Before I begin my remarks, I must let you know that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
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There is hereby established a Securities and Exchange Commission . . . to be composed of five commissioners to be appointed by the President by and with the advice and consent of the Senate.
So provides section 4(a) of the Securities Exchange Act of 1934 ("'34 Act"). Until the SEC was created in 1934, the Federal Trade Commission had administered the federal securities laws, then consisting of the Securities Act of 1933 ("'33 Act"). Much has changed since then.
Scores of influential developments have shaped the course of federal securities regulation over the SEC's 75-year history.1 Here is a sampling: After the '33 and '34 Acts came the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1939, and the Investment Company and Investment Advisers Acts of 1940. Other notable legislative developments have included the Private Securities Litigation Reform Act, the National Securities Markets Improvement Act, the Securities Litigation Uniform Standards Act, and the Sarbanes-Oxley Act.
In response to the recent financial crisis, Congress presently is considering a number of far-sweeping legislative proposals that would substantially change the future of securities regulation in this country.
Congress passes the statutes, but the SEC administers them as an independent agency. It goes without saying that since its founding, the SEC has been an active regulator. Just since I joined the Commission in August of 2008, the SEC has advanced a number of initiatives concerning matters such as credit rating agencies; short selling; the election of board members; public company compensation and governance disclosures; money market funds; flash orders; pay-to-pay arrangements; XBRL; mutual fund prospectus disclosure and delivery requirements; foreign private issuer disclosures; IFRS; municipal offerings; and equity indexed annuities. More is likely to follow. As always, I look forward to considering the comments we receive on our rulemakings.
In addition to Congress and the Commission, courts also have been instrumental in determining the reach and substance of securities regulation through their interpretation of the underlying statutes and rules and regulations. Consider, for example, the practical impact of cases such as Howey, Ralston Purina, Basic, Ernst & Ernst, Santa Fe Industries, Dura, TSC Industries, Central Bank, Chiarella, O'Hagan, Stoneridge, and Blue Chip Stamps.
This term alone, the Supreme Court is scheduled to hear cases concerning the constitutionality of the PCAOB,2 the triggering of "inquiry notice" for statute-of-limitations purposes in private securities litigation,3 and the fees an investment adviser can charge without breaching the adviser's Investment Company Act fiduciary obligations.4 The Court also has expressed interest in a case involving the extraterritorial reach of the federal securities law, having invited the Solicitor General to file a brief expressing the government's views.5
In addition to judicial opinions there exists a sort of "shadow common law" comprised of the accumulation of settlements the Commission has reached with defendants in enforcement actions. Although not of the same effect as judicial precedent, settlements, as reflected in Commission orders, affect not just the parties, but influence the conduct of other companies, investors, funds, broker-dealers, investment advisers, lawyers, accountants, and others involved in securities transactions and related matters. Prior settlements are consulted for guidance in understanding the SEC's view of the federal securities laws.
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Even as the superstructure of securities regulation has evolved over the decades with the accretion of statutory changes and new rules, regulations, and cases, the foundational cornerstone of the regulatory regime has remained fixed: It is disclosure. For 75 years, the SEC's signature mandate has been to use disclosure to promote transparency.
Louis Brandeis, whose ideas were a major influence on the disclosure philosophy of regulation that continues to animate the federal securities laws, summed things up as early as 1914: "Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman."6 Nearly 20 years later, in his March 29, 1933, message to Congress, President Roosevelt built on Brandeis's sentiment, stating:
Of course, the Federal Government cannot and should not take any action which might be construed as approving or guaranteeing that newly issued securities are sound in the sense that their value will be maintained or that the properties which they represent will earn profit.
There is, however, an obligation upon us to insist that every issue of new securities to be sold in interstate commerce shall be accompanied by full publicity and information, and that no essentially important element attending the issue shall be concealed from the buying public.7
The essence of the disclosure philosophy of securities regulation is that, when armed with information, investors are well-positioned to evaluate investment opportunities and to allocate their capital as they see fit. By ensuring that investors have the information they need to make informed decisions, mandatory disclosure, in turn, leverages market discipline as a means of accountability that stands in contrast to more substantive government oversight of securities-related activities. Through their investment decisions, investors are able to bring pressure to bear on directors, officers, fund managers, and other market participants to serve investor interests. Market participants are incentivized to satisfy investor demands because investors "reward" and "punish" by how they choose to invest.
