Are millionaires smarter than the rest of us? Our federal watchdogs at the Securities and Exchange Commission seem to think so. And based on that assumption, the nation's stock cops have reserved for big-money investors certain investment opportunities that are off-limits to less-moneyed citizens.
A lot of people trust government agencies like the SEC to preserve justice. But though it's supposed to be watching the financiers, someone should be watching the SEC. Public scrutiny of the commission, however, is so lacking that not many people have ever even heard of Regulation D, which grants certain investment privileges to millionaires—except the millionaires, of course. They take advantage of the rule every day.
We'll get to the rule in a bit, but first some background. Since 1933, the SEC has been regulating the sale of securities, predominantly according to the "rotten egg" philosophy. In other words, someone can sell you even a rotten egg (a worthless security, that is) as long as the person first tells you it's rotten. Unlike most other government agencies, such as, for example, the Food and Drug Administration, the SEC does not as a routine matter directly prohibit the sale of products under its jurisdiction. Nor, in fact, does it routinely make any qualitative judgment whatsoever about securities offered for sale. Its chief concern is that you have at your disposal, before you buy stock in a company, a certain amount of information about the company. Presumably, this will allow you to make an informed decision about the potential risks and returns.
To illustrate the difference between the SEC's approach to market regulation and the approach of most other agencies, such as the FDA, take the case of Laetrile. In this country you cannot buy Laetrile, once thought by some to be useful in treating cancer, because according to the FDA it has not been proven safe and effective. Even if you walked into the FDA's offices in Washington, D.C., pointed to the portion of your body being ravaged by cancer, and told the person in charge that you're fully aware he thinks Laetrile won't help you but, what the heck, you figure you'd like to give it a shot, he would be obligated under FDA policy to refuse to allow you to buy it.
Under SEC policy, on the other hand, you could buy stock in a company that proposed as its sole potential source of revenue the sale of Laetrile. As long as the company told you that its revenues were entirely dependent upon the sale of a drug of questionable legitimacy, and thus you may never get a return on your investment, the SEC would leave it up to you to decide whether you should throw your money away.
It's a Good Theory, But… At least in theory, the SEC regulatory philosophy, which aspires to the maxim "Let the informed buyer beware," is the better of the two. It avoids the oppressively paternalistic approach of agencies such as the FDA, which endeavor to do what's best for you whether you like it or not. Also, the SEC approach actually might be "efficient," in the economic sense: by increasing the availability of information, the SEC may be making it easier for buyers and sellers to recognize their true best interests and, therefore, to more actively pursue them. The presence of uninformed buyers and sellers is one of the most significant reasons (another is transaction costs) why the market does not always behave as efficiently as the economists' models of it. Increasing the amount of available information assists owners of capital resources in pursuing the most profitable—and, therefore, we hope, the most productive—investments.
It's a good theory. Unfortunately, as one might expect, the concept does not work as well in practice, because information is not costless. Or, with apologies to Milton Friedman, there's no such thing as a free prospectus. Information, though perhaps less tangible than guns, butter, or corporate securities, is itself a good nonetheless, subject to the forces of supply and demand. In a free market, investor demand for information about their investments would quite likely result in an optimum amount of such information being supplied, with due regard given to the cost of providing it.
There is not much doubt, however, that current SEC regulations require companies to supply much more information than they otherwise would. Any company preparing to make a public offering of its stock must distribute to all potential investors a booklet known as a "prospectus." Because of the detailed nature of the information that must appear in a prospectus, and because of the huge legal liabilities to which a company is exposed if the prospectus contains any misinformation whatsoever, a no-frills prospectus for a relatively simple transaction can easily cost more than $100,000 (mostly in attorneys' and accountants' fees and printing expenses). The cost in a moderately complex transaction could be five times as much. In the face of these expensive disclosure requirements, many companies look for different ways to raise capital, such as borrowing money from banks or other institutional lenders.
And even if a public offering involved no out-of-pocket expenses whatsoever, many companies would continue to use other methods of raising capital because the SEC's registration procedure, which requires among other things that the company wait for certain approvals to come from the SEC in Washington, can delay the company's efforts to solicit investors. The financial market is relatively volatile; stocks fall in and out of favor so quickly that even a slight delay can cost a company thousands of dollars in lost capital. Also, after the offering has been made, a publicly held company must comply with certain on-going reporting requirements, such as disclosing information about its business in quarterly and annual filings with the SEC.
As if that were not enough, a publicly held company must make special filings any time a material change occurs in its operations. Not only will the law firm make a nice fee from the initial offering, but if the company survives it can provide the law firm with something like an annuity. The firm will get a steady stream of legal business from the company for preparing these regular filings. Many companies want to avoid such continuing expenses and also want to avoid revealing too much about their operations to competitors, since reports filed with the SEC are freely available to the public. All these costs, monetary and nonmonetary, prevent many companies from offering stock to you.
