Fraud on the market: A relational investment approach

Abstract

Regulators of securities markets across the globe uniformly impose strict liability on firms that raise capital by means of a misleading prospectus. But regulators are divided in their approach regarding the circulation of false information in the secondary market. Indeed, on one side of the Atlantic, we find England adhering to its conservative Common Law approach and on the other side, the United States with the broad liability embodied in the “Fraud on the Market” paradigm under Rule 10b-5. Fraud on the Market (FOMA) has been one of the most popular topics of discussion among American legal scholars over the last two decades. The focus of scholarship has been placed mainly on the effect of FOMA on the efficiency and on the fairness of the American stock market. 1 This paper takes a different approach: it highlights and compares the effects of three liability regimes on corporate governance and, in particular, on the relational investment structure of a publicly held firm. Moreover, the paper shifts the focus of discussion from the effect of liability on a firm’s incentives to the effect of the compensatory scheme of each regime on investor conduct. The three liability regimes this paper examines are as follows: The traditional Common Law regime, under which plaintiffs must demonstrate proximity, reliance, and causation; The reliance regime, under which plaintiffs are required only to demonstrate reliance and causation; and The fraud on the market regime, whereby plaintiffs prevail if they can establish causation. The first part of this paper examines the effect of liability on monitoring. In particular, I argue that the traditional Common Law regime manifests and fosters the monitoring role institutional investors play in England. The American deviation from the traditional rule, in the form of the Fraud on the Market regime, discourages such relational investment and encourages shareholder passivity. The second part of the paper adopts an (almost) opposite agency model: whereas the first part treats the collective body of shareholders as principals concerned with their manager-agent performance, the second part treats the manager as the principal who solicits feedback from informed investors-agents. Whereas monitors are inspecting the managers’ hidden actions, thereby diminishing the firm’s agency costs, feedback providers are actually informing managers, thereby enabling the latter to run the firm more efficiently. I show that each liability regime provides a different set of incentives to investors and, therefore, facilitates the operation of a different feedback mechanism.