The disclosure philosophy does not presuppose that investors are perfect decision makers. Indeed, the more recent teachings of behavioral finance suggest the extent to which investors may err. Even when investors are empowered with extensive disclosures, for example, certain cognitive biases and decision-making shortcuts — so-called "heuristics" — may lead to inferior decisions. That said, disclosure puts into operation the view that, over the long run, the collective judgment of the marketplace — disciplined as it is by market forces — should be respected as a worthy alternative to more substantive government control of private-sector conduct. For the test is not whether investors are perfect decision makers; rather, the test is whether it is preferable to leave certain decisions to market institutions instead of relying more on government officials, who also err, to dictate results through regulation.
To be clear, even a disclosure-based approach to regulation contemplates a meaningful role for government. The federal securities laws, for example, mandate certain disclosures from companies, mutual funds, investment advisers, and even investors. Furthermore, to be useful, disclosures need to be truthful, whether the disclosures are mandatory or provided voluntarily in response to the demand of investors for more information. Here, the antifraud provisions of the federal securities laws, such as section 10(b) of the '34 Act and Rule 10b-5 thereunder, are particularly constructive in promoting an effective disclosure regime.
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Since the agency's creation, disclosure has been fundamental to what the Commission does. Accordingly, it seems sensible to call for more disclosure in response to any number of regulatory concerns. But mandatory disclosure is not costless, notwithstanding the considerable benefits that flow from transparency. Once the cost of disclosure is properly accounted for, whether to require even more disclosure becomes a more challenging regulatory decision. Leaving it to the marketplace to sort out what, if any, additional information should be forthcoming and under what conditions is sometimes preferable.
Out-of-pocket compliance costs, which can be considerable, are the most obvious cost of complying with mandatory disclosure requirements. In addition, time and effort dedicated to compliance can distract valuable resources from more productive efforts that, on net, better serve investors and our economy generally.
Financial and other compliance burdens may be particularly challenging for small businesses. Recognizing this, the federal securities laws are scaled in important respects to provide relief for small enterprises. Consider, for example, section 3(b) of the '33 Act authorizing the SEC to adopt rules exempting certain small offerings from the demanding and time-consuming registration requirements of section 5. Pursuant to section 3(b), the Commission has most notably adopted Rules 504 and 505 of Regulation D. By allowing an issuer to forego a statutory prospectus and registration statement, these rules facilitate capital formation for startups and other small companies.
It also is possible for there simply to be too much information for investors and others to work through constructively. The risk of "information overload," in other words, is a cost of mandatory disclosure. Investors today are inundated with volumes of information, so much so they sometimes are unable to distinguish what is important to their decision making from what is not. As a result, investors too frequently do not bother carefully studying the information that is available and get overwhelmed or distracted, misplacing their focus on less important matters. In short, the sheer amount of information can frustrate its effective use. The trouble is that when information is not processed and interpreted effectively, disclosure does not translate into better decision making. Ironically, if investors are overloaded, more disclosure actually can result in less transparency and worse decisions.
Information overload is not a new concern. Take what constitutes a "material" misstatement or omission under the antifraud provisions of the federal securities laws. Over 30 years ago, in TSC Industries v. Northway,8 the Supreme Court held that a fact is "material" if "there is a substantial likelihood that a reasonable investor would consider it important in deciding how to vote."9 In rejecting the view that a fact is "material" if an investor "might" find it important, Justice Marshall, writing for the Court, warned against information overload: "[M]anagement's fear of exposing itself to substantial liability," Justice Marshall wrote, "may cause it simply to bury the shareholders in an avalanche of trivial information - a result that is hardly conducive to informed decisionmaking."10
This leads to a practical suggestion. While disclosure serves key regulatory objectives, too much disclosure can be counterproductive. The Commission should account for this in fashioning its disclosure regime. We need to consider the impact on investors as disclosure obligations mount and investors are thus presented with more and more information to work through. It may be better for investors to have shorter, more manageable prospectuses and proxy statements, for example, that contain more targeted information instead of lengthy documents that are not fully digested and that in too many instances are entirely ignored. One important step the SEC recently took to streamline information for investors was to provide for the mutual fund summary prospectus.11
Even though new disclosures may be required from time-to-time, we should be open to the prospect that certain disclosures should be more narrowly focused or otherwise scaled back if they are not "essentially important." In sum, mandatory disclosure is viewed differently if one recognizes that more information is not always better than less.
