THE DEVELOPMENT OF MICRO-CAP SECURITIES MARKETS IN
SUB-SAHARAN AFRICA: NEW APPROACHES TO FOSTERING ENTERPRISE GROWTH
by Professor Stuart R. COHN
(Article Reference: Document No.18, November 2002)

Proposals for Development of Micro-Cap Markets
In response to the problems and concerns discussed above, adoption of several new measures are necessary to foster micro-cap markets in which SME securities can be sold and traded. They include the following:

(A) Exemptions for Registration

Registration requirements, whether contained in company laws or securities laws, should be modified to allow exemptions from registration for qualifying SME's that conduct small or otherwise limited offerings of securities. Exemptions could be developed based upon one or more of the following elements:

• the amount of securities being offered,
  
• the knowledge and experience of the potential investors
  
• the relationship of potential investors to the company
  
• the financial abilities of the potential investors
  
• the degree of government regulation already applicable to the issuing company (such as regulated entities), or such other factors as policy-makers consider appropriate. In the United States, different exemptions from registration exist for offerings up to $1 million (Rule 504), offerings up to $5 million (Rule 505 and Regulation A), and for offerings of an unlimited amount directed at knowledgeable and experienced investors (Rule 506 and Section 4(2)). Based on analogous factors, registration exemptions in SSA countries could be considered, for example:
  
  • for offerings below a certain amount,
    
  • for offerings between certain minimum and maximum amounts that are accompanied by basic disclosure documents,
    
  • for offerings only to experienced and capable investors, such as institutional investors, investment funds, unit trusts, and persons meeting net worth tests (called "accredited investors" in the United States),
    
  • offerings limited to persons who have a direct relationship to the company, such as employees, creditors, suppliers, consultants, and principal customers.

Investor protection must continue to be a central element of all securities offerings. The following measures are among those that could be considered appropriate in adopting registration exemptions:

• Exempt securities offerings would continue to be subject to all liability provisions applicable to registered offerings. The exemption would apply only to registration, not to disclosure liabilities.
  
• All exempt offerings would be made only through a written disclosure document provided in advance to all purchasers. No offers to purchase securities could be accepted without prior delivery of the disclosure document.
  
• The requirement for audited financial statements could be modified or entirely eliminated for some types of offerings, but un-audited financial information should be set forth to the same extent and in the same manner as with audited statements.
  
• The disclosure document need only contain fundamental information that is necessary to an understanding of the company and its management. Such fundamental information could include, for example:
  
  • a brief history of the company
    
  • names and business experiences of each of the directors and officers
    
  • description of any transactions entered into or proposed between the company and any of its directors or officers
    
  • description of the products and services provided by the company, with approximate percentage of respective contributions to revenues and profits
    
  • proposed use of proceeds of the offering
    
  • information regarding the potential secondary trading market for the securities
    
  • a list of risk factors advising potential investors of the principal categories and risks faced by the company and shareholders.
    
  • The securities commission, capital markets authority, or Central Bank division charged with supervisory powers regarding securities offerings could consider adopting "merit review" standards for exempt offerings. The concept of merit review allows agencies to refuse to permit an offering to proceed if the agency concludes that the offering involves to high a risk of loss to investors. There is a wealth of merit review standards developed by the North American Securities Administration Association (NASAA) that could serve as a basis for adoption of local standards. Regulators should keep in mind, however, that SME's often experience difficult times in early years. If offerings are not allowed to go forward until certain profit levels or assets are achieved, the purpose of promoting SME offerings may be significantly undermined.
    
  • Directors, officers, and other insiders should be prohibited from immediately selling their shares in whatever secondary market is created by reason of the SME's public offering. Such sales would have the inevitable effect of depressing market value, leaving the newer shareholders holding shares that might have a reduced market value. Exempt offerings should include the requirement that company insiders can sell their own shares in the ensuing public market in limited quantities spaced over time. This is analogous to the Rule 144 in the United States that applies such resale limitations on all control persons.

(B) Creation of An Over-The-Counter Market

Just as the privatization movement required the establishment of stock exchanges in those countries lacking them, so too the loosening of strictures on SME securities offerings requires the development of an over-the-counter market. As previously noted, most SME's will not qualify for stock exchange listing, even after engaging in a public sale of securities. Tier II eligibility standards might be met for exchanges that create tiers, but the trading experiences for Tier II companies have not been generally successful. One approach to the 2-tier problem is to have only one tier of listed companies, all meeting the same listing standards. This would require a reduction in listing requirements to bring SME's into the trading market, a move that is likely to be opposed by many exchange managers.

