How the SEC Subsidizes Stocks
[Presented September 16, 1999, at the Mises Institute conference "Austrian Economics and the Financial Markets," Toronto, Canada]
My topic is How the SEC Subsidizes Stocks, and my subtitle could be: Why and How is the government in the securities industry? I mean "subsidy" in the broadest possible sense here and not direct cash support. Specifically, I mean the federal government’s indirect support of the securities industry. The form of subsidy is a protectionism, which helps them to capture a customer base that might not otherwise be available to them.
The often-stated rationale of the Securities and Exchange Commission (SEC) is investor protection. There is a big difference between the motive of protection and the motive of protectionism. Securities regulators seem to have won the propaganda battle by virtue of their steady drumbeat of press releases. This echoes Tom DiLorenzo’s point that the perception of crisis, more than reality, is the fuel for those in government who want to provide public services. They say, "We protect you, we protect the little guy." If you, a member of the general public, read the papers every day, about how the SEC busts day-trading firms and flaky brokerages, how it punishes banks and other large firms who allegedly manipulate earnings, you will tend to think that there is a lot of hanky panky out there. And you would be right some of the time.
But what is the protection offered by the SEC? Does is overprotect, under protect, create false hopes, what? On net, are they helping or hurting? They say they want to root out fraud, which undermines confidence and thereby upsets smoothly functioning, highly liquid markets. Thus Congress awards the SEC wide discretion to punish those who upset markets. But fraud (real fraud) is only one way of upsetting markets. If you upset the SEC’s vision of how a market should work, you are by definition, committing a crime (in many cases). An economic policy embraced by regulators—smoothly functioning, highly liquid markets—has become the law of the land. Ultimately, the laws that govern securities market are geared less to specific credible rules against fraud than to enhancing the securities industry’s ability to attract investors.
Protecting the industry’s position and reputation has some important implications. Do SEC rules create any kind of artificial preference for stocks as against other things to do with your money? Are they in effect, a branch of the Federal Reserve system, promoting confidence in securities markets like bank regulators create confidence in banks or S&Ls or farm lenders, with potentially the same disastrous results? Artificial preferences for anything are going to affect their public values.
These are the questions that everyone is asking or should be asking these days. Is the confidence of investors far out of synch with grounded expectations? The SEC itself thinks so, on the basis of their public surveys. The aura of protection and safety for average investors may put them in over their head. Today a large segment of investors are feeling supercharged. The cash that flows into their retail consumer brokerage accounts is turning into, if not hot money, pseudo hot money, the kind that turns on a dime.
Let me make a brief side point here about the way assets are valued. For years, mutual funds have been taking market share from banks, which is good in some ways—they are shrewd competitors. Is there any way to know whether that is a healthy development? Banks value assets differently than securities markets. Should all of the asset values that we observe be public market values, trading in securities market, or is there any room for bank lenders, or other complex subtle, private valuations, made behind closed doors, with lenders and analysts, perhaps someone channeling the ghost of J.P. Morgan? Does everything including the kitchen sink have to be a security?
The modern SEC is like any other government agency that has industry cooperation and sponsorship. In some ways it is the marketing arm of the industry it regulates. That is no surprise given what we know about other agencies. The industry does not want investors to believe that the market could be uneven or rigged any more than food companies want the public to believe processed food is tainted.
They preach that they want to make the market fair for the little guy. We live in the new era of democratic capital, where everybody gets a piece of the action. Stock trading—what was kind of naughty in the 20s—is now kind of nice in the 90s. We are all Investors now. And our chaperone is the SEC. They wedge themselves between firms and exchanges and exchanges and investors. No dirty dancing is allowed.
Their central activity is to regulate business speech between firms and investors. They ban insider trading and other wicked-sounding practices. They promote disclosure and transparency. While at first those communication regulations sound innocuous and popular—kind of like "consumer protection"—they have bad effects. By painting with far too big a brush they undermine the very trade in information that they are supposed to protect.
In some cases, but not all, insider trading is appropriate. In other cases it is not. There is such a thing as property rights in intangible things, and that seems lost on the SEC. In some cases, transparency is appropriate. Other times it is not. There are business secrets that are proprietary, disclosures that are not cost effective, and situations where investors could care less whether they get various facts.
Earlier this year, the SEC was burdened by the problem of selective disclosure. And if you read about Maytag yesterday (September 15, 1999), you know what I am talking about. Executive managers are sitting on a valuable asset. They are banned from using inside information to benefit themselves (whether their corporate board would permit them to trade or not). Firms create valuable property, tangible and intangible. Who assigns that the rights to use those? Jonathan Macey, law and economics professor at Cornell University, once said that banning insider trading is like a rule that says: throw money out the window of corporate headquarters. In this instance, instead of throwing it out the window, executives reveal it strategically, to favored analysts, hoping for a good review, and perhaps delaying contrary opinion.
How does the SEC approach this problem? There are a few options. They can recognize reality that some information is too complex to be synthesized by average or small investors. Or, they can let firms experiment with assigning rights to the use of that intangible information (while not undermining the public participation). Or they can simply say to the public, "Honestly folks, we recognize that this is obnoxious. But influencing analysts with favoritism happens all the time—research is often biased—and so you should watch yourself."
None of these are chosen. Instead, they continue down the path of threats and punishment. Here are the words of a current commissioner, talking about making rules that deal with the problem of selective disclosure. "In drawing bright lines by rulemaking, we always run the risk of legitimizing conduct that falls just below the line—conduct that we may still find unpalatable…And given a compelling set of facts [on a selective disclosure case], we are not averse to testing our legal theories in this area through an enforcement action." In other words, if we don’t like it, we have the power to stamp it out, so watch it.
