Abolishing IPos

7/29/2019 Abolishing IPos

1/41Electronic copy available at: http://ssrn.com/abstract=2103246

RevisitingTruthinSecuritiesRevisited:AbolishingIPOsandHarnessingPrivateMarketsinthePublicGood

A.C.Pritchard*

Abstract: This essay explores the line between private and public markets. Iproposeatwotiermarketsystemtoreplaceinitialpublicofferings.Thelowertierwouldbeaprivatemarketrestrictedtoaccreditedinvestors;thetoptierwouldbeapublic market with unlimited access. The transition between the two marketswouldbebasedonissuerchoiceandmarketcapitalization,followedbyaseasoningperiod ofdisclosure and trading inthe publicmarket before the issuerwouldbeallowedtomakeapublicoffering.Iarguethatsuchsystemwouldpromotenotonlyefficientcapitalformation,butalsoinvestorprotection.

I. Introduction

Milton Cohen, in his seminal article, Truthin

Securities

Revisited,1was the

first tohighlight the awkwardness created by the enactment of Securities Act of

1933,2whichregulatespublicofferingsofsecurities,priortotheenactmentofthe

SecuritiesExchangeActof1934,whichgovernsthedisclosureobligationsofpublic

companies.3Cohen pointed out that if the Securities Act had been adopted

subsequentto,orsimultaneouslywith,theExchangeAct,itwouldhavebeennatural

forpublic offeringdisclosureobligations topiggybackon theperiodicdisclosure

obligationsmandated forpublic companies.4Franklin Delano Rooseveltspolitical

calculation, however, ensured that the bills would be separate and that the

* Frances and George Skestos Professor ofLaw, University of Michigan Law School. This

article was prepared for the Berle IV Conference held at University College, London. Thanks toparticipants at that conference for helpful suggestions and criticisms, aswell as Jesse Fried andChuckWhitehead.

SpecialthanksgotoDonLangevoortandBobThompson.Iwasaskedtocommentontheirarticle, Publicness in Contemporary Securities Regulation after the JOBS Act, 101 GEO. L.J.(forthcoming,2012),whichwastheinspirationforthisproject.Theirarticleprovidesamuchmorecomprehensive discussion of the background issues raised here; we disagree on the best wayforward,butIhavebenefittedfromanumberofhelpfulconversationswiththemonthistopic.IamgratefultotheCookFundoftheUniversityofMichiganLawSchoolforsupportforthisproject.

179 HARV. L. REV 1340 (1966)2Pub.L.No.7338,48Stat.74(1933),codifiedasamendedat15U.S.C.77.3Pub.L.No.73404,48Stat.881(1934),codifiedasamendedat15U.S.C.78.4Cohen,supranote,at13411342.



RevisitingTruthinSecuritiesRevisited

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Exchange Act would come second.5That accident of history meant that the two

statuteswoulddevelopseparatedisclosureobligations.Thatseparatedevelopment

ignoredtheeconomicrealitythattheinformationinvestorswouldseekinvaluing

securitieswouldbelargelythesame,regardlessofwhethertheywerepurchasing

from an issuer in a primary transaction or another investor in a secondary

transaction.

Companiespublicofferingandsecondarymarketdisclosureobligationshave

gradually converged since Cohen wrote in the 1960s. The rise of integrated

disclosureobligationsforthetwoActsinthe1980s6isgenerallyconsideredaway

station along the path to fullblown company registration.7Company registration

wouldallowacompanytoregisterasapubliccompanyjustonce,thereafteroffering

andsellingsecuritieswheneveritwantedwithouttheneedtoregisterthesecurities

themselves.8Themovetowardcompanyregistrationbeganwithshelfregistration

underRule415,9whichallowsforconsiderableincorporationbyreferenceofprior

publicdisclosureinregistrationstatementsforofferingsbypubliccompanies.That

movementculminatedintheSECs2005offeringreformswhichstreamlinedshelf

registration.10 Now, the largest public issuers operate under the functional

5SeeJoelSeligman,THETRANSFORMATIONOFWALLSTREET5153(3ded.,2003).6SeeAdoptionofIntegratedDisclosureSystem,SecuritiesActRel.No.6383(1982).7SeeStephenJ.Choi,CompanyRegistration:TowardaStatusBasedAntifraudRegime,64U.

CHI.L.REV.567(1997).8CompanyregistrationistheorganizingprincipleunderlyingtheAmericanLawInstitutesproposedcodificationoffederalsecuritieslaw.SeeFEDERALSECURITIESCODE(1980).In1996,theSECsAdvisoryCommitteeontheCapitalFormationandRegulatoryProcessesissuedareportoutliningavoluntarypilotprogramforcompanyregistration.ReportoftheAdvisoryCommitteeontheCapitalFormation and Regulatory Processes (1996), available athttp://www.sec.gov/news/studies/capform.htm.

9SecuritiesActRel.No.336499(1983)10SecuritiesActRel.No.338591(2005).




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equivalent of company registration. The advantages of company registration are

available,however,onlyforasubsetofthecompaniesthathavepreviouslymade

thetransitionfromprivatetopubliccompanystatus.Initialpublicofferings(IPOs),

the customary pathfor attainingpublic companystatus,arenot includedinshelf

registration;theycontinuetobesubjecttothetraditionalregulatoryregime,with

itsgunjumpingrestrictionsonvoluntarydisclosuresandofferspriortotheSECs

approvalofacompanysregistrationstatement.Thegunjumpingrulesareintended

toquellspeculativefervorbyforcingdisclosureintotheSECsmandatoryformat.

TheseparateenactmentoftheSecuritiesActandtheExchangeActhasalso

influenced the development of the distinction between public and private under

those two statutes. Both the Securities Act and the Exchange Act reflect a

public/privatedivide,buttheytakeverydifferentapproachestodrawingthatline.

The Securities Act draws the line between public and private in a manner that

focusesexplicitlyoninvestorprotection.ThedividinglineundertheExchangeAct,

by contrast, is a compromise, reflecting not only investor protection, but also

interestsincapitalformationandpracticaleaseofapplication.Iargueherethatthe

resultingmismatchbetween thepublic/private dividing lines under the twoActs

means that the transition fromprivate topublicwill inevitablybeawkwardand

abrupt, fraught with problems for issuers, investors, and regulators. Can we

reconcilethetwodividinglinessothatcompaniescannavigatethispassagefrom

privatetopublicmoresmoothly?


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Congress has addressed this problem, in a partial way, with its recent

adoption of the JOBS Act (short for Jumpstart Our Business Startups Act).11

Unhappy with the SECs somewhat tepid efforts to facilitate capital raising by

smallercompanies,CongressgavetheSECnewauthoritytoexemptofferingsfrom

the requirements for registered offerings. Along with that exemptive authority,

Congress authorized the SEC to adopt less demanding periodic disclosure from

companieswhoavailthemselvesofthisnewofferingexemption.Thesedisclosure

requirements would presumably only apply until a company triggered the

standardsforfullfledgedpubliccompanystatus.Thosepubliccompanystandards

arealsonewlyraisedbytheJOBSAct.TheseJOBSActreformshavethepotentialto

createalowertierofpubliccompanies,thusblurringthelinebetweenpublicand

private. These changes have been roundly criticized by advocates for investor

protection,however,asopeningthedoorwideforfraudandmanipulation. 12Those

criticismscarrysomeweight,giventheabusesthatrepeatedlyoccurinthepenny

stockmarket.

Mythesisisthatthetransitionbetweenprivateandpubliccompanystatus

couldbemadelessbumpyifweunifiedthepublic/privatedividinglineunderthe

SecuritiesActandExchangeAct.TheinsightbuildsonCohensthoughtexperiment

in which Congress enacted the Exchange Act first. My proposed private/public

standardwouldtakethecompanyregistrationmodeltoitslogicalconclusion.The

11Pub.L.No.,Stat.(2012).12AndrewAckerman,ScrapOverEasingIPORules,WALLST.J.C3(March16,2012)(Former

SecuritiesandExchangeCommissionChairmanArthurLevittcalleditthemostinvestorunfriendlybillthatIhaveexperiencedinthepasttwodecades.).


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customary path to public company status is through an IPO, typically with

simultaneous listingof the shares onan exchange. There isnothing about public

offerings, however, that makes them inherently antecedent to public company

status.What if companies becamepublic,with requiredperiodicdisclosures toa

secondarymarket,beforetheywereallowedtomakepublicofferings?

I propose a twotiermarket for both primary and secondary transactions

keyedtoinvestorsophistication.Theprivatemarketwouldbelimitedtoaccredited

investors,whilethepublicmarketwouldbeaccessibletoall.Thetransitionbetween

thetwowouldbetriggeredbyaneasilymeasuredquantitativebenchmarkmarket

capitalization or trading volume whichwould allow companies to elect public

statusafterreachingthatthreshold.Onceacompanyoptedforpublicstatus,that

newly public company would have a seasoning period, during which periodic

disclosures would be required. Only after that seasoning period would newly

minted public companies beallowed to sell shares to the public at large.Such a

regime would substantially enhance the information available to the primary

market once a public offering was made. More importantly, it would allow the

secondary market to process that information prior to any public offering. This

regulatory framework would go a long way toward promoting efficient capital

formation and eliminatingthewaste currently associatedwith IPOs. Ahappyby

productwouldbemorevigorousinvestorprotectionforunsophisticatedinvestors.

