Speech by SEC Commissioner:
Is Excessive Regulation and Litigation Eroding U.S. Financial Competitiveness?
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
Conference co-sponsored by the American Enterprise Institute and the Brookings Institution
April 20, 2007
Thank you very much for the invitation to be here today with you and thanks to the American Enterprise Institute and the Brookings Institution for co-sponsoring today's event. In the past six months, several critical studies have been published regarding the competitiveness of the U.S. capital markets and suggesting recommendations to improve our competitiveness.
These studies have taken a great deal of time, thought, and effort. So I very much appreciate all who have contributed and give you my personal thanks, especially to those of you here today in person. Of course, my thanks must be personal, because my remarks represent my own views and not necessarily the views of the Commission or any other Commissioner.
These reports have stimulated a national — and global — discussion about whether the United States is losing its competitive edge as a market for raising capital. Whether you agree or disagree with some or all of the recommendations of these reports, I think nearly everyone would agree that we ought to be concerned about our global competitiveness for capital and its implications for our future.
Why is our competitiveness in this area so important? It is easy to see why someone in the financial centers of New York, Chicago, or Charlotte would be concerned, but what about other places? Our competitiveness in financial services means more than jobs in the financial services sector. It affects the attractiveness of our country as an investment destination and as a place that entrepreneurs from around the world come to offer our investors the opportunity to share in the development of new ideas.
Globalization today means that both seekers and providers of capital have choices and that competition will only become stiffer in future decades as overseas markets mature and develop. We should not — and cannot — take our domestic public capital markets for granted. From a historical perspective, we have been fortunate in this country with respect to the development of our capital markets. The United States emerged from the end of World War II with its capital, industrial and scientific structures intact. The rest of the industrialized world lay in ruins. Communism and socialist ideas then suppressed the formation of financial markets in many parts of the world. So for many decades, these external factors made the United States the dominant financial marketplace in the world. Regardless of our regulatory costs, there were no other financial marketplaces with the size, liquidity, and depth of the United States — a position that we have continued to maintain to this day.
Through it all, American investors enjoyed a great investment environment — people from around the world have come here, on our terms, under our laws — to seek out our investment. As a result, Americans generally benefited from the protections of American laws and our court system. Now that is changing. Many global competitive forces will continue to challenge the position of the United States, including the rise of liquidity pools and capital markets in Europe, Russia, China, India, and other places as well. Americans through technology have unprecedented access to these markets. E-Trade, for example, now offers its customers direct access to foreign markets with a click of a computer mouse. With burgeoning foreign capital centers and easy direct access of Americans to those markets, foreign companies no longer have to come here.
Some critics of these reports might argue that, given these global competitive forces, all of this hand-wringing over U.S. competitiveness is an exercise in futility. I strongly disagree. To use a sports analogy, this is no excuse for not putting the best team on the field. As a regulator, I believe our objective is to put forth the most competitive regulatory environment possible and then let market forces do the rest.
I realize that even the optimal legal and regulatory structure will not guarantee the continued preeminence of our financial markets. But placing blinders on ourselves and ignoring what other countries are doing will not address these problems. To proclaim that our current regulatory structure as superior and dismiss the capital markets of other countries as the "Wild West" or some other pejorative label will not solve the issue either.
In a free market economy driven by innovation, our regulatory structure cannot remain static. We are in need of constant adjustments so that our markets remain the most attractive and competitive. In 1991, then-Federal Reserve chairman Alan Greenspan gave his thoughts on financial and securities regulation in an address to the annual meeting of the International Organization of Securities Commissions, sponsored by the SEC here in Washington.1 Chairman Greenspan noted that "[f]inancial markets that do not provide adequate supervision stand to lose business to other markets, especially as the globalization process continues and better alternatives to domestic markets develop." But, he presciently warned, "[w]hile adequate supervision is necessary, there is a danger that supervision and regulation can be excessive," which can lead to "unnecessarily high transaction costs, distortions to asset prices and a stifling of innovation." In such circumstances, incentives mount to shift "business to other markets."
Government securities regulators should be acutely aware of the regulatory costs that they impose on the market. It is important to note that these costs are cumulative. Perhaps they are not particularly significant in any given year, but over twenty years or more, the aggregate costs may be significant. Of course, the real question is not one of cost, but one of value: what are the benefits obtained by the markets as a result of these regulatory costs? If the benefits to the market provided by the collective supervision of the Commission, the Justice Department, the self-regulatory organizations and the states are greater than the costs, then I would say our regulatory approach has added value. But if these regulatory costs are not providing value, then it would be prudent to pare back those non-value adding aspects of regulation.
