Capital Punishment

Like taxes, economic regulations are burdens; and also like taxes, once regulatory burdens become heavy enough, they will drive business to jurisdictions where it can be transacted more cheaply and efficiently. And since money moves so easily across national boundaries, trends in the financial markets will signal when the U.S has passed the regulatory tipping point.

Headshot of Resident Fellow Peter J. Wallison
Resident Fellow Peter J. Wallison
Consider these signals, which have been reported often enough: Between 1996 and 2001, the New York Stock Exchange averaged 50 new non-U.S. listings annually; in 2005, it was 19. In the same year, the London Stock Exchange, including its small company affiliate, the Alternative Investment Market, gained 139 new listings while Nasdaq attracted 19. Since the end of 2004, 30 foreign companies have left the NYSE and Nasdaq.

Financial capital--the kind that finances mergers, acquisitions and new business formation--is also increasingly finding a more comfortable home abroad. Large offerings by Chinese, Korean and Russian companies--involving billions of dollars--have occurred in Hong Kong and London; meanwhile, large new foreign offerings this year by Russian aluminum producers and Kazakhstan oil and copper companies are planning to list in London.

Something is clearly wrong: At the margin, where the parties have a choice, the U.S. is no longer the preferred venue for financing. Why?

The most obvious answer, Sarbanes-Oxley, is not the whole story. Preceding and following Sarbox were a number of other regulatory burdens that, cumulatively, are taking the already heavy U.S. regulatory structure over the edge.

The SEC's Regulation NMS, for example, extended the restrictive trade-through rule to the electronic markets. It was adopted last year and, due to technical complexity, has yet to be put into effect. Nevertheless, brokers have had to install the necessary facilities for proving that their trades did not bypass (or "trade through") limit orders posted at better prices. One study placed NMS compliance costs for broker dealers at $544 million over four years.

Clearly, this regulation is one of the contributors to a recent Securities Industry Association estimate that the industry spends $25 billion annually on SEC compliance. These costs get passed along to individuals or companies that make use of the U.S. securities markets. Is it surprising, then, that a recent study by the London Stock Exchange showed that underwriting costs in London were roughly half of those in the U.S.?

Regulation FD--and an uncontrolled and occasionally abusive SEC enforcement process--are also a needless burden. Regulation FD requires companies to announce publicly any "material" information they provide to analysts. Rather than worrying about whether information is material, many small companies have simply stopped meeting with analysts, and many small brokers have simply reduced their team of analysts, resulting in a widescale reduction in analyst coverage for small and mid-cap companies.

Coupled with the costs of Sarbanes-Oxley, Regulation FD has made public ownership less attractive to small companies, as well as providing an incentive for a public firm to go private.

But even large companies face difficulties determining whether certain details about their operations are "material" information that will subject them to an SEC enforcement action if they guess wrong. And this is clearly something they have to worry about, since the SEC's enforcement process, operating with little policy control from the commission level, forces companies to settle cases they might otherwise win in court. The choice frequently is to settle with the SEC staff, or face costly litigation and an extended period of adverse publicity.

Similar choices are faced by companies caught in the toils of securities class-action litigation. Should they submit to a costly settlement, benefiting mostly the plaintiffs' lawyers, or endure years of litigation and bad publicity? Congress has made efforts to control class-action litigation, but these have not been successful. The inflation-adjusted value of class action settlements rose to more than $3 billion (excluding the WorldCom settlement) last year, up from $150 million in 1997.

And then of course there is Sarbanes-Oxley, whose onerous requirements fall disproportionately on the small and mid-cap companies--the most innovative and entrepreneurial drivers of change. But the most far-reaching effect of Sarbox may be indirect and intangible. By placing a congressional imprimatur on the notion that corporate managements have to be supervised and controlled by independent boards, the act may have set up an adversarial relationship between managements and boards that will, over time, impair corporate risk-taking and thus economic growth. Academic studies and recent articles about the buildup of cash in corporate treasuries provide evidence that this is occurring. A recent Ernst & Young survey of independent directors found that "boards are more focused on compliance with standards and regulations than they are on obtaining a competitive advantage."

Perhaps the deep capital markets in the U.S. would have retained their attraction to foreign companies if only one or two of these regulatory elements were in place. With all of them, many foreign companies seem to have given up on committing themselves to the U.S. capital markets.

To investigate the drift of financial business away from the U.S., two "blue ribbon" commissions are now functioning: one established by the U.S. Chamber of Commerce, the other by prominent academics. These efforts are seldom successful. If they include a wide diversity of opinion their recommendations are watered down; if they include those directly affected, they are regarded as biased. Policy makers should push forward, despite the cavils. We should not fear, or object to, the competition of foreign markets; in fact, we should welcome it. But we shouldn't impair our own ability to compete with needless and costly regulation. Blue ribbon commissions are fine--but the markets are already telling us what we need to know.

Peter J. Wallison is a resident fellow at AEI.

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