Investment Analysts Typically Do Not Cover Smaller-Cap Illiquid Stocks
In my previous articles, I’ve discussed the issues driving the disappearance of small-cap public companies in the US market. Another example of the in-hospitability of the capital markets to smaller-cap companies is that investment analysts typically do not cover them.[1] According to a 2017 OTC markets survey, 68% of OTC issuers surveyed said they do not have any investment analyst coverage. Similarly, 62% of NASDAQ companies with market capitalizations under $50M do not have any investment analyst coverage.
This lack of investment analyst coverage negatively impacts these companies since academic studies have shown that when an analyst initiates coverage on an issuer its share price increases and its stock trading liquidity increases.
Keep in mind, there are two types of investment analysts: “buy-side” analysts and “sell-side” analysts. A buy-side analyst typically works for an investment fund/institutional investor and writes research reports on issuers whose stock the investment fund/institutional investor is considering purchasing. A sell-side analyst typically works for an investment banking firm and writes research reports on issuers who the analyst believes is an attractive investment opportunity. The report is then distributed to investment funds/institutional investors with the hope they will generate trading commissions for the investment banking firm by purchasing the stock of the issuer that is the subject of the research report.
This article focuses on sell-side analysts, as buy-side analysts do not distribute their reports.
So, why do so few sell-side investment analysts cover illiquid, smaller-cap company stocks?[2]
Because, as explained below, the analyst’s investment banking firm employer typically is not able to monetize a research report covering an illiquid, smaller-cap company.
The analyst’s investment banking firm employer wants to reduce the “overhead expense” of the analyst by having the analyst generate revenue. Hence, the analyst provides the research report to various investment fund/institutional investors with the hope (expectation) that they will initiate a trade in the subject issuer and thereby generate trading commissions for the banking firm.
However, there are NO trading commissions to be made by the analyst’s employer if the analyst’s report covers an illiquid, smaller-cap company because, as explained in an earlier article, investment firms typically do not invest in illiquid, smaller-cap company stocks.
Since there is nil financial gain to the investment banking firm for the investment analyst to write a research report on smaller-cap companies, these research reports typically are not written. Rather, research reports ARE written on companies that have a higher likelihood of generating trading commissions, i.e., those with sufficient trading liquidity to attract investment firm capital.
It was said back in ancient times that “all roads lead to Rome.” For smaller-cap companies — all “roads” to attract investment firm capital require stock trading liquidity.
Not All Stock Investment Analysts are Created Equal
Naturally, an issuer wants to attract investment analysts to cover its stock to increase its stock trading liquidity and its stock price.
Beware: all investment analyst reports are NOT created equal!
Some say that the “buy” or “hold” recommendations issued by sell-side investment analysts are “skewed” to the positive for the purpose of pleasing the issuer about whom the analyst’s report is written. These critics note that approximately less than 7% of sell-side investment analyst ratings are “sell,” with the remainder being “buy” or “hold” or equivalent.
According to these critics, the investment analyst’s employer (typically an investment banking firm) wants to be hired (or continue to be hired) to perform corporate finance activities for the issuer (raising capital, mergers & acquisitions, etc.). They posit that a company is less likely to do business with an investment banking firm whose investment analyst recommends “sell” on its stock. Common sense suggests they are correct.
On the other hand, SEC Regulation AC requires that an investment analyst certify that the views expressed in the report accurately reflect the analyst’s personal views. Hence, an investment analyst’s report presumptively is free of the skewed bias alleged by critics. There is also a so-called “Chinese Wall” between an investment banking firm’s investment analyst department and the firm’s investment banking department to insulate the investment analysts from being influenced by the firm’s investment banking activities.
Commentators have differing views as to the efficacy of these regulatory safeguards.
Academics have studied the efficacy of investment analyst research. These academics have divided sell-side investment analysts into four categories.[3]
These four categories are:
Analysts affiliated with investment banking firms that had NOT done a corporate finance “deal” for the covered issuer within the past year.
Analysts that write research reports for a fee paid by the covered issuer.
Analysts affiliated with investment banking firms that HAD done a corporate finance “deal” for the covered issuer within the past year.
Reports issued by brokerage/independent research firms.
Not surprisingly, the study concluded that reports of analysts in category (1) were perceived as more credible to investors than the reports of analysts in category (3) and, hence, were more effective in increasing the covered issuer’s stock price and increasing the stock’s trading liquidity.
The reports of analysts in category (3) typically are viewed skeptically because the investment banking firm employer had done corporate finance work for the covered company within the prior year (and likely collected a hefty fee). No surprise here.
NOTE: I am NOT saying to reject the offer of an investment analyst report in category (3). If an issuer has the chance to obtain an investment analyst report, typically the issuer should take it.[4]
What does surprise many is that the study concluded that research reports written by investment analysts in category (2) were equally as effective in increasing stock price and stock trading liquidity as the reports of the so-called “unbiased” investment analysts in category (1).
This study’s conclusion is surprising to many because they have the preconception that reports written by analysts in category (2) will be viewed skeptically by investors because the issuer is paying for the report. For this reason, many CEOs and CFOs are hesitant to pay for investment analysts to write a report on their companies. In the face of this academic research, perhaps they should reconsider!
The research reports of firms in category (4) were determined to be equally as ineffective as the research reports in category (3).
There are several firms in category (2) who provide “paid for” investment analyst research reports. They can be located via Internet search. If you contact me through LinkedIn, I can introduce you to some I am aware of.
Next up: How does a company WITHOUT investment analyst coverage obtain such coverage?
What can a company do to increase the trading liquidity of its stock?
The next article discusses increasing your company’s stock trading liquidity with the assistance of an investor relations firm.
[1] This is a “truism” well-documented by a number of sources, including on pages 37 – 38 of the US Treasury 2017 Capital Markets Report available at this link.
[2] An investment analyst will often initiate coverage on a company for whom the analyst’s investment banking firm employer has raised capital or performed other corporate finance activity. As illuminated below, reports of these analysts are often viewed skeptically by investors.
[3] “The First Analyst Coverage of Neglected Stocks, Cem Demiroglu, Michael Ryngaert (2010). The study’s conclusions appear on pages 555 – 558 and 581 – 582.
[4] The reasons are beyond the scope of this article.
