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Requiring SEC to Perform Economic Analyses Hinders Financial Reform

by Michael W. Stocker and Philip C. Smith
New York Law Journal |
A drastic new change to long-established rulemaking practices may signal that our increasingly partisan political process is now exerting a powerful influence on proposed rules relating to the financial markets.

 


<p class="MsoNormal">A drastic new change to long-established rulemaking practices may signal that our increasingly partisan political process is now exerting a powerful influence on proposed rules relating to the financial markets. The consequences of this shift may affect investors and the broader markets for years to come.

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<strong style="mso-bidi-font-weight:normal">Background</strong></p>

<p>Historically, rulemaking by the Securities and Exchange Commission and other independent regulators rarely attracted much interest outside policy circles. This was attributable in part to the fact that the legislative process was seen as the arena for playing out the political concerns that drive the substance of new statutes. Congress would hash out differences of opinion across the aisle, and then regulators would simply propound rules implementing legislative intent pursuant to a procedure clearly defined by statutes.

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<br />Financial regulation was no exception. The framework for the SEC&#39;s oversight of the securities markets is largely set out in the federal securities laws, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Sarbanes-Oxley Act. Congress drafted these statutes broadly, establishing their basic principles, objectives, and parameters, but leaving many details to regulators to resolve in the implementation process. In turn, the Commission&#39;s charge has been to ensure, through rulemaking, that the intent of Congress is carried out in the application of these statutes when issues would arise as the securities markets evolved technologically, expanded in size, and offered new products and services.

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<br />The judiciary has traditionally been deferential to the Commission&#39;s rulemaking. Pursuant to §706 of the Administrative Procedure Act (5 U.S.C. §706) (APA), the Commission&#39;s conclusions of law with respect to the statutes it administers are meant to be "binding in the courts unless procedurally defective, arbitrary or capricious in substance, or manifestly contrary to the statute."

<em>United States v. Mead</em>, 533 U.S. 218, 227 (2001) (citing

<em>Chevron, U.S.A. v. Natural Res. Def. Council</em>, 467 U.S. 837, 843-44 (1984)). Similarly, the Commission&#39;s findings of fact are meant to be conclusive so long as they are supported by substantial evidence. See, e.g.,

<a href="http://scholar.google.com/scholar_case?case=18260212004956528722" target="new">

<em>

<span style="color:windowtext;text-decoration:none;text-underline: none">Graham v. SEC</span>

</em>

</a>, 222 F.3d 994, 999-1000 (D.C. Cir. 2000) (applying substantial evidence standard to SEC&#39;s findings of facts); see also

<em>Time Warner Entm&#39;t v. FCC</em>, 240 F.3d 1126, 1133 (D.C. Cir. 2001) ("Substantial evidence does not require a complete factual record-we must give appropriate deference to predictive judgments that necessarily involve the expertise and experience of the agency").

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<strong style="mso-bidi-font-weight:normal">Dodd-Frank</strong>

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<br />This historical deference was shaken soon after Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, a statute intended to address the structural causes of the financial crisis of 2007 and 2008. While Dodd-Frank&#39;s reforms were warmly welcomed by the investor community, they provoked strong opposition in the financial services sector.

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<br />There can be no doubt that the statute was wide-ranging in scope. Dodd-Frank contains approximately 400 specific mandates, to be implemented by agency rulemaking, with the intent to "promote the financial stability of the United States by improving accountability and transparency in the financial system." Dodd-Frank Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010). Of these mandates, the SEC was made responsible for approximately 100.

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<br />In the view of many in the financial services industry, these hundreds of mandates represented untold hours of internal corporate compliance procedures and paperwork, restructuring and expanding corporate governance departments, and additional potentially costly reporting expenses. Having lost the argument over these burdens in the legislature, the financial industry&#39;s response was to target the Commission&#39;s rulemaking process with repeated lawsuits. The most successful of these challenges has centered on the adequacy of the SEC&#39;s "cost/benefit analysis" in its rulemaking.

