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SOX: a case studyin extra-territoriality

Tod Ackerly IICentral Banking Publications

A reprint from

The Financial RegulatorVolume 12 Number 2

September 2007

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Future historians, when describing globalfinancial markets in the late 20th and early

21st centuries, will surely cite the passage ofthe Sarbanes-Oxley Act of 2002 (SOX)1 as awatershed event. Its ultimate legacy, however,remains unclear. Will it be described as aprime example of overbearing regulation bythe United States?2 Will it be seen as the eventthat knocked New York off its pedestal as the“financial capital of the world,”3 or will ithave exactly the opposite effect?

Genesis of the act

Sarbanes-Oxley was enacted in the heat ofthe Washington summer of 2002 in anatmosphere of near political panic.4 MajorUS corporations had been discoveredcommitting fraud on a massive scale.Hundreds of thousands, if not millions, ofinvestors had lost large sums of money, andmany people had lost their entire retirementnest-eggs. The pressure on Congress to “dosomething” was enormous. If some of theprovisions of SOX appear out of place inthe US federal system of securitiesregulation, it is because they were proposedin response to some abuse or perceivedabuse that had received attention in thepress, and opposing them would have beentantamount to political suicide in theatmosphere that prevailed that summer.

The application of SOX to non-UScompanies (“foreign private issuers” orFPIs) is a good example. The SEC had along history of making accommodations forFPIs to ease their ability to access UScapital markets, and as recently as June 142002, the commission had proposed thatpost-Enron anti-abuse measures not beapplicable to FPIs.5 However, the presscarried stories of several well-known UScompanies that had re-incorporated offshorein order to save taxes. The argument wasmade that if SOX were not applied to allcompanies publicly traded in the US –regardless of place of incorporation – therewould be an exodus of US companiesreincorporating offshore simply to avoid it.6

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SOX: a case study inextra-territorialityWith New York losing financial business to London, many have pointed to theSarbanes-Oxley Act as a leading culprit of over-regulation. But as Tod Ackerly IIwrites, its consequences may be even further reaching.

Tod Ackerly is sen-ior counsel withCovington & BurlingLLP. A US-qualifiedsecurities lawyerwho has representedissuers and under-writers in a broad

range of capital markets transactions,his experience includes representationof financial markets and market partic-ipants on cross-border securities-lawand market-regulation issues.

The adequacy of foreign corporategovernance structures and their relationshipto the new rules was simply not addressed.7

The question of applying the legislation toFPIs was still open as the conferencecommittee set to work to resolve thedifferences between the bill passed by theHouse and the version passed by the Senate.In the conference, some argued that theforeign companies had chosen to come to theUS markets; that they should play by ourrules; and that, if they didn’t like it, they couldleave. That argument carried the day, and thelegislative language was drafted broadlyenough to include FPIs.8

Over-reaction

Ironically, those who made this argumentmust have forgotten, or had never heard about,Section 12(g) of the Securities Exchange Actof 1934. Perhaps they can be forgiven. Theywere, after all, working almost around theclock to get the legislation completed. Whatthey apparently failed to realise was that thissection and its implementing regulationsrequire any SEC reporting company, domesticor foreign, to continue to be subject to theSEC rules, unless it has fewer than 300 USshareholders.9 Since virtually any publiclytraded company has many more USshareholders than that, they were stuck in“Hotel California”10 or a “roach motel.”11

At a conference in Dublin later that fall, a

European authority on corporate governanceasked me: “How do you explainSarbanes-Oxley from a philosophical pointof view?”

It was an interesting question. I thought fora moment and replied, “You can’t. It violatesthe Kantian categorical imperative.12 You canexplain it only from a political point of view.Given the atmosphere at the time, politicalimperatives overwhelmed all others.”

The fall-out from SOX, of course, wasvirtually instantaneous. A major Europeancorporation almost immediately announcedthat it was suspending its planned stockoffering in the US. Others followed suit.Numerous studies since then have addressedthe attractiveness, or lack thereof, of the NewYork market.13

The events of the past five years raise twointeresting questions.

First, to what extent can the shrinkage ofNew York’s share of the global securitiesmarket14 be attributed to SOX? Second, isSOX a good example of the US attitudetoward extra-territoriality in the field ofsecurities law?

