Civil liability and mandatory disclosure

Columbia Law Review

Volumn 109, Issue 2, 2009, Pages 237-308

  Fox, Merritt B ^a  

^a Columbia Law School ^*  (United States)

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EID: 64649103742     PISSN: 00101958     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (331)

1. Pub. L. No. 73-22, 48 Stat. 74 (codified as amended at 15 U.S.C. §§77a-77aa (2006)).
2. Pub. L. No. 73-291, 48 Stat. 881 (codified as amended at 15 U.S.C. §§78a-78lll).
3. Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Prices, 59 Stan. L. Rev. 1465,1469-71 (2007) (attributing development of modern U.S. corporations' orientation toward share value maximization and prevalence of independent director-dominated monitoring boards to increase in informedness of share prices and liquidity of capital markets).
4. Winners whose work was primarily in financial economics include George Stigler (1982), Franco Modigliani (1985), Harry Markowitz (1990), Merton Miller (1990), William Sharpe (1990), Robert Merton (1997), and Myron Scholes (1997). See All Laureates in Economics, at http://nobelprize.org/nobel-prizes/economics/ laureates/ (last visited Jan. 14, 2009) (on file with the Columbia Law Review).
5. Section 11 (a) of the Securities Act provides that any person acquiring a security whose registration statement contains "an untrue statement of a material fact or omit[s] to state a material fact required to be stated therein or necessary to make the statements therein not misleading" may bring an action for damages against, among others, the directors and top officers of the issuer, the offering's underwriters, and every other person who signs the registration statement, which includes the issuer. 15 U.S.C. §77k(a).
6. Section 11 (a), as just noted, imposes absolute liability on each of these actors. See id. Section 11 (b) frees each of these actors (but not the issuer) from this liability if the actor can affirmatively establish that "he had, after reasonable investigation, reasonable ground to believe and did believe" that the registration did not contain the untrue statement or omission triggering the section 11(a) claim. Id. §77k(b)(3)(A).
7. See Edward F. Greene, Determining the Responsibilities of Underwriters Distributing Securities Within an Integrated Disclosure System, 56 Notre Dame L. Rev. 755, 767-70 (1981) (noting that full disclosure was key goal in drafting of section 11 of Securities Act);
8. see also Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 581 (E.D.N.Y. 1971) (" 'Only the underwriter and the accountant are free to assume an adverse role, have little incentive to accept the risk of liability, and possess the facilities and competence to undertake an independent investigation. They may therefore reasonably be required to share the burden of verification.' "
9. (quoting Comment, BarChris: Due Diligence Redefined, 68 Colum. L. Rev. 1411, 1421 (1968)));
10. Escott v. BarChris Constr. Corp., 283 F. Supp. 643, 696-97 (S.D.N.Y. 1968) (discussing responsibility of underwriters to protect investors by verifying information). Commentary by persons intimately involved with the creation of the Securities Act confirm that this in terrorem arrangement for imposing damages in the absence of adequate investigation was a critical part of the legislative plan to promote full disclosure.
11. See William O. Douglas & George Bates, The Federal Securities Act of 1933, 43 Yale L.J. 171, 173 (1933) (asserting that civil liabilities were "set high to guarantee that the risk of their invocation will be effective in assuring that the 'truth about securities' will be told");
12. Felix Frankfurter, The Securities Act: II, Fortune, Aug. 1933, at 53, 108 ("The scope of the liability is carefully defined. Untruth in a material fact or its omission-the means whereby investors are misled-makes all who are chargeable with the duty of knowing and revealing the truth liable to an investor in ignorance of the truth.").
13. As a formal matter, a material misstatement in any of these Exchange Act periodic filings is subject to liability pursuant to section 18(a) of the Exchange Act. 15 U.S.C. §78r. Court decisions, however, have concluded that to succeed, the plaintiff must establish "eyeball reliance" on the misstatement in the filed document.
14. See, e.g., Ross v. A.H. Robins Co., 607 F.2d 545, 552-53 (2d Cir. 1979) (" 'Reliance on the actual [filed] report is an essential prerequisite for a Section 18 action and constructive reliance is not sufficient.' "
15. (quoting Heit v. Weitzen, 402 F.2d 909, 916 (2d Cir. 1968))). This requirement cuts out most investors since the typical investor, when making a buy or sell decision, does not read the issuer's actual Exchange Act filings. At most, she would find out about a misstatement in such a filing only indirectly, by learning information based on the misstatement contained in an online, newspaper, or analyst report. Also, because the eyeball reliance requirement involves particularized proof with regard to each claimant, class actions are not practical. Without the availability of a class action, most securities claims are not worth the costs of pursuing. As a result of these factors, section 18(a) has largely been considered a "dead letter." David L. Ratner & Thomas Lee Hazen, Securities Regulation: Cases and Materials 328-31 (5th ed. 1996). Liability for such a misstatement was also not available based on Exchange Act section 10(b), 15 U.S.C. §78j(b), and Rule 10b-5, 17C.F.R.§ 240.10b-5 (2008), at least as a practical matter, until the issuance of court decisions, discussed infra note 16, broadening the interpretation of the Rule's "in connection with the purchase or sale of a security" requirement and facilitating class actions by allowing a presumption of reliance based on the fraud-on-the-market theory.
16. See Richard A. Brealey, Stewart C. Myers & Franklin Allen, Principles of Corporate Finance 358-59 (9th ed. 2008) (summarizing EMH).
17. The core logic of company registration is that established issuers are already required on a continuing basis to answer most of the questions that they have traditionally been asked to answer when registering new offerings and that no useful purpose is served in requiring the questions to be answered again at the time of each securities offering. According to the efficient market hypothesis, for an established issuer whose shares trade in a thick, efficient market, its answers to these questions in its periodic filings will already be reflected in the prevailing secondary market price at the time of the new primary offering. The price of the shares in the new offering will be determined primarily by this secondary market price. The origins of the company registration concept can be traced to a 1966 article by Milton Cohen. Milton H. Cohen, "Truth in Securities" Revisited, 79 Harv. L. Rev. 1340, 1341-42 (1966). It subsequently formed the organizing principle behind the American Law Institute's proposed codification of federal securities law.
18. See Fed. Sec. Code, at xx-xxi (1980) (citing Cohen, supra, as an impetus for codification project). Congress never enacted the wholesale reform of the securities acts envisioned in the ALI Code, but the ideas in the code and in Cohen's article have animated much SEC rulemaking over the last few decades.
19. See infra note 11.
20. This shift began in the 1970s with the SEC's adoption of Regulation S-K, which served as the basis for coordinating disclosure under both the Securities Act registration requirements for new offerings and the Exchange Act periodic disclosure requirements by having the requirements for each incorporate by reference questions set out in a single regulation. See 17 C.F.R. § 229. This development was followed in the early 1980s by the periodic disclosure. The starting point is amended Rule 405, which provides a definition for "Well-Known Seasoned Issuers" ("WKSIs"), a category intended to cover large, established, publicly traded corporations expected to be thickly traded and followed by analysts in the market. 17 C.F.R. § 230.405;
21. Securities Offering Reform, 70 Fed. Reg. at 44, 726-27 (describing WKSIs). WKSIs are permitted under the amended Rule 415 to register "for the shelf" an unlimited number of shares to be offered (subject to refiling requirement every three years) at any point in the future, from time to time, or on a continuous basis. 17 C.F.R. § 230.405. Under this "automatic shelf registration" procedure, payment of registration fees is allowed on a "pay as you go" basis, rather than at the time of registration, as was required previously.
22. Id. § 230.456. Immediate "takedowns" of securities so registered can occur without any delay for possible SEC review of updating filings.
23. Id. § 230.415(a)(5). Because of a change in Rule 415(a)(4), shares registered pursuant to the automatic shelf registration procedure may also be used for "at the market offerings" made directly into the secondary market, either by the issuer itself or with the aid of a broker. Unlike before, there is no need to name an underwriter in the registration statement and no limit on the number of shares so offered. 1 Louis Loss, Joel Seligman & Troy Paredes, Securities Regulation 550 (4th ed. 2006).
24. In theory, since the underwriter continues to face section 11 liability, it could insist that the offering be held up pending completion of a proper due diligence investigation. Delays, however, are costly for issuers. This cost was not present before the short form and shelf registration reforms made speedy registration possible. For a fuller discussion of the reasons why short form and shelf registration led investment banks to stop performing their traditional due diligence role, see Merritt B. Fox, Shelf Registration, Integrated Disclosure, and Underwriter Due Diligence: An Economic Analysis, 70 Va. L. Rev. 1005, 1025-30 (1984) [hereinafter Fox, Shelf Registration].
25. See In re Worldcom, Inc. Sec. Litig., 346 F. Supp. 2d 628, 662-64 (S.D.N.Y. 2004) (noting requirement that underwriter's behavior be "reasonable").
26. In Professor Coffee's view, underwriters could simply regard the risk of liability from not doing due diligence as a necessary cost of doing business in order to compete and provide the issuer with quick access to the market. They could raise their fees or increase insurance coverage to compensate for this risk. John C. Coffee, Due Diligence After WorldCom, N.Y.L.J., Jan. 20, 2005, at 5.
27. See Circumstances Affecting the Determination of What Constitutes Reasonable Investigation and Reasonable Grounds for Belief Under Section 11 of the Securities Act, Securities Act Release No. 6335, Exchange Act Release No, 18,011, Investment Company Act Release No. 11,889, 46 Fed. Reg. 42,015, 42,017 (proposed Aug. 18, 1981) (to be codified at 17 C.F.R, pt. 230) ("[T] his reduction in preparation time, together with competitive pressures, will restrict the ability of responsible underwriters to conduct what would be deemed to be a reasonable investigation .... [I]ssuers may be reluctant to wait for responsible underwriters to finish their inquiry . . . ."); see also Comm'n on Fed. Regulation of Sec, Report of Task Force on Sellers' Due Diligence and Similar Defenses Under the Federal Securities Laws, 48 Bus. Law. 1185, 1239 (1993) ("The 'integrated disclosure system' and the expansion of shelf registration statements have called into question whether underwriters any longer 'sponsor' an issue in a meaningful way, as opposed to delivering advice and distribution services.");
28. Letter from ABA Comm'n on Fed. Regulation of Sec, Bus. Law Section, to David B.H. Martin, Dir., Div. of Corp. Fin., SEC (Aug. 22, 2001), available at http://www.abanet.org/buslaw/committees/CL410000 pub/comments/20010822010000.pdf (on file with the Columbia Law Review) ("[T]he benefits of 'on demand financing' ... are undermined by continuing to impose on financial intermediaries and other 'gatekeepers' the responsibility ... to do a sufficient due diligence investigation . . . without recognizing and making allowances for their difficulty or even inability to do so.");
29. Letter from The Bond Mkt, Ass'n to Jonathan G. Katz, Sec'y, SEC (Jan. 31, 2005) (on file with the Columbia Law Review) (urging relaxation of underwriter liability on shelf registration);
30. Letter from Davis Polk & Wardwell to Jonadian G. Katz, Sec'y, SEC (Jan. 31, 2005) (on file with the Columbia Law Review) (same) ;
31. Letter from Merrill Lynch to Jonathan G. Katz, Sec'y, SEC (Jan. 31, 2005) (on file with the Columbia Law Review) (same) ;
32. Letter from Sec, Indus. Ass'n to Jonathan G. Katz, Sec'y, SEC (Jan, 31, 2005) (on file with the Columbia Law Review) (same);
33. Letter from Sullivan & Cromwell LLP to Jonathan G. Katz, Sec'y, SEC (Jan. 31, 2005) (on file with the Columbia Law Review) (same).
