The UK FSA lapdogs

I know it's been a while since I bitched about the UK Financial Services Authority, but last Monday the Wall Street Journal (of all places!) published an article by Alistair MacDonald titled Assessing U.K. Watchdog -- FSA's Regulatory Model Gets Some Raves in U.S.; A Lapdog at Home? Of course, you have to have a subscription to the WSJ to read it -- a silly policy that's contributing to why Rupert Murdoch is going to buy out their asses and fire a quarter of the staff. Nonetheless, for a newspaper committed to a "principles-based" approach to financial regulation, I found the article both fun and interesting.

The WSJ article describes the FSA as a toothless "lapdog," barely regulating and never enforcing even the rules it has. (You can really get the British goat by calling something a "lapdog" these days. Ah, the effects of Murdoch already...) The WSJ draws on some recent research by Howell Jackson, a Harvard Law School professor currently studying how different countries regulate their securities markets. (One of Jackson's recent preliminary papers on this topic can be read here.) Jackson's research, along with a recent paper by Columbia Law School professor John Coffee (which can be read here), show that the degree of enforcement of securities regulations in the United States is qualitatively different from other countries. When compared to the UK FSA, this is particularly apparent. The US spends considerably more on securities regulation than does the UK, even when accounting for market and economic size. But the area that really stands out is enforcement. Between 2002 and 2004, on average, the US Securities and Exchange Commission took 639 enforcement actions, and levied $2.1 billion in fines. By contrast, the UK FSA took 72 enforcement actions per year, and on average levied $27 million in fines.

And this actually understates the differences, since the FSA combines within it many of the regulatory functions that in the US are divided among the SEC, the self-regulatory organizations (such as the National Association of Securities Dealers), and some state regulators. When all of those are added together, the US brought 2,985 enforcement cases and levied $5.3 billion in fines. Even this, however, understates enforcement activity in the US since, as Coffee shows, US private enforcement activity (i.e., securities class action suits) levies the equivalent of another $2 - $9.7 billion per year.

What this all means is that if you misbehave in the United States, you can expect to be slapped with a market-adjusted fine that is 10 times greater than similar activity might fetch you in the UK. And that's not counting the private lawsuits, which are very rare in the UK. Or the criminal penalties. Did I mention the criminal penalties? Oh, yeah -- Coffee notes that between 1978 and 2004, joint SEC-Department of Justice investigations led to criminal indictments of 755 individuals and 40 companies for various kinds of severe market shenanigans. The indictments led to 1230.7 years of incarceration (or 4.2 years in the hoosegow on average). In the UK, criminal indictments for securities law violations are very rare, and convictions as rare as hens' teeth.

Your chances of getting busted in the US are also much higher, not least because the US devotes considerably more resources towards investigating infractions. Coffee notes that 40 percent of the SEC staff are part of the Division of Enforcement, while only 12 percent of the UK FSA is in enforcement -- and this group splits it time between policing the securities, insurance and banking sectors.

None of this necessarily means anything, of course. It's possible that the US devotes so much of its regulatory resources to enforcement because its market is plagued by crooks. It's also possible that you can over-enforce -- an argument that Coffee also makes, particularly with regard to private lawsuits. In other words, a scourge of scorpions may not be the best thing for market efficiency. However, another recent study -- this by the team of Craig Doidge, George Karolyi, and René Stulz argues that the stronger investor protections and enforcement system in the US provides a markedly lower cost of capital for foreign issuers listing on a US exchange. (See "Has New York Become Less Competitive in Global Markets? Evaluating Foreign Listing Choices over Time" (July 2007)). Doidge, Karolyi and Stulz also show that this US listing premium has not diminished since passage of the Sarbanes-Oxley Act. So take that, all you SOX haters out there. Yeah, I'm talking about you, Bainbridge. You too, Ribstein.

And while I'm at it, you too, Paulson Committee and Chuck Schumer and Michael Bloomberg. One of the interesting points in the Doidge, Karolyi and Stulz paper is that, when you look at the types of foreign companies that have listed with NASDAQ and the New York Stock Exchange in the past, there hasn't actually been a drop-off in IPOs in New York since passage of SOX, contrary to what the Paulson Committee and others claim. Doidge, et al. analyze the types of companies that traditionally have listed in New York in the past and find that these tend to be larger companies with a history of cash flow and high Tobin's q ratios. By contrast, many of the IPOs over the past several years have been smaller companies, with no cash flow, and low Tobin's q ratios. Indeed, these types of companies have become the bread-and-butter of London's Alternative Investment Market (AIM). (I'm not saying these companies suck, but can you say "Russian corporate governance"? I mean, without snickering, ducking, or hiring a food-taster.) In other words, most of the issuers "not going to New York" these days wouldn't have gone to New York even before SOX. Most likely, they would have just borrowed from a bank or had to recapitalize earnings.

