CREATING LIQUIDITY FOR
EMERGING COMPANY EQUITY
BY IMPLEMENTING A NEW MARKET STRUCTURE
Can Berk Şen
ANR: 877803
Supervisor: Patricia Gil Lemstra
2018
Table of Contents 1. Introduction ...... 2
2. Paths for Emerging Growth Companies ...... 5
a. Emerging Growth Companies and Their Importance ...... 5
b. Achieving Liquidity by Going Public ...... 8
3. Secondary Markets for Private Shares in the Shadow of Major Public Markets ...... 11
a. Evolution of the Secondary Markets ...... 11
b. Current Regulatory Environment ...... 14
i. Registration Requirement ...... 14
ii. The Section 4 (1½) Phenomenon ...... 15
iii. Rule 144 ...... 17
c. The Functionality of Nasdaq Private Market (former SecondMarket) and SharesPost ...... 19
d. Rule 144A and Equity Markets Under This Exemption ...... 23
4. A New Structure of Regulations for Secondary Markets ...... 25
a. The Market for Emerging Companies ...... 27
i. Reduced Compliance Obligations...... 28
ii. Reducing Litigation Expenses ...... 31
iii. Listing Requirements ...... 34
b. Mature Company Market ...... 37
c. Market for Delisted Companies...... 40
d. Private Securities Transactions ...... 42
5. Conclusion ...... 43
BIBLIOGRAPHY ...... 45
1
1. Introduction
Many growing small businesses depend on equity capital to finance their businesses1. These emerging companies can raise equity capital through four significant sources: angel investors, venture capital funds, private placement of securities, and public offerings of securities. Among these options, the amount of private equity funds raised in Europe has been increasing since 2012, reaching about 51 billion euros in 2016.
Traditionally, private companies which use raised funds to develop their business and commercialize a business concept successfully, go public through an initial public offering (IPO). By going public, companies raise a significant amount of equity capital to boost their business, as well as provide its investors and employees with liquidity, since public markets offer a highly liquid market for those who want to sell their shares.
However, the traditional route of going public through an IPO has become less attractive for the companies in the recent years, mainly because of the tight regulatory environment that makes it costly. Compared to the 1980s and the 1990s far fewer companies have gone public in the recent years. The IPO exits have been extremely rare for firms first financed after 1999 in the U.S., and as a consequence, there was an increase in the percentage of firms that remain private2. Meanwhile, in Europe, the value of IPOs in 2016 decreased drastically by 51% if compared to 20153.
Public equity markets rely on young companies replacing the ones in decline, and investors and early-stage employees of emerging companies depend on the existence of a liquid secondary market to resell their equity4. In this context decline in
1 U.S. Gen. Accounting Office, ‘Small Business: Efforts To Facilitate Equity Capital Formation 1’ (2000). 2 Michael Ewens and Joan Farre-Mensa, ‘The Deregulation of the Private Equity Markets and the Decline in IPOs’ [2012], available at https://ssrn.com/abstract=3017610 3 IPO Watch Europe Annual Review 2016 (2017). PricewaterhouseCoopers LLC. Available at: https://www.pwc.co.uk/audit-assurance/assets/pdf/ipo-watch-europe-annual-review-2016.pdf 4 Victor Fleischer, ‘The Rational Exuberance of Structuring Venture Capital Start-ups’, UCLA School of Law, Law & Econ Research Paper No. 03-20 (2003). available at: https://ssrn.com/abstract=432840 2
IPOs is concerning, the alternatives to a public listing are not sufficient to provide liquidity. While the securities laws comprehensively regulate the way to go public and what is required from the firms to do so, regulations regarding secondary markets for securities in private companies are problematic and undeveloped. Shareholders of private companies can sell their shares under exemptions deriving from the securities laws, but these exemptions cannot provide sellers with sufficient liquidity, and contain investor protection loopholes. In the recent years, new platforms have surfaced for the sale of private shares, such as NLX or SecondMarket, but the regulations and the exemptions upon which these markets are founded are unsuitable to provide healthy liquidity alternatives.
Companies that want to avoid the traditional IPO have other ways of accessing public markets without going through the IPO process, and without complying with the regulatory requirements needed for the IPO. For example, reverse mergers provide a backdoor for private companies to become a public one by merging with a public entity.
However, taking an alternative route into the public markets has a set of drawbacks. There is a distinction between being just a public firm and being a public firm that trades on one of the premier exchanges.5 When a company fails to qualify for elite trading platforms, its shares are often relegated to be traded on the over the counter (OTC) markets. Even though recent innovations improved the quality of the OTC platforms, such platforms are still of low quality compared to established trading venues and remain as a poor alternative. They offer little liquidity and lack investor protection. Therefore, the alternative ways of going public are not a sufficient substitute for the firms.
Regulation of the secondary market securities is clear regarding companies trading on the premier exchanges such as NASDAQ or NYSE, although, outside of that area, the regulations consist of a series of disconnected exemptions and rules that make little sense individually or together.6 As regulations are making traditional stock markets an unattractive listing venue, a suitable alternative has yet to arise.
5 Jeff Schwartz, 'The Twilight of Equity Liquidity' [2012] 34(2) Cardozo Law Review. 6 Campbell Rutheford B., 'Resales of Securities: The New Rules and the New Approach of the SEC' [2009] 37(4)Securities Regulation Law Journal 317-343.
3
The needs of investors and entrepreneurs on the topic of liquidity demand a broad rethinking of secondary-market regulations.
To what extent can regulation help improve liquidity through equity for emerging companies? Liquidity problem of emerging companies is addressed in this paper by analyzing the existing exit strategies and regulations in the U.S., since the U.S. is the pioneer when it comes to equity markets and their regulations. A new structure for regulations which is responsive to the emerging companies’ development and evolution is proposed in order to provide investors of emerging companies with liquidity. Since my goal is to provide liquidity by regulating equity markets, crowdfunding is not included in this paper.
In Chapter 2 of this paper, emerging companies would be discussed and the relationship between public equity markets and young firms would be analyzed in order to understand what made IPOs unattractive.
Chapter 3 focuses on assessing existing secondary markets for private shares as a substitute for public equity markets. In this chapter I discuss the regulations regarding secondary markets for private shares, and make an in depth analysis of why they cannot provide a healthy liquidity platform for investors.
In the light of these chapters, in Chapter 4, a new structure for regulations is proposed in order to provide liquidity for early-stage investors and shareholders of emerging companies.
4
2. Emerging Growth Companies and Liquidity
In the recent years many startups and innovative companies have emerged by taking advantage of innovative and advanced technologies, and these companies play a significant role in the economy by creating more jobs. Considering that these companies are growing fastest during their early years, financing is vital during these early years. However, conducting an IPO to raise capital is hard to afford for these young companies because of its exorbitant costs. The Jumpstart Our Business Startups Act, or the JOBS Act is a law that aims to improve funding of young companies by easing many of the U.S. securities regulations.
Emerging growth company is a new category of issuers created by the JOBS Act. In order to qualify as an emerging growth company, the company must have “total annual gross revenues of less than $1,000,000,000 … during its most recently completed fiscal year.”7 Additionally, companies that conducted an IPO on or before December 8, 2011, are excluded from the definition of emerging growth companies8. JOBS Act created the category of “emerging growth companies” as a requirement to benefit from eased regulations stipulated by the Act. The intentions of the Act with these provisions are creating more jobs and stimulating economy by removing regulatory obstacles for young firms when they decide to go public.
a. Emerging Growth Companies and Their Importance
First of all, young emerging firms are essential as job-creators. Even though policymakers consider that small businesses create most private sector jobs, new research shows that young firms are the ones hiring people, not small firms9. Young firms constitute nearly all net new job creation –which is an overall increase in jobs, taking lost jobs also into account- and almost 20 percent of gross job creation in the
7 JOBS Act § 101 (a). 8 JOBS Act § 101 (d). 9 John Haltiwanger and others, 'Who Creates Jobs? Small versus Large versus Young' [May 2013] 95(2) The Review of Economics and Statistics 347-361 5
U.S.. Furthermore, an average of 1.5 million jobs per year is created by firms less than one year old10.
The contribution of young firms in the area of job creation peaks after they go public. The post-IPO report demonstrates that emerging growth companies went public during June 1996-December 2010 had a 156 percent increase in employment, far more than the average increase of all companies went public during the same period11. This significant contribution of young-public firms shows us that the costs imposed on these firms by regulations need to be analyzed carefully. Since the costs of regulatory compliance are high in proportion to their earnings, if compliance costs are eased, young firms will most likely spend the money saved on compliance towards hiring new employees, while others might spend the money on dividends and management perquisites. Therefore, cutting costs of going public for young firms would benefit the economy by creating more jobs.
Furthermore, young firms are important for the long-term viability of the equity markets. Established companies tend to have lower growth. Consequently, the absence of young firms entering the market would cause stagnation. In this case, Joseph Schumpeter’s notion of creative destruction12 applies to firms as well. Innovative new firms replace established firms that lose their competitive edge. For instance, only 12% of the Fortune 500 companies from 1955 were still on the list in 2016.13 This fact shows us the Schumpeterian creative destruction over the last decades.
On the other hand, based on decades worth of market data, lifespans of big companies are getting shorter than ever in the last century. Companies in the S&P 500 Index in 1965 has remained in the index for an average of 33 years. The
10 Kaufmann Foundation, 'The Importance of Young Firms for Economic Growth' (2015)
Equity markets, especially the public markets, are the most common platforms to provide early-stage employees and investors with liquidity. In this regard, the equity markets’ role in entrepreneurial finance is crucial. If equity markets become an unattractive alternative for providing liquidity, young firms will look for other liquidity options. Nevertheless, existing alternatives are not as sufficient as being listed on a public market.
The first alternative for firms that seek liquidity would be pursuing trade sale. Trade sale provides investors, employees and entrepreneurs with liquidity, by allowing them to sell their shares to a single buyer15. However, trade sales have some downsides. First of all, trade sales do not provide investors with liquidity at all times. The structure of acquisition may provide only venture capitalists with liquidity while employees are left with stock in the acquirer company. Another issue is that acquirers have the bargaining power in trade sales. This allows them to extract some of the firm’s value from its shareholders, as a result trade sales provide existing shareholders with lower returns than an IPO16.
