Congress, which blasted a hole in debt and derivative trading profits with the Wall Street Reform and Consumer Protection Act of 2009 (Dodd-Frank), now has taken aim at investment banking.
The stated purpose of the recently adopted Jumpstart Our Business Startups (JOBS) Act is to improve access to the public capital markets for emerging growth companies. In the Congressional hearings that led to the legislation, its advocates lamented the decline in public offerings over the last decade and promoted the bill as the means to reverse this trend.
Ironically, I would expect there to be many fewer public offerings in the wake of the JOBS Act. The Act also will narrow the regulatory divide that currently isolates the United States from Europe and Asia. It is not clear whether those consequences were intended by its promoters.
The foundation of U.S. securities law is the Securities Act of 1933 (Securities Act), which was also the first federal securities law to be adopted by Congress. The cornerstone of the Securities Act is its Section 5, which essentially prohibits any public offering of securities unless a registration statement is first filed with the Securities and Exchange Commission (SEC). The most important part of the registration statement is the prospectus, a document that is used to sell the securities and also to provide essential disclosures to investors.
The primacy of Section 5 is demonstrated by the regulatory resources devoted to its implementation. A substantial portion of the SEC’s resources are expended in the regulation of disclosures in public offerings and the Division of Corporation Finance, which supervises the offering process, is one of the SEC’s largest Divisions.
This strong emphasis on the public offering process differentiates U.S. securities regulation from the rest of the world. The “Prospectus Directive” in Europe was, for the most part, an afterthought intended as a not particularly serious nod in the direction of U.S. regulation. In Europe and Asia, securities regulators spend most of their efforts regulating markets rather than offering disclosure. In contrast, the SEC’s Division of Trading and Markets is much smaller.
The Securities Act contemplates that public offerings will be accomplished through investment banks acting as underwriters. Issuers are strictly liable to investors for material misstatements and omissions in the prospectus; underwriters also are liable, but the performance of adequate due diligence to ascertain that the statements in the prospectus are accurate provides a defense to underwriters’ liability.
Issuers have a powerful incentive to raise capital. In many cases, their very survival may depend upon a successful offering, which causes issuers to engage in fraud to raise capital from time to time. Investment banks, on the other hand, work for a commission, which is never enough to compensate them for the liability they may incur in connection with a fraudulent offering. It is this law of financial nature that gives the Securities Act its teeth. The existence of a due diligence defense means that investment banks have a strong incentive to perform due diligence, and due diligence prevents most fraudulent public offerings from taking place. Investment banks, therefore, serve as mini-regulators of the offering process or, as the SEC is fond of describing them, “gatekeepers.”
Unfortunately, this same liability quotient and the reliance on underwriting makes the public offering process in the United States very expensive. Underwriters insist that lawyers obtain support for every statement in a prospectus, and due diligence is performed by teams of issuer’s and underwriter’s counsel who comb through every sentence of a prospectus to ferret out misleading statements.
Besides the expense, the due diligence process produces a bland prospectus, laden with legal terms of art, rather than robust and informative sales material. It is fair to say that prospectuses are more often read by lawyers than by prospective investors, which defeats the purpose of the exercise. The SEC has launched many initiatives to encourage the production of “plain English” prospectuses, with limited results. While many lawyers long to be writers, very few are capable of composing prose that anyone wants to read.
Nevertheless, the largest expense of the public offering process, by far, is neither lawyers, nor due diligence, nor even the negative effect on the sales process resulting from bland prospectuses. These expenses are dwarfed by the fees that investment banks charge for acting as underwriters, which typically run about 7 percent of the offering.
So what are the services performed by investment bankers that justify fees generally running into the tens of millions for the typical IPO? Investment bankers typically stress their sound market insights and technical expertise, but the reality is something less mysterious. Investment banks have customers who will invest in a public offering. Under the system set in motion by Section 5 of the Securities Act, there really is no way for an issuer to reach those prospective investors, except through an investment bank.
The public offering process is not the only way to raise capital. Since its inception, the Securities Act has permitted issuers to raise capital in private placements of securities. Prior to the JOBS Act, to accomplish a private placement without transgressing Section 5, issuers had to keep the offering truly private. An issuer could not engage in “general solicitation” or “general advertising” to sell securities in a private placement. This obviously precluded placing an ad in the Wall Street Journal. But, the SEC also has interpreted its rules to mean that an issuer cannot sell securities in a private placement to anyone with whom it does not have a “pre-existing business relationship.”
