Thomas Jefferson once observed, “The whole art of government consists in the art of being honest.” When government regulators abandon this principle by saying one thing but doing the opposite, they harm not only those directly regulated, but the American public as well.
By law, regulators cannot burden us or restrict important aspects of our lives without providing public notice of a proposed rule, allowing a meaningful opportunity to comment on the proposed rule’s text, and either implementing comments received or explaining why they did not.
These requirements mean that changes made to proposed regulations must be consistent with, or a “logical outgrowth” of, the original proposals — that is, the public can anticipate those changes. If changes are not a “logical outgrowth,” agencies must provide another opportunity for public comment. This principle permits agencies to modify their approaches in response to comments, but precludes alterations that deprive the public of adequate notice and meaningful opportunity to comment.
Recent developments, however, suggest that financial regulators may be giving short shrift to these fundamental, nondiscretionary requirements.
To inform and fine-tune complex rule making, agencies often pose questions. For example, if a rule proposes a 10 percent threshold, an agency might ask, “Should the threshold be higher or lower, and why?” Although the agency is uncertain of the precise threshold, the public understands a threshold is contemplated. In such cases, a final rule imposing a different threshold would likely be a “logical outgrowth.”
Questions can also enable agencies to explore different alternatives not embodied in the text of a proposed rule. If an agency chooses such alternatives, it must include the alternatives in a reproposed rule to provide for notice and comment.
Rules adopted without following this principle can impose serious unintended consequences on the public and on legitimate business operations, resulting in regulations that fail to achieve their objectives while causing regulatory compliance costs to soar. For example, financial regulators last December inappropriately approved a final set of implementing regulations for the Volcker Rule, which governs bank investments, by incorporating into the final rule text alternatives referenced only in questions, untethered to text of the proposed regulations. This resulted in a need for emergency action to avoid imposing $600 million in losses on small community banks — an action that could have been avoided by another notice-and-comment opportunity.
Recently, the Securities and Exchange Commission (SEC) has utilized questions that short-circuit standard notice-and-comment procedures, especially where its questions explicitly advise that it is “not proposing” an alternative. The apparent rationale for these “shadow proposals” is that alluding to alternatives in questions provides sufficient notice the agency might implement those alternatives — even though it explicitly stated it was not contemplating alternatives for inclusion in the final rule. The agency receives few comments on such questions because of its representation that alternatives are not actually being proposed and because no text exists to permit public understanding of these non-alternatives’ contours. Worse, the public cannot consider meaningful economic analyses of implied — but explicitly unproposed — alternatives.
This last factor is particularly significant. SEC rules have recently been successfully challenged in court, largely as a result of economic-analysis deficiencies. Considerable staff effort is being expended to reverse that trend, but shadow proposals sidestep the SEC’s rigorous new process. After all, it is a waste of resources to perform economic analyses on alternatives explicitly not being proposed (and such non-proposals are rarely detailed enough to allow analysis in any case).
Sound regulatory policies demand that such shadow proposals be clearly and honestly identified as alternatives, with alternative-rule text and supporting economic analysis included in the initial notice for comment. Otherwise, principles of honest government require that if the agency ultimately chooses to pursue such alternatives, the rule should be reproposed, accompanied by new text and robust economic analyses.
Those responsible for ensuring truth in financial reporting and securities transactions should treat their rule making equally truthfully. The SEC should not require the public to comb through every word in proposing releases hundreds of pages long to guess which of the dozens or hundreds of questions might lead to alternative approaches (and what those approaches may be). In short, the SEC should not act like Humpty Dumpty in “Through the Looking-Glass,” who scornfully told Alice, “When I use a word, it means just what I choose it to mean — neither more nor less.” Instead, it should emulate Horton in “Horton Hatches the Egg,” who proudly pronounced, “I said what I meant, and I meant what I said.”
Daniel M. Gallagher is a member of the Securities and Exchange Commission. Harvey L. Pitt, CEO of Kalorama Partners, is a former chairman of the commission.