Feb 14, 2022

Amanda Rose on the Mission, Governance, and Politics of the SEC and Its Major Challenges Moving Forward

Crypto, SPAC, and ESG considerations are just a few of the issues that the SEC must tackle in the near future.
David Beckworth Senior Research Fellow , Amanda Rose

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Amanda Rose is a professor at Vanderbilt Law School where she works as a scholar on securities law and the institutional design of the regulatory regimes enforcing those laws. Amanda joins Macro Musings to talk about the Securities and Exchange Commission (SEC), its work and role in promoting financial stability, and her research on the SEC. Amanda and David specifically discuss the politics, governance, and politicization of the SEC, the mission of the agency, and the major issues that it must face moving forward.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Amanda, welcome to the show.

Amanda Rose: Thank you, David. It's a pleasure to be here.

Beckworth: Well, it's great to have you on. And I have to just get this out from the start, and that is, you are actually at an SEC school, a different kind of SEC. And I'm a big SEC football fan. In fact, I went to the University of Georgia in grad school. So I'm very happy at this point since we won the National Championship. But you are part of the SEC. So just out the gate, let's put to a side, we're not talking about SEC football, we're talking about the Securities and Exchange Commission, but you are a part of the SEC Conference yourself. Well, it's great to get you on. I've had some of your colleagues on the show, Yesha Yadav, Morgan Ricks, yourself, I've been to your campus a few times. So it's a delight to have someone like you on this show. And I really enjoyed preparing for this because we talk a lot about financial stability on the podcast.

Beckworth: And we typically come from a macroeconomic perspective, maybe macro prudential perspective, but we often kind of gloss over the institutional issues, the governance issues, and a big part of that is the SEC. And so you're an SEC governance expert, you've written a lot on that. We're going to touch on some of your work and you're going to help guide us through how to think about the SEC. So I'm really looking forward to our conversation today. But before we get into all that, why don't you tell the listeners a little bit about yourself? How did you get to this place where you are a SEC expert?

Rose: Sure, David. So I guess my journey began in law school. I went to the University of California Berkeley School of Law. Then I clerked on the Ninth Circuit Court of Appeals for a year for William Fletcher, and then joined the law firm of Gibson, Dunn & Crutcher where I did class action defense work, and quite a bit of securities fraud defense work and that is when I really took an interest in the SEC.

Rose: We defended companies who were subject to SEC investigations, securities class action lawsuits, investigations by state regulators and I became interested in how all of these different enforcement mechanisms worked together and decided to sort of turn to academia where I first did a sort of a stint at Berkeley, where I did research and taught and then I went on the back on the job market and came to Vanderbilt. And I've been there over a decade now. I teach securities regulation, corporate law, teach a course at the business school and my research is focused both on securities fraud, deterrence, and other issues related to the SEC.

Beckworth: Okay, well, let's talk about the SEC. And let's begin with a very basic question, what is the mission of the SEC?

The Mission and Structure of the SEC

Rose: So the SEC expresses its mission as sort of advancing in three related goals, one, the protection of investors, two, the promotion of efficient markets and three, capital formation. And so those are sort of the three guideposts. Often those goals are mutually supportive, sometimes they ostensibly stand in tension with one another.

Beckworth: So the first two, I recognize probably the first ones, the one that I recognize the most, protect investors. You think of things like insider trading, making sure the investor comes out whole. The second one echoes back to the great financial crisis. I think we thought a lot more about the SEC coming out of that. What is the third part though, the third pillar, promote capital formation? What's the idea behind that?

Rose: So a healthy economy, it offers a situation which companies can raise capital on good terms. And so there are policies that make it more expensive for companies to raise capital and there are policies that make it cheaper. And so that's something that the SEC needs to think about when it's enacting rules, how can we make access to capital easier for companies? How can they earn more value when they sell their securities?

Beckworth: Okay. Tell us about the structure, the commissioners, how many commissioners, how are they appointed, terms, things like that.

Rose: Right. So the SEC is an agency that was born of the New Deal era when the federal securities laws themselves were born, was born by statute. It has five commissioners. By statute, only three of the five commissioners can be from the same political party. So there is an attempt there to sort of limit partisanship on the part of the agency. Another sort of structural feature of the agency that is worth noting is that it's an independent administrative agency rather than an executive branch agency, which means that it has more independence from the executive branch. The president appoints the commissioners with the advice and the consent of the Senate but can't fire them except with cause, which again, kind of provides a layer of political insulation.

Beckworth: And these five commissioners, do they serve staggered terms? Does one president, I guess, have the ability to appoint... Even if he appoints the other party, does he have the opportunity to appoint many at one time or are the terms staggered to avoid that?

Rose: So the terms last five years and they are staggered. So typically presidents will have an opportunity to replace some but not all of the commissioners. It isn't unusual for a commissioner to choose to resign before the five year period is over, in which case that's another opportunity for the president to appoint someone.

Beckworth: That's interesting. So they tend to stick with their whole term. We cover the Fed a lot here and they have 14 year terms and most governors do not stick around the entire 14 years. I guess the opportunity cost of their value outside in the private marketplace is high so they leave or they have other opportunities. But the five commissioners, we have the chair and of course Gary Gensler is the one that's been appointed by President Biden, we'll come back to him.

Beckworth: And I understand there's five divisions at the SEC as well. And let me run down the list and if you have any comments, let me know. But the five divisions, I understand them, one is corporate finance. So that's the part that requires disclosures that we know about. Trading and markets, they oversee self-regulatory organizations like FINRA. There's the investment management part of the SEC enforcement and then economic and risk analysis. Of those five divisions, which ones do you work with the most or you research or cover the most?

