Tuesday, May 22, 2012

Capital market access & the problem of insider trading

The NYT asks, is insider trading part of the fabric of Wall Street? and answers yes, probably, with Lehman as a case study; while the Economist runs a story on the demise of the public corporation [gated] and with it, the diminishing opportunities for the middle class to participate in the capital markets.  This presents a tough juxtaposition.  We want people to have access to markets, but it's very difficult to overcome the information asymmetry that makes investing so risky for the less sophisticated/less connected (read: less rich) investors.

From the Times:
[E]vidence [points] to frequent insider trading involving analyst research at Lehman, but the S.E.C. ultimately did not bring a case. [A Lehman whistleblower] spent two and a half years giving information to the S.E.C. He produced materials indicating that Lehman sales representatives were tipped off to upcoming research changes; data showing suspicious trades in dozens of stocks; organizational charts and floor plans showing that some Lehman executives who were part of the research department were located near sales and trading desks. These departments are supposed to be separated. 
With that ammunition, the S.E.C. opened an investigation, case HO-10864. Officials told him that his evidence was credible. 
Then the case died. And after Lehman’s collapse its employees have scattered across Wall Street.
The whistleblowers' view is that insider trading is institutionalized:
The flow of information between a firm’s analysts, its traders and its clients — a lucrative heads-up on stock upgrades and downgrades, for instance — can bolster trading profits, brokerage commissions and, ultimately, Wall Street paydays. Those in the know can get rich before the rest of us know what happened.
 And from the Economist:
The public company was invented in the mid-19th century to provide the giants of the industrial age with capital. That Facebook is joining Microsoft and Google on the stockmarket suggests that public listings are performing the same miracle for the internet age. Not every 19th-century invention has weathered so well.
Yet more companies are staying private for as log as possible, e.g., Facebook, because going public entails compliance with a slew of regulatory regimes:
The burden of regulation has grown heavier for public companies since the collapse of Enron in 2001. Corporate chiefs complain that the combination of fussy regulators and demanding money managers makes it impossible to focus on long-term growth. Shareholders are also angry. Their interests seldom seem to be properly aligned at public companies with those of the managers, who often waste squillions on empire-building and sumptuous perks. Shareholders are typically too dispersed to monitor the men on the spot. 
...alternative corporate forms have addressed some of the structural weaknesses that once held them back. Access to capital? Private-equity firms, helped by tax breaks, and venture capitalists both have cash to spare, and there are private markets such as SecondMarket (where $1 billion-worth of shares has changed hands since 2008). Limited liability? Partners need no longer be fully liable, and firms can have as many partners as they want. Professional managers? Family firms employ them by the HBS-load and state-owned ones are no longer just sinecures for the well-connected. 
Does all this matter? The increase in the number of corporate forms is a good thing: a varied ecosystem is more robust. But there are reasons to worry about the decline of an organisation that has spread prosperity for 150 years.
Some reasons to worry: public companies "let in daylight" while "private companies and family firms operate in a fog of secrecy." But perhaps more importantly:
...public companies give ordinary people a chance to invest directly in capitalism’s most important wealth-creating machines. The 20th century saw shareholding broadened, as state firms were privatised and mutual funds proliferated. But today popular capitalism is in retreat. Fewer IPOs mean fewer chances for ordinary people to put their money into a future Google. The rise of private equity and the spread of private markets are returning power to a club of privileged investors.
So the Economist blames regulation (no surprise there) for making business owners want to stay private, thus depriving ordinary investors from sharing the wealth, with the result that business is run by rich insiders.  It concludes:
Because public companies sell shares to the unsophisticated, policymakers are right to regulate them more tightly than other forms of corporate organisation. But not so tightly that entrepreneurs start to dread the prospect of a public listing.
 I'd say there is precious little middle ground to work with here.

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