Regulating Public Offerings of Truly New Securities: First Principles

Merritt B. Fox is Michael E. Patterson Professor of Law and the NASDAQ Professor for the Law and Economics of Capital Markets at Columbia Law School. This post is based on his recent article, published in the Duke Law Journal.

Much attention has been paid recently to fostering the ability of small and medium size enterprises (SMEs) to raise capital through offerings that lead to liquid trading of their shares. Liquidity makes the shares more valuable to prospective investors, who will therefore be willing to pay more for them. The traditional route to achieving such liquidity has been an IPO registered under the Securities Act. Registration has proven impracticably burdensome for many SMEs, however. Under the JOBS Act and the FAST ACT, Congress has reacted by creating pathways for more lightly regulated “quasi-IPOs.” These reforms are a brave experiment, but one likely to end poorly. In creating these pathways, Congress has ignored economic principles relating to the market-destroying information asymmetries between potential investors and the issuing firm. A more promising approach is the SEC’s current Disclosure Effectiveness Initiative, also triggered by Congressional action, which may lead to a cost-benefit-based paring of the questions that must be answered under the traditional registration process and periodically thereafter. Such a streamlined set of questions could help at least some SMEs. Whatever the regulatory reform, however, the hard reality is that the cost of compliance will still make a public offering an impractical form of finance for most firms below a certain size.

The Concerns Driving Reform

The central concern driving reform has been that compliance with the Securities Act registration process, and with the follow-on Exchange Act periodic disclosure requirements, involves considerable economies of scale. This makes the traditional registered IPO too expensive on a per-dollar-raised basis for many SMEs. Congress has exhibited the natural reaction to this problem by easing the burden through the creation of pathways for issuers to conduct more lightly regulated quasi-IPOs. A number of new statutory provisions are involved, including the mandate that the SEC adopt the Rule 506(c) registration exemption that allows general solicitation for certain unregistered offerings, the mandate that it adopt rules allowing crowdfunding, the introduction of the Regulation A+ offerings, the new §4(a)(7) to exemption to Securities Act registration for qualifying secondary transactions in unregistered shares, and the Exchange Act §12(g) amendment that increases the number of record shareholders needed to trigger the Act’s periodic disclosure requirements. The full article describes how these provisions, in different combinations, create a number of pathways for issuers to undertake offerings that lead to a liquid market for their shares without the full burdens of traditional Securities Act registration. Depending on the pathway chosen, this burden lightening can include the reduction or elimination of what is required to be disclosed at the time of offering or periodically thereafter, the reduction or elimination of previously imposed restrictions on communications soliciting potential investors, and the easing the standard of liability applicable to participants in the offering if sued by purchasers claiming to have been damaged by a material misstatement or omission.

Evaluating Offering Regulatory Regimes

To what extent is the regulatory easing embodied in these recent Congressional reforms appropriate from the points of view of promoting economic efficiency and fairness? Answering the question requires going back to first principles. As noted, when an issuer first contemplates an offering that would create a liquid trading market for its shares, the information asymmetries between persons associated with the issuer and potential investors are particularly large. Unlike an established issuer whose securities are trading in an efficient market, much less is typically known about this new issuer and the persons associated with it. Also, there is no price in the secondary trading market to serve as some kind of valuation of the securities being offered. These observations are relatively self-evident, but they lead to four, perhaps less obvious, points that are key to evaluating an regime for regulating such offerings.

  1. Adverse selection. The presence of these particularly large information asymmetries can lead to a severe adverse-selection problem. Unless investors are made confident an issuer is providing a certain level of credible disclosure at the time of the offering, these asymmetries will often prevent a worthy offering from being successfully marketed. The issuer seeking to make the worthy offering is simply unable to distinguish itself in the eyes of potential investors from issuers with less worthy offerings. This is the so-called “lemons” problem. The critical point is that the lemons problem is no less severe for a smaller offering than for a larger one: each potential investor has the same concerns for each dollar she invests regardless of the size of the overall offering.
  • A legal regime relying solely on market-based antidotes to this problem—signaling, underwriter reputation, and accountant or credit-rating certification—and backed only by liability for intentional affirmative misrepresentation is, in many circumstances, not a sufficient solution to this lemons problem. More specifically, the larger the number of offerees, the lesser their financial sophistication, and the smaller the absolute number of dollars each is likely to invest, the less likely it is that such a purely market-based regime will solve the problem.
  1. Solving the adverse selection problem with an optional regime of heightened disclosure and the issue of externalities. One possible way to deal with the lemons problem is for the government, or a respected private entity, to offer to issuers a regime that requires them to make certain disclosures, but to make the regime’s adoption optional so that similarly situated issuers not adopting the regime would still be allowed to make offerings as well. The availability of such a regime could well allow some worthy firms to distinguish their offerings from those of less worthy firms. It is unlikely to be fully socially adequate solution to the larger adverse selection problem, however. Because of externalities, the private costs of each individual issuer’s disclosures will be higher than the social costs, and the private benefits from these disclosures will be less than the social benefits. For an individual issuer, its private costs include the disadvantage that knowing the disclosed information enables its competitors to compete more effectively and its major suppliers and major customers to bargain more effectively. This disadvantage is not a net social cost, however, because it is counterbalanced by the advantages that the information confers on these other firms. As for benefits, an individual issuer’s disclosures do not just reduce information asymmetries between it and the market. The same information can be useful as well in analyzing other issuers and thus reducing the negative consequences of the information asymmetries between these other issuers and the market. This gain with respect to other issuers is part of the social benefits from the original issuer’s disclosures, but not a benefit this the issuer can capture. If the disclosure regime is optional, issuers will decide whether to impose it on themselves based on their private benefits and costs, not the social ones, thereby resulting in a socially suboptimal level of disclosure and unnecessarily limiting its effectiveness in curing the lemons problem.
  2. Follow-on periodic disclosure. An additional tool for ameliorating the severity of the adverse-selection problem at the time of an offering is the expectation that thereafter the issuer will be providing ongoing periodic disclosure meeting certain required standards. Being subjected to such an ongoing periodic disclosure regime improves an issuer’s corporate governance discipline through a variety of mechanisms. This in turn renders less important the fact that, at time of the offering, investors typically know relatively less about the intentions and abilities of the managers and any control shareholders of new issuers than about those of established issuers whose shares already trade in liquid markets.
  3. Civil liability to promote truthful disclosure and full compliance. The adverse-selection problem cannot be solved by disclosure rules alone. There must be appropriately negative consequences for misstatements and failures to provide the required disclosures. For a variety of reasons, sole reliance on criminal and administrative sanctions is unlikely to be ideal, and so there needs to be civil liability as well. The questions are which participants in the offering process should be subject to civil liability—the issuer itself, its officers and directors, the underwriters if any, the dealers, and the accountants and other certifiers—and, for each type of participant subject to liability, what the standard should be: strict, strict with a due-diligence defense, negligence, or intent. The overall goal should be for the overall process to produce issuer disclosure that is as truthful and compliant with the regulations as is cost-effectively possible. Coming up with the right answers requires attention to the incentives that the liability standard creates for each type of participant to be honest and exercise care in informing itself. Attention also needs to be paid to which parties are most likely to have possession of the relevant evidence to as whether a violation occurred, to the costs of litigation, and to the likelihood and consequences of adjudicatory error.

