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The liquidity crisis of 2008 is in full swing. Regulators in Western countries have prohibited short sales of hundreds of financial institutions. According to a Reuters news story on Sept. 19, Republican John McCain said he would offer reforms to prevent financial firms from concealing bad practices because “an inexcusable lack of financial transparency allowed Wall Street firms to engage in reckless behaviour that padded their profits and fattened executive bonuses when times were good.”

This reaction follows the pattern that has been established since the U.S. Securities Act was enacted in 1933. A crisis precipitates more regulation. The regulations come into effect, but the next crisis happens anyway. While commerce must be regulated, how much is too much?

For securities regulation, too much is when the cost of complying with the regulations does not justify the benefit to investors. The latest regulations resulting from a financial crisis, those imposed by the Sarbanes-Oxley Act of 2001, have resulted in much greater cost for companies, ultimately born by investors, than was originally estimated by the Securities Exchange Commission (SEC). The regulations have been in effect for several years in the U.S. and to a lesser extent in Canada, and yet the liquidity crisis of 2008 still occurred.

In fact, the very companies — like investment banks — that fully complied with Sarbanes-Oxley were the ones whose business practices led to the 2008 financial meltdown.

In their submission to the expert panel on securities regulation dated July 15, the British Columbia Securities Commission (BCSC) stated that their mission is to foster “a securities market that is fair and warrants public confidence” and “a dynamic and competitive industry.” They state that all Canadian securities administrators have similar objectives and that “the primary means through which regulators can foster competitiveness is to ensure that regulation is cost effective... One of the best ways for a regulator to be cost-effective is to intervene only when demonstrably necessary and when intervention is necessary, to design a regulatory response that will be most effective at the least cost.”

Interestingly for a regulator, the BCSC goes on to state: “All too often, commentators and even market participants label some activity as ‘unregulated’ as if that were necessarily a bad thing, and demand that regulators do something. In many cases, the problem has self corrected by the time the regulator has developed a new rule, but momentum carries the rule into place, resulting in an unnecessary regulatory burden.”

I agree with the BCSC. The SEC has failed, in particular with respect to Sarbanes-Oxley regulation, to make any realistic analysis as to whether the rules have been effective in solving the problems they were meant to address in relation to the costs and burdens imposed on the securities industry.
The SEC has shown a total lack of interest in the cost of regulation in the U.S. as compared to the rest of the world. This could have long-term implications for the U.S. securities industry in terms of jobs, financial clout, companies’ ability to access capital and U.S. competitiveness with the rest of the world.

If the reaction of U.S. regulators to each financial crisis is to create new and expensive regulation for all securities issuers to comply with, issuers will avoid the U.S. markets more and more. At a time when the euro is now for the first time legitimately vying against the U.S. dollar for dominance as the world’s most important currency, this type of isolationist attitude and regulatory frenzy will further detract from the vitality of the U.S. dollar, and along with that, cause harm to the U.S. economy as U.S. and other issuers raise capital in other markets.

What can be done? One idea is that a portion of the profits generated from investment sales go into a fund for compensation to those who cannot get compensated fully by insurance and investment firm capital. Participant payees would include investment banks, brokers, rating agencies and others profiting from investment advising. The fund should be established in addition to any insurance and substantive capital requirements for investment banks and brokers to cover legitimate claims.

While such a fund could encourage brokers to recommend even riskier investments than they do currently, I do not believe this is likely to happen, especially if each fund participant was required to pay negligence-related losses out of its insurance coverage first and then its capital. Only after these payments occurred would recourse be available against the fund.

While the markets are in turmoil and investment in new products is low, an additional fee paid by brokers may seem like pouring salt on a wound. But brokers would soon see the merit of having a large fund backing up their recommendations, since investors would more quickly regain faith in the investment system.

Bernard Pinsky is head of the Corporate Finance/Securities Group and of the U.S. Practice Group at Clark Wilson LLP in Vancouver.