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New Equity Offering Model: the Semi-Public Market

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Corporations have a fiduciary responsibility to their debt and equity holders—collectively called their stakeholders. But when a company decides to issue stock in the public market, they lose significant control over how their shares are valued and traded. This is deemed acceptable, of course, because there are many shareholder advantages when a private company goes public.

With the recent meltdown in the global-financial system, it became apparent that risky-trading behavior is a rampant, real issue in financial markets. Whereas requiring strict disclosure and transparency may help ameliorate risky trading in general, a new study explains a possible genetic link to risky economic behavior. Taking measured risks in business are necessary. But it is never wise to make financial gambles. This is exactly what happened and continues to happen today.

How can corporations accrue some of the advantages of the open market while better insulating themselves from banking and insurance firms that literally game the system? I believe that the current two-part equity system–private or public–does not currently make that goal possible. The two-part system does not offer corporations–who choose to take advantage of the benefits of “going public”–a sufficient level of fiduciary control over their capital structures.

What if another option existed? What if corporations could decide the terms with which their stock would be publicly traded?

I propose that the SEC create a new type of stock market—the semi-public market. In this market, corporations would decide the listing terms of their stock from a SEC-predefined list of market-trading options.

Options might include:

  • Whether or not the stock would be allowed to trade on the derivatives market
  • Whether or not the stock could be shorted
  • Whether or not the stock could be bought on margin
  • The number of days the stock had to be held before it could be sold: (zero – ?)
  • Whether the stock traded on a third-party market or on the corporation’s own, regulated trading platform
  • The maximum percentage ownership of the float allowed to various entities: institutional investors, private equity, hedge funds, individual investors
  • The terms of their IPO

In summary, I propose that companies are offered three structures for issuing their stock:

  1. private
  2. semi-public
  3. public

Allowing corporations the ability to customize the market environment in which their shares trade offers three obvious advantages to stakeholders. First, potential shareholders will have a wider selection of investment options that better suit their risk profiles. Second, corporations will regain an acceptable level of fiduciary control over their capital structure while still having an option to go public. Third, some of the market manipulation that publicly-trade companies currently face can be alleviated which will result in increased insulation from some forms of systemic risk.

What do you think? Should corporations have three options for issuing their stock instead of the current two?

Article Comments

  1. Sorry, jeff, I think you’re off on this one. It wasn’t “risky-trading behavior” that caused or even had anything to do with the recent melt-down. Trading in any public shares represents the collective valuation of those shares by all market participants. When markets panic, there is an underlying reason for that panic which is directly related to the business represented by those shares and the economy, to varying degrees.

    So when AIG shares made a b-line to zero back in the Fall of ’08 (was it that long ago?) it wasn’t because of risky trading in AIG shares. It was because it was coming to light that AIG had gobs of CDS (Credit Default Swap) risk on their books. Yes, the ensuing trading was frenzied, but that can be explained by the uncertainty of the ensuing guesses at the real valuation of the risk. This had nothing to do with anyone making “risky trades” much of the financial crisis was brought on by bad things allowed to be done with companies, not their securities. A CDS is not inherently a bad thing. It’s actually a good thing. it IS hard to value, to be sure. I have tried to build valuation models and getting 35 cross-correlations right on credit risk is not small feat. That said, when the CFTA lobbies and wins the rule that says companies (read AIG et al) can have unlimited notional CDS risk on their books and they don’t have to tell anyone, you have problems.

    Creating a new class of semi-private securities is not the solution to protect investors. A company could theoretically do a bad thing, not tell this new class who might then be prevented from selling once they found out (under your rules)

    It can also be shown that short selling has very little effect on a stock price’s direction (witness the 50% decline in the market’s value AFTER the ban on short selling was imposed.. but that’s a different story.

    On a different note, I whole-heartedly endorse the notion of risk taking in the studies you point to.

    Great post, Jeff

  2. Jeff Sayre says:

    I appreciate your point of view. I should have been more thorough in setting up my point.

    Although not equity trades, CDOs and CDSs are of course traded. My basic point is that excessively risky behavior led to the current meltdown—or more precisely set the conditions for the damn to break. Whereas there’s nothing inherently wrong with the concept of CDOs and CDSs, the valuation models used to justify the underwriting on a handful of those instruments was greedy at best, shady at worst.

    As you know, I have no issue with risk taking. But I do have issues with risk that is not properly calculated or justified. What a few, large players participated in was more along the lines of gambling.

    The potential risks and returns of a properly established semi-public market should theoretically fall in between the private and public options. Of course liquidity could be an issue, but it should not be as big of an issue as it is with private equity holdings. Transparency should also be improved compared to the private market.

    This is more of a thought experiment than anything else. The complex interweaving of our financial system and the dependencies it creates in our global economy will surely make my idea highly improbable.

  3. I often get chided for leaning too heavily on “market forces” and transparency” as dominant factors in keeping players in check from doing crazy or stupid things. I certainly don’t think it’s the only way to achieve the goals to which we are all striving. I will connect these dots though as it plays out all the time: investors have a lot of money, both retail and institutional (which is just a proxy for retail e.g. Fidelity) -> they simply do not allow a company to do stupid/risky things. How -> if they (the co) do, their stock is sold mercilessly. It is only when the company is deceiving investors that a stock gets bough up unwittingly. Sadly, companies deceive investors all the time. The CDS is a decent example here. Given how darn hard they are to value, I doubt AIG would have even taken them onto their books if they were forced to tell us. It would be like telling investors in the WSJ one day that they took all their profit and bought M&Ms. The market would have been “WTF?” and reacted accordingly which would have killed AIG’s business (thankfully keeping them from doing things like buying M&M’s with profits)

    Another pitfall of bifurcating a company’s securities: fungibility. The reason our markets work so well is that a share is a share is a share. The only time different classes of shares crop up is when they actually have different representations of value (e.g. voting rights, etc) Here, the difference is in the investor type, not the security or underlying company.

    I know it was just a thought experiment but it gets the conversation going. We need to discuss things like this. Another topic would be on why Obama’s administration feels the right thing to do is give away TARP $$ with no conditions and then cry foul when the banks use TARP to make money. Answer? Well, just tax the money back into the coffers. Sheesh.

  4. Jeff Sayre says:

    You and I are on the same page when it comes to the belief that full transparency would make all the difference. There are many market players—corporate boards of traded companies, many flavors of investment firms and market makers, the various exchanges, government institutions. All it takes is for a few unscrupulous players or clueless players who wield enormous power, anywhere in the market web, to cause turmoil. Full transparency and accountability would go a long way toward making it more difficult for this to happen again.

    TARP is clearly another topic that needs to be discussed. Both political parties handled this in such a bumbling way, that it was headed for trouble from the start. Combine that with the fact that the executive branches of the past and current administrations were careless with setting proper terms and conditions, and we’ve ended up where we are today.

    You are obviously more intimately involved in the system and understand its nuances more than I ever will. These discussions are a great way to help elevate the debate and education on this important topic. Economic security is a crucial glue for our society.

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