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The Emperor Has Unsuitable Clothes (and by the Way, He Is No Longer the Emperor)

by: Richard Murray

January 28, 2007

48 HARV. INT'L L.J. ONLINE 15 (2007)

Richard Murray is managing director and chief claims strategist of Swiss Re and a member of the U.S. Chamber of Commerce Commission on the Regulation of U.S. Capital Markets in the 21st Century.

This article expresses the author’s views and does not necessarily reflect those of Swiss Re or the U.S. Chamber of Commerce Capital Markets Commission.

I. Introduction

The first car I owned was produced in 1934, as was the Securities Exchange Act.¹ I hasten to add that the car was quite used before it came into my hands, again, like the ‘34 Act. It was a good car for the needs of its day, and so were the Exchange Act and its companion, the Securities Act of 1933.² But, while the federal securities laws have been the subject of numerous modernizations over the past seventy-two years, they look and function more like the original model than current automobiles look like my 1934 Ford.

From this perspective, it is a great pleasure to read and have the privilege of commenting on the seminal work that Mr. Tafara’s and Mr. Peterson’s article, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework (“the Blueprint”), represents.³ In the gentlest of ways, the authors have suggested that the robes of the Securities and Exchange Commission (“SEC”) are not non-existent, as in the Hans Christian Andersen fable, but less than fully suitable for today’s needs. And with even greater care, they have reminded us that the U.S. capital markets are not alone in the world; the SEC is no longer the emperor of global market activity.

My first and strongest reaction to the Blueprint is a blend of admiration for the authors’ insight and appreciation that individuals of their stature at the SEC have the freedom to speak so clearly of the need for new tailoring of the U.S. regulatory wardrobe. It is also a pleasure to recognize how deftly they suggest that this wardrobe needs only a few nips and tucks to facilitate the healthy global marketplace that will best serve the interests of U.S. investors in the rapidly shifting conditions they describe.

Put in more traditional terms, Mr. Tafara and Mr. Peterson offer suggestions for how the United States can enable the creation of “a new international framework.” They recognize that the United States will be unable to dominate global capital markets activity in the 21st century as it has done in the past, but they posit that it can legitimately aspire to lead one global marketplace. In addition, they make a convincing case that competing through collaboration will further the interests of U.S. investors and commerce.

The authors’ vision for the future is both clear and ambitious. They seek two goals for capital markets: transparency and liquidity, and egalitarianism and blindness to national origin.

An efficient capital market requires transparency and liquidity. Transparency is afforded by thorough disclosure requirements, top-notch accounting standards, and independent audits conducted under the highest-quality audit standards. Liquidity is offered by investors who have confidence in the market and the standards under which market participants operate, and who have faith in the legal system and the quality and thoroughness of the enforcement of securities laws and regulations.

An efficient capital market also requires a degree of egalitarianism and blindness to national origin. Ceteris paribus, the larger the pool of investors bidding on a company’s securities, the more efficiently the price of those securities will be set and the more liquid the market for them will be. If our objective is to offer U.S. public companies the lowest cost of capital a market can provide, these companies should be free to accept that capital from whichever investors offer them the best price for their securities.⁴

Mr. Tafara and Mr. Peterson are master weavers who primarily pursue egalitarianism and blindness to national origin by creating a rich tapestry of both traditional and innovative thought. I have neither the desire nor the capacity to enhance their effort regarding this second goal.

Because the first goal is background to their theme, it receives less attention in this article. Yet the benefits of egalitarianism and blindness to national origin cannot be fully realized without also recognizing the current obstacles to an optimally transparent and liquid global capital market. This note addresses a few of the key obstacles under current consideration by a variety of commissions and studies, including the U.S. Commission on the Capital Markets in the 21st Century, whose report will be published in mid-March. The concerns addressed here relate to accounting standards, independent audits, and the legal system.

