“The U.S. pursues securities law violations with a regulatory intensity unmatched elsewhere in the world,” according to John C. Coffee, Jr., director of the Center on Corporate Governance at Columbia University Law School. In a talk titled, “Law and the Market: The Impact of Enforcement,” Coffee told the audience at a recent Wharton Impact Conference on international corporate governance that when it comes to creating good governance and adding value to corporations, securities law enforcement is critical and too often overlooked. “I am interested in the variance in enforcement intensity. Not what the laws on the books say, but what actually happens,” he said.
Securities law enforcement is important at the moment because it sits at the intersection of three current debates, Coffee noted. The first debate is whether U.S. capital markets are losing their competitiveness. The second is about the differences in governance between countries where the legal system is based on common law, like the U.S., U.K. and Australia, and those based on civil law. Finally, he said, enforcement may be a factor in the decision by companies to cross-list or migrate to one country or another.
When it comes to spending on securities regulation as a percentage of stock market capitalization, Coffee pointed out that the United States falls behind the United Kingdom, and far behind Australia and Canada. Overall, though, common law countries spend much more on securities law enforcement than civil law countries, and the United States brings far more actions and imposes much higher penalties — or “high intensity” enforcement — than England and many other nations.
“The U.S. imposes very draconian penalties,” Coffee said. In 2005, the U.S. Securities and Exchange Commission (SEC) imposed $1.8 billion in penalties, a 60-to-1 ratio when compared to the agency’s equivalent in the U.K., the Financial Services Authority (FSA).
Coffee also discussed differences in the size and structure of regulatory agencies.
In the U.K., the FSA budget for enforcement is between 12.5% and 13% of its total budget, which Coffee said is consistent with many other countries. The SEC spends around 40% of its overall budget on enforcement, and Australia spends even more — nearly 47% in 2005. Coffee also noted that the SEC has 1,200 attorneys working full time for the agency. The FSA, he said, maintains a “skeletal” legal staff and outsources cases when necessary. In Britain and many other countries, regulators place more emphasis on negotiating settlements to avoid formal enforcement actions. “They don’t like to keep a legal enforcement staff because they see enforcement as a last-ditch effort.”
In addition, he said, there are differences in the type of enforcement cases the SEC and the FSA choose to go after. The FSA does not bring many cases against corporations for financial irregularities, choosing instead to focus on broker-dealers who commit fraud against clients.
The SEC is more diligent about pursuing broader financial fraud. For example, about 12% of SEC enforcement actions are related to insider trading. Australia, too, is aggressive in pursuing insider trading cases. Coffee argued that Australia and the United States may experience greater political pressure to curb corporate abuse because shares are more widely held by individuals than in other countries where institutional holdings make up a larger percentage of securities ownership. “The retail level of ownership is probably the best predictor of the intensity of the enforcement efforts.”
Class Action Bounty Hunters
The United States, he noted, is just one of three countries — Australia and Canada are the others — that allow class action securities litigation. Of those, the United States is the only one that allows legal fees to be contingent on the award if the case is successful at trial — a factor that has created a group of lawyers Coffee compared to bounty hunters. “The contingent fee is the real engine of enforcement in the United States,” he said.
In Canada, where there is no national securities regulator, enforcement is “balkanized” by 13 provisional governments, according to Coffee. He pointed to research by Howell Jackson at Harvard University Law School that found the SEC alone imposed 384 times the sanctions imposed by Canada. If all U.S. government actions are added up, the figure rises to 718 times that of Canada.
Public actions, however, are only part of the enforcement picture, Coffee noted. U.S. government entities collected enforcement payments of $1.8 billion, according to Jackson’s research. Private actions, such as class action securities litigations, topped $2 billion. In 2005 alone, private sector enforcements totaled $9.7 billion (although $6.2 billion was due to cases against WorldCom).
Private enforcement actions represent a major liability for foreign firms choosing to list in the United States. Coffee noted that cases against the foreign firms Royal Ahold and Nortel are among the largest class action settlements in U.S. history.
If a foreign company issues just 1% of its shares in the United States, he added, it becomes liable to any infraction class action plaintiffs might wish to pursue on behalf of shareholders anywhere in the world. In effect, U.S. class action suits have become global class actions for companies that have cross-listed any stock in the United States. “For one percent of the equity and some improved cost of capital you take the risk that all shareholders could sue and threaten you with insolvency.”
If you list in New York, “you are not only vulnerable to American investors but vulnerable to the whole world,” he continued. “You are inviting disaster if your stock price falls. That is what lies behind a lot of the fear that is beginning to develop in Europe.”
The Bonding Hypothesis
In the wake of corporate scandals in the U.S., criminal enforcement is the “ultimate deterrence,” Coffee said. Citing research from cases between 1978 and 2004, he noted that some 755 individuals and 40 firms were indicted for “financial misrepresentation,” which he said is just a small subset of securities violations. In all, 1,230.7 years of incarceration and 397.5 years of probation were imposed, with an average sentence of 4.2 years.
Criminal actions are rare in England and Canada, whereas Australia and Japan have both been aggressive in criminal enforcement compared to other developed nations. On the whole, however, “there is very little criminal enforcement outside the United States,” he pointed out.
Is tougher enforcement driving companies to move securities listings to London and other exchanges? Coffee says the recent fall-off in U.S. listings is not related to enforcement, but to the sharp decline in market demand for new initial public offerings following the market collapse in 2000. “The United States was no longer attractive to do an IPO. That’s a different story than saying Sarbanes-Oxley scared them off.” A better test, he said, will be watching what happens with listings in the current market surge.
In Coffee’s view, U.S. markets will continue to be attractive to companies. Tougher laws and enforcement will give investors enough comfort that their investments will be safe, so they will be willing to pay a premium for U.S. companies. That lowers the listing companies’ overall cost of capital. Coffee called this idea the “bonding hypothesis.”
When non-U.S. companies cross-list in the U.S. market, they gain a reduction in the cost of capital, ranging from a minimum of 6% for Japanese companies that cross-list to 25% for Egyptian companies. On average, companies listing in the United States save 13% on their cost of capital, Coffee said, citing research by Wharton accounting professor Luzi Hail and Christian Leuz, an accounting professor at the University of Chicago.
Not all companies are primarily interested in gaining the most shareholder value possible and will continue to list in loosely regulated exchanges, he noted. “Many foreign issuers prefer to maximize the private benefits of control that minority shareholders can enjoy in foreign markets. Enhancing shareholder value is not a universal goal.”
If many of the legal protections enjoyed by investors in the United States were reduced, that might lead to more listings, and that would benefit the exchanges. “But those [listing] companies might be the ones that were previously deterred because the controlling shareholders want to enjoy the private benefits of control,” he said. “That would be a dubious achievement. It would not necessarily be attractive for investors. It would benefit the exchanges, but it would raise the cost of capital and injure the overall American economy.”
Coffee agreed that private class action securities litigation does create a strong deterrence to listing in the United States. It would be a mistake for companies to list in the United States for a small equity offering when the benefits of lower capital costs would not offset the risk of facing a catastrophic judgment. If reform or “relaxation” is considered, it should begin in this area, he added.
Finally, Coffee stressed the importance of attacking securities fraud and abuse through firm public policy, not only regulation. He quoted George Clemenceau, the French prime minister during World War I, who said “War is too important to be left to the generals” and proceeded to check in at the front lines one day a week for the duration of the war.
Coffee made the same link to the war on securities fraud. “Enforcement policy,” he said, “is … too important to be left to the discretion of the regulators.”