Dimensions: 6'' x 9'' 312 pages AEI Press  (Washington) Publication Date: December 2002 Paperback ISBN: 0-8447-4173-6 Price: $ 25.00 Add to Cart   Examination Copies

December 2002
The Advantage of Competitive Federalism for Securities Regulation
By Roberta Romano

This book suggests that the best way to improve securities regulation for both investors and corporations is to eliminate the exclusive jurisdiction of the Securities and Exchange Commission and instead follow the successful model of competitive federalism for corporate charters. Under such a model, the high entry costs would decrease, and companies would be able to choose the regulatory regime that best suits their corporate needs and investors.

How can we best create incentives for securities regulators to align their actions with investors' interests? What ought to be the scope of the Securities and Exchange Commission's authority to regulate securities after the collapse of the Enron Corporation? In The Advantage of Competitive Federalism for Securities Regulation, Roberta Romano contends that the current approach toward U.S. securities regulation, exclusive jurisdiction of the SEC, is misguided and should be revamped by implementing a regime of competitive federalism. Under such a system, firms would select their regulator from among the states, the SEC, or other nations. Romano maintains that competitive federalism harnesses the high-powered incentives of markets to the regulatory state to produce regulatory arrangements most compatible with investors' preferences.

Firms will locate in the domicile investors prefer so as to reduce their cost of capital, and the feedback from the net flow of firms across securities regimes will provide regulators with the incentives and information to adapt their regimes to mesh better with investors' preferences. Enhancing regulatory competition is especially important in the context of the collapse of Enron, which underscored a failure of financial accounting standards whose solution is best advanced by a regime of competitive federalism. The experimentation in accounting regimes that would occur under a competitive securities regulatory system would provide a mechanism for identifying the optimal solution.

The view that consumers are protected from producer exploitation by competitive product markets is prosaic. But a number of legal commentators blanch at the suggestion of applying that wisdom to securities regulation. As this book demonstrates, upon analysis, the analogy is entirely appropriate. In today's global financial markets, which are dominated by sophisticated institutional investors, competition among securities regulators would not only protect investors, both large and small, but also provide a superior regulatory regime.

Romano reviews how empirical research provides little indication that the SEC is effective in achieving its stated objectives. The commission's expansion of disclosure requirements over the years has not enhanced investors' wealth. In addition, the evidence from institutional equity and debt markets and cross-country listing practices demonstrates that firms voluntarily disclose substantial information beyond mandatory requirements to provide the information investors require. Finally, numerous examples exist where SEC policy perversely had an adverse impact on investors (such as its support of fixed commissions and its opposition to firms' provision of earnings forecasts). The agency's track record does not make a case for retaining its exclusive jurisdiction over securities regulation.

Critics of competition in securities regulation often blur the true issue by referring to their position not as a defense of a single regulator but as a defense of mandatory disclosure, on what is a fantastic premise, that there would be no significant disclosure component in a competitive regime. Objections to competition have, accordingly, often been inseparably intertwined with a defense of the SEC's mandatory disclosure regime. That argument is flawed: if investors want mandatory rules, competing regulators will offer them. Moreover, as the evidence detailed in the book shows, it is difficult to defend the SEC's monopoly as delivering what investors want. Romano therefore contends that we ought not to offer the status quo a privileged position in regulating securities. Instead, we should apply to securities regulation the overarching organizational principle of our political and economic system, decentralized competition.

One of the striking features of U.S. securities regulation is that it is organized along different principles from U.S. corporate law, yet both legal regimes are directed at the same goal, protecting the interests of investors. The securities regime consists of mandatory rules administered by a federal government agency, while corporate law is left to the states and consists of enabling statutes whose default rules can be adjusted by individual firms to meet their particular needs. Corporations, moreover, select which state's corporation code will govern their affairs by choosing their state of incorporation, a statutory domicile that is independent of physical presence in the state. One small state, Delaware, has come to dominate the market for corporations: Over half of the firms listed on the New York Stock Exchange, for example, are incorporated in Delaware. Its success derives from its responsiveness to changing business needs by continually updating its corporate law and an expert judiciary. Indeed, Delaware has a financial incentive to be responsive to firms' needs: annual franchise fees paid by corporations are approximately 20 percent of Delaware's tax revenues.

While other states have not duplicated Delaware's financial success, they respond to its legal reforms to satisfy local corporations and to discourage them from reincorporating in Delaware. As detailed in the book, the empirical evidence indicates that investors have benefited from that competitive situation. The proposal for competitive federalism in securities regulation draws on the experience with state corporate law by extending its institutional arrangement to the securities context.

Until recently, state authority over securities regulation has, for the most part, overlapped with that of the SEC. Yet, in contrast to corporate law, competition has not developed in that context, and the mandatory federal regulatory overlay is not the sole explanation. In addition, the jurisdictional basis for state authority differs. It depends on the security purchaser's domicile (the site of the transaction), not the domicile of the issuer, and it is therefore not uniform across investors in a firm. Because sovereignty varies with the purchaser of the security, in contrast to corporate law where it is the same for all investors, no one state has control over the legal regime affecting an issuer, and public issuers cannot control their regime (as that would require prohibitively expensive restrictions on securities trading). States, accordingly, have no incentive to innovate and develop their legal regime in the interest of investors and issuers, because such activity will not affect the number of firms under their authority.

