Securities Law Archives – Southern California Law Review

Meme Corporate Governance

October 2024October 2024Dhruv Aggarwal,* Albert H. Choi† & Yoon-Ho Alex Lee‡

Can retail investors revolutionize corporate governance and make public companies more responsive to social concerns? Beginning in 2021, there was a dramatic influx of retail investors into the shareholder base of “meme” stock companies such as GameStop, AMC, and Bed Bath & Beyond. Observing the unprecedented, coordinated trading among retail investors, scholars and practitioners predicted that the influx of retail investors would reduce the power of large institutional investors and democratize corporate governance. These predictions were driven by three factors: generational, with assumptions that millennial and Gen Z investors would challenge corporate management; societal, reflecting growing discontent with slow progress on issues such as sustainability and boardroom diversity; and technological, with the advent of easily accessible and user-friendly mobile apps allowing investors to directly intervene in corporate governance. While plausible, these predictions have so far not been tested. This Article empirically analyzes the impact of retail investors on corporate governance, particularly at meme stock companies. We provide new quantitative evidence regarding the origins of meme investing and conclude that—despite their coordinated trading behavior in the market—meme investors have not democratized corporate governance or advanced social issues. The Article presents three principal findings. First, we show how the “meme stock” frenzy was affected by the abolition of trading commissions by major brokerages in 2019. Meme stock companies experienced positive abnormal stock returns when commission-free trading was widely introduced and saw elevated trading volumes afterward. Second, we find that despite the promise of a more active retail shareholder base, meme stock companies experienced a significant decrease in shareholder voting. Shareholder proposals have also been very limited, with most meme stock companies seeing no proposals after the rapid rise in retail ownership. Third, we do not find any improvement in meme stock companies’ corporate governance, financial performance, and social responsibility, as represented by director independence, board gender diversity, ESG scores, and capital and R&D expenditures. Collectively, our findings suggest that the influx of retail shareholders has not translated into more “democratic” governance regimes or encouraged shareholder participation in corporate governance at companies most affected by the meme investor storm.

INTRODUCTION

Buoyed by pandemic checks and the advent of commission-free mobile apps such as Robinhood, retail investors took Wall Street by storm in early 2021.¹ Coordinating through social media sites such as Reddit and using catchy “memes,”² retail investors engaged in an active “buy” campaign to dramatically push up the GameStop stock price from $4 a share to a stratospheric level of over $485 per share. GameStop, a gaming merchandise retailer, had been losing money and seemed headed toward bankruptcy.³ A number of hedge funds had taken large short positions against the stock, betting that the price would drop even further.⁴ Meme investors seem to have been motivated to “punish” the hedge funds by driving up the stock price and creating a “short squeeze” against them.⁵ The end result was a severe loss and a subsequent retreat for the hedge funds.⁶ Taking advantage of the elevated stock price, GameStop raised large amounts of capital through stock sales,⁷ alleviating its dire liquidity condition. Retail shareholders, who have long played second-fiddle to institutional asset managers and pension funds, thus seemed to have vanquished Wall Street hedge funds and resurrected an ailing company destined for bankruptcy.

Over the ensuing months, it became clear that the GameStop saga was but one instance of more widespread meme stock surges. A number of other companies (hereinafter “meme stock companies” or “meme companies”) would experience surges in their stock prices, which, like GameStop, could not be explained by their financial fundamentals. Investing has become a social phenomenon. Furthermore, meme investing has remained a persistent phenomenon: long after the GameStop saga, meme investors continue to target regional bank stocks,⁸ special purpose acquisition companies (“SPACs”),⁹ and even firms that have filed for bankruptcy.¹⁰ What this persistence implies is that GameStop’s meme surge was not a one-time event: meme investing and meme surges are here to stay. Furthermore, the meme surges tell us a broader and more generalizable story about the behavior of retail investors and the impact of the change in shareholder base. The potentially transformative effect of retail investors—driven by demographic, societal, and technological factors—has emerged as one of the central debates in corporate finance and corporate governance.

These experiences have motivated scholars, practitioners, and policymakers to ask several important questions. What impact did the influx of retail shareholders have on meme stock companies? More specifically, how did the new retail shareholders affect their governance and performance? Do the meme surges signify broader and more general implications for corporate and financial law and policy?

This Article’s key contribution is to focus on meme stock companies—the firms where retail investors are most likely to have become more powerful—and empirically test how corporate governance and performance has been affected by the dramatic influx of retail investors in their shareholder base. We start by analyzing the background of meme trading. The existing scholarship has almost exclusively associated meme stocks with the surge in social media interest (such as Reddit forums) in these companies starting in 2021.¹¹ While social media surely played an important role in popularizing these stocks, we trace the origins of meme trading further back, to the pre-pandemic era. Using an event study methodology, we find that meme stocks exhibited abnormal returns (and an abnormal increase in trading volume) in October 2019, when major brokerages abolished commissions for trading.¹² This suggests that meme stock companies were well positioned to benefit from the subsequent surge in retail investor interest: zero-commission trading laid the groundwork for the subsequent surge. The emergence and the significance of zero-commission trading for the meme stock phenomenon implies more fundamental changes that can happen at other public companies and across the financial markets.

After documenting the impact of zero-commission trading on meme stocks, we proceed to examine the consequences of meme trading for corporate governance and performance at meme stock companies. Specifically, we ask: Did the influx of retail investors create a more engaged shareholder base at meme stock companies and change corporate governance or environmental, social, and governance (“ESG”) activity at these companies? To answer these questions, we begin with corporate law’s paradigmatic framework for shareholder influence in public corporations: voting and shareholder proposals.¹³ Somewhat surprisingly, we find that non-voting—that is, the share of votes that were not cast for or against, or marked as abstentions—significantly increased in the year of the meme surge for meme stock companies, as compared with other, non-meme stock companies.¹⁴ Even more surprisingly, we find that the fraction of non-votes began to increase in 2019 and continued to increase in 2022, long before and after the meme surge of 2021. By late 2021 and early 2022 the retail investors who remain loyal to the company would presumably care more about the company’s (long-term) performance and governance.¹⁵ The fact that the level of shareholder engagement seems to be getting worse in 2019 and 2022 indicates that the increase in non-vote shares is not driven just by short-term speculators.

Turning to shareholder proposals, we find no evidence that shareholders at meme stock companies are more likely to participate in governance activities by submitting shareholder proposals, either before or after the meme surge.¹⁶ Between 2015 and 2022, only one meme stock company—Bed Bath & Beyond—had any shareholder proposals included in the company’s definitive proxy statements at all (three proposals, all in 2016), but these proposals predate the introduction of zero-commission trading and the influx of retail investors. Within the sample companies, there was also no record of any shareholder proposal being excluded via the Securities and Exchange Commission’s (“SEC”) no-action letter process during the sample period—apart from GameStop, which successfully excluded three shareholder proposals submitted in 2022. The evidence is consistent with retail investors brought in by the meme phenomenon being either uninterested in voting or making proposals, or unable to do so effectively.

Third, we examine whether retail investors might have had an indirect effect on meme stock companies. One of the most visible ways contemporary insurgent shareholders can affect company policy is to alter its orientation toward ESG goals. For example, in 2021, a small hedge fund (named Engine No. 1) waged a stunningly successful campaign to install three of its directors on the Exxon Mobil board to pressure the energy company to reduce its carbon footprint.¹⁷ Utilizing the data from the standard MSCI ESG Indexes, we find that meme stock companies actually deteriorated in terms of prosocial performance after the meme surge of 2021.¹⁸ We also look at whether meme stock companies performed better in terms of director independence or board gender diversity—other salient issues in corporate governance—and find no evidence that meme stock companies performed better (or worse) on these metrics after the surge of retail investor interest.¹⁹ Thus, meme retail investors do not seem to have made their companies’ policies more prosocial or improved the quality of corporate governance. If anything, the ESG result suggests that these firms’ orientation toward social causes may have worsened in recent years.

As a final measure of indirect impact, we look at how the affected companies changed their operations and performance after both the abolition of commissions in 2019 and the meme surge of early 2021. Meme stock companies’ average return on assets (“ROA”), an important metric for profitability, has substantially worsened over the period compared with non-meme stock companies. If meme investors were engaged and pushing management to make value-increasing investments, one might have expected a rise in expenditures on research and development (“R&D”) or capital investments. These expenses could potentially help meme stock companies adjust their business model and business operations so that they can improve their long-term profitability. We instead find that meme stock companies significantly reduced R&D expenses after the influx of retail investors.²⁰ This result suggests that retail shareholders may not be effective in (directly or indirectly) pressuring management to make productive investments. This contrasts with the findings that an increase in institutional investor ownership is correlated with more innovative activities at firms.²¹

Viewing these results collectively, we find that there is, so far, little evidence to suggest that corporate governance is being “democratized” in the way that the investing public has been. The organized movement among retail investors seems to be limited to their trading behavior and has not otherwise affected retail shareholders’ engagement with corporations in a noticeable way.²² If anything, the evidence points in the opposite direction. As a large block of retail investors remain passive, paradoxically, this can give institutional shareholders, who are active shareholders,²³ even more influence. We do not take issue with the three trends identified as potentially presaging a larger role for retail investors: generational shifts in investor attitudes, societal concerns over social and environmental issues, and technological changes making it easier for retail investors to participate in financial markets. Nevertheless, our empirical findings show that corporate governance has not significantly been democratized or changed yet, even at the companies most dramatically affected by the influx of retail shareholders.²⁴

The remainder of this Article is organized as follows: Part I surveys the demographic, societal, and technological changes that have led some commentators and scholars to express high hopes for the impact of meme and other retail investors on corporate governance. Part II explains our data sources and presents summary statistics. Part III examines the origins of meme trading and explains the importance of the 2019 abolition of commissions by online brokerages. Part IV shows that, despite the surge of retail investor interest in meme stock companies, shareholder nonvoting at meme stock companies increased in recent years, and retail investors failed to make much of an impact using the shareholder proposal process. Part V looks at potential indirect effects of shareholder engagements, such as firm ESG performance, board independence, gender diversity, R&D, and capital expenditures. We find that these companies have not become more prosocial recently, and meme firms’ ESG scores have decreased. We also find that these companies decreased both R&D as well as capital expenditures. In Part VI, we explore potential reasons as to why corporate governance has not been democratized notwithstanding the prevailing scholarly predictions. In doing so, we highlight important differences between the activities involved in meme investing versus those involved in meme shareholding. We then conclude and offer some possible directions for a future meme stock research agenda.

I. RETAIL INVESTORS, RETAIL SHAREHOLDERS, AND MEME TRADERS

When GameStop was experiencing a dramatic meme surge in January 2021, it was easy to dismiss the phenomenon as a transient anomaly that could be explained away by pandemic boredom and stimulus checks.²⁵ However, the pandemic has long ended and meme surges continue, albeit sporadically. Experts now believe meme trading is here to stay.²⁶ If meme trading has become a fact of life, it begs the question of what we should expect from retail investors participating in meme trading or trading more generally. Given that (coordinated) retail investing is here to stay, what impact will the shifting of the shareholder and investor base away from institutional shareholders and toward retail shareholders have on financial markets and corporations?

There are three principal drivers scholars and commentators have proposed as to how retail investors have become poised to transform financial markets and corporate governance. The first relates to perceived generational shifts in investor preferences. In this story, millennials and Gen Z entering the market as retail investors will seek to create a footprint, based on their social, cultural, and distributional preferences, on corporate policies.²⁷ Some analyses of these market participants have concluded that this generation cares deeply about issues beyond profit maximization, and are willing to forsake returns to pursue these interests through the corporation. For instance, Professors Michal Barzuza, Quinn Curtis, and David Webber argue that in order to attract investment from millennials, index funds should push more for various governance and social changes at companies—such as board diversity—which are issues that millennials care about.²⁸ Similarly, Professors Sergio Alberto Gramitto Ricci and Christina Sautter observe that millennials have a generationally defined and distinct set of values, and are more likely to prioritize ESG goals over profit.²⁹ In their telling, meme investors will seamlessly transform into engaged shareholders and usher in a new paradigm for corporate governance.³⁰

Secondly, meme investors could be highly motivated to affect corporate policies because of the societal time period in which the meme surge occurred. Some have argued that decades of profit-centric corporate governance have led to workers, residents of surrounding communities, and the environment all suffering from profit-centric corporate policies.³¹ The shareholders best positioned to change corporate policies—large asset managers such as BlackRock and Vanguard, who own more than a fifth of the average S&P 500 firm³²—are constrained in their ability to pressure management to change policies because any such change would hurt the interests of at least some of the hundreds of investment funds they operate.³³ In this vein, Professor Jill Fisch has argued that retail investors are a useful antidote to the concentration of market power in large institutional investors, and can help enlist ordinary citizens in the larger project of national economic development.³⁴ Free from the structural constraints faced by institutional investors, who owe a fiduciary duty to their clients and are likely to be obligated to pursue profit maximization,³⁵ retail shareholders are theoretically able to demand that firms adopt prosocial policies even at the expense of profit. Citizen involvement via retail investing could also have the advantage of tempering corporate power, with retail investors able to sway management through their ability to influence close votes.³⁶ An example of this from the meme surge came from meme investors who wanted to keep AMC theaters open despite the COVID-19 pandemic severely disrupting the firm’s business model.³⁷ By putting their money into the company (through additional capital raising) and keeping the movie theaters running, meme investors arguably offered a lifeline to the thousands of workers employed by the chain.

Finally, there is a technological element to the promise of meme and other retail investing. Since the mid-2010s, Robinhood has offered a game-like and easily accessible mobile app allowing retail investors to participate in the market. Financial economics literature has shown that retail investors overreact to market signals and allow overconfidence to distort portfolio allocation, reducing their financial returns.³⁸ Given this research, it is unsurprising that many retail investors decided to engage in stock-picking after gaining uninterrupted access to a flashy mobile investing app. Beyond investing apps, the GameStop saga and the meme stock frenzy of 2021 demonstrated the power of social media technology to coalesce dispersed individuals who can unite to bring about an impact and put checks on the forces of institutional players. Today, social media platforms such as Facebook, Reddit, and X (formerly known as Twitter), provide a space where individuals form communities, share information, and engage in collective action. These platforms have also made it easier for people to spread information quickly, allowing them to mobilize and respond to events in real time. From these perspectives, the meme surges of early 2021 could be seen as foreshadowing a future in which technology can further enable and empower dispersed individuals to overcome the cost of collective action and promote a collectively cobbled together agenda.

Collectively, the demographic, societal, and technological trends could be seen as ushering in an amplified role for retail investors. Consistent with this intuition, a study by Professors Alon Brav, Matthew Cain, and Jonathon Zytnick empirically assesses the collective voting heft of retail investors using a large proprietary sample of shareholder ownership and voting records.³⁹ They conclude that retail investor voting can have as much of an impact on corporate outcomes as the voting preferences of the three largest institutional investors.⁴⁰ This suggests that, to the extent meme stock surges can motivate greater retail shareholder participation, there is a realistic possibility of significant changes in corporate governance. For these reasons, more than three years after the GameStop saga, this Article seeks to empirically examine what changes, if any, have taken place in the governance of the companies subject to meme surges.

II. DATA AND SUMMARY STATISTICS

We use a variety of sources to collect information about both meme and non-meme stocks. Our first step is to identify which companies qualify as meme stock companies in the relevant period. We use Factiva⁴¹ searches and Internet queries with appropriate keywords (“meme,” “retail investors,” and “Reddit” in conjunction with “stock” and so on), modeling our approach on the nascent financial economics literature studying the meme trading phenomenon.⁴² We identify the following eight companies as meme stock companies: GameStop,⁴³ AMC Entertainment, Inc.,⁴⁴ Bed Bath & Beyond,⁴⁵ Blackberry,⁴⁶ Express, Inc.,⁴⁷ Koss,⁴⁸ Robinhood,⁴⁹ and Vinco.⁵⁰ For meme and non-meme stocks (i.e., other public companies), we collect an array of financial and non-financial information for the time period of 2015 to 2022. First, stock price information comes from the Center for Research in Stock Prices (“CRSP”). Firm financial data (size as proxied by assets in millions of dollars, performance (return on assets), debt ratio, cash ratio, closing stock price at the end of the fiscal year, and market value in millions), R&D, and capital expenditures are collected from Compustat. Finally, we get data on shareholder voting from Institutional Shareholder Services (“ISS”) (formerly known as Riskmetrics).

Table 1 presents the summary statistics for our dataset. Vote figures are organized at the shareholder proposal level and are matched to the firm-year level observations for financials from Compustat.⁵¹ Panel A displays the overall descriptive statistics (in millions for financial measures), while Panel B compares the relevant statistics between meme and non-meme companies, along with t-test results. The first statistic in Panel B, Percent Non-Votes, measures the extent of shareholder non-participation in direct governance. Following the accounting literature, we define shareholder non-participation as the percentage of outstanding shares that were not voted “for,” “against,” or “abstention” with respect to proposals at a meeting. Between 2015 and 2022, the average yearly non-participation rate for meme stocks was 28.75%. This is higher than the 25.04% average for non-meme firms and the difference is significant at the 1% level.

The next four statistics in Panel B, Return on Assets, Cash Ratio, Debt Ratio, and the natural logarithm of assets, present a picture of their respective financial status and performance. When we compare the respective returns on assets, we see that the mean return on assets for meme stocks over the entire period is –0.098, which is statistically significantly (at the 1% level) lower than –0.05 for the non-meme companies. In addition, while Cash Ratio and Ln(Assets) are not statistically significantly different, the meme companies have a statistically significantly higher debt ratio (at 32%) compared with non-meme companies (at 28%).

Table 1. Summary Statistics
Panel A
	N	Mean	SD
Percent Votes for Proposal	289422	70.53	19.16
Percent Votes Against Proposal	289422	4.34	8.6
Percent Non-Votes	289422	24.84	17.26
Ln(Assets)	282189	7.8	2.31
Cash Ratio	276587	0.12	0.18
Debt Ratio	224586	0.28	0.24
Return on Assets	282061	–0.04	0.25
R&D Expense	180296	294.56	2123.57
Capital Expenditures	228832	449.6	2117.09
Closing Price	288369	56.14	141.04
Market Value	259924	15314.18	74007.27

Panel B
	Non-Meme Firms (1)	Meme Firms (2)	t-statistic (1)–(2)
Percent Non-Votes	25.04	28.75	–3.94***
Return on Assets	–0.05	–0.098	3.17***
Cash Ratio	0.14	0.13	1.3
Debt Ratio	0.28	0.32	–3.05***
Ln(Assets)	7.56	7.37	1.54
Closing Price	56.18	28.54	3.72***
Market Value	15331.22	3023.8	3.15**
Note: Panel A presents information on the shareholder voting results and financial variables for the meme stocks identified in Part II, for the period of 2015–22. All financial variables are winsorized at the 1% level. Panel B presents t-tests for some of these variables between meme and non-meme stocks. The *, , and * denote significance at the 1%, 5%, and 10% levels.

Finally, the last two statistics in Panel B, Closing Price and Market Value (in millions), show some of the characteristics of the respective stock. Perhaps not surprisingly, meme companies, on average, had lower stock prices and lower market capitalization than non-meme companies: the average stock price of meme companies is about half of non-meme companies and the average market capitalization of meme companies (a little over $3 billion), one-fifth of that of non-meme companies. In sum, the descriptive statistics indicate that meme companies are on average less profitable (or unprofitable), more heavily leveraged, and have lower stock prices and market capitalizations, consistent with media reports.⁵²

III. THE TWIN SHOCKS TO MEME STOCKS

In the popular imagination, social media usage during the coronavirus pandemic has been singled out as the main driver of the emergence of meme stocks. The New York Times has characterized meme stock investments as being “propelled by a social media frenzy and a bit of boredom” during the pandemic.⁵³ The Wikipedia entry for “meme stock” defines it as “a stock that gains popularity among retail investors through social media.”⁵⁴ However, for our set of meme stocks, we identify an association with retail investors that (1) predates the pandemic and (2) does not relate to social media platforms, such as Reddit or X (formerly known as Twitter). More specifically, we look at the meme stocks’ response to the abolition of commissions by major brokerage platforms in late 2019.

On October 1, 2019, the major online brokerages Charles Schwab and TD Ameritrade eliminated commissions for all their customers. These platforms, which had dominated the online brokerage business, were responding to stiff competition from a new rival, Robinhood, which had heavily utilized the zero-commission trading model.⁵⁵ The advent of zero-commission trading has been widely acknowledged as a root cause of the explosion in retail investing activity. One of the leading explanations for why individuals do not participate in the stock market is that there is a fixed cost of investing that proves potentially insurmountable for the less wealthy.⁵⁶ It is unsurprising that, by reducing the entry cost of trading (i.e., commissions), the 2019 decision by major brokerages increased retail investor activity.⁵⁷

How did the abolition of trading commissions affect meme stocks? The relatively unexpected and sudden decision of the major brokerage platforms to introduce commission-free trading allows us to use the event study methodology to assess its impact. Given that this was prior to the meme stock surge of 2021, to the extent that the market was informationally “efficient,” the stock prices around October 1, 2019, would reasonably reflect the impact of the abolition of commissions on meme stocks.⁵⁸ First, we identify what the expected return for each stock would have been during the event period if the event had not occurred (that is, if the commissions had not been dropped). Using the standard Fama-French three-factor model,⁵⁹ this may be written as:

Here, Rit is the return on stock i on date t minus the risk free rate; Rmt is the market return on date t minus the risk free rate; RSMB is the return on a portfolio of small companies; and RHML is the book to market factor that is the portfolio of firms with a high book value to market value ratio. The abnormal return that can be traced to the event (that is, the associated stock price movement) is the actual return minus the expected return:

We calculate the abnormal returns on October 1, 2019, for all companies in the Compustat database, and regress them against an indicator for whether the company is one of our eight meme stocks. Table 2 presents the results from the event study. Column (1) shows that meme stocks had abnormal returns that were 2.25 percentage points higher than the market, and the coefficient on the indicator variable is highly statistically significant.⁶⁰ Column (2) reruns the regression in model (1) adding controls for firm financials (size as proxied by the natural logarithm of assets, cash ratio, debt ratio, and return on assets) and the results remain largely unchanged. One concern with our results could be that meme stocks are categorically different from non-meme companies. As a final robustness check, we control for the possibility that the financials of meme and non-meme companies may be different. Using the entropy-balancing technique invented in the social science literature,⁶¹ we balance the means of the covariates for meme and non-meme companies. As shown in column (3), our result for meme stocks remains robust to the entropy-balancing method.

Table 2. Event Study Results
	(1)	(2)	(3)
	Baseline	With Financials	Entropy Balanced
Meme Stock	2.252***	2.238***	2.230***
	(0.645)	(0.655)	(0.614)
Constant	–0.127***	–0.269	0.300
	(0.0269)	(0.246)	(0.768)
Observations	7,110	3,531	3,531
R-squared	0.001	0.010	0.208
Firm Financials	No	Yes	Yes
Note: This table presents results from an event study using the Fama-French three-factor model. The dependent variable in this linear regression model is the abnormal stock return on October 1, 2019. Columns (1) and (2) use ordinary least squares regression and column (3) balances covariates for meme and non-meme companies using the entropy-balancing technique. Columns (2) and (3) add controls for firm size (proxied by the natural logarithm of assets), cash ratio, debt ratio, and return on assets. All financial variables are winsorized at the 1% level. The *, , and * denote significance at the 1%, 5%, and 10% levels.

Figure 1 graphs the mean cumulative abnormal returns of meme stocks. The mean abnormal returns are represented by the solid line in the middle, while the dotted lines enclose the 95% confidence interval. Day “0” in this figure refers to October 1, 2019. The figure shows an economically and statistically significant gain for meme stocks around the time the major brokerages dropped trading commissions. In unreported results, we find that meme stocks had significant abnormal returns on October 1, 2019, when we use alternative asset pricing models such as the capital asset pricing model (“CAPM”) or Carhart four-factor model.⁶²

Figure 1. Cumulative Abnormal Returns for Meme Stocks

Note: This figure graphs the mean cumulative abnormal returns for meme stocks around October 1, 2019, when major brokerages abolished trading commissions (denoted as day 0). The dotted lines represent the 95% confidence interval for cumulative abnormal returns.

In addition to the abnormal returns, we also examine the magnitude of share turnover. Figure 2 presents data on the share turnover for meme stocks and other companies between 2015 and 2022. We define turnover as the daily average of the number of stocks of the firm traded as a percentage of total outstanding common stock, using data from CRSP. Since meme stocks are, on average, smaller firms, we subdivide non-meme companies into those belonging to the smallest quartile in terms of market capitalization and other bigger firms. Meme stocks saw both an increase in trading volume after the abolition of commissions on October 1, 2019, and a further increase in 2021–22 after the explosion of social media interest in these firms. There was a significant increase compared to both smallest-quartile and larger non-meme firms. Three points are notable. First, meme stocks had a higher turnover compared with non-meme stocks even in the first period, that is, before the abolition of commissions. Second, both meme and non-meme stocks saw an increase in trading volumes after the abolition of commissions, although the increase was markedly greater for meme companies. Third, during the time of meme surge, while the meme stock trading volume exploded, there seems to be no noticeable increase in trading volume for non-meme stocks.

Figure 2. Average Turnover for Meme Stocks and Other Firms

Note: This figure graphs the mean share turnover (shares traded each day as a percentage of total outstanding common stock) according to CRSP data. The data is presented separately for meme and non-meme stocks. Non-meme stocks are further subdivided into those that belong to the smallest quartile by market capitalization and larger firms. “Pre-Zero Commission” refers to the period from 2015 to September 2019, “Post-Zero Commission” to October 1, 2019, to December 31, 2020, and “Post-Meme Surge” to 2021–22.

We estimate a regression model in which we analyze the factors affecting the average daily turnover for CRSP companies in all three periods. We include as explanatory variables an indicator for meme stock, two dummies for Post-Zero Commission and Post-Meme Surge, and the interaction of the meme indicator with each time dummy. We include firm fixed effects to make sure the results are not driven by idiosyncratic factors unique to any given company. Both interaction terms are positive and statistically significant. The results are presented in Table 3. Note that, even controlling for firm fixed effects and time trends, meme companies seem to have especially gained with respect to this measure of liquidity in the latter time periods. The results remain qualitatively unchanged when we additionally control for firm market value. The event study results presented in this Section show that meme stock companies gained value around the time major brokerages abolished commissions. The influx of retail investors precipitated by zero commissions could therefore have been particularly impactful for the meme stocks. Moreover, the results on turnover indicate that meme firms saw greater trading volumes after the major brokerages eliminated commissions.

Table 3. Meme Stocks and Trading Volume
Post-Zero Commission	0.664***
	(0.0714)
Post-Zero Commission x Meme	3.252*
	(1.874)
Post-Meme Surge	0.517***
	(0.0822)
Post-Meme Surge x Meme	12.23***
	(3.634)
Constant	1.080***
	(0.0402)

Observations	20,764
R-squared	0.875
Firm Fixed Effects	Yes
Note: This table presents the results of a linear regression model in which the dependent variable is the daily percentage of outstanding shares that are traded. “Post-Zero Commission” refers to the time period of October 1, 2019, through December 31, 2020, and “Post-Meme Surge” to 2021–22. The regression model includes firm fixed effects, and all standard errors are clustered at the firm level. The *, , and * denote significance at the 1%, 5%, and 10% levels.

IV. DIRECT SHAREHOLDER ENGAGEMENT AT MEME STOCK COMPANIES

In this Part, we explore the effect of meme stock investing on the direct mechanisms for shareholder engagement: voting and submitting shareholder proposals. This can help us empirically assess claims that the influx of retail investors would affect corporate governance and possibly empower shareholders to engage with management more actively. To briefly summarize the findings, our empirical results show that predictions of retail investor-driven changes in corporate governance may be overstated. First, the level of shareholder voting at meme companies decreased after the abolition of commissions by online brokerages and decreased still further in the aftermath of 2021 meme surge. Second, we find no evidence of active shareholder engagement by way of submitting shareholder proposals at the companies in our sample, except in limited circumstances unrelated to corporate governance.

A. Non-Voting at Meme Stock Companies

An important claim in the literature is that the retail shareholders brought in after the meme phenomenon may be more likely to be assertive and more vigorously engage with management.⁶³ This is a plausible claim: if retail investors could coordinate their trades to attack institutional investors—a feat previously unimaginable—so, too, can they coordinate votes to have their voices heard. Accordingly, one could expect more retail shareholders to vote on governance proposals, including director elections and other consequential decisions (such as mergers and acquisitions and charter amendments), at these firms after 2021. Ideally, if we can observe each shareholder’s characteristics (for example, institutional versus retail), how many shares are owned by each shareholder, and how many of those shares are voted on, we will be able to tell exactly what the rate of participation among retail shareholders is. Nevertheless, due largely to the limitations on data, we do not have access to any information on whether certain votes came from a retail versus an institutional shareholder.⁶⁴

Instead, we rely on an indirect measure in estimating shareholder participation that is commonly used in the accounting literature. One way of such an indirect estimation is by measuring aggregate non-votes at shareholder meetings. The accounting scholarship attributes non-votes in shareholder meetings (that is, votes that were not cast for or against a proposal and were not abstentions) to retail investors.⁶⁵ Corporate insiders and institutional investors, on the other hand, are much more diligent in registering their votes. Under this standard assumption, if retail investors became more engaged after 2021, we could expect the overall share of non-votes to fall.⁶⁶

In analyzing the rate of non-votes, it is also important to account for the type of proposal. Shareholder proposals at U.S. public companies are generally of two types: routine and non-routine. Routine proposals are those that pertain to the company’s day-to-day operations but are not expected to significantly affect the company’s overall operation and performance. Examples of this type are proposals for the ratification of auditors or approving stock splits. By contrast, non-routine proposals typically relate to the company’s long-term strategy or are expected to have a significant impact on the company’s financial performance. Examples include the issuance of new stock, election of directors, a merger with another company, divesting a business unit, or any other proposal stockholders could have concerns with and would affect their ownership. For our purposes, there is an important distinction between these two types: brokers can vote shares on behalf of the beneficial owners for routine matters, but not for non-routine matters. Therefore, only shareholders can vote their own shares for non-routine proposals.⁶⁷

Figure 3 graphically presents the yearly average of non-vote rates on proposals at both meme and non-meme companies between 2015 and 2022. We hand-coded each proposal listed in the Institutional Shareholder Services (“ISS”) data as either “routine” or “non-routine” based on Rule 452 of the New York Stock Exchange (“NYSE”).⁶⁸ As expected, we find that non-routine proposals (in which brokers cannot vote on behalf of shareholders) have consistently higher levels of non-participation for both meme and non-meme firms.

More importantly, we find an increase in shareholder non-voting rate after 2018, concentrated in meme companies (for both routine and non-routine proposals). In fact, before 2019, meme companies had lower non-vote rates compared with non-meme companies, but by 2022, non-vote rates are at above 50% and 30% on non-routine and routine matters, respectively, at meme companies. At the same time, at non-meme companies, as Figure 3 shows, there seems to have been only marginal changes in non-vote shares over the same period. This is the opposite trend from what one would expect if the retail shareholders were more engaged with respect to corporate governance at meme firms, such as AMC and GameStop. Instead of seeing a burst of shareholder engagement, meme companies have seen increasing retail shareholder apathy in recent years.

Figure 3. Average Share of Non-Votes for Meme and Non-Meme Stocks over Time, by Proposal Type

Note: This figure presents information on the yearly average percentage of votes that were not voted in shareholder meetings. We define the number of non-votes as Total Outstanding Shares minus (Votes For + Votes Against + Abstentions). We split the data by meme/non-meme stock as well as proposal type (that is, whether it qualifies as “routine” as defined in NYSE Rule 452).

If we were to expect that retail shareholders are less likely to participate in direct governance, this finding, on the one hand, may not be too surprising. Recall, however, that many of these retail investors were the drivers of coordinated meme surges in early 2021, collectively taking a stance against institutional investors. There is also reason to believe that many of them have remained loyal to the firm.⁶⁹ If the fraction of retail investors at meme stock companies remains relatively high through 2021 and 2022, and many of them care more about the companies’ survival and performance, one would expect them to be more active in firm governance. From this perspective, the fact that the share of no-votes keeps increasing through 2021 and 2022, long after the initial “meme surge” was over, is surprising.

Table 4 presents a more formal regression analysis (using linear regression models), in which the dependent variable is the percentage of non-votes at a shareholder proposal level. We collected this data for all companies from the ISS database (from 2015 through 2022) to make sure we captured any secular time trends in shareholder voting across the market. Column (1) presents the baseline model, while column (2) adds financial variables as controls. We included firm fixed effects to account for any idiosyncratic factors unique to each company. Note, foremost, that the coefficient estimates (except for the estimate on the variable “Meme x 2019–20”), along with their statistical significance, are fairly consistent across the two models, indicating that the specifications are fairly robust. In terms of the results, at the top of the table, the dummy for non-routine proposals is positive (with the point estimates of 14.04 and 13.98, respectively) and highly statistically significant (at the 1% level), indicating that these types of matters generally have greater non-participation than routine proposals (per stock exchange regulations): non-vote shares on non-routine matters are about 14 percentage points higher compared with those on routine matters.

The coefficient estimates on 2019–20 and 2021–22 indicator variables are also positive and statistically significant, indicating that there is a general trend toward non-votes across all companies. When we interact both time period dummies with the Meme indicator, the coefficient for these terms is positive and highly statistically significant, at least in the baseline model, indicating that there seems to be more non-voting at meme companies after both the abolition of commissions and the surge in social media interest in these companies.⁷⁰ The rise in non-voting for meme stocks seems concentrated in non-routine proposals, as one would expect since brokers cannot vote on behalf of the shareholders on these issues. Most tellingly, the triple interaction of Meme, each time period dummy, and Non-Routine is also positive (with coefficient estimates ranging from about 7.5 to 8.1) and highly statistically significant (at the 1% level) in both the baseline model and with financial controls.

Table 4. Meme Stocks and Non-Voting
	(1)	(2)
	Baseline	With Financials
Non-Routine	14.04***	13.98***
	(0.198)	(0.223)
Meme x Non-Routine	–5.607***	–5.585***
	(1.495)	(1.534)
2019–20	0.681***	0.830***
	(0.140)	(0.170)
Meme x 2019–20	5.204***	2.650
	(1.780)	(1.760)
Non-Routine x 2019–20	–0.630***	–0.688***
	(0.149)	(0.162)
Meme x Non-Routine x 2019–20	7.910***	8.125***
	(1.406)	(1.425)
2021–22	3.899***	4.622***
	(0.195)	(0.232)
Meme x 2021–22	13.91***	11.59**
	(4.841)	(4.672)
Non-Routine x 2021–22	–3.297***	–3.531***
	(0.178)	(0.195)
Meme x Non-Routine x 2021–22	7.503***	7.901***
	(1.725)	(1.942)
Constant	12.29***	23.68***
	(0.179)	(2.087)

Observations	238,506	194,929
R-squared	0.699	0.735
Firm Fixed Effects	Yes	Yes
Firm Financials	No	Yes
Note: This table presents the results of a linear regression model in which the dependent variable is the percentage of shares that were not voted for a proposal at shareholder meetings. We define the number of non-votes as Total Outstanding Shares – (Votes For + Votes Against + Abstentions). 2019–20 equals 1 for years 2019 and 2020, while 2021–22 equals 1 for 2021 and 2022. We split the data by proposal type (that is, whether or not it qualifies as “routine” as defined in NYSE Rule 452). Column (2) adds controls for firm assets, cash ratio, debt ratio, and return on assets. Columns (1) and (2) include year and firm fixed effects, and all standard errors are clustered at the firm level. The *, , and * denote significance at the 1%, 5%, and 10% levels.

The estimates tell us that, compared with routine matters at meme companies at these two time periods, the share of non-votes on non-routine matters are about 7.5 to 8 percentage points higher. The results indicate that, for 2019–22, meme companies saw a greater rise in non-voting among shareholders as compared with non-meme companies, and this effect was especially pronounced for non-routine proposals for which brokers could not vote on behalf of shareholders.

B. Shareholder Proposals at Meme Stock Companies

As another measure of shareholder engagement, we looked at the number (and the content) of shareholder proposals that were submitted by retail shareholders at meme stock companies. For example, it is possible that even if the level of retail shareholder voting at meme companies has remained low (or decreased), the meme surge may have emboldened a minority of retail shareholders to take more active steps in submitting shareholder proposals to affect corporate governance and corporate policies. While there are other channels of influencing corporate governance—such as running a proxy contest or nominating a director candidate through proxy access (if the company allows it)—these other channels require significant economic resources (in the case of proxy contests) or more substantial ownership thresholds and holding periods (in the case of accessing proxy ballots directly). As such, these are less salient means for meme traders. For this reason, the more promising route for meme traders is likely through submission of a shareholder proposal.

First, we discuss some institutional background and a potential complication for our empirical analysis. The eligibility requirement for a shareholder to submit a shareholder proposal is governed by Rule 14a-8,⁷¹ which imposes an ownership threshold and a holding period requirement. Once a proposal is submitted by an eligible shareholder, the SEC rule requires the company to add the proposal to the agenda for voting at the next annual shareholders’ meeting, unless the SEC provides special permission to exclude it from consideration.⁷² Since 1998, Rule 14a-8 has maintained a relatively low share ownership threshold: it required only that a shareholder had held at least $2,000 or 1% of a company’s securities for at least one year.⁷³ The SEC, however, in 2020 replaced the $2,000 threshold with three alternative thresholds and adjusted the corresponding holding periods. Specifically, (1) if a shareholder owns more than or equal to $25,000, then he may submit a proposal if he has held the shares for at least one year; (2) if a shareholder owns less than $25,000 but more than or equal to $15,000, he must have owned company shares for at least two years; and (3) if a shareholder owns less than $15,000 but more than or equal to $2,000, he must have been a stockholder for at least three years.⁷⁴ The rule was proposed on November 5, 2019,⁷⁵ adopted on September 23, 2020, and went into effect on January 4, 2021.⁷⁶ However, the SEC noted that the changed thresholds would only affect proposals submitted for annual meetings that take place after January 1, 2022.⁷⁷

The SEC’s revised thresholds are more difficult to meet, and this was indeed the Agency’s intention. The previous requirement of $2,000 and a one-year holding period is arguably a more achievable threshold for meme traders. The revised thresholds and the corresponding holding periods are much less likely to be met by meme traders—especially the segment of retail investors that began participating in the stock market only after the introduction of commission-free trading platforms. For this reason, we can reasonably expect little activity from meme traders by way of shareholder proposals for annual meetings taking place after January 1, 2022.

As a threshold inquiry, we first examined whether investors reacted to the SEC’s decision to change the Rule 14a-8 thresholds. There were no changes in the thresholds between the SEC’s rule proposal (November 5, 2019) and rule adoption (September 23, 2020). We examined both event dates—the rule proposal date as setting the market’s expectation and the rule adoption date as finalizing the proposal through adoption. If meme traders were particularly committed to influencing corporate governance, these events may correlate with negative stock market reactions. In unreported results, we found no significant market reactions for meme stock companies for either event. We interpreted this finding to be consistent with the idea that meme traders were never particularly interested in participating in corporate governance.

We followed through by reviewing the meme stock companies’ definitive proxy statements filed with the SEC’s EDGAR system from 2015 through 2022 to see whether they included shareholder proposals. These proxy statements typically indicate whether a particular proposal is submitted by a shareholder. Even in the absence of any such specification, the proxy statements will invariably indicate whether the board approves each proposal, which is a good indication that the proposal is internally proposed. Note, however, that the lack of shareholder proposals in definitive proxy statements does not necessarily indicate that no shareholder submitted a proposal to be included in the proxy. First, under Rule 14a-8, management is permitted to exclude a shareholder proposal under a few specific circumstances.⁷⁸ However, exclusion is permitted only after management submits its reasons to the SEC. For this reason, we also searched through the SEC’s no-action letter archives to see whether any of these companies sought to exclude shareholder proposals, and if so, on what grounds. Second, it is also possible for management to persuade a shareholder to withdraw a proposal through negotiation.⁷⁹ These are done through private agreements, and we are unaware of any public data set that would capture withdrawn proposals.⁸⁰ For this reason, for data analysis purposes, we will assume that all properly submitted shareholder proposals are reflected under our search. Nevertheless, given the possibility of negotiations that may occur as a result of submitted-but-withdrawn shareholder proposals, we will look to other measures of shareholder engagement in Part V.

For all meme companies in the sample, with respect to observable shareholder proposals, we verified our numbers and analysis for this Section using the SharkWatch dataset, which is a standard resource for studying shareholder proposals.⁸¹ Table 5 describes, for each meme stock company, the number of shareholder proposals (1) included in the company’s proxy statements, (2) approved each year, and (3) properly excluded via the SEC’s no-action letter. Some benchmark figures may be helpful to set proper expectations. In terms of raw numbers of shareholder proposals among the S&P 1500 companies, Professors Kobi Kastiel and Yaron Nili document “a relatively steady and significant number of shareholder proposals submitted to the S&P 1500 [between 2005 and 2018] (an average of 517 proposals per year).”⁸² The pattern, however, is not uniform across all 1500 companies. In 2015, for example, “over 450 proposals were submitted to companies in the S&P 500, which is comprised of large-cap companies,” while “fewer than 150 shareholder proposals [combined] were submitted to the small- and mid-cap companies that comprise the S&P Mid-Cap 400 (S&P 400) and S&P 600, respectively.”⁸³ Given that meme stock companies are small-cap to mid-cap companies, there would be no expectation that any of these companies would be inundated with shareholder proposals.

Nevertheless, the results shown in Table 5 are revealing. For AMC Entertainment, Inc., Blackberry, Express, Inc., Koss, and Vinco Ventures, there were no shareholder proposals submitted between 2015 and 2022.⁸⁴ The same is true with Robinhood, but the company went public recently, and thus has had only one definitive proxy statement issued (in 2022). Thus, for these companies, no proposal was ever included in any definitive proxy statement (which the board did not recommend), and none of these companies have had to request no-action letters from the SEC (to exclude a shareholder proposal) during the time frame.

Table 5. Shareholder Proposals at Meme Stock Companies, 2015–2022
Company\Year	Shareholder Proposals Included/Approved/Excluded
Company\Year	2015	2016	2017	2018	2019	2020	2021	2022
AMC Entertainment, Inc.	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0
Bed Bath & Beyond	0/0/0	3/2/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0
Blackberry	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0
Express, Inc.	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0
GameStop Corp.	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/3
Koss	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0
Robinhood	N/A	N/A	N/A	N/A	N/A	N/A	N/A	0/0/0
Vinco Ventures	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0	0/0/0
Note: This table presents the number of shareholder proposals at meme companies between 2015 and 2022. For each company-year observation, we provide the total number of shareholder proposals included in the proxy statements, approved by shareholder vote, and excluded via SEC no-action letters.

Bed Bath & Beyond received three shareholder proposals in 2016, all of which the board recommended against. These included (i) a proposal for the board to implement proxy access, (ii) a proposal to have shareholders approve future severance packages, and (iii) a proposal for equity-based compensation for senior executives. Of these three, only the last one failed to pass.⁸⁵ Note also that these proposals significantly predate the meme surge, and as such, cannot be attributed to the influx of retail investors.

Finally, GameStop sought and received three no-action letters from the SEC for excluding shareholder proposals, all dating to April 22, 2022.⁸⁶ These involved proposals by three different shareholders, and management could permissibly exclude all of them for failing to meet the deadline for submission. Note, however, that given that these proposals were for the 2022 annual meeting, which requires the raised thresholds, these shareholders are unlikely to be meme traders. Meanwhile, the content of these proposals is also worth examining.

In one proposal, a self-described registered GameStop shareholder (who didn’t specify how many shares he held) proposed that the company offer a non-fungible token (“NFT”) dividend to its stockholders.⁸⁷ In another proposal, a shareholder who claims to own 191 Class A shares proposed that the board “immediately engage the services of the Company’s Transfer Agent, Computershare Limited (“Computershare”) to enable both investment and Direct Registration of Class A shares in both Roth and Traditional Individual Requirement Account (“IRA”) Shareholder Investment Programs at Computershare.”⁸⁸ Finally, a third shareholder who beneficially owns 540 Class A shares of GME submitted an identical proposal as the second shareholder.⁸⁹

What can we learn from the shareholder proposals we examined? The 2016 proposals by Bed Bath & Beyond shareholders do reflect a genuine attempt at participating in corporate governance matters, but as mentioned already, these efforts predate the influx of retail investors. The GameStop shareholder proposals, however, tell a different story. On the one hand, they do indicate retail investor participation: it is possible that they were encouraged by the meme surge of 2021 to organize some activist effort. On the other hand, these proposals also do not relate to corporate governance matters: one is a dividend payment suggestion, while the other is a proposal to help certain retail shareholders obtain tax advantages. As of yet, there is no indication that GameStop investors—meme traders or not—are particularly likely to bring about governance reforms through shareholder proposals.

V. BEYOND VOTING: ESG, DIRECTOR INDEPENDENCE, BOARD GENDER DIVERSITY, AND R&D

Voting and shareholder proposals are not the only ways shareholders can influence corporate governance at public companies. Boards, institutional investors, and policymakers are increasingly paying attention to a firm’s prosocial performance as captured by ESG metrics.⁹⁰ Even if retail investors do not directly participate in governance (through voting or submitting proposals), it is possible that their presence and preferences could indirectly influence how firms are governed. For example, the meme surge could have left a considerable imprint on public companies if retail investors managed to make their firms’ preferences more prosocial. For one thing, because management may be able to raise extra cash through at-the-market offerings at inflated stock prices,⁹¹ managers have reason to cater to the preferences of meme traders—that is, to make sure that meme surges persist (especially in times of trouble) and that these investors do not go away. In addition, it is also possible that a meme trader may have submitted a shareholder proposal but decided to withdraw it in return for some concession from the board or management, such as instituting some prosocial changes. Another possible indirect effect of meme surges could have been an increase in R&D spending. For example, those companies that engaged in at-the-market offerings could have invested the new funds in transformative innovative activity. Below, we also explain other mechanisms that were highlighted in the finance literature.⁹² To estimate these possible indirect influences, in this Part, we first assess the impact of the meme phenomenon on firm ESG scores, board independence, and gender diversity. We then investigate whether meme companies spent more on R&D and capital expenditures after the influx of retail investors.

A. ESG Scores at Meme Stock Companies

An important claim in the legal scholarship on retail investors is that these new entrants to the financial markets have different goals and expectations from management (as compared with more established institutional players or to retail investors from the previous generation). Gramitto Ricci and Sauter, for example, envisage meme trading as “a social movement able to bring business corporations to serve their original partly-private-partly-public purpose.”⁹³ In other words, scholars envisioned meme companies as potentially deviating from the shareholder wealth-maximization norm and instead advancing social and environmental causes with pressure from retail investors. There is a demographic aspect to this argument. As Fisch observes, many of the retail investors who invested in meme stocks were younger people. Since some argue that the millennial generation has different preferences and is in favor of socially responsible investing even at the cost of wealth-maximization, Fisch expected the young cohort of retail investors to potentially pressure management to improve ESG metrics.⁹⁴ However, Fisch also notes that “the extent to which citizens will pursue stakeholder or societal goals in their role as investors remains unclear.”⁹⁵

To shed some light on the extent to which meme traders affected socially responsible investing and management, we obtained data on ESG scores for each firm in the Compustat dataset between 2015 and 2021. The ESG scores are taken from the MSCI ESG Score Indexes. This index measures ESG in several different ways, but we chose the most comprehensive measure—industry-adjusted total ESG score—as our outcome of interest.⁹⁶ MSCI measures the ESG score for each firm at different points in the year. Therefore, we counted an ESG score to “belong” to a given year if it was assessed after June 30 of the previous calendar year or before June 30 of that year. For example, any ESG score assessed between June 30, 2015, and June 30, 2016, is counted as that firm’s 2016 ESG score. We estimated a difference-in-difference regression model assessing whether ESG scores changed differently for meme stocks after the abolition of commissions and the meme surge of 2021. Table 6 presents the results of this regression.

Table 6. Meme Stocks and ESG Scores
	(1)	(2)
	Baseline	With Financials
2019–20	0.326***	0.295***
	(0.0305)	(0.0348)
2019–20 x Meme	–0.0817	–0.0115
	(0.127)	(0.125)
2021	0.644***	0.604***
	(0.0434)	(0.0493)
2021 x Meme	–1.818**	–1.727*
	(0.918)	(0.909)
Constant	4.219***	4.244***
	(0.0515)	(0.0792)

Observations	13,739	12,039
R-squared	0.804	0.805
Firm Fixed Effects	Yes	Yes
Firm Financials	No	Yes
Note: This table presents the results of a linear regression model in which the dependent variable is the yearly industry adjusted ESG score reported for each firm by MSCI ESG Indexes. 2019–20 equals 1 for years 2019 and 2020, while 2021 equals 1 for 2021. Column (2) adds controls for firm assets, cash ratio, debt ratio, and return on assets. Columns (1) and (2) include firm fixed effects, and all standard errors are clustered at the firm level. Continuous variables are winsorized at the 1% level. The *, , and * denote significance at the 1%, 5%, and 10% levels.

As shown in Table 6, there is no observable positive effect of meme trading on our treated companies with respect to ESG scores, either after the abolition of commissions in 2019 or the rise in social media interest in 2021. In fact, not only are all the coefficient estimates on (2019–20 x Meme) and (2021 x Meme) variables negative, but the coefficient estimates on (2021 x Meme) variable are also statistically significantly negative, with or without financial controls, at 10% and 5% levels, respectively. While not conclusive, these results are consistent with the earlier results on shareholder voting and proposals, and perhaps not too surprising. If we expect that the new retail investors are more passive, it would not be surprising to expect that the companies would face less pressure from the retail investors and be less inclined to improve upon ESG issues, even if retail investors may care more about these topics in their personal lives. Furthermore, as discussed briefly in Parts II and III, meme firms had higher debt than other firms, and many of them had faltering business models. With an influx of new passive shareholders, management at these firms may have been tempted to reduce expenditure in compliance or ESG initiatives, especially when they know that they will face little pressure from their retail shareholder base.

B. Board Independence and Diversity at Meme Stock Companies

Next, we looked at the relationship between meme trading and board characteristics. We used data on director independence and board gender diversity from BoardEx, with the dependent variable equaling the percentage of a company’s board that is independent or female, depending on the empirical test.⁹⁷ Table 7 presents regression analyses in which the percentage of independent directors is the dependent variable. Leading academic commentators, regulators, and institutional investors usually take a higher share of independent directors to be a sign of better corporate governance,⁹⁸ even though the empirical evidence on the correlation between board independence and firm performance is mixed.⁹⁹ Regardless of whether director independence boosts firm value, the results in Table 7 indicate that meme firms did not experience a significant increase in the share of independent directors either after the abolition of commissions or during the meme surges on social media. Nevertheless, unlike the ESG results in Table 6, we do not see meme companies performing “worse” than other companies. Our results simply suggest that there is no significant relationship between the meme phenomenon and director independence.

Table 7. Meme Stocks and Board Independence
	(1)	(2)
	Baseline	With Financials
2019–20	1.489***	1.437***
	(0.143)	(0.165)
2019–20 x Meme	4.573	4.753
	(2.920)	(2.932)
2021–22	2.729***	2.545***
	(0.184)	(0.219)
2021–22 x Meme	5.251	5.596
	(3.771)	(3.782)
Constant	75.99***	71.91***
	(0.0641)	(1.404)

Observations	21,581	19,538
R-squared	0.805	0.805
Firm Fixed Effects	Yes	Yes
Firm Financials	No	Yes
Note: This table presents the results of a linear regression model in which the dependent variable is the percentage of directors that are independent, per BoardEx. 2019–20 equals 1 for years 2019 and 2020, while 2021–22 equals 1 for 2021 and 2022. Column (2) adds controls for firm assets, cash ratio, debt ratio, and return on assets. Columns (1) and (2) include firm fixed effects, and all standard errors are clustered at the firm level. Continuous variables are winsorized at the 1% level. The *, , and * denote significance at the 1%, 5%, and 10% levels.

Board gender diversity is another area in which major corporations have focused in recent years, seeking to improve the representation of women. For example, California recently passed legislation mandating that firms headquartered in the state ensure that they had at least a minimum number of women directors on the board.¹⁰⁰ As with director independence, the empirical evidence for board gender diversity improving firm performance is mixed.¹⁰¹ Given, however, the concerted recent efforts to improve board gender diversity, we examine whether meme firms saw any changes with respect to this corporate governance measure. The regression analyses presented in Table 8 do not show meme companies granting women greater representation on boards after either the abolition of commissions or the advent of the social media-driven meme surges. Therefore, like director independence, we do not observe any significant recent changes for meme firms when analyzing board gender diversity.

Table 8. Meme Stocks and Board Gender Diversity
	(1)	(2)
	Baseline	With Financials
2019–20	6.012***	5.689***
	(0.167)	(0.191)
2019–20 x Meme	3.033	3.314
	(3.842)	(3.850)
2021–22	10.50***	9.986***
	(0.226)	(0.262)
2021–22 x Meme	–3.707	–2.981
	(6.055)	(6.128)
Constant	14.09***	2.532
	(0.0767)	(1.617)

Observations	21,581	19,538
R-squared	0.763	0.759
Firm Fixed Effects	Yes	Yes
Firm Financials	No	Yes
Note: This table presents the results of a linear regression model in which the dependent variable is the percentage of directors that are female, per BoardEx. 2019–20 equals 1 for years 2019 and 2020, while 2021–22 equals 1 for 2021 and 2022. Column (2) adds controls for firm assets, cash ratio, debt ratio, and return on assets. Columns (1) and (2) include firm fixed effects, and all standard errors are clustered at the firm level. Continuous variables are winsorized at the 1% level. The *, , and * denote significance at the 1%, 5%, and 10% levels.

We note that the results from this Part are not necessarily inconsistent with the observations made in the literature about retail investors primarily belonging to the millennial generation¹⁰² or this age cohort of investors having pro-ESG preferences. Instead, taken together with the earlier results about low levels of voting by retail investors, they suggest that retail investor apathy renders them unlikely to be able to change management policies toward the environment or social causes. Therefore, while the earlier scholarship on retail investors understandably thought millennial and Gen Z retail investors would move firms away from the wealth-maximization norm once they got a seat at the table, they underestimated the possibility that these investors would neglect to actually take their seat by voting or otherwise engaging with management.

