Thursday, June 21, 2012

In letter to SEC Chair, and In Light of Facebook IPO, House Leader Wants Dialogue on Fundamental Reform of the IPO Process

In light of the substantial flaws in the IPO process revealed by the Facebook IPO, Chairman Darrell Issa (R-CA) of the House Oversight Committee wants to begin a dialogue with the SEC to fundamentally transform the regulation of the IPO process. In a letter to SEC Chair Mary Schapiro, Chairman Issa emphasized that Congress must revisit the Securities Act of 1933, which has given investment banks almost 60 years to enjoy what is essentially flawed legislation fraught with conflicts of interest and incentives to misprice shares. Among other things, he asked the SEC to take advantage of the vast technological improvements to protect investors while unleashing capital formation. More broadly, given the fierce global competition for capital, he noted, the continued protection, over-regulation and coddling of US financial firms will lead to a weakening of US financial markets.

The oversight chair then posed a series of specific questions that he wants Chairman Schapiro to answer by July 3, 2012. The Committee on Oversight and Government Reform is the principal oversight committee of the House with broad authority to investigate any matter at any time under House Rule X.

Chairman Issa asks if the exercise of substantial initial pricing discretion provided to underwriters and issues in the 1933 Act can lead to pricing errors and conflicts of interest. Specifically, he asks if the pricing discretion exercised in the Facebook IPO harmed retail investors. Regarding underpricing and allocations, he asked the SEC to provide a summary of internal or external research the Commission has relied on with regard to IPO overpricing and underpricing throughout the past 20 years. The oversight chair also wants to know if the vast majority of shares go to institutional investors and wants to see summary data on the allocation of IPO shares over the past 20 years to institutional investors.

The House leader also had a number of questions regarding barriers to communicating with investors. He noted that the Securities Act enables underwriters to determine the price of the issuance while they develop support from select potential investors under protection from public debate on the issuers’ valuation. The protection from public debate arises out of the restrictions to communicate outside of the prospectus. These communications restrictions generally fall within the quiet period. Separately Securities Act Rule 175, in the view of Chairman Issa, fails to properly carve out analyst research reports made by on or behalf of an issuer from Rule 10b-5 liability. As a result of Rule 175, he averred, analyst research is withheld from retail investors.

It seemed to him that the liability construct provided under Securities Act Rule 175 needlessly prevents ordinary investors from receiving valuable information on IPOs. Chairman Issa asked the SEC if it recognizes that the quiet period rules and liability under Rule 175 provide institutional investors an informational advantage over ordinary investors. Similarly, he asked the Commission if the quiet period is more and more difficult to enforce given the advances in information technology. Specifically, he requested SEC comment on the costs and benefits of enforcing restrictions on communication in light of current technology. More broadly, he wants to know if the restrictions on communication in the Securities Act inhibit price discovery in the IPO process.

Chairman Issa also asks the SEC to explain how restricting the access of ordinary investors to marketing materials from an issuer protects them. He queries if the quiet period is intended to protect ordinary investors from themselves. 

He also questioned if analysts working in the research departments of brokerage firms suffer potential liability under Rule 175(a) if their analysis fails to accurately predict the performance of an IPO issuer. He asked if the SEC believes that it is reasonable to expect that analyst estimates are accurate ex-post and that any liability should be associated with something as unrealistic as predicting the future. Further, he wonders if subjective requirements for a reasonable basis and good faith open the door to needless and excessive litigation and prevent ordinary investors from receiving valuable information.

He asks the SEC if it believes that, under the Section 27A safe harbor for forward-looking information, these same analysts can provide earnings estimates for public companies without being subject to liability if their earnings fail to meet the estimates. The SEC should explain the substantive basis for treating analysts of an IPO issuer differently than the analysis of a public company. Finally on this theme, Chairman Issa asks the SEC if it would, consistent with Section 27A, consider amending Rule 175 to provide a broad safe harbor for forward-looking information about the issuer.

On the issue of market price and fair market value, Chairman Issa asks for an explanation on why the SEC considers market price to be the best determinant of market value and contrast this approach with the non-market approach applied to traditional IPOs. He asks if the common post-IPO pop in share price reflects artificial underpricing and whether the pop reflects positively or negatively on securities market efficiency. He queries if the SEC has the authority to impose a market-based IPO price determination process without legislation.

Further, the SEC should address whether a market-based auction model would eliminate the pricing discretion exercised by the underwriter and the issuer. More particularly, would the SEC ask Congress for the complete abandonment of the non-market based approach provided by the 1933 Act in favor of a market-based approach, such as a Dutch auction that the issuer opens to all market participants. The SEC is requested to provide the Committee with information on whether allowing short selling within the Dutch auction could act to eliminate concerns over puffing by opening up the IPO to a broader set of initial investors.