[Senate Hearing 112-721]
[From the U.S. Government Publishing Office]
S. Hrg. 112-721
EXAMINING THE IPO PROCESS: IS IT WORKING FOR ORDINARY INVESTORS?
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
ON
EXAMINING THE IPO PROCESS
__________
JUNE 20, 2012
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Available at: http: //www.fdsys.gov /
_____
U.S. GOVERNMENT PRINTING OFFICE
78-882 PDF WASHINGTON : 2013
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing
Office Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; DC
area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC
20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
MIKE CRAPO, Idaho, Ranking Republican Member
CHARLES E. SCHUMER, New York PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
HERB KOHL, Wisconsin JIM DeMINT, South Carolina
MARK R. WARNER, Virginia DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota
Kara Stein, Subcommittee Staff Director
Gregg Richard, Republican Subcommittee Staff Directorr
Catherine Topping, FDIC Detailee
(ii)
C O N T E N T S
----------
WEDNESDAY, JUNE 20, 2012
Page
Opening statement of Chairman Reed............................... 1
WITNESSES
Ann E. Sherman, Associate Professor of Finance, DePaul University 3
Prepared statement........................................... 21
Lise Buyer, Founder and Principal, Class V Group, LLC............ 5
Prepared statement........................................... 24
Joel H. Trotter, Partner, Latham & Watkins LLP................... 6
Prepared statement........................................... 28
Ilan Moscovitz, Senior Analyst, The Motley Fool.................. 8
Prepared statement........................................... 34
(iii)
EXAMINING THE IPO PROCESS: IS IT WORKING FOR ORDINARY INVESTORS?
----------
WEDNESDAY, JUNE 20, 2012
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 9:34 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. Let me call the hearing to order. My Ranking
Member, Senator Crapo, is delayed. We anticipate that other
colleagues will be arriving shortly, but since the panel is
assembled and the time has come, it is appropriate to begin the
hearing.
Let me welcome everyone to the hearing. It is a very
important topic, ``Examining the IPO Process: Is It Working for
Ordinary Investors?''
I have had the opportunity to read your testimony, and let
me thank you all for very thoughtful and insightful comments. I
appreciate it, and I look forward to the questioning.
The number of individuals participating in our capital
markets has grown substantially, especially for investors
trying to save for retirement through their 401(k) plans and
other retirement plans. Once an opportunity that was limited
primarily to institutional investors, now the chance to
participate in initial public offerings is increasingly
available to ordinary investors.
A central question I want this hearing to answer is: Is the
system fair and transparent, and is it working for everyone,
particularly individual investors? A dysfunctional IPO market
can harm our economy. While the summer is typically the peak
season for IPOs, in the wake of Facebook's highly publicized
IPO troubles, which was marred by technical mishaps, many
planned IPOs have been postponed or canceled, and more
Americans and the investment community are questioning the
integrity of the IPO process. And, frankly, I think we all
recognize that without confidence by investors, the ability to
efficiently form capital and to generate jobs is impaired. That
confidence is fundamental to our free market system.
Regulators continue their investigation into some of the
specific problems surrounding the Facebook IPO. This hearing is
a chance to broadly and publicly examine the procedures for
taking a company public. That is one data point. But it is a
much, much broader set of issues that we want to confront this
morning.
There is also concern that the JOBS Act recently passed
made some of the biggest regulatory changes to U.S. capital
markets in decades and weakened some key investor protections.
It may have caused some other new problems, such as allowing
more shell companies for reverse mergers to go public in the
United States. Indeed, a recent Wall Street Journal article
quoted special purpose acquisition companies and blank-check
companies--basically empty shells with almost no employees that
are used in mergers or as a back-door route to U.S. stock
listings--have been quick to identify themselves in regulatory
filings as ``emerging growth companies.'' The new law uses that
label to describe which companies, once they have applied to go
public, should be exempt from some financial reporting and
corporate governance rules.
Companies with less than $1 billion in annual growth
revenues are eligible for the less restrictive rules--a
standard that would have been met by a majority of companies
conducting an IPO in the last several years. So this is a very
high threshold, obviously. Companies that qualify as emerging
growth companies do not have to comply with the Sarbanes-Oxley
Act's requirements that auditors review their internal
controls. It also allows them to make fewer financial
disclosures, use a new confidential SEC review process for
IPOs, and lets their bankers communicate more freely with
selective investors, the more sophisticated players and
investment banks.
Underwriting the IPOs of emerging growth companies is a big
business on Wall Street. Investment banks are expected to take
full advantage of the new, less stringent requirements. As a
result, retail investors may be denied critical information
that is essential to making sound investment decisions.
Unfortunately, during the expedited process used to pass
the JOBS Act, improving the efficiency and transparency of the
existing IPO system was not really discussed. With full and
fair information from investors, our capital markets are more
efficient and transparent and can better facilitate the capital
formation so important to our Nation's economy.
Clearly, all investors face certain risks when contributing
capital to either small or large companies. In fact, the
panelists made the case quite clearly that risk is inherent in
all of these IPOs, and that should be acknowledged. However, we
need to ensure that there is not one set of rules for
sophisticated clients and another set for ordinary investors.
Everyone should have access to the same set of data and
disclosures, or at least equivalent data and disclosures.
Chairman Johnson has instructed Committee staff to conduct
its due diligence regarding issues raised in the news about
Facebook's IPO. This hearing will be part of that, but, again,
the focus is on the broader issue of IPOs. And many have stated
that once these briefings have concluded, we will determine if
a full Committee hearing is necessary.
So today's hearing will serve as a jumping-off point,
broadly examining the procedures for taking a company public,
and I think it will be a very productive hearing.
When Senator Crapo arrives, if he is able to arrive, or my
colleagues, if they wish to make an opening statement, I will
interrupt your statements and give them that opportunity. But
let me now proceed to introduce the witnesses and ask for your
statements.
Our first witness is Dr. Ann Sherman. Dr. Sherman is
associate professor of finance at DePaul University. She
received her Ph.D. in economics from the University of
Minnesota. Dr. Sherman's research on IPO methods has been
published in top finance journals, and she was a consultant on
the Google IPO. Dr. Sherman has taught finance at the
University of Wisconsin, Madison, the University of Notre Dame,
and Hong Kong University of Science and Technology.
Our next witness is Ms. Lise Buyer. Ms. Buyer is the
founder and principal of the Class V Group, an organization
providing strategic and logistical guidance to companies
contemplating an initial public offering. Ms. Buyer has
firsthand experience as an institutional investor, investment
banker, venture capitalist, board member, and internal IPO
coordinator analyst and employee. Previously, Ms. Buyer was the
director of business optimization for Google, Inc., where she
was one of the chief architects of the company's innovative
IPO.
Our next witness is Mr. Joel H. Trotter. Mr. Trotter is a
partner at Latham & Watkins and is the global cochair of the
firm's public company representation practice group and the
deputy chair of the corporate department in the Washington, DC,
office. Mr. Trotter's practice focuses on capital markets
transactions, mergers and acquisitions, securities regulation,
and general corporate matters. Thank you, Mr. Trotter.
And, finally, our last witness is Mr. Ilan Moscovitz. He is
a senior analyst for The Motley Fool, a global financial
service company and tireless advocate for individual investors,
specializing in financial reform, macroeconomics, and
shareholder rights. Mr. Moscovitz's research has been cited
numerous times in the national press.
We thank you all for being here. All of your testimony will
be made part of the record in its entirety, and I would ask you
to summarize it within 5 minutes. We will begin with Dr.
Sherman.
STATEMENT OF ANN E. SHERMAN, ASSOCIATE PROFESSOR OF FINANCE,
DEPAUL UNIVERSITY
Ms. Sherman. Chairman Reed, thank you for inviting me to
testify today. My research has been primarily on IPO methods in
various countries, and in the last three decades, there has
been a lot of experimentation in various countries with
different methods.
Now, one of the main points I want to make today is that
the U.S. method, commonly called ``book building,'' is the most
popular method around the planet. And it was not always that
way. If you go back to the early 1990s, it was used really only
in the U.S. and sometimes Canada. By the end of the 1990s, it
was the dominant method, and it has become even more popular
since then.
Now, the difference between book building and the other
methods is that with book building, the underwriter gets
feedback from investors before setting the offer price. And it
is not always easy to get people to honestly tell you that they
like an offering if they know that you are going to use that
information to raise the price. And that is why it is important
that the underwriter also controls allocations, who gets what.
So by controlling allocations, the underwriter can favor
regular investors that do not just try to cherrypick the hot
offerings, can favor investors that give feedback that help to
set the price, and can favor long-term investors. So there are
reasons why the underwriter may favor institutional investors.
Ordinary investors may not have the expertise or resources to
play the same role in an IPO.
Now, that does not mean that they cannot participate. If
you look around the world, most countries open up the IPO
process to all ordinary investors, but the key is that they
open up the allocations, but they do not control the price
setting. Ordinary investors do not help to set the price for
IPOs. They just get a chance to get shares.
So the most popular method outside the U.S. is a hybrid or
a combination where they have a tranche that uses book building
and they use that to set the price and allocate to
institutional investors; and then for ordinary investors, they
have a separate tranche. Ahead of time it is announced what
proportion of shares will go into each tranche, and everyone is
allowed to order shares in the retail tranche. And if it is
oversubscribed, they have basically a lottery. So it is open,
it is transparent, everyone has a chance to get shares; but
they do not disrupt the price-setting process. That is a method
that has worked well around the world.
The method that has not worked well around the world is to
use an auction that is open to everyone so that everyone has an
equal say in setting the price. I do not want to use up too
much of my introductory time, but I would be happy to answer
questions on that. The auction method has been used in more
than two dozen countries, and they have pretty much all
abandoned it because of huge problems.
When I was doing literature searches or newspaper searches
to find out more about various IPO auctions, I learned that
good search terms were ``flop,'' ``disaster,'' ``debacle,''
``catastrophe,'' ``calamity.'' The auction method is one that
has blown up in people's faces around the world, which is why
countries stopped using it. Retail investors should be allowed
to participate, but you have to be very careful about giving
them a major role in the price-setting process.
So what should the U.S. do? Frankly, I am neutral on
whether the U.S. should require issuers to give a bigger role
to ordinary investors. But I feel strongly that if we are going
to do that, it should be through the hybrid method with a
separate tranche so that everyone has an equal chance of
getting shares, but it does not disrupt the price setting.
Last, on the role that small investors should play in
private equity--and in particular crowdfunding, where you have
maybe a Web site and a bunch of people put up a few hundred
dollars each--I see two big problems with that.
The first is: Who is going to do the due diligence? Fraud
is a major problem with these. Someone needs to screen these
offerings before they get funding, and someone needs to
continue to monitor them. And if we do not find a way to do
that, crowdfunding could be a disaster for ordinary investors.
And the second question is: Who is going to set the price?
I hope that I have communicated that letting ordinary investors
price IPOs has been disastrous, and if they are not good at
pricing relatively sophisticated or advanced IPOs, then there
is even less reason to think that they can price early stage
startups.
Again, thank you, and I would be happy to answer any
questions.
Chairman Reed. Thank you very much, Dr. Sherman.
Ms. Buyer, please.
STATEMENT OF LISE BUYER, FOUNDER AND PRINCIPAL, CLASS V GROUP,
LLC
Ms. Buyer. Chairman Reed, thank you very much for inviting
me to be here today. I am honored to be able to submit my
commentary to such an important discussion of the IPO process,
which is clearly such an important rite of passage for so many
companies. Having been an institutional investor responsible
for deploying the assets of aggregate individuals; an
investment banker, part of the team that designed and
implemented a unique and high-profile, IPO; and a board member
of a company as it transitioned from private to public, and
then afterwards; I have looked at the IPO process from a
variety of perspectives, and it is from that combination of
perspectives that I offer my comments today.
IPOs, as you mentioned, are always and inherently very
risky--riskier than investing in seasoned companies. In fact,
if we look at the class of 2012, as of a day ago the best-
performing IPO year to date is a Buffalo, New York-based
company, Synacor, which had a very difficult time getting
public, traded up 5 percent day one, and now is up an
incremental 162 percent.
Then there is Ceres, which was warmly embraced by the
market in its IPO in February, up 14 percent day one, currently
down 31 percent.
And then there is the higher-profile Splunk, which was up
109 percent on the day of its IPO, today is up 90 percent,
meaning that those people who participated in the frenzy of day
one may be underwater even though the stock has nearly doubled
from its initial public offering.
The point of that is to say it is very difficult to predict
what any stock will do on its IPO or shortly after. And, in
fact, there is no right answer. There are always winners and
losers.
I believe that--in fact, the people who invest just day one
are really speculators, not investors. Investors need to be in
for a longer period of time.
I believe the importance here is for overseers to make sure
that up front anyone who chooses to participate in an IPO fully
consider not only the possible rewards but also the very, very
real risks. And, in fact, if I may make only one suggestion
here today, I would suggest that before confirming an order, be
it by phone or in person or online, every individual be asked
to read, or be read to, acknowledge, and confirm agreement with
a very short, simple, bold statement along these lines: ``I
fully acknowledge that this stock has an equal chance of
trading up or trading down from my purchase price. Furthermore,
I acknowledge that shares of newly public companies routinely
trade below the prices at which they are initially offered.''
