Sarbanes-Oxley Starts a Foreign Affair

Flight of IPOs from U.S. points to challenges ahead for securities regulation.


Critics of the Sarbanes-Oxley Act (SOX) have been pointing to the nearly total migration of large initial public offerings (IPOs) to non-U.S. exchanges in 2005 as proof that the law is counterproductive, driving new issuers to list on other countries' exchanges. Ventana Research thinks they have a valid point, but the policy implications are much more nuanced than simply rolling back the law could address. We believe Sarbanes-Oxley will not disappear and, indeed, over time we expect there will develop a "race to the top" approach to disclosure requirements around the world. Yet the era of regulatory dominance the United States has enjoyed since the end of the Cold War is over. It is unlikely that politicians will pass securities regulations as sweeping as SOX again without considering the potentially negative consequences for the U.S. capital markets.

During 2005, 24 of the 25 largest initial public offerings were listed on exchanges outside of the United States. Those who oppose the Sarbanes-Oxley Act (particularly its infamous Section 404) are pointing to this movement as market-based proof that the law has been counterproductive, driving new issues that might have been listed (if only partially) in the U.S. to other exchanges. Ventana Research thinks they have a point, but over time, it will prove to be a minor one.

For one thing, the shift was inevitable. The United States' dominance of the equity capital markets is likely to erode over the next decade simply because the increasing pools of savings in other countries will drive the growth of those markets. Many of the largest IPOs of 2005 were once nationalized companies, so their listing in local exchanges made sense. This will become the case for smaller companies as well. An Indian grocery chain or a regional Chinese trucking firm, for example, will be served best by a local listing. For smaller countries, electronic trading has enabled regionalization, eliminating fragmented national exchanges that were not very competitive with the New York Stock Exchange and NASDAQ.

The real issue is whether there will be a mass movement by U.S. companies to list abroad because they find reporting requirements here too onerous. There is scant evidence this is occurring, and with the less stringent stance the Securities and Exchange Commission (SEC) and the Public Company Accounting Oversight Board (PCAOB) have taken with respect to the audit process, reporting deadlines and other matters over the past nine months, we think it is unlikely to happen. In terms of value, one-quarter of new issues were listed on U.S. exchanges, with the New York Stock Exchange taking the leading position for IPOs worldwide. Public companies also have been making changes in their accounting systems and processes to ease the compliance burden. We believe a majority of companies that have done this are finding that in addition to making Sarbanes-Oxley compliance easier, these steps are reducing the cost of finance operations generally.

Moreover, the history of securities regulation has shown that investors are less concerned with quality of earnings, transparency and the like in good times than in bad ones. After all, it was the bubble mentality of the 1990s and the lack of interest in due diligence that accompanied it that led to the financial scandals and drove passage of SOX. Financial scandals provoke regulation. We expect that as such transgressions occur in emerging stock markets, government regulators will step in to prevent them from recurring. Even without external regulation, companies that want to attract sophisticated equity investment capital will need to conform to a level of transparency and quality consistent with the most stringent requirements, or they will pay a higher cost for equity capital.

The Sarbanes-Oxley Act of 2002 was neither a disaster nor a panacea, although the cost of complying with it has been huge. In addition, we doubt that even this will prevent the next Enron, or conversely that it was necessary for the one-fourth to one-third of larger U.S. public companies that already had sufficient financial controls in place. On the other hand, the Act was created in the wake of a series of serious financial scandals. It was passed with the belief that such legislation was needed to restore confidence in the capital markets, which it certainly did at the time. We think SOX has improved the quality and transparency of financial reporting for U.S. companies. Still, it is difficult for us to imagine that in the future sweeping securities regulations like it will occur without regard to the consequences in increasingly international capital markets; that caution will dilute the ability of the U.S. Government to dictate reporting requirements.

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