TCS Daily

Spitzer Goes Over the Line

By Stephen Bainbridge - February 9, 2004 12:00 AM

Elliot Spitzer, the attorney general of New York, whom the Economist calls "publicity hungry," recently ramped up his crusade of suing financial institutions by going after the mutual fund industry.

Most notably, Spitzer got Alliance Capital to cut its fees by 20% in order to settle late trading and market timing charges. Spitzer recently defended the Alliance Capital settlement before a Congressional Committee, angrily arguing that:

"Requiring mutual funds to return to investors money that should never have been taken from them is not rate setting," Spitzer told the financial management subcommittee of the Senate's Governmental Affairs Committee. "It's what regulators across the country do every day when they uncover evidence that consumers have been ripped off" ....

No, it isn't.

Spitzer has no statutory or regulatory power over mutual funds fees. He simply isn't entitled to decide whether Alliance Capital's fees were too high or not. As such, his oft-stated plan to require fee reductions as part of any settlements he reaches with fund companies is a gross abuse of prosecutorial power. Alliance's fee structure had nothing to do with the legitimate charges against it -- late trading and market timing. It's as though you got busted for pot possession and the DA said you had to give up snowboarding. What business does the prosecutor have using his leverage that way?

Even if he had regulatory authority over fees, Spitzer's attack on them would still be misplaced. Why? Well, for one thing, the highly competitive mutual fund industry offers a wide range of fund options, ranging from low fee index funds sold directly to investors to high fee actively managed funds sold through brokers. Every fund fully discloses its fees in its prospectus. Alliance Capital's investors knowingly and voluntarily agreed to pay those fees when they invested with it. They simply were not ripped off.

If mutual fund fees are to be regulated, it should be done through formal SEC action rather than ad hoc litigation settlements. As, Mike O'Sullivan's Corp Law Blog observed, SEC rulemaking is subject to a number of constraints: "The SEC cannot adopt rules without first notifying the public of its intended rule, accepting and evaluating comments, publishing a final rule and waiting a certain period of time following publication before it can enforce the new rule." In contrast, no such constraints limit Spitzer's use of his prosecutorial power. He is accountable to no one, except New York voters.

Even though the SEC admittedly seems to have been asleep at the switch, creating a regulatory vacuum Spitzer has been only too pleased to fill, the whole point of having federal securities regulation is to avoid balkanizing the capital markets by competing state regulations. Since Spitzer shows no sign of exercising self-restraint, the time has come for the federal government to preempt the Martin Act -- the principal New York statute upon which Spitzer relies -- insofar as it applies to the national securities markets.

I am an unabashed proponent of competitive federalism -- i.e., the idea that having corporate law regulated at the state level promotes competition between states seeking to attract corporations to incorporate in their state, which competition tends to lead to efficient legal rules. Can I square federal preemption of Spitzer's state law crusade with competitive federalism? You bet.

The basic idea behind competitive federalism is that both efficiency and liberty are promoted when jurisdictions compete for the opportunity to regulate you. According to the high priestess of competitive federalism (Roberta Romano) and its elder statesman (Ralph Winter), this condition is satisfied with respect to corporate law. Corporations pay franchise taxes to the state that incorporated them. The more corporations a state incorporates, the more the state earns in franchise taxes. (Delaware, which is the run away winner of state competition in corporate law, historically earned 15-20% of its annual revenues from corporate franchise taxes.) This competition leads to a race to the top in drafting corporate law rules. Rational investors will not pay as much for securities of firms incorporated in states that do not protect investor interests. As a result, those firms' cost of capital will rise, which gives corporate managers an incentive to incorporate in a state offering rules preferred by investors. Accordingly, competition for corporate charters leads states to adopt efficient corporate laws so as to attract incorporations.

What then are we to make of Elliot Spitzer's hyperactive enforcement regime? Must we conclude that Spitzer has raced to the top? No. Competitive federalism only works when the entity being regulated has an exit option. So long as firms may freely select among multiple competing regulators, the power of each regulator is limited by the right of exit. In such an environment, if a particular regulator gets eager, firms can exit that regulator's jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, such that exit by the regulated party is no longer an option, this check on excessive regulation is lost. The problem we face today is that Spitzer has not limited himself to businesses incorporated in New York. Instead, Spitzer has assumed jurisdiction over purported wrongdoers without regard to the state in which their firm was incorporated. If his sweeping assertion of regulatory jurisdiction goes unchallenged, Spitzer will have eliminated the exit option that makes competitive federalism work.

Accordingly, even a competitive federalist could (and should) prefer federal to state regulation in this context (bear in mind that arguments for competitive federalism should not be equated with "states rights"). As the Supreme Court plurality in MITE explained, a state has "no legitimate interest in protecting non-resident shareholders" [Edgar v. MITE Corp., 457 U.S. 624 (1982)]. For example, what do we do if Spitzer thinks a corporation's board harmed a Delaware corporation's shareholders, but the Delaware courts think otherwise? Who wins? Because Spitzer claims national jurisdiction, there is no exit option and, accordingly, no state competition. Entities cannot escape to a more laissez-faire jurisdiction. In the absence of state competition, federal regulation seems preferable. After all, did not the Founding Fathers adopt a Constitution in large part to avoid the economic Balkanization threatened by the Articles of Confederation?

When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. If one regulator overreaches, as noted above, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when a single regulator can reach all firms, such that exit by the regulated is no longer an option, the essential check on excessive regulation provided by competitive federalism is lost.

Of course, a hard core competitive federalist would prefer a regime in which firms could choose not only their corporate governance regime but also their securities regulation rules by incorporating in a specific jurisdiction. This is, for example, the argument made by Roberta Romano in her book The Advantage of Competitive Federalism for Securities Regulation. But that is, perhaps, a subject for another day. In the meanwhile, can't we at least get Spitzer to shut up?

The author is a professor of law at UCLA, where he currently teaches Business Associations, Unincorporated Business Associations, and Advanced Corporation Law. He is also a frequent TCS contributor. He last wrote for TCS about President Bush's immigration reform proposal.


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