Oliver Damian, UTS Student No 02110423 International Banking and Finance Law, Spring 2005 The Meandering Roads to a Single European Financial Market Roads leading to Rome All the changes and reform in the regulation of financial markets happening in Europe at the

moment can be seen as roads leading to what was originally envisioned at the Treaty of Rome-

free movement of persons, services, and capital1. Clearly there are economic benefits to a single

and integrated European financial market. Furthermore, the creation of the Economic Monetary

Union (EMU) and the Euro as the single currency has created the impetus for an integrated

financial market2.

However, at present there is no consensus as to what form this single market would take and

which road will lead there. The debate on the topic is important not only for Europe but for the rest

of the world. As the world capital markets get more interconnected, and international, there is the

need for a model of regulation to enable issuers and investors to meet at the global level without

going through the labyrinth of disparate national regimes. Further, with all the corporate scandals

rocking the U.S. Capital markets and the corresponding Sarbanes Oxley reaction,3 the position of

the U.S. Securities and Exchange Commission (SEC) as setting the global de facto model of

choice in capital market regulation is being put into question.

Will the current European experiment in minimum harmonization and mutual recognition work or is

it doomed to fail?

The Road the Wise Men set to follow The current situation of minimum harmonisation and mutual recognition is borne of the efforts of

the Committee of Wise men outlined in the well known Lamfalussy Report in 20014. It identified

that the then system of directives and national implementation was too slow and rigid to adapt to

rapid development in the capital markets. The principles and the measures to implement these

were mixed in the too much detailed directives. There was a low risk for a member state to be sued

for failure to implement a directive. Furthermore, a system with 40 different national regulators was

too unwieldy to be effective. To address these issues, the Lamfalussy Report advocated a 4 level

process for the creation of securities legislation and the creation of the European Securities

1 Title III. ‘Free Movement of Persons, Services and Capital’, Treaty Establishing the European Community

as Amended by Subsequent Treaties ROME (1957) < http://www.hri.org/docs/Rome57/ > at 26 October 2005.

2 Gikas A. Hardouvelis, Dimitrios Malliaropulos, and Richard Priestley, ‘EMU and European Stock Market Integration’<http://papers.ssrn.com/sol3/papers.cfm?abstract_id=280775 > at 26 October 2005.

3 Robert C. Pozen ‘Can European Companies Escape U.S. Listings?’ < http://ssrn.com/abstract=511942> at 26 October 2005.

4 Founding texts CESR <http://www.cesr-eu.org/ > at 26 October 2005.

Committee (ESC) and the Committee of European Securities Regulators (CESR). ESC is

composed of economic and finance ministers as EU member state nominees, chaired by a

representative of the European Commission (EC). CESR is composed of senior representatives of

national regulatory agencies.

Level 1 involves the setting of principles as framework legislation – directives and regulation

through the co-decision process by the Council of Ministers and European Parliament on advice of

the ESC. Level 2 involves the setting of measures as technical implementation of the Level 1

framework. These measures are envisioned to be used frequently to keep up with developments in

the capital markets. Level 2 involves a streamlined rule making process of ‘comitology’ with CESR

acting as an independent, transparent body drafting the technical measures put to a vote by ESC.

Level 3 involves the EC ensuring common and uniform implementation of Level 2 measures with a

lot of help from CESR and EC through interpretative guidelines and standards amongst the

regulators. Level 4 deals with EC enforcing the legislation.

Now, this Lamfalussy process was adopted in the context of something needed to be done

urgently, and within the existing arrangements of the EU Treaty. The report did hint at the

possibility of a European SEC in the future. But arguably, the setting up of this body would require

a change in the treaty, in the same manner as the creation of the European Central Bank (ECB).

Is the system working?

When the Lamfalussy process was adopted by the EC there was a sunset review provision

scheduled in 2004. It did pass that review and judging from the activities, reports, and timetables

published in the CESR website, the process seems to be moving on full steam ahead. However, it

may be too early to know if the process is working or not. This is because most of the projects are

still at Levels 2 and 3. The real test would be at level 4 – if, when and how strictly would the

legislation be enforced amongst the members. The real test does not really lie in the harmonisation

itself but the in the actual implementation.

