0001
 1           U.S. SECURITIES AND EXCHANGE COMMISSION 
 2   
 3   
 4   
 5                        MEETING OF
 6                  SEC ADVISORY COMMITTEE ON 
 7                 SMALL AND EMERGING COMPANIES 
 8   
 9   
10   
11   
12   
13   
14   
15                 Friday, September 7, 2012
16                         9:00 A.M.
17   
18   
19   
20   
21   
22           U.S. Securities and Exchange Commission 
23               San Francisco Regional Office
24              44 Montgomery Street, Suite 2800
25                 San Francisco, California
0002
 1   PARTICIPANTS:
 2   
 3   ADVISORY COMMITTEE MEMBERS:
 4         STEPHEN M. GRAHAM, CO-CHAIR
 5         M. CHRISTINE JACOBS, CO-CHAIR
 6         DAVID A. BOCHNOWSKI
 7         JOHN J. BORER, III
 8         DAN CHACE
 9         MILTON CHANG
10         JOSEPH (LEROY) DENNIS
11         SHANNON L. GREENE
12         RICHARD L. LEZA
13         KATHLEEN A. McGOWAN
14         CATHERINE V. MOTT
15         KARYN SMITH
16         CHARLIE SUNDLING
17         TIMOTHY WALSH
18   
19   SEC PERSONNEL:
20         KATHLEEN HANLEY
21         GERALD LAPORTE
22         LONA NALLENGARA
23         TED VENUTI
24         JENNIFER ZEPRALKA
25   
0003
 1   PARTICIPANTS (CONT.)
 2   
 3   PANELISTS:
 4   
 5   MORNING SESSION:
 6         JAY RITTER, Ph.D.
 7         DAVID WEILD
 8         EDWARD KIM
 9   
10   AFTERNOON SESSION:
11         STEVEN E. BOCHNER
12         JEFF SCHWARTZ
13         ROBERT BARTLETT
14   
15   STAFF PRESENTATION:
16         MARC FAGEL
17   
18   
19   
20   
21   
22   
23   
24   
25   
0004
 1                     P R O C E E D I N G S
 2                                                (9:00 a.m.)
 3             MR. GRAHAM:  Okay.  Why don't we get started. 
 4   First of all, this is a minor administrative matter. 
 5   Just to make sure the video has feedback through the
 6   mic, just make sure that the iPhones, BlackBerrys, etc.,
 7   are, if not back in your pocket, at least away from the
 8   mic.
 9             Is someone taking attendance?
10             Do we have a quorum?
11             MR. LAPORTE:  Yes, yeah, we have a quorum.
12             MR. GRAHAM:  Okay.  Good.
13             Well, thank you everyone for coming.  Once
14   again, I thank the committee members for giving us their
15   time and helping to address the issues that we've been
16   assembled to address.  And as always, we appreciate
17   greatly all the work of the SEC staff.  I think the
18   thing I appreciate most, based on the West Coast, is
19   we're meeting on the West Coast.  This is something I
20   could definitely get used to.
21             As we all know, the charge of this committee
22   is to do -- to make recommendations to the SEC for
23   changes that will improve access to capital for smaller
24   businesses who -- related to that is of course the
25   compliance cost/benefit, which involve the burden of
0005
 1   time and capital.
 2             We have made a number of recommendations, as
 3   you know, since we've been at this for the past -- I
 4   guess about a year.
 5             MS. JACOBS:  I think so.
 6             MR. GRAHAM:  Okay.  And as you know, many of
 7   those recommendations showed up in the JOBS Act, and I think
 8   we have made -- made some progress down the road of
 9   improving access to capital for businesses.  But
10   there's -- obviously, there's still a lot of work.
11             And the next areas we wanted to tackle as a
12   Committee, which was touched on in the last Committee
13   meeting, are the areas of market structure and also the
14   area of compliance.
15             In terms of market structure, the notion is
16   that there are certain -- when we think about -- when we
17   think about the demise of the small IPO, and try to, you
18   know, understand why this has occurred, certainly we can
19   understand the effects of this having occurred, but to
20   really kind of understand the causes and gain a greater
21   appreciation for perhaps what can be done in order to
22   correct the situation, if you will.
23             There are obviously differing points of view.
24   There's lots of room for debate.  Certainly one of the
25   things that I think we're all aware of, the discussion
0006
 1   around the, you know, so-called tick sizes, that is --
 2   that is -- we're going to spend our time this morning
 3   discussing.
 4             And to assist us with that discussion, we have
 5   put together an expert panel.  And if you don't -- if
 6   you bear with me, then I'd just like to read who's
 7   speaking.
 8             First of all, Jay Ritter.
 9             Jay, thanks for coming.
10             Jay is the Joseph Cordell Eminent Scholar in
11   the Department of Finance at the University of Florida.
12   He holds a Ph.D. in Economics and Finance from the
13   University of Chicago and has previously taught at the
14   Wharton School, the University of Michigan, University
15   of Illinois at Urbana-Champaign, and MIT Sloan School of
16   Management.  He is known best for his articles on
17   financial issues.
18             Thank you, Jay.
19             Dave Weild is probably familiar to most of
20   you. David has written extensively in the area of tick
21   sizes and structural changes that occurred in the market
22   over the last number of years that led to a number of
23   regulations that have perhaps unintended consequences.
24   And he was in our last -- in our last meeting.  I think
25   you're familiar with his work.  I don't think anybody
0007
 1   knows about this area better than David.  You can have a
 2   different point of view, but one thing for sure is that
 3   David knows his stuff.
 4             He oversees Capital Markets and Institutional
 5   Acceptance at Grant Thornton.  He's also Chairman and
 6   CEO of Capital Markets Advisory Partners, the firm that
 7   specializes in equity capital markets advice to issuers.
 8   He is a former Vice Chairman and Executive Committee
 9   member of the NASDAQ Stock Market.  And prior to NASDAQ,
10   David worked at Prudential Securities in senior
11   management roles.
12             Thank you again, David, for joining us.
13             This time, David brought one of his partners,
14   and that is Edward Kim, who is Co-Founder and Managing
15   Director of Capital Markets Advisory Partners and is
16   also a senior member of the Capital Markets group at
17   Grant Thornton.  Ed has over 20 years of capital
18   markets, finance, and operations experience.
19             Again, David and Ed have produced a series of
20   studies that have been influential in the debate over
21   whether the structural and regulatory changes to the
22   stock markets have undermined capital formation in the
23   U.S.
24             Those will be our speakers this morning.  They
25   will impart some of their knowledge to us.  And the idea
0008
 1   is that not only will they make presentations, but they
 2   will be part of the conversation.  And so we would
 3   expect members to join in with questions and comments in
 4   part of the conversation.
 5             The idea today is that, you know, after we
 6   hear from this morning's panel, we will break, and then
 7   we'll spend a little bit of time on just kind of a JOBS
 8   Act update recap.
 9             We will then break for lunch, and then we will
10   hear from the panel that is going to address compliance
11   and some of the regulatory burdens that the smaller
12   companies face.  We will talk about those this
13   afternoon.
14             After we hear from that panel, we will break
15   and then take time to discuss what we've heard in the
16   process following the recommendations to the SEC in
17   these areas and, you know, anything else that you want
18   to add.
19             Flipping back, the SEC staff with us today
20   are: Lona Nallengara; Gerry Laporte; Jennifer Zepralka;
21   Kathleen Hanley, and -- who is the Deputy Director and
22   Deputy Chief Economist, Division of Risk, Strategy, and
23   Innovation; and Ted Venuti, who is over in the corner,
24   who is Senior Special Counsel in the division of Trading
25   and Markets.
0009
 1             And again, we thank the staff for all the work
 2   that they do to support this Committee, and certainly
 3   all the work they do on that basis.  For those of us
 4   close to the SEC, we understand -- at least we have --
 5   can't say understand, but at least we have some sense of
 6   the pressure and the burdens and workload that you guys
 7   face, and we thank you for that.
 8             Chris, do you have anything to add?
 9             MS. JACOBS:  No.  You covered it, I think.
10             MR. GRAHAM:  Without further ado -- Mr.
11   Nallengara, do you have anything?
12             MR. NALLENGARA:  No.  Steve, we're going to
13   start with a brief update on -- I'm not sure if we sent
14   with the materials -- the report the SEC staff prepared
15   on decimalization on tick size.  Kathleen --
16             MR. GRAHAM:  Can I stop you?
17             MR. NALLENGARA:  Sure.
18             MR. GRAHAM:  I hate to kind of interrupt
19   somebody's flow of thought.
20             MR. NALLENGARA:  Go ahead.
21             MR. GRAHAM:  Apparently the audio feed is not
22   very good for us.  And so everyone who is speaking,
23   speak into the mic.
24             MS. NALLENGARA:  Okay.  So as I mentioned, we
25   had -- the JOBS Act required that the SEC to do a report
0010
 1   within 90 days of the enactment of the JOBS Act, which
 2   was July 4th, on -- on the effects of tick size and
 3   decimalization on IPOs.
 4             So the staff prepared this report.  Kathleen
 5   led our efforts on that, and that report was posted on
 6   our website a few days -- weeks after the deadline, but
 7   it is complete, and Kathleen is going to give us a brief
 8   update on that.
 9             And we turn it over to you.
10             MS. HANLEY:  Thank you.
11             So as Lona mentioned, we had 90 days to do a
12   study.  We took a three-prong approach to doing the
13   study.  The study was mandated to look at the effect of
14   decimalization on IPOs and specifically on small- and
15   mid-cap companies.  Given the tight deadline, we
16   concentrated our efforts at looking at the academic
17   literature to begin with.  And then we had our
18   roundtable here where David spoke and Professor Harris
19   spoke, and we looked at international tick sizes.
20             For the most part, the studies that we were
21   able to find talked mostly about the effect of
22   decimalization around the time of decimalization on
23   market quality, things like spreads, depth, and that
24   sort of thing.
25             We did not find any studies that purported to
0011
 1   speak to the link between decimalization and capital
 2   formation.  And I'll return to that in a moment.
 3             For the most part, the effect of
 4   decimalization at the time it was enacted appeared to
 5   improve market quality for large liquid stocks the most.
 6             We have one study that focused on small and
 7   mid cap stocks, but there was no statistically
 8   significant change in spreads at the time the
 9   decimalization occurred.
10             I leave it to you to see the rest of the
11   findings.
12             Overall, market quality improved, particularly
13   for large stocks.  Many did not make a distinction
14   between large and small stocks, and where they did, we
15   noted that.
16             But there are some caveats with using this
17   literature to draw strong conclusions about the effect
18   of tick sizes on capital formation.
19             First of all, the studies were done around the
20   time of enactment.  And of course many, many years have
21   passed since then, and the markets have changed
22   substantially, the market for capital has changed
23   substantially, and these studies could not speak to
24   that.
25             In addition, the samples, many of these did
0012
 1   not focus on small companies.  And I don't think the
 2   concerns were there at the time that the studies were
 3   done.  They were looking to see market quality issues.
 4             So, you know, we're very cautious about saying
 5   that the academic literature should drive us in any
 6   direction with respect to what we should be doing or
 7   what the Commission should be doing with respect to tick
 8   sizes.
 9             We did survey internationally.  The U.S. has a
10   one-size-fits-all policy as compared to a number of
11   international venues, such as Hong Kong and Japan and
12   the UK, which have sometimes quite elaborate tick size
13   schemes, to the point where sometimes we had to spend
14   some time to figure out what tick would apply to what
15   type of company.  So we are mindful that other
16   regulators and other exchanges have noticed that tick
17   size may be important for smaller companies.  Generally
18   tick sizes increased with the -- with the -- with the
19   price, the company went lower.
20             And so given the discussion, we were mindful
21   that some of the direct linkages between changing tick
22   sizes and capital formation appeared to be not well
23   documented, and we wanted in the study to tee up having
24   a roundtable that would allow us to address a number of
25   questions.
0013
 1             And I think there are three primary challenges
 2   that I think we face when they think about this issue,
 3   and I think this group may be well-suited to begin the
 4   discussion of these types of challenges.
 5             So the first thing is it's uncertain whether
 6   or not increasing the tick size would in fact increase
 7   spreads.  So that would be the first.  Spreads, and
 8   obviously when Gregg Berman was here last time, we
 9   noted that tick sizes are not spread sizes.  They're
10   price movements.  And so, therefore, would tick sizes
11   increase spreads?  So that's the first thing.
12             And if they did increase spreads, would that
13   increase market maker profitability, or would investors
14   who benefit from lower transaction costs not transact as
15   frequently in smaller public companies?
16             So would there be an offsetting effect from
17   investors who now have to pay potentially a larger
18   spread to transact?
19             Third, if in fact investors did not take that
20   into consideration, it did not have an offsetting effect to
21   the size of spread, would market makers indeed use the
22   extra profits they have on spreads to use that money to
23   aid companies in analyst coverage and other things that
24   capital formation might benefit?
25             And so we're convening the roundtable sometime
0014
 1   in the next few months, and we hope that in addition to
 2   this we would have some answers to that question.
 3             Also, some guidelines on how to find direct
 4   causality between changing tick sizes and capital
 5   formation is that it seems to be a road that has a
 6   number of different paths that could occur, as well as a
 7   number of different circles that, you know, one can
 8   travel around to get to that point.  There's analyst
 9   coverage we're trying to fix.  And I'm sure the
10   panelists here will have a nice viewpoint with respect
11   to that.  So we're looking forward to having that,
12   whether or not we should do a pilot study, how that
13   pilot study should be conducted.
14             So we're convening a roundtable, and you
15   should be hearing more about that in the future.  If you
16   have any questions about, I'm happy to answer questions
17   about that today.
18             (No audible response.)
19             MS. HANLEY:  No?
20             I'll turn it over to Jay.
21             DR. RITTER:  Thank you.
22             Feel free to interrupt with questions at this
23   time.  Feel free to interrupt with questions or comments
24   as we go along here.
25             My presentation is going to be loosely based
0015
 1   upon a working paper that I have with two co-authors,
 2   Xiaohui Gao and Zhongyan Zhu, both who are educators in
 3   the United States, but now teach in Hong Kong, although
 4   actually, Xiaohui Gao is visiting at the University of
 5   Maryland this year.
 6             And the question that we're addressing here is
 7   the question that is of interest to all of us:  Where
 8   have all the IPOs gone?
 9             I believe at the June meeting Professor Jeff
10   Harris showed this -- this graph or a very similar graph
11   where this shows the annual volume of operating
12   companies in the United States from 1980 to 2011.  And
13   what we see here is that from 1980 to 2000 on average
14   302 companies went public every year -- I'm sorry, 311
15   companies went public every year in the United States.
16   And in the last 11 years, which I'll call the last
17   decade for convenience, only 99 companies on average
18   have gone public.  And this drop-off is even more
19   dramatic if we think about during the last three decades
20   U.S. real GDP has doubled, more than doubled.  And so if
21   you think there ought to be the same number of IPOs per
22   trillion dollars of GDP, we ought to see a doubling from
23   the beginning to the end rather than this big drop-off.
24             And as we're all aware, over the last decade
25   there have been some bear markets, but the market has
0016
 1   recovered, and we haven't seen a recovery in IPO volume
 2   to anywhere near the levels of a normal year in the
 3   1990s.
 4             And even more dramatically, this big drop-off
 5   has been concentrated among small company IPOs.  This
 6   graph defines big and small companies, not on the basis
 7   of the proceeds raised or the market cap of the
 8   offering, but the annual inflation adjusted sales of the
 9   company in the year before going public using $50
10   million as a cutoff, where approximately half of all the
11   companies that have gone public in the last 32 years
12   were below $50 million and half above that.
13             And what you see, the red lines in back, the
14   red bars give the annual volume of large company IPOs.
15   The blue lines in front give the annual volume of small
16   company IPOs.  And before 2000, from 1980 to 2000, a
17   typical year at least as many small companies went
18   public as big companies.  Since then, the number of
19   small companies has been dramatically lower.  And the
20   drop-off from an average year in the previous couple of
21   decades to this decade has been about 80 percent for the
22   number of small companies going public, you know.
23             So this is what we're all worried about.  A
24   lot of public policy discussions focus on this.  The
25   JOBS Act was certainly motivated by part of this
0017
 1   pattern.
 2             And as we can see here as well, even when the
 3   stock market was closer to its peaks in 2007, and now
 4   there has not been anywhere near the number of small
 5   company IPOs as was typical in the 1980s and '90s.
 6             If we look at the age distribution of
 7   companies going public, this is each year, the 25th,
 8   50th, and 75th percentile of the age since founding of
 9   companies going public, what you see is in the '80s and
10   '90s, most years the median age was about seven or eight
11   years. That dropped a bit during the Internet bubble
12   period. But in the last decade very few young companies
13   have been going public.  So whether we focus on sales or
14   the age of companies going public, young small companies
15   just have not been going public this decade.
16             That doesn't mean that there aren't any young
17   small companies out there.  The venture capitalists have
18   poured a lot of money into financing small companies,
19   merging companies in the last decade.  There's a big
20   increase in the amount of VC funds committed in '99 and
21   2000.  And if you would think more money being poured
22   into venture capital ought to lead five years later to
23   more IPOs, we would have expected to see more IPOs this
24   decade rather than fewer.
25             This graph shows from 1990 to 2011 of the
0018
 1   exits of venture capitalists, so in other words, of
 2   their portfolio companies that they're exiting either by
 3   a trade sale or by taking the company public.
 4             The green part of the bars are the exits via
 5   going public, and the lower black parts are the
 6   percentage of exits via having a company acquired,
 7   merger and acquisition, a trade sale.  And what you can
 8   see there is in the 1990s a steady upward trend, and
 9   then this decade, very few exits via IPOs, much larger
10   fraction of exits via trade sales.
11             And one big question is:  For the lack of
12   IPOs, is it because the IPO market is broken, or is it
13   because of some other factor that's made trade sales
14   more attractive, or more likely some combination of
15   these things?  I don't think there is one simple
16   explanation to describe all of these patterns together.
17             Well, the conventional wisdom is that the IPO
18   market is broken, and we're all familiar with a lot of
19   the arguments.
20             The Sarbanes-Oxley Act of 2002 imposed costs on
21   publicly traded companies, especially burdensome for
22   small companies, although some of the burdensome
23   requirements were relaxed in 2007.  And the JOBS Act
24   also further relaxes some of these things.
25             And as David Weild and Ed Kim will be talking
0019
 1   about decimalization, Regulation FD in 2000, the Global
 2   Settlement in 2003, various other things, both from
 3   regulation and changes in market practice, have resulted
 4   in a drop in analyst coverage, in particular, of small
 5   companies.  And if we make the assumption that analyst
 6   coverage results in more investor interest, a greater
 7   willingness of companies to pay -- a greater willingness
 8   of investors to pay out a bigger price for your company.
 9   The lack of analyst coverage has depressed the prices of
10   publicly traded small companies and, therefore, changed
11   the relevant price in private markets to public markets
12   and made it less attractive for a company to go public.
13             We call these explanations in our paper the
14   regulatory overreach hypothesis to over-simplify that
15   heavy-handed regulation, and some unintended
16   consequences of some of that regulation has resulted in
17   it being more expensive to be a publicly traded company,
18   and the valuation that a company can get in public
19   markets has decreased to the detriment of capital
20   formation.
21             Life is full of trade-offs, and, you know, in
22   terms of attempting to protect investors from fraud,
23   possibly some regulatory changes have gone too far.  And
24   the benefits of reduced investor fraud have been more
25   than offset by excessive compliance costs, regulatory
0020
 1   costs, etc.
 2             I'm glad I'm not a regulator who has to get
 3   these balances exactly right to trade off investor
 4   protection and capital formation.  I don't want to
 5   pretend that the answers are always easy or how to get
 6   the balances right.
 7             MR. WALSH:  Professor.
 8             DR. RITTER:  Yes.
 9             MR. WALSH:  Would you repeat what you said
10   about the benefits?
11             DR. RITTER:  The benefits of compliance and
12   investor protection.  One way to think about it is,
13   instead of stocks, what if we're talking about going
14   into a produce store and buying apples?  And there's a
15   barrel of apples, a hundred apples in the barrel.  And
16   from experience, we know that two of them are probably
17   rotten inside and 98 percent of those apples are going
18   to be nice and tasty.
19             Well, if we were willing to pay a dollar for a
20   good apple, we would be willing to pay 98 cents for a 98
21   percent chance that we're going to get a good apple.
22             Now, if for a penny of compliance cost the
23   store provider or we could screen out all of the bad
24   apples and figure out inside is it a good apple or a bad
25   apple and for a penny get rid of the two bad apples,
0021
 1   that then there would be 98 good apples in that barrel,
 2   and we would be willing to pay a dollar for each of
 3   those good apples.
 4             And in this simple example, the one penny in
 5   compliance cost is worth more than the two cents in bad
 6   apples that we're getting rid of.
 7             On the other hand, if there's compliance cost
 8   for 20 cents, I think most of us would be willing to pay
 9   for a 2 percent chance of a bad apple rather than paying
10   20 cents to get rid of a 2 percent chance of a bad
11   apple.
12             So, you know, depending upon the numbers,
13   maybe it would be worthwhile to screen out the bad
14   apples, maybe it would not be.
15             And, you know, if we're talking about massive
16   frauds like WorldCom and Enron, compliance costs are
17   reasonable.  Certainly some investor protection is
18   worthwhile, but clearly you can overdo it as well.
19             MR. WALSH:  Great analogy.
20             DR. RITTER:  In our paper we're arguing that,
21   while there may be overreaching regulation, we think
22   that an important reason for there being fewer small
23   company IPOs is that there has been a long-term
24   structural change going on, something that did not just
25   happen overnight, but basically getting big fast is more
0022
 1   important than it used to be, especially for technology
 2   companies, that for a variety of reasons increased speed
 3   of communications, the half-life of innovation has
 4   gotten shorter, speeding a product to market before too
 5   long occurs, and the competition has a better product.
 6   All of these have been gradually changing over time. And
 7   getting big fast is more important than it used to be.
 8             And consequently, for a company to grow slowly
 9   organically is in some cases no longer the optimal
10   profit maximizing business strategy.  That, instead,
11   getting big fast, possibly by making acquisitions,
12   possibly by getting acquired and allowing a bigger
13   organization to rapidly realize economies of scope.
14             Economies of scope refer to the concept of
15   related businesses having cost efficiencies or greater
16   revenue potential if you can combine related businesses.
17             Classic example is if you're selling ice cream
18   and refrigerated milk.  Well, two separate companies
19   could have a truck going from grocery store to grocery
20   store delivering milk and another truck delivering ice
21   cream, but there are obvious efficiencies in the
22   distribution if you have one truck delivering both ice
23   cream and milk to the grocery stores.  That would be an
24   example of economies of scope.
25             And because of the long-changing structural
0023
 1   changes going on, we think that these economies of
 2   scope in many industries have gotten bigger, and
 3   increased importance of speed to market has become more
 4   important as well.
 5             And just to illustrate an idea with an
 6   example, couple of years ago, this company Android came
 7   up with some better operating system.  I believe that
 8   was an eight-person operation.  And one of things that
 9   they could have done was hire more engineers, more
10   software people, come up with some improved products and
11   maybe come out with a better smartphone three years from
12   now.
13             But what would they be competing against? 
14   They wouldn't be competing against Samsung and Apple's
15   current model.  They would be competing against Samsung
16   and Google's model three years from now.
17             And Android decided, rather than to go public
18   and build a hard product, they decided to sell out and
19   approach some potential buyers.
20             They approached Samsung.  I heard the story in
21   Korea last December when I was there.  And Samsung said:
22   Yeah, you got some pretty neat technology here, but
23   we've got 500 in-house Ph.D. engineers and scientists.
24   We don't need to buy your product; we can figure it out
25   ourselves.
0024
 1             And so instead, Google bought Android.  And
 2   I've read that Google considers it their best
 3   acquisition ever.
 4             I don't think that Android didn't go public
 5   because they were afraid of Sarbanes-Oxley compliance
 6   cost or lack of analyst coverage.  They decided to sell
 7   out because they thought somebody like Google would be
 8   able and willing to pay a much higher price now because
 9   they could realize a lot of value, than if Android
10   stayed as an independent company and tried to build
11   itself up through organic growth.
12             So we call this the economies of scope
13   hypothesis that a lot of, in particular, tech companies
14   are selling out rather than going public, not because
15   the IPO market is broken, it's not a public company
16   versus a private company choice; it's a big company
17   versus small company choice, that getting big fast is
18   important, and very frequently merging is the way to get
19   big fast.
20             So the idea is based upon structural changes
21   in the product market that did not happen overnight.  It
22   did not happen in April 2000 that resulted in before
23   then lots of IPOs, and suddenly after April of 2008 very
24   few IPOs.
25             Well, what's the evidence supporting this
0025
 1   idea? Well, one thing we could do is look at the
 2   profitability of small firms.
 3             And this graph gives from 1980 to 2009 for
 4   companies that have been publicly traded for at least
 5   three years.  So this is excluding recent IPOs.  What
 6   fraction of them in each fiscal year are reporting
 7   negative earnings per share?  And we divide this into
 8   big companies and large firms and small firms using a
 9   cutoff of $250 million in inflation adjusted sales.
10             What you see is on the bottom for large firms
11   there's been a little bit of an uptrend in the fraction
12   of companies every year reporting negative earnings. And
13   you definitely see some business cycle effects there as
14   well.
15             And then on top is the fraction of small
16   publicly traded firms that are reporting negative
17   earnings.  And what you see there is in the 1980s there
18   was a big increase in the fraction reporting negative
19   earnings.  And since then, a little bit of a continued
20   upswing.  And in every year, small companies are much
21   likely to be profitable, more likely to be unprofitable
22   than big companies.
23             Now, part of the reason in recent years in the
24   last decade that companies have been having a greater
25   difficulty reporting positive earnings is, for instance,
0026
 1   Sarbanes-Oxley compliance costs.  And so what we do is
 2   we say, well, what would the earnings have been if
 3   companies didn't have those extra costs?  And based upon
 4   some estimates from SEC studies, we say, well, pretty
 5   big company, what if they had $2.5 million less in
 6   costs, and for a small company, what if they had
 7   $650,000 less in annual costs; what fraction of them
 8   would be profitable then?
 9             And that's where those dotted lines come in
10   from 2002 through 2009.  And what you see is the big
11   companies on the bottom.  That gap between the lines,
12   it's called 1 percent, that only a small number of
13   companies that were unprofitable would have been
14   profitable if they didn't have that $2.5 million extra in
15   expenses.  And for small companies, the gap is about 5
16   percent.  So, you know, definitely compliance costs are
17   making it harder to be profitable.  But we -- the
18   patterns would largely still be there.
19             MR. WALSH:  These are earnings per share
20   negative in a year?
21             DR. RITTER:  Yeah, yeah, they're fiscal year.
22             MR. WALSH:  Over five percent of the companies
23   are negative in a year because they have $650,000 in
24   compliance costs?
25             DR. RITTER:  Right.  That if you look in 2009,
0027
 1   the numbers for small companies are 60 percent
 2   unprofitable, and it would be 55 percent -- in other
 3   words, there are about 5 percent of companies where a
 4   $650,000 change in earnings would shift them from being
 5   unprofitable to profitable.
 6             MS. JACOBS:  Can I ask a quick question?
 7             DR. RITTER:  Yes.
 8             MS. JACOBS:  The $600,000 estimate on the
 9   small companies, what was your market cap?
10             DR. RITTER:  These -- there's no market cap
11   being used here.  $250 million in annual sales is being
12   used as the definition of big and small companies.
13             MS. JACOBS:  Yeah.  I don't know how the rest
14   of the members feel, but I don't think the $600,000 is a
15   real number.
16             DR. RITTER:  Now, this is the incremental
17   costs.
18             MS. JACOBS:  That's right, yeah.
19             DR. RITTER:  And --
20             MS. JACOBS:  It's the cost of being public,
21   and I think we as --
22             DR. RITTER:  Well, this is the change in the
23   cost of being public --
24             MS. JACOBS:  With SOX.
25             DR. RITTER:  -- relative -- correct.
0028
 1             MS. JACOBS:  Yeah, got it.
 2             QUESTION:  Just a clarification, because of
 3   per 404, non-accelerated filers are exempt, does this
 4   account for that?
 5             DR. RITTER:  No, it does not.  This assumes
 6   that every company with less than $250 million in annual
 7   sales has to pay an extra $650,000 in compliance costs as
 8   a result of Sarbanes-Oxley.  So for a company,
 9   especially those exempt or since 2007, this might be an
10   overestimate.
11             You know, there's a lot of evidence that the
12   first year or two, when auditing firms were billing lots
13   of stuff, that those numbers were bigger than they have
14   been since then.  And obviously for a biotech company
15   with zero sales, the numbers are likely to be smaller
16   than for another company that's got really complicated
17   revenue and all sorts of complicated accounting.
18             Okay.  Another question is:  Of companies that
19   are public, have a lot been going private?  And this
20   graph shows, of companies that went public, how many of
21   them then went private within three years?  Not getting
22   acquired by a bigger company, but going private.
23             And what you see here is most years the number
24   is about 1 or 2 percent per year.  So of the companies
25   that go public this year, we could anticipate that 1 or
0029
 1   2 percent of them within the next three years will
 2   decide, we made a mistake, we're going private.
 3             Being bought out by a private equity firm, for
 4   instance, would be going private.  Going dark, going
 5   private.  Being bought and acquired by a bigger company,
 6   we don't count that as being private.  So this is not
 7   the big firm versus small firm issue; this is the
 8   private firm versus public firm issue.
 9             Most importantly, this decade there has been
10   no increase in the probability of going private than
11   there used to be.  So there doesn't -- you know, it
12   seems to be something where a small number of companies
13   that went public decided within a couple of years it was
14   a mistake, but it doesn't seem to have changed much over
15   time.
16             Now, before, we were looking at companies that
17   were public for at least three years, what fraction are
18   reporting negative earnings.  These are companies that
19   went public, and within three years of going public, how
20   profitable are they.
21             So, for instance, in 1980 the numbers that are
22   graphed there are for the companies for fiscal year
23   1980.  Of the companies that went public in '77, '78,
24   '79 that are reporting in 1980, what fraction of them
25   are reporting negative earnings?
0030
 1             And what you can see here is for the small
 2   firm IPOs the same uptrend for big -- for IPOs a little
 3   bit of an uptrend.  But just as we saw it in the other
 4   graph, small companies are much more likely to report
 5   negative earnings than big companies.
 6             And note that April of 2000 is nothing special
 7   here.  It's not as if suddenly there was this dramatic
 8   change when the tech stock boom collapsed or when
 9   Sarbanes-Oxley came in or anything else.  You know,
10   we've got a gradual trend going on consistent with the
11   notion that there have been some long-term trends going
12   on making it harder and harder for small independent
13   companies to make money.
14             Now, this is just tech stocks or just biotech
15   stocks.  A lot of numbers here.  Not going to ask you to
16   memorize all these numbers.  The effects are a little
17   stronger for tech stocks than for other industries.  But
18   the patterns are there for other industries as well, and
19   the patterns are stronger for small companies than big
20   companies.
21             MR. DENNIS:  Professor, going back to your
22   graph, it showed something like 60 percent of small
23   companies are losing money?
24             DR. RITTER:  Yeah.  And here, for small IPOs,
25   you see it's over 70 percent.
0031
 1             MR. DENNIS:  Okay.  Well, yeah, I was looking
 2   at the earlier one:
 3             DR. RITTER:  Yeah.
 4             MR. DENNIS:  So you're saying that's not --
 5   you know, when I look at the original bubble back in the
 6   '90s or so -- yeah, in that one.  Let's see.  Where it
 7   went from 20 to about 45 percent or so.
 8             DR. RITTER:  Yeah, in the 1980s.
 9             MR. DENNIS:  In the '80s, '90s.  Now, my
10   assumption without any fact is that that's more a high
11   tech or start-up that.  Are you telling me there's
12   really not much difference?  If we graph this for plain
13   old manufacturing companies that we would see the same
14   kind of relationship?
15             DR. RITTER:  Yeah.  Indeed, go to the numbers
16   for Panel C would be the plain old manufacturing
17   companies and retailers and others, fast food chains. 
18   We see that for the small companies in 1980 to 2000, 49
19   percent of those nontech companies were reporting
20   negative earnings.  The last decade has been typically
21   90 percent.  So it increased, not as dramatic as the
22   deterioration and profitability of tech firms, but the
23   pattern is still there for other industries as well.
24             What about being acquired?  This graph gives
25   for IPOs what's the probability of being acquired within
0032
 1   three years of going public?
 2             And the orange lines give large firms; the
 3   blue bars give small companies.  Once again, $50 million
 4   in pre-IPO annual sales being the definition of small
 5   versus large companies.
 6             And we see a bit of an uptrend, especially in
 7   the 1990s, for those blue bars, that in the 1990s there
 8   was a pronounced trend, where in the early '90s very few
 9   companies that went public got acquired within three
10   years.  By the end of the '90s, a very large percentage
11   of companies that went public got acquired within three
12   years.
13             So the pattern of more likely to be getting
14   acquired was there before the tech stock bubble burst
15   and the low volume of IPOs that we see in this decade.
16             Everything we've looked at has been from the
17   United States.  What about other countries?
18             Here's for Germany.  See 32 years, as the
19   United States.  The bars are the annual number of IPOs
20   in Germany, one of the world's largest economies.  The
21   connected lines on the left-hand axis are the average
22   for the returns on IPOs.  And what we see there is a
23   very different scale than the United States.
24             In most years in Germany, if we look at the
25   1980s, typically only 10 or 20 companies went public in
0033
 1   Germany.  They did not have Silicon Valley.  They still
 2   don't.  In the late '90s they had a bit of a tech stock
 3   boom, but it hasn't been there this decade either.
 4             And if we look at other continental European
 5   countries, the patterns are very similar to Germany.
 6             If we look at China, of course it's a
 7   different pattern.  Lots of state-owned companies have
 8   been going public in recent years.
 9             What about the returns earned by investors?
10             At the June meeting I believe Professor Jeff
11   Harris gave some numbers from my website.  These are
12   obviously perfectly correlated with the numbers that he
13   presented.
14             On the left-hand side here, we see for small
15   company IPOs.  From 1980 to 2000, the gray bar gives the
16   three-year buy-and-hold return from the first date
17   closing price to three years later, how much did
18   investors earn.  And what you can see there, an average
19   three-year buy-and-hold return of about 7 percent,
20   annualized only about 2 percent per year as small
21   company IPOs.  Whereas if you had bought other small
22   companies on the same day as the IPO, sold them on the
23   same day, you would have gotten that red bar, about 20
24   percent buy-and-hold returns.  In other words, small
25   companies underperform.
0034
 1             What about the last decade?  From 2001 to
 2   2009, the difference in returns has been even more
 3   dramatic. You would have actually earned negative
 4   average returns on the small company IPOs, whereas you
 5   would have earned positive returns on investing in other
 6   publicly-traded small company stocks.
 7             On the left-hand side, we've got large firm
 8   IPOs where there's basically no difference between the
 9   gray and red bars.  For larger companies going public,
10   they don't underperform other similar kind of companies
11   either in the '80s or '90s or in this decade.
