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In this report, Expanding the On-Ramp: Recommendations to Help More Companies Go and Stay Public, eight organizations—the American Securities Association, Biotechnology Innovation Organization, Equity Dealers of America, Nasdaq, National Venture Capital Association, Securities Industry and Financial Markets Association, TechNet and the U.S. Chamber of Commerce—joined forces to make recommendations about how to revitalize the IPO market and make public company status more appealing. Many of these recommendations have in the past been the subject of legislation or proposed rulemaking or have otherwise been floated in the ether but, nevertheless, have not advanced.  Will the weight of these groups propel any of these recommendations forward?

The report begins by reminding us of the benefits to the economy that result from an environment that would induce companies to go public: according to one study, “the 2,766 companies that went public from 1996 to 2010 collectively employed 2.2 million more people in 2010 than they did before they went public, while total sales among these companies increased by over $1 trillion during the same period.  Another study… in 2010 found that 92% of a company’s job growth occurs after it completes an IPO.”

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See also this speech from new SEC Commissioner Hester Peirce, who advocated that we need “to look at the bigger picture. I worry that we can be too myopic when considering capital formation. Discussions often focus on the issuers, or maybe on the jobs the issuers might create, or on the money investors can earn. These things are extremely important to any discussion of capital formation, of course, but none is the reason we actually need robust capital formation. We need it because of what the companies create. Perhaps it sounds a bit like an advertising slogan, but vibrant capital markets fund the good ideas that make life better. It’s not too much to say that how well our markets work is a matter of life and death; markets fund new cancer drugs, car safety features, and medical devices. When companies doing good things can’t access the money they need, we lose out and we will never know just how much we’re losing. We don’t know what new invention was waiting to be created that now never will be. I realize this may be an obvious point, but I worry that it often gets lost in the conversation.”

However, the report continues with a familiar  lament: these benefits notwithstanding,

“the public company model has become increasingly unattractive to businesses: the United States is now home to roughly half the number of public companies than existed 20 years ago, while the number of public companies in the United States is little changed from 1982. Not only are fewer companies going public, but the companies that do are typically doing so much later in their lifecycle. When companies go public at a relatively mature age, many of the early stage returns generated by those businesses accrue to institutional investors such as private equity funds or wealthy individuals who are allowed and able to invest in private offerings.   Main Street investors thus have limited opportunities to participate early on in a company’s growth cycle. All too often, Main Street investors are simply left out.”

The report recognizes that the problem is complex and that there are no easy solutions.  Some of the reasons for the reluctance of companies to go public—such as the availability of capital through the currently vibrant private markets—are not, the report concludes, within the control of policymakers.  What policymakers can control, the report asserts, are laws and regulations, and those need to be updated.

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But will easing the regulatory burden really  make a big difference here? Many commentators view the issue of the decline in IPOs as more complex than just the volume of red tape. Among the factors commonly cited for the decline in IPOs and public companies are the availability of capital in the private markets, the greater maturity expected of IPO candidates, more opportunities for liquidity for investors and employees through secondary trading in the private markets, changes to the Exchange Act registration threshold that permit companies to stay private longer and concerns regarding hedge-fund activists with short-term views, among other reasons.

According to EY, the decline in the number of public companies—largely the result of  acquisitions and delistings—happened primarily by 2002; it’s not just a recent phenomenon. And much of the decline may reflect the popping of the dot-com bubble in the first years of the new millennium. Accordingly, some would argue that a number of those companies should not have gone public in the first place and that measuring against the height of the bubble is wrong-headed.

As observed at a 2017 meeting of the SEC’s Investor Advisory Committee, when a number of CFOs were asked why they would decide not to go public, at the top of the list was the need to maintain decision-making control. In the private market, another panelist suggested, companies and investors have a kind of unspoken “pact” about long-term strategy. But, said one panelist, the rise of hedge-fund activism in tech and other product-cycle-driven public companies—a relatively recent phenomenon—has fueled concerns among founders and other management that they will be hampered in pursuing long-term strategic goals by activists with short-term perspectives. These companies fear that activity that may have significant long-term payout, but a near-term adverse price impact (e.g., M&A activity, change in product strategy, substantial investment in R&D), will draw scrutiny and intervention from opportunistic hedge-fund activists (fka corporate raiders, now successfully rebranded as “activists”). Hence the recent prevalence of dual-class capital structures, which one panelist characterized as merging some private company benefits into a public company structure. Perhaps dual-class structures are a blunt instrument, the panelist indicated, but it’s one tool that is available. At the bottom of the CFO list of reasons not to go public was the burden of regulatory compliance.  (See this PubCo post.)

