CONTENTS I. INTRODUCTION II. COLLECTIVE ACTION AND THE ROLE OF INSTITUTIONAL INVESTORS III. SECURITIES MARKET INTERMEDIARIES A. Securities Analysts B. Auditors C. Proxy Advisory Services D. Shareholder Activism E. Administrative Services IV. THE FINANCING CHALLENGE A. Identifying the Financing Dilemma B. Existing Legal Responses 1. Mandatory Issuer-Based Subsidies 2. Regulation of Conflicts C. Summary of Inadequacies of the Present Legal Response V. THE VOUCHER FINANCING PROPOSAL A. A New System of Intermediary Financing 1. Origination of Funds 2. Allocation of Vouchers 3. Refining the Voucher Proposal B. Potential Problems with Voucher Financing 1. Coordination Problems 2. Exclusivity and Intermediary Corruption 3. Voucher Financing and Auditors C. Benefits of the Proposal D. A Comparison to the Spitzer Settlement VI. CONCLUSION I. INTRODUCTION
Investors face a difficult task when they value a particular securities investment. They typically put money into an investment with the expectation of taking out even more money sometime in the future. Unlike more tangible investments, securities provide returns only through intangible rights to an issuer's cash flows in the form of dividends and rights to assets in liquidation. As a result, having credible information on the nature of these intangible rights, as well as on the underlying business of the issuer, is important for individuals and entities seeking to value risk and expected return. Once they have this information, investors must also have the requisite expertise to evaluate it. Both gathering and assessing such information is costly.
These problems persist after the initial investment; investors must decide how to manage their investment (for example, by exercising shareholder rights) and when to sell. Although an important component of share ownership is corporate governance rights, including the right to elect directors, many shareholders fail to exercise these rights. The explanation for shareholder passivity in large, publicly held corporations is straightforward. The dispersed shareholder body is poorly positioned to engage in effective collective action; the costs of monitoring management or leading a proxy contest typically far outweigh the benefits to an individual shareholder. As a result, shareholder collective action is rare, even though it may benefit shareholders as a group. (1)
The information cost and collective action problems facing dispersed shareholders in public corporations create at least two possibilities for opportunism. First, corporations may attempt to issue securities at inflated prices, thereby shifting value from new investors to preexisting shareholders. Second, managers may take advantage of deficiencies in shareholder monitoring to expropriate a portion of the issuer's value for their own private benefit through large salaries, insider trading, and other forms of self-dealing. (2)
The market response to these problems is one of pricing. Investors aware of the possibility of opportunism will be more reluctant to invest and will demand a higher return (leading to a reduced price) to compensate them for the risks of self-dealing. (3) Where investors cannot distinguish among corporations with varying risks of opportunism, they will discount all securities prices. The investors' inability to identify riskier issuers leads to a classic lemons problem. (4) Corporations that expropriate a lower amount from investors are given the same discount as corporations with higher levels of expropriation, creating a scenario in which the more investor-friendly issuers may exit the capital markets. (5)
Securities intermediaries offer a market response to the lemons problem. For purposes of this Article, we define intermediaries by their function as collectivizing agents for shareholders--providing services that benefit shareholders directly or indirectly. (6) In particular, this Article focuses on information and activism services, which assist shareholders by providing information to the marketplace and by improving shareholder monitoring. Such intermediaries include auditors, who verify and report on the accuracy of corporate disclosures; analysts, who research and disseminate securities information to the marketplace; proxy advisors, who supply voting guidance and, in some cases, facilitate shareholder activism through the voting process; and others who increase shareholder information or reduce the costs of collective action. Individual shareholders themselves may take on an intermediary role when acting on behalf of all shareholders, such as when they initiate a proxy contest or introduce a shareholder proposal. Issuers also benefit from intermediary services that, by reducing risk to investors, reduce the issuers' cost of capital. (7)
Intermediaries do not always function effectively, however. Indeed, the presence of high-reputation intermediaries may lull investors into a false sense of security, causing them to rely on the intermediaries and seek out less information on their own. Once lulled, investors may lose more money than when the investors enjoyed no intermediary-provided protections. Investors in Enron, for example, expected intermediaries to monitor and disclose the company's financial condition and were misled by the intermediaries' failure to identify and report the company's problems. (8) As Enron's auditor, Arthur Andersen overlooked widespread accounting violations and failed to report the company's financial status accurately, leading to large investor losses. (9) Securities analysts ignored serious indications of financial problems and continued to recommend Enron as an investment long after the company entered its death spiral. (10)
As recent congressional inquiries and media reports have made clear, many of the problems with intermediary performance can be traced to conflicts of interest. Analyst reports are often influenced by a brokerage firm's desire to attract or retain investment banking business. (11) Firms that audit an issuer's financial statements also provide lucrative consulting services that compromise auditing independence. Even shareholder activists may be driven more by personal gain than collective shareholder welfare. The approach toward addressing the problems facing securities market intermediaries has largely consisted of piecemeal efforts to reduce these conflicts. In the case of analysts, the principal reform seeks to separate analyst research from investment banking business. Merrill Lynch recently entered into a settlement with the New York State Attorney General effecting a partial separation of these roles. (12) The National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE) have also implemented conflict-of-interest rules designed to increase the independence of analysts. (13) Similarly, the Sarbanes-Oxley Act of 2002 forbids outside auditors from providing a wide range of consulting services to their audit clients. (14)
Eliminating intermediary conflicts is a flawed solution, however. Someone has to pay for intermediary services, and eliminating conflicts may block an important source of financing. We argue that existing intermediary conflicts have arisen, in large part, because intermediary services are not self-supporting. Regulations that force the separation of intermediary services from more lucrative services may reduce or eliminate services that are not independently profitable and may thus actually exacerbate existing shortages of intermediary services. In particular, although intermediaries presently provide information and technical support, their provision of more active services--such as the initiation of proxy contests--has been limited.
Indeed, we argue that the persistence of intermediary conflicts signals a more general market failure. Individual transactions under the current market structure may fail to provide efficient levels of intermediary services, leading to excessive provision of some intermediary services and inadequate provision of others. Free riding and shareholder collective action problems inhibit the efficient provision of intermediary services. In many cases, issuers respond to these problems by acting as collectivizing agents, bearing the cost of services that benefit all shareholders. Issuers do this, for example, when they hire an outside auditor to certify their financial statements or when they disseminate a shareholder proposal in accordance with SEC Rule 14a-8. (15) Similarly, some commentators have argued that managers used selective disclosures to subsidize analysts prior to the promulgation of Regulation FD, which severely curtailed such disclosures. (16) Alternatively, intermediaries may cross-subsidize their activities with revenues from related business services. Analyst research, for example, has long been cross-subsidized, first from brokerage commissions and more recently from investment banking services. (17)
Issuer-based subsidies, however, create a conflict of interest for intermediaries. Although companies may work to centralize the funding of securities market intermediaries, corporate managers allocate the company's funds. Managers are more likely to fund intermediaries that favor managers than those that effectively curb management opportunism. (18) Control over allocation decisions enables managers to influence intermediary output, leading to biased research and other services. Similarly, cross-subsidization may encourage intermediaries to tailor their output to attract more lucrative ancillary business. (19)
Our central observation is that the problems plaguing securities intermediaries result from a financing dilemma. Absent cross-subsidies or issuer-based subsidies, the market cannot sustain the optimal level of intermediary activity. Understanding the issue as a financing dilemma suggests that reform proposals aimed at reducing conflicts of interest without identifying alternative...