One of the things that I hope to spend more time doing now that I have returned to the blogosphere is open-source article writing. By that I mean blogging about an article idea and updating it as I progress. Some say it’s a bad plan…people might steal your ideas, or maybe you expose yourself to the possibility of being wrong. I don’t think it’s an issue, particularly if readers take my musings in the rough-and-tumble blogging spirit. If you think I have interpreted a provision incorrectly, great. Email me and tell me why. Better that you send me a case I missed than I learn about it after the article is published.
First some background. The National Securities Markets Improvement Act of 1996 amended The Securities Exchange Act of 1934, the Securities Act of 1933 and the Investment Company Act of 1940 to provide the following new restrictions on SEC rule-making:
Whenever pursuant to this title the Commission is engaged in rulemaking, or in the review of a rule of a self-regulatory organization, and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.
Investor protection, efficiency, competition, and capital formation. Oh my. In the interest of short-hand let’s call them the four guiding principles of securities regulation. The recent proxy access case reminds us of the importance of the four principles, as the DC Circuit struck down a rule specifically authorized by Congress for failure to adequately consider the four principles. David Zaring observes “It is worth noting that there is no explicit requirement that a cost-benefit analysis be done in the statute.” Of course he is right. The requirement is not explicit. (Though, presidential executive orders have required even independent agencies to engage in cost-benefit analysis, but that’s a different question for another day). I do however think that a natural reading of the “efficiency” principle invokes the same economic ideas on which the cost-benefit analysis branch of regulatory economics is based.
The problem I think is that despite the the importance of the four principles they are inadequately defined in the statute. I included Apple Pie and Puppies in the title of this post because I actually think, given the uncertainty clouding the four principles, it wouldn’t really change court review to also require the Commission consider the effect of new rules on “apple pie production and puppy formation.”
I want to write an article that explores this problem and begins to think through building a comprehensive description of what is required by the four principles in SEC rule-making and review of SRO rulemaking. Note, I don’t blame the DC Circuit for the remaining uncertainty. Their job is to provide just enough analysis to decide the case. It’s not their job to exhaustively resolve puzzles like these. This is particularly true where the rule does a bad job of economic analysis. For example, in the proxy access case the 400 page rule failed to even consider the principle objection to the rule that the conflicts posed by various institutional investors would damage share value. So, the DC Circuit didn’t actually need to engage in much statutory interpretation of the four principles to decide the case. I suppose untying the remaining knots is the ivory tower’s calling.
First I think you have to do some simple statutory interpretation. I hate this exercise, and I get the feeling that appeals courts often share my malaise. What do you do with unclear drafting? How do you interpret operative language that uses synonyms. What’s the difference between, for example, investor protection and capital formation? I would think regulations that impose a net cost (benefit) on share values would both harm (help) investors and inhibit (promote) capital formation. But the policy arguments over these terms suggest an inherent tradeoff between capital formation and investor protection, as though capital formation speaks to costs imposed solely on issuers.
My first step will be to head over to the Georgetown Law Library, which houses the entire legislative history of the ’33, ’34 and ’40 Acts. Not as fun as going to the movies, but still a good way to escape the heatwave hitting DC. The full transcripts of the Pecora hearings into the stock market crash of 1929 as well as legislative and committee debates over the 33′ and 34′ Acts rest on a dusty shelf in the deep dungeons of the law library. Before the summer is over I plan to pore through the source text and try to get a better handle on what Congress had in mind when it considered the first of the four principles, investor protection, in the ’33, ’34 and ’40 Acts. Then I think it would be worthwhile to review the Committee hearings and legislative history of the National Securities Markets Improvement Act of 1996 to understand the three relatively new constraints.
Then you have to consider what investor protection, efficiency, capital formation, and competition mean through the lens of the economic and financial literature. For efficiency, are we talking about Kaldor-Hicks, Pareto, or something else? Does it mean a cost-benefit analysis along the lines of what the Office of Information and Regulatory Affairs at the White House Office of Management and Budget would expect? If so, that would incorporate a wide literature. For example, we would need to decide what statistical value of human life the SEC would use, particularly where we start to debate capital formation in the life sciences or pharmaceutical sectors. (And before you accuse me of being morbid, realize that most agencies have a number they use to value human life.) The existing cases tend to show a respect for empirical literature, as where the DC Circuit focused on a lack of empirical support in both the proxy access case and its review of the independent mutual fund chairmen rule. Does this mean stock price event studies of rule announcements?
