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AmericasApril 1 2007

Can New York break free?

As the global financial services pie expands, New York City’s business is contracting and many blame this on unfavourable regulation. Dan Barnes reports on the prospects for regulatory reform.
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“We have it within our power to take sensible, effective steps to ensure that US markets are the most fair, efficient, transparent and attractive in the world. The question is, can we find the political will to take them,” asks the Commission on the Regulation of the US Capital Markets in the 21st Century, in its March 2007 report. New York City (NYC) is losing business; its prized title as the world centre for capital markets is contested from abroad and, for those fighting to keep it, the rallying cry is “reform”. Reform of the immigration restrictions that are starving the city of talent, of the regulations brought in to prevent recurrence of the disastrous corporate scandals that marked the beginning of the 21st century and of the structure and culture of regulation. The city wants to be loosened of its regulatory chains.

But New York’s current restrictions are in place for a good reason. This is the city that became a hunting ground for then district attorney Eliot Spitzer early in the century, as he exposed the duplicitous analysts inflating the dotcom bubble. Then there were the tragic terrorist attacks of September 11, 2001; border security across the US was tightened as a result. Further blows came as Enron, WorldCom and Tyco International demonstrated that corporate oversight was open to abuse. These scandals reduced the ‘Big Five’ accounting firms to four and engendered the toughening of corporate governance with the introduction of the Sarbanes-Oxley Act.

Rules for US protection

The world economy has recovered from these shocks but the rules protecting the US and its citizens are still in place. The effect, according to a McKinsey report released in January, has been to hold back the US financial centre’s ability to compete in what is now a very global environment.

The report, commissioned by New York mayor Michael Bloomberg and senator Charles Schumer, indicates, for example, that between 2002 and 2005 the city’s employment in financial services fell by 0.7%, a net loss of more than 2000 jobs. This does not appear to be a general market trend – London grew its workforce by 4.3% in the same period, roughly 13,000 more jobs. The report also indicated that large hedge funds are moving away from New York, where 28 resident in 2002 were reduced to 18 by 2006; while London’s numbers are increasing: three resident in 2002, rising to 12 last year. The latest Global Financial Centres Index by market intelligence provider Z/Yen places London as the most competitive of all financial centres and cites respondents as saying that Sarbanes-Oxley is the main negative factor against New York, which is placed at number two.

The McKinsey report concluded that lost business was a result of tough immigration policies (one source for The Banker notes that 40% of Chinese visa applicants that they have seen are declined), an increasingly litigious atmosphere (the value of settlements had gone from $1.6bn in 2000 to $3.5bn in 2005, not including exceptional settlements such as Cendant and WorldCom), the cost of regulatory compliance (with Sarbanes-Oxley commonly cited as the major challenge) and multiple regulators.

The “will” that the Commission for Capital Markets seeks depends on the authorities believing that they can relax some of these regulations or rework them into a system that frees up business, with the acceptance that regulatory reform will do more good than harm.

Bigger pie to slice from

There is little doubt that NYC is losing business. According to Thomson Financial, in 2006 $38.8bn of capital was withdrawn from the New York Stock Exchange and $11bn from Nasdaq. In contrast, there was growth in initial public offerings (IPOs) of more than 50% on both Euronext and Deutsche Börse. However, there are normal economic reasons for some of this movement. A certain amount of business is being conducted overseas because markets are maturing, giving them the ability to carry out functions that New York would have traditionally handled.

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Arnab Das: market-oriented reforms and liberalisation of financial centres is changing global financial markets to create a ‘bigger pie’

As Arnab Das, managing director for emerging markets research at Dresdner Kleinwort, says: “The pie is getting bigger and the pieces more evenly distributed.” Through the process of financial deepening, “where countries had stunted or non-existent financial markets – for example in command economies where you have directed credit based on a central plan – you didn’t have a financial market, for example in the Soviet Union, China and to a degree in India”, he says. “That is changed through market-oriented reforms and through liberalising the financial centre. That, in turn, is bound to create this process where financial markets grow much faster and become more liquid than they were, eventually growing faster than the economy grows.”

This in itself puts New York in a weaker comparative position. Mr Das says that, although there has been a shift of IPO activity towards London – partly due to efforts to avoid stronger US disclosure rules – he does not see any shift of general trading activity away from the US and toward Asia or the Middle East, only natural growth in those regions. Taking established markets alone, however, the tension has been showing.