12             And if I were to break this out in more
13   detail, in the 1980s, the small company IPOs
14   underperformed; in the 1990s, they underperformed; in
15   the bubble years, they underperformed; in this decade,
16   they've underperformed.  One of the few patterns that
17   has been reliable, just period after period.
18             And, you know, maybe one of the reasons that
19   investors are willing to pay as much for small company
20   IPOs is they've learned, you know, after decade after
21   decade of having so few of the companies become
22   profitable and earn big returns for investors, they just
23   had kind of a buyers strike.  But it's not because
24   investors are irrational; it's because the companies
25   just haven't been turning the corner and becoming
0035
 1   profitable frequently enough.
 2             MR. CHACE:  The $50 million is the threshold
 3   that you used, right, for small companies?
 4             DR. RITTER:  Yes.
 5             MR. CHACE:  If you break that either by
 6   deciles or quartiles kind of market cap size, is the
 7   relationship linear to larger?  Because my perception is
 8   that $50 million is a pretty small --
 9             DR. RITTER:  Yeah.
10             MR. CHACE:  Hard to understand for sure.
11             DR. RITTER:  It's linear as you go from zero
12   up to 50.  The lower the sales, the worse the returns
13   are. Once you hit that $50 million cut-off, it's pretty
14   much the returns are similar to other companies of the
15   same market cap in value versus growth characteristics.
16             MR. CHACE:  So it is kind of the smallest of
17   the small.
18             DR. RITTER:  Yes.  Now, the reason I'm using
19   sales rather than market cap is when you use market cap,
20   you're combining both big companies like Facebook and
21   overvalued companies like Facebook.
22             And in particular, in the bubble years you had
23   a lot of really tiny companies at astronomical valuation
24   that then crashed and burned.  And if I did this on the
25   basis of proceeds or market cap, the numbers would look
0036
 1   even worse.
 2             MR. GRAHAM:  To what extent do you think the
 3   lack of access to capital plays a role in small
 4   companies failing to provide a better return?  Talking about a
 5   vicious circle in some cases here?
 6             DR. RITTER:  Yeah, yeah.  Obviously there are
 7   some companies where if they had access to capital, they
 8   could have turned a corner.  But I'd be -- you know, and
 9   there certainly are some companies that have a viable
10   business strategy that weren't able to raise financing
11   at sufficiently attractive terms, that they never did
12   make the investment that would have turned out to be
13   good.
14             However, if we look at the realized returns
15   earned on venture capital investments over the last
16   decade, which in general has been pretty poor, I'd be
17   willing to assert that the problem is not lack of
18   capital; it's lack of good companies, lack of good
19   investment opportunities.
20             Indeed maybe even the problem has been too
21   much capital resulting in low returns for both venture
22   capitalists and public market investors.  If the prices
23   that investors paid were lower, the returns would have
24   been higher.
25             Now, getting the balance right is not easy,
0037
 1   you know.  For companies with good prospects, they ought
 2   to be able to raise money at fair terms reflecting their
 3   growth prospects.  And for companies that don't have
 4   good investments, the market is working when the market
 5   refuses to fund those companies.
 6             I'd be more concerned about capital formation
 7   being the fundamental problem if venture capitalists and
 8   their limited partners were earning incredibly high
 9   returns over the last decade.
10             I'm not going to claim that I know how to get
11   things right, that I know what the right amount of
12   capital is or what the right regulations are.  But the
13   main point that I want to make is that it's been really
14   difficult for a lot of small companies, especially in
15   the technology space, to come up with viable business
16   models that earn positive profits and earn high returns
17   for their investors as freestanding independent
18   companies; that I think a major reason that a lot of
19   companies are selling out, venture capitalists are
20   exiting by selling out rather than taking their company
21   public is because the company is worth more as part of a
22   larger organization that can speed products to market,
23   integrate technology, create value, than if the company
24   was trying to grow organically.
25             MR. GRAHAM:  So --
0038
 1             DR. RITTER:  And there's not one business
 2   model that fits all for every company.
 3             MR. GRAHAM:  Right, it's a complicated
 4   question, and there are a lot of factors.  But some
 5   companies fit some model, some companies don't.
 6             DR. RITTER:  I agree.  And, look, my focus on
 7   IPOs has been for more than 30 years.  I would really
 8   like it to be the case there is a vibrant market for
 9   IPOs in the United States and throughout the world.
10             MR. CHANG:  These statistics are very
11   interesting and informative, but I'm not sure where
12   we're going with this.  It's a little bit like the
13   problem with the apple analogy.  If you pick that one
14   bad apple, I mean, you lost it, you lost your one buck.
15             So what does that really tell us in terms of
16   from an investor standpoint?
17             DR. RITTER:  What it tells us is that
18   investors haven't been able to find enough good apples. 
19   That, you know, for every eBay and Google that have
20   given investors really good returns, there just have
21   been too many companies that have been disappointments.
22             Now, you know, just like with venture capital,
23   the fact that a lot of the companies have lost money,
24   that doesn't bother me.  You know, venture capitalists
25   are counting on the right skewness, enough tenbaggers to
0039
 1   balance out a lot of write-offs.
 2             And when you invest in young companies, even
 3   if it's a public young company, a lot of them are going
 4   to disappoint.  If there were enough winners to offset
 5   the losers, the average return would be fine.
 6             But, you know, the evidence -- and I wish the
 7   numbers were different than they are.  The evidence
 8   seems to be that there just haven't been enough
 9   companies that have been able to transform their
10   business into a big successful business when they go
11   public at a very young age in their lifecycle.
12             You know, and if we think about Microsoft,
13   Google, they were already big, successful, profitable
14   companies when they went public.  That -- I have
15   difficulty coming up with a lot of examples of companies
16   that went on to big success that went public at a very
17   early stage before they had demonstrated a fair amount
18   of operating success.
19             MR. LEZA:  On one of the -- do you have a
20   chart? For example, there's been a lot of what I call
21   structural changes.
22             In one of them, for example, and I've never
23   seen a chart, is when you look at -- and especially if
24   you look at high technology and you look before the
25   bubble, you look at the multiples that people were being
0040
 1   acquired versus the multiples from a strategy point of
 2   view that are being acquired after the bubble, I mean,
 3   there's a tremendous change.  Before the bubble, you
 4   never heard about a multiple from a corporation taking
 5   7X, you know.
 6             And that's a big change.  And that's why a lot
 7   of people, you know, they'd rather take it now than wait
 8   and say, okay, let's go IPO and see what happens.
 9             You ever done a multiple chart to show that?
10             DR. RITTER:  I've done related things.  Let's
11   give another example here.
12             Facebook.  The IPO has gotten a lot of
13   criticism.  It's still a great company.  The only
14   problem is investors made too high a multiple.  You
15   know, they built in expectations that were just too
16   optimistic.  You know, I still think it's a great
17   company.  I'm too old to be a user myself, but, you
18   know, they've got a business model that's working.  You
19   know, maybe it's not going to be as profitable as some
20   people had hoped it would be.  Only time will tell on
21   that.
22             By the way, Steve, how am I doing for time?
23             MR. GRAHAM:  You're okay.
24             DR. RITTER:  Okay.
25             MR. GRAHAM:  I'm assuming that you're going
0041
 1   for another hour.
 2             DR. RITTER:  I won't take it that long.
 3             MR. GRAHAM:  You're good.
 4             MR. BORER:  Question:  Given your years --
 5   your years in the field and given some of these
 6   statistics we've seen, given that the number of
 7   transactions pertaining here down by 60 percent in IPOs,
 8   the number of trade sales by venture capitalists and
 9   private equity, strategic (inaudible) other companies in
10   lieu of IPOs, is part of this return driven by the fact,
11   in your opinion, that the better companies didn't IPO on
12   average, went another route, and that the market itself
13   of IPOs, given all the people involved, is not very good
14   at discriminating between what's a good opportunity and
15   a bad, and obviously over time efficiency prevails,
16   based on performance, growth, profitability, etc.?
17             DR. RITTER:  You know, it's clear, you know,
18   with the benefit of hindsight in 1999, 2000, there was a
19   bubble that investors were too optimistic in paying
20   prices that were not justifiable.
21             You know, a year or two ago, lots of people
22   were asking about social media companies, are we in
23   bubble 2.0?  And the answer I gave them is:  I'm not
24   sure.  That in '99, 2000, I had no question in my mind
25   that there was a bubble going on, just like six years
0042
 1   ago I had no question in my mind that there was a real
 2   estate bubble going on.
 3             With social media companies like Facebook, the
 4   fact that Google is now making $10 billion a year in
 5   annual after-tax profits demonstrated how profitable
 6   targeted search advertising can be as a business model.
 7   If Google hadn't been so successful, Facebook would have
 8   never gotten the valuation that it had gotten to.
 9             And a year ago, even six months ago, I was not
10   at all positive that Facebook's valuation was too
11   optimistic.  You know, right now, I'd probably revise
12   that answer.
13             But, you know, I don't think that it was
14   obvious that the social media frenzy gotten has too
15   completely out of whack.  You know, most of the time
16   when there is a bubble, you can tell a rational story or
17   optimize.  The only question is, is it too optimistic a
18   story?  And it's hard to quantify when you've got a lot
19   of uncertainty about the future.
20             I'm not sure if that fully answers your
21   question, but I'm not sure that I've got a single
22   answer.
23             Okay.  So let me just summarize the evidence
24   so far.  Small firm IPOs have become less profitable
25   post IPO.  There has been a dramatic decline in
0043
 1   profitability after 2000, but that decline in
 2   profitability is not limited to tech firms, and there
 3   had been a trend going on for quite a while.
 4             And mergers have become more common, both
 5   venture capitalists selling out in a trade sale and
 6   companies going public, and then merging.  Either being
 7   acquired or -- I haven't shown it, but other studies
 8   have demonstrated that there has been an uptrend over
 9   time in other companies that do go public, how many of
10   them make acquisitions themselves within a couple of
11   years.
12             You know, so all of this is consistent with
13   the notion that getting big fast, possibly via M&A
14   activity, is increasingly the popular business model.
15             Evidence is also that small firm IPOs have
16   generated disappointing returns.  And the one way we can
17   summarize this is eat or be eaten.  You know, that
18   getting big fast either as an acquirer or being acquired
19   is increasingly the value-maximizing business strategy,
20   not for every single business, but, you know, on
21   average, especially in the technology space.
22             Now, I'd like to spend some time talking about
23   analyst coverage and tick size, something that I and David
24   Weild and Ed Kim will be talking about further this
25   morning as well.
0044
 1             In my paper, co-authored paper "Where Have All
 2   the IPOs Gone?" we track down from all the companies
 3   that went public from '94 to 2009 what was the analyst
 4   coverage on these stocks.
 5             And we find that both from '94 to 2001 on the
 6   right and from 2002 to 2009 on the right, '94 to 2001 is
 7   on your left, that the gray bars are small company IPOs,
 8   the red bars are large company IPOs.  Close to 100
 9   percent of the companies that go public do get analyst
10   coverage.  That was true in the '90s; it's still been
11   true now.
12             Of the handful of companies that don't get
13   analyst coverage, typically there are very small firms
14   or there's some special circumstance, or maybe the data
15   is missing the coverage that actually was there.
16             A few years ago I did a separate study where I
17   started out using a standard database, IFES, looking at
18   analyst coverage, and then looked at the companies where
19   IFES was complaining there was no analyst coverage.
20   Started going to the underwriters’ website and doing
21   Google searches and discovered that almost all the times
22   there actually was analyst coverage from the lead
23   underwriters' analyst, it's just that IFES didn't list
24   it for some reason or another.
25             Now, what this does not answer is:  How many
0045
 1   companies aren't going public because they couldn't find
 2   an underwriter that was willing to provide analyst
 3   coverage?
 4             And, you know, certainly there are some
 5   companies that are so small that any reputable
 6   underwriter is going to say, look, the economics just
 7   aren't going to work for me to have an analyst cover
 8   your company.  Come back with -- when you're bigger, and
 9   then we can consider it.
10             But of the companies that do go public, it's
11   pretty rare that they don't have analyst coverage.  And
12   usually coverage from multiple layers.
13             Now, regarding tick sizes and stock.
14             MR. WEILD:  Jay.
15             DR. RITTER:  Yes.
16             MR. WEILD:  If I can, we've done studies on
17   research -- we didn't bring them here today.  But the
18   ratio of number of research analysts to companies has
19   definitely declined over time.
20             DR. RITTER:  I agree.
21             MR. WEILD:  And some of the stuff in the
22   economic literature, and I'm not fresh on, that
23   basically says that you need about six research analysts
24   for stocks to trade, you know, more efficiently.
25             We think that the problem with research,
0046
 1   though, is not a research problem per se, that a lot of
 2   this research is sitting on the shelf collecting dust,
 3   that nobody is actively marketing it to drive liquidity.
 4   And so, you know, it's up there for show to make -- to
 5   make the issuers feel like they're actually getting
 6   something.  But the actual amount of time that an
 7   analyst is spending with the company is -- is -- is --
 8   can be pretty trivial.  And particularly as you get into
 9   smaller companies.
10             DR. RITTER:  I agree with you.  I'm not sure
11   that six analysts -- you know, there's no magic number. 
12   The more, the better.  And by the time you're up to the
13   23rd analyst, the 24th analyst isn't going to make much
14   difference.
15             Obviously the first couple of analysts are
16   more important, and having analysts that really are
17   involved, rather than just sitting there doing very
18   little, certainly makes a difference as well.
19             MR. WEILD:  Yeah, I agree, yeah.
20             DR. RITTER:  As Kathleen Hanley pointed out at
21   the beginning, bid-ask spreads have declined over time. 
22   For small company stocks before 1994, they were
23   typically 25 cents or 50 cents; now more typically 1 to
24   10 cents, you know, sometimes larger than that.  And for
25   big company stocks, you know, one penny is a very
0047
 1   typical spread.
 2             At the same time, depth has decreased over the
 3   last two decades as well.  You can't trade as many
 4   shares without the price moving a little bit.
 5             And the reduction in bid-ask spreads for small
 6   stocks has been very good for individual investors who
 7   are buying less than a thousand shares of a stock.
 8             For institutional investors that want to buy
 9   or sell a big block, the lack of depth has been a
10   detriment to them offsetting some of the benefits of
11   lower gross spreads.
12             This is a very simple summary of things
13   obviously in light as more complicated issues go on as
14   well.
15             Let's ask:  How does a larger spread boost a
16   stock's price?  You know, the logic is wide bid-ask
17   spreads are profitable for market makers.  Profitable
18   market-making creates an incentive to generate trading
19   volume.  Analyst coverage generates trading volume, so a
20   securities firm that makes markets in a stock -- or
21   makes a market in a stock has an incentive to have an
22   analyst cover that stock or cover stocks in general.
23             So, you know, the logic, which I completely
24   agree with, is wider bid-ask spreads don't make trading
25   more profitable, that creates an incentive for a market
0048
 1   maker to have an affiliated analyst generating trade
 2   volume.
 3             Also, analyst coverage increases the demand to
 4   own the stock and hold it as well as trade the stock.
 5             MR. WALSH:  Professor, how do you define
 6   "securities firm"?
 7             DR. RITTER:  I would -- I'm thinking of that
 8   in terms of an integrated securities firm that does both
 9   underwriting, market-making.
10             And, you know, one of the market structure
11   changes that's been going on in the last decade in
12   particular is how specialists and market makers have
13   largely been replaced by high frequency traders.
14             MR. WALSH:  Which are essentially securities
15   firms?
16             DR. RITTER:  Yes, sometimes hedge funds being
17   made to high traders.  But certainly there have been
18   some major structural changes there.
19             MR. WALSH:  There are structural changes
20   coming down the road making it harder and harder for
21   traditional securities firms -- Goldman Sachs, Merrill
22   Lynch -- to make markets --
23             DR. RITTER:  Right, I agree with that.
24             MR. WALSH:  -- getting ready for the next
25   chapter.
0049
 1             DR. RITTER:  And analyst coverage increases
 2   the demand to own the stock, boosting the stock price.
 3             While I agree with this logic, the question
 4   is: Well, how big is the effect?  What's the
 5   quantitative effect?  Well, there is some evidence out
 6   there.
 7             Actually, one of my colleagues, Mike Ryngaert,
 8   along with one of our former doctoral students, Cem
 9   Demiroglu, published an article two years ago where they
10   looked at over 500 companies that had no analyst
11   coverage where an analyst initiated coverage, typically
12   by grading, and looked at what happens to stock price
13   when the analyst started covering the stock.  And they
14   found that, on average, the stock price jumped 5
15   percent.  And there was no evidence that it immediately
16   decreased back down to where it had been before.  And
17   almost all of these were small company stocks with a
18   market cap of less than $250 million.
19             So I think there, you know, is definitely
20   quantitative evidence out there about just how much
21   analyst coverage does affect a stock's price.
22             Now, this is a short run effect.  If that
23   analyst puts out a report once and then never does
24   anything again, you know, ten years from now, I'm sure
25   the stock would have gone back down to where it would
0050
 1   otherwise be.
 2             If the analyst, you know, continues to
 3   actively cover the stock, I would expect that the stock,
 4   after going up by 5 percent, would largely stay up.
 5             But, you know, in the long run what happens to
 6   the stock prices is mainly dependent on the operations
 7   of the company.  You know, if the company fails to
 8   execute, the stock prices, eventually it's going to go
 9   to zero no matter how many analysts are covering it. And
10   if the company becomes incredibly profitable, the stock
11   is going to be going up no matter how many analysts
12   cover it.  And more analysts will cover it, as the
13   market cap increases.  So we've got some quantitative
14   measure.
15             MR. CHACE:  I just have to add a little bit of
16   skepticism to that, to put it politely, but I'm kind of
17   skeptical of research, the effect of research on small
18   and micro cap firms and its value.
19             Generally, my perception is that neglected
20   stocks that get research coverage typically have
21   something positive going on.
22             And I don't know the duration of this, you
23   know, the 5 percent.  It sounds like it's kind of
24   immediate.
25             But I think there's some risk.  And without
0051
 1   having read the study, it's a group of stocks that may
 2   have some positive things going on.
 3             DR. RITTER:  You're raising a very good point. 
 4   In one respect this might be an upper-bound estimate and
 5   potential overestimate in terms of -- you know, if I'm
 6   an analyst and I'm looking at some companies that are
 7   currently uncovered, and I'm thinking, you know, should
 8   I initiate coverage on this, when I start doing my due
 9   diligence investigation, if I decide, you know, this
10   company's prospects aren't all that good, my incentive
11   is almost certainly -- I'm not going to bother covering
12   this.
13             Whereas if I decide, hey, yeah, this company
14   has really got some good things going on, but the market
15   hasn't discovered yet, I'm much more likely to decide to
16   initiate coverage.
17             And so what's going on when I announce I'm
18   covering the stock is I'm also telling the market about
19   some good things that would have been eventually
20   presumably coming out anyway.  But I'm just kind of
21   moving up the date at which the market finds out about
22   the good news.
23             So indeed, it is difficult to disentangle kind
24   of the information from the coverage itself.  And it's
25   very plausible to think, as you are, that we've got two
0052
 1   effects going on that are compounded into this one
 2   number.  And so 5 percent would be an overestimate.
 3             It also depends on who the analyst is.  If
 4   it's an analyst at Goldman Sachs who has got a lot of
 5   credibility already, there's likely to be a much bigger
 6   effect.  If it's a no-name analyst at a regional
 7   brokerage firm, that hasn't got very good following.
 8             MR. WALSH:  There's also other kinds.  The
 9   product firm that look to buy these things, hedge funds. 
10   Just because someone is an analyst doesn't mean they're
11   the only expert.
12             DR. RITTER:  Right.  This is restricted to
13   sell-side analysts from securities firms.
14             And there are a variety of reasons to treat
15   any number with a little bit of a grain of salt and
16   think about what else is going on as well.
17             You know, we've got some trade-offs.  Wider
18   bid-ask spreads increase the cost of trading, which,
19   everything else the same, ought to result in lower
20   liquidity and a lower stock price.  So we've got this
21   benefit to the company of a wider bid-ask spread
22   encouraging their analyst coverage, but we've got a
23   negative to the company of a wider bid-ask spread to
24   make the stock much liquid.
25             And empirically, which effect is going to
0053
 1   dominate?  Well, partly it depends on how much bang for
 2   the buck do you get with more analyst coverage from a
 3   wider bid-ask spread.  Is 5 cents the right bid-ask
 4   spread?  Is 25 cents?  Is $2?
 5             Obviously too wide of a bid-ask spread is
 6   going to have such a negative effect on trading that the
 7   benefits to the company are going to be more than offset
 8   by that bid-ask spread that's too wide.
 9             And I'm not sure exactly how to balance this,
10   but obviously I'm quantifying what effects would be
11   needed on what the right ticks would be.
12             Now, as I indicated before, how lower bid-ask
13   spreads benefitted small traders, wider bid-ask spreads
14   are a tax on small traders.  If you think about this as
15   a tax, why have an implicit tax of, let's say, as a
16   bid-ask spread moves from a penny to 5 cents, well,
17   that's a tax of 4 cents per share on a trade.  Why do it
18   in a disguised manner rather than just have a tax, you
19   know, an explicit tax of 4 cents per share with a 1 cent
20   bid-ask spread?
21             And the tax revenue could be paid directly to
22   the analyst.  So rather than having all these indirect
23   effects, if the goal is to have more analyst coverage,
24   why not do it in the most efficient way possible of, you
25   know, raising money to pay the analysts directly?
0054
 1             That then raises the question:  Who should be
 2   taxed?  Should we be taxing traders, or should you tax
 3   the company?  You know, should a company pay $100,000 a
 4   year to pay analysts to cover the stock?
 5             Well, a couple of years ago I was part of a
 6   NASDAQ/Reuters joint venture designed to get analyst
 7   coverage for uncovered small company stocks called the
 8   Independent Research Network, where this joint venture
 9   went out and talked to companies and proposed, look, for
10   $120,000 a year, you pay us, the middleman, to go out
11   and hire three independent analysts.
12             There's an obvious conflict of interest if you
13   pay the analyst directly, you know, because everybody
14   knows you're only going to be paying for an analyst if
15   it's by recommendation and that analyst is going to have
16   a lot of credibility.
17             But the NASDAQ/Reuters joint venture idea was:
18   We'll be the middleman.  And in return for you making a
19   three-year commitment for analyst coverage, we will go
20   out and hire three independent analysts who agree to
21   cover your company for three years.  And part of the
22   deal is, even if that analyst puts out a buy
23   recommendation, we still have to talk to the analyst.
24   You know, we want there to be independence, so that in
25   fact this analyst has credibility.
0055
 1             And the idea is that this was not going to be
 2   enough money, you know, subsidy of maybe $25,000 per
 3   analyst per year to fully incentivize an analyst to
 4   cover a company where the analyst wouldn't.  But if the
 5   analyst also generated some more trading volume and got
 6   soft dollars, you know, there would be additional
 7   sources of revenue for the analyst as well, but this
 8   would result in more analyst coverage for companies that
 9   were uncovered.
10             And what this joint venture found out when
11   they went out and started marketing the idea to
12   companies is there just weren't many companies willing
13   to pay $120,000 a year.
14             So let me just wrap up.
15             You know, we've talked about a problem with
16   declining profitability for small companies.  I just
17   talked about tick size to analyst coverage a bit.  There
18   are other possible explanations why there have been
19   fewer small company IPOs that I'm sure you discussed
20   already:  the demise of Four Horsemen, fewer securities
21   firms that can kind of focus on small companies,
22   depressed stock market over the last decade.
23             But on the other hand today, both the level of
24   NASDAQ and the S&P 500 are way above what they were in
25   1996.  And there are a lot more small company IPOs in
0056
 1   1996 than there are today.
 2             The litigation environment certainly doesn't
 3   make it attractive to become a public company, but I'm
 4   not sure the litigation environment today is worse than
 5   it was 15 years ago.
 6             Patent trolls are a problem for companies. 
 7   But whether you're private or public, patent trolls are
 8   a problem.
 9             So what about the policy --
10             MR. WALSH:  What is a "patent troll"?
11             DR. RITTER:  A patent troll would be a company
12   or lawyers that buy out patents and then sue people, sue
13   people for patent infringement.  Basically they're
14   trying to make their money from lawsuit settlements and
15   royalties from owning the patents rather than creating
16   value for society themselves.
17             So what are some of the policy implications?
18   Well, the stock exchanges and some elements of the VC
19   industry argue that structural changes, like subsidizing
20   analyst coverage, lowering regulatory burdens, are
21   needed to boost IPO activity.
22             And I'm sympathetic to these ideas.  I think
23   they would boost IPO activity, but my guess is
24   quantitatively they're only going to boost IPO activity
25   by a very tiny amount, that I think the main thing going
0057
 1   on is some of these bigger structural changes that the
 2   fundamental problem is getting big fast is increasingly
 3   the profit (inaudible) business model.  It's not a
 4   private versus public market issue; it's a big company
 5   versus small company issue.
 6             So thank you for your thoughts and --
 7             MR. GRAHAM:  Okay.  Thank you.
 8             DR. RITTER:  -- I'll be here the rest of the
 9   day as well.
10             MR. GRAHAM:  Thank you.
11             Why don't we keep going and -- are you up for
12   your presentation, David, or would people still like to
13   take a break?
14             MS. HANLEY:  Five minutes?
15             MR. GRAHAM:  Five minutes?  Okay.  Five-minute
16   break and we'll reconvene.
17             (A brief recess was taken.)
18             MR. GRAHAM:  So we're about to hear from David
19   and Ed.  If we could all take our seats.
20             Okay.  David and Edward, it's all yours.
21             MR. WEILD:  Terrific.
22             Well, first, on behalf of Ed and myself, I'd
23   like to just say thank you for inviting us back again.
24   And any time that you can do something that in your
25   heart of hearts you think really can materially benefit
0058
 1   the U.S. economy, I think is just a very special and
 2   cherished opportunity.
 3             I wanted to mention, before we kind of watch a
 4   couple of things about some of the data sets that we
 5   were looking at, we have, I think as everybody knows who
 6   saw me speak the last time, I like to say I'm a
 7   practitioner with an analytical bend.  And one of the
 8   things that we've been able to do since we started
 9   publishing, we go around the country and speak at quite
10   a number of events, to securities attorneys, we also
11   spoke at the American Bar Association, Securities
12   Regulation luncheon in Washington, D.C., the Securities
13   Regulation Institute, at sell-side conferences sometimes.
14   And we spend a lot of time with venture capitalists,
15   people that sort of share -- some of the people that are
16   on the board, the advisory -- the Venture Advisory Board
17   of Silicon Valley Bank, I was in seeing Kate Mitchell,
18   who chaired the IPO Task Force to the U.S. Treasury
19   recently.  Have known sort of the last five chairmen of
20   the venture -- of the National Venture Capital
21   Association.
22             And so what I -- what I, you know, heard
23   pretty consistently over the last decade is that venture
24   capitalists don't trust the IPO markets and are building
25   companies for sale.
0059
 1             And the first question out of their mouth,
 2   which is very different from a decade ago, is -- or 15
 3   years ago, really, is, you know:  Who are the natural
 4   buyers for your company?
 5             And in our advisory practice, when we sit at
 6   the table with CEOs and CFOs discussing about their
 7   outlook, a lot of them will sit there and say:  We just
 8   don't trust the IPO market.  I don't want to get turned
 9   into a zombie stock.  And these are profitable
10   companies.
11             I'll give you a case in point.  BigFix, which
12   is up in Emeryville, California, just a little bit right
13   over the Bay Bridge, and is a venture-funded company.
14   And they had some volatility in their earnings.
15   Profitable company.  They just said:  No, can't take the
16   risk of how the market is going to treat us.  If we miss
17   a number, we'll never get dug out of the ditch.  We'll
18   lose our coverage, we won't get supported, we won't come
19   back, and we will end up becoming effectively a zombie
20   stock.
21             So they ended up selling to IBM for a very,
22   you know, attractive price.  Probably left quite a bit
23   of money on the table.
24             But these are the kinds of decisions or
25   discussions that go on at the board level every day.
0060
 1             And I think that when you look in the sample
 2   set, sometimes there's a bit of adverse like -- two
 3   things going on.
 4             One is that companies that have to go, you
 5   know, public, they don't have the alternative for being
 6   forced.  They're probably not the creme de la creme in
 7   some instances.
 8             Certainly biotechnology, because of the scale
 9   amount of capital, many times has to go public, and
10   these companies are clearly, you know, needing the
11   capital markets.  And I think that it's -- it's created
12   a kind of a world of dysfunction.
13             We're going to talk about economic incentive
14   as we get through it, but we think that this is
15   absolutely the critical third leg to the stool.  And if
16   you don't fix the economic incentives -- we're going
17   kinda -- I'm going to rearrange the deck chairs here for
18   you in terms of how you think about spreads, because I'm
19   listening to the discussion here, and people don't think
20   about spreads appropriately.  And we're going to get
21   into that.
22             Just by way of background, Ed, my partner
23   here, traded equities for Lehman Brothers
24   internationally, traded stocks on every market in the
25   1990s internationally.  He was based in London.  So we
0061
 1   have, you know, a pretty fair sense of stock trading. 
 2   He is actually a material science engineer out of MIT by
 3   training.  And both of us actually have a little bit of
 4   a science background.  I started out as an molecular
 5   geneticist.  So we bring kind of, again, an analytical
 6   bent to sort of everything that  we do.
 7             And we're really passionate about sort of the
 8   transformative kinds of companies and investment that we
 9   think will spearhead next generation economic growth, if
10   you will, the sort of creative destruction and
11   reinvention of the U.S. economy.
12             And fundamentally, we think that by -- by
13   harming the ability of the stock markets to support that
14   process, what we have is a lot of creative destruction
15   going on right now and not enough creative reinvention.
16             You have the draft of the paper which I
17   distributed.  I would urge you all -- I know it's a bit
18   of a tome to read it.  There's a lot of good
19   information.
20             We talked about some of the -- we respond to
21   some of the SEC discussion around the report on
22   decimalization.  We also talk specifically about what a
23   lot of people are saying on tick size.  Let's just say
24   that we think that there's an avalanche of opinion
25   coming in the direction that we have to increase tick
0062
 1   sizes from some pretty smart people.  Ed will get into
 2   that; I don't want to belabor it.
 3             But this is -- this study that we present I
 4   think is written for sort of the layman, if you will.
 5   And it's pretty much on point.  And I just want to give
 6   you some conceptual -- a conceptual framework to think
 7   about stock markets, which is that at some point the
 8   stock markets are absolutely free, the entire
 9   infrastructure implodes.  Okay.  You need money to
10   reinvest and to support the stock market.  And I think
11   that's intuitive.
12             So when is there too little money to support
13   the aggregate infrastructure and ecosystem?  It's a key
14   question.
15             And these are all things about sort of
16   tipping points that we don't think about, including, for
17   example, when do you have too much indexation and too
18   many exchange traded funds where all of a sudden stock
19   prices start to detach from fundamentals?  There's not
20   enough -- there's not enough money.  It's more costly to
21   do fundamental research sales and trading than it is to
22   use computers.
23             And computers are information mining
24   strategies, for the most part.  They're not information
25   additive.
0063
 1             And if you all of a sudden get everything into
 2   the information mining bucket, stock prices are almost
 3   by definition going to detach from fundamental value.
 4   And the ability of markets to allocate capital will be
 5   destroyed.  Okay.
 6             Only question is, when do you reach that
 7   tipping point.
 8             So by the way, the paper is pretty much
 9   complete -- there may be some typos, and which I
10   apologize; Mark Graff should be through proofing -- and
11   out in the public domain printed next week.  The -- but
12   we thought it was important to get it in your hands.
13             Now, this is an absolutely critical chart and
14   got a lot going on.  But I want to point out that it's
15   not spreads, it's not tick sizes.  It's two things going
16   on here.  Okay?  There is a shift from a quote-driven
17   market with Reg ATS to an electronic order execution
18   market, an electronic order book market.  That happens
19   in 1998 with the implementation of Reg ATS, called
20   Alternative Trading System.
21             So I'm going to give you a couple of
22   definitions.  One is the idea of a quoted spread, which
23   is what Professor Ritter, you know, talked about, what
24   everybody sees, which is what is the actual spread in
25   the market.
0064
 1             And the other is the notion of a bankable
 2   spread, which, as a trader, is how much money can I
 3   actually make.
 4             And if somebody can step ahead -- we had this
 5   discussion last time.  If somebody can step ahead of my
 6   bid for a penny, okay, then that -- even if the spread
 7   is quoted at a quarter point, my bankable spread goes
 8   from a quarter point down to a penny.  So when you make
 9   that shift from a quote-driven market to an electronic
10   order book market, okay, what happens is the bankable
11   spread, which was equivalent to the quoted spread, goes
12   down to the tick size.
13             So in 1998 -- and everybody is looking at
14   decimalization, which is in 2001 here, okay, the key
15   thing to think about in terms of the change of economic
16   incentives, the massive shift actually occurs in 1998
17   with the implementation of Reg ATS.
18             And we're going from -- we go from a quarter
19   point down to -- actually, there's two different tick
20   sizes that -- that are in bold there.  One for smaller
21   cap stocks at 1/32 and one for smaller price stocks at a
22   1/32, and larger price at 1/16.  This is the NASDAQ
23   market.
24             Actually, in the appendix here you have a
25   similar chart for what's going on in the New York Stock
0065
 1   Exchange and on AMEX at the time.
 2             And what you see is you've gone from a quarter
 3   point from most stocks down to a 1/16 or a 1/32, which
 4   means you lost from 75 percent to 87.5 percent of your
 5   economic opportunity as a trading firm.
 6             So when we used to buy stocks on the -- in the
 7   old days on a -- on the trading desk, we buy 100,000
 8   shares at $10, have a quarter point spread, bankable
 9   spread was -- because it was quote-driven market, it was
10   a quarter point.  And we could mark that stock up from
11   10 to 10 and a quarter, make 2 and a half percent, and
12   dial for dollars, get salesmen on the phone to create an
13   order flow.  And that's how liquidity was created.
14             Now, all of a sudden, when you shift to an
15   electronic order book market, whatever that tick size is
16   at a 1/16 -- or a 1/32, 1/16 represents -- what is it?
17   6.25 cents?
18             MR. KIM:  (Nodding.)
19             MR. WEILD:  That I've gone from 25 cent
20   economic opportunity to 6.25 cents overnight, because
21   anybody can step in front of me for a 1/16 or 1/32 as
22   the case might be.
23             MR. CHACE:  Can I ask a question?
24             MR. WEILD:  Yeah.
25             MR. CHACE:  How responsible is high frequency
0066
 1   trading for that stepping-ahead dynamic that you talked
 2   about versus competition from other --
 3             MR. WEILD:  It's automated.  I mean, you know,
 4   Dan, you're -- you know, it's a great point.
 5             I mean, what we've done with computers now is
 6   that we have the systems that automatically play cat and
 7   mouse.  So if you get into the box and you trade
 8   electronically now, I mean, automatically somebody is
 9   stepping ahead.  You put in an order at a price, you
10   know, somebody steps ahead of you for a penny.  So by
11   definition, it's causing this unnatural spread
12   compression.
13             However, if you listen to others, they'll say
14   that in the micro and the nano cap stocks -- micro being
15   defined as sub $500 million and nano cap sub $10
16   million -- by the way, that's where most capital
17   formation, IPO capital formation, historically live.
