Judge Napolitano has written an excellent book on Natural Law from the perspective of an attorney.  He attacks legal Positivists, who believe the law is whatever the government says it is.  He points out the moral bankruptcy of Positivists by pointing out that they have no logical basis to be against Hitler’s final solution of wiping out all Jews – since it was a validly passed law.  He also rejects the non-sense of “majority rule” or Democracy.

He explains that Natural Law is like science.  He states:

Only man-made theories for what those rules are and how the operate may change.

However, without an explanation or understanding, those rules remain just as “true”: Penicillin will combat certain infections, and gravity will always pull things toward the center of the Earth, regardless of whether or not we understand how.

He also states something that will not sit well with conservatives:

Truisms reject moral relativism, and American Exceptionalism.  They compel and understanding of the laws of nature that animate and regulate all human beings at all times, in all places, and under all circumstances.  And truisms equal freedom.

The book starts off with the Declaration of Independents.  It moves onto eminent domain issues where the judge has a number of illuminating points.  I particularly liked the freedom of association chapter.  Napolitano I think is one of the few people to write about this issue.  I also found the right to petition chapter illuminating.  I believe that only someone with Judge Napolitano’s legal background could have done this chapter justice.  His chapter on the growth of the Defense Industry was illuminating.  While I did not agree with all his points, he makes it clear that the Defense Industry has grown completely out of control.  According to the Judge the US military is in over 130 countries.  The quote from Fredrick the Great comes to mind “in trying to defend everything he defended nothing.”  The US military has become just another welfare/crony capitalism project.  The military will complain that defense spending as a percentage of GDP is less than it was during the Korean War.  However, we did not have the Department of Homeland Security, the Department of Energy, the Border Patrol, etc, which are all really part of our defense spending at the time of the Korean War.

Unfortunately, the book is marred by two problems.  I am in complete agreement with the Judge’s emphasis on Natural Law, but he defines it in terms of “essential yearnings.”  Someone might have an essential yearning to torture people or kill them.  That does not make it a natural right.  It is enough to state that people have ownership of their body.  The rest of Natural Law and Natural Rights flows from this simple concept.  Once I own myself, I clearly own the product of my labor which leads to all of property law, including patents.  Criminal law comes from violating my rights in my body or in my property.  The “essential yearnings” adds nothing to the concept of Natural Law and Natural Rights.

The second problem with the book is Judge Napolitano’s analysis of fractional reserve banking.  The Judge and some Austrian economists incorrectly state that fractional reserve banking allows banks to create money out of nothing.  A fractional reserve bank is a bank that lends out part of its depositors money.  Fractional reserve banking is how all modern banks (since at least 1750s) operate.  Wikipedia defines a Fractional-reserve banking as a type of banking whereby the bank does not retain all of a customer’s deposits within the bank. Funds received by the bank are generally on-loan to other customers. This means that available funds (called bank reserves) are only a fraction (called the reserve ratio) of the quantity of deposits at the bank. As most bank deposits are treated as money in their own right, fractional reserve banking increases the money supply, and banks are said to create money.

The history of fractional reserve banking starts with the concept of an exchange bank.  I explain in my book, The Decline and Fall of the America Entrepreneur: How Little Known Laws and Regulations are Killing Innovation:

Modern banking started in the early 1600s with the Bank of Amsterdam.  Merchants could deposit coins with the Bank of Amsterdam and use this account to pay for transactions.  Using checks, a merchant’s account was debited and another merchant’s account was credited.  This meant that coins did not have to be transported from one merchant to another with the attendant risk of theft and loss or the cost of transportation.  The Bank of Amsterdam was just an exchange bank that facilitated transactions between merchants.  Next came the Swedish Riksbank established in 1656.  The Riksbank was not only an exchange bank, it also lent money making it the first modern fractional reserve bank.  Fractional reserve banking is the banking practice in which banks keep only a fraction of their deposits in reserve (as cash and other highly liquid assets) and lend out the remainder, while maintaining the simultaneous obligation to redeem all these deposits upon demand.  Commonly, loans are made against collateral such as land or jewelry.  … Some people believe fractional reserve banking creates money out of thin air, but what really happens was the money for these loans were backed by some collateral other than coins or bullion.  The downside of other types of collateral is they are not as liquid as species (coins, bullion).  As a result, if large numbers of customers of a fractional reserve bank wanted species (currency) at the same time, the bank would not able to fulfill all its customer’s demands.  This is a classic run on a bank.  A run on a bank is a cash flow issue.  A sound bank may have plenty of collateral and performing loans, but if most of its customers demand species at the same time it will not be able to fulfill these requests.  Fractional reserve banks free up capital from low performing assets so that they can be invested in higher performing assets.  For example, if you owned a large tract of ranching land that was not highly profitable but represented a large amount of capital and you want to invest in an oil well, without fractional reserve banking you would have to sell some of the land in order to invest.  With fractional reserve banking you could convert your land into a generally accepted form of money, by pledging your land as collateral to a bank for a loan.  In the modern world, the loan to you is just a computer entry in your bank account.

