A well-intentioned feature of U.S. law helps firms planning initial public offerings (IPOs) maintain confidentiality on their regulatory filings and related correspondence until two weeks before they launch their road shows. In an unintended outcome, pre-IPO firms have used that confidentiality provision to avoid costly, time-consuming and distracting lawsuits from competitors, former or current employees, suppliers, customers and other such non-shareholders, according to recent research by faculty at Wharton and elsewhere.
Freedom from prying eyes and litigation is a big benefit for IPO aspirants that opt for confidentiality of their disclosures to the regulator, the Securities and Exchange Commission (SEC). Firms that publicly disclose their IPO registration documents and correspondence with the SEC experience a 25% increase in non-shareholder lawsuits in the pre-IPO period. (They would have public shareholders after the IPO.) Firms that use the confidential filing provision do not experience such an increase around the IPO. That is the principal finding of a paper titled “Disclosure and Lawsuits Ahead of IPOs,” written by visiting Wharton finance professor Burcu Esmer and accounting professors N. Bugra Ozel, who has appointments at the University of Texas at Dallas and at Wharton, and Suhas A. Sridharan of Emory University. Their findings suggest that withholding information before the IPO period mitigates, rather than delays, opportunistic litigation.
The law that permits confidential IPO filings is the 2012 Jumpstart Our Business Startups Act, or JOBS Act, which aims to stimulate funding avenues for small businesses by easing securities regulations. Under the act, so-called “emerging growth companies” (EGCs) with gross annual revenues below $1 billion could enjoy confidentiality of their IPO filings and related correspondence with the SEC until 21 days before they begin their road shows to attract investors.
The SEC in December 2015 reduced that window to 15 days, making it even easier for firms to go public. In July 2017, it also relaxed the eligibility criteria and allowed all firms, and not just EGCs, to use the confidentiality provision. Prior to the passing of the JOBS Act in April 2012, firms planning IPOs were required to make public their regulatory disclosures five months ahead of their road shows.
The study’s sample included 205 EGCs, including 176 confidential filers, that conducted an IPO within the first two years after the JOBS Act was enacted, and 256 others that had IPOs between January 2008 and March 2012, or before the JOBS Act. Business equipment and health care were the two most common industries in the sample, consistent with the prevalence of IPOs in those sectors, the paper said. It tracked a total of 244 lawsuits that were filed against the firms in its matched sample.
“The confidential filing provision creates severe asymmetric information between firms and investors.” –Burcu Esmer
How Firms Benefit by Filing Confidentially
When firms have the option to file for their IPOs confidentially, the majority of them do, the study revealed. An overwhelming 86% of firms that filed for IPOs between April 2012 and April 2014 opted for confidential filings, the researchers found. “One benefit of filing confidentially is that firms are able walk away without attracting public scrutiny,” Esmer noted. “But relatively few firms change their minds after filing for an IPO and decide to stay private. So, there must be some other benefits related to filing confidentially” she added.
“We show that the deferral of disclosures via the confidential filing provision has the specific, quantifiable and potentially unintended benefit of reducing costly non-shareholder lawsuits prior to the IPO,” the authors stated in their paper. Their research revealed “a heightened incidence of business initiated lawsuits as well as meritless lawsuits around IPOs for firms that file for IPO publicly,” they noted. “Failure to recognize this trend causes investors to overestimate the uncertainty surrounding the IPOs and thus undervalue IPO firms.” Their study showed that each business-related lawsuit in the pre-IPO period is associated with a 5.9% decrease in IPO proceeds, on average. By filing confidentially, firms are able to avoid such lawsuits and related undervaluation in the offering.
The paper explained why a firm preparing for an IPO is an attractive target for competitors. First, its IPO registration statement and SEC “comment letters” help outsiders gain insights into the firm’s operations, products and financial condition. Here, the confidential filing provision helps IPO aspirants significantly reduce the time available for outsiders to process its regulatory filings.
Second, the mere fact that a firm is ready for an IPO is a signal that it aims to gain “financial strength and competitive power,” which may incentivize competitors and others “to attempt to derail the IPO process,” the researchers write. While the IPO firm would rather avoid the negative publicity and time consumption that lawsuits would entail, “potential plaintiffs have greater leverage and incentives to strike during this period.”
