[Senate Hearing 112-465]
[From the U.S. Government Publishing Office]
S. Hrg. 112-465
EXAMINING INVESTOR RISKS IN CAPITAL RAISING
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
EXAMINING INVESTOR RISKS IN CAPITAL RAISING
__________
DECEMBER 14, 2011
__________
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Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
MIKE CRAPO, Idaho, Ranking Republican Member
CHARLES E. SCHUMER, New York PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
HERB KOHL, Wisconsin JIM DeMINT, South Carolina
MARK R. WARNER, Virginia DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota
Kara Stein, Subcommittee Staff Director
Gregg Richard, Republican Subcommittee Staff Directorr
(ii)
C O N T E N T S
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WEDNESDAY, DECEMBER 14, 2011
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Crapo................................................ 2
WITNESSES
John C. Coates IV, John F. Cogan, Jr., Professor of Law and
Economics, Harvard Law School.................................. 4
Prepared statement........................................... 27
Kate Mitchell, Managing Director, Scale Venture Partners......... 6
Prepared statement........................................... 37
Barry E. Silbert, Founder and Chief Executive Officer,
SecondMarket, Inc.............................................. 8
Prepared statement........................................... 88
Stephen Luparello, Vice Chairman, Financial Industry Regulatory
Authority...................................................... 9
Prepared statement........................................... 99
Mark T. Hiraide, Partner, Petillon, Hiraide & Loomis, LLP........ 11
Prepared statement........................................... 102
Additional Material Supplied for the Record
State Enforcement Actions Concerning Securities Fraud, Capital
Formation, and Internet Offerings from NASSA submitted by
Chairman Jack Reed............................................. 106
Statement submitted by Jeff Lynn, Chief Executive Officer, Seedrs 113
(iii)
EXAMINING INVESTOR RISKS IN CAPITAL RAISING
----------
WEDNESDAY, DECEMBER 14, 2011
U.S. Senate,
Subcommittee on Securities, Insurance, and Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 9:34 a.m., in room SD-538, Dirksen
Senate Office Building, Hon. Jack Reed, Chairman of the
Subcommittee, presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. I want to call the hearing to order. I want
to welcome everyone to this hearing on ``Examining Investor
Risk in Capital Raising.'' I want to thank my Ranking Member,
Senator Crapo, for his participation and his support not just
in this hearing but throughout this legislative session.
The capital markets today play a vital role in the United
States economy, providing capital to small and large companies
to fund the search for new ideas, to develop new products, and
ultimately, and very importantly, the hiring of new workers.
Spurring the growth of American business and job creation is an
important aspect of this Banking Committee and our
responsibilities.
The recent financial crisis has had a devastating effect on
our economy. With a fragile economy and continued high
unemployment, directing the flow of capital to enterprises that
will improve the economy and put people to work is vitally
important. However, we must not forget that gaps in regulation
and transparency contributed to the enormous losses caused by
the financial crisis.
Earlier this year, Mary Schapiro, the Chairman of the
Securities and Exchange Commission, announced that the SEC was
taking a fresh look at the rules for companies raising capital
from investors. Chairman Schapiro also formed the Advisory
Committee on Small and Emerging Companies in September to look
for ways to make capital formation for small and emerging
companies more efficient and effective.
In January, the Administration formed Startup America to
inspire high-growth entrepreneurship throughout the Nation.
In March the Treasury Department held an Access to Capital
Conference which led to the formation of the independent IPO
Task Force. The task force report was released in October and
will be part of our discussion today.
In addition to these initiatives, a number of bills have
also been introduced that seek to improve the flow of capital
from investors to businesses. Some of the proposals focus on
reducing costs, others focus on eliminating regulations, and
some on creating new paradigms for raising funds.
As we seek to improve job growth by examining how to
improve the process of raising capital, we also, however, need
to improve the process for protecting investors. Unfortunately,
fraud and deception exist in our securities markets, and we
have to take effective steps to minimize both of those
unfortunate aspects of the securities markets.
Clearly, investors face certain risks when contributing
capital to either small or large companies. Will the investment
lose money? Can the securities be sold immediately or is there
a holding period? Are the investments suitable? If the company
does well, will the investor get the share of the profits? Or
will the investors be left out of the profits because the
company left them behind in favor of new investors? These are
all vital questions that we hope to address today.
Today's hearing will examine different proposals to update
and streamline and our capital-raising process. We will focus
on how we can best protect investors and on finding an
appropriate balance between improving the ability of small and
large companies to access capital and providing modern and
updated investor protections. I look forward to our witnesses'
testimony this morning on all of these important topics.
Now I will recognize Senator Crapo.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. Thank you very much, Mr. Chairman. I
appreciate your holding this hearing. I have for some time now
been very concerned about the state of capital formation in the
United States and want to assure that as we develop the proper
policies for our economy, we make it so that America continues
to be the place where people come to form capital, and that
that can happen not only for large but small businesses alike.
Emerging growth companies seek capital to fund new
projects, grow their businesses, and compete globally with
their innovative products and services. When unnecessary
regulatory barriers to capital formation are removed, everyone
wins. Investors enjoy better investment opportunities,
consumers enjoy better products at cheaper prices, and local
communities enjoy better employment opportunities.
As the December 1st hearing highlighted, we can do more to
expand economic activity by removing unnecessary restrictions
on capital formation to enhance access to capital for early-
stage startups as well as later-stage growth companies. The
House recently passed some targeted bipartisan legislation that
makes it easier for private companies to raise capital by
increasing the 500-shareholder registration threshold,
expanding the scope of Regulation A offerings to $50 million,
permitting general solicitation of investors in Regulation D
offerings, and allowing small businesses and startups to raise
capital from small-dollar investors through crowdfunding.
Proposals are also being considered to reverse the American
IPO decline while balancing increased capital market access
with investor protections. Mr. Chairman, as you indicated, the
President's Council on Jobs and Competitiveness' Interim Report
and the IPO Task Force provide recommendations that could
result in a larger supply of emerging growth companies going
public and increase job creation over the long term. The IPO
Task Force recommended providing an on-ramp that would provide
emerging growth companies up to 5 years to scale up to IPO
regulation and disclosure compliance. During this period,
emerging growth companies could follow streamlined financial
statement requirements and minimize compliance costs and be
exempted from certain regulatory requirements imposed by
Sarbanes-Oxley and Dodd-Frank.
On December 8th, SBA Administrator Karen Mills and National
Economic Council Director Gene Sperling posted a joint online
statement about helping job creators get the capital they need
by passing legislation relating to crowdfunding, Regulation A
mini offerings, and creating an on-ramp for emerging growth
companies.
There is strong bipartisan support for these proposals, and
I look forward to working together with you, Mr. Chairman, and
others to enact the necessary changed to promote investment in
the American job growth sector while protecting investors.
Thank you.
Chairman Reed. Thank you very much, Senator Crapo.
Senator Merkley, do you have an opening statement?
Senator Merkley. Thank you, Mr. Chair. I prefer to get
right to the testimony.
Chairman Reed. Thank you. Let me introduce the panel.
Our first witness is Professor John Coates. Professor John
Coates joined the faculty of Harvard Law School in 1997 after
10 years in private practice in New York specializing in
corporate and securities law. He was named the John F. Cogan
Professor of Law and Economics in 2008. He teaches and conducts
empirical research on corporate and securities law. Thank you,
Professor Coates, for being here.
Ms. Kate Mitchell is a cofounder of Scale Venture Partners,
a venture capital fund located in Silicon Valley, California.
She leads investments in software companies across the United
States, bringing more than 25 years' experience in technology
development, finance, and general management to her portfolio.
Ms. Mitchell was the 2010-11 chairman of the National Venture
Capital Association and remains active in policy matters that
impact startups and innovation. Thank you, Ms. Mitchell.
Mr. Barry Silbert is the founder and CEO of SecondMarket.
Prior to founding SecondMarket in 2004, Mr. Silbert was an
investment banker at Houlihan Lokey where he focused on
financial restructurings, mergers and acquisitions, and
corporate financing transactions. Thank you, sir.
Mr. Stephen Luparello is the vice chairman of the Financial
Industry Regulatory Authority, FINRA. In this capacity, Mr.
Luparello oversees FINRA's regulatory operations, including
enforcement, market regulation, member regulation, and business
solutions. Prior to this position, Mr. Luparello served as
FINRA's interim chief executive officer.
Mr. Mark Hiraide serves as legal counsel to entrepreneurs
in small- and mid-sized public companies, assisting them in
private and public securities offerings. He practice includes
defending officers and directors in civil litigation arising
out of securities offerings and prosecuting civil claims on
behalf of aggrieved investors. He also practices before the SEC
and FINRA in regulatory defense matters. He entered private
practice after having served 8 years as an attorney for the
Securities and Exchange Commission in both the Division of
Enforcement and Corporate Finance.
All of your written testimonies will be made part of the
record, without objection, and so I would urge you to summarize
your remarks in a period of about 5 minutes per witness.
Professor Coates, you may begin.
STATEMENT OF JOHN C. COATES IV, JOHN F. COGAN, JR., PROFESSOR
OF LAW AND ECONOMICS, HARVARD LAW SCHOOL
Mr. Coates. Chairman Reed, Ranking Member Crapo, and
Members of the Subcommittee, thank you for inviting me to
testify here today on this topic. Effective and efficient
capital regulation is a foundation for economic growth, and it
is something that we all have a profound interest in.
I should say at the outset I work as a consultant and as an
expert for all kinds of participants in the securities markets,
and I do not think any of them have any particular interest in
the legislation at issue today, but just so that that is out
there, I work for large banks, small banks, individuals,
everyone.
In my 5 minutes, I am just going to make a couple of
general points and then a couple of specific points about the
bills. There is obviously a lot to cover given the different
nature of many of the bills on the table.
The first general point is I think all of the bills ought
best to be understood not in the way some have cast them as
reducing regulation in order to spur growth; rather, they are
all efforts to balance the cost of raising capital against the
cost of capital. That is to say, there clearly are costs that
regulations impose on entrepreneurs who want to raise capital.
Simply having to hire a lawyer to know what the rules are is a
big part of that. But regulation, at least well-crafted
regulation, can reduce the costs that entrepreneurs are charged
for the money that strangers give them to run their businesses.
In effect, disclosure, antifraud regulation, the ability to
verify the information that you are providing and not simply
provide the information, all of those things make it safer and
easier for strangers to turn their money over and easier for
them to reduce the price that they are charging for their
capital. So, really, all of the bills are about growth in both
directions, and one important, therefore, lesson from that
observation is that the bills could harm job growth, too.
The follow-on point to that is that to know for sure how
the two kinds of costs tradeoff--capital-raising costs going
down, capital costs potentially going up--you would have to
know a lot of things that I do not think anyone actually knows,
including the SEC, not me, I do not think any of the other
witnesses that have testified in the Banking Committee earlier
or are likely to testify today.
Here are the kinds of things you need to know: How much
more fraud is likely to occur as a result of the changes? There
will be some more. I do not think there is anybody who would
dispute that. All by itself, that does not mean the changes are
bad, but that is something you would need to know.
How much more capital will, in fact, be formed? That is
also something I think reasonable people could have
disagreements about each of the different proposals on the
table.
And so when you start putting together the different kinds
of things you would need to know in order to tradeoff the two
kinds of costs that are on the table, I do not think anyone can
say with confidence how this is going to affect job growth.
Just to restate the point you made at the outset, even
market advocates as fierce as Judge Richard Posner have granted
that financial deregulation can, in fact, cause job
destruction, essentially, as a result of the financial crisis.
So how do you think about these bills? They are essentially
proposals for experiments, and whenever I think about
experiments with something as important as the capital markets,
I think they ought to be cautiously adopted.
And, in particular, I would suggest all of them have
attached to them a sunset period. If any of them are adopted,
you should put them in the law for a limited period of time,
direct the SEC to follow what is happening on the ground as
they are enacted. Then you will have the information to be able
to evaluate the proposals as they are running as an experiment.
And then the law should end unless the SEC could be able to
satisfy itself that the benefits are outweighing the costs of
the changes.
So that would be a general suggestion for all of them. Just
a couple quick points on two of them. I do think S. 1933, the
IPO bill, is the most carefully written and calibrated,
cautious of the bills, the most likely to do more good than
harm. I still think it should be sunsetted. The sunset period
would need to be several years because the whole point of the
bill is to allow a multiyear phase-in to public company status.
I am frankly a little skeptical that some of the changes
will do much because I think the downturn in IPOs was not
really driven primarily by regulation. The downturn started
before Sarbanes-Oxley and continued even after companies had
been exempted from Sarbanes-Oxley. Nevertheless, that is not a
reason not to try it. I think as an experiment it would be a
good idea to try.
On the other hand, I think 1824 raising the 12(g) threshold
to 2,000, is the most risky of the proposals, and just to state
one simple fact, half of the public companies that are
providing to Compustat could go dark as a result of that one
change. I do not think the proponents really have thought
through whether they want to embark on that kind of radical
deregulation without much careful thought.
Just one company, Hyatt Hotels, a public float of $1.6
billion, it has 504 record holders, so it would be able to go
dark immediately. I do not think that is the kind of company
that the proponents have in mind when they are thinking about
raising and making it easier to comply with the 1934 act.
Thank you.
Chairman Reed. Thank you, Professor Coates.
We have been joined by Senator Toomey. Senator, do you want
to make a few initial comments?
Senator Toomey. Thanks, Mr. Chairman. I will pass on that.
Chairman Reed. Thank you very much.
At that point let me now recognize Ms. Mitchell. Ms.
Mitchell, please.
STATEMENT OF KATE MITCHELL, MANAGING DIRECTOR, SCALE VENTURE
PARTNERS
Ms. Mitchell. Thank you, Chairman Reed and Ranking Member
Crapo and Senators. Thank you for the opportunity to speak
today and for your attention to the issues of capital formation
and investor protection. With research showing that 92 percent
of a company's job growth occurs after its IPO, restoring
access to the public markets for emerging growth companies is
of national importance.
In that spirit, I would like to begin by publicly
supporting S. 1933, the Reopening American Capital Markets to
Emerging Growth Companies Act of 2011. I believe that this
bipartisan legislation will help spur U.S. job creation and
economic growth at a time when we desperately need both, and it
will do so without increasing risk for our country's investors.
My support of S. 1933 is an outgrowth of my service as
chairman of the IPO Task Force, a private and independent group
of professionals representing experienced CEOs, public
investors, venture capitalists, securities lawyers,
academicians, and investment bankers. We came together
initially at the Treasury Department's Access to Capital
Conference in March that Chairman Reed referred to where the
dearth of IPOs was discussed at length.
In response to this concern, we formed a task force to
develop practical yet meaningful recommendations for restoring
effective access to the public markets for emerging growth
companies. Because public investors were an integral part of
our team, we believe that the scaled regulations that we
recommend, which S. 1933 reflects, strikes the right balance
between targeted reform and maintaining appropriate regulatory
safeguards.
Why do we believe reform is necessary? For the last half-
century, America's most promising young companies have pursued
IPOs to access the additional capital they need to hire new
employees, develop their products, and expand their businesses.
However, over the last 15 years, the number of IPOs has
plummeted. From 1990 to 1996, over 1,200 U.S. venture-backed
companies went public on the U.S. exchanges. Yet from 2004 to
2010, there were just 324 of those offerings.
A number of analyses suggest that there is no single event
behind this decline; rather, the cumulative effect of recent
regulations along with changing market practices and economic
conditions has driven up costs and uncertainty for emerging
growth companies and has constrained the amount of information
available to investors about such companies, making them more
difficult to understand and to invest in.
The Reopening American Capital Markets to Emerging Growth
Companies Act of 2011 addresses these issues in two crucial
ways.
First, S. 1933 provides emerging growth companies with a
limited, temporary, and scaled regulatory compliance pathway,
or on-ramp, that will reduce their costs for accessing public
capital without compromising investor protection. This on-ramp
period will enable emerging growth companies to allocate more
of the capital they raise from the IPO process toward growth
instead of meeting compliance requirements designed for much
larger companies. That means they can use that capital to hire
new employees and grow their businesses.
The on-ramp status scales regulations for a small number of
elements and would last only for a limited period from 1 to 5
years, depending on the company's size, and would require full
compliance as the company matures. In this way, the on-ramp
mirrors prior SEC regulatory actions that carefully balance the
need for capital formation and investor protection for the very
smallest of companies.
Second, S. 1933 addresses the flow of information to
investors about these small companies. When our task force
surveyed emerging growth CEOs, many of them expressed a concern
that the lack of available information about their companies
would lead to a lack of liquidity for their shares.
Interestingly, institutional investors expressed a similar
concern about the dearth of information and exposure they had
to IPO companies, making it difficult for investors to make
informed investing decisions about these new issues.
S. 1933 improves the flow of information about emerging
growth IPOs by allowing investors to have access to research
about the companies concurrent with their IPOs. The bill
provides a way for investors to obtain research about IPO
candidates while leaving unchanged the robust and extensive
investor protections that exist to ensure the integrity of
analyst research reports.
S. 1933 also permits small companies to test the waters
prior to filing a registration statement. By expanding the
range of permissible prefiling communications to institutional
and qualified investors, the bill would provide a critically
important mechanism for emerging growth companies to determine
the likelihood of a successful IPO. This also benefits issuers
and the public markets by allowing otherwise promising
companies to get investor feedback and avoid a premature
offering. It is important to note that all of the antifraud
provisions of the securities laws would still apply to these
communications, and the bill ensures that the delivery of a
statutory prospectus is still required prior to the sale of
securities.
In all these ways, S. 1933 provides measured, limited
relief to a small population of strategically important
companies with disproportionately positive effects on job
growth and innovation. That is why I urge the Members of this
Committee to support the passage of this bill. By doing so, we
can reenergize U.S. job creation and economic growth by helping
reconnect emerging companies with public capital without
compromising investor protection.
Thank you.
Chairman Reed. Thank you very much.
Please go ahead, Mr. Silbert.
STATEMENT OF BARRY E. SILBERT, FOUNDER AND CHIEF EXECUTIVE
OFFICER, SECONDMARKET, INC.
Mr. Silbert. Good morning, Chairman Reed, Ranking Member
Crapo, and Members of the Committee. I am grateful for the
opportunity to testify this morning.
The issues raised in my testimony directly impact startup
growth, job creation, and American global competitiveness. I am
here today representing now just my company and our 135
employees, but also the millions of job-creating entrepreneurs
around our country. I founded SecondMarket in 2004 to create a
regulated, transparent, centralized market for alternative
investments, including stock in private companies. Our unique
model allows private companies to create liquidity programs for
their stock as well as control every aspect of the program,
such as setting eligible buyers and the timing of trading
windows.
When a company uses SecondMarket to establish a liquidity
program, we require the company to provide financial
disclosures to all buyers and sellers in their market.
Transparency is a critical factor to ensure investor
protection, and we believe that all participants in a company-
sponsored program must have access to material information in
order to make informed investment decisions.
SecondMarket has become an important part of the capital
formation process. By helping companies provide interim
liquidity to shareholders, we serve as a bridge to an IPO for
companies that eventually want to go public or as an
alternative for companies that wish to remain private.
Up until a decade ago, fast-growing startups followed a
very similar capital formation path. They raised capital, a few
rounds of venture capital, and went public in about 5 years.
However, the capital formation process has evolved over the
past decade, and the public markets are no longer receptive to
smaller companies. It now takes companies twice as long, nearly
10 years, to grow large enough to reach the public market. As a
result, private companies are accumulating more shareholders
than ever. Thus, I believe that Congress should immediately
move to modernize the so-called 500 shareholder rule.
As you may know, the pay structure at startups generally
involves giving employees below-market salaries coupled with
stock options. These options enable employees to realize the
financial upside while also enabling the startup to hire top
talents. As a result, this rule has created a disincentive for
private companies to hire new employees, raise capital broadly,
or acquire other businesses for stock as companies fear taking
on too many shareholders and, thus, triggering the public
filing requirement.
There has been some recent discussion and even some
confusion regarding the mechanics around counting shareholders
for public and private companies and the distinction between
holders of record and beneficial owners. Today the vast
majority of securities of publicly traded companies are held in
``street name,'' meaning that the names of brokers who
purchased the shares on behalf of their clients are listed as
the holders of record. A broker may own stock on behalf of
several thousand beneficial owners, but the broker is
considered as only one holder of record.
While this dynamic is applicable to public companies,
private companies are quite different as they closely manage
their investor base and typically place restrictions on the
sale of shares. Accordingly, they do not want brokers holding
stock on behalf of individuals unknown to the company.
Therefore, shareholders of most private companies directly own
the shares and, thus, there is no distinction between the
number of holders of record and beneficial owners. Plus, if a
private company attempted to use a broker to circumvent the 500
shareholder rule, the SEC could use the anti-evasion in the
Securities Act to require companies to count the beneficial
owners as holders of record.
I believe that all the bills under consideration today are
important for our country's entrepreneurs and will improve
access to capital for startups, bolster job creation, modernize
and improve investment protection, and help entrepreneurs
pursue the American dream. However, I wish to focus on three
that warrant immediate passage.
First is S. 1824, which increases the shareholder threshold
from 500 to 2,000 record holders and also excludes employee
owners from the counts. The bill also contains a provision to
allow publicly traded community banks to deregister from the
SEC if they have less than 1,200 record holders. Worth noting,
this provision does not apply to other publicly traded
companies and will not increase the instances of companies
going--nonbanks going dark. So this means that Hyatt could not
go dark under this bill, and I would encourage Professor Coates
to reread the draft legislation.
There is strong support for this bill across the private
sector and a multitude of industries. This week, a letter was
sent to Congress signed by some of the leading American
technology entrepreneurs, venture capitalists, and angel
investors urging immediate passage of the bill. And just
yesterday, the Progressive Policy Institute, an independent
think tank, issued a white paper strongly endorsing the
legislation.
The next bill is S. 1831, which eliminates the ban against
general solicitation in the context of private placements
provided that the purchaser qualifies as an accredited
investor.
And, finally, I fully support S. 1933, which establishes an
on-ramp for a new category of small issuers to help them go
public.
These complementary bills will make it easier for smaller
private companies to flourish and grow into large job-creating
public companies. The problems facing startups must be
addressed, and the failure to support these young companies
will significantly limit access to capital, restrict job
growth, stifle innovation, and weaken the U.S. globally.
Thank you.
Chairman Reed. Thank you very much.
Mr. Luparello, please.
STATEMENT OF STEPHEN LUPARELLO, VICE CHAIRMAN, FINANCIAL
INDUSTRY REGULATORY AUTHORITY
Mr. Luparello. Chairman Reed, Ranking Member Crapo, and
Members of the Subcommittee, thank you for the opportunity to
testify today. My name is Steve Luparello, and I am vice
chairman of the Financial Industry Regulatory Authority, or
FINRA. We appreciate the Subcommittee's continued focus on
improving access to capital for startups and small businesses
while maintaining protections for investors.
