The multienforcer approach to securities fraud deterrence: A critical analysis

University of Pennsylvania Law Review

Volumn 158, Issue 7, 2010, Pages 2173-2231

  Rose, Amanda M ^a  

^a VANDERBILT UNIVERSITY LAW SCHOOL   (United States)

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EID: 77955541211     PISSN: 00419907     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Conference Paper

References (199)

1. C.F.R. § 240.10b-5 (2009) (prohibiting, inter alia, the making of "any untrue statement of a material fact⋯ in connection with the purchase or sale of any security").
2. Pub. L. No. 104-67, 109 Stat 737 (codified as amended in scattered sections of 15 U.S.C.).
3. Pub. L. No. 105-353, 112 Stat 3227 (codified as amended in scattered sections of 15U.S.C).
4. U.S.C. § § 77p(b), 78bb(f)(l) (2006) (proscribing "covered class acdon[s] based upon the statutory or common law of any State" alleging fraud "in connection with the purchase or sale of a covered security").
5. Id. § § 77p(e), 78bb(f)(4) (permitting "State[s] [to] retain jurisdiction ⋯ to investigate and bring enforcement actions").
6. The Department of Justice should be added to this list, as should the Financial Industry Regulatory Authority, a self-regulatory organization with authority to pursue fraud claims against brokers and brokerage firms.
7. Nothing akin to the "internal affairs" doctrine in corporate law applies to securities fraud. The internal affairs doctrine provides that a corporation shall be subject to the state laws only of its state of incorporation with respect to "matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders - because otherwise a corporation could be faced with conflicting demands." Edgar v. Mite Corp., 457 U.S. 624, 645 (1982) (5-4 decision).
8. By contrast, in securities fraud litigation modern jurisdictional and choice-of-law principles generally allow any state to sue pursuant to its own laws so long as one of its citizens purchased the implicated securities
9. See Michael A. Perino, Fraud and Federalism: Preempting Private State Securities Fraud Causes of Action, 50 STAN. L. REV. 273, 326 (1998) ("As a practical matter, because issuers cannot prevent the residents of particular states from buying their securities on impersonal national exchanges, corporations will have no choice but to subject themselves to the laws of all states.").
10. For example, the federal securities laws predate the Supreme Court's adoption of the "minimum contacts" test in International Shoe Co. v. Washington, 326 U.S. 310 (1945), and therefore were enacted at a time when most state courts had difficulty obtaining personal jurisdiction over out-of-state defendants in securities fraud cases.
11. See Margaret V. Sachs, The International Reach of Rule 10b-5: The Myth of Congressional Silence, 28 COLUM. J. TRANSNAT'L L. 677, 704 (1990) (noting that Congress enacted securities laws when personal jurisdiction was still "largely territorial"). Moreover, when the SEC promulgated Rule 10b-5 in 1942, it never intended for the rule to be privately enforced, and the judges who later found the rule to imply a private cause of action could not have foreseen the development of the modern Rule 10b-5 class action. For a detailed historical account of how the private cause of action under Rule 10b-5 evolved.
12. see Amanda M. Rose, Reforming Securities Litigation Reform: Restructuring the Relationship Between Public and Private Enforcement of Rule 10b-5, 108 COLUM. L. REV. 1301, 1307-15 (2008).
13. MICHAEL R. BLOOMBERG & CHARLES E. SCHUMER, SUSTAINING NEW YORK'S AND THE US' GLOBAL FINANCIAL SERVICES LEADERSHIP 17 (2007), available at hup://www.nyc.gov/html/om/pdf/ny-report-final.pdf.
14. The Obama administration's blueprint for financial regulatory reform calls for granting a new federal agency - the "Consumer Financial Protecdon Agency" - broad authority to interpret and enforce federal statutes related to "credit, savings, payment, and other consumer financial products and services, " while at the same time granting states the right to concurrendy enforce these laws and preserving their authority to enforce stricter state laws. U.S. DEP'T OF THE TREASURY, FINANCIAL REGULATORY REFORM - A NEW FOUNDATION: REBUILDING FINANCIAL SUPERVISION AND REGULATION 14 (2009), available at http://www.financialstability.gov/docs/ regs/FinalReport-web.pdf.
15. Emerging scholarship suggests that enforcement is a better predictor of a nation's financial development than the formal "law on the books, " further bolstering the case for enforcer-focused reform. See, e.g., John C. Coffee, Jr., Law and the Market: The Impact of Enforcement, 156 U. PA. L. REV. 229, 245-55 (2007) (suggesting that enforcement may be a more important variable than substantive doctrinal differences in explaining the development of countries' capital markets, and casting doubt on prior studies that focused on the latter - most notably.
16. Rafael La Porta et al.'s seminal article, Law and Finance, 106 J. POL. EOON. 1113 (1998));
17. Howell E.Jackson, Variation in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications, 24 YALE J. ON REG. 253, 275 (2007) (hypothesizing that it may not be "law, but enforcement that matters" to capital market development).
18. To be truly optimal, the liability regime must also minimize social costs relative to other possible forms of legal intervention, such as government preclearance of corporate communications for accuracy. See STEVEN SHAVELL, FOUNDATIONS OF ECONOMIC ANALYSIS OF LAW 575-81 (2004) (discussing the determinants of the "optimal structure of legal intervention").
19. Marcel Kahan, Securities Laws and the Social Costs of "Inaccurate" Stock Prices, 41 DUKEL J. 977, 1010 (1992).
20. Merritt B. Fox, Civil Liability and Mandatory Disclosure, 109 COLUM. L. REV. 237, 253 (2009).
21. A deterrence regime is concerned with distributional effects only insofar as "the possibility of an uncompensated wealth transfer may cause certain socially detrimental investments and result in other reductions in societal wealth." Paul G. Mahoney, Precaution Costs and the Law of Fraud in Impersonal Markets, 78 VA. L. REV. 623, 630 (1992).
22. Donald C. Langevoort, Capping Damages for Open-Market Securities Fraud, 38 ARIZ. L. REV. 639, 642 (1996) (observing that so-called "fraud-on-the- market" class actions, which target secondary market fraud, are "the subject of most of the attention with respect to allegedly abusive litigation").