Mr. Woessner mentors, advises, and raises capital for companies in the start-up and smaller-cap company ecosphere. He also advocates in Washington DC for policies that create a more hospitable public company environment for smaller-cap companies, enhance capital formation, support small business, promote entrepreneurship, and increase upward mobility for all Americans, particularly minorities. For more information on Mr. Woessner’s background, see the link here.
SEC Provides Enforcement Driven Guidance On Digital Asset Issuances And Trading
On November 16, 2018, the SEC settled two actions involving cryptocurrency offerings which settlement requires the registration of the digital assets. On the same day, the SEC issued a public statement stating, “[T]hese two matters demonstrate that there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”
The two settled actions, CarrierEQ Inc., known as Airfox and Paragon Coin Inc., both involved an unregistered issuance of a cryptocurrency. In its statement the SEC highlighted three other recent settled actions involving digital assets and, in particular, the actions involving Crypto Asset Management, TokenLot and EtherDelta. The three additional cases involved investment vehicles investing in digital assets and the providing of investment advice, and secondary market trading of digital asset securities.
The SEC has developed a consistent mantra declaring both support for technological innovation while emphasizing the requirement to “adhere to [our] well-established and well-functioning federal securities law framework…” However, as Commissioner Hester Peirce has pointed out in her speeches, the current federal securities law may not be the best framework for the regulation of digital asset securities and their secondary trading. Although the overall purpose and structure of the Securities Act of 1933 (“Securities Act”) and its implementing rules, including the idea that the offer and sale of securities must either be registered or issued under an available exemption, and that investors are entitled to disclosure, may be appropriate, the granular requirements under the Act need to be updated to encompass new technology including blockchain and digital assets. Likewise, and maybe even more so, the broker-dealer, ATS and national exchange registration requirements, and the reporting requirement of issuers found in the Securities Exchange Act of 1934 (“Exchange Act”) and its implementing rules, need to be reviewed and updated.
Airfox and Paragon Coin Inc. – Offers and Sales of Digital Asset Securities
The SEC has brought many actions related to the offers and sales of digital assets – some before, and many after, the issuance of its Section 21(a) Report related to the offer and sale of tokens by the DAO. The Section 21(a) Report clearly laid out that a determination of whether a digital asset is a security requires an analysis using the Howey test as set out in the U.S. Supreme Court case SEC v. W. J. Howey Co. In various speeches and public statements following that Report, SEC officials, including Chair Jay Clayton, expressed their views that pretty well all ICOs to date involved the offer and sale of a security and, unfortunately, many had not complied with the federal securities laws. A slew of enforcement proceedings followed and a shift in the ICO craze to a more compliant securities token offering (STO) resulted.
However, to date, STOs have relied on registration exemptions, such as Regulation D, in their offerings rather than registration under the Securities Act. When registering an issuance under the Securities Act, an issuer must comply with the full disclosure obligations under Regulations S-K and S-X. This has proven challenging for both issuers and the SEC when the security being registered is a digital asset. Among the numerous issues to figure out have been providing a wallet to recipients, the custody of digital securities, the maintenance of a registrar and transfer agent duties, the lack of a licensed operational secondary market, cybersecurity issues, programming the digital security for the myriad of rights it may have (analogous to common stock, or completely different such that it could morph into a utility), selling and distribution methods, and the numerous issues with accepting other digital assets or cryptocurrencies as payment for the registered securities token.
If a placement agent or underwriter is involved, that placement agent or underwriter must not only resolve all of these matters, but additional issues such as escrow provisions, KYC and AML matters and even their own compensation, which typically involves not only cash, but payment in the security being sold either directly or through convertible instruments such as warrants.
These issues have not only added cost to a registration process, but time as well. The SEC has unapologetically informed registrants that the process would not follow the usual comment review timeline. Yet time has been beneficial to the entire industry as the SEC has continued to make efforts to educate its staff and figure out how to help companies successfully register digital securities. At the American Bar Association’s fall meeting in November, SEC Division of Corporation Finance (“Corp Fin”) Director, William Hinman, remarked that about half a dozen ICO S-1’s and a dozen ICO Regulation A+ filings are currently being reviewed by Corp Fin on a confidential basis.
Unlike a registration for the issuance and sale of specified securities, a registration statement under the Exchange Act registers a class of securities and thereafter makes the registrant subject to ongoing reporting requirements. Registration under the Exchange Act provides information about a company and its securities but does not involve an issuance of a security and therefore does not contain disclosures related to offers, sales, issuances, plans of distribution and the like. A registration under the Exchange Act (i.e., a Form 10) is slightly more robust than an annual report on Form 10-K and much less robust than a registration statement under the Securities Act. Although subject to some comment and review, a Form 10 registration statement automatically goes effective 60 days following the date of filing.
In the AirFox and Paragon Coin settlements, the SEC is requiring both companies to file registration statements on Form 10 to register their class of tokens under the Exchange Act. Both companies will thereafter have to file periodic reports with the SEC, including quarterly Forms 10-Q with reviewed financial statements, an annual Form 10-K with audited financial statements and interim Forms 8-K upon certain triggering events. Furthermore, the companies will be subject to the proxy rules under Section 14 of the Exchange Act and insider filing and related requirements under Sections 13 and 16 of the Exchange Act. The settlement also included penalties and an agreement to compensate an investors who elect to make a claim. Interestingly, in its statement, the SEC indicates that “[T]he registration undertakings are designed to ensure that investors receive the type of information they would have received had these issuers complied with the registration provisions of the Securities Act of 1933 (“Securities Act”) prior to the offer and sale of tokens in their respective ICOs.” As described above, I don’t really agree with the statement, but I do agree that the ongoing disclosure will provide information to investors in deciding whether to seek reimbursement or continue to hold their tokens.
Investment Vehicles Investing in Digital Assets
The Investment Company Act of 1940 (“Investment Company Act”) establishes a registration and regulatory framework for pooled vehicles that invest in securities. This framework applies to a pooled investment vehicle, and its service providers, even when the securities in which it invests are digital asset securities. There are several exemptions for private pooled investment funds with Section 3(c)(1) (a fund with less than 100 investors) and 3(c)(7) (a fund with only “qualified purchasers”) being the most commonly utilized. Both exemptions prohibit the fund from making a public offering of its securities. In fact, there are no Investment Company Act exemptions where a company has engaged in a public offering. Separately, the Investment Advisors Act of 1940 (“Advisors Act”) requires the registration of managers and advisors to investment companies.
