Two recent developments in the law and practice of business include: (1) the advent of benefit corporations (and kindred organizational forms) and (2) the application of crowdfunding practices to capital-raising for start-ups. My thesis here is that these two innovations will become disruptive legal technologies. In other words, benefit corporations and capital crowdfunding will change the landscape of business organization substantially.
A disruptive technology is one that changes the foundational context of business. Think of the internet and the rise of Amazon, Google, etc. Or consider the invention of laptops and the rise of Microsoft and the fall of the old IBM. Automobiles displace horses, and telephones make the telegraph obsolete. The Harvard economist Joseph Schumpeter coined a phrase for the phenomenon: “creative destruction.”
Technologies can be further divided into two types: physical technologies (e.g., new scientific inventions or mechanical innovations) and social technologies (such as law and accounting). See Business Persons, p. 1 (citing Richard R. Nelson, Technology, Institutions, and Economic Growth (2005), pp. 153–65, 195–209). The legal innovations of benefit corporations and capital crowdfunding count as major changes in social technologies. (Perhaps the biggest legal technological invention remains the corporation itself.)
1. Benefit corporations began as a nonprofit idea, hatched in my hometown of Philadelphia (actually Berwyn, Pennsylvania, but I’ll claim it as close enough). A nonprofit organization called B Lab began to offer an independent brand to business firms (somewhat confusingly not limited to corporations) that agree to adopt a “social purpose” as well as the usual self-seeking goal of profit-making. In addition, a “Certified B Corporation” must meet a transparency requirement of regular reporting on its “social” as well as financial progress. Other similar efforts include the advent of “low-profit” limited liability companies or L3Cs, which attempt to combine nonprofit/social and profit objectives. In my theory of business, I label these kind of firms “hybrid social enterprises.” Business Persons, pp. 206-15.
A significant change occurred in the last few years with the passage of legislation that gave teeth to the benefit corporation idea. Previously, the nonprofit label for a B Corp required a firm to declare adherence to a corporate constituency statute or to adopt a similar constituency by-law or other governing provision which signaled that a firm’s sense of its business objective extended beyond shareholders or other equity-owners alone. (One of my first academic articles addressed the topic at an earlier stage. See “Beyond Shareholders: Interpreting Corporate Constituency Statutes.” I also gave a recent video interview on the topic here.) Beginning in 2010, a number of U.S. states passed formal statutes authorizing benefit corporations. One recent count finds that twenty-seven states have now passed similar statutes. California has allowed for an option of all corporations to “opt in” to a “flexible purpose corporation” statute which combines features of benefit corporations and constituency statutes. Most notably, Delaware – the center of gravity of U.S. incorporations – adopted a benefit corporation statute in the summer of 2013. According to Alicia Plerhoples, fifty-five corporations opted in to the Delaware benefit corporation form within six months. Better known companies that have chosen to operate as benefit corporations include Method Products in Delaware and Patagonia in California.
2. Crowdfunding firms. Crowdfunding along the lines of Kickstarter and Indiegogo campaigns for the creation of new products have become commonplace. And the amounts of capital raised have sometimes been eye-popping. An article in Forbes relates the recent case of a robotics company raising $1.4 million in three weeks for a new project. Nonprofit funding for the microfinance of small business ventures in developing countries seems also to be successful. Kiva is probably the best known example. (Disclosure: my family has been an investor in various Kiva projects, and I’ve been surprised and encouraged by the fact that no loans have so far defaulted!)
However, a truly disruptive change in the capital funding of enterprises – perhaps including hybrid social enterprises – may be signaled by the Jumpstart Our Business Start-ups (JOBS) Act passed in 2012. Although it is limited at the moment in terms of the range of investors that may be tapped for crowdfunding (including a $1 million capital limit and sophisticated/wealthy investors requirement), a successful initial run may result in amendments that may begin to change the face of capital fundraising for firms. Judging from some recent books at least, crowdfunding for new ventures seems to have arrived. See Kevin Lawton and Dan Marom’s The Crowdfunding Revolution (2012) and Gary Spirer’s Crowdfunding: The Next Big Thing (2013).
