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  Issue Date: 
Recession Shock
Posted Dec. 7, 2001

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.
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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