Speech by SEC Staff:
The Securities Act Reform Project:
Improving Capital Formation in Our Markets1
Director, Division of Corporation Finance
U.S. Securities and Exchange Commission
at the Nineteenth Annual Ray Garrett, Jr., Corporate and Securities Law Institute
The Corporate Counsel Center of Northwestern University School of Law
April 22, 1999
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.
Last November, the SEC published a sweeping set of proposals to modernize a 65-year-old set of laws governing the capital formation process. The proposals are the result of years of work by the Commission staff. The proposals address a number of the difficulties present in the regulatory structure for offerings. Just as the major reforms to the regulatory structure in 1964 and the early and late 1980s drew a host of criticisms from market participants, so too have our most recent efforts.
Our capital markets are the envy of the world. Nevertheless, capital formation in our markets is hindered by a patchwork regulatory structure that has evolved episodically. The reason for the evolution largely has been that the Commission, until recently, has had very limited authority to make systemic changes in the registration system. The end result of that limitation is a regulatory structure that, while mostly sound, contains an odd mixture of barriers to activities that many people view as legitimate and ineffective implementation of important investor protections.
The calls for significant reform of the Securities Act of 1933 ("Securities Act") date back over 30 years.2 Calls for reform did not end, however, with the changes adopted by the Commission over the years. As the American Bar Association stated when it wrote to the Commission in late 1996, "the present system, although it has served us over the years, is an anachronism that needs to be fixed without delay. [T]he time has come to recognize that the current jury-rigged system requires fundamental reforms."
Today, I would like to speak a bit about the proposed reforms. In part, I want to do so because I believe there has been too little focus placed on the benefits that these proposals hold for many of those participating in the capital formation process. I have heard little discussion of benefits such as: greater speed in accessing the capital markets in many registered offerings, much greater freedom in communications and use of new communication technologies, and greater access for investors to more information on a more timely and fair basis. I also want to address the main arguments that I have heard for not proceeding with selected aspects of the proposals. Before I do either, however, I thought I would focus on a few of the observations we made and conclusions we reached in the process of re-examining the regulatory structure. I think it would be helpful to note for you the primary reasons that we feel reform of the regulatory structure is needed.
Stimulus for Change
1. Restricted Flow of Information
One of the strongest catalysts for change is the advent of the so-called "Information Age" driven by technology. The Securities Act envisions that a prospectus will be the primary source of information that an investor will read and rely upon in making an investment decision. In the 1930s, there may not have been many alternative sources of financial information anyway. Today, we are bombarded with seemingly unlimited sources of financial information. The Internet provides a wealth of information, including access to the Commission's EDGAR database. On-line brokers provide free research reports, and companies include detailed information and press releases on their websites. Also, let us not forget the 24-hour financial cable networks. Speedier transactions require speedier information flows. For some companies, the prospectus is now perhaps the North Star in a constellation of information.
While there are many mechanisms by which information is disseminated today, issuer lines of communications are not always open. The current regulatory scheme, of course, regulates the timing of offers as well as restricting the content of written offers. Since offers have been defined broadly to encompass many communications around the time of an offering, some consider it dangerous to speak before filing a registration statement with the SEC. It is illegal to send an investor a written offering document, other than the prospectus, prior to effectiveness of the registration statement and delivery of the final prospectus. This structure has caused two problems in particular. First, the system deters issuers and underwriters from providing some information during this "quiet period." Second, the law allows greater freedom to make oral statements than written statements. It is illegal generally to fax someone a sales document (other than the prospectus) during the "waiting period" before effectiveness of a registration statement. It is perfectly fine, however, to read the contents of the same sales document to the investor over the telephone.
This unequal treatment of oral communications generally favors the larger institutional shareholder, as opposed to the smaller or retail investor, since the underwriter is more likely to be in person-to-person contact with the large investors. This furthers the occurrence of "selective disclosure" which causes excluded investors to be at a competitive disadvantage. At the same time, widely disseminated written communications could be very useful to an investor.
