[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

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                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

                              ----------                              

                      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.
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    (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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \16\ Stephen Choi, ``Regulating Investors, Not Issuers: A Market-
Based Proposal'', 88 Cal. L. Rev. 279 (2000).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    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?
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \22\ See, generally Seligman, supra note 1.
---------------------------------------------------------------------------
    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 
---------------------------------------------------------------------------
        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\
---------------------------------------------------------------------------
     \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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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.'').
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.''
---------------------------------------------------------------------------
     \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\
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
     \1\ Office of the Inspector General, Securities and Exchange 
Commission, Regulation D Exemption Process 2 (March 31, 2009).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
     \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
     \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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


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   STATEMENT SUBMITTED BY JEFF LYNN, CHIEF EXECUTIVE OFFICER, SEEDRS


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