American Investor Protection is Protectionist

The spate of corporate financial scandals in the US has set off a judicial and legislative onslaught that is reaching beyond America's borders. The Sarbanes-Oxley Act has caught 300 European Union companies, untainted by scandal, in a dragnet that threatens to destabilise their boardrooms and de-legitimise their governance structures.

The remarkable thing is not that Sarbanes-Oxley is so brazenly extra-territorial - European firms are already well acquainted with US extraterritoriality in the Helms-Burton and D'Amato Acts of the 1990s. More surprising is the archaic nature of the power of the Sarbanes-Oxley Act.

The ultimate cause of grief to 300 European companies is that they list American Depositary Receipts on the New York Stock Exchange and Nasdaq. These ADRs, which cost millions of dollars in legal, accounting and listing fees to establish and maintain, are not created because EU companies need them to provide US investors with a trading vehicle for EU securities. Instead, they stem from US regulatory barriers, deriving from Depression-era legislation. These regulations deter US investors from buying securities where they are most liquid and therefore cheapest - on their respective home exchanges in Europe.

All EU exchanges operate electronic trading systems that can be used to extend trading access to US brokers and institutional investors almost as cheaply as to their local members in Europe. Indeed, under a liberal regime operated by the US Commodity Futures Trading Commission, European derivatives exchanges have provided such access in the US since 1997.

Yet the Securities and Exchange Commission still forbids any non-US stock exchanges from doing the same thing. Although the SEC has powers that would allow it to mimic the CFTC's regime, it chooses not to do so. It justifies this stance on the grounds of investor protection. The SEC maintains that shares are different from futures, since stocks must have a financial disclosure regime attached. It insists that US investors are offered only registered securities meeting the disclosure requirements of US generally accepted accounting principles.

But the sanctity of GAAP was well and truly undermined by the Enron scandal and cover-up. GAAP accounting represents no bar to the wilful public dissemination of misleading, or even patently false, financial figures. Moreover, even the proper application of GAAP to companies operating primarily outside the US legal and tax environment can provide US investors with a highly distorted view of their true financial condition.

Deutsche Bank, for example, switched from International Accounting Standards to GAAP in 2001 to accommodate its NYSE listing. Because of an inappropriate synthetic tax charge, compulsory under GAAP rules, Deutsche Bank's net income figures for 2002 are hugely distorted. This will probably continue until 2004, as the bank disposes of industrial holdings and incurs GAAP tax accounting charges without any real tax liability. This fact led to a rare sell recommendation from a big investment bank, whose analyst called on Deutsche Bank to return to IAS accounting before it confused its investors even more.

If US investors are better off reading Deutsche Bank's financial statements in IAS rather than GAAP language, what advantages do they, or the bank itself, get from the NYSE listing? Absolutely none. Only the NYSE benefits. The shares are more liquid in Frankfurt and could be bought and sold more easily in the US if only Deutsche Borse were permitted to provide direct trading access to US brokers and institutional investors. Individual US investors would be no less protected in trading these shares on Deutsche Borse, as they would continue to do so through SEC-regulated brokers.

They would also get a better deal. My research with Ian Domowitz into the economic impact of trading automation suggests strongly that a true integration of the US and EU securities markets would cut trading costs by about 60 per cent and lower the cost of equity capital by about 9 per cent on both sides of the Atlantic.

Yet such integration can only proceed rapidly if exchanges on each side are permitted to operate on a transatlantic basis. The European Commission has already pledged support for the idea of a transatlantic mutual recognition agreement on exchange access. It is time for the new US Treasury team, in the interests of US investors and US companies, to override both SEC inertia and protectionist pressures from the NYSE, and conclude a deal.