Tossing Fish and Catching Capital: Remarks at the Washington State Bar Association

Thank you, Judy [Anderson], for that kind introduction. I am pleased to be here today. Before I begin, I need to remind you that my remarks are my own and do not necessarily reflect the views of the Commission or my fellow Commissioners.

When one of my friends heard that I was going to visit Seattle for the first time, she suggested that I visit Pike Place Market. She told me that I would find lots of wonderful fruits and vegetables, but emphasized that the highlight would be standing by a stall that sells fish in the hopes of witnessing fish mongers toss fish to one another. My first thought—since I am a regulator—was “Oooh that sounds dangerous! Flying salmon and swordfish—imagine the damage it could do. One slip of the hands of an unqualified fish tosser and fish will slam into an innocent bystander.” My second thought—since I am a markets regulator—was “Oh that sounds fascinating. Markets have such interesting customs and practices. They are not only places for mutually beneficial transactions to occur, but places in which mutually beneficial human interactions happen.”

The moral of the story is that even fish markets can lead me to think about capital markets. This morning, what I’d like to talk about is capital formation—an issue that’s on most of our minds these days, especially given the disappointingly low numbers of IPOs in recent years despite a growing economy. Because it is Small Business week, I’ll give particular attention to small business capital formation.

I’ll get into specifics shortly, but before we delve into the regulatory weeds, I want to take a minute to look at the bigger picture. I worry that we can be too myopic when considering capital formation. Discussions often focus on the issuers, or maybe on the jobs the issuers might create, or on the money investors can earn. These things are extremely important to any discussion of capital formation, of course, but none is the reason we actually need robust capital formation. We need it because of what the companies create. Perhaps it sounds a bit like an advertising slogan, but vibrant capital markets fund the good ideas that make life better. It’s not too much to say that how well our markets work is a matter of life and death; markets fund new cancer drugs, car safety features, and medical devices. When companies doing good things can’t access the money they need, we lose out and we will never know just how much we’re losing. We don’t know what new invention was waiting to be created that now never will be. I realize this may be an obvious point, but I worry that it often gets lost in the conversation. Yet it is the reason that this discussion actually matters.

It matters especially here in the United States. While other countries depend heavily on the banking sector to fund business growth, we depend much more on our unparalleled capital markets. That’s an excellent feature of our economic system. It opens the door to greater risk-taking by entrepreneurs, which allows more creativity and more opportunity for useful innovation. Capital markets can fund an idea that may not meet a bank’s underwriting standards but that will ultimately be a terrific success. Banks, the failure of which we have made a government matter, are looking for safe investments with predictable cash flows, not novel ideas with uncertain payouts. Our reliance on capital markets brings a dynamism to our economy that’s necessary for the economic growth we have enjoyed over much of the course of our history. This dynamism-growth combination has become increasingly important as Americans rely more and more on their own investments to fund their retirements.

This is why I’m often puzzled when investor protection is presented as somehow in opposition to capital formation. The SEC’s tripartite mission—to facilitate capital formation, protect investors, and maintain fair, orderly, and efficient markets—works as a cohesive whole. No one mandate is in tension with another, and focusing on one doesn’t mean sacrificing another. While investor protection means deterring and punishing truly bad actors, it also means not erecting barriers that prevent investors from accessing investment. Facilitating capital formation means, in part, facilitating investor opportunity.

Facilitating both of these effectively requires some adjustments to our regulatory framework. I would like to outline a few of them here, but as always, I invite those of you working in this area to reach out with suggestions of your own. Your experience working directly on these types of offerings can shine a light on issues that we might not be able to see clearly through the fog of Washington, D.C.

Now that you know why I care about these issues, let’s think a bit about public companies. Our securities laws use the public offering as the principal template, and other types of offerings are the exceptions to that basic structure. In the past, the initial public offering, or IPO, was one of the defining transactions in any ambitious company’s life. Going public was the only way to access a large injection of capital. It provided early investors with an exit. And, crucially, it functioned as a sort of coming of age for a growing enterprise.

