The stated mission of the Securities and Exchange Commission is to protect investors; maintain fair, orderly, and efficient markets; and to facilitate capital formation.
We can now be assured that the third pillar of those mandates is the priority for new Chairman Jay Clayton. He said as much in his public debut, convening a May 10 meeting in Washington, D.C., of the SEC’s Advisory Committee on Small and Emerging Companies.
“I am pleased that my first public remarks as chairman could be to this very important group,” President Trump’s choice to head the Commission said. “One of my priorities is for the Commission to focus on facilitating capital-raising opportunities for all companies, including, and importantly, small- and medium-sized businesses. Doing so will not only help those companies, but it also will provide expanded opportunities for investors, help our economy grow, facilitate innovation, and further job creation.”
On the same day Clayton spoke in D.C., SEC Commissioner Michael Piwowar was in New York City, sharing a similar (and possibly coordinated) message at a “Dialogue on Securities Market Regulation” at NYU’s Salomon Center for the Study of Financial Institutions.
The event, against the background of 15 years of low levels of IPO (initial public offering activity), explored ways to encourage more, and more effective, capital raising. Piwowar trumpeted his new boss’ arrival: “He has made it clear that, under his leadership, making public capital markets more attractive to business while providing appropriate safeguards for investors will be a priority for the Commission.”
Piwowar stressed the importance of the IPO market, calling it “one of the most meaningful steps in the lifecycle of a company.”
Going public also has important implications for employees for whom a portion of pre-IPO compensation is a promise of future payment from options and stock grants, he said, adding that retail investors “can share in the wealth created by these companies and enhance their overall risk diversification.”
For decades, the United States enjoyed a strong IPO market that produced a steady supply of newly public firms. For foreign companies, an American IPO enabled them to expand their funding sources and take advantage of a lower cost of capital compared to their domestic markets. Between 30 percent and 50 percent of worldwide IPOs occurred in the United States during the 1990s.
In the last 15 years, however, the reduction in IPO activity “has been dramatic,” Piwowar said. Since 2000, the average annual number of IPOs is 135, less than one-third the average annual number of IPOs (457) in the 1990s.
The decline has occurred despite the fact there has been no downward trend in the creation of new companies over the same period.
The disappearance of small IPOs is seen by many experts as a particularly troubling phenomenon.
In the 1980s and 1990s, IPOs with proceeds of less than $30 million constituted approximately 60 percent and 30 percent, respectively, of all IPOs. Some of the most iconic and innovative U.S. companies, such as Apple, Cisco, and Genentech, entered the public market as small IPOs.
This trend, however, reversed in the 2000s, Piwowar said. IPOs with proceeds less than $30 million accounted for only 10 percent of all public offerings from 2000-2015. By comparison, large IPOs have increased from 13 percent in the 1990s to approximately 45 percent of all public offerings.
“By boosting the demand for smaller-company shares, policymakers could do far more to invigorate the IPO market than they are likely to accomplish by focusing on the supply side of the equation and whittling away at disclosure requirements or shareholder rights in an effort to attract more companies to the public markets.”
Rick Fleming, Investor Advocate, SEC
What caused the precipitous decline in IPOs, particularly those of small firms, after 2000? The question was a hot topic and cause for debate at the NYU event.
Among the reasons discussed: the availability of alternative sources of capital, including private equity, hedge funds, and even mutual funds. These capital sources mean that private firms may be able to finance growth without having to go public. The emergence of trading venues that provide liquidity for privately held shares has had a similar effect.
Piwowar suggested other possibilities. New offering methods—notably crowdfunding and Regulation A—have provided alternatives to an IPO.
Also, he said, consolidation in investment banking and brokerage services has left fewer underwriters for small IPOs.
Changes in the economic environment due to globalization, along with the “winner takes all” trend in some industries, means that “firms have to get bigger faster to improve profitability, and therefore may prefer being acquired by a large company instead of growing organically.”
Macroeconomic factors, among them cheaper debt financing and increased mergers and acquisitions activity, may also play a role, he said.
Where Piwowar’s views may reflect upcoming Commission priorities became apparent when he discussed regulatory changes that may have contributed to the downward trend in IPOs.
