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OTC Markets Are the Whipping Post for Too Many Microcap Stocks

Image: Cover of debut album by The Allman Brothers Band. Atco Records, Capricorn Records, 1969

Sometimes I feel, sometimes I feel,

Like I been tied to the whippin’ post.

Tied to the whippin’ post, tied to the whippin’ post.

Good Lord, I feel like I’m dyin’.

– Whipping Post, The Allman Brothers Band, 1969*

This is a reprint of an article of mine originally published by equities.com here.

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Previous articles of mine have described the disappearing US publicly traded company, the inhospitability of the US public markets to smaller cap companies, and the disappearing smaller IPO.[1]

After reading these and similar articles one might reasonably conclude that the US exchange-listed markets are dying.[2] This is a fair characterization, based on the objective measures of there being 40% fewer publicly-listed companies than there were 20 years and ago and approximately 4,500 fewer publicly-listed companies than the US should have based on GDP comparison with other countries.

Thankfully, under the leadership of SEC Chairman Jay Clayton, the SEC is now focused on the dying US publicly listed markets and is examining potential regulatory initiatives to reverse this trend.[3] I am particularly encouraged by the SEC’s proposed changes to the Reg. A and Crowdfunding rules that it promulgated this week. Those changes would greatly improve prospects for private capital formation.

This article examines the state of the other component of the US public markets, the publicly-traded OTC Markets.[4]

Capital markets policy makers and regulators over the last decade or more have been singularly focused on investor protection, trading efficiencies, and anti-money laundering. Of course, that is not a bad thing, since these are laudatory objectives. The unintended consequence of this singular focus, though, is that little-to-no attention has been given to policies that promote entrepreneurship, private capital formation, and access to capital for startups, which are the lifeblood of the US economy.

The consequent dying of the exchange-listed markets is bad enough: let’s now consider the plight of the OTC Markets, which are in a far worse circumstance than either the NYSE or Nasdaq markets, as illuminated by the following data points.

Data point #1.

Of the top 20 OTC Markets traded issuers by volume, exactly 0 of them are US companies. Yes, you read that correctly. Of the top 20 OTC Markets traded issuers,[5] comprising 83% of daily trading volume,[6] ZERO, ZIP, NADA, NONE of them is actually a US company.7

Data point #2.

As of a recent date, 90% of the OTC market making was performed by only eight market makers.[8] Moreover, only 43 market makers traded at least one share on the OTC Markets marketplace. This represents a 89% decrease from the over 400 OTC market makers in 1997.[9]

Data point #3

Since as noted above 20 OTC Markets traded companies account for 83% of the daily trading volume,[10] the remaining 10,797 OTC Markets traded companies account for just 17% of the trading volume. Common sense informs us that the preponderance of these remaining issuers have illiquid stocks. And, indeed that is the case particularly for the nano-cap issuers with less than $50 million in market cap. The average daily dollar volume for the 393 companies in the OTCQB tier was only approximately $31,000 according to 2018 data. Some of these companies have daily trading volumes amounting to merely hundreds of dollars per share per day.

Data point #4.

Zealous enforcement of the anti-money laundering (AML) rules by the SEC and FINRA discourages firms from making a market in OTC Markets issuers. The number of AML cases brought by the regulators against nearly all customer servicing firms and the fine amounts against those firms is astonishing. US regulators imposed a total of $19.85 billion in AML fines between 2002 and April 2019.[11]

I am told by colleagues who have dealt with the regulators that nearly all firms settle these regulatory actions rather than contest them. It is virtually impossible to successfully defend them because the enforcement actions typically involve hypothetical “could/should have” allegations, rather than an actual money laundering transaction. Further, the courts typically give deference to the regulator’s interpretation of the regulations.

These regulatory actions typically involve a metaphysical evaluation by the regulator, in the regulator’s subjective view, of whether or not a firm’s policies or procedures are “strong enough” to stop or prohibit money laundering, or whether or not the firm “could have” done more to detect hypothetical money laundering, or whether or not the firm “should have” more robust policies or procedures to detect hypothetical money laundering. Keep in mind that rarely is money laundering proven or even alleged by the regulator.