This isn’t to say that every company that had an IPO was destined for success. We all can think of examples where an IPO was the last bright spot before failure. For many companies, however, the IPO was not a capstone achievement but an important waystation. Indeed, the newly public company hoped that the IPO was just the start of its hockey-stick trajectory.[1]

It’s no secret that IPOs have been down lately. The dot-com bubble high of nearly 700 IPOs in 1996 may not be our target—we’re not looking for another burst bubble—but the 115 IPOs we had in 2015, or 74 in 2016, or 108 in 2017 are far from what we would expect to see, given the growth elsewhere in the economy.[2] Looking at another measure—the total number of public companies—it amazes me that in a country of so many people, we only about 4,500 public companies.[3]

The fact that we do have growth means that many companies in fact are getting funded. Much of this growth is, however, coming through private offerings, or through mergers and not through IPOs.[4] This dearth of public companies does a few harmful things. To the extent that companies opt for acquisition as an exit for investors instead of going public, that results in greater concentration in the market. To the extent that they opt to stay private, it means that fewer investors share in the growth they produce. There may be good reasons for a company to stay private, and mergers often make strategic sense. Certainly being public is not the right choice for every company. But to the extent that there are features of our regulatory structure that have artificially increased the ranks of private companies at the expense of the ranks of public companies, it’s the SEC’s duty to examine these features.

Some companies, of course, opt for private offerings simply because of economies of scale—there are certain fixed costs of going and being public. So the smallest issuers will rarely be good candidates for IPOs in any regulatory regime. That clearly isn’t the full picture, however. We know that there are sizable offerings occurring in the private market, including some that exceed many public offerings.[5] This fact suggests that the problem isn’t simply one of size. My colleague Commissioner Jackson gave a recent speech titled “The Middle-Market IPO Tax,” that suggests there may be non-regulatory reasons to blame for the failure of some companies to IPO,[6] but I believe that there are regulatory factors at play too.

I have several potential regulatory culprits in mind. First, we put lots of requirements on our public companies. Some of these requirements may be disproportionately burdensome for small companies. The most notable example is the auditor attestation of internal controls required under Section 404(b) of the Sarbanes-Oxley Act. For smaller companies with few decision-makers where a fairly rudimentary set of internal controls is entirely adequate, the additional expense presented by 404(b) is unnecessary and counterproductive.[7] For a pre-revenue company, such as a drug company going through human trials, the bill for a 404(b) audit can be particularly painful.

Some of the requirements come out of left field, so a company looking at going public has no idea what it is signing up for. Dodd-Frank exemplifies a troubling trend of requiring companies to make non-material disclosures. Historically, the disclosures mandated by federal securities law have had one aim: to get investors information about whether a company will provide a return on their investment. The concept of “material information,” central to much of federal securities law, has traditionally been understood to mean information material to an issuer’s financial health.

Dodd-Frank introduced several new requirements that were not designed for investors at all; they were designed for curious people, regardless of whether they were shareholders. How could any company that IPO’ed in 2005 predict that ten years later it would be required to make a conflict minerals disclosure in its securities filings?[8] The statutory mandate was rooted in Congress’s concern that “the exploitation and trade of conflict minerals originating in the Democratic Republic of the Congo is helping to finance conflict characterized by extreme levels of violence…and contributing to an emergency humanitarian situation therein.” Wanting to help those who are suffering is commendable; pressing an entirely unsuitable disclosure regime into service in an attempt to do so is not. Trying to solve societal problems through public company disclosure eats at the core of our securities laws. Saddest of all, this particular mandate seems to have made matters worse for the people it was intended to help.[9]

Even more difficult to justify was the Dodd-Frank mandate that public companies disclose the ratio of the CEO’s pay to the median employee pay.[10] A clever tool to generate “data” for people like my Lyft driver the other day to use in his tirade against CEO pay, but a severe burden on companies subject to it. That disclosure too is flawed since it depends heavily on the nature of the company, the location of its workers, and so forth. Given the fact that CEO compensation is already a mandatory disclosure, it’s difficult to see what the ratio adds to the information mix for actual investors.

