It is an honor to participate in The Atlantic’s Ideas Tour to commemorate the magazine’s 150th anniversary. The first topic in the tour – American Competitiveness – has been discussed in the pages of the magazine since the earliest issues. Over the last 150 years The Atlantic has reported the country’s commitment to prosperity through competition in a wide range of fields.
In our own time, we have witnessed dramatic change in the U.S. economy. During the last 150 years the United States has transformed from a decentralized agricultural economy into an industrial economy dominated by a few large businesses, themselves controlled by a handful of families or other groups, and then into an economic powerhouse diversified among numerous businesses. Some of these businesses are now several orders of magnitude larger than even the largest companies of a century ago. And some are very, very small but anticipate enormous opportunities for growth in the future.
Perhaps even more significant than the change in the number or size of U.S. companies is the fact that this change was fueled by public investment. To an extent unmatched in any other country, we have gone from a system in which our businesses were generally owned and controlled by small groups of people – and often managed by those same people – to a system in which our businesses are owned by public investors, each of whom share a stake in the prosperity of new business opportunities and innovations. The U.S. has achieved this widespread participation by maintaining high quality disclosure standards and enforcement policies that protect the interests of public investors.
In today’s discussion, I would like to describe some encouraging research showing that U.S. laws on investor protections have provided U.S. businesses, as well as non-U.S. businesses that are willing to submit to our minority investor protections, the lowest cost of equity capital in the world. With this in mind, I would also like to discuss the concerns some have expressed that the cost of U.S. securities regulation may deter companies from U.S. markets. As you’ll see, there are indications that weakening securities regulation to save certain costs runs the risk of damaging the competitiveness of U.S. companies by raising their cost of capital. Before I continue, though, I must note that the views I express today are my own, and not necessarily those of the other members or staff of the PCAOB.
Today, half of all American households, and one in three individuals, own stocks directly or through mutual funds, up from about one-fifth in 1983. Nearly all of these individual investors follow a buy-and-hold investment philosophy and view their equity holdings as long-term investments. These individual investors are investing both in U.S.-based companies and, increasingly, in non-U.S. companies, either by purchasing American Depositary Receipts or by acquiring shares in mutual funds that invest in non-U.S. or international companies.
In no other country does the general public participate in business growth opportunities to the extent that the American population does. Other countries are, however, beginning to see both demand from their citizenry to invest their savings in businesses as well as economic benefits of shifting to a defined contribution model of retirement savings, which the U.S. did some time ago.
Businesses outside the U.S. tend still to be controlled by small groups of wealthy investors, some of whom still even manage the business. For example, many businesses in Europe, Latin America, and Asia are still partly owned by governments, although some countries in these regions are currently engaged in privatization programs. In addition, in countries as diverse as Korea, India and Brazil, wealthy families still control many of the largest industrial companies.
When growth opportunities exceed the ability of existing owners to continue to fund them, the company may well turn to public investment in its own country or elsewhere. There are several reasons why, to date, once a non-U.S. company decides to seek public capital, it seeks it outside its own country. For one thing, local markets may not offer enough capital or capital at the best price, because the market is not liquid, because of real or perceived restrictions on investment in equities, because legal systems do not provide adequate protection to outside investors, or other reasons.
When companies have decided they need public investment to fund growth opportunities, they often seek such investment in U.S. markets. Research has shown that non-U.S. companies that cross-list in the United States enjoy a significantly lower cost of equity capital, indeed the lowest in the world. Specifically, the cost-of-capital reduction from using U.S. public equity markets ranges from at least six percent (for Japanese companies that list in the United States) to 25 percent (for Egyptian companies) and averages 13 percent.
This reduction in the cost of capital for non-U.S. companies that list their securities in the United States translates into a premium on their respective valuations that can reach as high as 37 percent more than their valuations would have been in their home market. While markets in other countries have become more aggressive in seeking listings, they have not been able to show that companies receive a valuation premium by listing on them. This includes, for example, the London Stock Exchange, which some have touted as a lightly regulated alternative to U.S. markets. Companies that opt for that leniency pay considerably more for their capital.
