Thursday, September 21, 2006

Sarbanes-Oxley: What this is all about (and why you should care)

I dearly love stupid stuff, and stupid people. They are fun to write about. But my last several posts have been about serious, very boring stuff. In particular, the Sarbanes-Oxley Act and the increasingly bitter pissing match going on between London and New York over regulation, whose got the better market, etc. Today, in fact, after several weeks of teeing it up, the Financial Times issued its own editorial on the issue (“Regulatory creep from across the Atlantic: Sarbanes-Oxley’s writ is offensive and damaging to business”).

Hey, “regulatory creep from across the Atlantic”. Doesn’t that sound familiar? Why yes, I believe it does — in the article I mentioned yesterday. You know, the one masquerading as news rather than opinion? Well, they upgraded it today.

This all seems like a tempest in a teacup, except that it’s not. A tempest in a teacup is Hugo Chavez giving speeches at the UN. Please, he’s a little mouse running around saying the tiger is out to get him and that the rest of the “South” needs to line up behind him to fight off the nasty tiger. But the tiger doesn’t even know he exists, as evidenced by the fact he still exists. While the US does think Iran is a problem, running up and kissing Iran’s president doesn’t put you in his league. It just makes you look kinda gay — and in a creepy, rather than hip, sorta way. (Plus, Latin American pseudo-Marxist dictators are just so 1970s. I half expected to see Chavez wearing an open-collared brightly colored disco shirt and a Rerun hat while visiting Cuba. Oh, wait a minute—I did!)

Trillions of dollars, however, is hardly a tempest in a teacup. And, at the end of the day, that’s what all this Sarbanes-Oxley and London Stock Exchange stuff is about.

Professor Jeremy J. Siegel of the Wharton School of Business at the University of Pennsylvania had an article in today’s Wall Street Journal called “Gray World” in which he describes the impeding demographic changes that much of the developing world is about to experience, and the need to do something about it by finding a source of income for all these old fogies. His solution is to attract the capital of the developing world.

There is no easy way out of this crisis. To be sure, rising productivity brings higher income, but it also brings higher benefits, since benefits are based on income. Immigration of high-income workers would ease the situation, but the numbers would need to be prodigious to keep the retirement age from rising.

But there is a solution that can help aging economies. The developing world has a much younger age profile than the developed world. This difference in age establishes an opportunity to make a trade: Goods produced by the younger developing world can be exchanged for assets of the older developed world. This trade is not new. The transfer of goods for assets has taken place throughout history, first between family members (parents giving to children in exchange for old-age support), and then extending to clans, communities and, finally, whole nations. Soon it can be done on a worldwide basis. The developing world has the capability of simultaneously providing us with goods and acquiring our assets, filling the gap left by our aging workers.

I call this the "global solution to the age wave" and it relies on huge global capital flows to be effective. My studies show the inflow of goods and services produced abroad in exchange for capital can have dramatic effects, reducing the projected retirement age in the U.S. from the mid-70s to the upper 60s.

Why would the developing world wish to acquire our capital when their countries are expanding so rapidly? One of the first lessons one learns from studying international capital markets is that the best returns are rarely found in countries that are growing the fastest. Witness China's dismal returns despite being the fastest growing country in the last 20 years. Investors can often find better returns in slow-growing countries and industries.

To that end, U.S. capital markets have many attractive attributes. Our country is still viewed as the fountainhead of innovation, discovery, invention and entertainment, and our institutions of higher education are second to none. Our capital markets are deep, and easy to access, and willing to provide capital to those who wish to innovate. Equally important is that many U.S. brand names have great appeal world-wide so the growth of consumer markets abroad holds high promise for many U.S. firms.

For these capital movements to occur, we must be far more receptive to international capital. Although there has already been a large number of cross-country mergers, there has also been increasing opposition, witness Cnooc's bid for Unocal and the Dubai Ports fiasco. But if we rebuff goods or capital originating abroad, our growth will decline since we will be forced to rely only on our own dwindling supply of savings.

We cannot escape from our demographic realities. But we can take actions that will lead to a much brighter outcome. The integration of the world's economies and capital markets is the key to our future well-being. If we shun this path, our future will in no way be as bright as our past.

UCLA Law Professor Stephen Bainbridge writes about this article on his blog here, and uses it as a launching point to attack the Sarbanes-Oxley Act. His blog does a good job pointing out why this issue is so important. But he woefully misses the main point, juxtaposing Siegel’s concerns about the need to be more receptive to international capital, and’s blog about Sarbanes-Oxley pushing initial public offerings to London. The two might both be problems, but they aren’t logically linked.

The reason that they aren’t logically linked is that Sarbanes-Oxley isn’t an example of being unreceptive to international capital. You could argue that it’s unreceptive to capital formation (period), but it is not more harsh on foreign companies than on domestic. In fact, the SEC’s implementation rules for foreign issuers are considerably more lax than they are for domestic issuers. SOX may be a good thing or a bad thing, but it is a largely equal-opportunity thing.

Second, Bainbridge makes the rather surprising mistake of confusing raising capital with investing it. Siegel says we should be more accepting of foreigners who want to put money into our economy, because that will generate economic growth. But Bainbridge confuses this with foreign companies coming to the United States and asking Americans (among others) to invest in them. (That, after all, is what a company does with an IPO — it asks investors to give it money.)

But that isn’t to say that investing in foreign companies isn’t also a good thing (though Siegel, if you read closely, questions this at least for developing markets, since studies show that the companies in the fastest growing economies rarely post the best returns to investors). America’s baby boomers need to seek the highest return on their savings if they are going to have sufficient money to retire, and a portfolio with a high return is a diversified portfolio. Foreign stocks are a key component of a diversified portfolio, because foreign companies may do well when domestic companies do poorly (for a variety of reasons).

But this itself argues against Bainbridge’s position (and gets back to why this is all important). Sarbanes-Oxley has definitely raised the transaction costs of selling stock in the United States. But this isn’t about transaction costs. It’s not even about companies. It’s about investors. Smart investors don’t put their money into just any investment opportunity. And they don’t invest in just any market. Even if they don’t read all the financial literature their brokers send them, they have faith the market is transparent and the price-setting mechanism for company stocks is efficient. And, unless you believe in an absolutely strong version of the efficient market hypothesis (in which case all regulation is unnecessary), this efficiency depends on regulators with strong enforcement powers and regulations that require thorough disclosures of all material information about the company’s prospects. Otherwise, you might as well take your savings and go play the slots in Atlantic City.

The crucial question in all of this is whether the costs imposed by Sarbanes-Oxley — in particular, forcing companies to test their internal controls to make sure that their financial statements are accurate — are more than or less than the benefit investors derive from the additional faith in the market. Because if the benefit to investors is greater than the costs to issuers, issuers themselves will benefit by paying less for the capital they seek. Certainly, there will be some companies who will actually find that transparency raises their cost of capital. But do we really want our retirees investing in crooked companies? Who’s going to pay the bill on that when it comes due?

Finally, to take Professor Siegel’s point, nothing is more receptive to foreign capital than a market with integrity.

And that’s the reason all of this is so important.


Anonymous said...

You were right in your first paragraph. This subject is boring.

M.D. Fatwa said...

You are a meanie, Mary-N-Texas! If you're so smart, then why don't elect fewer dumbass politicians?!

Yeah! How do you like that? Teach you to mess with me...