Iproceedasfollows.PartIIoutlinesthepublic/privatedividinglinesasthey

nowstandundertheSecuritiesActandtheExchangeAct.ThisPartalsoexploresthe

recenttransitionofFacebookfromprivatetopublicstatusunderthatframework,as


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wellasCongresss recent intervention inthefieldwiththeJOBSAct.PartIIIthen

explorestheproblemsofmakingthetransitionfromprivatetopublic,focusingon

IPOs and their role in capital allocation. Facebooks IPO again provides an

illustration(andcautionarytale).PartIVthensketchesanalternativetothecurrent

regulatory framework based on the twotiermarketproposalsummarizedabove.

PartVconcludes.

II. Privatev.Public

The distinction between public and private is an important triggering

mechanismunderboththeSecuritiesActandExchangeAct.Asnotedabove,thetwo

statutes differing demarcations between public and private date back to their

original enactment during the New Deal. Common to both, however, are the

significant regulatory consequences that flow from public designation.

Consequently, companies and their lawyers spend considerable energy avoiding

public status.This regulatoryarbitragehas inturninducedtheSEC tospend like

effortincurtailingthoseattemptedevasionsofpublicstatus.ThefencesthattheSEC

has erected around private companies and private offerings means thatmarkets

faceaninformational voidwhenacompanyis readytomakethe transition from

private to public. The problems created by that transition are illustrated by

FacebooksrecentIPOandthedevelopmentsthatprecededit.Thosedevelopments

helpedtriggerthetweaksthatCongressmadetotheprivate/publicdividinglinein

theJOBSAct.


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A. ThePublicTrigger1. TheSecuritiesAct

Under the Securities Act, public offerings are open to any and all comers.

Accordingly, public offerings are subject not only to extensive disclosure

requirements, but also to a byzantine array of gunjumping rules limiting

voluntary disclosure intended to curb speculative frenzies for newlyissued

securities.13Privateofferingsareexemptedfromregistrationand thegunjumping

rulesby4(a)(2)oftheSecuritiesAct.TheSupremeCourthasinterpreted4(a)(2)

inRalstonPurinaaspermittingprivateofferingsonlytoinvestorswhocanfendfor

themselves, and therefore do not need the protections afforded by registration

under the Securities Act.14Because they are limited to sophisticated investors,

privateofferingsaresubjecttoconsiderablylessonerousdisclosurerequirements

than public offerings. Private offerings are subject, however, to a number of

proceduresdesigned topreventend runs around thepublic offeringprocess, i.e.,

nominallyprivateofferingsthatarefunneledthroughintermediariestothepublicat

large:distributions.15

The SEC has provided a safe harbor for 4(a)(2) under Rule 506 of

Regulation D.16Rule 506 offerings are limited to investors with the requisite

sophisticationtoevaluatethe investment.17Thisrequirementisdilutedsomewhat,

13Those rules areaccompaniedbyanequallybyzantine array ofexemptions tomake the

whole scheme viable, if expensive. For a comprehensive summary, see Stephen J. Choi & A.C.Pritchard,SECURITIESREGULATION:CASESANDANALYSIS404451(3rded.2011).

14SECv.RalstonPurinaCo,346U.S.119(1953).15SeeUnitedStatesv.Wolfson,405F.2d779(2dCir.1968).1617C.F.R.506.17Rule506(b)(2)(ii).


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however,byRegulationDsconclusivepresumptionthataccreditedinvestors,which

includes individualswith $200,000 inannual income or $1million in assets, are

deemed to have the requisite investment sophistication.18This presumption,

although somewhat difficult to square with Ralston Purina (and reality for that

matter),encouragesmanycompaniestolimittheirofferingstoaccreditedinvestors

exclusively. The regulatory presumption is thatwealthy investors are capable of

assessing the merits of an investment on their own, without the disclosure

mandated pursuant to the Securities Act.Market demands,however, dictate that

somedisclosure,comparable to thecoremandatorydisclosurerequirements,will

beforthcoming.Queryhowaccuratethatdisclosurewillbewithoutthesanctionof

theSecuritiesActsliabilityprovisions.

2. TheExchangeActTheExchangeActalsohasapublicprivatedividingline,butitisframedvery

differently.TheExchangeActdividinglinehasbeenshapedbyitshistory.Whenthe

Securities Exchange Act was enacted in 1934, there were two types of trading

venues: stock exchanges, with the New York Stock Exchange being the most

dominant, and the overthecounter (OTC) market. At first, Congress chose to

requiredisclosureonlyfromexchangelistedcompanies.19In1936,Congressadded

companies making a public offering to the list of public companies; periodic

disclosureswould be required after the IPO.20Both of these categories could be

avoided;issuersthatdidnotlistonanexchangeanddidnotmakeapublicoffering

18RegulationD,Rule501(a)(5)&(6).19ExchangeAct12(a)&(b),15U.S.C.78l(a)&(b).20CodifiedatExchangeAct15(d),15U.S.C.78o(d).


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would not be burdened by disclosure requirements, albeit at the cost of less

liquidity and less access to capital. It was not until 1964 that Congress added

companiestradingintheOTCmarkettothelist,closingaloopholelongdislikedby

boththeSECandtheexchanges.21Eventhen,notallOTCcompanieswerebrought

within the rubric of public status; only companies with 500 or more record

shareholdersthatwerealsoabove acertainminimumassetsize (currently set at

$10million)were included.22Smaller companies, for which the opportunities for

fraud and manipulation are most prevalent, remained largely unregulated. If

anything,the500shareholderlimittendedtodisguisethesubstantialspaceleftfor

smaller companies to remain private. The 500 number tallied record ownership

rather than beneficial ownership, so if brokerdealers held the shares on the

companys record books asnominees for their customers, companies couldhave

thousandsofbeneficialownershiddenbeneatharecordshareholdernumberthat

remainedunder500.

Notably absent from these criteria for public company status under the

ExchangeActwasanyconsiderationofthecharacteroftheinvestors.Sophisticated

institutionsandsmallretailinvestorsweretreatedalikeforpurposesofthetallyto

500thattriggeredpubliccompanystatus.Issuerscouldnotavoidpubliccompany

statusbylimitingtheirinvestorbasetoaccreditedinvestors.Suchalimitationcould

beachievedthroughtheimpositionoftransferrestrictions,butitwouldnotavoid

public status if the 500shareholder limit was passed. Regardless of the

2178Stat.565.(1964),codifiedatExchangeAct12(g),15U.S.C.78l(g).22ExchangeActRule12g1.


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sophisticationofthose500investors,thecompanyhadnochoicebuttocomplywith

the periodic disclosure requirements of the Exchange Act once the number was

passed.

Why the numerical trigger? Joel Seligman suggests the number reflects a

politicalcompromise,withCongresssplittingthedifferencebetweentheregulators

andthe securitiesindustry.23Thenumericalcriterionhasa certain logic. Investor

protectionmaybemore important for larger companies because theyhavemore

investors, but capital formation for larger companies is also potentially more

significant.Biggercompanies,becauseofthewiderscopeoftheiroperations,might

have greater influence on the efficiency of capital allocation in the overall

economy.24(Of course, smaller companies might be more significant to capital

formationatthemarginbecausetheyhavegreaterpotentialforgrowth.)Whatever

themotivation,thenumericaltriggeradoptedin1964extendedtheearlierpattern

offorcingdisclosurefromcompaniespresumedtobethesubjectofactiveinvestor

interest. 25 Companies with fewer investors were excluded for reasons of

practicality, despite theSECs recommendationofabroaderreach in itsSpecial

Study of theSecuritiesMarkets.26Obviously, investorprotectionwouldhavebeen

maximizedbygivingtheSECthegreaterregulatoryreachthatitsought.Evenwhile

greatlyexpandingthescopeofregulation,however,politicianswereconcernedby

23Seligman,supranote,at315.24See, e.g., Gil Sadka, TheEconomicConsequencesofAccountingFraud inProductMarkets:

TheoryandaCasefromtheU.S.TelecommunicationsIndustry(WorldCom),8AM.L.&ECON.REV.439(2006)(demonstratingmarketdistortionscreatedbymassivefraudatWorldCom).

25Cohen,supranote,at1341.26Cohen,supranote,at1368.TheSECsrecommendationisfoundinReportoftheSpecial

StudyofSecuritiesMarketsoftheSecuritiesandExchangeCommission,H.R.Doc.95,88thCong.,1stSess.,pt.3,at6264(1963).


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thenegativeeffectsthatmightariseifsmallcompanieswereropedintotheburdens

ofpubliccompanystatus.Investorprotectionwouldhavetobebalancedagainstthe

needtofostercapitalformation.

