Rulemaking is one of the key roles of the U.S. Securities and Exchange Commission (SEC). It was, therefore, a blow to the SEC when a federal appeals court vacated the SEC’s proxy access rule in late 2011 for failing to conduct adequate economic analysis. Since the ruling, the SEC has taken steps to enhance the role of economic analysis in rulemaking, making it a prerequisite for any policy decision.
Daniel M. Gallagher, a current SEC Commissioner, and Craig M. Lewis, former Chief Economist and Director of the Division of Economic and Risk Analysis (DERA), spoke last spring about economic analysis in SEC’s rulemaking at a lecture at the Wharton School.
Commissioner Gallagher began the lecture by introducing the status of rulemaking in the SEC. In response to the financial crisis, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act, which mandated roughly 400 rulemakings, of which the SEC was responsible for creating about 100 new rules. Separately, the Jumpstart Our Business Startups Act (JOBS Act) gave the SEC some additional rulemaking mandates.
Beyond the sheer number of rules it must make, the SEC faces another a problem: getting sued. Since 2005, businesses and other interest groups have sued the SEC six times over issues related to its rulemaking, and the Commission has lost all six cases. Of all these legal setbacks, the loss of the proxy access rule case in the D.C. Circuit was particularly significant to the SEC because the court rejected the agency’s economic analysis – a key component not only of the proxy access rule, but of any future SEC rulemaking.
Lewis explained the framework of economic analysis in the SEC. Several statutory provisions require the SEC to consider economic factors in its rulemaking. For example, the Administrative Procedure Act expects a governmental agency to provide sound analysis to support its rules. In addition, the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company of 1940 require the SEC to “consider efficiency, competition, and capital formation” in rulemaking.
Under these provisions, the SEC had conducted economic analysis of rules before the D.C. Circuit’s decision in the proxy access case – but often the Commission did so only after it had made its policy choices. The court decision has spurred the SEC to start conducting economic analysis at an earlier stage – prior to policy choices.
The SEC has expanded DERA, which was established in 2009. Around June 2011, DERA had 45 staff members, of which 20 were economists. To keep up with increased demand for economic analysis, DERA doubled its staff by early 2014 and expects to expand by another 50% by the end of the year.
The main role of DERA is to analyze the economic impact of policies and rules to support rulemaking. The SEC’s “Guidance on Economic Analysis” describes the general role of economic analysis in the rulemaking process. Almost all securities regulations are corrective actions when the market cannot provide an efficient solution. Therefore, the first step of economic analysis in rulemaking is identifying what the market failure is and how to fix it.
Next, the SEC must understand the current state of the market to analyze a proposed rule’s costs and benefits. The SEC then considers possible policy choices and chooses one that is economically efficient. All rules impose costs; thus, a rule’s benefits must justify these costs. Moreover, before promulgating a rule, the SEC must consider reasonable alternatives and analyze costs and benefits associated with those alternatives.
Lewis further explained the role of economic analysis in creating a new rule on money market funds, which the SEC recently adopted. When Lehman Brothers went bankrupt in September 2008, the value of a particular fund dropped significantly due to the write-off of Lehman Brothers’ commercial paper. This caused a run on money market funds as investors rushed to sell primary money market funds.
By examining the mechanism of fund and investor behavior during the crisis, the SEC’s analysts have pointed out that certain features of money market funds prompt investors to redeem their funds when the market value of underlying assets decreases. Before it recently changed its rules, the SEC allowed investment companies to compute the net asset value (NAV) of money market funds by rounding so that funds could maintain a NAV of $1.00 per share, so long as the market value of underlying assets was within one-half penny of $1.00. Such rounding apparently enabled investors to purchase and sell money market funds at $1.00 per a share even when the market value of underlying assets fluctuated. If some investors redeem their fund holdings at $1.00 per share when the market value is less than $1.00, the remaining investors have to bear the loss. Thus, investors may have incentive to sell their holdings to avoid a loss.
In addition, certain types of securities, including commercial paper, are difficult to liquidate due to the lack of a secondary market. Therefore, when investors redeem a large amount of their investments, money market funds might have to sell their assets at a discount to obtain liquidity. This could accelerate the redemption of primary money market funds in a stressed market.
Based on its economic analysis, the SEC proposed three options to address the issue:
Option A: Floating NAV – forcing primary money market funds to value at the market value.
Option B: Liquidity fees and redemption restriction – enabling money market funds to impose liquidity fees and suspend redemption when they face large-scale redemption.
Option C: A combination of A and B.
The SEC has indicated that a floating NAV will reduce the incentive for investors to sell their holdings quickly to avoid a loss. A floating NAV may also enable investors to watch the market value of money market funds, thus increasing the transparency of these funds. Additionally, liquidity fees and a redemption restriction would reduce the loss of redemption.
The SEC has also analyzed capital buffers as an alternative. After conducting its economic analysis, however, the SEC decided not to propose capital buffers because money market funds need sponsors to provide capital for a certain cost to obtain capital buffers. Taking the cost into account, the agency concluded that capital buffers would make the risk and return of primary money market funds similar to Treasury money market funds, which are virtually risk free. Capital buffers, therefore, disguise the utility of primary money market funds.
In response to questions from the audience, Gallagher and Lewis touched upon the SEC’s fight against misconduct in the financial market and the Commission’s use of risk analysis in investigating potential wrongdoings. The Commissioner, while emphasizing the SEC’s determination to combat fraud, was candid about the SEC’s resource constraints relative to the number of actors with the potential for misconduct.
Lewis added that, to increase the efficiency of investigations, the SEC is trying to use risk analysis, another function of the office of economic research. The SEC has a significant amount of data, such as market transaction records and filing documents. By analyzing this data, the SEC hopes to be able to narrow down investigation targets in a more efficient manner. For example, the SEC has developed a performance analysis model that aims to identify certain patterns of hedge fund performance that possibly imply fraudulent activities. The model has already apparently helped detect nine fraud cases.
Another example discussed was an analytical tool to identify accounting fraud. Lewis mentioned that by analyzing certain features of financial statements, the SEC could identify a pool of companies that have a higher possibility of misstatement. For instance, an empirical study suggested that fraudulent firms tend to over-disclose cash and complexity and under-disclose risks. Lewis suggested that investigating those companies that met certain criteria will allow the SEC to ferret out accounting fraud more efficiently.