Race to the bottom

There has been talk of a ‘race to the bottom’, in which it is suggested that companies are keen to work in the least regulated and least expensive environment – the implication being that ‘better run’ markets could be penalised for their rigorous standards. Across the Atlantic, this has sparked a war of words. John Thain, chief executive of the New York Stock Exchange (NYSE), said in January that London’s Alternative Investment Market (AIM) “did not have any standards at all and anyone could list”. And in March, Roel Campos of the Securities and Exchange Commission reportedly claimed that 30% of AIM -listed companies were “gone in a year” and likened AIM to a casino. The London Stock Exchange (LSE) leapt to its defence, stating that only 3% of companies listed on AIM failed annually in line with the main market.

However, Mr Campos amended his comment when speaking to the Financial Times, saying that what he was referring to was a “generalised situation in which if [regulatory] standards are ignored and you have a spiral downward, you could get into a situation where an exchange could be nothing more than a casino”.

In a letter to the Financial Times, LSE CEO Clara Furse responded in person to US critics of AIM, writing: “Rather than navel-gazing based on the dubious premise that the US is ‘the home of capitalism’, they might be better served by accepting that the flow of capital is global and will seek out the most efficient and effective marketplaces.” New York-based exchanges have themselves been keen to move to foreign shores: the NYSE has acquired Euronext, and Nasdaq bought up 30% of the LSE following a failed takeover bid.

Systemic burden

The cost of the regulatory burden is not only to New York, but to the US as a whole, as Anthony Sabino, professor of law and business at St John’s University in New York, notes. “If you look at criticism of Sarbanes-Oxley, the American regulatory system and the American legal system, those issues are systemic; if you go to exchanges of Chicago or Philadelphia, it’s the same law.”

However, according to the deputy mayor of New York, Daniel Doctoroff, the Bloomberg administration reorganised its economic development teams into industry-focused groups when it took office, and began to gather anecdotal evidence that the city was losing market share in some sectors of the financial services, such as the securities sector, and this began the introspection. He accepts that there will be some natural drift but says that the research has highlighted key areas in which the city did not have to lose out.

“One of the things that people always pointed to, that we viewed as somewhat less important, was the IPOs of large issuers. There were others that we were seeing, such as hedge fund activity, the derivatives business and a handful of others, where the trend was certainly not positive. We see ourselves retaining the global leadership role but we don’t want to wait until we lose that role before we act,” says Mr Doctoroff.

The torch has been taken up by the great and the good around Wall Street. Few stand against the idea of reforms, according to Mr Doctoroff. “On a bipartisan basis, the response has been extremely positive. On the republican side, you have [Treasury] secretary [Henry] Paulson, who clearly understands the global dynamic of the securities industry, and SEC chairman [Christopher] Cox has been very supportive. And the Democratic side has been equally supportive: senator Schumer is in a very powerful position, sitting on the Senate finance committee and the committee on banking, housing and urban affairs. Significantly, [New York] governor Spitzer, who is viewed as the pre-eminent defender of shareholder rights, also endorsed the report.”

Reforms and risks

The question is: which reforms can be made without increasing the risk that they initially reduced? The McKinsey report makes the point that a “highly skilled workforce is essential for the US to remain dominant in financial services” and that immigration policies are limiting this. The issue of immigration visas can be dealt with through improvements to the entry system, which is a matter of additional resources and financing.

Kathryn Wylde, president and CEO of the Partnership for New York City, says that the change in Congress at the end of last year has already set the scene for such reforms. “Some of the more protectionist views were coming out of Congress. They had the problem with Dubai Ports [purchasing P&O and so controlling some US port facilities] and [Chinese oil corporation] CNOOC buying Unicol,” she says.

She believes that the strength of opinion behind these revisions and the strength of leadership makes for a strong case. “It is being made at the national level, at the New York level, by business and by public sector leaders. The fact that the blues (Democrats) now have a majority in Congress has set a different power equation in place and, as a result, in 2007 I think we’ll see significant movement on all the issues that have been raised.“The biggest challenge will still be tort (litigation) reform. We haven’t yet worked out how to be a less litigious society,” she says.

