Oluwasegun Popoola

Introduction

Purpose

Capital markets regulation have attained an unprecedented level world wide as a result of

growing investor concerns, economic recessions, corporate scandals, trade imbalances and fears

about the impact of failure of any of the players in the global market place. Indeed, as a result of

technological innovations, there has been an integration of financial markets worldwide such that

capital markets regulation in one part of the world is wholly or partly adapted in other countries

and economic blocs worldwide.

The relative importance of regulating the capital markets is accentuated by the revelation that

most capital market operators regard regulatory compliance as the most important strategic

priority required to ensuring the continued survival of their business.1

The goal of this paper therefore is to:

• Understand the existing and proposed changes to regulatory capital market

requirements and the impact they have had and will have and;

• Ascertain whether or not the changes have been effective or will be effective in

meeting the twin objectives of stakeholders’ protection and financial stability.

The Argument for Regulation of Capital Markets

Several reasons have been adduced for regulating the capital markets among which are the

following:

• Protection of investors (process, rights and responsibilities)

• Improvement of corporate governance and promotion of ethical business practices

1
Several surveys including the 2005 survey conducted by Deloitte have identified regulatory compliance as
the most important strategic priority of every business.

1
 Oluwasegun Popoola

• Enhancement of transparency among market players

• Ensure the efficient allocation of resources to their most optimal use in the economy

• Emergence of fair, efficient and transparent markets

• Reduction of systemic risk2

• Establishment of standards for accounting and auditing

• Transparency of financial statements and disclosures

• Emergence of a regime of strong supervision and enforcement

• Promotion of international competitiveness

Background

Overview of Existing and Proposed Legal and Regulatory Frameworks and Legislations

While several legislations have emerged in the course of time, this paper will highlight a few of

those legislations that have had a significant impact on businesses around the world.

(i) Sarbanes-Oxley3 (SOX) Act

The Public Company Accounting Reform and Investor Protection Act of 2002 (i.e. the Sarbanes-

Oxley Act of 2002) is by far one of the most popular regulatory frameworks which emerged from

the United States of America and has been adapted wholly and partly in several countries across

the world. The SOX Act was rapidly introduced after the Enron, WorldCom and Tyco scandals

which occurred between December 2001 and June 2002. The SOX Act introduced significant

changes to financial practice and corporate governance regulation, including stringent new rules

designed to protect investors by improving the accuracy and reliability of corporate and financial

disclosures.

2
Systemic risk is defined as the likelihood of the collapse of a financial system, such as a general stock
market crash or a joint breakdown of the banking system. - Adapted from Wikipedia.
3
The Act is named after the sponsors - Senator Paul Sarbanes (D–Md.) and Representative Michael G.
Oxley (R–Oh.).

2
 Oluwasegun Popoola

The most important part of the Act by all accounts is Section 404 which requires management to

submit to the Securities and Exchange Commission (SEC) with the company’s annually filed

financial statements, an internal control report, which shall state the responsibility of management

for establishing and maintaining an adequate internal control structure and procedures for

financial reporting. It should also contain an assessment, as at the end of the financial year, the

effectiveness of the internal control structure.

Highlights of the Act

• Establishes an independent, full time oversight board (i.e. Public Company Accounting

Oversight Board – PCAOB)

• Communicates new responsibilities for audit committees and corporate officers

• Emphasizes several new public company reporting requirements

• Strengthens penalties for corporate fraud

• Requires rules to address analyst conflict of interest

(ii) The Cadbury Code4

A review of Corporate Governance would be incomplete without a look at the Cadbury code

which is widely regarded as a forerunner to the Sarbanes-Oxley Act. The Cadbury code has

witnessed a lot of modifications since 1992 to reflect changes in the general operating

environment. In 1998, it became a combined code consolidating the principles of the Cadbury,

Greenbury and Hampel reports. It was reviewed again in 2003 following the publication of the

4
The Cadbury code was codified from the Cadbury Report titled Financial Aspects of Corporate
Governance. The Cadbury report is the report of a committee chaired by Adrian Cadbury that sets out
recommendations on the arrangement of company boards and accounting systems to mitigate corporate
governance risks and failures. The report was published in 1992 and has been adopted in varying degree by
the European Union, the United States, the World Bank, and others.