II. Accounting Principles

While the globalization of commerce was gathering momentum in the 1970s, the developed economies viewed the unique characteristics of their national accounting principles to be a competitive advantage for the protection of domestic commerce. Many of today’s policymakers are too young to recall how vastly differentiated those national standards once were. It was the accounting profession that recognized the incongruity of the situation and began the long, hard slog toward the creation of a single harmonized set of global financial measurements and reporting principles. Public policymakers in the developed economies joined in the effort and, consequently, much has been accomplished in the search for the Holy Grail of universally accepted accounting principles. There is a heartening trend toward symmetry in the degree of prescriptive control of accounting principles and toward reconciliation of differing views of how specific issues should be treated.

This subject is often discussed as a problem discovered in the wake of the Asian financial crisis of 1997-1998, when observers identified incongruent accounting principles as one of the causes of turbulence.⁵ But this has not been a problem for only developing economies. Not so long ago, the most developed European democracies rejected the long-standing use of off-balance sheet reserves for financial institutions as a means of stabilizing operating results. And, as Tafara and Peterson note, many in the United States continue to believe that U.S. accounting principles remain a competitive advantage for U.S. capital markets.⁶

Completing the process of harmonizing accounting principles has turned out to be very similar to the early challenges of computer programming, where the closer one progressed toward completing a uniform system, the more numerous and difficult the remaining obstacles became.

The accounting profession, regulators, and policymakers worldwide have much to be proud of in the progress that has been made. Indeed, the prospect that the SEC might soon permit foreign registrants to operate on U.S. exchanges using what have become generally accepted international accounting principles is encouraging. But the Blueprint’s vision cannot be fully achieved until tolerance of differences is replaced by true harmonization.

III. Auditing Standards and Regulation

There are many similarities between the movement to harmonize accounting principles and efforts to establish a single global standard for audit performance and regulation. Like the issue of harmonizing accounting principles, the issue of auditing standards and regulation has evolved over the past thirty to forty years.

In the early phases of the effort, the differences were vast and reflective of the variety of ways in which auditing had evolved. Anglo-American auditing, born in Scotland and transported via the British Empire, rested on a foundation of objectivity and independence, while many Asian countries viewed auditing as an arm of national policy. As recently as the 1970s, some European civil law countries were comfortable with auditing as an enterprise owned by leading banks. While much harmonization has been accomplished, significant differences remain in relation to independence requirements and the exposure of auditors to civil damage rules and regulatory control.

The most significant difference in relation to optimizing financial transparency is the long-standing principle in nearly all developed economies that audit firms must operate as partnerships composed solely of auditors qualified to practice by their own country’s standards. This requirement perpetuates deep differences in auditing standards and regulation between countries and has prevented audit firms from becoming global enterprises in the same manner as the companies they audit. As globally integrated multinational companies have grown in scale, geographic scope, and influence, their auditors remain partially balkanized by law and regulation. This has inhibited audit effectiveness.

There has been progress toward the harmonization of auditing standards and regulation. The formation of the International Organization of Securities Commissions (IOSCO) by audit regulators in the world’s leading economies has been a major step forward. But as long as fundamental barriers continue to preclude the formation of truly global audit businesses, Mr. Tafara’s and Mr. Peterson’s vision of “audits conducted under the highest-quality audit standards”⁷ will remain an aspiration rather than a reality.

IV. Legal Systems and the Cost of Liability Regimes

Few topics at the intersection of law and economics have received as much public comment over the past decade as the costs generated by the U.S. tort system. As with most large and complex subjects, the reality is rarely as bad, or as good, as it is perceived at any given moment.

It is widely perceived, both within the United States and global markets, that U.S. tort costs have exploded over the past fifteen years and that the explosion is the product of some inexplicable madness in our society or in our judicial system. The perceived explosion and lack of manageable logic are viewed as causing an additional, if indirect, cost of capital and generating a volatility of earnings that together constitute an obstacle to a level playing field and a deterrent to optional participation in the U.S. capital markets.

