Is Effective Junior Equity Market Regulation Possible?

The authors examined Canada’s Capital Pool Company (CPC) program, a regulated blind pool program, since its inception in 1986. They found that the CPC regulations increased the quality of both the junior equity companies going public and the underwriters taking those companies public and significantly reduced the incidence of fraud in that market. Overall, the authors found that effective regulation can help create a viable junior equity market that facilitates the development of smaller companies.The existence of a viable junior equity market is critical to the economic health of a nation; however, many developed countries, including the United States, have experienced a decline in small-company IPOs over time. Previous research has attributed the IPO decline to a number of factors, including an ineffective regulatory structure for junior equity issues, and has found that the lack of IPO capital has significantly slowed the growth rate of smaller companies and resulted in a large number of lost jobs. Achieving the delicate balance between protecting investors while not creating a regulatory system that is too expensive or cumbersome for issuing companies seeking to raise capital has proven difficult in many countries.In our study, we examined Canada’s Capital Pool Company (CPC) program, a regulated blind pool program. In Canada, securities regulation is a provincial responsibility, and the CPC program began in the province of Alberta in 1986 in response to some of the same fraudulent behavior that was observed in the US blind pool market in the late 1980s. The differing responses to junior equity fraud by Canadian and US regulators create a natural experiment to examine the effectiveness of junior equity market regulation.Whereas previous research has documented that the US regulations effectively closed down the US blind pool market (for junior equity issues), we examined all Canadian junior blind pool IPOs from 1986 to 2010 and found that although the number of such offerings has fluctuated over time, it has remained high even after the senior market slowdowns during the early 2000s and the 2008 global financial crisis. We found that by 2010, a total of 2,161 companies had used the CPC program to raise $726.3 million in IPO capital. Part of the reason why the program has remained robust over time is that it has expanded to include the majority of Canadian provinces and now attracts listings by companies from across Canada and internationally.We examined the effectiveness of the CPC regulations by comparing the performance of Canadian blind pool offerings that occurred before and after the adoption of the regulations. We found that more than 72.2% of the population of CPCs completed their qualifying transaction (an asset acquisition or merger with a private company that transforms the blind pool into a regularly listed company) and remained listed for at least five years following this transaction or were delisted owing to an amalgamation, a takeover, or graduation to a more senior exchange. In comparison, prior to the adoption of the CPC regulations, only 38.1% of blind pool companies became regularly listed and remained so for the next five years.We also found that an increasing percentage of higher-quality underwriters are willing to take CPCs public, especially since the program was expanded to Canada’s major provinces. More specifically, prior to the adoption of the CPC regulations, less than 5% of blind pool offerings were underwritten by a top 20 underwriter from the league tables, but since the regulations were adopted, more than 45% of blind pool offerings have been underwritten by a top 20 underwriter.Finally, we found that the adoption of the CPC regulations significantly lowered the incidence of fraud in the Canadian junior equity blind pool market. Prior to the adoption of the CPC regulations, almost one in five Canadian blind pools were investigated for or found guilty of fraudulent behavior. The percentage of fraud declined significantly once the CPC program began in Alberta and has continued to decline as the program has been adopted in other Canadian jurisdictions.Overall, our study provides strong support for the effectiveness of the CPC regulations in developing a vibrant junior equity market that strikes the right balance between facilitating a company’s development and protecting investors. Thus, we conclude that effective regulation can help create a viable junior equity market that facilitates the development of smaller companies.