The Need for Greater Secondary Market Liquidity for Small Businesses

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s public statement at a recent meeting of the SEC Advisory Committee on Small and Emerging Companies; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

I am delighted to see that today’s [March 4, 2015] meeting will discuss the secondary trading environment for the securities of small businesses. The lack of a fair, liquid, and transparent secondary market for these securities is a longstanding problem that needs an effective solution. Indeed, I’ve spoken publicly about this very issue on a number of occasions, most recently less than two weeks ago at the annual SEC Speaks conference. This topic is increasingly urgent in light of certain new, or anticipated, Commission rules required by the JOBS Act that would result in a far wider range of small business securities needing to find liquidity in the secondary markets. Specifically, proposed rules under Regulation A-plus and Crowdfunding, and final rules under Rule 506(c) of Regulation D, would permit wide distributions of securities and also allow such securities to be freely-traded by security holders immediately upon issuance, or after a one-year holding period. These registration exemptions also provide—or are expected to provide—for lesser on-going reporting requirements than is required for listed securities.

Moreover, under the Commission’s recently proposed rules to amend Section 12(g) of the Securities Exchange Act of 1934 (the “Exchange Act”), as required by the JOBS Act, the number of record holders a company may have before it is required to publish annual and quarterly reports would greatly increase. In addition, the Crowdfunding proposal, as required by the JOBS Act, would permanently exclude any purchaser of the shares from counting as a record holder for purposes of Section 12(g)—and any future secondary purchasers of those shares would also be excluded. Thus, regardless of the resulting number of record holders of such shares, the Section 12(g) provisions would never be triggered.

The combined results of these existing and pending rules is that companies will be able to sell their securities to a wider swath of the public and remain outside of the protections of the registration provisions of the Exchange Act for longer periods of time—perhaps even permanently. As a result, investors who acquire these shares—many who are expected to be less financially sophisticated and need not be so-called “accredited investors”—may be left holding shares that they are unable to sell.

Viability of “Venture Exchanges”

One idea that been suggested as a way to foster an active secondary market for small company stocks is for the Commission to approve one or more venture exchanges. Such exchanges would be limited to smaller cap companies that are expected to meet less stringent listing standards. Clearly, the coming tsunami of unregistered and unlisted shares requires some new solutions—and venture exchanges may be a viable alternative. Venture exchanges are hardly a new idea, however, and prior efforts to establish them in this country have fared poorly. Accordingly, we need a thoughtful and prudent approach that carefully examines why the prior attempts failed. As we all know, “[t]hose who cannot remember the past are condemned to repeat it.”

For example, we should carefully examine the reasons for the demise of the American Stock Exchange’s Emerging Company Marketplace, known as the ECM. Although the ECM’s lower transaction costs allowed it to thrive for a time, the exchange eventually succumbed to a number of serious design flaws. For instance, the profitable firms that joined the ECM eventually graduated to the American Stock Exchange. This created the impression that the ECM was populated only by unsuccessful companies. The ECM’s image problem was only made worse by the exchange’s failure to properly screen candidate firms. Scandals involving some ECM companies only cemented the exchange’s reputation as a lawless Wild West. Finally, one academic study suggests that the narrow bid/ask spreads that prevailed on the ECM may have dissuaded broker-dealers from making markets for these stocks, which may have decreased liquidity. It may also have deterred broker-dealers from distributing research on these companies.

The issues raised by ECM’s demise are both complex and interrelated. But, it is not the only source of guidance available to us. There have been other attempts to create viable markets for smaller companies. For example, many European stock markets have experimented with a junior exchange for companies too small to meet normal listing requirements. These efforts generally proved unsuccessful, and we should try to understand why. Moreover, efforts in 2011 to establish a new venture exchange in the U.S., the Nasdaq BX Venture Market, appear to have stalled. Finally, we should examine the recent struggles of Canada’s TSX venture exchange. It has been reported that TSX’s over-reliance on mining and energy firms has left that exchange in the midst of a crisis, due to the global collapse in commodity prices.

In addition, it’s been reported that venture exchanges—both here and abroad—have suffered from low liquidity and, at times, high volatility. This means investors could lose a lot of money quickly, and could have trouble selling their shares in a downturn. The Commission should attempt to determine the underlying causes of these problems and how best to address them. In this regard, we may need to ask some difficult questions. For example, should venture exchanges be structured as dealer markets, rather than auction markets? Also, could venture exchanges enhance liquidity through batch auctions, rather than continuous trading? How can the Commission, consistent with the Exchange Act, encourage traders to execute transactions on venture exchanges, rather than in off-exchange venues? And, finally, could larger ticker sizes enhance liquidity by encouraging market maker activity and fostering research coverage? In this regard, the Commission’s proposed tick size pilot program may offer valuable insights on the role of tick sizes in ensuring an active secondary market for smaller companies.

Importantly, each of these questions presents the possibility of a trade-off between what is best for investors, and what is best for the exchange and its participating broker-dealers. We must be mindful of these trade-offs as we review any proposals for new venture exchanges. We must also never lose sight of our core responsibility, which is to protect investors above all else.

Investors will also need to understand what venture exchanges are—and what they are not. Investors may think venture exchanges will be the place to find the next Apple, Google, or Facebook. But it’s never that easy. In fact, one study showed that London’s venture exchange, the Alternative Investment Market, actually has had fewer high performance firms than traditional exchanges. Instead, studies show that venture exchanges tend to have a high proportion of small, early stage companies operating in high-risk business sectors. This means that companies listed on venture exchanges can significantly underperform and, thus, tend to present a far higher risk profile than firms found on traditional exchanges.

