[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


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            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\
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     \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.


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    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\
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     \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\
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     \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.