Furthermore, trade sales also affect job creation. Job creation is impeded when a young firm gets acquired by another company. Generally, acquisitions cause job losses due to operations to boost efficiency for the acquired firm. In short, trade sales cause job losses, while IPOs create jobs.
Listing the firm abroad is another alternative that has major downsides. The main issue is transaction costs, as the process of listing abroad involves hiring counsel and fitting the business to the regulatory scheme of the target country. Especially for small firms in environments with weak corporate governance, these
14 Innosight ‘Corporate Longevity: Turbulence Ahead for Large Organizations’ [2016] available at:
Additionally, listing abroad may affect investor protection negatively. Investors of the origin country are forced to participate in foreign legal regimes instead of a regulatory regime designed to protect their interests. Even though regulations regarding investor protection are improving globally, investor protection standards are not universal. Corporate officials might plan the listings in overvalued markets to boost their valuation19. Since average investors are ill-equipped to participate in foreign markets, over-valuation may cause investors to be swindled. Therefore, a domestic market that offers necessary investor protection standards is optimal for the investors.
Considering the issues regarding its alternatives, traditional IPO mechanism is still the optimal option for providing investors with liquidity.
b. Achieving Liquidity by Going Public Seeing that IPOs are still the traditional mechanism to provide liquidity, in order to assess the relationship between equity markets and emerging firms, the frequency of the IPOs need to be analyzed. In short, a decline in the number of the IPOs would indicate a problem.
The average annual IPOs in the U.S. fell from 310 during 1980 – 2000 period to 99 between 2001 and 201220. IPO activity in Europe has also declined in the same period, falling approximately one third after 2000, from 293 IPOs each year in between 1995 and 2000 to 199 IPOs per year in between 2001 and 201121.
17 Nuno Fernandes and Mariassunta Giannetti, 'On the Fortunes of Stock Exchanges and Their Reversals Evidence from Foreign Listings' [September 2013] 1585 ECB Working Paper Series 18 Steven M. Davidoff Solomon, Regulating Listings in a Global Market, 86 N.C. L. Rev. 89 (2007) 19 See supra note 17 20 Gao, X., Ritter, J., & Zhu, Z. (2013). Where Have All the IPOs Gone? Journal of Financial and Quantitative Analysis,48(6), 1663-1692 21 Jay Ritter, Economies of Scope and IPO Activity in Europe. in Mario Levis and Silvio Vismara (eds), Handbook of Research on IPOs (Edward Elgar Publishing 2013) 11-37 8
In addition, VC-backed IPOs have declined consistently with the IPO market, in fact, they even dropped to single digits in 2008 and 200922. However, small sized IPOs had the sharpest decline, falling from 165 IPOs annually in 1980-2000 to 28 IPOs in 2001 - 201223. While IPO count has been gradually decreasing, especially for the small firms, public markets are also affected, since delisted firms are not being replaced by new ones. There are 45% fewer companies listed in the U.S. in 2015 compared to 1997.
It is hard to point out one or two dominant sources of this overall decline in IPOs, but the increasing cost generated by securities regulations directed at the IPOs is a significant factor. PwC estimated that in 2017, in addition to underwriter fees, companies going public incur $4.2 million on average in offering costs and $1 million on average in one-time costs as a result of going public24. Based on a survey that consists of over 60% of the public companies, on average $1 million is spent annually on recurring costs as a result of being a public company.
Costs of being a public company increased sharply in the 2000s, additional reporting obligations, various operational burdens have been imposed on publicly traded companies. As a result, companies sensibly aim to avoid compliance impose costs. For instance, a small firm with sixty employees would not want to devote a significant amount of money for reporting requirement. Although regulatory requirements apply to all firms, the costs are felt mostly by emerging firms. Costs are proportionally higher for emerging firms since they tend to be smaller. In this regard, compliance requirements are usually a bother25, and scare away possible candidates of public markets.
The decline in the number of IPOs means that the relationship between entrepreneurs and public equity markets is in distress. Furthermore, the absence of a healthy relationship between entrepreneurs and public equity markets harms both
22 Wilmerhale, 2017 IPO Report available at: https://www.wilmerhale.com/uploadedFiles/Shared_Content/Editorial/Publications/Documents/ 2017-WilmerHale-IPO-Report.pdf 23 Gao (n 20). 24 PwC, “Considering an IPO to fuel your company’s future? Insight into the costs of going public and being public” available at: https://www.pwc.com/us/en/deals/publications/assets/cost-of-an- ipo.pdf 25 Amy Deen Westbrook and David A. Westbrook, 'Unicorns, Guardians, and the Concentration of the US Equity Markets' [2018] 96(688) Nebraska Law Review 9 parties, since the lack of IPOs cause the equity markets to lose their vitality, and hinder entrepreneurs access to a suitable liquidity platform.
However, an IPO is not the only liquidity alternative provided by securities laws. In order to suggest a potential reform, alternative venues that offer equity liquidity need to be assessed. If small firms have access to secondary-market liquidity without conducting a traditional IPO, and those secondary-markets are suitable alternatives, a reform might be unnecessary. For his reason, in the next chapter, alternatives for secondary-market liquidity will be analyzed.
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3. Secondary Markets for Private Shares in the Shadow of Major Public Markets
Multiple alternatives to the traditional IPO are introduced by analyzing the structure of securities regulations. If a firm decides to eschew the traditional IPO path, it has the option to stay private or to go public through a less complex process. However, both of these options are insufficient to provide emerging company investors with liquidity. Moreover, the structure for secondary market regulations pose investor protections concerns and are inconsistent26. A broad analysis of the area demonstrates that significant reform is needed.
a. Evolution of the Secondary Markets The secondary market for venture capital assets surfaced after the Internet bubble burst in the late 1990s, and it proliferated after that, reaching sales exceeding one billion dollars a year27. Secondary markets enable the trading of private company shares by giving the opportunity for emerging company investors to sell their shares before the first exit event such as sale, merger or an IPO28.
The growth of secondary market transactions has its source in several factors. First of all, as mentioned in the earlier chapter the sharp decrease in the IPOs over the last two decades has forced investors to look for alternative exits. Also, the Sarbanes-Oxley Act of 2002, which intended to improve the accuracy and reliability of company disclosures to protect investors, imposed increased disclosure, litigation, and opportunity costs for the public companies29. According to the survey conducted
26 Schwartz J, 'The Twilight of Equity Liquidity.' (2012) 34(2) Cardozo L Rev 531 27 Dan Burstein and Sam Schwerin, ‘Inside the Growing Secondary Market for Venture Capital Assets’ [2008], Millennium Technology Value Partners, L.P., 5, available at http://www.mtvlp.com/files/resources/burstein.pdf 28 Darian M. Ibrahim, 'The New Exit in Venture Capital' [2012] 65(1) Vanderbilt Law Review 29 Roberta Romano, Does the Sarbanes-Oxley Act Have a Future?, 26 YALE J. ON REG. 229, 252 n.92 (2009) 11 by Financial Executives International, the total average costs of compliance with Section 404 of the Act were $1.6 million per the U.S. accelerated filer30.
Another factor being pointed out is market structure changes, especially the regulatory change regarding decimalization. A white paper by the accounting firm Grant Thornton suggests that the IPO crisis started before the Sarbanes-Oxley Act, replacing the former fractional system of recording stock spreads in increments of $0.25 per share with a system that records stock spreads in increments of $0.01 per share made it easier for investors to engage in speculation activity and harder for young small firms to attract research and investors31.
Xiaohui Gao et al. propose another explanation for the diminishing IPOs by focusing on a firm’s choice between staying small or becoming large. Instead of going public, young emerging firms rather choose being acquired to achieve economies of scale under the wings of a large company32.
The increase in employee incentives in the last two decades also contributed to the growth of the secondary markets33. This equity-based compensation is trending, because of cash constraints young emerging companies are facing, employee attraction and retention for the vesting period34.
Private firms started offering equity options to a broad range of employees in 1980s35. According to the research made by the National Center for Employee Ownership, as of 2017, approximately 28 million employees are provided with stock options, and employees control 8% of the corporate equity. As a consequence of the growth in equity compensation, employees’ need for markets to liquidate their
30 Fin. Executives Int'l, Fei Audit Fee Survey: Including Sarbanes-Oxley Section 404, 12 (2008). 31 David Weild and Edward Kim, ‘Market Structure Is Causing Ipo Crisis – and More’ (2010), available at https://sharespost.com/site/assets/files/1534/market_structure_is_causing_the_ipo_crisis_and_more.p df 32 Gao, X., Ritter, J., & Zhu, Z. (2013). Where Have All the IPOs Gone? Journal of Financial and Quantitative Analysis,48(6), 1663-1692 33 Robert Anderson IV, Employee Incentives and the Federal Securities Laws, 57 U. MIAMI L. REV. 1195, 1195 (2002); Corey Rosen, Equity Compensation: Who Gets What?, NAT'L CTR. FOR EMP. OWNERSHIP (Apr. 2012), http://www.nceo.org/main/article.phplid/7/ 34 Spencer E. Ante, SecondMarket Gets Its Own Funding, WALL ST. J. (Nov. 2, 2011), available at https://www.wsj.com/articles/SB10001424052970203707504577012303010455414 35 Exemption of Compensatory Employee Stock Option from Registration under Section 12(g) of the Securities Exchange Act of 1934, 72 Fed. Reg. 37608 (July 10, 2007) (codified at 17 C.F.R. § 240.12h-1), available at http://www.sec.gov/rules/proposed/2007/34-56010fr.pdf. 12 securities surfaced. However, restrictions on the transferability of the stocks cause a major drawback for secondary market transactions.
In 2009 secondary market for private shares had a breakthrough by the launch of two electronic marketplaces: SecondMarket36 and SharesPost37. These marketplaces offered a platform for buyers and sellers of private company stocks to meet, and they set an adequate price for stocks by providing a “central location for trading” and sharing recent bids38.
