Donald J. Devine

UNLEASHING THE SMALLCAP MARKET: TURNING PENNIES INTO BILLIONS
May 20, 2002

The SmallCap Market
A majority of the American workforce is employed by small business with fewer than 500 employees. Small firms have created all of the net new jobs in the American economy since the
1990s. They account for a majority of sales made and half of the entire private gross domestic product [1]

Without this potent sector, the United States economy would be stagnant like that of Europe or that of America's large firms, neither of which have produced any net new jobs in decades.

Like all firms, small companies need capital to survive, to say nothing of growing to meet the increasing demand for the goods, services, and jobs that power the world's most
dynamic economy. Most small firms raise their capital privately, especially in
the beginning. [2]

Yet, if they are to grow, most must turn to the securities markets. Those that utilize those markets are generally called "small cap" or small public companies. There they face an amazingly bureaucratic puzzle they must master or fail. The basic principles and procedures that organize this process go back to the founding of federal regulation in 1933. But if sufficient new firms do not successfully navigate the hazards, the new Microsofts, Home Depots and Wal Marts--and the jobs they produce--will not be created for the future.

General supervision of the securities markets is given to the Securities and Exchange Commission. But all 50 states also regulate the process, usually through their attorneys general. And the private xchanges also exercise regulatory authority, bolstered by SEC pressure and--in many cases--by requirements for their formal approval. The New York Stock Exchange, Nasdaq and others all have different requirements. Nasdaq has a National Market, a SmallCap market and an Over the Counter Bulletin Board, all of which have their own requirements too both for initial and continued listing. In general, there is a rough hierarchy of standards reaching from the most demanding (highest equity worth, number of shares, stockholders and price) in the NYSE down to the OTC.

The economic effects were immediate and devastating. While the stock market soared after the Reagan Administration adoption of the Rule 504 exemptions--which allowed small firms to offer stock with minimal paperwork--following the April 7, 1999 effective date of the SECs amended rule eliminating the exemption, the small cap market dropped drastically. For the year-plus period of the following SEC-OTC re-eligibility process, the market was extremely unstable. After the OTC closed its re-eligibility process on June 28, 2000, the small cap market fell dramatically again, this time to what was then its lowest level. [7] It has never really recovered since. Who knows how much effect this one government decision had upon the following recession but it is clear that investment funds for small capitalization firms virtually dried up.

 Historically, the SEC has considered itself in a policeman role, with its major function being to prevent
and punish fraud. [8] As recently as 2000, the SEC's associate director warned private firms to
"fasten their seat belts" for its new assault on "fraud" through its recently formed Financial Fraud Task Force. One favorably inclined source characterized his tone as "threatening" and considered this statement of SEC policy equally supported by then chairman, Arthur Levitt. [9] By the end of Mr. Levitt's tenure, 250 cases of potential fraud were still under active investigation. [10] Yet, actual SEC proceedings against fraud only totaled 29 cases in 1999, 22 in 2000 and 28 in 2001--none of them other than straightforward traditional fraud cases. [11] The problem is that the 200 firms that will not be indited suffer great disruptions during the time they are being investigated. Many innocent firms do not survive a mere review as a result of the bureaucratic delay. While the new chairman, Harvey Pitt is said to be "less nitpicking," history suggests that this adversarial SEC culture will prove difficult to change. [12]

In 1988, Congress passed a law requiring stronger SEC oversight of fraud in so called penny stocks.
Subsequent SEC regulations defined "penny stocks" as securities selling for less than $5 per share and not listed or authorized for quotation on a Nasdaq or higher stock exchange. Significant additional filing and disclosure were required. Why $5 is a "penny" stock only a bureaucrat could explain. If exchanges were not exempted, the increased regulation and paperwork expense would have had a much more widespread effect. One third of listed firms often trade at $5 or less (and 8 to 10% often trade under one dollar). [13] In fact, a major study found that most SEC requirements did little to control
fraud itself. [14] All they did was increase the paperwork. In 1997, the SEC began to become
concerned with fraud supposedly taking place in the Rule 504 program that allowed small public offerings significant exemptions from paperwork requirements. This exemption from excessive reporting, as mentioned, resulted in a boom in small public company offerings and billions in growth capital for them. When, in 1999, the SEC basically eliminated public 504 offerings, together
with OTC's de-listing process, the market for capital for small cap firms dried up. It is not unreasonable to ascribe the cause as the re-imposition of SEC's regulatory mindset.

