Man Without Qualities

Friday, March 15, 2002

Just What Was All That Dot Com Shouting About?

KausFiles tweaks InstaPundit for tweaking Congress for passing a stimulus bill “second-guessing corporate executives on their business judgment” (in the words of InstaPundit), and hard a heels the Fed’s announcing that the recovery is now well underway. KausFiles argues, “Wasn't this the first downturn in a long time to be produced, not by some sort of policy mistake or external shock but by a colossal failure of business judgment on the part of the executives, corporate and non-, who wasted billions on idiotic projects? They could have used some second-guessing!” InstaPundit responds by quoting a reader, Will Allen, in part that “The virtue of a free market is not that it ever achieves perfection, but that the transactions are the by-product of, well, freedom.”

I’m not sure these arguments meet. Isn’t KausFiles asking whether a marginal increase in government second-guessing of the market is justified if it produces a more-than-compensating but still marginal increase in wealth? Whatever the intrinsic “value” of economic freedom may be, it surely must be balanced against wealth enhancement effects. Otherwise, advocating economic freedom comes to resemble a religious tenet, a kind of secular transubstantiation but lacking the words of a divine prophet to back up its claim to being an essential benefit we should care about more than, say, eating or having a few extra dollars to pay for the kid’s piano lessons. The immorality of communism, for example, is well demonstrated by the huge numbers of people who have been impoverished or died, through starvation and otherwise, from the actions of those advancing that particular secular religion. One would have to be a very serious libertarian of a particular stripe to argue that economic freedom is entitled to respect regardless of whether it results in the creation of wealth.

The above exchange is interesting in part because it is another of the recurring indications that the legal and political systems continue to fail to address the “new economy” with even as much coherence as they address the rest of the economy. Was there a rational basis for the dot com mania? Should the government have done more to second guess the “irrational exuberance” of that market bubble – if, indeed, it was a “bubble?” It’s not just that there is disagreement on policy (that is with us always), but rather that one often has the feeling that the disputants are not quite sure where to start or where they are where the "new economy" is involved.

I want to suggest that there were two substantial but largely overlooked factors that contributed considerably to the recently expired dot com “mania”: elimination of “merit” review of securities by the states during the decade ending in 1996 and a curious “hidden” political/economic expectation that the internet represented a means of avoid the costs of the regulatory state. The second factor will be the subject of a later post. Here, I want to consider possible effects of the first factor.

Until reforms passed during the decade ending in 1996 there were two important levels of public securities regulation. Federal regulation mostly came under the Securities Act of 1933 and the Securities Exchange Act of 1934. But regulation by individual states – commonly called “Blue Sky” regulations – was the second level of regulation. The two tiers of regulation had different foundations. Federal regulation of securities is based on disclosure principles. Federal regulations do not generally concern themselves with whether a particular security has merit as an investment – the focus is on whether the risks of the investment are adequately disclosed. However, the situation was quite different under the Blue-Sky laws of many states. The so-called “Blue Sky Commission” of many states had the power to evaluate whether a particular security had sufficient merit as an investment. The Blue Sky Commissioner then decided whether the securities could be traded in that state and, in particular, whether the securities could be sold to residents of that state.

Capping a ten year trend towards reduced state intervention, in 1996 Congress stopped the states from evaluating the “merits” of many securities, including those listing on NASDAQ’s national market system (“NASDAQ/NMS”), the preferred high tech trading venue. That trend had received a big push from the Revised Uniform Securities Act of 1985 (“RUSA”), a proposed uniform state law that included an exemption from Blue Sky securities registration for securities listing on NASDAQ/NMS. (The American and New York Stock Exchange stocks already enjoyed exemptions.) Most states enacted RUSA’s proposed NASDAQ exemption by 1990. Congress passed the National Securities Markets Improvement Act of 1996 (“NSMIA”, also known as the Capital Markets Efficiency Act of 1996), which prohibited all “merit review” by state securities commissions of NASDAQ/NMS stocks. The states were also prohibited from imposing significant registration or filing requirements for such securities, or any conditions on the prospectus or offering document prepared – including on any "advertising or sales literature used in connection with such offerings." Although NSMIA itself represented a marginal additional restriction on state “merit review,” the cumulative effect of the reforms during the ten-year period was substantial. Sales to the general public – normally critical in dot com public offerings – almost always required some form of Blue-Sky Commission approval prior to the reform decade ending with the 1996 legislation. As one commentator describes an example of the pre-1985 process:

