From Bloomberg Business Week Online March 14, 2011
Viewpoint March 13, 2011, 10:37PM EST
How to Turn Stock Speculators into Investors
Tweaking circuit breakers or demanding further trading disclosures won't take the casino out of Wall Street. Instead, public stock ownership should be treated more like a private investment
By Greg Blonder
Imagine opening a bakery with your cousins. You work 18-hour days to build a loyal following of bread-and-pastry connoisseurs—only to discover that cousin Joey is treating his partnership shares like a roulette wheel. He pulls out cash when the bakery is under stress, instead of pulling together with the family to save the business. He pledges his shares to a competitor to buy a boat. Then Joey repurchases them in time to vote cousin Eddie out of the kitchen.
No one in their right mind would tolerate this kind of behavior, even from your favorite aunt's son. But it's standard operating procedure in the public stock market, where far too many investors behave like cousin Joey, caring more about lining their own pockets than building valuable companies.
How can we turn speculators back into investors?
The wrong way is to impose additional market circuit breakers, as was recommended last month by the "Flash Crash" panel of the U.S. Commodity Futures Trading Commission and the Securities and Exchange Commission. The same goes for further trading-disclosure rules. And bonus restrictions and salary caps. These treat symptoms, not the root cause, which is an imbalance between stockholder and company financial-value systems. The solution can better be secured by treating public stock ownership more like a private investment.
Companies Serve Three Vital Masters
All companies serve three masters: their investors, their customers, and their employees. All are essential in their own way. Without customers, you have no revenue. Without employees, there are no products or future profits. Without shareholders, there's no capital or liquidity.
Without a doubt, private shareholders deserve a seat at the table. Their cash, expertise, and patience provide companies with the time and resources to succeed. In the last few decades, however, the period for which the average public stockholder hangs on to shares has dropped from around seven years to just a few months. Like Joey, these "investors" aren't loyal to the company, its employees, or its customers. They care only about its stock price. They seek all the gain with none of the responsibilities. Why should they dominate our economic system?
Even after the financial system meltdown, I still believe in open markets. But as a matter of public policy and wise economic stewardship there is no reason to treat drive-by investors any better, say, than we treat gamblers at the track. We must encourage investors to carefully evaluate the long-term prospects of a company—before they invest—so the stock price will reflect its true enterprise value, uncolored by speculation.
Issue Long-Term and Speculative Stock
How? Create two classes of shares for all listed public companies. Class A shares would have to be held for at least one year after purchase. Class B shares could be traded freely.
Only Class A shares would qualify for long-term capital gains treatment. (Granted, active traders in B shares would rarely qualify for long-term gains, but this distinction would mark a bright line between the classes.) Since market cycles often run for five years, and companies value stable financing during hard times, I'd prorate the long-term capital gains tax from 20 percent (at one year) to 5 percent (if held five years or longer).
Second, only Class A shares would qualify to receive dividends. If you're not investing in the long-term health of a company, you don't deserve a share of its long-term accumulated wealth.
Third, only Class A shares could vote.
Write Off "B" Losses as Gamblers Must
Finally, Class B capital losses would be treated as gambling debts are—deductible only in the current year and only against other short-term Class B gains. If you are rolling the dice on stocks more frequently than once a year, you are gambling with the shares, not investing in the strength of the American economy.
Given today's modern financial platforms, the exchange of stock into these two classes could be completed within three years. The changes would be minor, at best, if the body politic were willing. A simplified version of the existing Rule 144 applies to Class A restricted stock. And with the SEC's universal cost-basis tracking mandate (section 6045) phasing in starting this year, capital gains calculations will be nearly automatic. New listings might choose to issue only Class A shares, letting Class B shares wither away. I bet Google (GOOG)—among other big-name initial public offerings—would have joined the "A" camp.
It's time for Joey to class up or get out of the kitchen.
Greg Blonder, formerly chief technical advisor at AT&T, is an entrepreneur and venture capitalist in the New York area.
Additional details, speculating on a possible implementation plan:
Stock Proposal Mechanics Q&A
If I hold Class A shares for under a year, and some news event (Mid-east unrest, a tsunami, competitive product announcements, etc.) affects the company’s apparent prospects, shouldn’t I be able to sell?
- Well, the company, it’s customers and employees have to deal with these news events as they happen- they can’t run and hide after every wire story. Class A Investors should accept similar risks if they are true company partners. And, relatively speaking, your shares are liquid by comparison.
Class A shares are intended to reflect the company’s long term enterprise value. What do Class B shares reflect?
- Class B shares will, like a mixture of options and derivatives, reflect shorter term and more speculative views of the company’s prospects. They may be used to hedge Class A risks. Class A investors may look to Class B trends as a signal to sell or buy, and vice versa. Trading volume (on a percentage basis) will likely be higher for Class B than Class A shares.
Do you expect the Class A and Class B share prices to diverge over time?
- Yes. They reflect either long or short term viewpoints, and are likely to be held by different constituencies.
Won’t the Class A restrictions make it harder for companies to raise capital?
- Not really. The company can always issue Class B shares, which will more or less satisfy those traders currently favoring short-term investments. And, longer term investors will value the potentially higher dividend rates, plus the potentially lower volatility, of Class A shares.
Isn't this some kind of anti-day-trader witch hunt?
- Day traders can still trade Class B shares. A free market does not mean a free-for-all. The point of the stock market is to support companies, not generate zero-sum trading profits for investors. Companies should be able to set the terms under which they offer their stock for sale- this gives them a second option. In fact, this system forces investor to more carefully analyze a company's prospects before purchasing Class A shares, while they can still buy Class B on a rumor or a hunch.
Will Class B shares be converted into Class A after a year? What if I hold Class B shares for more than a year- why aren’t these shares eligible for dividends and longer term capital gains treatment?
- The intent is to create a bright line between both classes. The company cannot plan accurately if shares may or may not convert, or may or may not receive dividends. The pricing of each stock class will reflect this difference with greater clarity, only if the shares offer distinctly different features.
What happens if I sell a Class A share after bad news, then realize I should have held the stock for the long term?
- Well, you may have lost the benefit of a lower capital gains rate. And, when you repurchase the shares, you will have to wait another year before selling. These disincentives to flipping Class A shares are intentional, and will encourage a purchaser to think before trading.
When a company goes public, how are shares allocated?
- The company can issue as many Class B shares as allowed by the board, and they are immediately tradable. Class A shares would be sold to the market over the course of a year, and would be tradable a year after purchase.
When the company issues new shares, do they have to issue both share classes?
- No, the company can choose to issue either class at any time
Can the company buy back share classes selectively?
- Yes, the company may, at its discretion, choose to buy back only Class B or A shares. It might decide, as authorized by the board, to tender an offer to buy out (and thus close from public trading) either class.
How will this affect mutual funds and ETFs?
- We expect some funds will specialize in only one Class, for example, a Class A Russell 1000 mutual fund. This will provide investors with the ability to invest for the long or short term, without one class dragging the other class’s pricing in unexpected directions. It may, depending on resulting market dynamics, result in a Class A stock market with fewer wild swings and more systematic tracking between economic strength and share valuations.
How will the transition occur?
- A year after this plan is approved and back-office systems are readied, notice of the conversion date will be issued. This date would be at least 18 months into the future. Then, on that date any shares already held for at least one year would be converted to Class A, and the remainder to Class B. Class A shares, as they were already held for more than 12 months, would be immediately tradable. However, once sold and then repurchased, the 12 month holding period is re-attached.