Grading the Commission´s Record on Capital Formation: A+, D, or Incomplete?

Commissioner Daniel M. Gallagher

Vanderbilt Law School´s 17th Annual Law and Business Conference
Nashville, TN

March 27, 2015

Thank you, Jim [Cheek] for that kind introduction.  It is an honor to be here at Vanderbilt today.  Not only because Vanderbilt is such a distinguished university, but because it is home to a dear friend of mine, Craig Lewis.  As Director of the SEC´s Division of Economic and Risk Analysis, Craig did more to transform the agency — in particular by crafting a new paradigm for cost-benefit analysis in the work of the Commission — than any other staffer in the Commission´s recent history.  I miss having Craig at the SEC — our loss is truly Vanderbilt´s gain — but his successor Mark Flannery is doing a great job running with the baton that Craig passed to him.

It is also nice to be in Nashville.  It´s always refreshing to get away from the often-acrimonious debates inside the Beltway and hear some straight talk from real entrepreneurs trying to grow their businesses.  So later today, as part of what I´ve been calling my capital formation listening tour, I´m going to the Nashville Chamber of Commerce to meet with some of these folks and hear what they have to say about how we could be doing our job better.

But, right now, I´d like to take some time to discuss with you what I view to be critical capital formation issues facing the Commission.

I.Regulation A+ and Venture Exchanges

The biggest news, of course, is that the Commission just two days ago adopted final rules implementing Title IV of the JOBS Act, which required us to revitalize the currently-moribund Regulation A offering exemption.[1]  According to a GAO report, old Regulation A suffered from several flaws, including a lack of preemption of state blue sky regulation, and an inadequate $5 million cap on the size of the offering.[2]  As between a Regulation A offering and an unlimited, state-preempted private placement under Rule 506 of Regulation D, the choice was a no-brainer.

I am very pleased that the Commission was finally able to adopt changes to Regulation A to substantially resolve several of the key issues that previously afflicted the rule.  The cap on the size of the offering has been raised to the statutory minimum of $50 million, and offers and sales for so-called "Tier 2" issuers preempt state blue sky law.  The latter point is critical:  issuers looking to make a nationwide offering need only have their offerings qualified by the SEC; they do not need to undergo the review processes, including merit review, of 50+ securities regulators.  We´ve also given these issuers a conditional exemption from Section 12(g) of the Exchange Act, so that Tier 2 issuers have some breathing room to raise capital and grow without triggering the burden of full Section 13 reporting requirements.[3]

I am thrilled about this development.  But, as I noted at the open meeting, the rule is not as good as it could have been.[4]  Three years after the law was enacted, we should have exercised our clear authority under the JOBS Act to raise the offering limit to $75 million.[5]  We should have deemed Regulation A´s semiannual reporting to be "reasonably current" for purposes of Rules 15c2-11, 144, and 144A.[6]  And, we should have allowed reporting issuers to use Regulation A.[7]  But putting these and some other issues aside, in this era of regulatory excess, it is refreshing to see the Commission finally taking action to facilitate capital formation.

That being said, this is no time to rest on our laurels.  We still have a lot to accomplish in order to ensure that Regulation A is a success.

First, setting aside the problems I´ve just mentioned, I expect that additional issues will crop up in practice, despite heroic efforts by some of the brightest and hardest-working staffers at the SEC to anticipate and resolve everything in advance.  I want Regulation A to achieve its goal of being a meaningful, quasi-public means of capital formation.  So, as companies begin to make use of these new rules to raise capital, if you find inefficiencies in our final regulatory scheme, please raise them soon, and raise them loudly.

Second, as I´ve mentioned many times before, the revisions to Regulation A were targeted at enhancing the primary issuance of securities.[8]  But if we could significantly enhance secondary market liquidity for these shares, we could invigorate Regulation A even further.  Investors will be more likely to purchase securities, and at a higher price, if they know they can readily exit their investment.  For this reason, I continue to believe that venture exchanges are the answer to this secondary market liquidity conundrum.

I was delighted to see the SEC´s Advisory Committee on Small and Emerging Companies take up the issue of secondary market liquidity for small company shares, in particular the Committee´s emphasis on venture exchanges.[9]  There also appears to be sincere interest in this idea by the Commission,[10] and it has been a hot topic in Congress lately.[11]  Simply put, there is a real need to pursue venture exchanges for small companies.  The old, tired arguments against them are simply defenses of the status quo by those who either benefit from the status quo, or who can´t escape the past.  The Commission can and should pursue the creation of venture exchanges, and I assume that, if we do not, Congress would be more than happy to do it for us, just as they did on other issues in the JOBS Act.[12]