Last month the SEC redefined materiality, yet again. (See the New York Times, 8/17/99) In the past, accounting firms argued convincingly that misstatements or errors that were small as a percentage of earning were irrelevant. That is a good rule: don’t sweat the relatively small stuff. Now they say that you cannot hide behind a fixed numerical test. The SEC’s rule is now: if we say 5%, we might mean 4%. At 4%, watch out too, because we might mean 3 or 2%. In other words, it is material when we say it is.
This attitude arose in the wake of CUC, a conglomerate that lied to its accountants, Ernst and Young. The accounting firm thought it was an immaterial error. And it would have been, had CUC not lied to them. But the result is that this fraud expands the scope of SEC powers and imposes more costs on firms. The new rule is: sweat the small stuff.
They even have bizarre issues with Internet distribution. The fine-tuning mentality is really far beyond the pale, and I can refer you to several recent speeches that will make your hair curl, straighten, grow or fall out. 70 million people have Internet access, which is only 20 % of households. And that is just not good enough for the SEC: they split hairs over when information is disseminated, published, available, at what time, if it is on the website, is it published? And what if Dow, Reuters or Bloomberg didn’t get it?
Fortunately, I have the best and final technical solution to make sure that investor information in future generations is equal everywhere. It’s like the V-Chip, I call it the 10K chip. Everyone gets a wireless receiver and storage device implanted in their brain at birth. Later in life, you can upgrade to the 10KAR which is the 10K chip doubler that allows you to receive annual reports with graphics and video. Other modifications are available: You can have it Buffet-ized too. It will select out for you only the 5 or 6 things that Warren Buffet looks for. The possibilities are endless here. By the way, I am advising the Gore campaign this year.
This issue—investor protection or industry promotion—is a bit confusing. There is a chicken and egg quality to it. In some high profile cases—Milken in particular—the situation is totally unique and unprecedented. The establishment reacted to Drexel’s extraordinary success by going to the Feds and Congress for protection. The late business historian Robert Sobel of Hofstra University told me the thing you have to remember is that Drexel had no friends on Wall Street. It’s a very long and complicated story, but in the end, the SEC was the instrument of the hostility of the industry, the public and the congress. Banning Michael Milken from securities market for life to protect the average investor sounds far-fetched. But remember the head of the SEC at the time was vicious, comparing him to a Mafia kingpin.
Other lower profile issues the SEC deals with can be ambiguous. Earlier this year, the floor traders at the NYSE were in trouble. They charge a commission to their customers. Depending on the way the commission is structured, it can resemble profit sharing. That can bias the floor traders decision on who to deal with, and—we slide down the slope—commissions look like bribery. This seems to be common pattern in SEC enforcement: traders and others become the victim of a new law applied to a conventional or aggressive practice.
What is the value in having traders who show utter indifference toward clients—who basically act like computers, showing no favoritism? That strikes me as a means of widening participation. The marketing effect on investors is operative rather than the protections offered investors.
I want someone to explain to me why a floor trader cannot or should not distinguish between a good customer and a bad customer. Every other agent develops good relations. Why should new, low volume customers get the identical treatment of older, more reliable, high volume customers? Customer relationships are a fact of market life. There no good reason why producers would want to let only the new customers know the score?
Also over the last year, there has been talk of regulation of electronic trading. One of the key features of electronic trading is that counterparties can simply bypass the member exchanges and trade anonymously and in large volume. Member exchanges fear disintermediation, just a big word for the money going somewhere else. In the interest of market transparency, the SEC wants the electronic exchanges to reveal information. But institutional investors don’t want to make their positions known. That disclosure rule would push institutional investors back to the member exchanges (or to the telephones) where they have to pay to achieve anonymity. They break up their orders into small parts and use several traders, thereby not revealing their interest.
Here then is a law that invokes the gospel of transparency ("we want to furnish the public the full size of the best buy and sell orders") which simply denies the reality of the market power of institutional investors and their ability to do what they want. The rule here clearly squashes the electronic exchanges’ edge and benefits an SEC constituent: the member exchange.
The market is not made better by regulation that promises protection but more often lures the unwary. The fears of the little guy are not answered, but hijacked for special interests. These examples show that the member exchanges benefit, the connected investment banks benefit, and the Congress benefits. It is not clear that overall, reasonable investors, or any other form of the vaguely defined investor community are better off by banning electronic exchanges, banning selective disclosure, and banning customer relations among floor traders, and banning Drexel Burnham Lambert. But one thing is clear here, and that is that money flows.
The stock exchange, the stock market makers and the investment bank trading units benefit from trading, and the more that trading is perceived to be fair, the more the general public will trade in stocks. That much is easy to understand. What is more complicated for the public to get is that fraud is defined not in the context of property rights but in reference to the economic policy of wide, deep liquid securities markets. Violate that policy, and you have committed fraud.
The SEC and the member exchanges define healthy markets in a special way that serves their interests. They have the right to attract wide participation in the stock market and ensure its continuance by voluntary means. But wide participation is not the standard for evaluating the market. Markets with less participation are not imperfect or inferior and subsequently not in need of correction.
The member exchanges do not have the right to create or hijack an agency, especially an agency with extraordinary power to find and eradicate "unpalatable conduct." No market can live up to the level of perfection the SEC demands. By their lights, all securities markets are deficient and in need of correction by public servants. To create a false perception of fairness in order to attract capital is a fraud itself and a public disservice. Phony fairness to naïve investors is the SEC’s contribution to the "suspension of disbelief" that characterizes today’s economy. The alleged benefits of investor protection, looked at in this light, I think, are far more sinister than the average investor realizes.