The rules for private placements, therefore, generally prevent issuers from reaching out directly to investors to raise significant amounts of capital. As a result, the restrictions on general solicitation and general advertising forced issuers to use investment banks to gain access to their customers for investment capital.
Of course, another way of looking at this is to view the private placement rules as insulating investment banks from competition and enabling them to charge high fees for the regulated privilege of accessing their customers. I leave it to economists to determine the amount of an investment bank’s underwriting fee that can be attributed to the anti-competitive effects of the private placement regulations under the Securities Act, but clearly there is some amount of “regulatory capture” benefitting the investment banking business.
The JOBS Act changes this regulatory arrangement by requiring the SEC to allow general solicitation and general advertising by an issuer, provided that the issuer seeks to raise capital in private placements only from accredited investors. Issuers will still need to use investment banks if they solicit investments from non-accredited investors, but the reality is that most investors who directly participate in public offerings are institutions and accredited investors. True non-accredited retail investors are much more likely to invest in mutual funds. Using an investment bank to reach out to non-accredited investors is unlikely to justify a 7% commission and due diligence expenses if accredited investors can be tapped directly.
It seems likely that investment banks will therefore find themselves in direct competition with public relations and advertising agencies as facilitators of capital-raising. Under current law, public relations and advertising agencies are not required to perform due diligence on their customers’ businesses and do not face liability for misleading statements. The JOBS Act, therefore, is likely to place downward pressure on investment banking fees from underwriting and, lamentably, is likely to limit the fees that anyone is willing to pay lawyers for performing due diligence scrutiny of offering documents.
If I am right about all of this, the focus of securities regulation in the United States will also change.
In the United States, securities regulation is focused on disclosure. The idea is that an informed investor will not purchase bogus securities. While this may not always be true, Americans are not comfortable with the idea that a regulator should be given the power to determine what securities may be sold to the public. Instead, we prefer a system that requires good disclosure but permits investors to make their own decisions about the merits of an investment, even if that means some fools will invest in businesses with nonsensical, but fully disclosed, business plans.
Since this laissez faire approach to securities regulation is so bound up with our culture, I don’t see the focus on disclosure changing to some version of merit review. Instead, regulators will shift their attention away from offering disclosure, and instead focus on market regulation.
At the present time, an issuer is not required to make disclosures under any federal or state law merely because its stock is publicly traded in the over the counter markets. Disclosures are required only if an issuer chooses to list stock on a national securities exchange, or if has either 2,000 holders of record or 500 who are non-accredited investors. Since the only holders of record are brokerage firms or banks who have accounts with DTC (plus those few investors who prefer to hold actual share certificates), it is entirely possible to be a large, publicly traded corporation with tens of thousands of shareholders and not be required to provide any disclosures under federal securities law.
Issuers list on national securities exchanges not as an act of kindness to their investors, but because investment banks, who are members of national securities exchanges, insist that stocks be listed so that they can easily be resold. Listing also facilitates efforts to keep market prices above initial offering prices, thereby protecting the bank from liability. But, the over the counter markets have become much more efficient in recent years, which has reduced investor demand for listing.
In a world where issuers can reach investors without going through investment banks, and where there is less pressure to list securities on national securities exchanges, the amount and type of disclosure will not be governed by existing securities regulation, but by the desired results of advertising campaigns. This is a recipe for fraud.
As a result, I expect the SEC and investor advocacy groups to press for more rigorous regulation of market disclosure, perhaps prohibiting or severely limiting the public trading of securities without adequate disclosure. The SEC will also shift its resources from the Division of Corporation Finance to its Division of Trading and Markets. Securities regulation in the United States will then much more closely resemble European and Asian securities regulations, whose regulatory attention is devoted primarily to markets.
What we will lose in the process is the investment bank serving as gatekeeper.
Stephen J. Nelson is a principal of The Nelson Law Firm in White Plains, N.Y. Nelson is a contributor and columnist to Traders Magazine’s online edition. He can be reached at sjnelson@nelsonlf.com
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
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