18   That's the small IPO.  Okay?  Spreads are still pretty
19   wide.  Okay?
20             The problem is nobody can bank those spreads.
21   You got the worst of both worlds.  High spreads, no
22   institutional liquidity.  And if you do analysis -- we
23   did this I think the last time, but you're seeing a
24   shift of asset ownership in small micro-cap stocks to
25   smaller and smaller institutional investors.  It's not
0067
 1   that it's not there; it's just that they don't have
 2   liquidity constraints.
 3             What it's saying is that liquidity is
 4   declining in small and micro-cap stock, so I've got to
 5   move down market.  I mean, I've got to be a smaller
 6   asset manager because I can -- you know, my position
 7   size is a half a million dollars.  I can manage
 8   half-a-million-dollar chunks, but if I'm from Fidelity
 9   with a half trillion dollars in assets under management,
10   I can't make that math work.  It's just I have to cover
11   too many stocks to get to any real size in my portfolio.
12             MS. JACOBS:  For the benefit of committee
13   members -- I am not a researcher; however, I found this
14   chart and this set of data so compelling that I went
15   back after the data was presented to us last time and I asked my
16   financing and accounting folks to go back.  And the
17   first question I asked was I asked to take our share
18   price and plot it against, but then we decided against
19   your timeline here because these are transactions of $50
20   million or less.  Correct?
21             MR. WEILD:  Right.
22             MS. JACOBS:  So we took our share price.  I
23   got to thinking, no, no, no, too many extraneous things
24   would affect the share price.
25             But what about average trading volume? 
0068
 1   Because there's -- liquidity is the real page 2 here,
 2   right?
 3             MR. WEILD:  Yeah.
 4             MS. JACOBS:  Both for investors and for the
 5   public companies.
 6             So I asked them to take our average trading
 7   volume over that exact same chart and see what happens
 8   to our daily trading volume.  And we had ended up with a
 9   coefficient of correlation of 0.91.
10             Now, so I don't need to show you what that
11   says, but there is a consequence to all of this that
12   affects every one of us in this room where the public
13   companies are concerned.
14             MR. WEILD:  Absolutely.
15             MS. JACOBS:  It was dynamic.  In fact the
16   folks in the office, they couldn't believe it because we
17   had always complained about Sarbanes-Oxley, and what
18   happened to the share price and what happened to our
19   coverage.
20             Well, go look at the average trading volume
21   per day, plot it, and it's amazingly consistent with
22   what you're saying, David.
23             MR. WEILD:  I mean, it's a really -- it's a
24   really thorny problem to figure out what -- you know,
25   what the causes of this are.  Because what happens is --
0069
 1   you know, you got the dot-com bubble going on during the
 2   period that these changes were made, and it totally
 3   obfuscates what's going on in the lower end of the
 4   market.
 5             And, you know, guys that are -- you know, one
 6   of my old friends was Dan Case, who was the head of --
 7   president of Hambrecht & Quist years ago.  He died in
 8   2002 of a brain tumor.  Terrific guy.  Steve Case's
 9   brother, who ran AOL.
10             And Dan, you know, had said to me -- we had
11   taken a run at buying Hambrecht & Quist and had a long
12   discussion about it.  And for a variety of reasons, the
13   time wasn't right for them to sell.
14             So I got a courtesy call when they sold to
15   J.P. Morgan.  And Dan told me that a lot of people think
16   we're going to be brilliant in top-ticking the market
17   and selling it five times book.
18             But what we're really doing is we, you know,
19   believe that these order handling rules and the
20   electronic stock markets are going to make it impossible
21   for us to keep the lights on in a bad equities market.
22   The cash -- the equities business is going to become
23   unprofitable.
24             And if you actually look at the history of
25   when these rules were implemented, there were a lot of
0070
 1   people that told the SEC that this was going to have a
 2   devastating impact on the profitability of the cash
 3   equities business, and they pretty much dismissed the
 4   people at the time, those particular concerns.
 5             And I think -- I think that when I look at it
 6   as a practitioner, somebody who hired and fired
 7   people -- and by the way, one of the things on my resume
 8   is I ran back the -- the strategic planning for banking
 9   research sales and trading back when you could put all
10   those together at Prudential Securities years ago.  And
11   so we made the hiring and firing decisions.
12             And I can tell you that when we were looking
13   at small cap stocks after Reg ATS was put into effect,
14   that we were cutting back commitments on the
15   over-the-counter NASDAQ trading desk at the time because
16   we just -- we couldn't make the math work.
17             Okay.  Simple thing.  Lots of stocks in a
18   small micro-cap area are trading at 100,000 shares or
19   less a day.  Okay.  If you look at J.P. Morgan, their
20   average revenue per share at J.P. Morgan, this is their
21   statistics, is one and a half cents.  So let's just say
22   that the revenue opportunity, earnings opportunity may
23   be a penny.  100,000 shares, that's for the entire
24   market, that's a thousand dollars' worth of profit per
25   day.  Okay?
0071
 1             And a lot of that's going off in machines, so
 2   you maybe you're fighting for, if you've got a research
 3   analyst dedicated, a couple hundred bucks.  Nobody is
 4   making an investment like that.  10,000 shares, you're
 5   down to a hundred -- a hundred dollars' revenue
 6   opportunity.  Forget it.  Okay?
 7             So the economic opportunity here, the
 8   incentive, if you will, is -- is the vast majority of
 9   the problem here when you get to the dysfunction of
10   small micro cap stocks and, in turn, the IPO market.
11   With a hundred percent certainty -- and I don't want to
12   be -- I don't want to be coy.  You know, I have no doubt
13   that this is what's killing the IPO market in this
14   country.
15             So it has to be fixed.  And I will tell you
16   that it will be fixed.
17             MR. BORER:  David, can I ask you a question? 
18   You do a great job, by the way.  I was trying to get my
19   mind to lay on the, you know, the development of ECNs,
20   the establishment of the SOES system, which is taking
21   money out of pocket, the settlement with the NASDAQ
22   market makers back in -- you know, 10, 12 years ago.
23             Were those all at around the same time,
24   between this '98 and '01, '02 period?  Because I recall
25   generally, I was sitting on (inaudible) --
0072
 1             MR. WEILD:  Right.
 2             MR. BORER:  -- SOES bandits (inaudible).
 3             MR. WEILD:  Right.
 4             MR. BORER:  The point here, it wasn't the
 5   dealers who were stealing the money; it was a system put
 6   in place so the dealer who really wasn't a brokerage
 7   firm could hire a bunch of day traders, put them on a
 8   NASDAQ platform directly for the trade, and then take
 9   the money from -- whether it's the Knights or the
10   Goldmans or the Rothmans, etc.  Is it about the same
11   point in time?
12             MR. WEILD:  Well, it started -- I mean, the
13   two things that started before this was SOES -- SOES, I
14   think was -- Ed, do you remember?  Was it the late '80s?
15             MR. KIM:  SOES was the late '80s.
16             MR. WEILD:  But it had an effect.  It started
17   to undermine the profitability.  Had Instinet there too.
18             Well, what happened was you still could quote,
19   and so you could still buy and manage the spread, if you
20   will.  You could buy it at 10 and mark it up a quarter.
21   Okay?  Because while the trades would go off within the
22   spread -- it used to drive retail crazy because they'd
23   see ticks -- you know, they'd see trades go up within
24   the spread, and they'd say, why didn't I get that price?
25             And then you'd -- but what you would be doing
0073
 1   is you would be negotiating -- because all the SOES and
 2   the Instinet for the most part -- Instinet was a little
 3   junkier, but SOES was all 100-, 1,000-share increments,
 4   whatever you had in the -- what we call the NASDAQ Level
 5   III machine at the time.  That was -- you would put in
 6   either a hundred with -- your market size was either a
 7   hundred or a thousand shares by convention.  So you
 8   would get picked off.  The SOES bandits would bang the
 9   bid, and so people would start ducking away and you
10   would see the market makers just drop in seriatim as
11   each of them were taken out by a so-called SOES bandit.
12             But you still were able to monetize or bank
13   that quarter point for the most part.  People were able
14   to hold that in place.
15             And so the degradation, you're right, had --
16   was starting.  And, you know, in some respects, if you
17   look at the sub $50 million dollar tranche, which is the
18   blue there of IPOs, you know, you're seeing some
19   degradation, if you will, as a percentage, whether or
20   not that's statistically significant.  But, "phoomp," it
21   drops off a cliff in 1998 when we go from a quote-driven
22   market, with SOES and Instinet in between, to all of a
23   sudden everything is electronic posting of orders.
24             So we take all of the order handling rules
25   that you've gotta -- you've gotta post your orders into
0074
 1   the market, but there was no way to really handle all
 2   those retail limit orders.
 3             Now, all of a sudden with the ECNs coming
 4   into -- into existence -- the Brutes, Ready Books, all
 5   the -- all the electronic order books, boom, everything
 6   is getting posted into the market in 1998, which starts
 7   the degradation of that -- of that -- of that quoted
 8   spread.
 9             So the quoted spread becomes much less
10   important, and anybody that wants to sort of step --
11   restart that whole business of stepping in front of --
12   in front of -- in front of quotes, quote market's blown
13   to bits.  And that's why when you -- you know, you go
14   through this, it is -- it is really that kind of shift.
15             And so, you know, very simply, there's three
16   ways to improve economics, right?
17             One is commissions.  And commissions don't --
18   we talked to a lot of institutional investors.  I talked
19   to Wasatch's folks, but -- you know, trying to get a
20   sense of what works and what doesn't work.  Commissions
21   are horrible for small cap growth money managers,
22   because what it does, it goes into expense ratios, and
23   Morningstar gets all over it.
24             Tick sizes are actually a pretty interesting
25   way to improve economics because it gets into the cost
0075
 1   basis from an accounting standpoint much better.
 2             And then you could go back to a quote-driven
 3   market, but I don't think anybody is going to do that,
 4   right.
 5             So the only way, if you understand the
 6   formula, is that bankable spread, you know, is -- you
 7   know, in a quote-driven market is pretty much equivalent
 8   to the quoted spread, but in an electronic order book
 9   market, bankable spread is equal to minimum tick size. 
10   And by definition, you have to take up tick size to
11   improve the economics.
12             So that answer the question?
13             MR. BORER:  Very helpful.
14             DR. RITTER:  I agree with you that wider tick
15   sizes increase the economics for securities firms
16   trading stock.  You said that the lower tick sizes were
17   killing the IPO market.
18             Could you quantify how much higher stock
19   market prices would be if the bid-ask spreads were -- if
20   the tick sizes were wider?
21             Are we talking about a stock, micro-cap stocks
22   that are currently trading for $10 a share, would they
23   go to $28 a share or to $10.12 per share?
24             MR. WEILD:  Well, I think it's a -- first of
25   all, the last time, Jay, we had an exhibit, which I
0076
 1   don't include here, you look in the old material, about
 2   what's the profitability of the $25 million IPO.  And I
 3   don't know if it's in this batch.  It's in one of our
 4   papers.
 5             But what happened with this shift was that
 6   the -- that you used to basically double -- as a book
 7   running manager double your profit potential on an IPO
 8   prior -- when we were looking at a quote-driven market.
 9   And when --
10             MR. KIM:  Appendix E.
11             MR. WEILD:  Is it Appendix E?  Okay.
12             And then all of a sudden we went to losing
13   money to support stocks in the aftermarket on the $25
14   million IPO.  And I know that math because I did this
15   for a living.  Right?  We --
16             DR. RITTER:  Okay.  So the problem is
17   investment bankers aren't making enough money, so why
18   don't they increase the gross spread from 7 percent to
19   14 percent if they want to double the economics?
20             MR. WEILD:  Well, it wouldn't -- wouldn't
21   solve the problem because every day that I have to
22   provide support in the aftermarket is a day that I lose
23   money.  So you'd just be overpaying the investment
24   bankers on the front end.  And, you know, what you're
25   really looking for, you really need aftermarket support.
0077
 1             And another one of the great, you know,
 2   misconceptions to the market is that everybody looks at
 3   research as the aftermarket support proxy, right, the
 4   market for aftermarket support.  In point of fact, what
 5   it is is a salesman making phone calls and people
 6   committing capital in a liquid stock.
 7             There are two types of stocks, broadly
 8   defined. I mean, the market is actually in continuum.
 9             One is symmetrical order book stocks where you
10   have lots of buyers offsetting sellers.  It's the
11   natural state of the S&P 500.
12             And then there's asymmetrical order book
13   stocks.  Big buyer, no -- no offsetting seller.  Big
14   seller, no buyer.  And what happens is somebody's got to
15   go out and create liquidity for the institution.
16             And so what happens is, is that you can still
17   play around in those stocks as a retail consumer, you
18   know, with a hundred thousand shares, blah, blah, blah.
19   But when you have to get a -- when you have to put up --
20   you know, you have to put up 500,000 shares of stock and
21   acquire that kind of position over time, you know,
22   you're going to get bored with it.  You're not going to
23   be able to do it.  You're sitting there playing cat and
24   mouse and ultimately you flush the position.
25             And that's what institutions that are playing
0078
 1   in these markets tell me they do all the time.  You
 2   know, they got sold on the idea, and then they can't get
 3   enough to make their -- make it work.
 4             And so now you have to -- as a CEO, you have to
 5   figure out, can I put some kind of a shelf registration
 6   or something in, or do a PIPE transaction to get them
 7   started with some volume?  It's a very, you know,
 8   ineffective kind of, you know, as a practical matter,
 9   market to bring institutional liquidity into it.
10             And what we're seeing is like -- you know,
11   my -- back to my old analogy of flesh-eating bacteria,
12   you know, you're gradually -- you're gradually from the
13   bottom up, you know, eating out this infrastructure to
14   support, and institutions are gradually saying, okay,
15   not enough liquidity, liquidity is dried up, and I'm
16   moving out of the market.
17             So the more that you start shaving ticks --
18   and this is one of the dangers of sub-penny quotes,
19   sub-penny tick sizes, is that if you apply them to micro
20   markets, you actually then start pushing this stuff
21   higher and higher into the marketplace.  You can get
22   away with it for S&P 500 stocks, but you can't get away
23   with it in the -- in the micro caps, the small caps and
24   micro caps.  So --
25             DR. RITTER:  Have you answered my question?
0079
 1             MR. WEILD:  Well, your question is -- you
 2   know, your question is where would the share prices be,
 3   right?
 4             And I think that -- I don't think you -- I --
 5   this is my judgment:  I don't think you can answer that
 6   question.  Right?  I mean, I don't know -- I don't --
 7   from a scientific standpoint, I don't think you can
 8   answer it.
 9             The fact of the matter is these stocks lose
10   their visibility.  Right?  And when -- the natural state
11   of most companies is they need visibility creators.
12   Okay.  And companies are struggling to get visibility
13   with investors all the time.
14             Now, they're very different -- there's two
15   types -- two types of stocks from a visibility
16   standpoint.  In our consulting practice we talk about
17   supply push and demand pull.
18             A demand pull stock is like a Zynga, somebody
19   that has great -- great visibility in the consumer
20   markets.  It sort of creates its own demand.  Facebook
21   was a case in point.  And so it's not Wall Street
22   creating their demand; it's the stocks and the brands
23   created their demand.  Tesla Motors.  The vast majority
24   of these people are actually getting on the phone and
25   selling the story.  And when you take all the visibility
0080
 1   creators out of the market, Jay, you have to be hurting
 2   share prices.
 3             DR. RITTER:  Yeah, but -- but it seemed to me
 4   that there's a very simple way to quantify this.  To
 5   look -- you were talking before about the dichotomy
 6   between the liquid stocks, you use symmetrical,
 7   asymmetrical.
 8             MR. WEILD:  Yeah, it's an academic term.
 9             DR. RITTER:  Why not look at the price
10   earnings ratio of the symmetrical versus the
11   asymmetrical stock before 1994 and now?
12             Wouldn't that be a way of quantifying the
13   change in the relative outcome?
14             MR. WEILD:  It could, but you have to ask the
15   question, what's in the sample set?
16             You know, good companies -- you know,
17   companies that have alternatives are saying, I'm going
18   to sell out.  You lose them, you know, you lose them
19   from the sample set.
20             You know, there's a lot of guys with
21   alternatives that just throw the towel in and say, this
22   market is too dysfunctional, I can't get the thing to
23   work and I'm going.  And so that's what you're hearing
24   from practitioners.
25             So I'm very -- I'm very skeptical that you can
0081
 1   cut all the numbers you want, but you have to take into
 2   account what people that are making these decisions
 3   every day are doing.  And a lot of them are just saying,
 4   keep me the hell out of the market.  Excuse my French.
 5             So why -- why getting markets --
 6             DR. RITTER:  (Inaudible.)
 7             MR. GRAHAM:  Let's just go -- let's just go
 8   on.
 9             MR. WEILD:  What?  Why getting markets right
10   matters.
11             You know, look, I plead guilty sometimes to
12   being a little Pollyanna-ish, but 20 percent of kids in
13   the United States are living below the poverty line, and
14   40 percent of children are -- are -- are under what
15   they -- what's defined as low -- lower income.  And this
16   is from the National Center of Children and Poverty.
17             So anything that we can do that is going to
18   drive job formation -- and I pull my hair out a little
19   bit sometimes with -- with unions, because union --
20   union members are typically not day-trading stocks.
21             And what happens is if you can drive more
22   companies into the public market and more -- more
23   volume, you're going to create greater tax revenues,
24   which is going to go into the coffers and
25   municipalities, which is going to allow us to employ
0082
 1   more -- more teachers, firemen, and policemen.  These
 2   things are all related.
 3             And when you -- there is nothing more
 4   important in the United States to consumer confidence
 5   than a functioning IPO market.  I mean, anybody here,
 6   and there's a lot of people that are old enough,
 7   remember what -- there's a lot of things wrong with the
 8   dot-com bubble, but it certainly gave everybody a sense
 9   that there was an opportunity, and there was a lot of
10   entrepreneurial fervor.
11             And one of the things that gets lost in these
12   job creation estimates that we do is the impact on the
13   private markets, which is that you're going to invest a
14   lot more money, take a lot more private company risk in
15   this country if all of a sudden you see that the IPO
16   market works.
17             Also, it has an impact on the M&A market.  And
18   I'll quote Ray Rothrock, who's the current chairman of
19   the National Venture Capital Association, who says that
20   it takes an IPO market to keep the M&A market honest.
21             So, you know, we have said, what did the JOBS
22   Act do in broad terms?
23             It did a couple of things.  It lowered cost
24   for issuers, and it improved issuer communications with
25   investors.
0083
 1             And we say that there is an actual, essential
 2   third leg to the stool, that without that, you will
 3   not -- and this paper actually calls for JOBS Act 2,
 4   Part 2. You have to improve economic incentives to
 5   support especially small cap stocks.  And the way you --
 6   the way to do that, the best way to do that is to
 7   increase tick sizes.
 8             There's just a couple of guys recently -- and
 9   we have these quotes in the study that we circulated.
10             There's one from John Bogle:  "The financial
11   system has been wounded by a flood of so-called
12   innovations that merely promote hyper-rapid trading.
13   Individual investors are being shortchanged."
14             We have Professor Schwartz.  And I don't know
15   if you know Bob, but Bob does this conference in New
16   York for the trading community, the exchange community.
17   And it is probably the best -- of course, he's been
18   doing it for years and years and years.  And Bob said in
19   his opening remarks last year that, "Markets are still
20   adjusting to regulatory changes like the Order Handling
21   Rules and Reg ATS that were made over a decade ago."  I
22   mean, again, back to the flesh-eating bacteria.
23             Then finally, Arthur Levitt, and this was on
24   "Bloomberg Surveillance" very recently, August 2nd.  And
25   Arthur said, "The irony of this is that the change in
0084
 1   the Order Handling Rules in 1997 that were instituted
 2   under my watch at the SEC has resulted in the
 3   proliferation of markets, technologies, and automation
 4   that brought about the flash crash and yesterday's" --
 5   he's speaking about Knight Securities' algorithmic
 6   issues -- "events.  I think public confidence is
 7   severely shaken by things of this kind."
 8             And then my point is, is that there's just
 9   lots of unintended consequences.  And people are
10   beginning to realize that these two things, Order
11   Handling Rules and Reg ATS, had a pretty profound impact
12   on how markets change -- and while Arthur doesn't say
13   it, I will say it -- killing the IPO market.
14             Supportive observations from micro market
15   economists.  And this is recently James Angel:  "A large
16   relative tick provides an incentive for dealers to make
17   markets and for investors to provide liquidity by
18   placing limit orders."  I know that Jim has spoken to
19   this Committee before.
20             David Allen, Josephine Sudiman in Indonesia.
21   Okay.  This is an academic paper.  "As tick size is
22   diminished, encouragement is given to front runners."
23             This is what we mentioned before, right,
24   stepping ahead.  Traders are more reluctant to show
25   their orders.  Things move into dark pools.
0085
 1             By the way, you have to be careful when you set
 2   tick size.  You can't allow people to do all these
 3   rebates and trade within the -- within the tick size
 4   because then you defeat the purpose of the economic
 5   incentive that you're trying to create.  So if you do
 6   payment for order flow, and if I earn a nickel, for the
 7   sake of argument, and I can share that with somebody,
 8   that this intermediates my tick size again.
 9             David Bourghelle and Fany Declerck:  "We find
10   that a relatively coarse pricing grid," okay, higher
11   tick size, "encourages traders to submit and expose
12   limit orders, while a tighter price grid induces
13   frequent undercutting strategies."
14             Michael Aitken and Carol Comerton-Forde in
15   Australia:  "Stocks with relatively" -- "with small
16   relative tick sizes and low trading volume experience
17   reduced liquidity."
18             And Ed, he's going to talk about that in a
19   little bit.
20             But you cut tick sizes in micro cap, small cap
21   stocks, you harm liquidity.
22             I'm sorry.  I think that -- go ahead.
23             MR. KIM:  No, you're on a roll.  Go.
24             We've talked about -- thank you, by the way,
25   for letting me -- letting me talk to you today.
0086
 1             We've talked about the importance of tick
 2   sizes, and it's not just -- although the focus is on
 3   small and micro cap stocks, it's obviously critical for
 4   large cap stocks as well.
 5             And the studies have shown, both in academia
 6   and practically by practitioners, that smaller tick
 7   sizes do increase liquidity for large cap stocks, but
 8   they absolutely decrease liquidity for small micro cap
 9   stocks, which are -- which are naturally illiquid
10   anyway.  And so they just -- they -- they aggravate the
11   current situation.
12             What smaller tick sizes do for large cap
13   stocks, however, that is violently negative is it
14   encourages and fosters this gaming behavior, this
15   undercutting or stepping-ahead behavior, where --
16   whereby the high frequency trading firms and everybody
17   that isn't a non-fundamental trader, a non-fundamental
18   investor can be in and out of stocks -- for no reason
19   that is tied to investment, for no reason that is tied
20   to the long-term interest in the company, but is purely
21   about gaming for a penny in and out.
22             We have created a market that is absolutely a
23   market that a high frequency trader would have designed,
24   and is absolutely not the market that a long-term
25   investor has any interest in.
0087
 1             And the -- if we can introduce larger tick
 2   sizes, we can restore the conditions that created the
 3   fertile ground that we had for IPOs for so long.  So I'm
 4   going to go through this, because I know we're running a
 5   little bit -- a little bit late.
 6             MR. GRAHAM:  You're -- you're doing fine.
 7             MR. KIM:  Milton -- Milton Friedman said
 8   there's -- to paraphrase, there's no such thing as a
 9   free lunch.
10             And for us, it all -- it boils down I think to
11   economics.  And with respect to Professor Ritter's
12   findings about economies of scale and economies of
13   scope, I do think that at the end of the day it's all
14   about the dollar.
15             If you follow investment banks, as an example,
16   which are -- which are critical for all this, we're
17   talking about restoring economics for investment banks.
18   Investment banks are only going to do the things that
19   make them money.  It's not an indictment on the banks.
20   It is -- they're purely logical creatures.  If Goldman
21   Sachs and Morgan Stanley could make money in small caps,
22   they'd be doing it.  They'd be doing it all day long.
23             The fact that the small cap market has been
24   abandoned by the Goldmans and Morgans, the fact that
25   nobody has come in to replace Robertson, Hambrecht &
0088
 1   Quist, Ellis, Rothschild, and Montgomery Securities,
 2   nobody can make money.
 3             If you look at what happened before Reg ATS,
 4   or the conditions that existed before Reg ATS, you had,
 5   as David alluded to, bankable spreads of a quarter a
 6   share, 25 cents a share, which in the ensuing period
 7   dropped to essentially a penny a share, a 96 percent
 8   reduction in -- in the bankable spread, in the economics
 9   to run the business.
10             If you take a business and you suck out 96
11   percent of the funding for that business, that business
12   cannot survive.
13             MR. WEILD:  It's okay for naturally liquid S&P
14   500 stocks to let the orders interact, if you will.  I
15   mean, there's enough incentive because of the sheer
16   scale volume.  Some of these stocks trade in 20 million
17   shares a day.  Right?
18             But when you get into things that are trading
19   episodically and trading in increments of 10,000 or
20   100,000 shares a day, it decimates them.  There's just
21   not enough money in at -- when you go from a quarter
22   down to a penny.
23             MR. KIM:  You have 167 different investment
24   banks book running deals in the early '90s.  Post bubble
25   and post all of this, you were left with 39 banks. 
0089
 1   There's even fewer today who are -- who are running
 2   deals.
 3             MR. WALSH:  You wouldn't say that across
 4   myriad industries -- across --
 5             MR. KIM:  Across myriad -- across every
 6   industry.
 7             MR. WALSH:  That, to me, is irrelevant.  So
 8   what?
 9             MR. WEILD:  No, I think --
10             MR. WALSH:  Banks, are there 2,000 fewer
11   commercial banks in the States in that time period?
12             MR. BOCHNOWSKI:  More than that.
13             MR. WALSH:  Okay.  So --
14             MR. WEILD:  What's happening, which is
15   catastrophic, is people are focusing on scale volume. 
16   They're looking at economies of scale to move their
17   meter.  You're a larger -- you're dealing with larger
18   and larger institutions that have no incentive to
19   support, you know, small and micro cap stocks.
20             MR. WALSH:  I disagree.  I think these high
21   frequency traders -- I don't want to belabor things --
22   but they're essentially replacing --
23             MR. WEILD:  How?
24             MR. WALSH:  -- they actually replaced them in
25   making liquidity.
0090
 1             MR. WEILD:  Oh, that's -- that's the biggest
 2   joke on the face of the planet --
 3             (Talking simultaneously.)
 4             MR. WALSH:  (Inaudible.)
 5             MR. WEILD:  -- the fact that -- that's not
 6   liquidity, guys.  Average holding period is 11 seconds.
 7   Okay?
 8             (Talking simultaneously.)
 9             MR. WALSH:  (Inaudible.)
10             MR. WEILD:  How is that liquidity?  Does
11   anybody call -- call somebody and create an order on the
12   other side?  It's not liquidity.
13             MR. WALSH:  But --
14             MR. WEILD:  It's volume, it's volume.  70
15   percent of that stuff right now is volume.  There's no
16   liquidity. It's the biggest lie that's been perpetrated
17   on the market that that's real liquidity.
18             MR. WALSH:  And -- okay.  If you want to go
19   back to the pre-'97 days, the way that the regulatory is
20   set up right now, these banks can't hold the train.
21             MR. WEILD:  That the banks can't what?
22             MR. WALSH:  Basel III coming down the road,
23   investments banks can't hold them to it.  The Volcker rule,
24   I mean, they're basically telling you they don't want
25   people holding -- they don't want investment banks and
0091
 1   commercial banks.
 2             MR. WEILD:  I mean, when you run a trading
 3   desk -- first of all, you're not a storage department
 4   when you're a market maker.  What you're doing is you're
 5   running a portfolio of long and short securities.  And
 6   so the actual capital committed to facilitate liquidity
 7   is not huge, and it never was in the old days.
 8             I mean, you know, I'll run -- I'll run an
 9   equivalent -- if I want to be market neutral running a
10   trading desk, I'm going to be -- I may have, you know --
11   I may have 1,000 positions out, 500 -- 550 of them are
12   long, and 450 of them are short.  That's the way you do
13   it.  Okay.  So the actual capital, out-of-pocket capital
14   commitment is not huge.
15             And so what was huge was the incentive to get
16   on the phone to find the other side of the order when
17   somebody needed -- needed liquidity to be made.
18             I mean, there's -- the big difference between
19   S&P 500 stocks, you don't -- nobody was really making
20   markets per se in large cap stocks.
21             There's something called the Amivest liquidity
22   ratio, which looks at -- and by the way, liquidity is
23   how much stock can I move over a defined period -- a
24   defined period of time within a price tolerance.
25             And so you would find the Amivest liquidity
0092
 1   ratio that -- that large cap S&P 500 stocks would be
 2   over a half a billion dollars a pop.  So there was no
 3   specialist that could commit a half billion dollars'
 4   worth of capital to move a stock 1 percent.  They just
 5   wouldn't.
 6             So if you talk to Dick Grasso, which I have,
 7   and Richard Bernard, who was the old General Counsel at
 8   the New York Stock Exchange, they had an allocation
 9   system.  And they were actually, as a public policy
10   matter, enjoying excess profits on large cap stocks to
11   subsidize liquidity in micro caps.  That's what went on.
12             Okay.  But what happened was, those subsidies,
13   when you went -- when you convert to markets with Reg
14   ATS and then ultimately NMS, the ability to do all that
15   left the market and --
16             So large cap, you know, again, you know, you
17   have natural liquidity, natural visibility, back to the
18   kind of the demand pull versus supply push stocks. Micro
19   cap's natural state is -- is supply push.  People have
20   to get on the phone and create visibility.  And that's
21   what's gone from the market.
22             MR. BORER:  Because I live in this ecosystem,
23   I have for a long time, the number of market makers and
24   underwriters and those types of things around 20 years
25   ago, I'm familiar with some of the names you mentioned
0093
 1   earlier.
 2             There was -- there was not the gigantic gulf
 3   that there is today between the few small firms that
 4   will take on an underwriting firm for a company.  And up
 5   to the Jeffrey Siebold or even, you know, Raymond James
 6   type people, from Loewen, Goldman, Citibank, Credit
 7   Suisse, CPS, etc.  So there's -- that group of people
 8   has completely gone away through acquisition or just
 9   dissipate, going out of business.  There are no new --
10   you know, take ten people out of Credit Suisse, start a
11   new firm, all of a sudden you have option for -- you
12   know, which becomes a firm.  It's not happening.  And
13   I'm not sure exactly why.
14             But I know I watch all the [SafePlace?].  This is
15   a very interesting thesis because margin came out of it,
16   not only the big end, but the small end.  I think that's
17   what's taking place.
18             So to say that the 39 could do what the 167
19   used to do, they may, but they won't.  Credit Suisse is
20   not going to do a $40 million deal.  That seems to be
21   the decline in --
22             MR. WALSH:  There's also Morningstar.
23             MR. WEILD:  They don't do underwriting.
24             MR. WALSH:  Not underwriting, research,
25   research.
0094
 1             MR. WEILD:  No, but they don't call anybody on
 2   the phone who's putting out research.  So again it's the
 3   demand pull versus --
 4             MR. WALSH:  Still follow -- the world's
 5   changed, in my opinion.
 6             MR. WEILD:  That's to the point --
 7             MR. WALSH:  Also in 1997 there was ability to
 8   enter, right?
 9             MR. WEILD:  You want to have a robust IPO
10   market with robust aftermarket support, you want to
11   drive job growth, economic reinvention in the U.S.
12   economy, you gotta put incentive back to support small
13   cap companies that require capital and actually drive
14   growth.
15             And if you don't, the world's changed
16   because -- remember, it's not the market.  We create
17   markets.  We create market incentives.  You know, the
18   notion of the market decides, nonsense.
19             We created this market.  We had the old
20   quote-driven market.  We put a carrot out there.  You
21   look at the credit crisis, we decided that we were going
22   to engage in liar loans and low interest rates, teaser
23   interest rates and no-money-down mortgages.  And what
24   did we do?  We created a bubble because we changed the
25   incentives.  We changed the market structure.  We
0095
 1   changed the market structure here.
 2             You gotta put it back to create incentives if
 3   you -- if you care about this market.  It's -- it's
 4   binary.
 5             MR. KIM:  The one point I would make about --
 6   you had said that high frequency trading firms (“HFT firms”) have replaced the old
 7   investment banks.  And I think that's -- I think that's
 8   a very unfair characterization.
 9             High frequency trading firms live in the upper
10   end of the market, they live in stocks that trade
11   anyway.  They create zero liquidity on the low end of
12   the market.  And all they're creating really is
13   additional volume at the high end of the market.
14             So I don't think that HFT firms, despite how
15   they might want to portray themselves, have been
16   anything but -- but a negative for our markets.
17             DR. RITTER:  You're saying for the micro cap
18   stocks, high frequency trading firms are --
19             MR. KIM:  They don't trade there.
20             MR. WEILD:  They don't trade there.
21             DR. RITTER:  And yet you're blaming them for
22   causing a problem there?
23             MR. KIM:  No, no, I didn't say that.  I don't
24   think I said that.  No.  I was trying to address Mr.
25   Walsh's comment about HFT firms replacing what the
0096
 1   investment banks used to do.
 2             DR. RITTER:  Okay.  But if HFT firms aren't
 3   replacing investment banks with small cap stocks, why is
 4   there a problem for investment banks?
 5             MR. WEILD:  Because the economic incentives
 6   are gone, Jay.  There's nobody -- nobody replacing what
 7   the investment banks used to do for those small cap
 8   stocks.
 9             DR. RITTER:  And what's your explanation for
10   why this spread has fallen there, then?
11             MR. WEILD:  Well, first of all, a lot of those
12   small micro cap stocks -- I mean, I don't know,
13   you're -- I mean, I've been told that a lot of those
14   spreads are pretty fat, right?  So --
15             DR. RITTER:  They are.
16             MR. WEILD:  They are.  Okay.  And it's not a
17   spread issue; it's a bankable spread issue.  Anybody can
18   step in front of you for a penny.  So, you know, if I
19   need to get size done and I'm hanging out there,
20   somebody will step in front of you, Jay, if you're
21   sitting there trying to buy two -- getting 200,000
22   shares done, and they sniff that out, they will be in
23   front of you.
24             Now, the reason why the high frequency guy --
25   by the way, if high frequency was adding liquidity,
0097
 1   don't you think that they would be on the press and in
 2   the market which is the most illiquid, which is the
 3   micro caps?  No, they're not there.  They don't add
 4   liquidity.
 5             But there's -- you can't get something done in
 6   the micro cap/nano cap space because people aren't
 7   willing to make the risk.  They're not making outbound
 8   phone calls.
 9             Micro cap liquidity is created by getting on
10   the phone and selling investors; stocks are sold,
11   they're not bought for the most part, with the exception
12   of the demand pull stocks, the big brand names, you
13   know.
14             And so what we've got is the -- what's the
15   median equity market value of a listed company in the
16   United States?  It's $450 million.
17             DR. RITTER:  Okay.  But what I'm having
18   difficulty understanding is, if the bankable spread has
19   decreased for the small cap stocks, who is it who's
20   stepping in front?