It is clear from history that fractional reserve banks are not some sort of government institution, like the Federal Reserve.  Without fractional reserve banking it is would be very difficult to securitize (Collateralize) many assets, such as houses and land.  This would significantly impede the economic growth of a country.  Logically if you are against fractional reserve banking you should be against a stock market.  Both are just a way of securitizing assets.  The stock of paper money act as a claim against various assets and/or future earnings.

When Sarbanes Oxley was passed, the SEC (Securities and Exchange Commission) estimated the cost of compliance would be $91,000.00 per year for each public company.  The most recent estimates for the cost of compliance are between $4.0 million and $5.0 million per year for publicly traded companies.  This clearly has an affect on the number of IPOs.

Is the cost of this law worth its incredible price? Has Sarbanes Oxley achieved its goal of protecting investors from fraud?  Sarbanes Oxley has cost the U.S. economy at least $400 billion since it passage.  This is just the direct costs and does not include the opportunity costs, which are most likely substantially higher.  The stock market has been flat or declining since its passage.  As a result, it is hard to argue that this legislation increased shareholder value.  The banking scandals of 2008 & 2009 that included Bear Sterns, Lehman Brothers, American International Group (AIG), Merrill Lynch, and the Bernie Madoff fraud make it impossible to suggest that Sarbanes Oxley has protected investors from fraud.

An ironic result about these rules is that the liberal left that pushed these socialist rules is unhappy with them.  They feel that the rules did not go far enough and that the regulatory process was captured by large companies.  Gee, that’s surprising.  Just look at how large Wall Street banks have used financial regulation to get rid of competition.  The large railroads did the same thing years ago.

Another ironic angle of these rules is that no consumer has come forward to complain about the way the internet works today.  A couple of very large technology companies have complained about issues of access.  They are part of the socialist groups that want to take someone else’s property without paying for it.  This is ultimately a fight between large companies that want to use the government to game the system in their favor.

A sad result of these rules is the useful idiots who believed that by supporting Net Neutrality they were supporting freedom and instead were supporting repression.  The FCC is out of control.  This is another assault by the FCC on free speech.  The FCC should be abolished.

The things that effect the IPO market are the cost of going public, the return for going public, the alternatives to going public, and the willingness of an investment bank to take you public (might be part of the cost).  While not stated explicitly in the report, they seem to imply that there is little incentive for investment banks to take small companies public or to create a market in their securities after the fact.  If true, I think this would contribute to the IPO downturn, but I do not think they have stated their case very strongly.

It is common for a small company thinking about an IPO to compare going public to private equity (including venture capital), bank loans, and strategic partnerships.  At any given time the advantage of one type of financing method varies compared to other modes of financing.  It is my opinion (unsubstantiated) that in the late 90s venture capital was a better choice than going public for a small IPO.  So I do not buy their argument that the IPO market for small public offerings were necessarily falling off for the reasons they state.  I think there were more attractive alternatives for small IPOs at that point in time.

In general, I do not think a great alternative to going public has been developed in the last decade.  The report does not mention any new alternatives.  I do not think the decline in IPOs is due to a competing source of financing or just the normal fluctuations between types of financing.  This is not a small decline in the number of IPOs it is cataclysmic change.

The speculation, lack of quality research and online brokerage argument seem like red herrings, especially speculation.  This is always a favorite whipping boy of all populist since the beginning of stock markets, maybe markets generally.  The other factors only seem relevant if they have decreased the value of an investment bank’s participation in taking a company public.  I do not have enough information here but the points they list do not appear large enough to result in a cataclysmic change.