“[T]aking an ‘Apple Computer’ and getting it approved in Texas, banned in Massachusetts and, faced with certain denial, avoiding such states as Illinois, Michigan, Missouri, and Wisconsin altogether. The challenge was to review the offering documents before filing, catalog the potential problems, and then bet on which states would approve and which states would deny. More than a few investors became irate when they could not participate in the Apple Computer offering because their state regulator had already made the investment decision.”

Also, although the above discussion is directed at public offerings, one astute and knowledgeable reader has pointed out that, “Where NSMIA did have an impact was in private offerings, ie financing to venture capitalists. Prior to 1996, state blue-sky laws (and Federal Regulation D) required issuers to jump through a bunch of hoops to do a private offering.”

The effects of pre-reform Blue-Sky regulation were erratic, inconsistent and unpredictable – and it is not my purpose to defend it. But – as the Apple example indicates – prior to the “reform decade” culminating in NSMIA, stock issued by a company with a business plan as problematic and non-traditional as those of most dot com companies would have attracted considerable attention, criticism and disapproval from the more intrusive Blue Sky commissions, especially if the stock were issued in an initial public offering at a high price. A whole series of such offerings by companies with such business plans, such as the offerings that formed the basis for the dot com boom, would almost certainly have provoked strong, public, and, ultimately, coordinated action by many Blue Sky Commissions.

Soon after NSMIA was enacted, NASDAQ/NMS began to fly. In retrospect, it seems likely that suppression of state Blue-Sky "merit" review resulting from federal and state reform discussed above did significantly exaggerate the run up in the dot com securities market. First, there is the suggestive timing, as noted above. The big NASDAQ run up began at the close of the reform decade culminating in the federal legislation. Of course, suggestion is not proof. But it is also worth noting that to the extent “merit review” went beyond mere disclosure requirements, the dot com companies obviously lacked “merit.” The dot coms could almost have been used as test cases in training Blue Sky analysts in what they were supposed to look for and object to. In evaluating “merit” before 1996, Blue Sky Commissions often looked for things like a history of profitability, the existence of contracts with established companies, favorable comparisons with already successful competitors, and seasoned management. In short, many of the most important things Blue Sky Commissions looked for to determine “merit” were just the things that the dot coms lacked – even more than a company like Apple Computers. In many respects, the approach of many Blue Sky Commissions resembled that of what are known as “value investor funds.” Blue Sky Commissions often had investment criteria and agendas which caused them to function something like “value” fund managers of an unsophisticated stripe, but with the added power to prohibit throughout their state general purchases of securities the Commissions found lacking in “merit.” “Value” funds suffered severely during the dot com boom in comparison to “growth’ and “momentum” funds that were the principal purchasers among funds of dot com stocks – which suggests that Blue Sky Commissions would have done what they could to restrain sales of such stocks.

The presence of a chorus of such state officials disapproving a particular kind of securities – such as dot com stock – should have exerted downward pressure on the price of such securities in the same way the chorus of optimistic dot com stock analysts exerted upward pressure on such prices during the boom. Moreover, one concern raised by the Enron fiasco is that stock analysts employed by the large securities houses may be reluctant to “talk down” a stock (or a type of stock) in which the analyst’s employer has an interest. The Blue Sky Commissions were affected by a skew roughly the opposite of what may affects such institutional analysts: as state regulators, they felt their most intense heat when an approved investment failed, but were largely taken for granted or considered irrelevant when approved investments prospered. So removing “merit” evaluation power from the Blue Sky commissions may have removed from the market a set of powerful and highly (perhaps, overly) conservative investment analysts. Of course, the conservatism of Blue Sky commissions was to some extent moderated by the heat they could (and sometimes did) experience from state residents who were frustrated by from purchasing a disapproved investment that later soared. But “lost profits” are generally inherently more speculative than actual lost investments, and that meant that the Blue-Sky commissions tended to rather conservative approach.

