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Regulating public offerings of truly new securities: first principles.


Absent a regulatory intervention, the question of liability of issuers, issuer directors and officers, underwriters, dealers, and experts such as accountants or rating agencies for misstatements and omissions of required disclosures will be determined by tort law and the terms of the contracts these various parties enter into with regard to the offering. These contracts will also determine the standards for imposing such liability with regard to questions of fault, due diligence, and burdens of evidentiary persuasion. As a general matter, a contractual representation is a warranty. When the representation turns out to be false, the party who has made it is liable, without any need for the claimant to show fault. (56) Only the counterparty to whom the claim was made can be a claimant, however. As for any other actions based on a false statement of one of the offering participants, the tort of deceit requires, among other things, that the claimant show that the statement was made with scienter and that the claimant relied on the statement in deciding to purchase the security. (57) The issue addressed here is what considerations might justify regulatory intervention to alter this basic scheme.

A. The Rationale for Imposing Liability on Operating Corporate Issuers

The rationales for a mandatory-disclosure regime set out just above imply that the regime should call for a higher level of disclosure than would occur if the private parties were left to contract disclosure terms on their own and to rely on contract and tort law remedies to police misrepresentations. These mandatory-disclosure rules will not accomplish their purpose if they are not complied with. Issuer liability is one way to encourage compliance. Because the parties would not agree on their own to terms requiring the higher level of disclosure called for by the mandatory regime, they also cannot be expected to agree to socially cost-effective terms concerning compliance-inducing issuer liability when this level of disclosure is not provided.

The analysis of issuer liability must be seen in light of the ideal set out earlier: assuring, to the extent practicable and cost-effective, that all available information is reflected in price. When this happens, society's scarce savings are steered to the proposed real investment projects in the economy that available knowledge suggests are the most promising. (58)

Consider the situation where the total available information known by insiders of the firm, including its nonpublic information, suggests that its proposed real investment project is not a good use of the economy's scarce savings, given the greater promise of proposed projects of other firms. If the information possessed by insiders is disclosed, its offering's prospective market price would be sufficiently low that the proceeds would be less than the discounted present value of additional payouts that the firm would need to make later due to the share dilution (or additional debt service) resulting from the additional securities outstanding. Thus, the issuer will not proceed with the offering and will not invest in the project. Doing so would reduce the value of the firm. (59)

The issuer may be tempted, however, not to disclose whatever is negative in the information possessed by the insiders, or even to make false positive statements. If it does not disclose the negative information or makes false positive statements, it may be able to get a high enough price in a securities offering to make the offering and the investment in the unpromising project worthwhile. The prospect of liability reduces or eliminates this temptation because it would require the issuer to return to investors the amount by which the offering price was inflated due to the violation of the disclosure rules. (60)

B. The Choice of Liability Regime for the Issuer

The question remains what the nature of this issuer liability scheme should be. One possibility is an absolute strict issuer liability regime, as is in fact imposed on issuers pursuant to Section 11(a) of the Securities Act for disclosure violations in offerings subject to Section 5 registration. Another is absolute issuer liability with a defense if the top officials of the issuer engaged in adequate due diligence. This is similar to the liability scheme under Sections 11(a) and 11(b) of the Securities Act currently imposed on the officials themselves and on underwriters. A third possibility is scienter-based issuer liability, where liability is imposed on the issuer only if the plaintiff investor proves that the top officials were aware of the information or were highly reckless in not knowing of it. This is the liability scheme under Section 10(b) and Rule 10b-5 of the Exchange Act, (61) the only federal securities-law bases for a damages suit against an issuer when the sale of securities by an issuer involving a misstatement is neither registered under the Securities Act nor made pursuant to Regulation A+. (62)

1. What Constitutes an Omission or a False or Misleading Statement of Fact? The starting point in the analysis of this question is to note that, whichever liability scheme is chosen, a necessary condition is the existence of a violation of the disclosure regime's rules by the issuer. This requires that material information required to be disclosed was in fact not disclosed, or that the issuer made a statement covered by the disclosure regime that was materially false or misleading. In other words, at the time of the offering, someone in the world must have possessed material information that was either omitted contrary to the rules or that renders false or misleading some affirmative statement by the issuer. Such knowledge, if it is known by someone in the world, would normally be possessed by at least some individuals within the issuer's organization. The fact that this information is deemed material means, according to the standard definition, that there is a substantial likelihood that a reasonable investor would consider it important in deciding whether to buy, sell, or hold the issuer's shares. (63) If the issuer has properly functioning channels of internal intelligence, information of this importance would likely become available to the top officials of the issuer in the ordinary course of day-to-day business. These top officials are ultimately responsible for the content of the issuer's disclosures in connection with the offering. For example, under the Securities Act registration procedures, these officials are required to sign the statement. (64)

2. Comparing Strict Absolute Liability to Scienter-Based Liability. Consider first an issuer liability scheme whereby liability is only imposed on the issuer if some relevant top official has scienter with respect to this information, in essence the Rule 10b-5 damages action scheme. This liability scheme has three distinct disadvantages relative to absolute strict issuer liability. First, a scienter requirement creates incentives to distort the functioning of an issuer's channels of internal intelligence so as to keep its top officials from receiving information that indicates that a planned offering's disclosures violate the disclosure rules. The benefit to the issuer is that, with the top officials in the dark, the issuer could violate the rules free of any liability and be able to keep the gains from the resulting inflated price of its offering. Such distorted channels of internal intelligence, however, will obviously degrade the issuer's ability to make efficient operating and real investment decisions as a firm. Hence they will damage the overall efficiency of the economy.

Second, to the extent that such distorted channels succeed in protecting top officers from information, an offering that might not be worthwhile at a price that reflects this information can proceed without its disclosure. As a result, the economy's scarce savings will be misallocated to an inferior investment project.

Third, a liability system for top officials requiring a showing of scienter significantly expands the range of facts that will be in contention in litigation because it introduces the additional issue of who knew what. This increases the amount of society's scarce resources that will be consumed by each side in any case where suit is brought. Moreover, with the plaintiff investor facing higher costs if she brings a suit, a disclosure violation is less likely to trigger such suit. The resulting diminished likelihood that the issuer will have to pay damages reduces deterrence. (65)

3. Comparing Strict Absolute Liability to Absolute Liability with a Due-Diligence Defense. Absolute strict issuer liability also has advantages relative to a second possible liability standard--strict issuer liability with a defense available when the issuer can show that its top officials engaged in adequate due diligence (66)--though the advantages are fewer than when the comparison is with scienter-based liability. A more detailed analysis of the operation of such a due-diligence defense follows in connection with the discussion below of underwriter liability. (67) A couple of observations with regard to its operation when applied to the issuer are appropriate here, however. Unlike scienter-based issuer liability, allowing the issuer a due-diligence defense would not likely create incentives to distort the functioning of an issuer's channels of internal intelligence. This is because credible evidence that a firm distorted its channels of communication to keep its top officials in the dark would prevent the firm from being able to maintain the due-diligence defense and thus the firm would be absolutely liable anyway. On the other hand, allowing the defense would still enlarge the range of facts that will be in contention in litigation, thereby increasing the social resources that will be expended by each side in any case where suit is brought and reducing deterrence by making suits costlier for plaintiff investors to bring. Relative to requiring plaintiffs to show scienter, however, these effects would be modest because the defense would be difficult to maintain given the likelihood that the top officers would find out the information in the ordinary course of business.

C. The Rationale for Underwriter Liability

Even if an issuer is subject to absolute strict liability and it is costless for a plaintiff investor to bring a suit for damages on any occasion where an issuer engaging in a securities offering violates the mandatory-disclosure rules, deterrence would not be fully effective. One reason is that the undisclosed information that makes the offering statement disclosures in violation of the rules often relates to the possibility of an event that ultimately bankrupts the issuer, particularly an issuer publicly offering truly new securities. Bankruptcy can render the issuer partially or totally judgment-proof. Another is that the issuer's agents, including its top officials, may engage in a kind of "emphasis on the positive" or "keep the boss happy" groupthink. As a result, even where relevant information is available to the top managers, it is downplayed. Hence the top managers become blinded to its importance and thus to the liability that would flow from its nondisclosure.

