I like to imagine that my grandparents have an idea of capital markets that could have come from the pages of The Protestant Ethic. In my caricature, investors like them whittle away a small portion of their paycheck from Hudson's Bay Company or General Electric (full disclosure – no one in my family has ever worked at HBC or General Electric) and diligently invest that money back into shares of HBC and General Electric. Those shares would generate fat dividends and appreciate in value over time so that, after paying off the miniscule mortgage on your North Toronto home, you could cash those shares in and retire down to Florida.
In my highly stylized world, companies need share capital because they need money to invest in growth. Securities regulation exists to protect our frugal Protestant grandparents from unscrupulous hucksters who abused capital markets to make a quick buck. The solution to this problem was an elegant and intuitive one – disclose everything through a big document called a prospectus, or face stiff penalties.
Of course, not all people needed the same protection. Accredited investors (read: rich people), friends and family of company founders, and prior investors, were presumed to have more capacity to evaluate investments. These people were given exemptions from securities law requirements, giving companies the ability to easily raise money from knowledgeable investors.
This story makes me feel very warm and fuzzy, but regardless of whether or not it was ever true, the world has changed. Two recent transactions – techno-utopian and law-hating taxi cab company Uber's private placement of "at least $1 billion" in the U.S., and TSX-traded Australian junior miner Paladin Energy Ltd.'s $144-million Australian rights offering, as well the Canadian Securities Administrators' proposed new rules for rights offerings – reveal just how difficult it is for regulators to balance prudent regulation with market pressures for cheaper capital and more risk.
The Uber deal was spurred by new U.S. securities regulation that allows companies to raise money from private wealth clients prior to an initial public offering. But why even bother with an IPO if you can raise over a billion dollars privately without complying with strenuous IPO rules? Bloomberg View columnist Matt Levine has a convincing answer: IPOs are about your initial investors with a market in which to sell the shares that you've already bought through a private offering and realize a return on your investment, or rewarding those that don't sell with dividends. Hence, the S&P 500 spends 95 percent of its earnings on dividends and buybacks. Some public markets aren't about growth, they're about exit.
Paladin Energy and other junior miners operate under a different set of concerns. Mining, especially the kind of exploratory and developmental mining that junior miners do, is a risky proposition. The industry is speculative and capital intensive, and many junior miners never see positive capital flow. One model of a junior mining company is that companies first raise money through private placements to accredited investors, do an IPO – which forces upon them a bunch of disclosure obligations about the state of their mine – and then hope that they find something so a big miner who can actually develop the mine comes along to either take over or invest alongside the junior miner. Equity in that case is better than debt because equity gives you substantial upside if a junior whose shares you hold finds some gold, while debt and equity likely both get wiped out if the mine is barren.
This is why retail investors in Paladin were so mad that their shares were getting diluted by the company's Australian rights offering (a deal offered only to existing security holders) that allowed Canadian institutional investors to participate but not Canadian retail investors. From a regulatory perspective, the Australian regime requires much less disclosure than the Canadian one, as it allows the company to do the deal without a prospectus. Given that rights offerings are a good way for troubled companies to raise funds – because of the threat of dilution for non-participating shareholders – Canadian rules tend to err on the side of more disclosure and restrict investors from participating in these kinds of rights offerings. Now, if you're a Canadian retail investor who has decided to play the junior miner lottery with Paladin, you're not going to be pleased about this.
Neither the Uber nor the Paladin model are much like my grandparents' model: Uber is using the promise of an IPO to entice private investors; Paladin is using the equity markets as a way to sustain itself before making its investors rich through an eventual takeover or large investment by a major miner that will allow it to realize its potential.
Both transactions show that there's a push from both investors and companies to raise equity outside of traditional public offerings. And regulators are listening. The Canadian Securities Administration has proposed a new streamlined rights offering procedure that, among other things, allows companies to issue rights without securities regulatory review. The increased risk is offset by the fact that the CSA may propose post-offering reviews, and that civil liability for disclosure is meant to apply to rights offered under the new exemption.
Taken together, all of this shows that securities regulators in jurisdictions everywhere are facing pressure from both investors and other jurisdictions to loosen rules for raising capital. When making rules, regulators have to balance appropriate protections for the market with competition from other jurisdictions. Every move that makes it easier for companies to raise capital is also a move that increases the risk to investors and markets. And it seems like rules are being loosened everywhere.
There's no tidy punchline here. Too much regulation chases companies out of capital markets; too little brings excess risk. And for regulators, things are a heck of a lot more complicated than making sure that HBC is a safe investment for mom and pop to to base their retirement on.