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RevisitingTruthinSecuritiesRevisited:AbolishingIPOsandHarnessingPrivateMarketsinthePublicGood
A.C.Pritchard*
Abstract: This essay explores the line between private and public markets. Iproposeatwotiermarketsystemtoreplaceinitialpublicofferings.Thelowertierwouldbeaprivatemarketrestrictedtoaccreditedinvestors;thetoptierwouldbeapublic market with unlimited access. The transition between the two marketswouldbebasedonissuerchoiceandmarketcapitalization,followedbyaseasoningperiod ofdisclosure and trading inthe publicmarket before the issuerwouldbeallowedtomakeapublicoffering.Iarguethatsuchsystemwouldpromotenotonlyefficientcapitalformation,butalsoinvestorprotection.
I. Introduction
Milton Cohen, in his seminal article, Truthin
Securities
Revisited,1was the
first tohighlight the awkwardness created by the enactment of Securities Act of
1933,2whichregulatespublicofferingsofsecurities,priortotheenactmentofthe
SecuritiesExchangeActof1934,whichgovernsthedisclosureobligationsofpublic
companies.3Cohen pointed out that if the Securities Act had been adopted
subsequentto,orsimultaneouslywith,theExchangeAct,itwouldhavebeennatural
forpublic offeringdisclosureobligations topiggybackon theperiodicdisclosure
obligationsmandated forpublic companies.4Franklin Delano Rooseveltspolitical
calculation, however, ensured that the bills would be separate and that the
* Frances and George Skestos Professor ofLaw, University of Michigan Law School. This
article was prepared for the Berle IV Conference held at University College, London. Thanks toparticipants at that conference for helpful suggestions and criticisms, aswell as Jesse Fried andChuckWhitehead.
SpecialthanksgotoDonLangevoortandBobThompson.Iwasaskedtocommentontheirarticle, Publicness in Contemporary Securities Regulation after the JOBS Act, 101 GEO. L.J.(forthcoming,2012),whichwastheinspirationforthisproject.Theirarticleprovidesamuchmorecomprehensive discussion of the background issues raised here; we disagree on the best wayforward,butIhavebenefittedfromanumberofhelpfulconversationswiththemonthistopic.IamgratefultotheCookFundoftheUniversityofMichiganLawSchoolforsupportforthisproject.
179 HARV. L. REV 1340 (1966)2Pub.L.No.7338,48Stat.74(1933),codifiedasamendedat15U.S.C.77.3Pub.L.No.73404,48Stat.881(1934),codifiedasamendedat15U.S.C.78.4Cohen,supranote,at13411342.
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Exchange Act would come second.5That accident of history meant that the two
statuteswoulddevelopseparatedisclosureobligations.Thatseparatedevelopment
ignoredtheeconomicrealitythattheinformationinvestorswouldseekinvaluing
securitieswouldbelargelythesame,regardlessofwhethertheywerepurchasing
from an issuer in a primary transaction or another investor in a secondary
transaction.
Companiespublicofferingandsecondarymarketdisclosureobligationshave
gradually converged since Cohen wrote in the 1960s. The rise of integrated
disclosureobligationsforthetwoActsinthe1980s6isgenerallyconsideredaway
station along the path to fullblown company registration.7Company registration
wouldallowacompanytoregisterasapubliccompanyjustonce,thereafteroffering
andsellingsecuritieswheneveritwantedwithouttheneedtoregisterthesecurities
themselves.8Themovetowardcompanyregistrationbeganwithshelfregistration
underRule415,9whichallowsforconsiderableincorporationbyreferenceofprior
publicdisclosureinregistrationstatementsforofferingsbypubliccompanies.That
movementculminatedintheSECs2005offeringreformswhichstreamlinedshelf
registration.10 Now, the largest public issuers operate under the functional
5SeeJoelSeligman,THETRANSFORMATIONOFWALLSTREET5153(3ded.,2003).6SeeAdoptionofIntegratedDisclosureSystem,SecuritiesActRel.No.6383(1982).7SeeStephenJ.Choi,CompanyRegistration:TowardaStatusBasedAntifraudRegime,64U.
CHI.L.REV.567(1997).8CompanyregistrationistheorganizingprincipleunderlyingtheAmericanLawInstitutesproposedcodificationoffederalsecuritieslaw.SeeFEDERALSECURITIESCODE(1980).In1996,theSECsAdvisoryCommitteeontheCapitalFormationandRegulatoryProcessesissuedareportoutliningavoluntarypilotprogramforcompanyregistration.ReportoftheAdvisoryCommitteeontheCapitalFormation and Regulatory Processes (1996), available athttp://www.sec.gov/news/studies/capform.htm.
9SecuritiesActRel.No.336499(1983)10SecuritiesActRel.No.338591(2005).
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equivalent of company registration. The advantages of company registration are
available,however,onlyforasubsetofthecompaniesthathavepreviouslymade
thetransitionfromprivatetopubliccompanystatus.Initialpublicofferings(IPOs),
the customary pathfor attainingpublic companystatus,arenot includedinshelf
registration;theycontinuetobesubjecttothetraditionalregulatoryregime,with
itsgunjumpingrestrictionsonvoluntarydisclosuresandofferspriortotheSECs
approvalofacompanysregistrationstatement.Thegunjumpingrulesareintended
toquellspeculativefervorbyforcingdisclosureintotheSECsmandatoryformat.
TheseparateenactmentoftheSecuritiesActandtheExchangeActhasalso
influenced the development of the distinction between public and private under
those two statutes. Both the Securities Act and the Exchange Act reflect a
public/privatedivide,buttheytakeverydifferentapproachestodrawingthatline.
The Securities Act draws the line between public and private in a manner that
focusesexplicitlyoninvestorprotection.ThedividinglineundertheExchangeAct,
by contrast, is a compromise, reflecting not only investor protection, but also
interestsincapitalformationandpracticaleaseofapplication.Iargueherethatthe
resultingmismatchbetween thepublic/private dividing lines under the twoActs
means that the transition fromprivate topublicwill inevitablybeawkwardand
abrupt, fraught with problems for issuers, investors, and regulators. Can we
reconcilethetwodividinglinessothatcompaniescannavigatethispassagefrom
privatetopublicmoresmoothly?
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Congress has addressed this problem, in a partial way, with its recent
adoption of the JOBS Act (short for Jumpstart Our Business Startups Act).11
Unhappy with the SECs somewhat tepid efforts to facilitate capital raising by
smallercompanies,CongressgavetheSECnewauthoritytoexemptofferingsfrom
the requirements for registered offerings. Along with that exemptive authority,
Congress authorized the SEC to adopt less demanding periodic disclosure from
companieswhoavailthemselvesofthisnewofferingexemption.Thesedisclosure
requirements would presumably only apply until a company triggered the
standardsforfullfledgedpubliccompanystatus.Thosepubliccompanystandards
arealsonewlyraisedbytheJOBSAct.TheseJOBSActreformshavethepotentialto
createalowertierofpubliccompanies,thusblurringthelinebetweenpublicand
private. These changes have been roundly criticized by advocates for investor
protection,however,asopeningthedoorwideforfraudandmanipulation. 12Those
criticismscarrysomeweight,giventheabusesthatrepeatedlyoccurinthepenny
stockmarket.
Mythesisisthatthetransitionbetweenprivateandpubliccompanystatus
couldbemadelessbumpyifweunifiedthepublic/privatedividinglineunderthe
SecuritiesActandExchangeAct.TheinsightbuildsonCohensthoughtexperiment
in which Congress enacted the Exchange Act first. My proposed private/public
standardwouldtakethecompanyregistrationmodeltoitslogicalconclusion.The
11Pub.L.No.,Stat.(2012).12AndrewAckerman,ScrapOverEasingIPORules,WALLST.J.C3(March16,2012)(Former
SecuritiesandExchangeCommissionChairmanArthurLevittcalleditthemostinvestorunfriendlybillthatIhaveexperiencedinthepasttwodecades.).
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customary path to public company status is through an IPO, typically with
simultaneous listingof the shares onan exchange. There isnothing about public
offerings, however, that makes them inherently antecedent to public company
status.What if companies becamepublic,with requiredperiodicdisclosures toa
secondarymarket,beforetheywereallowedtomakepublicofferings?
I propose a twotiermarket for both primary and secondary transactions
keyedtoinvestorsophistication.Theprivatemarketwouldbelimitedtoaccredited
investors,whilethepublicmarketwouldbeaccessibletoall.Thetransitionbetween
thetwowouldbetriggeredbyaneasilymeasuredquantitativebenchmarkmarket
capitalization or trading volume whichwould allow companies to elect public
statusafterreachingthatthreshold.Onceacompanyoptedforpublicstatus,that
newly public company would have a seasoning period, during which periodic
disclosures would be required. Only after that seasoning period would newly
minted public companies beallowed to sell shares to the public at large.Such a
regime would substantially enhance the information available to the primary
market once a public offering was made. More importantly, it would allow the
secondary market to process that information prior to any public offering. This
regulatory framework would go a long way toward promoting efficient capital
formation and eliminatingthewaste currently associatedwith IPOs. Ahappyby
productwouldbemorevigorousinvestorprotectionforunsophisticatedinvestors.
