EMILIOS AVGOULEAS

THE POLITICAL ECONOMY OF EUROPEAN FINANCIAL MARKET REGULATION AND THE ADVENT OF E- COMMERCE

(Draft only, not for quotation without author’s permission)

Abstract:

This paper intends to open a new path in the debate concerning the direction of the new EU financial markets regulation. This legislation is the product of two landmark events. The publication in 1998 of the Commission Action Plan for Financial Services and the publication of the Final Report of the Wise Men Committee in February 2001. Old and new EU financial markets regulation, and the processes surrounding it, can only be properly understood if the conflicting ideologies guiding its drafting and implementation are clearly identified. The paper argues that this has not happened in an EU context. There is a lamentable dearth of research in the area of EU financial services legislation from a political and economic analysis (public choice) perspective. As a result, the ideologies reflected on this legislation and the role that major players in the financial services industry, such as the organizations ISDA and BMA and their large law firm advisors, play in its drafting remain largely uninvestigated. On the other hand, US securities regulation and the New Deal statutes have been subjected to extensive political and economic analysis by law and economics scholars. Thus, a new research field has become wide open to European law and economics scholars. The demand for undertaking an extensive analysis of this kind has become even more pressing since 1997. The technological advancements, such as the trading of financial products on the Internet and the remote provision of financial services by the same means, placed into mass market use during that year threaten to alter radically the cost and geographic structure of the EU financial services industry and the fundamentals of the provider/user relationship. The paper identifies the ideological confusion that permeates EU financial markets regulation as the basic problem inhibiting the fast and effective enactment of the new EU financial markets legislation. It argues that the confusion that has surrounded the progress and implementation of EU Commission’s proposals for new financial markets legislation due to national government, European Parliament or industry lobbying groups’ intervention or rejection of its proposals is owed to this lack of guiding policy direction. This has led to serious delays in the enactment and implementation of necessary financial markets legislation.

 LL.B (Athens), LL.M (LSE), PhD (LSE), Department of European and International Studies, University of Piraeus. Formerly, Lecturer, Law Department, University of Manchester and Managing Associate, Financial Markets Group, Linklaters.

1 // 1. Introduction

The term political economy in its wider context encompasses the application of the tools of economics for the analysis of the political, social and legal phenomenon and it is with this meaning that is used here.1 The first step in the economic analysis of the regulation of financial services in the EU is to identify the aims, objectives, rationales and interests that such regulation should pursue in the first place. A number of developments have made this question more timely than ever. These developments are the recent financial scandals that have tarnished the US economy and have led to the collapse of such giants as Enron and WorldCom,2 which have had severely adverse effects on EU stock markets and corporations, the Commission’s Action Plan for Financial Services and the recommendations made in the Final Report of the Committee of Wise Men on the Regulation of European Securities Markets.3

2.The Political Economy of EU Financial Services Legislation

2.1 The EC’s New Deal for Financial Services

1 See D. P. Levine, Theories of Political Economy (1992); D. K. Whynes, ed., What is Political Economy?: Eight Perspectives (1984); G. S. Becker, The Economic Approach to Human Behavior (1976). The leading works in the use of economic principles to explain the wider political and legal discource are J. M. Buchanan & G. Tullock, The Calculus of Consent (1962) and R. A Posner, The Economics of Justice (1981). 2 See for detailed journalistic reporting and analysis of the recent financial scandals in the US and the reaction of the US Senate and regulators see the Financial Times Special Reports: “Enron: The Collapse”, “WorldCom”, “Tyco”, “Capitalism in Crisis”, “Corporate America in Crisis”, “Barons of Bankruptcy” available at http://www.ft.com.

3 Final Report of the Committee of Wise Men on the Regulation of European Securities Markets, Brussels, 15.02.2001. This Committee was chaired by Baron Alexandre Lamfalussy. Hereinafter, the Report of the Wise Men Committee. This is available at http://www.europa.eu.int/comm/ internal_market/en/finances /general/lamfalussyen.pdf

2 // A great deal has been written in respect of the economic analysis of US securities regulation.4 This, before the newly enacted and implemented Sarbanes-Oxley,5 was largely based on the “New Deal” statutes of the early thirties.6 On the other hand, very little has been said, from an economic analysis perspective, about the underlying fundamentals of the political consensus reached between the Delors’ Commission and the member states which led to the Single European Act and the subsequent EC financial services legislation of the late eighties and early nineties. Nor much has been said about the subsequent collapse of this consensus in the mid-nineties. I shall call this consensus, somewhat licentiously, the “EC’s New Deal for Financial Services”.7

4 See, indicatively, G. J. Stigler, “Public Regulation of the Securities Markets” 37 Journal of Business 117 (1964); H-K Wu, “An Economist Looks at Section 16 of the Securities Exchange Act of 1934” (1968) 68 Columbia Law Review 260; G. J. Benston, “Required Disclosure and the Stock Market: An Evaluation of the Securities Exchange Act of 1934” (1973) 63 American Economic Review 132; I. Friend & R. Westerfield, “Required Disclosure and the Stock Market: Comment” (1975) 65 American Economic Review 467; G. A. Jarell, “The Economic Effects of Federal Regulation on the Market for New Security Issues” (1981) 24 Journal of Law and Economics 613; J. Seligman, “The Historical Need for a Mandatory Corporate Disclosure System” (1983) 9 Journal of Corporate Law 1; J. Coffee, “Market Failure and the Economic Case for a Mandatory Disclosure System” (1984) 70 Virginia Law Review 717; F. H. Easterbrook & D. R. Fischel, “Mandatory Disclosure and the Protection of Investors” (1984) 70 Virginia Law Review 669; C. J. Simon, “The Effect of 1933 Securities Act on Investor Information and the Performance of New Issues” (1989) 79 American Economic Review 295 (1989); D. R. Fischel & D. J. Ross, “Should the Law Prohibit ‘Manipulation’ in Financial Markets?” (1991) 105 Harvard Law Review 503.

