Recession
Shock Posted Dec. 7,
2001 By John
Berlau
John Shad, who
headed the SEC under Ronald Reagan, exempted
small firms from many regulations, making it
easier for them to raise money. But the
Clinton-era SEC hurt small businesses, which led
to a weakened economy.
For nearly 20 years it was
the boom that couldn't end. Although Bill Clinton
loved to take the credit, the prosperity of the
1990s was part of "one continuous boom since the
early 1980s," says Brian Wesbury, chief economist
at the brokerage firm of Griffin, Kubik, Stephens
& Thompson in Chicago. From 1982 to 2000, save
only for two quarters in the early 1990s, the
United States experienced such economic growth and
prosperity as she never before had seen. Almost 35
million new jobs were created. The Dow Jones
industrial average rose thirteenfold, dramatically
increasing the wealth of middle-Americans invested
in 401(k) plans and mutual funds.
Then
suddenly, a few months before George W. Bush took
office, it all seemed to come to an
end.
What happened? Conventional wisdom has
it that much of the growth was a bubble in which
Internet and technology stocks were bid out of
sight by speculative mania. But some observers
notice that something else was going on at the
time the markets started to fall: The Clinton
Securities and Exchange Commission (SEC), led by
Chairman Arthur Levitt, was busy dismantling
reforms from the Reagan administration that had
made it easier for small businesses to raise money
from the stock market.
Economist Lawrence
Kudlow puts the time of the fall of the NASDAQ
high-tech market as March 2000. This is almost
precisely when, through a series of administrative
rules, Levitt's SEC blocked small entrepreneurial
firms from the access to capital markets that
they'd enjoyed since the early 1980s, says Don
Devine, senior scholar of the American
Conservative Union's Task Force on Regulatory
Reform and director of the Office of Personnel
Management in the Reagan administration. "Unlike
most of the times in the past, it looks like this
was a stock-market-led recession," Devine tells
Insight. "Levitt and Clinton disrupted the
markets, and then the [shocked] market led to the
weakening of the economy."
With the
Democratic Party preparing a national advertising
campaign to bemoan the alleged "Bush recession,"
Devine, who is reputed to be as politically savvy
as they come, thinks Republicans should set the
record straight about what he calls the
"Clinton-Levitt recession."
There are
signs that some Republicans may be following his
advice. In late June, the House Financial Services
subcommittee on Oversight and Investigations held
a hearing in which Devine and others testified on
Levitt's effective repeal of Rule 504, which the
Reagan SEC created to exempt small businesses
raising $1 million or less on the stock market
from most SEC regulations. Since, as is widely
agreed, small business fueled the boom of the
1980s and 1990s, the SEC's move against this
sector apparently helped move the economy into
recession, says an aide to Rep. Sue Kelly
(R-N.Y.), chairwoman of the subcommittee.
Levitt's regulations were "definitely a
contributing factor," the aide tells Insight. "As
Mrs. Kelly will say all the time, small business
is the engine of the economy. The ability of small
business to raise funds and have access to loans
or to the capital market is essential. With small
businesses not having the capital they need,
they're not able to make the investments they
require to grow." And this, in turn, hampers
growth in the overall economy, the aide says.
That was tough stuff, and the
congresswoman decided to be careful. A Kelly
spokesman now says Kelly doesn't agree with the
aide's opinions that the SEC's actions contributed
to the recession. But, she said in a statement
sent to Insight, "for a quick recovery, we must do
all we can to create greater access to the capital
markets for small business."
To many
pundits the economy of the 1990s simply
overheated, requiring a huge and painful cyclical
correction. But Wesbury, former chief economist
for the Joint Economic Committee, disagrees with
the "cycles of greed and fear" theory, which he
attributes to the influence of liberal economist
John Maynard Keynes. "When I say there was no
bubble, I'm not saying there weren't a number of
companies, IPOs [initial public offerings] and
funding that should have never happened," Wesbury
tells Insight. "But those dumb investments would
have ended badly no matter what happened in the
economy. What causes booms and busts in any
economy is [government] policy."
Wesbury
says recessions are caused mostly by "policy
mistakes." He attributes the current slump to
Federal Reserve Chairman Alan Greenspan's
tightening of interest rates beginning in May
2000, to taxes being at a record-high share of
gross domestic product (GDP) and to the chilling
effect on the technology sector of the
government's pursuit of Microsoft Corp. He adds
that the SEC regulations "could have easily
contributed heavily to this. … Anything that
inhibits the free flow of capital is a negative
for economic growth in the long run or even in the
short run."
