Volume 10 / Number 1 / Spring 2006



Behavioral Analysis of Corporate Law: Instruction or Distraction?

Reflections on Scienter (and the Securities Fraud Case
Against Martha Stewart that Never Happened)

Donald C. Langevoort 

This paper considers what research in cognitive psychology and behavioral economics has to say about one of the basic “state of mind” constructs in the law of fraud: scienter. It takes a clinical approach, examining the securities fraud case that never happened against Martha Stewart. In granting a judgment of acquittal in Stewart’s favor on the securities fraud charge, the court seemingly misunderstood the law of scienter, which turns on awareness rather than purpose. But that simply provides an opportunity to think about what awareness means in the context of financial transactions. From publicly available sources, interesting inferences can be drawn about what Martha Stewart was thinking (and feeling) during the events at issue.

The Irrational Auditor and Irrational Liability

A.C. Pritchard 

This Article argues that less liability for auditors in certain areas might encourage more accurate and useful financial statements, or at least equally accurate statements at a lower cost. Audit quality is promoted by three incentives: reputation, regulation, and litigation. When we take reputation and regulation into account, exposing auditors to potentially massive liability may undermine the effectiveness of reputation and regulation, thereby diminishing integrity of audited financial statements. The relation of litigation to the other incentives that promote audit quality has become more important in light of the sea change that occurred in the regulation of the auditing profession with the adoption of the Sarbanes-Oxley Act. Given these fundamental changes in the regulatory backdrop, I argue that the marginal benefit of litigation has been substantially diminished and in many cases that it is likely to be ineffective in promoting greater audit quality. I propose a knowledge standard for auditor liability in securities fraud cases. 

Regulatory Responses to Investor Irrationality:
The Case of the Research Analyst

Jill E. Fisch

An extensive body of behavioral economics literature suggests that investors do not behave with perfect rationality. Instead, investors are subject to a variety of biases that may cause them to react inappropriately to information. The policy challenge posed by this observation is to identify the appropriate response to investor irrationality. In particular, should regulators attempt to protect investors from bad investment decisions that may be the result of irrational behavior?

This Article considers the appropriate regulatory response to investor irrationality within the concrete context of the research analyst. Many commentators have argued that analyst conflicts of interest led to biased reports and recommendations that distorted analyst behavior. In the wake of the analyst scandals, regulators have responded—most recently by mandating increased independence. This response can be understood as an effort to make investor reliance reasonable.

The Article questions this mission. In particular, the Article challenges the role of regulators in identifying appropriate sources of investment information or determining when investor behavior is rational. This fallibility of regulatory oversight coupled with the costs of regulation suggests that regulators should exercise caution, particularly in light of the market’s capacity to discipline investor decisions.

Behavioral Economics and the Regulation of Public Offerings

Stephen J. Choi 

The SEC adopted new rules in 2005 governing registered public offerings in the United States. Few, if any, of the rules make sense if we start from a presumption that investors are rational and are able to account properly for any information they receive during the public offering process. In this Article, I examine the new rules and assess the implicit behavioral assumptions about investors contained in the rules. I also provide an assessment of the behavioral biases that may affect regulators at the SEC. Regulator biases may lead the SEC to take an ad hoc evaluative process often ending with a reference to “investor confidence” in justifying new regulations. As a minimal solution, I propose that the SEC bear the burden of specifying its assumptions behind investor behavior explicitly together with how regulations will benefit investors suffering from such biases (as well as how other investors are affected by the regulations). Taking such an approach will lead to a more consistent approach in how the SEC deals with investor biases and reduce unnecessary regulation (as opposed to the SEC’s present ad hoc approach as typified in the public offering rules). To the extent other more public choice factors motivate regulation and references to “investor confidence” are merely a pretext, my proposal would help bring transparency to these other factors by focusing attention on whether the “investor confidence” rationale, in fact, is justified.

Fraud on a Noisy Market

Larry E. Ribstein 

Behavioral finance raises questions about market efficiency, suggesting that securities prices are influenced by “noise traders,” whose trades are motivated by behavioral biases. This creates a conundrum for the fraud on the market theory. While some fraud remedy is arguably necessary to ensure adequate disclosure, behavioral finance raises doubt about the efficiency of fraud remedies in noisy markets. These issues are particularly important in the wake of the Supreme Court’s opinion in Dura Pharmaceuticals, Inc. v. Broudo, which tightens proof of loss causation in fraud on the market cases and creates uncertainty about the future of the fraud on the market theory. This Article argues for interpreting Dura to sharply constrain the fraud on the market theory. It also proposes dealing with the need to deter fraud by allowing state courts and legislatures to supplement federal liability. More broadly, this Article suggests that, contrary to the assertions of many of its proponents, the indeterminacy of behavioral economics generally, and behavioral finance in particular, may support reducing rather than increasing legal paternalism.

Remarks on the Lewis & Clark Law School Business Law Forum: Behavioral Analysis of Corporate Law: Instruction or Distraction?

Henry Manne

Remarks on the Lewis & Clark Law School Business Law Forum: Behavioral Analysis of Corporate Law: Instruction or Distraction?

Thomas S. Ulen



Arguing for the Eclectic: Personality and the Legal Profession

Jeffrey H. Goldfien 

Entitled Arguing for the Eclectic: Personality and the Legal Profession, this book review describes and comments on Professor Susan Daicoff’s provocative book, Lawyer Know Thyself: A Psychological Analysis of Personality Strengths and Weaknesses. The subject of lawyer personality is of increasing interest to legal scholars and empiricists in other fields such as psychology, sociology, political science, and business administration. It has also gained the attention of legal educators and those concerned with the administration of legal institutions. Because lawyers perform key roles in the legal system as well as other social institutions, the impact of personality and other elements of lawyers’ psychology are highly relevant to legal education, dispute resolution, ethics and professionalism, legal advocacy, and jurisprudence, just to name a few. The Review closely examines Professor Daicoff’s argument, breaking it down for the reader and adding context so that both the argument and its implications can be readily understood.