Should the exclusive jurisdiction of the Securities and Exchange Commission to regulate securities be retained in a post-Enron environment? What is the best way to align the actions of regulators with the interests of investors? In The Advantage of Competitive Federalism for Securities Regulation (AEI Press, fall 2002), Roberta Romano, the Allen Duffy/Class of 1960 Professor of Law at Yale Law School, contends that the current exclusive jurisdiction of the SEC is misguided and should be replaced by a regime of competitive federalism.

Under such a system, firms would choose to be regulated by a state, the SEC, or another country. Romano explains that competitive federalism produces regulatory arrangements most compatible with investors' preferences. Investors will pay more for shares in firms that operate under the system of securities regulations that they consider the most effective for protecting their interests. The resulting influx of funds would reduce the firm's cost of raising capital. Thus, firms that need capital will register under the regulatory regime that investors prefer, so as to lower their capital costs. In addition, the flow of firms in and out of jurisdictions in response to the cost of capital in a competitive regulatory environment would provide information and incentives for regulators 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. The experimentation in accounting regimes that would occur under a competitive securities arrangement would offer investors a choice of accounting systems and therefore a mechanism for identifying the optimal system.

Empirical research reviewed by Romano indicates that the SEC has not been effective in regulating securities. For example, the commission's expansion of disclosure requirements over the years has not enhanced investors' wealth. In fact, firms currently voluntarily disclose much more data than required by regulators in order to provide investors with the information they demand. SEC policy has even had an adverse impact on investors. For example, for decades the SEC prohibited the companies from disclosing their earnings forecasts, despite the crucial importance of this information to investors. Ironically, that approach disadvantaged the small investors the agency thought it was protecting by closing off their ability to obtain information on projected earnings, as firms would not make forecasts public for fear of liability. To remedy the situation, Romano suggests that we apply decentralized competition--the core principle of our political and economic system--to securities regulation.

Romano also points out that competitive federalism has important implications for international securities regulation. The current regulatory system follows a territorial jurisdictional principle. That is, securities are governed by the regulatory authority where the shares are traded. Thus, the SEC regulates foreign firms listed on the New York Stock Exchange. Under competitive federalism, such firms could continue to trade in the United States while complying with the securities regulations of their home country instead of those of the SEC. This would not disadvantage U.S. investors because issuing firms would be required to provide full notification of the securities rules under which they operate. U.S. investors would be able to invest in companies working under a preferred securities regime, or pay less for shares of companies operating under rules considered insufficiently protective of their interests. Because geographic boundaries are increasingly becoming obsolete as a source of jurisdiction with the growing use of electronic trading, issuer domicile is the most feasible alternative to the present territorial approach to securities jurisdiction.

A competitive regime will have the greatest impact on capital market opportunities for foreign firms that have been unable to comply with U.S. accounting rules and therefore cannot be listed in U.S. markets. New American corporations are in a similar position to that of foreign companies. They are more likely to benefit from a competitive securities regime than their older counterparts that have already made substantial investments--including compliance with the myriad SEC disclosure rules and the establishment of working relations with agency personnel--so that it is less expensive for them to operate under the existing system. But new and older companies still compete for capital. Romano describes a regulatory environment in which even older mature firms would have to keep up with younger corporations regulated by a different, preferred securities regime. Older firms would have to switch domicile to reduce their cost of capital. To stem such moves, the SEC might respond to the competition by improving its product and by scrapping problematic regulations. Investors would benefit under all these scenarios.

Romano warns us that the historic vibrancy of U.S. capital markets compared with other nations may lead some to discount the need for adopting the market-driven approach to securities regulation offered by competitive federalism. Doing so is a mistake, says Romano. It is incorrect to attribute the greater size and liquidity of U.S. capital markets to the operation of the SEC. American capital markets have been the most liquid and the largest since World War I--some two decades before the SEC was established. Romano concludes that under a system of competitive federalism for securities regulations, 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 rules will better meet investors' requirements.