The rationale for adding underwriter liability to the scheme starts with the fact again that a disclosure violation can allow a public offering to proceed that otherwise would not, with the resulting misallocation of society's scarce savings. (68) As developed below, underwriter liability can help make up for these two sources of shortfall in the ability of issuer liability to deter such violations. In the stages leading up to a public offering, the underwriter is in a much better position to discover information related to potential disclosure violations by an issuer than are the prospective investors. The prospect that the underwriter will face liability for investor losses if it is aware of such undisclosed information will likely lead the underwriter to force the issuer to disclose it. If the issuer does not comply, the underwriter is likely to refuse to proceed with the offering. The expected cost of participating in the offering without the disclosure is just too high. Just as with issuer liability, the conclusion that the parties would not, on their own, negotiate the socially justified higher level of disclosure called for by the mandatory rules also implies that they cannot be counted on to negotiate socially cost-effective terms with regard to compliance-inducing underwriter liability. (69)

1. Issuer Bankruptcy. Assume, as happens not infrequently, that information exists suggesting the possibility of an event that, if it occurs, will bankrupt the issuer. Assume also that the increased likelihood of bankruptcy suggested by the information is sufficiently great that the information would be considered material and its nondisclosure would violate the disclosure regime's rules. Not disclosing the information would inflate the price at which the securities could be sold. Both the issuer's top management and the underwriter know the information, and each will act rationally in the face of whatever liability regime it faces.

With these assumptions in mind, consider a regime where the underwriter is potentially liable as well as the issuer. Relative to the issuer, the underwriter has less to gain, and, if liable, more to lose on an expected basis, from the nondisclosure of this information. In terms of gain, the underwriter's percentage commission is just a small fraction of the sales price of the offering and thus it gets only a small fraction of the violation's inflation in price; all the rest of the sales-price inflation goes to the issuer. (70) In terms of loss, at the time that the issuer officials are deciding whether to make the offering without disclosing the information, they know that if the event ultimately does not occur, the issuer will enjoy the upside of a more favorable price. If the event ultimately does occur, the issuer will be judgment-proof and thus will not be able to pay investors the damages assessed against it in litigation.

On an expected basis, the issuer may thus rationally find it worthwhile to make the offering without disclosing the information. The calculation of the underwriter is much different. Its upside, if the event does not occur, is only the small fraction of the inflation in the offering price. If the event does occur and the issuer becomes judgment-proof, the underwriter will be liable for the full amount. The underwriter is much more likely to be good for the judgment and thus required to pay. This is because the underwriter is likely to start off well capitalized and subject to a more diversified set of risks. So, its net worth usually will be at most only mildly affected by the event that bankrupted the issuer. In sum, even based just on the calculations considered so far and assuming that the underwriter does in fact know the information, making the underwriter liable in addition to the issuer can significantly add to the likelihood that the information will be disclosed.

2. Issuer Irrationality. Now consider an additional source of issuer-liability-deterrence shortfall: the possibility that the issuer's top officials, despite having the relevant information available to them, do not rationally perceive the violations imbedded in their planned disclosures and the future liabilities that these violations would engender. As a consequence, with only issuer liability, these officials might proceed with the offering without disclosure even though this is not the rational share-value-maximizing decision. Agents of the underwriter are from an organization separate from that of the issuer. This is important from a behavioral and group-dynamics point of view because persons who are members of a single organization, including those near or at the top, are prone to engage in "emphasis on the positive" or "keep the boss happy" groupthink. (71) This is a danger when an issuer is going through the group decision process of deciding the disclosures to provide in connection with a securities offering. The underwriter's agents are outside the issuer organization and are less likely to be trapped by this tendency. Thus they are better able to appreciate the liability implications of available information. Also, the process of generating a registration statement involves dialogue among many different people from the underwriter's and issuer's organizations. Agents of the underwriter, because they are not part of the issuer's hierarchy, will feel freer to pose hard questions to the issuer's top officials than do more junior individuals within the issuer's own organization. (72)

D. The Choice of Liability Regime for Underwriters

Again there is the question of what the nature of this underwriter liability scheme should be: scienter-based liability, strict absolute liability, or absolute liability with a due-diligence defense.

1. Scienter-Based Liability Versus Strict Liability With or Without a Due-Diligence Defense. As with issuer liability, scienter-based underwriter liability has distinct disadvantages relative to the other two possible regimes. First, scienter-based underwriter liability less effectively counteracts the shortfalls in the deterrence value of issuer liability. This is because, under such a scheme, the underwriter is less likely to face liability in situations where issuer-liability deterrence has failed. If a plaintiff investor does bring suit, the underwriter will escape liability unless the plaintiff can affirmatively prove that the underwriter was aware of the information the nondisclosure of which renders the issuer's offering materials in violation of the rules. Even if the underwriter did know the information, the plaintiff may not be able to prove this fact because of difficulties in obtaining the relevant evidence. Moreover, because the requirement adds to the cost of the plaintiff investor bringing suit, fewer suits will be brought. Second, under a scienter-based underwriter liability regime, an underwriter will not face liability if it in fact had not learned the information.

Beyond this, and most seriously, a scienter-based regime actually creates a disincentive for the underwriter to engage in due diligence in which, because of a concern with its reputation, it would otherwise have engaged. This is because in a scienter-based liability system, the underwriter cannot be liable for what it does not find out.

2. Strict Liability With or Without a Due-Diligence Defense. The foregoing discussion suggests that strict underwriter liability with or without a due-diligence defense is preferable to scienter-based underwriter liability. But which form of strict liability is preferable?

a. Assuming a Costless, Error-Free Determination of the Due-Diligence Defense. If the underwriter is strictly liable and is allowed no due-diligence defense, rationally it will perform due diligence up to the point at which, at the margin, the cost of expending additional effort is greater than the resulting decrease in expected damages as the result of an investor suit. As we have seen, the measure of these damages is, roughly, the inflation in the offering's price as a result of the offering document's misstatement or omission. (73) In other words, the underwriter will keep looking for possible problems until the point where the cost of further search is greater than its assessment of (x) the probability, based on what it has found so far, of finding additional, as yet undetected, problems, multiplied by (y) the amount by which the disclosure violations associated with these additional possible problems would inflate the price of the offering. The underwriter would be faced with what information economists refer to as an optimal-stopping problem. (74)

What would be the effect of providing such an underwriter with a defense if it can show that it engaged in a reasonable due-diligence effort? This is the regime under the Securities Act for registered public offerings, where Section 11(a) imposes absolute liability on the underwriter and Section 11(b) modifies this by allowing the underwriter the affirmative defense that it engaged in a reasonable investigation and reasonably believed there was no disclosure violation.

The first point to note is that a rational underwriter will expend the same level of effort with or without the defense if the determination of whether the defense was met could be made through costless and perfectly accurate adjudication. To see this, first consider the position of an underwriter where the defense is available. Because the standard for the investigation is reasonableness, the underwriter is entitled to be free of liability if it expends effort in due diligence at least up to the point that, at the margin, additional effort will cost the underwriter more than the expected improvement in the wealth position of investors through the disclosure of additional problems that would inflate the price that investors need to pay if not disclosed. (75) It would be irrational for an underwriter to expend less effort than what meets the reasonableness standard. If it does expend less effort, the defense will not be available and so it will be absolutely liable and face expected costs of liability--damages equal to the amount by which the nondisclosure of the undetected problem inflates price--that are greater than the costs of the additional effort that would detect the problem. On the other side, it would also be irrational for the underwriter to expend, at least for fear-of-liability reasons, more effort than what meets the reasonableness standard because doing so is not necessary to avoid liability.

Now consider the position of the underwriter if the defense were not available. It would again be irrational to do less than the standard for exactly the same reason: it will be absolutely liable and the costs of a more thorough investigation are less than the amount of expected liability that the more thorough investigation would avoid. And it would be irrational to do more than the standard because, although the underwriter now will be liable for undetected problems even if its investigation meets the reasonableness standard, the expected costs of liability from these more hidden problems are less than the costs of the additional effort needed to detect them.

In sum, under the assumption that the determination of the due-diligence defense is costless and error-free, the underwriter will expend the same level of effort in due diligence with or without a due-diligence defense. Thus, in the choice as to whether or not to permit underwriters a due-diligence defense, the fear that, absent the defense, underwriters will expend too much effort searching for problems that are too insignificant or too unlikely to be worth the trouble would not be a good reason for providing the defense. (76)

b. Taking Account of the Cost of Determining the Due-Diligence Defense and the Chance of Judicial Error. A significant consideration against providing the due-diligence defense to underwriters relates to the real-world facts that there are costs that come from enlarging the range of facts that will be in contention in litigation and that there is a possibility of judicial error in their determination. Again, enlarging the range of facts in contention means that each side will consume more of society's scarce resources in battle. Also, because a plaintiff investor's cost of bringing suit is higher, the underwriter is less likely to face suit even when it did fail to perform a reasonable investigation. With the resulting reduction in the underwriter's expected damages payments if it fails to perform a reasonable investigation, the underwriter will not have as strong incentives to act in the ways that counteract the shortfalls in the deterrence value of issuer liability.