Rose: So I would say that my research is most related to the work of the enforcement division to the extent that I'm focused on issues of fraud and deterrence. Also corporate finance would be a division that intersects with my work. So corporate finance reviews the disclosure documents that companies are required to submit when they're doing public offerings, their ongoing disclosure obligations are vetted, and the choice of mandatory disclosure items is made in the first instance in that division. So I would say that also intersects with some of my more recent work on pathways to publicness and mandatory disclosure.

Beckworth: All right. So we have the SEC, we have its structure, and we have its mission. Again, its three part mission that you outline is protect investors, maintain fair, orderly, and efficient markets and facilitate capital formation. How does the SEC actually implement that mission? What are the tools, the approaches it takes?

Enforcing the SEC’s Mission

Rose: Well, it has a lot of obligations, a lot of things that the law has sort of assigned it to it. The federal securities laws have a lot of specific provisions, but many of them grant the SEC a considerable amount of discretion to provide the details. And so part of the SEC's job is to flesh out those details, to determine, for example, under what type of disclosures are required at the time a company raises money when on a periodic basis, under what circumstances does an offering of securities need to be registered, and under what circumstances can it avoid registration, what we would colloquially refer to as a private placement or a private offering.

Rose: Who can participate as a purchaser in private offerings? What are the restrictions on resale of securities that were purchased in a private offering? How's the broker-dealer industry regulated? What requirements do we pose on national securities exchanges? All of that plus much more including important things like the regulation of the mutual fund industry falls on the lap of the SEC which requires it to undergo formal rule making, which of course, with the dynamic nature of the markets needs to be revised and updated on a continuous basis.

Rose: So as it undertakes those more discreet tasks, it's keeping in mind those three goals and detailing the rules. It also issues informal guidance that's important that kind of signals to the market how it's thinking about things and how it interprets the law in its enforcement choices. It has to keep those factors in mind as well. And so it really is just sort of infused into much more concrete decisions that the SEC has to make.

Beckworth: So that's a big list there, they have a lot on their plate. And the ones that I see or think of when I think of the SEC is the disclosure requirements, quarterly earning reports. We see that on the news watching CNBC, what is Apple's latest quarterly report or Google. Then the other one would be the enforcement. You hear about the enforcement or maybe the lack of enforcement and you hear about the quarterly earnings. I mean, are disclosure and enforcement, do you think the two most prominent areas of the SEC or are there any others that I'm missing out?

Rose: Well maybe those are the ones that make the headlines the most, but the SEC does a lot of important work. I mean, the regulation of the investment management industry given how much Americans have invested in mutual funds, obviously very important. The sort of market structure oversight is very important. So I think that all of these areas are important, but certainly disclosure issues and enforcement are right out there at the top of the list.

Beckworth: I want to look closer at the enforcement part of fulfilling that mission. And I want to look at a recent report that came out from the SEC, and this, I guess, their annual report on enforcement results for fiscal year 2021. And they provide a large list of things they have done. They list, for example, they list corporations they've gone after, I'll just give a few examples here. They had a case charging General Electric with violating anti-fraud reporting disclosure controls and accounting controls provisions of the security laws. They also have individuals they've gone after. They have charged corporate executives and other players, including former CEO and chairman of Wells Fargo and the former head of Wells Fargo's community banks.

Beckworth: They have auditors that I see they've gone after on this front. They have a section on rooting out misconduct in crypto, which is probably a relatively new one. They have a section on market integrity. They charged the S&P Dow Jones index for some issues. They also have insider trading, which is the one, again, I'm probably the most familiar with, or I think of when you say the SEC, first one that comes to mind. So a number of cases there in insider trading. And the last one they talk about on this list, which was interesting, and it's related to your work is rewarding and protecting whistleblowers. So maybe walk us through that. What role do whistleblowers play in this process of enforcing the mission of the SEC?

The Role of Whistleblowers Within the SEC

Rose: So the whistleblower program is a creation of one of many creations of the Dodd-Frank Act of 2010. And it provides financial incentives for individuals who report securities law misconduct to the SEC and it rewards them quite richly. In the event that a whistleblower tip leads to a successful SEC enforcement action that results in at least a million dollars of penalties, the whistleblower gets between 10 and 30% of that recovery. So it's high stakes financial incentives to root out misconduct… it's very difficult. I mean, the enforcement division has a difficult task in identifying some types of frauds that occur deep inside an organization. So this creates incentives. And it has been a successful program. They have paid out quite a bit in monetary rewards, and it's seen, I think, largely as a success, although some of the details of the rules were changed last year and one of the items on chairman Gensler's regulatory agendas to reconsider those rule revisions. So there is some sort of reevaluation of the details of how the program works.

Beckworth: One of your articles that you've written on this, a 2019 paper, you have *Calculating the SEC Whistleblower Awards: A Theoretical Approach.* What I got from that article is there's a tension or there's some tradeoffs. You want to reward, incentivize people to come forward, make it worth their time. If they come forward, there's a good chance they may no longer work at that organization so you want to compensate them, maybe give them a financial cushion as they move forward. But you don't want to be overly generous and give them the bank because the formula is based on percentages. Is that correct? And so in theory, if the penalty's really, really large, it could be a large payout to the whistle blower. So is that the concern that they get paid too little or too much?

Rose: Yeah, it's difficult to sort of get the calculus right. You want to encourage tips, but you want to encourage strong credible tips and not sort of bury the SEC in frivolous tips that detract from the broader mission. And so in that paper, it's sort of a bit technical. I suggest some ways that that can be achieved. And part of the reforms that I mentioned last year dealt with awards in excess of $30 million and the type of maybe more discretionary criteria the SEC might implement to lower rewards of that magnitude, and that's what's under reconsideration now. And it's this question of again, the quality of the tip, the incentives to get people to come forward in situations which may be personally detrimental and trying to find the right mix. So the last word on that hasn't come through. The whistleblower bar was critical of the reforms that were adopted. Again, it's just talking about very large awards, but that's sort of the policy question there.