The Federal securities laws provide protection to retail
investors through several mechanisms: antifraud authority,
disclosure, regulation of intermediaries, qualification of
investors, and market regulation. These fundamental protections
are intended to achieve two primary objectives. First, they are
designed to protect customers from abusive or fraudulent
practices. Second, and equally important, they are intended to
provide the investing public with confidence that market
participants will treat their customers fairly.
In the course of our work, FINRA examines broker-dealer
firms for compliance with the securities laws, SEC rules, and
our own rules. That work covers the panoply of business models,
products, and communications used by broker-dealers. Per this
Subcommittee's request, I will focus my comments on the types
of activities and scenarios FINRA sees in the area of
unregistered securities and microcap fraud and the role that
oversight of intermediaries plays in the fabric of investor
protection.
Given that the current private placement market is a
relevant analogy to a number of the capital-raising proposals
under consideration, we believe our experience with that market
may be helpful to the Subcommittee.
The private placement market is an essential source of
capital for American business, particularly small firms.
Regulation D under the Securities Act of 1933 provides the most
important avenue for a company to privately issue shares.
According to one estimate, in 2008 companies intended to issue
approximately $609 billion of securities in Regulation D
offerings.
Private placements are an important source of capital for
many U.S. companies and are often sold directly by issuers
without the service of intermediaries. That said,
intermediaries often play a role, especially when the issuer
seeks to reach a broader set of potential investors. In those
situations, investors rightly have an expectation that the
intermediary will be objective.
Throughout our examinations and investigations, FINRA has
found significant problems in this segment of the market,
including fraud and sales practice abuses in Regulation D
offerings. FINRA recently sanctioned a number of firms and
individuals for providing private placement memoranda and sales
material to investors that contained inaccurate statements or
omitted information necessary to make informed investment
decisions.
As a response to these problems, last year FINRA issued
guidance to firms reminding them of FINRA's suitability rule
and broker-dealer obligations to conduct a reasonable
investigation prior to recommending Regulation D offerings. The
guidance also made clear that the requirement to conduct a
reasonable investigation is a duty of the broker-dealer that
arises from a long history of case law and under FINRA's just
and equitable principles of trade. This duty requires the
broker-dealer to understand the Regulation D securities and
take reasonable steps to ensure that the customer understands
their risks and their essential features.
In October, FINRA filed with the SEC proposed rule
amendments specifically to require that firms make basic
disclosures about private placements that they recommend to
their retail customers. Still pending at the Commission, this
proposal would require firms to disclose the anticipated use of
offering proceeds, the amount and type of offering expenses,
and the amount and type of compensation to be paid. The
proposal would also require notice filings with FINRA of a
broker-dealer's private placement activities.
Turning to microcaps, this market consists of issuers that
are often startup or shell companies whose stock is thinly
traded in the over-the-counter market. These companies
generally are not followed by independent financial analysts,
and the publicly available information about the company may
not provide a sufficient basis to evaluate the company's claims
about its business prospects.
FINRA has referred over 500 matters to the SEC in the last
2 years involving potential microcap fraud. Often fraudulent
schemes in microcap stocks seek to exploit well-publicized news
events or trends. We have referred matters to the SEC involving
stocks linked to China, the gulf oil spill, gold, and clean
energy.
As noted above, Federal securities laws and SRO rules
provide a variety of protections to retail investors. The
legislative proposals currently under consideration attempt to
build in some or all of those mechanisms. We hope that by
sharing our experiences in dealing with the regulatory
challenges in the private placement market, we will provide
useful insight as the Subcommittee continues to evaluate the
many bills pending relative to this issue.
We would be happy to continue to work with the Subcommittee
and its Members as you consider how best to balance the goals
of providing new opportunities for building capital while
protecting investors.
Again, thank you for the opportunity to share our views,
and I would be happy to answer any questions that you have.
Chairman Reed. Thank you very much.
Mr. Hiraide, please.
STATEMENT OF MARK T. HIRAIDE, PARTNER, PETILLON, HIRAIDE &
LOOMIS, LLP
Mr. Hiraide. Chairman Reed, Ranking Member Crapo,
distinguished Members of the Committee, thank you very much for
the opportunity to appear here today to discuss risks in
investor capital raising. My name is Mark Hiraide. I am a
partner with Petillon, Hiraide & Loomis in Los Angeles. I am a
securities lawyer and, of course, I am familiar with the costs
associated with raising capital that Professor Coates
referenced.
The importance of early-stage capital to our economy and
the challenges to entrepreneurs in accessing it, even prior to
the recent economic downturn, has been well documented. In my
experience, a startup's first seed capital of investment, the
investment between $250,000 to about $500,000, is critical to
the development of a healthy equity market food chain. By that
I mean this initial funding level allows technologies and
concepts to be validated or not. With such validation, our
client entrepreneurs may then move up the food chain to be
considered by professional venture capital and angel investors.
I believe that the failure to feed this portion of the food
chain is in large part responsible for the starvation of the
IPO market.
Now, can the Internet and modern communication technologies
help close the funding gap? If the current statutory
limitations on conducting private offerings are eliminated,
what are the risks to investors? I look forward to answering
your questions regarding each of the bills being considered by
the Committee. However, I would like to share my experience
that may prove helpful in your consideration of the
crowdfunding legislation, as this legislation has the greatest
potential for abuse, along with the risk of going dark, which
Professor Coates referenced.
Yes, it is true that one of the bills, S. 1824, relates to
increasing the 500 shareholder limit under Section 12(g)
relating to banks, but other legislation being considered would
apply that across the board to all companies.
Attempts at utilizing technology to make processes more
efficient, in this case the market for seed and early-stage
capital, are not new. In the early 1990s, as the world was for
the first time coming online, ``disintermediation'' was the
mantra. Technology would cut out the middleman. In the case of
the market for early-stage capital, however, it did not.
In 1997, the Small Business Administration's Office of
Advocacy, working with the SEC and NASA, launched the Angel
Capital Electronic Network, more commonly known as ACE-Net. It
was an Internet-based matching service for accredited investors
and entrepreneurs seeking up to $1 million in seed financing.
Although ACE-Net provided a mechanism through which
entrepreneurs could conduct a general solicitation of their
offering, ACE-Net was not successful, in part because
sophisticated investors simply did not identify investment
candidates by searching companies at random over the ACE-Net
portal. Without an active connection between entrepreneurs and
the investment community, deals did not get done. Although
today many more people are connected through social media, a
passive portal or even several of them through which an
investor may access potentially hundreds of investment
opportunities may not be the catalyst to spur seed round
capital formation.
The old adage that securities are sold, rarely are they
purchased, especially by nonprofessional investors, was as true
in 1997 as it was in 1933 and as it is likely true today. We
learned that more sophisticated individual investors invest
when the investment has, in some sense, been validated.
Although this validation may come in the form of participation
in the offering by recognized investors, most often, it is
based on a recommendation from a trusted advisor.
Yes, the sharing of information by crowds will force
entrepreneurs to answer important questions. However, we cannot
ignore that the active involvement of securities professionals,
both those regulated by Mr. Luparello as well as those
unregulated, participate in the capital raising process and
this is a reality that is critical to capital formation.
Now, if I can just address for a moment the unregulated
market, in Southern California as well as other places around
the country, the so-called securities consultants have emerged.
Others refer to them as boiler rooms. They are a class of
unregulated securities salespersons who work to develop
relationships with individuals, many of whom were at home and
retired. Although oftentimes the individuals solicited appeared
on a list of purportedly prequalified investors, in most cases,
investors were solicited by telephonic cold calls. Eventually,
the experienced unlicensed salesperson indeed developed a
preexisting relationship with the investors as many of these
investors serially invested in deals offered by the
salesperson. For the unlicensed securities intermediary, this
investor pool served as their wellspring, which they continued
to tap, generating for themselves literally hundreds of
millions of dollars in commissions during the Internet boom and
beyond.
I believe the challenge in adopting new legislation to
stimulate early-stage capital formation is to maintain
effective regulation over those professionals while not
imposing too high a regulatory barrier to entry and to ensure
incentives are not inadvertently created that lead to the
formation of unregulated securities markets.
I look forward to answering your questions.
Chairman Reed. Thank you very much. Thank you all for your
excellent testimony.
We will do 7-minute rounds, and if we want to do a second
round, I think we will have the time. We have a vote at 10:45,
I am told.
Thank you all again. One of the conclusions that I think
emerges from all of your testimony, both written and oral, is
that this is a multidimensional problem as a result of actions
taken over probably two decades, some intended, some
unintended. And I was particularly struck with Mr. Silbert's
testimony, where he laid out the problems in the public stock
market: Online brokers, which takes the place of the trusted
advisor who you knew and was registered; decimalization;
Sarbanes-Oxley; global research settlement, which restricts
access to research for these new companies; high frequency
trading, which is now 75 percent of the trading, and startling
to me, over the past 40 years, the average time the public
market investor holds stock has dropped from approximately 5
years in 1970 to less than 3 months today, which essentially
suggests that the market is not a place where someone is going
to invest in an emerging company, hold it, et cetera. This is
just get in and get out as fast as you can. And it also raises
the question, too, given the shock of 2007, 2008, et cetera, of
just the public's appetite to invest in the stock market at
this time.
So with all of these factors together, and it goes back to
a point I think Professor Coates suggested, all this
legislation is thoughtful and meaningful, but is it going to
fix the problem? Is the problem much bigger than that? Is it
about investor confidence? Is it about all the factors Mr.
Silbert laid out so graphically? And will this have any effect,
any of this legislation, or are there much bigger problems? And
that is sort of a cosmic question, so I will begin with
Professor Coates and ask all the panelists to respond.
Mr. Coates. So I think the answer is consistent with what I
said in my opening remarks, which is I do not know whether all
of this will do anything. I think, as I indicated, S. 1933, as
crafted, is the most promising as a way to reduce some of the
marginal costs faced as a company approaches an IPO. If you
think about what a company approaching an IPO is wrestling
with, they are having to adapt their mindset to projecting to a
public that they have never had to deal with before, and if you
add to that having to also completely redo the relationship
with their auditor because they are going to be subject to
Sarbanes-Oxley, I could see that that might deter some
companies from making that final step. And since the effect of
the bill would be to delay and not eliminate the need to
develop a good control system, one that a good, big public
company ought to have, then I think it is an experiment worth
running, but I do think it is an experiment and it is something
that ought to be watched carefully.
I think if you took all of the bills as currently written
and passed them all, I honestly think collectively they would
have the opposite effect of what they are all individually
intended to do because I do think each of them opens the way to
different types of potential fraud, different types of
potential abuse by some people, not all, but some. And all it
would take is for a significant front-page story about a
crowdfunded fraud to reap fairly severe damage on the existing
successful business models of companies like Mr. Silbert.
So that is why I urge caution and I urge that each bill be
thought about separately and together to think about the
possible effects, but to sunset whatever you do and have the
SEC track closely what is going on on the ground.
Chairman Reed. Ms. Mitchell, your comments, please.
Ms. Mitchell. I will be quick, and I agree with Professor
Coates that S. 1933, the nice aspect of that piece of it is
that it builds on existing regulation, because straying too far
away from that, we thought, was not appropriate from an
investor protection point of view.
The question you asked about is there a bigger issue here,
I think is a very fair one. Certainly, IPOs are impacted by
broader economic cycles, such as what is happening in Europe
and what is happening in credit markets, so there is absolutely
no doubt about that.
It is interesting, though. When you looked at the CEO
survey that we did, and it came out much more strongly than I
would have expected, over 85 percent of pre- and post-IPO CEOs
were concerned and felt that the markets were not as friendly
as they were back in the mid-1990s, the time that we really
want to bring back, and that reticence, therefore, to want to
build a company that could go public and take it all that way
is what is really hurting the economy.
And again, we do not want to go back to the bubble period
of 2000. I think there were a lot of things about that that
were wrong, and why this regulatory structure makes sense that
we have got today and why we want to work within it. But when
you go back to 1990 to 1995, there were 496 IPOs per year under
$200 million, and those were small companies. This year, it is
89. Last year, it was 120. We have not gotten over 200 in the
last decade. So it really is down.
Interesting, and it was noted in the IPO Task Force Report,
the returns for the first year post-IPO exceeds that of the
broader market. And when we talk to institutional investors
across the board, their frustration on behalf of their retail
constituents, meaning pensioneers and the retail investors and
their funds, was they could not get access to the growth that
they were able to in the late 1980s and 1990s. They like
regulated markets because they are more consistent, fair,
transparent, and they cannot get the growth for their clients,
and again, pensioneers and retail customers, that they could
previously. So----
Chairman Reed. Thank you.
Ms. Mitchell. ----I think both are true.
Chairman Reed. Mr. Silbert, then we are going to get
everybody.
Mr. Silbert. So thank you for making note of my testimony.
I think we have got three choices. We can do nothing. We can
try to fix all the public market's problems. Or we can make
incremental fixes and changes when it makes sense.
You know, Kate did mention in her testimony that there was
not one cause of all of this. I think at the end of the day, if
you look at this as efforts to create jobs, these create jobs.
You know, with all respect to Professor Coates, in reading his
bio, I am not sure he has personally created jobs. In talking
with technology entrepreneurs, in talking with angel investors,
in talking with venture capitalists, they are all behind this.
The New York Stock Exchange is behind this. Wawa is behind
this. Cargill is behind this.
So at the end of the day, while I would love to have a
separate conversation with you about the broader public market
issues, I think specifically as it relates to this legislation
for trying to create jobs, this is all good for job creation.
Chairman Reed. Mr. Luparello.
Mr. Luparello. Mr. Chairman, I would quickly align myself
with your statement about the need to look at the broader
issues especially around market structure and the secondary
market. Whether it is around incentives to provide liquidity or
disincentives to provide liquidity or just fundamental investor
confidence based on things like high-frequency trading, fixing
the front end of the market without analyzing the market
structure issues that also continue to be out there, that seem
to be creating barriers to individual investors wanting to
participate, is essential to get the broader look at the
picture.
Chairman Reed. Thank you.
Mr. Hiraide.
Mr. Hiraide. Yes, Senator. After having practiced
securities laws for 27 years, I agree with Professor Coates'
characterization of the bills as largely an experiment,
underscoring the need to carefully consider the consequences,
both intended and unintended.
I also agree with Professor Coates regarding the cost of
accessing capital and balancing it against the cost of capital.
Increasing fraud, increasing loss of investor integrity of the
market is going to raise costs of capital and impact job
growth.
One comment with respect to this issue of going dark. The
going dark issue has to do with eliminating the requirement to
comply with the Securities Exchange Act of 1934, protections
such as periodic reporting, insider trading restrictions, other
restrictions such as those. The issue of going dark is very
concerning to me because many companies with many large numbers
of shareholders will be able to go dark. By increasing the
limits both to enter the system but also to exit the system, it
is going to, in my opinion, largely increase the number of
companies that will not be subject to 1934 Act reporting, 1934
Act protections, as well as the other protections that publicly
traded companies are afforded. Thank you.
Chairman Reed. Thank you.
Senator Crapo, please.
Senator Crapo. Thank you very much, Mr. Chairman.
I think I would like to explore with the panel this issue
of going dark a little better so we understand it, because--and
I will start with you, Professor Coates, and we can let others
who want to get in on this discuss it. Professor, you indicated
that raising the shareholder threshold cap to 2,000 would allow
more than half of the public companies to go dark.
As I understand it, though, S. 824 would allow a private
company going forward to take advantage of the new provisions,
but that if a nonbank currently public company wanted to try to
deregister, they would still be subject, as I understand it, to
the deregistration requirements of the code. Then they would
have to meet the current 12(g)(4) requirements that nonbanks
must have less than 300 record holders before they could
deregister. Am I missing something there?
Mr. Coates. No. I think that is absolutely right. The point
that I was trying to get across was that companies like Hyatt,
and just to pick another one, Accenture, currently has less
than 100. So it would not have to comply with the 1934 Act
unless it chose to, which it has obviously chosen to do.
But your question is a great question because it points out
that, currently, the 500 shareholder rule is itself outmoded.
That part I agree with the proponents of the revisions. But the
reason it is outmoded is because nobody uses recordholders in
the way that people used to. Almost all new public companies
have brokers intermediating between the ultimate shareholders
and the company. And so it would not require an intentional
fraudulent scheme, as Barry was suggesting earlier, to produce
the ability of companies to remain completely private. It would
just be most normal public companies will increasingly be able
to remain outside the scope of the 1934 Act if they choose to
by having the intermediaries between them.
Senator Crapo. So that is prospective, right?
Mr. Coates. Absolutely, and I assume that is the kind of
companies that Barry is mostly focusing on. I was using Hyatt
as an example of a very large company as an illustration of the
kind of company we would not think we would want to be private,
with as many shareholders as it, in fact, has.
Senator Crapo. So then I will let others who want to speak
on this do so, but if I understand you right, then you are not
saying that the bill would allow half those currently
registered companies to go dark. What you are saying is that
companies like those that----
Mr. Coates. Yes.
Senator Crapo. --are currently registered would not have to
comply if the law were changed.
Mr. Coates. Correct, but I would add one other thing, which
is that unless the recordholder test is changed to something
more sensible, like beneficial holders or public float, over
time, the companies will, in fact, be able to go dark because
they will be below 300, which is the test that, as you suggest,
would prevent them from exiting the system. So there is a
problem. It is just not the one that is being identified in the
bill.
Senator Crapo. Mr. Silbert, did you want to respond?
Mr. Silbert. Yes. Thank you. So let us separate this into
two issues. There is the way the bill reads. Just so I think
everybody is clear, the bill does not allow nonbanks to go
private, to go dark. There is no change to that. It is still
300. The change is with respect to community banks.
So on the topic of record versus beneficial owners, as I
had mentioned in my written and oral testimony, Hyatt or any of
these folks, they could do it today if they wanted to, if they
wanted to try to cram their thousands of shareholders into 300
slots. So this draft legislation does not affect their ability
to do that.
But as I mentioned before, as well, private companies,
recordholders equals beneficial. It is really that
straightforward. We are unaware--I am unaware of any instances
where that is not the case. It is different in the public
market. In the public market, there are a lot of benefits to
doing it in street name, but there is not in the private
market.
Senator Crapo. Thank you.
Mr. Hiraide, did you want to----
Mr. Hiraide. Yes. Thank you, Senator Crapo. I was referring
to other legislative efforts that I wrote about to reduce the
12(g) limit with respect to nonbank companies. But as I
understand S. 1894, applicable to bank and bank holding
companies, it will reduce the--increase the 12(g)
deregistration from 300 to 1,200 shareholders. And again, that
is shareholders of record, not beneficial owners. So all those
shares held in street name are not counted.
The concern I have with going dark, whether it is applied
to bank or nonbank, is that the company is not subject to,
again, the stringent requirements of the 1934 Act. As an
example, a company would be able to go dark, then no longer
report to its public shareholders other than the information
that is required by State law, which is very minimal. The
company could then effect a going private transaction. That is,
they could cash out minority shareholders and not be subject to
the 1934 Act's requirement under Rule 13(a)(4), which requires
very comprehensive disclosure when a company goes private, that
is, when it cashes out minority shareholders.
The 1934 Act requirements require full disclosure,
sunshine, about all of the conflicts of interest in a cash out
transaction. Typically, you have the majority controlling
shareholder cashing out the minority. The minority is not able
to negotiate, and so the minority is forced to accept the price
that the majority shareholders determine is fair.
Now, the State law, of course, imposes fiduciary
responsibilities on the directors of the corporation, but the
kind of sunshine provisions, as I call them, the disclosure
provisions under the 1934 Act, the protections that Rule 1383
affords, provides kind of a prophylactic that the transactions
will be fair to minority shareholders.
Senator Crapo. All right. Thank you.
Ms. Mitchell or Mr. Luparello, did you want to respond on
this one? All right.
Then my last question, then, I would like to direct to you,
Ms. Mitchell. I am looking at the ``Rebuilding the IPO On-
Ramp'' report and I am looking at the chart that shows the
information you presented about the decline of U.S. IPOs. For
some time, we have actually had on our side a Republican task
force on capital markets, trying to figure out why we are
seeing this precipitous decline in the United States and what
we can do about it, and I would just like to ask you if you
could, in terms of your role as a leader in this report, just
explain what are the various factors that you think have led to
the decline of our IPOs in the United States from the mid-1990s
to today.
Ms. Mitchell. Well, certainly, and it is interesting, when
you look, by the way, at the data that is in that report, what
you see is actually the decline in IPOs begins when a lot of
these regulations start to be implemented, which actually even
predate Sarbanes-Oxley, which is 2002 and the late 1990s,
electronic trading, decimalization, et cetera. And you see the
IPOs start to decline, particularly small company IPOs as the
economy continued to not only grow, but, in fact, boom. So you
see that while economic cycles certainly make a big impact on
small companies, these regulations have also had a significant
impact.
And when we spoke to CEOs, their perspective on this is
that it is very daunting. They are concerned that they are
unprepared, that it takes too much of their capital. If I am a
small company, every $100,000 I have in front of me--I have
duct tape on my carpet--every $100,000 in front of me is a
choice. Do I hire a new employee or do I prepare to go public
in a market that is uncertain? It has become so much more
expensive, and they often choose to build their company. But
that is why we have almost 90 percent of the companies today
being sold off to larger companies as divisions, which, in
fact, serves to reduce jobs, not bring them forward.
So that is why we went back and said, what can we do to
make a meaningful impact on that but yet be practical in our
approach? Let us see what we can do to reduce the cost and
improve investor communication, but do so in a way that does
not disrupt markets, as Professor Coates referred to.
Senator Crapo. Thank you.
Chairman Reed. Thank you very much.
Senator Merkley.
Senator Merkley. Thank you, Mr. Chair, and thank you all
for your testimony.
I wanted to shift to the crowdfunding issues and
specifically how we balance the ability to raise substantial
sums for small companies against the accountability and avoid
the boiler room challenge that was mentioned or ``pump and
dump'' schemes, et cetera. I have introduced a bill in
partnership with Senator Bennet and Senator Landrieu to try to
strike a balance, after consultation with a number of experts,
and that is S. 1970.
But I wanted to specifically start, Mr. Hiraide, with I
think you have had a chance to look at that. We put in
individual limits, per person, per company. We set, if folks
are more affluent, $50,000 annual income, they can invest
larger amounts, 1 percent of their income. More than $100,000,
they could invest more. We have left to the SEC the ability to
regulate the number of individual stock investors. You can
raise $1 million a year. We have left in accountability for the
accuracy of the statements that are issued, basic financial
information that would have to be provided. Those are the basic
outlines of what we have tried to do to give enough
information.
And then, also, we have put in a rapid response fraud
clause in which every 6 months for the first 2 years, the SEC
would do a report, a study of fraud on the crowdfunding
activities, and would have the power to adopt rules to address
issues that come up so that we try to be able to respond
quickly to making sure that blatant issues are addressed with
the viewpoint that confidence, investor confidence, is
extremely important to maintain if this is going to be a
successful avenue for people to raise funds and successful for
investors to make money, if you will. Those are the basic
outlines, but I just wanted to get your thoughts.
Mr. Hiraide. Yes, Senator. I am familiar with all of the
crowdfunding bills, the bill that was passed by the House as
well as the two in the Senate, including S. 1970.
