On August 8, 2017 the SEC Division of Economic and Risk Analysis (DERA) published a 315-page report describing trends in primary securities issuance and secondary market liquidity and assessing how those trends relate to impacts of the Dodd-Frank Act, including the Volcker Rule. The report examines the issuances of debt, equity and asset-backed securities and reviews liquidity in U.S. treasuries, corporate bonds, credit default swaps and bond funds. Included in the reports is a study of trends in unregistered offerings, including Regulation C and Regulation Crowdfunding.
This blog summarizes portions of the report that I think will be of interest to the small-cap marketplace.
Disclaimers and Considerations
The report begins with a level of disclaimers and the obvious issue of isolating the impact of particular rules, especially when multiple rules are being implemented in the same time period. Even without the DERA notes that noted trends and behaviors could have occurred absent rule changes or reforms. The financial crisis that resulted in the implementation of Dodd-Frank, necessarily resulted in changes in market trends in and of itself, as did post crisis changes other than Dodd-Frank such as much lower interest rates. Furthermore, observed changes could be a result of numerous other factors such as various regulations (besides the studies Dodd-Frank and JOBS Act), non-regulatory market structure changes and technological advances.
Moreover, five broad economic considerations shaped the DERA analysis. First, capital raising in primary markets and liquidity in secondary markets are inextricably intertwined. There is a direct correlation between the ability to exit investments on the secondary market and the inflow of new investments for primary issuances. Second, alternative credit risk products impact activity and liquidity in bond markets. Third, liquidity is an important characteristic of capital markets, impacting the ability of investors to execute trades of different sizes, quickly and at a low cost. Fourth, although large sample analysis is used to study the markets, this information may not reflect the behaviors of smaller market segments. For example, since the sample size and offering size for companies relying on the JOBS Act provisions is relatively small, and its time of use is relatively short, the DERA declines to reach conclusions regarding future trends related to these offerings. Fifth, regulations that affect one group over another, affect the ability to observe overall changes in market indicators and links to such regulations.
Changes and Trends in Primary Issuance
As I reiterate in many of my blogs, all offers and sales of securities must be either registered with the SEC under the Securities Act of 1933 (the “Securities Act”) or conducted under an exemption from registration. All offerings require disclosure to potential investors with registered offerings requiring detailed disclosures and financial information delineated by regulations, including Regulations S-K and S-X. Companies completing registered offerings become subject to ongoing reporting requirements under the Securities Exchange Act of 1934 (the “Exchange Act”).
One of the purposes of exempt offerings is to reduce the burden on companies during the capital-raising process and thereafter. Certainly not all companies can afford, nor should take on the expense of, a registered offering and ongoing SEC reporting requirements. Since exempt offerings require fewer disclosures and have far less regulatory oversight, they are subject to investor limitations, such as accreditation, and for some, offering limits. The investor protection provisions of the exemption claimed must be met to qualify for the exemption from registration.
The JOBS Act, enacted in 2012, was designed to promote registered and exempt offerings. The JOBS Actcreated emerging growth companies (EGC’s), expanded Rule 506 of Regulation D by creating Rule 506(c) allowing general solicitation and advertising in exempt offerings limited to accredited investors, amended Rule 144A to allow general solicitation and advertising, revamped Regulation A completely and created Regulation CF (Title III Crowdfunding). The DERA notes that these changes would be expected to have important effects on the amount of capital being raised and personally, I think that the changes have had a dramatic impact on primary issuances and especially for smaller companies.
As noted above, the DERA is reluctant to directly tie increases in primary market issuances to the JOBS Act because it involves relatively newer regulations (the provisions were enacted over time from 2012 through 2016), and smaller sample sizes for analysis, but the report can’t deny the uptick, noting the increase in activity around its implementation.
The DERA analyzed the primary issuance of debt, equity and asset-backed securities. The DERA reviewed changes in IPO’s, seasoned follow-on offerings, Regulation A and exempt offerings of debt and equity under Regulation D. Total capital formation from the signing of Dodd-Frank into law in 2010 through the end of 2016 was $20.20 trillion, of which $8.8 trillion was raised through registered offerings and the balance through private offerings. The DERA did not find a decrease in total primary market security issuances as a result of Dodd-Frank, though it did find that there was an increase around the implementation of the JOBS Act in 2012.
The DERA did note several trends, including that capital raised through initial public offerings (IPO’s) ebbs and flows over time, reaching highs in 1999, 2007 and 2014 and lows in 2003, 2008 and 2016. The number of small company IPO’s has increased in recent years. IPO’s of less than $30 million increased from 17% of total IPO’s to 22% following passage of the JOBS Act. Although I do not believe that emerging growth companies (EGC’s) are necessarily small companies, more than 75% of IPO’s were by EGC’s in 2016. The use of Regulation A also continues to increase.
In addition, private offerings have increased substantially over the years. The amount raised through private offerings in the period from 2012 through 2016 was more than 26% higher than the amount raised in registered offerings in the same time period.
Changes and Trends in Market Liquidity
The DERA found it more difficult to tie changes in market liquidity to regulatory reform, citing other factors such as the electronification of markets, changes in macroeconomic conditions, and post-crisis changes in dealer risk preferences as influencers.
The report focused on treasuries, corporate bonds, single-name credit default swaps and funds in its liquidity analysis, devoting 191 pages to these topics. A discussion of this areas is beyond the scope of this blog.
The DERA does state that it found no empirical evidence that U.S. Treasury market liquidity deteriorated after regulatory reforms. Trading activity in corporate bond markets has generally improved or remained flat. Furthermore, transaction costs have decreased over the years on whole. Dealers in corporate bond markets have reduced their capital commitment since 2007, which is consistent with the Volcker Rule.