The chart above, excerpted from an article by noted financial analyst Michael Markowski, who predicted the demise of Lehman, Bear Stearns and Merrill Lynch, appears to illustrate that the Dodd-Frank legislation crushed the values of smaller cap companies. Mr. Markowski’s article appears at this link: https://www.equities.com/news/dodd-frank-boon-for-large-caps-bust-for-micro-caps
Is this causation, or merely correlation? We don’t know for sure.
What we do know is that smaller cap public company valuations have diverged markedly from larger cap public company valuations, regardless of the proximate cause. As an investment asset class, they appear to have performed poorly.
Further, to add to the woes of the smaller cap public companies, we also know that the US public markets are generally* inhospitable to smaller cap companies. This inhospitability manifests itself as follows:
(1) Smaller-cap stocks are illiquid
(2) Institutional investors avoid investing in illiquid smaller cap stocks
(3) Smaller-cap companies have little-to-no investment analyst coverage
(4) Smaller-cap companies are starving for capital
(5) Much of the available capital to smaller-cap companies is “toxic”
(5) Gaps in SEC “short” selling regulations enable short sellers unfairly to damage smaller-cap company valuations and the companies themselves
We will review each of these elements of inhospitabililty in subsequent articles.
* Of course, there will be exceptions to the above general principles, particularly if the company is in the biotech or cannabis space.
Image: Amur leopard, a critically endangered species. Source:
World Wildlife Fund
According to a recent Forbes article, America ranks as the best
country for female entrepreneurship. That’s “good.” On the other
hand, the “bad” is that companies founded by women entrepreneurs are
less likely to be funded by a venture capital firm than the Earth being struck
by an asteroid, as I discussed previously in this space.
That’s “not so bad,” though. Women entrepreneurs are
not missing out on much by not being funded by venture capital firms =>
since venture capital firms fund only approximately five of every 10,000
startups in America, according to Entrepreneur.com.
The “worst,” news, however, is that women
entrepreneurs will join their male counterparts in struggling to raise capital
to keep their businesses alive because of the lack of investment capital for
start-up businesses in America as a whole.
This lack of investment capital for US start-up businesses is an
endemic problem. Like an invisible chain, it extends across the length and
breadth of the US and restrains an entire ecosystem, beginning with startups in
a garage, and extending to OTC Markets traded companies, and further extending
to smaller-cap publicly listed companies.
Without sufficient capital, these businesses fail.
Predictably, many would-be entrepreneurs decide to keep their
day jobs rather than taking the entrepreneurial leap when they see the
businesses of their friends, neighbors, or relatives go “out of business” and
the often-consequent loss of life savings and the family home.
With this background in mind, you might be thinking that fewer
and fewer Americans want to become entrepreneurs today than in previous years.
You are correct.
The data demonstrates that entrepreneurship in America is dying.
In February of this year, Mr. David Weild IV, “Father of JOBS Act
1.0,” former Vice Chairman of NASDAQ and New York investment banker, gave
a presentation at The Yale Club of NYC. The JOBS Act, signed into law by
President Obama in 2012, was a great start for the movement to level the
playing field for emerging growth companies, but even Mr. Weild will tell you
that more needs to be done.
The presentation included a “heat” map, derived from
Census Bureau statistics of US business formations by state per capita. The
heat map shows business startups by state, per capita, in 2006 versus 2017. In
2006, the map shows much of the US as dark red, connoting high numbers of
startups per capita. Disturbingly, in 2017, the map shows much of the US as
pale pink, connoting a paucity of startups.
Business Formations within 4 Quarters by State – Per 1,000
People
And, while entrepreneurship in America is dying, so are the US public markets according to some. Others say the public markets are inhospitable to smaller cap companies or that the public markets are “broken.” Regardless of the choice of words, the US public capital markets are no longer the envy of the world, as they once were. To wit:
(1) 3,500 (40%) of the approximate 8,700 NASDAQ/NYSE trading
symbols (mainly smaller-cap issuers) have average daily trading volumes under
50,000 shares per day, and approximately 50% had volumes under 100,000 per day,
according to the SEC.
(2) There are approximately 50% fewer public companies today
than 20 years ago.
(3) The number of book runners for smaller IPOs (<$100
million in proceeds) has decreased from 162 in 1994 to 31 in 2014.
Americans are struggling. The US public markets are dying.
Entrepreneurship is dying. It’s time for Congress or the SEC, or both, to adopt
pro-capital formation policies before matters continue to get worse. If not
remediated, the US will forfeit its position as the financial capital of the
world. And, that would be really, really bad.
More on this topic to follow.
Article originally published on November 25, 2019 by equities. com here.
The probability of planet Earth having a catastrophic collision with an asteroid is higher than the probability that a startup founded by all women will be funded by a US venture capital firm.
Startling, isn’t it? Read on.
According to the entrepreneur.com article here, as seen in the chart below, venture capital firms fund about 0.05% (1/20 of 1%) of US startups.
1 Excludes ICOs. 2 According to the article here of StartEngine, one of the largest equity crowdfunding portals, as of February 2019, since inception only $176 Million has been raised via crowdfunding. In comparison, venture capital firms funded $130.9 billion across 8,949 US companies in 2018!
As
recently widely reported, for example in the article here, of these
1/20 of 1% of startups funded by venture capital firms, only 2.5% have all women
founders.
So
according to the math:
0.0005 * 0.025 = 0.000125 of startups in
America will have all women founders and will be funded by venture capital
firms, or 1.25 of every 10,000 startups.
In comparison, the odds of the earth having
a catastrophic collision with an asteroid in the next 100 years may be as high
as 1 in 5,000 according to the
article here.
