Speech by SEC Staff:
The Role of the States (Foreign and Domestic)
Brian G. Cartwright
U.S. Securities and Exchange Commission
Distinguished Scholar Address — Widener University School of Law
March 28, 2008
Thank you very much for that very kind introduction. It's an honor to be a part of this program.
There's one formality I have to get out of the way right at the outset. I'm required by our rules at the SEC to remind you that the views I express today are my own and not necessarily those of the Securities and Exchange Commission, of its Chairman, of its Commissioners, or of my colleagues on the staff. Those of us who work at the SEC are all required to recite that disclaimer whenever we speak publicly.
Sometimes, of course, SEC speakers nonetheless do go on to communicate perspectives they believe to be relevant to the current work of the agency. In this academic setting today, however, I have no such short-term focus in mind. So I'm sorry to disappoint you if you've come in the hope of learning some useful intelligence about possible Commission policies or actions in the coming year. You won't be getting that today.
Also, when I was a student, I observed that the better law professors raised a multitude of good questions, but somehow managed to leave the answers for their students to puzzle out. While I'm here at the law school, I certainly want to emulate only the better law professors. So I may use that ploy a bit this afternoon.
Given that we're here in the state of Delaware, I'm sure you won't be surprised to learn that my invitation to be with you today was accompanied by a little gentle encouragement to use my remarks to address the "role of the states."
I hope you will indulge my taking some liberties with that notion by crafting my topic as: "The Role of the States (Foreign and Domestic)." I wanted to broaden the topic in that fashion, because these days you risk missing a lot that's important if you fail to take the rest of the world into account.
When you do take the rest of the world into account, it becomes even more obvious than it was before how rapidly our world is changing. Each of us — everyone in this room — has no choice but to try to adapt to ever-changing conditions.
We regulators are no exception. Like everyone else, we must look ahead, or surely we will fall behind. Today, like never before, that means looking outward, towards the rest of the world. Because the rest of the world is coming to us, like never before.
Let me start with an example. I'd like to call your attention to a measure of how much interest U.S. investors have in foreign stocks. The title of this measure is the "U.S. gross activity in foreign stocks."
"U.S. gross activity in foreign stocks" has a simple definition: it's just the sum of the dollar value of all purchases by U.S. residents of foreign stocks from foreigners, plus the dollar value of all sales by U.S. residents of foreign stocks to foreigners.
So "U.S. gross activity in foreign stocks" is a convenient estimate of the amount of trading — both buying and selling — we in the United States do in foreign stocks. But because we Americans also trade foreign stocks with one another, it's really only a lower limit on the amount of such trading. For that reason it provides a rather conservative estimate.
"U.S. gross activity in foreign stocks" is quite a mouthful, so I'm going to call it just "U.S. trading in foreign stocks" instead.
I graduated from law school a little over a quarter of a century ago — in 1980. So let's consider how U.S. trading in foreign stocks has grown since I graduated. I ask you this: after adjusting for inflation, how many times larger do you think the U.S. trading in foreign stocks was last year than it was when I graduated from law school in 1980?
I'm not going to risk embarrassing any of you by calling on you to take a stab at the answer. I'll leave all that to your professors. But I will ask each of you to imagine what your guess would be if I did.
So please think about it a moment. What would your guess be? How many times larger do you think U.S. trading in foreign stocks was in 2007 than in 1980? Do you all have a guess in mind?
OK. Did you guess ten times larger? Twenty times? Even fifty times? Is there anyone who would guess U.S. trading in foreign stocks, measured in constant dollars, was as much as a hundred times larger in 2007 than in 1980?
Are you ready for the actual answer?
What if I told you that, on an inflation-adjusted basis, U.S. trading in foreign stocks in 2007 was almost 210 times larger than it was in 1980 — that in 2007, U.S. residents bought and sold from and to foreigners almost 210 times the dollar amount of foreign stocks they did in 1980?
You can do the math: that corresponds to about a 22% compound annual growth rate over a little more than a quarter century.
Now that is quite a trend. A trend of that size that has continued for decades should interest us. Because, whatever the ups and downs there may be in this year or that year, a trend that big that lasts that long is worth taking very seriously.
And, by the way, the actual dollar value of U.S. trading in foreign stocks last year also was eye-popping: $10.5 trillion. That's $10.5 trillion, with a "t".
Not exactly chump change.
