A  self-proclaimed ‘independent, non-partisan’ group of investment bankers, hedge fund operators, leveraged buyout experts, venture capitalists, fund managers, lawyers, accountants, and closely associated academics formed a “Committee on Capital Market Regulation“ that issued a report on US equity markets on November 30, 2020, after less than two months of deliberation.

The announced purpose of this Committee is to ‘recommend policy changes that should be made, or areas of research that should be pursued, to preserve and enhance the balance between efficient and competitive capital markets and shareholder protection.’

Because this group is extremely well-financed and well-connected, with the ear of the US Securities and Exchange Commission and the Democratic-controlled Congress (through the Brookings Institution, a Committee member, and through Wall Street financial contributions to Representative Barney Frank), its recommendations may effect the future of US capital market regulation for years to come.

There are no representatives of small shareholders on this Committee, and in this regards, the Committee is truly independent from inconvenient opinions of common investors, who blindly trust in Wall Street and the Common Stock Legend, channeling their life savings through retirement funds into equities and 401(k) and IRA plans.

Why Is Sarbanes-Oxley So Hated By Wall Street?

The main recommendation in the first report of the “Committee on Capital Market Regulation” is to weaken provisions of Section 404 of the Sarbanes-Oxley Act of 2002 that call for effective internal controls over accounting practices of public companies.

The Committee reported (in mock horror) that the incremental annual auditing cost incurred under Section 404 for public companies, averages about $4.3 million.

Although this cost is only about 30% of the annual pay of the average CEO of a Fortune 500 company and is falling rapidly as companies establish essential systems of internal controls, the Committee claims this burden to be intolerable, leading to a loss of competitive advantage of Wall Street bankers when soliciting the underwriting of foreign issues into the US market.

However, the Federal Reserve flow of funds accounts show that claims of declining new offerings by foreign issuers in the US market are simply untrue. (See: “Foreign Stock Issues Continue Despite Sarbanes-Oxley“)

Furthermore, sound internal controls are merely a cost of good management and a lack of controls can have disastrous consequences for shareholders, as has been seen with Barings Bank and Enron.

An understanding of the principles of internal controls is not a required discipline to be mastered by graduates of the Harvard Business School. Skills in the more exciting field of “creative finance” are considered more relevant than the dull task of assuring that financial reports are correct or that someone is not stealing a company from under one’s nose.

However, it seems likely that Section 404 is merely a straw man for the real, unspoken objection that Wall Street has to other sections of Sarbanes-Oxley:

Section 401(j) requires that executives certify financial reports as true, and Section 906 provides fines of up to $5 million and up to 20 years in prison for “failure to certify”. (See: “Sarbanes-Oxley and the Shortage of Equities“)

It is much more seemly for executives to righteously point to “excessive costs” and “loss of competitive advantage” supposedly due to Section 404 and “over-regulation” than to admit that they fear stiff penalties for sloppy financial control of public companies imposed by Sarbanes-Oxley.

It is likely that while headlines focus on “reforms” of Section 404 and “improved competitiveness” , the more objectionable aspects of Section 401(j) and Section 906 will be quietly killed in the dead of night by staffers on Barney Frank’s House Financial Services Committee.

Why Barney Frank Will Weaken Sarbanes-Oxley

The new Democratic-controlled Congress will have Barney Frank, the representative of the 4th District of Massachusetts, as Chairman of the House Financial Services Committee.

Representative Frank has already announced before the Greater Boston Chamber of Commerce his intention to weaken Section 404 of the Sarbannes-Oxley Act, citing as justification many of the same reasons (with the same wording and phrases) as in the report of The Committee on Capital Market Regulation.

This is not surprising. The largest contributions, by far, to Barney Frank’s election campaign of 2006 came from Wall Street, led by JP Morgan Chase.

Now, there never was the slightest doubt that Barney Frank would win the 2006 election in the 4th Congressional District of Massachusetts, as he had in every election for over a generation.

• First: The 4th Congressional District is Barney Frank’s own personal pet Gerrymander — a true marvel of American Democracy that assures his reelection year after year.

• Second: In some years, Barney Frank even runs unopposed. In 2006, there was no Republican candidate and only a weak Independent with no chance of winning.

Therefore, the only reason for Wall Street’s massive campaign contributions to Representative Frank would have been to buy access and a sympathetic hearing for their views, especially with regards to Sarbanes-Oxley and SEC regulation.

The timing of the formation of the Committee on Capital Market Regulation, the ties of its members to Barney Frank, and Representative Frank’s quick parroting of the Committee’s views before the Greater Boston Chamber of Commerce, all lead me to believe that the House Financial Services Committee over the next two years will seek to weaken, rather than strengthen protection for American small investors. (See: “Is the SEC Obsolete: Problems with Non-Merit Regulation“)

Wall Street Will Continue To Lose Competitive Advantage

Of course, with or without Sarbanes-Oxley, Wall Street will continue to lose competitive advantage to foreign capital markets, as has occurred over the last fifty years.