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<strong>Cost/Benefit Challenge</strong>

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<br />In general terms, cost/benefit analysis is a methodology that involves the estimation, in monetary terms, of the net economic value of a given policy, and then the weighing of these benefits against the economic costs. No statute requires the Commission to conduct a formal cost/benefit analysis as part of its rulemaking activities. In fact, the Government Accountability Office (GAO) has explicitly stated to the contrary:

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<p class="block" style="margin-left:.5in">As part of the rulemaking process, federal financial regulatory agencies are required to conduct a variety of regulatory analyses, but benefit-cost analysis is not among the requirements.</p>

<p style="text-align: right">GAO-12-151 at 9 (2011).

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<p>However, since the early 1980s, the Commission has been considering potential costs and benefits as a matter of good regulatory practice whenever it adopts rules, and it has been telling Congress as much. This may be what has given the cost/benefit analysis challenge its traction.

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<strong style="mso-bidi-font-weight:normal">

<em style="mso-bidi-font-style:normal">Rule 14a-11.</em>

</strong>The landmark lawsuit attempting to make such analyses mandatory and much more detailed, at least for certain regulations issued pursuant to the Dodd-Frank Act, was brought by the Business Roundtable and Chamber of Commerce. The suit challenged the SEC&#39;s Dodd-Frank-authorized Rule 14a-11, the "proxy access" rule, intended to facilitate the effective exercise of shareholders&#39; state-law rights to nominate and elect directors to company boards of directors. Specifically, Rule 14a-11 required a company, under certain circumstances, to include in its proxy materials information about and the ability to vote for shareholders&#39; nominees for director.

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<strong style="mso-bidi-font-weight:normal">

<em style="mso-bidi-font-style:normal">Commission Analysis.</em>

</strong>The Commission determined that, by enabling nominating shareholders to include their director nominees in a company&#39;s proxy materials instead of engaging in a traditional proxy contest, Rule 14a-11 would provide shareholders direct cost savings in the form of reduced expenditures for advertising and promoting their director nominees as well as reduced printing and postage costs. In addition, the Commission determined that nominating shareholders would result in certain intangible benefits.

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<br />First, the cost savings resulting from the proposed Rule 14a-11 could mitigate "collective action" and "free-rider" problems, which can discourage an individual shareholder from exercising its state-law right to nominate and elect its own director candidates, despite the prospect of a greater aggregate benefit for all shareholders, because it alone would have to bear the costs of a traditional proxy contest.

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<br />Second, the proposed rule could address a problem encountered in a traditional proxy contest, in which shareholders might not evaluate a shareholder nominee in the same manner as management nominees due to a different, and perhaps negative, reaction to the presentation of a shareholder nominee in a separate, unfamiliar set of proxy materials.

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<br />Third, the Commission concluded that shareholders relying on Rule 14a-11 would see less need for additional soliciting efforts-such as the hiring of a proxy solicitor, public relations advisers, or advertising-if their nominees are presented alongside management nominees in a set of proxy materials with which shareholders are familiar.

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<br />Finally, by including management and shareholder nominees in one set of proxy materials, Rule 14a-11 could simplify shareholders&#39; decision-making and reduce confusion, potentially resulting in greater shareholder participation in corporate governance.

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<br />The Commission also considered the contrary possibility that Rule 14a-11 could adversely affect company and board performance, including considering various studies with conclusions that would argue against the adoption of Rule 14a-11. In addition, it considered whether the rule could result in costs from disclosures, printing and mailing, and additional solicitations.

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<br />Over a year after the rule was first proposed, and after multiple comment periods, the Commission finally adopted the rule in "Facilitating Shareholder Director Nominations," Securities Act Release No. 9136, Securities Exchange Act Release No. 62764, Investment Company Act Release No. 29384, which was published in the Federal Register at 75 Fed. Reg. 56,668 (Sept. 16, 2010).