The securities laws impose upon the Commission a statutory duty (i) to protect investors and (ii) to promote efficiency, competition, and capital formation. So how should we assess the competitiveness of a regulatory environment? It is certainly not a race to the bottom, as some critics of these efforts to reform our current system have alleged. Rather, a competitive regulatory environment achieves results — that is, benefits — at least in proportion to its costs.
There are a number of regulatory approaches to the securities markets: (i) a broad-based, vaguely delineated, fraud-only regime like the New York Martin Act; (ii) a disclosure-based regime such as large parts of the federal securities laws; and (iii) a merit-based system, where the government decides if a security is appropriate to be offered. Which approach comparatively adds the most value would be highly dependent upon its implementation. I can easily imagine situations where no regulation might be superior to a badly-implemented, alternative regulatory structure.
For instance, let us take the example of a merit-based system in which government bureaucrats are extremely worried about being responsible for allowing a "bad" investment to be approved. They may require lots of information, so it may take a fair amount of time to perform the necessary diligence to approve an offering. As a result, fewer capital raising transactions would be done and relatively fewer products would be available in the marketplace.
In fact, this is exactly what happened to Apple Computer when it first went public in 1980.2 The Commission approved Apple's registration statement under the federal Securities Act, but the offering was still subject to merit review in various states. Massachusetts prohibited the offering of Apple shares because they were "too risky." The joke was that Apple was "banned in Boston." Texas approved the sale after an extensive review, but its securities regulator called his decision "a close call." And Apple did not even bother to offer its shares in Illinois due to strict state laws on new issues.
The Apple situation was one where government bureaucrats made the decision about the value of the offering, not the markets. The result? Investors in Massachusetts and Illinois could not buy in what became a very successful IPO and ultimately a successful company. Fortunately, I think our collective thinking has evolved since that time. For the national capital markets, the regulatory approach of the federal securities law is a combination of mandated disclosure and antifraud enforcement. Except in a few, narrowly-defined areas, the federal securities laws impose no substantive or merit-based requirements on securities offerings.
The competitiveness reports recognize the importance of "value-added" regulation. When confidence in a fair regulatory system is felt by both issuers and investors alike, the cost of capital can be reduced, thereby providing an additional incentive for economic growth. I think there are few, if any regulators, who espouse the view that our regulatory efforts ought to be approached from a different perspective.
Nonetheless, seventy-plus years of federal regulation have not necessarily made the Commission or Congress smarter regulators. Is it because we, as regulators, have become too complacent, especially when it comes to economic analysis of regulations? Do we review existing regulations to ensure that those on the books still add value? Do we mistakenly think that the U.S. capital markets have succeeded solely because of our regulatory approach?
Take, for example, the debate around the implementation of Sarbanes-Oxley section 404. Most people have now concluded that Audit Standard 2 of the PCAOB has been a failure — the costs exceed the benefits, especially to smaller companies. However, I still hear people say in this debate that "If you cannot afford to do a real 404 review, you should not be a public company." If that is true, who should make that decision? Politicians, regulators, or bureaucrats? Or investors? In fact, our actions in calibrating the standards for management, accountants, and lawyers in performing internal control reviews and assessments create barriers to entry to some number of companies. Some may decide that going public is not worth it and others may decide to go public elsewhere. Is that good for investors? Is this not similar to the merit regulation of the Apple Computer IPO? Keeping this in mind, we must apply stringent cost-benefit analysis in setting regulatory standards.
The Commission has been long dominated by lawyers, who in some cases have viewed economic analysis as a black box, something to be consigned to post-hoc justification of a rule rather than used as a guide to regulation. Lawyers often are risk averse, seeking to avoid blame for the next Enron rather than laying the groundwork for the next Microsoft or Google.
Without a competitive threat, have we failed to undertake the necessary critical self-analysis to insure that our regulatory structure is operating as efficiently as possible? Have we, as a result, layered rule after rule upon the capital markets — always in response to the latest scandal — without carefully considering the cumulative weight of such regulations?