In 1956, when I first went to work on Wall Street, New York City was the undisputed financial center of the world. Europe and Japan were still digging out from the rubble of World War II, London was laboring under socialist government, and the emerging markets of Latin America and Asia were not even imagined by the wildest visionaries.

For the rest of the century, the United States, with Wall Street playing a leading role, worked to fortify the economies of the rest of the world. US investment poured into multi-national corporations that went to build economies, not only in Europe and Japan, but throughout the third world.

US bankers, along with dollar financing, brought techniques of Wall Street to every non-communist country — and after the fall of the Soviet Union, even to the communist world.

From the 1970s onwards, the World Bank, USAID, and the Asian Development Bank, spent hundreds of millions building capital markets in virtually every nation on earth, sending consultants, experts, and advisers from the United States.

Citibank, with the Group of Thirty, led the effort to improve clearings and settlement worldwide.

The SEC, through IOSCO, championed orderly market development along the US model, in hundreds of countries.

See: Globalization and Capital Flows

By the 1990s, with the fall of the Soviet Union, new stock exchanges came into being in every corner of the globe, from Albania to Zimbabwe, and from Angola to Uzbekistan.

Furthermore, Wall Street firms set up offices in developing markets overseas and vigorously competed for underwritings and the business of local issuers and investors, trading on local stock exchanges, and adopting business plans calling for development of foreign markets, rather than the channeling of business to the United States.

So the lamented loss of “competitive advantage” by Wall Street is pure hooey — a weak excuse by ethically challenged corporate executives to avoid accountability to shareholders.

It has nothing at all to do with Sarbanes-Oxley or over-regulation, but is instead the inevitable consequence of globalization — a large part due to the efforts of Wall Street itself — and the relatively fast growth of the rest of the world, compared to the United States.

A Committee on Capital Market Regulations Could Be Useful If …

Now, there is no doubt that a Committee on Capital Market Regulation that would do all the things this Committee proposes is sorely needed and could be most useful if set up to seek ways to better protect investors and correct distortions in the US capital market. For example, something should be done about the great stock buyback scam, the overpaid corporate executives, and the demise of dividend yields.

But, I’m afraid, judging from this first report, this Committee is likely to champion the status quo and serve interests of its members, rather than suggest reforms that might benefit the great mass of investors or that would ensure a healthy US capital market.

The regulatory principles of the United States Securities and Exchange Commission were established three-quarters of a century ago and have been copied by securities regulators throughout the world.

The SEC sets forth its principles on its web site:

The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept:

All investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.

To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public.

This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security.

Only through the steady flow of timely, comprehensive, and accurate information can people make sound investment decisions.

This high-sounding institutional promotional jive is called ‘non-merit regulation’. The SEC requires issuers to make certain information available to investors, and if investors are too stupid, uninformed, uneducated, busy, or lazy to make use of this information, the SEC washes its hands of the matter.

The SEC does not judge the merits of a security offering or give investors any clue in this respect — it is the investor’s responsibility to determine this, no matter how unqualified the investor may be for the task.

The Securities Market in 1933 and Today

There have been drastic changes in the securities market since 1993, but no significant changes in the principles of security market regulation, which have become obsolete with the passage of time.

Here is what has changed:

• Dumber Investors: The percentage of the population investing in equities has increased from less than 5% in 1933 to almost 50% today. Most investors in 1933 were businessmen, buying and selling securities directly for their own account. Today, most investors are employees, generally with only a high school education, passing off their investment decisions through a chain of multiple fiduciaries in tax-deferred savings plans funded by payroll deductions. Although there are no statistics to prove it, commonsense and a glance at the Bell Curve suggests that today’s investors, on average, are most certainly less intelligent and less able to decide on the merit of securities than were investors in 1933.

• Lawyered-Up Prospectuses: The information on which these less capable investors are supposed to make an “informed judgment” is delivered in the form of gray, dull “offering statements” and “company reports”, packed with legal boilerplate, all-encompassing disclaimers, mind-numbing warnings, SEC-approved, but misleading tables, endless footnotes, irrelevancies, and information “included by reference” (i.e., not in the prospectus, but somewhere else that the investor is unlikely to ever see). A typical prospectus would take a college graduate trained in financial analysis days to examine in detail and consider, especially when loaded with references to exotic derivatives and devoid of information that provides sufficient context regarding the issuer’s business.

