How To Promote Small-Business Jobs And Protect Investors
Five years ago last month, a Democratic President, a Democratic Senate, and a Republican House overwhelmingly agreed that the regulatory tax on capital was preventing small businesses from creating jobs. To address this, the JOBS Act was passed.
The JOBS Act removed some of the regulatory tax by reducing or eliminating certain regulations for small business. The law established a category of companies with revenue under $1 billion known as emerging growth companies, or EGCs.
EGCs are eligible for a streamlined IPO process and receive exemptions from certain rules once they become public. The JOBS Act also relaxed rules that apply to private securities offerings, and revived the long-dormant Regulation A market so issuers could pursue a “quasi-public” offering of stock.
Unfortunately, due to the discretion that Congress gave to the SEC, many of these implementing regulations ended up being more complex than necessary. Consequently, the JOBS Act has not lived up to its full potential.
While the JOBS Act led to a short-term spike in the IPO market, the U.S. still has less than half of the public companies that existed twenty years ago. While the cause of decline is unclear, what is clear is that the regulatory and market-structure environment remains inhospitable for small businesses.
The SEC’s disclosure regime has become increasingly costly to comply with, and trading rules under Regulation NMS (Reg NMS) do not work for small and microcap companies. Not surprisingly, small companies choose to stay private or be acquired, rather than publicly access America’s capital markets.
The regulatory tax consists of the initial cost small businesses incur when taking a company public, the ongoing cost necessary to comply with regulations, and the quarterly cost of hiring extremely expensive experts to confirm a company’s assumptions about its compliance program.
The JOBS Act tried to reduce the regulatory tax on small businesses, but more can be done.
Broadly speaking, we need a policy that will remove the power of decision-making from regulators and give it back to small-business owners and entrepreneurs. Only then can we create the right environment for entrepreneurs to take risks and create jobs.
The current market structure for small-cap stocks is broken. To remedy this, we must recognize that one size does not fit all and treat EGC companies differently than mature companies.
EGC issuers (current or future) should be able to opt out of having their securities classified as a Reg NMS Security. Reg NMS is a one-size-fits-all regulation that focuses on price and not on execution quality, and while it may be an efficient model for large-cap stocks that trade millions of shares a day, it is not appropriate for illiquid small caps with limited research coverage.
It is time for policymakers to recognize that different tiers of equity market structure exist, that Reg NMS is not working for small-cap stocks, and that a viable trading option for these companies is badly needed.
An EGC issuer should have the option to choose (1) the trading venue where it wants its stock to be listed, and (2) the appropriate tick-size increment for its listed stock. This choice would centralize liquidity for each EGC security on one trading venue and encourage venues to compete for EGC listings based on the incentives they provide to the EGC.
Trading venues should be permitted to pay for market-maker programs in EGC securities. Broker-dealers who were compensated for market-making in EGC stocks would have an incentive to use those funds to expand research coverage of EGCs.
Expanded research coverage, in turn, should stimulate investment by asset managers and others, including fiduciaries, who would have the information necessary to satisfy their due diligence obligations.
We believe an increase in EGC investment by institutional investors, pension funds, mutual funds and asset managers should expand the available liquidity for EGC securities, improve execution quality and alleviate investors’ fear that high transaction costs will devour their investment profits.
High-frequency trading firms should also benefit from the opportunity to trade EGC securities in a deeper, centralized pool of liquidity. This would give EGCs the time they need to grow their businesses and graduate into the NMS system without harming liquidity or the flow of information to investors.
During the EGC’s IPO process, it should be allowed to meet with research analysts and investment bankers to discuss the valuation of the EGC and its industry peers.
To facilitate a free-flowing discussion, pre-IPO valuation discussions should not be subject to Section 17 liability, although liability would remain for any misstatements in the offering documents.
This is about investor protection. Analysts and bankers do not have the same agenda when they speak with a company about valuation. A research analysts’ questions are focused on the future value of the company; bankers are focused on the current value of the company.
Most important, an analysts’ reputation and ability to continue to work in the industry rests on accuracy and independence. The Enron-like conflicts associated with keeping analyst ratings artificially high to preserve a steady flow of underwriting fees are not present with EGCs.
EGC issuers should have the choice to opt out of the current quarterly SEC filing regime and only file an annual report supplemented by periodic material disclosures through 8-Ks, if that option appeals to their investors.
EGC disclosure should be targeted and driven by the company and industry-specific information necessary for investors to make informed investment decisions. EGC issuers could provide information beyond the streamlined regulatory floor, but they wouldn’t be liable to investors if they didn’t.
Together, these reforms will remove the regulatory tax on small-business capital, incentivize job creation and empower entrepreneurs — not federal or state government bureaucrats — to decide what is the highest, most efficient use of their company’s capital.
This is an American recipe for job creation that the president, members of Congress, and the SEC should pursue.
—Christopher A. Iacovella is CEO of the Equity Dealers of America and former special counsel and policy advisor to the U.S. House of Representatives Committee on Financial Services and U.S. CFTC Commissioner Scott O’Malia.