Speech by SEC Commissioner:
"Observations of an Economist Commissioner on Leaving the SEC"
Cynthia A. Glassman
U.S. Securities and Exchange Commission
National Economists Club
July 6, 2006
Thank you, Anne, for your kind words. As my days at the SEC draw to a close, I can think of no more fitting place to sum up my thoughts and experiences over the past four and one-half years than the National Economists Club. Being an economist in a Commission full of lawyers was a defining experience for me, and of all people, you in this group will understand what I mean. Leaving the Commission is bittersweet. I'm looking forward to some interesting opportunities (and having the summer off in the meantime), but I will miss dealing with the challenging issues we face at the Commission and, of course, the people. One thing I won't miss and this is probably the last time I'll ever have to say it is our standard disclaimer. The thoughts I express today are my own and do not reflect those of the Commission, my fellow Commissioners or our staff.
In one of my earliest speeches as a Commissioner, given in 2002, I gave SEC watchers a summary of my philosophy and regulatory goals. As you would expect from an economist, I stated that we should let markets work freely where possible, that a free market philosophy requires a free flow of information, and that our financial disclosure system should be designed or redesigned to reflect economic reality. I also talked about the use of incentives to achieve appropriate behavior, on both the individual and corporate level, and the need for greater emphasis on investor education.
In working toward these goals over the last four years, I have tried to instill more economic analysis into the Commission's rulemaking and enforcement initiatives and to show the value of empirical data in framing rules designed to protect investors and maintain the integrity of the markets in the most efficient, effective way. The Commission and the staff predominantly lawyers have not always been as receptive to this approach as I would like, but I believe I've made some inroads that future economist commissioners and our own Office of Economic Analysis will be in a position to build on. I am encouraged that, during my tenure, OEA has reorganized, adding a new layer of management and staff liaisons to enhance the office's relationship with the operating divisions enforcement, market regulation, investment management and corporation finance. This has led to an expanded OEA presence at the Commission.
Among other things, OEA played an important role in the development of our corporate penalty guidelines, and its analysis has been helpful to the Commission in what has proven to be the very difficult task of applying the guidelines in particular enforcement cases. OEA's analysis of the extent of the benefit that a company might have derived from fraudulent conduct or the degree to which shareholders have been harmed by the conduct and how to measure these factors has informed my thinking. OEA has also helped the Commission deal with issues relating to the distribution of disgorgement and penalty amounts to shareholders through so-called Fair Funds. In the market regulation area, OEA has been instrumental in designing the short sale pilot program and will have an important role to play in the anticipated options penny pilot. In the corporate finance area, OEA helped formulate the threshold for the "well-known seasoned issuer" or WKSI concept in the Securities Act Reform initiative, and has done extensive analysis on the foreign issuer deregistration proposal. In the aftermath of Sarbanes-Oxley, foreign registrants became increasingly vocal on the difficulty of deregistering their shares. Our initial proposal to liberalize the deregistration requirements received less than favorable comment from the foreign issuer community because it appeared that relatively few foreign registrants would be able to take advantage of the relaxed requirements. OEA is working to provide additional analysis as we refine our proposal.
In addition to advocating for higher visibility for OEA in particular matters, I would like to think I have had a hand in raising the profile of economic analysis at the Commission. Along the way, I've had some help in this effort from the D.C. Circuit which has twice rebuked the Commission in the past year for failing to conduct a proper cost analysis. Overall, however, I believe that we are beginning to produce more robust cost-benefit analyses and exhibiting increased sophistication both in the description of the economic impact of our actions and in the level of arguments based on economic analysis. I know that Chairman Cox is committed to having a thorough economic analysis done of the effects of proposed rules. It is a constant struggle, however, to keep economic analysis from being used to justify a preconceived result, rather than to find out the economic implications of a rule or rule proposal before a decision is made regarding whether and what to propose. Let me give you a few examples.
In the aftermath of the mutual fund scandals, the Commission brought numerous enforcement actions against mutual funds and investment advisers for facilitating late trading and market timing, and considered a number of rulemaking initiatives to prevent fraud on shareholders. One initiative was a mutual fund governance proposal requiring funds to have at least 75% independent directors and an independent chair. In analyzing this proposal, I asked the questions I always ask about a rule proposal. What are the objectives of the rule? Will the rule meet the objectives? Does it go far enough or does it go too far? Does it meet the spirit as well as the letter of the law? Does it make sense? Are there likely to be unintended consequences? Are the costs commensurate with the benefits? Does it create unrealistic expectations? What are the regulatory alternatives? The answers to these questions help me determine whether a proposed rule will be appropriate, effective and efficient.
