Front matter 11/4/02 9:55 PM Page i The Advantage of Competitive Federalism for Securities Regulation Front matter 11/4/02 9:55 PM Page ii Front matter 11/4/02 9:55 PM Page iii The Advantage of Competitive Federalism for Securities Regulation Roberta Romano The AEI Press Publisher for the American Enterprise Institute W ASHINGTON, D.C. 2002 Front matter 11/4/02 9:55 PM Page iv 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 arrange- ment 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) 1 3 5 7 9 10 8 6 4 2 © 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 neces- sarily reflect the views of the staff, advisory panels, officers, or trustees of AEI. Printed in the United States of America Front matter 11/4/02 9:55 PM Page v Contents PREFACE vii 1INTRODUCTION 1 2RATIONALES FOR SECURITIES REGULATION, THE EFFECTIVENESS OF THE SEC, AND COMPETITIVE FEDERALISM 12 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 3STATE COMPETITION FOR CORPORATE CHARTERS 63 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 4IMPLEMENTING COMPETITIVE FEDERALISM FOR SECURITIES REGULATION 112 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 v Front matter 11/4/02 9:55 PM Page vi vi 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 5COMPETITIVE FEDERALISM AND INTERNATIONAL SECURITIES REGULATION 147 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 6CONCLUSION 172 NOTES 177 INDEX 293 ABOUT THE AUTHOR 301 LIST OF TABLES 4-1 Delaware’s Revenue from Corporate Charters 133 4-2 The SEC’s Financing 134 Front matter 11/4/02 9:55 PM Page vii 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 vii Front matter 11/4/02 9:55 PM Page viii viii 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. Chap 1 11/4/02 9:55 PM Page 1 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 require- ments, 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 prospec- tus, 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 quanti- tative and qualitative disclosures on a periodic basis, in public filings with the agency and in an annual report distributed to shareholders in prepa- ration 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 Chap 1 11/4/02 9:55 PM Page 2 2 COMPETITIVE FEDERALISM FOR SECURITIES REGULATION 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 transac- tions was