B. FacebookFacebooks recent transition from a private company to a public one

illustratestheproblemscreatedbythedifferingprivate/publicdividinglinesunder

the two Acts. The Exchange Acts numerical trigger for public company status

recently emerged from technical obscurity as Facebook inched its way toward

becoming a public company. In late 2010, Goldman Sachs proposed selling a

significant block of Facebook shares.27The transaction drew attention because

Facebook atthat timewas aprivatecompanyandwasplanningtomaintain that

status,atleastintheshortterm.GoldmanplannedtopreserveFacebooksprivate

status by selling the companys shares to institutional and other sophisticated

investors via a trust that would bundle their interests in a single investment

vehicle.28Thebundlingwastheunusualfeatureofthetransaction,designedtokeep

thenumberofrecordFacebookinvestorsundertheExchangeActs500shareholder

filingthreshold.29Whetherthisapproachwasaviablestrategy,however,wasopen

todebate.Rule12g51(a)oftheExchangeActallowssharesheldofrecordbyalegal

entitytobecountedasoneperson.Rule12g51(b),however,stipulatesthat[i]fthe

issuerknowsorhasreasontoknowthattheformofholdingsecuritiesofrecordis

27Evan Weinberger, Goldmans Facebook Stake May Force SECs Hand Law 360 (Jan. 4,

2011).28Id.29Facebooksassetswerealreadywellinexcessof$10million.


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usedprimarilytocircumventthefilingrequirement,thebeneficialownersofsuch

securities shall be deemed to be the record owners thereof. In other words,

subsection (b) suggests that the SEC would look through the legal entity to the

actual owners, if the issuer knows that the entity is being used to avoid public

companyfiling.

Theproposedtransactionattractedconsiderablemediaattention,whichled

totheofferingseventualdemise.Thedealwaspulledbecauseofconcernsthatthe

mediaattentioncouldbedeemedtobeageneralsolicitation,whichwouldcause

theoffertobecomepublic,therebyrunningafouloftheSecuritiesActof1933.30

Goldman instead placed the shares in an offshore transaction.31Facebook has

subsequentlymadethetransitiontoapubliccompanywithitsinitialpublicoffering

asubjectIdiscussingreaterdetailbelow.32

Facebooksinteractionwiththeprivate/publicdividewasalsohighlightedin

anotherstorythatsurfacedataroundthesametime.WordleakedthattheSECwas

investigating secondary trading markets for violations relating to the resale of

securities issued byprivate companies.33Facebook was among the more notable

companies traded on one of these venues, SecondMarket. These markets cater

mainlytoemployees(bothcurrentandformer)ofprivatecompanies,butalsosome

30

Regulation D, Rule502(c) (prohibiting general solicitations in connectionwith privateplacementsunderRule506).31LizRappaport,AaronLucchetti&GeoffreyA.Fowler,GoldmanLimitsFacebookOffering,

WALLST.J.,Jan.18,2011(GoldmanSachsGroupInc.slammedthedooronU.S.clientshopingtoinvestinaprivateofferingofsharesinFacebookInc.,becauseitsaidtheintensemediaspotlightleftthedealindangerofviolatingU.S.securitieslaws).

32Seetextatinfranotes.33PeterLattman, StockTradinginPrivateCompaniesDrawsS.E.C.Scrutiny,N.Y.Times(Dec.

27,2010).


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earlyround investors. They have experienced strong growth in recent years.

AccordingtotheNewYorkTimes,In2009,SecondMarketcompleted$100million

worthoftransactionsinprivateshares.Lastyear,itsvolumewasnearlysixtimes

thatamount,withFacebooktradesmakingupthebulk.ItsrivalSharesPostlogged

$625millionintransactionslastyear,morethandoubleitstotalfrom2010. 34This

growthwasthreatenedbytheSECsinvestigation.

TheSEClaterannouncedthatithadreachedasettlementofanenforcement

action with SharesPost. The agencys complaint in that action alleged that the

trading venue had been operating as an unlicensed brokerdealer.35At the same

time, the SEC announced the filing of an enforcement action against Felix

Investments.TheSECscomplaintallegedthatFelixtooksecretcommissionsfrom

thesellersofprivateshares,inadditiontothefeespaidbypurchasers.Theagency

alsoallegedthatFelixhadmisleadinvestorsinconnectionwiththesaleofFacebook

shares.TheSharesPostenforcementactionisamereregulatoryviolation;theFelix

action,however,isareminderofthevulnerabilitytomanipulationofthinlytraded

markets.36

Despitethegrowthofprivatemarkets,thesetradingvenuesarestilldwarfed

by the trading of public company shares on registered exchanges. There are

substantial limits on the volume of trading in theseprivatemarketsascurrently

34EvelynM.Rusli&PeterLattman,LosingaGooseThatLaidtheGoldenEgg,N.Y.TIMES(Feb.2,2012).

35Evelyn M. Rusli, ChargesFiledAgainstBrokerageFirmsThatTradePrivate Shares N.Y.TIMES(March14,2012).

36FacebooksinitialregistrationstatementforitsIPOdisclosedthatithadbeencontactedbySECstaffin connectionwith itsinvestigationintoalternative tradingvenues.AlisonFrankel,Whateveryone missed in Facebooks IPO filing, ThomsonReuters News & Insight Feb. 2, 2012). Noenforcementaction,however,wasfiledagainstFacebook.


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structured.SecondMarketandsimilarvenuesdonotprovidetheliquidityafforded

byanexchange,astheylackspecialistsandmarketmakers.Instead,theyprovide

the more limited liquidity service of matching buyers and sellers in a central

(virtual) location.37These trading venues are limited toaccredited investors, and

thevenuesscreenprospectiveinvestorstoensurethattheyqualifyasaccredited. 38

These precautions are taken to help ensure that the shares are not being

distributedtothepublic,whichcouldrenderthetradingvenueanunderwriterfor

purposesoftheSecuritiesAct.39TheExchangeActsnumericalshareholderlimitfor

privatecompaniesalsoposesanobstacletofurthergrowthoftheseprivatemarkets.

Notwithstanding these limitations under current regulation, the growth of these

venues suggests clear potential for expansion, if the regulatory scheme would

accommodateit.TheSECsinvestigation,however,castsashadowoverthefutureof

privatemarkets.

C. TheJOBSActThe fallout from Goldmans failed private offering of Facebook shares

triggered a rather dramatic legislative response. Lawmakers in Congress seized

uponthesalientoccasiontoattacktheSECfortheobstaclesthatitwasplacingin

37Richard Teitelbaum, Facebook Drives SecondMarket Broking $1 Billion Private Shares,

BloombergMarketsMagazine,April27,2011availableathttp://www.bloomberg.com/news/20110427/facebookdrivessecond.

38Id.39SeeGilligan,Will&Co.v.SEC,267F.2d461(2dCir.1959)(interpreting2(a)(11)ofthe

SecuritiesAct,definitionofanunderwriter).


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thepathofcapitalformation.40TheSECrespondedintimewornfashion,promising

areviewof its regulationsto assesstheir effect ontheU.S. capitalmarkets.41The

SECs delaying tactic did not work, however, as a Republican House of

Representatives,anxioustolatchontoawedgeissuetomaketheDemocratslook

badinanelectionyear,pushedforwardwithlegislation.Thatbillwouldultimately

becometheJOBSAct.PresidentBarackObama,anxioustobeseenasprogrowth

whilefacinganeconomystillplaguedbyhighlevelsofunemployment,signedthe

JOBSActintolaw.42TheSECsoppositiontothebill43carriedlittleweightintheface

ofthoseelectoralimperatives.

1. ExchangeActReforms The JOBS Act makes it easier to remain a private company. The 500

shareholder limit for triggeringpublic companystatus under the ExchangeAct is

nowgone.TheJOBSActraisesthatnumberto500personswhoarenotaccredited

investors,orthemorecriticalnumber,2,000investorsoverall.44Excludedfromthat

number are shareholders who received the securities under an employee

40LetterfromU.S.RepresentativeDarrellIssatoMarySchapiro,Chairman,SEC(March22,

2011),availableathttp://www.knowledgemosaic.com/resourcecenter/Issa.041211.pdf.41LetterfromS.E.C.ChairmanMarySchapirotoU.S.RepresentativeDarrellIssa,Chairman,

U.S.HouseOversightCommittee,availableathttp://www.sec.gov/news/press/schapiroissaletter040611.pdf(April6,2011).

42JonathanWeisman,FinalApprovalbyHouseSendsJobsBilltoPresidentforSignature,N.Y.Times(March27,2012).

43

David Hilzenrath, Jobs

Act

could

remove

investor

protections,

SEC

chair

Mary

Schapiro

warns,WASH.POST (March 14, 2012)( Toooften, investors are the target of fraudulent schemesdisguisedasinvestmentopportunities,Schapirowrote.Asyouknow,ifthebalanceistippedtothepointwhereinvestorsarenotconfidentthatthereareappropriateprotections,investorswillloseconfidence in our markets, and capital formation will ultimately be made more difficult andexpensive.). State securities regulators also voiced their opposition. North American SecuritiesAdministratorsAssociation,TheJOBSActanInvestorProtectionDisasterWaitingtoHappen (March22,2012).

