By HAL S. SCOTT
Originally published by The Financial Times on May 10, 2017
Over the past 10 years the number of initial public offerings in the US, and the total amount of equity raised by them, are way down on historical averages. If these had held there would have been more than 3,000 new public companies in the past decade. Instead, we have had fewer than half the number of IPOs.
Against that, private companies in the US, including the likes of Lyft and SpaceX, are raising a record amount of equity capital in private markets. Private companies raised almost $120bn through private offerings in 2016, according to the Committee on Capital Markets Regulation, a policy group. Last year US IPOs raised $24bn in equity, compared with a historical average of nearly $60bn.
This is a problem, as going public enables private companies to grow and create jobs. And since retail investors can only invest in public companies, they need companies such as Uber and Airbnb to go public. A strong IPO market is in the interests of workers and investors.
US companies are staying private because this enables them to avoid burdensome regulatory requirements that apply to public companies, including governance and disclosure requirements, and less exposure to securities class actions.
Addressing this situation and restarting the US’s stalled IPO markets is a priority for Jay Clayton, the new chair of the Securities and Exchange Commission. There are lots of things that need fixing, but two stand out: litigation risk and excessively stringent disclosure regimes.
Today, when private companies go public they become exposed to litigation risk from securities class actions that can cost billions of dollars. The US is the only developed country where shareholders of a public company can form a class and sue it for a violation of securities laws, primarily consisting of disclosure failures.
In 2016 roughly one in every 10 US public companies was the target of a filing. The mere filing of such a suit has been shown to reduce a target company’s market value by 10 per cent. And the settlements of these suits have cost public companies an additional $55.6bn over the past 10 years.
Securities class actions also do not deter wrongdoing, since the defendants are companies and their shareholders, not the individual wrongdoers. The only real winners are the lawyers who get a big slice of any settlement values.
Fortunately, there is an easy way for Mr Clayton to solve this problem. He should allow US shareholders the choice of enacting bylaws that would replace securities class actions with non-class mandatory arbitration.
Fixing the securities class actions problem will not by itself be enough. The SEC’s disclosure regime for IPOs and public companies requires excessive corporate disclosures that encourage investors to put short-term performance ahead of long-term growth. This may not suit young private companies that often prioritise future growth at the expense of short-term returns — something that private funders are willing to support Other countries, notably China, have less stringent disclosure regimes, and much more buoyant IPO markets.
Mr Clayton should convene a working group of private companies and their private funders to recommend a disclosure regime that would better suit young companies.
Ultimately, only private companies and their investors know exactly why they are avoiding public markets. At his confirmation hearing in March Mr Clayton was right to note that the state of the US IPO market is unacceptable. He must adopt an aggressive approach to fixing it. If he does not the US will be the poorer for it.
The writer is director of the committee on capital markets regulation and professor of international finance systems at Harvard University.