Deregulation Dilemma

The recent performance of the SEC chairman before the Senate Banking Committee reminds one yet again of one of the sadder ironies of the Bush administration. How did President Bush, who one might be forgiven to have supposed had a pro-market bias, appoint William Donaldson as chairman of the Securities and Exchange Commission? For since his appointment in February 2003, Mr. Donaldson has time and again sided with the Democratic members of the SEC in a series of important split-vote decisions in favor of investment industry regulation of highly dubious merit.

With hindsight, one must wonder whether Mr. Donaldson's background as a Wall Street insider with a stint as CEO of the New York Stock Exchange best equipped him to reform the industry with which he has been so intimately involved over a long career. This is a great pity, since it almost certainly will result over time in lesser choice, higher fees and worse investment performance for the small-mutual-fund investor. It also does not bode well for future SEC decisions in the remainder of Mr. Donaldson's tenure, such as rulings on the elimination of the trade-through rule or the reform of the National Market Structure, which can only add further costs to the small investor.

Among the clearer indications of the seeming disregard that the SEC under Mr. Donaldson has had for the damage that its actions might have for investor fees and performance was its decision last June on the mutual-fund industry. That decision set the unhealthy and overreaching precedent of basically mandating a particular corporate model for the mutual fund industry. For in a purported effort to "protect" mutual fund investors--in what most observers would consider to be a highly competitive and already heavily regulated industry--the SEC took it upon itself to require that every mutual fund have a chairman who is independent of the company that actually manages the fund.

The SEC decision on this matter was taken despite the fact that serious research filed with the SEC casts grave doubts on the notion that independent chairmen will have the incentive to do a better job for investors than chairmen who are tied to the fund's management. Indeed, comprehensive research of all fund houses with assets of $10 million or more by Geoffrey Bobroff and Thomas Mack suggests exactly the opposite.

They found that funds with non-independent chairmen charged expenses that were on average 16 basis points lower than funds with independent chairmen. More tellingly, they also found that funds with non-independent chairman significantly outperformed those with independent chairmen. This latter point was reflected by average returns of the non-independents that placed them in the 48th percentile of Morningstar's rankings as compared with the 59th percentile for the independents.

As if it were not satisfied with harming the mutual-fund industry, Mr. Donaldson's SEC has now decided to weigh in on regulating the hedge-fund industry. The initial step proposed by the SEC in that direction earlier this month was to require that all hedge-fund managers file with the SEC. It seems to matter little to Mr. Donaldson that no less an expert than Federal Reserve Chairman Alan Greenspan has testified before Congress that the SEC's proposed regulation would do little to prevent fraud in the hedge-fund industry, while it might do a lot to drive some of those hedge funds out of business. It also seems to matter little to Mr. Donaldson that he might be jeopardizing the highly important contribution that the hedge funds have made to the flexibility of our financial system by providing much-needed liquidity.

In assessing Mr. Donaldson's performance over the past 18 months, one must be left wondering whether the many ill-conceived regulatory reforms by the SEC under his watch were but a hasty reaction to New York Attorney General Elliot Spitzer's overzealous crusade against Wall Street abuses. Could it be that Mr. Donaldson felt compelled to act, no matter how, so as not to be upstaged by a hyperactive Mr. Spitzer? Could it be that Mr. Donaldson's own background in the industry has clouded his judgment on the nature of the reforms required?

On the basis of his past performance, it is probably too much to hope that Mr. Donaldson might now in part redeem himself by a trade-through ruling that will truly benefit the small investor. This must leave one wondering how much less market-friendly than Mr. Donaldson could be his future replacement under a different administration.

Desmond Lachman is an AEI resident fellow who researches major emerging-market economies and the role of multilateral lending institutions.

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The Constitution as political theory

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