Securities Regulation Doesn't Work

by George Bragues

To supporters of government regulation, nothing can apparently ever take place to falsify their beliefs. If the very evils regulation was framed to prevent nevertheless end up being realized, the crisis is met with a universal cry for more regulation. The idea that the regulatory project itself has been exposed as useless hardly crosses anybody’s mind.

This was precisely the script played out after the 1990s bull market collapsed in the spring of 2000. One by one, corporate executives, directors, auditors, consultants, investment bankers and stock analysts were condemned for having exploited gaps in the regulatory structure to feed investors with misinformation that drove them to overpay for stocks. The result, two years ago, was the Sarbanes-Oxley Act, which sought to improve the information that investors receive.

Yet the events that led to Sarbanes-Oxley only confirmed what was already evident well before the bull market came along: Securities regulation doesn’t work. Not only are the likes of the SEC and OSC superfluous; they are incapable of containing the market frenzy that arises whenever bad monetary policy mars investors’ judgments.

Spearheaded by the United States in the 1930s, securities regulation is founded on the fact that those involved in supplying equity shares, namely corporations and the investment firms that assist them, have better access to information than the investors buying the shares. More critically, it is assumed that were equity suppliers left to themselves, they would exploit their informational edge at the expense of investors by not adequately disclosing what’s happening inside companies. When a company about to go public, for instance, is suddenly hit by a slide in revenues, management and their investment bankers would keep silent in order that the IPO can go off at a high price. To remedy this, the massive edifice of securities regulation is centered on the principle of mandated disclosure. This principle obligates firms to issue a detailed prospectus when first issuing securities and subsequently provide periodic financial reports.

But just how many people would continually invite exploitation by dealing with parties that leave them in the dark? One would have to see investors as complete idiots in order to evade the conclusion that corporations have definite incentives to disclose relevant information on their own. They have to in order to initially obtain equity financing on reasonable terms. Were they not to maintain a reputation for helpful and timely disclosure, they’d be greeted with a hostile reaction from investors the next time they asked for funds. Thus, before the United States passed securities legislation in 1934, every stock listed on the NYSE was audited. Most firms provided data on sales, gross margin, depreciation and working capital. Maintaining a good reputation, to be sure, may not hold back someone tempted by huge gains on a one-shot deal, or who otherwise loses sight of their true interest in honesty. For such cases, the prospect of lawsuits and a criminal fraud conviction can deter wrongdoing. In other words, a securities regulator adds little to what market incentives and the courts already provide.

In 1964, George Stigler, the Nobel Prizewinning economist, was the first to document the futility of securities regulation. He discovered that the one-year market-adjusted returns of IPOs were no different after mandated disclosure than before. Investors buying new issues thus saw no benefits from securities regulation. George Benston later compared firms that weren’t reporting revenues prior to securities regulation to those that were. No significant difference in returns was found between stocks in the two groups both before and after regulation was instituted. A difference would have shown up if the information required by securities regulators mattered to investors. Analogous findings were made in a 1981 study by Greg Jarrell published in The Journal of Law and Economics, as well as a 1989 study by Carol J. Simon in The American Economic Review.

Interestingly, most of these studies found the volatility of stock price movements declined after mandated disclosure came into play. Riskier, more entrepreneurial firms tend to have more volatile stocks. The implication is that regulation reduced market swings by shutting out these firms from publicly traded equities, hindering a key source of economic dynamism.

What is so revealing about the recent spate of corporate wrongdoing is that we have witnessed far more instances of financial fraud now than before the SEC ever existed. In a review of the accounting industry written in 1935, Wiley Rich noted, “an extensive survey has revealed not a single case in which a public accountant has been held liable in a crime for fraud.” Around this time, Congressional hearings were held and prosecutions were launched, but little fraud was proved.

Over the last few years, misconduct has been somewhat more pronounced in the United States than in Europe or Canada, even though Americans have the toughest securities laws in the world. That is not something a backer of securities regulation would have been expected to predict. Mandated disclosure should also have been expected to maintain the quality of IPOs, where information is hardest to come by, yet it was precisely on Internet start-ups such as and that investors got colossally burned.

What happened was this: In the late 1990s, the U.S. Federal Reserve ran an overly easy monetary policy, mostly on Alan Greenspan’s calculation that higher levels of productivity ushered in by the so-called “New Economy” had constrained inflationary tendencies. With interest rates thus driven below what the market could truly bear, the demand for equities shot up to the point that investors were willing to entertain even the most dubious projects. Analysts who catered to this demand by writing up glowing reports on dicey companies were lavishly rewarded. Believing the regulatory framework offered protection, investors were all the more willing to assume inordinate risks. Amid all the excitement, top executives were blindly lionized, rather than skeptically watched, enticing a few among them infected with weak moral fiber and shortsightedness to try to make a killing from this once-in-a-lifetime opportunity.

To have spoiled the party would have incurred investors’ wrath, which meant regulators could do little ­ just as they have done little since assuming the supervision of the markets.

George Bragues teaches economics, politics, and philosophy at Toronto’s Humber Institute of Technology and Advanced Learning as well as the University of Guelph-Humber.