Something for Nothing?

By James Kwak

The so-called JOBS act is a victory of faith over basic logic. The motivating idea seems to be that if we reduce the regulations that govern the process of raising capital, small companies will find it easier to raise money, and that money will translate into jobs. Many people have pointed out some of the problems with the bill: recently, for example, Andrew Ross Sorkin highlighted the potential for companies to take advantage of investors, and Steven Davidoff pointed out that regulation is probably not the reason for the decline in the number of small company IPOs.

There are a couple of more fundamental misunderstanding I want to focus on, however. First, it’s not clear that relaxing regulations will actually make it cheaper for companies to raise money. Sure, eliminating the independent audit requirement will save companies a few bucks. But what really affects the cost of capital is not out-of-pocket fees but the price that investors are willing to pay for equity. The less confidence that investors have in a company’s prospects, the cheaper that company will have to sell its stock. If small companies are allowed to provide less information to investors, that could simply make it more expensive for them to raise money.

Second, and more important, it is definitely not true that more capital for everyone is always a good thing. The point of the financial system is to allocate capital to its most productive uses. The housing bubble, if nothing else, should have convinced us of that point. There are plenty of startups that are are risky and should face a high cost of capital; there are plenty of others that have no business raising money at all. (Think back to the Internet bubble, for example.) Making it easier for such companies to raise money is a bad thing, not a good thing. From a public policy perspective, making it easier for small companies to dodge reporting requirements and thereby raise money from gullible investors is no better than raising taxes and having the government loan the proceeds to small companies with political connections: in either case, you’re mucking around with the ordinary process of capital allocation.

Two more points on this topic: Relaxed reporting requirements can actually be bad for good companies. Good companies benefit from tougher disclosures because it makes it possible for them to differentiate themselves from bad companies. The effect of the JOBS Act will be to divert capital from good companies to bad companies, since investors will find it harder to tell the difference. (Or, in a best-case scenario, good companies will voluntarily comply with the old requirements in order to differentiate themselves—in which case the JOBS Act will have done nothing.)

In addition, the JOBS Act has reporting standards precisely backward. If you’re going to have different standards for large and small companies, the requirements for small companies should be higher. One theory of securities markets is that regulation is unnecessary because market participants will police issuers—basically by studying them very carefully. I have doubts about this theory, but it is certainly more true for large companies, which get tons of attention from institutional investors, than for small ones. Sure, if you don’t require independent audits, you could have fraud in any size company. But you are probably going to find it in a big company simply because so many more people will be looking at it more closely.

It is possible that, on balance, our current system includes too many regulations. I don’t think so—because it is precisely those regulations that encourage broad participation in the markets, which is what lowers the cost of capital for everyone—but that’s a plausible argument. But less regulation does not automatically mean provide more capital for investment—nor is more capital for small companies always a good thing.

19 responses to “Something for Nothing?

  1. edwardsargisson

    Naive investors will often rely on the return to signal the safety of their money; in the lack of much public information this signal can be dangerously misleading.

    New Zealand’s version of the property crash was the failure of a large number of finance companies. These were shadow banks but not regulated as banks. They took deposits and leant them out long on property developments.

    Most of them failed and a common comment from the mostly elderly investors was that they were paying interest lower than competitors so they must have been safer. However, no one was actually examining the books and dealings in enough detail to catch the problems and force a higher interest rate.

  2. When does bad regulation ever turn good? Bring back hard cider and if you feel bad about it. Don’t buy it, but don’t stop the good ones from enjoying it too.

  3. Another sign that Obama is the best Republican President since Teddy Roosevelt.

  4. But one can avoid the small company problems by not buying their securities. Perhaps a better term for the act is the Stock Buyer Beware Act. You may miss a few big winners, but will avoid a lot of loosers. But of course so many want to get rich quick and buy into Ponzi schemes and other investment frauds (see American Greed on CNBC for examples), its clear that either most investment advisors are stupid or perhaps as was suggested for Ken Lay on crack.

  5. I agree strongly with your main point. On ‘too many’ regulations, that likely is true because of the approach to financial regulation. Basel makes the system worse but setting up risk categories that in turn demand more and more rules to fix. Yet it is the basic approach that is flawed — that of assessing risk one asset at a time. A simple leverage requirement does away with much regulation, is more transparent, and could be more effective. And of course no one seems to look at the benefits and costs of financial regulation when they are established.