Let me say that I fully support the intent behind the
crowdfunding bills. However, I share Professor Coffee's
concerns that unregistered salespersons may abuse the broker-
dealer exemption set forth in Section 7 of the S. 1791 Senate
bill. Unregistered salespersons of the sort that I describe, I
think, will, with little effort, satisfy the requirements for
the exemption from broker-dealer registration in Section 7 of
S. 1791.
On the other hand, S. 1970 that you mentioned adopts a
regulatory regime for intermediaries that require them to
either elect to register with the Commission as a broker-dealer
or as a newly defined funding portal, be subject to several
definitional prescriptions. S. 1970 appropriately limits the
scope of permissible activity of a funding portal by
prohibiting it from offering investment advice, soliciting
purchases, compensating employees, agents, or other third
parties for such solicitation.
S. 1970 also provides reasonable limits on maximum
individual investment limits. I think by including an aggregate
limit applicable to all crowdfunded investments in addition to
dollar investment limits per company, S. 1970 addresses a
concern known as stacking, whereby an individual investor
invests in successive offerings but manages to satisfy the
requirements of each individual offering.
I think, finally, again, with respect to S. 1970, the
million dollar exemption limit may be adjusted by the
Commission to reflect the annual change in the Consumer Price
Index, and I think if the Commission were permitted by rule to
increase the exemption limit, the exemption, if successful for
seed offerings up to a million, could be scaled up to cover
even a greater portion of the funding gap.
So I do believe that S. 1970, while again keeping in mind
that all of these bills are experimental efforts, including
this one, I think S. 1970 does balance the need to facilitate
access to critical seed capital with important investor
safeguards.
Senator Merkley. And you referred to the million dollars as
a million dollars per year, but I take your point about being
scalable.
Mr. Silbert, you are immersed in thinking about these kinds
of issues. Do you have a sense of how some of these different
strategies might be striking the right balance or might be
missing the mark in terms of a reliable crowdfunding
marketplace?
Mr. Silbert. So the concept of crowdfunding is an exciting
one. It is one that I think we have seen some initial success
with on projects. You know, Kickstarter is an example that is
used frequently. I am not aware of there being any fraud issues
there. I also understand that overseas, there are some
successful crowdfunding platforms. You know, specific kind of
safeguards, which I agree are incredibly important. I think
investor protection is very important.
I cannot comment specifically on what has been suggested,
but I do think that is, whether it is considered a pilot or
what have you, it is a very exciting opportunity for us to
create additional capital flows to these small growing
businesses.
Senator Merkley. Well, I will look forward to following up
with you to bring some more specifics and what we have learned
from the foreign examples which we have been examining.
Would anyone else like to kick in on this crowdfunding
approach? Yes.
Mr. Luparello. I guess I would add that to the extent to
which the bill focuses clearly on the role of intermediaries
and the increased likelihood of fraud, it is focusing on
exactly the right things. We have concerns in the private
placement market that we regulate now that intermediaries can
play a very helpful role, but can also, again, because of that
expectation of objectivity, play a very destructive role. And
looking at the obligations that get placed on intermediaries in
the crowdfunding space is as important as it is in the private
placement space that exists right now because there will be
possibilities for fraud, and that ability to enforce both
against issuers and intermediaries will be important to
ensuring that there is no loss of confidence in this effort.
Senator Merkley. One thing we tried to do was leave in--and
I will just close with this closing comment because my time is
up--but to require the entrepreneur who is providing the
information to be accountable for material misstatements or
omissions so that there is a real direct incentive to be
presenting accurate information. That is one of the many
pieces.
Thank you, Mr. Chair.
Chairman Reed. Thank you very much.
Senator Toomey, please.
Senator Toomey. Thanks very much, Mr. Chairman, and thanks
to all the witnesses for this very helpful testimony.
I would like to ask a question of Ms. Mitchell about bill
1933, but first I just want to comment on the characterization
that Professor Coates and I think Mr. Hiraide have made about
these bills as a series of proposals for experiments.
At least in the case of 1933, certainly, it seems to me
that one of the central provisions, one of the most important
provisions in this bill, if not the most important provision,
is the fact that it would allow these emerging growth companies
for a limited period of time--so a very small subset of all
companies for a limited period of time--to simply be relieved
of a relatively new regulation, which is 404(b) of Sarbanes-
Oxley, which is only about 10 years old. So for untold previous
decades, while the United States capital markets became the
largest, deepest, most efficient, most sophisticated, most
advanced markets in the history of the world, we never had any
such regulation during that entire period of time. So to
suggest that we simply go back to that regime for a brief
period for a small subset of companies does not strike me as
terribly experimental, but it does strike me as very
constructive for the companies that would otherwise be faced
with the very, very expensive cost of complying with this
provision.
But I had a narrower question for Ms. Mitchell, if I could,
which is, with respect to this bill, is it your understanding
that this bill would actually reduce or eliminate the ability
of the SEC and FINRA to regulate analysts with respect to small
companies? Or would it, rather, enable the small emerging
growth companies to simply get the kind of coverage that bigger
companies get?
Ms. Mitchell. Absolutely. Senate bill 1933 that you
sponsored absolutely builds on and extends existing
regulations. We really made a point of wanting to be, again,
meaningful but practical. And when it comes to investor
communications, yes, it modernizes it; yes, it allows small
companies to have the same ability to communicate with
investors as large companies do. It does it within the context
of existing regulations, and SEC and FINRA absolutely continue
to regulate this market, particularly for research analysts.
I would also say, by the way, to your comment earlier about
404(b), I agree. I do not see that as an experiment--you know,
certainly an experiment to recent history, but not our long
history; and, second, not an experiment if I am Ford Motor
Company and going public, I get 2 years to comply with 404(b).
We are simply saying for a smaller company, give me another 3
years.
So, again, we were looking to do things that really built
on existing regulations to go forward, including investor
communication.
Senator Toomey. Thanks. I look at it as giving small
companies the opportunity to grow into the ability to handle
this cost.
Ms. Mitchell. Absolutely.
Senator Toomey. Thanks very much for that. I have a couple
questions for Mr. Silbert, if I could, about bill 1824, because
it seems to me--and I was hoping you could develop it from the
testimony that you provided--that in many ways the limit that
we have on shareholders now has unintended consequences that
curb the ability of small companies to grow and prosper and
have the unintended effect of making our capital markets less
efficient.
So, for instance, you point out that this limit on the
number of shareholders under current law makes it harder to
compensate employees, especially prospective employees, with
stock options, because over time options get exercised, you
have new shareholders. Is that a significant consideration, do
you think, for growing companies?
Mr. Silbert. Absolutely. The fact that this bill has been
characterized as an experiment I do not think is necessarily
the right way to look at it. It really is updating a rule that
was put in place in 1964, so we are almost 50 years later now.
The markets have changed. Companies are staying private twice
as long as ever.
Senator Toomey. I acknowledge that. I just want to make a
couple of other points. Just to observe the other ways in which
we are limiting flexibility and growth in these companies, tell
me if you disagree. One is the ability of small and growing
companies to acquire other companies using their stock as a
currency, which I know from personal experience can be a very,
very important way to grow. Do you----
Mr. Silbert. I agree. The ability to buy other companies
with your stock has not been an option for private companies.
Senator Toomey. So we curtail the flexibility of these
companies to expand in their marketplace or others. I do not
remember seeing this in your testimony, but it strikes me that
given the shareholder limitation, if a company needs to grow
and needs access to capital, could this have the unintended--
the current low shareholder threshold, could it have the
unintended effect of driving companies a little bit on the
margin, more toward debt instead of equity? You can go to a
bank and borrow more money without triggering these
requirements.
Mr. Silbert. I think that probably happens, and I think it
is important to understand that enabling companies to raise
capital with the institutions and accredited investors on a
broader basis is going to result in lower cost of capital for
those companies.
Senator Toomey. And, Ms. Mitchell, at the end of the day
this increase in the number of shareholders would, as a
practical matter, allow more--typically accredited investors,
and that is who is typically making these investments.
Ms. Mitchell. Right, right.
Senator Toomey. So these tend to be sophisticated people--
--
Ms. Mitchell. Absolutely.
Senator Toomey. ----who have the knowledge, the experience,
and the ability, and the resources to understand what they are
getting themselves----
Ms. Mitchell. Some of the same investors that end up
investing in IPOs are the same investors that this bill refers
to as well, and it provides flexibility for these companies so
that they can time their approach to the market when they are
ready and when the markets are friendly to IPOs.
Senator Toomey. And I welcome any input from anybody on the
panel, but it seems to me the cumulative value of giving
greater flexibility in terms of whom you hire and ways that you
can compensate potential employees, greater flexibility in how
one acquires other companies, diminishing unintended
consequences such as perhaps favoring debt over equity, and the
fact that the expanded universe would apply mostly to
accredited shareholders anyway, I think the cumulative effect
of these is clearly progrowth and clearly encourages the growth
of these companies. But I would welcome comments from anybody
on this.
Mr. Coates. I have already said I disagree with your last
general statement, but I will make just one point about the
expansion of the record holder trigger. It has been referred to
frequently as outdated. I have not seen anybody articulate why.
Unlike the asset threshold which has to be adjusted with
inflation over time to reflect growth in the economy, the 500-
shareholder threshold originally was meant to be a test for the
capacity of dispersed shareholders who do not know each other,
who do not have an ability to communicate with each other very
easily, and even if they can, have a hard time coordinating
their action, to use their rights collectively that they have
to own the company, their rights as owners of the company. And
it seems to me that 500 still remains a pretty good number for
thinking about how difficult it is to organize and get people
to agree. I think that is roughly the number of people in
Congress, and Congress sometimes has a hard time getting
coordination among itself. And 500, it seems to me like a
reasonable number to use even today for difficulties of
dispersed owners to coordinate their activities.
Senator Toomey. I would just suggest that Congress is
dysfunctional for many reasons that might not relate directly
to the numbers, but I would also suggest the ability to
communicate is now just unspeakably superior to what it was
when this regulation was put into effect, and to share
information.
Mr. Coates. With due respect, not about coordinating, for
example, a proxy fight, a lawsuit, something to enforce one's
rights that you have as an investor in a company, those things
actually remain quite difficult to accomplish. Even for
publicly held companies with 30 institutions, they have a very
hard time sometimes getting together to put pressure on a board
to do something that is clearly the right thing to do.
Mr. Toomey. I see I am running out of time, but if the
other panelists would have a chance to respond, Mr. Chairman, I
would appreciate that. Any further comments?
Mr. Hiraide. Yes, Senator. I agree with you completely that
having stock as currency is very critical to our economy. I
would note, though, that unless there is a public market for
the stock, most investors are not going to be likely to want to
take stock as currency unless they have the opportunity to
liquidate.
One other comment about Section 404(b) of Sarbanes-Oxley,
and I can only share with you my anecdotal experience, but we
have had--404(b), of course, is the requirement that an outside
auditor attests to the internal controls of management. We have
had the requirement on the books since 1977 with the enactment
of the Foreign Corrupt Practices Act to maintain adequate
internal books and controls. When Sarbanes-Oxley was enacted,
frankly I wondered whether or not we needed to have an
additional requirement to have outside auditors look at the
internal controls when the requirements were already on the
books.
Similarly, with SOX's requirement to make the CEO and CFO
certify a number of matters that they were already liable for
under the existing provisions of the 1934 act because they were
required to sign documents filed with the SEC prior to the
enactment of SOX.
But now, after having experienced SOX and counseled
companies in a number of years since the enactment of SOX, I
have to say that those requirements of SOX, in my opinion,
significantly enhanced the accuracy of the financial reporting.
For some reason, the CFO and the CEO having to sign a
certification makes a difference. Similarly with SOX's
corporate governance provisions regarding committee charters,
for some reason having the charter, having the requirement that
the committee actually have a charter that the directors have
to sign and read enhances corporate governance.
Now, with respect to Section 404(b) in particular, I think
initially when SOX was first adopted, there was quite a bit of
uncertainty and costs associated with complying with 404(b), I
think primarily because it was a completely new requirement.
SOX created a completely new agency, the PCAOB. The PCAOB was
enacting completely new regulations, and so there was a lot of
uncertainty after SOX's initial implementation about how to
comply. And, yes, it did increase very significantly the costs
for public companies of complying. But I think those were
initial transitional costs. For the most part, our clients now
understand what the requirements are. Again, those requirements
have always been on the books. The requirement of 404(b) is
simply that the auditors come in and attest to management's
assertions about the adequacy of internal control. And I have
to say that after the experiences with Enron, Adelphia, and
Tyco, which all occurred before SOX--and, again, while the
requirement to have adequate internal controls was on the
books, the inclusion of the 404(b) requirement, in my opinion,
enhances the accuracy of financial reporting.
Senator Toomey. Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Toomey.
The questions of all my colleagues have been extremely
thoughtful, and to raise just two general areas that I would
like to quickly raise, one, Ms. Mitchell, it seems--and I might
be grossly mischaracterizing it--that the choice for the
emerging entrepreneurial private company is do I go public or
do I sell to a big company. And we are trying in these various
legislative proposals to reduce the costs of going public. But
I will ask you since you are a practitioner. It would seem to
me that if someone comes in and says, ``I am buying the
company, here is a check,'' that is a pretty costless--you
know, relatively costless transaction on the part of the
entrepreneur. Is there any way--I am being a little
melodramatic--any way you can lower the cost enough with these
proposals that that option is no longer attractive? Or I guess
alternatively, have we found ourselves in a situation now where
there is not really, given this competing alternative with big
companies that are going out aggressively buying other
companies, that that is the reason why the IPO market is not so
hot any longer and that is not going to be directly affected by
what we do or may do?
Ms. Mitchell. Well, certainly an M&A transaction can be
attractive in the short run, and particularly even to the
private investors that are invested in a small company. The
cost of that, though, is future growth and job creation. You
know, one of my colleagues often says, ``Imagine what Seattle
would look like without Microsoft and what Silicon Valley would
look like without Intel.'' And that is really the issue, and
entrepreneurs do want to build big companies that actually
become dominant, large providers.
One of the interesting things you see actually even in the
M&A market is there are significantly fewer acquirers because
there have been no new IPOs. There has been incredible
consolidation that actually serves to lower that opportunity.
And, again, those are companies that can even be acquired ex
U.S., with, therefore, some of the drain of both jobs and
innovation outside our borders that we really do not want to
have happen.
Let me also go back to Mr. Hiraide's comments about 404(b).
I do not disagree with him in spirit. The bill 1933 that is
being proposed in the Senate right now, A, still requires
disclosure of material weaknesses; B, the CEO and CFO still
certify, and they take that incredibly seriously. And you saw
that in responses to our small company survey, they absolutely
comply with all corporate governance.
And, again, we are not suggesting that 404(b) does not have
value, but if Ford Motor Company gets 2 years, a small startup
should get 4 or 5.
Chairman Reed. And let me raise another general question,
too, and that is, we have talked a lot about stocks, you know,
stockholders, the number, et cetera. It seems to me--I mean,
the question can be raised, this notion of beneficial ownership
seems to be outdated if you can have a company like Hyatt that
has 100 owners--you know, beneficial ownership versus record
owner, 100 owners--we had a few days ago a hearing in which
Wawa, which is very well run, prosperous convenience store
operation, is a private company, but all their employees are
part of some type of stock plan, which is one record owner. So
there are thousands and thousands of people that actually have
an interest in the stock, yet it is a private company.
Do we have to start thinking beyond just these bills in
terms of definition of beneficial ownership? And I would say
also accredited investors. Let me ask for Professor Coates'
comment.
Mr. Coates. Yes, I completely agree with the idea that
before thinking about where to draw the line, we ought to be
drawing the line on the right thing. And right now we are
drawing the line at record holders, which means one thing for a
new company and means something completely different for a
public utility that has been around for decades and, therefore,
has lots of retail local record holders. So we have got both
apples and oranges in the way we are measuring things, and a
record holder in the end is going to go away. I mean, by the
time we all retire on this panel, it really will be a
completely meaningless concept.
So the right thing to do is to think either about
beneficial ownership or about public float, which is
essentially the same thing but related just to market value of
the outside ownership. I would use that as the test.
One last point on this that Barry said a couple times, that
private companies do not have intermediaries owning their
stock. That may be quite true for lots of private companies. It
may be completely true for all the companies that he is
familiar with. It is not true generally for the private company
universe. Privately held companies that are owned by PE funds,
for example, have layer upon layer of intermediaries owning the
stock of privately held companies. And so if you want to think
more generally about the right way to structure the triggers
for Securities Exchange Act registration, I think to stick with
record owner is a mistake, as you suggest.
Chairman Reed. Mr. Silbert, you want to comment?
Mr. Silbert. Yes, thank you. There is an important
distinction between street name and then whether it is held as
a custodian or through a fund like Gates, two different
concepts. So I completely agree. Private company stock is held
in lots of different places, but it is not held in street name
for the purposes of that one broker appearing as one record
holder on the books.
Chairman Reed. Thank you. Any other comments?
[No response.]
Chairman Reed. Once again I want to thank the panel for
excellent testimony and very thoughtful responses to questions.
Your testimony has provided us critical insights as we grapple
with what we recognize as a common challenge, which is to grow
jobs here in this country, and to use our securities laws to
help facilitate job growth without endangering investors,
because there are two sides to every one of these issues, at
least.
If my colleagues have their own written statements or
additional questions for the witnesses, I would suggest they be
submitted no later than next Wednesday, December 21st, prior to
Christmas.
I ask unanimous consent to include in the hearing record a
summary of State enforcement actions concerning fraud and
capital formation in Internet offerings from the North American
Securities Administrators Association.
And also a letter from Jeff Lynn from the Coalition for a
Digital Economy. Without objection, so ordered.
The witnesses' complete testimony will become part of the
hearing record. We ask that any additional questions for our
witnesses be submitted no later than close of business next
Wednesday, December 21st. And the witnesses are asked to
respond to any questions within 3 weeks. I note that the record
will close after 6 weeks in order for the hearing record to be
prepared for printing.
Thank you again very, very much. With that this hearing is
adjourned.
[Whereupon, at 10:55 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF JOHN C. COATES IV
John F. Cogan, Jr., Professor of Law and Economics, Harvard Law School
December 14, 2011
Abstract
Amid an economic downturn caused in part by financial deregulation, it
is odd to most people outside the Beltway that Congress should be
actively considering (and indeed have passed in the House) a raft of
proposal for more financial deregulation. Yet the politics for both
parties require efforts to generate job growth, without spending or
taxing, and some deregulatory proposals may plausibly do that. The
following testimony takes up three themes related to pending proposals
to revise securities laws to (among other things) deregulate widely
held but unlisted companies and banks, to permit unregistered
``crowdfinancing,'' and to loosen constraints on small public
offerings: (1) the proposals under review all raise the same general
trade-off, which is best understood not as economic growth vs. investor
protection, but as increasing economic growth by reducing the costs of
capital-raising vs. reducing economic growth by raising the costs of
capital; (2) no one can with any degree of certainty predict whether
any proposal on its own, much less in combination, will increase job
growth or reduce it, because the evidence that would allow one to make
that prediction with confidence is not available; and (3) the proposals
are thus all best viewed as proposals for risky but potentially
valuable experiments, and should be treated as such--with an open mind,
but also with caution and care. A general suggestion follows: any
proposal should contain a sunset, with the SEC directed to study the
effects of the proposal during a ``test'' phase, and authorized to re-
adopt the proposals if their benefits exceed their costs. Specific
comments on each bill are contained in Part III of the testimony. [JEL
classification: G18, G21, G24, G28, G30, G32, G38, K22]
Introduction
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, I want to thank you for inviting me to testify. Effective
and efficient securities regulation is a foundation for economic
growth, and I am honored to comment on the topic of protecting
investors in the capital-raising process.
In Part I of my remarks, I make three preliminary and general
points: (1) the proposals under review all raise the same general
trade-off, which is best understood not as economic growth vs. investor
protection, but as increasing economic growth by reducing the costs of
capital-raising vs. reducing economic growth by raising the costs of
capital; (2) neither I, nor any other witness, nor the SEC, nor any
third party, can with any degree of certainty predict whether any
proposal on its own, much less in combination, will in fact increase
economic growth or reduce it, because the evidence that would allow one
to make that prediction with confidence is not available; and (3) the
proposals are thus all best viewed as proposals for risky but
potentially valuable experiments, and should be treated as such--with
an open mind, but also with caution and care. In Part II, I make a
general suggestion that could be applied to any of the proposals that
are adopted that is in keeping with the need for cautious and careful
experimentation. In Part III, I provide responses to specific questions
I was asked to address in the invitation to testify, including comments
on each of the pending bills.
I. Growth vs. Growth, Uncertainty, and Experiments
While the various proposals being considered have been
characterized as promoting jobs and economic growth by reducing
regulatory burdens and costs, it is better to understand them as
changing, in similar ways, the balance that existing securities laws
and regulations have struck between the transaction costs of raising
capital, on the one hand, and the combined costs of fraud risk and
asymmetric and unverifiable information, on the other hand.
Importantly, fraud and asymmetric information not only have effects on
fraud victims, but also on the cost of capital itself. Investors
rationally increase the price they charge for capital if they
anticipate fraud risk or do not have or cannot verify relevant
information. Antifraud laws and disclosure and compliance obligations
coupled with enforcement mechanisms reduce the cost of capital.
Each reform bill proposes a different way of achieving growth:
lowering offer costs but raising higher capital costs (because of fraud
risk and asymmetric information). Whether the proposals will in fact
increase job growth depends on how intensively they will lower offer
costs, how extensively new offerings will take advantage of the new
means of raising capital, how much more often fraud can be expected to
occur as a result of the changes, how serious the fraud will be, and
how much the reduction in information verifiability will be as a result
of the changes.
Thus, the proposals could not only generate front-page scandals,
but reduce the very thing they are being promoted to increase: job
growth. Suppose, for example, that the incidence of fraud is likely to
be higher among issuers that rely on the reforms. \1\ If so, and if
investors cannot distinguish between new, higher-fraud-risk issuers
from the current flow of lower-fraud-risk issuers, the changes may
increase the cost of capital for all issuers at a rate in excess of the
increase in new offerings facilitated by lower offering costs. \2\
There is rarely a truly free lunch in this world.
---------------------------------------------------------------------------
\1\ This assumption is widely believed. For example, one proponent
of a crowdfinancing exemption states, ``Small businesses propose a
disproportionate risk of fraud.'' C. Steven Bradford, ``Crowdfunding
and the Federal Securities Laws'', Working Paper (Oct. 7, 2011), at 62.
But it is surprisingly difficult to find hard evidence to back up this
claim. Bradford cites Jill E. Fisch, ``Can Internet Offerings Bridge
the Small Business Capital Barrier?'', 2 J. Small & Emerging Bus. L. 57
(1998) and William K. Sjostrom, Jr., ``Going Public Through an Internet
Direct Public Offering: A Sensible Alternative for Small Companies?'',
53 Fla. L. Rev. 529 (2001). Fisch relies on an SEC Web site that does
not provide detailed data, and Sjostrom cites Fisch and Donald C.
