The Advantage of Competitive Federalism for Securities

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Author: Robert Romano

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Front matter

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The Advantage of Competitive Federalism for Securities Regulation

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The Advantage of Competitive Federalism for Securities Regulation Roberta Romano

The AEI Press Publisher for the American Enterprise Institute WA S H I N G T O N , D . C . 2002

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Available in the United States from the AEI Press, c/o Publisher Resources Inc., 1224 Heil Quaker Blvd., P.O. Box 7001, La Vergne, TN 37086-7001. To order, call toll free: 1-800-937-5557. Distributed outside the United States by arrangement with Eurospan, 3 Henrietta Street, London WC2E 8LU, England.

Library of Congress Cataloging-in-Publication Data Romano, Roberta. The advantage of competitive federalism for securities regulation / Roberta Romano. p. cm. Includes index. ISBN 0-8447-4173-6 (pbk.) 1. Securities—United States—States. 2. Securities—United States— State supervision—Economic aspects. 3. Corporation law—United States—States. I. Title. KF1439 .R66 2002 346.73' 092—dc21 2002025360

ISBN 0-8447-4173-6 (pbk.: alk. paper)

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© 2002 by the American Enterprise Institute for Public Policy Research, Washington, D.C. All rights reserved. No part of this publication may be used or reproduced in any manner whatsoever without permission in writing from the American Enterprise Institute except in the case of brief quotations embodied in news articles, critical articles, or reviews. The views expressed in the publications of the American Enterprise Institute are those of the authors and do not necessarily reflect the views of the staff, advisory panels, officers, or trustees of AEI. Printed in the United States of America

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Contents

PREFACE

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1 INTRODUCTION 2 RATIONALES FOR SECURITIES REGULATION, THE EFFECTIVENESS OF THE SEC, AND COMPETITIVE FEDERALISM Underproduction of Information 13 Underproduction of Information Concerning Interfirm Externalities 29 Protection against Fraud and Manipulation 42 The Essence of Competitive Federalism 45 Benefits of a Competitive Securities Regime 48 Should Initial Offerings and Secondary Trading Markets Be Distinguished? 50 What Are the Implications of the Collapse of Enron? 53 3 STATE COMPETITION FOR CORPORATE CHARTERS The Evidence That State Competition for Charters Benefits Shareholders 64 Do U.S. States Compete for Charters? 75 Is State Competition Inefficient Because of Network Externalities? 83 Is State Takeover Regulation Evidence That a National Regime Would Be Superior to State Competition? 92 4 IMPLEMENTING COMPETITIVE FEDERALISM FOR SECURITIES REGULATION What Must Be Done to Achieve Competition? 112 Additional Requirements for Competitive Federalism to Be Effective 124 How Would State Competition for Securities Regulation Work? 131

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COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Uniformity and Variety in Securities Regulation under Competitive Federalism 137 Is Securities Regulation Sufficiently Different from Corporate Law to Render Competition Ineffectual? 142 Regulation by Exchanges 144 5 COMPETITIVE FEDERALISM AND INTERNATIONAL SECURITIES REGULATION Implementing Competitive Federalism in the International Setting 147 Feasibility of International Competition 149 Implications for Foreign Issuers in U.S. Markets 152 Investor Protection Concerns under International Regulatory Competition 156 Comparison with Other Reform Proposals 168 6 CONCLUSION

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NOTES

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INDEX

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ABOUT THE AUTHOR

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LIST OF TABLES 4-1 Delaware’s Revenue from Corporate Charters 133 4-2 The SEC’s Financing 134

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Preface

I initially contemplated the thesis of this book, that the production of U.S. securities law should be subject to the same market forces that produce U.S. corporate law, in my previous book published by the American Enterprise Institute on state competition for corporate charters, The Genius of American Corporate Law. But it was not until several years later that I decided to pursue the idea, and it was published in 1998 as an article, “Empowering Investors: A Market Approach to Securities Regulation,” in the Yale Law Journal. Because the thesis, opening up U.S. securities regulation to competition, questioned fundamental beliefs of many securities and corporate law commentators regarding the efficacy of present-day securities regulation, it drew a number of critiques. I responded to those critics in “The Need for Competition in International Securities Regulation,” an article written for the Conference on Protection of Investors in the Global Economy, sponsored by the Cegla Institute for Comparative and Private International Law of the Tel Aviv University Law School, that was published in the institute’s journal, Theoretical Inquiries in Law, in 2001. This book synthesizes and expands upon the ideas in those two publications for a broader audience willing to consider rethinking the regulation of capital markets and corporations. A number of individuals commented on drafts of the earlier articles. They include Barry Adler, Anne Alstott, Yakov Amihud, Ian Ayres, Lucian Bebchuk, Boris Bittker, Stephen Choi, John Coates, Robert Daines, Boris Feldman, Allen Ferrell, Jill Fisch, Merritt Fox, Henry Hansmann, Howell Jackson, Marcel Kahan, Ehud Kamar, Michael Klausner, Alvin Klevorick, John Lott, Jonathan Macey, Paul Mahoney, Geoffrey Miller, Richard Painter, Edward Rock, Peter Schuck, Alan Schwartz, Joel Seligman, Linda Silberman, Erik Sirri, and Michael Solimine. In addition, I wish to

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COMPETITIVE FEDERALISM FOR SECURITIES REGULATION

thank participants at a number of seminars, including the University of California at San Diego Political Science Department Law and Behavioral Studies Seminar, a seminar at the Commissione Nazionale per le Società e la Borsa in Rome, the Harvard Law School Seminar in Law and Economics, the Max Planck Institut Symposium on Comparative Corporate Governance in Hamburg, the New York University Center for Law and Business Law and Finance Seminar, the Stanford Law School Law and Economics Workshop, the Yale Law School Faculty Workshop, and the Cegla Institute Conference on Protection of Investors in the Global Economy in Tel Aviv. While I have benefited from the suggestions of those individuals and seminar participants, they are, of course, not responsible for what several consider to be my wayward thinking. Finally, I would like to thank Christopher DeMuth for providing me with the encouragement and opportunity to revise and expand upon my articles so as to make them more widely accessible.

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1 Introduction

The Securities and Exchange Commission, an independent agency of the federal government, regulates securities transactions in the United States. The establishment of the commission is widely considered to be one of the great achievements of the New Deal Congress. The Securities Exchange Act of 1934,1 which covers trading in secondary markets and created the SEC, followed the enactment of the Securities Act of 1933,2 which had established a system of registration and disclosure requirements for new issues of publicly traded securities. All firms with securities listed on a national stock exchange, or with 500 shareholders and assets of $1 million, must register with the SEC and comply with its requirements. With investor protection as the stated objective, the SEC’s regulation of issuers consists of a comprehensive set of mandatory disclosure requirements, which include extensive financial accounting information as well as more qualitative disclosures concerning business operations and top personnel. The detail prescribed by the agency is substantial: a prospectus, the name of the SEC document that must accompany the sale of a new issue, runs in the hundreds of pages. The mandatory disclosure is also continuous. After an issue starts trading, the firm must make quantitative and qualitative disclosures on a periodic basis, in public filings with the agency and in an annual report distributed to shareholders in preparation for voting at the annual shareholders’ meeting to elect directors. The SEC further regulates the disclosures that accompany the proxy process by which public corporations accomplish shareholder voting. Included in those regulations are the rules governing the provision of shareholder proposals in the disclosure materials. The disclosure regime is bolstered by statutory antifraud provisions that prohibit material misrepresentations or omissions in the prescribed disclosure documents 1

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and restrict the right of insiders to trade on private information.3 Beyond the agency’s enforcement powers, individuals who have purchased or sold shares can bring private rights of action for damages under the antifraud provisions. The New Deal legislation included several other important grants of authority to the SEC, including jurisdiction over mutual funds and public utility holding companies. In addition, the 1934 act gave the SEC the authority to regulate market professionals, such as brokers and dealers, and stock exchanges. The commission’s power was further extended in 1968 to regulate the terms and conditions of cash tender offers to purchase all or a significant number of registered firms’ shares. Until recently, the ability of the states to regulate securities transactions was preserved as an area of jurisdiction overlapping with the federal securities laws. Most states did not, however, vigorously exercise that authority. For example, although new issues must be registered in each state in which they are sold under state securities laws, a majority of states exempted from their registration requirements corporations whose shares are listed on national exchanges and piggybacked instead on the SEC’s regime for new issues. It should also be noted that nonexempt firms could avoid state registration requirements by not selling their shares in a state without losing the state’s citizens as an investor pool, because the states did not prevent the unsolicited purchase of unregistered shares by their citizens in the secondary market. States do undertake antifraud enforcement actions for violations of antifraud provisions in state securities laws, often in coordination among themselves to deal with interstate fraud. Moreover, New York state has engaged in several high-profile securities fraud prosecutions, sometimes in competition with federal prosecutors.4 But as a generalization, it would be most descriptively accurate to say that federal securities law has occupied the securities field and that state law development has been marginal. Most recently, when Congress tightened the requirements for bringing a private action for damages—as opposed to suits by state agencies—under the federal securities laws in the Private Securities Litigation Reform Act of 1995, filings in state courts under state securities laws increased. Because of concern that state lawsuits were undermining Congress’s

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effort to restrict securities litigation, Congress responded by further amending the federal statutes in 1998 to preempt such private litigation. That followed upon Congress’s preempting state regulation of new issues in 1996, an action motivated by nonexempt issuers’ concerns over having to comply with multiple state requirements. Thus, over just a few years in the late 1990s, Congress completed the SEC’s monopolization of securities regulation. The thesis of this book is that the current legislative approach to securities regulation is profoundly mistaken and that preemption is not the solution to frivolous lawsuits or the cost of compliance with multiple registration regimes. The book advocates instead a market-oriented approach of competitive federalism that would expand, not reduce, the role of the states in securities regulation. Under such an approach, corporations would be able to select their securities regime from among those offered by states, the SEC, and even other nations, with the result that securities regulators would compete for firms’ registrations. The market approach would thereby fundamentally reconceptualize the regulatory approach to securities regulation and is at odds with both sides of the debate over the 1995 Reform Act—the plaintiff’s bar and issuers, especially high-technology firms—each of which has sought to use national laws as a weapon to beat down its opponent’s position by monopolizing the regulatory field. Informing and guiding the proposal is the regulatory experience in an area of law integrally related to securities law, corporate law. In contrast to securities regulation, the regulation of all other relations between firms and the purchasers of their shares, encompassed in the body of substantive law known as corporate law, is a matter left exclusively to the states. In fact, when the SEC attempted to regulate voting rights through its authority over stock exchange listing rules, a federal court invalidated the regulation as a matter for the states that was beyond the agency’s authority.5 The content of state corporation codes ranges from relatively trivial housekeeping matters (such as specifying that the corporate name be in the charter) to fundamental features of the shareholder-manager relation (such as the allocation of voting rights to shareholders and directors and

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the specification of fiduciary duties of managers). In addition, most provisions are enabling, which means firms can tailor statutory defaults to meet their specific needs. Corporations select which state’s code will govern their affairs by choosing their state of incorporation, a statutory domicile that is independent of physical presence in the state, from among the fifty states and the District of Columbia. Although one small state, Delaware, has come to predominate in the market for large corporations (for example, it is the domicile of over half of New York Stock Exchange–listed firms), corporate law is an area where competitive federalism is alive and well in the United States. States compete with Delaware for local firms’ charters in a dynamic process including innovation in legislation and administrative processing.6 The more responsive states’ corporation codes are to firms, the more states can increase financial revenues from incorporation fees.7 Moreover, a substantial literature on this particular manifestation of U.S. federalism indicates that shareholders have benefited from the federal system of corporate law by its production of corporate codes that, for the most part, maximize share value.8 It is a curious fact that the legal regimes for corporate and securities laws are organized along diametrically opposite lines, as they are largely directed at the same substantive issue, specification of the duties owed by the managers of a firm to its investors. The explanation for this situation is historical fortuity. At the start of the New Deal, only a few states regulated securities transactions, the first being Kansas, where populist sentiment against Wall Street firms selling securities ran high.9 The New Deal Congress also capitalized on public hostility to Wall Street after the stock market crash by demonizing investment bankers and brokers to lay the groundwork for enactment of federal regulation. Contemporary research has demonstrated, however, that the attacks on Wall Street during the congressional hearings preceding the enactment of the securities laws were grossly inaccurate and misinformed.10 Focusing on the stock market crash as having caused the depression, however, Congress never turned its attention to remaking state corporate law. But congressional action is not the sole explanation of the difference in the regulatory approach to corporate and securities laws. A key difference exists in the source of jurisdictional authority across the two fields:

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under the choice-of-law rule for securities regulation, the state with jurisdiction over the transaction is the investor’s domicile (that is, the site of a securities transaction) in contrast to the corporate law choice-of-law rule, which gives authority to the issuer’s statutory domicile. Hence, the sovereign authority varies with the purchaser of the security under securities law, whereas under corporate law all of a firm’s investors are governed by the same state code. That technical jurisdictional distinction is critical for understanding why competitive federalism is vibrant in corporate law and nonexistent in state securities law and would continue to be so were the exclusivity of the federal regime scrapped without a corresponding change in the jurisdictional rule. In brief, by creating exclusive jurisdiction in one state chosen by the issuer, the statutory domicile choice-of-law rule provides states with an incentive to compete for issuers that goads them to adopt a regime that issuers prefer. Because firms compete for equity capital, that regime is also one that investors prefer. This book proposes extending the competition among states for corporate charters to two of the three principal components of federal securities regulation under the 1933 and 1934 acts: the registration of securities and the related continuous disclosure regime for issuers; and the antifraud provisions that police the system. The third component, the regulation of market professionals, is not included in the proposed reform, nor is the related area of SEC authority, mutual fund regulation.11 Brokers are excluded because the domicile choices of brokerage firms are not subject to the same capital market forces that provide incentives to competing regulators to adopt rules preferred by investors. The owners of issuers are the beneficiaries of issuer regulation, but that is not true for broker-dealers, whose owners need not have any relation to the users of their services, who are the beneficiaries of broker regulation. Exchanges are excluded for a more pragmatic reason: exchanges are self-regulating under the federal securities scheme, and the benefits from regulatory competition would thus be more attenuated for them than for issuers. The exclusion of mutual fund regulation from the proposal is more problematic. Mutual funds should be subject to the same forces as issuers because the fund owners are the investors whose protection is the regulation’s objective. In contrast to direct equity investments, however, a

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majority of mutual fund assets are still held by individual investors rather than institutions. The proportion of assets held by individuals has been declining—for instance, in 1999, individuals held 54.4 percent of mutual fund assets, compared with 63 percent in 1991,12 and among institutions, the second largest and fastest growing mutual fund asset holders are retirement plans, which accounted for 29 percent of total institutional assets in 1995, up from 19 percent five years earlier.13 Those plans are typically 401(k) plans or similar defined contribution plans in which the employer selects a set of mutual funds into which the individual plan participants allocate and direct contributions. If the amounts held in such retirement plan accounts are included in individuals’ direct mutual fund holdings, then institutions hold only 20 percent of mutual fund assets.14 Because the effectiveness of competition depends on informed investors, the substantial holdings in mutual funds by individuals, particularly if individual pension plan assets are treated as individual rather than institutional holdings, suggests that the possibility exists that there might not be a sufficient number of informed investors for competition to work well. Cutting against that concern is the fact that employers have an incentive to monitor the quality of their pension plan’s mutual funds, not the least of which is their fiduciary obligation under federal law, and they would presumably inform themselves of selected funds’ legal regime under competition. This book therefore leaves for future consideration what is, in my judgment, very much an open question, especially in view of the changing composition of mutual fund investors, the applicability of regulatory competition to mutual fund regulation. The proposed market approach can be implemented by modifying the federal securities laws in favor of a menu approach to securities regulation under which firms elect whether to be covered by federal law or by the securities law of a specified state, such as their state of incorporation. To work, the choice-of-law rule for securities regulation must be altered to replicate the corporate law approach: only one sovereign, the issuer’s selected securities domicile, can have regulatory authority over transactions in an issuer’s securities, wherever the transactions occur. The aim of the competitive federalism approach is to replicate for the securities setting the benefits produced by state competition for corporate charters—

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a responsive legal regime that has tended to maximize share value—and thereby to eliminate the frustration experienced at efforts to reform the national regime. As a competitive legal market supplants a monopolist federal agency in the fashioning of regulation, it would produce rules more aligned with the preferences of investors, whose decisions drive the capital market. Most readers will find the statement that consumers are protected from producer exploitation by competitive product markets prosaic and intuitively obvious. But a number of legal commentators blanch at the suggestion of applying that wisdom to securities regulation. As this book intends to demonstrate, upon analysis, the analogy is entirely apt. In today’s global financial markets, which are dominated by sophisticated institutional investors, competition among securities regulators would not only protect investors, both large and small, but also provide a superior regulatory regime. Critics of competition in securities regulation often blur the true issue by referring to their position not as a defense of a single regulator but as a defense of mandatory disclosure, on what is, in my judgment, a fantastic premise, that there would be no significant disclosure component in a competitive regime. Objections to competition have, accordingly, frequently been inseparably intertwined with a defense of the SEC’s mandatory disclosure regime. That argument is flawed: if investors want mandatory rules, competing regulators will offer them. Moreover, the evidence reviewed in the book shows that it is difficult to defend the SEC’s monopoly as delivering what investors want. We therefore ought not to privilege the status quo in the area of securities regulation, and we should instead apply to it the overarching organizational principle of our political and economic system, decentralized competition. Some critics of regulatory competition maintain that the SEC is not, in fact, a “monopolist.” They point to the SEC’s liberalization of private placement rules for offshore and certain domestic offerings and to its exemptions for foreign issuers from a few disclosure requirements as evidence that it is a bureaucracy acting responsively to a competitive environment.15 The claim is misplaced: those agency actions have no connection to the regulation of U.S. equity issuers’ disclosure and fraud

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liability, which is the object of the regulatory competition advocated in this book, but rather, have to do with foreign issuers or the securities of U.S. issuers that are not publicly traded. Entirely consistent with the theory of regulatory competition, the SEC has been responsive where it has encountered competition from foreign regulators or other federal regulators such as the Commodity Futures Trading Commission.16 But the reality is that over the past two decades of such liberalization, it has not at all been responsive in the domain in which it has no competition, the disclosure regulations for U.S. issuers of public equity; to the contrary it has continuously added mandated items whose disclosure other nations do not require.17 Competitive federalism for U.S. securities regulation has important implications for international securities regulation. Present-day international securities regulation follows a jurisdictional principle similar to domestic regulation: the regulatory authority is the regulator where the securities are listed. But the proposed jurisdictional principle applicable to domestic securities transactions under competitive federalism should be equally applicable to foreign issuers listing on a U.S. exchange: they should be able to opt out of the federal securities laws and choose those of another nation, such as their country of incorporation, or those of a U.S. state, to govern transactions in their securities in the United States. The federal securities laws would also, of course, not apply to transactions by U.S. investors in the shares of any firms that opt for a non–U.S. securities domicile under the market approach. Under that approach, U.S. laws would apply only to corporations affirmatively opting to be covered by U.S. law, whether or not they are based in the United States and regardless of where the shares are listed or their shareholders reside. Such an approach would therefore put an end to the ever expanding extraterritorial reach of U.S. securities regulation, which currently extends to transactions abroad involving foreign firms, as long as there are any U.S. shareholders or U.S. effects.18 To establish a fully competitive global securities regime, however, multilateral government action would be necessary through which nations agreed to alter their present territorial approach to securities regulation and to recognize each issuer’s chosen

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securities domicile as the appropriate regulatory authority, regardless of where the securities are traded. Stemming the trend of extraterritorial application of U.S. law will not harm U.S. investors because they have, in fact, often been disadvantaged by the expansion of U.S. securities jurisdiction. For example, to avoid the application of U.S. law, foreign firms have frequently explicitly excluded U.S. investors from takeover offers, and such investors have thus missed out on bid premiums.19 In addition, adoption of the market approach will facilitate foreign firms’ access to capital, as they will be able to issue securities in the United States without complying with U.S. disclosure and accounting rules that differ substantially from their home rules, a requirement that has been a significant deterrent to listings.20 That consequence of the proposed modification of U.S. law would also benefit U.S. investors, who would no longer incur the higher transaction costs of purchasing shares abroad to make direct investments in foreign firms. There may be an understandable desire to discount the need for adopting a market-driven approach to securities regulation because of the vibrancy of U.S. capital markets. Doing so would be a mistake. While U.S. capital markets are the largest and most liquid in the world, it is incorrect to attribute that fact to the operation of the SEC. U.S. capital markets were the largest and most liquid global markets from World War I,21 well before the federal regime was established, and their share of global capitalization has declined markedly over the past two decades,22 facts at odds with the contention that the current federal regime is the explanation for the depth of U.S. capital markets. It may further seem to some that the proposal for regulatory competition is purely an academic exercise because issuers who have already expended the effort to comply with the myriad SEC disclosure rules and legal counsel who have established relations with agency personnel to be able to transact business with relative satisfaction do not find the SEC disclosure regime unduly burdensome. I am highly skeptical that this is an accurate portrayal of the current situation. Rather, I believe that it is more plausible that the normative power of existing institutions renders it difficult for many securities professionals to imagine that a superior regime could be implemented that would make the cost of change worthwhile. In

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my judgment, the absence of calls for comprehensive reform is a function of a lack of imagination, rather than evidence that the current regulatory apparatus does not produce deadweight losses for investors. Corporations and their counsel have focused their efforts on shifting regulatory authority from the states to the federal level to eliminate the state-level problems of civil liability plaintiffs’ forum shopping and burdensome registration requirements, most probably because they perceive preemption as the easiest political fix to sell to members of Congress. As William Carney suggests, the preemption strategy should not be interpreted as an example of issuers’ lobbying to increase the SEC’s regulatory authority in endorsement of its monopoly position but rather as lobbying to rid nationwide offerings of fifty-two regulators and subject them to one standard.23 But such problems would be eliminated by altering the state jurisdictional rule of investor domicile to that followed by corporate law, under which only one state, chosen by the issuer as its securities domicile, has jurisdiction over all transactions in the firm’s securities. The investment of mature corporations in the SEC regime no doubt renders them less interested in fundamental regulatory reform, but new issuers have not yet made an investment in a specific securities regime. It would therefore be worth the while of a state, such as Delaware, to compete for new issuers’ business by offering a quality disclosure regime that eliminates the more inefficient or superfluous SEC requirements. For example, Frederick Choi identified over 100 accounting items, required by the SEC, that are unnecessary and excessive by international standards.24 Because new and mature issuers compete for capital in capital markets, or as competitors in product or labor markets, if a superior securities regime were to emerge under which new issuers operated that was more cost-effective than the SEC’s regime, then even mature issuers would switch domicile to reduce their cost of capital. An equally desirable outcome to regime-switching by mature issuers in that instance would be a response by the SEC to the rival regimes of new issuers, in an effort to maintain its sphere of influence, in which it scrapped problematic requirements and improved its product. Some may conclude that competitive federalism for securities regulation does not go far enough and that all government regulation of capital

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markets, whether federal or state, should be terminated. I believe that the intermediate position advocated in this book is the more sensible public policy than eliminating all government involvement. This is so because competitive federalism does not foreclose the possibility of comprehensive deregulation should that be desired by investors. A state could, for instance, adopt a securities regime that delegates regulatory authority over issuers to stock exchanges, just as the current federal regime delegates regulatory authority for market professionals to the stock exchanges and the National Association of Securities Dealers. More important, competitive federalism permits experimentation with purely private regulatory arrangements, while retaining a mechanism to reverse course easily— migration to states that do not adopt such an approach—which is not present in a purely private regime. A final point to draw from the proposal is that the current trend to extend the federal government’s monopoly over securities regulation should be halted, as it is not the most effective solution to the problem reformers seek to address. Instead of supplanting state securities regulation, Congress should rationalize it by legislatively altering the multijurisdictional, transactional basis of state regulatory authority to an issuer-domicile basis, which by creating regulatory competition will introduce into securities law the benefits that have accrued to investors under corporate charter competition.

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2 Rationales for Securities Regulation, the Effectiveness of the SEC, and Competitive Federalism Federal intervention in capital markets in the 1930s was justified by a contention that securities markets operate poorly on two specific dimensions. First, capital markets produce an inadequate level of corporate disclosure because the firm bearing the cost of producing the information cannot appropriate all the benefits. Second, capital markets fail to protect investors from stock price manipulation and fraud. Neither justification presents a barrier to regulatory competition, however, particularly given the sea change in equity markets since the federal securities laws were enacted. Today, institutional investors who are sophisticated repeat players dominate the stock market, and the available information sources regarding investments are extensive. Beyond institutional investors’ substantial resources directed at research, financial analysts and other information services abound, and the amount of investment information available on the Internet is rapidly growing, so that voluminous information is accessible even to individual investors. In addition, a number of organizations, such as the Council of Institutional Investors, Institutional Shareholder Services, and the Investor Responsibility Research Center, coordinate corporate governance voting policies for institutional investors and thus mitigate potential collective action problems regarding information gathering with respect to investors’ holdings in firms. While the transformation of equity investing since the New Deal has rendered any hypothesized benefit from the federal securities laws far less meaningful as a mechanism of investor protection from possible management exploitation than ever before, even more important, both historic 12

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RATIONALES FOR SECURITIES REGULATION 13 rationales for regulation are as consistent with state as with federal regulation. Therefore, the rationale for government intervention does not stand in the way of opening up the federal regime to regulatory competition. In addition, there is a disturbing absence of evidence that the federal securities regime has in fact been particularly effective at achieving its stated objectives. A variant of the inadequate disclosure rationale for federal intervention advanced by contemporary commentators, relating to underproduction of information involving interfirm externalities, arguably could warrant a single regulator, but the case against competition even under that rationale is exceedingly problematic because it lacks robust theoretical justification and empirical support. Regulatory competition, moreover, offers a distinctive advantage over a single regulator for securities law. It better aligns the incentives of issuers, and of regulators, with the interests of investors, and will thereby lead to the promulgation of rules that investors most prefer. That is so because issuers will be drawn to the regime preferred by investors to lower their cost of capital, and regulators will be able to discern the efficacy of their regulatory choices by the flow of firms into and out of jurisdictions. Underproduction of Information The conventional economic explanation for governmental intervention in the market allocation of goods and services concerns situations in which market pricing will not produce the optimal output because private parties cannot properly equate the product’s marginal cost and benefit. Such scenarios, known as market failures, include the presence of externalities or public goods. An externality occurs when costs and benefits accrue to parties other than the contracting parties and thus are not internalized or priced in a market transaction. A textbook illustration of an externality is pollution. A factory located upstream from a town dumps toxic waste into a river as a byproduct of producing a good. Because the factory will not bear the town’s cost of cleaning the river or bringing in clean water from elsewhere, it will not pass that cost on to the consumers of the product, and the firm will overproduce the good in terms of its net contribution to social

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welfare. Namely, the market price includes only the cost and benefit to the firm and its customers, the parties involved in the transaction to purchase the good, parties to whom the cost of the pollution is zero because they do not live in the downstream town. Government action is needed to price the externality, so that the market will produce the output level that equates the marginal social cost and benefit of all persons affected by the good’s production. A public good is a good whose marginal cost of production is zero. The good’s consumption is nonrivalrous, that is, one person’s consumption of the good does not diminish the good’s availability for another person, and nonexcludable, that is, the cost of excluding nonpaying users or beneficiaries of the good is prohibitively high. Hence, the producer of such a good does not capture the value to additional users in the pricing mechanism of a market. A classic example of a public good is a street lamp: one person’s being guided by the lamp’s light at night does not affect any other person’s similar ability to use the lamplight. The marginal cost of an additional user of light is zero, but it is difficult, if not impossible, to prevent passersby who are not local taxpayers from benefiting from the light of the lamp. That creates a free-rider problem, where individuals do not pay their share of a good’s production because nonpayment does not prevent them from obtaining the benefit of the good. Markets, by contrast, operate by excluding individuals from consumption when they are unwilling to pay the going price, and thus they will not produce the optimal amount of a public good. Should We Expect Firm-Level Disclosure to Be Inadequate? Firm-level information used in investment decisions has often been characterized as a public good, although whether it is under- or overproduced is a subject of contention. The conventional public goods analysis suggests that firms will underproduce information about a security: one person’s obtaining information about a firm does not restrict another person’s ability to obtain and use it, and the low cost of retransmission of information makes it difficult for the producer of the information to capture its value.1 But because of the trading gain that the first person to discover private firm-level information captures, such information may instead be

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RATIONALES FOR SECURITIES REGULATION 15 overproduced.2 Both explanations can be used to advocate government intervention to mandate disclosure, but supporters of securities regulation typically rely on the underproduction rationale.3 If one puts aside the minimal guidance for public policy that theoretical analysis provides regarding how much information firms produce, it is implausible to think that firms would significantly underproduce information in the absence of a single securities regulator. That is so because firms have a strong incentive to distinguish themselves to obtain capital by providing information regarding their projects. Firms with less favorable information must also disclose such information about their projects because an adverse signal will be drawn by investors concerning firms that do not disclose any information—no news is bad news.4 The signaling hypothesis of information disclosure, that silence implies bad news, is a plausible scenario in today’s capital markets in which a majority of investors are sophisticated institutions. Despite varying assumptions, formal models of the disclosure that is made in a signaling scenario conclude that information will not be underproduced if a sufficient number of investors understand the significance of nondisclosure.5 In addition, when sufficiently numerous uninformed consumers exist so that mandatory disclosure can be beneficial, the consumer suffers no loss from the voluntary disclosure failure: the benefit of mandatory disclosure goes to the selling firm as consumers pay the expected value of the product in either situation.6 In today’s institutional marketplace, however, it is not credible to contend that the conditions for signaling—a sufficient number of informed investors—are absent and that underproduction of information will be a significant problem. In 2000, for example, the proportion of equity directly held by individuals was less than 40 percent, a steady decline from 90 percent in 1950, 68 percent in 1970, and 51 percent in 1990.7 Finally, a theoretical need for regulation to address a market failure is not equivalent to a need for a single regulator. The premise of competitive federalism is that if the market underproduces corporate information to investors’ detriment, then there would be a demand for, matched by supply of, mandated disclosure regulation in a regime of state competition for securities regulation, just as in the single-regulator system of the Securities and

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Exchange Commission. But mandated disclosure under competition will more closely follow investor preferences as firms, to reduce their cost of capital, will select the regulatory regime that investors prefer. Is the SEC’s Mandated Disclosure Regime Effective? A number of scholars have sought to ascertain how the SEC’s mandatory disclosure regime has fared compared with voluntary practices by firms. The answer provided by a fair reading of the literature is that the agency has added little value. The empirical studies support the economic theory suggesting that underproduction of firm-level information is not a significant problem and thus support adoption of a competitive regime, because the SEC has not perfected the market. Studies of the impact of disclosures mandated under the 1934 act. Little tangible evidence exists to support the claim that the market underproduces corporate information or the corollary that the benefits to investors from information that firms do not produce in the absence of mandatory disclosure actually outweigh their costs. For instance, before the enactment of the federal securities laws in the 1930s, public corporations voluntarily disclosed financial statements, usually under a stock exchange listing requirement, that contained substantially all the information subsequently required under the federal laws. In addition, financial disclosures were typically audited: the vast majority of New York Stock Exchange firms’ financial statements were audited before the NYSE required the practice in 1932.8 In fact, entrepreneurs have been voluntarily submitting to independent audits for centuries. Ross Watts and Jerold Zimmerman, for example, have detailed the voluntary use of independent auditors from thirteenth century merchant guilds to the earliest known corporate forms, including joint stock companies, for centuries before the United Kingdom’s codification of the 600-year practice in 1844 and note that audits of U.S. corporations occurred in the nineteenth century.9 In an important and still underappreciated study, George Benston examined the impact of the only fundamental item whose disclosure the SEC mandated that a significant number of firms had not reported before

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RATIONALES FOR SECURITIES REGULATION 17 the 1934 legislation, sales. Comparing pre- and postlegislation stock returns of the firms for which the legislation was relevant (firms that had not previously reported sales, which were 38 percent of NYSE-listed corporations) with those for which it was not (the remaining 62 percent of NYSE corporations that had disclosed sales information), he finds no significant price effect from the new mandated disclosure.10 Benston’s finding is important because modern finance theory indicates that the stock market is efficient so that new public information is rapidly incorporated into stock prices. If voluntary disclosure practices before the 1934 act omitted important firm information, then the SEC’s mandated disclosure of that information should have had a significant impact on stock prices. Accordingly, we can infer from the absence of a price effect that the agency’s mandated disclosure of sales data did not provide new information of value to investors. Benston’s finding thus presents a serious problem for advocates of the SEC and by extension of a single-regulator regime because the finding is at odds with characterizing the mandated disclosure as improving investor welfare over the preexisting voluntary disclosure scheme. Not surprisingly, his study has been criticized, but to little effect. Most recently, Merritt Fox, an advocate of a single-regulator regime, has maintained that Benston did not correctly test the welfare effects of the 1934 act. His claim has two parts. He raises a series of objections to the specifics of Benston’s test of a stock price return effect. He also asserts that to improve investor welfare, the mandated disclosure of the act should affect not the stock returns but their variance. Fox’s first objection concerns Benston’s examination of a “single disclosure item.”11 That objection is inappropriate. The “single” item in question, sales, is the only significant financial datum that the SEC required that the NYSE did not require of listed firms before the act, as well as the only item of the mandated items that many NYSE firms did not voluntarily disclose before the act.12 Consequently, that is the best piece of information with which to test whether the act had a significant effect, for it provides us with a natural experiment. We can contrast the impact of the act on firms for which it imposed a disclosure requirement compared with those for which it did not.

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Fox next questions what is the beauty of Benston’s test, his hypothesis that the act should have an effect on prior nondisclosers. Fox contends instead that the correct hypothesis is that there should be no effect, that is, the price impact should not differ between preact disclosing and nondisclosing firms. Fox’s revised prediction is founded on the view that the quality of sales information disclosed before the establishment of the SEC was lower than the information disclosed after the agency’s creation and hence that all firms, regardless of their disclosure status before the 1934 act, benefited equally from the legislation. That is an odd hypothesis because it implies that the agency’s mandated disclosure of sales imposed a new disclosure requirement on all firms and not simply on those firms that had not previously disclosed sales. Under that hypothesis, investors would reevaluate the price of firms disclosing sales information for the first time after the act identically to that of firms that had disclosed sales information before the act. The assertion that the impact of the act was no different for disclosers and nondisclosers is, however, implausible. If the SEC was remedying a market failure and sales information was important to investors, then investors should reassess the share value of a firm that goes from zero disclosure to disclosure of a sales figure after the act differently from their assessment of the value of a firm that had always disclosed some sales information. Fox does not provide an explanation for why moving from zero to high-quality disclosure would have precisely the same price effect as moving from low- to high-quality disclosure—a rationale necessary given Benston’s data. Moreover, no data show that the preact disclosers’ sales figures improved in quality after the act, which would also be necessary for Fox’s hypothesis to be correct.13 Finally, if all firms’ disclosures improved, then Benston should have found a systematic change in price for all firms, which he did not: runs tests showed that the price changes of both groups of firms were random. In addition, data concerning the disclosure of cost of goods sold cast further doubt on Fox’s contention that Benston’s results are questionable because of an absolute improvement in disclosure quality after the act. Although the number of firms disclosing the cost of goods sold after the

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RATIONALES FOR SECURITIES REGULATION 19 act increased—a rise from thirty-three to forty-seven firms—the increase occurred primarily in the disclosure category that is described as the lowest quality, the one that did not include depreciation or selling, general and administrative expenses—a rise from eight to seventeen firms. In the disclosure category described as the highest quality that included all such items, there was a decline from nine to five firms.14 Thus, the cost of goods sold, an item mandated by the SEC that was not required by the NYSE, is not an item for which Fox’s assertion of an increase in the quality of disclosure by all firms after the act holds. Yet Benston’s results were identical—there was no price effect—when he used the cost of goods sold instead of sales in his analysis of the act’s impact. That suggests that the most plausible explanation of the data is Benston’s, not Fox’s: there was no price effect because mandated disclosure did not improve upon the voluntary disclosure provided before the act. Although the act had no effect on stock returns, Benston did find that the variance of returns decreased after the act.15 Fox therefore advanced the novel position that the mandatory disclosure of new information should not, in fact, affect returns, but, rather, should affect the variance of returns.16 But the premise of that contention is false. It is textbook learning that, in an efficient market such as the stock market, new information that is of value to investors affects stock prices, not their variance.17 As Benston details in his hypothesis tests, variance changes of significance for policy analysis will be accompanied by changes in returns.18 Moreover, the relevant measure of risk that affects value in modern finance theory is not firms’ total variance, the measure on which Fox focuses, but market or systematic risk—the component of an asset’s returns that changes with moves in the market as a whole.19 Market risk is the only risk of concern to investors in modern finance theory because investors will not pay for a reduction in own-firm variance—the component of changes in a firm’s returns due to events that relate only to that firm—as diversification eliminates that risk.20 Most important to Benston’s analysis, however, is a finding that no difference exists in the variance effect across the two groups of firms, preact disclosers and nondisclosers.21 Namely, the firms for which the act’s mandate had bite, the preact nondisclosers of sales, did not experience a

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greater reduction in variance than those that had always disclosed sales. In fact, their variance was slightly lower than that of the firms disclosing sales before the act, in both the pre- and post-SEC periods. Because the decline in variance occurred for both sets of firms and not simply for the firms whose disclosure the act brought about, Benston concluded that the 1934 act did not affect the variance in stock returns.22 In addition, the decline in variance occurred in either mid-1933 or mid-1936—depending on how one views the scatterplots of the data—and neither of those years can readily be associated with an impact from the 1934 act.23 Even if we accept Fox’s rather than Benston’s interpretation of the data—that the standard for a welfare gain from a variance effect does not require a differential effect on the variance of preact disclosers and nondisclosers—and we gloss over the fact that it was not market risk that decreased after the act, it is important to note that a reduction in variance across the board does not imply that government intervention to mandate disclosure is required to improve investor welfare. Interpreting the data most favorably to Fox’s position, that variance actually decreased, the finding would suggest that the effect of the 1934 act was standardization of disclosure, not production of new information: namely, the spread in stock returns could decrease without a price effect if the SEC’s disclosure regulation made firms easier to compare. There is, however, no need for government regulation to obtain standardization. Standardization has, for instance, occurred in contemporary financial markets without SEC assistance. The unregulated financial derivatives sector developed its own standard-form contract for swaps. In addition, in numerous nonfinancial sectors, such as electronics, product standardization has occurred without regulatory intervention. Moreover, before the federal securities laws were enacted, stock exchanges were starting to implement uniform disclosure standards, a role that they could readily resume today. Government intervention might be called for if the market adopted a standard that was suboptimal. But that is scarcely to be expected in the securities disclosure context for several reasons. First, a multiplicity of repeat-play financial intermediaries stand to gain from the choice of the right standard. Second, exchanges, with a natural source of disclosure standards through listing requirements in the absence of regulation, have

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RATIONALES FOR SECURITIES REGULATION 21 the ability to internalize the costs and benefits of uniform disclosure where a single firm would not because exchanges “own” the marketplace on which the firms trade.24 Most important, even if government is necessary to provide a standard, competing regulators are not an obstacle to its accomplishment. For example, although the United States has fifty state corporation codes, their substantive content is substantially uniform.25 In addition, all the states have accepted the accounting standards adopted by the Financial Accounting Standards Board in the exercise of their licensing power over the accounting profession, while they could have applied different rules for solely local (in-state) businesses, as they have done with respect to the registration requirements for new issues. It is important to conclude the discussion of Benston’s study by making clear what is in dispute regarding the significance of his findings. The issue regarding the efficacy of the single-regulator system is not whether a regulator can possibly identify more items than firms will disclose voluntarily. Because information production is costly, a regulator can always find some item that has not been voluntarily disclosed by all firms and might be of use to some investors. The issue is, however, whether such additional disclosures are cost-justified from the investors’ perspective. None of Fox’s criticisms of Benston’s study addresses that question. Benston’s finding that stock prices did not increase upon the SEC’s enhanced disclosure requirements implies that the market’s cost-benefit calculation was, in fact, correct: the information was either already available or was not of sufficient value to investors to justify the cost to firms in disclosing it. This should not be surprising: markets are particularly well suited for making such judgments. Finally, we should also note that research on the impact of disclosure requirements imposed by the SEC in the contemporary era is in accord with Benston’s study of the impact of the 1934 act. The numerous studies investigating the SEC’s adoption of segment-reporting requirements in 1969 failed to identify any stock price effect from the new disclosures.26 In addition, when the SEC mandated disclosure of the replacement cost of assets in 1976, the change had no effect on stock prices.27 Thus, neither mandate provided new information regarding firm values. The data showing no price effect from SEC disclosure regulation are consistent,

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overwhelming, and irrefutable. The findings that SEC mandates have not been directed at producing information of value to investors are inconsistent with the hypothesis that a single government regulator will set an optimal disclosure policy beyond what is voluntarily produced and, to the contrary, demonstrate the need to think more creatively about how to fashion bureaucratic incentives for developing the optimal disclosure policy. That is what regulatory competition in securities law attempts to address. Studies of the impact of the 1933 act. While no research has duplicated Benston’s study of the 1934 act for the 1933 act by comparing specific disclosure levels of new issues before and after the act, several studies, beginning with George Stigler’s pathbreaking 1964 study of the 1933 act, have examined the act’s impact on the value of new issues. Paralleling the findings on the 1934 act, all the studies of the impact of the 1933 act find that it had absolutely no price effect.28 That suggests that, like the 1934 act, the 1933 act did not provide investors with meaningful new information regarding new issues. Merritt Fox contends, however, that we should not expect to see a price effect from the 1933 act’s newly mandated disclosure because inadequate disclosure before the legislation would be impounded in stock prices and equalize returns before and after the act.29 That position is inconsistent with Fox’s contention that the inadequacy of the disclosure produced by the market necessitated mandated disclosure. If voluntary disclosure was inadequate, then after the 1933 act, investors would no longer be misled about firm values (or discount prices because of lack of information) and returns should improve as investors could then correctly price the securities. In other words, the relative rate of return on new issues should have increased after the act compared with the rate of return on such issues before the act if the act solved an information failure in the new issues market. Fox further contends, paralleling his argument regarding the 1934 act, that the predicted effect of the 1933 act should be a reduction in the variance of returns and not an increase in returns. But that contention is incorrect. If a disclosure provides new firm information—the rationale for

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RATIONALES FOR SECURITIES REGULATION 23 mandating disclosure, that it is providing valuable information that was not released voluntarily—then disclosure should have an impact on returns. That is the textbook understanding of the operation of capital markets: they are efficient such that the public disclosure of a new piece of information that affects investors’ assessment of firms’ future cash flows will immediately be impounded into the stock’s price. When there is no price effect, it signifies that the new disclosure is not informative—that is, it does not alter investors’ valuation of the firm. Accordingly, the studies of the 1933 act suggest that the proponents of the act were simply mistaken in their assumption of the capital market’s imperfections regarding new issue disclosures and the remedial efficacy of the legislation. In contrast to the ambiguous data regarding the impact of the 1934 act on the variance of stock returns, the 1933 act did, in fact, reduce the variance of the returns of new issues. In Fox’s view, the reduction in variance evinces that investors’ ability to estimate firms’ future cash flows improved after the legislation. But there is suggestive evidence that the reduction in risk after the 1933 act is an indication that the act drove firms with higher risk from public capital markets and not an indication that investors were able to make better forecasts because of the mandated disclosure. That is the explanation of the finding advanced by Stigler in his study. In particular, Gregg Jarrell found that the proportion of outstanding new issues of common stock to debt decreased after the 1933 act and that the private placement market for debt of high-risk bonds dramatically increased.30 He also found that there were fewer new issues with high market risk after the act than before it.31 The only plausible explanation that reconciles all those findings is that the act led to a decrease in public offerings with high risk. That interpretation is important because a reduction in the variance of returns due to a contraction in investment opportunities following the legislation is not a self-evident welfare improvement. To the contrary, since investors merely require higher compensation to invest in securities with greater risk, the restricted availability of financing for high-risk ventures by the loss of access to public markets entails a net social loss. Why would the 1933 act shift issues with greater risk away from the public sector? One hypothesis, advanced by Seha Tinic, is that the 1933

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act’s liability regime deterred the offering of such issues under the act because the act subjected underwriters of issues to strict liability, and the possibility of subsequent poor performance is higher for issues with greater risk.32 Tinic advanced his thesis to explain the well-documented phenomenon that initial public offerings are underpriced and presented evidence that the new offering discount increased after 1933. But his study provides more suggestive evidence supporting the explanation of the 1933 act’s variance reduction as removing issues with high risk from the market: a showing that the new securities that reputable underwriters, who had the most to lose from litigation, were willing to offer shifted after the 1933 act to larger issues with less risk.33 A further explanation for why the 1933 act could have eliminated high-risk issues from public markets involves the restrictions the SEC placed on the accounting information that could be revealed in the financial documents of public securities. The SEC followed the conventional conservative bias in accounting and required the use of historical cost as opposed to market value of assets, prohibited the use of appraisals and earnings forecasts, and led the campaign to eliminate goodwill from balance sheets.34 To the extent that it is more important for high-risk firms than for low-risk firms to convey such information to investors to obtain the best issue price, the agency’s disclosure policy would force those highrisk firms into the private placement market, where they could continue to provide the prohibited information. Suggestive data on this issue exist. George Benston investigated which industries most frequently used private debt—a market that largely did not exist before 1934—for new issues after the 1933 act. He found that those industries tended to be the ones for which, according to his rankings, conservative accounting was misleading and consequently, those for which the SEC’s reporting requirements could produce a negative bias in investors.35 Those were extractive industries, where historical cost of property is less meaningful and appraisals of estimates of oil in the ground are critical for valuation, and transportation and retail firms, where intangibles, such as monopoly franchises and goodwill, are major assets. Unfortunately, Benston did not measure industry risk. Hence, we cannot conclude from his research that the accounting explanation of why

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RATIONALES FOR SECURITIES REGULATION 25 the legislation would remove high-risk issues from public markets is correct. But as with Tinic’s data, Benston’s data suggest that the federal securities laws affected the composition of offerings. A third possible explanation for a decrease in the risk of new issues after the 1933 act is related to the fact that many of the procedures established for public underwriting in the act were directed at protecting the interest of the more established sectors of the financial industry (wholesale investment banks) over newer interests (integrated retailers).36 The legislation’s distributional impact on the financial industry provides an even more straightforward explanation for why the number of public offerings of high-risk issues would decline after 1933. The act appears to have driven out of business many smaller regional underwriters, who tended to handle high-risk issues.37 Supporters of the SEC such as Fox may not find persuasive any of these explanations—the act’s strict liability for underwriters, the SEC’s conservative disclosure requirements, or the act’s adverse impact on regional underwriters—of why the 1933 act would force high-risk issuers from the public market. But they are coherent explanations, consistent with the data regarding the impact of the act. The alternative explanation of the variance effect of the act as a change in the accuracy of stock value assessments rather than as a change in the composition of public issues, in contrast, cannot account for Jarrell’s findings regarding high-risk issues. That alternative only explains the finding of a reduction in the variance of returns after 1933. But even if we were to accept Fox’s and not Stigler’s and Jarrell’s interpretation of the change in variance around the 1933 act, a reduction in the variance of stock returns does not demonstrate that mandatory disclosure by a single regulator is necessary. First, the variance reduction detected in the studies of the 1933 act was a measure of firm-specific and not market risk. As previously noted, textbook finance theory teaches that the risk that is priced is market risk; hence, a reduction in firm-specific risk, which is diversifiable, does not affect investor wealth. Consequently, the reduction in variance of the 1933 act cannot be characterized as significantly improving investor welfare, so the data do not support a single-regulator regime. Second and related, when a mandated disclosure

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produces no price effect, then that mandate has not provided new information concerning cash flows. The appropriate conclusion is that the information was either already available in the marketplace or of no value to investors. It is not that the single-regulator regime perfected the market for new issues. The reduction in variance without a price effect has two further implications. At best, it implies that the 1933 act standardized disclosure for new issues. At worst, it implies that the act reduced the level of reliable information produced by new issuers because prices change less frequently when new information is not revealed in a timely fashion. But it bears repeating that, even under the most benign interpretation of the data regarding the act’s effect on investors, standardization requires neither a single regulator nor a mandatory regime. As previously noted, standardization can be and is accomplished voluntarily and under competitive regulatory regimes. We can glean additional evidence in support of that assertion from Carol Simon’s study of the 1933 act. Simon finds that the greatest impact on variance was for the small issues that were not traded on the NYSE.38 One explanation for the smaller effect on NYSE firms, suggested by Simon, is that the NYSE was already providing a standardizing function comparable to that of the SEC. No plausible reason exists to assume that the stock exchanges would not have developed satisfactory uniform practices in the absence of federal legislation. Studies of firms’ voluntary disclosure. The findings that SEC mandates have not produced positive price effects should not, upon reflection, be surprising. Because firms need capital and investors need information, firms have powerful incentives to disclose information if they are to compete successfully for funds against alternative investment opportunities. Consistent with that explanation, numerous studies have found that the quantity and quality of publicly traded firms’ voluntary disclosures, such as earnings forecasts, are positively correlated with the issuance of securities and stock prices.39 In other words, increased voluntary disclosure reduces firms’ cost of capital. In addition, increases in the level of voluntary disclosure, as well as the general quality of disclosure, reduce the stock’s bid-ask spread—the difference between the price at which a market maker purchases and sells a stock, which constitutes the

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RATIONALES FOR SECURITIES REGULATION 27 market maker’s profit—and correspondingly improve the stock’s liquidity.40 Both effects are beneficial for investors and thus lower firms’ cost of capital. Indeed, managers release information voluntarily when there is greater information asymmetry between the firm and investors regarding its value, where asymmetry is measured by the bid-ask spread, so as to reduce that asymmetry and thereby increase the value of the shares.41 In addition, firms with significant levels of intangible assets, for which traditional accounting reports provide inadequate valuation, voluntarily make significantly more supplementary nonaccounting disclosures than firms without such assets.42 Moreover, considerable evidence exists that firms systematically voluntarily disclose significant amounts of information beyond that mandated by securities regulators when accessing capital markets. For example, the disclosure accompanying debt issued in the private placement market duplicates the disclosure of public debt, although it is not required.43 It is possible that those issuers are responding not only to investor desires for more information but also to potential liability under SEC rule 10b-5, which applies to private placements as well as public issues. That could lead the private placement issuers to follow public issue disclosure requirements because precedents involving public securities will set disclosure standards for private issues too.44 But even if meeting investor preferences is not the sole motivation underlying the high level of private debt disclosure, as William Carney has noted, the extraordinary depth of the private market suggests that the SEC regime imposes high costs on issuers, so that they have exited from the regulated public market.45 In addition, European firms listing in London typically comply with U.K. disclosure requirements, which are higher than continental requirements, even though they could instead comply with their home state’s lower-disclosure regime under the European Union directives.46 Moreover, European firms engaging in international-style offerings in the institutional market, which is not subject to formal disclosure requirements, disclose even more information than is required by any European nation.47 Those firms select a level of disclosure closer to U.S. disclosure standards. Consistent with those studies, a review of the accounting

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literature on the disclosure of multinational firms indicates that international capital market pressures result in additional voluntary disclosures (that is, multinational firms listed on more than one market engage in more voluntary disclosures than other firms).48 Finally, the listing requirements of the newly created Neuer Markt in Germany require greater disclosure than the older exchanges, such as the Frankfurt Stock Exchange, and its market has prospered.49 Although the identity of the listings— technology and other growth companies—undoubtedly accounts for part of the exchange’s success, the Neuer Markt is actively engaged in satisfying investor preferences, having, for example, amended its listing requirements when investors raised concerns that listed companies were flouting the exchange’s lockup rules.50 Extensive voluntary disclosure is not a new or unusual phenomenon: as earlier discussed, before the creation of the federal securities laws, NYSE firms disclosed considerable information and provided certified audited financial statements, as businesses had voluntarily been doing for centuries. Moreover, investment analysts assign rankings to firms not simply according to the adequacy of their mandatory disclosure but also according to their voluntary disclosures, a fact of itself indicating that the practice of disclosing more than required is commonplace.51 The private sector also provides significant information concerning valuation beyond mandated SEC disclosures. Financial analysts’ earnings forecasts, for instance, provide information to the market regarding equity valuation beyond firms’ mandated disclosures.52 The data indicate not only that regulators have not divined the optimal mix of disclosure in their mandated regimes, but also that it is difficult to make the case that regulation is necessary because voluntary disclosure practices are woefully inadequate. The international and domestic evidence is overwhelming that firms provide a substantial amount of information to investors regardless of the regulatory regime. Firms persistently engage in greater disclosure than regulators have required. They also do not migrate, when a choice of securities regime is possible, to the regime requiring the least amount of disclosure. Some commentators mistakenly believe that this fact reveals an absence of effective regulatory competition.53 But that is indeed the

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RATIONALES FOR SECURITIES REGULATION 29 essence of regulatory competition: firms will choose the regime that best meets their needs, and that choice will not be the regime requiring the lowest level of disclosure. Underproduction of Information Concerning Interfirm Externalities Frank Easterbrook and Daniel Fischel have suggested that the federal securities laws can be rationalized because of an information failure—but with a twist. If a problem regarding the voluntary production of information about securities exists, it does not, in their view, concern information of interest to the firm’s investors; the firm will optimally produce that information voluntarily. Rather, the problem concerns information that is of value to third parties not investing in the firm—the firms’ competitors, and that information is termed an interfirm externality.54 Merritt Fox has adopted Easterbrook and Fischel’s suggestion to critique regulatory competition for securities law.55 Fox maintains that social welfare requires the disclosure of information concerning interfirm externalities. His premise is that the increased welfare of the disclosing firms’ competitors offsets the lower welfare of the disclosing firms and their investors. Because disclosure is unambiguously bad for the disclosing entity and good for its competitors in Fox’s scenario, firms will not voluntarily disclose such information. That creates a market failure calling for government intervention—by a monopolist regulator—as Fox equates the regime choices under competition with the disclosure choices of firms in an unregulated setting. Fox’s position has three core problems. First, theoretically, the presence of interfirm externalities does not render a mandatory regime optimal compared with a voluntary regime as Fox maintains. Second, in practice, a majority of investors hold diversified portfolios and, therefore, in contrast to issuers, they can internalize the externalities with which Fox is concerned, so that regulatory competition could replicate the results of a single-regulator regime were regulation warranted. Third, even if a theoretical basis for advocating a mandatory disclosure regime because of interfirm externalities existed, that does not imply that a government

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agency could effectively implement such a regime. No evidence exists that the information the SEC requires is of the substantive sort that Fox envisions to be significant for rivals’ competitive position, and, to the contrary, highly suggestive data exist that the SEC, in fact, does not require the disclosure of such information. Mandatory Disclosure Is Not Theoretically Preferred in the Presence of Interfirm Externalities. Economists have modeled disclosure policy in the context in which Easterbrook and Fischel have suggested that a role for mandatory disclosure exists—the situation in which the information to be disclosed involves interfirm externalities.56 Although the two relevant economic models have different assumptions regarding the presence of private information and investor risk aversion, the key result in both models is that mandatory disclosure is not always preferable to, and indeed may well be worse than, voluntary disclosure from the standpoint of social welfare. The first model, by Ronald Dye, considers two types of externalities, financial externalities, where the disclosing firm’s information affects solely investor perceptions of the value of other firms, and real externalities, where the disclosed information affects actual value (that is, cash flows) of other firms.57 The latter type of externalities are the sort of information emphasized by Easterbrook and Fischel and Fox as requiring regulatory intervention. Dye’s model yields the following results. When externalities are financial, voluntary disclosure and optimal mandated disclosures virtually always coincide; when externalities are real, however, firms’ optimal disclosure under a mandatory regime diverges from that under a voluntary one, when entrepreneurs are undiversified. When entrepreneurs are diversified, mandatory and voluntary disclosure policies coincide. The nature of the divergence in firms’ disclosure in the presence of real externalities under mandatory and voluntary disclosure regimes depends on how the specified disclosure affects the returns of other firms as well as that of the disclosing firm. If the firm’s private return from a disclosure is negative while the return to other firms is positive, then mandatory rules increase disclosure; if the situation is reversed and the firm’s private return from a disclosure is positive while the marketwide—other

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RATIONALES FOR SECURITIES REGULATION 31 firms’—return is negative, then disclosure is greater under a voluntary regime. For a mandatory disclosure regime to produce the optimal disclosure level, a regulator must possess a priori knowledge of the relation between private and market returns concerning specified disclosures, for disclosure should be required only when the effect on other firms is positive. That is information that a government regulator cannot possibly know at the time of establishing disclosure policy. It is, moreover, improbable that information involving interfirm externalities always produces positive price effects on competitors—the one scenario in Dye’s model in which mandatory government disclosure will be more effective than a voluntary disclosure system and the scenario that informs Merritt Fox’s critique of competitive federalism for securities regulation, whose disclosure output he equates with a voluntary regime. For example, researchers have identified examples of negative interfirm externalities in cases of product tampering, product liability and recalls, and airplane crashes.58 While the examples of disclosure’s having a negative impact on rivals that have been empirically studied concern information with a negative impact on the disclosing firm as well, other scenarios readily come to mind where the impact on rivals could be negative and that on the disclosing firm positive. A steel products manufacturer can, for instance, announce that it has acquired property on which it plans to build a large production plant that will triple its capacity, which is considered a profitable course of action and positively affects its price as such information deters competitors’ entry or similar expansion into the market. The disclosure thereby also decreases the competitors’ stock price, given the profitability of expansion.59 An extensive economic literature exists on the strategy of firms’ use of credible commitments in the form of sunk costs that expand capacity to limit competition, and the liability rules for fraudulent disclosure under the securities laws materially assist firms in engaging in such a strategy: if the steel manufacturer has no intention of building the plant, it can be sued for substantial damages under the securities laws.60 Although such a disclosure is the epitome of an interfirm externality because it provides critical information to competitors, its release will have an adverse impact on social welfare by reducing competition and thereby raising steel product prices.

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The important theoretical point of Dye’s model, and of providing the above examples of disclosures having negative effects on rival firms, is that the interfirm externality rationale for regulation works only if the externality is positive for all information for all firms. Dye’s model thus highlights the heavy burden Fox’s position would place on a regulator. The regulator has to be able to estimate the impact that information will have on the returns of the disclosing firm and all other firms to implement the optimal mandatory disclosure policy, which would include prohibiting disclosures, such as the plant expansion example, that are of importance to investors but harm competitors. Without question, firms have stronger incentives to disclose voluntarily information that takes the form of a negative, rather than positive, externality. A more refined position than Fox’s position that only positive interfirm externalities exist would be a claim that a mandatory regime cannot solve the negative externality problem (since it cannot prohibit disclosures) but can alleviate the positive externality problem. Such a position is not conceptually satisfactory, however, because if the objective is to maximize social welfare by factoring in the impact of a firm’s disclosures on its competitors, then the regulatory regime must address both positive and negative externalities. That is so because we do not know whether, in the aggregate, positive externalities will outweigh negative externalities with respect to rival firms’ values or the reverse. Thus, the refined position does not avoid the problem with Fox’s rationale for a single-regulator regime that Dye’s model underscores—that it would be extremely difficult for a regulator to fine-tune a disclosure mandate to reveal solely positive externalities. A second model, by Anat Admati and Paul Pfleiderer, in contrast to Dye’s model, assumes that the interfirm externality is always positive, which is consistent with Fox’s claim.61 But that change does not assist Fox’s position because their model also does not lead to the conclusion that mandatory disclosure is always desirable. The core result of the model is that regulation is not always optimal. The level of individual firms’ disclosure when disclosure is voluntary is less than the socially optimal disclosure level when the correlation of firm values is high, which suggests a role for regulation that sets a minimum disclosure level. But

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RATIONALES FOR SECURITIES REGULATION 33 when the correlation in firm values is low, the level of voluntary disclosure does not differ from the social optimum; hence, regulation has no role. Moreover, the result regarding the benefit of regulation when the correlation is high holds unambiguously only when firms are identical— that is, when they are symmetrical in sale value and disclosure cost. If symmetry does not hold, so the costs and benefits of disclosure vary across firms, then while voluntary disclosure is still generally optimal for low correlations and regulation is superior for high correlations, the disclosure requirement must, in fact, be specific to the different firms for regulation to produce a higher level of welfare than voluntary disclosure. That is so because the socially efficient outcome is no disclosure for some firms and disclosure for other firms, depending on their varying disclosure costs. If, as occurs in the real world of SEC regulation, the disclosure standard must be uniform across all firms, because all firms are not identical in the costs and benefits they accrue from disclosure, the SEC’s regulation will not necessarily improve the situation over voluntary disclosure and may, in fact, be unambiguously worse than what occurs in the unregulated context.62 Admati and Pfleiderer also consider an alternative form of government intervention to mandatory disclosure regulation—the provision of uniform cash subsidies to firms, which reduce the cost of disclosure and hence change firms’ incentives to disclose. They provide an example, in the context of firms whose costs and benefits of disclosure are not identical, in which subsidies could move firms to the socially optimal level compared with voluntary disclosure and mandatory disclosure regulation, if the subsidies were chosen appropriately. That is a big if, however. The result does not hold generally, and while in some cases subsidies can improve social welfare, in others they cannot. Admati and Pfleiderer thus conclude that they cannot recommend one form of government intervention over the other. Their nuanced position is sharply at odds with Fox’s claim that interfirm externalities require mandatory disclosure. I have devoted considerable discussion to the results of the formal models that have investigated the choice of disclosure regime in the presence of interfirm externalities. I have not done so because the models

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precisely represent reality; they do not. The modeling issues would become intractable were all institutional complexities introduced. But models that incrementally add complexity invariably increase the ambiguity of the results of simpler models, because the greater the complexity of a model, the more restrictive must the assumptions be to obtain any equilibria, the more likely the model will produce multiple or no equilibria, and hence the less probable it is that the model will be able to generate any determinate policy conclusions. That is what Admati and Pfleiderer found to be the case, for instance, in preliminary efforts to extend their model on only one dimension by conditioning the choice of disclosure on the firm’s value.63 Accordingly, we can draw one conclusion with assurance from the results of the models of disclosure policy in the context of interfirm externalities, and that is the reason for reviewing the models in some detail. That conclusion is that it is inappropriate to assert with any appreciable confidence, particularly with the absolute certainty that commentators such as Fox convey, that government intervention to mandate disclosure to remedy interfirm externalities will maximize social welfare. Diversified Investors and Interfirm Externalities. The majority of investors hold portfolios, not single shares of stock. Indeed, major market players such as the Teachers Insurance and Annuity Association–College Retirement Equities Fund, the California Public Employees Retirement System, and the Vanguard Group of investment funds index significant parts of their portfolios to the Standard & Poor’s 500 and Wilshire 5000 indexes, which include numerous firms in each industry sector of the United States.64 Therefore, unlike an issuer, investors can internalize informational externalities regarding disclosure policy, just as a regulator can. That is, investors who hold portfolios will desire a regime requiring such information’s disclosure because, by the definition of a positive externality, the gain on their shares in the discloser’s competitors will offset the loss on their shares in the disclosing firm. Consequently, a serious analytical problem is inherent in the position that only a government entity with a monopoly over disclosure regulation can internalize the costs and benefits of disclosure involving interfirm

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RATIONALES FOR SECURITIES REGULATION 35 externalities. The source of the error of advocates of that view such as Fox is their exclusive focus on the incentives of issuers rather than on those of investors. In a competitive securities regime, issuers’ choices of their securities domicile are guided by investor preferences. Thus, if disclosure of interfirm externalities is cost-effective so that the gain to rival firms exceeds the cost to the disclosing firm, then diversified investors will desire such disclosures, and the disclosures will be a component of the prevalent securities regime.65 While some investors might overvalue the harm to a disclosing firm compared with the gain to its competitors because cognitive psychology suggests that losses figure more prominently in an individual’s calculus than gains,66 it is implausible that such behavior will prevail in a decision when significant dollars are at stake for such sophisticated repeat players as institutional investors. Moreover, we have no reason to believe that the staff of a single government regulator would make fewer mistakes than sophisticated market participants with substantial wealth at stake in establishing the optimal disclosure system. Finally, we should note that whether investors or an agency internalizes the costs and benefits of interfirm externalities, a further reason exists for why social welfare is not self-evidently maximized with the disclosure of interfirm externalities. The disclosures that are the objective of such a mandatory disclosure regime, information regarding firm-level costs and profit margins, are data that could facilitate collusion and hence anticompetitive behavior among firms. That, of course, is the reason for the long-standing prohibition against firms’ information sharing under the U.S. antitrust regime. Is Disclosure of Interfirm Externalities Practicably Implementable? While it is highly questionable whether interfirm externalities are in theory an appropriate justification for the federal securities regime, the empirical support for that rationale for securities regulation is nonexistent. The SEC’s mandated disclosure does not in practice require firms to disclose private proprietary information such that the released information will significantly assist competitors. Nor can the agency effectively require such disclosure because firms would undoubtedly exit the regulatory

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regime if it adversely affected their competitive position. Those factors render the interfirm externality rationale for securities regulation wholly unworkable and thereby inappropriate as the basis for public policy. For example, express provisions in the SEC’s codified disclosure requirement, Regulation S-K, explicitly exempt firms from disclosing information that would “affect adversely the registrant’s competitive position.”67 If the SEC explicitly excludes such information for the specified items—new products and lines of business—why should we assume that the agency intends or expects the release of other items in the document to have such an impact? It would be more plausible to assume that the SEC does not expect significant proprietary information to be contained in mandated disclosures concerning existing businesses compared with those of new businesses and that where the SEC considers it likely that disclosure could compromise proprietary information, the agency makes explicit that such information does not have to be disclosed. The SEC’s current disclosure practice supports that interpretation of the agency’s view of proprietary information. In its most recent substantive addition to the disclosure requirements of Regulation S-K, the 1997 rules requiring the disclosure of the market risk of firms’ positions in financial derivatives, the SEC adapted its disclosure requirements in response to commentators’ concerns that specific detailed disclosures would reveal proprietary information. Namely, in response to the concern that “competitors, suppliers, and market traders potentially may be able to use the information to exploit the registrants’ positions in the market,” the SEC adopted four provisions that permit the aggregation of the disclosures over instruments and time periods so as to ensure that the “disclosures do not reveal proprietary information.”68 The explicit policy against the disclosure of proprietary information—which is information relevant to the interfirm externalities rationale for a single-regulator regime—suffuses the federal securities laws and not only the specific issuer mandates of Regulation S-K. In particular, money managers are not required to disclose their entire portfolio holdings to protect the proprietary information of their investment strategy under the agency’s established procedure for requesting confidential treatment of such information.69 In addition, under the more general disclosure

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RATIONALES FOR SECURITIES REGULATION 37 standards of the antifraud provisions of the federal securities laws, both the agency and the courts permit firms to abstain from disclosing information that entails significant interfirm externalities, that is, items of substantial importance to competitors, such as a significant mineral lode discovery made by extracting firms,70 and preliminary merger negotiations.71 If the courts and SEC interpreted their mandate to mitigate interfirm externalities, as critics of competition such as Fox assert is the rationale for the agency, then firms would have to provide competitors with the timely disclosure of information useful in assessing rivals’ profitability, and those exclusions would not be a fixture of the securities regime. Indeed, if the purpose of the federal regime was to mitigate interfirm externalities, as opposed to the conventionally understood rationale of protecting investors from firms’ underproduction of information, then the system of civil liability for disclosure violations under the securities laws would be dramatically different. Shareholders of issuers would not have private rights of action, but, rather, competitors who benefit from the externalities that are the ostensible object of mandatory disclosures would have those rights. In addition, an inappropriate agency is administering the statute: the Federal Trade Commission is surely better positioned, given its expertise in administering the antitrust laws, to determine what information would facilitate competition than is the SEC. Besides attempting to divine the SEC’s intentions from the presence or absence of exemptive provisos for disclosure of proprietary information and from a civil liability regime and an administering agency not in conformance with the objective of solving interfirm externalities, we can ascertain whether the agency’s disclosure mandates are solving interfirm externalities by examining the actual disclosure practices of firms, particularly with respect to items that commentators assert reveal information of significant value to rival firms: research and development spending, future capital spending plans, cost ratios, liquidity constraints, backlogs, inventories and sources of supply, and line-of-business or segment reporting.72 An examination of the SEC filings of randomly selected firms’ disclosure of those items indicates that firms disclose virtually no specific information that would be of use to a rival for ascertaining the

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profitability of the industry.73 The disclosures tend to be generic, providing little detail about cost or profit margins. In addition, nothing suggests that a rival could combine those boilerplate disclosures with proprietary information to glean an insight into the profitability of an industry or product line, nor has any advocate of the interfirm externalities rationale for securities regulation provided concrete examples of such use. Where information is provided beyond the standard boilerplate disclosures, the information is of such significance to the firm’s own investors that the firm in practice reveals the information in advance of the SEC’s mandated filing, despite the potential value of the information to competitors. Either the firm independently reveals the information in press releases or financial journalists and analysts report it.74 If SEC filings provide any meaningful competitive information about rivals in the context of the information-intensive activities of financial analysts, arbitrageurs, and other market professionals, as well as competitors’ own information about their business, it is surely not by design. Perhaps advocates of the interfirm externalities rationale for securities regulation would respond to this criticism that important firmspecific information with spillover effects released in advance of SEC filings would not be reported by firms or uncovered by independent sources if the SEC did not mandate its eventual disclosure. But such a contention would not be convincing. Announcements of capital and R&D expenditures, for example, have significantly positive stock price effects.75 Hence, managers have a strong incentive to reveal information about such activities because they benefit from their revelation and do not need a government mandate to prod disclosure. Financial difficulties, on the other hand, as revealed by liquidity constraint disclosures, are not matters that management benefits from revealing, unless the disclosure would indicate that problems are less severe than investors anticipated, as silence is considered bad news. Quite apart from the incentive of managers to reveal information to avoid the adverse inferences that investors draw from silence, market professionals have powerful incentives to uncover adverse information about firms. Moreover, financial difficulties affect third-party relations—dealings with customers, suppliers, and creditors. Hence, the information finds its way into the business press. Before

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RATIONALES FOR SECURITIES REGULATION 39 running up against explicit liquidity constraints, for instance, firms’ troubles are well known and invariably lead to downgrades by bond-rating agencies that are publicized events. Fox’s intuition is undoubtedly correct that detailed information about costs is not likely to be disclosed voluntarily. That is so because investors are interested in predicting a firm’s future cash flows, while competitors are not,76 and information of relevance to competitors will be disclosed only when there is an overlap between the two groups’ information demands, that is, when information that meets investors’ needs coincides with information of use to competitors. Competitors have a pretty good idea regarding rivals’ revenues from their own revenue information, as well as their access to data on market shares, and hence, in contrast to investors, they would benefit from more precise cost, not revenue, disclosure. But for cash flow estimation—the information of interest to investors—greater precision in revenue information serves as well as more precise cost information. Firms can thereby satisfy investors’ disclosure needs in that regard without assisting competitors. According to Fox’s rationale for a mandatory disclosure regime, then, precise cost, rather than revenue, disclosures should be required. That is, however, emphatically not the current regime, which is what Fox claims to be rationalizing, just as it was not the focus of the disclosure changes effected by the 1934 act.77 In 1997, for example, the FASB amended its segment reporting rules, going beyond the SEC’s requirements, so as to render the disclosure more informative but, at odds with Fox’s rationale and consistent with my critique of his position, the mandates were directed at more precise disclosure of revenue, not cost, information.78 Still another reason exists to be skeptical of Fox’s claim that SEC–mandated disclosures reveal important interfirm externalities if we consider his example of the required disclosure of sales by the newly created SEC. Fox’s source, a 1939 law review article by two SEC staff attorneys, states, consistent with his thesis, that firms did not want to disclose sales information because those figures would give competitors an advantage and that originally the agency accepted firms’ proprietary concerns and granted exemptions from disclosure.79 The article goes on to state, however, that the SEC changed the policy when “investigations later

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revealed that in most cases competitors and customers already had obtained the ‘confidential’ information, and that disclosure had little effect upon buying policy.”80 That statement demolishes Fox’s claim regarding the sales data because if the information was available to competitors without its being released in firms’ financial statements, then the SEC– mandated disclosure could hardly be an instance of remediation of interfirm externalities, information that was neither voluntarily produced nor discoverable. Moreover, the article indicates, in direct contradiction of Fox’s hypothesized regulatory rationale, that when the agency believed that disclosure would adversely affect firms’ competitive position, it did not require the disclosure. The line-of-business or segment reporting standards best illustrate the thesis that the interfirm externalities rationale for mandatory disclosure is of no value for the formulation of public policy because the SEC cannot effectively implement such a policy. Those reporting standards, adopted in the late 1960s, have been intensively studied by accountants and economists. Information regarding the profitability of a conglomerate by line of business can be useful to competitors and produce a real cash flow effect and thus meets the definition of an interfirm externality. But the implementation of that reporting requirement under the SEC rules has rendered such an effect impossible. As Edmund Kitch has cogently indicated, under the line-of-business reporting rules, a firm is accorded broad discretion to allocate costs and group activities. Consequently, the rules cannot be expected to lead to any significant disclosure of private information that would benefit competitors.81 Kitch explains the somewhat paradoxical result by contending that it is virtually impossible in practice to implement a disclosure regime that includes proprietary information of the sort of concern to Fox: either firms will not meaningfully disclose the information, or they will delist to avoid disclosure.82 Kitch’s thesis sheds light on the SEC’s implementation of its segment reporting requirement: recognizing the quandary, the agency naturally prefers nonmeaningful disclosures to delistings. The best available data support Kitch’s analysis, rather than Fox’s position. First, the change in the FASB standard for segment accounting in 1997 did not have the expected effect. Although analysts expected

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RATIONALES FOR SECURITIES REGULATION 41 an increase in the number of segments reported by firms that could previously exploit the vagueness of the segment definition by lumping together dissimilar lines, a study of whether the revision lived up to analysts’ expectations found that the new standard was minimally successful in achieving its goal: the rule change resulted in a barely detectable increase in the number of reported segments.83 In addition, firms in more concentrated industries reported a smaller increase (larger decrease) in the number of segments.84 To the extent that firms in less competitive industries are more likely to have monopoly profits, one would expect them to experience a greater competitive disadvantage from detailed segment disclosure. Those findings bolster the cogency of Kitch’s insight and indicate that Fox’s regulatory goal is futile: companies will adapt strategically to disclosure mandates so as not to disclose proprietary information that would adversely affect them. Second, empirical studies of the adoption of segment reporting in the 1960s uniformly show that the practice had no price impact.85 Fox asserts that we should expect that result because some information should affect firms positively and other information should affect firms negatively.86 But that rationalization is at odds with his criticism of Dye’s model and with the basis for his social welfare analysis of disclosure policy, in which he asserts that interfirm externalities are necessarily of one direction—positive. Fox cannot have it both ways. Under Fox’s hypothesis, there should be a negative price effect on disclosing firms because they are releasing proprietary information that will adversely affect their value. Otherwise, they would have voluntarily disclosed the information. If Fox meant instead to contend that the lack of a price effect is due to disclosing firms’ benefiting from rivals’ simultaneous disclosures regarding their lines of business, then, again, his rationalization of the data is inconsistent with his theory of regulation: because under his analysis of interfirm externalities, the gains of competitors are, by definition, greater than the losses of disclosing firms, then there should still be a significant price effect for the portfolio of disclosing firms, albeit a positive, not a negative, one. But there was no price effect, positive or negative. The best explanation of the absence of a price effect is that Fox is incorrect that the segment reporting requirements reveal new information related to interfirm externalities.