23. Id, at 646
24. (citing Frank H. Easterbrook & Daniel R. Fischel, Optimal Damages in Securities Cases, 52 U. CHI. L. REV. 611, 634 (1985) (revised and reprinted in FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE ECONOMIC STRUCTURE OF CORPORATE LAW 334 (1991))).
25. See Alicia Davis Evans, The Investor Compensation Fund, 33 J. CORP. L. 223, 227-34 (2007) (explaining that even diversified investors can suffer net losses from secondary market fraud); James J. Park, Shareholder Compensation as Dividend, 108 MICH. L. REV. 323, 340-42 (2009) (noting the limitations of diversification as a shield against securities fraud losses).
26. Fox, supra note 14, at 283.
27. This is not a fanciful idea. See Lynnley Browning, Madojf Victims Will Get a Tax Break, N.Y. TIMES, Mar. 18, 2009, at B3 (reporting on the IRS plan to provide tax deductions to victims of Madoff s financial fraud);
28. see also SEC, REPORT PURSUANT TO SECTION 308(C) OF THE SARBANES OXLEY ACT OF 2002, at 1-5 (2003), available at http://www.sec.gov/news/studies/ sox308creport.pdf (explaining that the "Fair Fund" provision of the Sarbanes-Oxley Act of 2002 permits the SEC to pay penalties recovered in administrative proceedings to defrauded investors).
29. Cass R. Sunstein, Commentary, Incompletely Theorized Agreements, 108 HARV. L. REV. 1733, 1735 (1995). This Article's brief discussion of the topic is unlikely to satisfy those concerned about the distributional consequences of securities fraud, but the goal of this Article is to apply, not defend, the deterrence framework. For a vigorous normative defense of the economic approach to social policymaking
30. see generally LOUIS KAPLOW & STEVEN SHAVELL, FAIRNESS VERSUS WELFARE (2002).
31. GORDON TULLOCK, THE LOGIC OF THE LAW 228 (1971).
32. See, e.g., Jennifer H. Arlen & William J. Carney, Vicarious Liability for Fraud on Securities Markets: Theory and Evidence, 1992 U. ILL. L. REV. 691, 694 ("Fraud on the Market is a product of agency costs between owners and managers in circumstances where the managers fear themselves to be in their last period of employment").
33. See Coffee, Jr., supra note 11, at 296 (hypothesizing that securities enforcement in the United Kingdom may be less rigorous than in the United States in part because the corporate governance regimes prevailing in the United Kingdom permit shareholders to protect themselves more effectively);
34. Robert B. Thompson & Hillary A. Sale, Securities Fraud as Corporate Governance: Reflections upon Federalism, 56 VAND. L. REV. 859, 905 (2003) (arguing that U.S. federal securities fraud litigation works "to fill the hole in Delaware law brought about by the lack of liability for, and concomitant inability to sustain, suits for breaches of the fiduciary duty of care").
35. Donald C. Langevoort, Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market Investors (and Cause Other Social Harms), 146 U. PA. L. REV. 101, 108, 167 (1997).
36. John Coffee has defined gatekeepers as possessing two key characteristics: First, the gatekeeper is a person who has significant reputational capital, acquired over many years and many clients, which it pledges to assure the accuracy of statements or representations that it either makes or verifies. Second, the gatekeeper receives a far smaller benefit or payoff for its role, as an agent, in approving, certifying, or verifying information than does the principal from the transaction that the gatekeeper facilitates or enables.
37. John C. Coffee, Jr., Gatekeeper Failure and Reform: The Challenge of Fashioning Relevant Reforms, 84 B.U. L. REV. 301, 308 (2004).
38. These features make it unlikely (though certainly not foolproof, see generally id.) that a gatekeeper would knowingly participate in its client's fraud, thus providing investors with some assurance of the credibility of the client's disclosures. "Legal scholars long have recognized that investment banking, accounting, and law firms can act as private gatekeepers to financial markets." Frank Partnoy, Barbarians at the Gatekeepers?: A Proposal for a Modified Strict Liability Regime, 79 WASH. U. L.Q. 491, 491 (2001).
39. See, e.g., Arlen & Carney, supra note 23, at 692 n.8 (suggesting that over- deterrence is not an issue in securities fraud cases due to fraud's scienter requirement).
40. This assumption is relaxed in subsecdon I.B.2.b infra.
41. Christine Jolls et al., A Behavioral Approach to Law and Economics, in BEHAVIORAL LAW AND ECONOMICS 13, 38 (Cass R. Sunstein ed., 2000).
42. Mitu Gulati et al., Fraud by Hindsight, 98 Nw. U. L. REV. 773, 774 (2004).
43. See Bruce A. Hiler, The SEC and the Courts' Approach to Disclosure of Earnings Projections, Asset Appraisals, and Other Soft Information: Old Problems, Changing Views, 46 MD. L. REV. 1114, 1121 (1987) ("'Persons invest with the future in mind and the market value of a security reflects the judgments of investors about the future economic performance of the issuer.'") (quoting Disclosure of Projections of Future Economic Performance, Securities Act Release No. 5362, [1972-1973 Transfer Binder] Fed. Sec. L. Rep. (CCH) 179, 211, at 82, 667 (Feb. 2, 1973)).
44. See Richard Craswell & John E. Calfee, Deterrence and Uncertain Legal Standards, 2 J.L. ECON. & ORG. 279, 280 (1986) ("[U]ncertainty often allows an actor to reduce the probability of punishment⋯ by 'playing it safe' and modifying his behavior by more than the law requires.⋯ [This] can give even risk-neutral parties an incentive to 'overcomply.'");
45. Jason S. Johnston, Bayesian Fact-Finding and Efficiency: Toward an Economic Theory of Liability Under Uncertainty, 61 S. CAL. L. REV. 137, 159 (1987) ("[W]hen fact-finding is imperfect and the risk of being found liable falls as care increases, the defendant may be induced to take too much care.").
46. See generally Troy A. Paredes, Blinded by the Light: Information Overload and Its Consequences for Securities Regulation, 81 WASH. U. L.Q. 417 (2003) (evaluating mandatory disclosure in securities regulation).
47. Seejolls et al., supra note 29, at 42 (noting that since the liability "determination must be made against the backdrop of knowledge that the issue or problem in fact materialized, and produced a large drop in the company's stock price, " a "decision maker will likely find it difficult to see how a reasonable ex ante decision maker might have thought the prospective issue or problem other than material").