The possibility of legal error further weakens these incentives. The underwriter, when deciding how much due-diligence effort to make, knows that a court may find that its investigation was sufficient to meet the defense when in fact it was not. If this happens, the underwriter will not have to pay damages. Relative to a strict absolute liability regime, the possibility of this error reduces the expected cost of failing to conduct an adequate investigation. Thus, it reduces the incentives to conduct such an investigation. Of course, the court also might err in the other way and find that the investigation was not sufficient when in fact it was. That possibility, however, simply puts the issuer in the same position as if it did not have the defense.

c. Absolute Strict Liability Ties a Due-Diligence and an Insurance Function. There is also a significant consideration in favor of providing the due-diligence defense, however. Without the defense, some firms will be inefficiently discouraged from being in the underwriting business because providing underwriting services would require tying together two rather different businesses. One is the investigation of issuers and merchandising of securities--traditional functions of investment banks. The other business is insuring investors against risks that exist but are not worth searching out to eliminate--what we might call the "pure insurance" business. Even though, in a competitive equilibrium, any potential underwriter would be able to pass on to investors the expected payouts for this pure insurance, some such potential underwriters, although well suited to provide investigation and merchandising services, are not well suited to perform the pure insurance business. Being well suited to provide the pure insurance business would require quite different firm qualities: some combination of substantial capital on hand to cover years where actual aggregate payouts exceed the level of expected payouts and a large scale of operations in terms of the number of offerings underwritten so that, through the law of large numbers, its actual aggregate annual payouts would be very unlikely to deviate sharply from the expected level of payouts.

d. Conclusion. It is hard to know for certain whether, for offerings by ordinary operating corporate issuers, the favorable or the unfavorable considerations with respect to the defense predominate. It should be noted, however, that the concerns about costs and legal error associated with providing the defense are softened by the nature of the facts in contention. The primary issue before a court will not be whether the underwriter knew the information that rendered the issuer's offering disclosures in violation of the rules but what the underwriter did to conduct its investigation. Such conduct is relatively easily ascertainable and objectively measurable, which reduces both the cost of having them in contention and the likelihood of judicial error.


Parts I-IV of this Article go back to first principles to answer a number of questions. First, should the government provide a system of disclosure regulation at the time of the offering of truly new securities and thereafter, and if so, under what circumstances? Second, if there is such a regulatory regime, should it be mandatory or should an issuer be able to choose whether to be subject to it? Third, which participants in the offering, if any, should be held civilly liable for damages if, at the time of the offering, there were misstatements or omissions of required disclosures? Fourth, for any participant that is liable, what should the standard be? This final Part applies what has been learned to evaluate the contemporary legal treatment of public offerings of truly new securities in the United States.

Traditionally, essentially all offerings of truly new securities that would be considered "public" as the term is used here (77) were subject to the disclosure-oriented registration process under Section 5 of the Securities Act. Exemptions from this registration process were available for certain offerings based on such factors as the limited number of offerees; the sophistication, wealth, and prior knowledge about the issuer held by the offerees; and the amount being raised. But in general the exempted offerings would not be considered public in this sense.

Compliance with this regulatory scheme is expensive and involves fixed-cost elements that mean that there are considerable economies of scale in terms of offering size. Typically, the smaller the firm, the smaller the scale of the proposed project that it seeks to fund. So, when a smaller firm contemplates a public offering of truly new securities to fund such a project, the size of the offering that it can plausibly justify is likely to be smaller. The smaller the size of the offering, the greater the cost per dollar raised for compliance with the traditional regulatory structure. In sum, the smaller the size of the firm, the less likely it is that a public offering of truly new securities will be an economically sensible way of raising capital. Concern that most firms below a certain size cannot practically use a public offering of truly new securities as a means of raising capital has led in recent years to the development of alternative, more lenient regimes for certain kinds of public offerings, culminating with Rule 506(c) and Regulation A+ and the crowdfunding rules.

As will be developed below, aspects of these reforms seem ill-advised. The main features of the Section 5 registration process adhere closely to what is called for by the first-principles analysis in Parts IIV, whereas certain important features of these alternative regimes do not.

A. The Section 5 Registration Process

The traditional Section 5 registration process, combined with its civil-liability provisions under Section 11, has four core components. First, rather than relying on signaling backed by scienter-based liability for material misstatements, the regime requires issuers to affirmatively answer a set of questions. Second, this regime is mandatorily applied to all securities offerings not explicitly exempted. Third, the issuer, by conducting a registered IPO, automatically becomes subject to the Exchange Act's mandatory ongoing periodic-disclosure regime as well. Fourth, in the event that the registration statement contains a disclosure violation, (78) the issuer is faced with strict absolute liability, and the underwriter is faced with absolute liability subject to an affirmative due-diligence defense. (79) These core elements thus largely correspond with what the analysis in Parts I-IV suggest would be optimal.

B. Rule 506(c) Offerings

Rule 506(c), (80) promulgated by the SEC in 2013 (81) pursuant to a mandate under the JOBS Act enacted in 2012, (82) allows any issuer to make a public offering of truly new securities without going through the traditional Securities Act registration process. Most commentators have not fully grasped how potentially revolutionary this exemption is.

1. Required Structure of the Offering. The exemption from registration has remarkably few restrictions and a Rule 506(c) offering is less burdened by regulation than a traditional one in a number of ways. The issuer may engage in a general solicitation to raise an unlimited amount of money from an unlimited number of investors as long as it takes reasonable steps to verify that each actual purchaser is an "accredited investor." In general, an individual qualifies as an accredited investor if she has an income of at least $200,000 or net assets (not including her primary residence) of at least $1 million. (83) Because most of the individually held stock in the country is held by such persons, this restriction does not cut out a substantial amount of potential demand that would have been present with a registered offering. (84) Rule 506(c) has no affirmative disclosure obligations associated with it, and an offering under the rule does not trigger an obligation to provide ongoing periodic disclosure. The issuer is subject only to scienter-based liability under Rule 10b-5 for any material misstatements it makes in connection with the offering. Because the exemption is only available to issuers, (85) the offering cannot be made pursuant to a firm-commitment underwriting, whereby an investment bank buys the securities from the issuer and resells them in the offering to the public. The absence of a restriction on general solicitation means, however, that a broker can be used to solicit purchasers. The broker would also be subject only to scienter-based Rule 10b-5 liability and only for any material misstatement that the broker itself makes.

2. Subsequent Trading of Shares. The only way that a Rule 506(c) offering is more burdened by regulation than a traditional registered offering is that the offered securities are "restricted." This means that purchasers in the offering can only resell their shares pursuant to Securities Act registration or an exemption therefrom. (86) Here too, however, recent reforms take much of the sting out of this disadvantage and offer the prospect that the securities will be relatively freely tradable soon after the offering.

a. Rule 144. One route to relatively free secondary-market trading is via Rule 144, (87) which in recent years has been subject to easing amendments several times. As a result, restricted shares of an issuer not providing Exchange Act periodic disclosures become unrestricted after being held for a period of only one year in the hands of one or more investors unaffiliated with the issuer. (88) As unrestricted shares, they can be traded freely between any two persons. Liquidity will be maximized if the issuer chooses to list its stock on the New York Stock Exchange (NYSE) or NASDAQ, but doing so will, under Sections 12 and 13 of the Exchange Act, trigger imposition of the Act's ongoing periodic-disclosure requirements that is otherwise avoided by doing a Rule 506(c) offering rather than the traditional registered offering.

Alternatively, the stock could start trading on an electronic trading venue that is not registered as an exchange under the Exchange Act, such as OTCQX or OTCB. Unlike the NYSE or NASDAQ, trading on this kind of venue would not by itself trigger imposition of the Exchange Act's periodic-disclosure requirements. The other periodic-disclosure-requirement trigger, Exchange Act 12(g), (89) is based on the number of shareholders of record, a number that was increased in 2012 by the JOBS Act from 500 to 2000. (90) A smaller issuer utilizing a Rule 506(c) offering would be unlikely to trigger the requirements this way for many years, if ever, after the offering. This is because the typical shareholder only has a beneficial ownership of her shares, with record ownership being held by a nominee of her broker, who is the same record owner for many of the broker's other customers who beneficially own the issuer's stock. (91)

b. Securities Act Section 4(a)(7). A second route to relatively free secondary-market trading is via Securities Act Section 4(a)(7), (92) a new registration exemption enacted under the FAST Act in late 2015. (93) Under this exemption, as a general matter, a purchaser in a 506(c) offering would be able to resell her shares without any waiting period, as can each subsequent holder, as long as, in each case, the subsequent purchaser is an accredited investor and the seller does not engage in a general solicitation. This would appear to allow shares acquired in a 506(c) offering to be freely traded immediately after the offering on electronic trading venues such as SharesPost and the NASDAQ Private Market, venues that restrict themselves only to orders placed by accredited investors.