• Fiduciary Confusionary: The US securities laws have little to say about fiduciary responsibility, and even less about the responsibilities of “chain-fiduciaries“. Is a corporate director responsible to the mutual funds that are the first-in-line shareholders, or to the custodians of mutual fund shares who are trustees for the 401(k) investment plans of workers, or to the plan administrators, or even to the final, eventual beneficiary, the workers who have their life savings tied up in 401(k) plans? This whole structure of “chain fiduciaries” has blossomed into a dominant force in the market since the 1970s, two generations after the SEC was formed. ERISA only requires that that fiduciaries act with the “care, skill, prudence, and diligence under the circumstances then prevailing” that a prudent person “acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims.” Whatever that means.

• The Rise of Collective Investments: Most US investors put their savings in collective investment vehicles, like mutual funds, closed-end funds, money market funds, variable annuities, and exchange traded funds. However, the SEC has caved in to Wall Street lobbyists and generally granted issuers exemption from providing meaningful information about funds that would be useful to an intelligent investor trying to make an informed decision. Instead, the SEC allows phony marketing numbers like “total returns” to substitute fundamental facts. Collective investment funds need not provide investor basic data about portfolios, such as weighted average price-earnings ratios, dividend yields, dividend coverage, book-to-market ratios, corporate leverage, earnings growth rates, or dividend growth rates. Indeed, in many cases issues are excused from even revealing to investors the content of their portfolios, until months after the fact, and then often “by reference” to documents filed elsewhere.

• The Rise of Mercenary Economic Quackery: In the 1930s, leading economic theory about investments was provided by actual market practitioners, like Benjamin Graham and John Burr Williams, whose observations were heavily grounded in commonsense and market experience. Today, we have Nobel laureates in “economic science” (non-existent in the 1930s), who put forth theories ‘ex cathedra” and who are often hired as consultants to Wall Street, pushing ideas such as the “Efficient Market Hypothesis”, which says that whatever the price of stocks, it is the right price, because of the “efficient market”. In the 1930s, stock market quackery was confined to certified “nut cases”, like W. D. Gann with his “Theory of Vibrations” and “Fludd’s Devine Monochord”. Today, such nonsense is cloaked in partial differential equations and unrealistic assumptions and earns their proponents Nobel prizes and contracts to help Wall Street in its marketing efforts. What chance does our less intelligent investor stand?

• Vastly More Complex Financial Instruments: Finally, we have the development of a multitude of derivatives, largely relegated to brief mention in scanty footnotes in SEC-mandated prospectuses, and barely understood by almost everyone, especially when recast and combined into bizarre new financial products. Although puts and calls existed in the 1930s, they were traded in obscure over-the-counter markets and were unlikely to find their way into portfolios of the average investor. Today, with collective investments, chain fiduciaries, and lawyered-up prospectuses, it is hard to see how the SEC can still claim (as it does on its website) that, “the SEC requires public companies to disclose meaningful financial and other information to the public.”

• Substitution of Dividends by Unrealized Capital Gains: In the 1930s, investor could count on two-thirds or more of their return on investment to come in the form of cash dividends, paid equitably to all investors pro rata. In this context, the SEC’s idea of “non-merit regulation” was at least workable, because investors were smarter, companies were simpler, and the main question an investor had to ask was, “Does this company have the financial capacity to continue paying dividends?” Today, many companies pay no dividends at all; stocks of “blue chips” trade at fifty or sixty times earnings, and the SEC doesn’t bat an eye when such “investments” are put into portfolios of widows and orphans. Prices are jacked up by corporate manipulation through stock buybacks, while the SEC grants an exemption from prison to executive miscreants with conflicted interests. Because the SEC has been sleeping at the switch for so long, the retirement of millions of Baby Boomers now depends upon their ability to sell financial assets to smaller, future generations, who may by then, perhaps, be smarter.

Is the SEC’s Regulatory Philosophy Obsolete?

In the 1920s, the historical background against US securities laws were drafted, there were three major problems that legislators sought to address:

• Dishonest Door-to-door Stock Salesmen: During the 1920s, new issues were often sold door-to-door with selling arguments that were lacking in relevant information and often related to phony companies and fraudulent propositions.

• Unprofessional Stock Exchanges: Even serious, informed Investors, Like Benjamin Graham, dealing on the major stock exchanges, complained of the lack of data on listed companies and rampant stock manipulation.

• Bankers’ Improper Involvement in the Stock Market: Misuse of margin accounts and banker’s use of depositors’ money to buy stocks, contributed to the crash of 1929 and hundreds of bank failures.

The new federal securities laws of the 1930s did much to effectively clean up these problems. By requiring that securities salesmen and stock brokers be licensed and regulated by the SEC, and by mandating the use of selling prospectuses, blatant fraud in door-to-door selling was cut drastically. Regulation of the stock exchanges and continuous disclosure requirements for issuers, improved the quality of exchange business. Finally, the separation of banking from the investment business eliminated a major cause of bad practices in financial markets.

But that was then. What about today?