34. The starting point for the development of fraud-on-the-market class actions against an issuer for damages suffered as a result of an issuer misstatement goes back forty years. In SEC v. Texas Gulf Sulphur Co., the court found that whenever an issuer makes a statement that is "reasonably calculated to influence the investing public," such statement satisfies Rule lOb-5's requirement that it be "in connection with the purchase or sale of a security," even if neither the issuer nor its managers buy or sell shares themselves. 401 F.2d 833, 860-62 (2d Cir. 1968). This potential liability did not become a serious threat to most issuers, however, until class actions became possible with the development of the fraud-onthe-market theory of reliance, which was first enunciated in the lower courts in the 1970s and was affirmed by the Supreme Court only in 1988.
35. See Basic Inc. v Levinson, 485 U.S. 224, 247 (1988). A material public misstatement by an official of an issuer whose shares trade in an efficient market will, under the efficient market hypothesis, affect ťhe issuer's share price. This effect provides a plaintiff a way to establish "the requisite causal connection between a defendant's misrepresentation and a plaintiffs injury."
36. Id. at 243. This is an alternative to establishing this connection through a showing of traditional reliance, which involves demonstrating that the misstatement induced the plaintiff to purchase or sell the security. In the case of a falsely positive statement, for example, allowing the plaintiff to show reliance by establishing that the defendant's misstatement caused the plaintiff to pay too much, rather than that it caused the defendant to enter into what turned out to be an unfavorable transaction, eliminates the need to make particularized claims of reliance for each purchaser. Thus, common issues of fact predominate and class actions become possible. Prior to the fraud-on-the-market presumption of reliance that made class actions practical, the individual investor rarely found the prospective recovery of just her own damages sufficient to justify the cost of bringing suit.
37. See Todd Foster et al., NERA Econ. Consulting, Recent Trends in Shareholder Class Action Litigation: Filings Stay Low and Average Settlements Stay High-But Are These Trends Reversing? 1 (2007), available at http://www.nera.com/image/PUB- RecentTrends-Sep2007-FINAL.pdf (on file with the Columbia Law Review) (noting average settlement values were at all-time high in first half of 2007, and "[f]or the first time, all of the top ten shareholder class action settiements exceed $1 billion");
38. see also infra note 18 (discussing large amounts that issuers paid out annually in connection with such suits in prior years).
39. See, e.g., John C. Coffee, Jr., Reforming the Class Action, 106 Colum. L. Rev. 1534, 1562-63 (2006) [hereinafter Coffee, Reforming] (describing argument that fraudon-the-market class actions may shift costs to shareholders, who may themselves be victims of securities fraud). For the years 2000 through 2005, total annual securities class action settlements have averaged about $4.1 billion.
40. See Laura E. Simmons & Ellen M. Ryan, Cornerstone Research, Post-Reform Act Securities Setdements: 2005 Review and Analysis 1 fig.l (2006), available at http://securities.cornerstone.com/pdfs/settlements-2005.pdf (on file with the Columbia Law Review) (reaching $4.1 billion figure by averaging total settlement dollars each year from 2000 to 2005). Studies suggest that contingent fee awards to plaintiffs' lawyers in securities class actions average around thirty percent.
41. See Frederick C. Dunbar & Vinita M. Juneja, Nat'l Econ. Research Assoes., Recent Trends II: What Explains Setdements in Shareholder Class Actions? tbl.4 (1993) (finding that attorneys' fees averaged 31.32% of setdements in sample of 135 cases from July 1991 through June 1993);
42. Frederick C. Dunbar et al., Nat'l Econ. Research Assoes., Recent Trends III: What Explains Settlements in Shareholder Class Actions? ii (1995) (finding that although average setdements fell between 1993 and 1994, plaintiffs' attorneys' fees remained constant, averaging one-third of settlement awards, or $1.96 million in 1993 and $2.03 million in 1994). If we assume that defendants' lawyers are paid comparable fees, this would suggest that the total annual legal expenses associated with these actions averaged about $2.46 billion ((,30 + ,30) x $4.1 billion). The plaintiffs' expenses come out of the judgment or settlement and hence diminish what would otherwise be paid to the investors who claim to be injured. The issuer defendants' expenses are ultimately borne by their shareholders at the time suit is brought. Other social costs include use of the judicial system and the time and attention the issuers' executives devoted to the litigation.
43. See John C. Coffee, Jr., Gatekeepers: The Role of the Professions and Corporate Governance 15 (2006) [hereinafter Coffee, Gatekeepers] (describing rash of financial scandals, including those involving Enron and Worldcom, whereby issuers attempted to maximize market price of their securities by creating misimpressions as to what their future cash flows were likely to be, and hundreds of resulting restatements).
44. See Anjan V. Thakor with Jeffrey S. Nielsen St David A. Gulley, U.S. Chamber Inst, for Legal Reform, The Economic Reality of Securities Class Action Litigation 4-6 (2005), available at http://www.instituteforlegalreform.org/ issues/docload.cfmPdocID-855 (on file with the Columbia Law Review) (concluding that class action securities litigation often overcompensates institutional investors);
45. Anjan V, Thakor, U.S. Chamber Inst, for Legal Reform, The Unintended Consequences of Securities Litigation 14 (2005), available at http://www.instituteforlegalreform.org/issues/docload.cfm?docID=857 (on file with the Columbia Law Review) [hereinafter Thakor, Unintended Consequences] (arguing that litigation destroys shareholder wealth, creates deadweight loss, and lowers firms' capital investment);
46. see also Coffee, Reforming, supra note 18, at 1585-86 (concluding that securities class action does not benefit shareholders and should be reconfigured into "mechanism for deterrence");
47. Donald C. Langevoort, Capping Damages for Open-Market Securities Fraud, 38 Ariz. L. Rev. 639, 646-47 (1996) (finding that "direct net harm" of fraud may be zero and that litigation overcompensates investors);
48. Amanda M. Rose, Reforming Securities Litigation Reform: Restructuring the Relationship Between Public and Private Enforcement of Rule 10b-5,108 Colum. L. Rev. 1301,1304-05 (2008) (arguing that litigation can lead to overcompensation and stymie governmental efforts to set effective enforcement policy).
49. The Committee on Capital Markets Regulation, also known as the "Paulson Committee," claims, for example, that there has been a reduction in the competitiveness of U.S. capital markets versus markets abroad due in part to the costs imposed on issuers by fraud-on-the-market class actions and the uncertainty that they create. The Committee calls for reforms that would effectively reduce or eliminate such actions. For example, it calls upon the SEC to impose a stricter standard than most courts have adopted concerning what must be shown to demonstrate that the market for a security is sufficiendy efficient to justify application of the fraud-on-the-market theory. See Interim Report of the Committee on Capital Markets Regulation 81-82 (2006), available at http://www. capmktsreg.org/pdfs/ll.30Committee-Interim-ReportREV2. pdf (on file with the Columbia Law Review) (calling for adoption of In re PolyMedica Corp. Securities Litigation, 432 F.3d 1, 26 (1st Cir. 2005), rule that plaintiffs must prove market price fully reflects all publicly available information). More importantly, the Committee calls for the SEC to permit managers, with the approval of shareholders, to adopt charter amendments barring shareholders from bringing fraud-on-the-market damage actions to court. Such claims would instead be heard in arbitration. If the charter amendment so provided, the claims could be brought only individually by each shareholder, not by a class action.
50. Id. at 109-11. As noted supra note 16, this would largely eliminate issuer liability altogether since, for most investors, individual actions do not have the prospect of sufficiently large recovery to merit the costs of bringing the action.
51. See infra Part IV.
52. See Bernard S. Black, The Legal and Institutional Preconditions for Strong Securities Markets, 48 UCLA L. Rev. 781, 832-38 (2001) [hereinafter Black, Legal and Institutional Preconditions] (discussing qualitative advantages of strong securities markets and collecting studies showing relationship between strong securities markets and economic growth);
53. Ross Levine, Financial Development and Economic Growth: Views and Agenda, 35 J. Econ. Lit. 688, 703-20 (1997) (compiling evidence indicating "strong, positive link between financial development and economic growth"). For empirical evidence that the direction of causation leads from financial development generally (both in the form of a banking sector and of stock markets) to economic growth and not the other way around,
54. see Raghuram G. Rajan & Luigi Zingales, Financial Dependence and Growth, 88 Am. Econ. Rev. 559, 584 (1998). For further discussion of the advantages of dispersed ownership,
55. see Erik Berglõf & Stijn Claessens, Enforcement and Corporate Governance 3 (World Bank Policy Research, Working Paper No. 3409, 2004), available at http://ssrn.com/abstract-625286 (on file with the Columbia Law Review) (finding that consolidated ownership leads to "entrenchment of the manager and owner, poor performance of firms, limited risk diversification, liquidity costs as the owner cannot sell its stake easily, and minority rights expropriation").
56. See infra Part II.D (arguing that greater disclosure increases liquidity and reduces cost of capital, leading to more efficient allocation of scarce resources).
57. See Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets, 47 J. Fin. Econ. 243, 257-64 (1998) (showing that venture capitalists' successful exits take place disproportionately through IPOs).
58. See Coffee, Gatekeepers, supra note 19, at 109 (describing impossibility of dispersed ownership and separation of ownership from control without reliable, audited financial statements);
59. Erik Berglöf & A. Pajuste, Emerging Owners, Eclipsing Markets: Corporate Governance in Central and Eastern Europe, in Corporate Governance and Capital Flows in a Global Economy 267, 267-68 (Peter K. Cornelius & Bruce Kogut eds., 2003) (explaining how countries with poor transparency were quickly transformed, after initial privatization auctions created dispersed ownership, to concentrated ownership economies);
60. Black, Legal and Institutional Preconditions, supra note 23, at 783, 834-35 (collecting empirical studies showing relationship between transparency and depth of equity markets measured by indicators such as ratio of stock market capitalization to GDP);
61. John C. Coffee, Privatization and Corporate Governance: The Lessons from Securities Market Failure, in Corporate Governance Lessons from Transition Economy Reforms 265, 274-81 (Merritt B, Fox & Michael A. Heller eds., 2006) (comparing disappearance of market trading for most of nearly 1,500 Czech issuers created by privatization in early 1990s with better performance of Polish capital markets and attributing difference in part to very poor issuer disclosure in Czech Republic versus relatively high quality issuer disclosure in Poland);
62. Frank B. Cross & Robert A. Prentice, The Economic Value of Securities Regulation, 28 Cardozo L. Rev. 333, 376-89 (2006) (collecting empirical studies showing relationship between transparency and depth of equity markets measured by indicators such as ratio of stock market capitalization to GDP) ;
63. Hazem Daouk et al., Capital Market Governance: How Do Security Laws Affect Market Performance? 25 (Feb. 16, 2006) (unpublished manuscript, on file with the Columbia Law Review), available at http:// ssrn.com/abstract= 702682 (linking "increased enforcement of insider trading laws, improved accounting standards . . . and a relaxation of short selling" to market performance).
64. See, e.g., OECD Principles of Corporate Governance 49-57 (2004), available at http://www.oecd.org/DATAOECD/32/18/31557724.pdf (on file with the Columbia Law Review) (detailing importance of transparency in business);
65. Mark J. Roe, Corporate Law's Limits, 31 J. Legal Stud. 233, 243-44 (2002) (arguing that corporate law is ineffective without transparency),
66. Bill 198 to the Ontario Securities Act, which effectively eliminated the need for plaintiffs to establish reliance or loss causation, became effective on December 31, 2005. Canada Introduces Securities Disclosure Liability, Can. Int'l Fin, L. Rev., Jan. 1, 2006, at 28, 28;
67. see also Bradley Davis, Bill 198 Will Bring a New Era in Class Action Litigation in 2006, Law, WkIy., Oct. 14, 2005, at 9.