Now, I could go on to rattle off a whole series of other statistics demonstrating beyond cavil that over the last quarter century U.S. investors have become dramatically more interested in buying, selling and holding foreign securities — and another equally impressive series of statistics demonstrating that over the same period foreign investors have become dramatically more interested in buying, selling and holding U.S. securities. It goes both ways.
But I'd rather not risk boring you with a parade of numbers neither you nor I are likely to remember anyway. Instead, allow me to report to you just one item of anecdotal evidence.
I am a long-time investor in a mutual fund. So I get periodic reports from the mutual fund complex that sponsors it. They always include some short articles about investing along with the other materials they send. Their last mailing included an article I'd like to tell you about.
The title of the piece was: "International stocks: What's a reasonable amount?" The answer suggested by the article was: somewhere between 20% and 50%.
Twenty to 50%! As much as half! Today, of course, many other advisers are making similar recommendations. And, even if many of the best companies in the world continue to be home-grown U.S. enterprises, with ever-increasing globalization we can expect the recommended percentages only to increase in the coming years. We must ask ourselves: if many investors ultimately follow those recommendations, what will the implications be?
Of course, it's not only investors who are looking overseas and across borders. So are the businesses in which they invest. By now, every proverbial school child must know that business and commerce is global, and that even public companies of modest size often have extensive international operations. There's even a category of start-up companies called "micro-multinationals," because they have people and operations in various places around the world from Day 1.
Over the space of my own professional life, I've personally experienced the movement from local to regional to national to global. When I started practicing law, the law firm I joined was known as a "Los Angeles firm."
By the time I arrived, it already had opened offices in two other cities in Southern California and was becoming a regional firm, and had just taken the first step on the road to becoming a national firm, by opening a small office in Washington, DC.
By the time I left the firm to join the public sector, the firm's largest office was in New York, not Los Angeles, and of its more than twenty offices around the world, ten were located outside the United States in places like London, Paris, Hong Kong and Singapore, with much, if not most, of the growth in lawyer headcount and revenues coming from the locations outside the United States.
I don't know, but I doubt this trend has slowed since my departure.
So what does all this mean? Where might we reasonably expect to be in five, ten or twenty years?
I think we can anticipate living in a world — and to some significant extent we already do — in which many companies no longer retain much of a national identity, but instead do business around the globe on behalf of stockholders drawn from around the globe — transnational businesses with a global stockholder base.
And how will the stock of such companies be traded? We can guess, because we've seen the pattern before.
In the late nineteenth century, there were something like 100 stock exchanges operating in cities around the United States. But after the telegraph and the telephone made it easy to transmit orders across great distances, the importance of the larger exchanges, with their greater pools of liquidity, began to grow.
By the turn of the twentieth century, New York already was dominant. Companies often dually listed their stock — both in New York and on a regional exchange closer to home. But that was just a transitional phenomenon. Over time, the smaller regional exchanges first consolidated, and then, disappeared.
Today, there's something like 50 stock exchanges operating around the globe. Would it be surprising to see a pattern similar to what we observed in the U.S. play out once again, this time on a global scale?
So it's not too hard to imagine a future world in which a global stockholder base trades the stock of transnational companies in just a few market centers with global reach.
And if that happens, I think investors will stop thinking of the companies whose stock they own as being "foreign." They'll start thinking of them as being just "companies."
After all, if you live in Delaware, when you think about a company that has employees all over the United States and does business all over the United States, a company whose stock trades on the New York Stock Exchange and whose headquarters happens to be in Chicago — when you think of that company, you usually don't think of it as an "Illinois company." You think of it as a U.S. company.
In the future, why won't investors increasingly view global companies in a similar light?
In fact, there are signs this already is starting to happen. For some time, investment advisers have been telling us that sound portfolio management includes a significant asset allocation to foreign stocks, often divided into "emerging markets" and "developed markets." I gave you an example of such advice from the folks who run my mutual fund just a few moments ago. But recently, some other advisers have begun saying it no longer makes sense to operate that way.
Instead, they say you should just look for great companies and great stocks wherever they may be found in the world, rather than targeting any predetermined allocation between domestic and foreign investments. These advisers are saying it doesn't matter as much whether a company is foreign or domestic — what matters is simply whether the company's stock is an attractive investment. From their perspective, a company is a company, no matter where it's located.