And what about competition? Correct me if I am wrong Josh, but I thought the FTC was the agency charged with overseeing competition. Does this solely relate to SEC review of questions like exchange consolidation and brokerage pricing, or does it apply more broadly to disclosure rules under the 34′ Act? Do we need more industrial economists in addition to the (relatively few) financial economists on the Commission staff? The inclusion of competition in the four principles may have something to do with the fact that the FTC was originally intended to enforce the 33′ Act, and the 34′ Act subsequently created the SEC and gave it jurisdiction over the securities markets, so perhaps it was intended to clarify the SEC’s review of competitive effects of exchange consolidations, but it could also be read to apply much more broadly.
Then you get into complicating questions of patchwork. By that I mean Congress has sewn into the various Acts a complex web of permissive and mandatory authority to promulgate rules under successive amendments. In some instances, they include mandatory rules that wouldn’t even remotely survive a review under the four guiding principles, no matter how you define them. Then what do you do? The proxy access case makes clear that when the SEC exercises permissive authority it is still bound by the four principles. The SEC has taken the position that it is not bound by the four principles when it exercises mandatory authority, but as I have blogged before I think that position is misguided. Where Congress gives a very broad stroke mandate to the SEC, as it has done under many of the Dodd-Frank authorizing provisions, the SEC effectively paints on an empty canvas. They’re told to paint a picture of a duck, but they choose the brush, the colors and the frame. I think to the extent that the SEC makes choices, it remains bound by the four principles.
There is an interesting twist on the four principles when it comes to the Division of Trading and Markets and SEC review of SRO rule-making designed to address speculation. If it is true that one man’s trash is another man’s treasure, I think its safe to say that one man’s speculation is another man’s investment. The same trading activity that some decry as speculation also can provide advantages in liquidity. And it’s hard to know until the game is over whether a trade is speculative or truly insightful. This has given rise to a sharp debate over regulation in this context.
As a Hayekian, I tend to believe the price system is best equipped to sort it out, but the 34′ Act doesn’t seem to agree with me. Section 2 of the Securities Exchange Act of 1934 is titled “Necessity for Regulation” and provides a very succinct explanation of congressional intent with respect to the ’34 Act. The word “Speculation” shows up in two paragraphs.
Paragraph 3 provides:
frequently the prices of securities on such exchanges and markets are susceptible to manipulation and control, and the dissemination of such prices gives rise to excessive speculation, resulting in sudden and unreasonable fluctuations in the prices of securities which (a) cause alternately unreasonable expansion and unreasonable contraction of the volume of credit available for trade, transportation, and industry in interstate commerce, (b) hinder the proper appraisal of the value of securities and thus prevent a fair calculation of taxes owing to the United States and to the several States by owners, buyers, and sellers of securities, and (c) prevent the fair valuation of collateral for bank loans and/or obstruct the effective operation of the national banking system and Federal Reserve System.
Paragraph 4 provides:
National emergencies, which produce widespread unemployment and the dislocation of trade, transportation, and industry, and which burden interstate commerce and adversely affect the general welfare, are precipitated, intensified, and prolonged by manipulation and sudden and unreasonable fluctuations of security prices and by excessive speculation on such exchanges and markets, and to meet such emergencies the Federal Government is put to such great expense as to burden the national credit.
Unfortunately, I think these paragraphs limit application of the four principles for rule-making in the context of exchange and broker oversight that has an anti-speculation focus. The NSMIA doesn’t specifically amend that provision. Perhaps one could argue that impliedly repeals these two paragraphs, but it could be a tough argument. I know on short sales restrictions blog colleague Larry Ribstein has argued here, and blog neighbor Steve Bainbridge has argued here, that the Commission’s unreasonable suspicion of short sellers inhibits price discovery and liquidity. These are great policy arguments that Commissioners should consider in voting on new rules, and that the Divisions should consider in drafting and interpreting rules, but I fear that Section 2 limits any potential for challenge under the APA to rules issued under the authority of the Division of Trading and Markets or in SRO review that are based on curbing what the Commission considers to be speculative activity.
If idle hands are the devil’s playground, hopefully this project will keep me busy for awhile. Thoughts?