Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment
Langevoort, Donald C., Law and Contemporary Problems
DONALD C. LANGEVOORT [*]
Shortly after the Securities Act of 1933  ("1933 Act") became law, critics from the securities industry charged that the civil liability provisions created by Section 11 of the Act made it excessively draconian. Mandatory disclosure and prospectus delivery, even pre-clearance by a federal agency, were troublesome enough. However, strict liability to investors for issuers, and failure of "due diligence" liability for underwriters, accountants, officers, and directors for material misstatements in a registration statement, were quite another matter--making Section 11 the "bete noire," in Louis Loss's words, of the legislative scheme.  Opponents ominously warned that the legislation would dry up American capital-raising.  Even though they were eventually proven wrong in that particular prediction,  the industry was right to see the threat of private civil liability as the engine that drives the 1933 Act.  Estimates in the finance literature suggest, for example, that a sizable portion of the unde rwriters' spread is a liability risk premium,  and lawyer-disseminated fear of liability casts a harsh shadow over the due diligence process. 
In the late 1970s and early 1980s, concerns about the relationship between liability and capital-raising efficacy reappeared. Large, seasoned issuers were moving significant capital-raising transactions offshore, into the so-called Eurodollar market. Delays associated with the Securities and Exchange Commission ("SEC") review and limits on publicity and marketing of domestic offerings were blamed. In response, the SEC introduced "short-form" registration for large capitalization issuers via Form S-3 and modernized and expanded the availability of shelf registration, thereby permitting large issuers to move quickly to take advantage of market opportunities without excessive regulatory delays.  In the political process and in academic debates, however, the principal risk associated with speeding up the distribution process was readily identified. Disclosure quality is threatened by the de facto loss of opportunity for external due diligence by underwriters and others associated with the issuance from the ti me the decision to sell is made to the time securities are purchased by investors.  Underwriters thus found themselves in a world of de jure liability if there were misstatements or omissions; only a vague Commission rule, coupled with some informal suggestions for ex ante "continuous due diligence" as protection, seemed to suggest a more permissive standard of due diligence in such settings. 
Today, few suggest that we should, or can, backtrack on liberalization of the 1933 Act.  Instead, regulatory efforts all point to the opposite: further expansion of the speed and limited disclosure responsibilities associated with large company capital-raising.  Yet, this simply focuses all the more attention on liability, and to this point, the Commission has suggested only minimal reform: clarifying the due diligence responsibilities associated with short-form offerings to take account of "practicability" concerns. Indeed, to the consternation of many, the Commission suggested expanding the kinds of issuer-generated information that would otherwise be subject to negligence-based civil liability under the 1933 Act. 
This article is an effort to rethink civil liability in capital-raising transactions by large capitalization issuers.  After a brief digression about who should set liability standards, the article then addresses two related questions. The first deals with a natural question: Should not the primary regulatory effort for large issuers be to assure continuous disclosure in the secondary marketplace, given the far larger volume of such trading in that market compared to that in primary transactions?  Second, if we have developed a satisfactory regime of disclosure responsibilities for this setting, what more, if anything, in terms of liability protection, is needed when such issuers sell new stock into an existing market for their securities?
My conclusions on the first question come in a discrete series of recommendations. I think that the existing system is largely satisfactory as a conceptual matter, although public resources for enforcing that regime are woefully lacking; I would not significantly expand private rights of action for continuous disclosure transgressions. I would, however, create a much more determinate obligation on the part of seasoned issuers to implement an efficient disclosure monitoring system, an elaboration of the current obligation to have a reasonable system of internal accounting controls found in Section 13(b)(2)(B) of the Securities Exchange Act ("1934 Act"). As a "carrot" to induce compliance, I would reduce the fraud-on-the-market exposure for issuers who demonstrate that such a system was in place and functioning.
Having made minor reforms to the 1934 Act liability structure, I would then deconstruct Section ii as applied to larger issuers. The effect of this proposal would be to retain a regime of negligence-based liability for insiders in connection with public offerings, but to substitute a scienter-based liability regime under Rule 10b-5 for others associated with the offering. The article ends by asking whether, drawing from what we have concluded, other 1933 Act liability reforms are appropriate.
DIGRESSION: WHO SHOULD SET THE STANDARDS?
Before turning to the substance of reform, we should consider seriously what many scholars are recommending as a threshold jurisdictional matter: eliminating exclusive federal jurisdiction over capital-raising disclosure standards and enforcement. Various proposals have been advanced. One is to assign such responsibility to a securities exchange for listed companies or exchange-equivalent, so that the exchange would define both the substance of required disclosure and the sanctions for violations.  Another is to give the same power to the various states in the United States, or to foreign countries.  With more or less freedom, issuers could opt in to whatever locus of jurisdiction they choose, so long as the choice was made known to investors in advance of the offering. Another related possibility would be to allow the SEC to retain its role as a "form-giver" and enforcer, but then to permit companies a large amount of freedom to opt out of federal mandatory disclosure responsibilities. This would pu t the SEC into competition with other potential form-givers, public and private, though preserving the Commission's role with respect to actual fraud. 
