The Committee on Capital Markets Regulation, an independent and bipartisan group comprised of 22 leaders from the investor community, business, finance, law, accounting and academia, yesterday issued its interim report with recommendations for changes in capital markets regulation based on the twin goals of enhancing shareholders rights while reducing excessive and overly burdensome regulation and litigation.
The Committee outlined 32 specific recommendations in four key areas – shareholder rights, the regulatory process, public and private enforcement and Section 404 of the Sarbanes-Oxley Act of 2002 – to improve the regulatory system and give U.S. capital markets the competitive boost necessary to respond to the increasingly aggressive efforts of other countries to attract equity capital markets.
“Maximizing the competitiveness of U.S. capital markets is critical to ensuring economic growth, job creation, low cost of capital, innovation, entrepreneurship and a strong tax base in key areas of the country,” said Glenn Hubbard, Dean of Columbia Business School and co-chairman of the Committee. “While U.S. capital markets historically have been the deepest, most liquid financial and lowest cost markets anywhere, the world is vastly different today. There are several viable markets for raising capital, and many companies now are using cost-benefit analysis – including the potential cost of litigation and the complexity of regulation – to focus on the competitive differences among the markets.
John L. Thornton, Chairman of the Brookings Institution and co-chairman of the Committee, said, “Investor protection and shareholder rights are bedrock principles of U.S. capital markets. The Committee believes that enhancing shareholder rights and facilitating more efficient regulation will strengthen U.S. market global competitiveness.”
Hal S. Scott, Nomura Professor and Director of International Financial Systems at Harvard Law School and Director of the Committee, added, “The Sarbanes-Oxley Act of 2002 helped restore market confidence after several high-profile scandals. However, the cost of auditing internal controls is unnecessarily high and can be brought down. The major problem is the cost of litigation, which can be addressed by resolving legal uncertainties and giving shareholders the right to choose more efficient ways to resolve disputes with their companies. We will continue to explore these and other issues affecting the competitiveness of our capital markets for the next two years and we look forward to a lively public discussion.”
Findings on U.S. Capital Markets Competitiveness
While some erosion of the historically immense U.S. market-share of global equity listings, trading and total equity financing is natural, it cannot fully explain why:
- 5% of the value of global initial public offerings was raised in the U.S. last year, compared to 50% in 2000.
- The U.S. share of total equity capital raised in the world’s 10 top countries has declined to 27.9% so far this year from 41% in 1995.
- The decrease in U.S. listing premiums erodes the traditional edge maintained by the U.S. on cheaper cost of capital.
- Private equity firms, almost non-existent in 1980, sponsored more than $200 billion of capital commitments last year alone.
- Since 2003, private equity fundraising in the U.S. has even exceeded net cash flows into mutual funds and going private transactions have accounted for more than a quarter of publicly announced takeovers. The increased use of private markets disadvantages the average investor, who typically cannot participate in such markets.
- The dramatic increase in the use of private U.S. markets is important evidence that regulation and litigation are keeping them out of the public market.
Key Recommendations
Following are highlights of the Committee’s recommendations from each of the four areas of the report:
Shareholder Rights
- Classified boards should be required to obtain shareholder authorization to adopt a poison pill, and if this is not done within three months, the pill should automatically be redeemed.
- The Committee endorsed majority – rather than plurality – voting, which is a cornerstone of shareholder rights, and the Committee will study how it may best operate.
- Shareholders should be given the choice to decide how disputes with their companies should be resolved – through arbitration (with or without class actions) or non-jury trials.
- The SEC should resolve issues on ballot access caused by a recent court decision.
Regulatory Process
- The SEC and self-regulatory organizations should move to a more risk-based regulatory process, emphasizing the costs and benefits of new rules. In weighing the costs and benefits of new rules, regulators should rely on empirical evidence to the extent possible. Also to the extent possible, regulations should rely on principles-based rules and guidance.
- The SEC should periodically test existing rules to ensure they still meet reasonable cost/benefit standards.
- Public enforcement bodies like the SEC, Justice Department and state securities commissioners and attorneys general need to coordinate their activities, providing for federal precedence where enforcement implications are national in scope. There should be more effective communication and cooperation among federal regulators. The President’s Working Group on Financial Markets is one natural venue for ensuring such cooperation.
Public and Private Enforcement
- Greater clarity for private litigation under SEC Rule 10b-5, and from the SEC on materiality, scienter (knowledge of wrongdoing) and reliance is needed. Criminal enforcement against companies should be a last resort, reserved for companies that have become criminal enterprises from top to bottom. We should not hold outside directors responsible for corporate malfeasance that they cannot possibly detect.
- Public enforcement authorities should not be allowed to threaten corporate defendants with denial of their employees’ right to due process.
- The SEC should protect outside board members against liability from relying in good faith on the validity of audited financial statements – otherwise, it will be difficult to attract independent directors to boards.
- Congress should explore protecting audit firms against catastrophic loss through the provision of caps or safe harbors, as do some European countries and as the European Union is actively considering. Any use of such protection must be balanced against stiff action against those responsible for misconduct.
Sarbanes-Oxley
- The SEC should adopt a more reasonable materiality standard both for internal controls and financial statements.
- The SEC and the PCAOB should adopt enhanced guidance on auditors’ roles and duties in testing for compliance with Section 404.
- If a revised Section 404 is too burdensome for small companies ($75 million market cap and less), even after the general reforms outline above are implemented, the SEC should recommend to Congress that small companies be exempt from auditor attestation and be subject to a more reasonable standard for management certification.
