A bright spot in the bleak financial industry regulatory firmament
Between the various power grabs and dubious regulatory proposals (each more dubious than the last!) from the likes of Geithner, Bernanke, Frank (.pdf), Dodd, etc., etc. you’d be excused for thinking the financial news from Washington (remember when financial news used to come from New York?) was all bad and growing only worse.
But there is a bright spot in this sad state of affairs: SEC Commissioner Troy Paredes. Appointed shortly before Bush left office (with one hand he gave us Troy Paredes; with the other he gave us import duties on Roquefort cheese. I leave it to you to assess the net), Troy is a once and presumably future law professor, treatise author, and all-around sound thinker on issues of corporate governance, corporate law and securities regulation.
Troy has voted against the SEC’s misguided proxy access proposal (see his official comments on the topic here), and he has made impassioned speeches evidencing an otherwise absent understanding of basic corporate governance explaining why the proposal (and others in the same vein) are problematic. Fundamental to his approach are an understanding of the role of risk, a humility born of his appreciation for the complexity of markets, and a constant emphasis on data and evidence-based regulation.
For example, here are some essential points from an excellent speech on the overall regulatory response to the crisis. You’ll never here the likes of Barney Frank, Tim Geithner or Larry Summers (the government incarnation) saying these things:
My basic point is this: Even in times of crisis and hardship, when the benefits of regulation seem apparent and there is pressure to “do something,” we cannot overlook the risk of overregulating. It is essential for the government to retain a healthy respect for the role of markets; and we must appreciate that there are limits to what we can and should expect from regulation.
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Regulating to avoid excessive risk is not costless, whatever the benefits may be of securing the financial system and protecting investors and others from misfortune. Some risks simply are worth it if avoiding them is too costly because legitimate, wealth-creating enterprises and transactions are stifled. In other instances, efforts to clamp down on certain practices and activities may have unintended adverse effects, some of which could exacerbate the concern the regulation targets. This includes the prospect that government action may foster moral hazard. When properly framed, then, the regulatory objective should be to achieve the optimal degree of risk, not necessarily to minimize risk. Achieving the optimal degree of risk involves making tough tradeoffs, netting costs against benefits.
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But I am more troubled by “how” systemic risk might be regulated. Identifying a market failure does not necessarily tell us what the appropriate government response should be. Even when there is a market breakdown, it remains possible for the government’s response to do more harm than good.
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My principal concern turns on the potential scope of the systemic risk regulator’s authority. As a threshold matter, I still have not heard a satisfying definition of what constitutes a systemic risk. Systemic risk is easy enough to conceptualize in theory, but it is much more difficult to identify in practice. What does it mean for a firm to be “too big” or “too interconnected” to fail? A sort of “I know it when I see it” approach to regulating systemic risk is untenable. Such open-endedness accords the regulator too much discretion and is too unpredictable.
Moreover, Troy has made a basic, fundamental argument that I have heard from literally no one else in Washington in all of the debates surrounding executive compensation: While managers may take on too much risk, they also may take on too little (an argument I have also recently made here):
In large part, the disclosure amendments respond to the potential that companies will take excessive risks. As regulatory reforms are proposed to address excessive risk taking, it is important not to overlook that just as a company can assume too much risk, a company also can be overly cautious. Placing undue emphasis on mitigating downside risk can be costly if it chills enterprises from taking the kind of prudent business risks that drive competition, innovation, and entrepreneurism. Our dynamic economy — marked by a constant stream of cutting-edge goods and services and an ever-expanding set of opportunities — depends on the willingness of individuals to take risks.
Most recently he has spoken about the impending Jones v. Harris case in the Supreme Court (on which see this essential post by Josh), and made some sensible remarks concerning the risks of intrusion (by courts as well as regulators) into well-functioning (and, to be fair, already-regulated) market transactions:
First, adequate market discipline can obviate the need for more exacting and burdensome regulation, including demanding judicial scrutiny of advisory fees. One can conceive of the section 36(b) fiduciary duty as compensating for a lack of competition in the mutual fund industry. Put differently, the legal accountability of section 36(b) can be thought of as substituting for a lack of market-based accountability. The industry, however, has changed since section 36(b) was adopted in 1970 and Gartenberg was decided in 1982. To the extent the industry has become more competitive, it may argue for greater judicial deference to the bargain the adviser and the fund strike. In the face of sufficient market forces that constrain advisory fees, the need for courts to monitor as strictly the adviser/board fee negotiations is mitigated.
Second, courts are not well-positioned to second-guess the business decisions that boards and others in business make in good faith. Judges may exercise expert legal judgment, but not expert business judgment. A judge may be equipped to monitor a board’s decision-making process, but should steer clear of the temptation to override substantive outcomes. These sensibilities cut against reading section 36(b) as implementing a sort of substantive limit on fees and instead recommend that courts focus on the process by which the fees were determined.
Of course I would be more strident and incautious in my remarks, but then I am not a public official with a need to ensure I don’t marginalize myself (a fact that may be endogenous to my stridency and recklessness, come to think of it).
There is more from Troy (find his speeches and statements here (scroll down)), and I expect we will see much more to come. I know that there are many of us in the legal and academic communities who welcome these views, and I hope we will do whatever we can to ensure that they gain as much currency as possible. I harbor no illusions about Troy’s ability to redirect Barney Frank’s steamroller, but I am delighted that he is out there, at the highest ranks of the government, fighting the good fight.