Our recent consideration of rules governing the mutual fund industry is a good example. The rule as adopted twice by the Commission, both times over my dissent, would have required each fund to have a board made up of at least 75% independent directors, one of whom is chairman. I say "would have required" because these requirements were struck down twice by unanimous panels of the D.C. Circuit because the Commission failed to consider adequately the costs of, and alternatives to, the measure. I note that Chief Judge Ginsburg, who will be one of your speakers later this afternoon, wrote the opinion for one of those panels.
When the Commission first proposed the rule in 2004 at an open meeting, my former colleague Commissioner Cyndi Glassman, a Ph.D. economist, pointed out the need for empirical analysis to support the rule. In response, she was told that there probably was not empirical evidence to support the rule, but that the rule should be looked upon as "an experiment that will have to be reversed if it was a problem." In any event, then Chairman William Donaldson infamously told her that "there are no empirical studies that are worth much."
Late last year, the Commission was under pressure to re-propose the independent chairman rule. During the course of these discussions, it was brought to my attention that the Commission's Office of Economic Analysis had previously performed a couple of studies on this very issue, although those studies had not been circulated among the commissioners.
To Chairman Cox's credit, he moved to release these studies for public comment rather than move forward with a specific rule proposal. Now that we have had a chance to review the recently-released mutual fund governance studies, the justification for an industry-wide experiment seems even more tenuous. I read these studies as to conclude that while there may be some statistical correlation between having an independent chair and the level of fees charged by the mutual fund's adviser, there is no strong correlation with overall return.
One of the important focal points of the Commission's economic studies concerns whether the proposed changes will lead to a superior return. Sometimes lawyers and politicians tend to get too caught up in the legalities and nuances of regulation rather than the end result. As an investor, the key focus should be on risk and return and trying to correlate those two factors to satisfy one's particular needs. For example, am I more interested in achieving the returns regardless of volatility or do I prefer to have more predicable returns?
The concepts of economic risk and return also affect a different proposal of the Commission relating to private investment funds. Specifically, part of the Commission's proposal would add an additional requirement for any natural accredited person to have at least $2.5 million in investments before he or she could invest in a private investment fund, like a hedge fund or private equity fund, other than a venture capital fund.
The underlying premise for the Commission's proposal is that these types of investments are "too risky" for individuals other than the very rich. Therefore, we will have to presume that the non-rich are either unsophisticated or lack access to sophistication and it is simply not tolerable to have these types of people at risk of losing their money on a hedge fund. Assuming that these premises are true, however, what evidence does the Commission have to support the conclusion that private investment funds are the most risky? What makes a hedge fund or a private equity fund more risky than a venture capital fund? And how does the risk profile of a pooled investment compare to the risks of investing in the securities of a single issuer, for which this new $2.5 million standard is not applicable.
Many public comment letters express indignation at the Commission's proposal. One commentator wrote, "[s]tay out of my wallet, stop trying to protect me from myself, stop presuming to know more than I do about my own life, risk-tolerance and financial sophistication." The Commission's proposal may very well prevent the non-rich from losing their money in private investment funds, but it also certainly will prevent the non-rich from participating in any upside profits and gains on these funds. Does this mean the rich get richer while the non-rich should be content to just hold their place on the economic ladder?
This is not a mere rhetorical question, because the so-called "smart money" investors are allocating increasing amounts of their portfolios to private investments funds as alternative investments. Although this is still a minor part of their allocation, this change in allocation is clearly a market reaction to developments in the capital markets.
Why are the large sophisticated institutional investors like CalPERS and the New York State retirement funds placing more of their investment assets into private equity funds? With their "standard" 2% annual management fee and a 20% carried interest, the expenses of investing in private equity funds are significantly higher than investing directly in the market or through institutional-class mutual funds. I can only surmise that their professional investment staffs have determined, notwithstanding the fee structure, private equity managers will be able to obtain superior returns over those obtainable in the public markets.
The simple fact that the "smart money" believes that they can obtain a better return in private equity despite the typical 2-and-20 fee structure — sometimes higher — is a stark indictment of the current regulatory environment. And the themes of today's conference — excessive regulation and excessive litigation — are substantial factors that contribute to a perception of such regulatory environment.
The competitiveness reports raise a host of recommendations. Some of these recommendations, such as reforming the implementation of Section 404 of the Sarbanes-Oxley Act, have been subject to an extensive effort by the Commission and others to rectify. So I will spend the rest of my remarks highlighting a number of issues that have received less attention, yet are ones that remain important to U.S. competitiveness.