C. Profitability, R&D, and Capital Expenditure

As the final set of empirical exercises, we explore whether the influx of retail investors at the meme stock companies may have (indirectly) affected the financial performance or operations at the companies. To set the stage, Figure 4 presents three graphs on the average ROA, average R&D expenses, and average capital expenditures (“CapEx”), for meme and non-meme companies between 2015 and 2021. With respect to the ROA (a profitability measure) shown in the upper panel, there is a clear downward trend at meme companies while the non-meme companies’ average profitability seems much more stable over the same period. At the beginning of the sample period, in fact, meme stock companies were on average more profitable than other, non-meme companies, but the meme companies have experienced a sustained slide in their ROA, and by the end of the sample period, meme companies are performing significantly worse than non-meme companies. Despite some meme companies raising large sums of money by conducting at-the-market offerings at elevated prices,¹⁰³ notably Game Stop and AMC, these firms saw a decrease in profitability.

The substantial decrease in profitability of meme companies could be because their business models may have been fundamentally untenable in a changing world. It is also possible that the agency costs within these firms have gotten worse due, for instance, to less monitoring and less activism by their new retail shareholders.¹⁰⁴ The average R&D expenses and capital expenditure trends (as shown in the middle panel and lower panel, respectively) seem to suggest that, at the operational level, meme companies are spending less on innovation and structural improvements. Before we proceed, we should note that the small number of meme stocks is bound to introduce more variability in numerical averages. As such, there may generally be more noise in the time-trends in Figure 4 for meme (as compared with non-meme) stocks. However, the consistent downward trend for meme companies does indicate a real trend in profitability and innovative expenditures for these firms.¹⁰⁵

Figure 4. Average Return on Assets, R&D Expenses, and Capital Expenditures for Meme and Non-Meme Stocks

Note: This figure presents three separate graphs: mean return on assets, R&D expenses, and capital expenditures, between 2015 and 2021, separately for meme and non-meme companies.

To get a better understanding of meme companies’ performance, we took a closer look at the two operational measures: R&D and capital expenditures. Two theories of R&D spending are potentially relevant to meme companies. First, financial economists have explored the link between an increase in firms’ market valuation and innovation activity. Specifically, a study by a group of financial economists, using mutual fund flows as a measure of market’s optimistic valuation, found a “very strong and robust association” between firm overvaluation and R&D spending.¹⁰⁶ They found that R&D spending is more sensitive to firm overvaluation than to growth in company sales and cash flow.¹⁰⁷ The underlying reasoning seems to be that corporate managers respond to higher market valuations by becoming more optimistic and engaging in more creative (and higher-risk) forms of innovation. If this theory applies to meme companies, one might expect that meme surges would have emboldened executives at these companies to increase R&D spending.

On the other hand, others have documented increase in R&D spending (and other innovative activities) associated with a larger fraction of institutional ownership.¹⁰⁸ As institutional ownership increases, one can argue that this will increase shareholder monitoring (and lower agency costs) and induce the firm managers to engage in more innovative activities (and not shirk), which, in turn, should correlate with various measures of innovation and long-term investment, such as R&D spending and capital expenditures. Moreover, institutional investors have a long-term orientation, which allows managers to make risky expenditures on innovative projects without fear of being fired for failing to deliver short-term profits.¹⁰⁹ To the extent that this theory applies to meme stock companies, one might expect that the influx of retail investors and the resulting transformation of the stockholder base at these companies¹¹⁰ would lead to these companies to decrease their R&D spending, since these firms saw ownership change hands from institutional investors to retail participants. Accordingly, examining how R&D spending has changed at meme stock companies could shed light on which of the two theories is more likely at play. We explored this question by conducting the standard difference-in-difference regression as in the rest of this Article and using R&D and capital expenditures as alternate dependent variables.¹¹¹

Table 9. Meme Stocks and Expenditures on Innovation
	(1)	(2)
	R&D Expenses	Capital Expenditures
2019–20	14.38***	2.485
	(1.574)	(3.943)
2019–20 x Meme	–28.59**	–62.43***
	(12.85)	(20.67)
2021–22	30.10***	18.58***
	(2.801)	(5.872)
2021–22 x Meme	–46.20***	–91.18*
	(15.10)	(48.18)
Constant	95.81***	273.9***
	(0.896)	(1.967)

Observations	28,247	34,519
R-squared	0.969	0.957
Firm Fixed Effects	Yes	Yes
Note: This table presents the results of a linear regression model in which the dependent variable is annual corporate R&D spending in column (1) and capital expenditures in column (2). 2019–20 equals 1 for years 2019 and 2020, while 2021–22 equals 1 for 2021 and 2022. Columns (1) and (2) include firm fixed effects, and all standard errors are clustered at the firm level. The *, , and * denote significance at the 1%, 5%, and 10% levels.

Table 9 presents the results of these regressions. As seen by the negative coefficient estimates on two interaction dummy variables, “2019–20 x Meme” and “2021–22 x Meme,” the regression results show that there was a significant decrease in both R&D and capital expenditures at the meme companies both after the 2019 abolition of commissions and the meme surge of 2021.¹¹² Except for the coefficient estimate on the “2021–22 x Meme” in capital expenditures regression, which is significantly negative at the 10% level, the other estimates are significant at the 5% level. These results indicate that, unlike the case for more traditional measures of cash inflows, such as mutual fund flows, meme surges are not associated with increases in either R&D spending or capital expenditure. Rather, the results support the existing findings in the literature that an increase in institutional ownership is correlated with more R&D and capital expenditure spending. Therefore, when meme companies swapped institutional investors for meme traders in recent years, managerial incentives to spend on innovation may have decreased.

VI. DISENTANGLING MEME INVESTING AND MEME SHAREHOLDING

The central inquiry of this Article has been how a dramatic change in shareholder base can affect corporate governance and whether retail investors can bring about meaningful changes as retail shareholders. While the time trends surveyed in Part I are consistent with more meme investing, meme investing is not, in turn, synonymous with meme shareholding. Indeed, the results discussed in Part II to Part V suggest that these new market entrants have not shaken up the way corporations are governed on an ongoing basis. The main question is why. In this Part, we explore several reasons as to why meme investing has not translated into meme shareholding.

A starting point is recognizing that despite the natural connection between retail investors and retail shareholders, their actual activities are quite different. As an investor, an individual is concerned about profitable short or long run transactions. Her activities include studying market information and diversifying portfolios. As a shareholder, an individual is concerned about capital gains, dividend payments, and her control rights (what may collectively be called “corporate governance”). She has the right to participate in shareholder voting, nominate director candidates, submit proposals, or even run proxy contests.¹¹³ An individual faces different challenges depending on whether she is acting as an investor or as a shareholder. A trader is vulnerable at the moment she is transacting because she may be purchasing or selling stocks at an unfair price due to undisclosed information.¹¹⁴ By contrast, a shareholder is vulnerable as long as she owns the stock because corporate misconduct and breaches of fiduciary duties can reduce the share price.¹¹⁵

More to the point, there is a significant difference between the payoffs of these activities. Retail traders participating in a meme surge will trade with a certain expectation and the payoff from their trades may be realized (relatively) quickly. There is a sense of instant gratification as well as an immediate opportunity to participate in a social activity. By contrast, retail shareholders may cast their votes only to find out that their votes have made no difference to the outcomes—for example, because the median voter is not among them—or that the proposals approved do not bring about any immediate changes in the way their corporations are run. In addition, if meme stock traders are driven by quick payoffs, they may not even be shareholders as of their company’s record date—in other words, they may not be eligible to vote by the record date for the annual meetings.

Another factor that may be driving the result is that technological developments may have reduced participation costs for shareholder engagement but not information costs. Participation costs refer to the resources the ordinary individual would need to learn about a firm and invest in it, while information costs are the costs she must incur to conduct research into the firm’s business operations and corporate governance. The digital innovations that sparked meme trading, such as the abolition of trading commissions, may not have reduced the information costs of shareholder participation in the same manner that they reduced participation costs of trading. Because meme trading is not an information-intensive activity, mobile apps like Robinhood and the abolition of trading commissions paved the way for retail traders. By contrast, shareholder voting is an inherently information-intensive activity, and thus, even with technologies that are designed to reduce participation costs, information costs that come with voting cannot be fully eradicated. This may account for why a sudden burst of enthusiasm for one type of activity may not instantly translate to a groundswell for another form of market participation.¹¹⁶

It is also not insignificant that meme surges to date have been limited to a small set of companies that are not randomly selected. In discussing some common denominators among meme stock companies, one analysis catalogues factors such as low stock prices and enduring cultural relevance.¹¹⁷ Indeed, our analysis of meme stocks reveals that these firms are mid- to small-cap companies, valued under $10 billion in market capitalization (some, in fact, have a much smaller market capitalization), with low stock prices.¹¹⁸ Their modest sizes imply that even trades by a subset of retail investors can affect their stock prices—as such, they can be targets of short squeezes. At the same time, small companies are also more likely to suffer from a lack of significant corporate governance activities. As Kastiel and Nili documented, firms with smaller market capitalizations are less likely to adopt “best practices” in corporate governance and are less organized in doing so.¹¹⁹ This could in part be because they are less likely to be targets of engagements by institutional shareholders¹²⁰ or attract shareholder proposals related to governance.¹²¹ Since meme companies have thus far been smaller firms, this suggests that they are unlikely to become overnight corporate governance exemplars.

Finally, one explanation consistent with our findings is that the segment of retail investors that entered the market as the result of the abolition of commission fees is not representative of the previously existing retail investor base.¹²² Rather, they represent a particular subset of investors—those that were highly sensitive to then-existing low transaction fees. While they may have welcomed the commission-free trading platforms and have actively participated in such activities, those investors may also be presumptively unlikely to bear other types of transaction costs, such as submitting shareholder proposals or voting at annual meetings.

We believe the disjuncture between investing and share ownership may explain why meme surges and their impacts have been confined to the trading markets and presently remain divorced from meaningful shareholder activities in corporate America. These differences, of course, are not set in stone. As companies innovate and technological innovations lower the cost of shareholder engagement, it remains possible that future retail shareholders can make a meaningful difference at companies. This can also shift the balance of power away from institutional shareholders and toward retail shareholders. The jury is out on how such changes will come about in the future.

CONCLUSION

This Article has examined the impact of the dramatic influx of retail shareholders (from the “meme surge” of 2021) on various corporate governance and financial metrics at meme stock companies. Our analysis suggests that retail shareholders could be the leopards that failed to change their spots. For one, during the period when retail investor ownership of meme stocks has increased, the rates of non-voting have significantly risen at meme companies. This is in contrast to the rate of non-voting at non-meme companies, which has remained fairly stable over the same period. Although we cannot directly measure that the non-votes were coming more from retail investors—given that non-participation is generally attributed to retail investors and other non-meme companies were not experiencing anything similar in shareholder participation¹²³—the result supports the hypothesis that the surge of retail investor interest in these companies is linked to the rise in non-voting.

Importantly, we observe that the increase in non-votes began in 2019, the same year that major brokerages abolished trading commissions, and the rate of non-votes went even higher in 2022, long after the meme surge was over. This indicates that the non-votes were not being driven by short-term speculators who may have participated in the meme surge of 2021 purely for financial gain and without any interest in democratic participation. The result is also consistent with the event-study evidence that the 2019 advent of zero-commission trading could have stirred retail investor interest in meme stocks (along with others). Retail investors have also failed to affect corporate governance at meme companies through the shareholder proposal process.

The Article also explored possible indirect avenues through which retail investors could have influenced meme companies. We find that the retail investors have been unable to translate their preferences into concrete improvements in the firms’ ESG scores or board independence and gender diversity. Furthermore, meme surges have not had an indirect effect on corporate innovation through R&D spending and capital expenditure. This finding contrasts with the earlier scholarship that showed positive correlation between increased valuation (for example, from mutual fund flows) and R&D spending, but it is consistent with the findings that showed a positive correlation between an increase in institutional ownership and innovative activities. In sum, all evidence to date suggests that meme trading may be a social phenomenon that remains largely orthogonal to retail shareholders’ aspirations to transform corporate governance. The demographic, societal, and technological changes surveyed in Part I could surely presage an increased role for retail investors at some time in the future. However, our empirical analysis suggests that this notion of democratized governance is yet to arrive at the firms targeted by the recent meme surges.

The Article’s primary focus has been on a handful of meme stock companies, such as GameStop, AMC, and Bed Bath & Beyond, with the principal finding that the new retail shareholders at these companies do not seem to be active in engaging with the management or in influencing the companies’ governance outcomes. Given that the Article’s focus is on a small number of companies that went through an unusual experience of facing a sudden surge of retail investors’ interest, one needs to be cautious about generalizing the results to other companies or making overarching conclusions. At the same time, these companies were chosen precisely because they were the primary targets of meme trading. Thus, to the extent we should have observed a new paradigm of corporate governance associated with meme surges, these companies would have been the most promising ones. Furthermore, particularly with respect to retail investors who remained loyal to the meme companies long after the “meme surge” was over, one would have expected them to be much more active in corporate governance and improving firm performance.

In sum, we believe that the Article’s findings are informative in getting a better understanding of retail shareholders’ engagement and potential democratizing benefits of allowing more retail investor participation. To get a better understanding of the importance of retail investor base on corporate governance, a future research project may take a closer look at how technological changes, including the introduction of zero-commission trading, may have had a broader effect on the capital markets and the more general impact of retail investors on corporate governance across a larger segment of the market. As the meme phenomenon spreads to banking stocks, SPACs, and bankrupt firms, research into meme investing and shareholder activity will become more important¹²⁴ and shed new light on the issue of shareholder base and corporate governance.

97 S. Cal. L. Rev. 1419

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Dhruv Aggarwal*

* Assistant Professor of Law, Northwestern Pritzker School of Law.

Albert H. Choi†

† Paul G. Kauper Professor of Law, University of Michigan Law School; Research Member, European Corporate Governance Institute (“ECGI”).

Yoon-Ho Alex Lee‡

‡ Professor of Law, Northwestern Pritzker School of Law; Director, Northwestern University Center on Law, Business, and Economics. The authors thank Quinn Curtis, Jill Fisch, Sue Guan, Dorothy Shapiro Lund, Frank Partnoy, Alex Platt, Roberta Romano, Kathy Spier, George Triantis, and Jonathon Zytnick; conference participants at the 2023 Corporate and Securities Litigation Workshop, the 2023 Korean Commercial Law Association Annual Meeting, the 2023 American Law and Economics Association Annual Meeting, the 2023 Winter Deals Conference, the 2023 Conference on Empirical Legal Studies, and the Law and Technology Conference at the University of Southern California; and workshop participants at Vanderbilt University Law School, Northwestern Pritzker School of Law, University of Michigan Law School, Bocconi University, Corporate Law Academic Webinar Series (CLAWS), Council of Institutional Investors (CII) Webinar Series and 2023 NYU Corporate Roundtable for many helpful comments and suggestions. The authors thank Irving A. Birkner (Kellogg School of Management at Northwestern University), Shay Elbaum (University of Michigan Law Library), and Clare Gaynor Willis (Northwestern Pritzker School of Law Library) for help with data collection, and Danny Damitio, Andrea Lofquist, Michael Palmer, and Nanzhu Wang for their excellent research assistance. Comments are welcome to dhruv.aggarwal@law.northwestern.edu, alchoi@umich.edu, and alex.lee@law.northwestern.edu.

Auditor Independence: Moving Toward Harmonization or Simplification?

June 2024June 2024Nikita Patel*

INTRODUCTION

Auditor independence has been a priority for the Securities and Exchange Commission (“SEC”) under the leadership of both the Trump Administration and the Biden Administration. In 2020, former SEC Chair, Jay Clayton, pointed out that in the United States “auditor independence rules are far-reaching and restrictive,” which could have “unintended, negative consequences.”¹ Shortly thereafter, the SEC issued new regulation that lowered auditor independence requirements and brought the SEC’s independence rules closer to the rules set forth by the Public Company Accounting Oversight Board (“PCAOB”) and American Institute of Certified Public Accountants (“AICPA”), the other two regulatory entities responsible for auditor independence.² Meanwhile, the current chair, Gary Gensler, has signaled that auditor independence remains a “perennial problem area,” indicating that a tightening of the auditor independence requirements is soon to be seen.³

While the future of auditor independence regulations remains up in the air, the problems associated with a lack of auditor independence continue. In 2019, the SEC alleged that PricewaterhouseCoopers LLP, one of the “Big Four” accounting firms, had violated auditor independence rules in connection with nineteen service engagements for fifteen publicly traded companies by providing prohibited non-audit services that could have impaired the firm’s objectivity.⁴ Non-audit services are ancillary services, such as reviews of accounting software or tax advice, that do not assist in the goal of auditing, which is reviewing the financial statements for fraud or error. The SEC also alleged that another Big Four accounting firm, Ernst & Young LLP, had violated auditor independence standards, along with one of its partners and two of its former partners.⁵ The Chief Accounting Officer for Ernst & Young’s client on this engagement was also allegedly involved with this misconduct, indicating how far-reaching auditor independence violations can be.⁶

Auditor independence is governed by a self-regulatory model, in which the SEC, in partnership with the PCAOB, the specialized non-profit corporation created by the Sarbanes-Oxley Act of 2002,⁷ provides oversight over the AICPA, which is a private industry professional organization charged with setting substantive auditor regulation. Despite the importance of auditor independence regulation in investor protection and the existence of this self-regulatory model, the regulatory framework in this area remains entangled.

While the SEC and PCAOB provide oversight over the AICPA, they also issue their own auditor independence regulation and have enforcement practices associated with auditors.⁸ Among the SEC, PCAOB, and AICPA, each standard-setter has rules that overlap with the others in the same subject-matter and some rules that defer to the rules set by the other organizations.⁹ This leads to a waterfall effect, in which all three entities have to change their regulations any time one of the other two does, in order to ensure that the rules are not in conflict.¹⁰ This effort has been called “harmonization,” and has the goal of ensuring that all regulatory frameworks in this area are made consistent with each other, to provide more certainty to the accounting firms and other stakeholders involved in audits, including public company boards of directors.¹¹ However, an alternative solution to harmonization may be “simplification,” in which instead of expending effort to harmonize the regulation of the three entities each time one of them makes a change, the existing self-regulatory model could be streamlined so that the AICPA is the primary or sole standard setter, with the SEC and PCAOB providing government oversight.

To explore whether simplification is a compelling alternative to harmonization, this paper turns to federal judicial decisions by conducting a novel case study of all auditor independence cases decided after the passage of the Sarbanes-Oxley Act of 2002. These decisions indicate that the courts largely use AICPA standards and case law requirements in assessing auditor independence, rather than SEC or PCAOB standards. This new finding suggests that simplification of the regulatory framework by relying solely on AICPA rulemaking is a viable solution, given that the federal courts already rely on AICPA rules.¹²

This paper will proceed as follows. First, Part I provides a brief summary of the business of public company audits to preview how the structure of the audit industry gives rise to unique incentivizes and pressures that may impact auditor independence. Next, Part II includes an overview of the impact of the Sarbanes-Oxley Act of 2002 on the audit industry and highlights the debate over auditor independence, including the ways that various stakeholders have argued whether auditor independence is a worthy goal, or if auditors’ role as gatekeepers is unnecessary. Thereafter, Part III provides an overview of the self-regulatory model that governs auditor regulation, as well as regulations promulgated by the SEC, PCAOB, and AICPA in the area of auditor independence, including a summary of recent efforts to harmonize the standards set by each entity. The core of the paper’s contribution to the literature on auditor independence regulation is in Part IV, which a presents a novel case study that examines which body of regulation, between the SEC, PCAOB, and AICPA, is preferred by the federal courts when determining whether there have been auditor independence violations. This leads to the key finding that, in determining whether auditor independence violations have occurred, the federal courts rely almost exclusively on AICPA standards and case law requirements developed by the courts, rather than SEC or PCAOB standards. Accordingly, the paper then briefly examines in Part V whether this finding indicates that rule-making authority should be consolidated by giving the AICPA authority to set substantive auditor independence regulation, with the SEC and PCAOB providing oversight, given that there is already a self-regulatory model in place. Put differently, the paper concludes by considering whether the three regulatory frameworks should be simplified into that of the AICPA, the standard setter that is the most comprehensive, and the one that has been most acknowledged by the courts.

I. THE BUSINESS OF PUBLIC COMPANY AUDITS

The role of auditors in public company financial reporting is to provide third-party reasonable assurance to investors that the financial statements of their client companies “are free of material misstatement, whether caused by error or fraud,” in the form of a formally issued audit opinion, which is appended to the clients’ public company SEC filings.¹³ Audit opinions state whether the auditor believes that the financial statements included in the filings are free, in all material respects, from error or fraud.

Generally, auditors are viewed as “gatekeepers,” meaning individuals who are “reputational intermediaries who provide verification and certification services to investors.”¹⁴ As gatekeepers, auditors have incentives to signal to outsiders that they are credible because their reputation of trustworthiness is what allows them to attract future clients and remain in business by giving credibility to their audit opinions.¹⁵ The reputation of auditors is also partially what enables them to provide verification services because investors recognize that auditors have fewer incentives than their clients’ management teams to mislead investors because the management teams are corporate insiders whereas auditors are objective third parties.¹⁶ A traditional understanding of the audit profession puts forth the proposition that auditors are trustworthy because they are not incentivized to risk their reputation by assisting one client with fraud, which could lose them many additional clients and destroy their reputational capital.¹⁷

Additionally, auditors have built up years of expertise that demonstrates to third parties that their services and opinions can be trusted.¹⁸ The utility of auditors extends from the fact that they have specialized technical expertise in the area of accounting. Members of accounting firms that conduct audits are generally expected to hold state licenses as Certified Public Accountants, which give them both reputational capital and technical expertise.¹⁹ Additionally, these accounting firms are typically well staffed with local and global teams to address the audit needs of multinational companies that are listed on exchanges in the United States, despite the complexity and geographical scope of the audit procedures that may be required.²⁰

It is widely known that auditing is part of an oligopoly, in which the “Big Four” accounting firms—PricewaterhouseCoopers LLP (“PwC”), Ernst & Young Global Limited (“Ernst & Young”), Deloitte Touche Tohmatsu Limited (“Deloitte”), and KPMG International Limited (“KPMG”)—dominate the market. The Big Four were responsible for the audits of 88% of SEC large accelerated filers—which are companies with a public float of larger than $700 million that are required by the SEC to submit securities filings on a shorter timeline than other filers—and 44.7% of all public companies in 2022.²¹ There are several smaller players in the market as well, including RSM US LLP, BDO USA LLP, and Grant Thornton LLP; however, the largest of these entities produces less than a third of the revenue produced by the smallest Big Four accounting firm, leaving the market substantially dominated by the Big Four accounting firms, which have offices globally.²²

Auditors for public companies are required to examine their clients’ financial statements and notes to the financial statements, which provide supplemental information. Auditors use a variety of mechanisms, including inspecting records, confirming balances with third parties, checking compliance with internal policies, and completing detailed tests of transactions to ensure the financial statements are free from material error or fraud.²³ Auditors also often test the robustness of management’s internal controls over financial reporting. Internal controls over financial reporting are policies and procedures surrounding accounting and reporting that are designed to limit the risk of fraud and error in the financial statements. All of this testing is done with an expectation of independence—that the auditors are not personally invested in the entity they are auditing, do not have conflicts of interests, and are reviewing the information with an air of “professional skepticism.”²⁴

II. THE DEBATE OVER AUDITOR INDEPENDENCE

When discussing auditor independence, much emphasis has been placed on the fact that each of the large public accounting firms have three lines of business: audit, tax, and consulting services. In the wake of the Enron scandal, debate over whether these three lines of business lead to inherent conflicts within public accounting firms that obstruct independence. Enron was a publicly traded energy company based in Texas that went bankrupt in 2001, partially as a result of a major decline in stock price after accounting irregularities were discovered at the company.²⁵ At the time, Enron was the seventh-largest company in the United States based on market capitalization, and its bankruptcy was the largest in United States history.²⁶ The accounting irregularities alleged were largely technical in nature, involving the use of (1) mark-to-market accounting, a practice that can lead to the overstatement of the value of assets by recording them at their current market value rather than their historical cost; (2) improper recognition of liabilities within “special purpose entities” that were owned by the company, which reduced the liabilities that were attributed to Enron; as well as (3) alleged improper payments to company officers, all of which were not in accordance with Generally Accepted Accounting Principles (“GAAP”) that are set by the AICPA and required to be followed by public companies.²⁷ Arthur Andersen LLP (“Arthur Andersen”), the public accounting firm responsible for Enron’s audit, did not, however, note any of these issues with GAAP in the audit opinions it issued about the accuracy of Enron’s financial statements, which led to surprise when the company collapsed.²⁸

In the wake of the Enron scandal, many stakeholders argued that one of the main contributing factors to Enron’s collapse was that the company’s auditor, Arthur Andersen, was receiving more revenue from its consulting engagement with Enron than it was from its audit engagement, to a factor of 1.08 times.²⁹ Arthur Andersen received approximately $27 million in annual non-audit fees and $25 million in annual audit fees from Enron in 2000 and expected to grow the overall fees to approximately $100 million annually, which some alleged was why Arthur Andersen did not disclose Enron’s lack of compliance with GAAP.³⁰ Arthur Andersen was exonerated of any liability; however, the court did not reach the issue of whether the firm was conflicted and what effect that may have had on the audit.³¹

Enron was used as an example of how pressure on accounting firms to maximize revenue from consulting engagements prevents accounting firms from robustly auditing financial statements. Primarily, stakeholders worried that accounting firms would fail to report material misstatements or fraud in financial statements in order to preserve relationships with management of the companies they were auditing or to sell them consulting services; in extreme cases such as Enron’s, the concern was that this failure to report could collapse the company entirely and thus completely eliminate a revenue-generating client.³²

The furor and fallout over Enron and implications on the weaknesses of accounting firms was used as a major justification for Congress’s passage of the Sarbanes-Oxley Act of 2002, given that investors lost billions upon Enron’s collapse.³³ Specifically, the social costs of the Enron collapse were high because pension funds that supported teachers, firefighters, and government employees were endangered from the losses, leading to outcries for reform.³⁴ William Donaldson, the SEC Chair during the time of the passage of Sarbanes-Oxley, testified before Congress that Enron was a major event leading to the reforms that were implemented in Sarbanes-Oxley.³⁵

Sarbanes-Oxley included sweeping regulatory changes designed, in part, to “restor[e] public confidence” in the accounting profession, emphasizing for the first time in Congressional legislation the importance of auditor independence.³⁶ The Act created the PCAOB to inspect accounting firms and set auditing regulations, departing from the prior regulatory structure in which the accounting profession was almost entirely self-regulated by the AICPA.³⁷ Sarbanes-Oxley also created a slew of additional auditor independence rules, such as requiring audit committees to pre-approve all audit and non-audit services provided by an auditor, reducing the consulting services that could be provided by an auditor, requiring that certain auditors rotate off an audit engagement on a regular schedule, requiring that independence concerns be raised to the audit committee when auditors identified them, and requiring disclosure to investors of non-audit and audit services provided by accounting firms.³⁸ The stated purpose of these reforms was not only to “restor[e] public confidence in the independence and performance of auditors of public companies’ financial statements,” but also to “enhance the integrity of the audit process and the reliability of audit reports.”³⁹

While Sarbanes-Oxley seemed to significantly reduce the opportunity for accounting firms to provide both audit services and consulting services to their clients, there exists a gray area in which accounting firms are able to provide certain “non-audit services” to their audit clients.⁴⁰ Accounting firms have found that these non-audit services can be a profitable substitute for revenue lost from consulting services, and according to a study that reviewed audit revenue as compared to non-audit revenue disclosures in annual proxy statements—which require public companies to disclose certain matters prior to their annual shareholder meetings—non-audit revenue represented 18% of the fees paid to auditors by public companies in 2021.⁴¹ These non-audit services allow public company auditors to provide a number of ancillary services to their audit clients, such as, (1) audits over accounting and information systems, including payroll software and human resources software, (2) “carve-out” audits that evaluate portions of the business that are set to be divested, (3) tax services, (4) statutory audits, which are audits that comply with local governmental audit requirements, especially in foreign countries, and (5) employee benefit plan audits, typically meaning audits over pension plans. All of these services can be provided without impairing independence under the SEC, PCAOB or AICPA rules, and several of them are repeat, annual services, making them especially lucrative and enticing to accounting firms.⁴²

The oligopoly presented by the Big Four accounting firms also puts significant cost pressure on accounting firms to lower audit costs to attract and retain clients, while still maximizing revenue and market share.⁴³ This balance is primarily struck by the accounting firms in two ways.

First, the accounting firms can look to drive efficiencies in the audit process to lower the cost of annual audits to clients.⁴⁴ This is often accomplished by retaining clients and using institutional knowledge gained over years of repeat audits to streamline audit processes and thus reduce hours and audit costs.⁴⁵ However, this has the added effect of lowering auditor independence as auditors become entrenched in relationships with their clients over a number of years.⁴⁶ For this reason, mandatory rotation of audit firms has been adopted in a number of foreign jurisdictions, including in Europe.⁴⁷ Some have also argued that mandatory audit firm rotations should be adopted in the United States, in addition to the existing United States requirement of rotation of the individuals who lead each audit project, known as audit engagement partners and who are usually equity partners in the accounting firms.⁴⁸

Alternatively, accounting firms can look to increase revenue from ancillary, non-audit services.⁴⁹ This method of increasing revenue by cross-selling non-audit services along with public company audits is seen as a positive to many because efficiencies are driven by the institutional knowledge that auditors already have as a result of their financial statement testing, lowering the costs for both the audit and the non-audit services. For example, an accounting firm that is performing both a public-company financial statement audit and a report on internal controls for the same client can use some of the testing done for the financial statement audit to satisfy testing requirements for internal controls, thus lowering the costs for the combined services.⁵⁰

Many argue that this bundling is a positive development, and given that audit services are fungible, lower transaction costs for companies in the form of reduced fees to accounting firms increase shareholder value.⁵¹ Additionally, tracking independence over each and every ancillary service would increase transaction costs without providing shareholder value, given that some of these non-audit services can be provided without impairing auditor independence, and especially because some argue that accounting firms are already conflicted by virtue of the fact that they are paid for audit services provided.⁵² Further, proponents of bundling argue that auditors are still incentivized to provide quality audits because despite the pressure to increase non-audit service revenue, auditors would not want to risk their reputational capital, which allows them to stay in business and attract other clients.⁵³

However, others argue that fee dependence on non-audit services poses the same problems as those that existed prior to Sarbanes-Oxley, in which instead of sacrificing audit quality to retain consulting revenue, firms are now sacrificing audit quality to retain other non-audit service revenue.⁵⁴ This leads to concerns that auditor independence will be impaired in a way that increases costs to investors because material misstatements are less likely to be caught, and this outweighs the costs saved from efficiencies by the same accounting firm providing both audit and non-audit services.⁵⁵

While this paper reserves judgment on these questions of how non-audit services effect auditor independence, the primary view of auditor regulation since the accountings scandals of the early-2000s and Sarbanes-Oxley has been that auditor independence is of paramount importance to the audit industry in order to protect investors from fraud or inadvertent material errors from management.⁵⁶ In the following Part, this paper will explore the existing regulation surrounding auditor independence, including identifying the many agencies and self-regulatory organizations that promulgate such regulations, and untangle the many requirements for independence as they have appeared over time.

III. SELF-REGULATION AND THE TANGLED REGULATORY FRAMEWORK OF AUDITOR INDEPENDENCE

Modern third party audits have existed since approximately the 1920s and have varied widely in their form and requirements.⁵⁷ However, it was not until the Securities Act of 1933 that companies were required to have their financial statements certified by an independent accountant before they could register on the public markets.⁵⁸ This requirement was expanded with the passage of the Securities Exchange Act of 1934, which mandated annual and quarterly financial reporting for public companies, as well as reporting on material events, all of which were required to be certified by “independent public accountants.”⁵⁹ The Federal Trade Commission and SEC subsequently passed rulemaking that defined “independent public accountants” as those who had neither served as officers or directors of the company to be audited, nor had a “substantial financial interest” in the company, which was defined as more than one percent of the auditor’s net worth.⁶⁰

While the SEC retained statutory authority over auditor independence regulations, eventually the AICPA formed its own auditor independence requirements and in 1977 created the Public Oversight Board (“POB”) to serve as a self-regulatory organization over the accounting profession.⁶¹ The AICPA is independently funded by membership dues from members, which include individual accountants who are certified public accountants.⁶² The AICPA is governed by a council consisting of AICPA members elected by their fellow members in each state, representatives of state CPAs, and members-at-large of the AICPA, among others.⁶³ However, in the wake of the accounting scandals of the early 2000s, the SEC issued additional independence rules to move away from complete industry self-regulation by the AICPA and POB without public oversight, and these rules were then amended to coincide with the sweeping reforms passed by Congress in the Sarbanes-Oxley Act.⁶⁴ Sarbanes-Oxley required the formation of the PCAOB—a nonprofit corporation under the oversight of the SEC—but still allowed the AICPA to issue auditor independence standards.⁶⁵ The membership of the PCAOB, which consists of a five person Board, is determined by appointment from the Chair of SEC and a vote of the five SEC commissioners.⁶⁶ The PCAOB is funded by mandatory fees from public companies who are subject to audit requirements under the Exchange Act as well as fees from brokers and dealers subject to SEC regulation.⁶⁷ As a result, since 2003, when Sarbanes-Oxley took effect, the accounting profession has been governed by three primary sets of auditor independence standards, those set by the SEC, PCAOB, and the AICPA.⁶⁸ A summary of the interaction of the regulations set by the AICPA, SEC, and PCAOB is provided below and will be discussed further in the following sections:

Figure 1.

A. Self-Regulatory Models in United States Financial Regulation

The diffuse structure that contains SEC, PCAOB, and AICPA involvement in auditor independence regulation is not unheard of within United States financial services regulation. The SEC is involved in several self-regulatory models in which the SEC provides oversight to an industry organization that sets standards, and, in some cases, enforces those standards. For example, the Financial Industry Regulatory Authority (“FINRA”) sets regulation for registered broker-dealer firms and registered brokers⁶⁹ and enforces those rules.⁷⁰ The Exchange Act gives the SEC the authority to approve any rule changes made by FINRA⁷¹ as well as revoke the authority of FINRA or issue sanctions against FINRA.⁷²

The SEC is also part of self-regulatory frameworks with national securities exchanges.⁷³ The self-regulatory framework between the national securities exchanges and the SEC works much in the same way as SEC’s oversight of FINRA, in which the SEC provides oversight over and approval of the rulemaking of each securities exchange and issues sanctions for violations of the Securities Act of 1933, the Investment Advisers Act of 1940, and the Investment Company Act of 1940.⁷⁴

The SEC also has a self-regulatory model with respect to credit rating agencies.⁷⁵ Pursuant to Section 15E of the Securities and Exchange Act of 1934, each credit rating agency was required to set internal controls and policies to ensure accurate credit ratings,⁷⁶ and the SEC was required to review such policies to ensure they were robust.⁷⁷ Additionally, prior to the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), the SEC relied on credit agencies to provide a measure of credit-worthiness in SEC rules.⁷⁸ However, Section 939A of the Dodd-Frank Act required that the SEC remove such references to the credit agencies within its rules and instead create its own independent standards.⁷⁹

Although the examples above illustrate that the self-regulatory model has been widely used, the model has also been subject to debate over its merits.⁸⁰ Supporters of the model argue it is beneficial because the knowledge of industry participants enhances the usefulness of rulemaking,⁸¹ places the costs of enforcement on industry,⁸² and is more adaptive than the state-driven model because industry entities have the experience and ability to focus on specialized regulations in a way that public entities with vast oversight responsibilities may not.⁸³ However, others believe that the self-regulatory model is not as beneficial as the European state-driven model, in which public entities are the singular or primary regulators with little or no input from industry organizations, because the self-regulatory model can result in conflicts of interest in terms of funding and regulatory capture, given that individual standard setters may be members of the group facing regulation and may seek to avoid restrictions.⁸⁴ In response, proponents of self-regulation may argue that the oversight of the public entities is sufficient to mitigate these conflicts and harness the benefits of a specialized industry standard-setter working hand-in-hand with a public oversight agency, especially when safeguards such as individual term limits for regulators, or limitations on the ability of individual regulators to participate in a “revolving door” in which they rotate between industry and regulatory entity, are put in place.⁸⁵

While the self-regulatory model is not unique to auditor regulation, what is somewhat distinctive about the auditor regulation self-regulatory model is that the SEC and PCAOB not only provide oversight over the AICPA, which is the industry organization run by accountants, but the SEC and PCAOB also have concurrent jurisdiction to set independence standards and have set their own standards for auditor independence in addition to those of the AICPA.⁸⁶ While there are additional organizations that set auditor independence standards, including state boards of accountancy, state CPA societies, federal and state agencies, and the International Ethics Standards Board, the standards set by these entities are heterogeneous and are generally superseded by the SEC, PCAOB, and AICPA rules.⁸⁷ Therefore, the regulation promulgated by these entities will not be examined in this paper. In order to assess the current landscape of auditor regulation, this paper will examine the regulations passed by the SEC, PCAOB, and AICPA in Sections III.B–D.

B. SEC Independence Rules

Under the current SEC independence rules:

The [SEC] will not recognize an accountant as independent . . . if the accountant is not, or a reasonable investor with knowledge of all relevant facts and circumstances would conclude that the accountant is not, capable of exercising objective and impartial judgment on all issues encompassed within the accountant’s engagement. In determining whether an accountant is independent, the [SEC] will consider all relevant circumstances, including all relationships between the accountant and the audit client.⁸⁸

The SEC independence rules then set forth a non-exhaustive list of instances in which an auditor would not be independent, primarily consisting of eight categories: (1) lack of financial independence, (2) client investment in the accounting firm, (3) employment by client, (4) non-audit services, (5) contingent fees,⁸⁹ (6) improper partner rotation, (7) lack of audit committee approval,⁹⁰ and (8) improper compensation.⁹¹ Perhaps the most important of these rules are those defining financial independence because without financial independence, an auditor may have conflicts of interest that prevent them from conducting a robust audit.⁹² Accordingly, a summary of these rules is given below, along with a brief summary of the independence restrictions posed by the remainder of the SEC independence rules.

1. Financial Interests

SEC Independence Rule 2-01 states that independence is impaired when (1) the accountant has a direct financial interest or material indirect financial interest in their client;⁹³ (2) the accounting firm, a covered person in the firm, or any of the covered person’s immediate family members have a direct investment in the client, in which “covered person” includes individual accountants within a firm that provide services to a client;⁹⁴ (3) any partner or employee in the firm, including their close family, has more than 5% beneficial ownership of the client’s securities or controls the client;⁹⁵ or (4) the accounting firm, a covered person in the firm, or any of the covered person’s immediate family members have loans, savings accounts, checking accounts, broker-dealer accounts, insurance products, futures commission merchant accounts, consumer loans, or financial interests in investment companies that own the client.⁹⁶

In addition to the requirements of financial independence listed above, the SEC independence rules also prohibit the audit client from investing in the accounting firm or underwriting an accounting firm’s securities.⁹⁷ Moreover, the SEC independence rules place limits on accounting firm employees from being employed at the client both during and after the audit engagement.⁹⁸

2. Audit Conduct

The SEC independence rules also mandate certain conduct during the audit. For example, auditors are not allowed to provide non-audit services that could impair their independence, such as bookkeeping services, financial information systems design and implementation, appraisal or valuation services, actuarial services, management functions, human resources, investment advising, legal services, or expert services unrelated to the audit.⁹⁹ Much of the intent behind this regulation is to reduce the types of conflicts discussed in Part II, in which auditors are incentivized to ignore errors in the audit in order to receive revenue for these non-audit services.¹⁰⁰ Additionally, audit partners are required to rotate every five years if they are the lead partner on the engagement or every seven years otherwise, to avoid forming ties with clients that may impair independence.¹⁰¹ Auditors are also not allowed to receive contingent fees or have partners compensated for any services other than audit services.¹⁰² The audit engagement, typically including fees and non-audit services, must also be approved by the client’s audit committee to ensure independence.¹⁰³

3. Enforcement and Entanglement

The SEC’s enforcement mechanism for auditor independence violations is relatively straightforward. Under the SEC independence rules, the SEC can “censure a person or deny, temporarily or permanently, the privilege of appearing or practicing before [the SEC] in any way to any person who is found by the Commission after notice and opportunity for hearing”¹⁰⁴ to have “engaged in unethical or improper professional conduct.”¹⁰⁵ What is interesting about this mechanism is that it defers to “applicable professional standards” in determining whether there has been “unethical or improper professional conduct.”¹⁰⁶ As a result, the SEC defers the determination of the standard for violations of independence standards to the body that sets the professional standards, which has often been interpreted, both by the SEC’s Administrative Law Judges and the federal courts, to be the AICPA.¹⁰⁷ This is one instance in which the auditor independence regulations are entangled between two different standard setters—the SEC and the AICPA.

One other instance in which the auditor independence rules are entangled between regulators is that although the SEC has delegated the authority to the PCAOB to set auditor independence standards, the SEC independence rules passed in the wake of Sarbanes-Oxley in 2003 are still effective.¹⁰⁸ Aside from some minor updates to debtor-creditor relationships passed in 2019, the SEC independence rules remained largely untouched until 2020,¹⁰⁹ at which point the SEC, along with making minor updates to the independence rules, brought the PCAOB rules into harmony with the SEC rules where they conflicted, acknowledging that for several years there had been a period in which the SEC and PCAOB rules surrounding auditor independence were not consistent.¹¹⁰ This inconsistency is explored further in the sections below, including analyzing the frequency with which the courts used the SEC and PCAOB standards during this time, or the AICPA standards, which are defined in Part III.D.

C. PCAOB Standards

The PCAOB sets forth “Ethics and Independence” standards for accounting firms and their associated persons.¹¹¹

standards/ethics-independence-rules [https://perma.cc/WP6J-2LLD]. While several of these rules set forth additional requirements when compared to the SEC rules, several are similar or aligned with the SEC independence rules and AICPA standards.¹¹² First, accounting firms and their employees are required to “comply with all applicable auditing and related professional practice standards,” which implies that SEC and AICPA standards are binding.¹¹³ However, in 2003, the PCAOB released a note to PCAOB Rule 3500T, which states that the “[PCAOB’s] Interim Independence Standards do not supersede the [SEC’s] auditor independence rules” and that in situations when the SEC Rules are more or less restrictive than the PCAOB rules, the more restrictive rule is to be followed.¹¹⁴ Additionally, the PCAOB explicitly requires that accounting firms and their employees comply with AICPA Code of Professional Conduct Rules 101 and 102, including any interpretations and rulings under these rules.¹¹⁵ Further analysis of the AICPA rules will be provided in Section III.C.

The PCAOB independence rules extend beyond the SEC independence rules in three areas: (1) limiting auditors’ ability to provide audit clients with tax services,¹¹⁶ (2) requiring auditors to communicate with the client Board’s audit committee about certain independence-related matters,¹¹⁷ and (3) requiring auditors to submit a form to the PCAOB that summarizes audit hours by partner (“Form AP”).¹¹⁸

1. Tax Services

Generally, the PCAOB rules extend beyond the SEC rules by maintaining that an accounting firm is not independent of its audit client if the firm provides “marketing, planning, or opining in favor of the tax treatment of” confidential transactions or aggressive tax position transactions, or if the firm provides “tax service to a person in a financial reporting oversight role” at the client, which generally prohibits providing tax advice or preparation services to management and finance employees of the audit client.¹¹⁹

2. Audit Committee Communication

Further, the PCAOB goes beyond the SEC rules and requires accounting firms to seek audit committee pre-approval before the firms perform any permissible tax service or non-audit service related to internal controls.¹²⁰ Part of the intent of these rules is to present to the audit committee the ways that it might impair the accounting firm’s independence to provide both tax and non-audit services to the client.¹²¹ In line with this requirement, accounting firms are required to describe to the audit committees of their clients “all relationships between the registered public accounting firm . . . and the audit client or persons in financial reporting oversight roles at the potential audit client that . . . may reasonably be thought to bear on independence” both prior to beginning the audit and annually thereafter, including an annual affirmation of independence to the audit committee, which essentially requires accounting firms to disclose personal relationships that may impair independence.¹²²

3. Form AP Filing Requirements

Finally, the PCAOB requires that accounting firms file a “Form AP” with the PCAOB for each audit report it issues for a client.¹²³ The Form AP lists the lead engagement partner for the audit and notes the hours they have completed on the audit engagement, with the goal of providing users of financial statements information about the “independence of the specific individuals and firms that participate in the audit.”¹²⁴

004.pdf [https://perma.cc/U3D4-2X49] .

D. AICPA Standards

The AICPA promulgates what is the most rigorous standard of independence requirements for auditors, when compared to the SEC and PCOAB. The AICPA Code of Professional Conduct begins by setting forth a single independence rule: “A member in public practice shall be independent in the performance of professional services as required by standards promulgated by bodies designated by [the AICPA Governing] Council.”¹²⁵ Stemming from this rule, the AICPA has then set forth hundreds of interpretations,¹²⁶ which are binding on accounting firms and accountants performing “attest engagements,” which are any services to a client requiring independence from the client, including audits.¹²⁷

Given the complexity of the interpretations to the independence rule and the many scenarios effecting independence that they address, it would be impractical to describe all interpretations within this paper. However, to summarize, the interpretations to the independence rule cover a variety of situations regarding the independence of individual accountants, such as how to handle the employment of a family member at an audit client¹²⁸ and how to address whether an individual accountant’s financial investments in a client’s securities impair their independence.¹²⁹ The interpretations also cover more complex situations regarding the independence of accounting firms as a whole, such as how to maintain independence in situations in which a nonclient acquires a current client¹³⁰ or how “network firms” with multiple offices should each remain independent of each other’s clients.¹³¹

In the absence of any relevant interpretation, accounting firms and accountants are expected to apply the AICPA’s “Conceptual Framework for Independence.”¹³² The Conceptual Framework for Independence requires that accountants evaluate whether a particular “relationship or circumstance” would lead a reasonable person “to conclude that there is a threat to . . . independence . . . that is not at an acceptable level.”¹³³ The Conceptual Framework then lists potential “threats” to independence, such as holding an adverse interest from the client, advocating for the client, familiarity with the client, auditor participation in management of the client, self-interest, self-review, and undue influence by the client or a third party.¹³⁴ Following the potential threats, the Conceptual Framework identifies “safeguards” which can reduce threats to an acceptable level that will ensure independence, such as external review, competency requirements for professional licensing, analysis of an accounting firm’s revenue dependence on one client, and accounting firm policies for engagement quality control, such as external review.¹³⁵ By ensuring threats are low or nonexistent or by balancing them with safeguards, accounting firms and accountants can ensure compliance with independence standards under the Conceptual Framework in situations in which there is no authoritative interpretation set forth by the AICPA.¹³⁶

The AICPA also has a senior committee, the Auditing Standards Board, that sets forth Generally Accepted Auditing Standards (“GAAS”).¹³⁷ GAAS sets forth specific testing requirements and procedures for auditors as they undertake audit engagements for clients.¹³⁸ In addition to these audit testing requirements—which are largely technical in nature and outside of the scope of this paper—GAAS also sets for ethical requirements relating to audits of financial statements, stating that an “auditor must be independent of [a client] when performing an engagement in accordance with GAAS.”¹³⁹ GAAS then defers to the Code of Professional Conduct’s Conceptual Framework, which was discussed previously.¹⁴⁰ GAAS is often referenced more frequently than the Code of Professional Conduct, as will be discussed in Part IV, because GAAS includes not only ethical requirements for auditors, but substantive guidance for how audits are to be conducted in practice.¹⁴¹

Overall, there is significant overlap between the regulations set forth by the AICPA and the SEC and PCAOB.¹⁴² The AICPA standards set forth detailed guidance for accounting firms to ensure they comply with the broader standards set forth by the SEC and PCAOB. For example, while the SEC and PCAOB rules prevent auditors from receiving contingent fees from their clients, the AICPA rules state that same proposition and provide guidance that states contingent fees include finder’s fees, fees based on cost-savings achieved by the client, and exclude fees based on the results of judicial proceedings in tax matters.¹⁴³ This level of detailed guidance means that practitioners often consult the AICPA standards, as they set forth a more restrictive set of guidelines and also a more informative set of interpretations that can be applied to specific circumstances. This delegation of substantive regulation to the private industry organization—AICPA—is also consistent with other self-regulatory models.

E. Harmonization Efforts

In October 2020, the SEC issued updates to the auditor independence rules set forth in SEC Independence Rule 2-01.¹⁴⁴ These updates covered a variety of miscellaneous matters in the SEC independence rules, including refining the definition of affiliates of audit clients, amending the definition of an “audit and professional engagement period,” excluding some student loans from causing independence violations, and addressing inadvertent violations of the independence rules due to mergers and acquisitions, among other matters.¹⁴⁵

As a result, stakeholders raised concerns that the PCAOB rules, particularly those related to affiliates of audit clients, such as subsidiaries, were no longer consistent with the SEC independence rules.¹⁴⁶ In response, and to “provide greater regulatory certainty,” the PCAOB amended its rules to align with the SEC independence rule changes.¹⁴⁷ Additionally, several of the PCAOB rules that needed realignment with the new SEC rules were those that the PCAOB adopted directly from the AICPA or had interpreted based on the AICPA rules.¹⁴⁸ As a result, the AICPA issued a temporary policy statement as a stop-gap measure that stated to accounting firms and accountants that they would be considered in compliance with the AICPA Code of Professional Conduct if they complied with the updated SEC independence rules.¹⁴⁹ Soon thereafter, the AICPA put forth a proposal to change its rules and definitions to align with the SEC and PCAOB changes.¹⁵⁰ This proposal has not been adopted as of the time of this paper, but it seems likely that the AICPA will bring its standards into alignment with the current SEC and PCAOB independence rules.

Overall, this amendment waterfall that began with the SEC proposing changes in October 2020 that were then adopted by the PCAOB, and which still have not been adopted by the AICPA two years later, shows that the regulatory framework for auditor independence remains entangled. This entanglement may be occurring because the Sarbanes-Oxley Act created the PCAOB, which is allowed to pass audit regulations subject to the oversight of the SEC; and the Sarbanes-Oxley Act also allowed the SEC to become more involved in rule-setting for auditors, which had previously been handled entirely by the AICPA.¹⁵¹ While some argue that harmonization between these three entities is a worthy goal to disentangle regulations that are not consistent between the three entities,¹⁵² one might also consider whether harmonization is the answer, or rather whether simplification is a better goal, to avoid having to involve three regulatory agencies in rule changes, in order to ensure clear standards for accounting firms, clients, and stakeholders in the market. The following section of the paper will explore whether one regulatory entity is dominant over the others, and whether this agency should be favored for simplification that centers around focusing auditor independence on this agency and its rules exclusively, rather than the standards set across all three entities.

IV. CASE STUDY

As discussed, the following case study will assess published federal court opinions in which auditor independence was at issue in a civil litigation to determine whether SEC, PCAOB, or AICPA standards were used in the courts’ reasoning.¹⁵³ While a study of administrative law decisions from the SEC was considered, federal court decisions were deemed to be a more relevant indicator of which body of regulation is used in deciding civil matters because SEC administrative law decisions rely almost exclusively on a single, broad rule, SEC Rule 102(e)(1)(ii), which “censure[s] a person . . . after finding that a person engaged in improper professional conduct.”¹⁵⁴

There were fifteen cases decided by federal courts in which auditor independence was at issue in civil litigation, and which were used to comprise the population for this case study.¹⁵⁵ The population of cases includes only cases in which auditors were performing financial statement audits, and therefore excludes government and internal audit services, as these non-financial statement audits are typically not part of the debate over auditor independence because they involve different monetary incentives, risks for auditors and investors, and different auditing standards. Additionally, cases were only observed after May 6, 2003, which was the effective date of the Sarbanes-Oxley legislation, given that Sarbanes Oxley completely changed the landscape of auditor independence, giving the SEC broad authority to issue rulemaking in this area and effectively creating the PCAOB.¹⁵⁶ Finally, cases that relied on state regulations over auditor licensing and independence were excluded, as they do not address the relevant issue of federal regulatory structure.¹⁵⁷

This case study aims to examine which body of regulatory law federal courts rely on in making determinations over whether auditors have breached their independence obligations. Each of the AICPA, SEC, and PCAOB have their own enforcement mechanisms to sanction auditors who do not adhere to independence requirements, and each enforcement division uses their own regulation as well as occasionally relies on the regulation of the other entities to sanction auditors.¹⁵⁸ However, the civil courts do not have a requirement to adhere to the regulations of any particular standard-setter under the requirements of Sarbanes-Oxley or the Securities and Exchange Act of 1934. Given this lack of constraints, the standard used by the federal courts in determining independence violations has not been examined and is ripe for analysis to determine whether one set of standards (that is, those of the AICPA, SEC, or PCAOB) is preferred over the others. Therefore, this study will examine all fifteen federal court decisions to determine what standards have been used by the courts in the area of auditor independence as well as whether the result was in favor of the auditor or against the auditor in each scenario.

There are three major areas in which auditor independence has been examined by the federal courts. First, individuals who have been sanctioned by the SEC for violations of auditor independence standards can appeal to the federal courts for a review of the SEC’s decisions under a broad “abuse of discretion” standard to argue that the agency acted arbitrarily and capriciously in a way that requires the SEC’s decision to be overturned under 5 U.S.C. 706(2)(A).¹⁵⁹

Next, auditor independence is frequently at issue in Securities and Exchange Act Section 10(b) and SEC Rule 10b-5 claims, which are often brought as class-actions.¹⁶⁰ To prevail on these claims, plaintiffs must prove scienter, meaning that the defendant employed a “device, scheme, or artifice to defraud,” in addition to proving the elements of a material misstatement or omission, on which the plaintiff relied, and was the proximate cause of the plaintiff’s loss.¹⁶¹ Plaintiffs often allege that auditors’ violations of independence rules are evidence of scienter for purposes of satisfying this element to bring a successful 10(b) or 10b-5 claim.¹⁶² However, this practice has been complicated by the heightened pleading requirements for Section 10(b) and Rule 10b-5 claims established in the Private Securities Litigation Reform Act of 1995 (“PSLRA”), which was passed in part to reduce the number of non-meritorious securities class action claims raised by plaintiffs and requires that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”¹⁶³ The PSLRA has resulted in different pleading standards for scienter among and within circuits, however, many courts find “scienter [is] plead with particularity by facts supporting a ‘motive or opportunity’ to commit fraud.” ¹⁶⁴ As will be discussed in Section IV.B, this heightened pleading standard has reduced the circumstances in which courts have viewed violations of auditor independence rules to be sufficient to show scienter.

