Thank you, Carl, for that kind introduction. It is an honor to address the NABE, a group of economists united by a commitment to "use the latest economic data and trends to enhance their ability to make sound business decisions."1 I appreciate and share the commitment to apply economics to make sound regulatory decisions. At times during my tenure on the Securities and Exchange Commission, it seems to have been the minority approach. Some like to say that our agency is of, by, and for lawyers. Sure, we let in a few accountants, economists and MBAs, but the SEC tends to be lawyer-dominated and lawyer-driven. I guess that you could say that one sign that the lawyers are in charge of my life is that before I begin, I must tell you that the views that I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or of my fellow Commissioners.
The all-too-frequent lack of interest in the economic justification for and consequences of regulatory actions at the SEC has manifested itself in numerous, often troublesome ways, some of which I will discuss today. Chairman Cox, during his tenure at the Commission, has taken important steps towards integrating economics into policymaking. I will discuss some of those steps today as well.
Thirty years before his death last November, Milton Friedman remarked, in his Nobel memorial prize lecture:
In order to recommend a course of action to achieve an objective, we must first know whether that course of action will in fact promote the objective. Positive scientific knowledge that enables us to predict the consequences of a possible course of action is clearly a prerequisite for the normative judgment whether that course of action is desirable.2
He went on to say that many of the difficult problems the world was then experiencing, including "misuse of economic resources, and, in some cases, the suppression of human freedom" existed not because those in power "deliberately sought to achieve these results … but because of erroneous judgments about the consequences of government measures: errors that at least in principle are capable of being corrected by the progress of positive economic science."3
In Dr. Friedman's view, economics could and should be used to help us to anticipate the effects of contemplated regulatory actions before those actions are undertaken. This sounds eminently reasonable in theory, but, in practice, regulatory actions at times can seem to be taken with an open eye towards their superficial appeal and a blind eye towards their economic justification and consequences.
Regulatory agencies should use economics not only in determining what the effects of a particular regulatory action will be, but more fundamentally in identifying whether regulatory action is needed in the first place. As of the beginning of the year, all agencies are under a presidential order to do just that. Specifically, each agency must:
identify in writing the specific market failure (such as externalities, market power, lack of information) or other specific problem that it intends to address (including, where applicable, the failures of public institutions) that warrant new agency action, as well as assess the significance of that problem, to enable assessment of whether any new regulation is warranted.4
Although some say that the SEC as an independent agency may not be technically bound by that instruction, Chairman Cox, on his own initiative, has called for a top-to-bottom review by the General Counsel of the Commission's compliance with its obligations to analyze the economic effects of the Commission's rules.5 In addition to this comprehensive look at how well the Commission is using its economic resources in policymaking, the Chairman also has been instrumental in ensuring that the Commission considers the economic ramifications of specific regulatory actions.
One recent example of the Chairman's commitment to the importance of economic analysis was his decision at the end of last year to publish for comment two studies by our Office of Economic Analysis related to investment company governance. These papers had been prepared — but not published — prior to the Chairman's arrival at the Commission in connection with a far-reaching rule that sought to alter the governance structure of every mutual fund in the country. The rule as adopted twice by the Commission, both times over my dissent, would have required each fund to have a board made up of at least 75% independent directors, one of whom is chairman. I say "would have required" because these requirements were struck down twice in court for the Commission's having failed to consider adequately the costs of and alternatives to the measure.
The Chairman's decision to release our economists' studies last December — before deciding whether to undertake any fund governance changes — was a watershed event in the life of a rule that has been marked by a dismissal of economic consequences.
When the Commission first proposed the rule in 2004, my former colleague Commissioner Cyndi Glassman, a PhD economist, pointed out the need for empirical analysis to support the rule.6 In response, she was told that there probably was not empirical evidence to support the rule, but that the rule should be looked upon as "an experiment that will have to be reversed if it was a problem."7 Industry-wide regulatory mandates are not the appropriate forum for scientific experimentation. In the words of Commissioner Glassman, "I wouldn't want to experiment with 90 million investors."8
Experimentation is not out of the question as a way to assess whether a rule will be workable, but the beauty of a controlled experiment is that it enables you to see what happens in a small segment of the market befores deciding whether to apply a rule across the board. The experiment should be limited to a part of the market so that any unexpected consequences are also limited.
Our Office of Economic Analysis concluded just such an experiment recently in connection with short sales. For many years, academics had been questioning whether the SEC's short sale price test, or "tick test," was needed. The tick test, which has been on the books for seventy years, restricts the prices at which short sales may be executed. Our economists conducted a pilot test on approximately 1,000 securities to investigate whether removing the price tests would make stocks more susceptible to patterns associated with downward manipulation. They did not find evidence to suggest that pilot stocks are more likely to be manipulated downward than other stocks. Based on the results of the pilot, the Commission proposed last December to eliminate the tick test across the board. I commend the ingenuity of the staff in formulating this approach, and I look forward to seeing similar empirical methods used in the future.
