Before SEC Commissioner Michael Piwowar’s May 16, 2017, speech at the SEC-NYU Dialogue on Securities Market Regulation regarding the U.S. IPO Market (see summary HERE), and SEC Chair Jay Clayton’s July 12, 2017, speech to the Economic Club of New York (see summary HERE), the topic of the U.S. IPO markethad already gained significant market attention. Earlier this year, NASDAQ issued a paper titled “The Promise of Market Reform: Reigniting American’s Economic Engine” with its views and position on how to revitalize the U.S. equities and IPO market (the “NASDAQ Paper”). This blog summarizes the NASDAQ Paper.
The NASDAQ Paper begins with a statement by Adena Friedman, President and CEO of NASDAQ. The statement begins with a decidedly positive outlook, noting that “The U.S. equities markets exist to facilitate job creation and wealth creation for millions of people, ultimately driving economic growth for our country.” Ms. Friedman adds that “[E]xceptional market returns in recent years reflect the growing strength of the U.S. and global economy and continued confidence in the health of U.S. markets.”
However, on the other side she points out that there are structural issues that need to be addressed, noting that markets have become more complex and costly for companies that are already public or considering going public. The problem runs deep. Again quoting Ms. Friedman: “[I]f the volume of IPOs continues to fall and more companies choose to stay or go private, job creation and economic growth could suffer, and income inequality could worsen as average investors become increasingly shut out of the most attractive offerings.” In that regard, NASDAQ has issued its Paper setting out reforms that it advocates for to improve interest in the U.S. public markets.
The NASDAQ Paper
Following an Executive Summary, the NASDAQ Paper is broken down into three sections: (i) Reconstructing the Regulatory Framework; (ii) Modernizing Market Structure; and (iii) Promoting Long-Termism.
Like Ms. Friedman’s statement, the executive summary at the beginning of the NASDAQ Paper touts the importance of robust U.S. public markets to our economy, a message I have reiterated in many blogs over the years. Citing the SEC’s own statistics, the NASDAQ Paper points out that since 1970, 92% of job creation has come from public companies and that the vast majority of Americans are invested in public companies either directly or indirectly through pension funds, mutual funds and other retirement accounts. Furthermore, index funds have gained in popularity, but for an index strategy to work, there needs to be a healthy selection of public companies to comprise these indexes and provide diversification and profitability.
Although many pension funds invest in private equity firms that in turn invest in private companies, these private investments are illiquid and hard to value. Accordingly, public markets remain and will continue to remain the investment of choice for U.S. retirement accounts.
However, with the necessary transparency of public companies comes greater obligations and compliance costs. Over the years the U.S. has continued to add layers of regulation such that the burdens of being public can outweigh the benefits. I note this is more so for larger companies that do not qualify as emerging growth or smaller public companies and are required to comply with even greater levels of disclosure, including compliance with Sarbanes-Oxley Act Section 404. For more on public company disclosure requirements, see HERE and HERE. A summary of the ongoing SEC Disclosure Effectiveness Initiative is at the end of this blog.
The NASDAQ Paper cites many reasons for the slowdown in the U.S. IPO market, including: (i) shareholder activists; (ii) frivolous shareholder lawsuits; (iii) pressure to prioritize short-term returns over long-term strategic growth; (iv) burdensome costs and headaches of the proxy process; and (v) irrelevant disclosure obligations. Moreover, the better companies have no problem finding private equity and often choose that route.
In addition to the direct causes for the slowdown, NASDAQ has three main concerns over the U.S. public markets, including: (i) complex regulations disincentivize market participation; (ii) a one-size-fits-all market structure does not work for small and emerging growth companies; and (iii) a culture in the investment community and media that prioritizes short-term return over long-term growth. NASDAQ offers its view and suggested solutions for each of these issues.
Reconstructing the Regulatory Framework
Although regulations and oversight are obviously a necessity, regulations which were put into place as a result of the financial crisis now need to be reviewed and particularly in relation to the burdens they impose on public companies and those considering entering the public markets. Moreover, years of layering of regulations, without a top-down view, has created unnecessary complexities for companies.
NASDAQ points to the proxy process as an area needing crucial regulatory reform. Although shareholders should have an ability to raise legitimate concerns, the proxy process is being used for nuisance value at a significant cost to companies. NASDAQ suggests that the SEC:
(i) Raise the minimum ownership amount and holding period to ensure that proposals have meaningful shareholder backing. Currently, the SEC rules allow a shareholder holding $2,000 or more of company stock for a period of one year or longer, to include issues in a company proxy statement, regardless of materiality, subject to the company’s ability to seek SEC no-action letter redress, which of course requires time and expense. For more on this process, see HERE. NASDAQ suggests increasing the minimum ownership to at least 1% of the company’s outstanding stock and increasing the minimum holding period to 3 years.