SecondMarket was founded in 2004 by Barry E. Silbert, a former investment banker who specialized in financial restructurings. It was founded to provide liquidity for restricted securities of public firms. However, in the beginning of 2008 SecondMarket expanded into other asset classes including private company stock. After a year of development and pilot testing, SecondMarket’s market for private company stocks has been added to the platform in April 2009. The platform grew rapidly since its foundation; private company transactions went up from $100 million in 2009 to $400 million in 201039. This growth was noticed by Nasdaq, in 2015 Nasdaq acquired SecondMarket Solutions and rebranded it as the Nasdaq Private Market. The growth continued after the acquisition, 2017 was the biggest year for Nasdaq Private Market, total secondary private transaction volume increased by approximately 300% from 2016 reaching $3.2 billion40.
The Securities and Exchange Commission allows the trading of unregistered securities only for selected investors. Nasdaq Private Market has an online accreditation and verification process in order to let only accredited investors trade on their platform. Potential investors have to upload supporting documentation regarding their income and net worth. After related documents are reviewed, a unique one year valid I.D. is given to the applicants who are verified as accredited investors.
Nasdaq Private Market considers prospective buyers as “participants” since the investors secondary market are repeat buyers. A social network platform was
36 SecondMarket (NASDAQ Private Market), https://www.nasdaqprivatemarket.com 37 SharesPost, http://www.sharespost.com/ 38 Darian M. Ibrahim, The New Exit in Venture Capital, 65 VAND. L. REV. 1, 16 (2012) 39 Bloomberg Markets, June 2011, pp 33-44 40Secondary Market 2017 Retrospective, Nasdaq Private Market, available at: https://www.cooley.com/~/media/cooley/pdf/reprints/2018/2018-01-31-nasdaq-private-market- retrospective.ashx?la=en 13 also introduced in March 2011, for participants to share investment ideas and cooperate with each other.
Secondary markets’ rapid growth and development in recent years are promising. However, they are still in the early stages and face serious challenges. Big private companies such as Facebook Inc., LinkedIn and Groupon Inc. choose to go public in recent years. Some claim these large company exits are threatening for these markets since they will now have to attract new firms to join their platforms41. However, the current regulatory structure constitutes a major drawback for secondary markets.
b. Current Regulatory Environment Securities regulation focuses on the public market while markets for private shares remain in its shadow. The secondary markets for private shares are subject to section 4(1) of the Securities Act and in Securities Act Rules 144 and 144A. There were no markets to facilitate transactions under these provisions until SecondMarket, SharesPost and Portal Alliance were established. SecondMarket and SharesPost mainly host sales under section 4(1) and rule 144, while Portal Alliance operates under rule 144A. Despite the positive comments and publicity these secondary markets generated42, current regulatory foundation and the exemptions these markets are founded on are insufficient to provide robust liquidity platforms.
i. Registration Requirement
Section 5 of the Securities Act requires registration of all securities that have been offered for sale by the issuers43. The registration is required not solely for initial offerings, also for secondary market transactions between shareholders. However, registration being costly forces issuers and shareholders who are looking to resell their securities to avoid it.
41 Steven Russolillo, Public Problem: Private Markets Grapple With Tech IPOs, Wall Street Journal (Oct. 31, 2011), available at: https://www.wsj.com/articles/SB10001424052970203687504576655311056016704; Erik Sherman, Life After Facebook: Private Investment Markets Regroup, INC. (May 23, 2012), available at: https://www.inc.com/erik-sherman/life-after-facebook-private-investment-markets-regroup.html 42 Andrew Ross Sorkin, ‘An Exchange Without the Volatility’, N.Y. TIMES DEALBOOK (Sept. 26, 2011), available at: https://dealbook.nytimes.com/2011/09/26/secondmarket-an-exchange-without- the-volatility/ 43 15 U.S.C. § 77e (2006) 14
Issuers and shareholders need to find an exemption from the blanket requirement to eschew registration. Issuers turn to section 4(2), which is about the exemption of private offerings by issuers44. On the other hand, resellers in secondary market transactions turn to section 4(1), which exempts not involving an issuer, underwriter or dealer from registration transactions45. The focal point of this provision is to exempt secondary market transactions in public markets. This allows securities transactions in public exchange markets like NYSE and NASDAQ to be free of regulatory friction.
Regarding transactions in the securities of private companies, however, application of this exemption is rather limited. The important risk of the seller being considered an “underwriter” in the sale of private shares causes the secondary market transactions of private shares to be excluded from exemption treatment. Section 2(a)(11) of the Securities Act defines the term “underwriter” broadly, as any person who has purchased a security from an issuer with a “view to … distribution”46. Purpose of this broad definition is to prevent issuers to circumvent the registration requirement. In other words, in the absence of this definition, an issuer could sell its shares in a private offering exempt from registration under section 4(2) to a group of shareholders, with its intention being that the group of shareholders to flip the shares to the public. The rule provides a backstop by excluding those who buy shares with “a view to … distribution” from the scope of section 4(1).
In the end, the validity of resales without registration under section 4(1), in other words, the regulatory structure for the resale of private shares, comes down to the interpretation of this crucial language.
ii. The Section 4 (1½) Phenomenon Despite being logically unquestionable, the common-law approach gives rise to unsatisfactory doctrine. Courts identified “view to” as intent and “distribution” as a public offering while defining the central language47. Considering the definition made by the courts, the inquiry is in analyzing both the initial sale and the resale transactions, to decide upon whether the person is attempting to resell with an intent
44 15 U.S.C. § 77d (a) (2) 45 15 U.S.C. § 77d (a) (1) 46 15 U.S.C. § 77b(a)(11) 47 Ackerberg v. Johnson, 892 F.2d 1328, 1335-37 (8th Cir. 1989) 15 to transfer the securities to the public. In that case, exemption deriving from section 4(1) will not be available for the resale transaction.
Courts analyze both aspects of the resell separately while conducting the inquiry. They consider the time period that securities have been held to decide upon the intent issue. The longer the person holds the securities means less intent to flip the shares to the public. There is also a rebuttable presumption that after three years there is no intent to resell48. On the issue of resale constituting a public offering, the courts adopt the common-law analysis that interprets this issue with reference to section 4(2), which provides that “transactions by an issuer not involving any public offering” do not need to be registered49. This corresponding precedent creates the section 4 (1½) phenomenon, as an exemption technically deriving from section 4(1).
General consideration of the rule for section 4 (1½) is that a resale to limited amount of -certainly less than 25- sophisticated and informed purchasers, who are able to evaluate the risks of the investment and have no intent to flip the stock to the public, is lawful, if the seller holds the shares for a time period that shows seller’s investment intent50.
The uncertainty of the language makes the boundaries of these criteria unclear, and this issue reveals that this rule is inadequate to provide a foundation for a liquid secondary market. It is hard to identify which secondary market transactions qualify under section 4 (1½) framework51. This unpredictability impairs liquidity, considering the risk of the transaction being deemed illegitimate, only a few investors get involved in these transactions.
Hazy boundaries of the rule are not the only issue. The black-line rule of purchasers being able to sell their shares freely after years is problematic. Allowing purchasers to sell after three years, threatens investor protection and harms liquidity. Since there are no requirements to provide information to prospective purchasers, corrupt sellers could clear out valueless shares on the unsophisticated investors. The
48 J. William Hicks, Resales Of Restricted Securities § 6:13 n.3 (2011). 49 15 U.S.C. § 77d(a)(2) 50 Robert B. Robbins, “Offers, Sales and Resales of Securities Under Section 4[a](1-1/2) and Rule 144A,” ALI CLE Course of Study, March 14–16, 2013, http://www.pillsburylaw.com/siteFiles/Publications/RobbinsSalesandResalesunder4112andRule144A2 013.pdf (accessed May 1, 2016) 51 William K. Sjostrom, Jr., 'The Birth of Rule 144a Equity Offerings' [2008] 56(1) UCLA Law Review 409-433. 16 lack of regulations on this topic conflicts with an essential element of securities law framework. Sales and resales of securities to ordinary investors are allowed only if up to date extensive information is available. However, no information is required if the security is held for at least three years under section 4 (1½).
Considering the issues regarding the rule, it is insufficient to provide liquidity or investor protection. As a result, it is not suitable as the foundation of a liquid secondary market. Even though the general opinion was to avoid it52, SecondMarket and SharesPost established secondary markets based on this exemption.
Since the language of this section is ambiguous, apart from clear cases, it is hard to decide what transactions would qualify under this section. This issue harms liquidity because investors would refrain from taking part in transactions that might be deemed illegal. Taking all this into account, jurisprudence regarding this section was created to support the legislature’s intent to prevent public offerings circumventing securities regulation by disguising as private ones53, instead of supporting the idea of the secondary market liquidity. Legislation solely focusing on the issue of unregistered public offerings creates a gap on the subject of a well-thought regulatory framework for the resale of private shares. In order to clarify secondary market transactions, the SEC promulgated rule 144.
iii. Rule 144 The SEC enacted the rule 144 in 1972, to clarify the issues related to the application of section 4(1)54. The rule sets right the underwriter status by stating that a person "shall be deemed not to be an underwriter... within the meaning of section 2(a)(11) of the Securities Act."55. By addressing the uncertainties regarding underwriter status, rule 144 clarifies the application of section 4(1) for resellers. In the matter of secondary market liquidity, the rule’s approach to prospective resellers in private companies is the most significant aspect of the rule.
52 Harold S. Bloomenthal & Samuel Wolff, Going Public Handbook: Going Public, The Integrated Disclosure System And Exemption Financing § 2:77 (2006) 53 J. William Hicks, Exempted Transactions Under The Securities Act Of 1933 §§ 9:109-:129 (2012) 54 Notice of Adoption of Rule 144, Securities Act Release No. 33-5223, 37 Fed. Reg. 591, 1972 WL 121583, '3-4 (Jan. 11, 1972) 55 17 C.F.R. § 230.144(b) (2012) 17
First of all, rule 144 divides shareholders as affiliates and nonaffiliates. Nonaffiliated shareholders cannot resell their shares before one year, however, following the completion of one year holding period shares can be resold at will. For affiliates, on the other hand, the rule demands much more. An affiliate is defined as, a person or an entity that "directly, or indirectly through one or more intermediaries, controls, or is controlled by, or is under common control with, [the] issuer."56. While determining affiliates, whether the seller is an officer, director or owner of more than 10% of the issuer’s securities has vital importance57.
