CLS Blue Sky Blog

The Case for a Junior Equity Market

The following post comes from Professor Jeff Schwartz of the University of Utah S.J. Quinney College of Law:

The influential SEC Advisory Committee on Small and Emerging Companies recently approved a new set of recommendations.  The boldest among them is the committee’s unanimously-endorsed proposal that the SEC encourage the creation of a junior equity market for small and emerging firms.

Here is why this makes sense.  Over the last fifteen years, the traditional public markets, like the NYSE and NASDAQ, have become increasingly inhospitable places for all but the largest public companies.  Unsurprisingly, this shift has been accompanied by a precipitous decline in IPOs, particularly among smaller firms.  This is a worrisome trend in that it represents a breakdown in the structure of entrepreneurial finance that has long-served as the basis for innovation and job-creation.

The rationale for the committee’s proposal is straightfoward — that if a market were created to fill the void that the traditional venues have left behind, then IPOs would return.  What this means in practice is a market designed from the ground up with federal regulations narrowly-tailored to fit small and emerging firms and market rules on listing and trading drafted with the same goal in mind.

Despite its appealing logic, this proposal is likely to face criticism from two opposite directions as it moves from the committee to the SEC.  Some will contend that a variety of markets exist that already offer what the proposal seeks to create from scratch.  What they’ll have in mind are venues like SecondMarket, which made their name facilitating the transfer of shares in private companies like Facebook and LinkedIn prior to their IPOs.

These platforms, though, are a crutch rather than a cure.  SecondMarket and its ilk are attempting to build markets on a mishmash of regulations for private-share trading that were never designed to support such ambitions.  This lack of a sound foundation has hobbled their efforts to create viable alternative trading venues.  A new market built on specially-designed regulations would be much better positioned to succeed.

The other main critique this recommendation is likely to confront is the claim that it gives short shrift to investor protection.  Though the committee has not specified the regulatory contours it envisions, ostensibly firms trading on this market would not be required to disclose as much as the GMs of the world.  Relief from parts of Sarbanes-Oxley and Dodd-Frank are also surely in the mix.  The very specter of such deregulation will be troubling to some.

But this market will not be a Petrie dish for fraud.  The idea is to create a place where the core elements of securities regulation, such as disclosure of material information and SEC fraud enforcement, remain in place.  While there may be some increased risk when trading on this platform, the goal of securities law was never to provide as much protection as possible.   If this market is done right, it will be a place where both investors and firms feel they are treated fairly.

In fact, if I were to quibble with the committee, it would be in regards to its recommendation to confine the market to accredited investors.  This was likely done to signal its commitment to investor protection.  But a market that hues to the principles just set forth need not be fenced off.  In addition, a restriction so conceived runs contrary to the egalitarian core of public markets and, as such, deprives many of the opportunity to invest in promising young companies.

Structural details like this can be ironed out in the regulatory process.  Indeed, the rules created to govern market participants and integrate the new trading venue into the existing regulatory and market framework are central to the success of this proposal.

How the abstract is rendered concrete is always crucial but never easy.  It is work worth doing, though, given the exciting prospect of a reinvigorated marketplace for small and emerging firms.

The committee’s proposal is based on my recent article in the Cardozo Law Review (available here) and on my presentation to the committee last fall (a transcript of the proceedings is available here).

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