Berkeley Program in Law and Economics

This Article posits that the essential role of securities regulations is to create a competitive market for sophisticated professional investors and analysts ("information traders"). The Article advances two related theses—one descriptive and the other normative. Descriptively, the Article demonstrates that securities regulation is specifically designed to facilitate and protect the work of information traders. Consequently, the Article refutes the conventional wisdom that securities regulation protects the common investor; properly understood, securities regulation is not a consumer protection law. Normatively, the Article shows that information traders can best underwrite efficient and liquid capital markets, and, hence, it is this group that securities regulation should strive to protect. By protecting information traders, securities regulations enhance efficiency and liquidity in financial markets. Furthermore, by protecting information traders, securities regulation represents the highest form of market integrity by ensuring accurate pricing and superior liquidity to all investors. In this way, securities regulation improves the allocation of resources in the economy.

Our analysis reveals that securities regulation's essential role is to facilitate a competitive market for information traders. Securities regulation may be divided into three broad categories: (i) disclosure duties; (ii) restrictions on fraud and manipulation; and (iii) restrictions on insider trading—each of which contributes to the creation of a vibrant market for information traders. Disclosure duties reduce information traders’ costs of searching and gathering information. Restrictions on fraud and manipulation lower information traders’ cost of verifying the credibility of information, and thus enhance information traders’ ability to make accurate predictions. Finally, restrictions on insider trading protect information traders from competition from insiders that would undercut the ability of information traders to recoup their investment in information and thereby drive information traders out of the market. Moreover, a competitive market for information traders reduces management agency costs. While courts can discern fraud or illegal transfers, they are ill-equipped to evaluate the quality of business decisions. Judicial oversight can curtail breaches of the duty of loyalty but not breaches of the duty of care; the tasks of curbing breaches of the duty of care and restraining inefficient investments are performed by information traders.

Our account has important implications for several policy debates. First, our account supports the system of mandatory disclosure. We show that, while market forces may provide management with an adequate incentive to disclose at the initial public offering (IPO) stage, they cannot be relied on to effect optimal disclosure thereafter. Second, our analysis categorically rejects the calls to limit disclosure duties to hard information and self-dealing by management. Third, our analysis supports the use of the fraud-on-the-market presumption in all fraud cases even when markets are inefficient. Fourth, our analysis suggests that in cases involving corporate misstatements, the appropriate standard of care should, in principle, be negligence, not fraud.