Iproceedasfollows.PartIIoutlinesthepublic/privatedividinglinesasthey
nowstandundertheSecuritiesActandtheExchangeAct.ThisPartalsoexploresthe
recenttransitionofFacebookfromprivatetopublicstatusunderthatframework,as
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wellasCongresss recent intervention inthefieldwiththeJOBSAct.PartIIIthen
explorestheproblemsofmakingthetransitionfromprivatetopublic,focusingon
IPOs and their role in capital allocation. Facebooks IPO again provides an
illustration(andcautionarytale).PartIVthensketchesanalternativetothecurrent
regulatory framework based on the twotiermarketproposalsummarizedabove.
PartVconcludes.
II. Privatev.Public
The distinction between public and private is an important triggering
mechanismunderboththeSecuritiesActandExchangeAct.Asnotedabove,thetwo
statutes differing demarcations between public and private date back to their
original enactment during the New Deal. Common to both, however, are the
significant regulatory consequences that flow from public designation.
Consequently, companies and their lawyers spend considerable energy avoiding
public status.This regulatoryarbitragehas inturninducedtheSEC tospend like
effortincurtailingthoseattemptedevasionsofpublicstatus.ThefencesthattheSEC
has erected around private companies and private offerings means thatmarkets
faceaninformational voidwhenacompanyis readytomakethe transition from
private to public. The problems created by that transition are illustrated by
FacebooksrecentIPOandthedevelopmentsthatprecededit.Thosedevelopments
helpedtriggerthetweaksthatCongressmadetotheprivate/publicdividinglinein
theJOBSAct.
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A. ThePublicTrigger1. TheSecuritiesAct
Under the Securities Act, public offerings are open to any and all comers.
Accordingly, public offerings are subject not only to extensive disclosure
requirements, but also to a byzantine array of gunjumping rules limiting
voluntary disclosure intended to curb speculative frenzies for newlyissued
securities.13Privateofferingsareexemptedfromregistrationand thegunjumping
rulesby4(a)(2)oftheSecuritiesAct.TheSupremeCourthasinterpreted4(a)(2)
inRalstonPurinaaspermittingprivateofferingsonlytoinvestorswhocanfendfor
themselves, and therefore do not need the protections afforded by registration
under the Securities Act.14Because they are limited to sophisticated investors,
privateofferingsaresubjecttoconsiderablylessonerousdisclosurerequirements
than public offerings. Private offerings are subject, however, to a number of
proceduresdesigned topreventend runs around thepublic offeringprocess, i.e.,
nominallyprivateofferingsthatarefunneledthroughintermediariestothepublicat
large:distributions.15
The SEC has provided a safe harbor for 4(a)(2) under Rule 506 of
Regulation D.16Rule 506 offerings are limited to investors with the requisite
sophisticationtoevaluatethe investment.17Thisrequirementisdilutedsomewhat,
13Those rules areaccompaniedbyanequallybyzantine array ofexemptions tomake the
whole scheme viable, if expensive. For a comprehensive summary, see Stephen J. Choi & A.C.Pritchard,SECURITIESREGULATION:CASESANDANALYSIS404451(3rded.2011).
14SECv.RalstonPurinaCo,346U.S.119(1953).15SeeUnitedStatesv.Wolfson,405F.2d779(2dCir.1968).1617C.F.R.506.17Rule506(b)(2)(ii).
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however,byRegulationDsconclusivepresumptionthataccreditedinvestors,which
includes individualswith $200,000 inannual income or $1million in assets, are
deemed to have the requisite investment sophistication.18This presumption,
although somewhat difficult to square with Ralston Purina (and reality for that
matter),encouragesmanycompaniestolimittheirofferingstoaccreditedinvestors
exclusively. The regulatory presumption is thatwealthy investors are capable of
assessing the merits of an investment on their own, without the disclosure
mandated pursuant to the Securities Act.Market demands,however, dictate that
somedisclosure,comparable to thecoremandatorydisclosurerequirements,will
beforthcoming.Queryhowaccuratethatdisclosurewillbewithoutthesanctionof
theSecuritiesActsliabilityprovisions.
2. TheExchangeActTheExchangeActalsohasapublicprivatedividingline,butitisframedvery
differently.TheExchangeActdividinglinehasbeenshapedbyitshistory.Whenthe
Securities Exchange Act was enacted in 1934, there were two types of trading
venues: stock exchanges, with the New York Stock Exchange being the most
dominant, and the overthecounter (OTC) market. At first, Congress chose to
requiredisclosureonlyfromexchangelistedcompanies.19In1936,Congressadded
companies making a public offering to the list of public companies; periodic
disclosureswould be required after the IPO.20Both of these categories could be
avoided;issuersthatdidnotlistonanexchangeanddidnotmakeapublicoffering
18RegulationD,Rule501(a)(5)&(6).19ExchangeAct12(a)&(b),15U.S.C.78l(a)&(b).20CodifiedatExchangeAct15(d),15U.S.C.78o(d).
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would not be burdened by disclosure requirements, albeit at the cost of less
liquidity and less access to capital. It was not until 1964 that Congress added
companiestradingintheOTCmarkettothelist,closingaloopholelongdislikedby
boththeSECandtheexchanges.21Eventhen,notallOTCcompanieswerebrought
within the rubric of public status; only companies with 500 or more record
shareholdersthatwerealsoabove acertainminimumassetsize (currently set at
$10million)were included.22Smaller companies, for which the opportunities for
fraud and manipulation are most prevalent, remained largely unregulated. If
anything,the500shareholderlimittendedtodisguisethesubstantialspaceleftfor
smaller companies to remain private. The 500 number tallied record ownership
rather than beneficial ownership, so if brokerdealers held the shares on the
companys record books asnominees for their customers, companies couldhave
thousandsofbeneficialownershiddenbeneatharecordshareholdernumberthat
remainedunder500.
Notably absent from these criteria for public company status under the
ExchangeActwasanyconsiderationofthecharacteroftheinvestors.Sophisticated
institutionsandsmallretailinvestorsweretreatedalikeforpurposesofthetallyto
500thattriggeredpubliccompanystatus.Issuerscouldnotavoidpubliccompany
statusbylimitingtheirinvestorbasetoaccreditedinvestors.Suchalimitationcould
beachievedthroughtheimpositionoftransferrestrictions,butitwouldnotavoid
public status if the 500shareholder limit was passed. Regardless of the
2178Stat.565.(1964),codifiedatExchangeAct12(g),15U.S.C.78l(g).22ExchangeActRule12g1.
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sophisticationofthose500investors,thecompanyhadnochoicebuttocomplywith
the periodic disclosure requirements of the Exchange Act once the number was
passed.
Why the numerical trigger? Joel Seligman suggests the number reflects a
politicalcompromise,withCongresssplittingthedifferencebetweentheregulators
andthe securitiesindustry.23Thenumericalcriterionhasa certain logic. Investor
protectionmaybemore important for larger companies because theyhavemore
investors, but capital formation for larger companies is also potentially more
significant.Biggercompanies,becauseofthewiderscopeoftheiroperations,might
have greater influence on the efficiency of capital allocation in the overall
economy.24(Of course, smaller companies might be more significant to capital
formationatthemarginbecausetheyhavegreaterpotentialforgrowth.)Whatever
themotivation,thenumericaltriggeradoptedin1964extendedtheearlierpattern
offorcingdisclosurefromcompaniespresumedtobethesubjectofactiveinvestor
interest. 25 Companies with fewer investors were excluded for reasons of
practicality, despite theSECs recommendationofabroaderreach in itsSpecial
Study of theSecuritiesMarkets.26Obviously, investorprotectionwouldhavebeen
maximizedbygivingtheSECthegreaterregulatoryreachthatitsought.Evenwhile
greatlyexpandingthescopeofregulation,however,politicianswereconcernedby
23Seligman,supranote,at315.24See, e.g., Gil Sadka, TheEconomicConsequencesofAccountingFraud inProductMarkets:
TheoryandaCasefromtheU.S.TelecommunicationsIndustry(WorldCom),8AM.L.&ECON.REV.439(2006)(demonstratingmarketdistortionscreatedbymassivefraudatWorldCom).
25Cohen,supranote,at1341.26Cohen,supranote,at1368.TheSECsrecommendationisfoundinReportoftheSpecial
StudyofSecuritiesMarketsoftheSecuritiesandExchangeCommission,H.R.Doc.95,88thCong.,1stSess.,pt.3,at6264(1963).
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thenegativeeffectsthatmightariseifsmallcompanieswereropedintotheburdens
ofpubliccompanystatus.Investorprotectionwouldhavetobebalancedagainstthe
needtofostercapitalformation.