Among the well known companies that attracted litigation in the IPO phase are wearable fitness device company Fitbit, PayPal, Facebook, Zynga, Groupon and LinkedIn, the paper noted. “Knowing that soon-to-be-public firms have strong incentives to minimize factors that can adversely affect their valuation, reputation, and interest in the IPO, potential plaintiffs may feel emboldened to initiate lawsuits in order to extract a quick settlement,” the researchers wrote.
Some firms planning IPOs have the resources to try and fend off potential lawsuits, such as China’s Alibaba Group, the paper noted. Alibaba purchased more than 100 patents before its 2014 IPO in order to reduce the risk of intellectual property litigation during the IPO process. As it turned out, Alibaba raised a record $13 billion in that initial offering.
In that unwelcome setting for firms looking to go public, the confidential filing provision is helpful in shielding them from lawsuits, by “reducing the salience of the IPO process and the time available for conducting a detailed analysis of the firm,” the researchers note.
“An IPO that is underpriced means the company has less money to make investments and grow. Anything that hurts the company hurts the investor, as well.” –Burcu Esmer
Where the Confidentiality Provision Hurts
However, other firms that opt to keep their pre-IPO regulatory disclosures private find their shares “underpriced” at listing, because investors associate that opacity with “uncertainty,” Esmer told Knowledge@Wharton. “The confidential filing provision creates severe asymmetric information between firms and investors,” and that results in “significant underpricing of IPOs,” she said. Investors apply about an 8% discount to firms that take advantage of the reduced disclosure regulations, according to earlier research by accounting professors Daniel Taylor from Wharton, Mary E. Barth of Stanford University and Wayne R. Landsman of the University of North Carolina.
At first glance, such IPO underpricing might appear to benefit investors, since they get their shares in those firms at bargain prices. However, in reality, they are shareholders in a company that “was able to raise less money than it could have,” said Esmer. “An IPO that is underpriced means the company has less money to make investments and grow. Anything that hurts the company hurts the investor, as well.”
Another unsettling aspect of confidential filings is that firms could begin marketing their IPOs to institutional investors while their disclosures remain private, keeping individual retail investors in the dark about their true state of affairs. Retail investors would have the opportunity to study the regulatory filings two weeks before the road show. Esmer noted that “on one hand, two weeks seems like a short time for retail investors to assess the value of the IPO firm. On the other hand, one cannot determine if individual investors conducted research months ahead of an IPO before the JOBS Act was enacted, and so it is hard to compare that to how the present regime may impact investors.”
The significance of allowing retail investors sufficient time to research an IPO candidate is perhaps best captured by the case of Groupon, which operates a daily deals site. It had filed its IPO documents in June 2011, five months before its November 2011 listing and IPO. That was before the JOBS Act came into force, and so it did not have the option to keep its filings confidential. In the intervening period, Groupon faced intense scrutiny from the SEC over how it reported its revenues, and was compelled to restate its finances, literally halving its revenue number.
If Groupon were to have kept its filings and SEC comment letters confidential, investors would have had no idea about how it had overstated its revenues, said Esmer. “They would only have seen that the final report was approved by the SEC,” she added. “So, in a way, by filing confidentially, companies actually can hide such information.”
However, investors would be able to review the filings two weeks before the IPO road show when the confidentiality protection is lifted, she reiterated. “[Those] companies are not hiding information forever; they are [merely] delaying disclosure.”
The U.S. is not exactly an outlier in allowing pre-IPO confidentiality for firms aspiring to go public. Several countries have different forms of confidentiality provisions for IPO firms, but nothing similar to that in the U.S., said Esmer.
For instance, Canada earlier this year allowed pre-IPO firms to file their prospectuses confidentially. The provision aims “to foster capital formation and give companies greater flexibility and more certainty in their capital-raising planning,” according to the announcement. But it did obliquely recognize the challenging times IPO aspirants face in the wake of the coronavirus pandemic. “Although not introduced in response to COVID-19, the confidential pre-file process may be particularly helpful for issuers who are trying to navigate the current volatility in the markets,” it stated.