It's difficult to sort of get the calculus right. You want to encourage tips, but you want to encourage strong credible tips and not sort of bury the SEC in frivolous tips that detract from the broader mission.

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Beckworth: One other question on enforcements before we move on. So insider trading, going after insider traders, that's part of enforcement as well. Is that an area that's hard to prove? Is it easy to make a case that someone has been doing insider trading? The reason I ask this is there's a story I just saw recently about Peloton, the bikes that people have at home. And apparently, their executives sold a lot of stocks right before the stock price dropped recently. So it looks bad on the surface from the outside, but I imagine it's a lot harder as an enforcer. You can't just say, "Hey, see, the timing is suspicious." You got to have paperwork. I mean, walk us through that. What is it like to try to convict someone of insider trading?

The Insider Trading Conviction Process

Rose: Well, it depends on who the target is. If it's a company insider who clearly had access to the non-public information prior to their trades and is not trading pursuant to something that's referred to as a rule 10b5-1 plan, that's an easier case. So there are obviously corporate executives, come into possession and sell their company stock with some frequency, as well they should. They want to maintain diversification so when their options become exercisable and they're able to sell stock, they want to divest. But they're sort of always in possession of non-public information. And so the solution is for them to come up with pre designed plans by which they say, "Well, I'm going to sell this amount of stock in this periodic fashion," and that's a defense to an assertion that they committed insider trading.

Rose: So I don't know the facts of the Peloton case and whether or not those trades which at first glance might look suspicious, had actually been planned pursuant to a 10b5-1 plan or not. Another type of insider trading suit that often gets a lot of press are tipper, tippee cases. And those can be quite difficult because of the sort of arcane way that insider trading law works in the US where you have to establish that there was a duty and that that duty was passed on to the next person in the chain. And it becomes quite complicated because in the US, the main insider trading prohibition is really devised from an anti-fraud rule. And so it's a fraud of omission and a failure to disclose to your counter party the non-public information. And so that creates a lot of sort of oddities. So it can be difficult in these broader tippee, tipper cases for the SEC to succeed.

Beckworth: Well, let me throw at you a potential insider trading case which you may or may not have an opinion on, which is fine. But I'll throw it out there because we've discussed it on the show before, and that's the Federal Reserves’ officials' trading of stocks in 2020 during those moments when markets were crashing or catering and new programs were being introduced. And so a number of Fed officials have resigned over this. And I believe Senator Elizabeth Warren sent a letter to Chairman Gensler, take a look at this. So my question is, does the SEC have jurisdiction over something like that? I mean, can it go after someone at the Fed or is it constrained by law to non-Fed, I guess, activity?

Rose: So I'm not aware of anything that would sort of provide immunity to individuals if the insider trading laws otherwise applied simply because they also hold a position at the Treasury. I don't know enough to comment on the specifics of that case. I will mention that the theory that comes to mind is the misappropriation theory. So there are situations in which someone trades in securities and they're not an executive or fiduciary of that company, that's sort of the classical case when the CEO trades in his or her own company stock, that's sort of the classic case. But you can also be someone who doesn't have a relationship with the company and yet owes a duty to the source of the non-public information not to use it for personal benefit. And so I don't know if the trading activity at issue here was in violation of some duty owed to the agency that was worked for. From what I see on the news, there wasn't necessarily a duty not to trade and maybe there should be in the future, but it's a complicated question, I need more facts.

Beckworth: Sure thing. All right. Well, let's step back and talk about the SEC maybe from a broader perspective, and that is the politics of the SEC. And we mentioned earlier that the original design was to make it nonpartisan. You got equal representation from both parties and whoever's in power presumably gets to appoint the chair. But do you think the SEC is becoming politicized as the rest of the country is? I mean, there's concerns that this politicization's seeping into all of our institutions or is the SEC you think relatively unscathed from this kind of change that's taking place in the US?

The Politics, Governance, and Politicization of the SEC

Rose: So I don't think that it's unscathed. I do think we see a bit of the broader trends at the SEC. I mean, the SEC despite these structural features that try to insulate it from partisan influence has never been completely insulated from partisan influence. Traditionally, we talked about the goals that the SEC should be striving to achieve. And in the context of any discreet rule making, you're trying to weigh the costs and benefits, you're trying to trade off these different goals. And often the impact different rules will have is uncertain. And people have different intuitions as to how the costs and benefits are going to shake out and it kind of depends on people's priors about the efficacy of government, the efficacy of markets, what the cost and benefits of a particular rule will be.

The SEC despite these structural features that try to insulate it from partisan influence has never been completely insulated from partisan influence. Traditionally, we talked about the goals that the SEC should be striving to achieve. And in the context of any discreet rule making, you're trying to weigh the costs and benefits, you're trying to trade off these different goals. And often the impact different rules will have is uncertain.

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Rose: So even though everyone has the same objective, often in light of this uncertainty, you see people supporting or dissenting from particular rules because of priors that happen to line up with political affiliation. And so that's nothing new. I do think currently there are some items on the regulatory agenda of the SEC that are sort of more political or more overtly political than perhaps we've seen in the past. For example, proposals related to diversity on corporate boards, proposals related to so-called ESG disclosure, climate change disclosure, those sort of are more directly related to political issues and sort of heightened, I think the level of attention that those things are receiving and concerns about... Well, rewind politicization.