5 “ An Act to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes”, One Hundred Seventh Congress of the United States of America, 2nd Session, H. R. 3763. The Act may be cited as the ‘‘Sarbanes-Oxley Act of 2002’’. It is a wide ranging corporate governance and accounting reform law, designed to improve the quality of financial reporting, independent audits and accounting services for public companies, to strengthen the independence of accounting firms that audit public companies and to increase the responsibility of management for a public company's financial and corporate disclosures. To enforce these objectives, the Act substantially increases civil and criminal penalties for securities law violations. On July 30, 2002, President Bush, upon signing the Sarbanes-Oxley Act, described it as mandating "the most far-reaching reforms of American business practice since the time of Franklin Delano Roosevelt." 6 I.e., the Securities Act 1933 and the Securities and Exchange Act 1934.

7 Arguably, this trend reached its concluding summit with the adoption of the Second Banking Directive in 1989 (89/646EEC, OJ 1989, L 386/1) (“2BCD”), and of the Investment Services (93/22/EEC, OJ 1993, L 141/27) (“ISD”) and Capital Adequacy Directives (93/6/EEC, 93 OJ 1993, L 141/1) (“CAD”) in 1993.

3 // Colin Mayer’s8 and Marco Pagano’s9 research on the transaction cost aspects of the integrated EU financial market and expected benefits has been methodologically rigorous and ultimately convincing. This, however, has been restricted to certain aspects of the internal market for financial services. Mayer’s research in this area has mostly focused on the differing regulation of the asset management industry and Pagano’s on the differing structure and costs of securities trading between the different EU financial markets. In addition, little thought has been given to the interest group analysis of the EU financial services legislation. Most of the existing literature in this area has, in fact, focused on justifying centrally driven harmonization of the rules of conduct in EU financial markets.10 As a result, neither the aims of EU financial services legislation, nor its results have been extensively examined from a political and economic analysis perspective,11 despite the fact that other aspects of the internal market have been subjected, to a certain extent, into such analysis.12

8 C. Mayer, J Franks & Luis Correia da Silva, Asset Management and Investor Protection: An International Study, Oxford: Oxford University Press, 2002/3, forthcoming; and J. Franks & C. Mayer, Risk, Regulation and Investor Protection, with J. Franks, Oxford: Oxford University Press 1989. See also, C. Mayer, “European Capital Markets: Competition Between Systems”, European Banking After EMU: EIB Papers, Vol.4:1, 1999, pp.47-58.

9 M. Pagano, “The Changing Microstructure of European Equity Markets”, Paper delivered in the University of Genoa Conference: European Investment Markets, Implementation of the ISD and National Law Reforms, November 1996, also published as “The Costs of Trading in European Equity Markets”, London: LSE Financial Markets Group, 1996 & M. Pagano & Alisa Roell, “Dually-traded Italian Equities: London vs.Milan”, London: LSE Financial Markets Group, 1991.

10 See E. Avgouleas, “The Harmonisation of Rules of Conduct in EC Financial Markets: Economic Analysis, Subsidiarity and Investor Protection” (2000) 6 European Law Journal 72, pp. 89-91.

11 US literature in this area includes, indicatively, B. Peter Pashigian, “The Political Economy of Futures Market Regulation” (1986) 59 Journal of Business S55; David D. Haddock, “An Economic Analysis of the Brady Report: Public Interest, Special Interest, or Rent Extraction?” (1989) 74 Cornell Law Review 836; Roberta Romano, “The Political Dynamics of Derivative Securities Regulation” (1997) Yale Journal on Regulation 279.

12 See, indicatively, Andrew McGee & Stephen Weatherill, “The Evolution of the Single Market – Harmonisation or Liberalisation” (1990) 53 Modern Law Review 578.

4 // 2.2 The Internal Market “is not working”

The drive towards the harmonisation of the rules for the prudential regulation of credit institutions and investment firms acquired an unstoppable momentum in the course of EC’s New Deal for Financial Services. The water dams and the river defenses of the doubters were flooded by the wave of optimism, which surrounded the enactment of 2BCD, ISD and CAD. Many commentators, perceived these as the vehicle that would bring about the “promised land” of the EU single market for financial services and attendant benefits. I shall call this attitude the “post-ISD euphoria”.13 At the same time, and possibly for that reason, insufficient thought was given to the gaps it was leaving behind. These gaps can be mainly found in the area of rules of conduct and their enforcement in the context of cross-border transactions.14

To make matters worse by the mid-nineties the harmonisation zeal had eclipsed due to prevailing decentralization attitudes to EU legislation, supported strongly by the UK and a number of other EU member states.

Subsequently, in the autumn of 1998 the EU Action Plan on Financial Services15 and the follow up Commission Communication in the spring of 199916 (together referred to, hereinafter, as the “Action Plan”) confirmed what most people in the field suspected by

13 The biggest exponent of the post-ISD euphoria was, of course, the Commission itself, as it fostered, in a quite uncritical fashion, the wider spreading of the belief that the integrated internal market for financial services was ante portas. Its benefits obvious: with the help of an integrated financial market and the advent of the EMU, the EU would take on the US establishing itself as the world’s predominant economic power. Some belief, indeed. 14 Op. cit. note 10, pp. 74-77; The Wise Men Committee identified a list of gaps in EU financial markets legislation. This list is reproduced in Appendix A. See Report of the Wise Men Committee, pp. 11-13.