Langevoort, ``Angels on the Internet: The Elusive Promise of
`Technological Disintermediation' for Unregistered Offerings of
Securities'', 2 J. Small & Emerging Bus. L. 1 (1998). Langevoort relies
on Louis Loss & Joel Seligman, ``Fundamentals of Securities Regulation
301'' (3d ed. 1995), who rely on Joel Seligman, ``The Historical Need
for a Mandatory Corporate Disclosure System'', 9 J. Corp. L. 1, 34-36
(1983), who relies on the SEC's 1963 ``Special Study'', which found
that of 107 fraud proceedings in 1961 and 1962, 93 percent involved
issuers not subject to the Securities and Exchange Act of 1934 (1934
Act), i.e., unlisted issuers, and on a 1980 GAO report finding that in
the 3 years ended 1978, in 142 private placements triggered SEC fraud
investigations, but the studies do not rigorously compare large and
small firm securities offerings. One more recent set of data consistent
with the claim is contained in Tables 11, 18, and 25 of Appendix I of
the Final Report of the SEC's Advisory Committee on Smaller Public
Companies, dated Mar. 3, 2006, available at www.sec.gov/info/smallbus/
acspc/appendi.pdf, which shows that in 2004 and 2005 the percentage of
firms with material weaknesses in their financial reporting control
systems was over 20 percent at firms with less than $75 million in
market capitalization, as compared to less than 5 percent for firms
with greater than $10 billion in market capitalization, the percentage
of firms with material weaknesses declines almost monotonically with
market capitalization, and also declines (albeit less consistently)
with revenues. See also, ``Separate Statement of Mr. Schacht'', at 71
Fed. Reg. 11130 (stating ``these small firms . . . make up the bulk of
accounting fraud cases under review by regulators and the courts (one
study puts it at 75 percent of the cases from 1998 to 2003),'' but not
providing any reference). Compare Jonathan M. Karpoff, D. Scott Lee,
and Gerald S. Martin, ``The Cost to Firms of Cooking the Books'', 43 J.
Fin. Quant. Anal. 581-612 (2008) (Table 2, showing that the incidence
of enforcement actions for financial reporting in the period 1978-2002
by firm size, and that the number of actions was similar across firm
size deciles, based on all firms in the CRSP database); Natasha Burns
and Simi Kedia, ``The Impact of Performance-Based Compensation on
Misreporting'', 79 J. Fin. Econ. 35-67 (2006) at 55 (larger firms
within the S&P 1500 over the period 1995 to 2002 were more likely to
announce an accounting restatement).
\2\ The benefits of securities disclosure regulation are
articulated and/or evidenced in, among others: Luzi Hail and Christian
Leuz, ``International Differences in the Cost of Equity Capital: Do
Legal Institutions and Securities Regulation Matter?'', 44 J. Acc'g
Res. 485-(2006) (``firms from countries with more extensive disclosure
requirements, stronger securities regulation and stricter enforcement
mechanisms have a significantly lower cost of capital''); Andrei
Shleifer and Daniel Wolfenzon, ``Investor Protection and Equity
Markets'', 66 J. Fin. Econ. 3-27 (2002); Allen Ferrell, ``The Case for
Mandatory Disclosure in Securities Regulation Around the World'',
Brooklyn Journal of Corporate, Financial, and Commercial Law 81 (2007-
2008); Allen Ferrell, ``Mandated Disclosure and Stock Returns: Evidence
From the Over-the-Counter Market'', 36 J. Legal Stud. 213-51 (2007)
(finding that 1964 Securities Acts Amendments reduced volatility and
increased returns among OTC firms compared to benchmark NYSE-listed
firms); Michael Greenstone, Paul Oyer, and Annette Vissing-Jorgensen,
``Mandated Disclosure, Stock Returns, and the 1964 Securities Acts
Amendments'', 121 Q.J. Econ. 399-46 (2006) (finding that OTC firms
subject to new disclosure mandates in the 1964 Securities Act
Amendments experienced abnormal returns around the passage of the law);
cf. Robert Battalio, Brian Hatch and Tim Loughran, ``Who Benefited From
the Mandated Disclosures of the 1964 Securities Acts Amendments?'', J.
Corp. Fin. (forthcoming 2011) (finding no statistical difference in
announcement returns for OTS firms moving to NYSE before or after 1964
Securities Acts Amendments and claiming that OTS firms already were
disclosing substantial information, but not addressing fact that the
SEC ``Special Study'' that led to the 1964 legislation found that many
firms were not disclosing information, that many of those disclosing
information left substantial gaps in the information, that disclosures
that were being made were not adequately enforced, given that Rule 10b-
5 litigation had not developed at the time; the article also
inconsistently dismisses nondifferences in NYSE seat prices on the
ground that the 1964 legislation was anticipated before its adoption,
but treats nondifferences in announcement of NYSE-listings before and
after the 1964 legislation as showing the legislation provided no
benefit to investors in OTC firms).
---------------------------------------------------------------------------
The reform proposals all present difficult judgments about what
will best increase job growth--and not a simple choice between
generating job growth versus protecting investors. The trade-offs are
highly uncertain, one by one, and even more uncertain in combination.
Specific ways the proposals risk increasing the cost of capital to all
entrepreneurs are discussed in Part III below. Between them, the SEC,
the PCAOB, and FINRA already have authority to enact all or nearly all
of the proposals without a Congressional act. These bills can thus only
be understood as experiments in Congressional micromanagement of those
agencies, which in general terms have more expertise and resources
dedicating to studying the trade-offs than any other group of public
officials.
It is true, however, that the agencies would need to get public
comments on any of the reforms before adopting them. In the process,
they probably would improve the results. But they would take a long
time to do that, even in the best of times. And these are times of
stress for the financial regulatory agencies as much as for the
financial markets. Fewer than one in five of the rules required of the
SEC and other financial regulatory agencies under Dodd-Frank have been
finalized, and the public is in the middle of commenting on (and the
agency staff are still trying to digest comments on) more than 50
pending regulatory proposals from the SEC alone. \3\ Congress did not
give the SEC self-funding authority in Dodd-Frank, and as a result, the
SEC is budget-constrained, \4\ and cannot devote the resources that
would be ideal to trying to move towards smarter regulation.
---------------------------------------------------------------------------
\3\ See, Davis Polk Regulatory Tracker, ``Dodd-Frank Progress
Report'' (Dec. 1, 2011), at 4-5.
\4\ In 2011, the SEC was allocated $115 million less than its
budget request, and was able to hire staff for 342 fewer full-time
equivalent positions than it sought to do, despite taking in more than
its request in fees. Compare U.S. Securities and Exchange Commission,
FY2011 Congressional Justification (Feb. 2010) (www.sec.gov/about/
secfy11congbudgjust.pdf, last visited December 11, 2011) at 8-9, with
U.S. Securities and Exchange Commission, FY2012 Congressional
Justification (Feb. 2011) (www.sec.gov/ about/ secfy12congbudgjust.pdf,
last visited December 11, 2011), at 9-10.
---------------------------------------------------------------------------
(This is a point that those who oppose ``active'' regulatory
agencies often miss--the same procedures and budget constraints that
slow or deter regulation also slow and deter deregulation or improved
regulation. Congress could fix this by giving the SEC the same self-
funding authority it has given to the Federal Reserve Board, or by
requiring the SEC to devote a portion of its budget to deregulatory
proposals, or simply by giving the SEC enough funds that it has no
excuse for moving slowly on reform proposals. Even if one of these
proposals were implemented, however, the Administrative Procedures Act
(APA) \5\ would mean that the SEC would move slowly on any reform
proposal in any event.)
---------------------------------------------------------------------------
\5\ 5 U.S.C. 551 et seq.
---------------------------------------------------------------------------
In addition, finally, the agencies would have also to worry about
being sued. In recent years, it has become an almost predictable ritual
that any new and controversial rulemaking by the SEC will attract
litigation by trade groups that perceive their members as having been
disadvantaged by the rule, even for what distant observers would view
as ``deregulation.'' Frequently, the SEC has lost this litigation, \6\
at times on grounds that have been in my view legally dubious. \7\
Knowing that court scrutiny of this kind is likely even when an agency
advances a modest but controversial reform would make any regulatory
agency rationally reluctant to move quickly, and instead will lead it
to act deliberately to pile up as impressive a record as possible to
present in the expected litigation.
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\6\ For example, Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006)
struck down a SEC rule requiring registration of hedge fund advisers
under Advisers Act); Financial Planning Assoc. v. SEC, No. 04-1242
(D.C. Cir. Mar. 30, 2007) struck down a SEC rule exempting broker-
dealers from Advisers Act despite receiving ``special compensation'' if
``incidental'' to brokerage; PAZ Securities, Inc. v. SEC, No. 05 1467
(D.C. Cir. July 20, 2007) struck down an SEC order affirming expulsion
of a NASD-member firm and barring its president from the securities
industry for failing to comply with various examination requests;
American Equity Investment Life Ins. Co. v. SEC, 613 F.3d 166 (D.C.
Cir. 2010) struck down a rule treating a new class of annuities as
securities; Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005)
struck down a rule mandating proportion of independent directors on
mutual fund boards.
\7\ The D.C. Circuit's recent decision striking down the SEC's
``proxy access'' rule is a case in point. Business Roundtable v. SEC,
647 F.3d 1144 (D.C. Cir. 2011). Despite the SEC having debated the
issue for over a decade, developed an extensive public record before
enacting Rule 14a-11, and adopted the rule under the explicit authority
and implicit direction of Congress in Section 971 of the Dodd-Frank
Act, a panel of the D.C. Circuit struck the rule down as ``arbitrary
and capricious'' on the ground that the 25 single-spaced pages devoted
to cost-benefit and related analyses in the adopting release was
inadequate under the APA and ``failed . . . adequately to assess the
economic effects of a new rule.'' The D.C. Circuit failed to
acknowledge that there is no currently available scientific or other
technique for the SEC to ``assess the economic effects'' of the rule
along the lines that the Court seemed to think legally required--as
when the Court held that the SEC ``relied upon insufficient empirical
data when it concluded that Rule 14a-11 [would] improve board
performance and increase shareholder value by facilitating the election
of dissident shareholder nominees,'' at 1150, or when it held that the
SEC had ``arbitrarily ignored the effect of the final rule'' because
the SEC ``did not address whether and to what extent Rule 14a-11 will
take the place of traditional proxy contests,'' at 1153. Instead, the
D.C. Circuit substituted its own judgment for that of the SEC in
evaluating the existing research relevant to proxy contests, going so
far (for example) as to characterize (without explanation) a peer-
reviewed article published in the Journal of Financial Economics as
``relatively unpersuasive.'' At 1151. This result was clearly not
intended by Congress in adopting the APA, and is clearly inconsistent
with decades of precedent under that statute, including a 2005 decision
by the same court, Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir.
2005), which held at 143 that the SEC need only ``determine as best it
can the economic implications'' of a rule to be upheld under the APA.
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As a result, given the urgency of the political and economic
situation, and given that no more straightforward jobs proposal seem to
be acceptable to both parties, it is understandable why these
experiments are being proposed now, despite their already being
underway SEC studies of several of the proposals, and despite the
uncertainties they raise. It would also be understandable if lawmakers
ultimately choose to act now, and not wait on agency action. But if it
does that, it should do so with the uncertainty about the growth-growth
trade-offs presented by the reform experiments in mind.
II. A General Suggestion
Given that any of these proposals will entail risks of increasing
fraud and capital costs, even if modified as I suggest in Part III
below, or as suggested by others, it would make sense to include in all
of the adopted proposals a sunset provision, such that the proposals
would by their terms last for no more than 2 or 3 years (or, in the
case of S. 1933, 7 years). At the end of that testing period, they
would remain in place if--but only if--the SEC affirmatively finds that
the benefits of continuing the proposals would outweigh their costs.
During the testing period, the SEC would be able to complete its
currently underway studies, as well as track the use of the new
capital-raising options, as well as the extent of fraud that they
permit. If the fears of fraud are overblown, and capital has been
raised as their backers suggest will be the case, then the cost-benefit
analysis should be simple, and the reforms would become permanent. If,
however, large amounts of fraud occurs in the test phase, or if even a
modest amount of fraud occurs but the reforms do not permit meaningful
amounts of new capital-raising, then the agencies might not be able to
conclude their benefits outweighed their costs, and the reforms would
end.
To be practical, this suggestion might in some cases involve
grandfathering market participants, as well as simple and inexpensive
notice provisions to allow the agencies to track the use of the
reforms, as already reflected in the crowdfinancing proposals. The
reforms could be tested in this way individually, so that some could
remain in place and other not.
The advantage of the sunset approach would be to generate at least
some of the information that would be needed to evaluate the reforms,
to allow the reforms to be used but only for a modest time before that
evaluation is completed, to allow for capital raising in the short-
term, while the economy is stressed, and allow for a measured
revisiting of the reforms once (we all hope) the economy has returned
to a more normal state. Congress could, of course, reenact the reforms
on a permanent basis if it disagrees with the agencies.
III. Specific Responses and Comments
The following remarks respond to comments in the invitation to
testify:
1. What factors influence the timing and extent of an issuer's access
to the capital markets? How does investor confidence impact markets?
What factors contribute to a high degree of investor confidence in the
securities markets?
The extent and timing of an issuer's access to capital markets
depends on both demand and supply side factors. On the demand side are
the number, \8\ wealth, \9\ intelligence, \10\ liquidity- and risk-
appetites, and confidence of investors, which affects market liquidity,
\11\ as well as the attractiveness of opportunities to spend or invest
their money elsewhere. On the supply side, the foremost factors are
those that make a given issuer a potentially good investment: the
quality of the issuer's management, business plan, and its growth
prospects, etc. But other supply side factors are important, include
the legal protections afforded investors (including both the laws and
the enforcement mechanisms for those laws), \12\ the information
required or voluntarily disclosed to investors, \13\ including by way
of analyst coverage, \14\ and the direct offering costs of raising
capital from investors.
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\8\ Yakov Amihud and Haim Mendelson, ``Asset Pricing and the Bid-
Ask Spread'', 17 J. Fin. Econ. 223-249 (1986) (liquidity increases firm
value and lowers its cost of capital).
\9\ Annette Vissing-Jorgensen, ``Limited Asset Market
Participation and the Elasticity of Intertemporal Substitution'', 110
J. Pol. Econ. 825-853 (2002).
\10\ Mark Grinblatt, Matti Keloharju, and Juhani Linnainmaa,`` IQ
and Stock Market Participation'', 66 J. Fin. 2121-64 (2011).
\11\ E.g., Pankaj K. Jain and Zabihollah Rezaee, ``The Sarbanes-
Oxley Act of 2002 and Capital Market Behavior'', 23 Contemp. Acc'g Res.
629-54 (2006).
\12\ La Porta, et al., ``What Works in Securities Laws?'', 61 J.
Fin. 1-32 (2006), at 20 (in a cross-country study, laws mandating
disclosures and public enforcement of those laws ``has a large economic
effect'' making initial public offerings more common); Luzi Hail and
Christian Leuz, ``International Differences in the Cost of Equity
Capital: Do Legal Institutions and Securities Regulation Matter?'', 44
J. Acc'g Res. 485-(2006) (``firms from countries with more extensive
disclosure requirements, stronger securities regulation and stricter
enforcement mechanisms have a significantly lower cost of capital'');
Dan S. Dhaliwal, ``Disclosure Regulations and the Cost of Capital'', 45
So. Econ. J. 785 (1979) (adoption of additional disclosure requirements
lowered the cost of equity capital for covered firms).
\13\ S. Myers and N. Majluf, ``Corporate Financing And Investment
Decisions When Firms Have Information That Investors Do Not Have'', 13
J. Fin. Econ. 187-221 (1984); D.W. Diamond and R.E. Verrecchia,
``Disclosure, Liquidity and the Cost of Capital'', 46 J. Fin. 1325-59
(1991).
\14\ Darren T. Roulstone, ``Analyst Following and Market
Liquidity'', 20 Contemp. Acc'g Res. 551-78 (2003) (more analyst
coverage increases liquidity, which lowers the cost of capital).
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The largest single direct offering cost for any public offering is
usually the cost of hiring underwriters--which almost uniformly charge
7 percent for initial public offerings in the U.S., as compared to 4
percent in the EU. \15\ Offering costs also include those that are the
focus of the pending reform proposals: legal, compliance and audit
costs, both for the offering and on an ongoing basis as a result of
laws triggered by capital-raising on the markets, which can be
significant, particularly for smaller issuers. As noted, however, a
reduction in these costs can be more than offset in an increase in
capital costs, if the reduction in direct offering costs decreases
investor confidence or the content or reliability of information
required by investors.
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\15\ Mark Abrahamson, Tim Jenkinson, and Howard Jones, ``Why Don't
Issuers Demand European Fees for IPOs?'', 66 J. Fin. 2055-82 (2011).
Data from Renaissance Capital shows that the median annual U.S. IPO
raised between $94 and $157 million in the 2000s (see,
www.renaissancecapital.com, last visited Dec. 8, 2001). Thus, $7
million were typically paid to the underwriters in the typical U.S. IPO
in recent years. Average underwriter fees were more than twice as high,
due to some large issuers (e.g., General Motors) pulling up the average
offering size. Total legal, audit, and compliance costs for an IPO, by
contrast, are reported to be $2.5 million. IPO Task Force, Rebuilding
the IPO On-Ramp, Presented to the U.S. Treasury (Oct. 20, 2011).
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2. What legal, financial, and practical risks do companies face when
offering securities through the Internet or other social media?
In general, the use of the Internet and social media do not in my
view dramatically change the risks that companies face when offering
securities from the risks that are present whenever the public is
solicited to invest, except that offers via Internet and social media
are able to reach a much larger potential investor group more quickly,
and without care and expense, their Internet-based efforts will be
treated (as they should be) as a general solicitation covered by
Section 5 of the 1933 Act. I discuss the effects of the Internet more
particularly below, in the context of commenting on the crowdfinancing
proposals below.
3. What risks do investors face when investing in publicly held
securities?
The economic risks include fraud, expropriation, and loss of
investment, risks present in any investment. Many investors also fall
prey to the illusion (sometimes reinforced by luck) that they can
safely trade in and out of publicly held securities on a frequent
basis, not focusing on the dramatically negative effects that frequent
trading by uninformed or poorly informed investors typically have on
their total returns over time. The risks are generally lower for
publicly held securities, because the investments are liquid, because
the issuers are required to make disclosures, reviewed by the SEC
staff, because the issuers are subject to greater compliance
obligations, and because more public enforcement resources are devoted
to public companies than to private companies. Nevertheless, the risks
remain.
4. What investor protections (e.g., basic disclosures, liability, etc.)
should exist when securities are sold to investors in public or private
markets? Should those protections vary with the size of the offering,
whether they are public or private, and whether they are offered to
mainstream investors or accredited investors?
Investors should receive the most efficient bundle of protections
that trades off the marginal cost of capital-raising, which represents
the cost of those protections, against the marginal cost of capital,
which is determined in part by the value of those protections. The
precise configuration of protections is likely to vary across
investments, investor dispersion (widely held vs. closely held), firm
and offering size, and the nature of the investors. In general terms,
the current SEC approach makes sense: generous exemptions and
relatively light requirements for securities privately placed with
qualified institutional buyers, narrow exemptions and heavier
requirements for securities sold to the dispersed and often
unsophisticated retail investors. One observation is that in my view
the current ``accredited investor'' test is too weak--too many
nominally accredited investors obtain the wealth that qualifies them as
such in ways that do not reflect any ability or training to invest
wisely (e.g., inheritance, gifts, high salaries for talented young
athletes). It would be better if the SEC took more seriously the job of
dividing knowledgeable investors from others, through the use of
tests--such as we require for everyone to legally drive, and create
incentives for those who cannot or do not have the interest in so
qualifying to invest through intermediaries, such as diversified mutual
funds. \16\ Congress could direct the SEC to do so.
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\16\ Stephen Choi, ``Regulating Investors, Not Issuers: A Market-
Based Proposal'', 88 Cal. L. Rev. 279 (2000).
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5. Do secondary market investors face risks different from those who
purchase securities primary offerings? How does the availability of
information in the secondary market affect liquidity and price?
Yes, the risks are different in secondary and primary offerings. In
a primary offering, there is usually no prior market price, and
investors must decide on a price on their own, based on their due
diligence and information received from the company. In a secondary
offering, at least one in a genuinely liquid market, a new investor can
rely to an extent on prior market prices to at least simplify the task
of price formation. Of course, secondary market prices can be
manipulated, particularly if the market is illiquid, and secondary
market prices are only as good as the information on which the prior
trades were based. More and better information typically increases
liquidity and price.
6. How would current legislative proposals affect investors? What
changes, if any, should be considered in these proposals?
The proposed reforms fall into four categories: (1) crowdfunding
(S. 1791 and S. 1970); (2) small offerings (S. 1544); (3) 1934 Act
registration triggers (S. 556, S. 1824 and S. 1941); and (4) initial
public offerings (IPOs) (S. 1933). I address each in turn.
1. Crowdfunding
The one genuinely new reform proposals on the table relate to
crowdfinancing. Modeled on crowdsourced volunteer successes such as
Wikipedia, person-to-person lending platforms such as Prosper
Marketplace, Inc., \17\ and crowdfunded (but not financed) schemes for
authorship or ownership rights to new music, plays, and discrete
products (but not securities or investments), such as Kickstarter, \18\
crowdfinancing promises to allow for entrepreneurs otherwise
unconnected to conventional early-stage financing sources (family,
friends, angels) to connect through the Internet to ``investors'' who
would be willing to risk small amounts to strangers for the hope of
angel-investments-like returns. For fans of the Internet, and for
entrepreneurs unable to raise capital in other ways, would-be
crowdfinanciers make an appealing pitch. Proponents add a dash of anti-
Wall-Street and/or Silicon Valley sentiment--crowdfinancing will enable
the common man to avoid entanglements with the corrupt traditional
centers of capital formation--and then point to a handful of
experiments in other countries to show that the model can work.
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\17\ On person-to-person lending, see, Andrew Verstein, ``The
Misregulation of Person-to-Person Lending'', 45 U.C. Davis Law Review
(forthcoming, 2011), available at http://ssrn.com/abstract=1823763.
\18\ On crowdfunded projects, see, Paul Belleflamme, et al.,
``Working Paper'' (June 2011), available at http://ssrn.com/
abstract=1578175.
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The entirety of the crowdfinancing concept suggests nothing to me
so much as a catchy, high-risk, and very possibly fraudulent investment
scheme. It might work. It might turn out to be a neat new thing. Or it
might turn out to be mostly a cheaper, better vehicle for fraud, with
negative spillover effects on the current person-to-person lending and
crowdfunding project sites. Let me sketch some reasons to be cautious
about crowdfinancing per se, as opposed to crowdsourced lending or
product funding or social entrepreneurship.