68. Ryu Jin, Assembly Passes Watered-Down Class Action Bill, Korea Times, Dec. 23, 2003, at 2.
69. See Stefano M, Grace, Strengthening Investor Confidence in Europe: U.S.-Style Securities Class Actions and the Acquis Communautaire, 15 J. Transnat'l. L. & Pol'y 281, 290-300 (2006) (noting effects of different political economies on allowing class action litigation);
70. Peter Geier, A Wary Europe Moves a Step Closer to Class Actions, Nat'l L.J., Dec. 5, 2006, at http://www.law.com/jsp/article.jsp?id=l165244464820# (on file with the Columbia Law Review) (commenting on change in five years since Europe allowed plaintiffs to bring increased class action securities suits);
71. Press Release, German Fed. Ministry of Justice, The German "Capital Markets Model Case Act" (Jan. 12, 2006), available at http:// www.bmj.bund.de/media/archive/1056.pdf (on file with the Columbia Law Review) (discussing similarities and differences between U.S. and new German class action systems).
72. Geier, supra note 30.
73. Guido Ferrarini & Paolo Giudici, Financial Scandals and the Role of Private Enforcement: The Parmalat Case 3 (European Corporate Governance Inst., Law Working Paper No. 40/2005, 2005), available at http://ssrn.com/abstract- 730403 (on file with the Columbia Law Review) (noting influence of media on quickly formed class action system in Italian courts after Parmalat).
74. For recent overviews of "collective action" reforms in Europe, see Heather Smith, Is America Exporting Class Actions to Europe?, Law.com In-House Counsel, Feb. 28, 2006, available at http://www.law.com/jsp/ihc/ PubArticleIHC.jspPid-1141047298349 (on file with the Columbia Law Review) (documenting first product liability class action court case in Europe);
75. see also Linklaters, Global Dispute Resolution: Class Action (2008), available at http://linklaters.com/pdfs/publications/Litigation/Classactions.pdf (on file with the Columbia Law Review) (describing increasingly stringent U.S. class certification standards designed to increase viability of similar systems in Europe).
76. See, e.g., Black, Legal and Institutional Preconditions, supra note 23, at 796 (explaining historical success of stock market listing standards requiring corporate disclosure in increasing dispersed ownership);
77. Rafael La Porta, Florencio Lopez-De-Silanes & Andrei Shleifer, What Works In Securities Laws?, 61 J. Fin. 1, 19 (2006) (studying empirical relationship between availability of private enforcement of securities laws and capital market development);
78. Kadiarina Pistor, Martin Raiser & Stanislaw Geifer, Law & Finance in Transition Economies, 8 Econ, Transition 325, 348 (2000) (noting that effective laws rather than rapidly changing laws are most likely to influence external financial situations positively);
79. Jennifer Arlen, Public Versus Private Enforcement of Securities Fraud 12-19 (2007) (unpublished manuscript, on file with the Columbia Law Review) (examining best allocation of public and private enforcement authority);
80. Berglöf & Claessens, supra note 23, at 15, 22 (distinguishing effects of private versus public enforcement mechanisms).
81. Good corporate governance encourages firm managers to select more accurately the most promising from among all the proposed investment projects in the economy and to better operate their existing projects.
82. The importance of economic efficiency as a goal for disclosure regulation has gained increasing recognition over the last twenty-five years. Professor Coffee, for example, states: "Th[e] focus on fairness, rather than efficiency, is not surprising because proponents of a mandatory disclosure system have historically stressed the former over the latter. Nonetheless, the strongest arguments for a mandatory disclosure system may be efficiency-based." John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Va. L. Rev. 717, 751 (1984)
83. [hereinafter Coffee, Market Failure]; see also Zohar Goshen & Gideon Parchomovsky, The Essential Role of Securities Regulation, 55 Duke L.J. 711, 713 (2006) ("[T]he ultimate goal of securities regulation is to attain efficient financial markets and thereby improve the allocation of resources in the economy.");
84. Steven A. Ross, Disclosure Regulation in Financial Markets: Implications of Modern Finance Theory and Signaling Theory, in Issues in Financial Regulation 177, 191 (Franklin Edwards ed., 1979) (discussing costs of compliance with disclosure requirements).
85. For other perspectives on the efficiency-enhancing features of securities disclosure, see Marcel Kahan, Securities Laws and the Social Costs of "Inaccurate" Stock Prices, 41 Duke LJ. 977, 985, 1006 (1992) (linking disclosure rules to accurate stock pricing and efficient resource allocation);
86. Paul G. Mahoney, Mandatory Disclosure as a Solution to Agency Problems, 62 U. Chi. L. Rev. 1047, 1048, 1050 (1995) (arguing that goal of disclosure should be focused on, and limited to, helping investors uncover breaches of contractual or fiduciary obligations).
87. The growing importance of efficiency is also illustrated by the enactment in the United States of The National Securities Market Improvement Act of 1996, Pub. L. No. 104-290, 110 Stat. 3416 (codified as amended in scattered sections of 15 U.S.C), which amended the Securities Act to add section 2(b) providing that: Whenever pursuant to this tide the Commission is engaged in rulemaking and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.
88. Id. § 106(a), 110 Stat, at 3424 (codified as amended at 15 U.S.C. § 77b(b)(2006)) (emphasis added). The 1996 Act made an essentially identical amendment to the Securities Exchange Act by the addition of section 3(f).
89. See id. § 106(b), 110 Stat, at 3424-25 (codified as amended at 15 U.S.C. § 78c (f)).
90. I have considered the points discussed here in significandy more detail elsewhere. See Merritt B. Fox, Securities Disclosure in a Globalizing Market: Who Should Regulate Whom, 95 Mich. L. Rev. 2498, 2532-44 (1997) [hereinafter Fox, Disclosure in a Globalizing Market] (rejecting fairness as compelling reason for disclosure and examining risk reduction strategies other than disclosure).
91. See infra Part IV.B.l.
92. For further discussion and empirical evidence of how corporate disclosure and the resulting increase in share price accuracy lead to the improved allocation of resources in the real economy, see Merritt B. Fox et al., Law, Share Price Accuracy, and Economic Performance: The New Evidence, 102 Mich. L. Rev. 331, 338-41 (2003) [hereinafter Fox et al., Share Price Accuracy] (examining empirical evidence suggesting disclosure can increase economic efficiency).
93. See Michael C. Jensen & William H. Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305, 308 (1976) ("The principal can limit divergences from his interest by establishing appropriate incentives for the agent and by incurring monitoring costs designed to limit the aberrant activities of the agent."). For a discussion of the differences in typical ownership patterns between the United States and other countries as well as differences in views concerning the goal of share value maximization, see infra note 96 and accompanying text,
94. For evidence that analyst coverage can reduce the agency costs associated with dispersed share ownership, which separates ownership from control, see John A. Doukas et al., Security Analysis, Agency Costs, and Company Characteristics, 56 Fin. Analysts J, 54, 54 (2000).
95. Jay C. Hartzell & Laura T. Starks, Institutional Investors and Executive Compensation 7 (Sept. 2002) (unpublished manuscript, on file with the Columbia Law Review), available at http://ssrn.com/abstract-468800 (finding, in sample including all firms in the S&P 500 Index, the S&P Midcap Index, and the S&P Smallcap Index, average aggregate institutional holdings to be 53.1% of shares outstanding and average holdings of top five institutional investors in a firm to be 22% of outstanding shares and 44% of aggregate institutional holdings);
96. accord Anthony Saunders et al., The Impact of Institutional Ownership on Corporate Operating Performance 14 (NYU Stern Finance, Working Paper No, 03-033, 2003), available at http://ssrn.com/abstract-468800 (on file with the Columbia Law Review) (finding, in sample of firms in the S&P 100, that 59.3% of shares outstanding were held by institutions and average holdings of top five institutional investors in a firm is 20.1% of outstanding shares),
97. For a more detailed discussion of these collective action problems, see Merritt B. Fox, Required Disclosure and Corporate Governance, 62 Law & Contemp. Prob. 113, 116-18 (1999) [hereinafter Fox, Required Disclosure]. Ideally the amount of information that should be made available to each such larger shareholder would be the amount that a single owner of the same enterprise would want from an agent who was managing the enterprise if the enterprise instead had a single owner ownership structure. This is because there are substantial externalities when this larger shareholder receives information since it increases the likelihood that the shareholder will exercise its franchise in a way that will enhance the interests of all shareholders.
98. See Frank P. VanderPloeg, Legal Standards for Adoption of Executive Compensation Programs and Contracts, in Tax Strategies for Corporate Acquisitions, Dispositions, Spin-Offs, Joint Ventures, Financings, Reorganizations & Restructurings 2008, at 167, 169 (PLI Tax Law & Estate Planning, Course Handbook Series No. 833, 2008).
99. Id.
100. The contrast between institutional investor votes and activist hedge fund votes is established in Marcel Kahan & Edward B. Rock, Hedge Funds in Corporate Governance and Corporate Control, at i (Univ. of Pa. Inst, for Law & Econ. Research, Working Paper No. 06-16, 2006), available at http://ssrn.com/abstract=919881 (on file with the Columbia Law Review) ("[H] edge fund activism differs from activism by traditional institutions in several ways: it is directed at significant changes in individual companies (rather than small, systemic changes), it entails higher costs, and it is strategic and ex ante (rather than intermittent and ex post).").
101. But see Lucian Bebchuk, The Myth of the Shareholder Franchise, 93 Va. L. Rev. 675, 676 (2007) (arguing that shareholders generally have little influence through their franchise).
102. William W. Bratton, Hedge Funds and Governance Targets 11 (European Corporate Governance Inst., Working Paper No. 80/2007, 2007), available at http://ssrn. com/abstract-928689 (on file with the Columbia Law Review) (describing hedge funds' high record of success in using proxy system to achieve corporate change);
103. Alon Brav et al., Hedge Fund Activism, Corporate Performance, and Firm Performance 1 (Sept. 22, 2006) (unpublished manuscript, on file with the Columbia Law Review), available at http://www. fdic.gov/bank/analytical/ cfr/2006/oct/hedge-fund.pdf (concluding that activists are at least partially successful at achieving corporate change two-thirds of the time and that there are statistically significant abnormal returns in the range of five to seven percent around time of announcement that hedge fund has become active with respect to particular issuer).
104. The SEC, by twice putting out for comment proposals to provide shareholder access to the company proxy under certain defined circumstances, flirted with increasing the shareholder role in the selection of directors of public companies. See Shareholder Proposals, Exchange Act Release No. 56,160, Investment Company Act Release No. 27,913, 72 Fed. Reg. 43,466, 43,469 (proposed Aug. 3, 2007) (to be codified at 17 C.F.R. pt. 240);
105. Security Holder Director Nominations, Exchange Act Release No. 48,626, Investment Company Act Release No. 26,206, 68 Fed. Reg. 60,784, 60,785 (proposed Oct. 23, 2003) (to be codified at 17 C.F.R. pts. 240, 249 & 274). Ultimately, however, it decided to maintain the Rule 14a-8(i)(8) exclusion of election-related shareholder proposals from company proxy materials and to amend the rule to clarify that it excludes not just proposals for a specific person to be nominated or elected director, but also proposals relating to the procedures for nomination and election. Shareholder Proposals Relating to the Election of Directors, Exchange Act Release No. 56,914, Investment Company Act Release No. 28,075, 72 Fed. Reg. 70,450, 70,453 (Dec. 11, 2007) (codified at 17 C.F.R. pt. 240.14a8(1) (8)) (2008).
