The law and economics of scaled equity market regulation.

• Author: Schwartz, Jeff

1. INTRODUCTION II. THE EVOLUTION OF SECURITIES MARKETS AND THE GROWING IMPORT OF REGULATORY SCALING A. The Public-Private Dichotomy B. Growing Dissatisfaction and Reform C. Legitimizing Regulatory Scaling Reforms III. THE MARGINAL-ANALYSIS MODEL A. Microeconomics Foundation B. Marginal Analysis as a Mechanism to Assess Regulatory Scaling C. Marginal Analysis in the Context of Securities Regulation 1. Outline of Securities Regulation 2. The Benefits of Securities Regulation a. Quantifying the Benefits of Securities Regulation 3. The Costs of Securities Regulation 4. Externalities and Efficiency IV. A MARGINAL ANALYSIS OF WHETHER SMALL AND EMERGING FIRMS SHOULD BE SUBJECT TO LESS REGULATION A. Regulatory Scaling for Smaller Firms 1. Marginal Benefits Analysis: Why Regulating Larger Firms May Yield Higher Marginal Benefits 2. Marginal Benefits Analysis: Why Regulating Smaller Firms May Yield Higher Marginal Benefits a. Small Firms and Investor Protection b. Small Firms and Retail Investors i. The Proportion of Retail Investors in Small Firms ii. The Susceptibility of Retail Investors as a Reason for Greater Regulation iii. Less Efficiency as a Reason for More Regulation (a) Inefficiency in the Small-Firm Arena (b) Regulatory Implications of Inefficiency 3. Comparison of Marginal Benefits 4. Marginal Costs a. Marginal Cost Comparison of Larger Versus Smaller Firms i. Absolute Costs of Securities Regulation ii. Proportional Costs of Securities Regulation 5. Summary of Marginal Analysis for Smaller Firms B. Marginal Analysis of Young Versus Mature Firms C. Exogenous Arguments 1. An Exogenous Argument for Regulatory Relief: The Positive Externalities of Small and Emerging Firms 2. Exogenous Arguments Against Regulatory Relief A. Reductions in Regulatory Costs are Offset by Increases in Costs of Capital B. Implementation-Related Concerns D. Potential Misgivings About Marginal Analysis V. GENERAL AND SPECIFIC POLICY IMPLICATIONS A. An Assessment of the IPO On-Ramp B. An Assessment of the SRC Regime VI. CONCLUSION I. INTRODUCTION

   The expanding scale and scope of securities regulation has been much praised and much condemned. (1) An accelerating countercurrent, however, has attracted far less attention. As the regulatory apparatus has grown, so too has fear that its requirements have become overly burdensome for younger and smaller firms. The policy offspring of this concern is the prescription that regulation should be scaled back for these entities to more appropriately reflect their age and size.

   This concept, in various incarnations, has been proposed by governmental advisory committees in recent years (2) and has won Congressional backing. The recently enacted Jumpstart Our Business Startups Act (the JOBS Act) was an effort at regulatory relief; (3) even the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), a statute otherwise noteworthy for its breadth, made special accommodations for smaller firms. (4) With a "JOBS Act 2.0" reportedly in the works, this trend shows no signs of abatement and foretells a significant shift in the regulatory structure of securities markets. (5)

   These efforts have been driven largely by a legitimate dissatisfaction with the current configuration of securities regulation, which has been called into doubt by a steep decline in initial public offerings (IPOs) and an accompanying contraction of the public markets. (6) But discontent with the status quo is an insufficient basis for such reforms; there must also be a case for why smaller and younger firms should be treated differently. Without this, there is no reason to think these changes improve matters.

   Despite the fundamental importance of this issue, policy materials rationalizing regulatory scaling gloss over it; (7) while the academic debate scrutinizes aspects of the problem, the literature is disjointed and underdeveloped. (8) This Article addresses the current void by directly and comprehensively considering whether there is a theoretical and empirical basis for subjecting small and emerging firms to reduced securities-law compliance obligations. I find that there is a good case for regulatory relief for small firms, but that the case for treating young firms similarly lacks solid support. (9) Building on these conclusions, I also argue that recent regulatory-scaling efforts are partially misdirected, and I provide suggestions about how the well-grounded portions can serve as the basis for future improvements to the regulatory structure. (10)

   This Article examines the probity of regulatory dispensation for small and emerging firms through a microeconomics lens. Doing so transcends the shallow policy rhetoric and transforms the rudderless academic debate about the topic into a structured analysis that depends on an empirically informed weighing of the relevant considerations.

