Over the course of its history, the Securities and Exchange Commission has been one of the most valuable resources for average investors. By enforcing securities laws that require public companies to provide financial information to the general public, the SEC plays an instrumental role in allowing nonprofessional investors to operate on a more level playing field for making investments.
Now, though, the SEC is considering a move that would take treatment of small investors in the wrong direction. Using a rule that, until now, has applied only to certain small businesses, the SEC is weighing whether to allow all companies planning an initial public offering (IPO) to release information only to large financial institutions and other institutional investors -- without releasing that same information to the public.
Despite some perceived advantages, selective disclosures would give institutions even more of an edge over small investors, at a time when it's more important than ever to encourage small investors to invest in the stock market.
The SEC and the testing-the-waters rule
In 2012, the Jumpstart Our Business Startups Act allowed relatively small companies to avoid some of the more onerous elements of the securities laws. For businesses that qualified as what the law called "emerging growth companies" -- generally, a company with revenue of less than $1 billion that has never sold stock publicly after filing an SEC registration statement -- less extensive narrative explanations were necessary. Requirements for audited financial statements, internal controls under Sarbanes-Oxley, and compliance with accounting-standard changes were also relaxed.
In addition, emerging growth companies are now allowed to do what's known as "testing the waters" in deciding whether to raise capital through an IPO. The rule specifically allows communications with qualified institutional buyers and institutional accredited investors.
Those communications can include a lot of valuable information. Companies can reveal information about their sources of revenue, the experience of their top executives, and their overall corporate strategy under the rules. Moreover, these disclosures can happen either before or after the company files a regular S-1 registration statement with the SEC. That means even after an emerging growth company decides it wants to go public, it can use the rule to gauge interest among financial institutions by sharing sensitive information selectively -- while not having to reveal the same information to all investors.
Letting every company test the waters
Now the SEC wants to open up the testing-the-waters rule to all companies seeking to go public, not just emerging growth companies. A newly proposed version of the rule would allow companies with more than $1 billion in revenue to go through the process.
Proponents of the measure argue that the amended rule would help more companies go public at a time when fewer IPOs have been taking place. SEC chairman Jay Clayton argued that the trend toward companies remaining privately held has prevented investors from benefiting from their growth. Clayton contends that removing restrictions on the IPO process would give small investors greater access to investments, by making more companies available on public stock exchanges.
In addition, proponents seem to argue that eventually, any information that institutions get first will be disclosed later to the general public if the company moves forward with an IPO.
Going too far?
However, the rule change goes much further than what is necessary to accomplish that goal. Not only would testing the waters be available to privately held companies doing IPOs, but many existing public companies would also be able to use the provisions if they wanted to issue a secondary offering. That would presumably also include business development companies and regulated investment companies that are considering secondary offerings of stock.
The SEC proposal is just the latest in a series of moves and suggestions to give businesses more options. In 2017, the agency allowed companies to file a confidential draft registration statement in order to get an initial SEC review without disclosing information publicly. Late last year, the SEC decided to evaluate whether requiring all companies to release quarterly financial reports was the optimal way for investors to get information about the businesses in which they invest.
Support the securities laws
For 85 years, the Securities Act and the Exchange Act have helped ensure that investors have fair access to information regardless of their size or level of experience. Securities laws do recognize the value of experience and sophistication among investors, and some investments that are arguably too risky for individual investors might not be inappropriate for professional investors.
Nevertheless, opening avenues for confidential sharing of financial information between companies and large institutions should be the exception, not the rule. Rather than accentuating the differences between institutional and individual investors, the SEC should do everything it can to take away those differences. That doesn't have to discourage companies from going public, if information disclosure requirements are reasonable, and the same information is made available to all.
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