Any new system when first implemented is sure to experience a period of uncertainty and

adjustment, the recent implementation of the Prospectus Directive (PD) dubbed as the ‘biggest

change in Europe’s capital markets for decades’5 is no certainly no exception to this. Of the 16 EU

members, only 6 countries have fully implemented the directive and met the 1 July 2005

implementation deadline. Even then there were still some legal ambiguities in the implementation.

The remaining 10 countries had partial implementation or missed the deadline altogether. This has

created an uncertainty in the market. In theory, PD should make it easier and less expensive to do

a Europe-wide capital-raising. PD creates a passport for a prospectus or offering circular which

allows an issuer to obtain approval in one home member state, after which it can be used to sell to

5 Michael Evans, ‘Many EU states miss Prospectus Directive deadline’ (2005) International Financial Law

Review < http://www.iflr.com/default.asp?page=10&PUBID=33&ISS=17457&SID=522855> at 26 October 2005.

other member states without further approval or documentation apart from a summary in the local

language for some member states. However, as stated earlier the actual implementation has

created uncertainty which is not good for any market. It remains to be seen if this uncertainty is just

a temporary adjustment period that will pass or if it would linger and become a prevalent problem

for all future directive implementation.

Failure as Key to Success – a transition period to centralised regulation?

There are those who predict that the current system will fail and will lead to increased

harmonization and centralised supervision creating a European Securities and Exchange

Commission (ESEC) which would initially focus on corporate disclosure issues and would

implement a ‘soft enforcement’ approach. This is because the current Lamfalussy process

addresses the symptoms and not the cause – the cause being national protectionism and

bureaucratic inertia leading to weak enforcement. Also, the further enlargement of the EU creates

a practical necessity of aiming for maximum harmonisation and centralisation.6

Another issue raised, at least in relation to the Markets in Financial Instruments Directive (MiFID)7,

is that the Lamfalussy process has produced debate and implementation that are too detailed and

technical which results in further re-regulation and regulations that are rigid and abstract. Further,

the political compromise along the way has watered down the regulations to inefficacy.

It is also quite useful to remember that one of the main points of market integration is to harness

the economies of scale and scope. It is doubtful if this could be achieved in the EU other than by

centralised regulation. Furthermore, there are strong arguments for the effectiveness of a strong

central regulator to coordinate efforts in maintaining market stability is times of crisis, given the

greater interconnected of markets of today and the inherent contagion effect this carries8. For

example, would the present EU system without a strong central regulator been able to implement

the U.S. Fed rescue of the Long Term Capital Management (LTCM)?

There is also an argument that Europe is not in want of a single regulator because it is effectively

regulated by the US SEC through its huge influence in the European market, the prevalence of the

take-up of US style international offerings. Still, Europe needs a counterweight to the SEC in

setting International standards and this can only be done through a single regulator who will forge

the markets together.9

Finally, home bias in terms of the trade off in scale and accountability in the enforcement of rules is 6 Hertig, Gerard and Lee, Ruben ‘Four Predictions About the Future of EU Securities Regulation’ (2003).

<http://ssrn.com/abstract=376720> at 26 October 2005. 7 Guido Ferrarini ‘Contract Standards and the Markets in Financial Instruments Directive (MiFID): An

Assessment of the Lamfalussy Regulatory Architecture’ (2005) < http://www.extenza-eps.com/WDG/doi/abs/10.1515/ercl.2005.1.1.19> at 26 October 2005.

8 Kern Alexander ‘Working Paper No 7 Establishing A European Securities Regulator: Overcoming The Institutional and Legal Obstacles’ < http://www.cerf.cam.ac.uk/publications/files/Alexander%2007.pdf> at 26 October 2005.

9 Eric J Pan, ‘Harmonization of U.S.-EU securities regulation: The case for a single European securities regulator’(Winter 2003) 34 (2) Law and Policy in International Business 499

an issue to be considered. Some see this happening even within the US SEC itself which is seen

not reluctant to pursue extra-territorial enforcement. This makes the case for a European SEC

stronger and more over there is even a call for a worldwide securities regulator.