By process of elimination it appears that the most relevant factor is the cost of going public or more broadly the return for going public.  SOX has clearly increased the cost of going public and reduced the return of being a public company.  I am not saying that it is only factor, but it appears to me that it probably is the major factor.  A weak patent system has also inhibit small company creation and growth.  There are probably other factors, but they fail to met Occam’s razor in my opinion.  SOX is the simplest explanation for the decline in IPOs that is consistent with the facts.

In 1996 60% of worldwide IPOs went public in the US.  In 2005 only 20% of worldwide IPOs were in the US.  The US is the only major country to have fewer public companies today than a decade ago.  As far as I know online trading is available in all these other countries.  There is no reason to suggest that the amount of speculation is different between the US market and other foreign markets.  All these facts seem consistent with SOX being the major factor for the decline in IPOs.

Sarbanes Oxley has severely damaged the technology start-up market and the financial industry in the U.S.  Sarbox is very expensive: including enormous direct and indirect costs to our economy and to innovation.  It has not met its goals of improving the quality of auditing or preventing fraud.  The effects of this law include fewer public companies, fewer companies going public, more companies choosing to go public in foreign markets, absurdly high auditing expenses and a significant decrease in risk capital.

For More information see Sarbanes Oxley – Is the Medicine Worse Than the Disease – 1 and Sarbanes Oxley – Is the Medicine Worse Than the Disease – 2 .

The FCC’s response is that all their proposed rules include the limitation “Subject to reasonable network management.”  They argue this prevents the FCC from being overly onerous in the application of these rules.  Of course, the catch is who gets to determine what is reasonable.  If it is the internet providers, then the rules are meaningless, since they will clearly believe that their network management is reasonable.  Thus, it is clear that the FCC intends that someone other than the internet providers, get to decide what is reasonable.  We know from history this will be lawyers, special interest groups, and large corporations defining reasonable to meet their special interest at the expense of the owners of the network and the public in general. 

 In addition to limiting innovation, the Net Neutrality rules are widely seen as the first step in a “Fairness Doctrine” for the internet.  The Fairness Doctrine, which applies to radio and television, has been used to stifle free speech in this country.  The Fairness Doctrine will kill the value of the internet as an outlet to monitor and police the government. 

 There is no justification for the Net Neutrality rules, they will stifle innovation, and they will lead to a Fairness Doctrine for the internet.

            Before delving into the rules of stock options, it will be helpful to first define the role of accounting.  Dictionary.com defines accounting as a detailed report of the financial state or transactions of a person or entity.  In layman’s terms accounting is the measurement of financial parameters.  A key concept in measuring physical parameters is to make sure the measurement system does not disturb the parameter being measured.  If the measurement system alters the system being measured, then the user does not know how the system is behaving or how to adjust the system to meet the objectives of the user.  Analogously, the goal of accounting should be to measure the financial parameters without altering the business being measured, so the client can make decisions about how they want to run their business.  As we will see, the FASB rule on stock options is so complicated and expensive that it alters the entity being measured. 

            According to an article in the Journal of Business & Economic Research,[1] stock options were necessitated by the separation of company ownership and management.  Stock options were used to overcome the “agency problem” and tie the interests of management and owners.[2]  In 1972, the Accounting Principles Board (APB) Opinion No. 25, defined how to account for stock options.  This rule only required expensing stock options that had intrinsic value – in the money options with a strike price below the market value.  Between 1985 and 1988 FASB conducted research on stock based compensation programs.[3]  The conclusion was companies should be required to expense the fair value of stock options, resulting in out of the money stock options being expensed.  Many high technology companies criticized the conclusions and FASB received over 200 letters on the issue, most of which were critical of the proposed rule.[4]  During 1992-1993, FASB again reviewed the issue of employee stock options.  They reached the same conclusion as in 1988 and received over 450 letters mainly against the proposed change.  Opponents of expensing employee stock options argued that expensing stock options would result in their elimination.[5]  The other concern was that companies’ earnings per share would be significantly reduced by the extra phantom expense. 