21             MR. WEILD:  If I want to go position 200,000
22   shares of stock right now in the market, I need to hold
23   that spread intact to be able to mark it up.  If you say
24   the spread was a dime, it was 10 cents, and I buy it at
25   ten and I want to mark it up to ten-ten, okay, the
0098
 1   minute somebody gets wind of the fact that I'm doing
 2   some size in that market, they will step ahead of me for
 3   a penny.
 4             DR. RITTER:  Okay.  Who is -- who is this? 
 5   It's not the high frequency traders.
 6             MR. WEILD:  Anybody that has a trading machine
 7   and an algorithm that sits there and sniffs something
 8   out will be in front of me.  A human being that sees me
 9   do that will step in front of me for a penny.
10             MR. KIM:  The high frequency firms are going
11   to go wherever -- wherever there is significant and
12   sufficient volume.  That's where they'll live.  They
13   live now -- they live now, and they've lived for years
14   now, at the high end of the market.  They're not
15   creating any new liquidity at the low end of the market. 
16   If we try, to David's point, their algorithms would
17   sniff out any irregularity, any -- any difference in the
18   normal day-to-day volume.  And any attempt to introduce,
19   you know, a position of 30 days' worth of trading
20   volume, for example, into the lower end of the market --
21             MR. WEILD:  I can't --
22             MR. KIM:  -- it wouldn't work.
23             MR. WEILD:  I can't get compensated for taking
24   that risk as a trader, Jay.  Okay?  I mean, if I'm
25   sitting there and I'm hanging out and I make a capital
0099
 1   commitment on 200,000 shares of stock at ten bucks a
 2   share, $2 million, the risk then, probability of it that
 3   somebody sees me doing that, buying that stock, and
 4   pushes it down to a lower price, it -- it -- my upside
 5   potential is capped at a penny, if somebody -- if
 6   somebody steps in front of me for a penny, and my
 7   downside is that I'm long 2 million shares of stock that
 8   somebody pushes down a nickel or a quarter, the math
 9   doesn't work any longer.  It's just that the model is
10   dead.
11             And that's what you've seen in terms of
12   wholesale shifts in markets.  I mean, I'm looking at
13   John.  You know, John Borer, but your firm, you know,
14   people used to make a lot of money getting on the phone,
15   creating visibility.
16             Again, it's not -- it's less a research
17   problem.  It's, what do you do with the salesmen, the
18   sales traders all making phone calls?  They're the
19   amplification system, if you will, for research.
20             Research gives you a pretext for a
21   conversation, but he's only one guy.  So how many phone
22   calls can he make?
23             But if you need to move size, a block of
24   200,000 shares, and you've got a sales force of 35 guys
25   and, you know, 20 sales traders, all of a sudden people
0100
 1   are out there finding the other side of the order.  But
 2   they have to be incented to do that.
 3             And if you position it -- and the upside is
 4   now down to a penny because somebody can step in front
 5   of you for a penny, you will -- you will very quickly
 6   lose a ton of dough committing capital to those stocks.
 7             You know, Dan, I don't know at Wasatch, but,
 8   you know, people used to commit lots of capital in the
 9   micro cap names.  Nobody commits capital down there any
10   longer.  You know that.
11             I mean, I'm not telling anybody -- this
12   shouldn't be revelatory, at least for people that are in
13   the business.  People don't commit capital.  Get on a
14   trading desk.  Okay.  And for those of you that were on
15   the trading desk 15, 20 years ago, it was a pretty noisy
16   environment.  People were talking to each other, picking
17   up the phone.  Now you can hear a computer.  You know,
18   all you -- all you -- all you hear is the whir of
19   computers.  It's deathly silent.  But there's nobody,
20   nobody on the phone.
21             And, in fact, if you go to a morning call,
22   institutionally, one of the things that happens is that,
23   you know, they -- a lot of times they -- the research
24   salesmen will get voicemail.  And they've automated
25   things with computer-aided telephone, and they just take
0101
 1   a -- one voicemail message and they -- if they get the
 2   voicemail, they just drop it into the voicemail box.
 3   They hit the button, hit the button, hit the button, hit
 4   the button.
 5             So that -- those things have changed the whole
 6   ability to market.  And you've been forced to do that
 7   because the economics of the business are just
 8   unprofitable.  So you're only paying for a trade, for a
 9   trade execution.  That's what's in the market.  All the
10   value components that are required to support a small
11   cap infrastructure in this country have been starved.
12             MR. CHACE:  Can I ask a bit of a different
13   question? I mean, we were talking about markets, and
14   markets have provided innovation and created value in
15   finding ways to capture that value.  And Professor
16   Ritter has argued that there's value in research
17   coverage in terms of higher stock prices, and hopefully
18   in terms of generating ideas for investors to make
19   money.  You've argued -- or I think would argue that
20   there's value in providing liquidity to institutional
21   investors to buy and sell securities in bulk.
22             Are there alternative models?  I mean, beyond
23   what I think I kind of read this, and I'm not an expert
24   by any means, but it kind of feels like a tax on
25   investors to fund something.
0102
 1             But are there different models rather than
 2   tick sizes that would sort of facilitate what you're
 3   describing?
 4             MR. WEILD:  Well, it's an economic incentive
 5   issue, Dan.  And I, you know, mentioned there's three
 6   ways you can be:  You can either be back at a
 7   quote-driven market, you can up commissions, or you can
 8   up tick sizes.
 9             But the one that I think works for
10   institutional investors, from my conversations with, you
11   know, Karey, you know, Barker, we talked about the
12   accounting issue -- that's one of the senior -- you
13   know, one of -- one of Dan's colleagues -- is -- is it
14   has to be in the cost basis, the stock and mutual funds
15   to work, and tick sizes does that.
16             With commissions it will actually go into the
17   expense ratios.  And then Morningstar ratings for small
18   cap growth managers would actually look less attractive
19   relative to large cap funds.  And that wouldn't -- that
20   wouldn't get us where we need to go.
21             So it's economic incentive.
22             There may be a different way that I haven't
23   thought of.  I'm not a proponent -- for instance,
24   there's been some discussion in Congress about just flat
25   out, you know, because of the high frequency stuff, just
0103
 1   taxing stock transactions.  But the problem is that then
 2   the money doesn't go into the -- you know, into the
 3   market, into the ecosystem.  And if you don't have a --
 4   have an economic linkage with the tax, with the value
 5   creation of that, which is creating the liquidity, then
 6   why are people going to get into the business of
 7   creating liquidity.
 8             And one of the reasons why that model you
 9   talked about, the research -- the paid research model
10   that NASDAQ and Reuters tried to do, one of the reasons
11   why it failed was also because -- not because simply it
12   was $120,000, is that it was $120,000 for a research
13   report that wasn't going to then actively get marketed
14   because there was no economic incentive to market it in
15   the aftermarket and drive volume and visibility.
16             So you got research coverage, and it works for
17   some institutions and some investors that are smart
18   enough to go track down the research, but it doesn't
19   actually do the other piece of it, which is create
20   active visibility and active liquidity through
21   marketing.
22             Does that make sense?
23             DR. RITTER:  Okay.  I thought institutions
24   were willing to pay soft dollars as a way of incentive,
25   you know, giving knowledge to the analyst.
0104
 1             MR. WEILD:  Yeah, but a soft dollar -- I'll
 2   pay -- I'll pay you on a micro cap trade with a trade in
 3   IBM all day long for the research.  It doesn't actually
 4   help the liquidity creation of the micro cap name.  It
 5   may do that.
 6             You know, I mean, guys are -- guys are -- you
 7   know, I don't trust you to do an execution on this micro
 8   cap name or whatever, so I'll go execute it through
 9   somebody who's my preferred trader, and I'll pay you
10   with things that are totally irrelevant, totally
11   different industry, you'll get those trades over your
12   desk in soft dollars all the time.  Right.
13             Dan?
14             MR. CHACE:  Yeah.  There's execution and less
15   execution paid for that.  But it's true, as David said,
16   it's not always addressed.  You add value on this side;
17   therefore, you trade.
18             MR. WEILD:  And institutions will sit there,
19   and, you know, they'll go through what they call the
20   broker vote and they'll decide, this is how much -- this
21   is what we think our commission pie is going to look
22   like, and this is how much we have to pay this firm,
23   this is how much we have to pay this firm during the
24   course of the year.
25             So the actual linkage is -- is not necessarily
0105
 1   there.  It's about the holistic relationship.  And the
 2   trader has discretion on the desk to -- you know, he's
 3   just got to make sure that he gets a certain amount of
 4   commissions to that firm during the course of the year.
 5             But how he does it is entirely up to him to
 6   get the best price execution for each of the funds that
 7   are under management.
 8             Okay.  Sorry.
 9             MR. GRAHAM:  David, this is all very
10   interesting. It's great.
11             How much more time do you need?
12             MR. KIM:  I need -- I need two more minutes,
13   and then -- and then I'm done.
14             MR. WEILD:  Then I want to get into
15   recommendations.
16             MR. GRAHAM:  Okay.  So five, ten minutes?
17             MR. WEILD:  Yeah, ten, give us ten.
18             MR. GRAHAM:  Okay.  Give you ten.
19             MR. KIM:  We've covered this, but this is --
20   what the current level covers is only the cost of
21   execution. We have lost the ability to cover the costs
22   of the elements that were needed to create liquidity. 
23   So, you know, it's capital commitment, sales research,
24   creating visibility.  This is essentially an
25   execution-only market now.
0106
 1             In recent months, from a very broad
 2   cross-section of market practitioners, everyone from
 3   exchange specialists to academics to small investment
 4   banks, we've seen growing recognition of our assertion
 5   that increase in tick sizes is a viable and necessary
 6   way to go.  Everyone from Duncan Niederauer with the New
 7   York Stock Exchange who has said on the record that
 8   they've been looking at this internally, and that it
 9   would be fairly easy to implement; Kevin Cronin, head of
10   trading at Invesco; William O'Brien of Direct Edge; Jim
11   Toes, the president of the Securities Traders
12   Association.
13             We have -- at the Congressional Subcommittee
14   hearing that David was at two months ago, we heard from
15   a very broad cross-section of folks that all were in
16   support, universally in support of at least a pilot
17   study to explore what happens with tick sizes.
18             MR. WEILD:  The Investment Company Institute
19   that represents the mutual fund industry came out for it
20   in Congress.
21             MR. KIM:  So this is -- this will be our -- or
22   my last line, and then I'll let David go.
23             If you look at all of the potential causes,
24   and, again, bearing in mind that timeline that you saw
25   before from when Reg ATS was first instituted,
0107
 1   Sarbanes-Oxley -- we're not saying that Sarbanes-Oxley
 2   has no effect.  Clearly it has effect, clearly it has a
 3   cost impact.
 4             But based on two things:  Based on the timing
 5   of Sarbanes, which was in 2002, and based on the actual
 6   amount of dollars involved, we think that the impact of
 7   Sarbanes-Oxley on the IPO market itself has actually
 8   been very small.  And we also -- I absolutely respect
 9   Professor Ritter's studies and his thesis about
10   economies of scope, but, again, I think the notion that
11   small firms can create more profits by selling
12   themselves to larger firms, a lot of that is technology
13   driven, a lot of that I think is, as it relates to the
14   IPO market itself, again, I think the -- I think the
15   impact is very small.
16             The largest impact that we have seen boils
17   down to the economics available for the intermediaries
18   in the business, which are the investment banks and
19   brokers, to create the support infrastructure that
20   worked for decades in this market.  For decades.
21             And the dire situation that we find ourselves
22   in today I think is the inevitable consequence of the
23   loss of the economic infrastructure.  We are today
24   exactly where we were destined to be once we sucked the
25   economics out of the system.
0108
 1             MR. WEILD:  We had -- I'm just going to plow
 2   through these very quickly.  This is about equity
 3   distribution infrastructure and how it's eroded.  And,
 4   you know, there's -- every single bulge bracket, major
 5   bracket firm handling middle market institutional sales
 6   desks, they've all been shuttered.
 7             The top 60 accounts represent about 90 percent
 8   of the top commission opportunity institutionally for
 9   firms.  A lot of it is coming from the lending business,
10   and prime brokerage is no longer even stocked.  So if
11   you want to get out -- if you want to see who's
12   distributing to the smaller institutions, basically
13   nobody.  I mean, you can't -- there's about 3,000
14   institutions in the United States right now that have
15   over a hundred million dollars.
16             And so Dan Chace is not getting an allocation
17   on a new issue, even though he's a growth manager with
18   $12 billion under -- under management for most of the
19   time because he's not big enough to be covered
20   effectively by Morgan Stanley.  And actually, at $12
21   billion, he's -- there are a lot of institutions that
22   are not getting allocations at $50 billion in assets
23   under management.  I mean, that's how big the cutoff is.
24   And people are chasing the dollar.
25             We're going to go flip through --
0109
 1             MR. KIM:  The most active hedge funds pay
 2   investment banks in excess of a hundred million dollars
 3   a year in their total relationship.  Stevie Cohen pays
 4   Goldman Sachs well over a hundred million dollars a
 5   year.
 6             So your CEO, with a hundred million dollar IPO
 7   that's going to generate at best three million bucks,
 8   you're not the customer anymore, you're food, and that's
 9   the problem.
10             MR. WEILD:  You know, you talked about this is
11   trailing 30 IPOs, you know, and this is -- you know, one
12   of the things that I do agree with Jay is that if these
13   things are not supported and properly distributed, and
14   they're not being priced on fundamentals because they're
15   going to too many -- too many people that are not really
16   focused on the fundamentals, they're renters, not owners
17   to the stocks, we're seeing IPO success rates decline.
18   And when people lose money, then the window shuts; you
19   can't keep it open.  It's pretty simple.
20             MR. KIM:  And this is for large -- it's for
21   larger deals as well.  It's not just on small deals. 
22   IPO success rates on all deals of any size have
23   declined.
24             MR. WEILD:  So I -- and by the way, the SEC
25   has been inundated with information mostly on the S&P
0110
 1   500.  And you can see how different these markets are. 
 2   This is where the S&P 500 is, and this is where the
 3   Russell 2000 -- even the Russell 2000 has -- is -- is --
 4   which people use as the small cap index, is bigger on
 5   average than where this dysfunction is occurring.
 6             So, you know, you can't -- and by the way, a
 7   lot of the data on the Russell 2000 says that spreads
 8   haven't come in.  So you can imagine, a lot of them in
 9   the micro cap/nano cap may have even -- even -- even
10   widened.  I don't know, I haven't seen any analysis on
11   that.
12             But that certainly is the trend line.  You can
13   see this is the market value of these stocks.  The
14   number of stocks are all clustered down at the bottom,
15   and -- and -- and this is the market value up here.
16             And as you can see, these stocks down where
17   capital formation lives are totally different because
18   they represent only 6.6 percent of market value spread
19   across -- spread across a large 81 -- -1.1 percent of
20   all publicly listed companies.
21             So just right into recommendations.  And what
22   we've been able to, you know, surmise, we think that you
23   need to do mass customization of tick sizes because one
24   size doesn't fit all.  And there's a lot of people that
25   would argue if you could have even small tick sizes in
0111
 1   S&P 500 stocks.  And the question is:  Do you want to
 2   proliferate gaming and stepping ahead and those kinds of
 3   behaviors?
 4             But at the end of the day, the downside is
 5   probably not great for the market.  But where it is, is
 6   that you need higher tick sizes to support small caps.
 7             And every stock is different.  The mini
 8   micros, the nano caps are going to require higher tick
 9   sizes than a -- than a micro and than a small cap stock,
10   so on and so forth.
11             Then the question is:  How do you create a
12   system where the market can determine tick sizes?
13             Well, there's two methodologies here that
14   could work that we've come up with, one of which was
15   from conversation we had with stock exchanges, and one
16   which was ours, which Professor Angel has endorsed,
17   which is allow issuers to choose their tick size after
18   consultation, if you will, with institutional investors
19   and with Wall Street firms.  Because what you're trying
20   to do is figure out, how do I get people to pay
21   attention?  Okay.  And so if you have a lever, maybe
22   that's within some tolerance, zero to 5 percent of the
23   share price.
24             The other one is to try and think about doing
25   it algorithmically.  And you can use the algorithmic
0112
 1   methodology as a default, which basically says, here's
 2   the spread for the last year, and we're going to make
 3   spread equivalent to tick size, which creates a bankable
 4   spread, converts a quoted spread to a bankable spread.
 5             So if it's -- the market has also already sort
 6   of determined that the average trading spread is a dime,
 7   then make that the tick size.  It's pretty simple.
 8   Because nobody can monetize it anyway.  So at least you
 9   create value by incentivising investors to -- market makers
10   and others to kind of go after that spread.
11             So those are the two concepts.  This is the --
12   you know, how the range would work on share prices so,
13   you know, the SEC could oversee this.
14             And then here's -- you know, here's just the
15   basic math of the algorithm.  It's pretty darn simple;
16   it would be pretty simple to implement across the
17   market.
18             And -- and then finally, with -- you know,
19   these are some -- this was something that was socialized
20   at NIRI, National Investor Relations Institute, which is
21   just an issuer bill of rights which -- that we think
22   that issuers and issuer advocates need to have an equal
23   voice in stock market structure.  And sometimes we think
24   that the traders inundate the trading interest, inundate
25   the Division of Trading and Markets.  I've said this to
0113
 1   Chairman Schapiro, by the way, probably about a year ago.
 2             And so I would like to see Gerry Laporte's
 3   group, which represents small companies, represented in,
 4   you know, an equivalent kind of structure in the
 5   Division of Trading and Markets, because I think you
 6   guys are confined to Corporation Finance, if I'm
 7   not mistaken.
 8             At any rate, I may be wrong about that, but it
 9   just appears outwardly that when you take Reg ATS and
10   Reg NMS and you proliferate lots of stock exchanges that
11   don't represent any issuer interest -- there's only two,
12   NASDAQ and then New York, and there's about 13 exchanges
13   in total and all sorts of Reg ATS -- that you're going
14   to have lots of trading-only interests that are lobbying
15   the SEC and Congress for things that are really
16   beneficial to electronic execution and trading and not
17   necessarily in the best interest of issuers.  It's
18   just -- you know, it's outsize representation.
19             We'd like to create greater transparency,
20   timeliness, and completeness in terms of share -- share
21   ownership.  And there's no reason why people shouldn't
22   be able to understand who's shorting their stock.
23             I get very, very fit to be tied when I see
24   issuers wasting tons of time being dragged around to see
25   hedge funds and other people that are doing damage to
0114
 1   their stock when they should be back in the office
 2   running their business.
 3             And because the lack of transparency on this
 4   information -- by the way, you have insider trading
 5   issues you'd have to control around, but they really
 6   should have real-time information.  Every CEO deserves
 7   that, in my judgment.
 8             Choice in market structure.  Again, no more
 9   one size fits all.  You can do it with sort of the --
10   lots of things that you can do.  But we are now a
11   country with one tick size and one market structure all
12   homogenized because of Regulation National Market
13   System.  And that is a lot of systemic risk.  We bet
14   everything on black here.  We have no choice.
15             And then finally market structures that
16   encourage fundamental investing over training.  This is
17   a very trading-centric market.
18             And we need to get people back to basics.  We
19   need -- we need firms like Wasatch -- I don't want to
20   pick on you, Dan, but these are the firms that are going
21   to lead us going forward and going to allocate capital
22   efficiently in the marketplaces.  And we need -- we
23   need -- we need market structures that favor fundamental
24   investors like the Wasatches, the AllianceBernsteins of
25   the world, and not trading centric hedge funds that are
0115
 1   long shorts, where -- where the idea of a long-term hold
 2   is buy it on the open and sell it on the close.
 3             MS. HANLEY:  Great.  Thank you.  I have just
 4   one question as we go through this.
 5             So I'm hearing from you that there are a
 6   certain amount of profitability from the investment
 7   banking side or the trading side that should be earned
 8   in the market, and that these changes, regulation
 9   changes that we have done has taken away rent from
10   investment bankers and given them essentially to
11   investors.  They're trading at too low a price and then
12   investment bankers can no longer make any money.
13             So you want to swing the pendulum, I
14   understand, back to sort of more of the middle ground
15   where those rents can be split perhaps more evenly.
16             Do you have some idea of what is the
17   appropriate split, so to speak?  What is the -- if --
18   when we -- if we were to change tick sizes, how do we
19   quantify where that tick size should be that we now have
20   a better understanding of, you know, how much should go
21   to the market maker vis-a-vis how much should be going
22   to the investor?  Do you have a sense of how we would
23   measure that?
24             MR. WEILD:  I think that, you know, the market
25   to some degree, I think, Kathleen, is already -- already
0116
 1   telling you a little bit where the spreads are.  I think
 2   that the spread is a pretty good indicia.  If it's
 3   sitting there on average over time at 20 cents, I mean,
 4   that's probably -- you know, it's not doing -- it's not
 5   creating any value for anybody.  Make the spread, you
 6   know, 20 cents.
 7             You could look at how the quote-driven market
 8   actually occurred before the IPO dysfunction, you know,
 9   happened in 1998.
10             And for a long time, we had two ticks per
11   quarter point.  Right?  It was an 1/8 -- it was a 1/8
12   tick.  And it allowed institutions, if you will, to --
13   for the most part, to trade within this spread.
14             And so you could, you know -- you could
15   play -- I mean, if I was going to do it, I would
16   probably sit there and say, take the spread, do one
17   sample set at a -- at a -- at -- where the tick is equal
18   to the natural spread.  And I would take another sample
19   set and maybe experiment with, you know, two ticks or
20   three ticks and see what happened.
21             The problem is you're going to get -- if you
22   do a pilot study around that, you're going to get
23   short-term interest.  But the real hard-core, long-term
24   investments and people resources are not going to
25   accelerate until people know that the pilot is --
0117
 1             MS. HANLEY:  Yeah, that -- well, that -- that
 2   is definitely a challenge with the pilot.
 3             And more importantly, I think it's important
 4   that we get the number right so that the incentives
 5   occur, right?
 6             MR. WEILD:  Right.
 7             MS. HANLEY:  If we set the tick sizes too
 8   small, again, we'll be in the same realm.
 9             MR. WEILD:  But --
10             MS. HANLEY:  If we set it too large, we'll
11   drive away investors.  And so we don't need to answer it
12   here --
13             MR. WEILD:  But -- but --
14             MS. HANLEY:  -- but as an advisory committee
15   and as the --
16             MR. WEILD:  Well --
17             MS. HANLEY:  -- roundtable will occur, I think
18   it's important that we think--
19             MR. WEILD:  But we also said, you know, why
20   not let -- why not let issuers choose?  Because I think
21   that at some point they're going to get beat -- they
22   want to get interest, they're going to get beaten up by,
23   you know, Wasatch.
24             I mean, they're not going to be -- they're not
25   going to be coy.  They're going to say the tick size is
0118
 1   too high.  The bankers are going to say the tick size is
 2   too low.
 3             At some point, people have to come up -- by
 4   the way, it would put -- it would cause issuers to
 5   finally take an interest in market structure and how it
 6   impacts, you know, their -- their stock prices.
 7             And so there are some problems; you know,
 8   everybody is uncomfortable with the idea.  But the fact
 9   of the matter is that one tick size doesn't fit all.
10             And a chemical stock with a hundred million
11   dollar flow, for the sake of argument, is going to
12   trade -- has a very different ecosystem than a “SaaS”
13   stock, a software as a services company.  There's a lot
14   more research analysts, if you will, naturally around
15   SaaS as an industry than there are -- and market
16   participants, than they are necessarily around certain
17   small cap chemical stocks.  And so -- so the answer is
18   going to be different for them.
19             So whether that -- you take the natural spread
20   and set it equivalent to the tick size, you let
21   issuers -- you get -- you get to -- you get to a model
22   which is mass customization of tick size, which I think
23   is the right answer.
24             MR. GRAHAM:  Okay.  Well, thank you.  Thank
25   you again, David.
0119
 1             Lona, do you want to go into JOBS Act?
 2             MR. NALLENGARA:  Sure.  I think I can update
 3   on what's happened since our last meeting with respect
 4   to the JOBS Act.
 5             One of the larger events was our proposing
 6   release of Title II.  Title II is the general
 7   solicitation.  We talked about it at a couple of
 8   meetings.
 9             There was a provision in the JOBS Act that
10   would remove the restriction on general advertising in Rule
11   506 offerings.  These are private placements.  Under
12   Rule 506, currently you cannot advertise, you can't have
13   newspaper ads, you can't have an open access website.
14   Title II would now permit you to do that if you only
15   sold securities to accredited investors.
16             And in the JOBS Act, they added an additional
17   provision to that that requires an issuer to take steps
18   to verify that who they're actually selling to are
19   accredited investors.
20             It's somewhat straightforward to remove the
21   restriction on general solicitation.  It's a little
22   more challenging outlining what those procedures are for
23   an issuer to take to verify who your accredited investor
24   is.
25             If you're an institution, if you're a
0120
 1   broker-dealer, showing or -- or providing an issuer with
 2   some verification that you are -- rather, an accredited
 3   investor, it's likely to be straightforward.
 4             But if you're an individual, providing support
 5   that you are an accredited investor could be more
 6   challenging.  There's a net income test, there's a net
 7   worth test.
 8             So when this provision was included in the
 9   JOBS Act and enacted, people were asking questions on
10   how would you go about and -- and -- how would an issuer
11   verify that someone is an accredited investor or not?
12   Would they need a W-2?  Would they need to get -- would
13   they need to see tax returns?  Would they need to have
14   bank statements?  How would an issuer know that they
15   were selling to an accredited investor?  So that's what
16   we were left with in connection with the rulemaking.
17             And the proposal that came out last week
18   creates a -- creates a framework where an issuer has to
19   look at the facts and circumstances of the transaction.
20   How are they finding their -- how are they finding the
21   purchaser of their securities?  Are they -- are these
22   long-time holders of their securities?  Are
23   broker-dealers providing them with the connection with
24   those -- with those purchasers, or are these individuals
25   that they're finding because they are clicking a page on
0121
 1   their website that says buy securities.  So that's one
 2   part of the package in this analysis.
 3             You could also look at, what are the terms of
 4   the offering?  Is there a minimum investment amount?  Is
 5   the amount that a purchaser is required to buy high
 6   enough that you are -- that that's a fact you can look
 7   at to determine that that person is a person who's an
 8   accredited investor?  If there's a $5 million minimum
 9   investment amount,it's not hard to make an assessment
10   that that person may have a net worth in excess of -- in
11   excess of a million dollars.
12             So we – in the proposing release, the Commission
13   made clear that they weren't identifying specific
14   procedures that you had to do in a particular
15   circumstance.  But rather, look at your -- asking
16   issuers to look at the facts and circumstances of the
17   transaction and make an assessment of what are -- what
18   would be appropriate, given what you know about the
19   purchaser, how you found the purchaser, and the nature
20   of the transaction.  Take those steps and make an
21   assessment of what needs to be done.
22             So that's, in a nutshell, the proposal.
23             One additional part of the proposal is that
24   there is a Form D requirement for when you complete a
25   506 offering.  You are supposed to file a Form D.
0122
 1             What we've proposed to include is a box that
 2   you check on the form that would indicate that you
 3   are -- you, as part of the offering, you generally
 4   solicited or not.  This is a way for us to be able to
 5   track, identify which offerings, which market
 6   participants have been participating in offerings where
 7   there's general solicitation.
 8             So we can go back and look, after the rules are adopted,
 9   to see what procedures are being used, is the framework
10   that we've set up one that works, and be able to look at
11   the market more generally.
12             So that's the proposal.  There's a 30-day
13   comment period.  We expect, as there was in the comments
14   before we proposed the rule, we expect there would be a
15   wide range of views.  Many people have indicated that
16   they're -- that they like the proposal.  And as you can
17   imagine, there are alot of people who said they don't agree
18   with the proposal.  So we're hoping to hear from
19   everyone on that.
20             I'm not sure if anyone has any questions on
21   the proposal.
22             MR. WALSH:  What are some of the reasons
23   against it?
24             MR. NALLENGARA:  Well, some of the reasons are
25   that there should be more definitive requirements.  Some
0123
 1   are saying there should be more definitive requirements.
 2   You should be -- you should be -- there should be more
 3   onus on an issuer who's doing a general solicitation
 4   deal to have more third-party information, documented
 5   information.  So there are -- I think there are probably
 6  letters on our site that indicate that the issuer
 7   should be getting some third-party information to
 8   support whether an issuer -- whether a purchaser is
 9   actually an accredited investor.
10             MR. WALSH:  W-2s.
11             MR. NALLENGARA:  W-2s.  And there are letters
12   on the other side saying that would grind -- that would
13   grind the 506 offering to a halt, that people just wouldn't -- I
14   mean, if I'm -- if I'm -- I wouldn't want -- you know,
15   it's one thing to provide information to a
16   broker-dealer. I'd be more comfortable, some of the
17   comments are saying, I'm comfortable giving that
18   information to a broker-dealer.  But if this provision
19   is designed to allow issuers to access the market
20   without a broker-dealer if they don't want to, if they
21   want to access it on their own, am I -- is a person
22   going to be willing to provide that information just to
23   the issuer that they've never met before?  They have no
24   idea, there's certain kind of privacy rights concerns.
25             So there's other comments indicated that if
0124
 1   you're going to allow for general solicitation, there's
 2   lots more stuff you should be looking at.
 3             The definition of accredited investor, many
 4   people have said for a long time that definition is an
 5   old definition.  You shouldn't just be looking at net
 6   worth, you shouldn't just be looking at income.  You
 7   should be looking at investment.  How much money do you
 8   have invested in private securities?  Is that a better
 9   test?
10             And there's Dodd-Frank, which tasked the
11   GAO to do studies that will be coming in the next year
12   that would look at the accredited investor definition
13   broadly.
14             So what the -- what the Chairman's statement
15   at the time of the proposal was, there's lots of
16   stuff within the 506 market, specifically about Reg D
17   generally, that needs to be looked at.  The definition. And
18  the form itself, the one where we propose having a box
19   checked.
20             There's lots more information we could ask
21   for. We could ask for -- you know, we could -- we -- a
22   lot of information could be drawn from that that would
23   help us understand what the market is like.  All of that
24   is, you know, subject to review.
25             But the terms was Title II requirement, what
0125
 1   Congress asked us to do was a narrow one, so we focused
 2   just on that narrow part.  So other -- I'm sorry.
 3             MS. MOTT:  I have a question.
 4             MR. NALLENGARA:  Yes.
 5             MS. MOTT:  I can see where in a case where a
 6   company that's raising -- a startup company that's
 7   raising money, the ruling can apply to both.
 8             You know, if they're going to give it to a
 9   crowd funding issuer, you know, obviously because you
10   can't tax -- to answer your question, it can bring and
11   attract people who might not be accredited.  So you
12   really have to find a way they are accredited.
13             But let's say they're going to generally
14   advertise through this issuer who's online or whatever
15   else, but then doesn't raise enough money, now has to
16   come to, you know, the angel group, let's say, who, by
17   the way, aren't going to give the entrepreneur who's
18   coming to them their information, you know, their tax
19   returns, their, you know, net worth statements, things
20   like that.
21             So in this case, we have the ruling applying
22   over here, but maybe all of a sudden now they're not
23   going -- not going to -- it's not general advertising or
24   it is because it's accredited investors who have
25   invested in, you know, these types of companies before.
0126
 1   I mean, I guess I'm a little confused by it.
 2             MR. NALLENGARA:  I think -- what you're asking
 3   is --
 4             MS. MOTT:  Am I asking?  I don't have --
 5             MR. NALLENGARA:  If you start an offering as a
 6   general offering, is that --
 7             MS. MOTT:  That's it.
 8             MR. NALLENGARA:  Well, there's a lot of
 9   questions on it.  We have a number of rules related
10   to -- related to integrating an offering, whether if you
11   generally solicit in an offering and then continue, can
12   you -- for example, you know, real quick, the rule
13   proposal keeps intact the current Rule 507.
14             If you want to do your regular way 506
15   offering where you're not -- you're using a broker,
16   you're using your existing investors, you don't
17   necessarily have to -- you don't have to go through --
18   you don't have to look at this new proposal for the
19   final rule.  You can continue to use your established
20   procedures.
21             If you want to generally solicit, that means
22   if you want to have newspaper ads, if you want have a
23   website, then you need to look at the verification
24   standard.
25             What the practices are now currently may
0127
 1   already satisfy that verification.  A lot of
 2   companies that are doing current practice 506 offerings
 3   are using practices that are -- that would be consistent
 4   with this verification model.
 5             So if a company starts an offering by way
 6   of -- by way of a general solicitation, and they want to
 7   move back to a sort of regular 506 offering, what
 8   they're going to have to look at is they're going to
 9   have to look -- it's not as easy as saying, yes, they
10   can do it. They're going to have to look at what general
11   solicitation activities they're going to do and whether
12   that -- whether general solicitation is in fact how your
13   folks for the angel network have been attracted.
14             But I would gather that there's probably
15   methods by which your network could establish
16   accreditation levels for members that would satisfy
17   the requirement.
18             The rule proposal suggests there will likely
19   be third parties that will develop -- that will accredit
20   investors.  So SecondMarket has indicated that they --
21   this is an area that they'd like to work in as being a
22   repository of accredited investors.  So you could get -- you
23   know, you could get the SecondMarket stance that would
24   say this person is an accredited investor.  We've looked
25   at their -- you know, we've looked at their information.
0128
 1   They were -- and -- and an investor may be more
 2   comfortable providing information to a known entity, whether it's an
 3   angel investor or whether it's SecondMarket or some
 4   other third party.  It would be a way which -- you don't
 5   necessarily have to provide that information to the
 6   issuer.
 7             MS. SMITH:  So the company sells shares based
 8   on the representation certified by the third-party but it turns out that the person is a
 9   non-accredited investor where -- is there a
10   violation of that rule?  Is there going to be a filing
11   rule?
12             MR. NALLENGARA:  That's a great question,
13   Karen. The current rule, as well as the proposal, has a
14   reasonable belief standard on it.  So if you've taken steps to verify, and
15   the person -- and the person -- let's say they went
16   through a third party, and the third party is
17   documenting the procedures they go through in
18   establishing whether someone is an accredited investor,
19   and they certify to the issuer that we've checked --
20   we've checked Karen Smith, and we've gone through what
21   our normal procedures are, and Karen Smith is an
22   accredited investor.  And I rely on that information, and we find
23   out that you doctored, you gave a fake tax return, I
24   still have a good -- I still have a good 506.  It's sort
25   of reasonable for me to rely on this third-party
0129
 1   established procedure.  I wouldn't lose my 506.
 2             Actually, there are a number of cases where
 3   individuals who have -- who have faked their accredited
 4   investor status, have purchased securities, then wanted
 5   to rescind the transaction because they weren't an
 6   accredited investor.  And they have been unsuccessful.
 7   So I'm not sure that was a plan of yours.
 8             MS. SMITH:  No, not a plan.
 9             MR. NALLENGARA:  I think we're at 12:00.  We
10   have -- for the members we have lunch.  And Marc -- I
11   think I saw Marc.  Marc Fagel, who's the head of our San
12   Francisco office, was going to talk to everyone about
13   some areas of interest to small companies unrelated to both
14   topics today, but we thought it would be interesting for
15   all of you to hear that.
16             Steve, you want to take ten minutes while we
17   get lunch together, and then we'll reconvene?  I think
18   Marc will speak for about 15 minutes, and then we'll --
19   and then I guess sort of have free time back until 1:00.
