Fears that the U.S. capital markets are failing to land their share of global IPOs have U.S. legislators and the business community re-evaluating the corporate governance and enforcement controls put in place following the market scandals earlier this decade. That spells good news for foreign issuers and Canadian companies that inter-list on U.S. exchanges. But is it good news for shareholders?
Relief is coming to companies that list on U.S. exchanges, as American authorities look to rollback some of the more controversial aspects of corporate governance policy and regulation that was put in place following the corporate scandals involving Enron and WorldCom.
Both the Public Company Accounting Oversight Board (PCAOB) and Securities Exchange Commission (SEC) are circulating new rules for comment that would ease the pressures on companies in living up to obligations under s. 404 of SOX.
But there are also private-sector initiatives underway to solicit change — as New York Mayor Michael Bloomberg and Eliot Spitzer, former crusading prosecutor-turned-governor, lobby for changes — over concerns that tougher oversight is driving companies away from U.S. capital markets.
Concern over market competitiveness has even prompted a blue-chip panel of corporate executives, professionals, and academics to band together and form their own committee to pressure regulators and legislators for change.
Committee calls for reform
The Committee on Capital Markets Regulation has issued its own interim report that goes farther and calls for changes to shareholder litigation and the ability for investors to launch class action suits. It is part of 32 recommendations put forward as part of the debate.
Hal Scott, a Harvard Law School professor in Boston who is director of the committee, says, “We’re seeing parts of the fruit of our labours. I think the proposals that are outstanding that have to do with so-called SOX 404, they have moved in the direction we have advocated; we don’t think they move far enough.”
James Cox, a professor of law at Duke University in Durham, N.C., says, “I think what’s happening is some adjustment. What you find is some necessary tinkering going on, some pretty big tinkering.”
That’s good news for inter-listed companies and the in-house lawyers who have to concern themselves with living up to U.S. corporate governance laws.
At the end of January, there were 202 inter-listed Canadian companies trading on both the TSX and one of four U.S. exchanges. The NYSE has the most with 86, followed by the Amex (68), the NASDAQ Global Market (39), and the NASDAQ Capital Market (8), according to TSX figures.
However, those 202 companies account for a significant portion of capital market activity here. At the end of December, Canadian-based inter-listed companies represented $1.17 billion, about 57 per cent of the total TSX market cap of $2.06 billion. So changes to U.S. corporate governance have a big impact north of the border.
Proponents of change are quick to dismiss the notion that there is a full-scale retreat or rollback in corporate governance underway in the U.S. “We’re certainly not rolling back any corporate governance,” says Scott.
SOX costs staggering
Rather, it’s more of a return to what it was supposed to be, says Joris Hogan, a partner with Torys LLP in New York. When SOX was first passed, the internal controls provision was not expected to “make a big impact,” says Hogan, and the SEC estimated it would cost companies about US$94,000 to comply.
However, he says, it quickly took on a life of its own, including a 300-page accounting standard issued by audit regulators, and the costs escalated. Financial Executives International, an association of financial executives, estimates the average cost of complying with s. 404 is US$4.36 million, while financial services consulting firm Charles River Associates pegs the costs at US$1.24 million for small companies and US$8.5 million for larger companies, or a total of US$15 to $20 billion in 2004.
It’s those spiraling costs that have raised alarms south of the border over the health of the U.S. capital markets and prompted a wide-scale revisiting of initiatives passed after the Enron scandal.
In January, New York City Mayor Michael Bloomberg and U.S. Senator Charles E. Schumer released a report commissioned by McKinsey and Company that warned, “New York could lose its status as a global financial market without a major shift in public policy.” The report says that strict regulation, litigation risk, and immigration policy were conspiring to drive business away from the country’s main capital markets, a key driver of the state economy. The industry is responsible for 2.2 per cent of all jobs in the state, 12.5 per cent of total wages, and 18.7 per cent of total tax receipts.
The report found that, “Left unchecked, the United States would miss out on between $15 billion and $30 billion in financial services revenues annually by 2011. Those revenues, if retained, could translate into as many as 30,000 to 60,000 jobs in the U.S.” Backing the announcement was N.Y. Governor Eliot Spitzer, who made his mark prosecuting high-profile executives accused of market manipulations that added to the governance crackdown. Now governor, Spitzer is singing from a different song sheet, joining the chorus of executives calling for better guidance on SOX and a cutback on runaway class action suits.
Declining share of global IPOs
The Committee on Capital Markets Regulation has also expressed concern about the health of the U.S. capital markets, noting in its extensive series of studies a serious decline in global IPOs on U.S. markets.
“Twenty-four of 25 of the largest IPOs in 2005 and nine of the 10 largest IPOs in 2006 to date took place outside the United States.” As measured by value, the U.S. share declined from 50 per cent in 2000 to five per cent and as measured by number U.S. share plummeted from 37 per cent to 10 per cent in 2005.
Not everyone is quick to point to SOX and related governance measures as the leading culprits in the declining competitiveness of U.S. capital markets. Professor Cox says, “I actually think the SOX legislation was quite balanced. SOX is blamed for a lot of things that SOX doesn’t do. It’s responsible for planting in foreign issuers minds that there’s a bogeyman in the U.S. capital markets and that bogeyman is Sarbanes-Oxley.”
