Is There a “Free Market Solution” to Securities Fraud?

Like the healthcare bill before it, regardless of its dilution to earn Republican votes, the Dodd-Frank financial reform bill is a BFD.

It’s also one that’s continued the trend towards shunting enforcement of the Securities and Exchange Acts away from private litigators, and to the SEC. The bill preserves the rule that private citizens can’t litigate securities fraud premised on “aiding and abetting” liability, but makes it easier for the SEC to do just that; and it restores to the SEC the ability to regulate “foreign-cubed” (foreign-centered) securities fraud, an ability private plaintiffs lost early last month when the Supreme Court decided Morrison v. Nat’l Australia Bank.

There’s cause to doubt whether this is the most efficient solution. Securities enforcement is an area of law particularly susceptible to the Republican argument that, given the right tools, private actors motivated by self-interest might better control industry excess than overburdened government agencies. The SEC, after all, has limited resources; the private market has no such limitation. Thanks the class action device, and rules permitting attorneys to earn large contingency fees, an individual with a plausible claim, even one with very modest means, can attract skilled counsel and take down even top firms. This privateering model is uniquely American, and remarkably effective. If we’re worried about securities fraud, why not “unleash the free market”?

Because, for one, it’s probably too effective. Securities litigation is so lucrative for the plaintiff’s bar that Clinton’s Congress passed laws, over the President’s well-informed veto, to make it harder for plaintiffs to sue in the first instance. Rules designed to weed out meritless claims save firms from costly litigation over petty breaches, and thus preserve the attractiveness of American markets to foreign investors, but permit private redress of real fraud.

Could we successfully “re-privatize” securities enforcement, and guard against frivolous litigation by instituting still stricter threshold requirements? Yes. Would this system better control fraud, without destroying valuable market incentives? Maybe. That’s a question for law professors with both the time and the inclination to make a full study. The argument, though, is at least plausible, more so than many (any?) of the right’s anti-reform arguments. Why haven’t they made it, then?



  1. There is a very obvious Free market solution to Securities Fraud. The system collapses. Thus making it necessary for the people to either correct their ways or destroy themselves.

    Simply but very effective when dealing with people who learn from mistakes. Problem is not everyone does learn from their mistakes.

    However, more financial regulation doesn’t fix the problem. It doesn’t prevent people from being fraudulent. If it did all we would have to do to end fraud is pass a law. Corrupt people will ignore regulations or find ways to be dishonest that are legal. Probably by being a politician or something.

    True change has to come at the individual level. Good analysis though. Id love to see more of what you have to say about it.

    1. Regulations only work when they are enforced, and regulators have not been enforcing, hence the current mess. In 2006 we had billboards and radio spots coast to coast touting bank and securities fraud, and no one said a thing about it. At least not until it was way too late.

      Letting it all cave in is hardly an efficient solution, not with the resulting dead pensions, destroyed capital, and a host of other bad things. Further, what the market needs is transparency, and that requires regulation, because the market left to itself encourages opacity. Regulation, then, needs to ensure two things: 1) transparency, so that it isn’t simply an inside game, and 2) independence of regulators, so they will actually regulate, instead of merely being the lapdogs of the regulated.

  2. Although no nation has enacted legislation of such massive scope and sweeping coverage, many countries have passed laws with the same general purpose to eliminate fraud and protect investors from unfair trade practices in domestic securities markets. Perhaps not surprisingly, the original drafters of the Exchange Act did not directly address the applicability of their law to transnational securities transactions.

    Thanks for sharing….

    Securities Fraud Attorney

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