15 Commission Communication, “Financial Services: Building a Framework for Action”, 28.10.1998, COM (1998) 625, available at http://www.europa.eu.int/comm/internal market/en/finances/general/fsen.pdf. For the latest Commission Progress Report on the Action Plan see: Commission Communication, “Financial Services, An improving climate – but quite some way to go, Sixth Progress Report”, 3.06.2002, COM(2002)267, available at http://www.europa.eu.int/comm/internal_market/en/finances/actionplan/ progress6_en.pdf; and for a comprehensive guide of what has been done so far and what is pending see Progress on the Financial Services Action Plan, 22 July 2002, available at http://www.europa.eu.int/comm/ internal_market/en/finances/actionplan/annex.pdf.

16Commission Communication, “Financial Services: Implementing the Framework for Financial Markets:Action Plan”, 11.05.1999, COM(1999)232, available at http://www. europa.eu.int/ comm/internal market/en/finances/general/actionen.pdf.

5 // then. Despite the significant inroads that harmonisation legislation made in the late eighties and early nineties in the areas of prudential regulation of banks, insurance undertakings and investment firms and the regulation of the public offer of securities and fund products, the integrated financial market was not ante portas. According to the Commission, wide differences prevailed throughout the EU: (a) in the way financial services contracts are formed; (b) the way national conduct of business rules regulate the relationship between financial services intermediaries and their clients; (c) the way exemptions from the public offer rules are provided or administered in various member states; (d) in the application of marketing and investment advertisement rules; and (e) in the way regulators understand and interpret the harmonised legislation. 17

This, of course, does not mean that earlier commentators were not right to stress the importance of the harmonisation legislation of the late eighties and early nineties and the benefits it brought about. It’s just that, the “post-ISD euphoria” concealed, to a significant degree, the importance of the remaining barriers to free movement of financial services in the EU.

2.3 Efficiency versus Fairness

For historical reasons that go as far back as the Treaty of Rome, which encompasses in the same text both the objective of a liberal market economy and social democracy, no serious thought has ever been given to the question whether the predominant aims of harmonisation legislation in the area of financial services are mutually compatible. Arguably, the two main rationales of EU financial services legislation (as these can be found in the recitals of most EU financial markets directives) are the opening up of national markets (“liberalization”), and improved investor protection (“fairness”).

17 Alexandre Lamfalussy introduced the work of his Committee during the press conference for the release of the Final Report with the following remarks: “The basic legislation for an integrated financial market is not in place. The mosaic of European regulatory structures is well documented – over 40 of them – with different powers and competences. The current regulatory system is simply too slow, too rigid and ill adapted to the needs of modern financial markets. Even when it does work, which is rare, it often produces texts of legendary ambiguity – along with little or no common effort to transpose the agreed texts consistently – nor enforce their proper application.” (Italic added for emphasis). Lamfalussy’s Press release available at http://www.europa.eu.int/comm/ internal_market/en/finances/general/comments.pdf.

6 // “Liberalisation” is held to lead to increased efficiencies in intra-state trade within the EU through reduced transaction costs bringing about more competitive and better priced markets, facilitating thus market integration. It is achieved through the targeted reduction of national barriers (e.g., legal and regulatory barriers and attendant costs of multiple compliance) in the establishment of EU firms in member states other than their home country and the cross-border conduct of banking investment and insurance business. In this way, harmonized legislation has created a “level playing field” between home firms and those established in other EU member states. Increased investor protection, on the other hand, is achieved by raising the protective content of investor protection rules in the harmonised legislation

The pursuit of both aims, namely, that of increased efficiency through deregulatory measures that result in reduction of transaction costs so that to achieve an integrated market, and that of fairness (i.e., increased investor protection) through paternalistic regulation would seem to many theorists as impossible, given the apparent tension between the two. The debate regarding the (im)possibility to pursue efficient outcomes, which are also (morally) fair is, of course, as old as law and economics,18 and in fact much predates the law and economics movement.19 However, the fact that, views on the subject differ widely, does nothing to diminish the importance of the tension between the two most stated objectives of modern social and economic life and legal initiatives.20 EU financial services legislation cannot be an exception to this rule. Furthermore, the concern and skepticism expressed in this paper regarding the apparent “ideological confusion” 18 R. H. Coase, “The Problem of Social Cost” (1960) 3 Journal of Law & Economics 1.

19 As the theoretical fundamentals of this question are very familiar to the law and economics scholars, I will not provide here a long list of the literature concerned with this question. The most significant recent work concerned with the wider debate is by the Harvard Professors Kaplow and Shavell. Their article focuses mostly on the fairness versus (individual) welfare debate explaining the tension and perceived incompatibility between the two. Kaplow and Shavell argue that guiding society in its evaluation of legal policy is a role exclusively held for “the welfare based normative approach”. In Kaplow-Shavell’s view, whatever the justification for the prominence society gives to notions of fairness (including corrective justice) these do not merit being treated as independent evaluative principles. Louis Kaplow & S. Shavell, “Fairness versus Welfare” (2001) 114 Harvard Law Review 961, pp. 967-976. See also Louis Kaplow & S. Shavell, “The Conflict between Notions of Fairness and the Pareto Principle” (1999) 1 American Law & Econ. Review 63. 20 See Amartya Sen, “The Impossibility of a Paretian Liberal” (1970) 78 Journal of Political. Economy 152. Sen’s view, of course, runs directly counter to that held by the majority of law and economics scholars, including Kaplow & Shavell.

7 // permeating most parts of EU financial services legislation is not at all “theoretical”. Essentially, as explained above, national regulators are invited to implement and enforce pieces of legislation, which, in the same space, ask them to both open up their national markets and raise the level of “protectionism” within their jurisdictions.

