Many recent press articles lamenting “short-termism” in corporate America blame research analysts for focusing on quarterly earnings. In a recent paper titled, “Analyst Coverage and the Quality of Corporate Investment Decisions” authors Thomas To, Marco A. Navone and Eliza Wu demonstrate a causal connection between analyst coverage and good investment decisions. The authors assess the impact of financial analyst coverage on corporate investments by evaluating corporate total factor productivity (or efficiency gains) for US listed companies from 1991 to 2013. Their “information hypothesis” postulates that analyst coverage delivers information about companies to the market and may therefore provide those companies with access to funding that permits companies to make capital expenditures and other investments. Also, as a result of analysts monitoring companies and revealing negative information and assessments to the market, it ensures that company management’s will undertake the most productive projects. In this latter case, analysts effectively serve as monitors prompting companies to improve capital allocation efficiency. The study also shows that a reduction in analyst coverage reduces capital expenditures and institutional monitoring. In this light, perhaps the claims that analysts contribute to short-termism should be reevaluated.
Securities Related Bills Pass in the House of Representatives
A number of capital formation-related bills passed in the House this week with bipartisan support. These include:
- H.R. 5877, the “Main Street Growth Act,” sponsored by Rep. Tom Emmer (R-MN), which would amend the Securities Exchange Act of 1934 to allow for the registration of venture exchanges with the Securities and Exchange Commission.
- H.R. 5970, the “Modernizing Disclosures for Investors Act,” sponsored by Rep. Ann Wagner (R-MO), which would require that the Commission no later than 180 days after enactment provide a report to Congress with a cost-benefit analysis of emerging growth companies’ use of Form 10-Q and recommendations for decreasing costs, increasing transparency, and increasing efficiency of quarterly financial reporting by emerging growth companies.
- H.R. 6139, the “Improving Investment Research for Small and Emerging Issuers Act,” sponsored by Rep. Bill Huizenga (R-MI) , which would require the Commission to carry out a study to evaluate the issues affecting the provision of and reliance upon investment research into small issuers, including emerging growth companies and pre-IPO companies
Other Legislative Proposals Affecting Capital Formation
There are a number of legislative proposals making their way through the House, including: H.R. 5054, the Small Company Disclosure Simplification Act of 2018, which provides EGCs and smaller reporting companies an exemption from xBRL requirements (referred to in our prior blog post), H.R. 6035, the Streamlining Communications for Investors Act, which is a measure that would direct the Securities and Exchange Commission to amend Rule 163 under the Securities Act in order to allow underwriters and dealers acting by or on behalf of a WKSI to engage in certain communications, and a measure that would direct the Commission to increase and align the smaller reporting company definition and the non-accelerated filer financial thresholds, and a measure requiring the Commission to conduct a study with respect to research coverage of small issuers before their initial public offerings.
All of these bills emanated from the recommendations contained in the report prepared by SIFMA and other trade associations titled “Expanding the On-Ramp: Recommendations to Help More Companies Go and Stay Public,” which we blogged about previously.
The Financial Services Committee has passed H.R. 6035 with some bipartisan consensus. This measure is similar in scope to the amendments to Rule 163 of the Securities Act that the Commission had proposed a few years ago and never adopted. Given the fact that most follow-on offerings are conducted on a wall-crossed basis these days, it would make sense to allow underwriters acting on a WKSI’s behalf to approach investors even prior to the WKSI filing an automatic shelf registration statement.