48. Langevoort, supra note 16, at 654.
49. Nor would overdeterrence be a risk if the firm knew with certainty that it could cosdessly and completely shift its liability back to the offending agent. But if the firm could fully and freely offload its risk in this manner, the specter of liability would not affect its behavior and thus would not decrease underdeterrence costs either.
50. Jennifer Arlen, The Potentially Perverse Effects of Corporate Criminal Liability, 23 J. LEGAL STUD. 833, 836 (1994).
51. JOHN c. COFFEE, JR., GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE 370 (2006).
52. Reinier H. Kraakman, Corporate Liability Strategies and the Costs of Legal Controls, 93 YALE L.J. 857, 892 (1984).
53. For the seminal article on optimal sanctions, see Gary S. Becker, Crime and Punishment: An Economic Approach, 76 J. POL. ECON. 169 (1968).
54. See Michael K. Block, Optimal Penalties, Criminal Law and the Control of Corporate Behavior, 71 B.U. L. REV. 395, 398 (1991) ("[The optimal deterrence] framework ensures that fines promote efficient results in which the allocation of resources maximizes societal wealth.");
55. A. Mitchell Polinsky & Steven Shavell, The Optimal Tradeoff Between the Probability and Magnitude of Fines, 69 AM. ECON. REV. 880, 880 (1979) (analogizing optimal sanctions to a Pigouvian tax).
56. To use terminology coined by Robert Cooter, it would be better to "sanction" than to "price" securities fraud. See Robert Cooter, Prices and Sanctions, 84 COLUM. L. REV. 1523, 1523 (1984) (defining a sanction as "a detriment imposed for doing what is forbidden, and a price as money extracted for doing what is permitted").
57. John Coffee explains that a "sanction, " in Cooter's lexicon, "inherendy creates an abrupt, discontinuous jump in the costs the actor must incur when he violates the legal standard." John C. Coffee, Jr., Does "Unlawful" Mean "Criminal"?: Reflections on the Disappearing Tort/Crime Distinction in American Law, 71 B.U. L. REV. 193, 226 (1991).
58. But "this abrupt jump disappears when a pricing system is used because prices are continuous and thus bring costs and benefits into balance." Id.
59. See John E. Calfee & Richard Craswell, Some Effects of Uncertainty on Compliance xuith Legal Standards, 70 VA. L. REV. 965, 995 (1984) ("Even when the probability of punishment is less than one, if that probability declines as defendants take more care, then defendants may tend to overcomply. In such a case, increasing the expected fine or damage award [to reflect the possibility of nonenforcement] would only increase overdeterrence, exacerbating the problem rather than curing it.").
60. Craswell & Calfee, supra note 32, at 280 n.3.
61. Risk shifting from agent to firm will not reduce the risk that vicarious liability will cause firms to overinvest in precautionary measures or take other socially cosdy actions to avoid liability.
62. See Bruce Chapman, Corporate Tort Liability and the Problem of Overcompliance, 69 S. CAL. L. REV. 1679, 1688 (1996) ("[individual agents who are employees within [a] corporation have their future very specifically invested there, and are understandably quite averse to risking any of the assets of the corporation which employs them.").
63. Posner R.A., An economic theory of the criminal law, 85 COLUM. L. REV., 1193, 1985, 1228. ("[S]ince corporations are either risk neutral or if risk averse less so than individuals, ⋯ there is much less danger of causing the shareholders to be too careful in hiring, supervising, and terminating directors (and through the board of directors, the managing employees).").
64. See SHAVELL, supra note 12, at 526-28 (discussing when permitting sanction insurance is likely to promote social welfare);
65. Alan O. Sykes, The Economics of Vicarious Liability, 93 YALE LJ. 1231, 1236-37 (1984) (highlighting the tradeoffs between the benefits of risk shifting and the costs of deterrent dilution when agent behavior is unobservable).
66. Lynn A. Stout, Type I Error, Type II Error, and the Private Securities Litigation Reform Act, 38 ARIZ. L. REV. 711, 711 (1996).
67. Stout L.A., 38 ARIZ. L. REV., Id.
68. False positives can increase underdeterrence costs, as well, by reducing the cost of wrongdoing relative to compliance. See SHAVELL, supra note 12, at 452 ("[T]he incentive to obey the law is enhanced by reducing errors that penalize the innocent.⋯ ").
69. Certain procedural innovations may improve accuracy without these sorts of tradeoffs - for example, greater rights to appellate review. See Louis Kaplow, The Value of Accuracy in Adjudication: An Economic Analysis, 23 J. LEGAL STUD. 307, 356 (1994) (explaining that "better information or better analysis" can reduce the potential for false positives and false negatives).
70. Isaac Ehrlich & Richard A. Posner, An Economic Analysis of Legal Rulemaking, 3 J. LEGAL STUD. 257, 276 (1974) (discussing the reduction of the prosecutor's burden of proof and the increased specificity of the substantive legal rule as alternative methods for increasing deterrence and comparing their relative effectiveness);
71. Johnston, supra note 32, at 140 (suggesting that "one way to eliminate over-deterrence is to reduce the legal standard or require a more extreme departure for liability" and that another way is "to increase the plaintiffs burden of proof, " while pointing out that increasing penalties could offset the reduced incentives to comply);
72. V.S. Khanna, Corporate Criminal Liability: What Purpose Does It Serve?, 109 HARV. L. REV. 1477, 1514 (1996) ("[T]he possibility of a severe sanction under an uncertain legal standard may chill desirable behavior.⋯ A higher standard of proof may be useful to mitigate this chilling effect." (footnote omitted));
73. Posner, supra note 47, at 1206 ("[I]t may make sense to make proof easier but at the same time make the penalty less severe in order to reduce avoidance and error costs.").
74. Mahoney, supra note 15, at 649.
75. Id.
76. For example, an enforcer is likely to develop expertise regarding corporate communications, as well as a sensitivity to the workings of hindsight bias, that will render it better at making scienter assessments than the factfinder, particularly if the factfinder is a lay jury or a generalist judge.