From the perspective of the honest entrepreneur, what does
crowdfinancing promise? Given the limits that all crowdfinancing
proposals currently include--particularly the cap of $1 million per
firm--the funds you can obtain this way will practically only benefit a
limited class of entrepreneurs--those working on low-capital-
expenditure, low operating-expenditure projects (such as software
products) that can be produced with sweat equity, a laptop, bandwidth,
and a coffee maker. Still, these firms may find the prospect of cheap
financing attractive, and the past 20 years have demonstrated
repeatedly that such firms can create real value.
Nevertheless, creators of such firms should think carefully before
moving to crowdfinancing. Without significant investment of time on
your part to screen investors, a host of strangers will end up owning a
chunk of your company. You will have obligations to them as a
fiduciary. Among them may be competitors, gadflies, journalists,
cranks, and crooks. They will have rights to get information from your
firm. They have standing to sue you. True, their rights are practically
useless to them in protecting their legitimate interests as
shareholders, but they can cause havoc in your already overworked
schedule simply by making demands or filing a complaint. Almost by
definition, they will be good at using the Internet to retaliate--with
gossip, rumors, exaggerations, or lies--if you treat them in ways they
do not think appropriate. If you succeed, their expectations will soar,
and if as is likely you eventually sell more equity--to a venture
capital fund, for example--you will likely need to cash out the
crowdfinancing investors in order to get the venture capitalists to
come in. If you ever need them to commit to a lock-up agreement or
otherwise facilitate an initial public offering, good luck trying to
get them all to agree. (Contrast this with person-to-person lending,
where the recipient receives cash in return for a fixed repayment
obligation, no different in kind than a credit card, that can generally
be paid off at any time.)
From the perspective of investors, crowdfinancing should be
understood as an act of faith, at least as it would play out under S.
1791. Investors would have no practically effective ways to collect any
return on their investment, except to the extent shares could be sold
to some other investor equally or more optimistic or irrational or
charitable or profligate, depending on one's point of view.
Under S. 1791, securities regulators will have no ex ante role to
play in reviewing disclosures. Ex post fraud liability, even if the
heightened standards normally applied under the 1933 Act were applied,
would do little to protect against such ordinary corporate transactions
as recapitalizations at a low price, low-price mergers with companies
controlled by the entrepreneurs, asset sales at a low price, or high
compensation reducing to nearly zero any cash flow that the firm were
to generate. While such actions might be actionable as breaches of
fiduciary duty under corporate law, they would not likely constitute
``fraud'' in the narrow sense that courts have interpreted Rule 10b-5.
As a practical matter, the small amount of money to be invested by any
one crowdfinancier would make a private corporate law suit cost-
prohibitive, and no self-respecting class action plaintiffs' attorney
could be relied upon to know about much less police start-ups that are
too small to even be called ``microcap.''
Unlike crowdfunded products, where a song or other computer-based
good can be obtained and its quality verified, investments take time to
grow in value, are constantly fluctuating in value, and are inherently
based on future--indeed, the standard finance model of the value of a
stock is to project future cash flows generated by the firm that has
sold that stock. Unlike person-to-person lending, where the borrower
has immediate interest or repayment obligations that can be monitored
cheaply, the entrepreneur receiving a crowdfinanced investment will
have no fixed obligations unless and until the firm is sold or
liquidated, before which time many corporate finance transactions can
rewrite the terms of the deal on a difficult-to-police basis.
While it is possible to imagine an honest entrepreneur using
crowdfinancing to generate a firm of great value and then, out of
honesty, sharing that value with the initial investors, a well-advised
investor would have to recognize that such outcomes will depend almost
entirely upon the character of the entrepreneur. While crowdfinancing
is unlikely to reach the scale to cause any serious systemic financial
problems, it would be well to remember that in the last financial
bubble, ``liar's loans'' were a common way for borrowers to obtain a
mortgage--essentially loans based on character. That method of finance
did not turn out so well.
In sum, crowdfinancing should be recognized as a long shot for both
entrepreneurs and investors alike. It might work, in very limited
contexts, if the participants have some social or other extra-legal
reason to trust one another, and to fulfill that trust. To the extent
crowdfinancing genuinely is meant to resemble its predecessors in the
Internet space, the investments would be made by numerous investors
(contrary to the usual angel or venture capital model) who nevertheless
know and vet each other through an existing and ongoing online
community, who can identify each other in a verifiable way (and so weed
out sock-puppets and shills) and can communicate with one another about
their common investments, rely on each other for information and
advice, and would only make small diversified investments with specific
safeguards, such as an escrow account into which investments would be
placed until a designated project amount was reached--the idea being
that no one investor's money would be used until the project had been
``approved'' by virtue of a large number of other investors committing
their money. And at the end of the day, the investors would make their
investments knowing, in effect, not simply that the investments were
``risky'' or even ``highly risky,'' but near-charitable donations that
might produce a windfall--more akin to a lottery than anything else.
While we can rely to an extent on reputation to substitute for law
in some contexts, and crowdfinancing intermediaries might be able to
develop and impose similar rules of the road on participants, we can
also count on some intermediaries to not do that extra work, and to try
to generate revenues in the short run on the hopes and dreams of
entrepreneurs and investors alike. When they do, and when the conflicts
and fraud emerge, the effects will spill over onto the otherwise
legitimate crowdfinancing intermediaries, and will further spill over
onto firms already successfully operating person-to-person lending
platforms and crowdfunded product platforms. In some ways, those firms
have the most to lose from an ill-considered experiment with
crowdfinancing.
Moreover, the limits that are currently in S. 1791 are not
practically enforceable. While individual investments are limited to
$1,000 per year, and any one firm can only raise $1 million in a year,
there is no mechanism required of issuers, investors, or crowdfinancing
intermediaries to verify whether the individual has complied with the
limit, other than the vague requirement that intermediaries ``take
reasonable measure to reduce the risk of fraud.'' (Even under current
rules, requirements that ``accredited investor'' status be verified are
weak at best, with investor self-certification and a short delay
sufficing at many online stock-trading platforms.) Even if we did not
feel sorry for investors who lied their way into a crowdfinanced Web
site, a fraudster could set up multiple fraudulent firms and attract
multiple investments of $1,000 each, greatly exceeding the savings of
most typical Americans. \19\ When that fraud is uncovered, all Web-
based financing efforts are likely to lose reputational capital, even
the diligent ones that do a good job of screening and monitoring
investors and entrepreneurs.
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\19\ ``A 2010 survey found that 30 percent of all [American]
adults had no savings (excluding retirement savings). . . . Forty-nine
percent of . . . respondents [to another survey] found it difficult
merely to pay all of their bills each month.'' Bradford, supra n. 1, at
n. 581.
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In contrast, the requirements of S. 1970 are more robust, and more
likely to prevent reputational spillovers of fraudulent crowdfinancing
schemes onto legitimate Internet based financial firms. By building in
express authority for the SEC to condition intermediary status on
various forms of investor protection, S. 1970 is a more thoughtful
delegation of difficult implementation issues. However, let me caution
that--as noted above--the current litigation climate affecting all SEC
regulation means that the SEC's ability to act on its authority cannot
be taken for granted. Thus, I would condition any sales under the
crowdfinancing exemption upon prior SEC rulemaking that is currently in
effect, so that if the rules were to be struck down by a court, the
exemption too would fall. And, as noted above, I would suggest having
any crowdfinancing exemption sunset by its terms after 2 or 3 years to
permit a careful review of how it is being used, before permitting it
to continue.
2. Small Offerings
The effort to reinvigorate Regulation A small offerings represented
by S. 1544 strikes me as neither promising nor threatening. It is not
particularly threatening (to capital costs or investor protection)
because without blanket preemption of State blue-sky laws, it is
unlikely to be used. It is not promising for the same reason, and
because Regulation D coupled with Rule 144A and innovations such as
SecondMarket make the small offering path to capital formation both
unattractive for policy reasons (why invite middle class investors to
invest with the least protections?) and practical reasons (if a firm
cannot raise funds from qualified institutional buyers, how likely is
it that a firm could do so from unaccredited investors--other than by
misleading them?).
If enacted, and particularly if a blanket blue-sky preemption
clause were included or added later, it seems to me that moving from $5
million to $50 million in one swoop is unnecessarily risky,
dramatically so in light of its reduced liability standards relative to
conventional public offerings, and even more so if Section 12(g)
triggers are raised, as separately proposed. Even though a good case
can be made for reducing disclosure, audit, and compliance costs for
smaller companies selling shares to the public, relative to large
existing public companies, this is better addressed by S. 1933, and
there is no clear reason to reduce the disclosure and liability
standards applicable to any public offering in which hundreds of
unaccredited investors are asked to speculate simultaneously on an
unproven technology and a control-free cash management system. If S.
1544 is adopted, I would combine the use of a sunset clause suggested
above with a more gradual approach to the amount: begin with a $15 or
$25 million exemption, which would revert to $5 million if the SEC did
not find that the higher threshold met a cost/benefit test, and
condition any further increase on a similar subsequent testing phase,
sunset, with review and reapproval by the SEC. In addition, caution
with this experiment would also suggest adding an all-time fund-raising
cap that integrates all offerings under this modified exemption over
time, and also integrates it with offerings under Regulation D, rather
than simply capping the amount that can be raised in 1 year. Without
those changes, the combination of Regulation A and manipulation of the
``record holder'' formality under current Section 12(g) could open up a
path to complete evasion of public registration requirements, which
would not be in keeping with the idea of a ``limited'' or ``small''
offering exemption.
3. 1934 Registration Triggers
Two of the pending bills propose raising the triggers for 1934 Act
registration from the current 500 record holder trigger, one for banks,
one for all companies, and, in addition, to exempt employee owners from
counting towards the trigger. In my view, these are the riskiest
proposals being discussed. Raising the cap to 2,000 record holders
would allow more than half of all public companies to go ``dark.'' \20\
This might be a boon to some companies, which could immediately cut
compliance costs. But for investors who have already invested in the
suddenly much larger number of firms that could ``go dark,'' such a
radical change would upset legitimate investment expectations, and have
spillover effects on liquidity, capital costs, and value of the firms
that choose to ``remain lit.'' \21\ Particularly if combined with
permission for private offerings to target the public in general
solicitations, as in S. 1544, raising the Section 12(g) limit in this
way would effectively gut the securities laws for all but the largest
issuers. Such a dramatic change would, if proposed by the SEC, almost
certainly generate a great deal of comment and discussion, and rightly
result in an extensive public debate. Does it make sense for the
Congress to rush in radical deregulation on the hope that it might
generate short-term job growth?
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\20\ John C. Coates, ``The Powerful and Pervasive Effects of
Ownership on M&A'', Working Paper (June 2010), available at http://
ssrn.com/abstract=1544500 (last visited December 12, 2011). In that
paper, I find that over a third of all firms in Compustat have fewer
than 300 record holders, and that the median number of record holders
of such firms in 2007 was 700.
\21\ While some researchers have noted that many firms choose to
go ``dark'' when they are forced to comply with new disclosure
requirements, see Brian J. Bushee and Christan Leuz, ``Economic
Consequences of SEC Disclosure Regulation: Evidence From the OTC
Bulletin Board'', 39 J. Acc'g and Econ. 233-264 (2005), few have noted
that over a third of public firms large enough to be included in
databases such as Compustat have fewer than 300 record holders, and
thus can be thought of the reverse of firms that have ``gone dark''--
firms that have chosen to ``stay lit,'' presumably because the lower
cost of capital produced by effectively enforced securities laws is
worth the lowered cost of compliance that being private would permit.
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If the objection of proponents to public registration under the
1934 Act centers on control systems and compliance costs, the better
path is that represented by S. 1933--and also even more
straightforwardly by demanding that the PCAOB use its existing
authority to tailor the requirements under Section 404(b) of the
Sarbanes-Oxley Act as applied to smaller or newer companies. The
objection may, however, be primarily about wanting to keep investors in
the dark about executive compensation, corporate governance, insider
trading, proxy manipulation of the kind documented at over-the-counter
companies in the SEC's 1963 Special Study, \22\ conflict of interest
transactions, earnings ``management,'' capital expenditures, and other
ways in which investors and their money can be misused. Perhaps the
reduction of capital-raising costs entailed by such changes is worth
trading off against the increased cost of capital for widely held firms
generally, on an experimental basis.
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\22\ See, generally Seligman, supra note 1.
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But if so, a better case needs to be made than the one thus far
presented by advocates, who simply repeat the talking point that the
500 record holder limit is ``out of date.'' Advocates do not ever
explain why dispersed investors today are any less in need of strongly
enforced disclosure laws, or better capable of protecting themselves
without such laws, than they were in 1964. (By contrast, it makes
obvious sense that the asset trigger in the 1934 Act would need to be
raised, to reflect growth in the economy and average investor wealth.)
Ample research shows that dispersed shareholders remain usually unable
to easily or cheaply use their existing rights to protect even their
most basic rights to elect the boards of directors of the companies in
which they invest.
Carving out employee ownership of stock would at least be
consistent with SEC exemptions or no-action positions on options and
restricted stock units. However, it is unclear why employees are less
in need of information and antifraud protection than outside investors.
While they are in a good position to monitor some aspects of a firm,
and equity ownership is clearly an incentive tool for many companies,
particularly cash-constrained firms, such as start-ups, few employees
have access to or an ability to check the members of the C-suite, and
the fact that their investments represent a doubling down on the human
capital investment they have in the form of firm-specific knowledge and
relationships built up in their employment has long meant that employee
investors are peculiarly exposed to the investment risks represented by
employer stock. Some of the current use of employee stock or stock
option compensation is generated by tax incentives similar in kind to
the mortgage interest deductions--seemingly attractive ideas that are
in need of rethinking.
A better case can be made to raise the limits in this fashion for
banks, since they are directly regulated by bank regulatory agencies
and are required to file call reports and make other disclosures to
depositors, which equity investors can also access. However, these
disclosures may not be widely known to many bank investors, and if the
goal of S. 556 is in fact to permit the continued family or community
ownership of community banks without triggering SEC registration, it
would be better to develop tailored exemptions for ownership by direct
or indirect heirs, or community-based owners geographically proximate
to the bank with some long-standing depositor or other relationship to
the bank, to increase the odds that the investor has information about
and can protect their interest in the issuing bank.
Finally, it should be emphasized that the current use of ``record
holders'' as a trigger for 1934 Act reporting is in fact ``out of
date,'' not because of the number 500, which while arbitrary seems
reasonable as a measure of ``dispersion'' of shareholders, but because
of the use of ``record holder'' as the thing to count. As others have
previously testified, the methods of distributing equity have long made
the use of record ownership an anachronism. While record holder counts
correlate with beneficial owner counts, they do so weakly, and
increasingly weakly, over time. Firms that make disclosures to their
shareholders already have beneficial owner counts, in order to know how
many annual reports or proxy or information statements to provide to
record holders to pass through to beneficial owners, and it has long
been a puzzle to outsiders why the SEC has not moved to using
beneficial ownership as the relevant metric. To be sure, there are many
beneficial owners who object to having their identities known to a
company, but it is hard to see why any beneficial owner would object to
being counted for disclosure purposes. To be sure, there are
fluctuations in beneficial owner counts, and they are probably measured
with more noise and greater lags than record holder counts, but the
rules could allows firms to rely upon record holder reports of
beneficial owners as of a certain date, eliminating such uncertainties
for issuers' legal obligations. Alternatively, one could imagine moving
to a ``public float'' trigger measured by reference to value of
unaffiliated investments, rather than counts of outside investors, as
others have suggested. However, doing so will increase to some extent
the arbitrariness of the test, since it will focus less on ownership
dispersion--which presumably is the theoretical reason that investors
cannot be counted on to demand information on their own--and more on
market valuations, which can vary rapidly without regard to the
relative power or information needs of investors. Nevertheless, either
method of counting would be great improvement over the current trigger,
which effectively rewards well-advised firms who carefully structure
their investors' investments in order to keep their nominal record
holder count down, and punishes older firms like Wawa, Inc., which has
long done the more straightforward thing and issued stock to employees
as holders of record.
4. IPOs
Last, I address S. 1933, the ``Reopening American Capital Markets
to Emerging Growth Companies Act of 2011.'' This bill is the most
thoughtful and carefully structured bill being considered, and (with
two caveats, discussed below) raises the fewest risks. While I would
shorten the start-up period to 4 years, rather than 5, and couple it
with a sunset--after 6 or 7 years, rather than 2 or 3 as for the other
proposals, in order to let the 4-year ramp-up period play out--I
believe that the relatively modest reductions in investor protection
that it would permit pose the least risk to the current regulatory
system while holding out the promise of at least some meaningful
nonfraudulent capital formation.
To be sure, I am not sure that the bill will dramatically increase
the number or reduce the size of IPOs, as advocates of this reform seek
to do, or whether IPOs are as central to job creation as the investment
banking community would like to believe. While a case can certainly be
made that compliance costs have impeded marginal firms in the last 10
years, the fall-off in IPOs began well before Enron, much less
Sarbanes-Oxley, and microcap firms have never been subject to Section
404(b) of that law, yet there has been no resurgence of IPOs by 404(b)-
exempt firms, even after the exemption for microcap companies was made
permanent. More serious impediments to a renewals of IPOs, it seems to
me, include the increased ``deretailization'' of the equity markets,
which in many respects is a good thing, as retail investors have
increasingly realized that they are the most likely to make poor
investment decisions, and have increasingly come to rely not on broker-
dealers paid to generate value-destroying churn, but on fee-only
advisers, particularly advisers to mutual funds and other regulated
collective investments, who in turn increasingly invest through private
equity funds. Institutions seek not just investments but liquidity
depth, making smaller or thinly traded IPOs that might once have
attracted a retail investor following unlikely to generate the same
interest from the institutions that now bundle those investors' dollars
and invest collectively. Where the institutions are content without
that liquidity, they have Regulation D and Rule 144A, which permit
issuers to raise a great deal of liquid capital from dispersed
institutional investors without going public.
Nevertheless, there probably are at least some firms that would be
able to reduce their capital costs by going public, that are
nonetheless deterred by the marginally higher offering costs generated
by 404(b) and other disclosure requirements. Thus, the bill may do some
good. Because the firms would still need to meet all of the other
requirements of the 1933 and 1934 Acts, including obtaining audited
financial statements (albeit for a reduced period), and because the
sponsors would remain subject to the full liability regime of the
securities laws, the risks of the deferral of some of the disclosure
obligations under the 1934 Act seem appropriately small, and worth
taking, particularly because the result is to increase the amount of
publicly traded securities, with spillover liquidity benefits for other
firms.
I add two caveats. First, I have not had a chance to think
carefully about the provisions of the bill that relate to research
analysts. They are modestly complex, as they require thinking through
the potential conflicts of interest between underwriters, dealers, and
firms issuing research, under both the SEC's rules and the rules of
FINRA. Analyst coverage is clearly a key linch-pin in developing a
liquid market for a prospective public company, but analysts, too, have
played a sad role in recent bubbles, particularly in the build-up of
telecoms in the late 1990s and early 2000s. The bill proposes to
explicitly and clearly take away authority from the SEC and FINRA to
regulate analysts in the IPO context, and it is not clear to me--and,
since this bill was introduced only 10 calendar days ago, I suspect it
is not clear to anyone other than the sponsors and those who advise
them--whether this narrowing of regulatory authority makes sense, or is
necessary, in its current form, to accomplish the legitimate goal of
increasing analyst coverage of newly public firms. Second, I would have
thought a more straightforward way to accomplish at least the goal of
reducing SOX 404(b) costs would be to command the SEC and the PCAOB to
use their authority to better tailor the compliance, audit, and
attestation requirements for newly public companies.
Spurring regulatory innovation is one of the most important tasks
Congress has. One way to do it is to deregulate and hope for the best.
Another way to do it is to command the agencies to regulate in a more
sensible way, with explicit metrics to show that it has worked. For
example, Congress could require the agencies to take action within a
set period of time to modify the SOX 404(b) requirements, and then
report on the effects on compliance costs using surveys of firms. If
the costs had not come down, the agencies would be required to go
further. While this would take time--and not generate any new jobs
before the next election--it would be more likely to produce an
efficient trade-off between capital-raising costs and capital costs
than the cycle in which we seem to be currently stuck: deregulating,
hoping for the best, and then rushing to reregulate after the next
scandalous financial collapse.
______
PREPARED STATEMENT OF KATE MITCHELL
Managing Director, Scale Venture Partners
December 14, 2011
Chairman Reed, Ranking Member Crapo, my name is Kate Mitchell and I
am a managing director at Scale Venture Partners, a Silicon Valley-
based venture capital firm that has investments in information
technology companies across the United States. Venture capitalists are
committed to funding America's most innovative entrepreneurs. We work
closely with them to transform breakthrough ideas into emerging growth
companies that drive U.S. job creation and economic growth. We believe
that IPOs drive job creation and economic growth because, as our data
show, 92 percent of a company's job growth occurs after its IPO.
I am also a former chairman and current member of the National
Venture Capital Association. Companies that were founded with venture
capital accounted for 12 million private sector jobs and $3.1 trillion
in revenue in the U.S. in 2010, according to a 2011 study by IHS Global
Insight. That equals approximately 22 percent of the Nation's GDP.
Almost all of these companies, which include Apple, Cisco, Genentech,
and Starbucks, began small but remained on a disciplined growth
trajectory and ultimately went public on a U.S. stock exchange.
More recently, I served as chairman of the IPO Task Force, a
private and independent group of professionals representing the entire
ecosystem of emerging growth companies--including experienced CEOs,
public investors, venture capitalists, securities lawyers, academicians
and investment bankers. This diverse coalition came together initially
as part of a working group conversation at the U.S. Department of the
Treasury's Access to Capital Conference in March 2011, where the dearth
of initial public offerings, or IPOs, was discussed at length. In
response to this shared concern, we formed the IPO Task Force to
examine the challenges facing America's troubled market for IPOs and
make recommendations for restoring effective access to the public
markets for emerging growth companies.
Our task force developed our proposals based on a consensus
approach that considered, and in many cases rejected, a variety of
possible approaches. We left behind many ideas based on the valuable
input we received from the variety of interdisciplinary perspectives
that our membership represented. We released our report, ``Rebuilding
the IPO On-Ramp'', in October of this year. We shared our findings and
recommendations with Members of Congress and the Administration,
including the Treasury Department and the Securities and Exchange
Commission (SEC). I have submitted a copy of this report along with my
written testimony today.
On behalf of the diverse members of the IPO Task Force, I am here
today to support S. 1933, the ``Reopening American Capital Markets to
Emerging Growth Companies Act of 2011.'' This bipartisan legislation,
introduced by Senators Schumer, Toomey, Warner, and Subcommittee
Ranking Member Crapo, will help restore effective access to the public
markets for emerging growth companies without compromising investor
protection. Restoring that access will spur U.S. job creation and
economic growth at a time when we desperately need both. I appreciate
the opportunity to discuss with you the challenges we face and the
merits of this important bill.
Challenges Facing the U.S. IPO Market
For the last half-century, America's most promising young companies
have pursued IPOs to access the additional capital they need to hire
new employees, develop their products and expand their businesses
nationally and globally. Often the most significant step in a company's
development, IPOs have enabled emerging growth companies to generate
new jobs for the U.S. economy, while public investors of all types have
harnessed that growth to build their portfolios and retirement
accounts.