20             MR. GRAHAM:  Perfect.
21             MR. NALLENGARA:  Okay.
22             MR. GRAHAM:  Let's do it.
23             MR. NALLENGARA:  Sorry.  So if you wanted --
24   the security is a little different than our meetings in
25   headquarters.  So you're obviously allowed to leave and
0130
 1   we'll all -- and we'll let you back in.  But it's a
 2   little more challenging to get back into the building
 3   than it is at Headquarters.  So I guess for the members,
 4   we're going to reconvene in about ten minutes, lunch,
 5   and then Marc will speak.  And then if you want to
 6   leave, you just have to -- you have to come back closer
 7   to 1:00.  Come back to the 28th floor, and we'll bring
 8   you all back down again.
 9             For those in the public who want to leave and
10   come back at 1:00, if you can just come back at ten
11   minutes to 1:00, go back to the 28th floor, then we'll
12   come and get you and bring you back down.
13             MS. ZEPRALKA:  If any members of the public are leaving and not coming back for the afternoon session, please hand me your lanyards on the way out.
14             MR. GRAHAM:  Great.
15             MR. NALLENGARA:  Back in ten minutes.
16             (Whereupon, at 12:01 p.m., a luncheon recess
17   was taken.)
18               A F T E R N O O N  S E S S I O N
19                                               (12:23 p.m.)
20             MR. GRAHAM:  Committee members, time for
21   noontime program.  And as I think you know, Marc
22   Fagel -- I guess you're based in San Francisco -- has
23   agreed to spend some time with us talking about some of
24   the -- some of the important issues, I understand, the
25   effect on smaller companies.
0131
 1             I think we're going to hear a little bit
 2   about -- more about the traffic is going to get worse
 3   and essentially how to keep out of trouble.  And kind of
 4   stay in the terms of time.
 5             MR. FAGEL:  Well, thank you.  Yes, so my name
 6   is Marc Fagel.  I'm the Regional Director of this
 7   office, and I welcome all of you to our new facility. 
 8   Hopefully things are working -- working well.
 9             We've got about just over 100 folks out here,
10   about half of whom do enforcement, the other half are
11   examiners and broker-dealers and advisors in funds and
12   the like.
13             But I'm here to talk about enforcement.  And
14   we just thought it would be nice to throw in a little
15   breather during the program and talk about how to really
16   avoid you ever having to be back in this office again.
17             So before I do that, I do have the standard
18   disclaimer that I'm sure my peers agree, which is that
19   the opinions I'm going to share with you are my own.  I
20   don't speak on behalf of the Commission or the
21   Commissioners.
22             But I want to talk a little about some of the
23   high priority areas and the sorts of enforcement matters
24   that come to our attention that involve newly public
25   companies or emerging companies.
0132
 1             The -- you know, not surprisingly, one of the
 2   top priorities, certainly for this office, but
 3   nationally, has long been financial accounting fraud by
 4   public companies.  And in this office in particular,
 5   we're responsible for Silicon Valley, Seattle, Portland.
 6   We have a lot of tech companies, biotech companies that
 7   are emerging with their own set of accounting issues.
 8             And dating back, I've been here about 15
 9   years, and, as far as I can remember, that's always been
10   our number one component of our -- of our docket.  And
11   traditionally, it could be a quarter, up to a third of
12   the cases we do in our office involve accounting or
13   disclosure issues with public companies.
14             The piece of good news for the folks in the
15   room is that that is way down.  And for the last fiscal
16   year, SEC-wide, only about 15 percent of the enforcement
17   matters we brought involved accounting and disclosure
18   matters for public companies.
19             And I can't tell you exactly why that is.
20   Personally, my belief is that a lot of that has to do
21   with Sarbanes-Oxley.  And I know that certainly for
22   those of you in the room and in the industry, there are
23   a lot of concerns with Sarbanes-Oxley and the costs. All
24   I can tell you is that the number of restatements and
25   the number of enforcement matters has gone way down in
0133
 1   the last decade.
 2             Now, some of that is also just going to be the
 3   post-Enron, WorldCom environment where I think companies
 4   got a little more careful.  I think auditors became much
 5   more aggressive, I think boards were more engaged.  I
 6   think that has no doubt helped quite a bit.
 7             I do, unfortunately, have a cynical view that
 8   a lot of people have short memories, so I wouldn't be
 9   surprised to see that number starting to go back up,
10   certainly as the economy improves.
11             And once again, there's the expectation for
12   companies to reporting -- to be reporting great revenue
13   numbers. I think that's when games start getting played.
14             The piece of bad news I have to share is that
15   to the extent that we do continue to see accounting
16   fraud cases coming out of our office and nationally, a
17   lot of those do tend to be with smaller, newly public
18   companies.  I think the quality of internal controls is
19   not quite the same with -- as with an established
20   company.  We do see a lot of companies that go public
21   before they necessarily have the mechanisms in place,
22   the internal controls they need to prevent the sort of
23   recurring financial accounting issues we've seen.
24             So some of the classic cases, last day of the
25   quarter, you're not making your numbers, your salesmen
0134
 1   are calling all their favorite customers and saying, I
 2   know you don't need the product today, maybe six months
 3   from now, but let me ship it to you; you don't have to
 4   pay, we'll work something out tomorrow, and don't tell
 5   our CFO, continues to happens, continues to happens,
 6   especially with smaller companies.  Tends to happen more
 7   frequently I think, at least anecdotally, with companies
 8   with offshore operations.
 9             So even companies that may have the HQ here in
10   San Jose doing a bang-up job with their internal
11   controls may not have the same focus on what's going on
12   in Singapore.
13             So to the extent there are ongoing financial
14   cases, you know, small companies do need to make sure
15   that they have the appropriate controls, training for
16   their sales staff and finance staff on what is
17   appropriate, what is not.
18             And the top-down pressure always matters.  And
19   if you have the CEO and the CFO sending out those
20   e-mails on the last week of the quarter saying, make
21   your numbers or you may be looking for work, you cannot
22   be surprised when games get played to help make those
23   numbers.
24             The -- the other change I've noticed in recent
25   years, in addition to the general decline of these
0135
 1   cases, is that to the extent we do continue to see
 2   cases, it tends to be less in the revenue area.
 3   Historically, it was always revenue.  The analyst wanted
 4   to see revenue growth, and that's where a lot of the
 5   tricks were being played.
 6             These days, I think analysts are a little more
 7   attuned to that, companies are a little more careful
 8   there, but you do continue to see games being played
 9   with earnings management.
10             So the inventory numbers, for example, make
11   your margins look better, make your expenses look lower.
12   So you do continue to see that sort of matter.
13             Another area where we have a lot of focus in
14   enforcement is, no surprise, the Foreign Corrupt
15   Practices Act, or the FCPA.  This has definitely been an
16   area of huge growth for enforcement.  You look back in
17   the past couple decades that that statute has been in
18   existence, and there were very few cases.
19             It's now -- we're actually breaking out
20   statistics on that as a separate area because it's
21   become so prevalent for enforcement interest.  About three
22   percent of our enforcement actions last year involved
23   FCPA violations, improper payments to foreign officials
24   in order to secure business.  three percent --
25             MR. GRAHAM:  Marc?
0136
 1             MR. FAGEL:  I'm sorry?
 2             MR. GRAHAM:  Where there's kind of a hair
 3   trigger or are people, in other words, being surprised
 4   because they think what they're doing is perfectly
 5   normal?  I should take that back.  It could be normal in
 6   that context, but you know what I mean.
 7             MR. FAGEL:  You know, I'm not sure how to
 8   characterize it.  You know, as an enforcement attorney,
 9   I'm always looking for evidence of scienter.  You know,
10   it's not, you know, no one had a clue this was going on,
11   we're shocked.  That can still be a violation.
12             But the cases that tend to be more attractive
13   if we're going to have to litigate them are those that
14   have the terrific e-mail where somebody says, don't put
15   this in another e-mail.  That happens.  There are a lot
16   of e-mails, that is a search term when we are looking at
17   e-mails.
18             So, you know, I can't pretend that there are a
19   significant number of cases where there is obvious
20   knowledge of what's going on at headquarters.  You know,
21   you don't -- do not typically have the CFO who says, I'm
22   going to ship you a box of cash so you can get
23   customers.
24             More frequently you'll see very, again, lax
25   controls, where you'll have offshore operations where
0137
 1   they are, for example, asking for tens or hundreds of
 2   thousands of dollars for a travel budget and no one back
 3   in the home office is paying attention that training is
 4   being secured for their new customers at Disney World.
 5             You know, so, again, it's more, are you not
 6   noticing what's going on?  Are you not asking the right
 7   questions?  Why are we spending so much to run the small
 8   operation?  And coincidentally, we just got a great
 9   government contract out of there and we're flying all
10   these people here for a supposed training in Orlando.
11             So, you know, I think that the internal
12   control issue is a significant one.  You really do have
13   to be on top of your offshore operations.  What are they
14   doing? How are they securing contracts?  How are they
15   accounting for their expenses?  Are there slush funds
16   being created so that cash or gifts or other rewards can
17   be made to customers or to distributors who are helping
18   to secure the foreign business?
19             And, again, this is the sort of situation
20   where smaller companies are particularly ripe for this
21   abuse because they may not have the controls.  They're
22   growing rapidly.  There are mergers happening with
23   offshore operations where they may not have the same
24   controls in place to make sure that they're keeping an
25   eye on these sorts of payments.
0138
 1             The bigger problem with FCPA, of course, is
 2   that it gets tremendous criminal interest.  Now, all the
 3   securities laws can be enforced criminally, but the FCPA
 4   is one area in particular where the Department of
 5   Justice finds them hugely interesting.
 6             So in a typical SEC investigation into bribery
 7   payments, there will most likely be a parallel criminal
 8   investigation.  We'll work closely with the Department
 9   of Justice.  And, obviously, the penalties are much
10   greater.  It's one thing to be paying a fine to the SEC;
11   it's another thing for your executives to risk
12   incarceration.  So the stakes are very high and the
13   costs are very high.
14             Once one of these things arises, you're
15   talking about doing internal investigation and dealing
16   with a government investigation where all the activity
17   is offshore.  And once you have paid a large firm to
18   send a large number of partners and associates to China
19   for six months, those bills rack up very, very quickly.
20             So the stakes are very high; very important to
21   make sure that you’ve got internal compliance down and
22   you've got training to prevent this problem before it
23   arises.
24             MR. GRAHAM:  How often does incarceration
25   occur?
0139
 1             MR. FAGEL:  I don't think it happens very
 2   often.  I think the mere threat of it is enough to avoid
 3   the issues.
 4             And like I said, it is pretty rare where you
 5   will see the scienter evidence arise to a level where
 6   you can show a senior executive actually knew or ordered
 7   this to happen.  But it's not without precedent.
 8             And I think one of the bigger threats, it's
 9   not so much our authorities, when you're dealing with
10   foreign executives and you're dealing with the foreign
11   government who learns about corruption, and they've got
12   to deal with their own political situation when it comes
13   to light that members of the government are receiving
14   bribes, they may have a different approach to how they
15   deal with executives there.
16             MS. JACOBS:  Marc, how do you feel about
17   self-reporting?
18             MR. FAGEL:  It's a great question, and
19   something I was exactly going to talk about.  I'll talk
20   about it now.
21             MS. JACOBS:  Oh, I'm to go --
22             MR. FAGEL:  I think it is -- I think it's
23   essential. And I think it can make all the difference in
24   the world in the outcome of an investigation, when there
25   is a -- is self-reporting.  But let me circle back to
0140
 1   that and talk about it.  It's a great question.
 2             Let me hit on two more quick areas on public
 3   companies and then turn to a couple short ones on
 4   private companies.
 5             Two additional areas of interest for public
 6   companies, Reg FD, fair disclosure.  It's a regulation,
 7   been in place about ten years or so.  There were a few
 8   cases right off the bat when we brought it, then it was
 9   quiet.  Now there's a bit of a comeback.  There have
10   been a few cases.
11             Essentially for those of you not familiar with
12   it, it is a regulation geared at selective disclosure of
13   non-public information to deal with the concern among
14   investors that some companies are reaching out to
15   favored analysts, favored institutional investors, and
16   giving them a bit of a heads-up of some good news or bad
17   news that's not quite out there in the public eye yet.
18             And we continue to see cases.  And there have
19   been a number of investigations in the last couple
20   years, some of which have resulted in enforcement
21   actions, where you do see senior executives, you see the
22   CFO going home on a Saturday after reading what the
23   analysts are saying and making one-on-one phone calls to
24   a few analysts to talk them down off their numbers. Some
25   pretty -- some pretty blatant abuses out there.
0141
 1             I think when the regulation was first passed,
 2   there were concerns that, well, what if -- what if
 3   someone has body language during an earnings call and
 4   everyone picks up on it, is that unfair?
 5             If you look at the cases that have been
 6   brought, it's not body language.  There are,
 7   unfortunately, some corporate executives who will go out
 8   there to a hedge fund who has made some general advances
 9   in the past and actually pick up the phone and call them
10   and say, you know, your numbers aren't quite right.
11             So the calls I think that we've made have
12   definitely been cases where people would agree has been
13   a violation of selective disclosure.
14             And then the last area that's of perennial
15   interest to us in Enforcement is insider trading.  And a
16   lot of these cases are very high profile.  The playing
17   field here has really changed in the last few years for
18   the SEC and certainly for the criminal authorities who
19   pay attention.
20             Historically, you'll see basically one-off
21   situations.  An executive, a director, an employee who
22   learned something non-public about the company and trades
23   on it or tips.
24             What you've seen changing in the last couple
25   years are large-scale trading rings, systematic trading
0142
 1   where you see networks of individuals who provide
 2   information, say, to hedge funds reaching out to
 3   employees of multiple public companies and
 4   systematically obtain non-public information, allowing
 5   investors to make millions of dollars.
 6             These cases, you know, the repercussions are
 7   huge.  They have gotten much criminal interest.  You
 8   have wire taps involved, which really changed the degree
 9   and nature of the investigation.  Fascinating cases, and
10   not the sort of thing any public company wants to get
11   involved in.
12             Now, the repercussions tend to be for those
13   individuals who are trading and tipping, not necessarily
14   for the company itself.  But again, there are huge
15   resource costs.
16             And if the SEC comes calling and next thing
17   you know you've got a senior executive or a member of
18   your board who's wrapped up in an SEC investigation,
19   that can have some serious implications for the future
20   of that individual at your company.
21             So it's definitely, again, worth -- you know,
22   I say it over and over, make sure you got the internal
23   controls in place.  Make sure that any non-public
24   information is disseminated only to those who need to
25   know and at the last possible moment to reduce the risk
0143
 1   of that leaking out.
 2             The other piece of advice I have to give you,
 3   especially if you are involved with a newly public
 4   company, is the importance of a trading plan.  There is
 5   an SEC rule that provides for presumption, that if
 6   somebody who is trading pursuant to a regular trading
 7   plan is not trading on the basis of non-public
 8   information.
 9             So if your executives have received a large
10   amount of stock, which has value once the company goes
11   public, and get on a trading plan, so that the first day
12   after every earnings announcement every quarter, X
13   percent of the portfolio is liquidated, it makes it very
14   hard for us to get interested.
15             When we see that a CFO made a very large sale
16   the day before an announcement, we will make a phone
17   call and ask about that trade.  If we get a copy of the
18   trading plan that says, well, we trade on that day of
19   that month every single month, and we've done that for
20   three years, that's probably the last you'll hear from
21   us.
22             So I can't emphasize about the importance of
23   having a trading plan.  And following it.  The trading
24   plan doesn't do much good if you don't follow it, or if
25   your trading plan is that I will trade a lot of stock
0144
 1   the day after, the day before really good news and --
 2   that's not going to work.
 3             But if it's -- if it's a legitimate plan that
 4   is followed that's objective and it really takes away
 5   the element of trying to capitalize on nonpublic
 6   information, it's an excellent idea.
 7             And then, finally, I wanted to hit on two
 8   issues that come up with companies that are not yet
 9   public that tend to be repeat players in our office.
10             Private companies out there financing through
11   private offerings that are playing fast and loose with the facts.  You know, the number of fraud cases, it's an
13   ongoing area for our interest when you've got false
14   statements being made in connection with private
15   offerings.
16             Most importantly are representations about how
17   the money is going to be used, the proceeds are going to
18   be used, especially if the money is going into the
19   pockets of the individuals running the company.  It very
20   quickly begins to look like misappropriation if there is
21   a disclosure about a certain compensation structure that
22   will be used, but most of the funds, the offering proceeds
23   are going into the pocket of the executives or they're
24   getting large loans that may never be repaid.  So
25   representations about what is going to happen with the
0145
 1   proceeds of the offering are going to get our attention.
 2             We said we repeatedly see instances of playing
 3   fast and loose with the background, whether educational,
 4   employment background of the principals of the company.
 5   Going to attend a seminar one day does not make you a
 6   Harvard graduate.
 7             You see, you know, overselling of the
 8   prospects of the product or service that the company
 9   sells; revenue projections that have absolutely no basis
10   in reality.  Again, just because you're in telecom space
11   does not mean that you can have the same projections as
12   Apple does for the iPhone.
13             Similarly, talking about your business
14   prospect, your business partnerships has to be honest.
15   And again, you know, the fact that you carry an iPhone
16   does not mean that Apple is a strategic partner of your
17   company.
18             So the things that people will say are crazy.
19   And it's, again, not very difficult for us to disprove a
20   lot of the representations we see.
21             Yes, sir.
22             MR. WALSH:  When you mentioned right before
23   about the private placement, do you find a lot of --
24   more issues with private placement than debt, issuing
25   debt as opposed to friends and family trying to raise
0146
 1   some money (inaudible)?
 2             MR. FAGEL:  I would say that, you know,
 3   frankly, where we most frequently see it are in equity
 4   securities offerings by small companies, which sometimes
 5   start to appear very quickly to be more akin to a Ponzi
 6   scheme. So a company that is out there with what they call a
 7   private offering, what I think you would do is more
 8   public offering.
 9             You start having seminars when you reach out
10   to family and friends, and have them share your
11   prospectus with everybody they know.  And very quickly,
12   you've got hundreds of people that you've never met
13   sending you money for stock.  Those tend to be, you
14   know, where this arises.
15             And again, you know, we are -- there's no
16   secret that we have very limited resources at the
17   Commission.  So to get our attention, we really do have
18   to be doing an analysis of:  Is this something that
19   we've got the resources, the time, and the manpower to
20   take a look at?
21             So if you're raising a small amount of money
22   from a small number of people, even if there is
23   out-and-out fraud, it may just not be something we're
24   able to deal with.  It may result in a referral to a
25   state agency or a district attorney, for example.  But
0147
 1   the wider, the broader, and the more successful the
 2   offering, the more likely we're going to focus on it.
 3             And then the last area I touched on are -- and
 4   hopefully this isn't something that happens too
 5   prevalently with the folks in the room, but companies
 6   that choose to go public through a reverse merger with a
 7   shell.  There are companies that can do that
 8   legitimately.
 9             I'm not here to disparage whether or not that
10   is an appropriate way of going public, but I do have to
11   say a large number of market manipulation investigations
12   come from what may be at one point legitimate private
13   companies that seek to create liquidity through a
14   reverse merger.
15             And any time the mechanism for going public
16   results in a large proportion of the non-restricted
17   shares being held by a stock promoter or people closely
18   affiliated with the company, I do think that there is a
19   large risk of that company having its stock manipulated
20   for personal gain.
21             And those cases are just -- you know, it's a
22   deluge.  They come in day after day, a small company,
23   public through a reverse merger, you see the spam, you
24   see the fax go out, the stock goes from a quarter to 50
25   cents, which doesn't get a lot of our attention, but the
0148
 1   stock promoter can make a few million dollars over the
 2   course of a weekend through one of these fax campaigns.
 3             Turning from these areas to a couple of ways
 4   to -- other things for you to be thinking about.  One of
 5   the major changes in recent years has been the change in
 6   our law on whistleblowers under Dodd-Frank.  And this
 7   is a very new phenomenon where the Commission now has a
 8   mechanism and the ability and an incentive to pay cash
 9   to individuals who refer information to us that allow us
10   to successfully investigate and prosecute a fraud.
11             This is something that was on the mind of
12   Congress at the time of passage of Dodd-Frank to make
13   sure that individuals had an incentive to come forward
14   with useful information to the SEC and to make sure we
15   had at the staff level an ability to process that and
16   reward that information, which really changes the nature
17   of the game.
18             The number of referrals and complaints we get
19   at the SEC is astronomical.  But when there is a price
20   tag and incentive for somebody to give us information
21   that may actually allow them to reap millions of
22   dollars, the numbers can be quite large.
23             The quality of information can go up quite a
24   bit, and the incentives for people who have really
25   meaningful information can go up.  You know, I can't
0149
 1   tell you how many e-mails we get from somebody saying,
 2   my broker is crooked, can you take a look at him? That's
 3   of limited use.
 4             It's another story if you've got somebody who
 5   is a current employee of a company saying, I think our
 6   CFO is doing something inappropriate; here's some
 7   e-mails, here's some documents I've got, and sign me up
 8   because if you successfully investigate this, I'd like
 9   to get 10 to 30 percent of any recovery, quality of
10   information is different and the incentive for a current
11   employee to get involved and come to the SEC has really
12   been ratcheted up.
13             It's still a relatively new program.  The very
14   first award under the program was made recently.
15             Looking back at some of the areas I mentioned
16   before, you take, for example, a Foreign Corrupt
17   Practices Act case where you may have a $10 million
18   penalty, where we have the ability under Dodd-Frank to
19   give 10 to 30 percent back, you've got somebody with an
20   incentive who can make $3 million by giving us some
21   documents showing us that a bribe has been paid.
22             You know, it's a real incentive maybe for your
23   employees, maybe for your competitors who are feeling a
24   little aggrieved that they did not get the business you
25   got to come to the SEC and say, I've been talking with
0150
 1   that distributor, and I can tell you exactly why they
 2   made the sale and we didn't; and it's because ABC did
 3   XYZ.
 4             So we do have regular daily calls coming in
 5   from people with valuable information.  So, you know,
 6   for all of you who are -- who are out there, you do need
 7   to be thinking about, what are the employees doing?  If
 8   they are coming forward to company management or the
 9   board with information, that you're taking it seriously,
10   because if you're not, it's pretty likely that they're
11   talking to the SEC.
12             Which brings me to the last issue, which is --
13   which is something that you raised, which is
14   self-reporting.
15             You know, given that there are more
16   whistle-blowers who are coming to us, the question is,
17   if the information is coming to the company itself as
18   well, what is the company doing?  Is the company coming
19   to the SEC?
20             Now, for the past decade or so, we have tried
21   to make it very clear within Enforcement that we do
22   have an expectation for companies to self-report issues
23   to the Division of Enforcement, to work with us to
24   assist in our investigations, and that there are
25   material differences in the results of any investigation
0151
 1   depending on the level of cooperation that we receive
 2   from the company.
 3             So, you know, a company that comes -- and this
 4   happens all the time.  You know, they'll call me or
 5   they'll call our head of Enforcement and say, our
 6   auditors came across something unusual, we're conducting
 7   an internal investigation, we would like to come to your
 8   office and share the information, share some documents,
 9   talk about what we learn through our interviews of some
10   of our employees.  That is something that is looked upon
11   pretty favorably.
12             A company that decides to wait to see how it
13   works out, and the first we hear of it is because a
14   whistleblower comes and calls us up and says, you know,
15   this whole thing is going on with the company and you
16   don't know about it or we read about it in the paper or
17   the company announces a restatement, which is news to
18   us, we're already wondering, is this company going to
19   ultimately want to do the right thing when they weren't
20   even talking to us about it?
21             So it is very important for companies to think
22   seriously about reaching out to Enforcement, giving us a
23   heads-up and sharing information.
24             And, you know, I know that there's a serious
25   calculation among defense counsel about whether or not
0152
 1   to do that.
 2             I come back to what I said earlier about our
 3   limited resources.  If a company calls me up and says,
 4   we've got an issue, we're taking a look at it, can we
 5   come in in a month or two when we're done with our
 6   internal investigation and share the information, it's
 7   going to mean I can sit back and not be sending out
 8   subpoenas, not be forcing my staff to cut up an
 9   otherwise busy day to run out and start talking to
10   witnesses.  That is good for me and would be something
11   we'd want to be thinking about later on in deciding what
12   to do with a company if there is a problem.
13             If it turns out there is no problem and the
14   company comes and we've got a basis to believe that
15   they're shooting straight, sharing information, and it
16   turns out that there's nothing there of interest, we
17   probably are going to go away.  We've got better things
18   to do.  I've got a million other cases that we can be
19   investigating.
20             So I think there's a perception of a major
21   downside of fronting the issue for us, but if it turns
22   out to be nothing, we've got other things to do; if it
23   turns out to be something, I think the company benefits
24   by giving us a heads-up and working with us.
25             I think to the extent there's a perception
0153
 1   that if the company doesn't share the information and
 2   hopes for the best it's going to work out, I don't think
 3   that's right.  If we read about a restatement and the
 4   company is saying, well, send us subpoenas and you'll
 5   learn what you learn, we're going to send those
 6   subpoenas.  You may, you know, have about 30 executives
 7   spending, you know, a lot of days in this room being
 8   questioned because we don't know what's going on and
 9   we're trying to figure out what happened.  We're going
10   to be asking for an awful lot of documents because we
11   need to figure out for ourselves what went wrong.
12             In contrast, if independent counsel, forensic
13   experts hired by the company come in, make a
14   presentation to us, and say, here's what we've looked
15   at, here's five individuals who you need to talk to,
16   these are the top people involved.  These five people
17   know nothing, we've talked to them.  Here are the key
18   documents that are going to help you make a decision,
19   it's going to allow us to narrow our investigation.
20             Again, we don't have the resources or the
21   inclination to look under every rock.  If we can
22   understand from the company and believe we're getting
23   fair information on what might be out there, we've got
24   every incentive in the world to focus our investigation,
25   to wrap things up quickly, and then to look favorably
0154
 1   about the company when we're trying to decide what --
 2   how to resolve it.
 3             So that's what -- what I wanted to share with
 4   all of you.  Happy to take any questions in our
 5   remaining time.
 6             MS. JACOBS:  I have one question.
 7             MR. FAGEL:  Sure.
 8             MS. JACOBS:  I'm sure I'll get some of the
 9   specifics wrong, because it's not the criminal activity
10   thing, but like when there's a question and we get
11   comment, what are they called, comment letters or
12   something about our filings or perhaps there was some
13   kind of activity with trading and you get a FINRA letter
14   that says, what do you know, and what was everybody
15   doing on March 6th? That kind of a letter.
16             How come you answer everything, and then you
17   don't get a response back?  And you're supposed to
18   believe that if the file is sort of divisible by two,
19   it's over.  Do you know what I mean?  Or we don't get a
20   response back from the Exchange that says, oh, we're
21   okay with what y'all did on March 6th, and it's over. In
22   other words, you never seem to get case-closed letters.
23             MR. FAGEL:  Yeah.  No, I understand what
24   you're saying.  There's a few different issues wrapped
25   up there.
0155
 1             In terms of FINRA, you know, when there is an
 2   insider trading issue, the exchanges are incredibly
 3   sophisticated.  So they've got bells and whistles that
 4   go off anytime there's an announcement and significant
 5   trading in the days leading up to that.  So it would not
 6   be unusual to get a letter from the exchange.
 7             MR. JACOBS:  Right.
 8             MR. FAGEL:  You know, NASDAQ will send a
 9   letter saying, can you tell us who was involved in this
10   announcement?  You know, I can't tell you what their
11   practice is and why they do or don't respond to what
12   happens afterwards to the extent that results in a
13   referral from the exchange to us, which is typically
14   what will happen.
15             If we begin investigating and talk to you, it is
16   the practice, standard practice of the Division of
17   Enforcement that we complete -- when we complete our
18   investigation, we send a closing letter.  That should be
19   done as a matter of course.
20             It is the instruction to my staff that when we
21   are done, you send a closing letter and say, we're done,
22   and we're not making any recommendation to the
23   Commission that enforcement be brought.
24             MS. JACOBS:  Is that unique to y'all out here?
25             MR. FAGEL:  No.  That is the policy of the
0156
 1   Division of Enforcement.
 2             There are exceptions.  If there is, for
 3   example, criminal interest or if there are different
 4   matters that are related and we're concerned if we send
 5   this closing letter to you and you make it public and it
 6   creates perception, that everything has gone away.
 7             So there's exceptions, but for the most part
 8   that is the practice.
 9             I do get this question periodically from
10   defense counsel who say, well, we haven't heard from
11   you.  You can call.  And, you know, I can't tell you how
12   many times I hear, well, I'm afraid if I call, I'll
13   remind you to take a look at this investigation.
14             My job is to manage what happens in my office.
15   We have multiple levels of management.  I get -- have
16   quarterly calls with Rob Khuzami, the Director of
17   Enforcement in Washington, to go over our docket.
18             We haven't forgotten about the investigation.
19   You're not going to remind us, oh, yeah, that case, we
20   need to sue this company.
21             So it's not that hard to pick up and say --
22   and a lot of people do it, and say, you know, we haven't
23   heard from you in some time, what's going on?  Sometimes
24   they'll say, you know, that slipped through the cracks,
25   we're done.  Sometimes we'll say, it's still going on.
0157
 1             Sometimes, look, you get a difficult matter
 2   and it can take months and months for us to decide how
 3   to resolve it, to work through the Divisions in D.C.  We
 4   can't bring any Enforcement action without the five
 5   Commissioners in Washington signing off.  That process
 6   can take some time, especially for something that's 
 7   novel or controversial.
 8             So sometimes the answer is, I can't tell you
 9   what's going on, but I'll get back to you.  But if it's
10   really we're done, we'll tell you.  That is the policy.
11             In terms of a letter to Corporation Finance, I
12   can't -- I do not know what the process is for closing
13   those down.
14             MR. NALLENGARA:  We do the same thing.  Our
15   policy is to send a letter saying that we're done.  And
16   if we don't, you should -- you should call Marc too. 
17   I'm just kidding.
18             MS. GREENE:  On a standard comment letter like
19   something on a question on filing, isn't there -- and we
20   haven't gotten one in a really long time, no big deal,
21   but I think it says, unless -- once you respond, unless
22   you hear from us, you assume --
23             MR. NALLENGARA:  I think --
24             MS. GREENE:  Is that old?
25             MR. NALLENGARA:  Yeah, I think that's old. 
0158
 1   You shouldn't be getting that.
 2             MS. GREENE:  I don't know how long it's been.
 3             MS. ZEPRALKA:  We send a “no further comments” letter.
 4             MR. FAGEL:  Any other questions I can answer?
 5             MR. DENNIS:  What's your opinion of the crowd
 6   funding?
 7             MR. FAGEL:  What's my opinion of the crowd
 8   funding? Well, I leave it to the regulatory folks to
 9   make those decisions.  I only have to clean up the mess
10   when something goes awry.
11             Okay.  I can't weigh in on that itself.  What
12   I can tell you is the Enforcement staff here gets very
13   busy anytime it is easier for smaller entities and
14   individuals to raise money.  And that's the way it
15   works.  The more -- I do see that the regulatory
16   burdens, as expensive and onerous as they may sometimes
17   be, they minimize fraud.  So it's a trade-off that the
18   industry has to make and that the regulators have to
19   make at what -- you know, what's the cost versus what's
20   the fraud prevention?
21             You know, any time that there is more ability
22   to, you know, widen the net of how many people can be
23   out there raising money for more people, I'm going to
24   get busy with fraud cases.  And I can't tell you how
25   many operators are already out there using the word
0159
 1   "crowdfunding" in their offerings of what are probably
 2   outright frauds or Ponzi schemes.
 3             So, you know, I think that there's some risk
 4   in there.  You know, does it help small businesses?  You
 5   know, that's not for me to say in the equation that I
 6   get into, but there are trade-offs involved.  And I
 7   think it is important to recognize the trade-offs that
 8   it is going to likely result in some problems.
 9             MR. NALLENGARA:  Thank you, Marc.
10             MR. FAGEL:  Thank you.
11             MR. GRAHAM:  So that gives us five minutes.
12             MR. NALLENGARA:  Give people time to check
13   back home.  Meet in ten -- no, no, five.
14             MR. GRAHAM:  It's a negotiation.  Okay.  Ten
15   minutes.
16             (A brief recess was taken.)
17             MR. GRAHAM:  Let's get back together with the
18   afternoon session.  As you know, this afternoon we are
19   talking about the disclosure rules of smaller companies
20   and the issue of scaling.  And we've put together a panel
21   for this afternoon to give us some background.
22             And their full biographies are in the
23   materials that you've received earlier.  Let me just
24   kind of run down briefly who you will be hearing from.
25             First is Steve Bochner sitting next to Lona.
0160
 1   He's a partner at Wilson Sonsini with more than 30 years
 2   of experience practicing corporate and securities law.
 3             From 2009 to 2012, Steve worked as the firm's
 4   chief executive officer, and is currently a member of
 5   its board of directors.
 6             He also recently served on the IPO Task
 7   Force, whose recommendations served as the basis for the
 8   IPO-related provisions of the JOBS Act.
 9             From 1996 to 2011, Steve served on the NASDAQ
10   Listing and Hearing Review Council, and he also served
11   on the California Department of Corporation and
12   Securities Regulation Advisory Committee.
13             Steve also -- Steve was also a member of the
14   SEC's previous Advisory Committee on Smaller Public
15   Companies that was formed in 2005.
16             Steve, welcome.
17             Jeff Schwartz is an associate who -- we kind
18   of skipped over you.  I see "Bobby" in the notes.  Do
19   you go by Bobby?
20             MR. BARTLETT:  I have never been able to shake
21   it.
22             MR. GRAHAM:  Well, we just skipped right over
23   you, Bobby.
24             And finishing up with Jeff Schwartz, he is an
25   Associate Professor at the University of Utah, S.J. --
0161
 1   the S.J. Quinney College of Law.  He teaches business
 2   organizations and corporate finance, and his research
 3   centers on securities law, investment-management
 4   regulation, and retirement policy.
 5             Prior to joining the faculty of University of
 6   Utah, Jeff taught and practiced law in Southern
 7   California.
 8             In practice, he served both as in-house
 9   counsel and as a corporate attorney for Munger Tolles
10   where he represented clients regarding mergers and
11   acquisitions, corporate governance matters, and
12   securities law compliance.  So Jeff.
13             Now back to Bobby.  Robert Bartlett is a
14   Professor of Law at Berkeley.  His primary research --
15   his primary research interests focus on the intersection
16   of finance and business law, and he teaches in the areas
17   of securities regulation, corporate finance, and
18   contracts.
19             He also serves as a member of the faculty for
20   the Berkeley Center on Law, Business and the Economy.
21             So that's -- is that a journal?
22             MR. BARTLETT:  No, it's a center at Berkeley.
23             MR. GRAHAM:  Okay.
24             MR. BARTLETT:  Actually, Steve's there as
25   well.
0162
 1             (Outside noise.)
 2             MR. GRAHAM:  What is that noise?
 3             Okay.  Let's see.  And you're an editor of
 4   Berkeley's -- of Berkeley's VC Research Network.
 5             Bobby previously worked as a corporate
 6   associate at Gunderson.