2. Prospectus Delivery
The current regulatory scheme, although placing great emphasis on the final prospectus, does not assure that written disclosure arrives in time to inform an investor's decision. Other than in initial public offerings ("IPOs"), there is no requirement to deliver a prospectus to an investor until the confirmation of sale is sent. The delivery requirement for IPOs, which is shortly before the confirmation, also fails to guarantee arrival prior to investment decisions. This means that investors may not have the opportunity to read full offering disclosure until after they pay for the securities. Fortunately for today's investors, many transactions involving lesser-known companies simply cannot go forward unless the underwriter provides some written informational materials in advance of the investment decision. In terms of investor protection, however, this regulatory structure seems backwards.
3. The Growing Dominance of the Private Markets
While shelf registration made the public markets more attractive to some issuers, a series of regulatory adjustments over the past 20 years have made the private markets even more attractive to issuers. For example, in 1990, the Commission adopted Rule 144A. This rule deregulated the trading in "restricted" securities among large institutional buyers. In effect, it created a capital-raising alternative to the registration system that allows issuers to access a very liquid private institutional market.
In the past few years, the number of transactions in the private markets has grown significantly, especially in the debt markets. Recent Division studies show that over 75% of all debt and convertible securities are sold in the private markets, as well as over 20% of the stock. Perhaps the only reason we do not see the rest of the market move to Rule 144A is because most U.S. public companies are not permitted to offer and sell their common stock under that rule.
Private markets have the advantage of speed for issuers because private offerings are not subject to SEC staff review. In private offerings, however, investors receive restricted securities and fewer investor protections, while the marketplace often does not learn of these transactions in a timely, meaningful way. It is curious that we have provided regulatory incentives to tap private markets at the expense of the public markets.
Let me mention two of the incentives that we have provided for private offerings. In order to avoid the possibility of staff review of what would be a public offering, issuers are permitted to engage in a private offering conditioned on a subsequent registered public resale of the same securities. Not only are issuers able to get the money immediately, because the Division staff at most reviews only the resale into the public markets, but they also can use short-form registration that otherwise often would be unavailable to them. For example, if a small company wanted to sell stock directly to the public, it would risk the possibility of staff review and would need to use a long-form registration statement (Form S-1). Instead, however, if an issuer sells to a private investor first, it gets no staff review of the private transaction and can use the short-form registration for the resale if it has been reporting for a year. Thus, we permit something to be accomplished indirectly that we would not permit directly.
This was broadened further in the Exxon Capital lines of staff letters. Under those letters, an issuer sells privately a class of non-convertible debt or preferred securities (or common stock, if a foreign issuer). The investors, however, want freely tradable securities. Under the letters, rather than register the resale by the investors, the staff permits the registration of the exchange of the securities for identical registered securities. While the securities can then be sold to any member of the public, this registration is accomplished with the prospectus being delivered only to the institutional buyers that already decided to purchase those securities. The underwriter, if there was one involved in the private transaction, may or may not have any responsibility for the registration statement. Investors that purchase from the original buyers, unlike in the case of a resale registration statement, do not get an updated prospectus delivered to them. In addition, courts have not resolved whether the remedies that accompany resale registration would apply. If the staff reviews the disclosure at all, it is only after the investment decisions have been made.
Not surprisingly, this method of capital raising is extremely popular, especially with private companies seeking to "go public." Even though its strongest proponents admit that this staff position lacks a logical or investor protection basis under Securities Act principles, the practice has overtaken public debt deals. The only reason that this technique has not overcome the equity market is because the staff has not extended the position to common stock of domestic companies.
Conclusions Underlying the
Securities Act Reform Project Proposals
Having made all of these observations, we came to a few conclusions about reform. The first conclusion to note is that the current regulatory scheme needs to be
reformed to reflect today's world. The Commission established an Advisory Committee on Capital Formation in 1995 that went a long way towards identifying cracks in the system and advocating reform. A number of those writing comment letters on the Commission's 1996 SEC concept release on Securities Act reform agreed strongly that the time for reform had come.
