Just out today, here's a link to one of my projects for my semester "off": Vanderbilt Law Review asked me to contribute to an online symposium offering advice for the SEC in its JOBS Act rulemaking. There's no abstract, but here's my opener:
Watch enough late night television and you’ll see advertisements for weight-loss elixirs, hair restoratives, and cures for ailments you never dreamed existed. Imagine, if you will, yet another huckster, this one touting PrivateDeal, a “never-before-available investment opportunity, the chance of a lifetime! Get in on the ground floor of a start-up boasting triple-digit growth!” The PrivateDeal hawker goes on to declare: “This investment was previously only available to the ultrarich, but now, thanks to recent developments in the law, it can be yours!”
Jim, an intrigued investor, calls the 800 number on the bottom of his screen, expecting to encounter an operator ready to take his credit card information. Instead, he gets an agent who starts peppering him with questions about his income and net worth. Gradually it dawns on Jim that he may not be able to invest in PrivateDeal after all. Indeed, five minutes into the conversation, the agent confirms that he is not qualified to invest.
“But. . .why. . .” Jim begins to splutter.
“Sir,” the agent explains patiently—Jim senses she has started this speech many times already tonight—“The fine print in the ad specifies that only accredited investors are eligible to buy shares in PrivateDeal.”
To which Jim responds: “Well, what’s an accredited investor?”
Welcome to post-JOBS Act private investing.
As you can tell, I had fun with the piece--my opening might (or might not) have been the product of bad late night television that I may (or may not) have been watching while up feeding my small one. I reveled in the freedom of the hybrid blogpost/essay form. I've done a few of these short online pieces for law reviews (here on SPACs for the Harvard Business Law Review), here for the Texas Law Review to respond to a Brian Galle article, and I've found each to be quite satisfying. I welcome the opportunity to produce timely, easy-to-digest morsels of scholarship.
Let me know what you think of the piece, and head over to Vanderbilt Law Review's website to check out offerings from my friends Andrew Schwartz of Colorado Law and Doug Ellenoff, a practitioner whom I met in the course of my SPAC research.
Today's WSJ brings news that private equity giant Carlyle Group is "lowering the velvet rope" : letting some people buy into their funds "with as little as $50,000." While this doesn't exactly open up private equity for your average Joe, it lowers the traditional private equity buy-in bar, which was $5 -20 million at Carlyle, at least. The article characterized Carlyle's move as part of a trend among private equity to broaden their investment offerings. KKR now offers mutual funds investing with a minimum of $2,500 ad Blackstone launched a fund "that for the first time lets affluent individuals invest in hedge funds."
Do you have $50,000 lying around? Think the acquisition market will be heating up and want to catch the next buy-out wave? Not so fast, buddy. To qualify for Carlyle's new fund you also have to be an accredited investor, with $1 million in net worth or $200,000 in income ($300,000 if filing jointly).
I've written recently about the fact that the rich get access to more investing opportunities than everyone else. In Securities Law's Dirty Little Secret I speculate that this differential treatment might be getting harder to maintain. I speculate that investors may not be content for much longer with being shut out of buyout funds and the like. Indeed, I'm working on a short piece now that will argue that JOBS Act Section 201's elimination of the prohibition on general advertising will make the contrast between the investing opportunities available to haves and have-nots all the more stark. It used to be that we couldn't hear advertisements from hedge funds and other private investment opportunities. No more. In the post-JOBS world the airwaves and Internet may tout investment after investment that only the wealthy can actually take advantage of.
Today's WSJ article suggests that there's pressure on the sell side as well as the buy side. It observes that as pension funds-- "the cash cow that for decades has filled [private-equity firms'] coffers" --dry up, buyout shops need new sources of investing dollars. One logical choice is the wealth of accredited individual investors. But the WSJ suggests private equity hunger for still more riches: "Some private-equity executives long to offer their funds to typical workers through 401(k) savings plans, calling access to that pool of money their 'holy grail.'"
Yet more evidence that the old lines between accredited and nonaccredited investors may not hold.
Today, the SEC will convene a much-anticipated roundtable examining the current regime of penny-priced tick sizes on U.S. stock markets. A principal purpose of the roundtable is to explore whether the transition to penny-priced quotations in 2001 (known as “decimalization”) has harmed liquidity in the securities of small and middle-sized companies. The general theory, initially advanced in this Grant Thornton white paper, is that when securities were quoted in sixteenths of a dollar, trading spreads were kept artificially wide given the fact that bid-ask spreads could be no less than $0.0625 per share, creating large profit margins for dealers making markets in U.S. equities. Such market-making profits, so the argument goes, were then used to support trading operations and analyst research in thinly-traded securities and the securities of newly-public firms. In this fashion, the argument continues, the higher trading costs associated with fractional-quoting were actually part of a healthy ecosystem for nurturing the market for IPO stocks and smaller company securities more generally.
