THE DEVELOPMENT OF MICRO-CAP SECURITIES
SUB-SAHARAN AFRICA: NEW APPROACHES TO FOSTERING ENTERPRISE GROWTH
by Professor Stuart
Reference: Document No.18, November 2002)
Proposals for Development of Micro-Cap
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
- the amount of securities being offered,
- the knowledge and experience of the
- the relationship of potential investors
to the company
- the financial abilities of the potential
- 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
- 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
- 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,
- 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
- 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
- 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
- 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.
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
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
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
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;
- 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
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