(ii) Update the SEC process for removing repetitive, unsuccessful proposals from proxies. NASDAQ backs the Financial Choice Act proposal, which would significantly increase the level of shareholder support a rejected proposal would need to have to be reintroduced at a future meeting. Moreover, the topics of shareholder proposals should be better identified to ensure that only matters that are meaningful to the shareholders are considered at annual meetings.
(iii) Create transparency and fairness in the proxy advisory industry. Due to the large number of proxies to consider each year, institutional investors rely on proxy advisory firms, which are unregulated and “rife with opacity, lack of accountability and conflicts of interest.” NASDAQ suggests that voting is often at the whim of these advisory firms, with no obligation to provide information related to their analysis, financial interests, or stock ownership (including long or short positions).
NASDAQ also advocates changes in corporate disclosure requirements. Although transparency is critically important, companies should have the flexibility to provide full disclosure that is shareholder-friendly (readable) and less burdensome on companies. I’ve included more information on the SEC’s Disclosure Effectiveness Initiative at the end of this blog. NASDAQ has strong views in this regard, and suggests the following changes:
(i) Offer flexibility on quarterly reporting. NASDAQ suggests allowing companies to file semiannual reports with material interim updates via press releases and Form 8-K’s.
(ii) Streamline quarterly reporting obligations for small and medium growth companies. NASDAQ suggests that “if companies report all key financial and business details in quarterly press releases, we should consider eliminating the archaic 10-Q form, which is duplicative and bureaucratic. We should also study options that allow for greater flexibility in reporting schedules, so that as long as companies are transparent with shareholders, they have the flexibility to report on a less-rigid structure. This would also promote our third goal of promoting long-termism.” In addition, NASDAQ questions the usefulness of XBRL, noting that many analysts use their own technology in any event.
(iii) Expand classifications for disclosure relief. In particular, NASDAQ suggests expanding the class of companies that will qualify as a “smaller reporting company” and “emerging growth company” to take advantage of the scaled-down disclosure requirements available to these companies.
(v) Allow all companies to file confidential draft registration statements. Since the time that NASDAQ issued its Paper, the SEC has, in fact, implemented this change. See HERE for more information.
(vi) Increase the definition of emerging growth company from the current $1,070,000,000 to $1.5 billion and eliminate the five-year phase-out period,
(vii) Harmonize the definitions and obligations of smaller reporting company with non-accelerated filer and emerging growth company. For more on the distinctions between these categories, see HERE. Also, for a summary of the current proposed changes to the definition of a smaller reporting company, see HERE.
(viii) Allow all companies to use shelf registrations regardless of size.
(ix) Roll back politically motivated disclosure requirements such that disclosures are only required that help investors evaluate a company’s financial performance and economic prospects. Examples of politically motivated disclosures include the conflict mineral disclosures and executive pay ratio.
(x) The SEC should complete its Disclosure Effectiveness Initiative to strip out unnecessary requirements and simplify the process all around.
NASDAQ suggests the need for comprehensive litigation reform. There has been a record rate of securities class actions, many of which are dismissed and are clearly filed for nuisance value. In fact, NASDAQ suggests, and I agree, that class actions have become a method of negotiation and ordinary standard business practice. However, the cost to companies to defend frivolous lawsuits is huge, as is the deterrent to entering the public arena. NASDAQ has several suggestions in this regard, including, for example: (i) ease the standards for imposing sanction on lawyers for bringing frivolous lawsuits; (ii) tighten the requirements for granting class certification; (iii) allow interlocutory appeals of decisions; (iv) require disclosure of third-party financing of the litigation; (v) limit plaintiffs’ legal fees; (vi) allow a plaintiff to amend its complaint only once; (vii) further codify the standards for pleading with respect to scienter and loss causation, and clarify the exclusive nature of federal jurisdiction over securities claims; (viii) increase the burden of proof; (ix) require the loser to pay the legal fees of the winner and require plaintiffs to post a bond to ensure this right; and (x) allow enforceable arbitration provisions for shareholder matters.
