March 9, 2017 / 5:24 PM / 2 years ago

COMMENTARY: Congressional push to ease regulation ignores regulatory arbitrage

NEW YORK (Thomson Reuters Regulatory Intelligence) - The U.S. House of Representatives has passed a variety of measures to reform how administrative agencies issue regulations, mainly by requiring cost-benefit analyses before the adoption of significant regulation. Republicans and business interests say (here) the bills will boost the economy by reducing the regulatory burden on business. Democrats and consumer and labor interests counter (here) that the bills will work to erode consumer and worker protections.

An employee of puzzle maker Beverly holds a piece of the company's white micro 1000 piece jigsaw puzzle at the International Toy Show in Tokyo June 14, 2012.

Lawmakers who blame regulators for doing too much, or too little, could use a dose of the prescription that they have written for regulators. Furthermore, the reform agenda routinely ignores the impact of regulatory arbitrage, the practice where companies exploit loopholes to circumvent unfavorable laws and regulations. Economic analysis should also include the systematic examination of how firms can exploit loopholes in proposed legislation and regulation.


The Administrative Procedure Act of 1946, supplemented by Executive Order 12866, already imposes the cost-benefit requirement on executive branch agencies like the U.S. Treasury Department. According to the Congressional Research Service (here), independent regulatory agencies such as the U.S. Securities and Exchange Commission conduct varying degrees of economic analysis under a patchwork of other statutory and executive order provisions and their own internal guidelines. Judicial scrutiny of rulemaking (here) has also been a factor in the increasing reliance by independent agencies on prospective economic analysis.

Two of the new bills, the Regulatory Accountability Act of 2017 (H.R. 5) and the SEC Regulatory Accountability Act (H.R. 78), join a long list of measures introduced over the years that seek to bolster the analytical requirements and more thoroughly extend the mandate to the independent regulatory agencies.

H.R. 5 also aims to set aside doctrines established by the U.S. Supreme Court that defer to federal agencies’ interpretations of ambiguity in either statutes (the “Chevron” deference) or their own earlier regulations (the “Seminole Rock” or “Auer” deference) when issuing new regulations.

Both of the so-called “deference doctrines” require judicial deference unless the agency’s interpretation is deemed arbitrary or unreasonable. Neither doctrine prevents Congress from taking legislative action to reverse regulatory action, even if the agency’s interpretation is reasonable.

While the Supreme Court as recently as May, 2016 declined to reopen the question of Auer deference, there is a growing chorus of conservative opposition to both of the deference doctrines. Judge Neil Gorsuch’s appointment to the Supreme Court, if approved by the Senate, might push litigants to test these doctrines in the high court whether or not H.R. 5 becomes law.


Congress creates the framework for regulators, who are supposed to be the experts, to fill in the blanks. Article 1 of the U.S. Constitution gives legislative powers to Congress, but the high court has held that Congress can delegate its powers as long as its framework is “intelligible.”

This means that legislators have wide discretion to determine both the issues they want to delegate and the amount of downstream regulatory autonomy they want to allow. Congress can explicitly authorize agencies to take action, but the deference doctrines give agencies plenty of breathing room to expand their own power when the enabling statute or even their own regulations are silent or ambiguous.

As a result, legislators can control the “sound bite” issues that make them look principled and decisive to their constituents, and to delegate the more complicated and intractable issues to the agencies. This makes it easy for politicians to blame the bureaucrats when the regulations fail, such as when stakeholders arbitrage the regulations to defeat the purpose of the upstream statute.

The pattern plays out many times in business law and regulation. The result is a lot of finger-pointing and hand-wringing on how to solve the most pressing legal and compliance issues.


A top issue in corporate governance illustrates how this can affect government decisions. Managers have lobbied for years for an amendment to Section 13(d) of the Securities Exchange Act, enacted by the Williams Act in 1968, to stop insurgent shareholders from acquiring significant stakes in public companies before managers and other shareholders notice.

Section 13(d) requires any person or group that acquires more than 5 percent “beneficial ownership” of public company equity securities to disclose its position on Schedule 13D within 10 days of crossing the threshold. Congress set the ownership threshold and the time-frame, but left it up to the SEC to deal with many other issues, including the definition of beneficial ownership, which is not set by statute.

In the meantime, corporate raiders and activists have drawn on almost 50 years of financial and technological innovation to game the reporting requirements and obscure both their influence on companies and their trading profits. The SEC already imputes beneficial ownership to holders of most options, warrants, convertible bonds, and securities futures. However, insurgents continue to push the envelope by harnessing equity swaps, short positions, and even credit derivatives to achieve their goals.

