TCS Daily


Assessing the Donaldson Era

By Peter J. Wallison - July 15, 2005 12:00 AM

The William Donaldson era at the SEC recently came to an end. Fittingly, it went out in a storm of controversy, as the commission's hasty effort to re-adopt a rule recently struck down by the courts brought bitter opposition from many former chairmen and commissioners -- both Democrats and Republicans. Once again, on Donaldson's side in the re-adoption were the two Democratic Commissioners -- both of whom, as it happens, are over the limits of their terms and should have had the good sense not to have voted at all. Like a clock that strikes thirteen, this last act was not only wrong in itself but cast doubt on everything that went before.

That the Donaldson era should end on this note is also fitting because the issue involved -- whether to require that mutual funds have an independent chair -- was so fully emblematic of what was wrong with his tenure in the first place. Until the SEC made its rule, the chairs of most funds were officers of the fund's investment adviser. Mr. Donaldson and the two Democrats on the Commission saw this as a compliance problem; in their view, the boards of the funds -- which are in any event made up of a majority of independent directors -- would be less diligent in protecting the fund's shareholders if the chairman was not independent. Hence the rule.

But if this were really true, then fund shareholders should be the first to grasp it. They could decide, based on their overall view of the fund's performance, whether they wanted to remain as shareholders when the fund's chair was not independent of the adviser. Thus, all that was required was disclosure. The fact that the Donaldson commission did not see disclosure as an option in this simple case -- one of the reasons the court found fault with the rule-making process -- speaks volumes about Mr. Donaldson and the Democratic appointees who consistently vote with him to impose new regulations. Clearly, underlying their choice was a bias in favor of rules, and -- one must say it -- a lack of confidence in, maybe event contempt for, the ability of investors to make the simplest of choices for themselves.

This in fact is the thread that runs through all the most controversial and disputed actions of the SEC under Mr. Donaldson's chairmanship. The first of these, the famous shareholder access proposal, was designed to give shareholders a greater voice in choosing directors. It was founded on the notion that shareholders who are disappointed with a company's management would not sell the stock but would sit around and stew about their inability to get one or two representatives on the board. Once again, shareholders were pictured as dolts, unable to find their way off a stalled escalator.

Then came the plan to regulate the advisers of hedge funds. Hedge funds are not regulated because their investors are the most sophisticated investors in the market and presumably can make intelligent and informed decisions for themselves. But in support of the rule, Mr. Donaldson and his two supportive commissioners argued that hedge fund fraud was increasing -- in effect that these sophisticated investors need the SEC's protection. If this is true, a longer Donaldson tenure might have resulted in a challenge to the underlying theory of private placements.

Finally, there is Regulation NMS, adopted in April but eventually published in final form only weeks ago. This regulation requires investors to take the best price in the market when they buy or sell securities in any electronic venue. Although it seems obvious at first that investors will want the best price, that is not always the case. When an investor is looking for a large number of shares to purchase or sell in a fast moving electronic market, it may be best to by-pass a smaller volume to take a larger bid or offer at an inferior price -- lest the market move away and the larger volume disappear in the interim. Investors were always able to do this in the Nasdaq market, which is a vital and competitive venue where Nasdaq and a number of electronic communications networks (known as ECNs) were vying for the trading interest of investors. Investors in Nasdaq were able to access trades so that they got the best overall price, not necessarily the best price on every single trade. And they were happy with this setup, since the competition among the various trading venues guaranteed them low spreads, low transaction costs, and high levels of innovation.

But Chairman Donaldson and his two Democratic backers did not see it this way. To them, it was important to channel and direct investor buying and selling by regulation, denying traders the possibility of by-passing a small order with the best price in order to access a larger volume that gave them a better overall result. Thus was born a regulation that Mr. Donaldson dubbed the Best Price Rule. In due course, it was applied to Nasdaq -- a market that had been functioning perfectly well without a rule -- and investors joined shareholders as a group seriously in need of the SEC's paternal ministrations

The SEC used to be the most respected regulatory agency in Washington, largely because it favored disclosure rather than mandatory rules for achieving its goals. This treated investors and shareholders as the adults they are. In the Donaldson era, however, things changed radically, as the SEC joined the Nanny set. Fortunately, new leadership is on the way. Soon, perhaps, investors and shareholders will be allowed to make their own decisions.

Peter J. Wallison is a resident fellow at the American Enterprise Institute He was General Counsel of the Treasury and White House Counsel in the Reagan administration.

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