Finally, plaintiffs also bring state law claims—including negligent misrepresentation, professional negligence, and fraud suits—against auditors who have violated auditor independence standards, using the alleged violations of these standards as de facto evidence of a breach of duty.¹⁶⁵ In one instance, a plaintiff also attempted to bring a state law breach of fiduciary duty claim against an auditor who allegedly did not comply with auditor independence standards.¹⁶⁶

Given the heterogeneity of the claims within these cases, this paper examines the cases within these three groups—reviews of SEC administrative decisions, federal securities law claims, and state law tort claims—to identify developments in the case law regarding auditor independence and to examine when courts apply SEC, PCAOB, or AICPA standards in determining whether there has been an independence violation sufficient to warrant a judgment against auditors.

A. Appeals of SEC Administrative Decisions

In Ponce v. SEC, the Ninth Circuit reviewed an appeal from a decision that the SEC made to bar a plaintiff accountant from practice, and the court acknowledged that as part of the SEC’s decision, the accountant had been held in violation of SEC Independence Rule 102(e)(1)(ii), which means he engaged in “improper professional conduct.”¹⁶⁷ In order to determine whether there was truly “improper professional conduct,” the court turned to AICPA standards and ruled that the auditor failed to maintain his independence because he allowed his clients to run up a substantial balance of unpaid fees, which under AICPA guidance, resulted in a presumed lack of independence because the AICPA standards set forth that “independence is considered to be impaired if fees for all professional services rendered for prior years are not collected before the issuance of the member’s report for the current year.”¹⁶⁸

Similarly, in Dearlove v. SEC, the Court of Appeals for the District of Columbia Circuit used the same approach as Ponce, albeit six years after the decision¹⁶⁹ and six years after the implementation of Sarbanes-Oxley, including its resulting reform of SEC independence rules and the formation of the PCAOB. In Dearlove, the court concluded that “the appropriate standard of care . . . is supplied by . . . GAAS” when reviewing whether the SEC had abused its discretion in determining that an accountant violated SEC Independence Rule 102(e)(1)(ii) by failing to maintain independence from their audit client.¹⁷⁰

Ponce and Dearlove are indicators of how the federal courts have given credibility to the AICPA standards, including GAAS, in determining whether there has been a violation of auditor independence. The court’s opinion in Dearlove references SEC Independence Rule 102(e)(1)(ii), but it does so only to note that the SEC rule states “improper professional conduct” will warrant sanctions, before deferring to the AICPA GAAS standards to assess what improper conduct is.¹⁷¹ The court also stated that “the SEC need not establish a standard of care separate from the GAAS in order to give meaning to” what SEC Independence Rule 102(e)(1)(iv)(B)(2) describes as “unreasonable conduct,” showing further deference to AICPA standards.¹⁷² The fact that this decision came more than six years after the implementation of Sarbanes-Oxley, when the court had the ability to reference the updated SEC independence rules or PCAOB rules, but chose not to, shows even more significant reliance on the standards set by the AICPA.

B. Determinations of Scienter in Securities Claims

Similarly, in In re WorldCom, Inc. Securities Litigation, defendants moved for summary judgment on the matter of whether Arthur Andersen, the auditors at the helm of both the Enron, and in this case, WorldCom accounting scandals, had the requisite scienter to be in violation of Section 10(b) of the Securities and Exchange Act and SEC Rule 10b-5 because they allegedly recklessly issued false audit opinions.¹⁷³ The plaintiff alleged that violations of the AICPA’s GAAS were sufficient to prove scienter, even under the heightened pleading standards required by the PSLRA, which required the plaintiffs to plead recklessness in order to avoid their claim being dismissed.¹⁷⁴ The court recognized the importance of violations of GAAS in proving scienter, but ultimately denied summary judgment due to conflicting expert reports on whether GAAS was violated.¹⁷⁵ Although the claim survived the motion for summary judgment due to unresolved questions of fact, this case was another high profile example of the federal courts giving credence to AICPA standards in determining whether there was auditor wrongdoing.¹⁷⁶

In re WorldCom, Inc. Securities Litigation also included a Securities Act claim, in which the plaintiffs alleged that Arthur Andersen was in violation of Section 11 of the Securities Act, which states that a “preparing or certifying accountant . . . may be liable ‘if any part of the registration statement . . . contained an untrue statement of a material fact.’ ”¹⁷⁷ Arthur Andersen attempted to assert a due diligence defense, in which it claimed that it “had, after reasonable investigation, reasonable ground to believe and did believe, at the time . . . the registration statement became effective, that the statements therein were true,” and then moved for summary judgment.¹⁷⁸ In deciding whether summary judgment was appropriate on this issue, the court issued an even stronger affirmance of the relevance of AICPA standards, concluding that a “reasonable investigation” that would support a due diligence defense, like that raised by Arthur Andersen, must be a “GAAS-compliant audit.”¹⁷⁹ Because the plaintiff presented sufficient evidence to rebut the argument that the audit was “GAAS-compliant,” Arthur Andersen’s motion for summary judgment was denied. While this second issue is not directly related to auditor independence rules, it shows the courts’ general deference to the AICPA’s GAAS.

However, not all courts have agreed with the Southern District of New York’s decision in WorldCom, which may be in part due to differing interpretations of the heightened pleading requirements of the PSLRA. In In re Cardinal Health, Inc. Securities Litigations, the Southern District Court of Ohio ruled that Ernst & Young’s failure to adhere to the AICPA’s GAAS requirements for auditor independence did not establish the requisite scienter for a plaintiff’s claim to survive Ernst & Young’s motion to dismiss on a Rule 10b-5 claim.¹⁸⁰ The Court reasoned that while recklessness is generally sufficient to meet the pleading standard under the PSLRA, claims brought against auditors were subject to the even more heightened pleading standard of “a mental state ‘so culpable that it approximate[s] an actual intent to aid in the fraud being perpetrated by the audited company,’ ” which was not met in this case based merely on the alleged failure of Ernst & Young to adhere to AICPA GAAS requirements.¹⁸¹

Further, the court opined that an auditor’s past sanctions in SEC administrative proceedings were insufficient to prove scienter.¹⁸² In this case, the court also noted that SEC administrative decisions were not dispositive in determining scienter for Rule 10b-5 claims, perhaps suggesting that judicial interpretation of independence violations supersedes determinations by regulatory bodies.¹⁸³ This is in line with existing administrative law doctrines that do not require federal courts to defer to the SEC’s interpretations of the Exchange Act.¹⁸⁴

Similarly, in In re Royal Ahold N.V. Securities and ERISA Litigation, the United States District Court for the District of Maryland ruled that alleged violations of AICPA’s GAAS standards on independence—in which the only allegations from the plaintiff were that auditor independence was impaired due to the auditor providing audit and non-audit services—were not sufficient to establish scienter for a Rule 10b-5 claim against an auditor.¹⁸⁵ However, the court did note that violations of AICPA’s GAAS can be sufficient to plead scienter when they are coupled with allegations that show that “the nature of the violations of those violations was such that scienter is properly inferred.”¹⁸⁶ Likewise, in New Jersey v. Sprint Corp., a group of class action plaintiffs brought Rule 10b-5 claims against Sprint Corporation and Ernst & Young for filing false and misleading registration statements, prospectus supplements, and proxy statements that did not disclose that the company had considered dismissing their auditor, Ernst & Young, and that there were conflicts between executives at the company and the auditor, which resulted in auditor independence violations under AICPA’s GAAS.¹⁸⁷ The court relied on the AICPA’s GAAS to assess independence, noting that the plaintiffs did not plead sufficient facts to show that Ernst & Young lacked the independence in “mental attitude” required by GAAS, and even if sufficient facts were pled to show that Ernst & Young violated GAAS, this would not be sufficient under the PSLRA to establish scienter because the standard for scienter is recklessness, that is “so obvious that the defendant must have been aware of it” which goes beyond a mere violation of GAAS. ¹⁸⁸ Therefore, the motion to dismiss was granted in favor of Ernst & Young.¹⁸⁹

While the varied interpretations in different jurisdictions over whether violations of the AICPA’s GAAS standards is sufficient to plead scienter persists, some courts have ruled that merely “articulating violations of GAAS and GAAP alone is insufficient” to satisfy the element of scienter under the PSLRA’s heightened pleading requirements and instead imposed additional requirements to plead scienter through case law.¹⁹⁰ For example, the court in Grand Lodge of Pennsylvania v. Peters determined that in order to prove scienter, violations of GAAS must be accompanied by “red flags” that would put a reasonable auditor on notice that their client was committing fraud.¹⁹¹ Therefore, the plaintiff’s allegations in this case that the auditor was conflicted by providing consulting services to the client in violation of GAAS were insufficient to establish scienter for a Rule 10b-5 claim.¹⁹² Additionally, the court in In re Williams Securities Litigation ruled that “GAAS violations must be coupled with evidence that the violations were the result of the auditor’s fraudulent intent to mislead investors,” in order to have a sufficient pleading of scienter.¹⁹³ This supports the idea that some courts grant credibility to the AICPA standards, however, they impose additional burdens on plaintiffs that are developed through case law.

This case law has developed in the years since the passage of the PSLRA. The Ninth Circuit Court of Appeals summarized the development of the additional requirements to prove scienter, other than GAAS violations, in New Mexico State Investment Council v. Ernst & Young LLP.¹⁹⁴ The court ruled that failing to “maintain independence in mental attitude during an audit,” in violation of GAAS and PCAOB standards, is not sufficient to prove scienter.¹⁹⁵ Rather, there should be “red flags” that a reasonable auditor would have investigated as well as a showing that there were violations that amount to more than “alleging a poor audit.”¹⁹⁶ New Mexico State Investment Council indicates how the courts’ reliance solely on AICPA standards has lessened slightly over the years, as the burden to meet additional case law requirements for scienter has increased due to the passage of the PSLRA and its heighted pleading requirements, which require that plaintiffs “state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”¹⁹⁷

While the discussion above indicates that courts have largely relied on violations of AICPA’s GAAS and case law requirements in determining whether auditor independence violations are sufficient to show scienter, other courts have discussed Sarbanes-Oxley in determining whether an auditor independence violation is sufficient to show scienter as an element of a Rule 10b-5 violation.¹⁹⁸ In Brody v. Stone Webster, Inc., the First Circuit Court of Appeals examined whether scienter could be presumed on the part of PwC in connection with a 10b-5 claim because PwC allegedly turned a blind eye toward accounting irregularities to protect its accounting and consulting revenue from a client.¹⁹⁹ The court determined that “turn[ing] a bind [sic] eye” to misleading accounting for a “profit motive” may have been a rationale for the passage of Sarbanes Oxley, but it is not enough in itself to prove scienter sufficient for a valid Rule 10b-5 claim under the PSLRA without specific allegations that the auditor ignored “red-flags” that were signs of fraud.²⁰⁰

Courts have also been reluctant to find that scienter has been sufficiently pled in accordance with the PSLRA when plaintiffs allege auditor independence violations on the basis of general policy arguments against auditors depending on fees from clients.²⁰¹ In In re ArthoCare Corporation Securities Litigation, plaintiffs alleged that PwC was not independent in its audit because the firm had a longstanding relationship with its client and was dependent on the client’s audit fees.²⁰² The United States District Court for the Western District of Texas found that general allegations based on a perceived lack of independence or violations of GAAS due to fee dependence or long-standing relationships, which are allegedly against public policy, are not sufficient to establish scienter on the part of auditors under the PSLRA.²⁰³ Similarly, in Ley v. Visteon Corporation, the Sixth Circuit determined that an allegation that Ernst & Young was not independent during an audit because it sought to preserve revenue from a client by not pointing out the client’s alleged accounting irregularities was not sufficient to plead scienter on the part of the auditors under the PSLRA’s requirements because it was merely an allegation of a “motive.”²⁰⁴

On the whole, these cases show a broad trend of the courts giving credibility to the AICPA’s standards, as compared to SEC or PCAOB standards. As the case law has developed, violation of AICPA standards has been shown as one of the avenues plaintiffs can use to establish scienter for Securities and Exchange Act Section 10(b) and SEC Rule 10b-5 claims, when additional case law requirements are met. Notably, neither violations of the PCAOB independence rules nor the SEC independence rules have been used by the federal courts to assess whether there has been scienter for the purposes of a Section 10(b) or Rule 10b-5 claim that has been sufficiently pled in accordance with the PSLRA. Instead, the courts have relied on the AICPA rules as one factor for establishing scienter, and then have developed additional case law standards, such as finding “red flags” and alleging more than a poor audit, in order for plaintiffs to prevail on Section 10(b) and Rule 10b-5 claims against auditors. This focus on the AICPA rules is aligned with the deference given by the courts to AICPA standards in appeals of SEC enforcement decisions, discussed in Section IV.A.

C. Fraud, Negligence, and Other State Law Causes of Action

In state law actions for fraud, courts have required a heightened standard for liability that extends beyond a violation of the AICPA’s GAAS independence standards in order to hold auditors liable. For example, in In re Parmalat Securities Litigation, plaintiffs pled that Deloitte aided an audit client with common law fraud.²⁰⁵ Given that this was a state law cause of action, the court applied the New York common law requirements for fraud, requiring the plaintiff to prove “that the defendant (1) made a material, false statement; (2) knowing that the representation was false; (3) acting with intent to defraud; and that plaintiff (4) reasonably relied on the false representation; and (5) suffered damage proximately caused by the defendant’s actions.”²⁰⁶ The court focused primarily on the intent to defraud and ruled that an auditor’s violation of GAAS does not by itself show intent, however “an auditor’s decision to take on non-audit work that threatens to compromise its duty of independence gives rise to a strong inference of . . . [fraudulent] intent . . . when . . . the auditor has a ‘direct stake’ in the alleged fraud.”²⁰⁷ This heightened standard to show the intent element for common law fraud in New York, which includes not only a GAAS violation but also an auditor’s direct stake in the fraud, is in some ways analogous to the heightened standard to prove scienter on the part of auditors, as discussed in Section IV.B, because in both instances the courts have recognized a violation of the AICPA’s GAAS standards as helpful in showing intent, in addition to adding case law requirements to plead a valid claim.

However, some courts have not found it necessary to analyze auditor independence regulation when determining whether auditors were negligent in their review of their clients’ financial statements. In a consolidated action, insurance companies brought state law claims against Enron, Enron management, and Enron’s auditors, Arthur Andersen, in the wake of the Enron accounting scandal and resulting collapse.²⁰⁸ The plaintiffs specifically alleged that Arthur Andersen made negligent misrepresentations to investors and committed common law fraud in violation of Texas law.²⁰⁹ In connection with the negligent misrepresentation claim, the plaintiffs were required to show (1) the defendant provided information (2) that was false, (3) the defendant did not exercise reasonable care or competence in obtaining or communicating the information, (4) the plaintiff justifiably relied on the information, and (5) the plaintiff suffered loss by justifiably relying on the information.²¹⁰ In connection with the common law fraud claim under Texas law, the plaintiffs were required to show “(1) a material representation was made; (2) the representation was false; (3) when the representation was made, the speaker knew it was false or made it recklessly . . . (4) the representation was made with the intention that it be acted upon by the other party; (5) the party actually and justifiably acted in reliance upon the representation; and (6) the party suffered injury.”²¹¹ While the plaintiffs alleged that Arthur Andersen’s violations of AICPA’s GAAS standards showed the firm lacked independence, which they claimed was sufficient to show that Arthur Andersen did not meet the standard of care and competence as required by the negligent misrepresentation claim,²¹² and that the violation of GAAS showed that Arthur Andersen made false representations about its independence sufficient for a common law fraud claim,²¹³ the court did not reach these issues, instead dismissing both claims because the plaintiffs could not show they relied on Arthur Andersen’s representations.²¹⁴

Another area in which courts have assessed whether auditor independence gives rise to liability is in the area of state law claims for breach of fiduciary duties. In In re SmarTalk Teleservices, Inc. Securities Litigation, a trustee argued that PwC exceeded its normal role as an independent auditor, as defined by the AICPA’s GAAS, and therefore PwC owed a trustee fiduciary duties that the firm then breached by providing inadequate accounting and audit services.²¹⁵ While the court did not reach the issue of whether there was a valid cause of action for breach of fiduciary duty, the court determined that whether PwC violated GAAS standards for independence was a genuine issue of material fact and denied the auditor’s motion for summary judgment on the breach of fiduciary duty claim, providing yet another example of the federal courts giving credence to the AICPA standards in determining auditor liability.²¹⁶

V. IMPLICATIONS OF STUDY ON HARMONIZATION OR SIMPLIFICATION OBJECTIVES

In all three areas of the law covered by the case study, including appeals of SEC enforcement decisions, federal securities claims, and state law claims, the federal courts have preferred to use the AICPA standards, including GAAS, in their decision-making over auditor independence. In many instances when AICPA standards were used in federal securities actions, case law requirements were also supplied to determine whether there was sufficient evidence presented to plead scienter. But, notably, there were no cases found that apply PCAOB or SEC auditor independence rules.

On the whole, this paper does not aim to provide a normative proposal for auditor independence regulation. However, the case study presented in Part IV can shed light on the process of harmonization, which, as discussed in Section III.E, involves the SEC, PCAOB, and AICPA each having to change their rules regarding auditor independence each time one of the other entities changes their independence rules, in order to ensure that the rules are not in conflict. Given that the case study indicates that AICPA standards are preferred by the federal courts, along with case law, in determining whether auditor independence has been violated, there is an argument to be made that the power to regulate auditor independence should be simplified into one regulatory framework run by a single entity—the AICPA. Under this proposal of “simplification,” the regulations set by each entity would not need to be harmonized each time one entity makes a change in auditor independence rules. Rather, given that the federal courts rely on AICPA standards, the substantive rule-making authority would be given to the AICPA alone. This is because the current framework has two entities, the SEC and PCAOB, whose frameworks are rarely applied in the federal courts or outside of internal enforcement actions and investigations.

As discussed in Part III, the AICPA, PCAOB, and SEC are involved in a self-regulatory model, in which the SEC provides oversight over the PCAOB, and the SEC and PCAOB have concurrent jurisdiction to set auditor independence standards as a federal regulatory agency and as a non-profit corporation subject to the oversight of the SEC, respectively. In this self-regulatory model, the SEC also provides oversight over the AICPA, which is a private industry organization run by accountants and which sets substantive auditor independence regulation. This self-regulatory model could be simplified to reflect other self-regulatory structures in United States financial services regulation so that rule-making authority is deferred entirely to the AICPA, with oversight by the SEC, in order to simplify the regulatory framework and reduce conflicts between the independence rules set by the AICPA, SEC, and PCAOB. This would be similar to the model between the SEC and FINRA, in which the SEC allows FINRA to set rules for national securities exchanges and provides oversight over that rulemaking, rather than having the SEC set its own detailed regulation over exchanges. Given that the AICPA sets forth the most comprehensive rulemaking and interpretations of auditor independence standards, and the federal courts rely on these standards, simplifying the regulatory framework for auditor independence by deferring to the AICPA seems like a possible solution.

Overall, the relative costs and benefits of self-regulation and the outsourcing of rulemaking to private industry are beyond the scope of this paper; however, the following arguments are meant to provide a brief summary of why simplification of rule-making authority regarding auditor independence regulations by giving authority to the AICPA and oversight to the SEC may or may not be beneficial.

There are valid reasons to argue against simplification that comes in the form of allowing the AICPA to be the only standard-setter in the area of auditor independence. Several critics have pointed out that self-regulation was one of the issues at the forefront of the Enron collapse and resulting scandal, and that the accounting profession needs an external regulator.²¹⁷ However, others have argued that it was not self-regulation, but market failures and misaligned incentives over reputational costs that caused the accounting scandals during the early 2000s.²¹⁸ Further, self-regulatory organizations, such as FINRA, have successfully provided guidance to their respective stakeholders, with some oversight from the SEC, indicating that self-regulatory organizations with some administrative oversight can be successful.²¹⁹

Additionally, critics may argue that the AICPA relies on the SEC and PCAOB enforcement practices in addition to running its own enforcement program,²²⁰ and to split up the enforcement and regulation practices could pose problems. However, given that the current system splits the enforcement burden between the SEC, PCAOB, and AICPA, and each uses violations of the other’s regulations to bring sanctions, consolidating the regulations into one body would not have to change this framework.

CONCLUSION

This paper reserves judgment on the relative merits of self-regulation and instead notes that the current regulatory harmonization effort is not the only solution to disentangle the regulatory framework for auditor independence. Instead, this paper poses a new potential solution—simplification—to the problem of unwinding the tangled regulatory framework of auditor independence to promote efficiency in rulemaking and clarity for stakeholder accounting firms, regulators, and clients.

Given that the courts frequently defer to AICPA auditor independence standards—along with case law requirements for pleading federal securities law violations—rather than SEC and PCAOB standards, and having three regulatory frameworks that need to be continuously updated to align with each other is complex and costly, simplification is a worthy goal. However, it is just one solution of many. As the SEC, PCAOB, and AICPA continue to pursue harmonization,²²¹ it is worth considering whether other alternative approaches to auditor independence regulation, such as simplification, exist.

APPENDIX

Appendix
	Case Name and Citation	Procedural Posture	Body of Law Applied	Result in Favor of Auditor?
1	Ponce v. SEC, 345 F.3d 722 (9th Cir. 2003).	Appeal of Administrative Decision	AICPA and SEC	No
2	Dearlove v. SEC, 573 F.3d 801 (D.C. Cir. 2009).	Appeal of Administrative Decision	AICPA and SEC	No
3	New Jersey v. Sprint Corp., 314 F. Supp. 2d 1119 (D. Kan. 2004).	Motion to Dismiss	AICPA	Yes
4	Newby v. Enron Corp. (In re Enron Corp. Secs., Derivative & ERISA Litig.), 762 F. Supp. 2d 942 (S.D. Tex. 2010).	Motion to Dismiss	AICPA^a	Yes
5	In re WorldCom, Inc. Sec. Litig., 352 F. Supp. 2d 472 (S.D.N.Y. 2005).	Motion for Summary Judgment	AICPA and SEC	No, on Securities Act Claim. Yes, on SEC Rule 10b-5 claim.
6	In re Cardinal Health, Inc. Sec. Litigs., 426 F. Supp. 2d 688 (S.D. Ohio 2006).	Motion to Dismiss	AICPA	Yes
7	In re Royal Ahold N.V. Sec. & ERISA Litig., 351 F. Supp. 2d 334 (D. Md. 2004).	Motion to Dismiss	AICPA	Yes
8	Brody v. Stone & Webster, Inc. (In re Stone & Webster, Inc., Sec. Litig.), 414 F.3d 187 (1st Cir. 2005).	Motion to Dismiss	Sarbanes-Oxley	Yes
9	Ley v. Visteon Corp., 543 F.3d 801 (6th Cir. 2008).	Motion to Dismiss	AICPA	Yes
10	Grand Lodge of PA v. Peters, 550 F. Supp. 2d 1363 (M.D. Fla. 2008).	Motion to Dismiss	AICPA	Yes
11	In re Williams Sec. Litig., 496 F. Supp. 2d 1195 (N.D. Okla. 2007).	Motion for Summary Judgment	AICPA	Yes
12	N.M. State Inv. Council v. Ernst & Young LLP, 641 F.3d 1089 (9th Cir. 2011).	Motion for Summary Judgment	AICPA	Yes
13	In re Parmalat Sec. Litig., 501 F. Supp. 2d 560 (S.D.N.Y. 2007).	Motion to Dismiss	AICPA	Yes
14	In re ArthroCare Corp. Secs. Litig., 726 F. Supp. 2d 696 (W.D. Tex. 2010).	Motion to Dismiss	AICPA	Yes
15	In re SmarTalk Teleservices, Inc. Secs. Litig., 487 F. Supp. 2d 928 (S.D. Ohio 2007).	Motion for Summary Judgment	AICPA	No
Note: The plaintiffs pled a violation of AICPA standards, but the court did not reach the issue in this case before making its final determination.

97 S. Cal. L. Rev. 495

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Nikita Patel*

* Executive Articles Editor, Southern California Law Review, Volume 97; J.D. Candidate, University of Southern California Gould School of Law, 2024; B.S., B.A., Boston College, 2017. Many thanks to Professor Jonathan Barnett for his feedback and guidance, as well as to the editors of the Southern California Law Review for their thoughtful suggestions. All mistakes are my own.

Secondary Trading Crypto Fraud and the Propriety of Securities Class Actions

April 2024April 2024Menesh S. Patel*

Traders participating in secondary crypto asset markets risk significant loss. Some trading loss will arise simply because of market dynamics, including inherently volatile crypto asset prices. But secondary crypto asset traders also risk considerable monetary injury resulting from fraudulent statements or acts by crypto asset sponsors or others occurring in connection with their secondary transactions. If subjected to such fraud, the affected crypto asset traders may turn to a Rule 10b-5 class action for redress.

Crypto asset traders’ reliance on Rule 10b-5 class actions implicates important doctrinal and public policy questions. This Article analyzes two of these questions—one doctrinal and another in the domain of public policy. In its doctrinal analysis, the Article evaluates issues pertinent to the threshold definitional question of when an exchange-traded crypto asset will constitute an investment contract and therefore fall within the definitional perimeter of a security. The Article proposes a slight generalization of the horizontal commonality test that renders the test suitable for use in both primary transaction and secondary transaction cases, and also addresses aspects of Howey’s efforts of others prong that are relevant to Howey’s application in the crypto asset context.

With respect to the public policy question, the Article evaluates whether the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than for stock-based Rule 10b-5 class actions. The Article’s public policy determinations break in different directions and in some respects are to be considered preliminary, but the analysis does not justify limiting the availability of crypto asset-based Rule 10b-5 class actions any more than stock-based Rule 10b-5 class actions.

INTRODUCTION

Asset digitization through distributed ledger technology has transformed trading markets. Traders in the United States now routinely trade hundreds of crypto assets on various crypto exchanges, and the pool of tradable assets is growing.¹ Through these secondary transactions, crypto asset traders have seen both financial gain and financial loss, which at times have been substantial.

Recent events have amplified the prospect of secondary crypto asset traders incurring significant monetary loss through incidents of fraud. Misconduct was commonplace in the 2017 to 2019 time period, when a high frequency of crypto asset initial offerings were riddled with fraud, causing investors to lose substantial amounts.² Now, traders transacting in secondary crypto asset markets risk being subject to fraud by crypto asset sponsors or others occurring in connection with their secondary transactions, which the Article refers to as secondary trading crypto asset fraud.³ The injurious effects of secondary trading crypto asset fraud extend beyond the defrauded traders. Such fraud, in combination with other types of misconduct, has the potential to fully undermine the legitimacy of the entire crypto asset ecosphere, including causing collateral damage to the reputation of economically scrupulous actors, and to strengthen the calls by some that the sector be subject to intense regulatory scrutiny.

To take an example that mirrors allegations from a recent fraud suit, suppose that a crypto asset sponsor develops a novel blockchain protocol and an accompanying crypto asset that serves as the blockchain’s native token.⁴ Suppose that the crypto asset goes on to trade on one or more crypto exchanges after its initial offering. At some later point, the crypto asset sponsor falsely represents that a payment provider has adopted the developed blockchain to process payments. Because the fraudulent statement is understood to evidence a new and potentially monetizable use value for both the blockchain and the associated crypto asset, secondary traders update their valuation of the crypto asset, which causes additional trading activity resulting in the crypto asset’s price appreciating on the secondary markets in which it trades. Traders who purchase the crypto asset at the resulting higher price will suffer financial harm once the market becomes aware of the falsity of the sponsor’s fraudulent statement and the crypto asset’s price falls in response. Depending on the magnitude and nature of the fraud, traders’ losses may be substantial.⁵

Additional regulation of the crypto asset space may diminish the prospect of fraud ex ante, but defrauded crypto asset traders may seek ex post relief in the form of private litigation. Traders sustaining losses in connection with secondary transactions of stock and other more conventional assets routinely seek class-wide relief under Rule 10b-5,⁶ which serves as the workhorse of federal securities laws’ antifraud prohibitions. Given the prominence of Rule 10b-5 class actions in modern securities litigation, defrauded crypto asset traders likewise may turn to Rule 10b-5 class relief to recover their secondary trading losses.

These observations raise an important question: Should defrauded crypto asset traders be able to rely on Rule 10b-5 class actions to recover their secondary trading losses, both as a doctrinal matter and as a matter of public policy? A host of considerations bear on this question, and this Article focuses on two leading considerations, one doctrinal and one public policy related.

A primary consideration pertinent to the doctrinal propriety of secondary crypto asset traders relying on Rule 10b-5 class actions is the fundamental question: under what conditions will an exchange-traded crypto asset be within the definitional scope of a security because it is an investment contract under the multipronged test enunciated by the Supreme Court in Howey?⁷ Scholars have dedicated considerable attention to this definitional inquiry but not with a specific focus on exchange-traded crypto assets.⁸

The Article evaluates the investment contract issue as it relates to exchange-traded crypto assets with an emphasis on Howey’s “common enterprise” and “efforts of others” prongs. The contours of these and Howey’s other prongs have been shaped by courts in primary transaction cases, that is, cases in which investors directly or indirectly transacted with the enterprise’s promoter. In a secondary transaction case—such as a case involving an exchange-traded crypto asset—investors will have transacted with their trading counterparties, perhaps with the involvement of one or more intermediaries, and those counterparties ordinarily will not have been the enterprise’s promoter. Unlike crypto assets, earlier occurring investment contract cases arising in connection with primary transactions did not involve instruments that readily lent themselves to secondary trading, so courts have not had much occasion to consider the operation of Howey in the secondary transaction context.

In many instances, the investment contract rules that courts have developed in primary transaction cases have been articulated in a manner that allows them to be sensibly applied to secondary transaction cases. That is not the case for the horizontal commonality test, one of the three tests that courts use to assess Howey’s common enterprise prong. As the Article explains, because of its pooling requirement, that test is ill-suited for use in secondary transaction cases and thus requires reorientation.

The Article proposes a slight generalization of the horizontal commonality test that renders the test suitable for use in both secondary transaction and primary transaction cases. The generalized test recognizes that pooling is but one method by which investors’ financial interests in the underlying enterprise can become intertwined in the manner that horizontal commonality requires. Under the generalized test, horizontal commonality will be present if there is some mechanism, pooling or otherwise, that ties investors’ fortunes to one another and dependent on the enterprise in which they are invested.

The generalized test reasonably broadens the scope of instruments for which horizontal commonality would be found. As relevant to the Article’s question of interest, even if there were no pooling of a secondary crypto asset investors’ purchase amounts, the generalized horizontal commonality test may still be satisfied because the asset’s trading price can serve as a non-pooling mechanism that causes the pecuniary interests of the crypto asset’s traders to be linked and dependent on the success of the crypto asset and any of its associated applications. For the crypto asset’s price to actually have served that non-pooling role for purposes of the generalized horizontal commonality test, the crypto asset’s price must generally respond to material, public information in a directionally appropriate way. As part of its analysis, the Article also explains why certain facts that are present in the investment contract cases that courts have analyzed to date—such as the presence of a contract among the investment contract’s promoter and the investors—simply represent common factual features shared by the decided cases, rather than elements of the pertinent legal rule.

The Article also addresses two aspects of Howey’s efforts of others prong relevant to application of Howey to exchange-traded crypto assets. First, the Article explains that Howey’s efforts of others prong should not be understood as requiring the presence of a centralized body that exerts the requisite entrepreneurial or managerial efforts. Instead, Howey’s efforts of others prong is better understood as requiring investors to have reasonably believed that their profits were significantly determined by the entrepreneurial or managerial efforts of those other than the investors themselves, whether or not those “others” constituted a centralized group.

Second, as the Article explains, investors’ expectations concerning the use of their sales proceeds is doctrinally irrelevant to Howey’s efforts of others analysis, which instead focuses on investors’ expectations concerning whose entrepreneurial or managerial efforts significantly determined their expected profits. Thus, the fact that investors’ sales proceeds in a secondary crypto asset transaction case may not have flowed to the crypto asset’s sponsors would not itself prevent Howey’s efforts of others prong from being met. This and the Article’s other Howey-related conclusions are not limited to the specific context of a Rule 10b-5 class action and instead also are applicable to other securities claims involving secondary crypto asset transactions.

The Article’s public policy analysis is prompted by the observation that stock-based Rule 10b-5 class actions have been the subject of academic criticism, intense at times. Supported by two longstanding primary critiques known as the circularity critique and the diversification critique, prominent voices have argued that stock-based Rule 10b-5 class actions fail to properly advance their intended public policy objectives of deterrence and compensation. Other scholars have disputed the relevance of the circularity and the diversification critiques and also have identified theories that provide alternate public policy justifications for stock-based Rule 10b-5 class actions, with the leading example being a corporate governance justification for stock-based Rule 10b-5 class actions.

A normative inquiry into whether defrauded crypto asset traders should be able to rely on Rule 10b-5 class actions implicates a range of subsidiary questions. One constituent question is whether the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than for stock-based Rule 10b-5 class actions. If so, then that would support legal change that limits the availability of crypto asset-based Rule 10b-5 class actions, relative to stock-based Rule 10b-5 class actions, such as the adoption of prophylactic steps in the form of legislative action or doctrinal modification that would curb crypto asset-based Rule 10b-5 class actions before they become commonplace as stock-based Rule 10b-5 class actions have become. The Article evaluates that specific public policy question in terms of the circularity and diversification critiques and the corporate governance justification.

While its public policy determinations are mixed and in part preliminary, the Article’s analysis does not lend support to the notion that the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than the public policy justification for stock-based Rule 10b-5 class actions. As reflected in the discussion below, the circularity critique has significantly less relevance in the crypto asset context than in the stock context. While the diversification critique may be more or less relevant in the crypto asset context than the stock context, nothing in the analysis indicates that it is significantly more relevant in the crypto asset context than the stock context. An offsetting consideration is that the corporate governance justification loses its relevancy in the crypto asset context.

The Article is organized as follows. Part I provides a high-level summary of three key features of crypto assets that are pertinent to the Article’s substantive analysis. Part II addresses the investment contract question, while Part III provides the public policy analysis.

I. FEATURES OF EXCHANGE-TRADED CRYPTO ASSETS

While exchange-traded crypto assets vary in their characteristics and features, they share key points of commonality relevant to an inquiry into the propriety of defrauded secondary crypto asset traders relying on Rule 10b-5 class actions as a means of redress. Three points of commonality are discussed below: operational decentralization, the absence of cash flow, and significant price volatility.

A. Operational Decentralization

As a rough approximation, a crypto asset’s lifecycle will have three stages. The first stage is the period preceding the asset’s initial offering, during which the crypto asset’s sponsors develop the asset and any associated applications.⁹ The second stage of a crypto asset’s lifecycle is the asset’s offering period. During this stage, the asset’s sponsors first offer and sell the crypto asset, or rights to the future delivery of the crypto asset, to the public and others.¹⁰ Historically, crypto asset offerings have been unregistered offerings, with very limited exceptions.¹¹

com/articles/1186166 [https://perma.cc/QSQ8-ZDJJ] (describing an offering pursuant to Regulation A). There appears to be just one instance of a registered crypto asset offering. See INX Ltd., Registration Statement Under the Securities Act of 1933 (Form F-1) (Aug. 19, 2019), https://
http://www.sec.gov/Archives/edgar/data/1725882/000121390019016285/ff12019_inxlimited.htm [http://web.
archive.org/web/20230324012325/https://www.sec.gov/Archives/edgar/data/1725882/000121390019016285/ff12019_inxlimited.htm] (showing INX Ltd.’s registered offering of its INX crypto asset). The third and final stage is the period following the crypto asset’s offering, or the period after the crypto asset is delivered to those who previously purchased rights to its delivery, during which the asset trades on one or more crypto exchanges.¹² In some instances, a crypto asset may have a fourth stage when it is delisted from the crypto exchanges on which it trades and then ceases all secondary trading.¹³

At some point in this lifecycle, the development, operation, management, and promotion of a crypto asset and any associated applications may move from a small group of sponsors to a significantly larger group of stakeholders. This latter process can be referred to as operational decentralization, and the resulting set of designated decision‑makers ordinarily will include the crypto asset’s holders. The modifier “operational” reflects the fact that other aspects of a crypto asset or its application may be decentralized, but in ways not directly relevant to the securities law definitional question discussed in Part II below.¹⁴

As an example of these observations, consider the application Filecoin, which is an innovative blockchain-based data storage network that enables those needing computing storage to remotely use others’ idle computing storage.¹⁵ So, for instance, a large data center or an individual maintaining unused computing storage space can have that dormant storage incorporated in Filecoin’s storage network, thereby allowing other Filecoin users to access its idle storage in exchange for payment.¹⁶ Filecoin generates economic benefit by facilitating mutually beneficial transactions, allowing unused computing storage space to be put to productive use.

The crypto asset “FIL” is associated with and facilitates Filecoin’s storage network. Transactions on the Filecoin network are conducted in FIL, in that users of Filecoin’s storage network pay storage providers in FIL rather than fiat currency.¹⁷ Filecoin’s users who want to acquire or sell their FIL holdings can do so on various crypto exchanges.¹⁸ As reflected in publicly available information, FIL’s holders do not buy and sell the crypto asset purely for its use value on the Filecoin network, but also, or perhaps primarily, trade the asset for investment purposes, seeking financial gain from appreciations in the crypto asset’s price.¹⁹ FIL presently has a market capitalization near $2.9 billion and its 24-hour transaction volume ordinarily exceeds $200 million.²⁰

Protocol Labs, an innovative research and development company founded in 2014, developed both Filecoin and FIL.²¹ In 2017, Protocol Labs conducted two Reg D offerings through which it sold accredited investors the rights to the future delivery of FIL²² and raised over $200 million.²³ In 2020, Filecoin became fully operational, and Protocol Labs distributed FIL to the accredited investors who had purchased the future delivery rights to FIL in the two 2017 Reg D offerings.²⁴ The crypto asset thereafter began trading on a number of crypto exchanges.²⁵

FIL and its associated application Filecoin exhibit features of the operational decentralization discussed above. In the years following FIL’s initial offering in 2017, Protocol Labs continued to develop Filecoin and FIL but continuously expanded the ability of other stakeholders, including the general public, to contribute to Filecoin and FIL’s development. In the immediate period following FIL’s initial offering, the public’s role in facilitating Filecoin and FIL’s development was limited to referring potential employees and early users to Protocol Labs and suggesting improvements to the underlying protocol.²⁶ Subsequently, but before Filecoin became fully operational and FIL started trading in secondary markets, Protocol Labs made several key aspects of Filecoin and FIL’s software code available to the public for review and comment.²⁷ This important milestone provided the public with an indirect way to guide Filecoin and FIL’s development but ultimate authority remained vested in Protocol Labs.

Protocol Labs’ current decision-making authority over Filecoin and FIL is much more attenuated than before. Now, while Protocol Labs remains actively involved in Filecoin and FIL’s development²⁸ and potentially may still maintain significant holdings of FIL,²⁹ Protocol Labs does not have sole decision-making authority over the crypto asset or its associated application. First, another centralized body, Filecoin Foundation, facilitates governance of the Filecoin network.³⁰ Moreover, any person can influence Filecoin’s governance by submitting a Filecoin Improvement Proposal.³¹ Filecoin’s many stakeholders, including FIL holders and Filecoin’s developers, determine whether to adopt the proposal.³² Modifications and improvements to Filecoin’s technical features are undertaken through a similarly decentralized process, with any individual able to propose a technical change and then Filecoin’s many stakeholders deciding whether to adopt the technical modification.³³

B. Absence of Cash Flow

A specific crypto asset may provide its holders with a range of benefits. In addition to investment gain, some crypto assets also may be used as methods of payment for conventional goods and services, while others may enable their holders to use an associated application or exercise governance rights with respect to the crypto asset or an associated application.³⁴

Despite these benefits, a crypto asset ordinarily will not provide its holders with dividends or cash flow in any form, realized or expected. Even if there exists a centralized body with some involvement in the crypto asset’s development and operation, the crypto asset’s holders usually will not be entitled to any income from the profits of that centralized body. In contrast, a public company’s common shareholders will receive cash flow at the board’s discretion in the form of dividends paid from the company’s net income.

More generally, a crypto asset’s holders usually will not be entitled to income from any entity or individual involved in the development and operation of the crypto asset and any associated applications. Holders of some crypto assets may earn income through staking, which is the process through which a crypto asset holder agrees to lock up their assets to facilitate the validation of transactions on a blockchain that uses a proof-of-stake consensus mechanism.³⁵ But staking is an optional process that requires the holder to forgo transacting the staked assets.³⁶ While it is theoretically possible for a crypto asset to entitle its holders to cash flow, very few crypto assets with this feature have actually been implemented to date.³⁷

C. Significant Price Volatility

Crypto assets exhibit significant price volatility. Crypto asset prices can change markedly, even in relatively short periods of time. Take for instance, “SOL,” the crypto asset associated with the Solana blockchain. On July 1, 2022, SOL traded at $32.80, according to CoinMarketCap’s calculated average price on a group of crypto exchanges.³⁸

solana/historical-data [http://web.archive.org/web/20230627040245/https://coinmarketcap.com/
currencies/solana/historical-data]. On August 1, 2022, and September 1, 2022, SOL traded at $41.79 and $31.59, respectively, according to CoinMarketCap’s calculated average price.³⁹ So, within one month, the price of SOL appreciated by more than 27%, but then dropped by more than 24% the next month. Crypto asset prices can swing dramatically even over shorter durations, such as weeks or days.

Statistical analysis shows that crypto asset prices can be much more volatile than stock prices. For instance, Liu and Tsyvinski examined the returns of over 1,700 crypto assets between January 1, 2011 and December 31, 2018.⁴⁰ The authors created an index of the crypto assets in their sample and found that over the sample period, the standard deviation of daily returns of the index was 5.46%, which was five times higher than the standard deviation of daily stock returns over the sample period.⁴¹ The authors also found that crypto asset returns over the sample period yielded extreme losses and gains with high probability.⁴² According to their findings, a trader who held the constructed index over the sample period would have experienced an extreme 20% negative return to daily returns with a probability of 0.48% and an extreme gain of 20% positive return to daily returns with a probability of 0.89%.⁴³

Though crypto asset prices may be more volatile than stocks, some crypto assets may exhibit significantly less price volatility than others.⁴⁴ The volatility of some crypto assets may be closer to that of stock. Additionally, there is some empirical evidence showing that crypto asset volatility decreases over time. For instance, returning to the study discussed above, the authors found that the standard deviation of the index’s returns diminished over the sample period.⁴⁵

II. THE DOCTRINAL PROPRIETY OF CRYPTO ASSET-BASED RULE 10B-5 CLASS ACTIONS

The propriety of crypto asset traders using Rule 10b-5 class actions as a means of recovering losses caused by secondary crypto asset fraud implicates a set of important doctrinal and public policy considerations. In the discussion below, the Article focuses on the leading doctrinal question of when secondary trading crypto asset fraud constitutes securities fraud and so is properly within the scope of Rule 10b-5. The pertinent issue is whether the exchange-traded crypto asset on which the Rule 10b-5 claim is predicated is definitionally a security because it is an investment contract.⁴⁶ To better frame the issue, it is helpful to first provide some observations on the nature of secondary trading crypto asset fraud and Rule 10b-5 relief.

A. The Nature of Secondary Trading Crypto Asset Fraud and Rule 10b-5 Relief

Secondary trading crypto asset fraud can inflict trader harm by altering the prices at which traders transact. The motivating hypothetical from the Article’s Introduction involved the sponsor of an exchange-traded crypto asset making misrepresentations about a new and potentially monetizable use value for the crypto asset. Defrauded crypto asset traders who purchased at the resulting inflated prices may seek relief though a Rule 10b-5 class action. Their ability to viably do so requires, among other things, that (1) the at-issue crypto asset satisfies Howey’s four-part test for an investment contract—the focus of the discussion in the next Section; (2) the substantive elements of Rule 10b-5 are met; and (3) the pertinent elements of Rule 23 are met.

Different variants of the Introduction’s hypothetical may cause the case to turn more heavily on one of the necessary legal determinations. For instance, suppose that the false or misleading statement instead was made by a person of notoriety that the crypto asset sponsor had monetarily incentivized to provide promotional services, but all other facts of the hypothetical were unchanged. In this case, if the plaintiffs asserted their Rule 10b-5 claim against the influencer, greater focus may be on the materiality of the statement than if it were made directly by the crypto asset sponsor as in the baseline hypothetical. Depending on the circumstances, such as the identity of the influencer and other background considerations, a reasonable person may not consider the misrepresentation important to their trading decision, in which case it would not be material,⁴⁷ while they may consider it important to their trading decision if it had instead been made by the crypto asset’s sponsor.⁴⁸ Or consider a statement by an influencer opining about a crypto asset’s expected future price. In addition to the statement potentially being immaterial, it may be a nonactionable opinion statement under the rule in Omnicare.⁴⁹

Some crypto assets may be more amenable to secondary crypto asset fraud than others. In the hypothetical from the Introduction, the associated crypto asset had potential use value, in that its associated blockchain could be used to facilitate economically meaningful activity. That is not the case for all crypto assets. Consider meme coins, which are crypto assets that are based on an Internet meme or joke. These assets often have no use value, though they vigorously trade on crypto exchanges and can have significant market capitalization. The body of statements that investors may consider important to their trading decisions may be circumscribed. For instance, if a meme coin has no intended use value, and traders understand that fact, then they may not consider a statement about a potential use value for the crypto asset to be relevant to their trading decision.⁵⁰

The alleged fraud in each of these examples is an instance of statement-based fraud. Secondary trading crypto asset fraud can also be in the form of deceptive schemes. In the hypothetical in the Introduction, suppose that the crypto asset’s sponsor and the payment provider instead had devised a clandestine scheme that caused the crypto asset’s traders to believe that the payment provider would begin using the crypto asset’s blockchain to process payments. Traders who purchased the crypto asset at the resulting higher prices would suffer financial injury, just as in the baseline hypothetical in which the fraud was in the form of a false statement by the crypto asset’s sponsor.

Finally, crypto asset traders’ ability to rely on Rule 10b-5 class actions to recover losses sustained in connection with secondary crypto asset transactions raises doctrinal issues beyond the definitional one addressed below. For instance, putting Affiliated Ute to the side,⁵¹ secondary market crypto asset traders will only be able to litigate their Rule 10b-5 claims as a class if they are able to avail themselves of fraud on the market.⁵² The question thus arises whether fraud on the market properly extends to the crypto asset context. Or, to take another example, a private plaintiff Rule 10b-5 claim only reaches transactions that are within the extraterritorial reach of the securities laws as defined by Morrison.⁵³ But suppose the crypto exchange on which the at-issue transactions occurred is not a registered exchange and maintains no trading operations in the United States.⁵⁴ This scenario raises the doctrinal question of whether those secondary crypto asset transactions cannot be the subject of a private Rule 10b-5 suit because they do not satisfy Morrison’s requirements.⁵⁵ While some academic focus has been directed at these non-definitional doctrinal questions, additional research is necessary.⁵⁶

B. Is Secondary Trading Crypto Asset Fraud Securities Fraud?

If secondary crypto asset traders incur trading loss because of fraud, they will be able to pursue Rule 10b-5 relief based on those secondary transactions only if the exchange-traded crypto asset at issue is an investment contract under Howey’s multipronged test.⁵⁷ Many issues pertinent to that definitional inquiry will be the same as those relevant to an assessment of whether a crypto asset at its offering stage satisfies Howey’s definition of an investment contract.⁵⁸ For instance, if an exchange-traded crypto asset is promoted for its use value because it enables its holders to use an associated application, and if the asset’s holders in fact hold the asset primarily for that purpose rather than its investment value, then Howey’s “expectation of profit” prong would not be met under Forman’s investment/consumption distinction.⁵⁹ This very issue has been litigated in cases in which a crypto asset was alleged to have been an investment contract at its offering stage.⁶⁰

But there are issues pertinent to the application of Howey in the context of exchange-traded crypto assets that are not present, or are much less salient, in the context of crypto assets at their offering stage. This Section explores a set of such issues relating to Howey’s common enterprise and efforts of others prongs.

1. Exchange-Traded Crypto Assets and Common Enterprise

Doctrinal development of Howey’s common enterprise prong, as with all other parts of Howey’s test, has occurred through investment contract cases involving a primary transaction, that is, a transaction in which investors purchased the instrument when it was first offered for sale directly or indirectly from the enterprise’s promoter.⁶¹ That was the case in Howey, for instance. The other investment contract cases to date have similarly involved primary transactions and include such varied examples as sale-and-leasebacks,⁶² annuities,⁶³ and crypto assets.⁶⁴ There are virtually no investment contract cases concerning secondary transactions, in which investors purchased the putative investment contract from other investors.⁶⁵

The factual orientation of the body of investment contract cases naturally has resulted in courts shaping investment contract doctrine around primary transactions. But a Rule 10b-5 case involving an exchange-traded crypto asset will involve secondary transactions, rather than primary transactions, and the two transactions differ in important ways. As noted, in a primary transaction, investors transact directly or indirectly with the promoter. In a secondary transaction, investors transact with their trading counterparties, perhaps with the involvement of one or more intermediaries, and those counterparties ordinarily will not be the promoter.⁶⁶ Also, depending on the circumstances, it may also be that when a secondary transaction occurs, the promoter who facilitated the instrument’s initial offering no longer has any meaningful involvement in the underlying enterprise, though there may be other non-investors who facilitate the enterprise.

In many instances, the legal rules that courts have developed in primary transaction cases concerning the investment contract question are equally sensible in secondary transaction cases. Take, for instance, the rule that Howey’s “investment of money” prong does not require a cash payment and instead is satisfied when any form of consideration is provided.⁶⁷ That rule is as sensible in the secondary transaction context as the primary transaction context, as consideration in either context may involve cash or noncash payment. That is not the case for the horizontal commonality test, one of the three commonality tests that courts have developed in primary transaction cases to evaluate the presence of common enterprise.⁶⁸ As discussed below, the horizontal commonality test, as it is presently articulated, is analytically ill-suited for use in secondary transaction cases because of the test’s requirement that investors’ assets be pooled.

i. Secondary Transactions, Horizontal Commonality, and the Pooling Requirement

The horizontal commonality test evaluates relationships among the investment contract’s investors⁶⁹ and inquires whether the investors’ fortunes are intertwined and collectively dependent on the success of the enterprise in which they are invested.⁷⁰ The test usually is defined in relation to a pooling requirement, which requires investors’ assets be combined and comingled in a manner that causes investors’ fortunes associated with the enterprise to be codetermined. Specifically, in the primary market transaction cases in which the test was developed, courts usually find horizontal commonality only when there is “the tying of each individual investor’s fortunes to the fortunes of the other investors by the pooling of assets.”⁷¹

A good description of the pooling requirement comes from the court in Savino v. E.F. Hutton:⁷²

“Pooling” has been interpreted to refer to an arrangement whereby the account constitutes a single unit of a larger investment enterprise in which units are sold to different investors and the profitability of each unit depends on the profitability of the investment enterprise as a whole. Thus, an example of horizontal commonality involving brokerage accounts would be a “commodity pool,” in which investors’ funds are placed in a single account and transactions are executed on behalf of the entire account rather than being attributed to any particular subsidiary account. The profit or loss shown by the account as a whole is ultimately allocated to each investor according to the relative size of his or her contribution to the fund. Each investor’s rate of return is thus entirely a function of the rate of return shown by the entire account.⁷³

In other words, pooling can be understood as the usual mechanism in a primary transaction case that causes investors’ fortunes in the enterprise to be interconnected and dependent on the enterprise’s success. Consider, for instance, the Seventh Circuit’s decision in Milnarik v. M-S Commodities.⁷⁴ There, the plaintiff opened a discretionary trading account in commodities futures with a broker.⁷⁵ Many other investors also had opened their own discretionary trading accounts with the same broker.⁷⁶ The plaintiff’s account sustained losses, and the plaintiff sued for violation of Section 5’s registration requirement, on the theory that the discretionary trading account contract was an investment contract.⁷⁷ The Seventh Circuit rejected that claim because it found no pooling and thus no investment contract under Howey.⁷⁸

The absence of the pooling of investors’ funds unsurprisingly led to the court’s conclusion in Milnarik that the investors’ fortunes were not intertwined and mutually dependent on the success of their collective trading accounts.⁷⁹ Because investors’ accounts were separately maintained and their funds not combined, the value of any given investor’s trading account was independent of the value of any other investor’s trading account.⁸⁰ This would not have been the case had the arrangement instead involved the defendant combining the various investors’ funds in a single account, executing trades with respect to that single account, and then distributing any profits to the investors. If this had been the case, then every investor would have been made financially better off as the account became more profitable and financially worse off as its value dropped. In other words, the aggregation of investors’ funds would have caused the investors’ individual financial interests in the combined account to be tethered together and dependent on the underlying enterprise.

But pooling is not an analytically meaningful way of evaluating the presence of horizontal commonality in an investment contract case involving secondary transactions. In primary market transactions, like the ones in Howey and Milnarik, investors will have transacted directly or indirectly with the promoter. In such cases, the promoter may have pooled investors’ assets in a manner that caused investors’ fortunes in the enterprise to rise or fall together, as horizontal commonality requires.

On the other hand, secondary market investors will have transacted with trading counterparties. If those trading counterparties were separate persons or economic entities, then those counterparties would have no reason to aggregate the amounts they received from their sales, except in rare and idiosyncratic circumstances. If, alternatively, the trading counterparties included one or more persons or entities who sold to multiple traders, then it is possible that the counterparty aggregated the amounts it received for its sales, because it may have some business or other reason for doing so. Nonetheless, the counterparty’s aggregation of secondary investors’ assets, unlike the promoter’s aggregation of primary market investors’ assets, will usually not create a linkage between the secondary investors’ financial interests in the enterprise because the success of the underlying enterprise will not turn on whether the counterparty aggregated the sales proceeds it received or how it used any aggregated amounts. Simply put, there is no analytical justification for the horizontal commonality question in a secondary transaction case to turn on the pooling requirement.

