The Dangers of Investor Protection in Securities Markets

I. INTRODUCTION: TROUBLESOME TIMES The purpose of this short Article is to step back a bit from the current controversies to ask this question: What is the proper way to understand the impact of domestic regulation on international securities markets? Any proper analysis has to call into question the basic structure of securities regulation. It must also deal with recent innovations such as Sarbanes-Oxley.1 This analysis does not take place in a vacuum. It is instead yet another act in the long-term clash between two worldviews. The first is that of individuals who hold a general classical liberal orientation. That approach sets its initial presumption to fear, not welcome, government regulation of financial markets on the simple ground that private incentives for profit and gain will do a better job of ferreting out fraud and other forms of misconduct than schemes of government regulation that require expensive standard measures-e.g. registration statements-to supply prophylactic responses to fraud. On the other side of this divide lie individuals who think that actors in private markets are much more limited in their ability to detect and to contain fraud. On this view, extensive forms of regulation, including command and control mechanisms, are needed even for transactions that involve only sophisticated parties, and even more so, in order to protect the small investor from various forms of abuse. To be sure, within this arena, we need not enter the larger debate over whether we should welcome private capital markets at all. The only question is the nature and extent of the regulation needed to combat fraud and other sharp practices. Many of these major regulatory schemes must be rethought with the rise of global markets, which surely changes the mix of sophisticated and unsophisticated investors. If any antifraud system of regulation makes sense, then we should expect to draw foreign capital and investors into the United States, for sophisticated investors around the globe crave confidence in the probity of capital markets. But if that assumption on extensive, or new, levels of regulation turns out to be wrong, foreign investors should reduce their position in the United States in light of the dislocation that regulation creates. The direction of capital flows should give strong indication as to the net benefit of the package of legislation, even if it will not allow us to decide which particular reforms or practices are desirable and which not. To set the stage, let me first deal with some of the common misconceptions of regulation, of which it is possible to identify four. The first deals with the unstated depreciation rates of regulation. The second addresses the supposedly inelastic response to regulation. The third deals with the underapprecation of future regulation. The fourth deals with the indirect consequences of regulation. Once this is done, I shall talk about the legal upshot in both administrative and constitutional law that follows from these wrong conceptions: strong deference to government actors, which accelerates the rate of direct regulation, and with it the level of capital flight from the domestic public securities market. Next, I shall evaluate how this framework applies in two concrete situations: the basic design of the securities acts, and the rise of the independent director. The last section then explains why the cumulative impact of these reforms has been to reduce the attractiveness of United States securities markets on the world stage. II. COMMON MISTAKES ON REGULATION A. Regulatory Depreciation The first of the pitfalls associated with regulatory interventions is that of hidden depreciation. Regulation, especially good regulation, should be thought of as a kind of social asset. Its value is determined like that of any other asset. What is the value of the system when it is first put into place? And what is its rate of depreciation (or, occasionally, appreciation) over time? …