With benefits like this for listing on the U.S., it could seem irrational for any company not to take advantage of them. Why is it that every company does not list its equity securities in the United States? Indeed why has the U.S. share of world IPO activity been declining since 1996 (see Figure 1)?
Some have claimed that the cost of regulatory compliance in the United States – and in particular the cost of complying with certain provisions of the Sarbanes-Oxley Act of 2002 – deters new companies from listing here, especially when some markets are actively soliciting listings on the basis that their regulatory costs are cheaper than in the United States. The timing alone belies any correlation between the costs of complying with the new requirements and the gradual decline in U.S. listings that began in 1996.
More fundamental, though, I question the intellectual underpinnings of those claims. Companies that list their shares on U.S. markets enjoy low-cost capital in large part because of the strong investor protections provided by U.S. federal securities laws. This gives such companies a competitive advantage to grow in the least expensive manner available.
Notwithstanding the competitive advantage of seeking capital in U.S. markets, many companies choose not to for rational reasons that are unrelated to the cost of compliance with the U.S. federal securities laws. Specifically, research has shown that companies with significant control groups are not likely to seek capital in markets that provide minority investor protections, unless those companies’ growth opportunities exceed the controlling shareholders’ ability to fund that growth. According to that research, there are two variables that determine whether a company is likely to seek low-cost equity capital in the U.S.
The first variable is the value of private benefits that the individual or group that controls a company can expect to be able to receive from the company without seeking access to public capital. Such control groups – which can include managers, so I’ll call these people, collectively, “insiders” – of companies in countries with poor investor protections tend to have valuable private benefits derived from control, because they are able to extract benefits from the company unchecked by minority shareholder rights. Insiders give up these private benefits when a company submits to investor protections for minority shareholders, such as by listing its shares on U.S. markets, which have consistently provided relatively strong investor protection.
Investor protection of minority investors makes extraction of private benefits more difficult. As investor protection improves, it becomes gradually more difficult for insiders to expropriate assets, such as by setting up intermediary companies into which they can channel assets, as occurred at the Mexican-based media company, TV Azteca, where company insiders engaged in an elaborate scheme to conceal one insider’s role in a series of transactions through which he personally profited by $109 million.
While insiders of U.S. companies may of course try to extract personal benefits without disclosure to outside investors, lest the outside investors oppose the benefits, strong investor protection serves as a formidable deterrent. Take, for example, the widely discussed findings of a University of Iowa researcher relating to backdated stock option grants to insiders. That researcher opined that a suspiciously favorable correlation between the dates certain insiders claimed to have received stock options and the dates that the stock at issue hit relative lows could be attributable to the insiders having retroactively granted themselves and other insiders options to purchase shares at below market prices. Because some companies appear to have failed to disclose the added benefit to the insiders of the below-market option prices, such insiders effectively paid themselves more than they disclosed to outside investors. Not only does such behavior, when not approved by the company’s board or shareholders, expropriate shareholder assets, but by understating compensation expenses it also obscures the true level of productivity of the company, which can mislead markets and investors about a company’s value.
Changes in the disclosure and accounting for stock option grants – required by Sarbanes-Oxley and a new accounting standard on option compensation – have significantly reduced U.S. companies’ opportunity and incentive to backdate grants, and as a result investors in U.S. companies should expect more reliable statements of compensation cost. Importantly, the researcher who uncovered these problems has expressed some concern that it may be difficult to study the extent to which non-U.S. companies may have used similar tactics, given limitations of disclosure in other countries.
When diversion techniques become more difficult, as they are in the United States given our relatively strong investor protection laws and enforcement policies, insiders expropriate less, and their private benefits of control diminish. For example, by requiring companies to submit to audits of their internal control over financial reporting, U.S. law substantially limits insiders’ ability to expropriate corporate assets, either directly or by overstating the company’s performance to trigger additional compensation. As another example, by requiring robust disclosure of related party transactions and insider compensation, U.S. law discourages insider compensation at a level higher than necessary to meet competitive demands or to establish incentives to meet corporate goals.
The second variable is the value of what would be the insiders’ share of growth opportunities if the company did seek capital in a market that provides investor protections. If this share does not exceed the private benefits that the insiders currently enjoy, there is no incentive for the insiders to grow the company. It would be a rational decision for them not to seek public capital in markets that would prevent them from continuing to extract their private benefits.
