An SEC blueprint for mutual recognition?

The Harvard International Law Journal recently published an article by two members of the SEC’s Office of International Affairs which proposes that the SEC should adopt a “substituted compliance” approach to foreign stock exchanges and broker-dealers. (See A Blueprint for Cross-Border Access to United States Investors: A New International Framework.) The authors outline an approach under which the SEC would evaluate a foreign jurisdiction’s securities regulations and enforcement history and, if the regulations and enforcement philosophies are similar enough to those in the United States that investors are properly protected, the SEC would allow stock exchanges and stock brokers from that country to operate in the U.S. without having to fully register (and be regulated by) the SEC. If this proposal were to be adopted, it would signify a major change in how U.S. capital markets are regulated.

Currently, stock exchanges and broker-dealers wishing to offer their services to investors in the United States must register with the SEC and be subject to SEC oversight. American investors, of course, can invest in foreign securities that are not registered with the SEC. But U.S. brokers can’t suggest these securities to American investors, and foreign brokers can’t volunteer their services. To invest in non-registered foreign securities, American investors must first research the foreign securities on their own, and either ask their own broker or a foreign broker to conduct the transaction for them. Usually, this entails having to pay brokerage fees twice — once to the U.S. broker and again to the foreign broker who actually executes the trade. U.S. investors seeking out foreign brokers on their own will often find the brokers reluctant to conduct anything more than the most basic transactions for fear of falling under the SEC's watchful gaze.

According to the article's authors, this traditional approach protects investors, but at a cost. Yet, because other jurisdictions have adopted higher investor protection standards and American investors have shown an increasing appetite for foreign investment opportunities, Tafara and Peterson question whether the cost is always worth the benefit. Instead, they suggest that a new approach by which the SEC would coordinate with "like-minded" foreign jurisdictions would reduce transaction costs for investors, lower unnecessary regulatory barriers for foreign broker-dealers and exchanges, and increase competition in the financial services market, all while preserving critical investor protections.

The Tafara/Peterson proposal comes with some strings attached. First, the foreign government would have to have similar laws and “enforcement philosophies” as in the United States. Obviously, it’s open to interpretation about what that means. Areas mentioned in the article include:

… a comparability assessment of financial and non-financial statement disclosure requirements, the robustness of the accounting standards required in the jurisdiction, the adequacy of local auditing standards, and auditor oversight controls. It would also entail a comparability analysis of other issuer requirements designed to ensure that issuer disclosures are accurate and complete. Such requirements might include a comparison of the jurisdiction’s corporate governance, internal controls, director independence, and shareholder protection laws and regulations.

The foreign government would also have to sign an agreement with the SEC allowing for the exchange of enforcement and inspections information. And, of course, there would have to be full reciprocity — U.S. brokers and exchanges would have to be given similar access to investors in the foreign country.

The SEC would not cede all power under this arrangement. Foreign exchanges and broker-dealers would still be subject to U.S. anti-fraud laws — in particular, Rule 10b-5. However, the article seems to imply that only the federal government would have the power to enforce these anti-fraud provisions. Shareholder lawsuits would be limited to those permitted under the foreign country’s rules. (Currently, U.S. shareholders have an implied right of action under Rule 10b-5 — see here.) In addition, the foreign exchanges and brokers would have to make certain basic disclosures to the SEC, and, before engaging in any business, would have to provide U.S. investors with a warning that informs them that U.S. laws won’t apply to their transactions.

The Harvard ILJ has also published a series of comments on the Tafara/Peterson Blueprint, from Ontario Securities Commission vice-chair Susan Wolburgh Jenah (Commentary on “A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework”), Citigroup general counsel Edward F. Greene (Beyond Borders: Time To Tear Down the Barriers to Global Investing), TIAA-CREF’s general counsel George W. Madison and associate general counsel Stewart P. Greene (TIAA-CREF Response to “A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework”), and Harvard Law Professor Howell E. Jackson (A System of Selective Substitute Compliance). Wolburgh Jenah, Citigroup's Greene, and Jackson support the proposal. Greene calls the proposal “long overdue...Investing in non-U.S. markets is no longer the exclusive province of megainstitutions or the ultrawealthy; it is an essential component of prudent portfolio diversification for all investors.” Jackson agrees, and adds, “By temperament, academics like to think of themselves as being well in the forefront of government bureaucrats. But here I find myself in the uncomfortable posture of having to play catch-up with senior SEC staff who have advanced a far more ambitious program than my own.” However, TIAA-CREF’s Madison and Greene warn that the proposal is dangerous, since the SEC may come under intense political pressure to recognize a foreign jurisdiction’s rules as substantially the same as those in the U.S. when, in fact, they are not.

Interestingly, Professor Jackson, who, otherwise strongly supports the proposal, agrees that this is the most significant risk:

...there are good reasons why federal agencies do not like to get in the business of picking favorites among foreign governments. While it is possible to develop short blacklists of off-shore havens that clearly have substandard controls over money laundering and tax reporting, it is a more difficult task to distinguish between major jurisdictions, some of which will be valued political allies, on the basis of whether their regulatory controls are acceptable substitutes for U.S. oversight. Official government distinctions of this sort tend to generate reactions from the State Department and one can imagine the complexities that will arise when the first Turkish broker-dealer seeks an exemptive ruling while renegotiation of military basing rights are pending elsewhere in the government.

TIAA-CREF also raise other (somewhat strange) objections:

A key assumption of this new framework is the need for retail investors to have greater access to foreign investment opportunities. In order to deliver this greater market access, Tafara and Peterson propose measures that would lower the barriers to entry for these investors. Yet it can be argued that the lowering of these barriers may not be entirely in the interest of retail investors since these barriers can serve to protect them. Retail investors currently face high barriers, such as having to use foreign broker affiliates and facing multiple layers of fees, that make direct investment abroad difficult, although not impossible. In dealing with these barriers, the retail investor is well aware that they are going into foreign markets and leaving behind the protection of the SEC regulatory framework.

I take it this means TIAA-CREF believes that it’s good that US investors have to pay a lot more to buy foreign securities, because that keeps them from doing something stupid with their money. I’m not sure that’s in the spirit of U.S. securities laws, but, hey, the TIAA-CREF folks are professional investors, not stupid money like you or me. (Though in the following few sentences, Madison and Greene acknowledge that TIAA-CREF itself doesn't face these higher transaction costs, since it has obtained exemptions that allow it to deal directly with foreign exchanges and brokers without the exchanges or brokers having to fear violating U.S. law.)

At the end of the day, it's not at all clear how widely supported these ideas are within the SEC. While it is true that SEC Chairman Christopher Cox (see speech here) and SEC Commissioners Paul Atkins (see here) and Roel Campos (see here) have all spoken in favor of various aspects of “substituted compliance,” its seems likely that such a radical departure from current SEC policy will be an uphill battle. Nonetheless, if this proposal does gain traction, one wonders what effect it may have on other markets. Does this increase, or decrease, the value of the NYSE-Euronext merger? Will it add pressure on the London Stock Exchange to merge with NASDAQ? And, perhaps more long-term, since the “substituted compliance” framework means the foreign jurisdiction must have a regulatory approach similar to that in the United States, does this mean that Sarbanes-Oxley will end up being a major U.S. export? Or, conversely, if the foreign rules must be similar (but not identical) to the U.S. approach, will this create future pressures on the SEC to scale back its regulation if U.S. investors seem to prefer a foreign approach?