In such case when there is no incident that has actually occurred, it is virtually impossible to defend against a regulator’s subjective view that more “could/should” have been done by the firm. It is no wonder that nearly all firms settle these regulatory actions, rather than contest them.

Many regulatory sanctions against firms relate to “suspicious activity reports” (SARs). The regulators can fine a firm if the regulator determines:

  • that the firm should have filed a SAR – even though the firm determined in the exercise of its good faith business judgment that the activity didn’t rise to a level requiring the filing of a SAR; or
  • that the firm did not provide enough detail – even though the firm provided the facts and circumstances; or
  • that the firm did not file the SAR quickly enough [12] — even though the firm did in fact file the SAR; or
  • that the firm filed too many SARs. [13]

Of course, the regulators have the benefit of hindsight and typically are judging the firm against a hypothetical, subjective standard as opposed to an actual incident of untoward activity. The regulator initiates an action and typically prevails by merely alleging that the firm did not file the SAR in a timely enough fashion, the filed SAR lacked sufficient detail, the firm should have filed a SAR, the firm filed too many SARs, etc. In other words, whatever the firm did or didn’t do, it should have done it better.

This overreaching by the regulators acutely manifests in the OTC Markets and in the lower-priced NASDAQ issuer ecosphere because customary behavior and activity in this ecosphere are “red-flags” that could/should have trigger(ed) a SAR filing in the eyes of the regulator. See the following examples of ordinary and customary behavior in the smaller cap, thinly-traded issuer ecosphere that are FINRA “red flags”[14] requiring the filing of a SAR.

  • A customer opens a new account and deposits physical certificates, or delivers in shares electronically, representing a large block of thinly traded or low-priced securities.

Comment: “Large block” is not defined – I have been told that regulators consider 10,000 shares or more a large block. For smaller cap issuers, with thinly traded and lower priced securities, virtually every stockholder owns more than 10,000 shares requiring deposit. 10,000 shares of a $.50 stock = $5,000. Nothing out of the ordinary here in the smaller cap ecosphere, but it is a “suspicious activity” for SAR purposes.

  • A customer has a pattern of depositing physical share certificates, or a pattern of delivering in shares electronically, immediately selling the shares and then wiring, or otherwise transferring out the proceeds of the sale(s).

Comment: This is common practice in the smaller cap issuer, thinly traded ecosphere. A stockholder, who has held paper certificates for months, if not years, wants to sell the shares, so the stockholder opens an account at one of the few brokerage firms that actually will accept the paper certificates and process a sale transaction. The stockholder then wires the money to the stockholder’s normal brokerage account. Nothing out of the ordinary here in the smaller cap ecosphere, but it is a “suspicious activity” for SAR purposes.

  • Seemingly unrelated clients open accounts on or at about the same time, deposit the same low-priced security and subsequently liquidate the security in a manner that suggests coordination.

Comment: Since very few firms accept deposits in low priced securities, it is very common to have one firm receive multiple shareholder deposits in an issuer’s securities at or around the same time. Nothing out of the ordinary here in the smaller cap ecosphere, but it is a “suspicious activity” for SAR purposes.

  • There is a sudden spike in investor demand for, coupled with a rising price in, a thinly traded or low-priced security.

Comment: Price movements are always exaggerated in thinly traded securities. Nothing out of the ordinary here in the smaller cap ecosphere, but it is a “suspicious activity” for SAR purposes.

  • The customer’s activity represents a significant proportion of the daily trading volume in a thinly traded or low-priced security.

Comment: Individual sales in a thinly-traded security typically represent a significant portion of the daily trading volume. For example, a customer sells 1,000 shares of a $.50 stock in a security that trades 2,000 shares daily on average represents majority of the trading volume. Nothing out of the ordinary here in the smaller cap ecosphere, but it is a “suspicious activity” for SAR purposes.

  • The customer is known to have friends or family who work at or for the securities issuer, which may be a red flag for potential insider trading or unlawful sales of unregistered securities.

