8.2.4.1 The underproduction of information

Despite academic criticism, however, the maj ority view among both scholars and regulators is that public companies would underproduce information in the absence of mandatory disclosure. The accounting scandals at a number of large American corporations, such as Enron and WorldCom, that came to light as this Chapter was being written, strongly suggest that the conventional wisdom is right. But why would public companies not disclose adequately without strong legal pressure?

There are a number of reasons why firms might disclose too little or lie outright if allowed to do so, some of which are subtle and some not. The first—and possibly the most important—is the very unsubtle agency problem between public shareholders and corporate insiders. In firms with dispersed shareholdings, bad news hurts managers by reducing their compensation and diminishing their job security. Thus, the worse news becomes, the less likely managers are to disclose it voluntarily, and the more likely they are tempted to misrepresent the company's finances outright. Moreover, controlling shareholders are equally loath to disclose bad news that will inevitably reduce the value of their shareholdings and raise the firm's cost of capital. Mandating disclosure of news, whether good or bad, minimizes this agency problem for public investors—providing, of course, that the law's mandate is effectively enforced.

A second reason why firms might disclose too little without legal intervention turns on the private costs of establishing credibility in the market. In the absence of mandatory disclosure, the capital markets would expect corporate insiders to

55 Sec, e.g., Merritt B. Fox, The Issuer Choice Debate, 2 THEORETICAL INQUIRIES IN LAW (Online

Edition) No. 2, Article 2 (2001); id., Retaining Mandatory Secunttes Disclosure: Why Issuer Choice is

not Investor Empowerment, 85 VIRGINIA LAW REVIEW 1335 (1999); Roberta Romano, The Need for

Competition m International Securities Regulation, 2 THEORETICAL INQUIRIES IN LAW (Online

Edition) No. 2, Article 1 (2001); id., Empowering Investors: A Market Approach to Securities

Regulation, 107 YALE LAW JOURNAL 2359 (1998).

56 See, e.g., Paul G. Mahoney, Mandatory Disclosure as a Solution to Agency Problems, 62

UNIVERSITY OF CHICAGO LAW REVIEW 1047 (1995); Marcel Kahan, Securities Laws and the Social

Costs of'Inaccurate'Stock Prices, 41 DUKE LAW JOURNAL 977 (1992).

withhold bad news, and would discount the share prices of companies accordingly. To avoid such a discount, confident managers and controlling shareholders might attempt to bond themselves ex ante to reveal all information, good or bad. Under conditions of asymmetric information, however, there is no guarantee that the expected returns from bonding tnithful disclosure will exceed the bonding costs, much less the private benefits to insiders that might follow from non-disclosure. In addition, private bonding devices are often costly or unavailable, creating a second obstacle to optimal disclosure. Regulatory intervention can supplement such bonding failures by providing legal liability as an alternative means to assure the market about the quality of corporate disclosure—and about the credibility of cotnmitments to continue to disclose in the future.57

The third obstacle to sufficient voluntary disclosure is the divergence between the private benefits of disclosure to the company and the social benefits. Disclosure can impose private costs on firms by aiding their competitors, even though it enhances the welfare of diversified investors (and social welfare) by improving the accuracy of share prices and facilitating more efficient investment. It follows that individual managers will not disclose enough information, as measured by the preferences of shareholders, precisely because managers want to maximize corporate value by thwarting competitors.

To be sure, the competitive losses of diversified shareholders in some firms will be matched by gains in other (rival) firms, but these offsets leave portfolio values unaffected. Additional information, on the other hand, should reduce both their nrm-specific risk (by improving firm transparency and corporate governance) and their market risk (through more accurate share prices), thus raising portfolio values. Diversified investors are also likely to reap the net economic benefits of more informed competition, since the value of their portfolios will not be tied to the fortunes of particular firms. Without a regime of mandatory disclosure, however, even diversified shareholders are unlikely to object to managers withholding information of interest to competitors, since disclosure would always disproportionately reduce the market value of the disclosing firm.58

A fourth obstacle to disclosure arises from the fact that information is of less value to investors—and hence incentives to disclose are weaker—to the extent that it is idiosyncratic, without standardized format, content, and quality. At

17 Ronald J. Gilson and Reinier H. Kraakman, The Mechanisms of Market Efficiency, 70 VIRGINIA LAW REVIEW 549 (1984); John C. Coffee, The Future as History: The Prospects for Global Convergence m Corporate Governance and its Implications, 93 NORTHWESTERN UNIVERSITY LAW REVIEW 641 (1999).