77. See Jeffrey J. Rachlinski & Cynthia R. Farina, Cognitive Psychology and Optimal Government Design, 87 CORNELL L. REV. 549, 558-60, 577- 78 (2002) (discussing the potential for experts to make better decisions than lay people, including juries and judges, because they have experience with particular substantive questions and an ability to adapt to cognitive limitations that impair decisionmaking).
78. Relying on discretionary nonenforcement has long been recognized as a potentially superior alternative to rewriting substantive laws to eliminate overinclusion. See, e.g., William M. Landes & Richard A. Posner, The Private Enforcement of Law, 4 J. LEGAL STUD. 1, 38 (1975) (arguing that, in light of the inability of the legislature to tailor a criminal statute perfecdy, discretionary nonenforcement is an attractive way to reduce the costs of an overinclusive statute without increasing the costs of an underinclusive one). My discussion above suggests that similar advantages may flow from using a self- restrained enforcer in situations where the law itself is not technically overinclusive (and a scienter-based fraud prohibition is not), but rather becomes overinclusive in practice due to legal error.
79. See Coffee, Jr., supra note 26, at 323-26.
80. The enforcer is also better positioned to make these sorts of adjustments than courts. See Richard A. Nagareda, Class Actions in the Administrative State: Kalven and Ro- senfield Revisited, 75 U. CHI. L. REV. 603, 606 (2008) (observing that the policy concerns underlying discretionary nonenforcement are properly considered "by an administrative agency when setting its enforcement priorities, but they are much more awkward for judicial consideration").
81. This argument assumes that the enforcer can identify adequate internal controls, notwithstanding lawmakers' inability to discern the information necessary to craft the optimal sanction. Though these propositions stand in some tension with one another, they are not irreconcilable. The information needed to craft the optimal sanction differs somewhat from that needed to determine the cost-effectiveness of internal controls. To set optimal sanctions, one must know both the externalized social costs of fraud and how firms perceive the probability of enforcement.
82. But to identify whether the internal controls a particular firm adopts are adequate, one must estimate only whether the marginal cost of investing more in precautions would have exceeded the marginal gain in the form of reduced social harm from fraud. The latter information may be easier to obtain - or, more realistically, approximate - than the former. Cf. Cooter, supra note 42, at 1552 (observing that if it is more expensive to obtain "accurate information about external costs" than it is to obtain "accurate information about efficient behavior, " then it is best to enact a standard backed by a "sanction, " rather than to adopt a strict liability rule backed by a "price").
83. See, e.g., Rose, supra note 8, at 1321-24 (discussing various academic proposals in this vein). There are, however, some exceptions to this trend.
84. See generally A.C. Prit- chard, Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers, 85 VA. L. REV. 925 (1999) (arguing for enforcement by the securities exchanges);
85. Rose, supra note 8 (proposing enforcer-focused securities litigation reform).
86. For example, the Supreme Court eliminated aiding-and-abetting liability in Central Bank of Denver v. First Interstate Bank of Denver, noting that, in the face of uncertain liability, securities professionals might refuse to provide services to some companies altogether and might increase the prices they charged to others. 511 U.S. 164, 189 (1994). Accordingly, the Court concluded that aiding-and-abetting liability might "ex- act[] costs that⋯ disserve the goals of fair dealing and efficiency in the securities markets."
87. Id. at 188.
88. The Court recendy reinforced that decision in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., observing that a broad interpretation of primary liability in private Rule 10b-5 actions might shift securities offerings away from domestic capital markets. 552 U.S. 148, 164 (2008). Courts also developed the "bespeaks caution" doctrine to shield forward-looking statements accompanied by sufficient cautionary language from liability, and Congress later codified a variant of this doctrine in the PSLRA
89. See 15 U.S.C. § § 77z-2(c)(l)(A)(i), 78u-5(c)(l)(A)(i) (2006) (providing a safe harbor for forward-looking statements "accompanied by meaningful cautionary statements"). The justification for this statutory safe harbor is explicitly based upon overdeterrence concerns. The PSLRA's Senate Report asserts that "[f]ear that inaccurate projections will trigger the filing of a securities fraud lawsuit has muzzled corporate management"; the safe harbor is thus "intended to enhance market efficiency by encouraging companies to disclose forward-looking information." S. REP. NO. 104-98, at 16 (1995), as reprinted in 1995 U.S.C.CA.N. 679, 695.
90. Well before the PSLRA, courts began applying heightened pleading standards in Rule 10b-5 class actions. Federal Rule of Civil Procedure 9(b) generally requires heightened pleading in cases alleging fraud, but it provides that allegations of state of mind may be asserted generally. See FED. R. Crv. P. 9(b). Some courts, nonetheless, required more particularized scienter allegations in securities fraud cases given the uniquely high risk of overdeterrence.
91. See Hillary A. Sale, Heightened Pleading and Discovery Stays: An Analysis of the Effect of the PSLRA's Internal-Information Standard on '33 and '34 Act Claims, 76 WASH. U. L.Q. 537, 549-51 (1998) (discussing pre-PSLRA case law requiring heightened pleading of scienter).
92. The PSLRA later codified that heightened standard, mandating that Rule 10b-5 plaintiffs allege with specificity facts giving rise to a "strong inference" of scienter. 15 U.S.C. § 78u-4(b)(l)-(2). The expressed purpose of this provision is to "curtail the filing of meridess lawsuits." H.R. REP. No. 104-369, at 41 (1995), as reprinted in 1995 U.S.C.C.AN. 730, 740. The PSLRA also adjusts procedure in other important ways. For example, it stays discovery pending decision on a modon to dismiss, thus relieving the pressure to setde at least through that stage of adjudicadon. 15 U.S.C. § § 77z-l(b)(l), 78u-4(b)(3)(B).
93. Compare, e.g., Brief for Former SEC Commissioners and Officials and Law and Finance Professors as Amici Curiae Supporting Respondents at 7, Stoneridge Inv. Partners, 552 U.S. 148 (No. 06-43) (warning that reversal could "give rise to substantial costs that might exceed its questionable deterrent benefits").
94. with Brief for Professors James D. Cox, Jill E. Fisch, Donald C. Langevoort, Richard M. Buxbaum, Melvin A Eisenberg, and Hillary A. Sale as Amici Curiae Supporting Petitioners at 4, Stoneridge Inv. Partners, 552 U.S. 148 (No. 06-43) (cautioning that affirmance "could seriously impair the integrity of our securities markets").