Even if the Commissions had retained their pre-reform authority and propensities, is it reasonable to suppose that they could have influenced the dot com price run up? That is, setting aside whether their authority was good or bad for the market, did they have significant influence? While I see no way of definitively settling the matter, there are indications that the Commissions’ decisions did have serious influence. For example, various studies in the 1970’s attempted to trace the effects of the Commissions’ efforts. While there is a great deal of dispute over whether those effects were positive or negative, there seems to be agreement that the effects were often substantial. The rising chorus of protests against the Commissions which led to reform also suggests that the Commissions were often serious obstacles to the agenda of many companies – and that these obstacles went far beyond the annoying need to hire and pay local counsel to deal with local Blue Sky laws. Further, as government regulators, the Commissions had the power to question and investigate individual securities issues with an authority beyond what any private analyst could achieve. Blue Sky commissions could insist that additional disclosure be included in the offering documents, before this power was also ended by the 1996 legislation – and some of them were not shy about using that power. While it is not likely that the Blue Sky commissions would have used this power in every case, or even most cases, it seems likely that the sheer volume of “meritless” dot com issues would have resulted in some fairly violent denunciations of this entire class of companies by at least some Blue Sky commission – and that would likely have served to counterbalance what they would almost certainly have construed to be increasingly irrational market enthusiasm.

Disapproval of a particular security by Blue Sky Commissions could dampen the enthusiasms of a would-be fiduciary purchaser (that is, a purchaser who owed a legal duty of “trust” to another person with respect to the purchase), of which there are a great many. Such dampening would likely occur even if the fiduciary were technically not bound by such disapproval. For example, a corporate trustee (such as Morgan Guaranty, for example) managing a fund for a minor or incompetent, might have reservations about purchasing a security that came burdened with the disapprovals of several state Blue Sky Commissions – even if the trustee was not located in any of those states – simply because the disapprovals could be evidence that such a purchase was not appropriate for the trust.

As noted, Blue-Sky commissions tended to take a rather conservative (if often unsophisticated) approach to evaluating “merit”, which often led them to rather bearish evaluations of non-traditional and speculative companies. Although the Blue-Sky commission had their own agendas and sets of priorities that could skew their evaluations, those agendas and priorities were set by political – not financial – considerations. In that sense, especially given their governmental investigatory authority, the commissions often provided a distinct and bearish set of voices – especially with respect to investments like the dot com companies. Overall, it seems likely that suppression of the power of state Blue Sky laws and commissions by the 1996 Congressional legislation and by state reform in the preceding decade probably also suppressed a set of potentially powerful “bearish” voices which might otherwise have acted to dampen the run up dot com in stock prices.

What does that mean for the future? Are the markets more volatile and likely to “bubble” in the absence of government “merit” evaluations? Should some version of “merit” evaluation be reintroduced?

It is too early to tell. The Blue-Sky commissions imposed serious costs and burdens on the market while they were active. It is difficult to imagine that having the states employ squadrons of unsophisticated, generally bearish, risk-adverse operatives to pass on the “merit” of public securities is the best solution. One would normally expect a large, complex, private market such as the securities markets to take some period of time to adjust to legislation of the scale of the 1996 act – which also included other provisions at least as profound as the one stripping the Blue Sky commissions of their powers. The dot com run up was the first major strain on the securities markets following the reform decade ending in 1996. The stock markets seem to have seriously begun adjusting in early 2000 after what may have been a period of diminished capacity in 1997 through 1999. Further, the apparent increase in attention to the role played by private “buy-side” analysts – also related to the Enron fiasco, but going much further - is consistent with a market struggling to find the right balance in the aftermath of the removal of some set of bearish voices, perhaps voices belonging to the Commissions.

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