What if easier capital crowdfunding combined with benefit corporation structures? Is it possible to imagine the construction of new securities markets that would raise capital for benefit corporations -- outside of traditional Wall Street markets where the norm of “shareholder value maximization” rules? There are some reasons for doubt: securities regulations change slowly (with the financial status quo more than willing to lobby against disruptive changes) and hopes for “do-good” business models may run into trouble if consumer markets don’t support them strongly. But it’s at least possible to imagine a different world of business emerging with the energy and commitment of a generation of entrepreneurs who might care about more in their lives than making themselves rich. Benefit corporations fueled by capital crowdfunding might lead a revolution: or, less provocatively, may at least challenge traditional business models that for too long have assumed a narrow economic model of profit-maximizing self-interest. James Surowiecki, in his recent column in The New Yorker, captures a more modest possibility: “The rise of B corps is a reminder that the idea that corporations should be only lean, mean, profit-maximizing machines isn’t dictated by the inherent nature of capitalism, let alone by human nature. As individuals, we try to make our work not just profitable but also meaningful. It may be time for more companies to do the same.”
So a combination of hybrid social enterprises and capital crowdfunding doesn’t need to displace all of the traditional modes of doing business to change the world. If a significant number of entrepreneurs, employees, investors, and customers lock-in to these new social technologies, then they will indeed become “disruptive.”
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Back in October I posted about a fantastic conference at the University of Kentucky on the Securities Act at 80. I've just posted my article on SSRN, abstract below. Any guesses on which JOBS Act change had an effect on underwriting spreads? You'll have to download to find out!*
*OK, that was kind of obnoxious, I'll just tell you. I find a statistically significant correlation between emerging growth companies that file a confidential draft registration statement and a lower gross spread. But go read the whole thing and tell me what you think.
U.S. underwriting fees, or spreads, have somewhat inexplicably clustered around 7% for years, a phenomenon that some have suggested evidences implicit collusion. The goal of Title I the JOBS Act of 2012 was to make going public easier for smaller firms; certain provisions specifically should make the underwriters’ task less risky, and thus less expensive. Presuming these provisions are effective, then one would predict that underwriting spreads would decrease as the costs to the underwriter for a public offering declined. Admittedly the prior presumption is a big one: it may be that the JOBS Act reforms were largely ineffective, and thus could be expected to have little effect on underwriter cost. This article is the first to examine post-JOBS Act underwriting spreads to determine whether spreads have in fact declined. A finding that underwriting costs stayed constant might be evidence of either collusion or that the JOBS Act was ineffective at reducing the cost of going public. I find that one provision has lowering the spread, thus suggesting elasticity in the spread and offering at least some evidence of the Act’s effectiveness.
Good morning! Were you looking for some beach reading material as Spring Break draws nearer? I just posted my latest paper, Pricing Disintermediation: Crowdfunding and Online Auction IPOs. Were you wondering what the future holds for raising equity online after Proposed Regulation Crowdfunding? Have you ever thought that maybe the quick birth and death of the online auction IPO could inform that question? Moreover, have you ever thought that maybe the social entrepreneurship crowdfunding space might fare differently? That corporate finance might solve the mission drift problem, not corporate governance? Have I got a page-turner for you!
It's unlikely, but not impossible. Twitter was a big lobbying force for the JOBS Act provision that changed the Section 12(g) of the Exchange Act's threshold from 500 to 2000 investors. And we know from this prospectus that it went public with 755 shareholders (p. 155) of record. But 12(g) has a second threshold: you have to register under the Exchange Act if you have 500 or more unaccredited shareholders. I was curious whether Twitter would break out the number of unaccredited shareholders in its prospectus, but it doesn't. To be fair, I don't suggest it has to: the regulations don't require it, at least as far as I know.
We know Twitter was approaching that magic 500 number when JOBS was passed, but JOBS changed the rules regarding counting: employee stockholders who gain their shares via vesting of stock options don't count in the tally. Presumably once Twitter excluded these stockholders it was well under the 500 unaccredited threshold. But it would be interesting to know.
On Wednesday, as many now know, the U.S. Securities and Exchange Commission (SEC) released its long-awaited rule proposal release under Title III of the Jumpstart Our Business Startups (JOBS) Act, signed into law by President Obama in April 2012. Title III of the JOBS Act, also known as the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure (CROWDFUND) Act, governs securities--a/k/a investment--crowdfunding. Importantly, this part of the JOBS Act allows securities crowdfunding conducted under specified parameters to proceed without registration under the Securities Act of 1933, as amended (1933 Act). As you may recall, I blogged here about the CROWDFUND Act as part of a forum on the JOBS Act shortly after its adoption. Those forum posts outline the key terms and provisions of the CROWDFUND Act and the JOBS Act as a whole.
