Is Excessive Regulation and Litigation Eroding U.S. Financial Competitiveness?
With an Address by SEC Commissioner Paul S. Atkins
The Brookings Institution
About This Event

Last November, the Committee on Capital Markets Regulation--a group of academic experts and market specialists--issued the first comprehensive report on whether excessive regulation and litigation were causing a migration of financial transactions away from the United States. The report concluded there was strong evidence of this possibility and recommended various Listen to Audio


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steps to restore a better balance in regulating financial services in the United States. Since the committee’s report was presented, two other studies on U.S. financial competitiveness have been completed--one by New York mayor Michael Bloomberg and Senator Charles Schumer (D-N.Y.), and one other by the United States Chamber of Commerce. Key elements of the committee’s report will be presented by the authors, and panelists will discuss its findings and the prospects for legislative or regulatory action based on its recommendations.

This conference is cosponsored by AEI and the Brookings Institution.

Agenda
8:45 a.m.
Registration
9:00
Introduction:
Peter J. Wallison, AEI
9:15
Panel I: State-Federal Relations
Presenter:
Hal S. Scott, Harvard Law School
Panelists:
Michael S. Greve, AEI
Kenneth E. Scott, Stanford Law School
10:30
Panel II: Litigation Reform
Presenter:
Robert E. Litan, Brookings Institution
Panelists:
Merritt B. Fox, Columbia Law School
Kenneth E. Scott, Stanford Law School
Noon
Luncheon
Keynote Speaker:
Paul S. Atkins, U.S. Securities and Exchange Commission
2:00 p.m.
Panel III: Reform of the Securities and Exchange Commission
Presenter:
Robert R. Glauber, Harvard Law School
Panelists:
Edward F. Greene, Citigroup
Kenneth M. Lehn, University of Pittsburgh
3:30
Panel IV: Shareholder Rights
Presenter:
Allen Ferrell, Harvard Law School
Panelists:
Douglas H. Ginsburg, U.S. Court of Appeals for the District of Columbia Circuit
Heidi M. Schooner, Catholic University of America
5:00
Adjournment
Event Summary

April 2007

Is Excessive Regulation and Litigation Eroding U.S. Financial Competitiveness?

Last November, the Committee on Capital Markets Regulation--a group of academic experts and market specialists--issued the first comprehensive report on whether excessive regulation and litigation were causing a migration of financial transactions away from the United States. The report concluded there was strong evidence of this possibility and recommended various steps to restore a better balance in regulating financial services in the United States. Since the committee's report was presented, two other studies on U.S. financial competitiveness have been completed--one by New York mayor Michael Bloomberg and Senator Charles Schumer (D-N.Y.), and one other by the United States Chamber of Commerce. At an April 20 AEI conference, committee members presented key elements of their report and panelists discussed its findings and the prospects for legislative or regulatory action based on its recommendations.

Peter J. Wallison
AEI

Over the past few months, three separate reports on the competitiveness of U.S. financial markets have arrived at the same conclusion: excessive regulation and high litigation risk is impairing the ability of the U.S. financial economy to compete with venues around the world. While regulation can enhance the attractiveness of a financial marketplace by providing investors with confidence about the honesty of the game, excessive regulation can end up driving away transactions. The fact that in 2006 foreign companies raised more equity in private transactions in the United States than on all U.S. exchanges combined indicates that the country may have gone beyond the tipping point in the regulatory costs it is imposing.

