Home Business & Finance Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them
Nowadays, only the regulation of food and drugs goes as unquestioned as the government’s oversight of the stock market. Encomiums of securities regulation often appear in the financial press, whether markets are flourishing or under stress. Whenever they are flourishing, government superintendence is lauded for nurturing confidence among investors in the fairness and integrity of the markets. Whenever they are under stress, it is seen as a cure for whatever has assailed the markets, even when regulators were already in place and charged with patrol duty at the time trouble was brewing. Nothing can happen, it seems, that can falsify the principle that the state should be involved in supervising the markets. This represents a violation of Karl Popper’s criterion of a valid theory, according to which a scientific hypothesis must specify an event that could possibly falsify it. The flouting of this criterion should lead us to scrutinize the thesis that securities regulation is an indisputable political good. For just as serious questions can be raised about the performance of agencies like the Federal and Drug Administration, so too can one justly wonder whether the SEC has lived up to its promise.
After all, it is not as if companies have no incentive whatsoever to inform investors of their doings and prospects. To the extent that greater investor knowledge reduces the rates at which a firm’s future cash flows are discounted, its share prices rise. That, in turn, lowers the cost of equity capital for firms, which they have an obvious interest in realizing when first going public and afterwards for secondary offerings of shares. Even where neither of these is on the horizon, corporate executives are incentivized to proffer relevant information. Their pay, after all, is often tied to the performance of their company’s shares. If they are nevertheless tempted to slight these incentives out of a short-sighted impulse to make a big one-time killing, the courts are there to deter them with the prospect of civil lawsuits and criminal fraud charges. George Stigler, a renowned economist, discovered that the returns of investing in IPO firms were no different before the onset of mandated disclosure in 1933 than afterwards. Certainly, the IPOs that passed SEC muster, but which nevertheless burned investors in the 1990’s dotcom boom, lend credence to Stigler’s contention. In this connection, one need only recall pets. com and boo.com. Several studies completed by George Bentson, Greg Jarrell, and Carol J. Simon after Stigler published his seminal 1964 paper verified his assessment. True, a multinational comparison of disclosure laws suggests that more stringent regulations correspond to smaller levels of IPO underpricing and, thus, a lower cost of equity for companies going public. One cannot, however, invoke this finding to support mandated disclosure finding without also considering the costs of producing the additional information that the law requires. Only if this is less than the gain implicit in a lower cost of equity does compelling firms to divulge information make economic sense from a social point of view. Yet, if this condition is satisfied, companies will find it beneficial to voluntarily undertake the extra effort of giving investors more details of its present condition and prospects. To the critics of leaving disclosure to market forces, it must also be granted that, after the original passage of the US securities laws, the volatility of stocks subsequently declined. But this implies that smaller firms, the ones that display larger variances in their share prices, were shut out of the market by the regulation, thus hindering a key source of economic dynamism.
That securities regulations adversely affect small companies was acknowledged in the aftermath of Sarbanes-Oxley. This was a major reform of accounting rules passed by Congress after the 1990’s bull market collapsed. It was the last time that a bear market, which extended
Fig. 5.3 Number of US IPOs, 1980-2014. Source: Jay Ritter
from 2000 to 2002, gave rise to a major addition to the regulatory edifice for stocks. In an admission that Sarbanes-Oxley went too far, President Obama signed legislation in 2012 that temporarily excuses small companies from the accounting strictures of Sarbanes-Oxley. In doing so, his administration effectively yielded to a conclusion frequently arrived in studies concerning section 404 of the law. In requiring assurances that adequate internal financial controls are in place, that part of Sarbanes-Oxley confronts smaller firms with formidable compliance costs. There is also reason to suspect that Sarbanes-Oxley may have tipped the regulatory equation to the point where becoming a publicly traded company, or even remaining one, makes little sense for a large swath of companies. On average, there were 311 IPO’s per year from 1980 to 2000. Since then, through to the end of 2014, the average per year has fallen to 112 (Fig. 5.3).
Research Paper, no. C07-9 (2007).