An illustration of the confusion arising from the pursuit of conflicting objectives in the implementation into national law of EU financial services legislation constitute the public offer and prospectus directive21 and the ISD. Arguably, if protectionist attitudes had not inhibited the drive for liberalisation, there would have been much less differentiation across the EU in the treatment of professional and expert investors or in the utilisation of the private placement exemptions.22 This confusion and asymmetry, aided also by diverging national conduct of business and marketing regimes, including investment advertisement regimes, have created significant barriers to the offer of financial services in the EU on a cross-border basis. In addition, confusion has often led to regulatory paralysis. For example, under the ISD host country regulators are entrusted with the supervision of incoming firms’ compliance with domestic conduct of business rules, despite the fact that these are also supervised by their home state regulator.

It is this largely unacknowledged tension and sometimes-outright conflict between the pursuit of deregulatory objectives and paternalistic regulation that has, in the author’s view, created the current trail of confusion that surrounds the implementation of the Commission’s Action Plan and enactment of new EU financial services legislation, as envisaged in the Action Plan. An example of “confused” lawmaking as a result of serious disagreements between the proponents of liberalization and the proponents of protection - 21 Public Offer Prospectus Directive, 89/298, OJ 1989, L 124/8. 22 On the one hand, mutual recognition of public offer prospectuses is a very imperfect and burdensome mechanism, and on the other the definition of the private placement exemptions and regulatory requirements for effecting them (e.g., whether there is a need or not register the placement with the regulator) differ widely in the EU, raising significantly potential offerees transaction costs (e.g., compliance costs). Steps are taken to remedy this situation in the draft Public offer Prospectus Directive which will succeed the existing directive and will establish, by means of one stop shop, a clear and comprehensive regime for mutual recognition removing most of the existing bureaucratic impediments. See “Proposal for a Directive of the European Parliament and of the Council on the prospectus to be published when securities are offered to the public or admitted to trading” COM/2001/280, 30/05/2001. The Barcelona European Council (March 2002) asked the Council and the European Parliament to adopt the Directive as early as possible in 2002. See also, Directive 2001/34/EC of the European Parliament and of the Council of 28 May 2001 on the admission of securities to official stock exchange listing and on information to be published on those securities, 6.7.2001, OJ L 184/1.

8 // who under the guise of investor protection concerns are bound to also try to protect national commercial interests - constitute the “trials and tribulations” that have followed the draft 13the Company law directive (“The Takeovers directive”). The draft 13th company law directive, harmonising takeover regulation within the EC, began in 1990 but subsequently the impetus for its enactment faded out. In the mid-1990s, interest was renewed and in November 1997, the European Commission presented an amended proposal for a directive on takeover bids. In June 1999,23 it was announced that the Internal Market Council had reached a political agreement on all but one aspect of the proposed 13th Company Law Directive. A year later, in June 2000, work had progressed to the extent that the Council of Ministers adopted a Common Position on the directive on takeover bids.24 The directive was then sent to the European Parliament for a second reading, a procedure which was formalised by the July 2000 Communication from the Commission to Parliament. The European Parliament, which was supposed to have completed its second reading by October 2000, instead came out with suggestions for 15 further amendments to the directive during its December plenary session. The Commission could fully accept only three of them. A conciliation procedure was initiated in April 2001. A compromise text was agreed in June 2001. The European Parliament however voted to reject this compromise solution.25

Other recent examples of this confusion in legislative objectives constitute the draft market abuse directive26 and the draft directive for the remote selling of financial

23 A summary of the amended proposal is available at http://europa.eu.int/comm/internal_market/en/ company/company/news/1022.htm 24 This is available at http://europa.eu.int/comm/internal_market/en/company/company/news/takeover2. htm#2.

25 Efforts have been made recently by he Commission to revive the Takeovers Directive, see Report of the High Level Group of Company Law Experts on Issues Related to Takeover Bids, Brussels, 10 January 2002. This document is available at http://europa.eu.int/comm/internal_market/en/company/ company/ news/hlg01-2002.pdf. For the current debate between academics and practitioners on the draft Takeovers Directive see the online debate hosted by the European Corporate Governance Institute. Relevant academic papers may be accessed at the Institute’s site at http://www.ecgi.org/takeovers/papers.htm. Academics and Practitioner’s views are also aired in the online forum on the Takeovers directive hosted by the Financial Times (“Should the EU adopt a common takeover code?”), available at http://forums.ft.com/2/ OpenTopic?

26 “ Proposal for a directive on insider dealing and market manipulation (market abuse) adopted by the Commission” COM(2001)281, 30/05/2001.

9 // services.27 The first, especially at level two (implementing provisions),28 is “unashamedly” protectionist, and admittedly for good reason, considering the recent scandals that have tarnished the reputation of corporate America. At the same time, the proposal directive for the distant selling of financial Services constitutes a genuine liberalisation measure. The draft directive aims to establish an appropriate harmonised legal framework governing distance contracts for financial services. It consolidates and completes the existing legal framework, so as to facilitate the functioning of the internal market. In particular, it comprises details of the information that has to be provided before conclusion of the contract, an obligation to provide written confirmation of this information, a right of withdrawal, except in the case of certain specific services, the principle of payment for the service provided before withdrawal, consumer protection with regard to payment by card, a ban on unsolicited sales, a limit on using means of distance communication, and measures to facilitate the settling of disputes. Although the proposal directive reaches arbitrary solutions in a number of areas, e.g., regarding contract cancellation, cooling off periods, adjudication of disputes, it, arguably, provides a level of protection that is lower than that already provided in some continental jurisdictions to retail users of financial services, e.g., Spain, Italy, France. In this respect, it constitutes a fine compromise between the suggestions of the providers of E-commerce financial services and the very restrictive provisions that the aforementioned jurisdictions have in place. The fact, however, that both documents may constitute good solutions to

27 See “Proposal for a Directive of the European Parliament and of the Council concerning the distance marketing of consumer financial services and amending Council Directive 90/619/EEC and Directives 97/7/EC and 98/27/EC”, COM/98/0468. An amended proposal was adopted by the Commission on 23 July 1999 (COM(1999)385). Political agreement on the proposal was reached at the Internal Market Council on 27 September 2001 and the Commission put forward on 26 June 2002, following a second vote by European Parliament and suggested amendments an “Opinion of the Commission pursuant to Article 251(2), third subparagraph, point (c) of the EC Treaty on the European Parliament's amendments to the Council's common position regarding the proposal for a Directive of the European Parliament and of the Council concerning the distance marketing of consumer financial services and amending Directives 97/7/EC and 98/27/EC amending the proposal of the Commission pursuant to Article 250(2) of the EC Treaty”, COM/2002/0360. It is widely expected that following these final amendments the draft directive will soon become law, as the Barcelona European Council (March 2002) has asked the Council and the European Parliament to adopt it as early as possible in 2002.