3. Evaluation. Recall that the essential problem with the public offering of truly new securities is the adverse selection that arises from a situation of severe information asymmetry: potential investors know much less about the issuer and the persons associated with it than they do in an offering by an established issuer, and there is no price for the same security established in an efficient secondary market to guide them. Without solutions to this information-asymmetry problem, the market will unravel. A Rule 506(c) offering relies almost entirely on the market-based solutions to this problem discussed in Part II, with little regulatory intervention to ameliorate any of the shortcomings of these solutions.

a. Signaling. As we have seen, signaling can fail to solve the adverse-selection problem for a number of reasons: issuer claims of high quality are not fully credible, issuers have reasons not to disclose positive information and so silence does not necessarily mean that the issuer is low quality, silence by a low-quality issuer does not reveal how much worse it is compared to the issuer that is affirmatively disclosing facts demonstrating its high quality, and many retail investors are not attentive to the absence of disclosure on each of a myriad of different topics nor sophisticated in the inferences that they draw.

The traditional registration process ameliorates all of these problems and the Rule 506(c) offering process ameliorates none of them. The traditional procedure increases the expected cost of making a misstatement for an issuer by substituting absolute strict liability for the much harder-to-prove scienter-based liability. Scienter-based liability, as discussed in Part IV, less effectively deters misstatements and omissions of mandated information because it makes a claim harder to bring, consumes more social resources when litigation does occur, and encourages firms to inefficiently distort their internal information systems to keep top officials ignorant of material information that, if disclosed, would lower share price. By mandating disclosure concerning many matters, the traditional registration process clarifies the ambiguity that silence has under the 506(c) procedure with regard to these matters and makes clear the extent of the differences between the superior and inferior firms. Required disclosure also makes these many matters more salient to retail investors and their advisors than would be the case if they had to sort out which firms made disclosures and which remained silent.

b. Intermediation. The Rule 506(c) offering process, unlike the traditional registration process, does not allow for a firm-commitment underwriting. This forecloses an investment bank from lending its reputation to the offering by purchasing the securities and reselling them to the public. The 506(c) procedure, because it permits general solicitation, (94) does allow the involvement of brokers, who also can lend their reputation to the offering. This is likely to be less effective at combating adverse selection than a firm-commitment underwriting, however. This is because a broker has much less at stake with respect to each deal in which it is involved, so there is less value in achieving, and thereafter protecting, a reputation for only marketing-quality, truthful issuers. Also, the broker is liable only for its own misstatements, not the issuer's, and claimants must prove the broker had scienter. In contrast, the underwriter is potentially liable for the issuer's misstatements under the standard of strict liability subject to a due-diligence defense, which encourages the bank to investigate the issuer and insist on disclosure of what it finds.

c. Third-Party Certification. Third-party certification by accountants and other experts is as available to an issuer under the 506(c) process as under the traditional registration process. The traditional registration process creates greater incentives than the 506(c) process for the certifier to be truthful and fully informed, however, because it backs up the certifier's potentially somewhat tenuous concerns about reputation in the statements it makes with strict liability subject to a due-diligence defense, not just Rule 10b-5 scienter-based liability.

d. Buyer Search. There is little reason to believe that the 506(c) offering process does a better job than the traditional registration process at ameliorating the shortcomings of buyer search as a way of combating adverse selection. It may in fact do a worse job. Although the 506(c) process confines purchasers to accredited investors, a large portion of all retail purchasers in a traditional registered offering would fall into this category anyway. So the 506(c) restriction does little to increase the percentage of buyers that would be sophisticated enough to do effective diligence on the quality of an issuer. The lack of restriction on the number of investors means that the issuer has no reason, just to fit the requirements of the exemption, to try to raise the total funds it needs from a smaller number of investors who each invest more and thereby to create greater economies of scale for investor diligence. Most importantly, the Rule 506(c) offering process, unlike the traditional registration process, does not require that all investors be offered the securities at the same price. (95) This means that even if a retail investor knows that some large sophisticated institutional investors are purchasing shares in the offering, she cannot rule out the possibility that the offering appears to them to be a good deal only because they are being offered a lower price than she is being offered. (96)

e. Conclusion. Congress, though perhaps not fully aware, was starting a brave experiment in mandating that the SEC adopt Rule 506(c). The experiment may prove that the traditional regulatory approach to the public offering of truly new securities has been an unnecessary burden. The analysis in Parts I-IV suggests, however, that there is a good chance that it will end poorly.

The most innocuous scenario by which it ends poorly is that the shortcomings catalogued above are indeed important, but these shortcomings are recognized by the market from the outset. Under this scenario, the Rule 506(c) procedure simply generates little interest by issuers seeking to make public offerings of truly new securities. (97)

A more harmful scenario by which the experiment ends poorly would be for these shortcomings to be indeed important, but the shortcomings are not at first recognized by the market. Under this scenario, a substantial number of 506(c) offerings funding negative NPV projects go forward, offerings that would not have succeeded if the issuer had been required to use the traditional registration process. Thus the market for 506(c) offerings does not unravel immediately. Rather, the unraveling does not occur until an economic downturn or the equivalent of the 2001 bursting of the tech bubble. This turn of events will reveal the substantial number of offerings that, unknown to their investors, were low quality from the beginning.

A final way for the experiment to end poorly would be for these shortcomings to turn out to be less severe than I suggest and for a whole alternative system to develop for firms to go public and be publicly traded without being subject to either mandatory offering or periodic disclosure. Because of this alternative system's lower private costs to issuers, it would gradually hollow out the traditional system where issuers are subject to mandatory offering and periodic disclosure. But, as discussed in Part IV, the private costs of disclosure are greater than its social costs and the private benefits less than its social benefits. So the level of disclosure associated with this increasingly dominant alternative system would be below what is socially optimal.

C. Regulation A+

The JOBS Act also amended the Securities Act to add to its provisions relating to exempt securities Sections 3(b)(2) through 3(b)(5). (98) Under these amendments, the SEC was directed to establish what is known as Regulation A+, an alternative system to the traditional registration process that would be available for a public offering of truly new securities as long as the offering, combined with any subsequent offering within twelve months, does not in total exceed $50 million. (99) Regulation A+ in many ways resembles the traditional registration process but is simpler and less burdensome on issuers. The SEC adopted final A+ Rules in the spring of 2015.

1. Required Structure of the Offering. Under Regulation A+, the issuer may engage in a general solicitation to raise money from an unlimited number of investors. Unlike a 506(c) offering, a firm-commitment underwriting may be used in connection with the offering. Like with a traditional registered offering, and unlike a 506(c) offering, there is no need for the investors to be accredited. There is mandatory affirmative disclosure at the time of the offering, but less is asked than in a traditional registered offering. There is also a periodic-disclosure obligation but again it is less burdensome than standard Exchange Act periodic reporting. The standard of liability imposed on the issuer for misstatements made in connection with the offering is strict liability subject to a due-diligence defense. Underwriters and brokers are subject to liability under the same standard as well.

2. Subsequent Trading of Shares. Shares purchased in a Regulation A+ offering are unrestricted, which means they can be traded freely between any two persons as soon as they are purchased in the offering, the same situation that prevails with a 506(a) offering because of Rule 144 but a year faster. Thus again the issuer can maximize liquidity by listing its stock on the NYSE or NASDAQ if it is willing to have Exchange Act periodic-disclosure obligations imposed upon it. Alternatively, it can have its shares trade on less liquid OTCQX or OTCB venues and would only need to provide the less burdensome level of periodic disclosure required by Regulation A+.

3. Evaluation. From the foregoing, we can see that a Regulation A+ offering differs from a traditional registered offering in two important ways. One is that the issuer, though strictly liable, has a due-diligence defense. (100) The other is that less is asked of the issuer in the form of mandatory disclosure both at the time of the offering and periodically thereafter. (101)

a. Lower Liability Standard. The analysis in Part IV suggests that there is little justification for allowing an issuer a due-diligence defense just because the issuer is smaller or is raising less than $50 million. Regardless of these factors, the misstatement or omission of required information would inflate the price of the security above its value. Allowing the issuer a due-diligence defense, although not nearly as serious a problem as requiring the claimant to show scienter, lessens deterrence by making it harder to succeed against an issuer that has made a misstatement or omitted mandated information. Moreover, the suits that are brought consume more social resources than in an absolute strict-liability regime because more issues are at play. The fact that the issuer is smaller or is raising less than $50 million is really irrelevant and in no way reduces the force of these observations.

b. Less Required Disclosure. Whether less disclosure should be asked of an issuer if it is smaller or is raising less than $50 million is a more complicated question. One argument for asking less is that the most persuasive argument in the first place for making an affirmative-disclosure regime mandatory rather than voluntary--that the social costs of an issuer's disclosure are less than its private costs and the social benefits greater than its private benefits--is less compelling in the case of a smaller firm making a smaller offering. (102) The simple idea here is that the actions of such a firm have less impact on the rest of the world and so the deviation between its social and private costs and benefits is smaller. Less should be required of such a firm above what would be required by the regime that the issuer would voluntarily choose based on its private calculations of cost and benefit. Consequently, the mandatory regime should require less of it relative to what is required of a larger firm making a larger offering. It is important to note, though, that this argument has no force in terms of the minimum level of disclosure needed to avoid adverse selection.

