Taking Stock of Rush to Invest in Small Firms

You can easily buy stock in giant Microsoft Corp. or in Anheuser-Busch Cos. So why not in your neighbor’s fledgling software company or in a local microbrewery?

Or for that matter, why not in the corner dry cleaner?

As Wall Street’s bull market surges ahead, small-company stocks have emerged as the new stars. The public’s hunger for them is so intense that a record number of companies--most of them relatively young--have been able to “go public” so far in 1996, selling shares to investors for the first time.

Now federal and state regulators, embracing the Republican Congress’ pro-small-business attitude, are rushing to make it simpler for even the tiniest firms to solicit investors.

Yet even those who support liberalizing stock-offering rules for small companies worry that the idea will have disastrous consequences if too many individual investors clamor to buy shares of untested companies--perhaps over the burgeoning Internet--only to see those stocks collapse in the next big market downturn.

“We’re in the oxymoronic position of trying to peddle the most risky part of the market to the public,” admits Barry Guthary, director of securities regulation for Massachusetts.

Others, however, contend that such worries are overblown, that individual investors are unlikely to sink much of their savings into such stocks, and that whatever the risks, the higher long-run cost to the U.S. economy would be in hindering legitimate entrepreneurs from getting the capital they need.

“If we just make these stocks unavailable, then we’re for sure protecting the public” from potential loss, said Debra Bortner, securities administrator for the state of Washington. “But I don’t think we can do that anymore. We live in an age where small businesses are creating a lot of jobs” and thus feel that they have a greater right to funding, she noted.

Among the efforts to ease restrictions on small companies, California is on the verge of eliminating its arduous “merit review” system, whereby the state Department of Corporations judges whether a small business can freely market its stock to potential buyers.

Also, eight Western states, including California, recently began a program to reduce paperwork for small firms that want to offer shares across state lines. Under the program, an offering approved in one of the states will be approved in all of them.

At the federal level, the Securities and Exchange Commission has a number of initiatives underway to remove roadblocks for small-share issues.

Yet even as regulators focus on greasing the money wheel for smaller companies, the most important stock market for those firms, the electronic Nasdaq Stock Market, may soon find itself in the ironic position of making it more difficult, rather than less, for smaller firms to get or keep a coveted Nasdaq trading slot for their shares.

Inherent Risks

The National Assn. of Securities Dealers, the self-policing organization of the U.S. securities industry and the operator of the 6,100-issue Nasdaq market, has been forced to launch a sweeping review of Nasdaq listing standards because of a trading fiasco last month in one of its smallest stocks: Newport Beach-based Comparator Systems Corp.

The stock soared from 6 cents to $1.88 in mid-May before plunging again, attracting national attention.

On Friday, the SEC charged Comparator with fraud, asserting that it “sold tens of millions of shares . . . to investors while making material misrepresentations” about its financial status. Comparator officials Saturday denied the allegations.

In some ways, Comparator is a classic illustration of the risks inherent in very small stocks. But in other ways, Comparator is a one-of-a-kind company that was a market debacle waiting to happen.

The reason: Despite its tiny size (1995 sales: just $90,161), the company has issued 610 million shares over the years, a massive number that exceeds the outstanding shares of such corporate giants as IBM Corp. or Chrysler Corp.

Comparator’s chief executive, Robert Rogers, said the often financially strapped company routinely paid senior executives with shares in lieu of cash. Other debts were also settled with shares. There is no NASD or SEC restriction on the number of shares a company can issue, regardless of its size or financial resources.

In the past few years, Comparator stock has mostly wallowed between 3 and 7 cents a share, as the company said it struggled to develop a new fingerprint-identification technology.

Then, on May 3, the stock nearly quadrupled to close at 28 cents a share as 123 million shares changed hands--a Nasdaq record for any issue in one trading session. New volume records were set the following week as well, and the stock jumped as high as $1.88, then plunged to 56 cents, grabbing headlines nationwide, until the NASD suddenly suspended trading.

Comparator’s wild stock action, loosely linked to the firm’s introduction of a new fingerprint-identification device of questionable potential, smelled of classic market manipulation, but by whom wasn’t (and still isn’t) clear.

Soon there were charges that there was much less to Comparator than has been represented to Nasdaq.

Under intense NASD scrutiny several days after the stock surged, Comparator conceded that it lacked the capital to build its fingerprint-identification device. More problematic for Nasdaq, Comparator admitted that it may have overstated the value of 77% of its assets in various SEC filings, which raised questions about whether the stock even had the right to a prized Nasdaq listing.

Ordinarily, a Nasdaq company whose stock price falls below $1 faces delisting, the basic idea being that if the market thinks so little of a stock, it doesn’t merit national exposure to potential investors on the high-profile Nasdaq market.

But under an exception that the NASD adopted in 1992, Nasdaq-listed companies with such “penny” stocks can remain on the Nasdaq market if their corporate capital, or net worth, is at least $2 million.

The SEC now alleges that Comparator falsified its net worth simply to keep its Nasdaq slot.

That is making the net-worth exception an embarrassment for the NASD. Joseph Hardiman, the NASD’s chief executive, admits that “several hundred” Nasdaq companies faced delisting in 1992 when the $1-minimum-stock-price rule was instituted, and “a number of them lobbied hard” for the net-worth exception in order to keep their market listings.

But with the Comparator fiasco raising questions about the quality of the nearly 2,000 officially designated “small-cap” (for capitalization) stocks permitted to list on the booming Nasdaq market, Hardiman announced May 14 that the organization will study raising its listing standards across the board for the first time since 1992.

In particular, he said, the review will focus on financial benchmarks that companies must maintain to keep their Nasdaq address.

The implication is that even as investors’ interest in small stocks zooms, the NASD could be on the verge of booting hundreds of small companies off the Nasdaq market, in the name of investor protection.