The report does recognize that the need to maintain decision-making control is a factor for companies considering an IPO, but its recommendations in that regard, while important, are limited to advocating a regulatory hands-off approach:

“Another trend that has developed recently is companies adopting corporate structures that help founders maintain control. For example, dual class or multi-class share structures retain voting rights only for certain shareholders. While such structures have received criticism from some observers, policymakers should recognize that this trend has coincided with a steady rise in shareholder activism, and that companies should be free to choose a corporate structure that they believe will best enhance long-term performance. Instead of contemplating whether to prohibit or limit the use of such structures, policymakers should instead focus on the underlying causes of the trend and whether it is merely a symptom of a broken public company model. A broad focus on encouraging investor choice while assuring that issuer disclosure keeps investors sufficiently informed is necessary to prevent prescriptive regulations that harm market dynamism.”

JOBS Act 2.0

While the report views the JOBS Act as a beginning, it contends that now is the right time for policymakers to “seriously address the impediments both to launching IPOs and to reverse the increase in costs associated with remaining a public company.”  Accordingly, the report recommends:

  • For issuers that continue to meet the definition of an EGC, extend certain JOBS Act Title I “on-ramp” provisions from five years to ten years, including streamlined financial and compensation disclosure and exemptions from say-on-pay, say-on-frequency, say-on-golden parachutes, pay-for-performance and pay-ratio disclosure.
  • Permit all issuers to “test the waters” with QIBs and institutional accredited investors to determine interest in a securities offering.

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In February, the WSJ reported that “people familiar with the matter”—every reporter’s favorite source—said that the SEC was “weighing” expanding “test the waters” beyond just EGCs.  You might recall that, in 2012, the JOBS Act allowed IPO candidates that were EGCs to take preliminary steps to determine the potential level of investor interest before committing to the expensive and time-consuming prospectus drafting and SEC review process.  (See this PubCo post.) The testing-the waters provisions in the JOBS Act significantly relaxed “gun-jumping” restrictions by permitting an EGC, and any person acting on its behalf, to engage in pre-filing communications with qualified institutional buyers and institutional accredited investors. This relaxation of the gun-jumping rules allowed companies to reduce risk by gauging in advance investor interest in a potential offering. (See this Cooley Alert.)  Prior to the JOBS Act, only WKSIs could engage in similar testing-the-waters communications. A 2017 Treasury report also recommended expanding this provision of the JOBS Act to allow all companies, not just EGCs, to get their toes wet. (See this PubCo post.)  See also HR 3903 and Senate Bill 2347, which would expand the test-the-waters provision beyond EGCs.

  • Extend the JOBS Act exemption from SOX 404(b), the requirement to have an auditor attestation and report on management’s assessment of internal control over financial reporting, from five years to ten years for EGCs that have less than $50 million in revenue and less than $700 million in public float. The report contends that costs associated with SOX 404(b) “have not been scalable for small and midsize public companies” and that there is “no evidence” that the JOBS Act exemptions from SOX 404(b) “have compromised investor protection or market confidence.”

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Those same people familiar with the matter also told the WSJ that the SEC was looking at exempting smaller companies from SOX 404(b). The auditor attestation requirement has recently been much maligned as time-consuming and expensive for smaller companies, diverting capital from other more important uses such as R&D.  However, many see value in these controls audits.  According to a GAO study, companies exempt from controls audits had more restatements. In addition, another study showed that companies that had controls audits had higher valuation premiums and lower cost of debt.  See this PubCo post.  In her speech cited above, Commissioner Peirce cited SOX 404(b) along with conflict minerals and pay-ratio disclosures as examples of burdensome regulation that she believed deterred companies from going public.

  • Remove “phase-out” rules that “increase the complexity and uncertainty regarding EGC status,” thus allowing EGCs to retain their EGC status even if they crossed a market cap threshold (although the report allows that the SEC could still set a public float cap.) The report indicates that, for example, in 2014, about 30% of EGCs that went public in 2012 found that they had to comply with SOX 404(b) because they had become large accelerated filers and, as a result, therefore ceased to qualify as EGCs.

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I would gamble that providing some consistency among the various categories of filers would be warmly welcomed.  At a 2015 meeting of the SEC’s Advisory Committee on Small and Emerging Companies, the Committee approved a set of recommendations—albeit with a different approach than that taken by the report here—many of which were aimed at harmonizing the jumble of rules applicable to the various categories of small companies and expanding the application of the small-company disclosure accommodations generally. (See this PubCo post.)

