Capture at the SEC? Let’s Pause for a Sec

by Laurence Tai

The financial crisis of 2008 was perceived as a failure not only of financial institutions, but also of their regulators. A popular narrative is that the industry has “captured” agencies so that bureaucrats serve its interests instead of the public interest. Definitions of capture vary, but perhaps this one corresponds to common intuitions: “the result or process by which regulation, in law or application, is consistently or repeatedly directed away from the public interest and toward the interests of the regulated industry, by intent and action of the industry itself.”

To consider just one agency, the U.S. Securities and Exchange Commission (SEC) has a record of policymaking in recent years that seems to indicate capture. For example, it has failed to regulate high-frequency trading and has delayed further regulations on money market funds, which were involved in the crisis. Instead, it has catered to sophisticated traders and securities trading companies by abolishing the longstanding uptick rule for short sales, and it relaxed net capital requirements, allowing the largest securities trading firms to take on greater risk. Also, the SEC has settled most civil enforcement actions rather than taking them to trial and frequently rescued firms from the full consequences of securities law violations.

Dan Carpenter and I suggest in our article, “SEC Capture by Revolving Door: Strengths and Weaknesses in the Evidence Base” in the Law and Financial Markets Review,2 that the evidence for capture at the SEC is more mixed than these seemingly unfavorable outcomes would suggest. In reviewing these cases, we found two important factors to consider before concluding that a policy evinces capture:

First, an agency’s decision may not be against the public interest, even if it appears otherwise. Though the public interest is difficult to define, it is possible to identify the extent to which an agency has catered to different stakeholders, which, for the SEC, includes investors in securities and non-financial firms that rely on Wall Street firms to help generate capital. For instance, in the case of money market funds, there was concern that additional restrictions, if not carefully researched beforehand, would cause investors or their fund managers to switch to unregulated investments. Thus, the agency’s decision not to further regulate such funds was, at least in part, plausibly in the public interest. In contrast, the SEC’s relaxation of net capital requirements benefited only a small number of large firms, and not even their customers, whom the net capital requirements were designed to protect.

Second, agencies with limited time and resources need to prioritize among various activities, so inaction is more excusable than action. To say that the SEC should have done something requires an understanding that other tasks might have suffered. For example, even if the SEC could have brought more financial industry players to trial and won, these trials would have been much costlier than the settlement negotiations it pursued, so it probably could not have pursued as many enforcement actions to a judgment. (Also, Congress has not seemed willing to vastly increase its enforcement budget.) On the other hand, one can question whether it was necessary to abolish the uptick rule, which the SEC originally enacted in 1938, for marginal increases in liquidity and pricing efficiency.

With these dimensions, some policies present a substantially stronger case for capture than others.  In the end, more important than the abstract question of whether the SEC is captured are the causes of potential capture and the proposed remedies. In our Law and Financial Markets Review article we find that attribution to the mechanism most popularly viewed as indicating capture, the revolving door between government and the private sector, to be problematic.

Specifically, the notion that SEC officials would be predisposed toward industry hoping, even subconsciously, for favors or work in return is not borne out by analysis of where they actually work after leaving the agency. Instead of usually working directly for Wall Street firms, SEC alumni who appear before the Commission tend to be employees of law and accounting firms that serve the financial industry. Since payments to these service firms do not depend on the outcome of a matter, it is difficult to see how a Commission employee could even vicariously have a stake in the financial firm’s result. More concretely, if an SEC alumna worked at Goldman Sachs as in-house counsel, it might raise questions as to whether she had been generous toward it or other Wall Street firms as an agency official; however, if the same alumna took a job at a law firm like Debevoise & Plimpton (current SEC Chair Mary Jo White’s former firm), it should not. It is equally, if not more, likely that a regulator would be more aggressive toward a firm in the industry to prove her competence for a high-paying job at a non-client company in the private sector.

A more nuanced version of the idea of the revolving door suggests that past or anticipated future work in the financial industry colors a bureaucrat’s thought process, even when she tries to scrutinize industry arguments. However, work in an academic setting or a past career in politics might also affect one’s outlook on financial regulation, but this type of transition is not part of the core revolving door concept, which deals with movement between industry and government. Thus, to the extent that the standard revolving door increases the risk of capture, it seems mostly to be part of the general role that past experience plays in influencing one’s perspectives. These perspectives are potentially valuable, even if they can cause a regulator to be unconsciously biased toward industry.

This distinction is important because of calls to place additional restrictions on the revolving door, such as limiting interactions between employees and the topics they can work on. If, instead of revolving door incentives, any capture at the SEC derives primarily from biased thinking that comes incidentally from movement into and out of government service, it is better to counteract the bias directly during the decision-making process. Though more research is needed, developing ways to debias is arguably a more productive way to deal with unsatisfactory policymaking at the SEC than asserting capture and trying to shut or slow the revolving door.

[1] Daniel Carpenter and David A. Moss, “Introduction,” in Preventing Regulatory Capture: Special Interest Influence and How to Limit It (Cambridge University Press, 2014), 13.

[2] Available through Harvard Library systems to those with access, or through your own library system.