Comment: Guess what? Private securities offerings of smaller cap issuers ALWAYS involve selling shares to friends and family. Nothing out of the ordinary here in the smaller cap ecosphere, but it is a “suspicious activity” for SAR purposes.

Not surprisingly, many firms have simply stopped allowing deposits, resales and sometimes even purchases of low-priced securities. This reminds me of a classic Ronald Reagan quote regarding a regulator’s view of economic activity: “If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”

As stated in an earlier article, I am aware of only one firm that accepts deposits of paper certificates. If readers know of firms that do accept deposits of paper certificates, please let me know and I will compile and publish a list.

The regulators have almost succeeded in killing the ability of OTC-traded issuers to raise capital in private offerings. If investors are unable to deposit the paper certificates and sell the shares, they will cease investing in OTC-traded issuers, which are already starving for capital.

[Notes appear below]

* A reader suggested this would be an apropos title for an article discussing the OTC Markets since most OTC Markets companies are tied to the “whipping post” of low trading liquidity, virtually no investment analyst coverage, and virtually no non-toxic capital, which collectively create an inhospitable environment.

1. The decline in the number of US publicly listed companies (so-called “listing gap”) is virtually 100% explained by the disappearance of the smaller IPO (<$50 – $100 million) beginning in 2000, i.e., smaller-cap companies began avoiding the public markets in droves since 1999. See “Hunting High & Low: The Decline of the Small IPO and What to Do About It.” Lux and Pead, April 2018 at p. 8.

2. “Exchange-listed” refers to issuers listed on Nasdaq and NYSE.

3. One recent example is the SEC’s request for suggestions to alleviate the plight of thinly-traded issuers. See the Commission Statement on Market Structure Innovation for Thinly Traded Securities.

4. Special thanks to Mr. David Lopez, CEO of Matador Capital Markets, and former broker-dealer compliance officer, for providing much of the data included in this article.

5. There were 10,817 OTC issuers as of a recent date.

6. These 20 symbols accounted for 83% of the total $874,977,308 OTC Market daily trading volume as of a recent date, according to OTC Markets.

7. Three of them are domiciled in the US (Greyscale Bitcoin Trust, Freddie Mac and Fannie Mae), but none of those are corporate operating businesses. The remaining 17 are foreign common stock or American Depositary Receipts (ADR) issuers.

8. These market makers accounted for $273,637,588 of the total $304,332,336 OTC market maker daily trading volume as of a recent date, according to OTC Markets.

9. See SEC Release No. 34-39670; File No. 57-3-98, February 17, 1998.

10. See footnote 6 above

11. Data from Comply Advantage.

12. The regulator is judging from its “ivory tower” perspective of how quickly the busy brokerage firm, which is monitoring the activities of dozens or hundreds of brokers, processing daily tens of thousands of stock transactions, and opening and closing dozens of accounts daily, should have filed the form.

13. A firm is fined if it files too few SARs and if it files too many SARs.

14. There are 98 FINRA red flags that require a SAR filing.

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OTC Stocks and the ‘Hotel California’ Problem

This is a reprint of my article originally published by equities.com here.

Many smaller cap stocks are illiquid compared to their larger cap cousins. 40% of the ticker symbols traded on NASDAQ and NYSE have average daily trading (ADV) volumes of less than 50,000 shares per day, according to the SEC. The median ADV within this group is only 10,000 shares per day. 50% of these ticker symbols have ADV of less than 100,000 shares a day.

Adam Epstein, nationally recognized small-cap expert and author of the “Systemically Overlooked Anomalies of Governing Small-Cap Companies” chapter of the Handbook of Board Governance: A Comprehensive Guide for Public, Private and Not for Profit Board Members (Wiley, 2016), has said that investing in smaller-cap NMS companies with illiquid stock presents the “Hotel California” problem for investors: they can invest in the company, but because of the stock trading liquidity, it’s virtually impossible to exit their stock position: “You can you check out any time you like, but you can never leave.”1

The ability of smaller cap stocks with low trading volumes to attract non-toxic professional investment capital approaches ZERO for reasons illuminated in earlier articles of mine.

