Is New York becoming uncompetitive vis-à-vis other global financial centers such as London? New evidence proves that certain regulations are in fact valued by markets and investors, and that over-regulation is not the source of America's woes for foreign firms coming to the U.S. to enjoy its bounty. Groundbreaking research by Finance Chair Darius Miller of SMU Cox, Ugur Lel of the Federal Reserve Board, and Nuno Fernandez of IMD International shows that an attempt to enhance U.S. competitiveness by relaxing regulations for foreign firms listing in the U.S. has had the opposite effect.

Heard of Hotel California or the roach motel? In March 2007, the SEC's passed Rule 12h-6, which loosed the regulations of the 1933/1934 Exchange and Securities Acts. The rule required foreign firms which listed on the New York Stock Exchange (NYSE) to register their firms and maintain registration with the SEC as long as there were 300 shareholders of record. Thus foreign firms that wanted the benefits of access to U.S. capital markets were held accountable to all the investor protections, including reporting requirements, laws and enforcements as long as there were over 300 U.S. shareholders of record. Trouble was if the foreign firm ever wanted to leave the U.S., it was nearly impossible to get down to the 300 count since  hunting down the retiree in Iowa who purchased your stock was difficult.  And so, for foreign firms that came to the U.S., the environment was likened to a roach motel. 'You can go there but you can never leave' as Don Henley of the Eagles sings in "Hotel California."

Think tanks and industry experts lobbied the SEC to amend the registration regulation, to relax the 300 shareholder record law. The SEC changed the rule whereby they wouldn't force the 'nose count' but look to trading volume instead. Miller says, " They relaxed the rule to allow easier deregistering with the SEC. The argument was that it was so hard to come to the U.S. and then leave, if needed. Foreign firms wishing to be in the U.S. would be stuck in the 'roach motel,' and would prefer therefore to go to London. After this relaxing of the rule, it was expected that more business would be coming to the U.S." He continued, "That's only the case, if the costs of being registered and listed in the U.S. market exceeds the benefits."

The goal of the deregulation was to encourage more foreign firms to register in the U.S. However, the number of de-registrations have increased dramatically In fact, 80 firms have left since the rule was changed, 8 months hence-the most in U.S. history. "There was in fact a value to this type of regulation, which has been lost in the debate about regulation and U.S. financial markets competitiveness. Though regulation is costly, there are benefits to investors, especially for certain types of firms.
 

The Experiment

"We saw this, as we say in academia, as a natural experiment," Miller said, "to see the before and after. What do investors say about the ability of firms to easily leave the U.S. market." As shareholder, you can feel good that a firm from Venezuela, for example, has to adhere to certain reporting and accounting standards and be held accountable in U.S. courts for malfeasance, Miller reflects. "As a shareholder, you would have more rights than you did before. If firms can be more transparent, that's a good thing."

This was a simple analysis about what markets say about foreign stocks that were trading in the U.S. The study analyzed 638 firms from 36 countries which were registered in the U.S. "When the gun went off saying: 'You can all leave now.' It turned out that stock prices went down for certain companies, particularly those located in countries that are considered the worst for investor protections," Millers states. "To leave the strong U.S. environment, and be able to go home was not viewed favorably." For firms that could now de-register that were from weak investor protection regimes, they lost on average $112 million of firm value. If market value goes down for firms that now have the option to leave, then the benefits of registration exceed the costs.

That the U.S. market is not necessarily over-regulated is one by-product of the research. Certain regulations are valued by investors. In the great debate about the U.S's competitiveness and its costliness because of Sarbanes-Oxley, the nuances of regulations' effects came into better focus. "Everyone has been looking at same data with different conclusions," Miller says. "This is a clean way to test the hypotheses, to see the drivers of behavior."


To Regulate or Not

U.S. financial regulation is going through a great churn. Deregulation has been considered one source of our current financial crisis. The research proves there's 'a big value to U.S. regulation.' Miller states, "Rights that the U.S. market brings to investors is valued by investors world-wide.  Though some impose costs, the benefits outweigh the costs in this case." Some say it's expensive to comply with U.S. regulations and that might be true. "The real question," for Miller is, "whether the benefits exceed costs or other way around. And this is what gets lost in the debate."

The novelty of the study is that the authors test the relative benefits versus the costs for foreign firms. (And in a globalized world, that's an important factor.) There are not 2000 firms clamoring to register on the Bolsa (Mexican exchange). "Firms come to the U.S. because this is where the money is," Miller recants. "They come because investors are allowed the most protections and rights because of regulation, laws, and enforcement."

Financial crisis are relatively rare events Miller notes. And everyone has ideas about the roots of the current crisis, but it is hard to untangle all the variables, let alone test them.  This research debunks the U.S.-as-not-competitive myth. Though costs may be high, there may be benefits that are overlooked. " Arguably, even if the U.S. has become less competitive, this response was not the right one," Miller states. This deregulation attempt basically decreased one of the biggest benefits for foreign firms to register in the U.S. This rule was actually valued by investors for certain types of firms.


Concluding Remarks

The study is a true market assessment of how the market calculates the costs and benefits, not positions and opinions. The U.S. market affords certain benefits to foreign firms that list and register. If you're an investor in a firm located in a country that has bad investor protections, you'll be afraid that there could be expropriations. If there's no lending to your firm, it's hard to raise capital. Your firm can't grow; the country can't grow because of under-developed shareholder laws, etc. A firm's recourse is to leave that country's legal environment by cross-listing in another country that has stronger laws, better corporate governance, and shareholder rights. "So the SEC rule has weakened this," mentions Miller. "As a firm, I can come to US and now leave. It lessens the attractiveness of the U.S."

Some firms, such as Germany's E.ON, were the first to leave when the rule changed.  Now that it is easy to leave, what type of firms left? Those with previous run-ins with the law and those that were doing suspicious things left first, noted Miller from the study's findings. "It doesn't give one confidence that we're doing the right thing by relaxing the rule," he remarked.

The goal of the deregulation was to encourage more foreign firms to register in the U.S. The number of de-registrations have increase and have exceeded the number of new registrations for the first time in history. There was a value to this type of regulation, which has been lost in the debate about regulation and U.S. financial markets competitiveness. Though regulation is costly, there are benefits, especially for certain types of firms.


The paper "Escape from New York: The Market Impact of Loosening Disclosure Requirements" by Finance Chair Darius Miller of SMU Cox, Nuno Fernandez of IMD International, and Ugur Lel of the Federal Reserve Board is forthcoming in Journal of Financial Economics.


Written by Jennifer Warren.