An evaluation of horizontal commonality in a secondary transaction case using the lens of pooling can be both underinclusive and overinclusive. First, in a secondary transaction case, investors’ financial interests in the underlying endeavor may still be interdependent even if the investors’ sales proceeds were not aggregated. To see this, suppose that in Howey, each of the primary market investors had sold their interests to another, later stage investor. Those secondary investors’ purchase amounts presumably will not have been pooled. The secondary investors purchased from the primary market investors, rather than the promoters, and those primary market investors would ordinarily have no reason to aggregate their individual sales proceeds. Nonetheless, horizontal commonality would be present with respect to the secondary investors because those investors’ profits would have been intertwined and dependent on the success of the enterprise. If, for instance, there was a poor harvest because of the promoters’ neglect or malfeasance, each of the secondary investors would have seen their profits fall.

Second, just as the absence of an aggregation of investors’ assets does not demonstrate a lack of horizontal commonality, the presence of asset aggregation, by itself, may not necessarily establish horizontal commonality in a secondary transaction case. In the example in the previous paragraph, suppose that the primary market investors in fact had aggregated the proceeds from their resales because, for instance, they wanted to collectively invest in a new venture. That pooling of the secondary investors’ assets by the primary market investors itself has no bearing on whether the secondary purchasers’ profits associated with the orange orchard enterprise would have moved in tandem as required by horizontal commonality.

Imposing a pooling requirement in secondary transaction cases not only would be analytically infirm but also would prevent nearly all investment contracts that arise in connection with secondary transactions from satisfying the horizontal commonality test.⁸¹ That would effectively cause those transactions to be categorically excluded from the investment contract category in those jurisdictions in which horizontal commonality is the only recognized test for common enterprise.⁸² Such limitation finds no basis in logic or public policy and also runs roughshod over the Supreme Court’s directive that the term security be interpreted in fidelity to economic reality and not hindered by rigid formalities.⁸³

ii. Generalization of the Horizontal Commonality Test

Because it is logically inapt in secondary transaction cases, the pooling requirement renders the horizontal commonality test ill-suited for use in those cases. Hence, the test must be appropriately generalized so that it is articulated in a manner that renders it sensible both in secondary transaction cases and the primary transaction cases in which it and Howey’s other rules have been developed. As discussed below, the necessary reformulation of the horizontal commonality test requires only a slight generalization of the test from its present form.

As an initial observation, recall that pooling is neither necessary nor sufficient for investors’ profits to be intertwined and mutually dependent on the success of the underlying enterprise as doctrinally required. Instead, as discussed above, pooling is the usual way that the requisite financial linkages arise in a primary transaction case. In other words, pooling is the usual path to interrelated investor profits in a subset of investment contract cases. An appropriately generalized articulation of the horizontal commonality test must recognize pooling as just one possible mechanism that ties investors’ financial interests in the enterprise together.

So that it has a sensible analytical meaning in both primary transaction cases and secondary transaction cases, the horizontal commonality test must be framed so that the test is met whenever the pooling of investors’ assets or some other non-pooling mechanism causes investors’ fortunes to be tied to one another and dependent on the success of the enterprise in which they are invested. In other words, the horizontal commonality rule must be articulated so that it accurately reflects that pooling is but one mechanism that results in investors’ profits being intertwined, not the only mechanism. Note that the generalized test does not merely require that pooling or some other mechanism caused investors’ fortunes to be tied together but, consistent with the underlying analytical underpinning of the test, also requires their fortunes to be dependent on the underlying enterprise.⁸⁴

The generalized test is consistent with Howey, in that there is nothing in the opinion indicating that the Court sought to impose a pooling requirement, even in primary market cases. In fact, it is difficult to support a conclusion that there was a pooling of investors’ assets in Howey, and for that reason the presence of horizontal commonality under the test’s present formulation. In Howey, the promoters sold each investor their own tract of land and an individual service contract.⁸⁵ The promoter did not aggregate investors’ purchase amounts and then use that aggregated amount to sell investors’ a single tract of land serviced by the promoter in which each investor maintained a fractional interest, as the usual definition of pooling would require.⁸⁶

The proposed generalization is superior to the present articulation that implicitly assumes that pooling is the only path to investor wellbeing interdependence. First, a primary transaction case in which a court would find horizontal commonality under the present test would continue to satisfy the horizontal commonality test under the generalized test outlined above. The presence of pooling necessary for a finding of horizontal commonality under the current test would also cause the generalized test to be met.

Second, the generalized test does not excessively broaden the scope of horizontal commonality in primary transaction cases. If a primary transaction case would not satisfy the horizontal commonality test as it is presently articulated because of a lack of pooling, the generalized test would admit a finding of horizontal commonality only if there was some other mechanism that caused investors’ profits to be intertwined and dependent on the success of the underlying enterprise. For instance, returning to Milnarik, there are no facts in the opinion suggesting that there was some non-pooling mechanism that caused investors’ profits to be intertwined.⁸⁷

The generalized formulation would admit a broader array of investment contracts in primary transaction cases than under the current formulation, but these would be sensible additions. For instance, suppose in Milnarik, the broker’s policy and practice was to execute identical transactions for each of the accounts over which it had discretionary authority. In this case, while there would be no pooling of the investors’ assets,⁸⁸ there would be horizontal commonality under the generalized test, as the value of investors’ portfolios would move in unison because of the broker’s trading policy and practice. The investors in this example can be understood to be in a common enterprise with one another because the value of each of their accounts is dictated by the same trading practice, even though their funds were not pooled.

Unlike the present restrictive formulation, the generalized formulation would result in investment contracts that arise in connection with secondary transactions satisfying the horizontal commonality test even in the absence of pooling, so long as there was some non-pooling mechanism that met the doctrinal requirement that investors’ profits were interrelated and dependent on the success of the underlying enterprise. The generalized test is sufficiently circumscribed and not all investment contracts arising in connection with secondary transactions will meet it. For instance, suppose that the investors in Milnarik had sold their interests in their accounts to other investors, with all other facts the same. In addition to an absence of pooling, there would be no other mechanism connecting the profits of those later investors to one another and thus no finding of horizontal commonality as to those secondary transactions under the generalized test.

a. Application to Exchange-Traded Crypto Assets

Investors in a crypto asset offering ordinarily will have the proceeds from their purchases pooled by the crypto asset’s sponsors to facilitate the asset and any associated applications.⁸⁹ That may not be the case for secondary crypto asset traders who transact on crypto exchanges, as those transactions would have occurred with trading counterparties and those trading counterparties, in turn, may have had no reason to pool the amounts they received. Despite any lack of pooling of the secondary investors’ purchase amounts, the crypto asset may still meet the generalized horizontal commonality test through its price, which can serve as a potential non-pooling mechanism that causes the pecuniary interests of the crypto asset’s traders to be linked and dependent on the success of the underlying enterprise, that is, the crypto asset and any associated applications.

Start first with the requirement that secondary traders’ fortunes in the crypto asset are linked. A given exchange-traded crypto asset can trade on multiple exchanges,⁹⁰ which may either be centralized or decentralized. A centralized crypto exchange will involve an intermediary to facilitate transactions, while a decentralized crypto exchange will not. The two types of exchanges also may differ in their pricing mechanism. A centralized crypto exchange will use a limit order book to match buyers and sellers, and therefore the exchange’s prices will be set directly by traders’ submitted orders.⁹¹ Rather than relying on a limit order book, a decentralized exchange may facilitate transactions using an automated market maker, in which prices are set through a pricing algorithm.⁹²

Whether a crypto exchange uses a limit order book or an automated market maker, the exchange’s pricing mechanism will generate, for a given crypto asset, a single price at which any trader can transact, holding fixed other traders’ transactions. That single trading price links together the financial wellbeing of all the crypto asset’s secondary investors. Every investor holding the crypto asset is made financially better off as the crypto asset’s price on the exchange rises and each is made worse off as the price drops. The fact that a crypto asset trades on multiple exchanges does not break the linkages between the financial wellbeing of traders on different exchanges since arbitrage causes crypto asset prices across different exchanges to closely align.⁹³

A crypto asset’s trading price thus provides a mechanism that links together its secondary investors’ financial interests. It is the case that a crypto asset’s trading price will be influenced by market fluctuations, but the doctrinal relevance of that observation is better understood as concerning Howey’s efforts of others prong, which is discussed below, rather than the common enterprise prong.⁹⁴

A crypto asset’s price also may provide the doctrinally necessary linkage between the financial interests of the crypto asset’s secondary traders and success of the underlying enterprise. Empirical studies show that the prices of exchange-traded crypto assets generally respond in the directionally appropriate way to material, public information.⁹⁵ For this reason, as a general matter, the financial interests of a crypto asset’s holders will be dependent on the success of the crypto asset and any associated applications. If, for instance, the crypto asset undergoes some value-enhancing change, then once that change is publicly known, the crypto asset’s price would be expected to increase, because of the directionally appropriate responsiveness of crypto asset prices to material, public information as a general matter.

Nonetheless, it is possible that while the prices of crypto assets—as an asset class—generally respond in a directionally appropriate way to material, public information, that is not the case for any given exchange-traded crypto asset. If the specific crypto asset being evaluated as a potential investment contract lacks that requisite informational responsiveness, then the crypto asset’s price would not connect the financial interests of the crypto asset’s secondary traders with success of the underlying enterprise. For instance, if the crypto asset underwent some value-reducing change, but the asset’s price was either impervious to material, public information or moved in the directionally inappropriate way to material, public information, then the value reducing change would either have generated no change to the crypto asset’s price (and thus would have made the crypto asset’s holders no better or worse off) or increased the crypto asset’s price (and thus would have made the crypto asset’s holders better, not worse, off).

Accordingly, a crypto asset’s price can serve the role of a non-pooling mechanism that satisfies the requirements of the generalized horizontal commonality test only if the crypto asset’s price generally responds to material, public information in a directionally appropriate way. If the plaintiffs in a crypto asset case implicating the Howey question rely on the asset’s price to serve that non-pooling role, then the generalized horizontal commonality test demands that there be a showing of the necessary price responsiveness. The plaintiffs can make that showing using an event study that demonstrates that the crypto asset’s price generally responds to material, public information in a directionally appropriate way.

If the plaintiffs cannot establish the necessary price responsiveness of the crypto asset, then the asset’s price cannot serve the role of a non-pooling mechanism that satisfies the requirements of the generalized horizontal commonality test, because in that circumstance, the plaintiffs will not have established that the asset’s price connects the secondary investors’ pecuniary interests to the success of the enterprise in which they are invested. In this case, the generalized horizontal commonality test will be met with respect to the at-issue crypto asset only if there was pooling of the secondary traders’ purchase amounts or there was some non-pooling mechanism other than the crypto asset’s price that caused the pecuniary interests of the crypto asset’s traders to be linked and dependent on success of the crypto asset and any associated applications.

b. Other Reformulations of the Horizontal Commonality Test

In addition to generalizing Howey’s horizontal commonality test in the manner discussed above, there are other sensible ways to reformulate the test so that it is suitable for use in both secondary transaction and primary transaction cases. One possibility is to broaden the test so that it is also met in secondary transaction cases if (1) there was pooling of the primary market investors’ assets, and (2) the primary market investors purchased the instrument only because they reasonably expected the ability to resell their interests to secondary investors. If these two conditions are met, then the secondary investors can be understood to have effectively pooled their assets, in the sense that the reasonable expectation of eventual resales to secondary investors was a necessary condition to the primary market investors engaging in the transactions that resulted in their assets being pooled. This type of pooling by the secondary market investors can be referred to as effective pooling.

Finally, unlike the horizontal commonality test, the two vertical commonality tests do not require reformulation to be analytically workable notions in secondary transaction cases. Strict vertical commonality is met when “the fortunes of investors [are] tied to the fortunes of the promoter” and broad vertical commonality is met when the “the fortunes of the investors [are] linked . . . to the efforts of the promoter.”⁹⁶ It is worth observing that the role of the promoter in secondary transaction cases will be different than in primary transactions cases. In a primary transaction case, the promoter ordinarily will have facilitated the enterprise in part by soliciting investors. In a secondary transaction case, the promoter likely will not have engaged in any such solicitation because it usually will not have been an active participant in the secondary markets, though the promoter may have directed other efforts to facilitate the enterprise.

c. The Irrelevance of a Contractual Relationship

Finally, while a primary transaction case ordinarily will involve contracts between the promoter and the investors, that usually will not be the case in secondary transaction case, because secondary market traders will not have transacted with the promoter, except in rare circumstances.⁹⁷ Nonetheless, the absence of a contractual relationship between the promoter and investors—whether those investors were secondary market traders or purchasers in a primary market transaction—does not provide a proper basis for defeating a finding of an investment contract. In Howey, the Supreme Court did not limit the investment contract category to just formal contractual arrangements between the promoter and the investors. Instead, the Court articulated the definitional category more expansively so that, in addition to contractual arrangements, the investment contract category also encompasses “transactions” and “schemes.”⁹⁸ Though the Court did not define the term “scheme,” had it meant for scheme to simply mean a series of contractual arrangements, then it would have just used the term “contracts” rather than scheme.

Howey’s lack of a contract requirement is sensible. As a matter of public policy, the investor protection objectives of the securities laws are not weakened simply because the relevant transactions were not undertaken pursuant to a formal contract.⁹⁹ And while Howey and the other Supreme Court’s investment contract cases to date have involved contractual arrangements between the promoter and the investors, this common factual feature has not become a part of the Court’s enunciated rule.¹⁰⁰ Instead, the Supreme Court’s post-Howey investment contract cases have consistently invoked Howey’s articulation of the investment contract category as encompassing schemes.¹⁰¹

Stated differently, simply because a set of cases share a common factual predicate does not mean that the factual predicate necessarily becomes a component of the pertinent rule of law. As another example of this somewhat unremarkable observation, note that the profits that investors received in the Supreme Court’s investment contract cases arose through income generated by a business enterprise that was organized and facilitated by the promoter. But the fact that these cases share this common factual predicate does not mean that the factual predicate is part of the operative rule. As the cases recognize, investors’ “profits” for purposes of the Howey determination are not limited to proceeds from an investment in a business enterprise and instead include capital appreciation more generally.¹⁰² This observation is especially relevant to the crypto asset context because, as noted in Section I.B above, a crypto asset’s holders ordinarily do not receive and are not entitled to any income arising from development and operation of the crypto asset or any associated applications.

2. Exchange-Traded Crypto Assets and Efforts of Others

For a given instrument to be an investment contract, it must also satisfy Howey’s efforts of others prong. In the context of an exchange-traded crypto asset, that requirement will be met if investors reasonably expected the crypto asset’s value to be significantly determined by the entrepreneurial or managerial efforts of others.¹⁰³ Whether this requirement is met will depend on the at-issue crypto asset’s specific features, including the extent of its operational decentralization. This subpart explores issues pertinent to application of Howey’s efforts of others prong in the secondary trading crypto asset context.

The discussion below makes two points regarding Howey’s efforts of others prong. First, the discussion explains why operational decentralization, by itself, is not a per se bar to Howey’s efforts of others prong being met, though there may be specific factual features that result in a particular exchange-traded crypto asset not satisfying that Howey element. Second, the discussion below also explains the doctrinal irrelevancy of investors’ expectations concerning the use of their sales proceeds.

i. Why Operational Decentralization Is Not a Per Se Bar

The first issue to consider is whether a crypto asset’s operational decentralization should preclude satisfaction of Howey’s efforts of others prong. To structure the analysis, consider two possibilities. The first possibility is that the exchange-traded crypto asset has achieved some operational decentralization but a centralized third party continues to direct some entrepreneurial or managerial efforts toward the crypto asset’s success. The second possibility is that the crypto asset has achieved complete operational decentralization, in the sense that no centralized third party directs entrepreneurial or managerial efforts toward the success of the crypto asset; instead, those efforts are undertaken by a decentralized group of unaffiliated persons.¹⁰⁴

a. Continued Involvement by Sponsors or Other Centralized Third Party

If the crypto asset’s sponsors or some other centralized third party continue to exert entrepreneurial or managerial efforts such that investors reasonably expect those efforts to significantly determine the crypto asset’s value, as usually embodied by its trading price, then Howey’s efforts of others prong will be met.¹⁰⁵ This observation is reflected in courts’ determinations of the Howey question as it pertains to crypto assets at their offering stage,¹⁰⁶ which have found the efforts of others prong to have been satisfied because the crypto asset’s investors reasonably expected their profits to arise from the sponsor’s entrepreneurial or managerial efforts.¹⁰⁷

Presently, nearly all crypto assets appear to be associated with one or more centralized bodies that have at least some involvement facilitating their success, including through developing, operating, managing, and promoting the crypto assets and any associated applications.¹⁰⁸ While the importance of the efforts of such centralized bodies on a given crypto asset’s success may ebb as the crypto asset matures and becomes the subject of additional secondary trading, those efforts may remain instrumental to the crypto asset’s success. Even crypto assets like ether that have experienced significant operational decentralization have at times benefited from the focused efforts of a collective group of developers.¹⁰⁹

Whether the presence and activities of these centralized groups is sufficient to satisfy Howey’s efforts of others prong will hinge on the nature of the centralized third party’s involvement. A series of issues await judicial determination. For instance, a crypto asset or its associated applications, if any, ordinarily will have a presence on software code repositories and messaging platforms, where the crypto asset’s developers, investors, and others come together and communicate to improve the asset or its associated applications.¹¹⁰ Some of these activities may be managed by the crypto asset’s sponsors rather than investors.¹¹¹ If those managerial efforts are important to the viability of the crypto asset or any associated applications, then that would militate in favor of a finding that Howey’s efforts of others prong was met.¹¹²

The availability of pricing data opens the possibility of using empirical techniques to assess Howey’s efforts of others prong in investment contract cases involving an exchange-traded crypto asset. An assessment of whether a crypto asset’s trading price was influenced by the activities of a centralized body is relevant to the efforts of others question, which demands a determination whether reasonable investors would expect the asset’s value, as ordinarily measured by its price, to be significantly determined by the entrepreneurial or managerial efforts of the centralized body. If a crypto asset’s price was influenced by the efforts of a centralized body, then the crypto asset’s price would be expected to move in a directionally appropriate way once value-relevant activity by the centralized body became known to the market. For instance, an announced improvement in a crypto asset’s associated application by the centralized body would be expected to cause the crypto asset’s price to increase, assuming that Howey’s efforts of others prong was met.

An event study therefore could be used to assess the extent to which the at-issue crypto asset does or does not respond to potentially value-relevant activities of a centralized body.¹¹³ However, the use of event studies in that context should be undertaken with care. First, there are important methodological considerations, such as the issue of low power, which are amplified in the crypto asset context because of high crypto asset price volatility.¹¹⁴ Second, the event study may be underinclusive in that it would not capture the effects of a centralized body’s ongoing influence on a crypto asset’s price and instead would be limited to analysis of how episodic events associated with the centralized body affected the asset’s price. Finally, even if the event study showed that the crypto asset’s price responds to value-relevant activities of a centralized body, that finding would not fully resolve the pertinent question of whether investors reasonably expected the crypto asset’s price to be significantly determined by the centralized body’s entrepreneurial or managerial efforts, though it would be one important determinant in that inquiry.

b. Absence of Any Centralized Third Party

Now, suppose instead that the crypto asset is fully decentralized in that there is no centralized third party that directs entrepreneurial or managerial efforts toward the crypto asset’s success; instead, those efforts are undertaken by a decentralized group of unaffiliated persons. The prospect of full decentralization raises the question of whether Howey’s efforts of others prong requires the existence of one or more centralized third parties whose entrepreneurial or managerial efforts significantly affect the investment contract’s success. If such centralized third parties in fact are necessary, then sufficient decentralization would by itself preclude satisfaction of Howey’s efforts of other prong.

SEC staff guidance concerning the application of Howey in the crypto asset context can be reasonably interpreted to envision the presence of one or more such centralized third parties for purposes of evaluating Howey’s efforts of others prong.¹¹⁵ That guidance defines an “Active Participant” as “a promoter, sponsor, or other third party (or affiliated group of third parties)” and then goes on to explain that Howey’s efforts of others prong in the crypto asset context requires an inquiry into whether “the purchaser reasonably expect[s] to rely on the efforts of an [Active Participant]” and the nature of those efforts.¹¹⁶ In other words, the SEC staff’s definition of an Active Participant could be read to exclude the efforts of a decentralized group of unaffiliated third parties from meeting Howey’s efforts of others prong. Scholars also have proposed tests for assessing Howey’s efforts of others prong in the crypto asset context that similarly appear to hinge on the presence of one or more centralized third parties, such as the crypto asset’s sponsors.¹¹⁷

The well-publicized 2018 speech by the SEC’s then-Director of Corporate Finance, Bill Hinman, can also be interpreted as implicitly adopting the notion that Howey’s efforts of others prong requires the presence of a centralized third party. In that speech, then-Director Hinman observed that increasing operational decentralization during a crypto asset’s lifecycle could cause a crypto asset that previously satisfied Howey’s test of an investment contract to no longer satisfy that test because no centralized group is tasked with the crypto asset’s entrepreneurial or managerial functions.¹¹⁸ That proposition has been featured prominently in crypto asset litigation that implicate the Howey question¹¹⁹ and has been the subject of academic inquiry.¹²⁰

Howey should not be read as requiring the presence of one or more centralized third parties for purposes of its efforts of others prong. There is nothing in the language or reasoning of Howey suggesting that the requisite entrepreneurial or managerial efforts must be undertaken by a centralized third party.¹²¹ Howey’s efforts of others prong instead is better understood as requiring investors to have reasonably expected their profits to have been significantly determined by the entrepreneurial or managerial efforts of those other than the investors themselves, whether or not those “others” constituted a centralized group.¹²²

Compared with a formulation of Howey’s efforts of others prong that requires the presence of a value-enhancing centralized party, an advantage of a formulation that permits the prong to be satisfied even in the absence of a centralized party is that it better focuses the analysis on an essential feature of an investment: delegation of entrepreneurial or managerial efforts to those outside of the investor class. So long as investors are sufficiently passive, in the sense they ceded sufficient entrepreneurial and managerial efforts to others, the putative investment contract will bear this indicium, independent of the degree of centralization of the group to whom those efforts were delegated. The investment contract cases addressing whether investors’ managerial involvement in the enterprise defeats Howey’s efforts of others prong embody this observation. Those cases evaluate the efforts of others prong by focusing on the extent of investors’ passivity.¹²³

Because Howey’s efforts of others prong should not be understood as mandating the presence of a value-generating centralized body, the prong may be met even if a crypto asset has undergone substantial operational decentralization such that there is no centralized third party that exerts entrepreneurial or managerial efforts influencing the crypto asset’s value. The relevant inquiry is whether the crypto asset’s investors reasonably believed the asset’s value was significantly determined by the entrepreneurial or managerial efforts of individuals or entities other than the investors themselves. If the asset’s investors had those reasonable expectations, then Howey’s efforts of others prong would be met even if the pertinent efforts were undertaken by a dispersed and large number of unaffiliated individuals or entities.

Not all exchange-traded crypto assets will satisfy Howey’s efforts of others prong. First, if the putative investment contract is such that it requires no ongoing entrepreneurial or managerial efforts to succeed, then Howey’s efforts of others prong would not be met. Mining, the energy-intensive process of validating transactions on proof-of-work blockchains,¹²⁴ should be considered ministerial rather than entrepreneurial or managerial.¹²⁵ Second, if the investors were the ones who significantly directed the entrepreneurial or managerial efforts pertinent to the investment contract’s success, then Howey’s efforts of others prong also will not be met.¹²⁶ This may be the case if the crypto asset provided investors with extensive governance rights that they can readily exercise.

Additionally, Howey does not admit as investment contracts instruments whose value is driven almost entirely by market forces. In such a circumstance, it would not be reasonable for the putative investment contract’s investors to believe that its value is significantly determined by any person’s entrepreneurial or managerial efforts.¹²⁷ That is the case, for instance, for such varied tradeable items such as gold, baseball cards, and bitcoin, which are all understood to have their value driven almost entirely by market forces rather than by any person or persons’ entrepreneurial or managerial efforts. At the same time, even if the crypto asset’s price is determined in part by market forces—for instance, if its price moves in part because of price changes of another crypto asset such as bitcoin—investors may still reasonably expect the asset’s price to be significantly determined by the entrepreneurial or managerial efforts of others, in which case Howey’s efforts of others prong will be met.¹²⁸

ii. The Irrelevance of Investors’ Expectations Concerning the Use of Their Sales Proceeds

In a primary transaction case, investors’ sales proceeds ultimately will flow to the promoter, who then is expected to use the proceeds to facilitate the enterprise in which the purchasers are invested. That will not be the case in a secondary transaction case. In this circumstance, investors’ sales proceeds instead will flow to the trading counterparties, who ordinarily will not be the enterprise’s promoter and also will not direct the sales proceeds to the promoter. For instance, in a secondary crypto asset transaction, the purchasers’ proceeds usually will not flow to the crypto asset’s sponsors and instead will be retained by the trading counterparties. For this reason, while investors in a primary transaction case may have a reasonable expectation that their sales proceeds will be used by the promoter to facilitate the enterprise in which they are invested, investors in a secondary transaction case generally will not reasonably have those expectations, as their sales proceeds will directly flow to trading counterparties, who will usually not be the promoter, though investors may reasonably have those expectations in certain circumstances.¹²⁹

The fact that investors in a secondary transaction case may not reasonably believe that their sales proceeds will be used by the promoter to facilitate the enterprise is doctrinally irrelevant to Howey’s efforts of others prong. Howey’s efforts of others prong requires that investors reasonably expected their profits to have been significantly determined by others’ entrepreneurial or managerial efforts, and the operative rule makes no mention of investors’ expectations concerning the use of their sales proceeds.¹³⁰ So, for example, while investors’ sales proceeds in a secondary crypto asset transaction case may not have flowed to the crypto asset’s sponsors, Howey’s efforts of others prong will still have been met so long as traders reasonably expected the crypto asset’s value to have been significantly determined by the entrepreneurial or managerial efforts of others, such as the sponsor.¹³¹ In other words, the appropriate focus of Howey’s efforts of others prong is on investors’ beliefs about whose entrepreneurial or managerial efforts significantly determined their expected profits, not investors’ beliefs about how their sales proceeds specifically would be put to use.¹³²

There is no public policy justification for limiting the investment contract category to only those circumstances in which investors reasonably expected the promoter to use their funds to facilitate the enterprise in which they are invested. First, the adoption of that limiting rule would permit instruments that otherwise would be investment contracts to permissibly be the subject of an unregistered public offering if the offering were structured in a manner that investors could not readily discern whether their proceeds would flow to the sponsor.¹³³ For example, if a promoter simultaneously undertook multiple investment projects, the promoter could pool all investors’ funds, which may result in investors of any given project not knowing whether the promoter specifically used their funds to finance their project, even though there was no question that the investors’ profits would be significantly determined by the promoter’s entrepreneurial or managerial efforts.

Second, limiting the investment contract category so that it only encompasses circumstances in which investors reasonably expected the promoter to use their funds to facilitate the enterprise would exclude an expansive swath of secondary transaction investment contract cases from the scope of federal securities law. This near wholesale carveout of an entire transaction class from the reach of the securities laws would serve no public policy goal and instead would undermine the investor protection objectives that the securities laws seek to promote.

C. The Value of Additional Definitional Clarity

Crypto asset sponsors and crypto exchanges sometimes criticize Howey’s investment contract analysis when applied to the crypto asset context as unreasonably uncertain.¹³⁴

20231119200747/https://www.sec.gov/files/rules/petitions/2022/petn4-789.pdf] (“Applying the Howey test[] piecemeal to an entire market sector has proven itself to be an unworkable solution.”). Any offering of securities, unless exempted, must be registered, and any exchange that facilitates securities transactions must register, unless exempted. It is thus important to crypto asset sponsors and exchanges that they have clear guidance on which of the crypto assets they may offer or list are securities under federal securities law. Crypto asset sponsors and crypto exchanges contend that Howey fails to clearly inform them which crypto assets may be securities, and thus subject them to federal securities law, including its robust registration requirements.¹³⁵ The effect of Howey’s uncertainty on crypto asset sponsors and exchanges is heightened because the pertinent transactions are not one-off or episodic transactions but instead are the foundations of those market participants’ business models.

The discussion in the previous Section shows that the effects of any uncertainty in Howey’s application in the crypto asset context extends beyond crypto asset sponsors and exchanges and also encompasses crypto asset traders. Crypto asset traders who are subject to secondary crypto asset trading fraud, or other forms of misconduct prohibited by the federal securities laws such as market manipulation, may seek to recover through claims asserted under the securities laws but only to find their claims dismissed on grounds that the pertinent transactions did not involve securities.¹³⁶

As the case law grows and matures, crypto asset market participants’ uncertainty about Howey’s analysis in the crypto asset context should abate.¹³⁷ The opinions courts have authored to date in crypto asset cases concerning the investment contract question have been detailed and reasoned (even if one disagrees with their reasoning or conclusions).¹³⁸ Future opinions at that level of care should provide market participants with a clearer understanding of when crypto asset transactions are within the scope of securities law. SEC staff may also offer additional guidance on crypto assets and the definitional question.¹³⁹

The pace of such doctrinal development may be slower than market participants prefer, especially crypto asset sponsors and exchanges.¹⁴⁰ Further clarity may come in the form of legislation that seeks to articulate with more specificity the circumstances when a given crypto asset will be within the scope of securities law. Some of the introduced or contemplated bills would define a large class of crypto assets as commodities rather than securities.¹⁴¹ To the extent a crypto asset is deemed to be a commodity rather than a security, traders sustaining losses from secondary trading crypto asset fraud could seek recovery through a CFTC Rule 180.1 class action rather than a Rule 10b-5 class action.¹⁴² If the substantive claim underlying secondary trading crypto asset fraud class actions were to shift to Rule 180.1, the public policy discussion in Part III below would also apply in that context.

Finally, it is worth observing that certain aspects of the securities laws’ registration and post-offering disclosure requirements are not especially well-suited for the crypto asset context. With respect to the registration process, scholars have observed that because the disclosures required by registration were developed with an eye to offerings of more conventional securities like stocks and bonds, they do not always align well with crypto asset offerings.¹⁴³ This point about incongruity also applies to the regulatorily mandated post-offering disclosures. For instance, suppose that a crypto asset sponsor conducts a registered offering of the crypto asset. Through section 15(d) of the Securities Exchange Act,¹⁴⁴ the sponsor becomes subject to the ongoing reporting requirements of section 13(a) of the Exchange Act, such as the requirement to prepare and file an annual report.¹⁴⁵ Suppose that, at some point, the crypto asset undergoes complete operational decentralization such that the crypto asset sponsor ceases to be involved in any aspect of the crypto asset and instead the development, operation, management, and promotion of the crypto asset and any associated applications are undertaken by a decentralized group of other stakeholders.

In this case, should the sponsor, as the crypto asset’s issuer, still be obligated to make the required ongoing disclosures, on the ground that section 13(a) obligates the “issuer” to make those disclosures?¹⁴⁶ Alternatively, if the ongoing reporting obligations instead were to somehow apply to the decentralized non-issuer group, then how, as a practical matter, could such a diffused group be able to prepare the necessary periodic and current reports? There is also the question of whether the information called for by the required post-offering disclosures is meaningful and appropriate for the crypto asset context. These questions demonstrate that some regulatory effort should be directed at reformulating the post-offering disclosure requirements so that they are better suited for the crypto asset context.¹⁴⁷

III. PUBLIC POLICY CONSIDERATIONS PERTINENT TO CRYPTO ASSET-BASED RULE 10B-5 CLASS ACTIONS

In addition to the doctrinal propriety of defrauded crypto asset traders relying on Rule 10b-5 class actions, there is the normative question of whether defrauded traders should be able to rely on Rule 10b-5 class relief as a matter of public policy. That issue arises in part because of the considerable skepticism that some legal scholars have expressed about the use of Rule 10b-5 class actions in stock-based cases as effective compensation and deterrence mechanisms.

The assault on stock-based Rule 10b-5 class actions has primarily been through two longstanding critiques—the circularity and diversification critiques.¹⁴⁸ More recently, some scholars have challenged the relevancy of those critiques,¹⁴⁹ while others have articulated theories that provide alternate public policy justifications for stock-based Rule 10b-5 class actions, with the leading example being a corporate governance justification for stock-based Rule 10b-5 class actions.¹⁵⁰ Despite the lingering skepticism by some academics that stock-based Rule 10b-5 class actions fail to achieve their public policy objectives, they remain a core fixture of securities practice.

If the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than stock-based Rule 10b-5 class actions, then we may want a preemptive curtailment of those litigations through legislative action or doctrinal reorientation before they become commonplace as stock-based Rule 10b-5 class actions have become. More generally, if the public policy justifications are significantly weaker for crypto asset-based Rule 10b-5 class actions than stock-based ones, that would justify different legal treatment of the two types of class actions. This Part of the Article evaluates that particular public policy question viewed through the lens of the circularity and diversification critiques and the corporate governance justification.

The public policy determinations below are mixed and preliminary in part, but do not lend support to the notion that the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than the public policy justification for stock-based Rule 10b-5 class actions. First, the circularity critique—the leading critique in the stock-based Rule 10b-5 context—is significantly attenuated in the crypto asset context because the principal factors supporting the circularity critique in the stock context are substantially absent in the crypto asset context. There are countervailing reasons why the diversification critique may be more or less relevant in the crypto asset context than in the stock context, but no reason to expect that the diversification critique has significantly more force in the crypto asset context than in the stock context. On the other hand, the corporate governance justification loses relevance in the crypto asset context.

Sections A, B, and C below address the circularity critique, the diversification critique, and the corporate governance justification, respectively. Section D provides a few comments concerning the issue of frivolous litigation.

A. The Circularity Critique

The key critique against Rule 10b-5 stock-based class actions is circularity, which is the idea that when class actions settle, as nearly all do, the settlement is ultimately paid for by the company’s shareholders.¹⁵¹ This serves to undermine both the deterrence and compensatory features of the class action process. Because of its centrality to public policy analysis of securities class actions, it is valuable to work through some of the details of the circularity critique before turning to its applicability in the crypto asset context.¹⁵²

1. Circularity in the Stock Context

Circularity arises in the stock context for two reasons. The first driver of the circularity critique is that individually named directors and officers usually will not directly pay any of the settlement amount because of D&O insurance and indemnification. A study by Klausner, Hegland, and Goforth, for instance, evaluated a sample of over two hundred and fifty securities class actions that had settled and found that directors and officers did not make any payments in 98% of those cases.¹⁵³ That number is not surprising given that nearly all public companies purchase D&O insurance.¹⁵⁴ Empirical studies also indicate that directors and officers may not pay any reputational penalty when they are accused of fraud.¹⁵⁵ The lack of director and officer liability thus mitigates the deterrence effect of securities class actions on director and officer conduct.

The second driver of the circularity critique is the relationship between shareholders and the company’s net income. Because individually-named defendants ordinarily do not contribute to stock-based securities class action settlements, settlements instead are paid for by the company, either directly or through the company’s D&O insurance, or some combination of the two.¹⁵⁶ Accordingly, settlement of a Rule 10b-5 class action against an issuer and its directors and officers usually will be funded by the issuer directly or indirectly through the cost of the D&O insurance that the issuer has purchased. Because shareholders are the company’s residual claimants, these corporate expenditures associated with settlement payments are ultimately borne by shareholders in the form of diminished cash flow.

One group of shareholders bearing the cost of settlement will be the same ones who were injured by the fraud (assuming they did not sell their shares). Because these shareholders will be partially footing their own recovery, full compensation will not be achieved. The other of the firm’s current shareholders responsible for the settlement will be ones who were not class plaintiffs. These shareholders have no direct responsibility for the fraud but will be paying for the injured shareholders’ recovery, which implicates fairness considerations.

The circularity critique can be more formally illustrated through a simple model that embodies these observations. Consider a stock-based Rule 10b-5 class action in which the subject company has N shares outstanding that were trading at a pre-fraud price of P₀ per share. Assume there was a fraudulent material misrepresentation attributed to the issuer and its directors and officers that increased the stock’s price to P₁, which eventually returned to the pre-fraud level of P₀ once the market became aware of the fraudulent statement.

Suppose that the class of the company’s shareholders who purchased shares at the inflated price bring a Rule 10b-5 class action against the company and its directors and officers. For simplicity, assume these injured shareholders do not sell their shares. Of the company’s N shares outstanding, suppose that n shares are represented by the litigating class. So, if π is the fraction of the company’s outstanding shares represented by the litigating class, then π = n/N. The case settles and then pays s dollars per share to each of the n shares purchased during the class period, for a total settlement payment of s*n. Given the discussion above regarding corporate obligations for class action settlements, the company will pay a fraction α of the settlement, where α is between 0 and 1, which ultimately will be borne by the firm’s shareholders holding the N shares. In discussions of the circularity critique it is ordinarily assumed, either expressly or implicitly, that the company directly or indirectly pays the entirety of the settlement, which corresponds to the circumstance in which α = 1.

Given this setup, first consider the post-settlement welfare of the shareholders who were injured by the fraud because they paid the inflated price for the company’s stock. For expositional simplicity, consider a shareholder who is a member of the class and who purchased just a single share of the company’s stock. The value of the share that the shareholder maintains is P₀, but they purchased the share for P₁, which means that the net value of their portfolio is P₀– P₁. The shareholder receives a settlement payment of s but because shareholders ultimately bear the company’s settlement expenditure of α(s*n), each of the firm’s shareholders bears a per share settlement expense equal to α(s*n)/N, or α(s*π). Thus, a class plaintiff receives a per-share net settlement amount of s – α(s*π). Collecting terms, the per-share post-settlement welfare of a class plaintiff is:

P₀ – P₁ + s(1 – α*π) (1)

Even in the hypothetical but unrealistic world in which there are no litigation costs and no plaintiffs’ attorney fee awards,¹⁵⁷ and even if the settlement were to compensate defrauded shareholders for the full amount of their overcharge, a settlement would not make the injured shareholders whole so long as the corporation pays at least some portion of the settlement. That is evident in the model above. To see this, suppose there are no litigation costs or plaintiffs’ attorney fee awards and the settlement fully pays the overcharge—that is, s = P₁ – P₀. In this case, the post-settlement welfare of the injured shareholder discussed above who holds one share of the stock is – α*π(P₁ – P₀),¹⁵⁸ which is negative whenever the corporation pays at least some portion of the settlement, that is, whenever α is greater than 0.

In other words, while the settlement makes class shareholders whole in the first instance, they ultimately are not fully compensated because they each pay a portion of the settlement amount equal to α(s*π) per share. Each of the other firm’s shareholders also pay a per-share amount equal to α(s*π) to finance the settlement. As this example shows, the circularity critique supports the position of those who argue that stock-based Rule 10b-5 class actions fail to meet compensation and deterrence objectives and implicate fairness concerns.¹⁵⁹

2. Circularity in the Crypto Asset Context

Circularity is a significantly attenuated consideration for Rule 10b-5 crypto asset class actions because the drivers of the critique discussed above are substantially absent in the crypto asset context. To start, individual defendants in crypto asset Rule 10b-5 class actions are much less likely to be able to rely on insurance or indemnification as a shield from personal liability, relative to the stock-based context. First, because of the operational decentralization discussed in Section I.A above, an individual wrongdoer may not be associated with any entity such as a corporate body that provides indemnification rights or insurance coverage. Second, while publicly available data is lacking, D&O coverage appears very limited in the crypto asset context because of an avoidance by D&O carriers of the crypto space, as well as high premiums and unfavorable terms.¹⁶⁰

news/international/2022/12/19/699978.htm [https://perma.cc/VME7-JJG3] (“Insurers were already reluctant [prior to the collapse of the crypto exchange FTX] to underwrite asset and directors and officers (D&O) protection policies for crypto companies because of scant market regulation and the volatile prices of Bitcoin and other cryptocurrencies. Now, the collapse of FTX . . . has amplified concerns.”); Josh Liberatore, Crypto Winter Raises Host of D&O Coverage Issues, Law360 (Feb. 10, 2023, 9:38 PM), https://www.law360.com/articles/1575237 [https://perma.cc/FLC9-2XG9] (quoting a D&O lawyer for the observation that “[m]ost D&O underwriters view crypto firms as toxic in today’s environment, so the availability of D&O insurance for those firms is quite limited . . . . Even when available, the insurance is expensive and somewhat limited in scope of coverage”). So, even if an individual wrongdoer is affiliated with a centralized entity, the individual may not have the protection of D&O coverage, or only very limited protection, relative to an individual defendant in a stock-based Rule 10b-5 action. Furthermore, the apparent rarity of D&O coverage presumably would make indemnification a rarity as well, as a crypto asset entity would not be readily able to purchase Side B coverage to cover its indemnification expenses.¹⁶¹

The absence of crypto asset holders’ cash flow rights further diminishes the relevance of the circularity critique in the crypto asset context. As discussed in Section I.B above, except in very rare circumstances, a crypto asset’s holders will not be the recipients of any profit distributions resulting from their crypto asset holdings. So, if a Rule 10b-5 crypto asset class action settles, then the crypto asset’s holders may not bear any of the cost of the settlement, as would be the case in the stock context.

For instance, suppose the defendant set in a Rule 10b-5 crypto class action includes an entity involved in developing the crypto asset and the entities’ directors or officers. Suppose that the class action settles for s dollars per asset purchased during the class period. None of the settlement amount will be borne by the crypto asset’s holders (other than any defendant who may be a holder). Even if only some of the settlement is paid by the individual defendants, leaving some of the settlement to be paid by the named entity, that expenditure will not be passed down to the class plaintiffs or any other of the crypto asset’s traders because none have cash flow rights in the named entity.

With respect to the stylized model above, the named entity defendant may pay a fraction α of the settlement but because that amount is not borne by the crypto asset’s traders, the class plaintiffs’ welfare after the settlement is P₀ – P₁ + s for each share purchased during the class period. Putting aside any litigation costs or attorney fee awards, this then supports the feasibility of complete compensation if the settlement amount is set equal to the overcharge.¹⁶² One countervailing consideration is that, to the extent the defendant is actively involved in developing or supporting the crypto asset or any associated applications, a settlement payment by the defendant may impede its ability to effectively engage in those facilitating efforts. By decreasing the perceived value of the crypto asset or any associated applications, the settlement may lower the crypto asset’s price, which would adversely affect the crypto asset’s holders, including class plaintiffs.

In addition to the possibility of full compensation, because crypto asset traders outside of the class are not paying for the settlement of the class plaintiffs, the fairness concerns noted above are ameliorated in the crypto asset context. A related implication of the circularity critique in the stock-based context is that putting litigation costs to the side, litigation is zero-sum, in that shareholders’ aggregate wealth is unchanged after a settlement or judgment.¹⁶³ That is not the case in the crypto asset context. Because the cost of a settlement is not borne by the crypto asset’s traders, their aggregate welfare will increase after a settlement, putting aside the point above about a settlement potentially having adverse effects on development of the crypto asset or any associated applications. Finally, deterrence is heightened relative to the stock context because of the significantly greater likelihood that the individual defendants responsible for the fraud will incur monetary liability and thus be better incentivized to avoid that conduct in the first instance.

B. The Diversification Critique

Diversification is another leading critique lodged in the literature against stock-based Rule 10b-5 class actions. While circularity focuses on compensation and deterrence considerations in a single securities class action, the diversification critique peers with a broader lens. It inquires how a shareholder’s entire portfolio is affected by fraud and concludes that the cost of fraud can be diversified away, thereby nullifying the role of Rule 10b‑5 class actions as a remedial mechanism.¹⁶⁴

The key features of the diversification critique can be seen through a simplified model. Suppose that there are N publicly traded firms and a single investor. There are two time periods, period one and period two. In period one, the investor decides, for each one of the N firms, whether or not to purchase a single share of the firm’s common stock. So, in the first period, the investor can purchase up to N shares—one share of each of the N firms—but may invest in just a subset of the N firms. In the second period, the investor sells all of the shares that they purchased in the first period.

Suppose further that each of the N firms will be the target of fraud, the effect of which will be to artificially and temporarily inflate the firm’s stock price. Assume, for further simplicity, that all firms have the same fundamental, that is, non-fraud, share price and that the fraud will have the same price-inflating effect on each firm’s stock. For any given firm, there are two possibilities of the timing of the fraud. One possibility (which can be referred to as scenario one) is that the fraud occurred immediately before period one and is revealed to the market between period one and period two. The second possibility (which can be referred to as scenario two) is that the fraud occurred immediately after period one and is revealed to the market after period two. Firms are randomly assigned to the two scenarios with equal probability and the firms’ assignments are uncorrelated.

This setup illuminates the two key tenants of the diversification critique. First, the diversification critique postulates that, for any given issuer, every shareholder of the firm ex ante is as likely to be a victim of fraud as a beneficiary. This can be seen in the model above. For any firm in which the investor became a shareholder in period one, the investor’s likelihood of being in scenario one (in which case the investor will have purchased at the fraud-inflated price and sold at the lower, fundamental price) is the same as the likelihood of being in scenario two (in which case the investor will have purchased at the fundamental price and sold at the higher, fraud-inflated price). This means that even without a compensatory scheme in place, the expected cost of fraud to the investor for any given stock in their portfolio is zero: the likelihood that a shareholder will incur the cost of fraud is the same as the likelihood that they benefit, and the cost and gains are the same. But note that while the expected cost to the shareholder from fraud directed at any given firm in which the shareholder is invested is zero, fraud still affects the variability of the shareholder’s portfolio, since half the time the trader will be a victim of fraud and the other half the time, a beneficiary.

The second key tenant of the diversification critique is that investors can diversify away the risk that fraud injects into their portfolio. In the stylized model above, that diversification occurs through the investor taking positions in a greater number of firms. In the context of that model, while fraud will have the same, non-zero effect on the expected value of a portfolio comprised of the shares of a single firm and a portfolio comprised of the shares of many firms, fraud will result in the latter portfolio being less risky than the former portfolio. If stock traders are sufficiently diversified, then fraud will not only have zero expected cost on their portfolios but also will cause traders’ portfolios to be exposed to only limited additional risk.¹⁶⁵

As this discussion indicates, the strength of the diversification critique as a basis for concluding that fraud has no ex ante adverse effect on shareholder welfare turns primarily on two things. First, the theory’s strength depends on the extent to which shareholders are diversified. If shareholders are not well-diversified, then even though fraud will not affect the expected value of shareholders’ portfolios, it will increase their portfolios’ riskiness, which will undermine the welfare of risk averse shareholders. Second, the critique’s strength turns on the extent of shareholder risk aversion. If shareholders are strongly risk averse, then the effects of fraud on shareholder welfare through increased portfolio volatility will be more pronounced than if they were less risk averse, all else equal. The reason is that a more risk averse shareholder experiences greater disutility from an increase in portfolio risk than a less risk averse shareholder, all else equal.¹⁶⁶

These observations show that an assessment of whether the diversification critique is more or less pronounced in the crypto asset context than the stock context should focus, at least in the first instance, on comparing the extent of stock traders’ diversification and risk aversion with the extent of crypto asset traders’ diversification and risk aversion.¹⁶⁷ Empirical work is needed in order to be able to competently assess how the extent of crypto asset investors’ diversification and degree of risk aversion compares to that of stock traders.

Though strong conclusions are not possible in the absence of this empirical analysis, it is reasonable to expect that the implications of the diversification and risk aversion considerations break in different directions, but nothing suggests that those considerations are such that the diversification critique has significantly greater relevance in the crypto asset context than in the stock context. Turning first to trader diversification, it is likely that stock traders are better diversified than crypto asset traders. Through the widespread availability of index funds, index-based exchange-traded funds (“ETFs”), and managed funds, equity traders can readily and cheaply diversify their stock portfolios. The prominence of those instruments suggests that many equity traders do maintain diversified stock portfolios. That likely is not the case for crypto asset investors given that the means for crypto asset investors to easily diversify their crypto asset holdings, such as through tokenized index funds that track a broad basket of crypto assets, are not commonplace, and crypto asset investors appear to prefer purchasing and selling individual crypto assets rather than funds.

To the extent crypto asset traders are less diversified than stock traders, this would translate into the diversification critique having less relevance in the crypto asset context than in the stock context. On the other hand, it is reasonable to expect the risk aversion consideration to work in the other direction, because crypto asset traders may be less risk averse than stock traders. As discussed in Section I.C above, crypto asset prices are very volatile as a general matter and more volatile than stock prices as a relative matter. That crypto asset traders are willing to trade in the face of such volatile prices may be reflective of those traders being more willing to accommodate risk than stock traders. To the extent that is correct, then this would provide a mechanism for the diversification critique to have more, not less, relevance in the crypto asset context than in the stock context.

C. The Corporate Governance Justification

The circularity and diversification critiques have been the primary arguments asserted against stock-based Rule 10b-5 class actions. One rejoinder to those critiques is a corporate governance justification that posits that stock-based Rule 10b-5 class actions advance public policy through improvements in corporate governance.¹⁶⁸

The corporate governance justification focuses on securities law’s disclosure regime. The justification is based on the notion that more accurate disclosures by companies subject to the disclosure regime translate into improvements to legal and nonlegal channels of corporate governance. These improved corporate governance mechanisms, in turn, incentivize managers to be better focused on share value maximization, which results in economic gain. For example, the corporate governance justification posits that more accurate corporate disclosures increase the disciplinary power of a hostile takeover. The underlying reasoning is that more accurate company disclosures enable potential acquirers to more readily identify managerial deviations from share value maximization, where the threat of such takeover better incentivizes managers to maximize share value in the first instance.¹⁶⁹ The corporate governance justification concludes that securities class actions work alongside public enforcement to improve the accuracy of company disclosures, which serves to facilitate these and other forms of economic gain.¹⁷⁰

The corporate governance justification loses relevance in the crypto asset context. The primary reason is that crypto asset sponsors are not reporting companies, and thus subject to the securities law’s ongoing disclosure obligations, at least under current law and practice.¹⁷¹ Crypto asset sponsors also do not voluntarily furnish the market with information that is substantively similar to the disclosures provided by public companies.¹⁷² So, it is not meaningful to ask whether crypto asset-based Rule 10b-5 class actions generate disclosure improvements.

Second, the various channels of corporate governance that the corporate governance justification posits to be improved by stock-based Rule 10b-5 class action have no or little applicability in the crypto asset context. For example, crypto asset sponsors are not publicly traded companies and so cannot be the subject of a takeover effort. Even if a party were to acquire significant amounts of a crypto asset, that would not allow the acquirer to exercise control over the crypto asset’s sponsor or to replace its management, as may be the case with the acquisition of sufficient voting shares of a publicly traded company.

D. Price Volatility and Frivolous Litigation

The analysis above, when aggregated, does not provide a basis for concluding that the public policy justification for crypto asset-based Rule 10b-5 class actions is substantially weaker than the public policy justification for stock-based Rule 10b-5 class actions. The circularity critique is significantly less relevant in the crypto asset context than in the stock context, and the diversification critique may be more or less relevant in the crypto asset context than the stock context, but nothing indicates that it is significantly more relevant. An offsetting consideration is that the corporate governance justification ceases relevancy in the crypto asset context.

Absent from the discussion above is the issue of frivolous litigation, which can impose social cost by causing the defendants to divert resources away from value-enhancing activity to paying legal expenses and incurring settlement payments. One question pertinent to the Article’s public policy question is whether unmeritorious Rule 10b-5 class actions are more likely to be expected in the crypto asset context than in the stock context.

The prospect of frivolous lawsuits is heightened in the crypto asset context because of the significant price volatility discussed in Section I.C above. A crypto asset’s traders may lose significant amounts simply because of inherent price changes. In the face of a significant volatility-induced price drop, financially impaired crypto asset traders may seek to use Rule 10b-5 to recover their non-fraud losses, understanding that such cases often result in at least some recovery through settlement. Instead of crypto asset investors leading the charge to the courtroom in such circumstances, lawyers may be the first movers.¹⁷³ In either case, frivolous suits may deplete or deteriorate the budgets of crypto asset sponsors and others who are involved in the development of crypto assets and their applications, which would serve to diminish incentives to innovate. That prospect of dampened innovative activity is amplified given the apparent current rarity of D&O insurance.¹⁷⁴

This is an important consideration, but the same price volatility that may incentivize non-meritorious suits may also work to disincentivize them. At various points of their Rule 10b-5 class action, crypto asset traders will need to establish aspects of their case through statistical methods. For instance, the plaintiff traders will need to establish loss causation, which will necessitate use of an event study to show that the crypto asset’s price responded in a statistically significant manner to one or more corrective disclosures.¹⁷⁵ As has been documented elsewhere, event studies in Rule 10b-5 class actions may not be able to identify statistically significant price effects because of low power.¹⁷⁶ The issue of low power is heightened when there is high price volatility, as in the crypto asset context.¹⁷⁷ For this reason, whether or not a crypto asset Rule 10b-5 case is meritorious or not, the issue of low power will make it difficult for crypto asset traders to establish elements of their claim. That inability combined with an awareness that other aspects of their claim may have poor factual support may dissuade crypto asset traders from bringing frivolous Rule 10b-5 cases.¹⁷⁸ As this discussion shows, the same relatively high price volatility that could cause more frivolous crypto asset Rule 10b-5 class actions to be litigated than stock-based Rule 10b-5 class actions simultaneously provides a reason why there may be fewer frivolous suits of the former type than the latter.

CONCLUSION

Traders who participate in secondary crypto asset trading markets understand that any trading gains are accompanied by the risk of trading losses. Most traders presumably also understand that their losses at times can be significant because of the high volatility of crypto asset prices. But accompanying these market-determined losses are potentially significant trading losses caused by fraud occurring in connection with traders’ secondary transactions. In response to incidents of secondary trading crypto asset fraud, crypto asset traders may seek recovery for their trading losses through Rule 10b-5 class actions. The propriety of crypto asset traders relying on that form of relief implicates a host of doctrinal and public policy questions. This Article sought to analyze two such questions, one doctrinal and one public policy related.