106. Notwithstanding the retrenchment at the SEC, increasingly corporations have adopted on their own a majority voting standard for director elections. See AT&T Inc.: Majority Voting Standard Is Adopted for Some Elections, Wall St. J., Nov. 21, 2006, at Al 1 (announcing amendment to AT&T bylaws to adopt majority voting standard for director nominees in uncontested elections);
107. Neal E. Brunette &John D. Stoll, GM Board Declines to Discuss Meeting on Alliance, Turnaround, Wall St, J., Oct. 4, 2006, at A2 (noting that GM's board amended company bylaws "to allow majority voting in the election of directors");
108. Jared A. Favole, Delaware Lets Firms Enact Rule on Majority Vote, Wall St, J. Online, Oct. 4, 2006, available at LexisNexis, WSJNL file (citing Clorox, Co., Agilent Technologies Inc., Martek Biosciences Corp., and Wal-Mart Stores Inc. as recent examples of Delaware-incorporated companies "to enact majority-vote standards with teeth");
109. McDonald's Corp.: Bylaws Are Amended to Address Uncontested Director Elections, Wall St. J., Nov. 15, 2006, at B12 (noting that McDonald's Corp. amended bylaws to adopt majority voting standard for directors in uncontested elections) ;
110. Kara Scannell, SEC Proxy Plan May Spur Debate-Agency Takes up Issues of Shareholders' Access, Directors' Accountability, Wall St. J., July 25, 2007, at A3 (announcing SEC vote on whether to allow shareholders to amend election-related bylaws).
111. See Internet Availability of Proxy Materials, Exchange Act Release No. 52,926, Investment Company Act Release No. 74,598, 80 Fed. Reg. 74,598, 74,598 (proposed Dec. 15, 2005) (to be codified at 17 C.F.R. pts. 240, 249 & 274) ("We are proposing amendments to the proxy rules ... to furnish proxy materials to shareholders by posting them on an Internet Web site and providing shareholders with notice of the availability of proxy materials.").
112. See Mahoney, supra note 36, at 1089-95 (conducting efficiency analysis of mandatory disclosure regime).
113. For a more detailed discussion of these points, see Fox, Required Disclosure, supra note 43, at 118-20 ("Absent required disclosure, managers are not inclined to provide information that might suggest the existence of a breach of fiduciary duty. Without that information, it is often impossible for shareholders to know about the potential breach.");
114. see also Roe, supra note 27, at 269-71 (discussing value of corporate law in "protecting distant shareholders").
115. Corporate managers and directors also, of course, have a duty of care. Because of the business judgment rule, however, successful legal action against breaches of this duty are extremely rare. See Lyman Johnson, Rethinking Judicial Review of Director Care, 24 Del. J. Corp. L. 787, 801 (1999) (noting rarity of adjudicated breaches of duty of care). Disclosure, however, does enhance the functioning of substitute deterrents to duty of care violations: the shareholder franchise discussed here and market mechanisms for reducing managerial agency costs-the takeover threat and share price-based compensation-discussed immediately below.
116. See Goshen & Parchomovsky, supra note 36, at 741-42.
117. See, e.g., Merritt B. Fox, Finance and Industrial Performance in a Dynamic Economy: Theory, Practice, and Policy 84-91 (1987) [hereinafter Fox, Finance and Industrial Performance] (analyzing managerial decisionmaking based on return/risk ratio);
118. Fox, Disclosure in a Globalizing Market, supra note 37, at 2546-48 ("[F]ear of a takeover will motivate incumbent management to make decisions more in accord with the best interests of shareholders than it might otherwise make.");
119. Aaron S. Edlin & Joseph E. Stiglitz, Discouraging Rivals: Managerial Rent-Seeking and Economic Inefficiencies 1302 (Nat'l Bureau of Econ. Research, Working Paper No. W4145, 1997), available at http:// ssrn.com/abstract-227981 (on file with the Columbia Law Review) ("[M]anagerial rentseeking affects not only the level of investment, but also the form").
120. Empirical evidence demonstrates that a reduction in the riskiness of an issuer's stock will increase the proportion of stock-based compensation that a manager is willing to accept. See Clifford G. Holderness, Randall S. Kroszner & Dennis P. Sheehan, Were the Good Old Days That Good? Changes in Managerial Stock Ownership Since the Great Depression, 54 J. Fin. 435, 437 (1999) ("[R]eduction in costs and increase in benefits of managerial ownership provide an explanation for the increase in managerial ownership ....").
121. Coffee, Gatekeepers, supra note 19, at 55-56, 62-64.
122. Id. at 55.
123. The most common ways of inflating current earnings are to recognize revenues prematurely, to postpone recognition of expenses, and to capitalize expenditures that will not in fact contribute to future profitability and hence are properly categorized as expenses. Each of these acts will reduce earnings in the future and therefore have a depressing effect on future share price. Thus it is harder for managers to manipulate earnings to increase their personal rewards if the share price-based compensation plan emphasizes the longer run and hence captures this later depression in price.
124. See Merton H. Miller & Franco Modigliani, Dividend Policy, Growth, and the Valuation of Shares, 34 J. Bus. 411, 413-14 (1961) ("Having established that [a firm's current market value] is unaffected by the current dividend decision it is easy to go on to show that [it] must also be unaffected by any future dividend decisions as well.").
125. Brealey, Myers & Allen, supra note 9, at 17.
126. Id. at 215-17.
127. By the same logic, implementing projects with a zero NPV has no effect on share value and implementing negative NPV projects decreases share value.
128. See, e.g., Daniel R. Fischel, The Law and Economics of Dividend Policy, 67 Va. L. Rev. 699, 701-02 (1981) (describing "irrelevance" of dividend policy on share value).
129. The importance of these rationales for separating the finance and investment decisions emerges in the case of a firm that has overpriced shares, but has only a negative NPV investment project under consideration, i.e., the expected rate of return on the project is below what shareholders could earn if they received an amount of dividends equal to the cost of the project and reinvested this amount in the market in securities with risk comparable to that of the project. Separating the finance from the investment decisions suggests that the firm should sell additional shares but should not invest the proceeds in the project. The proceeds should instead be paid out to the shareholders as additional dividends. Id.
130. Such a distribution would signal that the issuer sold its immediately preceding new issue of shares simply because it believed they were overpriced in the market. This signal might complicate shareholder relations and future sales of equity.
131. See Homer Kripke, The SEC and Corporate Disclosure: Regulation in Search of a Purpose 123 (1979) (discussing importance of "market price of shares" for "the company's borrowing power, the interest rate it pays on its borrowings, and the value of its 'paper' in mergers and acquisitions").
132. Brealey, Myers & Allen, supra note 9, at 488-90. In the situation where top management is reasonably confident that the share price is too low because it has information that has not been credibly disclosed to the market, there may be a corrective to this distorting effect of an inaccurate share price. Normally such a deviation between share price and management's perception of share value will disappear fairly soon, before the equity offering to rebalance the debt/equity ratio would need to occur. This corrective is less likely to be at work, however, in the case of an issuer that does not disclose at a high level because it is not subject to rigorous mandatory disclosure regulations and does not otherwise have a policy of providing high disclosure. Two factors make the manager of such an issuer less likely to perceive the inaccuracy in share price. First, the manager receives a smaller flow of information in the first place. The exercise of gathering and presenting information for SEC filings is consciousness-raising. Thus, less of the negative or positive information that exists somewhere within the firm (perhaps in some kind of disaggregated form) makes its way into top management's awareness because top management is not forced to answer the questions that would be asked as part of a high disclosure regime. See Fox, Required Disclosure, supra note 43, at 123-25 (discussing role of disclosure requirements in raising managerial consciousness);
133. Louis Lowenstein, Financial Transparency and Corporate Governance: You Manage What You Measure, 96 Colum. L. Rev. 1335, 1342 (1996) (describing benefits of disclosure requirements). Second, managers do not have a monopoly of wisdom on the implications of a particular piece of information within their possession for their firm's future cash flows. When disclosed, the impact of the piece on price reflects the combination of the piece itself combined with the expertise and other information held by myriad persons in the market who analyze the piece's implications. When less information is disclosed, part of the reason that the price is less accurate relates to these factors that are outside the understanding of managers and hence of which they are not aware.
134. Again, if management knows that the share price is too high or too low because of information it possesses, the inaccurate price may not have this effect. But the managers of lower disclosure issuers are likely to be less aware of price inaccuracies. See supra note 67.
135. See Fox, Finance and Industrial Performance, supra note 54, at 282-87 (noting that "a company with a good image will have a good chance of making a success out of a new investment" and describing factors that contribute to image).
136. See infra notes 87-89 and accompanying text.
137. Larry Harris, Trading & Exchanges: Market Microstructure for Practitioners 287-88, 299-302 (2003) (describing "bid/ask" spreads);
138. Lawrence R. Glosten & Paul R. Milgrom, Bid, Ask and Transaction Prices in a Specialist Market with Heterogeneously Informed Traders, 14 J. Fin. Econ. 71, 72 (1985) (same).
139. The cost of capital is larger because the prospect of a larger bid/ask spread results in the same issuer's expected future cash flow being discounted to present value at a higher discount rate.
140. For models working out these points more rigorously, see Robert E. Verrecchia, Essays on Disclosure, 32 J. Acct. & Econ. 97, 164-72 (2001) (finding that disclosure reduces information asymmetries and lowers cost of capital);
141. David Easley & Maureen O'Hara, Information and the Cost of Capital 32-33 (Nov. 2001) (unpublished manuscript, on file with the Columbia Law Review), available at http://ssrn.com/abstract-300715 (same).
142. See Luzi Hail & Christian Leuz, Cost of Capital Effects and Changes in Growth Expectations Around U.S. Cross Listings 40 (European Corporate Governance Inst., Fin Research Paper No. 46/2004, 2008), available at http://ssrn.com/abstract-938230 (on file with the Columbia Law Review) [hereinafter Hail & Leuz, U.S. Cross Listings];
143. see also Luzi Hail & Christian Leuz, International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?, 44 J. Acct. Res. 485, 524 (2006) (finding, from cross-country comparison, inverse relationship between effectiveness of securities regimes and cost of capital). For other empirical studies showing that greater disclosure leads to increased liquidity and a lower cost of capital,
144. see Christine A. Botosan, Disclosure Level and the Cost of Equity Capital, 72 Acct. Rev. 323, 325 (1997) (presenting empirical findings that for firms that attract low analyst following, greater disclosure is associated with lower cost of equity capital) ;
145. Christian Leuz & Robert E. Verrecchia, The Economic Consequences of Increased Disclosure, 38 J. Acct. Res. 91, 113 (Supp. 2000) (presenting empirical findings, from study of German firms, that increased disclosure leads to lower cost of capital) ;
146. Michael Welker, Disclosure Policy, Information Asymmetry, and Liquidity in Equity Markets, 11 Contemp. Acct. Res. 801, 801 (1995) (presenting empirical findings "that a well-regarded disclosure policy reduces information asymmetry and hence increases liquidity in equity markets").
147. Hail & Leuz, U.S. Cross Listings, supra note 74, at 1.
148. Id. at 2 (explaining model that analyzes "ex-ante estimates of firms' cost of equity capital implied by market prices and analyst forecasts" in order to isolate issue of cash flow).
149. Id. at 7-8 (explaining effects of bonding on companies under increased U.S. disclosure requirements and threats of SEC enforcement and shareholder suits).
150. Id. at 1.
151. See 17 C.F.R. §230.144A (2008).
152. See Hail & Leuz, supra note 74, at 40.
153. See William J. Baumol, Economic Theory and Operations Analysis 517 (4th ed. 1977) (describing market imperfections from welfare economics perspective).
154. See Harris, supra note 71, at 214-15 (describing public benefits of liquid markets). More liquidity also lowers the transaction costs associated with speculative trading based on acquiring a variety of bits of publicly available information and analyzing them to make more accurate predictions of an issuer's cash flows. It therefore stimulates such activity, and in the process increases share price accuracy.
155. Id. Thus disclosure's enhancement of liquidity also provides a second, more indirect way that it improves share price accuracy, with the attendant social benefits described supra Parts II.B and U.C.
