1.3The Environment forRaising Capital in the United States

The Legal Environment

Amyriad of regulations govern public debt and equity issues. These regulations cer-

tainly increase the costs of issuing public securities, but they also provide protection

for investors which enhances the value of the securities. The value of these regulations

can be illustrated by contrasting the situation in Western Europe and the United States,

where markets are highly regulated, to the situation in some of the emerging markets,

which are much less regulated. Amajor risk in the emerging markets is that shareholder

rights will not be respected and, as a result, many stocks traded in these markets sell

for substantially less than the value of their assets. For example, in 1995 Lukoil, Rus-

sia’s biggest oil company with proven reserves of 16 billion barrels, was valued at $850

million, which implies that its oil was worth about five cents a barrel.⁴At about the

same time, Royal Dutch/Shell, with about 17 billion barrels of reserves, had a market

value of $94 billion in 1995, making its oil worth more than $5 a barrel. Lukoil is

worth substantially less because of uncertainty about shareholders’rights in Russia.

Although economists and policymakers may argue about the optimal level of regula-

tion, most prefer the more highly regulated U.S. environment to that in the emerging

markets where shareholder rights are usually not as well defined.

Although government regulations play an important role for securities issued in the

United States, this was not always so. Regulation in the United States expanded sub-

stantially in the 1930s because of charges of stock price manipulation that came in the

wake of the 1929 stock market crash. Congress enacted several pieces of legislation

that radically altered the landscape for firms issuing securities. The three most impor-

tant pieces of legislation were the Securities Act of 1933, the Securities Exchange Act

of 1934, and the Banking Act of 1933 (commonly called the Glass-Steagall Act after

the two congressmen who sponsored it).

The Securities Acts of 1933 and 1934.The Securities Act of 1933and theSecuri-

ties Exchange Act of 1934require registration of all public offerings by firms except

short-term instruments (less than 270 days) and intrastate offerings. Specifically, the

acts require that companies file a registration statementwith the SEC. The required

registration statement contains:

⁴The Economist,Jan. 21, 1995.

Grinblatt44Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw44Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 1

Raising Capital

9

•	General information about the firm and detailed financial data.
•	Adescription of the security being issued.
•	The agreement between the investment bank that acts as the underwriter, whooriginates and distributes the issue, and the issuing firm.
•	The composition of the underwriting syndicate,a group of banks that sell theissue.

Most of the information in the registration statement must be made available to

investors in the form of a prospectus, a printed document that includes information

about the security and the firm. The prospectus is widely distributed before the sale of

the securities and bears the dire warning, printed in red ink, that the securities have not

yet been approved for sale.⁵

Once filed with the SEC, registration statements do not become effective for 20

days, the so-called cooling off period during which selling the stock is prohibited. If

the SEC determines that the registration statement is complete, they approve it or “make

it effective.” If, however, the registration exhibits egregious flaws, the SEC requires

that the firm fix it. Once the SEC approves the registration statement, the underwriter

is free to start selling the securities in what is known as the primary offering. The SEC’s

approval of the registration statement is not an endorsement of the security, but simply

an affirmation that the firm has met the disclosure requirements of the 1933 act.

Because all signatories to the registration statement are liable for any misstatements

it might contain, the underwriters must investigate the issuing company with due dili-

gence. Due diligencemeans investigating and disclosing any information that is rele-

vant to investors and providing an audit of the accounting numbers by a certified pub-

lic accounting firm. If material information is not disclosed and the security performs

poorly, the underwriters can be sued by investors.

The Glass-Steagall Act.In the wake of the Depression, Congress enacted the Bank-

ing Act of 1933, commonly called the Glass-Steagall Act. This legislation changed the

landscape of investment banking by requiring banks to divorce their commercial bank-

ing activities from their investment banking activities.

Glass-Steagall gave rise to many of the modern investment banks, both living and

defunct, that most finance professionals are familiar with today. For instance, the firms

of J. P. Morgan, Drexel, and Brown Brothers Harriman opted to abandon underwriting

and instead concentrate on private banking for wealthy individuals. Several partners

from J. P. Morgan and Drexel decided to form Morgan Stanley, an investment banking

firm. Similarly, the First Boston Corporation, now part of Credit Suisse, is derived from

the securities affiliate of the First National Bank of Boston.

After Glass-Steagall, firms that stayed in the underwriting business were forced to

build “Chinese walls” to separate their underwriting activities from other financial func-

tions. Chinese wallsinvolve structuring a company’s procedures to prevent certain

types of communication between the corporate side of the bank and the bank’s sales

and trading sectors. The underwriting part of these businesses must have no connec-

tion with other activities, such as stock recommendations, market making, and institu-

tional sales.

⁵Because of the red ink, prior to approval the prospectus is often called the “red herring.”

Grinblatt46Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw46Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

10Part IFinancial Markets and Financial Instruments

ATrend toward Deregulation.Roe (1994) advanced the provocative argument that

these three pieces of legislation and others, such as the Investment Company Act of

1940, which regulates mutual funds, and the Bank Holding Company Act of 1956,

which allows limited banking mergers, fundamentally altered the role of financial insti-

tutions in corporate governance. Roe argued that the legislation caused the fragmenta-

tion of financial institutions and institutional portfolios, thereby preventing the emer-

gence of powerful large-block shareholders who might exert pressure on management.

In contrast, countries such as Japan and Germany, which do not operate under the same

constraints, developed systems in which banks played a much larger role in firms’affairs.

Congress and the regulatory agencies, recognizing that U.S. financial institutions

are heavily constrained, have started relaxing these constraints. The Glass-Steagall

restrictions were repealed with the passage of the Financial Services Modernization Act

of 1999. Commercial and investment banks have been drawing closer to universal

banking; that is, they are beginning to offer a whole range of services from taking

deposits to selling securities. In addition, interstate banking was legalized in 1994.

Because of the fierce competition that these trends will generate, there will almost cer-

tainly be fewer commercial and investment banks in the United States in the future.

Surviving banks will tend to be bigger, better capitalized, and better prepared to serve

business firms in creative ways.