On the other hand, when insiders’ private benefits are lower than their share of potential growth opportunities, companies have tended to seek low-cost public capital. For companies that have crossed this threshold, there is no cheaper equity capital than that available through a U.S. exchange.
Recent events may stimulate improvements in investor protection in other countries, which may lead to lower cost of capital for companies that issue securities in those countries’ markets. These events include changes in national policies to shift from state-funded, defined benefit retirement systems to defined contribution retirement systems based on individual investment, as well as actions by activist hedge funds to improve corporate efficiency.
For example, beginning in 1997, the German Bundesbank has made a strong call for equities to play a greater role in the German investment system, saying this was "urgently needed" to help meet the economic challenges facing the country. To spur this shift toward greater reliance on individual investments, the German government outlawed insider trading and required quicker and more comprehensive disclosure of market-moving news and shareholding stakes.
In addition, some activist hedge funds may spur companies to eliminate insider benefits and thus become more efficient users of capital. For example, this year the activist hedge fund manager Carl Icahn purchased a significant stake in South Korean tobacco maker KT&G and, with an investment partner, won a seat on KT&G’s board in March 2006. While represented on the board, Icahn and his partner pressed the company to sell underperforming businesses run by related parties and to limit dilution of shareholder value caused by sales of treasury stock to insider relatives and friends. During this time, the company’s public shares rose in value, and emboldened wider efforts to enhance investor protections in South Korea.
Cash-rich hedge funds will likely continue to troll international markets for chances to improve shareholder value by limiting insiders’ private benefits. Until such efforts are institutionalized through national laws and enforcement policies, though, they are unlikely to result in long-term reductions in cost of capital.
Of course, as countries improve their investor protections, markets in those countries may also begin to enjoy reductions in the cost of capital. I was fortunate to be able to visit Brazil in August this year, where I witnessed first hand the Brazilian stock exchange’s initiative to establish a new exchange – the Novo Mercado – on the basis of higher quality financial reporting and corporate governance standards. Early indications are that this initiative is making a difference in the valuation of Brazilian companies, which were formerly consistently valued at a discount.
The concern on policy makers’ minds everywhere has been whether the costs of regulation and enforcement in the United States – in particular, the cost of complying with new U.S. requirements relating to internal control over financial reporting – outweigh the benefits of using U.S. markets to obtain capital. To my mind, the answer is a resounding “No!” for many reasons, including that the U.S.’s low cost of capital reflects the effectiveness of our securities regulations.
There have been many surveys about the cost of U.S. regulation, and, particularly when one takes into account the new internal control reporting requirements, by all accounts it is significant. Nevertheless, the available evidence indicates that savings in cost of capital that companies listed on U.S. markets enjoy is several orders of magnitude greater. While emotions may run high with concern about the personal burdens of compliance and enforcement on managers, as the Head of Nasdaq’s International Listings office has said, “The key reasons companies are still coming to the U.S. remain the same. International listing activity is still driven by U.S. valuations.”
Non-U.S. companies’ approach to the differential in underwriting fees applicable in different markets bears this point out. That is, companies have consistently endured relatively higher fees in the U.S., because of the net savings in cost of capital (and net valuation premium) in the U.S. Indeed, I understand even today the greatest costs companies listing in the U.S. face are not compliance costs but rather are these underwriting fees. One recent study has estimated that underwriting fees consume 6.5 to 7 percent of IPO receipts in the U.S., compared to 3 to 4 percent in Europe.
Moreover, there is no evidence that the cost of complying with U.S. regulation, including after enactment of the Sarbanes-Oxley Act, have cut into the cross-listing premium. To the contrary, it has increased since 2002, when it dipped to its lowest point since 1997 (see Figure 2).
The U.S. share of IPOs throughout the world – which is so often cited as an indicator that Sarbanes-Oxley has deterred companies from going public – declined dramatically beginning in 1996 and through 2001 (from about 60 percent of all IPOs to less than 8 percent), after which it has on average increased somewhat (to about 15 percent in 2005). (See Figure 3.)