I should emphasise that I write from mypersonal perspective only. I am a privatelawyer who has represented both issuersseeking to raise capital and foreign marketsseeking to attract the business of those issuers.I have no experience as a regulator, and I havenot conducted any learned broad-basedstatistical analyses these issues. My views arebased solely on my personal experience.

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Impact of SOX on US markets

As to the first question, my view is that SOXis a factor, but that it is only one of many.

The costs of SOX are very real. Forexample, the costs of complying withsection 404 have turned out to besubstantially higher than initiallyestimated.15 However, there are many otherfactors, and the relative importance of SOXamong the entire mix of considerationsvaries depending on each issuer’s particularcircumstances. For example, features of theUS securities regulatory regime totallyunrelated to SOX can play a significant role.Offerings can be accomplished much morerapidly in markets other than in the US.16

Thus, if a company believes that the timingis right and that the market may fall awayfrom it, it will conduct its offering where itcan get to market most rapidly.

Other regulatory factors include the moreextensive disclosure that US regulationsrequire on various subjects, executivecompensation being only one example. Also,the recent SEC interpretation of rule 415 hascaused PIPE issuers and investors to lookoutside the US. for sources of liquidity.17

Factors totally unrelated to regulatoryregimes also play a substantial role.Litigation risk is one factor. Market trends areanother factor: at any given point in time, theNew York market may not be as receptive asthe London market to companies with aparticular profile. Moreover, if an issuer has

important connections with another country,such as significant investors or a largecustomer base there, that country may makemore sense than the US. The issuer’s industrycan also make a difference. For example,companies in the minerals exploration anddevelopment industry consider other marketsas being more receptive to their particular“story” than the US.

The list goes on. My point simply is thatCongress could repeal Sarbanes-Oxleytomorrow and New York would notautomatically regain a position of pre-eminence.

Foreign consequences

The second issue is the apparent disinclinationof the US to pay sufficient attention to theproblems caused beyond its borders by theextraterritorial application of its domestic lawsand regulations. On the surface, of course,SOX appears to be an obvious case ofover-reaching, but there is more to the story.

Over the past five years, there has been astartling, almost miraculous, sea-change in theattitude of US regulators toward the rest of theworld. The US has traditionally followed a“national treatment” approach to securitiesregulation, ie, with only limited exceptions, itapplies a uniform standard to all marketparticipants regardless of nationality. Theconcept of “mutual recognition,” with whichEuropeans are so well acquainted, was simplynot in the SEC’s vocabulary five years ago.

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SOX

Let me mention just one example. Duringthe fall of 2002 and the early months of2003, as the SEC was proposing and thenadopting its regulations underSarbanes-Oxley, numerous delegations fromother countries came to the SEC and madethe following plea: “Our country has a goodcorporate governance system. It is notbroken. SOX was passed to fix the corporategovernance system in the US, which wasbroken. There is no reason to force ourcompanies to adopt the corporate governance‘fixes’ that the US has now imposed. Pleaserecognise our system as being worthy ofyour respect and exempt us.”

The SEC took a hard-line position: “Wewill give you an exemption only if you candemonstrate a direct conflict between yourlocal law or market practice and the SOXrequirements. If you are actually prohibitedfrom adopting the SOX rules, then we willconsider an exemption. We will not consideran exemption otherwise.”18

Humble pie

Today, the attitude at the SEC is markedlydifferent. At least two commissioners,19 thedirector of the division of marketregulation20 and the director of the office ofinternational affairs,21 have each madestrong statements supporting “mutualrecognition” (or “substituted compliance”)with respect to at least some issues.

How can this change be explained? Thereare a number of factors, including pressurefrom Wall Street and an increasing flow ofUS investors going directly to offshoremarkets. From my perspective, however,SOX has had a lot to do with it. In effect,the act has been a poster child, a whippingboy, “Exhibit A” (use whatever analogy youlike). It has been the catalyst for a broadrealisation that US securities regulation hasgone too far in the direction ofextra-territoriality and that the pendulumshould swing back. In substantial partbecause of SOX, it is becoming more andmore widely accepted that the US needs toreach out if it is to avoid being isolated asthe rest of the world moves on.

I should emphasise that this change hasoccurred primarily at a very high,conceptual, level and that it is not yet clearto what extent it will be implemented on asubject-by-subject basis. Thus, the newattitude is largely untested and, as always,the devil is in the details. One concreteexample is the recent adoption of rule12h-6, which establishes a mechanism forFPIs to gain freedom from their SECreporting obligations even though they mayhave substantially more than 300 USshareholders. This is an important step inthe right direction.