Litigious nature

The “broader reforms” that the McKinsey report recommends for principle-based regulation, along with its second point of discouraging “frivolous” litigation, could be an enormous challenge.

Tom Russo, chief legal officer at Lehman Brothers, identifies a couple of possible options for reforming the regulators. First, the US could copy the UK’s principles-based Financial Services Authority (FSA) in style completely, which would involve the merger of various supervisory agencies under one roof; something that he says “would be very challenging to get through Congress and, quite frankly, a lot to ask”. Another would be to use the President’s Working Group on Financial Markets, chaired by the Treasury secretary and containing representatives from the SEC, the Commodity Futures Trading Commission and the Federal Reserve System, as a “principles co-ordinator”.

“The President’s Working Group could be used as a co-ordinating vehicle to draft a broad set of principles that would guide regulation in the US,” says Mr Russo. “Each agency would then seek to follow those principles and implement them within the confines of their own rules. That is one way in which you could get the co-ordination without the difficulties of merging the regulatory structures.”

To the degree that the US moves toward a more principles-based system, Mr Russo believes that it is a good step, although not without risks. “To the extent that US regulators get more principles-based, it is a good thing in that it creates flexibility, without being confined to rules that quickly become outdated,” he says.

He says that although the system works in the UK, in the litigious US, “there would be fewer ‘bright lines’ and that could create a field day for plaintiffs’ lawyers. So you would have to be very careful in how you do that. In certain areas, you may still need rules for clarity purposes.” A balance between rules-based and principles-based regulation could be struck, although it would have to be balanced with higher standards for plaintiffs’ lawyers so as not to add to the litigation problem, he adds.

Regulatory culture

Such a move would mean a change to the regulatory culture in the US if reforms were to work, says professor Julia Black of the Law Department at the London School of Economics. She notes that principles-based regulation is seen as a panacea, creating increased flexibility for firms, increased innovation leading to competition helping the macro economy and increased substantive compliance assisting regulators and the regulated companies. But she warns that this can only come about if the business has a relationship with the regulator.

“When they are checking on their own compliance and have uncertainty, they must be able to sit down with the regulator and have a grown-up conversation about it,” she says.

Ms Wylde cites an anecdote that indicates how far the regulator is from this. “At a recent lunch, Callum McCarthy [chairman of the FSA] told a group of US bankers that he hoped that bankers in the UK would always come to him with their problems. The American bankers looked aghast and one said: ‘It is unimaginable that the SEC would ever invite us to discuss our problems’.”

In comparison with London, a city with a single regulator and principles-based regulation, New York has the rules-based regulation necessary to provide a legal line in the infamously litigious US and multiple regulators: a securities broker is likely to report to the National Association of Securities Dealers, the SEC, the CFTC and any state regulator. To change this would require an enormous upheaval of law, authority and possibly investor protection.

Investor protection

The greatest concerns for investor protection are associated with the discussion of reforms to the Sarbanes-Oxley Act. Mr Russo says that the challenge in getting reform passed will be the way in which it is promoted. “If you couch this as the investors getting less protection, then you get one answer; and if you couch it in terms of keeping people’s jobs and making the US more competitive and that regulations have gone too far, you may get another answer. It depends to some extent on how you ask the question,” he says.

Many regard the current rules as fully justified, given the impact that poor transparency and corporate governance had on the global economy earlier in the decade. Mr Sabino says that complaints about Sarbanes-Oxley are unlikely to garner much support for two reasons: “First, I don’t believe that Sarbanes-Oxley would have prevented Enron but it would have greatly diminished the impact. Big business asked for this and got what they deserved. Second is about the cost of compliance: there is always a cost to doing business. In the case of Sarbanes-Oxley, big business complains about the cost but they don’t hesitate in passing it on to the consumer, whether public or industrial. I’ve yet to see a Chapter 11 filing [bankruptcy] blamed on Sarbanes-Oxley – it’s just not going to happen.”

Mr Sabino says that compliance with the regulation is very positive for business, the investor and the marketplace. “The benefits for companies that can comply with Sarbanes-Oxley are significant. It is a qualitative measure but the bottom line is that this is a credibility factor that can’t be diminished.

“If you look at the recent stock meltdown in China, as recent reports have said, there were companies there that no-one understood, yet they’ve driven up the stock and then collapsed. In America, our system may not be foolproof but the American markets are much more protected against that,” he says.

