Revisiting "truth in Securities" Revisited: Abolishing Ipos and Harnessing Private Markets in the Public Good

• Publication year: 2012

Washington Law ReviewVolume 36, No. 2, WINTER 2013

Revisiting "Truth in Securities" Revisited: Abolishing IPOs and Harnessing Private Markets in the Public Good

A. C. Pritchard(fn*)

I. INTRODUCTION

Milton Cohen, in his seminal article, "Truth in Securities" Revisited,(fn1) was the first to highlight the awkwardness created by the enactment of the Securities Act of 1933(fn2) before the enactment of the Securities Exchange Act of 1934.(fn3) Cohen pointed out that if the Securities Act, which regulates public offerings of securities, had been adopted subsequent to or simultaneously with the Exchange Act, which regulates the disclosure obligations of public companies, then public-offering disclosure obligations would naturally piggyback on the periodic disclosure obligations mandated for public companies.(fn4) Franklin Delano Roosevelt's political calculation, however, ensured that the bills would be separate and that the Exchange Act would come second.(fn5) That accident of history meant that the two statutes would develop separate disclosure obligations. That separate development ignored the economic reality that investors would seek largely the same information in valuing securities, regardless of whether they were purchasing from an issuer in a primary transaction or another investor in a secondary transaction.

Companies' public-offering and secondary-market disclosure obligations have gradually converged since Cohen wrote in the 1960s. The rise of integrated disclosure obligations for the two Acts in the 1980s(fn6) is generally considered a way station along the path to full-blown company registration.(fn7) Company registration would allow a company to register as a public company just once; thereafter, the company could offer and sell securities whenever it wanted, without the need to register the securities themselves. (fn8) The move toward company registration began with shelf registration under Rule 415,(fn9) which allows for considerable incorporation by reference of prior public disclosure in registration statements for offerings by public companies. That movement culminated in the SEC's 2005 offering reforms, which streamlined shelf registration.(fn10) Now, the largest public issuers operate under the functional equivalent of company registration. The advantages of company registration are available, however, only for a subset of the companies that have previously transitioned from private- to public-company status. Initial public offerings (IPOs), the customary path for attaining public-company status, are not included in shelf registration. Instead, IPOs are still subject to the traditional regulatory regime, with its "gun-jumping" restrictions on voluntary disclosures and offers made before the SEC's approval of a company's registration statement. The gun-jumping rules are intended to quell speculative fervor by forcing disclosure into the SEC's mandatory format.

The separate enactment of the Securities Act and the Exchange Act also influenced the development of the distinction between public and private under those two statutes. Both the Securities Act and the Exchange Act reflect a public-private divide, but they take very different approaches to drawing that line. The Securities Act draws the line between public and private in a manner that focuses explicitly on investor protection. The dividing line under the Exchange Act, by contrast, is a compromise-reflecting not only investor protection, but also interests in capital formation and practical ease of application. I argue here that the resulting mismatch between the public-private dividing lines under the two Acts means that the transition from private to public will inevitably be awkward, abrupt, and fraught with problems for issuers, investors, and regulators. Can we reconcile the two dividing lines so that companies can navigate this passage from private to public more smoothly?

Congress has partially addressed this problem with its recent adoption of the Jumpstart Our Business Startups Act (JOBS Act). Unhappy with the SEC's somewhat tepid efforts to facilitate capital raising by smaller companies, Congress gave the SEC new authority to exempt offerings from the requirements for registered offerings. Along with that exemptive authority, Congress authorized the SEC to adopt less demanding periodic disclosure requirements for companies who avail themselves of this new offering exemption. These disclosure requirements would presumably only apply until a company triggered the standards for full-fledged public-company status. Those public-company standards are also newly raised by the JOBS Act. The JOBS Act reforms have the potential to create a lower tier of public companies, thus blurring the line between public and private. Advocates for investor protection have roundly criticized these changes, asserting that it opens the door for fraud and manip-ulation.(fn11) Such criticisms carry some weight, given the abuses that repeatedly occur in the penny stock market.

My thesis is that the transition between private- and public-company status could be less bumpy if we unify the public-private dividing line under the Securities Act and Exchange Act. The insight builds on Cohen's thought experiment where Congress first enacted the Exchange Act. My proposed public-private standard would take the company-registration model to its logical conclusion. The customary path to public-company status is through an IPO, typically with simultaneous listing of the shares on an exchange. There is nothing about public offerings, however, that makes them inherently antecedent to public-company status. What if companies became public, with required periodic disclosures to a secondary market, before they were allowed to make public offerings?

I propose a two-tier market for both primary and secondary transactions keyed to investor sophistication. The private market would be limited to accredited investors, while the public market would be accessible to all. An easily measured quantitative benchmark-market capitalization or trading volume-would trigger the transition between public and private markets, allowing companies to elect public status after reaching that threshold. Once a company opts for public status, that newly public company would have a seasoning period during which periodic disclosures would be required. Only after the seasoning period could newly minted public companies sell shares to the public at large. Such a regime would substantially enhance the information available to the primary market once a company makes a public offering. More importantly, it would allow the secondary market to process that information before any public offerings. This regulatory framework would go a long way toward both promoting efficient capital formation and eliminating the waste currently associated with IPOs. A happy byproduct would be more vigorous protection for unsophisticated investors.

I proceed as follows. Part II outlines the current public-private dividing lines under the Securities Act and the Exchange Act. This part also explores Facebook's recent transition from private to public status under that framework, as well as Congress's recent intervention in the field with the JOBS Act. Part III explores the problems of making the transition from private to public, focusing on IPOs and their role in capital allocation. This part uses Facebook's IPO as both an illustration and as a cautionary tale. Part IV sketches an alternative to the current regulatory framework based on the two-tier-market proposal summarized above. Part v concludes.

II. PUBLIC VERSUS PRIVATE

The distinction between public and private companies is an important triggering mechanism under both the Securities Act and the Exchange Act. As noted above, the two statutes' differing demarcations between public and private date back to their original enactment during the New Deal. Common to both are the significant regulatory consequences that flow from public designation. Consequently, companies and their lawyers spend considerable energy avoiding public status. This regulatory arbitrage has induced the SEC to spend like effort in curtailing those attempted evasions of public status. The SEC has erected fences around private companies and private offerings that result in markets facing an informational void when a company is ready to make the transition from private to public. Facebook's recent IPO and preceding developments illustrate the problems created by the transition. Those developments helped spark the tweaks that Congress made to the public-private dividing line in the JOBS Act.

A. The Public Trigger

1. The Securities Act

Under the Securities Act, public offerings are open to any and all comers. Accordingly, public offerings are subject not only to extensive disclosure requirements, but also to a byzantine array of gun-jumping rules limiting voluntary disclosure intended to curb speculative frenzies for newly issued securities.(fn12) Private offerings are exempt from registration and the gun-jumping rules under § 4(a)(2) of the Securities Act. The Supreme Court has interpreted § 4(a)(2) in SEC v. Ralston Purina Co.(fn13) as permitting private offerings only to investors who can "fend for themselves," and therefore do not need the protections afforded by registration under the Securities Act. Because they are limited to sophisticated investors, private offerings are...