Beckworth: Okay. Well, let me ask a related question relating to governance and the politics of the SEC, so just kind of stepping back. So we've touched on politics as we normally think about them, but there's also the politics of which cases do you go after. So I had on this show a while back, Jesse Eisinger. In fact, I went down to Vanderbilt Law School. He gave a talk on his book that he did a few years ago. And it really was a critique of the department of justice not being as aggressive as Jesse would like it to be. And he also points to the SEC in that book as well. And one of the things he highlights looking back at the financial crisis 2008, 2009, is that there weren't many top-level executives who were prosecuted.

Beckworth: There were few low-level people who were prosecuted and went to jail, maybe paid fines, but he's just aghast and other commentators, why didn't the government go after higher level executives after the financial crisis? Certainly seems like there was something going on there, some insider trading maybe, who knows? But do you have any thoughts on that? Is there other factors that come into play when making these decisions?

Rose: Yeah. My view is that the vast majority of people at the SEC are devoted public servants that are trying to make the right calls. But I think anyone of course is going to be influenced by the incentive structure that they find themselves in and lawyers whether the DOJ, the SEC or in private law firms care about winning cases, that's natural, and so that's going to factor in. And it's difficult, it's more difficult to succeed against individual defendants who really have something significant at stake than it is to get a public company to agree to a large fine. And I think that that is a problem and it's one that the SEC sporadically talks about. We want to go after individuals, we create greater deterrents. Settlements paid by public companies are really paid for ultimately by public investors and there's a circularity there that's perverse. But again, it's difficult to actually prove a fraud claim, [inaudible] or state of mind is an element. Were they attempting to defraud? What did they actually know and when? Those are hard cases to build. And so it's tricky. One might think about ways to change the incentives within the enforcement agency to reward that type of risk taking, but it's difficult.

My view is that the vast majority of people at the SEC are devoted public servants that are trying to make the right calls. But I think anyone of course is going to be influenced by the incentive structure that they find themselves in and lawyers whether the DOJ, the SEC or in private law firms care about winning cases, that's natural, and so that's going to factor in.

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Beckworth: Yeah, that was one of the big takeaways from that book, is that the incentive structure is kind of set up so that if you're a lawyer in the department of justice or SEC, you want to win a case. It looks better on your record for promotion, for going places, even getting a job after the Department of Justice. If you're going to go to big law firm, you want to show that you were successful. On top of that, going after a big corporation, they have deep pockets, they have resources, and they can fight you a prolonged battle where someone lower would be easier to go after, they wouldn't be able to put the fight up. So it does seem at least from a surface glance, and I've had conversations with lawyers who tell me, "It's more complicated, David." But it looks like the deck is stacked. Or maybe that's the wrong way of saying it, the incentives are set up such that it is difficult to go after individuals who may have committed fraud.

Rose: Yeah. I think that it's detrimental more broadly because so many companies settle with the SEC rather than gamble with a litigation and a loss, we don't get the development of the case law, we don't get the benefits of actually litigating these cases and individuals would fight back. You would see more cases go to trial. And so that's another cost of the system that we have but it's not an easy thing to fix.

Big Issues Facing the SEC Moving Forward

Beckworth: All right. Let's talk about the big issues facing the SEC going forward. I want to touch on some of your research here. You've had several papers that are really interesting on this front. But before we do that, I want to bring up a few other areas. And you may want to comment or not on this, but that I see, I think everyone sees happening at the SEC and the first one is crypto. I was watching one interview that said 2021 was the year of crypto for DC. The US government finally woke up and started thinking about… and that included the SEC and Gary Gensler the chair. And I was just looking at a Bloomberg article that came out this week and the title says *Crypto Exchanges Will Face More Scrutiny From the SEC, Gensler Says.* And let me just read an excerpt from it.

Beckworth: “Crypto exchanges are set to be a primary focus of the US Securities and Exchange Commission crack down on digital assets in 2022… SEC Gary Gensler said on Wednesday that he's hopeful that trading platforms will take steps in coming months to be more directly regulated by Washington's financial regulators. The additional scrutiny is crucial for crypto investors to get the type of protections they get when trading stocks or other assets according to Gensler. ‘I've asked staff to look at every way to get these platforms inside investor protection remit,’ Gensler told reporters in a virtual press conference. ‘If the trading platforms don't come into the regulated space, it would be another year of the public being vulnerable,’’ Gary Gensler again.

Beckworth: “Gensler rattled the crypto industry last year, 2021, including when he argued that most tokens were akin to securities that should be covered by the SEC's tough rules. Many coin enthusiasts however argue that the assets shouldn't be subject to the same regulations that have long covered equities and bond trading.” And I've had a few guests on here before that have pushed back against some of the characterizations that Gary Gensler has made toward for example, stablecoins. So maybe they don't disagree with everything he says, but they make a case, stablecoins, maybe they are like money market funds, maybe they can be set up in a way they'll be more stable. But it does seem to be it's on the radar of the SEC and things are happening already. Is that a fair assessment?

Rose: Yeah. Well, certainly chairman Gensler has signaled that crypto wasn't on the regulatory agenda that came out last year, which surprised some because it is an important area that probably could benefit from some rules of the road. But this more recent statement suggest that we should stay tuned. It'll be interesting to see how that progresses.

It's detrimental more broadly because so many companies settle with the SEC rather than gamble with a litigation and a loss, we don't get the development of the case law, we don't get the benefits of actually litigating these cases and individuals would fight back. You would see more cases go to trial. And so that's another cost of the system that we have but it's not an easy thing to fix.