A recent report from research company Glass, Lewis said that Sarbanes-Oxley is now proven to be good for investor protection – despite companies’ protests. In 2006, the report said, a record one in 10 listed companies in the US filed a restatement of their financial position, compared with one in 12 in 2005, the significance being that “the median stock return of companies that filed restatements last year was minus 6%”. It said that Sarbanes-Oxley, particularly section 404 (which requires a company to produce an internal control report that affirms the “responsibility of management for establishing and maintaining an adequate internal control structure and procedures for financial reporting”) is improving business practices and is therefore to be supported. “Without it, we feel certain that investors still would be relying today on false financial reports at many of the 2198 companies that restated their accounts in 2005 and 2006,” said the report.

The Glass, Lewis report also noted that the dubious practice that it refers to as “stealth restatements”, in which companies “didn’t file amended financial statements and didn’t make the proper Form 8-K filings with the SEC to warn investors that their past reports weren’t reliable”, has risen in number from 163 in 2005 to 254 in 2006. These companies included Tyco.

Regulations are changing

Some reform has already been announced by the SEC. It is changing the requirement that foreign companies that have de-listed from US exchanges are still subject to SEC regulation if they have more than 300 American shareholders. If a company can now show that the average daily volume of trading in its shares in the US was no more than 5% of its total volume of trading over 12 months then it can it will be free to de-register from the SEC – the primary advantage being that companies de-listing can now escape compliance with Sarbanes Oxley and associated costs.

Mr Doctoroff is keen to point out that “we’re not calling for Sarbanes-Oxley to be repealed”. Almost all of the financial services executives that were interviewed for the McKinsey report said that Sarbanes-Oxley in general was a positive regulation with one main problem, he says. “There is Section 404, where there is great uncertainty over what is required. Executives and accounting firms are pleading for greater definition in terms of standards and the vast majority of policy makers have been pretty responsive to that,” he says.

The policy makers will tread carefully around this issue. If Mr Spitzer was seen as the defender of shareholder rights for tightening regulations, any relaxation could be perceived as damaging to investors, although Ms Wylde notes that his support for reform will balance opinions somewhat. “Mr Spitzer coming in to support this was really significant for public sector officials who were nervous of being accused of forgetting about the scandals that instigated this measure,” she says.

The route of progress

So the major players in the capital of the US financial system have some big changes to make. And they have to make them without reintroducing the risk that existed prior to the regulations and systems being put in place.

According to AB Culvahouse, co-chair of the Commission on the Regulation of US Capital Markets, a balance can be struck, “First, [regulators] need to ensure investor protection and capital formation are balanced. Second, the parts of the SEC that are responsible for regulating US financial institutions should be realigned to reflect the global marketplace. The examination and enforcement function need to be more closely aligned with the regulatory function,” he says.

“I think right now, the governors are trying too hard to prevent yesterday’s problems rather than to address today’s competitive challenges. A continuation of the current trend will protect investors but it will deny them opportunity,” he says.

To broaden the existing opportunities, Mr Campos has suggested that the SEC may launch a pilot programme with certain non-US regulators. Under this programme, the SEC would not be required to approve foreign IPOs being sold or marketed in the US as long as they had been approved by an accepted regulator with “equivalent” rules.

The increasingly upward trend of business growth across the globe will continue and the US realises that it will have to fit into this new geography.

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Micah Green: the US will have to fit into a new global geography

Micah Green, co-CEO of The Securities Industry and Financial Markets Association, believes this is driving the next step for US regulation. “If you look at it from the premise that open, global markets are a good thing, you have to ask ‘how does the US business environment match up against other environments around the globe?’ It is not about getting back what we lost; it is about ensuring that every economy can be good in a global environment,” he says. “So regulatory largesse, or an overly prescriptive mindset or a frame of laws that encourage litigation risk, if that doesn’t match up with the rest of the world – how is the US going to compete in that ever-expanding global market?”

The pieces are in place and Ms Black believes now the US has the greatest chance to change that it has ever had. “I think the chances of reform are now greater than they ever have been. The things that are being discussed in terms of the US regulatory situation are things I never thought would be on their agenda,” she says. “Some of the possibilities being put forward, such as a single regulator, were completely unthinkable 10, five or even two years ago.”

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