Remaking the U.S. Securities Laws: Not Your Father's Securities Reform

Thomas C. Klein, Shareholder, Greenberg Traurig LLP

Thomas Klein is a shareholder at the global law firm Greenberg Traurig LLP, and an adjunct lecturer at Santa Clara University Law School. He has taught securities regulation as an adjunct lecturer at Stanford University Law School and in the LLM Program at UC Davis Law School. The views expressed in this article are his own and should not be ascribed to any institution with which he is affiliated.

We can stop "reforming" the securities laws -- it isn't working. Securities "reform" has for too long meant just more disclosure without regard to material consequences on business operations. Climate change disclosure. Proxy access. Another round of the SEC beating the dead horse of executive compensation philosophies [1]. Obviously, the best securities laws would be those that make the U.S. capital markets not just competitive but dominant; that strike the ideal balance between facilitating capital formation and the proper amount of fraud prevention. There are two central pieces of evidence that suggest that the federal securities regime is sub-optimal on these two simple measures, but those two pieces of evidence tend to get overlooked in the debate over what next to "reform".

It is axiomatic that no one knows what the optimal securities laws and regulations should be, and even if one did know, the optimal laws and regulations would change over time to address new financial instruments, new modalities for the sale and exchange of those instruments, and new competition for capital. The recent passage of the JOBS Act with its halting enabling of "crowdfunding" evidences the need for a different model of securities regulation. Within this context of unknowability, what then would be the best securities law regime to assure U.S. dominance in the financial markets? The best regime would be a competition of regimes; i.e. experimentation of regimes to see which ones evolve to solve well the problems of capital formation and fraud-deterrence, and that are responsive to the dynamics of markets. The best regime would not be a top-down regulatory monopoly; rather it would be a variety of competing securities regulation regimes each competing for issuers, shareholders, and traders.

This idea of a market for regulatory regimes is not a new one. Roberta Romano, professor of law at Yale University Law School wrote the seminal article about regulatory competition in corporate and securities law in "Empowering Investors: A Market Approach to Securities Regulation", 107 Yale L.J. 2359, 1997-1998. In Professor Romano's article, she argued that a theoretical need for government regulation to prevent market failure is not equivalent to a need for a monopolist regulator. She also noted that there is little empirical evidence to suggest that the federal monopoly regime has affirmatively benefited investors, and that this lack of evidence should call into question whether a federal securities law monopoly was justified.

Competition sounds messy and complicated. Can it work? Not only can it work, but it is partly at work today in global securities market competition, and it worked for at least a century in this country before the federal monopoly on securities regulations was implemented about 80 years ago. Today, financial markets competition is global, and America faces competition from not just London, but Hong Kong, Germany, Japan, Australia, India, and soon Brazil and China in sales of securities in those markets and in listings of shares on exchanges in those countries. This increasing global competition is one reason the U.S. is hosting proportionately fewer new global listings each passing year. The U.S. markets are far from irrelevant, but their influence, and their dominance, is waning. This same model of global competition for the sale of shares and listings was actually the dominant regime within the domestic market of the United States prior to 1933. The exchanges [2] competed for listings of shares, and investment banks competed to sell companies' securities. Since there was no federal regulation, reputation was paramount; that was what drove new listings to the exchange or new clients to the investment bank. Investment banks usually purchased all or portion of the securities from the newly listing company and sold the shares over time to the bank's clients [3] Thus, reputation for carrying quality shares was important: since the bank would own the shares for weeks or months, the banks were careful to investigate the companies selling the stock. The banks were not perfect; they made mistakes, but the incentives were in place for them to minimize those mistakes.

An exchange's reputation was important as well. Shares listed on certain exchanges were granted exemptions from securities registration in certain states, depending on the listing standards of the exchanges. Listing on the New York or American Stock Exchanges was a top-tier listing because of the exchanges' stringent listing standards; thus, such a listing provided an exemption from any qualification of the securities in a large majority of states. The NYSE and AMEX listings were the gold standard, but if the owners of a corporation wanted a silver, tin, or lead standard for listing, that was available as well. It might be more difficult to place those shares because of their lower-quality listing, fewer jurisdictions might permit their sale, and many banks might not be interested in underwriting those securities, but raising capital was nevertheless still available for lower-tier issuers. It was simply the choice of the board and the shareholders (i.e. the owners) of that corporation, rather than having to comply with a regulatory monopoly's standards.