According to this theory, one way to bring back the IPO market is to undo the harm decimalization caused this ecosystem by increasing the tick size, or minimum price variation (MPV), when quoting the securities of smaller issuers. It is an argument that has gained considerable support over the past year, as reflected in both Section 106(b) of the JOBS Act (which required the SEC to study the effects of decimalization on the liquidity of smaller firms) and the draft recommendations of the SEC Advisory Committee on Small and Emerging Companies (which recommends a “meaningful increase in tick size as a necessary step toward encouraging the reestablishment of an infrastructure designed to increase liquidity for small public companies.”) And based on the agenda for today’s roundtable, a reasonable bet would be to see some form of pilot study being implemented in which the securities of certain firms must be quoted in an increment greater than $0.01.
While it is heartening to see the SEC take an empirically-driven approach to capital market reform, new research by Justin McCrary and myself underscores the need for the SEC to assess this issue especially carefully and for any policy changes to take place within an incremental framework. In our working paper, Shall We Haggle in Pennies at the Speed of Light or in Nickels in the Dark? How Minimum Price Variation Regulates High Frequency Trading and Dark Liquidity, we document how modification of the penny-based system of stock trading will likely have simultaneous and opposite effects on the incidence of both high frequency trading (HFT) and the trading of undisplayed (or “dark”) liquidity (what we refer to as “trading hidden liquidity” or THL). Specifically, in the event of an increase in the MPV, our research strongly suggests we can expect to see both an increase in off-exchange trading in venues such as dark pools and a decrease in HFT.
Although often conflated within the popular press, HFT and THL reflect two distinct types of trading strategies that have distinct consequences for price discovery and market liquidity. In terms of strategy, traders focusing on HFT typically seek to profit from discrete, short-lived pricing inefficiencies by rapidly bidding on and selling securities, customarily through pre-programmed algorithms. The emergence of so-called “maker/taker” fee structures at stock exchanges—whereby limit order providers are paid a “maker” rebate and traders using market orders are assessed a “taker” fee—creates an additional profit opportunity for such traders provided they can position their limit orders at the top of exchanges’ order books. For firms engaged in HFT, minimizing the latency of processing information and entering orders is therefore of paramount importance to profitability. In contrast, a firm focusing on THL will generally seek to profit by providing liquidity to investors without the necessity of publishing public bids or paying exchange access fees, thus minimizing the price impact and cost of the transaction. Access to investors looking for liquidity—rather than speed of trading per se—is accordingly a primary goal of those engaged in THL.
Despite the recent focus on changing tick sizes, there has been remarkably little focus on how each of these strategies is intimately connected with the rules governing the MPV. As was revealed following decimalization, smaller tick sizes have led to both a surge in market message traffic as prices dispersed across more price points as well as a dramatic reduction in quoted spreads. Both developments favor algorithmic trading strategies capable of processing quickly large flows of order messages, while reducing the costs of rapidly trading in and out of positions. With respect to THL, larger tick sizes create the opportunity for larger spreads and, consequently, larger profits for those firms that can capture them by trading against marketable orders from individuals and institutions seeking immediate liquidity. In this regard, dark pools and broker-dealer internalizers are aided by a technical rule concerning how the penny-pricing requirement is actually implemented: Although it is prohibited for anyone to quote (i.e., post an order) at other than a penny-increment, it is perfectly fine to execute a trade in subpenny increments. Using this flexibility to execute subpenny trades, a dark pool or internalizer can thus offer price improvement over the National Best Bid or Offer (NBBO) available at conventional stock exchanges (even if the improvement is as little as $0.0001 per share). In this fashion, dark pools and broker-dealer internalizers have both the incentive and the means to trade directly with incoming marketable orders rather than route them to exchanges.
To examine empirically how changes in the MPV might have these effects on the incidence of HFT and THL we turned to a peculiar quirk in the ban on sub-penny pricing described in the previous paragraph. In particular, the ban on sub-penny quotations (Rule 612 of Regulation NMS) only applies to equity orders priced at or above $1.00 per share, thus creating a sharp distinction in tick size regulation between those orders priced just above $1.00 per share and those priced just below it. Using a regression discontinuity (RD) research design, we can therefore identify in a clean, parsimonious way how changes in tick size regulations can affect the incidence of these two forms of trading. For our data, we used the NYSE’s Trade and Quote (TAQ) database, focusing on the 300 million trades and the 3 billion updates to exchanges’ best published bids and asks made during 2011 for securities that traded below $2.00 per share at some point in 2011.
