The Securities and Exchange Commission--once known for the thoroughness and professionalism of its staff work and analysis--has begun to propose and adopt rules and regulations without support in empirical data. As a result, its recent proposals have drawn unusually sharp opposition and even a lawsuit. If this pattern continues, the agency will forfeit its reputation for deliberate action and make serious policy errors in regulating a vital area of the U.S. economy.
Throughout its seventy-year history, the Securities and Exchange Commission has always distinguished itself among regulatory agencies by the care and thoroughness with which it approached the issues within its jurisdiction. Major initiatives and even relatively modest reform measures were often preceded by extensive staff studies or reports from advisory committees of distinguished members of the securities industry or the securities bar.
Recent examples, among the dozens that have been done only in the last twelve years, are the report of the Division of Investment Management in 1992, which recommends various steps to modernize the regulation of the investment industry; the Report of the SEC staff Task Force on Disclosure Simplification in 1996; the staff Report on the Practice of Preferencing in 1997; the Inspection Report on the Soft Dollar Practices of Broker Dealers, Investment Advisers, and Mutual Funds in 1998; the Special Study of Payment for Order Flow and Internalization in the Options Markets in 2000; and the Report Concerning Display of Customer Limit Orders in May 2000. These reports, studies, and analyses provided an empirical foundation for subsequent commission action, and their thoroughness persuaded those affected by commission decisions that at least the commission had done its homework.
This tradition is fully in accord with the underlying rationale for the creation of the SEC and other independent regulatory agencies as a so-called fourth branch of government. These commissions and their members are supposed to be expert in the fields they regulate, and despite the fact that regulatory agency membership is required to be bipartisan, the matters they deal with are supposed to be largely technical and specialized and subject to resolution on nonpartisan and nonpolitical grounds.
Thus, it has been surprising and disappointing that in the last year, for reasons that are not yet clear, the SEC has abandoned its customary mode of operation and begun to propose major changes in its rules and regulations that are not apparently based on any empirical work by the commission's staff or any significant reliance on academic or other outside studies. As a result, the commission's recent initiatives have seemed ad hoc and superficial--indeed, almost ideologically driven--and as a result have drawn far more opposition from inside and outside the securities industry and within the commission itself than has historically been true of SEC rulemaking.
The first of these initiatives was the so-called shareholder access rule, proposed in the fall of 2003, that would--under certain limited circumstances--permit shareholders of public companies to nominate one or two candidates for membership on a corporation's board, as alternatives to the nominees of the company's directors and management. The rationale for the rule, spelled out in the SEC's accompanying release, is oddly vague. It never describes with specificity what the rule is actually supposed to accomplish, what shareholder rights it is intended to vindicate, or what evidence the commission had assembled in support of the rule. Instead, the rule is said to be necessary in cases where a company's proxy process is "ineffective," or shareholders are "dissatisfied," or shareholder views have not been "adequately taken into account." What the commission exactly meant when it described shareholders as "dissatisfied," or a proxy process as "ineffective," was never spelled out in the accompanying release.
It would be surprising if a rule in this area were really necessary. Public companies have a very strong incentive to make sure their shareholders are not dissatisfied, since by selling the company's stock shareholders have an easy and readily applied remedy if they are truly disaffected. This increases the company's cost of capital and--where the management is compensated in part with stock options--directly reduces management compensation. Accordingly, many public companies have senior officials who are charged with investor or shareholder relations and maintain staffs to answer questions and follow up on shareholder requests. Thus, it would seem unlikely that there is any significant amount of shareholder malaise to be addressed by the SEC--even if that were a fit subject for an SEC regulation.
However, the commission never sought to determine whether in fact this shareholder malaise actually existed. It would not have been difficult to ascertain. Questionnaires, polling, and other methods of investigation would readily have enabled the commission's staff to determine whether dissatisfaction was present among shareholders to such an extent that action by the commission was necessary. This was not done. Instead, after the regulation had been proposed and adverse comment poured in, the commission held a series of "roundtables" at which supporters and opponents of the proposal could have their say. This produced a number of anecdotes about shareholder satisfaction and dissatisfaction, which no serious policy process would regard as evidence, even if it had been solicited and supplied before the SEC advanced its proposal.
The opposition to the shareholder access rule has not diminished since it was proposed. News reports indicate that SEC chairman William Donaldson is negotiating with various business groups to find a formula that they will accept. What is clear is that by proposing a rule that seemed to have no evidentiary or empirical backing, the SEC has forfeited the presumption of good faith and regularity that accompanies sound scholarship.
Mutual Fund Chairs
One of the reasons that Chairman Donaldson may be seeking a compromise on the shareholder access proposal is that putting the rule in final form without that compromise may embroil the commission in a lawsuit. That has already happened with another of the commission's rules--a proposal to require that all mutual funds have independent chairs. Adopted in July 2004, this is yet another example of the commission adopting a regulation without any significant empirical support. Indeed, in this case, the commission had contrary evidence before it--evidence that showed that mutual funds without independent chairs performed better than those in which the chairs were not connected in any way to the investment adviser.
