Two recent bipartisan reports make the case that US capital markets may be dangerously over regulated.
The Committee report
The first report of the blue ribbon Committee on Capital Markets Regulation, issued on 30 November 2006, documented several types of evidence that the competitiveness of US capital markets appears to be eroding and made 32 recommendations to enhance that competitiveness. This committee of private experts is headed by Hal Scott, a professor at the Harvard Law School; Glenn Hubbard, the dean of the graduate business school at Columbia University; and John Thornton, the chairman of the Brookings Institution. Over the next two years, the Committee also expects to issue reports on the competitiveness of mutual funds and derivative markets. The major findings of this first report are the following:
- In 2000, 50 percent of the value of world-wide initial public offerings was raised in the US, falling to five percent in 2005.
- The US share of total equity capital raised in the world’s top 10 markets was 41 percent in 1995, falling to about 28 percent in 2006.
- The listing premiums on US stock exchanges have declined substantially.
- Private equity firms, almost non-existent in 1980, sponsored more than $200 billion of capital commitments in 2005.
- Since 2003, private equity fundraising in the US has exceeded net flows into mutual funds, and going private transactions have accounted for more than a quarter of publicly announced takeovers.
Some of the decline in the US share of world equity markets is probably due to the increased efficiency of major foreign markets. The dramatic increase in the use of private US markets, however, is important evidence that regulation and litigation are contributing to the flight of many companies from the public markets.
Although the findings of this report are quite dramatic, the Committee’s recommendations are surprisingly tepid. The Committee proposed several increases in shareholder rights based on little more than a wistful hope that this would reduce litigation. The financial regulatory organisations are encouraged “to move to a more riskbased regulatory process, emphasising the costs and benefits of new rules” and to periodically test existing rules by the same standard. And, of course, “There should be more effective communication and cooperation among federal regulators.” The most substantive proposals would limit the authority of the federal enforcement authorities and the liability of outside board members and the audit firms. The report concludes that only “If the SEC finds that, even after the general reforms outlined above are implemented, the revised Section 404 is still too burdensome for small companies, it should recommend that Congress exempt small firms from auditor attestation.” The report offers surprisingly little analysis and evidence that their recommendations would enhance the competitiveness of US capital markets, and it makes no proposals to change the major federal regulatory laws.
The Schumer-Bloomberg Report
A second report, issued on 22 January 2007, “warned that New York financial markets, stifled by stringent regulations and high litigation risks, are in danger of losing businesses and high-skilled workers to overseas competitors,” estimating that US financial service revenues would fall between $15 billion and $30 billion a year without a major change in the public policies affecting US capital markets. This report was commissioned by US Senator Charles Schumer and New York City Mayor Michael Bloomberg, prepared by McKinsey and Company, and informed by interviews with more than 50 financial service specialists. Somewhat of a surprise, this report was endorsed at its release by Eliot Spitzer, the newly elected governor of New York, who was critical of the prior report by the Committee on Capital Markets Regulation. The Schumer-Bloomberg report recognised “that while many of the causes (of the erosion of the competitiveness of US capital markets) are due to improved markets abroad and sophisticated technology that has virtually eliminated barriers to the flow of capital, a significant number of the causes … are selfimposed,” focusing on the effects of stringent US regulations, higher litigation risk, and restrictive immigration policy.
To my surprise, the Schumer-Bloomberg report recommends a substantially different set of policy changes than does the prior report by the Committee. The major policy recommendations that are quite different include the following:
- Implement securities litigation reform with particular shortterm emphasis on leveraging the SEC’s existing authority.
- Ease immigration restrictions facing skilled non - US professional workers.
- Protect US competitiveness in implementing the Basle II Capital Accord.
- Modernise financial services charters and holding company structures.
Potential Congressional action
The fact that two reports that addressed much the same issue led to such different policy recommendations will make it more difficult for Congress to resolve what to do about this problem of increasing concern. Nevertheless, both Barney Frank and Christopher Dodd, the new chairmen, respectively, of the House and Senate banking committees, are expected to hold hearings on the issues raised and the policy recommendations by these two reports. And the SEC has already made some minor changes to the implementation of Section 404 of the Sarbanes-Oxley Act to respond to these concerns. The new Democratic Congress seems willing to address these issues primarily because of the substantive findings of these two reports, the bipartisan endorsement of these reports, and the concentration of the financial industry in the northeastern states that are now represented primarily by Democrats.
Major remaining problems
My primary disappointment with both reports is that they do not address the major conditions that limit the rate of return on US equity markets.
- Very few corporate boards now include a member with sufficient voting shares to be a credible threat to the incumbent management. The origin of this problem is the federal Williams Act of 1968, which substantially increased the cost of successful tender offers and completely eliminated the potential for surprise. Over the next several decades, corporations chartered in almost every state were authorised to implement one or more takeover defenses, and most did so. An important 2003 study by Paul Gompers and colleagues, however, found that the rate of return on the equity of individual corporations has been a strong negative function of the number of takeover defenses in that firm. This issue has not been subject to a public discussion and nothing has been done to correct this problem.
- The Sarbanes-Oxley Act substantially increased the role of the independent auditing firms and created an expensive and arguably unconstitutional board to regulate these firms. This Act, however did not correct the major potential conflict of interest between corporations and their independent auditors, in that the audit firms are still paid by the corporations that they audit.
- The primary public rationale for the Sarbanes-Oxley Act was to restore investor confidence by improving the quality of reported earnings, and the Committee report asserted that this has been the effect. The best test of this effect is whether investors are now willing to pay a higher price for a stock per dollar of reported earnings. The price-earnings ratio on the S&P 500-stock index, however, has declined continuously since the Sarbanes-Oxley Act was being drafted in the spring of 2002. Five years later, there is still no objective evidence that this Act has restored investor confidence in the equity values of the stocks listed on US exchanges and thereby subject to the regulations required by the Act.
- The largest long-term cost of the Sarbanes-Oxley Act, however, may be more risk-averse behavior by corporate managers and board members. Most CEOs, for example, are not accountants, and the requirement that they personally attest to the accuracy of the audits at the risk of a jail sentence is likely to divert the CEOs from more productive activities and lead to more riskaverse decisions. Individual shareholders can reduce the risk of their portfolio more efficiently by investing in a broad-based mutual fund rather than by counting on individual corporations to reduce the risk of individual stocks. Legislation designed to reduce the probability of “another Enron” may reduce US economic growth.
My major disappointment about this whole episode is the recognition that so many intelligent and informed adults do not acknowledge that Congress has probably made a mistake that should be reversed rather than be considered a new pillar of American securities law. Michael Oxley, recently retired from Congress, was asked whether he would have done anything differently if he knew then what now is known about the effects of the Sarbanes-Oxley Act. “Absolutely,” Oxley answered. “Frankly, I would have written it differently, and he would have written it differently,” he added, referring to Sarbanes. “But it was not normal times.” Now is the time to revise or repeal the Sarbanes-Oxley Act.