156. See Jack Hirshleifer, The Private and Social Value of Information and the Reward to Inventive Activity, 61 Am. Econ. Rev. 561, 573 (1971) (stating that gains from obtaining information must be offset by costs of acquisition and dissemination).
157. See Frank H. Easterbrook & Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 Va. L. Rev. 669, 681-82 (1984) (arguing that mandatory disclosure reduces duplicative information searches).
158. See supra notes 10-11 and accompanying text (examining logic and history of mandatory registration).
159. The prospect of issuer liability counteracts any expected gain that managers or other nonissuer actors would otherwise derivatively enjoy as a result of the issuer selling its shares at an inflated price due to a disclosure violation.
160. l have argued elsewhere that to the extent that the managers of a management controlled firm can do so without risk of a hostile takeover, it is in management's best interests to maximize the firm's aggregate available cash flow (AACF), i.e., its aggregate future earnings, before deductions for depreciation and management compensation and expenses, discounted to present value at a rate reflecting management's time preference and risk aversion. See Fox, Finance and Industrial Performance, supra note 54, at 121-27. The greater the AACF, the greater the capacity of the firm over time to satisfy the interests of each of the top managers: compensation, luxury perquisites, respect, power, affection of those around him, and a sense of rectitude. Striving to make AACF as large as possible also implies, after deduction for management compensation and expenses, the largest possible growth in firm assets (subject, of course, to the constraint that each project invested in is not expected to actually lose money).
161. Id. The idea that managers gain utility simply from the size of the firm they run has a long history.
162. See, e.g., Robert A. Gordon, Business Leadership in the Large Corporation passim (1945) (examining incentives of managers to run large companies);
163. Frank Knight, Risk, Uncertainty, and Profit 291-312 (1921) (examining role of salaried corporate managers) ;
164. Joseph A. Schumpeter, The Theory of Economic Development 128-56 (Redvers Opie trans., Harvard Univ. Press 1949) (1911) (discussing "entrepreneurial profit"). Moreover, the greater the rate of growth of the assets, the more opportunities for promotion, thereby improving the relations between top managers and those directiy below them.
165. See Oliver Williamson, Markets and Hierarchies 120 (1975) (arguing that "dispute settling characteristics" lead to creation of specialized roles). The idea that managers of public corporations will under many circumstances have an interest in investing in negative NPV projects is also behind Jensen's so-called "free cash flow" hypothesis.
166. See Michael C Jensen, Agency Costs of Free Cash Flow, Corporate Finance and Takeovers, 76 Am. Econ. Rev. 323, 323 (1986) (explaining management incentives to grow firms beyond optimal size).
167. See Fox, Finance and Industrial Performance, supra note 54, at 132-40 (discussing management techniques for reading external scrutiny);
168. Frank H. Easterbrook, Two Agency-Cost Explanations of Dividends, 74 Am. Econ. Rev. 650, 654 (1984) (noting monitoring problem of managers who are not subject to outside scrutiny).
169. See, e.g., Gordon Donaldson, Corporate Debt Capacity 3-26 (1961) (introducing analysis of "the choice between debt and equity as the source of . . . long-term capital");
170. William J. Baumol et al., Earnings Retention, New Capital and the Growth of the Firm, 52 Rev. Econ. & Stat. 345, 354 (1970) (studying effect of source funding on investment projects).
171. For a critical review of these and several other studies, along with an estimate of the magnitude of the effects on the economy, see Fox, Finance and Industrial Performance, supra note 54, at 233-37;
172. see also Jensen, supra note 87, at 326-27 (reviewing empirical effects in oil industry);
173. Reinier Kraakman, Taking Discounts Seriously: The Implications of "Discounted" Share Prices as an Acquisition Motive, 88 Colum. L. Rev. 891, 898 (1988) (critiquing misinvestment and alternative discount hypotheses).
174. A publicly traded U.S. issuer is not permitted, however, to use Rule 144A to avoid Securities Act registration of an offering of its common stock. See 17 C.F.R. § 230.144A (2008).
175. See id. §§ 230.901-.905, Regulation S provides a safe harbor from registration of foreign debt and equity offerings. The conditions for falling within the safe harbor differ depending on whether an issuer is foreign or domestic, whether it is registered under the Exchange Act and providing Exchange Act periodic disclosure, and whether it is offering debt or equity securities.
176. Studies attempting to separate the effects of resale restrictions from other factors tending to discount the price of restricted stocks, such as the cost private investors incur to assess the quality of the issuing firm and to monitor it, estimate the illiquidity discount to be between seven percent and twenty percent. Revisions to Rule 144 and Rule 145 to Shorten Holding Period for Affiliates and Non-Affiliates, Securities Act Release No. 8813, 72 Fed. Reg. 36,822, 36,838 n.175 (proposed July 5, 2007) (to be codified at 17 C.F.R. pts. 230, 239) (citing studies estimating illiquidity discount excluding other price-discounting factors of restricted stocks).
177. See supra Part II.D.3.
178. Securities Act of 1933 § 5a, 15 U.S.C. § 77e (2006) (prohibiting sale of any security without registration).
179. See supra note 67 and accompanying text.
180. The ownership pattern of the typical publicly traded corporation in the United States is dispersed, with no single controlling shareholder. Raphael La Porta et al., Corporate Ownership Around the World, 54 J. Fin. 471, 491-94 (1999) (noting that "16 out of 20 [firms] in the United States fit the widely held description"). With such a corporation, the primary corporate governance problem is the divergence of interests between management and shareholders, i.e., the agency costs of management. See supra note 40 and accompanying text. As discussed, disclosure can ameliorate this problem.
181. Supra note 40 and accompanying text. In a substantial majority of other countries, most corporations are controlled by families or the state. La Porta et al., supra, at 496 ("[O]nly 24 percent of the large companies in rich countries are widely held, compared to 35 percent that are familycontrolled, [and] 20 percent are State-controlled . . , ."). As a consequence, the corporate governance problems differ from those in the United States. These differences may affect disclosure's usefulness for improving corporate governance and hence disclosure's level of social benefits.
182. Coffee, Gatekeepers, supra note 19, at 78-82 (explaining that dispersed ownership creates managerial incentives to exaggerate reported income whereas concentrated ownership tends to lead to extraction of private benefits of control);
183. John C. Coffee, Jr., The Rise of Dispersed Ownership: The Roles of Law and the State in the Separation of Ownership and Control, 111 Yale L.J. 1, 16-17 (2001) (discussing dispersed versus concentrated ownership). If, because of these corporate governance differences, the social benefits from disclosure in such a country are less, then the optimal level of incentives for compliance would likely be less as well, because providing stronger incentives tends to be more socially costly.
184. Fox, Disclosure in a Globalizing Market, supra note 37, at 2580 (detailing optimal apportionment of regulatory authority). But comparing the social benefits from disclosure in different countries is tricky. On one hand, the agency problems associated with management are lower in countries where most corporations are controlled by families or banks because persons with control can supervise managers more easily than can dispersed shareholders, Thus a high level of disclosure is not as necessary to keep managers in line. On the other hand, the persons with control may, at the expense of the noncontrol shareholders, seek to maximize their
185. own private benefits or those of nonshareholder stakeholders of the corporation, such as labor or the communities where the corporation is located. Disclosure can be helpful in discouraging such behavior, but the extent of its effectiveness depends greatly on the specific situation. News of such behavior may depress share prices, but if those in control direcdy or indirecdy determine the votes of a majority of the shares, such a decrease in price will not lead to a fear of being replaced by a hostile takeover. Whether disclosure has some other kind of deterring effect depends both on the overall social and business mores of the country and the extent to which such behavior can be meaningfully challenged in court. Also, to the extent that the share value-depressing behavior involves decisions that benefit other stakeholders at the expense of shareholders, there is a debate as to whether such behavior is socially undesirable in the first place. While a broad, though not universal, consensus exists among commentators in the United States that share valuediminishing decisions are generally socially undesirable, this view is far from fully accepted abroad. Compare Richard A. Posner, Economic Analysis of Law 453-56 (2007),
186. and Roberta Romano, The Genius of American Corporate Law 2, 130-31 (1993) (describing objective of American corporate law as maximization of share value and criticizing other systems that take other constituencies into account),
187. with Michael Gruson & Wienand Meilicke, The New Co-Determination Law in Germany, 32 Bus. Law. 571, 571-73 (1977),
188. and Detlev F. Vagts, Reforming the "Modern" Corporation: Perspectives from the German, 80 Harv. L. Rev. 23, 38-43 (1966) (describing corporate purpose of German corporations as extending beyond maximizing shareholder value).
189. Without such an updating requirement, issuers will have an incentive to offer securities immediately after they become aware of bad news and before they would be required to disclose it in their periodic reports. Such an updating requirement is included in the automatic shelf registration procedure that was introduced as part of the SEC's 2005 offering reforms and that brings the United States closer to a company registration-type mandatory disclosure regime for large established issuers (WKSIs). See supra note 11. The updating works as follows: Issuers filing an automatic shelf registration statement may incorporate by reference all reports filed under the Exchange Act.
190. See Registration Statement Under the Securities Act of 1933 (Form S-3), at 11-12 (2008). At the time of registration, the issuer need describe only "material changes" since its most recent Exchange Act filing, either by describing these material changes directly in its Form S-3 automatic shelf registration statement or by describing them in a Form 8-K that the issuer then files and incorporates by reference in the Form S-3.
191. See id. After the effective date of the registration statement, Item 512(a) of Regulation S-K requires the issuer, during any period when an offering is actually being made, to file a post-effective amendment to reflect any facts or events that represent a "fundamental change" in the information set forth in the registration statement.
192. See 17 C.F.R. § 229.512(a)(1) (2008). Additional updating at the time of the offering should probably be waived if the issuer is making a de minimis offering or offerings-such as, say, an offering in aggregate less than a few percent of its shares withn a three-month period. The waiver is appropriate because the gain the issuer could achieve by selling the shares at a possibly higher price because of bad news that it is not yet required to disclose under the periodic disclosure regime is not sufficiently large, given the relatively small number of shares offered, to create a special incentive to make an offering. Freeing such small offerings from the updating requirement would facilitate a "just in time" method of "at the market" equity financing. Facilitating such offerings is desirable because by not requiring the real resources that would otherwise go into marketing, they involve lower social costs. The 2005 offering reforms do not provide this kind of a waiver. See supra note 11 (discussing 2005 offering reforms). At the other extreme, if an offering is sufficiently large-perhaps equal to thirty or forty percent of outstanding equity-the disclosure and liability regime proposed here should not be applicable.
193. See supra note 11. For two reasons, the issuer should instead be treated in the same fashion as an IPO. First, an offering of this size is likely to
194. See supra note 11.
195. This is not to say that the price of the offering will necessarily be the same as it would have been in the secondary market if the new primary market offering had not been made. In fact, there are a number of reasons, discussed below, why the decision by an established issuer to raise cash through a new primary market offering might affect the secondary market price of the issuer's shares. The important point for this discussion, however, is that none of these reasons undermines the company registration logic of relying on secondary market prices to assure that the price of the primary offering reflects up-to-date information. One reason the decision to offer the securities could affect the secondary price is signaling. Even with mandatory disclosure, managers inevitably know more than outsiders, and outsiders may assume that the decision to offer equity means that managers, based on their private information, think the stock is worth less than its secondary market price. The announcement of the offering will therefore cause the price to drop. Brealey, Myers & Allen, supra note 9, at 490-93 (observing that rational investors will believe "[t]he attempt to sell stock shows that it must be worth less");
196. Stewart C. Myers Sc Nicholas S. Majluf, Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have, 13 J. Fin. Econ. 187, 188 (1984) (noting that investors will reason that "[t]he news conveyed by an issue is bad"). Presumably, though, the better the periodic mandatory disclosure regime, the smaller the signaling effect. The second and third reason offering the securities could affect the secondary market price both relate to the increased supply of the issuer's shares. The increased supply of shares could create a long-run or only short-run effect. The possible long-run effect relates to the much debated question of whether there is a downward sloping demand curve for each individual issuer's shares. The capital asset pricing model would suggest that there is not because a vast reservoir of other stocks with the same beta could substitute for the issuer's shares.