On Sept. 11, 2018, the SEC issued a settlement Order in the case involving the Crypto Asset Management LP and its principal Timothy Enneking, finding that the manager of a hedge fund formed for the purpose of investing in digital assets had improperly failed to register the fund as an investment company. The Order found that the manager engaged in an unlawful, unregistered, non-exempt, public offering of the fund. The Order also found that the fund was an investment company, and that it had engaged in a public offering of interests in the fund and thus no exemption was available. The Order additionally found that the fund’s manager was an investment adviser, and that the manager had violated the antifraud provisions of the Advisers Act by making misleading statements to investors in the fund.
This case is interesting because it provided the SEC with an opportunity to make a public announcement and provide enforcement-related guidance under the Investment Company Act and Investment Advisors Act related to digital assets for the first time. Although the Investment Company Act does not allow for an exemption where there is a public offering of securities, it does allow exempted funds to utilize Regulation D, Rule 506(c) which, in turn, allows for general solicitation and advertising. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company.
In a 506(c) offering, it is not enough for the investor to check a box confirming that they are accredited. Generally speaking, an offering that allows for general solicitation and advertising is considered a public offering (see HERE for more information). However, in a securities law nuance, the legislation implementing Rule 506(c) specifies that if all of the requirements of Rule 506(c) are satisfied, the offering will not be deemed a public offering under the Investment Company Act (see HERE).
The Crypto Asset Management LP made a mistake in that it engaged in general solicitation and advertising, but did not comply with Rule 506(c) by ensuring that all investors were accredited and verifying accredited status. This mistake gave the SEC the opportunity to issue a statement that “[I]nvestment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act and the Advisers Act.”
Trading of Digital Asset Securities
The SEC has brought multiple enforcement actions and has made public statements related to the secondary trading of digital assets, including the requirement to register as a national securities exchange or be exempt from such registration such as by operating as a broker-dealer ATS (see HERE). To date, although several broker-dealers are registered as an ATS, there is no operational secondary securities digital asset market place. In addition to SEC registration, broker-dealers must be members of FINRA, who regulates specific operations, including related to an ATS (see HERE and HERE).
The SEC’s recent enforcement action against the founder of EtherDelta, a platform facilitating the trading of digital assets securities, underscored the SEC’s Division of Trading and Markets’ ongoing concerns about the failure of platforms that facilitate trading in digital asset securities to register with the SEC or operate under a proper exemption from registration. According to the SEC’s order, EtherDelta, which was not registered with the SEC in any capacity, provided a marketplace for bringing together buyers and sellers for digital asset securities through the combined use of an order book, a website that displayed orders, and a smart contract run on the Ethereum blockchain. EtherDelta’s smart contract was coded to, among other things, validate order messages, confirm the terms and conditions of orders, execute paired orders, and direct the distributed ledger to be updated to reflect a trade. The SEC found that EtherDelta’s activities clearly fell within the definition of an exchange.
An analysis as to whether an entity is operating as an exchange requires a substance-over-form facts-and-circumstances review, regardless of terminology used by the operator. For example, if a system “brings together orders of buyer and sellers” – if, for example, it displays, or otherwise represents, trading interest entered on a system to users or if the system receives users’ orders centrally for future processing and execution – it is likely an exchange. Likewise, a system that uses non-discretionary methods to facilitate trades or bring together and execute orders, may fall within the definition of an exchange.
Even if an entity is not operating as an exchange, or would not require a full ATS license, it may be required to register as a broker-dealer. Entities that facilitate the issuance of digital asset securities or their secondary trading may be required to register as a broker-dealer. Section 15(a) of the Exchange Act provides that, absent an exception or exemption, it is unlawful for any broker or dealer to induce or attempt to induce the purchase or sale of any security unless such broker or dealer is registered in accordance with Section 15(b) of the Exchange Act. Section 3(a)(4) of the Exchange Act generally defines a “broker” to mean any person engaged in the business of effecting transactions in securities for the account of others. Section 3(a)(5) of the Exchange Act generally defines a “dealer” to mean any person engaged in the business of buying and selling securities for such person’s own account through a broker or otherwise. As with the “exchange” determination, a substance-over-form analysis must be applied to assess whether an entity meets the definition of a broker or dealer, regardless of how an entity may characterize either itself or the particular activities or technology used to provide the services.
Further Reading on DLT/Blockchain and ICOs
For a review of the 2014 case against BTC Trading Corp. for acting as an unlicensed broker-dealer for operating a bitcoin trading platform, see HERE.
For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.
For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICOs, see HERE.
For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICOs and accounting implications, see HERE;
For an update on state-distributed ledger technology and blockchain regulations, see HERE.
For a summary of the SEC and NASAA statements on ICOs and updates on enforcement proceedings as of January 2018, see HERE.
For a summary of the SEC and CFTC joint statements on cryptocurrencies, including The Wall Street Journal op-ed article and information on the International Organization of Securities Commissions statement and warning on ICOs, see HERE.
For a review of the CFTC’s role and position on cryptocurrencies, see HERE.
For a summary of the SEC and CFTC testimony to the United States Senate Committee on Banking Housing and Urban Affairs hearing on “Virtual Currencies: The Oversight Role of the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission,” see HERE.
To learn about SAFTs and the issues with the SAFT investment structure, see HERE.
To learn about the SEC’s position and concerns with crypto-related funds and ETFs, see HERE.
For more information on the SEC’s statements on online trading platforms for cryptocurrencies and more thoughts on the uncertainty and the need for even further guidance in this space, see HERE.
For a discussion of William Hinman’s speech related to ether and bitcoin and guidance in cryptocurrencies in general, see HERE.
For a review of FinCEN’s role in cryptocurrency offerings and money transmitter businesses, see HERE.
For a review of Wyoming’s blockchain legislation, see HERE.
For a review of FINRA’s request for public comment on FinTech in general and blockchain, see HERE.
For my three-part case study on securities tokens, including a discussion of bounty programs and dividend or airdrop offerings, see HERE; HERE; and HERE.