However, no matter how strong the calls are for a maximum harmonisation and an ESEC are, the

reluctance of each nation member to give up its power and hand it over to a supra national entity

remains strong and it is highly unlikely that each nation member would allow unfettered

enforcement by this ESEC in its home turf.

Regulatory competition ?10

There are other models put forth other than harmonisation and mutual recognition under various

degrees of regulatory competition.

There is the Romano model11 which fixes the disclosure rules at the county of incorporation. It

postulates that investors will factor in the discount for less disclosure when making investment

decisions. And that regulatory competition will lead to a race to the top rather than a race to the

bottom. There is a recent development in the EC corporate law which may enable this model.

Companies can now have a choice of jurisdiction at establishment. However, discrepancies exist in

capital, requirements, taxation and even possibly traditional system of law that could hamper the

expected mobility in cross-border incorporations. Add to this the existing difficulties in

reincorporation, it is perceived as unlikely that a US Delaware monopoly type of incorporation

harmonisation will take place in Europe.12Furthermore as discussed by Scott, the proposition that

investors can properly discount prices due to disclosure is highly questionable and a minimum

disclosure regime must still be in place for the discounting to make sense.

There is the Choi and Guzman portable reciprocity model13 which advocates freedom of choice in

the issuer in adopting the rules to follow. The major drawback which may make this model

untenable and impractical is that it makes the responsibility of enforcement unclear and could lead

to an enforcement black hole the way it happened with BCCI case.

Why is it so hard? the big picture

The foregoing discussion highlights the fact that the issue is a complex one. There may or would

be several models working at the same time in order to tame the financial services beast. The

definition of financial services is in itself rapidly evolving and consolidating. Hence, the advantage

of having one regulator within a jurisdiction to oversee the products and services like securities,

10 As discussed in Hal S Scott ‘Internationalization Primary Public Securities Markets’ (2000) < http://www.law.harvard.edu/programs/pifs/pdfs/Scott_21.pdf> at 26 October 2005. 11 Roberta Romano ‘Empowering Investors: A Market Approach to Securities Regulation’ (1998) 107 Yale

Law Journal 2359. 12 Tobias H. Troger, ‘Choice of Jurisdiction in European Corporate Law – Perspectives ̈ of European Corporate Governance’ (2005) 6 European Business Organization Law Review: 3-64 13 Stephen Choi & Andrew Guzman ‘Portable Reciprocity: Rethinking the International Reach of Securities

Regulation’ (1998) 71 South California Law Review 903.

insurance, and derivatives under the financial services banner, such as UK FSA. Most of the EU

member states don’t have this unified structure, making the job of enforcement more complicated.

More importantly, the regulation of capital markets can not really be divorced from the issues of

corporate governance. As it stands, there is movement towards harmonisation in the field of capital

markets regulation while the opposite occurs in corporate governance. This may have to do with

dichotomy of capital markets belonging to the public sphere of law whilst corporate governance to

the private. Furthermore, it doesn’t help that there are 4 main families of legal tradition co-existing

in the EC namely the UK common law, and the three strands of Continental Civil Law – French,

German, and Scandinavian14. As long as there is not a corresponding move towards harmonisation

in corporate governance, there will always be this challenging situation because enforcement

usually falls within the realm of corporation governance.

