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)

Current Impediments to SME Securities Offerings
Several reasons exist that preclude SME's from going into the public market to raise capital through the sale of securities. The principal reasons include:

1. Company Law Limitations

Company law throughout most of SAA is similar, owing their common inheritance from English and colonial statutes. The principal division in the company laws is between private and joint stock companies. Private companies are limited to no more than 50 shareholders, the securities are non-transferable, and private companies cannot offer any shares or debentures to the public. Joint stock companies, by contrast, can issue transferable securities and have any number of shareholders.

The dichotomy between private and joint stock companies is a long accepted construct but on close examination does not have any basic justification other than tradition. There is no reason why the structure, rights, and obligations of all companies that have equity shareholders should not be the same. That is the situation in the United States, where one corporate law applies to all companies, large or small. There is no compelling reason to support the prohibitions against selling securities and against the transfer of securities that apply to private companies. Such prohibitions preclude effective capital raising by private companies and have no inherent justification.

As a result of current company laws, private companies are limited to trying to attract investors who will be locked into their investment for an indefinite period of time. This is an extremely difficult task and should not be necessary from either a legal or economic perspective. If a shareholder of a so-called private company desires to sell his or her shares, the transaction should be governed by the securities laws, similar to any other stock transaction. Full disclosure is the key, and that applies to all companies, large and small. One might argue that the shareholder can sell his or her shares when (and if) the private company eventually becomes a joint stock company, but the timing of such transformation is uncertain and meanwhile investors hold an illiquid asset.

More significant as impediments to capital raising are the public offering provisions of most company and securities laws. Any offering of securities, regardless of size or number of purchasers, must comply with the full registration process set forth in a schedule to the company law statute. The registration requirements are essentially the same in those countries that have adopted securities legislation to replace or supplement the traditional company law. There are no "private" or "limited" offering exceptions. SME's desiring to raise a relatively small amount of capital must go through the same costly, time-consuming process of registration as if it were a multi-million dollar offering. SME capital requirements are often too low, too sporadic, and too immediate to warrant the required registration process. I have not examined all of such statutes, but ones that I have reviewed do not provide meaningful exceptions to the registration process. In a recent workshop in Harare, Zimbabwe, attended by representatives of 12 different African countries, not one participant was aware of any private or limited offering exception to the registration process.

2. The Problems of Listing on Stock Exchanges

Even if an SME was willing and able to undertake a full registration process for the sale of securities, there is likely to be very little investor interest because of the lack of a secondary market. A secondary market is the trading forum for buying and selling shares by shareholders. A stock exchange provides a secondary market for shareholders of companies listed on the exchange. Potential investors are not inclined to purchase securities if no secondary market exists for subsequent resale. Or, if they are willing to buy illiquid securities, they will do so only at depressed prices. For shares that have no trading market, a shareholder would have to find his own buyer, determine a price, and negotiate all elements of the transaction. This is highly inefficient and not an attractive prospect to potential investors. Thus, companies selling their shares to the public announce their intention to list the shares on the exchange so that a secondary market forum can exist. The promised existence of a secondary market makes the initial offering of securities more attractive.

Two serious problems exist in this area for SME's. The first is that many SME's, even
after the sale of shares in a public offering, will be too small to meet exchange listing standards. Stock exchanges listing requirements are usually quite high with regard to company assets, number of shareholders, and market capitalization. SME's in their early years of development are unlikely to meet listing requirements. Hence, such companies cannot provide an stock exchange listing to potential investors.

Some exchanges, recognizing the problem and seeking to attract smaller companies into their fold, create listing tiers. Tier I is composed of large companies that meet the regular listing requirements. Tier II is composed of smaller companies who qualify under modified listing standards. Although this arrangement has the merit of allowing smaller companies to be listed on the exchange, in practice the two tier system has generally not been successful. Many investors regard second tier companies with skepticism. A Tier II label is like a badge of demerit ---- a Tier II listing connotes a public company that is not "good enough" to make it to the "big board." Hence, trading in Tier II stocks tends to be sparse. This adversely affects both stock prices and liquidity (the two are linked). The potential of a Tier II listing is thus a meager inducement for SME's and potential investors.

3. Lack of An Over-The-Counter Market

The inability to meet exchange listing requirements would not be a serious impediment to a public offering by SMEs if those companies could assure potential investors that an over-the-counter ("OTC") market would be created for secondary trading. An OTC market provides a liquidity function for shareholders similar to that of an exchange. The OTC market can be as active and efficient as an exchange.
Most secondary trading in the U.S. occurs in the OTC market. Indeed, some companies prefer to remain in the OTC market even if they have the size and configuration to be eligible for exchange listing. These are often companies that started small, developed an active OTC market for their shares, and now see no benefit to listing their shares on an exchange despite their qualification to do so.

Unfortunately, an OTC market does not exist in most SSA countries. Zimbabwe, Nigeria, and a number of other countries actually prohibit an OTC market, for their stock exchange rules preclude brokers from trading in any securities not listed on the exchange. Other countries that do not have such a prohibition have not established any rules on requirements for OTC trading, which effectively results in brokers avoiding trading activity because of the absence of standards.

It would be wrong to suggest that the mere act of creating the mechanism for an OTC market is a panacea for SME liquidity problems. An OTC market requires brokerage firms willing to undertake the time and cost in its development, it requires a regulatory agency willing to adopt trading and disclosure rules, and it requires a sufficient number of companies on the OTC market to make the whole endeavor worthwhile. None of this will happen overnight. But it will never happen without changes in statutes and other rules to allow SME's to more readily solicit capital from the public.

If standards are put in place for an OTC market, that will also facilitate trading of securities through the Internet. The Internet is becoming the trading vehicle of choice for many investors. Although many investors might avoid SMEs because of risk and liquidity concerns, the ability of SMEs to have their shares traded over the Internet creates an additional marketing tool for capital raising.

4. Tax and Financial Disclosure Concerns

An oft-stated major impediment to attracting SME's to make public offerings is the concern that the required disclosure of audited financial statements will alert government authorities to possible prior under-reporting of taxable income. The two sets of books phenomenon is frequently noted in discussions. The tax collector sees a set of books that show little if any profit, while the owners' set of books shows the true condition of the company. If the company were to make a public offering that requires audited financial statements, prior under-reported income might be disclosed. Visions of fines and jail terms for tax evasion dance in the heads of SME owners who are being encouraged to undertake public offerings. For owners of SMEs who are at risk in such a situation, the decision to forego the offering is an easy one, even if the result is a foregoing of much needed capital for the company.

The idea of a tax amnesty has been floated from time to time as a means of encouraging companies to sell and list their shares on the exchange. Strong legal and political reasons, however, militate against the adoption of any forgiveness program. And so the problem remains. A number of countries offer a reduction in the corporate tax rate (such as from 35% to 30%) for companies listed on the national stock exchange. In light of the relatively low number of private companies that have chosen to list on stock exchanges, current tax inducements do not appear to be very effective. More thinking needs to be done to resolve this very practical problem. Several suggestions are discussed below in the Proposals portion of this article.


5. Control Concerns

Owners of SMEs are understandably reluctant to sell securities to the public if the result is a diminution or loss of management control. This is a very real personal problem, especially for SME's developed and nurtured within family units. It is a problem, however, that can be addressed through education of company owners as to alternative offering techniques, and through changes to existing statutes and regulations to permit more diversified ownership interests.

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