As Romano explains, no compelling theoretical justification exists for retaining the transactional jurisdictional approach to securities regulation, rather than adopting corporate law's statutory domicile approach. To implement competitive federalism in securities regulation, then, the securities jurisdictional rule must be replaced by that of corporate law, so that all securities transactions are governed by the same regime, the regime chosen by the issuer. Under the book's proposal, the statutory regime creating competitive federalism would include two additional safeguards for investors to ensure that replacing the existing securities choice-of-law rule with issuer selection of securities regime is equivalent to a regime of investor selection. Disclosure of the securities domicile would be required before the purchase of a security, and shareholder approval would be required for a midstream change in domicile. Regulatory competition will function properly when purchasers know what regime will apply to a security, as that facilitates the pricing of securities regimes. Because that price will not reflect the value of a new domicile unless investors anticipate the change at the time of purchase, the voting requirement will prevent insiders from shifting value away from the public through midstream switches to less desirable regimes (or eliminate the pricing discount that would arise from investors' expectations of the possibility of such behavior).

Over the past decade, dissatisfaction with the existing securities regime has led Congress to expand the scope of the SEC's authority in contrast to that of the states, most notably by preempting state securities lawsuits by private parties and by preempting state regulation of the registration of interstate securities issues. Romano maintains that the trend to expand the federal government's monopoly over securities regulation should be halted, as such a measure is not the most effective solution to the problems of an overlapping regulatory regime that reformers have sought to address. Instead of supplanting state regulation, Congress should rationalize it by altering the multijurisdictional transactional basis of state regulatory authority to an issuer-domicile basis. By creating regulatory competition, such a measure will introduce into securities laws the benefits that have accrued to investors under corporate charter competition.

Corporations and their counsel have focused their efforts on shifting regulatory authority from the states to the federal level to eliminate state-level problems of forum shopping by civil liability plaintiffs and the burdens of complying with different state registration requirements because firms perceive preemption as the easiest political fix to propose to members of Congress. But those problems would be eliminated by a change in the choice-of-law rule for securities transactions to a statutory domicile approach, whereby one state, selected by the issuer, had exclusive jurisdiction over all transactions in the firm's securities, which would be the operative jurisdictional rule of competitive federalism.

The book's proposal for competitive federalism in securities regulation also has important implications for international securities regulation. Present-day international securities regulation follows a territorial jurisdictional principle similar to domestic regulation: the regulatory authority is the regulator where the securities are listed. Thus foreign firms listed on the New York Stock Exchange are regulated by the SEC. Under competitive federalism, such firms could continue to trade in the United States but choose to comply with the securities regulations of their home country instead of those of the SEC. Such a measure would not disadvantage U.S. investors: as long as they are informed that an issuer is operating under a different regime, the one-disclosure mandate advocated for implementing competitive federalism. Investors will place a premium on the shares of firms operating under the securities regime that they prefer. Moreover, a shift to statutory domicile in that context is not far-fetched. With the growing use of electronic trading, geographic boundaries are increasingly becoming obsolete as a source of jurisdiction, and issuer domicile is the most feasible alternative jurisdictional basis.

Because for many foreign firms compliance with U.S. accounting rules presents a formidable barrier to a U.S. listing, a competitive regime will have the greatest impact on the capital market opportunities for those corporations. Mature U.S. issuers and their counsel have already expended the effort to comply with the myriad SEC disclosure rules and have established relations with agency personnel, measures that make it less expensive for those firms to operate under the existing regime. But new U.S. issuers are in the position of foreign firms, as they have not made substantial investments in a specific securities regime, and they are likely to benefit significantly from a competitive securities regime. As new and mature issuers compete for capital, if a superior securities regime were to emerge for new issuers that was more cost-effective than the SEC's regime, then even mature issuers would switch domicile to reduce their cost of capital, or the SEC would respond to the competition by scrapping problematic regulations and improving its product. Either scenario would benefit investors.

A desire may exist to discount the need for adopting the market-driven approach to securities regulation offered by competitive federalism because of the historic vibrancy of U.S. capital markets compared with those in other nations. Doing so is a mistake. It is incorrect to attribute the greater size and liquidity of U.S. capital markets to the operation of the SEC. U.S. capital markets have been the largest and most liquid markets since World War I, some twenty years before the SEC was established. Romano concludes that under a securities regime of competitive federalism, the aspects of the SEC's regime that are valuable to investors will be retained, those that are not will be discarded, and the resulting securities regime will better meet investors' requirements than does the present one.

Roberta Romano, the Allen Duffy/Class of 1960 Professor of Law at the Yale Law School, is also the author of The Genius of American Corporate Law (AEI Press, 1993).