My hope is that a cigarette-box type warning of this nature
could just add a moment of pause to transaction decisions that
are too often based on emotion and not on thoughtful analysis.
With my remaining time, I would add two other comments.
First, as we know, some institutions have the chance to
meet with management teams to see a presentation and ask
questions during a roadshow. Clearly, it is not possible for
individuals to have that same exposure, although with the
advent of the retail roadshow, they now have the chance to
watch the presentation, even though I suspect that most of them
do not. I wonder if there is a chance to level the playing
field by suggesting to companies going public that they add an
hour or they offer an hour of Q&A, online Q&A, for individual
investors, during which time they could respond to presubmitted
questions from any investor who had actually watched the retail
roadshow. Just a chance to level the playing field by allowing
small investors to have reasonable questions answered.
And, finally, a third comment I would make echoes what you
just said. I have significant concerns about many of the
provisions of the well-intentioned, recently passed JOBS Act as
these provisions reduce transparency and really roll back
important, in my opinion, investor protections. I would suggest
that that Act may need some refinement.
To the question in our initial invitation which Dr. Sherman
just addressed, pricing and allocation, based on my years of
watching IPOs, I would suggest that those final decisions need
to be completely in the hands of professionals who have a
fiduciary obligation for those whose money they are overseeing,
the management of the company selling stock, and the investment
bankers who have the best aggregated information about the
market and about interest in the particular security. I do not
think it is appropriate for retail investors to be able to set
the price in IPOs.
So, in summary, I think generally the process works very
well both for companies and for informed--and I would underline
``informed''--investors. I would recommend, one, that we add a
request for a signed, straightforward acknowledgment of risk;
two, perhaps management teams for a Q&A session for individual
investors; and, three, that we revisit the provisions of the
JOBS Act.
Thank you very much.
Chairman Reed. Thank you very much, Ms. Buyer.
Mr. Trotter, please.
STATEMENT OF JOEL H. TROTTER, PARTNER, LATHAM & WATKINS LLP
Mr. Trotter. Thank you, Mr. Chairman, and my thanks also to
Ranking Member Crapo and the other Members of the Subcommittee
and their staffs. I have provided you all with detailed
information in my written testimony and want to highlight four
key areas that bear emphasis: first, the national importance of
our IPO markets; second, a bedrock principle of our system of
Federal securities regulation, which is disclosure not merit
regulation; third, another bedrock principle, which is the
concept of materiality in that disclosure; and, finally, I want
to comment on the nature of risk, reward, and capital
formation.
The first point I would like to make is that IPOs must
compete with other forms of capital formation. Emerging growth
companies have two alternative paths for providing liquidity
into their early stage investors. They can either pursue an
IPO, or they can pursue a sale of the company. An inhospitable
IPO environment sends more early stage companies toward a sale
process and away from the IPO alternative, and that is exactly
what we have seen in recent years.
This matters a lot because IPOs play an important role in
fostering innovation and job growth. As President Obama said
when he signed the JOBS Act into law, ``New businesses overall
account for almost every new job that is created in America,
and going public is a major step toward expanding and hiring
more workers for those companies.''
The IPO on-ramp in Title I of the JOBS Act is an important
step in making it easier to go public while maintaining
important investor protections and providing significant cost
savings in the IPO process.
The second point I would like to address is what else we
can do to help IPOs. We can return to bedrock principles of
Federal securities regulation. From the beginning, Congress has
mandated a disclosure regime rather than merit regulation. My
mentor and former partner, John Huber, used a memorable
anecdote to contrast disclosure with merit regulation. John is
well known for a distinguished career and his distinguished
service as Director of the SEC's Division of Corporation
Finance, a disclosure regulator. But earlier in his career, he
had worked for a State securities commission, a merit
regulator.
His coworkers at that State commission proudly refused to
approve the shares of an untested, upstart company whose name
today everyone in this room would recognize. They had rejected
that company's request to sell shares to residents of their
State because the CEO's compensation was too high.
``What was the IPO price?'' John asked them. Answer: $22
per share. ``Well,'' John responded to his colleagues, ``the
stock is now trading at $60 per share, so how exactly did we
help investors in our State by preventing them from buying at
$22?''
That anecdote sums up merit regulation, and it highlights
the benefits of a disclosure regime that lets investors choose
the winners and losers.
The third point I want to make is about disclosure and what
information companies must provide to investors in a regime
that takes the path of disclosure rather than merit regulation.
The tried and true answer to that question is that disclosure
of all information that is material is required. Well, anyone
who has looked at an IPO prospectus recently may wonder whether
we have gone far afield from that central principle of
disclosing material information. An IPO prospectus today is a
lengthy and detailed document running as much as 200 pages or
more, often. Brevity may be the soul of wit, but it is hardly
the hallmark of an IPO prospectus.
A balanced and reasonable approach to materiality is
critical to the success of any disclosure-based regulatory
regime. An avalanche of trivial information obscures truly
important information and does nothing to increase the
protections to investors.
My last point is about risk. It is a simple fact of
economic life that not all IPOs succeed. Any commercial
enterprise that can earn a profit can also earn a loss. Like
any business, a newly public company may or may not make money
for its investors. For precisely that reason, the cover page of
every IPO prospectus today says this is our initial public
offering. No market currently exists for our shares, and the
prospectus has many pages of detailed risk factors highlighting
the risks that relate to the company and the offering.
In addition to transparency, our capital markets must offer
investors the opportunity to take risks. Risk-free capital
markets have no future, as SEC Commissioner Daniel Gallagher
recently said. Even if we could create risk-free capital
markets, he said, they would not offer enough upside to attract
companies or investors because investors would do just as well
or better putting their money into savings accounts or Treasury
bills.
Thank you very much. I welcome your questions.
Chairman Reed. Thank you very much, Mr. Trotter.
Mr. Moscovitz, please.
STATEMENT OF ILAN MOSCOVITZ, SENIOR ANALYST, THE MOTLEY FOOL
Mr. Moscovitz. Mr. Chairman and Members of the Committee, I
want to thank you for the opportunity to offer testimony and
recommendations today. My name is Ilan Moscovitz, senior
analyst for The Motley Fool.
Founded in 1993, The Motley Fool's purpose is to help the
world invest better. Millions of individual investors rely on
The Motley Fool not only for guidance on how to manage their
money, but also as an advocate for their rights as
shareholders. For years we have worked to create a level
playing field in the market. It is for this reason that we are
eager and grateful to discuss whether the IPO process is
working for ordinary investors.
It goes without saying that IPOs are critical to both
developing public markets and helping businesses raise the
capital they need to grow and hire.
From our vantage point as retail investors, the overarching
problem with IPOs is that there is an imbalance of both
information and access. Although issuers and venture
capitalists ultimately depend on us retail investors for
capital and for liquidity, the deck is stacked against us in at
least two major ways.
First, insiders, underwriters, and their favored clients
have access to more and better information than do ordinary
investors. This gives them an advantage in estimating a
company's fair value. Reports of Facebook's recent IPO provide
a prominent example of this.
Second, there is unequal access to shares. The initial
offering is traditionally limited to preferred clients of
underwriters. By the time we can buy shares, there has already
been a significant markup. It is estimated that from 1990 to
2009, the first day pop averaged 22 percent, totaling $124
billion. That $124 billion did not go to the companies coming
public but to friends and other clients of the underwriters.
Unfortunately, the IPO process is likely to get worse for
individual investors as a result of the recently passed JOBS
Act. The on-ramp section of the Act is intended to spur
economic growth by lowering the bar that a company must meet in
order to go public. But weakening reporting requirements means
less information for investors and a lower-quality pool of
IPOs. Think more Pets.com than Google.
When we lost faith in the quality of IPOs in the late
1990s, IPO volume crashed 75 percent in 2001. It is worth
pointing out that IPOs doubled from that level following the
Global Analyst Research Settlement and passage of Sarbanes-
Oxley--reforms which addressed some of the worst abuses of the
dot-com bubble and ensuing years. But the JOBS Act undoes many
of these reforms for nine out of ten companies coming public.
To remedy these problems, our objective should be to level
the playing field and restore trust in the IPO process by
maximizing transparency and useful disclosure. Here are three
recommendations:
First, extend the application and enforcement of regulation
fair disclosure to the beginning of the IPO process. This will
help to improve the flow of information to all investors and
reduce one of the most preventable information asymmetries--
between underwriters and their favored clients versus ordinary
investors.
Second, require that companies and underwriters allocate
shares in the initial offering in a more inclusive and
efficient manner. Companies like Google, Morningstar, and
Interactive Brokers have successfully employed variations on a
Dutch auction process, which gives all investors the
opportunity to participating at buying shares at the same
price, under an equitable plan of distribution. An added
benefit is that it lowers the cost of going public for
companies by more than half.
Finally, fix the most troubling portions of the JOBS Act
from the retail investor's perspective. While there are a
number of improvements that could be made, if you are looking
for the most straightforward remedies, here are two:
One would be to decrease the size threshold in the emerging
growth company definition in order to increase the amount of
information available to investors, as the Chairman has
previously recommended. The current definition needlessly
encompasses virtually all IPOs.
A second remedy would be to implement a lockup period
covering pre-IPO insiders which would extend from the offering
to at least 180 days after an issuer is subject to normal
reporting requirements, similar to common practice before
passage of the JOBS Act. This will better align the incentives
of insiders and ordinary investors. It will also help to ensure
that any capital raised via the emerging growth company
exemption serves its intended purpose by flowing to the company
and not to insiders exiting on the IPO on-ramp.
As the IPO process currently stands, ordinary investors
have unequal access to information and unequal access to the
market. We are asking for a level playing field, disclosure,
and transparency. We believe that the lack of these qualities
is what is most troubling about the IPO process right now.
I appreciate the opportunity to submit testimony on how
IPOs affect ordinary investors and would be happy to answer any
questions.
Chairman Reed. Well, thank you all very much for the very
excellent testimony, both your written testimony and your
comments this morning.
Let me begin with a question for the whole panel, and it
focuses on the issue of how do we best protect the retail
investor given that the prevailing model, with variations now
because of the JOBS Act, is the book building where managers of
the IPO with clients and--as the theory--in order to advance
price discovery, conduct all these roadshows, et cetera, but as
the Facebook IPO suggested, some critical information,
particularly at the very last minute, was available to favorite
investors and not as widely disseminated to the public. So I
just want your thoughts, each one of you, about if we are going
to involve retail investors, how do we do it in a way that they
are confident they are getting a good deal and they will
continue to invest in IPOs? Dr. Sherman.
Ms. Sherman. Certainly, it is important to level the
playing field in terms of information, and I was very surprised
with Facebook that analysts were allowed to talk to
institutions but not individuals. I can see why that is there,
because individuals, if they are allowed to be given these
forecasts--because it was not hard information; it was
expectations of the future--individuals might not understand
that these are speculative and they might not be able to
appreciate it. But I do think the same information should be
available to everyone.
One of the unusual things about the U.S. is the quiet
period regulation, and as Joel said, it's disclosure, not
merit. So it is very important that we try to give everyone the
same access to information, and I would second what Lise said
about the Q&A from the roadshow. I think that should be
available even to retail.
Chairman Reed. Let me just follow up. Under the JOBS Act,
there is a loosening of the analyst's role, as I read the Act,
that they now can be--unlike the universal settlement that Mr.
Moscovitz talked about, they now can be sort of compensated or
at least it is not the strict tall wall between the analyst and
the promoters of the--is that accurate from your reading of it?
Ms. Sherman. Mr. Trotter would probably be----
Chairman Reed. Well, if you do not know, that is fine.
Ms. Sherman. I do not know.
Chairman Reed. Ms. Buyer, your comments on the general
question.
Ms. Buyer. On the follow-up question or on the whole
question?
Chairman Reed. The whole question.
Ms. Buyer. On the whole question. Number one, let us all
remember that individuals do have the ability to participate in
IPOs through mutual funds. The favored clients we keep talking
about are really those big firms that have aggregated many
thousands of individuals' investments. So the firefighters and
the teachers all actually do get to participate in IPOs, just
through the screen of a professional investor.
The equal distribution of information is difficult, and I
understand this is not about Facebook, but let us remember that
everyone had access 2 days before that deal to the information
that General Motors was pulling their advertising. That was a
huge material piece of information that did not seem to in any
way quell the enthusiasm for the IPO.
The issue at hand in that particular case was Morgan
Stanley's estimate, which, of course, Morgan Stanley offered to
the clients who pay them. The estimate is a product that Morgan
Stanley sells to its customers, and I do not know that we ought
to be regulating what information investment companies can
share with their paying clients. I think this is a little bit
of a slippery slope, and if we insist that all investment banks
give their estimates, which are costly to develop, to everyone,
what incentive do the banks have to come up with estimates at
all?