While we're considering the prospect that we may soon have a significant number of transnational corporations whose securities are owned and traded by a global stockholder base on a few stock exchanges with global reach, we also should consider the importance of a related long-term trend: the spread of competitive free-market economies to an ever-increasing fraction of the world's population.
This development is lifting the living standards of more and more of our fellow men and women around the globe and, as a collateral consequence, is giving rise to new and vibrant capital markets outside the United States.
This is a trend we all can cheer.
Indeed, it is sad to see those who are being left behind, condemned to suffer under the misrule of the remaining governments that still cling to discredited alternatives. It is easy to forget that, at the time of the Cuban "revolution," Cuba was virtually tied with Japan in GDP per person. Since 1959, of course, their paths have diverged.
This economic growth in much of the rest of the world affects us. After World War II, our economy and our capital markets dominated the scene. But here in the United States we have only about 5% of the world's population. Nineteen out of 20 people on the planet live somewhere else.
It's therefore only natural that our percentage share of the global capital markets must decline as the rest of the world embraces the benefits of free-market capitalism. We should not chafe at this development, as the only alternative would be the continued impoverishment of a substantial segment of mankind. But it does mean that we no longer can expect to be the only game in town.
And that will have consequences.
So, summing up for a moment, we can envision a possible future world in which there are significant numbers of transnational corporations whose securities are owned and traded on exchanges with global reach by stockholders from all over the world. If and when that world arrives, the U.S. will likely still remain one of the leading capital markets in the world, if not the leading capital market. But the U.S. may no longer retain the commanding dominance it once enjoyed.
What would such a world imply for securities regulation? A world in which all the players are global in scope — the companies, the exchanges, the shareholder base — all except for the securities regulators, who remain bound within national borders?
Because we're in Delaware, and because I've been asked to speak about the "role of the states," I will focus today only on one small aspect, if nonetheless an interesting aspect, of this much larger question.
In particular, I'd like to begin to explore with you what all this will mean for what the Delaware statutes call the "general corporation law" — the law governing the internal affairs of corporations and their stockholders. Even thus narrowly constrained in our focus, in the short time we have together we'll be able to paint only in very broad brush strokes. But we can at least identify some important themes.
Let's start by summarizing what's most familiar: our current domestic arrangements here in the United States.
On what might be called the "vertical" level, no one doubts Congress could use its power under the Commerce Clause to create a uniform federal corporation law, but to date, with very modest exceptions, it has not chosen to do so. Congress has left the law governing the internal affairs of our corporations and their stockholders to the several states.
And among the several states, on what might be called the "horizontal" level, the small state of Delaware has played an outsized role, most often being the jurisdiction of choice for the organization of corporations whose founders decide not to incorporate in their home state.
It's interesting to note that a similar situation prevails in the European Union, after a case decided by the Court of Justice of the European Communities in 1999.
Here's what that case, Centros Ltd v. Trade and Companies Board,1 was about.
A Danish couple, Mr. and Mrs. Bryde, organized a private limited company under the laws of England and Wales. They had no plans to do business in the United Kingdom, however. They planned to do business only in Denmark.
So why did they organize their company in the UK? Because they preferred the UK company law.
Danish company law required approximately 200 times as much paid-in capital as did UK company law and, not only that, the UK law didn't require that the stated capital actually be paid into the company's account — it was enough that Mr. Bryde kept it in a lockbox at his home.
When Mr. and Mrs. Bryde went to register their company to do business in Denmark, however, they ran afoul of the Trade and Companies Board of the Danish Department of Trade, which refused to do so on the grounds that the Brydes were impermissibly attempting to circumvent Danish company law.
The Brydes appealed the judgment of the Board, and the case eventually worked all the way up to the Court of Justice of the European Communities. In addition to the Danish government, the French, Netherlands, Swedish and UK governments, as well as the European Commission, all submitted their views to the court.
The Court of Justice ruled on the matter in 1999, and its holding was clear: a member of the European Union cannot refuse admission to a company formed under the laws of another member state even if the company conducts no business in the state under whose laws it was formed and even if the company thereby evades the application of more restrictive company laws in the state in which it is doing business.
The Court of Justice also noted in passing that, under the applicable treaties, it was always open to the European Council to adopt a uniform company law applicable throughout the Union.