Indeed, scholars have found
that part of what got the 1980s boom going, in
addition to Reagan's cuts in marginal income-tax
rates, was his administration's reduction of
obstacles to capital formation created by the SEC.
When Reagan tapped John S.R. Shad, vice chairman
of the brokerage firm of E.F. Hutton, to head the
SEC, Wall Street had been in a slump since the
early 1970s. "In the late 1970s, the prime rate
was in the double digits," John Huber, the SEC's
director of corporation finance from 1983 to 1986
and now a partner at Latham & Watkins, recalls
to Insight. "People were saying the Eurobond was
the thing of the future. London was growing and
building [its international financial markets]. …
The changes in the 1980s resulted in making
American markets more efficient, in essence
retaking the market that the Eurobond market had
begun to take in the late 1970s."
Huber and
the late Shad put through a policy called
"integrated disclosure," which reduced the number
of forms public companies had to fill out to sell
stock. The paperwork had increased massively since
the SEC was created to oversee the stock market in
the 1930s. Integrated disclosure allowed companies
to save time and money by cross-referencing
earlier filings instead of preparing new ones with
the same information.
For small businesses
in particular, the paperwork and legal costs could
be prohibitive for raising money through the
capital markets. Shad's Rule 504 made it easier
for small firms to raise money by exempting them
from many SEC regulations if they raised $1
million or less over a year.
The results of
Shad's reforms were immediate. Small businesses
quickly realized that they could raise capital as
never before, and that sector became the engine of
growth for the new economy. In 1984, for instance,
two friends who owned a small ice-cream shop in
Vermont wanted to build a full-fledged
manufacturing plant to sell their product
nationally. Bypassing an underwriter or broker,
the friends raised $750,000 by selling directly to
Vermont residents. A year after raising this seed
capital, Ben & Jerry's listed on the NASDAQ
and soon became one of the best-selling brands in
the United States.
The New York Times
estimated in 1983 that Shad's overall changes had
brought an additional $500 million into the
markets in less than two years. "The SEC's new
approach undoubtedly contributed to the expansion
of the markets and the growth of new capital,"
wrote Philip Koslow in his book, The Securities
and Exchange Commission, published in 1990. "Wall
Street, which had seen some hard times since the
1970 slump, began to boom. New buildings were
going up throughout the financial district in
lower Manhattan, and firms were hiring thousands
of new workers. Suddenly Wall Street was the place
to be for the energetic and ambitious. … All this
activity clearly bolstered the economy in the
short run."
Critics worried that
deregulated companies would be able to bilk
investors, but Shad argued that his approach would
free oversight resources to go after the real
wrongdoers. He proved his point when the SEC took
on insider traders in the late 1980s. Some
conservatives even said he went too far in pursuit
of Michael Milken and others accused of insider
trading.
Shad's approach — cracking down on
wrongdoers while lifting barriers to capital
formation for legitimate companies — continued
throughout the administrations of Ronald Reagan
and the elder Bush. While George H.W. Bush
departed fatally from Reagan's policies by raising
taxes, his SEC kept to the free-market course.
And, in 1992, Bush's SEC commissioner, Richard
Breeden, further liberalized Rule 504 for small
businesses, removing all federal regulation except
penalties for fraud and trusting the judgment of
the states where the companies were
incorporated.
The GDP, which contracted for
two quarters in 1990 and 1991 after Bush signed
the tax increase and Saddam Hussein invaded
Kuwait, began rebounding in 1991. By the end of
1992 virtually all the leading economic indicators
(such as housing starts and retail sales) were up,
just in time for Clinton to take credit for the
recovery, notes Alan Reynolds, an economist at the
Cato Institute. Only unemployment remained
unchanged, but it "is a lagging indicator" because
people look for jobs when the economy gets better,
Reynolds says.
Once again small businesses
fueled the boom. According to the Small Business
Administration, more than one-half of all U.S.
employees work for companies with 500 employees or
less. These firms produce 47 percent of all
business receipts and nearly all the new job
growth. Firms with more than 500 employees
actually had a net decrease of jobs from 1992 to
1996.
