Reconsidering the institutional design of federal securities regulation.

• Author: Gubler, Zachary J.
• Position: II. Critiquing the Statute: Allocating Decision-Making Authority B. Critiquing the Revisionist Justifications for the Public-Private Divide through Conclusion, with footnotes, p. 434-465

2. Critiquing the Revisionist Justifications for the Public-Private Divide

   Is it possible to defend the Exchange Act's public-private divide in light of the modern case for mandatory disclosure? The first challenge lies in having to explain why any firm should be excluded from a mandatory disclosure regime under a view rooted in the third-party effects of information, since all firms must experience such effects to a certain degree. All firms have some current or potential competitor, or possibly a supplier, who might benefit from disclosure and therefore cause the firm to make sub-optimal disclosures. And most firms have at least the potential of an analyst following if only the firm would internalize those benefits and make more disclosures. (110) However, in light of regulatory resource constraints, it may nevertheless make sense to exclude some group of firms from the regime to focus disclosure efforts on those firms for which the market failure arising from the third-party effects of information is thought to be particularly acute.

   And in fact, one can discern in the literature a fairly recent attempt to justify the public-private divide in light of the modern case for mandatory disclosure along precisely these lines. (111) Not surprisingly, commentators differ on the question of which type of third-party effect is the most salient for purposes of making this determination. While these arguments are intriguing and more or less plausible, they nevertheless have a distinctly post hoc feel to them. In other words, they suggest that the current incarnation of the public-private divide, which Congress has given us, does not follow inexorably from the modern economic case for mandatory disclosure.

   The first revisionist justification to consider, articulated by Zohar Goshen and Gideon Parchomovsky, is that the most important beneficiaries of disclosure are information traders who attempt to profit by trading on superior information that they have gathered through costly research efforts. (112) According to this view, these third-party beneficiaries of disclosure are particularly important because they are the primary drivers of market efficiency, the promotion of which Goshen and Parchomovsky view as the main goal of the federal securities laws. (113) Mandatory disclosure places the search costs that would otherwise be incurred by such information traders on the issuers themselves, who can provide it more cheaply than the traders. (114) Additionally, mandatory disclosure allows information traders to exploit the economies of scale and scope that are only realized if a critical mass of firms discloses the optimal amount of information. (115) Because these information traders do not trade on information--and therefore are not shareholders of the disclosing firm--before they have that information, the benefits they receive from disclosure are grouped among the "positive externalities" (116) discussed earlier. And consequently, in the absence of mandatory disclosure, disclosing firms will lack proper incentives to make the disclosures demanded by these information traders. (117)

   But if this information trader view is the correct one, then it is questionable how well the current structure of the public-private divide furthers this goal. Nearly 30 percent of all firms listed on the NYSE, Nasdaq, and AMEX (now the NYSE MKT) have no "meaningful" analyst coverage. (118) Analyst coverage of firms on the other national securities exchanges is even more sparse. (119) Thus, the exchange-listed disclosure trigger of section 12(b) of the Exchange Act is substantially over-inclusive if the goal of the divide is to identify firms with significant analyst coverage. Nor does the public-offering disclosure trigger fare much better, because that is basically the same group as those firms listed on the NYSE, Nasdaq, and AMEX.

   The shareholder size disclosure trigger of section 12(g) potentially holds out greater promise, since analyst coverage is likely to be positively correlated with the amount of trading by institutional shareholders in the issuer's securities. Analyst compensation is at least in part determined by the amount of institutional trading that analysts drive toward their brokerage houses, and there is some evidence that institutional traders tend to reward good research by executing their trades at the brokerage house that produced the research in question. (120) Thus, analysts may decide to cover firms that have a significant amount of institutional trading, and in fact empirical studies suggest as much. (121) However, the size of a firm's shareholder base, although probably correlated with institutional trading volume, is nevertheless a crude proxy for such trading. And in fact, when studies of the determinants of analyst coverage attempt to measure the effects of analyst compensation on coverage considerations, they inevitably use the more obvious proxy of trading volume. (122) More importantly, these studies suggest that other factors, like a firm's accounting fundamentals, may be as important, if not moreso, than a firm's institutional trading volume in determining analyst coverage. (123) And yet, the Exchange Act does not attempt to address these factors. And of course, if this information trader view is the right one, then the most obvious disclosure trigger would be one that attempts to measure directly a firm's analyst coverage. (124)

