PRENTICE.DOC 05/07/02 10:54 AM Duke Law Journal VOLUME 51 MARCH 2002 NUMBER 5 WHITHER SECURITIES REGULATION? SOME BEHAVIORAL OBSERVATIONS REGARDING PROPOSALS FOR ITS FUTURE ROBERT PRENTICE† ABSTRACT Respected commentators have floated several proposals for star- tling reforms of America’s seventy-year-old securities regulation scheme. Many involve substantial deregulation with a view toward allowing issuers and investors to contract privately for desired levels of disclosure and fraud protection. The behavioral literature explored in this Article cautions that in a deregulated securities world it is ex- ceedingly optimistic to expect issuers voluntarily to disclose optimal levels of information, securities intermediaries such as stock ex- changes and stockbrokers to appropriately consider the interests of investors, or investors to be able to bargain efficiently for fraud pro- tection. TABLE OF CONTENTS Introduction...........................................................................................1399 I. Investor Regulation ...................................................................1402 II. Assumptions Underlying Investor Regulation.......................1408 A. Market Efficiency ...............................................................1409 Copyright © 2002 by Robert Prentice. † University Distinguished Teaching Professor and Ed & Molly Smith Centennial Profes- sor of Business Law, McCombs School of Business, University of Texas at Austin. PRENTICE.DOC 05/07/02 10:54 AM 1398 DUKE LAW JOURNAL [Vol. 51:1397 B. Optimal, Voluntary Issuer Disclosure..............................1412 1. Are Individuals and Organizations Rational?...........1413 2. Is Honest, Full Disclosure Rational?..........................1414 C. Intermediaries and Their Motives ....................................1426 1. Stockbrokers..................................................................1426 2. Securities Exchanges ....................................................1434 III. Investor Self-Protection ............................................................1442 A. Dealing with Issuers ...........................................................1442 1. Small Companies Raising Capital...............................1443 2. Companies Preparing to Go Public ............................1445 B. Dealing with Stockbrokers ................................................1448 1. Bounded Rationality and Rational Ignorance...........1454 2. Overoptimism and Overconfidence............................1457 3. The False Consensus Effect.........................................1462 4. Insensitivity to the Source of Information .................1462 5. Oral Versus Written Communications .......................1467 6. Other Heuristics and Biases.........................................1469 7. General Psychological Susceptibility to Influence ....1472 8. Calculating Probabilities ..............................................1480 9. Anchoring and Adjustment and the Status Quo Bias .................................................................................1483 10. Repeat Errors................................................................1485 C. Choi’s Behavioral Analysis................................................1489 IV. Unintended Consequences of Investor Regulation ...............1494 A. Reducing the Efficiency of the Capital Markets.............1495 B. Undermining Trust .............................................................1500 C. Stimulating Fraudulent Behavior......................................1502 D. Creating Opportunities for Organized Crime .................1506 Conclusion .............................................................................................1509 I can calculate the motions of heavenly bodies, but not the madness of people. Sir Isaac Newton1 1. NICHOLAS DUNBAR, INVENTING MONEY: THE STORY OF LONG-TERM CAPITAL MANAGEMENT AND THE LEGENDS BEHIND IT 1 (2000) (quoting Sir Isaac Newton, speaking after he lost £20,000 in the stock market). PRENTICE.DOC 05/07/02 10:54 AM 2002] SECURITIES REGULATION 1399 INTRODUCTION United States securities regulation is at a critical juncture. After eight years of investor-friendly Securities and Exchange Commission (SEC) leadership by Arthur Levitt,2 Congress is contemplating a top- to-bottom review of all federal securities laws, beginning with the 1933 and 1934 Securities Acts.3 In such a review, Congress might well turn for guidance to the writings of leading academics who propose dramatic changes in federal securities regulation. For example, Congress might well look at the writings of Profes- sor Paul Mahoney4 and Professor Adam Pritchard,5 who have both recommended a dramatically reduced role for current enforcement mechanisms