Another conclusion we reached is that investors should have access to more information in the investment process. The premise that the prospectus should be the exclusive means of information has limited applicability in today's world. The SEC regulates information given out by public companies and those selling securities generally. Today, a torrent of public information is generated by third parties whenever large public companies are selling securities. Since others are speaking so much, and there is so much company information already readily accessible at the Commission, the statute's strict controls on issuer and underwriter communications seems to make less sense. Companies, especially publicly traded ones, need greater freedom to speak. All public companies deserve greater certainty as to what constitutes the "quiet period."
The third observation is so basic that it almost need not be stated: information is most valuable when it is timely provided. As much as providing information after the fact is more efficient for sellers, offering disclosure received after the investment decision has little utility for investors.
The Advisory Committee pronounced another observation in very clear terms. Our regulatory system relies heavily on public companies' Exchange Act reports to supply investors with the company information they need. In light of that reliance, the need for the information in those reports to be further enhanced must not be forgotten. The need becomes even greater if the regulatory system moves towards further reliance on those reports in connection with offerings.
Finally, when we re-examined the regulatory system, we noted that a number of regulatory incentives to avoid the registration process, or to use it indirectly in a two-step process, had been worked into the structure over the years. We concluded that those should be removed. Business reasons to tap the private market instead of the public market are fine, but it is inappropriate for us to provide regulatory shortcuts that encourage issuers to enter a less liquid and less transparent market, or to evade investor protections by starting out in that market before registering.
Benefits of the Proposals
Before I get to a few aspects of the proposals that have sparked debate, I want to point out some of the strengths of this package of proposals. Aspects of the proposals will benefit each of the participants in the offering process.
Let's focus first on what the proposals hold for investors - whose protection is the Commission's main mission. As I mentioned before, overall investors would get more information in a more timely and fair manner. That is important enough to bear repeating.
Investors would be ensured of having prospectus information when they need it: before they choose to invest in an offering. If smaller companies are selling to less sophisticated investors or companies are making (or have just made) their initial public offering, investors will be guaranteed of having the information with sufficient time to consider the disclosure.
Investors also would have access sooner to information about the most significant current events affecting the public companies in which they have invested. For example, when an auditor tells a public company that it is resigning, the public investor will no longer be in the dark about it for 5 business days. The same will be true when an auditor withdraws its consent to a public company's reliance on the auditor's report on the company's financial statements.
We also have proposed that summary financial data about quarterly and annual results be reported sooner. This proposal would add a cost to some companies, but the earlier access, and equal access, to that information for investors should hopefully justify the cost.
Among the other proposals benefiting investors are:
- proposals to require regular reporting of risk factor information by public companies;
- proposals that would require equal access for all investors to information used in connection with an offering;
- proposals that provide an incentive to public companies to improve their disclosure in periodic reports by responding to the Commission's outstanding requests for amendments;
- proposals that would ensure the markets are informed earlier that public companies have made shelf-registered offerings; and
- proposals that would ensure that the statutory protections and remedies apply in all cases.
2. Small Businesses
Small businesses benefit even more from the proposals than larger public companies would. More small businesses would be able to qualify for the easier small business disclosure system. Small businesses would benefit from the safe harbors and exemptions that allow freer communications around the time of an offering. For the first time, small business issuers would not have to pay registration fees until the time of sale. They would have more streamlined registration because they will be able to incorporate their periodic reports by reference sooner.
When making some types of offerings, smaller issuers would have all the same benefits as the largest issuers. For example, they would have complete control over the timing of their registered offerings when selling only to existing holders, selling only to sophisticated investors, or selling only investment grade securities. They would have the same unlimited freedom to communicate around the time of those offerings, and the same delivery obligations in those offerings as larger issuers have.
In addition, small businesses would benefit even more than larger ones from the added flexibility to shift between public and private offerings. The integration safe harbors that give this flexibility also would enable small issuers to test the market for a public offering when they need to do so.
3. Larger Companies
Larger issuers have less to gain from changes to the registration system because they have been the beneficiaries of many past regulatory accommodations in that system. Nevertheless, there are aspects of the proposals that would benefit them. The largest issuers gain complete control over the timing of registration. They would be able to register an offering without being subject to staff review, and would not have to file a registration statement until the time they sell.
