Law and the Market: The Impact of Enforcement

Abstract

The intensity of enforcement efforts by securities regulators varies widely among financially developed nations, but countries with "common law origins" appear to systematically expend more on securities regulation than countries with "civil law origins." However, whether this variable of relative enforcement intensity explains the greater financial development of countries with common law origins or is instead the product of that differential in development remains open to question and depends on the direction of causality. This paper examines several explanations and prefers the hypothesis that enforcement intensity is a product of the level of retail ownership in the jurisdiction, with a high level of retail ownership creating a political demand for greater enforcement. Even more striking than this disparity between "common law" and "civil law" countries, however, is the outlier position of the United States, whose public and private enforcement efforts dwarf those of other nations. The United States is unique not in its expenditures on securities regulation, but in the amount and severity of the penalties it imposes. Enforcement efforts can be sensibly measured either in terms of "inputs" (i.e., budget and staff size) or outputs (i.e., enforcement actions brought or financial sanctions levied). After adjustment for market size or GDP, the U.S. does not differ materially from other common law countries in its expenditures, but it brings far more enforcement actions and imposes far greater financial penalties. For example, in 2005/06, the financial penalties imposed by the SEC exceeded those imposed by the U.K.'s Financial Services Agency ("FSA") by a thirty to one ratio, which, even after adjustment for differences in market capitalization, still translates into a ten to one ratio. The greater emphasis on enforcement in the United States is also evident in a comparison of the budgets of the major securities regulators, with the SEC devoting a percentage of its budget to enforcement that more than doubles that of the FSA. Behind this varying emphasis on enforcement may lie different approaches to regulation: an "ex ante" advisory and consulting approach elsewhere and an "ex post," deterrence-oriented emphasis in the United States. The greater use of public enforcement in the United States is more than paralleled by corresponding disparities in private enforcement and the use of the criminal sanction. Virtually alone, the United States recognizes the class action and the contingent fee. The actual financial sanctions imposed by private enforcement in the United States exceed those imposed by public enforcement, and the margin appears to be increasing. The only nation to rival the U.S. among "common law origin" countries is Australia, which actually devotes a higher percentage of its securities regulator's budget to enforcement and also uses the criminal sanction heavily. Australia is also characterized by a high level of retail ownership. What has been the consequence of this greater emphasis on enforcement in the United States? Much recent commentary has suggested that it has deterred foreign issuers from entering the U.S. and threatened U.S. capital market competitiveness. Closer examination suggests, however, that the firms most deterred from cross-listing have been firms with controlling shareholders and a pattern of extracting high private benefits of control. Foreign issuers that do cross-list in the United States incur a cost of capital reduction averaging 13% and a valuation premium (measured in terms of Tobin's q) that is 32% greater than that of non-cross-listing firms. Although the cross-listing decision involves a complex interaction of bonding, signaling, self-selection, and reduced informational asymmetry, the overall evidence supports the "bonding hypothesis" and suggests that U.S.'s greater emphasis on enforcement reduces informational asymmetry and gives it a lower cost of equity capital.