As revealed with a little more math,
1/5000
= 0.0002 odds of the earth having a catastrophic collision with an asteroid in
the next 100 years
1.25/10,000
= 0.000125 odds of an all-women start-up being funded by a venture capital firm
0.0002/0.000125
= 1.6
In sum, the earth is 1.6 times more likely to have a
catastrophic collision with an asteroid in the next 100 years than a start-up with
all women founders is to obtain funding from a venture capital firm!
As amusing as some may find the above comparison, it’s really quite a serious problem for America. Female human capital is simply not being given the opportunity to succeed. American entrepreneurship is stymied, tens of thousands of US jobs are lost, upward mobility is choked, and the US economy and future economic growth are being stunted — of of which, if left unchecked, will one day result in the US losing the current battle with China for worldwide technology dominance.
And, if you are a woman of color – the odds of securing venture funding approach zero. According to Ms. Kapin, only 0.0006% of venture funding has gone to women of color since 2007. Applying this metric to the $130.9 billion in 2018 venture funding noted in the chart above, approximately $785,000 would have gone to firms founded by women of color. More information on the topic of funding to minority founders appears here, “Untapped Opportunity: Minority Founders Still Being Overlooked.
As noted in an earlier article of mine, US public policy is killing small business and entrepreneurship in America, keeping the poor “poor” and thwarting the American Dream of “Main Street” upward mobility: the US public capital markets, once the envy of the world, are in-hospitable to smaller-cap companies; US entrepreneurship is at historical lows[1]; on a GDP basis, the US surpassed only two of the world’s top 26 IPO markets — Mexico and Brazil — as to the number of smaller-cap company IPOs[2]; the Chinese are lapping the US in the number of total IPOs[3]; and millions of high-quality U.S. jobs have been forfeited.
To remedy this, a “big-tent,” bi-partisan, multi-racial, male/female coalition advocacy effort is being organized in Washington, DC. The coalition, named “JUMMP” (“Jobs, Upward Mobility, and Making Markets Perform”), is being spearheaded by David Weild, former Vice-Chairman of Nasdaq, New York-based investment banker, and “Father of JOBS Act 1.0.” Pro-entrepreneur and pro-upward mobility Americans, including me and others, from both sides of the political aisle in Washington, DC, and throughout the US, are helping Mr. Weild.
The JUMMP Coalition’s objectives are
to:
restore America’s capital markets to their former health,
create millions of US jobs,
help US entrepreneurs regardless of color and gender succeed,
reverse the increasing income inequality trend,
reinvigorate the American Dream of upward mobility from one generation to the next,
bring millions of Americans, especially minorities and others who have not realized the financial benefits of the US economic expansion, to the metaphorical “mountain top,” and
assure the US maintains its worldwide technological dominance
In the meantime,
until the JUMMP Coalition achieves these objectives, if you are a woman founder of a startup and your
business plan requires venture capital funding – it would probably be best if
you have a backup plan.
[This is a reprint of an article published by equities.com here.]
+++++++++++++++++++++++++++++++++++++++++++++++++
[1] Unpublished White Paper of David Weild, former Vice-Chairman of Nasdaq, New York-based investment banker, and “Father of JOBS Act 1.0.” A “heat map” included in Mr. Weild’s White Paper shows that the number of start-ups in America in 2017 versus 2006 in the vast expanse of Middle America between the East and West coasts has decreased by approximately 50%.
[2]
“Making Stock Markets Work to Support
Economic Growth,” Weild, Kim & Newport for the OECD, July 11, 2013, at
p. 54. For the period from 2008-2012 the U.S. had a disastrous “Efficiency
Ratio” of GDP-weighted output of small IPOs — at only 0.4 IPOs per $100
billion of GDP (ahead of only Mexico and Brazil).
[3] According to Mr. Weild’s research, the number of public companies in China has increased by 381% since 1997, while the number of public companies in the US has decreased by 39%.
+++++++++++++++++++++++++++++++++++++++++++++++++
Mr. Woessner mentors, advises, and helps companies in the start-up and smaller-cap company ecosphere raise capital through Regulation Crowdfunding (CF) and other means, bringing to bear his 25+ years of experience in the smaller-cap, public company ecosphere as CEO and general counsel. 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. See herefor more information on Mr. Woessner’s background.
Ronald Woessner This is a reprint of an article of mine originally published by equities.com at the link here.
+++++++++++++++++++++++++++++++++++++++++++++++++
Public Policy is Killing Stock Markets for Smaller-Cap Companies
US Public policy has caused the well-publicized and alarming decrease in the number of US publicly-listed companies and is poisoning the public markets for smaller-cap companies.[1]
The number of US publicly-listed companies
decreased over the last two decades by about 44%, from 8,823 in 1997 to 4,916
in 2012, according to the World Federation of Exchanges. A 2018 academic study from the Harvard
Kennedy School reveals similar numbers.[2]
Other countries are lapping the
US in the number of their public company listings versus our public company
listings. During the comparable period in other developed countries, public
listings increased by about 48%.[3]
The US “should have”
approximately 10,000 public companies today, resulting in an estimated
“listing gap” of approximately 6,000 companies.[4]
This
decrease should be shocking and frightening to all Americans, regardless of
party affiliation, particularly when one considers that real GDP has grown by
over 60% in that time frame. Why, when our economy is growing strongly, has our
public listing machine come to a grinding halt?