NASDAQ also supports tax reform and, in particular, is supportive of the current administration’s efforts to reduce corporate tax rates for U.S. companies as well as territorial taxation for foreign corporate earnings. The exchange also advocates for lower individual taxes specifically related to gains from investments in public companies. In particular, NASDAQ suggests:
(i) Exploring a system that would create a tax structure for individual investors that ties a low level of taxes on investments to the overall value of the account, rather than a higher dividends and capital gains tax on earnings within the account. Sweden introduced such a system in 2012, and since that time approximately 16% of the total Swedish population has taken advantage of this system and the number of Swedish IPO’s has doubled.
(ii) Expand the tax exemption on the sale of small business stock in the secondary market. The tax code currently has a narrow exemption that only benefits venture capitalists and private equity investors.
(iii) Enact a 100% dividends received deduction for holders of corporate stock, avoiding double taxation of corporate profits.
(iv) Eliminate the net investment income tax, which was enacted in 2013 and invokes a 3.8% surcharge on dividends and capital gains.
(v) Exclude dividends and capital gains from income for purposes of determining the phase-out of itemized deductions.
Modernizing Market Structure
The NASDAQ Paper states the obvious: the current market structure needs to be updated for technological advances. A particular problem is the illiquidity faced by small public companies, a problem which NASDAQ believes can be addressed through market reforms leveraging new technology. NASDAQ is particularly critical of Regulation NMS. NASDAQ specifically recommends:
(i) Strengthen markets for smaller companies. Small and medium companies face liquidity issues that also result in market volatility. When a buy or sell order is placed on a stock with low trading volume, it can create dramatic price movements which do not reflect underlying value. NASDSAQ suggests that the problem stems from fragmentation with trading spread among too many trading venues. Interestingly, 15 years ago, 90% of trading was on a single exchange, but today there are 12 exchanges and 50 or more trading venues. Although most OTC Market securities would not qualify for an exchange listing, even if they wanted to, NASDAQ cites the existence of this and other alternative trading systems as also causing a spread-out of liquidity. NASDAQ believes concentrating that disaggregated liquidity onto a single exchange, with limited exceptions, will allow investors to better source liquidity.
I can’t say I agree with NASDAQ on this one. The OTC Markets provides a much-needed source of capital raising and secondary market trading for small and emerging growth companies, where no other option exists. I am, and continue to be, an avid supporter of the OTC Markets and advocate for its recognition as a venture exchange. A legislatively supported venture market would improve the system dramatically. See my article HERE. I also note that the OTC Markets has a platform in place and a desire to be such a venture market. However, as of today, it has failed to receive the legislative support necessary to make the effective changes needed to the system.
(ii) Give issuers a choice to consolidate liquidity and improve trading quality. NASDAQ advocates reducing Unlisted Trading Privileges (UTP) but at the same time creating an exchange that small and medium companies can trade on. However, from my viewpoint such a route would reduce the number of publicly traded securities, which of course would increase supply and demand for traded securities, but would leave many small and emerging growth companies with no access to public capital or secondary markets.
NASDAQ is careful not to suggest eliminating off-exchange (OTC Markets) trading, noting that “[O]ff-exchange trading represents 38.4% of small and medium growth company trading volume today. While there are great benefits to consolidating on-exchange trading, there is also important value provided by off-exchange trading that merit consideration, especially block trades and price-improved trades. The network of off-exchange brokers also supports systemic resiliency for the trading of these securities.We want to work with the industry towards constructive solutions that balance on- and off- exchange activities.” However, it continues arguing in favor of consolidation. In reading the Paper, I wonder if NASDAQ is ultimately suggesting that OTC Markets be turned into a national exchange and run by NASDAQ itself.
(iii) Deploy intelligent tick sizes for small and medium growth companies. NASDAQ cites research that a one-size-fits-all approach to tick size is suboptimal for many (particularly small and medium growth) companies, which should trade in a suitable tick regime determined by their listing exchange. NASDAQ believes trading could be on sub-penny, penny, nickel or dime increments. For information on the SEC tick size pilot program, see HERE.
(iv) Cultivate innovative market-level solutions that improve the trading of small and medium growth companies. NASDAQ advocates eliminating or greatly reducing Regulation NMS. Regulation NMS (National Market System) is a set of rules and regulations governing fairness in price execution, quote displays and access to market data. NASDAQ believes that these rules are restrictive to the market as a whole and negatively impact the liquidity of lower-priced securities.
(v) Implement an intelligent rebate/fee structure that promotes liquidity and avoids market distortion. In this recommendation, NASDAQ is suggesting plans for incentivizing market making in less liquid stocks.
(vi) Ensure fair and reasonable pricing for participants in the context of limiting exchange competition. Of course, if competition is eliminated, there must be rules in place to ensure that “the house” doesn’t win all! (My words, not NASDAQ’s.)