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Fox further contends that because some of the studies of segment reporting find a reduction in the variance of returns after the rule was adopted, such disclosures were an example of the information that he defines as remediating interfirm externalities. That contention is incorrect. If a piece of information entails an externality such that it increases competitors’ value at the expense of the disclosing firm, then the disclosure of such information must cause a price effect, not a variance effect. That is the definition of an interfirm externality: it affects the value of other firms. Greater accuracy of pricing does not affect firms’ cash flows. Hence, a reduction in the variance of returns does not indicate that the information released in segment reporting involves interfirm externalities. A reduction in the variance of prices from a disclosure policy can be understood as an effect produced by standardization that enables greater comparability across firms. While that may be a benefit to investors, as earlier discussed, a single regulator is not necessary to achieve standardized disclosure, nor is that Fox’s justification for mandatory disclosure by a single regulator. The need to mandate disclosure of interfirm externalities, as a rationale for securities regulation and for a single regulator, is problematic, then, not only from a theoretical perspective, but also from the viewpoint of what firms actually disclose under the SEC’s requirements. When a theory of regulation—the need to mandate disclosure of information relating to interfirm externalities—cannot be theoretically justified or practicably implemented, then the theory needs to be discarded rather than promoted as the basis for public policy. Protection against Fraud and Manipulation The antifraud rationale for regulation does not depend on the presence of an externality for government action because the activity directly affects the contracting parties—the issuers and investors; no spillover third-party effect exists. Consequently, the antifraud rationale presents even less of an objection to a system of competitive federalism than the mandatory disclosure rationale for interfirm externalities that maintains significant spillover effects exist. Joel Seligman states that a federal antifraud law was

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RATIONALES FOR SECURITIES REGULATION 43 needed in the 1930s because state securities laws did not reach out-ofstate sellers.87 Whatever the merit of the claim at that time, it is not applicable to modern jurisdictional doctrines and is therefore not relevant to today’s policy discussions. Moreover, if in the 1930s there was concern over the states’ capacities to handle securities fraud cases, that is no longer a serious issue. Given the overlapping jurisdictions of the current antifraud regime, the states have developed active securities law enforcement divisions and coordinating capacities to combat interstate fraud that include coordinating the regulation of electronic offerings on the Internet.88 Indeed, the Internet will facilitate state enforcement efforts, as it has for the SEC, as state securities regulators’ Web sites will offer an inexpensive means of communication of complaints by nonresident investors, and perpetrators of fraud over the Internet, who leave electronic trails, will continue to prove to be quick to catch.89 And at least one state—New York—has undertaken high-profile securities fraud investigations before the SEC has acted.90 The federal antifraud laws have not been a focus of as much empirical research as the federal disclosure regime. But even there we find little evidence that federal, as opposed to state, securities laws are necessary to protect investors from fraud and manipulation. In truth, the data that would be probative of the efficacy of the federal antifraud regime have not been compiled. Because all states had antifraud statutes before the adoption of the federal securities laws, and only Nevada did not have an administrative entity to investigate securities fraud at that time,91 an investigation of whether reported instances of investor fraud decreased after the enactment of federal securities laws would be a useful step in determining the efficacy of the federal regime. The difficulty, however, of establishing a preenactment baseline rate—given differences in enforcement regimes across states, for example—most probably renders the task infeasible. Other probative research would examine whether securities issued outside the SEC’s jurisdiction—intrastate issues of small firms, state and local government securities, or foreign issues—have higher frequencies of fraud and price manipulation than SEC–registered securities, although, again, developing good estimates of comparative base-rate frequencies would be difficult, if not insurmountable.

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Citing SEC testimony to Congress in the 1940s and a 1963 SEC study as part of the agency’s twenty-year effort to expand its jurisdiction over small firms, Seligman asserts that the SEC initiated more fraud investigations against issues exempt from federal registration requirements than against those that were registered.92 Those data are, in fact, of little import on the question whether the SEC’s monopoly over securities regulation is necessary. First, we do not know whether the SEC allocated more resources to investigating exempt issues than to investigating registered issues, an altogether plausible possibility given the SEC’s agenda at the time— extending its disclosure requirements to small firms exempt from its regulation. Such an enforcement policy would make it impossible to draw any conclusion concerning relative rates of fraud from the data. And, of course, the initiation of an investigation does not mean that fraud actually occurred. Second, it is important to ascertain the level of state antifraud activity against such issuers to determine whether federal intervention was necessary. Third, even if one accepted Seligman’s contention that securities frauds went undeterred by the states and necessitated the enactment of the federal laws, it would be important to determine whether fraud occurred more frequently in small rather than large firms. Such a finding would indicate that the lower rate of fraud investigations for firms covered by the federal law would not be a function of the mandatory disclosure regime, but of the population’s lower underlying occurrence rate of fraud. But the evidence supporting the core contention that pervasive fraud necessitated the federal laws is itself quite thin. After reviewing the legislative record and other sources, Benston concludes, in contrast to Seligman, that scant evidence exists of fraudulent financial statements before the 1934 act.93 Harold Bierman also reviewed the evidence concerning stock market fraud and manipulation before the 1929 crash. He scrutinized in particular the sensational charges raised against several prominent financiers in the congressional hearings that led to the federal securities legislation. Bierman concludes that the hearings and the prosecutions in their aftermath did not uncover fraudulent or dishonest behavior on Wall Street and that the amount of manipulation in the 1920s was “surprisingly small.”94 More important, an empirical study by Paul Mahoney of the operation of stock pools that were a principal

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RATIONALES FOR SECURITIES REGULATION 45 focus of the congressional investigation into Wall Street and were the justification for the enactment of the federal securities laws finds no evidence that the pools manipulated stock prices: the pattern of price changes was unrelated to pool trading and to what we would expect were the pools manipulating prices.95 In short, a fair reading of the literature on the effects of the federal securities laws points to an expanding regulatory apparatus without a discernible theoretical or empirical foundation. A competitive regulatory system would put such a characterization to the test, as firms would be able to seek out the securities regime investors prefer. The Essence of Competitive Federalism Competitive federalism applied to securities regulation consists of two significant departures from current law. First, a public corporation’s coverage under the national securities laws must be optional rather than mandatory. Second, the securities transactions of a corporation that elects not to be covered by the federal securities laws are to be regulated by the corporation’s selected domicile for securities regulation. The approach is premised on the idea that competition among sovereigns—including the fifty states, the District of Columbia, the federal government (represented by the SEC), or even foreign nations—in the production of securities laws would benefit investors in public corporations by facilitating the adoption of regulation aligned with investors’ preferences, as has been true of the competitive production of corporation codes. The motivation for the proposal is that no government entity can know better than market participants what regulations are in their interest, particularly as firms’ requirements are continually changing with shifting financial market conditions. Competing regulators would make fewer policy mistakes than a single regulator as competition harnesses the incentives of the market to regulatory institutions. Regulatory competition is desirable because when the choice of investments includes variation in legal regimes, promoters of firms will be able to select the regime that investors most prefer. In competitive capital markets, issuers of securities have incentives to select regulatory regimes

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that protect investors from exploitation by insiders because such choices lower the cost of capital. Informed investors will pay less for shares, or require a higher return, if they consider a securities regime’s provisions inadequate for protecting their interests. Investors set the price because financial capital is highly mobile and financial markets are highly competitive: the set of investment opportunities is extensive and, with the use of derivatives, virtually limitless. Even if individual investors are poorly informed regarding what level of disclosure or other protective mechanisms are necessary, because the distribution of equity returns is prorated by share ownership and there is one price for shares, informed institutional investors will dictate the regulatory choices of issuers, and less informed investors will thereby also be protected.96 We have no reason to assume that a conflict exists between the informational requirements of institutional and individual investors that will put individuals at a disadvantage under regulatory competition. Institutional investors rely on public information97 and prefer more to less disclosure. For example, in the private debt market, in which the SEC permits lower disclosure than for public issues because that debt is restricted to sophisticated (institutional and wealthy individual) investors, such investors demand disclosure of far more than is required—of an amount almost equal to what is required in the public debt market.98 Similarly, in the European equity issues market, the level of disclosure for international-style offerings whose purchase is limited to institutional investors is higher than the disclosure required by European countries.99 Those examples suggest that it is highly improbable that the demand for public disclosure of information by institutional investors will decrease under regulatory competition and place individual investors at a trading disadvantage. It is, moreover, reasonable to assume that investors are informed about liability rules, given the sophistication of the institutional investors who comprise the majority of stock market investors and whose actions determine market prices on which less informed investors rely. For instance, capital markets price contract terms that protect investor interests: Creditor protection provisions in bond indentures are positively priced,100 and firms experience statistically significant positive changes in

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RATIONALES FOR SECURITIES REGULATION 47 stock prices upon changing their incorporation state.101 In addition, for new public offerings, the choice of statutory domicile is of interest to underwriters, who must be responsive to their repeat institutional customers as well as to issuers, and it is therefore entirely plausible to assume that the choice of securities regime will be of equal concern to them, and thus they will protect investors’ interest.102 Finally, nations whose legal regimes offer greater shareholder protections have thicker capital markets, and the discount for nonvoting shares is far less.103 Promoters will thus bear the cost of operating under a legal regime inimical to investor preferences, and they will therefore select the regime that maximizes the joint welfare of promoters and investors. In the context of sophisticated consumers of securities laws, providing issuers with a choice of regulatory regimes—a market—is a superior mechanism to a single regulator for ascertaining what information disclosure (or liability regime) is in investors’ interest, that is, the information that satisfies a cost-benefit calculation. That is so because a net flow of capital will go to firms operating under the regimes investors prefer; hence regulators will have a feedback mechanism for ascertaining which rules are cost-effective. The entrepreneurial motivation to reduce capital costs that operates in a competitive legal system mitigates the otherwise core problem for a government regulator of identifying what regulation will benefit investors in capital markets. Investors do not have to value perfectly differences across regimes for competitive federalism to be effective; as long as they can correctly price regimes in relation to each other, they will direct promoters, and therefore regulators, to seek out the valuemaximizing regime. To establish competitive federalism for securities regulation, all restrictions on regime choice must, accordingly, be eliminated. That entails enabling issuers and investors to choose their regulator independent of firm or investor residence or securities transaction location. The central proposition is this: government authorities will be subject to meaningful competitive pressure only when parties to a securities transaction are able to select their regulatory regime without restriction. In such circumstances, if firms and investors find a particular regulatory regime burdensome or ineffective, they can easily switch to another one.

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COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Benefits of a Competitive Securities Regime

Regulatory competition subjects government agencies to fluctuating inflows and outflows of regulated entities, as firms transfer their activities to come under the jurisdiction of the regulator whose regime they prefer. Such competition is desirable because it reduces the possibility that a regulator will be able to transfer wealth across different regulated entities or redistribute wealth from the regulated sector to preferred individuals or organizations.104 The SEC, for instance, has historically been a source of wealth transfers across constituents, the most notable example being its long-standing acceptance of fixed commission rates, which benefited individual investors and exchange members at the expense of institutional investors.105 Firms’ ability to engage in regulatory arbitrage and switch regulators to a lower cost regime in a competitive regulatory environment restricts regulators’ ability to engage in such implicit taxation. Regulatory competition also more quickly corrects for policy mistakes than can a single regulator because, as with any competitive market, a built-in self-correcting mechanism exists as the actions of numerous actors aggregate information more efficiently. In particular, the flow of firms and investors into and out of different regulatory regimes provides information concerning which rules investors consider to be more desirable; that is an instance of the concept from consumer demand theory referred to as “revealed preference.”106 When two products are both available for purchase (that is, affordable) to a consumer, the consumer’s choice is an indication that the utility he obtains from the selected product is greater than that he would have obtained from the product that was not selected. Thus, observed choices are evidence of unobservable preferences. The transaction flows evincing such choices provide a feedback mechanism to regulators regarding the efficacy of their regime. Under the plausible assumption that regulators prefer to have within their jurisdiction more rather than fewer regulated firms and transactions,107 when regulators find that their jurisdiction is subject to a net outflow, they will reassess their regulatory regime so as to stem the decline in their jurisdictional sphere.

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RATIONALES FOR SECURITIES REGULATION 49 In addition, we can expect regulatory competition to foster innovation, as the feedback mechanism of interjurisdictional flows that reduces the possibility of regulatory error also provides an incentive for regulators to improve their regimes.108 Further feeding back into that process, when the choice of jurisdiction is restricted to products meeting particular criteria, regulated firms have incentives to devise new products to come under the preferred regulator. In the United States, where there has been regulatory competition, innovation in financial products,109 institutional practices,110 and legal rules has been significant.111 Indeed, the SEC has eliminated specific disclosure requirements where it has encountered competition—registrations of foreign equity issues and domestic debt issues (the Eurobond market)—but not where it has exclusive jurisdiction—domestic equity issues.112 Finally, if the differences in firm characteristics are so significant that the most suitable regulatory regime differs considerably across firms, then when firms and investors can choose their regulatory regime, they can select the more appropriate one.113 Alternatives to competition to achieve regulatory diversity exist: for example, although the federal securities regime today consists of mandatory rules, which offer no appreciable diversity for public issuers, a shift to an enabling regime could result in firms’ opting out of the default regime and could indirectly produce regulatory diversity. Jurisdictional competition would, however, be preferable to a single regulator with an enabling regime. First, it could reduce issuer transaction costs. If significant diversity in regulation were desirable, many firms would opt out of the single regulator’s default regime. With multiple regulators, each could offer a different regulatory package, and firms could adopt one of those packages rather than have to craft their own. That is not a preclusive consideration, however, because a single regulator could offer a menu of default regimes from which issuers could choose, and in such a scenario transaction costs might not be appreciably higher. Second, if the optimal regulatory mix consists of some mandatory and some enabling components, a single regulator would have greater difficulty ascertaining the optimal mix compared with a competitive regime, in which issuer choices across regime packages provide a ready and

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reliable source of information concerning investor preferences.114 Again, a single regulator adopting a menu of regimes could achieve diversity of regime choice. But it is problematic whether such an agency would be subject to the same feedback mechanism of firm inflows and outflows that facilitates identifying the desirable amount of regime diversity by competing sovereigns. Since all firms are under the single regulator’s jurisdiction regardless of the number of choices offered, the single regulator has less of an incentive to be as responsive to changing business conditions in devising alternative regime choices than competing regulators, who can increase the number of regulated entities under their jurisdictional reach by innovation. The potential need for regulatory diversity as a justification for facilitating competition in securities regulation, as is true of most arguments in its favor, is also an argument against regulators’ top-down efforts to effect regulatory harmonization.115 In fact, if issuers and investors do not prefer substantial regulatory diversity, then competition will produce uniform regulatory outcomes without a need for governmental agreements mandating harmonization. Considerable uniformity exists across state corporate law, for instance, notwithstanding the competition for corporate charters.116 The great benefit of uniformity produced by regulatory competition is that it derives from the bottom up instead of being imposed from the top down. Uniform regulatory standards that are a result of the choices of issuers and investors are more likely to maximize share value, since that is the selectors’ criterion, than are those produced by coordinating regulators, whose negotiations may be entangled with the accomplishment of a variety of nonfinancial objectives. Should Initial Offerings and Secondary Trading Markets Be Distinguished? All the benefits from regulatory competition apply, and hence my proposal applies, equally to new and existing issues. Some commentators have suggested instead that secondary trading should be distinguished from initial public offerings when advocating issuer choice of securities regime.117 The rationale for such a distinction is that managers can be less

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RATIONALES FOR SECURITIES REGULATION 51 responsive to investor preferences in secondary trading markets when they are not directly raising capital and hence do not bear an immediate cost from a lax disclosure policy. The distinction is, however, in my judgment, unfounded. Incentives exist for managers to respond to investor preferences concerning information production in secondary markets that parallel the incentive motivating disclosure in new-issue markets, a higher stock price. For instance, firms that do not satisfy institutional investors’ preferences regarding information disclosure may be subject to large-scale selling by those investors that could depress the firm’s stock price and thereby attract a hostile takeover bid or subject to pressure from the proxy activism of nonselling indexed investors. Because either of those alternatives makes managers’ lives uncomfortable, managers will seek to avoid those scenarios at the outset by maintaining desirable disclosure policies. In addition, compensation packages can be structured to induce managers to increase disclosure whether or not the firm is in the market for new capital.118 If analogous incentives did not exist in the primary and secondary trading markets, then the previously discussed empirical research on disclosure practices would not indicate that firms improve their disclosures to affect trading in both markets: managers increase disclosures not only before a new issue to increase the offering price but also when the bid-ask spread is large in the secondary trading market to improve the shares’ liquidity.119 Indeed, a study examining which firms increase their voluntary disclosures (provision of quarterly segment disclosures) found that the firms that changed their disclosure policy had experienced a decline in liquidity and an increase in information asymmetry (measured by analysts’ consensus) during the two years before the change, but they did not have a higher propensity to access capital markets, compared with nondisclosers.120 Finally, because accounting choices are “sticky”—firms voluntarily increasing financial disclosures, for instance, do not in subsequent years abandon the provision of the additional information—a publicly traded firm that increases its disclosure before a new equity offering will tend to maintain that level of disclosure even if it does not enter the capital market again thereafter.121 It is also a mistake to distinguish across the disclosure regimes in secondary and initial trading markets under regulatory competition

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because the investors who direct the choice of the IPO regime will be aware that the same regulator’s ongoing disclosure policy will apply to the firm. Consequently, the choice of the ongoing disclosure regime will be embedded in the choice of the regime for the IPO. The incentives informing issuers’ choice of disclosure policy are thereby indistinguishable across the primary and secondary markets: if firms issue new shares under a regime that has inadequate continuous disclosure requirements, they will receive a lower price (the cost of capital will be higher) for those shares. Only if IPO purchasers flip the shares (that is, immediately sell their IPO allotment upon receipt) and do not trade IPO firms’ shares in secondary markets and, at the same time, the buyers of the flipped shares are uninformed about the issuer’s disclosure regime would there then be no discount for IPO shares registered under an inadequate continuing disclosure regime and a distinction between the markets possibly warranted regarding the reach of regulatory competition. But the dominance in secondary markets of institutional investors, who are also the dominant players in the IPO market and the most favored investors for obtaining allotments to flip,122 renders implausible a scenario in which market segmentation would result in the absence of a discount for IPO shares subject to an inadequate ongoing disclosure regime. Ekkehart Boehmer and Raymond Fishe, for example, develop and provide empirical support for a model, in which underwriters encourage some flipping to create a liquid secondary market for the IPO, to explain the well-documented phenomenon of IPO underpricing.123 In the model the underwriters, who become informed of investors’ demand for the issue during the IPO book-building process, ration the IPO shares largely because of the SEC’s restrictions on price adjustments. Flippers, who are low valuation investors, profit by immediately selling their allotment to the higher valuation aftermarket investors who have not received their desired allotment of shares. The model does not depend on an IPO investor’s always being a low valuation investor, that is for flippers to restrict their trading to the IPO market, and no evidence exists that segmentation actually occurs across markets and institutional investors to raise concern regarding the efficacy of regulatory competition in secondary trading markets. Moreover, a study of actual flipping practices finds

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RATIONALES FOR SECURITIES REGULATION 53 that on average flipping accounts for only 15 percent of shares offered (19 percent of trading volume) over the first two days of trading, a finding indicating that most institutional investors’ allocations are not flipped.124 What Are the Implications of the Collapse of Enron? In the fall of 2001, U.S. markets were roiled by the sudden collapse of the Enron Corporation, a high-profile energy trading and distribution firm, in a scandal involving self-interested transactions between off-balance-sheet, special-purpose entities created by Enron and entities controlled by Enron’s chief financial officer as well as apparent accounting fraud regarding the transactions.125 Only a year earlier, Enron had been the seventh largest U.S. company as measured by market capitalization. Along with the firm’s sudden collapse were revelations that executives had cashed out substantial option positions before the bankruptcy, while employees who had chosen to invest their pensions solely in Enron stock were subject to restrictions on transactions.126 Moreover, because Enron had been an active contributor primarily to the campaigns of President George W. Bush and many Republican officeholders, in conjunction with the human-interest story of the pensioners, the firm’s seemingly overnight failure captured the investigatory attention of Congress and generated a media frenzy. Long-standing advocates of a variety of policy reforms sought to capitalize on the scandal as a means to propel their proposals to the top of the legislative agenda. Demands for wide-ranging reform to prevent a future “Enron” have included proposals to change campaign finance laws, pension laws, insider trading regulation, regulation of stock options, and disclosure requirements, to reverse the 1995 reform of private securities litigation, and to increase regulation of the accounting profession.127 In addition, some commentators pointed to Enron’s sudden collapse as evidence that the U.S. capital market is inefficient. They contended that if the market had been efficient, investors would have recognized that Enron’s auditor was not a credible certifier of its financial statements, or they would have “seen through” the false financial statements and discounted the price accordingly.128 Such contentions, however, are a misconception of what it means for a market to be efficient. According to the

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form of the efficient market hypothesis to which most financial economists subscribe, prices incorporate all publicly available information, such that investors cannot earn abnormal profits from trading on public information.129 An efficient market is neither omniscient nor fraud-proof: the accuracy of prices in such a market depends on the assimilation by investors of public, not private, information. Investors could not have ascertained that Enron’s auditor, Arthur Andersen, was either willfully or negligently permitting Enron to misrepresent its financial reports and thus could not have reduced the stock price to zero years before the accounting misrepresentation was publicly revealed. The information concerning the misrepresentations in Enron’s accounts was private—it was known only by insiders at Enron and possibly Andersen. Accounting firms audit hundreds of companies every year; if accounting fraud is subsequently uncovered at one such firm, it would not make sense for investors to conclude that all other firms with relatively high stock prices that had been audited by the accounting firm of the failed entity were also engaging in fraud. Similarly, the fact that investors did not “see through” the fraud in Enron’s financial statements is not evidence against the efficient market hypothesis. The theory of efficient markets asserts that investors see through known accounting choices that affect reported but not actual cash flows. Empirical data confirm that firms that engage in cosmetic changes in accounting methods do not increase their value, while firms that change accounting methods that lower reported earnings but increase cash flows because of the new method’s favorable tax effect do increase value.130 That type of accounting activity is decidedly not what was the problem with Enron’s accounting practices—the firm appears to have been deliberately falsely reporting (inflating) its cash flow, an act facilitated by minimal disclosure concerning its relations with its many affiliates and special-purpose entities. The failure of all of the firm’s corporate governance mechanisms— top management, outside directors, and outside professionals—as well as of the securities regulatory regime to have prevented, or at least to have uncovered at an earlier point in time, the apparent large-scale fraud regarding Enron’s financial position would appear to many observers to suggest a need to increase the regulatory authority of the SEC. Such a conclusion, in my judgment, would be mistaken, as it misses the central

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RATIONALES FOR SECURITIES REGULATION 55 lesson to be drawn from the scandal. If a lesson is to be gleaned from Enron, that lesson suggests the opposite by clarifying why there is a need for regulatory competition. The first lesson to be learned from Enron involves the axiom that no system is foolproof. As earlier mentioned, in the case of Enron all controls failed. But one must note that Enron is only one of a list of spectacular failures of public corporations, and no doubt Enron will not be the last.131 And it also has all of the indicia of conventional accounting fraud—overstatement of revenues and underreporting of losses, which were hidden from the corporate outsiders (although possibly not from the outside auditor), activities facilitated by a complex organizational structure with hundreds of affiliates and special-purpose entities and exacerbated by some key officers’ conflicted interests. The principal response to fraud is punishment after the fact for the purpose of deterring others. It is probable that individuals at the top of Enron’s management and possibly its auditor will serve prison sentences, although that is, of course, not of much consolation to the Enron investors and creditors whose losses will not be fully compensated. But it would be folly to expect government regulation to deter all fraud. Accordingly, a key issue for whether any adverse inference regarding the efficacy of competitive federalism can be drawn from the collapse of Enron under a singleregulator system requires consideration of the principal source of the fraud, or more precisely, of the source of the opportunity for fraud, which in my judgment is, at its core, a function of limitations in contemporary financial accounting. Namely, the critical factor in Enron’s demise was an accounting failure that is altogether different in kind from the debate over whether the SEC has exerted sufficient control over the accounting profession, such as its failure to prohibit consulting by auditors,132 or the corporate governance debate over whether Enron’s directors were sufficiently independent.133 The accounting failure involves, instead, a mismatch between what accounting is meant to accomplish and does best and the environment in which the modern business corporation operates. The SEC and many policymakers have not acknowledged the deep and troubling problem, and it has no self-evident solution.

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Accounting is a system of measurement, and at its core it has been motivated by a principle of conservatism in accounting for income, which errs on the side of accelerating the booking of expenses as opposed to revenue, and in accounting for assets, which conceptualizes the most reliable means of measuring firm value as the recording of corporate assets and liabilities at their historical cost. Such a bookkeeping system was one of the great business innovations and has worked reasonably well for traditional manufacturing firms, whose assets consist of factories and equipment. But contemporary businesses, such as Enron, hold significant intangible assets, the measurement of value for which accounting standards have not been well developed and, hence, which are not included on the balance sheet. Accounting for such assets is problematic because objective prices are not available for intangible assets—they do not trade in organized markets.134 Moreover, modern businesses, exemplified by Enron’s activities, increasingly use financial derivatives to hedge or speculate on future cash flows, transaction functions that have no connection to a historical cost-based approach to measurement. Not only are market prices unavailable for many derivatives, but accounting’s historical cost perspective is simply inapt for such forward-looking transactions. In that regard, accounting is in the midst of an intellectual crisis, and to some thoughtful observers no clear-cut solution exists. The SEC has not been as proactive in prodding development of reporting standards for the new business environment, such as improved reporting of intangible assets,135 as the agency has been with respect to other accounting matters, such as the hypothesized conflicts of interest of accounting firms that are thought to affect the independence of the auditor. That inaction may well be related to the agency’s long-standing view that “nonobjective” (non-cost-based) measures of value permit insiders to inflate firm value, an attitude that undergirded the agency’s opposition to management disclosure of earnings forecasts, notwithstanding the crucial importance of such information to investors.136 Modern finance and economic theory have only magnified the limitations of accounting. Those disciplines emphasize that future cash flows and not historical cost are what matter to investors, and hence those disciplines view accounting as largely irrelevant for valuation.137 Accordingly, it is not

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RATIONALES FOR SECURITIES REGULATION 57 surprising that investors tend to focus more on financial analysts’ forecasts than on accounting information. It would be altogether plausible to infer that accountants, influenced by such a critical intellectual environment, have become less attached to the importance of adhering to the principle of conservatism. Moreover, as a result of accounting’s difficulties in keeping pace with new, increasingly more complex business transactions, accounting standards devised under the shadow of the SEC have devolved into a set of highly detailed rules, rather than general principles, for handling specific transactions. Some commentators explain the development of detailed rules under the FASB as a function of corporations’ greater liability under the federal securities laws compared with other nations’ securities regimes.138 Roman Weil contends that this rule-based approach has resulted in aggressive accounting by managers and an inability for outside auditors to constrain them, since the auditor can no longer “appeal to first principles of accounting” to challenge a manager’s choice that is not covered by a specific accounting rule when the manager says, “Show me where it says I can’t [undertake the transaction].”139 That scenario, no doubt, aids in understanding some of the personal dynamics between Enron and its outside auditor (or between Enron’s outside auditor’s account manager and the senior partners of his firm). The combination of a sharp decline in the intellectual coherence of accounting principles, dramatic changes in standard business operations, and a concomitant trend to greater specificity in transactional accounting rules not only has made financial statements increasingly complicated and opaque but also has reduced the ability of auditors to exercise prudential authority over their clients’ transactions. That is the second important lesson of Enron. The London-based International Accounting Standards Board, an independent accounting standard setter with members from nine countries, is the principal competitor of the FASB in promoting its standards globally for cross-border listings. By 2005 all publicly listed European Union companies must meet the IASB’s standards. In contrast to the FASB, the IASB emphasizes general principles over specific rules.140 Thus, rather than focus on whether a transaction complies with a specific rule for accounting purposes, the auditor operating under IASB standards must consider whether the presentation is fair. Although U.S. auditors also must certify that financial

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statements present a fair snapshot of the corporation’s financial position, the conventional view is that a transaction that complies with specific rules meets a fair presentation standard, even though the situation, as in the context of many of Enron’s transactions, when viewed more broadly, would suggest otherwise. In addition, IASB standards are more restrictive of special-purpose entities and require a subjective assessment of effective control (a concept the FASB has been considering), which is thought to render it easier for an auditor to insist on consolidation of accounts. It should further be noted that the domestic accounting standards of the major capital market outside New York—London—are closer to the IASB than the FASB approach: the United Kingdom’s Accounting Standards Board requires the reporting of the substance of a transaction, regardless of its legal form. Given the differences in reporting requirements between the FASB and the IASB, the fallout from Enron has led some to propose that the United States shift toward the IASB approach.141 But whether the one approach is superior to the other for all transactions and circumstances is very much an open question. In my judgment, the most prudent response to Enron, given the substantial ambiguity in what is the best course of action to follow, is to open up the choice of accounting standards to competition. This book is not the place for development of that position, which others have advanced in detail.142 But that position strongly implies that instead of consolidating the SEC’s authority over accounting regulation, an even greater reason exists to promote competitive federalism after Enron. That is so because such a regime would encourage competition in the choice of accounting standards, as different regulators have opted for different standards, and under competition some regulators might go even further and permit firms to select either the FASB or the IASB standards. By such a mechanism, regulatory competition would provide information over time regarding which approach to accounting standards is preferable and would facilitate innovation in reporting.143 A final point to be made regarding the Enron debacle also underscores the absence of a need for greater consolidation of regulatory authority in the SEC. Events after Enron have vividly demonstrated the powerful self-correcting character of markets. The initial market response was felt by Enron itself. As soon as investors became aware of Enron’s potential problems—the proposed restatement of earnings involving only

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RATIONALES FOR SECURITIES REGULATION 59 one special-purpose entity transaction—Enron’s stock plummeted, and the firm was pushed into bankruptcy in a remarkable display of investors’ loss of confidence in management. Although the reduction in revenue upon the restatement was substantial, it was not large enough to suggest that the company was insolvent or close to insolvency. Enron’s insolvency has thus been characterized as a proverbial “run on the bank,” in which creditors lose confidence and call in their loans, a move that causes a liquidity crisis that pushes the debtor into bankruptcy.144 Next, and more important, almost immediately following the revelation of Enron’s restatement of its financial statements because of improper accounting for transactions with special-purpose entities, investors heavily discounted the stock of firms with balance sheets thought to be similarly opaque. In response to such discipline by financial markets, corporations by the scores began to disclose voluntarily additional information on their off-balance-sheet transactions. GE’s annual report, for example, ran to almost 100 pages, as management expanded disclosure practices to include 30 percent more financial information than in the prior year, including a new section detailing off-balance-sheet (special-purposeentity) transactions.145 The Williams Company, a natural gas production and pipeline company whose stock suffered from an “Enron effect,” issued an annual report of over 1,000 pages, three times longer than the prior year’s report.146 One firm even restructured a planned transaction to include it on its balance sheet.147 In addition, reputational injury suffered by the outside directors of Enron, who not only were grilled and ridiculed by congressional committees and castigated in the media but also were forced off other boards on which they served, including the boards of nonprofit organizations,148 was indelibly etched into the minds of directors throughout the country. Corporate directors experienced a wake-up call to check that their own firms’ governance and accounting controls were functioning. That resulted in outside directors’ asking harder questions about transactions, internal controls, and risk management strategies of the insiders and accountants and led to firms’ increased disclosures in post-Enron annual reports. A survey of directors by the National Association of Corporate Directors and the Institute of Internal Auditors on January 31, 2002,

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found that 55 percent had already questioned their auditors and management about risks similar to those discovered at Enron, and about half stated that off-balance-sheet transactions (and the adequacy of external auditing) were on the agenda for the next audit committee meeting.149 Indeed, in reaction to the plausible concern that even the most diligent outsiders may not be able to ferret out fraud by insiders, corporations have reported difficulty in attracting outside directors in the wake of the Enron scandal. Recruitment problems have particularly affected younger and smaller-scale entities, where the reputational and financial benefits of a directorship are far less while the risk of corporate failure is greater than for blue-chip corporations.150 The disciplining of corporations by the market after Enron is not a unique phenomenon but a ubiquitous feature of developed capital markets. Researchers have found that the market punishes firms far more severely than do government agencies for engaging in criminal conduct: Jonathan Karpoff and John Lott have documented the importance of reputational costs imposed on defendant corporations. They estimate that criminal restitution, civil penalties, and court costs comprise only about 7 percent of the shareholder wealth loss on the announcement of government investigations and prosecutions of criminal actions.151 In addition, Cindy Alexander shows that corporations committing related-party crime (that is, contract fraud) experience significant reputational losses (stock price declines). She provides one reason for that observation: in 57 percent of the cases, customer dealings were suspended or terminated.152 Finally, the reputational costs of corporate crime appear to be specific. In a study comparing the stock price effects of corporate fraud with those of crimes referred to as malum prohibitum crimes—that is, crimes that have negligible effect on parties in contractual relations with the firm, such as tax evasion, money laundering, and currency reporting violations— Michael Block finds significant negative price effects only for the fraud cases.153 The self-correcting market mechanism relating to reputational failure—the third lesson to be drawn from Enron—is not restricted to corporations and their directors, however. Professional firms are experiencing the same wake-up call as outside directors, upon the meltdown in

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RATIONALES FOR SECURITIES REGULATION 61 Enron’s wake of its auditor, Arthur Andersen.154 The number of restatements of corporate reports mushroomed after Enron, and this is without doubt a function of auditors’, and not simply directors’, scrutiny to ensure that their firms are not at the center of the next accounting scandal. In brief, no accounting firm wants to share Andersen’s fate, which means that those organizations’ headquarters or central offices will pay closer attention to the activities of their branches and that individual partners will scrutinize their clients’ transactions more carefully, both of which practices were inadequate at Andersen. Moreover, even accounting rulemakers have been affected by the market’s wrath. Taking heed in the recriminatory aftermath, the FASB announced that it would tighten the rules for special-purpose entities, with an expected time frame for rulemaking of several months, in contrast to the two-decade interval over which the board struggled to develop the current regime on entity consolidation.155 The pattern of rapid behavioral and procedural adjustment by market participants in the fallout from Enron’s collapse is a powerful indicator that increasing the regulatory authority of the SEC is not the sole or even a primary mechanism for deterring corporate fraud. To the contrary, the agency has even at times been a hindrance to addressing core problems, as it has been a laggard in recognizing the most serious deficiencies in accounting and has instead expended its efforts on formal organizational issues, such as the separation of consulting and auditing practices, even though data do not exist to support the belief that consulting fees are the reason for independent auditors’ failure to exercise judgment or the source of accounting fraud.156 Given that the crux of the problem at the heart of the Enron scandal lies in the need to reconceptualize an outdated accounting apparatus, the proper question for assessing regulatory competition after Enron involves a comparison of potential costs and benefits. We must ask whether the incidence of fraud will increase under competition compared with the current single-regulator regime such that the costs of increased fraud would exceed the substantial benefits investors and firms would realize from the ability of competing regulators to respond more quickly and agilely to changing investor informational needs and to foster experimentation that aids in ascertaining superior rules or standards. The answer, as

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should be evident from the discussion in this chapter regarding the justification of the SEC’s exclusive regime, and as developed further in the remaining chapters, is no. We have no reason to expect competing regulators to approve accounting standards inferior to those that the SEC has approved and, indeed, good reason to expect those regulators to provide a superior product.

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3 State Competition for Corporate Charters

The data casting doubt on the value added by the current securities regime suggest that it would be worthwhile to consider an alternative regulatory approach such as competitive federalism. Finding fault with such a suggestion, some commentators maintain that a competitive regulatory setting will do a worse job than the Securities and Exchange Commission in furthering the investor-protection goals of securities regulation. To support such a claim, critics of competition maintain that states will engage in a “race to the bottom,” by which they mean that states will cater to managers and enact rules that favor the interest of insiders over investors.1 Information concerning firms’ voluntary disclosure choices provides insight into what a competitive securities regime would look like and suggests that such criticism is misplaced. But it is, at best, still very much only an educated guess. There is, however, one context in which firms can and do choose their legal regime without restriction: the choice of corporate law in the United States. The rules governing relations between managers and shareholders are within the jurisdiction of the states, and the state recognized with jurisdictional authority over a firm is its chosen statutory domicile. The experience of investors under such a regime is instructive for the prospect of competition among securities regulators. That is so because the interests and incentives in the two settings are similar: the object of protection of both regimes is the financial interest of investors, and under competition, investors’ preferences will dictate the choice of regulator because insiders who require investment capital will bear the higher capital cost of an investor-unfriendly regime choice. A body of research has addressed whether state competition for charters in the United States improves shareholder welfare. That literature, in my judgment, indicates 63

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convincingly that shareholders, on balance, benefit from competition and, accordingly, implies that adopting competitive federalism for securities regulation will also stand investors in good stead. The Evidence That State Competition for Charters Benefits Shareholders A good proxy for ascertaining whether the legal regime decisions made by firms under competition benefit investors is the effect of a change in domicile on shareholder wealth. If a change in domicile increases firm value, it would be exceedingly difficult to maintain that charter competition is harmful to shareholders. The standard methodology used to examine wealth effects is known as an event study, because the researcher examines price effects surrounding an unanticipated event, which is an announcement providing new information about a firm, such as a proposal to change domicile. The assumption is that in efficient capital markets, prices incorporate information about a firm as soon as the information is public. Event studies follow conventional financial econometric techniques, which compare the change in stock return on the event date with the predicted change in return—an estimate using an asset pricing model based on prior price movements that indicates how the return would have changed in the absence of the new information. The difference between the predicted and actual return, known as the average residual or abnormal return, measures the wealth effect of the event.2 Eight event studies have investigated how a change in incorporation state affects stock prices.3 All the studies find positive abnormal stock returns. Four of the studies find a significant positive stock return at the time of the announcement of the domicile change;4 one finds a significant positive return for a subset of reincorporations;5 another finds a significant positive return over two years before the reincorporation;6 and the remaining two studies find positive returns that were significant at the 10 percent confidence level.7 The uniformly positive findings, in my judgment, are compelling evidence that competition for corporate charters benefits investors. One certainly cannot read that literature and conclude that state competition for charters is damaging to shareholders’ welfare.

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STATE COMPETITION FOR CORPORATE CHARTERS

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Lucian Bebchuk and his colleagues criticize the conclusion that the event study data indicate that shareholders benefit from competition by contending that the significantly positive abnormal returns of those studies were “modest” (on average 1 percent).8 It should be noted, however, that even if we accept the lowest figure across the studies for the positive abnormal returns from reincorporation, an investment project that generates positive abnormal returns of even 1 percent is, in fact, considerable for competitive capital markets: for example, the magnitude of the price effect of announcements of capital expenditures, joint ventures, product introductions, and acquisitions by acquiring firms is less than 1 percent.9 Moreover, that number is three times greater than the significantly negative abnormal return of .3 percent found for state takeover statutes in the study with the largest portfolio of firms and thus the study with the highest probability of finding statistically significant abnormal returns.10 Yet those same takeover statutes are the sole basis for the critique of state competition by Bebchuk and his colleagues.11 It is, in short, not plausible to claim that a change in corporate domicile producing a positive abnormal return of even only 1 percent is suggestive of the policy conclusion that state competition needs to be restrained and reformed. Of course, because reincorporation is subject to shareholder approval, it would be surprising to find firm value declining upon a domicile change. For that to be so, as some critics of state competition contend, shareholders would have to be ignorant, irrational, or coerced when they vote in favor of a domicile change, particularly a reincorporation into Delaware, which, as the dominant incorporation state,12 is often cast as the villain in the race-to-the-bottom explanation of competition, for enacting laws that facilitate managers’ exploitation of shareholders.13 But that is not a plausible scenario for the circumstances of votes on domicile changes by U.S. equity holders, which are predominantly sophisticated institutions holding large portfolios. Those institutions are repeat players on voting issues for whom the cost of being informed about legal regimes so as to vote intelligently on a reincorporation is quite low. Because reincorporations are typically accompanied by changes in business plans, however, a question remains whether the positive stock price effects are evidence of the market’s assessment of the change in

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business plan rather than the change in domicile.14 To examine whether the positive price effect was a function of investors’ responses to other changes in business plan accompanying the reincorporation and not their evaluation of the new legal regime, I compared the returns of the firms in my study by grouping them by the type of activity accompanying or motivating the reincorporation—engaging in a mergers and acquisitions program, undertaking takeover defenses, and a miscellaneous set of other activities including reducing taxes. Although one might expect the impact to vary across firms, with the antitakeover reincorporations’ experiencing negative returns because some commentators view takeover defenses as adverse to shareholders’ interest, while announcement of mergers and acquisitions programs produce positive abnormal returns,15 in fact, not only is the sign on the takeover defense group’s abnormal return positive, but no significant difference exists across the groups.16 That result implies that the significant positive returns upon reincorporation are due to investors’ positive assessment of the change in legal regime and not to a confounding of the impact of reincorporating firms’ other future projects.17 This result is consistent with the theory of the decision to change domicile that I provided in my study of reincorporation: firms change their domicile when the legal regime is expected to matter for future transactions. The data indicate that investors understand that motivation for a move and thereupon revalue the firm’s future cash flows upward on the announcement of the switch, in anticipation that the new regime will positively affect the value of the firm’s intended transactions.18 In contrast to my findings, Randall Heron and Wilbur Lewellen find a different price reaction, depending on whether the reincorporation is undertaken to limit directors’ liability (significantly positive) or to erect takeover defenses (significantly negative).19 They interpret their results as indicating that some reincorporations are undertaken to increase share value (the director liability limitation group) and others to entrench management (the defensive tactic group). A number of problems exist in Heron and Lewellen’s interpretation of the data, however, and, in particular, in interpreting the data as an indication that the other event studies’ results are best explained by confounding events or as evidence against competition. The takeover defense firms’ abnormal returns are

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significant only on the shareholder meeting date and not on the earlier proxy mailing date. That is an odd finding, given the results of the other reincorporation studies,20 which detect significant positive effects on mailing dates, and given the efficient market hypothesis, under which adverse information regarding a move should have been incorporated in the stock price at the earliest public announcement date.21 The use of the meeting date as the event date—the event date in the Heron and Lewellen study on which there is a significant negative impact—is, however, problematic for event study analysis and throws doubt on the reliability of the finding. James Brickley’s investigation of the event study methodology finds that random samples of annual meeting dates—that is, a sample on which there is no a priori reason to find a significant price effect—produce significant abnormal returns, in contrast to random samples of proxy mailing dates.22 Brickley’s explanation of the finding of abnormal returns on randomly selected meeting dates in contrast to mailing dates is that annual meeting dates are known in advance and often contain important management announcements, such as earnings forecasts, which can produce abnormal returns because “risk and expected returns can increase around predictable events likely to contain information.”23 That result suggests that Heron and Lewellen’s finding of abnormal returns on the annual meeting date, but not on the proxy mailing date, is not a reliable indication of the impact of reincorporation. Firms sometimes raise a reincorporation proposal at a special meeting, although that is not common because it entails the increased cost of holding an extra meeting compared with raising the issue at the annual meeting, and typically the timing of the move can be planned to coincide with the annual meeting. Brickley’s finding may thus not be directly relevant to some firms in Heron and Lewellen’s sample. Still, the theoretical basis for expecting the price effect for those firms to occur on the meeting rather than mailing date is lacking: the number of contested management proposals is so small that very little uncertainty exists over reincorporation voting outcomes to be resolved on the meeting date for enough firms to affect the full sample portfolio’s returns on the proxy mailing dates.24 But even if we were to assume that special meeting firms dominate the sample and that Heron and Lewellen can identify the new

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information available on the meeting date and construct a model of the market’s expectations concerning the passage of the reincorporation proposal and how that expectation changed25 to dispel the concern raised by Brickley’s study, the negative return on mailing dates for a subset of their antitakeover reincorporation firms is not probative for judging state competition adversely because of a further shortcoming in Heron and Lewellen’s understanding of the data. They mistakenly assert that the reincorporating firms’ takeover defenses could only have been undertaken in Delaware.26 But all the defenses they identify as adopted by the reincorporating firms—fair price and supermajority charter amendments, staggered boards, elimination of cumulative voting, and poison pills— could have been undertaken in any state at the time of their study and were not solely available in Delaware.27 That error undermines the view that the reincorporation was essential for adopting a takeover defense—in contrast, for example, to firms emigrating to a state with a takeover statute not present in the original state’s code, as was true for many firms in my study of reincorporations, which covered years when not all states had statutes, and for only a subset of firms in Heron and Lewellen’s study.28 A possible explanation for adopting some, although not all, of the antitakeover provisions that Heron and Lewellen identify in the reincorporating firms’ charters is that the firms were not adding new protections but instead were maintaining existing protections, because the default rules in Delaware are more favorable to bidders than the rules in other states.29 Hence, firms could require a charter provision to obtain equivalent protection. In that regard, a negative stock price reaction could be interpreted as disappointment by investors that the reincorporating firms were not obtaining the maximum benefit—facilitation of a bid—of a domicile change to Delaware.30 But such a reaction should still have been incorporated into stock prices on the proxy mailing, not meeting, date. Heron and Lewellen’s conclusion that the reincorporations accompanied by adoption of takeover defenses are exercises of managerialism may be correct, but it is beside the point regarding competition— managers did not need to reincorporate in Delaware to adopt those takeover defenses. Moreover, all the defenses they detail besides poison pills require approval by the same majority vote of shareholders as does a

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reincorporation. The only relevant concern regarding the efficacy of competition raised by their data is the possibility that by bundling the takeover defenses into one vote on a domicile change, rather than subjecting them to separate votes as charter amendments, management is more likely to garner sufficient shareholder support for the defenses, as shareholders are coerced to accept them to obtain the otherwise valueincreasing effects of the new regime. Because the proxy materials for a reincorporation must clearly describe any changes with respect to takeover defenses under the new domicile, including the new charter, the probability, in my judgment, is remote that bundling the takeover defenses in the new charter of the reincorporated firm would result in greater voting support than would separate voting on the defenses as charter amendments. The increase in shareholder votes against antitakeover tactics began in 1987, the year institutional investors began offering shareholder proposals, most of which were directed at defensive tactics,31 and the majority of reincorporations in Heron and Lewellen’s sample occurred in that time period. It is therefore highly improbable that shareholders approved domicile changes that included defenses that they would have voted down had there been no reincorporation. Indeed, many of the defenses Heron and Lewellen specify, although they provide no breakdown of the defenses, such as fair price and supermajority provisions, are not considered particularly potent and are not of concern to voting investors. For example, of 2,042 shareholder proposals offered from 1987 to 1994, only 24 involved fair price and supermajority provisions and even fewer (17) involved takeover statutes.32 Those data suggest that the antitakeover reincorporations in Heron and Lewellen’s study are not readily interpretable as acts of managerialist bundling—shareholders would have voted them down if the defenses were new and objectionable.33 It should further be noted that the positive price effect for the limited liability reincorporation sample in Heron and Lewellen’s study compared with the antitakeover sample is also not evidence that the positive price effects of reincorporation found in it and other event studies are due to confounding events. The reincorporations in their study for which there was a positive price effect were, in fact, undertaken solely to take

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advantage of the new domicile’s legal regime—the ability to limit directors’ liability—rather than an announced change in business plans. It is possible that investors interpret such moves as indicating that the company is planning to engage in a future transaction that would lead to frivolous litigation that the limited liability provision would prevent, and the unspecified transaction’s anticipation produces the abnormal return. But such an explanation is convoluted, and there is a simpler story consistent with interpreting the positive price effects as due to the Delaware legal regime, rather than a confounding event that is unspecified: namely, the positive effects are due to the regime’s beneficial effect on the cash flows accruing to firms from anticipated or unanticipated transactions by reducing the probability of litigation.34 In sum, the most plausible interpretation of the event studies’ data is that the positive price effects identified upon reincorporation represent investors’ valuation of their firms’ new legal regime, and, consequently, that they view domicile changes as value-enhancing transactions. Some scholars question the appropriateness of using event study methodology to assess the efficacy of state competition beyond the issue raised by the potential confounding of a domicile change and a change in business operations at the time of reincorporation in the price effect. For instance, Lucian Bebchuk asserts that stock price studies are not probative on whether state competition benefits shareholders, because state competition may produce some provisions that are harmful to shareholders even if the total package of provisions is not, and, hence, we would not detect a significantly negative price effect upon reincorporation.35 Bebchuk’s critique is not a troubling objection to the use of event studies in determining whether competition is preferable to a centralized federal statute. That is so because Bebchuk’s premise of offsetting price effects in which shareholders are forced to choose between bundles of good and bad statutes is founded on the mistaken premise that the statistical findings of the event studies are insignificant, which would imply the troubling possibility that codes are in equipoise between good and bad provisions. Yet nearly all event studies report significant positive price effects. In addition, as previously discussed, the data do not support his alternative contention that any significant positive results are due to

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confounding events. Most important, from the perspective of a corporate code and the efficacy of the output of competition, the net wealth effect of a code on investors is key, and that effect is positive. A further contention of Bebchuk and his colleagues is that the positive price effects of Delaware are due to network effects unrelated to the content of the legal regime (that is, investors value the presence of a stock of legal precedents independent of whether the precedents benefit investors or managers).36 That is surely a theoretical possibility. But Bebchuk and his colleagues provide no empirical support for that speculation, and without such data it cannot trump the alternative straightforward interpretation that the positive return is due to the quality of Delaware’s law. For example, to the extent that reincorporation event studies find positive abnormal returns for all reincorporations and not solely for firms moving to Delaware, the network effect is not a satisfactory explanation of the data, compared with the alternative that investors consider the destination states’ laws superior to those of the origination state.37 In addition, it is not a priori obvious that the value of the stock of precedents—the network externality Bebchuk and his colleagues assert is the benefit provided by Delaware identified in the event study results— should be inversely correlated with the value of the substantive law creating the precedents for investors. But for Bebchuk and his colleagues’ explanation of the event study results as a network effect to have bite, the substantive content of Delaware law must be adverse to shareholders’ wealth. Otherwise, a network effect is of no particular import for an evaluation of state competition, because it consists simply of reinforcing, not offsetting, the wealth effect from the choice of the substantive legal regime. It is difficult to see how over time the positive value of the certainty offered by Delaware’s stock of precedents for business planning would continue to outweigh the negative value of the buildup of substantive outcomes under statutes or judicial decisions that permitted managers to expropriate shareholder wealth (Bebchuk and his colleagues’ hypothesis). Bebchuk and his colleagues do not explain why investors would continue to place a positive benefit on a stock of precedents providing certainty for business planning that decreased their wealth. Instead, if Bebchuk and his colleagues’ negative

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characterization of Delaware law is correct and the positive price effects of event studies reflect only the value of being in a network, then we should observe the introduction of shareholder proposals to reincorporate out of Delaware at an increasing rate. Proposals to eliminate defensive takeover tactics, for instance, became increasingly numerous over that time period as those investors became cognizant that they needed to maintain the vigor of the takeover market. But the number of proposals seeking a reincorporation is inconsequential throughout the entire period. Of 2,042 shareholder proposals offered from 1987 through 1994, only a trivial number, 10, were directed at reincorporation, and the number per year decreased over the period, whereas proposals involving defensive tactics and voting procedures were offered in far greater numbers and at a constant or increasing rate (314 proposals were directed at repeal of classified boards, 249 at repeal of poison pills, 274 at adopting cumulative voting, and 252 at adopting confidential voting).38 I was able to identify nine of those ten reincorporation proposals, and I found that only one sought a reincorporation out of Delaware.39 The straightforward conclusion from the proposal data is that investors do not perceive incorporation in Delaware, or state competition the way Bebchuk and his colleagues perceive it, as a significant problem or source of wealth reduction.40 A final point on what to make of the event study data is in order. The most important fact regarding the impact of state charter competition on investors with respect to a policy position on competition in securities regulation is the finding across the several studies that domicile changes do not systematically reduce shareholder wealth. Even if no event study had found a significant positive price effect on reincorporation, only a persistent negative effect would be compelling evidence that competition harms investors. Insignificant price effects would indicate that competitive federalism for charters is, at worst, a zero–net-present-value proposition. Such a situation would still not lend support to a prediction that there would be a “race to the bottom” were the status quo in securities regulation altered. And that is the principal charge against changing federal policy. Other approaches to ascertain the impact of the corporate law regime on investor welfare besides event studies have been undertaken. Three studies examine whether firms’ performance improves upon a

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change in domicile by using accounting measures of performance—return on equity and earnings before interest and taxes.41 The studies find no significant difference in accounting performance for the reincorporating firms.42 One interpretation of the absence of significant differences is that the charter market is in equilibrium: firms are selecting the domicile most suited to the optimization of their future performance. The positive price effects on reincorporation would imply, however, a subsequent improvement in performance that was impounded in the price on the move. Finally, an alternative approach used to investigate whether competition benefits shareholders is to compare the value of firms incorporated in Delaware, the state that has been the most successful competitor, with that of firms incorporated in other states. The idea is that a significant difference for otherwise similar firms would represent the effect on firm value of the Delaware legal regime. Robert Daines undertook such a study, using as his measure of value Tobin’s Q, which is the ratio of a firm’s market to asset value, and thus is a measure of a firm’s intangible assets.43 Economists conventionally interpret the ratio as a proxy for a firm’s investment or growth opportunities, and Daines’s insight is to note that that should include opportunities added by corporate law rules.44 Daines finds that Delaware firms have significantly higher Tobin’s Q values than nonDelaware firms, when controlling for investment opportunities and a set of other variables known to affect Tobin’s Q, such as a firm’s business diversification. The controls are included as an effort to ensure, as best as possible, that he was measuring the effect of the legal regime.45 Daines’s finding is important because he used a completely different methodology from event studies, and yet it reproduces the same key result as those studies regarding state competition, that, on average, competition benefits shareholders. Indeed, his research complements those studies, as it suggests that the positive price effect on reincorporation—investors’ anticipation of higher firm value under the new legal regime (Delaware)— will be borne out. The fact that different methodologies produce similar results regarding the efficacy of competition renders it difficult for critics of charter competition to dismiss the empirical research that is at odds with their belief that competition and the Delaware legal regime in particular do not benefit investors.

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The studies discussed in this chapter also refute James Cox’s and Hal Scott’s opposition to regulatory competition in securities law on the grounds that investors will not differentiate securities disclosure regimes and discount stock prices accordingly.46 That is so because the positive price effects of reincorporations and the higher Tobin’s Q values of Delaware firms indicate that legal regimes are indeed priced by investors. Further evidence refuting their claims regarding inadequate discounting is the fact that bond investors price differences in indenture covenants: bonds with call protection and with event risk protection, for instance, have lower interest rates than those without such protections.47 Critics of charter competition conclude their analysis with the contention that the findings by Daines and the event study literature do not demonstrate that state competition benefits shareholders but rather are evidence that the victor of the competition is simply somewhat better than the rest of what is in essence a rotten bunch, and that the value of firms would be even higher under a regime of less competition that implements the legal rules the critics prefer to those produced by competition.48 If, however, the most successful competitor increases shareholder wealth or, to use the critics’ phrase, “offers a somewhat better deal,”49 then it is not possible for them to characterize competition as a “race to the bottom”: if competing regulators were racing to the bottom, then shareholders should fare the worst, not the best, under the most successful competitor’s regime. The assertion, without any empirical support, that the value of firms would be even higher were corporate law rules the ones espoused by the commentator rather than the ones produced by competition, is intellectual preening. It does not refute the research findings that Delaware law and hence competition for charters have provided shareholders with economic benefits.50 The empirical literature concerning the efficacy of state competition for corporate charters has been my focus of analysis, not only because an assessment of the efficacy of charter competition underlies the arguments for and against adopting competitive federalism for securities regulation, but also because economic theory provides limited guidance concerning whether a monopolist will provide the optimal degree of product quality, variety, or innovation—issues of importance in the regulatory context.