At the same time, several countries are in the midst of multi-year programs to privatize state-owned businesses. For example, the top five IPOs last year were privatizations of state-owned entities in China and France. Notwithstanding the significant valuation premium in the U.S., there are considerable political, cultural and other influences on such companies to list locally when their markets offer sufficient liquidity. To my mind, this is a significant factor in the competition for listings.
In addition, part of the drop in the U.S. share of worldwide IPOs is clearly due to the dramatic decrease in the number of IPOs by U.S. companies, from about 375 in 2000 to less than 100 in 2001. (See Figure 4.) Important to an evaluation of the competitiveness of the U.S. markets themselves, there was no commensurate shift by U.S.-based companies to markets in other countries. To be sure, the LSE’s AIM market is actively soliciting small companies from around the world with the promise of equity capital without the restrictions that usually pertain to organized markets, such as minimum market capitalizations. Nevertheless, as of March 2006, only 29 of the AIM’s 2,220 listed companies were based in the U.S. Looking even deeper, seven out of the 29 U.S. companies that have listed on the LSE’s AIM have a dual-listing or otherwise trade on a U.S. market. It’s questionable whether the remaining 22 small companies could have met the threshold listing requirements in the U.S., which is not surprising given that anecdotally we know that small U.S. companies tend to see the AIM market as an alternative to private financing as opposed to an IPO on a U.S. public capital market.
Lest I leave the misimpression that management of regulatory costs is irrelevant to corporate success, I should stress that costs that are unnecessary to achieve the intended benefits of compliance ought to be eliminated, through regulatory changes as well as through innovation. In the case of the provisions of the Sarbanes-Oxley Act that are the most controversial from a cost perspective – its internal control requirements – both processes are currently underway. Compared to the first year of implementation, companies and auditors have already achieved significant efficiencies in how they go about establishing internal control and testing its effectiveness, respectively.
The first year of the new internal control requirements was indeed more difficult and costly than it could have been. Both audit firms and companies faced enormous challenges, arising from the limited timeframe that companies and auditors had to implement the new requirements; a shortage of staff with prior training and experience in designing, evaluating, and testing controls; and related strains on available resources. These challenges were compounded in those companies that needed to make significant improvements in their internal control systems to make up for deferred maintenance of those systems.
Many of these problems have naturally abated after the first year. Estimates have varied, but one thing that is clear is that the costs of the new internal control reporting requirements have declined significantly after the first year of implementation of management’s and the auditor’s requirements.
Moreover, to spur additional savings, regulators are actively looking for ways to help companies and auditors reduce cost. Specifically, the SEC and the PCAOB announced last May initiatives to review their regulations implementing Sarbanes-Oxley’s internal control requirements, in order to improve the efficiency of compliance efforts, including by eliminating unnecessary procedures. I expect changes proposed to both reduce costs for companies that have been subject to the requirements so far and to help avoid some of the first-year problems I described for the non-U.S. companies and smaller U.S. companies that have been permitted extra time to comply.
It was reported this week that the scandal over backdating stock options to reward insiders with undisclosed compensation has cost $7.9 billion in lost market value of the companies involved. As I mentioned earlier, Sarbanes-Oxley and a new accounting standard on option compensation have significantly limited insiders’ opportunity to engage in such practices, but even without the new requirements it is easy to see the benefits, both to companies and their investors, of ensuring that financial reporting and disclosures are accurate. As one prominent securities lawyer recently said of clients involved in restatements: “[T]he concept of cost for a 404 audit is nothing compared to what happens when you face a restatement . . . . [E]very CFO I work with comes to a very simple conclusion, that being penny-wise and pound-foolish with respect to the costs of the audit really was a stupid thing to do.” As we’ve seen from the many financial reporting scandals reported throughout the world, damage from failing to provide an accurate picture of a company’s financial performance and position is not limited to the United States, and indeed companies in countries with weak investor protection ought not to feel immune from potentially catastrophic losses from poor disclosure.
To my mind, one of the most important aspects of Sarbanes-Oxley is that it focuses on reducing the risk of future catastrophic financial reporting failures. As I’ve described, even in countries with strong investor protection, insiders may still be motivated to break rules. Enforcement after the fact is an important deterrent. But what’s different about Sarbanes-Oxley – and in particular its provisions on internal control – is that it focuses management and auditors on identifying problems in a company’s internal control before those problems result in material misstatements in financial reports.
