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Merit Regulation via the Suitability Rules

Ronald J Colombo

Abstract

The philosophy underpinning federal securities regulation in the United States is one of disclosure. This has been the case since the inception of federal securities regulation in 1933,2 and continues to be the case with Congress’s most recent enactments on the subject, contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.3

In the wake of the financial industry’s collapse in 2008, and the recession it helped spark, some have questioned whether this paradigm remains advisable.4 They have suggested the introduction of merit regulation into the U.S. securities law regime, whereby the government would not merely mandate certain issuer disclosures, but would also prevent the offering of securities deemed too risky.5 Although not revolutionary (as several American states, and nations such as China, have a merit component to their securities laws), the concept of merit regulation is indeed largely alien to the scheme of U.S. federal securities regulation.6 As such, it would be a transformative development.

There is, however, a far more modest way of approximating the same result. And it builds upon our existing regulatory infrastructure: suitability rules. Via enhancements to the suitability rules, policymakers can achieve much of what merit regulation promises, without the significant, accompanying drawbacks. Properly enhanced, such rules could provide a system that safeguards investors from unsuitably risky investments on a case-by-case basis, thereby depriving neither corporations, nor investors, of mutually beneficial opportunities that might be fully appropriate for them despite their inappropriateness for others. It could also furnish an additional tool by which authorities could regulate systemic risk.

Like Caesar’s Gaul, this Article is divided into three parts. Part I will describe the disclosure-based federal securities regulatory regime that prevails in the United States today. It will highlight the limitations of this regime, as underscored by merit-regulation proponents seeking its reform. Part II will describe merit regulation, both in theory and in practice. It too will end with an articulation of the drawbacks associated with such an approach. Part III will describe the “suitability rules” component of U.S. securities law, as they are currently formulated. Part III will also demonstrate how the suitability rules can be utilized to essentially achieve the desideratum of merit regulation without the costs associated therewith.

Published on 7 Feb 2013 in WORLD SOCIAL and ECONOMIC REVIEW No 2, 2013