When the blue-ribbon Committee on Capital Markets Regulation (popularly known as the Paulson Committee) released its Interim Report (here) calling for regulatory reform, it based its case for reform in large part on the U.S securities exchanges’ loss of market share in the global IPO marketplace. As The D & O Diary has previously noted (here), there are serious grounds on which to question this premise. Recent developments provide additional grounds on which to question many of the Paulson Committee’s presumptions. Several of these presumptions are reviewed below, in light of these developments.
1. Lower Regulatory Requirements Give Foreign Exchanges an
The Paulson Committee’s Interim Report focused in particular on London’s Alternative Investment Market’s (AIM) "hands off" approach to regulation. The Report noted that the U.K. has been "relentless in stressing its regulatory advantage and indicating its commitment to maintaining a ‘light touch’ in regulation." This lighter touch may be attractive to certain companies, but whether this is an advantage for investors is doubtful.
A December 20, 2006 Wall Street Journal article entitled "Uncertain AIM: A Hot Market In London Has Its Risks, Too" (here, subscription required), examines whether AIM market’s "laissez faire" approach may be "treacherous for investors" because some of the companies that have gone public on AIM are "intrinsically dangerous businesses." The article also examines the limitations of, and inherent conflicts of interest involved with, the AIM market’s system of "nominated advisers" or "nomads," who both vet potential deals and pitch the new company’s shares to the marketplace. Indeed, because of perceived abuses, AIM is "finalizing a new rulebook that toughens some standards" and "may be preparing further steps to restore confidence in the market." In the meantime, investors have suffered, The article cites examples of "unpleasant surprises" for AIM investors in the last 18 months, including one AIM company whose shares plunged 60% when the company disclosed one month after its offering that the oil field it was exploring was not "commercially viable."
The AIM experience suggest that while lax standards have made it attractive for weaker companies, that is not a sustainable "advantage." AIM’s belated attempts to shore up its oversight weaknesses underscores that the most important advantage a marketplace can have is investors’ perception of trustworthiness. U.S. market’s regulatory standards allow companies whose shares trade here to enjoy a valuation premium (see my prior post about the valuation premium here). A valuation premium, now that is a competitive advantage. A regulatory race to the bottom to attract marginal companies would be a huge step backwards.
One undeniably real advantage that foreign exchanges do offer is lower cost access, both in terms of lower underwriting fees and lower listing fees. Concerns about the competitiveness of U.S. securities markets’ competitiveness would be more appropriately focused on these cost disadvantages, rather than the regulatory integrity of the U.S. securities markets.
The U.S. securities markets have lost global marketshare for IPO business, but the causes are even more numerous and diffuse than the Paulson Committee assumes. The Committee’s Interim Report acknowledges that part of the reason for the decline is that foreign markets have improved. But as I have discussed previously (here), the biggest reason for the decline in the U.S. marketshare is the decline in the number of U.S.-based companies’ IPOs. This decline in U.S. companies’ IPOs may be due to cyclical reasons -certainly recent IPO activity gives reason to hope that this activity may be cycling back up. According to CFO.com (here), the number of U.S. based companies completing IPOs through November 2006 (186) represents the highest annual number since 2000. And according to the Wall Street Journal (here, subscription required), last week’s 16 offerings made it the busiest week of the year for IPOs. The recent high level of U.S. based company IPO activity raises the question whether the concerns the Paulson Committee seeks to address may be temporary and have less to do with the attractiveness of the U.S. exchanges to foreign companies than with the conditions for companies inside the U.S.
And even with respect to foreign companies, the decline in U.S. market share may be a reflection of the mix of foreign sources for IPO companies. As a December 18, 2006 Wall Street Journal article entitled "Israel Fades, China Takes the Lead on Foreign IPOs Listed in the U.S." (here, subscription required) discusses, Israel was "the most active foreign source of listing…by a wide margin" in the late 1990s. Since that time, the number of Israeli companies conducting offerings, both inside and outside the U.S., has been "sparse," primarily as a result of M & A activity in Israel. Also, in the 90s many of the Israeli companies "went public too early," but the "level of sales and profits that you need to go public are much higher now."
China has replaced Israel as the leading source of foreign offerings, but Chinese companies often have unique political or economic reasons for staying with local exchanges. And experience has shown that some Chinese companies may not be completely ready for the scrutiny of public ownership.