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Whether a monopolist’s choice of quality is socially optimal depends on the difference between the marginal and the average consumers’ willingness to pay for quality, as is true of price-taking competitors; whether the monopolist will undersupply quality compared with the competitive market depends on the elasticity of demand.51 A similar ambiguity exists concerning whether a monopolist will produce too few or too many products; the answer again depends on the elasticities of demand and whether the goods in question are substitutes.52 Extending the theory of monopolistic firms to regulators, William Albrecht and his colleagues derived a model in which multiple regulators, in contrast to a monopolist (or to collusive regulators), provide efficient regulation when the goods regulated are substitutes.53 Although it is most plausible to conceptualize the products in the securities regulation context as substitutes, as all states’ securities codes are available to all firms, if different states’ laws are appropriate for specific types of firms and diversified investors desire to hold such firms in fixed proportions, the products could be conceptualized as complements. Lacking information on demand elasticities for securities laws, the model of Albrecht and his colleagues is only suggestive of the benefits of competitive federalism, and we must rely instead on the best available empirical evidence, the evidence from state competition for corporate charters. Charter competition has not resulted in product differentiation across states (that is, corporate law regimes are substitutes),54 and investors have benefited from the competition. Those data are consistent with the existence of substantial benefits for investors from opening up securities regulation to competition as well. Do U.S. States Compete for Charters? Some commentators contend that Delaware’s dominant position in the charter market implies that the corporate chartering market is not competitive.55 Their position is that other states cannot be characterized as even attempting to compete with Delaware for incorporations. That contention often is made in conjunction with the use of network economics to explain Delaware’s success: in that view, there are economies of scale in the

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choice of a legal regime—for example, the stock of legal precedents—that other states cannot duplicate and thereby render Delaware effectively a monopolist.56 The contention that Delaware operates in a noncompetitive market does not contradict the empirical evidence of the positive price effects of a Delaware domicile; rather, it makes those data all the more puzzling because they suggest that Delaware is not extracting all the possible monopoly rents from domestic corporations. Marcel Kahan and Ehud Kamar, who are skeptical that charter competition exists, for instance, maintain that states do not compete for charters. They infer that from other states’ failure to duplicate what makes Delaware the preeminent incorporation state—a specialized court and a higher franchise fee structure that leads to Delaware’s dependence on franchise tax revenues.57 Other states could not, however, easily duplicate Delaware’s higher franchise fee structure to compete for a share of local charters. Because Delaware offers a superior product, including a substantial stock of legal precedents, expert judiciary and administrative services, and a commitment to continued statutory responsiveness,58 for another state to compete it has to charge a lower, not a higher, price for its product to be able to attract sufficient firms to build up the legal capital that Delaware already possesses, and that is the reason for its product’s superiority. Indeed, the most straightforward explanation of Delaware’s higher charges for a domicile is that it offers a superior product, and not that it is operating as a monopolist in a noncompetitive market. Kahan and Kamar’s evidence for the contrary claim of monopolistic pricing behavior hinges on the proposition that Delaware’s higher fee structure evidences price discrimination against the larger public firms that benefit most from the Delaware legal regime because such firms are most likely to be involved in shareholder litigation.59 But Delaware’s price schedule is not the efficient form of price discrimination that Kahan and Kamar claim because it is nonlinear: franchise fees do not increase with firm size, since the total payment is capped at $150,000. As a consequence, the largest public firms, which should be paying the most under Kahan and Kamar’s price discrimination hypothesis, in fact, pay less than smaller public firms, as a percentage of their value or outstanding shares. Moreover, as Kahan and Kamar acknowledge, the difference in fees paid

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across the smallest and largest public firms is proportionate to the differential probability of litigation, which is related to the service that Delaware provides domiciled firms.60 That suggests that the differential fee structure is more likely a bona fide mechanism to cover the higher costs of servicing larger firms (a user fee) rather than an exercise of monopolistic price discrimination. Price discrimination depends on the relation between price and marginal cost: if the marginal cost of providing a product differs across customers, then it is not price discrimination if they are charged a different price for that good. Delaware’s marginal cost of providing its legal regime for larger firms is higher than that for smaller firms because such firms use the judicial system more. Further undermining Kahan and Kamar’s contention regarding Delaware’s monopolistic behavior and concomitant negative interpretation of Delaware’s legal regime is the fact that states can and do compete with Delaware for charters, even though they have not replicated its most valuable assets, a specialized court and a high ratio of franchise fees to other tax revenues. States engage in behavior that can be characterized as “defensive” competition, in that they seek to discourage local firms from reincorporating in Delaware, rather than affirmatively to attract firms away from Delaware. That would be difficult to do without undertaking the expense of duplicating the assets that have given Delaware its large market share and would be a high-risk undertaking, because the state might expend considerable resources and yet not unseat Delaware. Given their defensive activity, the states remain available, however, to undertake such investments and to recruit Delaware incorporations were Delaware to cease offering an up-to-date code and reverse course, as did New Jersey in the early twentieth century when Delaware replaced New Jersey as the leader.61 Considerable evidence exists of such defensive competitive behavior. First, Delaware is not the only state to be continually revising its corporation code: other states invariably follow suit and revise their codes to follow Delaware’s innovations. Indeed, one commentator has characterized recent revisions to the Model Business Corporation Act as evidence supporting the view that states compete for charters because the revisions bring that act, which many state codes follow, closer to the law of

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Delaware.62 After revising their codes, the states then publicize their legislative reform efforts as a reason to retain an in-state domicile rather than to incorporate in Delaware.63 If the states were indifferent to the retention of local corporations or the recruitment of foreign corporations as domestic incorporations, then they would have no reason to engage in such activity. Second, although Nevada has never seriously challenged Delaware as the leading reincorporation state, it expressly set out to be the “Delaware of the West” and is one of the few states to achieve a higher inflow than outflow of migrating firms.64 Third, if competition from other states was not a threat, Delaware would not update its code as attentively as it does.65 Delaware’s continued responsiveness through statutory innovation, despite its commanding lead in the incorporation market, rebuts a criticism of regulatory competition in securities law offered by Donald Langevoort that whatever state wins the “competition early on” will thereafter behave as a monopolist “threatening the benefits that would otherwise flow from true competition.”66 A further potential competitor constrains Delaware besides the states. Several commentators have sought to explain changes in Delaware doctrine as a preemptive response to ward off federal government intervention.67 That might be true. But potential competition by the national government does not offer a full explanation for Delaware’s responsive behavior. In my judgment that requires including concern by Delaware regarding the activity (real or potential) of other states. For example, it is improbable that Delaware adopted a limited liability statute during the changed business environment of a perceived directors’ and officers’ liability insurance crisis in the mid-1980s, because it feared that national action would affect its dominant status in the charter market rather than actions by other states.68 More systematic evidence of competition by states exists as well. Corporate law reforms diffuse across the states in an ogive or S-shaped cumulative distribution, which means that the proportion of adopters increases over time.69 That finding, in accord with the anecdotes concerning states’ publicizing their corporation code updating, is suggestive evidence that states compete with Delaware to retain local firms. The industrial organization literature on product innovation conventionally interprets that

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pattern to be an indicator of robust competition.70 In particular, a recent study examining the pattern of diffusion of new financial products across banks—a pattern in which the adoptions increased over time in a distribution resembling the ogive pattern of corporation code innovations— determined that competitive (“bandwagon”) pressure on nonadopters to maintain customer relations and market share explains the diffusion pattern rather than other explanations involving product profitability or information externalities.71 The adoption of innovations due to competitive bandwagon effects is, in fact, more likely when there are significant first-mover advantages and small adoption costs72—factors consistent with the characterization of defensive competition occurring in the corporate charter market. In addition, a positive relation exists between revenues collected from incorporation taxes and a state’s responsiveness to corporations’ legislative demands. (In the statistical tests, responsiveness is measured by a composite variable of whether and how rapidly a state adopted corporate law innovations that a survey of domicile-switching firms indicated were important in their decisions.) That positive relation persists even when Delaware is excluded from the statistical analysis.73 The positive relation between revenues and responsiveness is consistent with what I have termed a “hostage” theory of the charter market and Delaware’s success in which the more heavily a state relies on incorporation revenue, the more responsive it will be to corporate needs and hence the more it will be an attractive domicile for firms. The fact that the positive relation holds up even when Delaware is excluded from the analysis is important additional evidence suggesting that states are competing for domestic incorporations. Kahan and Kamar maintain that the adoption of corporation codes by states other than Delaware is evidence not of states’ engaging in competition but of states’ providing a “service” to citizens and that such a hypothesis may also explain the diffusion of innovations across the states.74 That characterization of the motive for code adoption and updating does not demonstrate that states do not compete. That is so because states do not have to provide such a service: their citizens can use Delaware’s code or that of another state and do business as a foreign corporation. We have to ask why the state would want to provide such a service: the only plausible answer is that an important interest group in

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the state wants domestic corporations. Once that is acknowledged, no matter what euphemism is used to describe the motivation for code adoption and updating activity, it is an indication that states are competing for local charters. The dominant interest behind the desire to revise codes to have local charters may well be the local corporate bar rather than the state treasurer, but that is standard operating procedure: in all states including Delaware the corporate bar is the engine of statutory reform.75 To be sure, Delaware state officials, and not just the corporate bar, pay close attention to their incorporation business. But other states’ officials’ attention need not be as focused for a state to engage in successful defensive charter competition; they can rely on the local bar to notify them if legislative action is necessary to maintain that position, just as members of Congress depend on constituents to inform them of problems in an agency’s administration rather than actively monitor the agency themselves.76 The state also still has a financial incentive to compete: the income of the local corporate bar and a state’s franchise revenues are, in all likelihood, positively correlated.77 In sum, to the extent that states are affirmatively providing the service of domestic incorporation, they are doing so to facilitate local incorporation (which aids the local bar) and thereby to discourage foreign incorporation and transfers of domicile affiliation; that is, they are defensively competing for local charters. Kahan and Kamar discount the positive relation between franchise revenue and corporate law responsiveness as evidence of state competition because the analysis uses total franchise tax revenues, rather than the marginal revenue a state receives from incorporations.78 They have a point: total franchise tax revenues constitute a less than ideal measure of states’ incentives than do marginal incorporation revenues, under the standard economic principle that marginalism drives behavior. But marginal incorporation revenue is a figure that is impossible to calculate accurately, given the form in which data on state tax revenues are made available. Hence, total franchise revenues are the best numbers we can use, and they will have to suffice. Moreover, the use of total rather than marginal revenues in relation to corporate law responsiveness as a test for the presence of competition is not the fatal difficulty that Kahan and Kamar’s objection might appear to

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suggest. Because firms have the freedom of choosing their incorporation state, it is plausible that there is a positive correlation between marginal and total revenues. Indeed, if there were no correlation between total and marginal revenues, there should not be the positive relation between total franchise revenues and corporate law responsiveness that the data identify. This is so because the most plausible explanation for the empirical finding relating responsiveness and total revenues is that marginalism is at work, that is, that states are competing for charters. Kahan and Kamar do not advance an alternative explanation of the finding. Their explanation that states offer corporation codes as a service to citizens, for example, would not predict a systematic positive relation between total franchise revenues and responsiveness, because states that are not competing for charters provide the service, regardless of the number of local firms and hence regardless of the revenues received from incorporations. If they were correct, no relation should exist between the variables. In addition, although they do not articulate their critique in such a fashion, Kahan and Kamar may be concerned that total revenues include foreign firms’ taxes and firms’ presence in a state other than Delaware may be inelastic—that is, the state collects franchise fees from all firms doing business in the state.79 But if that is their concern, then we should again expect to find no statistical relation between total revenues and responsiveness because states do not provide any service to foreign incorporations—they are covered by another state’s code. But the data are otherwise—the relation is significantly positive. In sum, the data indicating that states do compete for charters are compelling. Those data explain why Delaware is not, in Kahan and Kamar’s opinion, charging as high an incorporation fee as it could more parsimoniously than the alternative explanations they offer—charging an additional tax in the form of excessive litigation and unspecified “political” considerations that refer to interest groups’ and local officials’ desires not to raise fees.80 Delaware does not extract the full value of a domicile because it is not operating alone in the charter market. Rather, it is competing against the actions of other states that are affirmatively seeking to retain domestic corporations and that might successfully attract foreign (Delaware) corporations as well were Delaware to raise the cost of its

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domicile further. That is not idle speculation: in my survey of reincorporations, a number of firms migrated to Michigan from Delaware in the 1970s, after having previously migrated to Delaware from Michigan in the late 1960s to take advantage of Delaware’s 1967 code revision, and they emphasized that in the intervening decade Michigan, which was their state of physical presence and the lower-fee state, had overhauled its code to mirror Delaware’s.81 Indeed, Kahan and Kamar recognize as much when they note that interest groups in Delaware could be harmed if the state increased fees and drove “clients away from Delaware.”82 This section has detailed the evidence that indicates that states compete with Delaware to retain domestic firms. But Delaware’s production of corporate laws could replicate the output of a producer in a competitive market, even if the other states did not compete for charters, as Kahan and Kamar maintain. That is so because, as long as entry barriers are minimal, potential competitors can force what otherwise appear to be monopolists or oligopolists to behave as if there was perfect competition. The leading exponent of that thesis, which is known as the theory of contestable markets, is William Baumol, who in recent work has combined that market behavioral hypothesis with an analysis of the production of innovation in capitalist economies.83 Baumol identifies the prime attribute of an innovative industry in a capitalist economy as repeated outlays on innovative activities that have been routinized within large firms. In his view, investments that appear to be “sunk”—investments in innovation—are not entry barriers because the innovation does not require large initial investments to be sunk, compared with the subsequent cost of maintaining an innovative edge by continuing research and development activities, expenditures that the incumbent firm bears equally as a burden as do new entrants.84 Moreover, Baumol shows that price discrimination should be the normal result in such a contestable market: the incumbent firm with substantial fixed costs or a continuing need to sink substantial investment in a market in which entry is unimpeded is forced to adopt discriminatory prices that maximize profits (which maximal economic profits nevertheless equal zero, because of the threat of entry).85 The chartering market can be viewed as sharing the features Baumol describes of innovative industries in capitalist economies: initial entry is

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not expensive, as any state can adopt the Delaware corporation code and its extant body of precedents (as Delaware did when it replaced New Jersey as the dominant chartering firm at the turn of the twentieth century).86 Thereafter, the new entrant would bear the same costs as Delaware of maintaining innovative activity, through legislative reform and expert judges (that is, continual innovative expenditures must be undertaken). As a consequence, Baumol’s theory suggests that even if one does not see entry by other states, Delaware is still behaving as a producer in a competitive market rather than as a monopolist, despite its particular franchise fee structure.87 Is State Competition Inefficient Because of Network Externalities? Some commentators have used network economics to analyze state competition. In such a view, Delaware is successful in the corporate charter market because network externalities exist in corporate law: economies of scale and scope depend on the adoption by a large number of users of a product—in this case a state corporation code and economies in production of legal precedent. The network phenomenon enables Delaware to maintain a monopoly position, as rival states starting from a smaller base of corporations will not be able to provide the same value to consumers (incorporating firms). Proponents of the network approach advance two arguments to critique the efficacy of the corporate laws produced by state competition. They consist of the claim that the legal rules produced by state competition are suboptimal because of a lock-in effect in which it is overly costly for firms to shift from an inefficient to a more efficient legal network88 and the claim that to maintain its market power, which is derived from network externalities, Delaware crafts its legal rules to be excessively uncertain and unpredictable.89 While theoretically possible, neither of those claims stands up to scrutiny. Is There a Lock-In Effect? According to proponents of the network approach to corporate law, a potential consequence of a successful

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chartering business such as Delaware’s—in which the more domestically incorporated firms there are, the higher the value to firms of operating under the regime—is that inefficient corporate law provisions will be locked in. In other words, the network effect of legal precedents creates an externality, in which new firms are better off joining the existing network that has inefficient provisions rather than incorporating in a new network with fewer firms but a superior code.90 But as S. J. Leibowitz and Stephen Margolis have suggested, as an analytical matter, network effects are not necessarily externalities: they are only a problem, such that a more efficient network will not replace an inefficient one when market participants cannot internalize the effects.91 Thus, if a dominant network is inefficient compared with a competing one, the owner of the more efficient network will internalize the network’s costs, and with a more efficient product it will be able to subsidize switchers.92 While an individual corporation cannot internalize the cost of a charter regime, corporate law regimes have owners that can do so— the legislating states. If, for example, the Delaware state courts take actions that decrease share values, or if Delaware does not revise its corporation code to address a developing corporate law issue that another state code has remedied, Delaware’s franchise tax revenues would decrease if the flow of firms into the state would thereby decrease. The state would therefore bear the cost of the inefficient regime. In addition, Delaware counsel, whose human capital would diminish with a decline in Delaware incorporations and who are organized in a state bar association that mitigates free-rider problems, would ensure that the legislature ameliorates the problem. The contention that Delaware would internalize possible network externalities that would otherwise produce inefficient rules is not mere speculation. After a decision by the Delaware Supreme Court that was considered to be adverse to shareholder welfare because it increased the financial liability of outside directors at a time of an unstable liability insurance market, legislation was enacted to negate the impact of the decision by permitting shareholders to vote to limit outside directors’ liability.93 Other states had also been moving on legislative reform of director liability, a factor that further spurred Delaware’s action.94

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Additional support for the proposition that another set of rules will supplant a dominant legal network if the rules are more efficient is provided in a study of Australian corporate law by Michael Whincop.95 Whincop examines corporate charter terms regarding fiduciary duty—the mix of indemnification and liability release provisions—before the enactment of mandatory government terms in the late 1920s and classifies common clusters of terms into three “networks.”96 He then tracks the use of those clusters or networks—their “market share”—over time by taking account of switches by charter amendment. Whincop finds that a new mix of indemnification and release terms emerged and came to predominate, despite the existence of a substantial older network. His finding is consistent with the proposition that network effects of inefficient corporate law provisions—or provisions that lose their efficient properties as business conditions change—will not prevent the emergence of and switch to more efficient provisions. Whincop’s research parallels what casual empiricism would suggest regarding U.S. corporation codes: Delaware is constantly revising its code as business conditions change, despite its large stock of precedents that should, under a network externality analysis, prevent the state from updating to more efficient provisions. Those phenomena—the Australian contracting experience and Delaware’s continual code updating—suggest that early charter provision users will not impose significant externalities on subsequent users that result in the persistence of inefficient corporate charter provisions.97 A further difficulty with the lock-in argument concerns whether competing corporate law networks offer truly incompatible products—the reason a larger market share produces a lock-in effect. The Model Business Corporation Act is a competing network to Delaware law, as it enables adopting states to share in the precedents of all users of the act’s boilerplate, as well as the resources of the act’s drafting committee. But many of the Model Act’s provisions are similar to those of Delaware. Consequently, state courts can, and often do, borrow from Delaware precedents, whether or not the states have adopted the act.98 Those factors place a limit on the size advantage of Delaware’s network and no doubt explain why the state is continually updating its code: it is concerned about competition, which

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would not be the case if its size advantage—the network effect—was unlimited. An additional criticism of the significance of potential network effects involves the key assumption for there to be a such an effect—the existence of increasing returns to scale. To the extent that the increasing returns to a network eventually diminish, then competing networks are possible, and presumably the persistence of inefficient networks is unlikely.99 It is altogether possible that use of a legal regime manifests diminishing returns: one instance of such an effect is court docket congestion. Finally, if different rules are appropriate for different firms, then competing networks can develop to serve niche markets where size—network effects—is not a disadvantage.100 Niche filling does not seem to be a significant factor in corporate law because the content of state corporation codes does not vary substantially and enabling codes permit customization. Whether that is a more important concern in securities law is discussed in chapter 4. Is Delaware Law Excessively Indeterminate? The second claim of commentators using network economics to critique the output of state competition is that Delaware’s legal regime is “excessively” unpredictable or indeterminate compared with what it “could be.” That claim is associated with Ehud Kamar. The hypothesized motivation for having indeterminate legal rules is to prevent other states from successfully copying Delaware law and thus to preserve the monopoly position Delaware has achieved because of network externalities regarding legal precedents.101 The evidence Kamar adduces for that claim is the ”courtcentered” culture of Delaware corporate law and Delaware’s use of “factintensive standard-based tests,” which are not always used in other states or in SEC regulation.102 The initial difficulty with the contention that Delaware law is excessively fact-intensive is one of first principle, that the claim is founded on a misunderstanding of the common law process. Objecting to the factintensive nature of Delaware law misses the essence of judicial adjudication under common law, or, to put it another way, it is an objection to common law adjudication itself. Common law decisionmaking is, by definition, fact-intensive, because it is an inductive approach to decisionmaking

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that creates general rules from the resolution of specific disputes in incremental fashion. Moreover, the principal reason for judicial intervention in corporate law is to enforce fiduciary obligations that by their very nature cannot be well specified in a contract—otherwise they would be written into corporation statutes and documents. The judicial inquiry into such issues is, therefore, inherently fact-based.103 And, of course, courts, not legislatures, must undertake their resolution, as legislatures are not suited to engage in case-by-case decisionmaking. The second difficulty with the line of reasoning that Delaware law is excessively indeterminate involves a confusion between the choice of legal rules or standards and the unique position of Delaware compared with other states in the chartering market. In contrast to all other states, Delaware has a specialized judiciary that hears all corporate law cases, the chancery court, and corporate law expertise is usually an important selection criterion for state supreme court justices. It is, accordingly, a clear-cut benefit to shareholders of Delaware firms to use the judicial process to resolve fiduciary issues, as the parties have access to decisionmakers with significant expertise who can tailor a ruling to the specific problems of the claimants. In other states, recourse to the judiciary does not offer any such benefit to shareholders because courts of general jurisdiction, with no expertise in corporate law and infrequent exposure to corporate issues, hear corporate law cases. Thus, to compensate for their competitive disadvantage, states other than Delaware tend to adopt the defensive strategy of more explicit rules that are intended to reduce the need to resort to the judiciary in disputes. Indeed, some states attempt to promote that as a marketing advantage for local incorporation by stressing a lower level of reliance on the judiciary with explicit statutes compared with a Delaware domicile.104 Consequently, the fact that states other than Delaware tend to substitute bright-line rules for a standard to determine fiduciary issues is not proof that Delaware law is “excessively indeterminate” but, rather, evidence that they are seeking to make the best of what is a competitive disadvantage of their legal system. That characterization is consonant with the widely shared perception of corporate practitioners that Delaware courts are superior decisionmakers to other state courts when it comes to

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corporate law matters, as well as efforts by the corporate bar in some states to promote legislation to create specialized corporate law courts.105 Kamar seeks to support his claim that Delaware law is excessively indeterminate by asserting that U.S. securities law has greater clarity. He uses, as an example, the existence of safe-harbor rules for complying with registration requirements.106 That comparison is erroneous. The areas of securities law that are related to substantive corporate law issues, such as insider trading regulation and other forms of antifraud liability under rule 10-b5, do not, in fact, consist of bright-line rules but employ imprecise legal standards. Not only is the language of the antifraud rule more general than any of the Delaware fiduciary standards that Kamar finds wanting, but also the SEC opposes enactment of a statutory definition of insider trading, a position with which Congress has acquiesced, although a definition would provide a bright-line rule and eliminate the existing “standards” approach.107 Underscoring Kamar’s misplaced comparison is one former SEC solicitor’s comment that “insider trading is a classic example of common law in the federal courts.”108 A third and, in my judgment, insurmountable difficulty with Kamar’s thesis is how one could ever identify where, to use Kamar’s language, the level of indeterminacy of Delaware law may be “too high” or where it is “less predictable than it could be.”109 As corporate law practitioners well know, Delaware law is more predictable and certain than that of other states, and that is one of the principal reasons they prefer to incorporate clients in Delaware.110 Indeed, the settlement rate of Delaware cases does not significantly differ from that in other states.111 Yet that would not be the case if Delaware’s more fact-intensive, standard-based law increased the uncertainty of outcomes as Kamar contends, because risk-averse parties are less likely to litigate and more likely to settle when uncertainty regarding the legal rule is greater.112 To the extent that divergent perceptions of the likelihood of success at trial decrease the likelihood of settlement, a reduction in the uncertainty of predicting the outcome of litigation should increase the settlement rate.113 In either scenario, if, as Kamar contends, Delaware’s law is more unpredictable than that of other states because it is more standard-based, then the settlement rate should differ across cases brought in Delaware and those brought in other states.

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Moreover, if the level of certainty provided by the Delaware courts is excessively low, then when firms successfully lobbied Congress to preempt state securities litigation, they would not have supported the “Delaware carve-out” that is contained in the statute, which preserves the right of shareholders to bring fiduciary claims under state law while preempting all other state claims arising in connection with a securities law violation.114 Finally, the Delaware legislature has overturned decisions that it considered adverse to firms’ interests and, in particular, decisions that were perceived to increase uncertainty or “litigation intensity.”115 There is simply no force to characterizing Delaware’s law as not achieving an “optimal” degree of predictability when there is no real-world corporate legal system that does a superior job to Delaware in providing a predictable corporate legal regime. Writing with Kahan, Kamar has recently refined his thesis to contend that an appropriate benchmark for indeterminacy is an ideal corporate law and not necessarily the examples he provided from other states and federal agencies.116 But the analytical question whether rules are superior to standards is, in fact, extremely complex.117 Although, consistent with Kamar’s position, some economists view rules as generally superior to standards because of lower enforcement costs,118 the issue is far from settled. Standards may theoretically be more efficient than rules in the corporate context: Ian Ayres, for example, contends that the use of standards for corporate law is efficient because it is easier for parties to contract for precise rules than for standards, and thus a standards approach facilitates the ability of shareholders and managers to contract out of the defaults of judicial decisionmaking.119 More important, Kamar does not explain why explicit rules would be superior to standards in the fiduciary duty context, beyond those safe-harbor rules already present in the Delaware code regarding self-interested transactions. Casual empiricism would suggest instead that the flexibility of an expert decisionmaker’s application of a standard—Delaware’s approach— is preferable to the “one-size-fits-all” feature of explicit rules in the fiduciary context,120 contrary to Kamar’s critique. For example, the overwhelming choice of Delaware over other states by large corporations, which have a higher probability of experiencing litigation than small

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firms,121 is consistent with the claim that fiduciary duty is an area of law for which standards, when they will be interpreted by a knowledgeable decisionmaker, are superior to the less fact-intensive approach followed by other states that Kamar deems preferable. Moreover, the mix of rules and standards in Delaware case law is consistent with one of the criteria for choosing between them—the frequency of transactions.122 The judicial approach to dismissing a derivative action in the absence of a conflict of interest is straightforward and hence rulelike in nature, whereas the example Kamar provides of an overly fact-intensive standard is the fairness test applied to breaches of duty in self-interested transactions.123 Derivative suit filings are a relatively frequent occurrence, in which the benefit of applying a generalized rule is likely to outweigh the cost of implementing an individualized standard, compared with a court’s need to evaluate breaches of the duty of loyalty, the evaluation of which entails consideration of idiosyncratic facts in which individualized decisions will tend to be the more cost-effective adjudicative approach.124 The difficulty of identifying the counterfactual—how Delaware law could optimally be revised to be less “excessively” fact-intensive—cannot be finessed by contending that Delaware could adopt a more determinate fiduciary standard by “limiting or prioritizing the [applicable] criteria.”125 One needs to state exactly what those more refined standards are to assess the validity of the proposition.126 The final basis for Kamar’s claim that Delaware law is excessively indeterminate is his contention that the Delaware corporate bar benefits from uncertainty because it creates an excessive amount of litigation and thereby increases attorneys’ income. That claim is a variant of earlier work by Jonathan Macey and Geoffrey Miller, who contend that with regard to Delaware law, the key players concerned about Delaware’s success in charter competition are the members of the Delaware bar and that they engage in rent seeking in the legislative process by, for example, ensuring that Delaware’s code facilitates shareholder suits.127 It is true that a number of features of Delaware’s corporation code identified by Macey and Miller facilitate litigation compared with other states’ codes, such as the absence of a security-for-expenses provision requiring suing shareholders to post a bond for defense costs. But it is not

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apparent that all such features harm shareholders, and other aspects of Delaware’s regime discourage litigation, such as strict enforcement of the demand requirement in derivative suits, which puts the decision to sue in the hands of the board of directors.128 The same is true of Kamar’s claim about Delaware’s court-centered and standard-based jurisprudence: it is not self-evident that shareholders are disadvantaged by that approach, and features of Delaware fiduciary law are quite specific, such as the demand requirement and the approval process for self-interested transactions. Delaware’s commanding position in the charter market no doubt may enable the corporate bar to siphon off a share of Delaware’s rents by fashioning a legal regime that increases its income at the expense of share value. But the trade-off will not reach the point at which a firm will be indifferent to staying in Delaware or changing domicile. A competitive market for lawyers reduces the Delaware bar’s ability to create a legal regime that increases litigation, and hence attorney income, at the expense of shareholder wealth. For example, a study of the legal profession, though not finetuned to Delaware corporate practice, found that lawyers do not earn abnormal returns when income is adjusted for years of education.129 Moreover, public corporations, which comprise the bulk of Delaware’s chartering business, have inhouse counsel who monitor legal costs, often put litigation out to bid, and use multiple law firms. Such individuals operate under a budget constraint and will therefore not maintain a Delaware domicile if it is imposing undue costs from “excessive” litigation.130 For Kamar’s argument to be correct and for sophisticated inhouse counsel to be able to justify spending additional resources on excessive litigation by selecting a Delaware domicile, the costs would have to be offset by a judicial bias in favor of managers that would reduce the probability of firms’ liability to shareholders in Delaware to an insignificant figure compared with the liability level in other states where litigation is not excessive. As previously noted, however, shareholder suits are not more frequently dismissed in Delaware than in other state courts. Indeed, Kamar does not contend that Delaware law is weighted in that fashion, and it would be difficult to make such a claim. William Cary’s argument to that effect131 has been refuted by subsequent

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commentators analyzing judicial decisions in Delaware and federal courts.132 In fact, if Cary were correct, the empirical evidence of the shareholder wealth effects of state competition could not be as favorable as it is. This section has critiqued at length Kamar’s claim that Delaware case law is “excessively” indeterminate not because I believe that Delaware case law is perfect. I do not; it is not. Rather, the point is twofold: first, neither an empirical nor a theoretical basis exists for Kamar’s claim; and second, whatever imperfections exist in Delaware law, they have nothing to do with Delaware’s ability to charge monopoly prices and maintain its dominant market share in the corporate charter market. Rather, the imperfections are a function of the need for fiduciary duty law as a residual protective device for corporate shareholders and of a common law adjudicative process. Is State Takeover Regulation Evidence That a National Regime Would Be Superior to State Competition? In the 1980s, when hostile takeovers emerged as the mechanism of choice for a control change in which incumbent managers were replaced, the vast majority of states enacted laws that attempted to lower the success of a hostile bid. Because shareholders receive substantial premiums in hostile takeovers, most commentators hypothesize that the objective of such statutes is not to enhance shareholder welfare but to entrench management.133 Indeed, some antitakeover statutes make explicit an objective not to maximize shareholder wealth. Such laws, known as “other constituency statutes,” permit management to consider interests other than shareholders’ interest—factors other than the offered price—in deciding whether to oppose a bid.134 Some commentators, however, contend that takeover defenses benefit shareholders by solving a coordination problem that limits their bargaining ability to extract the highest price from the bidder.135 Most of the controversy among corporate law commentators over the efficacy of takeover defenses is not over whether takeovers benefit shareholders—the data on that are unequivocal—but over whether the

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net effect of defenses—increased competition among bidders and takeover auctions—benefits shareholders. The debate, in essence, is whether the increased premium shareholders would receive in an auction will be more than offset by an expected lower probability that a bid would be received in the first place, as bidders will presumably engage in less search for targets if their likelihood of success is reduced because other bidders, free riding on the first bidder’s search, can offer a higher price. In the context of that debate, commentators who viewed takeovers favorably because they increased the target’s share value were led to the question whether state efforts to restrict those transactions evidenced that state competition for charters was less desirable than a national corporation law. In prior work considering that debate, I concluded that competition was still for the better.136 Lucian Bebchuk and Allen Ferrell have sought to revive that inquiry. They contend that the widespread adoption of antitakeover statutes shows that state competition is a “race to the bottom” that produces laws favoring managers’ interest over that of shareholders.137 It must be underscored, however, that notwithstanding Bebchuk and Ferrell’s critique, advocates of charter competition have not ignored the state takeover phenomenon, and they do not contend that state competition is perfect.138 Rather, the position of proponents of competition is that, on average, it benefits investors and that its legal product is far superior to what a centralized regime would produce. Entering into the positive assessment of the efficacy of competition are three factors: the view that the data on competition’s enhancement of shareholder value outweigh any potential negative effect of the behavior of the states on takeovers; the stark differentiation between the legislative process for laws involving takeovers and other corporate code provisions, including Delaware’s very different position as an innovator in the two contexts; and the consideration that, in contrast to Delaware, in crafting a corporate law, the national government would have little incentive or ability to be responsive to changing business conditions. Not only would incentives to respond be reduced because of the absence of competition, but also there would be little financial incentive to respond as the revenues from the incorporation business, which averaged 17 percent of total taxes collected

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by Delaware from 1966 to 2000, would be an insignificant percentage of the federal budget.139 In addition, even if Congress desired to be responsive, implementing national legislation is more difficult than taking state action, as Congress has many more policy concerns and takes far longer to act than a state legislature.140 Critics of state competition such as Bebchuk and Ferrell minimize the import of all three of those factors regarding the relative efficacy of state competition. For competition to be preferable to a single national regime, however, the key issue is not perfection, as Bebchuk and Ferrell imply, but the relative performance of institutions. Delaware and Takeover Regulation. The empirical literature evaluating takeover defenses has produced mixed results, consistent with the scholarly controversy over whether takeover defenses and auctions benefit shareholders. For example, some event studies find that the enactment of antitakeover laws produces negative stock price reactions, while others find that the price effect is statistically insignificant.141 Similarly, other takeover restrictions undertaken at the firm level, such as antitakeover charter amendments and adoption of golden parachutes, often have no price effect and on occasion even a significant positive effect.142 In addition, the evidence on whether a trade-off exists between higher premiums in auctions and fewer initial bids is inconclusive: although auctions do increase target premiums, the rate of takeover auctions does not appear to differ across states with and without takeover statutes, and the findings conflict concerning whether the presence of a takeover statute or defense reduces the number of takeovers or raises bid premiums.143 Bebchuk and Ferrell’s critique of state action on takeovers is supported empirically by the subset of findings that takeover statutes (and some takeover defenses) have negative wealth effects. Their analysis, however, overlooks key differences between Delaware’s takeover statute and other states’ statutes as well as differences in the political process between enacting a takeover statute and enacting other corporate law provisions. Their analysis also neglects the dynamics of national politics, which must be factored in if one is to consider the alternative to state competition, which involves a national regime. Those omissions render implausible Bebchuk and Ferrell’s conclusion that the enactment of takeover laws

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requires a “reassessment” of state competition for corporate charters and, by implication, the suggestion that competition should be scrapped in favor of a national regime, as they expressly identify their position with that of William Cary, who advocated replacing state corporation laws with a national regime.144 The critical factor that Bebchuk and Ferrell do not adequately address in maintaining that state takeover laws should be considered paradigmatic of all corporate code provisions and the basis on which competition should be judged is that Delaware, the state with the largest stake in the chartering business, stands out as an anomaly in the pattern of takeover legislation on which Bebchuk and Ferrell’s argument relies. For instance, in contrast to its position as an innovator of corporation code provisions, in the takeover statute context Delaware has persistently been a laggard behind other states.145 By the time Delaware had enacted its first-generation takeover statute in 1975—seven years after the first such state law was enacted—seven states had already previously acted.146 In addition, Delaware did not adopt a second-generation statute until after the Supreme Court had upheld such statutes in CTS Corp. v. Dynamics Corp. of America,147 in contrast to twenty other states that had already done so.148 More important, Delaware’s takeover statute is considerably less restrictive of bids compared with those of most, if not all, other states. For example, bidders are exempt from the statute entirely if they obtain 85 percent of the shares in their offer, and the restrictions on bidders have a shorter duration—three years—compared with durations in other states, such as New York’s five years.149 Greater flexibility and protection for hostile bidders were also defining characteristics of Delaware’s firstgeneration takeover statute, which did not have a hearing requirement— the prime method by which those early statutes sought to defeat hostile bids—and in contrast to most states, the statute’s coverage was optional.150 Correspondingly, in contrast to the second-generation antitakeover statutes of other states, the Delaware statute did not have a negative stock price effect.151 Finally, John Coates has sought to measure the extent to which the default rules of a state corporation code restrict hostile bids by delaying

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their success. He concludes that Delaware is the least restrictive state; it has the lowest score on a scale in which the lower the score, the shorter the time a bid can be delayed and hence the easier it is for a hostile bidder to succeed.152 While firms can and do change the Delaware default rules, shareholders will have to approve the changes if the provisions are in the corporation’s charter or will be able to reverse the changes if the provisions are in the bylaws. Consistent with the data on Delaware’s takeover statute and corporation code defaults, Robert Daines finds that Delaware firms are more likely to receive a takeover bid and to be acquired than are firms incorporated in other states.153 That is an important finding because Delaware is the leading incorporation state, and its laws govern the majority of large publicly traded corporations, entities for which Bebchuk and Ferrell’s concern over managerial opportunism is highest, as those firms are the least likely to have controlling shareholders (managers owning a substantial percentage of the firm). The gulf between Delaware and other states regarding takeover legislation is considerable and it has real consequences. One reason Delaware’s statutory output regarding takeover regulation differs from that of other states is that Delaware’s political dynamics differ markedly from the politics of other states. More bidders and more targets are incorporated in Delaware than in other states, and no one target corporation can have significant legislative influence in obtaining a favorable law, as has been true in the passage of takeover laws in most other states.154 Bidders will focus their energy on lobbying in states where the rewards are greater—where a higher number of prospective targets exist—and where their efforts are more likely to pay off—where they have local contacts. Both those factors are true of Delaware. Moreover, in contrast to other states, in Delaware the corporate bar broadly vets all changes to the corporation code, and the legislature considers only revisions approved by the bar committee.155 The diversity in representation in corporate clients across the bar has ensured that all sides have input into the drafting process. Bebchuk and Ferrell overlook the distinctive features of Delaware politics and maintain instead that corporate managers lobby only for rules favorable for targets when it comes to takeover legislation.156 Although that

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is a plausible initial hypothesis, as many individuals care more about adverse outcomes than favorable ones,157 the members of the corporate bar, and not corporate managers, are the key players in the Delaware legislative process.158 If legal counsel were to lobby for laws that benefited managers at the cost of reducing share values, the value of counsel’s human capital would decrease as Delaware could lose its primacy among incorporation states. Attorneys in other states do not have an equivalently valuable asset to deplete, and as they typically represent solely targets, while Delaware lawyers tend to represent both sides of deals, non-Delaware lawyers have an additional reason to support laws favoring target management: after an acquisition, the combined entity most often uses the acquirer’s counsel, not the target’s counsel. It is simply not in the Delaware corporate bar’s selfinterest to eliminate the possibility of successful hostile bids. Furthermore, given contemporary compensation contracts that provide executives considerable sums of cash upon control changes, the scenario that Bebchuk and Ferrell have postulated concerning managers’ incentives—avoiding acquisition at all costs—is dated. Managers are far more likely to use defenses to increase the bid price—as they obtain increased equity compensation upon takeovers, because stock options accelerate and often increase in amount upon a takeover—than to thwart the bid.159 In addition, while the line between target and acquirer is not always clear-cut, firms that have extensive acquisition programs exist, and the vast majority of firms that have made an acquisition, as well as an acquisition classified as a hostile one, are incorporated in Delaware.160 The incentive of those firms’ managers is to ensure that Delaware’s legal regime does not restrict takeovers because it has the largest pool of targets, and not, as Bebchuk and Ferrell assert, to lobby for antitakeover legislation. By focusing exclusively on the domicile of the manager, Bebchuk and Ferrell lose sight of the fact that acquirer managers are intelligent enough to recognize that Delaware is the home of the vast majority of potential targets. Hence, having a law facilitating bids would be more important for the managers of acquirers than any concern about their own firms’ vulnerability to a bid, which can be satisfied by firm-level defenses. Moreover, in contrast to other states, no domestic Delaware corporation employs a significant in-state work force that could offset the

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magnitude of franchise tax collections and provide clout to obtain tailormade takeover legislation. Consequently, concerns other than stock price maximization, such as protecting target firm jobs, which tend to make legislators partial to the managers’ rather than to the shareholders’ position regarding the success of a bid, do not affect the making of takeover law in Delaware as much as they do in other states.161 Finally, although Bebchuk and Ferrell suggest that managers can exploit shareholders by selecting takeover regimes that enable them to expropriate shareholder wealth, that is simply not the case. Not only does the enactment of multiple takeover statutes in many states indicate that legislation does not stop bids, but the experience in one state that adopted a uniquely restrictive statute is highly instructive. When Pennsylvania adopted a takeover disgorgement statute that was considered to be more draconian than any other antitakeover law,162 institutional investors pressured managers to opt out of the statute, and a majority of firms did so. Of 199 publicly traded firms whose choices could be identified, 127 opted out of all or part of the statute while 72 did not.163 Moreover, other states did not copy the Pennsylvania statute. Managers do not operate in Bebchuk and Ferrell’s posited environment that permits them to ignore with impunity investors’ wishes regarding takeover regulation. In contrast to the situation in Pennsylvania, investors have not pressured managements to opt out of other takeover statutes, including Delaware’s, while they routinely press managers to rescind or subject to shareholder approval firm-level defenses, such as poison pills.164 The most plausible explanation of their behavior is that, while they disagree with managers about specific defensive tactics, they do not perceive that takeover statutes significantly affect the initiation or outcome of a takeover bid, rather than the characterization implicit in Bebchuk and Ferrell’s explanation and call for federal intervention, that they are helpless victims of managers’ expropriative regime choices. The finding of Robert Comment and G. William Schwert that state takeover laws do not reduce the number of bids supports that contention.165 Indeed, notwithstanding Bebchuk and Ferrell’s picture of a “fortress” corporate America constructed with the assistance of state legislatures, as takeover statutes proliferated across states, so did acquisitions. The thesis that Delaware has a relatively mild

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takeover statute is, accordingly, not an “excuse” for state competition as Bebchuk and Ferrell assert, but rather compelling evidence that the state most concerned about charter competition is the most responsive to shareholder interests. In their most recent paper, Bebchuk and his colleagues fashion a new argument related to state takeover laws that minimizes the import of the data that I have discussed in this chapter, which indicate that state competition benefits shareholders. They assert that the fact that many firms do not reincorporate in Delaware but remain domiciled in states with more restrictive takeover statutes than Delaware’s demonstrates that state competition harms shareholders and that a greater role for the federal government is warranted.166 They do not state what they believe the world would look like if competition were working well nor whether they consider the current state of affairs a long-run equilibrium, which makes it difficult to assess their objection. But the following two possibilities for a perfect competition equilibrium are implied from their analysis: either all firms should be in the state with no takeover statute (as they consider such statutes to harm shareholders); or, since they contend that competition forces all states to enact the same laws (a fact contradicted by their subsequent distinction of states by takeover statutes), firms should be indifferent about their statutory domicile and located randomly across the states. Obviously, neither of the patterns that are implied by their analysis of state competition occurs: not all firms are domiciled in the eight states with no takeover statutes, and firms are not randomly distributed across the states. But the discrepancies between the existing and implied domicile patterns are not the precise basis for their conclusion that competition is not working well. Rather, that conclusion relies on comparing the proportion of firms incorporated in the state in which they have their current headquarters and finding that it differs across the states. Bebchuk and his colleagues do not, however, provide a theory for why the outcome of competition should be assessed by comparing incorporations to physical domiciles; that is, they do not offer a theory, for example, under which firms that are indifferent to incorporation state should be located according to physical domicile, compared with a random distribution, and why

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100 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION benchmarking incorporations by current headquarters state would demonstrate that competition is a race to the top or to the bottom.167 Indeed, it is difficult to know what to infer from the discrepancies Bebchuk and his colleagues identify between firms’ domicile and headquarters states. That is so because they have data solely on current headquarters status. To illustrate the difficulty, consider the GTE Corporation, which is incorporated in New York and headquartered in Texas. They characterize that observation as a “loss” from Texas to New York and explain it as resulting from takeover statutes, because New York has more of the takeover statutes they deem relevant than does Texas. But the actual path of GTE’s domicile and headquarters locations muddies that characterization of the domicile selection process. GTE was organized as a New York corporation in 1935 to acquire the New York assets of a bankrupt Delaware utility holding company. Thus, its initial domicile and initial physical location were in the same state. In 1973 the firm moved its headquarters to Connecticut, while retaining the New York domicile. Neither state had a takeover statute at the time of the move. In 1998 GTE relocated its headquarters again, this time to Texas, and again it retained the New York domicile. Should we conclude that the relevant factor in the retention of the domicile in 1998 was the number of takeover statutes enacted by New York compared with those by Texas, a factor not possibly relevant when the domicile was retained in 1973 upon the earlier headquarters relocation? In my judgment, it is more plausible to conclude that numerous factors influence the domicile decision, and the correlation among takeover statutes, headquarters, and domiciles that Bebchuk and his colleagues find by examining current domiciles without controlling for changes in location, although interesting, is unsatisfactory as an explanation. A further issue to note is that it is a mistake to evaluate the efficacy of competition by comparison of the domicile choices of all corporations with the location of their headquarters, rather than to evaluate the charter market by the choices of the marginal consumer, the reincorporating firm. The premise of Bebchuk and his colleagues’ comparison of all firms’ domicile choices, rather than the decisions of reincorporating firms, is that the manager of a firm is constantly reevaluating the domicile choice,168 so that a firm that has not moved to Delaware reflects the firm’s minute

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reassessment of local law, and on one dimension, the state’s takeover statutes, compared with Delaware law. That assumption does not, however, square with reality. Just as homeowners do not ask themselves every day whether they should move, firms do not consider their domicile on a daily or even annual basis. Reincorporation is costly, and the legal regime matters only when the firm will be undertaking transactions that increase the likelihood of shareholder litigation, such as mergers or acquisitions.169 Accordingly, just as home sales are typically considered in conjunction with major changes in familial circumstances—such as a death or change in marital or employment status—a corporate domicile change is invariably considered only in conjunction with significant changes in firms’ operating plans related to the probability of undertaking litigationinducing transactions. It is therefore incorrect to assume that the specific content of the corporation code of the state in which they are headquartered, and, in particular, the number of takeover statutes, compared with that of other state codes, is a pressing concern to most firms and the reason for their domicile choice. In addition to the impact of firm-level changes, firms may become concerned about their legal regime because of exogenous shocks in the business environment that require new legislation for profitable operation. Under such circumstances they might consider reincorporation into a state that is more responsive, even though their particular circumstances have not changed. An example of that situation in corporate law is Delaware’s enactment of a limited liability statute in the mid-1980s when the business environment was changing dramatically, given an unsettled market for directors’ and officers’ liability insurance. Several firms reincorporated to Delaware shortly thereafter to be covered by the new statute.170 Again, a firm’s reconsideration of its statutory domicile under such circumstances has no relation to the yardstick by which Bebchuk and his colleagues would evaluate domicile choice, as the time frame in which they examine the pattern of incorporations was not a time of business flux or particular legal innovation. Firms, then, reassess their domicile choice quite differently from the hypothesis of Bebchuk and his colleagues, and one consequently cannot infer from the presence or absence of takeover statutes in a state that that

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102 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION is the reason why a firm is not incorporated in Delaware. In fact, little reason exists to contend, as do Bebchuk and his colleagues, that takeover statutes are, and should be, the sole dimension on which a firm would choose its domicile, and in particular, why that would be the distinguishing characteristic for choosing between Delaware and the state of the firm’s headquarters.171 Their statistical analysis using the number of takeover statutes as the distinguishing regime feature explains little of the variation in whether firms are domiciled in their headquarters state: in a regression with over 6,000 observations, the goodness of fit indicates that their model of domicile choice depending on state takeover statutes has explained only between 10 and 13 percent of the variation in domicile choice; that is even lower than the amount of variation (15 percent) explained by their regressions that exclude the state takeover statute variables.172 Accordingly, the positive correlation they report between the number of takeover statutes in a state and firms’ selection of their headquarters state as domicile does little to explain that domicile choice and may well be less important than other state characteristics omitted from the analysis. Additional characteristics of a state’s legal system, given the reasons why firms actually reincorporate,173 that Bebchuk and his colleagues should, but do not, control for are the responsiveness with which a state updates its corporation code, the quality of its judiciary in corporate law cases, and, correspondingly, the degree of certainty provided by the legal regime, including whether the state offers a stock of case law, either because there are many in-state corporations or because it is a Model Act state.174 Those factors reduce the desirability of a Delaware domicile regarding the provision of legal certainty and innovation (the network effects that Bebchuk and his colleagues emphasize are the reason firms select Delaware as their statutory domicile). A further difficulty with Bebchuk and his colleagues’ inference that state competition enables managers to expropriate shareholder wealth from the difference across states in firms’ choice of their headquarters location as domicile is their failure to include highly relevant firm characteristics in the statistical analysis. First, most firms will never become acquisition targets, let alone the object of a hostile takeover. Bebchuk and his colleagues do not, however, distinguish across firms’ probabilities of

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hostile takeover in comparing firms’ current statutory domiciles and headquarters states, although they could have attempted to do that, using the firm-specific characteristics that researchers have found to have predictive power on the probability of a bid.175 Without taking that into account, it is not possible to conclude that firms’ domicile choices (when they are incorporated in the same state as their current physical domicile) are determined solely by the presence of a takeover statute and are harmful to their investors. That is another reason why it is preferable to evaluate state competition by studying the choices of reincorporating firms which have a reason to make an active domicile choice (or of firms experiencing a corporate event that is often accompanied by a domicile change, because it changes the firm’s relation with the legal system, such as an initial public offering). Second, other studies have found specific firm characteristics to be related to domicile decisions, yet Bebchuk and his colleagues do not include those variables in their analysis. For instance, in a univariate analysis, I found that firms with a higher likelihood of shareholder litigation, using number of acquisitions as a proxy for that probability, were more likely to be incorporated in Delaware.176 Indeed, examined ex post, Delaware-domiciled firms had a significantly higher number of shareholder lawsuits filed against them.177 In addition, Barry Baysinger and Henry Butler found that insider ownership was inversely correlated with a Delaware domicile.178 The proportion of insider ownership would also be a relevant variable for identifying whether a firm is likely to be the target of a hostile bid and, accordingly, for whether the state-level variable emphasized by Bebchuk and his colleagues, the number of takeover statutes, would be of concern to a firm. Those data suggest that the choice of domicile is not likely to be unidimensional, as it is in Bebchuk and his colleagues’ model. At the least, the relative explanatory power of alternative statutory and firmlevel features ought to be compared with the number of takeover statutes enacted in a state before one concludes that takeover statutes determine domicile choice. There is, furthermore, another, straightforward explanation why the domicile data emphasized by Bebchuk and his colleagues do not demonstrate that state competition is a failure, apart from the problems already discussed. The central insight of Ralph Winter’s classic critique of Cary’s

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104 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION analysis of the adverse impact of state competition has bearing on Bebchuk and his colleagues’ analysis as well.179 To the extent that they are correct and the presence of many takeover statutes reduces shareholder wealth, then the share prices of firms incorporated in headquarters states with such regimes will be lower than the share prices of firms incorporated in Delaware. The adverse effect on shareholders will be impounded in the stock price and borne by the managers, as investors will pay less for firms that go public in states that have enacted such statutes.180 Of course, there would be a one-time wealth loss to investors whose firms were incorporated before their domicile states adopted the multitude of takeover statutes of interest to Bebchuk and his colleagues if those statutes are wealth-decreasing.181 But there is a mechanism for shareholders to ameliorate such a problem: they could propose reincorporating in Delaware or opting out of the wealth-decreasing state takeover laws. As earlier noted, however, institutional investors have not perceived the choice of domicile, nor coverage by takeover statutes besides Pennsylvania’s disgorgement statute, to be of any moment. The numerous studies of shareholder proposals report very few proposals to reincorporate or opt out of a takeover statute by either institutional or individual investors, in contrast to hundreds of proposals to eliminate firm-level takeover defenses such as staggered boards and poison pills.182 The absence of such investor activism suggests that Bebchuk and his colleagues’ assessment of the statutes is incorrect. Further support of this interpretation can be drawn from the fact noted earlier that the positive abnormal returns firms experience upon a reincorporation are greater in magnitude than the negative abnormal returns observed upon enactment of a takeover statute. Finally, it should be noted that Bebchuk and his colleagues place great weight in their analysis on the movement of firms among states other than Delaware. They stress that their takeover statute index, measured for the firms whose headquarters state differs from their non-Delaware domicile, is significantly higher than it would be had those firms remained domiciled in their headquarters state. They do not, however, consider movement to Delaware in their analysis. That is an important omission. The takeover statute index is significantly lower for the firms that have moved to

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Delaware than it would be had they remained domiciled in their headquarters state. Thus, Delaware is not simply a magnet for firms whose headquarters states have no takeover statutes, as Bebchuk and his colleagues’ analysis would appear to imply.183 Firms incorporating in Delaware on average decrease their level of takeover protection, while those incorporating elsewhere increase it. That comparison illustrates the thesis of this section: the beneficial impact, from the shareholders’ perspective, of the presence of the dominant state in the charter market, Delaware, in the takeover context. Bebchuk and his colleagues’ latest objection to state competition boils down to this: with the exception of firms headquartered in California, which they implicitly would want to stay domiciled at “home,” firms are criticized for incorporating in the state of their headquarters rather than in Delaware because those states have more takeover statutes than Delaware. That is a stunning concession, as it is a complete reversal of the long-standing characterization by critics of state competition, including Bebchuk, of Delaware as a pariah state promoting a “race to the bottom” among states with regard to shareholder welfare. It should also be noted that their implicit criticism of California-headquartered firms for being incorporated in Delaware—that Delaware has a takeover statute and California does not—is inconsistent with the policy position that Bebchuk and Ferrell have expressed in other articles: they advocate enactment of takeover regulation to prohibit partial bids as formulated in the London Code of Conduct or a control share acquisition statute.184 The Delaware business combination statute is, in fact, closer to their preferred form of takeover regulation, compared with California’s unregulated takeover market, because it makes partial bids more expensive by preventing the bidder from engaging in a second-step acquisition for three years after a takeover. But the view that all firms ought to be domiciled in Delaware (let alone in California) is also not what we should predict if competition is working well. As noted earlier, the transaction-cost explanation of reincorporation, which I elaborated in my work on state competition, provides an explanation why a corner solution—all firms are incorporated in one state such as Delaware—is not the predicted market equilibrium: the legal

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106 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION regime matters only to corporations that anticipate engaging in certain transactions, and a domicile change is sufficiently costly that firms will not reincorporate in the absence of plans to undertake those transactions.185 But even if, for the sake of argument, we were to concede that Bebchuk and his colleagues’ analysis of the problem was correct, their assertion that state charter competition needs to be replaced with an “alternative” corporate law regime and “federal intervention” does not follow. For if the difficulty is that not all firms are incorporated in the leading incorporation state because managers can stay at “home” when that state offers more favorable treatment on the takeover dimension than Delaware, all that would be required to remedy the hypothesized problem would be the procedural reform of permitting shareholders to approve a change in domicile without management approval.186 Would National Takeover Legislation Be Superior to the Output of State Competition? Because there would be no competing regimes whose takeover rules could differ, the national government might not feel as pressured to revise its takeover law repeatedly to thwart hostile bids, but it also would not be as constrained regarding the level of protection it chose by the presence of alternative opportunities facilitating bids, compared with states in a competitive federal system. In fact, the idealized national regulation that Bebchuk and Ferrell advocate in place of state competition is a pipe dream. The congressional legislative process regarding takeovers is similar to that of most states; it resembles more closely the dynamics of the Pennsylvania process than that of Delaware.187 The political failure, which is the linchpin of Bebchuk and Ferrell’s critique of state competition, that entrenchment-motivated management controls the legislative process, will therefore not miraculously disappear when Congress is the object of lobbying. The Williams Act, for example, is widely recognized as favoring targets by having increased the acquisition cost of bidders,188 and the act is more effective at delaying a bid and inducing an auction than the states’ second-generation statutes. It is highly improbable that Congress would adopt the form of takeover regulation that Bebchuk and Ferrell believe to be optimal. It is also worth noting that firms in Indiana, which enacted a statute indistinguishable from Bebchuk’s earlier

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proposed takeover regulation, experienced significant negative stock price effects from the legislation.189 The difference between Congress’s likely response and Bebchuk and Ferrell’s proposal is not simply speculation. Bebchuk and Ferrell praise as preferable to the output of state competition the takeover rules in the London Code of Conduct, established by the City’s Panel on Takeovers and Mergers, which regulates takeover bids in the United Kingdom.190 The London Code requires bidders to buy all target shares and prohibits defensive tactics without shareholder approval once a bid has commenced. Congress, however, expressly did not adopt the takeover rules embodied in the London Code, although it surely could have done so. In fact, the Williams Act expressly permits partial bids. Moreover, Congress never even considered restricting defenses when enacting the Williams Act, which instead increased management’s defensive arsenal by providing a basis for litigation: bidders’ failure to comply with various aspects of the act. Indeed, while over 200 bills regulating takeovers were introduced in Congress from 1963 through 1987, of the 67 bills directed at contested bids, 30 were directed solely at regulating hostile bids while 11 were directed solely at regulating defensive tactics or greenmail.191 The remaining bills included elements of both forms of regulation but often had provisions permitting firms to opt out of restrictions on management defensive tactics but not the restrictions on hostile bidders. In other words, the type of legislation of most interest to members of Congress is decidedly against facilitating bids or allocating greater authority to shareholders over incumbent managers in the bidding process, which is Bebchuk and Ferrell’s objective for federal legislation. Instead, it is in keeping with the state legislative approach. The contrast between the provisions of the London Code and the Williams Act makes clear that the U.S. national political process has no resemblance to Bebchuk and Ferrell’s perception of it, which is the premise for their preference for national legislation over the output of state competition.192 The contrast also indicates that their proposal for a federal takeover law option that would duplicate the London Code and eliminate defenses is utterly unrealistic regarding what would be the output of any federal takeover legislation, whether optional or mandatory.

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108 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Equally important, the provisions of the London Code that Bebchuk and Ferrell praise are largely beside the point in the U.S. takeover context. The London Code provision that bans midstream defenses without shareholder approval, while absent from state corporation codes, would have little practical significance for U.S. corporations. Today, the most effective defense that U.S. firms adopt midstream is a poison pill, which can also be adopted before a bid is in the offing and hence would not be prohibited by enacting the London Code. That is so because institutional investors vigorously oppose midstream charter amendments that erect takeover defenses. Hence, since the late 1980s, U.S. corporations have generally not been able successfully to propose defensive charter amendments such as classified boards or elimination of cumulative voting.193 In addition, the use of a poison pill defense to thwart a bid is limited, as a successful proxy fight can eliminate a pill and prominent state courts have not permitted managers to adopt provisions midstream that impede proxy fights.194 Finally, a ban on defenses without shareholder approval once a bid commences would simply result in managers’ rendering their firms more hostile bid–proof before any bid is on the horizon; it would not eliminate the use of defensive tactics. If bidders are deterred from making an offer by the existence of multiple defenses, then the consequence of enacting a rule similar to the London Code—the ratcheting up of defenses before a bid is in the offing—could well be to reduce the probability of a bid below that which occurs under the current regime, where defenses are adopted in response to bids. The other London Code provision, the 100 percent offer rule, is of even less significance as evidence of a political failure in state takeover law. Several states have, in fact, enacted takeover statutes with identical effect, for example, the requirement that bidders make 100 percent offers.195 Many firms have also adopted similar provisions in their charters with or without specific state authorization.196 In addition, with the development of junk bond financing in the 1980s, partial takeovers, although permitted, became a largely irrelevant factor in the U.S. acquisition market. Finally, and most important, the research on premiums and on success rates of full and partial bids indicates that partial bids do not produce a prisoner’s dilemma in which shareholders are forced to tender into a

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low-ball bid because they fear a majority will tender and they will receive less in a second-stage freezeout if they do not, which is the rationale for prohibiting such bids. Blended premiums in two-tier bids do not significantly differ from the premiums in 100 percent offers; when competition exists between 100 percent and two-tier offers, the one with the highest value calculated by the blended premium wins; and partial bids offering small premiums are rejected at high rates.197 Bebchuk and Ferrell focus on takeover statutes as the core of the case against state competition because much state activity in corporate law is legislative and the diffusion process of code reforms, as discussed earlier, is considered a sign of robust competition. But corporate counsel have never considered takeover statutes a particularly effective defense; they serve principally to assist targets that have not adopted adequate defenses before the emergence of a hostile bid. Rather, the poison pill is considered a firm’s most effective defense. Cognizant of that fact, Bebchuk and Ferrell add to their litany of complaints against state competition criticism of the Delaware judiciary for permitting the use of poison pills. But not all commentators accept Bebchuk and Ferrell’s negative assessment of defenses such as poison pills; as previously noted, some commentators view defenses as a useful bargaining device to obtain higher prices. From that perspective, judicial approval of poison pills is not a failure of state competition. Bebchuk and Ferrell also overstate the latitude that Delaware courts have permitted managers to exercise with respect to defensive tactics. Not only have Delaware courts required a pill to be redeemed when it ceased to serve its function—increasing the bid price—and was being used solely to entrench management,198 but they also have repeatedly refused to permit managers to adopt poison pills that cannot be eliminated by shareholder action—such as, deadhand pills that prevent shareholders from electing new directors who will redeem a pill in a hostile bidder’s favor— or otherwise impede the proxy process midstream.199 In contrast to the Delaware courts, federal district courts making state law rulings have permitted managements to craft poison pills that shareholders cannot eliminate after a successful proxy fight.200 It is ironic that district courts, the rulings of which Bebchuk and Ferrell would surely

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110 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION disapprove as they hinder shareholders’ ability to receive bids, are the very same courts that would be interpreting the national takeover law that Bebchuk and Ferrell advocate in place of competition, in contrast to the Delaware courts, whose rulings on the identical issue Bebchuk and Ferrell would presumably approve because they protected shareholders from management exploitation through unredeemable poison pills. Yet the Delaware courts would lose jurisdiction over management actions were Bebchuk and Ferrell’s normative position favoring national takeover regulation to be adopted. Finally, it should be noted that where charter competition is lacking, we do not find a higher rate of hostile takeovers or an absence of antitakeover devices, as Bebchuk and Ferrell’s analysis of state competition and national regulation implies. In continental Europe, for example, where a physical domicile choice-of-law rule prevents charter competition, firms with dispersed share ownership are rare, and groups retain control through elaborate voting arrangements and pyramid control structures that limit outside investors’ influence and prevent hostile takeovers. Indeed, what is considered in the United States one of the most effective takeover defenses, and yet rarely encountered in publicly traded firms, violation of the principle of one-share one-vote, in which insiders or other favored investors hold more votes than represented by their economic interests, is quite common in continental firms.201 While there are, to be sure, numerous reasons for the lack of hostile takeovers in Europe compared with the United States besides the absence of charter competition, it is instructive to note that the evidence from around the globe suggests that the output on takeover regulation of state competition is not as suboptimal as critics of state competition such as Bebchuk and Ferrell imply. An important closing point must be made regarding state competition, national noncompetitive regulation, and Bebchuk and Ferrell’s critique. If Bebchuk and Ferrell are correct, and takeover statutes are paradigmatic of the output of state competition such that one could characterize corporation codes as favoring managers over shareholders, then it is exceedingly difficult to explain the most salient features of comparative corporate governance in which the United States excels over

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virtually all other regimes: not only are U.S. capital markets the thickest in the world, but also U.S. corporations have a more dispersed shareholder base, operate under corporate laws with greater protection of public and minority shareholders, and are subject to more takeovers compared with corporations in other countries.202 In addition, crosscountry data further suggest that improved allocation of capital—a real economy effect—is positively related to shareholder protection under corporate law and the extent of capital market development.203 State competition for corporate charters is the most distinguishing feature of the U.S. legal regime that has produced those benefits for investors, as all other countries except for Canada and Australia have national corporate law systems, and those two nations do not have charter competition.204 The existence of the SEC cannot explain those facts. The dominance of U.S. capital markets as the largest and most liquid equity markets predates the creation of the SEC. Moreover, the empirical literature finds no value added by what the agency has done. The comparative governance data are undisputed, and they cannot be squared with Bebchuk and Ferrell’s unfavorable assessment of state competition.

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4 Implementing Competitive Federalism for Securities Regulation

Although both the states and federal government regulate some aspects of securities transactions, the current regulatory arrangements are a far cry from competitive federalism. While the federal laws do not preempt all state regulation, states cannot lower the regulatory standards applicable to firms covered by the federal regime because its requirements are mandatory. States have also been prevented from raising regulatory standards on some occasions. For example, in Edgar v. MITE, the Supreme Court invalidated a state takeover law that contained more extensive regulation of bids than the federal rules regarding such transactions, as a burden on interstate commerce.1 In addition, the legislative preemption of private securities litigation has prevented purchasers or sellers of publicly traded securities from benefiting from state standards that use negligence, rather than intentional misconduct, for securities fraud. As a consequence, the states have essentially abandoned the regulation of public firms, where they have not been stripped of it, to the Securities and Exchange Commission. Under competitive federalism, state and federal regulators would stand on an equal regulatory footing, and firms would be able to choose the applicable regulatory regime. What Must Be Done to Achieve Competition? Operationalizing competitive federalism for securities regulation for issuers requires two legislative reforms. The first and more straightforward reform is to make the federal securities laws optional. An act of Congress could achieve that. Alternatively, the SEC could cede its exclusive 112

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authority over public corporations under its exemptive power.2 That solution is, however, akin to asking the agency to put itself out of business, behavior that would be decidedly out of character for an agency that has historically sought to aggrandize, not minimize, its jurisdictional scope.3 In addition, an act of Congress expressly eliminating the SEC’s exclusive regulatory authority over publicly traded firms is the preferable course of action because the statute creating the SEC’s exemptive authority also preempted the states from applying registration requirements to nationally traded securities.4 The apparent inconsistency between using the exemption to increase state authority when Congress was otherwise reducing state authority would provide opponents of competitive federalism the opportunity to delay, if not defeat, its implementation through litigation. The second major policy reform—adapting the choice-of-law rule governing securities transactions (site of sale) to one compatible with competition (issuer domicile)—could be more complicated to accomplish because it would entail coordination by the states to adopt a new rule. It would therefore be more expedient for the congressional legislation making the federal regime optional also to institute the requisite change in choice of law, and this book advocates such an approach. But because Congress has not typically legislated choice-of-law rules, it will be useful not only to explain the requisite change but also to justify its adoption and critique the reigning conflicts approach. In addition to those two jurisdictional changes necessary to implement competitive federalism in securities regulation, a change must be made in the SEC’s regulation of market professionals to maintain the integrity of competitive federalism. To prevent the SEC from being able surreptitiously to regulate issuers not subject to its jurisdiction, the small subset of SEC regulations that relate market professionals’ conduct to substantive SEC regulation of issuers, such as the requirement that brokers and dealers obtain issuers’ periodic SEC filings before providing quotations,5 will have to be modified to refer to the substantive law of the issuer’s domicile. Such a reform will not undermine the SEC’s responsibility to oversee market professionals. Given that none of the SEC’s substantive issuer disclosure requirements are drafted with its market

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114 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION professional oversight responsibilities in mind, where states require a different or reduced set of issuer disclosures than the SEC, such information would also be adequate for the SEC’s oversight purposes, as competition will produce the level of issuer disclosure deemed cost-effective by investors. Even more important than the rules governing market professionals, a critical change must be made to the existing regulatory regime for exchanges to integrate successfully the SEC’s continued oversight of exchanges with a competitive regime for issuers. The SEC’s authority over exchanges must be statutorily limited to non-issuer-related matters, such as trading rules. Otherwise, the agency could undermine competitive federalism by introducing mandatory rules for issuers in the form of exchange requirements that preempt competing state regimes. That is a real concern. In the past, the SEC has sought to impose corporate governance requirements through exchange rules, which had to be thwarted by federal courts that viewed such matters as appropriately left to the states.6 The success of competitive federalism ought not to have to rely on the vagaries of policing the boundaries of the SEC’s regulation of exchanges by means of litigation. A need exists to delimit the SEC’s authority on that front. Congress can accomplish that by explicitly prohibiting the SEC’s ability to impose corporate governance requirements on exchanges and instructing the federal courts to strike down any such efforts by the agency. Finally, beyond the altered jurisdictional requirements, two additional statutory requirements are recommended to ensure the successful implementation of competitive federalism in the securities law context. They are the requirement of disclosure of an issuer’s securities domicile to the purchaser of a security at the time of the purchase and of a shareholder vote to approve a change in an issuer’s securities domicile. The Appropriate Choice-of-Law Rule for Securities Transactions. For competitive federalism to work, only one sovereign’s law can apply to an issuer’s securities transactions. That means that only one state’s securities law would govern securities transactions when the SEC option is not invoked. Similarly, when the SEC regulatory option is selected, it would

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preempt all state securities regulation, including antifraud provisions. The state with legislative jurisdiction7 must be voluntarily connected to the issuer to ensure that state competition operates properly—that one state’s law governs, and it is the state chosen by the issuer. That would necessitate recrafting the current choice-of-law approach, which follows the site of the securities transaction and not the issuer’s domicile. The prevailing choice-of-law approach to securities transactions is codified in provisions of the Uniform Securities Act. The applicable law is that of the site of the transaction, which is the state in which either the offer or the acceptance to buy the security takes place.8 More than one state can claim legislative jurisdiction over a transaction under that approach, and the state whose law governs is not connected to the issuer. The choice-of-law rule, under which the securities law varies across a firm’s stockholders according to where they purchased their shares, has a number of undesirable consequences. They include lack of uniform treatment across similarly situated individuals and unpredictable standards of conduct for issuers, given the possible application of fifty-one state and District of Columbia statutes. Those difficulties are, in fact, on occasion advanced as the rationale for the federal securities laws in cases involving the states’ overlapping jurisdiction with the federal regime, such as the regulation of broker-dealers.9 Frank Easterbrook and Daniel Fischel have suggested an analogous rationale for a federal law: the efficiency of enforcing all claims involving a particular transaction in one case.10 The corporation code setting eliminates the operational problems created by an absence of uniformity and predictability due to multistate shareholders because the choice-of-law rule recognized by all the states fixes one state’s law—that of the incorporation state—as governing all shareholders’ claims. That choice-of-law rule is known as the “internal affairs doctrine,” because the subject matter of corporate law concerns the internal affairs of the corporation—that is, how it is organized and governed—and not transactions with third parties.11 Recrafting the choice-oflaw rule for securities transactions to adopt the issuer-based jurisdictional approach of corporate law would resolve Easterbrook and Fischel’s concern regarding the consolidation of claims under state competition. As is true of shareholder class action claims for fiduciary breach at corporate

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116 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION law, all securities claims could be consolidated into one court action, with one law applying—that of the issuer’s securities domicile. Such a reform also resolves Easterbrook and Fischel’s other suggestion for why state competition would not work in the securities context: The potential to exploit out-of-state shareholders with rules favoring in-state shareholders, given the multistate jurisdictional rule based on shareholder residence.12 The potential problem of favoring residents at nonresidents’ expense would disappear because the reform would result in only one state’s law governing all shareholder transactions, regardless of shareholder residence. The rationale for applying the internal affairs rule to corporate law disputes is equally applicable to the choice of law for securities transactions. In particular, choice-of-law commentators justify the internal affairs doctrine by the need for uniform treatment of shareholders. For example, Robert Leflar and his colleagues assert: It would be intolerable for different holders of the same issue of stock to have different sets of rights and duties by reason of their stockholdings, perhaps according to the laws of the various places at which they acquired their stock. Unity of treatment is desirable, and the only single law by which it can be achieved is that of the corporation’s domicile.13

The Restatement (Second) of Conflicts of Law similarly stresses as the rationale for preserving the internal affairs rule the need for “[u]niform treatment of directors, officers and shareholders . . . which can only be attained by having [their] rights and liabilities . . . governed by a single law.”14 The Supreme Court has also followed that approach in considering whether state takeover laws violate the Commerce Clause. The Court’s validation of such statutes depends critically on a state’s exclusive legislative jurisdiction as the incorporation state—that is, on the internal affairs rule— which avoids the impermissible risk of a corporation’s encountering “inconsistent regulation by different States.”15 Application of the internal affairs rule to securities transactions should go further than cover litigation arising from initial public offerings

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under state registration requirements and should include secondary market trading. Fraud claims against an issuer should be uniformly adjudicated across investors. Differentiating fraud claims and corporate internal affairs is even more troubling than differentiating securities registration requirements from corporate law. No plausible rationale exists for distinguishing a fiduciary standard of conduct to govern an officer’s or director’s judgment concerning a corporate transaction, such as payment of a dividend or undertaking a merger, from that officer’s or director’s judgment concerning disclosure about the firm’s performance in a public document. Nor does a rationale exist for permitting the differentiation of such standards across shareholders. Yet choice-of-law rules establish the application of one state’s—the incorporation state’s—standard to fiduciary duties in corporate law but leave the decision on disclosure to vary with the investor’s domicile, even though a duty of full and fair disclosure is part of the fiduciary duties prescribed by state corporate law.16 Such intellectual incoherence concerning fiduciary conduct is the fallout of current choice-of-law doctrine. The bizarre possibility of fiduciary standards’ differing across shareholders according to their residence—or other location of their stock purchase or sale—has not been the focus of legislators’ or commentators’ attention because there have been few cases involving conflicting fiduciary standards: The vast majority of securities claims are brought in federal court and are settled.17 In particular, the problem of certifying a class when the standard of liability depends on the shareholder’s domicile or investment contract situs has not been raised with any frequency in the securities context, in contrast to the mass tort product liability context.18 Because the 1998 amendments to the securities laws preempted the filing of most civil actions for violations of securities laws in state courts, the issue should not arise in the future, unless state courts take an expansive view of the “Delaware carve-out” noted earlier,19 or the proposal for competitive federalism in securities regulation is adopted without simultaneously changing the current choice-of-law approach. An additional salutary effect of following an internal affairs approach to securities regulation would be elimination of the potential problem of underenforcement with multiple potential regulators. Without an

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118 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION exclusive regulator jurisdictional approach, ambiguity in regulatory responsibility could lead to regulatory free riding, as each regulator expects another regulator to do the work. The expansion of Internet trading increases the likelihood of such a scenario, as the electronic media enable an increasing number of investors from numerous jurisdictions to trade in an issuer’s securities.20 The internal affairs rule specifies precisely one regulator—the issuer’s securities domicile—and thereby removes the possibility of a free-riding problem. Flaws in the Reigning Choice-of-Law Approach to Securities Transactions. Conflict-of-law scholars typically rationalize the disparate choice-of-law approach to securities law that insulates state regulation of transactions in foreign corporations’ shares from application of the internal affairs rule by contending that individual securities transactions do not implicate concerns about uniformity.21 The explanation advanced for the distinction has two prongs. First, in stock transactions, the individual purchasers are not yet shareholders—that is, they are not members of the “corporate community.” Therefore, the transaction can be characterized as of purely local effect, which is said to give the buyer’s domicile state an interest in regulation more significant than the issuer’s state. Second, a corporation can avoid a state’s regulation by not selling its shares in that state. Thus, the corporation need not be subject to inconsistent regulations.22 The choice-of-law distinction between corporate and securities law is a legerdemain, but it has a certain practicality: It is more feasible for a corporation to issue fifty different disclosure statements to accompany the registration of securities than it is to operate with fifty different policies on dividend payouts and voting rights. The flaw in the choice-of-law analysis that distinguishes corporate and securities laws is, however, easy enough to identify. The common shares of a corporation are the same in whatever state they are sold, and it is arbitrary to apply different criteria to transactions in the same securities simply because of differences in purchasers’ residences. Indeed, securities litigation between investors and issuers is not individualized litigation. In the anonymity of modern capital markets, management’s defective disclosures are not differentially or personally directed at

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particular investors, and the composition of the class of affected shareholders—those who entered into transactions in the relevant interval—is therefore fortuitous. In short, neither the prospective feature of the shareholder relation for a buyer of new securities nor the voluntary choice of selling securities in particular states can be characterized as individualizing the multiparty context of the corporate contract sufficiently to overcome the desirability of regulatory uniformity across security transactions for the issuer, as well as for its investors, as they bear the increased cost of compliance with a panoply of regimes. The demand for uniform and consistent treatment across all investors in one firm is, in fact, recognized by the states’ voluntary refusal to exercise regulatory authority over the registration of securities of interstate, or exchange-traded, corporations. The shift in legal regime from mandatory to optional federal coverage would not alter the desirability of that approach. Just as the federal law has trumped securities choice-of-law analysis under the exemptive policy of the state statutes, where a public corporation has chosen a specific state over the SEC as its securities regulator, so should that state’s law govern registration requirements. Moreover, the limitation of a court’s exercise of local legislative jurisdiction by a contract’s choice-of-law clause selecting a foreign state is well established.23 Although courts refuse to enforce such provisions in specific circumstances—when defects exist in contract clause formation, such as when the contracts are unconscionable adhesion contracts, or when the contracts contravene the public policy of the state that would otherwise exert legislative jurisdiction24—those exceptions are not relevant for securities transactions. First, given the multiplicity of investment choices, securities transactions are not adhesion contracts. In addition, the proposed notice requirement concerning which state’s law applies would render highly remote the possibility that an investor’s agreement to a choice-of-law clause was fraudulently obtained. Second, securities transactions specifying the governing law of a state other than the buyer’s state are also not contracts in contravention of public policy, the enforcement of which would deprive the plaintiff of an adequate remedy. Even in the highly unlikely possibility that a securities domicile had no securities regulation at all, the absence of an appropriate remedy would not be an

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120 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION issue, because a defrauded purchaser could still pursue a complaint under that state’s common law fraud and fiduciary doctrines.25 The conventional conflicts-of-law objection to application of an internal affairs–type doctrine to securities transactions, which is captured by the public policy exception to choice-of-law clause enforcement and to requirements that the chosen state have a reasonable connection to the transaction or the parties, is that the investor’s domiciliary state has a more important “interest” in a securities dispute than the issuer’s domicile.26 The policy concern that is confusedly asserted as a state’s “interest” in this instance is that the issuer’s state will not provide an adequately protective regulatory regime against fraudulent sales practices, because the buyers— or a majority of them—are not its citizens. That concern is founded, however, on a mistaken premise: The research on state competition for charters, as earlier reviewed, indicates that states that compete successfully for corporate charters do not enact regimes that diminish investors’ wealth. Investors would benefit from an internal affairs rule for securities regulation as well because, as occurs in the chartering market, investors’ preferences will drive the regulatory competition. In addition, the proposed requirement that disclosure of securities domicile must be provided upon stock purchases would eliminate the concern of the buyer’s state that its citizens will be inadequately protected: Domicile notice ensures that buyers are informed of which state’s regime is applicable. If the regime of the issuer’s state is less favorable to investors than that of the buyer’s state, the investor will pay less for the shares or not purchase them in the first place. Consequently, a requirement of physical connection to the state to make contracting parties’ choice of law effective makes absolutely no sense in the securities context.27 Adapting the Securities Choice-of-Law Regime to the Needs of Competitive Federalism. Choice-of-law rules are generally creatures of judicial, rather than legislative, determination. But statutes may codify choice-of-law rules. For instance, several states have enacted the Uniform Securities Act’s choice-of-law provisions, which select the most common judge-made choice, the state where the securities are offered for sale.28 In addition, some states have adopted choice-of-law clause statutes, which

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guarantee enforcement of contractual choice-of-law provisions, regardless of standard conflict rules, such as whether the contracting parties have any relationship to the state.29 Coordinated statutory action by the states altering the site-of-sale rule to an issuer securities domicile rule, such as by amendment to the Uniform Securities Act, would be a more expeditious route than relying on judicial action for implementing the new domicile choice-of-law approach. An even more efficacious alternative than coordinated state statutory action would be for Congress to legislate the mandatory application of the issuer domicile approach as the securities transactions choice-of-law rule in the statute rendering the federal securities regime optional. Although Congress has not mandated choice-of-law rules, it could do so under its Commerce Clause and Article IV powers.30 Congressional action is the preferred mechanism for implementing the securities domicile choice-oflaw rule because congressional action is the most expeditious avenue for achieving that end, as it does not require coordination by fifty state courts or legislatures. Coordination can occur—the universal recognition of the internal affairs approach to corporate law is a prime example—but it is timeconsuming. For instance, most states enforce forum selection clauses; that sea change from an earlier era when such clauses were considered presumptively invalid has occurred by a mix of state legislative and judicial action, exemplifying a policy of reciprocity (that is, the states recognize residents’ contracts to litigate in another state) rather than conscious coordination through adoption of a uniform act.31 But the gradual shift to acceptance, led by Supreme Court decisions upholding such clauses in federal cases,32 took over two decades, and some states still do not enforce them.33 If there is a similar pattern in the securities context as in the recognition of forum selection clauses—increasing acceptance of the concept of securities domicile with an outstanding small number of holdouts after many years—making the federal securities regime optional would not engender successful competition in securities regulation, at a minimum in the short run, because the incentives to compete are diluted when the issuer’s selected domicile does not govern all securities transactions.

