Assessing Capital Markets Reform Proposals - A Corporate Practitioner's Perspective

Tuesday, May 1, 2007 - 00:00

Editor: Please tell our readers about your background.

Johnson: I practice in the Dallas office of Winstead, advising clients on a variety of corporate transactional work; I specialize predominantly in M&A work. The majority of our clients are in the U.S.; however, we handle international matters from time-to-time.

Editor: Is Texas a desirable location for foreign clients?

Johnson: The Dallas/Fort Worth Metroplex area is attractive for many reasons. We have a centrally located international airport that allows companies to service both coasts. We do not have a state income tax. We are a non-union state and we have a lot of inexpensive real estate. There are drawbacks as well that clients consider such as the high cost of living in the Dallas/Fort Worth area and in Austin and the quality of some of the local school systems. People seeking a location go through a process of weighing the pluses and minuses of each area before they decide what location makes the most sense for their operations.

Editor: Three recent reports attempt to identify reasons why our capital markets are losing business to foreign financial centers like the UK and Hong Kong. There is a perception that foreign issuers are avoiding the U.S. because of the uncertainties created by what is perceived to be our difficult regulatory and legal environment. Concerns were expressed in those reports about regulation by federal and state regulators with overlapping authority, prosecutors that bring criminal actions against corporations without regard to collateral damage to innocent stakeholders and a private bar that makes a business of intimidating corporations into huge settlements. Do you find that your foreign clients are deterred from setting up operations in this country, listing their securities here or seeking financing here?

Johnson: Most of our clients have already decided to enter the U.S. They have already thought about the criticisms that you mentioned and decided that the benefits of being here outweighed the uncertainties. I deal with a Swedish company that decided to locate a facility in Dallas. Before they came to Texas, they had already entered the U.S. market so they were more concerned with what they felt were the unique benefits of the business environment offered by Texas. Although the concerns you mention can be important from the standpoint of a company that has not yet made the move into the U.S., once they have come here, they find that there are great differences in the ways particular states treat business. My foreign clients have been very pleased with the business environment here in Texas.

Editor: How big a problem is Sarbanes-Oxley?

Johnson: Sarbanes-Oxley is undeniably the focus of attention for many commentators. The press is full of doom and gloom stories, but in reality SOX is simply the latest regulatory cost of doing business. It was not too long ago that we did not have antitrust laws or regulations, the federal securities laws, the EPA or OSHA in this country. If you were to turn back the clock and tell companies in the early 1900's about the laws and regulations that were about to be foisted upon them in each of those areas, they would have been appalled. However, in reality, each of those companies learned to adapt to and prosper in the evolving regulatory environment. SOX simply represents the latest variation on that theme. I suspect that companies in the U.S. will learn to adjust and prosper under SOX, as well.

Editor: Are your clients seeking private equity or venture capital rather than public IPOs because of Sarbanes-Oxley?

Johnson: There is a move in the capital markets towards private equity. There is simply a tremendous amount of capital available in private hands, and companies in need go where the money is. Who's to say whether that move is related to Sarbanes-Oxley or not, but SOX certainly hasn't impeded the move. Tangentially, I do wonder whether we would have seen the rush to the public markets in the late 90's that we saw if Sarbanes-Oxley had been in place 10 years ago; I suspect not, as the SOX driven costs of being public have now been shown to have a stifling effect on the IPO market. And you tell me, is that necessarily all bad? Except for the few folks who timed things right and cashed out at the top of the market, an argument could be made that the U.S. economy might have been better off without the run up of the tech market and the succeeding collapse. In that respect, the net effect of SOX is that it is causing fringe companies to think long and hard about going public or staying public.

Editor: The three reports I mentioned agree that the SEC should move to a "prudential" type of regulation similar to that found in the banking industry where there is more emphasis on open dialogue with companies and less emphasis on making law by enforcement. Do you agree?

Johnson: I believe a kinder regulatory environment would be beneficial. The reports contain several good ideas that make sense; who doesn't agree with the general proposition that the regulators should be nicer. However, I am not sure that the banking industry is all that similar to the securities industry. The banking industry may lend itself more to the prudential model because the regulators and bankers are accustomed to working together as a team on an almost day to day basis with the common objective of assuring the soundness of our banks. The SEC on the other hand has a different constituency; the SEC is in large part charged with looking out for the interests of the investing public. It is a fundamentally different regulatory regime. By definition, I believe it has to be more adversarial.

Editor: Should the rule making authority of the SEC be extended to permit it to exempt foreign and small companies under Section 404? What about changes in Section 404 to include a redefinition of materiality and a provision for more guidance from the PCAOB?

Johnson: I am in favor of this. The financial burdens of Section 404 are indeed onerous and some companies that are large enough to be public are nonetheless struggling under the financial burdens of 404.

Editor: Should reliance by directors on an audited financial statement or on an auditors SAS 100 review report be conclusive good faith evidence of due diligence? Should the same treatment be accorded good faith reliance on representations of officers after boardroom discussions?

Johnson: I am certainly in favor of it, depending on how good faith is defined. The language suggests that the directors would not be held liable for anything if they relied in good faith on the financial statements. It is difficult to know, however, what level of review will ultimately be deemed to constitute good faith. The devil will be in the details.

Editor: Should gatekeepers like auditors be exposed to liability under Section 10A if they fail to take action after they become aware that an illegal act has or may have occurred?

Johnson: I would agree that this provision is troublesome in that "taking action" may take many forms. What is required of the auditors should be more clearly defined, but auditors should not be entitled to look the other way if they uncover significant wrongdoing. I would not want my accountants or my client's accountants to do that.

Editor: How do you feel about the recommendations that quarterly earnings guidance be discontinued?

Johnson: The problem with that is that unless the SEC drops its quarterly reporting requirements, public companies will still manage quarter-to-quarter. The quarterly earnings guidance is not so much the problem; quarterly reporting is, and that's not likely to go away.

Editor: What do you believe the U.S. should do to maintain its supremacy in the capital markets?

Johnson: There was a time when Great Britain's economy was the strongest in the world; that is no longer the case. I am not sure that there is anything that the British could have done to change that fact. The world changes and the best we can all do is adapt and move along. In that respect, I do not think that we can counter the growth of Far Eastern capital markets or the European Community capital markets by tweaking our regulatory regime. Case in point, while significant capital has been redirected to the Far East in recent years, there has been a growing recognition that investing in and through those less regulated markets does have its costs. In some instances, some of the Far Eastern markets are somewhat akin to Wall Street in the 1920s; real good for some, not so good for others, depending on who has the inside information.

It is a fact that the U.S. capital markets are burdened with imposing disclosure rules and a heavy regulatory regime, but that is not necessarily a bad thing. It affords the U.S. capital markets a certain degree of predictability and reliability, two things that seasoned investors generally grow to appreciate. There is nothing like having your pocket picked once or twice in a less regulated foreign market to make you appreciate the burdens of our disclosure and regulatory practices.

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