The JOBS Act issue that I find of greatest concern--and you
mentioned the Global Research Settlement--is that many banks
are still bound by that agreement. So the analysts of the banks
who have the most information about a potential IPO are still
restricted from talking. The only ones who can now publish
research are those who are farther away from what is actually
happening, and I am not sure that that serves anyone's purpose.
Chairman Reed. OK. Mr. Trotter.
Mr. Trotter. Well, as I indicated in my written testimony,
I am not in a position to talk about any particular IPO or
company. But I will say that in the area of analyst research,
by far and away all of the protections that were developed in
the last decade remain in place and are unchanged as a result
of the JOBS Act. There were some changes, and many of those
changes relating to that area still need to be implemented
through FINRA interpretation and other interpretation by the
regulators in that area.
Chairman Reed. Mr. Moscovitz, your comments.
Mr. Moscovitz. With respect to the Global Analyst Research
Settlement, yes, that is my understanding as well. One concern
with the changes that were made in the JOBS Act is that if you
allow analysts to meet with prospective clients, there is a
possibility you can have analysts meeting clients--meeting
companies that want to come public, and that way the
underwriters can say, hey, here is our analyst, he has got a
nice suit, he will write nice things about your company, and he
will give you a strong buy recommendation. Obviously, during
the 1990s, lots and lots of companies were coming public, and
they were indirectly promised that they would get good buy
recommendations from analysts.
And then with respect to Facebook, I agree the problem is
not that shares went down because that can happen in any IPO. I
would just say that there is a problem with equal access to
this information. When reports from analysts are issued by
analysts who have special access to management, they can get
information that is not really available to all investors, and
when you see something like Facebook, there is a problem where
you have multiple analysts from various underwriters who all
cut their estimates from pretty much the same number to pretty
much the same number. You have reports that people from
Facebook may have indicated to analysts that they should go
over their estimates. And meanwhile the public gets sort of
some vague line in a massive--S-1 amendment about our
subscribers are continuing to grow at a faster pace than our
revenue. So the quality of information that is being presented
to prospective clients of the underwriters just is not on the
same level as the information that investors would have if they
have to dig through the S-1 to try to discern what that means.
Chairman Reed. Dr. Sherman, you point out that in other
countries the retail investors do not engage themselves in the
price discovery and price setting, that is restricted, too. And
I presume from your comments that you feel that that model is
an inappropriate way to set prices. But many countries have a
specific tranche for retail investors in which they can buy at
basically the same price. Can you comment about how effective
and successful that is? Is that something that we should look
at in terms of our approach to IPOs?
Ms. Sherman. I would like to see it considered here,
especially for larger offerings. I think with smaller
offerings, a lot of the smaller IPOs are already marketed more
to retail. But for larger offerings--and I contacted Facebook.
They never got back to me, but I tried to talk them into doing
this. That way everyone has an equal chance to participate.
When I lived in Hong Kong, I went in and placed orders. All
you needed was a Hong Kong ID number, and everyone had an equal
chance. But the problem that has occurred with auctions is that
when you get--retail investor demand is very uncertain. You can
get these floods of investors coming in and pushing the price
up to unsustainable levels, and then people lose money, and
then the retail go away again because they are scared of the
process. So there needs to be some coordination, and we can
easily then open up allocations and give everyone a chance
without disrupting the process, which is not good for anyone.
Chairman Reed. And one of the other aspects of the American
model, for want of a better term, is the roadshow in which
analysts are able to quiz management. As Ms. Buyer suggested,
it might be appropriate to consider making that much more
accessible. And I think in Facebook there was a version put on
the Net, but it neglected to have the questions of the
analysts, which was probably the most important part of the
demonstration.
Is the roadshow process the best mechanism in your view?
Ms. Sherman. I think that is important, and I would like to
see the question-and-answer filmed. If you look at why
investors go to the roadshow, it is to see the management in
action, to see how they respond to tough questions, to get a
feel for the people, because you are not just investing in the
idea or the product; you are investing or betting on the
management team. And Facebook, their first day for the
roadshow, replaced a lot of the Q&A with this 30-minute video,
and investors were very unhappy about that. And by the next day
in Boston, that was gone because there is--I have watched the
online roadshows, but then you are seeing management scripted
and rehearsed and filmed. It is just different to see them on
their feet responding to questions, and retail investors should
get the chance to do that.
Chairman Reed. Thank you.
Mr. Trotter, we have got the JOBS Act now, and you
suggested it is opening up new opportunities. But is one
opportunity, as has been at least suggested in reports by the
Wall Street Journal, to take a shell company, effectively, that
is already registered, presumably, and simply do some--and you
are the expert, not I, but a reverse merger, and so you do not
have to have audited--in some cases, audited financial
statements or you do not have to have the rigors of Sarbanes-
Oxley, yet you do not go through the traditional IPO process of
the book building, the analysis, or offering. Is that something
that concerns you about how, you know, either willingly or
unwittingly, this new Act could be used.
Mr. Trotter. Well, Mr. Chairman, many of the things that
you just said about shell companies are, in fact, true. They
were true before April 5, 2012, and they continue to be true
today. The JOBS Act did not really change the dynamic with
shell companies. They have always been a part of the system.
They have always been subject to SEC review, so before they can
register, they go through the same type of rigorous SEC review
process where they have to provide disclosures to their
investors. And in terms of Sarbanes-Oxley compliance by shell
companies, they almost exclusively are smaller reporting
companies, so they have already been exempted under Dodd-Frank
from the internal control audit required by Section 404(b) of
Sarbanes-Oxley. And so none of those aspects relating to shell
companies has changed as a result of the JOBS Act.
Chairman Reed. But one of the--and this might be the most
ironic aspect here of the JOBS Act, there is nothing in the
bill that requires any creation of jobs to qualify for all the
protections and all of the benefits of the JOBS Act. Is that
accurate?
Mr. Trotter. I think the premise underlying the IPO on-ramp
is that, again, going back to the competitive nature of the
capital formation process and the fact that if you have an
early stage company that needs to provide a return to its early
investors who bet on the company when it was just an idea, that
type of a company can pursue one of two paths. It can sell the
company to an acquirer and be part of a larger enterprise and
get absorbed and have redundant positions eliminated in the
short term, or it can raise its own capital to be independent.
And in raising your own capital to become an independent
enterprise, you are going to grow the business. And when you do
that, you are going to need more employees to help you run your
growing business. So you are going to need to hire people. And,
in fact, if you--you know, you can think of cities around our
Nation that are almost synonymous with certain major companies
today, and yet in almost every case they started out as
fledgling enterprises that nobody would have guessed would have
become household name companies today.
So when you think about the connection between IPOs and job
creation, you can just think of--pick your favorite city,
whether it is Seattle or Cupertino or Austin, Texas, and you
will think of a company that has changed the landscape of that
city.
Chairman Reed. But, specifically, all of the provisions of
the JOBS Act can be accessed by companies who do not grow one
additional job. They can avoid Sarbanes-Oxley reporting. They
can do this until they get to the size of $1 billion in
revenue. And it would seem to me that a company that has $1
billion in revenue could afford to have audit standards and
could afford many other things which would protect whatever
their shareholders. But the reality is that you do not have to
have one extra job to be an emerging growth company. Is that
correct?
Mr. Trotter. Yes, sir. And several points in response to
your very good questions there. The profit-and-loss system of
the capital markets and our free enterprise system entails both
profit and loss. We cannot--this goes back to the distinction
between merit regulation versus disclosure, and people now in
hindsight talk about certain dot-com companies and how they are
examples of bad ideas.
Well, nobody knew for sure at the outset whether they were
bad ideas. The investors had to choose and pick the winners and
losers. And some of those companies are long forgotten, but
many of those companies are around today and have even created
new industries and changed the way that we purchase products.
So that is one point in response.
Another one, on the issue of Sarbanes-Oxley complaint,
remember that the President's Jobs Council, headed by Mr.
Immelt from General Electric, recommended a permanent exemption
from Sarbanes-Oxley 404(b) compliance, the internal audit
attestation requirements of Sarbanes-Oxley, for all companies
below $1 billion in revenue. So the JOBS Act provision that
gives this on-ramp of 1 to 5 years, depending on the size of
the company, is much more limited than that recommendation from
the President's Jobs Council. And, again, any newly public
company has up to 2 years under prior law before it has to
comply, so it is really changing 2 to 5 in terms of Sarbanes-
Oxley internal control attestation.
Chairman Reed. But one could argue, given the 2-year
exemption for all companies before the JOBS Act, that the
requirement to eliminate that for the initial public offering
and for the 2 succeeding years might have been a little bit
more, you know, generous than was necessary. We already
recognized in Sarbanes-Oxley that companies coming online may
not be as well prepared.
Mr. Moscovitz, your comments about this whole area.
Mr. Moscovitz. Well, with regards to the JOBS Act, you are
referring, I believe, to some of the reporting in the Wall
Street Journal's ``Meet the JOBS Act's Jobs-Free Companies,''
about the JOBS Act, jobs-free companies, as well as some other
articles that are describing how lots of companies were
describing themselves as blank-check companies or trusts and
the like. There is a quote in that article, actually, from the
Nasdaq vice chairman who lobbied hard for passage of the JOBS
Act, and he said that he did not think that anybody was
thinking that this was going to be applied to reverse mergers
and the like.
And I guess I would say that we should be very careful
about what the emerging growth company exemptions are being
used for. We have seen, as you know, trouble in China, for
example, with their reverse merger disaster. Reporting in China
and the accounting standards in China just are not at the same
level that ours are. And we saw when investors very suddenly
realized this, very suddenly acted on this, starting in late
2010, shares of 93 percent of these companies fell by an
average of 50 percent for Chinese emerging growth companies.
Any of them that wanted to raise capital after that point, it
became very difficult to do that. You have companies that are
presumably growing at, 50 or 60 percent per year that have a PE
of 2. The only reason that happens is if people just believe
that they cannot trust any of the numbers coming out of China.
If you are investing in a small Chinese company right now, the
first risk factor you consider is whether or not it is a fraud.
So I would just say that we should be very careful--we do
not want to move in that direction.
Chairman Reed. Let me just ask you, Mr. Trotter, you
brought up merit regulation, which is, to my understanding
under the Federal securities laws, there is not merit
regulation. Is that correct?
Mr. Trotter. That is correct, Mr. Chairman. It is a matter
of degree. When you require--there are instances where
disclosure can veer into merit regulation, depending on whether
the requirement is simply to provide all investors with all
material information about the company, that would be pure
disclosure. Requiring specific disclosure about specific topics
or requiring companies to comply with substantive standards
that are not simply about disclosing to investors all of their
material information, then you are veering into merit
regulation.
Chairman Reed. Well, my understanding--and again, it might
be outdated--is that the SEC cannot refuse a registration
because they object to a business model or anything else. They
just can require you to spell it out in excruciating detail.
And that is not merit regulation. So it is setting up sort of a
straw man, I think, and saying, well, the fight is against
merit regulation and disclosure, I am for disclosure but not
for--we do not have merit regulation. Dr. Sherman, do you
consider us we have merit regulation here for Federal
securities laws?
Ms. Sherman. No, I do not think so, and that is very
important. Having seen a lot of other countries, particularly
in Asia, they give investors much less information and instead
rely on metrics such as has the company earned a profit for the
last 3 years, and if not, you cannot go public. And it closed
out a lot of good companies, and yet does not improve pricing
because people do not have enough information to judge. So I
think a strength of the U.S. is that we do have disclosure and
not merit.
Chairman Reed. And because of that, there is a strong
emphasis on very thorough disclosure, and as Mr. Trotter points
out, it leads to long prospectuses. But my feeling--and I will
ask both you and Ms. Buyer--is that these prospectuses are read
very closely by very sophisticated institutional investors, in
particular in preparation for an IPO, so that the information
is not just gratuitous or ignored. I mean, frankly, if I was
presented 200 pages, I would quickly--Evelyn Wood would be
proud of me, but when you have these roadshows, when you have
this process of iteration that these prospectuses ultimately
are very, very useful, I presume--is that accurate?
Ms. Sherman. Well, I think so. I tell my students in my IPO
and venture capital class that you get more information when a
company does an IPO than at any other time. There is just so
much in the prospectus. And when we do case studies, we go
through the risk factors, and they will have stories and extra
detail. You find out a lot more about how the company does
business, how the model works, from all of the detailed
disclosure. And you do not necessarily have to read all of it,
but you can look through and look for what you need, and
hopefully it is there.
So I think that is very important. I would hate to see us
loosen that.
Chairman Reed. Ms. Buyer, your comments.
Ms. Buyer. Yes, as an institutional investor, we would read
the prospectus cover to cover prior to meeting with the company
so as to be able to use the meeting time most effectively.
There is a tremendous amount of information available, and,
yes, it is written sometimes in arcane form, but it is
tremendously important and brings up another question about the
JOBS Act in that, of course, people now have--investors have
less time to study the prospectus given that they can now be
filed confidentially.
Chairman Reed. Yes. What is your reaction to the
confidential filing? How is that going to practically impact an
institutional investor like you who wants to invest perhaps but
also, you know, theoretically is helping to find the right
price, because you have all these details? What effect will
that have practically on you?
