Empowering investors: a market approach to securities regulation.

• Author: Romano, Roberta

The U.S. securities laws have repeatedly been assailed as burdensome or ineffective. Reform efforts have conversely been attacked for undermining an effective mechanism by which shareholders can discipline management. Moreover, even reformers have been dissatisfied with the effectiveness of their product. For example, after enacting the Private Securities Litigation Reform Act of 1995,(1) members of Congress became concerned that their efforts to rein in frivolous private lawsuits under the federal securities laws were being circumvented by state court filings and introduced legislation to preempt such action.(2) There is some validity to their concern: In a report to President Clinton on the impact of the 1995 Act, the Securities and Exchange Commission (SEC) cited preliminary studies indicating a decrease in federal court filings and an increase in state court filings.(3)

This Article contends that the current legislative approach to securities regulation is mistaken and that preemption is not the solution to frivolous lawsuits. It advocates instead a market-oriented approach of competitive federalism that would expand, not reduce, the role of the states in securities regulation. It thereby would fundamentally reconceptualize our regulatory approach and is at odds with both sides of the debate over the 1995 Act, each of which has sought to use national laws as a weapon to beat down its opponent's position by monopolizing the regulatory field.

The market approach to securities regulation advocated in this Article takes as its paradigm the successful experience of the U.S. states in corporate law, in which the fifty states and the District of Columbia compete for the business of corporate charters. There is a substantial literature on this particular manifestation of U.S. federalism indicating that shareholders have benefited from the federal system of corporate law by its production of corporate codes that, for the most part, maximize share value.(4) This Article proposes extending the competition among states for corporate charters to two of the three principal components of federal securities regulation: the registration of securities and the related continuous disclosure regime for issuers; and the antifraud provisions that police that system. The third component, the regulation of market professionals, is not included in the proposed reform. The proposed market approach can be implemented by modifying the federal securities laws in favor of a menu approach to securities regulation under which firms elect whether to be covered by federal law or by the securities law of a specified state, such as their state of incorporation.

Under a system of competitive federalism for securities regulation, only one sovereign would have jurisdiction over all transactions in the securities of a corporation that involve the issuer or its agents and investors. The aim is to replicate for the securities setting the benefits produced by state competition for corporate charters--a responsive legal regime that has tended to maximize share value--and thereby eliminate the frustration experienced at efforts to reform the national regime. As a competitive legal market supplants a monopolist federal agency in the fashioning of regulation, it would produce rules more aligned with the preferences of investors, whose decisions drive the capital market.

Competitive federalism for U.S. securities regulation also has important implications for international securities regulation. The jurisdictional principle applicable to domestic securities transactions is equally applicable to international securities transactions: Foreign issuers selling shares in the United States could opt out of the federal securities laws and choose those of another nation, such as their country of incorporation, or those of a U.S. state, to govern transactions in their securities in the United States. The federal securities laws would also, of course, not apply to transactions by U.S. investors abroad in the shares of firms that opt for a non-U.S. securities domicile. Under this approach, U.S. law would apply only to corporations affirmatively opting to be covered by U.S. law, whether they be U.S.- or non-U.S.-based firms. It therefore would put an end to the ever-expanding extraterritorial reach of U.S. securities regulation, which currently extends to transactions abroad involving foreign firms, as long as there are any U.S. shareholders or U.S. effects.(5)

Stemming the trend of extraterritorial application of U.S. law will not harm U.S. investors because they have, in fact, often been disadvantaged by the expansion of U.S. securities jurisdiction. For example, to avoid the application of U.S. law, foreign firms have frequently explicitly excluded U.S. investors from takeover offers, and such investors have thus missed out on bid premiums.(6) In addition, adoption of the market approach would facilitate foreign firms' access to capital, as they would be able to issue securities in the United States without complying with U.S. disclosure and accounting rules that differ substantially from their home rules, a requirement that has been a significant deterrent to listings.(7) This consequence of the proposed modification of U.S. law would also benefit U.S. investors, who would no longer incur the higher transaction costs of purchasing shares abroad in order to make direct investments in foreign firms.

The market approach to securities regulation is a natural extension of the literature on state competition for corporate charters, and commentators, recognizing the possibility of this extension, have occasionally mentioned it as an alternative to the current system of securities regulation.(8) Advancing those earlier suggestions, this Article makes a systematic case for competitive federalism by articulating the rationales for the approach and by crafting the mechanics of its implementation. The position advocated in this Article--elimination of the exclusive mandatory character of most of the federal securities laws--may seem on first impression to many readers surprising, if not unrealistic or worse. In my judgment, a compelling case can be made on the substantive merits of the proposal.

There may be an understandable desire to discount the need for the proposal because of the vibrancy of U.S. capital markets and the calls for piecemeal reform rather than comprehensive revamping of the current regime by issuers and investors. This would be a mistake. While U.S. capital markets are the largest and most liquid in the world, it is incorrect to attribute this fact to the federal regime. U.S. capital markets were the largest and most liquid global markets at the turn of the century,(9) before the federal regime was established, and their share of global capitalization has declined markedly over the past two decades,(10) facts at odds with the contention that the current federal regime is the reason for the depth of U.S. capital markets. The absence of calls for comprehensive reform is a function of a lack of imagination, rather than evidence that the current regulatory apparatus does not produce deadweight losses.(11) Blind adherence to the securities regulation status quo imposes real costs on investors and firms, and there is a better solution.

Some may conclude that the proposal does not go far enough, and that all government interference in capital markets, whether federal or state, should be abolished. I believe that the intermediate position advocated in this Article is a more sensible public policy than eliminating all government involvement. This is because state competition does not foreclose the possibility of deregulation should that be desired by investors: A state could adopt a securities regime that delegates regulatory authority over issuers to stock exchanges, just as the current federal regime delegates regulatory authority for market professionals to the stock exchanges and National Association of Securities Dealers (NASD). State competition permits experimentation with purely private regulatory arrangements, while retaining a mechanism to reverse course easily--migration to states that do not adopt such an approach--which is not present in a purely private regime. On a more pragmatic level, there is a more immediate point to the Article: to caution against the current impetus to extend the federal government's monopoly over securities regulation. Instead of supplanting state securities regulation, Congress should rationalize it by legislatively altering the multijurisdictional, transactional basis of state regulatory authority to an issuer-domicile basis.

The argument proceeds as follows. In Part I, a market-based approach to U.S. securities regulation is outlined, and the mandatory federal system is critiqued. The rationale for excluding from the proposal the third component of the federal securities regime, the regulation of market professionals, and comparisons with alternative market-oriented reforms, such as regulation by exchanges, are also provided. Part II discusses the details for implementing the proposal, including changing the current choice-of-law rule for securities transactions from one that focuses on the site of the transaction to an issuer-based approach analogous to the internal affairs rule applied in corporate law, and conditioning opting out of the federal regime upon compliance with two procedural requirements. The requirements, which seek to ensure the integrity of the investor decisions that drive the regulatory competition, are the disclosure of the issuer's securities domicile at the time of a security purchase and a shareholder vote to effectuate a change in securities domicile. Finally, Part III extends the proposal to international securities regulation.

1. COMPETITIVE FEDERALISM: A MARKET APPROACH TO SECURITIES REGULATION

   Although both the states and the federal government regulate securities transactions...