   To see why a new perspective is necessary, consider part of the current discourse with regard to whether small firms should be subject to reduced regulation. Proponents argue that compliance is too expensive for these firms (11) and that they need less oversight anyway because there is less money at stake. (12) Skeptics counter the first argument by pointing out that costs loom larger for smaller firms only because they lack regulatory economies of scale. (13) That large firms have a competitive advantage because of the scale of their operations, the argument runs, is not a reason for reform. Commentators also have a response to the claim that, because less is at stake, less regulation is desirable. The counter is that this argument glosses over what is truly important. Critics argue that what matters is investor protection, and because smaller firms pose greater investor-protection concerns, they should be specially scrutinized.14 All of these arguments seem reasonable enough, but they are mostly superficial and incommensurable, rendering the debate amorphous and inconclusive.

   The case for and against tiered regulation can be rigorously assessed, however, through use of marginal analysis. According to standard welfare economics, society should enact all regulations that provide a net social benefit--and only such regulations. (15) The debate about regulatory scaling thus boils down to whether, all else being equal, regulations exist that yield net benefits when applied to some companies but not to others. If this is the case, those in the latter group of firms should be subject to less regulation. The question with regard to small companies is thus whether there are regulations that provide net benefits when applied to large firms but not to small ones.

   For young companies the question is analogous: are there regulations that provide net benefits when applied to mature firms but not to new ones?

   Marginal analysis provides a framework for making these determinations. In microeconomics, this approach describes the maximizing behavior of rational actors. (16) For instance, a for-profit company seeks to maximize net profits. It does so by increasing production up to the point where the marginal revenue of making one more unit equals its marginal cost. (17) By analogy, regulators maximize the net benefits of regulation by adding compliance obligations up to the point at which the benefit of an additional regulation (i.e., its marginal benefit) and the cost of that regulation (i.e., its marginal cost) are the same. (18) If that point is reached more quickly for smaller and emerging firms than for larger and established ones, then the former categories should be subject to reduced regulations.

   When net benefits run out is determined by the level of marginal benefits and marginal costs. When there are greater marginal benefits relative to marginal costs, more regulations provide net benefits. The key to figuring out the wisdom of regulatory scaling is, therefore, to examine the extent to which the marginal benefits and marginal costs of regulation vary depending on the size and maturity of the regulated firms. If there are greater marginal benefits relative to marginal costs associated with regulating larger firms as opposed to smaller ones, then more regulations yield net benefits when applied to the former, and the latter should, therefore, be subject to less regulation. (19) The same is true when considering the regulation of older firms compared to younger ones.

   A multitude of factors come into play in these analyses, and their effects must be weighed against each other. When looking at size, a strong case emerges for lesser regulation of smaller companies. Most importantly, because the positive effects of regulation are spread across a larger pool of capital, there are greater marginal benefits associated with regulating more sizable firms. (20) While there are opposing considerations, their total impact is likely insufficient to counterbalance the amplifying effect of increased scale. (21)

   With regard to young firms, the analysis does not yield a similar conclusion. Because of their inexperience, regulation is likely more costly for these companies. (22) While this points in favor of less regulation, other characteristics of youth suggest otherwise. For example, because newer firms may serve as a front for fly-by-night schemes, there may be greater marginal benefits to regulating them. (23) Unlike in the case of small firms, without more empirical evidence, it is ultimately unclear how the competing considerations ultimately balance out. Thus, whether to provide a lower regulatory tier for emerging firms based solely on their youth remains uncertain. This does not mean, however, that younger companies should be subject to the same regulations as mature ones. Because many young firms are small, they should qualify for special treatment thanks to this attribute.

   Though this Article's focus is on whether scaling regulation is good policy, a rough outline of what a reasonable lower regulatory tier for smaller firms...