The other rationale for requiring less disclosure from a smaller firm making a smaller offering is that the offering of such a firm poses offerees with a less complicated financial proposition and so less information is needed. In essence, this is an argument that the smaller firm making a smaller offering is typically less complicated and so a set of questions that is appropriate for an adequate understanding of a more complicated firm is overkill for a simpler, smaller firm. Whether the current set of questions in connection with the traditional registered offering is in fact tilted toward what needs to be known about a more complicated firm is an open question, however. Most of the questions concern matters about which an investor would want information whether the firm was simple or complicated. More complicated firms just need to give longer answers.

D. Crowdfunding

The JOBS Act also amended the Securities Act to create a new Section 4(a)(6) exemption from Section 5 registration for "crowdfunded" offerings. (103) The SEC adopted rules for this exemption effective in the spring of 2016. (104) The idea is that capital is raised for a project through the pooling of numerous very small share purchases. Investors become aware of the offer from the website of a broker-dealer or a registered funding portal. An issuer can only raise up to $1 million in this fashion in any twelve-month period, (105) and so these are offerings that could not possibly be economically feasible as traditional registered offerings. Individual purchasers are limited in the amount they can invest, with investors with incomes or assets of less than $100,000 generally limited to 5 percent of their income and with better-off investors generally limited to 10 percent of their income. (106) There is required disclosure at the time of the offering, but it is considerably less than what is required under a traditional registered offering or even a Regulation A+ offering. (107) A crowdfunding offering does not trigger an obligation to provide Exchange Act periodic disclosure until the firm reaches $25 million in assets. (108) No general solicitation is allowed beyond the information available on the website posting the offering. (109) The exemption is only for issuers and so the offering cannot be pursued via a firm-commitment underwriting. (110) The issuer is strictly liable with a due-diligence defense.

The preceding evaluations of the different components of the 506(c) offering process and Regulation A+ offering process largely cover the components of the crowdfunding offering process one way or the other. Again, there appears to be no justification for providing the issuer with a due-diligence defense. The low level of affirmative disclosure, especially when combined with sharp limits on individual investments, raises serious concerns that adverse selection will cause the market for these offerings to unravel sooner or later, notwithstanding the idea that, given "wisdom of crowds," some worthwhile investment projects will get funding that would not have been able to receive funding from traditional non-public-offering sources. (111)

One way of looking at crowdfunding offerings is to note that most states provide legalized space for certain kinds of gambling notwithstanding the fact that the odds are always against the gamblers. Given the existence of a demand for opportunities to gamble, why not channel it into an activity that at least might occasionally fund a worthwhile project that would not otherwise have received funding, especially where income- and wealth-related caps protect the gamblers from damaging themselves too much when the gamble does not work out? Indeed, it is possible that if investors approach crowd-funding offers the same way that gamblers approach a casino or a race track, the market will not unravel despite experience demonstrating over time that the average offering has a low, or even negative, expected return.


Absent regulation, the determination of which public offerings of truly new securities go forward and succeed at raising funds, and which do not, is determined by tort law and the market-determined terms of contracts into which offering participants enter. This Article has gone back to first principles to answer whether, and, if so, under what circumstances, government regulation should be added to the mix. This regulation can relate to what the issuer should disclose at the time of the offering and thereafter. It can relate as well to the circumstances under which various offering participants should be held liable for damages if, at the time of the offering, there were misstatements or omissions of required disclosures.

These questions are live issues because numerous reforms have been made in recent years to lessen the burdens of regulation on smaller issuers making small offerings. The rationale for lessening the burden on smaller issuers is that the cost of the traditional registration process has scale economies associated with it that make offerings by them too expensive to be worth undertaking. This Article expresses skepticism about many of these reforms. Specifically, it suggests that these reforms ignore the fact that the core components of the traditional public-offering registration process play an essential role in countering the adverse-selection problem that inevitably accompanies a public offering of truly new securities. The analysis here advises against structural changes contained in some or all of these reforms, such as eliminating mandatory disclosure altogether, imposing on issuers a lower standard than strict absolute liability, and eliminating the possibility of underwriter intermediation. A more promising approach would be to review the questions that must be answered under the traditional registration process. Ones that add more cost to the process for smaller issuers than they reduce adverse selection should be eliminated. But such regulatory downsizing can only be taken so far. A certain minimum range of mandated questions will need to be kept if we wish to sustain a market for most offerings of truly new securities, at least outside of the small bets at stake in crowdfunding. Even if it is possible to scale back the range of questions in the way described here, the hard reality is that, for firms below a certain size, the cost of what is still required will make a public offering and public trading of their shares an impractical form of finance.

(1.) For a parallel effort with respect to the first category of transactions, see generally Merritt B. Fox, Civil Liability and Mandatory Disclosure, 109 COLUM. L. REV. 237 (2009) [hereinafter Fox, Civil Liability] (discussing disclosure obligations of established issuers and the structure of liabilities for their breach).

(2.) There are, of course, many offerings that may be in need of regulation but that do not fall neatly into one of these two categories. One example would be an offering where there is secondary trading already in identical securities, but the secondary market cannot be properly described as liquid and efficient. Another example would be an offering where there is no secondary trading prior to the offering and one cannot reasonably expect such trading to develop after the offering, given the limited number of purchasers purchasing relatively small blocks. Such situations have been subject to cogent analysis elsewhere by Professors Donald Langevoort and Robert Thompson. See Donald C. Langevoort & Robert B. Thompson, "Publicness" in Contemporary Securities Regulation After the JOBS Act, 101 Geo. L.J. 337, 372 (2013). Still, a significant portion of all new issues of securities does fall into one of the two archetypical categories set out here.

(3.) 17 C.F.R. [section] 230.506 (2015).

(4.) Securities Act of 1933 [section] 4(b), 15 U.S.C. [section] 77d(b) (2012).

(5.) 17 C.F.R. [section][section] 200, 230, 232, 239, 240.249, 260 (2015).

(6.) See generally Securities Offering Reform, Securities Act Release No. 8591, Exchange Act Release No. 52,026, Investment Company Act Release No. 26,993,70 Fed. Reg. 44,722 (Aug. 3, 2005).

(7.) See Bernard S. Black & Ronald J. Gilson, Venture Capital and the Structure of Capital Markets: Banks Versus Stock Markets, 47 J. FIN. ECON. 243, 266 (1999).

(8.) See Gert Wehinger, Bank Deleveraging, the Move from Bank to Market-Based Financing, and SME Financing, OECD J.. Jan. 2012, at 65, 68-70.

(9.) Jumpstart Our Business Startups (JOBS) Act. Pub. L. No. 112-06. [section] 302(a). 126 Stat. 306. 315 (2012) (codified at 15 U.S.C. [section] 77d (2012)).

(10.) Fixing America's Surface Transportation (FAST) Act. Pub. L. No. 114-94. [section][section] 71001-71003.129 Stat. 1312, 1784 (2015) (codified at 15 U.S.C. [section] 77f (Supp. Ill 2015)).

(11.) See generally Robert B. Thompson & Donald C. Langevoort. Redrawing the Public-Private Boundaries in Entrepreneurial Capital Raising, 98 CORNELL L. REV. 1573 (2013) (discussing the impact of loosening regulations from the JOBS Act and other reforms on early-stage capital raising).

(12.) See generally Action Plan on Building a Capital Markets Union, COM (2015) 468 final (Sept. 30. 2015) (discussing reforms to increase financing for European SMEs).


(14.) Adverse selection occurs when a potential market participant with a high-quality offering decides not to enter the market because persons on the other side of the market cannot distinguish it from participants with lower-quality offerings. For a more detailed discussion of this concept, see infra Part I.

(15.) See George A. Akerlof. The Market for "Lemons": Quality Uncertainty and the Market Mechanism, 84 Q.J. ECON. 488, 491-93 (1970).