            Despite this, Congress and the SEC (Securities and Exchange Commission) applied intense pressure on FASB to change the rule in the early 2000’s.  FASB reasserted its position in 2004 that employee stock options without any intrinsic value should be expensed.  This time, they received over 6,000 letters mainly against the rule.  The critics against expensing stock options included several Nobel Prize winning economists.  In December 2005 FASB implemented a rule, statement no. 123, requiring expensing of options.  Why did FASB implement a rule that went against the wishes of many of their clients?  The accounting profession is supposed to provide financial information for their clients, that the clients believe is useful in running their business.  Unfortunately, most accountants do not work for the people that pay them.  For instance, if you hire an accountant to help you with your taxes, the law has made it clear that the accountant’s first obligation is to the IRS – not to the client paying them.  Today as a result, it is almost impossible to get good tax advice now days.  Accountants preparing the books for a publicly traded company have a greater duty to the SEC than to the company paying their bill.  Other accountants do DOD (Department of Defense) auditing work or Medicare auditing work.  In all these cases the accountant is preparing information for the benefit of a government agency instead of the client.  As a result, many accountants do not consider a company’s goals for their accounting system to be important.   

            Government intrusion into accounting has changed it from a tool for business when making decisions into a government compliance issue.  As a result, some CEOs are suggesting that recent changes in the accounting rules, including those relating to stock options, have made it impossible for them to understand what is happening in their own business.[6]  The goal of accounting should be to measure the financial parameters that businesses find important, not measuring parameters the government believes are important. 

            Does the expensing of employee stock options make sense economically?  Bob Pavey in the November 2002 NVCA magazine points out that employee stock options neither result in a cash cost to the issuing company nor do they result in an opportunity cost.  He shows that there is no cash cost to the company by the hypothetical situation where a company with a thousand shares, grants a thousand shares to a new shareholder.  The company now has 2000 shares, but its revenues, expenses and assets are exactly the same as they were before the grant.  Similarly, granting stock options does not change the cash situation of the company, and the exercising of these stock options does not change the cash situation of the company either.  Since there will never be a cash expense associated with the granting of a stock option, why should companies have include a phantom expense for these options?  According to Mr. Pavey, the company has not incurred any opportunity costs since the company has not foreclosed any other equity sales opportunities.  The justification used by FASB and proponents of expensing stock options is that they have value to the employees receiving them.  If I own the rights to a book with a royalty stream and I assign a portion of that royalty stream to another person, I have not incurred an expense and neither has the book.  The assignment of a portion of the royalty stream has value to the other person, but no expense is incurred because of that transaction.  Expensing stock options does not make sense logically.  This is the same conclusion reached by a UC Berkeley business school position paper in 2006 that was signed by several Nobel Prize winning economists. 

            Another justification given by FASB for expensing stock options is that it would achieve convergence between U.S. and international accounting standards.  Is this a good reason for passing a law/rule?  This reasoning has weakened our patent laws and is used here to again attack the foundations of our high technology start-up community. 

            There is no logical way to determine the value of an employee stock option for a non-publicly traded company.  The Black Scholes model is based on an actively traded market for options.  In addition, this model was designed for options that are freely traded, while most employee stock options have a number of restrictions.  FASB’s solution is to suggest that companies use a lattice model to expense employee stock options.  According to Wikipedia:

a lattice model can be used to find the fair value of a stock option. The model divides time between now and the option’s expiration into N discrete periods. At the specific time n, the model has an infinite number of outcomes at time n + 1 such that every possible change in the state of the world between n and n + 1 is captured in a branch. This process is iterated until every possible path between n = 0 and n = N is mapped. Probabilities are then estimated for every n to n + 1 path. The outcomes and probabilities flow backwards through the tree until a fair value of the option today is calculated. A simple lattice model for options is the binomial options pricing model.

The lattice model is clearly a very complex method of estimating the unknown and the unknowable.  The complexity of expensing stock options has resulted in most start-up companies no longer issuing them.  As a result, the FASB rule on expensing stock options fails the goal of accounting – to measure an entity’s financial parameters without affecting them.  Washington accountants are dictating how businesses can conduct their business with this rule.

