INTRODUCTION I. OPTIMAL SECURITIES FRAUD DETERRENCE: A PRIMER A. The Social Costs of Securities Fraud 1. What Are They? 2. What Determines Their Severity? a. Likelihood of Fraud b. Market-Based Solutions B. The Social Costs of Enforcement 1. What Are They? 2. What Determines Their Severity? a. Substance b. Sanctions c. Procedure II. THE VALUE OF A WELL-INCENTIVIZED ENFORCER III. WHEN WILL MULTIPLE ENFORCERS PROMOTE OPTIMAL DETERRENCE? A. Public Servants as Social Welfare Maximizers 1. Public vs. Private Enforcement 2. Concurrent vs. Exclusive Enforcement 3. Federal vs. State Enforcement 4. Other Considerations a. Detection Advantages b. Enforcement Efficiencies c. Resource Constraints d. "Laboratories of Democracy" B. Public Servants as ... Something Else 1. Systematic Underdeterrence? a. A Public-Choice Account i. Congressional Dominance ii. Bureaucratic Slack b. A Behavioral Account 2. Net Savings in Social Costs? a. Private Enforcement b. State Enforcement 3. Superior Alternatives? a. Public Choice: Congressional Dominance b. Public Choice: Bureaucratic Slack c. Behavioral Biases IV. A NEW PATH FORWARD: ENFORCER-FOCUSED REFORM CONCLUSION INTRODUCTION
The United States employs a mishmash of enforcers to deter fraud in its national securities markets. Most controversially, it relies upon class action lawyers to supplement the Security and Exchange Commission's (SEC) enforcement of Rule 10b-5, the primary antifraud provision in federal securities law. (1) Complaints about Rule 10b-5 "strike suits" led Congress to enact the Private Securities Litigation Reform Act of 1995 (PSLRA), (2) which imposed a variety of new burdens on private plaintiffs bringing federal securities claims. Three years later, Congress enacted the Securities Litigation Uniform Standards Act of 1998 (SLUSA), (3) in response to charges that class action lawyers were avoiding the PSLRA's intended prohibitions by filing securities fraud claims under state law. SLUSA precludes most state-law-fraud class actions involving securities traded on national exchanges and those issued by large mutual fund companies. (4) It explicitly preserves, however, the authority of state officials to bring enforcement actions. (5) Thus, in addition to facing federal fraud liability at the hands of both the SEC and class action plaintiffs, (6) participants in the U.S. national securities markets also face potential fraud liability at the hands of fifty state governments. (7)
This multienforcer approach to securities fraud deterrence is more the product of historical happenstance than coherent design choices. (8) It is therefore worthwhile to step back and ask, from first principles, whether this approach makes any sense. The question is a timely one. Stories of the spectacular frauds perpetrated by Bernie Madoff and Allen Sandford have led many ordinary Americans to conclude that our securities fraud deterrence regime is broken, and the financial community has been complaining loudly in recent years that a "lack of coordination and clarity on the ways and means of enforcement" is a drag on the competitiveness of our capital markets. (9) Perhaps most urgently, the Obama administration is seeking to replicate the multienforcer approach in the realm of consumer financial protection, with potentially far-reaching consequences for the economy. (10)
This Article critically analyzes the United States' multienforcer approach to securities fraud deterrence. The analysis reveals that the efficacy of the approach is dubious. Although in theory there are conditions under which a multienforcer approach would promote optimal deterrence, it is highly uncertain whether those conditions exist in the United States. Unfortunately, additional empirical research, though warranted, is unlikely to resolve the issue. But maintenance of the status quo is not the best response to this irreducible uncertainty. Rather, this Article suggests that a superior approach would be to consolidate the enforcement authority now shared between federal regulators, state regulators, and class action lawyers in a federal agency, such as the SEC, and to grant that agency exclusive authority to prosecute national securities frauds--while simultaneously enacting reforms to align that agency's enforcement incentives more closely with the public interest. In addition to conferring the benefits of simplicity, a unitary-enforcer approach would allow the United States to capture important enforcer-based efficiency gains that are unattainable under the current regime.