Ms. Buyer. I would say mostly institutional investors read
the prospectus when it is in its final form. So for the most
part, the confidential filing does not much matter.
However, from time to time, the initial filing differs
quite widely from the final filing thanks to commentary from
the SEC, and investors learn a great deal in watching the
changes. An example would be the company Groupon, which
suffered mightily between filing its initial S-1 and the final
S-1, as it became apparent that the company's relationship with
the accounting rules was somewhat flexible. I would argue that
that knowledge, watching that process, was very valuable to
institutional--and retail--investors.
Chairman Reed. It just strikes me, too, that, again, you
know, we have a system which is based on transparency,
disclosure. Basic economic theory is perfect information is
what drives competitive markets. And here we have basically
said this is all going to be confidential until very late in
the process, et cetera, and I do not see how that accomplishes
significantly informing investors, either institutional
investors or retail investors.
Ms. Buyer. Mr. Chairman, I would agree with you, and I
would further comment that by allowing filing companies to keep
those facts hidden until later in the process, while
concurrently encouraging research provisions that allow
research to be published during that period, we are actually
asking investors to make their decisions based on opinion as
opposed to the facts that they could have had if they could
read the filings throughout the process. We have exactly
flipped the arrangement I believe should be in place.
Chairman Reed. Mr. Trotter, comment, because I know you
have a position on this.
Mr. Trotter. Well, I guess what I would say is that this
was--the confidential submission process is based on a
historical practice at the SEC accorded to foreign private
issuers, and so that is the genesis of the idea. Unlike in the
case of foreign private issuers, though, in the case of
emerging growth companies under the JOBS Act, they are required
to provide the original submission plus all amendments that
resulted from the SEC review process approximately a month
before the IPO will price. And so all of the information that
Ms. Buyer was referring to is publicly available in sequence,
and investors will have a month to pore over all of that
information.
Chairman Reed. Let me ask you another question, because
there is a presumption that the JOBS Act--proponents would
argue that it reduces costs. In fact, there are estimates, I
think, of 30 to 50 percent of the cost. I think that is what
you were suggesting in your testimony. Where do these cost
savings come form? Investment banking fees you believe will be
lowered because there is not the requirement to do these
elaborate roadshows? Is it because information--where are the
savings coming from?
Mr. Trotter. It is principally from two sources. The data
is based on surveys of pre- and post-IPO CEOs who responded to
the specific proposals and provided estimates of how much cost
savings they would recognize. But it is first through the
deferral of the Sarbanes-Oxley internal control audit
requirement, which, again, for companies of this size, the
President's Jobs Council recommended a permanent exemption from
Sarbanes-Oxley internal control audit attestation; and then
second from the benefits available from the scaled disclosure
system that the SEC has adopted for smaller reporting
companies. And so in the case of--you asked about merit
regulation versus disclosure. If you think about some of the
disclosures that are required of very large enterprises and
applying those disclosure requirements to much smaller
enterprises--and I think it is worth noting that all of the
companies that are captured within the definition of ``emerging
growth company'' represent approximately 3 percent of total
market capitalization.
So there is a concern expressed by my fellow witnesses here
that the definition is too broad, but I think you have to take
into account the fact that that definition captures roughly 3
percent of the total market capitalization of the United
States. So that is not a very large number.
Chairman Reed. This is one of the those issues that depends
on what you are measuring and what you are comparing it to.
Mr. Moscovitz, my sense was that having limits of up to $1
billion in revenue captures a lot of companies in the United
States.
Mr. Moscovitz. Right. Well----
Chairman Reed. Not just in capitalization but just sheer
numbers of companies.
Mr. Moscovitz. Right.
Chairman Reed. And probably captures every potential IPO
company.
Mr. Moscovitz. So I am not familiar with the 3-percent
number, but it could be right. In terms of the IPO Task Force,
they said it was 14 percent of companies, but in terms of IPOs
it is about 90 percent, maybe----
Chairman Reed. So, essentially, the world, when we are
talking about IPOs, it is about most of them, 90 percent of
them.
Mr. Moscovitz. Right.
Chairman Reed. And the issue about cost savings, this goes
to--and Mr. Trotter I think pointed out very accurately, one,
it is the internal controls; and, two, it is sort of disclosure
requirements that one could argue are more appropriate to large
corporations, et cetera. But, still, it goes to this issue of
disclosure and governance of the company. That is where the
savings are going to be. I do not think we will see any savings
from investment banking fees or from anything else. For the
investing public, both the initial investors and the ongoing
investors, does that make sense?
Mr. Moscovitz. The investment banking fees are substantial
for IPOs, and it would be nice if we could find ways to reduce
that. In terms of the compliance costs, you know, a company
that is doing $1 billion in sales whose market cap is $700
million, which is, you know, the upper limit here, can really
afford to comply with Sarbanes-Oxley.
Chairman Reed. Well, again, having participated with both
Chairman Sarbanes and Chairman Oxley in the legislation, this
was a direct response to abuses and lack of controls and those
things that ultimately cost shareholders dearly when the
companies cratered because they were not doing things they
assumed--the shareholders assumed were doing routinely adequate
audits.
Well, I have had the rare opportunity to be able to engage
with a splendid panel of experts. We have learned a great deal.
Let me just simply ask--I think it is appropriate--if there are
any concluding comments, Dr. Sherman and Ms. Buyer, Mr. Trotter
and Mr. Moscovitz, about the issue advice to us going forward.
Dr. Sherman.
Ms. Sherman. I think, and I tell my students, that one of
the great strengths of the U.S. economy really is the fact that
we have focused on giving investors the information they need
and letting them decide for themselves. So many countries take
a much more paternalistic approach, and you end up losing a lot
of great companies and funding a lot of bad companies that way.
So I hope that the U.S. will focus on giving people as much
information as possible, and then having them take
responsibility for their decisions.
Chairman Reed. Ms. Buyer, please.
Ms. Buyer. I would agree with Dr. Sherman's comments all
the way along the way. I would say that the promise of a public
offering spurs many individuals all over the country, but
certainly in Silicon Valley where I live, to try to make
businesses out of new ideas that can turn into large, new
companies that can employ thousands and thousands of people.
The markets are tremendously important, and mostly not broken.
Mostly they suffer through swings reflecting risks in the
economy and marketplace.
That said, I think there are a few changes that probably
could improve the process, and, again, I strongly recommend
many aspects of the JOBS Act be reconsidered, as much of what
it has accomplished is only to transfer risk, earlier in the
process, from private investors to public investors, which, as
you point out, does not actually create any jobs.
Chairman Reed. One other thing, too, and this is the
potential for not just the misallocation of resources but for
fraud. Does that concern you?
Ms. Buyer. Yes. Certainly, there will always be on the
margins some fraud, but we have not talked--and another time
probably--about crowdfunding, which is certainly very
interesting but also enables significant transfer of funds
between informed investors and uninformed investors, without
much regulation or control. Because we have pushed back the
size at which a company needs to reveal its information
publicly from 500 shareholders to 2,000 shareholders, we will
probably see much more activity on the secondary markets. And,
again, there are few requirements for information, and, in
fact, trading on inside information in the secondary markets is
perfectly legitimate. So without going on too long, yes, I
think we have some fraud issues coming.
Chairman Reed. And there is a further complication which
complicates our life in many different dimensions; that is,
with the Internet-based economy, these companies can be virtual
and located far beyond the reach of anyone, which further makes
it particularly complicated from the aspects of a potential
source of, you know, get-rich schemes. I have this terrible
feeling that the first thing on the Web page would be,
``Congress just recently authorized this tremendous advantage.
Please, take advantage of it. Your Congress''--and I do not
want to be too melodramatic, but that concerns me.
Ms. Buyer. Of course. Years ago, there was a cartoon in the
New Yorker that showed a hound sitting at a keyboard, and the
caption underneath was, ``On the Internet, no one knows that
you are a dog.''
Chairman Reed. Yes. Or very short. Anyway, Mr. Trotter.
Mr. Trotter. The IPO Task Force came to its work with the
view that the IPO process is critical to capital formation, and
particularly early stage investing, and that that is all
connected to innovation and job creation ultimately by the part
of the private sector that really creates jobs. So that is our
focus.
Then just a couple of points again on risk. You cannot
remove risk from the system because if you do, you remove the
opportunity to make a profit. And so the solution is not to
look for ways to eliminate risk from the system but to make the
system fair, and that is disclosure. But when you look at
disclosure, what are you requiring disclosure of? Is it the
type of information that the very largest companies in the
United States have to provide? Or is it the more scaled
disclosure that focuses on what is material to an investor in
an early stage company? And if you fail to recognize that
distinction and apply very detailed disclosure rules across the
board, then I think that you do have a system that veers into
merit regulation of smaller companies.
Chairman Reed. Thank you very much.
Mr. Moscovitz, you have the last word.
Mr. Moscovitz. Generally speaking, it is not a good idea
for investors, individual investors, to get involved in
companies too early. After a very brief period of time of
flipping stocks that occurs at the beginning of an IPO process
IPOs tend to actually underperform, and their share returns
tend to be negative.
The concern is that we do not want IPOs to be a process
where companies are coming public with the intention of getting
shares to favor clients of the underwriters so that they can
flip the stocks over to unwitting investors who do not
understand which companies are poor quality and which ones are
not. So I would say at a minimum it is important that we have
an equitable distribution of useful information.
I agree that these prospectuses are very detailed, there is
a lot of good information presented there. It is very difficult
to go through them and find out--you know, pick through it and
figure out what stuff is really important. The Facebook
example, you really had to read between the lines to figure
that out. And so I think at a minimum it would make sense for
investors to have access, the same kind of access that clients
of the underwriters have.
And then one final thing with regards to fraud. You know, a
lot of former securities felons have raised concerns about the
JOBS Act, so I would just say that we need to think carefully
about that. I have various recommendations with regard to
crowdfunding. I can talk about them, but I could also just
submit it to you later.
Chairman Reed. Thank you very much.
I thank all of you for your testimony. It has been very
thoughtful and very helpful. My colleagues may have their own
written statements, which they would be allowed to submit for
the record, and I would ask them to do so before next
Wednesday, June 27th. All of your testimony will be made part
of the record. Some of my colleagues may have written
questions. We may have additional written questions. We will
get them to you as quickly as possible and ask you to get them
back to us as quickly as possible so we can conclude the record
within a very short period of time and inform the Chairman and
the other Members of the Committee of this hearing.
With that, let me again thank you for excellent testimony,
and I adjourn the hearing.
[Whereupon, at 10:40 a.m., the hearing was adjourned.]
[Prepared statements supplied for the record follow:]
PREPARED STATEMENT OF ANN E. SHERMAN
Associate Professor of Finance, DePaul University
June 20, 2012
Introduction
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, I want to thank you for inviting me to testify. Funding
young, innovative companies is crucial for economic growth, and I am
honored to have been asked to participate in this exploration of the
initial public offering (IPO) process.
The Role of Investors, and How the IPO Process Differs From the
Secondary Market Process
The central point to remember about the IPO process is that IPOs
are difficult to price. The recent performance of Facebook's stock
reminds us that the aftermarket price path of an IPO stock is not
predetermined or easily predicted. Recent problems tempt us to try
something new, but we should first look at the evidence of what has and
hasn't worked in various countries, since there has been much
experimentation with IPO methods in the last three decades.
Currently in our system, institutional investor feedback plays an
important role in the price-setting process, as evidenced by the price
revision that occurs after the road show. The issuer and its
underwriter estimate the offer price by setting the initial price
range, but then the shares are marketed to investors, feedback is
gathered, and the final price is set, a final price that is often
substantially different from the initial estimate. Only about one-third
of U.S. IPOs end up being priced within their initial price range.
In research with Dr. Sheridan Titman of the University of Texas at
Austin, we modeled the process by which the underwriter forms a group
of regular investors to participate in this process, showing that
control of the pricing and allocation process allows the underwriter to
induce investors to pay attention, evaluate the offering and provide
feedback. \1\ Essentially, the average first day return or ``pop'' of
an IPO, which academics call underpricing, allows the underwriter to
buy the time and attention of institutional investors, inducing them to
attend the road show and listen to the pitch. By underpricing IPOs on
average, the underwriter cannot guarantee that investors will like
every offering, but it can at least induce them to show up and consider
each offering. Without this process, firms risk being overlooked by the
market and thus failing to attract a following.
---------------------------------------------------------------------------
\1\ Sherman, Ann, and Sheridan Titman, 2002, ``Building the IPO
Order Book: Underpricing and Participation Limits With Costly
Information'', Journal of Financial Economics 65, 3-29. Earlier work on
developing the conditions needed to induce investors to accurately
report their feedback is in: Benveniste, Lawrence, and Paul Spindt,
1989, ``How Investment Bankers Determine the Offer Price and Allocation
of New Issues'', Journal of Financial Economics 24, 343-361.
---------------------------------------------------------------------------
Thus the U.S. IPO method, known as book building, allows the
underwriter to coordinate offerings and reward regular investors that
contribute to the process. Institutional investors have the expertise
and resources to evaluate IPO shares, are more likely to participate
regularly in IPOs, and are more likely to be continued followers of the
shares in the secondary market, thus providing future liquidity.