95. James D. Cox & Randall S. Thomas, Mapping the American Shareholder Litigation Experience: A Survey of Empirical Studies of the Enforcement of the U.S. Securities Law 20-21 (Vanderbilt Univ. Law Sen. Law & Econ. Research Paper No. 09-10 & Duke Univ. Law Sch. Pub. Law & Legal Theory Research Paper No. 246, 2009), available at http://ssrn.com/abstract=1370508.
96. Empirical studies have suggested that private enforcement is more important than public enforcement in promoting financial development See Rafael La Porta et al., What Works in Securities Laws?, 61 J. FIN. 1, 27-28 (2006) (concluding that public enforcement matters litde, if at all, to larger stock markets, whereas "extensive disclosure requirements and standards of [private] liability" matter significandy).
97. Mpre recent scholarship, though, casts doubt on this conclusion, furher highlighting the need to rethink fundamentally the proper allocation of securities fraud enforcement authority in the United States. See Howell E. Jackson & Mark J. Roe, Public and Private Enforcement of Securities Laws: Resource-Based Evidence 34 (Harvard Univ. Law Sch. Pub. Law & Legal Theory Research Paper Series, Paper No. 0-28, & John M. Olin Ctr. for Law and Bus. Law & Econ. Research Paper Series, Paper No. 638, 2009)
98. available at http://ssrn.com/abstract=1000086 (refuting suggestions that public enforcement is unimportant to financial markets by demonstrating that it "correlated significandy with key financial outcomes");
99. see also Coffee, Jr., supra note 11, at 302 (acknowledging that recent evidence casts doubt upon the superiority of private enforcement).
100. If the rewards for bringing suit were not substantial enough to make private enforcement profitable, underdeterrence costs would increase relative to a world with exclusive public enforcement. Cf. Steven Shavell, The Social Versus the Private Incentive to Bring Suit in a Costly Legal System, 11 J. LEGAL STUD. 333, 334 (1982) (asserting that the "divergence between the social and the private benefits of suit may result either in a tendency toward too litde litigation ⋯ or toward too much litigation").
101. See supra note 62 and accompanying text. Notably, most of the limitations that have been imposed on private Rule 10b-5 litigants do not constrain the SEC. For example, the PSLRA's safe harbor for forward-looking statements does not apply to SEC enforcement actions, nor do its pleading requirements or discovery stay.
102. See 15 U.S.C. § § 77z-2 (c)(1) (A) (i), 78u-5(c)(l)(A)(i) (safe harbor requirement); 15 U.S.C. § 78u- 4(b)(l)-(2) (heightened pleading requirements); 15 U.S.C. § § 77z-l (b)(1), 78u- 4(b)(3)(B) (discovery stay). Moreover, the SEC retains authority to pursue aiders and abettors.
103. See 15 U.S.C. § 78t(e) (expressly granting the SEC this authority). Ostensibly, those who have crafted these reforms believe that the SEC presents fewer over- deterrence risks relative to private enforcers, such that authority that is intolerable in the hands of the latter is not when entrusted to the former.
104. Id. at 15.
105. Contract breaches and common law torts (including common law fraud acdons that involve privity of dealing between the victim and the fraudster) may have a detection rate close to 100%. If so, private enforcement would not cause the instability problem described here and would therefore be less of a concern.
106. See id. (explaining why the overenforcement theorem does not become a problem when the detection rate is 100%). Private enforcement would remain problematic, however, if inaccurate prosecution and legal error were significant concerns, or if the violation called for conditional deterrence and sanctions were particularly difficult to calculate.
107. Id. at 24. These opportunities arise because both parties would be better off negotiating a settlement for an amount that is less than the sanction facing the defendant but more than the bounty promised the enforcer. While setdements could be made subject to court approval, this is unlikely to be a foolproof remedy.
108. See Brian T. Fitzpatrick, The End of Objector Blackmail?, 62 VAND. L. REV. 1623, 1652 n.106 (2009) (quoting commentators who explain why courts tend to favor even poor setdements).
109. Thomas S. Ulen, Economic and Public-Choice Forces in Federalism, 6 GEO. MASON L. REV. 921, 928 (1998).
110. Samuel Issacharoff & Catherine M. Sharkey, Backdoor Federalization, 53 UCLA L. REV. 1353, 1387 (2006) (footnotes omitted) (cidng Robert P. Inman & Daniel L. Ru- binfeld, Making Sense of the Antitrust State-Action Doctrine: Balancing Political Participation and Economic Efficiency in Regulatory Federalism, 75 TEX. L. REV. 1203, 1234 (1997)).
111. This idea is traceable to Charles M. Tiebout's seminal ardcle, A Pure Theory of Local Expenditures, 64 J. POL. ECON. 416 (1956).
112. See ROBERTA ROMANO, THE ADVANTAGE OF COMPETITIVE FEDERALISM FOR SECURITIES REGULATION 45 (2002) ("Competing regulators would make fewer policy mistakes than a single regulator as competition harnesses the incentives of the market to regulatory institutions.").
113. The debate over regulatory competition as it relates to corporate law continues. See generally ROBERTA ROMANO, THE GENIUS OF AMERICAN CORPORATE LAW (1993) (arguing that state competition for revenues from corporate charters has produced a system that, for the most part, benefits investors);
114. Lucian Arye Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 105 HARV. L. REV. 1435 (1992) (suggesting limitations of state charter competition and advocating increased federal involvement in corporate law);
115. Chris Brummer, Corporate Law Preemption in an Age of Global Capital Markets, 81 S. CAL. L, REV. 1067 (2008) (positing that federal preemption of securities law enhances competition);
116. William L. Gary, Federalism and Corporate IMW: Reflections upon Delaware, 83 YALE L.J. 663 (1974) (proposing increased federal interest in corporate law in light of Delaware's lead in the "race to the bottom");
117. Ralph K. Winter, Jr., State Law, Shareholder Protection, and the Theory of the Corporation, 6 J. LEGAL STUD. 251 (1977) (arguing that state corporate regulation is superior to federal).
118. See, e.g., NASAA to Obama: Limiting Preemption Protects Investors, NASAA INSIGHT (N. Am. Sec. Adm'rs Ass'n, Wash., D.C.), Spring/Summer 2009, at 1.