Affiliates have to deal with several important restrictions while reselling their shares. Those affiliated with the company cannot sell their shares before one year, same as nonaffiliates. However, on the contrary of nonaffiliates, after one year they can only sell a limited amount58, brokers or similar means can only execute the transaction59. Furthermore, information about, among other things, the issuer’s state of incorporation, its financial status and the identity of its officers and directors must be provided by the broker to prospective buyers60.
The aim of this rule by easing the resale requirements was "to help companies to raise capital more easily and less expensively."61. However, the one year rule casts the same doubts as of the three year rule under the section 4 (1½) doctrine. Regarding the regulation of nonaffiliate transactions, the rule sets up the foundation for an unregulated marketplace for the resale of private securities when the holding period is complete. This issue impairs investor protection purpose of securities law and harms liquidity.
The rule is also problematic on the subject of affiliate transactions, but the problem is quite the opposite of nonaffiliated transactions. The limitations on sale, especially the requirement of sales being executed through a brokerage transaction, make the exemption ineffective. The rule forces brokers to sell shares of a private company solely to the people who are seeking to buy those particular shares62. This issue drastically lowers the chances of little-known private firms’ shares to be sold.
56 17 C.F.R. § 230.144(a)(1) 57 American-Standard, SEC No Action Letter, 1972 WL 19628, at *1 (Oct. 11, 1972) 58 § 230.144(e) 59 § 230.144(f)-(g) 60 §§ 230.144(c)(2), 240.15c2-11(a)(5)(i)-(a)(5)(xvi) 61 Revisions to Rule 144 and 145, 72 Fed. Reg. 71,546, 71,549 (Dec. 17, 2007) 62 17 C.F.R. § 230.144(g)(3)(i) - (iv) 18
As a result, there is substantially no market available for affiliates’ shares and an unregulated market for nonaffiliates’ shares.
c. The Functionality of Nasdaq Private Market (former SecondMarket) and SharesPost
As mentioned above, Nasdaq Private Market and SharesPost are online platforms that allow shareholders of private companies to resell their shares based on one or the other of two exemptions63.
The most important feature of these markets is that they provided a platform for the early-stage investors and employees to list their private shares on which prospective purchasers can analyze them. On the other hand, there is a crucial limitation that only accredited investors (high-net-worth individuals, banks, financial institutions) are able to purchase in both of these markets64. Even though the introduction of these markets was beneficial for the liquidity of the private shares, they present a temporary solution to satisfy the demand arising from the lack of IPOs rather than a long-term solution.
As explained above, when we look at the numbers, these markets are proliferating. However, the numbers do not reflect the actual state these markets are in. By looking at the numbers, one might think that private shares are fluidly bought and sold on these markets. In reality, both of these markets comprise several indications of illiquidity.
According to a 2011 Wall Street Journal article, these markets are “boring” and void of action. Additionally, it claims that the "numbers of buyers and sellers remain fitfully small" and that "real trades remain rare, with listings showing trades that grew stale months ago” on SharesPost65. While trades on public markets happen immediately, buying and selling on these private markets is “time-consuming and
63 Scott D. McKinney, ‘Securities Registration: Facebook and the Challenge of Staying Private’ [2011] INSIGHTS 25 (2) 5-6, available at https://www.huntonak.com/images/content/3/5/v3/3528/Facebook-McKinney-2.11.pdf. 64 Steven M. Davidoff, ‘Private Markets Offer Valuable Service But Little Disclosure’, N.Y. Times Dealbook (Nov. 22, 2011, 4:37 PM), https://dealbook.nytimes.com/2011/11/22/private-markets- offer-valuable-service-but-little-disclosure/ 65 Dennis K. Berman, The Game: My Dead Grandma, Facebook Investor, WALL. ST. J., Apr. 12, 2011, at C1 19 bureaucratic.”66 For instance, buying a share of Facebook, when it was being traded privately, would take a week to complete. As a result, despite numbers are showing the opposite, these private markets are illiquid67.
The issuer’s ongoing involvement in the sale process causes part of the idleness these markets are facing. Buyers are not only analyzing the value of the shares they are interested in, but they also need to find their way through several transfer restrictions that are in favor of the issuer68. The companies might take their time while sharing relevant information. Moreover, they might use their right of first refusal which allows them to match the offer and to intervene in transactions.
Legal regulations also slow down the sale process. As explained above, section 4 (1½) is problematic because of the compliance requirements, and rule 144’s requirements targeting affiliate resales make these sales almost impossible. Furthermore, section 12 (g) of the Exchange Act causes another drawback69. According to this law, companies with more than $10 million in assets and more than 499 shareholders must file Exchange Act reports70. The new statute that came in force by the JOBS Act preserved the structure of the rule, but raised the shareholder threshold to 2.000, as long as the company has no more than 499 unaccredited investors71. The companies that run up against these thresholds choose to go public because crossing the threshold means that the firm must disclose information like it is a public company72. In fact, this rule drove Google, Facebook, and Microsoft to their IPOs73.
66 Udayan Gupta, ‘Secondary Markets Find Way to Buy and Sell Shares of Privately Held Companies’, Institutional Investor, Apr. 18, 2011, https://www.institutionalinvestor.com/article/b150y7c8d06sg5/secondary-markets-find-way-to-buy-and- sell-shares-of-privately-held-companies 67 Richard Teitelbaum, Facebook Drives SecondMarket Broking $1 Billion Private Shares, Bloomberg Markets Mag., Apr 26. 2011, http://www.bloomberg.com/news/2011-04-27/facebook- drives-secondmarket-broking- 1-billion-private-shares.html 68 Ibrahim (n 15) [39], [41] 69 15 U.S.C. § 7 8 1(g)(1) (2006) 70 17 C.F.R. § 240.12g-1 (2012) (changing the dollar threshold to $10 million from the statutorily prescribed $1 million) 71 JOBS Act, Pub. L. No. 112-106, § 501, 126 Stat. 306, 325 (2012) 72 Petter Lattman, Share Rules Could Prompt an Offering by Facebook, N.Y. Times Dealbook (Dec. 28, 2010, 9:01 PM) http://dealbook.nytimes.com/2010/12/28/focus-onprivate- shares-could-push-a-public- offering 73 Steven M. Davidoff, Facebook May Be Forced to Go Public Amid Market Gloom, N.Y. Times Dealbook (Nov. 29, 2011, 7:58 PM), http://dealbook.nytimes.com/2011/11/29/facebook-may-be- forced-to-go-public-amid-market-gloom 20
Section 12 (g) has an apparent adverse effect on Nasdaq Private Market and SharesPost since it forces companies to leave their platform and go public. Moreover, private companies minimize their shareholder count to avoid a forced IPO. This situation encourages private companies to hamper certain sales since a company would prefer the sale to existing shareholders or a single buyer instead of a significant number of investors. Even though the JOBS Act reform is beneficial for the private companies, it does not entirely eliminate companies’ concerns. The existing shareholder limitations will continue to force companies to intervene in sales which will cause delays that impair secondary market liquidity.
Additionally, the lack of information and the information asymmetry between buyers and sellers raises concerns about investor protection in secondary markets. This issue is associated with both the quality and the amount of disclosed information74. When Groupon and Zynga -companies had listings on SecondMarket (Nasdaq Private Market) and SharesPost- filed for their IPOs, it was the first time that they were forced to disclose information subject to SEC review. Following the information disclosed, it became apparent that both companies were using questionable accounting methods. This issue coming up after both companies filed to go public reveals that SharesPost and SecondMarket (Nasdaq Private Market) lack transparency, government oversight, and standardized reporting. Ultimately, the root of the problem is the more significant concern that in the absence of a sufficient amount of proper information, the value private companies cannot be determined accurately75.
Furthermore, despite the decrease in the IPOs, innovative high-tech companies –such as Facebook or Zynga- that contributed a lot to SharesPost’s and SecondMarket’s (NPM) growth have been leaving these markets to go public. Transactions in Facebook stocks constituted 39% of SecondMarket’s transactions in the last quarter of 201076. This created an impression that unsuccessful companies populated secondary markets, and it was uncertain whether these markets could
74 Letter from Mary L. Schapiro, Chairman, SEC, to Darrell E. Issa, Chairman, House Comm. on Oversight and Gov’t Reform 24 (Apr. 6, 2011), available at http://www.sec.gov/news/press/schapiro-issa-letter-040611.pdf 75 Marcel Kahan, 'Securities Laws and the Social Costs of Inaccurate Stock Prices' [1992] 41(5) Duke Law Journal 76 Julianne Pepitone, Secondmarket Trading Doubles in Private Company Stock, CNN Money (Jan. 22, 2011, 9:43 AM), http://money.cnn.com/2011/01/21/technology/secondmarket_q4/index.htm 21 survive without the presence of Facebook and its likes77. However, highly valued emerging innovative firms, such as Lyft or Airbnb entered these secondary markets, and the total value of tradeable shares among the top private U.S. companies have reached $35 billion in 2016, more than three times the $11 billion in 201178.
Many companies adopting a counter-view regarding allowing employees to sell their shares in these markets constitutes another issue79. Lawyers for emerging companies structure equity compensation in order to prevent employees from using these platforms to sell their shares. Moreover, Nasdaq Private Market (SecondMarket) was described as an “Ebay” for private shares by its founder in the earlier years, but as of today the company considers itself as a “reasonable partner” with emerging companies to provide them with “structured liquidity platforms”80. In short, employees cannot sell their shares through the Nasdaq Private Market, unless their employer is a Nasdaq Private Market client81.
Considering that these markets are adopting a restrictive model, and the investor protection issues they are facing, the relevance of these markets will likely decline in the future. As of today, they offer a limited but useful service for the insiders wanting to sell and outsiders looking to buy. Since the regulatory exemptions these markets built on were not designed to comprise a basis for equity liquidity, and they provide a limited service, secondary markets should not be mistaken for liquid markets.