For this particular proposal, the key for me was information on how the performance of funds with inside chairmen compared to funds with independent chairmen. When I voted to approve publishing the proposal for comment, I stated that, without credible evidence that a specific board structure makes a difference to the outcomes that are important to investors, i.e., performance, cost, and the absence of self-dealing or other types of fraud, we would not be solving the problem of complacent boards of directors. To make a long story short, the data I needed to evaluate the rule proposal did not materialize. In the absence of any empirical support for the proposition that more independent directors and an independent chair would lead to better fund outcomes for investors, I dissented from the adoption of the rule. Rather than assume that more independent directors necessarily leads to governance that is better for shareholders, I wanted proof of a need for regulatory action and likely results of an action before interfering with the markets. What does independence mean? It should mean independence of thought and action, which is not necessarily guaranteed by having a higher number of outside directors. Just because you are deemed independent doesn't make it so.
In the litigation that followed, the U.S. Chamber of Commerce challenged the rule on two grounds. The Chamber alleged that the record did not contain an examination of all of the costs that the rule would impose in requiring the restructuring of fund boards, the designation of an independent chair, and the hiring of staff for the independent chair, to name just a few. The Chamber also alleged that the Commission failed to consider less invasive alternatives to achieve its goals. The D.C. Circuit's most recent ruling in the case required the Commission, to the extent that it wished to pursue rulemaking, to do the empirical homework it should have done in the first place. We have in the last month republished the proposal for comment, with explicit and broad request for comment on costs, regulatory alternatives, and any other relevant issues.
Another example of a rulemaking that went off track because of the lack of rigorous thinking and empirical support was the hedge fund adviser registration requirement. The initial staff study of the hedge fund industry was not an analytical one. The study was simply descriptive of the current state, and made no compelling findings to justify the burden of registration and examination requirements for hedge fund advisers. Enforcement actions for hedge fund fraud were relatively few in number, compared to the number of enforcement cases as a whole, and no convincing evidence was produced to support the study's claim of the "retailization" of hedge funds. Nonetheless, the study was used to support the need for a registration requirement for hedge fund advisers. This time, I dissented at the proposing stage as well as the adopting stage. Overall, insufficient thought was given to exactly what information the Commission needed about hedge funds and how we would use it. I thought we needed to do a rigorous study to determine the type of information needed to enable relevant, ongoing analysis.
As an alternative, based on comments we received, I suggested a notice and filing requirement that would have given us a census of existing hedge funds and useful information about them once we figured out what that information should be. What we ended up with was a limited census (the rule as adopted exempted advisers of hedge funds that had two-year lockups or that had fewer than 15 U.S. investors) and also information of limited usefulness on the investment adviser registration form.
Three weeks ago, the D.C. Circuit struck down the hedge fund rule. The basis of the court's ruling was that the Commission could not re-interpret the term "client" in the manner it did to gain jurisdiction over hedge funds. In a departure from the Commission's traditional interpretation of the term, the rule treated the investor in a hedge fund as the advisory "client," rather than the hedge fund itself.
Given the court rulings, it is unfortunate that we wasted so much time and effort on these two rules. Our time (and the time, effort and money of market participants) would have been better spent doing a more rigorous analysis of the many real issues we face and the most efficient and effective ways to resolve them. We could, for example, have devoted more attention to simplifying and rationalizing our rules and focusing on major issues such as auditor concentration in the accounting profession, similar products and services offered under different regulatory regimes, and exchange regulation on a global basis.
I believe that my most important contributions to the work of the SEC has been in instances in which I have thought "outside the box" of Commission precedent. Lawyers seem to focus on what the legal precedents are and what our authority is to take action. Economists, on the other hand at least this economist focus on what we are trying to accomplish and what the best way is to accomplish it. The two approaches are not mutually exclusive, but I do think that the way economists look at a problem is often better than the legal approach in getting to an appropriate solution.
