Issuer Liability: Ownership Structure and the Circularity Debate

In many countries, investors can hold publicly traded companies liable for public misstatements. Issuer liability is intuitively appealing because statements are generally made on behalf of the company by its representatives. Moreover, large companies typically have deep pockets, which ensures compensation for investors who incurred losses because they traded during the period when stock prices were distorted by false information.

However, in the United States – the country where securities class actions are most prevalent –, many scholars are highly skeptical about the social value of issuer liability through securities class actions. The critique is usually framed under the rubric of “circularity” and the “pocket-shifting” nature of issuer liability. A payout to aggrieved investors reduces firm value by the same amount, and since plaintiffs often own stock in the defendant, money is distributed from one of the investors’ “pockets” to the other, except for the cut taken by attorneys. Critics argue that diversified investors will not benefit from an issuer liability system, because they can be on the losing or winning side and suffer a loss from litigation costs. In addition, the incentive effects of issuer liability are often thought to be small. My forthcoming chapter argues that issuer liability could – at least in theory – create greater pressure to avoid public misstatements in corporate governance systems with more concentrated ownership.

Issuer Liability and the Lack of Deterrence

The deterrence effects of issuer liability are also doubtful. The actual beneficiaries of misrepresentations are managers hoping to embellish their performance, but they are rarely held personally liable. Thus, there are primarily two other parties that could be effectively deterred.

First, D&O insurance can significantly affect the incentives created by liability. While insurance may encourage moral hazard, the insurer should have incentives to reduce it by monitoring, requiring deductibles, or adjusting the insurance premium to the perceived risk. However, contrary to theoretical predictions, D&O insurers rarely monitor and usually do not use premia to create incentives. Baker and Griffith suggest that the likely explanation is agency cost: Insurance is chosen by managers or directors rather than shareholders, which results in the choice of insurance plans serving the interest of the intermediate beneficiaries. These plans reduce liability risk but do not typically result in monitoring or better incentives to avoid liability.

Issuer liability may also create incentives for shareholders to avert wrongful disclosures by corporations. However, issuer liability constitutes an agency problem between shareholders and managers: Managers will often benefit from embellishing corporate performance, whereas shareholders will collectively benefit from avoiding the financial harm from issuer liability.  As residual claimants, shareholders collectively should have incentives to reduce the probability of misconduct, because they would either suffer the loss in value of the stock from liability or increased insurance premia if the firm exhibited a high risk of making misrepresentations. Significant shareholders could monitor officers prone to misstatements or select officers who will avoid them. Shareholders will also want officers or managers that have engaged in misconduct to suffer financial and career penalties. For example, they could also push for firms to seek reimbursement from wrongdoers for financial losses resulting from issuer liability on a consistent basis. However, it appears that shareholders generally neither engage in meaningful monitoring of this type nor push for insurance mechanisms that would create incentives for management.

Does Concentrated Ownership Strengthen the Incentives of Issuer Liability?

The somewhat underexplored question is the extent to which this U.S.-centric debate can be generalized to other nations. The arguments developed against the backdrop of the U.S. corporate governance system do not apply in other jurisdictions where there are typically large blocks of shares. Therefore, I argue that issuer liability potentially has greater social value in corporate governance systems with concentrated ownership.

The incentive effects of liability depend primarily on how eager a board is to reduce liability risk. This will depend on the firm’s corporate governance structure and environment and whether they require directors to implement goals in the interest of the corporation and its shareholders. All else being equal, the incentives set by issuer liability would be stronger in a more concentrated ownership environment. While issuer liability, in principle, would create incentives to monitor and screen to avoid securities fraud, such incentives will be eviscerated by diversification. With only a small investment in any firm, efforts to reduce agency costs may not be cost-justified either for a diversified retail investor or a fund. Individual shareholders are unlikely to have incentives to ensure the selection of directors and officers who will avoid misconduct and securities fraud.

Dispersed ownership at the firm-level results in a reduction of the ability of shareholders to take effective measures, regardless of whether they have personal incentives. At least in passing, U.S. scholars have noted that the lack of a deterrent effect of securities litigation is likely the result of collective action problems caused by ownership structure. This is because collective action problems prevent shareholder monitoring in the classic Berle-Means corporation. Therefore, the board will consider shareholders’ collective financial interests to a lesser extent than is desirable.

Larger shareholders tend not to suffer from collective action problems. Some may even be consulted before essential transactions. Sometimes they are represented on the board, which provides them with direct decision-making powers and access to information. Concentrated ownership structures generally should strengthen the incentives resulting from issuer liability. With controlling shareholders sometimes involved in financial fraud, issuer liability creates incentives against possible wrongdoers. We cannot expect this relationship to change with the rise of institutional investors, especially passive ones following an index. Most observers agree that they have little to gain from firm-specific activism and have no incentive to reduce fraud because diversification protects them from firm-specific risk.

The Comparative Political Economy of Issuer Liability

If issuer liability creates monitoring incentives for large investors, why is it not more frequently used in concentrated ownership jurisdictions? The comparative corporate governance literature often discusses differences between jurisdictions with more dispersed and more concentrated ownership. Despite a constantly evolving landscape, block ownership (e.g., by families or governments) persists in many European and East Asian countries. Correspondingly, comparative research shows that issuer liability is most often imposed in the U.S., where a litigation model rooted in private enforcement has taken root. Jurisdictions where the model has expanded include Canada, Australia, and Israel. In much of the world, securities lawsuits remain comparatively rare, including in most of Europe.

In the U.S., securities litigation seems in political equilibrium among shareholders, institutional investors, management, and plaintiff lawyers. Eliminating issuer liability would be politically tricky because politicians will likely not want to be seen as undercutting the compensation of defrauded investors and letting deep-pocketed corporations off the hook. Issuers and their management oppose securities class actions at times. With attorneys benefiting from the current system, we should expect the system to stay in place.

Ownership structure also makes a difference in the political economy of issuer liability. Countries with more concentrated structures could benefit from more frequently imposed issuer liability because it creates incentives for large investors. Intuitively, one could speculate that those for whom the incentives are created – large shareholders and large creditors – also tend to be among the dominant interest groups in corporate governance in these jurisdictions. Opposition by groups who might lose from issuer liability aligns with the literature on path dependence in comparative corporate governance. Powerful interest groups such as these will prevent change that could better protect outside investors. With plaintiffs’ attorneys not being a powerful interest group, the interests of blockholders are likely to prevail and prevent change to the current system.

It is tempting to speculate whether the preferences of key interest groups in corporate governance have contributed to maintaining the current position. The critical interest group benefiting from issuer liability is plaintiff attorneys; the key interest group benefiting from its ineffectiveness in Europe is blockholders. Given the respective influence of these groups, we can expect differences in practices to persist.

This post comes to us from Professor Martin Gelter at Fordham University School of Law. It is based on his forthcoming book chapter, “Issuer Liability: Ownership Structure and the Circularity Debate,” a working-paper version of which is available here.

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