The US Committee on Capital Markets Regulation, an independent and bipartisan group comprised of 22 leaders from the US investor community, business, finance, law, accounting and academia, on Thursday issued its interim report with recommendations for changes in capital markets regulation based on the twin goals of enhancing shareholders rights while reducing excessive and overly burdensome regulation and litigation.
FIGURE I.6
Share of Global IPOs Captured by U.S. Exchanges
Percentage of global IPOs listed in a U.S. exchange (NYSE, NASDAQ, AMEX). An IPO is defined as global if a company goes public in a market other than its domestic market, regardless of whether the company was already public in the home market or not. The source of the data is Dealogic.
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| Blue line - by number; Pink line - by value |
The report says that investors have sharply reduced the premium they pay for shares of foreign companies listed in the United States since a regulatory crackdown on corporate fraud from 2002.
Shares of foreign companies listed both in the company's home market and on a US stock market have generally traded at a higher valuation as a percentage of book value than domestic peers that are not cross-listed.
The premium for listing on both a US and home stock market has dropped sharply since 2002, according to Luigi Zingales, a finance professor at the University of Chicago's Business School and a member of the Committee.
The report says that premium for listing on both US and foreign markets averaged 51 percentage points from 1997 to 2001. It dropped to 31 percentage points between 2002 and 2005, Zingales found.
In his research, Zingales found the premium for a US listing fell most sharply for companies from countries with well-regarded corporate-governance standards, such as Japan, Hong Kong, Canada and the United Kingdom.
In contrast, companies from countries with poorly reputed corporate-governance standards, such as Italy and Turkey, saw little change in the premium for cross-listing or an increase in the premium, which suggests investors in those countries viewed the additional benefit of meeting the post-2002 U.S. regulations equalled or outweighed the extra cost.
Zingales cited a variety of factors in the shift in environment: the 2002 Sarbanes-Oxley statute, increased federal and state prosecution of white-collar wrongdoing, higher visibility of shareholder lawsuits and the decline in the number of Wall Street analysts covering companies that trade in the United States.
The report says that when foreign companies have chosen not to do IPOs in the United States, they often have raised capital elsewhere in the US equity markets. The United States continues to provide an important source of capital for new equity offerings. But more often foreign companies accessed this pool through the private rather than the public markets. In 2005, foreign companies raised 10 times as much equity in the private US markets as in the public markets ($53.2 billion vs. $4.7 billion).
Further, of the global IPOs that raised money in non-US markets, 57 percent of these companies (94 percent of the capital raised) chose to raise additional capital in the US private markets. Although it is difficult to know the weight of considerations that gives rise to this preference for private over public markets, there is one consideration of great relevance to the concerns raised in this Report. When foreign companies raise US equity in the private market from qualified institutional investors (using so-called “Rule 144A” offerings), they avoid all the mandated disclosure requirements, Sarbanes-Oxley Act (SOX) Section 404 requirements, and the strict liability provisions of the Securities Act of 1933. Just as importantly, the average US investor cannot participate directly in these private markets.
TABLE I.2
Declines in Listing Premiums
This table reports the country average decline in the listing premium between the 2003-2005 period and the 1997-2001 one. All values are expressed in percentage terms. The listing premia are the differences in the market to book value of assets between cross listed and non cross listed stocks. The difference is computed between the average listing premium between the 2003-2005 period and the average in the 1997-2001 period.
Foreign companies are not the only firms showing a preference for US private markets over public markets. Going-private transactions have risen dramatically in recent years, topping 25 percent of public takeovers in the last three years. To fund these transactions, private equity funds have grown significantly, raising $200 billion in 2005 and more new capital in the last several years than net flows into mutual funds. The decision to “go private” or to access the private equity markets is a further suggestion of the regulatory and liability costs and burdens of accessing the public US markets.
The report says that the loss of US public market competitiveness compared to global public markets results from a number of factors: foreign markets have closed the technology, investor confidence, and liquidity gaps that traditionally favored US markets; significant pools of capital around the world have developed (more money is now raised outside than inside the United States); and the ease with which investors can invest abroad has increased. Even so, certainly one important factor contributing to this trend is the growth of US regulatory compliance costs and liability risks compared to other developed and respected market centers.
The Committee outlined 32 specific recommendations in four key areas – shareholder rights, the regulatory process, public and private enforcement and Section 404 of the Sarbanes-Oxley Act of 2002 – to improve the regulatory system and give U.S. capital markets the competitive boost necessary to respond to the increasingly aggressive efforts of other countries to attract equity capital markets.