197. Ronald J. Gilson & Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 Va. L. Rev. 549, 570 n.67 (1984). For empirical findings purporting to support this theory,
198. see Myron S. Scholes, The Market for Securities: Substitution Versus Price Pressure and the Effects of Information on Share Prices, 45 J. Bus. 179, 191-206 (1972).
199. But see Paul Asquith & David W. Mullins, Equity Issuers and Offering Dilution, 15 J. Fin. Econ. 61, 70-85 (1986) (presenting empirical research purporting to show downward-sloping curve);
200. Saul Levmore, Efficient Markets and Puzzling Intermediaries, 70 Va. L. Rev. 645, 653-54 (1984) (reviewing alternative explanations for Scholes's findings).
201. Alternatively, the increased supply might have only a temporary effect on the secondary market price if investors would need to adjust their portfolios for the new supply to be absorbed by the market. These adjustments entail transaction costs that must be compensated for by a decrease in price. Once the absorption occurs, however, price should return to the level dictated by fundamentals. Michael J. Barclay & Robert H. Litzenberger, Announcement Effects of New Equity Issues and the Use of Intraday Price Data, 21 J. Fin. Econ. 71, 97 (1988) (summarizing empirical findings purportedly consistent with this theory).
202. See supra notes 5, 10, 11 (discussing traditional role played by underwriters in enhancing quality of disclosure at time of securities offering and how movement toward company registration, with its gready reduced time to bring an offering to market, has undermined this function);
203. see also Coffee, Gatekeepers, supra note 19, at 206, 348-49 (discussing attorneys' traditional gatekeeping role);
204. Coffee, Re-Engineering, supra note 11, at 1157 (same); David J. Denis, Shelf Registration and the Market for Seasoned Equity Offerings, 64 J. Bus. 189, 197-98 (1991) (discussing price of underwriting under shelf procedure). For a description of the traditional registration statement's more leisurely drafting processes, which involved the active participation of the underwriters and their counsel, and citations to a variety of commentators who stated that this process generated significant additional disclosure beyond what was in an issuer's periodic filings,
205. see Fox, Shelf Registration, supra note 12, at 1025-26. An external certifier certifying an issuer's annual report would have as much time as the underwriter had in a traditional offering and so could play a similar role. Because the external certifier would face the same liability as the underwriter in the traditional offering, it would be motivated to perform this role similarly well.
206. See 17 C.F.R. § 229.303. There is empirical evidence that the late-1970s adoption of the revisions to the MD&A that prompted these disclosures resulted in a significant improvement in share price accuracy. See Fox et al., Share Price Accuracy, supra note 39, at 376.
207. Investment banks are currently oriented primarily toward selling financial products, trading on their own accounts, and arranging transactions. This orientation might suggest an organizational disinclination to developing a certification business, despite the synergies involved. There are other areas, however, where investment banks have chosen to exploit existing skills for new, nonsales applications-for example the provision of "fairness opinions" in corporate control and financial restructuring transactions.
208. Established major investment banks are highly capitalized because that is what is needed to perform their ordinary range of businesses. A survey of banks with major investment banking and underwriting operations-J.P. Morgan, Bank of America, UBS, Goldman Sachs, Citigroup, Credit Suisse, and Morgan Stanley-revealed that as of January 26, 2009, their total stock market capitalization ranged, respectively, from about $90 billion to $18 billion. Their latest reported total book equity ranged, in minor variation from this respective order, from about $147 billion to $28 billion. These figures were reflected in the data at Yahoo! Finance, http://finance.yahoo.com, on January 26, 2009. Copies of each relevant page are on file with the Columbia Law Review.
209. To prevent the entry of poorly capitalized "fly by night" investment banks or other entities into the certification business, the SEC or its equivalent abroad would, like a state insurance examiner, need to maintain some kind of supervision to assure the capital adequacy of the entities whose certifications it would accept, as well as their competency to perform due diligence.
210. Reinier H. Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 Yale L.J. 857, 858 (1984).
211. Id. at 867-68; see also Steven Shavell, Economic Analysis of Accidents 170-72 (1987).
212. See supra Part II.B.
213. See supra Part II.D.
214. Between an undiversified loser and an undiversified shareholder at the time suit is brought, a damage action would probably permit some loss spreading. At the time suit is brought, some of the issuer's shareholders have held their shares since before the issuer's misstatement and so suffered no trading loss as a result because they neither bought nor sold at a price influenced by the misstatement. Thus, not all of the issuer's shares were traded at a disadvantageous price due to the misstatement. As a result, providing damages will spread the losses from the persons who did engage in such disadvantageous trades across the holders of all the outstanding shares, which is larger in number than the number of shares traded at a disadvantageous price. But this loss spreading comes at the very high price of the substantial real resources consumed by securities litigation. See supra note 18 and accompanying text. Diversification offers a more effective, and far less expensive, way to reduce the risks associated with issuer misstatements. Thus risk reduction is an unconvincing rationale for imposing civil liability on issuers in order to provide damages to those who lose by trading at disadvantageous prices due to issuer misstatements.
215. For authors expressing skepticism toward the compensation rationale for civil liability imposed on issuers to provide damages to those who trade in the secondary market at disadvantageous prices due to issuer misstatements, see, e.g., Coffee, Reforming, supra note 18, at 1556-66;
216. Paul G. Mahoney, Precaution Costs and the Law of Fraud in Impersonal Markets, 78 Va. L. Rev. 623, 632 (1992);
217. Thakor, Unintended Consequences, supra note 20, at 6-8.
218. 109, Professors Arlen and Carney reach the same conclusion. They analyze th problem in terms of the three traditional rationales in the accident law context for favoring enterprise liability over agent liability: Enterprise liability deters more effectively, better spreads risk between the firm and its agents, and better allocates losses between the firm and the victims of the violation. They find that none of these rationales apply persuasively in the case of fraud-on-the-market violations of securities law. Jennifer H. Arlen & William J. Carney, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. Ill. L. Rev. 691, 700-20. While my reasoning and theirs overlap a great deal, our analyses differ in one important respect. They do not identify that from the appropriate ex ante perspective, secondary market investors are not damaged in terms of their trading profits by the prospect of buying and selling shares of corporations that engage in frequent misstatements rather than few or none. See supra Part IV.B.1. Recognizing this fact makes crystal clear that the only kind of damage, if any, that should give rise to liability is damage to the corporation itself. See supra note 88 and accompanying text. This insight saves steps in the analysis and eliminates the need for unrealistic assumptions, such as that there is no possibility of overdeterrence in the case of misstatements. See supra Part II.B-D. Given, for example, the possibility of legal error and the discretion that management has in fully answering questions required by its periodic disclosure filings (to say nothing of voluntary disclosure beyond the requirements of these filings), we need to recognize that the risk of liability can deter management from making what it believes is truthful disclosure. See infra Part IV.C.1. Similarly, through the level of care required to maintain a due diligence defense available to directors, officers, and the external certifier, we can affect the level of care that an issuer devotes to the accuracy of its disclosures. This care is costly and so there is some optimal level above which the care becomes socially wasteful. See supra note 96; infra Part IV.C.1.
219. In this context, the term "absolute liability" sounds more draconian than it really is. To give rise to liability, a statement of historical fact must be false or misleading at the time it is made. See, e.g., In re Navarre Corp. Sec. Litig., 299 F.3d 735, 742-43 (8th Cir. 2002) (stating plaintiffs complaint fails under heightened pleading standard of Private Securities Litigation Reform Act ("PSLRA") because it did not indicate why defendant's statements would have been false or misleading at time they were made). This suggests that whatever the state of mind of the issuer's agents, the true state of affairs must be knowable at the time, something that the plaintiff would have to show to establish falsity. Id. With respect to a forward-looking statement, which by definition cannot be a statement of fact, calling it "false" or "misleading" has to go to how reasonable a basis the forward looking statement has and the issuer's degree of conviction as to its accuracy. The specification of what constitutes an actionable forward-looking statement under U.S. securities law has undergone considerable development over the last forty years. The current law on actionable forward-looking statements comprises a mix of statutory and common law rules. Rule 175 and Rule 3b-6, promulgated under the Securities Act and the Exchange Act, respectively, provide a safe harbor for projections made with a reasonable basis and in good faith. Pub. L. No. 104-67, §§ 27A(g), 21E(g), 109 Stat. 737, 751-755 (codified at 15 U.S.C. §§ 77z-2, 78u-5 (2006)). For reporting issuers, the PSLRA amended the Securities Act and Exchange Act to provide additional safe harbors for certain projections. Id. Courts have also developed the "bespeaks caution doctrine," which protects projections if accompanied by meaningful cautionary statements. See, e.g., Romani v. Shearson Lehman Hutton, 929 F.2d 875, 879 (1st Cir. 1991) ("Documents such as this, which, 'clearly "bespeak caution,"' are not the stuff of which securities fraud claims are made." (quoting Luce v. Edelstein, 802 F.2d 49, 56 (2d Cir. 1986))).
220. See supra Part II.C.2.
221. The allocative efficiency effects of compensating investors are not free from ambiguity, however. With the discount being eliminated by compensation, more issuers that are making misstatements may also find it worthwhile to make offerings.
222. Each of the two alternative approaches to compensation creates serious problems. One approach allows secondary market purchasers to sue, but only if they purchased the specific shares originally sold in the offering. Secondary market purchaser compensation would be largely a chimera because, as a practical matter, in this market the shares from the offering are usually indistinguishable from those that were already outstanding. Even if the distinction could be made, it would be incompatible with a single secondary market for the issuer's shares because each type would have different rights and hence a different value. The alternative approach is to confine the cause of action only to primary market purchasers. This reduces the liquidity of the offered securities because they would lose their rights to damages when sold and hence, all else being equal, be worth less to the purchaser than to the seller.
223. Securities Act of 1933 § 11, 15 U.S.C. 77(k);
224. see also supra Part I.A.2.
225. See supra notes 7, 11-12, 99 and accompanying text.
226. Greater accuracy in firm disclosures requires a greater level of care by the firm's officers, directors, and external certifier. Greater care involves greater costs. Therefore, there is some optimal level of care. As discussed at the beginning of Part IV, this proposal assumes that the optimal level of care is what was required in the traditional registered public offering. See supra Part IV.A. If analysis for either the United States or another country suggests that a different level of care is optimal, then the level of care required of the officers, directors, and certifying investment bank, in order that each can maintain its due diligence defense, should be adjusted accordingly.
227. This Article does not deal specifically with the liability of accountants for misstatements in the audited financials contained in the annual report. Accountants are obviously vital gatekeepers. They too will have greater incentives to exercise care if subject to some kind of civil liability. It may be appropriate to subject accountants to an approach similar to what is recommended here for other nonissuer defendants, freeing them from fraud-on-the-market liability and substituting some other kind of measured liability that depends in part on the size of the issuer's annual investment rather than on trading volume during the period of the misstatement. But the issues relating to the tradeoffs between achieving any given level of care and the costs of doing so, as well as the history of the applicable rules of liability to date, are sufficiently different that they call for a separate inquiry.
228. For each phantom share offered, this measure is roughly equivalent to the aggregate amount of damages owed under section 11 (e) of the Securities Act to the one or more purchasers of the share in the period between the time of the offering and the time suit is brought. Under section 11 (e), subject to certain caps, the person holding this share at the time suit is brought has a prima facie case for damages equal to the difference between the price he paid and its "value" at the time of suit. Securities Act of 1933 § 11 (e), 15 U.S.C. § 77k(e). Value, in the case of an established issuer trading in an efficient market, is typically the price at time of suit.