None of this is much comfort to the NYSE or NASDAQ. Even if these issuers would never have gone got New York to begin with, slumming is big bucks these days and high US standards and a toothy watchdog preclude them from competing with AIM in attracting mobbed-up Russian issuers and risk-tolerant suckers investors. But, in my opinion, US regulators shouldn't be in the business of improving the NYSE's bottom line. They should be in the business of providing US companies with the lowest cost of capital. That's a key difference between the US and UK market.

"Paulson" Committee on Capital Markets Regulation Report (Part 3)

Last week the Committee on Capital Markets (also known as the "Paulson Committee") released its Interim Report. As I noted earlier this week (See "Paulson" Committee on Capital Markets Report and 'elegant whining'" and "Committee on Capital Markets Regulation Report (Part 2)"), this is a long report, so I've broken my review up into three parts. This is the third part, reviewing the CCMR's sections on Shareholder Rights and Sarbanes-Oxley Section 404

Shareholder Rights

If you've read anyone commenting on the CCMR's report and this person was universally critical of the report, it's a pretty sure sign that they haven't actually read it. (See, for example, New York governor-elect Eliot Spitzer's comments that, "This is the same old tired response from the defenders of the status quo who time and again jump to eviscerate the prosecutorial power of the only office who did anything in the past decade.") They particularly haven't read the section on shareholder rights, written principally by Harvard Law professor Allen Ferrell. (Ferrell is one of those increasingly common law professors with a Ph.D. in Economics.)

Ferrell's section has two targets -- "staggered" (or "classified") boards of directors, and "poison pill" anti-takeover defenses. Both phenomenon are actually devices to prevent "hostile" takeovers of corporations. Any corporate merger or takeover, of course, involves one company purchasing from another company's shareholders their ownership in the target company. A "hostile" takeover occurs when the purchasing company goes directly to the target company's shareholders and offers them money for their shares, without the express approval of the target company's board of directors or managers.

What's wrong with that, you ask? After all, if you own shares of a company and somebody comes along and offers you a lot of money for them (more than you think they are worth), why shouldn't you sell? Well, because then the company's managers and board of directors might lose their jobs, that why! And something had to be done about that! Remember all those '80s and early '90s movies about "corporate raiders" and the like -- you know, "Other People's Money," "Wall Street," "Barbarians at the Gate" and even "Pretty Woman"? You know why you don't see that plot device anymore? It's because hostile takeovers rarely happen anymore, mostly because of the adoption of staggered boards of directors, poison pills and similar anti-takeover devices.

Staggered boards of directors are corporate boards with member terms set like the U.S. Senate -- only a portion of which are up for election at any given time. This means that any group taking control of a majority of voting shares of a company still can't control the company's board. Even if all of the company's shareholders became so fed-up with the company's performance that they wanted to install a new board, it would not be possible for several years. (In reality, in the United States it would not be possible at all, since the board controls the board nominating process and board elections are like old Soviet elections -- you can vote for the candidate or you can abstain from voting, but you can't vote for a competing candidate.)

A "poison pill" is a resolution of the board that gives company shareholders (but not the purchasing company) the right to purchase additional shares of the company at a price substantially below market prices. In other words, if an acquiring company buys 10% of the target company's shares, and the board adopts a poison pill defense, the target company suddenly issues thousands or millions of new shares to existing shareholders, at pennies on the dollar, effectively diluting the purchasing company's ownership. Theoretically, a target company's board could do this infinitely many times, effectively making the price of the acquisition infinitely high.

Ferrell cites numerous academic studies that demonstrate that share prices drop when state laws permit either staggered boards or poison pill defenses, and that the use of poison pills is correlated with poor corporate performance. In other words, while anti-takeover devices are typically sold to the public as a way to "protect jobs," the evidence is clear that the jobs these devices are designed to protect are those of poorly performing CEOs and board members. Ferrell even shows that staggered boards of directors are correlated with high CEO pay that isn't linked to company performance. (Incoming House Financial Services Committee Chairman Barney Frank might wish to keep that in mind when he holds his promised hearings on soaring executive pay, particularly since his state of Massachusetts actually makes staggered boards of directors mandatory.)

