By Mark S. Nelson, J.D.
The SEC published a report prepared in response to a provision contained in the Consolidated Appropriations Act, 2021 that required the SEC to update Congress on the status of research availability on small issuers. The report did not identify specific causes of the perceived lack of analyst research on small issuers but did recommend that the agency monitor developments regarding regulations applicable to investment research and for the SEC to continue to engage with its global counterparts on the topic.
Study components. Section 106 of Division Q of the financial services title of the FY21 appropriations legislation required the SEC to study the availability of research on small issuers. The provision tracks the Improving Investment Research for Small and Emerging Issuers Act (H.R. 2919), sponsored by Rep. Bill Huizenga (R-Mich), which passed the House by voice vote in July 2019. The provision also includes emerging growth companies and companies mulling initial public offerings.
Specifically, the provision requires the SEC to examine: (1) demand for research; (2) availability of research; (3) conflicts of interest; (4) costs of research; (5) payment mechanisms; (6) the unique concerns of minority-, women-, and veteran-owned small issuers; and (7) a variety of other factors, including the concentration/consolidation of broker dealers and investment advisers, and SEC rules and overseas regulations such as the MiFID II.
Key findings. The main takeaway from the report is that SEC staff could not identify a specific reason for the lack of research on small companies. Said the report: “The staff’s evaluation suggests that a number of factors may have impacted research coverage of small issuers, including legislative and regulatory measures, MiFID II and other variables, such as the rise of client commission arrangements (‘CCAs’), a decline in the overall number of IPOs until 2020, falling equity commissions, fewer institutional investors that invest in small issuers, a shift from active to passive investment strategies, an increase in reliance on in-house research and an increase in alternative data sources.”
Overall, the report counted access to liquidity and investor recognition as being among the benefits that research can bring for small companies. Another positive benefit would be the increased transparency that may arise because of analyst’s public emphasis on a company’s governance structure such that research can serve an external governance function. The chief negative result of investor research is the potential for conflicts of interest that lead to biased reports on companies. According to the report, small companies are less likely than large companies to receive research coverage and that the number of analysts devoted to small and large companies varies significantly, with small companies typically having two analysts and large companies having nine analysts.
The report also considered the several laws and regulations that apply to investor research conducted by broker-dealers and other types of investment professionals. Key regulations include: (1) the Global Research Analyst Settlement; (2) Sarbanes-Oxley Act Section 501 (Exchange Act Section 15D); (3) FINRA Rule 2241; (4) Regulation Analyst Certification; (5) JOBS Act Sections 105(b) and 105(d); and (6) the European Union’s MiFID II.
The report noted that although state regulators may impose some registration or qualification requirements and bring enforcement actions regarding investment research, the SEC staff said it was unaware of specific state regulations that would limit the availability of research coverage for small companies.
With respect to the various applicable laws and regulations, both domestic and international, the report concluded: “There is evidence that some of these Measures – as well as other factors such as MiFID II – may have impacted research coverage of small issuers, but the extent of the Measures’ impact generally appears to be inconclusive, unclear, or difficult to isolate and individually measure.” The absence of specific causes for the dearth of research on small companies, thus, led the staff to recommend that the SEC further monitor developments and engage with global partners regarding the availability of research on small companies.
Lack of data on some topics. The statutory provision also required the SEC to study research on small companies in the context of minority-owned, women-owned, and veteran owned small companies. Footnote 10 to the report stated that the staff’s review of academic and other literature failed to reveal studies on some of the specific topics the statutory provision assigned to the SEC to study. With respect to minority-owned, women-owned, and veteran owned small companies, the report suggested several more general publications regarding business formation, capital formation, and ESG or environmental, social, and governance issues as these issues relate to public companies.
The statutory provision further required the SEC to study the availability of research on small companies as the topic relates to institutional and retail investors and the effects of concentration in the broker-dealer and investment advisor markets on such research. The report, however, said that here too there was little existing information to review.
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