28 CESR's Advice on possible Level 2 Implementing Measures for the proposed Market Abuse Directive, 5.07. 2002, CESR/02-089b.

10 // existing problems, does not mean that they do not stand on opposite poles in terms of actual, as opposed to suggested, objectives and outcomes.

3. The Impact of E-Commerce: Two clicks and “a prayer”

Significantly, it took two major developments in the global financial markets to fully expose the importance of the remaining barriers in intra state trade in financial products and services in the EC. The first was the introduction of the common currency (Euro). The second was the increased use of the Internet as a means for the distribution of financial products and provision of financial services on a cross-border basis. While the impact of the EMU on the integration of the internal market for financial services cannot be underestimated, the relevant discussion is best left to well qualified econometricians. What, however, can be discussed here with a certain degree of confidence is the effect that the provision of financial services over the Internet brought to the already creaking architecture created by the EC New Deal for Financial Services. Namely, although it would be very difficult to measure with precision, what are the exact economic benefits that the technological revolution is meant to bring to the internal market for financial services, and why can these only be safeguarded through the reform of EC financial services regime and the elimination of national legal barriers, some general assumptions can still be made.

One of the major criticisms directed at classical economics (i.e., the writings of Adam Smith & David Ricardo)29 and neoclassical economics (i.e., the synthesis between the writings of liberal free market theorists, the assumptions made in Alfred Marshall’s microeconomics and the Keynesian30 version of macroeconomics)31 is that it perceives

29 A. Smith, The Wealth of Nations (1776); D. Ricardo, The Principles of Political Economy and Taxation (1817). 30 J. M. Keynes, The General Theory of Employment, Interest and Money (1936).

31 The latter was often referred to as the neoclassical or post-war consensus, a consensus that eventually broke down following Friedman’s and other monetarists’ attacks on Keynesian economics.

11 // technology as an exogenous and random development (with the characteristics of public good) and it does not build it into its models of economic growth.32 Against this background, the New (Endogenous) Growth Theory, as developed by professors Lucas and Romer,33 regards technological development not only as a major factor for the increase of productivity of the other two major production factors that of capital and labour, but also as a factor that creates increased (and not diminishing) returns to the scale. It can be validly assumed that, Lucas and Romer theory can be extended to the alteration that technological change brings in the way financial products are distributed and services are offered to end users. This means that, because of the use of new technology, transaction costs in the distribution of financial products are reduced. It means, also, that the global financial services industry will become an even tighter oligopoly, dominated by the very few large players that will afford the initial sunk costs of building up multifunctional and reliable E-Commerce platforms, and who will reap the subsequent increased returns to the scale.

The advent of the E-Financial Services has, arguably, brought down the cost of transacting on a global scale for the financial services industry, especially in respect of dissemination of financial information (e.g., investment research) and distribution of savings and investment products. What was before offered only on the phone and to a selected list of clients (mostly institutional investors) has become now available on-line and accessible to a much wider group of potential users.34 Simple, as well as complex, financial products have become only a click away from the reach of even unsophisticated/retail investors. Such persons, did not have in the past, due to very high transaction costs, immediate and unlimited access, if they had any access at all, to the

32 The other major criticism directed at neoclassical economics is that it does not take into account the geographic (spatial) and temporal dimensions in its analysis of the economic phenomenon. See P. Krugman, Development, Geography and Economic Theory (1995). 33 P. M. Romer, “Increasing Returns and Long-Run Growth” (1986) 94 Journal of Political Economy 1002; R. Lucas, “On the Mechanics of Economic Development” (1988) 22 Journal of Monetary Economics 3; Romer, “Endogenous Technological Change” (1990) 98 Journal of Political Economy S71.

34 See also “Cross-border trade in Financial Services: Economics and Regulation” Chapter, in OECD, 75 Financial Market Trends 23, March 2000, pp. 36-38.

12 // majority of the products that the global financial services industry generates, including sophisticated investment information and exotic investment techniques.35

Another significant gain, that technological change, in the way financial services are provided, is expected to bring, is improved allocative efficiency. Unfettered investor access to competing providers of financial services allows them to compare the charges and products of competing providers and choose to transact with those that provide the best product or service for the lowest price. The fact that investment information is now available to a degree unthinkable in the past allows, this argument goes, investors to compare prices and performance and choose the products with the highest returns, for their risk appetite, which are provided from the most credible firms, minimizing, thus, inefficiency in the allocation of their investable savings.

How then, in practical terms, do national legal barriers to the integration of the internal market for financial services inhibit the cultivation of the expected benefits of the E- Commerce revolution? The next section will attempt to provide an answer to this question and will discuss the recent Commission initiatives in this area.

4. The New EU Financial Services Consensus

This section discusses the inadequacies of the internal market for financial services and the Commission’s reaction to the incomplete legal framework. Those practising in the area of financial markets in London and other European capitals have some “horror stories” to tell about the cost of setting up an E-Commerce platform in what is supposed to be a single market. A significant part of this expenditure goes on legal advice in an attempt to ensure the compliance of the platform with an interminable web of conflicting national public offer, investment advertisement, marketing and conduct of business rules.

