Regulators seem to have a hard time pleasing both the industry they oversee and the investors they protect. One problem may be the lack of economic incentives to perform. Perhaps, it’s time, then, to consider how well self-funding has worked, and whether it could be done better.

The inefficiency and inertia of the regulatory system has long been a source of frustration to issuers and dealers alike. In a recent article, Ed Waitzer, chairman of Stikeman Elliott LLP in Toronto and former chairman of the Ontario Securities Commission, examines the failure of Canadian authorities to craft a credible response to the U.S. effort to bolster investor confidence, the Sarbanes-Oxley Act. “Canada has missed a unique opportunity to think through its regulatory reform and come up with its own solutions,” he notes.

The market’s players aren’t the only ones questioning the value they get from regulators. Retail investors may not be much happier. “The fundamental problem is there is no authority with a single mandate of responsibility for protecting investors,” says Stan Buell, founder of the Small Investor Protection Association, in Markham, Ont.

It would seem both industry and investors are frustrated with regulators — and neither has any economic leverage with which to press for change.

Provincial securities commissions are strange beasts. They are effectively agents of government, charged with ensuring that markets operate fairly and efficiently. Rather than being funded by general revenue as most government agencies are, the major commissions are self-funded; their revenue is provided by fees assessed on the industry. This model insulates them from the task of competing for government funds. It also shields them from pressure to be efficient and innovative.

As a result, regulators don’t face the same economic incentives that drive most organizations. If firms fail to operate efficiently and deliver quality goods and services, they will quickly lose their revenue to rivals. Regulatory revenue is under no such pressure, unless fee-paying firms decide to quit the market altogether.

Retail investors certainly don’t have any financial leverage over regulators, nor do they contribute much that’s meaningful to policy-making, which is one area in which market players can get their views heard. Notwithstanding the fact that investor protection is a big part of the regulatory mandate, the lack of financial incentives or a policy voice working in investors’ favour means regulators can easily overlook retail investors’ interests.

Moreover, the distinction between government funding and self-funding is lost on retail investors. They think that because its their tax dollars at work, they have the right to critique the regulators.

So, the industry funds the regulators, but can’t demand performance. Retail investors must rely on the market police, but have little power to indicate their interests. For both sides, it’s regulation without much representation.

There must be a better way.

First, there’s little question that self-funding represents an improvement over government funding, at least in terms of the resources available to regulators. “Reverting to funding securities commissions out of general revenue would be a regressive step,” says independent industry commentator Glorianne Stromberg, a former OSC commissioner. “That’s what got us into the mess in the first place, when the OSC had to curtail its activities drastically because of budgetary constraints.”

Steve Sibold, former chairman of the Alberta Securities Commission and now counsel with Bennett Jones LLP in Calgary, agrees that self-funding has been a success because it has enabled securities commissions to increase hiring, improve the quality of staff and dramatically improve service levels. “I am a fan of self-funding,” says Sibold. “It has been very good for securities regulation, and for the capital markets.”

To be sure, the regulators have had plenty of money to spend since adopting self-funding. Indeed, in some cases, they have generated large surpluses. Some have voluntarily cut their fees, and the OSC has readjusted its fee model in an effort to match the costs of regulation with the levies it charges. But the changes have done little to improve the incentives to regulators.

Stromberg and others have suggested that the problem is not the practice of self-funding but the lack of oversight and accountability attached to the funds.

Sibold maintains that he doesn’t see any gap in regulatory governance — at least, in Alberta. He notes, for example, that the ASC’S budgets are subjected to exhaustive line-by-line reviews and reported to the government extensively. In fact, he cautions, too much government oversight could compromise the independence of the organization.

@page_break@That said, he suggests governments could ramp up demands on regulators by setting more specific performance criteria. He allows that not everything can be turned into a cost/benefit analysis, but governments could get more from their regulators if they were more demanding.

The problem with regulatory accountability, however, isn’t just that the quantity of government oversight seems low; it’s also a question of quality. Few, if any, members of the legislature have expertise in the area, nor do they generally demonstrate a great interest in securities regulation. Waitzer says the simple fact is that there’s just not a lot of political currency in paying close attention to regulators. “If the system were working right, there would be accountability to the legislature,” he says.

The lack of accountability has not gone unnoticed. Indeed, in 2003, the OSC’s five-year review committee, headed by Purdy Crawford, recommended that the provincial government consider whether to subject the OSC’s operations to studies similar to those carried out on the U.S. Securities and Exchange Commission by the General Accountability Office. Ontario’s standing committee on finance and economic affairs declared in an October 2004 report that that the “status quo is unacceptable” and recommended that the government initiate a review of the legislature’s oversight of the OSC and implement a new oversight mechanism.

The government has yet to act on those recommendations. The matter was highlighted in a recent debate in the Ontario legislature when MPP Michael Prue, a member of the standing committee, criticized the government for failing to follow through on a number of the recommendations in the SCFEA report, including improving oversight. He noted that a report by Stromberg “made some very strong and very good recommendations about where we should be heading, and none of those have been followed.”

As governments appear unwilling or unable to do the job properly, how about the commissioners themselves? One problem is the increasingly adversarial nature of the administrative tribunal function. Sibold notes that, historically, administrative tribunals were meant to be a form of quick justice meted out by a jury of peers. As the tribunals evolved toward operating more like courts, both sides have “lawyered up.” As a result, lawyers have come to dominate the commissions, and industry experience has faded.

Stromberg also sees the commissioners’ dual role as both boards of directors for the commission and tribunal adjudicators as “increasingly problematic, due to the complexity of many of the proceedings that come before the tribunal and the increasing criminalization of these proceedings, and the resultant changes that are necessary in the skill sets of the adjudicators.”

The appointment of former investment banker David Wilson to head the OSC is a step in the other direction. But perhaps still greater involvement by both industry and investors in governance is needed to keep regulators headed in the right direction.

Stromberg says a more robust board for the commissions could be an improvement. Waitzer agrees, noting that it would help to have people with varied experience on commissions’ boards. But he cautions against formal quotas and stresses that board members should remain government appointees.

One practice from Ontario that Sibold would like to see other commissions adopt is the OSC’s five-year review — despite the length of time it actually took to complete the first review. The process could be accelerated, he suggests, by giving the reviews a narrower focus.

If such incremental improvements to accountability are achievable, however, they won’t defuse the fundamental obstacle to reform that plagues the system: the convoluted regulatory structure in Canada. Much bigger changes are needed.

SIPA’s Buell maintains that it’s unlikely “regulators, as they exist today, will do much to change the regulatory system to provide investor protection.” For retail investors to receive meaningful protection, he says, it will take more than tinkering with the current governance structure.

SIPA advocates the creation of “a national authority with a mandate to provide investor protection and a means of resolving disputes,” says Buell. “As long as there is no authority to look after investors’ interests, the industry will continue to be three steps ahead of the regulators and unsophisticated investors will continue to be victimized.”

Others have long advocated a single national regulator as a solution to many of the systemic problems, but the political will has never been strong enough to create one. Waitzer says that, failing such a regulator, it may be preferable to improve oversight of the self-regulators and delegate more authority to them, particularly as they consolidate, or even consider outsourcing some responsibilities.

“If we cannot get our act together, why not outsource securities regulation — at least, for large public issuers?” Waitzer asks in his article. “While initially repugnant, [the idea] has a lot of appeal.”

Before it gets to that point, governments should realize that regulators respond to economic incentives, like any other organization, so they may want to build in incentives to encourage their regulators to be more innovative and efficient. IE