The decision to pursue an IPO is a complex one because alternatives
do exist: a company can seek to be acquired or can decide to remain
private. The most prevalent outcome today for the CEO of an emerging
growth company is to be acquired by a larger company. Yet the IPO
remains appealing, although demonstrably less so than it was a decade
ago, for a variety of reasons. In a survey the IPO Task Force conducted
of more than 100 CEOs of companies considering an IPO in the next 24
months, 84 percent of CEOs cited competitive advantage as the primary
motivation for going public, while two thirds of them indicated the
need for cash to support future growth. And while 94 percent of CEOs
agreed that a strong and accessible small-cap IPO market is critical to
maintaining U.S. competitiveness, only 9 percent agreed that the market
is currently accessible to them.
The data support that unfortunate conclusion. During the past 15
years, the number of emerging growth companies entering the capital
markets through IPOs has plummeted relative to historical norms. From
1990 to 1996, 1,272 U.S. venture-backed companies went public on U.S.
exchanges, yet from 2004 to 2010, there were just 324 of those
offerings. Those companies that do make it to the public markets are
taking almost twice as long to do so. During the most recent decade,
acquisitions have become the predominant path forward for most venture-
backed companies. This is significant because M&A events do not produce
the same job growth as IPOs. In fact, an acquisition often results in
job losses in the short term as redundant positions are eliminated by
the acquirer. While global trends and macroeconomic circumstances have
certainly contributed to this prevalence of acquisitions over IPOs, the
trend has transcended economic cycles and has hobbled U.S. job
creation.
What is driving this precipitous decline in America's IPO market? A
number of analyses, including that of the IPO Task Force, suggest that
there is no single event behind it. Rather, a complex series of changes
in the regulatory environment and related market practices have driven
up costs and uncertainty for emerging growth companies looking to go
public, and have constrained the amount of information available to
investors about such companies, making them more difficult to
understand and invest in. These changes have included the advent of
electronic trading, new order-routing rules, Regulation FD, the Gramm-
Leach-Bliley Act of 1999, decimalization, the Sarbanes-Oxley Act of
2002, the Global Research Analyst Settlement, and aspects of the Dodd-
Frank Act of 2009. Every one of these developments and each piece of
legislation addressed significant issues. Yet, the cumulative effects
of these regulations over the years have produced an unintended
consequence: They have limited the ability of emerging growth companies
to go public.
In effect, these changes have shifted the focus of emerging growth
companies away from pursuing IPOs and toward positioning themselves for
acquisition by a larger company. In fact, approximately 85 percent of
the emerging growth company CEOs surveyed by the IPO Task Force
indicated that going public is not as attractive as it was in 1995.
This shift toward acquisitions and away from IPOs by emerging growth
companies is problematic for the U.S. economy because, as mentioned,
acquisitions simply do not generate the same amount of job growth as
IPOs. Consider the impact on jobs and the general economy if companies
such as FedEx, Intel or Microsoft were acquired by larger corporations
instead of going public and maintaining the independent growth that led
them to be market leaders in their own right.
Addressing these multiple, interrelated factors and mitigating
their effects will require a measured and nuanced response. Many of the
new regulations in recent years have addressed specific concerns and
delivered valuable protections to investors--protections that any
efforts to rebalance the regulatory scales for emerging companies must
recognize and respect. These new requirements have raised the bar for
companies pursuing IPOs--in terms of size, compliance and cost--in ways
that should inspire greater investor confidence in our markets.
Similarly, many of the related market evolutions have increased access
and lowered costs for some public investors. These factors have
resulted in a fundamental restructuring of the U.S. capital markets
system over the past 15 years. Our IPO Task Force report examines this
restructuring and its implications in greater depth. For my purposes
here, I will focus on the regulatory aspects of the current IPO
challenge and how S. 1933 can mitigate it.
I believe the ``Reopening American Capital Markets to Emerging
Growth Companies Act of 2011'' provides an opportunity to thoughtfully
recalibrate these regulations to reduce barriers for ECG's in three
crucial ways. First, it recognizes emerging growth companies as a
unique category facing acute challenges in accessing public capital.
Second, it provides a limited, temporary and scaled regulatory
compliance pathway, which the IPO Task Force referred to as an ``on-
ramp,'' that will reduce the costs and uncertainties of accessing
public capital. Third, it improves the flow of information to investors
about the initial offerings for emerging growth companies. The
legislation follows a balanced approach by structuring the on-ramp as a
temporary feature available only for a limited period of 1 to 5 years,
depending on the size of the company.
Recognizing ``Emerging Growth Company'' Challenges
The ``Reopening American Capital Markets to Emerging Growth
Companies Act of 2011'' would establish a new category of issuer,
called an ``emerging growth company'' (EGC) that has less than $1
billion in annual revenues at the time of SEC registration. These
companies would benefit from a temporary regulatory on-ramp designed to
provide EGCs with a smooth entryway into the IPO market while ensuring
adequate investor protection. This on-ramp status would last only for a
limited period of 1 to 5 years, depending on the company's size, and it
would encourage EGCs to go public while ensuring that they achieve full
compliance as they mature and build the resources necessary to sustain
the level of compliance infrastructure associated with larger
enterprises.
As noted, EGC status, and the scaled regulation associated with the
on-ramp, would last for a limited period of 1 to 5 years. Specifically,
EGC status would cease at the first fiscal year-end after the company
(1) reaches $1 billion in annual revenue; (2) has been public for 5
years; or (3) becomes a ``large accelerated filer'' with more than $700
million in public float (i.e., market value of shares held by
nonaffiliates). To put the bill's limited scope in perspective, if the
on-ramp provisions were in effect today, they would apply to only 14
percent of public companies and only 3 percent of total market
capitalization, according to the IPO Task Force estimate. For example,
Ford Motor Company would not qualify as an EGC eligible for the on-
ramp. Nor would Zynga be expected to qualify. However, Carbonite and
Horizon Pharmaceuticals would.
As someone who has spent the last 15 years seeking out, evaluating,
investing in, and helping to build promising young companies, I cannot
overemphasize the value of a robust and accessible IPO market. In our
survey of emerging growth company CEOs, 86 percent of respondents
listed accounting and compliance costs as a major concern of going
public. Again, over 85 percent of CEOs said that going public was not
as attractive of an option as it was in 1995. Given these concerns, for
CEOs of successful companies deciding between pursuing an IPO or
positioning themselves for an acquisition, the scaled disclosure and
cost flexibility provided by the bill could help make an IPO the more
attractive option.
Reopening Access Through Scaled Regulation
The bill provides qualifying EGCs with a narrow, temporary and
scaled regulatory compliance pathway that would reduce the costs of
accessing public capital without compromising investor protection. The
bill's transitional relief is limited to those areas of compliance that
are significant cost drivers. While those requirements may sensibly
apply to larger enterprises, allowing EGCs to phase in these costs
would not compromise investor protection for smaller public companies
that are following the scaled regulation that the SEC has already
developed and approved for smaller reporting companies. In this way,
the on-ramp benefits from the SEC's prior regulatory actions that
carefully balanced both investor protection and the promotion of
efficiency, competition, and capital formation, consistent with Section
3(f) of the Securities Exchange Act of 1934. The scaled regulations
under the bill include:
Section 404(b) of Sarbanes-Oxley. In addition to the typical cost of
auditing their financial statements, large public companies must pay an
outside auditor to attest to the company's internal control over
financial reporting. Studies have shown that compliance with Sarbanes-
Oxley can cost companies more than $2 million per year, with much of
that cost associated with the Section 404(b) requirements. All
companies with a public float of less than $75 million are already
exempt from Section 404(b) because Congress has recognized the
substantial burden this requirement would impose on smaller companies.
In addition, existing regulations provide that all newly public
companies--regardless of their size or maturity--benefit from a
transition period of up to 2 years before they are required to comply
with Section 404(b) of Sarbanes-Oxley. Under current law, this
transitional relief is available even for very large companies that
would not qualify as EGCs. Moreover, this existing transitional relief
is necessary even though the auditing standard for the Section 404(b)
audit is intended to be flexible and scalable. (The Public Company
Accounting Oversight Board's Auditing Standard No. 5 expressly permits
a top-down, scalable approach for the audit and recognizes that ``a
smaller, less complex company'' may ``achieve its control objectives
differently than a more complex company.'') Building on these concepts,
S. 1933 provides EGCs with a limited and targeted extension of the
existing transition period during the on-ramp for compliance with
Section 404(b). The bill would not affect current requirements under
which management is responsible for establishing and maintaining
internal control over financial reporting and disclosure controls and
procedures.
Look-back for audited financials. EGCs would be required to provide
audited financial statements for the 2 years prior to registration,
rather than 3 years. This 2-year period already applies under existing
SEC rules for companies with a public float of less than $75 million.
For the year following its IPO, the EGC will go forward reporting 3
years of audited financials, similar to larger issuers, without facing
an incremental cost burden because the third year will have already
been audited in connection with the IPO. The transition period for this
element, therefore, will only extend for a year, which is much shorter
than the full on-ramp period.
Exemptions from long form compensation disclosure. The EGC will
disclose its compensation arrangements using the established format
that the SEC has adopted for smaller reporting companies. The bill
would also exempt EGCs from the requirement to hold an advisory
stockholder vote on executive compensation arrangements, including
advisory votes on change-of-control compensation arrangements and the
frequency of future advisory votes. The SEC has given smaller reporting
companies an additional year to comply with the new rules, in light of
the additional burden these requirements impose. The bill would extend
this transitional relief for EGCs during the on-ramp period. During
that time, EGCs would still be required to comply with all stock
exchange governance requirements, including director independence
requirements.
The on-ramp period will give EGCs the opportunity to realize the
benefits of going public in their first, critical years in the public
markets. They will be able to allocate more of the capital they raise
from the IPO process toward hiring new employees, developing new
products, expanding into new markets and implementing other elements of
their growth strategies--as opposed to funding the type of complex
compliance apparatus designed for larger, more mature companies. At the
same time, EGCs and their management will be able to devote more time,
energy and other resources to managing the business, charting the path
to future growth and implementing compliance systems that are
appropriate for smaller, more nimble companies. Indeed, 92 percent of
the public-company respondents in the IPO Task Force's CEO survey
identified the burden of administrative reporting as a significant
challenge, while 91 percent noted that reallocating their time from
company building to compliance management has been a major challenge.
The IPO Task Force's membership included institutional investors
who provided important perspectives that shaped the specific
recommendations we made. In particular, the scaled regulation that we
ultimately recommended, and which S. 1933 reflects, incorporated key
recommendations from the investor community that this constituency
believes is consistent with investor protection and will ensure full
disclosure of all relevant information by EGCs as well as the
availability and flow of information for investors.
Improving the Availability and Flow of Information for Investors
Along with compliance burdens, post-IPO liquidity ranked very high
among the concerns of emerging growth company CEOs. Institutional
investors in particular expressed concerns about the dearth of
information and exposure they had to IPO companies versus what they
receive for other securities, making it difficult to get enough
information to make an informed investing decision about a new issue.
In order to increase post-IPO liquidity, investors need efficient
markets with abundant, accurate information about newly public
companies. In an effort to make IPOs more attractive to EGCs and
investors, the bill would improve the flow of information about EGCs to
investors before and after an IPO. It will do so primarily by updating
existing regulations to account for advances in modes of communication
since the enactment, 78 years ago, of the Securities Act of 1933, and
to recognize changes in the information available to investors in the
Internet era. Current rules relating to analyst research were initially
adopted more than 40 years ago--long before the fundamental changes
that the Internet has brought regarding the availability of
information, including instantaneous access to registration statements
filed with the SEC. The SEC has amended these rules only modestly and
incrementally since that time. Specifically, the bill will:
Close the information gap for emerging growth companies. Existing rules
allow investment banks participating in the underwriting process to
publish research on large companies on a continuous basis, but prohibit
those investment banks from publishing research on EGCs. This bill
would allow investors to have access to research reports about EGCs
concurrently with their IPOs. In other words, S. 1933 extends to EGC
investors the research coverage currently enjoyed by investors in very
large companies. At the same time, the bill preserves the extensive
investor protections adopted in this area within recent years. For
example, S. 1933 leaves intact robust protections such as:
Sarbanes-Oxley Section 501, which requires analysts and
broker-dealers that publish research reports to disclose any
potential conflicts of interest that may arise when they
recommend an issuer's equity securities, including whether an
analyst or broker-dealer currently owns other debt or equity
investments in the issuer or has received compensation from the
issuer for publishing the report or whether the issuer is a
client of the broker-dealer.
SEC Regulation AC, which requires broker-dealers to include
in all research reports a statement by the research analyst
certifying that the views expressed in the research report
accurately reflect the research analyst's personal views about
the securities and to disclose whether the research analyst was
compensated in connection with the specific recommendations.
The Global Research Analyst Settlement of 2003, which
severed the link between research and investment banking
activities at large investment banks, required investment banks
to use independent research and made analysts' historical
ratings and price targets publicly available.
As the SEC recognized in 2005, the ``value of research reports in
continuing to provide the market and investors with information about
reporting issuers cannot be disputed.'' We agree that research reports
are indisputably valuable to investors and endorse the changes in S.
1933 that would permit research coverage of EGCs at the time of an IPO,
rather than the current regime, which permits research only for large,
established public companies. The bill's changes would address the
current information shortfall by providing a way for investors to
obtain research about IPO candidates, while leaving unchanged the
robust and extensive investor protections that exist to ensure the
integrity of analyst research reports.
Permit emerging growth companies to ``test the waters'' prior to filing
a registration statement. The bill would permit EGCs to gauge
preliminary interest in a potential offering by expanding the range of
permissible prefiling communications to institutional and qualified
investors. This would provide a critically important mechanism for EGCs
to determine the likelihood of a successful IPO. For a company on the
verge of going public, but not quite ready, getting that investor
feedback beforehand improves the chances of a successful IPO at a later
date. This benefits issuers and the public markets in the process by
helping otherwise-promising companies avoid a premature offering. All
of the antifraud provisions of the securities laws would still apply to
these communications, and the bill ensures that the delivery of a
statutory prospectus would still be required prior to any sale of
securities in the IPO.
Permit confidential prefiling with the SEC. Currently, foreign entities
are permitted to submit registration statements to the SEC on a
confidential basis under certain circumstances, even though U.S.
companies are not. Since the recent introduction of S. 1933, the SEC
staff has updated its policy in this area to permit confidential
filings for foreign Governments registering debt securities and foreign
private issuers that are listed or are concurrently listing on a non-
U.S. securities exchange. This accommodation is not available to
domestic issuers. Allowing U.S. companies to make confidential
submissions of draft registration statements would allow EGCs to
commence the SEC review process in a far more efficient and effective
manner. In particular, this process would remove a significant
inhibitor to IPO filings by allowing pre-IPO companies to begin the SEC
review process without publicly revealing to competitors sensitive
commercial and financial information before those pre-IPO companies are
able to make an informed decision about the feasibility of an IPO. The
bill would require U.S. companies that elect to use the confidential
submission process to make public the filing of the initial
confidential submission as well as all amendments resulting from the
SEC review process, thereby providing full access to the information
before an IPO that is traditionally disclosed to the public during the
registration process. The bill would also require such a public filing
at least 21 days before the pre-IPO company commences a road show with
potential investors, providing ample time for public review of all
changes made in all amendments to the registration statement occurring
during the SEC review process.
Conclusion
With the U.S. economic recovery stalled, unemployment hovering near
9 percent and global competition ramping up, the time to revive the
U.S. IPO market and jumpstart job creation is now. We believe that the
``Reopening American Capital Markets to Emerging Growth Companies Act
of 2011'' can help us accomplish those goals without compromising
important investor protections, including many of the reforms
implemented in recent years.
The bill provides measured and limited relief, for a period of 1 to
5 years, to a small population of strategically important companies
with disproportionately positive effects on job growth and innovation.
We believe that these changes could provide powerful incentives for
those emerging companies to more seriously consider an IPO as a
feasible alternative when they are deciding between the growth
potential of an IPO versus the safer and easier path of an acquisition
transaction. As a result, we believe these changes could bring those
alternatives back to their historical balance--a balance that has, in
prior years, allowed IPOs to occur more easily and, in so doing,
supported America's global economic primacy for decades.
I urge the Members of this Committee to support the passage of the
``Reopening American Capital Markets to Emerging Growth Companies Act
of 2011.'' By doing so, we can reenergize U.S. job creation and
economic growth by helping reconnect emerging companies with public
capital--all while enabling the broadest range of investors to
participate in the growth of those companies through a healthy and
globally respected U.S. capital markets system. These outcomes are not
only consistent with the spirit and intent of the current regulatory
regime, but also essential to preserving America's strength for decades
to come.
In closing, I want to personally thank you for the opportunity to
discuss these important issues with you today. I look forward to
answering any questions you may have and, I thank you for your service
to our country in your capacity as Members of Congress and your
attention to this critical issue.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF BARRY E. SILBERT
Founder and Chief Executive Officer, SecondMarket, Inc.
December 14, 2011
Barry Silbert is the Founder and CEO of SecondMarket, the largest
secondary market dedicated to creating liquidity for alternative
investments, including private company stock, fixed income, bankruptcy
claims and warrants/restricted stock. SecondMarket has over 75,000
registered market participants on its online platform and has conducted
billions of dollars in transactions across all of its asset classes.
In 2011, SecondMarket was honored by the World Economic Forum as a
Technology Pioneer, recognized by Fast Company as one of the ``Ten Most
Innovative Companies in Finance'' and named as one of Deloitte's
Technology Fast 500 companies. Barry was also invited to join Mayor
Michael Bloomberg's Council on Technology and Innovation, and was named
to Fortune's prestigious ``40 Under 40'' list. In 2009, Barry was a
category winner of Ernst & Young's Entrepreneur of the Year Award and a
winner of Crain's Entrepreneur of the Year Award. In addition,
SecondMarket was recently named as one of ``America's Most Promising
Companies'' by Forbes.
Prior to founding SecondMarket in 2004, Barry was an investment
banker at Houlihan Lokey, where he focused on financial restructurings,
mergers and acquisitions, and corporate financing transactions. Barry
graduated with honors from the Goizueta Business School of Emory
University, and holds Series 7, 24, and 63 licenses.
Barry is a frequent speaker on the topic of trading alternative
assets and has appeared in many leading publications, including The
Wall Street Journal, The New York Times, The Washington Post, Financial
Times, USA Today and Forbes. Barry has been featured on CNBC, CNN
Money, Bloomberg News, and Fox Business News.
Barry is also an active angel investor with investments in a number
of exciting startups, including Behind the Burner, ProFounder,
RealDirect, Send the Trend, Slated, TapAd, and Vator.tv.
Good morning Chairman Reed, Ranking Member Crapo, and Members of
the Committee. My name is Barry Silbert. I am the Founder and CEO of
SecondMarket. I am grateful for the opportunity to testify this morning
regarding these important subjects.
First, I'd like to describe SecondMarket. Second, I will discuss
the problems in the public stock markets that have made the markets
inhospitable to growth-stage companies. Next, I will describe the
important role that SecondMarket plays in the capital formation
process, by affording access to capital for private companies while
also providing investors with financial information to make informed
investment decisions.
Finally, I will urge passage of the legislation that is being
discussed at today's hearing, particularly the bills that support
growing private companies on their road to the public markets, while
also maintaining a high level of investor protection. Modernizing the
antiquated ``500 Shareholder Rule,'' eliminating the ban against
general solicitation, and easing the path to the public markets for
small-cap companies should be of paramount concern to Congress. These
complementary initiatives will make it easier for small private
companies to flourish and potentially grow into large public companies.
The issues raised in my testimony directly impact startup growth, job
creation and American global competitiveness.
My Background and the SecondMarket History
I was born and raised in Gaithersburg, Maryland, and attended
college at Emory University in Atlanta. After graduating in 1998, I
started my career as an investment banker at Houlihan Lokey where I
worked on some of the most prominent bankruptcies of the last decade,
including Enron and WorldCom. Houlihan typically represented creditors,
and the experience working on complex, problematic restructurings
proved invaluable. It was this experience that led me to the idea for
SecondMarket.
Upon emerging from bankruptcy, creditors in Chapter 11 cases would
sometimes receive stock in the restructured company that was not
saleable in the public markets. These creditors often would contact
Houlihan to inquire about selling these instruments. When I asked my
colleagues how we could assist the creditors with these sales, it was
suggested that I should pick up the telephone, start calling my
contacts, and find buyers. I was struck that there was no centralized
marketplace for these assets. Thus, the idea for SecondMarket was born:
a transparent, centralized marketplace where buyers and sellers could
transact in alternative assets.
Having long ago decided I wanted to start my own company, I left my
Wall Street job and began drafting a business plan. Although the idea
has evolved over time, we have always been committed to the notion of
providing transparency and centralization to markets that historically
had been fragmented and opaque. I founded SecondMarket in New York City
in late 2004, and we opened for business in 2005. We started small and
low-tech--just five guys in a tiny office with a few computers and
phones.
The first asset class that we focused on was restricted securities
in public companies. These are assets such as restricted stock,
warrants and convertibles that are issued by public companies but not
tradable in the public stock markets. Since that time, SecondMarket has
experienced significant growth, and we have added markets for fixed
income (e.g., auction-rate securities, mortgage-backed securities,
etc.), bankruptcy claims and private company stock. These asset classes
have unique characteristics, objectives and participants. However, they
share the common thread that they are illiquid, alternative investments
that benefit from a centralized marketplace.
While we have continued to add new asset classes, the size of our
participant base has exponentially grown. At the beginning of 2009, we
had 2,500 registered participants on SecondMarket. Today we have well
over 75,000 participants and the number is constantly growing. Our
technology has also substantially evolved as we have invested millions
of dollars into our online platform, which provides centralization and
efficiency to improve the user experience and streamline the sales
process.
Moreover, we are no longer a few individuals in a small office.
SecondMarket now employs over 130 people in New York and San Francisco,
and we currently have nearly 25 open positions. I should also note that
SecondMarket is an SEC and FINRA registered broker-dealer and operates
an SEC-registered Alternative Trading System for its private company
stock market.
SecondMarket is the leading marketplace for facilitating
transactions in private company stock. We have completed trades in over
50 different companies, including Facebook and Twitter. In 2008, we
completed $30 million in private company transactions. In 2009, that
number rose to $100 million and in 2010, we saw nearly a four-fold
increase in transactional value. To date, we have completed nearly one
billion dollars in private company stock transactions. Across all of
our asset classes, we have completed several billion dollars in trades.
SecondMarket has emerged as an innovative solution provider. We
have helped retirees get liquidity when their auction-rate securities
(which were often marketed as a cash equivalent) turned out to be long-
term, illiquid investments. We have been part of the sales team working
in conjunction with Deutsche Bank to help the Treasury Department sell
TARP warrants. And we've helped numerous private companies provide
liquidity for their shareholders, many of whom reinvested their money
into other startups.
