Allocating regulatory resources.

• Author: Aviram, Amitai

1. INTRODUCTION II. TRADEOFFS IN ALLOCATING REGULATORY RESOURCES A. There Is More to Resource Allocation Analysis than Costs and Deterrence B. Placebo Effects of Law Enforcement C. Administrative, Accountability, and Community Effects of Law Enforcement III. REGULATOR'S MOTIVATION IN ALLOCATING REGULATORY RESOURCES A. Bias Arbitrage: Private Incentives to Create Placebo Effects B. The Effect of Political Sensitivity on Resource Allocation C. Enforcement Allocation Structures 1. Public Actor, Multiple Balancers: Budget Oversight Structure 2. Public Actor, Single Balancer: Single Balancer Structure 3. Private Actor, Single Balancer: Private Balancer Structure 4. Private Actor, Multiple Balancers: Public Oversight Structure 5. Why Is the Budget Oversight Structure So Prevalent? IV. CONCLUSION I. INTRODUCTION

   In a recent speech, Securities and Exchange Commission (SEC) Commissioner Troy Paredes presented his views as to the allocation of the SEC's law enforcement efforts:

   [S]ometimes the best choice is not to bring a particular case or advance a particular charge. When deciding how best to allocate the agency's resources, the Commission has to make difficult choices. Enforcement is no exception. As much as we might like to, we simply cannot pursue to the fullest extent each and every possible violation of the securities laws. We have to make tradeoffs--reflective of our policy determinations--in light of the relevant costs and benefits that attend our different options. ... Even when we pursue a meritorious case, there is an opportunity cost that may argue for allocating the Commission's resources differently. Resources committed to a particular matter become unavailable for some other--perhaps better--purpose.... Case selection, then, is critical. (1) Commissioner Paredes went on to describe key considerations that "should inform how [the SEC allocates its] enforcement resources." (2) Though not expressly framed as such, these considerations assess the impact of enforcement on the behavior of potential wrongdoers--mostly through deterrence--and balance this impact with the cost of enforcement (mostly the opportunity cost, (3) which is the deterrent effect that could be achieved if enforcement resources were allocated to another case). (4)

   Commissioner Paredes' considerations are very sensible but, as this Article argues, they ignore an important aspect of enforcement--how enforcement changes the behavior of potential victims of the wrongdoing. This Article calls this effect the placebo effect of enforcement because--like a patient who feels better after taking a placebo, thinking it was real medicine--it reflects change to social welfare that is caused by the public's perception that the law is enforced, as opposed to change that is caused by the actual reduction in wrongdoing. Note that a legal placebo effect does not mean that the action is a pure placebo (in the case of enforcement, that enforcement does nothing to deter wrongdoing). The action may well also have objective effects, but in addition to those, there is a separate effect caused by potential victims' impression that enforcement affects a threat with which they are concerned. Analogized back to medicine, the placebo effect of medicine is the increased effectiveness of a medicine that is due not to the chemicals in it but to the fact that the patient knew she was ingesting medicine--how much slower or less fully would the patient heal if the medicine was secretly placed in her food and she was not aware that she was taking it?

   Commissioner Paredes' analysis reflects the common view that case selection (i.e., the allocation of enforcement resources) by law enforcement

   bodies ("regulators" (5)) is a tradeoff between enforcement costs and deterrence of potential wrongdoers. This Article argues that resource allocation in fact involves a more nuanced tradeoff between enforcement's social welfare effects on three key actors:

   * administrative effects (the effect of enforcement on regulators: enforcement costs and also benefits such as improved expertise and economies of scope in enforcement);

   * accountability effects (the effect of enforcement that is attributable to changing the behavior of potential wrongdoers: aligning potential wrongdoers' interests with those of society as a whole); and

   * community effects (the effect of enforcement that is attributable to changing the behavior and satisfying preferences of potential victims).