If the securities laws can be pressed into the service of any problem—from reducing wealth inequality to combatting violence—there are no reasonable limits on what might be required next. In thinking about whether to go public, a company must consider not only what the current cost is, but also what the ongoing costs are likely to be. If the company cannot reasonably predict what might be required in the future, it cannot estimate its future costs.

It is not just the potential for strange, new regulatory mandates that companies factor into their decisions about whether to go public or stay public, but the possibility that the company will face pressures to manage itself with an eye toward something other than maximizing the company’s long-term value. Public companies face pressure to answer to non-shareholder constituencies. Proxy advisors, for example, have gained substantial influence over public companies through an avenue opened by SEC staff action. These firms may offer valuable services, but they wield greater influence over public companies than some large shareholders. Likewise, the shareholder proposal process, which consumes much SEC time, allows small shareholders to exert an outsized influence and to impose costs on public companies.[11] Along similar lines, class action lawyers, who purport to speak for shareholders, pull public companies into expensive litigation, for which shareholders pay. If we prevent public companies from including binding arbitration provisions, we make it more difficult for corporations to protect their shareholders from costly litigation.

In addition to concerns about regulatory mandates and pressures from those without a meaningful stake in the company, a company contemplating an IPO might worry about what happens the day after the IPO. One key reason for going public is to make the company’s stock more liquid. Just last week, the SEC held a round table on thinly traded securities.[12] We heard from someone who works with public companies about how damaging low trading volume can be to a public company’s ability to operate.[13] The SEC is looking for ways to add flexibility to its market structure rules to ensure that the framework accommodates companies of all sizes.

A company looking at what our regulations now and could in the future require of—and allow to happen to—public companies might ask whether becoming a public company is less of a milestone than a millstone. I would answer with a resounding no; being a public company is something for which to strive and it does enhance a company’s ability to thrive. That said, we can and should continue to look for ways to lessen the costs of being public without undermining the disclosure, discipline, and distinction that being public carries with it.

Public companies, however, start out as small, private companies. Any discussion of capital formation must therefore include a discussion of how the smallest, newest companies access capital, and what their path toward public company status might be. When private markets work better, companies have more leverage to get good financing early in their lives, which can help to set them up for future success. While I hope that we can make regulatory changes that reduce the barriers to going public for some issuers, the increased availability of capital through private offerings is itself a positive change.

The JOBS Act of 2012 made significant changes to the options available to these companies. Six years after its passage, we are now at the point when it makes sense to take a look back and see whether these changes are operating as intended, whether adjustments are needed, and whether there is more to be done. The JOBS Act liberalized Regulation D, the primary regulation under which most private offerings are made.[14] It also raised the number of shareholders of record an issuer can have before it must register with the SEC.

The JOBS Act also attempted to revive the moribund Regulation A exemption, which has become known as Reg A+ in its revivified form. Reg A has a number of attractive characteristics. Its nickname, the “mini-IPO,” is apt. It allows public investment in a company without the full panoply of disclosures required of a traditional public company. The Act increased the cap on the amount that could be raised under the exemption from $5 million to $50 million. As implemented through regulation, the new Reg A+ also provides federal preemption of state securities laws in certain circumstances, which enables an issuer to use the exemption without either registering in 50 plus jurisdictions, or risking an impermissible offer in a one of the States. This exemption was deeply in need of reform. In 2011, the year before the JOBS Act was passed, there was only one offering that qualified under the old Reg A.

