Tuesday, May 3, 2016

Calling All Secondary Securities Market Aficionados! A Little Help?

What factors generate a healthy secondary market in securities?  That is my question for this week.  I have found myself struggling with this question since I was first called by a reporter writing a story for The Wall Street Journal about a work-in-process written by one of our colleagues, Seth Oranburg (a Visiting Assistant Professor at Chicago-Kent College of Law).  The article came out yesterday (and I was quoted in it--glory be!), but the puzzle remains . . . .

Secondary securities markets have been hot topics for a while now. I followed with interest Usha Rodrigues's work on this paper, for example, which came out in 2013.  Yet, that project focused on markets involving only accredited investors.  

Seth's idea, however, is intended to prime a different kind of secondary market in securities: a trading platform for securities bought by the average Joe (or Joan!) non-accredited investor in a crowdfunded offering (specifically, an offering conducted under the CROWDFUND Act, Title III of the JOBS Act).  [Note: I will not bother to unpack the statutory acronyms used in that last parenthetical expression, since I know most of our readers understand them well.  But please comment below or message me if you need help on that.]  Leaving aside one's view of the need for or desirability of a secondary market for securities acquired through crowdfunding  (which depends, at least to some extent, on the type of issuer, investment instrument, and investor involved in the crowdfunding), the idea of fostering a secondary securities market is intriguing.  What, other than willing buyers and sellers and a facilitating (or at least non-hostile) regulatory environment, makes a trading market in securities?

The time has come to try to solve this puzzle.  Many--including Securities and Exchange Commission ("SEC") member Daniel Gallagher--observe that, at least when it comes to privately held small business equity (including shares of stock obtained through equity crowdfunding), a secondary market can make or break the primary market.  This may or may not be true for debt or investment contract crowdfunding. 

At least one SEC member, Luis Aguilar, has resurrected the idea of venture exchanges. Subsequently, Congress took up the issuethe blogosphere has noticed, too.  Commissioner Aguilar and others (see, e.g., here) also are concerned about the need for changes to Rule 15c2-11 (adopted by the SEC under the Securities Exchange Act of 1934, as amended) to accommodate a secondary market for the privately held securities of non-public issuers.  It is unclear, however, where any of this is going.

I hope that those of you who know something about this area (in which I have truly done no research) will chime in by leaving a comment or sending me a message.  I would appreciate a leg up of some kind--e.g., an author who (or body of work that) I can consult for guidance.  I assume there is some market-oriented literature in economics that may be helpful.  But I also wonder whether there are finance papers or even law papers that address matters relevant to the creation of a sustainable secondary securities market.

In closing, I will note parenthetically the following: although my scholarship and teaching engagement with crowdfunding led me to this puzzle, I am not a proponent of across-the-board trading in crowdfunded securities, especially at this early stage of the securities crowdfunding market.  I may want to explain the reasons why in a separate post, since they are complex.  But I will note here that my overall ideal vision of crowdfunding as a small business capital formation alternative does not involve promoting a heavy use of equity crowdfunding or catering to traditional profit-centric investors.  That summary may give you a better idea of where I am coming from until I next pick up this thread . . . .


Corporate Finance, Crowdfunding, Joan Heminway, Securities Regulation | Permalink


I can think of a few things that would likely be associated with a successful secondary market.

1. Widely Dispersed Ownership
If a reasonable volume of shares are spread out among a large number of people, that may increase the likelihood that people will trade.

2. Market Makers
Market makers provide a good amount of liquidity in traditional markets. One possibility here may be to allow market makers more time to make trades than we would have for the regular market. Giving them more time to execute may increase liquidity. Instead of a trade taking seconds to execute, it may be more reasonable to give it two days or so in this space. That's probably sufficient liquidity.

3. High Quality Information Environment
People will buy on the secondary market if they can come up with a good idea of what it's worth. If the information about the company is poor, it may depress trading or cause it to trade at a discount.

The market incentive to produce information may not be strong for analysts if the total market size is small.

The tough thing is that a secondary market may be something that only functions well when you have more owners and a larger market value. That doesn't mean that there are not things that can be done to improve liquidity.

In the alternative, we could think of these capital raises as alternatives to VC financing. They don't normally get immediate liquidity when they invest.

Posted by: Ben Edwards | May 3, 2016 2:29:21 PM

Hey, Ben. Great to hear from you in this space. Thanks for weighing in.

I like your ideas, especially your thoughts in numbers 1 and 3 and your comment about maybe treating this like a VC (or other early-stage private capital raising) alternative. The issue with that last idea, as an analogy, is that the purchasers of the securities in crowdfunding do not have the same individualized bargaining power or opportunity. In this way, crowdfunding works more like a public offering or larger, institutional private placement. Maybe the better analogy in that regard is to a Reg D Rule 506 or Reg S offering . . . .

I want to think harder about your number 2--the need/desirability of market makers. If you have more to say on that, I would be interested. I have been working on intermediation in crowdfunding, and all of this relates to that work in illuminating ways.

Posted by: joanheminway | May 4, 2016 5:17:04 AM

Not sure that I have too much more on the market-maker front. My main thought is that if we're going to have a liquid secondary market, someone will have to provide that liquidity in thin trading times. Market makers may be a possibility, but they would probably need some incentive to provide that liquidity, perhaps more time to execute.

One possible question -- can individuals buy more than the offering limit in the secondary market? Imagine you bought the maximum amount permitted in the primary offering. If you like the company and want to increase your stake three months later, is that permitted?

There might be a possible issue if willing buyers are not able to buy more. This would mean that the informed stakeholders we would expect to buy will not provide liquidity for sellers.

Posted by: Ben Edwards | May 4, 2016 8:14:08 AM

Right. The thin trading issue may be real, especially at the outset. Truthfully, I wonder about the viability of any market for reselling crowdfunded securities that are not common equity.

And I really like your point on the investment limit, too. This is key. It would be an easy end-run around the protective effect of the individual investment limit if an investor in a crowdfunded offering could buy up more shares in the market. Of course, the securities are not transferable to an unaffiliated/unassociated third party for a year unless the purchaser is an accredited investor, but . . . .

Again, many thanks.

Posted by: joanheminway | May 4, 2016 10:44:21 AM

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