The public/private company dichotomy has been a perennial discussion topic. (See, e.g., this PubCo post, this PubCo post, this PubCo post and this PubCo post.) A statistic frequently tossed around is that there are about half as many public companies today as there were in 1996, and those that are around today are older and larger. And while the IPO market was in a bit of funk last year, the private markets have been viewed as consistently vibrant, with more capital raised in the private markets than in the public. But the question of why and how to address the decline in the number of public companies has been a point of contention: is excessive regulation of public companies a deterrent to going public or has deregulation of the private markets juiced their appeal, but sacrificed investor protection in the bargain? At the end of January, we heard from SEC Commissioner Caroline Crenshaw addressing the question of whether the securities laws governing private capital raises might be too lax. Now, SEC Commissioner Mark Uyeda is speaking his mind on the topic, presenting remarks at the at the “Going Public in the 2020s” conference at Columbia Law School.
SideBar
In her remarks, Crenshaw observed that Reg D, among other legal and regulatory mechanisms, has allowed “the development of pools of private capital sufficient to satisfy the needs of even the largest private issuers.” But has it provided adequate safeguards for investors? Is Reg D serving the purpose for which it was originally intended? Crenshaw opened with a bit of history: when the federal securities laws were first enacted, “companies could choose to offer to the broad investing public by taking on substantial disclosure obligations in exchange for exclusive access to the relatively unlimited pool of public capital; private companies, on the other hand, had to raise capital from insiders or certain large financial institutions, and were subject to restrictions on transfer and resale. Private markets were meant to be the exception to the proverbial rule.” The public offering process was designed “to reduce the stark information asymmetry between the issuer of securities and its current and potential investors.” Private companies engaging in exempt offerings did not offer this level of information and, therefore, were “intentionally constrained” in their ability to raise capital. Over time, however, Rule 506 of Reg D (and other exemptions) “have changed the landscape of the private markets entirely”; the markets' “unfettered access to capital through Rule 506 has had a bloating effect on private issuers,” leading to the current proliferation of “unicorns,” now numbering 1,205 with purported aggregate valuation of about $4 trillion. The growth of these companies, she contended, can have adverse effects on investor protection and result in inflated valuations, lack of corporate governance protections and potential unavailability of capital for smaller companies. She proposed reforms to Form D, as well as the adoption of a two-tier system that would impose greater disclosure obligations on the larger private issuers and issuances. (See this PubCo post.)
Uyeda begins with some stats: in the 1990s, there were just over 4,000 IPOs by U.S. operating companies, while in the 21st century, that number was cut almost in half, suggesting that private companies “no longer see them as a cost-effective method of raising capital.” Why is that? Uyeda recognizes that many factors are usually taken into account in making the decision to go public. For example, private companies may decide that it is more beneficial to be acquired than to conduct IPOs. After examining market conditions, private companies typically go through a cost-benefit analysis in determining whether to go public. Notably, one of the costs that factors into the equation is the burden of regulation as a public company, and, in some circumstances, he suggests, it can be a deterrent.
How should this issue be addressed? To be sure, Uyeda contends, “the answer to fewer companies going public is not to overregulate the private markets through prescriptive disclosure and governance requirements” (a retort perhaps, to Crenshaw's recommendation). In Uyeda's view, the answer is straightforward: the SEC should “create a regulatory environment that appropriately balances the costs and benefits associated with any required disclosures, while considering its investor protection mission.” To find this balance, the SEC “can encourage capital formation by promulgating rules that: (i) are grounded in financial materiality and (ii) adequately consider smaller public companies' ability to pay for the compliance costs.”
First, Uyeda maintains that the SEC should mandate disclosure based on financial materiality—that's an objective criterion that virtually all reasonable investors would consider, he contends. But there's much less consensus on disclosure “without an apparent financial impact. This is because there may be significant differences among investors' views of the importance of any given non-financial factor. As a result, it may be difficult to establish a reasonable investor standard for non-financial factors. The costs of providing such disclosure, however, are quite real.”
Although topics now on the SEC's agenda, such as climate change and human capital, “may be important to particular investors, the Supreme Court has held that materiality turns on an objective standard of the reasonable investor. However, for the rulemakings where the Commission has issued proposals, the required disclosure is often one-size-fits-all and prescriptive. The disclosure requirements do not appear to be rooted in whether a reasonable investor would consider the information important in his or her decision to invest in a company's stock.” Disclosures not based on financial materiality, perhaps added at the “whims of the Commission,” Uyeda suggests, could be costly to prepare, “but provide limited or no use to a reasonable investor making an investment decision.” They could also lead to expensive litigation, with costs passed on to customers. These regulatory costs—as well as the prospect of future burdensome requirements—could, in his view, deter companies from going public.
