|It'sNo Gamble- The Economic and Social Benefits of Stock Markets|
| Chapter 7:
THE OVERSEEING OF STOCK MARKETS in Canada is mostly a self-regulatory process. While in principle the activities of participants are regulated by provincial securities commissions, these bodies have typically delegated much of their authority to the exchanges and to the Investment Dealers Association. Bond dealers, broker-dealers (although to a limited extent, to be discussed later), and mutual funds dealers are also self-regulated. Regulation in general covers three sets of activities: prosecution of fraud, registration of market participants, and registration of traded securities (Hatch and Robinson, 1989).
Many stock market critics have called for stricter regulation and other forms of government intervention, citing a variety of shortcomings of the present system. An example of the prevailing hostile attitude to stock markets is contained in a recent report by the Economic Council of Canada
Much of this attitude results from not understanding the way that financial markets operate and the benefits they confer. We hope that this book will help educate interested parties in this regard. As well, many critics fail to realize that regulation has costs as well as supposed benefits.
If one attempts to distil the rhetoric of many of these critics, it becomes evident that there are two types of purported deficiencies in the present system: market failure and moral failure. Examples of supposed market failure include shareholder myopia (such as the alleged preference for short-term profits rather than investment in R&D, with the ensuing impairment of international competitiveness), market inefficiency (which erodes investor confidence and impairs economic growth), and the market's deficiencies in allocating capital for social as opposed to private profit-making objectives. [It is also often alleged that markets have become too volatile in recent years, largely as a result of trading in derivative securities. We show in chapter 12 that allegations of derivative-induced volatility have no empirical support. Kupiec (1991) shows further that there is no evidence of increasing sustained volatility in the major OECD equality markets over the last thirty years, with the short periods of abnormally high volatility that were experienced being quickly followed by a return to more "normal" levels. He also criticizes the remedies proposed to curtail the apparent problem, such as circuit breakers, transactions taxes, and margin requirements.] Examples of moral failure include the many instances of broker malfeasance that have unfortunately littered the history of stock markets, and which taint the ethical and legal activities of the majority of participants.
If valid, these criticisms would have serious implications for investor confidence (which in turn threatens the integrity of the capital formation process) and thus economic growth and global competitiveness. The remedies sometimes suggested for market failure include a stronger government role in capital allocation and in corporate governance. Moral failure is said to require stricter regulation. This chapter reviews the evidence on these apparent failings and makes recommendations on the appropriate role of government in the control and functioning of stock markets.
Specifically, we show that the market is better suited to making capital investment decisions than is government, and that better enforcement rather than more regulation is needed for industry supervision. We will also examine a two-tier regulatory system that allows freer access to capital for more established firms while affording investor protection in the more speculative junior capital sector.
Market myopia and competitive disadvantage
Porter (1992) is one of the leading proponents of the myopic market theory (discussed in chapter 2). The argument is that investors with short holding periods pressure management to take short-term profit-maximizing actions, to the detriment of longer-term strategic investments, for example in research and development and in human capital. The lack of investor interest in strategic investments means that their cost of capital is too high and the competitiveness of firms subject to the pressures of myopic markets is undermined (see Pecaut, 1993, and figure 10 in chapter 4).
Among the remedies recommended by Pecaut and others (see chapter 4) are various types of government intervention. For example, Pecaut claims that governments can lengthen investor horizons through tax measures, such as selective capital gains relief, extended tax credits for research and development and for training costs, and other tax measures including incentives for venture capital companies. Alternatively, governments can support targeted stock savings plans offering tax relief to investors, implement changes in the regulation of banks to permit more keiretsu-style corporate organizations (the Japanese model, where banks and industrial corporations have much closer ties than in North America), or create a state-owned "Bank of Industrial Organization" to serve as a main bank for innovation-based businesses.
Pecaut recognizes the difficulties with many of these remedies, particularly with changes in the regulation of banks and the formation of an industrial bank. In the longer term, the onus is on the private sector to develop the institutional framework to solve these problems. Two areas with particular promise are the development of new financial institutions and the improvement of relations between providers and users of capital (discussed below). With respect to the tax-based remedies, the empirical evidence on their efficacy is mixed. Suret (1994) shows that the various activities of the Quebec government in intervening in the investment process have been wasteful, inefficient and unnecessary.
