High-quality economic analysis is an essential part of SEC rulemaking, said the Division of Risk, Strategy, and Financial Innovation and the Office of the General Counsel in recently published guidance designed to ensure that decisions to propose and adopt regulations are informed by the best available information about a the economic consequences, and allows the Commission to meaningfully compare the proposed action with reasonable alternatives. The staff noted that the SEC has long recognized that a rule’s potential benefits and costs should be considered in making a reasoned determination that adopting it is in the public interest
The staff emphasized that every economic analysis in SEC rulemakings should include the following four elements: (1) a statement of the need for the proposed action; (2) the definition of a baseline against which to measure the likely economic consequences of the proposed regulation; (3) the identification of alternative regulatory approaches; and (4) an evaluation of the benefits and costs, both quantitative and qualitative, of the proposed action and the main alternatives identified by the analysis.
On the first element, the release must clearly identify the justification for the proposed regulation. In some circumstances, there will be more than one justification for a particular rulemaking. Frequently, the proposed rule will be a response to a market failure that market participants cannot solve because of collective action problems. Other justifications for rulemaking can include, among others, improving government processes, interpreting provisions in statutes the Commission administers, and providing exemptive relief from statutory prohibitions where the Commission concludes that doing so is in the public interest.
Additionally, OMB’s Circular A-4, implementing Executive Order 12866, recognizes that Congressional direction to adopt a regulation is, itself, an independent justification for rulemaking. The SEC staff has considered the recommendation in the Commission’s Inspector General Report No. 499 that even where Congress directs the Commission to engage in rulemaking, the Commission should identify a market failure or other compelling need for rulemaking apart from the Congressional directive, and concluded that this is unnecessary.
Instead, the staff believes the better approach is set forth in Executive Order 12866, which states that agencies should promulgate only such regulations as are required by law or are made necessary by compelling public need, such as material failures of private markets to protect or improve the health and safety of the public, the environment, or the well-being of the American people. In the staff’s view, the Executive Order clarifies that a statutory mandate and a market failure are alternative possible justifications for a rule.
Although having concluded that the SEC is not obligated to identify a justification for rulemaking beyond a Congressional mandate, the staff acknowledged that there may be circumstances in which it could be useful to do so. For example, where Congress has itself stated that the mandate to engage in rulemaking is premised on a market failure or other compelling social need, the rulemaking release may identify that justification and attribute it to Congress in its description of the statutory mandate and explain how the rule, including any discretionary choices the Commission is making in the rulemaking, responds to the market failure or other compelling need that Congress identified.
On the second element of a baseline, the economic consequences of proposed rules, potential costs and benefits including effects on efficiency, competition, and capital formation, should be measured against a baseline, said the SEC staff, which is the best assessment of how the world would look in the absence of the proposed action. The baseline serves as a primary point of comparison for an analysis of the proposed regulation. An economic analysis of a proposed regulatory action compares the current state of the world, including the problem that the rule is designed to address, to the expected state of the world with the proposed regulation or regulatory alternatives in effect.
On the third element, the release should identify and discuss reasonable potential alternatives to the approach in the proposed rule. Reasonable alternatives include only those that are available to the SEC and not those that the SEC lacks the authority to implement.
On the fourth element, said the guidance, rulewriting staff should work with the SEC staff economists to identify and describe the most likely economic benefits and costs of the proposed rule and alternatives; quantify those expected benefits and costs to the extent possible; and, for those elements of benefits and costs that are quantified, identify the source or method of quantification and discuss any uncertainties.
To achieve this objective, rulewriting staff should engage with staff economists at the earliest stages of rulemaking to determine whether there are areas in which monetization or other quantification can reasonably be undertaken and, if so, whether the Division of Risk, Strategy and Financial Innovation has the available resources necessary to develop such data. Before issuing a proposing release, staff should identify any specific data that would be necessary for or that would assist in quantification, and should consider various mechanisms by which to seek such data. The proposing release should also include a request for such data.
When particular benefits or costs cannot be monetized, advised Division staff, the release should present any available quantitative information: for example, quantification of the size of the market affected, or the number and size of market participants subject to the rule. Even without hard data, quantification may be possible by making and explaining certain assumptions. For example, if proposed rules would enable the operation of a new trading system, it may be reasonable to assume the system will attract a percentage of all market volume. With that assumption, reasoned staff, the cost-benefit analysis could then estimate a distributional effect of a certain magnitude. It is important to make assumptions and the rationales for them explicit and, where alternative assumptions are plausible, to include analysis based on each.
Division staff noted that court decisions addressing the economic analysis in SEC regulations have likewise stressed the need to attempt to quantify anticipated costs and benefits, even where the available data is imperfect and where doing so may require using estimates and extrapolating from analogous situations.
When monetization or other quantification is possible, said the Division staff, the proposing release should include those numbers and solicit comment on them, and the adopting release should address any comments on those numbers, including any data submitted to challenge them. When quantifying costs and benefits, staff should describe the measurement approach used, include references to statistical and stakeholder data if available, and specify the timeframe analyzed.