However it is too soon to claim this isrepresentative of a broad willingness by theSEC to modify existing regulations to“mutually recognise” non-US practices.

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SEC: resistant to change

In fact, in at least one instance the trend hasmoved in the opposite direction.

SEC Regulation S establishes the basicprinciple that “offshore” offerings do not haveto be registered under the Securities Act of’34. What does “offshore” mean? Reg. Sestablishes two safe harbours with ratherdetailed rules, and these rules vary dependingupon the identity of the issuer and thecircumstances of the offering. Foreign issuerstypically fall into “category one,” and therules are quite simple. US issuers, however,fall into “category three,” and the rules aremuch stricter and more complex.

The category three rules, which weredesigned to keep unregistered shares from“flowing back” into the US market, wereadopted in 1990 as a codification of practicesthat had been developed over the previous 25years. They do not work very well in thecontext of markets that are modern, electronicand highly automated.

In 1999 and 2000, the SEC staff grantedno-action letters to three non-US markets,approving “alternative procedures” that werecompatible with electronic trading systemsand still provided reasonable protectionagainst “flow back.” The SEC staff has nowsaid that they will not issue any moreno-action letters of this kind. Whatever thejustification, this position is hardly consistentwith a philosophical change in favour ofmutual recognition.

As a result of the SEC position, forexample, trades in shares of US companieson the AIM market in London are typicallysettled the old-fashioned way, using papercertificates. As one of the main drafters ofReg. S, who is now in private practice, wasquoted as saying not so long ago, settlingtrades with paper certificates is “silly”.22 Yes,it is silly, and it hurts the liquidity of thestock and therefore hurts the shareholders ofthese US companies. However, that is what amany London lawyers are requiring in orderto assure that their clients remain incompliance with Regulation S.

A new vocabulary

To return to my opening question, I believethat, in spite of being an obvious case ofregulatory over-reach, SOX will leave apositive legacy relative toextra-territoriality and the development ofthe global marketplace.

Precisely because it went too far and hashad dire consequences, or at leastconsequences that many view as being dire,SOX almost surely will be seen by futurehistorians as a turning point, as marking thebeginning of a period in which US securitiesregulation became more agile and lessmuscle-bound. As compared with the situationthat would have pertained if SOX had notbeen passed, mutual recognition will informmore decisions, and progress will be made

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SOX

more rapidly toward a smoothly functioningglobal market unimpeded by regulation-basedinefficiencies, a global market from which allplayers will benefit.

There will be hurdles. Progress will beslow. However, the vocabulary of the debatehas changed, and for that we owe a vote ofthanks to Sarbanes-Oxley.

Notes

1 Pub. L. 107–204, 116 Stat. 745 (2002).2 Extraterritoriality — the operation of laws upon persons

existing beyond the limits of the enacting state — is atopic with a proud history. See generally, Restatement ofthe Law Third, The Foreign Relations Law of the UnitedStates (1986) Part IV; Jessup, Transnational Law (NewHaven 1956) 72–113; Haight, “International Law andExtraterritorial Application of the Antitrust Laws,” 63Yale LJ 639 (1954). A discussion of the extent to whichSOX is justifiable under traditional principles ofextraterritoriality is beyond the scope of this article.

3 Europe’s Commissioner McCreevy stated recently thatthe US share of global IPOs has fallen from 57% in 2001to 16% in 2006, while Europe’s has increased from 33%to 63% during the same years. Wall Street Journal (March5, 2007) at A17. (Text at http://online.wsj.com/article_print/SB117304935844426392.html).

4 Eg, 148 Cong. Rec. H4480 (daily ed. July 10, 2002)(statement of Rep. Baldwin) (“Mr Speaker, there is acrisis in America. People are out of work and are worriedabout losing their jobs. … Without action to shore up theconfidence of the American public, our faith in the stockmarket will be shattered and, along with it, the backboneof our country’s financial system.)

5 SEC Release No. 34-46079 (Proposed Rule reCertification of Disclosure in Companies’ Quarterly andAnnual Reports) (June 14 2002) (“… mandatoryrequirements regarding internal procedures raise severalissues, since those requirements may be inconsistentwith the laws or practices of the foreign private issuers’home jurisdiction and stock exchange requirements. Forthese reasons, applying the proposed rules to foreign

private issuers would raise additional issues that do notexist for domestic companies. Therefore, we do notpropose to apply the certification and proceduralrequirements to foreign private issuers at this time.”)