Money Changes Everything The SEC itself has, over the years, come to recognize the burdensome nature of its own regulations, and thus it has created a rather elaborate set of exemptions from them. One of these exemptions, known as Regulation D, permits a company to offer securities without having to comply with the registration requirements of the Securities Act, provided, of course, that it meets certain conditions. One of these conditions is that the company must "reasonably believe that there are no more than 35 purchasers of securities" in the offering. It appears that if the company is trying to raise any significant amount of money, it must find 35 very rich people—except that certain investors, known as "Accredited Investors," have the privilege of buying in without being counted among the 35.
So who are these privileged "Accredited Investors"? Mostly, they are those you would expect to be favored by Congress (monied interest groups with powerful lobbies), such as banks, insurance companies, and other investment organizations. If you don't happen to qualify as such, but you're interested nonetheless in having companies beseech you with their Regulation D stock offerings, don't give up. You may be an Accredited Investor under one of the other definitions. The SEC gives Accredited Investor privileges to anybody "whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase, exceeds $1,000,000." The ostensible reason for classifying millionaires as Accredited Investors seems to be either that they are more wealthy, and therefore can better suffer the result of a sour investment, or that they are more sophisticated in financial matters and therefore do not need the protection supposedly supplied by SEC disclosure requirements.
The former argument is not very persuasive. There is nothing in Regulation D to prevent a millionaire from investing his entire fortune. Someone who loses his entire fortune in a bad investment is just as destitute whether he started out with a million dollars or just one. The other justification for the millionaire privilege—that rich people are more shrewd—remains.
There are a significant number of investment opportunities offered each year under Regulation D, and most people are prevented from participating in them. These investments, offered by companies who choose not to register with the SEC for whatever reason, are reserved for an elite class of supposedly sophisticated investors. Bus drivers, waitresses, and school teachers are left to buy securities only through registered offerings. This allegedly protects these nonmillionaires because they will have been given, before being allowed to invest in the registered offerings, a prospectus warning them of the risks of their investment.
Putting aside for the moment all other concerns (like morality and fairness), this SEC regulation is indefensible simply because it doesn't achieve its intended goal. It is based on a false premise: that rich people are smarter. Actress Pia Zadora, wife of millionaire Meshulam Riklis, is an Accredited Investor (about a hundred times over), while it is possible that a corporate securities analyst with the biggest investment house in New York would not be. Ms. Zadora might have a colossal talent for acting but,when it comes to finance, she may not know a spreadsheet from a bedsheet. It is presumptuous, at best, to assume that she is financially sophisticated simply because she married well.
Ms. Zadora may be one of the first examples to come to mind, but she is certainly not alone. In addition to marriage, there are many other devices—such as inheritances, lotteries, and the entertainment and sports industries—for the acquisition of great wealth by numb-brained baboons who wouldn't know an asset from an ass.
All of these devices make America a land of great opportunity, but they undermine the premise upon which Regulation D is based. The SEC, possibly infiltrated by a peculiar brand of economic Calvinists who believe only the deserving are rewarded, has fostered an investment elitism that utterly fails as a basis for fair policymaking. Regardless of the SEC's motive, the idea of creating a plutocracy of privileged millionaire investors is abhorrent.
Take This Prospectus—Please! Without question, the millionaire privilege should be scrapped. There is, however, a certain danger in advocating this position. Assuming the SEC could be convinced that millionaires are not one whit sharper than other people, the securities cops might conclude that all investors—rich and nonrich alike—need the "protection" of disclosure requirements, and thus the exemption should be repealed entirely. This would be a step in the wrong direction. The present system, although it may seem unfair to the not-so-privileged in taking a laissez-faire approach to some privileged investors, at least allows some people access to investment opportunities that they would not otherwise have. Partial deregulation is almost always better than none at all.
If pressured into doing something about the elitist nature of the exemption as presently written, the SEC would, unfortunately, probably abandon it altogether. Although the SEC does have congressional authority to widen the existing exemption, this would be a step toward a free market and, once it becomes apparent that a free market works so nicely, of course, it also becomes apparent that the SEC is unnecessary. It would be unreasonable to expect the commissioners of the SEC to reveal, upon their own initiative, the uselessness of their well-paid positions. Employment hara-kiri is too noble an act to be demanded of anyone. Congress must take responsibility and revise the Securities Act of 1933.