This
decrease has cost America tens of millions of jobs,[5]
reduced to a mere trickle the queue of future “Fortune 500” larger-cap
companies for Fidelity, CalPERS and hundreds of pension plans to invest in,[6]
and puts the US on the vector of falling behind China in China’s quest to
dominate the US technologically.[7]
Here’s the chain of causation that’s created the US Listing Gap:
Step 1: The introduction of electronic trading
execution, order handling rules, and smaller tick sizes collapsed buy/sell
trading spreads to $.01 from $.25 per share and collapsed retail sales
commissions to $5.00 per trade from $250 per trade.[8]
Step 2: These smaller bankable
spreads and reduced retail sales commissions DRASTICALLY reduced the
profitability (i.e., ability to make
money) of smaller and mid-size broker dealers. This drove 74% of IPO
bookrunners out of business[9] and drove 29% of
broker-dealers out of business.[10] Those remaining eliminated the investment
banking, research, retail sales, and capital committed to market making (i.e., creating stock trading liquidity) they
previously provided for smaller-cap companies.[11]
Step 3: Lack of this
“after-market” support from smaller and mid-size broker dealers has
left thousands of smaller-cap companies as public-company “orphans,”
with no broker-dealer or investment-banking sponsorship, and poisoned the public
markets for smaller-cap companies.[12]
Step 4: This
in-hospitability deters smaller-cap companies from conducting IPOs and going
public. The big investment banks discourage these smaller deals with smaller stock
trading “floats,” as they are difficult to market to their most
actively trading institutional clients. They are also difficult transactions
purely from an ROI and opportunity cost perspective of allocated resources.
Step 5: This disappearance of the smaller-cap
company IPO (< $50M) is predominantly responsible for the US Listing Gap
according to academic research and as stated by former SEC Commissioner Michael Piwowar during his
opening remarks at an SEC – NYU conference on IPOs in May 2017: “The
substantial drop in the number of IPOs in the United States is primarily driven
by the disappearance of small IPOs.”
Former Commissioner Piwowar is correct.
The number of IPOs raising less than $100 million collapsed starting in 2000.
The number of these small IPOs averaged 401 annually in the 1990s, but then
dropped to only 105 annually in the 18 years since. In the 1990s, small IPOs
represented 27% of all capital raised in the public markets, whereas in the
period from 2000 to present they have represented only 7% of all capital
raised.[13] Moreover, according
to an OECD study, during 2008 – 2012 on a GDP weighted basis the US was
third from the bottom for small IPOs among 26 countries studied — ahead
of only Mexico and Brazil.[14]
The electronic execution, order handling
rules and $.01 tick size trading rules created the salutary benefit of reducing
stock trading transaction costs. Nevertheless, they also had the unintended
negative consequence of killing the small-cap IPO and creating the currently
poisoned US public markets for smaller-cap companies. As eloquently stated by David
Weild,
former NASDAQ Vice-Chairman, Wall Street investment banker, father of JOBS Act 1.0,
and tireless advocate for the health of the US
capital markets:
“Why
have smaller-cap company IPOs disappeared? Because the profitability of the
investment banking-focused broker-dealers —
which previously sponsored and fostered a habitable environment for
smaller-cap companies through underwriting, distributing and supporting them in
the after-market via sales, research, and market-making (capital commitment) —
has been destroyed by electronic-order execution, small-tick-size markets,
that make it easy for predatory short-sellers to collapse trading spreads
(especially in advance of offerings) and spread lies to drive down stock prices
that cannot be countered because the investment banks that remain can no longer
afford to provide research and sales coverage to counteract the lies.”[15]
Through the “butterfly effect,”[16] the electronic execution,
order handling rules and $.01 tick size trading rules had the unintended
consequences[17]
of:
killing the
smaller-company IPO market,
causing the loss
of tens of millions of US jobs,
forcing businesses
to close because of lack of capital,
discouraging
entrepreneurship,
hindering upward
mobility for all Americans, especially minorities
destroying the
efficacy of the US capital markets, and
creating an
opportunity for the Chinese to technologically dominate the US.[18]
Who
would have thought that the lack of a few pennies in tick size would have
poisoned the US public capital markets, once the envy of the world?[19]
So,
what is to be done to remedy the current in-hospitability of the public markets
to smaller-cap issuers, which is causing them to avoid the US public market?
Let’s
use our common sense to intuit the policy solution. Since the $.01 bid/ask tick
size is a root cause of the current inhospitably of the public markets to
smaller-cap companies, then one would naturally think that increasing the tick
size to some larger number would remedy the issue.
And,
indeed, academic research demonstrates this to be precisely the case!
The
academic research of Mr. Weild and his colleagues demonstrates that widening
tick sizes for smaller-cap illiquid stocks results in more smaller-cap
companies going public. In
other countries where there are higher tick-sizes-as-a-percent-of-share price (which
in turn leads to higher bid-ask spreads) their smaller-cap IPOs are booming.
There is a nearly 70% correlation between tick-sizes greater than 1% of an
issuer’s trading price and a robust IPO market for companies under $500 million
in market value, according to the research.[20]
Now, a word about the two year 2016 – 2018
SEC tick
pilot study.[21] The study increased the tick size from $.01
to $.05 for the pilot stocks. It has been reported that the study was a
“failure” because it cost investors approximately $350M more to trade
the pilot stocks during the study period and did not produce the hoped-for and
anticipated increase in the trading liquidity of the pilot stocks.[22] Commentators have
incorrectly concluded from these reports that larger tick sizes and larger bid-ask spreads do not increase trading liquidity.
These
commentators are incorrect. The failure of the tick pilot study to produce the
hoped-for and anticipated increases in trading liquidity of the pilot stocks is
100% attributable to the inherently flawed design of the study.[23]
The
study design was inherently flawed in that that
there was a null set (i.e., ZERO) of stocks
in the pilot that could benefit from the tick pilot. The explanation
appears below.
Recall that the academic research says the
tick size must be > 1% of the stock share price. The $.05 tick was not >
1% for those stocks priced > $5.00 per share. The $.05 tick was > 1% for those stocks
priced < $5.00 per share … but broker-dealers cannot recommend them for
purchase because of brokerage firm policies[24] and such stocks cannot be
purchased on margin.
Since the study design
was inherently flawed to benefit ZERO issuers, it’s not surprising that ZERO
issuers benefitted.