I appreciate the opportunity given to me by my friends at The Glom to blog a bit about these rules, dubbed "Regulation Crowdfunding." I have spent the past several days digesting them, as time has permitted. No offense meant to the SEC, but I did fall asleep over the rules more than once over the past few days . . . .
My overall assessment is that the rules represent a thoughtful, conservative approach to regulation under what the U.S. Congress handed the SEC, which is (in my opinion) a poorly designed legislative product. Although some have criticized the SEC for taking so long to issue rules that (in many cases) merely repeat what Title III of the JOBS Act says, I have come to the view (reading a bit between the lines) that the SEC has thoughtfully considered what, if anything, it can do to make Title III crowdfunding accessible to investors and issuers while at the same time ensuring as best as possible (especially given the untested nature of a securities crowdfunding market) that the policies underlying our federal securities law are upheld. Signs of deliberation and reflection exist throughout the rule proposal.
For example, in addressing
- whether the amount of crowdfunded securities offered under Title III of the JOBS Act should be aggregated with the amount of securities offered under other 1933 Act registration exemptions for purposes of calculating the offering limits for issuers under Title III and
- whether crowdfunded securities offerings under Title III of the JOBS Act should be integrated with other securities offerings exempt from registration under the 1933 Act for purposes of determining compliance with the overall rules under Title III,
the SEC concludes based on the text of the JOBS Act, read in context, that neither aggregation nor integration of this kind should be applicable in Title III securities crowdfunding. In addition, the SEC offers helpful hints about how to tackle a few sticky issues at the intersection of crowdfunded offerings under Title III and other exempt offerings (e.g., the handling of certain types of concurrent offerings and the treatment of offerings by affiliates and predecessors). The SEC's conclusions seem right to me, but good arguments based on investor and market protection could be made to the contrary.
The SEC takes a similarly reasoned approach to addressing ambiguities in the investor caps provided for in Title III. After acknowledging the related public comments, the SEC divines an intent to broaden, withi--but not beyond--the constraints set out by Congress, the potential for investment in crowdfunded securities offerings. The SEC's rulemaking "fix" is simple and, again, appears to be in accord with the ostensible purpose of Title III. Interestingly, the SEC rule allows issuers, absent knowledge to the contrary, to rely on verification done by crowdfunding intermediaries on investor compliance with the cap.
The proposal release also manifests regulatory caution of other kinds. For instance, the SEC notes comments requesting an increase in the 12-month issuer aggregate offering limit from $1,000,000 (as provided in the CROWDFUND Act) to a higher amount. The SEC identifies this request (and other related queries) and declines to increase the aggregate offering limit through rulemaking. In the release, the SEC states (among other things) that Title III of the JOBS Act:
specifically provides for a maximum aggregate amount of $1 million sold in reliance on the exemption in any 12-month period. The only reference in the statute to changing that amount is the requirement that the Commission update the amount not less frequently than every five years based on the Consumer Price Index. Additionally, statements in the Congressional Record indicate that Congress believed that $1 million was a substantial amount for a small business. We do not believe that Congress intended for us to modify the maximum aggregate amount permitted to be sold under the exemption when promulgating rules to implement the statute.
While perhaps predictable, the SEC's regulatory restraint in this regard is not, apparently, merely a knee-jerk reaction borne of a desire to cabin or eliminate securities crowdfunding.
Although this post touches only on a few substantive provisions of Regulation Crowdfunding relating to issuers and investors, the rule proposal is replete with similar examples of deliberate, narrowly tailored rulemaking. The regulation of funding portals also gets and deserves significant attention in the release. Moreover, the SEC expressly seeks comments on general and specific matters highlighted throughout the release. Given the scope of the legislative exemption and the related rulemaking, there are a number of interesting discernable narratives in the 585-page release. To keep this post short, I will stop here. But if The Conglomerate will indulge me a bit more, I may post a few additional observations as time permits . . . .
Ever had that experience of presenting a paper at a conference and coming home to a front-page WSJ article on your topic? Me neither. Until now! The paper I presented at the Kentucky symposium (which was amazing-- I felt honored to be in such company) was very much a work in progress. It asks a simple question: did the JOBS Act affect underwriter IPO fees? The question I'm still mulling over is whether we would expect it to. And behold, this morning I awoke to an article on Twitter's underwriting fees!
