The Case of the Stock Market: Freedom vs. Regulation
MARCH 01, 1984 by S. DAVID YOUNG
Mr. Young is studying at the Darden School of Graduate Business Administration, the University of Virginia at Charlottesville.
Those who consider liberty as a primary value are naturally very reluctant to support any imposition of government authority. This is not to say that state action is always inappropriate, but the standards for determining instances when the state should intervene are strict and unyielding.
When calling for government regulation in any sphere of endeavor (whether economic, social, or political), it is prudent to bear in mind the fundamental principles upon which our country was founded. Due process, presumption of innocence, and limited government should be driving forces behind the analysis of any proposed government intervention.
Given the aforementioned principles, prerequisites can be derived which will serve as a model for evaluating the efficacy of proposed regulation.1 First, some readily identifiable event or phenomenon must have occurred (or is likely to occur) which needlessly and unfairly damages a distinct group of individuals. Second, this damage should neither be the result of infrequent law- breaking nor be addressed by existing laws. Third, a cost-effective free market alternative is not available. Fourth, a cost-effective government-imposed remedy is available. Fifth, the proposed regulation should not violate constitutional rights. And sixth, the burden of proof should be placed on the advocates of the proposed regulation, not on those who oppose it.
This article examines the regulation of the stock markets with respect to these prerequisites and concludes that the Securities and Exchange Commission (SEC), the federal agency tasked with regulating securities, has failed the test miserably. Indeed, if the SEC were to subject its own history and practices to the same scrutiny it focuses on the corporations it regulates, its commissioners, staff, and Congressional sponsors would be more than just a little embarrassed.
Prerequisite No. 1: Some event or phenomenon has occurred which unfairly damages a distinct group of individuals.
The 1920s was a period of uncommon optimism and speculation in the stock market. The decade was characterized by an almost constant bull market. There were occasional setbacks but recovery was always swift and strong. All of this came to an end, however, on October 24, 1929, the date known on Wall Street as “Black Thursday.” On that day, the market began a sudden and dramatic slide downward to the surprise of nearly everyone. Fortunes were lost overnight and the country was thrown into the depths of the Great Depression.
The stock market crash of 1929 and the ensuing depression were a puzzle to most people at the time. Part of the cause was thought to be the widespread abuse of securities markets by insiders and inadequate disclosure of financial data by corporations. The disastrous effects of the Federal Reserve Bank’s cheap money policies in the late 1920s and protectionist trade measures such as the Smoot-Hawley tariff were much more important reasons for the economic collapse, but few thought so at the time.
Shortly after his election, President Roosevelt appointed Ferdinand Pecora to head up a Senate investigation of abuses in the securities markets. The Pecora Committee, as it was called, documented numerous instances of alleged stock market fraud and abuse. The Committee’s revelations sparked a public furor and proposals for government regulation were soon forthcoming. Public demands for reform led to the enactment of two very important laws which together form the cornerstone of securities market regulation. The Securities Act of 1933 requires issuers of new securities to file a registration statement with the federal government and issue a prospectus to the public. The Securities Exchange Act of 1934 requires disclosure on a regular basis for firms which have their securities publicly traded. The latter act also established a federal agency to administer both acts, the Securities and Exchange Commission. The primary purpose of the legislation, then, was to redress abuses believed to be inherent in unregulated markets—abuses which were presumed to have cost naive investors dearly.
Unfortunately, very little empirical research was conducted at the time securities regulation was first debated in Congress. Evidence presented in support of government control was largely anecdotal in nature. A reasoned assessment of the costs of alleged abuses to the parties who were supposed to have been hurt by them was never conducted.
The SEC’s present scope of regulatory power includes not only disclosure requirements for new issues and publicly traded companies, but also constraints on insider trading, controls over the stock exchanges, antifraud regulation, regulation of investment companies (e.g., mutual funds) and investment advisors, and rules on corporate governance.
Prerequisite No. 2: The damage does not occur infrequently and existing laws are not sufficient to deal with it.