3
 Oluwasegun Popoola

Higgs report. The revised combined code requires that companies report on their compliance

against the code and should explain areas of non-compliance. The code calls for the following:

• A separation of the roles of the Chairman and Chief Executive.

• Candidates for board selection to be drawn from a wider pool.

• One member of the audit committee to have recent and relevant financial experience; and

• A board of at least half independent non-executive directors.

(iii) Basel II

Basel II is an attempt by international banking supervisors to update the original international

bank capital accord (Basel I), which has been in effect since 1988. The aim of the framework is to

improve the consistency of capital regulations internationally, make regulatory capital more risk

sensitive, and promote enhanced risk management practices among large and internationally

active banking organizations.

This regulatory framework even though targeted at financial institutions has a worldwide appeal

and is currently being implemented across the world.

(iv) Solvency II

Solvency II is a fundamental and wide-ranging review of the insurance industry in Europe. It

includes a review of the overall financial position of an insurance undertaking and not just the

solvency margin requirement. Its aim is to ensure adequate policy holder protection in all

European Union (EU) Member States. It will also take into account current developments in

insurance, risk management, finance techniques, international financial reporting and prudential

standards, etc. Another important feature of the new system will be the increased focus on the

supervisory review process. The aim is to increase the level of harmonization in general,

including that of supervisory methods, tools and powers.

4
 Oluwasegun Popoola

(v) Gramm-Leach-Bliley Act

The Gramm-Leach-Bliley Act, also known as the Financial Modernization Act of 1999, includes

provisions to protect consumers’ personal financial information held by financial institutions. The

three principal parts of the privacy requirements are the Financial Privacy Rule, Safeguards Rule

and Pretexting Provisions. The rules governs the collection and disclosure of customers’ personal

financial information by financial institutions, the design and implementation of safeguards to

protect customer information and the protection of consumers from individuals and companies

that obtain their personal financial information under false pretences.

Several versions of this regulation bordering on data privacy and security exist in Europe, Asia,

Latin America and Africa.

(vi) Self Regulatory Organizations (SROs)

A self-regulatory organization is an organization that exercises some degree of regulatory

authority over an industry or profession. The regulatory authority could be applied in addition to

some form of government regulation, or it could fill the vacuum of an absence of government

oversight and regulation. The ability of an SRO to exercise regulatory authority does not

necessarily derive from a grant of authority from the government.

Good examples of self regulatory organizations are stock exchanges located in different parts of

the world.

(vii) Regulations related to anti money laundering and fraud protection

Several countries have adopted different regulations to deal with money laundering and fraud

perpetration. The standards, minimum recommendations and framework that serve as baseline for

these regulations have being issued by the Financial Action Task Force (FATF). The FATF was

established by the G-7 Summit that was held in Paris in 1989 and given the responsibility of

examining money laundering techniques and trends, reviewing the action which had already been

5
 Oluwasegun Popoola

taken at a national or international level, and setting out the measures that still needed to be taken

to combat money laundering. Till date, the FATF has issued 40 recommendations on money

laundering and 9 special recommendations on terrorist financing.

Summary and Concluding Remarks

Perceived Costs and Benefits of Capital Markets Regulations

Compliance Costs and Benefits

This by far remains the most significant aspect of capital markets regulation. According to a

recent survey conducted by Deloitte, half of the executives that responded cited regulation as one

of the most top influences on profits over the next three to five years. Within regulation, 77%

cited the implementation cost of compliance as having the greatest impact on profits while more

than half (57%) saw the risk of noncompliance as a top influencer of profits.5

Another survey of 321 companies conducted by Financial Executive International (FEI) in July

2004, found that the average cost of complying with Section 404 of the SOX Act is

approximately $4.6 million, and that the average cost varies with firm size.6 In addition, to this,

the cost of implementing these legislations has been huge for small businesses. For instance, there

have been calls for the establishment of a toned down SOX framework that will take care of small

businesses and a further delay in Section 404 compliance for small companies and foreign private

issuers.