As of the end of 2017, 185 qualified offerings have disclosed raising a total of approximately $670 million under the new Reg A+.[15] While I am glad to see that the exemption is being used, it’s not at all clear that Reg A is working to its full potential. The JOBS Act not only raised the cap on Reg A, but also instructed the SEC to increase the cap every two years, or to justify to Congress its rationale for not doing so.[16]

It’s true that few Reg A offerings have hit the $50 million cap, but that fact has little bearing on whether there is a need for Reg A offerings at, for example, the $75 or $100 million level.[17] Currently, a company needing more than $50 million in capital will choose another option. If the cap were raised, the companies that are currently seeking funding above $50 million might consider Reg A a viable option. Additionally, the lower cap may be affecting the willingness of traditional gatekeepers—including underwriters and lawyers—to wade into the Reg A waters, and the willingness of issuers to pay for their services. A higher cap doesn’t mean just more of the same type of deal; a 50 percent increase in size could mean a change in the characteristics of the deals themselves. It is also worth looking at whether the other elements of the Reg A exemption are appropriately calibrated. Viewed as a stepping stone for growing companies on their path toward a full IPO, Reg A fills an important niche. Unfortunately, the stone may still be a bit too small to provide sound footing with its current limitations.

Reg A+ allows issuers to raise funds from the general public, which distinguishes it from fully private offerings, which are open almost exclusively to “accredited investors”—that is, certain insiders, institutions, and wealthy individuals. Although the exact number is hard to pin down, some estimates put the number of accredited individual investors at about 10 percent of the population.[18] Restricting investors’ access and choice always raises concerns, and as the capital markets have turned increasingly private, those concerns have become more pronounced. Excluding 90 percent of our investors from many of the most important investment opportunities is a very real and significant problem.

In tandem with finding ways to improve our public markets, we must find ways to open the private markets to more investors. Ideally, we would abandon the accredited investor concept altogether and allow individuals to choose for themselves how they would like to invest their money. Those who prefer the regime currently in place for public companies could continue to invest in registered offerings, but all investors would be free to invest in unregistered offerings as well.[19]

I refer you back to my opening disclaimer—the views I express do not necessarily represent the views of the Commission or my fellow Commissioners; in other words, my preferred solution is unlikely to prevail any time soon. Even if we can’t do away with the infringement of economic liberty that is the accredited investor standard, we can at least liberalize it. As it stands, for individual investors, the regulation looks at nothing else beyond wealth or income.[20] This, of course, ignores any actual sophistication that an individual might possess and creates bizarre outcomes. An investment adviser, for example, may advise clients to invest in offerings from which she herself is excluded. The current standard also ignores any insight industry-specific expertise may offer. A retired physician, for example, may be able to invest in new mining technology being developed by a private company, while a young mining engineer may not, even though the engineer almost certainly would have a better understanding of the technology and its potential usefulness in the industry.

A particular concern of mine, given that I am from Cleveland, is that the accredited investor standard privileges certain geographic areas over others. Coastal cities like San Francisco, Seattle, and New York have far more accredited investors than places like Cleveland and other cities throughout the beautiful Midwest. That fact has nothing to do with the relative financial sophistication of those residents and everything to do with the relative cost of living. Salaries are lower in those places because the cost of living is lower. Many of these areas’ economies could benefit greatly if local investors were permitted to invest in their neighbors’ enterprises.

To the extent that investment in private companies continues to be restricted, we should ensure that those restrictions are at least rationally related to the stated purpose of the restrictions. If the concern is that investors in private offerings should have a certain level of sophistication, the regulations should apply to actual sophistication. We should not have a restriction that selects for unrelated factors such as the part of the country in which the person happens to live.[21]

Speaking of geographic disparities, we also need to change the way issuers can find investors. In parts of the country with many start-ups, there are considerable networks available to help connect promising companies with potential investors. In other parts of the country, these networks are absent. Instead, people are likely to rely on informal networks to connect issuers with investors. The intermediaries in these areas aren’t people who make connections for a living. They may be lawyers or other professionals who come into contact with entrepreneurs and investors in passing, and may be willing to make a match as a one-off service. They aren’t in any real sense “brokers.” Except that, under current regulation, they are brokers, if they take a portion of the proceeds as their fee.[22] There have been numerous calls, including from the SEC’s own advisory committee on small and emerging companies, to create a “finders” exemption to permit such infrequent matchmakers to be paid to help investors and entrepreneurs find each other.[23] Such an exemption—which would be conditioned on satisfying certain requirements, but not the full panoply of broker-dealer rules—could provide significant help to companies operating outside the biggest innovation hubs.

