COMPLEX FINANCIAL MARKETS
Studies of risk perception indicate that the public especially fears risks when (1) the risks are not understood well, (2) the risks potentially bring catastrophes and (3) exposure is involuntary. People fear nuclear power, for instance, far more than technologies that are statistically more dangerous but more familiar and known, like smoking or automobile travel.152 “Short sales” are not nuclear
power plants, but they arguably produce a similar political psychology. Surveys show that levels of public understanding of financial market instruments and operations are not high,153 and a
large majority of the investing public probably does not have a good understanding of how short selling operates. Still, investors associate it generally with price declines and potential manipulation, especially when corporate issuers, prosecutors, and sometimes regulators point to abusive short selling as an explanation of stock price declines. Given that the original purpose of short selling was to profit from expected price declines, and the public bears the consequence of large market losses, steep market declines produce calls for more restraints on short selling.
There have been, and are, similar situations in other areas of financial market technology. For example, the public associated program trading in the 1980s, and derivatives since the 1990s, with financial crises in ways shaped largely by media coverage rather than direct knowledge or experience with program trading or derivatives.154 Specialized regulatory organizations operate most
effectively when they can credibly buffer themselves against exceptionally strong political pressures while managing complex problems in carefully analyzed ways.155 The SEC’s performance
since the 1930s has varied depending on how well it maintained a 152 STEPHEN BREYER, BREAKING THE VICIOUS CIRCLE: TOWARD EFFECTIVE RISK REGULATION 35–36 (1993).
153 See ANGELA A.HUNG ET AL.,INVESTOR AND INDUSTRY PERSPECTIVES ON INVESTMENT
ADVISERS AND BROKER-DEALERS xiv (2008), available at
http://www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf; see also Financial Literacy
and Education: The Effectiveness of Governmental and Private Sector Initiatives: Hearing Before the H. Comm. On Financial Services, 110th Cong. 271–82 (2008), available at
http://www.house.gov/apps/list/financialsvcs_dem/press041508.shtml (follow link for “Printed Hearing: 110-105”) (surveying economic and personal finance in our nation’s schools in 2007).
154 DAVID P. MCCAFFREY & DAVID W. HART, WALL STREET POLICES ITSELF: HOW SECURITIES FIRMS MANAGE THE LEGAL HAZARDS OF COMPETITIVE PRESSURES 135 (1998).
155 PETER EVANS, EMBEDDED AUTONOMY:STATES AND INDUSTRIAL TRANSFORMATION 75 (1995); JAMES M.LANDIS, THE ADMINISTRATIVE PROCESS 78 (1938).
virtuous circle of effective performance, leading to sufficient and well-managed resources, leading to legitimate discretion in dealing with controversial issues, and leading to continued effective performance.156 The broader political and economic environment,
including different levels of presidential support, obviously affected its success in doing this.
An exchange in 1995 between Representative Rick White (R- Washington) and SEC Chair Arthur Levitt illustrates the tension between regulatory judgment and Congressional authority in dealing with politically contentious issues. It concerned Congressional pressure to legislatively define broker-dealers’ obligations to consider the suitability of investments for sophisticated institutional investors.
Mr. White. . . . I think it’s better for Congress to set these policies rather than a regulatory agency.
And I’d be interested in your thinking why you think we should proceed with rulemaking rather than let Congress make some of these decisions?
Mr. Levitt. Well, I don’t know that either of us are going to come to the perfect solution, but I have, since I’ve been at the Commission, studiously tried to avoid asking Congress for anything.
Mr. White. I can understand that.
Mr. Levitt. With all due respect, I don’t know when we’re going to get it or what we’re going to wind up with. And the Commission, I think, has a more intimate ongoing concern about the issues which deal with our markets and the kinds of dangers that arise sometimes suddenly and unexpectedly that can impact our markets.
A response to those issues sometimes doesn’t lend itself to the prolonged process involved in the legislative response. The question of suitability is not a black or white question. I think Congress tends to deal best with black and white issues. And because of that, I urge great caution as we approach this issue.
. . . .