Conversely, an extensive joint study of internal controls at 667 companies by the University of

Wisconsin-Madison, the University of Texas at Austin, the University of Iowa and the MIT-Sloan

School of Management found that the SOX Act helped lower the cost of equity capital by 50 to

150 basis points.

5
The results of this survey are contained in the Deloitte 2006 Global FSI Outlook.
6
The results of this survey can be found in the report by the Financial Executives International at
www2.fei.org

6
 Oluwasegun Popoola

Generally, the SOX Act has ensured the greater ownership and appreciation of internal control

systems and the timely identification and remediation of internal control weaknesses that might

have not been detected otherwise.

Investor Confidence

Investor confidence is an off shoot of a belief in the integrity of the capital market. Indeed, the

primary purpose of any capital market legislation is to encourage investor confidence and

optimism in the sanctity of the market.

Disciplined Approach

Capital markets regulation will no doubt force a principle driven approach to policies, processes

and procedures (PPPs) and ensure that companies evolve a culture of values and ethos.

Ultimately, a compliance culture with a strong reward and penalty system will emerge.

Corporate Governance

Corporate governance is largely based on the view that increased shareholder engagement,

existence of an open and transparent financial disclosure regime and maintenance of a reliable

reward and penalty system are key drivers of good business practices.

Corporate Governance has continued to gain momentum as businesses begin to realize the

inherent advantages in managing their reputation.

In the United Kingdom, companies listed on the London Stock Exchange (LSE) have been

required, since 1998, to make a “statement of compliance” with the combined code7 in their

7
Please see the Cadbury code in Page 3 of this research paper.

7
 Oluwasegun Popoola

annual reports. Companies listed on the Johannesburg (JSE) are required to comply with King II8

which itself requires compliance with Global Reporting Initiative guidelines.

In the United States, audit committees are required to have a formal charter that must be disclosed

along with an annual disclosure by the Audit committee to shareholders as to whether the audit

committee satisfied its responsibilities in the prior year in compliance with its charter. In Nigeria,

corporate governance tenets were formally codified in October 2003 by the Securities and

Exchange Commission and are contained in its publication titled “Code of Corporate Governance

in Nigeria”.

Financial Stability

The myriad of regulations worldwide have discouraged the deliberate misstatement of revenues

and earnings which was a major driving force behind the scandals at Enron and WorldCom.

Improvement in the Depth and Liquidity of the Capital Market

The emergence of capital market regulation has encouraged newer investors and the emergence

of complex and advanced secondary markets. In addition, an array of financial products has also

been created in order to meet the expectations of a growing number of investors.

Recommendations

The global outcry by pundits over the incidence of over regulation has led to several studies in

different parts of the world. Findings from some of these studies have been mixed with most

concluding on the need to conduct extensive studies before the passage of capital market

regulations and legislations. The writer has therefore developed a conceptual framework for

8
King II is the abbreviated name for the King Report on Corporate Governance for South Africa published
2002 in South Africa.

8
 Oluwasegun Popoola

measuring proposed capital markets regulations and legislations which are called the 7C’s and

other benchmarks.

The 7C’s and other benchmarks

Comprehensive: Every capital market regulation must be encompassing and understandable and

take into account all possible scenarios.

Concise: Capital market regulations should be precise and straight to the point without losing

sight of its objective.

Cost Effective: The benefits of every capital market regulation should exceed the costs. It must

not only be seen to be cost effective in theory, it must be cost effective in practicality.

Consistent: Capital market regulations must constantly adhere to the same principles of thought

or action.

Communicable: A good capital market regulation must be capable of being transmitted to the

market players without any difficulty. Partnerships between the government and the private sector

will need to be sustained to ensure that regulations that can be easily transmitted and assimilated

are maintained.