Economist Wesbury also credits small
business for the dramatic growth in American
productivity that was responsible for the
prosperity of the 1990s. "It's across the board,"
he says. "Everything from restaurants and dry
cleaners to high-tech startups."
But as the
1990s boom was going full throttle, clouds were on
the horizon for small-business capital formation.
The SEC had a new sheriff determined to take the
agency in a radically different direction than the
Reagan and Bush appointees. In July 1993, Clinton
appointed Levitt as SEC chairman. Levitt was a
major Democratic fund-raiser who had served as
chairman of the American Stock Exchange from 1978
to 1989 and later headed New York City's Economic
Development Corp. Clinton reappointed Levitt in
1998; when Levitt left, early this year, he had
been the longest-serving SEC chairman in
history.
Levitt was lionized in the media
as a champion of the small investor. "Even as he
leaves, Arthur Levitt is watching out for the
little guy," cooed an Associated Press (AP)
article in January. Early in his tenure Levitt had
taken on the NASDAQ stock market for alleged
price-fixing and forced the parent National
Association of Securities Dealers (NASD) to
reorganize its board. Despite the fact that Levitt
was a multimillionaire whom the Washington Post
had caught billing taxpayers for first-class
airline upgrades and luxury hotels, he was
depicted as an advocate of the small investor who
took on the Wall Street
establishment.
After Levitt left, it turned
out that the establishment likes him just fine.
Mark Lackritz, president of the Securities
Industry Association, Wall Street's biggest trade
group, told the AP, "He's been the most effective
SEC chairman we've ever had." Levitt now is
working as a senior analyst for the prestigious
and powerful Carlyle Group, a private
investment-equity firm filled with Washington
insiders such as former secretary of state James
Baker as senior counselor and former secretary of
defense Frank Carlucci as chairman.
"It
shows who he really took on, doesn't it?" Devine
says with a laugh. "The fact that the big boys
like him shows that talk about going after them
was just noise, but what he did to the little guys
was serious." James Steinkirchner, cochairman of
the National Small Public Company Leadership
Council, agrees. "He focused on eliminating small
companies and favoring big companies,"
Steinkirchner tells this magazine.
Insight
called Levitt's office at the Carlyle Group, but
he declined comment through his assistant. Former
Clinton-appointed SEC commissioner Steve Wallman
also declined comment.
Levitt's SEC claimed
to see thinly traded small companies, which the
agency called "microcaps," as a source for fraud.
The commission used this as an excuse to roll back
the Reagan and Bush policies that had built
prosperity by giving small companies more access
to the capital markets. There had been instances
of con artists hyping worthless companies and then
selling short, but instead of prosecuting fraud
through the federal laws already on the books, as
Reagan's SEC had done, Levitt's SEC punished
legitimate businesses by radically altering Rule
504 in 1999 to make it all but obsolete. Although
the SEC admitted in its new regulations that the
problem of fraud was small in scope, it expressed
concern that "recent market innovations and
technological changes, most notably the Internet,
have created the possibility of nationwide Rule
504 offerings" not regulated by the SEC.
The SEC banned companies from advertising
their Rule 504 offerings and banned purchasers
from selling their shares for at least a year,
forcing companies to sell to the big boys at a
deep discount because of lack of liquidity,
critics say. The only exceptions to the ban were
if the company registered in a state that had
cumbersome paperwork requirements similar to that
of the SEC, or if the company only sold shares to
people who met the SEC's narrow definition of
"accredited investors," of which there are only 5
million out of 41 million individual U.S.
investors. Rule 504 offerings, which had doubled
from 2,000 to about 4,000 per year during the
1990s, dropped sharply after the 1999 rule.
On top of that the SEC and NASDAQ's
parent, the NASD, ruled that only SEC-registered
companies could list on the Over-the-Counter (OTC)
Bulletin Board. The NASD and the SEC gave the
companies only a year to comply with the SEC's
costly and time-consuming registration process,
while the SEC apparently made no attempt to speed
up approvals. As a result, nearly 3,000 small
firms — one-half the firms on the OTC Bulletin
Board — were kicked off in 2000. Devine notes that
the market tumbled furiously just days after the
SEC's Rule 504 changes became effective in April
1999 and then again after the NASDAQ eligibility
process was finalized a year later. One of the
reasons, critics say, was that nervous investors
sold shares as they realized their small companies
no longer might be able to raise more funds from
the capital markets.