B. FacebookFacebooks recent transition from a private company to a public one
illustratestheproblemscreatedbythedifferingprivate/publicdividinglinesunder
the two Acts. The Exchange Acts numerical trigger for public company status
recently emerged from technical obscurity as Facebook inched its way toward
becoming a public company. In late 2010, Goldman Sachs proposed selling a
significant block of Facebook shares.27The transaction drew attention because
Facebook atthat timewas aprivatecompanyandwasplanningtomaintain that
status,atleastintheshortterm.GoldmanplannedtopreserveFacebooksprivate
status by selling the companys shares to institutional and other sophisticated
investors via a trust that would bundle their interests in a single investment
vehicle.28Thebundlingwastheunusualfeatureofthetransaction,designedtokeep
thenumberofrecordFacebookinvestorsundertheExchangeActs500shareholder
filingthreshold.29Whetherthisapproachwasaviablestrategy,however,wasopen
todebate.Rule12g51(a)oftheExchangeActallowssharesheldofrecordbyalegal
entitytobecountedasoneperson.Rule12g51(b),however,stipulatesthat[i]fthe
issuerknowsorhasreasontoknowthattheformofholdingsecuritiesofrecordis
27Evan Weinberger, Goldmans Facebook Stake May Force SECs Hand Law 360 (Jan. 4,
2011).28Id.29Facebooksassetswerealreadywellinexcessof$10million.
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usedprimarilytocircumventthefilingrequirement,thebeneficialownersofsuch
securities shall be deemed to be the record owners thereof. In other words,
subsection (b) suggests that the SEC would look through the legal entity to the
actual owners, if the issuer knows that the entity is being used to avoid public
companyfiling.
Theproposedtransactionattractedconsiderablemediaattention,whichled
totheofferingseventualdemise.Thedealwaspulledbecauseofconcernsthatthe
mediaattentioncouldbedeemedtobeageneralsolicitation,whichwouldcause
theoffertobecomepublic,therebyrunningafouloftheSecuritiesActof1933.30
Goldman instead placed the shares in an offshore transaction.31Facebook has
subsequentlymadethetransitiontoapubliccompanywithitsinitialpublicoffering
asubjectIdiscussingreaterdetailbelow.32
Facebooksinteractionwiththeprivate/publicdividewasalsohighlightedin
anotherstorythatsurfacedataroundthesametime.WordleakedthattheSECwas
investigating secondary trading markets for violations relating to the resale of
securities issued byprivate companies.33Facebook was among the more notable
companies traded on one of these venues, SecondMarket. These markets cater
mainlytoemployees(bothcurrentandformer)ofprivatecompanies,butalsosome
30
Regulation D, Rule502(c) (prohibiting general solicitations in connectionwith privateplacementsunderRule506).31LizRappaport,AaronLucchetti&GeoffreyA.Fowler,GoldmanLimitsFacebookOffering,
WALLST.J.,Jan.18,2011(GoldmanSachsGroupInc.slammedthedooronU.S.clientshopingtoinvestinaprivateofferingofsharesinFacebookInc.,becauseitsaidtheintensemediaspotlightleftthedealindangerofviolatingU.S.securitieslaws).
32Seetextatinfranotes.33PeterLattman, StockTradinginPrivateCompaniesDrawsS.E.C.Scrutiny,N.Y.Times(Dec.
27,2010).
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earlyround investors. They have experienced strong growth in recent years.
AccordingtotheNewYorkTimes,In2009,SecondMarketcompleted$100million
worthoftransactionsinprivateshares.Lastyear,itsvolumewasnearlysixtimes
thatamount,withFacebooktradesmakingupthebulk.ItsrivalSharesPostlogged
$625millionintransactionslastyear,morethandoubleitstotalfrom2010. 34This
growthwasthreatenedbytheSECsinvestigation.
TheSEClaterannouncedthatithadreachedasettlementofanenforcement
action with SharesPost. The agencys complaint in that action alleged that the
trading venue had been operating as an unlicensed brokerdealer.35At the same
time, the SEC announced the filing of an enforcement action against Felix
Investments.TheSECscomplaintallegedthatFelixtooksecretcommissionsfrom
thesellersofprivateshares,inadditiontothefeespaidbypurchasers.Theagency
alsoallegedthatFelixhadmisleadinvestorsinconnectionwiththesaleofFacebook
shares.TheSharesPostenforcementactionisamereregulatoryviolation;theFelix
action,however,isareminderofthevulnerabilitytomanipulationofthinlytraded
markets.36
Despitethegrowthofprivatemarkets,thesetradingvenuesarestilldwarfed
by the trading of public company shares on registered exchanges. There are
substantial limits on the volume of trading in theseprivatemarketsascurrently
34EvelynM.Rusli&PeterLattman,LosingaGooseThatLaidtheGoldenEgg,N.Y.TIMES(Feb.2,2012).
35Evelyn M. Rusli, ChargesFiledAgainstBrokerageFirmsThatTradePrivate Shares N.Y.TIMES(March14,2012).
36FacebooksinitialregistrationstatementforitsIPOdisclosedthatithadbeencontactedbySECstaffin connectionwith itsinvestigationintoalternative tradingvenues.AlisonFrankel,Whateveryone missed in Facebooks IPO filing, ThomsonReuters News & Insight Feb. 2, 2012). Noenforcementaction,however,wasfiledagainstFacebook.
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structured.SecondMarketandsimilarvenuesdonotprovidetheliquidityafforded
byanexchange,astheylackspecialistsandmarketmakers.Instead,theyprovide
the more limited liquidity service of matching buyers and sellers in a central
(virtual) location.37These trading venues are limited toaccredited investors, and
thevenuesscreenprospectiveinvestorstoensurethattheyqualifyasaccredited. 38
These precautions are taken to help ensure that the shares are not being
distributedtothepublic,whichcouldrenderthetradingvenueanunderwriterfor
purposesoftheSecuritiesAct.39TheExchangeActsnumericalshareholderlimitfor
privatecompaniesalsoposesanobstacletofurthergrowthoftheseprivatemarkets.
Notwithstanding these limitations under current regulation, the growth of these
venues suggests clear potential for expansion, if the regulatory scheme would
accommodateit.TheSECsinvestigation,however,castsashadowoverthefutureof
privatemarkets.
C. TheJOBSActThe fallout from Goldmans failed private offering of Facebook shares
triggered a rather dramatic legislative response. Lawmakers in Congress seized
uponthesalientoccasiontoattacktheSECfortheobstaclesthatitwasplacingin
37Richard Teitelbaum, Facebook Drives SecondMarket Broking $1 Billion Private Shares,
BloombergMarketsMagazine,April27,2011availableathttp://www.bloomberg.com/news/20110427/facebookdrivessecond.
38Id.39SeeGilligan,Will&Co.v.SEC,267F.2d461(2dCir.1959)(interpreting2(a)(11)ofthe
SecuritiesAct,definitionofanunderwriter).
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thepathofcapitalformation.40TheSECrespondedintimewornfashion,promising
areviewof its regulationsto assesstheir effect ontheU.S. capitalmarkets.41The
SECs delaying tactic did not work, however, as a Republican House of
Representatives,anxioustolatchontoawedgeissuetomaketheDemocratslook
badinanelectionyear,pushedforwardwithlegislation.Thatbillwouldultimately
becometheJOBSAct.PresidentBarackObama,anxioustobeseenasprogrowth
whilefacinganeconomystillplaguedbyhighlevelsofunemployment,signedthe
JOBSActintolaw.42TheSECsoppositiontothebill43carriedlittleweightintheface
ofthoseelectoralimperatives.
1. ExchangeActReforms The JOBS Act makes it easier to remain a private company. The 500
shareholder limit for triggeringpublic companystatus under the ExchangeAct is
nowgone.TheJOBSActraisesthatnumberto500personswhoarenotaccredited
investors,orthemorecriticalnumber,2,000investorsoverall.44Excludedfromthat
number are shareholders who received the securities under an employee
40LetterfromU.S.RepresentativeDarrellIssatoMarySchapiro,Chairman,SEC(March22,
2011),availableathttp://www.knowledgemosaic.com/resourcecenter/Issa.041211.pdf.41LetterfromS.E.C.ChairmanMarySchapirotoU.S.RepresentativeDarrellIssa,Chairman,
U.S.HouseOversightCommittee,availableathttp://www.sec.gov/news/press/schapiroissaletter040611.pdf(April6,2011).
42JonathanWeisman,FinalApprovalbyHouseSendsJobsBilltoPresidentforSignature,N.Y.Times(March27,2012).
43
David Hilzenrath, Jobs
Act
could
remove
investor
protections,
SEC
chair
Mary
Schapiro
warns,WASH.POST (March 14, 2012)( Toooften, investors are the target of fraudulent schemesdisguisedasinvestmentopportunities,Schapirowrote.Asyouknow,ifthebalanceistippedtothepointwhereinvestorsarenotconfidentthatthereareappropriateprotections,investorswillloseconfidence in our markets, and capital formation will ultimately be made more difficult andexpensive.). State securities regulators also voiced their opposition. North American SecuritiesAdministratorsAssociation,TheJOBSActanInvestorProtectionDisasterWaitingtoHappen (March22,2012).