Let us start with excessive litigation. The competitiveness reports discuss the continuing need to re-examine our private securities litigation laws. The far bigger issue is abusive class actions that result in few or imaginary benefits for class members, but for which large cash fees are paid to plaintiffs' attorneys. Such suits add to the global perception that the U.S. legal system operates as a "lottery-like" system of justice. Modeled after the success of the tobacco lawsuits, businesses are now being subjected to various class actions that previously would have previously been thought laughable. There are legitimate purposes for class action tort lawsuits. But the key is to quickly separate those with merit from those without in a timely and cost-efficient manner.
One of the more interesting recommendations put forth in the U.S. Chamber's report relates to the practice of company earnings guidance and need to meet Wall Street expectations. While there is not much that the Commission can do with this recommendation from a rulemaking standpoint, I would encourage the business and investor communities to follow up on industry practices relating to this recommendation. During my tenure at the Commission, I have seen far too many instances in which company executives have falsified financial statements and other disclosures in order to meet Wall Street expectations.
Another recommendation that I support is making securities enforcement among the states and federal government more uniform. Since its passage in 1996, the Commission has not engaged in any serious effort under the National Securities Markets Improvement Act (NSMIA) to engage in "regulatory convergence" among federal and state securities regulators, especially as it may affect nationally and globally-offered securities. In passing NSMIA, Congress recognized that it was in the nation's interest to have uniform standards in the securities markets. So I pose the question, should securities fraud be different under state law than federal law? In other words, could an act or omission that is not fraudulent under federal law be fraudulent under a state law — or vice versa? I think most courts that have addressed securities fraud have viewed the federal and state laws as practically interchangeable.
For instance, some recent state enforcement cases involving several large mutual fund complexes and their in-house distributors are troubling. When the California Attorney General was asked by a Wall Street Journal reporter about whether he was seeking more disclosure than required by the Commission, his response was "that's fine" because he thought he should be "supplementing" SEC regulations.3 The setting of disclosure standards for nationally-offered securities such as mutual funds is a function that Congress, through NSMIA, clearly left to the Commission.
Another recommendation from the reports that the Commission should consider is how staff guidance is treated. Transparency in our regulatory process through public notice and comment is not just good practice — it is the law. For any rulemaking by the Commission, such proposed rules must be submitted for public comment under the Administrative Procedure Act. Staff guidance, on the other hand, whether it is in the form of staff accounting bulletins, staff legal bulletins, speeches, or no-action letters, are not subject to the Act.
I have no opposition to our staff's attempting to explain or apply an SEC rule or accounting standard to a current situation. Staff guidance can provide very helpful advice to all participants in the capital markets. Such guidance can be issued faster and is particularly appropriate to situations with a unique set of facts and circumstances.
But sometimes staff pronouncements can fundamentally change existing market practices. For example, Staff Accounting Bulletin No. 101 (SAB 101) addressed in depth various aspects of revenue recognition. The final guidance required registrants to reflect the adoption of SAB 101 as a change in accounting principle, similar to the adoption of a new FASB standard. With all of the attributes of rulemaking from the perspective of affecting the marketplace, it is difficult to argue that such pronouncements are not rules and should not be subject to the requirements of the Administrative Procedure Act
Finally, I appreciate the various recommendations put forth in the reports as to the most appropriate relationship between the Commission and its regulated entities, such as broker-dealers, exchanges, and investment advisers. Our inspections program, run by the Office of Compliance, Inspections, and Examinations (OCIE), provides the Commission with critical information as our eyes and ears on the ground with respect to regulated entities. Since the creation of OCIE as a standalone office, the level of interaction and communication with their former supervisors at the line divisions has been less than optimal. This strikes me as more of an operational issue than a structural issue. In my opinion, the Commission should be utilizing a prudential model of regulation, in which OCIE can be instrumental in communicating "best practices" models and heading off potential problems.
Thank you, again, for the invitation to be in such esteemed company today and for your efforts in this area. I wish each of you well in your efforts in trying to build a consensus on each of these issues. It is difficult enough sometimes to achieve a 5-0 view at the Commission, so I know you have an even greater challenge facing you. I would be pleased to answer any questions that you might have.