Minimum Stock Listing Price Requirements

A significant number of firms are de-listed each year. Some of these are for serious concerns but many
are cited simply for falling below the $1 requirement. In 1999, 440 Nasdaq firms were de-listed. In 2000, there were 240. Up until the September terrorist attack in 2001, there were 279 de-listings. [15]

Once a company is de-listed, it becomes virtually impossible to raise capital. Most financial institutions and market makers will deal only in exchange listed securities. Even if a company is successful raising capital at this point, the costs of this capital are usually enormous. Yet, if a company’s stock price is nearing or drops below its listing requirements, it is usually because of market conditions, economic factors, industry difficulties, or other conditions not under management’s control.

[16]

Recent Nasdaq Loosening of Dollar Minimum Requirement

 If one good thing came out of the tragic events of September 11, 2001, it forced the SEC and Nasdaq to
issue emergency decrees to limit unnecessary regulatory inflexibility as a means to respond to the terrorists' disruptions of the markets, especially in New York.
[19]   
In particular, on September 26, 2001, Nasdaq issued an emergency exception to the $1 minimum requirement for all of its exchanges, scheduled to expire on January 2, 2002. [20]   On December 12, 2001, Nasdaq reinstated the $1 minimum for its national market but partially retained it for the SmallCap Market until December 31, 2003. [21] Specifically, the grace period for a small cap firm to lift its price above $1 was increased from 90 to 180 days. [22]

The Nasdaq action was welcome for small cap companies. But it was needlessly timid. With the especially large number of firms in danger of being de-listed as a result of the economic recession in the so-called dot.com and small cap markets, this action will give many firms a chance to restore apitalization. But the remedy is not sufficient. In fact, the supposedly more restrictive New York Stock Exchange already allows a 180 day period.  The Nasdaq action represented needed relief from this arbitrary requirement, but not much.

As Sarah Lacy and Robert Mullins note, no one loses from the elimination of the $1 minimum rule.
Companies on the brink obviously benefit. Nasdaq wins because it continues to receive listing fees. Brokers and asset managers benefit because they can give shareholders in these investments a buy or sell option. Most important, investors can still sell in a market to salvage some funds or at least write-off
as a tax loss. [23] Of course, some additional fraud might take place too. If this results simply
because more transactions are being offered, certainly it is normal business risk. But there is no evidence that the low price alone increases the risk.

Raising capital and trading stocks are difficult enough without arbitrary and unnecessary government
or government-inspired requirements.  Owners need to focus upon improving their business plan and making it work rather than meeting artificial regulatory requirements. Common stock market wisdom says, “Implement your business plan and the stock price will take care of itself”. [24] With irrational regulation, it cannot. At his confirmation hearing, Chairman Pitt told the Banking Committee that the law was now "nearly 70 years old and reflects a time and a state of technology light years away from what we now confront daily. Commission rules are rapidly becoming the securities equivalent
of the Internal Revenue Code, making it difficult for those obliged to comply to understand their obligations." [25] Pitt's private sector writings suggest that he would be less regulatory in
attitude and the emergency orders are a step in the right direction. But they are very tentative and limited steps and might also reflect his years as a government regulator. As New York University business professor Jeanne Calderon noted, pro-regulation Levitt's background looked even better beforehand, as he was chairman of the American Stock Exchange for eleven years.
[26] At his hearing, Pitt was careful to say he had no preconceived conclusions about
what should result from a review. [27]

Eliminate Minimum Price Listing Requirements.

