Speech by SEC Commissioner:
Remarks Before the 27th Annual NABE Economic Policy Conference
by
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
Arlington, Virginia
March 8, 2011
Thank you for the kind welcome. It is a pleasure to join you this morning at the 27th Annual NABE Economic Policy Conference. The theme of this year’s conference – “Balancing Austerity and Growth: Delivering Policies That Work” – challenges us to work together to foster the conditions that will spur the business and investment activity that we depend on to drive our economy.
We all want to deliver policies that work. The difficulty is doing so. Accordingly, I welcome the opportunity to share with you some of my thoughts for fashioning the regulatory regime that governs our securities markets – the focus of my responsibility and attention as an SEC Commissioner. But before sharing these thoughts, as is customary for members of the SEC, I want to remind you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
When crafting the securities law regime, we are, at bottom, determining what conduct we are going to permit; what conduct we are going to prohibit; and what conduct we are going to mandate. In other words, as a regulator, I am in the business of drawing lines.
It can be a struggle to identify the appropriate demarcations. We often make decisions under tight time pressures; we always make decisions with imperfect information; and we never can predict the future with certainty. Every regulatory step we take – or decide not to take – has both costs and benefits associated with it. It should come as no surprise, then, that there can be disagreement on where to draw the regulatory lines that determine how far the government will reach into the private sector and how heavy the government’s hand will be.
In considering what the scope and nature of the securities law regime should be, I find it useful to keep the following in mind: That the essential purpose of our financial system is to promote capital formation and to facilitate the allocation of capital to its most productive uses in our economy. A regulatory regime that unduly frustrates this purpose is counterproductive. This takes me to Dodd-Frank.
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The Dodd-Frank Wall Street Reform and Consumer Protection Act has realigned the relationship between the government and the private sector. I will not flesh out this claim in detail, but instead will only suggest my reasoning by highlighting some of the ways that Dodd-Frank has extended the SEC’s regulation over the nation’s securities markets.
Dodd-Frank charges the SEC with extensive rulemaking. Among the scores of Dodd-Frank-related rulemakings that fall within the Commission’s jurisdiction – not to mention the numerous studies that Dodd-Frank instructs the agency to conduct – are regulatory initiatives concerning derivatives; asset securitization; the “Volcker Rule”; credit rating agencies; hedge funds, private equity funds, and venture capital funds; municipal securities; clearing agencies; and corporate governance and executive compensation.
Over the course of just the past few months, the Commission, in accordance with Dodd-Frank, has proposed or adopted rules to require investment advisers to hedge funds, private equity funds, and other private funds to report information to the SEC to assist the Financial Stability Oversight Council in assessing systemic risk;1 to establish a registration regime for security-based swap execution facilities and to implement 14 “Core Principles” to govern these trading venues;2 to begin removing references to credit ratings from SEC rules and regulations, including the requirement that money market funds hold commercial paper that is rated investment grade;3 to institute standards for the operation and governance of clearing agencies;4 to regulate incentive-based compensation arrangements at broker-dealers and investment advisers; 5 to further regulate the asset securitization process;6 to provide for the registration of municipal advisers;7 and to provide for shareholder approval of executive compensation and certain “golden parachute” compensation arrangements.8 I should note that I have not supported all of these rulemakings and that I look forward to continuing to evaluate the comments on the Commission’s outstanding proposals.
The Commission’s regulatory responsibilities under Dodd-Frank follow in the wake of what already has been an active period for the agency. Since the financial crisis, the SEC has advanced a number of non-Dodd-Frank-related initiatives concerning matters such as short selling;9 the election of board members;10 public company compensation and governance disclosures;11 money market funds;12 credit rating agencies;13 municipal securities;14 the custody of advisory client assets;15 investment adviser disclosures;16 asset-backed securities;17 target date funds;18 broker-dealer risk management controls;19 mutual fund fees;20 and dark pools.21
One also could add the May 6 “flash crash” to the mix, when the markets fell precipitously before rebounding rapidly. In the aftermath of May 6, single-stock circuit breakers were instituted22 and market maker “stub quotes” were effectively prohibited.23
Two concept releases that the Commission put forth last year – one regarding equity market structure24 and the other regarding the U.S. shareholder voting system25 – suggest still other items that are receiving attention. The equity market structure concept release solicits input from commenters on high frequency trading, co-location, proprietary data feeds, the price discovery process, order execution, undisplayed liquidity, the quality of our equity markets, as well as other things. The shareholder voting system concept release covers topics such as the distribution and solicitation of proxies, the role of proxy advisers, the accuracy and transparency of shareholder voting, the methods by which issuers communicate with shareholders, the extent and nature of shareholder voting participation, and the relationship between a shareholder’s voting power and economic interest.