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Beckworth: So another area, Amanda, that I'm seeing discussed is the NFTs, non-fungible tokens, and that of course is a hot thing right now. And I was surprised to find my former colleague have some comments on this. So I should have mentioned earlier in fact, that my former colleague is Hester Peirce who was a commissioner at the SEC, a good friend, had lots of great hallway conversations with her. And she kind of helped keep me on the straight and narrow path when I had crazy ideas about security markets or financial regulation.

Beckworth: She knows a lot about things beyond just securities. She was an active part in the conversations about Dodd-Frank when it was being formed in Congress. But there was an article from Payments.com and the title of the article is *Can NFTs Be Securities? The SEC Says Yes.* That's the title. So let me again, read an excerpt from this. The article says, “On the face of it, the idea that NFTs could be securities seem farfetched. Each one is by definition unique. That's what the non-fungible part of non-fungible token means. Each one is unlike any other. Of course, there's an obvious exception to this, tokenizing securities like shares of stock, but an NTF token holding a piece of art or song? No. A commodity, yes. A crypto punk certainly falls under the very broad legal definition of a commodity as covering all goods and articles but an artwork, avatar is not a share of stock.

Beckworth: So why did Hester Peirce, crypto's favorite Securities and Exchange Commission member spend 2021 warning NFT makers to be aware of crossing her agency? In words, fractionalization. One of the favorite examples of the business uses of NFT is real estate. Take a property, divide ownership of the property to 100 or 1000 parts and mint each one onto an NFT. This way, a hotel, strip mall, eight-figure Manhattan condo, even in orange orchard could be sold to smaller investors who normally don't have access to investments of that kind.” And here's Hester being quoted: "’People are being very creative in the types that NFTs they're putting out there,’ Peirce warned at a conference in March. ‘You better be careful that you're not creating something that's an investment product, that's a security.’”

Beckworth: And so she goes on to say, "Look, NFT creators of the world. It's great you're doing this, but you are moving into the space that we would call a security." And which is interesting coming from her, because she has this nick name, crypto mom, by the crypto enthusiasts. They love her dearly. And so when she came out and said this, I'm sure it was a bit of surprise to some of those individuals.

Rose: Well, I think that what's important is that you can't categorically say just because it's non-fungible, that it's not a security. Sort of the first week of securities regulation I teach my students the definition of a security, which originates in a Supreme Court case from 1940 that is still the prevailing standard today. And the hallmark of that is a very flexible standard that is designed to be flexible precisely because very motivated, very smart financial engineers are always standing ready to tweak what they're selling in some way so it's to avoid the reach of the federal securities laws.

Rose: And so the test comes from a famous case called the Howey case, is someone invests money in a common enterprise with the expectation of profits through the efforts of others. A very general test, a lot of judicial gloss on each of those elements. And it could be the case that an NFT might fall within that definition, maybe many of them don't. But I think Hester's point is that it's that test that is the guide. The case itself involved precisely what was referenced in the quote, which is that an orange grove that was divided up into strips of land and parcels of the land were sold to investors in order to evade securities regulation. And the court came up with that test and said, "No, that's a security, that's a capital raising effort to fund a business and we're going to call it what it is and not be stuck to sort of formalisms."

Beckworth: Okay. So crypto, NFTs, an interesting conversation that's going to continue for several years probably going forward. And I'm particularly interested to see where stablecoins go. Just yesterday the Federal Reserve released a white paper on central bank digital currency. And the way I understand it is they're looking for intermediated retail central bank digital currency. So banks will play a role, maybe fintechs will play a role.

Beckworth: People themselves won't have accounts at the Fed, but through these intermediaries they will. So things like stablecoins could be a part of this story, part of this development at the Fed. So interesting to keep our eyes on it and we'll follow up. All right. Let's move on to areas that you are working in your research that are forward looking and looking at developments, and one of them is SPACs and IPOs. So walk us through that and implications for the SEC and the regulation of those activities.

SPACs, IPOs, and Implications for the SEC

Rose: Right. So SPACs or special purpose acquisition companies have absolutely exploded over the last couple of years. These are shell companies that go public with the stated intention of merging with a private entity in a set period of time, typically 24 months. And just to give you some sense of the sort of dramatic rise in the level, recent statistics that I looked at showed that back in 2010 SPACs raised like $0.1 billion and accounted for 0.3% of all IPOs whereas in 2020 they raised over $75 billion and constituted 55% of all IPOs. And the numbers increased in 2021 quite dramatically as well. So this has been sort of a shock and has raised some regulatory alarm bells. The structure of SPACs are sort of riddled with conflicts of interest.

Rose: There has been some empirical work that has come out that has shown that investors who buy shares of SPACs at, or around the time a merger is announced sort of overall have done very poorly, whereas there's a separate set of investors who buy at the IPO stage and then redeem their investment prior to the merger who have been very successful. And this has raised some concerns and a lot of proposals for ways to deal with it. One of the important features I should say to sort of put that in context is that when you buy a share of a SPAC, you're technically buying a unit which consists of a share in a SPAC as well as a warrant to purchase additional shares after a merger has occurred. And you have the right up until the merger to withdraw your funds. So the funds are held in escrow. And so you can redeem and pull your money out, or you can decide to continue on and become a shareholder in the merged entity. So it's sort of complex. Retail investors have been purchasing SPAC shares, and there's a concern that maybe they don't fully understand the conflicts of interest and the potential for dilution and so on. So this is a big new topic, and it's one that I've been focused on, at least one kind of a concern that's been voiced.

Beckworth: What's the advantage of using a SPAC if you're the organization that's going to ultimately have the IPO?