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122 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Congressional enactment of a securities domicile conflicts rule would accelerate an evolutionary process by immediately implementing all states’ adherence to the securities domicile choice-of-law approach and would thereby preserve the advantages of competitive federalism. It is, no doubt, ironic that the byproduct of federal intervention in the states’ securities choice-of-law rulemaking would be a greatly invigorated competitive federalism. Which State Should Be the Securities Domicile? Three plausible candidates exist for the single state whose rules will govern a firm’s securities transactions in place of the SEC: a state chosen specifically for securities regulation by the issuer; the issuer’s incorporation state; and the issuer’s principal place of business. The first approach would be implemented through a choice-of-law clause in the corporation’s charter and noticed on the security. The clause would create, in effect, a statutory domicile for securities law. Under a choice-of-law clause approach, the choice of securities domicile could vary across a firm’s financial instruments, as well as differ from the firm’s statutory domicile—its incorporation state. The other two approaches operate automatically and hence do not require independent action by the corporation to effect a securities domicile choice, unless that choice were the SEC, which again would be implemented by notice on the security. The least desirable securities domicile approach is to choose the state of principal place of business, because a physical presence requirement introduces friction into state competition. When physical and human capital must be relocated to effect a change in legal regime, a firm’s decision to move to a more preferable securities domicile is considerably more expensive than when such a relocation can be accomplished by means of a paper filing. More important, there is no reason to expect that the factors relevant to optimal physical location decisions for firms will otherwise coincide with a jurisdiction’s securities regime. Few firms will change domicile to take advantage of incremental legal improvements under such a domicile approach compared with the other two approaches and, correspondingly, the incentives of states to provide securities codes responsive to investor preferences would be sharply diminished. The

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difference between the domicile choice of incorporation state—statutory domicile—and state of physical presence—referred to as the siège réel, the corporation’s real or effective seat, in some European nations—in corporate law is, in fact, a principal reason for the absence of charter competition across the nations of the European Union compared with U.S. states.34 Whether the most desirable approach for fostering competition over securities regulation is the choice-of-law clause or the incorporation state approach depends, in large part, on whether synergies exist from one state’s administering both the corporate and securities law regimes. That is so because the incorporation state approach harnesses the in-place apparatus of charter competition to the securities context. In general, such synergies should be substantial because corporate law expertise readily transfers to securities law. For instance, with one state’s law adjudicating both corporate and securities issues, the standards for directors’ and officers’ fiduciary duties, including disclosure obligations, would be integrated.35 More specifically, all litigation relating to conduct during hostile takeovers would be governed by one state’s law. In addition, all legal issues concerning shareholder meetings would be subject to the same legal regime, which would eliminate the considerable confusion surrounding the SEC’s rules regulating shareholder proxy proposals that simultaneously look to state corporate law’s allocation of authority between shareholders and managers and effectively ignore it.36 Where the synergies of an incorporation state securities domicile include the expertise of the judiciary, a firm could adopt a forum clause to ensure that securities claims are filed in the incorporation state.37 But even if the substantive law synergies were limited in number, the incorporation state approach affords a further benefit. Litigation costs will decrease because the significance of line drawing over whether a dispute implicates securities or corporate law declines, as the same sovereign’s rules apply in either scenario. Although the analysis supporting the choice of incorporation state as the securities domicile appears to be compelling, countervailing considerations militate against mandating such an approach compared with leaving the choice of domicile up to the issuer—the choice-of-law clause

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124 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION approach. First and most important, the choice-of-law clause approach obviates the need to guess whether the potential synergies of one regime for corporate and securities law are substantial—market participants’ domicile choices will provide the information. It is therefore most consistent with the competitive federalism approach to securities regulation. Second, given the variety of securities issued by firms, states might specialize in different securities, and consequently, firms might benefit from being able to select a different domicile for different issues. That is particularly relevant for debt securities, where no regulatory synergies with the incorporation state exist because corporate law deals solely with manager-shareholder relations.38 Third, permitting a self-standing securities domicile might enhance state competition, as a state could decide to compete more vigorously for securities issues than for corporate charters and thus prevent Delaware from not competing regarding the securities regime it offers because of its success in competing on the corporate law dimension of the choice of domicile. Additional Requirements for Competitive Federalism to Be Effective To ensure that the investor protection goal of the federal securities laws functions smoothly under the market approach, the congressional legislation that would render the federal regime optional and adopt an issuer domicile approach for the states’ securities choice-of-law rule should contain two additional statutory mandates. Those statutory requirements would establish investor safeguards at two critical transactional junctures, one occurring at the individual investor level and the other at the aggregate firm level. The first requirement is disclosure of the applicable legal regime—the firm’s securities domicile—at the time an investor acquires a security; the second is a vote of the affected security holders to accomplish a change in securities domicile. Albert Breton’s theory of competitive federalism offers a rationale for requiring such provisions as a means to ensure the vitality of competition, even though competitive securities regimes would most likely adopt the disclosure and voting requirements on their own. Breton maintains that a central

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government can play a useful role in stabilizing competitive federalism by monitoring state activity to prevent collusion or “races to the bottom” that would undermine the benefits of competition.39 The two statutory requirements of regime disclosure and shareholder approval of regime changes would reduce the need for the central government to monitor actively the competition over securities regimes. Disclosure of the Applicable Securities Regime. For regulatory competition to function properly, investors must know what regime will apply to a particular security.40 The domicile disclosure requirement would ensure that that condition holds. To accomplish the notice function, the securities domicile should be indicated on the instrument (stock certificate or note), just as corporate law requires that restrictions on share transferability, to be effective, must be noticed on the stock certificate.41 But because investors rarely receive a financial instrument, even after purchase—most stock investments transfer electronically and remain physically held by the clearinghouse depositary—a further mode of notice is essential. The most plausible additional means of domicile disclosure would entail a twopronged approach, directed at both brokers and firms. First, brokers should be required to inform prospective buyers of securities domicile at the time of purchase or short sale. As federal broker regulation would not be transferred from the SEC under the proposed approach, such a requirement could easily be implemented by agency regulation. Second and more important, issuers should be required to disclose their securities domicile at the time of initial public offerings as a condition of opting out of the federal regime. The required disclosure should be permitted to take a variety of forms. Where the issuer’s domicile requires use of a prospectus to sell securities, the federal requirement should be satisfied by indicating the domicile in that offering document. Where there is no requirement for a prospectus or other offering document, the issuer should have to inform the prospective buyer of the securities domicile in writing—an obligation that could be satisfied by the issuer’s contracting with the underwriting syndicate to provide the information in writing to prospective purchasers. In addition, for public offerings of a firm whose securities are already traded and whose securities domicile

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126 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION imposes periodic reporting requirements, disclosing securities domicile in the required reports should satisfy the issuer’s federal notice requirement as long as such reports are matters of public record—for example, filed with a state office—and thus available to prospective purchasers. Where a domicile imposes no periodic reporting requirements, voluntary disclosure of securities domicile in a public document available on a continuing periodic basis should also satisfy the federal disclosure requirement. Examples of acceptable disclosure locations include an annual financial report or proxy statement sent to shareholders for the annual meeting to elect directors, the corporate charter on file with the secretary of state, the corporation’s Web site, or a publicly available record kept by the stock exchange on which the shares trade. Those latter forms of disclosure would also suffice for any issuer responsibility regarding domicile notice to investors who acquire securities in secondary trading markets. Domicile disclosure would not be a costly requirement for issuers under any of the possible mechanisms that have been outlined. It would also not be costly for brokers to identify an issuer’s securities domicile to prospective purchasers. But mandating disclosure of securities domicile at the time of a securities purchase is not clearly necessary to protect investors: Markets will price significant differences in securities regimes, as sophisticated investors obtain domicile information before their purchases, even were domicile disclosure not mandated. Given the historical application of the federal regime to all securities, however, mandated domicile disclosure would go a considerable distance toward mitigating the remote possibility of less sophisticated investors’ not knowing that the federal regime might no longer apply to their transactions. Because such confusion is most likely to occur in the initial years following the adoption of the market approach, the domicile disclosure requirement could be enacted as a sunset provision, expiring, for example, three years after the statute’s effective date. For securities trading in markets where unsophisticated investors are predominant, such as penny stocks, the domicile disclosure requirement could be retained beyond such a transition period as a protective measure for such investors.

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The domicile disclosure requirement would not mandate disclosure of the substantive contents of the relevant regime. Firms could, of course, provide such information to investors in their domicile disclosure, but the statutory requirement would leave acquisition of such details to investors. To the extent that there might be concern that less sophisticated investors might mistakenly assume all state regimes contain similar protections and could thereby be duped into buying penny stocks registered under a regime that institutional investors shun, a written disclaimer could be required at the time of such securities’ acquisition, in addition to the domicile disclosure, that informs investors, in large print, that “their rights under the securities laws may differ significantly across the states.” Alternatively, a disclosure requirement could be fashioned to disclose the details of a regime’s significant differences. I am, however, reluctant to advocate such an approach, given the costly line-drawing questions it is likely to entail. It would, at minimum, require careful drafting to specify the norm against which differences are to be measured, such as the rules of a majority of the states, the old federal regime, and so forth. The prospect of litigation over the fulfillment of the domicile disclosure requirement under such an alternative leads me to opt for the more generic disclaimer approach, should any disclosure beyond the domicile be required.42 Security Holder Approval of Securities Domicile Changes. A different set of concerns regarding the securities domicile choice is implicated when an issuer determines to change its securities domicile midstream than when a shareholder purchases a security with a given domicile. Namely, the price the investor paid for the shares will not reflect the value of the new domicile unless the change was anticipated at the time of purchase. That is of concern if corporate insiders behave opportunistically and move to a securities domicile that requires less disclosure or has a lower securities fraud standard than the original regime. Such a move could shift value away from the public to insiders, if the outside investors did not anticipate such opportunistic behavior and pay less for the more protective domicile in the first place. Because investors will be aware that a domicile change can be effected midstream, that is not a severe problem, as they will discount the

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128 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION shares for the potential opportunism; hence, management will bear the cost of future opportunism.43 Indeed, management will have an interest in guaranteeing that it will not engage in subsequent opportunistic behavior regarding domicile, so as to lower the cost of capital when it issues shares. Moreover, appropriately structured incentive compensation aligns managers’ and shareholders’ interests and further reduces the benefit from such opportunistic behavior. Confirming that intuition, one study found that the extent of firms’ discretionary disclosure policies is positively related to the proportion of salary received in stock by the chief executive officer.44 But besides relying on management’s self-interest to draft securities contracts that restrict any subsequent domicile change or on stock-based incentive compensation to align management’s and shareholders’ regime choices, the potential for midstream opportunism can be mitigated by requiring shareholder voting approval before a domicile change is effected.45 Managers would thus not be able to switch to a regime with a lower level of disclosure unless their investors preferred such a regime and voted for the move. Such approval would be compelling evidence that the regime shift did not adversely affect investors. As in the corporate law context, the federal statute would create a minimum default for the required vote of a simple majority. Firms wishing to operate under a higher, supermajority voting requirement would therefore be able to do so. The most practical means of implementing a supermajority voting requirement would be for the corporation to include such a rule in its corporate charter and, if commitment to such a voting rule were of concern, to subject its repeal to an analogous supermajority vote. States could also establish higher voting minimum defaults in their securities codes. A supermajority voting statutory default to accomplish changes in securities domicile, however, would not be desirable from the perspective of competitive federalism: When exit from a regime is difficult, the signal from migration patterns concerning firms’ preferred provisions is weakened and the benefits of competition reduced. A majority voting requirement for securities domicile changes could ultimately aid insiders. In the absence of a voting requirement, it is possible that investors would expect value-diminishing moves to occur and

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would pay less for their shares initially. The presence of a voting requirement would commit insiders to proposing a domicile change only when the new regime increased firm value, rather than when it would disproportionately benefit their own shares, and, as a consequence, investors would not discount shares for opportunistic midstream domicile changes. To the extent that promoters value such a commitment device, a federal voting requirement may well be unnecessary because competitive state codes would include such a requirement. Nevertheless, placing the requirement in the federal statute establishing the regulatory regime would create a more robust commitment device because it would be more difficult to rescind than a provision in a state securities code, whose terms, like corporation codes, will be periodically reconsidered and revised. Some commentators contend that shareholder voting is not an effective safeguard against insider opportunism because it is irrational for shareholders to vote—that is, an individual shareholder’s cost of becoming informed to vote his interest outweighs the pro rata benefit he will receive from a correct outcome.46 That contention, in my judgment, is vastly overblown. For example, one can show that, under plausible assumptions concerning the breakdown of stock ownership among insiders, outside blockholders, and dispersed investors, a rational strategy for an uninformed shareholder concerned about the possibility of opportunism would not be the strategy of always supporting management with “yes” votes—the strategy emphasized by commentators critical of shareholder voting—but, rather, a mixed strategy of voting randomly against management’s proposals, or a strategy of not voting at all and leaving the decision to the informed voters. Both those latter strategies are better than always voting “no,” as well as always voting “yes.”47 More important, in a capital market dominated by institutional investors holding portfolios of stock, issues are repeatedly raised across portfolio firms, a factor that reduces information costs significantly on any one vote. Indeed, organizations exist that provide institutional investors with considerable information regarding how to vote on proxy issues, such as the Institutional Shareholder Services and Investor Responsibility Research Center; those organizations further reduce the cost of becoming an informed voter. In addition, many organizations have Web sites

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130 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION advertising how they vote their shares, and some even encourage the use of their sites to facilitate individual shareholder participation in an activist agenda.48 Hence, as with the initial domicile choice, the informed voting of institutions will protect less informed individual investors. While voting may not be a foolproof protective mechanism against a midstream domicile change under all circumstances, in my judgment, in combination with other incentives for managers to maintain disclosure levels that outside investors prefer, it will provide more than sufficient protection for investors. Voting approval of domicile changes is undoubtedly preferable to prohibiting changes in a firm’s securities domicile. Prohibition has obvious disadvantages, for as business conditions change, so do firms’ needs, and an initial domicile choice may no longer be the optimal regime. Moreover, unless firms can choose a different regime for each security issue to circumvent the prohibition of a domicile change—an option that could unduly complicate the regulatory regime—a prohibition on midstream switching will undermine the efficacy of regulatory competition because it reduces the firms available to affect transaction flows across regimes to only newly traded firms and thereby attenuates regulators’ incentives to adapt their regimes in response to investor preferences; the number of firms they could attract by being responsive is reduced. Voting rights in corporate law are often accompanied by appraisal rights—the right of dissenters to be cashed out of the firm at a price set by a court under statutory guidance.49 Appraisal rights mitigate adverse outcomes from uninformed voting: Informed shareholders can dissent and, under the statutory standard, obtain the cash value of their shares equal to the value “exclusive” of the transaction that was the subject of the vote.50 Thus, for a value-diminishing transaction such as an unfavorable domicile shift, the share’s appraisal value would be the stock price before any adverse effect from the market’s assessment of the value in the new domicile. Such rights could be mandated for dissenters to a domicile change. Appraisal rights, however, come with costs, such as the potential for an unwanted cash drain if many shareholders exercise their rights, the holdup power that comes from shareholders’ exercising rights against a

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non-value-decreasing proposal, and imprecise valuation of the shares that may over- or undercompensate the dissenters. Empirical research has not cross-sectionally examined the functioning of appraisal rights for charter amendments. Such research could provide information concerning how frequently such rights are used, what the stock price reaction is to amendments when the rights are used, and whether charter amendment proposals and vote outcomes differ systematically across firms when such rights are present. In states where appraisal rights are not statutorily provided for dissenters to charter amendments, firms do not appear to include such rights in their charters.51 A plausible inference from such behavior is that appraisal costs outweigh the benefits: either they are an inadequate remedy for opportunistic amendments or insiders rarely propose opportunistic charter amendments. Indeed, if midstream opportunism were rampant, institutional investors would become aware of the practice, and promoters would have incentives—higher share prices—to bind themselves against engaging in opportunistic charter amendment by providing appraisal rights for such votes or otherwise locking in initial charter provisions. Accordingly, rather than have Congress mandate dissenters’ rights in the securities domicile context, the rights of dissenters should be left to the decisions of securities domiciles, which can legislate such rights, and issuers, which can place such rights in the corporate charter or bylaws if the domicile does not mandate them. How Would State Competition for Securities Regulation Work? Assuming that the jurisdictional and other requirements necessary to implement competitive federalism for securities regulation are put in place, the question arises concerning how successful regulatory competition for securities law will be. For states to compete in the production of specific laws, a state must receive some benefit from the activity. In the corporate law setting, the benefit is largely financial: States collect franchise tax revenues from locally incorporated firms. From 1966 to 2000, the franchise tax revenue collected by Delaware, which is the leading incorporation state despite having few local corporations, averaged

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132 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION 17 percent of its total tax revenue. See table 4-1. That revenue greatly exceeds what Delaware spends on its corporate law system.52 If the regulation of securities transactions depended on incorporation state as well, the incentive to obtain franchise tax revenues would increase, as there would be more dimensions on which a state could serve its corporate clientele. That is, a state could increase the number of incorporations, and hence its franchise tax revenues, by offering a desirable securities law as well as a desirable corporate code. A further source of importance in charter competition, albeit not reflected in the table, is the income that the local bar and related personnel receive from servicing domestic corporations and the pursuit of shareholder lawsuits. Members of the state securities bar would have a strong interest in motivating their state governments to compete for securities registrants, just as corporate practitioners have prodded their states to compete in the chartering context. An additional potential revenue source for states competing over securities regulation is filing fees, which accompany the registration of a public offering of securities. Those fees can be substantial, as indicated in table 4-2, which reproduces the fees collected by the SEC from 1966 to 2000 for the registration of securities and various other filings.53 Since 1983, the SEC’s fee collections have been more than 100 percent, often more than 200 percent, of its gross outlays.54 As a monopolist, the SEC is able to charge higher fees than could competitive states, but competition need not drive such fees to zero. Delaware, for instance, charges higher incorporation fees than do other states and is still the leading incorporation state—a phenomenon indicating that firms are willing to pay a premium for a superior legal product.55 Securities transaction taxes could be a further source of revenue, for they are almost as high as the registration fees the SEC collects, but the competitiveness of capital markets has constrained other nations from imposing substantial taxes on share transfers. The trend in European countries, for example, has been to reduce or eliminate securities transaction taxes because of competition for stock exchange business.56 Annual securities domicile franchise fees, analogous to incorporation franchise fees, like filing fees, would be preferable to securities transaction taxes as a revenue source because they are assessed per firm, rather than

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Table 4-1 Delaware’s Revenue from Corporate Charters Year 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Franchise Taxes ($000) 14,091 17,615 21,414 20,572 43,924 55,212 49,129 50,777 57,073 55,030 67,887 57,949 60,509 63,046 66,738 70,942 76,591 80,031 92,270 121,057 132,816 152,152 180,583 195,862 200,201 203,868 297,004 284,839 307,008 336,348 350,035 390,739 439,828 459,860 541,112

Total Tax Collected (%) 10.9 12.6 14.8 13.1 22.5 24.9 19.1 17.1 18.5 16.4 18.9 14.8 13.5 12.8 12.9 12.9 12.9 12.5 12.9 14.8 15.0 15.4 17.7 17.3 17.7 17.5 22.1 21.3 21.3 21.2 20.7 22.4 22.2 22.6 25.4

Appropriation ($000) 492 517 606 645 722 836 697 699 984 1,051 1,208 1,255 1,385 1,482 1,899 2,230 2,448 2,847 2,721 3,242 3,809 4,746 4,719 4,873 6,398 6,953 6,591 6,831 7,980 7,104 9,462 10,372 11,817 11,958 12,249

Sources: U.S. Bureau of the Census, State Government Tax Collections (1966–2000); and Delaware Laws (1965–1999). Appropriations for Delaware’s chartering business consist of state outlays, for the fiscal year ending June 30, on the Division of Corporations in the Office of the Secretary of State and on the Supreme Court and Chancery Court.

according to individual trades, and will thus not adversely affect liquidity by deterring particular transactions.

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134 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Table 4-2 The SEC’s Financing Year

Appropriation ($000)

Fees Collected ($000)

Ratio of Fees to Appropriation (%)

1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990b 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

16,442 17,550 17,730 18,624 21,905 23,615 26,817 30,293 36,227 44,427 49,000a 56,270 62,475 67,100 72,739 80,200 83,306 86,690 94,000 106,382 106,323 114,500 135,221 142,640 166,633 189,083 225,792 253,235 259,000 267,000 297,400 305,400 315,000d 337,717 368,300

6,608 9,706 14,623 21,996 15,526 16,374 19,000 22,000 22,000 24,000 26,000 29,000 26,100 33,000 48,000 65,300 78,200 98,600 121,000 144,000 215,000 263,700 250,000 214,000 232,000 259,000 406,000 517,000 593,000 559,000 774,000 990,400c 1,780,000c 1,757,000 2,271,000

40 55 82 118 71 69 71 73 60 54 53 52 42 47 66 81 94 110 129 135 202 230 185 150 139 137 180 204 229 209 260 324 534 520 617

a. This excludes supplemental appropriations of over $13 million for the transitional quarter to accommodate the change in fiscal year. b. Since 1990, SEC appropriations acts have increased registration fees by .01 percent of the offering’s dollar value, with the increase offsetting the SEC’s costs rather than going into general revenues. c. The National Securities Markets Improvement Act of 1996 extended fee collections to over-thecounter transactions starting in 1997, increased the frequency of transaction fees collected on exchanges, which resulted in the collection of twenty months of fees in 1998, and reduced the registration fee rate. d. This excludes appropriations for year 2000 preparations. Sources: Securities and Exchange Commission, Annual Reports (1966–2000); the 1972–1977 figures were obtained from Henry I. Hoffman, assistant comptroller of the SEC.

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The financial incentives generating state charter competition have resulted in a race that has tended to the top in corporate law. That result suggests that it would be beneficial to create similar financial incentives for states in the securities law context. Currently, however, states have little of value to offer firms in return for the payment of securities “franchise” taxes. State securities case law is not as extensive as that for corporate law because the national securities laws until recently have occupied the field, given expansive interpretations of the federal antifraud provisions by the SEC and courts and the desirability of using federal courts.57 State securities law is not a complete void, however, because some litigants began turning to state actions in the aftermath of the Supreme Court’s restrictive interpretations, beginning in the 1970s, of the federal antifraud provisions—a trend temporarily accelerated with congressional reforms of private securities litigation in 1995.58 But that trend would appear to have been stymied with the preemption of state lawsuits. It remains to be seen whether the statefiduciary-law carve out is sufficiently broad to maintain the trend.59 The relative dearth of a developed body of securities case law places states at a distinct disadvantage in competing for corporations with the federal government in terms of substantive securities regulation. In choosing their statutory domicile, corporations place a premium on the presence of a comprehensive case law because a stock of precedents facilitates business planning: Firms can structure transactions to minimize the possibility of liability.60 States can, however, compensate for the problem of meager judicial precedents by formally incorporating federal court decisions interpreting the national laws, through either legislation or judicial action, to the extent that the state’s statutory language tracks the national laws. That approach is not novel and has, in fact, been adopted in the corporate law context: It facilitated the replacement of New Jersey as the leading incorporation state by Delaware when corporations sought an alternative statutory domicile after a lame-duck Governor Woodrow Wilson and the Progressive Party majority in the New Jersey legislature drastically revised the corporation code. Delaware’s judiciary had incorporated New Jersey precedents in interpreting its code, which was modeled on the former New Jersey statute.61 Moreover, a state such as Delaware, with a specialized corporate law court, can compensate for the dearth in precedents by offering litigants

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136 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION the prospect of far greater judicial expertise than the federal courts. Finally, a state could further compensate for the lack of precedents by clarifying issues the SEC has chosen to leave vague, such as defining insiders for the purpose of trading prohibitions. The limited experience of states with securities regulation is one important reason for maintaining a federal government option—at a minimum as a transitional mechanism—in the context of creating competitive federalism for securities law in contrast to corporate law, where no analogous federal code exists in the United States. It is, however, probable that opening securities regulation up to state competition will bring Delaware to the forefront in securities law. That is so because, to the extent that the national securities laws have been accurately taken to task for requiring costly and excessive disclosure and for fostering frivolous antifraud litigation, Delaware, in all likelihood, would offer a securities regime that mitigates those problems, just as it has crafted a corporation code that benefits shareholders. If synergies exist in the production and enforcement of corporate and securities law, then Delaware would be well situated to realize the benefits, given its expertise in the corporate law context. Delaware’s fiscal prosperity depends to a significant extent on providing rules that reduce firms’ costs of doing business. As a small state, Delaware does not have indigenous income sources to replace the substantial revenue it derives from the franchise tax were it to lose incorporations to a state more responsive to business needs. That motivation is a key to Delaware’s chartering market success: Delaware’s reliance on franchise tax revenues serves as a commitment device to ensure firms that it will continue to enact legislation that firms desire—statutes that maintain or improve share values as new business conditions warrant code revision.62 Such a commitment device is critical to the production of corporate charters because a corporate charter is a relational contract, extending over many years during which unforeseen contingencies are likely to arise. Such uncertainty makes it difficult for contracting parties to specify in advance their obligations, and, as performance is not simultaneous, the possibility of opportunistic breach is increased. In particular, firms select their domicile and pay franchise taxes based on the extant legal regime

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and run the risk that, as business conditions change thereafter, the state will not adapt its code—or will repeal key provisions to firms’ disadvantage. The opportunism problem of relational contracting is exacerbated when one of the contracting parties is the government, given its role as the enforcer of contracts through the court system. Delaware has surmounted the commitment problem by investing in assets that have little value outside the chartering market and thereby guaranteeing to firms that it will continue to be responsive in its code after they incorporate. Those assets include its specialized corporate court system and a reputation for responsiveness dependent on its high ratio of franchise taxes to total revenues.63 To the extent that Delaware can gain further franchise revenues from crafting a responsive securities regime, the same factors will operate in the securities, as in the chartering, context, and Delaware could have stronger incentives than the SEC to find the desirable regulatory balance. But once the SEC is subject to competition for issuers, if Congress refines its effort to make the agency’s budget selffinancing to permit the charging only of registration fees and not transaction fees from trading on the exchanges the agency regulates—except at a level to cover exchange-related regulatory costs—then the agency could face as potent a financial incentive to be responsive to issuers as Delaware. Uniformity and Variety in Securities Regulation under Competitive Federalism A more traditionally articulated benefit of federalism that is integrally related to the incentive effects of competition is that it permits experimentation in legal rules, as states implement different solutions to specific problems. That, in fact, occurs in the corporate chartering context. Successful corporate law innovations diffuse rapidly across the states.64 For instance, to address a perceived crisis in directors’ and officers’ liability insurance in the mid-1980s, states enacted a variety of statutory approaches, including permitting firms to cap or eliminate monetary liability of outside directors for negligence and changing the fiduciary duty standard of care from negligence to willful misconduct or recklessness.65

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138 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Within a few years, the vast majority of states copied Delaware’s approach and permitted charter amendments to eliminate liability.66 Far greater variation exists, however, in state approaches to securities regulation than in corporate law, which has tended to uniformity in key default provisions through the diffusion of statutory innovations.67 For example, some states have merit-review regimes that condition securities’ registration on their meeting a standard of investment worthiness or merit and are very different from the disclosure approach that, similar to the federal securities laws, the majority employ.68 The differentiation across state securities regimes is not black and white, however, because merit review for compliance with the investment standard can take the form of requiring greater disclosure of aspects of an issue viewed with disfavor by the regulator, rather than denial of registration.69 In addition, the import of the difference is limited because only a subset of securities are subject to state regulation; nationally traded shares are excluded, and individual exemptions are often granted.70 Investors can also avoid a home state’s merit-review regime: If a security is not registered in their state, they can acquire it in an unsolicited secondary market transaction rather than in the initial public offering.71 Still, even with those caveats, the interstate contrast in securities law regimes compared with corporation codes is striking. No state, for instance, in corporate law follows a mandatory rather than an enabling approach. Hence, nothing remotely approximates in charter competition the divergence in regulatory policy between merit-review and disclosure regime states in securities law. The absence of competition in the securities field most probably accounts for the greater variation in regulatory approach in securities law across the states than in corporate law.72 That is so because if the vast majority of investors prefer a particular regime, competition will produce incentives for regulators to choose that regime. Given the relative uniformity of competitive corporate codes, it is quite possible that the variation in securities regulation is due to regulators’ preference for merit review differing from that of investors. If that is so, in a competitive system merit regulation will not survive. In fact, even in the absence of regulatory competition, merit regulation has been on the decline, for, in addition to the expanding number of exemptions from coverage under merit regimes,

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several important states, such as Illinois, eliminated their merit review provisions in the 1980s.73 The interest of the local bar in maintaining clients who otherwise might switch to a non-merit-review state following underwriters’ advice regarding an offering probably influenced that trend and would accelerate it under regulatory competition. The empirical research on state securities laws does not provide much support for merit regulation. Studies find that securities sold in non-merit-review states have higher returns and greater risk than those sold in merit-review states;74 while that result is what merit regulators set out to accomplish, no evidence exists that the reduction in risk is desirable. Specifically, no evidence exists that securities risk is positively correlated with fraud, that investments in non-merit-review states are subject to more instances of fraud than those registered in merit-review states, or that investors residing in merit-review states are more risk-averse, uninformed, or financially unsophisticated than those in non-merit-review states to require such protection. The absence of a showing of significant benefits to investors from merit regulation suggests that opening state securities regulation up to competition will hasten its demise. The probability that competition will hasten the demise of merit regulation is important because it sheds light on a potential concern over abandoning the mandatory federal system: Would investors be harmed by a subsequent loss of standardized disclosure across firms governed potentially by fifty-plus regimes? Competitive federalism will not increase variation in the legal regime unless investors value variation. State charter competition has, in fact, produced substantial uniformity across corporate codes and has preserved variety in its enabling approach to rules, an approach that permits firms to customize their charters if the default provisions of the statutes are not suitable.75 That situation is likely to be true for competitive disclosure regimes, as the most desirable disclosure standards will diffuse across the states. More important, the most significant area of standardization, firms’ financial reporting, will still be controlled by the private sector under the Financial Accounting Standards Board and thus will be consistent across firms complying with its rules. States could require compliance with FASB standards to assist firms’ needs for uniformity,76 or stock exchanges could

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140 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION perform a standardizing function, as they did before the enactment of the federal regime, by adopting listing requirements prescribing compliance with the FASB or their own disclosure requirements. Even without such requirements, most firms would voluntarily comply with most FASB standards to reduce their cost of capital, just as firms at times disclose information beyond that required by regulators today. It is important to note that although the SEC does not exercise any statutory control over the FASB, the agency has authority to promulgate accounting rules,77 and it has thereby exerted significant influence over the FASB by the threat that it would adopt its own standards if the FASB would not act.78 In implementing regulatory competition, Congress will therefore have to clarify that the SEC’s authority over accounting standards applies only to firms choosing the SEC as their regulator. Because competitive federalism will eliminate the SEC’s prescription of accounting rules for any firms other than those voluntarily submitting to its jurisdiction, its ability to affect FASB standards will be greatly reduced under the proposal. Given the SEC’s intrusion into the accounting standard-setting process, it is an open question whether rules promulgated by the FASB are optimal. It is altogether possible that competition in accounting standards would benefit investors, and that the need for standardization in such a context has been overblown.79 Where FASB standards are undesirable, competing state securities regulators could recognize alternative standards, such as those promulgated by the International Accounting Standards Board, and could thereby increase registrations. Indeed, although the FASB standards have traditionally been considered higher and therefore preferable to international ones, in the wake of the Enron Corporation’s failure, supporters of the international standards have claimed that they are more desirable because they emphasize general principles, in contrast to the FASB’s rule-oriented approach, considered by some to have been at the core of the Enron fiasco.80 Which set of standards is better for investors is not self-evident, however, and perhaps the most powerful rationale for opening the choice of accounting standards to competition is that the competitive process would provide the information, now absent, to make such a determination.

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There is an intriguing natural experiment on the very issue of the superiority of one or the other set of standards that is going on at the newest German stock exchange: firms that list on the Neuer Markt are permitted a choice of accounting standards. Their accounting statements can be prepared in accordance with the accounting standards promulgated either by the FASB (U.S. generally accepted accounting principles) or by the IASB (international accounting standards). Christian Leuz drew on that unique environment to examine whether the German firms employing U.S. GAAP exhibited less information asymmetry and higher liquidity than the firms using international accounting standards, as a test of whether the FASB standards are of higher quality.81 He found no significant differences in the firms’ bid-ask spreads and trading volume (measures of information asymmetry and liquidity)82 and thus no evidence that the FASB standards are of higher quality than the international ones. When competition is introduced into securities regulation, specific rules under state disclosure regimes will undoubtedly develop that differ from those imposed by the SEC, as states experiment to find the regime most attractive to registering firms. That could occur through two routes: enactment of substantively different rules from SEC rules; or application to securities laws of the enabling approach taken to corporate law, in which state rules—which may or may not be the same as SEC rules— operate as default rules from which firms can opt out if they so choose. Where a majority of firms opt out of a default, the state obtains information concerning the appropriateness of that rule, and eventually the rule is revised by that state or another state that can obtain new registrations and hence increased revenue by enacting the more desirable default.83 Analogous to the states’ offering of special statutes for small firms (close corporation statutes) in the chartering context, with competitive securities regulation, a state could further offer firms a menu of regimes from which to choose—such as the choice of an extensive disclosure regime, a more limited disclosure regime, and a merit-review regime. If the SEC’s rules are optimal, as its supporters contend, then either firms will not opt out of SEC coverage or they will opt into state securities regimes that are identical to the SEC’s regime. But if all states simply

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142 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION mimicked the SEC’s rules, the benefits from adopting competitive federalism would be small. Although needed regime revisions could be more speedily undertaken as a state regulator would act more quickly than the SEC to update its code to meet investor preferences, investors will bear increased transaction costs under competition: firms have to inform investors and investors have to learn of the firms’ securities domicile choice. The absence of empirical support for the rationales underlying federal regulation, important instances of misguided SEC disclosure policy,84 and persistent concerns voiced over frivolous litigation suggest, however, that the particulars of securities regulation under competition will differ significantly from the present federal regime. Is Securities Regulation Sufficiently Different from Corporate Law to Render Competition Ineffectual? Ehud Kamar has suggested that competition will not develop in securities regulation because network externalities—economies of scale in administration, stock of precedent, and demand for uniformity in accounting disclosure—will result in a single regulator, which, upon attaining market dominance, will engage in uncompetitive behavior.85 That is an implication of Kamar’s position on the market for corporate charters. But several reasons exist for predicting that inefficiencies related to network externalities in the securities context will be even lower than in the corporate law setting. First, we do not know whether the benefit from using a common accounting standard increases linearly with the number of users or whether, instead, the rate of increase in the benefit drops significantly as the number of users increases.86 If the benefits of a network diminish with the number of users, then competing regulators will do as well as a monopolist in setting standards, independent of the benefits of competition. Second, in addition to the incentives of state regulators, discussed in the chartering context, to internalize the costs and benefits of possible network inefficiencies, in the securities context a further set of private actors exists—stock exchanges— that can also internalize network externalities regarding aspects of the regime, such as disclosure requirements, if such rules were within their jurisdiction. That occurred before the creation of the SEC and could occur

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with competition if a jurisdiction chose a securities regime that delegated disclosure standards for listed firms to exchanges. Stock exchanges control which firms list on their exchanges, and thus they can internalize any potential network externalities that would cause the maintenance of inefficient rules.87 Because firms pay annual listing fees, an exchange that devises a superior set of rules can subsidize firms to switch from another network. Third, as economies of scale are less important when different rules are appropriate for different firms, competing networks can exist because the benefit of size is limited. Although niche-filling does not seem to be a significant factor in corporate law, as state codes do not vary substantially, it may be more important in securities law.88 Of course, for an individual firm, the number of other listed firms on an exchange is not important; the firm cares only about the trading location that gives it the lowest cost of capital. But investors may prefer exchanges with numerous listings to obtain the benefit of standardization in disclosure when exchanges are the source of such standards, and their preferences will feed back into firms’ choice of exchange. It should be noted, however, that standardization is not of itself evidence of network effects. One standard may prevail over another because it is better adapted to investor needs.89 Finally, as previously mentioned, if the appropriate disclosure standard varies across firms or investor clienteles, then network effects will not be important, as small specialty networks will flourish alongside larger ones. A separate issue that might distinguish securities and corporate law that could also be subject to increasing returns to scale is enforcement. The question is whether policing securities violations requires affirmative steps by government in contrast to corporate law, which is policed by private litigation. In such a case, economies of scale in enforcement operations could limit competition as small states could lack the requisite resources to police securities violations. The enforcement question is not, however, upon reflection, a case of a true network externality—it is not a demandside effect—or a particular problem. Surely increasing production costs— decreasing returns to scale—exist in government enforcement activities. The SEC, for example, relies heavily on private litigation for enforcement support. Whether the SEC delegates enforcement activities to private parties because of limited resources or increasing production costs, smaller

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144 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION states could also rely on private enforcement to compensate for scale disadvantages, if the revenues produced by their securities business are insufficient to cover enforcement costs. A need for a minimum state size for enforcement purposes is therefore not likely to create a substantial barrier to the effectiveness of regulatory competition in the securities law context. A problem that unscrupulous promoters will exploit investors by choosing a jurisdiction with inadequate enforcement capacity could still exist. Resources for enforcement operations do not constitute a problem for large sovereigns or for small sovereigns that, by offering a superior regime, earn a significant financial return from domicile fees, as Delaware does from incorporation fees, to cover enforcement costs. As those jurisdictions would also, in all likelihood, be the domicile choice of most publicly traded firms, whose clientele includes sophisticated investors cognizant of enforcement issues, the enforcement-capacity problem is analogous to the earlier noted problem of segmented markets regarding substantive regime content and not a network effects problem. Prodding unsophisticated individuals to invest through financial intermediaries, an approach discussed in the next chapter because protection of less sophisticated investors by the presence of institutional investors may be less prevalent in an international, rather than the domestic, regulatory setting, would be the most effective solution to concerns about inadequate enforcement.90 Regulation by Exchanges A decidedly more deregulatory approach than competitive federalism would be to leave securities regulation to the stock exchanges on which firms list.91 In such a regime, exchange-listing conditions would include the substantive content of securities laws, such as periodic disclosure requirements. Exchanges can solve free-rider problems concerning information production encountered by individual firms, as well as coordination problems presented by investors’ need for standardized disclosure. Thus, exchanges could replace the government as the solution to a securities market failure. Indeed, much of the voluntary disclosure predating the 1934 act discussed by George Benston in his study of that legislation was an NYSE

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listing requirement.92 Moreover, multiple exchanges will compete for listings. To the extent that maximizing trading volume is a function of listings, exchanges would be subject to the same incentives as states competing for charters and would thus adopt listing requirements preferred by investors.93 As with a national default regime, an exchange-based regime would be likely to save transaction costs compared with state competition, because investors are directly informed of which regime applies when they trade shares.94 But the states could still have a regulatory role in an exchange-regulated system. Although the over-the-counter market for the largest stocks, NASD’s Automated Quotation System, is a sufficiently developed regulatory organization capable of offering its own securities regime, if the regime it offered was poorly suited for the smallest firms traded over-the-counter—“bulletin board” and “pink sheet” issues—it might be more cost-effective for a state, rather than for those firms’ market makers, to organize and operate a separate securities regime. State regulation does, moreover, offer some decided benefits over stock exchange regulation: a more effective mechanism of private dispute resolution for securities suits against issuers, and a public enforcement system, should the deterrent effect of criminal prosecution for securities law violations be a necessary complement to civil liability. Class action litigation is not well suited for private arbitration under current practices,95 and it is not surprising that arbitration programs currently administered by exchanges resolve individual complaints against brokers, not class complaints against issuers. As a consequence, even when courts have permitted classwide arbitration, they have retained substantial judicial involvement, including the initial determination of the certifiability of the class and review of the settlement.96 Thus, without substantial changes to the administration of the arbitration process, state or federal courts would be required to enforce the exchanges’ regulatory regime. That creates two difficulties. First, the use of tribunals not operated by exchanges externalizes the cost of their legal proceedings, which is a disadvantage from a social welfare, as opposed to investor, perspective. With state securities regulation, the fees the states earn in the registration process will defray the costs of administering securities cases. Charging exchanges for use of the court system would be necessary to minimize that problem.

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146 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Second, regulatory competition is most effective when the sovereign’s jurisdiction includes both the court and the legislature. Canada, for instance, has not developed a vigorous charter competition across the provinces in large part because the provincial governments do not control the adjudication of corporate law disputes; securities administrators of any province and the national supreme court share that authority with the incorporation province.97 That renders it impossible for a province to guarantee a responsive legal regime to prospective incorporators, because a securities administrator can impose obligations on firms countermanding provincial laws. Exchanges that are unable to adjudicate all the disputes arising under their securities regimes will experience a similar difficulty. The problem is, in fact, raised in a weaker form even under competitive federalism, for unless firms adopt forum clauses specifying that all securities claims are to be adjudicated in courts of their securities domicile, investors would be able to file in nondomicile courts. Although those courts would apply the law of the domicile, they would not have as much expertise as the domicile courts to adjudicate disputes effectively, and their rulings would affect the domicile’s law and reduce its control, until either a similar case came before its own courts or the legislature acted to overturn an undesirable holding. Similar problems arise for exchange-based regulation if criminal prosecutions are necessary for an effective securities regime. In sum, regulation by exchanges will at best still be a dual regulatory system, with much of the enforcement of exchange rules performed by the government.98 It is important to note, however, that competition for securities regulation would not preclude exchange-based regulation. A state could, for instance, enact no mandatory disclosure requirements and thereby leave the determination of such requirements to exchanges, or it could adopt a securities regime only for non-exchange-traded corporations. Because such an outcome would be within the realm of possible outcomes under competitive federalism, the prudent approach to regulatory reform is to implement incremental experimentation: Alter the position of the current monopolist regulator to that of an option among competing state regulators and thereby permit the competitive process to reach the judgment that an exchangebased securities regime provides a set of rules as good as or better than those provided by government authorities.

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5 Competitive Federalism and International Securities Regulation

Although a significant international regulatory regime exists for banking institutions,1 efforts at international harmonization of regulating securities transactions have not been successful. The absence of a uniform international regulatory scheme is, in fact, a benefit for investors in securities because it allows for some competition among securities regimes. But international securities regulation should be opened up to even greater regulatory competition than the scant competition that exists at present. The desirability of regulatory competition does not stop at national borders, for the same incentives are at work in a global setting: Financial capital is as mobile across nations as it is across U.S. states, and capital providers will require higher returns from investments governed by regimes less protective of their interests and thus will prod firms to seek out the securities regime they prefer to reduce the cost of capital.2 In addition, there are reasons to believe that the product of international negotiations over regulatory cooperation is more problematic than domestic legislation. As Paul Stephan has noted, international lawmakers do not stand for election and hence are more susceptible to rent-seeking as they face less political discipline compared with national legislators.3 The concept of competitive federalism for securities regulation should, accordingly, be extended to reach all issuers of securities, on all exchanges, and not simply to U.S. issuers. Implementing Competitive Federalism in the International Setting Present-day international securities regulation offers firms only a limited choice of regime. Regulation follows the location where the securities trade, 147

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148 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION similar to U.S. states’ territorial choice-of-law rule for securities transactions. That jurisdictional rule does provide some foreign firms with some choice: the regulatory regime for the many high-technology Israeli firms that have chosen to list on the New York Stock Exchange, for instance, is that of the United States, administered by a U.S. government agency, the Securities and Exchange Commission, rather than by an Israeli government agency. It is not obvious whether those firms list on the NYSE precisely to obtain the U.S. regulatory regime as a means of quality commitment to investors4 or whether the U.S. regime is simply a cost borne to access the deeper U.S. capital market and, in particular, to obtain coverage by U.S. financial analysts. Because those analysts are far more numerous than the Israeli analyst population and have considerably more exposure to technology stocks, they afford investors superior information about the firms.5 We do not know the answer because an Israeli firm cannot trade in the United States and remain subject solely to the Israeli regulatory schema; the firm is automatically subject to the U.S. regime upon listing on a U.S. exchange. Furthermore, the choice to come under U.S. law is a one-way street: U.S. firms cannot opt for non–U.S. coverage. A U.S. firm, for example, is unable to sidestep the authority of the SEC by listing on the Tel Aviv exchange and selling those shares directly to U.S. investors, because a firm with a substantial U.S. presence—as measured by statutory domicile or business activity and investor residence—is subject to U.S. securities law no matter where its securities are purchased.6 Since U.S. firms and U.S. investors comprise a large proportion of the international capital market, regulatory competition is severely circumscribed. To create a truly competitive international securities regulation regime, present restrictions on regime choice must be removed for all firms. That requires issuers and investors to be able to choose their regulator independent of firm or investor residence and independent of the location of the securities transaction, that is, independent of the place where a firm is raising capital. The central proposition is the same in the international as in the domestic setting: only when parties to a securities transaction are able to select their regulatory regime without restriction will government authorities be subject to meaningful competitive pressure. That is so because in such circumstances, if firms and investors find

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a particular regulatory regime burdensome or ineffectual, they can switch to another jurisdiction without undoing their financing choice. There are further benefits to regulatory competition in the international setting in addition to the benefits earlier discussed in the context of domestic regulatory competition. First, where the choice of regime is bundled with the source of capital, as it is in the international regulatory context, the signal regulators receive from transaction flows regarding the desirability of their legal regime is much more attenuated than under regulatory competition, because issuing firms must trade off the adequacy of the regime against access to capital. Second, regulatory competition should assist the development of capital markets in small emerging market nations that do not have the requisite resources to engage in effective securities regulation: their domestic corporations could subject themselves to a developed nation’s regime. The potential to benefit in that way is not purely speculative. Some scholars have contended that differences in the securities regimes between Poland and the Czech Republic led to significant financing difficulties for Czech issuers and the contraction of its capital market, as well as losses to investors;7 had corporations in the Czech Republic been able to select their securities domicile, it would have mitigated that problem, for they would have been able to select a more stringent regime and raise capital more effectively, as such actions would have enabled investors to infer firm quality (here propensity for selfdealing by management) by the domicile choice. An increase in registrants from emerging markets would, no doubt, place an additional burden on developed nations’ regulators, as the emerging market issuers would be registering with a regulator without necessarily listing on a market within the regulator’s geographic borders. Higher registration fees could be charged such registrants to defray the increased regulatory cost. In addition, private enforcement of compliance with securities laws could absorb some of the potential regulatory burden. Feasibility of International Competition It is not possible, however, to establish a fully competitive international regime without multilateral governmental action. Nations must agree to alter

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150 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION their present territorial jurisdictional approach to securities regulation and recognize instead a statutory securities domicile, as selected by an issuer. Although regulatory agencies enter into cooperative agreements, such as the SEC’s numerous memoranda of understanding with foreign regulators concerning the sharing of information and enforcement operations8 or the central banks’ accord on capital requirements, ceding a territorial jurisdictional rule is not a matter that is unambiguously within an agency’s purview. In the United States, for example, such rules are legislative or judicial in origin. Mutual recognition of statutory securities domicile would therefore have to be effectuated by a treaty or other executive agreement approved at a higher governmental level than securities agencies. That undoubtedly complicates the implementation of a competitive international regime. There are avenues for circumventing implementation of a statutory domicile and hence regulatory competition at the treaty level by actions at the agency level, such as the SEC’s recent proposal to consider permitting foreign firms to list on U.S. exchanges without complying with U.S. accounting standards.9 The SEC could, in fact, unilaterally implement a competitive system for U.S.–listed securities under its general exemptive authority, which permits it to “unconditionally exempt any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions” of the securities laws.10 But such action would not seem to be in the realm of the probable: with the notable exception of the Civil Aeronautics Board, which enthusiastically put itself out of business when it deregulated the airline industry in the 1970s, federal government agencies have not voluntarily abandoned their regulatory domain, and the SEC’s past behavior is no exception to that rule. The agency has consistently sought to expand its authority over equity derivatives,11 and its new proposal considering relieving foreign firms from following U.S. accounting standards would actually expand its jurisdiction by attracting more foreign listings onto U.S. exchanges. Moreover, that release contained not even a hint that it would ever reconsider the accounting standards applicable to domestic firms, and it has only increased, not decreased, the ongoing disclosure requirements for those firms. The discretionary power of non–U.S. regulators to implement regulatory competition without a treaty is undoubtedly more limited than that

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of the SEC. European Union regulators, for example, must recognize member states’ firms trading in their jurisdictions under their home states’ regime, but a series of directives has mandated minimum standards of harmonization across the EU, and mutual recognition does not extend to firms from non–EU nations.12 Moreover, non–U.S. regulators may also not wish to endorse a competitive approach, regardless of their statutory authority. In Israel, for instance, Israeli firms trading on U.S. exchanges did not cross-list on the Tel Aviv exchange to avoid having to comply with the additional burdens of the domestic disclosure regime, because the Israeli Securities Agency did not provide an exemption for compliance with U.S. disclosure requirements.13 Hence, working at the agency level is only a partial, less than ideal, solution. An alternative to agency action is a combination of self-help and judicial support. Namely, judicial enforcement of choice-of-law clauses in issuer documents regarding securities law jurisdiction would be equivalent to formal legislation changing the securities choice-of-law rule to issuer domicile. Stephan has suggested that judicial decisionmaking offers some advantages over legislative decisionmaking for choice-of-law rules that encourage regulatory competition in the international context, on the view that courts are less subject to interest-group politics and more open to arguments concerning appropriate public policy than legislatures.14 That approach has worked in some instances. U.S. courts, for example, have upheld choice-of-law clauses designating a foreign jurisdiction, the United Kingdom, that prevented U.S. investors from recourse to the U.S. securities laws in litigation involving the U.K. insurer Lloyd’s of London and its U.S. names.15 In the Lloyd’s of London litigation, however, the purchases were all made in the chosen domicile, the United Kingdom— the U.S. investors had to go to the United Kingdom to make their investment—and the investors were wealthy individuals who met a sophisticated investor test. It is more doubtful whether U.S. courts would as uniformly uphold choice-of-law provisions for securities purchased by unsophisticated investors in the United States. Moreover, non–U.S. courts would also have to enforce choice-of-law provisions for competitive federalism to work in the international arena. Reliance on courts to enforce issuer choice of domicile, rather than the pursuit of a more

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152 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION explicit change in the international choice-of-law rule to issuer choice, is a risky proposition, given the uncertainty of national courts’ approach to the issue without instruction through a higher source of law, such as a treaty. Because negotiating multilateral treaties on securities regulation may well be time-consuming, certain unilateral action could jump-start the process. In particular, given the importance of the U.S. market, if Congress were to alter the jurisdictional rule for securities regulation to eliminate the SEC’s monopoly over issuers and make effective a statutory securities domicile for all firms issuing public shares or trading in the United States, that would be a significant initial step toward introducing competition in international securities regulation. It is important to note that a shift from the present system of territorially based jurisdiction to a statutory securities domicile, which is at the heart of the competitive approach to securities regulation, is not a farfetched proposal for international securities regulation, as it might initially appear. In the new world of electronic and Internet trading, territoriality is rapidly becoming an empty concept. Physically located centralized securities exchanges are also on their way to becoming relics. The most well-known example of that phenomenon involves trading in futures on German government bonds: the creation of an electronic futures exchange in Frankfurt eliminated the long-standing dominant physical London market for the instrument, and as a result, the London futures exchange itself went electronic.16 Given such sweeping technological change, regulation by issuer domicile is more viable than regulation by trading location, as it will become far more problematic to identify a territorial location for a transaction. Implications for Foreign Issuers in U.S. Markets Under competitive federalism for international securities regulation, the issuer’s securities domicile controls for all securities sold in the United States, whether that domicile is a U.S. state or a foreign nation. That would be a dramatic turnabout from the SEC’s current practice, which assumes jurisdiction over all transactions occurring in the United States,

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and until recently asserted jurisdiction over foreign transactions involving U.S. citizens,17 a practice analogous to the states’ choice-of-law rule for securities transactions that looks to the sale location or purchaser domicile. The SEC’s territorial approach to jurisdiction prevents foreign issuers who are in compliance with their home states’ disclosure requirements— which are typically less extensive than the SEC’s—from listing on U.S. stock exchanges. The principal reason that the vast majority of non–U.S. firms who could qualify for exchange trading do not list in the United States is that their disclosure costs would significantly increase, particularly with respect to accounting data, as they would have to comply with the SEC’s, and therefore the FASB’s, requirements.18 Although the precise cost of reconciliation with U.S. generally accepted accounting principles is not publicly available, James Fanto and Roberta Karmel report that, given compliance costs, companies find a U.S. listing worthwhile only if large amounts of equity capital—over $300 million—are required.19 William Baumol and Burton Malkiel point out that beyond the time and expense entailed in the translation process for U.S. GAAP reconciliation, difficulties arise from the fact that U.S. GAAP requirements are not adapted to the “circumstances of the foreign firm,” such as the fact that U.S. GAAP rules are tailored to U.S. corporate tax rules, which vary significantly from other nations’ taxation.20 Other data suggestive of the costliness of reconciliation are that the London Stock Exchange lists many more foreign firms than the NYSE21 and that, after the SEC extended its reporting requirements to foreign firms trading on the NASDAQ, the number of such listings declined by almost 30 percent over the following seven years—after having tripled over the seven years before the change in reporting requirements.22 Competitive federalism in international securities regulation would open up U.S. markets to non–U.S. issuers. That is a policy shift that not only would make U.S. securities regulation more respectful of other nations’ policy decisions by reaffirming a norm of international comity, but would also benefit U.S. investors. They would no longer have to incur the substantial cost of purchasing shares on foreign exchanges, as they have been doing in increasing numbers, to invest directly in non–U.S. corporations.23

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154 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Under competitive federalism foreign firms—those not incorporated in the United States—would be able to choose their securities domicile for U.S. trading purposes and therefore would not need to comply with the SEC’s regime to trade in the United States. That result has some precedent. The Multijurisdictional Disclosure System adopted by the SEC and the Ontario and Quebec Securities Commissions in 1991 enables Canadian firms to trade in the United States by complying with Canadian disclosure requirements, although they must reconcile their financial data with U.S. GAAP.24 Canada is the only nation with which the SEC has entered into such an agreement, however, because its disclosure requirements are similar to U.S. requirements.25 In addition, the SEC has itself relaxed some of its disclosure requirements for non–U.S. firms by eliminating such nonfinancial items as management compensation and related party transactions.26 Competitive federalism would expand the SEC’s Multijurisdictional Disclosure System to all nationals, without requiring foreign disclosure regimes to be harmonized with SEC rules or U.S. GAAP reconciliation. Indeed, competitive federalism would go still further than an extension of that precedent. It would render inapplicable the antifraud provisions of the federal securities laws—unless the issuer opted for SEC regulation— in contrast to the Multijurisdictional Disclosure System, which retains U.S. antifraud liability for Canadian firms. If all nations were to adopt such an approach, then all of a firm’s shareholders would be subject to the same securities regime, wherever they purchased their shares, and treatment of those investors would be uniform, as occurs in the corporate law context. Rather than harmonization of national securities regimes, the universal application of competitive federalism should be the objective of international securities regulation. The SEC has been unwilling to extend the multijurisdictional accord globally to nations with lower levels of disclosure because, in its view, investors in U.S. markets would not be adequately protected if firms traded without releasing all the information that the SEC and U.S. accounting standards mandate. Evidence that the lower levels of disclosure in other nations adversely affect investors is absent, however. Studies of price reactions to foreign issuers’ release of information reconciling their financial

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reports with U.S. GAAP do not find any price effects over short windows around the filings, although studies that use more controversial valuation methodologies, such as returns regressions or returns-earnings association tests, sometimes find that the U.S. GAAP reports offer incremental value over foreign GAAP reports. Thus, a number of commentators have concluded that the SEC’s requirement that foreign firms’ disclosures conform to U.S. GAAP provides little benefit to investors.27 Because the reconciliations are released after firms’ foreign GAAP financial statements, one interpretation of the lack of a price effect is that investors are able to reconcile on their own the information revealed in the foreign accounting statements. In addition, there is no difference in the liquidity or informational asymmetry (as measured by the bid-ask spread) for the stock of firms listing on the German Neuer Markt whether they use international accounting standards or U.S. GAAP for their financial reporting.28 Moreover, despite the lower level of disclosure required of firms not following U.S. GAAP, foreign markets are no less efficient than U.S. markets.29 That suggests that U.S. investors would not be harmed by being able to trade shares in foreign firms that were not U.S. GAAP–compliant. Finally, differences in accounting systems do not appear to provide less information of importance to investors about firms’ financial situations. For instance, although German accounting is considerably less rigorous than U.S. GAAP, the information it discloses provides as good a probability estimate of a German firm’s bankruptcy as information disclosed under U.S. GAAP does for U.S. firms.30 Indeed, uniform accounting treatment could obfuscate critical differences across firms operating in different business environments. For example, consolidated returns accounting for corporate groups under U.S. standards is inappropriate for Japanese corporate groups, as the Japanese groups’ nonhierarchical structure, organized through crossholdings, is not well captured by the equity criterion used to identify U.S. corporate groups, which are organized in a hierarchical structure.31 If under regulatory competition a low level of disclosure under other nations’ regimes was of concern to U.S. investors or considered by them to affect investments adversely, then those investors would discount the shares of foreign firms or not invest in them in the first place. Because of

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156 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION such a response, many firms would voluntarily reveal more information than required by their home state—albeit less than the SEC would have required—under competition. At the same time, U.S. investors would be able to avoid the higher costs entailed by foreign purchases of those firms’ shares. An increase in U.S. listings of non–U.S. issuers that are covered by less extensive disclosure regimes than the SEC requires would not, therefore, impose a direct welfare loss on investors and should instead increase their welfare by lowering the transaction costs of foreign equity ownership. To the extent that foreign firms currently choose to list in the United States to come under the more stringent SEC disclosure requirements or to subject themselves to the more extensive U.S. liability regime as a credible commitment to signal their quality to investors and thereby reduce their cost of capital,32 they could, of course, continue to do so under regulatory competition. In addition, the credibility of a firm’s commitment to the U.S. regime can be sustained further by placing a supermajority voting rule in the corporate charter for approval of a securities domicile change.33 Investor Protection Concerns under International Regulatory Competition A nonterritorially based securities regime does create new complications for investors. An investor purchasing a security listed on an exchange in his or her own state is no longer assured that the home state’s securities rules apply to the transaction and subsequent acts of the issuer. That uncertainty over the applicable regime raises three key issues: will investors be able to discern a security’s regime (a premise of the effectiveness of regulatory competition)?; will they be able to enforce their legal rights under a nondomestic regime?; and will they be exploited by insiders’ changing securities regime midstream? To minimize those investor protection concerns, there should be disclosure of the relevant securities regime, and investor approval of a change in securities regime, just as would be required for implementing competitive federalism domestically. In addition, a third requirement directed at local courts rather than at issuers is also proposed: recognition of forum selection, including

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arbitration, clauses for the resolution of private securities lawsuits. That requirement is unnecessary in the domestic setting because such clauses are enforceable and enforced in the United States and because litigation costs are considerably higher when the forum is another country. Implementation of the three requirements would best be effected by express inclusion in the multilateral treaties creating the international competitive regime. Disclosure of the Securities Regime. To minimize any potential investor confusion concerning what regime governs a purchased security, paralleling the proposal for U.S. regulatory competition, at the time of a security purchase there should be disclosure of the applicable regime by the issuer in an initial public offering and by the broker in a secondary market transaction. That disclosure must make plain that the domestic civil and criminal liability regimes do not apply to the transaction where the issuer is not domestically domiciled. In the international setting, such a requirement should be included in the treaties establishing competition as a condition for mutual recognition, to be implemented, correspondingly, in each nation’s conforming legislation. Exchanges could also effectuate domicile disclosure as a listing requirement. Adopting such a policy would be advantageous for an exchange because, by reducing the transaction costs of determining domicile, it would be of value to investors and thereby increase trading volume. In addition to disclosing the securities domicile, if, in the remote event that a domicile has no issuer liability for fraud or no financial disclosure requirement, the disclosure requirement under the international agreements establishing regulatory competition should include those features of the regime’s content as well. Disclosure of a regime’s incapacity to prosecute issuers violating disclosure laws or otherwise engaging in fraud should also be required. The disclosure requirement concerning a regime’s content is limited to notice of the thoroughly aberrant case of no fraud liability or no financial disclosure requirement to minimize the possibility of significant litigation over whether appropriate disclosures regarding a regime’s content were made at the time of a securities transaction. Disclosure regarding the regime’s incapacity to prosecute violators is added to eliminate an obvious means of circumventing the content

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158 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION disclosure requirement: a regime with an antifraud provision that cannot be enforced is equivalent to a regime with no such provision. It admittedly may be difficult to measure enforcement capacity. Using as a base expenditures below a minimum level of resources allocated to enforcement, possible benchmark adjustments are market size, number of listings, or population. No such substantive disclosure requirements exist in the proposal to introduce competitive federalism solely into U.S. securities regulation, because an absence of fraud liability and disclosure requirements in any state securities regime is simply not in the realm of the probable. For example, all U.S. states have antifraud statutes, and competition will not alter that regime feature as no state competing for charters has eliminated the analogous type of misconduct in the corporate law setting, the duty of loyalty. In addition, enforcement capabilities are not a serious problem for U.S. states. It is, however, improbable that a foreign securities regime would have no liability for fraud or no financial disclosure requirement, for when investors have even a modicum of sophistication, they would not invest in securities under such circumstances—or they would pay a trivial sum for the shares. More important, since no reputable issuer would register under such a regime, it would not be enacted in a nation with public or multinational corporations that desired domestic registrations. Thus, a deviant regime with regard to fraud and disclosure regulation would be imaginable only in a small country catering to small firms with unscrupulous promoters targeting exclusively unsophisticated investors, that is, firms trading in a segmented equity market in which institutions do not participate. That hypothetical regime would be the international market analogue to penny-stock trading in the U.S. domestic setting. Firms of that sort presumably choose such a regime to prey on unsophisticated investors. In that regard, regime content disclosure under regulatory competition is a safeguard that is unnecessary for the vast majority of public stock issues, where markets are not bifurcated for institutional and individual investors. The problem relating to antifraud protection under a regime of regulatory competition is limited to small firms whose equity is not

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purchased by institutions or sold in the regulating state. That is so because those firms’ promoters could choose a regime facilitating fraud on the assumption that the targeted individual investors would be unaware of or otherwise misperceive the characteristics of the relevant securities regime. Two general approaches could be taken to mitigate that problem: mandatory disclosure of an investment’s securities regime and the prohibition of specified (foreign-regulated) investments. The protection of individual investors through the provision of information, a requirement of disclosure of the regime at the time of securities sales, follows the approach of U.S. securities regulation that disclosure, rather than product quality restriction, is the most appropriate mechanism for government intervention in capital market transactions. The notice investors receive when informed that their investments will be regulated by an obscure nation, particularly one with no rule against fraud or no resources allocated to enforce an antifraud law, should temper gullible individuals’ purchases, which will reduce the profitability from offering and, hence, deter the emergence of deviant regimes catering to unscrupulous promoters. Moreover, under regulatory competition, only regulators whose regimes appeal to institutional investors will succeed in obtaining numerous registrants and thereby be engaged in issuer, as well as broker, regulation. Because many regulators will have a marginal role concerning issuers—none or very few firms will be registered with them—those regulators’ efforts at individual investor protection will therefore necessarily be focused on broker, rather than issuer, regulation, and they can focus particularly on ensuring that brokers comply with the disclosure rule regarding the features of the domicile of the securities that they are hawking. Such a shift in regulatory focus would certainly be beneficial for small nations with limited regulatory resources. It should also aid unsophisticated investors by directing agency resources toward what is the more common source of such investors’ losses, broker misconduct.34 The abuse in U.S. small stock offerings, for example, as Alan Palmiter notes, is by securities professionals, not issuers, evidenced by the fact that the SEC’s enforcement initiative against small-stock fraud “focused on penny-stock brokers, not issuers.”35 No reason exists to assume that the situation would differ in the international securities setting.

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160 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Required disclosure of the absence of rudimentary investor protections—liability for fraud and financial disclosure—should alert even unsophisticated individuals of the danger entailed in making an investment in a company subject to such a regime and deter unscrupulous promoters from preying on the unwary. Apart from prohibiting specified citizens’ investment opportunities to, for example, domestic firms or those domiciled in regimes with specified protections, a state cannot undertake more regulation in the case of a foreign issuer besides regime disclosure to protect unsophisticated investors without generating significant costs for the vast majority of investors—who, it must be recalled, in developed public markets are institutions—and reputable firms, which have the capacity to select the most appropriate foreign regime. Even a senior SEC official candidly acknowledged that there are limits to what the government can do to prevent investors from inappropriate trading—and that is under what is considered to be the most stringent securities regime in the world. In an interview Laura Unger, an SEC commissioner who was active in the agency’s activities regarding online trading, was asked and responded: Interviewer: “For example, let’s say I’m signing up for an account with a brokerage firm, I don’t have a job, and I want to trade away the only $5,000 I have in the world—I can probably do that. Do you think I should be able to?” Unger: “I do think you should be able to. I wish you wouldn’t, but the industry and the commission are not here to guarantee that everyone is going to make money in the stock market.”36

Such reasoning is equally applicable in the context of trading in foreign securities. Indeed, quite apart from being ineffective, investor protection regulation beyond minimal regime disclosure could communicate to unsophisticated individuals the false impression that unscrupulous promoters have been eliminated from the market and thereby create perverse unintended consequences of moral hazard, in which individuals

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adopt higher risk investment strategies because they believe that the regulatory apparatus will protect them from possible loss. Nations could instead restrict individuals’ investment choices to securities registered in domiciles with minimum regime content or enforcement capacities to protect the unsophisticated from unscrupulous promoters. There are two severe, and in my judgment fatal, problems with such an approach, compared with the regime disclosure requirement advocated here. First, a substantial danger exists that such an approach would become in due course a transnational regulatory regime with all the costs associated with such a regime. National policies that restrict citizens’ investments to issuers registered under regimes with specified content are undesirable, in short, because they provide an avenue for regulators to undermine competition by specifying requirements that are not costeffective for the investors whose preferences under competition direct issuers’ choice of regime. Second, successful crafting of adequate investment prohibitions would be problematic. The regulator must determine what foreign investments to prohibit and to whom the restrictions apply, classification choices that will inevitably generate definitional problems of over- and underinclusion. In addition, because financial markets are dynamic, investment restrictions will need frequent updating. Otherwise, investment flexibility will be lost, and investors’ returns will suffer. Experience confirms that concern, as the use of investment prohibitions has not been a successful regulatory strategy. For instance, U.S. states have abandoned restrictions on private trust and public sector investments,37 and the performance of public funds operating under investment restrictions that were difficult to amend suffered.38 Moreover, restricting investments to locally regulated issues could create additional problems as legal lists can be employed for political purposes that can have unintended adverse financial consequences. In the United States, for example, some public pension funds that were directed to engage in socially responsible investing favoring local investments experienced sizable losses on those investments.39 Undoubtedly, there is a cost to implementing a regime disclosure requirement over regulators’ use of investment prohibitions as the mechanism of investor protection under regulatory competition: both the gains

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162 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION and losses on investment strategies could be higher for unsophisticated investors when their investment choices are not restricted by the government and they could end up purchasing a security registered under a regime that facilitated fraud. But even when investors are limited to issues regulated by the SEC, which is considered the most stringent securities regime in the world today, they have not been immune to fraud. In truth, the SEC has not eliminated, and it is questionable whether it, or any government regulator, ever could eliminate, all investment fraud. In fact, in one of the most spectacular contemporary fraud cases, the insurance Ponzi scheme undertaken by Equitable Funding Corporation of America, the SEC ironically “repeatedly missed opportunities to investigate Equity Funding” and instead sued the investment analyst who uncovered the fraud for insider trading.40 A better solution to the problem of unsophisticated individuals’ investing in inappropriate financial instruments under regulatory competition than enacting investment prohibitions is, in conjunction with the regime disclosure approach, for national regulators to encourage those individuals, through public educational programs and information campaigns, to use the expertise of financial intermediaries, such as by investing through mutual funds, rather than to engage in their own selection of stocks. Encouraging individuals to use intermediaries not only will provide them with greater investment opportunities than restricting their securities purchases to firms registered under specific states, but also will place less of a burden on a national regulator to monitor continuously and minutely the status of other regimes to determine whether they are acceptable domiciles for individual investments. If individuals invest through intermediaries, both the burden of domestic broker regulation, which is an important component for enforcing the regime disclosure requirements, and the benefit to issuers of locating in deviant regimes will be reduced, for as individuals shift to financial institutions for their investment vehicles, informed investors— financial intermediaries such as mutual funds—will be the ones that examine a security’s regime before purchase. At the same time, by not impeding the flow of firms under regulatory competition, as would investment restrictions based on domicile, a policy of encouraging individual investment through intermediaries will maximize the probability that those informed investors obtain the securities regime that they prefer.