As a response to these problems, the CCMR recommends that Delaware, or the stock exchanges, develop standards prohibiting companies that have staggered boards of directors from adopting poison pills without first getting shareholder approval, unless the company is the target of a takeover. If the company is a takeover target, the board could adopt a poison pill, but must get shareholder approval for the pill within three months. That would allow the board to make its case for why the takeover is not in the best interests of the shareholders, while also not making the takeover impossible should the shareholders disagree. (CCMR recognizes that the SEC probably does not have the power to make this a requirement itself. What is strange, though, is that no one ever seems to imagine taking all of this authority away from Delaware and actually having Congress pass a national corporations law, applicable for any company doing business across state lines.)

The CCMR also has a number of other recommendations to improve shareholder rights, most of which are good ideas. It recommends that the SEC resolve the issue of whether shareholders should have the right to put election-related materials on an issuer's proxy ballot -- something that the SEC is likely to consider this January in response to the 2nd Circuit's AFSCME v. AIG decision.

One recommendation I'm not sure I agree with, however, is CCMR's proposal that corporations should be able to adopt provisions that mandate that shareholders must settle disputes with the company through arbitration rather than through the courts (and, in particular, through class action lawsuits). As I mentioned in my review of the CCMR Report's Enforcement Section, I think it is clear that shareholder class action lawsuits are not necessarily a good thing. I also believe that, for the CCMR's proposals on limiting class action lawsuits to work, shareholders must have greater abilities to remove poorly performing boards of directors. However, mandatory arbitration clauses likely will go too far and return power to corporate boards and managers at a time when power should be shifting to shareholders. Without the disciplining effect of a real lawsuit (and not a slap-on-the-wrist arbitration board), it is hard for me to imagine that board member fiduciary duties won't suffer.

Sarbanes-Oxley Section 404

The last section of the CCMR Report deals with Section 404 of the Sarbanes-Oxley Act, and it is not so much bad as it is unnecessary. (This part of the CCMR Report was written mostly by Andrew Kuritzkes, a managing director of Mercer Oliver Wyman, a management consulting firm.)

The much-reviled Sarbanes-Oxley Act has quite a few provisions, but the one that most companies find really unpalatable is Section 404. Section 404 states that a company's management must give a report about the company's internal controls (the controls designed to track how and by whom money is spent), and that the company's independent auditor has to give an opinion about this report. Despite what Kuritzkes writes, mandating that issuers have internal controls is not new, but is actually a requirement of the Foreign Corrupt Practices Act of 1977. Independent auditors were always supposed to test these internal controls -- it's just that, prior to Sarbanes-Oxley, this testing was largely perfunctory. However, now, following what happened to Arthur Andersen and with the Public Company Accounting Oversight Board's Audit Standard 2 (AS2), this testing has become extremely thorough. And costly.

Kuritzkes notes that there likely are some efficiency benefits to Section 404, in terms of improved corporate management. In a prior life, I was involved in "strategic sourcing" and supply chain management at a management consulting firm, and I can attest that profitable, well-run companies know how they spend their money; and companies that don't know how they spend their money are rarely profitable or well-run. In this sense, Section 404 could be seen as a government-mandated management consulting exercise of the type that companies regularly spend millions of dollars on without complaint -- only, now that it's mandatory, there's a lot of complaining. That said, if this is the principal benefit to Section 404, it's hard to see that it should be government's business to require it. Section 404 stands or falls on whether the direct benefits to investors in aggregate outweigh the costs.

By now, it is not entirely clear that Section 404, as it is now implemented by AS2, is cost-effective. But that is what makes this part of the CCMR Report largely unnecessary. The SEC has already agreed to offer "management guidance" on Section 404 implementation, effectively forcing the PCAOB to revise AS2 (through a new AS5) in a way that should dramatically reduce audit costs. In other words, on Section 404, the CCMR is largely preaching to the choir, using the same sermon some other preacher gave last Sunday.

The only interesting point Kuritzkes makes on Section 404 is that the planned reforms should not include a blanket exemption for small and medium enterprises. He notes that, while SOX compliance costs for firms with less than $700 million in market capitalization are more than five times greater on a relative basis than for issuers with more than $700 million in market cap, these smaller firms historically have also posed a much greater risk of having to restate their financial statements because of poor internal controls. Exempting these issuers from Section 404 would be exempting precisely those firms most likely to present a risk to investors. While Section 404 compliance cost might force some of these small issuers away from the U.S. equity markets, exempting them likely will raise their cost of capital anyway as investors grow wary of all small issuers. Consequently, the CCMR recommends that small firms be subject to the same Section 404 requirements as large firms, or that Congress should redesign Section 404 as it applies to small companies. (Without Congress weighing in on this matter, the CCMR believes audit firms will bear unacceptable liability should the SEC exempt small firms from the audit-testing requirements of AS2 and a problem with internal controls later arise.)