44JOBSAct501,codifiedatExchangeAct12(g)(1)(A).


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compensationplanexemptedfromregistration. 45Thislatterprovisionpromisesto

delaythepointatwhichagrowingcompanywouldbeforcedtomaketheperiodic

disclosures required of public companies. Query whether this is an important

constraintforcompaniessmallerthanFacebookthatarestrivingtomaintaintheir

privatestatus.Dataonthisquestionaresimplynotavailable.

AkeygoaloftheJOBSActwastojumpstartthemarketforIPOsbyeasingthe

burdenofpubliccompanystatusonnewlypubliccompanies.Asubstantialexpense

was eliminated for postIPO companies by exempting them from 404 of the

SarbanesOxley Act, which requires auditor assessment of a companys internal

controls.46TheJOBSActalsoreducedtheauditedfinancialstatementrequirement

forIPOstoonlytwoyears.47Theseregulatoryrelaxationslastforfiveyearsfroma

companys IPO or until the company reaches $1 billion in annual revenue,

whicheverissooner.48

2. SecuritiesActReformsThe JOBSAct also loosens the gun jumping rules. The JOBSAct authorizes

issuers to test the waters with qualified institutional buyers and accredited

investors prior to filing a registration statement.49The goal is to assess whether

there is demand for the companys shares, allowing the company to avoid the

expenseoftheregistrationprocessifinterestislacking.Inaddition,thelawfrees

45JOBSAct502,codifiedatExchangeAct12(g)(5)(A).46JOBSAct103.47JOBSAct104,codifiedatSecuritiesAct7(a)(2)(A).48JOBSAct101,codifiedatSecuritiesAct2(a)(19)andExchangeAct3(a)(80).49JOBSAct105(c),codifiedat.


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analyststoissueresearchreportsfornewissuersduringtheofferingprocess. 50The

goal of this provision is to promote demand for the companys shares. The

combinationofthesetwoprovisionssuggeststhatCongressseesthegunjumping

rulesashopelesslyoutdated.

The JOBS Act also targeted a Securities Act regulation relevant to the

Facebook affair, the SECs ban on general solicitation inprivate placements. The

JOBSActrepealsthatprohibitionoutright.51UndertheJOBSAct,themediaattention

thatGoldmansproposedofferingdrewwouldnot havejeopardized the4(a)(2)

exemption,aslongasactualsalesweremadeonlytoaccreditedinvestors.

Anotherprovision ofthe JOBSAct has the potential toblur thedistinction

betweenprivateand public inamuchmore profoundway. Congressopened the

doorforpublicofferingsbysmallercompanieswithsubstantiallyfewerrestrictions.

It did so by increasing the SECs authority to exemptofferings from registration

under 5, raising the offering limit under 3(b) tenfold from $5million to $50

million.52Thegunjumpingrulesareputasidealtogether,ascompaniesareallowed

totest thewatersprior to filing a registration statement.53Moreover, Congress

also stipulated that the securities sold be unrestricted, i.e., they could be freely

resold to retail investors.54In a somewhatunusualmove,Congressmandated the

adoption of a new exemption by the SEC pursuant to this authority (perhaps

50JOBSAct105,codifiedas.51JOBSAct201,codifiedatSecuritiesAct4(b).Congressalsoauthorizedanexemptionforcrowdfunding.JOBSAct301305,codifiedat

SecuritiesAct4(a)(6),4A,&18(b)(4);ExchangeAct3(a)(1)(h)&12(g)52JOBSAct401,codifiedatSecuritiesAct3(b)(2)(A).53JOBSAct401,codifiedatSecuritiesAct3(b)(2)(E).54JOBSAct401,codifiedatSecuritiesAct3(b)(2)(B).


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recognizing that the SEC would simply ignore it otherwise). In a concession to

investor protection, however, Congress did allow the agency to require periodic

disclosures by companies that avail themselves of this new exemption.55It also

madeofferingdisclosuressubjectto12(a)(2)liabilityundertheSecuritiesAct,but

not,conspicuously,11sstrictliabilityregime.56

3. ImplicationsforthePrivate/PublicDividingLineAtfirstglance,theJOBSActisadirectshotacrosstheSECsbow,movingthe

line between public and private markets to afford private markets considerably

morespace. For the SEC,preservationofpublicmarketspopulatedbyasizable

contingentof retailinvestors(i.e.,voters) isanexistentialtask.Theagency,after

all,wrapsitselfinthemantleoftheinvestorsadvocate,anditspoliticalsupportis

inextricably connected to its regulation of those public markets. If the public

marketsceasedtoexist,Congresswouldhavelittleinterestinfundingtheagency.

Fromanotherperspective,however,theseprovisionsoftheJOBSActarefar

fromrevolutionary.RaisingthethresholdforfilingundertheExchangeActdoesnot

challengethenotionthatthereshouldbeanumericaldividinglinebetweenpublic

andprivate;itsimplyreflectsapolicydisagreementbetweentheSECandCongress

overwherethatlineshouldbedrawn.Congressraisedthenumberofinvestorsfor

triggering public company status, but left intact the basic architecture of the

securitiesmarketsbothprimaryandsecondaryasreflectedintheSecuritiesAct

of1933andtheSecuritiesExchangeActof1934.

55JOBSAct401,codifiedatSecuritiesAct3(b)(4).56JOBSAct401,codifiedatSecuritiesAct3(b)(2)(D).


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Wheredoestheprivate/publicdividinglinestandaftertheenactmentofthe

JOBSAct?Overall, the JOBSAct givesprivate companiesmore latitude to remain

private and eases the initial cost of transitioning to public status. Under the

Exchange Act, the JOBS Act raises the threshold for triggering public company

status. For companies that choose to seek public status, the periodicdisclosures

requiredforthefirstfiveyearsshouldbelessexpensivewithouttherequirementof

auditorcertificationofinternalcontrols.FortheSecuritiesAct,theJOBSActmakes

it easier to raise capital while staying private by opening the private placement

processbypermittinggeneralsolicitations.Finally,andpotentiallythemostradical

change, the new authority conferred upontheSEC toexemptofferings upto$50

million carrieswith it the intriguing possibility that the SEC will create a junior

varsity levelofpublic companies.Atthis point, the creationofapublic company

incubationpoolisonlyapossibility,asitiseasytoseetheSECdraggingitsheelsin

implementing this exemption, and Congress has not mandated a date for its

adoption.CertainlynothingwillhappenattheSECanytimesoon.Theagencyisstill

strugglingtogetoutfromunderarulemakingbacklogcreatedbytheDoddFrank

Act. After the 2012 election, with the spotlight from Capitol Hill perhaps less

glaring,57the SEC may feel that it has a freer hand in imposing substantial

requirementsontheexemptionthatiteventuallypromulgates.Ifitdoesso,theSEC

maystrangletheJOBSActofferingexemptioninitscrib.

57SeeMaryL.Shapiro,Chair, SEC,TestimonyConcerning the "JOBS Act in ActionPart II:

OverseeingEffectiveImplementationoftheJOBSActattheSEC"(June28,2012)(announcingthatSECwouldnotmeetdeadlinesimposedinJOBSAct).


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III. MediatingthetransitionfromprivatetopublicMilton Cohens central insight was that the disclosure needs of investors

were the same inthe primaryand secondarymarkets for securities.SinceCohen

wrotehisarticleinthemid1960s,theforceofhisinsighthasbeenreinforcedbythe

widespreadacceptanceoftheefficientcapitalmarkethypothesisbybothregulators

andcourts.Cohensargumentwassimplythecommonsensenotionthatdisclosure

obligationsshouldbemadeconsistentforthetwomarkets.Theimplicationofthe

efficient capital market hypothesis, however, is that disclosure particular to

securitiesofferingsmightbelargelyredundant.Ifthemarkethastheinformation

priortotheissueofthesecurities,investorsalreadyhavethetoolsthattheyneedto

assessthevalueofthatnewissue.Moreover, retail investors can freerideonthe

effortsofinstitutionalinvestorswhenpurchasingiftheyareallparticipatinginthe

samemarket,purchasingfromthesamefungiblepoolofsecurities.Iftheefficient

capital market hypothesis captures the reality of public offerings, the pricing

decisions of the institutional investorswill determine the market price, thereby

providingsomeassurancethatretailinvestorsaregettingafairdeal.

More fundamentally, with the advent of the efficient capital market

hypothesisanditsacceptancebytheSEC,theregulatoryfocusoftheExchangeAct

has shifted. Although the ExchangeAct may have been originally about investor

protection,thedevelopmentoftheefficientcapitalmarkethypothesishaspushed

toward accurate pricing as the goal of the ExchangeAct.58Investor protection is

58Merritt B. Fox, Retaining Mandatory Securities Disclosure: Why Investor Choice is Not

InvestorEmpowerment,85VA.L.REV.1335,1415(1999).