229. See In re Fortune Sys. Sec. Litig., 680 F. Supp. 1360, 1370 (N.D. Cal. 1987) ("The 'value' of a security may be found to be different from the actual price . . . , but this is an unusual and rare situation. In general, price and value are used interchangeably, and the courts have not often found the 'true value' of a stock to differ from its market value."). If this holder purchased the share in the secondary market rather than in the offering itself so that the share had one or more prior holders, each prior holder's prima facie case for damages equals the difference between price paid and price sold. Thus, except to the extent that certain caps alter the calculation, the potential aggregate prima facie case for damages associated with each share in the offering is the difference between the offering price and the price at the time suit is brought. Section 11(e) allows the defendant an affirmative defense to the extent that it can show that the decline was caused by something besides the misstatement. § 11(e), 15 U.S.C. § 77k(e). Each secondary market purchaser must also show that the share purchased was one sold in the offering.
230. See Rosenzweig v. Azurix Corp., 332 F.3d 854, 871-73 (5th Cir. 2003) ("[A]ll four courts of appeals to address the question have held that . . . aftermarket purchasers have standing to sue under §11.");
231. see also Gibb v. Delta Drilling Co., 104 F.R.D. 59, 69-70 (N.D. Tex. 1984) ("To recover under Section 11a party need only show that he purchased securities that are the direct subject of the prospectus and registration statement.").
232. This refers to underwriter liability akin to existing liability for false or misleading statements in the registration statement pursuant to section 11 of the 1933 Act. See § 11, 15 U.S.C. § 77(k). The underwriter should still be liable to purchasers in the offering for its own statements pursuant to a Rule 10b-5 antifraud standard. 17 C.F.R. § 240.10b-5 (2008). If the external certifier were also the investment bank that was acting as the underwriter, it would, of course, be liable as the external certifier just as if it were not the underwriter.
233. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, § 201, 109 Stat. 737, 758-62 (codified as amended at 15 U.S.C. §§ 77k(f), 78u-4(f)) (amending section 11(f) of Securities Act to limit liability of outside directors to proportionate liability, except in case of a knowing violation, to which joint and several liability would still attach).
234. See John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. Rev. 301, 355 (2004) (arguing that in order to relieve tension between lawyer as gatekeeper and lawyer as advocate, corporations should use two separate law firms, with one acting as outside disclosure counsel, where disclosure counsel would review issuer's filings). With this sort of procedure, if the disclosure counsel's opinion stated that no information had come to its attention that would suggest any disclosure violation, outside directors who reasonably relied on the opinion would have a very strong argument that they should be free from liability. The SEC could provide a safe harbor for such a director under its exemptive authority pursuant to its authority under Exchange Act sections 3(f) and 36. 15 U.S.C. §§ 78c(f) 15, 78mm. Some prominent commentators have even argued that outside directors should not be liable at all. See Bernard S. Black, Brian R. Cheffins & Michael Klausner, Outside Director Liability: A Policy Analysis, 162 J. Institutional & Theoretical Econ. 5, 6, 17 (2006) (suggesting liability for outside directors would "discourag[e] good candidates from serving, caus[e] counterproductive risk-avoidance among those who do serve, and induc [e] directors to focus unduly on taking procedural precautions designed to protect against liability").
235. Imposing on the gatekeeper the task of proving nonnegligence has a number of advantages over putting the burden on the plaintiff. There is less chance of legal error because the gatekeeper has most of the information about whether it met its standard of care. Assaf Hamdani & Reinier Kraakman, Rewarding Outside Directors, 105 Mich. L. Rev. 1677, 1693 (2007) (explaining benefits of "reverse negligence" regime). Moreover, the social resources consumed by the plaintiffs' lawyers, and the fee needed to be paid to them to induce them to bring actions where they are socially warranted, would be substantially less than in fraud-on-the-market suits since they would not need to show that the defendant had scienter, simply the existence of a material misstatement and a loss caused by the misstatement. This is often not difficult, for example in the case of an earnings restatement immediately followed by a sharp price drop.
236. See R. Franklin Balotti & Mark J. Gentile, Commentary from the Bar, Elimination or Limitation of Director Liability for Delaware Corporations, 12 Del. J. Corp. L. 5, 9 (1987) ("Many directors have resigned from their positions or have declined to seek to renew their terms as such when liability insurance is unavailable, and many qualified individuals have refused to accept directorships initially.").
237. Tom Baker & Sean J. Griffith, The Missing Monitor in Corporate Governance: The Directors' & Officers' Liability Insurer, 95 Geo. L.J. 1795, 1798-99 (2007).
238. In 2005, the government of Ontario, Canada, amended the Ontario Securities Act to provide for civil liability for secondary market disclosure violations. See supra note 28. For a liable director or officer of a responsible issuer, damages are limited to the greater of C$25,000 or fifty percent of the aggregate of the director's or officer's annual compensation from the responsible issuer and its affiliates. Ontario Securities Act, Part XXIII.1, R.S.O., ch. S.5, § 138.3 (1990).
239. Hamdani & Kraakman, supra note 122, at 1693.
240. See supra notes 71-73 and accompanying text.
241. Randall v. Loftsgaarden, 478 U.S. 647, 661-62 (1986);
242. Green v. Occidental Petrol. Corp., 541 F.2d 1335, 1341-46 (9th Cir. 1976) (Sneed, J., concurring);
243. Estate Counseling Serv., Inc. v. Merrill Lynch, 303 F.2d 527, 533 (10th Cir. 1962);
244. Loss et al., supra note 11, at 4413-14.
245. For any share purchased more than once during the period when the price was inflated, the total damages of all its purchasers under the out-of-pocket measure would equal the amount by which the misstatement inflated price at the time of the initial purchase.
246. See Securities Exchange Act of 1934 § 16(b), 15 U.S.C. § 78p(b) (2006);
247. Smolowe v. Delendo Corp., 136 F.2d 231, 241 (2d Cir. 1943).
248. See 19 Am. Jur. 2d Corporations § 2010 (2004). The Federal Rules of Civil Procedure also impose a contemporaneous ownership requirement on shareholders bringing derivative suits. See Fed. R. Civ. P. 23.1.
249. A suit to recover short swing profits under section 16(b) of the Exchange Act may be brought by the "owner of any security of the issuer." 15 U.S.C. § 78p(b). Courts have consistently held that the plaintiff in a 16(b) action need not have held the issuer's securities at the time of the alleged short swing transaction.
250. William E. Aiken, Jr., Annotation, Who Is "Issuer" or "Owner of Any Security of the Issuer" for Purposes of Enforcing Short-Swing Profits Provisions of § 16(b) of the Securities Exchange Act of 1934, 51 A.L.R. Fed. 785, 789-90 (1981).
251. The PSLRA provides that the presumptive lead plaintiff in a securities class action is the plaintiff with the largest financial interest in the relief sought and who otherwise satisfies the requirements of Rule 23 of the Federal Rules of Civil Procedure. 15 U.S.C. § 77z-1(a)(3)(B).
252. See, e.g., Lisa L. Casey, Reforming Securities Class Actions from the Bench: Judging Fiduciaries and Fiduciary Judging, 2003 BYU L. Rev. 1239, 1259-75 ("Agency theory posits that the nature of the private enforcement model itself, coupled with counsel's sizeable financial incentives, tempts plaintiffs' lawyers to engage in opportunistic behavior.");
253. John C. Coffee, Jr., Understanding the Plaintiff's Attorney: The Implications of Economic Theory for Private Enforcement of Law Through Class and Derivative Actions, 86 Colum. L. Rev. 669, 677-98 (1986) (discussing plaintiffs' attorneys' incentives to litigate class and derivative suits).
254. See, e.g., Janet Cooper Alexander, Do the Merits Matter? A Study of Settlements in Securities Class Actions, 43 Stan. L. Rev. 497, 524-54 (1991) (arguing that "structural characteristics of the legal system" result in settlements "without regard to the merits"). A conceptually similar problem occurs in the case of a highly marginal suit where, for the same reasons, plaintiffs' lawyers are able to obtain a settlement much larger than the expected value of the judgment, if any, that would result if the suit were fully litigated.
255. See id. at 541-42 (discussing incentives created by lodestar compensation of plaintiffs' attorneys);
256. see also In re Quantum Health Res., Inc. Sec. Litig., 962 F. Supp. 1254, 1257-58 (C.D. Cal. 1997) (stating that experience has shown that risk justifying large contingency fees in securities class actions does not exist);
257. Richard W. Painter, The New American Rule: A First Amendment to the Client's Bill of Rights, in Manhattan Institute, 2000 Civil Justice Report 1, 1-2 (2000), available at http://www.manhattaninstitute.org/html/cjr-1. htm (on file with the Columbia Law Review) (stating that market for contingency fee lawyers is not competitive, thus leading to inefficiencies and overcompensation).
258. See Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (codified as amended in scattered sections of 15 U.S.C). It is unclear, however, whether the PSLRA makes it more difficult to bring meritless fraud-on-the-market suits relative to the difficulty of bringing suits with merit, or whether it simply makes it more difficult to bring all fraud-on-the-market suits. The distinction is important. If all the weight of the PSLRA's restrictions falls on nonmeritorious actions, then it helps solve the problems of class actions without lessening deterrence. To the extent that it also makes it more difficult to bring actions with merit, however, any reduction in the class action problems comes at the cost of reduced deterrence. Overall, the evidence suggests that the PSLRA does in fact impose this tradeoff, though it does not resolve whether any reduction in the social costs associated with nonmeritorious suits is greater than any social losses associated with a reduced number of successful meritorious suits. Professors Johnson, Nelson, and Pritchard concluded that case quality may have improved post-PSLRA, finding a closer empirical relation between factors indicating fraud (restatements and abnormal insider stock sales) and securities class action filings.
259. See Marilyn F. Johnson, Karen K. Nelson & A.C. Pritchard, Do the Merits Matter More? The Impact of the Private Securities Litigation Reform Act, 23 J.L. Econ. & Org. 627, 648-49 (2007). Stephen Choi argued that although the PSLRA deters some frivolous suits, it has also deterred certain meritorious suits. Choi found that the PSLRA probably deters nonfrivolous securities lawsuits in two situations: those involving smaller companies with small offerings or low secondary market turnover and those where companies engage in fraud but there is a lack of prefiling hard evidence of that fraud.
260. See Stephen J. Choi, Do the Merits Matter Less After the Private Securities Litigation Reform Act?, 23 J.L. Econ. & Org. 598, 622-23 (2007);
261. see also Michael A. Peřino, Did the Private Securities Litigation Reform Act Work?, 2003 U. Ill. L. Rev. 913, 969 (arguing that PSLRA did not reduce nonmeritorious filings); Eric Talley & Gudrun Johnsen, Corporate Governance, Executive Compensation and Securities Litigation 26 (Univ. of S. Cal. Law Sch., Olin Research Paper No. 04-7, 2004), available at http://ssrn.com/abstract=536963 (on file with the Columbia Law Review) ("Our results appear inconsistent with the claims of the statute's proponents that the PSLRA systematically discouraged frivolous litigation without burdening meritorious claims.").
262. Because of the difficulty of meeting the traditional reliance requirements in a class action, most Rule 10b-5 class actions are fraud-on-the-market suits. See supra note 16. From 1997 to 2004, Rule 10b-5 claims were involved in over ninety-five percent of the settlements, while section 11 or section 12(a)(2) claims were involved in only twenty percent of the settlements. Laura E. Simmons & Ellen M. Ryan, Cornerstone Research, Post-Reform Act Securities Settlements: Updated Through December 2004, at 17 (2005), available at http://securities.cornerstone.com/pdfs/Settlements-2004.pdf (on file with the Columbia Law Review) (providing securities class action settlement statistics from 1997 to 2004). Section 11 and section 12(a)(2) claims continued to be involved in only twenty percent of securities class actions settlements through 2006. Laura E. Simmons & Ellen M. Ryan, Cornerstone Research, Securities Class Action Settlements: 2006 Review and Analysis 9 (2007), available at http://securities.cornerstone.com/pdfs/ Settlements-2006.pdf (on file with the Columbia Law Review).
