Truth on the Market

Law Review Editors…take note.  You may get an opportunity to catch this one in February if you play your cards right.

I’ve been blogging updates of my research for a new article developing what the economic analysis provisions of the National Securities Markets Improvement Act of 1996 requires of new SEC rulemaking.  Blog colleague Prof. Wright has a great title suggestion: “The Law and Economics Revolution in Securities Law.”  I like it.  I would add: “Constructing the Four Pillars.”

This project is inspired by the DC Circuit’s opinion in Business Roundtable v. SEC, which revives the four principles in a tremendous way, and the project forms the heart of my research plan as a fellow at the Hoover Institution this semester studying economic analysis of law and my syllabus for a seminar in the law and economics of financial regulation I am teaching at Stanford Law School this semester.  Prior posts are referenced here.

In prior posts I described the first portion of this article, which will use legislative and judicial history to elaborate on the SEC’s mandate to consider the impact of new rules on what I am calling the “four pillars” or “four principles” of securities regulation:  investor protection, efficiency, competition, and capital formation.  The second portion of the article will seek to link the various relevant literatures to prospective rulemaking.

The second portion of the article will start with a broad view of various strains of the economic literature and move to a more particular focus on individual articles.  Along the way I’ll be calling balls and strikes for the relevance of entire strains of the securities regulation, economics, and financial economics literature generally, and individual articles in particular.  I will do so using the hurdles presented by the legislative and judicial history of the NSMIA that, like Prometheus stealing flame from Olympus, brought us the four principles as a light by which to interpret the means and ends of securities regulation more clearly.

This article will be controversial (at least I hope).

The legislative and judicial history from the first half of this article will describe a lot of nuance, but the dominant theme taking shape is that the drafters of the NSMIA were inspired by the benefits of cost-benefit analysis (CBA) and economic analysis as a guiding principle in securities regulation.  The legislation was largely authored by Congressman Jack Fields who was appointed to chair the subcommittee overseeing the securities laws.  The law was promulgated pursuant to the Contract With America.  On the Senate side the legislation was sponsored by Senator Phil Gramm.  The legislative history, as described in a prior post, clearly envisioned in part some version of the regulatory analysis conducted by the SBA for small businesses and by the White House Office of Management and Budget (OMB) Office of Information and Regulatory Affairs (OIRA) more generally.  In the three judicial cases interpreting the NSMIA (all of which ruled against the SEC) the court demonstrated a premier focus on the empirical economic literature as well as a focus on indirect costs.  The four principles take cost-benefit analysis to a new level by considering impact on institutional incentives, capital market efficiency, and competition.

Logistical problems that should be considered:

1) What is the significance of what I would call the patchwork problem?  So many SEC regulations reference other regulations, and presume the existence of a number of other levers in the system of SEC regulation, and in some rule proposals also assume the existence of regulatory regimes administered by other agencies.  Must new regulations be measured against the alternative of not only the status quo, but of actually amending or eliminating prior regulations?

2) What about looking back?  Is a sunset requirement in SEC regulations generally, or in some specific areas, advisable?  Does it speak toward a heightened scrutiny from the DC Circuit for regulations that do not have a sunset requirement?  Does it require the SEC conduct a CBA at some point (5 or 10 years) after the rule is adopted?  What are the corresponding uncertainty or transition costs associated with firm compliance flowing from such a requirement?

3) What about the issue of potential implicit NSMIA repeal as Congress issues mandates that would otherwise fail a proper cost-benefit analysis?  The SEC has taken the position that it is not required to perform CBA where Congress explicitly mandates that it promulgate a rule.  But the SEC certainly has discretion at multiple decision points in adopting a rule.  Consider all the discretionary decisions that must be made by the SEC staff as they write a multi-hundred page rule proposal implementing a rule required by a paragraph long amendment in the authorizing legislation.  Shouldn’t the SEC be held to a requirement that it meet CBA requirements whenever it actually exercises discretion?  Conversely, if the SEC’s position is that Congress implicitly pre-empted the NSMIA with an affirmative requirement to adopt a rule, shouldn’t the SEC be required during judicial review to demonstrate that position by showing that there is no way to implement the rule in a way that would survive review under the four pillars of the NSMIA?

4) Position consistency is a principle that must be part of this calculus.  Should the SEC be allowed to take mutually inconsistent positions in different rules?  Note that the SEC cited a couple of studies in the final draft of Reg FD (which inhibited selective provision of information to analysts and required industry-wide announcements if any information is publicly provided) arguing that issuers had plenty of incentive, in spite of Reg FD, to share information with the market to facilitate new offerings and to maintain long term customer and supplier relationships.  That position directly contradicts the agency’s position in a number of other rules mandating affirmative disclosure of various items.  How does this play into judicial review for agency consideration of the four principles?