For a summary of three recent speeches by SEC Commissioner Hester Peirce, including her views on crypto and blockchain, and the SEC’s denial of a crypto-related fund or ETF, see HERE.
Mr. Woessner mentors, advises, and raises capital for companies in the start-up and smaller-cap company ecosphere. He also advocates in Washington DC for policies that create a more hospitable public company environment for smaller-cap companies, enhance capital formation, support small business, promote entrepreneurship, and increase upward mobility for all Americans, particularly minorities. For more information on Mr. Woessner’s background, see this link.
Ronald WoessnerThis is a reprint of an article originally published by equities.com here.
This article discusses public policy recommendations to encourage companies to go public. These recommendations appeared in an article[1] authored by scholars at the prestigious Harvard Kennedy School (“HKS”) and published earlier this year.
Before examining these recommendations, let’s review the benefits of being a public company.
The benefits[2] of being a public company typically include
Obtaining a source of permanent capital, usually at a cost lower than other alternatives,
Providing early-stage investors an exit, allowing them to reallocate their capital and talent to other ventures,
Attracting and retaining employees by providing equity-based compensation in the form of options and stock grants and an opportunity to monetize this equity by selling into the public market,
Providing a stock “currency” that can be used for acquisitions.
While these benefits are, in theory, available to all public companies, as a practical matter these benefits are NOT available to the estimated 40% of smaller-cap NASDAQ issuers and the estimated 95+% of smaller-cap OTC-traded companies whose stocks are illiquid. These benefits are NOT available because:
Investment firms are typically reluctant to invest in a company with an illiquid stock,
If a company’s stock is illiquid, it is difficult for early investors to exit their investment position by selling shares in the open market,
Equity-based compensation has little value to an employee if the employee is not readily able to convert the equity into cash by selling the equity in the open market,
The shareholders of an acquisition target are typically unwilling to accept the acquiring company’s shares rather than cash as the “deal” consideration if they are unable to readily “monetize” most if not all of the shares by selling them in the open market.
Point being: smaller-cap companies with illiquid stocks are incurring the burdens of public company status and receiving NONE of the benefits. It’s no surprise that they are avoiding the public markets as illuminated in an earlier article of mine. As noted in this article, the disappearance of the smaller IPO (< $50M – $100M) is virtually 100% responsible for the declining number of public companies in America.
See below the FOUR Harvard Kennedy School Policy Recommendations to encourage more smaller-cap companies to go public.
Increase the Threshold for Eligibility as a Smaller-Reporting Company and Non-Accelerated Filer
Companies that have more than $75M in market cap are required to file their quarterly and annual disclosure reports within 45 days and 75 days, respectively, of the end of the reporting period. They are also required to comply with Sarbanes-Oxley (“SOX”) Section 404(b), which requires an auditor attestation of the effectiveness of the company’s internal controls – this attestation is a major cost for small companies.
The HKS Policy Recommendation is to increase the $75M threshold to a materially higher number. A company with a market cap of only $75M is a TINY company by capital market standards. An issuer typically is not considered even to be a “small-cap” company until it has a market cap of $300M (and some say not until its market cap is $500M). Increasing the threshold would provide these tiny companies additional time to prepare their quarterly and annual filings. It would also exempt them from complying with the expensive SOX 404(b) internal control auditor attestation. SEC Chairman Jay Clayton has directed the SEC staff to consider increasing the $75M threshold.[3]
Extend to 10 Years the Emerging Growth Company “On-Ramp” Exemption.
“Emerging growth companies” (“EGC”) who “go public” are currently permitted to operate for five years under lighter disclosure regulations, including NOT being required to comply with the SOX 404(b) internal control auditor attestation.[4]
The HKS Policy Recommendation is to extend from five years to 10 years the lighter disclosure period. Increasing the five-year “on-ramp” to 10 years provides EGC companies contemplating an IPO more confidence that they will have sufficient time to meet the enhanced regulatory requirements after becoming public.
H.R. 1645, the “Fostering Innovation Act” included in the JOBS 3.0 legislation approved by the House of Representatives earlier this year (but not yet approved by the Senate), extends the lighter disclosure period to 10 years.
Increase the Shareholding Required to Demand Inclusion of Shareholder Proposals in Proxy Statements.
Current law permits a shareholder who owns as little as $2,000 of a company’s stock to demand that the company include the shareholder’s proposals for vote in the company’s proxy statement for the company’s annual shareholder meeting.[5] The $2,000 shareholding amount was created more than 30 years ago and is not fit for the present day.
Shareholder proposals consume significant time and company resources to deal with, yet they cost almost nothing for shareholders to submit. A Manhattan Institute study found that in 2016, one-third of all shareholder proposals were brought by just six individual investors. This suggests that the proposals are being instigated by activist investors to promote social policy agendas, rather than to effect a bona-fide corporate governance purpose. Moreover, a proponent is allowed to resubmit a proposal on multiple occasions even if the proposal was previously rejected by a vast majority of shareholders.
The HKS Policy Recommendation is to increase the shareholder ownership requirement to a more meaningful number.
Require Mandatory Arbitration of Shareholder Claims
The fourth and final HKS Policy Recommendation is to allow companies to mandate arbitration of shareholder disputes by including such provisions in their governing documents. Companies with shareholder dispute mandatory arbitration provisions typically are NOT permitted to list on NASDAQ or NYSE.
The current system of shareholder class-action litigation is viewed by many as a mechanism to redistribute wealth from the insurance carriers, on the one hand, to the plaintiff and defense securities bar, on the other hand. Public companies and their insurers paid $55.6 billion in shareholder class-action settlements in the last 10 years.
In 2016, plaintiff’s attorneys received $1.27 billion in fees and expenses from such cases, out of the $6.4 billion in settlements.[6] Defense attorneys collect substantial fees and expenses to defend these claims as well. Very rarely, if ever, do these cases proceed to trial and they are typically settled (which enables the plaintiffs’ attorneys and defense attorneys to collect hefty fees) within the insurance policy limits.