Companies are under increasing pressure to realize short-term profits for shareholders to the detriment of sustainable long-term growth. NASDAQ particularly points the blame finger at activist investors. Furthermore, unlike many investor groups, NASDAQ supports dual class structures which allow the entrepreneurs and internal management to invest in a motivating fashion along with external investors. NASDAQ’s specific recommendations include:
(i) Address concerns regarding activist investors. As shareholder activism has grown, its definition and purpose have become more muddled. Activism is a term used as an investment strategy that may or may not have any benefit to the company and its other shareholders. In addition to a need for dialogue and research in this area, NASDAQ advocates for further transparency and disclosure around arrangements and motivations by activists, including conflicts of interest.
(ii) Equalize short interest transparency. Short interest disclosures should tie in with Section 13 long position disclosure requirements. The NASDAQ Paper hits the nail on the head: “the asymmetry of information between long investors and those with short positions deprives companies of insights into trading activity and limits their ability to engage with investors and it deprives investors of information necessary to make meaningful investment decisions.”
(iii) Continue to support a dual class structure. Each public company, and their entrepreneurs and innovators, should have the flexibility to determine the best class structure for that company.
(iv) Encourage, rather than mandate, ESG disclosure. ESG stands for environmental, social and governance disclosures.
Further Reading on the SEC Disclosure Effectiveness Initiative
I have been keeping an ongoing summary of the SEC ongoing Disclosure Effectiveness Initiative. The following is a recap of such initiative and proposed and actual changes. Although the rate of changes has slowed down since the election and change in SEC control regime, I expect it to pick up again. In an upcoming blog, I will be writing about the SEC’s announced Regulatory Flexibility Agenda. The Agenda lists regulations the SEC expects to propose or finalize in the next 12 months. This year’s Agenda only includes 33 rules (last year’s contained 62), at least 8 of which are related to disclosure requirements.
On March 1, 2017, the SEC passed final rule amendments to Item 601 of Regulation S-K to require hyperlinks to exhibits in filings made with the SEC. The amendments require any company filing registration statements or reports with the SEC to include a hyperlink to all exhibits listed on the exhibit list. In addition, because ASCII cannot support hyperlinks, the amendment also requires that all exhibits be filed in HTML format. See my blog HERE on the Item 601 rule changes.
On August 25, 2016, the SEC requested public comment on possible changes to the disclosure requirements in Subpart 400 of Regulation S-K. Subpart 400 encompasses disclosures related to management, certain security holders and corporate governance. See my blog on the request for comment HERE.
On July 13, 2016, the SEC issued a proposed rule change on Regulation S-K and Regulation S-X to amend disclosures that are redundant, duplicative, overlapping, outdated or superseded (S-K and S-X Amendments). See my blog on the proposed rule change HERE. This proposal is slated for action in this year’s SEC regulatory agenda.
That proposed rule change and request for comments followed the concept release and request for public comment on sweeping changes to certain business and financial disclosure requirements issued on April 15, 2016. See my two-part blog on the S-K Concept Release HERE and HERE.
As part of the same initiative, on June 27, 2016, the SEC issued proposed amendments to the definition of “Small Reporting Company” (see my blog HERE). The SEC also previously issued a release related to disclosure requirements for entities other than the reporting company itself, including subsidiaries, acquired businesses, issuers of guaranteed securities and affiliates. See my blog HERE. Both of these items are slated for action in this year’s SEC regulatory agenda.
As part of the ongoing Disclosure Effectiveness Initiative, in September 2015 the SEC Advisory Committee on Small and Emerging Companies met and finalized its recommendation to the SEC regarding changes to the disclosure requirements for smaller publicly traded companies. For more information on that topic and for a discussion of the Reporting Requirements in general, see my blog HERE.
In March 2015 the American Bar Association submitted its second comment letter to the SEC making recommendations for changes to Regulation S-K. For more information on that topic, see my blog HERE.
In early December 2015 the FAST Act was passed into law. The FAST Act requires the SEC to adopt or amend rules to: (i) allow issuers to include a summary page to Form 10-K; and (ii) scale or eliminate duplicative, antiquated or unnecessary requirements for emerging growth companies, accelerated filers, smaller reporting companies and other smaller issuers in Regulation S-K. The current Regulation S-K and S-X Amendments are part of this initiative. In addition, the SEC is required to conduct a study within one year on all Regulation S-K disclosure requirements to determine how best to amend and modernize the rules to reduce costs and burdens while still providing all material information. See my blog HERE. These items are all included in this year’s SEC regulatory agenda.