77 Evelyn M. Rush & Peter Lattman, Losing a Goose That Laid the Golden Egg, N.Y. Times Dealbook (Feb. 2, 2012, 9:26 PM), http://dealbook.nytimes.com/2012/02/02/losing-thegoose-that-laid- the-golden-egg; Lee Spears, SecondMarket Acts to Offset Facebook Fees Selling Wine, Art, BLOOMBERG BUSINESSWEEK (May 17, 2012), http://www.businessweek.com/news/2012-05- 17/secondmarket-acts-to-offset-facebook-feesselling-wine 78 Riz Virk, Secondary Sales in VC-backed startups: A Quick Primer for Entrepreneurs https://medium.com/@rizstanford/secondary-sales-in-vc-backed-startups-a-quick-primer-for- entrepreneurs-bdc25ea7f39a 79 Wade Roush, ‘SecondMarket Attempts to Sell Startups on the Value of Letting Employees Trade Their Stock’, [2011] XCONOMY, https://www.xconomy.com/san- francisco/2011/08/18/secondmarket-attempts-to-sell-startups-on-the-value-of-letting-employees-trade- their-stock/ 80 Roush (n 80) 81 http://www.nasdaqomx.com/transactions/trading/private-shares “Structured liquidity programs on Nasdaq Private Market help efficiently address stakeholder liquidity needs while increasing a company’s control over the cap table. Companies determine who can buy and sell shares, how many shares can be sold, if any, the timing of transactions, and information sharing and disclosure.” 22
d. Rule 144A and Equity Markets Under This Exemption Rule 144A provides the final regulatory exemption that allows resale of private shares82. The provision is similar to Rule 144 since it sets the conditions under which a reseller of private securities will be presumed not an underwriter under section 4(1). On the other hand, different from rule 144, sellers affiliation with the issuer is no concern for this provision. Moreover, the rule 144A contains no holding-period requirement or a limitation on the amount of securities that can be sold.
Instead of these restraints on sellers, the limitations mainly focuses on the buyer in rule 144A. First of all, sellers must offer and sell securities only to qualified institutional buyers (QIBs), or to those the seller “reasonably believes” them to be QIBs83. QIBs are defined as institutional investors that invest at least $100 million in securities of issuers that are not affiliated with the company and registered broker- dealers with at least $10 million in assets84. The second limitation is related to the type of securities that are eligible. The non-fungibility condition of the rule is that the securities sold in 144A markets cannot be of the same class as securities listed on national exchanges. Finally, the rule also includes an information requirement85. When QIBs request information, companies have to provide financial and business information86.
Rule 144A’s most significant difference from the prior regulations is the lack of a reasonable understanding of the word “underwriter”. The absence of a holding period requirement allows shareholders to flip the shares just like an underwriter. Information requirement constitutes another difference from Section 4 (1½) jurisprudence and rule 144. As long as the seller has held the shares for a certain amount of time, there is no information required under these prior exemptions. The information requirement of the rule 144A, on the other hand, is permanent. Even
82 Resale of Restricted Securities; Changes to Method of Determining Holding Period of Restricted Securities Under Rules 144 and 145, Securities Act Release No. 6862, 55 Fed. Reg. 17,933, 17,934 (Apr. 23, 1990). 83 17 C.F.R. § 230.144A(d)(1). 84 17 C.F.R. § 230.144A(a). 85 William K. Sjostrom, Jr., 'The Birth of Rule 144a Equity Offerings' [2008] 56(1) UCLA Law Review 86 17 C.F.R. § 230.144A(d)(4). Issuers must provide "a very brief statement of the nature of the business of the issuer and the products and services it offers; and the issuer's most recent balance sheet and profit and loss and retained earnings statements, and similar financial statements for such part of the two preceding fiscal years as the issuer has been in operation. (the financial statements should be audited to the extent reasonably available)." 23 though this requirement seems positive, it means that QIBs have more protection than buyers under rule 144 or section 4 (1½). Information requirement in favor of high valued QIBs is bizarre since anyone could be a buyer under rule 144 or section 4 (1½), and buyers under these prior exemptions need more protection and information than QIBs.
The rule 144A’s difference from the prior regulations derives from the key goal in its adopting release. In contradistinction to previous exemptions, which aimed to prevent unregulated public offerings, rule 144A seeks to create a new secondary market. In rule 144A’s adopting release a key goal was determined as “a more liquid and efficient institutional resale market for unregistered securities."87
GS Tradeable Unregistered Equity OTC Market (GSTrUE) launched by the Goldman Sachs in 2007 has raised hopes after Oaktree Capital Management privately sold $880 million of its equity on this platform which constituted the first significant 144A equity offering in a U.S. company88. However, a resale market for these shares never seemed to exist. After Oaktree went public in 2012, it ended trading on GSTrUE by stating in its prospectus that there wasn’t an active trading market and only a limited amount of QIBs registered to participate in this market89.
Regarding shares of private U.S. issuers, rule 144A’s impact was almost none, since there were no markets for a while to facilitate transactions for private shares under 144A90. Even though, several new markets launched in the last ten years, these platforms still fail to provide liquid and efficient markets. Considering that only QIBs are participating, and there is a limited number of QIBs, there is little liquidity provided with a few potential buyers. Furthermore, QIB-type investors show little interest in small companies, so limiting this platform to QIBs makes it less appealing for emerging companies as well.91
87 Resale of Restricted Securities; Changes to Method of Determining Holding Period of Restricted Securities under Rules 144 and 145, Securities Act Release No. 6862, 55 Fed. Reg. 17,933, 17,934 (Apr. 30, 1990). 88 Steven M. Davidoff Solomon, ‘Paradigm Shift: Federal Securities Regulation in the New Millennium’ [2008] 2 Brooklyn Journal of Corporate, Financial & Commercial Law 339 – 339. 89 Oaktree Capital Group, LLC, Prospectus (Form 424B4), 232 (Apr. 11, 2012). 90 Sjostrom (n 86) [431] 91 Weild and Kim (n 31) [17] 24
4. A New Structure of Regulations for Secondary Markets
As explained in the earlier chapters, the current securities laws fail to regulate the secondary market for private shares efficiently. Even though the regulatory structure governing the trading of public company shares on national exchanges is sufficient, regulation regarding trading shares of private or non-listed companies fell short of providing a stable structure. On the other hand, SEC’s efforts to clarify this hazy regulatory environment are inconsistent and indecisive. Therefore, we are left with an uneven regulatory framework that comes up short of adequately accounting for the whole secondary market trading. Insufficiency of the current regulatory framework and therefore the need for reform remained hidden because of the vibrant IPO market. However, times have changed, and traditional IPOs have become less appealing to companies. This decrease in IPOs revealed that the current regulatory structure fails to provide alternative markets offering necessary liquidity and investor protection.
A life cycle model for the secondary market regulation would fulfill emerging companies’ need for a suitable listing platform by implementing a stage-based market structure. Stages to a life cycle were introduced to literature in 1962 by Alfred D. Chandler, in which he stated that as the stage changes, companies’ strategies and structures change as well92. A rough order of the stages was proposed by Miller and Friesen which included: birth, growth, maturity, and revival93. Furthermore, using the data from Miller and Friesen, Drazin and Kazanjian found support for a four stage model in their research as well94. So, primarily the life cycle of a company has four different stages: start-up, emerging growth, maturity, and revival.
These stages constitute the base of the different listing venues. By implementing this model, there would be a market for young emerging companies,
92 Chandler, A. D. 1962. Strategy and Structure. Cambridge, MA: MIT Press. 93 Danny Miller and Peter H. Friesen, 'Momentum and Revolution in Organizational Adaptation' [1980] 23(4) The Academy of Management Journal, 591-614 94 Robert Drazin and Robert K. Kazanjian, 'A Reanalysis of Miller and Friesen's Life Cycle Data' [1990] 11 Strategic Management Journal 319-325. 25 one for mature firms, another for companies that have an insolvency risk and lastly a market for private firms. Each market would have a regulatory framework that precisely designed to suit the companies that trade in that market. This model has the potential to unify the regulatory structure and restore the IPO activity.
Research suggests that opportunities, risks, and difficulties companies face, vary with the life cycle stages. For instance, a major concern for companies in the early stages of the life cycle is related to capital requirements.95 Considering that risks and opportunities change with the life cycle stages companies are in, a regulatory structure that fits these shifting life cycle stages would attract new firms, provide investor protection and be consistent. The regulation would increase and tighten as companies grow. However, it will decrease as companies become smaller.
Both young companies and old ones in decline being affected by costs more than the companies in between is the main reason for the bell-curved regulatory structure96. For young companies, costs tip the scales, since compliance is most expensive in the earlier stage and compliance costs taking a more significant percentage of their revenue97. Companies on decline face similar difficulties regarding costs. They tend to be small, and this causes relative costs to raise and high opportunity costs. A regulatory structure designed for these circumstances would lead to a more efficient market for young companies and also old companies in decline.
Furthermore, big mature companies have a significant impact on our society. For this reason, tightening regulations to which these companies are subject comes with benefits beyond investor protection98.
Taking all these into consideration, the shape of the regulatory structure becomes apparent. In order to render the model tangible, an example of the regulatory and market structure constituted on this approach should be given.
95 H. Robert Dodge and others, 'Stage of the organizational life cycle and competition as mediators of problem perception for small businesses' [1994] 15 Strategic Management Journal 121- 134. 96 Schwartz (n 5). 97 W. Michael Cox and Richard Aim, Creative Destruction, in The Concise Encyclopedia Of Economics 104 (David R. Henderson ed., 2d ed. 2007), available at http://www.econlib.org/library/Enc/CreativeDestruction.html. 98 Cary Coglianese, 'Legitimacy and Corporate Governance' [2007] 32(1) Delaware Journal of Corporate Law 159-167. 26
Therefore, a potential multi-staged market structure based on the stages companies are in will be provided below.
a. The Market for Emerging Companies A new market designed especially for entrepreneurial companies would be the cornerstone of the life cycle model. An emerging company market will provide the much needed listing venue for emerging entrepreneurial firms.
The transitional regulatory template would be the most crucial aspect of this market. As explained in the earlier chapters, current regulations are problematic, since they cannot provide the foundation for public and private alternatives for the traditional public exchange markets. Emerging Company Market would fill this gap by providing a listing venue for emerging young companies in the earlier stages of their life cycle.