SEC Proposes Expanding Safe Harbor to Promote Research on Investment Funds
On May 23, 2018, the Securities and Exchange Commission (the “Commission”) proposed establishing a research report safe harbor (Rule 139b) for unaffiliated brokers or dealers that publish or distribute research reports that cover investment funds. The Commission took this action in furtherance of the mandate of the Fair Access to Investment Research Act of 2017 (the “FAIR Act”). The FAIR Act required the Commission to expand the Rule 139 safe harbor for research reports to cover research reports on investment funds. Rule 139 permits a broker or dealer that is distributing an issuer’s securities to publish a research report about those securities without the report itself being deemed an offer to sell such securities. If adopted as proposed, the safe harbor would be made available to research reports on mutual funds, exchange-traded funds, registered closed-end funds, business development companies and similar covered investment funds. The safe harbor would be unavailable with respect to broker-dealers’ publication or distribution of research reports about closed-end registered investment companies or business development companies during their first year of operation. The adoption of an expanded safe harbor would reduce obstacles that currently prevent certain investors from accessing research reports on investment funds. However, the safe harbor would not extend to research reports issued by brokers or dealers affiliated with the investment fund. The public comment period will remain open for 30 days. The proposed rule is available here.
Expanding the On-Ramp
A number of industry groups, including SIFMA, have joined to put forward recommendations to promote capital formation and assist more companies in going public or remaining public. Many of the measures suggested in the report have been presented previously, whether in the U.S. Treasury Report on capital markets or in bills introduced in, or passed by, the House Financial Services Committee. For example, the group suggests:
- That for issuers that meet the EGC definition, extending the on-ramp provisions of Title I of the JOBS Act from five to ten years;
- Amending Section 5 of the Securities Act in order to extend the ability to test-the-waters to non-EGC issuers;
- Extending the Sarbanes-Oxley Section 404(b) exemption from five to ten years for lower revenue EGCs; and
- Simplifying or eliminating the “phase out” provisions relating to EGC status.
The report also addresses research related issues and suggests:
- Amending the Securities Act Rule 139 safe harbor to eliminate the Form S-3 eligibility prong;
- Allowing research and banking colleagues to attend pitch meetings and reviewing the Global Research Analyst Settlement; and
- Studying the factors impacting the decision of most firms not to publish pre-IPO research.
Finally, the report addresses other measures, such as regulation of proxy advisory firms, short-selling, the baby shelf restrictions for smaller issuers, and financial reporting and market structure matters, not as closely tied to the IPO market.
Market Structure and the Decline in Listed Companies
Recently, SIFMA held its Equity Market Structure conference, which addressed a broad range of issues. Of course, conference participants addressed market structure concerns that may affect a company’s decision to undertake an IPO or to remain public and pointed to recent statistics, reprinted below. The Securities and Exchange Commission has also undertaken discussions regarding equity market structure issues. Representatives from the Commission recently spoke at a University of Chicago-sponsored symposium commenting on the Treasury Department report recommendations to review market structure issues. The Commission has had the tick pilot in operation for some time providing for wider tick increments for smaller companies as a means of improving liquidity. While the pilot is set to expire early in the fall, it is clear that tick size increments alone are not a solution to achieve greater liquidity in the trading of stocks of smaller companies. For many companies considering an initial public offering, while listing rules, tick sizes and liquidity may factor into their considerations, these usually do not figure prominently in their decision making. It is interesting that the Treasury Department report recommendations regarding equity research rules have not received more attention by the Commission or by other market participants given that research coverage (and not market structure) concerns are top of mind for management of emerging growth companies.
Analyst Involvement in the IPO Process
Authors Michael Dambra, Laura Casares Field, Matthew T. Gustafson and Kevin Pisciotta recently published a paper, “The Consequences to Analyst Involvement in the IPO Process: Evidence Surrounding the JOBS Act,” which reviews research analyst involvement post-JOBS Act in offerings. The authors consider whether participation by affiliated analysts in securities offerings affects their research by evaluating analyst activity relating to EGCs. The control group used are non-EGC issuers. The authors conclude that pre-IPO participation increases analyst optimism resulting in less accurate reports. While the paper presents interesting data regarding the value of research, it is difficult to gauge the differences that were observed pre- and post-JOBS Act in research involvement. Compliance policies for firms, including many not subject to the analyst settlement, prevent analyst participation in the offering process. There has been little to no practical effect from the JOBS Act relaxation of certain research activities in relation to EGCs. To the extent that there is greater “optimism” with respect to EGCs, it is difficult to isolate and attribute such sentiment to analyst involvement.