All Stick and No Carrot? Reforming Public Offerings

The traditional IPO was once the dominant path to raising capital for a growing company, but challengers, most notably SPACs and direct listings, have emerged.  In our essay, we argue that the regulation of public offerings should seek to facilitate the transition from private company to public when this transition maximizes the joint welfare of investors and the issuer. Although the SEC frequently invokes investor protection as the goal of securities regulation, investors bear the cost of regulation, too. A lighter regulatory touch may be appropriate if markets have efficient price discovery.

To identify efficient pricing, we start with the end point: the public company. What attributes of a public company promote investor protection? Shares listed on a national exchange with sufficient market capitalization and trading volume attract the attention of institutional investors and analysts. That is the paradigm for informationally-efficient securities markets, fueled by a history of both mandatory disclosures filed with the SEC and voluntary disclosures made by companies seeking to bolster their shares’ liquidity. Such “high information” companies will have an incentive to make disclosures and adopt other investor protections if the benefits to investors (incorporated into the price) exceed the costs to the issuers. Retail investors benefit by free-riding on the efforts of the sophisticated investors who are setting market prices. An informationally-efficient secondary trading market is the closest we can come to a free lunch in the field of investor protection.

The traditional IPO attempts to bridge the gap between private and public with a heavy dose of regulation. In a traditional IPO, a private company sells shares following a restrictive “gun-jumping” process. The company drafts a mandatory disclosure document, the registration statement, providing audited financials, a description of its business, executive compensation disclosures, and much more. The SEC will review the IPO registration statements and provide comments. For misstatements that get past the SEC, heightened liability under Section 11 of the Securities Act awaits the company and its officers and directors. Liability also extends to the professionals who assist the company, including underwriters.

This heavy-handed regulation produces a market that seems rigged to benefit investment banks and their institutional investor clients. Investment banks extract a healthy – and somewhat cartel-like in its uniformity – commission of 7 percent for their services shepherding companies through the going-public process. In exchange, the investment banks act as gatekeepers to the public markets, serving the merit-regulation role denied to the SEC by Congress. The underwriters allocate the offered shares mainly to institutional investors, which benefit from the traditional underpricing of shares. Issuers pay the cost of this underpricing, “leaving money on the table.” Retail investors are generally relegated to buying newly-listed shares in the frothy secondary market, with disappointing long-term returns on average. Even the heavy-handed regulation of the traditional IPO does not prevent retail investors from getting the short end of the stick.

Given these limitations of the traditional IPO, providing alternative paths to public status may allow more issuers to raise funds at a lower cost or with greater speed. The securities laws provide limited choice, giving creative promoters the ability to bring the securities of private companies to the public market, in certain circumstances, without going through a traditional IPO. Most investors may freely resell securities sold through a private placement, after a holding period. If such securities are listed for trading on a national securities exchange through a direct listing, then the investors may resell the privately placed securities to the public. Private companies may also go public by merging with an existing public company, a process referred to as a reverse merger (and used by SPACs to bring private companies public through a “de-SPAC” merger). The agency’s default response to such choice has been to apply regulatory protections similar to those applicable to a traditional IPO, treating the traditional IPO as the gold standard.

The SEC’s instincts with respect to the existing alternatives to the traditional IPO may have some justification. The present choice in how to go public is more an artifact of the focus in the securities laws on transactions rather than a deliberate method to maximize issuer and investor welfare. From an investor protection perspective, there are legitimate concerns that opportunistic issuers with thinly-traded securities can take advantage of less sophisticated investors. In that scenario, choice for issuers can harm investors and the capital markets. Put another way, we have the wrong choice. But the traditional IPO is not great for retail investors, and it has its own deficiencies in promoting accurate pricing.

Can we engineer a system that provides choice in a way that maximizes the interests of issuers and investors? We outline an alternative regulatory approach focused on minimizing the costs of transition from public to private. Instead of a transaction – the traditional IPO – as the dominant path for making the transition from private to public, we propose that public offering regulation focus directly on the nature of the information environment for companies seeking to have securities trade in public markets.

Compare a high information public company with a private company that is contemplating going public through a traditional IPO. Private markets typically lack informational efficiency; they generally do not have a critical mass of sophisticated institutional investors to process the scant information that is available. Will a traditional IPO, which limits information distribution to investors during the IPO process and results in a single mandatory disclosure in the form of a registration statement, make this private company as informationally efficient as our high information public company? We think this is unlikely for most IPO issuers. Instead of regulating based on a single transaction, we propose that companies be given two options. Both focus on the quality of the information environment for a company and its securities, but they take different approaches based on timing: One focuses ex ante on developing a thick information environment (allowing high information companies to go public), the other ex post on strengthening mandatory investor protections until a company develops a high information environment.

Our ex ante option attempts to leverage the most attractive features of direct listing – market-based pricing and lower investment banking fees – in a way that promotes investor protection without creating inordinate liability risks. Companies could demonstrate a strong information environment as a requirement for transition to public company status by opting for a seasoning period with public reporting, including annual Form 10-Ks and quarterly Form 10-Qs, while remaining a private company. A period of public reporting, perhaps a year, would be subject to only SEC enforcement for misleading disclosures. The availability of information, along with the prospect of eventual public listing on the NYSE or Nasdaq, would encourage institutional investors to trade in the private markets for these companies and analysts to initiate coverage. Under this regime, companies would be eligible for public company status and listing on a national securities exchange after the seasoning period. Once public, the company could also do subsequent offerings under the SEC’s relaxed shelf-registration standards for seasoned companies and thereby avoid most of the gun-jumping rules. Disclose now, trade (and offer securities) later.

Under our ex post option, private companies that choose not to pursue the pre-IPO seasoning requirements but instead go through one of the existing avenues to go public would submit themselves (but not their affiliates, auditors and underwriters) to heightened liability for a period (again perhaps a year) after they go public. If a company chooses this ex post option, the change from the current regime would be that Section 11 liability would extend not only to registration statement disclosures made in connection with the initial offering, but also to Form 10-Qs and other SEC filings. This would allow for post-public seasoning without sacrificing investor protection. Under this regime, a private company would not need to undergo pre-IPO seasoning; heightened liability would make up for the initial weaker information environment for such companies. Trade now, but face potential liability later for any material misstatements.

Our post-IPO proposal that focuses on heightened liability is at best a blunt tool for promoting informational efficiency but nonetheless serves as a stick, providing a disincentive for companies seeking to go public without a thick information environment. Companies that encourage informationally efficient markets for their securities by making robust disclosures during a pre-IPO seasoning period should be rewarded with lower liability exposure, the carrot in our proposal. The goal of public offering regulation should be securities trading in informationally efficient markets, with pricing driven by sophisticated investors. Retail investors can participate in such markets with minimal investor protection concerns.

This post comes to us from professors Stephen J. Choi at New York University School of Law and Adam C. Pritchard at the University of Michigan Law School. It is based on their recent article, “All Stick and No Carrot? Reforming Public Offerings,” available here.

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