Panel I: State-Federal Relations

Hal S. Scott
Harvard Law School

The three major sectors of the U.S. financial services industry--banking, securities, and insurance--face different levels of state and federal regulation. For banking, there is a dual chartering system with full federal preemption for nationally chartered banks and partial preemption for state-chartered banks. Insurance companies, on the other hand, obtain charters only at the state level, with state law able to preempt federal law. In the securities sector there are concurrent state and federal laws, but since the 1970s, Congress has provided for greater federal preemption over state laws. The federal government and the Securities and Exchange Commission (SEC), however, lack preemptive authority over state enforcement actions, and in light of the Global Research Analyst Settlement, this lack of preemptive authority must be addressed. What makes the Global Settlement such a dangerous precedent was that the New York Attorney General's Office required as part of its settlement with twelve investment firms structural reforms of research analysts' operations and funding. This should not be something the states should determine, as it is a matter of national and even international importance. Therefore, the Committee proposes that while states should retain the ability to impose fines and other enforcement remedies, any structural remedies that would be part of a settlement must be approved by the SEC if it finds that the issue is one of national importance. Also, states should resort to criminal enforcement only in the most egregious instances of fraud. The prosecution of Arthur Andersen, which was a major disruption for numerous businesses who employed the firm as their auditor and resulted in even greater industry concentration, reveals that governments should be hesitant to see the demise of major financial institutions or auditing firms. Thus, any contemplated state indictment of a national financial or auditing firm should be reviewed by the Department of Justice before it is brought.

Michael S. Greve
AEI

The Committee's report contains impressive empirical evidence on the competitiveness of U.S. financial markets, and while its recommendations go in the right direction, they are modest and do not go far enough. For example, the Committee's proposal that the SEC have the final say in various enforcement actions will make little difference because the SEC becomes involved regardless, since financial companies subject to state litigation will involve the SEC in order to reach a comprehensive settlement and be done with it. A better way to deal with the problem of over-enforcement--the result of subjecting firms to both state and federal regulation--is to introduce regulatory competition. One option would be to have firms decide whether they wanted to be regulated by the SEC or by the state government. Firms would therefore gravitate towards the regulatory regime that adds the most value.

Kenneth E. Scott
Stanford Law School

When evaluating U.S. competitiveness, another statistic to take into account is the number of firms that decide to de-list themselves from U.S. stock exchanges. One explanation for the marked rise in de-listings is that it is more cost efficient for companies to avoid the regulations imposed on public companies by the Sarbanes-Oxley Act (SOX) and other laws. An alternative explanation is that firm managements want to avoid investor protection laws to extract greater control rents from the shareholders. According to a recent econometric study of companies that chose to de-list, the average stock price actually declined, which indicates that de-listing was not necessarily done for efficiency's sake.

In terms of preemption, one should keep in mind that there are many different ways that the federal government can intervene or coordinate with state regulators. These can range from the SEC filing amicus briefs in state anti-fraud cases, a very minimal intervention, to actually taking over the prosecution of law suits, a very high degree of involvement.

Panel II: Litigation Reform

Robert E. Litan
Brookings Institution and Kauffman Foundation

The Committee's report argues that litigation risk could be responsible for New York losing some of its competitive edge in global financial markets. Over the past few years, not only has the number of foreign listings on U.S. exchanges been declining, but the rate of public companies going private has also been on the rise. At the same time, the number of securities class action settlements has gone up considerably, as has the total amount of these settlements. Even though 2006 and 2007 have seen a rebound in IPOs of foreign companies in the United States and a reduction in the total number of class action lawsuits being filed, these statistics do not necessarily indicate that Sarbanes-Oxley and related regulations are not having a deleterious impact on U.S. capital markets. Because lawsuits typically occur during market corrections, it is necessary to wait and see what happens when the stock market cools off or goes down. Moreover, the fact that directors' and officers' liability insurance in the United States is higher than in Europe indicates that foreign companies still perceive a higher litigation risk in the United States.

In light of these developments in U.S. financial markets, the Committee made several recommendations to mitigate litigation risk. First, the SEC should provide more guidance on Rule 10b-5 liability, using a risk-based approach. The SEC should also prohibit "double recovery," in which defrauded shareholders receive restitution from the SEC's Fair Funds Account and then attempt to use a private right of action to reap additional damages from the company. The Committee also advocated preventing lawyers who donate to elected officials administering government pension funds from acting as lead plaintiff in class action lawsuits on those funds--so called pay-to-play practices--thereby eliminating a potential conflict of interest. Another recommendation is to cap accountants' liability to avoid the collapse of one of America's four big accounting firms, which could have systemic effects on the economy. Finally, if a foreign company wanting to offer its securities comes from a country with a strong, competent securities regulator, the SEC should consider allowing the company to operate under its own regulations and exempt it from SEC requirements.

