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Home | Library | The Regulators Will Botch It Again

The Regulators Will Botch It Again

February 17, 2004

Will the regulators ever get it right? Are the regulators ever capable of getting it right? This constant infernal tinkering with our lives and businesses never seems to end like the ever expanding bureaucracies that rule us.

Regulators, in the midst of various securities industry scandals over mutual finds, are under pressure to come up with a set of reforms that will, well, correct the previous set of reforms. Unfortunately, regulators, and their friends in Congress, usually just end up acting like historical illiterates—repeating the mistakes of the past.

Take soft dollars. Soft dollars are the custom whereby large institutional investors pay more than they normally would for brokerage execution services. In exchange, they receive a variety of research products and services that they would not normally be able to afford and can be valuable in helping to find the right investment strategies.

For decades the regulators have allowed the use of soft dollars without objection. In fact, regulators, in effect, invented soft dollars in the 1970s. And then issued rule after rule modifying how and when they could be used. Often they expanded their use. For example, recently they permitted them for use in the Nasdaq market. However, the question of the validity of soft dollars was not a debatable matter until recently. All that will change now.

Now the regulators, facing the criticism of a populist press and pols, are looking at abolishing or severely curtailing soft dollars as are some officials of trade industry groups.

Many trading and brokerage firms won't use soft dollars, believing the practice compromises the credibility of their actions. Others believe soft dollars are critical, that they benefit both the firm and their clients. Advocates argue that soft dollars give their clients a much better quality of service. Both sides can make a case.

Still, soft-dollar defenders have the ultimate rationale—the regulators have condoned the practice for over a quarter century. Soft dollars were created back in 1975, with an amendment to the Securities Exchange Act, Section 28(e). That amendment permitted higher commissions in exchange for research services. Since that amendment, the Securities and Exchange Commission has repeatedly certified the use of soft dollars.

Probably no one can impose a sensible soft dollar standard that is reasonable for every financial firm. And it is a futile exercise for those overseeing markets to say that no one should use soft dollars. Or that everyone should. But that has never stopped regulators before and likely it will not stop them now. They have bureaucracies to protect and, as always, competition tends to scare them. So the regulators, the same as their counterparts in the rest of the leviathan, often want splashy new rules and regs, just as Congress always wants to reform campaign finance laws. The regulators fail and so does Congress.

Back in the 1970s, in the wake of the Watergate scandals, Congress passed a package of campaign reforms that were hyped for the American people as a foolproof way of showing the door to all the bad pols.

Out of that era of reform came Pacs, the notorious political action committees. Today, soft spending, spending on political action committees, is the bane of the reformers. The cry in the political arena is for another round of, you guessed it attentive reader, more reform so as to fix the previous round of reforms, which were designed….

After a while, reforms, like the civil rights laws and the big government they feed, become a major growth industry. Regulators and pols always want more, never fewer, new laws or cumbersome rules. Fewer laws, like fewer government departments or commissions, is never a serious option. But the market, when it is unencumbered by the social engineers who want to regulate everything, has its own way of settling an issue, even something as exotic as soft dollars.

Some firms use soft dollars. Some don't. It was the same kind of situation here in the Rancid Apple before our draconian anti-smoking laws, another episode in regulatory mayhem. Some businesses voluntarily imposed these restrictions on themselves, thinking it would be good for them. Others, with lots of smokers as customers, wanted no part of it. The city didn't like that. Mayor Mad Mike Bloomberg ultimately decreed that only one flower could bloom here in Sodom on the Hudson. The mutual fund industry itself, at least its biggest trade group, seems to like the one flower philosophy.

So under pressure from regulators and the public, the Investment Company Institute (ICI)—itself the target of much press criticism because of the mutual fund scandal, which, by the way, isn't really much of a scandal because many of the supposed bad practices have been known to regulators for years—recently asked the Securities and Exchange Commission to bar the use of soft dollars for stock-research products, computers and software that comes from outside vendors. The goal of the soft dollar opponents is to have more effective trade executions. These executions would keep costs and expense ratios low, thereby obtaining, in theory, better returns for the average individual investor, few of whom know the details of soft dollars and fewer of whom even care, providing they are getting good returns. But how far do the regulators want to go down this road that leads to more and more regulation of anything and everything?

Will mutual funds that have high expense ratios—and there will always be some—also be slammed by the regulators as immediately under suspicion. Indeed, in the fund business, some investment companies charge clients 12b-1 fees. On the other hand, many fund complexes don't and make a point of using it as a selling point. That's competition. Competition, in theory, is exactly what the regulators and their bosses on the Hill claim that they want.

However, many of our leading reformers—like our hired help on the Potomac who, for many years, found nothing objectionable in smoking and happily gave butts to their good soldiers in World War II—have suddenly been knocked off their horses. These Sauls turned Pauls have come up ready to impose a dictatorship of virtue.

This crusade now requires that soft dollar relationships not be slightly modified—with better disclosure so everyone knows what is going on. Instead, it calls for soft dollar relationships to go the same way as the venal Soviet Union—to the ash heap of history. Indeed, one wonders if, as in the case of the big butt companies hauled before our ayatollahs of political correctness, there will be ex-post facto penalties for those who employed soft dollars because they thought that it was in the best interests of their clients and because the regulators said it was a legal practice (like smoking used to be in most places).

Yet ex-post facto penalties are supposedly outlawed by the United States Constitution. But given the lawlessness of the biggest criminal in our society, the federal government, our revered document of liberty has become, in many cases, a dead letter, about as valuable as bonds issued by the Confederate States of America. (By the way, I'm putting this in a parenthesis so no one will read it and I will not have my humble hovel picketed by a pack of political correctness terrorists, but Lord Acton called our Civil War "the Second War of American Independence").

But reformers beware. Dramatic changes in soft dollar relationships, like the political reforms of the 1970s or the incredibly flawed "save" Social Security reforms of the 1970s and 1980s, will likely have unintended consequences. For example, another goal of abolishing soft dollars is to provide better, more independent research that would benefit the individual investor. Nevertheless, one of the leaders of a giant fund complex, a fellow apparently not marching to the ICI party line, recently warned of the unintended consequences of rigorous soft dollar reform.

"I think it is likely that a number of highly valued, independent research organizations would no longer be in business. We would all lose valuable input which we think is integral to our investment process," said Stephen Canter, chairman and chief executive officer of Dreyfus and vice chairman of parent Mellon. Indeed, an analyst with the TowerGroup, a research firm covering the securities industry, says ending soft dollars would be a bad move.

"It would be a disaster. The industry is built on these kinds of reciprocal relationships," says Robert Hegarty, vice president, securities and investments, for TowerGroup. Hegarty's point is well taken. Indeed, much of the business world, much of our personal relationships, are built on "reciprocal relationships."

Once again, the regulators and reformers are about to make the wrong decision. Their system of relentless intervention is flawed in the same way American intervention around the globe is flawed—the people who supposedly have all the answers end up winging it. That means another generation of social engineers will have to come up with more reforms to correct the errors of the previous generation of reformers and busybodies.

Maybe, just maybe, given the sorry record of regulators—who remind one of the members of Congress constantly playing around with the tax code—it's time to stop tinkering. Maybe, it's time to leave the market alone. Maybe the regulatory social engineers should retire.

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Gregory Bresiger, a business writer living in Kew Gardens, New York. gbresiger@hotmail.com. See his  archive.


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