Who cares about the disappearing small public firms?

Kamar, Karaca-Mandic and Talley have an interesting new paper, Going-Private Decisions and the Sarbanes-Oxley Act of 2002: A Cross-Country Analysis, which adds to the mounting evidence that Sarbanes-Oxley is driving small firms to exit the public capital markets.

Vic Fleischer points to this paper, and asks:

If SOX is indeed encouraging small firms to go private or stay private, should we care? If SOX benefits large companies (and it's not yet clear if it does or doesn't) but hurts small ones, then maybe the status quo is just fine. Why should a company with a $25 million market cap should be publicly-traded in the first place? It's not like there's a shortage of capital in the private equity markets these days.

I’ll pass for the moment what Vic could mean by a “shortage of capital” or, conversely, what it means to have enough.   

The obvious answer to Vic’s question is that the liquidity, risk-bearing and informational advantages of public ownership potentially make firms more valuable than they would be if closely held. That's why owners' and investors' ability to exit at the back end into public markets is so important to the venture capital market, as Vic well knows.

That is not to say that all firms should be public, or that more public firms is better than less. Being public has downside transaction and agency costs. But it’s difficult to see why society should, in effect, tax public ownership. And if having a tax on public ownership were a good idea, I could think of a lot cheaper ways to do it than SOX.

In fact, the point of SOX is to decrease the cost of public ownership, and thereby encourage it. It supposedly does this by, in effect, “bonding” the firm’s disclosures and conduct. This benefit does not accrue to ordinary investors, but to the publicly held firms themselves – to save them from being traded in “lemons” market.

That’s what’s all this rhetoric about restoring “investors’ confidence” in the market is all about. If investors lacked confidence, they would stuff their money in mattresses, not buy more Enrons. SOX was supposed to get them back in the market. If we don't need public markets, we don't need SOX.

I don’t buy the investor confidence argument, but my point is, that’s the defense of SOX. And the firms that most need the law to bond their promises are newer, less established firms.

The bottom line is that if SOX is driving firms out of the public market, then this is not only socially costly, but contrary to the very reason we have SOX.

Let me turn this around.  Suppose we have too many public firms, as Vic suggests we might.  What we need to fix this is more fraud!  Get those lemons out there.  Assuming SOX stops fraud, repeal SOX.  And if it doesn't stop fraud, repeal it because it's pointless. 

Comments

[Victor Fleischer]

Hi Larry. The post seems a little unnecessarily sarcastic, but I'll respond.

The relevant policy question is what to do if, assuming for the sake of argument, SOX is (on balance) valuable for large public firms and costly for small public firms. I think Talley's cut off was about $15 million in market cap. If those firms can still get cheap equity capital from the private equity market, then is SOX still worth repealing?

I should add that if SOX only drives out the small firms, IPOs would remain a viable exit strategy.

[Larry E. Ribstein]

Vic
The question (as for everything) is whether SOX is having an effect on the margin, not whether firms generally can still get equity capital or do IPOS. See also my followup post today.

[Ann]

Didn't the SEC just change its regulations to allow less scrutiny of companies raising money through seasoned offerings, in order to draw more fundraising back to the public markets? The SEC was reportedly worried about too many funds being raised through 144As, especially by WKSIs (well known seasoned issuers).

It seems odd that they're reducing the scrutiny of companies that are trying to raise additional funds (the companies most likely to be lemons) to draw issues back to the public market, while raising the costs of being public. Do they want more or fewer public companies? Perhaps the conclusion is that the SEC wants fewer public companies, but wants to force those that remain public to always use the public markets - i.e. segregation of public and private markets, with fewer crossovers.

[Kate Litvak]

Ann: the SEC has only limited leeway in choosing how to enforce SOX. So, it's quite possible that the SEC wants to reduce the costs of being public by tweaking the rules wherever possible, but it still has to promulgate and enforce SOX-mandated rules, which increase those costs. The result, as you pointed, might be a bit schizophrenic.

Also, I don't think the authors of SOX _wanted_ to increase the costs of being public; that was merely an unintended consequence of their find-the-fraudster zeal.

[Allen Shulman]

A better reason to encourage the durability and introduction of small public companies is that they provide real competition to established well-capitalized companies that could otherwise exercise pricing power. Despite the well-publicized negatives, the dot-coms of the 1990's were able to effectively compete with giant firms because: 1) tax and accounting policies permitted them to attract outstanding talent by offering the potential to accumulate personal wealth through employee stock options; 2) low barriers to listing gave ready access to public capital to fuel growth within a very short time after founding; 3) NASDAQ listing conferred a level of cachet and brand recognition that eased acceptance by customers.

Larger companies have benefited by changes in GAAP treatment of employee stock options since their best employees and candidates are now less likely to accept offers from smaller competitors unwilling to accept the effect on their income statements required to issue option. These same companies also benefit when the managers and directors of private firms refrain from filing for an IPO out of fear of the personal liability and the high costs and distraction they perceive would be imposed by SOx and similarly motivated laws and regulations.

The discouragement of small public companies cuts down on the number of scrappy, nimble competitors with highly-motivated managers and flush treasuries whose businesses and brands are publicized by stock analysts and reporters. Private equity is certainly a reality, but it is fatuous to assume that a company financed by a private equity firm is the competitive equivalent of the sort of publicly traded company that flourished in the 90's.

Whether the benefits to investors and others of discouraging the formation and continuation of small public companies is worth the costs of reducing competitiveness is a debatable policy question; whether or not there are such costs is not.