In
conclusion, it is clear what needs to be done from a policy perspective to
remedy the poisoned and collapsing US public capital markets: create a special
exchange with special trading rules for smaller-cap issuers that permit higher
bid-ask spreads.[25]
These
higher bid-ask spreads will then create the profitability broker-dealers need
to begin again providing after-market
“sponsorship” and support for smaller-cap companies in the form of:
investment
banking,
investment analyst
research,
providing retail sales persons to solicit customer buy orders, and
committing capital
to make a trading market in the issuer’s stock
These
activities would in turn make the public capital markets more hospitable to
smaller-cap companies, which in turn would motivate more of them to go public,
and would enable those that are already public to thrive.
A
big-tent, bi-partisan advocacy effort is now being organized in Washington, DC,
to present this initiative to Congress and to the SEC. If you want to help:
restore America’s capital markets to their former health,
create millions of US jobs,
help America’s entrepreneurs succeed,
promote upward mobility and bring millions of Americans, especially minorities and others last hired during an economic recovery, to the metaphorical “mountain top,” and
assure the US maintains its worldwide technological dominance
[1] There are approximately 5,500 “publicly-listed” companies listed on the NYSE and NASDAQ. There are another approximately 10,500 “OTC-traded” companies. The term “public markets” as used in this article refers collectively to both publicly-listed and publicly-traded companies.
[2]“Hunting High and Low: The Decline of the Small IPO and What to Do About It,” Lux and Pead, Mossavar-Rahmani Center for Business and Government, Harvard Kennedy School (April 2018), https://www.hks.harvard.edu/centers/mrcbg/publications/awp/awp86 (hereinafter cited as “Lux & Pead”). The World Federation of Exchanges number of publicly-listed companies as of December 2018 is 5,343. There appears to have been a modest uptick resulting from JOBS Act 1.0 and JOBS Act 2.0 and the robust economy.
[3] 9,538 is the estimated “should have” number as of 2012 according to the study. “The U.S. Listing Gap,” Doidge, Karolyi, and Stulz, December 2015, at p. 8.
[4] The author
extrapolates to an estimated 10,000 “should have” number in 2019.
Other commentators peg the “should have” number of public companies
as > 13,000.
[5] It is estimated
that 22M jobs were lost between 1997 and 2010 because of the reduced level of
IPO activity. “A Wake-Up Call for America,” Weild & Kim, November
2009 (hereinafter cited as “Weild & Kim”), at p. 27.
[6] Today’s Fortune
500 companies were smaller-cap companies at one time. It’s necessary to have a public market
ecosystem that enables smaller-cap companies to thrive so that those
smaller-cap companies who have the potential to become a Fortune 500 company –
have a fighting chance to do so. Today’s
public market ecosystem is so inhospitable to smaller-cap companies that many
who have the potential to become a Fortune 500 company will never achieve their
potential.
[8] “Hearing on
Legislation to Further Reduce Impediments to Capital Formation,” Financial
Services Committee, on October 23, 2013, Statement of David Weild, at 15 – 16.
[9] As of 2012, there were only 44 IPO bookrunners still in business, down from 167 in 1994. Id.
[11] The $.01 bid/ask trading spreads
have (a) decimated the ranks of the small-to-mid size broker dealers/investment
banks who formerly provided after-market support for smaller-cap companies, (b)
eliminated virtually 100% of the retail salesmen who previously phoned retail
investors and solicited buy orders for a small-cap issuer’s shares of stock, and
(c) decimated the ranks of the sell-side investment analysts who left the
industry in droves to work for hedge funds and the like.
[13] Lux and Pead at
p. 8. A delta of 296 (401 – 105) * 18 years = 5,328, which predominantly
accounts for the Listing Gap.
[14] “Making Stock
Markets Work to Support Economic Growth,” Weild, Kim & Newport for the
OECD, July 11, 2013 at p. 54.
[15] “Fixing America’s IPO Markets, Why this is Essential for US National Interests, Ideas for JUMMP Act 1.0,” D. Weild, unpublished paper, February 2019.
[16] The butterfly effect is the phenomenon whereby a minute localized change in a complex system can have large effects elsewhere.
[18]Id. There is an additional network effect that magnifies the extent of this damage. Enrico Moretti at Berkeley in his book. “The New Geography of Jobs,” wrote about the “multiplier effect” of how a single high-tech job in an “innovation hub” like Boston, San Francisco, or Raleigh-Durham creates five new jobs in the surrounding service sector. Hence, all those IPOs that didn’t happen didn’t create a successful company that then didn’t hire people that then resulted in the communities not flourishing.
For want of a nail the shoe was lost. For want of a shoe the horse was lost. For want of a horse the rider was lost. For want of a rider the message was lost. For want of a message the battle was lost. For want of a battle the kingdom was lost. And all for the want of a horseshoe nail.
[20] “Making Stock Markets Work to Support Economic Growth,” Weild, Kim & Newport for the OECD, July 11, 2013, at p. 54. For the period from 2008-2012 the U.S. had a disastrous “Efficiency Ratio” of GDP-weighted output of small IPOs — at only 0.4 IPOs per $100 billion of GDP (ahead of only Mexico and Brazil). Why? Because the US has the lowest tick-sizes-as-a-percent-of-share price of any of the 26 countries studied. A number of countries enjoy 50x the GDP-weighted output of the number of small IPOs in the US. Id.
One
may ask: “How do we know this is causation and not merely
correlation?” Answer: because we have seen from our experience here
in the US how the lower bid/ask spreads created the loss of after-market
support for smaller-cap issuers. See note 12 above and the articles cited
therein.
[21] The SEC studied for two years the effects on the trading liquidity
of 1,200 NMS pilot stocks of widening the tick size from a penny ($.01) to a
nickel ($.05).