In its doctrinal analysis, the Article evaluated issues pertinent to the threshold definitional question of when an exchange-traded crypto asset will constitute an investment contract and therefore fall within the definitional perimeter of a security. That analysis identified a slight generalization of the horizontal commonality test so that the test is suitable for use in both primary transaction and secondary transaction cases. The analysis also explained why Howey’s efforts of others prong should not be understood to require the presence of a centralized third party and also explained why the prong does not concern itself with investors’ expectations concerning the use of their sales proceeds. These findings, though, are legal propositions. Whether or not a particular exchange-traded crypto asset is or is not an investment contract will depend on the pertinent facts and the totality of the circumstances.

In its public policy analysis, the Article evaluated whether the public policy justification for crypto asset-based Rule 10b-5 class actions is significantly weaker than stock-based Rule 10b-5 class actions. It structured its analysis around the primary theories advanced in the literature to assess whether stock-based Rule 10b-5 class actions advance their public policy objectives. The Article’s public policy determinations break in different directions and in some respects are to be considered preliminary, but the analysis does not justify limiting the availability of crypto asset-based Rule 10b-5 class actions any more than stock-based Rule 10b-5 class actions.

96 S. Cal. L. Rev. 1571

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Menesh S. Patel*

* Professor of Law, UC Davis School of Law. This Article benefited from helpful comments by Jordan Barry and Jill Fisch, as well as participants at the University of Southern California’s Digital Transformation in Business and Law Symposium. Parts of this Article build on and draw from points in a prior work. See Menesh S. Patel, Fraud on the Crypto Market, 36 Harv. J.L. & Tech. 171 (2022). I thank Merritt Fox for his comments on that earlier work, which motivated me to address points in Part III of this Article. I also thank Madeline Goossen, Jessica Langdon, Remy Merritt, and the other journal editors for their helpful suggestions and editing assistance. Maximilian Engel, Katherine Gan, and Ada (Xia) Wu provided excellent research assistance.

What’s in a Name? ESG Mutual Funds and the SEC’s Names Rule

April 2024April 2024Jill E. Fisch* & Adriana Z. Robertson†

As investor money flows into environmental, social and governance (“ESG”) mutual funds, regulators have raised growing concerns about greenwashing—specifically that a fund’s name will falsely suggest that the fund invests in companies that meet certain ESG standards. To address these concerns, the Securities & Exchange Commission (“SEC”) proposed amendments to the Investment Company Act (“Names Rule”). The amendments extend the scope of the Names Rule to funds whose names include terms such as ESG, green, or sustainable. If adopted, they will require such funds to invest at least 80% of the value of their assets in companies that meet the standards suggested by these terms.

We interrogate the SEC’s concern about greenwashing and the extent to which the extension of the Names Rule is rationally directed toward addressing that concern. One challenge is that the term ESG is too broad and imprecise to provide an objective basis for determining which companies appropriately fall within an 80% bucket. A second challenge is that the concept of an 80% requirement is in tension with most mainstream ESG investment strategies. Third, and perhaps most problematic, are the limitations of fund names in conveying the extent of information necessary to ensure that a fund meets the expectations of its investors.

We demonstrate these concerns empirically. First, to address the SEC’s concern that investors are not getting a meaningfully different product, we compare the composition of ESG funds with their most closely analogous non-ESG sister funds. Second, through the creation of synthetic Women in Leadership funds, we demonstrate the limitations of fund names in conveying sufficient information about a fund’s investment strategy, even for portfolio criteria that can be measured objectively. Our findings demonstrate that the SEC’s proposal is unlikely to increase investor protection and is likely to impede a variety of legitimate ESG strategies.

We conclude that the SEC’s effort to address greenwashing through the Names Rule reflects an overly simplistic and unworkable approach to characterizing portfolio companies and a narrow perception of plausible ESG investment strategies. Both are at odds with existing market practices and threaten further innovation.

INTRODUCTION

Names matter.¹ Mutual fund names have the power to impact the flow of investor funds substantially.² In recent years, this power has been reflected through large inflows into mutual funds with names conveying a strategy reflecting environmental, social and governance (“ESG”) considerations,³ funds that we will refer to as ESG funds.⁴

Concerned that the shareholders who invest in these funds may not be receiving a product that meets their expectations, and that mutual fund sponsors may inappropriately label their products with ESG names to capitalize on investor demand, in May 2022, the Securities & Exchange Commission proposed changes to Rule 35d-1 (the “Fund Names Rule”), designed to increase the likelihood that mutual funds align more closely with investor expectations.⁵ Specifically, the amendments would, among other requirements, extend the Names Rule to investment strategies and would require that, if a fund’s name suggests “an investment focus in companies that meet certain ESG standards,” at least 80% of the value of the fund’s investments be consistent with that focus.⁶

The proposed amendments reflect a misguided understanding of both the concept of an ESG investment and what it means to use an ESG investment strategy. By extending the Names Rule’s categorization approach to ESG, the SEC introduces an overly simplistic taxonomy into a subject rife with ambiguity. As Elizabeth Pollman explains, the term ESG includes a range of usages that can be applied to both companies and investment strategies, and “consensus on the meaning of ESG does not currently exist.”⁷ That ESG is a “big tent”⁸ makes it appealing to use the term in fund names, but, consequently, its use does not convey very much information. Commentators can, and do, reasonably disagree about whether it is appropriate to characterize a particular portfolio company as ESG or not,⁹ and market-based ratings organizations often differ widely in the ratings they assign to the same company.¹⁰ Notably, because ESG involves a range of factors, a company that appears to fall short in one dimension may nonetheless warrant a high overall score.¹¹

At the same time, investors can implement a variety of approaches to ESG investing.¹² Some strategies are relatively simplistic, such as inclusion—selecting companies based on certain characteristics or screening—excluding certain types of companies.¹³ Other ESG investing strategies can be more complex. They may involve overweighting companies with high ESG scores or underweighting companies with lower scores. An ESG strategy can also seek to maximize diversification by constructing a portfolio consisting of the more highly rated companies in each industry rather than excluding whole industry categories such as oil and gas.¹⁴ An ESG strategy can also be more targeted—such as seeking to obtain a portfolio level of conformity with one or more ESG characteristics such as low carbon emission or board gender diversity. And of course, ESG funds may strive for impact—endeavoring not to choose portfolios of companies with high ESG characteristics, but instead to improve the ESG profile of their portfolio companies.

As a result, there is little logic to policing the use of terms such as ESG through the Names Rule’s 80% investment requirement. In our empirical analyses we demonstrate both the impotency of an 80% requirement preventing the inclusion of companies that some investors would view as problematic from an ESG perspective, as well as the incoherence of applying an 80% requirement to portfolio-wide ESG investment strategies.¹⁵

We start by interrogating the concept of “greenwashing.”¹⁶ The SEC worries that managers are simply naming or renaming funds as ESG in order to capture investment flows without engaging in an ESG investment strategy.¹⁷ For the reasons suggested above, this proposition is difficult to test empirically. Unlike the categories of securities to which the Names Rule has traditionally been applied, such as tax-exempt securities or technology companies, the concept of ESG does not readily lend itself to determining whether a particular security belongs in a fund’s 80% bucket.

To overcome this problem, we adopt a different approach. For each ESG fund in our sample, we identify a “sister fund”—the non-ESG fund in the same fund family most comparable to the ESG fund. We then compare the portfolio composition of each fund pair.

Our comparison spans two dimensions. First, we test the extent to which ESG funds hold different portfolio companies than non-ESG funds. We find that, although a nontrivial number of ESG funds’ holdings overlap significantly with those of their sister funds, the vast majority of ESG funds look quite different. We then compare the performance of ESG funds to their sister funds. We find that ESG funds do not underperform their sister funds, nor do they charge higher fees. This holds both across the distribution of similarity and among ESG funds that are most similar to their sister funds.

While our findings cannot determine whether investors receive what they expect when they purchase an ESG fund, they cast doubt on the claim that ESG funds simply reflect opportunistic rebranding by fund managers. The ESG funds in our sample appear to be meaningfully different from their non-ESG sister funds, and we find no evidence that investors are paying more or receiving inferior returns.

Next, we consider the extent to which a fund name can do the work contemplated by the SEC in conveying sufficient information to meet investor expectations. We create a series of synthetic Women in Leadership funds that seek, through their investment strategy, to promote women in corporate leadership. We identify how modest differences in the implementation of this strategy—all of which are plausibly faithful to the fund name—result in substantial differences in fund composition. Our analysis also reveals how easily a portfolio that is consistent with the strategy conveyed by the fund’s name may nonetheless fail to meet the expectations of some fund investors.

Our findings demonstrate that the SEC’s proposed amendments to the 80% rule are misguided. Not only are they unlikely to reduce the potential for greenwashing, but they are also likely to deter innovation in fund offerings and investment strategies, potentially depriving investors of new products that better align with their investment goals.¹⁸

I. THE REGULATION OF MUTUAL FUND NAMES

A. The Importance of Mutual Fund Names

An emerging finance literature emphasizes the important role of fund names in driving investment decisions. Fund names can convey the characteristics of a fund’s investment portfolio—such as whether the fund invests in equity or fixed income securities.¹⁹ They can seek to attract investor attention by being clever or catchy.²⁰ A trade or generic name may also convey the quality of the fund’s management.²¹

As early as 2005, Cooper, Gulen, and Rau demonstrated that mutual fund name changes had a significant impact on fund flows.²² Responding to a newspaper article reporting that mutual funds were changing their names from growth funds to value funds, the authors found that mutual funds that changed their names to reflect a current hot investment style received substantial inflows whether or not the change was associated with a difference in fund holdings or performance.²³ They argued that investor responsiveness to these “cosmetic” changes is consistent with the fact that “most investors have little knowledge about the products that they are buying.”²⁴

Subsequent research found similar results. For example, Esplenlaud, Haq, and Khurshed studied fund name changes from 2002 to 2011.²⁵ They found that investors responded with increased fund flows to superficial name changes—specifically name changes that did not attempt to reflect the fund’s portfolio composition and that were not accompanied by meaningful portfolio adjustments.²⁶ They further found that these investors gained no benefit from the changes in the form of improved performance or lower fees. In another study, Greene and Stark found that sponsors were successful in attracting inflows by launching funds with trendy names.²⁷

The finding that investors respond to fund names extends to the use of names that convey an ESG-related investment strategy. A substantial number of mutual fund sponsors have repurposed and rebranded funds to take advantage of the popularity of ESG investing.²⁸ In one account that drew substantial media attention, BlackRock changed the name of a fund from impact, to ESG, and then to sustainable.²⁹ The name change purportedly attracted millions of dollars in inflows. Notably, however, the name changes did not appear to be cosmetic—along with changing the fund’s name, BlackRock modified the fund’s investment strategy.³⁰

A recent paper by Aymen Karoui and Sadok El Ghoul looked at twenty-eight funds that changed their names over the period from 2003 to 2018 to convey a sustainability-related strategy.³¹ They found that the name changes were correlated with substantial fund inflows in the first year after the change. Importantly, however, Karoui and El Ghoul investigated the extent to which the name changes were cosmetic and found that the name changes were accompanied by substantial rebalancing.³² They further found that investors were able to distinguish between cosmetic and non-cosmetic name changes, and that only the non-cosmetic changes drew increased asset flows.³³ To examine the potential of ESG fund names to mislead, Candelon, Hasse, and Lajaunie evaluated ESG funds according to their ESG ratings from Morningstar and MSCI.³⁴ They found that although the sample of ESG funds obtained higher average ESG ratings than those obtained by conventional funds, there was a substantial overlap between the two distributions.³⁵

Arguably the documented extent to which investors rely on fund names is problematic. The SEC requires mutual funds to make extensive disclosures about their holdings and strategy in a prospectus and a statement of additional information (“SAI”), as well as to provide periodic disclosure about their holdings and voting records.³⁶ Fund sponsors are required to post these documents on the internet and to make the information contained in them user-friendly. These disclosures provide substantial details on the nature of fund investment strategies and, for the most part, would effectively eliminate the risk that an investor would misunderstand how an ESG fund determines which securities qualify for inclusion in its portfolio.³⁷ The problem, of course, is that investors do not read these documents.³⁸

The situation is further aggravated by the fact that a substantial component of mutual fund investing today takes place through employer-sponsored employee-directed retirement plans.³⁹ In these plans, employers construct a menu of funds that are available to their employees, and employees choose the funds in which their money will be invested.⁴⁰ The standard menu provides employees with a list of fund names and possibly additional information such as asset class and fees, but an investor typically must make an affirmative effort to seek out additional information, and it is unclear how many investors do so.⁴¹

B. Section 35(d) & the Names Rule

Section 35(d) of the Investment Company Act of 1940 makes it unlawful for a mutual fund name to use any word or words that the Commission finds are materially deceptive or misleading.⁴² The statute authorizes the SEC to use its rulemaking authority to designate the circumstances under which a firm name is deceptive or misleading.

In 2001, the SEC used this authority to adopt Rule 35d-1, the Names Rule.⁴³ Rule 35d-1 requires funds using certain types of names to invest at least 80% of the value of their investments in a manner that is consistent with that name.⁴⁴ Under the current form of the rule, the 80% requirement applies to names suggesting investment in certain asset types of industries, names suggesting a focus on investments in a particular country or geographic region, names indicating that fund distributions are exempt from federal or state income tax, and names suggesting guarantee or approval by the United States government. In addition, the rule explicitly states that it does not apply to common investment strategies.⁴⁵ In adopting the rule, the SEC explicitly stated that the 80% requirement is not a safe harbor from liability; a fund may be found to have a misleading name despite its compliance with the 80% requirement.⁴⁶

The SEC has not amended Rule 35d-1 since 2001 although a variety of market developments have occurred in the subsequent two decades.⁴⁷ In particular, after the 2008 financial crisis, the SEC observed that a number of investors appeared to be misled by their investments in target date funds—funds that purported to shift their asset allocation between debt and equity in accordance with the approach of the designated target date. These funds, which are widely used for retirement investing, varied substantially in their asset allocations and glide paths, creating differing levels of risk exposure for investors in the funds.⁴⁸ The SEC’s proposed solution, however, was not to attempt to regulate the use of the term “target date” in a fund’s name, but instead to require changes to the marketing materials for target date funds.⁴⁹ Ultimately, the SEC did not adopt new regulations to address the problem.⁵⁰

C. The 2022 Proposed Amendments

On May 25, 2022, the SEC proposed amendments to the Names Rule.⁵¹ The amendments are explicitly designed to address ESG fund names. As SEC Chair Gary Gensler outlined in the remarks introducing the proposed rule, the release proposes four changes.⁵²

its%20name [https://perma.cc/J69K-FXNA]. First, it extends the scope of the 80% requirement to names that designate specific investment characteristics, including ESG-related names.⁵³ Second, it requires funds that “drift” out of compliance with the 80% requirement to become compliant within 30 days. Third, it requires funds to designate the specific holdings in their portfolios that count toward the 80% requirement.⁵⁴ Finally, it requires funds to use the notional value of derivatives for determining compliance with the 80% requirement.

The proposing release goes further in targeting ESG funds. For example, the proposal would codify the fact that a fund’s name may be materially misleading if the fund’s portfolio contains investments that are inconsistent with its investment strategy, even if it complies with the 80% requirement.⁵⁵ By way of example, the release cites a “fossil fuel-free fund” that makes a substantial investment in fossil fuel reserves.⁵⁶ Similarly the release expressly observes that a fund’s name can be misleading if it invests in an index that is included in the fund’s name, but that index contains “components that are contradictory to the index’s name.”⁵⁷

The proposing release explains the SEC’s justification for the amendments. In particular, the release singles out ESG funds as presenting particular investor protection concerns.⁵⁸ The release observes that the use of ESG terminology may be particularly powerful in attracting investors and that subjecting those funds to the 80% requirement would “help to prevent potential ‘greenwashing.’ ”⁵⁹ The release is explicit in calling out investment advisors for adopting and changing fund names out of “self-interest” in order to attract greater inflows.⁶⁰

II. ESG FUND NAMES AND GREENWASHING

A. The SEC’s Concerns

The proposing release offers some insight into the SEC’s concerns about ESG mutual funds. These concerns can be divided into three categories. The first is that an ESG fund will invest in securities that are not ESG. The SEC illustrates this through its example of a Fossil Free fund that is not, in fact, fossil free because it invests in fossil fuel companies.⁶¹

fossilfreefunds.org/fund/spdr-sp-500-fossil-fuel-reserves-free-etf/SPYX/fossil-fuel-investments/FS0000
C3K4/F00000WAP7 [https://perma.cc/EB9R-AR48]. It is unclear whether the SEC would consider the ETF’s name misleading under the terms of the proposed rule. The greenwashing concern expressed in the media, however, is broader—that a variety of companies in the portfolios of ESG mutual funds are simply inconsistent with an ESG or sustainability investment mandate. For example, the media has questioned whether an ESG fund can legitimately invest in companies in the oil and gas industry.⁶² This is the rationale for requiring funds to designate the securities that fall within their 80% basket—to highlight, and potentially expose a fund for claiming that its investment in Exxon conforms with its ESG investment strategy.⁶³

A related concern is the use of fund names that simply reference an underlying ESG index. Many ESG indexes involve complex strategies similar to those discussed above, including overweighting and underweighting or choosing the companies in each industry with (relatively) higher ESG scores. These strategies may result in an index including companies that the average investor might not view as reflecting ESG values. For example, funds that invest in accordance with the S&P 500 ESG index reflect one of the largest categories of ESG funds in terms of assets under management.⁶⁴ The S&P 500 ESG index is specifically designed to maintain the same industry group weights as the S&P 500 index, meaning that, by necessity, it invests in oil and gas, fossil fuel, and similar industries.⁶⁵

A second, and somewhat different concern, is that an ESG fund’s overall portfolio will not differ sufficiently from a fund that does not bear the ESG name. The SEC’s concern here is that asset managers are using ESG branding to attract asset flows, but not adopting genuine ESG investment strategies.⁶⁶ To this point, the proposing release cites empirical literature indicating that fund name changes are not associated with changes in fund styles.⁶⁷ A related consideration is that ESG funds may cost more than “plain vanilla” funds despite failing to provide additional screening of their investments.⁶⁸ A 2021 Bloomberg article, for example, cited a number of ESG funds with higher fees but with portfolio compositions that closely matched the comparable lower cost non-ESG index funds.⁶⁹

A third concern—the concern most frequently repeated by the SEC—is that ESG funds do not meet investor expectations. It is not entirely clear what this means. One possibility is that the fund manager and investors just disagree about which companies constitute ESG investments. As noted above, there is broad disagreement about this, and it is unlikely that fund names have the capacity to provide greater clarity, a point we interrogate through our empirical analysis below. A different and more subtle point is that investors may overestimate the impact of ESG investing on underlying social issues such as climate change or wealth inequality.⁷⁰

B. How Prevalent Is This Type of Greenwashing?

In this section, we probe the empirical basis for the SEC’s proposed rule. Rather than relying on anecdotes or generalized concerns about greenwashing, we investigate the extent to which ESG funds resemble the other funds that their sponsors offer.

To do so, we identify a non-ESG sister fund for each ESG fund in the market each year. We define the sister fund as the non-ESG fund in the same fund family (funds offered by the same management company) that most closely resembles the ESG fund in terms of the securities in the ESG fund’s portfolio that year.⁷¹ Following the logic of the proposed Names Rule, and, in particular, the proposition that an ESG fund should exclude non-ESG companies, the initial measure of similarity that we adopt—which we call the “portfolio inclusion”—is the percentage of the assets in the non–ESG sister fund’s portfolio that are also in the ESG fund’s portfolio. This measure captures the extent to which the ESG fund excludes assets that its sister fund owns.

Like the proposed Names Rule upon which it is based, portfolio inclusion is binary with respect to each asset in the fund’s portfolio: the asset is either included or it is excluded. Accordingly, this measure does not contemplate the fact that a fund can engage in a tilt-based strategy, which involves over- or under-weighting particular securities.⁷² As discussed in more detail in Part III.A, we view this as an important conceptual limitation of the proposed Names Rule. Accordingly, while we believe this to be a conceptual limitation of the measure in the abstract, we view it as a feature for the purposes of evaluating the Names Rule.

We begin with the universe of mutual funds in the CRSP Survivorship Bias Free database. Consistent with the proposed Names Rule, we identify ESG funds using the fund’s name⁷³ and restrict attention to domestic equity funds.⁷⁴ Because all classes of a particular fund share a common portfolio, we construct the portfolio inclusion measure at the fund (rather than class) level. We perform the analysis for each year between 2015 and 2022. The distribution of portfolio inclusion is presented in Figure 1. In the interest of space, we present the results from 2017 through 2022, but the results from 2015 and 2016 are broadly similar to those from 2017. Because the ESG market is relatively young, we break the results out by year to make it easier to spot trends over time.

Figure 1. Distribution of Portfolio Inclusion, by Year

The results make clear that the large majority of ESG funds are substantially different from their sister funds, based on this measure. In 2021, the average ESG fund excluded securities making up 42% (100%-58%) of its sister fund’s portfolio, with a median of 38%. There is, however, some evidence of “bunching” at the high end. In the “worst” year—2020—29% of ESG funds excluded securities making up less than 20% of their sister fund’s portfolio. Of course, this also means that 71% of funds excluded more than 20%. While there is some evidence that this bunching at the high end (say, 80% or more) increased in recent years, the pattern is not consistent: it dipped between 2017 and 2018 before rising through 2020 and then dipping again in 2021 and 2022. In 2022, 27% of ESG funds held assets making up at least 80% of the assets in their sister fund’s portfolio.

This bunching—the fact that a substantial number of funds only exclude a small percentage of the assets in their sister funds’ portfolios—is, at least superficially, consistent with the SEC’s greenwashing concern. Moreover, the SEC might reasonably conclude that evidence suggesting greenwashing at 27% (or, in 2020, 29%) of ESG funds is more than enough to warrant a regulatory intervention. As an agency primarily charged with enforcing an antifraud regime, the SEC is right to be much more focused on the fact that a relatively large group is concerning than on the attributes of the average fund.

But before jumping to the greenwashing conclusion, it is worth remembering that the portfolio inclusion measure is just part of the story. While excluding assets that are inconsistent with the fund’s ESG strategy is an intuitive, and very common, approach to ESG investing, it is not the only one. For example, rather than excluding companies, an ESG fund might seek out and invest in top ESG companies, based on whatever ESG metric(s) the fund employs. One can imagine an environmental fund, for example, seeking out companies that are producing innovative solar or wind energy products, as opposed to excluding fossil fuel companies. Even if a fund doesn’t exclude many companies, if it is affirmatively seeking out different assets, it is providing investors with something different from its sister fund. Accordingly, we develop a second measure, “portfolio overlap,” which is the percentage of the assets in the ESG fund’s portfolio that are also in the non-ESG fund’s portfolio. We use these two measures in combination to calculate a more refined measure that we call “portfolio similarity” between each ESG fund and its sister fund. This is simply the lesser of the portfolio exclusion and the portfolio overlap. Table 1 illustrates how these measures work.

Table 1. Example of Portfolio Overlap and Portfolio Inclusion
Asset	Portfolio Weight
Asset	Fund A (ESG Fund)	Fund B (ESG Fund)	Fund Z (Non-ESG Fund)
A	25%	0%	30%
B	35%	10%	40%
C	20%	45%	25%
D	0%	45%	5%
E	20%	0%	0%

In the example in Table 1, Fund A’s portfolio overlap with Fund Z is 80%, because 80% of the assets in its portfolio are assets that are also in the Fund Z’s portfolio. By the same logic, Fund B’s portfolio overlap with Fund Z is 100%. This is true even though there are assets in Fund Z’s portfolio that are not in Fund B’s, and even though the two portfolios differ substantially. At the same time, Fund A’s portfolio inclusion with Fund Z is 95%, because assets making up 95% of Fund Z’s portfolio can be found in Fund A’s portfolio (and 5% of the assets in Fund Z’s portfolio as excluded from Fund A’s portfolio). Fund B’s portfolio inclusion with Fund Z is only 70%. Accordingly, Fund A’s portfolio similarity to Fund Z is 80% (the lesser of 80% and 95%), and Fund B’s is 70% (the lesser of 100% and 70%).

We plot the distribution of portfolio similarity in Figure 2. These plots show much less cause for concern. Rather than something in the neighborhood of 30%, we now have fewer than 15% of funds even in the “worst” year whose portfolios are substantially similar to those of their sister funds. More strikingly, Figure 2 makes clear that the overwhelming majority of ESG funds are substantially different from their sister fund (as measured in the ways contemplated by the proposed Names Rule). We emphasize that the sister fund is defined as being the non-ESG fund in the same family that is most similar to the ESG fund—by definition, all other funds in the family are at least as different.

Figure 2. Distribution of Portfolio Similarity, by Year

Nevertheless, recognizing the SEC’s focus on the most concerning funds, we zoom in on the funds at the top of the distribution—those with a portfolio similarity of 80% or more. We present this in Figure 3. Several features stand out from this: first, even in the worst year, this group consists of, at most, 19 funds. It is unclear that this group of potentially concerning funds is large enough to warrant a rulemaking, particularly since the SEC does not need to revise the Names Rule to use its existing enforcement authority against funds with fraudulent and misleading names. Moreover, we note that the very top end—above 95%, say—is even more thinly populated. Using that cutoff, we are down to a total of no more than 4 funds.

Overall, while there are a small number of outliers, the evidence suggests that the overwhelming number of ESG funds are substantially different—based on the logic of the Names Rule—from the other funds in their family. This evidence seems to undercut the SEC’s apparent concern that fund sponsors are just slapping the ESG name onto a fund that is otherwise the same as one of its other offerings.

We stress that nothing in this analysis speaks to the question of whether these funds are giving investor what they want or expect. We simply ask whether they are different from the other funds. In other words, are investors getting something. The answer appears to be yes.

While misleading investors is a harm in and of itself, the concern about greenwashing is generally accompanied by a claim that greenwashing is motivated by a desire to charge investors higher fees. While a higher fee might be warranted if investors were truly receiving a different product, investors should not pay more for a fund that carries the ESG name but does not differ substantially from a non-ESG product. We therefore extend the sister fund analysis to investigate the empirical basis for this concern. Specifically, we investigate the extent to which the ESG funds that are more similar to their sister funds (as measured by portfolio similarity) tend to have higher fees and/or worse risk-adjusted (net of fees) performance than those that are more different.

Figure 3. Distribution of Portfolio Similarity Over 80%

To do so, we estimate a series of ordinary least squares (“OLS”) regression models. We begin by simply asking whether ESG funds tend to be more expensive, and lower performing, than their sister funds, and present the results in Table 2. The dependent variable in columns 1 and 2 is the difference between the ESG fund’s expense ratio and that of its sister fund. The dependent variable in columns 3 and 4 is the difference between the ESG fund’s alpha⁷⁵ and that of its sister fund. A higher expense ratio is generally interpreted as being bad for investors; the opposite is true with respect to alphas.

Table 2. Expenses and Performance of ESG Funds Relative to their Sister Funds
	Expense Ratio		Alpha
	(1)	(2)	(3)	(4)
Mean Difference	-0.10164***	-0.11374**	0.00245	0.01622
Mean Difference	(-4.56)	(-2.98)	(-0.09)	(-0.30)
ESG Fund Size Control	NO	YES	NO	YES
Adjusted R²	0.00000	0.00001	0.00000	-0.00003
N	7,701	7,695	10,176	10,170
Notes: ^aThis table presents results from OLS regression models using data from 2015 through 2022. ^bThe dependent variable in columns 1 and 2 is the difference between an ESG fund’s expense ratio and that of its sister fund (expressed in percent). ^cThe dependent variable in columns 3 and 4 is the difference between an ESG fund’s one-factor alpha (estimated using 12 monthly observations) and that of its sister fund (expressed as monthly alpha, in percent). ^dThese regressions are estimated at the class level, since fees, and therefore alphas, vary by class within a fund. ^eStandard errors are clustered at the (ESG) fund level. + p<0.1, * p<0.05, p<0.01, * p<0.001.

If anything, the ESG funds may be slightly cheaper than their sister funds. This is not to say that they are cheaper than the cheapest funds in the market.⁷⁶ While the point estimates are statistically significant, we note that the magnitudes of the point estimates are small: the standard deviation of the difference in expense ratios is about 0.6 (the standard deviation of the expense ratios of the ESG funds is similar, at about 0.5). The point estimates in columns 1 and 2 therefore represent less than a quarter of a standard deviation. A conservative conclusion is that the expenses of ESG funds do not differ substantially from those of their sister funds. Certainly, we find no evidence that ESG funds are more expensive. The analysis in columns 3 and 4 is consistent with this conclusion: we find no statistically significant difference in the alphas between ESG funds and their sister funds. The point estimates are also very small relative to the standard deviation of the dependent variable.⁷⁷

By construction, these analyses focus on the average. As discussed, the SEC may (reasonably) be more concerned about the most concerning funds than it is about the average funds. We therefore extend the analysis in Table 2 by adding the portfolio difference measure. We present the results in Table 3. In columns 1 to 3 we use an indicator variable equal to one if the portfolio similarity measure is over 80% to focus on funds at the top end of this measure.⁷⁸ In columns 4 to 6 we use the measure itself to explore the relationship between portfolio similarity and fund characteristics across the distribution.⁷⁹ The dependent variable in Panel A is the difference between the expense ratio of the ESG fund and that of its sister fund. The dependent variable in Panel B is the difference between the alpha of the ESG fund and its sister fund.⁸⁰ Because fees and performance are reported at the class level (rather than the fund level), all results are clustered at the fund level.

As in Table 2, we present the baseline relationship with no controls in column 1. In column 2 we include fixed effects for year, fund family (management company), whether the ESG fund is an index fund, and whether the ESG fund is an ETF. In column 3 we further add a control for the natural log of the assets under management in the ESG fund. We use the same pattern of controls in columns 4 through 6. The results are in Panel A of Table 3.

Panel A of Table 3 shows that there is no consistent relationship between portfolio similarity and ESG fund expenses, relative to their sister funds. The point estimates in columns 1 through 3 are small (relative to the standard deviation of the dependent variable, which is about 0.6) and statistically insignificant. Importantly, this analysis compares the funds that are most similar to their sister funds—and are therefore, from the perspective of the SEC, the most concerning—to the rest of the ESG funds in the market. The results in columns 4 through 6, in contrast, suggest that there is, at best, a modest relationship between fees and portfolio difference, although this difference is not statistically significant once we include the full battery of fixed effects. Even in column 4, the practical implications of the point estimates are likely to be small: the results in column 4 imply that going from a portfolio similarity of 0 to 100—the most extreme change possible—is associated with a change in relative expense ratios representing roughly a quarter of a standard deviation, and this is only marginally statistically significant. Once we add controls, this marginal statistical significance vanishes and the point estimates fall. Overall, the results in Panel A provide no evidence that ESG funds that are most clonelike (i.e., most similar to their sister funds) charge systematically higher fees than others.

Table 3. Relationship Between Portfolio Difference and Fund Characteristics (Expenses and Performance)
	(1)	(2)	(3)	(4)	(5)		(6)
	Panel A: Expense Ratio
Portfolio Similarity > 80%	-0.07272	0.01682	-0.03979
Portfolio Similarity > 80%	(-1.25)	(-0.31)	(-0.89)
Portfolio Similarity				0.00135+		0.00037		-0.00005
Portfolio Similarity				(-1.67)	(-0.44)		(-0.06)
Year, Fund Family, Index Fund, & ETF FE	NO	YES	YES	NO	YES		YES
ESG Fund Size Control	NO	NO	YES	NO	NO		YES
Adjusted R²	0.0026	0.13833	0.14307	0.00229	0.13841		0.14300
N	7,701	7,687	7,681	7,701	7,687		7,681
	Panel B: Alpha
Portfolio Similarity > 80%	0.04021	0.09501	0.08173
Portfolio Similarity > 80%	(-1.05)	(-1.15)	(-0.90)
Portfolio Similarity				0.00069	-0.00045		-0.00054
Portfolio Similarity				(-0.75)	(-0.22)		(-0.26)
Year, Fund Family, Index Fund, & ETF FE	NO	YES	YES	NO	YES		YES
ESG Fund Size Control	NO	NO	YES	NO	NO		YES
Adjusted R²	-0.00005	0.23960	0.23967	0.00015	0.23948		0.23962
N	10,176	10,159	10,153	10,176	10,159		10,153
Notes: ^aThis table presents results from OLS regression models. ^bThe dependent variable in columns 1–3 is the difference between an ESG fund’s expense ratio and that of its sister fund. ^cThe dependent variable in columns 4–6 is the difference between an ESG fund’s one-factor alpha (estimated using 12 monthly observations) and that of its sister fund. ^dStandard errors are clustered at the (ESG) fund level. + p<0.1, * p<0.05, p<0.01, * p<0.001.

Turning to Panel B, we again find no statistically significant relationship between portfolio similarity and performance. To some extent, this should not be surprising: 12-month alphas are quite noisy, making statistical inference difficult. We stress that we do not interpret this as evidence either for or against ESG funds as an investment option. Such a determination would require investigating the particular fund’s characteristics and matching those characteristics to an investor’s particular goals. But we do not find an evidentiary basis for the SEC’s specific regulatory intervention. Moreover, to the extent that the SEC believes that a specific fund is misleading investors, it has the power to bring an enforcement action under existing law.

III. SHORTCOMING OF THE PROPOSED RULE

Even if, contrary to the evidence presented in Part II.B, there were a problem with greenwashing of the type that the SEC is concerned about, the Names Rule is a poor solution. In this Part, we highlight two fundamental shortcomings of the proposed rule. First, in Part III.A, we show that the proposed rule ignores a wide variety of legitimate investing strategies. To accommodate these strategies would stretch the proposed Names Rule beyond recognition, but declining to do so would effectively outlaw funds that employ them. Then, in Part III.B, we extend that analysis to show that mutual fund names cannot bear the weight of fully describing a fund’s investment strategy. In other words, the SEC may be expecting too much from a name.

A. The Names Rule Ignores a Wide Variety of Legitimate Strategies

While superficially plausible, the proposed Names Rule takes an artificially narrow view of investing strategies. We discuss this problem analytically, and then illustrate it using a simple example: a synthetic “Women in Leadership” fund. The advantage of focusing on women in leadership—as opposed to more commonly described ESG characteristics such as climate change—is that the number of women on a company’s board of directors or in the executive suite can be quantified objectively—and uncontroversially—in a way that a firm’s environmental sustainability may not.

Underlying the Names Rule is an assumption that whether an investment in a particular security is consistent with the strategy conveyed by the fund’s name is objective and binary—the security either belongs in the fund or it does not. This approach is based on one common approach to ESG investing— the use of screens. Some funds employ exclusive screens, meaning that they eliminate from consideration portfolio companies or securities with certain characteristics. These screens can vary substantially in their stringency, which creates a tradeoff between the breadth of the resulting portfolio and the prioritization of the ESG characteristic(s) at issue. Others employ inclusive screens (a “buy winners” approach), where they target high performers based on the fund’s preferred metric. While different in important respects, both approaches involve restricting the fund’s portfolio to securities that meet certain criteria. As a result, we can think of these strategies as being based on security selection.

The Names Rule polices a strategy based on security selection by limiting the quantity of assets in a fund’s portfolio that do not conform to the selection criteria. This may be sensible in the contexts that the old names rule policed: a security is either tax exempt or it is not. Similarly, although exotic securities theoretically populate a grey area between debt and equity, most of the securities held in mutual funds can easily be characterized as one or the other. With respect to ESG investing, however, as noted above, the characterization of a specific security is less straightforward.

At the same time, common ESG strategies do not necessarily focus on individual securities, but rather on the overall composition of the portfolio.⁸¹ For example, a fund manager could look at the average or target level of the characteristic in question across the whole portfolio. In the carbon emissions setting, for example, a portfolio manager might seek to reduce carbon emissions across an entire portfolio by 10%, while at the same time making individual exclusion choices based on a range of criteria (rather than simply excluding the “dirtiest” companies).

Another option is to deploy an exclusionary (or inclusive) screen within particular portions of the portfolio. For example, the S&P 500 ESG index uses a variation on the basic exclusionary strategy, excluding the worst performing 25% of securities within each industry,⁸² rather than overall. While some have criticized this approach,⁸³ it is a sensible strategy for an investor interested in achieving some level of sustainable investing while retaining the benefit of diversification.

Still other approaches are based on security weighting rather than outright exclusion Under this approach to style investing, the portfolio manager implements her strategy by over-weighting certain securities in the fund’s portfolio and under-weighting others. These are sometimes called “tilt-based” strategies, because the portfolio is tilted towards (or away from) certain characteristics or securities without eliminating them entirely.

Tilt-based strategies are common across the financial markets and are not unique to ESG-based styles. For example, FTSE Russell, the maker of the popular Russell family of indices, offers a variety of tilt-based style indices that have nothing to do with ESG. One example of this is its line of minimum variance indices, which are designed to provide a portfolio that is less volatile than the base index while maintaining full allocation to the relevant market.⁸⁴ We provide a simple example of how tilt can affect a portfolio in Table 4.

Table 4. Examples of Portfolio Tilt
Asset	Portfolio Weight
Asset	Fund A (ESG Fund)	Fund B (ESG Fund)	Fund Z (Non-ESG Fund)
A	22%	5%	25%
B	22%	5%	25%
C	22%	45%	25%
D	22%	45%	25%
E	12%	0%	0%

Finally, an asset manager might use voice to achieve her ESG goals. Such approaches are sometimes called “impact” strategies: the fund makes investments in poorly performing issuers (or just invests broadly across the market), and then uses her clout to advance her ESG priorities. Despite their wide acceptance in the ESG space, the proposed Names Rule does not appear to contemplate their existence: Do poorly performing assets “count” towards the fund’s 80% basket because the manager intends to exert pressure on the issuers to improve? Even under this interpretation, how much pressure must the asset manager exert in order for it to do so? The proposed Names Rule is silent on this.

In Table 5, we illustrate how some of these strategies can be deployed in the ESG context with a very simple example, what we term a synthetic “Women in Leadership Fund.”⁸⁵ Assume the fund manager’s strategy is to use the S&P 500 index as the basis for the portfolio and to implement an investment approach that focuses on female leadership.

We start with five approaches that focus on board-level leadership. The first is a portfolio wide strategy: the fund manager targets a portfolio where the average number of women on the board of the companies in the portfolio is substantially higher than that of the base index. Specifically, she wants the average number of women on boards in her portfolio to be at least the number of women at the 75^th percentile of the base index. The portfolio manager accomplishes this by recording the number of women on the board of all companies on the base index. She then ranks companies by number of women (from smallest to largest) and then by weight in the index (again from smallest to largest). She then eliminates companies one after another until the average in the portfolio of the remaining securities meets her target. We call this the “Portfolio Wide 75^th Percentile” strategy.

The second is a tilt-based strategy. The portfolio manager sorts companies into quartiles by the number of women on their boards. She then under-weights the companies in the lower quartiles relative to the higher quartiles, meaning that she invests more assets, on a relative basis, in the companies with a higher number of women on the board, and fewer assets in the companies with a lower number of women. Specifically, she assigns a factor of 1 to the bottom quartile, a factor of 2 to the second quartile, and a factor of 3 and 4 to the third and fourth quartiles, respectively.⁸⁶ This means that the fund holds every company in the index, but it puts relatively more weight on companies with more women in leadership. We call this the “Board Tilt” strategy.

The final three strategies employ three simple types of exclusionary screens: (i) excluding companies with no women on their boards, (ii) excluding companies with fewer than two women on their boards, and (iii) excluding companies where the number of women on the board is in the bottom quartile of the index. From the perspective of the SEC’s concern about greenwashing, the obvious question is what each of these strategies implies for the companies that make it into the funds. We summarize this in Table 5.⁸⁷

Table 5. Hypothetical Women in Leadership Funds, Selected Characteristics
	Average Number of Women Directors	Percent of Portfolio with ≥50% Women Directors	Percent of S&P 500	Number of Securities
	Panel A: Director Based Strategies
Portfolio Wide 75^th Percentile	4.0	4%	67%	197
Board Tilt	3.9	5%	100%	505
Exclude Bottom Quartile	3.8	3%	84%	369
Exclude Companies with < 2 Women	3.5	3%	99%	490
Exclude Companies with No Women	3.5	3%	100%	505
	Panel B: S&P 500
S&P 500	3.5	3%	100%	505

Panel A in Table 5 demonstrates that the board tilt strategy is extremely effective at increasing the average number of women directors, as well as the proportion of the portfolio invested in high-achieving companies (that is, companies with boards consisting of at least 50% women). On both dimensions, it is comparable to the portfolio wide strategy, and, if the goal is to invest in companies with a substantial number of women directors, it is considerably more successful than the three exclusionary strategies, all while preserving a very wide portfolio (in terms of number of securities).

While the “exclude companies with no women directors” strategy might run into trouble with the Names Rule on other grounds (the criterion doesn’t eliminate any companies, and might therefore be fairly viewed as illusory), it is hard to object to the other two director-focused exclusionary strategies on the basis of their names. In contrast, it is not at all clear that the (more effective) tilt strategy satisfies the Names Rule, or how the Names Rule would even be applied to it. How should the portfolio manager “indicate, with respect to each portfolio investment, whether the investment is included in the fund’s 80% basket[?]”⁸⁸ Should she list the securities that she underweights as “included in the basket” even though they are, by her own estimation, the least consistent with her strategy? Doing so would permit her to include every security in the basket, effectively nullifying the rule. If not, which securities should she exclude, and on what basis? Without further clarity, this approach risks outlawing a large class of legitimate strategies entirely.

B. The Names Rule Expects Too Much Precision from Names

The proposed Names Rule’s limitations might be justified if it were likely to accomplish an important objective. Unfortunately, we fear that it may not be able to deliver on its promises. On March 3, 2022, SEC Chair Gensler released an “Office Hours” video that appeared to illustrate the SEC’s rationale for its proposal.⁸⁹ In the video, Chair Gensler explained that buying a mutual fund should be as easy as buying milk, where you can tell whether milk is fat-free or not simply by looking at the label.

Arguably, mutual funds are somewhat more complex and subject to a greater degree of variation than milk.⁹⁰ As we show in this section, by identifying as a regulatory concern that a fund may not meet an investor’s expectations, the proposed Names Rule is asking names to do too much. To do so, we continue the example of synthetic Women in Leadership funds. We again use this example to demonstrate that a variety of plausible approaches to constructing such a fund—all of which would presumably comply with the proposed Names Rule—would provide investors with very different portfolios. Given the range of possible portfolios that would be consistent with the fund’s name, it is hard to predict what investors might reasonably expect from that name.

To do so, we begin with the two strategies based on exclusionary screening in Table 5 that exclude at least one security from the index. We limit ourselves to exclusionary strategies to keep the exposition as simple as possible, and to make sure that the strategies are as close to “apples-to-apples” comparisons as possible.⁹¹ To this, we add four strategies that focus on corporate officers. In the first, we limit the portfolio to companies with a female CEO. In the second, we expand the portfolio to also include companies with a female CFO. In the third, we exclude companies with fewer than 2 female executives among the top-5 most highly compensated executives (as reported in the proxy statement). The fourth excludes companies with no women in that group.⁹²

We then calculate the extent to which the holdings overlap between these six hypothetical funds and present the results in Table 6. The entries in the table indicate the percentage of the row fund’s portfolio that is also in the column fund’s portfolio. So, for example, the “84%” in the bottom row of the first column means that 84% of the S&P 500 is in the portfolio that excludes companies that have fewer than three women directors (representing the bottom quartile), which corresponds to the information in Panel A of Table 5.

Table 6. Overlap Between Hypothetical Women in Leadership Funds Using the S&P 500 as the Base Index
	Women Directors		Women Executives				S&P 500
	Exclude Bottom Quartile	Exclude Companies with < 2	Require CEO	Require CEO or CFO	Exclude Companies with < 2	Exclude Companies with 0	S&P 500
Exclude Bottom Quartile of Woman Directors	100%	100%	5%	30%	24%	70%	100%
Exclude Companies with < 2 Women Directors	85%	100%	5%	27%	22%	65%	100%
Require Woman CEO	89%	100%	100%	100%	69%	100%	100%
Require Woman CEO or CFO	95%	100%	18%	100%	36%	100%	100%
Exclude Companies with < 2 Women Executives	96%	100%	16%	44%	100%	100%	100%
Exclude Companies with No Women Executives	90%	100%	7%	41%	33%	100%	100%
S&P 500	84%	99%	5%	26%	21%	65%	100%

At the risk of stating the obvious, Table 6 makes clear that these hypothetical funds deliver very different results to investors, yet all could presumably be sold under the name “Women in Leadership Fund” under the proposed Names Rule. For example, the fund that requires that the company have a female CEO—indisputably consistent with women in leadership—contains only 5% of the companies in the fund that excludes companies in the bottom quartile of female directors, another completely respectable approach. Interestingly, this is not solely because the former has a stricter criterion: 11% of the assets in the fund that requires a female CEO are excluded from the fund that excludes companies that are laggards with respect to female board representation. Similar patterns emerge between other pairs of hypothetical funds: 44% of the “require at least two female executives” strategy is also in the “require a female CEO or CFO” strategy; 36% of the “require a female CEO or CFO” strategy is on the “require at least two female executives” strategy. They are, in other words, different strategies. And yet both are clearly consistent with the same fund name.

While firms on the S&P 500 represent a substantial majority of the U.S. public equity market, an analysis that focuses on firms in the S&P 500 may not be representative of the universe of public companies. This is because firms on the S&P 500 have some of the largest institutional ownership and have been the subject of extensive pressure to increase the number of women in their senior leadership. Smaller firms, in contrast, have received significantly less attention. We therefore repeat the analysis using the S&P SmallCap 600 index and present the results in Table 7. If anything, these results are even more striking. For example, 54% of the assets in the “exclude companies with fewer than 3 women directors” strategy are also in the “exclude companies with no women executives” fund. Conversely, only 41% of the assets in the “exclude companies with no women executives” fund are also in the “exclude companies with fewer than 3 women directors” fund. In short, the overlap between these different funds is often minimal. Even in this very simple setting, this example demonstrates that a fund’s name simply cannot provide enough information to give investors even a general sense of which companies are included in the fund’s portfolio.

Table 7. Overlap Between Hypothetical Women in Leadership Funds Using the S&P SmallCap 600 as the Base Index
	Women Directors		Women Executives				S&P SmallCap 600
	Exclude Companies with < 3	Exclude Companies with < 2	Require CEO	Require CEO or CFO	Exclude Companies with < 2	Exclude Companies with 0	S&P SmallCap 600
Exclude Companies with < 3 Women Directors	100%	100%	11%	24%	20%	54%	100%
Exclude Companies with < 2 Women Directors	47%	100%	7%	20%	15%	52%	100%
Require Woman CEO	65%	95%	100%	100%	62%	100%	100%
Require Woman CEO or CFO	49%	85%	33%	100%	50%	100%	100%
Exclude Companies with < 2 Women Executives	54%	88%	27%	68%	100%	100%	100%
Exclude Companies with No Women Executives	41%	84%	12%	38%	28%	100%	100%
S&P SmallCap 600	38%	82%	6%	19%	14%	51%	100%

These differences may well matter to the type of investors interested in a Women in Leadership fund. Such investors may be motivated by a wide variety of different underlying goals.⁹³ Perhaps these investors are interested in ensuring that women are represented on corporate boards, a strategy that is consistent with both the California board diversity statute and the NASDAQ board diversity requirement. In such a case, the investors may be satisfied with any of the director-based strategies, but not necessarily the executive-based ones. Alternatively, perhaps they are focused on gender equality. Strategies that focus on having 2 or 3 women on corporate boards have been successful at producing that level of representation, but the road to gender equality appears to be stalled at near 25%.⁹⁴ Finally, they may be primarily interested in female empowerment, and might therefore care much more about seeing women in senior executive positions (perhaps even CEO or CFO positions) than in minority positions on boards.

C. The Challenges of Complexity and Nuance

The results in Section III.B focus on the extremely simple context of women in leadership. Most ESG-related investing contexts are more complex. We therefore expand our analysis from Section II.B to probe the differences between ESG funds with similar names. To do so, we focus on funds using the same ESG trigger term that also employ the same approach to ESG investing. Specifically, we select funds that use either “sustainable” or “ESG” in their names, and that, according to their prospectus, employ an exclusionary strategy. This allows us to restrict our attention to funds that look, at least superficially, relatively similar to a modestly attentive investor. We then look at the portfolio similarities of all pairs of funds within each of the two groups (that is, within exclusionary “sustainable” funds and within exclusionary “ESG” funds). Recognizing that the industry has been evolving rapidly, we do this only for 2022, so all comparisons are made at the same point in time.

Even within these two relatively narrow universes, we find substantial variability in holdings: in other words, different “sustainable” exclusionary funds turn out to have quite different holdings. Digging deeper, we find that some of this difference comes from the fact that the relevant exclusionary strategy has been layered over very different baseline funds. For example, it should come as no surprise that the holdings of an exclusionary small-cap sustainable fund are very different from those of an exclusionary large-cap sustainable fund. This further highlights the challenges associated with comparing funds under the broad ESG umbrella. Digging deeper still, we find evidence that suggests that fund families have a “house” approach to their various ESG strategies: different sustainable or ESG funds within a fund family appear to be more consistent (other things equal) than such funds across fund families.

The normative implications of this finding are, to some extent, in the eye of the beholder. On the one hand, within-family consistency is consistent with bona fide efforts to implement a coherent strategy, suggesting that asset managers are making good faith efforts to deliver the product that they are promising. On the other hand, the substantial across-family differences suggest meaningful limitations in the amount of information that can be conveyed through a term like ESG or sustainable. This analysis complements the analysis in section III.B. Finally, we think that, given the different approaches, attempts to impose a standardized meaning on ESG trigger words (like “sustainable” or “ESG”) may be ill-conceived.

IV. IMPLICATIONS

What are the implications of our analysis? First, consider the SEC’s concern that funds’ use of ESG names may be inappropriately attracting investor assets. Our empirical findings demonstrate that, using the logic underlying the SEC’s rule, the overwhelming majority of ESG funds differ substantially from their sister funds. At least by this logic, the ESG fund names in our study do not appear to be cosmetic. Nor do they appear to be a means of raising fees on unsuspecting investors. Rather, it seems more likely that fund sponsors are offering ESG funds because that is what investors want, and in doing so are offering a distinct product from their non-ESG offerings. Whether they are doing so in the best way, or even in a sensible way, is beyond the scope of both the proposed Names Rule and our analysis.

Concededly, our results reveal that there is a substantial degree of overlap between ESG and non-ESG funds. It is unclear, however, why that overlap should be viewed as problematic. Mutual funds are designed to provide investors with a diversified market rate of return. A fund that differed too substantially from the overall market could expose an investor to an unacceptably high level of risk, particularly if, in some cases, an ESG investing strategy may sacrifice returns. At the same time, other commentators have argued that some ESG investing considerations are associated with better economic performance. To the extent that they are right, one would expect to see components of an ESG investing strategy in a fund that was managed and marketed exclusively to maximize economic value. We, like the SEC, take no position on whether an ESG-based portfolio is the “right” investment strategy for any particular investor. We also, like the SEC, believe that it is not our place to decide “how ESG” a strategy needs to be in order to use that name. Unlike the SEC, however, we do not believe that the existing evidence warrants additional regulatory intervention.

Our findings also raise questions that we cannot fully explore within the confines of this article, about what it means for an investment to fall within the 80% bucket contemplated by the names rule. From the SEC’s description of the Fossil Free Fund, it doesn’t seem like the SEC really contemplates allowing ESG funds to hold 20% of securities that fall outside the ESG bucket. Rather, the example suggests that ESG funds should be holding 100% of their portfolios in investments that are consistent with their investing strategies. But how does one apply this requirement? In addition to evading precise definition, ESG appears to be more of a range or a spectrum than a binary, and while it may be possible to identify a handful of companies that most investors would characterize as “green” or “brown,” it is likely that the vast majority of publicly traded companies are more accurately described as “gray.”⁹⁵ Both ESG and non-ESG funds will invest primarily in these companies, an intuition that is supported by our tilt analysis. But it would be hard to describe most gray securities as within an 80% ESG bucket.

Finally, our analysis of the Women in Leadership funds suggests the limitations in using fund names to convey detailed information about a fund’s investment strategy. It is reasonable to demand that a fund’s name conveys that the securities in its portfolio comply with some objective criteria. A self-described bond fund should not be investing in equities; a tax-exempt fund should not invest in taxable securities. But what should a MAGA fund, a Magellan fund, or a God Bless America fund invest in? The reason investors rely heavily on fund names is that they convey information. As the ESG investment space continues to evolve, investors will demand, and sponsors will offer, an increasing variety of investment strategies. Although the process of describing those strategies through fund names is imperfect, it is likely far superior to a world in which a fund sponsor offers a series of products named Fund One, Fund Two, and Fund Three.

CONCLUSION

The debate around ESG investing has reached a fevered pitch, with a constant drumbeat of concerns about greenwashing. The SEC has an enormously difficult job, and it is understandable that it would endeavor to reduce fraudulent and misleading marketing. Fortunately, we find little evidence that such greenwashing—at least of the sort that the SEC’s proposed rule could curb—exists. Less fortunately, our analysis also shows that the SEC’s proposed rule is not benign. Because it fails to recognize tilt-based strategies, it is inconsistent with a large class of well-accepted investment strategies. Instead of amending the Names Rule, the SEC should focus its efforts on taking enforcement action against the small number of funds that do, in fact, have fraudulent or misleading names, whatever their purported strategy may be.

96 S. Cal. L. Rev. 1417

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Jill E. Fisch*

* Saul A. Fox Distinguished Professor of Business Law, University of Pennsylvania Carey Law School.

Adriana Z. Robertson†

† Donald N. Pritzker Professor of Business Law, University of Chicago Law School. This article has benefited from comments by participants at the Digital Transformation in Business Symposium at USC law school, the Penn/NYU Symposium on Law & Finance, the Duke Law & Economics Colloquium, the Foundations of Law & Finance LawFin Research Seminar, the University of Virginia Law & Economics Seminar, the BYU Winter Deals Conference, and the American Law & Economics Association Annual Meeting. Levi Haas provided exceptional research assistance. All errors are our own.

