8.3 Quality control: the trusteeship strategy

Mandatory disclosure is the most prominent device employed to protect investors, but it is not the only one. Indeed, to the extent that the problem of investor protection is seen to lie with unsophisticated investors themselves, rather than with the quality of information that they receive, only direct and paternalistic market regulation can protect investors from themselves. The most popular form of direct market regulation follows a trusteeship strategy, in which a disinterested third party is empowered to screen companies that wish to enter the public securities markets. Most major jurisdictions maintain at least vestigial traces of the trusteeship strategy in the form of substantive review by securities officials or stock exchanges.

In the vernacular of U.S. securities law, this form of trusteeship strategy is termed 'merit regulation.' Traditionally, federal securities regulation in the U.S. is based almost entirely on the entry strategy of mandatory disclosure (at least in theory64), while the regulation of securities issues under state law (so-called 'blue sky law') has been largely merit based.65 Under the laws of many U.S. states, then, securities administrators may decide to impound the proceeds of an issue until the issuer receives a specified amount, or they may order the restructuring

62 See also Donald C. Langevoort, Taming the Animal Spirits of the Stock Markets: A Behavioral

Approach to Securities Regulation, 97 NORTHWESTERN UNIVERSITY LAW REVIEW 135 (2002).

63 Compare Romano and Fox, supra note 55.

64 Covert merit regulation may occasionally occur when the SEC screens the adequacy of disclosure

in preliminary registration statements. The line between inadequate disclosure and an inadequate

offer is sometimes blurred.

** See, e.g., Loss and Seligman, supra note 34, 9-37; Paul G. Mahoney, The Ongins of the Blue Sky Laws: A Test of Competing Hypotheses, 46 JOURNAL OF LAW AND ECONOMICS 229 (2003).

of an offer to meet certain substantive guidelines. These officials may even refuse to approve a particularly risky issue if it appears to be without economic merit. In practice, regulatory vetoes of this sort occur rarely and are largely restricted to the initial public offers of small companies assisted by unknown underwriters.66 Nevertheless, merit regulation still occurs, even in the U.S.

European jurisdictions also employ the trusteeship strategy in the form of merit regulation. More specifically, most EU Member states have authorized market regulators to screen listing applications in the interests of the investing public. 67 Thus, the UK's Financial Services and Markets Act 2000 (FSMA) authorizes the UK Listing Authority (UKLA) to refuse an application if, for a reason related to the issuer, it considers that fisting the security would be detrimental to the interests of investors.68 Similarly, the French supervisory authority may oppose exchange listings that would seriously jeopardize investors' interests, while German stock exchanges are required to withhold listings that would 'lead to public deception' or 'damage substantial public interests.'69 However, time constraints and uncertainty about the permissible scope of review for listing authorities restrict the application of such merit screening as a practical matter.70 As a result, listing authorities generally prefer to require issuers to make additional disclosure ('warnings'), rather than to bar their listing applications outright under a trusteeship strategy.71

The vestigial character of the trusteeship strategy in the major jurisdictions speaks to the maturity of the public markets. However useful it might be to prevent issuers from unloading overpriced and poor quality shares on unsophisticated investors, the costs of merit regulation are obvious. It requires state administrators or stock exchange officials to rule on investments in which they have no financial interest. There is little reason to believe that their decisions would improve on the market's, but considerable reason to fear that they might bar risky firms from the capital markets out of a misplaced sense of prudence.

8.4 QUALITY CONTROL: THE RULES AND STANDARDS STRATEGIES

If it is too costly to give discretion over entry into the capital markets to government officials, it remains possible to protect public investors through rules or standards that govern the characteristics and behavior of public

66 Regarding the limited coverage of merit regulation, see, e.g., Roberta Romano, THE GENIUS OF

AMERICAN CORPORATE LAW 108-12 (1993).

67 Art. 12 Listing and Regular Information Directive.

68 §75 Financial Services and Markets Act.

69 Art. L 421-4 Code Monetaire et Financier and Reglement COB 96-01 (France); $30 BSrsenge-

setz (Germany).

70 For France, see de Vauplane and Bornet, supra note 52, N°454 (supervisory authority has five

days to react); for Germany: von Rosen, supra note 51, N°156.