[22] Trading liquidity
is necessary for a public issuer to attract investment firm capital. As noted
by Weild & Kim and in earlier articles of mine: without trading liquidity a public issuer has
virtually zero chance of attracting non-toxic investment firm capital. See, e.g., https://www.equities.com/news/why-do-investment-analysts-ignore-smaller-cap-companies.
[23] Early proponents of the SEC study criticized the proposed
study design at the time it was being designed.
At the time, Mr. Weild and others stated that the study design
was flawed and not remotely close to the tick size pilot they had advocated
for. The Carney – Duffy legislation,
which would have required the SEC to conduct the pilot according to certain
parameters, called for a 5- year pilot (not 2 years) and a $.10-cent tick size
(not $.05). The legislation never became
law and hence the SEC did not follow these parameters in designing the study.
[24] Brokerage firm policies prohibit
brokers from calling customers to solicit a buy order for stocks priced at
<$5.00 per share.
[25] This is the fundamental requirement. Obviously, there are hundreds of other details as well that would be necessary for such a trading venue to function properly.
+++++++++++++++++++++++++++++++++++++++++++++++++
Mr. Woessner mentors, advises, and helps companies in the start-up and smaller-cap company ecosphere raises capital through Regulation Crowdfunding (CF) and other means. 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. See here for more information on Mr. Woessner’s background.
Smaller-cap companies with thinly-traded stocks need to beware the short seller.
This article illuminates how smaller-cap companies (
particularly OTC-traded companies) are getting the “short end of the stick”[1] due to inadequate legal protections against abusive short-selling practices.Investors can either participate in the market by going “long” a stock or by going “short” a stock. Investors that are “long” a stock believe it will increase in value. Investors that are “short” a stock believe it will decrease in value.A short sale occurs when an investor sells a security the investor does not own. If the price of the security drops, the short seller buys the security at the lower price and makes a profit.[2]A sudden influx of short sales in a thinly-traded stock can cause an immediate and material decrease in the stock price. This results from the temporary imbalance between sales and purchases.[3]
The SEC and the courts have said there is nothing inherently wrong with short sales because short selling contributes to price efficiency and market liquidity. For example, in a 2014 short selling study, the SEC noted, “Short selling as employed by a variety of market participants can contribute substantially to overall market quality through its positive effects on price efficiency and market liquidity.”
While short selling, even in large volumes, is not inherently illegal, the following is illegal:
“Naked” short selling: This occurs when the short seller sells short but does not borrow the stock sold short or make arrangements to borrow the stock before the sale. SEC regulations require the short seller’s broker, prior to executing a short sale, to either borrow the security being sold, enter into a bona-fide arrangement to borrow the security, or have reasonable grounds to believe that the security can be borrowed so that it can be delivered to the buyer’s broker within the required two day (“T + 2”) settlement period.
“Short and distort” campaigns: This occurs when a stock manipulator shorts the stock of a particular company, then spreads false or unverified rumors about the company for the purpose of driving down its stock price. Once the stock price has fallen on these rumors, the stock manipulator purchases shares at the lower price to cover the manipulator’s short position and pockets the profit. Given the speed with which information (including false information) moves throughout the investment community via social media channels, these short and distort campaigns can gather momentum very quickly and cause material downward spikes in an issuer’s stock price within a short period of time during one day.
Those of us that operate in the public company ecosphere are grateful that the law protects issuers against the two abusive short-seller tactics noted above. We are relying on the SEC to be vigilant in monitoring for these abuses and aggressively move to stamp them out. Notwithstanding, there are at least four “gaps” where the law does not adequately protect issuers, as discussed below.
Gap No. 1: No Required Disclosure of Short Position
There is no public reporting requirement for investors who go “short” a company’s stock. In contrast, there are extensive public disclosure obligations for investors who go “long” a company’s stock. For example, Section 13(d) of the Securities Exchange Act of 1934 and the regulations thereunder require persons owning more than 5% of the outstanding stock of a ’34 Exchange Act listed company to report their stock ownership with the SEC.
NASDAQ recognizes that not requiring public disclosure of short positions is poor public policy, according to Mr. Edward S. Knight, chief legal officer for NASDAQ. In his testimony before the Capital Markets Subcommittee of the House Financial Services Committee in May 2018, Mr. Knight testified that there is material harm to the efficacy of the public markets without short position disclosures. He made the following specific points:
Short sellers can amass short positions secretly
This is “untenable” since short sellers have in recent years taken an activist role in corporate policy and governance
Because short sellers are not required to disclose their short position, neither the public nor companies know that the short seller may have a “hidden agenda” with respect to the activist positions it is pushing
Lack of information regarding short positions is detrimental to market efficiency
Biotech companies are particularly vulnerable to manipulative short-selling practices, according to testimony the same day, also before the Capital Markets Subcommittee, by Mr. Brian Hahn, chief financial officer of the bio-tech firm GlycoMimetics, Inc. Mr. Hahn testified on behalf of the Biotechnology Innovation Organization, a trade association for biotech companies. According to Mr. Hahn’s testimony:
Biotech companies often face attack by short sellers who spread online rumors or publish false or misleading data about clinical trials
Short sellers use the auspices of the US Patent and Trademark Office (“USPTO”) to drive biotech company stock prices down. After shorting a company’s stock, the short sellers then file spurious patent challenges through the USPTO. The company’s stock price is driven down as false rumors spread that the company’s patents may be in jeopardy.
In sum, these commentators (and our common sense) informs that short sale position disclosures would shine a “light” on short seller stock manipulation. Moreover, if short sale positions were disclosed, the SEC will know the identities of those who are potentially benefiting from stock price declines linked to false rumors and other manipulative behavior — and can start their investigation with those folks!
Gap No. 2: Holders of Convertible Notes Are Permitted to Short Prior to Note Conversion
Holders of convertible promissory notes are legally permitted to short the stock of the company that issued the convertible note and thereby drive the stock price down and receive more shares pursuant to the note conversion.
