Rationality is a strong assumption in the legal literature about how corporations and other organizations behave in market settings. The modern transaction-Cost economics on which most Contemporary corporate scholarship is based(1) concedes that the rationality of officers, directors, and other managers is "bounded" (that is, that they do not have perfect information or unlimited time, skill, and attention) and acknowledges that these agents have self-interests that differ from those of their firms' owners.(2) Because of these limits and the imperfection of contractual and other mechanisms for resolving them, firms will not always act in a way that maximizes shareholder wealth. But within such limitations, the world that is portrayed is still one of guileful rationality. Firms that depart too far or too often from this norm will lose access to needed capital and succumb to their more savvy competitors. Managers are presumed to understand this and act accordingly.
Borrowing from an explosion of work by social scientists on human judgment and decisionmaking, legal scholars have been increasingly willing to rethink strong assumptions of rationality in the context of individual behavior, even within markets.(3) They have not yet mined to any depth, however, an equally rich vein of research on organizational rationality.(4) Yet here we find the skeptic's mother lode: empirical accounts--grounded in sociology and social psychology, but increasingly integrated with economic analysis--for why organizations so often behave in the myopic, rigid manner that we seem to observe in the real world. This literature seeks to identify the social cognitions and norm structures(5) within organizations that can lead to a "loose coupling" between day-to-day activities and instrumental rationality for reasons that go well beyond managerial opportunism.(6) It works from the assumption that these social forces are sufficiently natural and ingrained that they cannot readily be eliminated by structural or contractual design, and sufficiently contingent on the personnel in place at any given time and the situation in which the firm finds itself that they cannot easily be learned away. Competitive forces are not irrelevant, but are only part of a complex set of institutional influences that operates over the entire marketplace.(7)
This research affects a good bit of what is taught as organizational behavior in business schools. There, managerial rationality tends to be treated more as a holy grail than as an observable reality. Empirical case studies abound of systemic decisionmaking flaws, with many of the examples drawn from companies hardly destined for Darwinian extinction. Take, for instance, Robert Burgelman's study of Intel Corporation's loss of a strong competitive advantage over a twenty-year period (roughly 1971-1991) in the dynamic random access memory (DRAM) market.(8) Ultimately, Intel recognized the error and successfully repositioned itself in the microprocessor business.(9) In the end, then, Intel did adapt; no doubt market discipline drove the hard lesson. But the interesting questions are why it took so long, and whether it could happen to Intel again in some different context. To offer answers to these questions here would be to give away too much of what is to follow in this Article. Suffice it to say that many organizational theorists suggest that the cognitive and informational difficulties that overcame Intel are pervasive and commonplace. Much of their theory is social constructionist, going to how organizations perceive themselves, their goals, and their environment, and the potential for myths in conditions of high ambiguity.(10)
My immediate interest in this scholarship stems from a continuing fascination with a fundamental question in securities regulation and the primary focus of this Article: Why do companies falsely portray themselves to the capital markets in filings with the Securities and Exchange Commission (the "SEC") and through other publicity? The most common sort of large-scale class-action lawsuit alleging securities fraud is one brought against a public corporation and its senior management for concealing bad news from investors, even though the company was not in the process of selling its own shares at the time. This nonprivity "fraud-on-the-market"(11) case typically involves some form of product or financial degeneration kept from public view until the last possible moment, leading to a rapid decline in the market price of the stock once the adverse information is disclosed, and a set of unhappy investors who bought at a time, they suspect, when the issuer's managers knew of the problems but nonetheless kept an optimistic public face.(12) Scores of cases decided by the courts each year under the principal antifraud provision of the SEC s regulations, Rule 10b-5,(13) fall into this category. In 1995, Congress passed the Private Securities Litigation Reform Act(14) largely to deal with perceived abuses associated with this kind of lawsuit.(15)
My intuition is that stories like Intel, if accurate, have something to say about this question. If Intel's business judgment was skewed by predictable social forces, its economic self-portrait in disclosure about its business prospects perhaps was as well.(16) This insight helps us solve a puzzle. From a rational standpoint, why would public companies ever deliberately lie to investors when, because they are neither buying nor selling stock in the open market, there is nothing directly to gain? When done intentionally, such activity is clearly unlawful and policed fairly visibly both by the SEC and the private plaintiffs' class-action bar. Yet cases of alleged deception seem to persist in large numbers. Of course, anything but the most strained anthropomorphic conception of the firm leads us quickly to observe that corporations cannot tell lies--only their managers can. The question of motivation, then, becomes largely a managerial one. But conventional economic analysis, at least, tells us that the interests of the company's highest executives are usually (albeit not always) fairly closely aligned with the ongoing interests of the firm, so that the question of why senior managers would engage in secondary-market deception remains an interesting one. This is especially so when one considers that in most bad-news scenarios, concealment simply delays the appreciation of the truth rather than avoids it indefinitely,(17) so that there are adverse reputational as well as legal consequences from concealing the truth.
The question has practical importance. From the standpoint of securities-litigation policy, a conclusion that managers seldom have a strong motive to lie under the prevailing regulatory framework (or have such motive only in special, confined circumstances) might lead us to doubt the merits of many of the fraud-on-the-market lawsuits brought today. This would lend inferential support to the view that the bulk of these cases are brought extortionately for their settlement value,(18) and justify the kind of aggressive pruning of such actions that Congress chose in 1995. Conversely, identifying a broader set of plausible motivations would suggest that there might well be plenty of securities fraud around, suggesting the need for care in the reform efforts lest too much deterrence be lost.
This Article seeks to provide a robust set of explanations for why managers of a public corporation would mislead stock market investors either in their filings or in ongoing publicity efforts. Part I begins by tracing the intellectual history of prior answers to this question. As we shall see, there are very good--but confined--explanations within the framework of conventional economic analysis, particularly the thesis advocated by Jennifer Arlen and William Carney(19) that in the face of the sort of liability now imposed for securities fraud (which is almost exclusively vicarious), open-market lies are predictable if (but largely only if) the top managers see themselves as facing a "last period problem" wherein the disclosure of the truth would result in insolvency and hence the loss of their jobs. The primary use of institutionalist organization theory here is simply to emphasize that the cost-benefit calculation that managers face when deciding whether to lie is a complex one: Firms have multiple constituencies, and lies that influence investors may really be directed at other audiences (for example, customers or employees) in order to prevent "runs" on external or internal resources.
We then turn to alternative stories that draw from materials that, as noted above, blend the insights of sociology and social psychology with economic analysis. Part II will move only slightly, if at all, from the world of economics in utilizing this literature. Part II extends the agency-cost analysis by raising the possibility that some forms of misleading may be traceable not to the distortion of information by the senior managers themselves but by arguably selfish distortions by lower-level managers in the flow of information that moves up to senior management. The interesting question here is whether the resulting misinformation to the marketplace is securities fraud at all.
Part III is the heart of this Article and will make much greater use of institutional theory as it has evolved in work on organizations outside of mainstream economics. Organizations are not the product of preexisting or stable preferences of a group of individual actors; instead, the structures and norms that have already evolved determine what those actors prefer and how they make sense of what is happening around them. Here, we see the possibility that managers simply might not recognize problems or risks because of systematic "perceptual filters"(20) that play crucial protective roles in the smooth functioning of the firm. My most provocative hypothesis is that corporate cultural biases, particularly...