Escape from New York
Wednesday, February 20, 2008
U.S. public securities markets are losing their competitive edge.
“Facts,” as John Adams said, “are stubborn things,” and once again the Committee on Capital Markets Regulation has presented some troubling ones about the competitive position of U.S. public securities markets. The Committee, a group of academics and market specialists assembled by Professor Hal Scott of Harvard Law School, last reported on this question in November 2006. At that time, it noted that several indicators pointed to a substantial decline in the number of financial transactions—especially public securities transactions—that were coming to the United States. The Committee attributed this decline to high regulatory costs—caused primarily by the Sarbanes-Oxley Act (SOX)—and high litigation risk.
Skeptics’ initial response was to question whether the decline in offerings by foreign companies merely reflected the growth and maturation of foreign securities markets. Certainly foreign markets are growing, but much of the data in the Committee’s latest report seem to confirm that there is more to the story. Indeed, the data seem consistent with only one conclusion: foreign and even U.S. companies are actively seeking to avoid U.S. public markets.
One particularly salient indication is the growth of offerings by foreign companies in the Rule 144A market. Under that rule, U.S and foreign companies can raise equity funds from private sources without having to register with the Securities and Exchange Commission. Between 2000 and 2005, Rule 144A offerings by foreign companies accounted for an annual average of about 6.8 percent of the funds raised by foreign issuers through public offerings. But according to the Committee, that figure surged to 80 percent in 2006; and although it declined to 31 percent in 2007, that was still nearly five times greater than the 2000-2005 average.
It is hard to understand this increase as anything other that an effort to avoid U.S. public securities markets and the litigation risk that those markets entail. The example of Rule 144A offerings is particularly striking because public equity is supposed to be less expensive for companies than private equity, which is more costly to raise and which comes from demanding sources that monitor their investments diligently.
There is a tipping point when the benefits of regulation are outweighed by the cost burden they impose. Sarbanes-Oxley may have pushed the United States past this tipping point.
Another striking fact in the Committee’s new report is the growing number of American companies that have chosen to offer their stock in initial public offerings outside the United States. The number has grown from an annual average of one-tenth of 1 percent between 1996 and 2005, to 1.1 percent in 2006 and 4.3 percent in 2007. This indicates that even U.S companies are beginning to abandon their home market for the lower-cost and lower-risk markets abroad.
The Committee’s initial report placed the blame for the loss of public securities transactions on onerous regulation and relatively high litigation risks. This is certainly plausible. The decline seemed to begin after the Sarbanes-Oxley Act was passed in 2002. The London Stock Exchange advertises itself as a SOX-free zone and has experienced a boom in listings during the post-SOX era.
It is not hard to imagine that there is a tipping point in regulatory costs when the benefits of regulation—the reduction in many of the operational risks associated with investing—begin to be outweighed by the cost burden they impose. When the tipping point is passed, companies begin to recognize that they don’t get any net value from entering a regulatory regime. SOX may have pushed the United States past this tipping point.
The same could be true of litigation risk. The Committee’s initial report made a strong case against private class action lawsuits, pointing out that they were simply a transfer of money from one group of shareholders to another, with a substantial cut taken by the lawyers on both sides. Surveys have shown that the litigation environment in the United States is one of the principal reasons foreign companies think twice before raising funds or locating facilities here.
Last week, the American Enterprise Institute held a conference to discuss the Committee’s latest report. Professor Scott argued that the most troubling part of the data is not simply the loss of business for brokerage firms and exchanges in the United States, but the fact that U.S. companies must live under a regulatory regime that foreign companies can escape. This suggests that U.S. companies are being placed at a cost disadvantage that will eventually impair their competitiveness on the business side. Yet others at the conference argued that if the price of restoring U.S. markets to a more competitive position was abandoning some of the investor protections in SOX and private securities litigation, then it wasn’t worth doing.
On the outcome of this debate—whether to remain competitive or to continue our current regulation and litigation policies—may hang the future of U.S. financial markets. The Treasury Department is currently completing a study of financial regulatory structure and policy. If Treasury concludes that the decline in U.S. public securities markets is both real and important to address, it will propose significant changes that will determine the future course of reform. If Treasury concludes otherwise, it may take a far more dramatic decline of U.S. markets for the problem to get any serious attention.
Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.