6 Eg, 148 Cong. Rec. S6688 (daily ed. July 12 2002)(statement of Sen. Dorgan) (quoting a Wall Street Journalarticle of July 8, 2002, which described the effect ofcompanies such as Tyco International Ltd. and GlobalCrossing Ltd. being incorporated in Bermuda); 148 Cong.Rec. H4479, H4484 (daily ed. July 10 2002) (statementsof Rep. Lee and Rep. Sanchez).

7 The failure to address the issues relating to FPIs ishighlighted by the fact that the staff of the SenateBanking Committee took a day-and-a-half to decidewhether the Senate bill applied to offshore corporations.148 Cong. Rec. S6689 (daily ed. July 12 2002)(statement by Sen. Dorgan) (“I have discussed myconcern with the staff of the Banking Committee. Theybelieve that their bill implicitly addressed thereincorporation problem. But Senator Graham of Floridaand I said we are not satisfied with ‘implicitly’ beingcovered. We want the issue addressed explicitly. Let mealso say, the technical people smile when I talk aboutthis, but, frankly, it took a day and a half for us toevaluate whether it was implicitly covered in the bill. Sobecause of that, I think it is important to have an explicitprovision in this bill that says those companies involvedin inversions that renounce their citizenship, they, too,will be required to certify their results.”)

8 Some conferees argued that Congress had not intended toinclude foreign private issuers. For example, Senator Enzistated, “… I believe we need to be clear with respect tothe area of foreign issuers and their coverage under thebill’s broad definitions. While foreign issuers can belisted and traded in the US if they agree to conform toGAAP and New York Stock Exchange rules, the SEChistorically has permitted the home country of the issuerto implement corporate governance standards. Foreignissuers are not part of the current problems being seen inthe US capital markets, and I do not believe it was theintent of the conferees to export US standardsdisregarding the sovereignty of other countries as well astheir regulators.” 148 Cong. rec. S7356 (daily ed. July 252002) (emphasis supplied). The senator continued, “[Thebill] gives the SEC wide authority to enact implementingregulations that are ‘necessary or appropriate in thepublic interest.’ I believe it is the intent of the conferees

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to permit the commission wide latitude in using theirrulemaking authority to deal with technical matters suchas the scope of the definitions and their applicability toforeign issuers. I would encourage the SEC to use itsauthority to make the act as workable as possibleconsistent with longstanding SEC interpretations.”

9 See 17 C.F.R. 240.12g-4 (a non-US issuer can terminateits US registration only if fewer than 300 holders of theissuer’s equity securities are US residents).

10 “Hotel California” is the title of a popular song by theEagles from the 1970s. It describes an establishmentwhere “you can check out anytime you like, but you cannever leave.”

11 It took five years, but this situation has now beenremedied. The SEC has adopted Rule 12h-6, whichpermits FPI’s to de-register with the SEC if certainconditions are met. See SEC Release No. 34-55540(March 27 2007).

12 The Kantian imperative is a more formal expression ofthe principle that many of us know as the “Golden Rule”:“Act only according to that maxim whereby you can at thesame time will that it should become a universal law.”Immanuel Kant, Metaphysics of Morals.

13 Eg, Commission on the Regulation of US Capital Marketsin the 21st Century, Report and Recommendations (USChamber of Commerce, March 2007).

14 It should be noted that New York’s alleged loss of marketshare is not accepted by everyone. Eg, remarks byCommissioner Raul C. Campos, London, England, March8, 2007 (text at http://www.sec.gov/news/speech/2007/spch030807rcc.htm) (“… a recent report byThomson Financial points to the strength of the US IPOmarket. The study found that foreign IPOs accounted for16% of the 208 IPOs in the US last year, the highestproportion of foreign IPOs in Thomson’s 20-year review.Also, foreign IPOs in the US last year raised $10.6 billionof the $45.3 billion in IPO offerings priced in the US,which equals 23% of IPO money raised year, the highestlevel since 1994. Further, and this is a quote: ‘since theadoption of Sarbanes-Oxley … in July 2002, there hasbeen little evidence that foreign issuer IPOs have beenshying away from the US market.’ The 34 foreign IPOs in2006 equaled the total in 2005 and represented thehighest level since SOX was enacted.”)