Benjamin Anderson, writing in the late 1940s, agreed that Congress was correct in its pursuit of truth in securities and its prohibitions against stock manipulation. But he felt that Congress and the SEC had clearly gone too far: “The normal functioning of the security business . . . is clean and sound . . . Every day transactions involving tens of millions of dollars . . . are made by word of mouth . . . . Transactions between the brokers on the floor of the exchanges are made by a word or even a nod of the head, each man making a memorandum of his own part in the transaction, but neither man giving the other a written document. Disputes regarding these transactions are very rare . . . . A very high order of integrity is necessary to make such a system work. Occasionally, however, criminal acts occur, as in every field . . . For these occasional criminal acts, there is need for criminal law and punishment. But there is no more need for the kind of supervision of multitudinous details in which the [SEC] engages . . . than in any other field.”
Just like brokers, dealers and investment bankers, accountants were also singled out for blame. Many opinion-makers believed that arbitrary accounting practices in the late 1920s encouraged fictitious financial reporting and, thus, contributed to stock price manipulation. Specifically, accountants were charged with arbitrary write-ups of asset values for the purpose of inflating financial statements, enabling companies to appear more profitable than they really were. The significance of this charge cannot be overstated for it served as a prime justification for government intrusion in corporate accounting practice and is widely accepted to this day.
How common were write-ups of assets in the years just prior to the Great Crash? A recent study, which examined the accounting policies of 110 NYSE companies chosen at random, shows that contrary to popular belief, accountants in the 1920s did not write-up asset values routinely.
In fact, write-offs (declines in book value) were much more common. For those companies that did write-up asset values on their books, rarely did the amount exceed 5 percent of total assets and never were write-ups reflected in the company’s income statement (they were always shown in surplus accounts on the balance sheet). The conclusion drawn from this evidence is that accounting practices of the late 1920s were not a contributing factor to the Great Crash.
Prerequisite No. 3: A cost-effective free market alternative is not available.
In the absence of government regulation, corporations are still compelled to disclose information about their financial affairs. They do this partly because of economic incentives and partly because private stock exchanges may impose rules on members. For example, prior to the securities acts, all companies listed on the New York and American Stock Exchanges were required by the Exchanges to make their financial statements publicly available. Also, over 90 per cent of all companies traded on the NYSE in 1933 were audited by independent certified public accountants. The legislation requiring periodic financial reporting and the audits of that information was not passed until 1934.
The most persistent critic of securities regulation, George Benston, states the case for voluntary disclosure simply and elegantly. According to Benston, corporations have strong incentives to disclose information in a free market. Prospective shareholders and creditors, whose funds the corporation wants to attract, demand information. Corporations that do not disclose in a free market run the risk of suspicion. And once a corporation begins disclosing, its managers find the practice difficult to give up.
In a free market, providing financial information that is audited by CPAs enhances investor beliefs that corporate resources will be used productively. Whenever managers have less than a 100 per cent ownership interest in a company, they have incentives to waste or misuse resources if the benefits to them exceed their share of the reduced profits. For example, managers may be inclined to spend lavish sums on personal office furnishings when the cost can be passed on to others. This problem is known in academic circles as “agency cost.” Investors are aware of this problem and so those in control must find a way of convincing investors that they do not intend to divert corporate assets. One way to do this is to install a system of accounting control and convince investors that the system is working. That is why corporations would hire CPAs even in the absence of regulation. CPAs are entrusted with determining the credibility of management’s representations in the financial statements not because they are inherently more trustworthy than others but because their reputation and ultimately their livelihood depends on professional integrity and expertise.
Benston’s theory becomes especially powerful when applied to the case of dishonest corporations (those that deliberately try to deceive investors). First, we must consider whether the SEC is effective in preventing the dissemination of false information. Benston points out that financial statements have proven to be inefficient vehicles for cheating investors. Accounting data presents a history of past events, yet potential investors are forward looking; that is, they seek information that helps them assess the present value of future cash flows. Therefore, crooks are more likely to mislead investors by floating rumors and spreading tips than by issuing fraudulent financial statements. Next, we should ask if crooks are capable of deceiving investors. The problem here is that those who use financial statements to defraud investors must either bribe the independent CPAs or do without their services. Either prospect is not conducive to a successful fraud.