Rose: Right. So for the target company, right, merging with a SPAC for a private operating company that is looking to access the public markets to become a public company, they have different options. They can do a traditional IPO, increasingly viable as an option now is to merge with a SPAC. They can do something called a direct listing. This is sort of an interesting development. It used to be that the only path really was to do an IPO and there's been disruptions to the IPO market, the ability to do a direct listing, which means to directly list on a stock exchange without doing a traditional IPO. And now the ability to merge with a SPAC is really kind of upending the traditional IPO market, which is interesting, which may suggest that there may be problems with the traditional IPO that are being solved through these alternative pathways.

There has been some empirical work that has come out that has shown that investors who buy shares of SPACs at, or around the time a merger is announced sort of overall have done very poorly, whereas there's a separate set of investors who buy at the IPO stage and then redeem their investment prior to the merger who have been very successful. And this has raised some concerns and a lot of proposals for ways to deal with it.

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Rose: To get directly to your question, what are the advantages, well, people involved in this give different explanations. One thing that is commonly said is that it's quicker to merge with a SPAC than it is to go through the full process of doing a traditional IPO. Others say that it's potentially less expensive. These are debatable assertions. Some say that, really, the timeline isn't that different and the expense is actually more in connection with the de-SPAC. Another advantage, and this is directly related to my research that people cite is that you are better able to communicate with the market in a de-SPAC transaction because you face less liability risk for forward looking statements than you do if you did a traditional IPO. So in a traditional IPO, you are unable to take advantage of this safe harbor that exists in the law for forward looking statements which provides a buffer of insulation from liability risk if your projections turn out not to come true.

Rose: And that is a safe harbor that IPO issuers are not entitled to rely upon. But in the de-SPAC merger context, the safe harbor is applicable. And we do see the sharing of projections and connection with these back mergers and we don't see that with respect to IPOs. The fear of liability essentially silences the release of projections and connection with IPOs. And so for companies who really need to tell a forward looking story, there is that attractive feature of going the de-SPAC route, being able to communicate that story without the liability fear.

Beckworth: So the SPACs provide a better way to communicate the vision, where this company's going to go, but the critics would say on the other side, it's also regulatory arbitrage. They have taken advantage of a loophole. And so where do you come out in this? And you have a paper, I want to mention it. We'll probably a link to it on the show notes, but your paper name is *SPAC Mergers, IPOs, PSLRA's Safe Harbor: Unpacking Claims of Regulatory Arbitrage.*

Rose: The point of the paper is really to probe this question, is this ability of companies doing a de-SPAC merger to more freely release projections and the inability of, or the inability of IPO issuers to rely on the safe harbor, is this problematic as many policymaker have suggested? They have suggested that the de-SPAC mergers be excluded from the safe harbor the same way that IPO issuers are. And I approach the question by taking a step back initially to say, well, whenever there's a claim of regulatory arbitrage, there are a set of questions we need to ask ourselves. First is, if a company can evade some regulation by altering the transaction design, the first question ought to be, well, what purpose does the evaded rule serve? Because if you're altering the transaction design, it may be that the economic realities of the alternative don't present the same problem, in which case there's no need to extend the evaded rule to that scenario.

For companies who really need to tell a forward looking story, there is that attractive feature of going the de-SPAC route, being able to communicate that story without the liability fear.

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Rose: So I think that's the first question to ask. And then only if the economic realities of the alternative transaction do present the same legal problem, then we need to consider whether we ought to extend the rule to that situation. And I think that requires some reflection on the part of regulators because regulatory arbitrage isn't always bad. It's only bad if the evaded rule is socially optimal and something that we want to extend. It could be that regulatory arbitrage is occurring because there's something deficient about the rule. And so it's an opportunity, I think, for regulators to assess the wisdom of the evaded rule. And so in my paper, I evaluate this exclusion from the safe harbor for IPOs and ask whether it's good public policy that we should extend to the de-SPAC merger case and I have some doubts about its wisdom.

Beckworth: Okay, one last question on SPACs. So do you sense that this will continue to be an important conversation? Will SPACs continue to be used as a way to do IPOs?

Rose: So there's been a down tick in the number of SPACs because of some actions by the SEC, some statements that have come out about accounting treatment that has caused SPACs to have to restate their financial statements and that has sort of slowed down the number of them that have gone public this year. Whether they'll continue, whether this is a fad, a SPAC bubble or whether it will persist, I don't know. It will depend in part on what steps the SEC takes rather to crack down on SPACs.

In my paper, I evaluate this exclusion from the safe harbor for IPOs and ask whether it's good public policy that we should extend to the de-SPAC merger case and I have some doubts about its wisdom.

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Rose: So I don't know. What I do know and I think is important is that these pressures on the traditional IPO are going to continue. And this question of whether, for example, we should be essentially de facto prohibiting the release of projections and connection with IPOs is a worthwhile question to be asking regardless of whether SPACs are sort of regulated out of existence. And so, again, this is sort of one of the benefits when you see regulatory arbitrage or however you want to label it, is shining a light on areas that may require some review. And so I think it would behoove the SEC to evaluate the safe harbor and its existing exclusions to see whether it's achieving public policy goals or maybe doing some things we don't want it to be doing.

Beckworth: Well, another area that you have been working in recently is the environmental, social and governance ESG disclosure framework that's been proposed for the SEC. And this is a hot topic. As you mentioned earlier, these issues are coming to the front. The Federal Reserve also has its own version of this it is wrestling with. And you've written a paper that was published in 2021 in a law review journal, was titled, *A Response to Calls for SEC-Mandated ESG Disclosures.* And you also had a policy brief with the Mercatus Center along the same lines titled, *Should the Securities and Exchange Commission Adopt a Mandatory ESG-Disclosure Framework?* So this is a hot topic, you've been writing on it. And let's begin with this question. What is ESG?