Look, for example, at our point of sale proposal. In the context of the mutual fund scandals and revelations of revenue-sharing arrangements between fund complexes and broker-dealers, the Commission addressed the need for better disclosure of the potential conflicts of interest between brokers and their customers with respect to compensation. Although surveys show that customers generally believe that brokers act in their best interest, our enforcement actions demonstrate that brokers can be influenced by the way their compensation is structured. The higher the pay-out a broker receives for selling a particular product, the more likely it is that the higher pay-out will affect his or her recommendations to customers, even to the extent of making recommendations that may not be suitable for the customer.
Our traditional approach to this issue was to propose enhanced disclosure of the conflicts on the confirmation notice. Adding more conflict disclosure to the confirmation of the trade was a good idea, but since customers don't receive the confirmation until a few days after they've made their investment decision, my reaction was that the information should be provided to the customer at the "point of sale" when the information would be the most useful. This appears to have been a new concept as far as I know, we had never required a point of sale document before!
Our staff then came up with a disclosure form that we thought contained useful information on how brokers are compensated for selling mutual fund shares, variable annuities and college savings plans. Then we tried out another new idea of mine. We tested the proposed form with some investor focus groups to assess whether our form was helpful or not. It turned out that the language our lawyers thought was clear and concise was anything but. This brings up another lesson, which is the importance of getting input from investors when you're working on an investor disclosure form. At this point, the form has been substantially revised based on the input from investors, and I hope that the Commission will eventually adopt a rule mandating its use.
Another initiative that I have championed relates to the similarity of financial products and services governed by different regulatory regimes broker-dealer regulation under the Securities Exchange Act of 1934 and investment adviser regulation under the Investment Advisers Act of 1940. The blurring of the lines among financial services products and providers has resulted, among other things, in investor confusion about the legal standards that attach to their brokers and advisers. At my initiative, the Commission has committed to conducting a study of the current situation the products and services currently being offered by the various financial service providers, and retail investors' expectations with respect to the products they are offered and the legal obligations of the providers. This is a very important study, and I have worked hard to develop the description of the key elements of the study and get it structured. Last Friday, we published a draft contract proposal in preparation for a major study comparing how the different regulatory systems that apply to broker-dealers and investment advisers affect individual investors. For those of you interested, I urge you to check our website for more information.
As I look back on my experience on the Commission, I find that most of the beliefs I had when I started the job have been confirmed. First, the market can be a force for good. The power of competition and the market's capacity for innovation cannot be overestimated. Our rules work best when they harness the market's competitive forces and align those forces with investors' interests.
Second, the regulator's role should be to set the standards, let markets and market participants compete on the basis of those standards, and take enforcement action when the standards are not met, commensurate with the violations. We should guard against attempts to micromanage through regulation, staff action or enforcement precedent. Regulatory bottlenecks for the approval of new market participants, new market practices and new products have anti-competitive implications that limit investor choice.
Third, rules should be clear and objective and attempt to accomplish their goals in a cost-effective manner with minimum disruption to markets. Empirical evidence often helps in formulating good rules.
Fourth, we need to improve our timeliness. Too many of the Commission's projects take too long. While rulemaking, enforcement actions, examinations, inspections and processing of exemptive applications are working their way through the Commission, peoples' lives and businesses are at stake. One of my and former Chairman Pitt's early goals was to undertake a comprehensive review of the overall structure of the securities laws and regulations to ensure that an approach conceived in the 1930s is still relevant and efficient today. I still think this is an important endeavor, and with the experience I've gained since then, I would expand the review to include the Commission's processes. We need to find ways to speed things up.
In conclusion, my parting words as an economist Commissioner to all economists who take an interest in the Commission's actions are actually a request. That request is, please comment on our proposals and focus especially on whether the problem has been clearly defined, whether the proposed solution will actually help fix the problem, whether the benefits justify the costs, and whether a market solution or an alternative regulatory solution would be preferable. As wonderful and professional as the staff and my colleagues at the Commission are, the regulation of our securities markets and the protection of our investors demand solutions that are economically as well as legally sound. It has been an honor and a privilege and, admittedly, a challenge for me to bring the economic perspective to the Commission, and I hope that the tradition will continue with perhaps more economist Commissioners in the future.
Thank you, and I'd be happy to take your questions.