The Treasury Department recently issued a new report, A Financial System That Creates Economic Opportunities—Capital Markets, that, in its recommendations, not surprisingly, echoed in many respects the House’s Financial CHOICE Act of 2017. Having passed the House, the CHOICE Act has since foundered in the Senate (see this PubCo post). The recommendations in the Treasury report addressed approaches to improving the attractiveness of primarily the public markets, focusing in particular on ways to increase the number of public companies by limiting the regulatory burden. According to this Bloomberg article, SEC Chair Jay Clayton “called the report ‘a valuable framework for discussion’ among market participants ‘that will most certainly benefit the American people….We appreciate Treasury’s willingness to seek the SEC’s input during the drafting process, and we look forward to working alongside other financial regulators and Congress as we pursue our three part mission to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation.’”
Commissioner Michael Piwowar has previously observed that, “since 2000, the average annual number of IPOs is 135—less than one-third the average annual number of IPOs—457—in the 1990s…. In the 1980s and 1990s, IPOs with proceeds of less than $30 million constituted approximately 60 percent and 30 percent, respectively, of all IPOs. In fact, some of the most iconic and innovative U.S. companies…entered the public market as small IPOs. This trend reversed in the 2000s. IPOs with proceeds less than $30 million accounted for only 10 percent of all IPOs in the period 2000-2015. By comparison, large IPOs have increased from 13 percent in the 1990s to approximately 45 percent of all IPOs since then.”
The report notes that, in its outreach efforts to ascertain the causes of the decline in IPOs and public companies, rather than the impact of particular regulations, respondents commented on the deleterious cumulative impact of newer regulations, such as SOX, Dodd-Frank, Reg FD and the shareholder proposal rules. But respondents also mentioned changes in equity market structure unfavorable to smaller companies, non-financial disclosure requirements, shareholder litigation risk, short-termism, inadequate oversight of proxy advisory firms and the dearth of research coverage for smaller companies, as well as non-regulatory factors such as globalization, the increase in service-based companies with lower capital needs, increased availability of debt and private funding and increased M&A activity. Not everyone agrees that the hand-wringing over the decline in IPOs is appropriate. According to EY, what happened—largely the result of acquisitions and delistings—happened primarily by 2002; it’s not just a recent phenomenon. And much of the decline may reflect the popping of the dot-com bubble in the first years of the new millennium. Accordingly, some would argue that a number of those companies should not have gone public in the first place and that measuring against the height of the bubble is wrong-headed. (For more discussion regarding the decline in IPOs and public companies, see this PubCo post, this PubCo post and this PubCo post.)
Below are summaries of key recommendations relating to access to capital in the public markets.
The Treasury report recommended the repeal of Section 1502 (conflict minerals), Section 1503 (mine safety), Section 1504 (resource extraction), and Section 953(b) (pay ratio) of Dodd-Frank and the withdrawal of related rules, as proposed by the Financial CHOICE Act of 2017. (The rules related to resource extraction payments disclosure have already been jettisoned by Congress. See this PubCo post.) The report argued that these provisions “have imposed requirements to disclose information that is not material to the reasonable investor for making investment decisions….Treasury recognizes that the original support for such provisions was well-intentioned. However, federal securities laws are ill-equipped to achieve such policy goals, and the effort to use securities disclosure to advance policy goals distracts from their purpose of providing effective disclosure to investors.” If Congress believes that disclosure relating to these issues is desirable, the report suggests, it should be required of both public and private companies and should be subject to oversight by a more appropriate agency, such as the State or Commerce Department. In the meantime, Treasury also recommended that the SEC exempt emerging growth companies and smaller reporting companies from these provisions.
Duplicative Disclosure Requirements
The report recommended that the SEC proceed with a proposal to update and streamline Reg S-K. The SEC approved the issuance of that proposal last week. (See this PubCo post.) Treasury also recommended that the SEC proceed with its 2016 proposal to remove SEC disclosure requirements that duplicate financial statement disclosures required under GAAP.
In the “Disclosure Update and Simplification Proposing Release,” the SEC identified a number of requirements that mandate substantially the same disclosures as U.S. GAAP, IFRS or other SEC disclosure requirements and proposed to eliminate the redundant SEC disclosure requirements. Most of these redundancies related to Reg S-X, but a couple involved S-K Item 601 exhibits. For example, the release proposed to eliminate Item 601(b)(11), which requires a statement showing the calculation of per-share earnings (unless the computation can be determined from information already in the report). According to the SEC, that requirement is duplicative of information required under GAAP, Reg S-X and IFRS. The release also identified SEC disclosure requirements that overlap with GAAP, IFRS or other SEC disclosure requirements, that is, they relate to those requirements, but are not exactly the same. In some cases, under the proposal, the SEC disclosure requirement would be deleted and, in other cases, integrated. In some cases, the result was a request for comment or referral to FASB. In her statement at the SEC open meeting to vote on issuing the release, SEC Commissioner Kara Stein protested that “this proposal may be framed in such a hyper-technical way that it fails to provide a bona fide opportunity for a wide variety of commenters to truly access and understand what is being proposed and what we are seeking comment on.” She may have had a point. This proposal has been languishing since its July 2016 issuance date. (See this PubCo post.)
Permit Additional Pre-IPO Communications
The JOBS Act relaxed the “gun-jumping” restrictions for EGCs by permitting them (and any person acting on their behalf) to engage in pre-filing communications with qualified institutional buyers (QIBs) and institutional accredited investors. This relaxation allowed companies to reduce risk by gauging in advance investor interest in a potential offering. (See this Cooley Alert.) Echoing the CHOICE Act, the Treasury report recommended expanding this provision of the JOBS Act to apply more broadly by allowing all companies, not just EGCs, to “test the waters.”