Here is a typical scenario where this could occur: a company issues a convertible promissory note to evidence a loan. Amounts owing under the note may be converted into the company’s common stock at the noteholder’s discretion. The conversion price is typically at a discount (often 15-20%) to the then-current trading price of the company’s common stock. (Convertible notes issued by OTC-traded companies often have “floorless” convert provisions, meaning there is no “floor price” that limits how low the conversion price can go. Floorless convert provisions are not permitted under NASDAQ rules for NASDAQ-traded companies.)
The convertible note holder could then legally short the company’s stock to drive the share price down. The note holder then coverts the note at the lower share price and receives more shares in the conversion.[4] While many CEOs and CFOs are shocked to learn that this abusive and manipulative tactic is legal — indeed it is! See the case of ATSI Communications Fund, Ltd. (2d Cir. 2009), where shorting prior to note conversions was alleged to have occurred. The court said it was perfectly legal for the convertible note holder to short the company’s stock prior to initiating a note conversion. The court stated, “Purchasing a floorless convertible security is not, by itself or when coupled with short selling, inherently manipulative.” (emphasis added.)
PRACTICE TIP: The above discussion should not be interpreted as suggesting that every convertible note holder will engage in this abusive, manipulative behavior. Nevertheless, as CEO or CFO it is prudent to attempt to protect your company against this manipulation by ensuring that the definitive agreements prohibit this behavior.
Gap No. 3: Short Selling Prior to Purchasing Shares in a PIPE
A “PIPE” is a Wall Street acronym for Private Issuance of Public Equity, meaning a transaction whereby a publicly-traded company issues shares in a private offering, typically via Regulation D.
The SEC short selling rules permit an investor who is purchasing stock in a PIPE transaction to short the issuer’s shares before purchasing the issuer’s shares in the transaction. The short seller/PIPE investor then uses the shares it purchased in the PIPE (which shares are typically priced at a 5% – 20% discount to the market price) to cover its short position!
Here is a typical scenario where this could occur: An issuer hires an investment banking firm to help the issuer raise $X by selling shares of its common stock in a PIPE transaction. The shares in the transaction will typically be sold at a 5-20% discount to the share market price on the day the deal closes.[5]
The investment banking firm approaches a number of potential investors to determine if they are interested in investing in the PIPE transaction. (This is considered “soliciting indications of interest” in Wall Street jargon.) Once indications of interest for the $X sought to be raised have been collected, the deal is “priced” and closed (i.e., the discounted price at which the company’s shares are to be sold is determined), the definitive agreements are signed, and the deal closes.
During the period between learning of the PIPE and the deal closing, an investor is legally permitted to short the issuer’s stock and then use the discounted shares it acquires in the PIPE to cover its short position. For example, if the market price of the issuer’s stock is $10 per share and the PIPE discount is 20%, the investor will be entitled to purchase the issuer’s shares at $8 per share. The investor legally could sell the issuer’s shares at the market price of $10 per share and then cover its short position using the $8 shares purchased in the PIPE transaction. The investor realizes a $2 gain per share in an apparently legal, riskless transaction.
The SEC has pursued legal claims, with limited success, against investors who have engaged in this manipulative behavior. See the May 2014 article, “SEC Enforcement in the PIPE Market: Actions and Consequences” in the Journal of Banking and Finance for more information on this topic.
Again, many readers — not surprisingly — are shocked to learn that this abusive and manipulative tactic is apparently legal.
PRACTICE TIP: The above discussion should not be interpreted as suggesting that every PIPE investor will engage in this abusive, manipulative behavior. Nevertheless, as CEO or CFO it is prudent to attempt to protect your company against this manipulation by ensuring that the definitive agreements prohibit this behavior.
Gap No. 4: The “Alternative Uptick Rule” Does Not Protect OTC Companies from Bear Raids
SEC Rule 201 (the “alternative uptick rule”) restricts short sellers from driving down the price of shares of NYSE- and NASDAQ-listed companies whose shares have experienced a price decline of 10% or more in one day. Once this “circuit breaker” price decline occurs, short sale orders for the remainder of the day and the following day must occur at a price above the current national best bid, subject to certain exceptions.
The purpose and effect of the Rule is to protect the company from short-seller attack by impeding a short seller’s ability to drive down the price of a stock that has experienced such a one-day price decline.
The Rule does not protect OTC-traded companies. This makes them vulnerable to “bear raids,” where a gang of short sellers collaborate and sell short shares of a particular company in an effort to drive down the price of the shares by creating a temporary imbalance of sellers versus buyers or creating the perception that the share price is falling for fundamental reasons. These “bears” then cover their short positions by purchasing the company shares at the manipulated, lower price and pocketing the gain between the higher price at which they sold the shares and the lower price at which they purchased the shares back.
In sum:
Smaller-cap companies with thinly-traded stocks, particularly OTC companies and biotech companies, are especially vulnerable to “bear attacks” and stock manipulation from short sellers because of these legal “gaps.”
Gaps 2 and 3 are disproportionately harmful to smaller-cap OTC companies because PIPE and convertible note financings are common sources of financings for OTC-traded companies.
Bottom line: CEOs and CFOs — be wary of short sellers!
Mr. Woessner mentors and advises companies in the start-up and smaller-cap company ecosphere and helps them raise capital. 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 https://www.linkedin.com/in/ronald-woessner-3645041a/.
[1] To get the “short end of the stick” is getting the bad end of a deal or receiving the least desirable outcome from something. The origin of the phrase dates back to the 1500s and appears to be a reference to carrying loads mounted on rods (sticks). When carrying a load, the person who has the shorter end of the supporting rods carries more of the load and, hence, they are getting the worst aspect of the situation.
[2] If the price of the security increases, the investor loses money. The higher the price goes, the more money the investor loses.