Finding a middle way regarding regulations would most likely attract emerging companies to this new listing venue. Considering that high regulatory costs are a significant reason for the decline in IPOs, easing regulatory burdens would get a positive response from emerging companies. Even if there are other factors involved in diminishing IPOs, cutting down regulatory costs would be significant. Conducting an IPO means rising costs and shrinking benefits for many young firms in recent years. Therefore, cutting these regulatory costs down would attract emerging companies to this new secondary market.
The most important aspect of the regulatory template is regarding how far should we go while easing regulatory burdens for emerging companies. To begin with, the remission of regulations need to be significant in order to have an impact on emerging companies’ interest. On the other hand, there is no need to demolish the public-market template. Insufficiency of alternatives to U.S. equity markets demonstrates that loose regulations can cause problems just like strict regulations. Furthermore, examples of secondary markets in Europe and the United Kingdom fail to provide a sufficient listing venue. For instance, even the most successful platform
27 in the United Kingdom, AIM Market, fails to provide its participants with liquidity99. Since there is no example of a secondary market that generates liquidity, patterning the regulation on prior examples is not an option.
Consequently, this new market should be a less regulated version of today’s well-functioning premier exchanges. Until the compliance obligations were introduced, the public market was thriving in the 1980s and 1990s despite the high level of regulation. Also, empirical evidence demonstrates that mandatory disclosure paves the way for robust securities markets and more IPOs100. For these reasons, fundamentals of public market regulations should be kept with the regulatory structure of this new market, while making adjustments to make emerging company market attractive for companies.
However, shaping the regulatory structure in accordance with the companies’ needs to gather interest would possibly expose investors to higher risk. To justify this tradeoff, far-reaching tangible economic benefits of fostering entrepreneurship should be considered against the restricted and conceptual benefits of nonessential investor protection rules (for instance, mandates related to fraud liability and the ongoing disclosure of key items)101.
If targeted correctly, necessary reforms to make public markets attractive again could lead to significant cost savings with no significant adverse effect on investor protection. Based on this reasoning, the market for emerging companies need; reforming costly and questionable regulations and eliminating regulations that are unsuitable for entrepreneurial companies.
i. Reduced Compliance Obligations
As mentioned in the earlier chapters, the Sarbanes-Oxley Act enacted in 2002 was a significant regulatory change that imposed increased costs to companies
99 Spurring Job Growth Through Capital Formation While Protecting Investors: Hearing Before the Subcomm. on Sec., Ins., and Inv. of the S. Committee on Banking, Housing, and Urban Affairs, 112th Cong. 5 (2012) (statement of Jay R. Ritter, Cordell Professor of Finance, University of Florida). 100 Rafael La porta and others, 'What Works in Securities Law?' [2006] 61 The Journal of Finance 1-32. 101 Donald C. Langevoort and Robert B. Thompson, 'Publicness' in Contemporary Securities Regulation After the JOBS Act [2013] Georgetown Law Faculty Publications and Other Works, available at http://papers.ssrn.com/sol3/papers.cfm?abstractid=1984686 28 during the period IPO count declined102. For this reason, this act stands out as the area that reform is necessary. Exempting companies on the emerging company market from this regulation would significantly cut the costs for those companies. Compliance costs in Sarbanes-Oxley are particularly high when a company is ramping up103. Therefore, companies funnel money on compliance costs instead of allocating funds on hiring and growth. Exempting emerging companies from this act would also clear the layer of regulation which is ill-suited for such companies. For instance, section 404, the most expensive provision obligates companies to have a robust system of internal controls104. This provision addresses the concern regarding mature companies. However, for emerging companies which even their business models are still developing, this provision is somewhat unnecessary or more precisely premature. On the other hand, emerging companies allocating their funds for hiring and growth rather than internal reporting structures is presumably better for the society as well.
Additionally, Dodd-Frank act is another statute that emerging companies should be exempted from. Even though Dodd-Frank does not mainly focus on securities regulation, it contains provisions regarding this topic105. The act imposes an increased compensation related disclosure. This provision forces companies to disclose information regarding the relationship between executive compensation and the financial performance of the issuer, and the comparison of executive compensation with the compensation of rank and file employees.
Although the concern related to increasing executive compensation is comprehensible, considering that the statute mandates a disclosure on how compensation affects the company’s performance and its comparison with rank-and- file employees rather than informing investors on management’s pay packages, it is not linked directly with investor protection. Accordingly, to prevent increasing of compliance costs and making going public even more complicated, emerging companies can be exempted from this act.
102 Cyrus Afshar and Rose Paul, 'Capital Markets Competitiveness: A Survey of Recent Reports' [2007] 2(1) Entrepreneurial Business Law Journal 439-478. 103 Stephen M. Bainbridge, 'Dodd-Frank: Quack Federal Corporate Governance Round II' [2011] 95(1) Minnesota Law Review 1779-1788. 104 15 U.S.C. § 7262 (2006). 105 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 951, 124 Stat. 1376, 1899-1900 (2010). 29
These changes would ease regulatory burdens that emerging companies face when they go public. Moreover, adverse effects regarding investor protection would presumably be minimal. Even if some decrease that is hard to determine in investor protection arises from this regulatory change, the tradeoff would be rewarding since it boosts entrepreneurial companies and revitalizes IPOs.
There are various other reforms should be taken into consideration in order to make disclosure obligations less costly. The Management Discussion and Analysis (MD&A) section106 and the executive compensation section107 of the securities disclosures, both being rules-based and principles-based, require disclosure of various topics and include open-ended requirements in order to companies to describe other material information108. This comprehensive approach which all the companies that go public are subject to increases costs especially for young emerging companies and leads to legalistic jargon-filled prose109. A principle-based approach in this subject would be more beneficial. For instance, regarding MD&As, a requirement of management providing a simple description of current state of the company that includes a discussion of its financial statements, challenges the company is facing, and their analysis of the future prospects can be implemented. On the other hand, for executive compensation, the company could be obligated to describe material aspects.
Besides easing compliance burdens, these changes would also increase liquidity. Considering that the analyst coverage for smaller companies is relatively inadequate, making disclosures more approachable for individual investors could encourage those individual investors to analyze themselves, and consequently they would be more willing to invest. Reducing investor dependence on analyst reports could enliven this emerging company market.
In that vein, making it possible for individual investors to access the summary of a company’s disclosures would help with the liquidity as well. Giving individual investors the opportunity to view a report of the company and its finances without consulting an analyst, would encourage their participation in this market. Since public
106 Item 303 of Regulation S-K, 17 C.F.R. § 229.303 (2011). 107 Item 402 of Regulation S-K, 17 C.F.R. §228.402. 108 Stephen M. Bainbridge, Corporate Governance and U.S. Capital Market Competitiveness 19-31 (2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstractid=1696303. 109 Kenneth R. Davis, 'Taking Stock—Salary and Options Too: the Looting of Corporate America' [2010] 69(3) Maryland Law Journal 445-446. 30 markets have mostly become institutionalized, the participation of individual investors is generally overlooked. However, individual investors’ participation is important regarding smaller companies and smaller IPOs, which are areas of concern in this chapter. The summaries of companies’ disclosures could be provided by the SEC since otherwise it would increase companies’ costs. The companies could submit the information required to the SEC, and with the help of an algorithm, the SEC could provide a summary of disclosures on its website110.
Additionally, the SEC could also waive filing fees for IPOs of small companies that have assets under a certain amount and reduce filing fees for ongoing reports for small companies in this market. These changes can be considered as subsidies for emerging companies. However, taking their contribution to the society (such as; creating jobs, technology) into consideration, this is a reasonable use of government funds.
ii. Reducing Litigation Expenses The Sarbanes-Oxley Act is one of the reasons litigation expenses also increased in the 2000s. The scope of culpable behavior broadened, and tougher penalties for misconduct put into force by the Sarbanes-Oxley Act. For example, as Professor Larry Ribstein states, the liability risk is widened by section 404, since “a clever trial lawyer might be able to trace virtually any business problem, in hindsight, to a failure to implement some internal control."111 Liability insurance of directors and officers doubling after the act’s passage indicates that liability exposure has expanded by the act112. Considering these issues, exempting entrepreneurial companies from Sarbanes-Oxley Act would decrease litigation expenses among with the compliance burdens.
However, the Sarbanes-Oxley Act is not the only or even a significant reason for the upsurge in litigation expenses. Aggressive use of the current legal remedies is
110 Troy A. Paredes, 'Blinded by the Light: Information Overload and Its Consequences for Securities Regulation' [2003] 81(1) Washington University Law Review, available at: https://openscholarship.wustl.edu/law_lawreview/vol81/iss2/7 111 Larry E. Ribstein, ‘Sarbanes-Oxley After Three Years’ [2005] U. Illinois Law & Econ. Research Paper No. LE-05-016, available at http://papers.ssrn.com/sol3/papers.cfm?abstract- id=746884. 112 James S. Linck and others, ‘The Effects and Unintended Consequences of the Sarbanes- Oxley Act on the Supply and Demand for Directors’ [2009] 22 (8) The Review of Financial Studies. 31 the primary cause of this issue. So in order to reduce litigation expenses, we need to minimize liability exposure of emerging companies deriving from the traditional causes of action.
Section 11 of the Securities Act allows shareholders to seek for private remedies for any material misleading statement contained in a registration statement without the necessity of proving scienter or causation113. The provision set out as a precaution mainly for young companies, due to the notion that they pose a higher risk of fraud because of the limited information they provide114. However, broad liability arising from this provision causes legitimate emerging companies taking costly diligence measures to avoid liability or opting out of entering the market altogether115.
Considering that there is a concern regarding lack of IPOs, and there is already a SEC review of IPO documents and 10b-5 liability attached to registration statements, section 11 seems more of an investor protection luxury than a necessity. In order to prevent this issue which can be considered as over-regulation, the right to sue could be given to the SEC instead of individual plaintiffs.
10b-5 liability for secondary market transactions could be curtailed for companies trading on emerging company market. Under the Rule 10b-5, an individual investor participating in a secondary market transaction can sue the company for material misstatements even if the company is not directly involved in the transaction116. Additionally, “fraud on the market” theory that allows any investor to sue the company even if that investor did not rely on the particular misstatement, renders the legal doctrine powerful117. Both the Rule 10b-5 and fraud on the market theory causes paradigmatic securities fraud class action filings118.