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simply a happybyproduct of efficient pricing. Ifmarkets are fully informed, the

theory goes, riskswill be accurately priced. If the goal is accuracy, rather than

paternalism, reflecting risks in the market price is good enough. Unfortunately,

therearesubstantialreasonstodoubttheefficiencyofthemarketforIPOs.

A. IPOs:BadDealsTheshiftinthefocusoftheExchangeActtowardaccuracyhasimplications

for the transition from private to public. Faith in the power of efficient capital

markets to protect investors rests, however, on the efficiency of the underlying

market.Thecomforttobothaccuratepricingandinvestorprotectionprovidedby

theefficientcapitalmarketshypothesisfallsapartwiththeIPO.Noonebelievesthat

IPOsreflectanefficientcapitalmarket.InfacttheevidenceisfairlystrongthatIPOs

are inefficient. IPOs are bad deals. The puzzle is why they persist, despite that

inefficiency.

IPOsarebadforcompanies,badforinsiders,andbadforretailinvestors.The

onlyparties that clearlybenefit from thesedealsare the individualswho service

them:accountants,lawyers,andunderwriters.Especiallyunderwriters,whotakea

standardcommissionof7%oftheofferingintheoverwhelmingmajorityofIPOs.59

Ineconomicjargon,theseprofessionalsaretermedtransactionscosts;thetermis

notintendedasacompliment.It is,however, lesstendentiousthanbloodsucking

59HsuanChiChen&JayR.Ritter, TheSevenPercentSolution,55J.FIN.1105,1105(2000)

(findingunderwritersinvariablychargeasevenpercentcommissionforIPOsbetween$20and$80million).


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parasite,whichisthetermthatmorethanoneentrepreneurmightuse,painedby

givingawaysuchasubstantialsliceoftheirgrowingbusinesstoameresalesman.60

It is possible, however, that underwriters are being paid for more than

simply marketing the offering. Underwriters typically provide marketmaking

servicesforIPOcompaniestosupportthesecondarymarketfollowingtheIPO.This

commitment is not a contractual obligation, however, but instead, a customary

understanding. If themarketmaking is notprofitable for brokerdealers standing

alone,theunderwritersdiscountmaybe,inpart,compensationforthoseefforts.

Whyare IPOsbad for companies?Apart fromthe substantialsumspaidto

the bloodsucking parasites, IPOs suffer from the wellknown phenomenon of

underpricing. Underpricing is the tendency for the price of stocks to rise

significantlyabovetheofferingpriceonthefirstdayofsecondarymarkettrading. 61

Fromtheperspectiveoftheissuer,thegapbetweenthesecondarymarketpriceand

theofferingpricereflectsunexploitedmarketdemandforthecompanysshares.The

explanations offered for underpricing are varied, including insurance against the

risk of liability,62and compensation to institutional investors for the cost of

60Tobefairtothebloodsuckingparasites,thepriceoftheofferingmaybemuchsmallerif

thecompanyisonlysellingasmallpercentageofitssharessay10%asistypical.Thefactthatcompaniessellonlyasmallpercentage,however,onlyreinforcestheinefficiencyofIPOs.Ifthetermswerebetter,companieswouldpresumablysellagreaterpercentage.Underthecurrentregime,IPOsaregenerallyapreludetoamoresubstantialseasonedoffering.

61

JayR.Ritter&IvoWelch,A

Review

of

IPO

Activity,

Pricing,

and

Allocations,57J.Fin.1795Table1 (2002)(findingthatbetween1980and2001,IPOswereunderpricedby22%onaverage,).SeeRogerG.Ibbotson&JeffreyF.Jaffe, "HotIssue"Markets,30J.Fin.1027(1975);JayR.Ritter,The"HotIssue"Marketof1980,57J.Bus.215(1984).SeealsoJudithS.Ruud, UnderwriterPriceSupportandtheIPOUnderpricingPuzzle,34J.Fin.Econ.135(1993).

62See,e.g.,PhilipD.Drake&MichaelR.Vetsuypens,IPOUnderpricingandInsuranceAgainstLegalLiability,22Fin.Mgmt.1(1993);SehaM.Tinic,AnatomyofInitialPublicofferingsofCommonStock,43J.Fin.789(1988).ButseeJanetCooperAlexander, TheLawsuitAvoidanceTheoryofWhyInitialPublicOfferingsAreUnderpriced,41UCLAL.Rev.17(1993).


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collecting information about the issuer.63Another theory is that underpricing

encouragesinstitutionalownerstoretainthesharesatleastuntilthelockupperiod

expires,typicallysixmonthsaftertheoffering,whentheinsiderswillbefreetosell

theirshares.

Thesefactorsmayplayarole,butthereisalsotheintriguingpossibilitythat

the runup in the secondary market reflects speculative frenzy among retail

investors.Thisspeculativefrenzycouldnotbecapturedbytheissuerbecausethe

runupisdriven,atleastinpart,bytherunupitself,momentumtradingonsteroids

ifyouwill.Theroleofspeculationwouldappeartobepartofthestoryofwhybook

built offerings continue to dominate auctions as a means of selling securities.

Accordingtothisaccount,auctionshavefailedtoattractamarketfollowingbecause

theyoffernowayofexcludingthedumbmoney.64Ifretailinvestorsareallowedto

dominatethepricingofshares,institutionalinvestors,waryofthewinnerscurse,

willavoidtheoffering.Ifinstitutionalinvestorsrefusetoparticipate,theprospects

foracompleteunravelingbecomealltooreal.Underpricingissimplythebyproduct

oftheneed toexclude the undesirables fromthe initialpricingprocess.Once the

dumbmoneypilesintothesecondarymarket,allbetsareoff.

Whatever the causeofunderpricing, companies pay itasthe cost ofentry

intothepublicmarkets.IPOsarelesscapitalraisesthantheyaredebutanteballs.

63Ravi Jagannathan&Ann E. Sherman, Reforming theBookbuildingProcessfor IPOs, 17 J.

AppliedCorp.Fin.2,6(2005).64WilliamVickrey,Counterspeculation,Auctions,andCompetitiveSealedTenders,16J.FIN.8,

20 (1961) ("[Wherethere ismuchvariation in thestate of informationor thegenerally expectedintensity of desire of the various players for the object, orwhere the bidders are insufficientlysophisticated to discern the equilibriumpoint strategy ... the Dutch auction is likely to proverelativelyinefficient....").


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Newlypubliccompaniesarejostlingfortheattentionofinvestors,andabigbumpin

price on the first dayof trading, like a fabulous gown, is sure to be noticed and

attracttradingvolume.Themediatreatasharpriseintheaftermarketpriceasa

reflectionoftheofferssuccess,ignoringthemoneytheissuerhasleftonthetable

duringthebookbuildingprocess.

WhyareIPOsbadforinsiders?Primarilybecauseinsiderssuffersubstantial

dilutionoftheirinterestsinthecompanyasaresultoftheIPO,whichhelpsexplain

whyIPOsaregenerallylimitedtoasmallpercentageofthecompanysequity.For

companies with the best prospects, the information asymmetry between the

insidersandoutsideinvestors(alongwiththepotentialforfraudbyinsiders)means

thatinvestorsarelikelytosubstantiallydiscounttheamounttheyarewillingtopay

forthecompanysshares.Thatdiscountingwillbemitigated,butnoteliminated,by

mandatory and voluntary disclosures. Antifraud enforcement operates

substantiallybelow100%accuracy,sosomestretchingofthetruthwillslipthrough

unsanctioned.Moreover, complete disclosure is a practical impossibilityeven for

companiesanxioustobeforthcoming.Worseyet,disclosurewillsometimesbebad

forbusiness,asitconveysusefulinformationtoafirmscompetitors.65Giventhese

limitationsondisclosure,companieswithbelowaverageprospectswillbeableto

hidethemselvesinthepoolofallIPOfirms.TheinclusionofbadfirmsintheIPO

poolmeans that better than average firmswill suffer from discounting, a partial

65See Michael D. Guttentag,AnArgumentfor ImposingDisclosureRequirements onPublic

Companies,32FLA.ST.L.REV.132,151(2004)(notinggreaterdisclosureinprivatedealsrelativetodisclosuresmadebypubliccompanies).


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lemonseffect.66Notwithstandingthesedilutioncosts,thebenefittoinsidersisthat

theywilleventuallyenjoyaliquidmarketfortheirsharesafterthelockupexpires.

Thecostsareworthitforsome.Othersstayprivate.

