Thank you, Buddy [Donohue], for the kind introduction. It is a pleasure to be part of "The SEC Speaks in 2009." This marks the first time I have participated in "SEC Speaks," and I am honored to be with some of the nation's finest securities lawyers — both inside the SEC and among the private bar. Before I begin, I must give you the standard disclaimer that the views I express here today are my own and do not necessarily reflect those of the U.S. Securities and Exchange Commission or my fellow Commissioners.
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Today, we are persevering through a tumultuous economy that recalls the challenges giving rise to the SEC and the laws it administers as part of the New Deal. During the past year, we have witnessed the demise of investment banks that were considered permanent fixtures on Wall Street. The notion that these institutions could fail had been unthinkable. We also have read about fraudsters whose Ponzi schemes preyed on investors and have heard allegations of market manipulation. We have seen the housing market collapse, credit freeze, IPOs stall, and unemployment rise, all while the government has taken unprecedented steps to stem the troubles. It is no surprise that investor confidence has suffered.
During the midst of the economic crisis last year, the SEC itself took a particularly extraordinary step: temporarily banning short selling.
Although perhaps not readily apparent, short selling can advance important economic goals. It can result in more liquidity, more capital formation, and more efficiently allocated risk. Short selling can buttress buying by allowing investors that go long — in other words, that purchase shares to hold as investments — to hedge their positions; and short selling can encourage market participation by leading to improved price discovery. Investors may be more reluctant to buy if the more pessimistic views of short sellers are not fully reflected in securities prices.
Short selling also is tied to investor confidence. Investor confidence depends on investors' faith in the integrity of markets. Investors expect that securities prices are meaningful in that they reflect the market's overall assessment of what a company is "worth" by aggregating into a single number the different views of market participants. Accordingly, in promoting market efficiency, short selling can foster investor confidence, as investors can be confident that securities prices reflect both optimistic and contrarian views.
Of course, these benefits may be offset if short sellers seek gains by engaging in fraud or manipulation; and selling pressure spurred by fear and uncertainty may contribute to mispricing and destabilized markets. That said, these are not grounds for singling out short selling. Fraud and manipulation, when it occurs, are not concerns peculiar to short selling; fraud and manipulation by those going long is not tolerated either. And just as irrational investor behavior may contribute to selling pressure, it also may lead to aggressive buying that inflates prices beyond their fundamental value.
So why ban short selling of financial sector stocks?
From my perspective, the ban was not directed at shoring up particular issuers for their own sake or lifting stock prices as such. Such goals fall outside the Commission's ambit. Rather, the purpose was to protect the financial system as a whole against systemic risk.
We were faced with a difficult choice. Banning short selling was costly, not least of all because we would lose the benefits of short selling just highlighted. However, it was possible that the ban would help stabilize financial markets at an especially critical time. It is worth remembering that the markets were under historic strains. Given the limited information we had, the outcome of the ban was uncertain; but for the ban to do any good, it had to be implemented swiftly and without conventional notice and comment.
For me, it boiled down to determining that if the ban might help stabilize the situation, the ban's potential benefits justified its costs, particularly given that the ban was temporary. Put differently, given the chance that the temporary ban would help stem the financial tumult, the cost of Commission inaction would have been too high. More to the point, as events stood, it was apparent that the private sector was not well-positioned to address the present systemic risk. Ensuring a sound, well-functioning financial system — a "public good" — called for a limited and temporary government response.
With the benefit of more but still imperfect information, the decision was made to terminate the ban a few weeks after its implementation. Speaking personally, it became apparent that the ban did not stabilize the markets but did result in inefficiencies and other market dislocations and disruptions. In short, the benefits of the ban did not materialize but the costs clearly did.
Although the ban was lifted, other contemporaneous steps the SEC took have remained in place. In September 2008, around the time of the ban, the Commission, on an emergency basis, adopted a temporary amendment to Regulation SHO imposing penalties if a short seller does not deliver the securities within three days after the sale transaction date.1 This so-called "T+3 rule" was directed at curbing "naked" short selling. The emergency rule subsequently was adopted as an interim final temporary rule, with some changes.2
Second, the Commission approved a final rule to eliminate the options market maker exception from the Regulation SHO close-out requirement.3 This broad exception had worked to undercut Regulation SHO's purpose of curbing "naked" short selling.