156 See JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET: A HISTORY OF THE
SECURITIES AND EXCHANGE COMMISSION AND MODERN CORPORATE FINANCE 268 (2003); ANNE
M.KHADEMIAN, THE SEC AND CAPITAL MARKET REGULATION:THE POLITICS OF EXPERTISE 11 (1992); Sue R. Faerman et al., Understanding Interorganizational Cooperation: Public-Private
Collaboration in Regulating Financial Market Innovation, 12 ORG. SCI. 372, 375 (2001),
Mr. White. I got the sense from your remarks that you may have the feeling that the Commission, because of its day to day dealings with the market, may have a little better sense of the subtleties and maybe you’re better equipped to deal with it in a more rational way than we are. Is that essentially what your thinking is?
Mr. Levitt. I think what I’m saying is the solution to the suitability issue set forward by this bill is one that I have reservations about.157
Currently the SEC, in dealing with short sales as well as other issues, is in a weaker position than it has been in the past. Over the past year the SEC Inspector General issued critical reports on the SEC’s management of the oversight of Bear Stearns and the consolidated supervised entity program in general, its management of complaints relating to naked short selling, and, most recently, controls on potential employee insider trading.158 In March the
Government Accountability Office issued a critical report on the SEC’s enforcement program,159 and not detecting Bernard Madoff’s
investment fraud despite numerous red flags particularly damaged the agency’s credibility.160 The SEC currently is in a position of
157 Capital Markets Deregulation and Liberalization Act of 1995, Hearing on H.R. 2131
Before the Subcomm. on Telecommunications and Finance of the H. Comm. on Commerce,
104th Cong. 137–38 (1995) (testimony of Arthur Levitt, Chairman, Sec. & Exch. Comm’n),
available at http://www.archive.org/details/capitalmarketsde00unit (follow “PDF” hyperlink).
158 See OFFICE OF THE INSPECTOR GEN.,U.S.SEC.&EXCH.COMM’N,SEC’S OVERSIGHT OF BEAR STEARNS AND RELATED ENTITIES:THE CONSOLIDATED SUPERVISED ENTITY PROGRAM viii (2008), available at http://finance.senate.gov/press/Gpress/2008/prg092608; OFFICE OF THE
INSPECTOR GEN., U.S. SEC. & EXCH. COMM’N, SEC’S OVERSIGHT OF BEAR STEARNS AND
RELATED ENTITIES: BROKER-DEALER ASSESSMENT PROGRAM v (2008), available at http://www.sec-oig.gov/Reports/AuditsInspections/2008/446-b.pdf; OFFICE OF THE INSPECTOR
GEN.,U.S.SEC.&EXCH.COMM’N,CASE NO.OIG-481,EMPLOYEE’S SECURITIES TRANSACTIONS
RAISE SUSPICIONS OF INSIDER TRADING AND CREATE APPEARANCES OF IMPROPRIETY;
VIOLATIONS OF FINANCIAL REPORTING REQUIREMENTS; AND LACK OF SEC EMPLOYEE
SECURITIES TRANSACTIONS COMPLIANCE SYSTEM 2–3 (2009),
available at http://www.securitiesdocket.com/wp-content/uploads/2009/05/secigreport
insidertrading.pdf; OFFICE OF THE INSPECTOR GEN.,U.S.SEC.&EXCH.COMM’N,REPORT NO.
450, PRACTICES RELATED TO NAKED SHORT SELLING COMPLAINTS
AND REFERRALS iii (2009), available at http://www.sec.oig.org/Reports/AuditInspections/2009/ 450.pdf.
159 U.S. GOV’T ACCOUNTABILITY OFFICE, SECURITIES AND EXCHANGE COMMISSION: GREATER ATTENTION NEEDED TO ENHANCE COMMUNICATION AND UTILIZATION OF RESOURCES
IN THE DIVISION OF ENFORCEMENT 7 (2009), available at
http://www.gao.gov/new.items/d09358.pdf.
160 Id. at 45; Assessing the Madoff Ponzi Scheme and Regulatory Failures: Hearing Before
the Subcomm. on Capital Markets, Insurance, and Gov’t Sponsored Enterprises of the Comm. on Financial Services, 111th Cong. 2 (2009), available at
http://www.house.gov/apps/list/hearing/financialsvcs_dem/hr020409.shtml (follow “Printed Hearing: 111-2” link at the bottom of the page).
having to defend its jurisdiction over investor protection functions given the general push for restructuring of regulation.
Thus, in 2007, when the SEC was weighing whether or not to repeal the tick test after extensive analysis, the agency was in a much stronger position to follow the judgment of its professional staff. Policy dynamics around short selling always have been contentious, as noted above. The especially complex political situation now makes managing regulatory policy around short sales even more difficult than it has been in the past.161