These remarks were not presented in person due to poor weather conditions.
Before I begin, I must tell you that the views I express here today are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
I am delighted to speak this afternoon at "The SEC Speaks in 2010." As you know, 2009 was a very busy year at the Commission, with every office and division working diligently on a range of challenging matters. The SEC, for example, pursued an active enforcement agenda last year and advanced a number of rulemaking initiatives concerning matters such as credit rating agencies, short selling, the election of board members, money market funds, flash orders, and the custody of investment adviser client assets, to name a few. Accordingly, before I say anything else, I want to thank the Commission staff for their hard work and dedication during a demanding time in the agency's history. I greatly appreciate your commitment and professionalism.
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Following the financial crisis, attention has centered on the problem of "too big to fail." Focus on "too big to fail" is needed; but as approaches are studied for mitigating systemic risk and the harm that can flow if a large and interconnected financial institution collapses, we cannot lose sight of a different segment of the economy: small business.
Small business fuels economic growth, generating valuable opportunities for investors, entrepreneurs, employees, and consumers. Startups and maturing enterprises drive innovation, provide opportunities for investors to earn higher returns and accumulate wealth, and spur job creation. Companies that today are household names can trace their origins to entrepreneurs and innovators of earlier periods who had the wherewithal and backing to start and grow a business.
In providing our economy with cutting-edge goods and services, new and smaller companies in turn pressure more established firms to run themselves more effectively. The market discipline of competition, in other words, holds larger enterprises accountable. Not only do we, then, benefit from the range of innovative products and new jobs that small businesses offer, but we benefit because larger firms must be even more responsive to the demands of stakeholders.
This is only part of the picture, however. Smaller companies also face distinct challenges and hurdles, some of which are rooted in regulatory requirements that can disproportionately burden small business. The out-of-pocket financial cost of complying with regulatory obligations can be considerable. In addition, regulatory compliance requires a commitment of time and effort that otherwise could be dedicated to running the business; smaller enterprises may not have excess human resources to distract from day-to-day operations. Put simply, the disproportionate strain of regulation on small business can create a barrier to entry or expansion.
In fashioning regulation, we need to be mindful of the costs we all bear if, as a result of regulatory burdens, businesses struggle to get off the ground or expand. When an emerging business cannot secure funding at a reasonable cost, for example, the economy is deprived of the firm's full participation in the marketplace.
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The practical challenge for securities regulation is to strike a balance that avoids unduly stifling the formation and fostering of new and smaller businesses. The federal securities laws have long recognized the need to be measured, as there is a tradition of scaling federal securities regulation in important respects to provide small businesses relief from select burdens that may be especially onerous for them. By way of illustration, let me highlight two distinct examples that illustrate the diverse contexts in which considerations particular to startups and other smaller enterprises have been accommodated. Both instances evidence the tailoring of securities regulation to better fit the regime to firms of different sizes and at different stages in their lifecycles. One example concerns capital formation and the other relates to the structure of equity markets.
The registration requirements of section 5 of the Securities Act of 1933 are the centerpiece of that legislation. Nonetheless, the full measure of section 5 does not apply to smaller businesses in practice. Section 3(b) of the '33 Act, for example, authorizes the SEC to adopt rules exempting certain small offerings from section 5's registration obligations, which can be demanding and time consuming. Under section 3(b), the Commission has adopted Rules 504 and 505 of Regulation D. By allowing an issuer to forego a statutory prospectus and registration statement, our rules facilitate capital formation for startups and other small firms long before they consider going public. Rule 506 also has encouraged small business capital formation by providing certainty and predictability in the form of a safe harbor under section 4(2) of the '33 Act.
As recently as 2007, the SEC adopted a host of reforms designed to ease the disclosure burden smaller companies face once they are public.1 The Commission also expanded the number of companies that can avail themselves of the more streamlined and efficient regulatory regime. These reforms further show that securities regulation can be fashioned to account for the unique circumstances of smaller enterprises while ensuring that investors are properly protected. In fact, investors can benefit when the regulatory regime is tailored to provide smaller companies prudent relief from undue regulatory demands. Efficient capital formation, for example, not only benefits the companies raising funds, but can provide investors with more attractive investment opportunities.
The second example is Regulation ATS, which placed particular emphasis on not discouraging entry as a source of competition and innovation in U.S. equity markets.2 With the purpose of advancing the goals of a national market system, the Commission adopted Regulation ATS in 1998 in response to the proliferation of alternative trading systems as venues that competed with registered exchanges and Nasdaq for trading activity. The Commission determined that ATSs, which were not regulated the same as exchanges or Nasdaq, required additional oversight, but did not want to subject alternative trading systems to regulatory burdens that could "jeopardiz[e] the commercial viability of these markets," as the adopting release put it. The Commission struck the balance by permitting an alternative trading system two choices: register as an exchange or register as a broker-dealer and meet the requirements of Regulation ATS.