Now that we have had a chance to review the recently-released mutual fund governance studies, the justification for an industry-wide experiment seems even more tenuous. The studies instead lend support for the point that there is not a universally optimal governance structure; independent chairmen are better for some funds and interested chairman are better for other funds. Further, the optimal structure for a particular fund may differ over time. One commenter, having reviewed the studies and found in them no evidence that the contemplated independence measures "would result in better governance of a fund, improve fund economics or provide other benefits to investors," recommended "allow[ing] those closest to understanding what best serves investors' interests to make these decisions as to what works best in their individual circumstances."9
Another commenter raised the broader question of whether "the proliferation of regulations in recent years has produced duplicative or disparate regulations and other inefficiencies in the mutual fund industry that need to be addressed."10
That is a good question for the Commission to ask itself periodically and across all the areas that it regulates, particularly after an active period of regulation. It is wise every so often to take a step back and assess the collective impact that our rules are having. We should be asking whether our rules are coming at such a pace or such a level of complexity and expense that they are discouraging new industry entrants or forcing small firms out of the industry. It is these types of issues that the Commission's economists, with full support from others within the Commission, can be particularly helpful in assessing. I also encourage economists outside of the Commission to assist us in understanding the effects of our regulatory initiatives.
Lately, because of concerns that overregulation is making U.S. capital markets less attractive, we have been getting considerable outside help in assessing the effectiveness and efficiency of our regulatory structure. This week, the Commission on the Regulation of U.S. Capital Markets in the 21st Century, a group organized by the U.S. Chamber of Commerce, issued its report with recommendations, including a recommendation that the SEC do thorough cost-benefit analyses before and a year or two after taking regulatory action.11 Last November, the Committee on Capital Markets Regulation, which is chaired by Glenn Hubbard and John Thornton and directed by Hal Scott, issued an interim report that similarly recommended that the SEC "systematically implement[] … a carefully applied cost-benefit analysis of its proposed rules and regulations" both prior to adoption and periodically thereafter.12
In January, Senator Charles Schumer and New York City Mayor Michael Bloomberg issued a report on the state of the financial services industry in New York and the U.S. as a whole.13 The report made a number of recommendations, several of which related to the SEC. Among these was a recommendation that the Commission eliminate the reconciliation requirement for International Financial Reporting Standards (IFRS) and continue to promote the global convergence of accounting standards. A week ago, the Commission hosted a roundtable on IFRS and heard very similar recommendations from the participants, who came from a wide range of perspectives.
One of the recommendations included in all of these reports was that the Commission and the Public Company Accounting Oversight Board (PCAOB) revisit the manner in which they have implemented Section 404 of the Sarbanes-Oxley Act. Section 404 requires each public company to include in its annual report an assessment by management on the state of the company's internal control over financial reporting. Section 404 also requires a company's auditor to attest to and report on management's assessment of internal controls.
Implementation of Section 404 has been a problem, even though the underlying objective of the Section is a worthy one. Our original cost estimate for Section 404 implementation was an average of $91,000 per company. Actual costs appear to be twenty times more than that. The Commission tried to adopt a principles-based standard for companies, but the PCAOB did not do the same for auditors. We simply underestimated the amount of work that would be spawned for both companies and auditors by the PCAOB's prescriptive, bottom-up standard that deprived auditors of the opportunity to employ their professional judgment, discouraged a risk-based approach, and encouraged the generation of massive amounts of documentation.
The SEC and PCAOB have already taken steps to improve the implementation of Section 404 in response to the concerns raised by the Capital Markets Committee, Senator Schumer, Mayor Bloomberg and many, many others. Most importantly, the SEC and the PCAOB are working on new guidelines to govern companies and auditors respectively in carrying out their responsibilities under Section 404. We received many comments in response to our respective proposals. The commenters made clear that there is still work to be done, but we have made great headway towards redirecting efforts under Section 404.
One commenter was able to reduce the problems that have been engendered by Section 404 to a lightbulb joke. Since the joke is about accountants, I feel safe telling it to a group of economists. "How many accountants does it take to change a lightbulb post-Sarbanes-Oxley?" According to this commenter, nine:
You'd probably need one to authorize the lightbulb change, one to supervise the change, one to physically twist the bulb out, one to bring the new bulb over, one to screw the new bulb in, one to check off that the bulb was changed, and then a minimum of three auditors to verify that everyone checked the right boxes — regardless of whether the bulb was properly changed or not.14
I think the commenter might have underestimated — there will have to be one to draw up the process charts and document the whole process and another to walk-through the process and yet another to write a report to document and prove that all that work had been done. Then, finally one to render the invoice and deliver it to the company for payment. That makes a lucky thirteen accountants in all.
Section 404 is certainly an area in which companies and the shareholders that own them would have benefited from implementing rules that were grounded in a rigorous cost-benefit analysis. Now that the SEC and PCAOB have a better sense of the types of unintended consequences that can occur, I hope that our new guidance will assist companies in building and maintaining a culture of strong internal controls at a reasonable cost to those companies and their shareholders.