44JOBSAct501,codifiedatExchangeAct12(g)(1)(A).
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compensationplanexemptedfromregistration. 45Thislatterprovisionpromisesto
delaythepointatwhichagrowingcompanywouldbeforcedtomaketheperiodic
disclosures required of public companies. Query whether this is an important
constraintforcompaniessmallerthanFacebookthatarestrivingtomaintaintheir
privatestatus.Dataonthisquestionaresimplynotavailable.
AkeygoaloftheJOBSActwastojumpstartthemarketforIPOsbyeasingthe
burdenofpubliccompanystatusonnewlypubliccompanies.Asubstantialexpense
was eliminated for postIPO companies by exempting them from 404 of the
SarbanesOxley Act, which requires auditor assessment of a companys internal
controls.46TheJOBSActalsoreducedtheauditedfinancialstatementrequirement
forIPOstoonlytwoyears.47Theseregulatoryrelaxationslastforfiveyearsfroma
companys IPO or until the company reaches $1 billion in annual revenue,
whicheverissooner.48
2. SecuritiesActReformsThe JOBSAct also loosens the gun jumping rules. The JOBSAct authorizes
issuers to test the waters with qualified institutional buyers and accredited
investors prior to filing a registration statement.49The goal is to assess whether
there is demand for the companys shares, allowing the company to avoid the
expenseoftheregistrationprocessifinterestislacking.Inaddition,thelawfrees
45JOBSAct502,codifiedatExchangeAct12(g)(5)(A).46JOBSAct103.47JOBSAct104,codifiedatSecuritiesAct7(a)(2)(A).48JOBSAct101,codifiedatSecuritiesAct2(a)(19)andExchangeAct3(a)(80).49JOBSAct105(c),codifiedat.
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analyststoissueresearchreportsfornewissuersduringtheofferingprocess. 50The
goal of this provision is to promote demand for the companys shares. The
combinationofthesetwoprovisionssuggeststhatCongressseesthegunjumping
rulesashopelesslyoutdated.
The JOBS Act also targeted a Securities Act regulation relevant to the
Facebook affair, the SECs ban on general solicitation inprivate placements. The
JOBSActrepealsthatprohibitionoutright.51UndertheJOBSAct,themediaattention
thatGoldmansproposedofferingdrewwouldnot havejeopardized the4(a)(2)
exemption,aslongasactualsalesweremadeonlytoaccreditedinvestors.
Anotherprovision ofthe JOBSAct has the potential toblur thedistinction
betweenprivateand public inamuchmore profoundway. Congressopened the
doorforpublicofferingsbysmallercompanieswithsubstantiallyfewerrestrictions.
It did so by increasing the SECs authority to exemptofferings from registration
under 5, raising the offering limit under 3(b) tenfold from $5million to $50
million.52Thegunjumpingrulesareputasidealtogether,ascompaniesareallowed
totest thewatersprior to filing a registration statement.53Moreover, Congress
also stipulated that the securities sold be unrestricted, i.e., they could be freely
resold to retail investors.54In a somewhatunusualmove,Congressmandated the
adoption of a new exemption by the SEC pursuant to this authority (perhaps
50JOBSAct105,codifiedas.51JOBSAct201,codifiedatSecuritiesAct4(b).Congressalsoauthorizedanexemptionforcrowdfunding.JOBSAct301305,codifiedat
SecuritiesAct4(a)(6),4A,&18(b)(4);ExchangeAct3(a)(1)(h)&12(g)52JOBSAct401,codifiedatSecuritiesAct3(b)(2)(A).53JOBSAct401,codifiedatSecuritiesAct3(b)(2)(E).54JOBSAct401,codifiedatSecuritiesAct3(b)(2)(B).
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recognizing that the SEC would simply ignore it otherwise). In a concession to
investor protection, however, Congress did allow the agency to require periodic
disclosures by companies that avail themselves of this new exemption.55It also
madeofferingdisclosuressubjectto12(a)(2)liabilityundertheSecuritiesAct,but
not,conspicuously,11sstrictliabilityregime.56
3. ImplicationsforthePrivate/PublicDividingLineAtfirstglance,theJOBSActisadirectshotacrosstheSECsbow,movingthe
line between public and private markets to afford private markets considerably
morespace. For the SEC,preservationofpublicmarketspopulatedbyasizable
contingentof retailinvestors(i.e.,voters) isanexistentialtask.Theagency,after
all,wrapsitselfinthemantleoftheinvestorsadvocate,anditspoliticalsupportis
inextricably connected to its regulation of those public markets. If the public
marketsceasedtoexist,Congresswouldhavelittleinterestinfundingtheagency.
Fromanotherperspective,however,theseprovisionsoftheJOBSActarefar
fromrevolutionary.RaisingthethresholdforfilingundertheExchangeActdoesnot
challengethenotionthatthereshouldbeanumericaldividinglinebetweenpublic
andprivate;itsimplyreflectsapolicydisagreementbetweentheSECandCongress
overwherethatlineshouldbedrawn.Congressraisedthenumberofinvestorsfor
triggering public company status, but left intact the basic architecture of the
securitiesmarketsbothprimaryandsecondaryasreflectedintheSecuritiesAct
of1933andtheSecuritiesExchangeActof1934.
55JOBSAct401,codifiedatSecuritiesAct3(b)(4).56JOBSAct401,codifiedatSecuritiesAct3(b)(2)(D).
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Wheredoestheprivate/publicdividinglinestandaftertheenactmentofthe
JOBSAct?Overall, the JOBSAct givesprivate companiesmore latitude to remain
private and eases the initial cost of transitioning to public status. Under the
Exchange Act, the JOBS Act raises the threshold for triggering public company
status. For companies that choose to seek public status, the periodicdisclosures
requiredforthefirstfiveyearsshouldbelessexpensivewithouttherequirementof
auditorcertificationofinternalcontrols.FortheSecuritiesAct,theJOBSActmakes
it easier to raise capital while staying private by opening the private placement
processbypermittinggeneralsolicitations.Finally,andpotentiallythemostradical
change, the new authority conferred upontheSEC toexemptofferings upto$50
million carrieswith it the intriguing possibility that the SEC will create a junior
varsity levelofpublic companies.Atthis point, the creationofapublic company
incubationpoolisonlyapossibility,asitiseasytoseetheSECdraggingitsheelsin
implementing this exemption, and Congress has not mandated a date for its
adoption.CertainlynothingwillhappenattheSECanytimesoon.Theagencyisstill
strugglingtogetoutfromunderarulemakingbacklogcreatedbytheDoddFrank
Act. After the 2012 election, with the spotlight from Capitol Hill perhaps less
glaring,57the SEC may feel that it has a freer hand in imposing substantial
requirementsontheexemptionthatiteventuallypromulgates.Ifitdoesso,theSEC
maystrangletheJOBSActofferingexemptioninitscrib.
57SeeMaryL.Shapiro,Chair, SEC,TestimonyConcerning the "JOBS Act in ActionPart II:
OverseeingEffectiveImplementationoftheJOBSActattheSEC"(June28,2012)(announcingthatSECwouldnotmeetdeadlinesimposedinJOBSAct).
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III. MediatingthetransitionfromprivatetopublicMilton Cohens central insight was that the disclosure needs of investors
were the same inthe primaryand secondarymarkets for securities.SinceCohen
wrotehisarticleinthemid1960s,theforceofhisinsighthasbeenreinforcedbythe
widespreadacceptanceoftheefficientcapitalmarkethypothesisbybothregulators
andcourts.Cohensargumentwassimplythecommonsensenotionthatdisclosure
obligationsshouldbemadeconsistentforthetwomarkets.Theimplicationofthe
efficient capital market hypothesis, however, is that disclosure particular to
securitiesofferingsmightbelargelyredundant.Ifthemarkethastheinformation
priortotheissueofthesecurities,investorsalreadyhavethetoolsthattheyneedto
assessthevalueofthatnewissue.Moreover, retail investors can freerideonthe
effortsofinstitutionalinvestorswhenpurchasingiftheyareallparticipatinginthe
samemarket,purchasingfromthesamefungiblepoolofsecurities.Iftheefficient
capital market hypothesis captures the reality of public offerings, the pricing
decisions of the institutional investorswill determine the market price, thereby
providingsomeassurancethatretailinvestorsaregettingafairdeal.
More fundamentally, with the advent of the efficient capital market
hypothesisanditsacceptancebytheSEC,theregulatoryfocusoftheExchangeAct
has shifted. Although the ExchangeAct may have been originally about investor
protection,thedevelopmentoftheefficientcapitalmarkethypothesishaspushed
toward accurate pricing as the goal of the ExchangeAct.58Investor protection is
58Merritt B. Fox, Retaining Mandatory Securities Disclosure: Why Investor Choice is Not
InvestorEmpowerment,85VA.L.REV.1335,1415(1999).
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simply a happybyproduct of efficient pricing. Ifmarkets are fully informed, the
theory goes, riskswill be accurately priced. If the goal is accuracy, rather than
paternalism, reflecting risks in the market price is good enough. Unfortunately,
therearesubstantialreasonstodoubttheefficiencyofthemarketforIPOs.