Congress responded in 2010 when it enacted Section 766(e) of the Dodd-Frank Act to add Section 13(o) to the Exchange Act. The new provision gave the SEC the authority, but not the mandate, to apply the reporting requirements to holders of security-based swaps. The broad delegation of authority threatened to upset the established consensus that many derivatives including physically-settled swaps already confer beneficial ownership.

The SEC therefore clarified its position in 2011 by simply readopting the existing Rule 13d-3 definition of “beneficial ownership.” This also helped to reaffirm the orthodox view that cash-settled equity swaps do not automatically convey beneficial ownership, unless used as part of a scheme to evade the reporting requirements.

Congress also punted on the time frame for reporting. Section 929R of Dodd-Frank gave the SEC the discretion to shorten the 13D filing period, but the SEC has not taken action. So in different ways on both the beneficial ownership and the temporal issues, Congress and the SEC did an elaborate dance to reaffirm the status quo.

In March, 2016, Senate Democrats took a more direct route by introducing the Brokaw Act (S. 2720), which explicitly commands the SEC to shorten the Schedule 13D reporting deadline to two business days. Brokaw, which has an uphill battle to become law in a Republican-controlled Congress, also would require the SEC to require the disclosure of short positions.

The bill would require the disclosure of activity that results in “the direct or indirect opportunity to profit from, or share in any profit derived from, a transaction in the subject security.” It casts a wide net that aims to cover cash-settled swaps and other derivatives that give the holder the ability to profit from the underlying equity security without conferring the two traditional indicators of beneficial ownership – voting and investment power. Brokaw also aims to tighten regulation regarding concerted activity by groups of shareholders, including hedge funds.

Recent developments relating to Section 13(d) illustrate the wide discretion Congress is willing to wield on delegation. Although there is an argument that the existing securities law framework strikes the right balance of power between incumbent management and insurgents, the perception of gridlock lessens public faith in our government institutions.


If lawmakers contribute to a dysfunctional regulatory environment, it is fair to ask whether it makes sense to require the affected agencies to help Congress conduct prospective economic analysis of proposed legislation.

The Congressional Budget Office (CBO) conducts economic analysis of bills approved by Congressional committees. Its analysis, however, is limited mostly to the impact of proposed legislation on federal spending and revenues.

For example, the CBO cost-estimate of the 2016 version of the SEC Regulatory Accountability Act (H.R. 5429) contains an analysis of the impact of the bill on SEC staffing. The report discusses, but does not attempt to quantify, the potential impact of the bill on new fees that the SEC might charge private parties to offset the increased cost of agency compliance. Nor does the report discuss how stakeholders, in this case, the SEC itself, can evade the law through policy memoranda, selective enforcement, and “creative” cost-benefit analysis.


Any analysis should systematically measure the likelihood of arbitrage, which can defeat the policy purposes of the proposed legislation. If arbitrage is a symptom of imprudent legislation, prospective analysis can expose bad policy objectives and help Congress to design laws that align good policy objectives with how the law implements those objectives.

Another factor that can trigger regulatory arbitrage is the inconsistent Congressional delegation of authority to multiple agencies. According to the Government Accounting Office, fragmentation of responsibilities among multiple agencies with overlapping authority has created challenges to effective oversight.

The GAO report cites several examples including fragmentation and overlap in the regulation of swaps and security-based swaps by the Commodity Futures Trading Commission (CFTC) and the SEC. The report also cites overlap in the regulation of insurers by both state insurance regulators and the Federal Reserve, something discussed in a previous column (here).

Furthermore, intentionally or unwittingly inconsistent Congressional delegation can stoke interagency regulatory competition. This can further fuel arbitrage as firms engineer their corporate structures and transactions to fall under more favorable regulatory environments.

Systematic analysis of potential arbitrage before enacting legislation would help Congress to calibrate the proper amount of interagency competition. This will allow the agencies to check each other’s power, and push beneficial economic activity to the appropriate stakeholders.

Merely forcing the agencies to conduct economic analysis of regulation after enactment of the underlying laws may make Congress look good, but it does little to mitigate the impact of ill-conceived legislation that forms the foundation for regulation. The result is that Congress will keep passing laws that look a lot like downstream regulation – lengthy, ambiguous, misdirected, and a minefield of unintended consequences.

-- H.R.5 - Regulatory Accountability Act of 2017: here

-- H.R.78 - SEC Regulatory Accountability Act: here

-- S.2720 - Brokaw Act: here

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters and author of the Corporate Transactions Handbook. The views expressed here are his own.)

This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on Feb. 28. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters

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