119. available at http://www.nasaa.org/content/Files/NASAA-Insight- SpringSummer09.pdf (toudng state regulators' role in fraud detection given, in the words of then-NASAA President and Colorado Securities Commissioner Fred Joseph, their "unique proximity to investors and to the industry participants within their state borders").
120. See, e.g., John C. Coffee, Jr., Rescuing the Private Attorney General: Why the Model of the Lawyer as Bounty Hunter Is Not Working, 42 MD. L. REV. 215, 224-25 (1983) (asserting that while it might be "more efficient for public agencies to concentrate on detection, " litigation should be left to private enforcers).
121. As Louis Kaplow observed, [A] general belief in the efficient functioning of the markets does not provide any basis for inferring good results in adjudication (unless the form of adjudication was itself chosen in the market, as when it is specified by contract). The reason is that virtually every act of a litigant, by design, hurts the opponent; externalities are thus a central characteristic of behavior in litigation. This fundamental difference between litigation and other goods and services is often overlooked. Kaplow, supra note 52, at 338 n.87.
122. See SHAVELL, supra note 12, at 581 (suggesting that if private enforcement were used in situations where effort must be expended to identify and apprehend violators, it would best be "undertaken by a large organization that has the basic characteristics of public enforcement organizations").
123. See, e.g., Renee M. Jones, Dynamic Federalism: Competition, Cooperation and Securities Enforcement, 11 CONN. INS. L.J. 107, 126-27 (2005) ("Because the SEC lacks adequate resources to effectively police the national securities market, supplemental enforcement is essential to achieve an appropriate level of deterrence.")
124. Langevoort, supra note 16, at 652 (accepting "the conventional view that private litigation is a necessary supplement to SEC enforcement" because of federal resource constraints, while suggesting that Rule 10b-5 class actions could be eliminated entirely "in a world with an optimally staffed SEC").
125. For such a system to be effective, states and private parties would have to be given appropriate incentives to pursue cases notwithstanding the potential intervention of the federal enforcer. See Rose, supra note 8, at 1357 & n.253 (describing mechanisms to maintain such incentives in an oversight regime).
126. New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting) ("It is one of the happy incidents of the federal system that a single courageous State may⋯ serve as a laboratory.⋯ ").
127. State regulation of purely intrastate frauds, by contrast, clearly does promote democratic principles due to the absence of any spillover effects.
128. How this reality affects a preference for regulatory competition among states is beyond the scope of this Article.
129. See, e.g., Elizabeth Chamblee Burch, Securities Class Actions as Pragmatic Ex Post Regulation, 43 GA. L. REV. 63, 99 (2008) (observing that "securities class actions ⋯ guard against selective enforcement and inaction by the SEC" and "over- comet] lackluster governmental incentives");
130. Jones, supra note 82, at 122 (arguing in favor of dual state/federal securities enforcement because "the existence of multiple layers of government makes regulatory capture a more arduous task for interest groups");
131. see also Jonathan R. Macey, Positive Political Theory and Federal Usurpation of the Regulation of Corporate Governance: The Coming Preemption of the Martin Act, 80 NOTRE DAME L. REV. 951, 958 (2005) (suggesting that the SEC's passivity in the wake of recent corporate scandals "was likely caused by the agency's capture by the very special interests it was ostensibly regulating, " along with "the acquiescence of Congress and the relevant oversight committees that monitor the SEC and control its budget").
132. Criticisms of the SEC also tend to be only anecdotally supported. There are, however, some notable recent exceptions. See Maria M. Correia, Political Connections, SEC Enforcement and Accounting Quality 4 (Rock Ctr. for Corporate Governance, Working Paper No. 61, 2009).
133. available at http://ssrn.com/abstract=1458478 (presenting evidence "that firms with low accounting quality have greater political expenditures on average" and that they increase these expenditures "during the period of misreporting and are more likely to target them to the Congressional Committees with stronger ties to the SEC during this period")
134. Stavros Gadinis, The SEC and the Financial Industry: Evidence from Enforcement Against Broker-Dealers 64-65 (Aug. 11, 2009) (unpublished manuscript), available at http://ssrn.com/abstract=1333717 (presenting evidence that the SEC treats big broker-dealer firms and their employees more favorably than they treat smaller broker-dealer firms and their employees, thus providing tentative support for the proposition that SEC officials treat defendants that could be their prospective employers preferentially)
135. Frank Yu & Xiaoyun Yu, Corporate Lobbying and Fraud Detection 29 (Feb. 9, 2010) (unpublished manuscript), available at http://ssrn.com/ abstracts954368 (presenting evidence showing that lobbying firms have a lower fraud detection rate and evade detection longer than nonlobbying firms, and that fraudulent firms spend more on lobbying than nonfraudulent firms).
136. See DENNIS C. MUELLER, PUBUC CHOICE III 1-2 (2003) ("The basic behavioral postulate of public choice ⋯ is that man is an egotistic, rational, utility maximizer.").
137. See Barry R. Weingast, The Congressional-Bureaucratic System: A Principal Agent Perspective (With Applications to the SEC), 44 PUB. CHOICE 147, 149 (1984) (arguing that "[i]t is not a bureaucratic imperative that drives agency decisionmaking but rather a congressional-electoral one" and detailing the mechanisms through which Congress exerts control).
138. See id at 150 ("For any particular agency⋯ it is not the Congress as a whole that is relevant for policymaking but rather the committee(s) with jurisdiction over the agency.").
139. "Bureaucracies have autonomy, it is often said, simply because the disciplinary weapons that external political forces might wield are imperfect.⋯ " Donald C. Langevoort, The SEC as a Lawmaker: Choices About Investor Protection in the Face of Uncertainty, 84 WASH. U. L. REV. 1591, 1602 (2006). Moreover, intra-agency agency costs may lead to "outcomes that diverge from what even the agency itself, if we imagine it anthropo- morphically, would consider to be in its best interest."
140. Id. at 1603.
141. See Barry R. Weingast & Mark J. Moran, Bureaucratic Discretion or Congressional Control? Regulatory Policymaking by the Federal Trade Commission, 91 J. POL. ECON. 765, 767 (1983) (describing the view that "bureaucratic insulation affords bureaucrats a degree of discretion which, in turn, is used to pursue their own private goals").