 7             So that is our expert panel, and looking
 8   forward to hearing what you have to say about scaling,
 9   if we can hear you through the scatter.
10             Who are we starting with?
11             MR. BOCHNER:  Starting with me.  Great to be
12   here. Sitting awfully tall.  Unusual for me.  So it's
13   really a pleasure, a privilege to be here today.  It's
14   hard to believe that our -- I was on the SEC Advisory
15   Committee seven years ago.  And Leroy was on that
16   committee, and there was another member who -- Richard
17   Brown, who's in the audience today.  It was a great
18   experience.  And many of our recommendations did
19   translate into -- directly and indirectly into real
20   (inaudible) form.
21             So we found that the staff took the
22   recommendations very seriously, and we felt like we made
23   an impact.  So I encourage you to take advantage of this
24   opportunity.
25             Some of the things that we focused on in those
0163
 1   days was -- SOX was pretty fresh, and so we spent an
 2   inordinate amount of time on 404.  And I think it had
 3   some role, Leroy, in actually getting the auditing
 4   standard changed.  I think we can take some credit for
 5   that.
 6             Other things like integrating S-B into
 7   Regulation S-K, which got rid of the stigma of using
 8   small reporting rules and other types of scaled
 9   disclosure.
10             So I think you can make a real impact.
11             And so some of the dialogue really hasn't
12   changed a lot from those days.  But 404 just sucked all
13   of the oxygen out of the room.  It seemed for most of
14   those sessions, we did spend a fair amount of time on
15   scaled disclosure.  And obviously that continues to be an
16   issue, how to make the markets, how to make securities
17   regulation achieve that very delicate balance between
18   investor protection and capital raising.
19             So we struggled in those days to try to find
20   it.  I'm sure you're struggling to try to find that
21   balance as well.
22             I'd like to start my remarks with making a
23   connection between the prior panel and the scaled
24   disclosure.  I do think market structure is directly
25   related to the scaled disclosure issue.  I'll talk a
0164
 1   little bit more about that in a moment.
 2             I think we're at a really important juncture
 3   here, and I feel that even more so than what we've
 4   learned since.  And the reason I think we're at a unique
 5   juncture, we have a confluence of changes in 
 6   technology, market pressures, foreign competition, all
 7   kind of coming together and I think creating a cocktail
 8   of, you know, whether you call it innovation or a
 9   thought process, that's really challenging what has up
10   to now been a fairly rigid structure, you know, for 80
11   years since -- almost 80 years since the
12   Securities Act of 1933 was adopted that sort of envisioned
13   a two-tier world: a paper-based world of purely private
14   placements, you know, with some exception.  And then
15   full-blown Sarbanes-Oxley, Dodd-Frank compliant world,
16   a public world.
17             And I think what you're seeing now is that
18   paradigm being challenged, being challenged for a number
19   of reasons.  But one of those is that I think the
20   confluence of increased regulation, some of the trading
21   issues we've heard about this morning, and we're going to
22   hear about later on today.  Investor expectations has
23   created what I call a gap in the capital market.  I
24   think this gap is tangible.  And you in fact have been
25   talking about it today.  It's a gap that's characterized
0165
 1   by how long it takes to get a company public.
 2             In my world, which is kind of Silicon Valley
 3   technology companies, you got a hundred million in
 4   revenue now and have market caps that are approaching a
 5   billion dollars.  We really don't have a viable
 6   chance -- absent some hyper-growth story perhaps, we
 7   really don't have a viable chance of getting Goldman
 8   Sachs, J.P. Morgan to get interested enough to expose
 9   you as an IPO candidate to a client base and -- their
10   customer base.
11             This -- this gap that's developed between the
12   private finance world, the seed round, Series A, B, C,
13   D, and then going public, which used to occur over five years
14   and used to occur when companies noted a $30 million
15   revenue range.  If you go back and look at Cisco and
16   Apple and Microsoft's prospectus, they really could not
17   go public today because they just don't have the scale
18   to support the expense structure that frankly investors
19   would expect through a company.
20             And this gap -- some aspects of this gap I
21   think are good things.  You know, I think to the extent
22   that we've improved investor protection with -- with
23   listing standards and regulation/government reform, some
24   of that is quite good for the retail investors I
25   suppose.
0166
 1             But what it's done in that gap, that move from
 2   five years to ten years, that move from 30 million in
 3   revenue to a hundred million in revenue, that increased
 4   expense structure to support a public company, is it's
 5   created capital raising and liquidity challenges in the
 6   end.  And that's, I think, a lot of what we're talking
 7   about and saying.
 8             As we talk about market structure and talk
 9   about scaling regulation, I think we're really zeroing
10   in on that gap.  And that gap is important because it
11   turns then to foreign competitiveness, growth --
12   economic growth, job creation, and the like.
13             The '33 Act construct, as I mentioned a bit
14   ago, is looking increasingly out of date.  You can
15   see -- you can see that out-of-date aspect to it, not
16   only in the size of the companies that are going public
17   today, but just in the use of technology.
18             The idea that -- that information outflows
19   instantaneously, versus 1933 when you actually had --
20   the rules were designed for paper-based, or paper changed
21   hands.  Investors can get information instantly.  The
22   idea that the prospectus was the sole disclosure
23   document created a regulatory environment around this
24   sort of sacrosanct piece of paper that we use to audit
25   or offer securities.
0167
 1             Now that's coming under a lot of pressure as
 2   investors are bombarded with all sorts of information,
 3   and they can get it instantaneously.
 4             Professor Schwartz, whose paper I read, I
 5   think shares these observations about the outmoded
 6   nature of our market structure.  I think there's only
 7   going to be increased pressure on our market structures
 8   as the need for -- I don't think this gap is going to go
 9   away.  We may be able to ameliorate it with some reduced
10   disclosure and so on.  But I think when the retail
11   investors dispose, I think it's going to be very hard to
12   submit and grow back a lot of reforms.
13             So what I'm intrigued about, is there -- is
14   this two-tiered market structure the best that we can
15   do?  Is that construct from 1933 really the right
16   construct, or are some of these new models that we're
17   seeing fill this gap that I described, whether it's, you
18   know, the SecondMarket/Sharespost providing liquidity
19   or AngelList providing capital raising capabilities,
20   should that be the solution as opposed to sort of
21   arguing about when we roll back SOX, what's the level of
22   disclosure and so on?  Can we be more innovative with
23   different types of market structures that I think are
24   very much in the vein of scaled disclosure?  Scale
25   disclosure by sort of taking the public company world
0168
 1   and trying to roll back disclosures based upon the size
 2   of the company.
 3             But that always presents a dilemma because
 4   those are the -- the smaller companies are the riskiest
 5   companies.  So if you roll back disclosures -- and this
 6   is some of the dialogue we had in our '05, '06 SEC
 7   Advisory Committee -- roll back disclosures for those who
 8   compromise investor protection, the risk is kind of
 9   cumbersome.  So that's the dilemma.
10             Whereas a market structure sort of solution
11   where you tier access to different markets based upon
12   the type of investor so that you -- investors that don't
13   need registration-level protection perhaps have access
14   to different kinds of markets maybe with different tick
15   sizes and some of the other innovations that all of you
16   are talking about, I think that's what -- that's what
17   intrigues me.
18             So I encourage you to think about scaled
19   disclosure and recommendations in both contexts, both --
20   you know, are there things -- is there low-hanging fruit
21   in terms of current securities regulatory environment
22   disclosure requirements and audit standards that really
23   are overkill and not necessary for investor protection,
24   kind of relook at that balancing between capital-raising
25   investor protection, but also take a look at whether the
0169
 1   actual structure of our market, this two-tiered world,
 2   this two-tiered regulatory environment, I might call it
 3   with some license, because obviously there's SEC rules
 4   that do different things.  Reg A might be a good
 5   example.
 6             But by and large, that's kind of how -- you
 7   know, that's how the world has worked.  Private
 8   placements, public offerings, those worlds have gotten
 9   further apart, it's created this gap in the middle, all
10   this pressure.  And I think that's a big reason why
11   you're here today.
12             Some of the changes that we need to bring
13   about these kinds of market structure innovations we
14   recommended in 2006.  And some of them have been
15   addressed at the SEC Small Business Forum over the years
16   or in the report.  I remember that; I presided over
17   that.
18             And some of them are -- have become law and
19   are about to become law under the JOBS Act.  And
20   examples of that are Section 12(g) relief, the 500 shareholder
21   relief, facilitating new methods of solicitation using
22   modern technologies.
23             Knocking on doors on Sandhill Road is one way
24   to find investors, but we have -- if we can find
25   people spouses on the Internet, can't we hook up more
0170
 1   efficiently investors and companies in some way that
 2   doesn't compromise investor protection?
 3             Professor Schwartz points out in his paper
 4   additional solutions should be scaled.  I mean, the size
 5   of the issuer, the investor protection.  And that
 6   would -- I think that would not only help with capital
 7   formation and job creation, but also help our foreign
 8   competitiveness against markets, which still have yet, I
 9   think, to be a real threat to our domestic markets here.
10             But I don't think that's going to last for a
11   decade or two decades.  I think more markets are
12   going to compete for listings or certain listings,
13   companies in those areas.  I think they've done that
14   successfully.
15             Where they have been less successful is
16   competing for listings with, you know, the mainstream
17   U.S. venture backed high profile issuer.  We've managed to
18   hang on to those, but I don't think we can take that for
19   granted.
20             You know, I think, as is the case with other
21   industries, the U.S. should innovate their market
22   structure, the same way it is innovative with respect to
23   information technologies and life sciences.
24             So I've been pontificating a bit, but I do
25   have some specific recommendations about things that you
0171
 1   can do.
 2             Before I go to those, let me -- let me just
 3   talk about an example of a new kind of market structure,
 4   which is AngelList.  And if you haven't seen AngelList,
 5   it's an online marketplace where you have to get -- you
 6   have to prove you're an accredited investor, and
 7   companies can list matches, investors, and companies.
 8             And we -- I think just a couple of days ago we
 9   announced in conjunction with AngelList that we are --
10   that they put up a new portion of their website where
11   startups can go and basically close a financing on an
12   automated basis using documents online.  And we -- and
13   we committed that for clients we then take on -- we'll
14   do that part of the closing process for free.
15             So you can see the, you know, the amazing
16   change over just a decade ago where you can go -- where
17   you go on a website, hopefully get access to investors
18   that are interested, have a term sheet negotiated, have
19   financing documents created.  And basically lawyers who
20   author them still need to be involved in things like
21   disclosure schedules and organization and securities law
22   for clients.  But the basic fundamentals of generating a
23   term sheet and generating a document and finding
24   investments are automated, and I think that's really
25   cool.
0172
 1             And I think there is -- excuse me.  I think
 2   there's more of that to come.  And I think SecondMarket
 3   and Sharespost will reflect that innovation with respect
 4   to liquidity.
 5             Several years ago I gave a series of talks on
 6   what kinds of regulatory changes would be necessary to
 7   bring about innovation with respect to these alternative
 8   markets.  And I said there were four changes which need
 9   to be made in order to have kind of this gap filled with
10   a different kind of market structure.
11             I said one was a change to the 500 shareholder
12   test.  Because if you had a robust alternative market,
13   as soon as you got the 500 shareholder, you go public,
14   you know, nobody was going to do that.  You weren't
15   going to have meaningful liquidity.  So I said there
16   needed to be some relief to allow companies to be able
17   to operate in that segment without fear of having to
18   register.
19             I said secondly there needed to be some
20   changes to the general solicitation provisions to use
21   modern technologies and access a broader swath of
22   investors using technology.
23             Thirdly, I suggested that federal preemption
24   of Blue Sky laws was necessary because Blue Sky amounted
25   to a 50-state Blue Sky compliance check.  And to do
0173
 1   compliance work, using a private company is expensive
 2   and burdensome.
 3             And lastly, I said that you needed to provide
 4   better liquidity through 144 amendment.
 5             So I said, if you could imagine all those
 6   things being done, you could envision a different kind
 7   of -- kind of market structure, perhaps with different
 8   governance standards and listing requirements that could
 9   provide some amount of liquidity, some amount of capital
10   raising, and be accessible by investors, that, from a
11   regulatory point of view, whether it's accredited
12   investors or some higher standard, are investors that
13   are deemed not to need registration’s
14   protection.  So sort of a scaled market approach.
15             So interestingly, the first two have actually
16   been accomplished during the process being accomplished
17   by the JOBS Act.  You have 12(g) relief under the JOBS
18   Act.  And the SEC, as Lona indicated this morning, just
19   published a proposal regarding the general solicitation
20   provision.  I'll comment on that in a moment.
21             I think that the two other changes are ones
22   that I hope you think about.
23             One is -- one is 144 change.  And let me
24   explain it this way:  Under Rule 506, if I'm an issuer,
25   I can sell stock to an accredited investor without
0174
 1   registration.  And let's say that investor is Sequoia
 2   Capital, a well-known venture capital fund.  Sequoia
 3   Capital, though, if it wants to sell those shares and
 4   rely on an SEC safe harbor, it has to have a one-year
 5   holding period, even if it's selling those shares to
 6   Kleiner Perkins.  And the reason that that's an issue
 7   is that creates stiction.  If you imagine an efficient
 8   middle market -- actually, it's stiction, which I
 9   believe is unnecessary.
10             In other words, if an issuer can tell -- sell
11   to Sequoia without registration because Sequoia meets
12   whatever standards are put into place for investors who
13   don't need registration-level protection, why does
14   Sequoia have to endure a one-year holding period to sell
15   to another similarly situated investor?  I would argue
16   you don't need that.  There's no investor protection
17   mandate in that one-year holding period as long as the
18   transferee meets the same standards as are required when
19   that first investor parts with their money.
20             So I think what that would do -- there is a
21   "if we build it will they come" aspect to this.  That
22   may be above my pay grade because it really relates to
23   our institutional investors in the market, you know. But
24   early indications if you look at AngelList are -- I
25   think are certainly intriguing in that regard.
0175
 1             MR. WALSH:  Do you know the rationale for that
 2   decision years ago?
 3             MR. BOCHNER:  What's that?
 4             MR. WALSH:  The one-year hold.
 5             MR. BOCHNER:  Yeah, there's a good rationale
 6   for it. And Lona can chime in here, too.
 7             But the thinking is that if you have -- if you
 8   go through -- from a regulatory point of view, if you
 9   require a company to file a registration statement, you
10   know, that exposes retail investors.  If you have a
11   private placement, you don't have to do that with
12   certain standards that you put in place like accredited
13   investors.
14             But yet, if accredited -- if you are an
15   issuer, I can sell to an accredited investor, and the
16   accredited investor can turn around and distribute the
17   shares publicly to a bunch of non-accredited investors
18   without registration, then that’s just really an end-run
19   around the registration requirement.
20             So it was put in place for a good reason. 
21   It's just that I think, you know, this -- you know, the
22   idea of this sort of secondary market, this middle
23   market was not really in existence then.
24             So I think we now need to expand that thinking
25   to say, well, trans -- we don't need a one-year holding
0176
 1   period if the transferee meets whatever standards we set
 2   for not needing registration level protection.  So --
 3             MS. SMITH:  Steve, your standard of time that
 4   they're warranting, you know, that there's a demand for
 5   accredited investors wanting to pick up that
 6   (inaudible).
 7             MR. BOCHNER:  Karen, well, you're -- given
 8   your background, you probably have more expertise on
 9   this than I do, but I think you suffered from the other
10   side of that in your prior role because I think
11   there's -- the answer is, from my experience, that
12   companies do want that, but they want to control it. 
13   And so I think a lot of, what I know you had to deal
14   with in your prior life was sort of the bad side of
15   that, shares getting out, being out of control, worrying
16   about the 500 shareholder test, worrying about the
17   company liability.
18             So I think that the standards aren't in place
19   yet, but I think the issuers would like to facilitate
20   that liquidity, but control it.
21             MS. SMITH:  Because the issue we had
22   (inaudible) --
23             MR. LAPORTE:  Could you make sure to
24   speak into the microphone, please?
25             MS. SMITH:  Sorry.
0177
 1             I mean, I think we have the issue of the
 2   example of Sequoia wanting to sell to Kleiner, it was
 3   employee A wanting to sell shares to some random person
 4   to offset the market.  I guess I'm just curious
 5   (inaudible).
 6             MR. NALLENGARA:  Yeah.  It's a fair question
 7   whether Sequoia can sell it through some trading
 8   facility, not sell it through another private -- I mean,
 9   their -- your question is whether they -- whether they
10   can freely trade the securities rather than rely on
11   other private placements to sell the securities.  So,
12   you know, Kleiner -- Sequoia sells to Kleiner, the
13   problem is you couldn't sell it, you couldn't put it in
14   newspaper ads and sell the securities you bought.
15             MR. BOCHNER:  Oh, correct, yeah.
16             MR. NALLENGARA:  What you're suggesting is
17   someone taking advantage of some -- someone being able
18   to take advantage of AngelList or some list like that to
19   be able to sell the securities.
20             MR. BOCHNER:  So if AngelList -- if AngelList,
21   not to pick on them.  You imagine some market structure
22   that's a credible market structure, maybe it has
23   listing -- some listing standards, maybe some governance
24   standards, but well below the Sarbanes-Oxley, Dodd-Frank
25   level.  It would be a place where you could go to raise
0178
 1   capital, like AngelList is facilitating today.  And
 2   hopefully there is going to become a meaningful middle
 3   market, would allow some -- some liquidity.
 4             And if I were saying that there would be an
 5   issuer control liquidity, I think the issuer should have
 6   control have to (inaudible) to the board.
 7             But to the extent that you had a one-year
 8   holding period existing today, so you actually had to
 9   buy it, that would create a lot of inefficiency.  But
10   there's -- you know, there are other ways to trade
11   securities like the four one and a half exemption, but there's
12   sort of a race to the bottom.
13             You're smiling, because you're well aware of
14   that.
15             So we do need -- I think we do need either --
16   in order to -- if you like the idea of a different
17   market structure and you like the idea of having some
18   liquidity in that market structure, then a one-year
19   holding period doesn't make sense.  As long as the buyer
20   of that is also on that -- on that marketplace that only
21   allows investors that don't need registration protection
22   and is done in a way that the issuer has decided to take
23   advantage of.  So the issuer is always going to say, I'm
24   either going to list there, I'm not going to list there.
25   I'll allow my shares to be traded there.
0179
 1             And certainly, as you point out, Karen, I
 2   think a lot of the liquidity strains are coming from
 3   employees who have worked for seven years and they want
 4   to buy a house or they have other health needs or
 5   whatever, and yet the company can't go public yet.  It
 6   doesn't meet this ever increasing threshold to go
 7   public.  I think a lot of stress and strain, frankly, I
 8   think a lot of these business models are propped up to
 9   deal with that.
10             And I think your prior employer is just sort
11   of one of the very early companies that started -- that
12   had gotten into -- that was kind of dealing with an
13   environment that was equipping it with all sorts of
14   issues.  And some of these, like the shareholder test,
15   help ameliorate to some degree.
16             So I'll hurry up so I'm not taking too much
17   time away from these other presentations.
18             So the first of my recommendations are to
19   consider both whether the 144 one-year holding period
20   makes sense if the transferee meets certain standards.
21   And the second is federal preemption with respect to
22   that secondary transfer, some kind of a 50-state Blue
23   Sky.
24             Secondly, and this is a little long-term, I
25   think the 500 shareholder relief is welcome.  There's
0180
 1   one little tweak that I'm kind of unhappy with, which is
 2   that while employees are excluded from the -- now the
 3   2,000 shareholder count, accredited investors aren't.
 4   And I would argue that if an accredited investor can buy
 5   shares from an issuer without registration, why should
 6   just a sheer number of them give rise to the need for
 7   registration under the '34 Act?
 8             So I think in addition to employees being
 9   excluded from the account -- 2,000 shareholder count,
10   which they are now under the JOBS Act, in theory, that
11   the protections aren't needed because these are
12   compensatory transactions, not capital raising
13   transactions.  I think the same theory should apply to
14   investors that are determined under other SEC rules not
15   to meet registration-level protection.  So just
16   adding -- adding the numbers shouldn't give rise to
17   that.
18             So my second recommendation, and I think this
19   is longer term, but would be to exclude accredited
20   investors from the count.
21             You know, I have a third recommendation, which
22   is not really in the scaled disclosure area, but it
23   relates to Rule 506.  Lona heard me make it on a webcast
24   the other day.  But I think the SEC's proposed rule
25   under the general solicitation provisions is too broad.
0181
 1   I was -- as Steve mentioned, I was a member of the IPO
 2   Task Force that helped come up with some of the ideas
 3   behind the JOBS Act, and general solicitation was one of
 4   them.
 5             But I certainly don't want to see late night
 6   TV ads, newspaper ads, Internet, you know, commercials,
 7   you know, blasting, hawking stock.  I think that's bad for
 8   the markets.  I think it's bad from a regulatory point
 9   of view.  And I think it's bad for the kind of reforms
10   we're talking about here.
11             And it -- you know, the question is whether
12   the SEC has the authority under the JOBS Act to
13   constrain that.  I actually think they do.  I think
14   it's -- I think even though the bill says eliminate the
15   general solicitation provisions, I don't think that
16   means that the SEC can't regulate as to how that
17   solicitation occurs.  And I think the SEC's experts in
18   these areas will have to decide whether or not I'm right
19   about that.
20             But I think SEC rules like 134 and 135 provide
21   a really good template for when the retail investor is
22   exposed, you know, how a company should be permitted to
23   offer stock in newspapers and TV and ads.  That's my
24   third recommendation.,
25             My fourth does finally -- I should get to scaled 
0182
 1   disclosure.  We took a hard look at this.  We -- in '05
 2   and '06 -- we suggested that many of the small business
 3   reforms get made accessible to a broad swath of smaller
 4   public companies.  And these are things like a reduced
 5   business section, reduced MD&A, reduced market risk
 6   disclosure, reduced executive compensation provisions.
 7   Some of these are addressed in the JOBS Act.
 8             I would encourage you to look at the
 9   threshold, to read it, that was established as a result
10   of our work in those days, which is a smaller reporting
11   company, $75 million in market cap, which is not very
12   meaningful. You get a company public with that kind of
13   market cap and ask yourselves whether that threshold
14   ought to be raised with some meaningful number.
15             You know, back in '06 we were -- I haven't
16   updated this, but I think we were given the information
17   by the SEC Office of Economic Analysis, which said that
18   companies above $787 million in market capitalization
19   represented basically 94 percent of U.S. market
20   capitalization, meaning that companies below that market
21   cap are very unlikely to result in systemic risk.  You
22   know, you're just not having that much of a market cap
23   affected.
24             And you kind of use that as a theory to say,
25   well, if that's the case, there's no real systemic risk,
0183
 1   which is sort of -- those were in those days
 2   Sarbanes-Oxley and Dodd-Frank, let's see if we can't do
 3   some things to make the disclosure burdens lessen.  So
 4   take a look at the scaled disclosure, the size, and see
 5   if there's other low-hanging fruit out there.
 6             And then I have one more recommendation.  And
 7   I have a prop for this recommendation, actually, that
 8   Lona took a peek at.
 9             This is my prop.  And this is -- this is -- I
10   had printed out a client's filings.
11             Anybody guess how many years of SEC filings
12   this is for my client?
13             PARTICIPANT:  One.
14             MR. BOCHNER:  One year.  And this is a --
15   there's a proxy statement, 10-Qs, and one 10-K.  And
16   back in '05, '06 we actually recommended that EDGAR be
17   reformed and looked at.
18             EDGAR, you know, is a -- if you go on EDGAR
19   today, what you get is sort of a chronological listing
20   of filings.  So 10-Q, 10-K, bunch of forms, proxy, 8-K.
21             And it's very hard to find stuff.  You know,
22   where's the current business section, where is -- I
23   mean, I couldn't -- if you ask me, and I kind of read
24   this stuff for a living, tell me what the CEO made last
25   year, I can sort of find it, but it would take me a
0184
 1   while.  I have to know what document to go in.
 2             And there's a lot of repetition in here. 
 3   There are financial statement footnotes that repeat over
 4   and over and over.  And it takes a lot of work, lawyers
 5   reviewing it, accountants reviewing it.
 6             And I would argue that, even if this is
 7   written in plain English, this really isn't plain
 8   English.  When something gets this big, it's not plain
 9   English.  It's just hard to find.
10             So I think that -- there was an SEC initiative
11   many years ago called the 21st Century Disclosure
12   Initiative.  I think it generated some ridicule to call it
13   that.  But I actually think it proposed a really
14   interesting idea, which is to sort of do away with the
15   idea of the serial chronological list of filings.
16             And when a company goes public, they file a
17   company registration.  That's their document.  That's a
18   disclosure document.  And every time a quarter occurs or
19   year occurs, you update that document, and you can see
20   where it got updated.  So there's one static document.
21   As the business section, as the current comp, you can go
22   back and I think with technology figure out what the
23   company -- what changes had gotten made.  But basically
24   there's one place to look.
25             And I think it would make -- I think it would
0185
 1   reduce costs, and I think it would make the ability of
 2   investors to ferret out information much, much better
 3   and can actually help the rest of us.
 4             So, again, thanks for having me here today,
 5   and I really look forward to reading your
 6   recommendations.
 7             MR. GRAHAM:  Thank you, Steve.
 8             Who's next?  Let's go.  We think it's you,
 9   Jeff.
10             MR. SCHWARTZ:  Okay.  So, first of all, thank
11   you very much for inviting me to share my thoughts
12   today.  I think, Bob -- Mr. Bochner --
13             (Outside noise.)
14             I think I'll wait.
15             (Pause.)
16             Okay.  So thanks a lot for having me.  I'm
17   very excited to share my thoughts with you all.  I've
18   been following the committee closely from afar.  I
19   watched the webcast of the last meeting, so it's a
20   little surreal.  I actually recognize all of you, but
21   you don't recognize me.  And that's all a little
22   surreal.
23             Anyway, so in preparing my comments for today,
24   what I tried to do is to make them as relevant as
25   possible for the Committee at this point in time as you
0186
 1   all seek to improve market conditions for small and
 2   emerging companies.
 3             To that end, what I thought I would do was
 4   first briefly assess the helpfulness of scaled disclosure
 5   and other current efforts to provide regulatory relief
 6   to small and emerging companies.  I plan to focus on the
 7   smaller reporting company or SRC rules that were adopted
 8   a few years ago, and then talk a little bit about the
 9   JOBS Act, which, of course, was adopted earlier this
10   year.
11             Second, I'll offer my thoughts on what might
12   be advisable next steps to build upon those recent
13   reform efforts.  I'll offer suggestions about how to
14   identify candidates for reform, and I'll give a few
15   suggestions of my own.
16             And then finally, I'll discuss if -- rather
17   than having small and emerging companies trade alongside
18   large established ones in the same market as we do
19   today, it might be better for these firms to have their
20   own market, with each of these markets set up with
21   specifically designed regulatory frameworks.  I think
22   that builds a lot on what Mr. Bochner was saying
23   earlier.
24             So, first, turning to the Smaller Reporting
25   Company rules, the SRC rules essentially provide for
0187
 1   scaled disclosure for companies with a public float of
 2   under $75 million.  As was already brought up, what this
 3   allows for, is it allows these companies to provide
 4   fewer years of financial statements and less information
 5   about their businesses and about their finances.
 6             And while this seems like a nice change,
 7   what's important to note about the SRC rules is that, in
 8   substance, they're based upon around and largely a
 9   continuation of the Small Business Issuer rules, which
10   has -- which had existed since 1992 throughout the
11   period of IPO decline.
12             What happened was that when the SRC rules were
13   put in place, the SEC essentially merged Regulation S-B
14   into Regulation S-K.  And while this certainly cleaned
15   up the statute a lot, the adoption of these new rules
16   didn't do anything to offer any additional regulatory
17   relief to these small and emerging companies.
18             What the new rules did do, however, was
19   broaden access to scaled disclosure.  Under Regulation
20   S-B, in order to qualify as a small business and to
21   receive scaled disclosures, you had to have under $25
22   million in revenues and a public float of under $25
23   million. Whereas, as I already alluded to, in order to
24   qualify for special treatment as an SRC, you can have up
25   to three times that amount in public float.
0188
 1             So the rules did make a substantive change
 2   here, in that, while they didn't actually provide for
 3   more regulatory relief, at least they brought in the
 4   number of firms that would be able to take advantage of
 5   it.
 6             But, as was already pointed out, $75 million
 7   is a very small number.  So it only extends the
 8   regulatory relief to the smallest of the public
 9   companies.
10             And while it's difficult to make too much of
11   this, the adoption of the SRC rules didn't seem to move
12   the needle much in terms of IPOs.  In other words, the
13   IPOs continued to decline after the SRC rules were put
14   in place, which at least suggests that it didn't do much
15   to make the public market that much more attractive to
16   emerging companies.
17             So my bottom line for the SRC rules is that,
18   while their heart is in the right place with scaled
19   disclosure, the regulatory relief that the rules provide
20   was likely too modest to do much good for any companies
21   that we're concerned about.
22             The JOBS Act, though, can be seen as an
23   attempt to offer further assistance.  And in contrast to
24   the SRC rules, the JOBS Act did make a lot of changes. 
25   But I'm not that optimistic that the JOBS Act will do
0189
 1   that much to improve matters either.
 2             So one thing that the JOBS Act does is that it
 3   focuses on emerging firms to the exclusion of small
 4   ones.  So small companies that went public prior to the
 5   JOBS Act got no additional regulatory relief under the
 6   statute.  And similarly, those companies that do go
 7   public under the JOBS Act lose the protection of the
 8   statute after five years.
 9             Another concern I have is that, even what the
10   JOBS Act does attract -- so what the JOBS Act does do is
11   it provides regulatory relief for emerging firms, I'm
12   afraid that the regulatory relief it provides for
13   emerging firms doesn't do enough to make the public
14   markets more attractive for them either.
15             What the JOBS Act does, among other things, is
16   that it eases the rules on providing research reports
17   regarding emerging companies, both before, during, and
18   after the IPO process, and it also adopts some scaled
19   disclosure.  But the scaled disclosure that the JOBS Act
20   provides for is rather modest.
21             And with respect to the provision of research
22   reports, there's been some rumblings that investment
23   banks and analysts are taking a wait-and-see approach
24   before taking advantage of the regulatory flexibility
25   that the statute provides for.  So I'm not confident
0190
 1   that those JOBS Act reforms will lead to that many more
 2   public companies.
 3             And finally, one particular worry I have about
 4   the JOBS Act is how the on-ramp provisions of the Act,
 5   which are designed to make going public more attractive,
 6   interact with the changes to Section 12(g), which, by
 7   raising the shareholder thresholds which trigger public
 8   reporting, makes it easier for companies to remain
 9   private.
10             What I'm concerned about is that because of
11   the changes to Section 12(g), more companies are going
12   to opt to remain private, and that this undermines the
13   goal of the on-ramp provisions and also can contribute
14   to the further erosion of our public equity market.
15             While this might be defensible, while having
16   firms stay private might be a defensible outcome, it
17   might be a defensible outcome if we thought that the
18   private markets had something to offer these small and
19   emerging companies.  If we thought the private markets
20   offered a viable alternative to small and emerging
21   firms, we might not be bothered by the fact that more
22   companies are opting to stay private.
23             But my own view is that the private markets
24   don't offer a viable alternative and that the lack of
25   regulatory structure that supports liquidity and
0191
 1   investor protection, and I think they raise various
 2   concerns to the extent that participation is limited to
 3   QIBS and accredited investors to the exclusion of
 4   everyone else.
 5             The way I view the equity markets overall is
 6   that there is a -- is that there is in fact -- no, let
 7   me say it again.
 8             The way I view the equity markets overall is
 9   that even though we have scaling in the SRC rules and
10   through the JOBS Act, that even though we have this,
11   there is this vast gulf between the highly regulated
12   public stock markets and the lightly regulated private
13   markets, and that neither of these alternatives is
14   attractive to emerging companies.  So it very much
15   builds on what Mr. Bochner was saying.
16             And I think in light of this vast gulf,
17   perhaps what is missing is an intermediate regulatory
18   framework. And the way I picture this framework is as
19   having many of the hallmarks of the public securities
20   regulation, but at the same time containing
21   significant-enough cuts to regulation to have a material
22   impact on the amount that the firms we're concerned
23   about actually spend on compliance.
24             Now, I'm under no illusion that regulatory
25   change would be a silver bullet.  As the Committee has
0192
 1   discussed, there are a number of reasons that explain
 2   the decline in a small company market over time.  But I
 3   don't think that's a reason not to make regulatory
 4   changes.  I think that if we put our efforts into
 5   designing an efficient regulatory structure, it would
 6   help matters.
 7             One way to go about this, one way to create
 8   this improved intermediate regulatory structure would be
 9   to broaden and deepen the scaling of regulations that
10   already exist under the current rules.
11             So first, looking at the broadening as already
12   noted, the SRC rules, special treatment under the SRC
13   rules is limited to companies under $75 million in
14   public equity outstanding.  But there are far more
15   companies out there that could likely benefit from
16   regulatory relief.
17             In fact, maybe we should be looking at this
18   from a different perspective.  Maybe instead of only
19   providing regulatory relief to the smallest public
20   companies, perhaps everyone should get regulatory
21   relief.  Everyone, that is, except for the largest
22   public firms.
23             Several academics have pointed out that the
24   regulations that have been added on in recent years have
25   had the largest public companies in mind.  They've been
0193
 1   targeted at their misdeeds.  And there's really been an
 2   effort to hold these firms accountable for their
 3   actions.  And that, really, small and emerging companies
 4   have just been caught up in the net.
 5             If we look at the world this way, you can
 6   picture a structure, a regulatory structure where the
 7   largest public companies, the corporate high -- the S&P
 8   500 type firms that make up the large percentage of the
 9   market capitalization, that these companies are subject
10   to the highest regulatory scrutiny, but that small,
11   midsized, and emerging firms are subject to an
12   intermediate level of security.
13             So only the highest, only the largest firms
14   would have this highest level of scrutiny.  Everyone
15   else would be subject to a subset under those
16   requirements.
17             Okay.  But what should those -- what should
18   that subset be?  So it's easy to say we should have an
19   intermediate regulatory structure, but, of course, it's
20   very difficult to actually come up with one.
21             In theory, regulation should decrease a firm's
22   cost of capital, right, as investors feel less of a need
23   to discount a firm's shares to account for fraud and
24   incomplete information.  This means that in cutting
25   regulation, we raise the risk of actually raising a
0194
 1   firm's cost of capital.  And if we raise a firm's cost
 2   of capital by more than we lower its compliance cost,
 3   then we've actually done damage to the very firms that
 4   we're trying to help.
 5             If we look at the world this way, then what it
 6   turns out we have to do is that we have to focus our
 7   efforts on finding those regulations that cost the most
 8   in terms of compliance, yet deliver the least in terms
 9   of benefits, deliver the least in terms of investor
10   protection.
11             While this also is hard to do in practice,
12   here's a list of some candidates at least to think
13   about, some candidates for further discussion, for
14   further investigation.
15             So up here, as you look at the regulation
16   category, we have the usual suspects, I guess, of
17   Sarbanes-Oxley and Dodd-Frank.  Smaller reporting
18   companies already get relief from Section 404(b) of
19   Sarbanes-Oxley, but perhaps they could also get relief
20   from 404(a), if not more.
