Change the Way Stock Prices Are Quoted to Help the Economy? The S.E.C. Is Skeptical

Harry Campbell

Call it the JOBS Act’s little brother.

Earlier this week, the House of Representatives, by an overwhelming vote of 412-4, passed the Small Cap Liquidity Reform Act, a bill to alter the way that stock prices are quoted. Given that almost nothing gets such bipartisan support, you’d think this would be a good thing.

An expert committee to advise the Securities and Exchange Commission on investor issues and the S.E.C. itself appear to disagree, and the evidence appears to be on their side.

The Small Cap Liquidity Reform Act would fundamentally change, by congressional fiat, the market for about 2,000 public companies. The act aims to make it easier to trade stocks of smaller companies — those with a market capitalization of $750 million or less — by rolling back the decimalization of stock quotes for all companies.

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Before 2000, stocks were quoted in eighths and sixteenths, a much wider spread than quoting stocks in pennies. The practice was controversial because it made trading more expensive for retail investors.

The beneficiaries were the market makers and brokerage firms that profited from trading these wide spreads. There were also accusations that brokers were fixing the quotations to keep spreads wider so they could make greater profits. Quoting prices in dollars and cents, rather than in fractions, was supposed to end this practice and benefit investors.

But in the last few years, the forces that passed the Jumpstart Our Business Startups Act, or JOBS Act, have argued that decimalization is hampering the I.P.O. market and thus job growth. Before the JOBS Act became law, a task force formed by the Treasury Department said decimalization was responsible for putting “the economic sustainability of sell-side research departments under stress by reducing the spreads and trading commissions that formerly helped to fund research analyst coverage.” In other words, many industry people charged by the Treasury Department to look at this concluded that the lack of sufficient profits to brokers on commissions and spreads was discouraging Wall Street firms from following the shares of smaller companies.

This report directly led to the passage of the JOBS Act, a bill that the S.E.C. also opposed. But the JOBS Act did not require a rollback of decimalization.

Instead, Congress ordered the S.E.C. to study the issue. If the S.E.C. decided that decimalization was a problem, the JOBS Act empowered the agency to limit decimalization by requiring stocks to be quoted in up to 10-cent increments. In its study, released in 2012, however, the S.E.C. staff recommended that the agency not increase tick size — the minimum movement of a trading instrument — but further study the issue.

This did not end the matter. A new group, the Equity Capital Formation Task Force, was founded to take up the cause. This task force describes itself as comprising “professionals from across America’s start-up and small-capitalization company ecosystems,” and its board includes representatives from N.Y.S.E., Nasdaq, venture capital firms and lawyers. The task force is co-led by the well-respected Jeffrey Solomon, chief executive of Cowen & Company, and Scott Kupor of Andreessen Horowitz.

The task force, in a report issued last year, recommended that there be a three- to five-year pilot program on rolling back decimalization. During this period, companies with market capitalizations of less than $750 million would be traded in 5-cent increments. The task force justified this as a pilot program because, although it encompasses thousands of public companies, it affects only 2 percent of the liquidity in traded stocks.

Once again, Congress is listening to an industry group instead of the S.E.C.

The Small Capital Liquidity Act largely adopted the task force’s recommendation but, this being Congress, takes it even further. The act would set up a five-year program in which all public companies with a market capitalization below $750 million would no longer have their stocks quoted in pennies. Instead, shares will be quoted in 5-cent increments or, if the company chooses, 10-cent increments. Companies would also have a one-time chance to opt out of the program altogether.

What could be wrong with a pilot program, you ask? While this is not a return to full fractional pricing, it still fundamentally restructures the market for thousands of companies against the apparent wishes of both the S.E.C. and its advisory committee on the matter. And it does so for five years, which some perceive to be an eternity in the capital markets.

In that 2012 report that the S.E.C. prepared under the JOBS Act, the agency reviewed the evidence on decimalization and concluded that “the impact of mandating an increase in the minimum tick size for small capitalization companies on the structure of our markets, and on the willingness of small companies to undertake initial public offerings is, at best, uncertain.” The S.E.C. made this recommendation because it found that previous studies of the effects of decimalization suggested that it “improved market quality, most notably for large capitalization securities.”

As for small- and medium-cap companies, the S.E.C. found that the research had determined the effect of decimalization, “particularly for spreads, appears to be relatively minor.”

The Investor Advisory Committee to the S.E.C., set up to represent investors, also agreed. The committee in its own reports found that “[t]he number of I.P.O.’s and companies listed on national exchanges in the U.S. actually started dropping in 1996, approximately five years prior to the adoption of decimalization.”

The committee also examined the evidence and recommended, with one dissent, that there be no pilot program for decimalization. The rationale was that the S.E.C had extensively studied the issue back before it adopted decimalization, and such a program would “test a policy that has, in the past, been shown to result in practices that are harmful to retail investors.”

The Equity Capital Formation Task Force does not directly address these reports but instead cites the success of the JOBS Act in renewing the I.P.O. market. It also cites the limited analyst coverage and volume in these stocks today along with the historical decline in initial public offerings. The task force also recommends a longer time period because its members believe that it takes this time for markets to adjust.

The task force is doing admirable work with a worthy goal of promoting growth, but it’s unclear whether the JOBS Act spurred last year’s I.P.O. surge. According to Capital IQ, there were nine I.P.O.’s in 2013 with market caps of less than $75 million. That is fewer than in 2010, before the JOBS Act, when there were 15. This is important because it was the loss of these low-capitalized I.P.O.’s back in the 1990s that spurred passage of the JOBS Act.

Instead, 46 percent of I.P.O.’s were large cap, for companies valued at more than $750 million, a modern day record. It doesn’t appear that the JOBS Act has had much effect in reviving the small I.P.O. market, which died off back in the 1990s before decimalization and passage of the Sarbanes-Oxley Act of 2002, which was aimed at preventing accounting fraud.

This fits in with what the academics have postulated, that the I.P.O. drought is simply a result of changes in our economy that channel large companies to the public markets and smaller companies to private sales. What most likely caused the I.P.O. boom last year was what most studies have found: a booming stock market, one of the best in history.

The evidence doesn’t favor adopting this bill, but that doesn’t mean that the Senate won’t also vote to pass it. This type of regulation is favored because it doesn’t require any cost-cutting or new taxes, while allowing Congress to say it is addressing the issue of jobs.

In other words, this legislation is built on a political dynamic and easy public relations arguments. This explains the overwhelming vote for the Small Cap Liquidity Reform Act of 2013. Yet, this could come at the expense of investors.

I’m willing to admit that, given the various opinions on the topic from very smart people, there is a compromise that may make sense. What Congress could do instead is defer to the S.E.C. and let the agency run a one- or two-year trading program with a small subset of companies. This could be done with more holistic measures like re-examining the controversial Regulation NMS, which requires brokers to obtain the best price.

A wider experiment in the markets would be justified in light of what I wrote earlier this week, that the markets are increasingly too fragmented and investors are losing out. In this case, any negative effects on investors would be minimized. It would also allow people to move on from this debate into perhaps bigger issues of reforming the markets entirely rather than through piecemeal direction from Congress.

A real experiment like this seems a better course than simply legislating a wholesale change in the markets – especially since it is a change that the evidence doesn’t seem to fully justify and that the S.E.C. doesn’t support.