            This rule should be repealed.  Employee stock options should never be expensed, even when they are “in the money” at the time of grant.  Stock options should only be taxed when converted into cash.  One of the supposed benefits of an income tax is that liability is only incurred when a person has the means to pay the tax.  Presently, stock options are generally taxed when converted to stock.  This has lead to some disastrous situations where an employee exercises their stock options and incurs tax liability, but shortly thereafter the stock price crashes and selling all of the stock does not even cover the tax liability.  The federal government wants the best of both worlds: to tax non-cash transfers but refusing to accept anything but legal tender.  As long as there are legal tender rules, income should only be recognized when an entity receives legal tender. 

[2] Ibid. p. 32.

[3] Ibid. p. 32.

[4] Ibid. p.32.

[5] Ibid. p. 33.

[6] Rodgers, T.J., “Corporate Accounting Congress and FASB Ignore Business Realities” Cato Institute Briefing Papers, No. 77, October 25, 2002.

This continues the trend of falling allowance rates that started in 2002. Why has the allowance rate changed so dramatically in the last six years?  Sometime early in this decade, the USPTO started to define the “quality” of examinations by the allowance rate.  The USPTO tracks the allowance rate of every examiner and grades the quality of their examinations by their allowance rate.  If one examiner’s allowance rate is higher than the average allowance rate of the group they work in, their examination of applications will be considered to be of lower quality.  If an examiner never allows any patent applications, they will be considered to have the highest quality examinations.  This has created a perverse incentive for examiners.

For an update on the allowance rate click here.

 In this article we will examine whether there is a lack of scarcity in the adoption and distribution of new technology.

            Tangible property rights include real property rights in land and buildings and personal property rights in things like cars and furniture.  Tangible or physical property is scarce since it can only be owned by one person at a time and it takes resources to create.  Intangible or intellectual property such as patents and copyrights, and software in the case of the open source community, is not scarce according to this theory.  Multiple people may own intellectual property without excluding others from the property.  According to Tom G. Palmer a proponent of the scarcity theory of property:

It is this scarcity that gives rise to property rights.  Intellectual property rights, however, do not rest on a natural  scarcity of goods, but on an “artificial, self created scarcity.”[2]

If Mr. Palmer is correct we would expect that in the absence of intellectual property rights new technologices would be instantly and universally adopted.

            Scientific principles are not subject to intellectual property rights.  Calculus was discovered over 300 year ago and is not the subject of intellectual property rights.  Despite this only a small percentage of the population understands it even in the most advanced economies.  Those people that do understand calculus generally paid an instructor to learn this area of math even though books on the subject can be reviewed for free at many libraries.  Almost everything a student learns through formal education, even in graduate school, is information that is readily available.  Even if the text book is copyrighted, the information is usually available in a non-copyrighted form or available for free from a library.  Despite this the U.S. spends over $500 billion a year on all forms of education.  Clearly, the cost of adopting and distribution ideas including inventions is not free and is subject to scarcity.

            According to venture capitalists, most start-ups will spend 2-10 times the amount on marketing their inventions than on developing them.  If the distribution of ideas was free, not subject to scarcity, this would clearly be unnecessary.

            University professors, doctors, lawyers, engineers, judges, marketers, sales people and computer scientists are mainly in the business of distributing or implementing known information.  If distributing information is free, not subject to scarcity, then all these people should either be thrown in jail for fraud or paid less than the average day laborer. 

            The U.S. has historically provided the strongest legal protection for inventions.[3]  The U.S. is not only the leader in the creation of new technology, but has had the fastest adoption and diffusion of new technologies.  Countries that had or have weak patent laws are associated with the slowest adoption and diffusion rates for new technologies.  This is in complete contradiction to the expected result predicted by advocates of the scarcity theory of property.

            The libertarians and open source advocates are clearly incorrect that inventions and ideas are not subject to scarcity.  This scarcity is not artificially induced, since strong patent laws are associate with greater rates of technology adoption and diffusion. 

            Advocates of the scarcity theory of property are correct that two people can understand the same idea (calculus) without diminishing the supply of the idea.  However, this is not the same thing as both people being the inventor of or discover of the idea.  Just because I understand calculus does not make me the discoverer of calculus any more than understanding how a steam engine works makes me the inventor of the steam engine.  If I were to conceive special relativity without any knowledge that Einstein had already discovered special relativity, this would not make me the discoverer of special relativity.  I did not add any information to the store of human knowledge, by my independent discovery.  The same is true of inventors, just because someone independently comes up with an idea after the inventor, does not make them an inventor.  An inventor is the person who adds to the store of human knowledge.  Being second, even without knowing that you are second does not add to the store of human knowledge or make you an inventor.  The patent laws require the inventor to be the first in the world to create an idea.