Telis Demos' WSJ article focuses on Twitter's "squeezing" its underwriting banks in two ways: first, by securing a $1 billion credit line from its bankers, and second, by negotiating a discount on the underwriting fee itself. Taking the second point first, in a firm-commitment IPO the underwriter buys the shares from the company at a discount, and then turns around and sells them to the public at full price. That discount, also called the gross spread, is the underwriter's overt compensation, and there's been a lot of literature about how it clusters at 7% for small and mid-sized IPOs.
The Journal reports that the banks' spread is 3.25%--not as low as Facebook's 1.1%, but pretty low. Suprisingly low? That's the question. Everyone agrees that as IPOs get bigger, the spreads should decline. It's just not that much more expensive to market a big deal versus a small deal, so economies of scale kick in. So is Twitter's low spread the function of its size, or has it really put the squeeze on the banks?
I examined U.S. IPOs from the passage of the JOBS Act through July 27, 2013. My sample excludes banks, S&Ls, REITs, ADRs, unit issuers, and closed-end funds. One problem is that Twitter is a really big IPO, with few comparables out there. During that period no emerging growth companies launched a Twitter-sized IPO (remember, Twitter is an EGC). The very biggest EGCs ranged from $430-630 million, and that spread averaged 5.67%. So 3.25% is obviously a much cheaper IPO price tag, but that could just be economies of scale kicking in.
Besides Facebook, there is one big non-EGC IPO, Zoetis, that raised north of $2.2 billion. Its spread was 3.7%. Which could suggest that perhaps Twitter did snag a deal--half the offering size, and yet a smaller discount rate. But that's just one data point, and a non-EGC company to boot. Hardly apples to apples.
Moreover, there's a lot going on with underwriting fees. As the WSJ article points out, Twitter also got what might be a sweetheart deal on its loan terms. And it might be that issuers are willing to pay more for sector expertise, or analyst coverage, marketing prowess, or plain old reputation. There's also the presence of underpricing, which may act as sub rosa compensation. And the fact that you may not want to pay rock bottom for underwriting--I don't remember anyone particularly highlighting the 1.1% spread during the fallout from Facebook's IPO debacle. But one wonders if you can cut the spread too low.
Watch for more from me on this topic once I can revise my draft. And let me know if you have any thoughts.
Today's the day! The ban on general solicitation is lifted effective today! It's a brave new world for private companies looking to raise money. See here for some details. I expect the news in the coming weeks will be filled with the creative ways entrepreneurs are soliciting investors. Let the games begin!
Update: John Coffee takes the SEC to task for allowing bad actors a clean slate when it comes to general solicitation. Worth a read.
When I teach Securities Regulation, after going through what is/is not a security, I begin with the topic of registration of securities, or the initial public offering. Then, I get to the exemptions, including Rule 506 of Regulation D and rules 144 and 144A. By this time, my students usually say, "So everything we learned about registration requirements is completely meaningless?" After the lifting of the ban on general solicitation for Rule 506, the answer seems to be unequivocally "yes."
If you are an issuer and want to raise a large amount of capital (over $5 million), your choices are basically a private placement of securities under Rule 506 or an IPO. Rule 506 has many fewer requirements, but historically it had to take place among the issuer, underwriter and institutional investors, funds, and high-worth individuals known to the underwriter. Now, "private placements" can be publicly advertised, even if the shares must only be "placed" in the hands of accredited investors. (See Usha's and Erik's posts from last week.) So, why would any issuer conduct an IPO?
In a registered offering, issuers and underwriters can't speak of the offering during the "quiet period" leading up to registration. Then, after registration, written communications must be through a statutory prospectus, or a "free writing prospectus" that meets certain requirements. Oral communications are allowed, but face-to-face and telephone conversations have practical limitations. The registration statement, with mandatory financials and disclosures, must be approved by the SEC, and prospectus delivery requirements continue once selling begins.
None of this applies to private placements! So, if Company A wants to raise $50 million in an IPO, it will cost more in legal and accounting fees, and Company A can't talk to the public about the offering until registration, then only with a detailed prospectus, and must wait for the SEC to declare the registration statement effective. Meanwhile, Company B can set up a website touting the offering, with no limitations on what it says or must say. Company B can purchase billboards, taxi signs, sandwich boards, Facebook ads, or even send an email to every person on earth. The catch is that it can accept offers to buy only from accredited investors.