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Litigation Rights. Another difficulty for investors under a competitive international regime is the enforcement of individual legal rights against a firm whose securities domicile is not the state in which it is traded—that is, where the investor resides.41 The question is where the investor would be able to sue, for a lawsuit prosecuted abroad is obviously more costly than a domestic one. U.S. investors could, for instance, bring actions in U.S. courts, which would apply the foreign domicile’s law rather than the law of the forum.42 That is a disadvantage in that U.S. judges will not be well versed in another nation’s law, and the investors will need legal counsel with foreign law expertise, which may be expensive if profits from bringing such suits domestically are insufficient to induce the creation of a specialized local bar.43 Of course, few federal judges are well versed in U.S. securities regulation, so that disadvantage can easily be exaggerated. U.S. judges will, nonetheless, be better able to obtain and master the relevant legal sources for U.S. than for foreign law. In addition, if the firm has no other contacts in the United States besides the listing, for the lawsuit to proceed the firm might have had to agree to be sued in the United States.44 That is not so worrisome a problem, however, for one can expect that foreign-domiciled firms selling shares in the United States will contractually agree to such a requirement in their offering and listing documents to induce U.S. investment. If sufficient concern exists that firms will not voluntarily contract to permit local litigation, the treaties and conforming legislation establishing mutual recognition of securities domicile could mandate consent to service of process and personal jurisdiction—provisions analogous to the requirements in U.S. corporation codes that foreign firms wishing to do business in a state must designate a local agent for service of process.45 In addition, stock exchanges competing for listings could require issuers’ consent to jurisdiction in the state in which the exchange is located as a listing requirement if they thought that such a rule would enhance the value of listed shares and thereby increase trading interest. Issues regarding litigation rights against foreign-domiciled firms trading in markets other than their securities domicile should be similarly resolvable in countries other than the United States. If they are not, it could limit the effectiveness of international competition, as firms might

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164 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION have to select as their domicile their listing site to satisfy investors’ concerns over litigation rights. But because securities litigation is far less pervasive and recoveries are smaller outside the United States, litigation rights are less likely to be a significant issue for investors elsewhere. Given the difficulties of enforcing litigation rights across borders, a superior approach to liability issues, were regulatory competition to become firmly established internationally, would be the development of a specialized system of international securities arbitration substituting for securities lawsuits. That is not a novel idea. In international business transactions, arbitration is already the dominant mechanism of dispute resolution. Arbitration would eliminate the problems surrounding litigation rights, and it comes with a further important advantage. Arbitration judgments are more readily enforceable internationally than those of courts, because virtually all nations have signed the international convention recognizing arbitration awards, while no such global treaty on the enforcement of judgments exists.46 For arbitration to replace securities litigation on a global level, however, all nations would have to follow a policy similar to that of the United States that explicitly permits the use of arbitration to resolve securities disputes.47 In addition, some features of U.S. securities litigation practices would need to be adapted to the arbitration process for it to be an adequate substitute for litigation, such as the use of representative actions. That is so because, despite arbitration’s lower cost compared with litigation, the profitability of most securities lawsuits comes from the ability of an attorney to aggregate claims. But since it is not clear-cut whether most investors would prefer arbitration or litigation, the most appropriate mechanism for ensuring the availability of litigation rights under regulatory competition is to require in the international accords adopting the competitive regime that all states recognize forum selection clauses, including those selecting arbitration over litigation, for the resolution of private securities disputes. Investor Approval of Midstream Regime Changes. To protect investors from opportunistic midstream regime changes, as in the proposal for domestic competition, shareholder approval would be required for a

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securities domicile change under international regulatory competition. But there is a concern in the international context that the protection against potential managerial opportunism of a midstream securities domicile change afforded by a shareholder vote may not be useful in countries other than the United States, because with possibly fewer institutional investors, particularly pension funds, shareholder activism in the voting process is less developed outside the United States. That suggests that voting rights may be a weaker protection for non–U.S. investors against opportunism. There are, however, trends indicating that shareholder voting in other nations is developing and approaching that of the United States.48 In particular, U.S. institutions are investors in many non–U.S. firms, and the leading activist institutional investors among U.S. institutions have adopted global corporate governance guidelines that mirror for foreign firms their policies toward U.S. firms.49 Indeed, shareholder activism in the European Union has increased in recent years along with U.S. institutions’ greater equity investments in European firms.50 And U.S. institutions are not the only active investors. The major pension funds from around the world created the International Corporate Governance Network, which has met annually for several years to devise global governance standards and develop governance strategies of concern to institutional investors.51 Those activities are beginning to have an impact: shareholder proposals at non–U.S. firms have increased in recent years.52 Moreover, non–U.S. firms have started to respond to those trends: some Japanese firms, for instance, have scheduled their annual meetings so as not to meet on the same day as all other firms and have moved toward better disclosure of executive compensation to stem institutional investors’ voting protests over those issues.53 It is possible that shareholder activism and the exercise of voting rights are less developed outside the United States because in those nations the level of shareholder rights is lower than in the United States. In such circumstances, while voting may not provide significant protection against midstream opportunism, the shares will already be discounted, and opportunism over the choice of securities domicile would be a far less important concern than more direct forms of expropriation

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166 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION under corporate law, illustrated by some nations’ courts’ apparent lack of scrutiny of controlling shareholders’ self-dealing transactions in corporate assets.54 Indeed, in addition to the lower level of shareholder rights in many countries other than the United States and United Kingdom, in those nations a substantial number of publicly traded firms have controlling shareholders unlike their U.S. and U.K. counterparts.55 To the extent that the presence of controlling shareholders makes opportunism regarding a change in securities domicile to the minority’s detriment more probable, that is no different from the higher probability of expropriation of the minority by such shareholders under existing domestic corporate and securities law. Similarly, the potential for such opportunistic behavior will be impounded in the stock price. In fact, suggestive evidence exists that shares trade at a substantial discount in the presence of controlling shareholders and the absence of legal protections for the minority, with significant variations in the discount across countries dependent upon the legal opportunities for self-dealing. For instance, the difference in price of the low- or nonvoting shares in dual class stock firms compared with the voting shares is substantially larger in countries that provide less legal protection for the minority shareholders (countries where the private benefits of control are high).56 In addition, firms in nations with greater shareholder protection trade in deeper capital markets and therefore have better access to external finance.57 The possibility of benefiting from minority expropriation (by, for instance, receipt of non-pro-rata distributions) distinguishes controlling shareholders from institutional investors, whose presence protects individual investors regarding regime choice because institutional and individual investors share cash flows equally. Controlling shareholders’ initial and midstream regime choices may therefore not be the same as those of institutions—they may prefer to trade off greater secrecy against the price received for shares sold to the public as they obtain benefits from the firm independent of cash dividends. That problem would be eliminated if controlling shares were excluded from the domicile vote, as the securities domicile would then be selected according to the preferences of outside shareholders.

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But there are two reasons for not mandating such an approach. First, a domicile voting rule excluding controlling shares would, in all likelihood, not be a feasible requirement for an international accord on securities competition, given the political influence controlling shareholders are likely to wield in the many nations in which group control is the predominant corporate ownership structure or where the government is a major shareholder in recently privatized firms. Second, individual investors are not likely to be harmed by the securities regime choice made by controlling shareholders because stock prices would be discounted for the insiders’ choices, just as prices are presently discounted according to the opportunity for insiders to obtain private benefits under existing corporate and securities laws. Since the controlling shareholders bear the cost of potential opportunism, they could, if they wish to increase the price paid for public shares, seek to commit to not changing domicile opportunistically, by placing in their charter a supermajority domicile voting rule, locked in by a supermajority vote for repeal, or otherwise contracting to vote their shares in proportion to the votes of outside shareholders. If supermajority charter provisions are not permissible or voting agreements are not enforceable in particular countries, then controlling shareholders will not be able to commit to only value-enhancing domicile shifts. Although the public would not bear the cost of opportunism over domicile changes in that situation, there would be a welfare loss, as both sets of shareholders would be better off if commitment were possible and share prices were higher. But no reason exists to believe that the potential welfare loss from insiders’ inability to commit to nonopportunistic behavior regarding domicile changes would be greater than the welfare loss from prohibition of midstream domicile changes, or from going as far as rejecting regulatory competition because of that possibility. The benefits from competition and the need for flexibility midstream, given the dynamics of the business environment, as discussed earlier in the domestic context, are just as great in the international setting and would, in all probability, outweigh the cost of the lack of effective commitment strategies. Moreover, if the politically influential controlling shareholders have a preference for commitment devices that are not achievable under domestic corporate law, then they could lobby their

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168 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION governments either to sign treaties with provisions that facilitate commitment strategies, such as excluding controlling shares from voting on domicile changes, or to revise domestic law to enable the use of effective commitment devices. Comparison with Other Reform Proposals One implication of the competitive federalism approach to international securities regulation—permitting the shares of non–U.S. issuers to trade in U.S. markets under a non–U.S. securities regime—is certainly not a new idea. A number of commentators have advocated reform of the SEC’s approach to foreign issuers to facilitate the trading of such issuers’ shares in U.S. markets by not having them come under the SEC’s regulatory regime or its more onerous components, such as U.S. GAAP reconciliation.58 Some commentators have more broadly called for an end to the extraterritorial application of U.S. securities laws.59 Depending on the concern of the commentator, the solutions have been to permit foreign firms to list on U.S. exchanges or, more narrowly, to permit U.S. investors to participate in foreign firms’ takeovers without having U.S. law apply,60 or to advocate a strict territorial—site of sale—approach, regardless of the shareholders’ ultimate residence or firm’s domicile.61 While those proposals resolve the most egregious problems in the extraterritorial application of U.S. law (the objective of their proponents), their coverage is more limited than the domicile approach of competitive federalism. As a consequence, those proposals would not be as effective at increasing regulators’ incentives to revise their regulations when they no longer meet investors’ needs as would be an international regime of full regulatory competition. Advocating comprehensive reform to rationalize international securities regulation, Merritt Fox has contended that an issuer nationality rule, which is equivalent to a physical presence domicile, is the regulatory approach that maximizes social welfare.62 Although the substantive policy outcome of Fox’s proposal and of competitive federalism may not significantly differ for some firms—that is, some non–U.S. issuers trading on a U.S. exchange may choose their home countries’ regimes— the rationales of the two proposals are fundamentally at odds, and Fox,

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in fact, considers competition as incompatible with his rationale for securities regulation. Fox believes that international regulatory competition will result in a “race to the bottom” regarding disclosure requirements. Although his statements regarding the low level of disclosure produced by competition are quite general, according to his regulatory rationale, the only relevant omission would be information involving interfirm externalities that a single regulator would require to be disclosed.63 Fox advocates a physical presence rule, in part, to foreclose regulatory competition. Firms would have to change their nationality to be able to change regulators—a costly undertaking. Competitive federalism is premised on an assessment of competition that is the precise opposite of Fox’s. As chapter 2 shows regarding the rationales for the federal securities regime in the United States, neither of Fox’s rationales depicting destructive competition holds up to scrutiny. The need to internalize third-party externalities is a tenuous rationale for securities regulation, and such externalities are not, in any event, likely to account for the items of mandatory disclosure pursued by the SEC or for the differences across national regimes. More important (in terms of current choice of regime practices), we have no reason to assume that firms would list on the exchange with the lowest level of disclosure requirements. Rather, they will choose the one whose requirements lower their cost of capital, which is not the exchange operating under the least amount of disclosure, because investors place affirmative value on information. The data at odds with the race-to-the-bottom thesis, as already noted, are that firms the world over voluntarily release more information than their securities regulators require so as to raise capital,64 and in other instructive contexts of regulatory competition, most notably state competition for charters in the United States, the race is definitely not to the bottom but, to the contrary, tends toward the top. Accordingly, while Fox’s proposed regulatory reform is compatible with a weak form of competitive federalism—it is not entirely impossible to change nationality, and hence his rule could produce a limited form of international regulatory competition—the rationales are diametrically opposed. Moreover, Fox’s policy recommendation of nationality-based securities jurisdiction is inconsistent with the logical implication of his

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170 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION rationale for securities regulation in his defense of the SEC’s monopoly and against regulatory competition for U.S. issuers. Under his interfirm externalities rationale, the crucial capital allocation decisions depend on firms’ being able to interpret accurately the significance of disclosures involving interfirm externalities—disclosures regarding rival firms’ industry or sector profitability. Because multinational firms’ competitors, in both their product and capital markets, are foreign corporations, when disclosure regimes differ by nationality, not all firms obtain the necessary proprietary information about their rivals. In particular, some nationals will be advantaged over others, and the optimal real asset allocations that Fox anticipates from his regime will not be undertaken because there will not be mandatory disclosure of all existing positive externalities. Fox’s solution therefore will not achieve his stated objective of the efficient allocation of capital. Indeed, if his thesis is correct, his solution may well hinder the efficient allocation of capital because it will increase the disclosure discrepancies across firms active in the same equity markets. Rather than propose different regulators for foreign firms listed on U.S. exchanges and a monopolist regulator for domestic listings, to be consistent Fox should instead advocate a megaregulator at the global level that would impose uniform disclosure requirements on all firms in a market. That alone would ensure that all of the externalities of concern to Fox are internalized. Moreover, those requirements should cover privately held as well as publicly traded corporations that compete in the same market, although Fox limits his attention to public firms, as do current securities regimes.65 Fox’s proposal has a further, secondorder inconsistency: under Fox’s normative theory of securities regulation—that national governments know best what the optimal disclosure regime is for domestic firms—issuers should be prevented from selecting a higher level of disclosure than that required by their home regulator, as, for instance, European firms listing in London or the United States routinely do. That is so because, according to Fox, a firm must be subject to its home country’s requirements to maximize social welfare. But he has not included that limitation in his proposal— foreign firms could continue to choose the U.S. regime—which is an

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inconsistency in his approach. In contrast to Fox’s proposal, the means and ends of the market approach to securities regulation are consistent: issuer choice of domicile is the most effective mechanism for implementing regulatory competition and thereby producing regimes that investors prefer.

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6 Conclusion

The current approach toward securities regulation should be revamped by implementing a regime of competitive federalism, under which firms would select their securities regulator from among the fifty states, the District of Columbia, the Securities and Exchange Commission, or other nations. Competitive federalism harnesses the high-powered incentives of markets to the regulatory state to produce regulatory arrangements compatible with investors’ preferences. That is so because firms will locate in the domicile whose regime investors prefer so as to reduce their cost of capital, and states will have financial incentives, such as incorporation and registration fees, to adapt their securities regimes to firms’ domicile decisions. That prediction regarding securities market participants’ and regulators’ responses to competition is well-grounded: a substantial literature examining the workings of competitive federalism for corporate charters indicates that regulatory competition on average benefits investors. To establish competitive federalism in the securities law context, policymakers must alter the current choice-of-law rule for securities transactions to follow the issuer’s chosen securities domicile rather than the securities’ site of sale. In addition, two procedural safeguards would be required of firms opting out of federal regulation: domicile disclosure upon securities purchases and a security-holder vote to effectuate a domicile change. Those requirements ensure that informed investor preferences drive the regulatory competition. When competition is introduced, SEC rules and regulations that are not cost-effective or are otherwise detrimental to investors will be replaced by competing regulators with rules investors prefer, as the domicile choices of capital market participants establish a new regulatory equilibrium. 172

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The mandatory federal securities regime has been in place for over sixty years, but the theoretical support for it is thin, and the empirical evidence does not indicate that it is effective in achieving its stated objectives. In fact, a developing literature points in the opposite direction. The best available evidence on the U.S. federal securities laws indicates that the regime is not more effective than voluntary disclosure practices, as its expansions of disclosure requirements have not had a significant impact on investor wealth. In my view, those data decisively trump the presumption in favor of the status quo, which is the SEC’s exclusive jurisdiction over U.S. securities transactions. At a minimum, the literature suggests that the securities status quo should no longer be privileged and that it should instead be opened up to market forces by means of competitive federalism. That is, in fact, the norm in corporate law, the area most related to securities law because of the laws’ shared objective of protecting the interests of investors, and the working hypothesis in a capitalist economy—a preference for market solutions where there is no showing of a market failure. Corporation codes have benefited from precisely such competition. The evidence on the U.S. charter market indicates that state competition has in general benefited investors. That experience provides a benchmark for projecting what would be the outcome under a competitive system of securities regulation: investors would reap the benefit of improved incentives for entrepreneurs and regulators to act in furtherance of shareholder value. Although the current legislative trend in Congress—supported by both the proponents and opponents of the existing regulatory regime—is to seek to monopolize even further securities regulation at the federal level, it would be far better public policy to expand, not restrain, state regulatory involvement. As long as only one state’s law, chosen by the issuer, controls the regulation of a firm’s securities transactions, regulatory competition will emerge, and compelling reasons exist to prefer such a regulatory arrangement to the mandatory federal regime. Critics of regulatory competition in securities law have contended that such competition will lead to a race to the bottom, with firms rushing to register in states with the lowest disclosure requirements, or that regulatory competition will result in a socially suboptimal disclosure level

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174 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION because firms will not have to disclose corporate information of a proprietary nature that entails interfirm externalities. The critics’ parade of horribles is unsupported and unsupportable. First, evidence from institutional equity and debt markets, as well as cross-country listing practices, indicates that the voluntary disclosure choices of firms are often higher than mandatory requirements; in other words, regulators do not require the mix of information that investors prefer, and firms respond by providing the information investors demand. Moreover, when competition has been permitted in sectors of the securities markets and in corporate law in the United States, we do not find firms opting for minimum disclosure regimes or for states whose corporation codes permit the exploitation of investors. No plausible reason exists to expect such behavior to change under securities regulatory competition. Second, there is no evidence that the focus of SEC disclosure requirements or their implementation by issuers entails the revelation of information bearing on interfirm externalities—the rationale advanced by some advocates of a single regulator. Nor could such a mandate be feasible: firms would either find a way not to disclose proprietary information, or they would exit from the regime by going private or moving to another jurisdiction. Moreover, formal models of disclosure regulation in the presence of interfirm externalities suggest that it would be difficult, if not impossible, for a regulator to ascertain the appropriate disclosure requirements that increase, rather than decrease, social welfare. Finally, if investors, rather than issuers, select the disclosure regime, as would occur under competition, then the hypothesized problem of an inadequate calculus under competition regarding the disclosure of interfirm externalities is mitigated, because the majority of shareholders are large institutions that hold diversified portfolios and will thereby be able to internalize the costs and benefits of such disclosures. International securities regulation should also be opened up to jurisdictional competition, in which all issuers would choose a statutory domicile for securities law purposes whose rules will govern their securities relations with investors, regardless of where the investors are located or the shares are traded. Such a regime would be superior to the existing territorially based international regulatory system because it will better

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track investor preferences and provide regulators with increased incentives to revise their regulations when they have fallen out of step with investor needs. It would, no doubt, take considerable effort to craft the multilateral accords necessary to achieve full implementation of international regulatory competition, but with the growing use of electronic trading, geographic boundaries are increasingly becoming obsolete as a source of jurisdiction, and issuer domicile is the most feasible alternative jurisdictional basis. The proposal for international regulatory competition will undoubtedly have the greatest impact on non–U.S. issuers who would be able to access U.S. capital markets without having to comply with SEC requirements, although some non–U.S. firms may for a variety of reasons, including committing to subscribe to higher disclosure levels than required by the home regulator, still choose to opt into the U.S. regime. That potentially differential impact results because, in contrast to foreign issuers, U.S. issuers have already incurred the start-up costs of complying with the SEC, and thus they would experience a more limited savings from experimenting with another jurisdiction that had a more refined set of disclosure requirements. If the SEC’s regime is not cost-justified, however, as the data suggest, a competing regulator will emerge, from among the fifty states, the District of Columbia, or other nations, with a superior regime that will attract not only new foreign and U.S. issuers, which have not yet incurred the start-up costs of SEC compliance, but eventually the mature issuers, which are competing for capital with new issuers. That is the central lesson to be drawn from the corporate charter market, and it is a lesson worth restating. Those aspects of the SEC regime that investors value will be retained, but those that are not will be discarded, and the resulting regime will accordingly better enhance investor welfare than the present one.

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Notes

Chapter 1: Introduction 1. 15 U.S.C. § 78a ff. 2. 15 U.S.C. § 77a ff. 3. No statutory definition of an “insider” exists for purposes of liability under the general antifraud provision of the 1934 act, section 10(b), and its implementation by the SEC in rule 10b-5, 17 C.F.R. § 240.10b-5. The prototypical insider is an officer or director trading in his firm’s shares, but the concept has been stretched to include any person with a fiduciary obligation restricting his trading on specific information, such as a lawyer working for a firm representing a hostile bidder whose law firm prohibits trading in the shares of the targets of clients’ bids. For a general discussion of the policy issues involving the regulation of insider trading, see Jonathan R. Macey, Insider Trading (Washington, D.C.: AEI Press, 1991). 4. As reported in “Morgenthau v. White,” New York Times, December 6, 1997, a criminal enforcement action for insider trading brought by the New York state prosecutor’s office was undercut by the U.S. attorney who seized the case and struck a plea bargain with the defendant after the state had developed the case and obtained an indictment. New York State was also ahead of the SEC in pursuing action against securities analysts for conflicts of interest regarding stock recommendations. See, for example, “SEC Joins the Pack, Opens Inquiry into Analysts,” Wall Street Journal, April 26, 2002. 5. See Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990). 6. For example, after Connecticut updated its code to follow the latest Model Business Corporation Act revision, local practitioners touted the reforms as a reason to incorporate in Connecticut instead of Delaware. See James I. Lotstein and Christopher Calio, “Why Choose Connecticut? Advantages of the Connecticut 177

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Business Corporation Act over the Delaware General Corporation Law,” Connecticut Lawyer, April 2000, 10. 7. For data indicating the competitive pattern of adoption of statutory innovations and the relation between franchise revenues and statutory innovation, see Roberta Romano, “Law as a Product: Some Pieces of the Incorporation Puzzle,” Journal of Law, Economics, and Organization 1 (1985): 225, 235–41. 8. See generally Roberta Romano, The Genius of American Corporate Law (Washington, D.C.: AEI Press, 1993). 9. For a discussion of the origins of state securities regulation that are referred to as blue sky laws and often include a form of merit regulation, in which the state conditions registration on its assessment of the investment worthiness of a security, rather than simply disclosure regulation, as is the approach of the federal securities regime, see Jonathan R. Macey and Geoffrey P. Miller, “Origin of the Blue Sky Laws,” Texas Law Review 70 (1991): 347. The authors suggest that the concern motivating the Kansas legislation was not prevention of the bilking of local investors by New York firms selling bogus securities but rather prevention of New York banks’ ability to compete with Kansas banks for the local investors’ funds. For a study finding that both populist ideology and small banks’ interest in stemming competition effected the adoption of blue sky laws, see Paul G. Mahoney, “The Origins of the Blue Sky Laws: A Test of Competing Hypotheses,” University of Virginia School of Law, Law and Economics Research Papers working paper no. 01-11, 2001. 10. See, for example, Harold Bierman, Jr., The Great Myths of 1929 and the Lessons to Be Learned (Westport, Conn.: Greenwood Press, 1991), 133–45 (showing no basis for manipulation claims motivating the federal securities legislation); George J. Benston, “Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934,” American Economic Review 63 (1973): 132, 135 (little evidence of a significant number of cases of fraud in financial statements prepared prior to enactment of federal securities laws); George J. Benston, “The Value of the SEC’s Accounting Disclosure Requirements,” Accounting Review 44 (1969): 515, 517–18 (same); Paul G. Mahoney, “The Stock Pools and the Securities Exchange Act,” Journal of Financial Economics 51 (1999): 343 (demonstrating fallacy of claims underlying 1934 act regarding stock pool manipulation). See also Paul G. Mahoney, “The Political Economy of the Securities Act of 1933,” Journal of Legal Studies 30 (2001): 1 (explaining the 1933 act’s new

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issue gun-jumping prohibitions as a means to reduce underwriting competition in favor of established investment banks and not as an investor protection device). 11. In addition, there is no discussion of the SEC’s authority over public utility holding companies because the SEC has proposed eliminating its authority in the area, given the limited number of such companies that exist today. 12. Ownership of mutual fund assets is available on the Web site of the Investment Company Institute, which is the mutual fund trade association. See Investment Company Institute, “Institutional Markets for Mutual Funds: 1999,” www.ici.org/aboutshareholders/inst_investor_survey_99.html; and Investment Company Institute, “Institutional Markets for Mutual Funds: 1995,” www.ici.org/aboutshareholders/inst_investor_survey_95.html. 13. Investment Company Institute, “Institutional Markets for Mutual Funds: 1995.” The largest category in the institutional market consists of fiduciary accounts (assets held by banks and individuals serving as trustees, guardians, and administrators). 14. Investment Company Institute, “2000 Mutual Fund Fact Book,” May 2000, 41, available at www.ici.org/pdf/00fb_ch5.pdf. That is an increase of 4 percent in the proportion of mutual fund assets that individuals owned at the start of the decade; the decline in institutional holdings is in fiduciaries’ assets, which fell from 16 percent to 9 percent over the decade and is largely a function of the increase in retirement plan holdings over the period. 15. See James D. Cox, “Premises for Reforming the Regulation of Securities Offerings: An Essay,” Law and Contemporary Problems 63 (2000): 11, 35 (claiming that “nearly every decision” of the SEC in the “past two decades” has been related to competition); and John C. Coates IV, “Private vs. Political Choice of Securities Regulation: A Political Cost/Benefit Analysis,” Virginia Journal of International Law 41 (2001): 531, 543 (contending that the SEC has not acted in a “monolithic” fashion on disclosure because its has “numerous flexible and open-textured disclosure obligations”). 16. See Roberta Romano, “Empowering Investors: A Market Approach to Securities Regulation,” Yale Law Journal 107 (1998): 2359, 2397–98. 17. An excellent recent example is the derivatives’ risk disclosure requirement, which calls for valuation information not required under derivatives accounting rules. See Securities and Exchange Commission, “Disclosure of

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Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments,” Federal Register 62 (February 10, 1997): 6044. A few years earlier, in 1992, the SEC expanded the disclosure requirements regarding executive compensation. See Securities and Exchange Commission, “Executive Compensation Disclosure,” Federal Register 57 (October 21, 1992): 48126. 18. For a discussion of SEC and court efforts at extraterritorial coverage in the context of securities regulation of takeover bids, for example, see Arthur R. Pinto, “The Internationalization of the Hostile Takeover Market: Its Implications for Choice of Law in Corporate and Securities Law,” Brooklyn Journal of International Law 16 (1990): 55. 19. Ibid., 67–76. The SEC recently amended its rules and regulations and provided investors with a limited form of relief from the problem: it exempted crossborder tender offers, where U.S. investors hold less than 10 percent of the securities subject to the bid, from federal takeover regulation, but at the same time it retained the applicability of the antifraud, manipulation, and civil liability provisions of the federal securities laws to the transactions. See “Cross-Border Tender and Exchange Offers, Business Combinations and Rights Offerings, Final Rule,” Federal Register 64 (November 10, 1999): 61382 (exemption effective January 24, 2000). 20. See, for example, Franklin R. Edwards, “SEC Requirements for Trading of Foreign Securities on U.S. Exchanges,” in Kenneth Lehn and Robert Kamphuis, eds., Modernizing U.S. Securities Regulation: Economic and Legal Perspectives (Burr Ridge, Ill.: Business One Irwin, 1992), 57–58. 21. See R. C. Michie, The London and New York Stock Exchanges 1850–1914 (London: Allen & Unwin, 1987), 34 (indicating that the New York exchange gained preeminence among the world’s security markets from World War I). 22. See Bruno Solnik, International Investments, 3d ed. (Reading, Mass.: Addison Wesley, 1996), 168, exhibit 6.1 (reporting that the U.S. share of global capitalization dropped from 57 percent to 36 percent from 1974 to 1994). With the recent market boom, the U.S. share rose to 41 percent in 1996. See Ibbotson Associates, AI/RI Global Portfolio Intensive Classroom Program 1997 (Chicago, Ill.: Ibbotson Associates, 1997), Day 1-16 (citing Developed Markets, Morgan Stanley

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Capital International EAFE and World Perspective (New York: Morgan Stanley Capital International, January 1996), 5; and International Finance Corporation, Emerging Market Data Base Monthly Review of Emerging Stock Markets (Washington, D.C.: International Finance Corporation, n.d.), 8). 23. William J. Carney, “Jurisdictional Choice in Securities Regulation,” Virginia Journal of International Law 41 (2001), 717, 721. John Coates raises a further objection to regulatory competition. He contends that if regulatory competition were implemented, then upon the experience of a downturn in the business cycle, whether or not accompanied by a financial panic or corporate scandal, the public outcry in a recession would lead to “reregulation” of the market that would be more burdensome not only than the content of the current regime but also than what would have resulted were the SEC still the exclusive regulator. Coates, “Private vs. Political Choice of Securities Regulation,” 565–72, 576–78. Coates asserts that the SEC would propose “reregulatory” policies “more attractive to the industry” than would Congress or the president on the apparent view that as an expert agency, the SEC acts as a buffer for the industry against a hostile public and Congress. Ibid., 579. That scenario is not credible. First, Congress has intervened on a number of occasions in support of industry complaints against the SEC’s position, notwithstanding Coates’s contention that the SEC protects corporations from congressional scrutiny. Examples are Congress’s restriction of private securities lawsuits in the Private Securities Litigation Reform Act of 1995, Public Law 104-67, 109 Stat. 737, action sought by the hightechnology industry and opposed by the SEC, and legislation introduced to prohibit a proposed accounting rule by the Financial Accounting Standards Board for the valuation of stock options (S. 1175, 103d Cong., 1st Sess. 1993) that resulted in the proposal’s withdrawal; the proposal was opposed by industry and encouraged by the SEC, which, although it has no formal control over the FASB, has authority to promulgate accounting rules that enables it to exert influence on FASB policy deliberations. Second, contrary to Coates’s contention, the more accurate description of the SEC’s lobbying behavior is that it relentlessly seeks to increase its regulatory authority rather than to deflect congressional attempts to regulate. The SEC adopts the latter strategy only when congressional action would diminish its sphere of influence, as is true of the examples Coates provides, the SEC’s opposition to creation of an FDIC apparatus for brokers, and the agency’s defense of the industry against the FBI’s pursuit of securities fraud cases. Coates,

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“Private vs. Political Choice,” 556. Indeed, after the stock market break of 1987, the SEC sought to obtain regulatory authority over equity-based derivatives and required exchanges to impose restraints on trading. That was certainly not the moderating voice that Coates describes, in contrast to the opposition to further regulation voiced by the CFTC and Federal Reserve Board. See Roberta Romano, “The Political Economy of Derivative Securities Regulation,” Yale Journal on Regulation 14 (1997): 279, 359–65. Consistent with the thrust of its regulatory agenda, most recently, despite congressional instructions to the contrary in its deregulation of the banking sector, the SEC drafted extensive regulations regarding banks’ securities activities that banks consider prohibitively burdensome. See “Opening Statement of John J. LaFalce, Ranking Member,” House Committee on Financial Services Hearing on the SEC’s Broker-Dealer Rules (August 2, 2001), available in LEXIS, legis library, hearng file. Finally, as William Carney has noted, it is an error to equate, as does Coates, regulatory competition in the twenty-first century with the world of the 1930s, when the federal government stepped in to regulate financial markets. Quite apart from the collapse of socialism, which many thoughtful people believed to be a viable alternative to capitalism in that era, the SEC would not only be one among several securities regulators but would still be a major player through its regulation of brokers under competitive federalism. See Carney, “Jurisdictional Choice in Securities Regulation,” 732. 24. See Frederick D. S. Choi, “Financial Reporting Requirements for Non–U.S. Registrants: International Market Perspectives,” Financial Markets, Institutions, and Instruments 6 (1997): 23, 29.

Chapter 2: Rationales for Securities Regulation, the Effectiveness of the SEC, and Competitive Federalism 1. See William H. Beaver, “The Nature of Mandated Disclosure,” in Report of the Advisory Committee on Corporate Disclosure to the SEC, 95th Cong., 1st Sess. (1977). 2. See Jack Hirshleifer, “The Private and Social Value of Information and the Reward to Inventive Activity,” American Economic Review 61 (1971): 561, 565–66. 3. See, for example, John C. Coffee, Jr., “Market Failure and the Economic Case for a Mandatory Disclosure System,” Virginia Law Review 70 (1984): 717.

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4. The classic signaling model of securities disclosure is Stephen A. Ross, “Disclosure Regulation in Financial Markets: Implications of Modern Finance Theory and Signaling Theory,” in Franklin R. Edwards, ed., Issues in Financial Regulation (New York: McGraw-Hill, 1979), 177, 185–89, 213. 5. See, for example, Ronald A. Dye, “Investor Sophistication and Voluntary Disclosures,” Review of Accounting Studies 3 (1998): 261; and Michael J. Fishman and Kathleen M. Hagerty, “Mandatory vs. Voluntary Disclosure in Markets with Informed and Uninformed Customers,” Northwestern University, Kellogg School of Management, 1999. 6. See Michael J. Fishman and Kathleen M. Hagerty, “Mandatory Disclosure,” in Peter Newman, ed., The New Palgrave Dictionary of Economics and the Law, vol. 2 (New York: Stockton Press, 1998), 605, 606–7. 7. See Franklin Allen, “Do Financial Institutions Matter?” Journal of Finance 56 (2001): 1165, 1166–67. A skeptic might wonder whether institutional investors can be relied on to choose securities regimes wisely, by contending that money managers engage in herding, that is, they select portfolios based not on their own information but on the observed actions of other managers—behavior that can produce information “cascades” that lead to incorrect investment choices. That is not a grave concern. First, the theory of information cascades indicates that cascades are unstable and subject to collapse with the introduction of just a little bit of new public information. See Sushil Bikhchandani, David Hirshleifer, and Ivo Welch, “Learning from the Behavior of Others: Conformity, Fads, and Informational Cascades,” Journal of Economic Perspectives 12 (3) (1998): 151. Thus, even if institutional investors herd in their portfolio selection by following other managers against their better judgment, in a competitive environment an inefficient cascade into an inferior regime could be overcome by a small amount of new information regarding regime quality, as could be provided by one issuer, regulator, or entrepreneurial fund manager. Second, the literature consists of a number of plausible theoretical models of herding creating potential market inefficiencies but lacks good empirical tests of whether such herding occurs (the literature relies on price patterns rather than on actual communications). See Andrea Devenow and Ivo Welch, “Rational Herding in Financial Economics,” European Economic Review 40 (1996): 603, 612. That feature of the literature limits the value of referencing herding models in considering whether to reform public policy in a direction that is otherwise in accord with economic

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first principles that competition is preferable to monopoly. Third, and more important, the most comprehensive empirical study of mutual fund herding, consisting of twenty years of trading from 1975 to 1994, finds that the amount of herding is low, and where it occurs (in the purchase and sale of small stocks), the stocks that funds buy into in large numbers significantly outperform the stocks that the funds sell—that is, herding is profitable and likely to be based on the receipt of new information. Russ Wermers, “Mutual Fund Herding and the Impact on Stock Prices,” Journal of Finance 54 (1999): 581, 584–85; see also Mark Grinblatt, Sheridan Titman, and Russ Wermers, “Momentum Investment Strategies, Portfolio Performance, and Herding: A Study of Mutual Fund Behavior,” American Economic Review 85 (1995): 1088. Those findings suggest that concern that institutions cannot be expected to select quality securities regimes because they engage in uninformed herding behavior is unfounded. 8. George Benston reports that 82 percent were audited in 1926 and 94 percent in 1934, for example. See George J. Benston, “The Value of the SEC’s Accounting Disclosure Requirements,” Accounting Review 44 (1969): 515, 519–20. Other sources from the 1930s indicate that at least 85 percent of NYSE firms were audited before enactment of the 1934 act. See Joel Seligman, The Transformation of Wall Street (Boston: Northeastern University Press, 1995), 48 n. 32, 633. The first required filing of financial statements under the 1934 act was July 1935. 9. See Ross L. Watts and Jerold L. Zimmerman, “Agency Problems, Auditing, and the Theory of the Firm: Some Evidence,” Journal of Law and Economics 26 (1983): 613. 10. See George J. Benston, “Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934,” American Economic Review 63 (1973): 132, 144–45. See also George J. Benston, “An Appraisal of the Costs and Benefits of Government-Required Disclosure: SEC and FTC Requirements,” Law and Contemporary Problems (Summer 1977): 30, 51–52. Joel Seligman has criticized the significance of that finding. See Seligman, Transformation of Wall Street, 16–17, but his objections, which follow those of Irwin Friend and Randolph Westerfield, actually reinforce George Benston’s conclusions. See Irwin Friend and Randolph Westerfield, “Required Disclosure and the Stock Market: Comment,” American Economic Review 65 (1975): 467. For example, in criticism of Benston’s finding of no stock price effect of the SEC’s disclosure requirements, Seligman cites more recent studies showing that data in SEC filings affect stock

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prices in an effort to prove that the SEC’s mandated disclosure program is of value to investors. But it is not the SEC’s disclosure requirements that are affecting stock value in those studies, because the information examined in the studies Seligman cites—earnings—was disclosed, as Benston demonstrates, even before the creation of the SEC and would continue to be disclosed if there were no SEC. Seligman also objects that Benston’s test does not adequately distinguish between disclosure and nondisclosure firms, because all the firms in Benston’s sample disclosed earnings. But that is precisely Benston’s point: The SEC’s mandated disclosure added only one item—sales—that had not been disclosed by NYSE firms, and release of the new information under the requirement had no effect on the stock prices of those firms not previously disclosing sales. 11. Merritt Fox, “Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment,” Virginia Law Review 85 (1999): 1335, 1373 n. 91. 12. Benston, “Required Disclosure,” 133, 142. The SEC apparently copied much of the NYSE disclosure requirements. See Paul G. Mahoney, “The Exchange as Regulator,” Virginia Law Review 83 (1997): 1453, 1466. The one other item that firms had not previously disclosed was the cost of goods sold, and Benston’s findings are the same for that item as for sales. Benston, “Required Disclosure,” 142 n. 12. 13. Fox’s source on the quality of sales disclosure, a 1939 article by SEC staff attorneys, provides the following information on sales disclosures in firms’ income statements: of the seventy firms in their sample, the number of firms disclosing net sales after the 1934 act approximately doubled (thirty-one compared to seventeen firms, including three firms that disclosed both gross and net sales either before or after the act). Maurice Kaplan and Daniel M. Reaugh, “Accounting, Reports to Stockholders, and the SEC,” Yale Law Journal 48 (1939): 935, 945 n. 42. The number of firms disclosing gross sales, “sales,” and “sales and operating revenue” is virtually unchanged (a rise from twenty-two to twenty-three firms), and two firms stopped disclosing net sales after the act. Kaplan and Reaugh’s data do not indicate, however, whether the new postact disclosers of net sales were preact disclosers of gross sales and not preact nondisclosers, nor correspondingly whether the postact disclosers of gross sales were the same firms as the preact nondisclosers and not preact disclosers of gross sales. Yet such distinctions are essential for Fox’s hypothesis regarding Benston’s findings to be correct.

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14. Ibid., 949 n. 59. 15. Benston, “Required Disclosure,” 146, 149. Variance is a statistical measure indicating how far a distribution is spread around its mean, and in finance is considered a measure of the risk of an investment. Indeed, Fox recharacterized Benston’s study as an investigation of the risk of stocks around the enactment of the 1934 act in contrast to how Benston viewed his study, as first and foremost a study of the act’s impact on prices. See ibid., 137 (“If the SEC’s disclosure requirements are meaningful, the statements they require should contain information[,] and [the effect] should be reflected in changes in [corporations’] stock prices.”). 16. Fox, “Retaining Mandatory Securities Disclosure,” 1375. 17. See, for example, Stephen A. Ross, Randolph W. Westerfield, and Jeffrey Jaffe, Corporate Finance, 6th ed. (New York: Irwin McGraw-Hill, 2002), 341–49. 18. Benston, “Required Disclosure,” 144. 19. Ross, Westerfield, and Jaffe, Corporate Finance, 268–74, 287–95. 20. Where firm-specific measures have been found empirically to affect returns, the variance of returns is not a significant variable; instead, price-toearnings and market-to-book value ratios are significant. See ibid., 284. 21. Benston, “Required Disclosure,” 145–49. 22. Ibid., 149. Note also that a decline in the variance of stock returns is not necessarily an improvement in investor welfare. In an efficient market, stock prices change frequently as information is released, so the more information that firms produce, the higher we might expect the volatility of returns to be. From that perspective, a decline in volatility after government action may indicate that in response to the rule change, firms reduced the amount of information they were producing. A rule resulting in a reduction in stock return variance when that is the case would not benefit investors. 23. George J. Benston, “Required Disclosure and the Stock Market: Rejoinder,” American Economic Review 65 (1975): 473, 475. 24. Were state legislatures to be the source of disclosure standards because they also own their legal systems, as they determine who can register in-state, no externality problem would exist with respect to standardization choices under state competition. 25. See William J. Carney, “The Production of Corporate Law,” Southern California Law Review 71 (1998): 715, 729–34; and Roberta Romano, The Genius of American Corporate Law (Washington, D.C.: AEI Press, 1993), 7.

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26. See Bipin B. Ajinkya, “An Empirical Evaluation of Line-of-Business Reporting,” Journal of Accounting Research 18 (1980): 343, 357–59 (no effect on returns, increased consensus in probability assessments); Daniel W. Collins and Richard R. Simonds, “SEC Line-of-Business Disclosure and Market Risk Adjustments,” Journal of Accounting Research 17 (1979): 352, 372–73, 378–80 (change in market risk); and Bertrand Horwitz and Richard Kolodny, “Line of Business Reporting and Security Prices: An Analysis of an SEC Disclosure Rule,” Bell Journal of Economics 8 (1977): 234, 239, 241–42, 246 (no effect on market risk or on returns). See generally Rosanne M. Mohr, “The Segmental Reporting Issue: A Review of Empirical Research,” Journal of Accounting Literature 2 (1983): 39, 45–52, 56–62 (literature review summarizing general results of no effect on returns, some improvements in analyst forecasts and increased consensus, and mixed evidence on whether market risk shifted). 27. See Ross L. Watts and Jerold L. Zimmerman, Positive Accounting Theory (Englewood Cliffs, N.J.: Prentice Hall, 1986), 174 and n. 9 (citing studies). 28. See George J. Stigler, “Public Regulation of the Securities Markets,” Journal of Business 37 (April 1964): 117; Gregg A. Jarrell, “The Economic Effects of Federal Regulation of the Market for New Securities Issues,” Journal of Law and Economics 24 (1981): 613; and Carol J. Simon, “The Effect of the 1933 Securities Act on Investor Information and the Performance of New Issues,” American Economic Review 79 (1989): 295. 29. See Fox, “Retaining Mandatory Securities Disclosure,” 1382. 30. See Jarrell, “Economic Effects of Federal Regulation,” 661, 664, 667, 669. 31. Ibid., 648. 32. Seha M. Tinic, “Anatomy of Initial Public Offerings of Common Stock,” Journal of Finance 43 (1988): 789. 33. Ibid., 813. 34. See, for example, Benston, “Value of the SEC’s Accounting Disclosure,” 526. 35. Ibid., 527–28. 36. Paul G. Mahoney, “The Political Economy of the Securities Act of 1933,” Journal of Legal Studies 30 (2001): 1. 37. Ibid., 28–29. Mahoney, who provides persuasive evidence of the distributional effect of the 1933 act, notes that Henry Manne suggested that the 1933 act helped, rather than hurt, the major investment banks, “who underwrote lowrisk securities and . . . had nothing to lose from a ‘full disclosure policy’ and much to gain from driving out underwriters of high-risk securities.” Ibid., 2.

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38. Simon, “Effect of the 1933 Securities Act,” 309–10. 39. See, for example, Richard Frankel et al., “Discretionary Disclosure and External Financing,” Accounting Review 70 (1995): 135, 141 (finding that firms are significantly more likely to forecast earnings if they access capital markets over sample period); Mark Lang and Russell Lundholm, “Cross-Sectional Determinants of Analyst Ratings of Corporate Disclosures,” Journal of Accounting Research 31 (1993): 246, 265–69 (finding that a firm’s Financial Analyst Federation disclosure quality rating increases with security issuance); and William Ruland et al., “Factors Associated with the Disclosure of Managers’ Forecasts,” Accounting Review 65 (1990): 710, 720 (finding that firms reporting forecasts are more likely to issue new capital). Compare Frederick D. S. Choi, “Financial Disclosure and Entry to the European Capital Market,” Journal of Accounting Research 11 (1973): 159, 168–70 (finding that firms entering Eurobond market increase disclosure); Paul M. Healy, Amy P. Hutton, and Krishna G. Palepu, “Stock Performance and Intermediation Changes Surrounding Sustained Increases in Disclosure Strategy,” Contemporary Accounting Research 16 (1999): 485, 498, 503, 508–9 (sustained improvements in voluntary disclosure result in improved stock performance and are also positively associated with stock issuance); Christine A. Botosan, “Disclosure Level and the Cost of Equity Capital,” Accounting Review 72 (1997): 323, 344, 346 (voluntary disclosure in annual report significantly explains cost of capital of firms with small analyst following). 40. See Healy, Hutton, and Palepu, “Stock Performance and Intermediation Changes” (sustained increases in voluntary disclosure result in increased liquidity); and Michael Welker, “Disclosure Policy, Information Asymmetry, and Liquidity in Equity Markets,” Contemporary Accounting Research 11 (1995): 801 (firms with high analyst disclosure ratings have smaller bid-ask spreads than firms with lower ratings). 41. See Carol A. Marquardt and Christine I. Wiedman, “Voluntary Disclosure, Information Asymmetry, and Insider Selling through Secondary Equity Offerings,” Contemporary Accounting Research 15 (1998): 505 (finding that, in secondary offerings, managers act as if reduced information asymmetry is correlated with reduced cost of capital, such that their participation in an offering explains the frequency of voluntary disclosure); Maribeth Coller and Teri Lombardi Yohn, “Management Forecasts and Information Asymmetry: An Examination of Bid-Ask Spreads,” Journal of Accounting Research 35 (1997): 181 (finding that firms with

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increasing bid-ask spreads release earnings forecasts to reduce spread); and Shuping Chen, Mark L. DeFond, and Chul W. Park, “Voluntary Disclosure of Balance Sheet Information in Quarterly Earnings Announcements,” Journal of Accounting and Economics 33 (forthcoming 2002) (managers more likely to make voluntary balance sheet disclosures when earnings are less informative to reduce information asymmetry). 42. David S. Gelb, “Intangible Assets and Firms’ Disclosures: An Empirical Investigation,” Journal of Business Finance and Accounting 29 (2002): 457 (finding firms that obtain significantly higher analysts’ ratings for voluntary disclosures and investor relations programs have higher levels of intangible assets, as measured by research and development and advertising expenditures). 43. See, for example, Luis F. Moreno Trevino, “Access to U.S. Capital Markets for Foreign Issuers: Rule 144A Private Placements,” Houston Journal of International Law 16 (1993): 159, 195. 44. See William J. Carney, “Jurisdictional Choice in Securities Regulation,” Virginia Journal of International Law 41 (2001): 717, 724. 45. Ibid., 725. 46. See Hal S. Scott and Philip A. Wellons, International Finance Transactions, Policy, and Regulation, 7th ed. (New York: Foundation Press, 2000), 311 (citing references concerning Danish and French firms’ compliance with United Kingdom standards); and G. K. Meek and S. J. Gray, “Globalization of Stock Markets and Foreign Listing Requirements: Voluntary Disclosures by Continental European Companies Listed on the London Stock Exchange,” Journal of International Business Studies 20 (1989): 315 (reviewing a sample of European companies trading in London). 47. See Howell E. Jackson and Eric J. Pan, “Regulatory Competition in International Securities Markets: Evidence from Europe in 1999—Part I,” Business Lawyer 56 (2001): 653 (interviews regarding capital-raising practices with twenty-eight European lawyers whose firms included eight of ten leading advisers to issuers by deal value and eight of thirteen leading advisers by deal number and who were advisers on over sixty European offerings in 1999). 48. Shahrokh M. Saudagaran and Gary K. Meek, “A Review of Research on the Relationship Between International Capital Markets and Financial Reporting by Multinational Firms,” Journal of Accounting Literature 16 (1997): 127, 143–45.

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49. See Vanessa Fuhrmans, “Playing by the Rules: How Neuer Markt Gets Respect,” Wall Street Journal, August 21, 2000. 50. Ibid. The bloom is currently off the rose of technology stocks as the industry has slumped worldwide, and Neuer Markt listings have plummeted. But the exchange has continued to follow its course of adopting regulations for listed companies that appeal to investors, such as requiring the reporting of directors’ share dealings. See “Penny Bazaar,” Economist, July 21, 2001, 60, 61. 51. See Christine A. Botosan and Marlene A. Plumlee, “Disclosure Level and Expected Cost of Equity Capital: An Examination of Analysts’ Rankings of Corporate Disclosure,” David Eccles School of Business, University of Utah, January 2000, 7 (the Association for Investment Management and Research evaluates corporate reporting practices by assigning ranks to firms according to the adequacy of their reporting in three disclosure categories, annual reports and other mandated disclosures, weighted at 40 to 50 percent; quarterly reports and other voluntary disclosures, weighted at 30 to 40 percent; and “other aspects,” which refers to “access to management through presentations to analysts, company-sponsored field trips, and interviews,” weighted at 20 to 30 percent). 52. See Eli Amir, Baruch Lev, and Theodore Sougiannis, “What Value Analysts?” Recanti School of Management, Tel Aviv University, 1999, 3 (examining analysts’ earnings forecasts from 1982 through 1997 for a total of over 18,000 firm/year observations, they find contribution of financial analysts to equity valuation is largest in high-tech industries). 53. See, for example, John C. Coffee, Jr., et al., “The Direction of Corporate Law: The Scholar’s Perspective,” Delaware Journal of Corporate Law 25 (2000): 79, 99 (foreign firms’ choice to come under stricter disclosure rules of U.S. listing means that regulatory arbitrage does not work) (remarks of John C. Coffee, Jr.). It is odd that commentators such as Coffee who have praised the ability of foreign firms to choose the U.S. regime instead of their home regulator have not sought to extend that choice to U.S. firms. There is no coherent rationale for distinguishing U.S. and non–U.S. firms in that manner: no evidence exists that U.S. managers are more likely to exploit shareholders, or that their investors are less informed than those of foreign firms, to require mandatory, rather than optional, coverage by the SEC. Just as foreign firms tend not to select the lowest level of disclosure that is available, neither will U.S. firms, if they can choose their regulatory regime. Indeed, both U.S. and non–U.S. firms that are under the SEC’s regime today, if the

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SEC were to lose its territorial monopoly, might choose another sovereign that better calibrated the costs and benefits of disclosure regarding investor needs than the SEC. 54. See Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law (Cambridge: Harvard University Press, 1991), 290–91. 55. See Fox, “Retaining Mandatory Securities Disclosure.” 56. The models are in Ronald A. Dye, “Mandatory versus Voluntary Disclosures: The Cases of Financial and Real Externalities,” Accounting Review 65 (1990): 1; and Anat Admati and Paul Pfleiderer, “Forcing Firms to Talk: Financial Disclosure Regulation and Externalities,” Review of Financial Studies 13 (2000): 479. An extended discussion of the plausibility of the assumptions and structures of the two models and their relevance to the policy debates over securities regulation can be found in Roberta Romano, “The Need for Competition in International Securities Regulation,” Theoretical Inquiries in Law 2 (2001): 387. 57. See Dye, “Mandatory versus Voluntary Disclosures.” 58. See, for example, Mark L. Mitchell, “The Impact of External Parties on Brand-Name Capital: The 1982 Tylenol Poisonings and Subsequent Cases,” Economic Inquiry 27 (1989): 601, 616 (documenting substantial stock price losses to Tylenol manufacturer after product tampering as well as to all over-the-counter drug marketers); Severin Borenstein and Martin B. Zimmerman, “Market Incentives for Safe Commercial Airline Operation,” American Economic Review 78 (1988): 913, 931–32 (small but significant negative price effect and demand effect on rival firms after ten large plane crashes); David W. Prince and Paul H. Rubin, “The Effects of Product Liability Litigation on the Value of Firms,” American Law and Economics Review 4 (2002): 44 (finding product liability litigation for firms in automobile industry had negative stock price effect on competitors whereas such litigation for firms in pharmaceutical industry did not); Gregg Jarrell and Sam Peltzman, “The Impact of Product Recalls on the Wealth of Sellers,” Journal of Political Economy 93 (1985): 512, 521, 532 (finding drug and auto recalls have negative stock price effect on stock price of competitors of producer of defective product); David Dranove and Chris Olsen, “The Economic Side Effects of Dangerous Drug Announcements,” Journal of Law and Economics 37 (1994): 323, 331 (significant negative stock price effect on competitors as well as manufacturer of recalled drugs in 1960s). But some researchers have not found statistically significant spillover effects from product recalls in contrast to

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Jarrell and Peltzman’s findings. See George E. Hoffer, Stephen W. Pruitt, and Robert J. Reilly, “The Impact of Product Recalls on the Wealth of Sellers: A Reexamination,” Journal of Political Economy 96 (1988): 663 (finding no price effect on firm subject to recall or on competitors for a subset of Jarrell and Peltzman’s automobile recalls they considered cleaner because recall overlaps were eliminated, as were government actions not deemed true recalls); and Brad M. Barber and Masako N. Darrough, “Product Reliability and Firm Value: The Experience of American and Japanese Automakers, 1973–1992,” Journal of Political Economy 104 (1996): 1084 (examining automobile recalls over longer period than Jarrell and Peltzman and including Japanese firms and finding negative price effect on firm subject to recall but no effect on competitors). Although Dranove and Olsen found significant negative stock price effects on competitors from drug recalls in the 1960s, they did not find a decline in competitors’ actual drug sales after the recalls, and examining only a subset of Jarrell and Peltzman’s drug recalls in the 1970s (seven of twenty-six), they found that the negative return to competitors was insignificant. That led them to conclude that the competitor stock price effect is due to investors’ anticipation that the cost of compliance with drug-testing regulation would increase in the 1960s and not a true spillover effect. 59. For some disclosures creating negative externalities for competitors, such as announcement of a successful patent, the impact of the disclosure is arguably a timing effect—the information concerning the patent will eventually be revealed, and competitors’ stock prices will decline at that later point in time. Critics of regulatory competition such as Fox could contend that such disclosures are not evidence at odds with the position that interfirm externalities are always positive because they depend on the act and not the fact of the disclosure. That is not the case, however, for the proposed plant expansion example because if the disclosure is made to deter otherwise profitable entry by competitors, then in the absence of the disclosure competitors would enter, and that conduct would alter the profitability of both the nondisclosing firm’s planned expansion and the competitors’ investments. Hence, the cash flow effects upon disclosure would differ from those occurring in the absence of the disclosure. But even when the negative impact of the disclosure is one of timing—the impact on rival’s prices comes from the act, rather than the fact, of disclosure’s hastening what is an inevitable decline in the competitors’ cash flow—pointing out the

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distinction between the act and fact of disclosure is not sufficient to resuscitate the position of critics such as Fox on the unidirectional price effect of interfirm externalities, because in competitive environments timing is everything. See, for example, Robert K. Elliott and Peter D. Jacobson, “Costs and Benefits of Business Information Disclosure,” Accounting Horizons 8 (1994): 80 (“The key factor in determining whether information . . . creates competitive disadvantage is timing. Products in development eventually come to market. Strategies become obvious from actions, and information about them can then no longer lead to competitive disadvantage. At some age disclosure simply loses its capacity to create competitive disadvantage. A given category of disclosure can be competitively disadvantageous or competitively meaningless depending on when the disclosure is made.”). 60. See, for example, B. Curtis Eaton and Richard G. Lipsey, “Capital, Commitment, and Entry Equilibrium,” Bell Journal of Economics 12 (1981): 593. For an excellent discussion of how firms can exploit the disclosure rules under the federal securities laws to gain strategic advantages over competitors, see Marcel Kahan, “Games, Lies, and Securities Fraud,” New York University Law Review 67 (1992): 750, 780–82. 61. See Admati and Pfleiderer, “Forcing Firms to Talk.” In contrast to Dye, they model disclosure of information creating financial externalities. Because a model of real externalities is more complicated, as Dye’s work shows, Admati and Pfleiderer’s results would not be more favorable to mandatory disclosure were they to model real, rather than financial, externalities. 62. Ibid., 505–9. 63. Ibid, 485 n. 9. 64. In addition, of the 200 largest defined benefit pension plans, 62 percent use indexation. E. Philip Davis and Benn Steil, Institutional Investors (Cambridge: MIT Press, 2001), 134. More generally, 35 percent of equity assets, accounting for 22 percent of total portfolios, are indexed. Ibid. 65. Not all investors need to hold shares in all firms, nor in the same proportions as other investors, for investors to internalize interfirm externalities in their choice of a disclosure regime. Under regulatory competition, the disclosure regime will be selected by the marginal investor. Because the majority of investors in equity are diversified institutions, institutional investors have the highest probability of being the marginal investor whose disclosure preference will dictate the choice of securities regime. In addition, evidence exists that institutional investors, in fact, consider

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the impact of their actions regarding one firm on other firms in their portfolio. Some commentators have contended that the shareholder proposals offered by activist institutions to reform corporate governance are intended to have, and do have, spillover effects to boost the performance of the stock market overall and not simply the specific firms that are the targets of a proposal, because the proposal proponents are indexed. See, for example, Diane Del Guercio and Jennifer Hawkins, “The Motivation and Impact of Pension Fund Activism,” Journal of Financial Economics 52 (1999): 293, 300. They provide as evidence of an externality reports that the California Public Employees Retirement System is contacted by nontargeted firms’ managers to stay off their target list. Those anecdotes of spillover effects in the shareholder proposal context indicate that institutional investors consider the impact of their actions on more than one firm, which is all that is necessary for the point that the incentives of institutional investors differ from issuers regarding the content of a securities regime to be correct and to undermine the claim of proponents of the interfirm externalities rationale for securities regulation that a single regulator is necessary to fulfill that objective. 66. See, for example, Russell Hardin, Collective Action (Baltimore: Johns Hopkins University Press, 1982), 82–83. The behavioral pattern is termed hysteresis; it is similar to the economic concept of risk aversion, with diminishing marginal utility of income, in which an individual values a one dollar loss greater than a one dollar gain. 67. Regulation S-K, item 101, 17 C.F.R. § 229.101(c)(ii) (providing that an issuer is not required to disclose narrative information concerning new business lines and products “the disclosure of which would affect adversely the registrant’s competitive position”). 68. Securities and Exchange Commission, “Disclosure of Accounting Policies for Derivative Financial Instruments and Derivative Commodity Instruments and Disclosure of Quantitative and Qualitative Information about Market Risk Inherent in Derivative Financial Instruments, Other Financial Instruments, and Derivative Commodity Instruments,” Federal Register 62 (February 10, 1997): 6044, 6055. 69. “Instructions for Confidential Treatment Requests,” Form 13F (Information Required of Institutional Investment Managers Pursuant to Section 13 (f) of the Securities Exchange Act of 1934 and Rules Thereunder), 17 C.F.R. 240.

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70. See SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), certiorari denied, 394 U.S. 976 (1969) (disclose or abstain rule for insider trading in context of discovery of major copper strike). 71. See Basic, Inc. v. Levinson, 485 U.S. 224 (1988) (whether company must disclose preliminary merger negotiations depends on particular facts of case). 72. See Fox, “Retaining Mandatory Securities Disclosure,” 1353. 73. For a set of examples from SEC filings demonstrating that point, see Romano, “Need for Competition in International Securities Regulation.” 74. For an example involving disclosure of liquidity constraints, see ibid. 75. See, for example, Su Han Chan, John D. Martin, and John W. Kensinger, “Corporate Research and Development Expenditures and Share Value,” Journal of Financial Economics 26 (1990): 255; John J. McConnell and Chris J. Muscarella, “Capital Expenditure Decisions and Market Value of the Firm,” Journal of Financial Economics 14 (1985): 399; and Office of Chief Economist, U.S. Securities and Exchange Commission, Institutional Ownership, Tender Offers, and Long-Term Investments (Washington, D.C.: Securities and Exchange Commission, 1985). 76. See Elliott and Jacobson, “Costs and Benefits of Business Information Disclosure.” 77. The disclosure mandated by the SEC under the 1934 act—gross or net sales (revenue figures)—was directed at assisting investors’ valuations of firms and did not reveal marginal cost data, information from which competitors could ascertain the discloser’s profitability. See Kaplan and Reaugh, “Accounting, Reports to Stockholders, and the SEC,” 948. 78. Financial Accounting Standards Board, Statement of Financial Accounting Standards Statement No. 131: Disclosures about Segments of an Enterprise and Related Information (issued June 1997). In contrast to the SEC’s categorical segment reporting requirements, which the prior FASB standard had followed, the new standard requires firms to report segment information the way they internally account for it. The change was promoted by financial analysts, who found the prior reporting inadequate because the reported segment data were typically unrelated to management’s discussion of business operations, which reflected their internal data. 79. Kaplan and Reaugh, “Accounting, Reports to Stockholders, and the SEC,” 946–47.

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80. Ibid., 947. 81. Edmund W. Kitch, “The Theory and Practice of Securities Disclosure,” Brooklyn Law Review 61 (1995): 763, 858. Economists and accountants have modeled the segment disclosure choice as a strategic game in which the disclosers use the information to disadvantage competitors, and a study testing such models found, consistent with Kitch’s hypothesis, that the choice to report a segment separately depends on the competitiveness of the industry and the variation in the firm’s earnings persistence (profitability) in that sector, such that firms are less likely to disclose segments separately when they are consistently earning abnormal profits. See Rachel M. Hayes and Russell Lundholm, “Segment Reporting to the Capital Market in the Presence of a Competitor,” Journal of Accounting Research 34 (1996): 261, 264 (one model of the strategic disclosure choice and discussion of findings of unpublished empirical study testing the strategic choice models). 82. Kitch, “Theory and Practice of Securities Disclosure,” 874. 83. Michael Ettredge, Soo Young Kwon, and David Smith, “The Effect of SFAS No. 131 on Numbers of Reported Business Segments,” University of Kansas, 2000, 22. See also Don Herrmann and Wayne B. Thomas, “An Analysis of Segment Disclosures under SFAS No. 131 and SFAS No. 14,” Accounting Horizons 14 (2000): 287 (while two-thirds of sample firms changed how they reported segments, the number of segments was not significantly different under the new standard). 84. Ettredge, Kwon, and Smith, “Effect of SFAS No. 131,” 20. 85. See Ajinkya, “Empirical Evaluation of Line-of-Business Reporting,” 357–59 (no effect on returns, increased consensus in probability assessments); Collins and Simonds, “SEC Line-of-Business Disclosure and Market Risk Adjustments,” 372–73, 378–80 (change in market risk); Horwitz and Kolodny, “Line of Business Reporting and Security Prices” 239, 241–42, 246 (no effect on market risk or on returns); Mohr, “The Segmental Reporting Issue: A Review of Empirical Research,” 45–52, 56–62 (literature review summarizing general results of no effect on returns, some improvements in analyst forecasts and increased consensus, and mixed evidence on whether market risk shifted). 86. Fox, “Retaining Mandatory Securities Disclosure,” 1355. 87. See Seligman, Transformation of Wall Street, 21. 88. See, for example, Mark A. Sargent, “A Future for Blue Sky Law,” University of Cincinnati Law Review 62 (1993): 471, 504–5 (coordination on interstate fraud); John C. Coffee, Jr., “Brave New World?: The Impact(s) of the Internet on

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Modern Securities Regulation,” Business Lawyer 52 (1997): 1195, 1231–32 (Internet offering coordination). 89. See John Reed Stark, “EnforceNet Redux: A Retrospective of the SEC’s Internet Program Four Years after Its Genesis,” Business Lawyer 57 (2001): 105, 114–15, 119–20. 90. See chapter 1, note 4. 91. See Easterbrook and Fischel, Economic Structure of Corporate Law, 277. 92. See Seligman, Transformation of Wall Street, 34–35. 93. See Benston, “Required Disclosure,” 135. 94. See Harold Bierman, Jr., The Great Myths of 1929 and the Lessons to Be Learned (Westport, Conn.: Greenwood Press, 1991), 133–45. For data suggesting that rampant fraud is also not an explanation for the adoption of blue sky laws, see Paul G. Mahoney, “The Origins of the Blue Sky Laws: A Test of Competing Hypotheses,” University of Virginia School of Law, Law and Economics Research Papers working paper no. 01-11, 2001 (finding that proxies for the level of fraud are insignificant in explaining the adoption of blue sky laws). 95. See Paul G. Mahoney, “The Stock Pools and the Securities Exchange Act,” Journal of Financial Economics 51 (1999): 343. 96. To the extent that there might be segregated investor markets for certain small stocks, individual investors will be protected by a disclosure requirement regarding the issuer’s domicile’s regime, as discussed in chapter 4. 97. The best evidence that institutional investors do not trade on private information is their inability to outperform the stock market. See, for example, Ross, Westerfield, and Jaffe, Corporate Finance, 353–54. 98. See, for example, Trevino, “Access to U.S. Capital Markets for Foreign Issuers,” 195. 99. See Jackson and Pan, “Regulatory Competition in International Securities Markets,” 653. 100. See, for example, Robert E. Chatfield and R. Charles Moyer, “‘Putting’ Away Bond Risk: An Empirical Examination of the Value of the Put Option on Bonds,” Financial Management 15 (Summer 1986): 26, 31–32; Leland Crabbe, “Event Risk: An Analysis of Losses to Bondholders and ‘Super Poison Put’ Bond Covenants,” Journal of Finance 46 (1991): 689, 690; Richard J. Kish and Miles Livingston, “Estimating the Value of Call Options on Corporate Bonds,” Journal of Applied Corporate Finance 6 (Fall 1993): 95, 97.

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101. See, for example, Roberta Romano, “Law as a Product: Some Pieces of the Incorporation Puzzle,” Journal of Law, Economics, and Organization 1 (1985): 271, and other studies discussed in chapter 3. 102. Firms that go public move in overwhelming numbers to Delaware before the stock issuance, and surveyed firms indicate that the move was suggested by outside counsel and, to a lesser extent, by investment bankers. See Romano, “Law as a Product,” 250, 274; Robert Daines, “Does Delaware Law Improve Firm Value?” Journal of Financial Economics 62 (2001): 525, 539. In discussing the question whether domicile choice was of concern to a venture capital–supported firm about to go public, participants from the venture capital industry at the University of Pennsylvania Law and Economics Institute Roundtable on May 12, 2000, indicated quite clearly that it was desirable for the company to be incorporated in Delaware for the offering. 103. See, for example, Luigi Zingales, “The Value of the Voting Right: A Study of the Milan Stock Exchange Experience,” Review of Financial Studies 7 (1994): 125 (comparing significant differences in premiums for voting shares across nations); Rafael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, “Legal Determinants of External Finance,” Journal of Finance 52 (1997): 1131 (across forty-nine countries, firms in nations with greater shareholder protections have better access to external finance, that is, capital markets are larger and deeper). 104. See, for example, Edward Kane, “De Jure Interstate Banking: Why Only Now?” Journal of Money, Credit, and Banking 28 (1996): 141. 105. See Susan M. Phillips and J. Richard Zecher, The SEC and the Public Interest (Cambridge: MIT Press, 1981), 72, 88–89. 106. For a technical discussion of the theory of revealed preference, see Marcel K. Richter, “Revealed Preference Theory,” in John Eatwell, Murray Milgate, and Peter Newman, eds., The New Palgrave: A Dictionary of Economics, vol. 4 (New York: Stockton Press, 1987), 167. 107. For the classic theoretical contribution on regulatory behavior that makes such an assumption, see William A. Niskanen, Jr., Bureaucracy and Representative Government (Chicago: Aldine Publishing Co., 1971), 38–41. 108. Susan Rose-Ackerman has developed a model in which local governments may not innovate because the innovator cannot capture the benefits of the innovation as other governments can copy it, and risk-averse politicians, to ensure

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their reelection by risk-averse voters, do not take on the risk of innovation. Susan Rose-Ackerman, “Risk Taking and Reelection: Does Federalism Promote Innovation?” Journal of Legal Studies 9 (1980): 593. While one condition of the model that decreases politicians’ incentives to innovate—restricted mobility of voters—is not present in charter competition and would not be present in securities regulation competition as corporations are far more mobile than voters because a domicile change entails solely a paper filing and no physical relocation, even if the model was fully applicable, Rose-Ackerman does not maintain that a single government would innovate more than multiple governments. Rather, she suggests that a national government could adopt programs to encourage innovation by local governments (such as through subsidies to innovators) while noting that the same political incentives dulling risk-taking of local officials will be present at the national government level, as the same citizens elect both sets of officials. Ibid., 615–16. 109. For instance, much of the extraordinary growth in financial derivatives can be attributed to the competitive regulatory regime. See, for example, Edward Kane, “Regulatory Structure in Futures Markets: Jurisdictional Competition between the SEC, the CFTC, and Other Agencies,” Journal of Futures Markets 4 (1984): 367, 380; Merton H. Miller, Merton Miller on Derivatives (New York: John Wiley & Sons, 1997), 52–53; Roberta Romano, “The Political Dynamics of Derivative Securities Regulation,” Yale Journal on Regulation 14 (1997): 279, 370, 382–83. 110. See, for example, Paul H. Kupiec and A. Patricia White, “Regulatory Competition and the Efficiency of Alternative Derivative Product Margining Systems,” Federal Reserve working paper, June 11, 1996 (describing impact of regulatory and market competition on development of optimal margining system for options). 111. In the competition for corporate charters among U.S. states, the leading incorporation state, Delaware, engages in significant and continual legal innovation. See, for example, Romano, “Law as a Product,” 240. 112. Romano, Genius of American Corporate Law, 97. For a detailed discussion of that trend and a proposal advocating that the SEC use its exemptive power to make the disclosure regime for new domestic issues optional, see Alan R. Palmiter, “Toward Disclosure Choice in Securities Offerings,” Columbia Business Law Review 1999 (1999): 1. Palmiter advocates an SEC exemptive approach

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because he does not believe that states will offer effective disclosure regimes, given past experience with state securities regulation and corporate law’s use of ex post liability for fiduciary duty violations rather than ex ante disclosure requirements. Ibid., 107. Because prior experience with state securities regimes did not occur under a competitive regime owing to a non-domicile-based choice-of-law rule, one has no reason to assume, as does Palmiter, that the states would be incompetent in competing for securities registrations. In addition, it is difficult to draw conclusions from corporate law’s emphasis on ex post liability over ex ante disclosure because the mandatory federal disclosure regime essentially preempted state action on that front. Of course, competitive federalism does not guarantee any state’s regulatory success: if states are ineffectual competitors compared with the SEC, then federal registrations will predominate. 113. For an analysis favoring regulatory competition because of firms’ need for diversity in regimes, see Stephen J. Choi and Andrew T. Guzman, “Portable Reciprocity: Rethinking the International Reach of Securities Regulation,” Southern California Law Review 81 (1998): 903. 114. Lucian Bebchuk suggests that there must be a single federal regulator to have mandatory rules. See Lucian Arye Bebchuk, “Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law,” Harvard Law Review 105 (1992): 1435. In fact, however, there are mandatory rules in corporation codes that are subject to state competition, such as the liability of directors and officers for breach of the duty of loyalty. But as I have maintained in greater detail elsewhere, those rules are only mandatory in the sense that if investors did not desire the presence of such rules, they would not be in the codes, that is, they are nonbinding constraints on behavior. See Roberta Romano, “Answering the Wrong Question: The Tenuous Case for Mandatory Corporate Laws,” Columbia Law Review 89 (1989): 1599, 1601. 115. For the development of such an argument in the private (corporate and commercial) law context, see Uriel Procaccia and Uzi Segal, “Thou Shalt Not Sow Thy Vineyard with Divers Seeds? The Case against the Harmonization of Private Law,” Hebrew University, 2000. 116. See, for example, Carney, “The Production of Corporate Law,” 729–34; and Romano, Genius of American Corporate Law, 47. 117. See, for example, Palmiter, “Toward Disclosure Choice in Securities Offerings,” 91, 106–7 (advocating issuer choice only for new offerings). Although

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Merritt Fox is not a proponent of issuer choice, he has expressed a similar concern. See Fox, “Retaining Mandatory Securities Disclosure,” 1352 (investors in secondary markets have “tenuous” influence over management because they are overwhelmed with “vast information asymmetries” and “collective action problems”). 118. See Venky Nagar, Dhananjay Nanda, and Peter Wysocki, “Compensation Policy and Discretionary Disclosure,” University of Michigan Business School, 2000, 20–21, 23–24 (frequency of voluntary earnings forecasts and analyst ratings of disclosure quality, controlling for other determinants of disclosure, are significantly positively correlated with proportion of CEO compensation dependent upon stock prices and concluding that this evidences optimal contracting between shareholders and managers). 119. Alan Palmiter suggests that the data indicating disclosure increases in conjunction with new issues may imply that the incentive for managers to disclose information in secondary markets is inadequate. Palmiter, “Toward Disclosure Choice in Securities Offerings,” 107. That is an improper inference to draw, as the argument in the text regarding managerial incentives in secondary markets should make plain. In addition, one study finds that increased voluntary disclosure comes with a cost, a change in ownership pool (attraction of institutional investors with a high propensity to trade), followed by an increase in volatility, which is considered undesirable because higher volatility could increase the likelihood of a lawsuit, increase the firm’s perceived riskiness and hence its cost of capital, or make incentive compensation less effective. See Brian J. Bushee and Christopher F. Noe, “Unintended Consequences of Attracting Institutional Investors with Improved Disclosure,” Harvard Business School working paper no. 00-033, October 1999, 5. See also Botosan and Plumlee, “Disclosure Level and Expected Cost of Equity Capital” (finding, unexpectedly, that in a sample of large firms, in contrast to small firms, a higher analyst ranking on voluntary disclosure leads to a higher cost of capital and suggesting that Bushee and Noe’s finding regarding institutional investors and volatility explains that result). That line of research suggests that it could be cost-effective to raise disclosure levels only when seeking new capital. 120. Christine A. Botosan and Mary S. Harris, “Motivations for a Change in Disclosure Frequency and Its Consequences: An Examination of Voluntary Quarterly Segment Disclosures,” Journal of Accounting Research 38 (2000): 329, 349–50.

