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SEC Regulation

Christopher P. Saari

“The Efficient Capital Market Hypothesis, Economic Theory and the Regulation of the Securities Industry.” Stanford Law Review 29 (May 1977): 1031–1076.

The American Securities and Exchange Commission (SEC) is a government regulatory agency which distrusts the free market's ability to protect investors and achieve optimal resource allocation. With its goal to protect investors, the SEC wants to make certain that all investors trade on the basis of equal market information. The means it has chosen to implement this goal is intervening in the market by mandating the disclosure of comprehensible securities information and by regulating “insider” trading.

In evaluating the primary means of SEC regulation—disclosure requirements and insider trading regulation—we have to measure these against the goal: protecting investors through “egalitarian” distribution of market information. Evidence derived from the Efficient Capital Market Hypothesis (ECMH) questions the wisdom of both the goal and the means of state regulated securities. This evidence suggests that state regulation harms the important social and economic purpose of capital markets in efficiently allocating capital.

The Efficient Market Hypothesis contends that the prices of securities do, infact, fully reflect information about those securities and that the prices quickly adjust to new available information. The most widely discussed variant of the Efficient Market Hypothesis—the semistrong form—contends that security prices fully reflect all publicly available information regarding the securities. This implies that the average investor, by analyzing publicly available information, cannot hope to consistently identify and profit from undervalued or overvalued securities (since the prices are already accurate mirrors of security values).

Recognition of the ECMH in SEC policies would radically alter traditional securities regulation. The SEC's view of the function of information in the securities market and their understanding of its role in investor protection are inconsistent with the ECMH. For example, the SEC does not recognize that disclosure regulations may actually decrease the information available to investors in making their investment decisions, and it neglects the fact that an efficient market may itself provide the best possible protection for investors.

If the SEC recognized the implications of ECMH, it would encourage the use of all sources of information by those who are in the best position to do so; it would abandon trying to ensure that all information pass through its tightly drawn disclosure mechanism before reaching the public. SEC must reject the unattainable model of investor protection through egalitarian information disclosure; it should also reappraise its traditional role in the securities market in light of a goal that more realistically protects investors: ensuring maximum information flow in the securities market. More specifically, we can hope for the relaxation of disclosure regulation and an increasing reliance on market mechanisms. Also questionable is whether the regulation of “insider” trading is desirable. Such trading serves to increase the information flow to the market and thereby improves market efficiency.

The market can provide more effective protection to investors than the SEC can. Evidence suggests that SEC regulation merely serves to hinder the efficiency of the market.