Public and Private Rule Making in Securities Markets

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Recent corporate scandals have ignited debateover appropriate rules for accounting and corporategovernance. The debate has largely ignoredan important preliminary question: who shouldset standards of corporate governance and disclosurefor publicly traded companies? This paperargues that stock exchanges have substantialadvantages, in comparison with governmentbodies, as the primary regulators of corporategovernance, disclosure, and accounting. Thoseadvantages stem from superior incentives. Stockexchanges gain from investors' willingness totrade and accordingly have an incentive to provideany cost-effective rules that will increaseinvestor welfare.

There are several standard arguments againstincreasing the role of exchanges in setting disclosureand governance rules. One is that exchangeshave market power, which dulls their incentive toset optimal rules. Another is that competitionfor listings will make exchanges reluctant toenforce their rules. A third is that disclosure ruleshave external effects that an exchange cannotinternalize. Finally, it is argued that exchangesmay lack sufficiently varied enforcement tools toensure compliance with their rules. Under currentpractice, the primary threat exchanges canhold over listed companies is delisting, whichmay be too large a penalty for some violationsand too slight for others.

Only the last of those is a significant obstacle,and even that can be resolved contractually tosome extent. Listing agreements could call forfines and other penalties for violation of rules.Nevertheless, government agencies have a clearadvantage in investigating and punishing wrong-doing.A natural solution, then, would be to maintainthe Securities and Exchange Commission asan enforcement agency but cede much of its rule-makingauthority to the exchanges.

Paul G. Mahoney

Paul G. Mahoney is Brokaw Professor of Corporate Law and Albert C. BeVier Research Professor at the University of Virginia School of Law.