Third, the Commission adopted Rule 10b-21, an antifraud rule clarifying that a short seller is subject to liability for fraud for deceiving certain persons as to the short seller's intent or ability to deliver the securities by the settlement date.4 Rule 10b-21 gives additional bite to Regulation SHO's "locate" requirement and otherwise further curtails fails to deliver.
Fourth, the Commission adopted temporary disclosure requirements for short sales by certain investment managers.5 These disclosure requirements subsequently were adopted, with some modifications, as an interim final temporary rule.6
We continue to receive comments on many of these rules, and I look forward to reading and considering the comments. As always, the notice-and-comment process undoubtedly will bring to the Commission's attention adverse consequences and potential benefits we might have missed.
This is all to say that my assessment of the ban — its costs, benefits, and the attendant tradeoffs — evolved over time as we learned more. Likewise, other emergency orders were modified before eventually adopted as interim final temporary rules to address concerns that arose from our efforts to curb abuses and stabilize the markets.
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This leads to a particular lesson from the Commission's recent experience with short selling. Simply put, regulatory decision making at the SEC — and throughout government generally — should be based on rigorous cost-benefit analysis, including sound economics. This is not so just when we take unprecedented steps, but also when taking seemingly routine ones. And cost-benefit analysis is valuable not only when evaluating potential new laws, but also when enforcing existing ones.
The discipline that cost-benefit analysis brings to decision making is especially important in a time of urgency like this country has been experiencing. During a crisis, it still is possible to regulate too much. Even when the benefits of regulation seem apparent, careful analysis may reveal that the benefits are less considerable than thought; and there are always costs to weigh. I am concerned that some of what has been called for during the present financial crisis would not stand up to a demanding cost-benefit analysis. Even proposals associated with net benefits may not be optimal. Rather, rigorous cost-benefit analysis would in some cases reveal yet unimagined options that would be better for government to pursue.
In my remaining time, let me flesh out some of what I envision by way of cost-benefit analysis.
First, rigorous cost-benefit analysis helps identify the range of consequences — both good and bad — that attend our decisions. A less diligent analysis might miss many of these effects, leading to regulatory missteps. The failure to account for certain benefits, for example, may lead to lost opportunities if we choose not to regulate when circumstances warrant that we do. Conversely, the failure to account for certain costs runs the risk that we do more harm than good when we do regulate. For example, aside from out-of-pocket compliance costs, adverse consequences such as lost innovation and dampened capital formation must be weighed. Just as we vigorously emphasize the benefits of our rulemakings, we need to identify and consider the potential downsides. If not, our decision making will be skewed.
When engaging in cost-benefit analysis, it is critically important to search purposefully for information that actually cuts against one's own position, instincts, and sensibilities. Considering information that is contrary to one's own views leads to more informed decision making and helps counteract the risk that a person will become overly committed to his own perspectives and beliefs and overconfident that what he advances is correct. Put simply, disagreement and deliberation are hallmarks of good decision making. In more concrete terms, this means that during a rulemaking, not only should we welcome criticism, but the Commission should proactively search for shortcomings with its own proposals.
Once the costs and benefits have been identified, difficult tradeoffs must be made. For cost-benefit analysis is rooted in the recognition that whatever the benefits, they may not justify the incurred costs.
Second, an effective cost-benefit analysis should be dynamic, not static; regulators should not hold too many things constant when assessing what, if any, steps to take. Rather, we should anticipate the types of adjustments stakeholders might make in response to what the Commission does and consider the long-run effects of our actions. How will things play out over time? For example, will the regulation not change behavior meaningfully, but nonetheless impose higher transaction costs on business and investing? If so, imposing such transaction costs would seem unjustified. Will certain conduct move offshore? It may be preferable to subject the conduct to less U.S. regulation and have it occur in the United States than take place overseas and be subject to even less government oversight. Will the regulated conduct cease altogether? What conduct might take its place? What new financial instruments or structures might replace ones that become uneconomic? What productive activity that we want to encourage might be chilled? It is difficult to fine tune regulation and its enforcement. We should factor in the prospect that our regulations may deter honest business and investing.
