Reconsidering the institutional design of federal securities regulation.

• Author: Gubler, Zachary J.
• Position: Introduction through II. Critiquing the Statute: Allocating Decision-Making Authority A. Critiquing the Original Justifications for the Public-Private Divide, p. 409-433

ABSTRACT

The institutional design literature is interested in the optimality of particular legal institutions, for example, judicial review of agency actions, corporate federalism, and environmental policy. This Article brings such an analysis to bear on federal securities regulation and argues that we could improve upon the current institutional structure. In particular, the Article proposes that the Securities and Exchange Commission (SEC) be given even more decision-making authority than it currently has under the statutory scheme, effectively authorizing the agency to create disclosure rules for any firm that operates in interstate commerce. At the same time, the Article proposes that we place greater controls on the risk of regulatory error at the SEC by creating a statutory scheme that would place limits on the level of regulatory costs that the agency is permitted to impose on the firms that it regulates. By granting the expert agency more decision-making authority, while at the same time controlling the risk of error inherent in the SEC's complicated regulatory task, the Article argues that we could create an institutional structure that generates disclosure rules that are both smarter and less error-prone. The Article also sketches a possible policy approach along these lines.

TABLE OF CONTENTS INTRODUCTION I. ALLOCATING DECISION-MAKING AUTHORITY AND MANAGING ERROR IN THE EXCHANGE ACT A. Allocating Decision-Making Authority in the Exchange Act: The Public-Private Divide B. Managing Regulatory Error in the Exchange Act: Reliance on Judicial Review II. CRITIQUING THE STATUTE: ALLOCATING DECISION-MAKING AUTHORITY A. Critiquing the Original Justifications for the Public-Private Divide 1. Critiquing the Leveling the Playing Field Justification 2. Critiquing the Investor Protection Justification for the Public-Private Divide B. Critiquing the Revisionist Justifications for the Public-Private Divide C. Expanding the SEC's Decision-Making Authority III. CRITIQUING THE STATUTE: MANAGING RISK OF REGULATORY ERROR A. Four Sources of Error 1. Psychological Biases 2. Public Choice Dynamics 3. Sophistication Constraints 4. Epistemic Limitations B. Judicial Review's Inadequacy as a Tool for Managing Administrative Error Arising from These Four Sources IV. POLICY IMPLICATIONS A. Deferring to the SEC on the Public-Private Divide B. Controlling for Regulatory Error at the SEC C. What About Decision Costs? CONCLUSION INTRODUCTION

The Securities Exchange Act of 1934 (Exchange Act) created the Securities and Exchange Commission (SEC) and the modern framework for regulating the securities markets. (1) As is the case with questions of institutional design more generally, (2) two central goals of the regime are allocating decision-making authority to the most expert institution and minimizing the costs of policy error. This Article argues that these two facets of the institutional design of federal securities regulation need to be reconsidered.

With respect to the allocation of decision-making authority, this Article argues that there are likely benefits to be reaped from giving the SEC even more decision-making authority than the statute already does. (3) This claim is likely to be surprising to many, if not most, securities law practitioners and scholars. After all, the delegation that Congress made to the SEC in the Exchange Act is expansive to say the least. Regarding what are typically referred to as "reporting" or "public" firms, the SEC is empowered to require all, some, or none of those firms to disclose whatever information the SEC decides is "necessary or appropriate in the public interest or for the protection of investors." (4) However, the grant of decision-making authority is not absolute. This is because Congress retains the all-important task of determining what types of firms are subject to the SEC's regulatory decisions. In other words, it is Congress that determines the contours of the divide separating the public (regulated) market from the private (unregulated) one. (5)

Yet, Congress's line drawing in this context increasingly seems arbitrary in light of subsequent developments in the economic analysis of law. When Congress created this public-private divide in 1934, it was largely concerned with placing non-disclosing or under-disclosing firms on an equal footing with those firms that were already disclosing information or that were disclosing a higher quality of information prior to the creation of the mandatory regime. (6) Public choice theory offers reasons to question whether this fairness concern was just political window dressing to mask an attempt by larger firms to place their smaller rivals at a competitive disadvantage through costly regulation. (7)

Furthermore, the economic case for mandatory disclosure implies that the optimal public-private divide is probably much more complex than the current one. The current divide is predicated on three factors: whether a firm's securities are listed on a national securities exchange, whether a firm has made a public offering of securities under the Exchange Act, or whether a firm has more than 2,000 shareholders of record. (8) If a firm can answer all of these questions in the negative, then it escapes the mandatory regime and is part of the private, unregulated market; otherwise, the firm is subject to the mandatory disclosure regime. (9)

However, the modern economic case for mandatory disclosure implies that these disclosure triggers are probably too crude, if not irrelevant altogether. The modern economic case posits that mandatory rules are necessary to correct market distortions caused by the benefits that disclosure creates for third parties. (10) The optimal public-private divide, therefore, would target mandatory disclosure rules at those firms or industries where the third-party effects of information are most significant; and it would do so in reliance on various metrics--for example, accounting profits, concentration ratios, and measures of vertical integration--that come from the accounting and industrial organization literature. (11) The SEC's relative expertise makes it the best institution for making these types of determinations. And consequently, the SEC, and not Congress, should be the one that determines the contours of the public-private divide. (12)

Not only might we benefit from allocating this additional decision-making authority to the SEC, but there are also benefits likely to be gained from adopting additional measures for minimizing the risk of policy error inherent in the SEC's regulatory task. The Exchange Act does not currently do much to deal with this problem, other than subjecting SEC rules to judicial review under the Administrative Procedure Act. (13) But while judicial review is commonly thought to help protect against agency error and bias, (14) it is at best an imperfect tool for minimizing the risk associated with the different sources of error that beset the SEC, which include errors resulting from psychological biases, public choice dynamics, sophistication deficits, and epistemic limitations. (15) For these reasons, additional error-reducing mechanisms may be necessary.

The centerpiece...