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121. See, for example, ibid. (once firms increased the frequency of segment reporting to a quarterly basis, when only annual reporting was mandated, they continued to do so over time and did not abandon the practice). 122. Institutional investors dominate IPO markets, as they do secondary trading. See, for example, Ekkehart Boehmer and Raymond P. H. Fishe, “Do Underwriters Encourage Stock Flipping? A New Explanation for the Underpricing of IPOs,” Securities and Exchange Commission, May 8, 2000, 28 (institutions received 76 percent of primary allocation in a sample of 110 IPOs from 1997 to 1998, compared with another study’s range of 65 percent to 70 percent). While investment banks often restrict IPO subscribers from flipping shares, they do not penalize institutional flippers, even though they can track who has flipped shares and could impose significant sanctions by not allocating subsequent IPO shares to a flipper. See ibid., 26; and Roben Farzad, “How the Street Rips Off Investors on Tempting IPOs: The Secret Penalty: Why You Will Never Beat the Big Boys on Wall Street,” National Post (Toronto ed.), December 9, 2000. 123. Boehmer and Fishe, “Do Underwriters Encourage Stock Flipping?” 124. Reena Aggarwal, “Allocation of Initial Public Offerings and Flipping Activity,” Georgetown University McDougal School of Business, June 2001. Institutions flip a larger proportion of their shares than individuals, but they do not do more flipping in weak (“cold”) than in hot initial public offerings—that is, when prices are soft or falling rather than rising. Ibid. 125. A special-purpose entity is an entity created for a limited purpose, with a limited life and limited activities, and designed to benefit a single company. If certain criteria are met, under U.S. accounting standards the special-purpose entity is treated as a separate entity from the company for whose benefit it was created. That means that its assets and liabilities are not consolidated with those of the company for whose benefit it was created, and revenues can be booked from transactions between the two. A special-purpose entity can be used to increase a company’s debt without the liability appearing on its balance sheet, and a sale to the entity of an asset that an independent third party would not purchase can inflate a company’s revenue. 126. For example, there was a blackout period against trades to accomplish administrative changes to the employee pension plan a few months before the bankruptcy, and the plan prohibited sales of stock received from companymatched contributions before the employee reached the age of fifty-five.

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Such restrictions, however, are quite common in corporate pension plans. Those particular restrictions were also not especially significant in accounting for Enron employees’ losses on their pensions. During the blackout period, only one Enron executive sold stock while the price of Enron stock fell from $15 to $10. Thus, most of the drop in stock price from Enron’s peak had occurred before the blackout period, and there was still a substantial distance to go before bankruptcy after the blackout ended. In addition, the matched stock subject to the restriction accounted for only 11 percent of the Enron stock held by employees in their pensions. Accordingly, the bulk of the pensions held in Enron stock was voluntarily selected by employees who were following an extremely risky strategy of not diversifying. As only 40 percent of Enron pensions were invested in its stock, a majority of the employees were not following such a risky strategy. For a discussion of those points, see the remarks of Richard Ippolito, former chief economist of the Pension Benefit Guaranty Corporation, at the Yale Law School Center for the Study of Corporate Law panel, “The Enron Situation: A View from the Professions” (February 15, 2002), available at www.yale.edu/law/ccl. 127. At the time this book went to press, only campaign finance reform had been enacted in response to the scandal. 128. See, for example, Jeffrey N. Gordon, “What Enron Means for the Management and Control of the Modern Business Corporation: Some Initial Reflections,” University of Chicago Law Review (forthcoming 2002); Donald C. Langevoort, “Taming the Animal Spirits of the Stock Markets: A Behavioral Approach to Securities Regulation,” Georgetown University Law Center, 2002, 23. 129. See, for example, Ross, Westerfield, and Jaffe, Corporate Finance, 323–24, 328–31, 341. 130. See ibid., 359–60; Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 6th ed. (New York: McGraw-Hill, 2000), 374; Ross Watts, “Does It Pay to Manipulate EPS?” in Joel M. Stern and Donald H. Chew, Jr., eds., The Revolution in Corporate Finance (Oxford: Basil Blackwell, 1986). 131. See, for example, Philip L. Zweig, “Learning Old Lessons from a New Scandal,” New York Times, February 2, 2002. 132. This is an issue that has been debated for quite some time, and the evidence is ambiguous regarding whether the provision of consulting services jeopardizes auditors’ independence. Andersen earned about as much from

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Enron on its auditing fees as on its consulting fees. But from the perspective of the accounting firm, although certainly not from its Houston branch, the revenue from the Enron account was extremely small (roughly $52 million according to Enron’s 2001 proxy statement) and certainly not of the magnitude to warrant engaging in conduct on that account to jeopardize the firm’s existence. 133. See, for instance, Judge Leo E. Strine, Jr., “Derivative Impact?: Some Early Reflections on the Corporation Law Implications of the Enron Debacle,” a paper presented at the University of Pennsylvania Corporate Law Roundtable, April 26, 2002. 134. For suggestions of alternative information that could be usefully reported, not all of which can be priced, for firms with substantial intangible assets, see, for example, Robert E. Litan and Peter J. Wallison, The GAAP Gap: Corporate Disclosure in the Age of the Internet (Washington, D.C.: AEI-Brookings Joint Center for Regulatory Studies, 2000). As they note, the FASB is aware of the problem, having produced a report (the “Jenkins Report”) on the use of business reporting, as opposed to financial reporting, for intangibles. Ibid., 37–38. 135. See ibid., 40 (noting that the SEC has not encouraged firms to release the relevant new types of information). 136. For a brief review of the agency’s position on earnings projections, see Roberta Romano, “Empowering Investors: A Market Approach to Securities Regulation,” Yale Law Journal 107 (1998): 2359, 2378–79. 137. In a few instances the FASB has moved away from historical cost to market value: in the accounting for traded financial instruments and in reconciliations regarding the replacement cost of assets. 138. This perception is noted, for example, in “Testimony of Robert E. Litan, Director of Economic Studies at the Brookings Institution, before the Senate Committee on Banking, Housing, and Urban Affairs,” March 14, 2002, n. 6, available in LEXIS, legis library, hearng file. 139. See “After Enron, What’s an Audit Committee to Do?” University of Chicago Magazine, April 2002, 8. 140. Some individuals question that distinction and assert that FASB standards are as principles-based as the IASB’s. See, for example, “Herz, FASB ChairmanDesignate, Supports ‘Principles-Based Standards’—With Qualifiers,” BNA Securities Regulation and Law Report, May 20, 2002, 813 (remarks of James Leisenring, a former FASB vice chairman and current IASB member).

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141. See, for example, “Reforms to Restore Confidence in Business,” Financial Times, February 19, 2002. 142. The choice of accounting standards is discussed further in chapter 5. For a proposal to permit firms to choose accounting standards from between the FASB and the IASB as a response to the Enron failure, see “Testimony of Robert E. Litan.” A more expanded case for permitting competition in accounting standards is Shyam Sunder, “Standards for Corporate Financial Reporting: Regulatory Competition within and across International Borders,” Yale School of Management, International Center for Finance working paper no. 00-75, November 2001. Another paper considering the issue is Lawrence J. White, “Globalized Securities Markets and Accounting: How Many Standards?” Stern School of Business, New York University, 2001. 143. For example, in the United States, regulatory competition over derivative securities has led to extensive product innovation and to innovation in institutional practices that have been to the benefit of investors in those markets. See Kane, “Regulatory Structure in Futures Markets: Jurisdictional Competition between the SEC, the CFTC, and Other Agencies” (discussing regulatory competition and product innovation); Kupiec and White, “Regulatory Competition and the Efficiency of Alternative Derivative Product Margining Systems” (describing the impact of regulatory and market competition on development of an optimal margining system for options). 144. For a review of this explanation, among others, of Enron’s collapse, see William W. Bratton, “Enron and the Dark Side of Shareholder Value,” Tulane Law Review (forthcoming 2002). The bank-run scenario was exacerbated for Enron because contingent liabilities from the special-purpose entities, when consolidated, led to a downgrade in its bond rating, which damaged its ability to sustain its trading operations as they depended on maintaining its credit-worthiness. Ibid. 145. See, for example, Rachel E. Silverman, “GE’s Annual Report Bulges with Data in Bid to Address Post-Enron Concerns,” Wall Street Journal, March 11, 2002. 146. See “Williams Shares Hit by the ‘Enron Effect,’” Los Angeles Times, January 30, 2002 (22 percent drop in stock price from disclosure of potential contingent liabilities from spinoff of related-party entity and delay in release of earnings report); Gretchen Morgenson, “Annual Reports: More Pages, but Better?” New York Times, March 17, 2002 (Williams Company’s annual report 1,234 pages long).

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147. See “Krispy Kreme Will Alter Accounting for Plant,” New York Times, February 13, 2002; Diana B. Henriques, “The Brick Stood Up Before. But Now?” New York Times, March 10, 2002. 148. “Enron Director to Leave Harvard Board,” New York Times, April 6, 2002 (noting three Enron outside directors’ resignations from other corporate and nonprofit boards). 149. The survey results are available on the Institute of Internal Auditors’ Web site, www.theiia.org. 150. See Raymond Hennessey and Janet Whitman, “After Enron, Companies Confront Dearth of Willing Board Members,” Wall Street Journal, May 8, 2002. 151. Jonathan M. Karpoff and John R. Lott, Jr., “The Reputational Penalty Firms Bear from Committing Criminal Fraud,” Journal of Law and Economics 36 (1993): 757; Jonathan M. Karpoff and John R. Lott, Jr., “On the Determinants and Importance of Punitive Damage Awards,” Journal of Law and Economics 42 (1999): 527. 152. Cindy R. Alexander, “On the Nature of the Reputational Penalty for Corporate Crime,” Journal of Law and Economics 42 (1999): 489. 153. Michael K. Block, “Optimal Penalties, Criminal Law, and the Control of Corporate Behavior,” Boston University Law Review 71 (1991): 395. Block also examined the stock price effects for certain civil fines—federal safety regulation violations by airlines—and found a significant negative price effect, of the same magnitude as that experienced by the firms charged with criminal fraud. That suggests that civil enforcement may be equally as effective in imposing reputational penalties on firms as is criminal enforcement. 154. A federal indictment for document destruction accelerated the desertion of clients and the departure of the firm’s foreign affiliates and some nonauditing businesses, but in all probability, the public revelation of the shredding of Enron documents was sufficient to destroy Andersen’s credibility as an auditor, so that it would have suffered the same fate even without the indictment. 155. See, for example, Mike McNamee, “FASB: Rewriting the Book on Bookkeeping,” Business Week, May 20, 2002, 123. Adoption of stricter requirements for the use of such entities to avoid consolidation is undoubtedly a wise policy. But it would be a mistake to focus only on that accounting rule as the cause of Enron’s collapse and thus as the sole object in need of reform. That would provide only a short-term fix for the deeper accounting problems that have

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been discussed: a management determined to accelerate revenue and hide losses would find another specific rule to bend, and the value of the growing number of firms with nonconventional assets would still not be usefully presented to investors. 156. Although the former chairman of the SEC, Arthur Levitt, believed it to be the case, the Independent Standards Board—created in 1997 during his chairmanship by an agreement with the SEC and the American Institute for Certified Public Accountants for the purpose of researching and developing standards for auditor independence—completed its task in a set of recommendations that did not include prohibition or separation of auditing and nonauditing services. The board disbanded in 2001 after the SEC adopted the recommendations in its November 2000 independent auditor rules that were directed at the composition of audit committees of listed companies and disclosure of auditor compensation for both types of services. See, for example, “Press Release: Independent Standards Board to Cease Operations” (2001), available at www.cpaindependence.org.

Chapter 3: State Competition for Corporate Charters 1. See, for example, Joel P. Trachtman, “Regulatory Competition and Regulatory Jurisdiction in International Securities Regulation,” in Daniel C. Esty and Damien Geradin, eds., Regulatory Competition and Economic Integration: Comparative Perspectives (New York: Oxford University Press, 2001) (“under [competition] some state, such as the Cayman Islands or Mongolia, would move to the reductio ad minimum: imposing no substantive obligations”); Joel Seligman, The Transformation of Wall Street (Boston: Northeastern University Press, 1995), 53–54 (asserting there is a need for mandatory national securities laws “because of the history of state corporate law ‘chartermongering’”). James D. Cox has maintained that under competition managers will choose inadequate disclosure regimes, which is essentially a “race-to-the-bottom” argument, although he professes not to hold the view that competition necessarily results in such a race. See James D. Cox, “Regulatory Duopoly in U.S. Securities Markets,” Columbia Law Review 99 (1999): 1200, 1201, 1232–33, 1236–37 (“though competition necessarily suggests that there is a race, it need not be a race ‘to the bottom’”; “An issuer’s preference for one regime over another may be

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due to some arcane lax disclosure requirement which is especially attractive, even though overall the chosen disclosure regime is otherwise understood to have demanding requirements. Thus, there is reason to doubt that conditions are ripe for regulatory competition with respect to competing disclosure policies”; “Correlatively, there is every reason to believe that some managers will act opportunistically with financial reporting practices when such practices permit them to do so. . . . In general, managers prefer disclosure standards that better portray their stewardship. Therefore, to the extent that there are differences in measurement and reporting between [accounting standards], managers will not be blind to a disclosure regime’s impact on their utility function.”). Cox’s critique depends on the assumption that investors will not appropriately discount securities registered under manager-favoring disclosure regimes (see ibid., 1233–36), an outcome that, as discussed in the text, is not probable. 2. For a review of the technique, see Stephen J. Brown and Jerold B. Warner, “Using Daily Stock Returns: The Case of Event Studies,” Journal of Financial Economics 14 (1985): 3. The Benston and Stigler studies of the federal securities laws were prototypes of event study research, which was honed in the 1980s as good stock price data became available. When the date on which the information is released is known and the sample size is large, the methodology is well specified to identify abnormal returns of even a few percentage points. For example, the power of the statistical test for a sample of 100 firms to identify an abnormal return of 1 percent or higher is 100 percent; for 50 firms, the power of the test for a 1 percent abnormal return is 94 percent, and for a 2 percent abnormal return it is 100 percent. A. Craig MacKinlay, “Event Studies in Economics and Finance,” Journal of Economic Literature 35 (1997): 13, 29. 3. Michael Bradley and Cindy A. Schipani, “The Relevance of the Duty of Care Standard in Corporate Governance,” Iowa Law Review 75 (1989): 1; Peter Dodd and Richard Leftwich, “The Market for Corporate Charters: ‘Unhealthy Competition’ vs. Federal Regulation,” Journal of Business 53 (1980): 259; Randall A. Heron and Wilbur G. Lewellen, “An Empirical Analysis of the Reincorporation Decision,” Journal of Financial and Quantitative Analysis 33 (1998): 549; Allen Hyman, “The Delaware Controversy—The Legal Debate,” Journal of Corporate Law 4 (1979): 368; Jeffry Netter and Annette Poulsen, “State Corporation Laws and Shareholders: The Recent Experience,” Financial Management 18 (1989): 29; Pamela Peterson, “Reincorporation Motives and Shareholder Wealth,” Financial

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Review 23 (1988): 151; Roberta Romano, “Law as a Product: Some Pieces of the Incorporation Puzzle,” Journal of Law, Economics, and Organization 1 (1985): 225, 235–41; Jianghong Wang, “Performance of Reincorporated Firms,” Yale School of Management, November 1995. The event dates used in those studies are the date of the proxy statement, filed with the SEC and sent to the shareholders, that notices the meeting at which the reincorporation is being proposed for a vote, with additional tests run using the later date of the actual shareholders’ meeting. In a stock price study, it is desirable to identify the first public announcement date of the event under study—here the reincorporation—to determine when investors would have first learned of the proposal, because in an efficient market, the effect of new information is immediately impounded into the price. The statistical tests continue to be well specified when the announcement date is uncertain and an interval is used instead of one date. See Brown and Warner, “Using Daily Stock Returns,” 14–15. 4. Bradley and Schipani, “The Relevance of the Duty of Care Standard in Corporate Governance,” 66–67 (significant positive returns on event date and approximately one month before); Romano, “Law as a Product,” 270–71 (significant positive returns at three-day, one-week, and one-month intervals before event); Wang, “Performance of Reincorporated Firms,” 14–18, 21 (significant positive returns for full sample over three-day event interval; significant positive returns for Delaware firms over forty days before event, positive returns over three-day event interval significant only at 10 percent but significant at 5 percent if shareholder meeting date used as event for three-day interval; returns to Delaware firms consistently higher than those to non-Delaware firms, which are negative throughout most of event interval); Hyman, “The Delaware Controversy,” 385 (significant positive returns four days before the event, by using difference-in-means test between price changes of reincorporating firms and the S&P index). 5. Heron and Lewellen, “An Empirical Analysis of the Reincorporation Decision,” 559 (table 6, clean sample of firms reincorporating to limit liability of directors). The abnormal returns for the full sample were statistically insignificantly negative. As discussed in the text, the Heron and Lewellen study found a statistically significant negative effect for a subsample of firms reincorporating for takeover defensive purposes at the time of the shareholders’ meeting but not at the proxy mailing date, ibid., 557–58. But as discussed below, good reason exists not to place much credence on that result as evidence that competition harms shareholders.

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6. Dodd and Leftwich, “The Market for Corporate Charters,” 272–75 (significant positive returns two years before event). 7. Netter and Poulsen, “State Corporation Laws and Shareholders,” 35–37 (positive returns one month around event that were significant at 10 percent level only); Peterson, “Reincorporation Motives and Shareholder Wealth,” 159 (return on day --1, day +3, and day +10 positively significant at 10 percent level for subsample of sixteen firms not reincorporating for takeover defense reasons; insignificant returns for full sample of thirty firms and fourteen-firm subsample reincorporating for takeover defense reasons). 8. See Lucian Bebchuk, Alma Cohen, and Allen Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” Harvard Law School, 2002, 16. My study, which found higher returns than the other studies, consisted of domicile switches in an earlier time period than the studies finding smaller abnormal returns. In the later period examined by the other reincorporation studies, Delaware law was arguably less distinctive compared with other states, as they began systematically to catch up with Delaware’s innovations, and that might reduce the abnormal returns from reincorporation: that is, the gains from a new legal regime should be less pronounced when the former state’s regime is not dramatically different. In addition, my sample contains many firms reincorporating for acquisitive purposes, which experienced large positive abnormal returns upon reincorporation, and it is possible that there are fewer reincorporations for such purposes in later years, although the differences in abnormal returns across the subsamples of reincorporations in my study are not significant. See Romano, “Law as a Product,” 272. 9. See Gregor Andrade, Mark Mitchell, and Erik Stafford, “New Evidence and Perspectives on Mergers,” Journal of Economic Perspectives 15 (2001): 103, 119. 10. See Jonathan M. Karpoff and Paul H. Malatesta, “The Wealth Effects of Second-Generation State Takeover Legislation,” Journal of Financial Economics 25 (1989): 291, 308. In a study of the 1990 Pennsylvania disgorgement statute, which is discussed later in this chapter, Karpoff and Malatesta report that Pennsylvania firms experienced a significant negative abnormal return of –1.4 percent on the first wire service story that legislation would be introduced. Jonathan M. Karpoff and Paul H. Malatesta, “State Takeover Legislation and Share Values: The Wealth Effects of Pennsylvania’s Act 36,” Journal of Corporate Finance 1

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(1995): 367, 374–75. But a majority of Pennsylvania firms opted out of the statute, and an event study of the opt-out decisions reports a significant positive abnormal return of .53 percent. See S. H. Szewczyk and G. P. Tsetsekos, “State Intervention in the Market for Corporate Control,” Journal of Finance 31 (1992): 3, 16. That result indicates that the net loss from the most restrictive state takeover statute is slightly lower than the gains from state competition reported in the reincorporation event studies. 11. See Lucian Arye Bebchuk and Allen Ferrell, “Federalism and Corporate Law: The Race to Protect Managers from Takeovers,” Columbia Law Review 99 (1999): 1168; Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 25–38. The import of takeover regulation for the efficacy of charter competition is discussed in a subsequent section of this chapter. 12. Delaware is the predominant choice of domicile of publicly traded corporations and particularly of reincorporating firms. For example, in my study of reincorporations between 1960 and 1983 of both NYSE and over-the-counter firms, over 80 percent of the reincorporations were in Delaware. Romano, “Law as a Product,” 244. 13. See Lucian Arye Bebchuk, “Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law,” Harvard Law Review 105 (1992): 1435, 1471–75. An alternative argument Bebchuk provides to explain the result—that shareholders voluntarily vote for moves to states with regimes favoring managers because the net effect of a move is an increase in share value—is discussed later in the text. Bebchuk uses the same assumptions noted in the text—investors are ignorant of the impact of the legal regime on their welfare or coerced by management’s bundling the reincorporation vote to “approve the entire package,” which “would not serve their interests standing alone”—in joint work to construct a formal model of his position against state competition, in which competition results in adoption of laws that favor managers over shareholders. See Oren Bar-Gill, Michal Barzuza, and Lucian A. Bebchuk, “A Model of State Competition in Corporate Law,” Harvard Law School, 2002, 14 (model assumes a positive probability that investors vote for a move to a domicile with a law favoring managers over shareholders). Other assumptions built into the model that produces a result that state law favors managers are that managers control the domicile decision, will only propose reincorporation into a state

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whose laws favor managers over shareholders, and can propose such moves without penalty. Given the assumptions, it is not surprising that such a model replicates William Cary’s characterization of state laws (see William Cary, “Federalism and Corporate Law: Reflections upon Delaware,” Yale Law Journal 83 (1974): 663), as it is a static model that takes as given Cary’s view in which there are no constraints on managers, such as would be imposed in a dynamic model of markets, which formed the basis of Ralph Winter’s critique of Cary’s position (see Ralph K. Winter, “State Law, Shareholder Protection, and the Theory of the Corporation,” Journal of Legal Studies 6 (1977): 251). Such constraints would include the regime preferences of new issuers—an important segment of the reincorporation market (see Romano, “Law as a Product,” 253, table 5 (close to one-third of reincorporations are IPOs))—and of nonpassive investors who can impose costs on managers who act against their interest. 14. See Romano, “Law as a Product,” 250. Lucian Bebchuk picked up on this analysis in my study and developed it into a mainstay of his criticism of state competition. See, for example, Bebchuk, “Federalism and the Corporation,” 1449. 15. See Katherine Schipper and Rex Thompson, “Evidence on the Capitalized Value of Mergers Activity for Acquiring Firms,” Journal of Financial Economics 11 (1983): 85. 16. See Romano, “Law as a Product,” 272 (analysis of variance test of cumulative residuals). Pamela Peterson also finds that the returns to firms reincorporating for antitakeover reasons are insignificant, while returns for firms reincorporating for other reasons are significantly positive at the 10 percent level on a few event days. Peterson, “Reincorporation Motives and Shareholder Wealth,” 159. She does not, however, test whether the returns across the different groups are statistically significantly different. Given the small sample size (thirty firms), the power of the test for the antitakeover reincorporations as well as the full sample is low. Peterson also does not indicate what announcement date she is using, which renders it difficult to assess the import of her results, although they are consistent with my study’s results. 17. To classify the reincorporations I used public data sources, including proxy statements and Moody’s and newspaper reports on firm’s activities before and after a reincorporation, in addition to survey responses to a questionnaire sent to reincorporating firms. See Romano, “Law as a Product,” 250. As a consequence, my classification of mergers and acquisitions reincorporations was

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based not only on statements at the time of the reincorporation but also on firms’ subsequent behavior—whether they entered into more than one acquisition within a few years of the move, information not available to investors at the time of the domicile change—and the classification is therefore imprecise. But that imprecision cuts against concern about confounding events. Unless the inference investors draw from a firm reincorporating for an unstated purpose is that it will be engaging in mergers and acquisitions in the future, then the positive price effect experienced on such firms’ domicile changes is attributable to the perceived value of the new regime (there is no specific confounding event at the event date). Bebchuk and his colleagues further question the result that the abnormal returns do not differ by reincorporation type by contending that there was noise in the data because some of the firms in the acquisition category were identified after the fact. See Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 22. It should be noted that such possible noise is absent for the firms in the other categories, however, as they were identified by the information available at the time of the move in the proxy materials. But that critique is beside the point for the interpretation of the difference-in-means test and its import for state competition. The abnormal return is a composite of the value of the transaction and of the regime of the new domicile. The issue at stake, which is evaluated by the difference-in-means test, is whether the predicted direction of the return differs across the two components, that is, whether an accompanying transaction is a wealth-increasing event but the new legal regime decreases wealth. There is no reason to believe that the value of the legal regime is negative for some firms and positive for others and that its value depends on the accompanying transaction, nor do Bebchuk and his colleagues make such a claim. Accordingly, if one set of transactions is predicted to have a negative impact and the other a positive impact, as, for example, Bebchuk and his colleagues suggest regarding restrictions on takeovers compared with engaging in acquisitions or reducing taxes, then it must follow that there be a significant difference in the abnormal returns across those types of reincorporations, because the expected signs differ for the confounding events in question while the sign of the impact of the legal regime will be the same (positive under the race-to-the-top thesis and negative under the raceto-the-bottom-thesis). Because that is not the case—the abnormal returns upon

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reincorporation for takeover defensive tactics are not significantly negative and different from the positive abnormal returns upon reincorporation for acquisitive or other purposes—and the direction of the effect is positive, the data clearly indicate that the impact of the legal regime must be positive. A final criticism of Bebchuk and his colleagues is that my sample may have included firms announcing an increase in dividends at the time of reincorporation, and that explains the abnormal positive returns and, more particularly, invalidates my test for differences across reincorporation types. See Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 22. It is possible, but unlikely, that the presence of dividend increases coincident with reincorporation explains my results, because the likelihood that most, or even many, reincorporations in my sample coincided with such an event is low. Heron and Lewellen, for instance, found that only 67 of 431 firms (16 percent) experienced either an acquisition or a dividend increase at the time of reincorporation, and I excluded from my study firms engaging in an acquisition at the time of reincorporation. Moreover, Bebchuk and his colleagues do not explain why they think the possible presence of firms with dividend increases would undermine the result of the statistical test for differences in abnormal returns across the classes of reincorporation. If dividend increases accompanied one type of reincorporation more than the others and the dividend increase was the cause of the sample abnormal returns, then the difference-in-means test should have been significant (the subset of firms with dividend increases should have higher abnormal returns than the other categories of firms). If, instead, firms with dividend increases are randomly distributed across reincorporation types, then that could obscure a difference in abnormal returns due to reincorporation type only if the positive impact of the dividend announcement exactly offset the negative returns in a class of reincorporations but was higher than the dividend announcement effect in a class of reincorporations generating positive returns, such that the two groups of reincorporations netted indistinguishable abnormal returns. 18. Lucian Bebchuk and his colleagues suggest an alternative but related explanation for positive abnormal returns upon reincorporation to the confounding events concern. They maintain that managers “time” the reincorporation vote to occur when “things are going better than average” and cite in support the three event studies that report positive abnormal returns two years or one month before the event date. Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor

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State Competition in Corporate Law?” 19. Thus, in their view, the positive abnormal return from something else happening at the firm before the reincorporation is announced masks an otherwise insignificant or negative impact of the domicile change. It is, however, difficult to maintain that management has engaged in “effective” timing of the reincorporation when the abnormal returns occur two years before the vote, which is the finding of the Dodd and Leftwich study that they cite in support for their timing hypothesis. They then note that two other studies (Bradley and Schipani’s and my study) reproduced Dodd and Leftwich’s finding, but that is technically imprecise: no other study cumulated returns over two years before the event. What they mean to say is that two other studies report abnormal returns both on the announcement date and cumulated over one month before that date (the Bradley and Schipani study) or one month centered on the event date—ten days before and ten after it (my study). But the findings of positive cumulative abnormal returns before the reincorporation announcement date are better explained by the well-known phenomenon of preannouncement leakage rather than by evidence of management’s timing a move to coincide with earlier abnormal earnings. That is so because corporate boards meet and approve reincorporation plans approximately one month before the proxy mailings for reincorporations, and the shell Delaware corporation into which the firm will reincorporate is incorporated even earlier still, while the proxy mailing is the event date used in the studies. See Romano, “Law as a Product,” 268. Unlike corporate acquisitions, reincorporation plans are not likely to be considered confidential events, subjected to serious policing to prevent information leakage of board decisions. And, of course, despite the highest level of efforts at maintaining secrecy, significant runups in stock prices precede acquisitive announcements. See, for example, Gregg Jarrell and Annette Poulsen, “Stock Trading Before the Announcement of Tender Offers: Insider Trading or Market Anticipation?” Journal of Law, Organization, and Economics 5 (1989): 225. 19. Heron and Lewellen, “An Empirical Analysis of the Reincorporation Decision,” 557–59. 20. In my study the cumulative abnormal returns around later dates were larger than those on earlier dates, but no sample’s returns changed from insignificance to significance with a change in event date. Romano, “Law as a Product,” 272. 21. See Stephen A. Ross, Randolph W. Westerfield, and Jeffrey Jaffe, Corporate Finance, 6th ed. (New York: Irwin McGraw-Hill, 2002), 341–54. It should be

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noted that the finding is at odds with Bebchuk and his colleagues’ “timing” explanation of the event study results, as the timing hypothesis predicts positive abnormal returns occurring before the earlier proxy mailing date, and Heron and Lewellen do not report any such results. One potential explanation of the different results in my and Heron and Lewellen’s studies is the different time periods of our samples. I do not, however, think that this explanation is correct. Heron and Lewellen’s sample overlaps with the Netter and Poulsen and the Wang studies, which report insignificantly positive price effects. Although Wang does not classify reincorporation types, Netter and Poulsen separately examine, as a proxy for defensive tactic reincorporations, a sample of California emigrations, which is a better indicator for a move based on a difference in takeover regime than the firm-level defenses in the Heron and Lewellen subsample because the latter defenses were valid in all states except California, which prohibited one of the defenses—staggered boards—during the Netter and Poulsen sample period and part of the Heron and Lewellen sample period. Netter and Poulsen report a positive stock price effect significant at 10 percent for those reincorporations, a result that is the opposite of Heron and Lewellen’s finding and similar to mine, while their sample period overlaps with that of Heron and Lewellen’s and not my sample. 22. See James A. Brickley, “Interpreting Common Stock Returns around Proxy Statement Disclosures and Annual Shareholder Meetings,” Journal of Financial and Quantitative Analysis 21 (1986): 343, 346–47. 23. Ibid., 347–48. Brickley’s data cover only part of Heron and Lewellen’s sample, so it is not apparent what pattern would be found throughout their sample period to try to salvage their results by attempting to adjust their average residuals by the average abnormal return Brickley reports, which was positive. Several anomalies in returns, for instance, have reversed over time, such as the small firm effect, which was positive in the early 1980s and negative in the late 1980s—a time period encompassed by the Heron and Lewellen sample. See, for example, Ibbotson Associates, Stocks, Bonds, Bills, and Inflation 2000 Yearbook (Chicago: Ibbotson Associates, 2000), 91. Moreover, Heron and Lewellen use a four-day interval for the proxy mailing date and a one-day interval for the meeting date. They provide no justification for that choice, and it raises a technical concern regarding whether the significance is due to genuinely abnormal performance or model misspecification. As James Brickley and his colleagues

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note, if, for example, “the market model does not hold,” and “if the true relation (whatever it is) between expected return and the market return is constant, the use of the standard market model will be expected to generate similar abnormal returns between any two arbitrary dates of approximately the same interval.” James A. Brickley, Sanjai Bhagat, and Ronald C. Lease, “The Impact of LongRange Managerial Compensation Plans on Shareholder Wealth,” Journal of Accounting and Economics 7 (1985): 115, 126. 24. Indeed, it is well known that managements consult proxy solicitation firms to determine the likely voting posture of their investors and do not put up proposals that have a substantial chance of being defeated. 25. For a study attempting to model such an expectation effect to determine abnormal performance around adoption of defensive charter amendments, see Sanjai Bhagat and Richard Jefferis, “Voting Power in the Proxy Process: The Case of Antitakeover Charter Amendments,” Journal of Financial Economics 30 (1991): 193. 26. Heron and Lewellen, “An Empirical Analysis of the Reincorporation Decision,” 554. 27. The only exception to that statement is firms emigrating from California, for which staggered boards were prohibited until 1989 (roughly two-thirds of their sample period), when California amended its corporation code to eliminate the mandatory application of cumulative voting and to permit staggered boards. See California Corporations Code §§ 301, 301.5 (Deering 2000) (providing legislative history, Amended Statutes (1989, chap. 876, §§ 1–2)). Heron and Lewellen do not indicate how many of their takeover defense firms were reincorporating from California. Delaware’s takeover statute could not have been an important motivation for reincorporation, as virtually all states had takeover statutes equal to or stricter than Delaware’s statute during the period of their study. See Roberta Romano, The Genius of American Corporate Law (Washington, D.C.: AEI Press, 1993), 59, 67. Moreover, Jarrell and Poulsen do not observe a negative price effect for California firms reincorporating in Delaware, as mentioned in note 21. 28. Heron and Lewellen do not report how many of the firms reincorporated to take advantage of a takeover statute, compared with firm-level defenses. Delaware did not have a takeover statute until February 1988, and over half of the reincorporations occurred before that date. But the Supreme Court upheld state takeover laws in 1987, the year with the bulk of reincorporations,

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and some firms may therefore have expected Delaware to pass some type of law. 29. See John C. Coates IV, “An Index of the Contestability of Corporate Control: Studying Variation in Legal Takeover Vulnerability,” Harvard Law School, 1999 (Delaware has lowest ranking in index based on statutory defaults with respect to ability to defend against hostile bids). For example, Heron and Lewellen refer to the adoption of fair price and supermajority charter amendments. See Heron and Lewellen, “An Empirical Analysis of the Reincorporation Decision,” 554. Such defenses are part of many states’ corporation codes but not Delaware’s. Heron and Lewellen state that for a subset of firms they used only those that gained additional defenses upon reincorporation by adding a charter amendment or poison pill or opting into a takeover statute (ibid., 558). But they do not identify all the defenses covered in that subsample, and therefore we do not know whether they should have checked for differences in the default rules in the original state code compared with Delaware’s that would necessitate a specific provision in a Delaware charter compared with the original charter. More important, they include in that subsample the adoption of a poison pill. Ibid., 558–59 (noting the returns are more negative for the subset of poison pill adoption firms in the subsample). That defense was available to managers in all states, without shareholder approval, and is therefore not a “gain” in takeover protection attributable to the new domicile’s regime, even though it is a “gain” at the time of the move. Hence, the subsample is not a clean test of the value of a change in legal regime. 30. For evidence that Delaware firms are more likely to be targets, see Robert Daines, “Does Delaware Law Improve Firm Value?” Journal of Financial Economics 62 (2001): 525. 31. See, for example, Diane Del Guercio and Jennifer Hawkins, “The Motivation and Impact of Pension Fund Activism,” Journal of Financial Economics 52 (1999): 293, 296–97. 32. See Stuart L. Gillan and Laura T. Starks, “Corporate Governance Proposals and Shareholder Activism: The Role of Institutional Investors,” Journal of Financial Economics 57 (2000): 275, 286. 33. The import of restrictions on takeovers for evaluating the efficacy of state competition, which is discussed later in this chapter, does not lead to a reassessment of the positive price effects upon reincorporation as indicating that charter competition benefits shareholders.

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34. One could further contend that the concern about confounding events in the context of a new business plan that motivates a domicile change depends on an incorrect premise regarding the relation between the two events—that they are independent and can differ in sign. Firms, in fact, change their domicile to reduce the cost of doing business and, in particular, when they anticipate engaging in new transactions for which the legal regime matters—that is, transactions whose value is significantly affected by corporate law rules, such as acquisitions. Romano, “Law as a Product,” 249–51. If the new domicile reduces the cost of undertaking the new business strategy that investors consider to be valueincreasing (which is the motivation for reincorporation), then the legal regime either improves the planned transaction’s favorable impact on future cash flows or is the reason for the transaction’s net positive effect. In either scenario, the price effect of the new business plan is intertwined with that of the legal regime (the reincorporation event) because the two actions are interdependent. The profitability of the new business plan, in other words, depends on its being conducted under the rules of the new legal domicile. And the direction of both events’ effect on the firm’s stock price is the same—positive. Confounding events are a problem for an event study only if the signs of the events are expected to differ or if the researcher needs to measure precisely the magnitude of one event’s effect, neither of which concern is relevant in this case for determining whether state competition benefits shareholders. 35. See Bebchuk, “Federalism and the Corporation,” 1449–50. Bebchuk also raises this contention as a theoretical claim, as an additional explanation for why shareholders would approve a domicile change—that it increases stock value “overall” because the new state (Delaware) has some superior statutes to the original state as well as some statutes that redistribute wealth from shareholders to managers. Ibid., 1471–72. The two other explanations, mentioned earlier, that Bebchuk offers for why shareholders vote for a reincorporation—ignorance or coercion—are offered as explanations for why they would vote for a move that decreased share value; that is, he does not associate those possibilities with the production of a positive price effect. Ibid., 1473–74. The theoretical version of this “net positive” objection to state competition is as unpersuasive as the empirically based one discussed in the text: the reason for advocating competitive federalism is not that it produces a perfect legal regime. No such regime exists. Rather, it is that, in a policy area characterized by uncertainty and a

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continually changing environment, sophisticated market participants are more likely than government bureaucrats to know what rules are appropriate, and competing regulators are expected, on average, to produce more welfare-enhancing rules than a monopolist regulator, because they will be more responsive to market participants. Bebchuk’s theoretical argument serves to support, not to refute, that point: if the most successful competitor, Delaware, has laws superior to those of other states such that the mix of laws it offers has a net positive impact on firm value, then competition benefits shareholders—it permits them to find a state under whose regime they realize higher share value—exactly as we hope and expect it to do. State competition, under that strand of Bebchuk’s many arguments against it, has in fact, improved shareholder welfare, even though he might be able to hypothesize a corporation code that he believed was superior to that of any state. 36. See Bar-Gill, Barzuza, and Bebchuk, “A Model of State Competition in Corporate Law.” Whether potential network effects affect the efficacy of corporate law rules is discussed in another section of this chapter. 37. For instance, in my study firms reincorporating to reduce taxes, which were firms not moving to Delaware, experienced significant positive returns, as well as firms reincorporating to engage in mergers and acquisitions, most, but not all, of which were firms moving to Delaware. Romano, “Law as a Product,” 271. I also found some evidence that the explanation for those returns could be related to the quality of the legal regime. First, states that were higher on my index of state law responsiveness were more likely to be destination states, independent of Delaware, than states with lower rankings, and when states modified their codes to imitate Delaware’s, the rate of migration was reduced. Ibid., 246. Second, firms reincorporating in states other than Delaware were less likely to perceive a difference in the quality of the legal regime of the old and new domicile, or to consider the legal regime an important factor for the move, than firms reincorporating in Delaware. Ibid., 258. But of the firms reincorporating outside Delaware, those moving to states ranking higher on my measure of responsiveness were more likely to perceive a difference in legal regime across the two domiciles and to indicate that the legal regime was an important reason for the move. Ibid. 260. Finally, examining the domicile of the top-200 Fortune industrials, I found that 79 percent of those firms not in Delaware were incorporated in the fifteen most responsive states on my index, whereas of those incorporated in Delaware, only 47 percent had previously been domiciled in one of the fifteen most responsive states. Ibid., 261.

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38. See Gillan and Starks, “Corporate Governance Proposals and Shareholder Activism,” 286. 39. Of the other eight proposing reincorporation out of states other than Delaware, two were proposals to reincorporate specifically in Delaware from Pennsylvania, a state with a particularly harsh takeover statute. 40. An alternative explanation of the absence of such proposals that equally undercuts Bebchuk and his colleagues’ hypothesis is that investors demand that their managers, or managers who are sensitive to investor interests voluntarily, transact around Delaware precedents to undo their adverse impact on shareholder wealth. 41. Barry Baysinger and Henry N. Butler, “The Role of Corporate Law in the Theory of the Firm,” Journal of Law and Economics 28 (1985): 179 (comparing performance of firms reincorporating in Delaware with that of firms incorporated in states deemed to have stricter codes than Delaware); Roberta Romano, “Corporate Law and Corporate Governance,” Industrial and Corporate Change 5 (1996): 277 (examining change in performance of reincorporating firms over three years following domicile switch, adjusted for industry average performance and also compared with a paired sample of nonreincorporating firms not incorporated in Delaware); and Wang, “Performance of Reincorporated Firms” (examining change in earnings before income and taxes adjusted for industry performance, before and after reincorporation, and comparing Delaware and non-Delaware reincorporations). There are far fewer performance studies than event studies for a reason. Economists consider stock price data more reliable than accounting data because investors are interested in future cash flows (that is what stock prices reflect), and accounting data not only measure past cash flows but also provide very imperfect measures of those flows. 42. Wang, however, finds that the change in earnings over the year after the domicile change is higher for the firms that reincorporated into Delaware, compared with the firms that reincorporated in other states. Wang, “Performance of Reincorporated Firms,” 23. That is a very interesting finding that is consistent with the event study data—investors anticipated the increased earnings—but it does not indicate whether the difference is due to Delaware or to the quality of the firms selecting Delaware. 43. Daines, “Does Delaware Law Improve Firm Value?” 44. Ibid., 530.

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45. The result of a higher value for Delaware firms holds up under a variety of robustness checks that Daines undertook, including tests controlling for a selection effect (that better performers choose Delaware domiciles). For a sense of the economic significance of his results, consider his 1996 finding that Delaware firms’ Tobin’s Q value is .07 higher than non-Delaware firms; that translates into a 5 percent higher market value for Delaware firms than non-Delaware firms. Ibid., 533. Daines offers one explanation of how Delaware corporate law could add value to firms—facilitation of takeover bids and sales of public firms by reducing acquisition costs. Ibid., 541. For evaluating the efficacy of state competition, ascertaining the precise reason for Daines’s result that Delaware’s legal regime enhances share value is not of strict importance; only determining whether it increases or decreases firm value is. But Daines’s thesis regarding facilitation of takeovers is consistent with the investor-disappointment interpretation of Heron and Lewellen’s finding concerning firms reincorporating for defensive tactics advanced earlier. Bebchuk and his colleagues assert that Daines’s finding is unrelated to Delaware law and instead indicates that better performing firms select Delaware as their domicile. Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 10. Although one can question whether Daines has sufficiently controlled for selection effects, that is not an adequate explanation of the data if, as Bebchuk and his colleagues also contend, Delaware law favors managers over shareholders. For then whatever it is that they claim makes those firms better performers should be negated by the firms’ domicile choice, and value should be transferred away from the shareholders to the managers over time. The Tobin Qs should have reversed over time and not continued to be higher over the ten years of Daines’s study, particularly for the mature firms in the sample that had been in Delaware for over fifteen years (since 1981). See Daines, “Does Delaware Law Improve Firm Value?” 550. That is what it means to characterize a legal regime as favoring managers over shareholders. It is of little import to state that a regime favors managers over shareholders if it has no actual or predicted adverse impact on firm value. Bebchuk, Cohen, and Ferrell also state that three unpublished studies report that they find no correlation between Tobin’s Q and Delaware domiciles in years occurring subsequent to Daines’s sample period or overlapping with the end of his sample years. Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 8–9. None of those studies controlled for

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the firm and industry characteristics for which Daines controls. That makes it difficult to ascertain whether they have properly identified the relation between domicile and Tobin’s Q in the late 1990s. But assuming those results hold up, the absence of a positive relation between a Delaware domicile and Tobin’s Q after 1995 could suggest either that other states’ laws had “caught up” to Delaware and thus reduced the differential value of a Delaware incorporation or that the decline in the takeover market over the period was reflected in firms’ Tobin Q values (recall that Daines’s explanation of his finding was Delaware firms’ higher probability of a takeover). It would also undermine Bebchuk, Cohen, and Ferrell’s criticism of Daines’s finding of a positive relation in earlier years as due to selection effects: they would have to explain why as of 1996 better managers ceased selecting Delaware as their domicile. 46. Cox, “Regulatory Duopoly,” 1233–36; Hal S. Scott, “Internationalization of Primary Public Securities Markets,” Law and Contemporary Problems 63 (2000): 71, 75. Scott has asserted that investors “sophisticated or otherwise” cannot know what information they are “missing” and thus cannot discount securities properly. That contention is plainly incorrect. First, investors know what fundamental financial information is and can generally tell whether a firm’s financial statements contain the information of importance to them. That is evidenced by the fact that firms respond to their demands to disclose information that is not required, as discussed earlier. Second, investors are able to compare the differences in disclosures required by competing regimes and will thus be able to discount the securities of issuers registered under regimes that require less disclosure where investors value the omitted information. The data, discussed in this section, on state competition and bond covenants provide compelling support for that proposition. Third, Scott does not offer any reason for why, in the case of what he has termed “missing” information—some item that no firm discloses so that no investor knows that the information is “missing”—a government agency would know what sophisticated investors do not know, that an important piece of information is missing, and would thereby mandate its disclosure so that the market could price it. Of course, when the ostensible missing disclosure concerns information about one firm that is disclosed by others, sophisticated investors and financial analysts will notice the omission and discount the stock and thereby treat silence adversely, a response that may prompt disclosure by the firm to reduce the discount.

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47. See, for example, Robert E. Chatfield and R. Charles Moyer, “‘Putting’ Away Bond Risk: An Empirical Examination of the Value of the Put Option on Bonds,” Financial Management 15 (Summer 1986): 26, 31–32; Leland Crabbe, “Event Risk: An Analysis of Losses to Bondholders and ‘Super Poison Put’ Bond Covenants,” Journal of Finance 46 (1991): 689, 690; Richard J. Kish and Miles Livingston, “Estimating the Value of Call Options on Corporate Bonds,” Journal of Applied Corporate Finance 6 (Fall 1993): 95, 97. 48. See, for example, Lucian Arye Bebchuk and Allen Ferrell, “A New Approach to Regulatory Competition and Takeover Law,” Virginia Law Review 87 (2001): 111, 138–39. 49. Ibid. 50. In fact, no evidence exists that the particular law that Bebchuk and Ferrell in “A New Approach to Regulatory Competition and Takeover Law” prefer to Delaware’s regime, the takeover code promulgated by the City of London’s Panel on Takeovers and Mergers, has made U.K. firms more valuable than Delaware firms. 51. In other words, while a social planner would set quality by the average consumer’s valuation because she looks at all consumers’ welfare, the monopolist, concerned with profits and not social surplus, sets quality by the marginal consumer’s valuation because the price increase for higher quality can be passed on to all inframarginal consumers. As the marginal consumer is not likely to be representative of the population, the monopolist’s product quality choice will differ from that of the social planner (that is, it will undersupply quality if the average valuation exceeds the marginal valuation). The bias in quality introduced by the monopolist can be identified only if output will be the same in both cases. That is generally not the case, because a monopolist tends to produce less output for a given quality. See Jean Tirole, The Theory of Industrial Organization (Cambridge: MIT Press, 1988), 100–102. 52. When the monopolist can produce only one product, because the monopolist cannot appropriate the net consumer surplus from introducing a new product design, there may be too few products under monopoly compared with the social optimum. When the monopolist can offer multiple products that are substitutes, it may introduce “too many” products compared with the social optimum because if it charges an above-marginal price for one good, it can create demand for a second good, which would not exist if the first good

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was competitively priced. See ibid., 104–5. The analysis concerning the monopolist’s choice for product diversity is substantially the same as that for product innovation. 53. See William P. Albrecht, Corinne Bronfman, and Harold C. Messenheimer, “Regulatory Regimes: The Interdependence of Rules and Regulatory Structure,” in Andrew W. Lo, ed., The Industrial Organization and Regulation of the Securities Industry (Chicago: University of Chicago Press, 1996), 9, 27. 54. See Romano, Genius of American Corporate Law, 45–48. 55. See, for example, Marcel Kahan and Ehud Kamar, “Price Discrimination in the Market for Corporate Law,” Cornell Law Review 86 (2001): 1205. 56. See, for example, Ehud Kamar, “A Regulatory Competition Theory of Indeterminacy in Corporate Law,” Columbia Law Review 98 (1998): 1908. Note that what distinguishes a network is increasing returns to scale that are a demandside effect (consumers—here, corporations—value the product more highly as the number of users increases) and not a supply-side effect, such as decreasing production costs. Delaware could be a monopolist in the latter case, but not because of network effects. For a similar claim—that states do not compete with Delaware for charters—that does not use network economics, see Mark J. Loewenstein, “Delaware as Demon: Twenty-five Years after Professor Cary’s Polemic,” University of Colorado Law Review 71 (2000): 497. James Cox does not question whether states compete for charters but, instead, contends that the states did not compete with the SEC over securities disclosure regulation in their blue sky laws and that the experience in the blue sky market, which he considers to have been a “race to the bottom,” rather than the experience in the corporate charter market, is the appropriate context from which to predict the output of securities regulatory competition. Cox, “Regulatory Duopoly in U.S. Securities Markets,” 1243–44. In a more recent article Cox restates the claim: he contends that because the states did not “impose demanding disclosure requirements,” but, rather, have deferred to the federal agency over the past several decades while they have operated securities regimes alongside the SEC’s mandatory regime, they will not impose stringent disclosure requirements under regulatory competition. James D. Cox, “Premises for Reforming the Regulation of Securities Offerings: An Essay,” Law and Contemporary Problems 63 (2000): 11, 34. Cox’s contention is mistaken, however. The experience under state securities law is not probative for regulatory competition because the jurisdictional rule, securities sale location,

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prevents states from competing: when a state does not exercise exclusive authority over an issuer but shares regulatory power with all sovereigns in which the shares are sold, the state has no incentive to fashion alternative disclosure regimes that would be of value to investors because firms cannot benefit from selecting such a state for an issue’s registration as they will not be subject solely to that jurisdiction’s rules. See Romano, Genius of American Corporate Law, 122–24 (discussing failure of competition in Canada due to provinces’ lack of control over their corporation codes, which is shared with securities administrators). 57. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1213, 1221. Lucian Bebchuk and Assaf Hamdani advocate, as a remedy for the ostensible lack of state competition identified by Kahan and Kamar, the provision of an additional corporate law choice by the national government. They cite Canada as an example of such an option for enhancing competition. Lucian Arye Bebchuk and Assaf Hamdani, “Vigorous Race or Leisurely Walk: Reconsidering the Debate on State Competition in Corporate Law,” Harvard Law School, 2002, 4. A federal law would not, however, serve such a purpose. Given the size of the federal budget, the national government has even less of an incentive to provide and update a quality corporation code than do large states, which, according to Bebchuk and Hamdani, do not have incentives to compete with Delaware. In addition, as elaborated in this chapter, national legislators, with far many more jurisdictional issues and a more time-consuming legislative process, will not have the same incentives or institutional means to respond quickly to changing business needs as state legislators. It should also be noted that the Canadian national statute does not appear to have created successful competition in Canada, although a number of reasons exist for the absence of competition, including the lack of provincial judicial independence to interpret corporation laws. See Ronald J. Daniels, “Should Provinces Compete? The Case for a Competitive Corporate Law Market,” McGill Law Journal 36 (1991): 130; Douglas J. Cumming and Jeffrey G. MacIntosh, “The Role of Interjurisdictional Competition in Shaping Canadian Corporate Law,” International Review of Law and Economics 20 (2001): 141. 58. See, for example, Romano, Genius of American Corporate Law, 38–41. 59. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1217–18. 60. Ibid., 1231–32, 1238 (litigation frequency fifteen times higher for largest firms compared with smallest firms and difference in franchise tax for largest to

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smallest firms is fifteen to one). They also develop their price discrimination claim by pointing out that Delaware charges substantially higher prices for public than nonpublic corporations—at a ratio of 500 to 1—beyond what might be attributed to differences in servicing costs related to litigation frequency, but that claim is not particularly relevant to the debate over state competition and the efficiency of the charter market. First, as some commentators have noted, states, including Delaware, do not appear to compete for close corporations. See Ian Ayres, “Judging Close Corporations in the Age of Statutes,” Washington University Law Quarterly 70 (1992): 365; Roberta Romano, “State Competition for Close Corporation Charters: A Commentary,” Washington University Law Quarterly 70 (1992): 409. One reason for that phenomenon is that because of the greater diversity and idiosyncracies of close corporation control arrangements, standardform contracts and judicial precedents are not very useful for such investors, and states will therefore not benefit from competition. Ibid., 413. That explanation is supported by data indicating that closely held firms have overwhelmingly opted to organize under new limited liability corporation statutes over limited liability partnership laws, despite the existence of a stock of judicial precedents for the partnership form. See Larry E. Ribstein, “Limited Liability Companies: Statutory Forms for Closely Held Firms: Theories and Evidence from LLCs,” Washington University Law Quarterly 73 (1995): 369, 429. Second, even if there were competition for close corporations, that market is distinct from the market for public corporation charters: the different clienteles result in different statutory needs, indicated by the adoption of special close corporation statutes or general corporate code provisions for close corporations, and judicial precedents for public corporations will thus not be of use for private firms. Accordingly, the provision by Delaware of a huge discount or subsidy for domestic incorporation for close corporations compared with public corporations does not bear on whether the pricing in the market for publicly traded firms is discriminatory. Finally, critics of the efficacy of state competition are concerned about publicly traded firms, for their focus is on the agency problem of the separation of ownership and control and, in particular, managers’ ability to block hostile takeovers that benefit shareholders, neither of which concerns is relevant to close corporations (their ownership is not separated from control and, with no traded shares, they are not subject to hostile takeovers). See, for example, Bebchuk and Ferrell, “Federalism and Corporate Law”; Bebchuk and Ferrell, “A New Approach to Regulatory

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Competition and Takeover Law”; Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 61. For information on Delaware’s replacement of New Jersey as the leading incorporation state, see Romano, Genius of American Corporate Law, 42–43. 62. Lawrence A. Cunningham, “The New Corporate Law—The 1999 Model Business Corporation Act,” in Aspen Law and Business Corporations 71 (May 15, 2000): 1, 5. 63. See, for example, James I. Lotstein and Christopher Calio, “Why Choose Connecticut? Advantages of the Connecticut Business Corporation Act over the Delaware General Corporation Law,” Connecticut Lawyer (April 2000), 10 (noting recent code updates in 1997 and 1999 following Model Act and pointing out consequent advantages of Connecticut incorporation over Delaware, such as use of explicit statutory guidance rather than case law interpretation for indemnification, derivative suits and conflicting interest transactions, and more flexible default rules, including treatment of legal capital). 64. Only two states besides Delaware had a net inflow of reincorporating firms in my study of reincorporations, Nevada and Virginia. See Romano, “Law as a Product,” 247 (figure 3). 65. One might contend instead that Delaware’s attentive updating of its code is simply innovation undertaken by a monopolist and not by a firm concerned about competition. But economic theory is ambiguous about whether monopolists innovate more than firms in a competitive industry. Monopolists tend to innovate more slowly than competitive firms when there is only one innovator and thus there is no patent race, but in the context of a patent race, both monopolists and competitive firms innovate more rapidly than they otherwise would, and a monopolist could have stronger incentives to innovate—and preempt a patent race—as it would obtain a higher return from preempting entry than a firm in a competitive market. See Dennis W. Carlton and Jeffrey M. Perloff, Modern Industrial Organization, 3d ed. (Reading, Mass.: Addison-Wesley, 2000), 534, 541. As corporate law is not patentable, however, the patent race analogy is not necessarily apt. The modeling of innovation in a nonpatentable context, such as innovation in financial products rather than in industrial (technological) products, is less advanced. Of two models that have sought to bridge that gap, one model with positive externalities (economies of scale that are a function of more consumers of the product and create profit opportunities analogous to

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patents for banks) results in inconclusive equilibria regarding whether more, if any, innovation occurs with a monopolist or under competition, while the other model shows that a lack of patent protection may in fact increase innovation and not induce free-rider problems in a competitive industry. See Philip Molyneux and Nidal Shamroukh, Financial Innovation (New York: John Wiley & Sons, 1999), 195–201. In fact, the latter model seems to approximate what has occurred in the banking sector—significant financial product innovation has occurred despite (if not because of) the competitiveness of the industry. Ibid., 47–48. 66. Donald C. Langevoort, “Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment,” Law and Contemporary Problems 63 (2000): 45, 50. 67. See, for example, Ronald J. Gilson and Bernard S. Black, The Law and Finance of Corporate Acquisitions, 2d ed. (Westbury, N.Y.: Foundation Press, 1995): 1256 (noting, and providing references for, the view that the Delaware Supreme Court’s adoption of a purpose test for freeze-outs in the Singer v. Magnavox decision was in reaction to calls for federal fiduciary standards); and Jeffrey N. Gordon, “Corporations, Markets, and Courts,” Columbia Law Review 91 (1991): 1931, 1965, 1970–71 (suggesting, but ultimately rejecting, fear of federal takeover legislation as the explanation for the Delaware Supreme Court’s pulling back on active review of management’s takeover defenses in the Paramount Communications v. Time decision). 68. For a discussion of the circumstances of that statute’s enactment, see Roberta Romano, “Corporate Governance in the Aftermath of the Insurance Crisis,” Emory Law Journal 39 (1990): 1154. 69. Romano, “Law as a Product,” 233–35. 70. Ibid., 235. 71. Molyneux and Shamroukh, Financial Innovation, 11, 262–63. 72. Ibid., 212. 73. Romano, “Law as a Product,” 236–41. 74. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1223 n. 77. Because state corporation codes contain special provisions governing close corporations and all states offer limited liability company statutes, which is an alternative organizational form for such businesses, states must contemplate the presence of domestic public corporations in offering the general

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incorporation statutes. It would be difficult, therefore, for Kahan and Kamar to recharacterize the “service” being provided by noncompeting states as directed solely at small, privately held local firms, whose concerns may not be the subject of competition with Delaware. 75. This is not a new point. Numerous commentators have discussed the crucial role of the corporate bar in the production of corporate law both in Delaware and in other states that follow the Model Business Corporation Act. See, for example, for Delaware, Jonathan R. Macey and Geoffrey P. Miller, “Toward an Interest-Group Theory of Delaware Law,” Texas Law Review 65 (1987): 469; and for the Model Act states, William J. Carney, “The Production of Corporate Law,” Southern California Law Review 71 (1998): 715. 76. See Mathew McCubbins and Thomas Schwartz, “Congressional Oversight Overlooked: Police Patrols versus Fire Alarms,” American Journal of Political Science 2 (1984): 165 (contrasting fire alarm and police patrol forms of congressional oversight of the executive branch). 77. There is, moreover, a direct fiscal payoff to a state for responding to demands of the bar to update its corporation code and not just an indirect benefit of higher income tax revenues from the local bar’s earnings from servicing domestic corporations: as earlier noted, the positive relation between franchise revenues and corporate law responsiveness holds up for all states and not simply for Delaware. 78. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1222 n. 74. 79. Because virtually all Delaware firms have no physical presence in Delaware, such a concern is not relevant with respect to Delaware, and a nearly perfect positive correlation exists between its total and marginal franchise fee revenues. 80. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1229. 81. Romano, “Law as a Product,” 244 n. 34. 82. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1230. That concern concludes their discussion of the “political considerations” that could explain the “modest” appearance of Delaware’s maximum charge. Ibid., 1229. 83. See William J. Baumol, The Free-Market Innovation Machine (Princeton: Princeton University Press, 2002).

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84. Ibid., 164. 85. Ibid., 168–71. 86. See, for example, Wilmington City Railway Co. v. People’s Railway Co., 47A. 245, 251 (Del. Ch. 1900). 87. As Baumol explains, a monopolist deterred by potential competition, such as Delaware, will not price its product (charters) at marginal cost; the innovative incumbent firm must be able to recover its fixed or sunk costs to remain solvent; entry (or the threat thereof) pushes prices down to “just permit competitive returns overall,” and prices exceeding marginal cost consequently “are patently not evidence of the absence of effective competition.” Baumol, The Free-Market Innovation Machine, 166–67. Moreover, as previously noted, the incumbent innovator firm’s pricing strategy will, where feasible, consist of price discrimination, but the firm is still a “price taker,” given the threat of entry. Ibid., 168–71. The applicability of Baumol’s theory to the chartering market is not exact, however, because the innovative industries he examines are characterized by apparent oligopolists rather than by apparent monopolists. 88. Michael Klausner, “Corporations, Corporate Law, and Networks of Contracts,” Virginia Law Review 81 (1995): 757, 850–51. 89. Kamar, “A Regulatory Competition Theory of Indeterminacy in Corporate Law”; Kahan and Kamar, “Price Discrimination in the Market for Corporate Law.” 90. See, for example, Klausner, “Corporations, Corporate Law, and Networks of Contracts,” 850–51. 91. See S. J. Leibowitz and Stephen E. Margolis, “Network Effects and Externalities,” in Peter Newman, ed., The New Palgrave Dictionary of Economics and the Law, vol. 2 (New York: Stockton Press, 1998), 671; and S. J. Leibowitz and Stephen E. Margolis, “Network Externality: An Uncommon Tragedy,” Journal of Economic Perspectives 8 (1994): 133, 141–42. 92. Michael Klausner suggests that the lock-in of an inefficient provision in corporate law would not be due to information imperfections—that the first firms adopting charters do not recognize that their choice of provisions is inefficient— but to an externality between early and later users of a product—the benefits of participating in the larger existing network despite its inefficient rules. See Michael Klausner, “A Comment on Contract and Jurisdictional Competition,” in Frank H. Buckley, ed., The Fall and Rise of Freedom of Contract (Durham, N.C.: Duke University Press, 1999), 349, 451 n. 15. Hence, that source of network

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inefficiencies is the focus of the discussion in the text. A lock-in of inefficient corporate laws because early adopters lacked information regarding the optimal provision would not be a sustainable charter market equilibrium over time. There are well-informed specialists—lawyers and investment bankers—who are repeat players in the charter market because they advise many firms. In contrast to an individual corporation, those experts will internalize the cost of becoming informed regarding an inefficient choice and either ensure that the state revises an inefficient provision or advise their clients to switch to the more efficient regime. 93. See Romano, “Corporate Governance in the Aftermath of the Insurance Crisis,” 1160. 94. Ibid. 95. Michael J. Whincop, “An Empirical Investigation of the Terms of Corporate Charters and Influences on Term Standardization in a Laissez-Faire Environment,” Griffith University Faculty of Law, 2000. 96. The separate networks he identifies are (1) low-level indemnity provisions with releases of personal liability subject to a dishonesty qualification; (2) wide indemnification and narrower releases, both qualified by willful default exceptions; and (3) limited releases and no or restricted indemnities (the statutory default requirement). The remaining firms that do not fit into those three groupings (30 percent of the sample) are classified into a fourth, miscellaneous category. The first group was not initially the most popular group and indeed was not as old as the others but emerged as the dominant choice and replaced the other clusters by the time the government enacted mandatory rules and ended the era of charter experimentation in fiduciary obligations. 97. That is, in fact, a common occurrence. For a comprehensive and compelling showing of the absence of lock-in effects in private industry where network externalities were hypothesized to exist, see Stan J. Leibowitz and Stephen E. Margolis, Winners, Losers, and Microsoft: Competition and Antitrust in HighTechnology (Oakland, Calif.: Independent Institute, 1999). 98. See Cunningham, “The New Corporate Law–The 1999 Model Business Corporation Act;” and Lotstein and Calio, “Why Choose Connecticut?” A recent example of a court’s analyzing a state code by reference to Delaware law is Hilton Hotels Corp. v. ITT Corp., 978 F. Supp. 1342 (D. Nev. 1997) (Nevada law). 99. Leibowitz and Margolis, “Network Effects and Externalities,” 672–73. 100. Ibid., 673.