[3] It’s more difficult to drive down the price of liquid stocks by short selling because there is more order depth (demand) on the buy-side to absorb the short sales. The more liquid the stock, the more shares required to be sold short to create a material price drop. The more illiquid the stock, the fewer shares required to be sold short to create a material price drop.
[4] Some have asked me why it would benefit a convertible note holder to obtain more shares at a lower stock price. The answer is that the lower stock price caused by the short selling is typically temporary, having been caused by an artificial imbalance between sales and purchases caused by the influx of the suddenly-introduced short sales. Once the normal equilibrium between purchases and sales is re-established, the stock price typically rebounds.
[5] The share purchase price is at a discount to the market price because the shares being issued are “restricted” and cannot be sold until the earlier of six months after purchase or such time as they are publicly registered for resale with the SEC.
Readers — an earlier article of mine published by equities. com at this link discussed how smaller-cap US public companies are being hurt by not having research investment analysts covering their stock. As bad as the lack of investment analyst coverage is now for smaller-cap companies (and it is REALLY bad), matters will get MUCH worse if the European MiFID II is adopted in the US.
According to the Bloomberg article below, which originally appeared at this link, the European MiFID II directive has decimated the European investment analyst ranks. If adopted in the US, it would have an equally decimating effect on the US investment analyst community and create an even worse circumstance for US smaller-cap companies! +++++++++++++++++++++++++++++++++++++++++++++++++
Research Analysts’ Existential Crisis Enters MiFID II Era
Analyst headcount falls as EU rules put price on research
Merian’s Buxton says quality of research is deteriorating
Predictably, by putting a price tag on research, the European Union rules have made asset managers more selective about what they need, especially since most have opted to swallow research costs rather than pass them to clients. Many have also boosted their in-house analysis capabilities.
More Pressure
Consequently, there’s even more pressure now to write reports with concrete conclusions, rather than trimming estimates by 3 percent on a stock rated “hold,” said an analyst who manages a team and asked not to be identified discussing internal matters. Another analyst who also requested anonymity said calls on a stock are now more important than long-term thematic pieces. Anthony Codling, an analyst at Jefferies LLC who quit recently, said he reduced the amount of what he deemed “maintenance research.”
“Why would a client pay to receive a note that says results are in line?” he said.
Those concrete conclusions are sometimes drawing rebuttals from companies. U.K. real estate services company Purplebricks Group Plc in February disputedCodling’s analysis of its accounting, while lab-testing company Eurofins Scientific SE said “factually wrong estimates” from Morgan Stanley’s Edward Stanley may have misled or confused investors. French grocer Casino Guichard-Perrachon SA contested research by Bernstein’s Monteyne.
Of course, many analysts would say research always should have had demonstrable value, even before MiFID II; what’s new is the intensifying competition for payments. But some lament that a new model that measures clicks and analyst interactions by the hour ignores the subjective quality of analysis.
While there have been murmurs about a supposed sensationalist turn in investment research, the caliber of analysts also is declining, meaning that one still sees meaningless reports, said Richard Buxton, chief executive officer of fund manager Merian Global Investors — such as when a brokerage says the outlook for the mining sector is increasingly a macro call.
Shrinking Coverage
“The quantum of coverage is shrinking, the quality of coverage is definitely shrinking, and it’s no surprise therefore that we are continuing to pay less and less for the research,” he said from London. “We know good people are leaving the sell side, and that has to be a consequence of [the fact that under] MiFID II people are not going to earn the same amount of money as they used to as a research analyst.”
Headcount for equity research at 12 major investment banks has declined 14 percent since 2013 to 1,200 as of the first half of 2018 in Europe, the Middle East and Africa, data from Coalition Development Ltd. show. Over the same period, the number of ratings on companies in the Stoxx Europe 600 Index has dropped 9 percent while the number on the Stoxx European small-cap index has fallen 12 percent, according to data compiled by Bloomberg.
To Robert Miller, head of research at Redburn, the biggest risk to the industry is the attrition of talent.
Talent Pool
“Because of the deflation in the industry, the risk is that the best talent decides that they really need to work on the buy side or in the industry or do something completely different,” he said. “The pool of high-quality, experienced talent in my industry is shrinking.”
The industry is seeing more mergers as revenue falls. AllianceBernstein Holding LP, the asset manager that owns Sanford Bernstein, agreed in November to buy Autonomous Research, which specializes in financial stocks. Germany’s MainFirst Holding AG last month took over Raymond James Financial Inc.’s institutional brokerage business in European stocks. U.S. securities firm Stifel Financial Corp., in turn, is buying MainFirst’s equity research and brokerage operations.
Research houses are also exploring new sources of revenue. More are now charging companies for reports about them — a “sponsored research” model that has spurred worries of conflicts of interest. Some firms say companies are paying larger retainers for brokerage services including research. One, French firm AlphaValue SA, is asking investors to “crowdfund” analyst reports.
Metrics-Driven
Regardless, investment research — an area of finance that can seem almost academic at times — is becoming more metrics-driven. Many banks now charge explicitly for meetings and calls with analysts, making investors more selective about such conversations. These interactions are now recorded for compliance, with their value scored by the user.
“The battleground is interaction between research analysts and the buy side, who are increasingly adopting the accountant or legal industries’ ‘gas meter’ model of by-hour pricing,” said Ed Allchin, head of sales and business development at Autonomous Research in London. “This has made fund managers more reluctant to contact analysts because they may be charged each time, with thought going in to the economics of that call or meeting.”
Gone are the days when investors would meet with analysts casually just because they happen to be in the area. There are now fewer ad-hoc meetings and more that are focused on specific subjects, said Redburn’s Miller, even though the research firm doesn’t charge by the hour. The number of calls fell at the start of the year, but has since recovered, said Bernstein’s Monteyne.