Conformable: Capital market regulation must be in consonance with the laws of the sovereign

territory where it is passed and the regulations of the body responsible for its passage. In addition,

it must not conflict with any existing regulation.

Constructive: Every capital market regulation which does not satisfy any value proposition is

unnecessary and wasteful. In other words, every capital market regulation must be advantageous

and contribute positively to the development of the market and the financial services industry in

general.

Enforcement of Regulations: Mandatory disclosure and a sound and strong regulatory and legal

framework are not effective if the expectation that the rules will be enforced is not powerful and

grounded. In other words, the existence of a politically insulated regulatory agency with the

9
 Oluwasegun Popoola

independence to impose sanctions on the country’s largest economic actors is a sine qua non. In

addition, an independent and effective judiciary is required.

Proactive: A good capital market regulation must be forward looking and anticipatory of

problems which may occur in the future.

Flexible: A good capital market regulation must be capable of being easily directed or influenced

for the achievement of certain objectives. It should also be modifiable with little or no costs to the

regulator and market players.

Indeed, there is no doubt that regulations that meet the above mentioned benchmarks are capable

of meeting the twin objectives of stakeholders’ protection and financial stability.

Conclusion

While capital markets regulations have been described as a welcome development, doubts have

been expressed about the effectiveness of these regulations. One thing comes clear though, all

market players with the exception of a negligible few agree on the need for a proactive regulatory

framework that is constantly ahead of time. However, the disagreement has been on the depth,

effects and costs of the regulations.

There is no doubt that we will continue to witness attempts by businesses, think-thanks and

stakeholders to quantify the beneficial or harmful effect of every capital market regulation.

In the long run, capital market legislation or regulation will depend on whether they will be

effective in meeting the twin objectives of stakeholders’ protection and financial stability.

10
 Oluwasegun Popoola

References

Anindya Ghose and Udday Rajan. (2006, March). The Economic Impact of Regulatory

Information Disclosure on Information Security Investments, Competition and Social Welfare.

Workshop on Economics of Information Security

Cadbury, A (1992). ‘Report of the Committee on the Financial Aspects of Corporate

Governance’. Gee; London.

International Organization of Securities Commissions – IOSCO. (1998, September). Objectives

and Principles of Securities Regulations.

International Organization of Securities Commissions – IOSCO. (1999, May). Supervisory

Framework for Markets. Report of the Technical Committee of the IOSCO.

KPMG (1995). ‘Greebury: A Practical Guide to the Disclosure Implications’, KPMG;

Huddersfield.

Rossouw, G.J. (2005, March). Business Ethics and Corporate Governance in Africa. Business and

Society.

Securities and Exchange Commission, Nigeria. (2003) Code of Corporate Governance in

Nigeria. Abuja, Nigeria.

Do High Regulatory Costs Force Public Firms to go Private?

http://knowledge.wharton.upenn.edu/article.cfm?articleid=847&CFID=2015230&CFTOKEN=35

976759 (last accessed on November 16 2006).

11
 Oluwasegun Popoola

Enhancing Shareholder Value through Capital Risk Management

http://www.aon.com.au/pdf/reinsurance/2001_conference_papers/The%20Impact%20of%20Regu

lations%20on%20Capital%20Risk%20Management.pdf (last accessed on November 16 2006).

Global Financial Services Industry Outlook

http://www.deloitte.com/dtt/cda/doc/content/dtt_gfsi_Global%20FSI%20Outlook_2006-04-

21.pdf (last accessed on November 16 2006).

Section 404 Could Cost Big Companies $4.6 Million, Or More

http://www2.fei.org/files/spacer.cfm?file_id=788 (last accessed on November 16 2006).

The essentials of an efficient market

http://www.uneca.org/eca_resources/major_eca_websites/cmd/workshop/The%20Essentials%20o

f%20An%20Efficient%20Market%20-%20Final.ppt (last accessed on November 16 2006).

12