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The State of Cost-Benefit Analysis at the S.E.C.

Regulators now decide whether to regulate by conducting a formal analysis of whether the costs of adopting a rule would outweigh its benefits.

The cost-benefit analysis is controversial. Influential regulatory voices ranging from the Chamber of Commerce to Cass Sunstein, President Obama’s former regulatory czar, have spoken out in favor of it.

Others have argued that it places roadblocks in the way of regulation; the Securities and Exchange Commission’s slowness to complete its work putting into effect the requirements of Dodd-Frank has been blamed, in part, on the fear that it will be faulted for the quality of its cost-benefit analysis.

The S.E.C.’s recent proposal of a compensation clawback rule can tell us something about the state of cost-benefit analysis in financial rule-making today.

The United States Court of Appeals in the District of Columbia, the country’s most important administrative law court, has told the S.E.C. that it has a “statutory obligation to determine as best it can the economic implications of the rule.” Between 2005 and 2012, the court consistently reversed the agency for not conducting an adequate cost-benefit analysis of the rules it proposed.

The court said, for example, that the S.E.C. had “inconsistently and opportunistically framed the costs and benefits” of its 2010 proxy access rule, a major agency initiative, and had “failed adequately to quantify the certain costs or to explain why those costs could not be quantified.” For a 2005 mutual fund governance regulation, the agency had failed to adequately apprise itself of “the economic consequences of a proposed regulation before it decided whether to adopt the measure.”

Since then, however, the court has added three new judges, and in its most recent big S.E.C. rule-making case gave the agency a pass for not trying to quantify the benefits of a rule aimed at discouraging the use of certain conflict minerals in southern Africa. The agency told the court it could not assess how much conflict would be curtailed by its rule, let alone how to measure the value of avoided conflict. The circuit court was sympathetic: The S.E.C. was not required “to measure the immeasurable.”

The court’s interest in cost-benefit analysis might be said to have two degrees in intensity. The first, a requirement that the S.E.C. do one, and do it carefully, appears to have been internalized by the agency. A second, more intensive, cost-benefit analysis would require a quantification of the costs and benefits. That component has never been definitively imposed on the agency by the circuit court, and the S.E.C. appears to be willing to propose rules that lack this sort of quantitative justification.

The clawback compensation rule exemplifies this resistance. The rule would permit companies to take back executive compensation paid if the compensation was based in part upon performance that later had to be re-evaluated. As the agency put it, “the trigger for the recovery of excess incentive-based compensation” would be when a publicly traded company “is required to prepare an accounting restatement as the result of a material error that affects a financial reporting measure based on which executive officers received incentive-based compensation.”

Fifty of the 198 pages of the rule are devoted to a cost-benefit analysis. This means that one-quarter of the agency’s proposal concerns not what the rule requires, but rather the reasons the agency thinks it is a good idea.

The S.E.C. spills a lot of ink on this sort of thing. The proxy access rule that did not survive judicial review devoted 16 percent of its proposed version and 17 percent of its final version to its economic analysis. The conflict minerals rule that did survive devoted 21 percent of its final version to the subject.

The clawback rule’s analysis does not spend much time quantifying its costs and benefits, but rather consists of an assessment of the implications on a variety of affected market participants. The agency notes that some 23 percent of publicly traded companies already have clawback proposals in place – meaning, presumably, that adopting clawbacks is not unprecedented or impossible.

The agency discusses the incentives that the rule would create for executives and companies. It identifies the costs for companies who do decide to claw back compensation, and speculates about the potential effects on American exchanges. The S.E.C. also considers some alternative ways to impose a clawback rule.

Throughout the cost-benefit analysis, the agency warns that it is “often difficult to separate the costs and benefits,” and that various effects of the rule are “difficult to predict.”

I suspect the agency thinks it doesn’t need to blow the court of appeals away with some numbers to survive, though of course the S.E.C. can do more cost-benefit analysis in the final rule. It does, however, believe that a lengthy consideration of the costs and benefits of a rule should be part and parcel of any proposal.

For those who think that cost-benefit analysis slows the pace of regulation, this may not be good news. Economists might wish that numbers were being appended to the discussion.

But I am happy enough to see rules without numbers. Justifying rules only with regard to their costs and benefits is pretty routine. As routines develop, it may become difficult for regulators and judges to consider new sorts of costs, and unforeseen benefits contained, for example, by the simple expression of what the rule favors and what it discourages. If we must have costs and benefits, perhaps it is good that the S.E.C. is trying to preserve flexibility about how it defines them.

David Zaring is assistant professor of legal studies at the Wharton School of the University of Pennsylvania.

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