35 Of course, technological revolution in the financial services industry did not only bring benefits. Investment information from all kinds of sources, including sources with an ulterior motive, is now available to everyone creating new regulatory challenges with a distinct international character. On the challenges that new technology has brought tot he global regulation of market abuse and suggested solutions see E. Avgouleas, “Financial Market Regulation and the New Market Landscape: In Search of a New Regulatory Framework for Market Abuse” (2000) 2 International and Comparative Law Journal 89.

13 // Of course, entry costs of a very large size can only dissuade new entrants, reducing, instead of increasing, competition in the EU financial services industry. This results in increased market concentration in what is already a highly oligopolistic market.

With the publication of the aforementioned Action Plan for financial services the EU Commission acknowledged the aforementioned pathogenies of the EU financial services regime and suggested a series of new directives to be adopted and implemented before 2005. Therefore, the Action Plan signaled the emergence of a new consensus for the continuation and completion of the harmonisation process, in the various areas of financial services regulation, with ultimate aim the achievement of a truly integrated market for financial services. Another major development in this area has been the establishment of the Wise Men Committee and the suggestions made in its Final Report. However, it is remarkable that, in either document, no attempt is made to initiate a serious discussion on the observed above asymmetry and possible incompatibility between the two main objectives of EU financial services legislation.

4.1 The Wise Men Committee

The Wise Men Committee was established as part of the Commission’s effort to answer industry and market demands to find an acceptable “fast track” process for the introduction of new EU securities legislation. The Committee published its Final Report in February 2001. It agreed with industry’s view that keeping pace with emerging market norms and practices should be of paramount concern for EU financial markets legislation.36 The Committee suggested a new 4 level regulatory approach.37 The first two levels of the Committee’s proposal are concerned with the “fast track” production of financial markets legislation by the EU bodies. It is undoubtful that the suggestions of the Wise Men Report will be used in the production of most future financial services directives. The Wise Men Committee has recommended that the EU Commission, the 36 “The Committee notes that an almost consensual view has emerged that the European Union’s current regulatory framework is too slow, too rigid, complex and ill-adapted to the pace of global financial market change.” Report of the Wise Men Committee, p. 7.

37 The proposals of the Lamfalussy Committee were endorsed by the European Council in Stockholm, 23/24 March 2001 and by Parliament on 5 February 2002.

14 // Council and the Parliament should produce, in the area of financial markets, only general principle - framework directives (Level 1).38 These should be followed by implementing measures (Level 2),39 which are imposed by the Commission with the assistance of the ESC,40 following consultation with CESR. A further level is envisaged comprising detailed measures (Level 3), which will have the objective of improving the common and uniform implementation of Level 1 and 2 acts in the Member States’ legal orders. Such rules may be imposed by national regulators through coordinated EU action following consultation within CESR and applied and enforced consistently across the EC.41

The Wise Men Committee deemed as a matter of primary importance the drawing up, by the EU bodies, even in the context of the amended Treaty following the Intergovernmental Conference, of a list of guiding principles for EU financial services legislation.42 The Committee constructed its own indicative list, which, essentially,

38According to the Report of the Wise Men Committee, Level 1 legislative acts should concentrate on the core political principles, the “essential elements” of each Directive or Regulation. In other words, the Council/European Parliament acting on a proposal from the Commission in Level 1 agree the key political direction and orientation for each subject. The division between Level 1 framework principles and Level 2 implementing measures is determined on a case-by-case basis. Also, the Report added that the Commission should consult, in a very open, transparent and systematic way, before making its Level 1 proposal.

39 According to the Report, Level 2 is composed of a network of national regulators, the European Commission and a new European Securities Committee to define, propose and decide on the implementing details of framework Level 1 Directives (or Regulations). The Report suggested the establishment of two new Committees occupied with the production of Level 2 legislation: (i) An EU securities committee (“ESC”) – a regulatory committee, and (ii) A EU securities regulators committee (“ESRC”) - with advisory functions. Commission set up both committees in June 2001. See Commission Decision of 6 June 2001 establishing the Committee of European Securities Regulators, 2001/527/EC, OJ L 191/43, 13.07.2001 and Commission Decision of 6 June 2001 establishing the European Securities Committee 2001/528/EC, OJ L 191/45, 13.06.2001. The second committee was named CESR, i.e., Committee of European Securities Regulators (“CESR”).

40 CESR is the successor of the less formal Forum of European Securities Commissions (“FESCO”). 41 Under Level 3 it is the responsibility of CESR, acting in a different capacity than in Level 2, to: (a) provide Consistent guidelines for administrative regulations and Joint interpretative recommendations and Common standards; (b) Compare and review regulatory practices; (c) Carry out peer reviews. In the words of Baron Lamfalussy, “Level 3 is European regulators working in a network to ensure consistent transposition and implementation of Level 1 and 2 legislation.” Level 4 is enforcement of EU financial services legislation.

42 “The Committee believes that all European financial services and securities legislation should be based around a conceptual framework of overarching principles. These principles should be consistently applied, and in the future could be either enacted in a framework Regulation jointly agreed by the Council of Ministers and the European Parliament or possibly in a future amendment to the Treaty at the next Intergovernmental Conference.” Report of the Wise Men Committee, p. 22.