Second, Uyeda observes that the impact of regulation on smaller companies has been more pronounced, with a steeper decline in the number of public companies and IPOs. Why? Because, Uyeda suggests, they have fewer resources to pay for public company regulatory compliance. To address these issues, Uyeda recommends that the SEC should again revise the definition of “smaller reporting company“ (see this Cooley Alert) to include a “test based on revenue or gross profit, either in addition to, or in lieu of, public float,” which he contends “is better suited to determine whether a company can qualify for the ability to provide scaled disclosure.” Moreover, he advocates that all SEC disclosure rules should provide for both scaled disclosure and delayed compliance dates of at least one year for smaller reporting companies, allowing smaller companies to benefit from the models and other work performed by larger companies to comply with new rules.
SideBar
[Below based only on my notes, so standard caveats apply.] Some of these public/private issues were also explored last week by a law professor from Duke at the SEC's Investor Advisory Committee meeting. She suggested that the private markets and public markets can't be viewed in isolation; rather, the problem lies in the upset of the previous public/private equilibrium. Originally, she explained, to have access to big money, a company needed to provide significant disclosure (as a public company); now, private companies have access to unlimited capital with very little mandated disclosure. That is, in the private markets, both the carrot and the stick have disappeared. As a result, she considered the public capital markets (which are typically viewed as a major strength of the US economy) to be more “fragile” than we like to admit. She questioned how justifiable it is to regulate public companies “as a set.” Does it make sense for two comparably-sized large companies in the same industry to be regulated completely differently just because one is public and the other private? As policy options, she suggested that there be some reduction in the regulatory gap, such as by increased requirements for private companies to provide financial statements, and amending Exchange Act Section 12(g) to require more companies to register. That latter approach was previously advocated by former SEC Commissioner Allison Herren Lee. (See this PubCo post.) Notably, on the SEC's agenda with a target date of April 2023 is whether to propose an amendment to the definition of “held of record” for purposes of Section 12(g) of the Exchange Act. (See this PubCo post.)
Why does the decline in IPOs and public companies matter? In Uyeda's view, as IPOs have become more a vehicle for mature companies to provide liquidity events for their insiders, “the pool of potential growth-stage investments available to Main Street investors” has declined, with the result that “Main Street investors—but not wealthy investors or venture funds—lose out on the ability to participate in the potential upside associated with some growth-stage companies and the diversification that investments in such companies can provide.” He found that trend to be “concerning.”
But the answer is not “to force those companies to undertake some form of public offering. So long as the burdens of being a public company remain significant,” efforts to limit private capital raising or otherwise increase costs of remaining private will not cause them to go public. Rather, he observes, “such restrictions could prevent new companies with innovative ideas from being started in the first place.”
Instead, the SEC should revisit “the binary ‘all or nothing' approach to accredited investors,” by, for example, “allowing an individual to invest a certain percentage of his or her income or net worth in one or more private companies during a year.” Financial thresholds can be problematic for several reasons: they do not take into account geographic cost-of-living differences, disadvantage younger people who may have “longer investment horizons and greater risk tolerance,” and ignore the investment diversification opportunity that may be appropriate for diversified portfolios. (Whether to propose amendments to Reg D, including updates to the accredited investor definition and to Form D, is on the SEC agenda with a target date for a proposal of April 2023.)
SideBar
In this paper, the authors from the Harvard Law and Business Schools take issue with all of these interpretations of the dramatic decline in the number of public companies. As they describe it, the “dominant explanations, often advanced by Securities and Exchange commissioners when considering policy initiatives, come from over- or under- corporate regulation of the stock market. The central legal explanation is that corporate and securities law has made the cost of being public too high. Conversely, goes the second legal explanation, capital-raising rules for private firms were once very strict but have loosened up. Private firms can now raise capital nearly as well as small- and medium-sized public firms. Either way, these views see legal imperatives as explaining the sharp decline in the public firm.”
But the authors want to quickly disabuse you of any notion that the public company sector is in decline. Yes, it's true, they say, that the number of public companies has dropped precipitously, but the public company sector is still vibrant: its “economic weight … is bigger by every other measure: total stock market capitalization is up greatly over the past three decades, profits are up, revenues are up, investment is up, and employment is up. Moreover, stock market capitalization, profits, revenues, and investment have not only increased but have all grown faster than the economy.” In their view, “the legal structures are supporting as much, or more, economic activity as ever.” The notion that the public company sector is weak and shrinking is not, they observe, correct: ‘If public firms have become poor places to do business because of legal burdens, then the total value of the stock market—and not just the total number of firms—should be shrinking as well. But it is not.”
In that case, they ask, should these securities-law explanations “continue to be as central to understanding why we have fewer public firms”? The potential error in the analysis is to focus only on the number of public companies. Perhaps the change to fewer, but more profitable and more valuable firms really reflects “a single transformation of the public firm sector.” The authors propose various alternative hypotheses for the decline in the number of public companies, but focus on a “real economy” explanation arising out of two possible changes in “industrial organization”: “that antitrust enforcement has weakened, allowing more mergers and concentration than before,” and “that economies of scale and similar changes have made size more important in many industries, pushing for fewer firms than before.” The authors conclude that, in light of the real strength of the public company sector, the decline in just the number of public companies should not point to further efforts at deregulation.
Happy International Women's Day!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.