Evaluating Stock-Trading Practices and Their Regulation

By Fox, Merritt B.; Haeberle, Kevin S. | Journal of Corporation Law, Summer 2017 | Go to article overview

Evaluating Stock-Trading Practices and Their Regulation


Fox, Merritt B., Haeberle, Kevin S., Journal of Corporation Law


I. Introduction......889

II. The Use of the Economy's Existing Productive Capacity...890

A. The Role of a Well-Functioning Stock Market in Promoting Accurate Share Prices. ..891

B. How More Accurate Share Prices Deter Non-Share-Value-Maximizing Production Decisions.892

1. Alerting Corrective Forces to Non-Maximizing Behavior.....893

2. Reducing the Riskiness of the Investment Necessary to Take Corrective Action.....894

3. Providing Guidance to Managers.........894

4. Enhancing the Effectiveness of Share-Price-Based Compensation..........895

C. Share Value Maximization and the Use of Existing Productive Capacity to Produce the Output of the Greatest Social Value............895

III. The Allocation of Capital.........897

A. The Meaning of Efficient Capital Allocation.........897

B. How More Accurate Share Prices Promote More Efficient Capital Allocation by Prompting Managers to Maximize Share Value...........898

1. Project Choice in the Presence of Available Internal Funds......898

2. Share-Value-Maximization Requires Avoiding the Implementation of Negative NPV Projects..........898

3. Avoiding the Implementation of Negative NPV Projects Avoids Socialvalue-decreasing Uses of Society 's Scarce Capital........899

4. The Natural Tendency of Managers to Use Internal Funds to Implement Negative NPV Projects and the Particular Importance of Accurate Prices to Combat This......899

5. The Danger of Inaccurately Low Share Prices Leading Managers to Avoid Implementing Positive NPV Projects..........901

C. How More Accurate Share Prices Promote Efficient Capital Allocation by

Their Effects on the Terms of External Finance......901

1. Classical Finance Theory.......901

2. Institutional Finance Theory........902

a. A firm with a Positive NPV Project and an Inaccurately Low Share Price.........902

b. A Firm with a Negative NPV Project and an Inaccurately High Share Price.........903

c. The Effect of Inaccurate Share Prices on the Use of Debt.........903

IV. The Allocation of Resources Over Time.........904

A. The Meaning of an Efficient Allocation of Resources Over Time.......904

B. How a More Liquid Market Can Promote the Efficient Allocation of Resources Over Time........905

V. The Allocation of Risk..........907

A. The Meaning of Efficient Risk Allocation.........907

B. How a More Liquid Market Can Promote the Efficient Allocation of Risk........908

VI. Additional Considerations..........909

A. Resource Consumption by the Market Itself..909

B. Fairness..........909

1. Actual Fairness........910

a. Situation 1: Ex Ante, the Person Whose Trade Was Affected by the Practice Was as Likely to Have Done Better in Terms of Trading Profits as to Have Done Worse.....910

b. Situation 2: Ex Ante, the Person Whose Trade Was Affected by the Practice Was Not as Likely to Have Done Better in Terms of Trading Profits as to Have Done Worse, But the General Existence of the Practice Leads to Some Kind of Fully Compensating Change.....911

2. Perceived Fairness.....912

C. Innovation....913

VII. Conclusion.....913

I. Introduction

Pundits, policymakers, and scholars alike have expressed a variety of views over recent years concerning the functioning of the market for the public trading of previously issued equity securities and how this market should be regulated. These commentators, however, have largely failed to consider the overall social criteria by which the answers to these questions should be judged. This Article seeks to set forth a guiding framework that provides these diverse voices with a common language that can facilitate informed analysis.

How exactly should trading-market practices and their regulation be evaluated? Answering this question requires thinking about why we care about this market in the first place. …

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