15 // constitutes a codification of the main principles espoused in the recitals of most EU financial markets directives:

“- to maintain confidence in European securities markets;

- to maintain high levels of prudential supervision;

- to contribute to the efforts of macro and micro prudential supervisors to ensure systemic stability;

- to ensure appropriate levels of consumer protection proportionate to the different degrees of risk involved;

- to respect the subsidiarity and proportionality principles of the Treaty;

- to promote competition and ensure that the Community’s competition rules are fully respected;

- to ensure that regulation is efficient as well as encouraging, not discouraging, innovation;

- to take account of the European, as well as the wider international dimension of, securities markets.”43

The Committee did not discuss the fundamental economic and social values that these principles reflect and whose attainment the relevant legislation aims at. It only provided scarce guidance as to how the suggested 2 levels of the new legislation will produce principles/rules molded into the overarching ideological framework that guides EU financial services regulation. It noted, however, that Level 1 legislation - the framework principles “are the core political principles, the essential elements of each proposal. They reflect the key political choices to be taken by the European Parliament and the Council of Ministers on the basis of a proposal by the European Commission. They determine the political direction and orientation, . . .”44

43 Report of the Wise Men Committee, p. 22 44 Ibid.

16 // 4.2 Commission Initiatives in the Area of E-Financial Services

E-Financial services like any other economic activity carried on, predominantly, via the Internet needs, in order to grow and expand, a simple and stable legal environment. Complex law and multiple regimes raise transaction costs and suffocate economic activity. Therefore, the adoption by the EU of the E- Commerce Directive45 constitutes a serious breakthrough and should be applauded. The application of the provisions of the E-Commerce Directive could signify the de facto adoption of the home country rule in the offer of financial services over the Internet throughout the EU. The natural consequence of this rule would have been that providers of E-Financial Services would only need to comply with the conduct of business, investment advertisement and marketing rules of the country of establishment. However, as the directive provides for a number of derogations this does not seem to be the case in the area of E-Financial Services. The Commission has initiated consultation46 with the aim to delineate the scope of the E-Commerce Directive in the field of financial services and identify measures that should be taken to bring financial services legislation in line with the provisions of the Directive, especially in the area of retail financial services.47

Admittedly, the E-Commerce and ISD Communications48 signify Commission’s resolve, despite serious opposition by some member states, to adopt the principle of “home country control” in all aspects of E-financial services, including the supervision of e-

45 Directive 2002/21/EC of the European Parliament and of the Council of 7 March 2002 on a common regulatory framework for electronic communications networks and services, 24.04.2002, OJ L 108/33. 46 Commission Communication, “E-Commerce and Financial Services”, COM(2001) 66, 7.02.2001, and Commission Report, “on E-commerce and Financial Services to the Financial Services Policy Group”, of 3 August 2001, available at: http://www.europa.eu.int/comm/internal_market/en/finances/general/fspg- report.htm. “E-Commerce Communication” hereinafter.

47 Ibid, pp. 6, 10-14.

48 See Commission Communication, “on the Application of Conduct of Business Rules Under Article 11 of the Investment Services Directive (ISD) (distinction between professional and retail investors)”, COM(2000)722, 14.11.2000; Commission Communication, “Follow-up to: Communication on upgrading the ISD”, COM(2000)729, 15.11.2000. The first consultation process was concluded in first quarter 2001 and the second consultation in April 2002.

17 // finance platforms’ compliance with national public offer, conduct of business and marketing rules. However, even this reform is not going to be sufficient to bring the desired simplicity and legal certainty that would further the integration of the internal market for financial services, unlocking the efficiency gains that an integrated markets is supposed to bring. In the author’s view, fundamental questions about the definition of securities and other financial investments, the meaning of public offers, the ambit of private placements, the definition of investment advertisement, collective investment schemes, professional (or expert) investors and how much protection such investors need should be revisited and answered, this time with clarity and certainty.49

Accordingly, an obvious danger arising from the Commission’s current focus on extensive regulations covering the offer of investment services to retail investors, as a means to compensate for a lack of clear policy direction, is the creation of a highly complex body of legislation. This, in turn, may mean that only a central regulator will be able properly to interpret and apply the relevant rules. The establishment of an EU securities regulator may present some real advantages. But, it, currently, faces insurmountable constitutional problems. Also, it is opposed strongly by several member states.

5. Future Regulation of E-Financial Services in the EC: “The Importance of being E[a]rnest”

Market players in the global financial services industry recognize the great potential the internal market for financial services holds for them. Given also the adverse demographics, which create a serious need for private investment schemes for the 300 million EU citizens. If barriers to entry are lowered, it is possible that such operators will establish e-commerce platforms covering most EU jurisdictions and extend the benefits of increased competition to large numbers of European investors and savers. It is, therefore, undesirable that they are prevented from doing so by the fragmentation of the

49 All these issues are also the subject of the consultation proceedings concerned with the drafting of an amended ISD that will harmonise conduct of business rules, provide uniform definitions of professional and non-professional investors and bring those Alternative Trading Systems (“ATS”) that satisfy its criteria into the definition of “regulated markets”. Ibid.

18 // internal market in financial services and its inability to regulate itself through a sensible and compatible set of national laws.

This paper has argued that the challenge of facilitating the provision of E-financial services in the EU has only unearthed, in a more acute form, the long existing structural divergences in the way the provision of financial services and the offer of financial products is regulated in the EC. Establishing the “home country” rule, as the predominant principle in the regulation of cross-border provision of financial services is a significant step forward. It is not, however, sufficient, by itself, to create an integrated market for financial services.