He notes that the decline in the U.S. share of global IPOs corresponds with a number of other “macro monetary” factors. The U.S. dollar has declined, as its twin budgets’ deficits rise, which makes it “unattractive to foreign issuers raising money.” As well, U.S. large cap stocks have performed poorly during much of the last six years, creating further impetus to avoid investing there. In addition, the capital markets have become much more competitive in the fight to land listings and the NYSE and NASDAQ are no longer the premier games in town and high listing fees in the U.S. could also be a factor.
Ed Waitzer, former Ontario Securities Commissioner and a lawyer at Stikeman Elliott LLP in Toronto, points to the rise of private equity as another factor dissuading IPOs in the U.S. Private equity firms have raised billions of dollars in the past few years and are busy deploying it. He says it’s “pretty attractive” for companies to go private, where they don’t have to face quarterly earning reports and more oversight. He says that while SOX has “gone some distance in restoring the public trust . . . it has imposed some very significant costs and is a distraction for management running the businesses.”
Reforms under way
It’s clear that authorities are listening to the concerns. The PCAOB proposed changes that would scale-back internal audit controls. They would:
•direct auditors to focus only on the most important controls and emphasize risk assessment;
•revise the definitions of significant deficiency and material weakness, as well as the “strong indicators” of a material weakness;
•clarify the role of materiality, including interim materiality, in the audit;
•remove the requirement to evaluate management’s process;
•permit consideration of knowledge obtained during previous audits;
•direct the auditor to tailor the audit to reflect the attributes of smaller and less complex companies;
•refocus the multi-location testing requirements on risk rather than coverage; and
•re-calibrate the walkthrough requirement.
At the same time, the SEC is proposing new rules and guidance on how companies can comply with the internal controls provision of SOX s. 404. Hogan says it will allow management to use a top-down risk approach in deciding which internal controls are material to the company’s financial statements. He says it will provide management with a “safe harbour” so that “good faith attempts to follow the guidance” can’t come back to haunt them.
Waitzer notes a shift also in the Department of Justice’s prosecution policy, with the release of what’s become known as the McNulty memo, named after Deputy Attorney General Paul J. McNulty. This directive replaces the much-criticized “Thompson” memo, which was issued in 2003 by former Deputy Attorney General Larry Thompson.
In deciding whether to charge a corporation, the Thompson memo advised prosecutors to consider factors such as whether a company agreed to waive solicitor-client privilege and declined to pay legal fees for its employees, a move that brought the wrath of legal groups such as the Association of Corporate Counsel. It was also criticized by a federal judge in a case involving KPMG and tax shelters.
The McNulty memo, however, takes a step back from Thompson and requires prosecutors to seek written approval before requesting a company waive solicitor-client privilege and advises prosecutors not to consider the issue of a company paying attorney fees for employees when making a decision to charge a company.
Groups want more change
While the various changes are being well received by the corporate world, there still remains a host of outstanding issues. Both Bloomberg/Schumer and the Committee on Capital Markets want regulators and legislators to go farther — much farther.
For example, the Bloomberg/Schumer report calls on the government and regulators to:
•implement securities litigation reform with particular short-term emphasis on leveraging the SEC’s existing authority;
•ease immigration restrictions facing skilled non-US professional workers;
•recognize International Financial Reporting Standards without reconciliation for listing purposes and promote convergence of accounting and auditing standards;
•protect U.S. global competitiveness in implementing the Basel II Capital Accord;
•form an independent, bipartisan National Commission on Financial Market Competitiveness to resolve long-term structural issues;
•modernize financial services charters and holding company structures;
•establish a public-private partnership to promote New York’s local agenda by acting as the high-level liaison
between individual industry participants and the city, as well as by driving forward the partnership’s broader strategic plan for New York's financial services development;
•more actively manage attraction and retention for financial services;
•establish a world-class Center for Applied Global Finance; and
•look at creating a special international financial services zone.
Meanwhile, the Committee on Capital Markets’ 32 recommendations fall into four areas: shareholder rights, the regulatory process, public and private enforcement, and SOX.
Some of the more controversial suggestions include:
•requiring boards to obtain shareholder approval to implement poison pills;
•endorsing majority rather than plurality voting;
•providing shareholders with a choice on how disputes with companies should be resolved, i.e. through
arbitration, class action of non-jury trials. This would involve making it part of a corporation’s charter;
•more co-ordination among federal and state enforcement agencies;
•reforms to private litigation under SEC s. 10b-5 to eliminate double recovery between the SEC and class action suits. The report notes that in 2004, U.S. companies paid $4.7 billion in civil penalties and an additional $3.5 billion in damage under class actions, compared to $40.5 million in the U.K.; and
•protection of outside board members from liability for relying in good faith on the validity of audited financial statements.
One factor working in the reformists’ favour is the change in Congress, notes Cox. Neither representative Michael Oxley nor senator Paul Sarbanes, the two legislators behind SOX, remain in power.
In the meantime, the SEC has a de-registration proposal pending. Traditionally, once a company is registered in the U.S. it has been difficult to escape the clutches of the SEC. “Foreign issuers in the short term are going to see an easier way out of the U.S. if they don’t like it,” Scott says.