Great Britain continues to rely on a corporate disclosure system that is privately run. Although Britain has laws that govern disclosure by companies, most of the functions performed by the SEC in this country are performed by the London Stock Exchange, which is not an agency of government. Unlike American securities regulation, British laws are self-contained and allow very limited discretionary power for government administrators. The result is a system that is not only less cumbersome, less costly and more flexible, but also has fewer frauds, proportionately, than our own capita] markets. Clearly, a cost-effective market alternative can and does exist.
Prerequisite No. 4: There is a cost-effective regulatory remedy.
According to supporters of government-mandated disclosure, the more investors know about a corporation, the better their investment decisions will be. As more information becomes publicly disseminated, stock prices approach the underlying value of the securities being traded. In other words, stocks become fairly priced. Disclosure, it is argued, increases the fairness of capital markets and renders the task of price manipulation more difficult.
The problem with this line of reasoning is that those who apply it nearly always ignore the fact that information costs money to produce. In a free market, corporate disclosure is governed by the same principles that govern resource allocations elsewhere in the economy. Resources would flow into corporate disclosure activity until the cost of additional resources exceeded the perceived benefits. When the SEC requires more disclosure than there would be in a free market, corporations are forced to devote more resources than efficiency demands.
Do the perceived social benefits of efficiency and fairness allegedly caused by mandatory disclosure exceed the costs? This is a difficult question to answer but, unfortunately, SEC supporters have rarely even tried. Even friendly critics of the commission frequently take it to task for its reluctance to perform any sort of cost-benefit analysis on proposed regulations.
George Benston has addressed the issue of whether there are some observable benefits from government regulation of corporate disclosure practices. The essence of Benston’s position is that required disclosure has not led to an increase in the efficiency of capital markets. Since competitive markets are already efficient, required disclosure adds nothing and because it costs money, we would be better off without it. His analysis is based on the idea that disclosed information should be perceived as valuable by market participants. Benston’s methodology, therefore, is designed to determine whether disclosure leads to observable and significant changes in stock prices. Based on observations of disclosure practices and stock price movements, he concludes that government-mandated disclosure does not have an economically significant impact.
Another issue we should consider is the effectiveness of government regulation on the trading of insiders. A study conducted in 1974 examined changes in trading volume and profitability of insider trading after each of three important legal decisions rendered in the 1960s. Because significant change in the properties of insider trading was not observed following any of these decisions, the author concluded that regulation had no apparent effect. In other words, taxpayers were paying for a service with no apparent equity or efficiency benefits.
A recent estimate of the costs of SEC-required disclosure to corporations, deliberately biased on the conservative side, puts the cost of conforming with periodic reporting requirements at $213 million in 1975. The cost of new issues disclosure was placed at $192 million. These figures have not been adjusted for subsequent inflation or the cost of additional requirements, but 1983 costs are likely to be well in excess of $1 billion. This evidence is lost on those advocates of government regulation who seemingly view information as a costless good.
The SEC imposes costs on business in other ways that are virtually impossible to quantify but are quite real nonetheless. For example, bureaucratic interference in the securities markets increases the time it takes for new products to reach the market. In some cases, potentially profitable investment vehicles may never reach the investor because sellers find the time delays and costs prohibitive. In fact, evidence has been presented suggesting that although SEC interference may have reduced the risk of new stock issues, it has also had the effect of reducing the average return on such issues. In other words, the SEC does not necessarily force out poorer quality issues, just riskier ones. For investors who are willing to incur high risk for the prospect of high return, their options have been limited.
Prerequisite No. 5: The proposed regulation should not violate Constitutional rights.
Roberta Karmel, in relating her experiences as an SEC Commissioner (1977-1980), describes a disturbing trend among Commission staffers toward a flagrant disrespect for the rights of business people. Harold Williams, SEC Chairman under President Carter, is charged with attempting to guide the SEC toward ever greater control over publicly held corporations and pro moting an anti-business atmo-sphere. Williams pursued certain policies not to secure investor interests but rather to promote his ideas about corporate governance. Investor protection became a facade behind which Williams and his followers justified their notions of proper public policy (namely an expanding role for government in the securities markets). Although Karmel still believes that the potential for corporate wrongdoing is a problem worthy of SEC attention, clearly the lack of government accountability is far worse.
