Securities markets are among the most heavily regulated sectors of the economy in developed nations, reflecting their central role in financing businesses and helping households to save for retirement, schooling, and health care, among other things. The costs and benefits of securities laws may accordingly have substantial welfare consequences. My recent paper, “The Economics of Securities Regulation: A Survey,” surveys the growing theoretical and empirical literature evaluating the regulatory system.
The paper begins by distinguishing securities regulation, which operates primarily through ex ante commands and restrictions on contractual terms, from the ordinary private law of contracts, agency, and fraud, which operate primarily through ex post litigation to remedy realized harms. It then discusses the Securities and Exchange Commission (“SEC”), its statutory powers, and its regulatory techniques. It also references the broader literature on economic regulation, contrasting public-interest and private-interest theories of regulation’s origins and effects.
Mandatory disclosure is the dominant technique of securities regulation. The primary theoretical justifications for mandatory disclosure turn on information asymmetry and agency problems. In the well-known Grossman and Hart (1980)model—where buyers are aware that sellers have private information, lying is illegal, and disclosure is costless—the seller has an incentive to disclose its private information to the buyer. When these restrictive assumptions are not met—particularly when disclosure is costly—the full disclosure result does not hold. Because disclosure may reveal trade secrets or information about profitability, it imposes what Verrecchia (1983) calls “proprietary” costs in addition to administrative costs.
Disclosures may also create positive or negative externalities for other firms. They are subject to network effects in the sense that investors may prefer that all companies disclose information in a standardized format, but no individual firm has sufficient incentive to bear the cost of designing a template. Finally, it may be difficult for a firm going public to commit credibly to a high degree of transparency going forward.
Agency cost arguments for mandatory disclosure have a similar structure. Under certain restrictive assumptions outlined in an influential paper by Jensen and Meckling (1976), agents bear all the cost of their expected shirking or misappropriation and therefore have an incentive to tie their own hands. However, when agents are risk-averse, contracting between the principal and agent cannot generally achieve first-best efficiency, opening a role for mandatory disclosure of the agent’s hidden actions or hidden information.
Disclosure’s social benefits come bundled with social costs. The same private administrative and proprietary costs that justify mandatory disclosure, coupled with liability risk for inaccurate disclosures, may lead companies to remain private and therefore out of the reach of the mandatory disclosure system for public companies. Such decisions can impose indirect social costs by keeping private firms operating at a suboptimal scale and by depriving retail investors of investment opportunities. The latter effect may exacerbate wealth inequalities because the regulatory system constrains the ability of typical retail investors to invest in privately held companies, but puts fewer constraints on high-income or high-net-worth households.
As has been extensively documented, the United States has a “listings gap” compared both to the peak number of public companies in the mid-1990s and to the rest of the developed world. There is ongoing debate about how much, if any, of this gap can be attributed to changes in the cost of going public since the 1990s, including those associated with the Sarbanes-Oxley Act of 2002 (“SOX”) and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”).
Both the benefits and costs of the mandatory disclosure system are easy to describe but difficult to measure. Until recently, there were few studies of the net impact of the U.S. disclosure system. The number and sophistication of studies is rapidly increasing.
Early studies attempted to compare long-term stock returns before and after the enactment of the primary federal securities laws in the 1930s and generally found no or modest effects. Studies of the 1930s reforms, however, face substantial identification and specification challenges because the new laws affected all public offerings and all listed companies, and because of the confounding effects of the Great Depression and the enormous outburst of new policies during the New Deal.
Studies of later extensions of the mandatory disclosure system face fewer complications. Some find that newly affected firms are more valuable or more liquid after certain legislative or regulatory changes compared to an unaffected control set. In general, these studies cannot draw conclusions about social welfare because they do not measure indirect costs such as firms’ avoidance efforts, lobbying costs, etc. A paper by Bushee and Leuz (2005), for example, found that after an extension of mandatory disclosures to certain firms listed on the Over-the-Counter Bulletin Board, some firms exited that market rather than comply with the disclosure mandate, while the newly compliant firms became more liquid.
Several studies attempt to determine whether SOX reduced the number of public companies or to measure its net effects on publicly traded companies. Some studies fail to distinguish going “dark” (that is, choosing to stop SEC reporting because the firm lacks the statutory minimum number of shareholders of record) from going private (that is, eliminating U.S. public shareholders through merger or other means). While the studies are subject to ongoing debate, some find that firms take costly measures to avoid becoming subject to the most burdensome SOX mandates (reporting and auditor attestation on internal controls) and that smaller firms face a relatively larger compliance burden.
The regulatory system is not composed solely of disclosure requirements. The Securities Act of 1933 and the SEC’s rules regulate the public offering process. To some extent, these rules reduce the amount of information available about a company undertaking an IPO. In principle, they could make it harder for the market to value IPO stocks. Congress and the SEC have relaxed these information-blocking provisions substantially in recent years.
