Free Trade in Stocks SEC staff are sending out feelers for a new approach that might let U.S. investors access Canadian stocks on our rules D. GRANT VINGOE, Financial Post, Thursday, March 22, 2007 Apersistent problem in international trade between Canada and the United States comes in an unexpected commodity -- not wheat, lumber or beef, but securities, through U.S. rules that raise barriers to buying them. There are now signs that the U.S. Securities and Exchange Commission is willing to consider dismantling some of these barriers. And, in a paper released with Finance Minister Jim Flaherty's budget this week, Ottawa echoed the call for free trade in securities. The federal government, it said, "will continue to advance free trade in securities bilaterally with the United States and in the G7, and will lead the process of domestic engagement necessary to make this idea a reality." The barriers to free trade in securities take three principal forms, in addition to a multitude of other frictions. First, U.S. institutional investors cannot directly trade on the Toronto Stock Exchange or any other marketplace in Canada since these markets cannot put their trading screens on U.S. desks. Canadian markets cannot admit U.S.-based members or subscribers, or allow any other equivalent access. To permit this access would require the marketplace to register as a U.S. stock exchange. This burden is impossible to comply with-- ultimately because U.S. exchanges are subject to a standard requiring them to exclusively serve U.S. financial and economic interests, in addition to different, detailed and duplicative U.S. standards for investor protection. The effect of this prohibition is twofold. Only the largest global securities firms have the infrastructure to work around these restrictions, limiting competition and denying U.S. retail investors the opportunity to trade Canadian stocks at a reasonable cost. Second, U.S. investors cannot call any Canadian dealer in order to buy and sell Canadian securities and conduct a normal brokerage relationship. U.S. authorities do not afford any recognition to Canadian securities regulation--either by securities commissions or by self-regulatory organizations (SROs) under which the Canadian securities industry polices itself. The result is that, except for institutions that can bargain for low commissions, investors have to pay twice--first their U.S. broker and then the Canadian broker that executes desired trades. Third, the 50 state securities (or "Blue Sky") laws, subject to only a handful of exceptions, prevent securities that trade only in Canada from being acquired by U.S. residents. State securities laws begin from the viewpoint that Canadian or other foreign securities are inherently improvident investments for U.S. residents. Even for Canadian securities that are listed in both Canadian and U.S. markets, SEC restrictions on the U.S. activities of Canadian stock exchanges restricts competition in both prices for securities and services provided. U.S. investors in these securities do not receive "best execution" of their trades, only the best available price in their local market. Some of these trade barriers exist on the Canadian side of the border as well, but in a much weaker form. U.S. brokers are prohibited from soliciting Canadian customers -- but Canadian enforcement of this restriction is weak and less onerous requirements. Only Canadian corporations can become members of the Canadian SRO, the Investment Dealers Association. This remains a continuing barrier, but one that U.S. brokerages can readily structure around. Trade agreements covering goods and services between Canada and the United States have broad exceptions for "prudential" regulation that can disguise protectionism. Securities trading has not been central in trade talks to date. On the U.S. side, until recently, there has been no reason to change since companies and investors have had to come to the world's largest capital market. The SEC could rest assured that this financial reality would help support the viewpoint that U.S. securities regulation was paramount (because its market is) and that, over time, all developed regulatory systems would converge with America's. This confidence has, to a modest degree, been impaired by the accounting and corporate governance scandals exemplified by Enron and World Com and by the flight of international IPOs to London and elsewhere to avoid perceived "over-regulation." The SEC has also increasingly had to accommodate commercial realities affecting U.S. market interests by imposing limits on its own jurisdiction to permit the NYSE to acquire the Euronext market since, if SEC regulation had been uniformly applied to the merged exchange, European governments would have told the NYSE to back off. Now, in a sea change reflected in a paper published in the winter edition of the Harvard International Law Journal by members of the SEC's Office of International Affairs, and in a speech earlier this month by Erik Sirri, the director of the SEC's Division of Market Regulation, the SEC staff is sending out feelers for a new approach to allow foreign exchanges and brokers to access U.S. investors based on home-country regulation in narrowly defined circumstances. The proposed framework involves a four-step process. First, a petition for exemption from the registration by the foreign entity. Second, negotiation of a bilateral agreement between the SEC and the foreign regulator involving an assessment of the comparability of the regulatory regimes on paper and in practice, with changes mandated by the SEC to achieve greater convergence where necessary. An agreement would have to be reached on very extensive information sharing at every level. Third, the broker or exchange seeking relief would have to submit to U.S. jurisdiction, particularly the anti-fraud provisions of U.S. securities laws, exemplified by Rule 10b-5 -- the primary U.S. anti-fraud rule that has been the foundation for SEC enforcement and shareholder class actions. Fourth, the arrangement would be subject to a public comment process in which one can expect level-playing-field and reciprocity considerations will be loudly voiced by the U.S. securities industry. Underlying the entire process is a searching examination of the foreign regulatory system and the making of adjustments to support a finding of comparability of regulation so that the SEC can fulfill its statutory investor-protection mandate. The arrangement would be subject to a sunset provision, requiring re-evaluation perhaps every five years. Prominent disclosures would be required to warn U.S. investors that they are no longer in Kansas, so to speak, and need to watch out for themselves in a less or differently regulated world. The golden ring of access to be obtained through this process would relate only to foreign securities, since the SEC staff propounding this framework cannot bring themselves to take the extra step of allowing full competition in U.S. securities, even after a finding of comparability and even if the particular domestic U.S. securities are offered in global markets. Many questions, of course, remain unanswered, including the following: - How will the SEC define a foreign security in an age where borders make little difference? - Is the proposed framework a disguised effort to promote convergence under the SEC's control or a true effort to accept comparable, but different, systems? - Would Canada be forced to adopt the more punitive approach to securities enforcement found in the United States and is it willing to do so? Similarly, is Canada willing to adopt the more robust system of shareholder rights found in the United States and carried out through U.S. class actions? - Are Canadian financial institutions willing to undertake this effort to remove barriers to entry on both sides of the border or will fear of competition derail this proposal? - Will Canadian securities regulators, in the absence of a single national regulator, be able to co-ordinate an effective response to the SEC's proposal? The framework that has been advanced by SEC staff holds considerable promise for more efficient North American markets and enhanced investor protection, but it is certainly not as liberalizing as Ottawa will want. It is uncertain whether the SEC's framework is workable and it is uncertain whether local protected interests will permit this proposal to be pursued. - D. Grant Vingoe is a partner in the New York office of Arnold &Porter LLP specializing in cross-border securities regulation.