Conclusions

In short, my review of the Committee on Capital Markets Regulation Interim Report can best be summarized as:

Section 1 on Competitiveness: Really Sucks. It's clear that capital markets are important for the U.S. economy, but Luigi Zingales is entirely unconvincing that U.S. competitiveness is suffering as a result of U.S. securities regulation, or that this competitiveness is reflected by whether foreign issuers want to list in New York.

Section 2 on Regulatory Process: Mostly Sucks. Robert Glauber's attempt to paint the UK's "principles-based" regulatory approach as a panacea to any U.S. competitiveness issues is unworkable and just generally a bad idea. It would undermine investor confidence in a market where investors are everyone and where investors matter most. It won't work in the U.S. -- and, for that matter, it probably won't work in the UK long-term, either.

Section 3 on Enforcement: Some Very Good Ideas. The "public" enforcement system (the SEC, Justice Department and exchanges) needs to remain strong and threatening to deter market fraud. However, the threat posed by shareholder class action lawsuits is so great and so universal that it has lost its deterrence value and is now just a cost on shareholders everywhere. Clarifying certain aspects of rule 10b-5 is a good idea, and practices such as "pay-to-play" where lawyers essentially bribe local officials to represent local pension funds in class action lawsuits should be banned. Likewise, the Justice Department's "Thompson Memo" should be revised so it stops serving to blackmail companies into waiving attorney-client privilege or paying for lawyers for their employees.

Section 4 on Shareholder Rights: Some Really Good Ideas. Staggered boards of directors and poison pills should stop, particularly is, as above, shareholder class action lawsuits are restricted. The only thing I would say about this part is that it doesn't go far enough: other corporate anti-takeover tactics should also be prohibited. But I guess you have to start somewhere.

Section 5 on Sarbanes-Oxley 404: Mostly Moot Points. But a good point that smaller firms should not be exempt from a revised, more cost-effective Section 404.

Committee on Capital Markets Regulation Report (Part 2)

Last week the Committee on Capital Markets (also known as the "Paulson Committee") released its Interim Report. It's a big report, so rather than bore you with a single enormously long blog, I thought I'd bore you with two long blogs. The CCMR report is divided into five parts: Competitiveness, Reform of the Regulatory Process, Enforcement, Shareholder Rights, and Sarbanes-Oxley Section 404. Yesterday I wrote about the first two sections of the report, what I liked and, more often, what I thought was dumb. (See "Paulson" Committee on Capital Markets Report and "elegant whining").

Today I'm going to write about the section on enforcement.

Enforcement

Unlike the first two sections of the CCMR report (by Luigi Zingales and Robert Glauber, respectively), the third section, by Harvard's Robert Litan, is good. Actually, I think it's the best part of the report, and, with a few exceptions, I agree with its proposals.

Litan begins by noting how strong (one might even say Draconian) the U.S. securities law enforcement regime is when compared to most other countries. Unlike the first two sections of the CCMR report, which go out of their way to praise the United Kingdom's approach to financial regulation even when such praise is clearly unwarranted (you really want to have the SEC's budget and commissioners appointed by the industry it regulates, Prof. Zingales??), Litan actually puts the UK's enforcement approach in context: in 2004, civil penalties for securities law violations in the United States amounted to $4.74 billion. In the UK, penalties for all financial sectors (securities, banking and insurance) amounted to $40.48 million. Or think of it this way -- during the late 1990s, Jack Grubman, the now-disgraced stock market analyst, was pulling in $100 million in salary and bonuses. That's a single Wall Street individual. Put in this context, $40.48 million is about the same as a large firm's client lunch budget. In other words, a cost of doing business, not a deterrent against fraud.

The problem, though, isn't that $4.74 billion is excessive. The CCMR report, wisely, points out that tough enforcement is essential for a strong securities market, since it deters wrongdoing and reassures investors that their money won't be stolen. The problem is that this $4.74 billion in civil penalties -- penalties extracted by the Securities and Exchange Commission (41%), Justice Department (14%), state agencies (21%) and the self-regulatory organizations (24%) -- are only part of the total penalties imposed on wayward companies and individuals. In 2004, another $5.5 billion were paid out by companies as part of class action lawsuit settlements. And 19-35% of this $5.5 billion did not go to defrauded shareholders, but to plaintiffs attorneys.