Ordinary individual investors, as a group, may not be equipped to play
the same role as institutional investors, and any regulatory changes
that are made to allow greater retail investor participation should
take these differences into account.
How Ordinary Investors Participate in IPOs in Other Countries
In research with Dr. Ravi Jagannathan and Dr. Andrei Jirnyi, both
of Northwestern University, we documented the IPO methods used in
countries around the world. \2\ In the early 1990s, the U.S. book
building method was rare outside North America. By the end of the 1990s
it was common around the world, having proved more popular than other
methods. However, what most countries have adopted is not ``pure'' book
building but a hybrid, or combination, of book building with a separate
tranche for ordinary investors. This separate tranche allows all
ordinary investors an equal chance of getting shares, but without
disrupting the central IPO process.
---------------------------------------------------------------------------
\2\ Jagannathan, Ravi, Andrei Jirnyi, and Ann Sherman, 2011, ``Why
Don't Issuers Choose IPO Auctions? The Complexity of Indirect
Mechanisms'', Unpublished working paper, available on the Social
Science Research Network at http://ssrn.com/abstract=1330691.
---------------------------------------------------------------------------
Thus, of all the countries around the world with relatively active
IPO markets, the U.S. is one of the few that does not have an open,
transparent way to allow ordinary investors to participate. It is
important to note that there are two ways to allow such participation:
by allowing ordinary investors to also help set the offer price, or by
restricting them to only ordering shares. The second approach--allowing
ordinary investors to buy shares but not to set the price--is now
common around the world. The first approach--giving all investors an
equal voice in the price-setting process, usually through an auction--
has been tried in at least two dozen countries, and has led to major
problems.
Including ordinary investors in the price-setting process on an
equal basis has led to dramatic swings: in some cases, large numbers of
investors have flooded into the IPOs, many bidding high prices to be
first in line for shares and thus driving the offer price up to
unsustainable levels; in other cases, participation has been
unexpectedly low. In some countries, such methods performed adequately
for a time, until finally enough investors got excited and poured into
an offering, pushing the price up to the point that the stock later
crashed on the aftermarket. Such crashes then led investors to stay
away from later IPOs, leading to undersubscribed offerings.
In secondary market trading, there is at least the possibility that
sophisticated investors might be able to take advantage of any
mispricing and, in the process, help to eliminate that mispricing. With
IPOs, on the other hand, our research shows that even sophisticated
investors are harmed by the uncertainty created by waves of
unpredictable retail investors, and ultimately the issuers have been
harmed and discouraged by the risks of such methods. Our research shows
that when issuers have gained experience with both methods and then are
given a choice between a method that allows ordinary investors to
participate in price-setting, and a method that allows the same
investors to participate in allocations but not in price-setting,
issuers have consistently chosen a method that puts the offer price in
the hands of professionals.
On the other hand, many IPOs in the U.S. have been successfully
marketed primarily to retail investors. The key is that the book
building method gives the underwriter discretion over which investors
can participate, and how much influence they can have over the price,
even when the shares are targeted mainly at retail investors. Issuers
and underwriters currently are allowed to choose which offerings to
market to retail rather than institutional investors, since
institutional investors do not want to get involved in smaller
offerings, while retail investors can more readily understand the
business model of, say, Netflix or Krispy Kreme than that of a biotech
company.
My concern is over methods that force the underwriter to give equal
weight to all orders, rather than allowing underwriters the kind of
discretion they currently have in terms of who can participate.
Therefore I am not advocating that all retail investors should be
forced out of the pricing-setting process, only that, as now, we do not
take away the discretion of the underwriter in terms of pricing the
offering or allocating shares in the book building tranche. Issuers
should still be allowed to place smaller offerings with retail
investors in a flexible manner, even if the U.S. chooses to require a
certain proportion of shares in larger offerings to be placed with
ordinary investors in a more open, transparent but rigid way that
guarantees all retail investors a chance to receive shares.
The method that has been successful in other countries is to give
all retail investors the opportunity to place orders in a separate
retail tranche where those investors are guaranteed an equal chance at
getting shares, at the same price paid by other investors in the
offering. \3\ The orders are similar to noncompetitive bids in Treasury
auctions, in that investors are not forced to specify a price. The
proportion of shares to be sold in the retail tranche is announced in
advance, so that there are no last-minute surprises. If demand is
greater than supply, the shares are allocated through balloting
(basically, a lottery). If demand is less than supply, the shares may
be re-allocated to the other tranche. The subscription ratio (total
shares ordered relative to shares available) for the retail tranche is
announced after the close of the subscription period but before the
beginning of trading. Thus, everything is transparent.
---------------------------------------------------------------------------
\3\ In some countries, the issuer/underwriter is allowed to
discriminate based on order size. In other words, the probability of
getting shares in an oversubscribed offering may depend on the size of
one's order, but all orders of the same size have the same probability
of getting shares.
---------------------------------------------------------------------------
I do not have strong feelings either way on whether lawmakers
should require that the U.S. IPO process be opened up to ordinary
investors. The concept of ``fairness'' is highly subjective--one could
argue that it is unfair to exclude ordinary investors from the process,
or that it is unfair to force issuers to include investors that are not
contributing to the process. The contribution that I hope to make today
is to suggest the best way for the U.S. to guarantee a role for
ordinary investors in IPOs, if and when we decide to do so. If
lawmakers choose to use regulation to open up the IPO process to
ordinary investors, my recommendations would be:
1. Give retail investors a separate tranche and do not force them to
name a price (i.e., place a bid) in order to participate.
2. Have issuers announce in advance what proportion of shares will
be allocated through this separate tranche, and require that
issuers re-file if they want to go too far from the expected
allocations (as is done now regarding pricing outside the
current price range); However, as in most countries, they
should be able to shift shares from one tranche to another if
one tranche is undersubscribed.
3. Make any participation requirements flexible, or waive them
completely, for smaller offerings, which are often already
marketed primarily to retail investors.
Retail Investors, Private Equity, and ``Crowdfunding''
The problems that have occurred when allowing ordinary investors to
actively participate in pricing IPOs have implications regarding the
role such investors should play in even earlier financing rounds for
private companies. Private equity markets, including the IPO market,
differ from secondary markets in that investors face far more
uncertainty with far less available information. Even in secondary
market trading, finance academics caution that most ordinary investors
would be better off buying shares in mutual funds, rather than trying
to pick stocks on their own. With private equity markets, small
investors face much greater challenges. Venture capitalists currently
play a major role in not only providing needed funds but also screening
and monitoring early stage companies, and providing advice and guidance
to them. Most ordinary investors are not equipped to play this role
and, moreover, it would not be cost-efficient for them to attempt it.
Spreading funding decisions over many small investors does not make
economic sense if there is a fixed evaluation cost for each investor,
particularly if those investors are relatively inexperienced and thus
face higher due diligence costs. Small investors putting up just a few
hundred or even a few thousand dollars each do not have the experience
or the resources or the personal presence needed to screen, monitor and
guide young startups.
Moreover, while ``crowdfunding'' sounds new and exciting and
egalitarian, there's every reason to expect that such a process will
result in even worse pricing of early stage private equity than of IPO
shares. One example of the problems with allowing ordinary investors to
participate in early stage funding is the fact that Facebook's shares
were auctioned at an unrealistically high price shortly before its IPO,
possibly inducing the underwriters to set an excessive offer price.
Granted, there were many factors in the Facebook IPO debacle, and this
hearing is not about just that one offering, but it is relevant for
today's hearing to remember that, in March and April of 2012, Facebook
shares were sold on SharesPost and SecondMarket through auctions that
allowed the price to be set by investors. The auction price set by
investors was between $42 and $44 per share, whereas even an offer
price of $38 per share proved to be unsustainable. By the end of May,
the shares were trading at around $28, 36 percent below their earlier
auction price.
Given the many problems that have resulted from allowing small
retail investors to participate in pricing IPOs, it's even less likely
that such investors will be able to consistently price early stage
private equity rounds without difficulties that will eventually drive
those investors out of the market entirely. Thus, if we want to allow
ordinary investors to participate in early stage funding, the best
approach would be for them to participate through something similar to
a mutual fund, where professional venture capitalists make the funding
decisions and provide the extensive due diligence and monitoring needed
for early stage investments.
Improving the Flow of Information to Investors
A unique feature of U.S. IPOs, relative to those in other
countries, is the quiet period. This is based on the admirable goal of
a level playing field, giving all investors access to the same
information. However, there appear to be two areas in which investor
access is not the same: road shows, and forecasts by the analysts
connected to the lead underwriters.
During road shows, the issuer is not allowed to reveal new, hard
information that is not in the Prospectus. Why, then, does anyone
attend? Investors attend road shows largely to observe the managers,
and in particular to see how they handle various questions. Although
the managers are prepped in advance and have rehearsed their answers,
investors still apparently find value in watching them on their feet,
dealing with tough questions. Facebook's management learned this
recently when, on the first day of its road show, it drastically
shortened the Q&A time to instead show a video. Investors protested,
and the video was dropped by the next morning. Professionals apparently
value the chance to observe management in action, and ordinary retail
investors might benefit from this same opportunity.
Thus, my first recommendation is to require the issuer to record
and post actual road show presentations, in particular the question and
answer portions, for at least two of the presentations, one early in
the process and one later. Many issuers already prepare online road
shows, but my recommendation is for posting actual presentations,
chosen in advance and with relatively large (expected) numbers of
investors, not staged videos made specifically to be posted, and not
presentations cherry-picked by the issuer and underwriter later, after
having filmed multiple presentations. Although this would not allow
ordinary investors to see every single road show presentation by the
issuer, it would give them at least as much information as the average
institutional investor that attends only one particular road show
meeting.
Regarding analyst forecasts, the current policy, as I understand
it, is to allow analysts connected to the lead underwriters to
communicate with institutional but not retail investors. There is a
reasonable basis for this restriction, because these communications
involve expectations of the future, not hard information regarding the
company's past, and forecasts can be manipulated. Relative to
institutional investors, ordinary investors may not be as aware of the
speculative nature of such forecasts, perhaps making them vulnerable to
overly optimistic predictions. Thus, the rationale for the current
restriction is understandable, but it creates at least the appearance
that institutional investors are being favored. Lawmakers should
consider allowing such forecasts to be available either to everyone, or
to no one.
Conclusion
Much of the growth of the U.S. economy, and of technological
progress around the world, is due to the U.S. regulatory environment
regarding funding of companies, a regulatory regime that has focused on
providing investors with information and allowing them to make their
own decisions. Many countries take a more paternalistic approach,
putting more power in the hands of bureaucrats and less information in
the hands of investors. I taught at a university in Hong Kong for 6
years in the 1990s and saw countries in Asia copying the outcomes of
U.S. financial markets, rather than adopting the process and regulatory
philosophy. I would like to see the U.S. continue and strengthen its
tradition of relying on markets and giving investors the ability to
make their own informed choices. Thus, further steps to level the
playing field for ordinary investors in terms of information are steps
in the right direction.
However, we should also recognize the differences in expertise and
resources between institutional and individual investors. Lawmakers
should not force issuers to give access to ordinary investors in a way
that disrupts the IPO pricing process, thus adding more risk for
everyone involved. If IPO issuers are required to set aside shares for
ordinary investors, it should be through a separate tranche that does
not directly affect the offer price, but simply allows them to
participate.
Thank you for the opportunity to testify before this Subcommittee.
______
PREPARED STATEMENT OF LISE BUYER
Founder and Principal, Class V Group, LLC
June 20, 2012
Introduction
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, thank you for asking me to join you today. I am honored
to be asked to contribute this testimony in support of the discussion
of the initial public offering process, a complicated and critical
right of passage so important to many companies and to our Nation's
economy.
Let me begin with perhaps the most important point . Initial public
offerings are always and inherently risky. Investors in IPOs must be
risk tolerant as the behavior of these new offerings are, by
definition, even less predictable than the stocks of any company with
established trading characteristics. These new issues are riskier than
the stocks of any companies that have demonstrated an ability to handle
the obligations appropriately asked of publicly traded companies.
Institutions or individuals that do not fully understand and accept the
fact that IPOs often involve short-term losses should not participate
until the stock has ``settled,'' usually after several weeks of
trading. On day one of trading, there are no investors, only
speculators.
What improvements need to be made to the process? In my opinion,
the one change that could most improve the IPO process, at least with
regard to individual investors, would be a simple addition to the IPO
purchase process. I believe this simple step could help individual
investors to better understand their investment decision. In clear and
straightforward terms, we should ask every investor to accept and
acknowledge the risks they are taking when purchasing a new issue.
Specifically, if I could make only one suggestion, it would be this:
Before confirming a buy order, in person, over the phone or online,
each investor should have to read or be read a short, simple sentence,
in large bold type, that states:
I fully acknowledge that this stock has an equal chance of
trading up or down from the price I am agreeing to pay.
Furthermore, I acknowledge that shares of newly public
companies routinely trade below their offering price at some
point.