(16.) An investment project's NPV equals its expected future net revenues discounted to present value less the project's cost. See RICHARD A. BREALEY, STEWART C. MYERS & FRANKLIN ALLEN, PRINCIPLES OF CORPORATE FINANCE 85-89 (8th ed. 2006).

(17.) Stewart C. Myers & Nicholas S. Majluf, Corporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have, 13 J. FIN. ECON. 187, 187 (1984). A positive NPV project is one where the project's cost is less than the expected future net revenues from the project discounted to present value at a rate of market return for cash flows with comparable risk. BREALEY, MYERS & ALLEN, supra note 16, at 17. Because this market rate of return represents the opportunity cost of implementing the project, implementing the project enhances economic welfare in society.

(18.) See supra Part I. A.

(19.) See Robert Forsythe, Russell Lundholm & Thomas Rietz, Cheap Talk, Fraud, and Adverse Selection in Financial Markets: Some Experimental Evidence, 12 REV. FIN. STUD. 481, 482-85 (1999) (discussing experimental evidence that investors will credit false claims not policed by tough sanctions so that the signaling model will fail).

(20.) The German effort to facilitate public offerings by SMEs by setting up a new market with less stringent requirements for initial public offerings (IPOs) is an illustration of the problem. It had initial success followed by collapse. See Ronald J. Gilson. Henry Hansmann & Mariana Pargendler. Regulatory Dualism as a Development Strategy: Corporate Reform in Brazil, the United States, and the European Union. 63 STAN. L. REV. 475.502-07 (2011): Hans-Peter Burghof & Adrian Hunger. Access to Stock Markets for Small and Medium Sized Growth Firms: The Temporary Success and Ultimate Failure of Germany's Neuer Markt 4 (Oct. 2003) (unpublished manuscript). [].

(21.) The efficient-market hypothesis from financial economics holds that the prices of securities of large, established issuers trading in liquid markets fully reflect all publicly available information. See BREALEY, MYERS & ALLEN, supra note 16, at 337-41.

(22.) In contrast, for registered public offerings of large, established issuers in the United States, the issuer need make available to prospective investors only a brief prospectus, under the theory that the efficient-market hypothesis assures that all publicly available information is reflected in the securities' secondary-market trading price. See Fox, Civil Liability, supra note 1, at 243-45, 243 n.10.

(23.) See supra Part I.B.

(24.) See, e.g., William L. Silber. Discounts on Restricted Stock: The Impact of Illiquidity on Stock Prices, 47 FIN. ANALYSTS J. 60, 60, 62 (1991) ("Companies issuing restricted stock alongside registered securities trading in the open market usually offer a price discount on the restricted securities to compensate for their relative illiquidity.").

(25.) See generally Merritt B. Fox, Promoting Innovation: The Law of Publicly Traded Corporations, 5 CAPITALISM & SOC'Y 1 (2010) (arguing that the diversity of potential providers of funds in an IPO and of the information channels by which they become informed makes this form of external finance more receptive to innovative investment proposals than is the case with internal finance).

(26.) The seminal article is Michael Spence, Job Market Signaling, 87 Q.J. ECON. 355 (1973).

(27.) See generally Stephen A. Ross, Disclosure Regulation in Financial Markets: Implications of Modern Finance Theory and Signaling Theory, in ISSUES IN FINANCIAL REGULATION 177 (Franklin R. Edwards ed., 1979) (synthesizing various disclosure issues and formulating an economic framework within which disclosure issues can be examined).

(28.) See Frank H. Easterbrook & Daniel r. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VA. L. REV. 669. 687 (1984).

(29.) Commentators have noted that, for this kind of reason, reality does not conform with signaling theory's prediction that voluntary disclosure will result in the market being fully informed. See John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System. 70 VA. L. REV. 717, 745 (1984); Joel Seligman, The Historical Need for a Mandatory Corporate Disclosure System. 9 J. CORP. L. 1, 5-7 n.24 (1983). Coffee points out that the market was not able, from the silence of the issuers involved, even to begin to infer in advance that New York City and the Washington Public Power System would each experience disastrous defaults. Coffee, supra, at 745. These were the two largest defaults of publicly issued securities in the history of the United States, but the issuers, as municipal entities, were exempt from the mandatory-disclosure system under the federal securities laws. See Ann Judith Gellis, Mandatory Disclosure for Municipal Securities: A Reevaluation. 36 BUFF. L. REV. 15. 18-19, 40-44 (1987).

(30.) Commentators have suggested that this concern explains the distinction that the Securities Act and the SEC make between public offerings of securities, where registration involving mandatory affirmative disclosure is required, and certain offerings that are limited to more sophisticated investors that are exempted from such registration. See DOUGLAS G. BAIRD, ROBERT H. GERTNER & RANDAL C. PICKER, GAME THEORY AND THE LAW 94. 96 (1994). As is discussed more in Part IV, infra, although this rationale might explain some kind of limited offering exemption from registration, it does not explain the breadth of the current exemption.

(31.) See Akerlof, supra note 15. at 496.

(32.) See James R. Booth & Richard L. Smith, II. Capital Raising, Underwriting and the Certification Hypothesis, 15 J. FIN. ECON. 261, 261-65 (1986); Ann E. Sherman. Underwriter Certification and the Effect of Shelf Registration on Due Diligence, 28 FIN. MGMT. J. 5,5-7 (1999).

(33.) Booth & Smith, supra note 32, at 267.

(34.) Judge Weinstein. in one of the early seminal cases concerning Securities Act Section 11's imposition on underwriters of strict liability subject to an affirmative due-diligence defense in cases involving misstatements in registered offerings, justified requiring underwriters to "assume an opposing posture with respect to management" by saying that the "average investor probably assumes that some issuers will lie. but he probably has somewhat more confidence in the average level of morality of an underwriter who has established a reputation for fair dealing." Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 581 (E.D.N.Y. 1971).

(35.) See generally Linda Elizabeth DeAngelo. Auditor Independence, "Low Balling," and Disclosure Regulation, 3 J. ACCT. & ECON. 113 (1981) (suggesting that "low balling" would not impair auditor independence partly because auditors, in deciding whether to cheat, consider loss in future audit fees resulting from the loss of reputation).

(36.) See generally L. McDonald Wakeman, The Real Function of Bond Rating Agencies, 1 CHASE FIN. Q. 18 (1981), reprinted in THE MODERN THEORY OF CORPORATE FINANCE 410 (Clifford W. Smith, Jr. ed., 2d ed. 1990) (suggesting that bond ratings mirrored the market's assessment of a bond's risk partly because bond-rating agencies depend on their reputation to obtain business).

(37.) See John Patrick Hunt, Credit Ruling Agencies and the "Worldwide Credit Crisis": The Limits of Reputation, the Insufficiency of Reform, and a Proposal for Improvement, 2009 COLUM. BUS. L. REV. 109. 120-24 (giving background on the 2008 financial crisis and discussing the role of credit agencies in how it unfolded).

(38.) See JOHN C. COFFEE, JR.. GATEKEEPERS: THE PROFESSIONS AND CORPORATE GOVERNANCE 108-92 (2006): Merritt B. Fox, Gatekeeper Failures: Why Important, What to Do, 106 MICH. L. REV. 1089. 1097-1108 (2008) (book review).

(39.) See Alan Schwartz & Louis L. Wilde, Competitive Equilibria in Markets for Heterogeneous Goods Under Imperfect Information: A Theoretical Analysis with Policy Implications, 13 BELL J. ECON. 181. 181-83 (1982) (proposing policy prescriptions after setting out a model somewhat resembling the example in the text).

(40.) This concept is comparable to the analysis in accident law to the role of defenses based on the concept of contributory negligence. See STEVEN SHAVELL, ECONOMIC ANALYSIS OF ACCIDENT LAW 9-21 (1987).

(41.) Internet-based solicitations of accredited investors based on Securities Act Rule 506(c), see infra Part V.B. provide an example. Successful such offerings involve substantial investments by well-known angel investors or venture capital firms, and the other investors rely on the expertise of these substantial investors. Darian m. Ibrahim, Equity Crowdfunding: A Market for Lemons?, 100 MINN. L. REV. 561, 565 (2015).

(42.) Russell Korobkin makes a similar point with respect to the limited capacity of market forces to police the fine-print terms in consumer contracts because, due to bounded rationality, consumers cannot absorb, analyze, and act on this information. See Russell Korobkin. Bounded Rationality, Standard Form Contracts, and Unconscionability, 70 U. CHI. L. REV. 1203, 1206-07 (2003).

(43.) Id. at 1247-54. This is an application of the more general principle in behavioral economics of the "what you see is all you get" phenomenon. See generally DANIEL KAHNEMAN. THINKING. FAST AND SLOW (2011).