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101. Kamar, “A Regulatory Competition Theory of Indeterminacy in Corporate Law,” 1928. 102. Ibid., 1932; Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1233. 103. See generally Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law (Cambridge: Harvard University Press, 1991), 90–93. 104. See Lotstein and Calio, “Why Choose Connecticut?” 10 (“the [Connecticut Business Corporation Act] contains more explicit guidance to corporations and their lawyers than the [Delaware General Corporation Law] which relies heavily on case law to interpret the statute”). 105. See, for example, Thomas A. Slowey, “Pa. Chancery Court Is a Sound Proposal,” Pennsylvania Law Weekly, May 2, 1994, 6. 106. Kamar, “A Regulatory Competition Theory of Indeterminacy in Corporate Law,” 1920. 107. See, for example, Larry E. Ribstein and Peter V. Letsou, Business Associations, 3d ed. (New York: Matthew Bender, 1996), 994. Kamar recognizes that elements of antifraud liability under the securities laws are as indeterminate as Delaware law. Kamar, “A Regulatory Competition Theory of Indeterminacy in Corporate Law,” 1952 n. 175. But he misses the implication—that the use of a standard is most plausibly integrally connected to the nature of the legal issue to be decided rather than to the strategic motivations of adjudicators in relation to chartering revenues. 108. Unidentified official quoted in Stephen M. Bainbridge, Securities Law: Insider Trading (Westbury, N.Y.: Foundation Press, 1999), 29. 109. Kamar, “A Regulatory Competition Theory of Indeterminacy in Corporate Law,” 1913–14. 110. See Romano, “Law as a Product,” 250, 274 (reasons provided by counsel for reincorporating firms). That theme was also repeatedly emphasized by corporate counsel attending the University of Pennsylvania Law and Economics Institute Roundtable on May 12, 2000, at which the Kahan and Kamar paper was presented. 111. In my sample of 139 shareholder lawsuits, 24 were brought solely in Delaware court and 24 solely in another state court. Of those, nineteen of the Delaware cases and seventeen of the non-Delaware cases were settled or terminated by the parties’ stipulation, and two of the Delaware and three of the

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non-Delaware cases were dismissed. See Roberta Romano, “The Shareholder Suit: Litigation without Foundation?” Journal of Law, Economics, and Organization 7 (1991): 55. The remaining cases were inactive or pending at the time of my study. Of the non-Delaware court cases, five involved Delaware corporations, of which four settled and one was dismissed. Of the Delaware court cases, one was a double derivative suit. The plaintiff was a shareholder in the parent, an Ohio corporation, while the wholly owned subsidiary was a Delaware corporation; that case settled. Whether the Delaware cases are classified by the forum (nineteen settlements of twenty-four cases) or by the defendant corporation’s statutory domicile (twenty-three settlements of twenty-nine cases, or twenty-two settlements of twenty-eight cases, depending on how one classifies the double derivative suit), chi-square tests cross-tabulating lawsuit disposition by state (Delaware versus all other states) indicate that no statistical difference exists in the settlement rate across the two groups (the probability values range from .4 to .5). 112. See Bruce L. Hay and Kathryn E. Spier, “Settlement of Litigation,” in Peter Newman, ed., The New Palgrave Dictionary of Economics and the Law, vol. 3 (New York: Stockton Press, 1998), 442. 113. See Richard A. Posner, Economic Analysis of Law, 5th ed. (Gaithersburg, Md.: Aspen Law and Business, 1998), 615. 114. See, for example, James D. Cox, Robert W. Hillman, and Donald C. Langevoort, Securities Regulation: Cases and Materials, 3d ed. (Gaithersburg, Md.: Aspen Law and Business, 2001), 808 (the “most notable” exemption in the 1998 Securities Litigation Uniform Standards Act preempting state securities actions is the “so-called Delaware carve-out” that preserves state court jurisdiction over certain fiduciary claims). 115. For example, it enacted legislation that reduced the uncertainty regarding outside directors’ liability for negligence generated by the Smith v. Van Gorkom decision by permitting firms to eliminate such liability entirely by charter amendment. As Judge Strine points out, examples of Delaware law that Kahan and Kamar criticize as unduly “indeterminate” are areas in which no consensus exists among corporate law practitioners and scholars regarding the correct approach, and in cases where consensus exists, the law is not indeterminate or is clarified to reduce indeterminateness. See Leo E. Strine, Jr., “Delaware’s Corporate-Law System: Is Corporate America Buying an Exquisite Jewel or a Diamond in the

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Rough? A Response to Kahan and Kamar’s Price Discrimination in the Market for Corporate Law,” Cornell Law Review 86 (2001): 1257, 1268–71. 116. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1236 (“relevant comparison is . . . between actual Delaware law and Delaware’s potential”). Kamar now discounts his earlier examples because he claims that states do not compete for charters. Ibid., 1235. 117. For an introduction to some of the competing considerations, see Posner, Economic Analysis of Law, 590–96. 118. See Louis Kaplow, “Rules versus Standards: An Economic Analysis,” Duke Law Review 42 (1992): 557. 119. Ian Ayres, “Review: Making a Difference: The Contractual Contributions of Easterbrook and Fischel,” University of Chicago Law Review 59 (1992): 1391, 1404. 120. As Justice Frankfurter famously remarked, “[T]o say that a man is a fiduciary only begins analysis.” SEC v. Chenery Corp., 318 U.S. 80, 85–86 (1943). For an alternative view of the Delaware judiciary that concludes that it enhances firm value rather than produces excessive indeterminacy, see Jill E. Fisch, “The Peculiar Role of the Delaware Courts in the Competition for Corporate Charters,” University of Cincinnati Law Review 68 (2000): 1061. 121. See, for example, Kahan and Kamar, “Price Discrimination in the Market for Corporate Law” (table 2) (data from late-1990s in Towers Perrin 1998 Directors and Officers Liability Survey); Wyatt Directors and Officers Liability Insurance Survey (Chicago, Ill.: Wyatt Co., 1987) (data from mid-1980s). 122. See Kaplow, “Rules versus Standards.” 123. See, for example, Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1236. 124. In my sample of shareholder suits, of the 139 lawsuits, 55 were derivative suits, and an additional 31 combined derivative and class claims. In contrast, only 22 suits alleged solely a duty of loyalty claim in the complaints, with an additional 48 combining a duty of loyalty claim with another type of claim, such as a breach of the duty of care. See Romano, “The Shareholder Suit.” Of course, to avoid a quick dismissal of a derivative suit under the demand requirement, plaintiffs must allege a conflict of interest—a loyalty breach. Thus, those figures overstate the presence of genuine fact patterns involving the duty of loyalty. For example, half of the 48 cases filed either only in Delaware or only in a different state court combined duty of care and duty of loyalty claims, and only 2 of those 24 cases did not entail derivative

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claims. Moreover, the previously noted high settlement rate of those lawsuits reduces the potential pool of cases that judges will have to adjudicate under the fairness standard. 125. Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1241. Informing that contention is Louis Kaplow’s article advocating the use of rules over standards, or more-rule-like standards over less-rule-like standards. Ibid., 1241, n. 150. Kaplow’s general analysis does not, however, demonstrate why it is optimal to adopt a more determinate standard than Delaware’s standard in the specific context of fiduciary duty law. First, the fiduciary context is not a context in which rules are preferable in Kaplow’s model because corporations have legal counsel on retainer and thus are in his category of cases where the cost of obtaining advice is low and there is no difference in conforming behavior to rules compared with standards. Kaplow, “Rules versus Standards: An Economic Analysis,” 564. Second, it is also not a context in which the ex ante, as opposed to ex post, determination of the legal rule is appropriate. Ibid. The only criterion of Kaplow’s model that could lead to rejecting a standards approach in the fiduciary context is the frequency of the conduct in question: transactions in which a fiduciary issue could arise, such as acquisitions, are not rare occurrences, although the probability of becoming a target is, on average, low. But to the extent that the particulars of the complaints vary significantly, and are often idiosyncratic, rules would still be less preferable to standards in this setting. 126. Kahan and Kamar also suggest the substitutability of shareholder votes for judicial fairness standards in conflict of interest transactions, as evidence for their claim that Delaware law is excessively “litigation-intensive” compared with its “potential.” Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1241. That approach is not as obviously an improvement over the existing regime, in terms of increasing either the predictability or the efficiency of Delaware law, as Kahan and Kamar claim. As Judge Strine has noted, a fairness standard has significant benefits in terms of transactional flexibility in contrast to Kahan and Kamar’s mandatory rule approach, and they provide no analysis indicating that a mandatory voting procedure is the more efficient approach for all or most interested transactions. See Strine, “Delaware’s Corporate-Law System,” 1277–78. In addition, there is likely to be considerable litigation over the validity of shareholder votes, such as whether appropriate disclosure was made, an outcome further undermining the notion that share-

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holder ratification would reduce litigation uncertainty compared with the fairness standard. Ibid. 127. See Macey and Miller, “Toward an Interest-Group Theory of Delaware Corporate Law.” Ian Ayres made a suggestion, analogous to Kamar’s, with respect to legislation rather than judicial interpretation, that Delaware might continuously update its code not only to create difficulties for competitors, but also to generate additional litigation. Ian Ayres, “Supply-Side Inefficiencies in Corporate Charter Competition: Lessons from Patents, Yachting, and Bluebooks,” Kansas Law Review 43 (1995): 541, 558–59. 128. See, for example, Levine v. Smith, 591 A.2d 194 (Del. 1991). 129. See Sherwin Rosen, “The Market for Lawyers,” Journal of Law and Economics 35 (1992): 215. 130. Kamar’s latest emendation on this theme, in his work with Kahan, suggests that the corporations most harmed by the uncertainty of Delaware law, large public corporations with the highest probability of being sued, have no incentive to seek clarification of the legal rules because they also benefit the most from a Delaware domicile because of its stock of legal precedents. See Kahan and Kamar, “Price Discrimination in the Market for Corporate Law,” 1232. That speculation is unjustified, and, conduct that is in fact the obverse would appear to be the most probable course of action by such firms. Because such corporations benefit most from a Delaware domicile, their in-house counsel have the greatest incentive to lobby the legislature for clarification of excessively indeterminate precedents, as reincorporating to avoid excessive litigation would be more expensive for them. 131. See Cary, “Federalism and Corporate Law.” 132. See, for example, Loewenstein, “Delaware as Demon.” 133. See, for example, Easterbrook and Fischel, Economic Structure of Corporate Law, 220–22. 134. For an analysis of those statutes, see Roberta Romano, “What Is the Value of Other Constituency Statutes to Shareholders?” University of Toronto Law Journal 43 (1993): 533. I found that those statutes had no significant stock price effect on the specific legislative event dates and within two-day event intervals. Ibid., 537. John Alexander and his colleagues, however, found a significant negative price effect for firms without poison pills or antitakeover charter amendments for two of the statutes that I examined when a longer event interval of two days before and three days after was used, and for a third statute, enacted by Indiana in 1989, that was

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improperly included in their sample because Indiana had an other constituency statute in effect since 1986. See John C. Alexander, Michael Spivey, and M. Wayne Marr, “Nonshareholder Constituency Statutes and Shareholder Wealth: A Note,” Journal of Banking and Finance 21 (1997): 417, 427. I found a negative effect for the earlier Indiana statute, but it is not a “clean” statute in that it was passed in a bill containing another antitakeover law, a control share acquisition provision. See Romano, “What Is the Value of Other Constituency Statutes to Shareholders?” 539. I did not find any difference for firms with or without defensive tactics in place, but I did not investigate that effect for each state statute separately as did Alexander and his colleagues. Therefore, the two studies’ results regarding the interaction between defensive tactics and other constituency statutes are not directly comparable. In addition, my sample consisted of relatively large firms, as it was constructed solely from NYSE listings, while Alexander and his colleagues included firms traded on the American Stock Exchange and NASD’s Automated Quotation System, which are, on average, smaller than NYSE firms, given the exchanges’ different listing requirements. Because at least one study has found that it is small firms that experience negative price effects from takeover statutes, the difference in the two studies’ samples may explain the difference in the statistical results. See M. Andrew Fields and Janet M. Todd, “Firm Size, Antitakeover Charter Amendments, and the Effect of State Antitakeover Legislation,” Managerial Finance 21 (1995): 35. 135. See, for example, William J. Carney, “Shareholder Coordination Costs, Shark Repellents, and Takeout Mergers: The Case against Fiduciary Duties,” American Bar Foundation Research Journal 1983 (1983): 341. 136. Romano, Genius of American Corporate Law. 137. Bebchuk and Ferrell, “Federalism and Corporate Law.” 138. For example, in prior work I criticized the opt-out default regimes of takeover statutes adopted by the majority of states and advocated that the statutory default should instead be an opt-in regime, as is the legislative practice in Georgia. See Romano, Genius of American Corporate Law, 56–57, 83–84. 139. See table 4-1. That is not to say that no financial incentive would exist for the national government to respond to corporate demands, as members of Congress are responsive to campaign contributions, but that is a far more expensive and less reliable incentive device for investors than the incentive mechanisms of state competition.

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140. More legislators’ support is needed, for example, as the number of members of one chamber of Congress, 435 representatives in the House, is greater than the number of legislators in both houses in the state with the largest number of legislators (424 in New Hampshire; the next largest state legislature, Pennsylvania’s, has only 253 members). Romano, Genius of American Corporate Law, 48. While specialization through congressional committees mitigates the coordination problem, it would not be likely to improve the legislative process relative to that of the states, especially a state whose attention is focused by franchise tax revenues. For example, congressional reversals of Supreme Court decisions invalidating federal statutes averaged 2.4 years from opinion to reversal, whereas the Delaware legislature took only 1.5 years to respond with legislation to a controversial decision on director liability. See ibid., 49. In addition, state takeover laws are often enacted within a few weeks or months of proposal. See, for example, Roberta Romano, “The Political Economy of Takeover Statutes,” Virginia Law Review 73 (1987): 111, 128, 131–32 (discussing political process in Connecticut). The low saliency of corporate law issues with members of the voting public would exacerbate the differential rate of responsive action between Congress and a competitive chartering state, as its members’ reelection probabilities would not suffer adverse consequences from inattentiveness to corporate needs, compared with legislators in Delaware, whose finances are dependent on revenues from incorporations. 141. The most comprehensive study, which aggregates the effect of forty statutes, finds a small but significant negative stock price effect. See Karpoff and Malatesta, “The Wealth Effects of Second-Generation State Takeover Legislation.” Many studies of individual statutes do not find significant stock price effects. See Romano, Genius of American Corporate Law, 60–67 (reviewing results of empirical studies on takeover statutes). 142. See, for example, Harry DeAngelo and Edward M. Rice, “Antitakeover Charter Amendments and Shareholder Wealth,” Journal of Financial Economics 11 (1983): 329 (insignificant effect); Scott C. Linn and John J. McConnell, “An Empirical Investigation of the Impact of ‘Antitakeover’ Amendments on Common Stock Prices,” Journal of Financial Economics 11 (1983): 361 (positive or insignificant effect); Gregg Jarrell and Annette Poulsen, “Shark Repellents and Stock Prices: The Effects of Antitakeover Amendments Since 1980,” Journal of Financial Economics 19 (1987): 127 (insignificant effect for fair price amendments, the majority of sample);

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James A. Brickley, Ronald C. Lease, and Clifford W. Smith, Jr., “Ownership Structure and Voting on Antitakeover Amendments,” Journal of Financial Economics 20 (1988): 267 (insignificant effect); Richard Lambert and Donald Larckner, “Golden Parachutes, Executive Decisionmaking, and Shareholder Wealth,” Journal of Accounting and Economics 7 (1985): 179 (significant positive effect); and Bhagat and Jefferis, “Voting Power in the Proxy Process” (after observing that returns around proxy mailings are higher for firms where no antitakeover amendments are proposed than for firms that make such proposals, they find a significant negative effect from a broad set of antitakeover amendments when adjusting for anticipation of such a proposal in a cross-sectional regression based on firm-specific characteristics). 143. See, for example, Jo Watson Hackl and Rosa Anna Testani, “Note, Second Generation State Takeover Statutes and Shareholder Wealth: An Empirical Study,” Yale Law Journal 97 (1988): 1193 (finding smaller increase in number of takeovers, controlling for incorporations, in states with second-generation statutes than in states with no such statutes, but bid premiums do not vary across regulating and nonregulating states, and auctions are not more frequent in states with statutes); Robert Comment and G. William Schwert, “Poison or Placebo? Evidence on the Deterrence and Wealth Effects of Modern Antitakeover Measures,” Journal of Financial Economics 39 (1995): 3 (finding takeover rates are not lower for firms covered by takeover statutes or poison pill defenses, but premiums are higher for such firms). 144. Cary, “Federalism and Corporate Law,” 663; Bebchuk and Ferrell, “Federalism and Corporate Law,” 1170. In a more recent article Bebchuk and Ferrell have proposed permitting firms to choose their takeover regime, from a federal option that would enact the takeover rules in the London Code of Conduct in addition to their incorporation state, a proposal that parallels this book’s proposal to open securities regulation up to competition. See Bebchuk and Ferrell, “A New Approach to Regulatory Competition and Takeover Law.” Their new proposal is not an alternative to state competition, but it is an endorsement of competition, as firms would choose their takeover regime. It is thus a proposal that essentially cedes the debate over corporate charters to the side in support of state competition. The specifics of the proposal are puzzling for two reasons, however. First, as discussed in the text, there is no guarantee that Congress would enact a takeover statute whose substantive content is identical to Bebchuk and Ferrell’s proposal and considerable evidence that it would, in all likelihood, not do so. Second, under existing Delaware law, firms can voluntarily adopt Bebchuk

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and Ferrell’s preferred takeover regime, but none appear to have done so in its entirety. Bebchuk and Ferrell presumably believe that this state of affairs is a function of managers’ trumping shareholder preferences under state competition. The alternative explanation, and in my judgment the more compelling one, is that their proposal is not as desirable as they claim. Although institutional investors make numerous proposals regarding takeover defenses, none have suggested that firms adopt the London regime. Because the optimal takeover regime is uncertain, given the unresolved empirical literature on the trade-off among premiums, auctions, and bid probabilities, a better solution for attaining Bebchuk and Ferrell’s stated goal to enhance shareholder choice through federal intervention (see ibid. 113) than permitting shareholders to opt in to their proposed substantive federal takeover law would be to recommend a federal procedural requirement that gave shareholders initiation rights to create and remove takeover defenses and thereby permitted shareholders to select their own takeover regime. Neither that solution nor Bebchuk and Ferrell’s idea is novel: several commentators have advocated federal intervention along the dimension of reallocating power between shareholders and managers. See, for example, William W. Bratton and Joseph A. McCahery, “Regulatory Competition, Regulatory Capture, and Corporate Self-Regulation,” North Carolina Law Review 73 (1995): 1861, and the references cited therein (ibid. 1872 n. 28). Bebchuk and Ferrell contend that their proposed substantive federal law is necessary because the states will not provide shareholders with a choice of a statute as favorable to bidders as their approach. Bebchuk and Ferrell, “A New Approach to Regulatory Competition and Takeover Law,” 154–55. That is, in my judgment, a red herring. Shareholders would not have to rely on state legislatures to provide them with the choice of a takeover regime that Bebchuk and Ferrell deem optimal. The active institutional investors who would sponsor proposals regarding takeover defenses hold international portfolios and are well aware of the London regime that Bebchuk and Ferrell emphasize. Besides proposing reincorporation in one of the several states with no restrictions on takeovers in their corporate codes, those investors could propose a charter amendment incorporating the features of the London regime of no partial offers and no defenses after a bid commences. 145. See Romano, “Law as a Product,” 237–40 (Delaware either first or one of first states to adopt major corporate law innovations apart from takeover statute).

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146. Romano, Genius of American Corporate Law, 59. 147. 481 U.S. 69 (1987). 148. See Roberta Romano, “The Future of Hostile Takeovers: Legislation and Public Opinion,” University of Cincinnati Law Review 57 (1988): 461–64. 149. Ibid., 464 n. 6. 150. See Romano, Genius of American Corporate Law, 59. First-generation statutes were structured as securities regulations, reviewing and postponing the consummation of hostile bids, similar to the federal takeover law. Those laws were struck down as burdens on interstate commerce in Edgar v. MITE, 457 U.S. 624 (1982). Second-generation statutes are structured as corporate governance measures and are typically optional statutes. They were enacted in some states immediately following the Edgar v. MITE decision and in virtually all states after the Supreme Court upheld Indiana’s second-generation statute, a control share acquisition statute, in CTS v. Dynamics Corp. of America, 481 U.S. 69 (1987). 151. See John S. Jahera and William N. Pugh, “State Takeover Legislation: The Case of Delaware,” Journal of Law, Economics, and Organization 7 (1991): 410, 416–19 (finding insignificant or positive returns over eight two-day event intervals); Karpoff and Malatesta, “Wealth Effects of Second-Generation State Takeover Legislation,” 315 (finding an insignificant price effect over two-day event interval). It is curious for Bebchuk and Ferrell to conclude from Delaware’s enactment of a takeover statute, which is considerably less restrictive of bidders than other statutes, that state competition is an abysmal failure. Bebchuk’s own proposal for a takeover statute, a law requiring a majority vote of the target shareholders to approve a takeover before it can proceed, is indistinguishable from the control share acquisition statutes adopted by numerous states, which permit a bidder to acquire shares (or, equivalently, to vote the shares it acquires) only upon a vote of the majority of the other shareholders in approval of the transaction. Compare Lucian Arye Bebchuk, “Toward Undistorted Choice and Equal Treatment in Corporate Takeovers,” Harvard Law Review 98 (1985): 1695, with Ohio Revised Code Annotated § 1701.831; Indiana Code § 23-1-42-1 and ff. Yet in contrast to the Delaware statute that had an insignificant positive price effect, Indiana’s control share acquisition statute that tracks Bebchuk’s recommended statute had a significant negative price effect. See, for example, Karpoff and Malatesta, “Wealth Effects of Second-Generation State Takeover Legislation”; and William N. Pugh and John S. Jahera, “State Antitakeover Legislation and

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Shareholder Wealth,” Journal of Financial Research 13 (1990): 221. The price effect of the Ohio statute was, however, insignificantly negative. 152. See Coates, “An Index of the Contestability of Corporate Control.” 153. Daines, “Does Delaware Law Improve Firm Value?” Bebchuk and his colleagues dispute Daines’s finding by stating that Guhan Subramanian reported to them that he has a data set in which there is no difference in incidence between hostile bids for Delaware and non-Delaware domiciled firms and by concluding from that report that Daines’s finding represents a higher rate of friendly acquisitions and only the incidence of hostile takeover bids is relevant to an assessment of Delaware law. Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 28. I cannot evaluate the validity of that contention, as I do not have information on the comparability of the two data sets. Bebchuk and his colleagues also do not indicate whether Subramanian’s data are in accord with Daines’s other finding of importance, that Delaware firms are more likely to be acquired than firms in other states, a statistic of far more significance to investors than the number of hostile bids. But if one assumes that the studies are comparable and that the contention is correct, it is neither a relevant nor telling objection, nor is it a refutation of Daines’s conclusion that the data indicate that Delaware is more friendly to takeovers than are other states. As Bebchuk and his colleagues acknowledge but then disregard, it is in practice extremely difficult to distinguish between hostile and friendly transactions. Indeed, in a comprehensive study of over 2,000 takeover contests from 1975 to 1996, G. William Schwert finds no substantive economic differences between the outcomes of perceived hostile and nonhostile bids and concludes that the classification at best distinguishes the negotiation strategy used by bidders and targets. See G. William Schwert, “Hostility in Takeovers: In the Eyes of the Beholder?” Journal of Finance 55 (2000): 2599. No unsolicited bid starts out as “friendly,” whether or not it is classified as hostile by the time it is made public. From the shareholders’ perspective—the improved investment value that comes from a takeover bid—the statistic of concern for assessing the efficacy of a corporate law regime is the total acquisition incidence, not a breakdown of hostile versus friendly activity. And Daines’s data indicate that that rate is higher in Delaware. Moreover, if Delaware firms engage in more friendly acquisitions than do firms in other states, as Bebchuk and his colleagues contend is the implication of Daines’s data, that fact alone does not imply the inference they further draw, that Delaware law is

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not more friendly to hostile transactions compared with the laws of other states. Rather it may well signify the opposite: for example, Delaware managers could face a lower likelihood of success for prolonged resistance to a hostile bid compared with the success of managers in other states and therefore would accede more quickly to unsolicited offers. Such behavior would result in the number of deals classified as friendly being higher in Delaware than in other states. Bebchuk and his colleagues conclude their critique by maintaining that Daines’s finding of a higher level of bids and acquisitions for Delaware firms is an instance of self-selection—firms incorporate in Delaware to be acquired—rather than an instance of the hospitality of Delaware laws to acquisitions. The authors note in support of that claim that a paper of which Bebchuk is a coauthor finds that domicile is not significant in explaining outcomes for a sample of hostile bids. Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” 28. They do not report how the incidence rate varies by domicile for those bids compared with other acquisitive transactions or what the correlation is between the firm characteristics they find to affect the outcome of hostile bids and domicile, information that is essential for assessing the validity of their alternative self-selection story. But a self-selection explanation of Daines’s data is not evidence that state competition is harmful to, or not beneficial for, shareholders. It is evidence of the reverse. State competition is the mechanism that permits firms that wish to be acquired to do so: they move to Delaware. 154. For lists of the specific takeover targets that were the source of state takeover laws, see Henry N. Butler, “Corporation-Specific Antitakeover Statutes and the Market for Corporate Charters,” Wisconsin Law Review 1988 (1988): 365; Romano, “Future of Hostile Takeovers,” 461 n. 11. That is one of the reasons why states have multiple takeover laws. A law is tailored to help a specific target stop a particular bid, and when the next target faces a bidder who has adapted itself to the existing defenses, it needs a new line of defense to protect it. Target managers turn to legislatures for assistance in adopting such defenses because in the context of a well-priced bid, their shareholders will not approve the adoption of the defense the target managers obtain from the legislature. 155. See Justice Andrew G. T. Moore II, “State Competition, Panel Response,” Cardozo Law Review 8 (1987): 779, 780–81. In other states the legislature may even ignore the local corporate bar in enacting antitakeover legislation at the prodding of a local firm. See Romano, “Political Economy of Takeover Statutes”

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(detailing enactment of Connecticut antitakeover law bypassing review by the relevant state bar committee, whose members opposed the legislation). 156. Bebchuk and Ferrell, “Federalism and Corporate Law,” 1176–77. For a more general version of the argument that the state legislative process favors managers over shareholders, see Bratton and McCahery, “Regulatory Competition, Regulatory Capture, and Corporate Self-Regulation.” 157. That well-known behavioral pattern is termed hysteresis by Russell Hardin, but it has much in common with the economic definition of risk aversion. See Russell Hardin, Collective Action (Baltimore: Johns Hopkins University Press, 1982), 82–83. 158. See, for example, Moore, “State Competition, Panel Response”; Macey and Miller, “Toward an Interest-Group Theory of Delaware Corporate Law.” 159. Executive Compensation Issues in Mergers and Acquisitions Panel, University of Miami School of Law Center for the Study of Mergers and Acquisitions Fourth Annual Institute, February 11, 2000 (comments by Barbara Nims, Davis, Polk & Wardwell, and members of audience). 160. For example, of all tender offers for which at least one firm was traded on a national exchange from 1958 through 1985, in the database that I used for predicting the adoption of a takeover statute in 1987 after the CTS decision, there were forty-nine NYSE–listed hostile bidders incorporated in Delaware, compared with a maximum of six in any other state, and ninety-five NYSE–listed acquirers incorporated in Delaware, compared with a maximum of fourteen in any other state. See Romano, “Political Economy of Takeover Statutes,” 143. 161. State legislatures often enact takeover statutes because they are concerned with local employment levels, even though little evidence exists that, on average, hostile takeovers result in the loss of production-level jobs. See, for example, Roberta Romano, “A Guide to Takeovers: Theory, Evidence, and Regulation,” Yale Journal on Regulation 9 (1992): 119, 137–42. For instance, the Connecticut legislature speedily called hearings on a bill designed to protect a local firm from a hostile bid, because it was alleged that the takeover would result in substantial layoffs. Connecticut did not enact the statute, despite earlier predictions that it would, after the United Auto Workers union indicated that it did not support the bill. It appears that the incumbent managers were less “prounion” than the bidder, which reached an agreement with the UAW in which, among other matters, it agreed to remain neutral if the UAW sought to unionize the local

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plant after the takeover. See Dan Haar, “House Rejects Takeover Measure; Vote Denies Echlin Protection against SPX’s Hostile Bid,” Hartford Courant, March 26, 1998. 162. Evidence of a significant negative stock price reaction to the legislation supports that interpretation. See, for example, Karpoff and Malatesta, “State Takeover Legislation and Share Values.” 163. See Romano, Genius of American Corporate Law, 68–69. The percentage opting out is higher for the larger firms (74 percent of exchange-listed Pennsylvania corporations opted out compared with 60 percent of firms traded on NASDAQ or over-the-counter). 164. See Gillan and Starks, “Corporate Governance Proposals and Shareholder Activism,” 286 (of 2,042 shareholder proposals offered between 1987 and 1994, 249 were directed at repealing poison pills, while only 17 were directed at opting out of takeover statutes). 165. Comment and Schwert, “Poison or Placebo?” Given the small but statistically significant negative price effect picked up in Karpoff and Malatesta’s comprehensive event study of takeover statutes, that explanation of investor behavior regarding takeover statutes would mean either that the market has changed its assessment of the significance of the statutes or that the takeover environment itself has changed (either a learning or a real economy effect due, for instance, to the evolution of poison pill defenses into a more prominent strategic position than the older statutory defenses). In more recent work examining additional years of acquisition data, Schwert finds that the percentage of offers characterized as hostile decreased after 1991 and speculates that the cause was defensive tactics, such as poison pills and state takeover laws. Schwert, “Hostility in Takeovers,” 2606 n. 1. But he does not report a significant decline in the total number of bids, and in fact the focus of the article is on the problems in classifying bids as hostile or friendly. 166. Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition?” 41. They also contend that the relative performance of Delaware compared with other states is irrelevant for assessing competition by continuing to emphasize the takeover statutes enacted in other states that this section has discussed, an argument that is surprising, given Bebchuk’s prior objections to the quality of Delaware’s legal regime, for it implicitly acknowledges that Delaware’s laws are more favorable to shareholders than are those of other states. See ibid., 22 (“Findings of marginal

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superiority of Delaware cannot answer how the state competition is performing overall and, in particular, whether it will perform better than an alternative regime.”). That assertion is incorrect. Delaware’s relative performance is still the most important factor in assessing state competition because its laws cover the majority of public corporations, including the majority of new public corporations as well as the majority of reincorporating ones, and hence dictate the welfare of most investors. While a state may offer a legal regime with draconian takeover statutes that are adverse to shareholder interests, in the long run such a state will not retain its share of new corporations. Bebchuk and his colleagues’ data do not, despite their claims to the contrary, dispute that fact. The principal evidence that they provide for that claim is their statement that they do not find a lower number of firms domiciled in Pennsylvania, compared with other states, despite that state’s enactment of a highly restrictive takeover statute, known as a disgorgement statute. They conclude from those data that Pennsylvania was not penalized for adopting a severely restrictive statute and that competition is a failure. But the domicile analysis of Bebchuk and his colleagues overlooks the critical fact that the vast majority of firms incorporated under the Pennsylvania disgorgement statute opted out of its coverage. Thus, their data emphatically do not show that Pennsylvania’s stock in the charter market was not damaged by the disgorgement statute, because they do not control for whether the statute is covering the incorporated firms. Namely, the fact that the majority of publicly traded firms incorporated in Pennsylvania were compelled by their investors to opt out of the statute provides a ready explanation for why Bebchuk and his colleagues do not find a decline in the state’s share of incorporations. If the overwhelming majority of firms incorporating under Pennsylvania are not covered by the statute, then investors will not care about the statute’s presence in the state code, and they will not actively seek a domicile change (nor eliminate that state’s firms from their portfolios, which would produce a similar effect—firm domicile changes to stem stock declines in the face of institutional sell-offs). Investor pressure about the statute imposed a substantial cost on managers of firms with a Pennsylvania domicile that compelled them to opt out of its coverage, and that action is equivalent to a penalty on Pennsylvania. Such investors, who are well aware of the statute, will discount the price of firms newly incorporating there unless they too opt out of the statute. Indeed, if firms had not been pressured to opt out, so that the disgorgement statute imposed no cost on the state and managers of local firms, then other states

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would have adopted that statute. Such a response must be so according to Bebchuk and his colleagues’ analysis. As the states are racing to adopt rules favoring managers by preventing takeovers, they benefit by having as many takeover statutes as possible (ibid., 37). And the disgorgement statute is widely characterized to be at the bottom of the heap from the shareholders’ perspective. Yet none adopted it. Moreover, Pennsylvania did not enact another takeover statute after its experience with the disgorgement statute, whereas under Bebchuk and his colleagues’ analysis, since the state was not penalized for enacting that statute, the state should have continued “to be busy,” as they put it, and to adopt additional statutes, such as Massachusetts’s classified board statute, which Bebchuk and his colleagues identify as equally, if not more, objectionable (ibid., 36). For Bebchuk and his colleagues to be correct that Pennsylvania suffered no penalty from its prior enactment, and hence that state competition must be judged an absolute failure in the takeover context, then they have to provide an explanation for why Pennsylvania stopped enacting additional takeover statutes after the disgorgement law and why other states did not follow its lead and adopt such a statute. Finally, consistent with this analysis, in contrast to Bebchuk and his colleagues, Guhan Subramanian undertakes a slightly different statistical analysis of firms’ current domicile and headquarters choices and finds that the more severe statutes—the Pennsylvania disgorgement statute and the Massachusetts staggered board statutes—have the opposite effect on firm domicile from other takeover statutes: they “repel rather than attract” firms. See Guhan Subramanian, “The Influence of Antitakeover Statutes on Incorporation Choice: Evidence on the ‘Race’ Debate and Antitakeover Overreaching,” University of Pennsylvania Law Review 150 (2002): 1795, 1840. 167. An explanation provided in the literature for the empirical pattern of interest to Bebchuk and his colleagues, that firms tend to be incorporated either in Delaware or in the state where they are headquartered, is that corporate lawyers have expertise in Delaware law and the law of the state in which they practice, and therefore it is transaction-cost reducing for them to advise their clients to select a domicile from among one of only those two choices. See Roberta Romano, “Law as a Product,” 273–76 (reincorporation decisions); Robert Daines, “How Firms Choose Corporate Law Rules: Some Evidence on Law, Lawyers and the Market for IPO Charters,” New York University School of Law, 2001 (IPO domicile decisions). The idea that lawyers dictate the choice of domicile as

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between Delaware and the headquarters state does not, however, provide a theory that is useful for Bebchuk and his colleagues’ principal hypothesis, that the basis for the choice between those two states is the relative number of takeover statutes. That is so because no plausible theory exists that can explain why lawyers in some large states, such as California, would discourage clients from local incorporations more than lawyers in other large states, such as Pennsylvania, depending on the number of takeover statutes, as those same lawyers are responsible for the enactment of the state codes that include takeover statutes. The large states comparison is the principal basis on which Bebchuk and his colleagues object to competition because of the success of large states with takeover statutes—they highlight in particular that more California- than Pennsylvania-headquartered firms go to Delaware, and the respective index values (count of takeover statutes) are for California zero, Pennsylvania five, and Delaware one. That difference presumably significantly contributes to their statistical results regarding the relation among domicile, firm size, and takeover statute index. The large state comparison is also relevant to the lawyer as decisionmaker theory of domicile choice because it controls for the fact that firm size appears to be larger in larger states. See Bebchuk, Cohen, and Ferrell, “Does the Evidence Favor State Competition in Corporate Law?” That comparison also controls for the fact that larger firms will be more likely to use large local law firms (or nonlocal law firms), whose partners will be versed in Delaware law. As the corporate bar is the key player in the adoption of corporation codes across the states, Bebchuk and his colleagues need to explain why, if California lawyers are advising their clients to incorporate in Delaware because of the absence of a takeover statute (particularly if that means they will lose business because non-California lawyers can also advise Delaware firms), that they have not pressured the legislature to enact a takeover statute similar to Delaware’s law. To put the problem more succinctly, if lawyers want in-state business and firms want takeover statutes, why do local lawyers not see to it that all states have all of the five takeover statutes that Bebchuk and his colleagues emphasize? Obviously, something else is going on in the decision to enact takeover statutes and to select a local domicile. Furthermore a lawyer as decisionmaker theory of domicile choice would not obviously produce the domicile selection that Bebchuk and his colleagues observe or consider relevant: firms in the smallest states, which do not have many large corporations and may, as a consequence,

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not have as many large law firms as larger states, should, under a lawyer as decisionmaker theory, retain the highest percentage of firms. But they do not. 168. See Bebchuk, “Federalism and the Corporation,” 1459 (“every public company makes an explicit or implicit reincorporation decision each year”). 169. See Romano, “Law as a Product.” 170. See, for example, Netter and Poulsen, “State Corporation Laws and Shareholders.” To continue the homeowner analogy, that situation is equivalent to homeowners’ considering whether to move when there is a market shock significantly affecting their prospects, such as a collapse in the local economy. 171. Nor do they provide a theoretical basis for their construction of a takeover statute variable as the sum of the presence or absence of five specific takeover statutes. There is no theory for adding up the number of takeover statutes in a code to rate its effectiveness to prevent a takeover, let alone for why such a sum would be relevant to a domicile choice. Namely, no data indicate that the number of such statutes is inversely correlated with the number of takeover attempts or the number of successful takeovers in a state. Nor do data indicate whether there are more negative price effects for a statute enacted in states with other takeover statutes or no other statutes. Furthermore, one of the takeover statutes included in the index, a statute permitting poison pills, measures absolutely nothing regarding a state’s regulation of takeovers, as state courts permit such defenses whether or not there is statutory authorization. The absence of an extant decision is not particularly important, despite Bebchuk and his colleagues’ claim that this justifies the statute’s inclusion: courts typically refer to other states’ decisions when faced with cases of first impression and, in particular, Delaware’s decisions, which have upheld poison pills. See, for example, Hilton Hotels Corp. v. ITT Corp., 978 F. Supp. 1342 (D. Nev. 1997) (Nevada would follow Delaware law on takeover defenses). From Bebchuk and his colleagues’ perspective, the preferable statutory variable to use to distinguish the states’ takeover regimes should instead be the presence of a takeover statute that they consider the most protective of managers (the most restrictive of hostile bids), which are the disgorgement and classified board statutes, as those have more negative price effects. Bebchuk and his colleagues understandably do not rely on that more plausible variable because, unlike their index, it turns out that it is not statistically significant. Finally, there are many other provisions in corporation codes besides the five they chose that can affect the probability of a successful takeover bid, such as

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whether shareholders can call special meetings. As earlier noted, John Coates has constructed an index that ranks the states according to their code’s cumulative potential impact on a bidder’s ability to replace the board, including such provisions, which is his measure of a state’s “hostility” or “friendliness” to takeovers. Bebchuk and his colleagues could have used his index and did not, yet they do not explain why their index is superior to Coates’s. Although Bebchuk and his colleagues do not provide a theory to justify their use of the sum of five takeover statutes as the crucial determinant of managers’ domicile choice, let me suggest an ad hoc explanation in support of use of a modified version of their index. As I discussed in earlier work, when a corporation is the subject of a hostile bid, in states other than Delaware the managers may be able to obtain legislative assistance in fending off the bid through a takeover statute bolstering their defenses. See Romano, “Future of Hostile Takeovers.” The strategy works particularly well when managers can instill in legislators concern over the loss of in-state employment upon a control change. Once a statute is in place, the hostile bidder for another domestic firm will adapt to its presence, and hence the new target will find that it needs another statute for protection. A responsive legislature will enact a second takeover statute. Managers might therefore consider the number of takeover statutes in a state code to be a proxy for the receptivity of the state legislature to come to a firm’s defense were it to become a target. Statutes adopted at the same time, however, would not be counted as two separate laws under that theory, a factor that would change the calculation of their index values, as Bebchuk and his colleagues do not make such a distinction. For example, Indiana adopted a control share acquisition and other constituency statute in the same legislation, as mentioned in note 134. A real-world calculation would, of course, not be limited to the five statutes used by Bebchuk and his colleagues, since several takeover statutes enacted at the behest of targets are not on their list, but would use all the possible takeover statutes, such as those included in Coates’s index. But even then, using such a criterion for domicile selection, or for takeover protection, would be risky. The political dynamics for obtaining a takeover statute are quite complicated. For example, in 1998, when one of the only Fortune 500 firms headquartered in Connecticut sought a takeover statute to block a hostile bid, the legislature did not enact it because the local union did not support incumbent management. See note 161. But in 1984 Connecticut enacted legislation in response to a local firm’s

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concern over a potential threat. See Romano, “Political Economy of Takeover Statutes,” 122–23. In fact, most targets of hostile bids are not the recipients of special takeover legislation. A better measure of a legislature’s responsiveness to target concerns for management would be the probability of receiving statutory protection, rather than the cruder measure of the sum of takeover statutes (that is, the percentage of domestic targets of hostile bids that sought and obtained legislative assistance). 172. The data and analysis in Bebchuk, Cohen, and Ferrell rely on the statistical analysis of the same data provided in Lucian Arye Bebchuk and Alma Cohen, “Firms’ Decisions Where to Incorporate,” Harvard University, 2002 (see tables 7, 10, and 11). 173. Bebchuk and his colleagues sometimes refer to their data as explaining “reincorporations,” but they have no actual data on reincorporations. Their data consist solely of firms’ current domiciles and headquarters locations. They assume that any firm for which those two differ has reincorporated away from the headquarters state. While that may be the proper inference to draw for many firms, another plausible possibility exists: the corporation has changed its headquarters. The firm discussed in the text, GTE, is one such example. Bebchuk and his colleagues have not collected and analyzed the data to ascertain which type of change explains their finding of divergences between physical and statutory domiciles and particularly the divergence in relation to the number of takeover statutes. Indeed, they essentially treat a firm’s choice of headquarters state as exogenous, in contrast to the choice of statutory domicile, but that is surely not appropriate: although it may be more costly to change physical than statutory domicile, the choice of headquarters is equally endogenous and would depend on numerous factors involving the general business environment, some of which may be influenced by corporate law rules. Guhan Subramanian provides a similar analysis of firms’ incorporation and physical locations in relation to takeover statutes and finds, like Bebchuk and his colleagues, that the presence of certain takeover statutes significantly affects firms’ domicile choice. See Subramanian, “Influence of Antitakeover Statutes.” Subramanian also has data on actual reincorporations, unlike Bebchuk and Cohen, but he does not use that information in his statistical analysis, as he puts it, “to minimize the bias against finding a race-to-the-bottom result” that might occur if only reincorporating firms were examined. Ibid. 1831. Instead, like Bebchuk and Cohen, he bases his

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analysis on differences in all corporations’ current domiciles and headquarters. That approach is especially problematic for reincorporating firms without information that he does not provide on the difference in successful classification between the actual reincorporation domiciles and his predicted domiciles derived from the pattern of all firms’ current domiciles and headquarters. Because he uses the same approach as Bebchuk and his colleagues to examine state competition, his work suffers from all the problems with their analysis and is accorded no separate critique. But it should further be noted that Subramanian includes no state-level variables besides the takeover statutes, and his regressions have even lower explanatory power than those of Bebchuk and Cohen (they explain only 4 to 6 percent of the variation in domicile-headquarters discrepancies). Those results again graphically raise the question whether there is some other feature about states besides takeover statutes that renders them successful in matching headquarters and domiciles. 174. The importance firms attribute to legal certainty, rather than takeover regulation, may well explain what Bebchuk and his colleagues identify as the failure of California to retain as many firms headquartered in it than do other states: in undertaking my 1985 study of firms’ reincorporation decisions, I interviewed several members of the California corporate bar. They all mentioned that they recommended a Delaware domicile because the unpredictability of California law prevented them from being able to provide quick legal opinions on business transactions, while they could readily do so under Delaware law. California firms were incorporating in Delaware in the early 1980s, a period well before there were any of the state takeover statutes that Bebchuk and his colleagues are summing (my interviews were undertaken in 1983, after the Supreme Court had overturned first-generation takeover statutes but before it had upheld second-generation ones). No reason exists to assume that legal certainty is not as important in the decision of California firms today as it was nearly twenty years ago. Bebchuk and his colleagues include a variable for a Model Act state which, in contrast to their summation of takeover statutes, is not significantly related to the choice of the headquarters state as domicile. The thirty-one states that have adopted a version of the Model Act in its entirety are small states with few corporations in Bebchuk and his colleagues’ data. Because many, if not most, of the provisions of the Model Act are also in the codes of states that have not adopted it in its entirety, including Delaware, which would not be classified as a Model

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Act state, the appropriate definition of what state is a Model Act state is, to say the least, murky. More important, Model Act states differ significantly in how quickly they conform their codes to Model Act revisions. See Carney, “Production of Corporate Law.” A state’s responsiveness to Model Act reforms is surely as important a factor as adherence to the Model Act in domicile decisions. Because Bebchuk and his colleagues do not grapple with the issues involving identification of Model Act states, varying rates of responsiveness to Model Act revisions, and the complications resulting from the correlation between reliance on the Model Act, the number of firms in a state (a variable that is included in the regressions), and the number of potential takeovers and takeover statutes, it is difficult to assess the robustness of the result regarding the Model Act. 175. See, for example, Krishna Palepu, “Predicting Takeover Targets: A Methodological and Empirical Analysis,” Journal of Accounting and Economics 8 (1986): 3; and Philip G. Berger and Eli Ofek, “Bustup Takeovers of Value-Destroying Diversified Firms,” Journal of Finance 51 (1996): 1175. 176. Romano, “Law as a Product,” 263. 177. Ibid., 264. 178. Baysinger and Butler, “The Role of Corporate Law in the Theory of the Firm.” 179. Winter, “State Law, Shareholder Protection, and the Theory of the Corporation”; Cary, “Federalism and Corporate Law.” 180. Close to 2,000 firms in Bebchuk and his colleagues’ data set went public after 1995. It should be noted that the explanation in the text is consistent with the event study results: namely, shareholders revise their wealth upward when firms leave states with numerous takeover statutes for Delaware. It is also consistent with Daines’s results that Delaware firms are worth more than firms in other states, particularly those with restrictive takeover statutes. 181. Moreover, to the extent that the enactment of a takeover statute depresses stock prices, the poorly run firms covered by the statute will ironically become even better candidates for a takeover bid, as there would be a larger range over which firm value could be improved; even Bebchuk and his colleagues do not claim that any of the takeover statutes that lead to a state’s success against Delaware as domicile are potent enough to kill a bid.

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182. See, for example, Gillan and Starks, “Corporate Governance Proposals and Shareholder Activism”; Del Guercio and Hawkins, “The Motivation and Impact of Pension Fund Activism.” 183. Using their data, I calculated the change in the value of the index: it declines to 1 (Delaware’s value) from an average of 2.6, for a mean difference of --1.576, which is statistically significant at .0001. That compares with a similarly significant difference in mean index value, in the opposite direction, of +1.03 (3.11 in the headquarters state and 4.13 in the domicile state) for firms incorporated outside their headquarters in a state other than Delaware. See Bebchuk and Cohen, “Firms’ Decisions Where to Incorporate,” A-13 (table 12b). Bebchuk and his colleagues disregard the low rank of Delaware on their index by suggesting that Delaware’s case law is equivalent to having the five statutes with which they construct their index. That reasoning is mistaken. First, the Delaware Supreme Court expressly rejected the substance of other constituency statutes, one of the statutory index set, in holding that the board cannot consider interests of other constituents unless to do so provides a benefit to the shareholders in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A. 2d 173 (Del. 1985). Second, the Delaware courts have not required and undoubtedly could not require corporations to comply with the specifications imposed on transactions by the fair price and control share acquisition statutes that are also in the index. Namely, they have not specified that bidders must always pay in the second step of a takeout merger the highest price as defined in the fair price statutes, nor do they require a majority vote before a bidder can purchase shares with voting rights from a target, as mandated by control share acquisition statutes. Indeed, no Delaware court has ever refused to count the votes of shares transferred after a bid has been announced in a proxy fight accompanying a bid to replace board members to redeem a poison pill, the voting rule mandated by control share acquisition statutes. It should be further noted that the Delaware bar, on recommending enactment of the business combination statute, expressly rejected the other statutes as inefficacious and thereby committed Delaware to only one statute, as all legislation on corporate law in Delaware is undertaken upon recommendation of the corporate bar. The remaining statute in the index not enacted by the Delaware legislature, a poison pill statute, is arguably equivalent to the Delaware courts’ practice, as Delaware courts permit poison pills. But even that comparison is inapt. Some states

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that adopted poison pill statutes include in their codes express legislative statements on directors’ fiduciary duties regarding poison pills and direct their state courts not to adjudicate when pills are to be redeemed so as to restrict their state courts’ authority compared with that of the Delaware courts that had ordered pill redemptions in a few cases. See Burns Indiana Code Annotated § 28-13-11-6 (b) and (c) (providing that directors are not required to redeem a poison pill adopted under the statute because of the effect it would have on a proposed takeover and that “certain judicial decisions in Delaware and other jurisdictions, which might otherwise be looked to for guidance in interpreting the duties of directors of corporations, including decisions relating to potential change of control that impose a different or higher degree of scrutiny . . . are inconsistent with the proper application of the business judgment rule under this article. . . . Therefore the general assembly intends to reaffirm that this section allows directors the full discretion to weigh the factors . . . they consider appropriate”); and Pennsylvania Consolidated Statutes 15 § 1715 (“the fiduciary duty of directors shall not be deemed to require them to redeem any rights plan”). Moreover, some state poison pill statutes authorize the “deadhand” variety, such as Official Code of Georgia Annotated §14-2-624, which the Delaware courts have expressly prohibited, for example, in Quickturn Design Systems, Inc. v. Mentor Graphics Corp., 721 A. 2d 1281 (Del. 1998). And again in contrast to Delaware, the courts that have upheld deadhand pills are located in states with poison pill statutes. See Invacare Corp. v. Healthdyne Technologies, Inc., 968 F. Supp. 1578 (N.D. Ga. 1997); and AMP Inc. v. Allied Signal, Inc., 1998 U.S. Dist. LEXIS 15617 (E.D. Penn.). More important, even if one treats the judicial approach in Delaware as equivalent to a poison pill statute and assigns Delaware a score of two rather than one on Bebchuk and his colleagues’ takeover statute index, there is still a significant decline in index value (that is, less takeover protection) for the firms incorporated in Delaware but headquartered elsewhere: the mean difference is a decrease of --.576, which is statistically significant at .03, and that value is still lower than the average value of the index of both the origin and destination states of the non-Delaware-domiciled firms whose domicile and headquarters state differ. 184. See Bebchuk and Ferrell, “Federalism and Corporate Law”; Bebchuk, “Toward Undistorted Choice.” 185. The other potential equilibrium under Bebchuk and his colleagues’ analysis were competition to work well, a uniform distribution of firms across

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the states with uniform codes, is also not the predicted equilibrium when the transaction-cost explanation of reincorporations is taken into account. That is because, as earlier discussed, states do not immediately copy the corporate law innovations introduced by Delaware, but rather, the reforms diffuse across the states over time, with an end product tending toward uniformity. Thus, states’ shares of incorporations should vary rather than be uniform at any point in time, as those states that were slow to enact a reform provision lose the firms for whose value the provision is most important to reform-pioneering states. For example, Delaware’s 1967 code revision that reduced the cost of acquisitions would have been of great import to firms engaged in active mergers and acquisition programs, and such firms would be the first to move to Delaware if a similar enactment by their home state did not seem to be in the immediate offing. 186. Shareholders can propose a domicile change under the SEC rules governing proxy submissions, but they cannot compel reincorporation if management is not supportive, because a change in domicile is accomplished by merger of the existing corporation into a shell corporation incorporated in the new domicile, and state law requires the board’s approval of a merger. See, for example, Delaware Code Annotated, title 8, §§ 251–252. In his formal model with other colleagues, Bebchuk appears to attribute the failure of state competition—its production of redistributive rules favoring managers—to the requirement that firm managers approve domicile changes, which implies that state competition would be a “race to the top” if shareholders could do so on their own. Bar-Gill, Barzuza, and Bebchuk, “A Model of State Competition in Corporate Law,” 33. 187. Romano, “Future of Hostile Takeovers,” 475–85. 188. See, for example, Easterbrook and Fischel, Economic Structure of Corporate Law, 224–25. 189. See note 151 in this chapter. 190. See Bebchuk and Ferrell, “Federalism and Corporate Law,” 1192. 191. Romano, “Future of Hostile Takeovers,” 470–73. The majority of the bills were directed at regulating tender offers generally (86 bills), restricting acquisitions in specific industries (49 bills) or by foreign purchasers (49 bills), and discouraging takeovers by increasing the tax on such transactions (28 bills). Ibid., 472. One would be hard-pressed to characterize those bills as being even

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remotely related to the type of regulation that Bebchuk and Ferrell seek from the federal government. 192. It should be noted that the London Code is not, as Bebchuk and Ferrell maintain, a market-based regulatory choice, and hence the alleged optimality of the London Code because it represents a free market choice is questionable. Although the Takeover Panel is not an official state organ or self-regulatory body, the official self-regulatory bodies that have monopoly licensing power over market professionals require their compliance with the Code of Conduct, and compliance is therefore decidedly not voluntary. Moreover, the Bank of England was a key force behind the Takeover Panel’s creation and appoints many of its members. See Brian R. Cheffins, Company Law: Theory, Structure, and Operation (New York: Clarendon Press, 1997), 407. 193. See, for example, John C. Coates IV, “Takeover Defenses in the Shadow of the Pill: A Critique of the Scientific Evidence,” Texas Law Review 79 (2000): 271 (indicating that shareholders have not approved midstream defenses in the 1990s). 194. See, for example, Quickturn Design Systems v. Mentor Graphics Corp., 721 A.2d 1281 (Del. 1998) (striking down deadhand pill that impaired proxy fight); and Chesapeake Corp. v. Shore, 771 A.2d 293 (Del. Ch. 2000) (striking down bylaw requiring a supermajority vote to amend bylaw, aimed at preventing bidder from removing bylaw establishing a staggered board). While proxy fights are not likely to take much longer than the success of a tender offer itself, depending upon a firm’s specific charter and bylaws and state law defaults, in John Coates’s estimation, proxy fights can take from six to eighteen months. See Coates, “Index of Contestability of Corporate Control.” 195. See, for example, Maine Revised Statutes Annotated, title 13-A, § 910 (redemption rights statute, requiring purchase of all shares upon 30 percent block acquisition). Other statutes have similar effect, by restricting what bidders for less than 100 percent of the stock (or those who obtain less than 100 percent) can do. See, for example, Maryland Corporations and Associations Code Annotated § 3-601 and ff. (fair price provision, restricting price in second step merger after acquisition of control); Delaware Code Annotated, title 8, § 203 (business combination freeze statute limiting actions bidder can take with respect to target assets after obtaining control). 196. See, for example, Linn and McConnell, “Empirical Investigation of the Impact of ‘Antitakeover’ Amendments”; Jarrell and Poulsen, “Shark Repellents and Stock Prices.”

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197. See Robert Comment and Gregg A. Jarrell, “Two-Tier and Negotiated Tender Offers: The Imprisonment of the Free-Riding Shareholder,” Journal of Financial Economics 19 (1987): 283. 198. See City Capital Associates v. Interco, 551 A.2d 787 (Del. Ch. 1988). The Delaware Supreme Court indicated that if the Chancery Court in Interco substituted its own judgment for what was a “better deal” over that of the board of directors, then the analysis was improper under the Unocal standard. See Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140, 1153 (Del. 1989). But the Delaware Supreme Court did not indicate that it would have reversed on the substantive result, nor would its more recent interpretations of the Unocal standard indicate otherwise, as a defense cannot be “preclusive” of a bid, and the Chancery Court in Interco found the failure to redeem the pill in that case preclusive. See Unitrin, Inc. v. American General Corp., 651 A.2d 1361 (Del. 1995). 199. See, for example, Chesapeake Corp. v. Shore, 771 A.2d 293 (Del. Ch. 2000) (striking down bylaw amendment that required supermajority vote of shareholders to amend bylaws); Blasius Industries v. Atlas Corp., 564 A.2d 651 (Del. Ch. 1988) (striking down bylaw amendments that impaired consent solicitation); Quickturn Design Systems v. Mentor Graphics Corp., 721 A.2d 1281 (Del. 1998) (striking down deadhand pill that impaired proxy fight); Carmody v. Toll Brothers, 723 A.2d 1180 (Del. Ch. 1998) (same). It should be noted further that the Delaware courts, notwithstanding Bebchuk and Ferrell’s contention, do not unambiguously permit a “just-say-no defense.” In both cases that they cite for that proposition, although the efficacy of management’s action could certainly be debated, the target management had proposed an alternative plan to the hostile bid, a merger in one case and a stock repurchase in the other. But even if they are correct regarding approval of a just-say-no defense, in practice that is not a viable strategy for management. Shareholders who lose out on a substantial premium and receive no cash payment (as in a stock repurchase defense) or follow-up bid are disgruntled investors who can make life difficult for managers, especially as it is understood that they will be receptive to opposition to management proposals, including director nominees. Even Martin Lipton, a prominent takeover lawyer who interprets the Delaware decisions as permitting a just-say-no defense, recognizes that such a defense is not likely to be available in practice. See Martin Lipton, “Takeover Response Checklist,” Aspen Law and Business Corporation 72

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(June 1, 2001): 1, 6. Hence, it is difficult to view the action by the Delaware courts as significant evidence in the construction of a case against competition. 200. See, for example, Invacare Corp. v. Healthdyne Technologies Inc., 968 F. Supp. 1578 (N.D. Ga. 1997) (upholding deadhand pill under Georgia law); Amp Inc. v. Allied Signal Inc., 1998 U.S. Dist. LEXIS 15617 (E.D. Pa. October 8, 1998) (upholding deadhand pill under Pennsylvania law). The Georgia legislature subsequently enacted a statute expressly permitting deadhand pills, out of concern that the Delaware state court decisions invalidating such pills, cited in note 199, had created uncertainty regarding the defense’s validity under the federal court decision in Invacare. See “Notes to 2000 Amendment,” Official Code of Georgia Annotated § 14-2-624. 201. See, for example, Rafael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, “Corporate Ownership around the World,” Journal of Finance 54 (1999): 471. 202. See, for example, Rafael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, “Legal Determinants of External Finance,” Journal of Finance 52 (1997): 1131; LaPorta, Lopez-de-Silanes, Shleifer, and Vishny, “Corporate Ownership around the World,” 471. That the United Kingdom does as well as the United States in those comparative studies suggests that an important source for cross-country discrepancies is the common law tradition. A distinguishing feature of the common law tradition, compared with that of civil law, is its decentralized political tradition of limited government. See, for example, Paul G. Mahoney, “The Common Law and Economic Growth: Hayek Might Be Right,” Journal of Legal Studies 30 (2001): 503. The U.S. corporate law regime epitomizes that tradition. It should further be noted that while LaPorta and his colleagues stress the similarities in market depth and ownership structure between the United States and the United Kingdom, British scholars have emphasized the differences in legal institutions and the timing of the dispersion of stock ownership across the two nations. See, for example, Brian R. Cheffins, “Does Law Matter? The Separation of Ownership and Control in the United Kingdom,” Journal of Legal Studies 30 (2001): 459. Cheffins suggests that private organizations in the United Kingdom fulfilled the role played by the legal system in the United States during the nineteenth and early twentieth centuries. The decentralized structure of those institutions, in contrast to the United Kingdom’s national corporation statute, might have approximated the competitiveness of the U.S. charter market.

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203. See Jeffrey Wurgler, “Financial Markets and the Allocation of Capital,” Journal of Financial Economics 58 (2000): 187. 204. See Romano, Genius of American Corporate Law, 122–28 (discussing why charter competition has not emerged in the Canadian context); Michael J. Whincop, “The Political Economy of Corporate Law Reform in Australia,” Federal Law Review 27 (1999): 77 (discussing the absence of competition in Australia).

Chapter 4: Implementing Competitive Federalism for Securities Regulation 1. 457 U.S. 624, 640–46 (1982). A plurality of the Court in MITE further held that the state takeover statute was preempted by the federal statute. See ibid., 634–40. 2. See National Securities Markets Improvement Act of 1996, Pub. L. No. 104290, § 105, 110 Stat. 3416, 3423 (codified in 15 U.S.C. §§ 77z-3, 78mm). 3. For an analysis of the SEC’s failed effort to expand its jurisdiction to include derivative securities, see Roberta Romano, “The Political Dynamics of Derivative Securities Regulation,” Yale Journal on Regulation 14 (1997): 355–80. 4. See National Securities Markets Improvement Act § 102, 110 Stat. 3417 (codified in 15 U.S.C. § 77r). 5. See 17 C.F.R. § 240.15c2-11. 6. See Business Roundtable v. SEC, 905 F.2d 406 (D.C. Cir. 1990). 7. I adopt here terminology more commonly used in the international, as opposed to domestic, law setting. According to Gary B. Born, International Civil Litigation in United States Courts: Commentary and Materials, 3d ed. (Boston: Kluwer Law International, 1996), 491, legislative or prescriptive jurisdiction is “the authority of a state to make its laws applicable to particular conduct, relationships or status” (whether or not that state is the forum state), as distinct from judicial jurisdiction, the power of a court to adjudicate a dispute, which, for U.S. courts, requires both personal jurisdiction and subject-matter jurisdiction. Ibid., 1–2. The federal securities laws confer both prescriptive and subject-matter jurisdiction on federal courts. 8. See Uniform Securities Act § 414, 7B U.L.A. 672 (1985). See also, for example, California Corporation Code § 25008 (Deering) (codifying section 414).

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9. See, for example, Orman v. Charles Schwab & Co., 676 N.E. 2d 241, 246 (Ill. App. Ct. 1996) (refusing to apply state law to claims against broker because such application would frustrate, if not destroy, the goal of federal uniformity and stating that “if uniformity is not to prevail, neither rule 10b-10 nor the SEC would serve any function or purpose in regulating disclosure”). 10. See Frank H. Easterbrook and Daniel R. Fischel, The Economic Structure of Corporate Law (Cambridge: Harvard University Press, 1991), 285. 11. See Restatement (Second) of Conflicts of Law (Philadelphia: American Law Institute, 1971), § 302. 12. See Easterbrook and Fischel, Economic Structure of Corporate Law, 301. 13. Robert A. Leflar, Luther L. McDougal III, and Robert L. Felix, American Conflicts Law, 4th ed. (Charlottesville, Va.: Michie Co., 1986), 700. For a similar analysis by a choice-of-law scholar who specializes in corporate law issues, see P. John Kozyris, “Some Observations on State Regulation of Multistate Takeovers—Controlling Choice of Law through the Commerce Clause,” Delaware Journal of Corporate Law 14 (1989): 499, 509–11. 14. Restatement (Second) of Conflicts of Law § 302 comment e. 15. CTS Corporation v. Dynamics Corporation of America, 481 U.S. 69, 89 (1987). For an analysis of the relation of the CTS decision to the corporate choiceof-law rule, see Kozyris, “Some Observations on State Regulation of Multistate Takeovers.” 16. For a discussion of the duty of full disclosure, see Lawrence A. Hamermesh, “Calling Off the Lynch Mob: The Corporate Directors’ Fiduciary Disclosure Duty,” Vanderbilt Law Review 49 (1996): 1087. 17. See Vincent E. O’Brien, A Study of Class Action Securities Fraud Cases 1988–1996, 4, available at www.lecg.com/study2.htm#att; accessed December 28, 1997. See also Joseph A. Grundfest and Michael A. Perino, “Securities Litigation Reform: The First Year’s Experience,” Stanford Law School, John M. Olin Program in Law and Economics working paper no. 140, 1997, 9, 31. 18. Compare Amchem Products, Inc. v. Windsor, 521 U.S. 591, 624–25 (1997) (affirming the appellate court’s rejection of an asbestos class action settlement for failing to meet statutory class requirements and suggesting that the predominance of common issues that is a problem in mass torts may not be a problem in securities fraud). In a small number of securities cases, the courts have referred to the class certification issue in passing and largely ignored it when certifying the

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federal class, adding, on occasion, the proviso that the class could be decertified or divided up at a later date if individual state law issues presented a problem. See, for example, Lubin v. Sybedon Corp., 688 F. Supp. 1425, 1460–61 (S.D. Cal. 1988) (holding that for purposes of the state securities claim, the federal class, if certified, would need to be divided into subclasses of California and nonCalifornia investors); Weinberger v. Jackson, 102 F.R.D. 839, 847 (N.D. Ca. 1984) (certifying a class despite the assertion that the need for individual determinations of state law applicable to members’ claims would overwhelm the commonality of the class, by finding the assertion of a conflicts problem premature as the defendants did not show that there was a true conflict among states’ interests). Moreover, when the federal suit thereafter settled, there was either no mention of the individual state law determination issue (see Weinberger v. Jackson, No. C-89-2301-CAL, 1991 U.S. Dist. LEXIS 3938 (N.D. Cal. March 19, 1991), or the federal class was certified without any mention of the need to subdivide it for the state claims (see, for example, In re U.S. Grant Hotel Association Securities Litigation, 740 F. Supp. 1460, 1464 (S.D. Ca. 1990) (declaring settlement of the Lubin v. Sybedon Corp. litigation). Matsushita Electric Industrial Co. v. Epstein, 516 U.S. 367 (1996), in which a state court settlement disposed of federal securities claims, did not raise the multijurisdictional issue because the state class action was a corporate law claim for breach of fiduciary duty and thus only one state’s law applied to the class members. See ibid., 882. 19. See, for example, James D. Cox, Robert W. Hillman, and Donald C. Langevoort, Securities Regulation Cases and Materials, 3d ed. (Gaithersburg, Md.: Aspen Law and Business, 2001), 808 (the “most notable” exemption in the 1998 Securities Litigation Uniform Standards Act preempting state securities actions is the “so-called Delaware carve-out” that preserves state court jurisdiction over certain fiduciary claims). 20. Compare Clay Harris, “European Regulators Probe Defunct ‘Virtual’ Brokerage,” Financial Times, December 22, 1997 (reporting that an Internet broker that sold U.S. over-the-counter shares globally was being investigated by four nations’ regulators after operations ceased). 21. See, for example, Restatement (Second) of Conflicts of Law § 302 comment e; Kozyris, “Some Observations on State Regulation of Multistate Takeovers,” 520–21. 22. See Kozyris, “Some Observations on State Regulation of Multistate Takeovers,” 521.

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23. See, for example, Born, International Civil Litigation, 654–55 (stating that the contemporary approach in U.S. law regards choice-of-law provisions as presumptively enforceable); Leflar, McDougal, and Felix, American Conflicts Law, 415–19 (noting that authorities generally both approve of the right of parties to determine themselves what law governs contracts and prefer that basis for contract choice of law (citing Restatement (Second) of Conflicts of Law § 187)). 24. See, for example, Born, International Civil Litigation, 655, 661; Leflar, McDougal, and Felix, American Conflicts Law, 416–17. Compare The Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 12–13, 15–16 (1972) (expressing similar concerns in enforcement of choice-of-forum clause). 25. See Roby v. Corporation of Lloyd’s, 996 F.2d 1353, 1365-66 (2d Cir. 1993) (upholding a United Kingdom choice-of-law contract provision over federal securities law claims, while noting the adequacy of remedies in English law). The adequacy-of-the-remedy prong of the Supreme Court’s exemptions from upholding contractual choice-of-law clauses has been raised in securities law cases because the federal securities laws prohibit waiver of compliance. See 15 U.S.C. §§ 77n, 78cc(a). Were the federal statutes optional, the antiwaiver provisions would not apply to firms opting out of the federal regime, and the argument against enforcing a choice-of-law clause would be even more attenuated than it is at present. 26. See Leflar, McDougal, and Felix, American Conflicts Law, 417 n. 18 (discussing the relationship between the “reasonable relation” requirement and the public policy limitation on choice-of-law clauses under the Uniform Commercial Code). For an excellent analysis of choice-of-law rules that rejects the reigning state interest approach in favor of the interest of the parties to the dispute and that supports the internal affairs approach to securities domicile advocated in this book, see Michael J. Whincop and Mary Keyes, Policy and Pragmatism in the Conflict of Laws (Burlington, Vt.: Ashgate and Dartmouth Publishing Cos., 2001). A recent decision of the Kansas Supreme Court that went against the trend of enforcing contractual choices illustrates the lawlessness of that approach. The court refused to enforce a choice-of-law provision in a brokerage contract on public policy grounds—“the state’s strong interest in protecting investors”—because the defendant was not liable under the law of the selected domicile but could be held liable under Kansas law. Brenner v. Oppenheimer & Co., 44 P. 3d 364 (Kan. 2002). The plaintiffs had purchased securities from an out-of-state broker that were not registered in Kansas.

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(An out-of-state purchase in the secondary market of a security not registered instate is not illegal if the transaction is unsolicited.) After withdrawing an arbitration claim that they had filed against the introducing broker—who went bankrupt— and the clearing broker, the plaintiffs sued the clearing broker (who had not solicited the purchase) on the theory that it had “aided and abetted” the sale of unregistered securities in violation of Kansas law. The court’s reasoning in invalidating the contract clause is typical of the state interest analysis approach to conflicts of law critiqued by Whincop and Keyes (18): unprincipled adjudication motivated by the desire to ensure in-state plaintiffs’ ability to recover damages. The court found that both states had the requisite contacts to assert jurisdiction and selected its own law (the law of the forum) over the law specified in the contract because the plaintiff would lose if the forum’s law was not applied. 27. The Restatement (Second) of Conflicts of Law (§ 187, comment f), the Uniform Commercial Code (§ 1-105), and many states recognize that geographic contacts may be unnecessary for parties’ effective choice. See, for example, New York General Obligations Law § 5-1401. See also Leflar, McDougal, and Felix, American Conflicts Law, 417–18 (discussing the implications of the New York provision). 28. See, for example, California Corporations Code § 25008 (codifying Uniform Securities Act § 414, 7B U.L.A. 672). 29. See, for example, Delaware Code Annotated, title 6, § 2708(c)(ii) (requiring a $100,000 minimum contractual amount); N.Y. General Obligations Law § 5-1404 (requiring a $250,000 minimum contractual amount). 30. See Leflar, McDougal, and Felix, American Conflicts Law, 6: [A]ssuming that the local law of a particular American state permits one of its courts to act in a given instance, the only authority which can effectively say that the court may not apply the law that it chooses is that of the federal government, under the powers delegated to it by the Federal Constitution. There is a well-established judicial tradition upholding forum clauses in commercial contexts, including securities transactions. See, for example, Scherk v. Alberto-Culver Co., 417 U.S. 506 (1974); The Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 18–19 (1972). But to the extent that there might be a question whether firms opting out of the federal regime can also opt out of the federal court system, the congressional legislation establishing the market approach

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should specify that federal courts are to enforce forum clauses selecting a state court. 31. See Michael E. Solimine, “Forum-Selection Clauses and the Privatization of Procedure,” Cornell International Law Journal 25 (1992): 51, 75–76. 32. See Scherk v. Alberto-Culver Co., 417 U.S. 506 (1974); The Bremen v. Zapata Off-Shore Co., 407 U.S. 1 (1972). 33. See Solimine, “Forum-Selection Clauses,” 55, 63, and n. 84 (“[A]t least four states explicitly reject . . . such clauses.”). 34. See Roberta Romano, The Genius of American Corporate Law (Washington, D.C.: AEI Press, 1993), 132–33. 35. Indeed, two Supreme Court cases interpreting the federal securities law illustrate the difficulties created by the two regimes’ being different. In Basic Inc. v. Levinson, 485 U.S. 224, 232–34 (1988), while imposing disclosure duties on managers regarding merger negotiations, the Court rejected as a valid concern the acquirer’s desire for secrecy when nondisclosure for such reasons would not be a breach of fiduciary duty at state law. In Virginia Bankshares Inc. v. Sandberg, 501 U.S. 1083, 1102–6 (1991), a case involving proxy statement misstatements, the Court did not find the requisite causation for a private right of action under section 14(a) of the 1934 act, 15 U.S.C. § 78n(a), where the complaining shareholders’ votes were not required by state law to authorize the action subject to the proxy solicitation. The Court left open the question whether there would be sufficient causation if the shareholders lost a state remedy otherwise available because of the misstatement. See Virginia Bankshares, 501 U.S. 1107–8. 36. Compare 17 C.F.R. §§ 240.14a-8(c)(1) and (7) (stating that firms can exclude proposals that are “not a proper subject for action by security holders” and involving “ordinary business operations”) with “Adoption of Amendments Relating to Proposals by Security Holders,” Exchange Act Release No. 12999, Federal Register 41 (1976): 52994 (permitting, where the subject is not proper for shareholder action, proposals couched in precatory language because recommendations to the board are not improper actions at state law, and permitting proposals involving ordinary business, such as employment practices, where they implicate social policy). 37. Such clauses are presumptively enforced at federal common law and by most states. See Carnival Cruise Lines, Inc. v. Shute, 499 U.S. 585, 593–95 (1991); Solimine, “Forum-Selection Clauses,” 63, 69.

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38. See, for example, Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173, 182 (Del. 1985) (finding that a board breached its fiduciary duty to shareholders in engaging in takeover defensive tactic that protected noteholders, whose rights are a matter of contract); Harff v. Kekorian, 324 A.2d 215, 219–20 (Del. Ch. 1974) (stating that bondholders cannot bring a derivative suit), reversed on other grounds, 347 A.2d 133, 134 (Del. 1975). A corporate code would be relevant for a bond contract only when a corporation is close to insolvency, for at that point some states might hold that the board’s fiduciary duty encompasses creditors. See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., No. 12150, 1991 Del. Ch. LEXIS 215, at *108 (Del. Ch. December 30, 1991) (suggesting that a board’s duty shifts away from shareholders when company enters the “vicinity of insolvency”). 39. See Albert Breton, Competitive Governments: An Economic Theory of Politics and Public Finance (New York: Cambridge University Press, 1996), 251. 40. Of course, not every investor needs to know a stock’s domicile; the informed investors will set the price. That is the meaning of an efficient market. The best available evidence indicates that the U.S. stock market is efficient regarding publicly available information. See Eugene Fama, “Efficient Capital Markets: II,” Journal of Finance 46 (1991): 1575, 1577, 1607 (stating that event studies, which test the “adjustment of prices to public announcements,” provide the “cleanest evidence on market efficiency”). For general models of information aggregation through prices with heterogeneously informed investors, see Alan Schwartz and Louis Wilde, “Competitive Equilibria in Markets for Heterogeneous Search Goods under Imperfect Information: A Theoretical Analysis with Policy Implications,” Bell Journal of Economics 13 (1982): 181; Michael J. Fishman and Kathleen M. Hagerty, “Mandatory vs. Voluntary Disclosure in Markets with Informed and Uninformed Customers,” Kellogg School of Management, Northwestern University, 1999; Ronald A. Dye, “Investor Sophistication and Voluntary Disclosures,” Review of Accounting Studies 3 (1998): 261. 41. See, for example, Delaware Code Annotated, title 8, § 202(a). 42. In the international context, as discussed in chapter 5, a further disclosure requirement might be necessary regarding aberrant regimes, as it is conceivable, albeit unlikely, that a small nation might adopt a regime with no fraud liability. Because all states currently have such liability in their securities and corporate codes, that is not a concern for competitive federalism in the domestic context.