There is also evidence that the problem may be overstated or the blame misdirected. Johnson and Pazderka (1993) demonstrate that Canada is not disadvantaged relative to the United States as far as the myopic behaviour of the stock market is concerned. Jog and Srivastava (1993) show that the wedge between internal and external funding (which reduces the aggregate amount of corporate investment) is more a matter of corporate behaviour than evidence of market failure; that is, many corporate financiers have an aversion to raising new capital despite the small incremental cost.
The solution to market myopia (if indeed it is a problem) rests with the private sector. The financial reorganization recommended by both Pecaut and by Jog and Srivastava seems to be already evolving as the fallout from the financial market deregulation that began in the 1980s continues. As an illustration, the Canadian bank-owned brokerage houses are approaching the critical size necessary for global competitiveness. Meanwhile, the venture capital industry is increasingly meeting the needs of smaller, innovative companies, which traditionally have not had access to stock market financing.
There is scope for more private sector involvement in corporate finance and corporate governance if various financial regulations are relaxed. MacIntosh and Daniels (1990) discuss the impact of the "three 10% rules." The first of these is the regulation in the Income Tax Act that constrained (at that time) pension fund holdings of foreign assets to ten percent of the book value of the portfolio. Since domestic investment opportunities are limited, pension fund managers frequently cannot sell Canadian stocks and are thus unable to voice disapproval of corporate management by "voting with their feet." That regulation has been relaxed somewhat, and pension funds may now hold up to 20 percent of their assets in foreign holdings. Ironically, this helps to make Canadian markets more effective since it gives the pension funds more choice and enhances their liquidity.
The second confining rule is the Bank Act constraint on ownership of Schedule A banks that restricts the maximum ownership of a bank by any one shareholder to ten percent. This results in less market discipline over bank management and the consequent reduced incentive for bank management to actively monitor their corporate clients.
The third confining regulation is the Bank Act prohibition on a bank's owning more than ten percent of a company. This limits both the incentive and the ability of bank managers to monitor their corporate investments. If they were allowed more concentrated ownership positions, they could exert more influence (and would have the incentive to do so).
There is evidence of a growing awareness of the implications of potential market myopia, as large institutional investors in both Canada and the U.S. are becoming increasingly interested in what has become known as "relationship investing." Institutional investors, such as Stephen Jarislowsky in Canada, and many of the larger American firms, are beginning to understand not only their power over corporate governance, but also their responsibility for more stable, partnership-like arrangements with the companies in which they invest. As noted in chapter 2, the Toronto Stock Exchange has recently established a Committee on Corporate Governance in Canada to study and make recommendations for improvement. Recent corporate restructuring and the turnover of senior officers at such companies as IBM, Sears, General Motors and Eastman Kodak can be attributed to institutional shareholder activism.
Market efficiency and investor confidence
Most of the deviations from market efficiency in Canada relate to insider trading (see chapter 4). Insider trading prevents the market from being efficient (in the sense of prices reflecting all information), since corporate insiders can make abnormal returns on their trades (Suret and Cormier, 1990). As well, it appears that opportunities for profits persist even after announcement of insider trades (Sharpe, Alexander, and Fowler, 1993), which implies that markets are slow to digest this particular form of information. This inertia tends to be clustered in industries which are not closely followed by professional analysts. Hence, there may be instances where a retail investor may be disadvantaged through lack of information (even though that information is available if anybody cared to look for it).
Does this evidence of information on insider trades not being reflected quickly in stock prices call for regulatory remedy? The natural response is the well-worn principle of caveat emptor : retail investors investing on their account (that is, not through a pooled fund such as a mutual fund) should either restrict their investments to more closely scrutinized companies, or should undertake to investigate and analyze the target companies by themselves. To the extent that retail investors may need additional protection, the two-tier market system discussed below in the section on moral failure should be adequate.
The social allocation of capital
It is sometimes stated that the invisible hand has no soul, [This is of course an overstatement; examples of the market's "soul" include the so-called "green" investment funds.] and as a consequence free markets will not undertake some socially desirable investments because private investors cannot capture enough of the benefits. Stock markets, according to this view, are therefore unable to assess such investments; that is, the capital formation process can fail for some socially desirable projects, and the government may be called upon to intervene for the good of society. [This is not the same phenomenon as government direct investment in competitive enterprises (such as Petro Canada), for which there is usually some other political agenda.] This form of intervention is not regulation per se (the subject of this chapter), but the issue naturally falls here under the broad discussion of alleged market failures.