New Markets; New Problems, Old Laws

Today, the average investor doesn’t buy stocks from door-to-door salesmen, or even by going downtown to visit a brokerage office. Rather, investors are likely to buy stocks indirectly, through mutual funds, often offered by the personnel departments in the companies at which they work (401k plans), or by phoning in orders in response to magazine ads touting mutual fund “total returns” with “star ratings”.

The SEC has gotten into bed with fund marketers, allowing them to promote funds based on misleading “SEC total return” figures and granting exemption from requirement to include fundamental information from fund selling documents (which are, in many cases, not seen by investors anyway).

The funds are in custody with big name banks , audited by famous public accountants, registered with the SEC (’the investor’s watchdog’), and packaged with slick, ‘official’ documentation, with frequent mention of laws and seriousness of purpose, all designed to inspire confidence.

To boost prices of equities and produce rosy “total returns” figures for fund marketeers, the SEC grants company executives exemption from stock manipulation rules, allowing them to divert investor’s dividends and jack up equity prices to give value to their own stock options.

The SEC and the Federal Reserve have also kow-towed to banks, allowing them back into the securities business — with a vengeance. Some of the largest banks now have much of their capital and depositor’s money, invested in speculative proprietary trading portfolios of over-the-counter derivatives.

The typical investor (say, a holder of mutual funds through a company 401k plan) has several problems:

1. No effective way to influence corporate executives who are paying themselves obscene salaries and other forms of remuneration with stockholder’s money, due to poorly regulated “chain-fiduciaries” that effective separate highly-diversified beneficial ownership from the hired managers who have administrative control over public corporate assets.
2. No effective knowledge of even what stocks are beneficially owned, due to drastic relaxation of fund disclosure requirements by the SEC and diversification to a point that it would be uneconomical to focus on a single company, even if the investor had the intelligence and talent to do so.
3. No effective advice as to the appropriateness of a certain investment for the investor’s needs, from any of the fiduciaries in the chain that handles the investor’s money: the plan administrator, the bank custodian, the fund directors, the fund managers, to company directors, or the company executives. The investor doesn’t have the skill, information, or intelligence to do this himself, and the SEC, quite frankly, my dear, doesn’t give a damn!

Because there are tens of millions of American investors in this position, holding retirement funds composed of diversified portfolios of over-priced equities, dependent upon hoped-for future capital gains to be realized when selling into a market ten or fifteen years from now, just as the “Baby Boomer retirement effect” reaches a peak, this is a problem with large social implications.

However, so far, neither political party seems to be exercised about this and the investors themselves won’t know they are in trouble until they try to cash in their retirement funds at the same time.

Will Things Get Better For Investors?

Don’t expect Congress to reform US security laws any time soon. The SEC philosophy of “non-merit regulation” is enshrined in security legislation throughout the world, thanks largely to IOSCO and consulting services provided to third world countries without charge by USAID, the World Bank, the Asian Development Bank and similar grantors of economic aid.

The entrenched interests of securities regulators, lawyers, accountants, and market participants in the existing system are simply too great to allow change without strenuous opposition.

In fact, in the United States, there is even a movement to close operations of state securities regulators, leaving the SEC supreme — the one and only “defender of the small investor”.

So what does this have to do with Capital Flow Analysis?

What I think it means is this:

• About the only potential “defenders” of the interests of the collective investor that now dominates the US market are — I hate to say — mercenary tort lawyers seeking class action damages from breach of fiduciary duty on the part of corporate executives, fund managers, and the multiple fiduciaries in the chain from the 401(k) or IRA plan holder to the issuer.

• It will take a market crash as Baby Boomers start liquidating in ernest, some years from now, before Congress wakes up — if then.

• The Irrationality Axiom is alive and well.

• Don’t count of the Efficient Market Hypothesis to protect you.

As the graph below shows, there has been a boom in the sale of new, single-family homes in the US since the late 1990s.

In recent weeks, common wisdom bandied about on financial talk shows is that this housing boom was somehow caused by Federal Reserve Chairman Greenspan’s reduction in short-term interest rates during the years 2000-2004.

But is this reasonable?

Might there not be some other explanation?

Consider Demographics Rather Than Interest Rates

The thing that strikes me about the graph of new home sales (besides the boom of the late 1990s) is that the addition of new homes to the US housing supply has been more or less stable for over thirty years, fluctuating around only 600,000 new homes a year.

In 1999, the stock of single family homes in the US was about 112 million units. That means that the supply of new homes, for over thirty years, was less that one percent of the number of homes in use at the end of the century.

New Immigrants and Internal Migrants Need Homes

Compare this to the statistics on legal immigration, which, since the end of World War II, has grown from about one million a year, to over nine million a year by 2000. See the graph in the article, “America Grows With Legal Immigration“.

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