Law and the market: the impact of enforcement.

• Author: Coffee, Jr., John C.

INTRODUCTION I. THE LEGAL ORIGINS DEBATE II. THE COMPARATIVE RESEARCH ON ENFORCEMENT A. Regulatory Structure B. Enforcement Inputs C. Enforcement Outputs D. A Special Case: Insider Trading E. Private Enforcement F. The Special Case of the United States G. Criminal Enforcement H. Enforcement Styles III. THE BONDING HYPOTHESIS IV. POLITICAL ECONOMY: WHY DO CML LAW AND COMMON LAW COUNTRIES DISAGREE OVER ENFORCEMENT? A. The Relative Need for Enforcement B. The Social Contract Theory C. The Political Consequences of Dispersed Ownership D. An Initial Summary V. THE POLICY TRADEOFFS A. Should the United States Relax Enforcement? B. Public Enforcement Versus Private Enforcement C. Reconsidering Public Enforcement D. Cross-Border Securities Regulation CONCLUSION INTRODUCTION

Are the U.S. capital markets losing their competitiveness? (1) A fascinating question, but what does it mean and how can it be intelligently assessed? This Article will explore the newly popular thesis that draconian enforcement and overregulation are injuring the United States and will offer a sharply contrasting interpretation: higher enforcement intensity gives the U.S. economy a lower cost of capital and higher securities valuations. This higher intensity attracts some foreign listings, but deters others.

This Article will proceed by first mapping the marked variation in the intensity of enforcement efforts by securities regulators in selected nations and then relating these variations to (1) the cost of equity capital, (2) the extraordinary listing premium that non-U.S., firms exhibit upon cross-listing on a U.S. exchange, (2) and (3) the alleged flight of some foreign issuers from the U.S. markets. (3) Once properly disaggregated, the impact of high-intensity enforcement appears to yield both costs and benefits. In overview, high-intensity enforcement may dissuade some issuers from entering the U.S. market and, thus, could be responsible for some of the asserted decline in the "competitiveness" of the U.S. capital markets. But, at the same time, other firms are attracted to U.S. markets. In effect, there is a separating equilibrium as foreign issuers go both ways. (4) The critical issue for the controlling shareholder of the foreign issuer (who is the real decision maker in most cross-listing decisions) is whether the private benefits of control that it will sacrifice by entering the U.S. market exceed (or fall below) the value to it of the higher securities valuation and reduced cost of capital that it will gain from cross-listing in the United States. (5)

More generally, enforcement may also be the hidden variable that explains much of the apparent difference in the impact of legal origins on financial development. For the last decade, academic theorists have been busily seeking to explain the differing pace of financial development and economic growth across nations. Although many theories have been offered, the best known have assigned a leading role to law and legal origins in their causal story. (6) These legal theories have been controversial, in particular because their proponents have been unable to identify any substantive legal differences that appear to be more than trivial, much less capable of explaining worldwide differences in financial development.

This Article does not seek to resolve the causal role of law in financial development. More narrowly, it suggests only that one legal variable--the level of enforcement intensity--distinguishes jurisdictions in a manner that can explain national differences in the cost of capital (especially between common law and civil law countries) and the valuation premium that foreign firms cross-listing into the United States (and only the United States) exhibit. Still, before one can assert that relative enforcement intensity explains differences in financial development, one must face a complicated question involving the direction of causality. Here, the deeper issue is: does high enforcement intensity precede or follow financial development? In reality, enforcement intensity appears to play a dual role: both enhancing share value for those foreign issuers that do cross-list into a high-enforcement legal regime and deterring other foreign issuers from entering high-enforcement jurisdictions. Depending on their goals, reasonable persons can disagree about whether the best policy response is to increase or relax enforcement intensity. As a result, the issue of the optimal level of enforcement intensity may be the common link among several ongoing and important debates, which need to be distinguished at the outset.