A. IPOs:BadDealsTheshiftinthefocusoftheExchangeActtowardaccuracyhasimplications
for the transition from private to public. Faith in the power of efficient capital
markets to protect investors rests, however, on the efficiency of the underlying
market.Thecomforttobothaccuratepricingandinvestorprotectionprovidedby
theefficientcapitalmarketshypothesisfallsapartwiththeIPO.Noonebelievesthat
IPOsreflectanefficientcapitalmarket.InfacttheevidenceisfairlystrongthatIPOs
are inefficient. IPOs are bad deals. The puzzle is why they persist, despite that
inefficiency.
IPOsarebadforcompanies,badforinsiders,andbadforretailinvestors.The
onlyparties that clearlybenefit from thesedealsare the individualswho service
them:accountants,lawyers,andunderwriters.Especiallyunderwriters,whotakea
standardcommissionof7%oftheofferingintheoverwhelmingmajorityofIPOs.59
Ineconomicjargon,theseprofessionalsaretermedtransactionscosts;thetermis
notintendedasacompliment.It is,however, lesstendentiousthanbloodsucking
59HsuanChiChen&JayR.Ritter, TheSevenPercentSolution,55J.FIN.1105,1105(2000)
(findingunderwritersinvariablychargeasevenpercentcommissionforIPOsbetween$20and$80million).
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parasite,whichisthetermthatmorethanoneentrepreneurmightuse,painedby
givingawaysuchasubstantialsliceoftheirgrowingbusinesstoameresalesman.60
It is possible, however, that underwriters are being paid for more than
simply marketing the offering. Underwriters typically provide marketmaking
servicesforIPOcompaniestosupportthesecondarymarketfollowingtheIPO.This
commitment is not a contractual obligation, however, but instead, a customary
understanding. If themarketmaking is notprofitable for brokerdealers standing
alone,theunderwritersdiscountmaybe,inpart,compensationforthoseefforts.
Whyare IPOsbad for companies?Apart fromthe substantialsumspaidto
the bloodsucking parasites, IPOs suffer from the wellknown phenomenon of
underpricing. Underpricing is the tendency for the price of stocks to rise
significantlyabovetheofferingpriceonthefirstdayofsecondarymarkettrading. 61
Fromtheperspectiveoftheissuer,thegapbetweenthesecondarymarketpriceand
theofferingpricereflectsunexploitedmarketdemandforthecompanysshares.The
explanations offered for underpricing are varied, including insurance against the
risk of liability,62and compensation to institutional investors for the cost of
60Tobefairtothebloodsuckingparasites,thepriceoftheofferingmaybemuchsmallerif
thecompanyisonlysellingasmallpercentageofitssharessay10%asistypical.Thefactthatcompaniessellonlyasmallpercentage,however,onlyreinforcestheinefficiencyofIPOs.Ifthetermswerebetter,companieswouldpresumablysellagreaterpercentage.Underthecurrentregime,IPOsaregenerallyapreludetoamoresubstantialseasonedoffering.
61
JayR.Ritter&IvoWelch,A
Review
of
IPO
Activity,
Pricing,
and
Allocations,57J.Fin.1795Table1 (2002)(findingthatbetween1980and2001,IPOswereunderpricedby22%onaverage,).SeeRogerG.Ibbotson&JeffreyF.Jaffe, "HotIssue"Markets,30J.Fin.1027(1975);JayR.Ritter,The"HotIssue"Marketof1980,57J.Bus.215(1984).SeealsoJudithS.Ruud, UnderwriterPriceSupportandtheIPOUnderpricingPuzzle,34J.Fin.Econ.135(1993).
62See,e.g.,PhilipD.Drake&MichaelR.Vetsuypens,IPOUnderpricingandInsuranceAgainstLegalLiability,22Fin.Mgmt.1(1993);SehaM.Tinic,AnatomyofInitialPublicofferingsofCommonStock,43J.Fin.789(1988).ButseeJanetCooperAlexander, TheLawsuitAvoidanceTheoryofWhyInitialPublicOfferingsAreUnderpriced,41UCLAL.Rev.17(1993).
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collecting information about the issuer.63Another theory is that underpricing
encouragesinstitutionalownerstoretainthesharesatleastuntilthelockupperiod
expires,typicallysixmonthsaftertheoffering,whentheinsiderswillbefreetosell
theirshares.
Thesefactorsmayplayarole,butthereisalsotheintriguingpossibilitythat
the runup in the secondary market reflects speculative frenzy among retail
investors.Thisspeculativefrenzycouldnotbecapturedbytheissuerbecausethe
runupisdriven,atleastinpart,bytherunupitself,momentumtradingonsteroids
ifyouwill.Theroleofspeculationwouldappeartobepartofthestoryofwhybook
built offerings continue to dominate auctions as a means of selling securities.
Accordingtothisaccount,auctionshavefailedtoattractamarketfollowingbecause
theyoffernowayofexcludingthedumbmoney.64Ifretailinvestorsareallowedto
dominatethepricingofshares,institutionalinvestors,waryofthewinnerscurse,
willavoidtheoffering.Ifinstitutionalinvestorsrefusetoparticipate,theprospects
foracompleteunravelingbecomealltooreal.Underpricingissimplythebyproduct
oftheneed toexclude the undesirables fromthe initialpricingprocess.Once the
dumbmoneypilesintothesecondarymarket,allbetsareoff.
Whatever the causeofunderpricing, companies pay itasthe cost ofentry
intothepublicmarkets.IPOsarelesscapitalraisesthantheyaredebutanteballs.
63Ravi Jagannathan&Ann E. Sherman, Reforming theBookbuildingProcessfor IPOs, 17 J.
AppliedCorp.Fin.2,6(2005).64WilliamVickrey,Counterspeculation,Auctions,andCompetitiveSealedTenders,16J.FIN.8,
20 (1961) ("[Wherethere ismuchvariation in thestate of informationor thegenerally expectedintensity of desire of the various players for the object, orwhere the bidders are insufficientlysophisticated to discern the equilibriumpoint strategy ... the Dutch auction is likely to proverelativelyinefficient....").
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Newlypubliccompaniesarejostlingfortheattentionofinvestors,andabigbumpin
price on the first dayof trading, like a fabulous gown, is sure to be noticed and
attracttradingvolume.Themediatreatasharpriseintheaftermarketpriceasa
reflectionoftheofferssuccess,ignoringthemoneytheissuerhasleftonthetable
duringthebookbuildingprocess.
WhyareIPOsbadforinsiders?Primarilybecauseinsiderssuffersubstantial
dilutionoftheirinterestsinthecompanyasaresultoftheIPO,whichhelpsexplain
whyIPOsaregenerallylimitedtoasmallpercentageofthecompanysequity.For
companies with the best prospects, the information asymmetry between the
insidersandoutsideinvestors(alongwiththepotentialforfraudbyinsiders)means
thatinvestorsarelikelytosubstantiallydiscounttheamounttheyarewillingtopay
forthecompanysshares.Thatdiscountingwillbemitigated,butnoteliminated,by
mandatory and voluntary disclosures. Antifraud enforcement operates
substantiallybelow100%accuracy,sosomestretchingofthetruthwillslipthrough
unsanctioned.Moreover, complete disclosure is a practical impossibilityeven for
companiesanxioustobeforthcoming.Worseyet,disclosurewillsometimesbebad
forbusiness,asitconveysusefulinformationtoafirmscompetitors.65Giventhese
limitationsondisclosure,companieswithbelowaverageprospectswillbeableto
hidethemselvesinthepoolofallIPOfirms.TheinclusionofbadfirmsintheIPO
poolmeans that better than average firmswill suffer from discounting, a partial
65See Michael D. Guttentag,AnArgumentfor ImposingDisclosureRequirements onPublic
Companies,32FLA.ST.L.REV.132,151(2004)(notinggreaterdisclosureinprivatedealsrelativetodisclosuresmadebypubliccompanies).
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lemonseffect.66Notwithstandingthesedilutioncosts,thebenefittoinsidersisthat
theywilleventuallyenjoyaliquidmarketfortheirsharesafterthelockupexpires.
Thecostsareworthitforsome.Othersstayprivate.
