When Does Regulation Work?

Markets are never entirely free. Rules, regulations, and referees shape the playing field, in the form of municipal codes and international trade agreements, tax incentives and penalties, an alphabet soup of agencies and voluntary industry standards. And players of all kinds try to gain advantage by influencing the creation of rules and their enforcement.

Yale Insights talked with experts in three markets where regulation plays a significant role: hedge funds, pharmaceuticals, and organic food and beverages. Among the themes that emerged: Regulation can engender trust among market participants, whether they are investors or consumers purchasing medicine. And good regulation requires collaboration between business and government.

Investing: Eli Combs, President and Co-Founder, Meehan Combs

By definition, investing involves risk. Regulation often aims to contain this risk, or at least direct it away from innocent bystanders. But in this fast-developing industry, the regulations often seem a step behind, perhaps because they were shaped in response to the last scam, scandal, or crisis.

Hedge funds typically seek to nimbly exploit market opportunities. Because they aren’t open to retail investors, hedge funds have been exempt from many regulations that cover investment vehicles such as mutual funds. Such funds have been prevented from advertising for the last 80 years, in an effort to limit the market to wealthy, sophisticated investors. But that rule was recently lifted.

Eli Combs ’01, president and co-founder of the hedge fund Meehan Combs, discusses the pros and cons he sees in some of the regulations facing his field.

Regulation of banks is crucial for the efficiency of transactions, for maintaining reasonable real interest rates, and for the transmission of monetary policy into the real economy. Banks have a unique position in our economy and benefit from this unique position by being explicitly supported by our government. As such, regulation is fair and reasonable.

In our industry, we have strong relationships with banks as counterparties, prime brokers, custodians, etc. Faith and trust in their operations reduces the cost of doing business with them. Having regulated entities in formal relationships with our company helps reinforce trust in our business. We directly benefit from the fact that they are regulated.

On the other hand, I believe that direct regulation of private investment funds is unnecessary, and the cost of compliance prevents formation of new businesses and thus is a disservice for investors because it limits choices and perpetuates the growth of the largest funds (which are often the least able to profitably exploit investment opportunities). I believe that markets and counterparties should “regulate” our industry through ongoing market decisions.

Our industry is most beneficial when we are allowed to take risk with the least amount of non-investment-based cost (in terms of dollars and time). This risk-taking has a direct benefit to society. It is different from banking in that we are not quasi-governmental entities and do not have a backstop from the government.

People and businesses regulate their behavior every day by the choices they make in what they buy and sell, and with whom they do business. I think it best to remember that lack of political/governmental regulation does not mean that businesses do not have scrutiny and are not regulated by their customers and suppliers. Regulation should not replace trust, and in fact should not be allowed to encourage people to forget trust.

Pharmaceuticals: Denise Landry, Senior Vice President and Chief Quality Officer, Emergent BioSolutions

The pharmaceutical industry is defined by laws and regulations on all sides. FDA oversight means that a product must be proven to safely do what drug makers claim. Patent protection creates a system where a few big winners can let a company stay profitable and pay for years of new R&D. The overall intent is to protect patients while incentivizing companies to take on the expense and uncertainty of drug development.

Denise Landry, senior vice president and chief quality officer at Emergent BioSolutions, a global specialty pharmaceutical company, describes the importance of regulators in maintaining standards and keeping consumers safe—in effect, protecting against bad actors.

Manufacturers and regulators have the same interest, really, which is putting a safe and effective product on the market. I've been in the pharmaceutical industry for about 35 years. For our industry, regulation is useful and necessary to protect consumers and assure patient safety. In 1989, when we had the generic-drug scandal, we found that there were some not-so-ethical players in the industry. Regulation holds everyone to a non-negotiable standard. There's certainly an obligation on the manufacturer of a drug product or vaccine to make sure that they are following the regulations and meeting and, in many cases, exceeding the required standard.

I really never think of regulations as having a negative impact. As industry progresses, regulations follow shortly behind. I think that the FDA has, in the last few years, really made great strides to have a dialog with industry so that you spend time talking to them as you develop new drugs. They become more consultants in those early phases as opposed to just telling you it's right or wrong after you've gone down the development path.

This concept of “quality by design” has been used in a lot of other industries, most notably the automotive industry. Essentially, it's being very thoughtful about the process of developing a new product. By understanding not only the biological and chemical aspects of a new product, but also the infrastructure of how it's going to be manufactured, the outcome is improved.

The FDA has embraced this in new drug applications and processes. Those thoughtful conversations up front and then developing and designing experiments improve the drug development process.

Organics: Seth Goldman, President and TeaEO, Honest Tea

Food and beverage manufacturers can appeal to consumers with a range of regulated and unregulated language. “All natural” is a compelling but completely undefined term. “Organic” was similarly unregulated for years, but in 1990 the Organic Foods Production Act created the framework for a standards board and certification process that is overseen by the USDA.

Seth Goldman ’95, president and TeaEO of Honest Tea, began buying organic ingredients before the word had a legal definition. He says that that regulatory structure for organic foods is one that works.

When we started in 1998, there was no single defining standard about what an organic label meant. As a result, the term had no real meaning. So even though we were spending extra money to make our product with certified organic ingredients, we weren’t realizing any benefits in the marketplace (though it may have had a karmic reward, which is worth something).

But since 2002 when the federal government collaborated with organic farmers and organic activists to create a single definition, consumers know what the USDA organic seal means. They may not all think that it’s worth paying for, but because it’s meaningful to some, stores are more deliberate about the way they design their offerings, manufacturers seek out organic ingredients, and consequently, farmers make the decision to go through the three-year conversion from conventional to organic. That means organic tea-growing communities see less chemical pesticides, fungicides, and herbicides. So what started with a government standard ripples all the way to a tea bush in India.

One reason the organic seal is so effective is because it’s a positive incentive: there’s no government mandate. There’s government enforcement of the standard, but nobody’s telling anybody they have to buy organic or make a product organic; it’s an aspirational standard with its own reward in the marketplace. It’s a great example of how business can attain a positive standard without a mandate or a big bureaucracy. Manufacturers, retailers, and consumers have the choice to reward organics or not.