There is one obvious piece of unresolved business in our Regulation A rule:  it does little to facilitate capital formation for Tier 1 issuers.  These issuers still have to navigate state blue sky law qualification, on top of the SEC´s review and qualification.  There has been improvement to that process, but it did not come from the SEC.  The new NASAA coordinated review program, from the limited sample set we´ve seen so far, appears to bring some speed and predictability to the states´ filing review.[13]  But, agreeing to participate in the coordinated review program means that issuers must undergo merit review.[14]  Merit review, of course, has given investors such gems as the prohibition on the sale of Apple IPO shares in Massachusetts.[15]  How´d that work out?[16]  Moreover, the lack of preemption for offers under Tier 1 — which is worse than the proposal — means that issuers would have to look to state law to determine if they may benefit from the "testing the waters" provisions of Regulation A.[17]

The increased size of the Tier 1 offering may prove useful for issuers looking to raise between $5 and $20 million in capital, as the larger offering size will help further defray the costs of undergoing the full qualification process.  We can also help this segment of issuers by closely supervising the implementation of the coordinated review program.  If NASAA cannot get all jurisdictions on board, and keep them on board — that is, if states start refusing to defer to the conclusions of the primary reviewers — then the SEC should reexamine whether to preempt state law in Tier 1 as well.

Ultimately, however, for an issuer looking to raise $0 to $5 million in capital under Regulation A — that is, within the scope of old Regulation A — our new rules don´t do much to help facilitate capital formation.  Tier 1, with state qualification, remains too expensive; and Tier 2, with ongoing reporting, will likely be too expensive as well.  This is unfortunate.  One solution would be to look at paradigms other than Regulation A, which seem to offer much more promise in helping the smallest companies raise money.

II.Raising Under $5 Million in Capital Shouldn´t Be So Hard

A.Crowdfunding

I´ll lead off with the obvious one:  crowdfunding.  Crowdfunding is a bit of a paradox right now.  Accredited investor crowdfunding, a consequence of the JOBS Act mandate to lift the general solicitation ban under Rule 506, has really taken off.  Crowdfunding to non-accredited investors under Title III of the JOBS Act is, of course, still stuck in SEC rulemaking limbo.  Not because the Commission lacks the will to move forward, but rather due to the weight of the accumulated, nanny state investor "protections" thrown into the JOBS Act mandate by the Senate.

Although Rule 506(c) was not specifically intended to facilitate crowdfunding, the rule´s flexibility has given rise to a robust and growing crowdfunding industry.[18]  When you contrast the regulatory framework of Title III crowdfunding with Rule 506(c) crowdfunding, the latter is much more flexible.  Of course, some will say it is the Wild West.  To me, though, it is a great example of the creativity and ingenuity of the markets and market participants.  And:  (1) the antifraud laws still apply, (2) accredited investor verification needs to be complied with, (3) no "bad actors" can be involved, (4) Form D must be filed, (5) and so forth.  Even the Wild West had its lawmen, as difficult as it may be to picture Andrew Ceresney as Wyatt Earp!

If 506(c) crowdfunding is the Wild West, Title III crowdfunding is 1970s East Germany.  The heavy hand of the state is omnipresent and smothering.  As amended by the Senate, Title III gets the theory of crowdfunding wrong, overlaying the usual issuer disclosure and broker-dealer regulatory regimes on crowdfunding transactions and intermediaries.  The result is an over-engineered regulatory approach.  The wisdom of the crowd has been displaced by the all-knowing Washington book club.  And so non-accredited investor crowdfunding, if adopted as proposed, is widely anticipated to be too burdensome for the smallest companies.[19]  Certainly, we can draw from our experience with Rule 506(c) crowdfunding to help inform rulemaking here; it may also be worthwhile to look to the UK FCA´s approach to crowdfunding, which has been operating successfully with a very light touch regime.[20]  A less prescriptive statute would of course greatly ease our ability to make Title III crowdfunding work, and perhaps Congress will look at this issue.[21]

B.Regulation D Exemptions

Despite all the attention paid to Rule 506 offerings, there are two other small issues exemptions in Regulation D.  Rules 504 and 505 permit capital raises of up to $1 million and $5 million, respectively — the former with general solicitation if registered with the states, and the latter without.  The available data show that these rules are infrequently used; issuers much prefer to use Rule 506 for offerings of any size.[22]  This is, I believe, directly attributable to the lack of state law preemption.[23]  To fix these rules, we need to better balance the costs and benefits of each of these exemptions.  For example, we could consider preempting state blue sky laws, raising the offering caps, and expanding the availability of general solicitation — similar to what we have now for Regulation A and Rule 506(c).[24]

Of course, there are some who take a different view:  that the registration and reporting obligations of the SEC are Holy Writ, making exemptions therefrom akin to blasphemy.  Exemptions, in their view, should be tightly cabined, in order to force securities issuance into registered offerings.  Rather than raising up Rules 504 and 505, they would rather see Rule 506 brought low.[25]  It was this view in particular that animated the stifling Regulation D amendments that were proposed in 2013, contemporaneously with our lifting the ban on general solicitation.[26]  The withdrawal of this millstone around the neck of the Regulation D market would give great confidence to market participants, and the Commission should take such action ASAP!  In the meantime, I understand the concern of those who are choosing to forego general solicitation until the Regulation D proposal has been resolved, but I can say it would be an absurd, if not illegal, result for any of the proposed Regulation D amendments to be applied retroactively to ongoing offerings.[27]

Also, apart from new 506(c), we have not changed the fundamental framework of Regulation D since it was initially adopted in 1982.  Given the substantial changes in technology and the markets since then — think Commodore VIC-20 to the Apple watch — it may be time to see if there are other ways to balance access to capital and investor protection, giving issuers other choices when raising capital.  For example, David Burton at the Heritage Foundation is advancing a "micro offering" safe harbor, which would deem certain extremely small or limited offerings as not involving a public offering under Section 4(a)(2) of the Securities Act.[28]  These are the types of ideas we should be exploring.