Third, one should not evaluate any single regulatory step in isolation. Instead, one has to take a broad look at the entire regulatory landscape that bears on the matter at hand. A particular proposal may seem prudent until one appreciates how it fits into the rest of the regulatory regime. Take short selling. Recently, the Commission took a number of steps to address abuses: the hard T+3 delivery requirement; the elimination of the options market maker exception; the Rule 10b-21 antifraud rule; and the short sale disclosure requirement. In considering what additional steps, if any, might be warranted, one would have to consider the cumulative effect of the complement of regulatory actions already taken and ask: What is the marginal benefit of another regulatory step compared to the marginal cost?
Fourth, a robust cost-benefit analysis not only considers the costs and benefits of a particular option, but compares different options against each other. Even if option A is good, it does not follow that option A is the best regulatory alternative. Instead, option B may be better. The failure to choose the superior option B can be conceived of as an opportunity cost of selecting option A.
Often, commenters to our rules provide alternatives that may be better than what we are proposing. As regulators, we should not let pride of ownership burden our decision making. We do not have a monopoly on good ideas.
Fifth, as an agency, the SEC has limited resources. Even if the agency's budget increases, we still will be faced with the challenge of allocating a finite number of people and funds. It is critical to recognize that there is an opportunity cost when we dedicate resources to administer particular regulations, undertake certain examinations and inspections, and pursue specific enforcement actions. When we decide to do "X," we must consider how the consequent allocation of resources compromises our ability to do other things that may more effectively advance our mission of protecting investors; maintaining fair, orderly, and efficient markets; and facilitating capital formation.
A basic point undergirds the call for robust cost-benefit analysis. Just because markets operate imperfectly, it does not follow that the government has effective answers. Government operates imperfectly too, and we need to recognize that government fixes may create more problems than they solve. Just as we point out the failures of the marketplace, we have to assess realistically the ability of the government to fashion the right responses. A "warts-and-all" evaluation of the market is appropriate; but so is a "warts-and-all" evaluation of the wherewithal of lawmakers to cure market ills.
A demanding cost-benefit analysis that evaluates outcomes and makes conscious, informed tradeoffs is the best way of achieving the common good. The discipline that cost-benefit analysis brings to decision making impresses upon regulators the complexity of the challenges and opportunities we face. By appreciating such complexity, it becomes more likely that regulators, myself included, will strike appropriate balances. Cost-benefit analysis is not an argument for or against regulation. Rather, it is an argument for regulatory approaches that fully account for both the good and the bad to ensure that we have smart regulation.
As we consider how to respond to the financial crisis, we should take a hard look at the present regulatory landscape and consider what should and should not change. In doing so, I hope we engage in the kind of thorough cost-benefit analysis I have outlined today. If we do not, we run the risk of doing more harm than good over the long run.
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The SEC is rich in tradition, strong in people, and resolved in purpose. The Commission is blessed with 3,500 individuals committed to advancing the public interest during these difficult times. I would like to thank each of the dedicated lawyers, economists, accountants, and other staff for their tireless efforts. Given my topic today, I would like to pay special thanks to the SEC's Office of Economic Analysis. I look forward to continuing to work with that office, and I hope that it plays an increasingly prominent role in our decisions.
Indeed, the SEC should be staffed with more economists and other non-lawyers who have a deep understanding of capital markets. We need economists, quantitative analysts, and others with strong trading and finance backgrounds more actively engaged in all that we do, from fashioning new regulations, to anticipating market developments, to assessing risks that help us target our examinations and inspections, to working with the Division of Enforcement in developing its cases.
Let me conclude by saying how humbled and honored I am by the opportunity to serve our country as a member of this great agency. I am confident that together we will emerge from these trying challenges stronger than ever.
Thank you and enjoy the rest of the program.