Comprehensive regulatory reform will no doubt be high on the agenda of Congress and the incoming Trump administration. One of the most controversial reform issues is whether the courts should review the quality of the economic analysis that accompanies an agency's major regulation when deciding whether that regulation should be upheld.
A high-quality economic analysis helps ensure that the regulation solves a real problem at a reasonable cost. Serious deficiencies in the analysis may signal that the agency doesn't really know whether the regulation will be effective or efficient. As I suggest in forthcoming research from the Mercatus Center on Securities and Exchange Commission regulations, judicial review could motivate agencies to improve their economic analysis substantially.
As an independent agency, the SEC is not subject to executive orders that require executive branch agencies to assess the need for a new regulation, alternatives, benefits and costs before regulating. But the SEC is required by law to conduct economic analysis when determining whether new regulations are in the public interest. Between 2005 and 2011, the D.C. Circuit Court of Appeals struck down three major SEC regulations due to shoddy economic analysis.
The most extensive court examination of SEC analysis occurred in Business Roundtable vs. SEC, a 2011 case that vacated the SEC's first rulemaking under the Dodd-Frank Act. The rule would have required public companies to include information about shareholder-nominated board candidates in the proxy materials they sent to shareholders.
The D.C. Circuit Court of Appeals pointed out seven distinct problems with the SEC's economic analysis. These included: failure to estimate some costs of the rule even though cost data was available; misattribution of costs that stem from the rule's encouragement of proxy contests to state laws that allow proxy contests; insufficient evidence supporting the SEC's claim that the rule would improve board performance; use of contradictory assumptions in calculating benefits and costs; and failure to consider whether the benefits and costs for mutual funds would be different from those for regular shareholder-owned companies.
The flaws that the court identified involve errors in reasoning, failure to consider evidence, contradictory assumptions and failure to consider relevant alternative versions of the regulation — all mistakes that judges ought to be able to assess competently.
After the Business Roundtable decision, Berkeley law professor Steven Davidoff commented disapprovingly. He wrote, “The opinion appears to create an almost insurmountable barrier for the SEC by requiring that it provide empirical support amounting to proof that its rules would be effective.”
But this is precisely what citizens deserve and should expect from their regulatory agencies. Better information about the factors identified in the court decisions could have helped the SEC determine whether a less burdensome regulation could have delivered most of the intended benefits, or whether the regulation was even necessary at all.
The SEC's general counsel and chief economist responded by issuing new guidance for economic analysis that reflects time-tested principles of regulatory analysis. New regulations should be accompanied by an analysis of the need for the regulation, identification of a clear baseline with which to compare the results of the regulation, identification of reasonable alternatives, and an assessment of the benefits and costs of the regulation and the alternatives.
The SEC also reorganized the process of developing regulations to involve economists at the outset. The number of financial economists with PhDs employed by the commission more than doubled between 2011 and 2015.
As a result, the quality of the SEC's economic analysis improved substantially on all of the factors the new guidance identified as important. Qualitative economic reasoning and quantitative estimates both improved. On average, the SEC's economic analysis of major regulations is about as good as the average analysis of financial regulations by executive branch agencies, such as the Office of the Comptroller of the Currency, the Employee Benefits Security Administration, and the Department of Housing and Urban Development. This parity occurs even though these executive branch agencies have been required to conduct this kind of analysis much longer — since 1981.
Prior to the new guidance, the economic analysis section of SEC rulemakings read like a check-the-box compliance exercise conducted after decisions were actually made. More recent SEC regulations are accompanied by much more thorough explanations of how the economic analysis is related to decisions.
The D.C. Circuit's decisions on SEC regulations, along with subsequent improvement in the commission's economic analysis, bode well for comprehensive regulatory reform that includes judicial review of agency analysis. And the SEC's response shows that the prospect of judicial review can mightily motivate agencies to do their homework.