SB Discussion of the divergence between the private and public benefits of disclosure enjoys a long history in the corporate law literature. See, e.g., Merritt B. Fox, The Securities Globalization Disclosure Debate, 78 WASHINGTON UNIVERSITY LAW QUARTERLY 567 (2000); id., Securities Disclosure in a Globalizing Market: Who Should Regulate Whom, 95 MICHIGAN LAW REVIEW 2498 (1997); Lucian A. Bebchuk, Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law, 105 HARVARD LAW REVIEW 1437, 1490-91 (1992); John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 VIRGINIA LAW REVIEW 717 (1984); and Frank H. Easterbrook and Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VIRGINIA LAW REVIEW 669 (1984). For a skeptical view, see Romano, supra note 55.

bottom, this is a coordination problem among firms or, alternatively, among shareholders. Standardization improves comprehensibihty and comparability, thus increasing the value of information to investors. While firms have surmounted this collective action problem in the past—for example, through stock exchange rules and accounting methodologies—a regime of mandatory disclosure permits immediate standardization without waiting for it to evolve through private ordering.

Finally, a last obstacle to optimal disclosure without legal intervention in some securities markets—and perhaps at some stage in the evolution of most markets—is that investors may simply be too unsophisticated to demand disclosure. If investors refuse to pay for a commitment to disclose in initial public offerings, firms might not undertake such a commitment, even if additional information would enhance share prices in subsequent trading in the secondary market.

8.2.4.2 The underutiltzation of information

In addition to the obstacles that might induce companies to disclose too little or attempt to actively mislead investors, an even more difficult problem is the possibility that some—or even most—investors in today's markets fail to make good use of the important information already available or that might be made available. Market traders might fail to act on information for a variety of reasons. They may be unsophisticated or—what amounts to the same thing— lack the time and resources to assess what firms disclose. They may be overconfident.59 They may be agents, such as portfolio managers, who prefer to follow the crowd rather than risk their jobs by bucking conventional wisdom. Or, finally, even sophisticated investors might ignore information about the fundamentals in order to exploit market fads and bubbles for profit.

To be sure, the empirical literature suggests that liquid share markets mitigate this problem of unsophisticated investors, since professional trading efficiently reflects public information into share prices, and so (inadvertently) protects poorly informed traders.60 Yet there is no such protection when markets are thin and illiquid because, for example, they lack a clientele of professional traders dealing in the shares of small and mid-sized issuers.61 Similarly, disclosure alone cannot protect unsophisticated investors in initial public offerings who

59 It seems that excessive optimism in their trading ability is as likely to cause retail investors to

disregard available information than lack of time, resources or gullibility; see, e.g., Brad M. Barber

and Terrance Odean, Boys Will be Boys: Gender, Overconfidence and Stock Investment,

116 QUARTERLY JOURNAL OF ECONOMICS 261 (2001); Robert J. Shiller, IRRATIONAL EXUBERANCE

142-6 (2000); Nicholas Barberis, Andrei Shleifer and Robert Vishny, A Model of Investor Sentiment,

49 JOURNAL OF FINANCIAL ECONOMICS 307 (1998).

60 See Gilson and Kraakman, supra note 57.

61 The presence of institutional investors may also play a role, but the extent to which their trading

indirectly protects retail investors remains debatable: see Donald C. Langevoort, Selling Hope, Selling

Risk: Some Lessons for Law from Behavioral Economics About Stockbrokers and Sophisticated

Customers, 84 CALIFORNIA LAW REVIEW 627 (1996).

do not know enough to look after themselves.62 Recall, for example, the perennial accounts of sales of over-priced securities to elderly investors, and the unequal treatment of retail investors that subscribed hot internet-related issues in the late 1990s. Finally, disclosure alone gives limited protection against bubbles, fads, and market enthusiasms that are propelled by their own dynamic rather than by the fundamentals of issuers.

The authors of this book agree that these problems of investor protection are very real. Public companies would disclose too httle without mandatory disclosure of some sort; and without the other protective elements of securities regulation (including merit regulation), unsophisticated investors would be bilked more often than they currently are. Less clear, however, is the form of legal intervention that is appropriate for these problems, including whether regulation ought to be mandatory, voluntary, or somewhere in between.153 Indeed, investor protection is the area of corporate law with the greatest division of opinion among legal scholars, even though, paradoxically, it is also an area with great similarity of legal regimes across jurisdictions.