Stocks traded on OTC Markets—about three times the total number of companies listed on the NYSE and Nasdaq combined—have two Hotel California problems. The first is that for most OTC Markets traded issuers, their stocks are LESS liquid than NYSE/Nasdaq stocks. The daily trading volumes for many OTC Markets traded companies is in the HUNDREDS of shares a day, i.e., virtually ZERO trading volume. Increasing their companies’ stock trading liquidity was the#1 capital markets priority for 80% of the CEOs/CFOs of OTC Markets issuers in a 2017 survey.2

The second Hotel California problem presents itself in this circumstance: to sell one’s OTC stock (other than in a privately negotiated sale), it is necessary to deposit the paper certificates with a brokerage firm. It is very, very difficult to find a brokerage firm to take possession of paper stock certificates.

Consider this scenario. An OTC Markets issuer raises needed capital in a private placement and sells shares of stock at, say, $.50 per share. The investor receives a paper stock certificate for the shares it has acquired. The company’s business progresses over the next 12 months and its stock price increases to $2.00 per share on reasonable trading volumes. With the Rule 144 holding period having elapsed, the investor decides to sell the shares for what should be a nice 300% gain. The investor call its brokerage firm to sell the shares. Guess what?

The brokerage firm refuses to take custody of the shares, citing the firm’s compliance department as the reason. The investor calls a dozen other brokerage firms and cannot find any that is willing to take the shares.3 The investor is unable to sell its shares to monetize its gain.

This is a very, very serious problem for OTC Markets traded companies. In fact, if investors in OTC Markets traded companies actually knew how difficult it would be to sell their shares, it’s reasonable to think that many of them would not have invested in the first instance.

All is not lost. As noted in my earlier articles on Equities.com, there are lawful and effective strategies for increasing stock trading liquidity. Contact me through LinkedIn at linkedin.com/in/ronwoessner for more information on this topic.

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1 Lyrics to “Hotel California” by the Eagles.

2 Reported in the 2017 OTC Markets CEO/CFOs survey. The #2 priority was increasing the company share price, and the #3 priority was raising capital.

3 I’ve been told there is at least one brokerage firm that will take possession of OTC Markets traded shares, and I’m told the sales transaction fees are very expensive.

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Going Public is an “On Ramp to Nowhere”​ for Smaller Cap Issuers

There has been much commentary about expanding the public company “on ramp” by making it easier for companies to go public. JOBS Act 2.0 made meaningful progress in that regard. Unfortunately, the U.S. public markets are an “on-ramp to nowhere” for many smaller-cap issuers because the public markets are inhospitable to smaller cap companies. Manifestations of this inhospitability are illuminated in a LinkedIn article appearing here, articles published by equities.com appearing here, and in my Response to Commission Statement on Market Structure Innovation for Thinly Traded Securities [Release No. 34-87327; File No. S7-18-19] published just TODAY by the SEC.

Quoting from slides 2 and 3 of the SEC filing:

  • As long as the view from the IPO “on-ramp” suggests that the prospects of taking on all the additional costs and risks of going public, but struggling to capitalize the benefits, many start-up founders, managers and investors will continue to think twice about choosing to finance their growth via the public market.
  • There are thousands of smaller-cap public companies, including OTC Markets issuers, that have the potential to create millions of jobs and grow GDP.
  • Many of these companies are “dying on the vine” because of their inability to access non-toxic capital and other inhospitable attributes of the US public markets.
  • Thousands of these issuers with the potential to grow, thrive and become vibrant NYSE or NASDAQ issuers and veritable job and GDP creation machines, NEVER will achieve that. Many will stagnate; others will go out of business … with the foreseeable result that the number of US publicly listed issuers will continue to decline, and one day there will be insufficient large cap issuers for Fidelity, Vanguard, large pension funds, etc. to invest in.

Read the entire filing at https://www.sec.gov/comments/s7-18-19/s71819-6671698-204008.pdf.

Thank you for your interest as we continue the struggle to keep the US public markets the world’s pre-eminent capital market and prevent the Chinese from overtaking America.

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Smaller Cap Issuer Valuations Crushed by Dodd-Frank?

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.

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Entrepreneurship in the US is an Endangered Species – reprinted by Ronald Woessner

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.