What supporters of government investment do not realize is that there are costs other than the out-of-pocket expenses of administering such programs. These include "the opportunity cost of the restrictions imposed on the efficiency of financial markets, the opportunity cost of lessened economic growth which in turn results from directing savings toward projects on the basis of social return as opposed to economic return, and, in certain cases, the redistributional effects which work to the detriment of low-income families" (Van Horne, 1984, p. 273).
Van Horne concludes that government intervention in the capital allocation process often leads to lesser efficiency and lower economic growth, especially because of interference with the tradeoff between risk and return:
This is not to say that capital markets are omnipotent or that there is no room for government involvement in socially desirable investments. However, the costs of such intervention must be carefully measured, and their broader implications for market efficiency and economic growth considered.
Stock markets today are much more closely regulated than in their earlier history, especially prior to the crash of 1929, and most of the evils characterizing early markets no longer exist. Early in this century, pools of investors formed in the U.S. to manipulate prices through "wash sales" (non-arm's-length trades designed to give the impression of broader interest) and "corners" (a practice of purchasing a sufficient quantity of the float so that short sellers would be squeezed). [Short sellers sell shares of stock which they do not own (typically their broker lends the stock to them) in the hope that share prices will drop, at which time the short sellers would purchase the now cheaper stock and replace the borrowed stock. In a corner, there is little or no stock available for the short sellers to purchase, so they will pay any sum to cover their short position.] As a result, smaller investors were severely disadvantaged. At the same time, smaller investors were encouraged to over-invest in the stoc market through virtually unlimited margin. This situation exacerbated the stock market crash of 1929, as investors had to dump their stock to meet margin calls.
The crash of 1929 led to the sweeping U.S. legislative reforms of the 1930s: the Securities Act of 1933, and the Securities Exchange Act of 1934. These laws established the Securities and Exchange Commission, provided for full public disclosure, banned manipulation, initiated registration of new securities issues, and established the concept of self-regulation by stock exchanges. The Bank Act of 1933 (better known as the Glass-Steagall Act) separated the banking and underwriting functions (Sloane, 1980, pp. 47-48).
Reform came to Canadian markets much later. Manipulation was still common in mining securities through the 1940s and 1950s, and "boiler rooms" (high pressure penny stock salespeople, the progenitors of today's broker-dealers) were active. There were no filing requirements for insider trading, and wash trades were common if not exactly legal. The Windfall Oils & Mines scandal of 1964, in which Viola MacMillan was accused of stock manipulation and wash sales, and convicted of the latter offence, led to the formation of a royal commission and a subsequent tightening of regulation of common stocks on the Toronto Stock Exchange in 1966 (Wells, 1991).
Many of the leading resource stock investors, led by Murray Pezim, then turned their attention to the Vancouver Stock Exchange. The book The Pez (Wells, 1991) provides detailed examples of the quasi-legal dealings of these speculators, such as manipulation, wash sales and "backdooring" (advising clients to buy, while simultaneously selling on own account). The VSE has frequently been criticized by domestic commentators, notably by Diane Francis of the Financial Post ; eventually, the international media began to spotlight some of these practices, and critical stories appeared in Barron's and Forbes (which labelled the VSE the "scam capital of the world"), and on U.S. television.
Recently, the British Columbia Securities Commission conducted a detailed review of the VSE's operations with a view to cleaning up its international image. The chairman of the commission, Douglas Hyndman, identified the major problems as: quality of listings; unsubstantiated ventures in fads; the conduct of directors, officers, and promoters; and the conduct of brokers. [The Globe and Mail , July 14, 1993, p. B11.]
The interim report of the review revealed that most of the investors who were surveyed believe that the companies listed on the VSE are "products more of promotion than substance," that "the VSE operates for the benefit of its members rather than investors," and that "the only way to make money on the VSE is with insider information." [The Globe and Mail , October 15, 1993, p. B3.] The areas for improvement suggested by investors include "more and clearer factual disclosure, non-voting public directors on company boards, a securities ombudsman, stricter penalties and enforcement, immediate insider reporting and declaration of all short positions, improved broker conduct and more effective and accessible civil remedies." [Ibid .]
The final report, issued by the chairman, James Matkin, in January 1994, recommended a sweeping overhaul of the "scandal-plagued" VSE, including a reduction in the power of the exchange and a reorganization of the B.C. Securities Commission. One of the focal points of the report was that "knowledge is power," and that the information the investors receive is flawed and not timely. Among the recommendations to redress this balance is the requirement that insider trades be published daily. The report concluded, however, that "the VSE is a speculative market and responsible regulation should not and cannot protect the public from every misadventure . . . ; investors should always obey the injunction, `caveat emptor.'" [The Globe and Mail , January 26, 1994, p. B7.]