Flourishing in the meantime has been the private equity category, made up of investment funds that take positions in limited liability companies whose shares do not trade on the markets. These companies save on the expenses incurred in having to abide by the securities regulations, including the requirement to periodically supply financial reports to investors. Freed of this obligation, companies can focus more on the long-run and less on meeting short-term quarterly expectations set by analysts and the investing public. Critics of capitalism often complain that firms are given to myopia. Yet what is almost always forgotten is that a short-term perspective is encouraged by the regulations. Were companies not obligated to provide financial reports on a quarterly basis, market forces would encourage companies to issue such reports at intervals that would accommodate the unique time pressures of their line of business and the needs of shareholders to know the condition of their investment. From Lowe’s Joint Stock Companies Act greatly facilitating the publicly traded corporation, we seem to be heading back in the direction of the Bubble Act, which greatly restricted that form of economic organization. Should this trend continue, the democratization in the ownership of the means of production that we have witnessed over the past half century or so is liable to being reversed.
Very much worth observing as well is the overwhelming evidence that mandated disclosure laws in general do not improve people’s decisionmaking. Surveying a variety of industry and institutional contexts, Omri Ben-Shahar and Carl E. Schneider found that mandated disclosure fails in banking, insurance, foods, health care, auto sales, real estate, vocational schools, and the justice system. Despite all the information that people receive, the majority do not comprehend the terms of a mortgage or the implications of alternative medical treatments. Nor do they understand the nutritional value of different food products or even the rights they are informed of when they become criminal suspects. The problem is the sheer quantity of the disclosures that legislators require. Too much information is provided for individuals to cognitively process. As the disclosures accumulate, individuals respond by ignoring them.
Once again here, democracy is the source of the dilemma. Whenever a public outcry is raised after an individual buyer has been harmed by a seller, elected politicians have an interest in being seen as doing something to fix it. In a democracy, that fix must respect the principle of individual freedom. Legislating the provision of information satisfies this dual imperative. The individual is not coerced away from purchasing a good or service they might desire. At the same time, the information that is forced upon them can be portrayed as helping them make a better decision for themselves—in other words, as an enhancement of their freedom. John Stuart Mill, the nineteenth-century British thinker, finessed the matter in this very manner in his hugely influential defense of freedom, his essay On Liberty: “when there is not a certainty, but only a danger of mischief, no one but the person himself can judge ... he ought, I conceive, to be only warned of the danger”. Democratic politicians have taken that recommendation to warn and have fulsomely expanded on it.
Anyone who has tried going to the SEC’s Edgar website to look up the filings of a publicly traded company will soon find out that the quantity of information problem also applies to the stock market. Certainly, the avalanche of disclosures has done nothing to turn the ordinary person into a better investor. Figure 5.4 shows how the average investor performed against a set of asset classes from 1995 to 2014. Their returns were worse than if they had just held on to stocks, bonds, or gold throughout that time frame. The average investor barely beat the rate of inflation. It is hard to fathom how they could have fared worse if companies were free to disclose whatever the marketplace demanded.
As if all that were not enough, securities regulation has completely failed to fulfill one of its original purposes. When the legal framework was built in the 1930s, the prevailing assumption was that 1920’s bull market reached unsustainable heights due to the combination of a plethora of culprits. Among these were excessive margin lending to investors in addition to pump and dump schemes. Blamed, too, was the painting of stocks in pollyannaish strokes by investment bankers, stock brokers, and corporate executives, not to mention the operation of investment pools
Fig. 5.4 Ordinary investor performance versus Major Asset Classes, 1995-2014. Source: Black Rock
in which individuals would combine to rig the price of a stock. By containing all these, securities regulation was supposed to prevent mania and crash sequences from recurring. Obviously, that has not happened. Partly, this is because government regulators have little incentive to appear as worrywarts and wet blankets by spoiling the party when markets are bubbling higher. Not only that, standing athwart a raging bull market requires a contrarian frame of mind, a willingness to go against the crowd that only a few human beings are capable of mustering. It is hardly to be expected that such rare souls will be concentrated in government agencies.
