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.