Federal Securities Regulation: Are We Moving Toward Merit Review? (Part 2)
Last week I blogged (here) about the possibility that the Supreme Court’s apparent increasing willingness to strike down regulation of corporate speech as contrary to the First Amendment could lead to a reconsideration of merit review as a part of our federal securities regulation regime (it is already a part of many states’ blue sky laws). The next day, Stephen Bainbridge responded: "No thanks!" (here).
Bainbridge noted the following criticisms of merit review (I provide some additional considerations):
Criticism: “[Merit review thus is] premised on the debatable notion that a security has an ascertainable fair price.” (Quoting Wendy Gerwick Couture, Price Fraud, 63 Baylor L. Rev. 1 (2011).)
Comment: “[While t]he fundamental value of a security cannot be reduced to a specific number … security analysis is used to identify a range of values that are supported by the fundamentals and reasonable assumptions…. factfinders are often asked to determine the fundamental value of securities in other contexts that are equally as complicated ….” Couture, Price Fraud, 63 Baylor L. Rev. at 61-62.
Criticism: “In addition, by lowering offering prices below what the market will bear, [it will] divert money away from the issuer to be scooped up by speculators in the secondary market.” Id.
Comment: We already have money being diverted from issuers when they offer their securities. It’s called underpricing, and it has so far not killed the market.
Criticism: “[M]erit review is widely criticized as unduly paternalistic…. in essence, merit review protects investors from themselves.” Id.
Comment: Actually, I think that what merit review should be about first and foremost is protecting the market from collapse. When we can figure out how to keep the health of the overall market from being implicated when individual investors burn their life savings up in bubble feeding frenzies, I might be more open to equating the old saw “a fool and his/her money are soon parted” with good policy. Relatedly, I recently watched the first Frontline episode of “Money, Power & Wall Street” wherein Frank Partnoy commented on the on-going industry debate about whether risk tends to end up in the smartest or the dumbest hands. Partnoy concluded that the latter appeared to be the case when we allowed credit default swaps to trade freely in unregulated markets.
Criticism: “[M]erit regulation has also provided a fertile breeding ground for rent seeking and corruption by regulators.” (Quoting Robin Hui Huang, 41 Hong Kong L. J. 261, 270.)
Comment: There is no such thing as a free lunch. If the SEC’s ability to protect markets by mandating certain types of disclosures is excessively constrained, merit review may be considered as a way to fill the regulatory void. The question of whether the cost of rent-seeking outweighs the cost of leaving markets vulnerable to another financial crisis is a complicated one. But the mere fact that we can expect to see some rent-seeking does not necessarily doom merit regulation as an effective regulatory choice.
Criticism: “Therese Maynard notes that merit review also has been blamed for impeding capital formation. ‘Small issuers in particular complained bitterly that the cost of complying with California's merit review standard in order to register their securities offerings for sale in this state substantially raised their capital formation costs.’” (Quoting 30 Loy. L.A. L. Rev. 1573, 1586.)
Comment: Recent events suggest we have the ability to address concerns related to small business capital formation directly.
Criticism: “What would I do if the Supreme Court struck down the current mandatory disclosure regime? … I'd rely on voluntary disclosure.”
Comment: Again, are we talking about the type of voluntary disclosure that kept the credit default swap market in check in the period leading up to our most recent financial crisis?
I certainly don’t claim to know whether the increasing protection of corporate speech will implicate securities regulation in such a way as to spur the SEC or Congress to look for regulatory alternatives. Nor am I certain that merit review would be a good choice if that were to be the case--it may be that the sum of Bainbridge's well-grounded criticisms above are too much to overcome even if there are adequate responses to them taken individually. I do, however, think both contentions are interesting and should not be dismissed prematurely.