Would that alone be enough for a company to forego the private placement and launch an IPO? So that the first-buyers of the shares can be retail (nonaccredited) investors? Exactly how many retail investors receive IPO shares? I'm going to say not many.
The only advantages of the IPO that I can see is first, that the secondary market starts immediately, as compared with the six-month or year waiting period with Rule 144 or the limited but immediate secondary market to qualified institutional buyers through Rule 144A. Second, the Facebook conundrum of mandatory registration under Section 12(g) if an issuer has over 2000 shareholders or 500 unaccredited investors. But I'm not sure that's enough to keep the struggling IPO market a strong alternative.
Earlier this year I participated in a Vanderbilt Law Review En Banc forum offering advice to the SEC regarding implementation of the JOBS Act. My piece focused on the SEC proposed rule lifting the ban on general solicitation; yesterday the SEC released final rules on the subject. The deal is that now private firms can advertise under new 506(c) of Reg D if they take reasonable steps to verify that any actual purchasers are in fact accredited.
What exactly are "reasonable steps?" There's the rub. The final rules track the proposed ones closely, save that the agency heeded the pleas of many, myself included, to articulate some concrete methods as to what constitutes a "reasonable step." I asked for a safe harbor, but the SEC declined to go so far.[Upon review, these methods are "deemed to satisfy the verification requirement, which sounds like a safe harbor to me.]
Here are the new, non-exclusive methods for an issuer to verify an investor's accredited status, along with my comments (for those not in the area, to qualify as an accredited investor you need to have income of over $200,000 ($300,000 joint) for the past 2 years, plus a reasonable expectation of the same in the current year) or $1 million net worth, excluding primary residence:
1. natural person income test:
- review of any forms filed with the IRS that report income, including a W-2, 1099, K-1, or 1040, for the past 2 years
- plus a written representation that the individual (and spouse, if applicable) reasonably expects to reach the income threshold for the current year.
- UR comment: seems pretty straightforward and reasonable.
- UR comment 2: the SEC suggests that a person could redact the form to avoid disclosing personally identifiable information like one's SSN. A good idea, especially since I'm concerned about scammers duping eager accredited investors with fake investment opportunities.
2. natural person net worth test:
- review of documents no more than 3 months old that verify assets, including: bank statements, brokerage statements and other statements of securities holdings, CDs, tax assessments and independent third-party appraisal reports
- plus for liabilities, a credit report from at least one national agency
- plus a written representation that all liabilities have been disclosed.
- UR comment: This was always the tricky one. Net worth is so easy to game--just disclose your assets and keep mum about your liabilities. There are still a lot of problems here: how do you know the third-party appraisals really are independent? What if forms are doctored? I know very little about what credit reports cover, but I'm sure there are large categories of liabilities they don't capture. I don't have any answers, but this method seems almost certain to cause problems down the road. If I were an issuer I would avoid it like the plague.
3. third-party verification method:
- written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney, or a CPA that the individual has after taking reasonable steps determined within the past 3 months that the purchaser is an accredited investor.
- UR comment: I advocated for this approach, and I like it. It risks creating a "cottage industry" of third-party verifiers, but the odds are that most accredited investors already share their financial information with one of these professionals, so it probably won't slow things down much. I wouldn't be surprised if a lot of issuers plump for this path, in effect outsourcing their duty to take reasonable steps to verify accredited investor status.
- If a natural person invested in an issuer's Rule 506(b) offering prior to July 10, as long as they remain an investor, written confirmation of accredited status at sale suffices.
I started my En Banc piece with a hypothetical late-night infomercial-type scenario that I thought was pretty fanciful, but truth is apparently stranger than legal scholarship. The WSJ tells of entrepreneurs looking to use billboards, social media, and the products themselves as advertising. For example, a startup that converts shipping containers into portable produce gardens plans to cover one side of the 40-by-9-foot containers with billboard-style ads. Another plans to use ads on buses and in newspapers, plus hire people to wear T-shirts with the message, "especially window washers, because the skyscrapers they clean could have wealthy executives inside."
As I have written about, we're in a brave new world of private firms advertising to the general public. I've predicted that people will get upset as they realize that all of these exciting sounding opportunities are only available to the accredited investor. Securities law's dirty little secret--that the wealthy have special investment opportunities average Joes lack--may not be a secret much longer.
Update: Commissioner Aguilar disagrees with the new rule, worrying about investor protection.
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...