The Essential Role of Securities Regulation

This Article posits that the essential role of securities regulation is to create a competitive market for sophisticated professional investors and analysts (information traders). The Article advances two related theses-one descriptive and the other normative. Descriptively, the Article demonstrates that securities regulation is specifically designed to facilitate and protect the work of information traders. Securities regulation may be divided into three broad categories: (i) disclosure duties; (ii) restrictions on fraud and manipulation; and (iii) restrictions on insider trading-each of which contributes to the creation of a vibrant market for information traders. Disclosure duties reduce information traders\u27 costs of searching and gathering information. Restrictions on fraud and manipulation lower information traders\u27 cost of verifying the credibility of information, and thus enhance information traders\u27 ability to make accurate predictions. Finally, restrictions on insider trading protect information traders from competition from insiders that would undermine information traders\u27 ability to recoup their investment in information. Normatively, the Article shows that information traders can best underwrite efficient and liquid capital markets, and, hence, it is this group that securities regulation should strive to protect. Our account has important implications for several policy debates. First, our account supports the system of mandatory disclosure. We show that, although market forces may provide management with an adequate incentive to disclose at the initial public offering (IPO) stage, they cannot be relied on to effect optimal disclosure thereafter. Second, our analysis categorically rejects calls to limit disclosure duties to hard information and self-dealing by management. Third, our analysis supports the use of the fraud-on-the-market presumption in all fraud cases even when markets are inefficient. Fourth, our analysis suggests that in cases involving corporate misstatements, the appropriate standard of care should, in principle, be negligence, not fraud

The Essential Role of Securities Regulation

This Article posits that the essential role of securities regulation is to create a competitive market for sophisticated professional investors and analysts (information traders). The Article advances two related theses-one descriptive and the other normative. Descriptively, the Article demonstrates that securities regulation is specifically designed to facilitate and protect the work of information traders. Securities regulation may be divided into three broad categories: (i) disclosure duties; (ii) restrictions on fraud and manipulation; and (iii) restrictions on insider trading-each of which contributes to the creation of a vibrant market for information traders. Disclosure duties reduce information traders\u27 costs of searching and gathering information. Restrictions on fraud and manipulation lower information traders\u27 cost of verifying the credibility of information, and thus enhance information traders\u27 ability to make accurate predictions. Finally, restrictions on insider trading protect information traders from competition from insiders that would undermine information traders\u27 ability to recoup their investment in information. Normatively, the Article shows that information traders can best underwrite efficient and liquid capital markets, and, hence, it is this group that securities regulation should strive to protect. Our account has important implications for several policy debates. First, our account supports the system of mandatory disclosure. We show that, although market forces may provide management with an adequate incentive to disclose at the initial public offering (IPO) stage, they cannot be relied on to effect optimal disclosure thereafter. Second, our analysis categorically rejects calls to limit disclosure duties to hard information and self-dealing by management. Third, our analysis supports the use of the fraud-on-the-market presumption in all fraud cases even when markets are inefficient. Fourth, our analysis suggests that in cases involving corporate misstatements, the appropriate standard of care should, in principle, be negligence, not fraud

Conflicts of Interest in Publicly-Traded and Closely-Held Corporations: A Comparative and Economic Analysis

Conflicts of interest in corporate law can be addressed by two main alternatives: a requirement of a majority of the minority vote or the imposition of duties of loyalty and fairness. A comparison of Delaware, the UK, Canada, and Israel reveals that while the conflicts of interest problem within publicly-traded corporations receives different treatment in the different jurisdictions — either a fairness rule or a majority of the minority rule — closely-held corporations receive the same treatment of an imposition of duties of loyalty and fairness. This article explains this finding, demonstrating that determining which of these rules is adopted is, in fact, a choice between liability rule protection and property rule protection. This choice depends on the total and relative transaction costs. These costs include both the negotiation costs attendant upon a property rule, as well as the adjudication costs associated with a liability rule. The sum of these costs is influenced by the efficacy of the judicial system and of extralegal mechanisms such as the market for corporate control, the capital market, and the types of investors active in the market. Because the different jurisdictions have different relative costs, due to differences in the economy and the legal systems, publicly-traded corporations are treated differently in each system. However, sometimes conflict of interest situations share the same main characteristics — as with closely-held corporations—leading to the domination of one solution, and thus the same solution is applied for closely-held corporations in the different jurisdictions