Problems in the Public Stock Markets
For several decades, startup companies in the United States
followed a similar path: they raised angel capital, a few rounds of
venture capital, and went public within 5 years. The vast majority of
IPOs were for companies raising $50 million or less, even adjusted for
inflation. Smaller companies could thrive in the public markets, with
equity research coverage and market makers driving investor interest in
growth-stage companies. Over the past 15 years, however, the market
structure forever changed and the public markets became inhospitable to
smaller companies.
Although SecondMarket is not involved in publishing research, we
closely follow research findings from industry observers and analysts.
\1\ Several factors have been recognized by these market observers as
contributing to the problems in the American public stock markets:
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\1\ See, ``A Wake-Up Call For America'', David Weild and Edward
Kim, Grant Thornton Capital Markets Series, Nov. 2009; ``Market
Structure Is Causing the IPO Crisis--and More'', David Weild and Edward
Kim, Grant Thornton Capital Markets Series, June 2010; ``It's Official:
The IPO Market is Crippled--and It Is hurting Our Country'', Alan
Patricof, Business Insider, Jan. 2011; ``Wall Street's Dead End'',
Felix Salmon, The New York Times, Feb. 2011; ``Welcome to the Lost
Decade (for Entrepreneurs, IPOs and VCs)'', Steve Blank, July 2010;
``U.S. Falls Behind in Stock Listings'', Aaron Lucchetti, The Wall
Street Journal, May 2011.
Online Brokers--although the introduction of online
brokerages helped to make trading less expensive, these online
brokers replaced retail brokers who helped buy, sell and market
small-cap, under-the-radar public companies. Stockbrokers
collectively made hundreds of thousands of calls per day to
their clients to discuss small-cap equity opportunities, and
the proliferation of online brokerages decimated the
profession. Those brokers provided a critical marketing tool
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for the country's small-cap companies.
Decimalization--stock prices used to be quoted in
fractions, and the difference between fractions created profit
for firms providing market making, research and sales support
to small-cap, public companies. When the markets began quoting
prices in decimals, trading spreads were reduced and profits
were significantly cut. It became unprofitable to market small-
cap equity and remains so today.
Sarbanes-Oxley--the legislation is often blamed for the
problems in the public markets, but many observers believe it
is not the most significant factor in companies electing to
remain private. Nonetheless, corporate compliance with the
Sarbanes-Oxley Act has certainly increased costs, especially
for smaller public companies.
Global Research Settlement--once the investment banks began
funding equity research, conflicts of interest emerged and
positive equity reports began to be written for undesirable
companies. This issue caused State Attorneys General to get
involved, eventually resulting in the global research
settlement. While based on sound public policy, the result was
that research reports essentially stopped being written for
small-cap public companies and, consequently, a significant
marketing mechanism for small-cap companies was eliminated. \2\
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\2\ A SecondMarket analysis of the Russell 3000 (the 3,000 largest
U.S. public companies) revealed that companies with a market cap in
excess of $10 billion have, on average, 25 different financial analysts
covering their stock performance. Conversely, companies with a market
cap of less than $500 million are on average covered by only five
analysts.
High-Frequency Trading--although high-frequency traders
bring significant liquidity to the public markets, by
definition, they require the volume and velocity that can only
be found in large public companies. A recent report stated that
high-frequency traders conduct almost 75 percent of the trades
taking place in the U.S. equity market, and those traders
essentially ignore small-cap companies. \3\
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\3\ ``Institutional Traders Around the World Concerned by High-
Frequency Trading, Global Survey Shows'', MarketWatch, Sep. 2011
(According to the Tabb Group, almost 75 percent of overall daily
equities trading can be attributed to high frequency trading.). ``How
Small Investors Can Get Stomped'' Jason Zweig, The Wall Street Journal,
Dec. 2011.
Average Hold Period--over the past 40 years, the average
time that a public market investor holds stock has dropped from
approximately 5 years in 1970, to less than 3 months today.
This further highlights the fact that investors are now
focusing their attention on short-term earnings performance,
versus long-term, business-building initiatives. \4\
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\4\ ``Investing Dying as Computer Trading, ETFs and Dark Pools
Proliferate'', John Melloy, CNBC, Jan. 2011; ``The Trading Game Is
Causing the Manic Market'', Daniel Indiviglio, The Atlantic, Aug. 2011.
Virtually all of these developments emerged from either well-
intentioned policy decisions or the natural evolution of the markets in
an electronic age. Nonetheless, taken in the aggregate, these (and
other \5\) factors have made the public markets undesirable for many
companies. These factors are not temporary and are unrelated to the
current economic climate. These changes to our public stock markets are
permanent and systemic, and the regulatory regime must reflect that
permanence.
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\5\ ``Why Merger Lawsuits Don't Pay'', Jessica Silver-Greenberg,
The Wall Street Journal, Aug. 2011 (Last year, a record 353 lawsuits
challenging proposed corporate mergers were filed in State and Federal
courts across the U.S., a 58 percent increase from 2009); ``A Wild Ride
to Profits'', Jenny Strasburg, The Wall Street Journal, Aug. 2011
(``High-frequency traders benefit from price gyrations and high
turnover in securities by moving in and out of holdings.'').
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Throughout the 1980s and 1990s, the regulatory environment and
overall market structure actively supported high-growth private
companies joining the public markets. From 1991 to 2000, there was an
average of 520 IPOs per year, with a peak of 756 IPOs in 1996. Today,
the lack of a properly functioning public market structure is
strikingly obvious. Since 2001, the United States has averaged only 126
IPOs per year, with 38 in 2008, 61 in 2009 and 71 in 2010. \6\
---------------------------------------------------------------------------
\6\ ``Market Structure is Causing the IPO Crisis--and More,''
David Weild and Edward Kim, Grant Thornton Capital Markets Series, June
2010.
---------------------------------------------------------------------------
Companies are electing to remain private longer than in previous
decades, and the average time a company remains private has essentially
doubled in recent years. \7\ Moreover, the profile of companies going
public has dramatically changed. Today, only the very largest companies
are going public, and are receiving the sales and research support
needed to successfully navigate the public markets.
---------------------------------------------------------------------------
\7\ Id.
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Simply put, the lackluster IPO market is not providing the solution
for investors and early employees who need liquidity. M&A is an
alternative option for companies to obtain liquidity; however,
acquisitions often result in job losses and stifled innovation. The
growth market is a significant and vital part of the capital formation
process, and the systemic failure of the U.S. capital markets to
support healthy IPOs inhibits our economy's ability to create jobs,
innovate and grow. Clearly, a new growth market must emerge.
The SecondMarket Solution
We were first approached about facilitating trades of private
company stock in late 2007, when a former Facebook employee contacted
us and asked if we could help him sell his shares. He had read about
how we facilitated transactions in restricted stock in public
companies. Since Facebook was not a public company, the stock was
unregistered and Facebook did not have any plans for an IPO. We
facilitated that transaction and then spent nearly a year conducting
diligence to assess the viability of the market. Once we understood
that companies were remaining private much longer than in prior years,
and that systemic changes in the public markets made it difficult for
companies to go public, we were convinced that we could fill the role
of a new growth market.
There is not a ``one-size-fits-all'' trading model for private
companies. Each company has its own goals and objectives. Some
companies value control and flexibility, others are more concerned with
liquidity and valuation. Our business model is premised on the fact
that we will not facilitate transactions in a company's equity unless
(and until) we have company authorization.
In that context, we allow companies to dictate the essential
elements of their marketplace, such as identifying eligible buyers and
sellers, setting the amount or percentage of shares to be sold, and
determining the frequency of transactions. Some companies want only
former employees to sell, and some want only existing shareholders to
buy. Some permit weekly trading, but most prefer to establish quarterly
or annual liquidity events.
When a company uses SecondMarket to establish a sponsored liquidity
program, we require the company to provide financial disclosures to
eligible buyers and sellers, including 2 years of audited financial
statements and company risk factors. Companies are increasingly
comfortable with the mechanics of our market as they recognize that the
confidential information they provide is only available to a company's
approved buyers and sellers in a secure, online data room administered
by SecondMarket.
Transparency is a critical factor to ensure investor protection and
confidence, but transparency does not necessarily mean that anyone can
view pricing details and the financial statements of private companies.
The cornerstone of transparency is that the actual market
participants--the buyers and sellers--have access to information to
allow them to make informed investment decisions.
In developing the private company market, SecondMarket has become
an important part of the capital formation process. By helping
companies provide interim liquidity to shareholders, we essentially
operate as a bridge to an IPO for companies that eventually want to go
public, or as an alternative option for companies that wish to remain
private.
Outdated Regulations
SEC Chairman Mary Schapiro has said that the SEC is reviewing the
regulatory landscape to lessen the burdens on private companies. In
this year's State of the Union address, President Obama ordered a
review of all Government regulations. He added: ``When we find rules
that put an unnecessary burden on businesses, we will fix them.'' \8\
In September, in his address on job creation, the President was even
more pointed in his remarks: ``We're also planning to cut away the red
tape that prevents too many rapidly growing start-up companies from
raising capital and going public.'' \9\
---------------------------------------------------------------------------
\8\ Remarks by the President of the United States in the State of
Union Address, The White House, Jan. 2011.
\9\ Address by the President of the United States to a Joint
Session of Congress, The White House, Sep. 2011.
---------------------------------------------------------------------------
I applaud the focus of the Administration, and I believe that the
``red tape'' that the President identified can be removed by passing
pending legislation that enjoys strong bipartisan support. Rule changes
in this area would directly impact companies' ability to access capital
more readily and cheaply, help companies retain existing employees and
hire new ones, and bolster American global competitiveness. At a time
when our lawmakers, policy makers, and regulators debate how best to
create new jobs, I believe the proposed changes to the regulatory rules
could have a major impact on job creation.
It is commonly understood that venture-backed companies fuel job
growth in this country, \10\ but most people do not appreciate the
astounding extent to which the statement is true. In a 2010 study, the
Kauffman Foundation noted that startups create an average of three
million new jobs annually and the most new net jobs in the United
States. \11\ The study bluntly states: ``Put simply . . . without
startups, there would be no net job growth in the U.S. economy.''
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\10\ Venture-backed companies in the United States account for
more than 12 million jobs, or 11 percent of the total private sector
employment. ``Venture Impact: The Economic Importance of Venture Backed
Companies to the U.S. Economy'', National Venture Capital Journal and
IHS Global Insight, 2009.
\11\ ``The Importance of Startups in Job Creation and Job
Destruction, Kauffman Foundation Research Series: Firm Formation and
Economic Growth'', July 2010. Significantly, the study notes that even
during poor economic conditions, ``job creation at startups remains
stable while net job losses at existing firms are highly sensitive to
the business cycle.''
---------------------------------------------------------------------------
Thus, it is essential that the regulatory framework recognizes this
dynamic and permits these startups to flourish. Policy makers need to
understand that any serious effort to create jobs has to address the
concerns of entrepreneurs. The Kauffman study concludes by noting that
``States and cities with job creation policies aimed at luring larger,
older employers can't help but fail, not just because they are zero-
sum, but because they are not based on realistic models of employment
growth. Job growth is driven, essentially entirely, by startup firms
that develop organically . . . effective policy to promote employment
growth must include a central consideration for startup firms.''
SecondMarket's clients are some of the fastest-growing, most
successful technology startups in the United States, and I've developed
strong relationships with executives at several of these private
companies. These executives are often concerned that they are not ready
or able to successfully navigate the public markets. They are also
concerned about regulatory hurdles that restrict their ability to
remain private. The concerns are varied, but two particular regulatory
hurdles often are identified:
The so-called ``500 Shareholder Rule'' codified in Section
12(g)(1) of the Exchange Act of 1934, which compels private
companies to become public reporting companies once they have
exceeded 499 holders of record and have more than $10 million
in assets at the end of any fiscal year.
The prohibition against ``general solicitation'' and
``advertising'' in connection with private placements of
unregistered securities, which has been broadly interpreted to
mean that potential investors must have a preexisting
relationship with an issuer or intermediary before the
potential investor can be notified that unregistered securities
are available for sale.
The shareholder threshold was established in 1964 and initially
worked quite well. For many years, companies were going public within a
few years of founding, and rarely were concerned about exceeding the
shareholder threshold. That is no longer the case.
The pay structure at startup companies generally involves giving
employees below-market salaries along with options which vest over
several years. The options are an economic incentive that allows
employees to realize the financial upside of contributing to a
successful startup. The companies prefer to give equity in lieu of cash
compensation because startups generally need to conserve capital in
order to grow their business. Option holders, in fact, are exempted
from being counted as common share owners under the 500 Shareholder
Rule, even if the options are vested, so awarding options to employees
does not adversely impact the shareholder count until the option
holders exercise the options. However, in the new reality of companies
taking nearly a decade to go public, option holders are often fully
vested well before an IPO, and shareholders who exercise their options
hold common stock and are counted towards the 500 shareholder cap.
The significance of this development cannot be overstated. The 500
Shareholder Rule has created a disincentive for private companies to
hire new employees, or acquire other businesses for stock, as these
private companies are fearful of taking on too many shareholders.
Application of the rule also discourages companies from providing
equity-based compensation to employees, removing one of the great
economic incentives attracting the country's best and brightest
employees to startups.
The 500 Shareholder Rule also directly impacts a company's
financing decisions. When a private company raises capital, its
management team understands that there are only 500 total ``slots'' for
common stock shareholders--both employee owners and investors. That
means limiting the pool of potential individual and institutional
investors that will have access to the investment opportunity.
There has been recent discussion (and confusion) about the
mechanics of counting shareholders for public and private companies,
and the distinction between ``holders of record'' and ``beneficial
owners.'' Today, the vast majority of securities of publicly traded
companies are held in ``street name'' rather than directly by the
actual owners, meaning that the name of brokers who purchases
securities on behalf of their clients (rather than the actual owners)
are listed as holders of record. A broker may own stock on behalf of
several dozen or several thousand beneficial owners, but because the
shares are held in street name, the broker is considered as only one
holder of record.
Some have speculated that this paradigm exists for private
companies, and allows private companies to have far more than 499
beneficial owners. However, private companies are in an entirely
different situation. Private companies closely manage their investor
base and typically place restrictions on the sale of shares, and they
do not want brokers holding stock on behalf of individuals unknown to
the companies. Shareholders of private companies directly own the
shares and, thus, there generally is no distinction between the number
of holders of record and beneficial owners. \12\ Regardless, if a
private company attempted to use a broker or an investment vehicle to
circumvent the 500 Shareholder Rule, the SEC could use the ``anti-
evasion'' rule in Section 12(g)(5)(1) of the Securities Act to require
companies to count the beneficial owners as holders of record. \13\
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\12\ Meredith Cross, the Director of Corporate Finance at the SEC,
recently testified before this Committee that the ``beneficial owner''
issue is unique to publicly traded companies. She said the shift to
brokers holding public company stock in street name on behalf of
investors ``means that for most publicly traded companies, much of
their individual shareholder base is not counted under the current
definition of `held of record.' Conversely, the shareholders of most
private companies, who generally hold their shares directly, are
counted as `holders of record' under the definition.'' Testimony on
``Spurring Job Growth Through Capital Formation While Protecting
Investors'' before the Committee on Banking, Housing, and Urban
Affairs, p. [50], Dec. 1, 2011.
\13\ ``If the issuer knows or has reason to know that the form of
holding securities of record is used primarily to circumvent the
provisions of Section 12(g) or 15(d) of the Act, the beneficial owners
of such securities shall be deemed to be the record owners thereof.''
Section 12(g)(5)(1), Securities Act of 1934.
---------------------------------------------------------------------------
The prohibition against general solicitation is similarly
problematic. Under many of the existing SEC private placement
exemptions, only ``accredited investors'' are eligible to purchase
private company stock. An individual must meet certain financial
standards to qualify as an accredited investor. The SEC and Congress
recognize that sophisticated, accredited individual and institutional
investors have greater capacity for risk and do not require the
enhanced protections provided to the average retail investor.
As previously noted, the prohibition against general solicitation
and advertising requires that issuers and intermediaries have a
preexisting relationship with the accredited investor in order to make
offerings available. In fact, if a nonaccredited individual is even
aware of an offering of unregistered securities, the entire offering
may be at risk due to the prohibition against general solicitation.
Frankly, if only accredited investors are eligible to purchase
unregistered securities, shouldn't we strive to maximize the pool of
accredited investors that have access to the offering? It should not
matter that nonaccredited individuals know that unregistered securities
are available for sale. No one prohibits car manufacturers from
advertising, even though children under the legal driving age are
viewing the advertisements, and pharmaceutical companies are free to
advertise to people who do not have (and are not eligible for)
prescription medication. The general solicitation prohibition
unnecessarily limits the pool of potential investors, thereby
restricting companies' ability to raise capital to fuel growth.
Currently, all buyers on SecondMarket must be accredited investors
(even in asset classes where it is not a regulatory requirement).
Should the ban on general solicitation be eliminated, we would support
an SEC effort to mandate a more stringent onboarding process for all
market participants to ensure that accredited investors meet the
eligibility requirements. In fact, to that end, we have actively been
exploring strengthening our internal onboarding and verification
processes to exceed current SEC requirements.
I believe that all of the capital formation bills being considered
by Congress (e.g., creating a crowdfunding exemption and increasing the
cap on ``mini offerings'' under Regulation A from $5 million to $50
million) are important for our country's entrepreneurs and will help
improve access to capital for startups. However, I wish to focus on
three of the bills that I believe warrant immediate passage by this
Congress:
1. ``The Private Company Flexibility and Growth Act'' (S. 1824),
which increases the 12(g)(1) shareholder threshold from 500 to
2,000 record holders, and includes an exemption that would
exclude current and former employee-shareholders from the
shareholder count. The bill also contains a provision to allow
publicly traded community banks to deregister from the SEC if
they have less than 1,200 record holders. Significantly, this
provision does not apply to other publicly traded companies
(i.e., nonbanks).
2. ``The Access to Capital for Job Creators Act'' (S. 1831), which
eliminates the ban against general solicitation and advertising
in the context of issuer private placements provided that the
ultimate purchaser qualifies as an accredited investor.
3. ``The Reopening American Capital Markets to Emerging Growth
Companies Act of 2011'' (S. 1933), which establishes a new
category of issuers, called ``emerging growth companies'' that
have less than $1 billion in annual revenues at the time they
register with the SEC, and less than $700 million in publicly
traded shares after the IPO. The legislation creates an ``on-
ramp'' for companies to help them go public.
These extremely important pieces of legislation complement each
other well. The effort to ease the path to the public markets for
companies is an essential policy objective, and Kate Mitchell and her
colleagues on the IPO Task Force have done an extraordinary job
formulating a commonsense strategy to address IPO problems. However,
Congress also needs to recognize that even with an easier on-ramp
process towards an IPO, companies will continue to remain private
longer than in past decades. The structural problems that exist in the
public markets--short-term trading fueled by computers, the lack of
research coverage for small-cap companies, the focus on beating
quarterly earnings projections, even the meteoric rise in shareholder
derivative lawsuits--will continue to exist. These and other factors
have whittled away the public's trust and confidence in the public
stock markets, and have made entrepreneurs such as myself less
interested in taking their companies public.
Thus, it is equally important that Congress modernizes the 500
Shareholder Rule to give private companies the flexibility to create
more jobs, compensate employees with equity, and raise capital from a
broader group of investors. A review of the Congressional cosponsors of
these bills underscores that many members understand the importance of
passing these bills--there is significant overlap in both the House and
Senate sponsorship.
There is also broad private sector support for modernizing the 500
Shareholder Rule. We submitted a letter to Congressional leadership and
Members of this Committee endorsed by some of the leading technology
entrepreneurs, venture capitalists and angel investors in the country
urging Congress to immediately pass this important legislation. Outside
of the technology sector, companies and advocacy groups across a wide
range of industries throughout the country have submitted endorsement
letters to Congress.
Moreover, modernizing the shareholder rule and eliminating the ban
against general solicitation are not new concepts: industry experts and
participants have advocated for implementing these changes for many
years. \14\ In 2009, the SEC kindly invited me to participate in its
Small Business Capital Formation Forum. I accepted the invitation and
participated on a panel regarding the state of small business capital
formation. I also listened to multiple panelists advocate for these
changes. In fact, for several years, the Forum's participants have
recommended that the SEC increase the shareholder threshold, and for
over a decade the participants have recommended that the SEC eliminate
the ban against general solicitation in the context of private
placements.
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\14\ See, e.g., Final Report of the SEC Government-Business Forum
on Small Business Capital Formation to the United States Securities and
Exchange Commission, Nov. 2010, Sep. 2009, Nov. 2008, Sep. 2005, Sep.
2004, Dec. 2003, Feb. 2002, May 2001 (advocating eliminating the
prohibition against general solicitation); Nov. 2010, Sep. 2009, Nov.
2008 (advocating exemption of accredited investors from the shareholder
limit); Nov. 2010, Sep. 2009 (advocating increasing the 500-shareholder
limit).
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Conclusion
In summary, I want to thank Chairman Reed, Ranking Member Crapo,
and the Members of the Committee for the opportunity to participate in
this important Hearing.
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PREPARED STATEMENT OF STEPHEN LUPARELLO
Vice Chairman, Financial Industry Regulatory Authority
December 14, 2011
Chairman Reed, Ranking Member Crapo, and Members of the
Subcommittee, I am Steve Luparello, Vice Chairman of the Financial
Industry Regulatory Authority, or FINRA. On behalf of FINRA, I would
like to thank you for the opportunity to testify today.
FINRA
FINRA is the largest independent regulator for all securities firms
doing business in the United States, and, through its comprehensive
oversight programs, regulates the firms and professionals that sell
securities in the United States and the U.S. securities markets. FINRA
oversees approximately 4,500 brokerage firms, 163,000 branch offices
and 636,000 registered securities representatives. FINRA touches
virtually every aspect of the securities business--from registering
industry participants to examining securities firms; writing rules and
enforcing those rules and the Federal securities laws; informing and
educating the investing public; providing trade reporting and other
industry utilities and administering the largest dispute resolution
forum for investors and registered firms.
In 2010, FINRA brought 1,310 disciplinary actions, collected fines
totaling $42.2 million and ordered the payment of almost $6.2 million
in restitution to harmed investors. FINRA expelled 14 firms from the
securities industry, barred 288 individuals and suspended 428 from
association with FINRA-regulated firms. Last year, FINRA conducted
approximately 2,600 cycle examinations and 7,300 cause examinations.
FINRA's activities are overseen by the SEC, which approves all
FINRA rules and has oversight authority over FINRA operations.
Protection of Retail Investors by the Federal Securities Laws
As a general matter, and depending upon the transaction, the
Federal securities laws provide the following types of protection to
retail investors:
Antifraud Authority--The Federal securities laws prohibit
various forms of fraud, including fraudulent, deceptive or
manipulative practices in connection with the purchase or sale
of a security. For example, Rule 10b-5 under the Securities
Exchange Act of 1934 has been used successfully to combat a
broad range of abusive practices, such as insider trading and
market manipulation.
Disclosure--For many transactions, the Federal securities
laws require disclosure about the issuer and the securities
being sold. For example, the Securities Act of 1933 generally
requires that publicly offered securities be sold through a
prospectus that provides important information about the
securities, the company's management and operations, and the
risks of buying the securities.