The better course might be to develop an OTC market in which brokerage firms assume responsibility for creating and operating trading markets for SME and other unlisted companies. There is financial incentive for brokerage firms to create such a market, as they benefit from share trading both as principal (when buying or selling shares they own) and brokers (through trading commissions). Additional advantages exist, including that OTC transactions are off the exchange and therefore not subject to exchange trading hours, price or spread limitations.

Creation of an OTC market will have to overcome current restrictions in some countries on brokers trading in equity securities off the exchange. This measure, designed to promote companies to list on the exchange, has not led to a significant growth in private company exchange listings. A new approach is in order. There is nothing novel about the OTC market. More companies are traded in the OTC market in the United States than on stock exchanges. The fact that an OTC market is established will serve to encourage SMEs to consider raising capital through public or limited offerings, as potential investors in those companies will know that a secondary market for resale of the securities is in existence.

A major concern in the OTC market is the development of quotation and trading standards. Since a large part of the OTC market is somewhat invisible, taking place mostly in broker-dealer offices, there should be a clear set of regulations applicable to OTC trading. In developed countries with OTC markets there exist substantial rules and standards to assure transparency in OTC transactions and customer fairness. Many of these provisions can be readily imported into existing capital market structures. Indeed, the growing use of the internet for secondary securities trading renders the existence of an OTC market inevitable. (See, "New Flow of Trade," Financial Mail. August 23, 2002, p. 20: "Trading in companies listed on African stock exchanges has never been easier, thanks to Johannesburg start-up LiquidAfrica's Internet-based rating and financial information platform.") Rather than subject the OTC market to the perils of an uninformed market, regulators should formalize requirements and procedures. This could be best achieved by working closely with broker-dealers in developing standards and practices for an OTC market. Broker-dealers should be encouraged to form a self-regulatory organization (SRO) for both rule-making and internal disciplinary measures, analogous to the stock exchange SRO that governs exchange trading.

A major gap in the securities legislation of most SSA countries is the failure to address disclosure requirements for non-listed companies. In countries that do not ban OTC trading, an informal market might exist to handle occasional buying and selling of non-listed company shares. If the OTC is to be developed and formalized, disclosure requirements analogous to those of listed companies should be adopted. That includes periodic reports disseminated to broker-dealers, shareholders and the media, and requirements for timely announcements of material events. Shareholders and potential investors in OTC companies are entitled to the same quality of information regarding material company developments as investors in exchange-listed companies.

(C) Improved Tax and Other Financial Incentives

Those interested in capital market development can plan and put procedures in place from here to eternity, but a viable market will not develop unless privately owned companies respond affirmatively. In that regard, the disclosure problem related to the reporting of company income noted above looms large. This problem must be more forcefully addressed if SME's are to be encouraged to go to the capital markets.

There is no easy solution to the problem of past transgressions. Amnesty is not politically or socially feasible. Perhaps, however, the problem is not as severe for many companies as generally considered. The disclosure problem will depend on whether and to what extent audited financial statements will be required for offerings that fall within a limited offering registration exemption. Offerings exempt from registration do not necessarily have to require the same degree of financial reporting as registered offerings. That is the case for exemptions in the United States. Under Regulation D (17 C.F.R. 230.501-508), for offerings up to $2 million the only audited statement required is a balance sheet. The income statement need not be audited. The same is true for offerings up to $7.5 million if the issuer cannot obtain audited statements "without unreasonable effort or expense." The limited financial disclosure requirements for exempt offerings in the United States have not proven to raise investor protection problems.

In addition, tax or other financial incentives could be affirmatively developed that will alleviate the disclosure concerns. Tax incentives could be granted to SMEs that develop a public market in their securities. Currently a number of countries provide some tax reduction for exchange-listed companies. The usual range is around 5%, e.g. from a 35% to 30% tax rate. That amounts to an effective tax reduction of approximately 14.3%. In my judgment this is a small incentive for most companies. The costs of registration and ongoing disclosures compliance can equal or exceed the 5% reduction in taxes, especially when one adds to these costs the increased exposure to securities law liability for both the company and its management and the annual accounting, listing, legal, and other costs associated with becoming a publicly-traded company. Moreover, a 5% reduction is scarce recognition of the potentially significant economic benefits that a company can generate by being an active participant in the country's economic development.