142. Cf. Steven P. Croley, Theories of Regulation: Incorporating the Administrative Process, 98 COLUM. L. REV. 1, 42 (1998) (noting that although "it seems safe to assume that legislators seek to retain their positions in office, " there are problems with assigning too much weight to legislators' electoral goals).
143. See A.C. Pritchard, The SEC at 70: Time for Retirement?, 80 NOTRE DAME L. REV. 1073, 1078 (2005) (nodng the "public outrage" over corporate accounting frauds following the collapse of Enron and Worldcom).
144. See Stephen J. Choi & A.C. Pritchard, Behavioral Economics and the SEC, 56 STAN. L. REV. 1, 16, 45 (2003) (observing that "investors are likely to exaggerate the likelihood of fraud given its salience, " while often ignoring the "widely dispersed, and thus less observable, potential benefits from reducing regulatory costs").
145. See Pritchard, supranote 95, at 1078, 1082 (describing the "political overreaction to the fallout of corruption revealed by a bear market, " and observing that scandal- driven reforms spurred by a desire on the part of politicians to "'do something[]' ⋯ mayjarove to be cosdy, ineffective or counterproductive").
146. See John C. Coates IV, Private vs. Political Choice of Securities Regulation: A Political Cost/Benefit Analysis, 41 VA. J. INT'L L. 531, 561 (2001) ("[D]uring periods of 'normal' politics when securities-related issues are not on the 'public agenda, '⋯ most voters do not concern themselves with the ordinary activities of the SEC") (footnote omitted)
147. (citing Michael E. Levine & Jennifer L. Forrence, Regulatory Capture, Public Interest, and the Public Agenda: Toward a Synthesis, 6J.L. ECON. & ORG. (SPECIAL ISSUE) 167 (1990)).
148. See id. at 564 ("It may well be that the externalities of securities regulation are sufficiently small that what is good for capital-raising firms is good for America.");
149. Langevoort, supra note 92, at 1599 ("[W]e could expect a reasonably vigorous andfraud program from the SEC even with general industry capture. ⋯ ").
150. See generally Gregg A. Jarrell, Change at the Exchange: The Causes and Effects of Deregulation, 27 J.L. & ECON. 273 (1984) (applying a political support-maximization theory to explain the SEC's abolition of fixed-rate commissions on the NYSE in the face of the rise of institutional investors as a powerful interest group).
151. See Pritchard, supra note 61, at 966-76 (explaining that floor traders, market makers, and brokers should be proponents of vigorous antifraud enforcement given fraud's effect on liquidity and transaction volume).
152. See supra subsection I.A.1 (explaining how securities fraud works to increase firms' cost of capital).
153. See Donald C. Langevoort, The SEC and the Madoff Scandal: Three Narratives in Search of a Story 16 (Georgetown Law Faculty Working Papers, Research Paper No. 1475433, 2009) available at http://ssrn.com/abstract=1475433 ("It is not because Wall Street wants to protect someone like Bernie Madoff, but because the abundance of tools and resources that might make [catching people like him] more likely⋯ can too easily be put to use to threaten more sensitive interests.").
154. See supra note 97 and accompanying text.
155. Langevoort, supra note 92, at 1621.
156. Id.
157. See Rachlinski & Farina, supra note 56, at 562-82 (comparing public-choice and psychological explanations for government error).
158. For a catalog of the behavioral biases that may plague an organization like the SEC, see Choi & Pritchard, supra note 96, at 21-36. Behavioral biases may also affect securities fraud enforcement by influencing lawmakers' decisions regarding the scope of the enforcer's authority and the size of the enforcer's budget.
159. Troy A. Paredes, On the Decision to Regulate Hedge Funds: The SEC's Regulatory Philosophy, Style, and Mission, 2006 U. ILL. L. REV. 975, 1008.
160. Id. at 1021 n.176.
161. Donald C. Langevoort, When Lawyers and Law Firms Invest in Their Corporate Clients' Stock, 80 WASH. U. L.Q. 569, 574 (2002).
162. Langevoort, supra note 92, at 1611.
163. Id. at 1606.
164. See Pritchard, supra note 95, at 1083-84 (nodng former SEC Chairman Arthur Levitt's statement, "Investor protecdon is our legal mandate. Investor protection is our moral responsibility. Investor protection is my top personal priority.") (quoting Arthur Levitt, Former Chairman, SEC, A Question of Integrity: Promoting Investor Confidence by Fighting Insider Trading, Remarks at the "S.E.C. Speaks" Conference (Feb. 27, 1998) (transcript available at http://www.sec.gov/news/speech/speecharchive/1998/ spch202.txt)).
165. See James D. Cox & Randall S. Thomas with the assistance of Dana Kiku, SEC Enforcement Heuristics: An Empirical Inquiry, 53 DUKE L.J. 737, 778 (2003) ("[T]he SEC's focus on firms in financial distress, coupled with its preoccupation with small capitalization firms, is⋯ consistent with the hypothesis that the SEC, at least during the [time^jeriod studied], preferred weak opponents.").
166. See Langevoort, supra note 103, at 8-9 (positing this theory).
167. See Langevoort, supra note 92, at 1610 (hypothesizing that agency "culture takes on a self-serving character, causing perceptions and inferences that comfortably coincide with career interests").
168. Gadinis, supra note 88, at 50.
169. An enforcement agency, however, is likely to be dominated by litigators, who may naturally be inclined "toward an expansive view of the law that is disconnected from cost-benefit analysis and leads to a more moralistic, 'right versus wrong' judgmental style." Langevoort, supra note 92, at 1621. Moreover, securities lawyers as a class may tend to "see more value to regulation than there really is, because they have expertise that generates rents and are motivated to see legitimacy in that to which they have committed their ⋯ careers."
170. Id. at 1610 (footnote omitted).
171. See, e.g., supra notes 82, 87.
172. See supra note 62.
173. See Michael Klausner, Are Securities Class Actions " Supplemental" to SEC Enforcement? An Empirical Analysis 30-31 (Feb. 23, 2010) (unpublished manuscript), available at http://www.law.upenn.edu/academics/ insdtutes/ile/penn-nyu2010.html (finding that 122 of 139 class acdons filed parallel to an SEC proceeding between 2000 and 2003 involved no payment by an officer or director).