The VSE, not surprisingly, refutes many of these charges and asserts that they largely reflect past practice. VSE President Donald Hudson notes that "the exchange has sharply raised the standards of performance that it demands from brokers," [Maclean's magazine, January 31, 1994, p. 34.] and has instituted a record number of sanctions against member firms and employees for breaching securities regulations. In addition, new rules require sponsoring brokers to monitor new listings for one year, and to report any irregularities to the Exchange. The VSE was also the first North American exchange to computerize, and its computers are designed to detect any suspicious trading patterns (such as wash sales and backdooring). Hudson states that the true market test is the number of successful companies that have listed on the Exchange, of which there are numerous examples.
In Ontario, the topics currently on the regulatory reform agenda include a tighter definition of "frontrunning" (trading with the knowledge of an imminent trade likely to move the market - a form of insider trading) and renewed calls to limit the activities of broker-dealers. Broker-dealers deal in penny stocks, and their trades often represent the entire market. They do not belong to the Canadian Investor Protection Fund (which protects investors against a brokerage collapse), nor do they have strict self-regulatory discipline. The concern is that investors may not be able to differentiate between broker-dealers and regular stock brokers. The lack of clear distinction, according to the Investment Dealers Association, "ultimately harms the reputation of our capital markets." [The Financial Post , November 13, 1992.]
Other areas where investor protection has been called for are "churning" and insider trading. Churning is a practice where the broker authorizes (in the case of discretionary accounts) or encourages an inordinate number of transactions in order to increase his or her commissions. Although illegal, prosecution for churning is slow and expensive, and the prospects for redress are limited. Many brokerage houses are moving away from transactions-based commissions to a system of flat, value-based fees, which should remove much of the incentive for churning. Insider trading remains a constant worry for regulators; U.S. regulators have recently enacted two new regulations to control the practice and to increase penalties (Gillis and Ciotti, 1992). Increased regulation in such areas as margin trading have also been called for (Singh and Talwar, 1987).
Whose interests are served by regulation? The principal players are investors, listed companies, brokers, and regulators, and it is instructive to consider their respective roles. There is an inherent tension between the need for investor protection and the need to "provide a supportive environment for business financing through accommodating primary markets anchored by an active secondary market" (Francis and Kirzner, 1988, p. 89). The capital formation process depends on investor confidence in the integrity of the system; its absence will lead to potential investors not investing, and economic growth suffering.
Standing between the investor and the company is the broker (see chapter 1 for a description of the broker's role in capital formation). Brokers are constrained by regulation, but at the same time they benefit from regulation in that (in most instances) it is impossible or at the least very difficult for investors to trade or for companies to raise new capital without using the services of brokers.
What about regulators? It could be argued that they are dispassionate agents of society who derive no inherent benefit from their role. However, like most public agencies, survival and growth are primary goals, and the maintenance and enhancement of the regulatory role tend to drive policy decisions. To a certain extent, regulators regulate because they like to regulate. Regulators also regulate because they have always done so: many regulations persist out of inertia and not from a continuing review of their ongoing usefulness. In the case of derivative securities, governments may have a concern that such securities remove control of cherished policy variables such as interest and exchange rates, since derivatives are created and traded largely outside the traditional system. As well, some governments are reacting to the supposed increase in the volatility of financial markets allegedly induced by derivatives, a phenomenon for which there is little empirical support (as we discussed in chapter 1).
Should stock markets be more tightly regulated? As Peter Drucker has been known to say, government should control the climate and not the weather. The previous section has shown that problems do exist, but many of them are a matter for better enforcement, not more regulation. Many critics have called for a centralization of securities regulation under federal jurisdiction in order to reduce duplication and to improve consistency; Daniels (1992) provides a critique of such recommendations and suggests that a modified provincial regulation system (described below) would be more effective.
There are instructive parallels between the regulation of stock markets and the regulation of public utilities. In both cases, protection of consumer interest is a paramount stated concern. In the case of public utilities, a regulatory revolution has taken place in the last decade as formerly regulated monopolistic lines of business (such as long distance telephone service) have been opened to competition, and the nature of regulation of the remaining regulated businesses (such as local exchange service) has been altered. U.S. and Canadian regulatory bodies (for example, the Federal Communications Commission and the Canadian Radio-Television and Telecommunications Commission, respectively) have recognized that regulation is not needed in the face of the force of competition, and that excess regulation can stifle innovation and productivity. The solution in the regulated utility industry has been a move toward incentive rate-of-return schemes (which reward efficient management) and away from strictly mechanistc cost-based regulation (which punishes efficient management).
