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As IPO market dries up, panel urges change in class action rules

April 23, 2017

The status of “public company” is expensive. Between forfeiture of sovereignty, vulnerability to class actions and millions of dollars in fees to ensure regulatory compliance, the whole package is increasingly unbecoming.

And the Committee on Capital Markets Regulation worries the lacking appeal may have significant economic impact.

Shrinking Public Markets

Last year recorded the lowest IPO equity capital in a decade. The $24 billion raised by 111 IPOs in 2016 barely registered beside the nearly $100 billion raised by 290 IPOs in 2014.

Not only that, but the continued trend of delisting lengthened a steady, 20-year decline in market population. Today’s cohort is slimmer than that of the early 1980s, which leaves investors with limited opportunity to diversify portfolios.

The Rise Of The Private Market

Meanwhile, as the public markets contract, the private markets are expanding, with the number of billion-dollar startups nearly tripling between 2013 and 2016. Concurrently, investors are shifting funds to the startup scene. Private Reg D offerings raised more than 4.5 times the amount accrued among IPOs in 2016 to sustain a nearly decade-long trend of private equity capital outpacing public capital.

Slim pickings in the public market may have something to do with it.

“There are fewer public companies out there, and they’re decreasing, so where are investors going to go?” Hal Scott, CCMR director and Harvard University law professor, told Benzinga. “They’re going to go to the part of the market that’s expanding and where there are increased opportunities for investment, which is the private market.”

He added that the cost burden of public companies also limits returns, which may deter investors.

Effects Of Privatization

Ultimately, the effect of a weak IPO market is stunted economic growth.

“If you look at the source of economic growth in this country, it’s largely because startups and the success of these startups,” Scott said, looking at the likes of Alphabet Inc GOOG 0.18% GOOGL 0.13% and Amazon.com, Inc. AMZN 0.39%.

Small businesses, bolstered by venture capital, can grow into corporations with significant economic influence, and he said this process of maturation is the true source of long-term economic growth in the United States. But startups without venture capital don’t make it very far, and the promise of an eventual IPO is what attracts those seeds.

“A very important element in the ability of these startups to attract venture capital is that the people investing in these companies see a payoff in the future from their investments, and that payoff has traditionally been an exit into the public market where they get a high multiple on what they originally invested,” Scott said. “So, when you take that possibility away, the natural impact of that is to reduce the incentives to invest and venture, and that all has a negative drag on economic growth.”

Consequences also manifest in the American household, where retail investors suffer a financial disadvantage.

“One problem with an increasingly private market is that U.S. retail investors do not have an effective way to directly invest in these young and exciting companies, including Uber and Airbnb,” John Gulliver, CCMR executive director of research, said in a press release.

Legal And Regulatory Changes

The CCMR said amending class action regulation to limit the legal risks of public companies may reverse the trends and heighten the appeal of going public. Scott said the rate of securities class actions is rising toward a rate similar but “not quite as bad” as the pre-Sarbanes-Oxley years, and private companies are wary of suffering both financial and reputational damage from these lawsuits.

The legal concerns not only disincentivize domestic companies from listing on U.S. exchanges but foreign companies, as well. The factor has prompted the rapid expansion of more loosely regulated international markets, such as that of China.

“I can tell you one big difference — there’s no securities class actions any place else in the world,” Scott said. “That’s a huge difference. I think also if you looked at the rest of the world you would find much less granularity about disclosure requirements. You would probably find in general that the pressure on short-term performance is probably somewhat less on other public markets around the world. But I think that the securities class action is a total difference and it probably plays a major role in those public markets being more dynamic than ours.”

Regulatory changes could then prove a major game-changer for U.S. markets and the greater economy. The committee specifically recommended that the U.S. Securities and Exchange Commission allow shareholders to decide on a company-by-company basis whether to permit securities class actions.

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