Voting (Insincerely) in Corporate Law

Voting lies at the center of collective decision-making in corporate law. While scholars have identified various problems with the voting mechanism, insincere voting—in the forms of strategic voting and conflict of interests voting—is perhaps the most fundamental. This article shows that insincere voting distorts the voting mechanism at its core, undermining its ability to determine transaction efficiency. As further demonstrated, strategic and conflict of interests problems frequently coincide with one another: voting strategically often means being in conflict, and many fact patterns present aspects of both problems. Finally, this article claims that although the two problems have seemingly different solutions, these solutions are essentially similar in nature: all solutions to insincere voting are variations on two basic rules, namely, property rules and liability rules

Voting (Insincerely) in Corporate Law

Voting lies at the center of collective decision-making in corporate law. While scholars have identified various problems with the voting mechanism, insincere voting — in the forms of strategic voting and conflict of interests voting — is perhaps the most fundamental. This article shows that insincere voting distorts the voting mechanism at its core, undermining its ability to determine transaction efficiency. As further demonstrated, strategic and conflict of interests problems frequently coincide with one another: voting strategically often means being in conflict, and many fact patterns present aspects of both problems. Finally, this article claims that although the two problems have seemingly different solutions, these solutions are essentially similar in nature: all solutions to insincere voting are variations on two basic rules, namely, property rules and liability rules

Shareholder Dividend Options

A firm\u27s dividend policy reflects management\u27s decision as to what portion of accumulated earnings will be distributed to shareholders and what portion will be retained for reinvestment.\u27 A firm\u27s retained earnings represent the amount of financing that the firm can utilize without having to compete against other firms in the capital markets. Because dividend policy wholly determines the amount of earnings that a firm retains, dividend policy also determines the extent to which a firm can escape the scrutiny of participants in the capital markets. Retained earnings are the greatest source of capital for firms. The typical U.S. industrial corporation finances almost seventy-five percent of its capital expenditures from retained earnings, whereas new equity issues provide a negligible fraction of corporate funding.2 Scholars have long recognized firms\u27 significant dependence on retained earnings and negligible dependence on equity financing. This phenomenon led Professor Baumol to the inescapable conclusion that a substantial proportion of firms manage to avoid the direct disciplining influences of the securities market, or at least to evade the type of discipline which can be imposed by the provision of funds to inefficient firms only on extremely unfavorable terms. 4 Unfortunately for the sake of allocative efficiency, in recent years, most firms have also managed to avoid even the indirect disciplining influences of the market for corporate control. Inefficient managers might try to escape a market inspection of their performance by adopting a low-payout dividend policy and avoiding the competitive external market for financing.6 Seemingly oblivious to this threat of managerial opportunism, state courts have established that directors possess sole discretion over whether or not to declare dividends, and that, absent abuse of discretion, the law will not second-guess the business judgment of corporate officers.7 The general rule is that only fraud, bad faith, or gross mismanagement can justify compelling distribution! This rule removes any effective limit on managerial decisions concerning the timing and quantity of dividend distributions. In granting management the protection of the business judgment rule, courts have placed a heavy burden on shareholders who wish to challenge management\u27s dividend policy. A shareholder suit to compel dividend distribution, based on the claim that management is investing in bad (negative net present value) projects, has virtually no chance of succeeding. In fact, in the last one hundred years, there has not been a single case in which U.S. courts have ordered a management-controlled, publicly traded corporation to increase the dividend on its common stock.