The SEC and Nasdaq should go all of the way and eliminate the $1 minimum requirement altogether. If it
makes some feel better, an initial price could be required to be set above $1. It likewise would make no economic sense but it would be less harmful. But setting an arbitrary minimum at any price for continuing to be listed makes no economic sense at all. In a few months, it should be obvious that the first step
of extending the period for recovery produced no harm. Hopefully, this experience would inspire bolder action from Nasdaq and the SEC to topple the minimums entirely.

The SEC and the exchanges need to go much further and eliminate the policeman mentality that gives rise to this type of regulation in the first place. It is clear that the SEC has all of the anti-fraud power it could ever desire. All recent changes have only increased the difficulty and expense of reporting with very little gained against fraud in the process. [28] In the wake of the Enron scandal, President George W. Bush proposed additional penalties--such as a lifetime ban from corporate office for fraud and allowing recovery from executive bonuses--as well as creating stronger accounting oversight. He also proposed making forms more understandable for investors. Yet, these are not new directions for the SEC but repeat promises frequently made over the years. The most useful part of the White House plan was to resist adding more rules, stressing the necessity for the SEC to enforce the rules already available. [29]

The SEC and the exchanges will never have enough inspectors to control fraud in any event. The only
effective way to expand the reach of watchful eyes is to empower stockholders. Levitt recognized this by increasing the independence of stockholder audit committees. It was a positive step, although his recent proposal to make a majority of all directors independent is probably unrealistic. [30]  
Pitt, too, sent a letter February 12, 2002, in the light of the Enron bankruptcy, suggesting that the exchanges develop additional steps toward audit committee independence. [31] What else could be done short of making directors so independent of the company as to be alienated from it? How about setting longer terms for audit committee directors with higher set compensation unrelated to stock prices for their term of office, and the inability to be re-appointed to the board thereafter? For the additional compensation, additional responsibilities could be identified that would contribute to more accurate accounting and auditing.

While better auditing would help provide more reliable information that might lead to more effective
markets, there is much else needed if American markets are to perform efficiently. Why not consider the bare-boned paperwork reporting requirements of the original Rule 504 for all stock offerings? Let the buyer beware must always the prime protection and fraud statutes must exist to punish those who seek to exploit the unwary. But additional paper reporting does not constitute fraud reduction. In fact, almost no one relies upon the formal SEC-required prospectus or the cumbersome, rigid and outdated forms. Sophisticated investors seek the independent information they require (some of which is from the SEC but has alternatives) and the rest tend to follow them. To file even the supposedly small business-friendly SB-2 costs a firm trying to raise capital a minimum of $250,000 and a half million total is not unusual. This is better than the $439,000 minimum estimated for a normal initial public offering plus an underwriting fee of $1.7 million, [32] but this simply makes one wonder why those other forms are used at all. More important, it takes four months for the SEC to approve even the SB-2 submission.
The whole economic world for a firm could change over that period of time--and probably will.

Allow Internet Reporting.

If filing and initial public offerings were allowed on the Internet, costs could be slashed even further. The 1930s securities law desperately needs to bring itself into the 21^st Century wireless world. In 2000, as a private consultant for Morgan Stanley Dean Witter, Merrill Lynch and Goldman Sachs, Mr. Pitt wrote a white paper advocating that stock markets be linked into a single electronic order system. [34]
He should go much further as SEC chairman, including allowing registration on line for initial public offerings. It is simple bureaucratic resistance that keeps this obviously needed reform from being enacted. Pitt can only make it happen, however, if he is willing to make it a high priority.

The SEC must become a rational regulator of modern securities markets. It is too early to know whether
it can change or whether Commissioner Pitt will even try. Critics argue that he tries to have it both ways." [35] We shall soon see whether the SEC will create the conditions for a new expansion
of the magnitude of the one the Reagan SEC unleashed in 1981--one that lasted until 1999, when the SEC put on the breaks-- or whether bureaucratic red tape will continue to set the agenda of the SEC. At his confirmation hearing, Mr. Pitt did agree that "the impenetrability of rules and statutes is something that he should not let exist."

[36]
Now he has his opportunity. If he follows the recommendations made here, he will change an agency fixated upon pennies to one that can free entrepreneurs to produce billions, if not trillions of dollars in additional economic prosperity, and millions of jobs.