The SEC’s ability to create a better environment for small businesses’ capital formation will be aided by the arrival of our small business advocate. The as-yet-unfilled position was created by statute in 2016, and I believe it will add a needed voice within the SEC.[24] The SEC has historically focused its attention on larger, public companies, perhaps in part because smaller companies relied heavily on bank lending. However, due to market trends and consolidation in the banking sector, trends which were exacerbated by the financial crisis, the capital markets have played an increasingly large role in the funding of smaller companies.[25] A new perspective devoted to the interests of small business should help deepen our responsiveness to the needs of these issuers and their investors.

Finally, no discussion of capital access would be complete in today’s crypto world without a discussion of that newcomer, the initial coin offering or ICO. I gave a speech on Wednesday specifically about ICOs, and those remarks will be posted on the SEC website, so my remarks here will be brief.[26] This technology presents interesting opportunities that may change the landscape in ways that no one has yet imagined. For this reason, I hope the SEC and other regulators will approach ICOs with caution and with curiosity.

It’s rare that an idea comes along in our world that is so innovative that it causes us to pause at the very first step of our regulatory analysis. The key question right now is, of course, are coins issued in an ICO a security? Is every ICO a securities offering? Is there ever a point at which a coin transforms from a security into something else? If it does transform, at what point and how does that affect regulation of the secondary market?

These questions are difficult and still lack answers. This is why I encourage all of us grappling with them to be exceedingly curious. I’ve had many visitors come to my office to tell me about what they’re doing in the world of tokens and distributed ledger technology. These meetings have been extremely valuable, and I look forward to learning much more in the coming months. The risk that we, as regulators, face at this moment is that we respond to novelty with fear. Such fear can result either in overzealous enforcement, which chills legitimate activity and deters beneficial innovation. Or regulators might jump too quickly to issue new rules that ultimately fail to fit the market that actually develops.

To prevent such undesirable outcomes, we regulators must do our best to understand the products and entities we are regulating. If we’re to do our job well, we’ll need the help of those behind these innovations. For that reason, I encourage those of you who may be working on ICOs or working with anyone considering similar new methods of capital raising to reach out to the SEC. We have a dedicated email address, FinTech@sec.gov, which is monitored by staff working on these issues. I also encourage you to reach out to my office. As I said, I’ve learned a great deal, but know there’s more to learn and welcome the opportunity to meet with people who can help me understand the developments in this space. I especially invite any suggestions for how the securities regulations might be adjusted to help relieve unnecessary difficulties.

As we contemplate ICOs, distributed ledger, and cryptocurrencies, I am becoming increasingly convinced that we need an Office of Innovation at the SEC to coordinate the Commission’s response to exemptive requests and other inquiries related to new technologies, platforms, and products. Too often, innovative ideas meet their ignoble end as they are bandied about within and among divisions at the SEC. Staff are to be commended for thoroughly analyzing issues, but an institutional recognition of the pressure on innovators to get their ideas to the market expeditiously could be helpful.

We still have work to do on the regulatory framework for our capital markets, but the fishmongers have nothing on us. I did get a chance to watch the fish-tossing. It was an impressive sight to behold, but our capital markets are even more fascinating and wonderful to watch. I am pleased to report that both Chairman Clayton and Bill Hinman, our Director of the Division of Corporation Finance, are committed to ensuring that our capital markets are the best in the world. I am delighted to have the opportunity to work together with them and you to ensure that our capital markets are supporting the functioning of the rest of the economy. That economy has really important work to do—bringing to life the new ideas that change how we do business, communicate with each other, and save lives.

Thank you. I am happy to take some questions.