As it turned out, I had to cut my remarks for the American Illness conference rather drastically. So here's what I planned to say:
Apologies for being unable to attend in person.
My paper for the conference is directed to the trend over the the last decade for U.S. capital markets to steadily became less competitive globally. The U.S. share of the global IPO market declined. Foreign companies long present in the U.S. delisted from U.S. stock markets, while U.S. firms went dark at an unusually high rate.
There are many reasons for this decline. It’s generally agreed that the growing maturity and liquidity of European and Asian markets is a very important factor.
But I believe the critical factor was the disproportionate growth of U.S. regulatory compliance costs and liability risks relative to other developed markets.
Before jumping into those topics, however, let me say a quick word about a subject that I excluded; namely, state corporate governance law. The Paulson report put particular emphasis on promoting shareholder rights. I don’t buy that for two reasons. First, unlike the issues we’re going to discuss, state corporate governance law has very limited extraterritorial impact. Second, the board centric model of US corporate governance has served us well for a long time. The current campaign for a more shareholder centric model rests on fundamentally flawed premises.
I don’t propose to say much about the litigation issue. Securities fraud and shareholder suits are part of the much broader problem of excess litigation. Projects such as the Manhattan Institute’s Trial Lawyers Inc. reports have well documented the negative impact the litigation industry has on our economy. Several of the papers at this conference also address this problem. Securities litigation and shareholder suits have some unique features, but they also deserve to be part of any global reform of class actions, tort law, and so on.
Instead, I’ll focus briefly on the issue of regulatory compliance costs. The paper focuses on Sarbanes-Oxley and has relatively little to say about Dodd-Frank. There are a couple of reasons for this. First, even though Dodd-Frank is a much larger Act, it ended up having a relatively modest number of corporate governance provisions. And, in fairness, the ultimate provisions are a lot less onerous than some that were proposed by folks like Senator Schumer in his Shareholder Rights bill.
Second, we don’t know yet what the costs of Dodd-Frank’s provisions will be, because most of them haven’t kicked in yet. In contrast, we know a lot about Sarbanes-Oxley’s costs and the adverse impact of those costs.
Finally, if you’ll permit me to veer into self-promotion for the moment, I’ve got a descriptive piece on the corporate governance provisions of Dodd-Frank that just came out in Engage and a normative piece that is forthcoming in the Minnesota Law Review.
SOX section 404 is the poster child for excess regulatory compliance costs, of course. The paper details the compliance process at some length so as to provide context for the analysis of the costs and benefits of the internal control assessment requirement.
I don’t deny that the 404 process probably has had some benefits. Unfortunately, it’s very hard to quantify those benefits. Most observers agree that 404 probably has reduced the amount of accounting fraud, for example, but nobody knows for sure by how much.
As for the costs, it’s true that the SEC and the PCAOB have made efforts to reduce the recurring costs associated with the 404 process. In particular, Auditing Standard No 5 eliminated a fair bit of duplication and wasted effort. We should also acknowledge that one good thing came out of Dodd-Frank; namely, the permanent exemption of microcaps from the auditor attestation requirement.
Even so, however, the evidence is clear that many 404 costs turned out to be not one-time startup costs, but rather to recur annually. Worse yet, 404 costs proved curiously resistant to scaling. Director compensation at small firms increased from $5.91 paid to non-employee directors on every $1,000 in sales in the pre-SOX period to $9.76 on every $1000 in sales in the post-SOX period. In contrast, large firms incurred 13 cents in director cash compensation per $1,000 in sales in the pre-SOX period, which increased only to 15 cents in the Post-SOX period. Likewise, companies with annual sales less than $250 million incurred $1.56 million in external resource costs to comply with § 404. In contrast, firms with annual sales of $1-2 billion incurred an average of $2.4 million in such costs. Accordingly, while SOX compliance costs do scale, they do so only to a rather limited extent. At many smaller firms, the disproportionately heavy additional costs imposed by § 404 are a significant percentage of their annual revenues.
There’s also very little doubt that the costs outweigh the benefits. On the one hand, SOX discouraged privately held corporations from going public. Start-up companies opted for “financing from private-equity firms,” rather than using an IPO to raise money from the capital markets. As I discussed at the outset, the post-SOX period saw the declining share of U.S. markets in such transactions as global IPOs and the trend for both foreign and US firms to exit the public US capital markets.
In light of this evidence, it is hardly surprising that all of the major reports on capital market competitiveness viewed 404 as a significant drag on the competitiveness of those markets.
Before leaving SOX, however, it’s worth reminding ourselves that while 404 gets 99% of the attention, the certification requirements in sections 302 and 906 significantly increase the regulatory burden on the CEO and CFO. In turn, because best practice requires the assistance of other key corporate executives, much of the top management team’s time is now be devoted to preparing these certifications instead of conducting business. In addition, of course, the heightened liability exposure created by these sections increases the risks to which these executives are subject, for which they will demand compensation. The monetary and opportunity costs associated with 302 and 906 compliance thus are also significant.
Why is SOX such a problem? It’s an example of what Larry Ribstein called a “bubble law.” There are three recurring problems with federal responses to the bursting of a stock market bubble. First, federal bubble laws tend to be enacted in a climate of political pressure that does not facilitate careful analysis of costs and benefits. Second, federal bubble laws tend to be driven by populist anti-corporate emotions. Finally, the content of federal bubble laws is often derived from prepackaged proposals advocated by policy entrepreneurs skeptical of corporations and markets.
Federal bubble laws tend to make corporate governance less effective and more costly. Unfortunately, federal corporate governance interventions have proven to be an example of what Robert Higgs identified as the ratchet effect. Higgs demonstrated that wars and other major crises typically trigger a dramatic growth in the size of government, accompanied by higher taxes, greater regulation, and loss of civil liberties. Once the crisis ends, government may shrink somewhat in size and power, but rarely back to pre-crisis levels. Just as a ratchet wrench works only in one direction, the size and scope of government tends to move in only one direction—upwards—because the interest groups that favored the changes now have an incentive to preserve the new status quo, as do the bureaucrats who gained new powers and prestige. Hence, Higgs argued, each crisis has the effect of ratcheting up the long-term size and scope of government.
We now observe the same pattern in corporate governance. As the paper shows, the federal government rarely intrudes in this sphere except when there is a crisis. At that point, policy entrepreneurs favoring federalization of corporate governance spring into action, hijacking the legislative response to the crisis to advance their agenda. Although there may be some subsequent retreat, such as Dodd-Frank’s § 404 relief for small reporting companies, the overall trend has been for each major financial crisis of the last century to result in an expansion of the federal role. The unfortunate conclusion thus seems to be that there is no cure in sight for the corporate governance aspects of the American Illness.
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