  6. Moses Herzog

    Watching President (I’m just about near taking that title away and just calling him by his last name, like some cheap furniture brand) Obama sign the inappropriately named “JOBS act” with that sh*t-eating grin really is the last straw. The man has proven that voting for him in November is a waste of fuel, a waste of energy, and a waste of time. He has shown repeated poor judgement on economic issues, bordering cluelessness, starting off with his early decision to choose a TAXCHEAT as Secretary of Treasury.

    It has been shown almost without exception, that when you let companies sell stock to the general public without reporting requirements, in the dark, with zero transparency, excessive abuse of investors is soon to follow. What’s the idea here exactly?—was Pres. Obama so tired of watching innumerous Chinese companies listed on American exchanges screwing American investors and running off with peoples’ money, he decided it was more satisfying to watch Americans cheating Americans? I mean “how dare the bast*rds out-cheat us!! We’ll show them!! We’ll screw and financially F*ck each other!! That’ll show’em!!”.

    I guess…. I guess…. the idea/logic of the “JOBS act” is, if Chinese competitors beating the sh*t out of your own domestic investors doesn’t “get you off”, you start systemic self-flagellating and see if you can get a “hard on” that way. That is the most “logic” I can twist and contort out of the “JOBS act”.

    I’m going to make another of my infamous strong suggestions to this site, which will no doubt be ignored like 95% of my other suggestions. You need to get John Coffey of Columbia Law School on to make a “Guest Post” on this very important issue, and allow him all the space he requires to write an essay on the negative impact this “JOBS act” (which is nothing of the kind and is a deep cutting insult to the intelligence of the American electorate).
    http://www.law.columbia.edu/fac/John_Coffee%20Jr.
    I think whatever he writes on the very insidious effects of this law will be prophetic, and when the damages to the American investor become reality (which they inevitably will) you can invite Professor Coffey back for an update on the asinine law signed today by a man wearing an asinine smile as he signed it.

  7. Per Kurowski

    @James Kwak “If small companies are allowed to provide less information to investors, that could simply make it more expensive for them to raise money”

    That is a truly silly comment Mr. Kwak. Nobody prohibits small companies to give their investors as much information… of the type that their particular investor might want.

  8. Per Kurowski

    @James Kwak” the requirements for small companies should be higher”

    So now not only do the capital requirements for banks have to normally be higher for the small “risky” companies but you also want them to give more information than the big businesses. What biggies are lobbying you Mr. Kwak?

  9. Per Kurowski

    @James Kwak ”regulations that encourage broad participation in the markets, which is what lowers the cost of capital for everyone”

    Not if you are for instance officially deemed as “risky” and being discriminated against, like the bank regulators do with their capital requirements… in that case your interest cost are way higher.

  10. Per Kurowski

    Jerry Carpio, be careful. The capital/funds James Kwak refers to is quite different from the capital/equity you refer to. I have been trying to make the point you make here in this blog for about three years, but the owners don’t get it. That said I am glad to see you are on board on the one simple transparent capital requirement… that one which does not confuse or otherwise distort the markets.

  11. I would make one counter arguement, although I think it is actually taking your point to its logical conclusion. Is it a bad thing if investors are wary of IPO’s? or investing in general?
    Has all the regulations protected the investors and/or depositors at IMF?
    Wasn’t part of the great recession due to investors phoning in due diligence to regulators and quasi regulators like the bond raters?
    I approach investing like I approach buying a house – you need a place to live, but the realitor is not your friend.

  12. You people really need to give up on politics a little more. As soon as you placed your first vote, you agreed to anything and everything a politician does. Now of course it works the same way with the TV, but start with baby steps before debating in circles.

  13. Breaking News: “Dark Equity Discovered in Our Little Corner of the Milky Way”
    —–
    It needs a more appropriate name. I propose the Dark Equity Act. And its associated “dark energy”, which will come in the form of a shower of IPO scams on all those small naive return starved investors by (likely) all the investment houses.