The Meme Stock Frenzy: Origins and Implications

April 2024April 2024Dhruv Aggarwal,* Albert H. Choi† & Yoon-Ho Alex Lee‡

In 2021, several publicly traded companies, such as GameStop, Bed Bath & Beyond, and AMC, became “meme stocks,” experiencing a sharp rise in their stock prices through a dramatic influx of retail investors into their shareholder base. Analyses of the meme stock surge and its implications for corporate governance have focused on the idiosyncratic creation of online communities around particular stocks during the COVID-19 pandemic. In this Article, we argue that the emergence of meme stocks is part of longer-running and more structural digital transformations in trading, investing, and governance. On the trading front, the abolition of commissions by major online brokerages in 2019 reduced entry (and exit) costs for retail investors. Zero-commission trading represents a modification of the payment for order flow (“PFOF”) system, which is itself a product of technological disruptions in the financial markets in the 1980s. With respect to investing, the emergence of social media communication amplified retail investors’ pre-existing dependence on social networks to make decisions regarding stock investing and portfolio construction. It also allowed them to coordinate their investing activities and affect the market price while expressing their non-financial interests. These structural changes imply that meme trading is here to stay. While some startups have attempted to bring the shareholder experience into the digital age and help retail investors participate in governance, these developments have been relatively modest. After tracing the meme stock phenomenon, we sketch a research agenda for law and finance scholars to explore the concrete effects of meme investing on corporate governance. First, we ask whether retail traders can transform into retail shareholders actively engaged in corporate governance. Second, we propose a broader metric for “meme-ness”: future scholarship can use modern advances in data science to better identify which companies are vulnerable to meme surges and social media-driven investing unrelated to their financial fundamentals.

INTRODUCTION

In the midst of the COVID-19 pandemic, the U.S. stock market experienced a rather unusual phenomenon. Several publicly traded companies, such as GameStop, Bed Bath & Beyond, and AMC, became “meme stocks” and experienced a dramatic influx of retail investors into their shareholder base.¹ A large number of retail investors responded to and engaged in a coordinated buying campaign, and over a short period of time, the stock prices surged to stratospheric levels.² Some of those companies, notably AMC and GameStop, took advantage of the surge and were able to raise a large amount of capital at elevated stock prices, thereby substantially improving their liquidity and solvency positions.³ While the stocks are no longer trading at such historic highs, prices are still (much) higher than the pre-surge levels, and many retail shareholders are staying “loyal” to the companies.⁴

The “meme surge” phenomenon, particularly the dramatic shift in shareholder base away from institutional ownership, presents a unique opportunity for analysts and scholars to (re)evaluate the current understanding of corporate finance and governance. To date, the observers of the meme stock surge and its implications for corporate governance have mostly focused on the idiosyncratic creation of online communities around individual stocks during the COVID-19 pandemic.⁵ The goal of this Article is to take a broader and longer-term view of the technological developments undergirding the meme surge. In so doing, we also sketch out a research agenda for scholars studying this topic.

We argue, in particular, that the emergence of meme stocks is part of longer-running and more systemic digital transformations in trading, investing, and governance.⁶ On the trading front, major online brokerages suddenly abolished commissions in 2019. This change echoed the business model of the popular retail trading app Robinhood, which had been growing its market share by not charging trading commissions. The abolition of commissions reduced (or eliminated) entry (and exit) costs and thereby encouraged greater retail investor participation in the stock market.⁷ Incidentally, zero-commission trading represents a modification of the payment for order flow (“PFOF”) system, which is itself a product of technological disruptions in the financial markets from the 1980s.⁸ With respect to investing, the growth of social media communication amplified retail investors’ pre-existing dependence on social networks to make decisions regarding stock investing and portfolio construction.⁹ These structural changes imply that the stock market is likely to experience meme trading and meme surges on an ongoing basis. Finally, while some startups have attempted to bring the shareholder experience into the digital age and help retail investors participate in governance, so far, these developments have been relatively modest.¹⁰

After examining the background technological developments—that we believe meaningfully contributed to the meme surge phenomenon—we sketch a research agenda for law and finance scholars to explore the concrete effects of meme investing on corporate governance outcomes. First, we ask whether retail traders can transform into retail shareholders actively engaged in corporate governance. Was the meme surge experience a social phenomenon limited to trading markets, or could it translate into a broader signal of engagement by retail shareholders? Some legal scholars have predicted that we will see more active retail shareholder engagement in governance issues, in terms of either traditional (bringing, or voting on, proposals) or contemporary (environmental, social, and governance (“ESG”) performance) dimensions.¹¹ At least in theory, one could argue that those retail investors who remain as shareholders after the surge would care about firm governance and performance and more actively exercise their rights as shareholders. While the jury is still out on the longer-term effect of meme-driven market entrants, to the extent that the meme surge event was driven mostly by coordinated trading rather than coordinated voting, it remains uncertain whether such an explosion of “retail governance” would, in fact, occur. Second, another puzzle presented by the meme surge was why some companies experienced the retail investor influx while other (similarly situated) companies did not. To address this puzzle, we explore a broader metric for “meme-ness,” and suggest that future scholarship should use modern advances in data science to better identify which companies are vulnerable to meme surges and social media-driven investing unrelated to their financial fundamentals.¹²

The Article is organized as follows. In Part I, we take a historical approach to sketch out the emergence and popularization of zero-commission trading by tying it back to the adoption of the PFOF protocol in the 1980s, under which broker-dealers get “rebates” from wholesalers (or “internalizers”) for delivering orders from their clients. In many ways, the elimination of trading commission for the retail shareholders, leaving broker-dealers to rely solely on PFOFs, was a logical evolutionary step from the PFOF system of the 1980s. In Part II, we take a closer look at the meme surge phenomenon, tying together several different factors: zero-commission trading, coordination through social media, and predatory trading. We also briefly discuss the implications of meme trading for securities regulation and consider the recent arguments about the shift towards retail shareholder base and possible democratization of corporate governance. Part III lays out a future research agenda, both with respect to coordinated voting and governance engagement and identification of meme stocks.

I. DIGITAL TRANSFORMATIONS IN TRADING, INVESTING, AND GOVERNANCE

A. Digital Transformation in Trading—Payment for Order Flow, 1980s and 2010s

In important ways, the meme stock revolution can be traced back to an unlikely digital transformation: Bernie Madoff’s promotion of the PFOF system in the 1980s. In 1983, following a congressional mandate, the Securities and Exchange Commission (“SEC”) required stock exchanges, like the New York Stock Exchange (“NYSE”), to publicly broadcast trading data in real time. This development marked a step toward bona fide “democratization” of investing: the market-making process of matching buy and sell orders on the NYSE was no longer restricted to its own specialists. Using the NYSE’s broadcasted quotes, market-makers in other venues, such as Madoff’s firm in the National Association of Securities Dealers Automated Quotations (“Nasdaq”), could execute trades on the NYSE at the best prices.¹³

PFOF is a conceptually straightforward system. A brokerage agrees to send its clients’ orders to another firm, often an internalizer or a wholesaler—such as Citadel and KCG Americas—which is a trading venue that matches buy orders with sell orders, in return for a small fee per transaction. After executing the order, the trading venue returns the payoff to the broker, which in turn transmits it to the client.¹⁴ Note that the broker is making money in two ways: from the transaction fee it collects from its client and from the trading venue. While the per-transaction fees paid by the trading venues under the PFOF system is a fraction of a dollar, the aggregate revenue accrued by brokers across thousands or millions of daily transactions can be economically significant. The trading venue, on the other hand, profits off the bid-ask spread and is guaranteed a higher volume of transactions because of its contractual arrangements with brokers.¹⁵ Madoff’s investment firm pioneered PFOF and acted as a trading venue in the 1980s, paying brokers one cent per share transmitted.¹⁶ This was a significant departure from the pre-PFOF system, in which the NYSE charged brokers between one and three cents to execute orders.¹⁷

From its beginnings in the 1980s, the PFOF ecosystem has revolved around the retail investor. Notably, Madoff would only perform market-making activities for orders of 5,000 or fewer shares¹⁸—on the understanding that these were uninformed retail investors who needed liquidity rather than informed professional traders who had superior information about the “true” value of the stock. Moreover, Madoff would avoid brokerages where a high share of traders was informed in order to avoid the economic phenomenon of “adverse selection.”¹⁹ Adverse selection is a widely-studied phenomenon wherein actors participate in economic activity because they possess “hidden knowledge.”²⁰ Applied to the PFOF context, a trading venue’s (such as Citadel) expected returns decrease if the investors on the other side are informed about the true value of the stock.²¹ Therefore, PFOF’s origins are inextricably linked to the notion that retail investors are relatively uninformed or unsophisticated, and primarily driven by liquidity concerns.

At a basic level, meme trading is a consequence of the classic PFOF model on steroids. In the mid-2010s, Robinhood pioneered the zero-commission model, charging users no commissions for placing trade orders.²² This zero-commission model was the driving force behind Robinhood’s emergence as the app of choice for young retail investors, who could now access the markets costlessly.²³ While the broker in the classic PFOF model was making money from two channels (first, the commission from the client, and second, the payment from the market-maker), Robinhood’s disruptive business model now focused exclusively on raising revenue through the market-maker’s payments for order flow. Robinhood’s hope was that the abolition of commissions would raise volumes from retail investors enough to compensate for revenues now solely depending on payments from its market-maker, Citadel.²⁴

Robinhood was a maverick—the new entrant whose unique business model allowed it to steal market share from more established online brokerages. Due in part to its innovation, Robinhood was able to grow relatively quickly. Older and established brokerage firms eventually responded to Robinhood’s challenge. On October 1, 2019, the major online brokerages Charles Schwab and TD Ameritrade eliminated commissions for all their customers.²⁵ These platforms were quickly followed by another major online brokerage, E-Trade. Collectively, these entities had dominated the online brokerage business before the emergence of Robinhood.²⁶

The significance of this event cannot be overstated. The advent of zero-commission trading has been widely cited as a root factor in the explosion in retail investing activity.²⁷ Indeed, one of the leading financial economics explanations for individual non-participation in the stock market is that there is a cost of investing (including the brokerage commissions) that deters the less wealthy from participating in the market.²⁸ By reducing the entry cost of trading (for example, brokerage commissions), the sudden 2019 decision by the major brokerages increased retail investor entry into the stock market.²⁹

Figure 1, which is replicated from our companion paper,³⁰ validates the importance of the abolition of commissions—specifically, for turnover in companies that experiences meme surges. The bar graphs show the average daily turnovers, that is, the percentage of outstanding shares that are traded, separately for companies that experienced meme surges (later) and other firms. The companies include AMC, Bed Bath & Beyond, Blackberry, Express, Inc., GameStop, Koss, Robinhood, and Vinco Ventures. They are identified based on Factiva and internet searches, as well as a survey of the nascent literature on meme stocks.³¹ The data for share turnover comes from the Center for Research in Stock Prices (“CRSP”). As Figure 1 indicates, while these firms had always seen a larger proportion of their outstanding shares traded, they saw a massive increase in turnover both after the abolition of commissions in October 2019 and the surge in 2021.

Figure 1. Average Turnover for Meme Stocks and Other Firms

Notes: This figure shows a graph of the mean share turnover (shares traded each day as a percentage of total outstanding common stock) according to CRSP data. The data is presented separately for meme and non-meme stocks. Meme stocks include AMC, Bed Bath & Beyond, Blackberry, Express, Inc., GameStop, Koss, Robinhood, and Vinco Ventures. “Pre-Zero Commission” refers to the period from January 2015 to September 2019, “Post-Zero Commission” refers to the period from September 2019 to December 2020, and “Post-Meme Surge” refers to the period from January 2021 to December 2022.

Put differently, viewed from the perspective of the longer institutional history of PFOF, the retail investor surge in companies like AMC and GameStop was less like a revolutionary break from history and more akin to the episodic technology-driven upheavals in financial markets. Like the live transmission of NYSE quotes and evolution of the classic PFOF model in the 1980s, the emergence of Robinhood and zero-commission trading in recent years allowed retail investors to participate in financial markets. While retail investor coordination through social media websites is clearly a novel contributing feature of the meme phenomenon, the longstanding role of digital disruptions and the PFOF model cannot be ignored.

B. Digital Transformation in Investing—Reddit and r/Wallstreetbets

Meanwhile, the online retail investing world was going through its own set of transformations. Social networks are central to the behavior and impact of retail investors. Inexperienced retail investors frequently turn to friends and family members for investing advice.³² Financial economists, for instance, have found that retail investors’ decisions on investing in the stock market and constructing their portfolios are highly correlated with those of their neighbors.³³ Interestingly, this research is consistent with braggartry being a key determinant of retail investors’ social behavior. It has been documented that when retail brokerages partnered with social networking platforms, investors became twice as likely to sell profitable assets and hold on to lossmaking stocks.³⁴ This is likely because of the “disposition effect”—retail investors wanted their peers to admire their stock-picking prowess, and not admit their mistakes.³⁵

Such bravado continues to characterize retail investors’ participation in online communities dedicated to meme stocks. The explosion in retail investor interest in meme stocks was propelled by posts on the Reddit group “r/Wallstreetbets.”³⁶ Posters engaged in bombastic exchanges, claiming to have made spectacular returns making bets on stocks that seems unmoored from realistic assessments of the companies’ business models or their fundamentals.³⁷ The Reddit board attracted thousands of new followers drawn to the prospect of sharing in the benefits from pushing up the prices of stocks like AMC and GameStop.³⁸

Another important aspect of the digital transformation in the investing community is that it allowed retail investors to coordinate their expressive participation in the financial markets. Beyond boasting about eye-popping returns, users of the r/Wallstreetbets board were able to express their idiosyncratic likes and dislikes about the business model or customer services of the video game or movie theater companies.³⁹ The design of investing apps such as Robinhood catered to this expressive function of investing, with flashy graphics and leaderboards allowing meme traders to derive non-pecuniary benefits from investing.⁴⁰ Scholars in other areas of the law have long recognized that individual actions are infused with social meaning, defined with reference to social norms.⁴¹ Social media platforms like Reddit thus represent a digital disruption that has allowed retail investors to exchange notes not just about their trading exploits, but also their expressive preferences about firms in a group setting.

A distinction ought to be made between digital transformations in trading versus those in investing. In the former, digital transformations gradually brought about changes in the business models of brokerage firms, thus providing the general public with greater access to capital markets. In the latter, digital transformations changed the social meaning of investing for individual investors. Investing is no longer just a form of rationally deferred consumption; it has become a social activity through which to bond with others and to express one’s preference and identity.

C. Digital Transformation in Governance—Corporate Forum Technology

Digital transformations have also shaped how management and shareholders engage in governance matters. To begin with, the onset of the COVID-19 pandemic has accelerated the trend toward allowing virtual shareholder meetings.⁴² A recent study found that many companies held their meetings exclusively online in 2020–21 due to the stay-at-home orders.⁴³ Forty-four states and the District of Columbia already permitted companies to hold their annual meetings virtually as of 2020,⁴⁴ but individual firms had been reluctant to allow online participation before the pandemic. Shareholder voting and engagement increased notably for firms that switched to online meetings.⁴⁵

Historically, retail shareholders’ propensity to cast their ballots in annual meetings has been low. According to one study, while retail domestic investors own approximately 26% (on average) of the outstanding shares of public companies,⁴⁶ they only account for 11% of voted shares because of their low turnout. In the aggregate, retail shareholders tend to vote, on average, only 32% of their own shares.⁴⁷ The contrast between retail investors and institutional investors in terms of corporate voting is stark: according to a proxy report, retail investors voted only 29% of their shares in 2014, while institutional investors voted 83%.⁴⁸

Multiple factors drive the low participation rate among retail investors. First, many retail shareholders may not even be aware that they have the right to vote in annual meetings. Often, they may not even receive notice of the meetings in a timely manner. Second, retail shareholders, many of whom do not have a significant stake, are busy with their daily lives and do not have incentives to spend the time or resources to understand the issues being voted on in corporate meetings. Voting can be particularly onerous when retail shareholders have a diversified portfolio and own shares in many (hundreds or even thousands of) companies. Third, because retail shareholders on average own only a tiny fraction of the outstanding shares, they will likely feel that their votes will not have an impact on the outcome.⁴⁹ Fourth, even for those interested in voting, the proposals being voted on can be complex, and retail shareholders may fear that they cannot make informed decisions in their best interest. In a similar vein, some shareholders may trust the management of the company and believe that they will act in the best interests of the shareholders, regardless of the outcome of the vote. All of these factors render retail shareholder apathy rational.

To address these concerns, a few startups have emerged, promising to harness technology to bring the shareholder experience into the twenty-first century. To this extent, there has been a noticeable increase in the development of shareholder voting apps.⁵⁰ This is due in part to the increasing popularity of mobile devices and the growing demand for convenience from investors. Shareholder voting apps are designed to make it easy for investors to vote their shares from their smartphones or tablets, without having to mail in a paper ballot, call a toll-free number, or log onto a website. Their features include: the ability to view and research company proposals; the ability to vote on company proposals; the ability to ask questions of company management; and the ability to receive timely updates on corporate news.

For example, Say Technologies is a platform recently acquired by Robinhood that allows shareholders to communicate directly with management, vote on polls, and submit questions for meetings and earnings calls, all through a smartphone app.⁵¹ Say Technologies is currently used by a variety of companies, including Tesla and Chevron.⁵² Other startups specifically focus on helping retail investors cast votes. Enhanced Broker Internet Platforms (“EBIPs”) serve retail investors by allowing them to access proxy materials and vote on their brokers’ websites.⁵³ Similar services are provided by Broadridge ProxyVote and eBallot—the latter being used by such companies as Apple, Amazon, and Facebook. Some apps provide more than just a platform for casting votes. For example, ProxyDemocracy goes further to inform retail investors how institutional investors plan to vote on different proposals.⁵⁴ Each of these apps is designed to reduce the cost of meaningfully participating in annual meetings for retail shareholders. From this perspective, these digital transformations can be compared to the abolition of trading commissions discussed in Section I.A.

Potentially more impactful than the development of these apps, sporadic movements have taken place among shareholders of various companies to coordinate their votes. For example, on March 20, 2021, a Wall Street Bets (“WSB”) “megathread” was formed “for the purpose of discussing how to vote at the 2021 AMC Entertainment shareholders’ meetings.”⁵⁵ If such threads were to become more commonplace and retail shareholders were to exhibit a herding behavior in their voting patterns or coordinate in voting, corporate governance could be democratized in ways akin to trading.

II. THE RISE OF MEME TRADING: CONSEQUENCES AND IMPLICATIONS

The previous Part examined the technological developments and new business models that facilitated greater retail investing and eventually opened an era of meme trading. GameStop’s meme surge from January of 2021 was just one prominent example of meme stock surges that have been taking place episodically in recent years. The New York Times noted that meme surges were initially attributed to “hobbyists stuck at home spending stimulus checks, crusading to topple Wall Street trading houses they felt had rigged the financial system against them,”⁵⁶ but conceded that these firms continued to see elevated stock prices into 2022 and concluded that this could be a longer-lasting market phenomenon.⁵⁷ Drawing on previous literature, this Part considers the consequences and implications of the rise of meme trading.

A. Meme Surges and Predatory Trading

The sudden influx of retail investors—coupled with a platform that facilitates costless transactions and an internet forum that enables communication—implies trading markets that look very different today. Previously, retail trading was thought to have little effect on stock price movements. Retail investors could not easily coordinate their trades, and as a result, their idiosyncratic trades would tend to cancel each other out.⁵⁸ Furthermore, in the presence of large institutional shareholders, including BlackRock, State Street, and Vanguard,⁵⁹ the volume of trade that originates from retail investors tends to be relatively modest, particularly for companies with a large market capitalization. With coordinated trading and meme stock surges, however, this is no longer true, at least for small- to medium-sized companies. Retail trades today can have significant price impacts for certain companies’ stocks.⁶⁰ This change comes at a cost, however. Retail trades—especially expressive trades—can be emotionally driven based on the underlying companies’ cultural relevance.⁶¹ There is no indication that meme stocks prices reflect information about the companies’ underlying fundamentals.

Recall how the events played out in the GameStop meme surge.⁶² GameStop had been losing money and was facing a liquidity crisis.⁶³ The market had been predicting (as evidenced by the low stock price) that the company would likely file for bankruptcy and possibly be liquidated in the near future.⁶⁴ A number of hedge funds—most prominently Melvin Capital—had taken a large short position against its stock, betting that the price would drop even further.⁶⁵ In January 2021, retail investors engaged in an active “buy” campaign to dramatically push up the GameStop stock price to the stratospheric level of over $483 per share from less than $4 per share.⁶⁶ Retail investors’ influx seems to have been driven in part to create a “short squeeze” against the hedge funds.⁶⁷ The end result was a large loss—and ultimate retreat—by the hedge funds.⁶⁸ Market analysts observed that meme traders used Reddit to decide on target firms that typically had a smaller number of outstanding shares, and delighted in punishing market participants that had taken short positions in the selected companies.⁶⁹

The short squeeze experienced by the hedge funds is an example of a more general class of trading, called “predatory trading”—trading that exploits known needs of other investors who must change their positions.⁷⁰ In an influential paper, Brunnermeier and Pedersen document historical examples of trades that exhibited these patterns and develop a formal model to analyze this scheme in the context where certain large investors have a known need to liquidate their portfolios.⁷¹ According to their analysis, where a large trader has a need to sell certain stocks, which is predicted by another large trader, this other trader can “front-run” and sell the stocks ahead, and subsequently buy them back at a lower price—after the original trader sells his stocks and further brings down the price. Under this pattern, “a trader profits from triggering another trader’s crisis, and the crisis can spill over across traders and across markets.”⁷² Importantly, the model assumes that the size of each strategic trade must be sufficiently large enough to have a price impact.⁷³

GameStop’s short squeeze was essentially the mirror image of the trading pattern analyzed by these authors: where a hedge fund’s need to buy stocks—to cover its short position—is known, other investors, as a group, can strategically buy a significant share of the same stock to front-run the fund first and later sell those shares at a higher price after the fund eventually engages in the buy. What is notable was that the GameStop surge is the first case of predatory trading attributable to retail investors.⁷⁴ The digital transformations we have witnessed in trading and investing have facilitated coordinated trades among retail investors to potentially participate in predatory trading for the first time and take a collective stance against hedge funds.⁷⁵ What also seems different about the meme surge is that, unlike traditional investing and predatory trading models, the retail investors (at least a large fraction of them) who participated in the surge seem to be driven not solely by the financial returns but seem to have been motivated by non-financial considerations, such as taking a stance against Wall Street or saving a company (possibly with some sentimental attachment) from bankruptcy. At least in theory, when a sufficiently large number of investors are willing to pay more than what a firm’s financials dictate, this could create a divergence between the stock price and the firm’s “fundamental” value.⁷⁶

An important question is whether the risk of short squeezes would discourage hedge funds from taking short positions on meme companies in the future despite their failing conditions. If hedge funds routinely stay away from short-selling meme stocks to avoid falling victim to meme surges, there will be a loss of price efficiency among those stocks. Of relevance, the SEC recently adopted a rule intended to increase transparency in short positions held by institutional investors.⁷⁷ The new rule would require certain institutional investment managers to report their short position data and short activity data for equity securities on a monthly basis.⁷⁸ In theory, this rule could potentially worsen the risk of short squeezes—a concern that the agency’s own economic analysis has acknowledged.⁷⁹ To address this concern, the SEC has decided to collect manger-specific data but release only aggregated and anonymized data to the public. The SEC believes that this arrangement “should reduce the likelihood of short squeezes” whole facilitating “improved detection of manipulative and potentially destabilizing activity.”⁸⁰ It is too soon to tell how this new rule may affect the future of meme trading.

B. At-the-Market Offering Opportunities

Meme surges do not affect investors alone. They have implications for meme stock companies as well. During its meme surge, GameStop took advantage of the elevated stock price and engaged in a large capital raising through a couple of stock sales—specifically, through at-the-market (“ATM”) offerings.⁸¹

d192873d424b5.htm [https://perma.cc/FUA9-PP4U] (“We have previously sold an aggregate of 3,500,000 shares of our common stock for aggregate gross proceeds of approximately $556,691,221 pursuant to the Sales Agreement and the prospectus supplement filed by us on April 5, 2021.”). An ATM offering allows an issuer to sell its stock at the prevailing market price. As a result, GameStop was able to address its dire need for liquidity. Once on the verge of running out of cash and filing for bankruptcy, GameStop was suddenly able to continue its business—thanks to its fan base that was purchasing its stock for reasons unrelated to its underlying business condition.⁸² Importantly, at the time GameStop engaged in stock sales, it openly acknowledged in its prospectus that its stock price was not correlated with any fundamental changes in its business.⁸³

Does the era of meme trading then imply an era of aggressive ATM offerings? While it is reasonable to expect most meme stock companies to raise capital during moments of meme surges, our search of the SEC’s public company filings system shows that only two companies—GameStop and AMC⁸⁴—took advantage of meme surges and made offerings.

It is unclear why other meme stock companies did not similarly choose to take advantage of meme surges. One theory, advanced by the columnist Matt Levine, is that these companies were more cautious and wanted to avoid being blamed for knowingly selling shares at an inflated price.⁸⁵ However, the extent to which any of these companies would be held liable for making an opportunistic ATM offering is unclear. Securities regulation is based on the principle of full disclosure.⁸⁶ Even if stock prices are over-inflated, there is no obvious theory of liability when these companies fully acknowledge the mismatch between stock price movements and the company’s underlying financial conditions. Nevertheless, the SEC may still find ways to prevent or delay certain offerings.⁸⁷

The possibility of ATM offerings amid meme surges points to an unusual consequence of expressive investing. In the olden days, the common wisdom was that if you want to support a company, you should buy its products or services, not its stock (in the secondary market). The company does not get to enjoy any of the proceeds from the secondary market transactions of its stock. However, the combination of ATM offering mechanisms and meme surges suggest this wisdom may be obsolete: in the era of meme trading, retail investors can meaningfully express their support for the company through secondary market purchase of its stock. Their purchases can contribute to meme surges, which would offer the company an opportunity to rake in cash through an ATM offering.

C. Implications for Securities Regulation

Beyond the implications for trading markets, meme trading has important implications for established doctrines in securities regulation. For example, Rule 10b-5 claims under the Securities and Exchange Act of 1934 represent the most common type of securities liability in the United States.⁸⁸ To establish a Rule 10b-5 cause of action, a plaintiff must demonstrate: “(1) a false statement or omission of material fact (2) made with scienter (3) upon which the plaintiff justifiably relied (4) that proximately caused the plaintiff’s injury.”⁸⁹ As we argue below, meme trading arguably undermines each of these four foundations of Rule 10b-5 liability. This could limit the retail investors’ recourse in case of misrepresentations or fraud.⁹⁰ Furthermore, it could reduce the disciplinary effect of litigation risk in curbing managerial misconduct.⁹¹

With respect to the first two elements of 10b-5 liability listed above—a material misstatement or omission and the scienter requirement—the general tumult of meme trading could allow managers to represent their actions as being immaterial or innocuous. For example, AMC’s CEO indulged his company’s committed meme followers online.⁹² He hosted them for a special movie screening, spent an hour every day reading feedback from meme traders on videos streamed on Twitter, and (allegedly) intentionally attended public Zoom meetings without his trousers on.⁹³ Would a securities class action litigant be able to show that the CEO had made a material misstatement in reading supportive messages from meme traders or encouraging them online? After all, the meme investors’ Reddit messages and tweets were already in the public domain and should have been priced in if the market is informationally efficient.⁹⁴ Of course, a plaintiff could argue that the CEO creating hype around his stock is qualitatively different from an existing mass of anonymous Reddit posts doing so. However, the corporate defendant would plausibly have a colorable claim that simply regurgitating the meme investors’ widespread sentiments is neither a material misstatement nor one made with scienter.

On the other hand, meme surges will also complicate how the plaintiff may establish materiality in other settings. For example, if the defendant were to make a rosy but faulty announcement regarding its financials during an extremely volatile meme surge, whose movement is otherwise uncorrelated with the company’s fundamentals, the plaintiff’s expert may have an extremely difficult time establishing that the announcement was material based on an event study.

The unique meme investing scenario also calls into question whether securities plaintiffs can establish reliance or loss causation. As Professor Sue Guan has noted, successive waves of meme activity mean that even if a company, such as AMC, restates its earnings or corrects a misstatement, the stock reaction to the corporate misconduct may be submerged by price movement due to meme trading. This is especially true because meme companies are generally smaller firms whose stock prices can be more easily moved. Reliance is undermined because the lack of a price reaction near the company’s alleged misstatement or omission could imply that traders did not buy shares in reliance on the contested managerial act. Loss causation can similarly be challenged if the defendant can convince the court that its actions did not inflate the price of shares; instead, it can argue that meme trading pushed up the stock price.⁹⁵ Meme traders and their bombastic puffery can thus serve as useful foot soldiers, insulating meme company executives from securities liability.

D. Beyond Trading Markets

If meme trading is here to stay, what can we expect from meme and other retail traders beyond trading markets? A natural question one can ask is whether retail investors participating in meme trades can bring about meaningful changes as retail shareholders. After all, the digital transformations discussed in Part I have brought down the cost of participating in trading, investing, and governance activities. The GameStop saga and the meme stock frenzy of 2021 demonstrated the power of technology to coalesce dispersed individuals who can unite to bring about an impact and provide a check on institutional players. Thus, one interpretation of these events is that future technological developments can allow dispersed individuals to overcome the cost of collective action to further their collective agenda.

One line of predictions says that increased retail access to capital markets will democratize finance and such retail shareholders will embed their “prosocial” preferences on corporate policies.⁹⁶ For example, Professors Sergio Alberto Gramitto Ricci and Christina Sautter observe that the new generation of investors will be more likely to pursue ESG goals rather than focusing on making a profit⁹⁷ and will engage in governance activities by exercising their shareholder rights.⁹⁸ The authors thus predict that meme traders and their activities will lead to a new paradigm for corporate governance. A similar view was echoed by Professor Jill Fisch. While focusing mostly on citizen capitalism’s benefits to economic development, Fisch also notes that “[c]itizen capitalism may also enhance the voice of ordinary citizens in corporate decisions” and argues that retail investors will be able to shape shareholder power.⁹⁹ She acknowledges that while governance measures “must ultimately command the support of institutions as well . . . . [I]n issuers with significant retail ownership, the retail vote can influence the outcome of critical shareholder votes.”¹⁰⁰

On the other hand, there are also reasons to question the link between the distinct transformations in investing and ongoing corporate ownership. For one thing, there are significant differences between meme traders and retail shareholders in terms of their activities, goals, and execution costs. First, their bona fide activities are quite distinct: an investor’s activities include information-gathering and buying and selling; a shareholder’s activities include voting, nominating director candidates, submitting proposals, or running proxy contests. Second, their goals and payoffs may also be very different: a meme trader might trade for profit motives, for the thrill of using game-like apps, or for expressive reasons. Most of these are immediately realized through the act of trading. By contrast, a retail shareholder may recognize that she has a very little chance of affecting any proposal outcomes and many of the changes may not be realized in the short run.¹⁰¹

Third, while digital transformations discussed in Part I largely reduced the participation costs for both meme traders’ activities (trading) and shareholders’ activities (voting), voting on corporate proposals still entails information costs (not present for pure meme trading activities) that have not been eradicated. Finally, meme trading does not take place across all companies. To date, meme surges have been limited to a relatively small set of companies with particular characteristics—such as low stock prices, low market capitalizations, high bid-ask spread, and cultural relevance.¹⁰² Indeed, all eight meme stock companies we analyze are mid- to small-cap companies, valued under $10 billion in market capitalization (and some with a much smaller market capitalization).¹⁰³ But in general, small companies are prima facie less likely to attract significant shareholder activities¹⁰⁴ and less likely to attract shareholder proposals.¹⁰⁵ Meme trading has thus centered on companies whose financial fundamentals do not augur well for sustained shareholder engagement.

For these reasons, a sudden burst of enthusiasm for meme trading may not instantly translate to one for shareholder activities, and meme surges and their impacts may remain orthogonal to shareholder activities. Given this uncertainty in the promise of meme trading, there are important research questions that remain unexplored, to which we now turn.

III. A MEME GOVERNANCE RESEARCH AGENDA

A. Traders and Shareholders

Future work in meme corporate governance should try to disentangle the extent to which sentiment-driven investors sustain their engagement when they become shareholders. The literature review from Part II makes clear that vigilance or activism looks different for investors and shareholders. Activism among retail investors may not necessarily translate to activism among retail shareholders. At the same time, particularly with respect to those retail investors who stayed as shareholders at meme stock companies long past the meme surge (and subsequent crash), one would argue that they are likely to care much more about the company’s governance and long-term performance and become more active in exercising their rights as shareholders. Relatedly, work in empirical corporate finance also finds that passive mutual funds, despite being “lazy investors,” directly or indirectly participate as shareholders. Increased shareholding by these institutional investors leads to greater board independence, fewer takeover defenses, and more equal voting rights.¹⁰⁶

In our companion project,¹⁰⁷ we uncover empirical evidence that meme (and other retail) shareholders may not display the same vigor or aspirations ascribed to them by the literature focused on meme investors. Examining shareholder voting, we find that participation in the proposal process substantially decreased for meme stock companies, like AMC and GameStop, after the abolition of commissions in 2019 and the meme surge in 2021 compared to other companies, even when we control for firm characteristics and include year fixed effects.¹⁰⁸ This can be easily seen in Figure 2, reproduced from our companion project.¹⁰⁹ The dark lines, both solid and dotted, represent the share of non-votes at meme stock companies, on routine and non-routine matters, respectively. Meme stocks are defined as explained in Section I.A.

Figure 2. Average Share of Non-Votes for Meme and Non-Meme Stocks by Proposal Type

Note: This figure presents information on the yearly average percentage of votes that were not voted in shareholder meetings. We define the number of non-votes as Total Outstanding Shares (Votes For + Votes Against + Abstentions). We split the data by meme/non-meme stock as well as proposal type (that is, whether or not it qualifies as “routine” as defined in NYSE Rule 452).

In Figure 2, we can see that, compared to other companies, the non-vote shares increased markedly since 2018. Though it is difficult to infer that the non-votes are all coming from retail shareholders, given the low rate of vote participation among retail shareholders, it would not be unreasonable to infer that the increase in non-vote shares comes from the dramatic shift in shareholder base to retail shareholders. The increase in non-voting at meme companies is especially stark for “non-routine” proposals, for which brokers cannot vote on behalf of their clients.¹¹⁰ What is perhaps surprising is the fact that the non-vote shares seem to be increasing even in 2022, a long time after the meme surge in early 2021, indicating that perhaps even those retail investors who stayed with the companies do not seem to be actively participating in firm governance. Moreover, no shareholder proposals made it onto the proxies of any of the meme companies after 2019.¹¹¹

With respect to indirect measures of corporate governance, we also find that meme companies’ performance on ESG issues as well as board gender diversity either declined or remained the same compared to other firms, once again controlling for firm characteristics and time trends.¹¹² In short, there is so far little evidence to suggest that retail investors have left much of a mark with respect to engaging management or nudging companies in more prosocial directions.

Any work on the meme phenomenon must confront the different incentives and behavioral patterns characterizing retail investors and retail shareholders. Apart from the natural functional disjuncture caused by the purchase of shares, one could also argue that technology and digital transformation plays less of a role for shareholders as compared to investors. While we have seen apps like Robinhood disrupt the PFOF system and “gamify” investing, large chunks of the shareholder experience seem trapped in amber. Corporate voting, for example, depends on a fragile and complex custodial system that is arguably decades out of date with contemporary digital capabilities, making it hard to ensure that shareholders can actually exercise their franchise.¹¹³ Admittedly, as described in Section I.C., some startups are trying to use technology to improve shareholder-management communication. However, until such initiatives become mainstream, the disconnect between twenty-first century investing and the twentieth century shareholding will continue to be an important line of inquiry for researchers.

B. Identifying Sentiment-Driven Stocks

A broader research agenda studying the effect of retail investor sentiment on corporate governance must necessarily define the core variable of interest: which companies could one credibly claim are affected by meme activity or online communities coordinated via social media? The current literature is somewhat reactive in nature, defining meme stocks based on which companies have already experienced meme surges or seen online communities formed around them.¹¹⁴ One concern with such an approach could be whether it is generalizable: are these companies meme stocks solely because of the PFOF system or Reddit discussions, or is there something intrinsically unique about them? Moreover, in comparing meme stocks with other companies, we need to make sure we do not misclassify other companies driven by retail investor sentiment as non-meme companies. For example, some online commentators even called Tesla a meme stock because of its dedicated group of online retail followers, and its chief executive officer’s high visibility on social media.¹¹⁵ However, Tesla has been excluded from most academic analyses of meme stocks since it differs from AMC, GameStop, and others in crucial ways (by, for example, having a credible business model and sufficient analyst coverage that could plausibly explain the stock’s success instead of online coordination by meme investors).¹¹⁶

Nevertheless, the broader point remains: there is a need for a generalizable definition of meme stocks that does not depend on factors that are idiosyncratic to those companies. This concern about endogeneity is a central feature of empirical corporate finance scholarship. For example, for many years, corporate law scholars believed that poison pills (antitakeover devices that directors can use to deter hostile takeovers) depressed firm value. However, more recent work shows that poison pills are adopted in the first place by firms that had suffered decreases in performance. Once we account for these pre-existing performance drops, there is little evidence that poison pills affect firm value.¹¹⁷ Similarly, an externally valid definition of meme stocks could help us rule out other explanatory factors for changes in corporate governance at any given set of companies.¹¹⁸

While this Article does not propose any particular measure of meme stock or retail investor sentiment, we believe there are three potentially promising avenues for finding such a metric. First, researchers could look at media coverage of companies. Firms that feature more prominently in the media and elicit more “emotional” responses (whether positive or negative) may be more likely to emerge as meme stocks. New methods in the textual analysis of data could help make such an empirical measure tractable.¹¹⁹ Second, one could look at how accessible companies are to resource-constrained retail investors. Meme companies, such as AMC and GameStop, were generally smaller (both in terms of market capitalization and trading volume) and had lower share prices.¹²⁰ Companies with such financial features could be more likely to attract retail investors.¹²¹ Finally, meme phenomena can also be closely tied to nostalgia. Many retail investors poured into AMC, for example, because they were millennials who fondly remembered going to the company’s movie theaters and did not want to lose the chain to a COVID-19-induced bankruptcy.¹²² Nostalgia, if amenable to a satisfactory definition, could be a predictor for a company’s attractiveness to millennial meme investors. Whichever definition proves most fruitful, robust empirical examination of the meme stock phenomenon would help us better understand the events of 2021–22.

CONCLUSION

The meme surge of 2020–21 captured the attention of investors, firms, and regulators across the world. In this Article, we have attempted to contextualize this phenomenon within the broader trend of digital transformations in trading, investing, and corporate ownership. The modification of the payment for order flow system through the abolition of commissions radically transformed the trading process, and lowered entry costs for retail investors thinking about entering the stock market or constructing their portfolio. The investing experience was also affected by the emergence of social media platforms that complemented existing online brokerages. These platforms allowed retail investors to exchange notes on investing strategy as well as their expressive likes or dislikes for meme companies (regardless of the quality of information undergirding these preferences). Digital transformation has been most modest, however, in reshaping the ownership or shareholding experience. While some startups have tried to make it easier for shareholders to vote or communicate with managers, many of the processes surrounding shareholder participation do not harness the latest technologies.

Moving from the origins to consequences of these digital transformations, we flag three potential troubling consequences of meme trading that go unaddressed by the current system for public regulation of securities markets. First, it could increase the occurrence of predatory trading (exploiting counterparties’ need to change positions), except that this time the predators could be retail investors. Second, meme surges could induce more ATM offerings by companies keenly followed on social media; firm management would want to timely raise capital while their share prices are inflated. Third, the unique setup of the meme investing ecosystem could undermine a potential securities plaintiff’s claim under Rule 10b-5, and undercut the role played by litigation risk in compensating defrauded investors and disciplining managerial misconduct.

Reviewing the existing literature on the promise of retail investors in corporate governance, we argue that in the absence of further technological disruption affecting the shareholding experience, it is unlikely that meme investing will lead to a “democratization” in governance. For a variety of reasons, it may be hard to transform retail investors into engaged retail shareholders. Finally, we sketch a research agenda for future work on meme stocks. First, future work must disentangle the extent to which non-traditional market participants can make an impact as traders versus as shareholders. Second, there is a need to develop a more objective metric to identify stocks moved by retail investor sentiment, rather than the somewhat idiosyncratic collection of companies that featured in the events of 2021–22.

This Article therefore cautions against viewing the meme surges as simply the product of the COVID-19 pandemic or Reddit social boards. Instead, systematic digital transformations in all facets of the financial markets have allowed retail investors to coordinate their expressive preferences for companies. Meme trading is here to stay. This retail coordination could lead to issues concerning predatory trading, ATM offerings, and reduced litigation liability that our current securities regulation system is ill-equipped to handle. While we lack evidence that these digital disruptions can transform retail investors into engaged shareholders, further research should seek to distinguish investing and shareholding activities, and better define what qualifies as a “meme stock.”

96 S. Cal. L. Rev. 1387

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Dhruv Aggarwal*

* Assistant Professor of Law, Northwestern Pritzker School of Law.

Albert H. Choi†

† Paul G. Kauper Professor of Law, University of Michigan Law School and European Corporate Governance Institute (“ECGI”).

Yoon-Ho Alex Lee‡

‡ Professor of Law, Northwestern Pritzker School of Law.

Adventure Capital

April 2024April 2024Elizabeth Pollman*

This symposium Article traces the history and rise of venture capital and venture-backed startups in the United States from a business law perspective and explores the current big questions in the field. This examination highlights that after lawmakers shaped the enabling environment for venture capital to flourish, corporate and securities law has responded to the rise of venture-backed startups incrementally but with profound effect. Although business law has not always fit easily with the distinctive features of venture-backed startups, it has provided an enormous space in the private realm for them to order their governance and maneuver with relative freedom. This private realm is a good fit for the needs of startups that drive economic growth and innovation, but their activity can also create lingering issues of social costs and policy that are difficult to address. Grappling with this reality is essential to continuing to foster a vibrant venture capital ecosystem while also developing a coherent business law response to the current wild era of “adventure capital.”

Venture capital has fueled the rise of some of largest businesses in the world.¹ This relatively small asset class produces huge social and economic impact. By one measure, venture capital funds less than one percent of companies started in the United States each year, yet accounts for the backing of nearly half of the companies that enter the public markets.² Among U.S. public companies founded since 1968, venture-backed companies account for 77% of total U.S. market capitalization, 41% of total employees, and 92% of research and development spending.³ Further, the impact of venture capital is not only evidenced in public markets, but also spans the footprint of disruptive startups operating in the private realm and the technology that they generate. From the personal computer you use to access the internet to the search engine by which you navigate it, the innovation fueled by venture capital touches everyday life in innumerable ways.⁴

The industry that produces such outsized social and economic impact is notably of relatively recent vintage and the result of both business and legal transformation. Some of today’s venture capital resembles aspects of the risk-sharing ventures of centuries ago from Genoese merchants to American whalers, but the modern industry began in earnest in the mid-twentieth century—originally coined “adventure capital.”⁵ It was not, however, until the 1980s when venture capital really took off. In 1979, the Department of Labor changed an Employment Retirement Income Security Act (“ERISA”) rule that freed pension fund managers to take portfolio diversification into account in fulfilling their “prudence” standard.⁶ With this change, pension fund managers could allocate a portion of their funds to venture capital even if companies in the venture fund’s portfolio were relatively illiquid or failed.⁷ With a greater influx of investment dollars, the venture capital sector grew quickly,⁸ and in less than half a century has become “the dominant source of financing for high-potential startups commercializing risky new ideas and technologies.”⁹

Although a significant and growing body of scholarly literature examines venture-backed startups, many questions remain open and legal scholars do not often step back to examine the broader landscape of business and legal transformation in this area. How has business law facilitated and responded to the rise of venture capital? What is the social welfare impact of venture capital? Should the law do more to shape the direction of entrepreneurial finance or startup governance? This Article takes aim at stimulating discussion and research about these important questions.

First, the Article traces the history and rise of venture capital in the United States and highlights that venture capital contracting has largely settled upon an established set of practices that create distinctive governance features in startups and the types of companies funded.¹⁰ This discussion illuminates how the rise of the modern venture capital industry evolved to rely on laws that enable private business entities and private markets.

Second, it argues that after lawmakers shaped the enabling environment for venture capital to flourish, in subsequent decades, corporate and securities law has responded to the rise of venture-backed startups incrementally and with some challenges or tensions with the distinctive features of venture capital and startups. The big picture, however, is that the enabling nature of corporate law and the deregulatory trend of securities law have facilitated an enormous space in the private realm for venture-backed startups to order their governance and maneuver with relative freedom. This private realm is highly useful for cultivating startups that drive valuable innovation and create outsized economic impact.

Notably, venture-backed startups also create lingering issues of social costs that have prompted rising concerns in recent years. Therefore, the Article concludes by highlighting two promising avenues for developing a deeper understanding of whether a business law response is warranted: a more systematic study of impacts on stakeholders such as employees and customers or users, and further inquiry into whether and when any governance intervention would be optimal using a realistic understanding of a startup’s timeline in the venture cycle. Building a solid foundation of understanding of these issues in the current era would advance a measured approach to the future of business law, while continuing to promote a vibrant ecosystem of startups and venture capital.

The Article proceeds as follows. Part I traces the rise of venture capital and the distinctive features of venture-backed startups. Following on this background, Part II examines how corporate and securities law has facilitated and responded to venture capital and venture-backed startups. Finally, Part III identifies and starts a conversation about the big questions that the current regime raises.

I. THE RISE OF VENTURE CAPITAL AND DISTINCTIVE FEATURES OF VENTURE-BACKED STARTUPS

Entrepreneurs have long sought financing for risky ventures.¹¹ The venture capital industry emerged in the United States in the mid-twentieth century with its own unique history, and subsequent decades have witnessed its meteoric rise and establishment as a key driver of innovation and economic growth in society. This Part provides an overview of the origins and development of venture capital, as well as an examination of the special characteristics and governance of the startup companies they fund. Although the venture capital industry continually changes, and startup governance varies by individual company, certain patterns have taken shape that can be described by their distinctive features.¹²

A. A Brief History of Venture Capital

Throughout the history of entrepreneurship in the United States, wealthy individuals and family offices have served as notable sources of funding when commercial banks and Wall Street financiers have been unwilling to invest or lend to risky new enterprises.¹³ It was not until the period after World War II, however, that formalized organizational structures started to emerge to provide high-risk, innovative new firms with financing.¹⁴ Startup capital before that time was relatively scarce—representing what many perceived as a funding gap or market failure.¹⁵

Historians pinpoint several key institutions, individuals, and policies that played an important role in catalyzing the modern venture capital industry. A few highlights are worth discussing here to capture how government policy as well as trial and error from enterprising individuals and firms were required before hitting upon the modern formulation of venture capital investing.

Some start the story with one of the most serious early experiments—American Research & Development Corporation (“ARD”).¹⁶ The Boston-based firm made high-risk investments in companies working on technology developed for World War II.¹⁷ The firm, established in 1946 by Harvard Business School professor Georges Doriot and MIT President Karl Compton, was structured as a publicly traded closed-end fund and imbued with public-service motives.¹⁸ It did not ultimately serve as a model organization for later venture investors as the public structure ensnared it in regulation that restricted its ability to invest fresh capital into portfolio companies, calculate the value of its investments, and grant employee stock options.¹⁹ Further, the firm’s public-service ethos that disdained financial incentives disappointed staff and investors, and prevented the firm from productively abandoning underperforming portfolio companies.²⁰

Nonetheless, ARD provided proof of concept of a couple of key ingredients for venture investing. First, a single investment—Digital Equipment Corporation—accounted for the lion’s share of all the gains that ARD generated over a quarter century.²¹ This represented an early demonstration of what later became known as the “power law”²² or “long-tail investing”²³ business model that attracted the attention of others interested in financing technological innovation. A small number of big “hits” can drive a fund’s success despite numerous other failures. Second, the leader of ARD and a key figure in risk capital during this era,²⁴ Doriot, was deeply involved in providing managerial counsel as well as capital to his portfolio companies.²⁵ In his view, founders were the visionary stars and venture capitalists’ role was to provide wisdom and guidance.²⁶

Another important development of the era was the passage in 1958 of the Small Business Investment Company (“SBIC”) Act, which reflected the U.S. government’s effort to respond to the perceived funding gap for entrepreneurial finance.²⁷ Under the SBIC Act, a privately-owned investment fund aimed at making investments in qualifying small businesses would be eligible for favorable tax treatment and a government loan at nominal rates.²⁸ The program engendered debate between advocates of government subsidy to encourage small business formation and those who believed in market-based solutions.²⁹ Neither side received total vindication as the government intervention made clear impact, but it was market players who ultimately pioneered what became the venture capital industry.

Practically speaking, the limitations on SBICs proved too restrictive for pioneering investors in the nascent venture capital industry who sought to finance startups—highly risky innovative ventures with the potential for outsized returns.³⁰ Most SBICs were small and undercapitalized.³¹ SBICs could not exceed a fund size of $450,000 to qualify for maximum assistance, and “could not compensate their investment staff with stock options, nor could they invest more than $60,000 into a portfolio company . . . .”³² SEC registration rules were burdensome and costly, and SBICs and their shareholders were subject to double taxation.³³ In sum, these rules were poorly suited for enabling venture capitalists to provide adequate capital to high-growth, innovative companies, and to compensate the investors for their efforts. Despite these drawbacks, or perhaps thanks to the lessons they generated, the program shed light on the legal policies and financial institutions that would clear the way for venture capital and startup entrepreneurship to thrive.³⁴

The year before the SBIC Act’s passage, and before ARD had financed Digital Equipment, one of the most significant events occurred in the history of venture capital—a tremor that became an earthquake that eventually opened a new landscape in the orange groves around Stanford University. A group of eight young Ph.D. graduates had been recruited by the renowned inventor William Shockley to work at Shockley Semiconductor Laboratory on developing new semiconductor devices at Fred Terman’s new research park.³⁵ These “Traitorous Eight” young engineers quickly became “fed up” with “suffering” under Shockley, the famous Nobel Prize winning “father of the semiconductor,” who acted as a “tyrant.”³⁶ One of the group members, Eugene Kleiner, had a connection through his father to a New York investment firm.³⁷ He wrote and asked if perhaps a financier could find an employer willing to hire all eight as a team.³⁸ Their “act of defection” in 1957 “created the magic culture of the Valley,”³⁹ and it was made possible by an equally visionary young banker, Arthur Rock, who was given the letter by Kleiner’s father.⁴⁰ Rock had already immersed himself in the emerging semiconductor industry and was intrigued by the request from an elite team so he flew out to San Francisco to meet with them. Rock proposed a possibility they had not even imagined: striking out on their own as founders of a new company that he would help finance.⁴¹

Rock’s vision was radical at the time.⁴² And, after trying to raise capital from numerous backers without avail, just one wealthy individual willing to fund the Shockley rebels emerged from Rock’s search—Sherman Fairchild.⁴³ But Fairchild cut a hard bargain—the eight co-founders put up a small amount of cash in return for 100 shares each, the budding venture capitalist bought 225 shares at the same price, 300 shares were set aside for recruiting managers, and Fairchild put in $1.4 million in the form of a loan that came with control via a voting trust and an option to purchase all of the company for $3 million down the line.⁴⁴ The startup, Fairchild Semiconductor, was wildly successful—within two years, each of the Traitorous Eight and Rock received six hundred times what they had invested, but Fairchild, the passive financier, did even better.⁴⁵

Beyond the obvious riches, one important takeaway from the Fairchild Semiconductor adventure was that without dedicated pools of money looking to finance startups, the investors held the bargaining power and the innovators got short shrift. In the 1960s, after a taste of success, Rock moved out to California, and, with a like-minded partner, started to raise a venture fund with a limited partnership structure in which the two general partners would seed the fund with some of their own capital.⁴⁶ By eschewing SBIC loans and public market money, they raised over $3 million from thirty “limited partners”—wealthy individuals who served as passive investors—and avoided the regulatory restrictions that had held back SBICs and ARD.⁴⁷ They had enough money to supply risky yet promising startups with the capital needed to grow aggressively, and they incentivized entrepreneurs and key employees with equity.⁴⁸ After fund raising, they made concentrated bets on a dozen or so companies, respectfully exercised a measure of governance control with the aim of helping the entrepreneurs succeed, and returned a handsome share of profits to limited partners on a set timeline by identifying and nurturing hits that could find an exit by going public or being acquired.⁴⁹

A winning formula for financing risky technology startups was finally found—it involved private business entities and private markets. Venture capitalists in the subsequent period built upon these early lessons, fine-tuning investment and governance practices, and pushing for favorable government policies. By the 1970s, several pioneering venture capital firms emerged alongside the early players—including Sequoia and Kleiner Perkins, among others.⁵⁰ They funded some of the big hits of the era, including Intel, Apple Computer, and Genentech.⁵¹ In this period, the importance of deal flow, repeat entrepreneurship, incentive compensation, and governance support were solidified.⁵² Venture capitalists learned to lower their risk by actively guiding founders and staging financings, with each capital infusion calculated to encourage the company to hit an agreed milestone and leaving open the possibility of abandoning underperforming startups.⁵³ Silicon Valley became an ecosystem of early-stage finance and entrepreneurship with universities, a pool of potential founders, specialized investors, large tech companies and employees, lawyers with dealmaking savvy, and more.⁵⁴

Further, the National Venture Capital Association, a trade association of venture capitalists founded in 1973, lobbied heavily for the legislative change that freed pension funds from previous restrictions in allocating a portion of their capital to venture funds.⁵⁵ Pension funds joined university endowments, insurance companies, and a handful of wealthy individuals in this nascent asset class.⁵⁶ With a supply side boost of capital thanks to supportive policymakers, the venture capital industry rapidly grew in the 1980s.⁵⁷

Over time it became clear that the venture capital industry and the tech firms they financed were subject to boom and bust cycles.⁵⁸ Further, it remained difficult to systematically generate outsized returns from “long-tail” portfolios.⁵⁹ The top-quartile funds have typically outperformed the bottom quartile by a wide margin.⁶⁰ But the overall trendline was one of continued growth and maturation of the industry and the Silicon Valley ecosystem.⁶¹ By the 1980s and 1990s, a set of practices around venture capital investing took shape which fostered a distinctive set of features for venture-backed startups that remain today.