Litan also notes that in 2004 fully 47.9% of all pending class actions were securities cases. The vast majority of these, of course, settle out of court once the class is established. But this itself is a problem: the money for such settlements comes from the companies' profits. In other words, shareholders who bought or sold shares during the period that the class action suit covers (usually about a year) are paid from money that would otherwise go to the company's existing shareholders, who did nothing wrong and may have been defrauded themselves. Since corporate directors and officers (i.e., the people usually responsible for any accounting or disclosure mischief that led to investor losses) are insured (with the insurance premiums paid by the company), very little of this settlement money ever comes from those who actually caused the problem. Litan notes that one 1995 study found that even when directors and officers are named as defendants, settlements were funded 68.2% by liability insurance and 31.4% by the company itself, with only 0.4% actually coming out of the pockets of managers and directors. Of course, the Enron and Worldcom settlements were different (with $25 million of the $6.1 billion Worldcom settlement paid by outside directors), but these are exceptions to the rule.

Making matters worse, securities class action lawsuits seem to be very poor mechanisms for compensating shareholders for their losses. Research cited by Litan suggests that the average securities class action suit settles for between two and three percent of investors' economic losses. When you take out lawyers' fees, even this shrinks. Add to this that the average retail shareholder is a "buy and hold" type (and therefore less likely to qualify as a member of the class) and what you have is a system that costs companies and shareholders lots of money while providing rather little bang for the buck in terms of deterring managerial wrongdoing.

The CCMR accordingly makes several recommendations. First, it suggests that the SEC should "provide more guidance" regarding Rule 10b-5 liability. In particular, the SEC should lay down guidelines about what types of disclosure misstatements are "material," clarify that plaintiffs need to establish a strong inference of fraudulent intent on the part of the defendant (and not a lower scienter standard such as "deliberate recklessness," whatever that means), and clarify under which conditions shareholders need to demonstrate that they actually relied on the false or misleading statement when they bought or sold shares.

Frankly, I'm not convinced that the SEC has the authority to "clarify" all of these matters on its own, even if they are good ideas. In some cases, divisions between the appellate courts will only be settled by Congress or the Supreme Court. However, other CCMR recommendations seem more promising. In particular, the CCMR recommends that the SEC prohibit shareholder lawsuits from seeking to recover damages from an issuer if the SEC itself has already done so through Section 308 of the Sarbanes-Oxley Act (the so-called "Fair Funds" provision that establishes a compensation fund for investors). This is logical -- there shouldn't be any "double dipping" or recovery preferences given to one set of defrauded shareholders over another. Likewise, the CCMR recommends that the Labor Department prohibit "Pay to Play" practices whereby lawyers give campaign contributions to local government officials in exchange for becoming the lead plaintiff's attorney when a state or local government pension fund is involved in a class action lawsuit. This is graft, pure and simple, and should be illegal.

However, two CCMR recommendations seem problematic. The first is just pointless. Litan recommends that the Justice Department only bring criminal charges against corporations in extreme circumstances. Arthur Andersen notwithstanding, I never got the impression that corporations were charged as criminal enterprises except in extreme circumstances. CCMR uses the Arthur Andersen case to show the dangers and injustices that can result when a large firm is charged as a criminal enterprise (even though Andersen was a repeat offender). But precisely because of this, I think a strong argument can be made that, particularly with audit firms, the U.S. government is so concerned about the ramifications of bringing criminal charges that it has stayed its hand even when, by all rights, it should not have. I'm thinking in this case of the KPMG tax evasion scandal, which likely would have resulted in a criminal charge against the firm except for the fact that the audit industry is so concentrated. In other words, with some firms, not only are they "too big to fail," but they are too important to be charged with a crime. That can't be a good thing.

For this same reason, I think the CCMR's arguments for limiting auditor liability are also misplaced. Certainly a class action lawsuit that brings down one of the Big Four accounting firms would be catastrophic. However, capping auditor liability would be begging for a moral hazard problem. And the last time the government constructed that kind of moral hazard, we had the S&L crisis.

