Time for Change in the Capital Markets
Friday, December 1, 2006
Bureaucratic hedging in a new blue-ribbon report can't hide the need for fundamental reform.
The Committee on Capital Markets Regulation—a select group of experts from the academic, business and financial worlds—issued an interim report yesterday on the vexing question of whether and why the United States appears to be losing its pre-eminence among the world’s financial markets. The committee’s conclusion is that the U.S. decline is real and caused by excessive regulation.
There are two parts to the report. The first, and most interesting, is the data that the committee has assembled to assess the seriousness of the current situation. Here, the report adds significantly to the publicly available information. Among its more important findings:
The committee cited these and other findings in support of its view that the U.S. regulatory system is responsible for the decline in the dominance of the U.S. markets. This is important; in drawing this conclusion, the committee rejected the idea that the U.S. decline is the result of the growing sophistication and liquidity of foreign markets, the weakening U.S. dollar, or technological factors such as the vast improvements in global communications in recent years. A conclusion of this kind by a group so distinguished should help to build a political consensus for reform.
The findings are bound to become the most influential part of the report.
But given its findings, the recommendations of the committee are relatively conventional and weak, a result to be expected from a group with widely varied views and perspectives. The dominant theme of the report is “balance”: change is necessary, but not too much. From a committee report, one would not expect dramatic ideas, and they are not there. Most of the suggestions are no better than ideas that current government officials—say, the top officials of the Treasury Department and the SEC—could easily come up with on their own (and probably will) once they are convinced that action of some kind is necessary. That’s why the findings of the committee—rather than its recommendations—are bound to be the most influential part of the report.
Its recommendations are sensible, but in most cases either insufficient to address the underlying problem or impossible to implement. For example, the committee recommends that the SEC should establish “explicit principles of effective regulation that will guide its activities to meet its statutory obligations.” These should include a “carefully applied cost-benefit analysis” of its proposed rules and regulations. Cost-benefit analysis was emphasized in the Wall Street Journal article published by the co-heads of the committee on the day of the report’s release, and seems to be a key element of the report.
Cost-benefit analysis is a great idea, and in some limited circumstances it might be workable and desirable, but as a general precept for action it is not going to be of much assistance to the SEC. Consider a cost-benefit analysis of the Sarbanes-Oxley Act, which the committee praises as restoring investor confidence after the Enron and WorldCom events. How much cost should the SEC impose in order to get the benefit of restoring investor confidence? Some analyses of SOX put the cost to investors at $1.4 trillion; others put the actual out-of-pocket cost to companies at a small fraction of that. All these figures are disputed. A sound cost-benefit analysis is a fine idea, but how can the SEC (as they say in Washington) “operationalize” such a recommendation?
The report has an interesting section on the value of securities class actions, pointing out that they do not recover more than 2 or 3 percent of losses, and involve huge transaction costs. It cites studies that indicate the net recovery—all things considered—is zero. If in fact one of the items that is keeping foreign companies from listing their shares in the U.S. is the cost and risk of securities class actions, this might be an argument for limiting or eliminating class actions, perhaps for allowing the SEC to be the sole enforcer of 10b-5. But the committee doesn’t suggest this. Instead, it offers marginal reforms that leave the current costly system fully in place.
The report also considers how to protect audit firms from catastrophic loss. Among the recommendations is the idea of a cap on auditor liability. That’s one possible solution, but here as elsewhere the report does not attempt to address the underlying problems. These are the mistaken idea that auditors can detect fraud through their normal testing processes, and the broad certification language that auditors are required to use in their opinions. A statement by the SEC or the Public Company Accounting Oversight Board (PCAOB)—the regulator of auditing firms established by SOX—to the effect that the failure to find fraudulent transactions in a company’s accounts is not prima facie evidence of negligence, would go much farther toward reducing auditor liability in civil suits than trying to get Congress to impose a cap on auditor liability. In addition, as recommended several years ago by a group brought together by the American Assembly, the SEC, the Financial Accounting Standards Board, and the PCAOB should also work on a revision of auditors’ certifications under GAAP, so that auditors are certifying what they can actually know—for example, the amount of cash the company has on hand—and not a bottom line earnings-per-share number that is largely a management estimate.
It is significant that the committee decided to review only Section 404 of SOX and not the entire act. To be sure, Section 404 has received the most attention, and is the easiest target, but it would have been worthwhile for the committee to consider many of the other provisions. Maybe the act will be considered as a whole in the committee’s forthcoming final report. But even the committee’s recommendations on reform of Section 404 seem excessively modest in light of the many criticisms of its costs—and again the committee does not delve into the underlying problem, but addresses only the surface issues. The underlying problem is the liability of auditors when, in hindsight, it is found that some internal control—had it been in place—would have or could have prevented some major loss. As long as this is a real liability for auditors, they will have strong incentives to insist on the most complete set of internal controls that can be devised. In the face of this, the committee’s recommendation that the PCAOB consider a better definition of a “material weakness” in internal controls is a weak solution indeed.
The committee has provided a significant service by affirming that the decline in the pre-eminence of the United States among the world’s financial markets is real, and is the result of excessive and unnecessary regulation. No matter how modest the remedies they suggest, their findings stand alone as powerful evidence in favor of major reform.