January 11, 2012
I am a corporate and securities lawyer in Boston and have practiced securities law for over 35 years. A client forwarded to me a copy of a blog report by a person who attended the recent meeting at the SEC among Chairman Schapiro and a number of small business committee members.
I thought many of the remarks at the meeting were not very well thought out. The balance of this letter reproduces (in italics) the portions of the blog that I have commented on followed by my comments. Ive underlined the key points in the italicized sections to make reading easier.
My views are very much different from those expressed at the meeting. I hope that you will consider these ideas and pass them along to others involved in the project. The comments are mine alone and not those of the law firm with which I am associated.
Exchange Act threshold
The first item on the agenda was the triggers for a companys initial registration and reporting, and the requirements for suspension of reporting. Regarding initial registration, there is a trigger, pursuant to section 12(g) of the Exchange Act where companies are required to register when they attract 500 shareholders of record (and assets exceeding $10 million). The issue under consideration is whether to refine the definition of holders because holders of record can include numerous underlying beneficial holders, resulting in the possibility of a company having an unlimited number of actual holders, while still remaining under 500 record holders, thus not having to register their shares. In fact, some private companies have one single stock fund as a shareholder, but in turn may have hundreds of investors of its own. The Commission also sought input from the Committee on a rule allowing companies to deregister and stop reporting when the number of record holders falls below 300. They inquired about the different levels to register and no longer register, and whether they should be at the same number of holders. The thrust of the discussion was the idea of redefining how to count the shareholders, and the SEC is looking for recommendations.
Exchange Act threshold
I believe that the issue is intertwined with the issues around the regulatory scheme for small companies. If they become subject to a stringent regulatory scheme, the number should be higher and vice versa.
It is hard to pick a number, but the most obvious solution would be to leave the number as is, but not tie it to record holders, which is meaningless. As for how you count, why not annually require every company, public or private, to get from each of the companys record stockholders who owns at least X% of that companys fully diluted common stock, the number (not names) of persons and entities that have a Y% economic interest in that record holder and use that number to do the count. If it is economic interests that are to be protected, then why not focus on economic interests.
A second item was the scaling of regulations. In 2008, the Commission adopted changes in reporting requirements to generally reduce the amount of information required to be disclosed of the newly defined smaller reporting companies (i.e. companies with less than $75M in public float). The Commission sought the members thoughts on scaling, not just for smaller companies but for newly public companies. Members responded that scaling is beneficial, but currently for many private companies an MA transaction is now more desirable than an IPO. One reason is the cost to a company, estimated at $1M, even before it gets public. Committee members continued on the reduced desirability of smaller companies to go public, citing the anticipation of limited research coverage, because of the Spitzer rule - not permitting research to be paid for by banking fees, and on decimalization which has reduced quoting increments and spreads, making trading smaller companies less profitable. Further, the number of small-cap focused bankers has shrunk resulting less advice being offered to smaller companies. An idea floated in terms of scaling, was for smaller reporting companies to only need two years of audited financials instead of three.
The Commission cited its July 2010 permanent exemption for companies with sub-$75 million in public float from complying with SOX section 404(b), and that 404(b) had never been effective for these companies. A Committee member offered that while SOX compliance is a burden, it has become systematized and less unpleasant. Another commented, negatively, that SOX is so ingrained in the minds of public companies as a burden, that there needs to be a marketing campaign accompanying any relief offered to change companies mindset about being public in the U.S. Another member from the buyside commented that 404(a) and (b) are of low importance to them as an institutional investor making an investment decision. .
Here is my take on current SEC regulations based on 35 years of dealing with them, often on behalf of small companies. Far too many SEC regulations are a political response to some scandal – SOX, for example. The new rules are highly unproductive since crooks are crooks, and there are thousands of companies that have to comply with rules that are exponentially too complex. Complex disclosure is not equivalent to good disclosure. In fact, it is just the opposite. Plus good guys get sued all of the time because of the complex regulations. The SEC has streamlined the regulations for smaller reporting companies. But the streamlined regulations are basically a cutting out of certain regulations, with the balance remaining far too complex for small businesses, particularly smaller small businesses.
What about a completely fresh look at what a truly streamlined set of regulations would look like for small businesses. A fresh look is what is needed since regulations, like legal documents, rarely get shorter and simpler. New regulations could be pieced together from the kernel of current regulations as well as new ones. One approach would be to have forms to fill out that are essentially questionnaires that invite responses point-by-point, with both the questionnaire and response being filed with the Commission? The questions would be directed at what investors really want to know (note the comment from the buyside analyst) and questions that are directed at flushing out the crooks. Fifteen pages of boilerplate risk factors is senseless.
