Improving SEC Regulations with Investor Ordering

Scott Hirst is Research Director of the Program on Institutional Investors and Lecturer on Law at Harvard Law School. This post is based on a recent article by Dr. Hirst, forthcoming in the Harvard Business Law Review. Related research from the Program on Corporate Governance includes Universal Proxies, by Dr. Hirst, and Private Ordering and the Proxy Access Debate, by Lucian Bebchuk and Dr. Hirst.

In my forthcoming article, The Case for Investor Ordering, I show that Securities and Exchange Commission (SEC) regulations regarding corporate arrangements could be substantially improved if investors in corporations were able to choose whether those regulations apply to the corporation. For all but a few SEC regulations, such “investor ordering” would result in greater aggregate net benefits for corporations and their investors. Investor ordering also interacts with requirements for cost-benefit analysis to reduce the cost of SEC regulation, and makes SEC regulations more dynamic. Investor ordering will be most beneficial for recent and future SEC regulations, such as regulations regarding internal controls, pay ratios, say-on-pay, proxy access, and universal proxies. These considerations should guide future SEC regulation, and deregulation, towards investor ordering.

The SEC has many regulations that affect the internal arrangements among corporations and their investors. These include regulations about what information corporations must disclose to their investors, how investors may vote in director elections, and the composition of boards of directors. Since the SEC’s inception, these “corporate regulations” have invariably been mandatory in nature—they require the same arrangement for all corporations covered by the regulation.

Why not allow the constituents of a corporations to choose whether the arrangement applies to their corporation, as state law generally does? Mandatory rules have been justified as necessary to control agency costs of managers, and externalities that would affect the capital market. This may have been true when the securities laws were enacted, but it is no longer the case. Institutional investors now hold the majority of equity of corporations, so have the capability to determine corporate arrangements. They have incentives to limit the agency costs of managers, and because they hold positions in many other corporations, to “internalize” the effects of an arrangement on other corporations in the capital market.

Investor ordering permits greater freedom than mandatory regulation, but has structural elements that limit the costs of unconstrained private ordering. Rather than mandating particular arrangements, SEC regulations would be default arrangements. Corporations could opt-out of an arrangement if a majority of outside shareholders approve. The SEC would set the default arrangement so as to encourage managers to initiate opt-outs whenever it would enhance the value of corporations.

The article demonstrates that, for all but a few SEC regulations, investor ordering will have the same or greater aggregate net benefit as mandatory regulation. Where the default arrangement has net benefits for corporations that are greater than the costs of opting-out, no corporations will opt-out, and the aggregate net benefit of investor ordering will be the same. If a default arrangement is more costly for any corporations than the cost of opting-out, those corporations would have greater net benefit with investor ordering, and investor ordering would be superior to a mandatory regulation. This analysis will apply in all situations where institutional investors represent a majority of outside investors in a corporation, which is the great majority of U.S. corporations, and for all regulations where institutional investors are likely to internalize the effects of the regulation. The rare exceptions where institutional investors will not internalize potential effects are those SEC regulations explicitly designed to achieve purposes outside the capital markets, such as regulations requiring conflict minerals disclosures.

This investor value rationale for investor ordering has important interactions with the requirement that the SEC undertake cost benefit analysis. As part of its cost-benefit analysis, the SEC is required to consider reasonable alternatives to its proposed regulations. If the SEC did not consider investor ordering, its regulations would be subject to invalidation by the Court of Appeals for the District of Columbia Circuit. Similarly, if the SEC implemented a mandatory regulation in a situation where investor ordering would have greater aggregate net benefit, the regulation could be considered arbitrary and capricious, and susceptible to invalidation under the Administrative Procedure Act.

The requirement that the SEC undertake cost-benefit analysis has substantially increased the costs of SEC rulemaking. Investor ordering would make it less costly to determine the cost of a regulation. Investor ordering effectively caps the cost to corporations of an arrangement at the cost of switching to an alternative arrangement. Because the switching process will be very similar for different corporations and different regulations, these switching costs will be straightforward for the SEC to calculate. Reducing the cost of cost-benefit analysis would reduce the resources devoted to SEC rule-making, or permit the SEC to undertake a greater level of rule-making on its fixed budget. This would also sidestep much of the academic debate about the merits of cost-benefit analysis.

Investor ordering would also improve retrospective analysis of SEC regulations. Mandatory arrangements must be evaluated to determine if they should be amended or repealed. Investor ordering substantially reduces the need for retrospective analysis. Where a default arrangement imposes significant costs on corporations, those corporations will simply switch to an alternative arrangement. The value or cost of investor ordered regulations are thus directly observable from the number of corporations that remain bound by the arrangement. To the extent retrospective analysis remains necessary, it is made easier by investor ordering. Investor ordering creates variations in arrangements and allows observation of the different outcomes that result, albeit complicating the separation of the effects of the regulation from the factors that lead corporations to opt-out. The lower cost of investor ordered regulations to investors would allow the SEC greater flexibility to experiment with potential rules. Collectively, this would result in regulation that is more dynamic, and better able to self-adjust towards optimal arrangements.

Together these benefits make the case that the SEC should implement investor ordering by default, for all categories of corporations where institutional investors have majority voting power, unless a regulation would have substantial externalities that institutional investors would not internalize. The article offers concrete suggestions as to how the SEC should implement investor ordering.

Prime candidates for investor ordered regulations are those where there is disagreement about whether the costs of the regulation outweigh its benefits. It would be less costly for corporations to opt-out of recent rules and those that have not yet been enacted. Potential or proposed rules that would be strong initial candidates for investor ordering include proxy access, universal proxies, claw-backs, and disclosure of political spending. Promising candidates among recent rules for deregulation by investor ordering include internal controls, conflict minerals, pay ratios, and say-on-pay. Some long-standing regulations have recently been attacked as costly for corporations, including blockholder disclosure, and requirements to include shareholder proposals in proxy statements. These could also be considered for deregulation through investor ordering.

Although the focus of the article is SEC regulation, its analysis has implications for federal legislation, and for state corporate law. Congress could improve the quality of SEC rule-making by refraining from express mandates or prohibitions on SEC regulations that hamper the SEC’s ability to design optimal rules. State law switching requirements are less likely to result in optimal arrangements than those proposed for investor ordering, and could be improved accordingly.

The complete article is available here.

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