While Regulation ATS did impose additional regulatory demands on alternative trading systems, the cost of registering as a broker-dealer plus complying with Regulation ATS was expected to be less than the cost of registering as an exchange. Even within the universe of alternative trading systems, Regulation ATS eased the requirements imposed on lower volume ATSs as compared to those where more trading occurred. The Commission expressly acknowledged the value of "allow[ing] new markets to start, without disproportionate burdens," and the benefits of a "flexible" regulatory regime that could accommodate "evolving technology" and the diverse "business objectives" of emerging trading venues.
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Having glanced back, I want to turn to the present and speak briefly about a current topic that bears directly on small business: venture capital. There is no question that firms need capital. A great idea combined with a great business plan does not get very far without adequate financing at a reasonable cost. For early stage and other smaller companies, access to private capital, such as from venture capital funds, can be key to getting off the ground and maturing as a business.
As part of the ongoing debate over financial regulatory reform, various initiatives have at times been put forth that would subject private pools of capital to additional government oversight. Although subjecting hedge funds to more regulation seems to be the primary purpose behind proposals aimed at private pools of capital, regulatory changes that have been advanced would encompass venture capital funds to one degree or another.
I do not have time for a more comprehensive assessment of the regulation of private pools of capital. Instead, I will offer some observations that, at a minimum, recommend proceeding with caution when it comes to the prospect of burdening venture capital funds and their advisers with additional regulation.
As a starting matter, it is worthwhile to recall that venture capital funds presently are bound by securities regulation and other legal strictures. Fund managers, for example, are subject to certain fiduciary obligations, and venture capital funds, along with other private investment pools, are subject to prohibitions against fraud and manipulation, together with various other constraints and requirements under the federal securities laws.
Market discipline also holds funds and their managers accountable. Consider, for example, that even though venture capital funds issue securities to their investors in private offerings and are not subject to periodic reporting obligations under the Securities Exchange Act, funds nonetheless routinely provide meaningful disclosure to their investors because investors demand information.
To be sure, venture capital funds are structured to benefit from certain regulatory exemptions. But that does not necessarily mean that there are "regulatory gaps" that warrant closing. By definition, a regulatory exemption has the effect of scaling back the reach of certain regulatory requirements, but there is a corresponding benefit that has to be considered. Exemptions can tailor the regulation regime so that commercial enterprises enjoy the latitude needed for private sector innovation and entrepreneurism to prosper, unhindered by undue regulatory constraints.
Concerning whether the cost-benefit tradeoff justifies burdening venture capital funds with additional regulation, I want to offer four further considerations.
First, the additional steps that a venture capital fund would have to take to meet new regulatory requirements could take time and effort, as well as financial resources, away from more productive endeavors that benefit fund investors and the companies the fund has backed. Time and effort that fund managers and other professionals could have spent analyzing investment opportunities or providing managerial guidance to startups and other early stage enterprises likely would be redirected to tend to new administrative obligations.
Second, expanded regulatory demands may erect barriers that preclude entry by new funds. Similarly, well-established funds that are better positioned to incur the added cost may gain a competitive advantage over smaller, less-established funds that struggle to meet the added burdens.
Third, additional regulation runs the risk of jeopardizing, to an appreciable degree, the benefits that venture capital contributes to our economy as an essential component of the U.S. system of financing commercial enterprise. To the extent venture capital funds are required to bear more regulatory burdens, one must account for the prospect that their activities will be impeded, which is to say that additional regulation could frustrate capital formation. To put it more concretely, when capital formation is frustrated, it becomes increasingly difficult for startups and other small businesses to finance the research and development of new ideas, to commercialize cutting-edge technologies and innovative products, and to create new jobs by entering the market or expanding their operations. Such undesirable results are not good for business; nor are they good for a venture capital fund's investors.
Fourth, whatever the causes may have been of the recent financial crisis, blame cannot reasonably be placed on the venture capital industry.
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Drawing appropriate regulatory distinctions — such as between smaller and larger businesses — and scaling regulatory demands accordingly helps guard against overburdening enterprises that do not present the kinds of concerns that, on balance, may warrant more costly regulation. Eschewing a one-size-fits-all regulatory approach when possible in favor of calibrating the securities law regime to account for different cost-benefit tradeoffs under different circumstances is prudent. This basic intuition undergirds the core point that my remarks today have driven toward — namely, that the SEC should actively consider ideas for tailoring securities regulation to ensure a measured approach is taken with respect to smaller enterprises.
Thank you and enjoy the rest of the afternoon.