Why are IPOs bad for retail investors? Despite the underpricing that

manifestsitselfinthesecondarymarketonthedaythatthecompanygoespublic,

thelongtermperformanceofIPOstockstrailstheriskadjustedreturnsavailable

fromholdingthemarketportfolio.67Giventhatthisunderperformanceisbothlong

standingandwelldocumented,whydo investorscontinueto invest in IPOs?One

answer is that they are lured into foolish purchases by crafty Wall Street

salespeople.ItisaWallStreettruismthatnewissuesaresold,notbought.68This

proposition is somewhat difficult to square with the prevalence of institutional

investors among the lucky recipients in IPO allocations.69Those institutional

investors, however, may be counting on the ability to flip the shares to retail

investors in the secondary market.70Lurking in the background here, especially

when combinedwith the underpricing phenomenon, is theworry that secondary

market pricesmay bedriven bya lotterymentality, at least in the near term. In

otherwords,theinstitutionalinvestorswhoreceiveallocationsintheIPOexpectto

makeaprofitduetotheinitialunderpricing.Theretailinvestorswhopurchasetheir66 George A. Akerlof, The Market for "Lemons": Quality Uncertainty and the Market

Mechanism,84Q.J.ECON.488(1970).67

Jonathan A. Shayne & Larry D. Soderquist, Inefficiency

in

the

Market

for

Initial

Public

Offerings, 448 VAND. L. REV. 965, 970 (1995); Terzah Ewing, BurntOfferings?StreetDebutsAreFizzlingAfterPop,WALLST.J.,Apr.26,2000,atC1.

68LouisLowenstein,ShareholderVotingRights:AResponsetoSECRule19c4andtoProfessorGilson,89Colum.L.Rev.979,998(1989).

69See Reena Aggarwal et al., InstitutionalAllocation in Initial Public Offerings: EmpiricalEvidence,57J.FIN.&QUANTITATIVEANAL.1421,1422(2002)(findingthatinstitutionalinvestorsreceiveapproximately75%oforiginalIPOsharesinanaverageoffering).

70D.Cooketal.,OnthemarketingofIPOs,82J.Fin.Econ.35.


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sharesinthesecondarymarket,however,arepronetoirrationalexuberance.Retail

investorsmaybewillingtotoleratemarketlaggingreturnsoverallinexchangefor

the possibility that one of theirpurchasesmay turn out to be the next Apple or

Microsoft.Thislotteryticketmentalityisnotlikelytoleadtoaccuratepricingofa

companysfuturecashflows.71

B. FacebookAgain

FacebookseventualIPOprovidedahighprofileexampleofhowIPOscango

badly wrong. Running contrary to the typical pattern of underpricing in IPOs,

Facebookssecondarymarketpricequicklytookasteepplunge,droppinginitsfirst

weekoftradingfromthe$38offerpricetolessthan$32.Withinacoupleofmonths,

the price had dropped to close to $20. Not surprisingly, a good deal of finger

pointingfollowed.Avarietyoffactorswereidentifiedastheculprit,withthemost

straightforward being the companys decision to issue 25% more shares than

originally contemplated.72That decision no doubt played a part in the unusually

largeallocationofsharestoretailinvestorsintheoffering. 73Thatinfluxofdumb

money gave rise to the spectre of the winners curse.74 Morgan Stanley,

71

Bill George, The LongTerm Value of Internet Companies, N.Y. Times (Aug. 3, 2012)(speculativetraderslookingforoutsizereturnscanincreasethevolatilityofcompanyvaluations.)72JoeNocera,FacebooksBrilliantDisaster,NYTimes(May25,2012).73SeeJacobBunge,AaronLucchetti&GinaChon, InvestorsPummelFacebook,WALLST.J.A1

(May 22, 2012) (Retail, or individual investors usually allocated up to 20% of the total sharesallottedinanIPO,butinFacebookscase,retailallocationwasaround25%).

74SeeLynnCowan, OversubscribedIsaWeakIPOSignal,WALLST.J.(June18,2012)(Attheheartofthe[Facebookoffering]sflopwasaverybasicproblem:Toomanysharesweresoldat toohighapricetotoomanyinvestorswhowerentcommittedtoholdingitforverylong.)


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Facebooksunderwriter,wasfaultedforitsaggressivepricingofthestock.75Nasdaq,

the exchange where Facebook listed its shares, had a technological meltdown,

causingasubstantialnumberoforderstoapparentlydisappearintotheetheronthe

firstdayoftrading.76Mostdamning,however,wastherevelationthatanalystsata

numberofbanks,includingMorganStanley,hadreviseddownwardtheirearnings

projections for Facebook, based on difficulties the company had disclosed with

makingmoneyoffofuserswhoaccessedFacebookthroughmobiledevices.Analysts

revised estimates were shared with thebanks institutional clients, but not with

retail investors.77Thoseloweredprojectionsnodoubtfueledtheinterestofthose

institutional investors in flipping their shares to retail investors as quickly as

possibleaftertheIPO.Lawsuitsquicklyfollowed, 78andCongresscalledhearingsto

examinetheIPOprocessgenerally.79

C. WhyDoIPOsPersist?

IfIPOsare suchbaddeals,whydotheypersist?Under thecurrentregime,

IPOsareapracticalnecessity,butfromtheperspectiveofefficientcapitalallocation

they have little to commend them. The common theme running through the

problems with IPOs for companies, insiders, and investors is information

75MichaelJ.DeLaMerced,EvelynM.Rusli,andSusaneCraig,AsFacebooksStockStruggles,

Fingers

Start

Pointing,NYTimes(May2,2012).176ChuckMikolajczakandJohnMcCrank, Facebooksharessink11percentasrealityovertakeshype,Reuters(May22,2012).

77EvelynM.Rusli,BenProtess,andMichaelJ.DeLaMerced,QuestionsofFairPlayAriseinFacebookI.P.O.Process,NYTimes(May23,2012).

78PeterJ.HenningandStevenM.Davidoff, TheFacebookI.P.O.sPotentialLegalExposure,NYTimes(May23,2012).

79JeanEagleshamandTelisDemos,LawmakersPushforOverhaulofIPOProcess,WallSt.J.(June21,2012).


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asymmetry.Investorsarenotfullyinformedanditiscostlytoprovidethemwith

credibleinformation.Speculationandirrationalexuberance,fueledbyWallStreet

marketingandmediaattention,greasethewheelsfordealsthatdonothavealotto

recommendthem.The raisondetreofIPOsseemstobethefactthattheyarethe

entre to the big leaguesofpublic companystatus. From the perspectiveofboth

capitalformationandinvestorprotection,IPOsareafailure.Weseesimilarlypoor

resultsforreversemergersandPIPEs,alternative(andsomewhatdimlylit)avenues

forreachingtheultimategoalofpubliccompanystatus.80Thesetransactionsshare

with the IPOs the expectation that the issued shareswill be dumped on public

investorsafteraholdingperiod,perhapsaccompaniedbyaggressivesellingefforts.

Thetransitionfromprivatetopublicseemstobearockyroad,whatevertheroute

taken.

Inthenextsection,IsketchoutanalternativetotheIPOdesignedtodeal

withtheproblemofinefficiencycreatedbyinformationasymmetry.Iarguethatmy

alternativeissuperiortotheexistingregime,bothfromtheperspectiveofefficient

capitalallocationandtheprotectionofretailinvestors.

IV. ATwoTierAlternative

The publicprivate dividing line is on shaky ground. Congress has pushed

backthepubliclinefortheExchangeActwiththeJOBSAct.FortheSecuritiesAct,

the SECs adoption of the effective equivalent of company registration for

80SeeRobertS.Thompson&DonaldC.Langevoort, RedrawingthePublicPrivateBoundaries

inEntrepreneurialCapitalRaising,CORNELLL.REV.(forthcoming,2013).


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establishedcompaniessuggestsalossoffaithinthegunjumpingrules.Atleastfor

seasonedofferingsbythelargestpublicissuers,theSECnolongerbelievesthatthe

gun jumping rulesareneeded toquell speculation. Congress isunlikelyto lead a

revival; the JOBS Act reflects a further erosion of the gunjumping rules for IPO

issuers. Congresss endorsement of testing the waters in the JOBS Act sends us

further along the road toward complete abolition of the gunjumping rules. This

trendappealstotheeconomicallyminded.Ifwehavefulldisclosure,thetechnology

todistributethatinformation,andaninformationallyefficientmarket,doweneed

thegunjumpingrulesof5?Thegunjumpingruleslingeron,inratherdilutedform

aftertheJOBSAct,onlyforIPOs.Andyetwesawinthelastsectionthatthegun

jumpingrulesleavemuchtobedesiredifthegoalisefficientcapitalformation;the

rules fall far short of achieving that goal in IPOs, incapable of overcoming the

fundamentalinefficiencyof thosemarkets.Theonlyremainingjustificationfor the

gunjumping, ifany, is investorprotection andeventhere, theempirical evidence

suggests that the rulesare ofdubious utility. The inefficiency of the IPOmarket

persistsdespitethedauntingarrayoflegalrestrictions.

This shift by Congress in the JOBS Act and the SEC with its virtual

adoptionof companyregistration raisesa number ofquestions for the dividing

line between private and public. In this section, I propose an alternative to the

current dividing line.What if all public offerings were seasoned offerings with a

priceinformedbothbyfulldisclosureandapreexistingtradingmarket?Couldwe

achieve more efficient capital formation and better investor protection

simultaneously?WouldretailinvestorsbeharmedifweeliminatedIPOs?


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Myproposal is inspiredbya simple sportinganalogy: the EnglishPremier

League.Theleaguehastwentyteams,andthethreeworstteamsattheendofeach

season are relegated to the Football League Championship, while the top three

teamsfromthatdivisionarepromoted.MyproposalisforaPremierLeaguefor

publiccompaniesandalowertierforprivatecompanies,withdistinctprimaryand

secondarymarketsforeach.

