May 15, 1999

Drs. Burton and Kochard are members of the Economics faculty at the University of Virginia. They have benefited from the advice and suggestions of Dr. Susan Chaplinsky, who is a finance professor at the University of Virginia’s Darden School. James Weston and Jason Fink contributed in important ways to the analysis contained herein. Finally, the authors would like to acknowledge the helpful assistance of Gigi Gurtis, Wolfe Jaffe, Kris Koutrakos and Amy Latham.

The American capital markets are generally considered the most efficient and investor friendly markets in the world. The American investor is the most knowledgeable investor in the world and, indeed, the most successful. The information available to investors is enormous and growing. Information flows to investors from every direction – from the investment firms, from the media, from the Internet. Information is the chief concern of American securities regulation. Disclosure of information has been the central theme of securities regulation in the United States. The Securities Act of 1933 set the legal framework for the public disclosure of information required for the public offering of securities.

There have been important changes since 1933 in the regulations that govern the implementation of the 1933 Act. A significant milestone was the 1984 adoption of Rule 415, which permitted the registration of delayed offerings – "shelf registration." Shelf registration, really for the first time, permitted seasoned companies to offer securities on an immediate basis. That immediacy was crucial to the development of a richer and deeper public bond market. The Medium-Term-Note market, for example, would likely not exist were it not for the adoption of Rule 415. Generally speaking, changes in securities regulation over the years have fostered simplification and improved cost efficiency, while promoting the main theme of investor protection.

In November of 1998, the Securities and Exchange Commission proposed extensive changes to the procedures that govern the public offering of securities. These changes are so significant and sweeping that they have come to be known as the "Aircraft Carrier." The Aircraft Carrier was the culmination of a series of studies and reports by the SEC, particularly the important Wallman Committee report issued in 1996, intended to simplify and streamline the public offering process in response to the dramatic and significant changes that have taken place in the capital markets and in technology, especially in the technology behind information dissemination.

The Aircraft Carrier proposal, among other things, pursues the goal of providing investors with information prior to the actual decision to purchase a security (during a public offering). This information would be in writing and subject to physical delivery. In most situations, this information delivery would involve a significant increase in the cost of issuance to issuers, principally because of the timing delays that such information delivery would introduce into the process. These are timing delays that are not currently a part of these offerings. In some cases, this pre-decision information requirement timing delay would likely seriously impair significant marketplaces.

There are at least four areas of important cost increases for issuers in the Aircraft Carrier proposal that relate to the time line path of public offerings:

1. The 7 day "prospectus before pricing" requirement for Form A (IPOs and offerings registered within one year of IPO)
2. The 3 day "prospectus before pricing" requirement for Form A (filed more than one year after IPO effective)
3. The 24 hour "material change" requirement
4. The Form B term sheet requirement and filing requirements

In the analysis that follows, we have reviewed the literature on public offerings, which includes a rather substantial literature on shelf registration and a very small amount of earlier research on timing costs. We have also collected and analyzed data on major markets that could be impaired by certain proposals contained in the Aircraft Carrier. Finally, we have applied standard economic analysis to the measurement of the increased burden of costs that would fall upon the capital markets if the various timing delay proposals advanced in the "Aircraft Carrier" are adopted.

Our conclusions are the following:

1. The various timing delays that are proposed in the "Aircraft Carrier" will impose substantial cost increases on the capital markets. These costs will be borne by both issuer and investor. Competition among securities firms is likely to be reduced by the imposition of these timing delays.
2. Some costs that will be imposed on issuers due to delays in the offering process can be estimated using widely accepted economic analysis. Other costs, which could be substantial, are difficult to quantify. We estimate two costs imposed on IPO issuers – the cost of a put option and the negative signaling cost associated with a delay. These costs total approximately 4 % of an IPO’s proceeds. Seasoned equity issuers will not incur the put option cost, but will incur the negative signal cost of about 0.4 % of the offering proceeds. More significantly, the pricing delay may have the unintended consequence of causing seasoned offerings to be withdrawn, imposing costs on both issuers and investors. We estimate the cost on shelf debt issuers to be in the range of 5 – 10 basis points per annum, with the cost imposed on issuers who will be required to file Form A being closer to the top of the range. It is our view that the public Medium-Term-Note ("MTN") market may not survive the proposals under discussion, which would impose costs of at least 10 basis points per annum, as issuers all attempt to crowd into the small private MTN market. Additional non-quantifiable costs will be imposed on all of these issuers. We view the above figures as understating the total cost of the proposed delays.
3. The three crucial underpinnings to the strength of American public capital markets are: (i) consistency and predictability of the regulatory environment; (ii) growing importance of ‘immediacy’ markets; and (iii) conceptual and technological innovation in securities markets. The "Aircraft Carrier" proposal would damage the first two of these underpinnings, while failing to take advantage of the third.
4. Capital markets are global. Markets, like capital, seek friendly havens. The "Aircraft Carrier" proposals, if adopted, could cause important capital markets now thriving in the United States to move offshore. This move could, in large part, be permanent even if, at some later stage, the timing delays are removed.