There is much that could be said about the particulars of the regulatory agenda, but for now, let me speak more generally, offering the following overarching thought: The extent to which the sweep of financial regulation will displace and distort private sector decision making in our economy concerns me, and I am troubled that ongoing regulatory initiatives – notably, the regulations implementing Dodd-Frank – will go too far, unduly burdening the financial system at the expense of economic growth. My concern is not an abstract one; there are concrete harms when the government overregulates.
The SEC’s far-reaching rulemaking authority under Dodd-Frank allows the agency a great deal of choice and discretion to shape the legislation’s practical contours and thus to determine Dodd-Frank’s ultimate impact. Without question, there is a fundamental role for government, including the SEC, in overseeing our financial markets and our economy more generally; and regulatory reform affords us the chance to fashion a regulatory framework that is resilient and that fits our increasingly interconnected and complex financial system.
Yet even as we share the common goal of mitigating the prospect of a future financial crisis and look to fend off the hardship that such a crisis would spawn, we have to recognize the real-life costs to society if the regulations implementing Dodd-Frank excessively constrain and hamper the U.S. financial system. We need to be mindful that, as the regulatory regime becomes increasingly restrictive, the cost of the capital that companies need to grow and hire may increase; the credit that consumers rely on may become more challenging for them find; the ability of businesses and investors to manage their risks appropriately may become more difficult; the investment opportunities investors can look to to accumulate wealth and earn income may become fewer; and the commercialization of new ideas and technologies may be stymied.
Put differently, as the U.S. regulatory regime becomes more confining and rigid, all of us are impacted – financial institutions, non-financial companies, entrepreneurs, consumers, employees, and investors – if the financial sector loses the flexibility it needs to provide the full range of products, transactions, capital-raising techniques, and services that drive our economy. New regulatory strictures that end up burdening the economy in these ways come at the expense of private sector innovation, entrepreneurism, and competition – which is to say, at the expense of U.S. economic growth.
This builds to a straightforward but important point – namely, we need to use the regulatory authority Dodd-Frank has conferred upon us cautiously, carefully evaluating the intended benefits of our actions while giving due regard to the potential undesirable effects of our regulatory choices. In short, the Commission must engage in rigorous cost-benefit analysis when fashioning the securities law regime. 26 A demanding cost-benefit analysis that permits us to make informed tradeoffs across a range of potential outcomes is the best way of achieving the common good, of ensuring that the benefits of regulation outweigh the costs. This should include assessing the cumulative impact of the entire package of new regulatory demands to anticipate the overall effect of the regulatory regime when viewed in its entirety.
The discipline that cost-benefit analysis brings to decision making should impress upon regulators the complexity of the challenges and opportunities we face and help manifest for us the potential unintended consequences of a regulatory initiative. Because we routinely discuss unintended consequences in the abstract, a concrete example may be useful.
Until Dodd-Frank rescinded the rule last year, Securities Act Rule 436(g) had exempted credit rating agencies from so-called “expert liability” under Section 11 of the ’33 Act. Dodd-Frank’s rescission of Rule 436(g) had two effects. First, rating agencies would be subjected to Section 11 liability. Second, if Regulation AB under the federal securities laws required an issuer of asset-backed securities (ABS) to include a public offering’s rating in the registration statement that must be filed with the SEC, the rating agency would have to consent to being named as an “expert.”
Credit rating agencies responded as one might expect, even if it was not the result Dodd-Frank hoped for: Rating agencies refused to consent to being named as experts because of worries about additional legal liability. This refusal threatened to halt public offerings of asset-backed securities because an ABS issuer’s registration statement could not include the issuance’s rating and identify the rating agency if the rating agency was unwilling to be named as an expert.
After a period of great uncertainty for the asset-backed securities market, the threat to such public offerings was alleviated, with the SEC’s Division of Corporation Finance providing no-action relief to ABS issuers that exclude the rating from the registration statement, notwithstanding that Regulation AB otherwise calls for it.
This short history evidences how unintended consequences can materialize. This short history also demonstrates how easing a regulatory burden and mitigating the risk of liability can promote capital formation – or, in other words, it demonstrates the risk of overregulating. In my view, investors and others who benefit when pools of assets can be securitized efficiently would have been worse off if, as a result of extending Section 11 liability to rating agencies, the public market for securitizations had seized.