Under my proposal, companies would go up and down between the

marketsaswarranted.Thenumberofcompaniesinthepublicmarketwouldnotbe

limited, however, as teams are in the Premier League. Any company reaching a

certain quantitative bench mark say $75 million in market capitalization, a

thresholdcurrentlyusedbytheSECforshelfregistration81wouldbeeligiblefor

elevation to the public market.82Issuers would be able to choose their status;

companieswouldnotbedraggedintothetoptieragainsttheirwill.Oncetheyopted

for public status, however, companies would be obliged to satisfy the periodic

reporting obligations of the Exchange Act for as long as they remained public.

Relegationtothelowertierwouldbesubjecttoashareholdervote.Idevelopbelow

howIanticipatetheprocessmightwork.

A. TheprivatemarketIssuersbelowthequantitativebenchmarkwouldbelimitedintheiraccessto

both the primary and secondarymarkets. Their securities could be sold only to

81SecuritiesAct,Rule415.82Iusemarketcapitalizationheresimplyforeaseofexposition.Thequantitativebenchmark

mightalternativelybebasedontradingvolume.SeeLangevoort&Thompson,supranote.


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accreditedinvestors,pursuanttothestandardsunderRegulationDor4(a)(2).In

contrast to current practice,however, those securities couldnot be freely resold

after aminimumholding period.83Instead, the issuer would be required to limit

transfer of those shares to accredited investors prior to becoming a public

company.84Among accredited investors, however, the securities could be resold

withoutjeopardizingtheissuersexemption.

I anticipate organized markets for private trading along the lines of

SecondMarket and SharesPost; the advent of these markets makes my proposal

feasible. The proposal here takes advantage of those developments, but it also

works off the success of the Rule 144A market, which is currently limited to

QualifiedInstitutionalBuyers (QIBs): institutional investorswithmore than$100

millionundermanagement.Theproposalherewould extend that existingmarket

forQIBs,byincludingaccreditedinvestors.TheQIBmarketisestimatedbyindustry

sourcestohaveover14,000participants;thenumberofaccreditedinvestorssurely

dwarfsthatbyseveralordersofmagnitude.ThesuccessofthatQIBmarketsuggests

that the privatemarket proposed here would have enough liquidity to function

effectively.

These privatemarketswould need the issuers consent for the trading of

their shares, a form of quasilisting. The private trading market would be

responsible forscreeningprospective investorstoensure that theymettheSECs

83Thatperiodiscurrentlyoneyearfornonpubliccompanies.SecuritiesAct,Rule144.84See Choi, supra note 7, at 608 (a true company registration system would similarly

restrict the trading of securities of lightly followed companies with little public informationregardlessofthepaththesecuritiestotooktomarket.).


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criteria for accredited investors. Only certified accredited investors would be

allowedtoparticipate.Thiscategoryincludesmutualfunds,soretailinvestorscould

accessexposuretothisprivatemarket.Theycoulddoso,however,onlythrougha

diversifiedvehicleadministeredbyaninvestmentmanager,whowouldbesubject

totheusualarrayofregulations.

Thequestionofdisclosureinthismarketposesachallengingissue.Itwould

defeatthemarketspurposetorequirethedisclosureexpectedofapubliccompany.

Ontheotherhand,somestandardizationofdisclosurepracticeswouldlikelybenefit

both investors and issuers. And the size of todays private offerings raises the

possibilityofacollectiveactionproblemforinvestorsmakingitdifficultforthemto

negotiate for contractual representations and warranties. 85 There are some

fundamentalshardto imaginedoingwithout,suchasauditedfinancialstatements.

Beyond that baseline, however, are a range of difficult questions regarding

materiality.

One possibilitywould be to allow privatemarkets to establish disclosure

requirements pursuant to their listing agreements, with those listing agreements

subjecttoSECapproval.86Suchanarrangementwouldallowforsomeflexibilityand

responsiveness tomarket forces, while still ensuring that disclosure did not fall

85SeeLangevoort&Thompson.supranoteat31(ifwehavedoubtsaboutcollectiveaction

asthenumberofinvestorsgrowsevenassumingwealthorsophisticationthecaseformandatoryperiodicdisclosurestrengthens.Inthefaceofdispersion,bothshareholdersandpotentialinvestorshavetogleaninformationontheirowntocompensateforanylackofvoluntarydisclosure,whichproducesinefficientduplicationofeffort.).

86MaryKissel,SoWhoNeedsWallStreet,WALLST.J.A13(Oct.2930,2011)(SecondMarketrequirescompaniestoprovideauditedfinancialsandriskfactorstopotentialinvestors.Thatsnotrequired under the SEC rules, [SecondMarkets CEO] says. We dont want to see fraudulentcompaniesonSecondMarket.Wedontwanttoseepeople,youknow,makinginvestmentdecisionswithoutbeingwellinformed.Thatsbadforusasamarketplace.).


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below some desired minimum. The SEC could perhaps implement regulatory

oversight through an exemption for the trading venues from exchange status by

imposingconditionsontheexemption.Alternatively,theSECcouldrelyonitsnew

3(b)exemptionauthority.TheSECcouldimposeperiodicdisclosurerequirements

on companies relying on the 3(b) exemption to sell shares to retail investors.

Companiesthatlimitedtheirsalestoaccreditedinvestorsandrestrictedthetransfer

of those shares only tootheraccredited investors couldbeexempted from those

disclosurerequirements.

B. ThepublicmarketElevationtothepublicmarketwouldbevoluntaryinmyscheme.Issuersthat

werenotpreparedtohandletheburdenofpubliccompanyobligationscouldlimit

thetransferoftheirsharestotheprivatemarket,whichwouldbeaccessibleonlyby

accreditedinvestors. Ifa companyfeltthat itcould satisfy its capitalneedsin the

privatemarketitwouldbefreetoremainthere.

Companies would graduate to the public market based on market

capitalizationortradingvolumeforcommonequity.Thesecriteriaaresimilartothe

Exchange Acts proxies for active investor interest, but they are more readily

measuredandlessvulnerabletomanipulation.Onceacompanyelectedtobecome

public,itwouldinitiatetheprocessoftransitioningto tradinginthepublicmarket

by first filing a Form 10K. A seasoning period would follow, with the filing of

requisite10Qsduringwhichtheshareswouldcontinuetobetradedintheprivate


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market.87Thepricesintheprivatemarket,however,wouldnowbeinformedbyfull

SECmandateddisclosure.Aftertheseasoningperiod,accreditedinvestorswouldbe

abletoselltheirsharesinthepublicmarket.Thisopportunitywouldbeavailable

whethertheaccreditedinvestorhadpurchasedtheirsharesfromthecompanyor

fromotheraccreditedinvestorsintheprivatetradingmarket.Thatpublicmarket

couldbeanexchange,ifthecompanychosetolist,ortheoverthecountermarket.

Eitherway,thetradingpriceinthepublicmarketwouldbeinformedbytheprior

trading in the private market, as well as the new information released in the

companys10Kand10Qs.

The private market seasoning period before public trading would be

permitted raises some difficult questions. It would not be practicable to limit

companiesfromanysalesduringtheseasoningperiod;capitalneedsdonotgoaway

simplybecausethecompanyismakingthetransitiontopublicstatus.Indeed,the

needforcapitalispresumablypushingthecompanytobeartheburdensofpublic

status.Thiscreates thepossibility thatcompanies coulduse investment banksor

otherintermediaries,suchashedgefunds,asconduitsduringtheseasoningperiod.

Theviabilityofthisstrategyislimited,however,bythefactthattheintermediaries

couldonlysellthesharestootheraccreditedinvestorsduringtheseasoningperiod.

Thus, the risks of an unregistered distribution to retail investors are low.

Moreover, unless the company has very pressing capital needs, it is unlikely to

toleratemuchofaliquiditydiscountforitsshares,whichitwillbeabletofreelysell

87Cf. SEC Release 3465708, Nov. 8, 2011 (approving Nasdaq rule change requiring a

seasoningperiodofayearfollowingareversemergerbeforecompanycanbelisted.)


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after the seasoning period expires. It might, however, be necessary to impose

volumelimitsonsellersinthepublicmarketsduringatransitionperiodtoallowthe

tradingmarkettodevelop.Aquickdumpofsharesimmediatelyaftertheseasoning

periodexpiredhasthepotentialtoreproducetheinefficientpricingandirrational

speculationthattaintsthemarketforIPOs.

Onlyafterthecompanygraduatedtohavingitssharestradedinthepublic

marketwould the companybe free to sell equity topublic investors.What form

shouldsalesofpublicequitybytheissuertake?Thelogicoftheproposal,withits

preference for the superior informational efficiency of tradingmarkets, suggests

that issuers selling equity should be limited to atthemarket (ATM) offerings.

