Clearhouse
Nasdaq Talks to the Equity Dealers Association about . . . Incentivizing EGCs to Go Public and Providing More Opportunities for Individual Investors
Publication Date: September 26, 2017

Reforming the capital markets has become a priority for investors, public equity firms, and regulators alike in the wake of the decline in the number of public companies in the U.S. At Nasdaq, we recently drafted a blueprint for revitalizing the capital market ecosystem, and are collaborating with other organizations intent on that same goal.

One such organization is the Equity Dealers of America (EDA). The EDA is a trade association formed to promote fair, efficient, and competitively balanced equity capital markets that protect investors, advance financial independence, stimulate job creation, and increase prosperity. In addition to policy advocacy and public outreach, the EDA hosts meetings on the equity markets to inform and educate its members on the issues relevant to their businesses.

"The EDA is working to incentivize emerging growth companies to enter the public equity markets and give individual investors an equal opportunity to participate in their growth," said Chris Iacovella, CEO of the EDA. "We want to ensure that small businesses can access the capital they need to create jobs and grow the American economy."

According to Iacovella, the path forward is two-fold and must be bipartisan. In order to reduce the compliance burden on EGCs and stimulate liquidity in their stocks, the EDA is drafting a regulatory agenda that can be implemented by the SEC as well as outlining statutory changes for Congress.

"Next year is an election year and since this is a jobs issue, the EDA believes there is a real opportunity to move forward to resolve these issues," said Iacovella. Following are a number of the capital market reforms the EDA is advocating:

Revamp market structure.

The JOBS Act was a good start to try and generate more IPOs in the marketplace, particularly by establishing a category of emerging growth companies (EGCs) with revenues under $1 billion. However, it's necessary to build on that concept to reduce disclosures and the costs associated with some of the internal controls, as well as modify the market structure so that it is applicable to emerging growth companies.

The one-size-fits-all construct put forth under Regulation NMS ten years ago does not work for small- and medium-sized companies, as the current equity market structure increases fragmentation and disproportionately harms EGCs. This needs to change, and the EDA is advocating for market structure reforms at the SEC.

There was an initiative recently to create venture exchanges to address this issue, but venture exchanges are not necessary. It makes more sense to empower issuers to choose whether they want to be a Reg NMS corporation or have their security traded on the exchange that they list on. This would cure the fragmentation occurring in smaller issuer stocks, as many are very illiquid and transact only 50,000 to 200,000 shares a day. If more EGCs choose to have their security traded only on the exchange that they're listed on, then centralized pools of liquidity will develop.

As liquidity improves, EGCs may be able to incentivize broker dealers to make markets and pay for research. The entire research ecosystem must be changed—the more research coverage that EGCs get, the better off they will be in terms of people wanting to transact in their stocks.

The time is right for a secondary market structure change, because the SEC's Investor Advisory Committee and Advisory Committee on Small and Emerging Companies are both also looking at ways to improve liquidity and increase research in these small company stocks.

Allow EGCs to opt out of Sarbanes-Oxley 404(b).

Allowing issuers that generate $1 billion or less in revenue to opt out of Sarbanes-Oxley 404(b) will lower the regulatory tax burden on those companies. Independent audits are one of the largest costs incurred by a small company when it first goes public, and those costs are ongoing.

Investors and issuers are aligned on this issue. Accounting firms want more public companies too, but reforms to Sarbanes-Oxley must be tackled in a manner that brings them into the process. For example, by relaxing independence rules for EGCs that choose to opt out of 404(b), accounting firms could be permitted to offer audit and consulting services to those companies until they exceed the $1 billion revenue level or become a Reg NMS security.

Streamline the SEC's disclosure regime.

There are certain industries, and companies within certain industries, where it doesn't make sense to go through the burden and substantial costs of filing 10Qs every quarter, supplementing with 8-Ks, and then bearing the cost of issuing a 10K at the end of the year.

For example, new biotech companies lose money until they have approval from the FDA. During the product development phase, it's not relevant to the investor to know anything other than where they are in the pipeline process of working their drug or their solutions through Phase 1, Phase 2, and Phase 3 of FDA approval. There are other industries that operate in a similar way.

While there is a substantial investment that goes into a biotech or any emerging company, the 8-K process can address those investors. If that information is not sufficient to investors, they will vote with their feet. If investors sell off a company's stock, then management will have to do something different, maybe go back to filing the Qs. Or perhaps the investors who hold the stock will say "We don't mind that you're only filing 8-Ks here, but we'd like to see at least some financials on a quarterly basis."

This idea also reduces short-termism by encouraging investors to allow enough time for critical research and development to bear fruit.

Increase the shareholder proposal threshold.

Frivolous shareholder proposals filed by low-dollar investors are becoming a burden for EGCs, who desperately need their time, resources, and capital to run and grow the business. Increasing the amount of stock that shareholders are required to own from $2,000 to $100,000 would reduce the costs associated with politically motivated proposals that are designed to advance personal agendas and interfere with corporate governance. This can only benefit EGCs as they will be able to put the limited resources they have to their highest and most efficient use.

Exempt pre-IPO discussions from Section 17 liability.

Fear of Section 17 misstatement liability is another hurdle to going public. Research analysts are focused on the future value of a company; however, potential issuers are often hesitant to speculate about future company valuations, cash flows, business lines, or multi-year growth projections because they're worried if projections don't come to fruition the company will be hit with a Section 17 misstatement liability. This issue could be resolved by allowing more free-flowing dialogue between issuers and potential investors and analysts during pre-IPO evaluation discussions and roadshows, while confining Section 17 liability to the offering documents themselves.

Increase the opportunities for individuals to invest in EGCs.

The ability to invest in EGCs has long been an opportunity for retail investors to build wealth. As the number of public companies dwindles, retail investors are being forced into passive investments, while private capital benefits from the wealth acquired during the growth stages of companies.

"The EDA wants to bring back the environment that existed when Walmart went public," said Iacovella. "In 1970, Walmart issued a 28-page prospectus and that initial offering raised just $5 million. The company continued to go back to the capital markets in subsequent years. The growth Walmart experienced since going public revitalized the economy of northwest Arkansas, and the folks who invested in Walmart over the years have been handsomely rewarded for it. That is a perfect example of how the equity capital markets are supposed to work."

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Chris Iacovella is Chief Executive Officer of the Equity Dealers of America (EDA). Previously he was the Senior Director of Global Government Affairs, Strategy, and Public Policy at Bloomberg, L.P. where he worked directly with Bloomberg's internal businesses on regulatory solutions and interfaced with policymakers and regulators across the globe to discuss equity, fixed income, and derivatives market structure policy.

Read more about Nasdaq's blueprint for Revitalizing the Capital Markets >>