Other notable regulations that arose out of the 1929-1932 bear market included restrictions on short selling. This is the attempt to profit from a decline in the price of a stock. More the province of sophisticated and active traders than ordinary investors, this type of trade is executed by selling shares first and then buying them afterwards. Those who first hear about short selling immediately wonder how one can possibly sell shares that one does not already own. To sidestep this dilemma, the shares are initially borrowed from someone who owns them, a service performed on behalf of the short seller by their broker. The borrowed shares are then immediately sold. Later, the shares have to be returned, which the short seller hopes to do by buying them on the market at a lower price than that at which they were first sold. If this happens, the short seller earns the difference; otherwise, they lose money. Even before Roosevelt came into office and the Pecora commission became a political force, short sellers were made the villains of the market’s relentless descent in the early 1930s. President Herbert Hoover continually railed against short sellers, alleging that they were “destroying public confidence” and engendering “discouragement to the country as a whole”. Short selling restrictions eventually came in the Roosevelt administration when the SEC instituted the uptick rule. This only allowed short selling at prices that were higher than that at which the stock previously traded. Heeding the counsel of economists, the SEC finally abolished the uptick rule in 2007. Still, it imposed a temporary freeze on short selling of financial stocks in 2008, as did a number of other countries in a bid to stem the financial tsunami. Naked short selling, in which the shares bet against are not borrowed, was banned in 2004 by the SEC and continues to be illegal. Elsewhere around the world, restrictions on ordinary short selling in the form of an uptick rule continue in force in a few countries like Canada, Russia, and Hong Kong. Blanket prohibitions of naked short selling are less common than those limited to financial stocks.
Setting aside short selling of the naked variety, one does find economists questioning the imposition of limits on ordinary forms of short selling. Little evidence exists, they point out, that short selling exacerbates market declines. A recent study verifying this is a New York Fed paper that examined the impact of the short selling prohibitions that were placed on financial stocks during the recent crisis. Limiting that trading strategy also reduces liquidity on the stock exchange along with an important source of demand for shares amid a falling market. After all, the person who sells short must eventually buy the shares back. And when these are declining sharply, he or she will be among the few traders willing to step in amid the maelstrom and purchase stock. In this way, short selling minimizes volatility. Short sellers, too, help keep stocks from climbing too far above what the fundamental prospects of the company dictate, particularly when investors happen to be in an overly exuberant mood. Perhaps the greatest service offered by short sellers to society is their ability to detect fraudulent accounting at companies—a talent no doubt cultivated by their interest in uncovering overpriced shares. Other than employees, nobody does a better job of ferreting out wrongdoing at companies than short sellers. Luigi Zingales and his colleagues examined 216 instances of corporate fraud from 1996 to 2004. What they discovered is that while whistle-blowers detected the chicanery in 17.1 % of the cases, short sellers came a close second at 14.5 %. The SEC came in last at 6.6 %, well behind financial analysts and the media.
Another cornerstone of securities regulation is the prohibition of insider trading. This was first highlighted as a political issue when Samuel Untermyer, a lawyer who had served as counsel in the House of Representatives, testified before the Pujo Committee in 1912. Insider trading was subsequently targeted in the 1934 Securities and Exchange Act. The legislation only specifically proscribed short-term trading profits by those holding a greater than 10 % stake in the company’s shares on the assumption that such parties are likely to be insiders. Using its rulemaking authority, while invoking the anti-fraud provisions of the Securities and Exchange Act, the SEC subsequently enlarged the scope of forbidden insider trading. This effort was largely sustained in a series of key Supreme Court rulings used in gauging when a violation has actually occurred. The result is that insider trading is now generally defined as taking place whenever an individual buys or sells securities while in the possession of material information that is not publicly available.
While numerous rationales are put forward to support insider trading laws, two are especially common. One of these appeals to the concept of fairness by maintaining that insider trading permits the better informed party to exploit their lesser informed counterpart. The second argument relies on the observation that the financial markets rely heavily on the participation of ordinary investors. They are liable, so the argument goes, to abandon investments in stocks if they ever came to the conclusion that the trading and pricing of securities was rigged against them. Of all the elements of securities law that can be defined as peculiarly American in origin, the prohibition of insider trading would certainly have to be among them, as the USA largely originated the approach and has seen it spread around the world.