So, after Centros, the situation in the European Union is similar to the situation here in the United States: the corporation law of the jurisdiction of incorporation controls, but a paramount power — the European Council in the E.U. and Congress in the U.S — can, if it chooses to do so, preempt the field. In both the E.U. and the U.S., however, the federal authority has so far chosen to make only limited forays into the field.
As you all know very well, this arrangement has been the occasion for a long-running debate here at home as to whether Delaware's preeminence is the result of a race to the bottom, a race to the top or a race to the optimal somewhere in between. And recently some commentators, challenging the "racing" metaphor, have questioned how much competition among the states in fact there has been.
I don't intend to rehearse today the by-now well worn arguments to and fro on these topics.
Instead, I wish to observe only that the existing arrangements in the United States and the European Union depend on the assumption that only one state or nation at a time can regulate the internal affairs of any given corporation. This is because any attempt at concurrent regulation — the application of more than one set of laws to the same circumstances — would inevitably lead to unacceptable conflicts.
A recent Delaware case I'm sure many of you know, VantagePoint Venture Partners,2 provided a dramatic demonstration of the kinds of conflicts concurrent regulation by multiple jurisdictions inevitably leads to.
In VantagePoint, a merger proposal was to be put to a vote of the stockholders. A venture capital fund held an 83% interest in a class of preferred stock. That interest, however, represented only about 13% of the total preferred and common shares taken together. The corporation in question was incorporated in Delaware, and Delaware required only a vote of all the stock voting together, so it looked like the fund's 13% of the total vote was not enough to block the merger.
But now the plot thickens. The fund alleged that more than 50% of the corporation's voting securities were held by persons with California addresses, and certain factors relating to the corporation's property, payroll and sales also were more than 50% in California.
Under those circumstances, Section 2115 of the California General Corporation Law treats a corporation as a "quasi-California" corporation, with California law overriding the law of the state of incorporation on numerous important matters.
In particular, in VantagePoint, California law required a separate vote of the preferred stock, which meant, contrary to the result under Delaware law, that the venture fund had a blocking position.
So you had the conflicting laws of two states purporting to apply to the same situation.
For what it's worth, the case ended up being litigated in Delaware, and the Delaware courts concluded Delaware law controlled.
Perhaps a California court would have concluded otherwise. Perhaps not.
But my point today is only that concurrent regulation by multiple jurisdictions of the internal affairs of a corporation is unlikely to work very well, because different rule books inevitably conflict with one another.
As an aside, I'd like to point out that some fields of law are far more susceptible to concurrent regulation. For example, as a general matter securities laws tell companies what they must disclose, but also permit additional disclosures, so long as the additional information is not false or misleading. It may, of course, be duplicative and inefficient for a single company to be subject to more than one disclosure rule book, but simultaneous compliance with two or more rule books generally won't lead to conflicts, just expense.
Not so with conduct regulations like those in the general corporation laws. Either there has to be a separate vote of the preferred stockholders — or there doesn't. Both can't be true at once.
So with respect to regulations like those governing the internal affairs of corporations, you need a single rule book or, at least, a meta-rule that tells you which of two or more competing rules controls.
We are familiar with this situation, of course, through our experience with our federal system. When both state and federal laws purport to apply concurrently to the same situation, if there's a conflict between them, the meta-rule simply is that federal law controls. That's a situation where there's a "vertical" relationship at work.
It's not so easy, though, when the relationships among competing jurisdictions are horizontal. Unless there is a supreme federal judicial authority, it is then left to each state or nation to determine the reach of its laws and how they should mesh with those of other states and nations at the same horizontal level, and conflicts are inevitable.
In the absence of a supreme judicial authority, if a variety of national regulators adopted an approach similar to that of California's section 2115, the result could be only unproductive conflict and confusion, if not chaos.
But on the global scale, of course, there is no such supervening, supranational authority. Perhaps the day will come when such an authority will be created by treaty. But, if so, that day does not appear to be just around the corner. So, for the foreseeable future, national regulators will have to make the most of the situation as it is.
To date, we haven't yet been forced to confront the full force of what this could mean, because we have yet fully to enter a world of transnational corporations with transnational stockholder bases like we envisioned together a few minutes ago. But if one tries to imagine such a world, the challenges are immediately evident.
So, as they sometimes say in the mathematics textbooks, I leave you with an exercise for the reader: What will it mean when Delaware — a small state — finds itself competing for public companies, not with other states — but with small nations?
It's been truly a pleasure to join you today. Thank you very much.