That said, Litan's point are well taken about the Justice Department's "Thompson Memo" guidelines for when criminal charges should be considered against a corporate entity. DOJ has used the threat of criminal charges as a weapon to force companies to waive attorney-client privilege and deny employees, officers and directors attorneys' fees. This is blackmail aimed at depriving corporations and individuals of their rights, and just isn't right.

Later this week: Shareholder rights and SOX Section 404!

"Paulson" Committee on Capital Markets Report and "elegant whining"

While flying into snow storms this past weekend, I managed to slog through the Interim Report of the Committee on Capital Markets Regulation. I say "slog" not so much because the report is poorly written as that it's long and I have a short attention span. MTV generation and all that. Even the Executive Summary was long. (Though, to be honest, I haven't yet read the Executive Summary. I thought it most fair to start with the actual report, since most of the reporters and commenters and assorted pundits will probably only read the summary, so you got all that already.)

First thing I want to react to is the news. To start, Carrie Johnson of the Washington Post notes in "Report on Corporate Rules is Assailed" that:

Investor groups sounded alarms yesterday after it emerged that a foundation with ties to a pair of well-heeled business donors and an executive battling civil charges had funded a controversial new report seeking to slash corporate regulation.
...
The charity has longstanding ties to Maurice R. "Hank" Greenberg, the former American International Group chief who was ousted from his post last year and is contesting civil charges filed by the New York attorney general. ... Two committee members, Wilbur L. Ross Jr., a private investor, and Citadel Investment Group manager Kenneth C. Griffin, contributed "a few hundred thousand dollars" more, Ross said in an interview.

I find this appalling. Not that certain "interested parties" funded the CCMR report. Of course they did! Where did you think the money was coming from, the research foundation fairies? What I find appalling is that certain opponents of these proposals have become so embedded in the Washington way that their first reaction to anything is the classic Washington ad hominem attack. Who cares what the report says or the strengths or weaknesses of its arguments? Look who's funding the thing! My God, don't you realize they would benefit from these ideas??

Idiots. These so-called investor groups should be ashamed. Or, rather, the Washington Post should be, since Johnson's article is rather sparse on who is actually saying that the CCMR report is corrupted by Hank Greenberg, et al., and I'm less inclined to give reporters the benefit of the doubt than I am pretty much anyone else. And, let's face it, scandal sells copy and it's much easier to explain to a general audience that a report on a dense, complicated topic such as finance is "tainted by special interest" than it is to say why its proposals are dumb.

That said, my own views of the CCMR Report are best reflected by a quote from former SEC chairman Richard Breeden (a Republican who ran the agency during the Bush I administration): "It is a bunch of warmed-over, impractical ideas, many of which have been kicking around for a long time... It is very elegant whining." (See Jenny Anderson's "Sharply Divided Reactions to Report on U.S. Markets" in the NYT.)

By the way, in case you want to see what inelegant whining looks like, look no further than the comments Eliot Spitzer gave about the report: "I will personally appear on Capitol Hill and appear with tens of thousands of investors to defend against these wayward and wrong-headed proposals... This is the same old tired response from the defenders of the status quo who time and again jump to eviscerate the prosecutorial power of the only office who did anything in the past decade."

It's clear, of course, that Spitzer hasn't actually read the report. All I can say is, thank God he's now more New York's problem than the nation's problem. You guys deserve him.

But enough with the pundits who aren't me. What have I got? I'm glad you asked!

The report is divided into five sections, that basically read like five separate papers: (1) Competitiveness, (2) Regulatory Process, (3) Enforcement, (4) Shareholder Rights, and (5) Sarbanes-Oxley Section 404. The primary authors are Luigi Zingales, a professor at the University of Chicago Graduate School of Business; Bob Glauber, former head of the National Association of Securities Dealers and currently a visiting professor at Harvard Law School; Robert Litan, a senior fellow at the Brookings Institution; Allen Ferrell, another professor at Harvard Law; and Andrew Kuritzkes, a managing director of Mercer Oliver Wyman, a management consulting firm.

Each of these sections has an associated "task force" that, presumably, provided input. As an aside, I make one observation: if you recall back in September when the Committee was formed (which I wrote about here), Harvard Law professor Hal Scott, director of the Committee, stated:

We generally tried not to include regulators...They may have a lack of objectivity. Anybody on this committee is in the real world and will bring with them real-world perspectives.

By looking at the task force members, we now know that apparently only American regulators "lack objectivity" and "real-world perspectives". One of the two members of the CCMR's task force on competitiveness is Sir Howard Davies, former head of the UK Financial Services Authority. So British regulator input is good. American regulatory input bad. Since the British financial industry allegedly benefits from the U.S. not being competitive, I wonder what the CCMR folks were thinking here?