Under the proposals, larger issuers would have the ability to communicate with investors at any time without the communication being considered an illegal offer under Section 5. They would have less strict advance delivery obligations than smaller issuers, and the possibility of fulfilling the delivery obligations without a full prospectus. The final prospectus delivery obligation would be removed, thus easing the clearance and settlement system. They would continue to have a form of shelf registration available to them, albeit with earlier filing of the transactional information supplementing the prospectus.
4. Companies of Any Size
Companies of any size would gain the ability to register any offering made solely to qualified institutional buyers ("QIBs") whenever they wish, without being subject to staff review. QIBs, in turn, would receive freely tradable unrestricted stock. (Contrary to what some commenters have surmised, as the Commission stated 16 years ago in The American Council of Life Insurance letter, QIBs who purchase in this type of offering would not be considered underwriters, "provided such securities are acquired in the ordinary course of business from the issuer or underwriter of those securities and such purchasers have no arrangement with any person to participate in the distribution of such securities."
Several of the benefits to companies also would benefit underwriters. Underwriters would gain additional freedom to issue research reports around the time of an offering. They also would benefit from the proposed freedom to use documents other than the prospectus to sell the offerings.
One aspect of the proposals would benefit underwriters exclusively. The Commission proposes to give additional guidance to those trying to assess whether an underwriter has established a "due diligence" defense in offerings that are done very quickly. While the proposed rule does not attempt to create a safe harbor, it would recognize as relevant to determining due diligence the actions of third parties as well as the actions of the underwriter under those circumstances.
Early Reactions to the Proposals
I believe there are no simple and consensus approaches to reform. (The comment letters on our 1996 Concept Release on reform of the capital formation regulatory structure certainly confirmed that.) The larger the scope of the reform project, the more likely one or more proposals would spark disagreement, particularly since the economic interests of the participants in the markets are often not aligned. Well, the size and complexity of this project is greater than any other initiative the Division has undertaken in a number of years. Thus, we are not surprised that people have found both aspects that they like and aspects that they do not like.
As with any balanced set of proposals, there are likely to be less popular aspects, including those that would add investor protection (which generally comes with some cost) or close loopholes and thereby limit some of the freedoms that exist today. When it comes to SEC releases, I have found over the years that those whose economic interests would be most affected are the most vocal commenters. This project is no exception. (In fact, it is reminiscent of the amount of controversy the Commission encountered when proposing shelf registration and Rule 144A.) But that is what comment periods are for - it allows all interested parties to provide input about how the proposals affect them and explain why they want the proposals to be altered.
In my remaining time, I am going to focus on the areas that have been most criticized by practicing securities lawyers representing the largest issuers and the largest members of the securities industry, pausing to respond to each of their major concerns. While the comment letters are not in yet, the sell side has been quite vocal. Because the Commission has yet to hear from the investor community and others about the specific proposals, the arguments I note are naturally made from the sellers' perspective.
1. Prospectus Delivery
Sellers of securities have indicated that the proposed requirements to deliver a prospectus earlier to investors are problematic. The proposals would prohibit selling securities to investors unless they had received a preliminary prospectus or term sheet in advance of their investment decisions. For IPOs, investors would have the benefit of seven days advance delivery. For repeat offerings of smaller companies, investors would have three days advance delivery. Finally, larger companies would have to deliver a term sheet any time prior to the investment decision (presumably the same day).
Sellers are worried that they will not be able to sell securities to an investor that shows up on the last day but did not receive a prospectus. They urge an exception in this case. I recognize that a small percentage of buyers may come to the table late in the offering, and that those buyers may be important to the sellers. On the other hand, I have heard suggestions to address this issue that would create exceptions large enough to swallow the entire delivery concept. Should the Commission choose to address these concerns, it seems to me that any exception must be crafted narrowly so as to avoid eviscerating the requirement.
