Samuel Waksal has gone to jail, Martha Stewart has been indicted, and several of the smaller fry in the Enron case have copped pleas. But the corporate scandals’ big fish—Enron’s Jeffrey Skilling, WorldCom’s Bernard Ebbers, Tyco’s Dennis Kozlowski—are still swimming free and still enjoying their millions in ill-gotten gains.
Federal securities justice moves at a glacial pace, an enduring source of frustration for burned investors and state law enforcement officials. (In August, for example, Oklahoma’s impatient attorney general indicted Ebbers.) Most investors—including Moneybox—assume that quick, rough justice for rich corporate bad guys would be both satisfying (Skilling in chains!) and beneficial to the markets (which would appreciate the fast resolution).
But according to this study by a troika of Ivy League economists—Dartmouth’s Rafael La Porta, Yale’s Florencio Lopez De Silanes, and Harvard’s Andrei Shleifer—stockholders shouldn’t hunger for perp walks and criminal prosecutions. In fact, markets develop better when civil—not criminal—law is strong.
Sellers rip off buyers: This is a fundamental downside of capitalism. Governments have three ways to deal with it. They can do nothing and trust (or hope) that financial and reputation concerns will keep securities-selling executives on the straight and narrow. (How quaint.) Second, they can establish a regime of private enforcement. Governments establish securities laws that impose disclosure obligations on those who sell stocks to the public and then provide avenues—i.e., lawsuits and arbitration—through which wronged investors can try to recoup losses. The third approach is more explicitly statist: public enforcement. Instead of just promulgating rules and letting the private sector fight it out, governments create agencies like the Securities and Exchange Commission—independent regulators with the power to investigate, prosecute, and fine. Many countries—including the United States—combine the second and third options.
In what must have been a heavy exercise in data-mining, the economists examined the 49 largest stock markets in the world, devised “quantitative measures of security laws and regulations” and indicators of stock market development, and then gauged the relationship between the two sets of variables: data such as the different kinds of liability regimes, the nature of securities enforcement agencies, and the number of domestic publicly traded firms in each country relative to its population. They used regression analysis to determine which variables correlate with more developed stock markets.
Their conclusion is surprising—and surprisingly practical. What works best, it turns out, is a combination of mandated disclosure (thus allowing the markets to work their efficient magic) and the ability of plaintiffs’ lawyers to sue the hell out of corrupt CEOs and underwriters. In short, a more private system.
As for cops at the SEC, they may talk tough and hold flashy press conferences when they nab insider traders. But in the global scheme of things, they may not be so important. “When we try to understand specifically what works in securities laws, we find that several aspects of public enforcement, such as having an independent and/or focused regulator or criminal sanctions, do not matter, and others matter in only some regressions.” In other words, “Public enforcement plays, at best, a modest role in the development of stock markets.”
In this scheme, the SEC still matters, but not as a prosecutor. Instead, it can do its best work by requiring disclosure and making it easier for investors to sue companies.
The United States has been gravitating toward a move private model, more or less by accident. In recent years, the SEC has convicted few high-profile executives or Wall Street figures. But at the same time, the government has significantly increased the mandates of disclosure—see Sarbanes-Oxley. And investor-inspired private legal activities have been surging. In some instances—such as the case in which attorney Jacob Zamansky sued Merrill Lynch and analyst Henry Blodget for dishing out dodgy research—the private enforcement preceded the public.
If the study is right, both left and right can take comfort in being only half-wrong. The left’s fixation on prosecuting corporate crime is wrong, but so is the right’s hatred of contingency-fee lawsuits. Wall Street will benefit from less public law, but more private.