Recommendations to Encourage More Research of EGCs and Other Small Public Companies

One widely recognized problem for smaller public companies is the dearth of analyst coverage, which can affect the liquidity and trading environment. The report cites a study showing that, for exchange-listed companies with less than a $100 million market cap, about 61% of have no research coverage at all. The report recommends:

  • Amend Rule 139 to provide that continuing coverage by research analysts of any issuer would not be deemed to constitute an offer or sale of a security of that issuer before, during or after an offering by such issuer, regardless of whether the issuer was S-3 eligible.
  • Allow investment banking and research analysts to jointly attend “pitch” meetings in order to have open and direct dialogue with EGCs. A holistic review of the Global Research Analyst Settlement should also be conducted, the report recommends. Currently, the JOBS Act permits joint attendance, but SEC guidance limits what may be discussed. The report recommends that the SEC expand the scope of permitted content that can be discussed “so long as no direct or indirect promises of favorable research are given.”
  • The SEC should examine why pre-IPO research has not materialized notwithstanding liberalization of the gun-jumping rules under the JOBS Act to permit publication of pre-IPO research. Are there other regulatory or liability concerns that should be addressed in this context?

Improvements to Certain Corporate Governance, Disclosure and Other Regulatory Requirements

The reports cites a 2011 report of an IPO Task Force for the proposition that “92% of public company CEOs found the ‘administrative burden of public reporting’ to be a significant barrier to completing an IPO.”   In addition, the report contends that companies are distracted by pressures from governance activists, bolstered by proxy advisors, over matters that are often immaterial.  The report recommends:

  • Institute reasonable and effective SEC oversight of proxy advisory firms. The report notes that ISS and Glass-Lewis have over 97% of market share and have become “de facto standard setters for corporate governance.”  But there’s a “startling lack of transparency and significant conflicts of interest, and [proxy advisors] have been prone to making errors in analysis….These issues are exacerbated by the lack of communication between the firms and small and midsize companies….” Congress should enact legislation (passed by the House in 2017) (see, e.g., this PubCo post and also R. 4015) that would require proxy advisors to register with the SEC, and the SEC should withdraw two old no-action letters that, through no-actions positions regarding investment advisors’ use of third-party recommendations, allowed proxy advisors to bypass “case-by-case scrutiny of their own conflicts of interest.”

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Note, however, that, in a 2014 SLB, the SEC staff did provide some guidance addressing these issues regarding conflicts of interest. That guidance sought to reinforce the responsibilities of investment advisers as voters by reinvigorating their due diligence and oversight obligations with respect to any proxy advisory firms on which they relied. In addition, the guidance strengthened, to a limited extent, the disclosure obligations of proxy advisory firms in connection with conflicts of interest. The SLB was intended to address some of the frequently voiced criticisms that proxy advisory firms wield too much influence—with too little accountability—in corporate elections and other corporate matters and that they are often subject to undisclosed conflicts of interest that may affect their vote recommendations.  However, the guidance paled in comparison to the potential requirements that were floated in connection with the SEC’s proxy plumbing concept release or the 2010 report from the NYSE Commission on Corporate Governance. Those bolder ideas included mandatory proxy advisory firm registration, requiring proxy advisory firms to provide more transparency regarding their policies and methodologies and the extent of research involved to formulate specific voting recommendations, requiring any conflicts of interest and the procedures to manage them to be described in filed reports and requiring proxy advisor recommendations to be filed with the SEC.  (See this Cooley Alert)

  • Reform shareholder proposal rules under Rule 14a-8, in particular by raising the “resubmission thresholds” —that is, the levels of support that proposals must receive in order to be eligible to be submitted again to shareholders. The report argues that “many of the longstanding guardrails put in place under [the shareholder proposal] system to protect investors from abuse of the proxy process have steadily weakened, and the shareholder proposal system today has become dominated by a minority of special interests that use it to advance idiosyncratic agendas.” The report suggests that a good starting point would be a 1997 SEC proposed rule (ultimately not adopted) that would have raised the thresholds “from the current 3%/6%/10% system to a more reasonable 6%/15%/30% system.” The report also recommends that the SEC withdraw SLB 14H, issued in 2015, regarding Rule 14a-8(i)(9) conflicting proposals. The SLB narrowed the application of the exclusion  by redefining the meaning of “direct conflict.” (See this PubCo post.)

