The Essential Role of Securities Regulation

This Article posits that the essential role of securities regulations is to create a competitive market for information traders (analysts). The Article advances two related theses - one descriptive and the other normative. Descriptively, it demonstrates that securities regulation is specifically designed to facilitate and protect the work of analysts. Normatively, the Article shows that analysts are the only group that can best underwrite efficient and liquid capital markets and, hence, it is the group securities regulation should strive to protect. By protecting analysts, securities regulations enhance efficiency and liquidity in financial markets. This protection, in turn, benefits other types of investors by reducing transaction costs. Furthermore, by protecting analysts, securities regulation represents the highest form of market integrity by ensuring accurate pricing to all investors, and improves the allocation of resources in the economy. Securities regulation may be divided into three broad categories: disclosure duties; restrictions on fraud and manipulation; and restrictions on insider trading - each of which contributes to the creation of a vibrant market for analysts. Disclosure duties reduce analysts - costs of gathering information, and diminish the ability of analysts to produce biased analyses in exchange for pay. Restrictions on fraud and manipulation lower analysts' cost of verifying the credibility of information, and enhance analysts' ability to make accurate predictions. Finally, restrictions on insider trading protect analysts from competition from insiders that would undercut the ability of analysts to recoup their investment in information, and thereby drive analysts out of the market. Thus, the effect of securities regulation is to develop and secure a competitive market for analysts. Moreover, a competitive market for analysts reduces management agency costs. While courts can discern fraud or illegal transfers, they are ill-equipped to evaluate the quality of business decisions. Judicial oversight can curtail breaches of the duty of loyalty but not breaches of the duty of care; the tasks of curbing breaches of the duty of care and restraining inefficient investments are performed by analysts. Furthermore, a competitive analysts' market generates positive externalities for the rest of the economy by improving the information market and facilitating the operations of the investment banking industry. Our account has important implications for several policy debates. First, our account supports the system of mandatory disclosure. We show that while market forces may provide management with an adequate incentive to disclose at the initial public offering (IPO) stage, they cannot be relied on to effect optimal disclosure thereafter. Second, our analysis categorically rejects the calls to limit disclosure duties to hard information and self-dealing by management. Third, our analysis supports Basic v. Levinson and the use of the fraud-on-the-market presumption in all fraud cases regardless of how efficient financial markets are. Fourth, our analysis suggests that in cases involving corporate misstatements, the appropriate standard of care should, in principle, be negligence, not fraud.