At a time when US relations with Old Europe are well off their all-time highs, it might seem utopian for an economist to call for transatlantic harmony.
I certainly wouldn’t. In the long quest to open up markets across borders, harmonizing has brought little more than strife and red tape. Trying to mesh A’s laws with B’s just tends to make new bad laws.
But there is another way. The European Union gave up trying to harmonize all their national financial market laws back in the 1980s, and opted for a radical alternative. After agreeing some limited base standards across the Union, they then agreed that when banks and exchanges based in A did business in B they could use A’s rules. This system, which combined mutual recognition of each country’s rules and standards with home market regulation, proved remarkably successful in integrating the 15 national markets.
An example of the opposite principle is to oblige A’s companies to adapt their most fundamental operating procedures, like their financial disclosure and governance regimes, to B’s procedures, and then radically to change the procedures once they’re in. So radically, in fact, that A’s companies are forced to violate A’s laws in order to obey B’s.
Welcome to the world of America’s Sarbanes-Oxley Act. Enacted in 2002 to address American corporate malfeasance, its extraterritorial reach is so wide that it’s hardly clear just whose Oxley’s being gored.
Because it applies to all companies listed on a US exchange, whether domestic or foreign, the act imposes sweeping new corporate governance and board structure requirements on a vast number of non-US firms, including 299 based in the EU and 183 based in Canada, as well as subjecting their directors to new legal liability in the US.
While the alarm around the globe has boosted the ranks of well-paid US lawyers and lobbyists in an effort confine the legislation’s reach, they are bound to be a losing investment. While the SEC is struggling to craft partial exemptions where the requirements actually clash with those in a company’s home market, its power to do so is limited. More importantly, exemptions address only a symptom of a much deeper problem. If you list on a US exchange, you will always be subject to the whims of US legal and regulatory reform.
So why have so many non-US companies listed on US exchanges? To hear the New York Stock Exchange tell it, it has to do with that great institution’s unparalleled place at the center of the US capital market. (Never mind its periodic threats to move to New Jersey.) Foreign firms happily fork out millions in legal, accounting, and exchange fees to produce American Depositary Receipts (ADRs) because American investors have such great faith in the exchange that has housed Justice Department favorites like Enron, Tyco and Computer Associates (on whose board the NYSE chairman sat from 1994 to 2002).
Listing is, in fact, the NYSE’s number one money spinner, accounting for over a third of annual revenues. And foreign blue-chip company listing is a big target for the Exchange, as big guys pay the fattest fees.
Yet Vivendi Universal, a nominally French company with a massive US presence, recently revealed that a mere 8.9% of their shares were held in the form of ADRs traded in New York. This is because the underlying shares on Euronext Paris are more liquid, and American institutions prefer to trade them there.
So just why do these ADRs exist? Back when the world’s major capitals were filled with living museums of capitalism like the NYSE, share trading was necessarily fragmented across far-flung trading floors. But most of the world’s markets have since evolved from the Neanderfloors, and virtually all stock exchanges outside of lower Manhattan now use some variation of the wholly electronic market run from Toronto by the TSX. For such exchanges, geography is irrelevant.
But that doesn’t mean that regulators are irrelevant. Whereas electronic middlemen can and do move orders across borders faster than a floor broker can penny jump a limit order, SEC regulations barring foreign exchanges from operating “in” the United States mean that too many of these middlemen are collecting tolls along the way. Eliminate the ones that are only there because of outdated regulations, and trading stocks electronically on foreign exchanges from the US would be so cheap that ADRs would finally go the way of the dinosaur.
So why won’t the SEC allow exchanges like the TSX to have US-based brokers as members, trading electronically on the exchange just like their cousins north of the border do? Ostensibly, to protect US investors from the dangers of foreign stocks. But the only ones actually “protected” are the NYSE and Nasdaq, which can attract US order flow in Canadian stocks thanks to the regulatory “tax” on orders directed to the TSX. American investors cannot logically be protected by an SEC ban on US broker access to the TSX: first because US investors are already free to tell any broker to buy any foreign stocks they wish, and second because the relationship between a US investor and a US broker member of the TSX would be wholly regulated by the SEC itself. Such protection, therefore, amounts to little more than protectionism.
What is the solution? Former SEC chairman Harvey Pitt went public with his willingness to turn it into a trade issue: you show me your market and I’ll show you mine. Whereas it would be better for the world if the SEC stuck to regulating rather than trade negotiating, reciprocity is clearly the best way to get politicians to act.
But the track record on financial market reciprocity between the US and Canada is poor. The 1991 US-Canada accord creating a “Multi-Jurisdictional Disclosure System” facilitated reciprocal access for US and Canadian listed companies to each other’s national capital markets. In practice, its primary effect was to allow Canadian firms with a market cap of at least $75 million to list on a US exchange using their Canadian disclosure documents.
There are three major problems with it. First, the SEC subsequently changed the ground rules, most notably when they reinstated the requirement to reconcile Canadian company financial reporting to US GAAP in 1993. Second, Canadian cross-listers still found themselves subject to US civil court action, particularly class-action suits, related to inadequate or inaccurate disclosure. Finally, cross-listing to bring Canadian companies closer to US capital is more costly to both the US investors and the Canadian companies than simply permitting Canadian exchanges to provide trading access in the US.
So is reciprocity doomed? Not at all. The solution is to make exchange access, rather than issuer access, reciprocal. Non-US issuers would thereby be exempt from having to adapt their disclosure and governance systems to those required by ever-changing US exchange listing rules, such as Sarbanes-Oxley.
In a report published in December, I detailed precisely how such reciprocity could be quickly implemented between the US and EU. With the cooperation of the US Treasury, the SEC, the European Commission, and the ECOFIN council of European finance ministers, US and EU exchanges would be able to provide direct trading access to brokers and institutional investors in the other’s jurisdiction on the basis of mutual recognition and home country control. This proposal was strongly endorsed by both the European Commission and the Federation of European Securities Exchanges (FESE).
In speeches made earlier this year in Paris, New York, and Toronto, TSX CEO Barbara Stymiest proposed that Canada and the EU conclude precisely this such arrangement between their two markets. This would give the TSX the ability to allow EU brokers, and institutions (if the TSX wishes), to transact as members directly on the TSX trading platform, side by side with Canadian members. Canadian companies would not have to cross-list, adapt their disclosure documents, or change their governance procedures. Reciprocally, Canadian brokers and institutions would have the same opportunities to become members of EU exchanges, allowing Canadians to invest in European securities more cheaply. FESE has reacted positively to Ms. Stymiest’s proposal, and I have little doubt that the European Commission will as well, once the Canadian government comes forward with an official endorsement.
Of course, the wider goal of both my proposal and Ms. Stymiest’s is to create a vast, integrated transatlantic securities market, one that will increase investment returns, lower capital costs and increase growth and living standards across North America and the European Union. I estimate in my report that a full integration of the US and EU securities markets, spreading best practice to each, has the potential to cut trading costs by 60% and the cost of equity capital by 9% on both sides.
Capitalists of the world unite! You have nothing to lose but your ADRs.
This piece was originally published in Financial Post (Canada) on March 27, 2003. Reprinted with permission.