To be clear, cost-benefit analysis is not an argument for or against regulation. Rather, by obligating us to justify our actions, it is an argument for regulatory decision making that fully accounts for both the good and the bad – that nets the costs against the benefits – to ensure that we have smart regulation.
Our analytic work should not stop, however, once an initial decision is made. Securities and other regulators need to revisit their decisions by selecting key rules and regulations for reevaluation from time-to-time. Only by studying the actual effects of a rule or regulation once it is operative can regulators ensure that the regulatory regime that has been put in place is serving its intended purpose at an acceptable cost.
What does all of this mean in practice for decision making at the Commission? I have three practical suggestions.
First, it is important to solicit – as the SEC has, especially when it comes to the implementation of Dodd-Frank – the full range of ideas and perspectives that interested parties have to offer. We are better equipped as regulators to make informed decisions when we receive input from those on the ground who would be impacted by the regulatory change. With this input, we can evaluate more critically the practical consequences and tradeoffs of choosing one regulatory course over another. Similarly, the detailed input we receive allows us to refine our regulations, tailoring the regulatory regime to fit the different cost-benefit analyses that attach to different facts and circumstances.
Second, regulatory decision making should be supported by data, to the extent available, and rigorous economic analysis. This is particularly important to stress insofar as the SEC is concerned, because the SEC is an agency that traditionally has overwhelmingly been comprised of lawyers. Data and economic analysis must be much more central to decision making at the SEC than has been the case.
Not only does empirical analysis allow the SEC to leverage its expertise, but data and economics often reveal insights – many of which are counterintuitive – that we might not have appreciated otherwise and that allow us to challenge, in fruitful ways, our presuppositions and inclinations. For example, new insights can inform the agency’s rulemaking agenda by highlighting unidentified areas of concern or, alternatively, assuaging suspicions that otherwise might have prompted regulation. Economic studies – whether they are empirical or theoretical – also can assist in revealing the potential impact of regulatory change over time, as parties act and react dynamically before the marketplace reaches equilibrium. In short, data and economics have a way of disciplining decision making so that we make better, more informed choices in discharging our regulatory duties.
The report prepared by the SEC and CFTC staffs on the May 6 “flash crash” exemplifies how the careful study of data can – and should – guide us as regulators.
Third, the SEC should exercise the choice and discretion we are permitted under Dodd-Frank to fashion a more incremental approach to regulatory reform, in contrast to initiating a more far-reaching set of regulations. Proceeding with such caution – namely, taking some regulatory steps now while deferring others until we can assess how the private sector has adjusted – allows for a more efficient and better calibrated regulatory regime to develop over time, having been grounded in the learning of experience and our consideration of the market’s adaptations. An appreciable measure of regulatory restraint – as manifested in a regulatory structure that is flexible enough to permit innovation and accommodate the forces of competition and market discipline – can be particularly prudent when regulators are exercising new authority and when the impact on private sector conduct and marketplace dynamics of extending the regulatory regime is highly contingent and indeterminate.
This brings to mind the new regulatory framework that the SEC is fashioning for security-based swaps under Dodd-Frank. Take, for example, the rules the Commission proposed in February for registering and regulating security-based swap execution facilities (SB SEFs).27 Dodd-Frank contemplates a new type of trading venue – security-based swap execution facilities – where parties will be able to transact in security-based swaps as an alternative to transacting in the over-the-counter derivatives market or on a national securities exchange. So-called Regulation SB SEF would impose an extensive regulatory construct on SB SEFs. Regulation SB SEF addresses, among other things, manipulation; trading and trade processing; the financial integrity of transactions; the publication of trading information; antitrust considerations; conflicts of interest; system safeguards; and an SB SEF’s financial, operational, and managerial resources. One of my concerns is that these obligations, if imposed on SB SEFs as proposed, could erect undue regulatory barriers to entry. Accordingly, it is important to ask whether certain of the new regulatory requirements should be phased-in incrementally – such as over time or based on the volume of transactions that occur on an SB SEF – so as not to unduly discourage entry by potential SB SEFs at the expense of innovation and competition. A similar question could be asked of other SEC initiatives too.
Once the rules have been adopted, whatever their substance may be, market participants will need to evaluate their business and investment options in light of the new regulation; structure their operations and activities accordingly; and develop and implement the systems, procedures, policies, and controls they will need to comply with the new regulatory regime. This will take time. Thus, we need to be realistic about how quickly after being adopted the new rules should become effective.