113 15 U.S.C. § 77k (20). 114 Hillary A. Sale, ‘Disappearing Without a Trace: Sections 11 and 12(a)(2) of the 1933 Securities Act’ [2000], 75 Washington Law Review. 115 Donald C. Langevoort, ‘Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment’, [2000] 63 Law and Contemporary Problems 45-46. 116 Louis Loss and Joel Seligman, Fundamentals Of Securities Regulation (5th edn, Aspen Publishers 2003) 149-208. 117 William W. Bratton and Michael L. Wachter, ‘The Political Economy of Fraud on the Market’ [2011], 160 University of Pennsylvania Law Review 69 - 111. 118 Amanda Rose, ‘Reforming Securities Litigation Reform: Restructuring the Relationship Between Public and Private Enforcement of Rule 10b-5’, [2008] 108 Columbia Law Review. 32
Considering that liability exposure being costly for the emerging companies119 and the rule’s investor protection intentions being uncertain and arguable, this legal doctrine applied to secondary market transactions needs reform as well. The major issue is shareholders –plaintiffs- are actually suing themselves. Since they are residual owners of the defendant company, in the end, they pay the damage awards to other shareholders. Most of the shareholders owning a diversified portfolio make the issue even worse120. Shareholders who own a diversified portfolio could be on both sides of the lawsuit; they might be in plaintiff class or owners of defendant companies. The outcome of this issue is that shareholders are not earning anything from these lawsuits in the end. As a matter of fact, as argued by Professor Coffee, because of attorneys taking a significant portion of damage awards, “from a compensatory perspective, the odds are high that shareholders are made systematically worse off by securities class actions.”121 Additionally, the deterrence function of the rule is also problematic. Corporate indemnification and directors- officers insurance protect the executives responsible for the misconduct from the personal liability122. Therefore deterrence is muted123.
On the other hand, most of the shareholders might have diversified portfolios, but still, some shareholders are not diversified. Undiversified victims of securities fraud do get a net benefit when they receive damages. Furthermore, even though that the management might avoid any personal liability, there is still a natural deterrence function. Executives that cause the fraud liability upon their company will most likely be laid off124. The merits of securities class action are not the question of debate, but rather the impact of this rule has on entrepreneurial companies is our concern. If the rule’s application to entrepreneurial companies were limited, a highly controversial remedy would be cut down for those companies. Since we seek to balance the costs and the benefits of the regulation, securities class action draws attention as a place where reform is needed.
119 Adam C. Pritchard, ‘Markets As Monitors: A Proposal to Replace Securities Class Actions with Exchanges as Securities Fraud Enforcers’ [1999] 85 Virginia Law Review. 120 John C. Coffee Jr., ‘Reforming the Securities Class Action: An Essay on Deterrence and Its Implementation’ [2006] 106 (7) Columbia Law Review. 121 John C. Coffee Jr., ‘Law and the Market: The Impact of Enforcement’ [2007] 156 University of Pennsylvania Law Review, 228 - 304. 122 Donald C. Langevoort, ‘Capping Damages for Open-Market Securities Fraud’ [1996] Arizona Law Review, 639 - 654. 123 Coffee (n 119). 124 Bratton (n 116). 33
Putting a limitation on damages from 10b-5 lawsuits related to secondary market transactions would be a reliable option for this issue. The suggestion put forward by Professor Langevoort, for instance, is to put an upper limit of $10 million for damages regarding large companies125. By placing a cap on damage awards, the shareholders would still be able to seek compensation for mismanagement, while the threat of liability deriving from their actions would put pressure on the management.
iii. Listing Requirements Our main goal, while considering a regulatory reform, is to lower costs for entrepreneurial companies without weakening investor protection. A similar balancing is required while planning listing requirements. Our goal is to provide a solid market structure that is appealing to successful entrepreneurial companies. Listing requirements should be strict enough to leave companies that lack some track records of operations out of the market. On the other hand, requirements should be loose enough to allow entrepreneurial companies conducting public fundraisers early in their development and to provide early-stage employees and investors with liquidity without waiting for a long time.
Well-balanced listing requirements would be beneficial for both investors and successful entrepreneurial companies. Successful companies will not use their funds to stand out amongst a pile of unpredictable and corrupted companies, and investors will not spend their money in order to avoid those corrupt companies.
Different opinions might surface regarding how quantitative requirements should be set. Limiting this market for companies that are operating for at least two years, with at least $10 million in assets and an estimated value of floating stocks of more than $2 million126. These quantitative requirements are not over-demanding. However, the requirements would be difficult to meet for companies without a legitimate business.
In that vein, this market should be limited to new ventures only. Companies that are listed on other markets or the delisted ones should not be eligible to be listed on emerging company market. This criterion would be a positive signal for the
125 Langevoort (n 121). 126 Schwartz (n 5). 34 investors127. Allowing such companies to join the emerging company market would make the platform far less attractive for the potential investors since they would not know without research whether the companies are promising emerging companies or not.
Besides the investor perspective, this criteria also serves as a special treatment to a group of companies because of their unusual conditions. It denies companies outside of this group to take advantage of these special regulatory easements designed to suit emerging companies.
Emerging company market is designed to supplement the traditional exchange markets. For this reason, companies trading on this platform should not stay forever. So, the companies should be forced to move on after a certain amount of years. A reasonable time limit could be ten years. It is enough time for emerging companies to grow and as seen on the table below, considering emerging companies show no increased job creation compared to older companies after ten years; this time limit is acceptable128. At the end of this period, without spending excessive amounts, companies would need to adjust to the regulatory template for mature companies.
127 Jonathan R. Macey and Hideki Kanda, ‘The Stock Exchange as a Firm: The Emergence of Close Substitutes for the New York and Tokyo Stock Exchanges’ [1990] 75 Cornell Law Review,1023 -1024. 128 Haltiwanger (n 9). 35
Table 1
Note: Reprinted from ‘The Role of Entrepreneurship in US Job Creation and Economic Dynamism’ by Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda Journal of Economic Perspectives (28) 3, 2014, Pages 3–24.
The premier exchange markets require corporate governance practices as qualitative standards. Another issue regarding emerging company market is whether we need these qualitative limitations or not. Despite such corporate governance measures seem appealing, empirical evidence for them is somewhat mixed129. Additionally, we can expect a well-established company to engage in corporate governance practices. However, it should be acceptable that an emerging young company is not developing those practices in the early years. Along these lines, even though it may be beneficial to require disclosure of corporate governance matters 130, a structural mandate is rather unneeded.
With the help of the reforms mentioned above, the IPO market will be revitalized. Public markets will not be a platform that entrepreneurial companies avoid anymore. Reduced compliance obligations and a platform specifically designed for emerging companies would constitute an essential step on the ladder towards premier exchange markets. An emerging company market that provides an exchange platform for young promising firms’ shares is the first step towards the solution, a regulatory and market structure that adjusts to companies as they develop would make going public more appealing.
129 Larry E. Ribstein, ‘Market vs. Regulatory Responses to Corporate Fraud: A Critique of the Sarbanes-Oxley Act of 2002’ , [2002] 28 (1) Journal of Corporation Law, 26-29. 130 17 C.F.R. § 229.407 (2012). 36
b. Mature Company Market
Companies will be obliged to move to the market designed for mature companies after a certain period of time. While developing the regulatory template for mature company market, we should consider the social costs and benefits of regulations for mature companies. Furthermore, mature companies differing from each other should also be taken into consideration. Even though companies vary because of several features, companies’ size is the most attention-grabbing amongst all. In order to address the concerns related to larger and smaller companies in the mature company market, this market needs to be divided into two platforms: one for mid-sized or smaller companies, and another one for the largest companies131.
Social costs of regulation regarding large companies are lower while the social benefits are higher. Accordingly, large companies in mature company market should be subject to a more strict regulatory structure compared to the smaller emerging companies. Compliance costs compose a small percentage of large companies’ budgets and bottom-lines. Thus, these expenses are tolerable for large companies132. In the same direction, canalizing funds towards compliance costs creates lower opportunity costs for larger companies when compared to young emerging ones. Considering that large companies are not the primary source of economic growth and innovation, compliance expenses imposed on them are justifiable.
Also, the actions of large companies also have a larger area of impact. A small company’s actions would affect its’ shareholders, but a large company’s actions may impact a large number of employees, customers, and even cities and nations133. Enron’s fraud demonstrated that such large companies present a threat to a larger area134.
The scope and consolidation of power in large companies became more similar to governmental entities. In that vein, Professor Langevoort claimed that the
131 Langewoort & Thompson (n 100). 132 Bainbridge (n 107). 133 Coglianese (n 96). 134 Kathleen F. Brickey, ‘From Enron to Worldcom and Beyond: Life and Crime After Sarbanes-Oxley’ [2003] 81 (2) Washington University Law Review 357 - 377. 37 aim of evolving securities regulation is not limited to "shareholder or investor welfare per se, and instead relates to the desire to impose norms that we associate with public governmental responsibility-accountability, transparency, openness, and deliberation-on nongovernmental institutions that have comparable power and impact on society."135
A similar argument was put forward by Professor Coglianese. He claimed that the public’s demand for legitimacy deriving from the power the governments have is the same with the demand directed towards large companies since those companies have a power akin to the governments136. The Sarbanes-Oxley focusing on enhancing corporate governance, as well as other measurements related to the same topic, can be described as ways to legitimize private companies with a government like power. Considering that large companies retain public-like features, public-like scrutiny is needed.
Taking all into consideration, retaining the status quo appears to be the preferable option while regulating the large company marketplace. Even though that the empirical evidence for the Sarbanes-Oxley is unsure and Dodd-Frank focuses primarily on mostly social issues, both statutes have upsides regarding large companies that can afford compliance costs and have a significant social influence. Conformably, even though securities class actions are considered imperfect, putting a limitation on damages is not appealing when applied for the larger companies. Large companies can easily afford the insurance premiums and other costs that come from securities class action suits. Additionally, when it comes to big corporations, the SEC is not necessarily a trustworthy enforcer of securities laws. The SEC focuses mainly on small companies while leaving large ones to be dealt with securities class actions as the main mechanism. In the end, even though reform is needed, the main focus should be increasing personal liability exposure of management rather than decreasing company expenses.