But it is a questionable export. To the overwhelming majority of market observers, the immorality of insider trading seems as obvious as that of theft and murder. Under examination, though, the arguments in favor of prohibiting the practice run into both logical contradictions and empirical objections. Consider first the claim that it is wrong for a person to take advantage of superior information at their disposal vis-a-vis another. Outside the confines of the stock exchange, this kind of informational asymmetry is commonly allowed in commercial transactions. Imagine that an art dealer comes across an original Claude Monet painting at a flea market and is asked $50 for it by the vendor. Were the dealer to buy the painting at the quoted price, indeed even if he or she were to haggle it down to $30, no judicial authority would lay civil or criminal charges. A real instance analogous to this came to light in a seminal 1968 US court case, SEC v. Texas Gulf Sulphur Company. In their ruling, the federal circuit justices sustained a conviction of company executives that were found guilty of trading on their knowledge of an ore discovery in Canada. Yet the executives of Texas Gulf Sulphur were legally permitted to use their non-public information in an attempt to buy adjacent land. To avoid the contradiction here, the defender of insider trading laws might counter that the art dealer and the mining company are entitled to take advantage of their private knowledge because they invested time and effort to acquire it. Otherwise, individuals would have little incentive to make commer?cially important discoveries. This is an entirely compelling argument. But it also applies to the financial markets. After all, people who come to possess non-public information about a stock often do so as a consequence of working to produce that information by, for example, arranging a takeover deal or running a company.
Theft and murder clearly leave someone worse off than they were before. But who exactly is harmed by insider trading? Suppose a takeover of XYZ Corporation is set to be announced at $100 per share, well above the current price of $70. Trading on this information prior to the announcement would bring XYZ’s stock price closer to $100, perhaps to $80. That would leave investors to trade at levels that better reflect the truth about the circumstances of the company. Is not encouraging stock prices to mirror objective reality what securities regulation is supposed to be primarily about? Granted, buyers will have to pay more for the stock than would otherwise be the case. But, then again, sellers will also receive more. Why the interests of the buyer should be given priority over the seller is far from evident, especially when it would involve preserving a less than truthful state of pricing affairs. Admittedly, the possibility exists that the insider trading generated rise to $80 will induce some XYZ shareholders to sell their stock before the acquisition is publicized. In that case, they would lose out on an additional $20 per share profit. It is also plausible, however, that momentum investors will be prompted to buy the stock as it moved toward $80. They will end up with the additional $20 profit. And once again this would raise the question why those provoked into selling by the initial assimilation of the takeover information should have their concerns granted precedence over those stimulated to buy. To repeat, the cause of truth in pricing would actually be served by favoring the latter. Should it be said that the previous owners of XYZ ought to be rewarded for their longer commitment to XYZ, the response can be made that anyone who sold the stock on a quick $10 jump is not likely to have been the model of a loyal shareholder in the first place. Such individuals will not actively trade the stock. This serves to remind us that the interests most furthered by insider trading prohibitions are those of professional traders, who have more than enough savvy to fend for themselves. Take away insider trader laws and what would happen is that sudden price changes would be watched more closely for their significance than they already are.
Nor is there much to fear with respect to a loss in investor confidence of the equity markets. Historically, insider trading has been enforced less rigorously in Europe, Canada, and Japan (where it only became illegal in
1988). This, by the way, is arguably no coincidence. Europe has an aristocratic tradition, Canada’s democracy is historically marked by its relative lack of populism, while Japan did not become democratic until after World War II and is still characterized by a hierarchical culture. In these less than democratic climes, it ought to be no surprise that insider trading has been viewed as less of a moral threat than in the more democratic USA. In any case, the fact is that Europe, Canada, and Japan have not taken the same puritanical approach to insider trading that America has and it has not hampered the functioning of their markets.
Note, too, that if the prevalence of insider trading were a cause of reduced public trust, then one would have expected the market to have performed poorly after a series of 1980s scandals related to the practice. These ensnared Ivan Boesky, R. Foster Winans, Denis Levine, and Michael Milken. Boesky was a takeover arbitrageur who sought to profit from the price differentials generated by mergers and acquisitions activity. His character was partially the basis for the character of Gordon Gekko in the film Wall Street. Winans was a journalist for the Wall Street Journal found guilty of profiting from companies he wrote about in the paper’s influential “Heard on the Street” column. Levine and Milken worked at Drexel Burnham when that investment firm was a leader in junk bonds. Despite all these figures alerting the investing public to the prevalence of insider trading on Wall Street, the US markets still went on to perform strongly during the ensuing decade of the 1990s. It is true that a more quantitatively exact parsing of the empirical evidence has shown that the enforcement of insider trading laws is associated with anywhere from a 0.3 % to a 7 % reduction in the cost of equity capital. This implies that companies are apt to invest greater amounts in more projects because these can be financed more affordably in the stock market. Even assuming that figure is at the higher portion of a very wide range, 4-7 % is not an especially alarming amount, particularly in a low interest rate environment. That number must also be considered against the price of enforcing insider trading laws, in terms of higher taxes and the opportunity costs of deploying the money elsewhere. There are also the allocative inefficiencies entailed in not having stock prices trading closer to levels reflecting all the potentially available information. By obstructing this, the ban on insider trading reduces the quality of the signals the markets send about which industries have the most and least promise.