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Women-Founded Start-Ups are Less Likely to be VC-Funded than … Earth Being Hit by an Asteroid — reprinted by Ronald Woessner

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.

Moreover, venture capital funds are leaving “billions on the table,” according to Allyson Kapin, Founder of Women Who Tech, in a recent interview with Yahoo! Finance The First Trade, which is cited in the article “Women Who Tech founder: Investors ‘are leaving billions’ behind by not funding women-led startups.“

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. 

© Ronald A. Woessner, April 9, 2019

[This is a reprint of an article published by equities.com here.]

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[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%.

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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 here for more information on Mr. Woessner’s background.

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Public Policy is Killing Stock Markets for Smaller-Cap Companies — reprinted by Ronald Woessner

Ronald Woessner This is a reprint of an article of mine originally published by equities.com at the link here.

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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

— please contact me through Linked In.

© Ronald A. Woessner, February 25, 2019

[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.

[7] See, e.g., Dodwell, “Be Afraid: China is on the path to global technology dominance.” March 24, 2017. https://www.scmp.com/business/global-economy/article/2081771/be-afraid-china-path-global-technology-dominance. If American firms are starved for capital, they will not grow, innovate, or create new technologies for the world. 

[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. 

[10] FINRA Member Statistical Review, 2003- 2017.

[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.

[12] Manifestations of this market in-hospitability vis-a-vis smaller-cap issuers are: (a) little-to-no investment analyst coverage; (b) crushed stock valuations; (c) little-to-no stock trading liquidity; (d) “bear raids” and short-sale attacks; and (e) no retail sales people on the phone soliciting buy orders to purchase the issuer’s stock in the open market. These concepts are discussed in the  following articles: https://www.equities.com/news/dodd-frank-death-spiral-how-small-cap-access-to-capital-got-crushed; https://www.equities.com/news/harvard-kennedy-schools-recommendations-to-encourage-companies-to-go-public; https://www.equities.com/news/why-do-investment-analysts-ignore-smaller-cap-companies; https://www.equities.com/news/smaller-cap-companies-beware-the-short-seller; Weild & Kim at p. 19 – 28.

[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.

[17] Weild & Kim at p. 19 – 28.

[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.

[19] This is reminiscent of the nail proverb:

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.

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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.

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A Paradigm Shift is About to Occur for School Security in the US – by Ronald Woessner

A paradigm shift is about to occur for protecting America’s school children in the classroom.  And virtually no one has seen it yet.

The paradigm shift will occur because of the confluence of three events.

Paradigm Influencing Event #1

The Indiana Sheriff’s Association has adopted “best practices” for school security.  The best practices are:

  • Instantaneous threat notification to law enforcement of a shooting or a threat
  • Make the classroom a “protected space” with hardened doors and other protections
  • Enable law enforcement visually to locate and track a shooter inside the school and see the shooter’s weapons platform – officers arrive on scene with “up to the second” situational intel
  • Enable law enforcement to launch countermeasures against the attack while officers are en-route
  • Enable classrooms to report their status (safe, injured, under threat, etc.) to law enforcement
  • Provide law enforcement full command and control of an incident by providing 100% actionable intelligence of the situation in the school.

The Indiana Sheriff’s Association video at this link shows how implementing these best practices will save children’s lives.

An attacker can kill and wound children within minutes of entering the school  — well before any law enforcement officer arrives on scene.  This reality is addressed by the Indiana Sheriffs’ Best Practices:

  • Hardened classroom doors and countermeasures slow the attack and limit casualties while officers are en-route
  • Instantaneous threat notification to law enforcement and providing law enforcement real-time intel as to where the shooter is within the school reduce officer response times

Reduced response times = fewer casualties.

The Indiana Sheriffs’ Best Practices reduce law enforcement response times from the 9 – 10 minute conventional response time to a 4 – 5 minute best practice response time, as illuminated in the graphs below.

 

Paradigm Influencing Event #2

The Indiana Sheriffs’ Best Practices are not the typical dry and obtuse ideas buried on page 95 of a 300 page study commissioned by the government, often read and rarely acted on.  Rather, they are actionable practices already  being implemented at the “Safest School in America” located in Shelbyville, Indiana as shown in this “NBC Nightly News with Lester Holt” episode here.