Issuerswouldselldirectlyintothepublictradingmarketinsteadofrelyingonan

underwritertoidentify(create?)demand.Thisapproachputsitsfaithinmarkets,

ratherthansalesmen,forefficientpricing.Unfortunately,thisstrategyhasitslimits.

ATMofferingsarearapidlygrowingportionofseasonedequityofferings,88butthey

arestilldwarfedbytraditionalbookbuiltofferings.Particularlyforlargerofferings,

theliquidityofthesecondarytradingmarketmaybeinsufficienttoabsorbsucha

largenumberofshareswithoutsubstantiallydilutingexistingshareholders.Tobe

sure,bookbuiltofferingswouldbesubstantiallyconstrainedbytheexistenceofa

market price. Couldwenudge issuers toward ATM offerings, withoutmandating

them?

88JamesD.SmallIII,W.ClaytonJohnson,&LeslieSilverman,TheresurgenceofUntiedStates

atthemarketequityofferingstoraisecapitalinvolatileequitymarkets,4CapitalMarketsL. J.290,292(2009)(FromJune2008throughtheendofApril2009,morethan25issuersregisteredwiththeSECalmost$6.9billionofequitysecuritiesforsalesunderequitydistributionprogrammes(ofwhichmorethan$3.2billionwassubsequentlysoldtoinvestors).)


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Onepossibilitywouldbetoeliminate11and12(a)(2)liabilityforatthe

market offerings, while retaining it for underwritten offerings. At aminimum, it

makes little sense to imposeunderwriter liability on the brokerdealershiredby

issuerstomanageATMofferings.Iflargevolumesneedtobesold,notbought,the

opportunities for abuse come in the sellingprocess. SEC and FINRAenforcement

wouldbeneededtoensurethattherewerenobackdoorsellingeffortstoprimethe

marketforanATMoffering.Evenfortheissuer,thedraconianthreatof11sstrict

liabilityseemsexcessiveforanATMoffering.ATMofferingsifgenuinelysoldinto

a preexisting market without stimulation do not really require a registration

statement ora prospectus; atmost they need an8K announcing the number of

sharestobeoffered,followedbyanother8Kdisclosingthenumberactuallysold.

AntifraudconcernscouldbeaddressedbythelessdraconianRule10b5.

C. RelegationIf there are private companies wanting to rise to the public level in my

scheme, it follows that there are likely to be public companies attracted to the

reducedburdensofprivatestatus.Animportantbenefitofatwotiermarketisthat

retailinvestorswouldnotbecompletelycutofffromliquidityifacompanychooses

to relegate itself to the private market. There is no reason to preclude retail

investors from selling their shares in the privatemarket, even if they would be

barred from purchasing shares in companies that dropped down to private

company status. Moreover, there is little to be gained by prohibiting companies

from exiting the public pool; a restrictive approach will simply discourage


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companies from pursuing public company status in the first place. On the other

hand,too lenientan approachmayput toomuchstressonthe fiduciaryduties of

directorsunderstatelawtopreventabuses.Arethereproceduresavailablethatcan

limittheopportunitiesforabuse?

I propose a shareholder vote be required before a company would be

permittedtodropfrompublictoprivatestatus. 89Avote,withtheusualdisclosures

requiredbythefederalproxyrules,wouldbeausefulcheckonprivatetopublicto

privatemanipulation schemes. Itwouldnot trap companies,however, that have

struggled after going public. The company would have to make its case to its

shareholdersthatthebenefitsofpubliccompanystatuswerenolongerworththe

candle. Who shouldbe eligible to participate in the voting? It seems prudent to

exclude the votes of insiders and controlling shareholders, but should we also

sterilize the votes of institutional investors? My instinct is that this additional

restrictionwouldnotbenecessary.Thelossofliquidityattendanttorelegationto

the private market affects noncontrolling institutional investors and retail

investorsinthesameway;theirinterestsarealigned.Givingthevetothreattotoo

narrowagroupraisesthepossibilityofholdup.

D. ObjectionsWontanexpandedprivatemarketopenthedoortofraudandmanipulation?

Theshortansweristhataslongaspeopleareinfectedbytheloveofmoney,fraud

89See Jesse M. Fried, FirmsGoneDark, 76 U.CHI. L.REV. 135 (2009) (advocating that a

shareholdervoteberequiredbeforeafirmcouldceaseperiodicdisclosures).


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will always be with us. Given that sad fact of human nature, we should funnel

transactionstothevenuesthatmakeitmostdifficulttogetawaywithfraud.Tobe

sure,theprivatemarketproposedhereislikelytohaveahigherincidenceoffraud

and manipulation than the public market. But the scope of that fraud will

necessarilybe limitedbythe smaller size ofthe privatemarkets relativeto their

public counterparts. Moreover, the entities sponsoring trading in those private

markets will have competitive incentives to take cost effective measures to

discourage fraud.90And the SEC and FINRA enforcement would be available to

counterthemostegregiousabuses.

The potential for abuse in the private market has to be weighed against

reductions in fraud elsewhere. In particular, my seasoning period requirement

substantiallyreducestheopportunitiesforfraudbycompaniesenteringthepublic

market.Onbalance,theoverallincidenceoffraudmaywellbereduced.Andretail

investors,whoareleastabletobearit,willalmostcertainlybeexposedtolessfraud.

Atthesametime,capitalformationefficientallocationofcapitaltocostjustified

projectswillbeenhanced.

Another potential objection is that liquidity will suffer if the role of

underwritersisdiminished.Oneoftheservicesprovidedbyunderwritersismarket

makingimmediatelyaftertheoffering.Myproposalanticipatesthemarketcoming

into existence prior to the public offering.Will brokerdealers step in toprovide

liquidityintheabsenceofunderwriters?Ifmarketmakingisprofitableonitsown,

90See A.C. Pritchard, Markets as Monitors: A Proposal To Replace Class Actions with

ExchangesasSecuritiesFraudMonitors,85VA.L.REV.925(1999)


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theanswerisobviouslyyes.Butifmarketmakingisnotprofitablestandingalone

forsmallerissuers,thereisnoreasonthatithastobebundledwithunderwriting.If

some issuers need to subsidize initial trading in their shares, this can be

accomplishedoutsideofanunderwritingrelationshipthroughadirectpayment.

Finally, objectors to my proposal should be careful to avoid the nirvana

fallacy. The alternative to my twotier proposal is not the tight regulation of

registeredofferings thatwesaw formuchoftheSecuritiesActshistory, it isthe

publiccompanylitestatusofofferingsexemptedunderthenew3(b)oftheJOBS

Act.Isthatpubliccompanyincubatorpoolreallysuperiorfromtheperspectiveof

investorprotection?

V. Conclusion

What ifwe just focused oncapital formation indrawing the line between

privateandpublicmarkets?Afocusoncapitalformationsuggeststhatweshould

putanendtoIPOs,ifwecanestablishaviablealternative.Inmyview,restrictions

onprivatemarketshavehinderedthatviablealternativefromemerging.TheJOBS

Actsincreaseto2,000shareholdersforapubliccompanystatusisabigsteptoward

a greater role for private markets. My proposed alternative to the current IPO

regime would bring the company registration initiative to its logical conclusion.

Private companies would be required to go through a seasoning period with

mandatorydisclosurebeforesellingsecuritiestothepublic.Thisseasoningperiod

wouldmarkthelinebetweenprivateandpublic,ratherthanthecurrentstandards


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ofexchangelisting,numberofshareholders,orthefilingofaregistrationstatement

foraninitialpublicoffering.

Thefoundationofmyproposalrestsontwocentralpremises:(1)IPOsarean

inefficient means of capital formation; and (2) private markets, with pools of

liquiditythatarecontinuingtoexpand,willbesufficienttosatisfythecapitalneeds

ofgrowingcompaniesuntiltheyarereadyfortheburdens thatcomewithpublic

companystatus.Theevidenceforthefirstpropositionisconsistentandstrong.The

secondpropositionblazesapathintostillunchartedterritory.TheRule144AQIB

marketandtheriseofprivatemarketslikeSecondMarketandSharesPostshowthe

potential ofprivate tradingmarkets.Until the passage of the JOBSAct, however,

thosemarketshavebeenhamstrungbythe500shareholderlimittriggeringpublic

company status. Raising that limit to 2000 shareholders of record, promises to

substantially increase the liquidity ofprivatemarkets.More timewill beneeded,

however,beforewecanassesswhetherthisexpansionoftheprivatemarketsgains

marketacceptance.

ThebottomlineisthatwiththepassageoftheJOBSAct,changeiscomingto

thedemarcationbetweenprivateandpublicstatusunderthesecuritieslaws.The

looming question is whether the SEC will attempt to obstruct this change, or

embraceitinanefforttopromotegreatercapitalformation.Myproposalaffordsthe

SEC an opportunity to promote capital formation while also enhancing investor

protection. The twotier private/public market scheme outlined here would

completethecompanyregistrationmodelputforwardbyMiltonCohennearlyahalf


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centuryago.Weshouldharnessprivatemarketstopromotethepublicgood.Private

marketsmayfinallyallowustoabolishinitialpublicofferings.

Documents

Abolishing IPos