An even more disturbing report exposes the SEC’s suppression of first amendment rights through its regulatory supervision of investment advisors. Emboldened with powers allegedly bestowed by the Investment Advisors Act of 1940, the Commission has seen fit to censor certain investment advisory publications and, in some cases, even prohibit publication altogether. This grievous attack on freedom of speech and press continues.
Prerequisite No. 6: The burden of proof should be placed on the advocates of regulation.
Determining the effects of any regulation is a difficult and often frustrating experience. George Benston and other critics of securities regulation have not “proven” that the SEC has failed to provide any benefits to investors. They do show us, however, a preponderance of evidence suggesting that the presence of such benefits has not been proven either. And in a country where people value the protections afforded by limited government, the burden of proof should lie squarely on those who support government regulation of the securities markets. Such proof was not required when securities regulation was first debated in the Senate hearings of 1933, and has yet to be required by those who set government policy.
So Why the SEC?
As we have just seen, when subjected to the stringent standards listed at the beginning of this article, the supporters of securities regulation have much to answer for. Why then are we still subjected to these burdensome securities laws? The answer lies partly in the self-interest of various constituencies which are affected by the laws. The most obvious of these constituencies are the staffers and commissioners of the SEC who possess considerable discretionary power, not to mention their impressive government salaries. Also securities lawyers and certified public accountants owe much of their livelihood to the SEC. Contrary to what we may think, the SEC is not a thorn in their side, for many of these professionals have made fortunes off the agency by helping their clients cope with the burden of regulatory requirements. Security analysts and portfolio managers also benefit from government-mandated disclosure. They need financial information in order to do their jobs and the more information they can get the better. And since they do not have to pay for the information, quite naturally they are at the forefront of demands for even greater disclosure.
One intriguing theory suggests that the securities laws were passed because Congressmen were anxious to appear as having addressed the problem of stock market abuses. Since stock fraud and inadequate disclosure were perceived as important causes of the 1929 Crash, anti-fraud legislation and government-mandated disclosure were perceived as the solution. According to this theory, the SEC’s budget is still determined by politicians concerned more with appearance than substance. This attitude is reflected in the actions of the SEC and helps to explain the near total absence of cost-benefit analysis.
Since there is no such thing as a free lunch, who pays for this legislation? Not surprisingly, taxpayers (who fund the SEC’s operations) and shareholders (who ultimately bear the cost in reduced corporate profits).
But if the rest of us are forced to bear these costs, why do we allow it to continue? One reason is that investors have been deluded into believing that confidence in our financial markets would be undermined without regulation. But another more subtle reason has to do with the per capita costs and benefits of the regulations. Because SEC employees, securities lawyers, CPAs, and security analysts have much more at stake in these laws on a per capita basis, they are more inclined to go to the trouble and expense of preserving their domain. The rest of us foot the bill but the per capita charges are not perceived as large enough to merit an effort at repeal.
We should not view the current debate over securities regulation as simply a contest between private capital and public interest as most lawmakers are inclined to do. After all, government policy makers are themselves private individuals with their own self-interests to pursue. The question is really one of which group of private decision-makers will determine how capital resources are allocated in the American economy. A system which allows investors applying the time-honored tradition of caveat emptor to make their own choices is far superior to a system in which government administrators, insulated from the risks and rewards of the marketplace, decide what investment opportunities can be made available. When investors are allowed to make their own choices, unconstrained by government control, they are the ultimate authority. 
1. R. K. Elliott and W. Schuetze, “Regulation of Accounting: Practitioners’ Viewpoint,” in Government Regulation of Accounting and Information, A. R. Abdel-khalik, ed. (University Presses of Florida, 1980).
5. G. J. Benston, “The Value of the SEC’s Accounting Disclosure Requirements,” The Ac counting Review, July 1969, pp. 515-538 and “Required Disclosure and the Stock Market: An Evaluation of the Securities and Exchange Act of 1934,” American Economic Review, March 1973, pp. 132-155.
11. Ross L. Watts, “Beauty is in the Eye of the Beholder: a Comment on John C. Burton’s ‘The SEC and Financial Reporting: the Sand in the Oyster,’” in Government Regulation of Accounting and Information.