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Enhancing SEC Rulemaking Through Rigorous Economic Analysis

This is the first post in a guest blog series on the SEC’s rulemaking process by former SEC Chief Economist Craig Lewis.

Between May 2011 and May 2014, I had the privilege of serving as the Chief Economist and Director of the Division of Economic and Risk Analysis (DERA) at the U.S. Securities and Exchange Commission (SEC). During this period, I led a significant initiative, in partnership with the Office of the General Counsel (OGC), to fortify the integration of thorough economic analysis into the SEC’s rulemaking process.

Historically, the primary responsibility for crafting economic analysis in SEC rule-writing was handled by divisions such as Corporation Finance, Investment Management, and Trading and Markets. DERA economists were allowed to contribute but not to lead. They could review but not mandate changes based on economic considerations, a limitation that became a critical issue.

This limitation was starkly highlighted when, in a landmark decision, the U.S. Court of Appeals for the District of Columbia Circuit vacated the SEC’s Rule 14a-11, also known as “Proxy Access.”[1] The court deemed the SEC’s economic analysis as “arbitrary and capricious,” criticizing the Commission for not adequately considering the rule’s economic effects on efficiency, competition, and capital formation, nor the costs it would impose on companies. Ironically, nine years later, the widespread voluntary adoption of proxy access bylaws by 76% of S&P 500 companies underscored its value as a governance tool.[2]

Even before this judicial setback, a team of DERA economists was already exploring ways to refine the SEC’s approach to economic analysis.[3] Despite initial skepticism about greater economist involvement, the Proxy Access ruling catalyzed a comprehensive reevaluation. Prompted by a critical review from the SEC’s Office of Inspector General (OIG) in March 2012, which underscored the need for transparent and rigorous economic analysis, DERA and the OGC developed and implemented the “Current Guidance on Economic Analysis in SEC Rulemaking.”

The Guidance aimed to insulate SEC regulations from judicial challenges related to economic analysis by systematically integrating economic considerations into rulemaking. It shifted the development of economic analyses to DERA, significantly enhancing the division’s role. A pivotal aspect of the Guidance was mandating formal concurrence from the Chief Economist on the economic analysis, effectively elevating the position’s influence within the SEC, and prompting some staff to refer to the Chief Economist as the “sixth commissioner.”

The essence of the Guidance aligns with practices of other regulatory bodies but is tailored to address the unique needs of the SEC. It comprises four key elements:

  1. Identifying the Rulemaking Need: It starts with pinpointing a “market failure” and outlining how the proposed rule intends to address this need.
  2. Establishing an Economic Baseline: This involves defining a baseline for assessing the likely economic impacts of the rule, serving as the foundation for a cost-benefit analysis that considers effects on market efficiency, competition, and capital formation.
  3. Evaluating Reasonable Alternatives: This step requires identifying and assessing reasonable regulatory alternatives.
  4. Assessing Economic Impacts: The Guidance calls for a thorough evaluation of the potential economic impacts of the proposed rule and its alternatives, leveraging the best available evidence to quantify costs and benefits wherever possible, and explaining any challenges in quantification.

The overarching goal of the Guidance is to ensure the benefits of a rule justify its costs, thus promoting more effective regulations. However, quantifying benefits poses challenges, as not all economic effects are easily measurable. The Guidance mandates that, when quantification is elusive, the SEC must clarify the reasons.

Integrating rigorous economic analysis into SEC rulemaking aims to ensure an objective and unbiased examination of potential regulatory impacts, striving not for a justification of a rule but for a comprehensive assessment of its implications. This methodology signifies a profound shift towards more informed decision-making within the SEC. However, the actual adherence to the Guidance can vary with shifts in the Commission’s makeup and changes in staff leadership positions. Such variability introduces the risk of regression, particularly if DERA staff begin to see their role more as advocates for certain outcomes rather than as impartial evaluators of economic consequences.

Currently, under the leadership of Gary Gensler, the SEC is at a critical crossroads regarding the execution of this robust economic analysis framework. From my perspective, the economic analyses accompanying recent SEC rule proposals and final rules have been lacking, marred by significant deficiencies. In forthcoming blog posts, I will delve into these issues within the context of specific regulatory initiatives, highlighting my primary concerns:

  1. Ill-Defined Regulatory Need: A frequent shortcoming in recent rules is their failure to clearly define a need for regulation. Often, if a compelling market failure is not identified, the SEC defaults to asserting an unfair disadvantage to a particular investor group, typically retail investors, or citing weak economic justifications such as asymmetric information.[4]
  2. Lack of Consideration for Interactive Effects: Proposed rules often interact with one another yet are analyzed in isolation, without acknowledgment of their cumulative impact. This approach overlooks the complex, interconnected nature of market dynamics, treating each rule as an isolated solution to the same perceived problem.
  3. Selective Academic References: The SEC’s economic analyses sometimes exhibit a biased treatment of academic research, selectively citing studies that support a rule while disregarding those that do not. In more concerning instances, academic work has been misquoted, undermining the integrity of the analysis. The controversy surrounding the “stock buyback” rule, which was recently vacated, serves as a case in point.
  4. Flawed Quantification Attempts: Certain rules have attempted quantification with flawed methodologies. I plan to discuss an example of this issue, specifically relating to the proposed Order Competition rule, in a subsequent post.
  5. Insufficient Planning for Non-quantifiable Impacts: When quantification proves challenging, there’s a noticeable absence of a comprehensive strategy for evaluating whether a rule achieves its intended outcomes. This includes a lack of plans for retrospective reviews to assess effectiveness, necessary data for such evaluations, and a timeline for completion. An innovative approach to incentivize these reviews could involve a stipulation that rules revert to their original baseline should the evidence contradict the rule’s objectives or if the SEC fails to conduct the review within a set deadline.

The faithful application of the Guidance in evaluating these aspects is paramount to maintaining the integrity and effectiveness of SEC rulemaking. Future discussions will further explore these challenges, offering insights into how they affect the regulatory landscape.

Author

Craig Lewis Craig M. Lewis is the Madison S. Wigginton Professor of Finance, Emeritus at the Owen Graduate School of Management at Vanderbilt University. He is a former Chief Economist and Director of the Division of Economic and Risk Analysis (DERA) at the U.S. Securities and Exchange Commission (SEC). 

Footnotes

[1] Business Roundtable and Chamber of Commerce vs. SEC, 2011, https://www.cadc.uscourts.gov/internet/opinions.nsf/8 9BE4D084BA5EBDA852578D5004FBBBE/$file/10-1305-1320103.pdf

[2] See Sidley, 2020, “Proxy Access: A Five Year Review.” https://www.sidley.com/en/insights/newsupdates/2020/01/proxy-access-a-five-year-review#:~:text=Proxy%20access%20is%20now%20mainstream,in%20the%20company’s%20proxy%20material.

[3] Although DERA was named Risk, Strategy and Financial Innovation at the time of these efforts, many DERA economists participated in developing a precursor to what eventually became the Guidance. The principal authors and those tasked with presenting ideas to the rule writing divisions were Bruce Kraus, Alex Lee, and myself.

[4] Although the Guidance uses asymmetric information as a possible market failure, some level of asymmetric is necessary to facilitate trading (Grossman and Stiglitz, Grossman, 1980, “On the Impossibility of Informationally Efficient Markets,” American Economic Review. 70 (3): 393–408.) A market failure only occurs when the level of asymmetric information impedes efficiency, competition and capital formation. The idea that some investors perform fundamental research that provides them with a trading advantage contributes to market efficiency and would not be the basis for regulation.

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