It is a pleasure to be here today to speak to you. I appreciate the opportunity to do so. I would like to spend my time addressing two recent landmark pieces of legislation that affect the area that I and my colleagues at the SEC oversee—the financial markets. They are the Dodd-Frank Act of 2010 and the JOBS Act of 2012.
First, however, I'd like to offer you a disclaimer about my remarks today. The SEC, as a matter of policy, disclaims responsibility for any of my statements to you today. The views that I express to you today are my own, and do not necessarily represent the views of the Commission, individual Commissioners, or any other member of the staff of the Commission.
We are slowly emerging from the greatest financial crisis to hit the United States since the Great Depression. Beginning in 2008, this crisis led to the loss of millions of jobs, saw the collapse of large financial firms and forced government bailouts of other large financial firms as well as bailouts and stimulus packages for the broader economy. Two packages, one signed by President Bush in 2008 and the other by President Obama in 2009, amounted to almost $1 trillion in government stimulus.
The exact causes of the crisis and recession will be studied and argued over in the years to come, but many can agree that the crisis revealed the following:
In response to the crisis and hoping to address the gaps and flaws in the regulatory landscape revealed by the crisis, and to enhance the stability and viability of our financial system, Congress passed the Dodd-Frank Act of 2010—legislation that affects almost all aspects of the financial system, touches all financial regulatory agencies and even creates some new ones. It has been described as a sweeping overhaul of our financial system. Since passage, we at the SEC have been working hard to produce the many rulemakings and studies required under the Act that we are responsible for.
I'd now like to first give a hopefully brief overview of the Act. Then, I'd like to more specifically note a couple of Dodd-Frank mandated studies that my office is responsible for.
One item learned from the crisis is the need to better see and manage the risks in our financial system. The crisis took many in industry and government by surprise, and measures and remedies had to be quickly formulated. If many of you recall the fall of 2008, from the bankruptcy of Lehman Brothers, to the steep drop in the market indices, to the passage of the TARP program, each one a milestone, happened in the span of a handful of months.
The Act created the Financial Stability Oversight Council. This council is charged with identifying threats to the stability of the financial system, promoting market discipline and responding to emerging risks. Before this, there wasn't a formal mechanism to bring the numerous financial regulators, such as the SEC, the Treasury, the Federal Reserve, the FDIC and the CFTC, together to discuss and share information.
I imagine most if not all of you have heard the term "too big to fail." The Act seeks to keep such a situation from happening again by providing orderly wind-down authority. Under the Act, the FDIC can swoop in and become a receiver for any bank or other financial institution that is failing and is determined to be systemically important. That means that if the bank or institution poses a significant risk to financial stability upon its failure (for example, by being very large), then the FDIC can take over control of the company for purposes of the liquidation. Of course, there are procedures in place for the company to challenge such action. No taxpayer funds are to be used in the company's liquidation. Instead, should the FDIC need money to pay for the liquidation process, the FDIC can ultimately assess the larger financial companies for the additional money.
Although not directly implicated in the recent financial crisis by many, the Dodd-Frank Act sought to more directly regulate hedge funds and other private funds, which were an opaque and little regulated area of the financial system. Large net-worth individuals and institutional investors invest a lot of money in these funds. The concern is with finding out more about the funds and how much risk these funds may pose to the financial system in the future. Previously, many funds and related investment advisers operated under an exemption from reporting to the SEC. The Act, along with rulemaking by the SEC, requires registration and regular reporting by many of these funds.
Derivatives are financial instruments derived from another underlying asset, security or index. Before Dodd-Frank, the derivatives market was largely unregulated and opaque.
In terms of the crisis, many financial participants held or wrote credit default swaps—a type of derivative—that were tied to mortgage-backed securities. Once the value of mortgage-backed securities began falling as a result of increasing defaults, those that had written credit default swaps that were meant to guarantee against such defaults found themselves with increasing and, for some, unmanageable exposure. Those holding the swaps as guarantee against default could no longer rely on them.