First, on the level of contemporary political discourse, a very public debate has begun over whether overregulation threatens the "competitiveness" of the United States' capital markets. The Committee on Capital Markets Regulation (better known as the Paulson Committee) issued an interim report in late 2006 concluding "that the United States is losing its leading competitive position as compared to stock markets and financial centers abroad." (7) Weeks later, in 2007, the Paulson Committee's report was followed by a similar study commissioned by New York Mayor Michael Bloomberg and Senator Charles Schumer and prepared by the consulting firm McKinsey & Co. (8) Going beyond the usual criticisms of the Sarbanes-Oxley Act, both reports found that transactions, listings, and trading volume are migrating to less intensively regulated securities markets, most notably those in London and Hong Kong. (9) Foreign issuers do not truly avoid the U.S. capital market, they assert, but instead access it through the United States' private markets (most notably through the Rule 144A market), thereby avoiding the public market and most of the SEC's mandatory disclosure requirements. (10) On this view of the data, Sarbanes-Oxley is a deterrent that has made the U.S. capital markets too costly for those issuers able to opt for other listings. So viewed, overregulation appears to be a force that constrains and retards financial development.

But an alternative view is at least equally plausible. A growing body of academic research has found that foreign corporations that do cross-list on a U.S. exchange seem to reap extraordinary benefits: (1) a valuation premium compared to otherwise similar firms that do not cross-list in the United States, which at least one study has found to average 37% for foreign firms cross-listing on a major U.S. exchange, (11) and (2) a significant reduction in the cross-listing firm's cost of capital. (12) Read together, this evidence gives rise to a double mystery: (1) What explains this positive market reaction? (2) Why do many foreign firms appear to be increasingly spurning a premium that is not available elsewhere? The most plausible explanation for the existence of this premium is supplied by the "bonding hypothesis," which explains that by subjecting themselves to the SEC's higher disclosure standards and the greater prospect of enforcement in the United States, foreign firms reduce their agency costs. (13) Although the finding of a listing premium for the stocks of foreign firms that cross-list in U.S. markets is now well documented and robust, (14) many remain skeptical of the bonding hypothesis, in large measure because the manner by which foreign firms bond themselves by listing in the United States remains uncertain.

Even if the source of this premium is uncertain, its absence elsewhere is conspicuous--much like Sherlock Holmes' dog that did not bark in the night. The principal other stock exchange on which foreign firms cross-list (namely, the London Stock Exchange) does not offer any similar valuation premium. (15) Although foreign securities markets can compete with U.S. markets by offering increased liquidity and visibility coupled with less regulation, they seemingly cannot offer valuation premiums. Nor do they appear to try, as they market their services instead by stressing that they offer "light" regulation and avoid imposing additional governance requirements on foreign issuers beyond those of the issuer's home jurisdiction. But this only deepens the mystery. Even if Sarbanes-Oxley did impose significantly increased costs for internal accounting controls, a valuation premium on the order of 30% or more would seemingly motivate rational issuers to accept very significant transaction costs. (16) To spurn this premium seemingly implies that these issuers are not seeking to maximize the value of their shares. Does this seem plausible?

This Article's answer is: it all depends on whose self-interest is to be maximized! Maximizing share value is not the only rational goal, particularly for a controlling shareholder who does not soon intend to sell. Although the corporation may have an interest in increasing its share value, this can be overridden by, for example, (1) the interest of its controlling shareholders in maintaining unfettered access to the private benefits of control; (2) a desire to retain business discretion and flexibility or to avoid specific governance norms required by U.S. exchanges; or (3) the fear (at least on the part of corporate managers) of enforcement penalties and the risk of private litigation in the United States. Simple as this answer sounds, its implication is that the United States might be the listing venue for higher-quality issuers that wish to pursue strategic plans that require them to obtain low-cost equity financing or to bond with their shareholders, while London (and other markets) instead provides a comfortable refuge for firms with a control group intent on enjoying either the private benefits of control or unfettered discretion. The result is a separating equilibrium, as some foreign firms list in the United States to bond and others migrate to London to enjoy "business as usual." (17)

Of course, this answer may be oversimplified. Corporations could well prefer to list in London for efficiency-enhancing...