The analogy in securities markets would be to have the degree of regulation dependent on the extent of "competition." In this context, competition is defined with respect to access to information, since, as discussed in chapter 4, information is the key to market efficiency. As in the case of evolving utility regulation, a residual level of investor protection is important to ensure confidence in the integrity of the system.
One interesting approach toward deregulation has been advocated by Daniels who envisions a two-tiered capital market (Daniels, 1992; MacIntosh and Daniels, 1990). The first tier would be populated by large, widely-followed companies whose securities are held by large, sophisticated institutional investors. The second tier would consist of smaller, more obscure companies and a larger number of less sophisticated retail investors. In the first tier, regulation is broadly unnecessary due to the sophistication of investors and the quantity of available information. In the second tier, a greater degree of regulation would be required.
In support of this model, MacIntosh and Daniels refer to the evidence on semi-strong form efficiency in Canada, where deviations from efficiency typically occur in those companies which are not widely followed by professional analysts. They also note that the lack of institutional investors in the second tier exposes retail investors to a higher risk of "predatory conduct" (actions taken by managers and inside shareholders to the detriment of outside shareholders).
The existence of a de facto two-tier market was recently acknowledged by the Toronto Stock Exchange (TSE), which began publicizing two new indexes: the TSE 100, comprising the largest 100 stocks on the TSE and designed to act as a benchmark for institutional investors; and the TSE 200, the smaller companies in the TSE 300, comprising more junior companies which typically lack the float or trading volume attractive to large institutional investors. In their news release of September 2, 1993, exchange officials touted the TSE 100 as providing "a more appropriate index for institutional performance since it contains an accurate list of the names of securities that large institutional investors can trade without size or liquidity limitations," while the TSE 200 was described as being "of use to equity fund managers interested in smaller-cap stocks." Haynes (1993) discusses the superiority of the TSE 100 over the TSE 35 and TSE 300 in the way it better reflects institutional activity.
There is already a degree of market segmentation in such activities as private placements, which are designed for larger investors and hence have less stringent disclosure requirements, and the use of prompt offering prospectuses (POPs). POPs were initiated in 1983 as a means of simplifying the disclosure requirements for new issuers of capital. Much of the information normally required by a prospectus can be pre-filed on an annual basis, and the company can then file simply the marginal information necessary at the time of a new share issuance. This considerably reduces the time to approve the issuance. This short form prospectus has been limited to larger companies with a history of reporting information.
The application of this model could take various forms. For example, the companies listed on a particular stock exchange could be separated by size and degree of information available, and regulated accordingly. This form of two-tier regulation has been proposed for the Canadian over-the-counter market, which comprises a mix of unlisted "blue chip" companies and unproven "penny stocks." "The top tier stocks would be those that meet tougher financial disclosure requirements, like minimum capital and net asset value numbers. The second tier would be the riskier stocks that don't." [The Financial Times , October 30, 1993, p. 13.]
Alternatively, different exchanges could be regulated differentially, based on the same factors. In this latter model, the VSE, for example, would have more stringent reporting and disclosure requirements than would the TSE. A variant of this model was suggested anonymously to James Matkin during his review of the VSE: the suggestion was made that the province of British Columbia should set up "a competing exchange, one of clear and unquestionable integrity," [Maclean's , op. cit., p. 35.] which would fight it out with the existing VSE for business. One benefit of this approach would be to separate investors (who enter the market for long-term gain based on fundamental economic prospects) from gamblers (who have a short-term trading mentality).
The benefit of this two-tier system is that it allows larger companies more unfettered access to capital markets, while still providing access to capital by smaller, newer companies. On the investor side, the retail investor would be afforded protection where it is most likely to be efficacious, while the institutional investor would be better suited for self-protection.
This chapter has examined the alleged failures of the stock market and the appropriate level of regulatory response. With respect to the market failures, we conclude that the market is better suited than government to remedy any deficiencies in capital investment decisions. With respect to the moral failures, we conclude that better enforcement and not more regulation are needed; the two-tier market system we recommend would lead to less regulation for more established firms, and would focus investor protection where it is needed, in the more junior ventures.