Saturday, November 16, 2019
I've frequently been asked to express a view on the spectacular decline of WeWork. Is there a broader lesson here? Or is this just a bizarre one-off?
I actually think there are a few lessons, and for this week’s post, I’ll start with the one about securities regulation and capital allocation.
One of the primary purposes of securities regulation is to ensure the efficient allocation of capital. See, e.g., John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Va. L. Rev. 717 (1984); see also Benjamin Edwards, Conflicts and Capital Allocation, 78 Ohio St. L. J. 181 (2017). SEC Chair Jay Clayton recently gave a speech in which he emphasized that the SEC is “not in the business of dictating a company’s strategic capital allocation decisions,” which is true – the SEC’s job is not to tell market actors where or how to invest – but the SEC is responsible for creating a disclosure regime that facilitates efficient capital allocation via investors’ choices. And by that measure, the securities laws are failing.
As we all know, the securities laws – both through statutory revisions (JOBS Act) and regulatory interpretation – have made it easier for companies to raise capital without public disclosure. The theory is that wealthy, institutional investors can bargain for the information they need to make an intelligent investment decision. But – as others have pointed out – when capital is raised privately, optimistic sentiment can be expressed but negative sentiment cannot. I’ll go further: Because private-market investors are a small group, they have strong incentives to keep their negative opinions to themselves lest they be shut out of future deals. Meanwhile, mutual funds have made a deep dive into the private markets, and agency costs infect those decisions: active managers, hoping to improve their market relative to competitors, may well think it would be worse to miss out on a great deal than to make a bad bet that puts their fund on par with everyone else’s.
The result is a bubble of private company valuations that meets reality only when it comes time to go public, as recent experience has demonstrated. But the injuries are not experienced by these sophisticated investors alone; they’re experienced by all of the other actors whose lives are affected by the allocation of capital to doomed business models.
The New York Times just published an expose on the havoc SoftBank has wreaked internationally by dumping cash into unprofitable startups, which have then gone on to persuade small business owners and independent contractors around the world to upend their plans in hopes of opportunities that never materialize. Violent and/or fire-laden protests have resulted in Indonesia, India, and Colombia. Obviously, many of these investments were outside of the scope of American securities regulation, but not all of them, and they serve as a cautionary tale of the consequences when capital is allocated to poorly-designed businesses. In this, SoftBank is not alone; American venture capital firms have been pouring money into U.S. startups, well beyond amounts that the companies themselves have requested; some founders apparently feel that if they don’t accept venture capital money they don’t need, the VCs will simply invest in a competitor and drive them out of business. See also Sheelah Kolhatkar, WeWork’s Downfall and a Reckoning for SoftBank (“The fact that the Vision Fund flooded its companies with capital made it difficult for other startups or traditional companies with even a modicum of fiscal discipline to compete.”)
It’s not just the investors or even the founders who suffer; the effects are felt throughout the economy. SoftBank’s ill-considered bet on WeWork has upended real estate markets on two continents and that doesn’t even get into the effects on employees; even WeWork’s janitorial staff was paid in stock.
Now, I’ve argued that the securities disclosure regime should not be broadly interpreted to encompass the interests of all actors in society; securities disclosure is, at its core, for investors, and if we’re worried about other corporate constituencies – and we should be – we should design a disclosure system for their needs. But even within the confines of securities disclosure, efficient allocation of capital should be one of the central goals. And the overwhelming evidence is that, wherever the appropriate line between privatization and “publicization,” the American system has gone too far in the direction of the private.