The Sarbanes-Oxley Act of 2002 imposed higher regulatory burdens on smaller public companies, he said. Decimalization and Regulation NMS “changed the economics of market making for small company stocks and left fewer market makers willing to organize a market for small stocks post-IPO.”
Modifications to the shareholder threshold introduced by the Jumpstart Our Business Startups (JOBS) Act in 2012 “also make it more likely that companies will stay private for a longer period of time.”
What, then, can be done to revitalize the IPO market, particularly for smaller companies? Title I of the JOBS Act provided an IPO on-ramp for emerging growth companies, allowing them to use scaled disclosure for a certain period of time. The Republican-led legislation, which earned bipartisan support, also sought to improve the information available for IPO firms by allowing analyst reports to be published during the quiet period. The solution, Piwowar said, may lie in similar efforts.
“Both Chairman Clayton and I are especially interested in any suggestions for regulatory and other reforms that could be implemented to reverse the more than decade-long decline in U.S. IPOs,” he told attendees.
Rick Fleming, the SEC’s Investor Advocate, may have an even tougher job as efforts to foster capital formation ramp up once again.
In addition to moderating a panel on IPO creation at the NYU event, he also presented his views at a North American Securities Administrators Association public policy conference the previous day.
REGULATION A SECURITIES
The following is from the Advisory Committee on Small and Emerging Companies’ recommendation, as approved at its May 10 meeting.
Recommendation Regarding Secondary Market Liquidity for Regulation A, Tier 2 Securities
The Advisory Committee’s objective is to provide the U.S. Securities and Exchange Commission with advice on its rules, regulations and policies with regard to its mission of protecting investors, maintaining fair, orderly and efficient markets, and facilitating capital formation, as they relate to, among other things, capital raising by emerging privately held small businesses and publicly traded companies with less than $250 million in public market capitalization.
Secondary market liquidity is integral to capital formation. Small businesses trying to attract capital often struggle because potential backers are reluctant to invest unless they are confident there will be an exit opportunity. Capital is often more expensive or not available for issuers that are not able to provide investors with secondary market liquidity.
Limited possibilities for liquidity means investors’ capital may be locked up longer than they would like, hindering their ability to build portfolios with multiple, diverse investments. Liquidity limitations also prevent capital from being put to use in the next investment.
Regulation A provides for the preemption of state securities law registration and qualification requirements for securities initially offered or sold in Tier 2 offerings; however, secondary sales of these same Tier 2 Regulation A securities require compliance with disparate state law requirements. This means willing sellers and buyers in the secondary trading market must find exemptions on a state by state basis.
There are substantive differences in the various state exemptions. This lack of uniformity inhibits the development of a national secondary trading market.
One popular exemption for secondary trading is the “manual exemption,” which is currently available in 39 of the 54 U.S. jurisdictions. These provide an exemption for secondary trading by non-issuers through a broker dealer, if the issuing company has financial and other information published in a designated securities manual. The exemption is based on the availability in the manual of current information about an issuer that enables parties on both sides of the trade to make an educated investment decision.
While there used to be more, there is currently only one remaining designated securities manual (published by Mergent, formerly known as Moody’s). However, company information available on certain OTC Markets marketplaces is now recognized for purposes of the state blue sky manual exemption in 21 jurisdictions.
Complying with the manual exemption can be costly for companies, since issuers must pay to have their information disseminated. Additionally, there is not currently a centralized information portal accepted by all jurisdictions where investors can find that information.
Tier 2 Regulation A issuers are subject to initial and ongoing disclosure requirements that are greater than the information that is included in a manual.
The information in Tier 2 Regulation A ongoing reports is easily available to the public on EDGAR.
The SEC and the states have a collaborative, productive relationship, with a recent capital formation success in the adoption of the Commission’s Securities Act Rule 147A to help facilitate intrastate offerings.
THE COMMITTEE RECOMMENDS THAT:
The Commission take steps to help reduce friction in secondary trading by holders of Tier 2 Regulation A securities where the issuer is current in its ongoing reports.
The Commission collaborate with NASAA in this endeavor.
The Commission consider using its authority under Section 18 of the Securities Act to preempt from state regulation the secondary trading in securities of Tier 2 Regulation A issuers that are current in their ongoing reports. This approach would replicate what is the equivalent of a uniform manual exemption across all 54 jurisdictions, with EDGAR serving as the central repository.