Majority Control and Minority Protection

This chapter examines legal issues concerning majority control and minority protection in firms with concentrated ownership governance structures, with particular emphasis on the tradeoff between the goals of protecting minority shareholders and allowing controllers to pursue their vision and how corporate law should balance these conflicting goals. Focusing primarily on Delaware corporate law, it suggests that holding a control block allows majority shareholders to pursue their idiosyncratic vision in the manner they see fit, even against minority investors’ objections. Idiosyncratic vision refers to the subjective value that entrepreneurs attach to their business idea or vision, and this chapter considers its role in the value of control. It also discusses the perils of asymmetric information and differences of opinion, as well as the risk of agency costs for minority investors

Agents of Inequality: Common Ownership and the Decline of the American Worker

The last forty years have seen two major economic trends: wages have stalled despite rising productivity, and institutional investors have replaced retail shareholders as the predominant owners of the U.S. equity markets. A few powerful institutional investors — dubbed common owners — now hold large stakes in most U.S. corporations. And in no coincidence, when U.S. workers acquired this new set of bosses, their wages stopped growing while shareholder returns increased. This Article explains how common owners shift wealth from labor to capital, thereby exacerbating income inequality. Powerful institutional investors pushing public corporations en masse to adopt strong corporate governance has an inherent, painful tradeoff. While strong governance can improve corporate efficiency by reducing management agency costs, it can also reduce social welfare by limiting investment and thus hiring. Common owners act as a wage cartel, pushing labor prices below their competitive level. Importantly, common owners transfer wealth from workers to shareholders not by actively pursuing anticompetitive measures but rather by allocating more control to shareholders — control that can then be exercised by other shareholders, such as hostile raiders and activist hedge funds. If policymakers wish to restore the equilibrium that existed before common ownership dominated the market, they should break up institutional investors by limiting their size

Corporate Control, Dual Class, and the Limits of Judicial Review

Companies with a dual-class structure have increasingly been involved in high-profile battles over the reallocation of control rights. Google, for instance, sought to entrench its founders’ control by recapital­izing from a dual-class into a triple-class structure. The CBS board, in contrast, attempted to dilute its controlling shareholder by distributing a voting stock dividend that would empower minority shareholders to block a merger it perceived to be harmful. These cases raise a fundamental question at the heart of corporate law: What is the proper judicial response to self-dealing claims regarding reallocations of corporate control rights? This Article shows that the reallocation of control rights raises an inevitable tradeoff between investors’ protection from agency costs and the controller’s ability to pursue its idiosyncratic vision, making the value of different allocations of control rights both firm specific and individual specific. It is thus inherently impossible to create objective valuation mod­els for the reallocation of control rights. The impossibility of creating reli­able valuation models sets the limits of judicial review: The legal tools long used by Delaware courts to adjudicate conflicts over cash-flow rights, such as entire fairness review, are fundamentally incompatible with the adjudication of conflicts over reallocations of control rights. This Article explores the policy implications of this insight and suggests that courts treat reallocations of control rights as questions of charter interpretation as to who has the power to decide such reallocations and avoid reviewing the discretion to use that power. Courts should enforce the decision of the parties as to reallocations of control rights and apply the business judg­ment rule when the charter is silent

Agents of Inequality: Common Ownership and the Decline of the American Worker

The last forty years have seen two major economic trends: wages have stalled despite rising productivity, and institutional investors have replaced retail shareholders as the predominant owners of the U.S. equity markets. A few powerful institutional investors—dubbed common owners—now hold large stakes in most U.S. corporations. And in no coincidence, when U.S. workers acquired this new set of bosses, their wages stopped growing while shareholder returns increased. This Article explains how common owners shift wealth from labor to capital, thereby exacerbating income inequality. Powerful institutional investors pushing public corporations en masse to adopt strong corporate governance has an inherent, painful tradeoff. While strong governance can improve corporate efficiency by reducing management agency costs, it can also reduce social welfare by limiting investment and thus hiring. Common owners act as a wage cartel, pushing labor prices below their competitive level. Importantly, common owners transfer wealth from workers to shareholders not by actively pursuing anticompetitive measures but rather by allocating more control to shareholders—control that can then be exercised by other shareholders, such as hostile raiders and activist hedge funds. If policymakers wish to restore the equilibrium that existed before common ownership dominated the market, they should break up institutional investors by limiting their size