I would recommend a much larger tax reduction be provided to encourage SME public offerings. A reduction closer to 33% (e.g. from 35% to 23.4%) would be much more meaningful than the current provisions. A larger tax reduction does not necessarily mean a concomitant reduction in government tax revenue, given the history and tradition of under-reporting of taxable income. Indeed, the economic growth generated by the newly raised capital, including increased employment, salaries, and trading activity may well lead to a net gain in government revenues regardless of the amount of corporate tax reduction.

Other tax or financial incentives should also be considered. Capital gains and dividend taxes might be substantially reduced or eliminated for publicly-held SME's. Licensing and import fees might also be modified. Priority consideration for bidding by government contracts might be given to publicly-traded SMEs. A government-backed loan program, similar to the Small Business Administration program in the United States, might be considered for qualified SME's. In some countries, NGO's have been formed to give financial and administrative assistance to companies engaging in public offerings. An example is the Business Uganda Development Scheme ("BUDS") created by the Uganda Private Sector Foundations. BUDS was developed as a cost-sharing grant scheme in which firms can receive up to 50% of professional and other fees incurred in public offering or other business planning schemes. No doubt other innovative financial incentives could be considered once policy-makers and the business community put their collective thoughts together.

(D) Education Program for SME Owners and Managers

A frequently voiced concern by SME owners is the potential loss of control that could occur through one or more public offerings of securities. It is certainly true that equity offerings could dilute the initial owners' percentage of stock ownership below majority levels. However, loss of control is not a necessary or even likely result even if a majority of the shares are sold to the public. Many owners and managers of SME's do not understand that they can maintain control of the company even under materially changed circumstances, nor are they aware of the significant economic benefits (in addition to capital raising) that can result from a public market in a company's securities. An ongoing educational process is required. The educational program could be developed by the securities commission, a Central Bank, a stock exchange or an NGO. What is important is the education process.

A public offering does not necessarily mean a loss of control of the company by existing management. Depending on capital requirements, an offering might involve less than a majority of the ordinary shares. Moreover, an offering need not consist entirely of ordinary shares. An offering that combines ordinary shares, preferred shares, and debentures could raise the needed capital with relatively little dilution of initial ownership interests. If company laws permit (if not they should be amended), multiple classes of ordinary shared could be offered, with management retaining control of the class that elects the majority of the directors. The New York Times newspaper is an excellent example of a publicly-held company involving one class of shares owned by the family of the early founders and a second class of stock owned by the public. The publicly-held shares pay a higher dividend than the management-controlled class. Dividends are often more important to shareholders than the ability to elect a majority of the board. Most shareholders have too few shares to have a significant impact on director elections and would gladly trade their ephemeral power to elect directors for a higher dividend rate.

This leads to the second main point to emphasize for SME owners, namely that even if they lose control of a majority of the voting shares they will probably continue to have working control of the company. Working control is different than absolute stock ownership. It refers to the fact that management controls the operation of the company regardless of the number of shares owned, and will continue to control management until a concerted effort to replace them is successful. History suggests that management can stay in control of a company long after the controlling family or founders have lost absolute voting control. That is because of a combination of investor support and the difficulty of replacing incumbent management. Investors purchase company's shares because they believe in the capacity of the managers. Shareholders do not revolt against existing management without good cause. Even if some shareholders become unhappy with management, it is no easy matter to displace them. Management often controls considerable number of shares, directly or through others, and they also are able to use company resources to fight any dissident shareholder movements. Unhappy shareholders must finance on their own any election fight, and that can be a very expensive undertaking. The advantage is entirely in the hands of existing management, who are likely to retain control of the company barring significant reversals, personal derelictions, or well-funded hostile take-over efforts by other companies.

A public market for the company's securities offers important advantages to the company and management in addition to providing the opportunity for capital formation. Advantages include:

• allowing the founding family or other initial owners to "cash in" at least a portion of their shares and thus enjoy a substantial economic benefit for their years of hard work;
  
• giving the initial owners an opportunity to diversify their economic risk by selling some of their shares in the market and using the proceeds for other investments;
  
• creating a marketable security that can be used as incentive to attract, retain, and reward company employees; and
  
• creating the ability to obtain personal loans from lending institutions using marketable securities as collateral.

Other tangible and intangible benefits flow to management by reason of their company becoming public. A complete exposition is not necessary here. What is important is to emphasize the role of education in fostering greater interest among SME's in considering the public sale of securities. Capital markets are a relatively new phenomenon in many sub-Saharan countries. Even the most astute business owner often thinks only of the potential downside and does not have sufficient understanding of the financial advantages that a public offering can provide.

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