Thursday, March 05, 2015

Venture Exchanges Could Boost Capital Formation for Small Companies, Proponents Say

[This story previously appeared in Securities Regulation Daily.]

By Lene Powell, J.D.

One-size-fits all stock trading has disadvantaged small companies and led to a significant decline in the number of listed companies and IPOs since the late 1990s, said investment banker David Weild in a meeting of the SEC Advisory Committee on Small and Emerging Companies. One possible solution, supported by Commissioner Daniel Gallagher, is to allow the formation of “venture exchanges” that have tailored periodic reporting and listing requirements more appropriate for small businesses.

Decline in IPOs. According to Weild, IPOs and the overall number of listed companies have been in serious decline. From 1998 to the present, listed companies in the U.S. fell from 9,000 to 5,000. IPOs fell from 500 per year to 150 per year, with the ranking falling from 1 to 2 in large IPOs and 1 to 12 in small IPOs. This has led to a decline in employment and innovation.

The reason for this is a one-size-fits-all market structure, which works for naturally liquid large and mid-cap stocks, but fails small, illiquid stocks, Weild said. Changes in order handling rules, Regulation ATS, Regulation NMS, and Sarbanes-Oxley have all played a role in this.

Venture exchange structure. The solution is to charter member-owned venture exchanges that permit listings of up to $2 billion in market value, said Weild. The exchanges and the companies they list would be exempt from order handling rules, Regulations ATS and NMS, unlisted trading privileges (Rule 12f-2), decimalization, Sarbanes-Oxley, and state blue sky laws. To create a pro-growth environment, they would be subject to SEC but not state review, SEC scaled disclosure, or JOBS Act research rules.

To support the exchanges, the SEC along with FINRA and DTCC should establish a “Venture Exchange Division.” This would institutionalize knowledge about venture exchanges and the small and emerging companies they list, Weild said.

Commissioner Gallagher said he is in favor of the rule changes necessary to allow venture exchanges, saying they are a “vital bookend” to JOBS Act rulemaking on Regulation A+. “We must depart from the failed policies and feeble ideas of the past, in order to pursue critically-needed innovation like Venture Exchanges. I believe this Commission has the courage and leadership to do so,” he stated.

Concerns. In a statement, Chair Mary Jo White agreed that one market structure might not fit all, and that the Commission must concretely focus on how to enhance the market structure for smaller companies. However, she noted that some early venture exchanges were not successful, and the reasons for this need to be carefully studied.

Commissioner Aguilar concurred, saying that venture exchanges are a possible solution to the “coming tsunami” of unregistered and unlisted shares of small businesses expected to come on the market due to new rules under Regulation A-plus, crowdfunding, and Rule 506(c) of Regulation D. But prior efforts to establish them in the U.S. have fared poorly, and a thoughtful and prudent approach is needed that carefully examines why the prior attempts failed, he said.

For example, the American Stock Exchange’s Emerging Company Marketplace (ECM) thrived for some time due to lower transaction costs, but the exchange eventually succumbed to a number of serious design flaws. Because profitable firms that joined the ECM eventually graduated to the American Stock Exchange, this created the impression that the ECM was populated only by unsuccessful companies. The exchange failed to properly screen firms and scandals led to the exchange’s reputation as a lawless Wild West. Also, narrow bid/ask spreads might have dissuaded broker-dealers from making markets for the stocks and distributing research on the companies, which may have decreased liquidity, said Aguilar.

To address these concerns, the SEC needs to look at specific questions of structure including dealer vs. auction markets, batch auctions vs. continuous trading, and possibly larger tick sizes, Aguilar said. Apart from these specific issues, though, it’s important for investors to understand that venture exchanges generally may have low liquidity and high volatility, meaning that investors could lose a lot of money quickly and could have trouble selling their shares in a downturn. And, in looking for the next Apple, Google, or Facebook, investors may not comprehend that venture exchanges tend to have a high proportion of small, early stage companies in high-risk business sectors, resulting in a higher risk profile than firms on traditional exchanges. The SEC needs to make sure investors understand these risks, cautioned Aguilar.

Senate Banking to examine. The topic of venture exchanges and small-cap securities will be examined at a Senate Banking Committee subcommittee hearing on March 10. Scheduled to testify are Stephen Luparello, Director of Division of Trading and Markets, as well as representatives from NYSE and NASDAQ OMX.

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