In order to define the parameters for qualifying as a “large company” an in- depth analysis is needed. However, considering the motivation behind the regulatory
135 Donald C. Langevoort, ‘The SEC, Retail Investors, and the Institutionalization of the Securities Markets’ [2009] 95 Virginia Law Review, 1025 - 1066. 136 Coglianese (n 96). 38 template for the mature company market, limiting this market to 500 of the largest companies -just as the S&P 500 index does- appears to be plausible.
On the other hand, smaller and mid-sized companies should not be subject to the same strict regulatory oversight. Because they cannot afford such extensive regulations, and they do not have a significant impact on the society like large companies do. However, smaller and mid-sized companies in this market are no longer in their growth stage either. Thus, they do not need as much money as growing companies do to fund development and they have already started integrating corporate governance procedures. Taking all this into account, regulations which smaller and mid-sized companies are subject to, should seek to find a balance between the loose regulations of the emerging company market and more strict regulations of the market for large companies.
Regulatory framework applied for mid-sized and smaller companies should adopt a scheme that is a little more restrictive than the one structured for the emerging company market. For instance, while we provide small and mid-sized companies with an efficient regulatory framework; limiting 10b-5 damages related to secondary market transactions, exempting mentioned companies from the Dodd- Frank Act, and allowing them to provide a principals-based MD&A would be beneficial for the companies. Additionally, to enable individual investors to access company disclosures easily, the SEC could follow the same route as in the emerging company market, and provide disclosure information summaries on its website. Different than the emerging company market, however, the Sarbanes-Oxley Act could be applied to these companies while excluding the section 404 of the Act; which is the most demanding and expensive provision. This change would allow companies to focus more on operating and governance practices.
On the topic of listing requirements, the emerging company market’s standards could be applied to this market with some minor adjustments. Companies that do not meet certain thresholds should be delisted. One requirement for companies could be to keep their share price above $1.00 and their market cap above $2 million. On the other hand, qualitative standards are unneeded in this market just as in emerging company market. For instance, director-independence requirements imposed on companies trading on premier exchanges would be costly
39 for smaller companies, and their investor protection merits are questionable137. Thus, these type of qualitative standards should not be imposed on companies in the mature company market.
Also, listing requirements and compliance obligations for this market should be kept relatively low to make going public appealing for mid-sized and smaller companies promoted from emerging company market. Tightening the regulation for mid-sized and smaller companies as soon as they move on to the upper market tier would be discouraging for them in the process of going public. So, lowering the listing requirements and compliance obligations would reassure smaller companies; they will not be drowning in compliance expenses even if they remain small in size.
The transition between mature company market tiers should be fluent for companies. It should be easy for growing companies to move up, and at the same time for shrinking companies to move down. The lower-tier market would serve as a cushion for shrinking large companies. Despite the fact that companies’ share price would go down after moving to the lower-tier, eased compliance obligations would allow those companies to free up funds to rejuvenate their businesses.
The tiered structure of the mature company market would allow companies to spend their funds efficiently to improve their businesses, and they would bring benefits to society by developing technology and creating jobs.
c. Market for Delisted Companies
Emerging company market would provide liquidity for small companies’ investors, however not all of those companies can survive for long years. The data from the U.S. Small Business Administration demonstrates that about 50% of establishments survive five years or longer, and one-third of them survive 10 years or longer138. Therefore, companies that cannot survive in the emerging company market should have a venue that keeps providing liquidity for their investors as they shrink.
Companies that cannot meet the thresholds for the small company market would be delisted and be traded on this market designed especially for them.
137 Ribstein (n 128). 138 U.S. Small Business Administration, ‘Frequently Asked Questions’ (2016), available at: https://www.sba.gov/sites/default/files/advocacy/SB-FAQ-2016_WEB.pdf 40
Considering that these companies are shrinking, designing a regulatory template that they can afford would be a challenging task. On the one hand, making the regulations too expensive would cause these companies not to comply with the regulations and consequently, there would be no market for such securities. On the other hand, making the regulations too loose would cause the risk of fraud which will overshadow the benefits we seek in maintaining a market for shrinking companies.
In the matter of finding the balance, it could be required from companies to provide unaudited financial statements together with a summary of the company’s business on a quarterly basis. These statements should be public and accessible in order to provide material information for the investors. Even though companies would be forced to spend some funds to fulfill these disclosure requirements, it should be acceptable for the companies, since a functioning market requires at least some transparency139. Additionally, companies will be allowed to provide more information than required, which will most likely benefit the company with more activity in the market140. Furthermore, there won’t be any qualitative nor quantitative listing standards, so companies that fail to satisfy basic disclosure obligations will not be allowed to trade on this market.
Taking the minimal disclosure obligations into account, the market for delisted companies could be deemed risky. Consequently, some might say that the market should be limited to sophisticated investors that can understand the risks of the market. However, limiting the market to a specific group of investors would impair liquidity, especially in a market that consists of companies in disfavor. In order to find a solution for this dilemma, this market could be identified as “highly risky”141. Investors who want to participate in the market could sign an agreement which validates that the investor understands the risks of trading on this market. This precaution would warn unsophisticated investors participating in the market without harming the liquidity.
139 Christian Leuz and others, ‘Why Do Firms Go Dark? Causes and Economic Consequences of Voluntary SEC Deregistrations’ [2009] 45 (1) Journal of Accounting and Economics 181 - 184. 140 Brian J. Bushee and Christian Leuz, ‘Economic Consequences of SEC Disclosure Regulation: Evidence from the OTC Bulletin Board’ [2005] 39 Journal of Accounting and Economics 233 - 236. 141 Jeff Schwartz, ‘Reconceptualizing Investment Management Regulation’ [2009] 16 George Mason Law Review 538 - 542. 41
d. Private Securities Transactions Despite making public markets appealing for emerging companies, not all the companies would prefer to disclose necessary information to be in the markets listed above. There should be a venue for those that prefer to stay private as well.
Building a legal structure that regulates transactions in companies that choose to stay private instead of going public would be the final challenge. Considering that there are companies which have no need of the capital flow from an IPO or do not have early-stage investors seeking liquidity, some companies might prefer to stay private even if the IPO environment is more welcoming than before. For instance, some big companies like Mars or Cargill avoided public markets142. As of today, transactions concerning these private companies are regulated under section 4(1½), rule 144 and rule 144A, however, as mentioned above, these regulations fail to provide a solid framework for private transactions143.
While regulating private transactions, legitimate private transactions would be allowed having regard to the fact that companies seek to avoid registration requirement should be prevented to do so. Implementing a holding-period requirement would restrain those who seek to by-pass registration requirement. In this regard, a one year lock-up period for the shareholders in private companies is plausible. During the lock-up period, resale to the company itself or existing shareholders of the company should be allowed. Furthermore, resale to a broader range of investors would be permitted after the one year lock-up has ended. Nevertheless, transactions after the end of the one year period should be subject to a regulatory framework in order to be deemed legitimate. To begin with, sale to family members and affiliates could be allowed. Considering that the private companies are generally family owned and share transfers to outsiders are uncommon, these sales would constitute most of the transfers in such companies144.
In the matter of solicitation to buy of third-party investors, however, disclosure should be required. The size of the private transactions would be directly proportional with the scope of disclosure required. Companies would be asked to provide plenty of
142 America's Largest Private Companies, FORBES, https://www.forbes.com/largest-private- companies/list/ (last visited Aug. 1, 2018). 143 Chapter 3. b. 144 Chenchuramaiah T. Bathala and others, ‘Sources of Capital and Debt Structures in Small Firms’ [2004] 9 (1) Journal of Entrepreneurial Finance 29 - 33. 42 information for larger sales; less disclosure would be asked if the transaction is smaller.
Since companies are not legally obliged to disclose information necessary for sales to take place, solicited private secondary-market transactions would most likely be difficult to sustain. As a consequence, sellers may fail to sell their shares to third- party investors, and they might be forced to sell to affiliates at a lower price. However, this is an expected downside of staying private. If a company prioritizes to provide liquidity to its shareholders, it should go public.
This structure prevents private company shareholders to sell their shares with no information provided. Demanding disclosure would make it difficult for private company shareholders to resell, but it is a fair constraint considering that it bolsters up investor-protection and promotes emerging company market145.
5. Conclusion
Liquidity of emerging company shares is a significant problem. There are no sufficient trading venues, nor the regulatory template to provide early-stage investors of emerging companies with liquidity. They either wait for the company to be acquired by or merged with a public firm or for the company to conduct an IPO itself. However, going public became less appealing than ever for the young companies.
The significant decrease in IPOs indicates that regulatory reform is needed. First of all, the problem with the traditional exchange markets should be determined. As argued above, traditional exchange markets no longer offer a sufficient platform for entrepreneurial companies to list their shares. As we look into alternative equity markets, it becomes apparent that they fail to provide a well-functioning substitute for traditional public markets. As a consequence, equity markets are deteriorating, and entrepreneurship is undermined, which means an unstable economy for the country.
145 Companies would favor emerging company market because they can’t avoid disclosure even if they stay private and minimal disclosure requirements of the emerging company market are appealing. 43
The solution offered in this paper is to implement the life-cycle model into the secondary-market regulation in order to provide a long term liquidity for emerging company investors. Considering the vital importance of the entrepreneurial companies in today’s world regulations should fit their needs, meaning regulations should adapt to the companies as they grow both in terms of age and size. Within this framework, there would be a market designed specifically for emerging companies, along with the markets regulated for mature companies. Young emerging companies would be attracted to join these public markets regulated with the life- cycle approach because the idea of these companies maturing in public markets designed for their companies’ needs and economic capacities would be appealing as well. Also, the new regulatory structure would also address investor-protection loopholes and internal inconsistencies of the current regulations.
Before diminishing IPOs was an issue, regulators ignored the fact that the regulatory structure of secondary-market is inadequate for this age. Since it became apparent that the current regulatory structure is a significant factor in IPO decline, the reform proposed would not only solve the IPO problem; it would also help foster the economy by rejuvenating the relationship between the entrepreneurial companies and the public markets. By implementing this new regulatory structure, early-stage investors and shareholders of the emerging companies would be provided with much-needed liquidity in the early stages without having to wait for the traditional exit routes.
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