The new EU financial services consensus must first establish clear guidelines regarding the objectives of the forthcoming legislation. The political economy of such legislation, and the underlying policy objectives it serves, must be clear before the relevant directives are adopted. The potentially conflicting objectives of liberalisation (“open borders”) and fairness (increased investor protection) may not be simultaneously attainable. If EU policy makers choose to give priority to liberalisation, for instance, instead of increased investor protection, this does not mean that the latter will necessarily be harmed. Leaving room in European financial services law for negotiation between the interested parties does not mean that retail investors will necessarily be prejudiced. In fact, the advent of E- Commerce and the changes that it brings in the cost and geographic structure and organisation of financial markets might be a unique opportunity for EU financial markets regulation to facilitate the achievement of Coasean distributions without the impediment of the endowment effect.50 Arguably, technological developments seem to de facto

50 On the meaning and applications in the analysis of social and economic rules and of their outcomes of the endowment effect see Jack L. Knetch & Richard H. Thaler, “Experimental tests of the Endowment Effect and the Coase Theorem (1990) 98 Journal of Political Economy 1325, at p. 1327 table 1; for its application to the analysis of legal rules see Christine Jolls, Cass R. Sunstein & Richard Thaler, “A Behavioural Approach to Law and Economics” (1998) 50 Stanford Law Review 1471, especially pp.1548-1550; Jolls, “Behavioral Economics Analysis of Redistributive Legal Rules” (1998) 51 Vanderbilt Law Review 1653; Elizabeth Hoffman & Matthew L. Spitzer, “Willingness to Pay vs. Willingness to Accept: Legal and Economic Implications” (1993) 71 Wash. U.L.Q 59, p. 99. For a partial refutation of the assumptions made by behavioral law and economics see R.A Posner, “Rational Choice Behavioral Economics and the Law” (1998) 50 Stanford Law Review 1551 and Mark Kelman, “Behavioral Economics as Part of a Rhetorical Duet: A Response to Jolls, Sunstein and Thaler” (1998) 50 Stanford Law Review 1577. Posner’s view is that both theories may well be valid, if, the different domains they apply, are clearly delineated, which, of course, runs directly counter to the holistic view of Jolls, Sunstein, Thaler et. al. Kelman, on the other hand, refuses to accept the language, but not all assumptions made by behavioral law and economics. He is in

19 // eradicate established players “endowments” in the area of financial markets facilitating rational rather than behavioral distributions. A good example of this is the erosion of the market share of established national and international exchanges. These not only have lost their quasi- natural monopoly position, because of technological developments,51 but also they consistently lose trading volume to ATS in the field of securities trading, 52 although reputational endowments are, of course, the hardest to eradicate.

Also, it is possible that the ensuing tension between consumers, national regulators and the forces of the market may lead to a new equilibrium in the construction of consumer contracts for the benefit of all parties involved. This may, in the beginning, be achieved through the use of commonly accepted industry codes. If irregularities persist causing grievances to retail investors, then once liberalization has been achieved, private law (i.e., contract law) harmonisation may follow. This solution has the additional advantage of incorporating any lessons learnt from the prior implementation of the liberalisation directives.

6. Conclusion

It has been argued in this paper that an effective equilibrium in EU financial services lawmaking can only be reached, if EU policy makers acknowledge that the pursuit of conflicting objectives has led to the creation of a continuous dis-equilibrium in the implementation and enforcement of EU investment laws. National regulators, who by favour of a more synthetic theory.

51 For the emergence of ATSs as close substitutes of stock exchanges for securities trading see Ruben Lee, What is an Exchange?: the Automation, Management, and Regulation of Financial markets (2000); J. H. Mulherin, J. M. Netter & J.A. Overdahl “Prices are Property: The Organisation of Financial Exchanges from a Transaction Cost Perspective” (1991) 34 Journal of Law and Economics 591; Jonathan Macey & Hiroshi Kanda, H, “The Stock Exchange as a Firm: The Emergence of Close Substitutes for the New York and Tokyo Stock Exchanges” (1990) 75 Cornell Law Review 1007; D. C. Langevoort, “Information Technology and the Structure of Securities Regulation” (1985) 98 Harvard Law Review 747; Emilios Avgouleas, “Market Accountability and Pre- and Post-trade Transparency: The Case for the Reform of the EU Regulatory Framework: Part 1” (1998) 19 Company Lawyer 162. 52 In fact, the latter would have become the main trading platforms in the area of commercial and government bonds, in the absence of a series of governmental measures to protect the dominant position of established exchanges, e.g., trade reporting to the listing exchange. See industry response on the proposed regulation of ATS under the new ISD as listed in CESR, Proposed Standards for Alternative Trading Systems - Paper for final consultation, 14.01.2002, CESR/02-001.

20 // definition possess highly protective instincts in their lawmaking and enforcement functions, have been continually instructed to, at the same time, raise the standard of investor protection in their legal orders and open up the domestic market. So far, national regulators’ reaction to this disharmony has been the production of conflicting and complex laws, which result in confusion and legal uncertainty. Arguably, confusion and legal uncertainty are the archenemies of integrative efforts for all social, economic and political systems. The EU cannot be an exception to this rule. Therefore, the introduction a clear sense of policy direction, instead of untenable compromises, should guide the new financial services directives. Embracing technological revolution, and providing simple and clear definitions of those concepts and products that constitute the foundations of the modern financial services industry could prove an excellent step forward.

21 // Appendix A

The most important gaps in the EU Financial Market Regulation according to the Report of the Wise Men a. Lack of commonly agreed guiding principles covering all financial services legislation; b. failure to make the mutual recognition principle work for the wholesale market business in the context of the Investment Services Directive (ISD); for regulated markets themselves; for the retail sector; or for a single passport prospectus working for cross-border capital raising; c. outdated rules on listing requirements, no distinction between admission to listing and to trading, and lack of a definition of a public offer; d. ambiguity over the scope and application of conduct of business rules (Article 11 of the ISD) as well as on the definition of who is a professional investor; e. no appropriate rules to deal with alternative trading systems (ATS); f. potential inconsistencies between the E-commerce Directive and financial services directives; g. no comprehensive market abuse regime; h. no cross-border collateral arrangements; i. no set of common European-wide accepted international accounting standards; j. outdated investment rules for UCITS and pension funds; k. unresolved public policy issues for clearing and settlement activities; l. no agreed takeover rules;

m. no high and equivalent levels of consumer protection and no efficient methods for resolving cross border consumer disputes.

22 // 23 //