All of these proposals work from essentially the same premise. Exclusive federal disclosure and enforcement standard-setting, whether through legislation or rule-making, risks either politicization or law-making incompetence. The effect of setting the standards too high is to weigh down the capital formation process except for those issuers that can easily engage in regulatory arbitrage by going outside of the United States to raise money. In contrast, a system of regulatory decentralization coupled with freedom of choice breeds competition among regulators. By hypothesis, issuers will choose the exchange or state that offers the most efficient system of law. Investors demand a reasonable degree of protection and will pay less for securities issued by companies that choose an inferior exchange or state. Hence, exchanges or states will work hard; after all, it is in their economic self-interest to develop optimal systems of regulation,  and capital will migrate to those jurisdictions that appear to the ma rket to be most successful in that venture, providing effective feedback.
To be sure, there is a theoretical appeal to this sort of structure. It resembles the "race to the top" argument in state corporation law. While that argument has rightly been criticized as inapplicable to firms that are not dependent on the capital markets for funds and relatively insulated from the threat of hostile takeovers,  the proposals here are not immediately subject to the same critique. Here, we are talking only about the legal regime that applies to the capital-raising transaction of a particular firm, which, by definition, is market-sensitive. Jurisdictions would develop reputations within investor communities, which would be tarnished to the extent that scandals subsequently emerged and were not remedied.
This literature has generated substantial debate,  which I do not want to revisit comprehensively. A threshold issue, of course, is whether the market would rationally "price" competing legal regimes.  At the very least, there must be differentiation between widely-followed stocks and initial offerings or those that trade in thinner markets. All I wish to do here is to make a narrower set of points that I do not think have received enough emphasis in the debate. As to the capacity of the exchanges, the main point made by commentators is whether the exchanges' lack of legal adjudicatory capacity would undermine the efficacy of any standards that they create.  I share that doubt, but also fear the exchange as a standard-setter or enforcer given the conflicting interests of its member-owners. To the extent that multi-service securities firms have significant political influence at the exchanges, there is considerable tension in their preferences. While they seemingly have the interest in promoting is suer candor that comes from their status as proprietary investors and marketmakers,  such firms also have positions of privileged access to private information through analyst contacts and the like that differ considerably from other investors. Hence, they would be uncertain champions of aggressive public disclosure obligations. And, of course, they are actively involved in the securities distribution process as underwriters. The resulting pressures on how the exchanges formulate disclosure and enforcement policy would be unpredictable and not necessarily conducive to the public good. While this problem might be minimal in an environment of intense competition for listings, the presence of such competition at the level necessary to eliminate all rent-seeking by exchange members is by no means obvious. 
As to the states or foreign countries, my concerns are different. One question is whether, absent some degree of "monopolization," individual states would have the incentives to invest in a start-up system of securities regulation and enforcement. To the extent that some administrative agency or public enforcement is desirable, perhaps on a fairly large scale, the willingness to invest taxpayer money on the bet that the state will be the "tournament" winner and be able to maintain that position over time is open to question. Beyond that, there is also an interesting question of whether the ability to regulate offerings of securities can be separated adequately from post-offering responsibilities and liabilities.  Integration of the 1933 and 1934 Acts is widely accepted today as both a conceptual and practical necessity. Would states then also regulate secondary trading in the issuer's stock? To do so would compound the resource pre-commitment problem noted above. Moreover, granting them the right would p resumably mean that once the issuer has chosen the site of its initial public offering, it would effectively be locked into that jurisdiction unless its shareholders have consented to exit. That would be acceptable if we assume that there would be an active migration via shareholder voting to innovative jurisdictions. But I would predict a high degree of path-dependency here. The state or states that win the competition early on, for whatever reason, will have a decided advantage in their ability to expend resources, build a regulatory infrastructure, and generate a reasonable degree of confidence and stability in its system. Having taken this lead, however, the state may well begin behaving as a monopolist, threatening the benefits that would otherwise flow from true competition.
For these reasons among others,  I am not persuaded by even the theoretical arguments in favor of a move away from federal control over disclosure and enforcement in the capital-raising process. But we need not dwell too long here, for even under a decentralized system, the crucial question is one of designing the optimal liability standards.
CONTINUOUS DISCLOSURE LIABILITY UNDER THE 1934 ACT
The Securities Exchange Act of 1934 is designed to promote the integrity of stock prices for publicly-traded issuers.  If the 1934 Act succeeds in creating a healthy disclosure environment, sales of securities by issuers into a pre-existing trading market should pose minimal additional threat, and the prevailing price will be a fair one.  On its face, at least, the 1934 Act seems well-suited to deter secondary-market price distortions.
