In The Complete Guide to Sarbanes-Oxley
Back in 1933, Congress considered three different models of securities regulation that states used in their blue sky laws:
- The merit model: Review by a state official of a proposed offering of securities to determine whether the deal included provisions that were “unfair, unjust, inequitable or oppressive” and whether it offered “a fair return.”
- The fraud model: Simply prohibit fraud in the sale of securities, with civil and/or criminal penalties for committing fraud.
- The disclosure model: Allow issuers to sell very risky or even unsound securities, provided they gave buyers enough information to make an informed investment decision.
In adopting the Securities Act of 1933, Congress opted for a mix of the latter two approaches. As a result, there is no merit review of whether investors will earn a decent return or the terms of the deal are fair. In theory, the act allows you to sell investors a rotten egg, as long as you tell them very clearly that the egg is rotten.
Stefan Padfield nevertheless proposes reconsidering "whether merit review might be a proper regulatory response to a Supreme Court that seems quite willing to strike down regulation of corporate speech."
It's not entirely clear whether he wants to consider merit review as an addition to the current disclosure-based regime or only as a substitute for the current regime in the unlikely event that the Supreme Court were to invalidate the mandatory disclosure regime as an infringement of corporate First Amendment rights.
In either case, however, it's worth remembering why merit review was rejected in the first place. Wendy Gerwick Couture has identified the common complaints lodged against merit review (63 Baylor L. Rev. 1):
Merit standards vary, but a typical statute imposes a “fair, just, and equitable” standard. One component of the merit evaluation is the fairness of the offering price. Regulators assess the fairness of the offering price by examining the company's earnings history and the potential for future earnings, among other factors.
[Merit review thus is] premised on the debatable notion that a security has an ascertainable fair price. In addition, by lowering offering prices below what the market will bear, [it will] divert money away from the issuer to be scooped up by speculators in the secondary market.
… [She then identifies three additional criticisms.] First, merit review is widely criticized as unduly paternalistic. The primary rationale for merit review of offering price is to protect the public from paying unduly high prices for securities--in essence, merit review protects investors from themselves. …
Second, merit review is often criticized for interposing an ill-equipped middleman between issuers and investors. As recognized by Professor Morrissey, a weakness in his argument for federal merit review is the Securities and Exchange Commission's ineffectiveness in its current role, much less in the expanded role of merit regulator. …
Third, merit review is often maligned for preventing issuers from raising capital by denying them registration. As Professor Rutherford B. Campbell, Jr. succinctly explained: “[M]erit regulation unnecessarily constrains the freedom of people to do business as they see fit, discourages entrepreneurial initiative and impedes the flow of capital to its most efficient use.”
In an assessment of merit review in Chinese securities law, Robin Hui Huang suggests another problem with merit review systems: "merit regulation has also provided a fertile breeding ground for rent seeking and corruption by regulators. This is because the approval requirement makes the right to do an IPO a scarce commodity and thus leads to many rent-seeking activities in the process." (41 Hong Kong L. J. 261, 270) Later in the article, Huang notes that US state "'blue sky' laws have been vehemently attacked in recent times for its problems similar to those China has experienced, such as associated costs, indefiniteness, inconsistency and the potential for corruption. In a developed market, it seems to be clearer that public regulators are unable to outperform the market in evaluating financial products." (277) Although he notes a potential role for merit review in emerging capital markets, the US capital markets hardly qualify for that characterization.
Therese Maynard notes that merit review also has been blamed for impeding capital formation. "Small issuers in particular complained bitterly that the cost of complying with California's merit review standard in order to register their securities offerings for sale in this state substantially raised their capital formation costs. These issuers, therefore, maintained that the merit review process as applied in California disproportionately impacted the small-business issuer's efforts to raise capital." (30 Loy. L.A. L. Rev. 1573, 1586.)
So let's just say no to merit review.
What would I do if the Supreme Court struck down the current mandatory disclosure regime? (You mean, besides being stunned?) I'd rely on voluntary disclosure. See my article Mandatory Disclosure: A Behavioral Analysis:
Mandatory disclosure is a defining characteristic of U.S. securities regulation. Issuers selling securities in a public offering must file a registration statement with the SEC containing detailed disclosures, and thereafter comply with the periodic disclosure regime. This regime has been highly controversial among legal academics. Some scholars argue market forces will produce optimal levels of disclosure in a regime of voluntary disclosure, while others argue that various market failures necessitate a legal mandatory disclosure system. To date, however, both sides in this debate have assumed, inter alia, that market actors rationally pursue wealth maximization goals. In contrast, this paper draws on the emergent behavioral economics literature to ask whether systematic departures from rationality, such as herd behavior or the status quo bias, might result in a capital market failure. The paper concludes that such a market failure could occur, especially in emerging markets, but also contends that one should not jump to the conclusion that legal intervention in the form of a mandatory disclosure system is necessary, especially insofar as the highly evolved U.S. capital markets are concerned. The paper concludes with a cautionary note against the potential for behavioral economics to be glibly invoked as a justification for government intervention.