Comparing the Reforms with the Traditional Regime

As developed in the full article, the main features of the traditional Securities Act registration process adhere surprisingly closely to what would be called for if one takes into account the four points outlined above. The traditional disclosure-oriented Securities Act registration process and follow-on Exchange Act periodic disclosure requirements have been, as a general matter, mandatory where an offering would lead to a liquid trading market in an issuer’s shares. Thus, the traditional regime addresses both the adverse-selection problem and the externalities issue. The issuer is absolutely liable for damages civilly if there were material misstatements or omissions of required disclosures at the time of the offering. And underwriters, issuer officers and directors, and experts are strictly liable subject to an affirmative due diligence defense. These liability standards make sense in terms of incentives for truthful and rules-compliant disclosure and in terms of concerns relating to evidence possession, the costs of litigation, and the possibilities for adjudicatory error.

Along one dimension or another, the various quasi-IPO pathways created under the recent reforms fail to adhere to what is called for by the four points outlined above. There have always been exemptions from the traditional Securities Act registration process. In the past, though, they have been based on such factors as the method of solicitation, the limited number of offerees and the sophistication, wealth, and prior knowledge about the issuer held by the offerees, the very features that would make market-based solutions to the adverse selection problem most likely to be adequate antidotes to the adverse selection problem. This is not the case with the exemptions allowed under the recent reforms that create the more lightly regulated quasi-IPO pathways.

Looking Forward

I have suggested that the Congressional experiment in creating these more lightly regulated quasi-IPO pathways is likely to end poorly. How might this happen? The most innocuous scenario is that the shortcomings catalogued above are as important as I have suggested and are recognized by the market from the outset. Under this scenario, the pathways for quasi-IPOs simply generate little interest and the provisions that have created them are not used for these purposes. Casual empiricism suggests that so far, there in fact has not been much such interest, but perhaps new possible ways of doing things have yet to catch fire.

A second, more harmful scenario would be for these shortcomings to be indeed important, but not at first recognized by the market. Under this scenario, once things take off, a substantial number quasi-IPOs will go forward that would have been revealed as unworthy and hence could not have gone forward under the traditional registration process. Thus the market for these offerings will not unravel immediately. Rather, it will require something like an economic downturn or the equivalent of the 2001 bursting of the tech bubble. This ultimate unraveling will reveal a substantial number of offerings that, unknown to their investors, were of low quality from the beginning and investors will then sour on quasi-IPOs. As result of the unworthy offerings that will have gone forward ahead of this day of reckoning, however, society’s scarce resources will have been wasted and investors unnecessarily hurt. This second scenario resembles the ultimate failure in the early 2000s of Germany’s Neuer Markt, which had been more lightly regulated than the mainstream market in order to attract offerings by innovative SMEs.

A final way for the experiment to end poorly would be for the adverse-selection shortcomings to turn out, even in the long run, to be less severe than I have predicted. Under this scenario, a whole alternative system would develop for firms to go public and be publicly traded without being subject to the traditional registered IPOs mandatory disclosure at the time of offering or periodically thereafter. Because of this alternative system’s lower private costs to issuers, it would gradually hollow out the traditional system. But, because of the externalities associated with issuer disclosure discussed above, the level of disclosure associated with this increasingly dominant alternative system would be below what is socially optimal and its effectiveness in dealing with the adverse selection problem incomplete.

This said, some help for SMEs is possible. The more promising approach, as noted at the beginning, would be a careful review of the questions that must be answered under the traditional registration process and periodically thereafter. The aim would be elimination of those that are not cost-benefit justified. But such regulatory downsizing can only be taken so far. A certain minimum range of mandated questions will need to be kept if we wish to sustain a market for most offerings that lead to liquid trading of an issuer’s shares. Even if it is possible to scale back the range of questions, the hard reality is that for firms below a certain size, the cost of what will still be required will make an offering leading to a liquid market in the issuer’s shares an impractical form of finance.

The complete article is available for download here.

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