While small refinements could presumably address the issue of delivery to each investor, concern of a more conceptual nature has been expressed about advance delivery in shelf-registered investment grade debt offerings and shelf-registered block trades of equity securities. In today's markets, it is common that such "shelf" sales of plain vanilla debt or very large issuers' equity is done in hours, over the telephone, to mostly large institutional investors. Sellers in those offerings would like to be free to deliver a written "term sheet" about the transaction in advance of sale if investors request it, but they do not want to be required to deliver one in every case. In the case of other securities on the shelf that have to be marketed today with written disclosure, the concern about delay caused by delivery is nevertheless being expressed.
Obviously, we believe that investors want some written information in many, if not most, cases. If it is not required, there is a legitimate concern that only the largest investors would have the leverage to demand it. In the current seller-dominated market, it is not far-fetched to estimate that even the largest buyers would not feel empowered to demand information for fear of being shut out of an offering. Also, it seems like a small burden to place on the seller to provide offering information for the buyer in advance. A term sheet, in particular, could be faxed or electronically delivered within minutes of the initial phone call. Likewise, it should not be too difficult for a salesperson to draft one, although I grant that (since it would be filed with the SEC later) counsel may want to review the document. I also understand that given the volatility of the market today, sellers seek to complete some transactions as speedily as possible. Their effort to act at the speed of light conflicts with proposals that run the risk of causing any delay, even if slight.
Under the proposals, selling materials could take many forms. I suspect if we asked today what sort of written materials an underwriter would choose to use to sell securities, the prospectus would be low on the sellers' list of possible choices. If many types of sales documents are permitted, the likelihood of the prospectus being delivered prior to investment decisions, absent a mandate, seems small. At the same time, early delivery of prospectus information would be even more important to investors because they would need it to test and filter out the key information from the rest of the communications "noise" in the marketplace.
Some argue that the advance delivery proposals should not be implemented at all because implementation is destined to drive the sellers of debt securities, in particular, to Europe. This sounds suspiciously like a suggestion that the Commission race to the regulatory "bottom" for fear that any improvement in investor protection could tip the scales, even while improvements for sellers would simultaneously be implemented. I note, however, that debt securities, especially investment grade or "plain vanilla" debt securities with which investors are very familiar, can present different issues and market dynamics.
Some sellers argue that as long as the investors are institutions, and not individuals, they have no need for the investor protections of the regulatory framework, including delivery requirements. To me, simply making an institutional/individual investor distinction is too simplistic. Not all institutions are equally sophisticated, just as not all individual investors are equally sophisticated. I worry that critics may be painting with an overly broad brush.
There are also those who believe that the Commission has no business regulating the delivery of disclosure in the offering process at all because one should simply trust that markets, left to themselves, will operate to deliver optimal disclosure to investors. These people also say that we can assume that sellers are currently giving all the information that investors want because if investors had asked for more then sellers would have given it to them. This argument assumes both completely open communications between sellers and buyers and sufficient power in the hands of each investor to demand all desired information. We intend to try to confirm this version of the marketplace with the buy side. We also find these arguments somewhat curious given the corresponding argument being made that it is simply impossible to create even the most basic written disclosure of the securities' key terms prior to an investor's commitment. While I believe the Commission still has an open mind as to the issue of what delivered information, if any, should be mandated in different offerings, a claim across the board that investors will be sufficiently protected if the Commission just eliminates all delivery requirements leaves me less than confident.
2. Filing Requirements
Sellers have objected to two filing requirements in the proposals. First, sellers that use shelf registration for offerings that are not marketed with a preliminary prospectus (e.g., many investment grade debt offerings) do not like the proposal to file the Form B registration statement at the time of sale. Second, although sellers appreciate the proposed liberalization of communications restrictions, they clearly do not relish the idea of filing written offering communications with the SEC.
A certain percentage of registered offerings are "shelf takedowns." These range from equity offerings that are marketed over the course of weeks, just like non-shelf equity offerings, to quick sales of investment grade debt securities accomplished within a day. Under the present shelf scheme, sellers have two days after sale to file prospectus supplements containing specific offering information with the SEC. In the case of shelf offerings marketed with a red herring prospectus, filing of the prospectus disclosure could easily precede sale. In the case of offerings in which sellers are not using a red herring prospectus for marketing, they state that the sales are made so quickly that no one has time to prepare prospectus supplement disclosure contemporaneously. I term today's market in these offerings as "sell then file in a while" whereas the proposals would change the approach to "file fast then sell."
