Committee on Capital Markets Regulation Calls for Legal, Regulatory Reform
November 30, 2006
On Nov. 30, 2006 the Committee on Capital Markets Regulation, a private sector committee of business and academic leaders, issued its Interim Report, containing recommendations for regulatory reform. A briefing on key findings of the report was presented in a webcast on November 30.
“As an overall matter,” the report states, “the committee concludes that the solution to the competitive problem of U.S. capital markets lies, on the one hand, in reducing the burden of litigation and regulation and, on the other hand, in increasing shareholder rights.” (These dual goals were described on the webcast as the “twin pillars” of the report.)
The report focuses on four broad areas where regulatory reform is needed – and includes a fifth area up front relating to overall competitiveness. These are:
1. Competitiveness/"loosen capital controls" (U.S. Securities and Exchange Commission (SEC) should make deregistration from U.S. market easier for foreign companies, since providing them easier exit may reduce their hesitation to enter);
2. Reform the Regulatory Process (SEC and Self Regulatory Organizations (SROs)) must do more rigorous cost-benefit analysis before and after rulemaking; focus on principles-based approach; federal and state enforcement should not be used for ad hoc rulemaking);
3. Enforcement (SEC should resolve uncertainties arising from conflicting court opinions as to Rule 10b-5 liability, particularly regarding materiality, scienter and reliance; DOJ should revise Thompson memorandum to prohibit prosecutors from seeking denial of legal fees and waiver of attorney-client privilege; Congress should consider liability cap for auditors/preventing catastrophic liability; regulators should not indict entire firm unless exceptional circumstances; SEC should reverse longstanding position that indemnification of directors is against public policy, and increase ability of directors to rely on auditors and company exec's as part of due diligence),
4. Shareholder rights (Shareholders of Corporations with Classified Boards Should be Able to Vote on
the adoption of poison pills and other takeover defenses, as well as adoption of alternate dispute resolution (ADR) procedures. In addition, the committee supports majority rather than plurality voting by shareholders)
5. Sarbanes-Oxley Section 404 (Committee does not call for amendments to statute (Sarbanes-Oxley Act) but calls on SEC and Public Company Accounting Oversight Board (PCAOB) to provide guidance to improve cost-benefit balance, such as a revised definition of materiality, rotational testing in support of annual assessment and encourage more use of judgment. After these changes are in place, depending on result of updated cost-benefit assessment, the committee states Congress may need to consider if special treatment for smaller companies is necessary. However, the committee does not support one approach suggested for smaller companies, of limiting scope of auditors or management's report to just the "design" of internal control.)
Committee Led by Hubbard, Thornton and Scott, Endorsed by Treasury Secretary Paulson
The committee, co-chaired by Glenn Hubbard, (dean of the Columbia School of Business and former chair of the President’s Council of Economic Advisers), and John L. Thornton, (chairman of the Brookings Institution, and former president of Goldman Sachs Inc.), had a diverse project team coordinated by Hal Scott of Harvard Law School, culminating in issuance of the more than 130-pages Interim Report.
Members of the committee include the CEOs of two of the six largest global audit firms (PricewaterhouseCoopers and Deloitte), the CEO of the Financial Services Forum and a number of corporate CEOs and chairmen, as well as leading attorneys, academics and investor representatives.
The report notes, “a few committee members had varying degrees of comfort with a few of the recommendations advanced in this report. Nevertheless, the report reflects a fair consensus of committee members’ viewpoints.” Additionally, the report “represents the work of the committee and not the institutions of which the members are a part.”
Formed in the private sector, the committee was nicknamed the “Paulson Committee,” following U.S. Treasury Secretary Henry Paulson’s endorsement of the committee in September, when he said: "I am pleased to learn The Committee on Capital Markets Regulation, an independent group of highly-respected leaders in each of their fields, will examine the competitiveness of the U.S. public capital markets… I look forward to reviewing their findings and ideas." (Source: committee press release)
In a speech on November 20, Paulson announced six principles for regulatory reform to strengthen the U.S. capital markets. The recommendations in the committee’s Interim Report issued November 30 are generally consistent with Paulson’s principles.
