The SEC And The Real World

Some advisors likely were a little wary to read in the April 10 Wall Street Journal that SEC Chairman Christopher Cox is considering naming Andrew Donahue to run the agency‚s Division of Investment Management. No doubt Donahue has solid legal credentials, but it is his most recent job as executive vice president and general counsel for Merrill Lynch Investment Managers that raises a few eyebrows.
If appointed, Donahue‚s chief task will be to complete designing and implementing a series of new regulations proposed for the mutual fund industry in the wake of the after-hours trading scandal that surfaced in 2002. Among the issues he faces is whether mutual fund boards should have an independent chairman and how much information should be disclosed to prospective investors.
Of course, advisors will be paying acute attention to how Donahue or another appointee handles the implementation of the so-called "Merrill Lynch rule" that exempts brokers from Registered Investment Advisor regulation as long as they offer "incidental" financial planning advice. But the SEC already has ruled on the brokerage exemption and, while folks at the Financial Planning Association continue to pursue an administrative lawsuit against the SEC, it‚s difficult to imagine that management at the giant brokerages are happy with the outcome, and its disclosure requirements, either. For a fascinating look at what the Merrill rule will mean when a broker meets with a client, read the column by Andy Gluck, our newest editor-at-large, on page 33.
It‚s the best take on what will really happen when the rubber meets the road that I‚ve read to date. Andy notes that the only issue remaining is determining exactly where a broker crosses the line and becomes an advisor. The guess here is that a coalition of different interests from consumer groups to the national media to FPA will have enough clout to prevent whoever is at the SEC from totally capitulating. It‚s also doubtful that any current or future regulator wants to meet the same fate as disgraced former SEC Chairman Harvey Pitt. Moreover, as several articles in this issue describe, a growing number of brokers are deciding to become RIAs.
Speaking of the SEC, it might be a good time for the agency to examine some of the assumptions implicit in many of its regulations, namely the normal distribution of equity market returns. Contributing Writer Harold Evensky recently sent me a fascinating article in the August 2005 issue of The Business Lawyer by University Of Texas professor of banking and finance law Henry T. C. Hu.
"The virtually impossible (under the normal probability distribution assumption) happens with astonishing frequency," Hu writes. "Assuming a normal probability distribution, the [1987] crash was a 25 standard deviation event. This meant if the stock market never took a holiday from the day the earth was formed, such a decline was still unlikely."
Another example Hu cites is that the chances of the dramatic three-day decline in the Dow Jones in July 2002, when the Enron and Worldcom scandals were "in full bloom, was one in four trillion." Of course, it is now widely accepted by academics and other serious investors that stock market returns are "highly non-normal." Hu explains that anyone who accepts "the structural bias" embedded "in the SEC‚s predictive system" comes away with "an absurdly optimistic notion" of how rare the "extreme events" are.

Assuming a normal probability
distribution, the [1987]
crash was a 25 standard
deviation event.

So what are the lessons? The first is that the stock market has always recovered from these frequent collapses. The second is that many folks at the SEC are oblivious to the real world.

Evan Simonoff