In Defense Of Sarbox
The economics of regulation teaches that regulation only matters if it is binding and compels people to change their behavior. It also teaches that because binding regulation compels change, those subject to it oppose it. After all, they preferred doing what they were doing before the regulation was passed. That carries an important political lesson: those subject to binding regulation will want it repealed.
These academic musings have direct relevance to business’s attack on the Sarbanes-Oxley Act (Sarbox) regulating capital markets. The story being told is that Sarbox has raised the cost of doing business in America’s financial markets, thereby undermining America’s competitive position. However, close inspection reveals that there is little foundation for these charges. Instead, they provide a case study of business’s anti-regulation scare tactics.
From its inception, Sarbox has faced strong opposition. The initial argument was that the frauds associated with Enron (Lay and Skilling), MCI-Worldcom (Ebbers) and Tyco (Kowalski) were just a “few bad apples” and the “barrel” remained fundamentally sound.
That argument has been scotched by the CEO stock options backdating scandal that may extend to one thousand companies, with Boards of Directors also apparently implicated. The media has focused on the money involved, but the money is actually chump change relative to what CEOs are already paid. The real story is the illustration of just how corrupted much of corporate America has become. That means the “few rotten apples” story is no longer credible, and the “barrel” really is the problem.
Unable to invoke the rotten apples defense, business groups have now shifted to their traditional anti-regulation line that regulation costs jobs. Top business economists, such as Glenn Hubbard, Dean of Columbia University Business School, have been engaged to come up with arguments for diluting Sarbox.
The self-styled, “blue ribbon” Committee on Capital Markets Regulation funded by Wall Street money and co-chaired by Hubbard, recently issued a report recommending making shareholder class action suits more difficult to bring, lowering the legal liability of auditors and directors and easing accounting certification requirements. All this in the name of making America’s financial markets more competitive.
The committee’s central piece of evidence was that U.S. markets have seen a decline in foreign listings, and that there has also been a decline in the U.S share of initial public offerings (IPOs). This is supposedly proof of regulatory excess. But there is a very different and more plausible explanation: Foreign financial markets are catching up in quality of technology and regulatory governance.
With foreign stock markets becoming better, deeper and more liquid, there is less incentive to list in the usual places, including the U.S. Thus, since 2000 London’s main stock market has seen foreign listings decline 23 percent since 2000, the Deutsche BÃ¶rse is down 58 percent and Tokyo is down 39 percent.
With regard to IPOs, these have fallen in part because comparison is made with 1999 when the market was in the throes of a speculative bubble. When the NASDAQ was at 5,000, firms had an incentive to bring offerings to market as quickly as possible. It also explains why the premium received by foreign companies for listing in U.S. markets has fallen. In 1999 U.S. investors were paying bubble prices, giving foreign companies a premium relative to what they could get in home country markets.
Another committee argument is that there has been significant de-listing of equities through private equity takeovers, which is supposedly indicative of Sarbox increasing the cost of public listing. However, the reality behind the private equity boom is the mainstreaming of junk bond finance combined with increased income and wealth inequality. These features have driven private-equity funds in which the super-rich pool their wealth and leverage it to take companies private. That is the explanation behind the activities of the Carlyle Group, the Blackstone Group, KKR and the Texas Pacific Group. It has little to do with public listing costs.
William Niskanen, another leading conservative economist from the Cato Institute, claims that declining stock market price-to-earnings (PE) ratios are further proof of Sarbox’s adverse effects. His argument is that Sarbox has made companies less valuable to investors, which is reflected in lower PE ratios. However, it is well known that PE ratios are counter-cyclical, being highest at the end of recessions when actual profits are low but prices are high because profits are expected to increase with future recovery. As recovery sets in, PE ratios fall as profits rise. They have remained low during the current expansion because it has been so generous to profits.
The Hubbard Committee’s report is one-sided. It also illustrates the phenomenon of “deep lobbying” by conservative business groups. These well-funded groups commission â€œexpert” reports that contain unbalanced views. Those reports then get covered extensively in the media, thereby becoming the reference point for debate. In this fashion, the policy playing field is tilted in favor of business - something we are now seeing in the run-up to Treasury Secretary Paulson’s high-profile conference on capital markets planned for spring 2007.
Copyright Thomas I. Palley