“In the risk reform debate, as in so many political debates, logic is often for losers.” So lamented Competitive Enterprise Institute founder and president emeritus Fred L. Smith, Jr. in 1995, and he has expressed similar sentiments many times since.
Yet Smith, a self-described “despairing optimist,” has never stopped trying to bring logic—backed by the strength of “values-based communication” that connects with emotions—to the debate about what risks people are allowed to take. He frequently highlights the illogical approach to risk of many policymakers, pointing out legal products and activities that are more dangerous than ones that are forbidden.
When it comes to risky activities, Smith writes, “we may elect to hang-glide, to hunt, to smoke, to explore underwater caves, to ski.” But Smith notes that by contrast, we are not allowed to take pharmaceutical products that haven’t been approved by a government agency, even if these may save our lives.
This illogic on risk unfortunately extends to the world of financial regulation, and ordinary Americans are literally the poorer for it. Due to the fact that the U.S. has the smallest number of public companies listed on our country’s stock exchanges in more than 40 years, translating into reduced opportunities for ordinary Americans to build wealth, a majority of the Securities and Exchange Commission (SEC) now wants to reform regulations that discourage smaller companies from going public.
SEC Chairman Jay Clayton, whose zealous regulatory approach toward cryptocurrency I have criticized, is on target here with the SEC’s proposed rule to grant relief to smaller companies from the costliest provision of the Sarbanes-Oxley Act of 2002, the mandatory audit of a company’s “internal controls.” Noting that the number of small and midsize public companies “has disproportionally decreased over the years” in U.S. public markets and that these firms offer ordinary investors some of the best opportunities to grow wealth, Clayton states that this rule would greatly “benefit our Main Street investors in these smaller, lower-revenue companies.”
Clayton points out that the incremental costs of the current mandated internal control audits have “a disproportionate impact on lower-revenue companies.” He’s right about that. As I have written many times before (and testified about before Congress), surveys show that these mandates quadrupled accounting costs for many public companies.
As I further said in my 2017 testimony at a hearing held by the House Financial Services Committee: “In the early 1990s, 80 percent of companies launching IPOs—including Starbucks and Cisco Systems—raised less than $50 million each from their offerings. Entrepreneurs were able to get capital from the public to grow their firms, while average American shareholders could grow wealthy with the small and midsize companies in which they invested.”
But all this changed dramatically after the enactment of Sarbanes-Oxley (aka “Sarbox”), a law rammed through Congress after the failures of Enron and Worldcom. As a result, a few years after Sarbox was enacted, 80 percent of firms went public with IPOs greater than $50 million, while IPOs greater than $1 billion—such as Google, Facebook, and Uber—have become a normal occurrence. This means that unlike in decades past, only wealthy SEC-designated “accredited investors” have the legal right to invest in companies before they go through this costly red tape and are at their biggest growth stages. Middle-class investors lose out.
To their credit, both Clayton and SEC Commissioner Hester Peirce seem to acknowledge there may be risks as well as returns in investing in smaller companies with fewer internal controls. They say rightly, however, that it must be up to investors to weigh those risks. Just as homeowners with a budget weigh the tradeoff between household items such as stronger locks to protect from burglary and upgrades to a home’s foundation, so investors should be free to decide whether they would like an extra auditor or extra investment in employees and processes to grow their companies.
Clayton says, “Investors in these companies will benefit from tailored requirements that will save costs that companies would be able to re-direct into growing their companies by investing in productive areas such as research and human capital.” Similarly Peirce asks in a tweet, “If an investor in a small biotech company had the option of having her money go to an audit of internal controls or the hiring of another scientist, what would she choose?”
This is heresy for paternalists like Clinton-appointed SEC Chairman Arthur Levitt who writes in The Wall Street Journal that “a fair-minded investor might … see an audit of internal controls as a form of financial insurance.” And since Levitt opposes the proposed rule, he wouldn’t give middle-class investors who don’t strike him as “fair-minded” any choice in the matter.
But these middle-class investors have plenty of choices of ways to lose their money in the non-investment world. As one tweet in response to Peirce’s states:
If an investor had a choice between betting on horse racing, lottery tickets, spins of a roulette wheel or startup companies they researched, which would they choose???
Trick question, unless they are RICH, they can’t bet on a startup company but can bet on the others…
— David Weisberger (@daveweisberger) May 11, 2019
So let’s make it easier for middle-class folks to grow wealth in small and midsize public companies.
Join me tomorrow as I discuss this on a teleforum with the Federalist Society. Info is here.
Competitive Enterprise Institute Research Associate Gibson Kirsch contributed to this post.