Global Parallels: Proportionate Governance for Increased Commerce

Stephen Boyko

The economy functions in the same way the video image and soundtrack combine to form a movie. That is to say, a financial sector paper product supports every good and service produced in the real sector of the economy. This article is a financial sector complement to Ian Campbell’s work published in the 2004 Spring issue of The National Interest entitled “Retreat from Globalization.”

In the process of analyzing American trade policy, Campbell states “unsustainable bubbles in asset prices have become the mainstay of U.S. policymaking.” Market bubbles are price distortions resulting from excess liquidity. Market bubbles emanate from two basic sources: one, a tsunami of paper currency overflowing hard assets resulting from either bad fiscal and/or monetary policy; or two, the financial equivalent of pate de foie gras resulting from bad regulatory policy that immobilizes the flow of capital.

I maintain that excessive and overly complex regulations designed for top-tier NYSE and NASDAQ issues create a regulatory divide that constrains commerce for both domestic and global small-to-medium enterprises (SMEs). While the bull market at the end of the twentieth century witnessed the globalization of capital markets, much of the wealth creation was confined primarily to the top-tier U.S. markets. This, in part, was due to the absence of a proportionate regulatory regime to govern the micro-cap market.

The core difficulty facing SMEs in pursuit of developmental equity financing is not investor indisposition, but a fundamental failure of one-size-fits-all securities regulations to adapt to modern market realities. Markets correct more quickly than regulators. Current regulatory convention differentiates SMEs from large-cap issues solely in terms of scale.  This simplistic view poses a danger to the historic foundation responsible for the growth of the US economy. Excessive regulatory commands result in a misallocation of capital that rations local business investment opportunities and frustrates economic development.

An analysis of capital market standards illustrate how disproportionate regulation has immobilized the flow of capital to the micro-cap market and commercially censored SMEs. Standards are prospective manifestations of societal aspirations that prescribe commercial effectiveness relative to providing a particular product or service. The FLITE Model depicts capital market standards in terms of fairness, liquidity, integration, transparency and efficiency.

Fairness ensures that investors, issuers and intermediaries conduct their market activities in accordance with high standards of commercial honor, and just and equitable principles of fair trade. Fairness exists when the consummation of the transaction depends exclusively on the terms of the trade. However, one-size-fits-all regulation unfairly discriminates against SME issuers by conflating risk and uncertainty.

There are two generic categories of equity securities: event-driven stocks that are "sold" and earnings-driven stocks that are "bought." The existing regulatory regime places a disproportionate focus on financial capacity relative to financial capability that is biased towards positive cash flow, top-tier stocks that are “bought”. Top-tier governance measures "risk" in an actuarial sense for stocks that are "bought" based on cash flow predictions from financial statements. This compares to SME governance that reduces "uncertainty" relative to a lack of measurable knowledge for stocks that are "sold." Until an SME realizes its critical corporate event that enables the enterprise to generate consistent positive cash flow, reduction of uncertainty is the best that investment research can provide. Yet top-tier regulation, such as Sarbanes-Oxley (SOX), requires SME issuers to forecast uncertain future events as though they were predictable[1].

Liquidity ensures sufficient buyers and sellers exist to consummate transactions at prices that are reasonably related to quoted market prices. Liquidity is a function of time, volatility, depth, breadth and resiliency of the market place. Recent history has witnessed a decline in micro-cap market liquidity. Entrepreneurial financing defined as a percentage of total capital formation decreased from 16.7 percent to 10.5 percent between 2000 and 2002. Concurrently, going-private filings rose from 197 to 316. Mergerstat reported that going-private deals comprised 17 percent of all public takeovers in 2002[2]. If securitization, as former Citicorp Chairman Walter Wriston stated, is the height of capital market efficiency, what does “going private” indicate?