            The debate over the whether property rights are conceptually based on scarcity or based on the right of a person to their labor both physical and mental is not just an academic exercise.  Failure to provide strong legal protection to inventors has severe consequences for our economic growth rate.  The U.S. does not have the luxury of just adopting other countries’ technology to provide economic growth, it must innovate in order to have an increasing standard of living for its citizens.  By denying the value of intellectual labor, libertarians have more closely aligned themselves with Marx’s labor (physical) theory of value than with the free market.  Adopting their approach will result in the same disastrous consequences as has occurred to countries that have adopted socialism and communism. 

[2] Palmer, Tom G., “Are Patents and Copyright Morally Justified? The Philosophy of Property Rights and Ideal Objects”, Harvard Journal of Law & Public Policy, Vol. 13, No. 3, Summer 1990, p. 865.

[3] Khan, Zorina B., The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920, Cambridge University Press, 2005, p. 298.

According to John Cogan, Jr., professor of Law and Economics and Harvard:

The primary goal of the Sarbanes Oxley Act was to fix auditing of U.S. public companies, consistent with its full, official name: the Public Company Accounting Reform and Investor Protection Act of 2002.  By consensus, auditing had been working poorly, and increasingly so.  The most important, and most promising, part of SarbanesOxley was the creation of a unique, quasi-public institution to oversee and regulate auditing, the Public Company Accounting Oversight Board (PCAOB).  In controversial section 404, the law also created new disclosure-based incentives for firms to spend money on internal controls, above increases that would have occurred after the corporate scandals of the early 2000s.[1]

The alleged benefits of Sarbanes Banes Oxley, in exchange for the costs of auditing, included:

“Investors will face a lower risk of losses from fraud and theft, and benefit from more reliable financial reporting, greater transparency, and accountability.  Public companies will pay a lower cost of capital, and the economy will benefit because of a better allocation of resources and faster growth.”[2]

When Sarbanes Oxley was passed, the SEC (Securities and Exchange Commission) estimated the cost of compliance would be $91,000.00 per year for each public company.  The most recent estimates for the cost of compliance are between $4.0 million and $5.0 million per year for publicly traded companies.  The United States has over 18,000 public companies, which means the U.S. spends around $80 Billion a year to comply with Sarbanes Oxley.  How much is $80 Billion a year?  It is roughly equal to IBM’s revenues per year, and about the cost of the auto industry bailout.

Is the cost of this law worth its incredible price?  Has Sarbanes Oxley achieved its goal of protecting investors from fraud?  Sarbanes Oxley has cost the U.S. economy at least $400 billion since it passage.  This is just the direct costs and does not include the opportunity costs, which are most likely substantially higher.  The stock market has been flat or declining since its passage.  As a result, it is hard to argue that this legislation increased shareholder value.  The banking scandals of 2008 & 2009 that included Bear Sterns, Lehman Brothers, American International Group (AIG), Merrill Lynch, and the Bernie Madoff fraud make it impossible to suggest that Sarbanes Oxley has protected investors from fraud.

Sources report that 100 to 200 publicly owned companies per year, including big names such as Dunkin’ Donuts and Neiman Marcus, have chosen to buy out their stockholders and revert to private ownership since Sarbanes Oxley was passed.  Many U.S. private firms are putting off initial public offerings, and more foreign companies are choosing to list on the Tokyo, London or other foreign exchanges rather than on the U.S. stock exchanges.

Sarbanes Oxley has essentially killed off the public market as an exit strategy for technology start-up companies, thereby reducing investment in innovative start-up companies.  In the second quarter of 2008, there were no public offerings of Silicon Valley venture capital-backed companies, a phenomenon not seen since 1978.  At $4-5 million per year for a company to go public and comply with Sarbanes Oxley, a company must have earnings of about $100 million and sales of around $1 billion.  Given these astronomical hurdles to an IPO (Initial Public Offer), it is not surprising that start-up companies no longer consider an IPO a realistic exit strategy.  By closing off the public market to start-up companies, the amount of risk capital available (e.g., venture capital) has declined precipitously.