There could of course be a benefit to a uniform unitary regulatory structure; that benefit might be enhanced efficiency in some measurable area, perhaps reducing the costs associated with raising capital. This might be due to "market integrity" -- that is, reducing fraud and fostering participation in the market thereby increasing liquidity; provided that fraud reduction indeed led to greater liquidity when measured against the lost volumes of transactions that anti-fraud rules might impose. The preemption of certain state regulation was likely a benefit in that it lowered the transactions costs of securities sales and trading. [4] Thus, complying with one federal set of laws could be efficient if it meant not having to comply with 50 different state laws. Through various means -- initially state exemptions by coordination and later by express preemption -- a federally compliant listing obviated having to comply with 50 different state laws. Therefore, before getting to the crucial two pieces of evidence showing that the current federal securities regime is suboptimal, one proposal for overcoming this sub-optimality of the federal securities laws is to foster competitive regulatory regimes in this country that offer the same efficiency in terms of preemption offered by the current monopoly federal securities regulatory apparatus.

What precisely would this competitive landscape look like? It would look a lot like the competition among the states in corporate law. Thus, any state could enact its own securities laws and regulations, any company could avail itself of that state's regime, and that state's regime would have the benefit of preemption of other state's securities law as if the state law had the preemption power of federal law. For example, if a company availed itself of Delaware's securities laws and regulatory structure [5], the offer and sale of that company's shares, and the ongoing reporting obligations (if any) required by the Delaware securities law would be the operative laws and regulations for that company rather than the federal securities laws and rather than any other state's laws.

The domestic "market" for securities laws would therefore become a matter of choice for issuers and shareholders. They could avail themselves of the "gold standard" -- the federal securities laws with SEC review under the federal full disclosure regime, or an issuer or its shareholders could select any other state regime offered. The states would compete for listings, and the reputation of each state and the federal regime would develop. A reputation for cost, fraud prevention, post-issuance litigation regimes [6], market integrity, and fairness [7] would develop for each regime. Purchasers may want to purchase only federally registered securities to get the benefit of the current anti-fraud rules, but other purchasers may prefer a Delaware registered security because perhaps fewer of the firm's financial resources might be devoted to compliance freeing up resources for better product innovations. Purchasers' welfare would be enhanced because they would choose what they value in their overall mix of securities regulation [8].

Might there be more securities fraud? [9] Potentially, but an absolute amount of fraud is not the measure of any regulatory regime, although many regulators and academics speak as if it is. The better measure is the amount of fraud compared to the amount of capital formation. The regulatory competition structure proposed could be measured on these terms; if the structure proved a colossal failure, it would not be difficult to re-regulate federally and re-institute a federal securities law monopoly; it was done in 1933 and 1934; it could be done again.

Finally, to the two pieces of evidence that proved that the federal monopoly regime was sub-optimal. First, from 1933 until 1990, there was no Rule 144A market for institutional buyers to resell their private securities among qualified institutional buyers (QIBs). For approximately 60 years, the total welfare of securities markets participants was at suboptimal levels because the regulatory regime did not allow for a means to obtain early liquidity by highly sophisticated buyers and sellers of securities. Most of what became the Rule 144A market was all traded outside the borders of the United States until 1990. The U.S. Rule 144A market traded $1 billion of Rule 144A securities in 1991 alone, the first full year after adoption of Rule 144A, growing to $60 billion by 1997 [10] and to $168 billion in 2011. [11] Had there been domestic regulatory competition, a market for the Rule 144A securities -- which had developed outside the U.S. -- would likely have been targeted for development by one of the states in the U.S. One can see that the cost of not having a Rule 144A regime earlier was years of dampened purchaser wealth, dampened transaction volume, and dampened capital formation. We do not see today the opportunities that never occur due to our regulatory monopoly, but the Rule 144A story is illustrative of these unseen costs. No doubt the same unseen costs are being borne in the Rule 506, private placement, and resale markets for privately-placed securities. Certain Rule 506 restrictions are proposed to be relaxed under the JOBS Act.

Second, the recent development of private company share listing services and brokered transactions is another area that shows suppressed capital formation. The ability to trade shares of unlisted companies -- private companies -- is now developing. The most prominent services for listing and trading are offered by SharesPost and registered broker-dealer SecondMarket. SharesPost was the subject of a recent SEC enforcement action and settlement requiring SharesPost to register as a broker-dealer. [12] The availability of a liquid or semi-liquid market for privately-issued securities would facilitate capital formation for private companies. The enhanced liquidity would on balance increase the value of the shares issued by the issuers (thus, on balance provide more capital at lower cost to issuers) and facilitate new purchaser entrants who require liquidity for holding stock (thus, greater liquidity). Capital formation could be enhanced quite easily in this area, and that is one reason Congress tried to permit a form of "crowdfunding" in the JOBS Act, but the result was so burdened by regulations that it is unlikely that any issuer will crowdsource funding anytime soon. A regulatory regime that fosters this liquidity without a spike in securities fraud would be a net benefit to capital formation in the U.S.