Integration enables capital to flow unencumbered to and from global market places in pursuit of investment opportunities. Slower-than-expected development of emerging markets is attributable, in part, to a misperception of the Former Soviet Union’s (FSU) governance structure for the state controlled the factors of production. “Soviet Inc.,” was an unprofitable firm, not an inefficient market. Employing market protocols of regulation and infrastructure to remedy firm maladies added complexity to the preexisting Byzantine structure. New financial shopping malls were built in the FSU with few products to put on the shelf. The misdiagnosis of the initial condition created false constructs and unintended consequences for the integration of global capital markets[3]. Joseph Stiglitz[4] argues:

“the failures of the reforms in Russia and most of the former Soviet Union are not just due to sound policies being poorly implemented … the failures go deeper, to a misunderstanding of the foundations of a market economy as well as a misunderstanding of the basics of an institutional reform process. Reform models based on conventional neoclassical economics are likely to under-estimate the importance of informational problems, including those arising from the problems of corporate governance; of social and organizational capital; and of the institutional and legal infrastructure required to make an effective market economy. They are also likely to underestimate the importance of the creation of new enterprises and the difficulties of doing so.”

Disproportionate regulation not only immobilizes the flow of capital to redline SME development, but it also constrains market functions from driving existing assets to their highest and best use.

Transparency refers to dissemination of information about issuers. Accurate and timely information increases valuation multiples and liquidity of the market.  Strategic transparency decisions in financial markets are determined to a large extent by the dominant investor[5]. In general, bank-controlled, debt-driven firms prefer less information attendant to stock market trading. This tends to protect firms in a weak competitive position. Conversely, equity shareholders prefer more disclosure to promote the strategic advantage of firms in a strong competitive position. America is predisposed to investment banking and equity-driven markets, whereas Europe is predisposed to commercial banking and debt-driven markets. The differences between accounting policy and procedures can best be illustrated by the $1 billion revision to earnings that Mercedes Benz experienced when it applied for listing on the New York Stock Exchange.

Efficiency measures the time, effort and cost required for changing property rights for the owners of securities. The lack of acceptance for Small Corporate Offering Registrations (SCOR) illustrates regulatory driven cost-inefficiency. Most state regulators required issuers to provide three years of audited financial statements.  This regulatory requirement created an expensive hurdle that many cash-strapped SCOR issuers could not afford. Also, issuers that complied with the requirement soon discovered that their universe of investors did not consider three years of audited statements relevant to understanding the company’s future milestones. The lack of access to the next level of funding due to incompatible SEC requirements caused capital rationing problems for potential SCOR companies[6].

Conflicted capital market standards render the micro-cap market ineffective insofar as it is not able to provide the scalable “sliver of equity” that SMEs require. Commercial censorship constrains SME development and diverts excess capital to create market bubbles. Financial fungibility requires that the capital market be analyzed from a systemic perspective. Changing one element of the capital market system alters the analytical metrics for the entire market; or, as proponents of Chaos Theory are fond of noting, “that a butterfly fluttering its wings in China can create a tornado in Kansas”.

An inefficient financial scoring system alters market realities. Capital that normally would have been allocated to fund SMEs was diverted to the housing mortgage market. The burden of disproportionate regulation that redlined SME development was ultimately borne by the labor market as measured in terms of outsource related unemployment. SMEs are the primary engine of job creation. The Small Business Administration (SBA) reports that SMEs generate more than half of net new jobs. Recent history demonstrated that tax reforms alone are insufficient to generate the desired job growth because they only marginally benefit SMEs[7]. For robust economic growth to take place in this important sector, tax relief must be accompanied with regulatory reform[8].

So what is the required regulatory reform? Given the difficulties associated with governing “sold” micro-cap issues using top-tier “bought” securities regulation, I argue that at some level of scale “risk” changes into “uncertainty” requiring capital market governance to be divided into three separate regulatory regimes to mobilize capital for:

·        Government securities that trade in virtual-equilibrium conditions and are bought for savings accounts;

·        Top-tier issues that trade in near-equilibrium conditions and are bought for investment accounts, and

·        Micro-cap SME stocks that trade in far-from-equilibrium conditions and are sold to venture accounts.

To this purpose, the Entrepreneurial Exchange (EntEx)[9] is proposed to reduce the cost of being a public company by substituting investor intellectual capital for financial capital. EntEx’s regulatory regime creates a niche market for sophisticated investors where compliance costs are priced more efficiently at the margin for only those services needed. EntEx provides scalable sponsorship and proportionate governance for the global economic development of innovative financial products and services.

Stephen A. Boyko is president of Global Market Thoughtware, Inc., an international consulting company that specializes in economic governance issues.