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What Sarbox Wrought—A Commentary by Jonathan Macey ’82

The following commentary was published in The Wall Street Journal on April 7, 2007.

What Sarbox Wrought
By Jonathan Macey ’82

The studies about what went wrong with U.S. capital markets are coming fast and furious. In November 2006, a market-oriented blue-ribbon Committee on Capital Regulation led by R. Glenn Hubbard and John Thornton observed that America was losing its dominance of world securities markets and urged modest deregulation. Next, in early 2007, a study commissioned by New York Sen. Charles Schumer and New York City Mayor Michael Bloomberg surprisingly urged more of the same.

The latest study, from a panel commissioned by the U.S. Chamber of Commerce, was released earlier this year and was the focus of a conference led by Secretary of the Treasury Henry Paulson. The studies are all quite modest and reasonable. Unfortunately, none of them appears fully to understand what is happening to global competition in corporate finance.

From the end of World War II until the middle of the year 2002, America dominated the world's capital markets surely and completely. Most securities traded here regardless of whether the issuers were U.S. or foreign companies. Markets here were thicker, deeper, more liquid and reputedly more honest than anywhere else.

Nowhere was America's dominance more complete than in the market for IPOs. Going public on a U.S. market, particularly the vaunted New York Stock Exchange, was a sign that a company had global reach among not only equity investors, but among bankers, customers and suppliers as well.

Over the years two divergent hypotheses emerged to explain America's dominance in the capital markets. On the one hand, economists pointed to structural features to explain America's singular position. After World War II, the U.S. was the world's only source of capital. Europe and Asia, especially Japan, were emerging from vast physical and economic devastation. In sharp contrast the U.S. was building, not rebuilding. The accumulation of U.S. savings and pension assets created the largest pool of investment capital in history.

Professional bureaucrats at the Securities and Exchange Commission and their allies in the corporate and securities bar had another theory. America, they said, was dominant thanks to its superior government regulations and protections for investors. According to this hypothesis, if a company didn't want to go public in the U.S. it must have something to hide.

On this view, the additional regulatory freight brought into play by the 2002 Sarbanes-Oxley Act should have been a godsend. By restoring the confidence in U.S. corporate governance that had been shaken by the Enron-era corporate scandals, America would assure its continued dominance of world capital markets well into the new millennium.

Alas, things have not quite turned out that way. Whatever good might be said of Sarbanes-Oxley (and there isn't much good to be said for its intrusive, circulatory and duplicative grab-bag of rules), the statute has triggered a complete change in the way the world views the U.S. as a center for capital formation.

Indeed, the relative decline of U.S. capital markets since Sarbox has, or should, put to bed the notion that more regulation is always part of the solution, rather than part of the problem. And in fact, the economists' hypothesis about this country's pre-eminent position was and is mostly right. America's dominance immediately after World War II was due to the fact that this country was for several decades the only game in the planetary town.

This early start gave the U.S. what is known as a "first-mover advantage," which is the competitive edge enjoyed by the first occupant of a particular market.

There are a variety of reasons why first movers often have an edge. In the case of U.S. capital markets, that edge arose from two sources. First, issuers, along with the underwriters and lawyers who advised them, became comfortable operating on our shores. For a business that abhors uncertainty, this put new rivals at a distinct disadvantage.

Second, from a marketing perspective, issuers selling securities outside of their home markets found themselves on the defensive. Underwriters and lawyers told these issuers that investors would worry that someone selling securities outside of the U.S. might be trying to hide something by avoiding the "transparency" required by U.S. capital-market regulation.

In other words, prior to Sarbox, issuers seen as trying to avoid the U.S. capital markets stuck out like a sore thumb. This made their securities hard to sell and served to entrench the U.S. as the dominant venue among the world's capital markets.

Sarbox upset this comfortable post-war competitive equilibrium. It is now becoming not just acceptable, but actually fashionable, for issuers to avoid U.S. markets. Unfortunately for the U.S., this means that even if the SEC granted relief to foreign issuers tomorrow -- or even if the entire statute were repealed -- the game has now changed.

Lots of companies already have gone public in London and Hong Kong (both of which have surpassed the U.S. in the market for IPOs) with great success; there is no longer any need to make an excuse for doing so. From a domestic policy perspective, this may be the largest hidden cost and unforeseen consequence of Sarbox. The U.S. has lost its first-mover advantage; there is no longer any fear that investors will think a company desiring to go public necessarily has something to hide if it chooses to avoid the litigation burden and SEC compliance issues in the U.S. Sarbox has given issuers what they have been waiting for: a reasonable basis for avoiding the U.S. capital markets.

All of a sudden it is no longer fashionable to be a U.S. public company: It's for suckers who can't access the piles of sophisticated "global" capital available elsewhere. U.S. financial institutions -- Bear Stearns, Goldman Sachs, Morgan Stanley, Merrill Lynch, JPMorgan Chase and Citigroup -- are moving their traditional business offshore to follow their clients. Nicholas Andrews, the Hong Kong-based head of Asia equities at JPMorgan, has gone so far as to tell the press, "It's irrelevant to us where companies list, we're able to help them in whichever market makes sense the most for their business."

Moreover, as noted by the Committee on Capital Regulation led by Messrs. Hubbard and Thornton, U.S. companies are staying private rather than face the dreaded one-two punch of the U.S. plaintiffs' bar and the SEC's regulatory juggernaut. Even more startlingly, some U.S. issuers are tapping foreign capital markets. Up from zero 10 years ago, last year more than a dozen U.S. companies went public -- in the U.K.

The SEC has recently proposed to give companies more flexibility in how their internal financial controls are tested under Sarbox's infamous Section 404. It has also proposed to extend the compliance deadline for the smallest public companies (those with a market capitalization of less than $75 million). Neither proposal has made a ripple in the tide moving away from U.S. capital markets.

If the U.S. is to regain its former position in the world capital market, much more will have to be done. Massive litigation risk remains, and compliance costs in the U.S. dwarf those in other countries. Underwriting fees in the U.S. are an order of magnitude higher in the U.S. than elsewhere. Since it is the same firms which are now underwriting new issuers all over the world, the cost differential reflects regulatory burdens and litigation risk.

We are in the midst of the greatest natural experiment in the history of finance. The three great pools of liquidity -- Hong Kong, London and New York -- all have modern trading systems. Under the thumb of the SEC, New York is competing along the vector of providing the "best," or at least the most, regulation. London lies in the middle, and Hong Kong does little in the way of actual enforcement. My guess is that the middle road will win.

Mr. Macey is deputy dean of Yale Law School.