Overall, our results are strongly consistent with the hypothesized effect of MPV on both THL and HFT. To measure THL, we examined for each completed trade the market center at which it occurred, using trades reported to a FINRA Trade Reporting Facility (TRF) as our measure for THL. The figure below presents our RD estimates of the effect of subpenny quoting on the incidence of such off-exchange trading. In the figure, the x-axis represents a transaction’s reported trade price truncated to two-decimal places, and the circles represent the fraction of all reported trades reported to a FINRA TRF at each such price. The solid line plots fitted values from a regression of the fraction of TRF trades on a fourth-order polynomial in two-decimal price (the point estimate and standard error are in the legend). As the figure indicates, trades executed at prices immediately above $1.00 per share revealed a sharp increase of 8 percentage points in the percent of trades reported to a TRF facility. Because all other market centers reflect stock exchanges, this translates to a corresponding decrease of 8 percentage points in the incidence of transactions on the public exchanges.
With respect to HFT, we examined (among other things) the incidence of “strategic runs” within the quotation data at each price point truncated to two-decimal places. Notably, the TAQ data does not permit tracking individual orders since it covers only updates to each exchange’s best bid or offer (BBO), but evidence of such strategic runs nevertheless appears in the TAQ data to the extent they affect an exchange’s BBO, which is continually updated by the exchanges to reflect the new orders that change it. Accordingly, we measure for each second of the trading day the rate of BBO updates for each security in our sample (a “security-second”). As might be expected in the (for modern financial markets) relatively quiet corner of penny stocks, the vast majority of security-seconds experienced no update of an exchange’s BBO. In particular, over 90% of the security-seconds in the sample showed no BBO updates, with higher-priced orders generally being more likely to have at least one BBO update per second. As shown in the figure below, RD analysis of security-seconds having at least one BBO update by two-decimal order price reveals that this trend was generally continuous at the $1.00 cut-off.
In contrast, analysis of those security-seconds where a BBO was updated with significant frequency reveals a sharp increase in the incidence of such strategic runs below the cut-off. The next figure, for instance, provides our RD estimates for the incidence of security-seconds where the BBO was updated at least fifty times per second. Consistent with the previous figure, the rate of these strategic runs generally declines from $2.00 to $1.00 where it reveals a discontinuous upward jump from .02% of all security-seconds to .1% of all security seconds, highlighting the negative relationship between the size of the MPV and the incidence of HFT.
In sum, these findings suggest that current proposals to increase the MPV may very well entail significant, unanticipated structural changes in the nature of how equity trading occurs on U.S. markets. To be sure, many of these changes in trading such as the higher incidence of THL would actually be consistent with a core objective of Section 106(b) of the JOBS Act insofar as they would increase the profitability of market-making in affected stocks. However, our finding that these market-making profits are generally captured by dark pools and internalizers causes us to question how these enhanced profits will translate into additional analyst coverage and sales support for emerging growth companies. For instance, most dark pools and the two largest internalizers by volume—Citadel Investments and Knight Capital—do not offer sell-side analysis or advisory services. Moreover, the new retail price improvement (RPI) programs at major U.S. stock exchanges—which seek to allow exchanges to compete with internalizers through establishing de facto dark pools to capture trading spreads—only further undermine the theorized benefits for IPO firms of larger tick sizes given that the beneficiaries of such programs (i.e., stock exchanges and RPI participants) are also not known to provide market support for emerging growth companies. To the extent the SEC chooses to implement a pilot program modifying tick sizes, coupling such a program with increased disclosures concerning which broker-dealers are reporting trades to a FINRA TRF could help ascertain whether the appropriate market participants are benefiting from the wider spreads.
A bit over a month ago, I had the privilege of attending a roundtable discussion at NYU on Title II of the JOBS Act. As you may recall, Bob Thompson and I earlier helped the Glom conduct a forum on the JOBS Act, and I asked Usha (who organized the forum) for permission to add this post as an epilogue of sorts (especially since we did not cover Title II in the earlier posts). Thanks, Usha et al., for this opportunity to extend the discussion. Thanks also to Steve Bainbridge for urging me to post on this after I posted on the roundtable on LinkedIn. (This post repeats much of what I said there and adds a bit to it.)