To be sure, venture exchanges can, and do, attract reputable and profitable companies. But experience has shown that venture exchanges and the companies they list may present more risks than investors realize. The Commission needs to understand how best to address these risks before approving more of these exchanges. It also needs to make certain that investors understand these risks.

Those who have studied venture exchanges believe that they are far more likely to succeed when they focus on investor protection and education. Venture exchanges that implement appropriate listing standards, enforce them conscientiously, and educate investors about the higher risks involved with small cap companies seem to do better. Those that have not have struggled.

In addition, experts have pointed to other factors that can improve venture exchanges’ performance. For example, several academics have argued that some listing standards are more important than others. These experts have asserted that, while it may be appropriate for venture exchanges to lower certain listing standards, such as minimum firm size, other standards should be inviolate. In particular, these experts believe that effective corporate governance standards and accounting requirements are essential to the viability of any venture exchange.

In sum, venture exchanges are a possible solution to a looming problem and need to be considered. We should do so in a thoughtful and measured manner—fully cognizant of benefits, costs, and challenges—and always with the needs of investors at the forefront.

Reform the Broker-Dealer “Piggy-Back” Rule

Another measure that should be considered to facilitate secondary trading of small business securities is to revise and update Exchange Act Rule 15c2-11, and its so-called “piggy-back” exception. Rule 15c2-11 is widely used by broker-dealers to trade in unlisted securities. In fact, in 2014, over 10,000 of these unlisted securities traded in the so-called “over-the-counter” (“OTC”) markets, amounting to a total dollar volume of over $240 billion.

In order to use Rule 15c2-11, broker-dealers who wish to publish a quote of unlisted securities, which will often be smaller issuers, are required to review and maintain certain information about the security and the issuer. In addition, Rule 15c2-11 requires broker-dealers, prior to publishing quotes of these unlisted securities, to have a reasonable basis for believing that this information is accurate in all material respects and that it was obtained from reliable sources. In this way, Rule 15c2-11 is about trust. Specifically, investors need to have confidence that the quotes for these securities are fair and accurate. Without this confidence, a fair and liquid secondary market for these securities will not exist.

In this regard, the use of current Rule 15c2-11 often fails to meet expectations of fair and accurate pricing, and often fails to result in reliable quotes. Most critically, under the rule’s “piggy-back” exception, broker-dealers are permitted to publish quotations for a security without complying with the rule’s information requirements if any other broker-dealer has published regular and frequent quotations for that security. Accordingly, a broker-dealer can “piggy-back” on either its own or another broker-dealer’s prior quotations. As a result, broker-dealers need not review the information collected and reviewed by other broker-dealers before publishing a quote. Moreover, because the exception allows broker-dealers simply to rely on their own prior quotations, broker-dealers have no obligation to confirm that the information they initially relied on when they first published a quotation is still valid, no matter how old the initial quotation is. This is hardly an effective way to create a fair and efficient market—and it’s a poor way to instill trust in this market.

The problems of Rule 15c2-11 have long been recognized. In fact, in 1998, and again in 1999, the Commission proposed comprehensive amendments to Rule 15c2-11 to address concerns about fraud and manipulation that had become increasingly common in microcap securities traded in the OTC market. At that time, the Commission acknowledged that microcap fraud was driven, in part, by broker-dealers’ routine failure to review any issuer information—whatsoever—before publishing quotations. The Commission hoped that the proposed amendments to Rule 15c2-11 would address abuses involving microcap securities, and more generally enhance the integrity of quotations for securities in this market sector. Unfortunately, these proposed rules were never finalized.

Many of the concerns originally raised by these proposed amendments to Rule 15c2-11 are equally applicable to today’s secondary market for small business shares. In fact, some of those proposals would be very helpful for dealing with today’s expanding market of small business securities, including:

  • Eliminating (or amending) the broker-dealer “piggyback” exception for small business securities. This would require broker-dealers that wish to publish quotations to conduct a review of issuer and security information, and not simply rely on other broker-dealers or their own stale review;
  • Requiring broker-dealers that publish quotations to obtain and review current information about an issuer at least annually. This would enhance accountability by requiring broker-dealers to do more than simply “check a box.” Instead, broker-dealers would need to review the information they receive from issuers each year in order to continue issuing quotes; and
  • Enhancing investor access to the information collected, reviewed, and maintained by the broker-dealer about the issuer. This information could be made easily accessible to investors over the internet to review the materials of such issuers.

In addition, it will be critical to update Rule 15c2-11 to take into account the new information and filing requirements that will be required when the Commission adopts the proposed rules under Regulation A-plus and Crowdfunding.


Before I conclude, I also note that today you will be considering recommendations on the “accredited investor” definition. This is a topic that I discussed with this Committee back in December 2014, and my views remain the same.

I also note another topic to be discussed today is whether to formalize the so-called “Rule 4(a)(1½)” exemption. Shareholders often rely on this exemption to sell their restricted securities in a private transaction without being considered an issuer or an underwriter. While I welcome the Committee’s views on formalizing Rule 4(a)(1½), it doesn’t solve the basic problem of whether a seller will be able to find a willing buyer or access a secondary trading market that will be fair, transparent, and liquid. For the latter to occur, we will need much more than simply clarifying the contours of the Rule 4(a)(1½) exemption.

Ultimately, the goal is to develop a viable secondary trading environment that promotes a fair, transparent, and liquid market for the securities of small businesses—a market in which investors can have confidence that they are being treated fairly. There is no better way to protect investors’ interests, while promoting the successful expansion of small businesses.

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