IPOs and the Slow Death of Section 5

Section 5 of the Securities Act of 1933 is slowly dying. We have to be careful about making such a bold-sounding claim because Section 5 performs two distinct legal functions. First, it creates a presumption that offerings of securities using the facilities of interstate commerce have to be registered with the Securities and Exchange Commission. That is not the aspect of Section 5 that concerns us here, however. Our aim in our current research is entirely at the separate function that takes up most of Section 5’s statutory text: restraining the marketing of registered public offerings so that salesmanship does not run ahead of the mandatory disclosure that is supposed to inform investor decisions of whether to buy or not, often referred to as “gun-jumping.” This is a devolution we find interesting and insufficiently examined in legal scholarship. Our focus is entirely on the IPO, the paradigmatic form of issuer capital-raising, and not offerings by seasoned issuers.

We describe this as a slow death because it began almost as soon as the Act was passed. Section 5 started as a simple, rigid and coherent rule that limited sales efforts after the SEC had declared the registration statement “effective.” The industry found this impracticable and to some extent just ignored it, setting in motion two decades of negotiations as to a proper balance between the demand for pre-effective marketing and the concerns about gun-jumping. A legislative compromise, eventually reached in 1954, gave us the statutory language that is mostly still with us today.

For many decades, this compromise had considerable bite. It generated what we call the quiet period, during which issuers and underwriters had to limit severely what they said outside of the statutory prospectus (and how and when they might say it) if the communication might in any way “whet the appetite” of investors and thus be an illegal offer. Gradually, quiet period practices emerged that put pressure on Section 5’s awkward distinctions, especially as between oral and written communications. In response to these and other concerns in a time of rapid technological evolution, the SEC acted in 2005 to thoroughly restructure the public offering environment through an extensive set of rule-based exemptions and safe harbors. Section 5 lost much of its heft as a result. In subtle and striking ways that have thus far received mostly superficial analysis, the JOBS Act recently took away even more with respect to most IPOs.

We document all this, and assess the current state of Section 5’s fragile health. To document and assess is not necessarily to criticize. The compromise reflected in Section 5 was conceptually incoherent from the beginning, and tied to an understanding of the public offering process that quickly became outdated. The quiet period was probably not that good an idea in the first place, and the markets have changed enough to demand a new regulatory regime. To this end, we survey the contemporary literature in financial economics on IPOs. Legal scholars have paid attention to certain aspects of the economics of public offerings, particularly the persistent underpricing that occurs and the abuses that ensue in allocating scarce shares. But by and large, the prevailing view of Section 5 among lawyers still seems rooted in an overly simplistic and archaic impression of the offering process. The persistence of book-building as the standard mechanism for U.S. (and to a large extent global) public offerings, and the value embedded in it of facilitating the flow of information from the purchasers to the underwriter and vice versa, reveals a complex negotiation between underwriters and institutional buyers that helps explain much of what is happening prior to the effective date of the registration statement, from which we can learn a great deal.

Our principal claim is that the demise of Section 5’s communication rules is best understood as an embrace of book-building, facilitating the two-way communication process on which that practice depends. But we also consider what might have been lost in this remarkable transformation of the selling rules. Because book-building involves communications with presumably sophisticated institutional investors, it becomes easy to doubt that there is much if any need for protection at all. But the finance literature also stresses the complex interplay between these institutional negotiations and the stimulation of largely retail investor-driven demand in the secondary trading market, which was once clearly within Section 5’s constraint but is less so after deregulation.

To assess whether investors are better off or not as a result, we turn to two main justifications that have been given for the deregulation. The first is that any loss in prophylactic protection can be made up for by the threat of liability, particularly with an enhanced Section 12(a)(2). We find this unpersuasive for a variety of important reasons. The other—amply visible in the long history of Section 5—is a faith in the “filtration” process, that retail investors gain protection because of the availability of the preliminary prospectus during the waiting period, to those involved in the selling process if not the investors themselves. Here again we are not entirely convinced. Putting aside the conflicts of interest that affect filtration, much of what is most important—and conveyed privately to the institutions in the course of book-building—is forward-looking information that probably need not appear in the formal disclosure, whether preliminary or final (something at issue in the pending Facebook IPO litigation). None of this is an argument for returning to the old prophylactics of Section 5. But it is cause for the SEC and FINRA to pay close attention to the retail investor effects of the IPO sales process, especially in the post-JOBS Act era.

The full paper is available for download here.