Why are IPOs bad for retail investors? Despite the underpricing that
manifestsitselfinthesecondarymarketonthedaythatthecompanygoespublic,
thelongtermperformanceofIPOstockstrailstheriskadjustedreturnsavailable
fromholdingthemarketportfolio.67Giventhatthisunderperformanceisbothlong
standingandwelldocumented,whydo investorscontinueto invest in IPOs?One
answer is that they are lured into foolish purchases by crafty Wall Street
salespeople.ItisaWallStreettruismthatnewissuesaresold,notbought.68This
proposition is somewhat difficult to square with the prevalence of institutional
investors among the lucky recipients in IPO allocations.69Those institutional
investors, however, may be counting on the ability to flip the shares to retail
investors in the secondary market.70Lurking in the background here, especially
when combinedwith the underpricing phenomenon, is theworry that secondary
market pricesmay bedriven bya lotterymentality, at least in the near term. In
otherwords,theinstitutionalinvestorswhoreceiveallocationsintheIPOexpectto
makeaprofitduetotheinitialunderpricing.Theretailinvestorswhopurchasetheir66 George A. Akerlof, The Market for "Lemons": Quality Uncertainty and the Market
Mechanism,84Q.J.ECON.488(1970).67
Jonathan A. Shayne & Larry D. Soderquist, Inefficiency
in
the
Market
for
Initial
Public
Offerings, 448 VAND. L. REV. 965, 970 (1995); Terzah Ewing, BurntOfferings?StreetDebutsAreFizzlingAfterPop,WALLST.J.,Apr.26,2000,atC1.
68LouisLowenstein,ShareholderVotingRights:AResponsetoSECRule19c4andtoProfessorGilson,89Colum.L.Rev.979,998(1989).
69See Reena Aggarwal et al., InstitutionalAllocation in Initial Public Offerings: EmpiricalEvidence,57J.FIN.&QUANTITATIVEANAL.1421,1422(2002)(findingthatinstitutionalinvestorsreceiveapproximately75%oforiginalIPOsharesinanaverageoffering).
70D.Cooketal.,OnthemarketingofIPOs,82J.Fin.Econ.35.
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sharesinthesecondarymarket,however,arepronetoirrationalexuberance.Retail
investorsmaybewillingtotoleratemarketlaggingreturnsoverallinexchangefor
the possibility that one of theirpurchasesmay turn out to be the next Apple or
Microsoft.Thislotteryticketmentalityisnotlikelytoleadtoaccuratepricingofa
companysfuturecashflows.71
B. FacebookAgain
FacebookseventualIPOprovidedahighprofileexampleofhowIPOscango
badly wrong. Running contrary to the typical pattern of underpricing in IPOs,
Facebookssecondarymarketpricequicklytookasteepplunge,droppinginitsfirst
weekoftradingfromthe$38offerpricetolessthan$32.Withinacoupleofmonths,
the price had dropped to close to $20. Not surprisingly, a good deal of finger
pointingfollowed.Avarietyoffactorswereidentifiedastheculprit,withthemost
straightforward being the companys decision to issue 25% more shares than
originally contemplated.72That decision no doubt played a part in the unusually
largeallocationofsharestoretailinvestorsintheoffering. 73Thatinfluxofdumb
money gave rise to the spectre of the winners curse.74 Morgan Stanley,
71
Bill George, The LongTerm Value of Internet Companies, N.Y. Times (Aug. 3, 2012)(speculativetraderslookingforoutsizereturnscanincreasethevolatilityofcompanyvaluations.)72JoeNocera,FacebooksBrilliantDisaster,NYTimes(May25,2012).73SeeJacobBunge,AaronLucchetti&GinaChon, InvestorsPummelFacebook,WALLST.J.A1
(May 22, 2012) (Retail, or individual investors usually allocated up to 20% of the total sharesallottedinanIPO,butinFacebookscase,retailallocationwasaround25%).
74SeeLynnCowan, OversubscribedIsaWeakIPOSignal,WALLST.J.(June18,2012)(Attheheartofthe[Facebookoffering]sflopwasaverybasicproblem:Toomanysharesweresoldat toohighapricetotoomanyinvestorswhowerentcommittedtoholdingitforverylong.)
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Facebooksunderwriter,wasfaultedforitsaggressivepricingofthestock.75Nasdaq,
the exchange where Facebook listed its shares, had a technological meltdown,
causingasubstantialnumberoforderstoapparentlydisappearintotheetheronthe
firstdayoftrading.76Mostdamning,however,wastherevelationthatanalystsata
numberofbanks,includingMorganStanley,hadreviseddownwardtheirearnings
projections for Facebook, based on difficulties the company had disclosed with
makingmoneyoffofuserswhoaccessedFacebookthroughmobiledevices.Analysts
revised estimates were shared with thebanks institutional clients, but not with
retail investors.77Thoseloweredprojectionsnodoubtfueledtheinterestofthose
institutional investors in flipping their shares to retail investors as quickly as
possibleaftertheIPO.Lawsuitsquicklyfollowed, 78andCongresscalledhearingsto
examinetheIPOprocessgenerally.79
C. WhyDoIPOsPersist?
IfIPOsare suchbaddeals,whydotheypersist?Under thecurrentregime,
IPOsareapracticalnecessity,butfromtheperspectiveofefficientcapitalallocation
they have little to commend them. The common theme running through the
problems with IPOs for companies, insiders, and investors is information
75MichaelJ.DeLaMerced,EvelynM.Rusli,andSusaneCraig,AsFacebooksStockStruggles,
Fingers
Start
Pointing,NYTimes(May2,2012).176ChuckMikolajczakandJohnMcCrank, Facebooksharessink11percentasrealityovertakeshype,Reuters(May22,2012).
77EvelynM.Rusli,BenProtess,andMichaelJ.DeLaMerced,QuestionsofFairPlayAriseinFacebookI.P.O.Process,NYTimes(May23,2012).
78PeterJ.HenningandStevenM.Davidoff, TheFacebookI.P.O.sPotentialLegalExposure,NYTimes(May23,2012).
79JeanEagleshamandTelisDemos,LawmakersPushforOverhaulofIPOProcess,WallSt.J.(June21,2012).
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asymmetry.Investorsarenotfullyinformedanditiscostlytoprovidethemwith
credibleinformation.Speculationandirrationalexuberance,fueledbyWallStreet
marketingandmediaattention,greasethewheelsfordealsthatdonothavealotto
recommendthem.The raisondetreofIPOsseemstobethefactthattheyarethe
entre to the big leaguesofpublic companystatus. From the perspectiveofboth
capitalformationandinvestorprotection,IPOsareafailure.Weseesimilarlypoor
resultsforreversemergersandPIPEs,alternative(andsomewhatdimlylit)avenues
forreachingtheultimategoalofpubliccompanystatus.80Thesetransactionsshare
with the IPOs the expectation that the issued shareswill be dumped on public
investorsafteraholdingperiod,perhapsaccompaniedbyaggressivesellingefforts.
Thetransitionfromprivatetopublicseemstobearockyroad,whatevertheroute
taken.
Inthenextsection,IsketchoutanalternativetotheIPOdesignedtodeal
withtheproblemofinefficiencycreatedbyinformationasymmetry.Iarguethatmy
alternativeissuperiortotheexistingregime,bothfromtheperspectiveofefficient
capitalallocationandtheprotectionofretailinvestors.
IV. ATwoTierAlternative
The publicprivate dividing line is on shaky ground. Congress has pushed
backthepubliclinefortheExchangeActwiththeJOBSAct.FortheSecuritiesAct,
the SECs adoption of the effective equivalent of company registration for
80SeeRobertS.Thompson&DonaldC.Langevoort, RedrawingthePublicPrivateBoundaries
inEntrepreneurialCapitalRaising,CORNELLL.REV.(forthcoming,2013).
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establishedcompaniessuggestsalossoffaithinthegunjumpingrules.Atleastfor
seasonedofferingsbythelargestpublicissuers,theSECnolongerbelievesthatthe
gun jumping rulesareneeded toquell speculation. Congress isunlikelyto lead a
revival; the JOBS Act reflects a further erosion of the gunjumping rules for IPO
issuers. Congresss endorsement of testing the waters in the JOBS Act sends us
further along the road toward complete abolition of the gunjumping rules. This
trendappealstotheeconomicallyminded.Ifwehavefulldisclosure,thetechnology
todistributethatinformation,andaninformationallyefficientmarket,doweneed
thegunjumpingrulesof5?Thegunjumpingruleslingeron,inratherdilutedform
aftertheJOBSAct,onlyforIPOs.Andyetwesawinthelastsectionthatthegun
jumpingrulesleavemuchtobedesiredifthegoalisefficientcapitalformation;the
rules fall far short of achieving that goal in IPOs, incapable of overcoming the
fundamentalinefficiencyof thosemarkets.Theonlyremainingjustificationfor the
gunjumping, ifany, is investorprotection andeventhere, theempirical evidence
suggests that the rulesare ofdubious utility. The inefficiency of the IPOmarket
persistsdespitethedauntingarrayoflegalrestrictions.
This shift by Congress in the JOBS Act and the SEC with its virtual
adoptionof companyregistration raisesa number ofquestions for the dividing
line between private and public. In this section, I propose an alternative to the
current dividing line.What if all public offerings were seasoned offerings with a
priceinformedbothbyfulldisclosureandapreexistingtradingmarket?Couldwe
achieve more efficient capital formation and better investor protection
simultaneously?WouldretailinvestorsbeharmedifweeliminatedIPOs?
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Myproposal is inspiredbya simple sportinganalogy: the EnglishPremier
League.Theleaguehastwentyteams,andthethreeworstteamsattheendofeach
season are relegated to the Football League Championship, while the top three
teamsfromthatdivisionarepromoted.MyproposalisforaPremierLeaguefor
publiccompaniesandalowertierforprivatecompanies,withdistinctprimaryand
secondarymarketsforeach.