The Article proceeds in four parts. To understand when a multienforcer approach may serve the cause of optimal deterrence, one must first understand the meaning of that goal. Part I thus provides a primer on optimal securities fraud deterrence, explaining how--notwithstanding its scienter requirement--securities fraud liability can produce nontrivial overdeterrence costs. The task of policymakers is to design a liability regime that minimizes the sum of these costs, other enforcement costs, and the social costs of securities fraud.
Part II explains why focusing on enforcer incentives--as opposed to narrowing the scope of the substantive fraud prohibition, lowering sanctions, or toughening procedural rules--is a superior way to deal with the risk of overdeterrence inherent in securities fraud litigation. Unlike those other methods, improving the incentives of the enforcer can reduce overdeterrence costs by increasing the accuracy of prosecutions without simultaneously weakening the regime's ability to deter fraud. Aligning enforcer incentives with society's interest in achieving optimal deterrence confers other important benefits as well: it increases the potential for regulatory flexibility and minimizes the unique risk of overdeterrence that the use of vicarious liability presents. Despite these benefits, enforcer-focused reforms have taken a backseat to substance-, sanction-, and procedure-focused reforms in the debate over how to improve the U.S. securities fraud deterrence regime. The neglect of enforcer-focused reforms would be understandable if it were clear that the securities fraud enforcers we currently employ are as good as it gets. But no one has rigorously examined the optimality of our current mix of enforcers. (11)
Part III begins to fill this gap. It explains that we cannot evaluate the efficacy of a multienforcer approach without first making important assumptions about regulatory behavior. If, for example, we believe that government agents seek to maximize the social welfare of the jurisdictions they serve, it would be unwise to use multiple enforcers to deter fraud in our national securities markets. Using concurrent enforcers generally, and private enforcers in particular, would lead to fewer of the enforcer-based efficiency gains discussed in Part II than would the use of an exclusive, public, federal enforcer--without providing any obvious offsetting benefits. If, instead, we take a more skeptical view, we cannot say anything so definite. In a world with imperfect government agents, a multienforcer approach to securities fraud deterrence may be efficient, but only if three conditions are met. Specifically, it must be the case that: (1) if a federal enforcer were given exclusive enforcement authority, it would systematically err on the side of underdeterrence; (2) additional enforcers save more in underdeterrence costs than they create in enforcement costs; and (3) no alternative reforms designed to align the federal enforcer's incentives more closely with the public's interest in optimal deterrence are available that would lead to an even greater net savings in social costs. The discussion in Part III illustrates that it is far from clear that these conditions are currently met in the United States, casting doubt on the efficacy of both state and private enforcement. Significant further research is warranted.
Part IV addresses what should be done in light of this uncertainty. It suggests that, rather than privileging the status quo, policymakers should consider unifying securities fraud enforcement authority under a single federal regulator, while simultaneously addressing any increased risk of systematic underdeterrence this change would create by enacting reforms designed to improve the federal enforcer's incentives. State and private enforcers might continue to play a role in securities fraud deterrence following such a change, but a role that is subordinate to that of the federal enforcer. Moving to a unitary-enforcer approach may or may not lead us closer to optimal deterrence--we cannot know based on existing evidence. But such a move would allow us to potentially capture the enforcer-based efficiency gains described in Part II. It would also simplify the U.S. securities fraud deterrence regime, making it easier to evaluate and improve its effectiveness going forward.
OPTIMAL SECURITIES FRAUD DETERRENCE: A PRIMER
This Article assumes that the goal of securities fraud liability is deterrence. To be justified, a deterrence-focused securities fraud liability regime must save more in social costs from fraud than it creates in enforcement costs. To be optimal, the regime must minimize the sum of these costs. (12) Section I.A briefly surveys the social costs of securities fraud and the circumstances that dictate their severity. Section I.B addresses the enforcement costs of a securities fraud deterrence regime, explaining how the regime's design will influence the magnitude of those costs.
The Social Costs of Securities Fraud
What Are They?
Securities fraud, like other failures in the market for information, produces deadweight social costs that may justify regulation. First, fraud increases the cost of capital in a variety of ways. For example, if potential investors in primary offerings fear that issuers will defraud them, they will predictably discount the price they are willing to pay for the securities...