The adoption of the rule drew a sharp dissent from two commissioners, Cynthia A. Glassman and Paul S. Atkins, and the dissent focused on the failure of the commission majority to provide any support for its position: "When the amendments were proposed, we asked that a more thorough analysis be undertaken before effecting these serious changes in an industry that is of such importance to so many investors. Proponents of the rule undertook no such analysis, and the Commission did not use its resources to conduct such an analysis. . . . The empirical data we did receive suggest that the amendments might not be beneficial. The data show a correlation between an inside chairperson and superior performance and no statistically significant negative effect on fees. Indeed, many of the funds that report the best performance and the lowest fees have inside chairpersons."
The absence of any empirical support for the rule was a principal focus of the lawsuit brought against the SEC by the U.S. Chamber of Commerce under the Administrative Procedure Act. After noting that the commission did no study or analysis of its own, and ignored the data generated in the study cited by Commissioners Glassman and Atkins, the complaint quotes from the transcript of the open meeting on the proposed rule at the time it was adopted: "'There are no empirical studies that are worth much,' the chairman of the commission stated in the Open Meeting where the commission voted to adopt the new rule. Economic studies should not be awaited, another commissioner stated, because 'methodologies will always be flawed, or at least subject to question.'" These statements suggest one reason why the commission has ceased to do the kind of analysis for which it was at one time justly respected, and why it has now begun to make rules and regulations that are so controversial and divisive that they bring on lawsuits from affected groups.
But important as the independent chairman requirement is to the mutual fund industry, it pales in comparison with the importance of proposed Regulation NMS--a regulation that would completely restructure the markets for trading securities. This regulation, described by the chairman as intended to "modernize the regulatory framework for the National Market System," was proposed in February 2004. Yet, once again, even in this vital area--central to the functioning of the capital markets in the United States--the commission acted without any significant empirical work, without any staff studies or reference to the extensive body of academic work in the field, and without the assistance of any advisory groups from the industries affected.
As a regulation intended to modernize the National Market System mandated in 1975 by Congress, Regulation NMS is indeed a far-reaching proposal. It consists of four principal elements that together would substantially change the structure of the existing securities market. In the original National Market System legislation, which followed serious SEC studies of the securities market in 1963 and 1971, Congress seemed to contemplate a number of regional securities markets that would compete with the New York Stock Exchange and a future in which investors would be able to access these markets without the use of intermediaries. This is not, of course, the structure that has since developed. Today, the NYSE remains the dominant market for NYSE-listed securities, many of the regional exchanges have withered, and investors who want to buy or sell NYSE-listed securities must still do so by placing orders with brokers. The NYSE remains largely what it has been for at least a century--an open-outcry auction market where one specialist firm makes a market in each listed security at a physical place on the trading floor of the NYSE.
But while the structure for trading NYSE-listed securities has remained largely immutable, there has been a virtual revolution elsewhere in the securities markets since 1975. An informal dealer market that traded non-listed securities over the counter in 1975 became a formalized dealer market known as Nasdaq; entirely new computerized order-matching venues (known as electronic communications networks, or ECNs), arose to challenge the Nasdaq dealer market; and in response Nasdaq itself became a fully electronic trading venue. Nasdaq has no "floor;" its trading activity occurs entirely on its computer servers, as is the case with the ECNs. In some ECNs, institutional traders can trade anonymously with other institutions without the intercession of a broker, but Nasdaq retains its character as a dealer market in which securities broker-dealers are the only participants.
Although the NYSE and Nasdaq compete for company listings, they do not truly compete for investor trading interest. If an investor wants to trade a NYSE-listed security, he or she will almost always do so on the NYSE, and an investor wishing to trade Nasdaq securities will do so virtually always on Nasdaq or on one of the ECNs that compete with one another and with Nasdaq. The reason all securities are not traded in all markets--the reason that NYSE securities are not traded on Nasdaq and vice versa--is SEC regulation. Since 1975, when it began to implement the National Market System, the SEC has favored a centralized market for trading securities and has approved rules--such as the so-called trade-through rule-that tend to support a single centralized market such as the NYSE. Although the details of the trade-through rule are beyond the scope of this memorandum, suffice it to say that the rule has the effect of reinforcing the liquidity advantages that a centralized market derives from its dominant position.
For historical reasons, the trade-through rule has never been applied to the Nasdaq market. This is because Nasdaq began, not as a securities exchange, but as a dealer market. Dealers made markets in individual securities, and as communications technology developed, their willingness to buy and sell was communicated to other dealers--and by them to investors--through a centralized Nasdaq screen. With the advent of ECNs, the Nasdaq dealer market came under significant pressure; the ability of ECNs to match buy and sell orders virtually instantaneously, at low cost and with anonymity and confidentiality, threatened to erode the business of traditional market makers. To address this situation, Nasdaq itself became an electronic market in which buy and sell orders are matched on Nasdaq's own proprietary system, known as Supermontage. Nevertheless, today less than 20 percent of the trading in Nasdaq securities occurs on Nasdaq itself.
