law Professor Comment Letter on Harmonization of Private Offering Rules

Comment letter filed on Sept. 24, 2019. File No. S7-08-19 We are fifteen law professors whose scholarship and teaching focuses on securities regulation. We appreciate the opportunity to comment on the U.S. Securities and Exchange Commission’s (“SEC” or the “Commission”) Concept Release on Harmonization of Securities Offering Exemptions (the “Concept Release”)

The Changing Landscape of Auditors’ Liability

We provide a comprehensive overview of shareholder litigation against auditors since the passage of the Private Securities Litigation Reform Act. The number of lawsuits per year has declined, dismissals have increased, and settlements in recent years have declined. Our study asks why. Tests indicate that the decline cannot be attributed solely to increases in audit quality, leading us to consider whether Supreme Court cases limiting the scope of Rule 10b-5 against private actors may have led to the decline. To study this possibility, we focus on the Supreme Court’s 2007 and 2011 rulings in Tellabs v. Makor and Janus v. First Derivative, respectively. Our analysis provides strong evidence that the higher liability standards imposed by Janus significantly reduced auditors’ liability exposure, but we find only limited evidence that the pleading standards imposed by Tellabs had a significant effect

State Contract Law and Debt Contracts

This paper examines the relationship between debt contracts and state contract law. We first develop an index to evaluate whether each state’s law is favorable or unfavorable to lenders. We then analyze how the contract terms, the frequency of covenant violations, and the repercussions of covenant violations vary across states. We find that cash collateral is most likely to be used when the contract is governed by law that is favorable to debtors and that out-of-state borrowers who use favorable law pay higher yield spreads. In addition, when the law is favorable to lenders, there are significantly fewer covenant violations, and the repercussions of covenant violations—measured as changes in the borrower’s investment policy—are more severe. We also compare the characteristics of relevant parties across states, and the results provide support for the theory that there is a market for contracts similar to the market for incorporations

State Contract Law and Debt Contracts

This paper examines the relationship between debt contracts and state contract law. We first develop an index to evaluate whether each state’s law is favorable or unfavorable to lenders. We then analyze how the contract terms, the frequency of covenant violations, and the repercussions of covenant violations vary across states. We find that cash collateral is most likely to be used when the contract is governed by law that is favorable to debtors and that out-of-state borrowers who use favorable law pay higher yield spreads. In addition, when the law is favorable to lenders, there are significantly fewer covenant violations, and the repercussions of covenant violations—measured as changes in the borrower’s investment policy—are more severe. We also compare the characteristics of relevant parties across states, and the results provide support for the theory that there is a market for contracts similar to the market for incorporations

The Changing Landscape of Auditors’ Liability

We provide a comprehensive overview of shareholder litigation against auditors since the passage of the Private Securities Litigation Reform Act. The number of lawsuits per year has declined, dismissals have increased, and settlements in recent years have declined. Our study asks why. Tests indicate that the decline cannot be attributed solely to increases in audit quality, leading us to consider whether Supreme Court cases limiting the scope of Rule 10b-5 against private actors may have led to the decline. To study this possibility, we focus on the Supreme Court’s 2007 and 2011 rulings in Tellabs v. Makor and Janus v. First Derivative, respectively. Our analysis provides strong evidence that the higher liability standards imposed by Janus significantly reduced auditors’ liability exposure, but we find only limited evidence that the pleading standards imposed by Tellabs had a significant effect