"The Rich Get Richer" by Jed S. Rakoff (NYRB)



Rethinking Securities Law

by Marc I. Steinberg

Oxford University Press, 339 pp., $85.00


Historically the regulation of companies in the United States has been a matter of state law. Corporations were primarily regulated by the state in which they were incorporated, which prior to the Civil War was usually the state where they did most of their business. But with the rise of large national corporations in the late nineteenth century, states began competing as sites of incorporation, offering financial advantages such as generous tax breaks in return for increased incorporation fees and other benefits. In what quickly became a race to the bottom, New Jersey and Delaware were the two chief competitors. But the Delaware General Corporation Law, enacted in 1899, reduced corporate taxes and shareholder “interference” with management to an extent that not even New Jersey could match. As a result, Delaware became the primary site of incorporation of most large US (and a great many foreign-owned) corporations, including more than two thirds of all Fortune 500 companies.

Despite occasional competition from Nevada and other states, Delaware’s dominance as the preferred state of incorporation, and its corresponding primacy in the development of corporate law, has been further solidified by its constant attention to the needs and desires of corporate management. Delaware law offers corporations, for example, freedom from liability for managerial actions taken in the exercise of “business judgment,” protection from unwanted takeovers, anonymity of ownership (especially for “offshore” companies), and, overall, very light regulation. Perhaps most important from a legal liability standpoint, Delaware funnels most corporate disputes into the state’s Court of Chancery, where, though the judges are very able, no jury trials are allowed.

The laws governing the affairs of large corporations have thus primarily become the laws of Delaware. During the Great Depression, however, the federal government—attributing much of the economic collapse to corporate dishonesty—decided to partially intervene with the Securities Act of 1933 and the Securities Exchange Act of 1934 (“securities” being a legalistic term encompassing, inter alia, corporate stocks and bonds). Both these acts were administered by a newly created federal agency, the Securities and Exchange Commission (SEC), which quickly developed a reputation for being less lenient toward corporate management than Delaware or most other states.

Essentially the federal securities laws sought to require public companies to disclose the true state of their finances. A failure to disclose, or a disclosure that was dishonest, could result in civil penalties, injunctive relief, and sometimes, if the mistakes could be shown to be intentional, criminal prosecution. But while these laws went some way toward creating a more honest marketplace in corporate securities, they were largely limited to mandating disclosure of information. Substantive regulation of how a company is structured and managed remains mostly a matter of state law.

In the years immediately following World War II, this division of regulation seemed to work well enough. While most Americans, still harboring memories of the Great Depression, continued to be leery about investing in corporate stocks and bonds, an increasing number began to do so, reassured that what companies were reporting about their profitability and net worth was accurate. By 1950, over 90 percent of the shares of publicly traded US companies were owned directly by individual investors. As a result, many Americans had a stake in US business and a reason for wanting it to be well managed. At the same time, as a consequence of progressive income tax policies and increased unionization, the percentage of US net wealth held by the richest one tenth of one percent of Americans had by 1950 declined to less than 10 percent, and it declined even further to around 7 percent by 1980.

In recent years, however, all this has changed dramatically. Most corporate securities are now held by institutional investors such as asset-management funds, pension funds, mutual funds, and hedge funds, which own, for example, more than 80 percent of the stock of S&P 500 companies. The three biggest asset-management funds—Vanguard, BlackRock, and State Street—hold almost a quarter of the equity in the nation’s largest corporations.

Many individual Americans are invested in these funds, but that does not provide them with any control over, or even much knowledge of, the companies in which the funds invest. That might not be so bad if the funds themselves cared about how these companies conduct their business over the long term. But with a few rare exceptions (such as BlackRock’s emphasis on investing in environmentally sensitive companies), such funds have little or no interest in corporate governance or behavior, because they are only investing for short-term profits and will rapidly change their investments from one company to another as financial trends dictate.

For example, in the 1970s, when most New York Stock Exchange (NYSE) securities were still owned directly by individual shareholders, the average length of time a share of an NYSE company was held by an average investor was about seven years. The average now, in this era of institutional investors, is a mere seven months. Indeed, according to some estimates, about 70 percent of all US securities trading is done by “hyper-speed” traders, who may own a share for just a few seconds. Much of this trading is accomplished by use of mathematical algorithms that are focused on short-term profitability. And even those funds that have a longer-term investment strategy commonly outsource their shareholder voting rights to separate services, so little do they care about exercising their power over management as long as the company returns high profits.