In fact, dispensing with the Securities Act in toto is at least an idea worth examining—although securities lawyers react to such talk as normal people would react to serious talk of dispensing with the earth's air in toto. Despite the self-interested ravings of the law industry, however, the Securities Act's disclosure regulations do not efficiently serve their intended purpose: protecting investors by providing them with helpful information. These regulations are based on a premise—that by reading the prospectus an unsophisticated investor can learn the risks inherent in a proposed investment—which is certainly not convincing to anyone who knows very much about how a prospectus is prepared.
Woven throughout the average prospectus are caveats, qualifications, and disclaimers, some in red ink, written in the strongest terms possible, which denounce the potential return of the investment and emphasize the risks. Securities lawyers, who usually get the job of preparing the prospectus, do this because it protects their corporate clients from responsibility for any misrepresentation. However, it does not really deter investors to any significant extent. All but the most naive investors glance quickly over these warnings, reading them no more carefully than most cigarette smokers read the Surgeon General's warning each time they reach for a smoke.
Securities lawyers have collectively cried wolf so long they now feel comfortable no one is listening. Behind the warnings on the prospectus is a densely packed abundance of arcane information unintelligible to most people. Hundreds of pages of tiny type, usually written in an extremely unengaging style, drown the few relevant bits of information in a wash of minutiae. The regulations call for completeness of information over all other concerns, including clarity, balanced importance, and accessibility. If the SEC were ever given responsibility for drafting criminal laws, it would no doubt do away with the simple Miranda warning and insist, instead, that each arrestee be given a complete set of criminal statutes and be left to read it on his own.
Securities Regulation—Who Needs It? Because the prospectus is so ineffective in communicating helpful information, its few apologists have been forced to come up with sort of a "trickle down" theory to justify it. This argument holds that, even though most people gain nothing from reading a prospectus, there are some (no doubt Talmudic scholars) who understand it, and other investors rely on their judgment of the investment, and then more investors rely on these investors…until eventually the market properly moves investment capital to the truly deserving companies.
If the market does, in fact, work this way, then perhaps the SEC's approach is not the absolute failure it might otherwise be. The market may be operating "efficiently" in some utilitarian sense. It is still unfair, however, in the moral sense, to the poor sap not lucky enough to be trickled upon. The average person is not very often privy to what's hot and what's not among the professional investor cliques. By the time information is generally disseminated, there is no more money to be made. The SEC's registration procedure does nothing to benefit the multitude of middle-income people who only invest occasionally.
This is why many of these investors turn to private investment counselors for advice. Messrs. Paine, Webber, Smith, Barney, Lynch, Hutton, et al. make up a sizeable industry in the sale of information about investments to people who have found the prospectus to be of no help at all. Even when an investor knows nothing about a particular company, he may feel relatively safe in investing if one of the large investment houses has put the stock on its recommended "buy" list. These houses make it their business to analyze all available investment information, and they would continue to do so even in the absence of government-mandated disclosures.
Companies about to offer stocks would find it in their interest to supply information to these houses (and, indeed, these houses would insist on it) in order to get a favorable recommendation. These private investment houses would fill the need for analyzing investments even if the government required no disclosures on the part of companies making stock offerings, just as these houses are presently filling this need under the current ineffective regulations.
The transition to a deregulated market would likely be smoother in the securities industry than in almost any other industry. The private services necessary to fill the need previously, though ineptly, filled by the government are already in existence. A diversified, competitive market in the sale of information about investments is well established and operating nicely.
Deregulation of the securities markets has never been a very popular cause. One reason for this may be that many people don't really understand the complexities of the securities industry. Securities regulation, like the electoral college, may be an institution that would instantly be torn apart by an angry mob, except that no one can ever find enough people who really understand it to make up a decent-sized mob.
Another reason the SEC has been quietly tolerated may be that it is one of the least offensive regulatory agencies. For that it should be applauded, but nonetheless it should not be neglected entirely. Other regulatory agencies, as a matter of principle, may be much more offensive to a society of free choice than the SEC, but in practice, misguided SEC policy can have extremely deleterious effects.
A blatantly undemocratic rule such as Regulation D is insulting, a little bit like being splashed with mud by a Rolls Royce. But the entire securities-regulation system, with the prohibitive costs it imposes, is something much worse. It excludes many people from the opportunity to own, each in tiny individual ways but collectively in socially and politically significant ways, a chunk of this country's resources. The SEC, in effect, disenfranchises a large portion of the population from citizenship in Corporate America.
Abolishing government regulation of securities, then, would help reestablish a level playing field for the nonrich and rich alike. It would allow buyers and sellers of securities to set the rules for their transactions—not a group of Washington bureaucrats. And it would give back to the people the right to make their own investment decisions—which is just the way things should be.
Craig Collins is an attorney and free-lance writer in Chicago.
This article originally appeared in print under the headline "Money Talks with the Stock Cops".