The new audit of internal control is critical to detecting and addressing potential future problems. That is, in the past, to the extent that auditors considered internal control in the context of their financial statement audits, it was for the purpose of evaluating whether there was a material misstatement in the financial statements under audit. Now, when accountants audit internal control, they are expected to find conditions that could result in controls failing to detect or prevent a material misstatement in the current period or in the future. This work allows auditors to adjust their financial-statement audits to account for internal control problems. But importantly, an auditor’s opinion that a company’s internal control is not effective also provides both outside investors and insiders critical new information about the risk of a problem in a company’s future financial statements. If internal control weaknesses are discovered early enough, companies should have time to address the risk before a material misstatement actually occurs – that is, before investors receive and act on materially wrong information.
For all these reasons, claims that the cost of securities regulation in the United States – and in particular improved investor protections adopted in and since the Sarbanes-Oxley Act – has damaged the competitiveness of U.S. companies and markets are to my mind overstated. Indeed, the U.S. financial reporting and disclosure system has strengthened U.S. markets’ resilience for the long-term and contributes significantly to the competitive edge the companies that list in U.S. markets enjoy due to favorable long-term funding.
 Nearly 57 million U.S. households own stocks directly or through mutual funds, according to a study by the Investment Company Institute and the Securities Industry Association. See Equity Ownership in America: 2005 (November 2005) (“Equity Ownership”), at 7, available at http://www.ici.org/pdf/rpt_05_equity_owners.pdf .
 Equity Ownership, at 4.
 Nearly two-thirds of all American equity investors today hold foreign equities through ownership of individual stock in foreign companies or ownership of international or global mutual funds, up from about half in 2002. Equity Ownership, at 23.
 See La Porta, R., Lopez-de-Silanes, F. and Shleifer, A., Corporate Ownership Around the World, 54 J. Finance 417 (Apr. 1999).
 See Hail, L. and Leuz, C., International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulations Matter?, 44 J. Accounting Res. 485 (June 2006).
 Id. at 494-495.
 See Doidge, C., Karolyi, A., and Stulz, R., Why Are Foreign Firms Listed in the U.S. Worth More?, Journal of Financial Economics, Volume 71(2), 205-238).
 See La Porta, R., Lopez-de-Silanes, F. and Shleifer, A., Investor Protection and Corporate Governance, 58 J. Fin’l Econ. 3 (Oct. 2000), available at http://www.economics.harvard.edu/faculty/shleifer/papers/ip_corpgov_paper.pdf#search=%22Laporta%20investor%20protection%20and%20corporate%20governance%22 (“Investor protection turns out to be crucial because, in many countries, expropriation of minority shareholders and creditors by the controlling shareholders is extensive. When outside investors finance firms, they face a risk, and sometimes near certainty, that the returns on their investments will never materialize because the controlling shareholders or managers expropriate them. . . . Corporate governance is, to a large extent, a set of mechanisms through which outside investors protect themselves against expropriation by the insiders.”)
 See SEC Lit. Rel. 19833 (Sept. 14, 2006). Because TV Azteca sold ADRs on the New York Stock Exchange, it was subject to U.S. enforcement of investor protections that prohibited this kind of undisclosed private benefits. Accordingly, in January 2005 the SEC filed charges against the company and the insiders involved, and upon accepting their offer of settlement, the SEC found this month that the company and insiders unlawfully failed to disclose CEO Richard Salinas's involvement in related party transactions between Unefon, a subsidiary of TV Azteca, and a private entity secretly co-owned by Salinas, called Codisco. Specifically, the SEC found that, in the related party transactions, Salinas purchased from a third party – at a steep discount – approximately $325 million of indebtedness owed by Unefon to the third party. The SEC further found that at the time that Salinas purchased the indebtedness, he was aware that Unefon was in negotiations with another large telecom company which would provide cash to Unefon, and enable Unefon to pay off the full amount of the indebtedness that Salinas had purchased at a discount. Only three months later, when Unefon closed the deal with the other telecom company, Salinas profited by $109 million upon Unefon's repayment of the debt at full value.