Regulation of Intermediaries--The Federal securities laws
regulate securities intermediaries. For example, the Securities
Exchange Act of 1934 generally requires the registration of any
firm or individual who is in the business of selling securities
as agent or principal, and subjects retail brokers and dealers
to FINRA's rigorous examinations and oversight. In general, a
person who is offering investment advice must register with the
SEC under the Investment Advisers Act of 1940 or with the
States.
Qualification of Investors--The level of regulation
provided by the Federal securities laws will often depend upon
the sophistication or wealth of the investor. For example, Rule
506 of Regulation D provides a safe harbor from registration
for securities sold to an unlimited number of ``accredited
investors,'' who meet certain thresholds of net worth or
income, and up to 35 nonaccredited investors. The rule also
requires that any unaccredited investors to whom the securities
are sold must have enough investment experience and knowledge
to make an informed decision about the merits and risks of the
investment.
Market Regulation--The Securities Exchange Act of 1934 and
the regulation of the stock exchanges and other market
participants by the SEC and FINRA establish standards that are
designed to protect the integrity of the public markets.
The Federal securities laws are intended to achieve at least two
objectives. First, they are designed to protect customers from abusive
or fraudulent practices. Second, and equally important, they are
intended to provide the investing public with confidence that market
participants will treat customers fairly.
This testimony will address FINRA's regulation of intermediaries.
From the perspective of a less sophisticated, retail investor, an
intermediary can appear objective in its selection of securities to
offer and reliable in its completion of the investor's securities
transaction. Perhaps in recognition of this relationship, Rule 506 of
Regulation D requires that each nonaccredited investor, ``either alone
or with his purchaser representative(s),'' have a specified degree of
financial sophistication.
These assumptions by a retail investor about the professionalism of
a securities intermediary necessitate that an intermediary be subject
to adequate oversight by a securities regulator. In the course of our
work, FINRA examines registered broker-dealers for compliance with the
securities laws, SEC rules and our own rules. Of course, the particular
requirements applicable to an intermediary should partly depend upon
the nature of the intermediary's business. FINRA thus makes every
effort to tailor its oversight according to the various business models
within the broker-dealer industry.
In response to the Subcommittee's request, we are focusing the
following discussion on the private placement and microcap markets.
Given that the private placement market is a relevant analogy to a
number of the capital-raising constructs currently under consideration,
we believe our experience with that market and the issues and
regulatory problems that we have found in that area may be particularly
helpful to the Subcommittee.
The Private Placement Market
The private placement market is an essential source of capital for
American business, particularly small firms. Regulation D under the
Securities Act of 1933 provides the most important avenue for a company
to privately issue shares. According to one estimate, in 2008 companies
intended to issue approximately $609 billion of securities in
Regulation D offerings. \1\ While the private placement market is an
important source of capital for many U.S. companies, the Federal
securities laws permit issuers to privately place their securities
directly with qualified purchasers, without necessitating the
protections of a regulated intermediary, and with limited or no
disclosure about the company. In our oversight of broker-dealers that
participate in Regulation D offerings, FINRA has uncovered fraud and
sales practices abuses. Recently, for example, FINRA sanctioned a
number of firms and individuals for providing private placement
memoranda and sales material to investors that contained inaccurate
statements or omitted information necessary to make informed investment
decisions.
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\1\ Office of the Inspector General, Securities and Exchange
Commission, Regulation D Exemption Process 2 (March 31, 2009).
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As a response to these problems, in 2010 FINRA issued guidance to
firms concerning their participation in Regulation D offerings. The
Notice reminded firms that FINRA's suitability rule requires that a
broker-dealer conduct a ``reasonable investigation'' concerning
recommended Regulation D offerings. The guidance also made clear that
the requirement to conduct a reasonable investigation is a duty of a
broker-dealer that arises from a long history of case law under the
antifraud provisions, and under FINRA's just and equitable principles
of trade. This duty requires the broker-dealer to understand the
Regulation D securities and to take reasonable steps to ensure that the
customer understands the risks and essential features of those
securities.
In October, FINRA filed with the SEC proposed rule amendments to
ensure that firms make basic disclosures about private placements that
they recommend to their retail customers. This proposal, which is still
pending at the SEC, would require firms to disclose the anticipated use
of offering proceeds, the amount and type of offering expenses, and the
amount and type of compensation to be paid. The proposed rule
amendments also would require ``notice'' filings with FINRA of a
broker-dealer's private placement activities.
Microcap Markets and Fraud
Microcap issuers are companies with low levels of capitalization.
Often they are startups or shell companies whose stock is thinly traded
in the over-the-counter market. Some may be private issuers whose
shares became eligible for trading in the over-the-counter market.
Others may have originally issued their shares through an exemption
from registration, such as Regulation D, but have since become public
companies through a reverse merger with a shell company or through
other means.
Even the microcap issuers whose shares have been registered under
the Securities Act of 1933 can present particular risks to retail
investors. These companies may not be followed by independent financial
analysts, their shares may be thinly traded, and the publicly available
information about the company may not provide a sufficient basis to
evaluate the company's claims about its business prospects.
During the last 2 years, FINRA has referred more than 500 matters
involving potential microcap fraud to the SEC. For example, in one
matter the SEC suspended trading in a purported power company and
charged several of its executives with inflating the price of its stock
by issuing a barrage of press releases touting the company, including
claims that it was building a $10 billion nuclear power plant. In fact,
the company, which went public through a reverse merger, had
essentially no revenue or operations. The SEC also alleged that the
company falsely claimed that its management had such confidence in the
company that they had not sold any of its stock; records obtained by
the SEC showed that two senior executives had secretly unloaded
extensive stock holdings.
Fraudulent schemes in microcap stocks often seek to exploit well-
publicized news events or trends. After the Japanese tsunami, FINRA
warned investors about scams involving companies that claimed to offer
products or services for detecting gamma rays or cleaning up nuclear
waste. FINRA has also referred matters to the SEC involving stocks
linked to China, the Gulf oil spill, gold, and clean energy.
FINRA's Office of Fraud Detection and Market Intelligence
Many of the referrals noted above originate in FINRA's Office of
Fraud Detection and Market Intelligence (OFDMI). OFDMI's mission is to
ensure that allegations of serious fraud received by FINRA in the form
of complaints, regulatory filings and other sources are subjected to a
heightened review. OFDMI serves as a centralized point of contact on
fraud issues, within FINRA and externally with other regulators and the
public. The creation of OFDMI has expedited fraud detection and
investigation, by pursuing matters as far as possible and by referring
cases that fall outside of FINRA's scope to the appropriate
authorities.
So far this year, OFDMI has referred more than 600 matters
involving potential fraudulent or illegal conduct to the SEC or other
Federal law enforcement agencies for further investigation. In 2010,
OFDMI made more than 550 referrals. These matters involved a wide range
of issues, including insider trading, microcap fraud and Ponzi schemes.
Through the Central Review Group unit, OFDMI has centralized the
receipt, analysis and distribution of tips, complaints and referrals
from the public and other regulators. In addition, OFDMI has
implemented a comprehensive prioritization system that is used across
all of FINRA's regulatory operations. This operational enhancement
means that serious matters are escalated and investigated more quickly.
FINRA's Office of the Whistleblower, first established in March
2009, continues to receive and process, on an expedited basis, a
significant amount of incoming information. As of November 2011, the
office has received and triaged over 180 substantive calls to its
hotline, and another 180 reviews were initiated from emails received
via a dedicated email address. The office made 37 formal referrals to
the SEC or other law enforcement agencies, and another 54 internal
referrals. As a result, 12 registered representatives have been
permanently barred from the securities industry, with an average of 135
days from the receipt of the matter to the imposition of the bar.
As of November 30, 2011, the Fraud Surveillance unit of OFDMI has
referred 277 matters to the SEC this year. The referrals include
matters involving issuer fraud, pump-and-dump schemes, market
manipulation and account intrusions. During the same time period,
OFDMI's Insider Trading Surveillance unit made 285 insider trading
referrals to the SEC, the highest in FINRA's history. The referrals
included suspicious trading ahead of material news announcements by
hedge funds, institutional investors, private equity funds and retail
investors.
Beyond the establishment of OFDMI, FINRA also has enhanced its
examination programs and procedures in a variety of ways intended to
help us better detect conduct that could be indicative of fraud. Our
examination teams are expected to focus most on those areas at firms
that pose a real risk to investors. FINRA staff created an ``Urgent''
designation for those regulatory matters posing the greatest potential
for substantial risk to the investing public. Urgent matters are
expedited and then reviewed to make certain that the right level of
resources and expertise are assigned to them, and to ensure there is
coordination and information sharing across FINRA departments. We also
have increased the number of staff in our district offices tasked with
in-depth and ongoing understanding of specific firms, including
increased real-time monitoring of business and financial changes
occurring at a firm. This expansion has enhanced our staff's ability to
evaluate available regulatory information and to target examinations
based on that information.
Investor Education
Investor education is a critical component of investor protection
and FINRA is uniquely positioned to provide valuable investor education
primers and tools. FINRA sponsors numerous investor forums and outreach
programs, and our Web site is a rich source of such material, including
investor alerts, unbiased primers on investing and interactive
financial planning tools. In addition to the investor education
activities of FINRA itself, the FINRA Investor Education Foundation is
the largest foundation in the United States dedicated to investor
education.
Relative to the issues we are discussing today, FINRA has produced
investor alerts that clearly explain the characteristics of the most
commonly used securities frauds, including Ponzi and pyramid schemes,
pump-and-dumps and offshore scams. For example, a range of investor
alerts issued just this last year warned investors about:
gold stock scams that mine investors' pocketbooks;
fraudulent schemes exploiting the tsunami and nuclear
crises in Japan; and
pre-IPO scams purporting to offer access to shares of
Facebook and other popular, well-known private companies.
Drawing on ground-breaking research supported by the FINRA Investor
Education Foundation, we have delivered dozens of investor seminars
that explore who is at risk, how to recognize the psychological
persuasion tactics used by fraudsters to lure in their victims--tactics
that are constant across a wide variety of frauds--and what simple,
actionable steps investors can take to avoid investment scams. To reach
an even wider audience, the FINRA Foundation produced an award-winning
documentary, Trick$ of the Trade: Outsmarting Investment Fraud, which
has aired more than 740 times on 170 public television stations in 30
States since September 2010.
A key theme of our investor protection initiatives is ``Ask and
Check.'' We encourage investors to find out whether an investment
professional is licensed--and to verify the information using FINRA's
BrokerCheck system. BrokerCheck allows investors to quickly access
information about the disciplinary history, professional background,
business practices and conduct of the brokerage firms and individual
brokers with whom they invest. While dealing with a licensed
professional isn't a guarantee against fraud, most investment scams
tend to involve unlicensed professionals touting unregistered
securities.
Conclusion
We appreciate the Subcommittee's continued focus on improving
access to capital for startups and small businesses while continuing to
provide protections for investors. We hope that sharing our experiences
in dealing with regulatory challenges in private offerings provides
useful insight as the Subcommittee continues its evaluation of the many
bills pending relative to this issue. As noted above, Federal
securities law and SRO rules provide protection for retail customers
through five primary mechanisms--antifraud authority, disclosure,
regulation of intermediaries, qualification of investors, and market
regulation. The legislative proposals currently under consideration
attempt to build in some or all of these mechanisms in various ways. We
would be happy to continue to work with the Subcommittee and its
Members as you consider how best to balance the goals of providing new
opportunities for building capital and protecting investors.
Again, I appreciate the opportunity to testify today. I would be
happy to answer any questions you may have.
______
PREPARED STATEMENT OF MARK T. HIRAIDE
Partner, Petillon, Hiraide & Loomis, LLP
December 14, 2011
Chairman Reed, Ranking Member Crapo, distinguished Members of the
Committee, thank you for the opportunity to appear here today to
discuss investor risks in capital raising.
My name is Mark Toshiro Hiraide. I am a partner in the law firm of
Petillon Hiraide & Loomis LLP, in Los Angeles, California. I have been
in private practice since forming the firm with my partners in 1994,
after serving 8 years as an attorney for the Securities and Exchange
Commission. \1\ Since leaving the Commission over 17 years ago, I have
spent my career as legal counsel to entrepreneurs and small and mid-
sized public companies, assisting them in private and public securities
offerings. My practice includes defending officers and directors in
civil litigation arising out of securities offerings and merger and
acquisition transactions and prosecuting civil claims on behalf of
aggrieved investors. I also practice before the SEC and FINRA in
regulatory defense matters. Relevant publications include the legal
treatise, ``Representing Start-Up Companies,'' published by Thomson
Reuters, of which I am a coauthor, and the ``Guide to California
Securities Practice'' published by the Corporations Committee of the
Business Law Section of The State Bar of California for which I served
on the Editorial Committee.
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\1\ I joined the Commission's Division of Enforcement, as an
attorney and later Branch Chief, in the Los Angeles Regional Office
from 1986 to 1989. From 1990 to 1994, I served as an Attorney-Advisor
in the Commission's Division of Corporation Finance in Washington, DC.
While at the Commission, I was appointed by the United States
Attorney's Office to serve as a Special Assistant United States
Attorney to prosecute a major criminal securities fraud case that I had
litigated for the Commission.
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The Funding Gap
The importance of early-stage capital to our economy, and the
challenges to entrepreneurs in accessing it, even prior to the recent
economic downturn, has been well documented. \2\ Recent events have
made it even more difficult for new companies requiring seed capital to
attract it. Home equity, traditionally a source of capital for seed
stage investors, has diminished with the deep decline in real estate
prices. Moreover, continuing economic uncertainty has caused many
early-stage investors to be risk averse.
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\2\ See, e.g., recently released Fall 2011 State of Small Business
Report, John Paglia, lead researcher of the Pepperdine Private Capital
Markets Project and associate professor of finance at Pepperdine
University's Graziadio School of Business and Management.
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In my experience, a start-up's first seed capital investment of
$250-$500,000 is critical to the development a health equity market
``food chain.'' This initial funding level allows technologies and
concepts to be validated. Without such validation, it is often
difficult for our client entrepreneurs even to be considered by
professional venture capital and Angel investors.
According to a recent survey, 76 percent of 253 investment bankers
surveyed said that the number of companies with $1 million EBITDA (a
company's earnings before the deduction of interest, tax, and
amortization expenses) who are worthy of investment exceeds the amount
of capital available (whereas, only 58 percent of the investment banked
respondents said the capital available exceeds the number of companies
with $100 million EBITDA that meet investment criteria). \3\
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\3\ Private Capital Markets Project Survey Report 2011-2012,
Private Capital Markets Project, Pepperdine University's Graziadio
School of Business and Management (www.bschool.pepperdine.edu/
privatecapital).
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Can the Internet and modern communication technologies help close
the funding gap? If the current statutory limitations on conducting
private offerings are eliminated, what are the risks to investors? I
look forward to answering any questions you may have regarding each of
the bills being considered by the Committee. However, I will limit my
remarks to two experiences that may prove instructive in considering
crowdfunding legislation, as this legislation has the greatest
potential for abuse.
Lessons Learned From Ace-Net--The Critical Role of Securities
Intermediaries
Attempts at utilizing technology to make processes more efficient,
in this case the market for seed and early-stage capital, are not new.
In the early 1990s, as the world was for the first time coming online,
``disintermediation'' was the mantra . . . technology would cut out the
middle-man. In the case of the market for early-stage capital, however,
it did not.
In 1997, the Small Business Administration's Office of Advocacy,
working in consultation with the Securities and Exchange Commission,
the North American Securities Administrators Association, and the
University of New Hampshire's Whittemore School of Business and
Economics, launched the Angel-Capital Electronic Network, more commonly
known as ``ACE-Net.'' \4\ It was an Internet-based matching service for
accredited investors and entrepreneurs seeking up to $1 million in seed
funding. The network was to be operated by local nonprofit entities and
universities.
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\4\ ACE-Net received a no-action letter from the staff of the
Commission (Angel Capital Electronic Network, SEC No-Action Letter,
1996 WL 636094 (Oct. 25, 1996)), key no-action letter that many have
relied on for guidance on the issue of whether organizers of Internet-
based matching services are required to register as broker-dealers or
investment advisers. In determining that ACE-Net was not required to
register, the Commission staff emphasized that ACE-Net and the local
operators did not provide advice about the merits of particular
investments, did not participate in negotiations for transactions
between participants, did not receive compensation from ACE-Net users,
other than flat fees to cover administrative costs (which were not
contingent on the completion of any transactions), did not hold
themselves out as providing securities-related services other than
operating ACE-Net.
After several years, the Office of Advocacy transferred ACE-Net to
a nonprofit organization in an attempt to ``privatize'' it. My law
partner, Lee Petillon, served as counsel pro bono to the nonprofit
organization, and we worked closely with Terry E. Bibbens, Entrepreneur
in Residence in the Office of Advocacy, U.S. Small Business
Administration, who was instrumental in ACE-Net's formation and
continued to work pro bono to create a viable Internet securities
intermediary.
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Although ACE-Net provided a mechanism through which entrepreneurs
could conduct a general solicitation of their offering, ACE-Net was not
successful, in part, because sophisticated investors simply did not
identify investment candidates by searching companies at random over
the ACE-Net portal. Without an active connection between entrepreneurs
and the investment community, deals did not get done.
Although, today, many more people are connected through social
media, a passive portal, or even several of them, through which an
investor may access potentially hundreds of investment opportunities,
may not be the catalyst to spur seed-round capital formation. The old
adage that securities are sold . . . rarely are they purchased,
especially by nonprofessional investors . . . was as true in 1997, as
it was in 1933, and as it likely is today.
We learned that more sophisticated individual investors invest when
the investment has, in some sense, been validated. Although this
validation may come in the form of participation in the offering by
recognized investors, most often it is based on a recommendation from a
trusted financial advisor. \5\
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\5\ Recommendations to purchase securities are, and should, be
regulated. The staff of the SEC rejected an ACE-Net proposal to permit
it to highlight to potential investors those offerings in which a
venture fund or organized Angel group participated. The SEC staff
deemed such activity constituted investment advice that was beyond the
scope of the staff's no-action letter, in which the staff agreed not to
take Enforcement action against ACE-Net for not registering as a
broker-dealer.
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In the light of this reality, we realized that the active
involvement of securities professionals in the capital raising process
is critical to capital formation. I believe the challenge in adopting
new legislation to stimulate early-stage capital formation is to
maintain effective regulation over those professionals, while not
imposing too high a regulatory barrier to entry, and to ensure that
incentives are not inadvertently created that lead to the formation of
unregulated securities markets.
Lessons Learned From Unregistered Finders--The Potential for Abuse
Since the enactment of the Securities Act of 1933, the most common
exemption from the requirement to register the offer and sale of
securities with the Securities and Exchange Commission is the so-called
``private offering'' exemption found in Section 4(2) of the Act. The
hallmark of the private offering is that a general solicitation of
securities is prohibited. One method for the issuer to satisfy this
requirement is for the issuer to show that it had a preexisting
relationship with the investor. Although the staff has stated that this
is not exclusive, neither it nor the courts have defined clear
boundaries around the general solicitation issue.
However, in recognition of the importance of securities
intermediaries to facilitate private offerings, since the 1980s, the
Commission staff has made clear through its no-action letters, that
issuers may engage a registered broker-dealer as placement agent and,
in effect, use the registered broker-dealers' ``preexisting
relationships'' with the broker-dealers' existing customers.
With one exception, this staff position, however, did not extend to
preexisting relationships between investors and ``finders,'' who are
nonregistered securities intermediaries. The exception was for the
unusual facts in the case of the entertainer Paul Anka. Anka, who
obtained a commission for providing names of certain of his
acquaintances to an issuer, obtained a no-action letter, as he clearly
was not in the business of effecting securities transactions, and this
was viewed by the staff as a one-time occurrence. Unfortunately, many
incorrectly interpreted the Paul Anka no-action letter and relied upon
it to create the so-called ``finders'' exception to the broker-dealer
registration requirement.
As a result, in Southern California, as well as in other places
around the country, ``boiler rooms'' emerged . . . a class of
unregulated securities salespersons who worked to develop relationships
with individuals, many of whom were at home and retired. Although
oftentimes the individual solicited appeared on a list of purportedly
``prequalified'' investors, in most cases investors were solicited by
telephonic cold-calls.
Eventually, the experienced unlicensed salesperson, indeed,
developed ``preexisting'' relationships with these investors, as many
of the investors serially invested in deals offered by the salesperson.
For the unlicensed securities intermediary, this investor pool served
as the wellspring for unregistered intermediaries who continued to tap
it, and generate hundreds of millions of dollars in commissions,
throughout the Internet boom and beyond. \6\
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\6\ Last year, the Commission staff issued a no-action letter,
Brumberg, Mackey & Wall, P.L.C. (May 17, 2010), stating that, ``A
person's receipt of transaction-based compensation in connection with
[securities sales] activities is a hallmark of broker-dealer
activity.''
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The Crowdfunding Bills (S. 1791 and S. 1970)
I fully support the intent behind the crowdfunding bills. However,
I share Professor Coffee's concerns that unregistered salespersons may
abuse the broker-dealer registration exemption set forth in Section 7
of the bill. Unregistered salespersons of the sort that I described
will, with little effort, satisfy the requirements for the exemption in
Section 7 of S. 1791.
On the other hand, S. 1970, adopts a regulatory regime for
intermediaries that requires them either to elect to register with the
Commission as a broker-dealer or as a newly defined ``funding portal,''
subject to several definitional proscriptions.
S. 1970 appropriately limits the scope of permissible activity of a
funding portal by prohibiting it from:
offering investment advice or recommendations;
soliciting purchases, sales, or offers to buy the
securities offered or displayed on its Web site or portal; and
compensating employees, agents, or other third parties for
such solicitation or based on the sale of securities displayed
or references on its Web site or portal.
S. 1970 also provides reasonable limits on maximum individual
investment limits. By including an aggregate limit applicable to all
crowdfunded investments, in addition to dollar investment limits per
company, S. 1970 addresses a concern known as ``stacking,'' whereby an
individual investor invests in successive offerings but manages to
satisfy the requirements of each individual offering.
Finally, the $1 million exemption limit under S. 1970 may be
adjusted by the Commission to reflect the annual change in the Consumer
Price Index for All Urban Consumers published by the Bureau of Labor
Statistics. If the Commission were permitted by rule to increase the
exemption limit, the exemption, if successful for seed offerings up to
$1 million, could be scaled to cover an even greater portion of the
funding gap.
In summary, S. 1970 balances the need to facilitate access to
critical seed capital with important investor safeguards.
Additional Material Supplied for the Record
STATE ENFORCEMENT ACTIONS CONCERNING SECURITIES FRAUD, CAPITAL
FORMATION, AND INTERNET OFFERINGS FROM NASSA, SUBMITTED BY CHAIRMAN
JACK REED
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
STATEMENT SUBMITTED BY JEFF LYNN, CHIEF EXECUTIVE OFFICER, SEEDRS
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]