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SEC Official Stresses Importance of Economic Analysis

SEC Chief Economist Chester Spatt, in a recent speech to the Society of Government Economists and the National Economists Club, discussed the importance of economics to the decision-making process by market participants and regulators. The cost-benefit analysis of a rule should use economic principles to determine the likely qualitative as well as the quantitative impact on behavior, in his view, even when the effects are not easy to quantify. The economic analysis of a rule should reflect not only why the rule is preferable to the status quo, but also why it is an improvement over relevant alternatives, he said. Spatt's prepared remarks are on the SEC's Web site.

Spatt emphasized the importance to regulators of understanding how economic evidence and principles bear on specific regulatory matters. Economic analysis can enhance the understanding of the consequences of potential rules, he explained, and can help with the cost-benefit analysis. Economic analysis is complementary to cost-benefit analysis, according to Spatt. The public comment process is not a substitute for a thoughtful economic analysis within the cost-benefit framework, he added.

Spatt reviewed a number of examples that illustrate the relevance of economic analysis to issues in the securities markets. One example is the SEC staff analysis of the impact of short sale pricing restrictions. The analysis led to the conclusion that removing pricing restrictions would not create substantive difficulties, so the SEC issued a proposal to eliminate the pricing restrictions.

Another example is the implementation guidance developed for options expensing with respect to both models and markets. Spatt said it was curious that some of the companies for whom option grants represented a significant portion of their compensation program were among those who argued that they did not know how to value the options. He said it was surprising for companies that did not understand the cost of options to use them to such a large extent.

Due to the efficiency of the financial markets, Spatt said he does not expect options expensing to lead to substantial changes in the valuation of companies that have significant option programs. One possible unintended effect may be the reduction in the overuse of these grants as boards become more aware of the costs.

Firms do not have to rely explicitly upon models for determining the expenses of employee stock options. Spatt noted that a few alternatives have been suggested to develop instruments that attempt to replicate the valuation of the options from the perspective of a market instrument. One potential advantage of these market-based instruments is that firms may be able to hedge their compensation exposure and make feasible new forms of employee option compensation, according to Spatt. He applauded the development of new designs and innovations in this area.

Spatt also talked about the unintended consequence of Internal Revenue Code section 162(m) which imposed a surtax on non-contingent compensation over $1 million. The intent was to restrain compensation, he said, but the result was that real compensation increased substantially.

After the SEC adopted new executive compensation disclosure requirements in 1992, Spatt said some companies began to use forms of compensation that were not as transparent, such as executive pensions. The SEC's recent adoption of new executive compensation rules reflects concerns about the effectiveness of the 1992 disclosure requirements, he said. The required disclosure of the dollar value of all compensation may reverse the forms of compensation that were artificially induced by the 1992 rules, Spatt explained. The cost-benefit analysis must consider the degree to which practices will adjust in response to new rules and regulations, he said.

Spatt suggested an issue that may be ripe for analysis is the potential alteration of executive compensation as a result of the disclosure of compensation statistics of other firms. The issue is not fully resolved, but is important, in his view.

Behavior can be altered in a variety of ways that may lead to unintended consequences of regulations. Spatt said it is important for a well executed cost-benefit analysis to reflect the broader economic consequences of a rulemaking and it must go beyond what is readily quantifiable.

Jacquelyn Lumb