21             Under Dodd-Frank, smaller reporting companies have a
22   temporary exemption from the Say-on-Pay rules, but
23   perhaps they could be exempt from a lot more of that Act
24   as well.
25             The Committee can also look at the MD&A, the
0195
 1   Executive Compensation section of the Exchange Act
 2   reports of these companies.  There's already some scaled
 3   disclosure for smaller reporting companies when it comes
 4   to those areas, but perhaps these could be extended upon
 5   as well.
 6             But I don't think the committee needs to stop
 7   and just look at how to scale regulation.  I think there
 8   are other areas where reforms could help lower costs as
 9   well.
10             So if we look at the middle category, we have
11   the litigation environment.  Perhaps steps can be taken
12   to make the litigation environment a bit less costly as
13   well.
14             One area that the committee could look at is
15   Rule 10(b)(5), at least as it pertains to secondary
16   market transactions.  So let me flesh that out a little
17   bit.
18             So Rule 10b-5 is a foundational provision,
19   but legal academics have actually long questioned the
20   usefulness of 10b-5 damage awards against companies
21   for fraud in connection with secondary market
22   transactions in which the company played no role.
24             In these secondary market transactions, in
25   this context, where the issuer was not involved with the
0196
 1   transaction, these damage awards tend to lack a term
 2   function because the officers and directors who were
 3   involved with the fraud are rarely personally liable
 4   because they will be indemnified or insured.  And these
 5   awards also lack a compensation value as well because
 6   what ends up happening is that these damage awards are
 7   both paid by and paid to diversified shareholders.  So
 8   in the aggregate, what ends up happening is shareholders
 9   end up paying themselves, minus a sizeable chunk for
10   attorneys.
11             So in light of this -- in light of the
12   circularity of 10b-5 damage awards in this context,
13   some academics have recommended a cap on 10b-5 damage
14   awards.  Perhaps if we can -- if all companies are in
15   this cap, it can be something that can be applied to
16   small and emerging firms.
17             I also have up there Section 11 liability.
18   Section 11 is a provision of the securities laws that
19   allows shareholders to sue based on material
20   misstatements in registration statements.  But the
21   shareholders do not need to show causation or (inaudible).
22             This heightened standard -- or I should say
23   this lowered standard in order to recover, this does
24   serve an investor protection function; that is, it provides
25   more protection for investors when they can sue without
0197
 1   having as many elements to show.
 2             But there are some folks out there who also
 3   think that the risk of Section 11 -- the risk of Section
 4   11 liability is deterring companies from going public
 5   and also leading to overly costly and perhaps
 6   duplicative due diligence efforts in order for companies
 7   who are -- the companies are taking in order to -- in
 8   order to avoid being sued.
 9             So in light of the expenses that arise with
10   Section 11, perhaps Congress could amend the section, so
11   that rather than providing that shareholders can sue
12   based upon it, perhaps it can only be the SEC.
13             Finally, the other category I have up there is
14   listing standards.  Today, among other things, New York
15   Stock Exchange, NASDAQ rules require that all the
16   companies have a majority independent board.  And while
17   this also may serve an investor protection function,
18   it's actually empirically and theoretically contested
19   exactly how much investor protection good independent
20   directors do.  And it turns out that independent
21   directors are particularly costly for small and emerging
22   companies.
23             So perhaps some thought can be given to using
24   these rules for small and emerging firms and simply
25   having these companies report on the extent to which
0198
 1   their directors are independent.  And this is already
 2   required that they report on this, and perhaps that rule
 3   would just be in case, and be the sole rule, that relates
 4   to director independence.
 5             MR. WALSH:  Can I ask a question?  What do you
 6   mean the more expensive independent director?
 7             MR. SCHWARTZ:  So there's a study -- so
 8   independent directors are just expensive because you
 9   have to pay them, right?  And it just -- it eats up a
10   greater percentage of the revenue of smaller firms to
11   pay these independent directors.
12             So there's been interesting studies out there
13   that show how much per dollar of revenue smaller
14   companies are paying on independent directors after
15   Sarbanes-Oxley, after these listing standards were put
16   in place, and it's a very high percentage, much higher
17   than it is for larger companies.
18             Does that answer your question?
19             MR. WALSH:  Mm-hmm.
20             MR. SCHWARTZ:  Great.
21             Okay.  So those are my candidates for reform.
22   I offer these as food for thought.  But I also think it
23   would be greatly helpful for the Committee, as part of
24   its ongoing efforts, to dive deeper into the costs and
25   benefits of securities regulation as it pertains to the
0199
 1   companies that we're concerned about.
 2             To add rigor to the difficult exercise of
 3   recommending exact reforms to the SEC and Congress, I
 4   think it would be helpful to do a couple of additional
 5   things.
 6             So one of which would be for the Committee to
 7   either review or commission a review of the recent
 8   empirical scholarship as it pertains to the cost and
 9   benefits of securities regulation in this area.  And
10   beyond that, the Committee could even undertake or
11   commission someone else to undertake its own study, a
12   study where it directly looks at the cost and benefits
13   of regulation in this area.
14             On the cost side, there can be a survey of
15   listed firms, preferably firms that are emerging
16   companies or smaller ones, to get a sense of what they
17   view as the most expensive and intrusive provisions. But
18   the cost is only one side of the equation, and likely
19   the easier side to measure.
20             It would also be beneficial for the Committee
21   to survey those who had input on the benefit side of the
22   securities laws.  So to that end, there could be a
23   survey of sophisticated investors.  Ask sophisticated
24   investors what they look at when valuing securities.  If
25   they don't think something is important when valuing
0200
 1   securities, likely it doesn't have that big of an
 2   investor protection benefit.  Because if it has an investor
 3   protection benefit, that should be reflected in the price.
 4   And these are the people who drive the prices.
 5             So like I said, I think what I mentioned are
 6   good areas to start looking, but I think digging deeper
 7   into the cost and benefits through your own study or by
 8   reviewing the empirical scholarship that already exists
 9   would also prove helpful.
10             Okay.  Finally, to transition just a little
11   bit abruptly into my final point, today, as we see on
12   the right side of the slide, we have emerging growth
13   companies and smaller reporting companies trading
14   alongside larger firms in the broader public market.
15             Because of this, the special regulatory
16   treatment to which SRC and emerging growth companies are
17   entitled under the JOBS Act and under the SRC rules,
18   because these firms trade alongside larger companies in
19   the broader market, this special regulatory treatment is
20   embedded within and, to the untrained eye, hidden within
21   the broader public markets.
22             If we simply continued to broaden and deepen
23   the regulatory relief provided under the JOBS Act and
24   the SRC rules, what we would also do is continue with
25   this construct, this construct where you have firms of
0201
 1   various shapes and sizes all trading together, but all
 2   subject to their own specific regulations.
 3             But I'm not sure this is the best approach.
 4   Instead, maybe it's better to separate things out, to
 5   have firms -- to have different types of firms trade on
 6   different markets, and to have these markets set up so
 7   that they have regulations and a market structure that
 8   actually fits these firms.  And that's what we see on
 9   the left side of the slide.
10             In my article that was included in the
11   background materials, I argue that we should have
12   separate markets for firms at different stages of their
13   lifecycle.  So we would have a market for emerging
14   companies and a market for midsize and smaller
15   companies.  And these markets could be subject to an
16   intermediate regulatory structure.
17             We would also have a market for large
18   companies.  And this market for large companies would be
19   subject to the highest level of regulatory scrutiny.
20             And I offer this suggestion because I think
21   there are several benefits to separating different firms
22   out into different markets that are narrowly tailored to
23   fit those firms.
24             One advantage is that if we were to separate
25   things out in this way, we would have regulatory
0202
 1   consistency within each market.  All of the firms in the
 2   market would be regulated similarly.  This would mean
 3   that they would be easily comparable, which would
 4   increase efficiency on the market.  Also, if we
 5   separated things out in this way, there would be less of
 6   a potential for investor confusion.
 7             So, for example, let's say that Congress or
 8   the SEC did choose to put a cap on its 10b-5 damage
 9   awards for smaller companies.  If this happened and if
10   these companies continued to trade alongside larger ones
11   in the broader public market, retail investors might not
12   realize that these smaller companies have this
13   limitation on litigation recovery.  If, however, we had
14   smaller and emerging firms trade on their own markets,
15   we could make this limitation much clearer.
16             Another benefit of separating firms out into
17   different markets is that you could structure the market
18   itself to fit the firms that trade their own.  So as
19   this Committee has discussed at length, smaller
20   companies face concerns regarding liquidity, and the SEC
21   or Congress may want to tackle those concerns by
22   allowing firms to choose their tick size or allowing
23   them to pay for liquidity or through some other avenue.
24             If regulators want to take that approach, I
25   think it would be much cleaner and much easier to do, if
0203
 1   these firms actually traded on their own markets.
 2             If instead you apply these tick size rules or
 3   other liquidity rules to these firms in this broader
 4   public market, I think it might be confusing, and it
 5   might just be difficult to do, and clearer if they were
 6   all separated out.
 7             Like, it would -- for example, it would be
 8   much easier if the midsize and smaller company market
 9   had one tick size, and the large company market had
10   another.  Or a small company market, you had a regime
11   where you could pick your tick size, whereas the large
12   company market you did not, something along those lines.
13             Finally, the last benefit is that today when
14   firms go public, they do so amidst a great deal of
15   regulatory uncertainty.  A firm goes public under one
16   regulatory regime, but in a few years, there's a good
17   chance that the regulations that they will be subject to
18   will be much more demanding and expensive.  And this has
19   to cause entrepreneurs to think twice about going public
20   at all, and must be doubly frustrating for emerging and
21   small companies who tend to get swept up in these
22   regulations that were meant to combat the misdeeds of
23   others.
24             I think if we separated these firms out into
25   different markets, it would be much more -- it would be
0204
 1   much less likely that smaller and emerging companies
 2   would be swept up in these reforms that were meant for
 3   other types of companies.  It would be much easier for
 4   regulators to target reforms at the appropriate firms
 5   and at the appropriate markets if different types of
 6   firms were separated out into markets meant for them.
 7             And I think if regulations in the future were
 8   more well targeted at the appropriate group, it would
 9   be -- it would be both fair and more efficient.
10             So although I think moving to a model where
11   you have different markets subject to different
12   regulations is different than the current scaling
13   approach that we've taken under the JOBS Act and the SRC
14   rules, I think it does offer some benefits and is,
15   therefore, a concept at least that's worth considering.
16             Thank you.  I hope this helped.
17             MR. GRAHAM:  I'm -- personally, I'm attracted
18   to that concept.  I think the whole notion of having at
19   least two markets, or, you know, seeing some sort of
20   system so that you can be more targeted with respect to
21   the approach that you're taking with respect to each of
22   those markets, based on who's participating.
23             Have you given much thought to the feasibility
24   of actually implementing such a system?
25             MR. SCHWARTZ:  A page worth in my article, out
0205
 1   of 80.  So I've thought about it.  I have thought about
 2   it a little bit, and I don't think it would be terribly
 3   difficult.
 4             So you already have the stock exchange.  The
 5   exchange is somewhat set up to have different markets.
 6   So NASDAQ, for instance, has its BX Venture Market.  You
 7   could envision setting -- so today the BX Venture Market
 8   has rules that are a little bit lesser than, but very
 9   similar to the rules that govern the New York Stock
10   Exchange, more generally.  You could picture that NASDAQ
11   venture market being governed by a different regulatory
12   template that is more intermediate in nature than it is
13   today, where it's just a slight tick below the New York
14   Stock Exchange.
15             So you could picture -- you could picture
16   markets adjusting -- you could picture the SEC working
17   with FINRA and the stock markets to actually change
18   regulations to fit existing -- to fit at least what
19   NASDAQ started to do.
20             So I don't think implementation would be easy,
21   but I don't think it's impossible either.  It's just a
22   matter of changing listing standards and changing
23   regulations and having FINRA and the SEC and Congress
24   work together to do that.
25             (Talking simultaneously.)
0206
 1             MR. GRAHAM:  Go ahead.
 2             MR. DENNIS:  Oh, I was going to say, one,
 3   we've got a market study for this.  And kind of with
 4   what Steven and I addressed on the previous Committee we
 5   had, the big issue you've got to deal with is
 6   perceptions because investors and companies are probably
 7   going to view the emerging company market in your
 8   example here as substandard compared to the large
 9   company market.  And so you, you know, you have to get
10   back by that psychological disadvantage.  To me, the
11   regulations part, that's the easy part.
12             MR. GRAHAM:  I don't think you have to do
13   that, though, because it says -- going back to the gap
14   that Steve was describing, you got your private
15   companies with a different set of rules, you got your
16   public companies with a different set of rules.  There's
17   no particular stigma necessarily attached to being a
18   private company versus a public company.
19             But you do have this gap that is drawn between
20   those two segments.  And if you just fill the gaps so
21   you have a natural progression, now I'm thinking
22   necessarily, you know, arrive at a situation where there
23   is going to be stigma attached to being in -- kind of
24   the first market that you hit to -- that you hit as your
25   company is evolving.
0207
 1             You know, simply put, you have private
 2   companies, then you have a market that is only for
 3   accredited investors.  Then as companies grow, you got
 4   basically what we have now.
 5             So it seems -- seems more like there's a way
 6   of doing it without kind of stigmatizing the
 7   participants the way, you know, Regulation S-B stigmatized
 8   companies.
 9             MR. DENNIS:  I think -- I think that's the
10   biggest issue, is how do you -- I think like putting the
11   regulations together and how you logistically transition
12   is -- we can do that.  I think the question is, will
13   people want to automatic -- the Facebooks of the world
14   are going to automatically want to jump to the highest
15   one and --
16             MR. GRAHAM:  That's good.  They're -- you're
17   up to, you know, the Facebook stage, they have plenty of
18   resources in terms of compliance, etc.  So, you know --
19   so imposing on companies of that magnitude the
20   requirement that they go through the effort to provide
21   the level of extra protection that -- with registration
22   statement-type protection is not going to -- it's not
23   going to be an issue for them because, again, they will
24   have the resources.  So --
25             MR. BOCHNER:  I guess the -- kind of
0208
 1   reconciling what Professor Schwartz talked about and
 2   what I talked about.  I think the big difference, we
 3   kind of came at the same problem at a slightly different
 4   angle.
 5             I think what I was envisioning was addressing
 6   that market, that -- those reduced requirements, and
 7   justifying that from an investor protection standpoint
 8   by limiting access to investors that are deemed not to
 9   need that greater protection.
10             And I think Professor Schwartz was sort of on
11   that same theme, but saying, well, let's -- let's do
12   that gradation by sort of size of company.  And, you
13   know, then the question is -- you know, they're both
14   sort of the same ideas coming at it from a slightly
15   different angle.
16             But the concern I had was whether -- I think
17   yours is a bigger idea.  I worry that it's more wood to
18   chop in the sense that you're exposing the -- you know,
19   you're exposing the non-accredited retail investor.  I
20   guess it's a question, really.
21             As you envision sort of that lowest end
22   market, would you limit access to that market kind of
23   the way I've envisioned in my -- in my world, or would
24   you let any investor access all those markets, and they
25   just sort of buyer beware based on the gradations of
0209
 1   listing standards and compliance?
 2             MR. SCHWARTZ:  I've thought about that a lot,
 3   and I don't have any good evidence to support this view. 
 4   But my bias tends to be in favor of letting everyone
 5   participate.  I don't -- it bothers me to have markets
 6   that are restricted to -- that have special access
 7   privileges.  I worry that retail investors aren't going
 8   to have access to the best companies if that happens.  I
 9   maybe have this kind of bucolic attachment to public
10   markets where everyone can participate.
11             So I am in favor of letting everyone
12   participate and putting warning stickers on the market
13   so that people can choose whether they want to be
14   exposed to those risks.
15             And the other, I guess, more practical concern
16   I have with limiting access to this intermediate type of
17   regulatory structure would be I worry about liquidity
18   and that whether there would be enough interest among
19   accredited investors and institutional investors to
20   support that market.  And if we have retail investors, I
21   think there is a better chance that we would have
22   liquidity.  So I think there's a trade-off between
23   liquidity and investor protection, and I guess I kind of
24   err on the side of liquidity.
25             MR. BORER:  Isn't there sort of an analogous
0210
 1   situation right now with the OTC market where they have
 2   this -- Cromwell Coulson runs this exchange.  It used to
 3   be the Pinks; they changed the name because I guess it's
 4   a derogatory name -- where companies can list without
 5   being fully reporting, whether it's a foreign company
 6   that lists here without becoming SEC filers.
 7             And they have, I think, three different tiers.
 8   One at the bottom, which is somebody can trade a stock
 9   with no reporting at all, there's no voluntary
10   disclosure through OTC market, and there's skull and
11   crossbones next to the name, all the way up to the ones
12   who may trade there and be fully reporting, SEC
13   compliant, etc.  There's an intermediate level of
14   disclosure, whether it is voluntary reporting to OTC
15   markets, it's not a full SEC report.
16             And I don't know if anybody in the panel
17   looked at that study and said, this is an effective
18   market and it's a -- because I know with respect to a
19   lot of what I've done over the last couple years,
20   especially with foreign companies, they would come here
21   and say, we want to dip our toe in the water, whether
22   it's from German exchanges, Australian exchanges, a lot
23   of Canadian companies in the resource sector, etc., that
24   didn't want to go, say, fully to the SEC under MJDS and
25   register in the United States; we're taking this as a
0211
 1   step.
 2             And it seems to me, at least with respect to
 3   the amount of trading that takes place there, that
 4   there's got to be enough trading to provide some level
 5   of good information to be able to decide whether it
 6   works.
 7             MR. SCHWARTZ:  You're right.  That's a great
 8   point. The OTC market has tried to -- has tried to do
 9   this. And I haven't looked at it extensively, but from
10   what I have looked at, they have not been that
11   successful.
12             So what would come close is the highest level
13   of the OTC market.  I think it's OTCQX.  That would be
14   kind of the most similar to what I would be proposing.
15             I think the difference would be -- and it goes
16   back to the point you raised on stigma.  I think the OTC
17   really has a stigma attached to it, and I think that
18   prevents it from becoming this really true legitimate
19   alternative because it has a stigma, so companies
20   aren't -- aren't -- don't want to go there.  I think OTC
21   has this reputation as being the place where companies
22   that are struggling can't meet the listing standards,
23   are going bankrupt, it has a stigma of being that
24   marketplace.  So I think they haven't been able to
25   overcome that stigma, and I think that's one trouble
0212
 1   they're having.
 2             Another difference is that the regulations at
 3   this OTCQX wouldn't be as high as I'm envisioning.  At
 4   OTCQX, you don't have to file Exchange Act reports.  You
 5   can do the OTC version of those reports.  So it wouldn't
 6   be -- it wouldn't be quite as high as what I would --
 7   what I had in mind.
 8             And finally, unrelated to that, the difference
 9   that I see is that the OTC market doesn't have --
10   there's no SEC there telling them what their rules have
11   to be.  So they're purely self-policed.  The OTC markets
12   group polices the OTC because the securities laws don't
13   put any parameters -- don't put any parameters on what
14   their rules should be.  Whereas from the market that I
15   envision, there would actually be this securities law
16   framework in place.
17             And I think that lends the market this
18   additional credibility, because when you just have a
19   market that's self-policed, I don't think it's a
20   credible market, and I think maybe that's also part of
21   the reason why it's not.  It's not a substitute for what
22   I'm thinking about.
23             MR. GRAHAM:  I want to just end things.  Let's
24   pause the discussion so that Professor Bartlett can have
25   an opportunity to present.
0213
 1             MR. BARTLETT:  Sure.  I can speak to some of
 2   these issues about the market.
 3             So first, I just want to thank you for
 4   allowing me to share some of my thoughts on scaled
 5   disclosure with you.
 6             I also want to thank each of you for being on
 7   this committee.  I know you all have real jobs that
 8   require an extraordinary amount of time.  So the fact
 9   that you decided to commit to this effort I think is
10   incredibly meaningful.  It's very important work.
11             When Gerry first asked me to be on this panel,
12   it was something that I know is important because when I
13   practiced, I remember drafting 10-Ks and 10-Qs.  And now
14   that I teach, I sort of sit back and I sort of observe
15   more generally sort of the evolution of these forms, and
16   it's clear there's this one-way ratchet that happens
17   with disclosure.  Most of the time we're adding more
18   disclosure provisions, you know.  So now we have
19   executive compensation disclosures, now we've got sort
20   of conflict mineral disclosures.  It just keeps adding
21   on.  You see risk factors too, right.  I
22   suspect there's probably Y2K risk factors out there
23   somewhere still.
24             So it's great we have an effort that tries to,
25   you know, take a step back and rationalize whether or
0214
 1   not we can actually have scaled disclosure that makes
 2   sense.  Because I certainly believe that's the case.  At
 3   the same time, I've also been daunted by the idea, and I
 4   also tip my hat to you for taking on this task because
 5   it's extraordinarily difficult to come up with optimal
 6   disclosure.
 7             I'm very pleased that Jeff and Steve are both
 8   sort of more daring than I in actually coming up with
 9   proposals.  And I think they make a lot of sense.  In
10   fact, I love this idea of sort of linking between SEC
11   disclosure documents and I’m thinking we can actually
12   plan to market something called a hyperlink.  So
13   I think that would actually be a great addition of the
14   concept of EDGAR, basically come up with a way to use
15   technology in a way that makes it easier, doesn't kill
16   so many trees.
17             Okay.  Well, what I'm going to talk about
18   today, though, notwithstanding this statement that I
19   actually want to see some unratcheting, some sort of
20   ratchet backwards, I'm going to talk about the
21   regulatory gap that I think you should fill.  Okay.  So,
22   in fact, Steve got wind of this and intended to leave,
23   but --  I'm just kidding, of course.
24             What I mean by this, well, what I want to talk
25   about is a regulatory gap that I think should concern
0215
 1   us, if we're concerned about small and emerging
 2   companies.  Because the alternative of filling this gap
 3   from the federal perspective is to allow the states to do
 4   it, and we just don't want to have that.  It's going to
 5   increase the cost of capital, it's going to increase
 6   complexity.  I think it's something to be concerned
 7   about.
 8             So what I would like to begin with is just
 9   sort of the conventional view of mandatory disclosure.
10   Generally, we sort of view the need for mandatory
11   disclosure as being driven by ownership structure.  So
12   you might have privately held companies, family-held, on
13   one end of the spectrum, and at the other end of the
14   spectrum you've got dispersed shareholders, many
15   publicly dispersed shareholders, retail shareholders
16   that trade in the marketplace.
17             Now, we say that this is basically going to
18   map onto a disclosure regime, because if you're on the
19   far side, if you're a private firm, there's every reason
20   to believe you don't need mandatory disclosure because
21   your investors won't invest without contractually
22   getting rights to information.  So this is a venture
23   capital model, for instance, right.  That we don't have
24   mandatory disclosure there because we have sophisticated
25   investors that have a relationship and influence and
0216
 1   they can get the information that they need.
 2             That's different, however, if you have retail,
 3   widely dispersed shareholders.  You have large
 4   information asymmetries between the shareholders and the
 5   managers of those firms.  There's also less of an
 6   incentive to provide the information if you're not in a
 7   capital-raising mode.  And of course there's a
 8   collective action problem because the investors may not
 9   have, you know, the incentive necessary to demand the
10   information in the same fashion that a venture
11   capitalist would.  So that's how we map our mandatory
12   disclosures by looking to the ownership structure.  And
13   you see this in Section 12.
14             Section 12(a) basically says if you want to
15   trade on a stock exchange, you've got to be subject to
16   the Section 13 filing obligations, or if you have
17   greater than a certain number of record shareholders.
18   And sort of we'll table for the moment what that means
19   for a record shareholder.
20             So you have a certain number of shareholders
21   in ten million in assets, you also need to be subjected
22   to mandatory disclosure because we use that as a proxy
23   to say you're kind of in the public ownership space. 
24   Okay. So therefore we're going to subject you to
25   mandatory disclosures.
0217
 1             Now, to give you some examples, we have, you
 2   know, plenty of private firms that don't disclose, or at
 3   least privately owned.  So Bechtel, for instance,
 4   family-owned firm.  Twitter, we say, you know, it's
 5   generally a private company, for the most part, venture
 6   capital investors and employee shareholders.  On the
 7   other end of the spectrum, you've got companies like
 8   Google, GM.  Zoom, it's a small -- it's a smaller public
 9   company that trades on NASDAQ.  And then we map that to
10   disclosure, which also is in some sense, it's all
11   spectrum, sort of, right?
12             So we have large accelerated filers that are
13   subject to all the rules.  Then we also have smaller
14   reporting companies, which Jeff discussed, and Jennifer
15   provided a wonderful summary of a few meetings back, I
16   believe.
17             And so what we do is we then map these public
18   companies into their appropriate bucket, based on
19   whether they need the metric for smaller reporting
20   company status or otherwise the residual categories of
21   accelerated and non-accelerated filers.
22             These other firms, however, are not subjected
23   to Section 13.  Okay.  So the question to ask is: Should
24   we care about scaled federal disclosure in this? The
25   answer is yes.  The reason I say yes is because if we
0218
 1   don't regulate this from a federal matter, I believe, my
 2   intuition and sort of my prediction is that we're going
 3   to see increasing movement on the state front.  So I
 4   think that behooves us to think seriously about whether
 5   or not it makes sense from both the issuer perspective
 6   as well as an investor perspective to impose some form
 7   of scaled disclosure in this space.
 8             And one of the reasons I think this is going
 9   to become more important, because that space has gotten
10   much, much bigger in light of the JOBS Act, because of
11   the fact now we went from 500 shareholders triggering
12   the thresholds all the way up to 2,000 non-employee
13   shareholders.
14             Okay.  So that's basically why I think we
15   should care about this.
16             Just give you a quick outline of what I'm
17   going to talk about.  I want to just go through in some
18   fashion the legal rules about why it is that these
19   private firms, these non-Exchange Act firms are in fact
20   subject to disclosure obligations.
21             I realize it sort of seems like a paradox or
22   just contradictory.  So I'm going to explain why it's
23   not.  I'm going to explain why there's some problems
24   with the state of affairs.  And then lastly, I'm going
25   to explain what the Commission can do about it with its
0219
 1   existing rulemaking authority.  Okay.
 2             So first, why is it that existing non-Exchange
 3   Act companies are subject to disclosure obligations?
 4   Well, let's take that -- take our dichotomy again.
 5   Ownership on a scale, we also have a disclosure 
 6   vector as well.  Let's not make it mutually exclusive.
 7   So you have this two-by-two grid, right.  You could have
 8   on the one hand a privately owned company that
 9   doesn't -- isn't subject to the federal regime.
10             So, for instance, Bechtel, okay, privately
11   owned.  It doesn't -- it does not disclose anything
12   through the federal EDGAR system for instance.
13             On the other hand, you could have a public,
14   public company.  You have GM, lots of dispersed
15   shareholders, and they also trade in the New York Stock
16   Exchange; and so, therefore, they're subject to Section
17   13.
18             But it turns out that these other two boxes
19   can also be filled.  So to give you an example, Toys 'R
20   Us, privately held, went through a leveraged buyout a few
21   years ago.  If you look them up on EDGAR, they're there.
22   Why did they do that?  Anyone have a guess?
23             MR. WALSH:  Debt.
24             MR. BARTLETT:  What's that?
25             MR. WALSH:  The debt.
0220
 1             MR. BARTLETT:  The debt, right.  Because, of
 2   course, the capital structure here is privately owned in
 3   terms of the ownership, but it has widely dispersed
 4   bondholders that was funded the LBO through high yield debt.
 5   And so, therefore, the bond investors, through the power
 6   of covenant, they say thou shalt file all Section 13 Act
 7   reports because that helps facilitate the trading market
 8   for high yield debt.
 9             We also have this other category here.  So
10   these are companies that are privately held.  I'm sorry.
11   They're private in terms of their disclosure.  They do
12   not show up on EDGAR, in terms of their Section 13
13   report.
14             But if you look at their ownership structure,
15   they're kind of public.  In fact, on this spectrum of
16   ownership, they have drifted far from the family-owned
17   model, much toward the Google widely dispersed
18   shareholder model.  So Twitter, for instance, got that
19   way because of SecondMarket and SharesPost, and the ability
20   to basically trade off the grid through private resale
21   transactions.
22             And likewise, Proxim Wireless trades on the
23   over-the-counter market it was formerly the Pink Sheets,
24   and rebranded itself on the OTC market.  And I'd like
25   you to just take a look at Proxim, for instance, and why
0221
 1   it is the case that I'm making a claim that this is a
 2   public company that raises all the same problems that we
 3   have with information asymmetry and the inability to
 4   contractually get information that investors might want.
 5             So if you go to OTC Market.  Okay.  Here we
 6   go. And we added the Proxim symbol.  So far this kinda
 7   looks and feels like NASDAQ.  You get Proxim Wireless
 8   Corporation.  You see the inside quote.  You see the
 9   price, $1.55.  You see the volume.  Doesn't trade a lot,
10   but it does trade.  You also get a lot of other metrics.
11   For instance, there is some financial information, but
12   it hasn't been -- they haven't filed any information
13   since 2010.  Okay.  This is a formerly public company,
14   public Exchange Act that went dark.  They now trade OTC.
15             And they do in fact trade.  So here, for
16   instance, historical trades of Proxim.  You see it's not
17   a lot of volume, but in any given day you could have a
18   few thousand shares change hands.  And these, of course,
19   are changing hands among dispersed shareholders.  This
20   company, from an ownership perspective, is actually
21   quite far along the spectrum from private to public.
22             So my contention is that it's a publicly
23   traded firm and so it raises the same policy
24   considerations that have long justified mandatory
25   disclosure.
0222
 1             Now, why isn't it subject to federal mandatory
 2   disclosure?  Well, that's just a function of the way
 3   that the federal securities laws work.  If you're a
 4   securities lawyer, this will make a lot of sense to you;
 5   if you're not, just trust me.
 6             So basically -- so the way it works -- so if
 7   you want to avoid Section 13 obligations, then you make
 8   sure that you don't trade on the stock exchange, and
 9   that you have fewer than the requisite number of record
10   holders.
11             And it turns out, by the way, that record
12   holders is actually just based on a formal requirement
13   of who is showing up as a stockholder record on your
14   books.  Most shares are held in indirect form, so it
15   turns out that those number of record holders bears
16   almost no relationship to the number of beneficial
17   owners.
18             So the number of record holders of General
19   Motors, for instance, is a staggering 275.  Okay.  So if
20   it turns out that if General Motors decided to delist
21   from the New York Stock Exchange, it could go dark
22   tomorrow, okay, because it has fewer than 300 record
23   holders, which is all that's required in order to file a
24   Form 15 and go dark.
25             Okay.  So in any event, though, this is the
0223
 1   method that you do it, is that you would get off the
 2   Exchange, and you have fewer than the triggering number
 3   of shareholders.
 4             Now, you can't raise any money because if you
 5   want to raise any money, you're probably going to be
 6   subjecting yourself to Section 5 of the '33 Act, which
 7   requires registration.  Okay.
 8             But if you're not raising capital, as many
 9   firms aren't, you can delist and you can stay underneath
10   this 300 shareholder record and you can be fine.
11             Now, your selling shareholders are also
12   subject to registration requirements, which could force
13   them to come up with a disclosure document.  But it
14   turns out that the selling shareholders, reselling
15   shareholders and the dealers that work with them are
16   going to be exempt under some exemption to Section 5,
17   which is known as Section 4(1), 4(3) exemptions.  So you can do it.
18             But that doesn't mean that you're not without
19   disclosure obligations.  Why?  Well, because you get one
20   great thing by being subject to all of these -- sort of
21   this onerous Section 13 reports. In exchange for
22   subjecting yourself to the conflict minerals disclosure,
23   you get federal preemption of state law.  Okay.  And
24   that comes about through something called Section 18 of
25   the '33 Act which says that if you are trading a covered
0224
 1   security, then the state, they can regulate fraud, but
 2   they can't regulate the disclosure documents that
 3   pertain to you.  And that's really important to
 4   understand, because it turns out that each state has its
 5   own separate securities regime.  They're called Blue Sky
 6   laws.  They work just like the federal regime.  They
 7   basically enforce disclosure obligations and they police
 8   fraud.
 9             Okay.  So if you are a company, you have
10   shareholders across the states, as many companies that
11   raise capital in our marketplace do, you have to worry
12   about complying with potentially 50 different state
13   regulations.  This is a huge mess.  It's been a long
14   mess ever since Blue Sky laws sort of were developed in
15   the early 20th Century.  It became a special mess when
16   we then had a federal regime in the 1930s.
17             So you had a dual regime where you had to
18   comply with the federal regime and the 50 different
19   states.  It was such a mess, in fact, that Congress
20   said, let's clean it up and create one standard, the
21   federal standard.  This would happen in 1996 through
22   something called the National Securities Market
23   Improvement Act and basically created Section 18.  Okay.
24   So as long as you're trading a covered security, you only
25   have to comply with one disclosure boss, and that's the
0225
 1   federal government.
 2             And the way that it works, it says if your
 3   securities are listed on a major stock exchange, it's a
 4   covered security.
 5             Alternatively, if the securities are sold in a
 6   Section 4(1) or 4(3) resale transaction and you're subject to
 7   13, then you're also going to preempt the state law.
 8   Okay.
 9             Now, what happened is that when you have OTC
10   transactions occurring, those companies that are not
11   subject to Section 13 filing obligations and they don't
12   trade in an Exchange, they no longer have the power of
13   saying these are covered securities.
14             So as a result, these transactions are all
15   going to be subject to the litany of state securities
16   laws that regulate resale transactions.
17             And so, for instance, here in California we
18   have 25130, which basically says that it's illegal to
19   resell a transaction unless you file a disclosure
20   document.  There's exemptions to it, but, as I read the
21   exemption, they are rarely met in a lot of resale
22   transactions that take place in these marketplaces.
23             So let's just take a look at these exemptions
24   that apply, right.  So you're now off the grid.  You're
25   at Proxim, right.  How does Proxim make sure that
0226
 1   they're not going to get in trouble with the various
 2   state securities laws because these resale transactions are
 3   taking place without being a covered securities?
 4             Well, there's a handful of exemptions.  These
 5   exemptions are often mapped onto something called a
 6   Uniform Securities Act.  It didn't take long to figure
 7   out the 50 conflicting securities laws, which are
 8   complicated.  So the national -- the state securities
 9   commissioners did actually try to come up with a uniform
10   system of state securities laws.  However, it's just a
11   template.  So the states are free to tweak it around the
12   edges, and they have tweaked it considerably since it
13   came out in the 1950s.
14             But generally, the exemptions try to map onto
15   these three resale exemptions.  And so one of them, for
16   instance, says that if you're not using a broker, if
17   it's like an eBay transaction, right, if I just decide
18   to sell a security to someone who is interested in the
19   market without using a broker, then 
20   theoretically we won't worry so much about that because
21   it's brokers that we have to worry about, because, as we
22   have heard about this morning, they really get on the
23   phone and try to market a stock, okay, which might be a
24   concern for any number of reasons.  So this unsolicited
25   resale transaction, it's going to be exempt.