  14. Here’s a market-based counter-argument to James’ point of view that supporters of the JOBS act could have used (although AFAIK they didn’t — perhaps it is too nuanced for today’s political discourse).

    Mandatory disclosure and reporting does make investments “safer” on some metric. However, the rules are generally predicated on maximizing transparency, and do impose substantial costs. Yet the transparency and presumed level of “safety” certainly lower the price of capital as well, as James points out. But it is not clear that the reduced cost of capital completely makes up for the imposed disclosure costs. There might be a level of disclosure that imposes lower up-front costs yet lowers the price of capital enough to be worthwhile. The JOBS act allows the small IPO market to empirically make the cost-benefit analysis that maximizes the outcomes for everyone (rather than just maximizing transparency as the existing rules do).

    The initial wave of new IPOs under the JOBS act rules is certainly going to be painful. However, the best outcome is that ultimately the small IPO market finds an appropriate level of disclosure, and that becomes a “best practice” that is duplicated voluntarily, since it represents the best cost-benefit tradeoff between reporting costs and the price of capital.

  15. edward ericson

    James says: “From a public policy perspective, making it easier for small companies to dodge reporting requirements and thereby raise money from gullible investors is no better than raising taxes and having the government loan the proceeds to small companies with political connections: in either case, you’re mucking around with the ordinary process of capital allocation.”

    But we do that. You’ve heard of the SBA? Why not have a look at the Small Business Investment Corporations–read politically connected, amateurish, public-private venture capital funds–the feds funded throughout the 1990s and early 2000s. Many tens of billions lost on the federal level, with a like amount of state-based taxpayer investment squandered. It maybe would have been big news had not there been two separate market crashes, two+ wars, a stolen presidential election, etc. etc. (and Snookie) over the past 15 years, with the concomitant reduction in journalists (because of adverse market conditions associated with mal-investment).

    People act like Solyndra was something new and different. . . .

  16. Per Kurowski

    What can cost the taxpayers the most and threaten the financial system the most… dark equity or regulators trying to save the world from the horrors of dark equity?

  17. bayardwaterbury

    Wonderful article, James. Let’s face it, the argument regarding regulation is simply a red herring. It is never about just regulation, but really about effective, intelligent and enforceable regulation. When the last vote was cast to put this law into action, and the President made clear his support, I felt that once again, either he was duped by his “friends” on Wall Street, or, he was duping the rest of us. He’s just not that naive, and to believe he is is to disqualify him as our President. Let’s face it, we know that this bill was motivated by, structured by, written by, and will be used by the greedy bastards who have led us down the primrose path to ruin.

    As this bill goes into effect, you can believe that the Goldman boys are doing their little greedy dance, just drooling over the number of small IPO’s they can create out of thin air to raise funds for more scams. This law is like an invitation to modern flimflammers, and will accelerate the decline of our economy by and order of magnitude. It should have been called the Legalize Deceptive Practices Act, since it obviously encourages that.

    Your reasoning is impeccable. But you stop short of the kind of critique that would point out the totally satanic cynicism which has created a world friendly to such Machiavelian Machinations.

  18. I seriously doubt that the *small IPO market* is the economic salvation to the BIG problems in the economy now that 7 trillion has been sucked out of it (Dark Energy abracadabra’d into Dark Equity).

    There is no *POLICY* in place to direct small markets into making something – no energy policy, no infrastructure modernization policy, no beating swords into ploughshares policy.

    But we are getting more and more extraction policies like no soup for you policies, die in the ER because you can’t afford either the fines or the cost of for-profit health insurance policies, cram more people into slum housing on polluted land since they failed at hone ownership policies…so it seems logical that the waiting in the stall small IPO markets are going to be following the increasing extraction policy…

  19. This reminds me of the Medicare fraud story on the nightly news the other day….lots of players selling hardware, billing Medicare, and so much of it fraud based.

    This JOBS thing is for more slimed fingers to EXTRACT and leaving the investor high and dry and broke, like the NINJA brokers did in the run up to the housing collapse.

    The more openings provided crooks, the higher price on society and the reeks and wrecks out there straightening cans at Walmarts for $7 USD per hour.

    We’re all a bunch of stupid apes getting sucked dry by scheming miscreants and bullshit artists.