Financial Markets and Institutions (2-downloads)

Unfilled Circuit City Limit Orders

Buy Orders

Sell Orders

37

100

37.12

300

37.25

100

37.37

200

37.50

500

37.62

100

Listed under Buy Orders are the highest prices

investors are willing to pay to buy the stock. Listed

under Sell Orders are the lowest prices investors

holding Circuit City are willing to accept to sell.

Currently, no transactions occur because there are no

cross-over or common prices. In other words, there is

currently no one willing to sell Circuit City at a price

anyone is willing to pay.

Unfilled Circuit City Limit Orders

Buy Orders

Sell Orders

36.88

500

37

100

37.12

100

37.50

500

37.62

100

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Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms

557

Due to asymmetric information, investors will not know as much about securi-

ties being offered for sale by firms as firm insiders will. If an average price is set for

all securities based on this lack of information, good securities would be withdrawn

and only poor and overpriced securities would remain for sale. With only these secu-

rities offered, the average price would fall. Now any securities worth more than this

new average would be withdrawn. Eventually, the market would fail as the average

security offered drops in quality and market prices fall as a result. One solution to the

lemons problem is for the government to regulate full disclosure so that asymmet-

ric information is reduced.

The securities laws were designed with two goals: to protect the integrity

of the markets and to restrict competition among securities firms so that they

would be less likely to fail. Two acts passed in 1933 and 1934 provide the pri-

mary basis for regulation of today’s securities markets. These acts were passed

shortly after the Great Depression and were largely responding to abuses that

many people at the time felt were partly responsible for the economic troubles

the country was suffering. The principal provisions of the 1933 and 1934 acts

are as follows:

•  To establish the Securities and Exchange Commission (SEC), which is

charged with administering securities laws

•  To require that issuers register new securities offerings and that they dis-

close all relevant information to potential investors

•  To require that all publicly held corporations file annual and semiannual

reports with the SEC; publicly held corporations must also file a report

whenever any event of “significant interest” to investors occurs

• To require that insiders file reports whenever shares are bought or sold

•  To prohibit any form of market manipulation

Prior to the passage of these acts, the market was subject to much abuse. For

example, a study conducted in 1933 showed evidence of 127 “investment pools” oper-

ating during 1932 alone. An investment pool is formed to manipulate the market. A

group of investors band together and spread false but damaging rumors about the

health of a firm. These rumors drive the price of the firm’s stock down. When the price

is depressed, the members of the pool buy the stock. Once they all hold shares pur-

chased at artificially low prices, the members of the pool release good news about the

company so that the price of the stock rises. Obviously, the members of the pool stand

to earn huge profits. Small, uninformed investors lose. Practices such as these were

outlawed by the securities acts of 1933 and 1934.

As noted in our discussion of private placements, not all securities issues are sub-

ject to SEC oversight. SEC registration is not required if less than $1.5 million in secu-

rities is issued per year, if the securities mature in less than 270 days, or if the

securities are issued by the U.S. government or most municipalities.

Other legislation of significance to securities firms include the Glass-Steagall Act

of 1933, which separated commercial and investment banking (mostly repealed by

the Gramm-Leach-Bliley Act); the Investment Advisers Act of 1940, which required

investment advisers to register with the SEC; and the Securities Protection

Corporation Act of 1970, which established the Securities Investor Protection

Corporation, which insures customers of securities firms from losses to their cash

accounts up to $100,000 and from losses of securities documents up to $500,000.

Other regulations related specifically to banks but of interest to securities firms are

discussed in Chapter 18.

Access the Securities and

Exchange Commission

Web site, 

www.sec.gov

,

which contains regulatory

actions, concept releases,

interpretive releases, 

and more.

G O   O N L I N E

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558

Part 6 The Financial Institutions Industry

Relationship Between Securities Firms and

Commercial Banks

For many years, commercial banks have lobbied for legislative relief to enable them

to compete with securities firms. Consider how the business of banking has been

eroded. Prior to the introduction of cash management accounts at Merrill Lynch,

the only source of checking accounts was a bank. The Merrill Lynch account not

only provided low-cost checking but also paid interest that was higher than the

law permitted banks to pay. Securities firms were allowed to make loans, offer

credit and debit cards, provide ATM access, and, most important, sell securities.

In addition, securities firms could sell some types of insurance. It is not hard to

understand why bankers were frustrated. Regulations prevented them from com-

peting with securities firms, but no laws restricted securities firms from compet-

ing with banks.

Commercial banks clamored on Capitol Hill for a “level playing field.” As noted

in Chapter 18 regulatory relief in 1980 and 1982 substantially slowed the movement

of funds from commercial banks to securities firms; however, banks were still not per-

mitted to sell securities. This is gradually changing.

Private Equity Investment

When you talk about investing, you are usually discussing stocks and bonds. Both of

these securities are sold to the public and have oversight by the SEC. The vast major-

ity of the volume handled by brokers and dealers is in these publicly held securi-

ties. However, there is an alternative to public equity investing, which is private

equity investing. With private equity investing, instead of raising capital by selling

securities to the public, a limited partnership is formed that raises money from a

small number of high-wealth investors. Within the broad universe of private equity

sectors, the two most common are venture funds and capital buyouts. In many

cases, the same firms are active in both arenas. Major investors in this industry

include KKR (Kohlberg, Kravis, Roberts & Co.), Bain Capital, and Blackstone Group.

Venture Capital Firms

Suppose that you develop and market a new process that you think has a great chance

of being a success. However, since it is new and unproven, you cannot get funding

from conventional sources. Commercial banks will not loan you money since there

is no established cash flow to use to repay the loan. It will be hard to sell stock to

the public through investment bankers because the company is so new and has not

yet proven that it can be successful. In the absence of alternative sources of funds,

your great idea may not have a true chance to be developed. Venture capital firms

provide the funds a start-up company needs to get established.

Description of Industry

Venture capital is usually defined as money supplied to

young, start-up firms. This money is most frequently raised by limited partnerships and

invested by the general partner in firms showing promise of high returns in the future.

Since the mid-1940s, venture capital firms have nurtured the growth of America’s

high-technology and entrepreneurial communities. Their activities have resulted in

job creation, economic growth, and international competitiveness. Venture capital-

ists backed many of the most successful high-technology companies during the 1980s

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Chapter 22 Investment Banks, Security Brokers and Dealers, and Venture Capital Firms

559

and 1990s, including Apple Computer, Cisco Systems, Genentech, Microsoft,

Netscape, and Sun Microsystems. A number of service firms, such as Staples,

Starbucks, and TCBY, also benefited from venture financing. Indeed, much of the

growth experienced through the 1980s and 1990s can be traced back to the fund-

ing provided by the venture capital industry. Table 22.2 shows the explosive growth

in venture capital funding witnessed during the 1990s and the rapid drop in activ-

ity after the markets fell in 2000 and 2009.

Venture Capitalists Reduce Asymmetric Information

Uncertainty and informa-

tion asymmetries frequently accompany start-up firms, especially in high-technology

communities. Managers of these firms may engage in wasteful expenditures, such

as leasing expensive office space, since the manager may benefit disproportionately

from them but does not bear their entire cost. The difficulty outside investors have

in tracking early-stage high-technology companies leads to other types of costs. For

example, a biotechnology company founder may invest in research that brings per-

sonal acclaim but little chance for significant returns to investors. As a result of these

informational asymmetries, external financing may be costly, difficult, or even impos-

sible to obtain.

TA B L E   2 2 . 2

Venture Capital Investments Made from 1990–2009