One metric that illuminates the plaintiff attorneys’ “shakedown” character of many of these lawsuits is the frequency with which three law firms file shareholder class action lawsuits. These three law firms in 2016 filed 66% of the shareholder class action lawsuits and filed over 50% of the lawsuits during 2014 – 2017.[7] In 2016, these three firms were appointed lead counsel 36% of the time.[8]
Another metric that illuminates the “shakedown” character of many of these lawsuits is the “algorithmic” calculation of the anticipated settlement amounts. The chart below shows the predicted settlement amount as a percentage of the claimed damages amounts:[9]
The plaintiffs’ law firms know these predicted settlement amounts before they file their lawsuits – hence, they can predict before filing the suit to a reasonable degree of certainty their estimated fees once the case settles – which as noted above, virtually all of them do.
Since 2006, the Committee on Capital Markets Regulation has urged the SEC to allow corporations to include in their charters a provision requiring mandatory arbitration of issuer-stockholder disputes. [10] Former SEC Commissioner Michael Piwowar in July 2017 endorsed this as well.
The HKS Policy Recommendation is to permit companies to require that shareholder class action litigation be settled via arbitration, rather than litigation.
With arbitration, these matters can be resolved quicker and less expensively. Also, arbitration is seen as a mechanism to discourage specious or flimsy claims from being brought in the first instance – often only for the purpose of obtaining quick cash settlement from companies (and their insurers) who want to avoid the cost and management distraction of the litigation.
These were the FOUR HKS Policy Recommendations to encourage more companies to go public. While excellent suggestions, they do NOT address the root cause of the inhospitality of the public markets to smaller-cap companies.
Stay-tuned for a completely NEW policy recommendation, credited to David Weild IV, who is widely reported as being the “Father of JOBS Act 1.0,” to combat the “disappearing US public company” phenomena. This NEWpolicy recommendation will be illuminated in a subsequent article.
Mr. Woessner mentors, advises, and raises capital for companies in the start-up and smaller-cap company ecosphere. He also advocates in Washington DC for policies to help smaller-cap companies access capital and for policies that create a more hospitable public company environment for them. See here for more information on Mr. Woessner’s background.
[4] This is one of the provisions of the so-called 2012 “JOBS 1.0” law.87% of all IPOs since the enactment of JOBS 1.0 have been identified as emerging growth companies.
[5] If the company determines NOT to include the proposal, then the company is required to justify its decision.
US public companies are disappearing! This trend is 100% opposite the trend in other developed countries with similar institutions and economic development.
Many private companies avoid going public, preferring instead to “exit” their investment by selling the company, or hold off going public as long as they can.
This trend is causing US public companies to disappear. For example, US public company listings decreased over the last two decades by about 46%, from 8,090 in 1996 to 4,331 in 2016, according to a 2018 academic study from the Harvard Kennedy School.[1]
Conversely, public company listings increased by about 48% in other developed countries over a comparable period, according to another academic study in 2015. According to that study, the US “should have had” approximately 9,500 public companies in 2012, resulting in an estimated “listing gap” of approximately 5,400 companies as of 2012. The listing gap is undoubtedly higher today.
This disappearing public company trend has profoundly negative consequences for US job growth. A March 2011 report from the Department of the Treasury’s “IPO Task Force” determined that 92% of the job growth among companies who had gone public occurred after the company’s IPO.
Another negative consequence of the disappearing public company is that as public companies disappear, there are fewer public companies for mutual funds (Vanguard, Fidelity, etc.), pension funds, and the like to invest in. If current trends continue, the “S&P 500” will become the “S&P 250.”
Moreover, not only does staying private thwart US job growth, it deprives mom-and-pop “Main Street” investors of opportunities to invest at the early stage of a business and reap significant gains in value during the business’ early, private years.
To wit, Uber and AirBnB are two well-known companies that have not yet gone public and whose investors (principally Silicon Valley and Wall Street investment firms and high-net worth individuals) are poised to make HUGE sums of money on their investments. In this regard, note the recent news reports that Uber’s proposed IPO market valuation is $120 BILLION. “Main Street” investors will made ZERO from the success of these (and similar) venture capital funded companies because these investment opportunities and similar ones are not made available to them. This statement is not a criticism of the investors who stand to make an enormous amount of money (after all they took a risk with their money and are entitled to a return) – it is simply a statement of fact.
As a counterweight to this trend of income being redistributed to Silicon Valley and Wall Street investment firms and high-net worth individuals, SEC Chairman Jay Clayton wants to let more “Main Street” investors participate in private deals. Within recent months he was quoted in The Wall Street Journal as saying:
Many companies have shunned the public markets in favor of private investors,
Regulators have for decades typically walled off most private deals from smaller investors, who must meet stringent income and net worth requirements to participate,
The SEC is now weighing a major overhaul of rules intended to protect mom-and-pop investors, with the goal of opening up new investment options for them.
We thank Chairman Clayton for recognizing the need for SEC policies that permit more Main Street investors to invest in private deals. But — permitting more Main Street investors to invest in privatedeals does NOT fix the problem of the declining number of US public companies.
CAUSES OF THE “DISAPPEARING” US PUBLIC COMPANY
So, what is behind the precipitous fall in the numbers of US public companies over the past decades? The following factors have played a significant role in this alarming trend:
More and more companies are turning to the private markets for their capital needs. According to a 2017 Report by the Department of the Treasury, from 2012 through 2016, the debt and equity capital raised through private offerings was 26% higher than that raised through the public markets.
Smaller-cap companies are not going public. The small (less than $50M – $100M) IPO has practically disappeared. The number of small IPOs averaged 401 in the 1990s, but then dropped to only 105 annually in the 18 years since. In the 1990s, small IPOs comprised 27% of capital raised in the public markets, whereas in the period from 2000 to present they have comprised only 7% of all capital raised. In fact, research shows that the collapse of the smaller IPOs is ~100% responsible for the listing gap between the current number of US public companies and the number of public companies the US “should have.”
