Split Decision at the SEC

Split Decision at the SEC

Smith Op-ed in The Washington Times
June 25, 2004

Nobel Prize economist Ronald Coase long ago warned of a political risk—that of wishing to be an "economic statesman," which he defined as a person who gives answers when there were none to give.  The newest such risk was this week's Securities and Exchange Commission ruling to require that mutual fund boards have chairmen independent of fund management, rather than leaving that up to directors. 

SEC Chairman William Donaldson should have followed the example of the Federal Trade Commission, which correctly reported last week that the spam problem could not be resolved by a do-not e-mail list.  With a level of honesty (unusual in the political world), the FTC noted there are problems unsolvable by facile government intervention.      

In contrast, Mr. Donaldson has already bent with the political winds by demanding all firms expense stock options, though the mandate leaves the valuation technique to the firm.  But now if a firm gets the number wrong in quarterly reports, it may face lawsuits and even criminal penalties.

A mandate that the chairmen of mutual funds be "independent" will mean greater micromanagement for these funds.  The rationale, as so often with our White Hat regulators, is to protect the consumer from "conflicts of interest."     

Fund managers, it is argued, benefit directly from the fee structures and operating policies of their funds.  If they also determine these policies, how will we know the investor is getting the "best buy?" 

That a fund is regulated far more effectively by the market than by the government seems to have eluded the SEC. Seeking "economic statesman" status, Mr. Donaldson is eager to reduce the "conflict of interest" he sees in the investment world.  But of course, that conflict is linked to potential consumer benefits: Fund managers, after all, are most familiar with the operating policies of the fund, the likelihood various incentive features will encourage better investor service, and the need for internal controls and incentives to discipline errant employee behavior.      

Of course, these management policies sometimes fail.  But the mistakes or bad luck of a fund are apparent to that fund's investors without the SEC, as every poorly performing fund has found to its manager's dismay.      

Mr. Donaldson's political judgment the consumer will benefit by gaining "independence" and sacrificing "knowledge" is certainly statesmanlike (Eliot Spitzer would surely approve).  But how does he know?  And, if wrong, he likely to suffer the quick discipline felt by many mutual funds in recent years? 

The corporation is subject to such market discipline: Firms continually change internal management systems, moving tasks into or out of the firm, modifying their corporate governance rules in myriad and complex ways.  Competition requires firms to seek improved performance continually, greater consumer satisfaction.  Does Mr. Donaldson really believe badly performing firms suffer no market penalty? 

Long ago, another Nobel Prize economist, George Stigler, noted the SEC was set up in response to losses in the Great Depression.  Investments certainly dropped in value, and cries of fraud and error abounded.  Mr. Stigler, however, sought to look deeper: How did investors fare after the SEC began "protecting" investors?  He found people had indeed lost money in the market-regulated stock world—and continued to do so in the SEC-regulated world.      

The SEC, in other words, added new burdens to the economy, made it harder for smaller firms to raise capital, and reduced faith in the market.  But there was little evidence it had done anything useful.      

Indeed, when the Bush administration arrived, there was some hope the failures of past political controls on the stock market might lead to less reliance on SEC-style rules and more on competitive market forces.  Some noted how existing regulations weakened the disciplinary force of competition, both by discouraging adverse information about a firm from affecting stock values (the restrictions on insider trading) and by making management changes more costly (the rules against "hostile" takeovers).  There was also growing awareness the SEC had seriously overreached in demanding a numerical value be assigned even the most arcane of assets and liabilities.  The case for reining in the SEC "statesmen" was strong.      

Sadly, the failures of Enron and WorldCom were misread by the media: The market had failed, government must do something.  It was ignored that the market had already, and earlier, moved quickly to punish the firms involved and that private litigation was moving ahead to address possible frauds.      

Mistakes had been made; the government must provide an immediate solution.  And "statesmen" rushed to meet that demand.  Sarbanes-Oxley, (the Patriot Act for the Economy, as one struggling investor labeled it), a poll-driven administration, and Governor-Candidate-to-Be Eliot Spitzer of New York moved to grant the SEC godlike powers over the stock market.      

Tragically, these new powers confer no new wisdom or competency.  One can only regret the FTC's spurt of honesty in its spam decision did not reach the SEC. America's economy needs more honest bureaucrats and fewer "statesmen."