I believe a simple plain English acknowledgement of that
description would both clearly warn investors of the risks and help
them accept responsibility for their actions in the event that the
stock does not perform as hoped. Prior to placing a ``buy'' order for a
new issue, every investor should be required to indicate his or her
acceptance of these simple statements.
Other Improvements
While the simple warning may be the most critical modification to
the current process from the perspective of an individual investor, the
process could also be improved with other changes. For instance, were
regulations to allow it, companies could send, electronically or
through brokers, a brief questionnaire to potential investors requiring
them to demonstrate an understanding of what the company does and at
least one risk that the company faces. The purpose of this ``speed
bump'' would be to slow down those looking to buy a stock only because
they heard it was ``hot.''
A third change to the process would redefine an ``emerging growth
company.'' Currently defined as an entity with gross revenues of less
than a billion dollars, the relaxed reporting and filing requirements
for these large businesses disadvantages investors with potential
interest in those stocks. By the time a company has reached even $250
million in revenue, it ought to be able to document its processes and
pay for historical audits.
In my opinion, these three could have a major beneficial impact on
the IPO process.
How Secondary Markets Differ From Initial Public Offerings
The secondary market process differs in most every way. In fact
there really is very little ``process'' in the secondary market.
Sellers are allowed to trade based on inside information and buyers
understand the rules are ``caveat emptor/buyer beware.'' There are no
required disclosure or marketing documents or rules about sharing the
same material information with each buyer. There is usually no roadshow
or chance to meet with or see a video of management. Secondary markets
are for those who understand the risks of owning companies where there
is little available information, are no audit requirements, no
assurance that an active market for the stock will ever develop and the
wherewithal to absorb a complete loss of invested funds. Investors in
secondary markets agree to accept these risks believing they will be
offset by outsized rewards.
Increasing the Efficiency and Transparency of the IPO Process
Information currently flows freely to those investors, both retail
and institutional, who are willing to look for it. The recent advent of
an online ``retail roadshow'' has closed a long-standing gap between
the information available for individuals and institutions. However, it
is not clear that individual investors are aware of the availability of
these online roadshows.
One further way to improve the flow of information would be to
require companies on a roadshow with institutions to offer a scheduled
``ask the management'' online Q&A session. During this part of the
roadshow, management teams would offer answers to individual investors'
questions which had submitted online. These questions would have been
prescreened to prevent inappropriate queries. One could collect
questions over a period of several days and then use the live session
to address those asked most frequently. In order to submit a question,
a potential investor would first have to have watched the retail
roadshow as both a show of genuine interest and in an effort to use the
Q&A session most effectively.
The Roles of IPO Market Participants
The roles of each of the following groups in the pricing and final
allocation of shares on an IPO are as follows:
Underwriters
Based on the company's finances and prospects, the current
trading ranges of already-public companies that are in some way
similar and overall market conditions, determine the offering
range at which the IPO will be initially be marketed.
Based on specific, aggregated, marketplace feedback from
experienced investors, and in conjunction with the board of
directors and management of the company going public, determine
what the actual offering price will be.
Either alone or in conjunction with management (but mostly
the former), determine to which accounts the shares to be sold
will be allocated.
Commit to ``make a market'' or provide a liquid trading
market in the security after the IPO, to insure those that seek
to buy and sell can do so every day the market is open.
Institutional Investors
To varying degrees, study the information available on the
company, evaluate the prospects of the business and the price
range at which the IPO is being offered to determine whether or
not the offering is attractive.
Often develop internal models and projections about the
company's future financial results based on the publicly
available information and on their own experience and knowledge
which they use to develop a price target for the new issue to
attain in a future period (usually 12-18 months)
Provide feedback to the underwriters on the institution's
level of interest at various prices in, below or above the
proposed pricing range.
Retail Investors
Limited role in the pricing and allocation process. These
investors have an ability to register interest with their
brokers if they have an account with one of the firms involved
in the underwriting.
What Role Should Each Play in the Pricing and Allocation of IPOs?
Underwriters
As it is the underwriting banks that will actually purchase the
shares from the company to be immediately resold to the institutional
investors, and since the underwriters are the best source of aggregated
information about market demand and historical account behavior, they
are critical in both the pricing and allocation decisions in all non-
Auction IPOs. Underwriters should reach the pricing and allocation
decision in conjunction with management and the board of directors of
the issuing company. The level of engagement and control exercised by
the issuer varies widely.
(Note: in an auction IPO, the investor bids play a much larger role in
determining pricing and allocation, although in many auctions,
management may exercise discretion around both price and account
allocations if that flexibility was built into the auction process and
explained to investors in the S-1.)
Institutional Investors
While having no voice in the actual, final pricing or allocation
discussions, the indicated interest levels of the institutions are
arguably the only voices that actually matter in the first 90 percent
of the pricing and allocation decisions. Just as with any other
product, if there are not enough interested buyers for a stock at a
certain price, the deal will not be done. Similarly, if institutions
indicate little price sensitivity, the price range may be raised. The
aggregated, indirect opinions of institutions are more important than
the underwriter's direct decisions.
Retail Investors
Just as in other fields ranging from sports (golf, racing of any
sort) to factory line production, benchmarks, or in this case pricing,
is best set by those who are fully committed in a professional
capacity. While there are some dedicated individual investors who do
read S-1s and do develop forward financial models, those are the rare
exceptions as the majority of individuals buying stocks separately, not
in mutual funds, do so periodically rather than on a full time basis.
Additionally, historical data suggests that retail investors in the
aggregate, tend to be more emotional and less analytical in pricing
securities. Therefore, it is generally not appropriate for individual
investors to have a voice in determining the price or the initial
allocations of IPOs. There are two uncommon exceptions to this
statement. First, in cases where a company chooses to conduct an
auction IPO, the retail investor has the same voice as an institutional
investor on a dollar for dollar basis both in pricing and allocation.
The other exception is in the case where individual investors, as
opposed to institutions, will buy the majority of the stock offered in
the IPO.
Promoting Capital Formation
Being a successful public company is an accomplishment, not an
entitlement.
Contrary to recently sighted commentary, IPOs do not create jobs
any more than red paint makes cars go faster, although in both cases
one could incorrectly interpret those relationships from available
data. Successful and well-run companies create sustainable jobs and
also often go public. The many premature IPOs of the late 1990s created
jobs--that lasted for a very short time period, sometimes measured in
months. When those newly public companies failed to deliver results,
they folded with dire consequences for their employees, investors and
the entire stock market, both at the time and for years afterwards.
Only now are markets for initial public offerings recovering from the
debacle that ensued when the bar for being a public company was set too
low.
If we make it too easy for young companies that are not prepared
for the rigors of being public and not yet able to document or, within
reason, project future financial results, we will increase the risk and
decrease the realized rewards of participating in the IPO market. At
that point, rational investors will bypass IPOs altogether in favor of
the more favorable risk/reward profile of ``seasoned'' stocks. As we
have clearly seen, once-bitten, twice-shy public investors can turn
away from funding new businesses for extended periods. In reducing the
slope of path required for a company to go public, we create the
potential for much more serious capital market problems in the future.
However, while I believe the market's long-term success depends on
having appropriate speed-bumps on the road to a public offering,
enabling nonpublic entities to raise money from fully informed-of-the-
risks individuals could have a very positive impact on capital
formation. Specifically:
Crowdfunding and other early stage capital formation should not
have a material negative impact on public markets, assuming investors
understand how extremely risky early-stage investing is. If
crowdfunding enables the growth of many new businesses, particularly in
regions with few traditional venture investors or angel investors, then
perhaps our Nation will benefit from even more growing entrepreneurial
ventures, geographically dispersed across the entire country, rather
than in a few select cities or regions.
The danger of crowdfunding comes in two forms: First, since a
crowdfunding effort requires little in terms of documentation or
information, it will likely attract individuals looking to take
advantage of enthusiastic but uninformed investors. Yet asking very
young start-up companies to prepare extensive documentation is
unrealistic almost by definition, as many will be no more than an
interesting, data-light idea. Therefore, some amount of fraud will be
inevitable. Secondly, contributors to a crowd-funded effort who fail to
fully process the fact that the vast majority of start-ups do not
succeed, and that investors in those companies lose their entire
investment, may react poorly (see subprime mortgage crisis) when the
inevitable happens. An adverse outcome in early stage investing may
lead to reduced participation in public markets and therefore, less
capital for successful businesses. Again, I believe that the biggest
challenge in creating a successful crowdfunding market can be easily
solved by asking participants to acknowledge a clearly written, short
explanation of the one major risk, that the investment could quickly
lose all of its value.
Appropriateness of Retail Investment in IPOs
As previously discussed, IPOs are very risky investment vehicles as
there is no trading track-record and as management teams are mostly new
at responding to obligations accepted in return for raising public
equity. The odds of a management misstep with negative share price
implications are greater for newly public companies. Therefore, the
only investors who ought participate heavily in the IPO market are
those with significant risk tolerance. As some IPOs do trade up
rapidly, it would not be appropriate to deny investors the chance to
purchase those stocks, and in a free market, investors of all
descriptions should have access to all public securities. However, all
investors should have to demonstrate that they understand and will take
responsibility for these risks. For most people, the best strategy for
participating in the IPO market is via mutual funds, where the
investment decisions are made by professional, analytical investors who
are paid to thoroughly evaluate new offerings on behalf of aggregated
groups of individuals.
Many important investor protections are already in place and should
not be rolled back. For instance, audits, equally disseminated
information and limits on promotional commentary in the period leading
up to the transaction are important to a trustworthy IPO process. While
complying with many of these regulations, including the Sarbanes-Oxley
Act is challenging, time consuming and expensive, companies unable to
meet these obligations are likely not ready to successfully handle the
time commitment and expense required to keep public investors
appropriately informed about the state and health of the business after
the initial public offering. Recent roll backs of some investor
protection provisions, including looser marketing restrictions, reduced
reporting requirements and the new ability to keep confidential the
entirety of conversations with the SEC until no fewer than 21 days
before the proposed IPO date, in my opinion do a disservice to
investors seeking to educate themselves with factual information, as
opposed to opinions, about these potential investments prior to the
public offering.
Recommended Modifications
I believe the recently enacted ``JOBS'' act needs significant
modification. Specifically:
I believe the definition of an ``emerging growth company''
should be reduced to apply only to those companies that still
are in the emerging stage. Once a company has achieved revenue
of greater than $250 million, it should have the resources to
comply with audit and disclosure requirements in place for
other public companies.
To allow management to cooperate with research analysts
during what was formerly a quiet period creates extra burdens
on management, disadvantages investment banks still subject to
the research restrictions of the 2004 Global Research
Settlement, and encourages other banks to produce positively
skewed research in an effort to win banking business. No
research analyst has incentive or enough data to write a
negative report on a company that has no trading price and can
not be sold.
As mentioned at the onset of this testimony, I believe a
mandated signature below a one or two sentence acknowledgement
of risk could provide an important deterrent for those
investors believing that IPO investments are an easy route to
quick gains. A cigarette package type warning may reduce
disappointment and misunderstanding for those investors who are
less familiar with the uncertainty of the market for new
issues.
Thank you for your time and for the opportunity to testify in front
of this Subcommittee.
______
PREPARED STATEMENT OF JOEL H. TROTTER
Partner, Latham & Watkins LLP
June 20, 2012
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, thank you for inviting me to appear before you today. I
appreciate all of the hard work that each of you and the members of
your staff give in service of our Nation.
Benefits of a Favorable IPO Environment
I have been a securities lawyer for 17 years, and it's fair to say
that initial public offerings (IPOs) have been at the core of my
practice for nearly all of my career. In the last 5 years, for example,
I have worked on most of the IPOs (approximately 110 of them) on which
my firm advised. Recently, I had the honor to serve on the IPO Task
Force, whose recommendations gave rise to Title I of the recently
enacted Jumpstart Our Business Startups Act, which passed Congress with
overwhelming bipartisan support. So, I am steeped in the law and lore
of IPOs, and that's the perspective I bring to you today.
In my view, the best way to make the IPO process work for ordinary
investors is to ensure that IPOs can happen in the first place. It's
important to keep in mind that private companies have two alternative
paths for providing liquidity to their early-stage investors: they can
choose to pursue either an IPO or a sale of the company. Some companies
might try both temporarily, using a dual-track process, but ultimately
they have to choose one or the other.
An inhospitable IPO environment sends more early-stage companies
toward a sale process and away from the IPO alternative. In recent
years, overall IPO activity has fallen off dramatically in the United
States, and smaller IPOs have all but disappeared. Over the same
period, ``the prevalence of IPOs versus acquisitions of emerging growth
companies has undergone a stunning reversal,'' as the IPO Task Force
noted last October in its report. \1\ In the most recent decade, the
vast majority of private company liquidity events have occurred by
means of a company sale rather than an IPO. In contrast, during the
decade prior to that, IPOs easily represented the majority of private
company liquidity events.
---------------------------------------------------------------------------
\1\ IPO Task Force, ``Rebuilding the IPO On-Ramp: Putting Emerging
Growth Companies and the Job Market Back''.