U.S. tort costs have long been higher than those of other industrialized democracies.⁸ But there has in fact been some recent escalation (with the possible exception of 2005),⁹ attributable to the burst of the bubble economy in conjunction with the maturing of the U.S. Tort Bar, whose successes in asbestos and tobacco claims make it a well-funded, imaginative and formidable force in the proliferation of class-action and mass-tort claims.

The pendulum swing toward escalation has begun to reverse in the past three years due to legal reforms and the more halcyon economy, though the playing field remains far from level.
The supposed irrationality of the U.S. tort practice is in fact logical and to a degree predictable. The United States is a populist nation with relatively few tax-supported compensation and support systems. In this it diverges from its European roots, which display tolerance for class distinction offset by broad social welfare and protection programs funded in the public sector. The United States is also a nation of wide income disparity. It is, therefore, hardly surprising that the power of a jury of one’s peers is a deeply embedded leveling force. Nor is it surprising that our civil justice system has evolved to take on some of the characteristics of a wealth-transfer mechanism. Consider as a single but dramatic example that, in enacting the original securities laws, Congress imposed civil damage rights only with respect to the issuers of new securities, but had no intention that violations of the securities laws in market trading would permit civil damage claims. Yet Congress has watched benignly while lawyers, judges, and juries transformed Section 10(b) of the ‘33 Act and its implementing regulation, 10(b)5, into a massive industry of securities fraud liability.

There are notable recent developments that could tend to level the liability playing field:

Australia’s recent success at truly stabilizing tort costs through comprehensive federal and state reform legislation.
The initiatives within European countries to transfer social welfare costs off the tax roles and into the private sector by adopting mechanisms for aggregating claims and rewarding tort lawyers in a modified form of the U.S. tort system model.

But wherever the U.S. tort-cost pendulum stands at the moment, or whichever way it is swinging, in the absence of more serious and nationally coordinated attention to needed reform, the perception of adverse relative capital costs in the United States will remain for the foreseeable future. Furthermore, the U.S. tort system will continue to produce greater volatility of earnings. As long as these conditions continue, the burdens of litigation will add to the accounting and auditing obstacles as impediments to the full realization of the vision articulated by Mr. Tafara and Mr. Peterson.

To view all responses to A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, please visit here.

¹15 U.S.C. § 78 (1934).
² 15 U.S.C. § 77a–77aa (1933).
³ Ethiopis Tafara & Robert J. Peterson, A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework, 48 HARV. INT’L L.J. 31 (2007).
⁴ Id. at 46 (citation omitted).
⁵See e.g., Carl-Johan Lindgren et al., Financial Sector Crisis and Restructuring: Lessons from Asia, 14 b.4 (Int’l Monetary Fund, Occasional Paper No. 188, 1999), available at http://www.imf.org/external/pubs/ft/op/opfinsec/op188.pdf; Mark J. Hanson, Becoming One: The SEC Should Join the World in Adopting the International Financial Reporting Standards, 28 LOY. L.A. INT’L & COMP. L. REV. 521, 558 n.260 (2006); Herbert V. Morais, The Quest for International Standards: Global Governance v. Sovereignty, 50 U. KAN. L. REV. 779, 817 (2002).
⁶ Tafara & Peterson, supra note 2, at 42.
⁷ Tafara & Peterson, supra note 2, at 46.
⁸ TILLINGHAST – TOWERS PERRIN, U.S. TORT COSTS AND CROSS-BORDER PERSPECTIVES: 2005 UPDATE 4 (2006), available at http://www.towersperrin.com/tp/getwebcachedoc?webc=TILL/USA/2006/200603/2005_Tort.pdf.
⁹ TILLINGHAST – TOWERS PERRIN, 2006 UPDATE ON U.S. TORT COST TRENDS 5-6 (2006), available at http://www.towersperrin.com/tp/getwebcachedoc?webc=TILL/USA/2006/200611/Tort_2006_FINAL.pdf.

Suggested Citation: Richard Murray, The Emperor Has Unsuitable Clothes (and by the Way, He Is No Longer the Emperor), 48 HARV. INT’L L.J. ONLINE 15 (2007), http://www.harvardilj.org/online/92.