“Maximizing the competitiveness of U.S. capital markets is critical to ensuring economic growth, job creation, low cost of capital, innovation, entrepreneurship and a strong tax base in key areas of the country,” said Glenn Hubbard, Dean of Columbia Business School and co-chairman of the Committee. “While U.S. capital markets historically have been the deepest, most liquid financial and lowest cost markets anywhere, the world is vastly different today. There are several viable markets for raising capital, and many companies now are using cost-benefit analysis – including the potential cost of litigation and the complexity of regulation – to focus on the competitive differences among the markets.
John L. Thornton, Chairman of the Brookings Institution and co-chairman of the Committee, said, “Investor protection and shareholder rights are bedrock principles of U.S. capital markets. The Committee believes that enhancing shareholder rights and facilitating more efficient regulation will strengthen U.S. market global competitiveness.”
Hal S. Scott, Nomura Professor and Director of International Financial Systems at Harvard Law School and Director of the Committee, added, “The Sarbanes-Oxley Act of 2002 helped restore market confidence after several high-profile scandals. However, the cost of auditing internal controls is unnecessarily high and can be brought down. The major problem is the cost of litigation, which can be addressed by resolving legal uncertainties and giving shareholders the right to choose more efficient ways to resolve disputes with their companies. We will continue to explore these and other issues affecting the competitiveness of our capital markets for the next two years and we look forward to a lively public discussion.”
Findings on U.S. Capital Markets Competitiveness
While some erosion of the historically immense U.S. market-share of global equity listings, trading and total equity financing is natural, it cannot fully explain why:
- 5% of the value of global initial public offerings was raised in the U.S. last year, compared to 50% in 2000.
- The U.S. share of total equity capital raised in the world’s 10 top countries has declined to 27.9% so far this year from 41% in 1995.
- The decrease in U.S. listing premiums erodes the traditional edge maintained by the U.S. on cheaper cost of capital.
- Private equity firms, almost non-existent in 1980, sponsored more than $200 billion of capital commitments last year alone.
- Since 2003, private equity fundraising in the U.S. has even exceeded net cash flows into mutual funds and going private transactions have accounted for more than a quarter of publicly announced takeovers. The increased use of private markets disadvantages the average investor, who typically cannot participate in such markets.
- The dramatic increase in the use of private U.S. markets is important evidence that regulation and litigation are keeping them out of the public market.
Key Recommendations
Following are highlights of the Committee’s recommendations from each of the four areas of the report:
Shareholder Rights
- Classified boards should be required to obtain shareholder authorization to adopt a poison pill, and if this is not done within three months, the pill should automatically be redeemed.
- The Committee endorsed majority – rather than plurality – voting, which is a cornerstone of shareholder rights, and the Committee will study how it may best operate.
- Shareholders should be given the choice to decide how disputes with their companies should be resolved – through arbitration (with or without class actions) or non-jury trials.
- The SEC should resolve issues on ballot access caused by a recent court decision.
Regulatory Process
- The SEC and self-regulatory organizations should move to a more risk-based regulatory process, emphasizing the costs and benefits of new rules. In weighing the costs and benefits of new rules, regulators should rely on empirical evidence to the extent possible. Also to the extent possible, regulations should rely on principles-based rules and guidance.
- The SEC should periodically test existing rules to ensure they still meet reasonable cost/benefit standards.
- Public enforcement bodies like the SEC, Justice Department and state securities commissioners and attorneys general need to coordinate their activities, providing for federal precedence where enforcement implications are national in scope. There should be more effective communication and cooperation among federal regulators. The President’s Working Group on Financial Markets is one natural venue for ensuring such cooperation.
Public and Private Enforcement
- Greater clarity for private litigation under SEC Rule 10b-5, and from the SEC on materiality, scienter (knowledge of wrongdoing) and reliance is needed. Criminal enforcement against companies should be a last resort, reserved for companies that have become criminal enterprises from top to bottom. We should not hold outside directors responsible for corporate malfeasance that they cannot possibly detect.
- Public enforcement authorities should not be allowed to threaten corporate defendants with denial of their employees’ right to due process.
- The SEC should protect outside board members against liability from relying in good faith on the validity of audited financial statements – otherwise, it will be difficult to attract independent directors to boards.
- Congress should explore protecting audit firms against catastrophic loss through the provision of caps or safe harbors, as do some European countries and as the European Union is actively considering. Any use of such protection must be balanced against stiff action against those responsible for misconduct.
Sarbanes-Oxley
- The SEC should adopt a more reasonable materiality standard both for internal controls and financial statements.
- The SEC and the PCAOB should adopt enhanced guidance on auditors’ roles and duties in testing for compliance with Section 404.
- If a revised Section 404 is too burdensome for small companies ($75 million market cap and less), even after the general reforms outline above are implemented, the SEC should recommend to Congress that small companies be exempt from auditor attestation and be subject to a more reasonable standard for management certification.
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