By Nick Paraskeva, Compliance Complete contributing author
The financial industry’s self-regulatory organizations (SROs) are being pressed to conduct more rigorous cost-benefit analyses of their rules, to the same standards as federal regulators. This follows recent court judgments overturning rules issued by the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC), in cases brought by the industry on grounds that the rules lacked such an analysis.
“Any rulemaking, whether by an SRO or by the SEC, should be the product of a careful and balanced assessment of the potential consequences that could arise,” said SEC Commissioner Daniel Gallagher at SIFMA’s Market Structure Conference last week. Gallagher advocated the change as part of a call for a fundamental review of the U.S. self-regulatory structure, which consists of both regulators and exchanges. Self-regulators should conduct a “thorough analysis of the intended benefits and the possible costs of a proposed rulemaking”, said Gallagher. This is more important given the current environment of stretched regulatory resources, and a very high level of rulemaking. Gallagher noted that the SEC is handling 10 times it’s normal post-legislation rulemaking volume, compared to the level in the aftermath of the Sarbanes-Oxley act.
The cost-benefit process should involve the regulator identifying the scope and nature of the underlying problem, and the likelihood that the proposed rule will mitigate or remedy it. This includes evaluating how the rule change could impact any firms affected, including the expected costs and benefits. Finally, regulators should justify their recommended rule or course of action, as compared to the main alternatives.
“Cost-benefit analysis isn’t easy, it isn’t quick, and it isn’t cheap,” Gallagher said. “If self-regulation is to remain viable, however, it is necessary.” He questioned whether SROs have the resources and willingness to perform cost benefit analyses to support rulemakings. He cited a dissent with fellow SEC Commissioner Troy Paredes in May, on an MSRB underwriting rule, because their analysis was not rigorous enough.
Gallagher questioned whether FINRA is becoming a “deputy SEC,” akin to a government regulator. With all of the issues facing the broker-dealer industry, he asked whether FINRA should be seeking to branch out into entirely new fields of responsibility, such as examination of investment advisors. He raised the issue of whether such “mission creep” was already affecting FINRA’s ability to perform its core duties.
FINRA’s CEO Rick Ketchum said, in the panel following the SEC’s Gallagher, that FINRA’s structure and governance needed to be different than traditional exchanges, such as the New York Stock Exchange. Describing FINRA as a way-station between classic self-regulation and government regulation, Ketchum asserted it provided a less bureaucratic way to communicate with industry, and requires different obligations for governance.
In response to Gallagher’s comments on cost-benefit analysis, Ketchum said standards in the Securities Exchange Act – the fundamental 1934 law governing securities trading — had not changed, and that the rules of an SRO only needed to be consistent with statute. There should be a level of deference from the SEC to SRO rulemaking, which is different to that used when assessing their own rules. Thus, the SEC does not need to review whether FINRA rules have the same level of analysis.
Ketchum conceded FINRA needs to rethink the informal way they revise and review rules, which has depended on industry input via comment letters and board members. “We have an obligation to reach out at an earlier stage in the process to be more transparent about the rulemaking we are thinking about. This should have regard to the costs, any alternatives to the rule and why the alternatives are not satisfactory”.
The Municipal Securities Rulemaking Board board is also developing a cost-benefit-analysis model, to assess the impact of new rules “We are re-examining the rules to ensure they accomplish what they are intended to, and are consistent where possible with FINRA,” new MSRB chairman Jay Goldstone said at a seminar last week. Consistency with FINRA rules would reduce duplicate compliance costs for firms subject to rules of both regulators.
“The SEC learned their lesson the hard way,” said Gallagher, after having several rules overturned by the courts for lack of process and cost benefit. He referred to industry lawyer Eugene Scalia’s op-ed in that day’s Wall Street Journal “Why Dodd-Frank Rules Keep Losing in Court” for an analysis of the reasons.
“The SEC (and, lately, the CFTC) often does a poor job with the hard work of the rule-making process” said Scalia in the op-ed. “An agency must listen carefully to what the public says about a proposed regulation, reconsider its approach in light of that public input, and then cogently explain (not merely assert) why it made the regulatory choices it did in crafting the final rule”.
Federal regulators are also subject to The National Securities Markets Improvement Act of 1996, which imposes heightened responsibilities on the SEC when determining whether a rule is consistent with the public interest, In addition to the protection of investors, the standard also requires the SEC to assess whether the rulemaking action will “promote efficiency, competition, and capital formation”.
The SEC’s director of the Division of Trading and Markets, Robert Cook, said Dodd-Frank imposed new time limits on the SEC to approve SRO rules, noting they receive 2,000 filings a year. The consolidated audit trail (CATS) rule took a new route of directing SROs to collectively come up with a plan, after discussions with industry, When the SRO’s do issue their plan, the SEC still has to do a full consultation and cost benefit analysis on that plan, likely leading to an even longer rule process.