(44.) See, e.g., ORG. FOR ECON. CO-OPERATION & DEV., OECD PRINCIPLES OF CORPORATE GOVERNANCE 29-32 (2004) (proposing that "corporate governance framework should promote transparent and efficient markets" to effect positive economic performance); Mark J. Roe, Corporate Law's Limits, 31 J. LEGAL STUD. 233. 244, 263-69 (2002) (arguing that corporate transparency facilitates the separation of ownership from control).

(45.) See DONALD C. LANGEVOORT. SELLING HOPE. SELLING RISK: CORPORATIONS, WALL STREET, AND THE DILEMMAS OF INVESTOR PROTECTION 31-32, 104 (2016) (explaining the importance of SEC mandatory-disclosure rules for reducing such self-interested behavior by managers and control shareholders): Bernard S. Black. The Legal and Institutional Preconditions of Strong Securities Markets, 48 UCLA L. REV. 781. 808 (2001) (same).

(46.) All of these points are worked out in more detail in Fox, Civil Liability, supra note 1, at 258-59.

(47.) Roberta Romano, Empowering Investors: A Market Approach to Securities Regulation, 107 YALE L.J. 2359.2365-72 (1998).

(48.) Stephen J. Choi & Andrew T. Guzman, Portable Reciprocity: Rethinking the International Reach of Securities Regulation, 71 S. CAL. L. REV. 903, 922-24 (1998); Stephen J. Choi & Andrew T. Guzman. The Dangerous Extraterritoriality of American Securities Law, 17 NW. J. INT'L L. & BUS. 207, 231-32 (1996).

(49.) See generally A.C. Pritchard, Markets as Monitors: A Proposal to Replace Class Actions with Exchanges as Securities Fraud Enforcers, 85 Va. L. Rev. 925 (1999) (proposing an exchange-administered enforcement regime for fraud-on-the-market claims).

(50.) See generally Merritt B. Fox. Retaining Mandatory Securities Disclosure: Why Issuer Choice Is Not Investor Empowerment. 85 VA. L. REV. 1335 (1999) (discussing benefits and costs of mandatory regulation of disclosures, nonregulation, and issuer choice regimes).

(51.) See supra Part III.B.

(52.) See Easterbrook & Fischel, supra note 28. at 685.

(53.) I have considered in more detail elsewhere the divergence of the private and social costs and benefits of issuer disclosure and the consequent tendency of unregulated issuers to disclose below their socially optimal level. See MERRITT B. FOX, Securities Disclosure in a Globalizing Market: Who Should Regulate Whom, 95 MICH. L. REV. 2498, 2532-51 (1997); see also Lucian Arye Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law. 105 HARV. L. REV. 1435,1490-91 (1992) (explaining that, if left to states, the laws passed would likely produce less disclosure in the United States); Easterbrook & Fischel. supra note 28. at 684-85 (discussing voluntary disclosure); Edmund W. Kitch. The Theory and Practice of Securities Disclosure. 61 BROOK. L. REV. 763, 846-74 (1995) (discussing the history of disclosure in the United States).

(54.) I discuss these points in more detail elsewhere. See Fox, Civil Liability, supra note 1. at 253-67.

(55.) In comparing a system where an issuer can choose its disclosure regime with a mandatory system, the argument for a mandatory approach is in one respect weaker in the case of a firm just going public than in the case of one that is already publicly traded and has a dispersed ownership structure. The insiders of a firm that is just going public are selling their shares in the offering and/or diluting their continuing share ownership in the company. Thus, if they are allowed to choose their disclosure regime, they will have an interest in choosing the regime that yields the highest share price. Because they make their decision based on the issuer's private costs and benefits, the required level of disclosure of the regime that they choose will, for the reasons discussed in the text, be lower than what is socially optimal. There is. however, at least a floor set by the insiders' desire to maximize share price. The managers of an already public firm, in contrast, may well choose a regime that requires even less disclosure than would the regime that would yield the highest share price. The less the market knows about what is going on inside the firm, the more protection the managers have against hostile takeover and the pressures on managers brought by activist hedge funds. The managers may well find that this added protection is worth more to them than whatever they are giving up due to a lower share price.

(56.) See RESTATEMENT (SECOND) OF CONTRACTS [section] 164 (AM. LAW INST. 1981) (stating that a contract is voidable if assent was induced by material misrepresentation, even absent fraud).


(58.) See supra Part I.D.

(59.) For a general discussion of discounted present value and the comparative opportunity costs of risky investments, see BREALEY, MYERS & Allen, supra note 16. at 16-17.

(60.) See Forsythe et al., supra note 19. at 482-84 (discussing experimental evidence that an absence of sanctions for false claims can lead investors to purchase inferior securities). Section 11(e) of the Securities Act provides a somewhat different damages formula, in essence giving the plaintiff a prima facie case for the difference between the price paid and the price at time of suit. 15 U.S.C. [section] 77k(e) (2012). The defendant has the burden of proving what damages would be under the formula suggested in the text. Id. The defendant enjoys a reduction in the prima facie measure of damages only to the extent that it can make this showing. Id.

(61.) See Ernst & Ernst v. Hochfelder, 425 U.S. 185,206-14 (1976) (declining to extend liability under [section] 10(b) and Rule 10b-5 of the Exchange Act to include negligent conduct). Although there is not complete agreement among the federal circuits as to which individual or individuals within a corporation's organization need to possess knowledge of facts that render the corporation's statement false or misleading for the statement to constitute a Rule 10b-5 violation by the corporation, the focus of most courts tends to be on the top officials. The Ninth Circuit, for example, affirmed the dismissal of a complaint against an issuer because insufficient evidence was alleged that the CEO, who spoke the alleged misstatement, knew the information rendering it false. See In re Apple Comput., Inc.. 127 F. App'x 296, 303 (9th Cir. 2005) ("A corporation is deemed to have the requisite scienter for fraud only if the individual corporate officer making the statement has the requisite level of scienter at the time that he or she makes the statement." (citing Nordstrom. Inc. v. Chubb & Son. Inc., 54 F.3d 1424,1435-36 (9th Cir. 1995))). Similarly, the Fifth Circuit has stated

   For purposes of determining whether a statement made by the
   corporation was made by it with the requisite Rule 10(b) scienter
   we believe it appropriate to look to the state of mind of the
   individual corporate official or officials who make or issue the
   statement (or order or approve it or its making or issuance, or who
   furnish information or language for inclusion therein, or the like)
   rather than generally to the collective knowledge of all the
   corporation's officers and employees acquired in the course of
   their employment.

Southland Sec. Corp. v. INSpire Ins. Sols. Inc., 365 F.3d 353,366 (5th Cir. 2004).

(62.) See infra Parts V.B-C.

(63.) See Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988); TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438,449(1976).

(64.) Section 11 imposes absolute liability also on these top officials, subject to a due-diligence defense. In applying this statutory scheme, however, the courts have acted in a way consistent with the view in the text that all material information about the issuer has very likely been made available to its top officials. The courts almost conclusively presume that an issuer's top officials know such information despite the theoretical availability of a due-diligence defense. See Feit v. Leasco Data Processing Equip. Corp.. 332 F. Supp. 544. 577-78 (E.D.N.Y. 1971) (explaining how insider directors are presumed to have greater knowledge of corporate affairs, making it almost impossible for them to establish a due-diligence defense); Ernest L. Folk. Ill, Civil Liabilities Under the Federal Securities Acts: The BarChris Case, 55 VA. L. REV. 1, 22, 30-38 (1969).

(65.) Absolute strict liability, in making suits easier to bring, will also increase the number of suits where, despite an issuer having a properly functioning intelligence system, the top management in fact did not know the relevant information. In such a situation, the prospect of liability would have no influence on behavior and hence no deterrence value. The additional social resources expended by the parties in such actions would thus serve no useful social purpose. The analysis in the text suggests that such situations will be rare, however, and so the gain from increased deterrence is the more important consequence of suits being easier to bring.

(66.) Absolute liability subject to a due-diligence defense is in fact essentially the liability scheme for issuers in connection with Regulation A+ offerings pursuant to Securities Act Section 3(b)(2)(D), which, in turn, imposes the liability scheme set out under Section 12(a)(2). See 15 U.S.C. [section] 77c(b)(2)(D) (2012).

(67.) See infra Part IV.D.

(68.) See supra Part I.D.

(69.) See supra Part IV.A.

(70.) This is so even if compliance with the disclosure rules would make the offered securities look sufficiently less attractive that the offering would not proceed at all, in which case the underwriter would lose the small fraction of what the total offering amount would be sold for with the breach, whereas the issuer would lose the whole rest of the value of the deal to it.

