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The Inevitability of a Strong SEC, 91 Cornell L Cornell Law Review Volume 91 Article 1 Issue 4 May 2006 The nevI itability of a Strong SEC Robert A. Prentice Follow this and additional works at: http://scholarship.law.cornell.edu/clr Part of the Law Commons Recommended Citation Robert A. Prentice, The Inevitability of a Strong SEC, 91 Cornell L. Rev. 775 (2006) Available at: http://scholarship.law.cornell.edu/clr/vol91/iss4/1 This Article is brought to you for free and open access by the Journals at Scholarship@Cornell Law: A Digital Repository. It has been accepted for inclusion in Cornell Law Review by an authorized administrator of Scholarship@Cornell Law: A Digital Repository. For more information, please contact [email protected]. THE INEVITABILITY OF A STRONG SEC Robert A. Prenticet There are many visions for the future of securities regulation. One prominent view fratures significant private contractingfor disclosure and fraud protection. Another envisions regulatory competition, enabling compa- nies to choosefrom among a menu of regulatory regimes provided by different states, nations, or securities exchanges competing for incorporations or list- ings. This article demonstrates that these two regulatory regimes rely too heavily upon the reputationalconstraint, which is insufficient for the signifi- cant task of securities regulation. Tenets of behavioral psychology suggest that self-serving bias and other factors will too often cause managers to choose regulatory regimes that serve their own best interests rather than those of shareholders. Around the globe, most developed economies have rejected private con- tracting and regulatory competition in favor of emulating the United States' current strong-SEC model. An impressive body of transnationalempirical evidence supports the viewpoint that the strong-SEC regulatory model is sig- nificantly more effective than alternatives at promoting capital markets. This article explains why the strong-SEC model best facilitatescapital market development and economic growth. INTRODUCTION ................................................... 776 I. THE REPUTATIONAL CONSTRAINT ......................... 780 A. The Firm and Its Principals ......................... 781 1. Issuing Companies: Earnings Management and Earnings Fraud .................................. 781 2. CEOs ........................................... 782 3. Boards of Directors ............................... 784 B. The Gatekeepers ................................... 785 1. A uditors ......................................... 785 2. A ttorneys ........................................ 787 3. Stockbrokers ...................................... 788 4. Securities Analysts ................................ 789 5. Investment Banks ................................ 792 6. M utual Funds ................................... 793 7. Rating Agencies .................................. 794 8. Stock Exchanges .................................. 795 C. The Reputational Constraint Under a Behavioral M icroscope ......................................... 797 t Ed & Molly Smith Centennial Professor of Business Law, McCombs School of Busi- ness, University of Texas at Austin. 776 CORNELL LAW REVIEW [Vol. 91:775 II. THE CASE FOR A STRONG SEC ........................... 799 A. Decision-Making Process ............................ 801 B. Effective H euristics ................................. 803 1. Disclosure Is Good ................................ 804 a. The Benefits of Disclosure ..................... 804 b. The Improbability of Adequate Voluntary Disclosure .................................... 806 i. Issuer Choice ............................. 811 ii. ManagerialDiscretion ..................... 813 c. Mandatory Disclosure as a Solution ............ 816 i. Benefits for Issuers ........................ 816 ii. Benefits for Investors ...................... 819 iii. Theory and Evidence ...................... 820 2. Fraud Is Bad .................................... 824 a. The Inefficiency of Fraud...................... 824 b. The Improbability of Adequate Voluntary Compliance .................................. 828 c. Strong SEC Enforcement as a Solution .......... 828 3. Global Emulation ................................ 832 a. A Central Agency ............................. 833 b. Mandatory Disclosure ......................... 834 c. Strong Antifraud Rules ....................... 836 d. Insider Trading Prohibitions................... 837 CONCLUSION ...................................................... 