There are three main sections in our analysis.

United States

We provide a brief description of some of the features that appear to be responsible for the tremendous successes of the American capital markets.

1. Regulatory Predictability

2. The ‘Immediacy’ Markets

3. Technological and Conceptual Change

4. The Economics of Shelf Registration

The second section highlights the ever-present competition for domestic markets presented by foreign markets. It is a challenge for US markets to maintain their competitive edge in a world with several other dynamic and growing financial centers. We show that markets, much like assets, move toward friendly environments. One of the important costs of increased regulation is the movement of markets offshore. The Eurobond market is presented as a case study of what can happen when the regulatory environment in a particular country changes in ways deemed unfriendly to capital markets.

Finally, the third section provides the analysis and details of the cost estimates of the timing problems that are introduced into the various offering processes by the proposals in the Aircraft Carrier.

Following these three sections, we provide a summary of our main conclusions.

The American capital market is the showcase capital market for the rest of the world. By every measure, the American market has been and continues to be the largest and most influential financial market in the world. There are three characteristics of the American capital market over past decades that appear to have produced the outstanding performance and growth in American financial markets: regulatory predictability, the growth of immediacy markets, and technological progress in the financial markets. In telling the story of what has made the American markets successful, it is important to outline the role played by each of these three factors. This section concludes with an economic analysis of the highly successful shelf registration market.

1. Regulatory Predictability

All public offerings look back to the Securities Act of 1933 for the foundation stones upon which are built the structure, timing and procedures of the offering process. Regulations put forth by the Securities and Exchange Commission as well as amendments to the original Act have guided the evolution of the public offering process. Generally, the regulatory history has moved in directions favorable to improving the efficiency of the marketplace and reducing the complexity of the regulatory process for issuers. The Aircraft Carrier proposals create (pure) timing delays not now present in three major types of offerings: equity IPOs, equity add-ons, and shelf registration transactions. The fact that these timing delays do not currently exist in these offerings is one of the critical reasons for the successful history of these marketplaces. We intend to show, in this section, that the regulatory predictability has led to strong and efficient marketplaces and procedures for these classes of offerings. The actual process, depending upon the nature of the offering, varies in complexity and detail. Perhaps the most delicate of the offering processes is that of an initial public offering (IPO).

1. The IPO Process

An initial public offering, if successful, is a once-in-a-lifetime event. The process of "going public" ostensibly involves a timeline that begins with the filing of an S-1 registration statement. In fact, the timeline usually has a much earlier start date. A private company often begins a year or two in advance, transforming itself into a more "public" looking company. Usually by the time of the S-1 filing, a substantial amount of time has been devoted to getting a company "ready." After the S-1 filing, the issuer and the underwriter resolve any comments from SEC staff. The first SEC comments typically arrive within 30 days of the filing. The time between filing and resolution of staff comments is, then, normally at least a month or more. The marketing period begins in earnest after all comments have been resolved. Preliminary prospectuses ("red herrings") begin to be distributed to prospective purchasers of the offering. The "road show" then commences, and the process of "building the book" begins. After two to three weeks, the book begins to "come together" and a pricing meeting is held. If all goes well, the price is set and the stock is then allocated to purchasers. Under current regulations, a prospectus is provided to each purchaser 48 hours prior to sending of the confirmation of purchase.

Figure 1