and an attendant increase in the power and responsibility of stock exchanges. In the alternative, they might examine Professor Roberta Romano’s proposal to largely replace federal securities regulation with state regulation in a system of competitive federal- ism.6 They also might study Professor Stephen Choi’s plan to refocus regulatory attention from the professional actors in the securities sys- tem to the investors.7 These proposals, however, should be considered with some trepidation because they are not informed by a large body of behav- ioral research8 that directly bears upon their premises and conse- 2. See Mike McNamee, Wanted: Another Investor-Friendly SEC Chief, BUS. WK., Jan. 29, 2001, at 39, 39 (describing that during the bull market of the 1990s “Levitt’s SEC championed lower fees, fuller disclosure, and crackdowns on insider games and Internet fraud”). 3. Before he resigned as chair of the Senate Banking Committee and announced his im- minent retirement, Senator Phil Gramm explicitly promised such a thorough review. Jaret Sei- berg, Gramm Aims to Make Changes in Securities Law, NAT’L L.J., Feb. 5, 2001, at B11. Cer- tainly the events of September 11, 2001, moved securities law reform down on the nation’s, and the Senate’s, list of priorities. The unfolding Enron scandal also will likely render any major de- regulatory moves politically unpopular for at least a time. 4. See generally Paul G. Mahoney, The Exchange as Regulator, 83 VA. L. REV. 1453 (1997). 5. See generally A.C. Pritchard, Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers, 85 VA. L. REV. 925 (1999). 6. See generally Roberta Romano, Empowering Investors: A Market Approach to Securi- ties Regulation, 107 YALE L.J. 2359 (1998). 7. See generally Stephen Choi, Regulating Investors Not Issuers: A Market-Based Pro- posal, 88 CAL. L. REV. 279 (2000). 8. Recent years have seen a significant injection of behavioral research into legal scholar- ship. Among the leading works not otherwise cited in this article are Hal R. Arkes & Cindy A. Schipani, Medical Malpractice v. the Business Judgment Rule: Differences in the Hindsight Bias, 73 OR. L. REV. 587, 621–30 (1994) (applying the insights of the psychology literature’s hindsight bias to the contrasting rules for reviewing decisions of doctors and directors); John C. Coffee, Jr., Beyond the Shut-Eyed Sentry: Toward a Theoretical View of Corporate Misconduct and an PRENTICE.DOC 05/07/02 10:54 AM 1400 DUKE LAW JOURNAL [Vol. 51:1397 quences; and they are inconsistent with a growing body of empirical evidence supporting the developing consensus that American securi- ties regulation is the optimal system for governing capital markets.9 Because the debate already has been joined regarding the “ex- change as regulator” proposals10 and Professor Romano’s competitive federalism plan,11 I focus my attention upon Professor Choi’s investor Effective Legal Response, 63 VA. L. REV. 1099, 1132–56 (1977) (presenting an early effort to apply behavioral psychology and organizational behavior research to the corporate setting); Russell B. Korobkin, Behavioral Analysis and Legal Form: Rules vs. Standards Revisited, 79 OR. L. REV. 23, 43–57 (2000) (using behavioral theory to evaluate the choice between rules and standards); Russell Korobkin & Chris Guthrie, Psychological Barriers to Litigation Settlement: An Experimental Approach, 93 MICH. L. REV. 107, 164–66 (1994) (suggesting that rational-actor based models used to analyze why parties fail to settle litigation should be replaced with a richer model incorporating psychology literature); Cass R. Sunstein et al., Assessing Punitive Damages (With Notes on Cognition and Valuation in Law), 107 YALE L.J. 2071, 2094–109 (1998) (at- tempting to explain punitive damages with behavioral insights); Richard L. Hasen, Comment, Efficiency Under Informational Asymmetry: The Effect of Framing on Legal Rules, 38 UCLA L. REV. 391, 435–38 (1990) (arguing that psychological models of human behavior produce more realistic and nuanced policy prescriptions than do economic models). Although the bandwagon for behavioral analysis is quickly adding new riders, several scholars have serious concerns about its implications. See, e.g., Robert A. Hillman, The Limits of Behavioral Decision Theory in Legal Analysis: The Case of Liquidated Damages, 85 CORNELL L. REV. 717, 718 (2000) (suggesting that because behavioral evidence indicates that human be- havior is “complex and contradictory,” behavioral theory “is not likely to contribute very suc- cessfully to instrumental legal reform”); Mark Kelman, Behavioral Economics as Part of a Rhetorical Duet: A Response to Jolls, Sunstein and Thaler, 50 STAN. L. REV. 1577, 1586–90 (1998) (expressing reservations that leading behavioral