There are also developments in technology that affects financial services like the internet enabling

broker screens to be located outside the country where the exchange is located. The definition of

the exchange itself is evolving as they have moved away from their previous public character to a

more private and enabler role. Add to this the competition, mergers and acquisitions happening

amongst and within the exchanges themselves and other financial institutions. Examples include

the Euronext15, EASDAQ16 and the proposed take over of London Stock Exchange (LSE) by

Macquarie Bank17. Furthermore there is the growth of off-exchange Alternative Trading Systems

(ATS), and cross-border exchanges like Virt-x18 which indirectly achieves a form of market

integration within the present system of regulations.19

Quixotic Quest and off-road transactions

The quest for one road or one best model of financial market regulation may be a quixotic one. In

reality and practically, issuers, investors, and financial institutions together with their lawyers

achieve a form of financial market integration away from the stricter rules of public capital market

regulation largely by means of private placements. The idea of achieving market integration mainly

by means of overarching regulation is also becoming questionable as self regulation among

institutions that are not politically elected or confined to the nation state is becoming more viable -

in the line of delegated regulation. Finally, in the context of economic efficiency even the idea of

extensive investor or consumer protection which is primarily the reason why the capital market

14 Amir N. Licht, ‘International Diversity in Securities Regulation: Some Roadblocks on the Way to Convergence’ (1998) Interdisciplinary Center Herzliyah - Radzyner School of Law -

<http://papers.ssrn.com/sol3/papers.cfm?abstract_id=86628 >at 26 October 2005. 15 <http://www.euronext.com/home/0,3766,1732,00.html> at 17 November 2005. 16 < http://www.easdaq.be/> at 17 November 2005. 17<http://news.google.co.uk/news?q=bid+for+lse&hl=en&lr=&cr=countryUK%7CcountryGB&sa=N&tab=nn&oi

=newsr> at 17 November 2005. 18 < http://www.virt-x.com/index.html> at 17 November 2005. 19 Guido Alessandro Ferrarini ‘Pan-European Securities Markets: Policy Issues and Regulatory Responses’

Università degli Studi di Genova - Law School; European Corporate Governance Institute (ECGI) <http://papers.ssrn.com/sol3/papers.cfm?abstract_id=314576 > at 26 October 2005.

legislation has become convoluted can be questioned.20

A recent example of the foregoing discussion can be seen with the growth and increasing

popularity of the LSE’s Alternative Investment Market (AIM)21 dubbed as the ‘most successful

growth market in the world’. This is primarily due to less strict regulations than the LSE Main

Market and because of the indirect implementation of the regulations by the UK FSA by means of

Nominated Advisers (Nomads) who are from the capital market industry. There is an increasing

number of companies from outside the UK that are listing in AIM such as Canada, Israel, Australia

and Russia22 AIM has even become attractive for US companies.23

Conclusion

There is not one road leading to the vision of the Treaty of Rome. There are many, and the roads

are not straight, they meander. This is because whilst the basis of financial market integration is

economic, in fact the benefits of regulation and market integration could even be quantified24, the

roads to get there are political. As such social forces25, culture, and history come into play. And

politics has always been a series of compromise, and negotiated settlements, rarely consensus.

Rather than seeing the current difficulties of the Lamfalussy process and the whole European

experiment as a failure, it is more of a step in the evolution towards the coveted goal.

20 Jonas Niemeyer, ‘An Economic Analysis of Securities Market Regulation and Supervision: Where to Go

after the Lamfalussy Report?’< http://ideas.repec.org/p/hhs/hastef/0482.html> at 26 October 2005. 21 < http://www.londonstockexchange.com/en-gb/products/companyservices/ourmarkets/aim/ > at 17

November 2005. 22<http://www.londonstockexchange.com/engb/pricesnews/statistics/othermarketstats/newissuessummary.ht

m > at 17 November 2005. 23 Kenneth R Lamb et al ‘Why US companies should consider AIM’ (2005) International Financial Law

Review < http://www.iflr.com/default.asp?page=10&PUBID=33&ISS=20856&SID=594942 > at 17 November 2005.

24 Luzi Hail & Christian Leuz ‘International Differences in the Cost of Equity Capital: Do Legal Institutions and Securities Regulation Matter?’ (2004) <http://www.afajof.org/pdfs/ 2005program/ UPDF/P1026_Corporate_Governance.pdf.> at 26 October 2005.

25 Hans-Jürgen Bieling ‘Social Forces in the Making of the new European Economy: the case of Financial Market Integration’-<http://scholar.google.com/scholar?hl=en&lr=&cluster=5185601784159840533 > at 26 October 2005.