Why are smaller-cap companies not going public or delaying going public until they are larger-cap companies? Answer: because the public company ecosphere is “inhospitable” to smaller-cap public companies, as evidenced by the below:o Regulatory requirements of Sarbanes – Oxley and Dodd-Frank are burdensome
o Smaller-cap companies are vulnerable to “bear raid” attacks by short sellers
o There is little to no sell-side investment analyst coverage
o Buy-side investing trends have changed whereby retail investors are moving to mutual funds, rather than investing in individual stocks
o The threat of class-action lawsuits is a deterrent
o The public company reporting (Form 10Q, 10K, 8K) requirement is a deterrent
As if the preceding reasons were not deleterious enough: public markets also are inhospitable to smaller-cap companies for the following reason: once publicly-traded, the stocks of many smaller-cap companies are likely to be illiquid[2]; and for companies with an illiquid stock, it is virtually impossible to raise non-toxic capital from investment firms because investment firms are reluctant to invest in smaller-cap, illiquid stocks.[3]
Private company CEOs and CFOs look at all of these in-hospitability factors and determine they simply don’t want to be a public company.
Despite the foregoing, smaller-cap companies can thrive in the public markets. If you are a CEO or CFO of a smaller-cap company with an illiquid stock and your company is struggling to raise non-toxic capital => don’t despair! A subsequent article will provide you specific, actionable recommendations for increasing your company’s stock liquidity.
Subsequent articles will also unveil a policy solution that, if implemented, will reverse the trend of The “Disappearing” US Public Company!
[2] According to a 2018 SEC study of thinly-traded securities, 3,500 of 8,700 NMS-traded securities had a dismal, median average daily volume of < 50,000 shares per day.The trading volumes of OTC-traded stocks are even more dismal. A subsequent article will provide more detail regarding these dismal trading volumes.
[3] Lack of trading liquidity makes it virtually impossible for investment firms initially to invest through the open market without affecting the stock price – similarly, lack of liquidity makes it virtually impossible for them to exit an investment position through the open market. See an earlier article here that addresses this topic in more detail.
This is a reprint of an article by Mr. Woessner published on December 12, 2018 by equities.com at this link.
Mr. Woessner mentors, advises, and helps raise capital for companies in the start-up and smaller-cap company ecosphere. He also advocates for policies to help smaller-cap companies access capital and for policies that create a more hospitable public company environment for them. For more information on Mr. Woessner’s background, see https://www.linkedin.com/in/ronald-woessner-3645041a/.
This article explains how Dodd-Frank crushed the ability of publicly-held[1], smaller-cap companies to raise capital. The unintended consequences of government regulation on the financial markets has taken a disproportionate toll on the small-cap market for decades, and has transformed what once was a vibrant, robust driver of the economy into a shell of its former self. Dodd-Frank has exacerbated this problem, further stifling emerging growth opportunities for startups and small-cap companies by restricting their access to capital, resulting in an increasingly top-heavy market.
The chart below, excerpted from an article by noted financial analyst Michael Markowski, who predicted the demise of Lehman, Bear Stearns and Merrill Lynch, illustrates that the Dodd-Frank legislation crushed the valuations of smaller-cap companies, in addition to dampening economic growth, creating higher unemployment and its many other documented harms to the US economy.
This in turn crushed the ability of smaller-cap companies to raise capital and obtain funding from sources other than Founders and Friends & Family investors.
The crushing of smaller-cap company valuations by Dodd-Frank led to other consequences for this asset class, and resulted in investment firms becoming more unwilling to invest in smaller cap companies.
To illuminate those steps smaller-cap companies can take to create access to investment firm capital in this ecosphere (which will be discussed in subsequent articles(, we first must understand the specific challenges these companies are facing under Dodd-Frank.
Why It Is Difficult for Smaller-Cap Companies to Raise Capital
Here are the typical sources of investment capital for start-up/emerging companies:
Personal Loans/Credit of Founders – fund 57% of start-ups
Friends & Family – fund 38%
Venture Capital Funds – fund .05%
Angel Investors – fund .91%
“JOBS 1.0 Act” Crowdfunding – not yet a significant capital source
As can be seen, venture capital funds and angel investors fund less than 1% of start-up/emerging companies in the US. Hence, unless your company is one of those companies that fits the specific company profile that venture capital firms or angel investors are seeking, your chances of raising capital from a venture capital firm or angel investor approach ZERO.
Rather, as the metrics above reveal, “Personal Loans/Credit of Founders” and “Friends & Family” provide the preponderance of capital for start-up/emerging companies. Of course, the capital of Founders and Friends & Family can become “tapped out” as not many of us entrepreneurs are wealthy or are fortunate enough to have wealthy friends willing to invest material amounts of capital in our business ventures.
As these capital sources become “tapped” out, our companies need to attract alternate sources of capital, such as investment firms (including family offices). Access to these alternate sources of capital is needed for our start-up/emerging companies to thrive or even survive.
Unfortunately, unless your business operates in a “hot sector,” such as biotech, cannabis, digital currency or whatever the hot sector trend happens to be during the market cycle when you are seeking capital, investment firms typically will not invest in your start-up/emerging ventures for a number of reasons.
One reason is because investment firms want to invest in asset classes that are increasing in value, and not those decreasing in value. Yet, the valuations of these companies have been crushed by Dodd-Frank, as previously noted. This creates a death spiral scenario for companies of this type.
Common sense informs us that since smaller-cap company valuations have decreased in value relative to other asset classes, it will be more difficult for smaller-cap companies to attract investment firm capital.
Further, this Dodd-Frank crushing of smaller-cap company valuations has not only crushed the ability of smaller-cap companies to raise capital it has also virtually killed the stock trading liquidity (i.e., number of shares traded daily through the public markets) of the smaller-cap company market segmentThis has created a downward “death spiral” of the trading price and trading volume for many publicly-traded smaller-cap company stocksThis downward “death” spiral looks like this
If the value of an asset class has been crushed — as DF has done to smaller-cap company shares — relative to alternative asset classes, there is less demand for that asset class
Less demand results in a lower trading volume
Lower trading volume results in a lower price (Economics 101: law of supply/demand)
Lower price s then leads to lower trading volume, which results in lower prices , which results in a lower trading volumes, and so forth as the death spiral cycle repeats
This vicious downward “death spiral” ensues in both stock price and trading volume.
Lower Trading Volume then results in ZERO Institutional Investment
Investment firms typically are unwilling to invest in companies that have low trading volumes.
Why?