Competitiveness

Anyway, as I said, the first section of the Report is called "Competitiveness" and is designed to show that (1) the competitiveness of the U.S. financial industry is important to the U.S. economy, and (2) this competitiveness is suffering. For the first point, Zingales does a decent job. But, of course, it's also an easy job. As for the second, I have some serious questions.

First, minor point. Zingales says:

If one examines recent data on growth in the most advanced economies, one sees that countries with a bigger stock market (like the United States and the United Kingdom) enjoyed a much better record of economic growth than other similarldevelopeded European economies (such as Germany, France and Italy) with less developed stock markets (Carlin and Mayer, 2000).

While I clearly think having a strong capital market is a good thing for your economy, this statement begs two questions: causation (does economic growth cause strong capital markets or vice versa), and why are you focusing on European economies when the second largest capital market is in Japan, not Europe?

Second minor point: as evidence of the importance of U.S. capital markets, and their decline, Zingales discusses the role venture capitalists play and how important IPO exits are to VCs.

Not only are IPO exists much more profitable than exists in the private market, but they also affect the profitability of acquisitions exits. The value of VC acquisitions exits is correlated with the number of IPO exits: when there is a "hot IPO window," the average value of acquisition exits increases. For example, in 1999, there were 304 disclosed VC backed acquisition exits, with a disclosed average valuation of $142 million; in 2004, there were 413 with an average valuation of $57 million. The failure of the U.S. "IPO window" to reopen after 2001 has caused considerable anxiety among American VCs.

This may be true, but isn't this just a bit like saying that venture capitalists make more money during market bubbles, when "dumb money" is plentiful and retail investors are willing to invest in any Internet dog-walking dot.bomb that comes their way? How does this add to the economy, rather than just shuffle the money around? And what the hell is a University of Chicago business professor doing suggesting that there is a valuation difference between public and private investors? Isn't that perilously close to suggesting that markets aren't efficient? Can't you get your tenure revoked for such heresy?

However, these two points are nothing compared to my major complaint. That is, after a lengthy discussion about why capital markets are important to the U.S. economy, Zingales begins his principal argument (Section II: The U.S. Public Equity Market is Losing Competitiveness to Foreign and Private Markets) with this statement:

A leading indicator of the competitiveness of U.S. public equity markets is the ability of the U.S. market to attract listings of foreign companies engaging in initial public offerings—so-called global IPOs.

Why? How come? Luigi, where's your support for this statement? Because pretty much everything else in this section of the CCMR Report is predicated on this statement, and, to me at least, this is not obvious.

Other questionable points: why do most of the data the Report uses start with 1999, at the height of the last market bubble? If Al Greenspan was right, and the market was experiencing "irrational exuberance" (which is clearly true in hindsight), isn't establishing your baseline at that point a little like an electric utility predicting annual air conditioning usage based on what people were using on the hottest day of the year? In other words, if 1999 involved an overheated U.S. market, wasn't the explosion of IPOs (and foreign IPOs) a result of a bubble rather than a "competitive" U.S. market? After all, it's not hard to attract issuers (foreign or domestic) if money is free. Competitiveness has nothing to do with it.

I've got other gripes, too. Namely:

Figure I.9 -- doesn't that demonstrate that Asia is "catching up," rather than that Europe is? After all, Europe's portion of global advisory and underwriting fees seem pretty steady since 1999, whereas Asia's has increased by nearly 90 percent. Indeed, relatively speaking, the greatest increase in Europe's portion of these fees happened between 1998 and 1999 -- way before Sarbanes-Oxley.

Table I.2 and Figure I.19 -- Zingales says that the U.S. listing premium nearly halves between 1997-2001 and 2003-2005, at a .10 confidence level. I don't know much about statistics, but isn't .10 just borderline for research purposes? Also, doesn't Figure I.19 merely demonstrate that the lower the quality of corporate governance standards in the foreign market, the greater the variance in listing premia? Am I missing something here? It doesn't seem to say anything about decline at all, does it?

Higher listing costs and underwriting fees in NY -- Nice try, but it seems that Zingales' dismissal of the effects listing costs and underwriting fees might have on foreign listings only holds true if all else is held equal. If, as Zingales elsewhere suggests, the listing premium in NY has decreased, higher listing costs and underwriting fees should increasingly influence a foreign company's decision on where to list.