   Legal placebo effects are a type of community effect of enforcement, just as deterrence is a type of accountability effect of enforcement. The concept of legal placebo effects provides insights not only (normatively) into how regulators should allocate resources, but also (descriptively) into how regulators allocate resources in practice. This is because the creation of placebo effects through regulation provides regulators with an opportunity to reap private benefits--a strategy called bias arbitrage. (6) Analogizing to medicine, bias arbitrage is akin to the benefit to the doctor from the gratitude and patronage of a patient whose health was improved by her belief in the doctor's skill and in the medicine and placebo's effectiveness. (7) When well-executed, bias arbitrage provides significant benefits to the regulator engaging in it, and unlike most deceptions, it often benefits the subjects (i.e., the public). (8) Furthermore, unlike most deceptions, events taking place after a well-executed bias arbitrage add to (rather than detract from) the credibility of the regulator. (9)

   Given the significant private incentive that bias arbitrage provides regulators, the opportunity a regulatory action provides for bias arbitrage is a good predictor of whether resources will be allocated to pursue the regulatory action by a regulator who can benefit from bias arbitrage. Not all regulators benefit to the same degree, however. Because it provides public appreciation and enhances credibility with the public, bias arbitrage is beneficial to regulators who are politically sensitive (that is, regulators who derive a private benefit if the public appreciates them, or who suffer a private loss if the public disapproves of them). In contrast, politically insulated regulators do not benefit much from bias arbitrage and can be expected to be guided in their resource allocation by other criteria.

   Therefore, the potential of bias arbitrage to predict and affect resource allocation depends on the political sensitivity of the regulator. Political sensitivity, in turn, depends on the regulator's enforcement allocation structure: the rules that determine who sets the various constraints that determine resource allocation and what private benefits they receive. (10) This Article considers common enforcement allocation structures, their impact on a regulator's political sensitivity, and ultimately on the allocation of enforcement resources. Besides illuminating regulators' resource allocation, this analysis contributes to the debate on the desirability of self-funding regulators, a debate most recently raised during the formulation of the Dodd-Frank Act by proposals to replace congressional budgeting of the SEC with self-funding through the fines and fees it collects. (11)

   Part II addresses the primary normative contribution of this Article: what should regulators consider when allocating enforcement resources? (12) It challenges the traditional, two-way (cost vs. deterrence) tradeoff framework of analyzing optimal law enforcement and explains why optimal law enforcement is better analyzed as a tradeoff between three types of effects: administrative effects (impact on regulators), accountability effects (impact on potential wrongdoers), and community effects (impact on potential victims).

   Part III turns to the descriptive contribution: what, in practice, motivates regulators in allocating enforcement resources? (13) It explains the method, private benefits, and public impact of bias arbitrage, then connects the private desirability of bias arbitrage to the political sensitivity of the regulator. It concludes with an analysis of the main determinant of a regulator's political sensitivity: enforcement allocation structures, which are the rules that determine who sets the constraints that determine resource allocation. (14) Part IV concludes.

2. TRADEOFFS IN ALLOCATING REGULATORY RESOURCES

   1. There Is More to Resource Allocation Analysis than Costs and Deterrence

      Analysis in optimal deterrence literature drives much of the current thinking about regulators' resource allocation. "Optimal deterrence" denotes a thread of the law and economics scholarship that is concerned with identifying the level of penalties that maximize social welfare by deterring violations of the law. (15) In the context of law enforcement, optimal deterrence models consider the costs and benefits of law enforcement and identify the optimal point as the one where the marginal cost of additional enforcement equals the marginal utility to society from preventing (e.g., through incarceration) and deterring future violations of the law. (16) Much of this literature focuses on modeling the impact of deterrence (e.g., is it better to increase the probability of detecting wrongdoing or the penalty to those who are caught?). (17) Models of optimal law enforcement consider the effects of enforcement on potential wrongdoers with increasing sophistication. (18)

      It is uncontroversial (at least to a utilitarian) that law should be enforced as long as the benefits outweigh the costs. But this analysis is only good if it incorporates all significant costs and benefits. The conventional analysis considers enforcement's impact on the behavior of two actors: regulators, who expend resources to enforce the law--a cost--and potential wrongdoers, who are deterred, incapacitated, and rehabilitated by enforcement--a benefit. Conventional analysis ignores a third actor--potential victims--who may...