Scholars propose SEC response to the failure of private anti-fraud mechanisms.
The 2008 financial meltdown left policymakers searching for avenues to tighten the screws on corporate fraud to avoid the recurrence of such a crisis. According to two prominent corporate law scholars, one such fraud-prevention vehicle is ripe for overhaul.
A federal cause of action known as “fraud on the market” is supposed to deter fraud by empowering private citizens to bring class action suits against those who violate federal anti-fraud securities statutes. In a recent chapter entitled “Reforming Securities Law Enforcement: Politics and Money at the Public/Private Divide” in the book Regulatory Breakdown, University of Pennsylvania Law School Professors William W. Bratton and Michael L. Wachter argue that “fraud on the market” is fundamentally broken. They propose a straightforward, even if politically unlikely, fix.
According to Bratton and Wachter, “fraud on the market” fails in achieving its two main goals. It neither deters individuals from fraudulent behavior nor adequately compensates victims for their loss. The authors contend that both failures are inescapable under the present “fraud on the market” framework.
On the deterrence side, the threat of paying large damages in a class action lawsuit is supposed to discourage corporate managers from committing fraud. In practice, the corporate employers, not the managers themselves, incur the cost of paying damages under the concept of enterprise liability. Thus, the shareholders suffer the consequences for fraud, as the buck passes from individual wrongdoers to the corporation. Without direct penalties, the authors argue, managers feel no pressure to conform to the rules.
“Fraud on the market” also fails to ensure that the victims of fraud receive proper compensation. Plaintiffs’ lawyers seek fast resolution and are inclined to settle at values far lower than the defrauded class would typically deserve, according to Bratton and Wachter.
As a solution, Bratton and Wachter propose a two-pronged overhaul of both the “fraud on the market” doctrine and the anti-fraud enforcement regime. First, they would eliminate the current presumption that victims relied on a misrepresentation. The authors explain that this change would have the practical effect of reducing the volume of private lawsuits. The reduction in private suits would be made up by their second proposal, namely that anti-fraud enforcement shift to the public sector.
The authors describe how the Securities Exchange Commission (SEC) has the capability to enforce anti-fraud measures while avoiding the pitfalls that render private enforcement ineffective. They argue that SEC enforcers, unlike plaintiffs’ lawyers, need not be motivated to settle. Without the misaligned incentive of a cash payout, the SEC can take the long view and seek full compensation for fraud.
To make the case for expanding the role of the SEC, Bratton and Wachter present data to debunk the theory that the SEC is inefficient and incapable relative to private “fraud on the market” litigation. They observe that SEC resources are not, as often presumed, dwarfed by those of the private sector. SEC budget and personnel have grown in concert with the expansion of the regulated markets.
In fact, the numbers they present show that increased staffing and funding has led to dramatic surges in productivity. Bratton and Wachter observe that the annual increase in SEC enforcement cases is growing far faster than the rate of personnel expansion and slightly faster than budget growth. The SEC enforcement division already brings a much higher number of class actions than the private sector, and it does so with a fleet of attorneys roughly equal to that in the private sector anti-fraud plaintiffs’ bar. According to Bratton and Wachter, the private sector earns a return of $4.35 for every dollar invested into enforcement, whereas the SEC earns $6.20 for each dollar.
They admit that empowering the SEC to take a greater role in anti-fraud enforcement would necessitate increasing funding, but they suggest that this can be done at no expense to taxpayers. The agency is funded by collecting fees from market transactions. Each year, it raises revenues that exceed its budget. Under the 2002 Fee Relief Act, leftover revenue is sent to a separate account for safekeeping.
Bratton and Wachter propose restoring the previous system, under which extra revenues were retained for discretionary use by the Treasury Department. Funding may also be realized if the SEC does not disburse the penalties it exacts from wrongdoers to the injured investors.
The authors concede that their proposal would run into stiff opposition from the beneficiaries of the status quo. Plaintiffs’ lawyers enjoy the rewards of the current system, where they seek vast sums from the employers of individual wrongdoers. Corporate managers prefer the current system because its focus on payouts makes a public “show of enforcement” – but without ever hitting their own personal pocketbooks. When the public believes the bad actors are being called to account, the symbolic action actually undercuts the demand for more substantial regulation.
Bratton and Wachter also expect resistance to change from Congress and the SEC. Congress faces political pressure from the business community, while many SEC attorneys may anticipate the day they can leave government, enlist in the private sector, and join in the profits private lawyers enjoy under the status quo.
Bratton and Wachter propose that the necessary political shift may need to come from a tradeoff between an increase in public enforcement and an attendant decrease in private enforcement. They argue that eliminating the presumption of reliance in “fraud on the market” will cause a dramatic reduction in private litigation, which business in principal should support, at least publicly. In exchange, Congress and business interests should consent to greater funding for the SEC.
Bratton and Wachter conclude that the current class action anti-fraud regime is a net loser for society, but the solution will prove difficult to implement. They do not anticipate that their proposal will be met with great enthusiasm, as too many self-interested actors prefer to leave “fraud on the market” untouched.
Bratton and Wachter’s paper appears as a chapter in the recently published book, Regulatory Breakdown: The Crisis of Confidence in U.S. Regulation, edited by Cary Coglianese and published by the University of Pennsylvania Press.
This post is part of The Regulatory Review’s three-week series, Regulatory Breakdown in the United States.