Another issue is the definition of a smaller reporting company? Companies with $75 million in unaffiliated market cap are real companies but struggle under the regulatory scheme. Maybe there are several breakpoints with increasing complexity of regulation. Companies with $250 million in unaffiliated market cap should be treated like everyone bigger. In my world, that is a big company. Also consider an approach where if the company has any bad boys it gets bumped up in compliance requirements.
Crowd funding and Reg. A
The Committee pushed on, addressing capital raising strategies. There was a discussion of a recent trend of raising capital via Crowdfunding and how much the SEC should be involved in its oversight. Crowdfunding, generally speaking, is where many people invest small amounts in, typically, a start-up company. Its limited to $10,000 per person and $1 million in total. The consensus among the Committee was that the SEC should not be overly involved, but should set basic regulations. Surprisingly, this new mechanism is being reviewed by the House Financial Services Committee. Discussion also surrounded whether Reg A offerings meet smaller, often private, company needs. Reg. A offerings according to the discussion seem to be viewed as a glass half-full or half-empty proposition. On one hand they are exempt from registration, no audited financials are required, ongoing reporting - post the offering - is not required, offers can be solicited generally, and the securities are not restricted. Alternately, Reg As do require an offering document, there is an SEC review – often requiring a two-three month time frame, they offers no blue-sky clearance, and it has a maximum raise of $5 million per year. So to some issuers it seems like almost as much work as a full S-1 registration. The Commission said that the House of Representatives may soon consider whether it made sense to increase the maximum to $50 million. The Committee thinks that increasing the limit generally makes sense.
Crowd funding and Reg. A.
This discussion goes against the very principles underlying the SECs role since 1933. It is shocking and reflects the perspective of the most well off in our society. I dont see how unregulated crowd funding would work effectively. Maybe a $10,000 investor is investing his entire net worth. Even the smallest company could fill out a questionnaire with only key questions asked. These questions would be simple questions that mimic the sections and subsections of the typical IPO prospectus. All answers would be required to be short. Like these:
What are your principal products and services and what percentage of your revenues is derived from each?
What is your business strategy?
Who are your principal competitors and your competitive status against them?
What are the five top risks of investing in your business that are not risks that face all similar businesses?
This approach may also be applied to the really small public companies.
Simply allowing a trading market to develop does not mean that there will be a trading market or a worthwhile trading market. For one thing, if there isnt reasonable public information, who would buy the stock – people with inside information? To me, Reg. A doesnt make sense as it is written now. Even for small deals, investors need protection. Thats what the SEC is supposed to do. If you do a public offering or a Reg. A offering, you should be subject to continuing regulation with varying levels of complexity. Its a matter of making the regulations truly simpler, to the point, and less burdensome. The current private placement rules would be unchanged. Reg. S-K has become absurdly bloated the compensation disclosure provisions are incomprehensible.
Also, I cant possibly imagine the horror show that would develop if audits were not required of every reporting company. Changing from three years to two years in most cases wont make much of a difference one way or the other.
General solicitation and accredited investors.
As Yogi Berra roughly said, it got late early at the meeting, and the last item on the agenda was the restriction on general solicitation. This restriction is where issuers involved in a non-public offering for accredited and sophisticated investors, under Reg Ds rule 506, cannot advertise the offering publicly. The rub is that since only these sophisticated investors can make an investment in such unregistered offerings, why cant the offering be made publicly known. One member commented that even though an investor may be accredited, the investment is not necessarily suitable. One argument for removing the restriction is that it will expand awareness and the potential investor market, and let other companies see that this is a mechanism for raising funds. There is even talk about a first amendment challenge to this prohibition. It seems that the SEC may be open to reconsidering the current limitation, and the House Financial Services Committee is evaluating a possible repeal.
General Solicitation and Accredited Investors.
Face the fact that the definition of accredited investor doesnt have much correlation to sophistication/need for protection. Who needs more protection – the retired dentist with the requisite net worth, or the new go-getter Harvard Business School graduate at Goldman Sachs who has a lot of school debt? This is a real-life issue.
As for general solicitation, I submit that this again is looking at the issue from the wrong angle. If you have a very broad-based solicitation but also very targeted and simple regulatory scheme, everyone would be reasonably protected and should be able to participate. If one of the generally solicited persons wants to participate, the company should be required to furnish the set of questions and answers discussed above.
Edwin L. Miller Jr.