And while the SEC was
prodding the small firms to register, it did
nothing to simplify the paperwork, Devine says.
The General Accounting Office found that legal and
accounting fees to comply with regulatory
requirements for a stock offering now averaged
$439,000, eating up nearly one-half the $1 million
that had been exempted under Rule 504.
On
top of this the SEC added a burdensome new
requirement that prospectuses for new companies
had to meet the agency's definition of plain
English. "We need to start writing disclosure
documents in a language investors can understand:
plain English," Levitt wrote in an introduction to
the SEC's "Plain English Handbook" published in
1998. Here the SEC offered detailed instructions
such as: "Use the active voice with strong verbs"
and "Try personal pronouns" and "Keep your
sentences short."
But this was not just
advice. Company officials who went through the
process tell Insight that SEC regulators would
hold up a public offering if they disagreed with
the grammar in the prospectus, even if the
language was not misleading. "They said 'These
letters can't be capitalized.' We went two or
three rounds," says Greg Halpern, chief executive
officer (CEO) of Circle Group Internet, a
Mudelein, Ill., business-consulting firm that was
trying to go public. Joan Sweeney, chief operating
officer of Allied Capital Corp., a
business-development corporation that helps small
companies go public, says SEC regulators began to
nitpick over commas. She says companies very often
would miss their windows because SEC regulators
didn't agree with the documents' grammar and
style.
This is what happened to Halpern.
He took his paperwork to the SEC in July 1999, he
says. After spending more than $1 million in
accounting and legal fees for his company, which
takes in $1.5 million in annual revenue, he
decided to pull out when the SEC still hadn't
given the green light in September 2000. "By then,
the market was no good," he says.
Halpern
also says SEC employees weren't the friendliest in
the world. After he called to ask about the status
of his offering, the employees called his lawyer
to have him tell Halpern not to call. "The general
impression I had of the Levitt administration was
that if you're on the Internet and you're raising
money you can't be legitimate," he
says.
Steinkirchner blames Levitt's
policies for the credit crunch that crippled the
market. After small firms lost the public capital
markets as sources of funds, banks and venture
capitalists were deluged with more offers than
they could handle, drying up that source as
well.
And on top of that, Steinkirchner
adds, it's not even clear that Levitt achieved his
stated objective of protecting investors and
reducing fraud. While the grammarians at the SEC
were busy parsing words and complaining about
commas in the documents of innovative small firms,
enforcement was being ignored elsewhere. For
instance, old-line Enron Corp. and its accountants
apparently were publishing woefully inaccurate
figures under the agency's nose. "Enron just
caused more investor fraud than all the violations
of penny stocks and small caps, rolled up,
probably for the last two decades," Steinkirchner
says.
But the Levitt SEC did go after some
big companies — those that had clashed with the
Clinton administration. After the Justice
Department filed antitrust charges against
Microsoft, the SEC followed suit with an
accounting probe. It continues after two years,
even as the company is settling with the Justice
Department.
San Jose, Calif.-based Cypress
Semiconductor, whose outspoken CEO, libertarian
Republican T.J. Rodgers, had said, "I don't know
how the Clinton administration can maintain they
are friends of Silicon Valley," faced similar
difficulties. "They sort of stonewalled on
[approving Cypress'] acquisitions and shut us down
for a while," Rodgers tells Insight. He believes
"it came directly from Levitt." Rodgers remembers
scheduling a meeting with Levitt to discuss a
general policy issue and tells Insight that the
SEC boss "literally fell asleep in the meeting we
were in."
Fortunately, Devine says, Bush
now has his man, Harvey Pitt, chairing the SEC.
Small-business people have noticed a change in
environment since Levitt left. Halpern says
businesspeople he knows are getting their
offerings approved in 60 to 90 days, in contrast
to the 14 months in which his company's paperwork
was hung out to linger. Pitt recently told a group
of accountants that, from now on, "the commission
will make sound decisions in a respectful,
affirmative way, not in a demeaning, demanding or
demonizing way."
But Devine says Pitt will
have to do more than that. He will have to reverse
Levitt's policies as well as push further
deregulation, both to stimulate the economy and to
"place the blame where it belongs."
John
Berlau is a writer for Insight. Brandon
Spun, a reporter for Insight, assisted with
this article.
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