Still, the realities differ for different research providers. Large investment banks can afford to sell analysis at lower prices, since it’s just one part of a large business. Independent research houses do not have that advantage but can tout their conflict-free specialization. The jury is still out on who will ultimately emerge victorious, but increasingly the worry is that the smaller players will drown.
Market Impact
For investors, the concern is that shrinking analyst coverage, especially in small- and mid-caps, will make the market less efficient, with lower liquidity, though some say that could help active stock pickers. Already smaller companies are feeling the pressure to beef up investor relations resources, as they can no longer count on analysts alone to tell their story.
The rules may be amended. European regulators are studying their impact, including on smaller stocks and independent research providers. U.K. regulators will step up scrutiny of falling pricing models and research budgeting, while elsewhere in Europe, rules may be softened to lessen the blow on smaller companies, Bloomberg Intelligence said in a note on Thursday.
But little is likely to reverse the existential crisis in research. For an industry that thrives on dissecting numbers and predicting winners and losers, it makes sense that its value and future should now determined by market forces.
“Investment research is a declining industry given the cost pressures,” said Ian Harnett, who left UBS in 2006 to start macro analysis firm Absolute Strategy Research Ltd. “If you survive through that process than maybe there is an opportunity to increase your market share. What we do not know is what the value of that market share will be in three years’ time.”
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Mr. Woessner mentors, advises, and helps companies in the start-up and smaller-cap company ecosphere raise capital. 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. See here for more information on Mr. Woessner’s background.
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.
WASHINGTON – Financial Services Committee Chairman Jeb Hensarling (R-TX) delivered the following speech on the House Floor today, urging the Senate to pass the “JOBS & Investor Confidence Act of 2018,” otherwise known as the JOBS Act 3.0:
“I come here today, Mr. Speaker, and I picked up a copy of this morning’s edition of the Wall Street Journal. Many Americans would consider it to be the most influential newspaper in America; but certainly at least on economic matters, I think, most would agree.
I just happened to read the lead editorial today, Mr. Speaker, and it says that the House, this body, “has done yeoman’s work shepherding bipartisan bills to expand access to capital.” Most influential paper in America. There’s a lot in between but let me go to the last sentence where it says, “The Senate shouldn’t scuttle what could be one of this congress’s better achievements.” That’s in today’s Wall Street Journal, Mr. Speaker, and the Journal’s talking about JOBS 3.0. It’s a bill that came out of this body 406-4, and its purpose, Mr. Speaker, is to promote small business, to promote entrepreneurial capitalism, to promote venture capital. Again, Mr. Speaker, it came out of this body 406-4. We couldn’t get 406-4 votes on a Mother’s Day resolution. And yet it languishes on that side of the Capitol.
So I’ve been in this body for 16 years, Mr. Speaker, and I’ve learned a few things. One of the things I’ve learned is never underestimate the Senate’s capacity to do nothing. And unfortunately, so far, the United States Senate has done nothing on a bill that passed 406-4.
Mr. Speaker, thanks to the leadership of President Donald Trump, thanks to the leadership of Speaker Paul Ryan, thanks to the leadership of Chairman Kevin Brady, we have what for most Americans – not all, but for most Americans – is the greatest economy they have had in their entire lifetime. Unemployment at a 50-year low. Cutting across all socioeconomic groups. Small business optimism, consumer optimism, off the charts. We are seeing more people come back into the labor force, and this is all great news.
But we cannot be blinded by the fact that as good as the economy is of today, we still have to concentrate on the economy of tomorrow. And we need to know, can we ensure that the seed capital is there? Can we make sure that our public policy nourishes the drivers of tomorrow’s economy, the next Amazons, the next Googles, the next Ubers; where are they going to come from?
So unfortunately, Mr. Speaker, what we have seen is that as recently as 2016, as recently as 2016, startups in America have been cut in half. And oh, incidentally the securities regulatory burden has increased by over 50% in the last 10 years, and by over 80%. It now costs, Mr. Speaker, twice as much to go public today as it did 10 years ago.
And what do we see? We see half the number of companies going public. They don’t seem to have that problem in China, Mr. Speaker, because China has over 1/3 of the world’s I.P.O.’s or initial public offerings.
Yet the United States, our I.P.O.’s have been cut in half. That’s why it’s so important that every Congress, every Congress we go back and we ensure that our securities laws are written in such a way that we make sure that entrepreneurial capitalism can’t just survive in America, but absolutely thrive. So I come to this floor again to ask that our colleagues on the other side of the Capitol, and I have many friends in that body, but I am often confused why, why they cannot act on something that has received incredible, incredible support in the House.
Mr. Speaker, November is National Entrepreneurship Month. There’s only two days left in the month. So I hope that my voice can be heard on the other side of the Capitol, and I would ask the United States Senate to immediately take up the JOBS 3.0 Act, and make sure that the economy of tomorrow for our children and grandchildren is as healthy and thriving as the economy of today.”
On May 23, 2018, as directed by Congress pursuant to the Fair Access to Investment Research Act of 2017, the SEC proposed a new rule under the Securities Act of 1933.
If adopted, the proposal would establish a safe harbor for an unaffiliated broker or dealer participating in a securities offering of a “covered investment fund” to publish or distribute a “covered investment fund research report.” If the conditions for the safe harbor are satisfied, this publication or distribution would be deemed not to be an offer for sale or offer to sell the covered investment fund’s securities for purposes of sections 2(a)(10) and 5(c) of the Securities Act of 1933.
The SEC also proposed a new rule under the Investment Company Act of 1940. This proposal would exclude a covered investment fund research report from the coverage of section 24(b) of the Investment Company Act (or the rules and regulations thereunder), except to the extent the research report is otherwise not subject to the content standards in self-regulatory
organization rules related to research reports, including those contained in the rules governing communications with the public regarding investment companies or substantially similar standards.
Public comments on the proposal were required to be submitted to the SEC on July 9, 2018.