The Securities Exchange Act of 1934 gives the SEC a role in corporate governance, including oversight of proxy voting. An SEC rule gives shareholders the right to propose matters to be voted on at an annual meeting and discussed in management’s proxy statement. Critics argue that these proposals often involve political and social issues that can destroy value if approved. The SEC recently tightened the requirements for these proposals but is currently reconsidering the change. Congress added several new and controversial corporate governance mandates to the securities laws through SOX and Dodd-Frank.
The SEC licenses, or “registers,” a wide range of market participants, including securities exchanges, crowdfunding portals, securities associations such as the Financial Industry Regulatory Authority, broker-dealers, transfer agents, clearing agencies, securities information processors, and rating agencies. Its regulation of these entities is focused on business practices and often designed to address conflicts of interest. There is often debate about whether the resulting restrictions on contracting between service providers and their customers or on the internal organization of service providers impose direct and indirect costs that exceed their benefits.
Prior to 1975, the SEC played only a limited role in equity market structure. In that year, however, Congress instructed the SEC to create a “national market system” without providing details on how such a system should be structured. The SEC gradually required exchanges to create a consolidated transaction reporting system, a consolidated quotation system, and intermarket linkages to allow exchanges to route orders electronically to one another. Most controversially, in 2005 it adopted Regulation NMS which, among other things, requires exchanges to decline to execute a transaction if another exchange is displaying an electronically accessible quotation at a better price.
In the years since Regulation NMS, costs of equity transactions have declined for retail investors. At the same time, critics have expressed concern about various market developments, including the rise of high-frequency trading, the proliferation of “dark” trading venues that do not display quotations, the growing number and complexity of order types, and the spread of complex pricing schemes and rebates for trading on an exchange. There is ongoing debate about whether Regulation NMS has contributed to these developments and about their net effects on investors.
The paper also analyzes the private securities litigation system. A few doctrinal legal developments, including amendments to the Federal Rules of Civil Procedure governing class actions and the Supreme Court’s adoption of the fraud-on-the-market presumption, facilitated class action litigation on behalf of large groups of investors with individually small amounts at stake. In these suits, the plaintiffs’ counsel, which operates on a contingency fee basis, usually has a larger financial stake than any individual plaintiff and in practice makes the key strategic decisions.
The incentives facing the class counsel and the managers of the defendant firm threaten to lead to collusive settlements that provide counsel with a quick return on its investment in litigation and the defendants with insulation from further claims. This led to a barrage of academic criticism of securities class actions and to a political backlash in the form of the Private Securities Litigation Reform Act of 1995.
The financial economics literature has attempted to identify factors that increase the risk that a company will be hit with a securities class action suit. The literature has found that higher market capitalization, higher share turnover, and higher returns in advance of a stock-price decline are associated with a greater incidence of suit. Incidence also varies by industry. The literature has not reached a consensus on whether these suits effectively deter fraud.
Permitting corporate insiders and certain others who possess material nonpublic information to make trades based on that information may reduce market liquidity as well as create disincentives for managers to make accurate disclosures. At the same time, banning these trades may slow the incorporation of new information into stock prices. As is the case with mandatory disclosure, there is a larger body of theoretical literature than empirical literature on insider trading.
Unfortunately, the SEC and the courts have not agreed on where to draw the line between (legal) informed and (illegal) insider trading. The SEC has frequently urged the courts to adopt a market-egalitarian theory of insider trading, in which the wrongdoing consists of a trader having information that the counterparty lacks. The Supreme Court, however, has consistently concluded that the language of the Securities Exchange Act’s general antifraud provision does not reach this far. The federal courts have accordingly adopted an information-protection theory under which the wrongdoing consists of the use of information for trading purposes not authorized by the information’s owner.
The core idea underlying securities regulation—that companies selling securities to the public or traded in the public markets must disclose information to investors—is largely uncontroversial. The scope of the federal securities laws and the SEC’s regulations thereunder, however, have increased steadily over time. The SEC’s forays into corporate governance and market structure have proved more controversial than its disclosure rules and have suffered several successful challenges in the federal courts. There is an ongoing concern that parts of the regulatory system impose costs that exceed the benefits and accordingly act as a tax on capital raising that may discourage companies from entering the public markets.
These concerns will likely increase given the SEC’s current inclination to prod companies to disclose information about their pursuit of environmental and social goals. There is lively debate, including among the SEC’s Commissioners, as to whether such disclosures fit within the SEC’s investor protection mandate. There will be ample room for further empirical study of new securities law initiatives in the coming years.
Paul G. Mahoney is a David and Mary Harrison Distinguished Professor of Law at the University of Virginia School of Law
This post is adapted from his paper, “The Economics of Securities Regulation: A Survey”, forthcoming in Foundations and Trends in Finance and available on SSRN.