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Investor Protection Through Economic Analysis

Craig M. Lewis

Chief Economist and Director
Division of Risk, Strategy, and Financial Innovation
U.S. Securities and Exchange Commission

Speech at the Pennsylvania Association of, Public Employee Retirement Systems Annual Spring Forum, Harrisburg, PA

May 23, 2013

Thank you so much for inviting me here to speak with you. Before I begin my remarks, I must make clear that the views I express today are mine alone and do not necessarily reflect the views of the Commission or of my colleagues on the Commission Staff.1

The mission of the SEC is both straightforward and broad: To protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Though none of these objectives exists in isolation-and indeed, they interact and reinforce each other-today I thought I would focus on our primary mission of protecting investors. Specifically, I would like to discuss the role of economic analysis in furthering the Commission's mission to protect investors and how the public can help the Commission craft regulations that effectively accomplish that goal.

Economic Analysis in Support of Commission Rulemaking

The Division of Risk, Strategy, and Financial Innovation (or "RSFI") supports the Commission in a variety of ways, but the one that perhaps most directly impacts the investing public is the Division's role in providing economic analysis in support of Commission rulemaking. And I believe that the economic analysis provided by RSFI is one of the essential elements of how the Commission works to fulfill its mission to protect investors.

First, some background. What do I mean when I keep saying "economic analysis in support of rulemaking"? For those of you that are unfamiliar with the Commission's rulemaking process, or RSFI's particular role in it, when the Commission proposes and adopts rules, it typically analyzes the economic effects of those rules. That analysis is then included in the public releases that the Commission issues when it proposes or adopts a rule. In general, the economic analysis contained in rulemakings considers the potential economic consequences of the SEC's policy choices and examines the effect of those choices on the market.

One clear goal of economic analysis is to ensure that the Commission, when making its regulatory choices, is informed of the potential market impacts of those choices. But as I've noted, the economic analysis is included in a release that is shared with the public, thus allowing stakeholders to understand-and in the case of a rule proposal, comment upon-the economic bases for the Commission's decisions. Indeed, when the Commission proposes rules for public comment, it often asks many specific questions intended to solicit information related to the potential economic effects and any reasonable alternative regulatory approaches. In these questions, the Commission often seeks data that can further help evaluate the economic effects of its proposed rules. The staff and the Commission will evaluate these comments and consider them when deciding what rule to adopt.

The Commission also has recently published guidance on how it conducts economic analysis in support of rulemaking. In March of last year, RSFI and the Office of the General Counsel circulated to the rulewriting Divisions and Offices a document that provides guidance on how the Staff should approach economic analysis. Colloquially referred to as "The Guidance" within the Commission, it lays out four basic elements of an economic analysis. Specifically, a robust economic analysis should contain the following elements: (1) an identification of the justification for the regulatory action; (2) a definition of the baseline against which to measure the economic effects of that regulatory action-in other words, the current state of the world without the regulation; (3) an identification of reasonable alternative regulatory approaches; and, (4) an evaluation of the economic consequences of the proposed rule and the principal regulatory alternatives, including an evaluation of the benefits and costs. I want to emphasize that our approach to economic analysis treats cost benefit analysis as only one aspect of the four elements rather than as a stand-alone approach to evaluating the economic effects of a rule.

I believe these four basic elements of a robust economic analysis all lend themselves to furthering the Commission's mission to protect investors. Indeed, as I will explain later-after I let the suspense build-I think each element adds a unique dimension to the Commission's consideration of investor protection.

Economic Analysis and Investor Protection

Now, I am not a lawyer, so I will not weigh in on the specific legal requirements governing Commission rulemaking, but, in general, Congress has required that in many rulemakings the Commission must consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.

It may be easy to see how the economic analysis provided by RSFI assists the Commission in considering whether an action will promote efficiency, competition, and capital formation; these are fundamental concepts-at least for economists-that can be analyzed, evaluated, and in some cases quantified. But, as I hope to explain, the Commission's approach to economic analysis also can play a vital role in fulfilling our mission to protect investors.

It is important to note at the outset that there is no clear line between considerations of efficiency, competition, and capital formation, and considerations of the protection of investors. I believe the Commission's consideration of efficiency, competition, and capital formation is important to the consideration of investor protection. Indeed, rules that ensure efficient and competitive markets often go a long way to ensuring that investors are protected. If rules create inefficiency or hamper competition, there may be more incentives or opportunities for market participants to engage in fraud or for certain firms to take advantage of investors. But if markets are operating in a way that maximizes efficiency, competition, and capital formation, many of these same vulnerabilities may not exist.

In any event, I think the Commission's approach to economic analysis provides a helpful framework that can facilitate and expand upon considerations of investor protection. And this is where the four elements of a robust economic analysis come in.