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<strong style="mso-bidi-font-weight:normal">

<em style="mso-bidi-font-style:normal">Suit.</em>

</strong> Before the ink on the new regulation was dry, on Sept. 29, 2010, the Business Roundtable sued the SEC in the U.S. Court of Appeals for the District of Columbia, arguing that the SEC had failed to perform a sufficiently detailed economic analysis of the impact of the proposed rule. The Business Roundtable argued that the SEC&#39;s analysis was insufficient given the significance of Rule 14a-11, calling it "among the most controversial regulatory issues in the Commission&#39;s history."

<em>Business Roundtable v. SEC</em>, Petitioners Reply Brief, No. 10-1305, 2011 WL 758644, at *16 (D.C. Cir. Feb. 10, 2011). Petitioners argued, among other things, that "[t]he Commission erred seriously in cost-justifying these Rules by marginalizing and even ignoring...powerful contending forces." Id.

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<strong style="mso-bidi-font-weight:normal">

<em style="mso-bidi-font-style:normal">Decision.</em>

</strong>A three-judge panel of the District of Columbia Circuit Court of Appeals (Ginsburg, Sentelle, and Brown, JJ.) agreed with this argument in a controversial July 22, 2011 decision striking down the rule. The court found that the SEC had not sufficiently considered the impact of the rule on capital markets, and that its cost/benefit analysis "relied upon insufficient empirical data" and ignored "commenters that reached the opposite result."

<a href="http://scholar.google.com/scholar_case?case=17333454295341746481" target="new">

<em>

<span style="color:windowtext;text-decoration:none;text-underline: none">Business Roundtable v. SEC</span>

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</a>, 647 F.3d 1144, 1150 (D.C. Cir. 2011).

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<strong style="mso-bidi-font-weight:normal">Impact</strong>

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<br />The decision was surprising. After all, the Commission had made a showing that it had considered potential costs and benefits of the rule, which had been sufficient in the past-and which was not even required under historical precedent. Indeed, the decision appears to call for a dramatic departure from previous practice, in that the reasoning of the

<em>Business Roundtable</em> decision may permit the judiciary to effectively co-opt the mandate of Congress. In other words, the D.C. Circuit appeared to circumscribe not only the ability of administrative agencies to formulate regulatory policy, but also the ability of Congress to direct agency policy formation. Moreover, in focusing on a strictly monetary analysis of the impact of the proposed rule, the court&#39;s opinion may stack the deck against investor interests: while it is relatively easy to calculate costs associated with compliance, it is much more challenging to "monetize" systemic benefits such as financial stability or investor confidence.

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<br />This tilted playing field seems reflected in the fact that the enthusiasm for court intervention into the rulemaking process seems thus far to be limited to financial reform regulations under Dodd-Frank. For example, around the same time the Chamber of Commerce was arguing to the D.C. Circuit that it should substitute its judgment for that of Congress, it was advocating on other cases that courts grant deference to the SEC in reliance to

<em>Chevron</em> and its progeny. See, e.g.,

<em>Bebchuk v. Elect. Arts</em>, No. 08-5842-cv, 2009 WL 8144053, at *18-19 (2d Cir. April 27, 2009).

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<br />There can be little debate that the

<em>Business Roundtable</em> decision had an immediate impact on the regulatory process. Less than a year after the decision, an intensive cost/benefit analysis became a de facto requirement for the Commission&#39;s rulemaking. On March 16, 2012, "new guidance" memorializing this requirement was circulated to the SEC&#39;s Staff of the Rulewriting Divisions and Offices.

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<br />These additional burdens on rulemaking have substantially slowed the progress of financial reform under Dodd-Frank. For example, after the Commission issued two rules on Aug. 22, 2012 implementing the section of Dodd-Frank designed to improve transparency and empower citizens of resource-rich countries to hold their governments accountable for the management of revenues derived from natural resources, industry interests saw opportunity to stymie in rulemaking for what they were unable to defeat in the legislature.

