Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Problems in US regulation of public offerings

Two events this week have highlighted the persistent problems in US
regulation of public offerings: first was the unacceptable effect that
the quiet period regulation had on the Blackstone IPO and the other
was the decision by the SEC to further tighten short selling
activities during a public offering.

While the Blackstone IPO was in progress, a bill was introduced in
the US Congress to increase the tax rates applicable to listed private
equity firms. Since this proposal came with a five year breather, the
market would have benefited from an analysis by the company
explaining the tax incidence in the light of anticipated profit
realization during the next five years. Unfortunately, as the Lex
column in the Financial Times pointed out
(“Blackstone’s tax bill”, June 18, 2007), the quiet
period regulation prevented Blackstone from commenting on the
situation at all. This is a totally unacceptable outcome. Clearly, the
regulations that were framed long ago in a much slower paced era need
to change to keep up with the times.

Sometimes, however, when regulations are changed, they are changed
for the worse. The SEC’s proposal to
tighten short selling restrictions during public offerings of
securities is an example of this kind. The SEC states:

When a trader expects to receive shares in an offering, there is an
incentive to sell short prior to pricing an offering and then cover
that short position with shares bought at the reduced offering
price. By doing so, the trader can cover the short sale with minimal
risk, and generally lock in a guaranteed profit – to the detriment of
the issuer and the other shareholders.

The amendments change the way the rule works to prevent this from
happening. They replace the rule’s current limitation on covering the
short sales in the offering with a prohibition on purchasing in the
offering after a short sale in the securities. This change was
triggered by persistent non-compliance with the rule and a string of
strategies to conceal the prohibited covering. Under the amended rule,
if a person sells short during the restricted period prior to pricing,
that person is prohibited from purchasing the offered security. Thus,
the amended rule changes the prohibited activity from covering to
purchasing the offered security.

Accurate price discovery is as important (if not more important)
during a public offering as at other times and short selling is a
critical element of good price discovery. In the absence of this
process, there is a risk that companies and their underwriters would
be able to manipulate the market and overprice their issues. In this
light, the rule proposed by the SEC is a step in the wrong


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