I worry that while we are tackling the Section 404 problem, another similar problem may be taking shape, this time as the result of a pronouncement that was issued last June by the Financial Accounting Standards Board. FIN 48, as it is called, deals with accounting for uncertainty in income taxes. Effective for fiscal years beginning after December 15, 2006, FIN 48 requires companies to assess their tax positions to determine whether they are more likely than not to be sustained upon examination.15
The FASB was flooded with pleas for an extension, but concluded that no extension was necessary, so companies are implementing it now. Supposedly, every well-run corporation already should have this documentation in place — that sounds eerily familiar to the comments made in the early days of 404. For Year One, companies face the difficult task of reviewing each of their open tax positions across multiple tax jurisdictions to determine whether and in what amount they can be recognized. One of the main problems with the PCAOB's audit standard under Section 404 was that it lacked a materiality filter. Does FIN 48 suffer from the same problem? Does every tax position, regardless of size, get the same level of scrutiny? Consequently, another concern is that FIN 48 may cause some of the same kinds of over-documentation problems that have characterized the first years of Section 404 implementation. As with Section 404, auditors are driving the process, so companies feel the need to produce reams of documentation to satisfy auditors, who otherwise might not sign off on the audits. The SEC staff has attempted to inject a sense of reasonableness into the documentation process, and I hope that companies and their auditors are taking this to heart.
Speaking of implementation problems, just last week, the long-delayed market structure rules that the SEC adopted in the spring of 2005, before Chris Cox was named chairman, went into effect. These rules are the notorious and hotly debated Regulation NMS16 — for National Market System. The rules basically arise from a wish to centralize our dynamic markets — the major means is via a market-wide rule against trade-throughs, even though there is little evidence that there is or was a problem regarding trading through better priced quotations.
I was staunchly opposed to the adoption of this burdensome and costly set of rules, which springs from a utopian philosophy that we know what is best for the marketplace, regardless of what market participants want, and that we will force our will on the marketplace, regardless of the costs and consequences. Some give NMS credit for pushing technological innovation in the marketplace. This credit is misplaced, because competition and customer pressure were and continue to be the real drivers of both technological and structural change. A government mandate cannot do a better job, and, in fact, can get in the way of the changes that investors are demanding. For example, E-Trade and others now offer easy access for US investors to foreign markets with the click of a mouse. Will NMS ultimately hurt the competitive position of the US as a marketplace? Can we even predict all of the ways in which our rules, currently designed for a static, insulated trading market, will be affected by the new globalized environment? We need your help.
Already the implementation of Regulation NMS has been delayed time and again because of a clearly unrealistic timetable that ignored the numerous interpretive questions and thorny technological issues raised by the rules. The SEC staff, through an amazingly broad set of powers delegated to it through the rule, has granted exemption after exemption that has exposed the rules' many flaws. They realize that there is a serious problem. During these first weeks and months, I will be watching carefully the implementation of Regulation NMS and hope that its consequences turn out to be a non-event — other than the thousands of hours and millions of dollars spent in an effort by market participants to implement it. The trouble is that the real consequences for our markets will not be known for years, after the damage has been done and after trading patterns have shifted in unpredictable ways and perhaps to other venues. It may be too late then to reverse the experiment.
Let me close by noting that economists have a role to play at the Commission outside of the rulemaking arena too. Economists also have much to add in guiding the Commission in enforcing its rules. Specifically, they can help us to determine whether there was harm, how much harm there was, who was harmed, and what the effects of our remedies will be.
Economists can also help lawyers at the SEC to understand the complexity of the cost-benefit analyses engaged in by those who are subjects of Commission enforcement actions. It entails much more than a weighing of the financial costs of proceeding to trial against the costs of settling. A person who does not believe that she violated the law might choose to settle anyway, simply because the prospect of the years of litigation will cost more personally, professionally, and monetarily than she can bear.
Another enforcement issue that economists can help us with is analyzing the imposition of financial penalties on corporations. Looking at corporate penalties through an economic lens leads one to ask whether it is appropriate for the shareholders of a corporation, who were often the ones victimized by a financial fraud, to pay a penalty. The Commission recognized this problem last year when it issued guidelines for the imposition of corporate penalties.17 In those principles, the Commission stated that a determination on the appropriateness of a corporate penalty would turn principally on two considerations: (1) the presence or absence of a direct benefit to the corporation as a result of the violation, and (2) the degree to which the penalty will recompense or further harm the injured shareholders.18 This was a positive step, but it will take persistent effort to resist the ever-present temptation to seek headline-grabbing penalties from corporations at the expense of the shareholders. It will take vigilant economists to remind us to look beyond the potential headlines to the economic reality of our actions.
Thank you for your attention. I know that you are nearing the end of a very full and thought-provoking conference, so I am particularly grateful that you have been such an attentive audience. I am interested in hearing your views on any of the issues that I discussed or any of the other issues that are facing the SEC at this time.