Merritt B. Fox
Columbia Law School

Fraud on the market (FOM) civil liability suits are a distinctive feature of the U.S. financial system, and, according to the Committee, they are a major contributor to the high U.S. regulatory intensity. The Committee emphasized the ways in which this regulatory intensity deters some foreign companies from listing their securities on U.S. exchanges. However, this same regulation also attracts foreign companies, as evidenced by the 30 percent listing premium, which results from the promise of greater cash flows to the company, the reduced bid-ask spread that results from the expectation of future cash flows, and the fact that enhanced disclosure requirements tend to encourage more efficient operations. Because the Committee seems to suggest that the only feasible policy options are to either decrease the regulatory intensity or keep it constant, it would appear that the United States faces a tradeoff between repelling fewer companies that want less regulation (but at the same time repelling those attracted by the U.S. regulatory framework) or attracting more companies that prefer the regulation while repelling those who would prefer less. A better alternative to this tradeoff would be to give foreign companies who list on U.S. exchanges the option of committing themselves to U.S. regulation. Therefore, the United States could attract companies that would otherwise be deterred by U.S. regulation, as well as those who seek its benefits. The Committee also depicts accurately the general problem with FOM civil liability suits--they amount to the transfer of wealth from one group of shareholders to another--but understates the way in which this system provides incentives for corporate truth-telling.

Kenneth E. Scott
Stanford Law School

One of the Committee's recommendations was to clarify the scope of private rights of action under Rule 10b-5, but this will prove difficult for several reasons. First, there are several challenges in measuring damages, the effect of misstatements and omissions on share price. Currently, there are several ways that can be used to do this, including econometric analysis, the application of the "materiality" criteria in Staff Accounting Bulletin 99, or leaving it to a jury to decide, but each of these has its disadvantages. In addition, it is notoriously difficult to arrive at precise definitions for "materiality," "scienter," and "recklessness," the criteria provided by the courts to define the basis for a cause of action. However, since the private right of action under Rule 10b-5 was not created through legislation, the SEC could clarify it through regulation.

While Peter J. Wallison has advocated abolishing the private right of action altogether because it is just a transfer between shareholder groups, and replacing it with enforcement by the SEC, these plaintiff class actions are still appropriate for cases in which shareholders have been defrauded by the company or "insiders." If a director or officer has committed fraud, shareholders should use a derivative suit, with compensation going to the company. Moreover, quite apart from shareholder suits, the current regulatory system, despite its flaws, still provides many incentives for corporations to produce accurate financial statements, an aspect that must be taken into account if the system is to be reformed.

Keynote Address

The Honorable Paul S. Atkins
U.S. Securities and Exchange Commission

Everyone should be concerned about our global competitiveness for capital and its implications for our future. If the United States is to continue to attract investment and entrepreneurs from around the world, maintaining a globally competitive financial marketplace is essential. To achieve this, financial services regulation must continually adjust in order to keep up with changes and innovation. Regulators must always ask whether the benefits that result from their rules exceed the costs and, if so, consider paring back the non-value adding aspects of regulation.

Recent reports on U.S. competitiveness have addressed the issue of excessive regulation and have made several important recommendations. In the area of abusive class action lawsuits, it is necessary to reach a timely and cost-efficient manner of separating those lawsuits with merit from those without. Another positive reform would be to better harmonize enforcement among federal and state securities regulators. In addition, SEC staff guidance that fundamentally changes existing market practices should be subject to public notice and comment. If the United States can accomplish these and other reforms, our capital markets will optimize their chances of continuing their historic successes.