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This idea might have a familiar ring to it. Commenting on the shareholder proposal process at the 2018 SEC-NYU Dialogue on Securities Markets, a representative of the Society of Corporate Governance advocated raising the resubmission thresholds to help avoid “tyranny” of the minority.  However, an ISS representative argued that it was important not to lock out retail shareholders, who often get the ball rolling on corporate governance issues. (See this PubCo post.)  In Senate testimony and in remarks before the Chamber of Commerce in 2017, SEC Chair Jay Clayton agreed that the resubmission thresholds for shareholder proposals should be continually reexamined. While some proposals have gained traction and brought positive change, there must be a balance to avoid allowing the “idiosyncratic views of a few shareholders” to cost the valuable time and money of others. The Chamber has also recommended that the resubmission rule should be amended to raise the thresholds levels based on the same 1997 SEC rulemaking proposal. (See this PubCo post and this PubCo post.)  Note also that Nasdaq has recently urged support for H.R.5756, which would increase the resubmission thresholds for shareholder proposals, modeled on the 1997 proposal.

  • Simplify quarterly reporting requirements and give EGCs the option to issue a press release with earnings results in lieu of a 10-Q. The underlying intention is to “provide investors with the material information they need to make informed decisions but reduce some of the unnecessary burden associated with the current quarterly reporting system.”

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Note that Nasdaq has recently sent out correspondence advocating support for H.R.5970, which would require the SEC to issue new rules allowing exchange-traded companies to elect to disclose quarterly financial information in a simplified manner, such as through a press release or by a shortened form, instead of on a Form 10-Q.

  • Continue to modernize corporate disclosure and scale requirements for EGCs, and maintain the “materiality” standard for corporate disclosure. This recommendation is directed toward the use of SEC disclosure to advance social policy agendas outside the historical purpose of the securities laws. Examples cited include the conflict-minerals and pay-ratio rules, which, the report argues, have cost billions “but have done little to provide investors with material information.”  Similarly,  the disclosure rules should not be used to inundate investors with immaterial information, the report suggests. At a minimum, the report recommends exempting EGCs from the conflict minerals, mine safety and resource extraction provisions of Dodd-Frank. In addition, the SEC should go forward with its October 2017 proposal to modernize and simplify Reg S-K, including scaling for EGCs. (See this PubCo post.)
  • Allow purchases of EGC shares to be qualifying investments for purposes of Registered Investment Adviser exemption determinations, a change designed to address the definition of “venture capital fund,” which the report contends is too narrow, and to expand the potential pool of EGC investors.
  • Amend Form S-3 to eliminate the “baby-shelf” restrictions and allow all issuers to use shelf registration Forms S-3 and F-3; the “baby-shelf” rules significantly limit the amount of capital that smaller companies can raise using a shelf registration statement.
  • Address abuses, such as “short and distort” campaigns, by market manipulators or unlawful activity related to short sales.
  • Amend Rule 163 to allow prospective underwriters to make offers of WKSI securities in advance of filing any registration statement. In 2009, the SEC proposed, but did not adopt, amendments to Rule 163 that would have allowed a WKSI to authorize an underwriter or dealer to act as its agent or representative in communicating about offerings of the issuer’s securities prior to the filing of a registration statement. (See this Cooley News Brief.)
  • Make XBRL compliance optional for EGCs, smaller reporting companies (SRCs) and non-accelerated filers. Implementing XBRL is costly “for EGCs and other small companies without much, if any, benefits to investors. The data reported by XBRL are heavily weighted toward traditional metrics that provide little to no insight into the health of a small or pre-revenue business. Investors largely realize this shortcoming of XBRL and thus often do not utilize XBRL reports to evaluate emerging companies, yet every single public company faces an identical XBRL compliance requirement.”

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See this Cooley New Brief for a discussion of a report from Columbia Business School indicating that the time-consuming and costly effort to implement XBRL “might have been a colossal waste of time.” As the author notes, after reading the report, anyone involved in the corporate reporting process might feel “like they just spent months building a ballpark in a cornfield, only to find that no one seems to be showing up.” Apparently, according to the report, the investors and analysts that were supposed to benefit from XBRL “don’t seem to be using it.  According to the report’s authors,… analysts and investors remain skeptical about XBRL and have many concerns about its utility.” The main complaint, according to the study, is that the data is still unreliable and fraught with errors.