Changing Economic and Regulatory Landscape
The aim of the committee’s recommendations is to increase the competitiveness of the U.S. capital markets, and the interim report, the first report issued by the committee, is focused on equity markets.
The report warns against dismissing the importance to the U.S. economy of the loss of global IPO listings in the U.S., saying: “In 2000, 100 foreign companies were listing in the United States, raising $55 billion in capital. Last year only 34 foreign companies listed here, raising only $5 billion in capital.”
The significant growth of private equity markets is also addressed in the report, viewed in part as arising from the perceived higher litigation risk (particularly securities class action) and regulatory burden associated with the public capital markets. “Although almost nonexistent in 1980, the private equity market sponsored more than $200 billion in capital commitments in 2005. Although still small in total size compared to the public equity market… since 2003 private equity fundraising has outpaced net cash flows into mutual funds (Welch, 2005) and going private transactions have accounted for over a quarter of public takeovers… Buyout volume has exhibited substantial growth and, in 2003, surpassed global levels relative to mergers and acquisitions.”
Four Factors Contribute to Loss of Competitiveness
The committee identified four factors it believes are responsible for loss of U.S. competitiveness to foreign and private markets:
1. an increase in the integrity of and trust in major foreign public markets resulting from more transparency and better disclosure;
2. a relative increase in the liquidity of foreign and private markets, thus making it less necessary to go to the U.S. public equity capital markets for funding;
3. improvements in technology that make it easier for U.S. investors to invest in foreign markets; and
4. differences in regulation between the U.S. public markets and the foreign and private alternatives.
“There is little public policy can do to reverse the impact of the first three factors,” says the report, “but the United States could try to adjust its litigation and regulatory system so that we can continue to protect investors, but at a lower cost.”
FEI has also called for regulatory guidance to make the implementation of the SEC and PCAOB rules under Sarbanes-Oxley Section 404 more efficient and effective, as evidenced in prior comment letters filed by FEI’s technical committees during 2006, here, here and here), in testimony of FEI President and CEO Colleen Cunningham at the SEC-PCAOB’s roundtable on internal control (May 10, 2006) and in testimony of FEI Senior Vice President Grace Hinchman before the Subcommittee on Regulatory Affairs of the House Government Reform Committee (April 5, 2006).
Further, FEI’s Cunningham addressed the need to focus more broadly on litigation reform and reform of the complex regulatory environment, in her testimony before the Capital Markets Subcommittee of the House Financial Services committee March 29, 2006, in which she recommended:
o that FASB prioritize its conceptual framework and codification projects and follow with principles-based rulemaking, which must be practicable in application, understandable by preparers, users and auditors and result in information that is "auditable;"
o that regulators avoid second-guessing reasonable interpretations of standards, and avoid issuing "informal guidance" instead of formal rulemakings for significant matters that could lead to a large number of restatements;
o that Congress assist in correcting today's litigious environment; and
o that preparers, auditors and users of financial statements all participate in being part of the solution.
Statistics from Financial Executive International (FEI)’s March 2006 Survey of Costs and Benefits of Section 404 are cited in the Committee on Capital Markets Regulation’s report numerous times.
A detailed summary of the 32 recommendations in the Committee on Capital Markets report is available here. Note: the detailed summary is available as a service to FEI members only. If you are interested in learning about the benefits of FEI membership – and joining the professional association of 15,000 senior financial executives (including CFOs, Controllers, Treasury and Tax directors, Audit Committee members, and leading finance professionals in government and academia) – celebrating its 75th anniversary in 2006, visit the "about fei" page and membership info., or call FEI at 973-765-1000.
Prepared Nov. 30, 2006 by Edith Orenstein (eorenstein@FinancialExecutives.org), Director, Technical Policy Analysis, Financial Executives International (FEI). This summary does not represent FEI opinion unless specified.