In doing so, I believe it would be constructive to start from a point of reference of the needs of real companies, and then figure out how to make the securities laws fit those ends.  Imagine that!  For example, when I was meeting with start-ups and small businesses in San Diego earlier this year, as part of my listening tour, a pair of young entrepreneurs running a winery noted their frustration with meeting fundraising goals.  They knew that, if they could just post their offer on Craigslist, they´d be able to readily connect with investors, and spend their time growing their company rather than fundraising.  I know the very thought of having a securities offering on Craigslist just made some people´s heads explode.  But that highlights the divide between the real needs of real entrepreneurs and the unfortunate reality of securities regulation today.  We need to find a reasonable way to bridge this gap.

III.Other Capital Formation Issues

For somewhat larger companies, I believe our rules aren´t fundamentally flawed, but there are certainly some improvements that can be made.

Some take the view that companies have to be perfectly seasoned before we can expose any unaccredited investor to the risk of investing in them.  In this view, companies that are not up to the standard of the largest issuers should be kept out of our most liquid markets.  What is unanswered, of course, is how those companies will get the capital they need to graduate to the "big leagues."  Or why ordinary investors should be limited to investing in blue chips, rather than taking a chance on a young upstart.

I take a different view:  investors are smart.  They just have to have the information they need to understand what they´re getting into.  If you want to go to the NYSE and buy GE, that´s fine; if you want to go to a venture exchange and purchase shares in the latest Silicon Valley app maker, that´s fine too.  It´s impossible for these smaller start-ups to comply with the reporting expected of the largest companies, though, so I´ve previously advanced a few ideas that I think could help.[29]  For example, we should further segment our small companies into bands based on commonly-used market definitions of "nanocap" and "microcap," and more radically scale reporting requirements for the smallest issuers.  Unfortunately, our recent rules do not inspire confidence that the Commission can resist slapping small companies with immaterial reporting requirements.  A majority of the Commission decided to apply our extraordinarily burdensome conflict minerals rule to smaller companies, with an oh-so-generous 2 year phase-in.[30]  And, we just proposed hedging disclosure requirements that, over my protest, would apply to smaller reporting and emerging growth companies.[31]  The only time the Commission seems willing to exempt SRCs and EGCs has been when Congress explicitly says to do so — and even then, it´s begrudgingly done.

My skepticism notwithstanding, I hope and expect that the Division of Corporation Finance will come out with an aggressive agenda for disclosure simplification as a result of its much-discussed study of disclosure requirements.  If that study simply affirms our existing disclosure regime, when there has been over a decade of unfinished efforts aimed at streamlining disclosures, it will have been a failure.  The difficulty, of course, is that every piece of disclosure in our rulebook will have some constituency who will cry loudly when their ox gets gored.[32]  But we need to take a hard look at whether the benefits that some assert exist are worth the burden placed on all shareholders — and eliminate or at least reduce the burden when it is not.  On the flip side, we´ve already seen partisans for added disclosure — particularly sustainability or integrated disclosure — make their case for inclusion in this project.[33]  Companies are free to make these disclosures voluntarily.  But I am absolutely opposed to broadening our already-burdensome disclosure requirements to include these non-material issues.[34]

In the meantime, I hope the SEC can do a more rigorous cost-benefit analysis of its new rules, including an analysis of the total burden of regulations.  We have deep and liquid capital markets, and the SEC makes it relatively straightforward for issuers to access them, but we´re steadily attaching more and more strings.  It´s only a matter of time before, like Gulliver tied to the ground by the Lilliputians, companies that have the misfortune to be public issuers will be unable to move, to innovate, to create.  And all investors will be harmed for it.

IV.Conclusion

Unfortunately, despite having passed Regulation A+, the Commission does not merit a grade of A+ in its attention to capital formation issues.  At best, our grade is "incomplete" given the significant number of critical investor protection issues that need to be taken up in the near future.  Yes, that´s right — capital formation and investor protections walk hand-in-hand.  Rulemaking derided as "deregulatory" may nonetheless help investors, if the costs of that disclosure, both direct, in terms of dollars diverted to compliance, and indirect, in terms of the opportunity costs of those dollars, are not outweighed by the benefits.  I believe our rulebook is full of such rules, and hope we can take them on, and soon.