As I mentioned, the first step in conducting an economic analysis is identifying the justification for the regulatory action-in short, why the rule is needed. Sometimes, the need for regulatory action is a market failure that requires the Commission's intervention. In other cases, the Commission needs to engage in rulemaking because Congress has required it to adopt rules on a particular topic. And, importantly, the justification for a particular rulemaking also can be related to investor protection.

For example, if the Commission believes that investors are vulnerable because of emerging market practices, or if it believes that new disclosures are necessary to provide additional protection to investors, these justifications could serve as the basis for rulemaking. The economic analysis would explain why investors are vulnerable and why a particular rulemaking would help address that vulnerability. This explanation would help provide a clear picture of Commission views about needed investor protections and would allow the public, including investors, to contribute to the decision-making process.

Second, after we determine why a regulation is needed, we need to develop a full understanding of the current state of the world in the absence of that regulation, or as we economists like to say, we define the baseline. This is a critical step because the baseline serves as the benchmark against which to measure the potential economic effects of the rule. An important aspect of the baseline discussion is that it provides the public with insight into how the Commission views the world as it exists without the proposed regulation. Thus, the baseline in an economic analysis is an important tool to explain, if relevant, what investor protections exist and how markets currently operate. The public can then understand, and comment on, the Commission's views to help ensure that the Commission is aware of areas where investors believe additional protections are needed.

Third, an economic analysis also identifies potential reasonable alternative regulatory approaches to achieve the goal we have identified. Again, this step in the economic analysis can help ensure that the Commission is able to fulfill its mission to protect investors. For example, by identifying and evaluating potential alternatives, the Commission has the opportunity to grapple with varying approaches to regulation, some of which may produce greater investor protection benefits than others.

Finally, the Commission's economic analysis generally considers the economic consequences of the regulatory action at issue, including the benefits and costs. Often this element of the economic analysis can provide the most thorough discussion of investor protection.

Typically, provisions of a regulation that further investor protection provide benefits that the Commission can describe. For example, if the Commission believes that certain disclosure provisions will provide protection to investors, it will explain the nature of this benefit. Then, the Commission can transparently evaluate how this investor protection benefit compares to any associated costs. But in certain rulemakings, issues related to investor protection also may show up on the other side of the ledger as a cost. For instance, if the Commission is evaluating a regulatory approach that provides less investor protection than an alternative proposed by a commenter, the Commission may consider the potential decrease in investor protection as a cost of the regulatory approach. Regardless of where the discussion of investor protection shows up, what is important is that an economic analysis allows the Commission to clearly spell out benefits and costs related to investor protection so that the public can understand, and comment on, the Commission's chosen approach.

I think it is important to note, however, that analyzing the benefits and costs of a proposed regulation can be complicated and nuanced, especially considering that not all benefits and costs can be quantified. For instance, the Commission can sometimes quantify the number of entities that will be affected by a proposed rule and perhaps assign a dollar cost to the compliance burden that a new regulatory approach will impose on those entities. But, with regard to investor protection, the Commission is often unable to reasonably quantify the related benefits or costs for numerous reasons. For example, the Commission may lack data necessary to quantify the benefits or costs with precision, or uncertainty about how investors or other market participants will react to regulatory changes may hinder precise quantification. Additionally, as a more concrete example that is relevant to many of the Dodd-Frank related rules designed to reduce systemic risk, it may not be possible to calculate the degree of reduction in systemic risk that can be attributed to a specific rulemaking.

Because it is not always possible to quantify important investor protection benefits and costs, some commentators argue that economic analysis may undervalue these benefits and costs. But the approach to economic analysis I have described acknowledges that not all benefits and costs can be quantified, and it is designed to ensure that the evaluation is still meaningful and does not give undue importance to any one benefit or cost. Specifically, the evaluation of benefits and costs always begins with developing a general framework that is entirely qualitative. Only once this framework has been developed does the analysis progress to quantifying benefits and costs, where possible, and evaluating the benefits and costs of the proposed regulatory approach and reasonable alternatives. By first developing a broad, qualitative view of the economic benefits and costs of a proposed rule, this approach places the quantified benefits and costs into a broader context. In my view, this helps prevent any particular benefit or cost from taking on unjustified significance.

And the public can further assist the Commission in ensuring that it fully understands and gives appropriate weight to investor protection concerns by providing comments. In particular, I hope you take the opportunity to provide more information to the Commission in the rulemaking process regarding investor protection related benefits or costs of proposed rules.

Quantifying benefits and costs can be one of the most challenging aspects of economic analysis. It is not always easy for the Commission to collect helpful data, as constraints, including those related to the Paperwork Reduction Act, limit how and when the Commission can collect certain information. But these challenges can be mitigated when we receive specific comments containing data and other information that clearly document the scope of investor protection that can be attributed to the rule. And if commenters are unable to provide quantitative information, providing thorough, descriptive, qualitative information also can assist in helping us understand the potential effects on investor protection. Moreover, regardless of whether commenters are able to submit quantitative or qualitative data, it is helpful if they clearly lay out, among other things, the scope of the information they are providing, the methodology used to collect the information, any assumptions underlying the conclusions, and any other information that would assist the Commission in evaluating the information submitted in the comment.