See below for an investment firm’s calculus relating to its evaluation of potential investment candidates, which illuminates why investment firms typically are unwilling to invest in smaller-cap company stocks:
The amount invested must be sizeable enough to “matter” for the investment firm
Let’s assume $2 million in capital is to be invested by the investment firm
The firm typically seeks to complete its investment within one month (20 trading days)
$2 million to be invested, divided by 20 trading days = $100,000 per day invested
The firm typically does not want its stock purchases to drive up the stock trading price, which would result in the firm’s paying more for the stock, so it typically seeks to limit its purchases to < 10 – 15% of daily trading volume so as not to drive up the stock price
To invest $100,000 per day within the 10 – 15% parameter means there must be a daily trading volume of between $667,000 – $1 million
Moreover, even if the investment firm is able to take an investment position in the stock, they will be concerned they cannot readily exit their investment position. Some have used the “Hotel California” metaphor: “You can check out any time you like, But you can never leave!”
Bottom line: companies WITHOUT the requisite trading volume will NOT receive investments from investment firms, regardless of how much the firm might otherwise like the company.
Former institutional small-cap investor Adam J. Epstein has written a book, The Perfect Corporate Board: A Handbook for Mastering the Unique Challenges of Small-Cap Companies, available on Amazon at this link, which has a more fulsome discussion of this topic.
Summary
In sum, Dodd-Frank’s killing of stock trading volumes of smaller-cap public companies has made it virtually impossible for many of them to raise investment firm capital, which cripples or even kills the company because as noted above, once a smaller-cap company runs out of Founder and Friends/Family money, they have virtually no where to go for capital.
But all is not lost – my subsequent articles will illuminate what can be done to overcome the effect of Dodd-Frank!
[1] While the focus of this article and others is this series is publicly-held, smaller-cap companies, many of the same principles apply to private companies.
This is a reprint of an article by Mr. Woessner published on December 4, 2018 by equities.com at this link.
Mr. Woessner mentors, advises, and helps raise capital for companies in the start-up and smaller-cap company ecosphere. He also advocates for policies to help smaller-cap companies access capital and for policies that create a more hospitable public company environment for them. For more information on Mr. Woessner’s background, see https://www.linkedin.com/in/ronald-woessner-3645041a/.
See below for an article by Cromwell Coulson, President, CEO and Director of OTC Markets Group, regarding “Understanding Short Sale Activity.”
Quality data is essential to well-functioning markets. Improving the availability, relevance and usefulness of data aligns with OTC Market Group’s mission to create better informed, more efficient financial markets. In our experience, short selling remains one of the most highly-debated topics among academics, companies, investors, market makers and broker-dealers. As a market operator and company CEO, I believe it’s critical to address the misconceptions that still exist around short sale data and the correlation to a stock’s fundamental value.
Short selling, the sale of a security that the seller does not own, has long been a controversial practice in public markets. Advocates for short selling believe it builds price efficiency, enhances liquidity and helps improve the public markets, while critics are concerned that it can facilitate illegal market manipulation and is detrimental to investors and public companies. Given the diverse range of opinions and opposing views, we believe the first step is to take a deeper dive into the data and help separate out the noise.
“The Reliable” – FINRA Equity Short Interest Data
The most accurate measure of short selling is the data reported by all broker-dealers to FINRA on a bi-weekly basis. These numbers reflect the total number of shares in the security sold short, i.e. the sum of all firm and customer accounts that have short positions.
This information is available on www.otcmarkets.com on the company quote pages. As an example, OTC Markets Group has a few hundred shares sold short on average, which represents a fraction of our daily trading volume and shares outstanding.
OTC Markets Group (OTCQX: OTCM) SHORT INTEREST Data
DATE
SHORT INTEREST
PERCENTAGE CHANGE
AVG. DAILY SHARE VOL
DAYS TO COVER
SPLIT
NEW ISSUE
9/28/2018
97
11.49
5,551
1
No
No
9/14/2018
87
8.75
4,423
1
No
No
8/31/2018
80
100.00
6,818
1
No
No
7/31/2018
103
-48.24
3,197
1
No
No
7/13/2018
199
-27.64
2,124
1
No
No
6/29/2018
275
166.99
3,239
1
No
No
6/15/2018
103
24.10
2,739
1
No
No
5/31/2018
83
-72.33
3,925
1
No
No
5/15/2018
300
1.69
3,944
1
No
No
4/30/2018
295
100.00
4,278
1
No
No
FINRA Rule 4560 requires FINRA member firms to report their total short positions in all over-the-counter (“OTC”) equity securities that are reflected as short as of the settlement date. In 2012 FINRA clarified that firms must report short positions in each individual firm or customer account on a gross basis under FINRA Rule 4560. Therefore, firms that maintain positions in master/sub-accounts or parent/child accounts must calculate and report short interest based on the short position in each sub- or child account.
Since this data is part of a clearing firm’s books and records, it is of high quality and FINRA regularly inspects broker-dealer compliance with the rule. Of course, it would be great if this data was collected and published daily (with an appropriate delay).
“The Misleading” – Daily Short Volume
In contrast, the most frequently misinterpreted data is the Daily Short Volume, sometimes referred to as Naked Short Interest. This data shows the percentage of published trade reports (called media transactions in FINRA Rules) that were marked short. As an example, the recent data for OTC Markets Group shows that up to 90% of the trading volume comes from short
selling on some days. If we did not carefully track our bi-weekly Short Interest, we could easily be led to believe that short selling is rampant in our stock.
Historical Short Volume Data for OTC Markets Group (OTCQX: OTCM)
DATE
VOLUME
SHORT VOLUME
PERCENTAGE of VOL SHORTED
Oct 18
3,341
1,399
41.87
Oct 17
5,989
3,198
53.40
Oct 16
16,120
7,509
46.58
Oct 15
24,155
12,991
53.78
Oct 12
6,297
4,914
78.04
Oct 11
4,059
1,553
38.26
Oct 10
2,185
999
45.72
Oct 9
7,473
4,556
60.97
Oct 5
880
525
59.66
Oct 4
492
200
40.65
Oct 3
2,041
801
39.25
Oct 2
4,786
1,560
32.60
Oct 1
3,973
2,607
65.62
Sep 28
244
23
9.43
Sep 27
882
805
91.27
Sep 26
259
189
72.97
Sep 25
3,085
2,250
72.93
Sep 24
967
571
59.05
Sep 21
2,350
825
35.11
Sep 20
7,164
6,453
90.08
Sep 19
297
202
68.01
Seeing the above data can be alarming for public companies and their investors, until they understand the inner workings of how dealer markets function and broker trades are reported—which render the data virtually meaningless.