To me, all of this is to say that we must approach our regulatory responsibilities with humility to ensure that we succeed in striking appropriate balances among diverse interests and competing considerations when we exercise the choice and discretion Dodd-Frank entrusts to us as regulators. We need to guard against being overconfident that we have crafted well-calibrated regulatory regimes that will do more good than harm. It helps to recognize that many core features of securities regulation have taken time to mature without the Commission trying to do too much too fast.
Speaking of doing too much too fast, let me say a few words about the deadlines Dodd-Frank sets for the Commission. Many of the rulemakings Dodd-Frank charges the agency with are to be completed by mid-July of this year according to the statute. Trying to do so much so quickly is fraught with risk.
Administrative agencies like the SEC are built on their expertise.28 The practice of the Commission as an “expert agency” is bolstered by its very structure: five Commissioners, no more than three of whom may be from the same political party. The wisdom of this structure is the promise that as five unique perspectives contribute to the Commission’s decisions, the dynamic will produce a better regulatory regime – one that incorporates a wider range of informed viewpoints, insights, and judgments.
The agency’s expertise, however, is not self-executing. The Commission is best equipped to exercise its expertise in overseeing our securities markets and to draw upon its members’ diverse views and experiences when the agency has good information and when we are afforded room to thoughtfully digest the information we have. This requires time and careful attention.
Accordingly, to deliver policies that work, we cannot rush our rulemakings under Dodd-Frank. Our paramount responsibility is to get the rules right. Nobody should be satisfied if the rulemaking deadlines under Dodd-Frank are met but the resulting regulatory regime does more harm than good.
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I want to conclude with three policy considerations that I hope will influence the choices we make as we continue determining the scope and nature of financial regulation. These considerations fix guideposts that must shape the regulatory regime for our policies to be as effective as they can be; they are not limited to the implementation of Dodd-Frank.
First, because legal uncertainty discourages investment, the U.S. regulatory regime must be predictable. Private sector transacting and enterprise – including business investment and capital formation – are frustrated when regulatory frameworks become unpredictable. This is so whether the uncertainty is because a doctrine or rule is applied inconsistently or because a doctrine or rule is expected to change but in an unknown way. Parties need to know what the rules of the road are; they need to have well-founded confidence that the rules will not shift beneath their feet; and they need a sound basis to trust that the contracts they enter into will be respected and not unsettled by regulators or other government officials who assert themselves after-the-fact to pick “winners” and “losers.”
Second, we need to ensure that the regulatory regime does not compromise the international competitiveness of U.S. financial markets. Capital and labor are mobile. Capital moves especially freely without regard to geographic boundaries. It takes little for capital flows and transactions to be redirected from one jurisdiction to another.
The U.S. has long played a leading role in the world of finance, but other countries have taken – and will continue to take – noticeable steps to present competing financial centers. As financial markets around the world continue to develop and innovate, and as transactions and securities offerings increasingly occur across borders and in other countries, the U.S. must continually reevaluate its regulatory framework to ensure that our competitive lead in the global financial marketplace is maintained. Indeed, it may be preferable to subject certain activity to less regulation in the U.S. and have the activity occur in the U.S. than to impose regulatory strictures and demands that spur the activity to migrate to other jurisdictions.
My regard for U.S. competitiveness is part and parcel of my concern that the regulations implementing Dodd-Frank will prove to be overly burdensome and prescriptive. The U.S. is far along in revamping our financial regulatory framework, outpacing other countries in key respects. One often associates moving first with having an advantage. Yet when it comes to regulating the financial system, there is a risk that if the U.S. regulatory regime is too restrictive, moving first could be particularly disadvantageous for U.S. markets. The U.S., by putting significant new features of its regulatory framework in place first, may be disadvantaged as compared to other jurisdictions that can benchmark against the U.S. regime to offer a regulatory system that proves to be more conducive to the business of investment and finance. One way to mitigate this prospect is for the U.S. regulatory regime to ensure that market participants are afforded an appropriate degree of flexibility and choice in running their enterprises and in transacting.29
Third, small business must be promoted. Startups and maturing enterprises drive innovation, provide opportunities for investors to earn higher returns and accumulate wealth, and spur job creation. Companies that today are household names can trace their origins to entrepreneurs and innovators of earlier periods who had the wherewithal and backing to start and grow a business.
In providing our economy with cutting-edge goods and services, new and smaller companies in turn pressure more established firms to run themselves more effectively. The market discipline of competition, in other words, holds larger incumbent enterprises accountable. Not only do we benefit from the range of innovative products, productivity gains, and new jobs that small businesses offer, but we benefit because larger firms must be even more responsive to the demands of stakeholders to remain competitive.
