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Will court short-circuit Dodd-Frank?—A Commentary by Elaine Buckberg and Jonathan Macey ’82 and James Overdahl

The following commentary was posted on on August 15, 2011.

Will court short-circuit Dodd-Frank?
By Elaine Buckberg and Jonathan Macey ’82 and James Overdahl

The Securities and Exchange Commission’s failure to consider the economic effects of its rules is now undermining its ability to reform the regulatory landscape under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

The D.C. Circuit Court of Appeals cited this failure in a July 22 decision, Business Roundtable v. SEC, when voiding the SEC’s new proxy access rule — which would give large shareholders the right to place nominees for corporate directors on the company’s own ballot.

Though the SEC ran a cost-benefit analysis of its rule, the D.C. Circuit, which has a thorough understanding of the capital markets and economic forces, found the quality, objectivity and completeness of the analysis insufficient. Judge Douglas Ginsberg wrote that the SEC “failed to respond to substantial problems raised by commenters,” by disregarding their economic arguments and empirical evidence.

The Business Roundtable decision has special significance because the SEC rule struck down was the first of approximately 250 new regulations required under Dodd-Frank.

This proxy access case is just the latest of several recent successful court challenges to SEC rules. In all these cases, the court identified weaknesses in the SEC’s regulatory reasoning — resulting in the challenged rules being rejected and sent back to the commission for further consideration. The clear message in all these decisions is that regulators must take more seriously the economic effects of their proposed rules in order to withstand judicial review. An appeal is always possible, of course, and the decision could be reversed by the entire D.C. Circuit or the Supreme Court.

By law, the SEC is required to consider the effects of a proposed regulation on efficiency, competition and capital formation. The D.C. Circuit, through this series of critical decisions, is telling the SEC that rigorous economic analysis is required — and this can’t be satisfied by offering unsupported assertions or legal arguments.

SEC Chairwoman Mary Schapiro created the Division of Risk, Strategy and Financial Innovation in a highly publicized September 2009 move. This is the first new SEC division in 37 years.

Its goal is “to help the commission approach complex matters” by drawing on economists and others whose “interdisciplinary insights are vital to good decision-making.” Shapiro even noted that her new division “has parachuted into complex legislative matters demanding immediate specialized expertise… including proxy access rulemaking.”

In May, the SEC appointed Craig Lewis, a Vanderbilt professor who is a leading financial economist, to run the division and also serve as the commission’s chief economist. This is a signal that the SEC is seriously engaging its staff of respected economists and integrating them into its regulatory process.

Better regulation, able to survive review by the D.C. Circuit Court, will likely require incorporating substantive and independent economic analysis into the development of every rule as standard operating procedure.

Congress was right to require administrative agencies, including the SEC, to examine the economic effects of their rules, because this consideration improves regulatory decision-making. Rigorous, data-driven economic analysis enables agencies like the SEC, to understand the trade-offs and consequences of proposed rules.

The SEC, as well as other federal bureaucracies, has an obligation to take economics seriously. Decisions like Business Roundtable tell the SEC that it cannot justify proposed rules with “back of the envelope” analysis; or by picking and choosing analysis on the basis of results rather than analytical quality.

The courts are demanding that economic analysis be given higher priority and be performed with integrity and analytical rigor.

Acceptable economic analysis is not a lawyers’ game involving advocacy. Whether the rules implementing Dodd-Frank survive the D.C. Circuit will depend on whether regulators responsibly consider the economic effects of their regulatory actions.

Elaine Buckberg is senior vice president at NERA Economic Consulting. Jonathan Macey is Sam Harris professor of corporate law, corporate finance and securities law at Yale Law School. James Overdahl is vice president at NERA Economic Consulting and served as chief economist at the Securities and Exchange Commission and the Commodity Futures Trading Commission. Buckberg and Macey co-wrote a report critical of the SEC’s original proposed proxy access rule, which was cited in the D.C. Circuit decision.