---------------------------------------------------------------------------
This trend warrants our attention because IPOs play an important
role in job growth:
from 1980 to 2005, companies less than 5 years old
accounted for all net job growth in the United States,
according to an IHS Global Insight study;
92 percent of job growth occurs after a company's IPO,
mostly within the first 5 years post-IPO, according to the same
study; and
companies that went public since 2006 reported an average
of 86 percent job growth post-IPO, according to a survey
conducted by the IPO Task Force.
Many of today's household-name companies emerged decades ago as
fledgling startups. These companies were, by today's standards, small
and untested at the time of their IPOs. And yet some of these now-
dominant companies have become so large that entire metropolitan
regions have built up around them. Around the Nation, these thriving
cityscapes of today would look altogether different if those fledgling
startups of yesterday had pursued a company sale in an M&A transaction
rather than pursuing independent growth by raising capital in an IPO.
So far, so good. A more robust IPO market will help investment
capital by providing more liquidity alternatives for early-stage
investors. And more IPOs will have a positive effect on innovation and
job creation. How, then, can we help the IPO process?
IPO On-Ramp (Title I of the JOBS Act)
The JOBS Act is an important step in helping the IPO process work
better. Title I of the JOBS Act contains the IPO on-ramp provisions
implementing the recommendations of the IPO Task Force. These
provisions make several important changes to the IPO process for
companies that qualify as emerging growth companies. For these
companies, Title I of the JOBS Act:
makes it easier to go public and provides significant cost
savings in the IPO process;
permits them to engage in pre-IPO discussions to gauge
investor interest before committing resources to undertake a
costly IPO process;
enables them to begin the SEC registration process
confidentially, rather than revealing their most sensitive
proprietary information many months before a possible IPO that
ultimately may not even occur;
permits emerging growth companies to present streamlined
financial statements using an approach that the SEC previously
adopted for smaller reporting companies; and
provides a limited transitional period of 1 to 5 years,
depending on the size of the company, when they may defer
compliance with the more costly regulatory requirements that
apply to public companies.
Based on a survey of CEOs of pre- and post-IPO companies, the IPO
Task Force estimated that going public costs approximately $2.5 million
and that remaining public costs approximately $1.5 million annually.
Based on survey data and interviews, we estimated that the
accommodations in the IPO on-ramp could save companies 30 to 50 percent
of those costs.
The accommodations in Title I of the JOBS Act apply to any issuer
that qualifies as an ``emerging growth company'' under the statute. An
emerging growth company is an issuer with less than $1 billion in
annual revenue for its most recently completed fiscal year. A company
will cease to qualify as an emerging growth company in 1 to 5 years,
depending on the size of the company. Specifically, emerging growth
company status terminates upon the earliest of four milestones:
the company becomes a ``large accelerated filer'' under the
existing SEC definition (requiring a public float of $700
million at the end of its second fiscal quarter, twelve months
of SEC registration and at least one annual report on file);
the company ends a fiscal year with $1 billion or more in
revenue;
the company issues more than $1 billion in nonconvertible
debt securities over any 3-year period; and
the fiscal year-end after the fifth anniversary of the IPO
pricing date.
With this definition in mind, I will summarize some of the
principal accommodations that the IPO on-ramp provides to emerging
growth companies:
(1) Testing the waters--Section 105(c) of the JOBS Act permits
emerging growth companies to engage in pre-IPO discussions with
institutional investors to determine whether the company has a good
chance of completing a successful offering. Before the JOBS Act, prior
restrictions prevented issuers from communicating with potential
investors in advance of filing a registration statement. Now, emerging
growth companies may engage in discussions to test the waters with
institutional investors before deciding whether to commit the time,
effort and resources necessary to pursue an IPO process. In the
interest of investor protection, the JOBS Act requires companies using
this process to deliver a copy of the statutory prospectus to each
investor in the IPO before anyone can purchase shares in the offering.
By permitting emerging growth companies to test the waters, the
JOBS Act fixes what some practitioners might call a ``glitch'' under
prior law. Before the JOBS Act, a company engaging in a private
placement to accredited investors could make an unlimited number of
offers, to dozens or even hundreds of prospective investors, and
ultimately sell the securities without ever providing those investors
with any statutory disclosure. In contrast, the communications
restrictions in the IPO process before the JOBS Act were much more
restrictive in how issuers could communicate with investors--so
restrictive, in fact, that many companies would have difficulty
determining whether they could expect sufficient investor interest to
complete a successful IPO. This result was not only oddly incongruous
but tended to stifle capital formation by inhibiting companies
contemplating an IPO. On the one hand, the company could make an
unlimited number of offers in an unregulated private placement to
accredited investors with no prescribed disclosure. On the other hand,
in the heavily regulated context of an IPO, an issuer previously could
not have engaged in any pre-filing offers of any kind, even to super-
heavyweight institutional investors. \2\ The JOBS Act fixes that by
permitting emerging growth companies to test the waters with
institutional investors so that an emerging growth company can better
determine the actual feasibility of an IPO before embarking on the
process.
---------------------------------------------------------------------------
\2\ Securities Act Rule 163 allows well-known seasoned issuers to
make pre-filing offers, but that rule does not apply to IPO issuers
and, in any event, contains its own so-called ``glitch'' that restricts
issuers from enlisting their bankers' assistance to test the waters
with prospective investors. Securities Act Rule 163(c); cf. Release No.
33-9098 (proposing to correct the glitch in Rule 163(c) by allowing
well-known seasoned issuers to use underwriters to help ``assess the
level of investor interest in their securities before filing a
registration statement'').
---------------------------------------------------------------------------
(2) Confidential submission--Section 106(a) of the JOBS Act enables
emerging growth companies to begin SEC registration on a confidential
basis. This follows the SEC's historical accommodation accorded to
foreign private issuers and, for emerging growth companies, represents
a meaningful change by removing a powerful disincentive for an emerging
growth company to pursue an IPO process. Now, an issuer that is an
emerging growth company may begin the months-long SEC registration
process while deferring until later in the IPO process competitors'
access to proprietary business and financial information of the issuer.
Companies using this alternative can now advance to the point where
they have a much better ability to predict, based on market conditions
and other vagaries of attempting to go public, whether they can
complete a successful IPO before publicly disclosing their confidential
information. In the interest of investor protection, emerging growth
companies must publicly file their original confidential submission to
the SEC, plus all amendments resulting from the confidential SEC
review, at least 21 days before conducting a traditional road show
process for the offering. As a result--unlike in the SEC's confidential
process historically accorded to foreign private issuers--investors and
other interested parties will have immediate Web-based access to the
complete submission and amendment history, including the initial draft
of the registration statement and each iteration in the nonpublic
review process, approximately 1 month before the issuer sells a single
share to any investor in the IPO.
(3) Financial statements--Section 102(b) of the JOBS Act allows
emerging growth companies to present 2 years, rather than 3 years, of
audited financial statements in their IPO registration statement. This
accommodation follows the framework that the SEC adopted for smaller
reporting companies, subject to a 3-year transition to the traditional
approach post-IPO. In each future year after the IPO, an emerging
growth company that used the accommodation for financial statements
would add one additional year so that, after 3 years, the emerging
growth company would present 3 years of audited financial statements
plus 2 years of selected financial data. By using the smaller reporting
company framework available under existing law, this provision of the
JOBS Act reflects the balance between capital formation and investor
protection that the SEC previously struck when it adopted the scaled
disclosure requirements that apply to smaller reporting companies.
(4) On-ramp transition period--Title I of the JOBS Act provides a
regulatory transitional period of 1 to 5 years, depending on the size
of the company, when emerging growth companies may defer the more
costly requirements that apply to public companies. Like other
provisions of Title I, the transition period builds on existing SEC
requirements. Under prior SEC rules, for example, all newly public
companies, regardless of their size, benefited from a transition period
of up to 2 years (until their second post-IPO annual report) before
needing an outside audit of their internal controls under Section
404(b) of the Sarbanes-Oxley Act. Title I of the JOBS Act builds on
this on-ramp concept by adding additional accommodations to the on-ramp
period and by scaling the requirements to the size of the affected
company rather than using a one-size-fits-all approach that would treat
all companies the same regardless of their size.
IPO On-Ramp Elements
The on-ramp transition period applies as long as the issuer
qualifies as an emerging growth company. Smaller companies will have
more time to achieve full compliance, while larger companies will have
less time. In any event, the transition period would conclude no later
than the fiscal year-end after the fifth anniversary of an emerging
growth company's IPO. At that point, the company must fully comply with
the traditional regulatory requirements that apply broadly to all
public companies.
During the transition period, an emerging growth company may:
defer the outside audit of internal control as required
under Section 404(b); \3\
---------------------------------------------------------------------------
\3\ JOBS Act 103.
follow streamlined executive compensation disclosure
modeled on existing requirements under the SEC's smaller
reporting company rules (which, though streamlined, still
require ``clear, concise, and understandable disclosure of all
. . . compensation'' of the top executives); \4\
---------------------------------------------------------------------------
\4\ JOBS Act 102(c).
defer compliance with the Dodd-Frank executive compensation
requirements to hold shareholder advisory votes (say-on-pay,
say-on-pay-frequency, and say-on-golden-parachutes) as well as
additional compensation disclosure requirements (the pay-for-
performance graph and CEO pay ratio disclosure); \5\
---------------------------------------------------------------------------
\5\ JOBS Act 102(a).
defer compliance with new or revised financial accounting
standards until those standards also apply to private
companies; \6\ and
---------------------------------------------------------------------------
\6\ JOBS Act 102(b). On occasion, new or revised accounting
standards provide private companies with more lead time for compliance
than public companies receive. This can occur with more complex
standards that require significant data gathering or additional
compliance personnel. In those cases, emerging growth companies may
follow the longer, private company phase-in period. Alternatively,
emerging growth companies may irrevocably elect to follow the shorter
phase-in periods that apply to all other public companies. JOBS Act
107(b).
benefit from an exemption from any future rules of the
Public Company Accounting Oversight Board mandating audit firm
rotation or an expanded narrative audit report, called auditor
discussion and analysis. \7\
---------------------------------------------------------------------------
\7\ The PCAOB recently issued controversial concept releases on
the subjects of whether the PCAOB should mandate audit firm rotation
and an expanded narrative, called auditor discussion and analysis, that
would appear as part of any financial statement audit. If the PCAOB
decides to adopt rules regarding either of these requirements, EGCs
will be exempt from those rules. In addition, no other new rule that
the PCAOB may adopt in the future will apply to an EGC unless the SEC
determines that the new PCAOB rule is ``necessary or appropriate in the
public interest,'' after considering investor protection and ``whether
the action will promote efficiency, competition and capital
formation.''
---------------------------------------------------------------------------
Disclosure vs. Merit Regulation
As you can see, I believe that the JOBS Act's measured reforms will
help the IPO process. But is the JOBS Act enough? Are additional
changes warranted?
In addressing these questions, I believe it is important to
remember how the Congress approached the issue of securities regulation
almost 80 years ago when it enacted the Securities Act of 1933.
Congress made disclosure the bedrock of our securities regulatory
system. But Congress took a very specific approach to disclosure--one
that has remained a key feature of our securities laws. In particular,
Congress has sought to mandate disclosure of material information
rather than attempting to pass on the merits of particular securities.
We find this approach reflected in the history and the text of the
Securities Act:
President Roosevelt specifically called for a disclosure
regime rather than merit regulation: ``The Federal Government
cannot and should not take any action which might be construed
as approving or guaranteeing that newly issued securities are
sound in the sense that their value will be maintained or that
the properties which they represent will earn a profit.''
Instead, Roosevelt envisioned that ``every issue of new
securities . . . shall be accompanied by full publicity and
information.'' \8\
---------------------------------------------------------------------------
\8\ H.R. Rep. No. 85, 73d Cong., 1st Sess. at 1-2 (1933).
---------------------------------------------------------------------------
Felix Frankfurter, one of the architects of the Securities
Act, explained that ``Unlike the theory on which State blue sky
laws are based, the Federal Securities Act does not place the
Government's imprimatur upon securities.'' The Securities Act,
he said, is ``designed merely to secure essential facts for the
investor, not to substitute the Government's judgment for his
own.'' \9\
---------------------------------------------------------------------------
\9\ Felix Frankfurter, ``The Federal Securities Act: II'', Fortune
(Aug. 1933).
The preamble of the Securities Act specifically reflects
this approach, stating that the statute's purpose is to provide
---------------------------------------------------------------------------
``full and fair disclosure of the character of securities.''
Merit regulation focuses principally on investor
protection, whereas a disclosure-based approach balances
investor protection and capital formation. Section 2(b) of the
Securities Act reflects that balanced approach by requiring the
SEC, whenever the agency considers whether rulemaking activity
is ``necessary or appropriate in the public interest,'' to
consider, ``in addition to the protection of investors, whether
the action will promote efficiency, competition, and capital
formation.''