Thus, because of the competition from ECNs, and without the protection of SEC regulation, the Nasdaq market is not a centralized trading venue like the NYSE; instead, it is a market made up of a large number of competing market centers, each of which vies for the business of investors by offering improved service and the lowest bid-asked spreads.
The fact that Nasdaq and the NYSE do not compete for the trading interest of investors raises significant questions. Since the two trading venues offer entirely different market structures--a centralized, noncompetitive market in the case of the NYSE, and a decentralized, competitive market in the case of Nasdaq--the most important question is simply: which market structure is best for investors? This question in turn raises a host of subsidiary questions:
- In which market are bid-asked spreads the lowest for comparable securities?
- Does the decentralization of trading--fragmentation, as it is called--in the Nasdaq market reduce the quality of executions that investors receive?
- Does the centralization of trading on the NYSE, on the other hand, improve the quality of executions?
- Does a human-mediated market like the NYSE function in a more orderly way--especially under conditions of stress--than an electronically mediated market such as Nasdaq?
- Is one market better than another in handling small trades or large trades? Is one market better than another for issuers?
- If their interests differ, should the interests of individual investors take precedence over the interests of institutional investors, or vice versa?
- Do institutional investors, as many of them claim, achieve better overall pricing on ECNs than they achieve on the NYSE?
- Does the information advantage of NYSE specialists and brokers increase the market impact of large orders by enabling specialists and brokers to trade ahead of or free ride on these orders?
Many of these questions have been discussed in academic papers and in reports by market participants of their own experiences. There are no clear and certain answers. But what is clear is that it makes no sense as matter of policy for there to be two separate and entirely different markets for trading securities in the United States, especially when--because of regulation--they do not compete with one another. One of these markets is best for investors, and will produce--on the whole--the most efficiency, the best service, and the lowest prices.
In the ordinary case, where two different service systems are available to the public, one of them eventually establishes dominance. An example is the dominance that the Windows operating system for computers has established over Macintosh and other systems. But this is true only where the two systems actually compete. If the NYSE and Nasdaq actually competed for investor trading interest--if NYSE securities, for example, could easily be traded on the ECNs or on Nasdaq without the limitations imposed by regulations such as the trade-through rule--there would be no need for these questions to be asked. The choices made by investors in seeking out the best services and prices would provide the answers. This is what happened in the Nasdaq market after the rise of ECNs; the choices made by investors eventually forced Nasdaq to change its structure in order to compete with what was apparently a superior technology.
One would think that since SEC regulation is responsible for the oddly bifurcated structure of the U.S. securities markets, the commission would seek to answer the questions outlined above before attempting any market reform. But once again the SEC has acted without any apparent interest in empirical data. The 200-page release that accompanied Regulation NMS does not contain any rationale for the proposal--no analysis comparing the benefits that investors or companies receive from a centralized market with the benefits they derive from a competitive market and no suggestion of what interests and purposes the SEC believes the securities market should serve. In Regulation NMS, the SEC has proposed to restructure the securities markets in significant ways, without the staff studies, the advisory committee reports or the extensive preliminary analysis that has characterized SEC action in the past.
As a result, the SEC is likely to encounter profound opposition to whatever course it adopts, and--if it ultimately adopts Regulation NMS--may once again find itself embroiled in litigation. Most important, however, is the fact that the SEC will have forfeited two important values--its reputation for thorough and unbiased work on behalf of investors and the opportunity to ensure the development in the United States of a securities market that will best serve investors in the future.
1. Also missing from the release is any clear statement of the source of the SEC's authority to make a rule that attempts to regulate corporate governance in order to address such things as shareholder "dissatisfaction." However, questions about the SEC's authority are beyond the scope of this paper.
2. Geoffrey H. Bobroff and Thomas H. Mack, Assessing the Significance of Mutual Fund Board Independent Chairs: A Study for Fidelity Investments, March 10, 2004.
3. Dissent of Commissioners Cynthia A Glassman and Paul S. Atkins, Investment Company Governance, Release no. IC-26520.
4. The complaint cites "Transcript of Open Meeting (June 23, 2004)."
5. The four elements are: (i) authorizing investors under certain circumstances to opt out of the trade-through rule (discussed infra); (ii) setting a cap for market access fees imposed by Electronic Communications Networks; (iii) prohibiting sub-penny quoting for stocks; and (iv) a new system for allocating data fees. This essay will discuss the proposal with respect to the trade-through rule.
6. See Peter J. Wallison, "The SEC and Market Structure Reform: No Data, No Analysis, No Vision," Financial Services Outlook, July 2004.
Peter J. Wallison is a resident fellow at AEI.