These best practices already being implemented at the “Safest School in America” are at the heart of the raging national debate regarding school security. They came into national view through the testimony of Max Schacter, whose son Alex was killed in the 2018 Parkland, Florida shooting.

Mr. Schacter has emerged as a leader of the Parkland families and has committed himself to establishing national standards for school safety through the “Safe Schools for Alex Foundation.”

Mr. Schacter testified in August 2018 before the Federal School Safety Commission, where he spoke of visiting Indiana’s “Safest School in America.” He stated that our “soft target” schools need to be “hardened,” like airports and federal buildings, with the protections implemented in the “Safest School in America,” in conformance with the Indiana Sheriffs’ Best Practices. Excerpts of his testimony appear below:

“If the door to Alex’s classroom had ballistic-hardened glass, he would still be alive today,” Schacter said during the meeting. After the shooting, he said, he traveled the country to see what other schools were doing to protect students, and the Indiana school stood out. “In the 19 years since the Columbine tragedy, we have focused most of our efforts on mental health and prevention. School hardening has been at the bottom of the list. Visiting that school in Indiana convinced me that it is time to bring hardening up to the top.”

More of Mr. Schacter’s testimony can be found here.

Paradigm Influencing Event #3

Event #3 is perhaps the most important paradigm influencing event because it reveals how school security systems can be paid for, i.e., where’s the money coming from for school security?  Most school district budgets simply do not have the capacity to pay for school security systems.  In fact, many teachers  routinely use personal funds to purchase school supplies for the children in their classrooms.  Finding substantial monies in state legislative budgets for annually-recurring expenses for school security measures is equally problematic as well.

To solve the funding issue, the State of Indiana has conceived and is acting on an idea that can provide ample funds for school districts to implement the Indiana Sheriffs’ Best Practices.

Legislation has been introduced in the Indiana State Senate that will give Indiana school districts the authority to conduct a referendum whereby the voters in the school district can vote to impose a dedicated property tax to fund school security systems in their school district.  The legislation, SB 127, introduced by Senator Travis Holdman, is expected to be approved and become law this year.  If approved, the legislation would enable Indiana voters to allocate up to $150M annually to provide safer schools for Indiana public school children.

By looking to property tax revenues, SB 127 recognizes and acknowledges that school “hardening” security measures should be viewed and funded as a school infrastructure cost similar to the cost of fire suppression equipment.

In sum, the paradigm shift will result from the confluence of the following three events:

  1. The Indiana Sheriffs have adopted best practices for school security systems.
  2. These best practices are already implemented in the “Safest School in America.”
  3. Following enactment of the Indiana legislation, Indiana parents will vote a tax to pay for school security systems to protect their children in conformance with the Indiana Sheriffs’ best practices for school security systems.

Other states will follow once Indiana moves forward,  This paradigm shift is about to occur.  Wait and see.

© Ronald A. Woessner

January 19, 2019

Mr. Woessner has worked in the smaller-cap company ecosphere for 25+ years in the capacity of General Counsel to two NASDAQ-listed companies and CEO of an OTC-traded company that he up-listed to NASDAQ.  He currently mentors and advises companies in the start-up and smaller-cap company ecosphere and helps them raise capital through Regulation CF crowdfunding and otherwise. 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. Mr. Woessner, a certified Toastmaster, speaks and writes about US public and private capital markets topics and his articles are published at equities.com and elsewhere. For more information on Mr. Woessner’s background or to contact him about a speaking engagement, see https://www.linkedin.com/in/ronald-woessner-3645041a/.

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Smaller-Cap Companies: Beware the Short Seller! – reprinted by Ronald Woessner

 This is a reprint of an article of mine originally published by equities.com at the link here.

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Ronald Woessner   | 

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!

©Ronald A. Woessner

January 9, 2019

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.

 

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More Bad News for US Smaller-Cap US Companies if MiFID II Reaches US — republished by Ronald Woessner

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

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  • 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.