174. Damages in "fraud-on-the-market" Rule 10b-5 class acdons are based on the out-of-pocket losses of all shareholders who purchased shares on the secondary market at a fraudulendy inflated price. Robert F. Serio et al., Basic Claims Under the Federal Securities Laws, in SECURITIES LITIGATION § 2:2.2[A][4] (Jonathan C. Dickey ed., 2006). These losses, which shareholders can largely offset through diversification, bear no relationship to - and likely far exceed - the true social costs of fraud.
175. See Langevoort, supra note 16, at 646 (observing that the measure of damages in secondary market fraud cases "is systematically excessive and dysfunctional").
176. As noted in subsection IA.2.a, securities fraud may best be thought of as a species of managerial agency costs, which faithful directors should naturally seek to minimize. In addition, a firm's stock price is apt to take a significant hit upon revelation of fraud.
177. See Jonathan M. Karpoff et al., The Cost to Firms of Cooking the Books, 43 J. FIN. & QUANTITATIVE ANALYSIS 581, 582 (2008) (finding that a firm's reputation losses as a result of financial fraud "exceed[] the legal penalty by over 7.5 times, and ⋯ exceed[] the amount by which firm value was artificially inflated by more than 2.5 times").
178. See Alexander Dyck et al., Who Blows the Whistle on Corporate Fraud? 7-8, 12 (Univ. Chi. Booth Sch. of Bus., Working Paper No. 08-22, 2008), available at http://ssrn.com/abstract=891482 (concluding that private securities litigation uncovered only 3% of the frauds exposed between 1996 and 2004 in companies with more than $ 750 million in assets).
179. See Samuel W. Buell, Potentially Perverse Effects of Corporate Civil Liability (discussing this phenomenon), in PROSECUTORS IN THE BOARDROOM: USING CRIMINAL LAW TO REGULATE CORPORATE CONDUCT (Anthony S. Barkow & Rachel E. Barkow eds., forthcoming 2010) (manuscript at 15-16, on file with the author).
180. See, e.g., Cox & Thomas, supra note 115, at 777.
181. Cf. BERNARD NASH ET AL., U.S. CHAMBER INST, FOR LEGAL REFORM, BEYOND DUE PROCESS - A LITIGATION PRIMER: CHALLENGING ATTORNEY GENERAL AND OTHER GOVERNMENT CONTINGENCY FEE ARRANGEMENTS 1 (Jan. 2009), available at http://www. insdtuteforlegalreform.com/images/stories/documents/pdf/research/ contingencyfeemanual.pdf ("An increasing number of plaintiffs' attorneys are soliciting state Attorneys General⋯ and other government officials to permit them to bring cases on behalf of state and local governments on a contingency fee basis.").
182. Pritchard, supra note 95, at 1080.
183. Stephen J. Choi, Channeling Competition in the Global Securities Market, 16 TRANS- NAT'LLAW. 111, 118 (2002).
184. Mary L. Schapiro, Chairman, SEC, News Conference Call: Statement Concerning Agency Self-Funding (Apr. 15, 2010) (transcript available at http://www.sec.gov/news/speech/2010/spch041510mls.htm) ("[S]elf funding ensures independence, facilitates long-term planning, and closes the resource gap between the agency and the enddes we regulate. In the process, it allows the SEC to better protect millions of investors whose savings are at stake.").
185. INVESTORS' WORKING GROUP, U.S. FINANCIAL REGULATORY REFORM: THE INVESTORS' PERSPECTIVE 9 (July 2009), available at http://www.cii.org/UserFiles/ file/resource%20center/investment%20issues/Investors%27%20Working%20Group% 20Report%20(July%202009).pdf ("0To the extent possible, agencies should have funding flexibility to respond to [market changes and financial innovation] on their own.").
186. See Rose, supra note 8, at 1354-58 (proposing that the SEC be granted such authority). For a creative alternative suggested in the antitrust context.
187. see David Rosenberg & James P. Sullivan, Coordinating Private Class Action and Public Agency Enforcement of Antitrust Law, 2 J. COMPETITION L. & ECON. 159, 178 (2006), in which the authors argue for an "auction- buyback" mechanism that allows the public enforcer "to auction off a private license to prosecute the class action while retaining the option of buying it back at the price of the winning bid."
188. See John C. Coffee, Jr., & Hillary A. Sale, Redesigning the SEC: Does the Treasury Have a Better Idea?, 95 VA. L. REV. 707, 779-81 (2009) (making this suggestion).
189. Rosenberg & Sullivan, supra note 133, at 166.
190. See, e.g., Yu & Yu, supra note 88, at 3-4 (suggesting that there be more transparency in corporate political spending).
191. See Pritchard, supra note 95, at 1099-1101 (arguing for such a shift);
192. Peter J. Henning, Should the SEC Spin Off the Enforcement Division? 11 (Wayne State Univ. Law Sch. Legal Studies Research Paper Series, Research Paper No. 09-20, 2009), available at http://ssrn.com/abstractsl470857 (suggesting that transferring the SEC's fraud enforcement authority to the Department of Justice would "lessen [] the ability of Wall Street to lobby for a weaker enforcement regime").
193. See supra note 103 and accompanying text.
194. See Gadinis, supra note 88, at 65-66 (suggesting various methods that "would provide benchmarks that could facilitate public monitoring of SEC enforcement").
195. Donald C. Langevoort, The SEC as a Bureaucracy: Public Choice, Institutional Rhetoric, and the Process of Policy Formulation, 47 WASH. & LEE L. REV. 527, 539 (1990);
196. see also Rachlinski & Farina, supra note 56, at 592 (noting that "[institutional designers can ⋯ attempt to build in requirements of data collection and analysis, as well as incentives for periodic policy reassessment" as a technique for mitigating biases).
197. Seejill E. Fisch, Top Cop or Regulatory Flop* The SEC at 75, 95 VA. L. REV. 785, 822 (2009) (arguing that the SEC should "incorporate a sufficient range of viewpoints to allow the agency to operate independendy of Wall Street financial firms, corporate issuers, and other influential market participants").
198. See supra note 88.
199. The SEC might perform better in such a world because it would be more accountable for securities fraud enforcement policy than it is today. On the other hand, it might be less disciplined if state and private enforcers were no longer around to expose its failings.