71 See, e.g., COB, Bulletin mensuel N°361 (December 2001) 59 (22 of the 26 issuers that listed on

the Nouveau marche" were required to post risk warnings in their prospectus as well as in any

advertising); Pierre-Henri Conac, LA REGULATION DES MARCHES BOURSIERS PAR LA COB ET LA

SEC N°39 (2002) (risk warnings for Internet bubble issuers).

firms.72 Rules and standards can only do so much, of course. The opportunity costs of tight constraints on public firms could match and exceed the costs of all-too-zealous trustees. Nevertheless, rules and standards hold out the promise of preventing the worst abuses of public investors.

8.4.1 The rules strategy

In general, our major jurisdictions make little effort to protect investors by attempting to regulate the 'quality' of public shares through the imposition of specific rules governing such matters as price, voting rights, and the like. This is true even for civil law jurisdictions, where corporate law has traditionally distinguished between closed and open corporate forms with freely transferable shares. Indeed, to the extent that the securities of the typical German Aktiengesellschaft or the French societes anonymes are subject to specific rules, these rules are designed to protect creditors rather than shareholders—such as capita! maintenance rules.73 Corporate law regulates the quality of traded securities largely as a byproduct of its effort to protect minority shares, which are, at least potentially, publicly traded.

By contrast, listing requirements are more likely to include rules that safeguard the quality of publicly traded securities. 'Official' or 'first tier' markets typically impose rules mandating minimum size for corporate issuers, minimum float for listed securities, and minimum history of published accounts. For example, the New York Stock Exchange (NYSE) requires a pre-tax corporate income of between $2 million and $4.5 million, net tangible assets of $40 million, and a float of publicly held shares that—depending on market conditions—must exceed $40 million. It also requires a minimum of 1.1 million shares of publicly held common stock, and a minimum number of shareholders (between 500 and 2,200, depending on trading volume).7'1

Other exchanges, with the exception of the Tokyo Stock Exchange,75 generally impose less rigorous listing requirements. For example, the EU minimum for an exchange listing is €1 million in 'foreseeable' market capitalization (or, if this cannot be assessed, in legal capital and reserves), and pre-existing financial accounts covering the company's prior operating history for at least three financial years.76 EU Member states have generally chosen not to add to these

72 For a discussion of the respective role of rules and standards, see supra 2.2.1.1.

73 See supra 4.2.2.1.

74 More precisely, the NYSE generally requires: either $2,5 million in income before federal income

taxes for the most recent year and $2 million pre-tax income for each of the preceding two years, or an

aggregate for the last three fiscal years of $6.5 million together with a minimum in the most recent

fiscal year of $4.5 million (all three years must be profitable).

75 The Tokyo exchange requires: at least 4 million shares; at least 1 billion yen in shareholders'

equity; at least 800 shareholders; and a high minimum pretax profit calculated over a two- or three-

year period.

76 Art. 43 and 44 Listing and Regular Information Directive. Member states may provide for

admission even if these conditions are not fulfilled, provided that the competent authorities are

satisfied there will be an adequate and informed market for the shai^s concerned.

requirements, as is shown by the German (minimum foreseeable market capitalization of €1.25 million) and UK listing rules (a minimum expected aggregate market value of £700,000).77

Finally, both regulatory authorities and stock exchanges employ the rule strategy to protect the quality of securities after they reach the public market. Thus, under NYSE rules, shareholders must vote on any transaction in which the firm will issue shares in excess of 17.5% of current equity, whether or not such a vote is required under state law. Similarly, for many years, the NYSE imposed a one-share/one-vote rule on listed companies that set the standard for most large corporations.78 On the regulatory side, the U.S. SEC has promulgated numerous rules designed to protect the interests of public investors. The best known of these are probably the rules on insider trading discussed in Chapter 5,79 but there are many others. For example, the SEC has adopted rules governing proxy voting, share repurchases, and tender offers, thus establishing minimum quality standards for registered public corporations that do not bind closely held firms.80 Similarly, the EU is undertaking reforms aiming at improving the rights and treatment of shareholders in corporations that are traded on regulated markets.81