B. Venture-Backed Startup Features and Governance

As the discussion so far has highlighted, the rise of the venture capital industry reflected a historically contingent confluence of business and legal transformation. Pioneers of the industry experimented with a variety of arrangements and then settled on a model that uses the limited partnership form to raise and deploy pools of risk capital over a set period of time. Further, the industry matured through the development of contracting and governance mechanisms aimed at addressing the particular challenges involved in financing and nurturing high-risk and potential high-reward innovative, young companies. The discussion will now turn to those practices and their implications for the kinds of businesses that get funding, and their governance.

It is worth emphasizing at the outset that the most fundamental aspect driving venture capital investing is the “power law.” As noted above, this is not a true law in any sense. Rather it is a phenomenon or understanding that a very small subset of deals typically generates the bulk of the returns for a successful venture capital fund.⁶² As one well-known venture capitalist, Peter Thiel of Founders Fund, has explained, “This is a scary rule, because it eliminates the vast majority of possible investments.”⁶³ Why? As no one knows with certainty in advance which companies will succeed, and as innovative startups are highly risky, many will fail or have mediocre returns. For this reason, “every single company in a good venture portfolio must have the potential to succeed at vast scale.”⁶⁴ Downside risk is limited to the total investment 1x while upside gain could be 100x or more within a relatively short amount of time.⁶⁵ Venture capitalists are therefore not just looking for startups with the possibility of becoming profitable—they are aiming at investing only in startups that have the potential to utterly disrupt or create industries with large addressable markets.⁶⁶ Crystallizing this point, Bill Gurley of Benchmark Capital has remarked, “Venture capital is not even a home run business. It’s a grand slam business.”⁶⁷

Further, the power law operates within an assumption that often goes unarticulated—not only must venture capitalists aim to invest only in potential grand slams, but they also need startups to find an exit within a timeframe that roughly corresponds with the term of their fund. There are just two main paths to a successful exit: sell the company or go public.⁶⁸ As venture capitalists typically use a 10–12 year term for their fund,⁶⁹ this dynamic shapes the type of companies they invest in and the way that they govern them.⁷⁰ One venture capitalist put it succinctly, “I sell jet fuel.”⁷¹ Venture-backed startups must grow fast to succeed.⁷²

This dual reality of power law returns and the need for exit on a relatively short timeframe distinguishes venture capital and the types of startups they invest in from other businesses or stages of a business life cycle. For example, private equity portfolios typically aim to optimize each portfolio company’s performance and leverage the gains.⁷³ They often target existing, underperforming businesses rather than help build new, innovative companies that have a large risk of failure.⁷⁴ Other private businesses include traditional closely held enterprises that range from small mom-and-pop businesses to virtual behemoths such as Cargill and Koch Industries.⁷⁵ These companies often begin as sole proprietorships, partnerships, or family businesses, and organically grow over time without a particular aim at exit.⁷⁶

In turn, because venture capitalists are specialized intermediaries uniquely tailored to financing innovative startups, they have developed contracting and governance mechanisms aimed at addressing the particular constellation of issues that these companies pose: uncertainty, information asymmetry, agency costs, and incomplete contracting.⁷⁷ In the early stages of a startup, its success is highly uncertain—more so even than the usual new business because startups are typically innovative, not replicative.⁷⁸ Entrepreneurs often have more information than investors and their interests are not fully aligned.⁷⁹ Contracts between entrepreneurs and venture capitalists will inevitably be incomplete because of the participants’ bounded rationality and their inability to foresee and resolve all potential contingencies.⁸⁰

These were the challenges faced by the pioneers of venture capital, from Georges Doriot to Arthur Rock. And, since the maturation of the venture industry in the 1980s and 90s, a set of contracting practices for venture capital funds and startup investing has become the norm, creating an “interrelated bundle of incentives and protections” that facilitates the flow of funds to entrepreneurs.⁸¹

Venture capital firms raise capital from passive limited partners, organized in funds with 10–12 year terms, charging an annual management fee and a percentage of profits.⁸² Acting as general partner of the fund, venture capitalists make and monitor investments in a portfolio of startups.⁸³ Startup founders and employees will typically have an incentive-based ownership stake that vests over time and takes the form of common stock or options.⁸⁴ Venture capitalists invest in syndicated, staged financing rounds for convertible preferred stock that come with liquidation preferences and other protections for downside risk and the ability to convert into common on the upside.⁸⁵ Notably, venture contracts separate cash flow ownership from voting and other control rights. Venture capitalists typically participate in board governance and bargain for shareholder voting rights and the right to veto certain major management decisions.⁸⁶ Over the life cycle of a venture-backed startup, as it increases the number of participants with varied interests and claims, the vertical and horizontal tensions among and between common and preferred shareholders tend to multiply.⁸⁷ Ultimately, if a venture-backed startup survives past its early stage, governance complexity increases and pressure builds for the startup to find a liquidity event.⁸⁸

These basic contours of venture capital investing and governance are well understood. Naturally, much more could be said about industry trends and entrepreneurial finance. The point here is to highlight that the basic practices of venture capital in the United States have been established for over four decades now—and have become sticky—fostering a distinctive set of companies and governance in the business world.⁸⁹

With this foundation set, the next Part can take up the big picture view of how business law has enabled and responded to the rise of venture capital and startups, with subsequent discussion to explore the lingering issues of social costs and policy they raise.

II. BUSINESS LAW’S CREATION AND RESPONSE TO THE RISE OF VENTURE CAPITAL AND VENTURE-BACKED STARTUPS

As the previous Part has highlighted, the rise of the modern venture capital industry developed to take advantage of laws that enable private business entities and private markets. Both state business law and federal securities laws facilitated this combination.⁹⁰

Traditionally, business entity formation and governance have been a matter of state law. Under enabling state laws, venture capitalists can form limited partnerships for the purpose of raising and operating venture funds, and founders can form corporations through which to engage in startup entrepreneurship. The internal affairs doctrine provides that the law of a firm’s state of incorporation governs the relationships among the firm, its investors, and managers.⁹¹ Venture capitalists and startup entrepreneurs have predominantly chosen Delaware as their preferred state for formation of limited partnerships and corporations.⁹²

Federal securities law, under the architecture of the Securities Act of 1933 and the Exchange Act of 1934, has partitioned issuers, securities, and offerings into two realms—public and private—with each side bearing distinct privileges and burdens.⁹³ Public company stock, once registered, can be freely issued and traded, but the issuing companies are subject to extensive mandatory disclosure as well as active enforcement mechanisms.⁹⁴ Conversely, the issuance and trading of private company stock must conform to restrictions of registration exemptions, but regulation of private firms is otherwise light.⁹⁵ Investment funds are subject to an analogous public-private divide.⁹⁶ Since Rock started his first fund in the 1960s, venture capital firms have organized their activity to fall on the private side in both the arrangement of their own funds and the portfolio companies in which they invest.

Given the importance of business law to venture capital and venture-backed startups, this Part takes up the question of how the law has responded to the developments traced thus far and describes the big picture of the growth of the private realm and the wild (and sometimes questionable) adventures of startups in it.

A. The Evolution of Corporate and Securities Law in an Age of Venture Capital and Startups

Corporate and securities law have taken vastly different approaches to the rise of venture capital since the industry began to solidify, grow, and mature in the 1980s. They have in common one high-level response: neither creates a legally defined category for venture-backed startups.⁹⁷

While the key corporate law state for startups—Delaware—has been generally enabling and highly regarded, its case law has not been particularly favorable for startup participants as it is not crafted for the distinctive characteristics of these companies and is instead often made in the context of very different public corporations. Despite these tensions, for the most part, startups are able to take advantage of the enabling nature of Delaware corporate law through venture contracting practices and can avoid ex post litigation, so state corporate law ultimately creates an environment for highly flexible governance practices and a stable backstop, albeit sometimes problematic, for the rare disputes that go to court.

By contrast, securities laws have responded to the rise of venture capital and venture-backed startups with enormously favorable provisions and a deregulatory trend that has facilitated a radical transformation of private markets over the past several decades. The combination of these relevant state corporate and federal securities laws, which are discussed further below, work in tandem to foster a growing public-private divide and startup governance challenges that characterize the present era and raise big questions for the role of business law in the future.

1. Corporate Law and Venture-Backed Startups

Delaware famously makes and applies one general corporate law.⁹⁸ Thus, the same statute and case law generally apply whether the corporation at hand is one of the world’s largest public corporations or a brand-new private startup. The rise of venture capital and venture-backed startups has therefore posed interesting and challenging issues of fit between corporate law and startup participants’ interests and needs.

As permitted under Delaware corporate law, venture-backed startups customize their governance arrangements through the organic documents of the corporation (charter and bylaws) and extensive shareholder agreements, typically re-bargaining these arrangements in each round of venture financing.⁹⁹ Delaware’s enabling approach is a boon in this regard. For example, it is mandatory to have a board of directors, but Delaware corporate law requires only one director, allows for different sizes and compositions, and does not impose requirements of independence, qualifications, committees, or the like.¹⁰⁰ When disputes arise, however, Delaware case law takes a highly fact-specific approach and often imposes its most rigorous standard of scrutiny—entire fairness—when venture-backed startups are involved because they generally lack disinterested and independent boards and shareholders.¹⁰¹

Over time, this divergent dynamic between public and private corporations and fiduciary litigation has become more pronounced as federal securities law has added a layer of corporate governance requirements on public companies, requiring majority independent boards.¹⁰² In addition, Delaware corporate law doctrine has developed more pathways to lighter review under the deferential business judgment rule if certain process protections are followed with disinterested and independent board members and/or shareholders.¹⁰³ This means that absent specific conflicts or the like, most public company boards would receive deferential review if their decisions are challenged and could likely dispose of litigation in early motion practice, whereas startup boards would not often be so lucky and might be encouraged to incur costly procedures such as banker fairness opinions or special committees that are not otherwise a fit for the norms or circumstances.¹⁰⁴

Furthermore, some venture-backed startup cases involving fiduciary litigation under the strenuous entire fairness standard have provoked controversy. Most notably, in a case involving a conflict between the interests of the common and preferred shareholders in an M&A exit, In re Trados, the Delaware Court of Chancery declared that directors owe a fiduciary duty to maximize value for the common shareholders as residual claimants.¹⁰⁵ Corporate law scholars have pointed out that this approach can give rise to inefficient outcomes that fail to maximize aggregate welfare.¹⁰⁶ Similarly in cases involving venture capital contracts and the status of preferred shareholder rights, Delaware courts have taken a strict construction approach that has elicited criticism given its potential to disrupt expectations and allocated risks.¹⁰⁷

None of these doctrinal tensions have been insurmountable impediments.¹⁰⁸ On balance, venture-backed startups and their participants have largely learned to take advantage of the freedom for private ordering and to generally avoid litigation. This latter point is likely a matter of practicality—given that failure or economic realities often make litigation less relevant for startups¹⁰⁹—as well as norms in an ecosystem of repeat players and reputational concerns.¹¹⁰ Further, a community of knowledgeable and experienced lawyers has flourished over decades, playing an important role as dealmakers and guides providing counsel to venture-backed startups through contracting practices, conflicts, fiduciary duties, and more.¹¹¹

2. Securities Law and Venture-Backed Startups

While corporate law’s response has been a mix of enabling rules with certain doctrinal tensions in application, securities law has provided a veritable windfall to the venture capital industry. The legal transformation to securities laws regulating private markets and companies has occurred incrementally over many years. In the aggregate, this deregulatory shift has been sufficiently dramatic to raise existential questions about the coherence of the securities law framework and its approach to venture capital and venture-backed startups.

First, in 1988, during a period of rapid growth in funds allocated to venture capital, the Securities and Exchange Commission (“SEC”) adopted Rule 701, permitting private companies to issue equity-based compensation to employees and service providers, in limited amounts, without registering the offering or providing extensive disclosures.¹¹² As the history of venture capital illuminates, equity-based compensation for founders and entrepreneurs has long been understood as a key ingredient for attracting and retaining talent in risky enterprises, and the SEC’s rule added important clarity for startups to offer equity compensation to prospective employees lacking sophistication or high net worth.¹¹³ At the time of adoption, the SEC had come under considerable pressure from scholars, industry representatives, and lawyers to create this special exemption.¹¹⁴ And, under continued lobbying pressure from industry players, the SEC has periodically, across decades, increasingly relaxed various aspects of the remaining Rule 701 restrictions, “turning [a] small exemption into a significant channel of securities offerings to household investors.”¹¹⁵

Second, a long trajectory of additional deregulatory actions since the early 2000s has opened the floodgates to private markets and loosened restrictions.¹¹⁶ The result is larger, more complex private markets and a regulatory environment in which two firms that are virtually identical in value, number of employees and shareholders, access to capital, and size and footprint of operations can be subject to vastly different regulatory obligations and oversight.¹¹⁷ The implicit bargain that venture-backed startups faced through the 1990s of becoming a public company subject to an extensive federal regulatory regime in order to access large and liquid pools of capital has been replaced by a new set of options.

After the dot-com bust and financial accounting scandals of the early 2000s, Congress passed the Sarbanes-Oxley Act of 2002, setting in motion a narrative of “over-regulation” amid a deepening decline in IPO activity.¹¹⁸ While the costs and obligations on public companies concerning governance arrangements, internal controls, and disclosures indeed ratcheted up, a set of market forces including increased M&A activity and greater availability of private capital also took effect.¹¹⁹ The number of IPOs and U.S. publicly traded companies significantly dropped.¹²⁰ Shortly after Congress passed the Dodd-Frank Act of 2010 in the wake of the global financial crisis, further increasing regulatory burdens on public corporations, it passed the JOBS Act of 2012, which deregulated major aspects of the rules concerning venture financings and easing startups’ exit pathway with a new IPO on-ramp.¹²¹ The venture capital industry, startups, and exchanges that stood to gain from the changes lobbied heavily in favor of them.¹²² As the “SEC continued to prioritize the deregulation of the private markets in the name of public capital formation,”¹²³ the tables began to turn—going public changed from a rite of passage that successful startups would go through after a few years in the venture cycle to an idiosyncratic, firm-specific choice that could be significantly delayed.¹²⁴ The pathway to exit via M&A became much more common than IPO.¹²⁵

With massive inflows of private capital and new investors to private markets, the SEC’s rationale for its deregulatory trend took an ironic twist away from capital formation to “democratizing” access to private markets.¹²⁶ Delayed timelines to venture-backed startup exits had effectively allowed startups to grow larger and for much of their growth to occur on the private side of the divide.¹²⁷ “Unicorn” companies that raised venture financing at a private valuation of $1 billion or more exploded.¹²⁸ In 2020, the SEC adopted extensive rule amendments to permit larger and more frequent private offerings to be offered more widely to the general public.¹²⁹

In hindsight, it became evident that a slow-motion series of piecemeal securities law developments transformed the public-private divide and the environment in which startups go through the venture cycle.

B. The Wild Adventures and Misadventures of Venture-Backed Startups in the Private Realm

With an understanding of the business and legal history that has brought about and transformed venture capital, startups, and the regulatory environment that they enjoy, the discussion can now explore the implications of these developments and what the role of business law might be in the future.

The heart of the matter concerns the enormous space that business law creates for venture-backed startups to operate for long periods without significant governance or disclosure requirements. Accountability mechanisms beyond the internal participants’ private ordering are also vastly limited in comparison with those in the public company context.¹³⁰ Private startups are generally free from securities class actions, short sellers, quarterly earnings pressures, public stock prices, and the like. Further, regulators at different levels from federal to local, in different areas of subject matter expertise, face challenging dynamics responding to innovative startups—their activity might fall into unmapped territory, legal gray areas, or regulatory blind spots until egregious circumstances develop.¹³¹ With limited resources, regulators might prioritize oversight and enforcement of large established companies.

This environment of relative freedom to push the envelope fits the needs of venture capital and startups, which are fundamentally “a machine for running experiments.”¹³² Moreover, given the power law, these startup experiments are typically not seeking to hit a single or double—they aim at “disrupting entrenched corporate power” in lucrative markets that could be grand slams.¹³³ As we have seen, venture capitalists are looking for “radical departures from the past.”¹³⁴ Room for maneuvering without disclosures that would prematurely share information with competitors or potential competitors is important for incubating innovative products and services. Longer timelines for staying private enable startups to try moonshots that might take significant time to develop or find product-market fit.

Recent years have witnessed venture-backed startup activity that has increasingly raised concern about the growing public-private divide and startup governance, however. The private space and relative freedom that are embraced by startup entrepreneurs and venture capitalists have given rise to scandals from Theranos to FTX, governance fiascos such as WeWork, and controversial products and services such as Juul’s vaping technology and Uber and Lyft’s ride sharing services. With a massive influx of private capital over the past decade, venture capital has spread sectorially to startups aimed at widespread industries from health to transportation.¹³⁵ And with this long timeline and large footprint have come concerns about harms to customers, employees, and other stakeholders, as well as questions about how society is impacted more generally by venture capital.¹³⁶

A vivid example of this complex dynamic of startups in the private realm comes from the burgeoning artificial intelligence (“AI”) industry. AI is posed to deliver some of the biggest financial hits of the current generation of startups and it threatens to destabilize countless industries and impact social and economic activity globally in unpredictable ways. Sam Altman, the CEO-founder of OpenAI, which has developed ChatGPT, currently valued at $29 billion, has declared that it is better to continue running the company privately so that his decisions are not limited.¹³⁷ Altman remarked, “When we develop superintelligence, we’re likely to make some decisions that public market investors would view very strangely.”¹³⁸

Notably, however, Altman made these statements about staying private while on a world tour of meetings with governments in which he warned them of the existential threat posed by AI. He testified to the U.S. Congress: “I think if this technology goes wrong, it can go quite wrong.”¹³⁹ And although he originally expressed a desire for his company to work with governments on responsibly regulating AI, he threatened that OpenAI would leave Europe in response to new European Union regulations.¹⁴⁰ He later backtracked after EU lawmaker pushback,¹⁴¹ but he could not unring the proverbial bell that raised questions about the dangers of the technology being developed and the sincerity of its stewards’ statements about embracing regulation.

As regulators’ ability to rein in the harms posed by venture-backed startups is often limited as a practical matter, and the protections of public markets are absent, focus has shifted to startup governance and the failures of private ordering to create checks and balances. For over a decade, with more private capital available in a low-interest rate environment and intense competition for venture deals, many venture capitalists adopted “founder-friendly” stances.¹⁴² Some founders have been allowed to act as “monarchs” with “unchecked power.”¹⁴³ Critics have expressed concern that venture capitalists have turned into “hype” people exercising little managerial oversight—“a money-hungry mob” pushing for “hyper growth” instead of the prudent “midwives to innovation” they had been in the past.¹⁴⁴

In some instances, utterly disastrous startup governance has come to light. One example is the collapse of FTX, one of the largest cryptocurrency exchanges, once privately valued at $40 billion.¹⁴⁵ The CEO-founder was “the paragon of crypto,” and vaulted to celebrity status as he led the startup through rocket-ship growth.¹⁴⁶ After troubling reports came to light about potential leverage and solvency concerns, customers attempted to pull out of FTX, precipitating the company’s downfall. Prosecutors and regulators quickly closed in on the CEO-founder, asserting that FTX had been illegally using clients’ deposits.¹⁴⁷ Shortly after, the CEO-founder resigned and the company filed for bankruptcy. One of the biggest unicorns crumbled within days.

In the aftermath, FTX installed a new CEO to handle the bankruptcy—the same person who had handled the cleanup of the massive accounting and audit scandal at Enron that had prompted the passage of the Sarbanes-Oxley Act in 2002.¹⁴⁸ After taking the helm at FTX, he said: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here.”¹⁴⁹ The company had no board of directors—none of the well-known venture firms that had financed FTX had taken seats.¹⁵⁰ According to media reports, “control was in the hands of ‘a very small group of inexperienced, unsophisticated and potentially compromised individuals.’ ”¹⁵¹ Company financials were not tracked.¹⁵² Software was reportedly used to conceal the misuse of client money.¹⁵³ The CEO-founder was arrested and charged with multiple criminal counts, and other top executives pleaded guilty and admitted that they knew what they did at the startup was wrong.¹⁵⁴ Potentially billions of dollars in customer funds went missing.¹⁵⁵

Apart from governance scandals is the separate concern that with venture capitalists raising and deploying dramatically larger funds, they might end up funding money-losing companies that are creating “disruption without social benefit.”¹⁵⁶ In some cases, startups might in fact be “destroying social value” and crowding out the development of superior technologies.¹⁵⁷ Venture capital goes to a narrow slice of potential innovators and not necessarily those that would produce the most social value or positive innovation.¹⁵⁸ Even venture capitalists themselves have raised this concern, for example noting, “We wanted flying cars, instead we got 140 characters.”¹⁵⁹ And while the social value that Twitter produced is certainly debatable, it compares favorably to many other startup inventions including robotic pizza makers and “Juicero” juicers.¹⁶⁰ Commentators have also raised concerns that only a relatively small number of venture capital investors shape the direction of a substantial amount of the capital that is financing radical technological change.¹⁶¹

A number of proposals for reform have been offered. These have tended to be somewhat narrowly focused on particular aspects of problematic facets of the public-private divide and startup governance. For example, proposals from scholars and regulators include special disclosure regimes for unicorns,¹⁶² enhanced disclosures for startup employees,¹⁶³ expanded anti-fraud enforcement efforts,¹⁶⁴ facilitating private company stock trading for price accuracy,¹⁶⁵ and reforming the “shareholders of record” trigger for public company status.¹⁶⁶

Without a more systematic approach to these issues, however, it is difficult to know if there is a problem with venture-backed startups and the private realm, and whether private ordering, new lawmaking, or enforcement could provide a solution. The next Part takes up some of the larger issues and promising avenues for future research.

III. THE BIG QUESTIONS

It might be impossible to accurately calculate the social welfare impact of venture capital, but researchers have begun to ask this question.¹⁶⁷ For most industry players, researchers, and others who are involved in some way in startups and venture capital, the answer is intuitively positive—despite drawbacks and harms, the gain is incalculably large as it is a key economic driver of growth and innovation that changes millions of lives.¹⁶⁸ The vibrant U.S. venture capital ecosystem is a jewel of the economy that countries around the world seek to emulate. Innovation is not automatically good for society,¹⁶⁹ but “in the long run, innovation is essential to productivity gains and economic growth.”¹⁷⁰

As one researcher explained: “Venture capitalists generate private value in the form of fund-level returns, but the social value they create surely exceeds that. That social value is equivalent to private value plus all other returns realized from the technological change that venture financing enables.”¹⁷¹ And on the latter point, “[n]umerous innovations developed by VC-backed firms, from memory chips to recombinant insulin . . . have moved society forward—and in turn, stimulated additional waves of technological development with immense collective impact.”¹⁷²

At the same time, even those who have a rosy or optimistic view about the aggregate social value that venture capital produces might be uncomfortable with the lingering impacts on stakeholders that arise in the context of venture-backed startups. Further, the rise of founders with unchecked power and the decline in active corporate governance by venture capitalists is concerning to many observers.

This Article offers two promising avenues for further inquiry for legal scholars and policymakers. Although the social welfare impact of venture capital may be somewhat intractable in the abstract, there are concrete related questions that would benefit from additional legal study and debate.

First, researchers can usefully focus attention on studying which persons impacted by venture-backed startups, if any, are systematically suffering harm. Key areas for additional investigation include startup employees and customers or users.

A number of researchers have raised concerns about startup employees developing incorrect expectations about the value of their equity compensation or suffering losses by exercising vested options and incurring tax consequences.¹⁷³ Assessing the value of startup equity compensation is challenging because of the lack of liquidity and a clear market price.¹⁷⁴ Further, as discussed above, startups rely on Rule 701 to avoid registering compensatory offerings with the SEC, and have limited disclosure obligations.¹⁷⁵ Complex and often opaque capital structures add to the challenges for startup employees to evaluate their equity compensation.¹⁷⁶ Venture capitalists typically receive preferred stock, which comes with contractual protections such as liquidation preferences, and is considerably more valuable than the common stock for which employees are typically granted stock options.¹⁷⁷ In short, an illiquid market, incomplete information, and complex capital structures often make it difficult for startup employees to make informed decisions about their equity compensation.¹⁷⁸ A more systematic study of the issue offers a concrete path for legal reform that could temper some of the harms of startup governance failures or fraud as other startup participants—venture capitalists, founders, and executives—are often better situated to bear the risk or avoid creating the harm in the first place.

Another group of individuals impacted by startups that deserves deeper inquiry are customers or users.¹⁷⁹ Some salient examples of startups that have harmed users in recent times have included the blood-testing company Theranos, vaping pioneer Juul, and the crypto exchange FTX.¹⁸⁰ Determining whether startups pose distinctive risks to customers is difficult, however. Corporate harms and externalities are certainly not unique to startups—closely held and publicly traded companies are involved in a range of pressing social issues from the opioid crisis to environmental pollution and catastrophes. Nonetheless, one could imagine that startups more frequently pose risks, or uncertain impacts, to customers or users stemming from the innovation or technology that is at the heart of venture-backed experiments. And yet, attempting to regulate the harms from innovation through corporate and securities laws may be inefficient or worse. Further work could be done to bring together relevant research across silos of business law, technology and innovation law, and regulatory and enforcement approaches.

Second, a worthy area of legal focus is whether and when a governance intervention is optimal on a startup’s timeline in the venture cycle. Many observers have bemoaned bad startup governance and even blamed it for major scandals, yet little work has been done to examine how the venture contracting and governance model could change to incentivize active monitoring or whether regulatory mandates are necessary.¹⁸¹

For example, would additional disclosure, due diligence, independent directors, audited financials, or some other mechanism improve startup governance? Is there a bargaining or market failure that prevents such a governance mechanism from being used in most startups? As many startups fail, particularly in their early stages, increasing governance or compliance costs may be unwise and impinge on the valuable space for maneuvering in the private realm that fosters a thriving startup ecosystem. Further, as startups mature, they are often navigating increasing potential tensions among a larger number of participants and greater costs of bargaining, while trying to find a path to a successful exit.¹⁸² Therefore, it may be relatively easy to point to startup governance failures as a problem in the abstract, but difficult to find an ideal moment in the timeline to introduce mandatory obligations and to know which solutions, if any, are optimal. As the topic of startup governance garners more attention, it is important to bolster the empirical and theoretical foundations for understanding whether any legal reform is due.

In sum, while the U.S. venture capital ecosystem is a jewel of the economy and a key driver of innovation, it has also catalyzed concerns about social costs which are worthy of further examination. Further inquiry into two key areas—whether any stakeholders systematically experience negative impacts and potential improvements to the venture contracting and governance model—could help illuminate a path for the future of business law in this area.

CONCLUSION

Technology and innovation in the digital era have profoundly transformed business and society. This Article has investigated how law, particularly corporate and securities law, has facilitated and responded to the rise of venture capital that has been the key financial driver of this transformation.

The discussion has explored in particular how, after lawmakers shaped the enabling environment for venture capital to flourish, corporate and securities law has responded to the rise of venture-backed startups incrementally but with profound effect. Although business law has not always fit easily with the distinctive features of venture capital and startups, it has provided an enormous space in the private realm for venture capital and startups to maneuver with relative freedom. This private realm is a good fit for the needs of innovative companies, but their activity creates lingering issues of social costs and policy. Important and promising areas of future research lie ahead to develop a coherent business law response to the current wild era of adventure capital..

96 S. Cal. L. Rev. 1341

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Elizabeth Pollman*

* Professor of Law, University of Pennsylvania Carey Law School. Special thanks to Danny Sokol and the participants and editors involved in the 2023 Symposium of the Southern California Law Review. Additional thanks for helpful comments and valuable discussion to Brian Broughman, Elisabeth de Fontenay, and workshop participants at Seoul National University School of Law, the Center for Advanced Studies on the Foundations of Law and Finance at Goethe University Frankfurt, and Bocconi University.

The Trading Game: An Analysis of Robinhood’s Use of Digital Engagement Practices

February 2024February 2024Antoinette Petkov

In December 2020, the Enforcement Section of the Massachusetts Securities Division of the Office of the Secretary of the Commonwealth filed an Administrative Complaint against Robinhood Financial LLC (“Robinhood”), a registered broker-dealer, in part, “for violations of Massachusetts law in connection with Robinhood’s . . . use of strategies such as gamification to encourage and entice continuous and repetitive use of its trading application [“app”].”¹ This action is part of a growing trend in which regulators have voiced potential concerns² about broker-dealer use of digital engagement practices (“DEPs”), which include “behavioral prompts, differential marketing, game-like features (commonly referred to as “gamification”), and other design elements or features designed to engage with retail investors on digital platforms.”³

This Note will evaluate the novel use of gamification, or game-like features, by broker-dealers in their online and mobile platforms. “A broker-dealer . . . is a person or firm in the business of buying and selling securities for its own account or on behalf of its customers” that serves several important roles like “providing investment advice to customers [and] . . . facilitating trading activities.”⁴ Broker-dealer use of gamification to perform these functions will specifically be analyzed in relation to two potential legal issues that the Financial Industry Regulatory Authority (“FINRA”) has already identified. These issues are whether broker-dealer marketing and advertising using game-like features follow regulations governing communications with the public and whether broker-dealers are making recommendations in compliance with relevant rules relating to recommendations when broker-dealers use game-like features.⁵ Ultimately, this Note concludes that the current use of game-like features, at least by Robinhood, does not violate existing regulations. However, additional information is necessary to complete the proposed analysis, which will hopefully be available following the Securities and Exchange Commission’s (“SEC”) recent request for public comment on broker-dealer use of DEPs.⁶ Therefore, based on the proposed analysis, if regulators want to rein in broker-dealer use of gamification, they will probably need to amend existing regulations. This is a favorable objective given critical policy concerns, like protecting retail investors, or “non-professional investor[s]” participating in the securities market,⁷ especially those that are inexperienced or young.

This Note will evaluate the issue of gamification in the context of popular online broker-dealer, Robinhood. The company was founded in 2013⁸ and, over the past few years, has grown into a major player in the securities industry.⁹ As of March 2021, the company had 18 million Net Cumulative Funded Accounts.¹⁰ However, the company has proven particularly popular with millennial and Generation Z investors; the company stated in its Form S-1 filed during its initial public offering in 2021 that “as of March 31, 2021, approximately 70% of our [Assets Under Custody] came from customers on our platform aged 18 to 40, and the median age of customers on our platform was 31,”¹¹ which will prove relevant to the issues analyzed in this Note.

This Note will proceed in several parts. Part I will present the concept of gamification, including its potential risks, the DEPs that Robinhood has implemented in its platform, the history of how broker-dealers came to use these features, including the development of the modern technologies that have made these features possible, and the legal issues raised by broker-dealer use of gamification. Part II will introduce the regulatory bodies that govern the U.S. securities industry, the specific regulations that are relevant to evaluating the legal issues in this Note, and the policy goals that underlie the U.S. securities regulation system. Finally, Part III will analyze whether Robinhood’s use of game-like features violates existing securities regulation, will summarize the legal and legislative actions that have already been taken regarding this issue, and will present policy concerns that lean in favor of increased regulation.

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Fractionalization to Securitization: How the SEC May Regulate the Emerging Assets of NFTs

April 2023April 2023Lauren Au*

Blockchain technology opened the world to a variety of new technological advances that reshaped the way humans interact and transact with one another. One of the most recent and trending applications of blockchain technology is non-fungible tokens or “NFTs.” NFTs are unique digital tokens encoded on a blockchain that represent ownership of specific digital assets such as artwork, collectibles, videos, domain names, and so forth.¹ NFTs can be thought of as certificates of authenticity. Although NFTs resemble cryptocurrencies, NFTs are non-fungible. This means that no two tokens are identical, and they are not interchangeable with one another. They are valuable because each comes with a unique digital signature or ledger that allows it to be easily authenticated, verified, and transferred. This has completely revolutionized the way people trade different assets, and many NFTs are sold online for millions of dollars.² Additionally, NFTs can come in different forms, ranging from whole NFTs of digital artwork or real property to fractionalized NFTs (“f-NFTs”) that break up ownership of an NFT into multiple “shards” so a larger number of people can own a piece of a single digital asset.³

NFTs are a new and influential technology that can have far-reaching implications for current securities law, intellectual property law, and other legal areas. In securities law, NFTs have established a new way for people to invest and gain returns from digital assets. This has disrupted the legal and financial sectors and created new risks for investors such as fraud and hacking.⁴ With the recent rise of NFTs as potential investment assets comes the possibility of government regulation to protect investors. The growing use of NFTs alerted many regulators, such as the Securities and Exchange Commission (“SEC”), to the possibility of regulating these digital assets as some type of security.⁵ However, regulatory and securities laws struggle to keep pace with emerging innovations and financial technologies like NFTs. Much of the SEC’s limited guidance focuses on cryptocurrencies and blockchain technology generally, with little guidance specifically on NFTs as a security. Leaders in the industry have requested no-action letters, although the SEC remains silent.⁶ Leaders believe “it would be a lot easier to operate in an environment where sensible ground rules are laid out that allow for innovation.”⁷ NFT creators, buyers, and exchange platforms must rely on general SEC regulations of other digital assets to guide their decision-making and avoid regulation. Given these issues, it is important for the SEC to provide guidance on NFTs to protect and inform potential investors, while also ensuring issuers can properly develop NFTs and NFT platforms without the fear of strict regulation.

This lack of guidance stems from the fact that many regulators are divided on whether NFTs can be classified as an “investment contract” security or regulated by the SEC. The Securities Act of 1933 defines a “security” as “any note, stock, . . . bond, debenture, . . . [or] investment contract.”⁸ In 1946, the U.S. Supreme Court developed a four-pronged test in SEC v. Howey to clarify whether an asset is an “investment contract” security.⁹ The Howey test holds that a contract, transaction, or scheme is an “investment contract” when an individual (1) makes an investment of money (2) in a common enterprise (3) with a reasonable expectation of profit (4) derived from the efforts of others.¹⁰ While some argue that NFTs are not an “investment contract” security under the Howey test because they do not satisfy either the second or fourth prong, others believe that fractionalized NFTs could pass all four prongs.¹¹ There has been little in-depth legal research and analysis that focuses specifically on f-NFTs as securities and the potential regulatory framework that could control this digital asset.¹² The legal field must catch up with rapid technology developments and take a revised look at current regulations to see how they can be applied to NFTs. To analyze if the SEC can regulate NFTs, two main questions need to be addressed: (1) whether certain NFTs can be classified as a security under federal law; and (2) if NFTs are securities, how SEC requirements can be applied to best protect the public’s interests.

To answer these questions, this Note will apply the Howey test to f-NFTs and identify the risks and opportunities of regulating them as securities to better understand how to protect investors while also allowing for the innovation of digital assets. This Note will first conclude that NFTs can be “investment contract” securities and satisfy the four Howey prongs if they are fractionalized. First, when purchasing f-NFTs, buyers make an investment using digital currency that is considered “money.” Second, having an NFT tied to the success of a company or celebrity, or having multiple fractional interests in an NFT that are shared by a pool of investors, are investments in the “common enterprise” of that individual company, celebrity, or whole NFT. Third, f-NFTs have a “reasonable expectation of profit” given that they are easily traded on secondary markets and promoted as a unique way to “unlock liquidity.” Lastly, an f-NFT’s financial return can be derived from the efforts of platforms or issuers to maintain or improve the f-NFT market and support the popularity or price of the digital asset. This Note will then explain that even if f-NFTs are deemed securities, the SEC will need to adopt a clearer regulatory framework for f-NFT issuers, buyers, and platforms by modernizing established regimes of other digital assets. The SEC may have trouble regulating issuers or buyers of f-NFTs because the decentralized networks of f-NFTs already provide a form of digital “registration” that gives sufficient information to investors and prevents fraud through the easily verifiable digital ledgers of an f-NFT’s transactions. However, a platform that creates and trades f-NFTs may be a security “exchange” under federal law, and thus the SEC may be able to place some modified regulations on these f-NFT platforms, such as notice and disclosure requirements or compliance with capacity, integrity, and security standards, which ensure f-NFT and investor protection.

Part I provides a general overview of NFTs by explaining the blockchain technology that powers them. This Part illustrates what NFTs are, how they work, the concept of fractionalizing NFTs, and the principal applications and potential importance of NFTs in the financial markets. Part II lays out the underlying securities law—in particular SEC v. Howey—and the SEC’s current regulatory framework for other blockchain-based financial assets such as cryptocurrencies and digital tokens. Part III applies the Howey test to f-NFTs to show that they can be classified as securities and bolsters this argument by comparing f-NFTs to a digital asset (DAO Tokens) that the SEC has previously determined to be an “investment contract.” Part IV analyzes the pros and cons of regulating certain NFT issuers, buyers, or exchange platforms and provides recommendations for an NFT regulatory framework using comparisons to other developed digital asset platforms. Part V provides a preliminary exploration of existing regulatory models like those that govern traditional stocks and Real Estate Investment Trusts (“REITs”) and how they can be applied to f-NFTs.

I. NFT BACKGROUND: A TECHNICAL OVERVIEW OF NFTS

A. TECHNICAL ASPECTS OF NFTS

An NFT is a cryptographic unit of data or digital signature stored in a “blockchain” that represents the ownership of a unique digital asset or real-life object.¹³ Since they use blockchain technology, NFTs are typically bought and sold online with cryptocurrency.¹⁴ NFTs are similar to cryptocurrencies such as Bitcoin and Ethereum because they all use blockchain technology to create a digital object (currency or token) using units of data on a digital ledger. The only difference is that digital currencies are meant to be fungible, in that one Bitcoin is the same as and interchangeable with another Bitcoin, while an NFT is meant to be non-fungible, in that each one is one-of-a-kind and not exchangeable with another NFT.¹⁵ The underlying data of an NFT is unique because there can only be one owner, and that person is the only one who can access or transfer that NFT. This non-fungibility and use of blockchain allow NFTs to have a built-in proof of ownership that is easily authenticated, create exclusivity, and allow for verified transfers.

B. BLOCKCHAIN TECHNOLOGY

NFTs rely on blockchain technology, which creates a secure, decentralized network for transactions of various digital assets. The blockchain is essentially a “chain” of “blocks,” each containing specific information regarding a digital asset and its transactions that is then stored on a digital, secure, peer-to-peer ledger.¹⁶ An NFT is a digital database that stores data in the form of a “smart contract” and a unique identification hash bundled together in “blocks” that are all “chained” together in a distributed network. A smart contract is defined as “a computerized transaction protocol that executes terms of a contract” and is meant to minimize fraud and transaction costs.¹⁷ In other words, smart contracts are programs stored on a blockchain that automatically execute certain terms of a contract once certain predetermined conditions are met.¹⁸ Each blockchain “block” contains three components: (1) data, (2) the hash of the block, and (3) the hash from the previous block.¹⁹ The hash is a digitally generated string of digits and letters used to identify each block in a blockchain structure and acts as a type of unique fingerprint.²⁰ The data for an NFT “block” includes a “smart contract” that points to where an NFT is located on the internet and how to retrieve it, dictates the terms of a transaction, provides a verification of ownership, and holds a ledger of the token’s ownership history and transaction record.²¹

FIGURE 1: NFT Blockchain Sequence Diagram

An issuer creates an NFT by deploying a code to develop a specific type of “smart contract” that contains a blockchain address, typically on the Ethereum Blockchain, where the smart contract resides.²² Later, when someone buys or sells an NFT, the blockchain automatically creates a new “block” and a new hash for this block to add this new transaction to the “chain.”²³ The blockchain is essentially recording a “change of state” to the NFT in which the “smart contract” updates its internal ledger and changes the structure of the NFT’s underlying blockchain to reflect the transfer of the NFT to and from different addresses.²⁴ In short, whenever an NFT is sold, this new ownership is noted as a “new block” in the blockchain ledger, and the digital hash of that NFT is changed.

When purchasing an NFT, you are only buying exclusive access to the unit of data that contains the NFT’s location and are relying on the issuer’s obligation to ensure authenticity.²⁵ You do not gain any property rights of the actual digital asset, such as intellectual property rights (right to copy, right to destroy, and so forth.). Similar to buying a painting, when buying an NFT, you are only buying display rights or the right to say that you own it, but nothing else. You are mostly buying a digital certificate of ownership and authenticity or unique access to a digital object, not the actual digital object itself.²⁶ In other words, you own the one-of-a-kind map of where the NFT is located and are the only one who has access to it. The underlying NFT is typically hosted or located on a regular Hypertext Transfer Protocol (“HTTP”) Uniform Resource Locator (“URL”) web address on the internet or on an InterPlanetary File System (“IPFS”) hash, which is a “system designed for hosting, storing, and accessing data in a decentralized manner.”²⁷ Using a regular HTTP web address is typically very risky given that a server owner could easily change the underlying content of that particular address and completely erase the actual NFT content that was originally purchased.²⁸ However, when housing an NFT on IPFS, the NFT gets assigned a unique content identifier (“CID”) hash that links to the data in the IPFS network.²⁹ Using an IPFS CID hash, as opposed to an HTTP URL, allows someone to find the NFT based on its content rather than by its location on a server. Thus, if the content of the NFT is changed, the original CID link would break and create a new one.³⁰

Even though NFTs only give a type of “bragging rights,” they provide various advantages that have changed the tech and financial markets. The benefits of an NFT are that it is easy to authenticate its originality, establish its exclusivity, and transfer the asset.³¹ The permanent digital ledger inherent in an NFT acts as a record of ownership and allows for easy traceability across the blockchain network so that the original creator or past owners can be easily traced through their past transactions.³² This has made NFTs a highly valuable avenue to establish verified ownership over assets such as digital artwork, digital trading cards, video highlight reels, social media posts, collectibles, and even real property.³³ An NFT also has the unique capability to internally incorporate royalty agreements into its “smart contract,” where it automatically carries out an agreed-upon payment system whenever the NFT is licensed, resold, or used for some particular purpose.³⁴ This has provided content creators with new ways to continuously and easily monetize their work through NFTs. Lastly, NFTs have created a new way for people to invest their money in digital assets. With billions of dollars recently being poured into the NFT market, many investors have flocked to these digital assets as a potential high-risk investment strategy.³⁵ However, NFTs have become the target of some security breaches and hacking due to their novelty and outdated or inefficient security protocols.³⁶ Additionally, the value of NFTs and their potential returns can be volatile and speculative because they are only worth as much as other people are willing to pay for them.³⁷ An NFT’s appreciating value seems to be derived either from its creator or its scarcity.³⁸ Thus, depending on these two factors, investors could either win the jackpot to resell their NFT for a large gain or end up with a worthless digital asset and a large loss.

C. FRACTIONALIZATION OF NFTS

One major innovation that has disrupted the way people view and use NFTs as investments is the concept of fractionalizing NFTs. Fractional NFTs, or “f-NFTs,” break an NFT into pieces, or “shards,” which can be subsequently traded and sold in the market at a lower price than the NFT as a whole.³⁹ F-NFTs represent a fraction of the larger digital asset in which an investor can now share a partial interest in an NFT with other investors.⁴⁰ Given that NFTs are routinely sold individually for thousands or millions of dollars, f-NFTs democratize these investments such that average investors can now purchase a smaller portion of a high-priced NFT.⁴¹ F-NFTs opened up access to NFT markets and allowed more people to invest in these new digital assets.

There are currently multiple platforms that facilitate the creation and trading of f-NFTs, such as Niftex, Fractional.art, and DAOfi. These f-NFT platforms allow owners to break NFTs into multiple shards and sell them at an initial fixed price.⁴² The shards can subsequently be traded in an open market on the platform. On Niftex, an f-NFT is created through a four-step process: (1) “Owners of NFTs create fractions (‘shards’) by choosing issuance and pricing”; (2) these fractions are then put on sale on the platform at a fixed price for two weeks or until they sell out; (3) once the fixed sale period ends, the fractions can be traded on a secondary market; and then (4) a whole NFT can be fully retrieved by purchasing all of the shards through the platform’s special “Buyout Clause.”⁴³ This Buyout Clause is embedded within an f-NFT’s smart contract and gives f-NFT investors who own a particular percentage of an NFT’s shards the opportunity to purchase the remaining shards to now own the whole NFT.⁴⁴ F-NFT platforms have also incorporated the ability to automatically give issuers a portion of the f-NFT created or to give some type of “curator fee.”⁴⁵

NFT issuers and platforms have become very creative in the ways in which they utilize and develop this digital asset. One theory is that platforms could put numerous NFTs into one basket and sell f-NFTs of that basket as an investment product or security (“f-NFT bundles”).⁴⁶ While some people do not think a traditional NFT could be a security, an f-NFT may be deemed a security under U.S. securities law. SEC Commissioner Hester Peirce warned issuers of f-NFTs that “the whole concept of an NFT is supposed to be non-fungible [meaning that] in general, it’s less likely to be a security,” but if issuers sell fractional interests in NFTs or NFT bundles, “you better be careful that you’re not creating something that’s an investment product—that is a security.”⁴⁷ Peirce argued that “the definition of a security can be pretty broad,” and thus f-NFTs could fall within the SEC’s definition of a security and be subject to some form of regulation.⁴⁸ With the high costs of a single NFT, the growing availability of blockchain platforms in the mainstream, and the large development of decentralized finance and decentralized applications, “the continued fractionalization of NFTs is almost inevitable.”⁴⁹

II. LEGAL BACKGROUND: DEFINING “SECURITIES”

The main statutes governing securities regulation are the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”). While the Securities Act mostly deals with the issuance of securities, the Exchange Act governs exchanges, brokers, and trading on secondary markets.⁵⁰ Together, these statutes establish a registration and disclosure regime that requires any offer or sale of securities to register with the SEC and any issuers of securities to provide accurate and complete disclosures of material information regarding their securities offering or company. These requirements provide key information to investors so that they can make the most informed decisions. The consequences of being subject to these registration and disclosure requirements include filing documents with the SEC any time you sell securities, such as a Form S-1 registration statement, and filing continuous, periodic reports regarding the company’s business operations and financials, such as Form 10-K, Form 10-Q, or Form 8-K.⁵¹ These statutes, along with regulatory rules, provide definitions and tests to help determine whether an asset is a “security” or an organization is an “exchange” that is subject to federal regulation.

A. SECURITIES ACT OF 1933

The Securities Act makes it illegal for an issuer to offer or sell any unregistered security within interstate commerce unless the security is exempt from registration.⁵² This statute defines an “issuer” as “every person who issues or proposed to issue any security,” where “person” includes “an individual, a corporation, . . . [or] any unincorporated organization.”⁵³ It also provides a broad definition of different types of assets that could be considered securities under U.S. federal securities law.⁵⁴ This definition specifically includes “investment contracts,” which can be seen as a catch-all term for any type of asset that behaves and feels like a security. Thus, it is sometimes difficult to determine if something falls within the definition of a security.

B. SEC V. HOWEY

In SEC v. Howey, the U.S. Supreme Court created the Howey test to help clarify what an “investment contract” security is under the Securities Act. The defendant, W.J. Howey Company, sold real estate contracts for orange groves in Florida for a fixed price per acre.⁵⁵ Howey then encouraged purchasers to set up service contracts in which they would lease the land back to the company to farm the orange groves, and in exchange the buyers would receive a share of the profits.⁵⁶ The Supreme Court held that these orange grove service contracts were “securities,” because purchasers were buying shares in Howey’s profits from the orange groves through these service contracts, not the actual orange groves themselves.⁵⁷ The Court developed a four-pronged test in which “an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”⁵⁸ There have since been a variety of cases that helped develop and clarify each of the four Howey prongs. The first prong of “an investment in money” does not need to be in the form of cash and can be satisfied using a different form of contribution or investment, such as cryptocurrency.⁵⁹

The second prong of “in a common enterprise” requires that the fortunes of the investor be linked to the success of the overall venture or enterprise. “Fortunes” refers to the “profits” (and benefits) or “losses” (and costs) that occur from a certain asset and that affect a person’s position.⁶⁰ There needs to be a kind of commonality or relationship, either among investors or between the “promoter” and investors, in which the investor depends on the actions and decisions of the promoter of the asset.⁶¹ A promoter is defined as any individual or organization that helps found and organize the business or enterprise of an issuer of any security or that receives ten percent or more of any class of the issuers securities or proceeds from the sale of such securities as consideration for their services or property.⁶² Federal courts have typically required that there be either “horizontal commonality” or “vertical commonality” for an asset to satisfy the “common enterprise” prong.⁶³ Horizontal commonality is defined as the relationship between investors and a pool of other investors. There is commonality when an individual investor’s fortunes are tied to the fortunes of other investors in a common venture by the pooling of assets, usually combined with the

pro-rata distribution of profits.⁶⁴ Vertical commonality is defined as the relationship between the promoter and the body of investors.⁶⁵ Commonality exists when there is a connection between the fortunes (strict vertical commonality) or efforts (broad vertical commonality) of the promoter and the fortunes or efforts of the investors. This type of commonality does not require a pooling of funds.⁶⁶

The third prong of “a reasonable expectation of profits” requires investors to realize some form of appreciation on the development of the asset or participate in the earnings resulting from the use of investors’ funds.⁶⁷ The SEC defines “profits” as “capital appreciation resulting from the development of the initial investment or business enterprise or a participation in earnings resulting from the use of purchasers’ funds.”⁶⁸ Courts also include “dividends, other periodic payments, or the increased value of the investment” in the definition of profits.⁶⁹ However, the SEC notes that “price appreciation resulting solely from external market forces (such as general inflationary trends or the economy) impacting the supply and demand for an underlying asset generally is not considered ‘profit’ under the Howey test.”⁷⁰ This prong is very fact-sensitive, and the SEC looks at several factors, like the trading of the asset on secondary markets, identity of the buyers, and marketing efforts, to determine whether an asset satisfies this prong.⁷¹

Finally, the fourth prong of “from the efforts of others” is satisfied when the promoter or issuer of an investment creates or supports the market for these assets or the value of the asset is dependent on the promoter’s efforts in generating demand.⁷² In Howey, the Supreme Court understood that the Securities Act’s definition of a “security” is broad, so it argued that “[f]orm was disregarded for substance and emphasis was placed upon economic reality.”⁷³ Thus, when determining whether something can be considered a security, one needs to focus on the specific circumstances, facts, and economic impact of the particular asset.⁷⁴ For an asset such as digital currencies or tokens, this test may consider factors such as the token’s design, issuance, and how it interacts with its platform or blockchain. Depending on how an NFT is created, structured, marketed, and sold or distributed, such NFTs could be deemed securities. This would mean that any sale of this NFT would be subject to the existing securities law framework.

C. CURRENT CASE LAW

Although there are few settled cases regarding whether certain digital assets are securities, there are a couple of key cases making their way through the court system. One of the leading cases being decided is SEC v. Ripple Labs, Inc., in which the SEC filed an enforcement action against Ripple Labs for selling crypto tokens that the SEC believed were unregistered securities.⁷⁵ The SEC argues that Ripple Labs failed to register its offer and sale of about $600 million of its digital asset called XRP to retail investors, which was used to finance the business. The SEC stated that XRPs were investment contract securities because purchasers of XRP invested into a common enterprise, given that XRP’s demand is tied to Ripple’s success or failure in propelling its trading, and Ripple publicly promised investors that it would “undertake significant entrepreneurial and managerial efforts to create a liquid market for XRP” that would in turn increase its uses, demand, and price, and led reasonable investors to expect profits from XRPs.⁷⁶ Another notable case that provides arguments for and against regulating NFTs as securities is the class action lawsuit filed against Dapper Labs.⁷⁷ Dapper Labs created the National Basketball Association’s (“NBA”) Top Shot, which sells NFTs of NBA highlights or “Moments” that can be bought or sold using the blockchain and marketplace Dapper Labs developed.⁷⁸ This class action argues that Dapper Labs is selling securities due to how it operates its resale marketplace and promotes the value of its NFTs. The plaintiffs allege that Moments were sold with “the expectation of profit” where “[t]he reality is that the growing fanatical NBA Top Shot database is all about the investment, speculation and appreciation of the Top Shot NFTs and the NBA Top Shot Marketplace.”⁷⁹ However, the plaintiffs conceded that NBA Top Shot’s Service Terms of Use state that users “are using NFTs primarily as objects of play and not for investment or speculative purposes.”⁸⁰ NBA Top Shot is promoting the NFTs as collectables as opposed to investments, which weighs in favor of the NFTs not being securities. Nevertheless, some argue that NBA Moments may still be “investment contracts” because Top Shot creates and maintains the sole marketplace for these NFTs and thus could be an unregistered exchange.⁸¹

D. SECURITIES EXCHANGE ACT OF 1934

Once an asset is deemed a “security,” the SEC and the Exchange Act impose numerous regulatory requirements on the “exchanges” or platforms that facilitate the trading of those assets. Section 5 of the Exchange Act makes it unlawful for any broker, dealer, or exchange to effect any transaction in a security unless the exchange is registered as a national securities exchange under section 6 of the Exchange Act or an appropriate exemption applies.⁸² Registration as a national securities exchange requires any person or entity that offers or sells securities to the public to provide “full and fair disclosure” through the delivery of a statutory prospectus that contains information necessary to give prospective purchasers the proper opportunity to make an informed investment decision.⁸³ Under the Exchange Act, an “exchange” is defined as any organization or group of persons (whether incorporated or unincorporated) that maintains or provides “a market place or facilities for bringing together purchasers and sellers of securities” or conducts functions commonly performed by stock exchanges.⁸⁴ The Code of Federal Regulations attempts to clarify when an entity must register as a national security exchange and provides a functional test to assess whether an entity meets the definition of an “exchange” under the Exchange Act. Rule 3b-16(a) states that an organization, association, or group of persons is considered to constitute or maintain an “exchange” if it (1) “brings together the orders for securities of multiple buyers and sellers” and (2) “uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other.”⁸⁵ Rule 3b-16(b) then lays out what is excluded from the definition of an exchange.⁸⁶ The SEC has argued that when analyzing whether a “system operates as a marketplace and meets the criteria of an exchange under Rule 3b-16(a),” one must look to “the activity that actually occurs between the buyers and sellers—and not the kind of technology or the terminology used by the entity operating or promoting the system.”⁸⁷ Thus, any trading system that meets the definition of an exchange under

Rule 3b-16(a), and is not excluded under Rule 3b-16(b), must register as a national securities exchange or operate pursuant to an appropriate exemption.⁸⁸

Exempted entities do not need to register as a national securities exchange under section 6.⁸⁹ Rule 3a-1-1(a)(2) states that an organization, association, or group of persons is exempt from the definition of “exchange” if it is operating as an alternative trading system (“ATS”) and is in compliance with Regulation ATS.⁹⁰ ATSs are SEC-regulated electronic trading systems that utilize the process of “dark pools” to match orders for buyers and sellers of securities.⁹¹ The SEC released a report regarding its adoption of new rules and amendments that allow ATSs to “choose whether to register as national securities exchanges, or to register as broker-dealers and comply with additional requirements under Regulation ATS, depending on their activities and trading volume.”⁹² ATSs typically face fewer and simpler regulations than national securities exchanges but still have some requirements, such as registering as a broker-dealer, giving notice of initial operations or material changes, providing fair access, keeping records, complying with capacity, integrity, and security standards, and other reporting requirements to safeguarding customer funds and securities.⁹³

E. RULES, REGULATIONS, AND GUIDANCE FROM AGENCIES

In addition to statutes, issuers and platforms of digital assets also rely on statements, reports, and frameworks from the SEC and other regulatory bodies to guide their decisions. As digital assets grew in popularity, the SEC took notice and came out with formal and informal statements regarding its views on cryptocurrencies and tokens. In 2018, SEC Chairman Jay Clayton testified before a Senate committee arguing that cryptocurrencies could be structured as securities products subject to federal securities laws and warned that certain Initial Coin Offerings (“ICO”) structures could implicate securities registration requirements.⁹⁴ More recently, at the Security Token Summit 2021, Peirce warned issuers of NFTs to be cautious when they create f-NFTs because when used in certain creative ways, they could create a security that is subject to regulation.⁹⁵

The SEC created a branch in 2018 called the Strategic Hub for Innovation and Financial Technology (“FinHub”) to coordinate and respond to emerging financial technology (“fintech”); serve as a public resource by consolidating, clarifying, and communicating the SEC’s views and actions related to fintech innovation; and inform policy research in these areas.⁹⁶ In 2019, FinHub published an SEC document called Framework for ‘Investment Contract’ Analysis of Digital Asset, which provided details on how the SEC applies the Howey Test to analyze whether digital assets could be considered an “investment contract” security.⁹⁷ This is one of the few documents available to guide digital asset creators and platforms.