Since this data also comes from FINRA, what gives? The daily short selling volume is misleading because market makers and principal trading firms report a large number of trades as short sales in positions that they quickly cover. For market makers with a customer order to sell, they will temporarily sell short (which gets published to the tape as a media transaction for public dissemination) and then immediately buy from their customer in a non-media transaction that is not publicly disseminated to avoid double counting share volumes. SEC guidance also mandates that almost all principal trading firms that provide liquidity at multiple price levels, or arbitrage international securities, must mark orders they enter as short, even though those firms might also have strategies that tend to flatten by end of day. Since the trade reporting process for market makers and principal trades makes the Daily Short Volume easily misleading, we do not display it on www.otcmarkets.com.
Making daily short reporting data easily-digestible and relevant is not hard. On the contrary, it should be easy to aggregate all of the short selling that is reported as agency trades, as well as all of the net sum of buying and selling by each market maker and principal trading firm. This would paint a clear picture for investors of overall daily short selling activity. Fixing the misleading daily short selling data would bring greater transparency and trust to the market.
“The Missing Piece”– Short Position Reporting by Large Investors
There is ample evidence that short selling contributes to efficient price formation, enhances liquidity and facilitates risk management. Experience shows that short sellers provide benefits to the overall market and investors in other important ways which include identifying and ferreting out instances of fraud and other misconduct taking place at public companies. That said, we
agree with the New York Stock Exchange and National Investor Relations Institute that there is a serious gap in the regulation of short sellers related to their disclosure obligations. We understand that well-functioning markets rely on powerful players who cannot be allowed to hide in the shadows. Since we require large investors, who accumulate long positions, to publicly disclose their holdings, why aren’t there disclosure obligations for large short sellers? This asymmetry deprives companies of insights into their trading activity and limits their ability to engage with investors. It also harms market functions and blocks investors from making meaningful investment decisions.
One point is clear, we all need to continue to work collaboratively with regulators to improve transparency, modernize regulations and provide investors with straightforward, understandable information about short selling activity. We want good public data sources that bring greater transparency to legal short selling activity as well as shine a light on manipulative activities. All while not restricting bona fide market makers from providing short-term trading liquidity that reduces volatility.
Cromwell Coulson
R. Cromwell Coulson – P resident, Chief Executive Officer and Director of OTC Markets Group(OTCQX:OTCM) R. Cromwell Coulson is President, CEO and a Director of OTC Markets Group, responsible for the company’s overall growth and strategic direction. Cromwell is a strong advocate of improving access to capital for small companies, supporting a diverse ecosystem of broker-dealers, and empowering investors with information. He has testified before Congress and spoken on these and other issues at numerous industry conferences. Cromwell is a former Chair (2017-2018) of the FINRA Market Regulation Committee that advises FINRA on rulemaking and trading issues. Prior to OTC Markets, Cromwell was an institutional trader and portfolio manager at Carr Securities Corporation. He holds an OPM from Harvard Business School and received his BBA from Southern Methodist University.
MONDAY, DECEMBER 10TH
On Monday, the House will meet at 12:00 p.m. for morning hour and 2:00 p.m. for legislative business. Votes will be postponed until 6:30 p.m.
One Minute Speeches
Legislation Considered Under Suspension of the Rules:
1) H.R. 5513 – Big Bear Land Exchange Act, as amended (Sponsored by Rep. Paul Cook / Natural Resources Committee)
2) H.R. 6108 – Preserving America’s Battlefields Act, as amended (Sponsored by Rep. Jody Hice / Natural Resources Committee)
3) H.R. 3008 – George W. Bush Childhood Home Study Act (Sponsored by Rep. Michael Conaway / Natural Resources Committee)
4) H.R. 6118 – To direct the Secretary of the Interior to annually designate at least one city in the United States as an American World War II Heritage City, and for other purposes, as amended (Sponsored by Rep. David Rouzer / Natural Resources Committee)
5) H.R. 6665 – Offshore Wind for Territories Act, as amended (Sponsored by Rep. Madeleine Bordallo / Natural Resources Committee)
6) H.Res. 792 – Urging the Secretary of the Interior to recognize the historical significance of Roberto Clemente’s place of death near Piñones in Loíza, Puerto Rico, by adding it to the National Register of Historic Places, as amended (Sponsored by Rep. José Serrano / Natural Resources Committee)
7) S. 245 – Indian Tribal Energy Development and Self-Determination Act Amendments of 2017 (Sponsored by Sen. John Hoeven / Natural Resources Committee)
8) S. 825 – Southeast Alaska Regional Health Consortium Land Transfer Act of 2017 (Sponsored by Sen. Lisa Murkowski / Natural Resources Committee)
9) S. 2511 – CENOTE Act of 2018, as amended (Sponsored by Sen. Roger Wicker / Natural Resources Committee)
10) H.R. 6893 – Secret Service Overtime Pay Extension Act, as amended (Sponsored by Rep. Steve Russell / Oversight and Government Reform Committee)
11) House Amendment to S. 2248 – Veterans Benefit and Transition Act of 2018 (Sponsored by Rep. Phil Roe / Veterans Affairs Committee)
Tom Ridge, former Secretary of the Department of Homeland Security, looks down on Sully, service dog to former President George H. W. Bush, who keeps watch over the casket of the former president in the Capitol Rotunda on Tuesday December 4, 2018.
Bob Dole, 95, is helped out of his wheelchair to salute the casket of fellow World War II veteran George H. W. Bush at the US Capitol rotunda on Tuesday, December 4, 2018. “A last, powerful gesture of respect from one member of the greatest generation … to another.” tweeted Bush’s spokesman Jim McGrath. Dole said Bush brought “wisdom,” and “incomparable patriotism” to the American people.
A state funeral was held Wednesday, December 5, 2018, for former president George H. W. Bush at the National Cathedral in Washington, D.C. Former president George W. Bush said of his father: “To us, he was the brightest of a 1,000 points of light.”
US public companies are disappearing! This trend is 100% opposite the trend in other developed countries with similar institutions and economic development.
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