838 INTRODUCTION A familiar cycle has occurred in U.S. securities regulation over the past few years: Loose regulation allows for scandal, which then creates a political atmosphere supportive of aggressive regulation, fol- lowed by a backlash by those regulated. This scenario in the 1920s and 1930s led Congress to introduce the first federal securities laws.1 More recently, Congress enacted the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley) 2 in response to the Enron and related corporate scandals 3 that resulted from a decade of an underfunded Securities 1 See, e.g., JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET: A HISTORY OF THE SECURITIES AND EXCHANGE COMMISSION AND MODERN CORPORATE FINANCE 1 (3d ed. 2005) ("The Securities and Exchange Commission was created at the conclusion of the Senate Banking and Currency Committee's 1932-1934 investigation of stock exchange practices ). The primary..... federal securities laws include the Securities Act of 1933, 15 U.S.C. §§ 77a-77aa (2000), and the Securities Exchange Act of 1934, 15 U.S.C. §§ 78a-7811 (2000). See Elisabeth Keller & Gregory A. Gehlmann, A HistoricalIntroduction to the Securities Act of 1933 and the Securities Exchange Act of 1934, 49 OHIo ST. L.J. 329, 342-47 (1988). 2 Pub. L. No. 107-204, 116 Stat. 745 (codified as amended in scattered sections of 11, 15, 18, 28, and 29 U.S.C.). 3 See S. REP. No. 107-205, at 2 (2002); H.R. REP. No. 107-414, at 18-19 (2002). 2006] THE INEVITABILITY OF A STRONG SEC and Exchange Commission (SEC) .4 Now the backlash has begun, as many criticize the specifics of Sarbanes-Oxley, especially section 404's provisions for internal financial controls and the Act's aggressive ex- traterritorial application. 5 This paper does not take a position on the specifics of Sarbanes-Oxley. Rather, it anticipates the broader, philo- sophically based critiques that are on the horizon. For serious students of securities regulation, the Enron scandal and the Sarbanes-Oxley response raise an overarching question: What should the future of securities regulation look like? Sarbanes-Oxley embodies the "strong-SEC" model, which many people abhor for po- litical and philosophical reasons. 6 Indeed, much brainpower has been spent in the last few decades in a seemingly quixotic quest for a preferable alternative to this strong-SEC model for securities 7 regulation. The most persuasive alternative has been a regulatory competi- tion model." Supporters argue that companies should be free to choose from a menu of securities regulation options offered by the fifty states,9 nations around the world, 10 and the world's stock ex- changes.'1 These supporters assert that if managers can choose their firm's regulatory environment, they will choose the level of regulation most efficient for the purchasers and sellers of securities. 12 Implicitly, 4 U.S. GEN. ACCOUNTING OFFICE, GAO-03-969T, SECURITIES AND EXCHANGE COMMIS- SION: PRELIMINARY OBSERVATIONS ON SEC's SPENDING AND STRATEGIC PLANNING EFFORTS 3 (2003), available at http://www.gao.gov/new.items/d03969t.pdf (reporting testimony of RichardJ. Hillman, Dir., Fin. Markets and Cmty. Inv., before the Subcomm. on Gov't Effi- ciency and Financial Mgmt., of the H. Comm. on Gov't Reform). 5 See, e.g.,Dan Roberts, The Boardroom Burden: Calls for Reform Are Replaced by Concern that Corporate Shake-Up Has Gone Too Far,FIN. TIMES, June 1, 2004, at 15 (noting that busi- ness leaders believe that the pendulum has swung too far toward regulation and needs recentering). 6 See, e.g., Roberta S. Karmel, Realizing the Dream of William 0. Douglas-The Securities and Exchange Commission Takes Charge of Corporate Governance, 30 DEL. J. CORP. L. 79, 111 (2005). 7 See Edmund W. Kitch, The Privatizationof SecuritiesLaws: Proposalsfor Reform of Securi- ties Regulation: An Overview, 41 VA. J. INT'L L. 629, 629 (2001). 8 See Lucian Arye Bebchuk & Alma Cohen, Firms'DecisionsWhere to Incorporate,46J. L. & ECON. 383, 384 (2003) ("According to the view that appears to dominate the current thinking of corporate law academics, state competition produces a 'race to the top' that benefits shareholders. On this view, the desire to attract incorporations induces states to develop and provide corporate arrangements that enhance shareholder value." (footnote omitted)). 9 See, e.g., ROBERTA ROMANO, THE ADVANTAGE OF COMPETITIVE FEDERALISM FOR SECUR- ITIES REGULATION (2002). 10 See, e.g., Stephen J. Choi & Andrew T. Guzman, Portable Reciprocity: Rethinking the InternationalReach of Securities Regulation, 71 S. CAL. L. REV. 903, 925-27 (1998). 11 See, e.g., A.C. Pritchard, Markets as Monitors: A Proposalto Replace Class Actions with Exchanges as Securities Fraud Enforcers, 85 VA. L. REV. 925, 983-1000 (1999) (suggesting that securities exchanges play the most prominent role in securities regulation). 12 See Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE LJ. 2359, 2366 (1998) ("Regulatory competition is desirable because when the CORNELL LAW REVIEW [Vol. 91:775 this regulation may be little or
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