Publicly traded issuers must file disclosure documents on a periodic basis. False statements or omissions in these documents can be sanctioned by the SEC through a variety of administrative and judicial proceedings,  pursuant to which the Commission can seek, among other things, civil penalties and injunctive relief. In addition, and no doubt of the most substantial in terrorem concern to issuers, material falsity in such filings can trigger liability for fraud under Rule 10b-5, giving investors a private action for damages. Such fraud-on-the-market lawsuits are aided by judicially-created presumptions regarding reliance and causation, and can lead to massive damage exposure.  Rule 10b-5, moreover, extends beyond required filings. Any form of issuer publicity that is reasonably calculated to affect the investing public can lead to the same combination of SEC and private liability. 
Reinforcing this threat of issuer liability are a host of "secondary" liability provisions. Lawyers and accountants, in particular, are exposed to sanction if they make misstatements directly to investors or willfully aid an issuer that misleads the investing public.  Under some circumstances, especially for accountants, this liability is sufficiently "primary" that the actors can be liable to investors for damages under Rule 10b-5. Even when it is secondary, the Commission's authority to bring enforcement actions against aiders and abettors, and its ability to discipline professionals under Rule 102(e),  would seem to add a significant element of deterrence for those who become intimately involved in issuer disclosure.
In addition to this legal regime are a variety of market forces that presumptively lead to high-quality issuer disclosure. One is the issuer's reputation.  A company that misleads investors risks a lower stock price if the fraud is discovered, with a host of adverse consequences ranging from the diminished value of executive compensation packages to a higher cost of any new capital sought through the public markets. Another constraint is the intense scrutiny given to large public companies by investment analysts and the financial press.  Such scrutiny makes fraud much more difficult to execute successfully, dampening the likelihood that it will occur in the first place.
Given all of the foregoing, it might seem difficult to imagine why large capitalization issuers would ever distort the truth and mislead investors. Yet there is a perception, particularly within the Commission,  that compliance with 1934 Act disclosure requirements--and the truth-telling regime generally--is less than it should be, which in turn fuels the fear that primary distributions into organized secondary markets can be harmful insofar as they occur at "inaccurate" prices.
Perhaps the perception that a high degree of 1934 Act disclosure compliance is the norm is simply wrong, and regulators have seized too readily on salient but aberrant instances of misconduct.  I am not so sure,  however, for two reasons. First, the system of sanctions is woefully underenforced. According to conventional theory, deterrence requires an appropriate balance between the size of the sanction and the frequency of detection and enforcement.  I suspect that SEC penalties are far smaller than they should be given the kinds of harm that comes from securities fraud. That is all the more true when we consider what may be the most serious flaw in the entire liability scheme: that the SEC's investigatory resources are insufficient to detect a significant portion of securities-related misconduct.  Furthermore, those inadequate resources must be divided up in a host of areas besides seasoned issuer disclosure violations.
The SEC is forced to leave the policing of the "high end" segment of securities compliance mainly to private enforcement through class action litigation. To be sure, the activity of the plaintiff's bar is highly visible here. Moreover, it is hard to argue that the potential liability exposure for issuers in fraud-on-the-market cases is too low. It is large, probably excessively so, in light of the nature of the underlying aggregate social harm.  Even here, however, deterrence is compromised to the extent that private securities litigation efforts detect or are perceived to detect only a fraction of meritorious cases and settle those for far less than the optimal measure of damages. While good statistics are hard to come by, I believe that (1) lawsuits are brought infrequently relative to the universe of potential disclosure violations;  (2) some significant but unknown proportion of those that are brought have little merit anyway; (3) recent legislative and judicial reforms have made meritorious case s harder to bring;" and (4) settlements are too high in the low-merit cases and too low in the high-merit ones.  Faced with this, issuers may perceive that the risk of detection and sanction in any given case is far less than certain, and somewhat arbitrary, insofar as even good-faith compliance can trigger litigation that has to be settled. That situation can lead to under-precaution.
While I think that there is a good bit of substance to the foregoing, it still does not sufficiently explain why issuers would take the risk of distortion or concealment, especially when they risk incurring litigation costs and the reputational threat that join with fear of actual liability. In fact, I doubt in the abstract that issuers very often would. However, disclosure decisions are made by human beings, not companies. There is ample reason to believe that these decisions often diverge from what would be optimal in the long run from the issuer's perspective.
One well-accepted reason pertains to agency costs. Because of stock-based compensation packages, company managers may have more to gain from shortterm upward distortions in the issuer's stock price than they have to lose in the long run as