Conclusion

Sarbanes Oxley is very expensive: including enormous direct and indirect costs to our economy and to innovation.  It has not met its goals of improving the quality of auditing or preventing fraud.  Nor have any of the benefits of these costs materialized.  Public companies have not experienced lower capital costs, investors have not been protected from fraud and there has not been faster economic growth due to more efficient allocation of resources.  The effects of this law include fewer public companies, fewer companies going public, more companies choosing to go public in foreign markets, absurdly high auditing expenses and a significant decrease in risk capital.

Interestingly, a number of econometric studies of the effectiveness of the SEC and securities laws before and after Sarbanes Oxley have shown no net effect on investor returns.[3] According to Liu et al. “we find that the conditional mean and variance of monthly total real stock returns were no different

during 1940-2007 than during 1871-1925.  Consequently, recent claims by high ranking government officials that stock market “stabilization” requires increased federal regulation implies greater faith in this method of protecting investors than is supported by the evidence.”[4] What these studies do not account for is the lost opportunity costs due to all the securities laws.  At least in the case of Sarbanes Oxley, the opportunity costs most likely far outweigh the direct costs.

Since the public market is not an option for innovative start-up companies, why don’t risk capital investors and company founders just obtain their return on investment through dividends and salary or alternatively, sell out to another public company?  Selling out to another public or private company has been the major exit strategy for most start-ups in the last decade (2000-2009).  The problem with this solution the limited number of companies that can purchase start-ups and generally these companies want to pay for the start-up with their stock.  Only when companies that believe their stock is well valued are likely to engage in acquisitions.  Because Sarbanes Oxley limits the number of companies in the public market, it limits public stocks that investors can purchase to mature, slower growing companies.  As a result, most public companies’ valuation by the market is not high and the amount of money they can pay for a start-up is correspondingly lower.

There are three reasons why dividends and salary are not good substitutes for going public: 1) taxes are higher on dividends and salary than on capital gains, 2) this requires pulling cash out of a company that needs the cash to grow, and 3) the timeframe to obtain the return is ten years or longer than a public offering.  Taxes on dividends and salary are at least double the taxes on capital gains.  Also, the founders and investors are only taxed when they sell their stock.  They may never sell all of their stock, further reducing the tax burden.

When a start-up goes public it infuses money into the company allowing it to grow faster.  The investors and founders can use the companies stock as money instead of withdrawing cash from the company.  Since the stock is now publicly traded, the founders can be confident that if they need cash they can sell some of their stock at that time.  This reduces their propensity to sell the stock immediately.  Venture capital firms can use the stock to pay off their investors or hold, confident that if they need cash they can sell some of their stock at that time.  The company can use its stock to purchase other start-ups.

If the founders and investors are limited to salary and dividends for their return and assuming the company would have a ten times multiple on earnings, it would take at least ten years for the founders and investors to obtain the same return.  When you add in the additional taxes for salary and dividends compared to going public and the time value of money, it would probably take even longer than ten years to obtain the same return.  This would slow the company’s growth by starving it for capital.

How should we reform securities laws to encourage innovation?  First, we should repeal Sarbanes Oxley.  In the 1990s the U.S. was the innovation leader of the world, state and federal tax revenues were burgeoning, and the stock market was booming.  This was the result of a thriving technology start-up ecosystem.  Then we passed Sarbanes Oxley and the stock market is down, the U.S. is no longer innovating and federal and state budgets are bleeding.  Sarbanes Oxley is a direct attack on the technology start-up ecosystem, starving it for capital.

Since there is no evidence for the efficacy of securities laws, the regulatory burden of these laws should be drastically reduced.  Regulation should be limited to requiring quarterly financial statements.  The goal of securities laws should not be to create “perfect competition” among investors.  Perfect competition is the enemy of innovation, resulting in investor apathy over which stocks they buy.  Ultimately, the question is whether the U.S going to choose the path of France after the Mississippi Company collapse and renounce innovation or the path of England after the South Sea bubble and embrace innovation?

[2] Ibid. p. 92.

[3] Liu, Tung, Santoni, Gary J., Stone, Courtenay C.,   Federal Securities Regulations and Stock Market Returns.  This paper surveys several papers that have studied the effects of securities laws all of which show no meaningful change in investor outcomes.

[4] Ibid. p. 21.