The Securities and Exchange Commission’s mission statement is to “protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” Plenty of people believe the last objective has been neglected lately—although perhaps that will soon change.
The SEC is gathering momentum to revisit the needs small companies have for tapping capital markets. Its actions could range from recasting the traditional definition of an accredited investor to the creation of new “venture exchanges” for companies that can’t yet crack into Nasdaq or the NYSE, or both.
“From a regulatory standpoint, the SEC was initially set up to regulate bigger companies,” says D.J. Paul, a member of the SEC’s Advisory Committee on Small & Emerging Companies and co-chair of Crowdfund Intermediary Regulatory Advocates. “The staff and commissioners certainly are very cognizant of the importance of capital formation for small and medium enterprises but, as a practical matter, they often have bigger fish to fry.”
Creating more capital for small business was, ostensibly, a primary goal of the JOBS Act of 2012. The growing call for venture exchanges could be seen either as a response to that directive from Congress, or an attempt to change the subject while related parts of the JOBS Act remain uncertain.
There is, for example, “Regulation A+,” intended by Congress to provide a simple, inexpensive way for businesses to raise limited amounts of capital through an upgrade to the seldom-used Reg A registration exemption. In December 2013, the SEC issued a proposed rule that preserves the existing Reg A framework, but adds a “second tier” that allows an exemption for offerings of up to $50 million during a 12-month period. It would also preempt state Blue Sky laws and instead subject issuers to the SEC’s disclosure regime and audited financial statements.
More than a year later, a final rule addressing Regulation A is nowhere to be seen. The delay is partly due to that tricky “preemption” part; state regulators object to the way they are pushed out of the process. The North American Securities Administrators Association, which represents state financial regulators, has countered with a new system that would facilitate multistate filings through a centralized filing process. Preemption proponents, however, say that the system remains untested, doesn’t include all states, is unnecessary, and runs the risk of devolving back into the past system where issuers were dragged through state-by-state reviews.
“The tension between the investor protection role of states and capital formation is a bit of a false flag. I don’t think that states don’t have a role in enforcement. For goodness sake, of course they do.”
D.J. Paul, Member of Advisory Committee on Small & Emerging Companies, SEC
“The tension between the investor protection role of states and capital formation is a bit of a false flag,” Paul counters. “I don’t think that states don’t have a role in enforcement—for goodness sake, of course they do. We are talking about the onerous nature of filing in 52 jurisdictions. I don’t see investor protection sacrificed one iota as a result of state preemption.”
The other elephant in the room is crowdfunding. In October 2013, acting on another JOBS Act mandate, the SEC proposed guidelines for investors and rules for issuers that want to raise up to $1 million a year without having to register those publicly offered securities. Where private companies can only seek out “accredited investors,” crowdfunded ones could reach out to anybody. Offerings would be registered through the SEC and facilitated through broker-dealers or online funding portals. The delay in final crowdfunding rules is a byproduct of heated debates over the adequacy of investor protections.
The sluggish pace of the Reg A+ rulemaking, and kick-the-can approach to crowdfunding, have opened the door for venture exchanges. In fact, while crowdfunding is a divisive topic among SEC commissioners, the exchanges have gained significant bipartisan support in recent weeks.
How It Would Work
The concept, as outlined by David Weild, former vice chairman of Nasdaq and one of its most vocal proponents, is that the SEC would charter member-owned exchanges for listings of up to $2 billion in market value. Companies and the exchanges would be exempt from order handling rules, decimalization, Sarbanes-Oxley compliance, and state blue sky laws, and they would be subject to state regulation, but not state review.
“The coming tsunami of unregistered and unlisted shares requires some new solutions, and venture exchanges may be a viable alternative,” Commissioner Luis Aguilar said recently. He cautioned, however, that “prior efforts to establish them in this country have fared poorly.”
Among those failures was the demise of the American Stock Exchange’s Emerging Company Marketplace; created in 1992, it ended just three years later, succumbing to a number of “serious design flaws,” Aguilar said. As profitable firms that joined the ECM eventually graduated to other exchanges, that created the impression that it was populated only by unsuccessful companies. Scandals involving some companies didn’t help.
PROMOTING CAPITAL FORMATION
The following are selections from public remarks made by SEC Commissioner Daniel Gallagher.