Defining ESG, Its Problems, and Its Policy Implications

Rose: That's a very good question, David. It's a very broad term and that's one of the points I emphasize in my work. It is a very broad umbrella term that is not well defined that means different things to different people, that includes a whole host of issues, that present different questions with respect to whether mandatory disclosure is called for. It includes things like climate change, corporate political spending, diversity and inclusion, cybersecurity, privacy, a whole host of issues. It's not a clearly defined concept.

Beckworth: You outline in your paper there are more multiple parties who are promoting this. I'm going to list the ones that I saw. And they include financially motivated investors, so people who actually think this will matter to the value of the firm and to their investments. Then there's values-based investors, people who might have some view of the world that they want to see reflected in decisions made by corporate executives.

Beckworth: And there's non-investor stakeholders, maybe employees, people concerned about the environment, diversity. And then the last one, which is really interesting and resonates with other developments we've seen in society, but a whole cottage industry of ESG experts, consultants, authorities. And you see this in other areas as well. Whenever there's some new regulation that imposes some structure, there's a bunch of experts that suddenly emerge and it's impossible to... Not impossible, tough to maybe reform and change it. So these are four groups behind this development. And what are some of the problems with ESG in general? And maybe we can talk about the SEC trying to implement a proposal for it.

What I do know and I think is important is that these pressures on the traditional IPO are going to continue. And this question of whether, for example, we should be essentially de facto prohibiting the release of projections and connection with IPOs is a worthwhile question to be asking regardless of whether SPACs are sort of regulated out of existence...And so I think it would behoove the SEC to evaluate the safe harbor and its existing exclusions to see whether it's achieving public policy goals or maybe doing some things we don't want it to be doing.

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Rose: The only other group that you missed that I would add to your list would be the asset managers who are also playing an ESG role on behalf of their investors, articulating interest in ESG. It's hard to answer what is the problem with ESG because again, that's a term that sort of defies precise meaning. I think that broad calls for the SEC to adopt an ESG disclosure framework are problematic because of this lack of precision. I think that the SEC ought to approach questions of ESG disclosure the same way it approaches any question of mandatory disclosure. And traditionally what the SEC does when deciding whether to mandate disclosure on a particular topic is to, as a first cut, ask is the information material? And that is a term that has a long accepted meaning in the securities laws. Its information a reasonable investor would consider important in making an investment decision.

Rose: So I think we should reframe the question around ESG in the following way, is ESG information important to reasonable investors? And of course there's a whole course that people who would shout yes, just look at all of this investor demand for ESG information. But I think that the question isn't are a lot of investors really hyped up about ESG, the question is, is the information important to reasonable investors? To answer that you need to know what is the information we're talking about? And the more normative question, who counts as a reasonable investor? So I think those are the questions to be asking. You can't even get off the ground when you don't specify what exactly you're talking about. Are you talking about political spending? Are you talking about scope one emissions that contribute to climate change? Are you talking about board diversity?

Rose: You have to isolate the issues, I think, to have a rigorous analytic approach. And then there's the second question of who is the reasonable investor. And that's a really interesting question and it's a normative question that I think is simmering here that is worth kind of paying explicit attention to, right? You have different conceptions of who the reasonable investor is. The kind of traditional view is that when we're thinking about mandatory disclosure and whether it's important to an investor, we're thinking about investors who care about financial returns at the firm level. There are ESG topics that will be material in that traditional sense for particular companies in particular industries, but it's going to be case specific, right?

Rose: It's going to depend on the information and for example, whether it's a consumer facing company or not, whether it's a fossil fuel company and the like. But that's pretty easy. There's nothing controversial about mandating information disclosure that is actually financially material at the firm level. And there are some ESG issues that will fall in that bucket. Then you've got another bucket which is, investors who are interested in financial returns at the portfolio level. And this is sort of a new argument that's being developed in some academic papers by others that suggest that for investors who are invested in a diversified portfolio, they're indifferent to firm specific risks but they do care about systematic risks that will affect the returns of their portfolio. And so some ESG topics may present systematic risk that maybe the investors could help to mitigate if they had the information.

I think we should reframe the question around ESG in the following way, is ESG information important to reasonable investors? And of course there's a whole course that people who would shout yes, just look at all of this investor demand for ESG information. But I think that the question isn't are a lot of investors really hyped up about ESG, the question is, is the information important to reasonable investors?

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Rose: And so you think of climate change and potentially other topics in that regard. And I think it's a harder question whether we should conceive of the reasonable investors encompassing that group. And I can come back and talk about some concerns that might raise. The third group would be socially motivated investors, and plenty of millennials fall in this bucket. They're not primarily concerned with financial returns, they want to make an impact, they want to use their voice as an investor to promote social changes. I think very strongly that that group should not be considered a reasonable investor. Basically that's pure stakeholder oriented disclosure and I think the SEC is ill-equipped to promulgate mandatory disclosure items in service of that group, because I think it really transforms the whole nature of what the SEC does and takes it outside of its core areas of competency.

Beckworth: The next question I was going to ask you is how does the ESG proposal fit into the mission of the SEC? So we outlined earlier three things, protect investors, maintain fair, orderly, and efficient markets, and third, facilitate capital formation. And I guess the strongest one I can see is maybe the second one, maintain fair, orderly, and efficient markets if there's climate risk, that it could disrupt markets. But the point you bring out so well in your paper is it's hard to define what is a climate risk. Even within the climate conversations, there's differing views. And if a firm goes one route or another route who judges, who determines? A lot of unanswered questions, a lot of vagueness as you outline, but how would you, I guess, see… or what would be the case that could be made for the ESG falling into the SEC's three pillars?

How Does the ESG Proposal Fit Within the SEC’s Mission?

