Amid market over-regulation complaints, Dems tackle dispute-resolution process

Senate Judiciary Committee Chairman Patrick LeahyPatrick Joseph LeahyMcConnell sets 'minibus' strategy for 2019 spending Dem senator mocks Pruitt over alleged security threats: 'Nobody even knows who you are' Pruitt tells senators: ‘I share your concerns about some of these decisions’ MORE (D-Vt.) on May 4 asked Securities and Exchange Commission (SEC) Chairman Christopher Cox to change the rules governing disputes between financial services firms and their investors over financial services accounts.

Leahy’s request signals that key congressional Democrats will not support mooted SEC rules that would allow companies to change or draft their bylaws to exclude litigation as a remedy for resolving shareholder disputes. It also represents the latest challenge to the widespread notion on Wall Street that excessive regulation and litigation are harming the competitiveness of U.S. capital markets.

Standard financial services contracts are now structured so that disputes are submitted to mandatory arbitration, as “consented” to by the investor. However, last week Leahy emphasized to the SEC that arbitration is not a satisfactory mechanism for resolving financial services disputes, because:

•full legal discovery is unavailable in these proceedings;
•standard rules of legal procedure — such as rules of evidence — do not apply;
•no written opinions are required to follow; and
•judicial review of decisions is severely limited.

Leahy asked the SEC to replace the current system with a rule that would either ban pre-dispute, mandatory arbitration clauses entirely, or require that consumers be given a choice between traditional judicial process and mandatory arbitration. His intervention is just the latest salvo in the battle between those who see U.S. capital markets as hampered by over-regulation, and those who suggest that the emphasis on shareholder rights and strict accounting standards benefits firms listed in the United States.

Barriers to change

Despite the changeover to Democratic control of Congress, Leahy’s request is unlikely to spur a legislative response.

Financial services firms will resist change that might increase their litigation exposure:

•Avoiding discovery requests. As part of the litigation process, courts frequently allow plaintiffs latitude to purse wide-ranging discovery requests, often leading to the release of embarrassing material.

•SEC favors arbitration. Leahy’s request comes at a time when the SEC is considering proposals that would allow public companies to specify in their bylaws (as in certain EU countries) that disputes between management and shareholder be submitted to mandatory binding arbitration, rather than being resolved by litigation. House Financial Services Chairman Barney Frank (D-Mass.) has also criticized this and a related proposal, to prohibit shareholders’ class action lawsuits, which would make it uneconomic for most individual shareholders to file lawsuits.

•Congressional response. At a minimum, Leahy’s Judiciary Committee is likely to explore alternatives to mandatory arbitration for brokerage disputes in hearings. The scope of such hearings could widen significantly if Cox proceeds to back any changes privileging arbitration over litigation.

SEC policymaking trends

The basic dynamic of policymaking under Cox differs greatly from that of his predecessor, William Donaldson. Donaldson pushed through a controversial, reformist, pro-investor agenda, although some rules enacted during his tenure — such as controversial hedge fund regulations — were subsequently overturned by the courts.

By contrast, Cox has privileged consensual decision-making, preferring to refine policies until they can be endorsed by a unanimous vote of the SEC’s five commissioners. This has led to more conservative policies, since it is difficult to get unanimous support for any significant change. Therefore, the SEC is very unlikely to pursue policies that would encourage further litigation.

Furthermore, litigation risk is often cited as a factor that is eroding the competitiveness of U.S. capital markets. An influential Wall Street-led lobby will resist any change that could facilitate investment-related lawsuits; this anti-litigation perspective enjoys the support of many leading policy-makers, including Treasury Secretary Henry Paulson, members of
Congress from both parties, and New York political figures.

Excessive regulatory burden

Yet in the face of these trends, recent academic evidence suggests that claims that various factors, including the litigation climate, have eroded the competitiveness of U.S. capital markets are overblown. A recent study by Craig Doidge of the University of Toronto, and Andrew Karolyi and Rene Stulz of Ohio State University, challenges concerns about the alleged declining competitiveness of U.S. capital markets — as a result of the adoption of the Sarbanes-Oxley Act of 2002, or other factors such as litigation or regulatory costs. The study’s conclusions also contradict received wisdom that sees the U.S. capital markets as enmeshed in a cycle of inexorable relative decline:

•Cross-listings (where companies would pursue listings in a home country and the United States, for example) have declined on both the London Stock Exchange’s (LSE’s) Main Market and the major U.S. exchanges.

•Sarbanes-Oxley has not reduced the benefits of cross-listings.

•Significantly, there remains a significant premium for U.S. listings, and that premium has not declined significantly in recent years (despite recent regulatory developments).

•Firms actually receive a governance benefit for opting into the U.S. regulatory environment.

•There is no premium attached to London listings.

•Following cross-listing in the United States, companies increase their capital-raising activity (both at home and abroad), whereas no similar benefit accrues from a London listing.

•An exchange listing in New York still continues to provide significant benefits to firms; Sarbanes-Oxley has not reduced such benefits, nor can they be recreated via merely listing in London.

Key implications

The study has two key implications, which run counter to the line being pushed by Wall Street firms as they seek to reduce regulatory burdens:

•New York still maintains a listing premium for “quality” deals. Indeed, the market share for U.S. listings on the New York Stock Exchange, NASDAQ, and the American Stock Exchange has increased relative to the LSE’s Main Market.

•The types of transactions that New York has allegedly “lost” in recent years, largely to the LSE’s Alternative Investment Market, would actually never have been allowed to come to market in New York anyway.

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