We at the SEC are not doing nearly enough to ensure that small businesses have the access to capital that they need to grow. We layer on rule after rule until it becomes prohibitively expensive to access the public capital markets. Only rarely do we remove any of our rules, even after they have long since ceased to serve their purpose or have become obsolete or worse.
Thankfully, the SEC has the ability to pursue meaningful reforms—both substantive and procedural—that could significantly improve small business capital formation. Hopefully, some day we actually will, unprompted by Congress.
We need to ensure that the rules that apply to small businesses are easily understandable, even without a law degree or expensive lawyers. At least for small businesses, our focus should be on aligning our exemptions with the ways in which companies raise capital, rather than shoehorning capital-raising techniques into existing, complicated exemptions.
We need a robust set of private offering exemptions under Regulation D that allow a company to access our capital markets while still remaining private as long as it so desires. But we also need the parallel ability for a company to access the public markets at the time, and through the means, of its choosing: for example, crowdfunding; Regulation A or A+ offerings; IPOs with emerging growth company scaling, including smaller reporting company scaling if applicable; and finally IPOs without any scaling or a registration under Section 12(g) of the Exchange Act.
We need to involve the entire Commission staff in promoting small business capital formation. This is not just a matter for the Division of Corporation Finance. Our Division of Trading and Markets, for example, has a role to play. While Corp Fin is focusing on the methods by which a growing company can seek to raise capital from public or private markets, TM should be thinking about how to facilitate secondary market liquidity for that company’s shares…And TM must constantly be evaluating the application of trading and registration rules to small entities…Our Office of the Chief Accountant, in supervising the FASB and PCAOB, needs to ensure that their respective accounting and auditing standards are scaled or scalable for smaller businesses.
While Aguilar’s interest in venture exchanges was cautious, Commissioner Daniel Gallagher’s support was bold. “Venture exchanges are a vital bookend to our JOBS Act rulemaking on Regulation A+,” he said, envisioning them as national securities exchanges with full state law preemption, but with tailored periodic reporting and listing requirements.
Stephen Luparello, director of the SEC’s Division of Trading and Markets, provided additional perspective on venture exchanges in testimony last week in front of the Senate Banking Committee. They could include existing or new exchanges that operate nationally, he explained. The Commission may also consider local or regional exchanges that focus on companies from a particular geographic area.
“I love the concept of venture exchanges, but that could be a one-to-three year process,” cautions Vincent Molinari, CEO of GATE Global Impact, a technology provider for trading platforms. Rather than wait for venture exchanges to emerge through SEC rulemaking or more legislation, he would like to see Regulation ATS (alternative trading system) rethought. Issued in 1998, Reg ATS requires electronic communications networks and call markets to register as either a broker-dealer or a national securities exchange, based on activities and trading volume. There are stricter recordkeeping, and it demands more intensive reporting on issues such as transparency once a system reaches more than 5 percent of the trading volume for any given security.
“If we simply took Reg ATS and streamlined the process around unregistered securities, then we’d have a regulatory mechanism to trade on a secondary basis,” Molinari says. “It is a simple regulatory fix that could be done within the SEC. It is not the venture exchange extraordinaire, but it moves capital formation to actionable items today.”
A more immediate effort may be the SEC’s long-awaited recrafting of its definition for who qualifies as an accredited investor, especially for offerings that use the Rule 506 registration exemptions of Regulation D. The current standard defines investing sophistication as someone having a net worth above $1 million or an annual salary of at least $200,000.
What the new standard should be, and whether third-party verification should play any role, has been an ongoing debate. Last month, the Advisory Committee on Small and Emerging Companies approved a recommendation that urged the SEC to “do no harm.”
Paul explains that the vote was a reaction to calls for scrapping the current model and starting again from scratch, an idea raised by the SEC’s Investor Advisory Committee. “That seemed so extreme, and maybe irresponsible, that we felt we should at least put a flag down and say this system, as it is, is working. One trillion dollars in annual capital formation through Reg D offerings is not something you want to be meddling with in a grand way,” he says. “If you want to make changes at all, they should be incremental.”
The committee also recommended that the SEC adjust thresholds for inflation and consider alternative assessments. “The definition has always been a lousy proxy for sophistication,” Paul says. Ideas under consideration by his committee include third-party accreditation, “or actually taking some sort of multiple choice or written test.”