My mentor and former partner, John Huber, previously served as
Director of the Division of Corporation Finance at the SEC. He used a
memorable anecdote to teach me the difference between merit regulation
and a disclosure regime. Early in his career, John worked at a State
securities commission. Staffers at the commission were proud of having
refused to approve the common stock of a company whose name everyone in
this room would recognize. The State securities commission had objected
to the level of the CEO's compensation and therefore refused to permit
the company to sell its stock to residents of that State. ``What was
the IPO price?'' John asked. Answer: $22 per share. ``Well,'' he
responded, ``the stock is now trading at $60 per share, so how exactly
did we help investors in our State by preventing them from buying at
$22?''
Disclosure in the IPO Process
That nicely sums up merit regulation. We can see why Felix
Frankfurter emphasized that the Securities Act would merely ``secure
essential facts for the investor'' rather than placing the Government
in the position of making investment decisions. This brings us to
another issue: what are the essential facts for the investor?
Again, I return to core principles of our securities laws. We
require disclosure of all information that is ``material.''
The Federal securities laws contain a matrix of antifraud
provisions designed to promote accurate and complete disclosure by
imposing liability on material misstatements or omissions in connection
with the purchase or sale of a security. In the landmark case of TSC
Industries v. Northway, a unanimous Supreme Court established the
fundamental test of materiality. The Court held that a fact is material
if there is a substantial likelihood that a reasonable investor would
consider the fact important in deciding whether or not purchase or sell
a security. Moreover, the Supreme Court explained, ``there must be a
substantial likelihood that the disclosure of the omitted fact would
have been viewed by the reasonable investor as having significantly
altered the ``total mix'' of information available.'' \10\
---------------------------------------------------------------------------
\10\ TSC Industries v. Northway, 426 U.S. 438, 449 (1976).
---------------------------------------------------------------------------
If you have picked up an IPO prospectus recently, you may wonder
whether we have drifted very far from the guiding principle of
disclosing material information. An IPO prospectus today is a lengthy
and detailed disclosure document often running as much as 200 or more
pages in which the issuer provides:
detailed narrative descriptions of the business, the
company's executive management team and board of directors;
risk factors identifying key risks relating to the company
and the offering;
audited financial statements and footnotes;
MD&A disclosure providing a narrative description of
management's perspective on the financial statements, including
known trends and uncertainties (together with the financial
statements, this narrative usually occupies almost half of the
page count in the prospectus); and
detailed disclosures on many other topics, including
executive compensation, related party transactions, principal
stockholders, description of the offered securities,
underwriting arrangements, and other types of details required
under SEC rules.
All of these are good and useful topics. But it can be hard to
resist the temptation to add just a few more sentences here and a
paragraph or two there, with the end result that the disclosure becomes
impressive for its heft rather than for being clear and insightful.
Brevity may be the soul of wit, but it is rarely the hallmark of an IPO
prospectus.
The SEC's Advisory Committee on Improvements to Financial Reporting
recognized this problem when it identified an ``overly broad
application of the concept of materiality and misinterpretations of the
existing guidance regarding materiality.'' \11\ Or, in the words of a
unanimous Supreme Court, ``Some information is of such dubious
significance that insistence on its disclosure may accomplish more harm
than good.'' An unduly low materiality standard, warned the Court, will
bury investors in an avalanche of trivia:
---------------------------------------------------------------------------
\11\ Final Report of the Advisory Committee on Improvements to
Financial Reporting (Aug. 1, 2008), at 76.
If the standard of materiality is unnecessarily low, not only
may the corporation and its management be subjected to
liability for insignificant omissions or misstatements, but
also management's fear of exposing itself to substantial
liability may cause it simply to bury the shareholders in an
avalanche of trivial information--a result that is hardly
conducive to informed decision making. \12\
---------------------------------------------------------------------------
\12\ TSC Industries, 426 U.S. at 448-449.
A balanced and reasonable approach to materiality is critical to
the success of a disclosure-based regulatory regime. To be sure, our
modern securities markets have changed in ways that would have seemed
inconceivable to President Roosevelt and the Members of the 73rd
Congress who enacted the Securities Act of 1933. But I respectfully
submit that a fundamental principle that guided them has served our
Nation well for the last eight decades of securities regulation--
disclosure of the ``essential facts for the investor,'' focusing on
what is truly material information. That principle continues to serve
individual investors best, even as the nature of the securities markets
changes.
Risk and Reward
I would like to conclude with one additional thought. It is a fact
of economic life that not all IPOs succeed. Any commercial enterprise
that can earn a profit can also earn a loss. That's part of the
tradeoff between risk and reward. IPO stocks can be very rewarding over
the long term, but that necessitates investment risk, and that in turn
brings the possibility of loss.
In other words, IPOs are potentially rewarding investments that
carry corresponding risk. Like any business, a newly public company may
or may not make money for its investors. That is why the cover page of
every IPO prospectus says, ``This is our initial public offering, and
no public market currently exists for our common stock.'' That is why
every IPO prospectus contains many pages of detailed risk factors
regarding the company and the offering.
SEC Commissioner Daniel Gallagher recently underscored the need for
capital markets that offer both transparency and the opportunity to put
investment capital at risk:
When we consider proposed regulation, and the economic policy
context in which we operate, we must think increasingly
consciously not only of the protections we hope to give
investors, but of the incentives and disincentives we create
for capital formation itself in our public markets. Fair,
transparent, and deep capital markets are good. Risk-free
capital markets have no future. Were we somehow to create one,
it wouldn't offer opportunity enough to attract either
companies to list or investors, who would do just as well in
savings accounts or Treasury bills. \13\
---------------------------------------------------------------------------
\13\ Daniel M. Gallagher, ``Remarks Before AusBiotech'' (May 1,
2012).
Thank you. It has been a pleasure to be here with you this morning.
For reasons I hope you understand, I cannot discuss any specific IPOs
and am unable to comment on any proposed regulatory changes. Otherwise,
I welcome any questions you may have.
______
PREPARED STATEMENT OF ILAN MOSCOVITZ
Senior Analyst, The Motley Fool
June 20, 2012
Mr. Chairman and Members of the Committee: I want to thank you for
the opportunity to offer testimony and recommendations today. My name
is Ilan Moscovitz, senior analyst for The Motley Fool.
Founded in 1993, The Motley Fool's purpose is to help the world
invest better. To that end, we have created the world's largest
investment community for individual investors to learn, share, and grow
together.
Millions of investors rely on The Motley Fool not only for guidance
on how to manage their money, but also as an advocate for their rights
as shareholders. For years we have worked to create a level playing
field in the market. It's for this reason that we are eager and
grateful to discuss whether the IPO process is working for ordinary
investors.
It goes without saying that IPOs are critical to both developing
public markets and helping businesses raise the capital they need to
grow and hire.
Public markets give ordinary investors the opportunity to
participate in the growth and success of companies. They also increase
transparency and accountability, making our economy more efficient and
competitive.
However, in a world of finite capital, we need to recognize that
there are good IPOs, and there are bad IPOs. On the one hand you have
Apple, Microsoft, and Starbucks, all of which went on to successfully
innovate their industries as public companies. And on the other, you
have Pets.com, a retailer with an unproven business model that was
losing money on every sale, and which filed for bankruptcy less than a
year after going public, taking with it the $82 million that it raised
from public investors. \1\ Needless to say, a properly functioning
market gives capital to good companies and not bad ones.
---------------------------------------------------------------------------
\1\ Pets.com was a retailer with negative gross margins. See,
Pets.com, S-1 Filing.
---------------------------------------------------------------------------
The quality of IPOs is just as important as their quantity.
From our vantage point as retail investors, the overarching problem
with IPOs is that there is an imbalance of both information and access.
Although issuers and venture capitalists ultimately depend on us for
capital and liquidity, the deck is stacked against us in at least two
major ways.
First, insiders, underwriters, and their favored clients have
access to more and better information than do ordinary investors. This
gives them an unfair advantage over us in estimating a company's fair
value. Reports of Facebook's recent IPO provide a prominent example of
this, \2\ and improved efficiency in IPO pricing when information is
freely available provides a statistical illustration of the problem.
\3\
---------------------------------------------------------------------------
\2\ See, Olivia Oran and Nadia Damouni, ``Facebook Advised
Analysts To Cut Forecasts Before Float'', Reuters.
\3\ Steven Davidoff, ``Why I.P.O.'s Get Underpriced'', New York
Times Dealbook.
---------------------------------------------------------------------------
Second, there's unequal access to shares. The initial offering is
traditionally limited to preferred clients of underwriters. By the time
we can buy shares, there's already been a significant markup. It's
estimated that from 1990 to 2009, that markup averaged 22 percent,
totaling $124 billion. \4\
---------------------------------------------------------------------------
\4\ Jay Ritter, ``Mean First-day Returns and Money Left on the
Table, 1990-2009''.
---------------------------------------------------------------------------
In addition to these two problems, the fact that IPOs are weighted
against individual investors needlessly diminishes confidence in our
markets.
Consider the chart below. \5\ After a period of artificially
inflated volume of IPOs in the mid-to-late 1990s, filings dropped by 75
percent from 2000-2001 once retail investors lost confidence in the
quality of companies coming public.
---------------------------------------------------------------------------
\5\ IPO Task Force, ``Rebuilding the IPO On-Ramp''.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Fast-forward to today, and we're on track to have the fewest number
of June IPO filings since 2003 (excluding the financial crisis) \6\ in
the aftermath of Groupon's questionable accounting and reports that
Facebook's underwriters disclosed material information to favored
clients and not to the rest of us.
---------------------------------------------------------------------------
\6\ Renaissance Capital IPO Home, ``U.S. IPO Filings''.
---------------------------------------------------------------------------
As a side note, it's worth pointing out that the number of IPO
filings had doubled after the global settlement and passage of
Sarbanes-Oxley addressed some of the worst abuses of the dot-com bubble
and ensuing years.
Unfortunately, the recently passed JOBS Act undoes many of these
reforms for most companies coming public, and provisions that weaken
reporting requirements will result in less information reaching
investors. The dramatic collapse of confidence in Chinese emerging-
growth companies in 2010 that followed reports of accounting problems
\7\ is another recent example of how reducing the quality of reporting
can ruin investors' faith in all emerging growth companies. In just 1
year, shares of 93 percent of Chinese emerging-growth companies fell,
cutting the average market value of Chinese emerging-growth companies
in half, costing public investors $11 billion, and harming the ability
of any good emerging-growth companies to raise capital. \8\
---------------------------------------------------------------------------
\7\ See, Bill Alpert and Leslie Norton, ``Beware This Chinese
Export'', Barron's, and Muddy Waters, ``Muddy Waters Initiating
Coverage on RINO--Strong Sell''.
\8\ Data from S&P Capital IQ. ``Cost of Capital'' here refers to a
company's earnings yield.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
This isn't to suggest that weakening the quality of American
accounting to be more closely aligned with China's will necessarily
cause an equivalent increase in the cost of capital for American EGCs,
but it's not the direction we want to move in.
To remedy these problems, our objective should be to level the
playing field and pre-empt such crises of legitimacy by maximizing
transparency and useful disclosure in the marketplace.
Here are three recommendations:
1. Extend the application and enforcement of Regulation Fair
Disclosure to the beginning of the IPO process. This will help
to improve the flow of information to all investors and reduce
one of the most preventable information asymmetries--between
underwriters and their favored clients, and ordinary investors.
2. Second, require that companies and underwriters allocate shares
in the initial offering in a more inclusive and efficient
manner. Over the past decade, companies like Google,
Morningstar, and Interactive Brokers have successfully employed
a Dutch auction process, which gives all investors the
opportunity to buy shares at the same price, under an equitable
plan of distribution. An ancillary benefit is to lower the cost
of going public for companies by more than half. \9\
---------------------------------------------------------------------------
\9\ Jason Zweig, ``The Demise of the IPO--And Ideas for How To
Revive It'', Wall Street Journal.
3. Finally, fix the most troubling portions of the JOBS Act from the
retail investor's perspective. While there are a number of
improvements that could be made, if you're looking for the most
straightforward remedies, one would be to decrease the size
threshold in the emerging-growth company definition, as the
Chairman has previously recommended, to increase the amount of
information available to investors. After all, the current
definition encompasses virtually all IPOs, and companies larger
than, say, $350 million in gross revenues really are large
enough to provide 3 years of audited financial statements. \10\
---------------------------------------------------------------------------
\10\ Data from S&P Capital IQ in Ilan Moscovitz, ``4 Scary Things
About the JOBS Act'', Fool.com.
A second remedy would be to implement a lockup period covering pre-
IPO insiders in emerging-growth companies. The period should include
the offering and extend for at least 180 days after an issuer is
subject to normal reporting requirements, which has been common
practice prior to passage of the JOBS Act. This will better align the
incentives of insiders and ordinary investors. It will also help to
ensure that any capital raised via the emerging-growth-company
exemption serves its intended purpose by flowing to the company and not
to insiders exiting on the IPO on-ramp.
As the IPO process currently stands, ordinary investors have
unequal access to information and unequal access to the market. We are
asking for a level playing field, disclosure, and transparency. We
believe the lack of these qualities is what's most troubling about the
IPO process right now.
I appreciate the opportunity to submit testimony on how IPOs affect
ordinary investors and would be happy to answer any questions.