Reconsidering the Institutional Design of Federal Securities Regulation

The scholarly literature on institutional design focuses on how legal institutions, including administrative agencies, legislatures and courts, should be organized in order to produce the best legal outcomes. In a recent article, I consider how this literature might help us think about the structure for regulating the U.S. securities industry. While the SEC is given substantial decision-making authority under the current state of things, I conclude that we might benefit from giving it even more. Additionally, I suggest, there might be benefits in adopting mechanisms, other than judicial review, aimed at reducing the risk of error inherent in the SEC’s regulatory task.

The analysis begins with the observation that although Congress’s delegation of decision-making authority to the SEC is expansive, it is by no means absolute. Under the Securities Exchange Act of 1934, Congress authorizes the SEC to make disclosure rules for certain “reporting” companies, but it is Congress that decides which companies fall within the SEC’s regulatory reach. Since the 1960s, the question of whether a company is subject to the SEC’s disclosure regulation depends on three factors: whether the issuer has securities listed on a national securities exchange, whether it has made a public offering of securities under the Securities Act of 1933, or whether it has more than a certain number of shareholders of record (2,000 by the most recent count). If a company can answer all of these questions in the negative, then it falls outside of the reach of the SEC’s disclosure rules and forms part of the private (federally unregulated) market for securities; otherwise, the company is subject to the SEC’s mandatory disclosure regime.

Does it make sense to draw the line between the public and private securities market in this manner — by reference to a company’s exchange listed status, public offering history or shareholder size? And perhaps more fundamentally, should Congress be the one to take up this line-drawing in the first place? It turns out that these two questions are related, because how one should go about distinguishing between the private, unregulated securities market and the public, regulated one tells us a lot about who — Congress or the SEC — is best equipped to engage in this exercise.

Although the justification for a mandatory securities disclosure regime is the topic of perennial debate, there does appear to be some agreement among scholars and commentators that an important piece of the puzzle has to do with the third-party effects of information. Certain information is likely to put securities issuers at a competitive disadvantage with respect to suppliers or competitors or other industry actors. And therefore, if disclosure were left up to the market, issuers would likely view these effects as the costs of disclosure. And yet, these aren’t really costs from a social welfare perspective, because the negative effects to the issuer are offset by the positive effects felt by other economic agents. Similarly, parties other than shareholders are likely to benefit from disclosure, including market analysts and society at large. And yet, issuers aren’t going to take into account these benefits of disclosure unless they can somehow figure out how to monetize them. In other words, if disclosure is left to the market, these third-party effects of information are likely to result in a sub-optimal amount of disclosure.

If this account justifies a mandatory disclosure regime, then it also suggests how one might draw the optimal public-private divide that is central to that regime. Specifically, it suggests that the optimal public-private divide would target mandatory disclosure rules at those firms or industries where the third-party effects of information are most significant (and therefore where the market is unlikely to produce the optimal amount of disclosure). For example, if it is determined that the market failure is largely due to the effects of disclosure on competitors or suppliers, then maybe the public-private divide should turn on measures of market competition (like industry concentration ratios) or vertical integration (like value added ratios). If the source of the market failure instead has to do with the effects of information on society at large, then maybe that public-private divide should turn on measures of a firm’s social footprint, like political activity or the size of the firm’s employment ranks.

This analysis leads to two observations and two accompanying policy implications. First, the optimal public-private divide in federal securities regulation likely turns on highly technical considerations requiring expertise in accounting and finance, the types of considerations that are best handled by an expert agency. In other words, this analysis implies that we might benefit as a policy matter by delegating even more decision-making authority to the SEC than we already do.

Second, this analysis suggests more generally that the regulatory task inherent in securities regulation is highly complicated, so complicated in fact that regulatory error should be expected as a feature of the enterprise. And yet, the Exchange Act doesn’t adopt any specific error-reducing mechanisms other than judicial review. Therefore, the policy implication is that we might benefit by adopting additional error-reducing mechanisms.

How might we implement these policy implications of increased decision-making authority at the SEC accompanied by more robust checks on regulatory error? The increased decision-making authority is straightforward – it would be a simple matter to amend the Exchange Act to effectively authorize the SEC to make disclosure rules for any firm that operates in interstate commerce.

On the other hand, adopting an effective error-reducing mechanism is more complicated. In the article, I sketch one possible approach: A regime where the SEC must ensure that the costs of disclosure borne by reporting companies fall within a specified range, failing which the SEC would be prevented from taking any action until cost compliance is attained. Of course, this type of suggestion could fairly be accused of magical thinking, since we are unlikely to have very good information about either the regulatory costs imposed by the hypothetical optimal disclosure regime or the actual costs imposed by the current regime. And for this reason, it would be difficult to justify an error-reducing mechanism of this type if it is based on bright-line statutory rules.

A more realistic approach might be through the use of an SEC advisory committee that reports directly to Congress and is charged with the task of managing the costs of regulatory error. Such a committee could develop cost ranges of the type described above and compare those ranges against actual disclosure costs, calculated from sampling a representative population of reporting firms. Of course, the advisory committee’s recommendations wouldn’t have any immediately binding effect on the SEC in the absence of congressional action. But it would at least go some distance in focusing the SEC and Congress on the risk of regulatory error.

The current institutional design of federal securities regulation has remained more or less the same since the 1960s. Since that time, our understanding of the goals and justifications of mandatory securities disclosure has changed dramatically. By rethinking this institutional design in light of these subsequent developments, we are likely to create a regime that produces rules that are both smarter and less error-prone.

The preceding post comes to us from Zachary J. Gubler, Associate Professor, Arizona State University, Sandra Day O’Connor College of Law. The post is based on his recent article, which is entitled “Reconsidering the Institutional Design of Federal Securities Regulation” and is forthcoming in 56 Wm. & Mary L. Rev. 409 (2014). The article is available here.