Federal securities regulation is based on a non-paternalistic approach to the securities markets. The law utilizes disclosure to regulate securities transactions. So long as material information is disclosed, investors can make investment decisions in accordance with their own preferences. The disclosure approach supports free market principles and preserves the autonomy of investors to decide for themselves whether they wish to participate in risky transactions.
The reality, however, is that the federal securities laws are much more paternalistic than at first appears, and over the last eighty years, have become increasingly more so. Examples of paternalistic securities rules abound, including bans on sales of securities to unsophisticated investors in private placement offerings, limits on the number of unaccredited investors in Regulation D offerings, dollar ceilings on how much a person can invest in crowdfunding transactions, and prohibitions on waiving or contracting out of the federal securities laws. The intent of these rules is to prevent investors from taking on more risk than the government believes is good for them and to protect them from making financial decisions that may harm them in the long run.
As the modern securities markets increase in complexity, we need to ask whether corresponding increases in paternalism are appropriate in our securities laws. In my recent article, Paternalism and Securities Regulation, to be published in the Stanford Journal of Law, Business & Finance, available here: http://ssrn.com/abstract=2593966, I question and analyze the validity of paternalistic government intervention in investors’ lives and the securities markets. To what extent should the law give individuals freedom of choice with regard to risks that may end up causing harm to themselves?
Rationales Supporting Paternalism
Paternalistic rules that interfere with investor choice might be justified for several reasons. First, the law has always sought to protect people when they suffer from ignorance, incompetence, or impairment that affects rational decisionmaking. Modern behavioral studies on cognitive constraints and biases reveal that people’s bounded rationality and bounded willpower consistently thwart sound financial decisionmaking. To the extent these psychological biases cause people unknowingly to make faulty decisions that harm their own interests, limited paternalistic interventions may be warranted.
Second, paternalistic protection reflects an ethic of care, concern, and empathy for the person whose ill-judged choices will harm his own welfare. This ethic of compassion and benevolence would require concern for the plight of investors who make overly risky and damaging decisions that can have disastrous financial consequences for themselves and their families. Paternalistic rules that prevent investors from taking unwise actions may help to avoid such results.
Third, while paternalism may appear to inhibit people’s immediate autonomy to make decisions, it can ultimately produce a net increase in their long-term autonomy, liberty, and freedom to make future choices. For example, a paternalistic rule that prohibits a person from selling himself into slavery interferes with his current freedom to do as he wishes with his life, but it effectively preserves his overall freedom to live autonomously and control his own future actions. By preventing people from making imprudent self-harming choices, paternalism may maximize people’s potential to achieve a greater volume of their most valuable long-term preferences.
Fourth, society has an interest in restraining people’s actions when they adversely affect third parties. Where a person’s poor decisions harm others or society generally, more is at stake than just protecting that person from himself. Investment decisions that are plagued by investor error, irrationality, and misguided risk-taking can cause damage not only to the investor, but also to those who are financially dependent on the investor, or the public if the investor must subsequently rely on support from the welfare state. To the extent numerous investors are massively unsuccessful in their financial decisions, society is faced with the prospect of providing a safety net for all who choose to risk too much. In this regard, paternalistic intervention might be justified to prevent harm to others.
Opposition to Paternalism
There are several important psychological, philosophical, and political objections to paternalism. I address these objections in detail in my article. For this blog post, I will highlight just one in particular. From a political standpoint, paternalism is objectionable because it suggests that the politically elite and powerful are superior decisionmakers and therefore get the right to make the paternalistic rules that the weak and impaired must obey. If regulatory agencies are captured by special interests, paternalistic policies might be adopted, not in the broader public interest, but in agency officials’ own self-interest or the interests of powerful groups. In the context of the securities markets, that may lead to the increased promulgation of securities rules favoring wealthy, institutional, and politically influential investors – for example, allowing them to engage freely in high-risk, wealth-producing securities transactions – while paternalistically prohibiting average, less politically connected investors from doing the same. Moreover, there is always the risk that mildly paternalistic policies will lead to more frequent and extreme paternalistic interventions, as paternalistic rules become the norm and people become accustomed to the steadily growing impositions. Once we start on the road of using paternalistic solutions to solve problems of risk, we may find ourselves on the slippery slope of increasingly intrusive government regulation of our decisionmaking.
For the anti-paternalist, the bottom line is that the markets should be allowed to operate freely without undue regulatory interference in the guise of protecting vulnerable investors. Investing in the stock market involves significant risk, and investors who choose to engage in the market had better know what they are doing, or stay out of the game. They should have to live with the consequences of their own investment decisions, whether profitable or disastrous. Paternalism breeds dependence and incompetence and is not an effective approach to regulation.
Alternatives to Paternalism
Rather than adopting paternalistic measures, we could utilize other less intrusive methods to protect investors. For example, we could mandate even greater disclosure by market participants to allow investors to make better informed decisions. We could also provide education to investors to increase their financial literacy, knowledge, and ability to evaluate the merits and risks of investments. The goal of such enhanced disclosure laws and financial education programs would be to equip investors with the tools to protect themselves. As I discuss in my article, however, the disclosure solution and the education solution both have significant weaknesses for several reasons. Supplying investors with more and more disclosure has not proven to be highly effective in facilitating good decisionmaking. Nor have financial education efforts resulted in large improvements in people’s financial skills and knowledge. While these alternatives sound good, they do not themselves present an entirely effective approach to investor protection.
Some measure of paternalism in securities regulation may be unavoidable to a degree. But how much paternalism is too much? When is it appropriate to let people make their own bad choices? Determining when and where paternalistic rules are appropriate will require the hard and time-consuming task of formulating substantive regulations that are tailored to specific problems. In the context of securities transactions, as financial products become riskier and more complex, we may see the adoption of stricter substantive rules. If paternalistic policies are necessary, they will need to be supported by careful cost-benefit analysis and sound moral judgment. To the extent possible, the potential costs of paternalistic intervention should be identified and weighed against the anticipated benefits that will accrue from the intervention. My article recommends a substantive, tailored approach to developing and implementing paternalistic securities rules to the extent we believe they are truly necessary to protect investors and the securities markets.
Paternalism is not an easy topic to discuss. It raises strongly held beliefs on both sides of the debate. The stakes are high in deciding whether to promulgate paternalistic rules to protect people from harming themselves or simply allow them to make their own way. Our commitment to individual autonomy, liberty, and freedom is in constant tension with our obligation to benevolence, empathy, and welfare. All paternalistic laws that seek to protect people from self-harming activities must balance the conflicting consequences of the intervention.
The preceding post comes to us from Susanna Kim Ripken, Professor of Law at the Dale E. Fowler School of Law, Chapman University. The post is based on her recent article, “Paternalism and Securities Regulation”, which is available here.