The theory behind the proposals is two-fold. First, the public market is better off having the information about the shelf takedown sooner. Investors in the market will want to know the size and nature of the offering, and the proposed filing requirement allows all investors to have access to that information sooner. Disclosure of information more quickly to the market is one of the investor enhancement aspects proposed in the release generally. It limits the effect of selective disclosure, which grants an unfair trading advantage to some investors. The second reason for filing of the supplemental materials before sale would be to protect buyers in the shelf takedowns in the event that they have not been previously delivered that information. Since the Commission has yet to decide what information would have to be delivered in those deals, the filing requirement could be what provides the written information to the buyers, as well as the public at large.
From the sellers' viewpoint, the earlier supplement filing would slow down some significant shelf takedown offerings. I wonder whether it would necessarily have as dramatic an effect as is argued by some sellers. It is difficult to understand that the biggest, most sophisticated sellers cannot prepare disclosure sooner. Query whether deals could proceed with similar speed but would require that counsel become involved earlier in the process. Query whether forms of supplements that simply require minor adjustments would be prepared in advance of any takedown. Perhaps more resources would be devoted to preparation of the filing materials if time were more of the essence. I suspect that sellers could adapt procedures to minimize the delaying effect in any shelf offering where it would arise. Possibly, for companies that frequently access the market, there could be versions of prospectuses on the shelf that need only minor supplemental information filed at the time of sale or some notice indicating which version applied to the takedown. Analogies can be made to the term sheet updates filed in MTN programs today.
The second concern I have heard expressed is with the proposed rule that would require written offering communications to be filed with the SEC. Here I wonder whether sellers are looking a "gift horse in the mouth." While I admit that it could create compliance costs and require adequate supervision of the brokers selling the securities, it should be worth the trade-off for rule changes allowing all types of written sales documents to be used and offers to be made at more times. After all, selling securities is a broker's main business. Don't brokerage firms already have a structure in place to control and monitor what it is the brokers are saying and giving to customers?
The theory underlying the filing requirement is not complicated. While companies want to communicate at any time and in many ways, investors presumably will benefit only if they have a chance to see this information. It would not be fair if the opening of communications resulted in only some investors having that benefit. Apart from the concerns of investors in the particular transaction, we are aware of the growing call to address the practice of "selective disclosure." Just as oral communications today seem to favor the institutional investor, so too could written sales materials under the proposals if they were not required to be filed. I see this proposal as a great leap forward in democratizing written sales literature.
I recognize that arguments are being made that filing will allow more people to look at disclosure, and that companies would therefore be deterred from communicating because more people would hold the company responsible if the disclosure contains material omissions or misstatements. If that were true, it means the sellers are content with the level of disclosure when it comes to some buyers in the transaction, but not all of them. Some argue that the companies would be deterred by the filing requirement because the information in the selling materials would not be the kind that less sophisticated buyers would fully understand. We have never, however, allowed sellers to decide just who is capable of understanding material disclosure and withhold it from the rest of the investors. That practice would conflict with the statutory principle of full and fair disclosure for all investors.
I also note that some have argued that a filing requirement would push disclosure from the written medium to an oral one. I cannot say that more oral disclosure will not result from the proposals. I expect more disclosure of all kinds to occur. On the other hand, I think investors will notice the difference between oral and written disclosure. Investors may not want oral disclosure either because oral information is harder to understand or retain or because buyers want the sellers to stand behind the information in writing.