 See Lie, E., “On the Timing of CEO Stock Option Awards,” Management Science (May 2005), at 802, available at http://www.biz.uiowa.edu/faculty/elie/Grants-MS.pdf .
 See id. at 4.
 See Fisher, A., Bundesbank Stresses Role of Equities, Financial Times (January 17, 1997).
 Choe Sang-Hun, Revenge of the shareholders: Korean firms on the spot, International Herald Tribute (Sept. 11, 2006). This article recently reported that South Korean investor advocates are “riding the coattails of other corporate activists like Carl Icahn and the Dubai-based Sovereign Asset Management.” For example, Sourth Korean textile manufacturer Daehan was “being asked some uncomfortable questions. Why was a textile company investing so much money in the cable TV and financial services units of the parent firm? Had the details of these connected transactions been fully declared? Was the purpose of these investments to benefit Daehan shareholders - or to advance Lee's family empire?”
 See Economist, “New Wave for the Novo Mercado; Brazilian IPOs,” Feb. 25, 2006.
 Earlier this year, a team of researchers led by Bill Kinney of the University of Texas reported on their findings that disclosures about the reliability of internal control have a significant effect on companies’ cost of capital. See Ashbaugh-Skaife, Collins, Kinney and LaFond, The Effect of Internal Control Deficiencies on Firm Risk and Cost of Equity Capital (April 2006). They found that when companies report they have corrected a previously reported material weakness in internal control, their cost of capital goes down on average 1.5 percent. Conversely, when companies report material weaknesses in audited financial reports after they had previously reported in unaudited statements that internal control was effective, their cost of capital goes up on average almost 1 percent (93 basis points). For a fuller discussion of indications that internal control reporting is producing real benefits, see my address at Baruch College’s Zicklin Center’s Fifth Annual Reporting Conference, available at http://www.pcaobus.org.
 Remarks of Charlotte Crosswell, Head of International Listings, NASDAQ, printed in Ernst & Young, Accelerated Growth: Global IPO Trends 2006, at 24.
 See Oxera Consulting Ltd., The Cost of Capital: An International Comparison (June 2006), at 4, available at http://www.londonstockexchange.com/NR/rdonlyres/B032122B-B1DA-4E4A-B1C8-42D2FAE8EB01/0/Costofcapital_full.pdf .
 See C., Karolyi, A., and Stulz, R., The Valuation Premium for Non-U.S. Stocks Listed in U.S. Markets (Sept. 2005), available at http://www.nyse.com/pdfs/Stulz_091505.pdf .
 See http://www.londonstockexchange.com/en-gb/products/companyservices/ourmarkets/ aim/; see also http://www.londonstockexchange.com/en-gb/products/companyservices/our markets/aim/aimus.htm (“In 2005, the London Stock Exchange attracted a record 19 companies from the US to AIM, raising a combined total of $2,126 million. There are now a total of 29 companies from the US quoted on AIM.”).
 See “Small U.S. Firms Take AIM in London,” Wall Street Journal, April 17, 2006, at C5.
 PCAOB Release No. 2005-023 , Report on the Initial Implementation of Auditing Standard No. 2, November 30, 2005 (“November 30 Report”), available at http://www.pcaobus.org.
 See CRA International, Sarbanes-Oxley Section 404 Costs and Implementation Issues: Spring 2006 Survey Update (available at http://www.s-oxinternalcontrolinfo.com/), reporting that total 404 costs, including internal costs, third party costs and fees for the internal control audit, declined 43.9 percent for a statistically valid sample of Fortune 1000 companies, and 30.7 percent for companies with market capitalization ranging from $75 million to $700 million. Of the total 404 costs in year two, CRA’s Spring 2006 Survey Update reported that internal control audit fees declined an average of 22.3 percent for the Fortune 1000 companies and 20.6 percent for the smaller companies.
 See Green, R., Options Probe Has Cost Investors $7.9 Billion in Market Value, Bloomberg News (Sept. 27, 2006).
 See Remarks of John Huber, SEC/PCAOB 2006 Roundtable on Second-year Experiences with Internal Control Reporting and Auditing Provisions (May 10, 2006), at 268, available at http://www.sec.gov/spotlight/soxcomp/soxcomp-transcript.txt.