The Capital Market Crackup

At the turn of the 20th century, most American companies were incorporated in the state of New Jersey. Today, of course, public companies are typically chartered in Delaware.

How did New Jersey lose the valuable corporate charter business to its southern neighbor? As New Jersey’s governor, Woodrow Wilson led a crusade to “trust bust” big businesses through the state’s unique position as the incorporation state of choice. Predictably, however, businesses chafed at the new restrictions and moved to Delaware, which had incorporation laws identical to New Jersey’s old regime. Today, Delaware’s low taxes are due in part to Wilson’s folly; the state earns over 40 percent of its general revenues from incorporation fees.

This history lesson is apropos today, as the U.S. appears to be losing its long-established grip on the market for publicly traded securities. IPOs on European exchanges surged past those in the U.S. in 2005, in terms of both number (603 to 433) and the total offering value (51 billion euros to 28 billion euros)-marking the first time that the U.S. had not led at least one of the two categories Only two of the 20 largest IPOs in 2005 were listed in the U.S.

Although some weakening of the American position is inevitable as foreign capital markets grow more sophisticated, closer examination of 2005 numbers makes this reversal of fortune more ominous. Among overseas IPOs, in which a registrant listed in a non-home market, Europe placed 126 offerings worth 9.6 billion euros, as compared to America’s 23 offerings worth 3 billion euros. London has become the venue of choice for large Russian and Chinese IPOs. Even for venture-backed start-ups, European exchanges hosted 60 IPOs in 2005 versus 41 in the U.S.; nine of the 10 largest VC offerings went public in Europe.

What explains the rush away from the U.S.? The biggest explanatory factor is the Sarbanes-Oxley Act of 2002. Its many new demands include greater reporting requirements for insider trading; firewalls to ensure auditor independence; bans on most personal loans to company officers and directors; and stiffer civil and criminal penalties.

Notable from the perspective of being publicly listed on U.S. exchanges is Section 404 of SOX, which requires an internal control report in each mandated annual 10-K filing. According to a survey of over 200 businesses with average revenue of over $5 billion, annual Section 404 compliance costs totaled over $4 million per company; analysts estimate a total direct compliance cost of $6 billion. Small-cap companies suffered a 22 percent rise in audit fees, versus 6 percent for mid-cap, and 4 percent for large-cap corporations.

What’s more, SOX imposes huge indirect costs through what Professors Larry Ribstein and Henry Butler, authors of The Sarbanes-Oxley Debacle, characterize as “interference with business management, distraction of managers, risk aversion by independent directors, over-criminalization of agency costs, reduced access to capital markets, and the crippling of the dynamic federalism that has created the best corporate governance structure in the world.” Ribstein and Butler estimate the total indirect costs of SOX to top $1 trillion and point to a “litigation time bomb” waiting to explode.

American businesses already suffer from an out-of-control legal system, which, even excluding securities litigation and the massive multistate tobacco settlement, costs more than twice as much as the legal systems of other developed nations as a percentage of the economy. Moreover, America’s securities litigation industry imposes a direct tax on companies that enter the U.S. public equity markets. Though hailed as defending the small investor, securities litigation brings no direct benefit to most shareholders.

What’s more, though the threat of litigation clearly creates incentives that affect the behavior of corporate officers, the changes in behavior do not seem to be related to improving information relevant to market pricing. In part, this failing can be explained by the excessive cost of discovery in securities class action litigation, which enables plaintiffs’ attorneys to extract substantial settlement values from defendant firms, regardless of case merits.

In 1995, Congress tried to reform securities litigation through the Private Securities Litigation Reform Act (PSLRA). First, the PSLRA tried to rein in “strike suits” in which securities lawsuits are filed whenever a stock price sees a rapid, major decline. Such stock price drops are regular occurrences in the technology sector, which naturally trade at high multiples of current earnings, if any, and are priced based on speculative assumptions about future earnings growth. The PSLRA sought to address the issue by requiring more in-depth pleading standards to support a securities claim and automatically staying discovery while a motion to dismiss is pending.

Second, the PSLRA tried to remedy what legal scholars call the “agency cost” problem inherent in any class action litigation. By definition, individual claims are small for class litigation, so no individual plaintiff typically has sufficient interest to monitor or control the class attorneys. As securities class action king Bill Lerach once boasted to Forbes, “I have the greatest practice in the world. I have no clients.” To fix this issue, the PSLRA forced judges to select the investor most likely to protect the class of claimants’ interests-typically the largest investor-as the lead plaintiff, rather than permitting the first plaintiff filing suit to control the litigation.

Unfortunately, the PSLRA did not, in general, work as intended. After an initial one-year decline, the number of securities lawsuits filed annually essentially returned to the pre-PSLRA level, and indeed increased slightly.

Enterprising plaintiffs’ lawyers realized that the largest investors in the economy were none other than public employee pension funds, typically governed by politicians and state employee union heads. The securities lawyers cultivated these constituencies. Furthermore, if federal prosecutors’ indictment against Milberg Weiss is to be believed, at least some securities lawyers skirted the PSLRA by offering kickbacks to individuals who filed bogus suits.

Meanwhile, SOX opens up new avenues of litigation by imposing hosts of new disclosure and monitoring requirements and thus theories of liability. It also gives firms strong incentives to develop more complex mechanized oversight systems, which will make public companies even more susceptible to onerous electronic discovery.

So what’s a CEO to do? There may be some synergies created by acquiring smaller companies overburdened by the new requirements. But such savings should not be overstated -and are likely outweighed by greater exposure to securities litigation.

Clearly, the incentive to take one’s company private, or to delist from U.S. markets and relist overseas, is now more compelling. But the preferable-and certainly the more patriotic-response is to encourage Congressional leaders to revisit SOX as part of a comprehensive securities law reform, closing the loopholes left open by the PSLRA. If not, U.S. markets may suffer New Jersey’s fate from a century ago.