Rose: Well, so again, it depends. I find it difficult to answer generic questions that refer to ESG. My initial title for that paper in the Washington University Law Review was going to be stop saying ESG just because it is so ambiguous of a term. I think, again, it kind of falls into the buckets I was just talking about. If a particular ESG topic is financially material at the firm level, then it is helpful to investors to have that information that's going to increase price accuracy, which relates to the efficiency of the markets and it's going to clearly, I think, fit within the SEC's goals. If on the other hand we're dealing with stakeholder-oriented disclosure, it's unclear how that fits within those goals. This area of sort of systematic risk is sort of, again, the hard question in the middle. I think you're right that it's difficult to define it. It's a question of where are the borders? The only thing that I think there's even approaching some consensus towards is that climate change would present systematic risk.

Socially motivated investors...They're not primarily concerned with financial returns, they want to make an impact, they want to use their voice as an investor to promote social changes. I think very strongly that that group should not be considered a reasonable investor. Basically that's pure stakeholder oriented disclosure and I think the SEC is ill-equipped to promulgate mandatory disclosure items in service of that group, because I think it really transforms the whole nature of what the SEC does and takes it outside of its core areas of competency.

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Rose: But others might view other things as presenting systematic risk. And if the SEC sort of has the freedom to pick what presents these systematic risks to the economy, then you're kind of devolving into giving it the same sort of authority it'd have if it were just pure stakeholder oriented disclosure. I think it's worthwhile to think about how the SEC would make these determinations but it's always hard. So just because something is material even in the traditional narrow sense of the term doesn't mean that it's going to be a mandatory disclosure item. The SEC always has to weigh costs and benefits, right? The cost to issuers of producing the information and the benefits to investors of its production. And that's never an easy calculus to make. But with respect to information that's financially material at the firm level, we can trust the SEC to do it. That's the kind of stuff that it should be balancing and thinking about. It has the expertise.

Rose: If it's more socially oriented stuff, how do you balance the cost to companies of producing the information against the sort of amorphous social value that it may produce? I think that is sort of inherently a political question that is way outside the SEC's legitimate scope of authority. So I think there's a lot of complicated questions that need to be unpacked when we talk about ESG. I think just sort of adopting a broad set of disclosure obligations without being specific about the items and how they fit with traditional notions of the SEC's role would be misguided.

Beckworth: And in the Mercatus policy paper, you outline a series of questions also in your law review, but you do them nice and very succinctly. And I just want to mention a few of them. You've touched on them, but one of the big questions you raise in that list is, does the SEC have their requisite institutional competence and democratic accountability? So this is an issue for the Federal Reserve as well, is it delves into issues that are very progressive, climate change inequality.

Beckworth: That may work while the Democrats are in power, but what happens in Republicans come to power? Are they going to swing it back the other direction? Are they going to say, "Look, the Fed's highly politicized. Where's the legitimacy behind what they're doing?" Going back to an earlier question, I see that as part of this concern about the politicization of our institutions. And I'm just wondering, do you see the same challenge here?

I think there's a lot of complicated questions that need to be unpacked when we talk about ESG. I think just sort of adopting a broad set of disclosure obligations without being specific about the items and how they fit with traditional notions of the SEC's role would be misguided.

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Rose: I mean, I think the SEC like other institutions pay a price when things become overly politicized and we sacrifice sort of the traditional institutional role. I mean, we see this sort of whipsaw, right? The current regulatory agenda for the SEC, many of the items are reassessing rules that were just passed under the chairmanship of Jay Clayton. And so to the extent that market participants can't account on the stability of rules coming out of financial regulators, it's problematic. And I think, again, going back to the history of the SEC, there was a recognition that the SEC shouldn't be viewed as a political agency because that kind of nonpartisan expert agency that avoid sort of political fluctuations is very valuable for the economy. So I'm sort of an institutionalist myself and I think it's regrettable when the SEC becomes overly politicized. This is, again, is something that happens over time and the SEC's never purely non-political, but I think we should try to avoid it when we can.

Beckworth: Right. One other question you raise in this paper is whether the SEC would have the resources to implement this new proposal. It would take a whole new level of expertise, maybe hiring new experts. And maybe a question I should have asked earlier, how is the SEC run? Does it have a good budget? I mean, would this be something that truly would be a constraint on its finances so it would have to maybe slim down one division and make this one more important? What are your thoughts?

Rose: So, I mean, the SEC's budget is just under $2 billion. It has over 4,000 employees. However, harken back to my description earlier of the mandate that the SEC has, it does a tremendous amount, right?

Beckworth: Right.

Rose: It regulates the entire capital markets. And so I do think that there would be tradeoffs that would be occasioned by a vast expansion of mandatory disclosure if they're going to police it. One of the motivations for mandating SEC disclosure on ESG topics is that these voluntary sustainability reports suffer from greenwashing as it's referred to. We can't trust in the credibility of the disclosures. And so it would be an advantage to those who are interested in ESG information to have the imprimatur of an SEC filing. But if the SEC doesn't police that or if the private bar doesn't police it, then you're not getting that extra credibility. So it would take additional work. And I think there are resource tradeoffs that would have to happen or the SEC's budget would have to be increased which obviously would detract from other policy goals.

Beckworth: Well, that's a political process too, right? The size of the SEC... It may be independent, but it has to go to Congress, get appropriations. And again, if Congress swings from Democrats to Republicans, Republicans don't like what they're seeing at the SEC, you could see a lot of problems emerging going forward. So I think it is important, as you said, to be an institutionalist and preserve the credibility of the institution going forward. Well, with that, our time is up. Our guest today has been Amanda Rose. Amanda, thank you for joining us to talk about the SEC.

Rose: Thank you so much, David, for having me. Be well.

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