19 Feb One Regulator to Rule Them All

“One regulator to rule them all; One regulator to find them; One regular to bring them all; And with enuf freakin red-tape bind them.” – The Lonely Realist

The SEC in late January proposed regulations that would impose new and costly burdens on managers of private equity and hedge funds. A leading American law firm described the SEC’s proposals as representing “a shift to direct regulation on a scale never seen before.” If adopted in their current form, private fund managers will become obligated to deal with their sophisticated institutional investors in many of the same ways as mutual fund managers are obligated to deal with unsophisticated retail investors. The SEC’s rationale is that private markets have grown in size and impact and although institutional investors are sophisticated, well-funded, and expertly-advised, they nevertheless are entitled to the same protections as the general public. The proposals include more detailed disclosure, reporting, recordkeeping, prescribed fee guidelines and required legal provisions that together would pile economic and competitive burdens on America’s world-leading financial markets and world-beating financial businesses. To be justified, the proposed measures must demonstrate discernable benefits that outweigh their costs and burdens. The SEC’s proposals do not do so.

Businesses that rely on raising funds from the general public are highly regulated …, and for good reason. The principal regulatory job of the SEC is to protect the general public, meaning those whose knowledge-level and limited access to information make it inappropriate to hold them to the common law standard of caveat emptor – let the buyer beware! Caveat emptor is a warning to buyers that sellers have more knowledge than they do, an information asymmetry especially relevant to today’s complex financial markets. That’s why the SEC requires public companies – that is, those companies whose securities trade on public markets and those that manage the general public’s retirement monies – to provide copious amounts of information to their investors at levels that enable them to achieve a degree of information/data symmetry. The additional protections provided to such investors are the result of regulatory impositions placed on public businesses by the SEC. The SEC’s approach has ensured that retail investors – the unsophisticated buyers of financial products – are not disproportionately disadvantaged in their dealings with the businesses that market those financial products. Satisfying additional burdensome regulatory obligations has been unnecessary when businesses deal exclusively with savvy, sophisticated investors. By limiting the investor-base, those non-public businesses sacrifice access to the enormous pools of capital available in the retail market. The principal obligation of businesses that limit themselves to market-savvy investors has been to not do bad, fraudulent, or misleading things …, and enforcement of that standard has been left largely to the sophisticated investors making the investments, a pragmatic approach, caveat emptor with guardrails. Now, however, the SEC has proposed equating retail investor protection with sophisticated investor protection.

Of the four sitting SEC Commissioners, only Republican-appointed Commissioner Hester Peirce dissented from the SEC’s regulatory proposals, stating: “[The proposed additions] embody a belief that many sophisticated institutions and high net worth individuals are not competent or assertive enough to obtain and analyze the information they need to make good investment decisions or to structure appropriately their relationships…. Therefore, the Commission judges it wise to divert resources from the protection of retail investors to safeguard these wealthy investors who are represented by sophisticated, experienced investment professionals. [The proposed regulatory] changes represent a meaningful recasting of the SEC’s mission.”

Indeed they do. There no doubt are asymmetries of knowledge and power between the most successful private companies and the institutional investors who invest in them. One consequence of such asymmetry, understandably, has been investor losses where greed overcomes good sense, examples of which include Theranos and Bernie Madoff (previously discussed by TLR here). Yet, that’s been an acceptable trade-off for affected investors. It therefore is not one that should weigh in the SEC’s calculus and certainly not one that should consume any portion of the SEC’s limited budget … or the budgets of affected businesses. Market-savvy investors have the wherewithal to absorb investment losses, while retail investors do not. Moreover, market-savvy investors have an over-abundance of investment choices, which retail investors do not. Should they decide to voluntarily abandon their negotiating leverage and invest without adequate disclosures, they do so with their eyes open and at their individual peril, which is not the same as general public peril. Different from retail investors, they very clearly understand the meaning of caveat emptor. With financial fraud making frequent headlines, it is notable that the SEC’s proposals do not attempt to provide greater investor protection against retail fraud via an enhanced budgetary allocation to enforcement. Instead, the current SEC proposals attempt to mandate “fairer” treatment for wealthy investors that will add legal, accounting and other costs. In doing so, the proposed regulations will spread the private sector’s regulatory budget thinner, benefiting those with the largest compliance budgets, increasing legal, accounting and recordkeeping costs and barriers to entry … and therefore discouraging competition, entrepreneurship and innovation, which will further the interests of existing businesses and justify increased costs to investors.

Even so, SEC Chair Gary Gensler is right in stating that the >$18 trillion of assets managed by hedge and private equity funds have an outsized influence on the markets. “Thus,” he noted, “it’s worth asking whether we can promote more efficiency, competition, and transparency in this field.” The problem is that the SEC’s proposals will not do any of those things. A focus on doing so would require an emphasis on enforcement over the promulgation of unnecessary regulations, an approach that might be less popular with the largest players in the financial industry … but far more productive. Government intervention in the marketplace twists economic incentives and skews supply and demand, reducing economic efficiency. As Commissioner Peirce noted, wealthy investors have the resources to protect themselves. Retail investors do not. All levels of the financial services industry have abusers whose actions damage the economy. TLR can attest to the panoply of existing Federal, international, and state securities, commodities, derivatives, anti-money laundering, know-your-client, tax, corporate and other laws, rules and regulations that are designed to protect investors and markets. Adding to those laws, rules and regulations only makes them denser. There is a never-ending incentive to close loopholes, champion unfairness, and protect those who might be disadvantaged …, including market-savvy investors. More regulations, however, do not necessarily result in better regulation. There needs to be a prioritization, a recognition that the more productive course of government action would be to ensure that the laws, rules and regulations already on the books are adequately properly enforced.

[After reading One Regulator to Rule Them All, an interested reader forwarded TLR a P.J. O’Rourke piece from 2001 that is linked here.]

Finally (from a good friend)