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43. For empirical support that shares with less legal protection trade at a discount, see Luigi Zingales, “The Value of the Voting Right: A Study of the Milan Stock Exchange Experience,” Review of Financial Studies 7 (1994): 125 (discount for low or nonvoting shares greater in countries with less shareholder protection); and Rafael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, “Legal Determinants of External Finance,” Journal of Finance 52 (1997): 1131 (firms in nations with greater shareholder protections have better access to external finance, that is, capital markets are larger and deeper). 44. See Venky Nagar, Dhananjay Nanda, and Peter D. Wysocki, “Compensation Policy and Discretionary Disclosure,” University of Michigan Business School, 2000, 20–21, 23–24 (finding the frequency of voluntary earnings forecasts and analyst ratings of disclosure quality, controlling for other determinants of disclosure, are significantly positively correlated with the proportion of CEO compensation dependent upon stock prices, and concluding this evidences optimal contracting between shareholders and managers). 45. A change in incorporation state—the firm’s statutory domicile—requires a shareholder vote because it is effected by a merger of the corporation into a subsidiary incorporated in the new domicile state, and under all state corporation codes a merger requires approval of the shareholders of the nonsurviving corporation. See, for example, Delaware Code Annotated, title 8, §§ 251–252. 46. See, for example, Jeffrey N. Gordon, “The Mandatory Structure of Corporate Law,” Columbia Law Review 89 (1989): 1549, 1575. 47. See Roberta Romano, “Answering the Wrong Question: The Tenuous Case for Mandatory Corporate Laws,” Columbia Law Review 89 (1989): 1607–10. 48. See “New Websites Post Proxy Voting Activity,” IRRC Corporate Governance Highlights 10 (April 16, 1999): 65 (Domini Social Investments, a socially responsible investment fund, is posting how its Equity Fund has voted shares in its 400 portfolio firms as well as adding an investor activism center with information on social issue proxy proposals and permitting e-mail to CEOs of targeted firms); Steve Hemmerick, “Internet Helps Link Shareholders,” Pensions and Investments, July 27, 1998, 3 (discussing how networking on Internet has linked individual and institutional shareholders on corporate governance issues). Large organizations with Web sites detailing their corporate governance activities include the California Public Employees Retirement System, the AFL-CIO, and the Council of Institutional Investors, an organization of public and private

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pension funds that serves as a clearinghouse for the funds’ corporate governance activities. 49. See, for example, Delaware Code Annotated, title 8, § 262 (providing appraisal rights in conjunction with mergers that require shareholder approval); Model Business Corporation Act § 13.02 (providing appraisal rights in conjunction with mergers, asset sales, amendments of articles of incorporation that materially and adversely affect shares by specified impact, and any actions taken pursuant to a shareholder vote where charter, bylaws, or board resolution would provide for such rights). 50. See, for example, Delaware Code Annotated, title 8, § 262(h) (providing that for merger dissenters entitled to appraisal, court to determine “fair value exclusive of any element of value arising from” the merger). 51. In the course of over a decade of research in which I have examined hundreds of corporate charters, I have not come across such a provision. 52. The figures in table 4-1 provide a conservative estimate of the profitability of Delaware’s chartering business because they overstate its expenditures by including, in addition to the appropriations for the Division of Corporations in the Office of the Secretary of State, which administers the corporate registration process, the total appropriations for the Delaware Chancery Court and Supreme Court, which hear corporate law cases at trial and on appeal, respectively, although such cases are a fraction of their caseload. For example, only 30 percent of Chancery Court cases are corporate law cases. See “Chancery Court High Stakes in Delaware,” National Law Journal (February 13, 1984): 32. In addition, the outlays for the Division of Corporations were separately itemized only after 1972; for the years before 1972, the table includes the entire appropriation for the secretary’s office, although in the subsequent years the ratio of the budget for the division to the budget for the office is slightly under 80 percent. 53. The bulk of the SEC’s fee revenue comes from securities registrations, followed closely by fees from transactions. For example, in 2000, fees for securities registrations accounted for 49 percent of the agency’s fee revenue, and fees for securities transactions comprised a further 48 percent, compared with 54 percent (58 percent) and 38 percent (36 percent) for securities registrations and transactions, respectively, in 1999 (1998). SEC 2000 Annual Report, available at www.sec.gov/pdf/annrep01; SEC 1999 Annual Report, available at www.sec.gov/pdf/annrep99/ar99full.pdf; SEC 1998 Annual Report, available

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at www.sec.gov/asec/annrep98. The figures for fees collected in the 1960s and 1970s include the fees from the registration of exchanges and brokers as well as securities. See, for example, SEC 33d Annual Report (Washington, D.C.: Government Printing Office, 1967), 149 (figures for 1965–1967); SEC Annual Report 36 (1970), 210 (figures for 1968–1970). 54. See Congressional Budget Office, 104th Cong., 1st Sess., Memorandum: Growth of Federal User Charges: An Update, committee print, 1995. The SEC’s revenue is so great that for many years it sought to be self-financing without success, as Congress did not want to give up the surplus produced for general revenues. Of the $1.76 billion in fees it raised in 1999, for example, only $214 million were used to fund the agency. SEC 1999 Annual Report, 125. In 1996 Congress enacted legislation reducing SEC fees over a ten-year period with the intent that no more in fees will be collected than it costs to run the agency. See National Securities Markets Improvement Act of 1996, Pub. L. No. 104-290, §§ 402–405, 110 Stat. 3416, 3441–44 (codified in 15 U.S.C. §§ 78a, 77f(b), 78ee). The SEC’s contribution to general revenues was eliminated in full in 2002, when Congress reduced the fees collected by the SEC and mandated that in all succeeding fiscal years “no [such] fees [are to] be deposited and credited as general revenue of the Treasury.” See Investor and Capital Markets Fee Relief Act, Pub. L. No. 107-123, to be codified in 15 U.S.C. §§ 78ee, 77f(b), 78m(e), 78n(g), and 77ggg(b), enacted January 16, 2002. The 1996 legislation also restricted states’ ability to charge filing fees for the registration of securities traded on national exchanges, at the same time as it preempted their ability to regulate such issues’ registration. See National Securities Markets Improvement Act § 102(a), 102(c)(2)(D), 110 Stat., 3417, 3420 (codified in 15 U.S.C. § 77r). Competitive federalism for securities regulation would require a rewording of that restriction to permit the issuer’s securities domicile alone to charge such fees, whether the domicile is a state, foreign country, or the SEC. 55. See Roberta Romano, “Law as a Product: Some Pieces of the Incorporation Puzzle,” Journal of Law, Economics, and Organization 1 (1985): 257; and Marcel Kahan and Ehud Kamar, “Price Discrimination in the Market for Corporate Law,” Cornell Law Review 86 (2001): 1205. As previously noted, Kahan and Kamar view that phenomenon as receipt of monopoly rents that are due to lack of competition rather than to product superiority. 56. See Colin Jamieson, “Stamp Duties in the European Community: Harmonisation by Abolition?” British Tax Review 1991 (1991): 318–19.

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57. See, for example, Thomas L. Hazen, The Law of Securities Regulation, 3d ed. (St. Paul, Minn.: West Publishing, 1996), 769, 773 (discussing the courts’ expansion of statutory scope). While the 1934 act provides the federal courts with exclusive jurisdiction for 1934 act violations (15 U.S.C. § 78aa), the 1933 act does not (15 U.S.C. § 77v), and until the 1998 preemptive legislation, plaintiffs could bring claims under state securities laws for conduct that would be a 1934 act violation. Nevertheless, the preponderance of securities lawsuits have been brought in federal court. See Grundfest and Perino, “Securities Litigation Reform.” 58. See, for example, Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 474–77 (1977) (holding that a breach of fiduciary duty was not a violation of federal securities law); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 201 (1976) (requiring scienter for liability under federal securities fraud statutes); see Grundfest and Perino, “Securities Litigation Reform” (increase in state court filings after the 1995 act). 59. See Greenfield v. Fritz Companies, Inc., 82 Cal. App. 4th. 741 (Cal. App. 2000) (permitting class action to proceed under state corporate law for fraud and negligent misrepresentation in financial statements, in the absence of a purchase or sale of a security by the plaintiffs, which is a prerequisite for pursuit of a federal antifraud claim). 60. See Romano, Genius of American Corporate Law, 32–34 (discussing how firms reincorporate to reduce litigation costs); Romano, “Law as a Product,” 249–51 (same). 61. See Wilmington City Railway v. People’s Railway, 47 A. 245, 251 (Del. Ch. 1900). For a more recent example of that approach, see Santa Fe Hills Golf and Country Club v. Safehi Realty Co., 349 S.W.2d 27, 34–35 (Mo. 1961). 62. For the details of the argument, see Romano, Genius of American Corporate Law, 38; and Romano, “Law as a Product,” 240–42. 63. Delaware has a further institutional mechanism through which it sustains its advantage in the charter market: a constitutional requirement that corporation code revisions be adopted by a supermajority vote of both houses of the legislature. That requirement makes it difficult for the state to change course regarding its corporate law and to cease being responsive to changing business needs. To the extent that corporations are risk-averse and employ a strategy of choosing the domicile that minimizes the worst-case scenario,

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the constitutional provision solidifies Delaware’s market position because it increases the probability that the legal regime will be no worse than what exists at the time of incorporation. See Romano, Genius of American Corporate Law, 41–42. 64. See William J. Carney, “Federalism and Corporate Law: A Non-Delaware View of the Results of Competition,” in Joseph McCahery, William W. Bratton, Sol Picciotto, and Colin Scott, eds., International Regulatory Competition and Coordination: Perspectives on Economic Regulation in Europe and the United States (New York: Clarendon Press, 1996), 153, 172–74; Romano, “Law as a Product,” 233–35. 65. See Roberta Romano, “Corporate Governance in the Aftermath of the Insurance Crisis,” Emory Law Journal 39 (1990): 1155, 1160–61. 66. See ibid. See also Carney, “Federalism and Corporate Law,” 167. Firms that reincorporated in Delaware to take advantage of the limited liability statute experienced positive returns, while event studies of the enactment of Delaware’s limited liability statute and of firms’ charter amendments to opt into the statute do not pick up a significant (positive or negative) price effect. See Romano, Genius of American Corporate Law, 19–24. 67. See Carney, “Federalism and Corporate Law,” 165, 174–75; Romano, “Law as a Product,” 235. 68. See Ad Hoc Subcommittee on Merit Regulation of the State Regulation of Securities Committee of the American Bar Association, “Report on State Merit Regulation of Securities Offerings,” Business Lawyer 41 (1986), 785, 790 (hereinafter ABA Report). Variation in states’ approaches to securities regulation dates from the initiation of state securities laws in the early 1900s, when a subset of the states adopted merit regulation modeled after Kansas’s pioneering law, which predated the federal legislation. See Jonathan R. Macey and Geoffrey P. Miller, “Origin of the Blue Sky Laws,” Texas Law Review 70 (1991): 347, 377–80. 69. See ABA Report, 823. 70. See ibid., 796 (describing exemptions for issues traded on national exchanges or registered with the SEC); Kevin G. Salwen, “State Laws Are Often Overkill, Some Say,” Wall Street Journal, July 20, 1987 (describing individual exemptions). Those issues are not, however, exempt from the states’ antifraud statutes. 71. See Uniform Securities Act § 402(b)(3), 7B U.L.A. 601 (1985) (providing an unsolicited offer exemption for securities resales). That option is often less

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desirable because the greatest profit from a new issue purchase comes from buying into the initial subscription and then selling as the price rises dramatically— and then falls—in the aftermarket (that is, an initial public offering is typically underpriced). 72. Saul Levmore offers two explanations of variety in legal rules that suggest that differences would remain across securities regimes even in the presence of competition. Variety exists because the rules “do not much matter or . . . raise issues about which reasonable people (even in the same culture) could disagree.” Saul Levmore, “Variety and Uniformity in the Treatment of the Good-Faith Purchaser,” Journal of Legal Studies 16 (1987): 43, 44. If reasonable people can disagree over which securities regime best safeguards investors against fraud and low-quality investments, competition would not eliminate merit regulation but rather would preserve it, as investors (and hence firms) self-selected across states and chose the regime that they considered preferable for protecting their financial interest. In addition, if the adoption of either merit review or disclosure regulation does not differentially affect the level of investor fraud, then the choice of regime would not matter, and variety could be preserved, although, as Levmore notes, in that instance the commercial needs of a national market would press toward uniformity despite the inconsequential effect of variety. Ibid., 60. 73. See, for example, ABA Report, 786 (reporting that Illinois and Louisiana abandoned merit review in 1983 and 1985, respectively). The 1996 amendments to the federal securities laws continued that trend by preempting merit review of registrations subject to the federal regime. 74. See David J. Brophy and Joseph A. Verga, “The Influence of Merit Regulation on the Return Performance of Initial Public Offerings,” University of Michigan School of Business Admininstration working paper no. 91-19, 1991 (reviewing other studies and presenting new data). 75. See Romano, Genius of American Corporate Law, 1. 76. In fact, most states currently recognize the FASB as the accounting standards-setter through their regulation of public accountants. State accounting boards, which license public accountants, control accountants’ activities by identifying sources of generally accepted accounting principles and enforcing compliance with such principles through ethics regulations, which typically recognize the FASB as the authority on GAAP. See Paul B. W. Miller, Rodney J.

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Redding, and Paul R. Bahnson, The FASB: The People, the Process, and the Politics, 3d ed. (Burr Ridge, Ill.: Irwin, 1994), 22. 77. See 15 U.S.C. § 78m. 78. See Pelham Gore, The FASB Conceptual Framework Project 1973–1985: An Analysis (New York: Manchester University Press, 1992), 18, 22. 79. For arguments in favor of and against competition over accounting standards, see Ronald A. Dye and Shyam Sunder, “Why Not Allow the FASB and IASB Standards to Compete in the U.S.?” Yale School of Management Working Paper Series AC, paper no. 2, May 2001. The arguments Dye and Sunder offer in favor of accounting standards competition parallel the arguments presented in this book in favor of regulatory competition. To the extent that accounting standards entail disclosure of a chosen method of reporting, rather than require a specific approach, then the significance of competition would be variation in “default” choices—that is, in what the accounting regulator considered an acceptable rationale for a selected reporting method or in differences in operative rules regarding particular choices. 80. See, for example, Paul Meller, “International Auditing Rules Urged on U.S.,” New York Times, Feburary 21, 2002. For a lucid exposition of the basis for preferring general principles to specific rules for accounting standards and the relation to the failure at Enron, see “Testimony of Roman L. Weil, University of Chicago Graduate School of Business, before the House Energy and Commerce Committee,” February 6, 2002, available on LEXIS, legis library, hearng file. Mechanical adherence to specific rules arguably led Enron’s auditor to approve numerous off-balance-sheet transactions, which had no plausible economic purpose and were being used to conceal losses, as well as to certify Enron’s financial statements, even though it is obvious to an outsider that, given the scale of the undisclosed off-balance-sheet transactions, the financial statements did not present a fair and accurate picture of the firm’s financial condition. 81. Christian Leuz, “IAS versus US GAAP: A (New) Market-Based Comparison,” Wharton School, University of Pennsylvania, 2001. 82. Ibid. The lack of significant differences held up when additional analyses were run to control for possible selection bias because the firms choose between the two standards. 83. An example of a default rule change in state corporation codes is the default for preemptive rights. In the earliest corporation codes, shareholders had

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those rights unless a firm expressly opted out of them in its charter, whereas in modern codes those rights exist only if the firm expressly includes them in its charter. See Samuel Arsht and Walter Stapleton, “Delaware’s New General Corporation Law: Substantive Changes,” Business Lawyer 23 (1967): 75, 76–77. 84. One particularly egregious example of the SEC’s problematic disclosure policies is that for decades the agency prohibited the disclosure of projected earnings despite the fact that such information is far more valuable to investors than the accounting information the SEC required, because stock value is a function of future cash flows, not historical data. See, for example, Homer Kripke, “Can the SEC Make Disclosure Policy Meaningful?” Journal of Portfolio Management 2 (Summer 1976): 32, 35–37. That approach made SEC disclosure documents of limited value for investment decisionmaking and was the subject of sustained criticisms throughout the 1970s. Ironically, the SEC’s approach disadvantaged individual investors by closing off their ability to obtain information on projected earnings, as firms would not make public earnings forecasts for fear of liability, although they would provide them to analysts and other professionals. Homer Kripke, “The SEC, the Accountants, Some Myths, and Some Realities,” New York University Law Review 45 (1970): 1151, 1199. 85. Ehud Kamar, “A Regulatory Competition Theory of Indeterminacy in Corporate Law,” Columbia Law Review 98 (1998): 1950–52. 86. See Dye and Sunder, “Why Not Allow the FASB and IASB Standards to Compete in the U.S.?” They provide the following example to illustrate the point: If everyone in the United States has a phone but no one in Russia does, it is not likely that most U.S. users would get much added benefit if all Russians were given phones. In other words, “we should expect the incremental network externalities associated with more users to become small at some point.” 87. Some important exchange services that have a network effect are fully priced: the provision of liquidity is borne by market participants in the form of the bid-ask spread (expected asset returns are an increasing function of the bidask spread). See, for example, Yakov Amihud and Haim Mendelson, “Asset Pricing and the Bid-Ask Spread,” Journal of Financial Economics 17 (1986): 223. 88. The federal securities regime makes distinctions in its disclosure requirements for new issues by offering size and investor type. See, for example, Regulation A of the Securities Act of 1933, 17 C.F.R. 230.251–.264 (small issues exemption); Section 4(6) of the Securities Act of 1933, 15 U.S.C. § 77d(6)

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(exemption for private placements with accredited investors). Whether such distinctions would be sustainable as niches under regulatory competition (compared with more flexible disclosure regimes extending across size and investor lines) is, however, an open question. 89. See S. J. Leibowitz and Stephen E. Margolis, “Network Effects and Externalities,” in Peter Newman, ed., The New Palgrave Dictionary of Economics and the Law, vol. 2 (New York: Stockton Press, 1998), 673. 90. Enforcement capacity is of greater concern in the international context than in the domestic context because it is improbable that a U.S. state will not devote sufficient resources to enforcement, given current levels of enforcement under state securities and consumer protection regimes and interstate comity and reputational concerns that would be implicated were one state to permit the fleecing of other states’ residents. Accordingly, the proposal for international securities regulatory competition discussed in chapter 5, in contrast to this chapter’s proposal for U.S. securities law, includes a disclosure requirement regarding enforcement capacity. It is difficult to craft a useful disclosure requirement regarding a jurisdiction’s enforcement capacity; possible measures are enforcement resources expended per issuer or registered shares. 91. For an article advocating that approach, see Paul G. Mahoney, “The Exchange as Regulator,” Virginia Law Review 83 (1997): 1453. 92. See George J. Benston, “Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934,” American Economic Review 63 (1973), 133. Paul Mahoney has provided a detailed description of the NYSE’s pre–SEC disclosure requirements. See Mahoney, “The Exchange as Regulator,” 1466. 93. See Daniel R. Fischel, “Organized Exchanges and the Regulation of Dual Class Common Stock,” University of Chicago Law Review 54 (1987): 119, 125; Mahoney, “The Exchange as Regulator,” 1459. Yakov Amihud and Haim Mendelson have argued that exchanges would provide trading rules that benefit investors only if firms, and not exchanges, choose where a security is listed (in the context of multiple listing of shares or the trading of derivative securities). See Yakov Amihud and Haim Mendelson, “A New Approach to the Regulation of Trading across Securities Markets,” New York University Law Review 71 (1996): 1411, 1442–46. The issues of interest here, however, involve issuer-shareholder transactions and not trading rules. The concerns of Amihud and Mendelson and

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other critics of exchange self-regulation, which focus on exchanges’ mismatched incentives regarding trading rules that can exploit investors (see, for example, Mahoney, “The Exchange as Regulator,” 1462–63), are thus not relevant to the discussion. 94. See chapter 2 for a comparison of competition and a national default regime. The transaction cost savings under exchange regulation would obviously be reduced if a firm’s shares were traded on more than one exchange. Even if the secondary exchange were to adopt a regime that recognized the primary exchange’s rules as governing all issuer shares, regardless of transaction location, investors still would have to know which exchange was the primary one. 95. The hybrid use of courts and arbitrators in class arbitration suggest some of the difficulties. See, for example, Keating v. Superior Court, 645 P.2d 1192, 1214–18 (Cal. 1982) (Richardson, J., dissenting) (describing problems with class arbitration). For a discussion of those and other difficulties by proponents of arbitration, see G. Richard Shell, “Arbitration and Corporate Governance,” North Carolina Law Review 67 (1989): 517, 551, 553–55, 561; and “Note, Classwide Arbitration: Efficient Adjudication or Procedural Quagmire?” Virginia Law Review 67 (1981): 787, 799, 805–6. Obviously, from the defendant corporation’s perspective (and one reason for the immersion of courts into the arbitration process in the class-action context), arbitration is not acceptable unless it has the effect of a final decision on all other potential claimants. 96. See Keating v. Superior Court, 645 P.2d, 1209–10 (holding that judicial involvement in class arbitration includes determination of certification and notice to class, supervision of adequacy of counsel, and dismissal or settlement; and remanding to the trial court to determine the feasibility of the class); Lewis v. Prudential Bache Securities, 235 Cal. Rptr. 69, 75-76 (Cal. Ct. App. 1986) (finding class arbitration feasible and leaving to trial court the determination of all issues necessary to certify class and provide proper notice); Izzi v. Mesquite Country Club, 231 Cal. Rptr. 315, 322 and n. 6 (Cal. Ct. App. 1986) (remanding to trial court to determine certifiability of the arbitration class and noting the preferability of court determination of any class-action problems involving notice and discovery). None of the cases permitting classwide arbitration has involved securities law claims. 97. See Ronald J. Daniels, “Should Provinces Compete? The Case for a Competitive Corporate Law Market,” McGill Law Journal 36 (1991): 130, 182–84.

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98. Compare Mahoney, “The Exchange as Regulator,” 1497–99 (discussing the use of government assistance in deterring fraud under a regime of exchangebased securities regulation, in which exchanges determine disclosure standards and rules on manipulation, margins, and short selling).

Chapter 5: Competitive Federalism and International Securities Regulation 1. The regime, established in 1988 under the auspices of the Bank for International Settlements and known as the Basle Accord, fixed capital requirements for international banks on the basis of a formulaic treatment of credit risk. For one of the many articles assessing the efficacy of the accord, see John D. Wagster, “Impact of the 1988 Basle Accord on International Banks,” Journal of Finance 51 (1996): 1321. The regime was amended to include in the required level of capital an adjustment for market or price risk (the risk of loss due to changes in asset values). See Bank for International Settlements, Amendment to the Capital Accord to Incorporate Market Risks (1996), available at www.bis.org. 2. Although investors favor their home countries in their portfolio allocations (see Kenneth R. French and James M. Poterba, “Investor Diversification and International Equity Markets,” American Economic Review 81 (1991): 222), crossborder flows of capital have dramatically increased over time and are expected to continue to do so. See Alan C. Shapiro, Multinational Financial Management, 4th ed. (Needham Heights, Mass.: Allyn and Bacon, 1991), 403–4. As financial markets have been deregulated globally, international market capitalizations have increased, and the benefits of international diversification are becoming widely recognized. See Bruno Solnik, International Investments, 3d ed. (Reading, Mass.: Addison Wesley, 1996), v–vi. 3. Paul B. Stephan, “Regulatory Cooperation and Competition: The Search for Virtue,” University of Virginia School of Law working paper no. 99-12, 1999. While Stephan’s examples are the international agreements and model laws drafted by international organizations that he considers “private legislatures,” whose nation-state members send representatives to periodic conferences to review and approve the work of task forces, and other international bureaucracies that have adjudicative functions, the international regulatory organizations associated with securities law—the International Organization of Securities

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Commissions and the International Accounting Standards Board—have similar features. None are elected officials of the nations they represent, and any uniform rules or harmonization schemes they devise are not typically presented to national legislatures for approval. See Paul B. Stephan, “The Futility of Unification and Harmonization in International Commercial Law,” Virginia Journal of International Law 39 (1999): 743, 753–57 (discussing examples of international private legislatures, such as The Hague Conference on Private International Law and the United Nations Commission on International Trade Law); Paul B. Stephan, “Accountability and International Lawmaking: Rules, Rents, and Legitimacy,” Northwestern Journal of International Law and Business 17 (1996–1997): 681, 684–85 (discussing examples of international adjudicative bureaucratic bodies, such as the International Monetary Fund and the World Trade Organization). 4. See, for example, Oren Fuerst, “A Game-Theoretic Analysis of the Investor Protection Regulations Argument for Global Listing of Stocks,” Yale School of Management, 1998 (providing bonding argument for issuer choice of exchange listing); Edward B. Rock, “Securities Regulation as Lobster Trap: A Credible Commitment Theory of Mandatory Disclosure,” Cardozo Law Review 23 (2002): 675 (providing bonding explanation for securities regulation). Israeli firms listing in the United States did not also list on the Tel Aviv Stock Exchange because they did not want to comply with two sets of disclosure requirements. See William A. Orme, Jr., “Israelis Ask If Their Exchange Is an Endangered Species,” New York Times, February 29, 2000. The need to comply with Israeli disclosure requirements was recently removed. See Amir N. Licht, “Managerial Opportunism and Foreign Listing: Some Direct Evidence,” University of Pennsylvania Journal of International Economic Law 22 (2001): 325 (Israeli cross-listings permitted by legislation, implemented by regulations issued by year-end 2000). Because the Israeli regime entails stricter disclosure than the U.S. regime on some dimensions, ibid., the bonding rationale for a U.S. listing by Israeli firms advanced by Fuerst and by Rock is an open question. 5. See, for example, Eli Amir, Baruch Lev, and Theodore Sougiannis, “What Value Analysts?” Stern School of Business, New York University, 1999, 3 (examining analysts’ earnings forecasts from 1982 through 1997 for a total of over 18,000 firm/year observations, they find that the contribution of financial analysts to equity valuation is greatest in high-tech industries).

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6. See, for example, Merritt Fox, “Securities Disclosure in a Globalizing Market: Who Should Regulate Whom,” Michigan Law Review 95 (1997): 2498, 2610–11 (discussing current U.S. approach in which U.S. jurisdiction is triggered by sale of securities in United States or by status as a U.S. issuer). It cannot be doubted that the SEC would exert jurisdiction over a U.S. firm selling shares to U.S. investors on a foreign exchange, despite the SEC’s current emphasis on U.S. capital markets rather than on investors for certain offshore transactions, which is described in Stephen J. Choi and Andrew T. Guzman, “The Dangerous Extraterritoriality of American Securities Laws,” Northwestern Journal of International Law and Business 17 (1997): 207, 221. 7. See Edward Glaeser, Simon Johnson, and Andrei Shleifer, “Coase versus the Coasians,” Quarterly Journal of Economics 116 (2001): 853. 8. See, for example, Securities and Exchange Commission, Memorandum of Understanding with the Government of Switzerland, 1982 SEC LEXIS 2631 (August 31, 1982) (insider trading law enforcement cooperation agreement); Canada–United States: Memorandum of Understanding on Administration and Enforcement of Securities Laws, 27 I.L.M. 410 (1988) (memorandum of understanding between SEC and Ontario, Quebec, and British Columbia Securities Commissions on cooperation in enforcement matters). 9. See SEC Release No. 33-7801, 17 C.F.R., parts 230 and 240, 2000 SEC LEXIS 256 (February 16, 2000). The firms will be permitted to comply with international accounting standards instead. It is not clear whether the proposal will be adopted; U.S. issuers are expected to object to competitors’ being permitted to follow international accounting standards, and other opponents fear that it will lead to a weakening in U.S. accounting standards, as domestic firms lobby to be subject to the same lower standard as foreign listings. The SEC had long opposed any substitution of international for U.S. accounting standards; the change expressed in the release is most likely a result of the recent decision to change the organization of the entity determining international accounting standards, formerly the International Accounting Standards Committee, now the International Accounting Standards Board, through which the SEC expects to exert greater influence over its decisionmaking. The approach in that release stands in contrast to the more limited reach of the SEC’s heretofore broadest mutual recognition agreement, the Multijurisdictional Disclosure System accord it signed with Canadian securities regulators, that permits Canadian firms to list

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in the United States while complying solely with Canadian disclosure rules, but mandates the reconciliation of their financial statements with U.S. accounting standards. See Multijurisdictional Disclosure and Modifications to the Current Registration and Reporting System for Canadian Issuers, Exchange Act Release No. 6902, Federal Register 56 (July 1, 1991): 30036. 10. Section 36 of the Securities Exchange Act of 1934, 15 U.S.C. § 78mm and section 28 of the Securities Act of 1933, 15 U.S.C. § 77z-3; see Alan R. Palmiter, “Toward Disclosure Choice in Securities Offerings,” Columbia Business Law Review 1999 (1999): 1, 89–91 (advocating that the SEC should, and could, use its statutory exemptive authority to permit corporations to select their own disclosure schemes for new issues but not extending his proposal to ongoing disclosures). Congress imposed only one constraint on the use of that authority, that no exceptions could be made regarding the regulations applicable to government securities brokers and dealers, 15 U.S.C. § 78mm(b), a limitation not relevant to competitive securities regulation for private issuers. Otherwise, the agency has the sole discretion to issue exemptions that are “necessary or appropriate in the public interest” and “consistent with the protection of investors,” 15 U.S.C. § 77z-3; 15 U.S.C. § 78mm(a)(1), criteria that the proposed regime of securities regulatory competition would satisfy. 11. See Roberta Romano, “The Political Dynamics of Derivative Securities Regulation,” Yale Journal on Regulation 14 (1997): 279, 354–69. 12. Council Directive No. 87/345, 1987 O.J. (L 185) 81 (directive requiring mutual recognition of a listing approved by any member state’s competent authority if the listing meets the EU’s minimum standards for securities regulation); Council Directive No. 80/390, 1980 O.J. (L 100) 1 (directive setting forth minimum disclosure standards); Council Directive No. 79/279, 1979 O.J. (L 66) 21 (directive setting forth minimum requirements for exchange trading of a security). 13. See Orme, “Israelis Ask If Their Exchange Is an Endangered Species.” The Israeli legislature changed the law to permit such cross-listings in July 2000, and the regulatory authority issued implementing regulations thereafter. Licht, “Managerial Opportunism and Foreign Listing: Some Direct Evidence,” 341. It appears that the push for recognition of U.S. listings was related not solely to the Tel Aviv Stock Exchange’s loss of high technology firm listings but also to a rebellion over a new national corporate law that had led Israeli firms to reincorporate in Delaware; the new corporation law was also revised at the time of the

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securities law change. As might be expected, the Israeli Securities Agency was not a prime mover behind the diminution of its authority. 14. Stephan, “Regulatory Cooperation and Competition: The Search for Virtue.” 15. See Lipcon v. Underwriters at Lloyd’s of London, 148 F.3d 1285 (11th Cir. 1998), certiorari denied, 525 U.S. 1093 (1999); Richards v. Lloyd’s of London, 135 F. 3d 1289 (9th Cir.), certiorari denied, 525 U.S. 943 (1998); Haynsworth v. Lloyd’s of London, 121 F.3d 959 (5th Cir. 1997), certiorari denied, 523 U.S. 1072 (1998); Allen v. Lloyd’s of London, 94 F.3d 923 (4th Cir. 1996); Shell v. R. W. Sturge, Ltd., 55 F.3d 1227 (6th Cir. 1995); Bonny v. Society of Lloyd’s, 3 F.3d 156 (7th Cir. 1993), certiorari denied, 510 U.S. 1113 (1994); Roby v. Corporation of Lloyd’s, 996 F.2d 1353 (2d Cir.), certiorari denied, 510 U.S. 945 (1993); Riley v. Kingsley Underwriting Agencies, Ltd., 953 (10th Cir.), certiorari denied, 506 U.S. 1021 (1992). 16. See, for example, E. Philip Davis and Benn Steil, Institutional Investors (Cambridge: MIT Press, 2001), 354–55. 17. See Registration of Foreign Offerings by Domestic Issuers, Exchange Act Release No. 33-4708, Federal Register 29 (1964): 9828 (stating that requirements of the 1933 act are “intended to protect American investors”); see also Choi and Guzman, “The Dangerous Extraterritoriality of American Securities Laws,” 221 (discussing SEC’s adoption of Regulation S, governing overseas transactions, which changed the regulatory emphasis from “the protection of U.S. investors, wherever they may be located, to the protection of American capital markets”). 18. See James L. Cochrane, “Are U.S Regulatory Requirements for Foreign Firms Appropriate?” Fordham International Law Journal 17 (1994): S58, S61 (noting that there are “2,000 foreign companies eligible to go on [NYSE’s] list . . . were it not for SEC regulations”); James A. Fanto and Roberta S. Karmel, “A Report on the Attitudes of Foreign Companies Regarding a U.S. Listing,” Stanford Journal of Law, Business, and Finance 3 (1997): 51, 70. 19. See Fanto and Karmel, “Report on the Attitudes of Foreign Companies,” 71. 20. William J. Baumol and Burton G. Malkiel, “Redundant Regulation of Foreign Security Trading and U.S. Competitiveness,” in Kenneth Lehn and Robert W. Kamphuis, Jr., eds. Modernizing U.S. Securities Regulation: Economic and Legal Perspectives (Burr Ridge, Ill.: Business One Irwin, 1992), 39, 41.

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21. See ibid., 41 (reporting that the LSE lists five times the number of foreign firms listed by the NYSE). 22. See Franklin R. Edwards, “SEC Requirements for Trading of Foreign Securities on U.S. Exchanges,” in Lehn and Kamphuis, eds., Modernizing U.S. Securities Regulation, 63. 23. See ibid., 58–59, 63–64. 24. See “Multijurisdictional Disclosure and Modifications to the Current Registration and Reporting System for Canadian Issuers.” 25. See Richard W. Jennings, Harold Marsh, Jr., and John C. Coffee, Securities Regulation Cases and Materials, 7th ed. (Westbury, N.Y.: Foundation Press, 1992), 1581. 26. See Fanto and Karmel, “Report on the Attitudes of Foreign Companies,” 56. 27. See Mohan Venkatachalam, “Are 20-F Reconciliations between IAS and US–GAAP Value-Relevant? A Discussion,” Journal of Accounting and Economics 26 (1999): 313, 315–16; Shahrokh M. Saudagaran and Gary K. Meek, “A Review of Research on the Relationship between International Capital Markets and Financial Reporting by Multinational Firms,” Journal of Accounting Literature 16 (1997): 127, 150–52 (evidence supporting value relevance of accounting restatements has “not been overwhelming”); Peter F. Pope, “Discussion of a Comparison of the Value-Relevance of U.S. versus Non–U.S. GAAP Accounting Measures Using Form 20-F Reconciliations,” Journal of Accounting and Economics 31 (supplement 1993): 265, 267–68; and Edwards, “SEC Requirements for Trading of Foreign Securities,” 65–66. 28. Christian Leuz, “IAS versus US GAAP: A (New) Market-Based Comparison,” Wharton School, University of Pennsylvania, 2001. 29. See, for example, Gabriel A. Hawawimi, European Equity Markets: Price, Behavior, and Efficiency (New York: Salomon Brothers Center for the Study of Financial Institutions, Stern School of Business, New York University, 1984); Baumol and Malkiel, “Redundant Regulation,” 46–50; Edwards, “SEC Requirements for Trading of Foreign Securities,” 64–66. 30. Jorg Baetge, “The Role of Disclosure and Auditing as Affecting Corporate Governance,” presentation at the Symposium on Comparative Corporate Governance at the Max Planck Institut, Hamburg, Germany, May 16, 1997. 31. See Shyam Sunder, “Design and Implementation of Contracts: A Comparison of Factor Markets Relevant to Financial Reporting in Japan and the

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United States,” in Shyam Sunder and Hidetoshi Yamaji, eds., The Japanese Style of Business Accounting (Westport, Conn.: Quorum Books, 1999), 209, 213–14. 32. For signaling explanations of foreign firm listings in the United States, see C. Sherman Cheung and Jason Lee, “Disclosure Environment and Listing on Foreign Stock Exchanges,” Journal of Banking and Finance 19 (1995): 347; Fuerst, “Game-Theoretic Analysis of the Investor Protection Regulations Argument for Global Listing of Stocks”; and Rock, “Securities Regulation as Lobster Trap.” 33. To the extent that the SEC requirement for deregistration of fewer than 300 shareholders (see Rock, “Securities Regulation as Lobster Trap,” 682–84 (discussing exit routes under SEC rules)) would no longer be applicable under competitive federalism because it would impede effective jurisdictional competition, firms could duplicate such an exit barrier by placing a similarly worded provision in their charters. Rock asserts that a credible commitment theory of foreign listings is dependent on the SEC’s regulatory monopoly and SEC (for exchangetraded firms, stock exchange) requirements that make exit difficult. Ibid., 695. He concludes that firms will not be able to sustain commitments to maintaining high-quality disclosure under competitive federalism. It is, however, plausible to assume that firms could voluntarily adopt identical exit restrictions in their charters that would be as difficult to circumvent as the SEC or stock exchange rules or that competing regulators could adopt the same restrictions on exit imposed by the SEC and exchanges, if investors desired them. Rock raises two concerns at the firm level against the proposed regime of competitive federalism that would permit domicile change by shareholder approval: that shareholder voting does not work because managers manipulate the process or because it is meaningless when managers own a majority of shares; and that contracts committing to long-term quality disclosure are not credible. Ibid., 695–96. Neither of those concerns, in my judgment, undermines the ability of firms to make commitments regarding their securities domicile under competitive federalism. As discussed in detail in chapter 4, where I introduced the voting requirement for a securities domicile change, both theory and data suggest that shareholders will indeed vote their interest on regime changes, as they do in other contexts, and will not be manipulated by management into supporting wealthdecreasing switches. (Rock’s support for the assertion that voting on a regime change will be manipulated is the article by Gordon, critiqued in chapter 4. See Jeffrey N. Gordon, “The Mandatory Structure of Corporate Law,” Columbia

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NOTE TO PAGE 156

285

Law Review 89 (1989): 1549.) Insider control also does not render competitive federalism ineffectual for commitment purposes. Where insiders have control, a majority voting rule is not of value to the outside minority, but, as all investors are cognizant of that fact, insiders who wish to commit to a particular disclosure regime will do so by adopting a charter provision that locks in a supermajority voting rule (or requires the vote of a majority of the minority) for a domicile switch or by selecting a disclosure regime that contains a restrictive exit requirement. Rock contends that such a regime will not emerge under competitive federalism because no analogue has emerged in charter competition. Rock, “A Credible Commitment Theory of Mandatory Disclosure,” 702. That is not a significant concern. Firms do not incorporate in a state to signal a long-term commitment to a domicile choice. As Rock notes, the commitment problem in the corporate law setting is on the side of the state, not that of the issuers. Therefore, no reason exists for a state to make exit difficult. The beauty of competition is that it responds to demand; if Rock’s theory of credible commitment is correct, a securities regime will develop to meet commitment needs. There is no reason to suppose that a state government would be less likely to enforce the exit rules necessary to foster issuer commitments than the SEC. One must accept the “race-to-the-bottom” thesis, which chapters 2 and 3 critique. In fact, Rock implies that the SEC does not appear to recognize that it is performing a valuable commitment function, for he describes how the SEC permitted a rule change at the New York Stock Exchange that made exit easier. Ibid., 700. A regulator that competed for registrants by crafting an exit rule to perform a commitment function would, unlike the SEC, be fully cognizant of the value of the function it was providing and act so as to maintain it. A final important response to Rock’s concern over competitive federalism should be noted. As earlier discussed, one must assess the efficacy of competitive federalism by making a benefit-cost calculation. It is improbable that the potential benefits of regulatory competition for international securities would be outweighed by the cost of the dilution of the value of majority-controlled foreign firm’s commitment strategy by a U.S. listing. Indeed, we do not even know what proportion, if any, of foreign firms listed on U.S. exchanges has controlling shareholders and has undertaken the listing to offer a credible commitment of quality.

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34. Although casebooks emphasize antifraud (insider trading and disclosure) cases, complaints against brokers are a more significant source of individual investor losses than the texts would suggest. The leading casebooks have at most one chapter on broker issues and sometimes no coverage at all. See, for example, Richard W. Jennings, Harold Marsh, Jr., and John C. Coffee, Jr., Securities Regulation: Cases and Materials, 7th ed. (Westbury, N.Y.: Foundation Press, 1992); David L. Ratner and Thomas Lee Hazen, Securities Regulation: Cases and Materials, 5th ed. (St. Paul, Minn.: West Publishing, 1996); and James D. Cox, Robert W. Hillman, and Donald C. Langevoort, Securities Regulation: Cases and Materials, 3d ed. (Gaithersburg, Md.: Aspen Law and Business, 2001). In contrast, the SEC allocates considerable enforcement time to broker misconduct, often more than it does to issuer misconduct. See, for example, SEC 1998 Annual Report (Washington, D.C.: Government Printing Office, 1999), 1–6, 10 (the vast majority of what the agency deemed “significant enforcement actions” for 1998 involved broker-dealer activities and not issuer disclosure or insider trading cases, and the over 50,000 investor complaints to which the agency responded, recovering over $1 million, involved broker-dealer claims) (formerly also available at www.sec.gov/annrep98/ar98main.htm); SEC 1999 Annual Report (Washington, D.C.: Government Printing Office, 2000), 1–10, 140 (approximately half of what agency deemed “significant enforcement actions” for 1999 involved broker-dealer activities and not issuer disclosure or insider trading cases; by percentage broker-dealer cases were 20 percent and newsletter cases were 6 percent compared with 18 percent for issuer/financial statement cases and 11 percent for insider trading cases; securities offering cases which can involve both brokers and issuers were 24 percent) (available at www.sec.gov/pdf/ annrep99/ ar99full.pdf). 35. Palmiter, “Toward Disclosure Choice in Securities Offerings,” 37. 36. Stacy Forster, “The Cop: An SEC Commissioner Talks about the Challenges of Battling Online Fraud,” Wall Street Journal, June 12, 2000. 37. See John H. Langbein, “The Uniform Prudent Investor Act and the Future of Trust Investing,” Iowa Law Review 81 (1996): 641 (detailing change in state law regulating private trusts from restricting specific investments to following general fiduciary standards, as modern portfolio theory changed the concept of a suitable investment by altering the conventional understanding of investment risk); and Roberta Romano, “Public Pension Fund Activism in Corporate Governance

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Reconsidered,” Columbia Law Review 93 (1993): 795, 800 (noting state approaches to public pension fund investments). 38. South Carolina prohibited public funds from investing in equity, and it was estimated that its pension fund would have earned an additional $5 million per day between 1994 and 1997 if it had been permitted to invest 40 percent of its assets in stocks or $1 million per day if the equity allocation had been 10 percent. See Susan Barreto, “Lost Opportunities: South Carolina Ends Long Day’s Journey into Equity,” Pensions and Investments, May 3, 1999, 35. The South Carolina restriction was in the state constitution; similar restrictions in other states were repealed before 1997 because, located in statutes, they were easier to change. 39. Romano, “Public Pension Fund Activism,” 803–8. 40. Dirks v. Securities and Exchange Commission, 463 U.S. 646, 652 n. 8 (1983). In particular, the analyst began investigating Equity Funding in March 1973 on a tip from an insider and within weeks verified and disclosed the fraud. The disclosure led to regulatory action against Equity Funding and its bankruptcy filing. Yet “as early as 1971, the SEC had received allegations of fraudulent accounting practices at Equity Funding” but failed to take action or otherwise uncover the fraud. Ibid., 650 n. 3. 41. Government enforcement is less of a problem: existing agreements between regulatory agencies call for information sharing and cooperation across agencies in enforcement actions, and there is no reason to expect the abandonment of such arrangements in a competitive international regime. 42. The proposition in the text assumes that in enacting a regime of regulatory competition, Congress eliminates the misplaced “public law” characterization of securities law that would prevent a U.S. court from exercising subject matter jurisdiction over a case in which prescriptive jurisdiction is lacking (that is, the doctrine under which a court must dismiss a case for which the law of the forum, U.S. law, does not apply) and instead recognizes that private securities litigation should be treated the same as tort and contract law claims, in which U.S. courts make choiceof-law decisions and therefore can take a case and apply foreign law. See Cox, Hillman, and Langevoort, Securities Regulation, 1258. Explicit congressional action might not be necessary, however, because rejection of the public law approach could be implied from congressional enactment of regulatory competition for securities law. In addition, the Supreme Court’s validation of arbitration for securities claims goes a considerable way toward undermining the public law characterization

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of securities law and treating it as “private.” See ibid., 1259. And the Court’s emphasis in that validation on Congress’s policy of fostering arbitration would analogously support the application of foreign securities law by U.S. courts as consistent with Congress’s policy of encouraging regulatory competition in securities law. 43. The further disadvantage that this would split the legislative and judicial authority of the securities domicile—which could limit the effectiveness of competition, as discussed in chapter 4 regarding regulation by exchanges rather than by states—might be offset in the international setting by the cost advantage to investors of being able to sue firms locally. 44. It is, however, quite plausible that the sale of a security would be sufficient under the Supreme Court’s “minimum contacts” doctrine to justify in personam jurisdiction over a firm. For a general discussion of the jurisdictional question in corporate law, see Harry G. Henn and John R. Alexander, Laws of Corporations, 3d ed. (St. Paul, Minn.: West Publishing, 1983), 209–14. 45. See, for example, Delaware Code Annotated, title 8, § 371 (to qualify to do business in the state, a foreign corporation must designate a registered agent in the state to accept service of process). 46. See Andreas F. Lowenfeld, International Litigation and Arbitration (St. Paul, Minn.: West Publishing Co., 1993), 332. 47. For the change in U.S. doctrine resulting in validation of arbitration clauses to resolve securities law disputes, see Rodriguez v. Shearson/American Express, Inc., 490 U.S. 477 (1989); Shearson/American Express, Inc. v. McMahon, 482 U.S. 220 (1987); Scherk v. Alberto-Culver Co., 417 U.S. 506 (1974) (overruling Wilko v. Swan, 346 U.S. 427 (1953)). 48. For a view that the German system will evolve toward a proxy-voting system similar to that in the United States with the adoption of registered shares by major companies, see Gregor Bachmann, “Registered Shares, Proxy Voting, and German Corporate Governance,” Wertpapiermitteilungen 53 (October 1999): 2100 (abstracted on the Legal Scholarship Network, Corporate Law Abstracts, Finance and Corporate Governance Law Accepted Paper Series 2 (8) (June 16, 2000)). 49. See “TIAA–CREF Follows CalPERS Lead to Adopt Global Guidelines,” IRRC Corporate Governance Bulletin 18 (February–April 2000): 23. 50. See, for example, Steve Hemmerick, “CalPERS Takes New Active Role in U.K.,” Pensions and Investments, January 12, 1998, 2.

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51. Carolyn Brancato and Michael Price, “The Institutional Investor’s Goals for Corporate Law in the Twenty-first Century,” Delaware Journal of Corporate Law 25 (2000): 35, 68–69 (comment of Dr. Carolyn Brancato of the Conference Board). 52. “Decline in Capital Proposals, Continued Increase in Other Proposals Mark Global Proxy Season 2000,” IRRC Corporate Governance Bulletin 18 (May–July 2000): 13. 53. “Japan’s Proxy Marathon 2000 Shows Hints of a Sea Change,” IRRC Corporate Governance Bulletin 18 (May–July 2000): 17. 54. See Simon Johnson, Rafael LaPorta, Florencio Lopez-de-Silanes, and Andrei Shleifer, “Tunnelling,” American Economic Review 90 (2000): 22 (describing various forms of permissible expropriation by controlling shareholders in the European Union). 55. See Rafael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, “Corporate Ownership around the World,” Journal of Finance 54 (1999): 471, 491–95. 56. See Luigi Zingales, “The Value of the Voting Right: A Study of the Milan Stock Exchange Experience,” Review of Financial Studies 7 (1994): 125, 125–26 (premium on voting shares of dual class firms in Italy is over 80 percent, compared with premiums of 5 to 20 percent in the United States, England, Canada, Sweden, and Switzerland, and the difference is due to the higher benefit of private control in Italy, that is, to greater ability of controlling shareholders to dilute minority property rights); Tatiana Nenova, “The Value of Corporate Votes and Control Benefits: A Cross-Country Analysis,” Harvard University, 2000 (estimated value of control for 661 dual class stock firms in eighteen countries, based on a model of predicted takeover premiums, ranges from 0 to 50 percent, and 75 percent of cross-country difference is explained by the quality of minority investor protection). See also Andrei Shleifer and Robert W. Vishny, “A Survey of Corporate Governance,” Journal of Finance 52 (1997): 737, 748 (collecting studies indicating dramatic differences in average voting premiums across countries). 57. See Rafael LaPorta, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert W. Vishny, “Legal Determinants of External Finance,” Journal of Finance 52 (1997): 1131 (across forty-nine countries, firms in nations with greater shareholder protections have better access to external finance, that is, capital markets are larger and deeper).

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58. See, for example, Cochrane, “Are U.S. Regulatory Requirements for Foreign Firms Appropriate?” S61, S63–65; Fox, “Securities Disclosure in a Globalizing Market,” 2582. 59. See, for example, Choi and Guzman, “Dangerous Extraterritoriality.” 60. See, for example, Cochrane, “Are U.S. Regulatory Requirements for Foreign Firms Appropriate?” S61, S63–65 (criticizing applicability of SEC disclosure requirements for NYSE listing); Jill E. Fisch, “Imprudent Power: Reconsidering U.S. Regulation of Foreign Tender Offers,” Northwestern University Law Review 87 (1993), 523, 573–74 (criticizing applicability of the Williams Act); Arthur R. Pinto, “The Internationalization of the Hostile Takeover Market: Its Implications for Choice of Law in Corporate and Securities Law,” Brooklyn Journal of International Law 16 (1990): 73 (same). 61. See, for example, Choi and Guzman, “Dangerous Extraterritoriality,” 241; Stephen J. Choi and Andrew T. Guzman, “National Laws, International Money: Regulation in a Global Capital Market,” Fordham Law Review 65 (1997): 1855, 1895. In a more recent article, Choi and Guzman’s position has evolved from advocating a strict territorial (site of sale) approach to the competitive federalism (issuer securities domicile) approach. See Stephen J. Choi and Andrew T. Guzman, “Portable Reciprocity: Rethinking the International Reach of Securities Regulation,” Southern California Law Review 81 (1998): 903. 62. See, for example, Merritt Fox, “The Political Economy of Statutory Reach: U.S. Disclosure Rules in a Globalizing Market for Securities,” Michigan Law Review 97 (1997): 696, 784. His position is based on the belief that national regulators will require the level of disclosure of interfirm externalities that is appropriate for domestic firms. 63. See Fox, “Securities Disclosure in a Globalizing Market,” 2626–27 (contending that nations competing for securities transactions will engage in a race to the bottom because of political pressures to reduce disclosure); Merritt Fox, “Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment,” Virginia Law Review 85 (1999): 1335, 1410 (contending that under competition managers will choose “as low a level of periodic disclosure as possible”); Merritt Fox, “The Political Economy of Statutory Reach,” 796 (“given the preferences of the persons making these choices [choices of securities regime under regulatory competition] issuers will generally choose regimes requiring a lower than socially optimal level of disclosure”).

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64. See, for example, Hal S. Scott and Philip A. Wellons, International Finance Transactions, Policy, and Regulation, 7th ed. (New York: Foundation Press, 2000), 311; G. K. Meek and S. J. Gray, “Globalization of Stock Markets and Foreign Listing Requirements: Voluntary Disclosures by Continental European Companies Listed on the London Stock Exchange,” Journal of International Business Studies 20 (1989): 315. One study of foreign stock exchange listings found an inverse relation between listings and disclosure requirements, but the exchanges with the lowest level of disclosure did not have the most foreign listings (although the United States, with the highest disclosure level, did have the fewest foreign listings); more important, the inverse relation was not significant when domestic and foreign exchange disclosure levels were compared. See Shahrokh M. Saudagaran and Gary C. Biddle, “Financial Disclosure Levels and Foreign Stock Exchange Listing Decisions,” in Frederick D. S. Choi and Richard M. Levich, eds., International Capital Markets in a World of Accounting Differences (Burr Ridge,Ill.: Irwin, 1994), 159, 181, 184. That is, the data did not support the race-to-the-bottom hypothesis that the probability of a firm’s listing on a given foreign exchange is inversely related to the exchange’s disclosure level when its disclosure level is higher than the disclosure level of the firm’s domestic exchange. See ibid. 65. Edmund Kitch has also noted this curious feature of Fox’s proposal. See Edmund W. Kitch, “Proposals for Reform of Securities Regulation: An Overview,” Virginia Journal of International Law 41 (2001): 629, 651.

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Index

Accounting practices, 24, 55, 139–42, 150, 154–55 standards and Enron Corporation, 55–58, 61–62 See also Financial Accounting Standards Board; Generally accepted accounting principles; International Accounting Standards Board Admati, Anat, 32–34 Albrecht, William P., 75 Alexander, Cindy R., 60 Andersen, Arthur, 54, 61 Antifraud rationale for regulation, 42–45 Antitakeover statutes, 93–99 Appraisal rights, 130 Arbitration, 145, 164 Australia, 85, 111

Benston, George J., 16–22, 24–25, 44, 144 Bierman, Harold, Jr., 44 Block, Michael K., 60 Blue sky laws. See State, securities regulation (merit review) Boehmar, Ekkehart, 52 Breton, Albert, 124–25 Brickley, James A., 67–68 Brokers, regulation of 5, 113, 125 and misconduct, 159 Butler, Henry N., 103

Ayres, Ian, 89

Carney, William J., 10, 27 Cary, William, 91–92, 95, 103 Chartering market and Delaware’s success, 136–37 evidence of benefits to shareholders, 64–75 and network externalities, 83–92 state competition in, 75–83, 173

Baumol, William J., 82–83, 153 Baysinger, Barry, 103 Bebchuk, Lucian Arye, 65, 70–72, 93–98, 99–105, 106–11, 200n114, 213–14nn17–18, 226n57

California, 105, 217n27, 249n167, 253n174 California Public Employees Retirement System, 34, 193n65 Canada, 111, 146, 154 Capital markets, U.S., 9, 53–54, 111

293

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294 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Choi, Frederick D. S., 10 Choice-of-law regime, 5–6, 113, 114–18 adaptations to competitive federalism, 120–22, 172 flaws in, 118–20 Close corporations, 226n60 Coates, John C., IV, 95–96, 181n23 Coffee, John C., Jr., 190n53 Comment, Robert, 98 Commodity Futures Trading Commission, 8 Common law, 86–87, 260n202 Competition in securities regulation benefits of, 45–50, 93–94, 173–75 reforms required, 47, 112–14, 125–27 uniformity and variety under, 50, 137–42 Conflicts of law. See Choice-of-law regime Congress, 2–3, 4, 107, 281n10, 287n42 and legislative reforms to achieve competition, 112–14, 121–22, 124–25 Connecticut, 177n6, 245n161 Contestable markets, theory of, 82–83 Corporate law, 3, 4–5, 63, 78–79, 82, 95, 138, 143, 274n83 Council of Institutional Investors, 12 Courts, 119 Delaware, 84, 87–89, 109 federal district, 109–10 U.S., and international competitive regime, 163–64 Cox, James D., 74, 207n1, 225n56

Daines, Robert, 73–74, 96 Delaware, 4, 65, 68 carve-out, 89, 117 as competitor for charters, 77–83, 136–37 courts, 84, 87–89, 109 firm values in, 73–74 franchise tax revenue, 76–77, 79, 131–37 legal regime, evaluation of, 86–92 as monopolist, 75–77, 83 and network effects, 71–72, 83–92 and shareholder litigation, 88–91 specialized judiciary, 87–88 and takeover regulation, 93, 94–106 Disclosure effectiveness of SEC’s regime, 16–28, 275n84 of firm-level information, 14–15 mandatory, rationales for, 39–41 policy, economic models for, 30–34 of securities regime under regulatory competition, 125–27, 157–62 violations, liability for, 37 voluntary, studies of, 26–29 Domicile, statutory (corporate law) change, 64, 70, 125–29, 164–68 choice compared with headquarters, 99–103, 104–6 for securities regulation, 122–25, 127–31 disclosure requirement of, 125–31 See also Event studies; Reincorporation Dye, Ronald A., 30–32, 41

index

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INDEX Easterbrook, Frank H., 29, 30, 115–16 Electronic trading, 152 Enforcement, of securities violations, 143–44, 157–59, 287n41 Enron Corporation, 53, 140 implications for regulatory policy of collapse of, 53–62 Equitable Funding Corporation of America, 162 Europe, 27, 46, 110, 132, 170 European Union, 27, 57, 123, 151, 165–66 Event studies defined, 64 of effect of change in incorporation state, 64–72 of restrictions on takeovers, 65, 94–95, 237n134 Externalities, interfirm, 29–30 disclosure models, 30–34 internalization by investors, 34–35 practicability of disclosure, 35–42 See also Network externalities Externality, defined, 13–14 Extraterritoriality. See U.S. worldwide securities jurisdiction Fanto, James A., 153 FASB. See Financial Accounting Standards Board Federal Trade Commission, 37 Ferrell, Allen, 93–99, 105–11

Financial Accounting Standards Board, 21, 39–40, 57–58, 61, 139–41 Firm values and incorporation in Delaware, 73–74 Fischel, Daniel R., 29, 30, 115–16 Fishe, Raymond P. H., 52 Flipping shares in initial public offerings, 52–53 Foreign firms and SEC, 150–51 in U.S. markets, 152–56, 168–71 Forum selection clauses, 121, 123, 146 and international securities regulation, 163–64 Fox, Merritt, 17–21, 22–23, 25, 29–33, 39–42, 168–71 Franchise tax revenue, 76–77, 80–81, 131–37 Fraud, 42–45, 157–59, 162 See also Enron Corporation GAAP. See Generally accepted accounting principles GE annual report, 59 Generally accepted accounting principles, 141, 153–55 Georgia, 260n200 Germany, 28, 141, 152, 155 Government intervention in market, reasons for, 12–13, 15, 20 GTE Corporation, domicile and headquarters change, 100

Fiduciary duty/standards, 89–90, 117 Filing fees, 132

295

Hamdani, Assaf, 226n57

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296 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Heron, Randall A., 66–69 IASB. See International Accounting Standards Board Illinois, 139 Indiana, 237n134, 251n171 Information, underproduction of, 14–15, 29–42 Initial public offerings, 50–53 Innovation, 49 Insider trading, 88, 179n3 Institute of Internal Auditors, 59 Institutional Shareholder Services, 12, 129 Intermediaries, financial, 162 Internal affairs doctrine, 115–18, 120 International Accounting Standards Board, 57–58, 140–41, 280n9 International Corporate Governance Network, 165 International securities regulation, competitive federalism in, 8–9 benefits of, 149 implementation of, 147–52 implications for U.S. markets, 152–56, 168–71, 175 investor protection concerns under, 156–58, 164–68 litigation rights, 163–64 security regime disclosures, 157–62 shareholder voting, 164–68 Internet, 12, 43, 118, 152 Investment prohibitions, 161–62 Investor Responsibility Research Center, 12, 129

Investors and interfirm externalities, 34–35, informed or sophisticated, 46–47, 129–30, 144 and information cascades (herding), 183n7 uninformed or unsophisticated, 126–27, 129–30, 144, 158–62 See also Shareholders Israel, 148, 151 Japan, 155, 165 Jarrell, Gregg A., 23, 25 Kahan, Marcel, 76–82, 89 Kamar, Ehud, 76–82, 86–92, 142 Kansas, 4, 264n26 Karmel, Roberta S., 153 Karpoff, Jonathan, 60 Kitch, Edmund W., 40–41 Langevoort, Donald C., 78 Leflar, Robert A., 116 Leibowitz, S. J., 84 Leuz, Christian, 141 Levitt, Arthur, 207n156 Lewellen, Wilbur G., 66–69 Liability civil, 37 for fraud (international), 157–59 limited, statute in Delaware, 99, 101, 137–38 Line-of-business reporting standards, 21, 40–42 See also Segment reporting

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INDEX Litigation, private, 143–44 rights, against foreign-domiciled firms, 163–64 Lloyd’s of London litigation, 151 Lock-in effect, 83–86 London Code of Conduct (City’s Panel on Takeovers and Mergers), 105, 107–9, 240n144 London Stock Exchange, 152, 153 Lott, John R., Jr., 60 Macey, Jonathan R., 90 Mahoney, Paul G., 44 Malkiel, Burton G., 153 Managers, 51 and domicile change, 128–30 and firm-specific information, 38–39 role in takeovers, 93, 96–98 Margolis, Stephen E., 84 Market professionals, 2, 5, 113–14 Massachusetts, 248n166 Merit regulation, 138–39 Michigan, 82 Miller, Geoffrey P., 90 Model Business Corporation Act, 77–78, 85, 102, 177n6 Monopolists, 74–77 Multijurisdictional Disclosure System, 154 Multilateral governmental action, 149–50 Mutual funds regulation, 5–6 herding by, 183n7

297

NASDAQ, 145, 153 National Association of Corporate Directors, 59 National Association of Securities Dealers, 11, 145 Nationality, corporate, based securities jurisdiction, 168–71 Network externalities and securities regulation, 142–43 and state competition, 71–72, 76, 83–92 Neuer Markt, 28, 141, 155 Nevada, 43, 78 New Jersey, 83, 135 New York, 2, 95, 100 New York Stock Exchange, 4, 16, 17, 19, 26, 28, 144, 148 Non–U.S. issuers. See Foreign firms Off-balance-sheet transactions, 53, 59–60 Palmiter, Alan R., 159, 199n112, 201n119 Pennsylvania, 98, 104, 106, 247n166, 249n167 Penny-stock trading, 126, 158, 159 Pfleiderer, Paul, 32–34 Poison pills, 109–10, 255n183 Private Securities Litigation Reform Act of 1995, 2, 3 Proprietary information, 36–38 Public good, defined, 14 Public pension funds, 161, 165

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298 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Race to the bottom, 63, 65, 72, 74, 93, 100, 105, 169 Regulation S-K, 36 Reincorporation, 65–75, 99–101 Reputational failure, 60–61 Restatement (Second) of Conflicts of Law, 116 Revealed preference, 48 Rock, Edward B., 284n33 Rose-Ackerman, Susan, 198n108

Securities Exchange Act of 1934, 1, 2 studies of impact of, 16–22 Securities transaction taxes, 132–33 Segment reporting, 39, 40–42 See also Line-of-business reporting standards Seligman, Joel, 42–44, 184n10 Shareholders benefits from state competition for charters, 64–75 effects of takeovers on, 90–92,

Schwert, G. William, 98 Scott, Hal S., 74 SEC. See Securities and Exchange Commission Secondary trading markets and regulatory competition, 50–53 Securities Act of 1933, 1 studies of impact of, 22–26 Securities and Exchange Commission, 1, 7–10, 24, 48, 49, 58, 88, 111, 112–13, 122, 123, 143, 173–75 and accounting practices, 140–42 financing, 132, 134t and foreign firms, 150–56 and fraud investigation, 44, 61 jurisdiction, international, 152–53 and legislative reforms, 112–14 mandatory disclosure, effectiveness of, 16–28 monopolization by, 3, 7–8 and proprietary information, 36–40 regulatory rationale, 12–16, 42–45 rule 10b-5, 27

97–104 proposals, 69, 72, 104, 194n65, 257n186 voting, 65, 236n126 and controlling shareholders, 166–67, 285n33 required for securities domicile change, 127–31, 164–68 See also Investors Simon, Carol J., 26 South Carolina, 287n38 Special-purpose entity, 53, 61 Standardization and government regulation, 20–21, 26 State antifraud statutes, 2, 43 competition for charters, 64–74, 75–83 competition and network externalities, 83–92 corporation codes, 3–5, 78–82 financial incentives for regulation, 79–81, 131–33, 135

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INDEX securities regulation (merit review), 138–39, 178n9 securities regulation (enforcement), 2, 43–44, 143–44 takeover regulation, 92–106 Stephan, Paul B., 147 Stigler, George J., 22–23, 25 Stock exchanges, regulation by, 11, 142–43, 144–46 Stocks, variance of returns, 19–20, 23, 25–26 Subramanian, Guhan, 252n173 Takeovers antitakeover statutes, 93–99 defenses, 68–70, 92 and Delaware, 94–106 legislation, national, 106–11 regulation, state, 92–106 Teachers Insurance and Annuity Association–College Retirement Equities Fund, 34 Tel Aviv exchange, 148, 151 Texas, 100

299

Tinic, Seha M., 23–24 Tobin’s Q, 73–74 Unger, Laura, 160 Uniform Securities Act, 115, 120–21 United Kingdom, 16, 27, 107, 151, 166, 260n202 U.K. Accounting Standards Board, 58 U.S. worldwide securities jurisdiction, 8–9, 148, 152–53 Vanguard Group, 34 Voting. See Shareholders, voting Wall Street, 4, 44 Watts, Ross L., 16 Weil, Roman, 57 Whincop, Michael J., 85 Williams Act, 106–7 Williams Company annual report, 59 Winter, Ralph K., 103 Zimmerman, Jerold L., 16

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about

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About the Author

Roberta Romano is the Allen Duffy/Class of 1960 Professor of Law at Yale Law School. She is the author of The Genius of American Corporate Law (AEI Press, 1993) and is the series editor of the Foundations of Law reader series of Foundation Press and editor of the volume in the series Foundations of Corporate Law (Foundation Press, 1993). She is a fellow of the American Academy of Arts and Sciences and a research associate of the National Bureau for Economic Research. Ms. Romano is a past president of the American Law and Economics Association and coeditor of the Journal of Law, Economics, and Organization. She is currently a member of the editorial boards of the American Law and Economics Review, the Journal of Law, Economics, and Organization, the European Business Organization Law Review, the Journal of Corporate Law Studies, and the Supreme Court Economic Review. Her research has focused on state competition for corporate charters, the political economy of takeover regulation, shareholder litigation, institutional investor activism in corporate governance, and the regulation of financial instruments and securities markets.

301

about

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AEI STUDIES ON FINANCIAL MARKET DEREGULATION Charles W. Calomiris and Peter J. Wallison, series editors THE ADVANTAGE OF COMPETITIVE FEDERALISM FOR SECURITIES REGULATION Roberta Romano GOVERNMENT-SPONSORED ENTERPRISES: MERCANTILIST COMPANIES IN THE MODERN WORLD Thomas H. Stanton HIGH LOAN-TO-VALUE MORTGAGE LENDING: PROBLEM OR CURE? Charles W. Calomiris and Joseph R. Mason IS THE BANK MERGER WAVE OF THE 1990S EFFICIENT? LESSONS FROM NINE CASE STUDIES Charles W. Calomiris and Jason Karceski NATIONALIZING MORTGAGE RISK: THE GROWTH OF FANNIE MAE AND FREDDIE MAC Peter J. Wallison and Bert Ely OPTIONAL FEDERAL CHARTERING AND REGULATION OF INSURANCE COMPANIES Edited by Peter J. Wallison THE POSTMODERN BANK SAFETY NET: LESSONS FROM DEVELOPED AND DEVELOPING COUNTRIES Charles W. Calomiris REFORMING BANK CAPITAL REGULATION: A PROPOSAL BY THE U.S. SHADOW FINANCIAL REGULATORY COMMITTEE Shadow Financial Regulatory Committee REGULATING FINANCIAL MARKETS: A CRITIQUE AND SOME PROPOSALS George J. Benston SERVING TWO MASTERS, YET OUT OF CONTROL: FANNIE MAE AND FREDDIE MAC Edited by Peter J. Wallison

The Advantage of Competitive Federalism for Securities

Competitive Advantage of Nations

Operations management for competitive advantage

Understanding Competitive Advantage

Integrating Design and Manufacturing for Competitive Advantage

Management of Technology: The Hidden Competitive Advantage

Business as War: Battling for Competitive Advantage

Operations Management for Competitive Advantage, 11e

Business as War: Battling for Competitive Advantage

The Competitive Advantage Period and the Industry Advantage Period

Organizational Behavior: Securing Competitive Advantage

Organizational Learning and Competitive Advantage

Healthcare Strategy: In Pursuit of Competitive Advantage

Strategic Operations Management: The New Competitive Advantage

Business Process Outsourcing: The Competitive Advantage

Clusters and Competitive Advantage: The Turkish Experience

Business Process Outsourcing: The Competitive Advantage

Application of It for Competitive Advantage at Keane, INC

Business Process Outsourcing: The Competitive Advantage

Pricing for Profitability: Activity-Based Pricing for Competitive Advantage

ECODESIGN -- The Competitive Advantage (Alliance for Global Sustainability Bookseries, 18)

The Leadership Gap: Building Leadership Capacity for Competitive Advantage

Pricing for Profitability: Activity-Based Pricing for Competitive Advantage

The New Competitive Advantage: The Renewal of American Industry

Neighbor Networks: Competitive Advantage Local and Personal

Talent : Making People Your Competitive Advantage

Strategic Procurement: Organizing Suppliers and Supply Chains for Competitive Advantage

Enhancing Competences for Competitive Advantage (Advances in Applied Business Strategy)

From Competitive Advantage to Corporate Strategy

Competitive Advantage: Creating and Sustaining Superior Performance

The Advantage of Competitive Federalism for Securities

Competitive Advantage of Nations

Operations management for competitive advantage

Understanding Competitive Advantage

Integrating Design and Manufacturing for Competitive Advantage

Management of Technology: The Hidden Competitive Advantage

Business as War: Battling for Competitive Advantage

Operations Management for Competitive Advantage, 11e

Business as War: Battling for Competitive Advantage

The Competitive Advantage Period and the Industry Advantage Period

Organizational Behavior: Securing Competitive Advantage

Organizational Learning and Competitive Advantage

Healthcare Strategy: In Pursuit of Competitive Advantage

Strategic Operations Management: The New Competitive Advantage

Business Process Outsourcing: The Competitive Advantage

Clusters and Competitive Advantage: The Turkish Experience

Business Process Outsourcing: The Competitive Advantage

Application of It for Competitive Advantage at Keane, INC

Business Process Outsourcing: The Competitive Advantage

Pricing for Profitability: Activity-Based Pricing for Competitive Advantage

ECODESIGN -- The Competitive Advantage (Alliance for Global Sustainability Bookseries, 18)

The Leadership Gap: Building Leadership Capacity for Competitive Advantage

Pricing for Profitability: Activity-Based Pricing for Competitive Advantage

The New Competitive Advantage: The Renewal of American Industry

Neighbor Networks: Competitive Advantage Local and Personal

Talent : Making People Your Competitive Advantage

Strategic Procurement: Organizing Suppliers and Supply Chains for Competitive Advantage

Enhancing Competences for Competitive Advantage (Advances in Applied Business Strategy)

From Competitive Advantage to Corporate Strategy

Competitive Advantage: Creating and Sustaining Superior Performance

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