An equally important change has been the shift from public to private financial markets, which are often free of most of the disclosure requirements of federal law. SEC commissioner Allison Herren Lee said in a recent speech:

Perhaps the single most significant development in securities markets in the new millennium has been the explosive growth of private markets…. More capital has been raised in these markets than in public markets each year for over a decade…. The increasing inflows into these markets have also significantly increased the overall portion of our equities markets and our economy that is non-transparent to investors, markets, policymakers, and the public.

Finally, the percentage of US net wealth held by the richest one tenth of one percent of Americans—mostly corporate executives, money managers, and their families—had by 2020 more than doubled from its postwar figure to about 20 percent, and the percentage held by the top one percent had, as of the end of 2021, increased to an astonishing 32.3 percent of US net wealth, much of it tied up in securities. While this may be chiefly due to reduced tax rates (for both wealthy individuals and corporations), the ability of lightly regulated companies to enhance their executives’ wealth through devices such as adjustable stock options clearly contributes to the skew. And judging from the apparent failure of the current administration to enact more progressive tax laws, this obscene division of wealth between the rich and the rest of us seems likely to become even more pronounced in the future.

Given these developments, it may well be time to reevaluate the balance between state and federal regulation of big business. In Rethinking Securities Law, Marc I. Steinberg of the Dedman School of Law at Southern Methodist University suggests that the federal government should become more involved, not only by broadening its disclosure requirements to meet the needs of these changed circumstances, but also by determining what conduct by a corporation is “fair” and “equitable,” matters mostly still reserved for the very limited oversight of state law.

Steinberg’s approach is notably different from the so-called ESG movement currently popular with many reformists. ESG proponents seek through private action to encourage investors to compel companies to meet a set of progressive environmental, social, and governance (ESG) standards. Whatever the merits of this approach, Steinberg focuses instead on proposed federal legislation that he believes would rectify many of the dangers and excesses in corporate conduct permitted by current state law.

For example, he proposes the total “federalization of corporate governance.” This would include, among other things, a federally mandated requirement that the chair of a company’s board of directors be an independent director holding no position in the company’s management, on the theory that such independence would provide a greater check on managerial malfeasance. Steinberg would also have federal law require that at least one member of the board be an “employee representative,” chosen by the company’s nonmanagement employees, and that this representative be part of the board’s compensation committee. And while federal securities law now requires disclosure of top executives’ compensation, Steinberg, again addressing substance rather than just disclosure, would impose a cap on the percentage of disparity between the CEO’s compensation and that of the median employee.

While most states hold that managers owe a fiduciary duty—that is, a duty of honesty and loyalty—to their corporation, states vary considerably on what that duty entails in practice. In particular, Delaware and other states often turn a blind eye to an executive’s using his position to promote his self-interests, provided that he is still exercising a reasonable “business judgment” on behalf of the corporation. Steinberg proposes instead that “federal securities laws,” not state laws, “should regulate substantive fiduciary conduct.” This would include, for example, making managers strictly liable for self-dealing, even when it is arguably in the company’s interest as well.

Also, while Delaware, like many states, allows a corporation’s charter to limit managerial liability for almost any kind of misconduct to intentional acts, Steinberg would expand such liability to negligent acts. Further, he would entirely eliminate the current requirement, derived from state and common law precedents though present in some federal laws as well, that a shareholder prove that she personally relied on management’s false or misleading statements before she can bring suit seeking to hold management liable for such statements.

Steinberg does not neglect enhanced disclosure. For example, he would eliminate the current guideline that management need not disclose “bad news” if the negative development has had an insufficient or unknowable impact on the company’s finances, i.e., is quantitatively “immaterial.” This much-used loophole allows a company, for example, to conceal that one or more of its top-level executives has engaged in misconduct ranging from sexual abuse to financial fraud. Steinberg would replace this judicially created loophole with a federal legislative requirement that a company disclose virtually any kind of misconduct or malfeasance on the part of its executives.

Steinberg has combined a reformist vision with detailed proposals for realizing that vision. It all sounds good on paper. But the question is how to get Congress to enact even a small portion of his proposals. With so much of the ownership of both public corporations and private markets controlled by institutional investors primarily interested in quick profits (and themselves often controlled by rich executives), there is little investor pressure for many of the reforms Steinberg proposes. And one may also imagine that the former senator from Delaware now occupying the Oval Office might be less than enthusiastic about shifting the focus of corporate law from his home state to Washington.