This is only part of the picture, however. Smaller companies also face distinct challenges and hurdles, some of which are rooted in regulatory requirements that can unduly burden small business. In short, the disproportionate strain of regulation on small business can create a barrier to entry or expansion.
The practical challenge for the SEC, therefore, is to draw appropriate regulatory lines – such as between smaller and larger firms – and to scale regulatory demands accordingly to guard against overburdening enterprises that do not present the kinds of concerns that, on balance, may warrant more costly regulation. Put differently, we should reject a one-size-fits-all regulatory approach when possible in favor of calibrating the securities law regime to ensure that small business is encouraged, not hampered.
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I want to conclude with one final thought: As lawmakers, we must acknowledge that just because markets operate imperfectly, it does not follow that the government has effective answers. Government operates imperfectly too, and we need to recognize that regulation sometimes delivers more problems than it solves.
Thank you.
Endnotes
1 See http://sec.gov/rules/proposed/2011/ia-3145.pdf.
2 See http://sec.gov/rules/proposed/2011/34-63825.pdf.
3 See http://sec.gov/rules/proposed/2011/33-9186.pdf; http://sec.gov/rules/proposed/2011/33-9193.pdf.
4 See http://sec.gov/rules/proposed/2011/34-64017.pdf.
5 See http://sec.gov/news/press/2011/2011-57.htm.
6 See http://sec.gov/rules/final/2011/33-9175.pdf; http://sec.gov/rules/final/2011/33-9176.pdf.
7 See http://sec.gov/rules/proposed/2010/34-63576.pdf.
8 See http://sec.gov/rules/final/2011/33-9178.pdf.
9 See http://www.sec.gov/rules/final/2010/34-61595.pdf.
10 See http://www.sec.gov/rules/final/2010/33-9136.pdf. But see http://www.sec.gov/rules/other/2010/33-9149.pdf (Commission order granting stay of final rules pending resolution of judicial challenge).
11 See http://www.sec.gov/rules/final/2009/33-9089.pdf.
12 See http://www.sec.gov/rules/final/2010/ic-29132.pdf.
13 See http://sec.gov/rules/final/2009/34-59342.pdf; http://sec.gov/rules/final/2009/34-61050.pdf; http://sec.gov/rules/proposed/2009/34-61051.pdf.
14 See http://sec.gov/rules/final/2010/34-62184a.pdf.
15 See http://sec.gov/rules/final/2009/ia-2968.pdf.
16 See http://sec.gov/rules/final/2010/ia-3060.pdf.
17 See http://sec.gov/rules/proposed/2010/33-9117.pdf.
18 See http://sec.gov/rules/proposed/2010/33-9126.pdf.
19 See http://sec.gov/rules/proposed/2010/34-61379.pdf.
20 See http://sec.gov/rules/proposed/2010/33-9128.pdf.
21 See http://sec.gov/rules/proposed/2009/34-60997.pdf.
22 See http://sec.gov/news/press/2010/2010-98.htm; http://sec.gov/news/press/2010/2010-167.htm.
23 See http://sec.gov/news/press/2010/2010-216.htm.
24 See http://sec.gov/rules/concept/2010/34-61358.pdf.
25 See http://sec.gov/rules/concept/2010/34-62495.pdf.
26 See also Troy A. Paredes, Commissioner, U.S. Securities & Exchange Commission, Remarks at “The SEC Speaks in 2009” (Feb. 6, 2009), available at http://sec.gov/news/speech/2009/spch020609tap.htm (discussing the role of cost-benefit analysis in regulatory decision making).
27 See http://sec.gov/rules/proposed/2011/34-63825.pdf.
28 See generally Stephen Breyer, Breaking the Vicious Circle: Toward Effective Risk Regulation (1993); James M. Landis, The Administrative Process (1938).
29 The Commission’s recently-proposed Regulation SB SEF offers an example. Under Dodd-Frank, certain security-based swaps must be traded on a security-based swap execution facility or national securities exchange. In offering an interpretation of what constitutes an SB SEF, the Commission underscored the value of investor choice. The Commission proposed to allow a party, when transacting on an SB SEF, to select its counterparty by sending its request for quote (RFQ) to one dealer without having to expose the RFQ to other liquidity providers so long as the party had the ability to send its RFQ to multiple liquidity providers on the SB SEF if it preferred to. The proposed approach would accommodate investor concerns about “front running” – that pre-trade transparency about a trade may enable other market participants to exploit information about the upcoming trade to the disadvantage of the investor initiating the transaction. I look forward to considering commenters’ views on the proposal.
http://www.sec.gov/news/speech/2011/spch030811tap.htm
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