None of this is to say that insider trading should in no way be restricted. It can, but, ideally, the task is best left to companies. After all, the information at issue with insider trading belongs to them insofar as it is the outcome of the labor of their employees and investments they have undertaken. Where the use of that information for investment purposes would jeopardize the corporation’s interests, by, for example, harming its reputation or raising the price of an acquisition target, it should be allowed to prohibit insider trading among its employees. Where the use of the firm’s private data to trade the company’s stock is deemed to be a suitable means of rewarding employees for their efforts, the shareholders should be free to allow insiders to take advantage of this compensation mechanism with a view to better aligning the interests of the owners and management. Only when insider trading takes the form of short selling is government interdiction truly justified. Otherwise, corporate executives would have incentives to worsen the company’s performance. All this being said, we cannot expect this more flexible and nuanced approach to insider trading to be adopted anytime soon. In a democracy, with its commitment to equality, any prerogative held by a group is automatically suspect. And whatever the larger benefits and moral logic of deregulating insider trading, its toleration looks, from a democratic view, like the granting of a special advantage to highly paid CEOs, investment bankers, and portfolio managers.
The best that one can hope for is to tame the excesses in the definition and prosecution of insider trading. The US Congress has never specifically defined that conduct for prosecutors, thus leaving the latter free to make a name for themselves by seeking to convict people on everbroader conceptions of insider trading. The most recent instance was the theory put forward by Preet Bharara, the US attorney for the Southern district of New York. Playing to the post-financial crisis resentment of Wall Street, he obtained numerous convictions on the notion that insider trading occurs whenever someone benefits from non-public information, even if they do not know that it is not public. Here we see the egalitarian impulse driving the moral interpretation of insider trading taken to its fullest extent. The simple possession and use of informational superiority over another becomes an offense. The Second US Circuit Court of Appeals in New York rejected Bharara’s definition and he was subsequently forced to dismiss the charges he had laid. Though the judicial branch did well here, the legislative branch needs to assume its rightful role in defining insider trading, take it away from the courts, and define insider trading in accord with traditional legal principles of criminal responsibility. As such, insider trading should only consist of the buying and selling of securities where one proceeds knowingly, or recklessly disregards knowing, while acting upon information which is not available to the public.
Looking at the entire securities regulatory structure from a broader pointer of view, what is most worrisome is how it exhibits the drift in our liberal democracies toward rule by administrators. Legislators elected by the people are supposed to make laws and policies, while executive officials similarly elected are supposed to implement them. But as the state over the past century has grown in size and scope to watch over even the minutest details of economic life, the legislative branch has been compelled to delegate a good deal of its rule-making authority to regulatory agencies, at the same time that the executive branch has had to cede some of its enforcement authority to these same agencies. Of the three branches of government, the judicial branch has been least affected by this development as the courts are generally empowered to review regulatory actions and rulings. Indeed, this is one of the arguments used to defend regulatory agencies from the charge of unconstitutionally undermining the separation of powers. Another is that the top officials in those bodies have to be appointed by elected officials and are only granted limited tenure. Thus, at the SEC, its five rule-making commissioners are selected by the US President, confirmed by the Senate, and given a five-year term. Not only that, to avoid either of the two political parties from dominating the securities regulator, no more than three of the five regulators can either be a Democrat or a Republican. The mistake in thinking that this suffices is in assuming that constitutionality is simply a matter of ensuring the ultimate accountability of regulators to the people. But the separation of powers that is a fundamental part of the design of liberal democracy, particularly its Anglo-Saxon variant, is primarily meant to prevent the same body from making, executing, and judging the laws. Like other regulators, the SEC performs all three tasks. Besides formulating new rules and implementing them, its staff also issues interpretations of existing regulations. Granted, these are not legally binding, but any prudent firm will heed those interpretations so as not to come under the sights of the regulator. As for the accountability mechanisms provided by the appointment power of elected officials and court oversight—which, alas, several provisions of the 2010 Dodd-Frank Act threaten—these have the baleful consequence of distancing the business of government from the people further than our representative system already does.
|< Prev||CONTENTS||Next >|