We Don’t Need No Stinkin’ Stockbrokers (Apologies to John Huston and Mel Brooks) [Guest Post]
Guest Post By Irwin Stein, Esq.
We Don’t Need No Stinkin’ Stockbrokers (Apologies to John Huston and Mel Brooks) [Guest Post]
It has been 20 years since the SEC first permitted companies to issue stock in an IPO directly to investors over the internet. The process was originally thought to have great potential because it would eliminate the investment banking and underwriting fees that were charged by the Wall Street firms and permit all investors to participate in these juicy IPOs.
When this idea first percolated in the late 1990s all IPOs were very much sought after because most of the companies were leveraging the “new world” of the internet. Conducting the IPOs over the internet was a logical thought at the time. Besides, the small investors would just line up so people began to question why we needed brokers to sell these offerings in the first place. About half dozen companies issued shares this way in the late 1990s with mixed success.
The idea was resurrected with the JOBS Act which amended the existing Regulation A to permit offerings of up to $50 million. The thinking was very much the same. These offerings were too small to attract the large wire houses and would provide capital to growing businesses that might not have access to Wall Street.
Some people thought that the new Reg. A + would leave Wall Street behind and usher in a new era where small companies could raise money and then list on the NASDAQ or NYSE. A few companies have done so, but overall Reg. A+ has been an abject failure.
The failure of Reg. A+ can easily be attributed to the fact that the people who are facilitating the offerings do not know what they are doing. They are busy “disrupting” Wall Street but at the same time have no clear understanding of what a Wall Street firm does when it underwrites a new issue.
Due Diligence
The very first offering that was registered and sold under Reg. A+, Elio Motors, was essentially a scam. Elio claimed it would make and market a 3-wheeled electric vehicle. It raised $16 million from thousands of unsuspecting small investors claiming it would get about $200 million more from a US government loan program for which Elio never qualified.
No self-respecting due diligence investigator at any Wall Street firm would have allowed Elio to claim that it was going to get that government loan. The crowdfunding platform that hyped Elio to those thousands of investors apparently did not spend a dime on any due diligence.
The idea that a small investor could read the small print of a government loan program, or that they would know that they should read the small print, is a central fallacy that proponents of Reg. A+ refuse to acknowledge. Due diligence can be an expensive process. Small investors have never been able to do it on their own.
Elio Motors was followed by a second Reg. A+ offering, Med-X, that the SEC halted mid-offering for using dated financial information. Again this is because the crowdfunding platform that hosted the offering had no due diligence officer. Any large Wall Street firm would have stopped the offering the day after the information became dated without waiting for the SEC to intervene.
Removing due diligence investigations from the underwriting process creates what is essentially a caveat emptor marketplace. That was never the intention of the JOBS Act and could never be an efficient way to raise capital. Investors might be willing to invest a small amount of money in a small company knowing that many small companies will fail. They are less likely to do so if they come to believe that most of the companies using Reg. A+ are scams.
Skin in The Game
When a Wall Street firm underwrites a new issue it does a lot more than just due diligence. The brokerage firm has skin in the game. It is making the offer to buy the shares to its existing customers who have a relationship with the stockbrokers the firm employs. Screw the customers with a bad offering or two and the customers and brokers will head for the door.
The fact that stockbrokers who sell new issues have a personal relationship with their customers is good for the issuers as well. In addition to telling their customers when to buy a new issue, they also tell their customers when to sell it. That has a positive effect on the price of the shares as they trade in the aftermarket.
The shares of virtually all of the companies that issued shares under Reg. A+ in the last year are today trading below the price at which they were first offered. That means virtually every investor in a Reg. A+ stock has lost money, in spite of the fact that we are still in the midst of a raging bull market.
The reason for this is that while the company and the platform drummed up interest in the company during the offering, they stopped in their tracks the moment the offering was completed. Where most Wall Street underwriters will become market makers of the shares they underwrite and follow the companies with research reports, the crowdfunding platforms that host Reg. A+ offerings do neither.
Where a stockbroker who sold the issue to customers might tell them to hold on for a while as the company uses the funds it acquired to grow, platforms are busy hyping their next offering. They are not concerned that the small, often new investors who are attracted to Reg. A+ offerings will sell what they acquired last month to buy what is being offered this month. Underwritings and aftermarket trading are managed by Wall Street firms. The crowdfunding platforms manage nothing.
A company that structures, packages and sells its own Reg. A+ offering on a crowdfunding platform without the help of an experienced underwriter is going slant the offering in favor of the company not strike a balance between what the company needs and what investors want. The hit or miss methodology of crowdfunding Reg. A+ offerings is a giant step backward for the capital markets.
The process of capital formation that Reg. A+ was attempting to disrupt did not need disrupting. There is more money available for start-ups and small business than ever before. Removing the professionals from the process can only lead to more scams, more failed offerings and more losses for investors. And that is exactly what is happening.
About Irwin Stein, Esq.
Irwin Stein is a Wall Street trained attorney with 4 decades of experience working in finance. He has represented banks and brokerage firms, venture funds and large private investors. He advises established companies and start-ups in need of funding. He blogs on Law and Economics in the Capital Markets. http://laweconomicscapital.com/
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