Panel III: Reform of the Securities and Exchange Commission

Robert R. Glauber
Harvard Law School

For forty-five years after World War II, the United States was unchallenged as the natural place for financial transactions. In recent years, however, other countries have become more competitive, and consequently, the costs and benefits of U.S. regulation are more important than ever before. Yet reducing regulation cannot be viewed as an end in itself; rather, the goal should be to find the proper regulatory balance.

In seeking this balance, the Committee made several proposals. One of these was for the SEC to adopt formal cost-benefit analysis for its proposed regulations, a requirement from which the SEC is currently exempt. Another proposal was for the Commission and the self-regulatory organizations (SROs) to adopt basic principles of regulation, similar to the guidelines adopted by the U.K. Financial Services Authority. The larger aim in this would be to reduce the current morass of complex, detailed rules and replace them with the broader behavioral principles, which would reduce compliance costs and expand flexibility for firms. Moreover, rules should be more risk-based to anticipate dangers to investors and markets. To make possible this change in regulatory approach, the SEC needs to modify its current approach to enforcement and supervision, which relies primarily on litigation, and adopt more of a prudential approach similar to that used by banking regulators. Even more importantly, the SEC and the SROs must avoid using litigation as a substitute for the formal process of drafting regulations. In addition, since many financial institutions and products are no longer easily differentiated by sector, the various regulatory agencies should foster greater cooperation and learning from one another, since actual consolidation of the various regulators is politically unlikely. Finally, there should be either greater harmonization between U.S. and foreign regulations or mutual recognition of each other's regulations, a proposal that would likely encourage foreign companies to do more business in the United States.

Edward F. Greene
Citigroup

The Committee is right to suggest that the United States has lost some of its competitive edge in financial services as a result of excessive, outdated, and inefficient SEC regulatory policy. For example, the SEC needs to improve the quality of its cost-benefit analysis, but because the agency is headed by lawyers and not economists, this change is unlikely to occur. In addition, the SEC's authority to reach anti-fraud settlements has had negative repercussions for U.S. financial services, namely because it has at times resulted in effectively new industry-governing regulations that were not developed through standard procedures. One way to improve the quality of U.S. regulation is to implement a more principles-based, prudential approach. While this is unlikely to be adopted throughout the SEC, mutual fund regulation, SROs, and the market system might be willing to adopt a more prudential as opposed to rules-based approach.

Kenneth M. Lehn
University of Pittsburgh

The Committee's recommendations for reform at the SEC are sensible, but should be bolder. Also, the SEC will be unlikely to adopt these reforms unless their incentives change. First of all, while the Committee is right to advise the SEC to conduct more cost-benefit analysis, cost-benefit analysis by itself will accomplish little. An alternative proposal is to have the Office of Economic Analysis (OEA) at the SEC issue an analysis and opinion of every rule proposed by the SEC staff, which does not have to include a cost-benefit analysis. An even bolder recommendation would be to allow the OEA to propose new regulations of its own or repeal existing ones. Regarding the Committee's recommendations about greater regulatory coordination between countries, it is important to recognize that "coordination" can end up resembling collusion, and this would deprive financial markets of the benefits of regulatory competition. Finally, in order to change the incentives of the SEC that make the agency averse to economic analysis, one possible solution is to make SEC funding independent from Congressional approval.

Panel IV: Shareholder Rights

Allen Ferrell
Harvard Law School

The Committee recommended that classified (staggered) boards should be required to obtain shareholder authorization prior to the adoption of a poison pill. A board can unilaterally adopt a poison pill--pursuant to the Committee's recommendation--in the face of a hostile bid, but must receive shareholder ratification of this decision within three months of adoption. According to econometric analysis, staggered boards tend to have a negative effect on the value of a firm. If a potential hostile takeover would be good for shareholders, they should have the opportunity to keep management from preventing it. The Committee also recommended that shareholders have the ability to specify in the corporate charter how securities actions should be handled. For example, shareholders should be able to decide whether disputes will be settled by arbitration or through a trial, and if through a trial, by a judge or jury. One advantage to this recommendation is that it recognizes that one size does not fit all and that different approaches might be superior for different firms with different shareholders. On the issue of giving proxy access to shareholders, the Committee found that it was to early to reach a conclusion. Many corporations have just started to adopt majority voting, and it will be necessary to see what influence this has on shareholder influence before providing yet another means.