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<br />On Oct. 10, 2012, the Chamber of Commerce and the American Petroleum Institute filed a petition challenging the SEC&#39;s final "extractive industries rule" requiring energy companies registered on American exchanges to publicly release commercially sensitive and detailed payment information about foreign energy investments. The petition argues that the SEC failed to adequately weigh the rule&#39;s costs and benefits. This case,

<em>American Petroleum Institute v. U.S. Securities and Exchange Commission</em>, has been filed in both the District Court for the District of Columbia, No. 12-cv-1668 and the U.S. Court of Appeals for the District of Columbia, No. 12-1398, until it can be determined which court will have jurisdiction to hear the case.

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<br />The Commission&#39;s cost/benefit analysis was again called into question on Oct. 19, 2012, when the Chamber of Commerce and National Association of Manufacturers filed a petition to modify or scrap Commission rules governing so-called conflict minerals. The SEC&#39;s regulation requires companies using gold, tin, tungsten and tantalum in their products to make "reasonable" efforts to determine if those materials came from the Democratic Republic of Congo or an adjoining country. On Nov. 21, 2012, the petitioners filed their preliminary statement of issues, and number one on the list was a challenge to the adequacy of the Commission&#39;s economic analysis.

<em>Nat&#39;l Ass&#39;n of Mfrs. v. SEC</em>, No. 12-1422 (D.C. Cir.).

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<br />The highly politicized nature of the attacks on the Commission&#39;s cost/benefit analyses is seen in the reluctance that many industry groups have had in arguing for the imposition of the same requirements for rulemaking under statutes that broadly favor commercial interests.

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<br />Unlike Dodd-Frank, the Jumpstart Our Business Startups (or "JOBS") Act, passed on March 27 of this year, is effectively de-regulatory rulemaking, weakening disclosure and accounting requirements intended to protect investors in an effort to promote capital formation. Though the SEC is now far behind meeting its rulemaking commitments under Dodd-Frank, which is now more than two years old, some are already arguing that the SEC has been too slow in issuing business-friendly rules under the new JOBS Act. Patrick McHenry, Chairman of the Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs, pressed SEC Chairwoman Mary Schapiro to speed up JOBS rulemaking, suggesting:

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<p class="block" style="margin-left:.5in">By kicking the can down the road, you are abdicating your responsibility to follow the law, failing to fulfill your sworn commitment to this subcommittee, and ignoring the will of Congress and the President of the United States.</p>

<p style="text-align: right">Aug. 16, 2012 letter from McHenry to Schapiro.

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<p>Under intense pressure to act quickly, the Commission issued its first JOBS Act-related rule on Aug. 29, 2012. The proposed rule, which would lift the ban on the general solicitation and advertising in private offerings to mom-and-pop non-accredited investors, was virtually bereft of any cost/benefit analysis, stating only that it "would likely reduce search costs associated with finding accredited investors who may be interested in a particular private offering, thus enhancing efficiency. The increase in the number of potential investors could result in greater competition among investors interested in investing in an issuer, which may result in a lower cost of capital for issuers."

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<br />Despite their attacks on Dodd-Frank rulemaking, few industry commentators suggested that further economic analysis was necessary for the new JOBS Act regulation. Instead, it fell to consumer advocates and state regulators such as the North American Securities Administrators Association (NASAA) to point out that the proposed rule&#39;s ambiguities left investors exposed to danger.

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<br />These investor advocates claimed, for example, that lifting the advertising ban on highly risky, illiquid offerings, without requiring appropriate safeguards, could create chaos in the market and expose investors to an even greater risk of fraud and abuse. And without adequate investor protections to safeguard the integrity of the private placement marketplace, investors will most likely flee from the market, leaving small businesses without an important source of capital.

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<br />The lack of careful analysis for the first round of rulemaking under the JOBS Rulemaking highlights a more fundamental problem. Requiring intensive economic analysis of only investor protection rules, while giving a free pass to rules favoring business interests, may introduce more volatility into the markets just as investors are beginning to recover their confidence.

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