“Overall, the public markets have been very good for investors,” he said. “You don’t have to search very far to find examples of companies that have given average Americans an opportunity to participate in significant wealth creation.”
For example, Amazon was founded in 1994 and went public in 1997 at a valuation of $0.4 billion. It is now worth almost $440 billion, growing 110,000 percent since its initial public offering.
“Now, consider the impact if Amazon had chosen—like Facebook—to remain private until it reached a market capitalization of $80 billion,” Fleming said. “It would still be a huge success story, but its post-IPO price would have multiplied only 5.5 times. Wealthy investors in the private markets would have captured a large share of the capital gains that would have otherwise gone to average households in the public markets.”
Investors stand to gain most when successful growth companies go public as soon as possible, he added. “So we on the investor side should not automatically take a defensive posture against reforms that will improve the IPO marketplace. We should join the conversation so that policymakers are considering reforms that are good for investors as well as issuers.”
Unfortunately, investor advocates are often forced into a defensive posture because efforts to spur the IPO market “tend to focus on the supply side of the equation, namely, how to reduce regulatory burdens on issuers so that more of them are interested in becoming public companies,” Fleming said. “We need to bring some balance to the conversation by helping people understand the demand side of the equation.”
He pledged to remind policymakers that the IPO market “cannot be revived in a one-sided fashion, by doing things like cutting back on disclosures that investors value or significantly altering the balance of power between shareholders and management.”
Fleming stressed that economic trends may pose a significant impediment to IPOs. For example, the number of individual investors who invest directly in stocks is relatively small and getting smaller.
“If you drill down further, you find that, of the wealthiest ten percent of U.S. households, half of them own stocks, and they own substantial amounts (an average of more than $700,000),” he said. “Stock ownership drops precipitously in less wealthy families.”
The proportion of stocks owned by individuals has also fallen by a significant degree. In 1976, individuals directly owned 50 percent of the equities in the U.S. stock markets; that number declined to 21.5 percent in 2016.
Instead of owning stocks directly, the average person now invests through various types of funds. Consequently, the assets under management of institutional investors has grown substantially in recent decades, increasing from $6 trillion in 1998 to $19 trillion this year.
“Because of this shift to institutional accounts instead of individual ownership of shares, institutions now hold the majority of U.S. stocks, up from less than 20 percent in 1976,” Fleming said. “Curiously, at the same time that the assets under management of funds has exploded, the number of IPOs has fallen.”
The average volume of IPOs fell from 310 per year during the period of 1980-2000 to only 99 per year during 2001-2012, according to the SEC data. In 2016, only 74 operating companies went public in the United States, the lowest total since 2009.
As bad as these numbers seem, they are even worse for smaller companies, which are also staying private longer.
Institutional investors who engage in active management seem to have little interest in shares of micro- or small-cap public companies, Fleming said, chalking it up to liquidity concerns. It is difficult to do trades of institutional size because there may not be enough buyers or sellers on the other side of the trade. In that environment, if a trade can be done at all, it may significantly impact the price of the security.
In addition, there are regulatory barriers that prevent funds from holding large positions in small companies.
“Scaled-back disclosure requirements for smaller public companies can also make them less attractive to sophisticated institutions [that] carefully scrutinize the data,” he said, offering an opinion that runs contrary to those pushing for even greater regulatory accommodations for emerging growth companies and their ilk.
Ultimately, more so than regulatory burden and disclosure demands, companies may not want to go public into an illiquid market because it negatively impacts the value of their shares. It also sets them on a course in which their subsequent offerings into the public markets may be less attractive, Fleming explained.
Consequently, companies may consider staying private until they are much larger and have a market capitalization that will support robust trading, which results in fewer small-company IPOs.
The SEC, Fleming said, should give more thought to potential reforms that could make institutional investors more interested in smaller public companies.
“By boosting the demand for smaller-company shares, policymakers could do far more to invigorate the IPO market than they are likely to accomplish by focusing on the supply side of the equation and whittling away at disclosure requirements or shareholder rights in an effort to attract more companies to the public markets,” he said.