Heidi M. Schooner
Catholic University of America

The Supreme Court has held that the arbitrability of a dispute depends on whether the parties agree to arbitrate and that, in turn, should be decided by applying state-law principles that govern the formation of contracts. Recent arbitration cases involving the enforceability of arbitration clauses found under the shrink wrap in the sale of consumer goods may provide clues as to how courts would evaluate the enforceability of an arbitration clause in a corporate charter. Courts are divided on the enforceability of arbitration clauses found under the shrink wrap. In the cases most favorable to the enforcement of such clauses (such as ProCD v. Zeidenberg), the court found the arbitration clause enforceable when the consumer was given the opportunity to read the arbitration clause and could reject the arbitration clause (and other boilerplate) by returning the goods within the specified time. This reasoning suggests that in order to have assent to a mandatory arbitration clause, the shareholder would have to receive the clause, have an opportunity to read it, and reject the shares before the contract was formed. The mere existence of the clause in the charter would not seem to coincide with shareholder assent. The availability of the arbitration clause in the prospectus prior to the actual purchase of the shares might be preferable but, of course, this does not help with shares purchased in the secondary market. In addition, while the Committee appropriately identifies the problems of excessive shareholder litigation, merely switching to a system based on arbitration might be an inferior solution. It is possible that judges and juries are not very good at distinguishing between meritorious and non-meritorious claims and that they too often allow non-meritorious claims to go forward. The arbitration solution, however, might simply substitute one type of error for another. Is the arbitration process any better at distinguishing between meritorious versus non-meritorious claims, or does the arbitration process simply ere on the side of denying the meritorious claim? Given, for example, the lack of pretrial discovery in arbitration, the errors in that forum may unduly favor defendants.

The Honorable Douglas H. Ginsburg
U.S. Court of Appeals for the District of Columbia Circuit

The Supreme Court has made clear that arbitration is a creature of contract and, to be enforceable, must be entered into knowingly and voluntarily. In the context of shareholder suits, the requisite assent to arbitrate might be implied by the shareholder's purchase of shares subject to the ordinary understanding that in matters of corporate governance the majority rules, so that a majority vote waiving shareholders' right to sue the corporation and substituting non-class arbitration therefore is deemed binding.

There is some risk, however, that courts will demand more in the way of prior notice to shareholders, because notice is indicative of whether there actually was an agreement to arbitrate and whether the provision was unconscionable and hence unenforceable. There are several ways of ensuring shareholders have notice, such as by disclosing the arbitration provision in the prospectus and limiting its application to purchasers of IPO shares; holding a shareholder meeting to vote on amending the charter B the Committee's proposal B which, also, could be reconsidered on a periodic basis to reflect turnover among shareholders; and widely publicizing the clause in SEC filings and reports to shareholders. Perhaps an issuer could make the arbitration clause evident each time shares are sold in the secondary market by identifying the shares as A common non-litigable shares. In addition to notice concerns, provisions in the arbitration clause that appear to burden a shareholder's ability to obtain relief, such as an inconvenient forum, a waiver of punitive damages, or a prohibitively expensive arbitration fee, make it less likely the arbitration agreement will be enforceable. Finally, to the extent these arbitration provisions include a waiver of class action rights, one should note that despite their excesses, class action lawsuits serve a valid purpose: to vindicate a claim where the expected recovery is less than the costs of pursuing it on an individual basis. This is particularly important where the claim being vindicated is grounded in a statutory right. An arbitration provision in a corporate charter need not preclude such claims, however; it could allow for class arbitration of claims below a certain low threshold or allow shareholders to collect costs on individual claims. Considering the variety of approaches that an issuer might take, it seems best to let the market determine the relative worth of such a waiver of suit in its pricing of shares.

AEI research assistant Daniel Geary prepared this summary.

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