The Dodd-Frank Act creates a new regulatory framework for derivatives. Notably, the Act requires mandatory clearing and trading of certain derivatives through regulated clearing organizations and regulated exchanges. This will hopefully contribute to a more visible and transparent marketplace. The CFTC and SEC both are involved in rulemaking for this area.
In response to concerns about consumer financial products, in particular the residential mortgages that became the center of the financial crisis, the Dodd-Frank Act created the Consumer Financial Protection Bureau to regulate consumer financial products and services. Included is the administration of new laws that will govern the residential mortgage industry that, for example, set minimum underwriting standards and appraisal requirements.
Lastly, a portion of the Dodd-Frank Act directly addresses the SEC itself and the matters regulated by the SEC, in addition to calling for a number of studies to be undertaken. The Act creates an Office of the Investor Advocate and an Investor Advisory Committee in order to increase the influence of investors. We have just recently determined the members of the committee and the first meeting of the committee will be on June 12.
The Act also increased the SEC's role in regulating credit rating agencies as well as increased the regulation of asset-backed securities in order to address issues that were raised by the financial crisis. Mortgage-backed securities (that proved central in the crisis) are a type of asset-backed security. One regulation requires the entity creating the security to retain an economic interest in it before transferring or selling it.
Now that I've given a brief overview of the Dodd-Frank Act, and I hope you can appreciate the breadth of what the Act covers and what is required of the federal regulators, I'd like to take a quick moment to more specifically mention two Dodd-Frank mandated studies that directly involve my office.
Last year, our office finished a study of ways to improve investor access to registration information about investment advisers, broker and dealers, and related persons. Currently, such information is contained in two databases—one administered by FINRA (for brokers and dealers) and one administered by the SEC (for investment advisers).
The Act specified that the study include an analysis of the advantages and disadvantages of further centralizing access to registration information, and identify data pertinent to investors and method and format for displaying and publishing the data to enhance accessibility and utility.
Our study made the following recommendations:
The second study—mandated by Dodd-Frank and spearheaded by our office—relates to financial literacy among investors. The goal of the study is to identify:
The report on this study is due to Congress by July 2012 and we are hard at work on it. Unfortunately, I can't elaborate more on this interesting study.
Now I'd like to turn to the JOBS Act which was signed into law on April 5, 2012.
Unlike the Dodd-Frank Act, which generally relates to the financial system and the larger institutions in it, the JOBS Act generally seeks to support the smaller businesses in our general economy. With the economy appearing to slowly recover at the beginning of 2012, Congress saw the need to help our smaller businesses raise funds in our public capital markets. With bipartisan support, Congress passed the JOBS Act—which stands for the Jumpstart Our Business Startups Act—to lessen the regulatory requirements in accessing public capital.
The JOBS Act does a number of things. I would like to give you a quick overview on some of the items that may more directly impact you.
First, the Act revises the requirements for emerging growth companies to go public or, in other words, undertake an IPO. An IPO is subject to a number of requirements under federal securities law, including registering the offering with the SEC. The JOBS Act reduces some of these requirements for "emerging growth companies." An "emerging growth company" is a company that has total annual gross revenue of less than $1 billion in its most recent fiscal year. This definition would actually cover a vast majority of the IPOs that have occurred and, for all practical purposes, this part of the JOBS Act should prove useful to most pre-IPO companies.
The Act reduces the requirements by:
These IPO changes apply immediately and are the one piece of the JOBS Act that isn't subject to SEC rulemaking.
Another part of the JOBS Act that you may have heard about is the part that deals with crowdfunding. For those that are unfamiliar, crowdfunding is a means to raise money by enticing relatively small individual contributions from a large number of people. The Internet and social media has made crowdfunding possible and, in the last few years, a number of crowdfunding websites have proliferated. The websites range from seeking small donations for charitable to artistic endeavors to contributions to help launch a business in return for the product being made or a thank-you item, like a T-shirt.