All of this should show that there are many reasons – the cyclical nature of the U.S. based IPO activity, declining IPO activity in key foreign countries – that are contributing causes for the decline in U.S. marketshare of global IPOs, and these causes certainly do not justify radical changes to the U.S. regulatory approach. Given these various factors, regulatory reform seems poorly calculated to alter the level of U.S. exchanges’ market share.
3. The U.S. Exchanges’ Loss of Global Market Share Will Hurt New York City, Its Businesses, Its Employees, and Its Taxpayers
Let’s be honest here. Nobody on Wall Street is starving. According to a December 20, 2006 New York Times article (here, registration required), securities industry employees in New York will receive almost $24 billion in compensation in 2006, up 17% from a year ago. Wall Street investment bankers are receiving record bonuses. (Goldman Sachs paid its 26,467 employees an average of $622,000 per person.) This translates into $1.6 billion in tax revenue for New York State and $580 million for New York City.
Remind me again: exactly what is the problem that New York City is facing and why does that justify gutting the U.S.’s strong regulatory regime? Isn’t it just possible that what makes all those New York investment bankers so filthy rich is that they have the privilege of working in a city with the most highly respected markets in the world?
Certainly if Wall Street is really worried about being competitive, it needs to take a hard look at its current level of profitability and then take another look at its underwriting and listing fees. Perhaps if Wall Street were a little less astonishingly profitable, the U.S. exchanges might be more attractive to foreign investors. But instead, according to news reports (here), NASDAQ plans to raise its listing fees, in order to support certain auxiliary services that it owns. That certainly is not going to make U.S. exchanges more attractive to foreign companies, or even to U.S. based companies.
The U.S. litigation culture does represent a burden. But as I have previously discussed (here), foreign investors increasingly are demanding accountability from company management, and increasingly are seeking (and getting) the ability to seek redress for alleged management misconduct in local courts. The most recent example of this is the class action (here) that investors in Australia initiated against senior officals at the Multiplex Group. (Hat tip to Adam Savett at the Lies, Damned Lies blog for the link). These kinds of suits will become even more common as foreign investors increasingly demand accountability from senior corporate officials. These trends mean that while the U.S. is more litigious, differences between the U.S and other countries in this respect are diminishing and will become less and less of a factor.
5. The Time is Right for Regulatory Reform
As I have previously stated (here), it is more than a little strange to be talking about regulatory reform so soon after the Enron criminal sentencings and in the midst of the options backdating scandal. But the call for reform is premature in other ways as well. An noted above, the causes of the ills the Paulson Committee seeks to remedy may in part be cyclical, and indeed there is some evidence that the evolution of the cycle will itself alleviate come of the issues with which the Committee is concerned.
Other evolutionary change may provide further relief without the need for an elaborate regulatory reform effort. Just within the last few days, the SEC (here) and the PCAOB (here) have announced efforts to address concerns about the requirements of Section 404 of the Sarbanes-Oxley Act, which is one of the Paulson Committees’ big issues. In addition, according to news reports (here), Pink Sheets LLC is looking at creating marketplace mechanisms that could prove more competitive with the AIM (refer also here). Incremental changes of these kinds may be more effective and cause less damage that a wholesale program of regulatory reform.
One thing is certain — the globalization of capital is neither a small nor a temporary phenomenon. According to an Ernst & Young study (here) released on December 18, 2006, global IPO activity was at record levels in 2006, and offerings from emerging market companies are leading the way. The largest offerings involve Chinese companies, and their listings on the Hong Kong Stock Exchange have given that marketplace the largest share of the new companies. The global economy is huge and dynamic, and financial capital has become increasingly global as well. But while the U.S. has lost manufacturing jobs to companies with lower environmental standards and fewer labor protections, few think the solution is for the U.S. to lower its own environmental standards or eliminate its labor protections. The threats and complications of the global economy represent very significant challenges, but we will not improve our lot by weakening ourselves just to compete. Just as in manufacturing, the most likely approch for success in the global economy for the financial services sector may lie in innovation, specialization and, most importantly, increased efficiencies.
4. The U.S. Litigation Environment Creates a Competitive
2. The U.S. Securities Markets’ Loss of Market Share is Due to the
Regulatory Burden and Threat of Litigation Here