SEC Not Going To Let Bankers And Research Analysts Nod Hello To Each Other In The Hallway Just Because Congress Told It To

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The SEC had a feisty week last week, telling off Congress with cheery abandon. Darrell Issa sent them a pretty crazy letter a few months back demanding that all IPOs be Dutch auctions for some reason, and last week Mary Schapiro sent him a deeply researched 32-page letter telling him, with appropriate condescension, that that wasn't happening. Also a few months back Congress passed a JOBS Act demanding that the SEC allow much more fraud in connection with sub-$1bn-company IPOs, in particular by occasionally allowing bankers and analysts to be in the same room with each other, and last Wednesday the SEC released a Q&A saying that that wasn't happening either.*

There is much to ponder but let's talk about the overall tone, which is:

  • the SEC wants to make sure you don't get bad information, but
  • it's not so concerned with you getting good information, or at least, not all the information you might want, or at least, not all the information that somebody richer and better-looking than you might get.

So there is a lot of protection against research analysts shading their analysis to win IPO business, and a lot of discussion in the letter to Issa about the danger to investors of getting incomplete information if they are given anything other than the 200-page chock-full-o-risk-factors prospectus for an IPO. But there is not much discussion of the fact that some people get more information - in particular, the fact that in the Facebook IPO the company seems to have told the banks' analysts to revise their estimates downwards, and the analysts seem to have done so and then told their biggest customers (and nobody else), and then those big customers seem to have piled out of the deal leaving it to retail investors who didn't know any better.

Since Facebook inspired Issa's letter this is kind of a weird omission. While the SEC is not so into Issa's idea of requiring every company to use a Dutch auction in its IPO because that's a "market price,"** it is open to allowing somewhat freer communication by companies in the IPO process, and is supposedly going to "review the 'quiet period' rules barring remarks about a firm's prospects around the time of a share sale."

But Schapiro also points out that companies are allowed to include projections in their prospectus right now, and even get a safe harbor from liability so long as those projections are in good faith and reasonable, and yet for some reason they basically never do. That reason is of course lawsuits, and lots of them, and I suspect it would keep CEOs from going on CNBC to puff their IPOs just as it currently keeps them from puffing them in the prospectus. You could maybe get a CEO to talk publicly about his company's prospects during an IPO, but it would either be (1) heavily lawyered and probably not say anything useful or (2) ill-advised and probably a huge fraud.

Similarly research analysts are allowed to say whatever they want, and even be wrong, as long as they're not fraudulent. Now, under the JOBS Act, they're even allowed to do so at or before the time of the IPO. And yet they don't - in part because they're worried about looking fraudulent, and in part because, well, from Schapiro's letter:

Another factor that has been indicated as impacting the dissemination of research reports is the proprietary nature of the analysis. Although the Commission has acknowledged the value of research to investors, the securities laws do not require broker-dealers to make their research reports, or related estimates regarding an issuer's future results, publicly available. Additionally, FINRA rule interpretations permit its members to provide different research products and services to different classes of customers. These classes can be based on different factors, including portfolio size and fees paid to the broker.

Right! They don't tell everyone what they think because, in their imagination, people are paying them to hear what they think.*** And therefore the only people who get to hear what they think are people who pay, and the more they pay the more thinking they get to hear. And when what they think is "I should tell my customers that Facebook is revising its estimates," well, the customers, or at least a few of them, get to hear that.

If you were Issa, you be kind of annoyed by this? But what can you do? Nobody - except, y'know, frauds - is going to want to issue projections widely unless they are immune from lawsuits if those projections turn out wrong, and you can't really make companies totally immune from liability for wrong projections because then all projections will be wrong. And you can't, like, require companies to issue projections, just like you can't require IPO underwriters to publish pre-deal research broadly to anyone who might invest in an IPO. (Can you? Why not? Is that a good idea? Probably not right?)

Still, that's probably fine. Back in ye (very) olden days, anyone could IPO with no information at all; all you had to do was get a broker - or, failing that, yourself - to say "THIS COMPANY WILL MAKE A ZILLION DOLLARS" and you're good to go. Now you need audited financials and management discussion and other factual and historical data, which makes it much harder - though not impossible - to go public based only on your own deep but misguided confidence in your future. Facebook - an IPO where selectively disclosed company/underwriter projections seem to have really mattered - is an exception; mostly investors actually care about factual information and can easily get it. If the problem in the IPO market is that companies with no past can't adequately express the depths of their optimism for the future, well, that may not actually be a problem.

Regulators Rethink Pre-IPO Chatter [WSJ & pdf letter]
Jumpstart Our Business Startups Act - Frequently Asked Questions About Research Analysts and Underwriters [SEC]

* For instance, the JOBS Act allowed analysts to go to pitch meetings to try to drum up business, presumably so that the banker could point to the analyst and say "ooh look here is a smart analyst who likes your sector and will pick up coverage if we get the deal." The SEC's Q&A, on the other hand, (1) made clear that under the Global Research Settlement, analysts at settlement banks (basically the 12 biggest ones) still can't go to pitch meetings and (2) made that attendance kind of a non-event even for non-settlement banks:

Prior to enactment of Section 105(b), SRO rules prohibited analysts of non-Global Settlement firms from attending meetings with issuer management that are also attended by investment banking personnel in connection with an IPO, including pitch meetings. Pursuant to Section 105(b), analysts may now attend such meetings, provided that the issuer qualifies as an emerging growth company. Section 105(b) does not, however, permit analysts to engage in otherwise prohibited conduct in such meetings. Section 105(b) does not, for example, affect SRO rules that otherwise prohibit an analyst from engaging in efforts to solicit investment banking business.

So if the banker says "we have a smart analyst who likes your sector sitting right here" and the analyst nods, is that a prohibited solicitation? I dunno. Analysts are, however, allowed to "introduce themselves, outline their research program and the types of factors that the analyst would consider in his or her analysis of a company, and ask follow-up questions to better understand a factual statement made by the emerging growth company’s management."

** Which Schapiro handles deftly, noting that a committee reviewed the IPO underwriting process and "concluded that 'the market, and not regulators, should determine whether book-building, a Dutch auction or another method is desirable for a particular IPO.'" Exactly: if you like markets so much, Issa, trust them when they opt for bookbuilding.

*** [Ponders own life.]

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