Regulatory Reform

My biggest gripe about this section, written by Bob Glauber, is that wherever Glauber says "other markets," "other countries," or "other financial regulators," the single example he gives is the United Kingdom and the UK Financial Services Authority. (The rest of the Report does this as well. Zingales, in fact, approvingly cites the fact that the UK FSA is governed by a board made up of representatives from the very industry it regulates. Yeah, good luck with that idea. No wonder Paulson has been distancing himself from the CCMR since his November 20 speech -- see here.)

The UK FSA is five years old, for all intents and purposes (seven if you count when the lease was signed). It has no enforcement teeth, and basically follows a risk-based, principles-based approach because it has neither the staff nor the expertise to do anything else. It has been very lucky that in its five years of existence it hasn't run into any major meltdowns, and its one big scandal (Royal Dutch Shell) was policed mostly by the U.S. SEC. It was only 23 months ago that the Economist said the FSA had problematic procedures and an incompetent staff (see "Regulator, heal thyself"). Accordingly, holding it up as an unqualified success story that should be emulated in the United States seems a bit premature.

Glauber's other proposals are equally half-baked. Glauber suggests that the SEC should conduct more in-depth cost-benefit analyses before creating new regulations (and that these analyses should not increase the amount of time the SEC takes in developing these regulations). Certainly, the idea that regulation should provide more benefits than costs is a good one. But the SEC already has an Office of the Chief Economist charged with conducting cost-benefit analyses of proposed regulations. The fact that the SEC did not adequately follow its own rules in this regard is what lead a U.S. appellate court to twice overturn the SEC's proposed regulations requiring mutual funds to have independent chairmen (see Chamber of Commerce v. SEC). Furthermore, as Glauber himself notes, many U.S. securities laws (such as the Sarbanes-Oxley Act) require the SEC to impose regulations regardless of whether the costs outweigh the benefits, and in the vast majority of cases, the costs and benefits of a proposed regulation are impossible to quantify beforehand with any degree of confidence. Why then the insistence on new cost-benefit requirements? Does anyone seriously think the SEC staff sets out to create rules that impose greater costs than benefits? Why would someone do that, unless the benefits went to some preferred group while the costs were borne by someone they didn't care about?

Enough has already been said about Glauber's proposals about creating more principles-based regulation, so I won't say much more. But I will say one thing. You want to see the perfect example of a principles-based rule? Try Rule 10b-5:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, a. To employ any device, scheme, or artifice to defraud, b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

In legal parlance, this is about as principles-based as the Seventh/Eighth Commandment (depending on how you count these things): Thou shalt not steal. Why then does everyone hate it? They hate it so much that one of the CCMR's recommendations is to "resolve existing uncertainties" about 10b-5 liability and provide more "guidance" on, for example, when shareholders have to demonstrate that they relied on the misstatements or omissions of an issuer in order to sue the issuer under 10b-5.

The answer, of course, is simple: principles are broadly written, and different courts might apply them in different ways. Principles are great when they cut your way, but they suck when they don't. So, the CCMR's elegant whining really is about passing new, more lax rules, that issuers can interpret their way, but that courts can't. Frankly, I just don't see that happening.

Glauber does have one very good point, though, and if the CCMR has legs on anything, it should be this: securities regulation should be made through the procedures established by the Administrative Procedures Act, and not through enforcement actions. Over the past few years, there have been too many cases of "settlements" with companies that have involved them agreeing to do or not do something and because these companies form the bulk of the industry, these settlements have the effect of regulation. But they do not have the public comment and input required of regulation in the United States. This should change. This tendency has been particularly egregious where states attorneys general (particularly Eliot Spitzer) have been involved. Securities regulation in the United States should be set at the federal level, through transparent procedures, and not at the state level through the threat of criminal or civil enforcement proceedings. While there may be a case made for competing enforcers on the U.S. market (the SEC, Justice Department, state attorneys general, private class action lawsuits), the end result is a mess, inefficient, and profoundly undemocratic.

I will complain about the remainder of the CCMR Report in a second post.

Committee on Capital Markets Regulation issues long-ballyhooed report

I've been busy this week and haven't had a chance to read over the "Paulson Committee" report released today, but for those of you looking for the report and willing to form your own opinions, here it is.

My previous blatherings on this committee (before it released today's report) are:

"Paulson Committee" may soon take on the trial lawyers by proposing limit on shareholder lawsuits

Bloomberg says Paulson in drive to reform U.S. financial Regulations

The future of world capital markets (Part 1): The Committee on Capital Markets Regulation