Undemocratization of capital markets


In the wake of accounting scandals at some of the country’s largest companies, the Sarbanes-Oxley Act of 2002 passed the House 423-3 and the Senate 99-0. The effects were immediate and profound. Sarbanes-Oxley imposed new CEO and CFO certification requirements, barred most loans to executives, called for real-time disclosure, added to the responsibilities of audit committees and increased the regulation of the accounting industry. Corporate boards and executives have responded by dedicating more of their time and energy to corporate governance. Whether the net effect is an increase in the quality of corporate governance such to compensate society for the cost of drawing management’s focus from their paramount duty to run their businesses remains unclear. What is clear is that compliance with Sarbanes-Oxley costs money. Therein lies a grave problem. The cost of compliance is causing a partial undemocratization of our capital markets.

Since the 1970s, our capital markets have become increasingly democratic institutions. First, we have witnessed the rise of the individual investor, particularly in the stock market, following the abolition of the system of fixed trading commissions on Wall Street, leading to a boom in the discount brokerage industry. Second, and more significantly, the capital markets have been profoundly influenced by the popularity of mutual funds and other asset pools driven substantially by middle income Americans saving for retirement in tax-advantaged accounts. The result is a system of capital allocation highly responsive to the needs and desires of an investing public as opposed to a cabal of the astronomically wealthy.

Sarbanes-Oxley makes it much more expensive to be a publicly traded company. According to a report commissioned by Foley & Lardner, the cost of compliance rose over 90% after the passage of the Act. For a mid-market public company, the annual cost went from $1,303,000 to $2,481,000. This additional cost has made the minimum efficient size of a public company significantly greater. There have been numerous cases like that of Carvel Corp., a medium-sized company famous for its ice cream cakes, where companies have decided to forgo the public capital market route altogether and turn to private equity and venture capital companies for funds.

Private equity and venture capital firms are not evil institutions. They have their place in the capital allocation process and have assisted many companies in their development and transition stages. The problem is that the universe of private equity firms and venture capital firms with sufficient scale to fill the public market void is tiny.

Negative implications abound. Middle income Americans have lost voice in many critical capital allocation decisions relative to the small number of private equity specialists and venture capitalists. One might dismiss this concern, believing that it matters little because most investors seek the highest returns and little else. Even if this is true, the situation is suboptimal. This is precisely why the undemocratization of capital markets matters.

Because the universe of suitable private equity specialists and venture capitalists is small – less than 500 people in the United States – and close-knit, often with different firms collaborating in investment pools or syndicates, they will explicitly or implicitly collude whenever possible. Most firms have policies that provide they will not invest in two competing companies. Combined with cross-investment agreements within the limited universe of suitable firms, the end result is a distorted flow of capital. These professionals act rationally, of course. Their interests simply differ from those of public market participants who are incapable of such collaboration and collectively bear more of the cost associated with diminished competition.

While Sarbanes-Oxley may cure some corporate governance ills, one is left to wonder whether it is worth the price – shifting power from middle income Americans to yet another astronomically wealthy cabal.

Fred Pollock’s financial news analysis appears weekly.