  • Increase the threshold for mutual funds to take positions in companies before triggering diversified fund limits from the current 10% of voting shares to 15%; the diversified fund limit rules have constrained the funds’ ability to take meaningful positions in small-cap companies.
  • Allow disclosure of selling stockholders to be done on a group basis under Rule 507 of Reg S-K if each selling stockholder is not a director or named executive officer of the company and holds less than 1% of outstanding shares.

Recommendations Related to Financial Reporting

Although EGCs are exempt from the SOX 404(b) internal control auditor attestation requirement, other proposals would provide additional exemptions based on public float or revenue. The contention is that policymakers should make an effort to make the costs associated with SOX 404(b) more scalable, after weighing costs and benefits.

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As noted above, SOX 404(b) has recently been the focus of heightened scrutiny as a significant contributor to the type of regulatory overload that has deterred companies from conducting IPOs. At a July 2017 hearing of the  Subcommittee on Capital Markets, Securities, and Investment of the House Financial Services Committee, a number of the witnesses trained their sights on SOX 404(b), arguing that it was too time-consuming and expensive for smaller companies, diverting capital from other more important uses such as R&D.  In addition, the definition of “internal control”  was characterized as too broad, and the scope of “attest” imposed by the PCAOB was too exclusive. According to another witness, however, an EY report showed that, following the effectiveness of the SOX attestation requirement, from 2005 to 2016, the number of financial restatements declined by 90%, and the aggregate amount of net income involved in restatements declined from $6 billion to $1 billion. Initially, in the first two years after SOX 404(b) went into effect, there were over 1,000 restatements in each year. If SOX 404(b) were eliminated, a witness speculated, the result could very well be that there is no beneficial effect on the number of public offerings, but that the risk of financial scandal has dramatically increased. (See this PubCo post.)

 

  • Consider aligning the SRC definition with the definition of a non-accelerated filer (which is exempt from SOX 404(b)) and institute a revenue-only test for low or pre-revenue companies that may nevertheless have high market caps. A 2016 SEC proposal would have raises the financial cap for SRCs from “less than $75 million” in public float to “less than $250 million,” allowing more companies to take advantage of scaled disclosures. However, the SEC did not propose to similarly increase the cap for non-accelerated filers on the basis of a 2011 staff study, which found

“no specific evidence that any potential savings from exempting registrants with public floats between $75 million and $250 million from the auditor attestation provisions of Section 404(b) would justify the loss of investor protections and benefits to registrants from such an exemption. Rather, the staff found that accelerated filers (including those with a public float between $75 million and $250 million) that were subject to the Section 404(b) auditor attestation requirements generally had a lower restatement rate than registrants that were not subject to the requirements. Moreover, the staff found that the population of registrants with public floats between $75 million and $250 million did not have sufficiently unique characteristics that would justify differentiating this population of registrants from other accelerated filers with respect to the Section 404 auditor attestation requirements.”

(See this PubCo post.) So much for the harmonization recommended by the SEC’s Advisory Committee on Small and Emerging Companies last year.  (See this PubCo post.) The report advocates that the SEC consider aligning the definitions, as well as an alternative “revenue only” test with a cap of less than $100 million in revenue, regardless of public float.

  • Modernize the PCAOB inspection process related to internal control over financial reporting. Although, in 2007, the SEC issued guidance allowing companies to prioritize the most important risks in ICFR, the report contends that companies are experiencing ICFR issues “primarily as a result of the audit process and the consequences of PCAOB inspections.” (See this Cooley News Brief.) The report advocates that the guidance be revisited to ensure that it is working properly.

Equity Market Structure

While advances in technology and venue competition have reduced trading costs and increased liquidity and efficiencies, these improvements have not occurred evenly across the equities markets, particularly the markets for smaller companies. The report suggests that regulators tailor regulations to help improve trading of EGCs and other small issuers.

  • Intelligent tick sizes should be examined as a way to help improve trading for EGCs and small capitalization stocks. While decimalization may work well for large cap, highly traded companies, “narrow spreads often generated by penny increments can actually serve as a disincentive for market makers to trade the shares of EGCs or other small issuers.”
  • Allow EGCs or small issuers with distressed liquidity the choice to opt out of unlisted trading privileges–which allow their stock to be traded on all of the more than a dozen registered national securities exchanges–to help concentrate liquidity and reduce fragmentation. While increased competition has contributed to some of the reduced costs mentioned above, it has also introduced a significant amount of market fragmentation that hinders the trading of illiquid stocks.

Posted by Cydney Posner

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