Thoughts taking shape about the various economic literatures:

A) Public Choice/Public Finance Economics—–I am not aware of a single instance where Henry Manne or Jon Macey’s work in the public choice problems of securities regulation have ever been cited in the cost-benefit analysis section of an SEC rule.  The Commission should be held to some consideration of the effect of new rules on this problem.  New rules alter the relationships between market participants in ways that accrue rents to I-bankers, lawyers, and accountants, particularly those with prior SEC experience.  I see no reason why this impact shouldn’t be relevant.  Deadweight losses are quite costly when rules are adopted.  With respect to analysis post-rule, one would need to ask to what extent rent seeking effects are dynamic, and to what extent they are static and thus capitalized into stock price as of the rule’s adoption.

B) Austrian Economics—–I think Austrian thought will be most useful in this project in offering some broad insights for regulatory architecture.  For instance, the role of the entrepreneur in discovering information and the pervasive uncertainty of the future demonstrated by the Austrian literature seem to argue against the SEC’s obsessive focus on uniformity.  This is true in accounting rules, in market structure, in the broker fiduciary duty debate, in mandatory private equity and hedge fund registration, and in the “dark pool” controversy.  There seems to be a marked hesitation at the SEC for diverse paths that develop for forming capital or institutions that develop idiosyncratic methods for valuing assets, structuring their board, deploying capital, etc.  This literature’s influence will be subtle, it won’t help to measure a compliance cost dollar figure for instance, but I think I can certainly incorporate the literature in a broad way to inform how the regulatory adoption process must be structured.  Reading Rizzo and Kirzner on the economics of time and information, I am convinced of the necessity to require that SEC rules be considered not only at the point of adoption, but that they must also be subject to an economic analysis requirement post-implementation.

C) Behavioral Economics—–Given the disclosure-based system, and the fraud on the market presumption, and the use of event studies in determining damages, the legislative history and judicial interpretations of the ’33, ’34 and ’40 Acts seem to presume semi-strong market rationality.  I think the four principles must be read in light of that presumption.  Thus behavioral economics has little relevance for new SEC rule-making with respect to arguments about the rationality of investors.  If we look to rationality arguments with respect to the biases of regulated actors, like directors or managers, in the vein of Don Langevoort’s work (see e.g. here), there are relevant issues to consider.  Although, once that door is opened, you also have to consider the behavioral biases exhibited by regulators along the lines of Professor, and current SEC Commissioner, Troy Paredes’ work here.

D) Financial/Empirical Economics—–The DC Circuit has demonstrated a particular focus for this type of work to demonstrate either the cost or the benefit side of the equation.  What types of studies count?  In corporate governance many writers have used event studies, but for the purpose of considering new rules event studies require an unanticipated event which will rarely be true for new rule proposals unless significant elements of the rule are unanticipated.  Most of the corporate governance empirical literature has also tried to compare different governance characteristics across firms to make a case for which governance methods should become mandatory, but that type of inquiry often suffers from quite severe endogeneity problems.

The real interesting question is what variables matter and which don’t, because I can see a potential for gamesmanship in selecting the variables impacted based on the what a writer wanted to accomplish.  SEC rules have at times cited to studies looking at impact on abnormal stock price returns, the bid-ask spread, Tobin’s q, trading volume, trading volatility, and brokerage costs, among a variety of other variables.  But how does one choose between these variables as superior indicators of the two “pillars” of efficiency and capital formation?  And what about considering a new SEC rule’s impact on bond yields or on the price of derivatives linked to common equity?  Surely the “capital formation” pillar should include the impact of a new rule on debt and derivatives instruments as well as equity?  What about impacts of rules on the debt/equity tradeoff?  The Miller/Modigliano Theorem of financing irrelevance envisions taxes and bankruptcy as primarily driving the debt/equity financing tradeoff, but shouldn’t we also consider the impact of mandatory disclosure on securities class action risk as well (in other words, the more onerous the risk of securities class action risk, the more attractive debt financing becomes)?

E) Direct Compliance Costs—–The SEC has often made use of direct industry compliance costs in its economic analysis of new rules.  This is a particularly limited measure and is frequently underestimated.  Not much in the way of applicable economic literature here, this estimate mostly relies on conflicted best guesses by SEC staff and likely conflicted estimates from industry comment letters.  The ridiculousness of the SEC staff estimates when viewed post-adoption argues in favor of a mandatory look-back requirement for economic analysis.  (When I say ridiculous, I am thinking of the SEC’s estimate in the rule implementing Sarbox Section 404 that implementation costs would average $90,000 per firm.  An SEC study five years later admits it was more like $2 million per firm.)

In a subsequent post, I will consider how to make more use of the transaction cost or New Institutional Economics literature, particularly with respect to rulemaking under the SEC Division of Corporation Finance and Division of Investment Management jurisdictions, as well as how economic game-theory can prove more useful to inform rulemaking in SEC oversight of the exchanges and SROs through the SEC Division of Trading and Markets.