Standards of Conduct and other Obligations of Broker-Dealers and Investment Advisers

I think recent Commission action related to standards of conduct for broker-dealers and investment advisers highlights the importance of public comment and how economic analysis assists the Commission in fulfilling its mission to protect investors.

As you may know, broker-dealers and investment advisers routinely engage in many similar activities related to providing personalized investment advice about securities to retail customers. But the two regulatory schemes that investment advisers and broker-dealers are subject to are designed to protect retail and other customers through different approaches. For example, investment advisers are fiduciaries to their clients and their regulation under the Investment Advisers Act is largely principles-based. In contrast, a broker-dealer is not uniformly considered a fiduciary to its customers and broker-dealer conduct is subject to regulation under the Securities Exchange Act and the rules of each self-regulatory organization to which the broker-dealer belongs.

In light of these differences, Congress mandated a study of the effectiveness of the existing legal or regulatory standards of care that apply when broker-dealers and investment advisers provide personalized investment advice and recommendations about securities to retail customers. In the study resulting from this Congressional requirement, the Commission staff recommended that the Commission engage in rulemaking using authority provided in the Dodd-Frank Act to adopt rules establishing a uniform fiduciary standard of conduct for all broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.

The Commission has not yet determined whether to commence a rulemaking as recommended by the Commission staff, but has recently published a release requesting information, and in particular quantitative data and economic analysis, related to the benefits and costs that could result from various alternative approaches regarding the standards of conduct and other obligations of broker-dealers and investment advisers. As the request notes, the Commission expects that this requested data and other information will assist in determining whether to engage in rulemaking, and if so, what the nature of the rulemaking ought to be.

The Commission's request for data is a prime example of how economic analysis is a key tool to further its mission to protect investors. For example, in the request the Commission is seeking information to better understand the relation between standards of conduct and the experience of retail customers, and information related to changes in the marketplace for personalized investment advice for retail customers that might occur as a result of implementing certain rules. Indeed, the Commission specifically is requesting information, data, and comment on the extent to which alternative regulatory approaches affect investor protection and confusion investors have about the standard of conduct applicable to their financial professionals when providing personalized investment advice about securities.

The data and economic analysis that the Commission receives in response to its request will be helpful as it determines whether and how to engage in rulemaking in this space. If the Commission does decide to go forward with a rulemaking, the information submitted through public comment could also assist the Commission in preparing its own economic analysis. For example, the data submitted by commenters could identify that there is a need for regulatory action related to investor protection and thus investor protection can serve as a justification for a rulemaking. Additionally, commenters could assist in informing the Commission about the current practices of retail investors and if there are particular vulnerabilities that exist in the markets. And, of course, the information that commenters may potentially submit about the benefits and costs of alternative regulatory approaches may be helpful to evaluate the potential investor protection related benefits and costs that different regulatory approaches may impose.

This request for comment also illustrates the difficulty the Commission often faces quantifying certain benefits and costs that I discussed earlier. In particular, in the request the Commission expressly recognizes that retail customers are unlikely to have significant empirical and quantitative information. But the fact that retail customers may not have significant quantitative information should not stop us from asking the questions and it does not prevent a potential economic analysis from evaluating, qualitatively, the investor protection benefits that may be highlighted by these customers. Indeed, the qualitative information provided can be vital to the Commission's understanding of the market and the effects of the Commission's regulatory decisions.

Concluding Thoughts

In conclusion, I hope I have made clear why I consider economic analysis an essential part of SEC rulemaking. It seeks to ensure that decisions to propose and adopt rules are informed by the best available information about a rule's economic consequences. And by ensuring that rulemakings are informed by information about the economic consequences of Commission action, economic analysis furthers the Commission's mission to maintain fair, orderly, and efficient markets, to facilitate capital formation, and, as I have focused on today, to protect investors.

Economic analysis in Commission rulemakings also facilitates the Commission's efforts to determine the most appropriate regulatory approach, by helping the Commission meaningfully compare a proposed action with reasonable alternatives, including the alternative of not adopting a rule. This may be the most important way that economic analysis facilitates investor protection. Indeed, in my opinion, a regulatory approach that is well-crafted and is chosen in light of the significant potential economic consequences of the regulation and competing alternatives is the best way to protect investors. Where regulations operate effectively and take into account existing economic realities, investors will not face the same vulnerabilities that may arise from a regulatory approach that ignores these economic realities.

I want to thank you again for inviting me here to speak with you today and I look forward to taking your questions.

1 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the speaker and do not necessarily reflect the views of the Commission or of the speaker's colleagues upon the staff of the Commission.

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