The one thing that crowdfunding could not do as a result of restrictions under the federal securities law was to offer an ownership interest, or a share in the profits of the business or venture, in other words a security. The JOBS Act creates a special exemption for crowdfunding so that companies can sell securities by way of crowdfunding.
Generally, under the Act, companies will be limited to raising $1 million in any 12-month period using crowdfunding. Companies cannot crowdfund on their own, but will have to engage an intermediary that's registered with the SEC as a broker or funding portal. These intermediaries will be required to do some vetting of the company seeking funding.
Individual investors will be limited in the amount they can invest by way of crowdfunding in any 12-month period to:
When calculating net worth, you should not count the value of your primary residence or any loans secured by the residence (up to the value of the residence).
The SEC must first write rules that govern how companies can use crowdfunding to raise money from investors and set out the responsibilities of intermediaries. These rules will include what must be disclosed to prospective investors before they decide to participate. As a result, companies cannot use crowdfunding to raise funds from investors until the SEC issues these rules. Obviously, you should be wary of any crowdfunding investment opportunities that are offered before these rules are in place. Once the rules are in place, my office will be issuing an Investor Bulletin that will highlight aspects of crowdfunding investing that you should keep in mind when deciding whether to invest or not. The SEC is required under the JOBS Act to have rules in place by the end of the year.
A lot has been written about the possibility of fraud with this new crowdfunding exemption. Our office plans to be diligent in watching this area once crowdfunding gets underway.
Now, I'd like to highlight one last part of the JOBS Act that may directly change your investing landscape, particularly if you are an accredited investor. Currently under the federal securities law, certain exemptions exist for companies to sell securities to investors without having to register with the SEC, such as what's required in the case of an IPO.
A frequently used exemption is what's called a Rule 506 exemption. Many start-ups, such as those in Silicon Valley, use this exemption to raise money from investors, like venture capital firms. The two principal limitations for using the exemption are that the offering be principally limited to accredited investors and that there is no general solicitation.
First, the restriction on general solicitation means that the company can't advertise the offering, such as on TV or in a print publication. Otherwise, this would be a public offering and registration would be required. The other limitation is that it mostly be for accredited investors. The exemption does allow for a limited number of non-accredited investors. From the standpoint of individual investors, accredited investors in short are high income or net worth individuals. The premise for the exemption is that these investors are capable of fending for themselves—principally because of their presumed ability to bear the loss or otherwise understand the risks involved—and do not need all the protections of the federal securities laws that would be afforded in a registered offering.
An accredited investor, in the context of an individual investor, is a person:
When calculating net worth, you should not count the value of your primary residence or any loans secured by the residence (up to the value of the residence). This exclusion of primary residence was a change made by the Dodd-Frank Act. Otherwise, the definition hasn't changed since it was conceived in 1982 and $200,000 in income is still a lot today but was more so 30 years ago. Under Dodd-Frank, the SEC can revisit the definition every four years and make changes.
These limitations, for all practical purposes, limited the pool of investors in any particular company's exempt offering.
Now, under the JOBS Act, companies can conduct general solicitation and advertising for a Rule 506 offering. This means that you may see a TV or newspaper advertisement to buy the common or preferred stock of a private company. You may also see a proliferation of websites that, similar to crowdfunding, offer a platform for companies to raise money with a Rule 506 offering online. However, only accredited investors may participate in these offerings that take advantage of general solicitation. This is unlike the existing exemption which allows for up to 35 non-accredited investors.
If you are an accredited investor and find yourself interested in investing in a private company, you should bear in mind the reasons that such offerings are limited from the public. These offerings are not for everyone and carry a very high degree of risk. For every successful venture, there are more numerous failed ventures.
You will not be seeing such advertising immediately as this area is again contingent on SEC rulemaking. The SEC is required under the JOBS Act to have rules in place by around the Fourth of July.
Once the rules are in place, our office intends to put out a bulletin that generally informs you about some of these private offerings.