What are the risks? The Senate Subcommittee on Securities, Insurance and Investment of the Committee on Banking, Housing, and Urban Affairs, held hearings in December 2011 with regard to crowdfunding and relaxed SOX requirements for smaller public companies. Professor John Coates of Harvard Law School noted that changes in the securities laws could inadvertently raise the cost of capital by making securities appear more risky, and thus purchasers would charge more to hold securities. Professor Coates noted this as the central risk in "reforming" securities laws. However, the evidence from the Rule 144A enactment and the development of private market liquidity suggest there has been and is suppression of capital formation. Is there evidence of increased fraud when these markets are opened up, such as when Rule 144A was enacted or when SharesPost and SecondMarket began facilitating transactions in private company shares? The author is not aware of studies proving that the fraud costs outweighed the benefits of enhanced capital formation of these reforms nor did Professor Coates cite studies proving an increase in fraud from those two episodes of securities reform. Furthermore, Professor Coates' testimony seemed to be premised on a continued federal regulatory monopoly in securities regulation. The notion that fraud prevention justifies a continued federal monopoly in securities regulation is as at best not proven. At worst, such a notion chills capital formation in the U.S.

Our globally competitive marketplace with ubiquitous and virtually free information -- in contrast to our "silo'ed" agrarian society of 80 years ago when the federal securities laws were first written -- presents an ideal environment to experiment with regulatory competition to promote capital formation. The lessons from state corporate law competition, from past successes in capital formation enablement, and from the history of regulatory competition, should prompt much greater innovation in securities regulation rather than merely more of the same "reform."

[1] It is still an open question whether CD&A is at all material. The expensive drafting and comment process on CD&A sometimes appears as a quest for a Platonic ideal of the "value" of executives' services, as if the marketplace for executive talent and the Board's best judgment were irrelevant.

[2] The principal stock exchanges at the time were the New York Stock Exchange, the American Stock Exchange, the Boston Stock Exchange, the Philadelphia Stock Exchange, the Midwest Stock Exchange, the Chicago Stock Exchange, the Kansas City Stock Exchange, the Denver Exchange, and the Pacific Stock Exchange; there were also regional commodity exchanges.

[3] That is, the securities were not simply held overnight with sweep agreements into customer accounts by the trading desk the following morning after the pricing to the underwriters; rather, the shares were held by the investment bank and sold over a period of weeks or months.

[4] And enhanced liquidity, although liquidity enhancement alone cannot be the foundation for regulation because one must know at what cost such enhancement imposes. For example, a very liquid market for only 10 listings could be less optimal than somewhat less liquidity for a market hosting 1,000 listings.

[5] Note that these securities regimes among the states would evolve to compete for listings by appealing to the owners of corporations -- the shareholders; just as states modify their corporate law to compete for incorporations (and formations of other entities).

[6] For example, not every state may adopt the current federal securities fraud structure, not every state may permit class action securities litigation, and not every state may allow for cash settlements with plaintiffs attorneys when no money damages are paid to presumably injured stockholders.

[7] Meaning, all market participants have access to the same information at the same time. This is sometimes not "efficient" in that the price of a security does not reflect all current information, but there is an inherent conflict in securities regulation between market efficiency and fairness. Each securities regime strikes its own balance in these two areas.

[8] Furthermore, no doubt the mutual fund and ETF industries would develop funds around different listing states, and purchasers could diversify in myriad ways they cannot today under the monopoly regulatory structure.

[9] There are also questions in many cases about whether there was indeed fraud. Some states under the proposed market structure may define fraud differently so when measuring fraud compared to capital formation, it is important to compare apples to apples.

[10] Data from "The Impact of SEC Rule 144A on Corporate Debt Issuance by International Firms", Susan Chaplinsky, UVA, the Darden School, The Journal of Business, June 2002. Some of these transactions might have occurred in U.S. registered markets after registration, and some may have occurred in offshore markets. The amount of suppressed capital formation before Rule 144A cannot be measured precisely, but it was undoubtedly a positive number. The author is not aware of data on the amount of fraud damages in the Rule 144A market.

[11] Data cited in "Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings", SEC Release No. 33-9354 (Aug. 29, 2012), p. 8.

[12] Reforming broker-dealer laws for "finders" is another area that would benefit greatly by regulatory competition.

Thomas C. Klein, Shareholder,

Tom is a shareholder of Greenberg Traurig LLP in its Silicon Valley office. Tom's practice includes representation of companies in formation, venture financing, other private and public financings, technology transactions, and mergers and acquisitions. Tom has been an adjunct lecturer in law at Santa Clara University since 2001, an adjunct lecturer in securities regulation at Stanford University Law School in 2006, and a visiting professor in the Master of Laws program teaching securities regulation at the UC Davis Law School in 2012. He has written on corporate, technology, securities, and mergers and acquisitions topics.

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Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Thomas C. Klein. This work reflects the law at the time of writing.