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.”
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.
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.
- 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.”
- 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.
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.”
- 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.)
- 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.”
- 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.”
- 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.
- 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.