Proxy Advisory Firms
In outreach meetings with public companies and institutional investors, Treasury heard mixed messages on proxy advisory firms, from investors that found the services valuable to companies that expressed concern regarding the limited competition and resulting market power, conflicts of interest and lack of transparency. The report recommended “further study,” which could include “regulatory responses to promote free market principles if appropriate.” (See this Cooley Alert.)
The report recommends “substantial” revision of the eligibility threshold for submission of shareholder proposals. Interestingly, instead of advocating a fixed dollar threshold or percentage of outstanding stock (as in the CHOICE Act), the report advocated exploring “options that better align shareholder interests (such as considering the shareholder’s dollar holding in company stock as a percentage of his or her net liquid assets) when evaluating eligibility….” The report also recommended that the resubmission thresholds for repeat proposals be substantially revised (although no percentage thresholds were suggested). In support of its position, the report cited a study from Proxy Monitor showing that “six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.” However, the report also acknowledged that a number of investor groups insisted that “the ability to submit proposals is a key right that allows them to hold management accountable and that many shareholder proposals have been adopted that have become widely accepted best practices in corporate governance.”
As discussed in this Pubco post, in remarks before the Chamber of Commerce in July, SEC Chair Clayton indicated that the SEC would be taking a hard look at the shareholder proposal rules. As reported in thedeal.com, Clayton advised that it is “very important to ask ourselves how much of a cost there is….how much costs should the quiet shareholder, the ordinary shareholder, bear for idiosyncratic interests of other [investors].” And as you may recall, in the CHOICE Act, the House also proposed to raise the eligibility and resubmission thresholds for shareholder proposals to levels that would have effectively curtailed the process altogether for all but the very largest holders. (See this PubCo post and this PubCo post.)
Class Action Litigation
Concerns about becoming the target of securities class actions may discourage companies from going public, the report asserted. To make matters worse, the report observed, the number of class actions has recently increased from 151 in 2012 to 272 last year, with 317 filed in the first nine months of 2017 (although still below the peak of 498 actions in 2001). The level of class actions was particularly striking in light of the decline in the number of public companies. However, most cases settled; according to the report, only “21 cases since the adoption of the Private Securities Litigation Reform Act of 1995 have gone to trial.” The report also observed that some commentators view class actions as useful tools for accountability and deterrence of wrongdoing. The report recommended that both the states and the SEC “investigate the various means to reduce costs of securities litigation for issuers in a way that protects investors’ rights and interests, including allowing companies and shareholders to settle disputes through arbitration.”
As discussed in this PubCo post, in Senate testimony earlier this month, Chair Clayton was asked by Senator Sherrod Brown about the speech by Commissioner Piwowar to the Heritage Foundation a few months ago indicating that the SEC was not averse to allowing companies contemplating IPOs to include mandatory shareholder arbitration provisions in their corporate charters. As reported, Piwowar “encouraged” companies to “come to us to ask for relief to put in mandatory arbitration into their charters.” (See this PubCo post.) And Clayton responded that, while he recognized the importance of the ability of shareholders to go to court, he would not “prejudge” the issue. The SEC, he said, had expressed its views on the issue only in particular contexts and had not articulated a firm view on this issue in the past. He also observed that some states preclude these provisions. According to some commentators, these views appear to indicate a significant shift in SEC policy on mandatory arbitration, which could signal “the beginning of the end of securities fraud class actions.”
Dual Class Stock
Given that “state law remains the principal authority for determining issues of corporate governance and shareholder rights,” the report recommends that “the SEC continue its efforts, when reviewing company offering documents, to comment on whether the documents provide adequate disclosure of dual class stock and its effects on shareholder voting.”
Challenges for Smaller Public Companies
As a preliminary matter, the report lamented the disproportionate drop in the number of small company IPOs, as discussed above, attributing the decline to regulatory overload (particularly the internal control auditor attestation requirement of SOX 404(b)), growth in mutual fund sizes (which makes holding smaller positions less attractive), changes in equity market structure, and the tendency of institutional holders to favor larger public companies.
The report advocated increasing the cap for SRC and non-accelerated filer status from $75 million in public float to $250 million in public float and extending the length of time a company may be considered an EGC to up to 10 years, subject to a revenue and/or public float threshold. Smaller reporting companies and EGCs may take advantage of scaled disclosure requirements, and EGCs and non-accelerated filers are exempt from the auditor attestation requirement of SOX 404(b). (For a discussion of the SEC proposal to raise the cap, see this PubCo post. See also this PubCo post and this PubCo post.)
To address market concerns, the report also recommended that the SEC review several rules that make it more difficult for institutional investors, such as mutual funds, to invest in smaller public companies. With regard to deficiencies in sell-side research coverage, which the report suggested were attributable to increased regulation and recent merger activity among investment banks, the report recommended a review of the Global Settlement and other rules. To expand access to capital through the private markets, the report recommended increasing Reg A eligibility to include reporting companies.
The report also recommended steps to increase liquidity in the secondary markets for Reg A issuances and to increase the Tier 2 limit to $75 million. Changes to the crowdfunding rules were also suggested. Acknowledging that women entrepreneurs “have been historically undeserved [sic?] by sources of venture capital,” the report suggested that changes be made to equity crowdfunding to increase flexibility and cost effectiveness. The report also recommended the creation of a regulatory structure for finders (see this PubCo post) and various changes to Reg D, including amending the definition of “accredited investor” to expand the pool. Recommendations to enhance investor due diligence efforts were also included