Highly Visible Listing

But Comparator notwithstanding, the Nasdaq-listed small companies that would be kicked off by possible rule changes aren’t likely to go quietly.

A Nasdaq listing assures a small company that its stock can appear on brokerage computer screens, online computer services and newspapers nationwide.

While the New York Stock Exchange is still considered the premier U.S. stock market, the electronic Nasdaq market--where brokerages trade shares over computers or over the phone--is “home” to the majority of stocks, including many of the country’s leading technology firms, such as Microsoft and Intel Corp.

In short, a Nasdaq listing means a company has exposure to investors, and its shares trade in real time on the Nasdaq network.

The Bulletin Board

Below the official Nasdaq market is the OTC Bulletin Board. Although operated by Nasdaq, the Bulletin Board doesn’t allow for the same instantaneous trading as the Nasdaq market. Hence, many of the 5,500 Bulletin Board stocks are rarely traded.

Many brokers and money managers, either by choice or by company policy, simply don’t deal in Bulletin Board stocks. “They drop off the visibility scale,” said Irene Gorman Hoover, research director at Juricka & Voyles Inc., an Oakland money manager.

The NASD’s Hardiman said that while the organization is “sympathetic” to small firms’ desire to have visible stock listings that aid in capital-raising efforts, “we have to balance the needs of small companies with adequate protection for investors.”

Some Nasdaq observers say the real irony of any NASD “get-tough” policy with smaller stocks is that the market oversight provided on the official Nasdaq market is vastly superior to what stocks receive when bounced down to the Bulletin Board.

In other words, if investor protection is an issue, frauds can be more quickly spotted by regulators on the Nasdaq market than on the Bulletin Board.

On the Bulletin Board market and rungs below it, “we have a real [regulatory] black hole,” said Debra Bollinger, director of the South Dakota division of securities. Neither the SEC, the NASD nor the states have the resources to adequately monitor those thousands of stocks, she said.

Yet that is exactly where most of the small stocks that federal and state regulators are under greatest pressure to accommodate would wind up. Many such stocks, in fact, would not officially “trade” at all and would have no daily pricing mechanism, even though they could have hundreds of shareholders.

As part of efforts to loosen restrictions on small companies, the SEC--ultimate watchdog over U.S. financial markets--wants Congress to double, to $10 million, the amount of money that can be raised from investors by any company small enough to be exempt from SEC financial oversight (generally, those with fewer than 500 shareholders).

The SEC also wants Congress to approve a proposal that would allow small companies to “test the waters” for stock offerings, soliciting potential investors before actually going ahead with a sale.

In California, meanwhile, the Assembly last week passed a bill that would terminate the state’s long-standing merit-review process for stock offerings by small companies. If, as expected, the Senate concurs and Gov. Pete Wilson signs it, many fledgling firms in the state will be able to offer stock directly to any investor, without the restrictions that have limited tens of thousands of companies to soliciting only fairly well-off investors.

Both the SEC and proponents of the California bill and similar initiatives in other states insist that regulation of small stocks is merely being streamlined, not eliminated.

The SEC points out that any untrue statement made by a company in stock disclosure statements would remain subject to federal anti-fraud provisions.

Keith Bishop, newly appointed head of the state Department of Corporations, said a fallacy about merit review was that it kept fraudulent companies from selling stock. “The department couldn’t go out and check every fact that companies asserted,” he noted.

Under the new system, if merit review is abolished, Bishop expects much more information about companies to be automatically available to the marketplace, “where it can be tested.”

Burden on Investors

But that effectively means that the burden of judging what is a worthy investment will fall almost entirely on individual investors, whose dollars small companies will be competing for, and in increasingly novel ways--such as via marketing of shares over the Internet, which gives companies access to literally millions of potential investors.

“The Internet is going to be an enormous tool for good--but also for evil” by unscrupulous companies and brokerages, warned Dee Harris, director of securities regulation for Arizona.

Some experts, however, say small-stock fraud concerns are vastly overblown.

Marc Lumer, a San Francisco accountant who is active in the California Capital Access Forum, a group backing more open markets, argues that investors should have the right to choose between buying stock in a neighbor’s fledgling business and buying stock in a multinational corporation, as long as both companies provide full documentation about their plans for the money and the risks involved in their stocks.

“The issue is whether small businesses can do what big businesses can do,” Lumer said. “All this will do is allow the small company to participate on an even playing field.”

In Washington state, where small companies have enjoyed a simplified stock-registration procedure since 1988, securities chief Bortner said her experience has been that individual investors don’t line up for miles to throw money at the companies. In fact, only 35 small companies have successfully attracted investors through the program, she said.

“People know that small companies go out of business all the time,” Bortner said. The firms that have succeeded in share offerings, she said, tend to be companies that people can relate to, such as local wineries and breweries. And even then, she added, “a lot of people put up just a little money, maybe $1,000,” investing more as a hobby than to make a killing.

Still, what worries many securities regulators is the risk that in the current roaring bull market on Wall Street some investors will sink their life savings into stock offerings from small companies that have almost no long-term chances of survival--or into stocks of outright frauds peddled by scamsters.

Paul H. Schultz, associate professor of business at Ohio State University in Columbus and an expert on capital formation, agreed that with looser rules regarding stock sales by small companies, “there’ll be more fraud--there’s no doubt about that.”

But he added, “I think that cost will be pretty small relative to the cost now of companies that go out of business because they can’t raise capital.”

Securities regulation, Schultz argues, should focus on “minimizing the cost to investors of finding out about a company and verifying that information about the company is accurate,” then letting people make their own choices.

“You can’t protect the public from making bad investment decisions,” he said.

Next: Touting--and selling--small stocks on the Internet.