Global Parallels: Proportionate Governance for Increased Commerce

The economy functions in the same way the video image and soundtrack combine to form a movie.

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?