263. Two features make fraud-on-the-market class actions particularly vulnerable to strike suits and to highly marginal suits that extract disproportionately large settlements relative to the expected value of a fully litigated judgment. First, the typical issuer does not expect to encounter such suits frequently. According to one study, the average public corporation has only a 1.9% probability of facing a shareholder class action lawsuit in a given year. Ronald I. Miller, Todd Foster & Elaine Buckberg, NERA Consulting, Recent Trends in Shareholder Class Action Litigation: Beyond the Mega-Settlements, Is Stabilization Ahead? 3 (2006), available at http://www.nera.com/image/BRO-RecentTrends2006-SEC979-PPB-FINAL.pdf (on file with the Columbia Law Review). Thus, for an issuer, there is little reward in fighting such action simply to develop a reputation that the issuer will resist meritless and highly marginal actions in the future. Instead, a rational issuer will compare the cost of settlement with the expected cost of continuing to litigate the action, which, once a case survives a motion to dismiss and discovery begins, is very substantial. See Stephen J. Choi, The Evidence on Securities Class Actions, 57 Vand. L. Rev. 1465, 1469 (2004) (describing high costs that pressure companies to settle even frivolous securities suits);
264. Avery Katz, The Effect of Frivolous Lawsuits on the Settlement of Litigation, 10 Int'l Rev. L. & Econ. 3, 5 (1990) (describing and modeling incentives facing plaintiffs and defendants with respect to settlement of frivolous lawsuits). Second, if a meritless case is fully litigated, there is always the possibility of legal error. The potential damages associated with an adverse fraud-on-the-market judgment make this risk hard to take. Damages can be huge relative to the size of the company, at least in the situation where the misstatement inflates price for a long time and trading has been heavy. Rather than "bet the company," the issuer settles for a substantial amount.
265. See Bernard Black, Brian Cheffins & Michael Klausner, Outside Director Liability, 58 Stan. L. Rev. 1055, 1059-60, 1080 (2006)
266. [hereinafter Black, Cheffins & Klausner, Director Liability] (noting that outside directors rarely contribute to securities class action settlements);
267. Coffee, Reforming, supra note 18, at 1550 (noting that corporate managers rarely contribute to securities class action settlements).
268. See supra Part IV.C2.b. Black, Cheffins, and Klausner found that actual payments of damages for securities lawsuits and state corporate lawsuits "are nearly always made by the companies involved - either directly or pursuant to directors' rights to indemnification-or by a D&O insurer, a major shareholder, or another third party." Black, Cheffins & Klausner, Director Liability, supra note 139, at 1059-60. In a section 11 case, the company is the most attractive defendant because it is held strictly liable. Id. at 1080.
269. Since the 1980s, the average annual turnover rate has continued to approach 100% annually. See Louis Lowenstein, What's Wrong with Wall Street: Short-Term Gain and the Absentee Shareholder 66-68 (1988) (noting that annual turnover rate for major exchange listed stock in 1986 was approximately eighty-seven percent);
270. Robert J. Shiller, Irrational Exuberance 39 (2000) (noting that in 1999, average annual turnover rate for NYSE-listed stocks was seventy-eight percent, while average annual turnover rate for stocks on NASDAQ was 221%);
271. Robert B. Thompson & Hillary A. Sale, Securities Fraud as Corporate Governance: Reflections Upon Federalism, 56 Vand. L. Rev. 859, 902 (2003) (finding average turnover rate to be approximately 100%). Casual empiricism suggests that the typical period of price inflation alleged in plaintiffs' class action complaints ranges from a few months to a few years.
272. As of January 2007, for the average publicly traded company with a market capitalization of at least one billion dollars, capital expenditures as a fraction of the firm's total market value were approximately 5.7%. This figure is the author's own calculation using data from the Value Line Database, which provides accounting and market data for approximately 7,000 public companies on a monthly basis. (Capital expenditures data was reported in the most recent 10-K as of January 2007; market capitalization data was the market value of equity on the last trading day of 2006.)
273. See supra note 18.
274. Coffee, Reforming, supra note 18, at 1550.
275. Even for the external certifier, its managers would probably be less inclined to agree to extra dollars in settlement than issuer managers in a fraud-on-the-market suit. The payout would reduce the net operating revenues for the certifier, which is in the business of covering such litigation risks, whereas it would be an extraordinary item for the issuer. A decline in earnings due to lower net operating revenues is generally regarded by investors as more serious than a decline due to an extraordinary item because it has more predictive power in terms of a company's future cash flow. Also, compared to the issuer, the external certifier is more likely to be a repeat defendant since, at any one time, it will presumably be the certifier of a number of issuers. Potential repeat defendants have a greater incentive to establish a reputation of not being willing to settle meritless claims just to get rid of nuisances.
276. The Federal Rules of Civil Procedure provide for judicial supervision of attorney fees in a class action. The court must approve any settlement and may propose terms for attorney fees and hold a hearing on an attorney fees award. Fed. R. Civ. P. 23(e), (h).
277. Many commentators argue that judicial supervision of class action settlements and attorney fees is largely ineffective, due to information problems, judicial misinterpretation of, or apathy toward, class members' input, and the judge's vested interest in settling a case. See, e.g., Alon Harel & Alex Stein, Auctioning for Loyalty: Selection and Monitoring of Class Counsel, 22 Yale L. & Pol'y Rev. 69, 90-91 (2004);
278. Christopher R. Leslie, The Significance of Silence: Collective Action Problems and Class Action Settlements, 59 Fla. L. Rev. 71, 72, 107-10 (2007);
279. William B. Rubenstein, The Fairness Hearing: Adversarial and Regulatory Approaches, 53 UCLA L. Rev. 1435, 1444-45 (2006).
280. See supra note 122.
281. See Stephen J. Choi, Company Registration: Toward a Status-Based Antifraud Regime, 64 U. Chi. L. Rev. 567, 588-91 (1997) [hereinafter Choi, Company Registration] (arguing that antifraud liability should be reduced for larger, more highly capitalized companies because those companies attract more frivolous litigation).
282. See id. at 573, 628, 649-50 ("Where companies trade in an efficient market... a company registration system could rely heavily on the market to transmit information on the company to all investors.").
283. See Donald C Langevoort, Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment, Law & Contemp. Probs., Summer 2000, at 45, 47, 52-55, 62
284. [hereinafter Langevoort, Deconstructing] (arguing that current isclosure regime is "largely satisfactory as a conceptual matter, although public resources for enforcing that regime are woefully lacking").
285. See id. at 47 (calling for creation of "a much more determinate obligation on the part of seasoned issuers to implement an efficient disclosure monitoring system").
286. See id. (suggesting negligence-based liability for insiders, and scienter-based liability for others).
287. See id. at 62 (suggesting that "boards take reasonable systemic steps to assure compliance with periodic disclosure obligations").
288. See Coffee, Re-Engineering, supra note 11, at 1166-68 (suggesting that arguments for increased disclosure to investors require only "modest adjustment in the company registration scheme").
289. See Coffee, Gatekeepers, supra note 19, at 347-52.
290. See Coffee, Re-Engineering, supra note 11, at 1147, 1182-85, 1187 (finding institutional investors to be adequate gatekeepers).
291. See Choi, Company Registration, supra note 149, at 588 (arguing in favor of tailoring market-based antifraud mechanisms).
292. See id. at 589 (attributing such targeting to plaintiffs' lawyers seeking large settlements from large companies due to increased monetary incentives).
293. See id. at 599.
294. See id. at 581-83.
295. See id. at 581.
296. See Coffee, Market Failure, supra note 36, at 722 (arguing that validity for this theory is limited);
297. Easterbrook & Fischel, supra note 84, at 684-85, 687 (advocating for, but noting limits on, self-induced disclosure).
298. See Choi, Company Registration, supra note 149, at 583-84.
299. See Coffee, Re-Engineering, supra note 11, at 1147-49;
300. Langevoort, Deconstructing, supra note 151, at 46. My proposal would eliminate underwriter liability altogether for this very reason. See supra Part IV.C2.e.
301. See Choi, Company Registration, supra note 149, at 584-87.
302. See id. at 587.
303. See supra Part V.A.
304. See Coffee, Gatekeepers, supra note 19, at 352-53. For the first proposal of this idea, at the time that integrated disclosure was introduced, see Fox, Shelf Registration, supra note 12, at 1034.
305. Coffee, Gatekeepers, supra note 19, at 353.
306. See id.
307. See supra Part II.
308. See Coffee, Gatekeepers, supra note 19, at 338-40, 353-55.
309. See id. at 353-54.
310. See id. at 356.
311. See supra Part IV.A.2.
312. In the Wallman Report, the Advisory Committee on the Capital Formation and Regulatory Process explored what a full-fledged company registration system would look like and recommended a voluntary pilot program. See Wallman Report, supra note 11, at i-xvi (summarizing committee's findings). The report suggested a number of benefits from eliminating the exemption for private placements. Id. at 19. Professor Coffee has stated that this was the preferred position of some members of the Committee. Coffee, ReEngineering, supra note 11, at 1180. The Advisory Committee, however, decided that in its proposed pilot program, each issuer accepting the SECs invitation to join a company registration system should have, at the time it joins, the option of a system with or without a private placement exemption. It gave as its reason a concern that "at this initial stage and until issuers become comfortable with the company registration concept, the loss of the ability to conduct exempt private placement and offshore offerings could be a deterrent to the voluntary use of the company registration system." Wallman Report, supra, at 34-35.
313. See Wallman Report, supra note 11, at 33.
314. Id. at 34.
315. Id. at A-48.
316. Id. at A-55;
317. see also supra note 91 and accompanying text (describing Regulation S).
318. See Coffee, Re-Engineering, supra note 11, at 1180-82.
319. Id. at 1180.
320. Id. at 1183.
321. Id.
322. See id. at 1182-85.
323. See Securities Offering Reform, Securities Act Release No. 8591, Exchange Act Release No. 52,056, Investment Company Act Release No. 26,998, 70 Fed. Reg. 44,722, 44,722 (Aug. 3, 2005) (codified in scattered sections of 17 C.F.R.) (announcing securities offering reforms).
324. See supra notes 182-186 and accompanying text.
325. Under the Securities Act of 1933, the private placement exemption, 15 U.S.C. § 77d(2) (2006), is an exemption from the requirement in section 5 that securities, to be legally offered, must be registered. Registration carries with it potential section 11 liability. Securities Act of 1933 § 11, 15 U.S.C. § 77k. An exempted transaction is not subject to such potential liability. § 5, 15 U.S.C. § 77e.
326. See supra Part II.
327. The contractual regime might impose absolute liability, for example, but use a different standard of materiality or a different measure of damages.
328. See Coffee, Re-Engineering, supra note 11, at 1183.
329. Securities Act of 1933 § 28A, 15 U.S.C. § 77z(3) ("The Commission . . . may conditionally or unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this subchapter . . . .");
330. Securities Exchange Act of 1934, 15 U.S.C § 78mm (same).
331. See, e.g., Brian J. Bushee et al., Institutional Investor Preferences for Corporate Governance Mechanisms 41 tbl.4 (Dec. 2007) (unpublished manuscript, on file with the Columbia Law Review), available at http://ssrn.com/ abstract=1070168 (measuring firms' preference for corporate governance from 1997 through 2004).