A good illustration of the difficulties in getting Congress to strengthen the laws against corporate misconduct is Steinberg’s proposals regarding insider trading. As he recognizes, insider trading—in which an executive entrusted with confidential information (such as a merger that has not yet been publicly announced) trades on the basis of that information for his personal benefit or discloses it to others so that they may do so—harms both the company that generated the information and the investors who, ignorant of the inside information, sell their stock to the insiders. In theory, then, there should be a wellspring of support for federal legislation broadly outlawing trading on inside information.

But this has not been the case. The SEC initially had to shoehorn regulations of insider trading into its general antifraud provision, SEC Rule 10b-5. But that strategy meant that insider trading cases had to contend with the various limitations on fraud lawsuits that had been developed over decades—indeed, over centuries—by state and common law (which disfavored such lawsuits because they tended to “chill” rapid commercial development). So, for example, since proof of fraud classically requires a misrepresentation while insider trading can occur without any representation being made at all, the SEC and then the courts had to develop convoluted theories for why someone had an affirmative duty to disclose the fact that he was seeking to trade on inside information. But this duty was owed, under state and common law rules, only to those who had entrusted him with the information (such as his employer) and not those who had sold their stock to the insider without knowing he had the unfair advantage of such information.

Over time, and often in reaction to difficult cases, the courts developed even more arcane rules about what was required to show that insider trading was genuinely fraudulent under the terms of Rule 10b-5. So, for example, an executive who purposely discloses confidential corporate information to an outsider (a “tippee”) who then trades on it cannot be held liable for insider trading unless the executive receives a personal benefit from making the tip. The result, as Steinberg correctly states, is that “the US securities law framework with respect to the regulation of insider trading is abysmal. Uncertainties and inconsistencies prevail.”

Steinberg urges that Congress should enact legislation totally prohibiting persons who are in a position to have access to nonpublic information from trading on or tipping others about it. And even though other developed countries initially lagged behind the US in appreciating the dangers of insider trading, many of them now have such laws. This and more modest reform laws have been repeatedly introduced in Congress for decades, yet they have never been enacted.

Partly this is the fault of the SEC, which originally opposed such legislation in the belief that a conservative Congress might impose even more arduous limitations on insider trading prosecutions than the courts had developed. But such legislative proposals have also received either opposition or at best lukewarm support from the US business community, which seems to fear that it will place too great a burden on the hard-driving, free-wheeling executives who foster corporate growth (and whose compensation is largely tied to movements in their companies’ stock).

The result is that despite many highly publicized prosecutions for insider trading, all the evidence suggests that it continues to be rampant, as shown by the frequency with which stock prices rise or fall in the days immediately preceding the announcement of good or bad news.

According to one recent study, trading records strongly indicate that substantial insider trading occurs in advance of one in five mergers and acquisitions.

 A simpler, broader prohibition on insider trading would doubtless not totally eliminate this problem: quick and easy profits will always be enticing. But surely it would help. Nevertheless, despite Steinberg’s well-reasoned advocacy for his proposals, history suggests that it will take more than logic to get Congress to act.

In broader perspective, this much seems apparent. The huge shifts in recent decades in corporate ownership, private markets, and income distribution have created regulatory challenges to achieving fairness and honesty in the conduct of business in the United States. The federal government has for too long relied on state legislatures and state courts to regulate how companies do business beyond matters of disclosure, and it is not an even match. Indeed, given ever-increasing foreign competition, only the federal government has the power to make reforms that will have any impact on such companies.

To be sure, when there is a major financial crisis, Congress sometimes passes legislation directed at the immediate problems that led to it—for example, the Sarbanes-Oxley Act of 2002 in response to the Enron and other corporate accounting scandals and the Dodd-Frank Act of 2010 in response to the crash of 2008. Since foresight is notoriously not the hallmark of democracy, perhaps that is the best we can hope for. But this piecemeal approach has not prevented big business in the US from getting more concentrated and more effectively unregulated, and business executives becoming more of a separate caste. Until the rest of us demand that our representatives recognize and reverse these insidious trends, even as progressive a group of proposals as Steinberg presents will be for naught.

Jed S. Rakoff is a United States District Judge for the Southern District of New York. (June 2022)



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