Although guidance from the SEC regarding digital assets is sparse, there is some case law and reports from the SEC. For example, the SEC issued an enforcement order against the creator of EtherDelta, which provides a marketplace for bringing together buyers and sellers of digital asset securities through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain.⁹⁸ This case held that EtherDelta violated section 5 of the Exchange Act because it issued digital asset securities using blockchain technology as an unregistered exchange.⁹⁹ This is one of the main cases analyzing whether a platform that houses digital assets can be an unregistered security exchange. Other regulatory bodies have provided reports of their research into the intersection of digital assets and securities law. For example, the Congressional Research Service (“CRS”) published a report containing a broad outline of how federal securities laws and regulations apply to cryptocurrencies, ICOs, and NFTs.¹⁰⁰

The SEC also published the Decentralized Autonomous Organization (“DAO”) Report, which discusses U.S. federal securities laws and their applicability to the new paradigm of “virtual organizations or capital raising entities that use distributed ledger or blockchain technology to facilitate capital raising and/or investment and the related offer and sale of securities.”¹⁰¹ The purpose of this report of investigation is to “advise those who would use a [‘DAO Entity’], or other distributed ledger or blockchain-enabled means for capital raising, to take appropriate steps to ensure compliance with the U.S. federal securities laws.”¹⁰² Slock.it created The DAO, which is a “for-profit entity whose objective was to fund projects in exchange for a return on investment.”¹⁰³ DAO Tokens represented a type of “crowdfunding contract” that would help raise “funds to grow [a] company in the crypto space.”¹⁰⁴ The DAO offered and sold DAO Tokens in exchange for Ether (“ETH”), a virtual currency used on the Ethereum Blockchain, and the proceeds from these sales were used to fund projects.¹⁰⁵ DAO Token holders had the right to vote on these projects and were entitled to any anticipated earnings from the projects it funded.¹⁰⁶ The DAO platform also had a group of individuals called “Curators” who were given “considerable power” to perform “crucial security functions” and maintain “ultimate control over what projects would be submitted to, voted on, and funded by The DAO.”¹⁰⁷ In applying the Howey test to the DAO Token, the SEC’s DAO report found that the tokens meet the criteria of a security and The DAO was required to register as an exchange under Rule 3b-16.¹⁰⁸

Even though there is some guidance for blockchain technologies generally, the SEC has not yet provided any guidance regarding NFTs specifically. Given this small amount of advice, many people have requested that the SEC provide regulatory clarity with respect to NFTs so that they know how to proceed.¹⁰⁹ These requests for guidance come in the form of “no-action” letter requests that encourage “the SEC to engage in a meaningful discussion of how to regulate FinTech companies and individuals that are creating NFTs that may be deemed digital asset securities and the platforms that facilitate the issuance and trading of NFTs.”¹¹⁰ The existing securities framework provides a “crude mechanism” for regulating NFTs, and the SEC needs to reevaluate or reapply these old frameworks to new financial technologies to establish sustainable guidance and prevent NFTs from becoming the “Wild West” of digital investments.¹¹¹

III. HOWEY TEST: ARE F-NFTS SECURITIES?

Although there are few articles or regulations specifically addressing NFTs, the current view is that NFTs may not be an “investment contract” security that can be regulated by the SEC because an NFT may gain its value through its uniqueness, as opposed to “a common enterprise” (second Howey prong), and any profits realized through an NFT may be derived from regular supply and demand, as opposed to the “efforts of others” (fourth Howey prong).¹¹² However, to determine an NFT’s ability to be categorized as a security, regulators need to focus on the “economic reality” and specific circumstances, such as how society defines the NFT’s value, how it is utilized, or how it is marketed. On one hand, if the purchaser is a collector and the NFT’s value comes from its uniqueness and artistry, the main purpose of buying the asset is to “consume” it by enjoying its aesthetics; the NFT may also be marketed as allowing buyers to join the ranks of premier owners and connoisseurs of unique digital objects. In such a scenario, an NFT is less likely to be a security. For example, some people may buy a Pudgy Penguins NFT from OpenSea (an NFT exchange website) because they think it is adorable and just want to look at it or display it as a profile picture on social media.¹¹³ On the other hand, if the purchaser is an investor and the NFT’s value comes from its ability to gain a return on investment, the main purpose of buying the asset is to sell it later for a profit; or if it is marketed as an asset that will appreciate in value to give a substantial return, then an NFT is more likely to be security. Some purchasers’ main goal in buying a Pudgy Penguin may be to increase their capital.¹¹⁴ In the end, NFTs may gain value from both their uniqueness and their ability to provide a return on investment.

Another prevailing view is that fractionalizing NFTs could create a type of security that is subject to regulation.¹¹⁵ F-NFTs could be an investment contract under the Howey test depending on the facts and circumstances of the particular f-NFT, such as if you put multiple NFTs into one basket and then sell f-NFTs out of that basket.¹¹⁶ Although the SEC has yet to initiate any enforcement action against creators or platforms that facilitate the offer and sale of f-NFTs, the SEC and courts have held in many cases that fractional interests in an asset can be a security even if the individual asset itself is not.¹¹⁷ This Part applies the four prongs of the Howey test to analyze whether an f-NFT can be an “investment contract” security and compares

f-NFTs to the DAO Token, which has already been deemed a security.

A. “MAKES AN INVESTMENT IN MONEY”

F-NFTs most likely satisfy the first prong of the Howey test given that people buy f-NFTs using cryptocurrency. The SEC argues that most digital assets, such as f-NFTs, pass the first Howey prong because they are purchased through an exchange for value.¹¹⁸ It does not matter that this exchange for value is in the form of digital currency such as cryptocurrency. Courts have held that an “investment of money” does not need to be in the form of cash, and thus purchasing something with cryptocurrency, as is the case with NFTs or f-NFTs, would satisfy this definition.¹¹⁹ When comparing f-NFTs to the DAO Token, both of these digital assets make an “investment in money” because both purchasers of the DAO Token and f-NFTs use ETH, the digital currency used on the Ethereum blockchain, to buy their respective digital assets.

B. “IN A COMMON ENTERPRISE”

A traditional NFT may not pass this second Howey prong because its value stems from its uniqueness—not a common enterprise—and there may not be a relationship between the seller or promoter of an NFT and a buyer or investors in that NFT. However, the SEC’s FinHub stated that a “common enterprise” typically exists for investments in digital assets because the fortunes of individual purchasers of digital assets are tied to other investors or tied to the success of the promoter’s efforts to expand a digital asset platform.¹²⁰ Also, courts have determined that the “common enterprise” prong is a distinct element of an investment contract analysis and “does not require vertical or horizontal commonality per se.”¹²¹ Thus, there are some arguments that f-NFTs may pass the second prong and have a common enterprise.

Horizontal commonality can be shown for f-NFTs through the fact that if a person owns a partial ownership interest in an underlying NFT, the value of this shard is tied to the fortunes of all the owners of the other shards of that fractionalized NFT.¹²² If the value of the underlying NFT increases, the value of each of its shards also increases. Thus, a common enterprise can be found through the relationship between an investor of an f-NFT and the pool of other investors who share ownership of the same fractionalized NFT. One of the very reasons to fractionalize an NFT is to enable smaller investors to “pool resources” together to purchase a smaller interest in an NFT and share in the returns of the whole NFT.¹²³ This is similar to the investors in the DAO Token who pooled together ETH to help The DAO fund large projects with the hope of a return on their investments.¹²⁴ Both the DAO Token and f-NFTs can satisfy horizontal commonality by pooling investors’ assets and tying their interests together. Also, an NFT can be part of a series of similar NFTs, like a collection of artworks by the same person, where the value of one will rise and fall along with the value of the others in the series.¹²⁵ The fortune of one NFT investor in the series may be tied to the increase and decrease in fortune of the other NFT investors in the same collection.

F-NFTs may also satisfy the vertical commonality requirement, given the relationship between the original issuer of the f-NFTs (promoter) and all the purchasers of the f-NFTs (body of investors). A common enterprise exists under broad vertical commonality when the investors are dependent on the promoter’s efforts or expertise for their increased returns.¹²⁶ For f-NFTs, a common enterprise may exist because the success of f-NFT investors gaining returns is dependent on f-NFT companies making the effort to fractionalize or bundle different NFTs and maintain the platform to protect f-NFTs and keep trading running. Additionally, strict vertical commonality can be established if f-NFT platforms gain some type of fee percentage from their efforts in fractionalizing and selling f-NFTs. Thus, if f-NFT platforms actively manage or charge fees for handling these assets, then the fortunes of f-NFT platforms are connected to the fortunes of the f-NFT investors. When f-NFT investors succeed, so does the f-NFT company.

Even certain, whole NFTs may pass the vertical commonality test. For example, many college and professional athletes have been creating NFTs of themselves through digital artwork, highlight reels, and other digital assets.¹²⁷ These NFTs may satisfy the “common enterprise” requirement because the value of the NFT would depend on the rise and fall of the athlete’s career and how much effort that athlete put into increasing their popularity. If the particular athlete who is issuing an NFT does better professionally in their sport or increases in popularity, then the value of their NFT may also increase. In other words, the fortunes of the owners of the athlete’s NFT would increase in correlation with the fortunes or the career of the athlete also increasing. The same argument can also be made for NFTs from specific artists or celebrities, such as Beeple or Martha Stewart.¹²⁸ Investors of Beeple’s NFTs have their fortunes tied to the efforts of Beeple and his other artworks. The value of an investor’s Beeple NFT will benefit from Beeple and his other artwork becoming more popular or valuable. Thus, there are good arguments that f-NFTs fulfill the second Howey prong.

C. “WITH A REASONABLE EXPECTATION OF PROFIT”

F-NFTs can satisfy the third Howey prong if purchasers buy f-NFTs with the expectation that they will realize some type of gain or profit. Given that this prong is heavily fact–sensitive, the SEC provided a list of characteristics that make it more likely for a digital asset to fulfill the “reasonable expectation of profits” prong.¹²⁹ F-NFTs seem to satisfy three of the characteristics listed: (1) the digital asset is “transferable or traded on or through a secondary market or platform,” (2) the issuer continuously “expend[s] funds from proceeds or operations to enhance the functionality or value of the network or digital asset,” and (3) the digital asset is marketed or promoted in a way that would cause a purchaser to have an expectation of profits. To determine whether an f-NFT can be classified as a security under this prong, one needs to focus on the transaction itself and the way the digital asset is offered and sold.¹³⁰

The first characteristic that increases the likelihood of f-NFTs fulfilling the third Howey prong is the fact that investors can transfer or trade these assets on secondary markets or online blockchain platforms.¹³¹ The ability to sell or buy NFTs or f-NFTs on secondary markets such as OpenSea provides proof that the investor may expect to realize some type of return or appreciation on the digital asset through secondary trading. This is much like how DAO Token holders were able to monetize their investments in DAO Tokens by reselling and trading them on various secondary trading platforms and markets.¹³²

The second characteristic that leans in favor of f-NFTs satisfying the third prong is the fact that f-NFT platforms may “provide essential managerial efforts that affect the success of the enterprise, and investors reasonably expect to derive profit from those efforts.”¹³³ The more likely that f-NFT issuers made efforts to increase the demand or value of the digital asset, the more likely the f-NFT will have a “reasonable expectation of profits.” Different cases have clarified that efforts to “increase the demand or value” include when issuers or platforms (1) create and manage an “ecosystem” for the digital asset which allows them to increase in value, (2) develop the network to inspire creative uses of its assets, or (3) add a new functionality using the proceeds from the token’s sales.¹³⁴ First, f-NFT platforms like Fractional.art and Nitfex made “essential managerial efforts” to increase demand or value of f-NFTs by taking continuous, active steps to fractionalize NFTs and make them more accessible to more investors. This created a new ecosystem where average investors could pool their funds together to share in the gains of valuable NFTs. Second, fractionalization networks inspired new creative uses such as bundling various NFTs together and selling f-NFTs of this bundle. The value of these f-NFTs would be dependent on the values of all the individual NFTs that the issuer chooses to place in the basket. Lastly, f-NFT platforms created a new functionality for NFTs by adding the ability to fractionalize one NFT into multiple shards. This allows purchasers to buy smaller interests in many different NFTs to diversify their collection, thus minimizing the volatility of this digital asset and increasing the potential returns.

This view of f-NFTs can be compared to the DAO Token that satisfied the third Howey prong because the proceeds from selling the DAO Tokens were used to fund different proposed projects in which holders had the potential to gain a share of the profits from these projects.¹³⁵ Also, much like how f-NFT platforms have created an ecosystem for the fractionalized assets, The DAO created a type of ecosystem for its “crowdfunding contracts.” While one may argue that f-NFT platforms are not using the proceeds from selling their tokens to directly improve their network, another may argue that f-NFT platforms collect fees from transactions that occur on their platform and then use these fees to maintain a secure network for f-NFT purchasers. Thus, this characteristic may depend on how the specific f-NFT platform is managed.

The third characteristic that makes f-NFTs more likely to provide a “reasonable expectation of profit” is the way in which f-NFTs are marketed to potential buyers. The SEC provided a list of ways a digital asset could be marketed that weigh in favor of the third Howey prong. F-NFTs may satisfy four of these methods: (1) the “intended use of the proceeds from the sale of the digital asset is to develop the network or digital asset”; (2) a key selling feature of f-NFTs is the ability to readily transfer it; (3) “[t]he potential profitability of the operations of the network, or the potential appreciation in the value of the digital asset, is emphasized in marketing or other promotional materials”; or (4) there is an available market for trading the digital asset or the issuer promises to create or support a trading market.¹³⁶ F-NFTs can satisfy these marketing characteristics, and many of them are also found in the DAO Token.

First, although current f-NFT platforms do not directly market that proceeds from f-NFT sales will be used to develop the network, one can assume that these platforms use the fees they collect from sales to maintain the network and allow for continuous fractionalization of NFTs. Second, the fact that f-NFTs are marketed as being easily transferable on platforms such as Niftex, Fractional.art, or DAOfi lean in favor of there being an “expectation of profit.”¹³⁷ This is similar to the DAO Token, which was promoted as being readily available to buy and sell on “a number of web-based platforms that supported secondary trading.”¹³⁸ Third, certain f-NFT platforms emphasize that these assets are a unique and better way to unlock liquidity, gain greater exposure and price discovery for your NFTs as fractions on the open market, trade NFTs with lower cost and greater diversification, get access to a variety of unique and iconic digital assets with low price thresholds, or provide liquidity for shard markets and earn transaction or curator fees.¹³⁹ These platforms focus on f-NFTs’ ability to increase exposure of a particular NFT in a market and diversify one’s investments in NFTs to spread out the risk of a single NFT losing value. Increased exposure and diversification can increase an f-NFT’s profitability, and a platform’s emphasis on this promotes an f-NFT’s appreciation in value. However, f-NFTs may simply be marketed as an easier, more accessible way for the average investor to partake in the NFT market.¹⁴⁰ If this is the case, it is less likely that f-NFTs satisfy the third Howey prong. The DAO platform emphasized its potential profitability by marketing it as an investment where purchasers could share in the profits of the proposed projects the DAO Token funded and thus gain a return on their initial investment.¹⁴¹ Although this is not exactly similar to how f-NFTs’ profitability were marketed, both seem to promise their purchaser some type of liquidity. Fourth, f-NFT platforms provide a readily available market for the trading of various f-NFTs. Creators or purchasers of f-NFTs can easily sell or buy these assets on different websites. These platforms support an f-NFT trading market by providing information regarding how the platform and fractionalization process operates and how the underlying technology works, a “frequently asked questions” section, a link to create or buy and sell f-NFTs, ways to “join the community,” and so forth.¹⁴² This is similar to the DAO Token issuers who supported a trading market for their token by developing a website, a link to detailed information regarding The DAO entity’s structure and source code, and a link to buy DAO Tokens; providing information on how The DAO operated; soliciting media attention; and posting on online forums.¹⁴³

A counterargument is that traditional NFTs are less likely to be a security because purchasers of traditional NFTs buy them for their artistry or bragging rights, proving that NFTs gain their value from their uniqueness, scarcity, or collectable status—not from any expected profits. An NFT’s value may just be based on the normal market forces of supply and demand, which is not considered “profit.”¹⁴⁴ The SEC also notes that digital assets are less likely to satisfy the Howey test if “[a]ny economic benefit that may be derived from appreciation in the value of the digital asset is incidental to obtaining the right to use it for its intended functionality.”¹⁴⁵ The intended functionality of an NFT may just be bragging rights or display rights, such as displaying a rare NFT artwork as your profile picture on your social media account. Thus, when an NFT increases in value, this may just be incidental to using the asset for its intended functionality of bragging rights. Also, if an f-NFT is marketed in a way that focuses on its role as a piece of digital artwork or a collectible, and not as an opportunity to gain any returns, this may work against f-NFTs being a security.¹⁴⁶ For example, some platforms market f-NFTs as a way to create more accessibility to the NFT market and not necessarily as a way to increase one’s returns.¹⁴⁷ Regulators will need to analyze the specific characteristics of certain f-NFTs and f-NFT platforms to determine whether they satisfy the third Howey prong.

D. “THROUGH THE EFFORTS OF OTHERS”

Some argue that although an NFT may provide the purchaser with a reasonable expectation of profits, this increase in financial returns is not derived from the “efforts of others” and instead comes from the NFT’s own scarcity and uniqueness. Thus, it may be more difficult to argue that an NFT satisfies the fourth and final Howey prong, which requires the asset’s increase in value to come from the “efforts of others.” While a traditional NFT may not fulfill this prong given that its value comes from its uniqueness, an f-NFT may be an exception because its value is derived from the efforts of the f-NFT platforms or issuers who support the f-NFT market. The fourth Howey prong is satisfied if an f-NFT issuer supports a market for f-NFTs or the value of these assets depend on the issuer’s efforts in generating demand.¹⁴⁸ Thus, if an NFT issuer or exchange puts in the work to develop the platform and increase buyers, and the purchasers reasonably expect a return based on this work, then an NFT may pass this last prong.

The SEC Framework for “Investment Contract” Analysis of Digital Assets lays out two key questions to consider when determining whether a digital asset can satisfy the “efforts of others” prong: (1) does the purchaser reasonably expect to rely on the efforts of an “Active Participant,” and (2) are those efforts “the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”?¹⁴⁹ To help answer these questions, the SEC provided a list of six characteristics that lean in favor of a digital asset fulfilling the fourth Howey prong. While none of the characteristics are dispositive, they provide a good framework to help determine when a digital asset gains its value through the “efforts of others.” F-NFTs may satisfy some of the characteristics and thus satisfy the last Howey prong.

The first characteristic is that an issuer is “responsible for the development, improvement (or enhancement), operation, or promotion of the network, particularly if purchasers of the digital asset expect an [issuer] to be performing or overseeing tasks.”¹⁵⁰ Platforms that issue f-NFTs may have this characteristic because they are responsible for promoting the f-NFTs on their platforms, bringing more buyers onto their networks, and improving their networks by offering more products such as f-NFT bundles or automatic royalties embedded in smart contracts.¹⁵¹ These development efforts can increase the value of the actual platform and thus increase the value of the f-NFTs traded on that specific platform. Also, if a platform markets f-NFTs as producing profit based on royalty payments or f-NFT bundles, purchasers may expect that the issuers are putting in some type of managerial efforts to oversee the asset and increase its value. The value of an f-NFT could come from the efforts of a person or entity promoting, selling, choosing, developing, and managing different f-NFT royalties or bundles. This is similar to the DAO Token Curators who managed different projects for investors to create returns by deciding what projects would be submitted to, voted on, and funded by DAO Token holders.¹⁵² DAO investors relied on the “managerial and entrepreneurial efforts” of the Curators to manage The DAO network and project proposals because the creators of The DAO represented that they “could be relied on to provide the significant managerial efforts required to make The DAO a success.”¹⁵³

The second characteristic is that the issuer performs essential tasks or responsibilities, as opposed to “an unaffiliated, dispersed community of network users (commonly known as a ‘decentralized’ network).”¹⁵⁴ This reference to a “decentralized” network may work against f-NFTs being deemed a security because they are inherently run on a “decentralized” network. One can argue that the blockchain technology, smart contracts, and digital ledger perform the “essential tasks or responsibilities” for f-NFTs as opposed to the issuer or platform. However, the DAO Token was still deemed a security even though it utilized blockchain technology, and smart contracts performed tasks for the usage of the DAO Tokens.¹⁵⁵ Although

f-NFTs are run on a “decentralized” network, issuers can perform essential tasks such as fractionalizing NFTs, using their expertise to bundle NFTs, or maintaining the network to ensure the f-NFTs are protected.

The third characteristic is that an issuer “creates or supports a market for, or the price of, the digital asset,” which can include (1) “control[ing] the creation and issuance of the digital asset,” or (2) “tak[ing] other actions to support a market price of the asset, such as by limiting supply or ensuring scarcity” through activities like buybacks.¹⁵⁶ Issuers of f-NFTs, such as Niftex and Fractional.art, may embody this characteristic because issuers set the original fixed price of an f-NFT when they initially fractionalize an NFT, and many f-NFT platforms have some type of “buyout” provision which lets f-NFT investors purchase the remaining shards to gain ownership of the full NFT.¹⁵⁷ This buyout provision is similar to a buyback because the original f-NFT issuer can buy back the whole NFT, which can subsequently support a market price of the f-NFTs. Also, as more NFTs are bought and sold on a platform, the rarity and scarcity of a specific NFT may increase, which then affects the price of that NFT.¹⁵⁸ Thus, if f-NFT platforms support the growth of their platforms to include more f-NFTs or other products, then these platforms can create a market for and support the price of f-NFTs. A counter argument is that an NFT’s lack of exchangeability with other NFTs impedes its ability to be classified as a security. Traditional securities increase their value from price fluctuation and exchangeability, but due to its uniqueness, an NFT only increases its value through profit increases and not exchangeability.¹⁵⁹ This issue may be limited with f-NFTs, whose value is tied to other types of price fluctuations.

The fourth characteristic is that the issuer has a “lead or central role in the direction of the ongoing development of the network or the digital asset.”¹⁶⁰ By simply maintaining the f-NFT network, these platforms are providing an active management role that contributes to the development and stability of f-NFTs and f-NFT networks. Since the actual NFT is typically hosted on external URLs or IPFS, some caution that NFT networks must be maintained to ensure that NFTs sold on the platform do not disappear, buyers do not lose their purchases, and NFTs do not lose their value. This dynamic can create a system in which “the value of the art is tethered to the value of the platform hosting it.”¹⁶¹ The managerial efforts of the NFT platforms would be directly tied to the value of the NFTs because if the NFT platforms are not run properly or are shut down, the value of the NFTs decreases or disappears altogether. An issuer can also take a lead role in continuously developing f-NFTs if the issuer is an artist, athlete, celebrity, or company, and the value of their f-NFT is tied to that specific issuer’s popularity or the efforts they undertake to grow their popularity. When buying an f-NFT, you are not buying the underlying artwork but instead are purchasing the right to gain profits from the increased popularity of the creator, whether it be an artist like Beeple or an athlete like Patrick Mahomes.¹⁶² People may invest in NFTs with the hope that the creator increases in fame, which can then increase the profits from the particular NFT. For example, many college athletes are creating their own NFTs, and as an athlete’s career progresses to professional sports, the value of that NFT could exponentially increase.¹⁶³ NFTs issued by corporations or influential public figures may also satisfy the “efforts of others” prong. For example, Nike recently announced its plan to sell “digital shoes,” which resemble an NFT for its iconic shoes; Martha Stewart also created an NFT collection consisting of digital art of her home décor.¹⁶⁴ Nike and Martha Stewart may have a central role in the ongoing development of their respective NFTs because as they put in effort to continuously grow the popularity and profitability of their brand, their NFTs may also grow in value. If an NFT is tied to a specific company or person, the NFT’s value relies on the efforts of that issuer to increase their popularity, which will in turn help develop the underlying NFT.

The fifth characteristic is that the issuer has “a continuing managerial role in making decisions about or exercising judgment concerning the network or the characteristics or rights the digital asset represents.”¹⁶⁵ Some examples of what constitutes a “managerial role” include: “determining whether and where the digital asset will trade,” having “responsibility for the ongoing security of the network,” and “making other managerial judgements or decisions that will directly or indirectly impact the success of the network or the value of the digital asset generally.”¹⁶⁶ The DAO Curators had a large managerial role over the DAO Token—and its potential value—because investors relied on the Curators’ expertise to monitor the operation of The DAO, safeguard their funds, and determine when proposed contracts should be put to a vote to fund projects.¹⁶⁷ F-NFT platforms may serve this “managerial role” through providing ongoing security for the network. For example, f-NFT platforms must manage their networks to prevent any hacking attempts or fraud that could steal funds during an NFT transaction or destroy the linkage to the underlying NFT.¹⁶⁸ This is similar to how The DAO and its Curators were relied on for “failsafe protection” and for protecting the system from “malicous [sic] actors.”¹⁶⁹ Current f-NFT platforms have yet to show how their managerial decisions can significantly impact the success of f-NFTs, given that they do not have Curator-type workers who actively control f-NFTs. However, if f-NFT platforms sold

f-NFT bundles, investors would have to rely on the platform’s judgment for what types of NFTs were being pooled together in a bundle and sold as

f-NFTs. The platform’s expertise may then affect the value of the f-NFT bundle, and it would be more likely that f-NFTs had continuous management from others.

The sixth characteristic is that “[p]urchasers would reasonably expect the [issuer] to undertake efforts to promote its own interests and enhance the value of the network or digital asset” where the issuer has a stake in the digital asset and can realize its own gain from the digital asset or monetize the value of the digital asset.¹⁷⁰ Issuers or creators of f-NFTs may satisfy this characteristic because they can program a smart contract to automatically charge a type of royalty or curator fee any time an f-NFT is resold or used in a specific way.¹⁷¹ This enables the issuer to monetize the value of the digital asset and promote its own interests in the digital asset. Some platforms such as Niftex have also automatically programmed their f-NFT smart contracts to set aside five percent of an NFT’s fractions for the artist.¹⁷² In this system, instead of the creator taking a cut every time a fraction is traded on the open market, they now get to share in the profits of just owning some of the shards. It seems that f-NFT issuers may promote their own interests and enhance the value of the digital asset, because the higher the value of the asset, the more money they can make off their own shards.

Whether or not f-NFTs satisfy the fourth Howey prong will once again come down to the specific facts of how the f-NFT is marketed to purchasers and the specific platform or issuer. However, given the various SEC characteristics taken together and their application to f-NFTs, there may be a good argument that f-NFTs can gain their value from the “efforts of others.” After analyzing f-NFTs under the four Howey prongs and comparing them to other established digital asset securities, f-NFTs can be considered securities.

IV. HOW CAN NFTS BE REGULATED?

Even if f-NFTs can satisfy all the Howey prongs and be classified as a security, the question still remains whether the SEC should regulate these digital assets and what regulatory framework should be adopted. The SEC cautioned that as financial technologies continue to innovate, there is a possibility that market participants (such as f-NFT buyers, sellers, and platforms) may be conducting activities that fall within the SEC’s jurisdiction in which their transactions, persons, or entities may be subject to registration, regulation, or oversight.¹⁷³ The SEC can regulate three different types of actors: (1) buyers of a security, (2) sellers or issuers of a security, and (3) platforms facilitating exchanges.¹⁷⁴ If designated as a security, buyers, sellers, or platforms of f-NFTs sold without registration may be subject to penalties, registration requirements, or filing periodic reports with the SEC.¹⁷⁵

The SEC needs to discover what types of regulations it can impose on buyers, sellers, and platforms of f-NFTs. This Part analyzes the risks and opportunities of regulating f-NFTs under the existing regulatory framework and how regulations can be applied to the three different actors within the NFT space to recommend a new, modified framework better suited for this digital asset.

A. REGULATION OF BUYERS

The SEC regulates buyers of securities by only allowing certain “accredited investors” to purchase unregistered securities, which typically are subject to fewer requirements and regulations.¹⁷⁶ SEC Regulation D (“Reg. D”) governs unregistered securities and explains the exemptions from being required to register with the SEC.¹⁷⁷ Under Rule 501(a) of Reg. D, accredited investors can be institutional investors and entities such as banks, mutual funds, insurance companies, or pension plans;¹⁷⁸ insiders within an issuer such as officers or directors of the issuer of the securities;¹⁷⁹ or wealthy natural persons such as those with a net worth of greater than $1 million, excluding primary residence and mortgage,¹⁸⁰ or those with an annual income of greater than $200,000 for the last two years ($300,000 if filing jointly with one’s spouse).¹⁸¹

The policy behind limiting buyers from purchasing certain securities through this regulation is to protect less-knowledgeable individual investors, who may not have the financial stability to absorb the high risks of investing in unregistered securities, while also promoting investments into risky entrepreneurial ventures. Accredited investors are treated differently from the general public because they are sophisticated enough to bear the risks, are more knowledgeable, or have the money to hire someone like a financial advisor to help them make informed decisions. Given that f-NFTs may be unregistered securities, the SEC could regulate f-NFT buyers by only allowing accredited investors to purchase them. However, it may be difficult to prevent people from buying a certain digital asset on a decentralized and easily accessible platform. This would mean that every time an f-NFT was created or sold, an issuer or platform would have to go through the

time-consuming and costly process of ensuring that every purchaser complies with the definition of an accredited investor. The whole purpose of fractionalizing NFTs was to make these digital assets more accessible to average investors. Thus, it seems counterintuitive to place a new barrier in front of average investors and their ability to participate in this emerging market. The accredited investor regulation is meant to protect average investors from more risky activities, but there may be other ways to prevent harm to less-knowledgeable investors than completely cutting them off from these new assets, such as requiring NFT platforms to provide easily accessible and relevant information regarding trading NFTs and maintaining certain security protocols to protect f-NFT investors and their funds. Thus, it is unlikely that the SEC could or should place any regulations on buyers of f-NFTs.

B. REGULATION OF SELLERS OR ISSUERS

The SEC may be able to place registration requirements on the initial creators or issuers of f-NFTs. Under section 5 of the Securities Act, any issuer offering or selling an unregistered security in interstate commerce must register non-exempt securities with the SEC.¹⁸² These registration requirements serve two main goals: (1) to provide investors with financial and other material information regarding the securities being offered or sold and (2) to prohibit and minimize fraud, deceit, misrepresentations, and other dangers in the sale of securities.¹⁸³ Requiring issuers to provide information regarding their assets to investors through the SEC increases the likelihood that investors will make well-informed decisions and provides a certain standard to minimize fraudulent sales. If f-NFTs are deemed to be securities, the individual or entity that initially fractionalizes the NFT and sells these

f-NFTs may be considered an issuer under section 5 and thus be subject to SEC requirements such as filing a registration statement and periodically disclosing material information.¹⁸⁴

The SEC has cracked down on digital assets and ICOs by bringing and winning enforcement actions against a variety of issuers who have offered and sold digital assets that are deemed securities and were not registered pursuant to the Securities Act.¹⁸⁵ In 2019, the SEC brought two high-profile enforcement actions against Kik Interactive Inc. (“Kik”) and Telegram Group Inc. (“Telegram”) arguing that the Kik and Telegram tokens were sold to investors as unregistered securities and thus violated federal securities law. The courts applied the Howey test and found that both tokens were securities because the funds from the token sale were used for operating the companies’ respective ecosystem and messaging apps, the tokens were marketed to prospective investors as a way “you could make a lot of money,” and the value of the investments depended on the companies’ respective efforts to develop their messaging apps.¹⁸⁶ While some issuers of digital assets like cryptocurrency were subject to registration requirements, other issuers of digital assets such as tokens for a membership rewards program (TurnKey Jet, Inc.) or tokens for video game currency (Pocketful of Quarters, Inc.) were given “no-action” letters from the SEC promising that the it would not take any enforcement action against these issuers for selling the digital assets without registration.¹⁸⁷ The SEC held that these rewards and video game tokens were not securities because none of the funds from the token sales were used to develop the issuer’s platform, the tokens were immediately usable for their intended functionality (purchasing air charter services or gaming) at the time they were sold, token transfers were restricted to only the company’s internal “wallets,” and the tokens were both marketed in a way that emphasized the functionality of the token for consumption.¹⁸⁸

Given the unchartered territory of f-NFTs, it is difficult to apply the regulation of issuers to the creators of f-NFTs. Although selling f-NFTs may look like a type of ICO, there may be policy reasons not to require registration every time creators wish to fractionalize their NFT. Registering the sale of an asset is a time-consuming and costly process, and it seems unnecessary to require extensive disclosures given that the costs of registration may outweigh the benefits of having an accessible f-NFT marketplace. The main goals of these registration requirements are to provide investors with sufficient information regarding the f-NFT and to prevent fraud.¹⁸⁹ However, f-NFTs’ blockchain and smart contract technology may satisfy these goals without the need for costly registration. Many platforms always display relevant information regarding an NFT right next to the image of the NFT. This information typically includes a description of the NFT, the total supply of fractionalized shards, the valuation, and some type of table showing all the transactions of that specific NFT, the date on which each sale occurred, the buyers and sellers for each sale, and the price at which it was sold.¹⁹⁰ Thus, potential purchasers can already easily see the relevant financial information regarding the assets to help them make an informed decision. Also, since each f-NFT has a digital ledger that automatically records every transaction and every buyer and seller of that f-NFT, it can be easier to fend off certain types of fraud and easily authenticate true ownership. F-NFTs’ blockchain technology, decentralized network, and easy authentication process can help satisfy the goals that registration requirements aim to reach.

One may argue that if an f-NFT is being sold by a specific entity, artist, or athlete, and the value of that f-NFT is tied to that entity or individual’s external success, then the issuer may need to provide disclosure regarding the entity or individual. For example, would a professional athlete’s f-NFT issuance require a registration statement about their professional sports career? Brands such as Nike and Martha Stewart have recently announced their digital asset plans such as Nike’s “digital shoes” and Martha Stewart’s NFT collection of digital images depicting her home decor and designs.¹⁹¹ Thus, if a company or brand is issuing an NFT or f-NFT, it seems more likely that the SEC may impose registration requirements and disclosures regarding that specific company or brand. Even if the SEC decides to impose registration requirements for the initial fractionalization of an NFT, there should be exemptions for small NFTs of little value or where there is a low number of shards in the initial fractionalization. For example, Reg. D under Rule 504 provides an exemption from registration requirements for companies that issue a small amount of securities, in which they are not allowed to sell more than $10 million worth of securities in any twelve-month period.¹⁹² This rule could easily be applied or adapted to fit small sales of f-NFTs such that issuers would not be required to register the sale of their f-NFTs if the total value of the sale was below a certain threshold. The SEC will need to balance the costs of the registration requirements for initial

f-NFT issuers with the need to promote or encourage new markets and assets and not stifle innovation and creativity.

C. REGULATION OF PLATFORMS OR EXCHANGES

Although it may be more difficult to regulate buyers or the initial creators of f-NFTs, it may be more reasonable to focus securities regulation on f-NFT platforms or networks that provide for the fractionalization of NFTs and manage the secondary market trading of these digital assets. If an f-NFT platform such as Niftex, Fractional.art, or DAOfi satisfies the definition of an “exchange” under Exchange Act Rule 3b-16(a)’s test, then these types of platforms will need to register with the SEC under section 6 of the Exchange Act as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system (“ATS”) in compliance with Regulation ATS.¹⁹³ The registration requirements for exchanges apply regardless if the issuing entity is a decentralized autonomous organization as opposed to a traditional company, if purchased using virtual currencies as opposed to traditional paper currency, or if distributed through ledger technology as opposed to certificated form.¹⁹⁴

Under the Exchange Act Rule 3b-16(a), an entity is an “exchange” if it (1) “brings together orders for securities of multiple buyers and sellers,” and (2) uses “established, non-discretionary methods.”¹⁹⁵ The SEC clarifies this two-pronged functional test by stating that a system “brings together orders” “if it displays, or otherwise represents, trading interests entered on the system to system users” or “if it receives subscribers’ orders centrally for future processing and execution.”¹⁹⁶ The SEC also explains that a system uses “established, non-discretionary methods either by providing a trading facility or by setting rules governing trading . . . among the multiple buyers and sellers entering orders into the system.”¹⁹⁷ These methods include a computer system in which orders interact, a “trading mechanism that provides a means or location for the bringing together and execut[ing] of orders,” or rules that impose execution procedures or priorities on orders.¹⁹⁸

Recently, this test was applied to the EtherDelta, which is an online trading platform that allows buyers and sellers to trade digital assets such as Ether and ERC20 tokens in secondary market trading. The SEC entered an enforcement order arguing that EtherDelta violated section 5 of the Exchange Act because its digital token was a security and the EtherDelta platform was an unregistered “exchange” that was transacting in a security.¹⁹⁹ This enforcement action found that EtherDelta satisfied the criteria of an “exchange” under Exchange Act Rule 3b-16(a) because it (1) operated as a marketplace for bringing together the orders of multiple buyers and sellers of a digital asset that was considered a securities under the Howey test “by receiving and storing orders in token in the EtherDelta order book and displaying the top 500 orders (including token symbol, size, and price) as bids and offers,” and (2) “provided means for orders to interact and execute through the combined use of the EtherDelta’s website, order book, and pre-programmed trading protocols on the EtherDelta smart contract.”²⁰⁰ The EtherDelta website also had numerous features that were similar to online securities trading platforms, such as providing access to the EtherDelta order book, sorting the tokens by price and color, and providing account information, market depth charts, lists of user’s confirmed trades, daily transaction volumes per token, and fields for users to input deposits, withdrawals, and trading interests.²⁰¹ Many of these features are similar to the online trading platforms of f-NFTs. When applying this functional test to f-NFT platforms and comparing them to the EtherDelta, it seems like f-NFT platforms can satisfy Rule 3b-16(a)’s two requirements.

First, f-NFT platforms bring together multiple buyers and sellers onto a single network to transact orders of f-NFTs. f-NFT platforms satisfy the “multiple buyers and sellers” aspect since there is a wide variety of f-NFTs issuers and multiple buyers who can purchase these f-NFTs.²⁰² These platforms satisfy the aspect of “bringing together” people to “transact orders” because they not only provide a place to fractionalize NFTs but also create and maintain marketplaces for users to trade their f-NFTs. Platforms typically receive and store f-NFT orders in a ledger on the Ethereum blockchain that keeps track of all the transactions of a specific f-NFT, much like the EtherDelta order book.²⁰³ All of these orders and f-NFTs are easily displayed on f-NFT platforms where users can see any past f-NFT transactions and execute orders to buy or sell these digital assets. Similar to EtherDelta, f-NFT platforms like Fracitonal.art also display the top orders and include information such as the token name, number of fractions, and price.²⁰⁴

Second, f-NFT platforms use a decentralized network that acts as a trading facility and sets rules for any f-NFT transaction through the underlying smart contracts that these platforms embed in the f-NFTs.²⁰⁵ Like EtherDelta, current f-NFT platforms provide a network or trading facility for orders to interact and execute through their individual websites such as Niftex, Fractional.art, or DAOfi, their digital ledgers, and their pre-programmed smart contracts with embedded trading protocols.²⁰⁶ These websites provide the “means or location” for bringing together users and executing orders for f-NFTs.²⁰⁷ Also, smart contracts use execution procedures and priorities to impose rules and determine the terms for any

f-NFT transaction on the network.²⁰⁸ Smart contracts can confirm the validity of the transactions and set the conditions of the order by checking certain information, such as whether the f-NFT contains a valid cryptographic signature, if the f-NFT comes with some type of royalty, if there is a buyout option, or if there is some type of curator fee.²⁰⁹ These characteristics provide the “established, non-discretionary methods” that govern how f-NFT orders interact with each other.

If an f-NFT platform is considered an “exchange,” it could still escape registration requirements if it satisfies one of the exemptions in Exchange Act Rule 3a1-1(a). It is unlikely that an NFT trading platform would fall under the 3a1-1(a)(1) (exemption for an ATS operated by a national securities association) or 3a1-1(a)(3) (exemption for an ATS not required to comply with Regulation ATS pursuant to Rule 301(a) of Regulation ATS) exemptions.²¹⁰ However one could analyze whether an f-NFT trading platform could be considered an ATS that complies with Regulation ATS and thus fits into the 3a1-1(a)(2) exemption for ATSs. This exemption would allow f-NFT exchanges to register as a broker-dealer, which has lower regulatory costs and fewer notice and reporting requirements, instead of as a national securities exchange.²¹¹ Although operating under this exemption would still come with some notice, reporting, and recordkeeping requirements, it could prevent f-NFT platforms from spending even more time and money on registering as a national securities exchange and dealing with periodic disclosures.

Although digital asset trading platforms resemble traditional exchanges or alternative trading systems, regulators may need to adjust the regulatory framework, much like they did for ATSs, to account for differing characteristics of blockchain-based exchange platforms. Differences between digital asset exchanges and national securities exchanges can include transparency, fairness, and efficiency.²¹² The decentralized aspects of f-NFT platforms may provide their own form of protection that may be more or equally as transparent, fair, and efficient as the regulations the SEC would impose. Thus, the SEC could adopt another new regulatory framework for exchange platforms of digital assets such as f-NFTs that requires less registration or fewer requirements than a national securities exchange and recognizes the fraud and misrepresentation protection that a blockchain platform already affords.

A decentralized platform may be better than SEC-imposed regulation at detecting fraud and protecting users on these types of f-NFT platforms. First, these platforms’ “decentralized” and public nature provides fairness because no one entity controls the network, and therefore anyone can easily access and interact on the platform and all transactions are verified by others on the network. Second, “decentralized” exchanges provide efficiency because the blockchain technology allows them to easily show users “verified business logic [in a publicly verified smart contact],” which a centralized exchange could not do.²¹³ Third, f-NFT platforms provide transparency because while traditional exchanges hold your funds with an “exchange owner,” decentralized ones hold your funds through easily verifiable and public digital ledgers that also contain a list of all transactions for a specific f-NFT, including the buyer, seller, and price.²¹⁴ The cryptographics embedded in f-NFTs make everything in a sense “registered” through its digital ledger, and all transactions are verified through the whole blockchain network. Thus, the sale of these digital assets may not need SEC regulation.

Even in decentralized networks, there is still a chance of hacking, fraud, and loss that may be mitigated through government regulation. Just as the SEC modernized the regulatory framework to “better integrate alternative trading systems into the national market system,” the SEC may need to modernize the regulatory framework again to integrate NFT trading systems and digital asset sales.²¹⁵ For example, the SEC may adopt a new regulatory framework that requires an f-NFT exchange platform to provide or display either convenient one-time reports or costly regular reports on its security protocols and how it deals with bad actors such as hackers that manipulate code to steal the proceeds of an NFT sale.²¹⁶ The SEC may also implement a limiting framework, similar to how Regulation ATS requirements are limited to a subset of ATSs that occupy a certain large percentage of the total trading volume of any security.²¹⁷ For example, the SEC could only require registration for f-NFT exchanges that account for a large volume of the overall traded f-NFTs. This may ensure investor protection from large actors while still allowing for innovation through smaller actors. The SEC can also require platforms to comply with certain capacity, integrity, and security standards to ensure f-NFT investors’ funds and assets are protected, given that an f-NFT’s value may be tied to the platform’s ability to maintain and retrieve the NFT.

SEC Commissioner Hester Peirce’s proposal for a “safe harbor” for digital assets and exchanges shows a glimpse into the beginning of a new framework that can provide guidance for digital asset issuers and exchanges. Peirce proposed a regulation in which digital asset exchanges would be allowed to begin distributing their tokens broadly if they provide disclosures such as plans for the network and who is behind the network.²¹⁸ These exchanges would then have three years from a token’s initial distribution to develop the network before they would be subject to any securities laws.²¹⁹ This three-year safe harbor allows issuers of digital assets to be exempt from SEC regulation for a certain time period and prevents their digital asset from being immediately classified as a security. It also gives digital asset creators time to set up their networks without government regulation and establish whether their digital asset can be classified as a security. This framework may allow creators to innovate digital and financial assets while continuing to protect investors. At the end of the day, the SEC needs to balance “encourag[ing] market innovation while ensuring basic investor protections.”²²⁰

V. PRELIMINARY EXPLORATION OF EXISTING REGULATORY MODELS

The SEC has existing regulation for non-digital securitized products, such as traditional stocks in companies or REITs, which may be applicable to f-NFT products and provide regulators with a starting point from which to develop regulations specific to f-NFTs.

When an individual or entity initially fractionalizes and issues their

f-NFTs, it could be called an “Initial Fractionalization Offering,” or “IFO.” An IFO, in which the issuer sells multiple shards of the same NFT to multiple buyers, is similar to a type of IPO or ICO, in which the issuer sells multiple stocks or tokens of the same company to multiple buyers. F-NFTs can be treated as a stock in the original whole NFT, and the sale of these f-NFTs can be the same as selling a share in an individual company. Thus, instead of developing a whole new set of regulations for f-NFTs, regulators can just look at existing securities laws for traditional stock sales and apply them to f-NFTs sales. The rules governing traditional, non-digital securities such as stocks could be slightly modified to better apply to f-NFT sales. For example, f-NFT creators could be required to register their f-NFT sale or IFOs with the SEC by filing a modified Form S-1 that contains information regarding the past performance of the NFT such as its trading history, information regarding the performance of other similar NFTs if the NFT is part of a collection, or information regarding the company or individual creating the NFT.²²¹ Providing the financial disclosures required by traditional IPOs may be more difficult for traditional NFTs because there is not any managerial or financial information behind a regular NFT besides its intrinsic or artistic value. However, NFTs from a particular brand, celebrity, or company would have an easier time producing accurate managerial and financial disclosures or material information regarding an NFT because these brands and celebrities typically have established financials or data regarding their performance, such as how popular a brand is or the performance statistics of an athlete. For example, Martha Stewart could be required to disclose managerial and financial information regarding her retail company if she tries to issue another NFT collection of her home décor, or Patrick Mahomes could be required to disclose information regarding his football statistics or other brand deals if he issued more NFTs. Thus, traditional registration requirements for issuing stock could be particularly appropriate for a celebrity or company that issues f-NFTs or NFTs and uses the proceeds from the sales to develop their brand or business.

REITs are another securitized product with an established regulatory structure that can be applied to f-NFT regulation. REITs are entities that own and typically operate various “income-producing real estate or real estate-related assets,” such as office buildings, apartments, shopping malls, hotels, or warehouses.²²² In addition to other requirements, a REIT must have seventy-five percent of the entity’s total assets coming from real estate investment, be managed by a board of directors, and distribute at least ninety percent of its taxable income to shareholders annually in the form of dividends.²²³ REITs register and file reports with the SEC, can list and trade their shares on a public stock exchange, and allow investors to invest in and own shares of multiple large-scale, income-producing real estate properties without actually having to buy the real estate.²²⁴ In other words, REITs take a bunch of commercial real estate assets, bundle them together in one company, and then sell shares of that company to investors so they can reap the benefits of owning commercial real estate. Issuing shares of a REIT is like issuing fractional shares of a basket of NFTs. For example, one way to issue f-NFTs is to take multiple whole NFTs, bundle them together in one large NFT basket, and then sell f-NFTs or fractional shares of that basket

(“f-NFT bundles”) to investors so they can own shares in multiple NFTs. Just as REITs sell investors shares of a basket of real estate investment properties, f-NFT bundles sell investors shares of a basket of NFTs.

Given these similarities, securities regulations that apply to REITs may also translate and apply to f-NFTs. Most REITs are registered with the SEC and publicly traded on a stock exchange. Under the Securities Act, REITs are required to register their securities using Form S-11 to make disclosures regarding the REIT’s management team and other significant information and make regular SEC disclosures such as quarterly and yearly financial reports.²²⁵ Regulators could follow this existing regulatory model from REITs and impose similar requirements for fractional shares of NFT bundles. Form S-11 requires REIT issuers to disclose information detailing the price of the deal, how the REIT plans to use the proceeds, certain financial data like trends in revenue and profits, descriptions of the real estate, operating data, information on its directors and executive officers, and other data.²²⁶ These types of requirements could easily be adopted to regulate f-NFT bundles by creating a new, similar form to Form S-11 for issuers of f-NFTs to file with the SEC. For example, issuers of f-NFT bundles could be required to file a form like Form S-11 that discloses information like the price of each f-NFT; how the individual or entity issuing these f-NFT bundles plans to use the proceeds, such as to purchase more NFTs to add to the bundle; a description of the NFTs currently in the bundle as if they are part of a trending collection; certain financial data of each NFT, such as its past transactions or price; information on the individuals managing the bundle, such as their credentials or how they have managed digital assets in the past; and so forth.

However, REITs are different from f-NFTs in that REIT investors earn a share of the income produced through the rent or mortgage interests from the commercial real estate, while f-NFT investors can only earn a share of the increased value of the underlying NFT.²²⁷ It may be possible that an NFT’s smart contract could charge money to anyone who views the particular NFT and then automatically distribute these proceeds out to the

f-NFT investors as a type of dividend, but this has yet to be seen. Thus, REIT regulations may not translate perfectly to regulating f-NFT bundles since it is difficult to see how f-NFT bundles would file quarterly and yearly financial statements regarding just NFTs. REITs can provide financial disclosures regarding the profits and losses of their various real estate properties, but f-NFTs do not have similar financials beside the increase and decrease in value of the various NFTs within the bundle. However, as described above, there may be more financial information when f-NFTs are issued by specific celebrities or companies. Regulators will need to determine how f-NFTs can disclose financial information to best inform investors. Additionally, there has been a surge of investors buying Metaverse Real Estate, which is real estate in virtual worlds bought and sold using NFTs and cryptocurrency.²²⁸ People can now go onto virtual real estate platforms such as SuperWorld where they can buy a plot of land in the form of an NFT and then share in any of the commerce that happens on that piece of property.²²⁹ These types of real estate NFTs would be able to charge rent or gain interest on these virtual properties and thus could then distribute income out to the NFT owners, much like REITs, and be subject to similar regulation. This analysis is outside the scope of this Note, but it is a relevant issue that regulators will need to face in the future. Nevertheless, REITs can provide a baseline to help regulators analyze and develop ways to regulate different types of f-NFTs and NFTs.

CONCLUSION

Given the foregoing analysis, f-NFTs can be deemed an “investment contract” security under the Howey test, and the SEC may be able to regulate the issuers or exchanges that facilitate these fractionalization and trading.

F-NFTs satisfy the four Howey prongs because (1) f-NFT buyers make an investment using money in the form of cryptocurrency; (2) this investment is in a “common enterprise” where the fortunes of the buyer are tied to the successes of either other fractional investors of one NFT or the brand or celebrity that issued the NFT; (3) buyers have a “reasonable expectation of profit” because f-NFTs are traded on secondary markets and promoted as a unique liquidity opportunity; and (4) these financial returns are derived from the efforts of issuers to support the popularity and price of an f-NFT and platforms to maintain and develop f-NFT exchanges and marketplaces.

If f-NFTs or NFTs are deemed securities, the SEC can use the existing regulatory models of digital currencies, traditional stock, and REITs to create initial regulations of a continuously developing digital asset. Due to the wide variety of f-NFTs and the ways in which they are owned and operated, regulators will have difficulty developing one standard that applies broadly. However, by comparing issuers and exchanges of f-NFTs or NFTs to existing securitized products, one can apply slight modifications to established regulations and require disclosures such as an NFT’s transaction history or how an issuer and exchange will use the proceeds from the sale.

Hopefully, this analysis will appeal not only to the legal field and regulators but also to the average investor who is interested in buying, selling, or understanding new digital assets like NFTs. The legal field and the government must face the current issues with NFTs and their classification and regulation as a financial instrument in order to protect investors while also allowing for the innovation of new financial technologies.

96 S. Cal. L. Rev. 253

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Lauren Au*

* J.D., University of Southern California Gould School of Law, 2023. B.A., University of California, Los Angeles, 2019.