3. Removing Regulatory Incentives To Avoid Registration Protections
As I have noted, we have created a few regulatory incentives to register in ways that do not extend the full protections of registration to investors. The first of these is anomalous, in part, because it stems from a staff interpretation rather than Commission action. In what can easily be viewed as an end run around full investor protection, this procedure essentially permits registration of a transaction after the investment decision has been made. As I described, the Exxon Capital position permits registration of an exchange of securities that are registered for securities with the same terms that were unregistered. The only prospectus delivery is made to the small group of institutional buyers that already made their purchase decisions. (Hardly a prime example of delivery in a timely manner.) Moreover, those investors get freely tradable securities that they can then sell to a wider audience of purchasers. Normally those investors would be protected by the delivery of an up-to-date prospectus when private placement buyers register their resales. Under Exxon Capital , those investors get no prospectus from the initial institutional buyers.
Our proposal to repeal Exxon Capital and its progeny has caused some turmoil. Most members of the Bar admit privately, if not publicly, that there is an intellectual disconnect between this staff position and the statutory scheme. They urge us, however, to retain the position because it is very beneficial to sellers. For example, this has become an extremely popular method of selling high yield debt. They also argue there is little potential for harm to investors, especially since institutions are involved. Sometimes after the staff writes an interpretive or no-action letter it takes on a life of its own that was not foreseen or intended when the letter was first written. This is the case here.
With Exxon Capital exchanges, the whole point of registration is to get freely tradable securities into the hands of the people that have already purchased securities in a private transaction. In the exchange, these private buyers are not making a new investment decision. Proponents of Exxon Capital claim that the buyers both in and after the private placement are generally institutional purchasers and they argue that therefore they do not require the usual registration investor protections. While it may be true that the initial buyers are institutions, it certainly appears that nothing prevents the sale of securities into the retail markets based on the registration disclosure. To the extent retail purchasers participate, our investor protection concerns are magnified. Even if they do not, the Commission will still need to consider the level of sophistication of institutions that are purchasing. The Commission has never concluded that core protections need not apply in a registered offering because institutions are the purchasers.
Obviously, the Commission has shown some willingness to distinguish among investors in the proposals themselves. In fact, most people appear to agree that one such aspect of the proposals will resolve the vast majority of the Exxon Capital debate. Proposed Form B would make many Exxon Capital transactions unnecessary. Instead of doing a two-step transaction and registering the exchange, Form B would permit a quick registration from the outset (with no staff review) for sales made to QIBs. By this approach, we hope to compete regulatorily with the private placement/Rule 144A market. I grant, however, that the proposals limit the Form B to seasoned companies, so, as proposed, this quick registration would not be available for IPOs or follow-on offerings within a year. Those also use Exxon Capital today. Under the proposals, they could still do those offerings in the 144A/private placement market and register the resale to get freely tradable securities. I know that resale registration is not as easy for issuers as Exxon Capital is, but it has the virtue of continuing key investor protections. Other ideas also have been mentioned with respect to these unseasoned offerings. I look forward to further comment on this area.
There is a second regulatory incentive that can be used to undermine investor protection. The Commission is rethinking the means by which companies may register indirectly in a manner we do not permit them to register directly. Namely, we permit small companies to use short-form and shelf registration if they appear to sell in two steps first a private offering then a resale registration statement. This process is called a "secondary offering" or a "secondary shelf."
The secondary shelf was created to help small companies keep their registration statements current while the "selling shareholders" pondered the precise moment to sell their registered shares. It has been important to let them incorporate their periodic reports by reference, rather than repeat the disclosure in a series of post-effective amendments to the registration statement. From an investor protection standpoint, special treatment for these secondary offerings is odd. We allow a person who either controls or is controlled by a company to deliver less information to investors in a registered sale than the company itself. Arguments can be made that the secondary shelf is not abusive in and of itself because plenty of people that resell on secondary shelves are not just acting as conduits for the issuer. We will look to the comment letters to see whether there is a fair mechanism to carve out any abusive practices in secondary shelf from those that are not.
Now that the proposals would permit small companies to incorporate by reference on the Form A, query whether the secondary shelf method is as necessary. The primary difference is that a small company, under the proposals, must deliver the reports that they incorporate by reference, rather than merely providing access to the information under today's secondary shelf procedure. To decide this issue you need to ask yourself two questions. For a lesser-known company, should the buyers get copies of the periodic reports (e.g. Form 10-K and Form 10-Q) delivered to them, or should they be compelled to get copies of this information from the SEC's EDGAR system? Second, is this flexibility for small companies worth the cost of encouraging them to shift to this form of capital raising, rather than the more transparent direct registration?