(71.) See, e.g., Irving L. JANIS, VICTIMS OF GROUPTHINK: A PSYCHOLOGICAL STUDY OF FOREIGN-POLICY DECISIONS AND FIASCOES 197-98 (1972). Donald Langevoort, in his recent book, emphasizes the capacity of a firm to irrationally underestimate the negative future consequences of disclosure violations because of the tendency of people to engage in self-deception in situations of ambiguity, the tendency for overconfident people to make it to top managerial positions, and pressures at all levels to accentuate the positives that inevitably arise from the development of team cohesion. LANGEVOORT, supra note 44, at 28, 36,40-41.

(72.) See id. at 88. The view that the underwriter can enhance compliance with the disclosure rules by playing a somewhat adverse, devil's advocate role vis-a-vis the issuer has deep roots in the jurisprudence of liability under Section 11 of the Securities Act. See, e.g., Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 544, 581-82 (E.D.N.Y. 1971); Escott v. BarChris Constr. Corp., 283 F. Supp. 643, 696-97 (S.D.N.Y. 1968).

(73.) See supra Part IV.B.

(74.) The optimal stopping problem concerns when it is the optimal time to take a certain action, in this case to stop looking for possible problems. For an application of optimal stopping in a somewhat different legal context, see Alan Schwartz, Products Liability, Corporate Structure, and Bankruptcy: Toxic Substances and the Remote Risk Relationship, 14 J. LEGAL STUD. 689,697-700 (1985).

(75.) Section 11(c) of the Securities Act, for example, provides that "the standard of reasonableness shall be that required of a prudent man in the management of his own property." 15 U.S.C. [section] 77k(c) (2012). This implies some kind of cost-benefit analysis: a prudent man would not, at the margin, spend more on investigation than the expected value of the poor returns that would be avoided by not purchasing assets the inferiority of which would only be revealed by more intense investigation. This point is affirmed by the holding in In re Software Toolworks, Inc. Sec. Litig., 789 F. Supp. 1489. 1496-1500 (N.D. Cal. 1992), affd in part, rev'd in part, 38 F.3d 1078 (9th Cir. 1994), amended by 50 F.3d 615 (9th Cir. 1995), which granted summary judgment to underwriters with respect to certain misstatements, the falsity of which could have been ascertained with more intensive due diligence, but where the court found no issue of fact that the underwriter did not make reasonable efforts. Similarly, the court in BarChris stated in dicta that accountants need not be held to a standard higher than that of their profession. BarChris, 283 F. Supp. at 703.

(76.) The foregoing discussion shows that the underwriter will engage in the optimal amount of search with absolute strict liability. It will engage in the same amount of diligence under a strict-liability regime with a due-diligence defense if the determination of whether the defense is met can be costlessly adjudicated free of error. If this determination is not costless or error-free, the availability of the defense will, as discussed below, reduce the amount of diligence.

(77.) See supra Introduction.

(78.) Securities Act Section 11(a) provides, without qualification, that each person signing the registration statement is liable if it contains a material misstatement or omission. The issuer is one of the required signatories. 15 U.S.C. [section] 77k(a).

(79.) Securities Act Section 11(a) provides, without qualification, that an offering's underwriters are liable if the registration statement contains a material misstatement or omission, but Section 11(b) provides that notwithstanding 11(a). an underwriter will not be liable if it can sustain a due-diligence defense. Id. [section] 77k(b).

(80.) 17 C.F.R. [section] 230.506 (2015).

(81.) Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, 78 Fed. Reg. 44.771 (July 24. 2013) (codified at 17 C.F.R. pts. 230, 239. 242).

(82.) Jumpstart Our Business Startups (JOBS) Act. Pub. L. No. 112-106, [section] 302(a). 126 Stat. 206. 315 (2012) (codified at 15 U.S.C. [section] 77d).

(83.) 17 C.F.R. [section] 230.501(a).

(84.) See Fatih Guvenen, Do Stockholders Share Risk More Effectively than Nonstockholders?, 89 REV. Econ. & STAT. 275. 281 (2007).

(85.) 17 C.F.R. [section] 230.506.

(86.) For a discussion of rules and statutory provisions that lead to this result, see Bradley Berman & Steven Bleiberg. Restricted Securities vs. Control Securities: What Are the Differences?, INSIGHTS: CORP. & SEC. L. ADVISOR. Dec. 2013, at 1-7.

(87.) 17 C.F.R. [section] 230.144.

(88.) Id. [section]. 230.144(d)(l)(ii).

(89.) Id. [section] 240.12g-2.

(90.) Jumpstart Our Business Startups (JOBS) Act. Pub. L. No. 112-106, [section] 501. 126 Stat. 306. 326 (2012) (codified as amended at 15 U.S.C. [section] 78/(g)(l)(a) (2012)).

(91.) See Henry T.C. Hu & Bernard Black, Hedge Funds, Insiders, and the Decoupling of Economic and Voting Ownership: Empty Voting and Hidden (Morphable) Ownership. 13 J. CORP. FIN. 343. 358 (2004).

(92.) 15 U.S.C. [section] 77d(a)(7) (Supp. Ill 2015).

(93.) Fixing America's Surface Transportation (FAST) Act, Pub. L. No. 114-94. [section] 76001, 129 Stat. 1312. 1787-89 (2015) (codified as amended at 15 U.S.C. [section] 77d (Supp. III 2015)).

(94.) 17 C.F.R. [section] 230.506.

(95.) Rule 506(c) offerings permit issuers to offer varying sale prices to different purchasers for the same securities, depending on factors such as quantity purchased and the desirability of the prospective purchaser as a shareholder. See 17 C.F.R. [section] 230.506(c).

(96.) This problem could be cured by a contractual provision between the issuer and purchasers providing that they are all paying the same price. It is not clear, however, that retail investors have sufficient sophistication for this to become a standard term. Retail investor sophistication would need to be great enough that satisfying the resulting market demand for such a term is more profitable than engaging in price discrimination among investors.

(97.) Figures comparing the amount of funds raised during the first two years of the availability of this kind of 506(c) by such a method versus by IPOs can be found in SCOTT BAUGUESS, RACHITA GULLAPALLI & VLADIMIR IVANOV, CAPITAL RAISING IN THE U.S.: AN ANALYSIS OF THE MARKET FOR UNREGISTERED SECURITIES OFFERINGS, 2009-2014, at 2,11-15 (2015).

(98.) Jumpstart Our Business Startups (JOBS) Act, Pub. L. No. 112-106, [section] 401, 126 Stat. 306, 323-25 (2012) (codified as amended at 15 U.S.C. [section] 77c(b) (2012)).

(99.) JOBS Act [section] 401,15 U.S.C. [section] 77c(b)(2).

(100.) Regulation A+ provides for Securities Act Section 12(a)(2) liability and allows for a due-diligence defense pursuant to 15 U.S.C. [section] 77k. See 17 C.F.R. [section][section] 200, 230, 232, 239, 240, 249, 260.

(101.) The lesser ongoing reporting requirements are provided by 17 C.F.R. [section] 240.15c2-11. See id. [section][section] 200. 230. 232. 239, 240. 249. 260.

(102.) See supra Part III.C.

(103.) JOBS Act [section] 302,15 U.S.C. [section] 77d(6) (2012).

(104.) Crowdfunding, 80 Fed. Reg. 71,388 (Nov. 16, 2015) (to be codified at 17 C.F.R. pts. 200, 227, 232,239. 240, 249, 269. 274).

(105.) 15 U.S.C. [section] 77d(6)(A).

(106.) Id. [section] 77d(6)(B)(i)-(ii).

(107.) See id. [section] 77d-1(b) (specifying disclosure requirements for issuers involved in small, crowdfunded transactions).

(108.) 17 C.F.R. 240.12g-6 (2015).

(109.) Id.

(110.) Id.

(111.) See C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 COLUM. BUS. L. Rev. 1, 114 (expressing optimism that the "wisdom of crowds" aspect of internet solicitation will substantially mitigate the adverse-selection problems associated with a low-disclosure offering to ordinary investors); Ibrahim, supra note 41, at 596-98 (same).

MERRITT B. FOX ([dagger])

Copyright [c] 2016 Merritt B. Fox

([dagger]) Michael E. Patterson Professor of Law, NASDAQ Professor for the Law and Economics of Capital Markets, Columbia Law School. The author wishes to thank Professors James Cox and Robert Jackson and the Honorable Denise Cote for their helpful comments on an earlier draft of this Article.
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Title Annotation:IV. Mandated Liability Terms through Conclusion, with footnotes, p. 702-727
Author:Fox, Merritt B.
Publication:Duke Law Journal
Date:Dec 1, 2016
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