   A contrasting revisionist view of the public-private divide is provided by Robert Thompson and Donald Langevoort, who believe that the greatest beneficiary of mandatory disclosure is society as a whole, and that society benefits the most when disclosure is imposed upon particularly large companies. (125) These scholars emphasize the analogy between large corporations and governments and argue that the same social norms that apply to the latter should apply to the former as well. (126) These social norms include "a reasonable degree of transparency, some level of accountability, and an openness to external voices," and are furthered to a certain extent by mandatory disclosure. (127) These scholars tend to emphasize the importance of a reporting status trigger that tracks the size of firms, such as section 12(g), which deals with the number of a firm's shareholders of record. (128)

   But the number of a firm's shareholders is probably not particularly closely correlated with its social footprint. After all, there are widely held companies that are nevertheless rather insignificant from a social standpoint, because, for example, they are rather small in terms of revenue or operate in an industry with relatively few environmental spillovers, or because they are not engaged in political lobbying. On the other hand, there are many closely held companies with a large social footprint. For example, as of 2013, there were 224 private firms in the United States with over $2 billion in annual revenue. (129) This list includes firms, like Koch Industries, with a significant environmental impact and substantial political lobbying. (130)

   A more promising revisionist theory in favor of shareholder numerosity as a basis for determining the domain of securities regulation is suggested by the work of Professor Michael Guttentag. (131) In one part of a larger project outlining a policy approach for repairing perceived shortfalls in the JOBS Act, Guttentag suggests that the shareholder numerosity trigger may play a role in identifying those firms that, in the absence of mandatory disclosure, may disclose too little due to concerns over the positive externalities that such disclosure might have with respect to competitors, suppliers, or customers. (132) Recall that because some types of disclosure could place disclosing firms at a competitive disadvantage vis-a-vis third parties, the disclosing firm may be reluctant to make these disclosures. (133) And yet in making this decision, the disclosing firm fails to take into account the offsetting competitive advantages that such disclosures produce with respect to these same third parties. This leads to less disclosure than is optimal from a social welfare perspective. (134) Guttentag argues that firms with fewer shareholders are less likely to take into account these costs of disclosure because a smaller shareholder base implies less risk that the disclosure will leak out to competitors or suppliers. (135)

   Although this is a reasonable defense of using the size of a firm's shareholder base as a disclosure trigger, Guttentag's argument nevertheless leaves some lingering questions. After all, diversified investors do not want the firms in which they invest to take into account these interfirm costs because they know that if the firms do so, it will lead to a sub-optimal amount of disclosure. Thus, as long as shareholders are relatively sophisticated and diversified, there is no reason to believe that there is much of a risk of information leakage on the part of shareholders. And it stands to reason that firms themselves, in the absence of mandatory disclosure, would have incentives to try to deliver disclosure in a way that would make it difficult to share beyond shareholders. Thus, if we were trying to formulate a disclosure trigger that would weed out those firms that are less likely to take into account these costs of disclosure, we might gravitate not toward a shareholder numerosity trigger, but rather toward some type of sophisticated diversified investor requirement.

   These revisionist theories therefore do not seem to follow inexorably from the modern case for mandatory disclosure. To be sure, this observation should not be taken as a criticism of the distinguished scholars who have advanced these revisionist justifications. Rather, it should be viewed as a criticism of the public-private divide itself, which, as we have seen, lacked much if any, theoretical justification to begin with. And what little justification that was offered...