4. Signature Certification
One aspect of the proposals that has definitely stirred controversy is the proposal to:
- have a majority of the board of directors sign their company's quarterly reports; and
- have the directors certify upon signing registration statements and annual and quarterly reports that they have read the document and "to their knowledge" the document does not contain an untrue statement of a material fact or a material omission.
The goal of that proposal is to enhance the quality of disclosure in Exchange Act reports and we believe that directors have the responsibility to assist in that effort to the best of their abilities. This is not to suggest that all directors of public companies are failing to hold up their end now. There is a widely perceived difference, however, in the quality of disclosure in Exchange Act reports and the quality of disclosure in Securities Act registration statements when they arrive at the Commission. We have the opportunity to see that across a broad spectrum of companies. Moreover, people have been making that observation for years. We would like to see the quality of this disclosure increase.
Directors of public companies are in possession of important information about those companies. That is one reason why they are already required to sign their companies' annual reports and registration statements. We are concerned about reports that some directors sign those disclosure documents without having looked at the disclosure. Those directors that are currently taking a less-than-attentive approach to disclosure in periodic reports may need to be spurred on by the proposed certification to pay closer attention.
Some have argued that this certification would impose new liability on the directors. Under existing signature requirements, I think directors already are responsible for the disclosure in Securities Act registration statements and Exchange Act annual reports if they know that the disclosure is materially misleading or has material omissions, or would have known had they read them. As the Commission noted most recently in its report of investigation relating to W.R. Grace & Co., directors who "review, approve, or sign their company's ... periodic reports must take steps to ensure the accuracy and completeness of the statements contained therein.... To fulfill this responsibility, ... directors must be vigilant in exercising their authority throughout the disclosure process." It seems to me that directors' potential liability for annual report disclosure is there whether or not they certify that they have read the report.
With the quarterly reports, which directors do not now have to sign, the boundaries of the directors' responsibilities are less clear. For those reports, the proposals to require certified signatures may, in fact, have the effect of increasing their disclosure responsibilities and thus their liability exposure. I have heard arguments that the disclosure in quarterly reports should be the province of the audit committee, and it is true that the Commission's proposals preceded the Report of the Blue Ribbon Committee in that area. I assume that the Commission will be factoring in those new developments in deciding how to proceed on these proposals.
Adding signatures and certifications is obviously not the only avenue for achieving the Commission's goal with respect to enhancing disclosure in periodic reports. Given the feedback already, I suspect that many suggestions for alternative approaches will be made to, and considered by, the Commission.
A lot of "sound and fury" has built up already around the proposals. The Commission has a long history of listening carefully to all sides before implementing reforms of significance. In any set of proposals this broad, some refinement prior to adoption is all part of the normal course. As always, the Commission has wisely built into the proposals a great deal of flexibility to modify its course before moving forward.
In closing, I have only to note that I look forward to considering ideas that commenters will bring to the table. In the past, the Commission often has benefited from the thoughtful and constructive approach that characterizes the comment letters we get, even where the writers do not always see eye-to-eye with the Commission. My hope is that representatives of all parties that participate in the capital formation process will see fit to write. To give everyone enough time, the Commission has even extended the (already lengthy) comment period to June 30. I look forward to reading the many letters I am sure will result.
1 This speech is based generally on remarks given at the 19th Annual Ray Garrett Jr. Corporate and Securities Law Institute in Chicago on April 22, 1999.
2 At that time, market scholars called for a better harmonization of Securities Act disclosure in prospectuses with the ongoing company disclosure required by the Securities Exchange Act of 1934. Ultimately, this led to the development of the "integrated disclosure" system in the late 1970s and the subsequent "shelf registration" system. Offerings under those systems rely on both a prospectus to supply transactional information and periodic filings to supply company information.