Title II of the JOBS Act includes only one section--Section 201. Among other things, this section takes aim at the general solicitation/advertising prohibitions applicable to offeirngs under Rule 506 of Regulation D under the Securities Act of 1933, as amended (1933 Act). Specifically, the section requires the Securities and Exchange Commission (SEC) to modify the general solicitation/advertising provisions in Rule 502(c) so they will not apply to Rule 506 offerings if all purchasers in the offering are accredited investors. Section 201 also provides for a similar amendment to Rule 144A to allow securities to be offered "to persons other than qualified institutional buyers, including by means of general solicitation or general advertising, provided that securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe is a qualified institutional buyer." This post only addresses the Regulation D part of Section 201 and only raises a few of the many issues to be faced in the rule-making process.
At the June roundtable, many of the most active participants were representatives of investment fund firms (vc, hedge, etc.) and their counsel. The relaxation of the general solicitation rules is of great importance to them because this deregulation has the potential to help their business operations (as investors in portfolio companies) and their ability to solicit investors in their own firms using Rule 506 offerings. The composition of the group enabled a very interesting discussion.
Perhaps the most interesting part of the conversation related to the portion of Section 201(a)(1) of the JOBS Act that directs the SEC to, in its rule-making, "require the issuer to take reasonable steps to verify that purchasers of the securities are accredited investors, using such methods as determined by the Commission." What might those reasonable steps be? Should the SEC script them out in detail, and if so, how? Should the same rules apply to, e.g., portfolio company offerings and offerings made by repeat financial industry issuers, like hedge funds?
There was a lot of sentiment around the table for having the SEC fashion rules that allow different types of industry players to determine what requirements are reasonable in their circumstances. The means of doing that could range from merely writing a rule that incorporates the reasonableness requirement in some general way, to working with safe harbor provisions that would set a core group of procedures, to using interpretive guidance to fill in details for different types of offerings. This turned out to be a rich conversation that bridged the gap between policy and practice.
We noted in the discussion that the reasonableness requirement in Section 201(a)(1) builds on the "reasonable belief" concept in the accredited investor definition in Rule 501 of Regulation D: "Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person . . . ." I noted in the discussion that a similar framework exists in the due diligence defense provisions in Section 11(b) of the 1933 Act: "after reasonable investigation, reasonable ground to believe and did believe, at the time such part of the registration statement became effective, that the statements therein were true and that there was no omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading . . . ." The processes underlying the successful navigation of this due diligence defense were determined privately, outside the scope of SEC rule-making, and were vetted in enforcement proceedings. So, there is some precedent for leaving these kinds of reasonableness requirements to the actors in the regulatory scheme, subject to an enforcement check, albeit in a different context. It's worth thinking through that analogy more rigorously given the different context, but it is a noteworthy analogy nevertheless (imho). Among the issues to be thought through more carefully are the nature of the regulatory costs (including the costs of legal change) associated with the various proposed regulatory solutions and the bearer of those regulatory costs.
The SEC expects to take up rule-making on this at the end of the month. This means that the rule making on Title II of the JOBS Act will be way behind Congress's schedule. In the mean time, folks still are posting formal and informal pre-comments in the designated area of the SEC's Web site. Although I haven't taken the time to wend my way through all of the commentary and carefully think it through, there are a few recent letters that address some of the issues raised in this post and, in my view, merit attention. These include the letters filed by the National Small Business Association and the North American Securities Administrators Association (to which there have been some replies here and here).
There is much work to be done here. I throw out these ideas as a way of starting a potential conversation. So, if you're interested, have at it.
There's a basic problem with the wording of the crowdfunding exemption in the JOBS Act. Here's the language at issue (from Sec. 302 of the JOBS Act), amending Section 4 of the 1933 Act to provide an exemption from registration for:
(6) transactions involving the offer or sale of securities by an issuer (including all entities controlled by or under common control with the issuer), provided that—
(B) the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption provided under this paragraph during the 12-month period preceding the date of such transaction, does not exceed—
(i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and
‘(ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000
Did you catch it? No? I was just innocently trying to work through the numbers, and posited a hypothetical investor who had a net worth of $900,000, no job, and annual investment income totalling $70,000. Let's call her Susan. It's not too outlandish a hypothetical--Susan is a well-off retiree who owns her own home. So, into which category does Susan fall?
Let's see. (B)(i), because her annual income is less than $100,000...And (B)(ii), because her net worth is more than $100,000.
Wait, that can't be right, can it? How much can Susan invest? 10% of her net worth or 5%?
Uh, Congress? Hello?
I'm not the first person to catch this mistake. Joan tells me it was discussed at the crowdfunding conference she recently attended. But it's so basic it makes me wonder about Brett's pessimistic story number two...