Under my proposal, companies would go up and down between the
marketsaswarranted.Thenumberofcompaniesinthepublicmarketwouldnotbe
limited, however, as teams are in the Premier League. Any company reaching a
certain quantitative bench mark say $75 million in market capitalization, a
thresholdcurrentlyusedbytheSECforshelfregistration81wouldbeeligiblefor
elevation to the public market.82Issuers would be able to choose their status;
companieswouldnotbedraggedintothetoptieragainsttheirwill.Oncetheyopted
for public status, however, companies would be obliged to satisfy the periodic
reporting obligations of the Exchange Act for as long as they remained public.
Relegationtothelowertierwouldbesubjecttoashareholdervote.Idevelopbelow
howIanticipatetheprocessmightwork.
A. TheprivatemarketIssuersbelowthequantitativebenchmarkwouldbelimitedintheiraccessto
both the primary and secondarymarkets. Their securities could be sold only to
81SecuritiesAct,Rule415.82Iusemarketcapitalizationheresimplyforeaseofexposition.Thequantitativebenchmark
mightalternativelybebasedontradingvolume.SeeLangevoort&Thompson,supranote.
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accreditedinvestors,pursuanttothestandardsunderRegulationDor4(a)(2).In
contrast to current practice,however, those securities couldnot be freely resold
after aminimumholding period.83Instead, the issuer would be required to limit
transfer of those shares to accredited investors prior to becoming a public
company.84Among accredited investors, however, the securities could be resold
withoutjeopardizingtheissuersexemption.
I anticipate organized markets for private trading along the lines of
SecondMarket and SharesPost; the advent of these markets makes my proposal
feasible. The proposal here takes advantage of those developments, but it also
works off the success of the Rule 144A market, which is currently limited to
QualifiedInstitutionalBuyers (QIBs): institutional investorswithmore than$100
millionundermanagement.Theproposalherewould extend that existingmarket
forQIBs,byincludingaccreditedinvestors.TheQIBmarketisestimatedbyindustry
sourcestohaveover14,000participants;thenumberofaccreditedinvestorssurely
dwarfsthatbyseveralordersofmagnitude.ThesuccessofthatQIBmarketsuggests
that the privatemarket proposed here would have enough liquidity to function
effectively.
These privatemarketswould need the issuers consent for the trading of
their shares, a form of quasilisting. The private trading market would be
responsible forscreeningprospective investorstoensure that theymettheSECs
83Thatperiodiscurrentlyoneyearfornonpubliccompanies.SecuritiesAct,Rule144.84See Choi, supra note 7, at 608 (a true company registration system would similarly
restrict the trading of securities of lightly followed companies with little public informationregardlessofthepaththesecuritiestotooktomarket.).
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criteria for accredited investors. Only certified accredited investors would be
allowedtoparticipate.Thiscategoryincludesmutualfunds,soretailinvestorscould
accessexposuretothisprivatemarket.Theycoulddoso,however,onlythrougha
diversifiedvehicleadministeredbyaninvestmentmanager,whowouldbesubject
totheusualarrayofregulations.
Thequestionofdisclosureinthismarketposesachallengingissue.Itwould
defeatthemarketspurposetorequirethedisclosureexpectedofapubliccompany.
Ontheotherhand,somestandardizationofdisclosurepracticeswouldlikelybenefit
both investors and issuers. And the size of todays private offerings raises the
possibilityofacollectiveactionproblemforinvestorsmakingitdifficultforthemto
negotiate for contractual representations and warranties. 85 There are some
fundamentalshardto imaginedoingwithout,suchasauditedfinancialstatements.
Beyond that baseline, however, are a range of difficult questions regarding
materiality.
One possibilitywould be to allow privatemarkets to establish disclosure
requirements pursuant to their listing agreements, with those listing agreements
subjecttoSECapproval.86Suchanarrangementwouldallowforsomeflexibilityand
responsiveness tomarket forces, while still ensuring that disclosure did not fall
85SeeLangevoort&Thompson.supranoteat31(ifwehavedoubtsaboutcollectiveaction
asthenumberofinvestorsgrowsevenassumingwealthorsophisticationthecaseformandatoryperiodicdisclosurestrengthens.Inthefaceofdispersion,bothshareholdersandpotentialinvestorshavetogleaninformationontheirowntocompensateforanylackofvoluntarydisclosure,whichproducesinefficientduplicationofeffort.).
86MaryKissel,SoWhoNeedsWallStreet,WALLST.J.A13(Oct.2930,2011)(SecondMarketrequirescompaniestoprovideauditedfinancialsandriskfactorstopotentialinvestors.Thatsnotrequired under the SEC rules, [SecondMarkets CEO] says. We dont want to see fraudulentcompaniesonSecondMarket.Wedontwanttoseepeople,youknow,makinginvestmentdecisionswithoutbeingwellinformed.Thatsbadforusasamarketplace.).
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below some desired minimum. The SEC could perhaps implement regulatory
oversight through an exemption for the trading venues from exchange status by
imposingconditionsontheexemption.Alternatively,theSECcouldrelyonitsnew
3(b)exemptionauthority.TheSECcouldimposeperiodicdisclosurerequirements
on companies relying on the 3(b) exemption to sell shares to retail investors.
Companiesthatlimitedtheirsalestoaccreditedinvestorsandrestrictedthetransfer
of those shares only tootheraccredited investors couldbeexempted from those
disclosurerequirements.
B. ThepublicmarketElevationtothepublicmarketwouldbevoluntaryinmyscheme.Issuersthat
werenotpreparedtohandletheburdenofpubliccompanyobligationscouldlimit
thetransferoftheirsharestotheprivatemarket,whichwouldbeaccessibleonlyby
accreditedinvestors. Ifa companyfeltthat itcould satisfy its capitalneedsin the
privatemarketitwouldbefreetoremainthere.
Companies would graduate to the public market based on market
capitalizationortradingvolumeforcommonequity.Thesecriteriaaresimilartothe
Exchange Acts proxies for active investor interest, but they are more readily
measuredandlessvulnerabletomanipulation.Onceacompanyelectedtobecome
public,itwouldinitiatetheprocessoftransitioningto tradinginthepublicmarket
by first filing a Form 10K. A seasoning period would follow, with the filing of
requisite10Qsduringwhichtheshareswouldcontinuetobetradedintheprivate
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market.87Thepricesintheprivatemarket,however,wouldnowbeinformedbyfull
SECmandateddisclosure.Aftertheseasoningperiod,accreditedinvestorswouldbe
abletoselltheirsharesinthepublicmarket.Thisopportunitywouldbeavailable
whethertheaccreditedinvestorhadpurchasedtheirsharesfromthecompanyor
fromotheraccreditedinvestorsintheprivatetradingmarket.Thatpublicmarket
couldbeanexchange,ifthecompanychosetolist,ortheoverthecountermarket.
Eitherway,thetradingpriceinthepublicmarketwouldbeinformedbytheprior
trading in the private market, as well as the new information released in the
companys10Kand10Qs.
The private market seasoning period before public trading would be
permitted raises some difficult questions. It would not be practicable to limit
companiesfromanysalesduringtheseasoningperiod;capitalneedsdonotgoaway
simplybecausethecompanyismakingthetransitiontopublicstatus.Indeed,the
needforcapitalispresumablypushingthecompanytobeartheburdensofpublic
status.Thiscreates thepossibility thatcompanies coulduse investment banksor
otherintermediaries,suchashedgefunds,asconduitsduringtheseasoningperiod.
Theviabilityofthisstrategyislimited,however,bythefactthattheintermediaries
couldonlysellthesharestootheraccreditedinvestorsduringtheseasoningperiod.
Thus, the risks of an unregistered distribution to retail investors are low.
Moreover, unless the company has very pressing capital needs, it is unlikely to
toleratemuchofaliquiditydiscountforitsshares,whichitwillbeabletofreelysell
87Cf. SEC Release 3465708, Nov. 8, 2011 (approving Nasdaq rule change requiring a
seasoningperiodofayearfollowingareversemergerbeforecompanycanbelisted.)
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after the seasoning period expires. It might, however, be necessary to impose
volumelimitsonsellersinthepublicmarketsduringatransitionperiodtoallowthe
tradingmarkettodevelop.Aquickdumpofsharesimmediatelyaftertheseasoning
periodexpiredhasthepotentialtoreproducetheinefficientpricingandirrational
speculationthattaintsthemarketforIPOs.
Onlyafterthecompanygraduatedtohavingitssharestradedinthepublic
marketwould the companybe free to sell equity topublic investors.What form
shouldsalesofpublicequitybytheissuertake?Thelogicoftheproposal,withits
preference for the superior informational efficiency of tradingmarkets, suggests
that issuers selling equity should be limited to atthemarket (ATM) offerings.