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A leading current issue is short selling, which, as you know, has received widespread attention. Much of the attention has focused on the so-called "uptick" rule, but short selling also implicates disclosure. In September and October of 2008, during the midst of the financial crisis, the Commission took steps to require disclosures by institutional investment managers of their short sales and short positions, culminating in Interim Final Temporary Rule 10a-3T.12 Initially, the disclosures were to be public, but the Commission, upon reconsideration, permitted the disclosures to remain confidential. This past July, the Commission chose not to extend the temporary rule and instead announced that the agency was working with relevant SROs to ensure enhanced public disclosure of short selling volume on a daily basis and individual short sale transactions on a delayed basis.13 The SEC also announced that fails-to-deliver data would be disclosed twice a month.
Questions persist as to whether additional short selling disclosure should be mandated beyond these enhancements. Two possibilities are of particular note, both of which were addressed at a recent SEC roundtable.14 The first, along the lines of Interim Final Temporary Rule 10a-3T, would be to require certain investors to disclose data regarding their shorting activities on a public, as compared to a nonpublic, basis. The second possibility would be to add an indicator to the consolidated tape marking whether a sale was short.
As an initial matter, it would seem that more public disclosure about short sales would promote market integrity by providing market participants with more complete information about other's trading. However, the analysis is not so straightforward. Let me briefly highlight a few considerations that might offset the transparency benefits of these possible short sale disclosures.
A principal drawback of requiring investors to disclose publicly their short sales or short positions is that such disclosure could compromise proprietary trading strategies, as well as chill hedging activities. Hedging is socially valuable in that, among other things, it can encourage investors to take long positions, thus facilitating capital formation. More active trading strategies that rely on short selling also serve an important purpose, improving market quality by incorporating the more pessimistic views of short sellers into securities prices. To the extent additional short sale disclosure results in less short selling, markets actually may become less transparent, with securities prices reflecting fewer perspectives.
Concerning the possibility of indicating short sales on the consolidated tape, there is a risk that investors could misinterpret the signal. Investors, for example, could interpret an identified short sale as reflecting a decision to sell based on fundamentals when, in fact, the short sale could be a hedging transaction. Consequently, such indicators could fuel excessive selling if investors cannot distinguish hedging from other short selling.
This streamlined discussion of short selling is all to say that we need to be mindful that certain disclosures can lead to misimpressions and might alter behavior in unpredictable — indeed, undesirable — ways. Before mandating a disclosure, it is important to consider carefully how investors will interpret the information and, in turn, how they will react. Transparency, achieved through disclosure, is central to the federal securities laws. Nonetheless, I hope that my remarks have demonstrated that, when evaluating the possibility of new disclosure requirements, it is not enough to emphasize the benefits of disclosure; one also has to engage the costs. Citing the goal of "transparency" or noting the disclosure philosophy of securities regulation should not distract from a rigorous analysis of the competing pros and cons. All things considered, some mandatory disclosures may be unwarranted.
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Over the course of the past 18 months, we have witnessed the demise of investment banks that were considered permanent fixtures on Wall Street. We 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. We also have seen the SEC come under intense scrutiny and face harsh criticism.
Without question, there is room for the Commission to improve; no organization is perfect. Everyday, leading businesses ask, "How can we do what we do better?" Everyday, we at the SEC need to ask ourselves the same question. Just because we are a government agency, we do not and should not get a pass from the obligation to reevaluate whether we have the right structures, processes, controls, and skills to ensure that we are exceeding every expectation of us.
That said, the bottom line should not be overlooked: The SEC is an agency of overall success, with a 75-year tradition of commitment, excellence, and expertise that promises a distinguished future. I am privileged to work closely with the dedicated Commission staff, and I am honored to have the opportunity to serve the public as a member of the SEC. Thank you for your attention and enjoy the rest of the symposium.
http://www.sec.gov/news/speech/2009/spch101609tap.htm