15 According to the Senate committee report issued on July3, 2002, high quality audits already “incorporateextensive internal control testing” and, as a result, the

committee did not expect the internal control provision tobe the basis for any increased fees or charges by outsideauditors. S. Rep. No. 107–205, Public CompanyAccounting Reform and Investor Protection Act of 2002(July 3 2002) at 31. Reasonably soon thereafter, the SECestimated that implementation of Section 404 would costan average of $91,000 per company, for a total of one anda quarter billion dollars. Management’s Reports onInternal Control Over Financial Reporting andCertification of Disclosure in Exchange Act PeriodicReports, SEC Release No. 33-8238 (June 5, 2003) atSection V(B). Recent estimates have put actual averagecosts at more than 20 times that amount. Remarks byCommissioner Paul S. Atkins at Finance Dublin, March26 2007 (text at http://www.sec.gov/ news/speech/2007/spch032607psa.htm).

16 Our firm has listed companies on AIM in 3 months, startto finish. The SEC registration process typically takes atleast twice as long.

17 Eg, “Gazing Abroad — US Regulations and OverseasOpportunities Creating Global PIPE Investors,” ThePIPEs Report (March 20 2007) at 1.

18 Eg, Speech by SEC chairman, Harvey L. Pitt, at theFinancial Times’ Conference on Regulation & Integrationof the International Capital Markets (London, October 82002) (“[SOX] generally makes no distinction betweenUS issuers and foreign private issuers listed in the UnitedStates. It applies equally to all who seek to access UScapital markets. And we are committed to implementationof the Act that is fully consistent with its purpose andintent. … [However] … I urge foreign companies … tocomment on our rule proposals and to let us know whenour proposals conflict with local law of local stockexchange requirements …”). In fact, a few exemptionswere granted on this basis. Eg, SEC Release No. 33-8220(April 16 2003) text at footnotes 146–156 (“Section10A(m) of the Exchange Act makes no distinctionbetween domestic and foreign issuers. … However, asdiscussed in the Proposing Release, we are aware that therequirements may conflict with legal requirements,corporate governance standards and the methods forproviding auditor oversight in the home jurisdictions ofsome foreign issuers. … We understand that somecountries, such as Germany, require thatnon-management employees, who would not be viewed as“independent” under the requirements, serve on thesupervisory board or audit committee. Having such

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SOX

employees serve on the board or audit committee canprovide an independent check on management, whichitself is one of the purposes of the independencerequirements under the Sarbanes-Oxley Act. Accordingly,we are adopting as proposed a limited exemption from theindependence requirements to address this concern, solong as the employees are not executive officers, …).

19 Eg, Remarks by Commissioner Paul S. Atkins at FinanceDublin, March 26 2007 (text at http://www.sec.gov/news/speech/2007/spch032607psa.htm) (“I believe thatthe territorial approach should continue to be theCommission’s guiding principle as we deal with whatappears to be an unprecedented series of majorinternational developments in the markets.”); remarks byCommissioner Raul C. Campos, London, England, March8 2007 (text at http://www. sec.gov/news/speech/2007/spch030807rcc.htm) (“Instead of mentioning what theSEC has done to ease the regulatory burden on foreignissuers, I’ll now turn to what the SEC might do.Specifically, I’m referring to ideas that have been termed‘mutual recognition’ and a ‘cooperative approach.’”)

20 Erik R. Sirri, “Trading Foreign Shares” (Boston, MA,March 1 2007) (text at http://www.sec.gov/news/speech/2007/ spch030107ers.htm).

21 Tafara and Peterson, “A Blueprint for Cross-BorderAccess to US Investors: A New InternationalFramework,” 48 Harv. Int’l L.J. 31, 51 (winter 2007). Arespected former SEC official has even suggested that“mutual recognition” be extended from market-regulationissues to area of securities offerings. Greene, “BeyondBorders II: A New Approach to the Regulation of GlobalSecurities Offerings” (June 2007) (text ath t tp : / /www.sech i s to r i ca l .o rg /co l l ec t ion /papers /2000/2007_0501_GreeneBeyondT.pdf.)

22 Burns, “LSE Offers Plan To Speed Settlement OfRestricted Shares” (Dow Jones Newswires, May 262006).

This article is adapted from remarks made at aconference sponsored by the Royal Institute ofInternational Affairs, June 15 2007.

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