Issuerswouldselldirectlyintothepublictradingmarketinsteadofrelyingonan
underwritertoidentify(create?)demand.Thisapproachputsitsfaithinmarkets,
ratherthansalesmen,forefficientpricing.Unfortunately,thisstrategyhasitslimits.
ATMofferingsarearapidlygrowingportionofseasonedequityofferings,88butthey
arestilldwarfedbytraditionalbookbuiltofferings.Particularlyforlargerofferings,
theliquidityofthesecondarytradingmarketmaybeinsufficienttoabsorbsucha
largenumberofshareswithoutsubstantiallydilutingexistingshareholders.Tobe
sure,bookbuiltofferingswouldbesubstantiallyconstrainedbytheexistenceofa
market price. Couldwenudge issuers toward ATM offerings, withoutmandating
them?
88JamesD.SmallIII,W.ClaytonJohnson,&LeslieSilverman,TheresurgenceofUntiedStates
atthemarketequityofferingstoraisecapitalinvolatileequitymarkets,4CapitalMarketsL. J.290,292(2009)(FromJune2008throughtheendofApril2009,morethan25issuersregisteredwiththeSECalmost$6.9billionofequitysecuritiesforsalesunderequitydistributionprogrammes(ofwhichmorethan$3.2billionwassubsequentlysoldtoinvestors).)
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Onepossibilitywouldbetoeliminate11and12(a)(2)liabilityforatthe
market offerings, while retaining it for underwritten offerings. At aminimum, it
makes little sense to imposeunderwriter liability on the brokerdealershiredby
issuerstomanageATMofferings.Iflargevolumesneedtobesold,notbought,the
opportunities for abuse come in the sellingprocess. SEC and FINRAenforcement
wouldbeneededtoensurethattherewerenobackdoorsellingeffortstoprimethe
marketforanATMoffering.Evenfortheissuer,thedraconianthreatof11sstrict
liabilityseemsexcessiveforanATMoffering.ATMofferingsifgenuinelysoldinto
a preexisting market without stimulation do not really require a registration
statement ora prospectus; atmost they need an8K announcing the number of
sharestobeoffered,followedbyanother8Kdisclosingthenumberactuallysold.
AntifraudconcernscouldbeaddressedbythelessdraconianRule10b5.
C. RelegationIf there are private companies wanting to rise to the public level in my
scheme, it follows that there are likely to be public companies attracted to the
reducedburdensofprivatestatus.Animportantbenefitofatwotiermarketisthat
retailinvestorswouldnotbecompletelycutofffromliquidityifacompanychooses
to relegate itself to the private market. There is no reason to preclude retail
investors from selling their shares in the privatemarket, even if they would be
barred from purchasing shares in companies that dropped down to private
company status. Moreover, there is little to be gained by prohibiting companies
from exiting the public pool; a restrictive approach will simply discourage
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companies from pursuing public company status in the first place. On the other
hand,too lenientan approachmayput toomuchstressonthe fiduciaryduties of
directorsunderstatelawtopreventabuses.Arethereproceduresavailablethatcan
limittheopportunitiesforabuse?
I propose a shareholder vote be required before a company would be
permittedtodropfrompublictoprivatestatus. 89Avote,withtheusualdisclosures
requiredbythefederalproxyrules,wouldbeausefulcheckonprivatetopublicto
privatemanipulation schemes. Itwouldnot trap companies,however, that have
struggled after going public. The company would have to make its case to its
shareholdersthatthebenefitsofpubliccompanystatuswerenolongerworththe
candle. Who shouldbe eligible to participate in the voting? It seems prudent to
exclude the votes of insiders and controlling shareholders, but should we also
sterilize the votes of institutional investors? My instinct is that this additional
restrictionwouldnotbenecessary.Thelossofliquidityattendanttorelegationto
the private market affects noncontrolling institutional investors and retail
investorsinthesameway;theirinterestsarealigned.Givingthevetothreattotoo
narrowagroupraisesthepossibilityofholdup.
D. ObjectionsWontanexpandedprivatemarketopenthedoortofraudandmanipulation?
Theshortansweristhataslongaspeopleareinfectedbytheloveofmoney,fraud
89See Jesse M. Fried, FirmsGoneDark, 76 U.CHI. L.REV. 135 (2009) (advocating that a
shareholdervoteberequiredbeforeafirmcouldceaseperiodicdisclosures).
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will always be with us. Given that sad fact of human nature, we should funnel
transactionstothevenuesthatmakeitmostdifficulttogetawaywithfraud.Tobe
sure,theprivatemarketproposedhereislikelytohaveahigherincidenceoffraud
and manipulation than the public market. But the scope of that fraud will
necessarilybe limitedbythe smaller size ofthe privatemarkets relativeto their
public counterparts. Moreover, the entities sponsoring trading in those private
markets will have competitive incentives to take cost effective measures to
discourage fraud.90And the SEC and FINRA enforcement would be available to
counterthemostegregiousabuses.
The potential for abuse in the private market has to be weighed against
reductions in fraud elsewhere. In particular, my seasoning period requirement
substantiallyreducestheopportunitiesforfraudbycompaniesenteringthepublic
market.Onbalance,theoverallincidenceoffraudmaywellbereduced.Andretail
investors,whoareleastabletobearit,willalmostcertainlybeexposedtolessfraud.
Atthesametime,capitalformationefficientallocationofcapitaltocostjustified
projectswillbeenhanced.
Another potential objection is that liquidity will suffer if the role of
underwritersisdiminished.Oneoftheservicesprovidedbyunderwritersismarket
makingimmediatelyaftertheoffering.Myproposalanticipatesthemarketcoming
into existence prior to the public offering.Will brokerdealers step in toprovide
liquidityintheabsenceofunderwriters?Ifmarketmakingisprofitableonitsown,
90See A.C. Pritchard, Markets as Monitors: A Proposal To Replace Class Actions with
ExchangesasSecuritiesFraudMonitors,85VA.L.REV.925(1999)
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theanswerisobviouslyyes.Butifmarketmakingisnotprofitablestandingalone
forsmallerissuers,thereisnoreasonthatithastobebundledwithunderwriting.If
some issuers need to subsidize initial trading in their shares, this can be
accomplishedoutsideofanunderwritingrelationshipthroughadirectpayment.
Finally, objectors to my proposal should be careful to avoid the nirvana
fallacy. The alternative to my twotier proposal is not the tight regulation of
registeredofferings thatwesaw formuchoftheSecuritiesActshistory, it isthe
publiccompanylitestatusofofferingsexemptedunderthenew3(b)oftheJOBS
Act.Isthatpubliccompanyincubatorpoolreallysuperiorfromtheperspectiveof
investorprotection?
V. Conclusion
What ifwe just focused oncapital formation indrawing the line between
privateandpublicmarkets?Afocusoncapitalformationsuggeststhatweshould
putanendtoIPOs,ifwecanestablishaviablealternative.Inmyview,restrictions
onprivatemarketshavehinderedthatviablealternativefromemerging.TheJOBS
Actsincreaseto2,000shareholdersforapubliccompanystatusisabigsteptoward
a greater role for private markets. My proposed alternative to the current IPO
regime would bring the company registration initiative to its logical conclusion.
Private companies would be required to go through a seasoning period with
mandatorydisclosurebeforesellingsecuritiestothepublic.Thisseasoningperiod
wouldmarkthelinebetweenprivateandpublic,ratherthanthecurrentstandards
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ofexchangelisting,numberofshareholders,orthefilingofaregistrationstatement
foraninitialpublicoffering.
Thefoundationofmyproposalrestsontwocentralpremises:(1)IPOsarean
inefficient means of capital formation; and (2) private markets, with pools of
liquiditythatarecontinuingtoexpand,willbesufficienttosatisfythecapitalneeds
ofgrowingcompaniesuntiltheyarereadyfortheburdens thatcomewithpublic
companystatus.Theevidenceforthefirstpropositionisconsistentandstrong.The
secondpropositionblazesapathintostillunchartedterritory.TheRule144AQIB
marketandtheriseofprivatemarketslikeSecondMarketandSharesPostshowthe
potential ofprivate tradingmarkets.Until the passage of the JOBSAct, however,
thosemarketshavebeenhamstrungbythe500shareholderlimittriggeringpublic
company status. Raising that limit to 2000 shareholders of record, promises to
substantially increase the liquidity ofprivatemarkets.More timewill beneeded,
however,beforewecanassesswhetherthisexpansionoftheprivatemarketsgains
marketacceptance.
ThebottomlineisthatwiththepassageoftheJOBSAct,changeiscomingto
thedemarcationbetweenprivateandpublicstatusunderthesecuritieslaws.The
looming question is whether the SEC will attempt to obstruct this change, or
embraceitinanefforttopromotegreatercapitalformation.Myproposalaffordsthe
SEC an opportunity to promote capital formation while also enhancing investor
protection. The twotier private/public market scheme outlined here would
completethecompanyregistrationmodelputforwardbyMiltonCohennearlyahalf
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centuryago.Weshouldharnessprivatemarketstopromotethepublicgood.Private
marketsmayfinallyallowustoabolishinitialpublicofferings.
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