0227
 1             At the same time, we also have an exemption
 2   that says if it's an isolated sort of one-off
 3   transaction, even if it involves a broker, that can
 4   be -- that can be okay as well, as long as you know --
 5   if it's basically you're just -- you know, house caught
 6   fire, you sell your -- sort of your holdings of Proxim
 7   securities, it's the only time you ever sold it, we
 8   generally allow you a free pass as well.
 9             Likewise, there's always private resale
10   transactions.  It's a -- in California, for instance, it
11   says if you sell to an accredited investor effectively,
12   it's also going to be exempt.
13             And there's also something called a manual
14   exemption, which is incredibly important actually for
15   complying state laws.  And what it says is that if you
16   aren't subject to Section 13 and if you want to have an
17   active market in your securities on the OTC, what you're
18   supposed to do is you're supposed to file your annual
19   financials with a recognized manual.  And the manual is
20   published by a couple of agencies, which tend to be agencies
21   rating as well as Standard & Poor's.  Mergent is
22   one as well.  And these are all publicly available and
23   so you're supposed to be able to go and look up Proxim's
24   last balance sheet.
25             Turns out, however, that it's not perfect
0228
 1   because this is only possible in 37 states.  The
 2   conditions for being manual eligible differ in these 37
 3   states.  And the manual doesn't exist in certain states
 4   such as California, which tend to be a large market.  So
 5   that's -- that's -- that's one limitation.
 6             And there's one other thing, too, that
 7   imposes, while I'm staying with these private
 8   non-Exchange Act companies are actually subject to
 9   disclosure obligations, is because there's actually a
10   federal rule that applies to a broker-dealer.  And it's
11   Rule 15c2-11.
12             It says that if you want to quote a security
13   that's not on NASDAQ, it's not an exchange, then you
14   have to make sure that you get -- you receive from the
15   company some financial information.  It's about 16 items
16   of information.  It basically says that you can't
17   legally trade as a broker-dealer quote unless you get
18   these 16 items of information.  So they include things
19   from basic corporate details, who the officers and
20   directors are, and some financial information, so
21   balance sheet and a recent income statement.  So those
22   are some of the disclosure obligations that apply.
23             So that's why I contend that these
24   non-Exchange Act firms are in fact subject to disclosure
25   obligations.
0229
 1             Now, what are the problems with it?  Well,
 2   first of all, let's take a look at the state resale
 3   exemptions, why you might even be uncomfortable if
 4   you're a company on OTC being subjected to these
 5   requirements.
 6             So the first one is that it's just complex.
 7   Okay.  So if you represent Proxim and you -- I mean, I
 8   would sort of go running and screaming if I was aware
 9   that, you know, the company wants to have investors or
10   raise capital across 50 different states potentially.
11             I feel fortunate that most of my clients were
12   in fact having covered securities, so that I only have
13   to worry about one federal regime, which is complicated
14   enough.
15             So, for instance, you know, what is an
16   isolated transaction?  It turns out that you're going to
17   have to look how states have interpreted that, and they
18   might differ in how they interpret it.
19             For instance, likewise, has the state complied
20   with the manual requirements, which might differ across
21   different states as well?
22             What about these non-manual states, like
23   California; have you complied with their somewhat
24   idiosyncratic resale requirements?  So it's complex in
25   order to have a compliant resale regime in this domain
0230
 1   or to raise capital across these 50 states.
 2             There's also the question about whether or not
 3   these resale transaction exemptions still make sense.
 4   And the reason I think that this is something that we
 5   might see some movement on recently is that the space
 6   that we're talking about here, these publicly traded
 7   private firms is growing by leaps and bounds.  It's
 8   growing very, very quickly.  It's going to grow even
 9   quicker because of the JOBS Act.
10             And so this is a period of time where we might
11   see these provisions being tested by state regulators
12   and say, you know what, this unsolicited quote
13   transaction, I don't know if it makes much sense because
14   all of a sudden these broker-dealers are saying they're
15   getting tons of unsolicited interest.  Why?  Well,
16   because OTC marketplace is online.  It's very easy if
17   you're interested in sort of trading, just sort of
18   submit an order that's not solicited just by virtue of
19   the technology of the OTC market today.
20             So you can see that this might be nearing a
21   time when some of these exemptions might simply
22   disappear.  And in fact that has been the case in some
23   of the states.
24             And so, for instance, the manual exemption has
25   been eliminated in certain states in recent years as
0231
 1   well out of concern that it's really not a very
 2   functional way to assure investor protection in a
 3   publicly traded over-the-counter marketplace.
 4             And then likewise, I think there's reason to
 5   believe that because of the complexity, because of past
 6   attendance of only focusing on the federal regime, a lot
 7   of companies just aren't complying with these rules. And
 8   why -- and here's a quote, by the way, from "The
 9   Corporate Counsel" talking about SharesPost and
10   SecondMarket.  These rules all apply to those firms as
11   well.  And they say:  "Companies on these markets often
12   ignore the Blue Sky stuff; they don't require that
13   counsel's opinions address these matters."
14             And when I talk with participants in this
15   market, I am curious what these legal opinions cover,
16   because typically you're going to get a resale legal
17   opinion, and they tend to govern the '33 Act and they
18   don't cover state securities law, although I would love
19   to hear whether that has changed over time.
20             The reason I think that this is problematic is
21   because a lot of these state provisions have the same
22   remedy for violations of the registration requirement
23   that the federal regime is, which is rescission.  And so
24   it very well may be the case a lot of people are walking
25   around with effective put options on the stock that they
0232
 1   purchased in the over-the-counter marketplace, which can
 2   create a huge mess in the event that the company
 3   underperforms.  And I'm not sure that this option is
 4   actually being priced in the marketplace, as of course
 5   it should be.
 6             Okay.  So as I said, these are some of the
 7   problems.  I think these problems may be -- oh.  With
 8   the state disclosure, here are some problems with
 9   15c2-11 disclosure.  This is not news.  This is one of
10   the more critiqued rules that I've seen by the SEC.
11             Basically some of the problems are it only
12   governs initiation of quotations.  So of course the
13   financial information that the broker-dealer gets could
14   get stale very, very quickly.
15             It doesn't cover at all the situation on 
16   SecondMarket or SharesPost, where there's no quotation
17   being done by a broker-dealer.  Those tend to be more
18   like -- well, SharesPost claims it's a patented bulletin
19   board.  These represent customer interests.  There's no
20   quotes there being offered.  So it doesn't apply at all
21   in those markets.
22             There's no public repository of this
23   information as well.  So it goes in a file of the
24   broker-dealer.  And they have to make it available upon
25   request, but there's no public repository like there is,
0233
 1   for instance, say, with the SEC.
 2             And then there's a bunch of exemptions that
 3   broker-dealers have to the rule, which also limits its
 4   effectiveness.
 5             So, for instance, it doesn't apply to
 6   unsolicited quotations.  This is actually dual-pronged.
 7   Pink Sheets actually got concerned that broker-dealers
 8   were saying, we don't need to have the 15c2-11
 9   information to quote because we're getting unsolicited
10   interest.  Because of course they could realistically
11   say, we're getting a lot of trading interest because of
12   the electronic platform of OTC market.
13             And then likewise, there's something called
14   the piggyback exception, which basically says that as
15   long as you see the market maker quoting a security, and
16   that security has been quoted for 30 days with no more
17   than four lapses of quotations, you can go ahead and
18   start quoting that security as well without having to
19   get the 15c2-11, even if the original person who got
20   that information has decided to stop making a market. 
21   And so you can have piggyback after piggyback after
22   piggyback without anyone knowing even where the 15c2-11
23   form actually is.
24             Okay.  So not surprisingly, this is -- again,
25   as I said, it's been heavily critiqued.  It's been
0234
 1   critiqued -- and there was proposals actually to amend it in
 2   the '90s that never survived.  There was a roundtable
 3   market structure, a microstructure last October, I
 4   believe, where this came up as well as in need of
 5   potential reform.
 6             This is -- the CEO of Pink Sheets describes
 7   "Rule 15c2-11 is a rule of darkness," as opposed to a
 8   rule of transparency.
 9             Okay.  So there's some problems, and these
10   problems are going to become potentially more serious, I
11   think, to contend with for companies that trade in this
12   space, the space as well that both Steve and Jeff are
13   talking about potentially to invigorate in terms of the
14   marketplace.  I think these legal problems are going to
15   grow.
16             So to give you a sense, there are 3,000 OTC no-17   information firms.  Okay.  I looked in June, and there's
18   about 2,700.  300 more somehow appeared in just the span
19   of a few months.  Okay.  This is a marketplace that is
20   growing by leaps and bounds.  And for reasons that you
21   can probably all understand, because who wants to comply
22   with the conflict mineral rule if you have a marketplace
23   where you have real liquidity without the need to comply
24   with any of the disclosure obligations?
25             Also, the reason I think that states are
0235
 1   getting increasingly focused on this space is because
 2   they already are concerned.  So in response to the JOBS
 3   Act, for instance -- here's the President of the
 4   National Association of Securities Enforcers.  His
 5   testimony says we have -- and this is in specific
 6   response to increasing the 500 threshold to 2,000, or I
 7   think it was 1,000 at the time.  
 8             He said, "We do have concerns about drastic
 9   changes in the thresholds for reporting companies or the
10   information they must disclose.  The primary reason for
11   requiring a company to be public is to facilitate
12   secondary trading of the company's securities by
13   providing easily-accessible information to potential
14   purchasers.  The principal concerns for states is the
15   facilitation of this secondary trading market with
16   adequate and accurate information."
17             So it's already on the radar.  Okay.  So this
18   is why I think that it could potentially be an
19   increasingly important issue for companies in this
20   space.
21             As they say, you know, Eliot Spitzer has had
22   kind of an interesting career.  I think it might be
23   interesting for me as well to see where I might be able
24   to find some exciting regulatory initiatives.
25             So, again, it's just a prediction.  I'd be
0236
 1   happy to be proven wrong, but it's something, I think,
 2   to take seriously.
 3             So what can the Commission do about it?  I
 4   don't think doing nothing makes sense.  A wait-and-see
 5   approach is going to I think potentially be problematic
 6   for companies because they're going to have to choose
 7   between do I want to comply with these 50 -- you know,
 8   these 50 different states and all the complexity that
 9   imposes, or do I file Section 13 reports, as unappealing
10   as that is?  That's kind of a Hobson's choice.  I'm not
11   sure we really want to put companies in that position.
12             So what I think makes sense is a uniform
13   system of disclosure.  I think that that actually
14   facilitates capital formation for smaller companies,
15   again, because it simply makes it easier to see your
16   transaction cost, people understand it.  It's good for
17   investors because if it -- if the disclosure regime
18   makes sense, it can help eliminate some of the
19   information asymmetries that we all know drive the need
20   for mandatory disclosure.
21             So I'm a fan of uniform, a uniform system of
22   law.  So all the Federalists in the audience, I
23   apologize.
24             So there are two rulemaking approaches that you
25   can take if you're the SEC.  And as a Committee, I would
0237
 1   urge you to consider these.  I think one is superior.
 2             So one is you could focus on 15c2-11.  It's
 3   got lots of problems.  It's -- you could eliminate the
 4   piggyback exemption.  That's been proposed already.  I
 5   can't take credit for it.
 6             You could make the information more easily
 7   accessible, have a public repository.  That's also
 8   already been suggested, so I can't take credit for that
 9   as well.  In fact, I would urge you to go back to the
10   original proposal of 1998, I believe, to reform this
11   rule, because these problems with it are well-known.
12             Why might that help?  It would help in the
13   sense that at least the problem wouldn't look so
14   dramatic to state securities regulators, right.  They
15   wouldn't be able to point to 15c2-11 and say, you know,
16   this rule of darkness requires us to step in and
17   regulate.
18             However, it's not preemption.  It's not a very
19   strong form of creating a uniform system.  And so what
20   can the Commission do?
21             Well, it turns out that the Commission still
22   has Section 18 to work with, and it actually has some
23   rulemaking authority within Section 18 that gives it --
24   that creates the authority to reach into non-Section 13
25   Exchange Act companies and say, you need to start
0238
 1   reporting on a scaled basis if you want to preempt state
 2   laws.
 3             Okay.  So the way that this could work, for
 4   instance, is two ways.  One, the SEC was long ago
 5   empowered to create a covered security if it was sold to
 6   a qualified purchaser, as defined by the SEC.  There was
 7   a proposal once to say a qualified purchaser is is any
 8   accredited investor.  That never became a final rule, so
 9   this has yet to be defined by the SEC.
10             So one approach you might consider, if you
11   worry about this, is to say that, well, look, what we'll
12   do is we'll give you preemption, Proxim, conditional on
13   your selling to a qualified purchaser defined as an
14   individual who either has access to information or you
15   provide specified disclosure.
16             This is actually not a new idea, in fact. 
17   This is how we long -- have long interpreted the private
18   placement rule, which says that you can sell to
19   sophisticated investors, but sophistication being
20   defined as either someone who has access to information
21   or someone who has been provided with requisite
22   disclosure documents.
23             Okay.  So you can simply say a qualified
24   purchaser, just like we use -- do in the 4(1) -- or the
25   4(2) jurisprudence.  We say that if you sell to someone
0239
 1   who has access like a venture capitalist or someone who
 2   doesn't necessarily have access, like a retail investor,
 3   but you give them a disclosure document that has an
 4   appropriate amount of information, certainly not all
 5   Section 13 information, but maybe something that's
 6   scaled appropriately for an over-the-counter company,
 7   then you can get federal preemption.
 8             An alternative approach as well is to say that
 9   covered security includes a security sold in a resale
10   transaction under Section 4(1) or 4(3), which is most
11   non-insider resale transactions, if the company files
12   Section 13 reports.
13             So one approach is to do what high yield
14   investors do, is they say, we know that you're not
15   required to file Section 13 reports, but you can always
16   voluntarily file Section 13 reports.  And so one
17   approach is to simply use that model and say, what we'll
18   do is we'll create a special set of Section 13 reports
19   that are only eligible to be used if you create the
20   right classification of a company.
21             That might be one of these companies that Jeff
22   was suggesting, that sort of -- you know, a small tech
23   company that doesn't trade on the New York Stock
24   Exchange.  Or another criteria that indicate that we're
25   really trying to focus on the eligibility.
0240
 1             To use these forms, you have to be like
 2   Proxim, a company that doesn't want to be subjected to
 3   Section 13 but trades in a public marketplace.
 4             So if you do that, they may then voluntarily
 5   choose to file these sort of lighter forms of Section 13
 6   and then claim that the resale transactions are exempt
 7   because they're done under 4(1) and 4(3) and we are
 8   voluntarily filing Section 13 reports; and so,
 9   therefore, these are covered securities.
10             So those are two approaches I think that make
11   the most sense because you get federal preemption.  And
12   I think this is sort of, at least in my mind, an issue
13   that is going to increasingly become a problem for small
14   and emerging companies that operate currently in this
15   unregulated space beneath, well, 2,000 shareholders as
16   of today.  So that's all for that.
17             MR. GRAHAM:  Thank you, Bobby.
18             Couple more minutes before we break at 3:00.
19             Any more questions for Jeff or Bobby?
20             (No audible response.)
21             Hearing none --
22             MS. JACOBS:  Yeah, why don't we take a quick
23   five-minute break, and then we're going to open up for
24   discussion.  And, please, as many members as possible
25   hang around because this is where we're going to need
0241
 1   y'all.
 2             (A brief recess was taken.)
 3             MR. GRAHAM:  I'd like to get started with the
 4   discussion, kind of our -- kind of our discussion part
 5   of the afternoon.  Surely, it's one of the more
 6   important parts.  I wish that we had more time for it,
 7   but we don't.  And I also understand that there are a
 8   number of people that have planes to catch, and so - -I
 9   think maybe before we actually conclude, so I want to
10   get started and give everybody an opportunity to weigh
11   in a little bit.
12             Again, so going back to what we said this
13   morning, the purpose of today was to look at two general
14   areas and think about what kind of recommendations we
15   can make with respect to those areas that would help
16   further the interests that we're trying to further as a
17   committee.
18             Those, of course, are the structural issues
19   that we find in the marketplace, number one, and, number
20   two, the scaled disclosure.
21             You know, I think what I would -- what I would
22   like to do is have a conversation.  We heard -- we've
23   heard a lot things today.  I think some were kind of
24   more interesting from kind of a broader -- kind of a
25   context point of view; I think others more directly
0242
 1   related to what it is that we're trying to accomplish in
 2   terms of coming up with specific recommendations.
 3             So what I would like to do is begin the
 4   conversation and, at least before we break, have a
 5   sense for where we feel we should be headed as a
 6   committee.
 7             If one or two specific recommendations fall
 8   out of the discussion, great.  If not, that's okay too. 
 9   But let's begin the discussion.  And then I think what
10   is likely to happen is that following this meeting we
11   will -- you know, Chris and I will think about what
12   we've heard and begin to kind of draw some
13   recommendations into focus that we've been discussing to
14   help finalize.
15             Before we kind of open it up for discussion, I
16   think Chris has a couple of things she would like to
17   say.
18             Is that true?
19             MS. JACOBS:  Yeah.  Just to begin to set the
20   stage for the discussion, we've spent several meetings
21   on the IPO Task Force, the IPO on-ramp.  And as we begin
22   the discussion this afternoon, maybe ask y'all to change
23   momentum here a second and look towards day two.
24             The one thing I know, as a sitting CEO, is you
25   don't ever create or set up with your company with your
0243
 1   IPO as your end game.  Your IPO should be the beginning
 2   of your next step.  And that next step and what that
 3   environment entails for us is what we need to discuss
 4   today.  Because the environment for these public
 5   companies, day two.  Once the IPO is finished, we have a
 6   set of rules and regulations that are well documented as
 7   being a burden.
 8             Professor Schwartz, I'll probably be putting
 9   you in my will sometime next week because you hit a lot
10   of the points that I think we -- I'd like to see us
11   cover.
12             And I would like to hear whether you're an
13   investor.  And maybe as investors, y'all don't have a
14   dog in that hunt, but to those of us that are associated
15   with small reporting public companies, there's a lot of
16   reform that could be done now that's not quite the
17   burden of perhaps a new set of markets.  Because we've
18   got that -- let me give you an example.
19             We've got the $75 million market cap as the
20   hurdle for exemption.  Well, as you brought up, Professor
21   Schwartz, why is that 75 million, when the JOBS Act has
22   given a hurdle rate of a billion dollars in revenue
23   and five years of reprieve?  There is a real disconnect
24   here.
25             And so all I wanted to do is sort of set the
0244
 1   stage on what we were hoping we would hear from you this
 2   afternoon about scaling and that day two for these
 3   public companies.
 4             MR. GRAHAM:  One last maybe point of order,
 5   how would you guys like to manage the discussion?  I
 6   would like to hear from everyone.
 7             MR. SUNDLING:  Free flowing.
 8             MR. GRAHAM:  Would you like to comment on both
 9   scaling and the kind of market issue, or shall we spend
10   a half an hour on market issues and then switch over to
11   scaling?
12             MR. SUNDLING:  I think it depends on who's
13   speaking.
14             MS. JACOBS:  Yeah.
15             MR. SUNDLING:  And -- yeah.  If you don't -- I
16   don't know what everybody else thinks, but I think that
17   the opinions and the things that people might want to
18   talk about are going to differ depending on your
19   background, what company you're representing here.
20             MR. GRAHAM:  Oh, absolutely.  I don't disagree
21   with that.
22             So why don't we just kind of start with maybe
23   the structural issues, and some people have more to say
24   on that and others less, and then we'll move on to the
25   subject of scaling, if that's okay.
0245
 1             So we've heard a lot about tick size, whether
 2   that matters.  I guess what I'd like to do is, again,
 3   just kind of open things up for discussion, think about
 4   what we might want to say about that as a committee.
 5             Does anyone want to start?
 6             MR. SUNDLING:  I'll start, if you don't mind.
 7             MR. GRAHAM:  Okay.
 8             MR. SUNDLING:  But if you don't mind, I'd like
 9   to back up just a little bit.
10             So first of all, the speakers and presenters
11   here today have been phenomenal.  Thanks for your
12   participation.  I know I learned a lot, probably a lot
13   of -- you know, there was a lot of information there
14   that I don't think I absorbed today, maybe never will.
15   Some extremely deep expertise from David on the way
16   the trading markets work and from the professor on kind
17   of the observation around -- you know, I saw a lot of
18   analysis done on just charts of what the markets are
19   doing.
20             But I think, you know, if we back into what's
21   the charter of this committee in looking at capital
22   formation is one problem, and a form of capital
23   formation is going public, right.  So you go public to
24   raise money, and then, you know, as Christine said, then
25   what's your Phase II once you are public?
0246
 1             And so coming from the angle of a sub $50
 2   million software company, right, so everybody -- we got
 3   investment bankers here, we got regulators, and folks
 4   from the academic world -- from my perspective, if
 5   you -- and I belong to a lot of groups, right, with a
 6   bunch of other CEOs that are in the same -- probably in
 7   100 million and below software space.  You don't even
 8   talk about IPOs anymore, right.
 9             It's -- and I think we have to realize that,
10   for all intents and purposes -- you know, I keep
11   thinking about the regulatory changes they're talking
12   about.  That's akin to kind of just bumping this can a
13   quarter inch at a time, and it needs to move five feet,
14   right, to really get people excited about the objective
15   of becoming a publicly traded company.
16             There's got to be radical reform, not just
17   around regulatory requirements.  But I think there's a
18   marketing problem, right.  I think that if you turn the
19   clock back to 1996, the only thing anybody ever talked
20   about was the IPO.
21             You talk to any of these CEOs, and we're --
22   you know, we're trying to extrapolate from these market
23   statistics and all these other things what they might be
24   thinking.  It's easy.  Just survey them.  Call them.  I
25   talk to them all the time.  And I am one of them, and we
0247
 1   would never consider an IPO.
 2             And with all due respect, right, if the idea
 3   is to figure out -- you know, all the things that I even
 4   heard in the last few hours and then in prior sessions
 5   is you're not selling me on going public, that's for
 6   sure, right.  It's --
 7             MS. JACOBS:  Why is that, Charlie?
 8             MR. SUNDLING:  Well, I think just -- it's
 9   just -- it's difficult.  And when you look at the exit
10   options, you always have to see what is the competition. 
11   The competition for liquidity is M&A.  The M&A market’s
12   red hot, right.  It's not hassle-free.  Nothing is. 
13   But really compared to going public, it's an easy way
14   out. You've got investors.
15             You know, when Steve was here, I think it was
16   he who made the statements from a VC perspective, right,
17   there's kind of two things they look at.  One is in the
18   initial discussions, who's your buyer, you know we're
19   going to put money in you, who are the most likely
20   buyers, which is a very fair question.
21             And from an IPO perspective, it's -- I think
22   he said a hundred million in revenue or bigger, and
23   market cap, you know, day one IPO, nearing the billion
24   dollar mark, before you get any, you know, of the A
25   player anyhow, i-bankers involved in your deal.
0248
 1             But I think the perception that I have, and I
 2   spend a lot of time, and I realize the complexity.  We
 3   do a lot of complex stuff in our business, right.  Our
 4   customers are very big global energy companies, nuclear
 5   power producers.  So everything we do is complicated.
 6             I'm not afraid of complicated.  When I look at
 7   what it's going to take to go public and remain public
 8   in all those -- you know, until you reach a very
 9   substantial scale, it's not even the money, a million
10   bucks a year, whatever, to pay the auditors and all
11   that.  It's more the risk.  It's the distraction from
12   your business.  It's the fact that, from a liquidity
13   standpoint, it's a lot easier to get a big check from a
14   strategic buyer, right.
15             And so I think in looking at -- so there's the
16   two things that we've maybe been -- the two big things
17   anyhow brought together to discuss is access to capital,
18   and then somewhere along the line this whole discussion
19   about IPOs came in because I think it related to access
20   to capital, as far as I can tell.
21             And then you get into the systemic functioning
22   of the market, right.  So on the trading side, right,
23   the things that David brought up about, you know, the
24   spreads and on, you know, the decimalization and all
25   these things that are kind of impediments to that side
0249
 1   of the market.
 2             You combine that with kind of the -- you know,
 3   this whole notion of what still sticks in the minds of
 4   every entrepreneur I know is when Sarbanes-Oxley came
 5   out, you wrote off the IPO thing.  It's not even really
 6   talked about.  And it comes up once in a while, but it's
 7   really -- you know, if you've got a business model
 8   that's a potential rocket ship, like a Facebook, you
 9   know, the other dimension.  And you really got to get
10   into the details.
11             I would really recommend that in the research
12   that's done you -- there's -- you drill down into some
13   of the more detailed aspects of this round of psychology
14   of the CEO and the board and the VC, then map it across,
15   you know, all those metrics over the years.
16             And I would bet one of the things you find are
17   things like, you know, the -- depending on what market
18   you were in, if you were in the B-to-C world, well, you
19   know, that's something where you can go public, you can
20   remain independent, and you could have a grand slam
21   because you're selling to an emotional buyer, right. You
22   look at the IPOs, Facebook, LinkedIn, Groupon, they're
23   selling to an emotional buyer, to consumer.
24             If you switch over to the B to B world, right, if
25   you're an enterprise software company or a SaaS
0250
 1   provider, look at the competition, and your likelihood
 2   of surviving as an independent company and growing and
 3   getting anybody interested in your stock, right, and I
 4   think what you find is there has been massive
 5   aggregation in the tech space.  There's going to be ten
 6   big companies left on the planet at this rate, right.
 7   Most of them have acronyms for names.
 8             And at the end of the day, right, if you are
 9   going to remain independent, those are your competitors
10   in the B to B world.  Our smallest competitor has a $64
11   billion market cap.  That's the small one, right.
12             So can we compete with them?  Not over the
13   long-term, right.
14             Well, what we and most of the CEOs I talk to
15   that are in this kind of boat, what they do themselves
16   is outsource R&D for big companies, right.
17             What we're trying to do is build a product and
18   out-engineer them, get it to market.  Can we ever
19   compete globally when they dominate the channels of
20   distribution and all the servicing integration partners?
21   No.  Right.  All you can do is put yourself on the
22   tracks, right, and hopefully get a bidding war going
23   between a few of them that all want that piece.
24             I think it'd be really interesting to map all
25   these charts against the M&A in the growth of these big
0251
 1   companies.
 2             Again, in our space, you know, if you look at
 3   the big companies in this -- and I think someone
 4   mentioned a recent IBM acquisition in this group.  Just
 5   look at the size and scale of these companies.  On one
 6   chart where it said what are the impacts -- the
 7   impactful items to people wanting to go public or remain
 8   public.  One of them was this -- it was -- I can't
 9   remember the term, but it was about the scope, the
10   example that was given earlier about the refrigeration
11   truck, right, the ice cream and the milk.
12             I think -- and that was rated as not
13   important. I think that is massively important, because
14   out there in the competitive world, what happens is you
15   have a product that -- and you look at profitability. 
16   So this chart that shows small companies aren't
17   profitable. Well, yeah, because you have to fund
18   overcoming that channel dominance and effective
19   monopolies of control in these customers in the B to B
20   world.
21             I would suspect that's not true when you look
22   at consumer-oriented target markets, although in some it
23   may be true.
24             But absolutely in tech, B to B, it's all about
25   distribution, right.  And those are very tightly
0252
 1   controlled quasi, almost cartels, right, that used to --
 2   what was the saying, right, you don't get fired for
 3   buying IBM.  Well, you don't get fired for buying HP,
 4   you don't get fired for buying Dell.  Right.  You could
 5   get fired for buying Pipeline, because nobody knows who
 6   we are.  We're very specialized and, in our niche, the
 7   best at what we do.
 8             But there's a very kind of dominant evolving
 9   market of really big companies that nobody wants to
10   compete with.  You certainly wouldn't want to go public
11   and get hammered for a couple of quarters.  And when you
12   look at what your marketing spend is to overcome some of
13   these distribution channels, that's why the
14   profitability is low.
15             So bottom line to me is -- and again, you
16   know, I don't think it's a Charlie-ism.  I think it
17   would be great to, you know, let's do a survey and talk
18   to all these people and they'll say the same thing, is
19   you're crazy for going public, right.  You built some
20   value, try to lock down a patent or two, get a little
21   bit of leverage, and then you sell.
22             MR. GRAHAM:  Now, when you say you're crazy
23   for going public, how would things have to change?
24             MR. SUNDLING:  Well, so that's a great
25   question. And I've been -- and I'm trying to remain
0253
 1   optimistic, believe it or not, and trying to think what
 2   if, again, someone was trying to convince me to go
 3   public, what would have to change?
 4             And, you know, it's actually pretty tough to
 5   say because I think that the fundamental market has
 6   changed and your chances of survival in a public market,
 7   it depends on the size of the company.  If you're sub 50
 8   million, one of the great things about being a small
 9   private company is you don't have to tell anybody what
10   our revenue is or what anybody is getting paid, and all
11   these things that competitors are going to pull right
12   out of your Qs and Ks and use against you, maybe even
13   customers will.  Our customers are very, very large
14   companies.  You know, so there's the dimension of
15   disclosure and risk, right.  So you put financials out
16   there for the world to see, again, depending on what
17   kind of shape you're in and what you're trying to do,
18   you may not want to do that.
19             What would need to change, right, is -- it's
20   probably a whole bunch of things, but at the end of the
21   day, they all add up to risk mitigation.  If I were to
22   go to my investors and say, hey, I want to go public --
23   I mean, I don't even know how that story could be sold,
24   right, because the other thing that's happening --
25             MR. GRAHAM:  Certainly not in today's
0254
 1   environment.
 2             MR. SUNDLING:  Well, you can't.  And a big
 3   part of that reason is the lucrative nature of M&A,
 4   right.  So the private company deals that are getting
 5   done, the volume of them, the multiples being paid by
 6   strategics. You know, unless you think you've got
 7   something that's going to be a 20-year business, right,
 8   and exist in perpetuity -- which I think is not in the
 9   mind set anymore, right.
10             And I can remember the days, right, and I'm
11   sure y'all do as well, that the only discussion ever was
12   about building a great company that's going to last a
13   hundred years, and it's going to be billions.  And
14   everyone was, you know, drinking the same Kool-Aid.
15             Well, Kool-Aid these days is, right, highly
16   leveraged investments that even VCs, they're doing these
17   tiny rounds.  They want to just see proofs and
18   technology, very incremental, and they're looking for
19   the tenbagger that might be under a 50 to 100 million
20   dollar total deal, right, which means total investment
21   is going to be 2 to 10 million.
22             That's the other thing that we're seeing is,
23   you know, the -- other than the very rare, exceptionally
24   large transactions, that lower end market is really
25   research for big companies, right.
0255
 1             One of the -- I mean, one of the potential
 2   theoretical remedies to the whole thing is what was
 3   discussed earlier, which is just a completely different
 4   alternative market, right.
 5             The one that I used to follow that was
 6   interesting is this whole London AIM thing.  I don't
 7   know if you guys pay much attention to it.  But I
 8   remember some British bankers telling me, yes, just the
 9   public venture capital, right.  Is the reporting -- you
10   report once a year.  You get this thing called a nomad,
11   who's your nominated advisor.  All the requirements are
12   very low.  And everybody knew that effectively this
13   thing was just a way to raise money.  Easy, very low
14   regulations, didn't distract you from your business, and
15   gave you some kind of liquidity.
16             It's not, you know, an actively traded, you
17   know, volume traded stock to where all the investors are
18   liquid, but now you've at least got a vehicle where you
19   can bring in institutions and other things, and founders
20   can liquidate some of their stock.  So some kind of
21   alternative vehicle, maybe a modified version of the OTC
22   would be interesting.  I don't know.
23             But, you know, I think in the U.S. in general,
24   nobody would argue that we really kind of put the
25   regulatory screws to all of this.  And now it's got
0256
 1   to be spun back.  But even after they are, I would argue
 2   it's a five-year marketing job to unwind it, right.  So
 3   is everybody prepared for another decade of slow small cap
 4   IPOs?  Because I think realistically that's probably
 5   what's going to happen if you fixed it today.
 6             MS. JACOBS:  I didn't hear.  I want to make
 7   sure, though.  I did hear you say that the regulations
 8   are as much an impediment as market structure?
 9             MR. SUNDLING:  Yeah.  I think there's
10   multiple -- yeah, regulations, market structure, and
11   whatever you want to call it, the change in psychology
12   of the executives and to some extent the investors.
13             MS. JACOBS:  Right, the macro.
14             MR. SUNDLING:  Yeah.
15             MR. GRAHAM:  Okay.  David, I know, has got to
16   leave pretty soon.
17             So before you do, anything you want to say
18   besides goodbye?
19             MR. BOCHNOWSKI:  It's been a great day.  You
20   know, the evidence that we saw is that there was a
21   period when the IPO market was something everybody
22   wanted to do. Clearly we're not going to go back to that
23   time. There's no way to change things that have
24   occurred.
25             I believe that Professor Schwartz, he'll be in
0257
 1   my will, too, because I think at least he's given us a
 2   path to whatever the future is going to be.  I think we
 3   have to think about what that future is going to look
 4   like.
 5             Many of these issues don't really directly
 6   relate to me as a CEO because I'm a community banker.
 7   Where it does relate is that we know that the IPOs
 8   created more jobs over time, and that gets back to what
 9   I do every day.  And the more jobs there are, the
10   happier bankers are.
11             So I think we've got to figure out a way to
12   come up with a new regime, and I think that's what
13   you're suggesting.  And we've got to create whatever
14   that future is so that the economy can continue to
15   thrive.
16             I thought that one of the things I learned
17   today was very instructive to me, and that was when you
18   shifted to the electronic order book.  Where that
19   discussion impacts me as a company is that every time
20   our stock has been slammed down -- and we have an
21   average volume of under 200 shares a day -- it's always
22   happened electronically, never happened through the
23   book.
24             And so I think there is that investor class
25   and there's the trader class.  The trader class is not
0258
 1   helping what we all do every day.  And I think that has
 2   to be addressed.
 3             On scaling, clearly the idea that my company
 4   or any company that is of our size has to report at the
 5   same level and do the same things every day that the
 6   very large companies that do offer systemic risk to the
 7   American economy and to investors is the risk management
 8   portion of this that I think we need to address as a
 9   group.  And we have to be sure that the risks that some
10   of us take on and the rewards that some of us have for
11   taking on those risks are scaled appropriately to
12   whatever might happen within the economy that would be a
13   negative to the overall status of our nation.
14             But some of us clearly don't offer those
15   systemic risks and shouldn't have to go through the same
16   things as those who do.  So that's why I applaud what
17   you -- the seed you have planted.
18             MR. GRAHAM:  Milton.
19             MR. CHANG:  I think we're not going to roll
20   the clock back.  I think if we can fight them, I think
21   we should think of ways to supersede them.
22             My prediction is that the IPO market is going to
23   continue to be in bad shape for the foreseeable future.
24   Because if you look at the feeding part of it, in terms
25   of where VCs park their money, is mostly in the web and
0259
 1   mobile space, where tends to be very -- just very little
 2   product differentiation where the ticks are off.  And
 3   you're going to have very few IPOs for big ones.  Where
 4   on the manufacturing side, product side, there are room
 5   for differentiation; therefore, there are many IPOs.
 6             So I don't think that's going to be changed in
 7   the sense that's the investment trend on the feeding
 8   end.
 9             And I think the objective is about job
10   creation and economy.  And if that's the case, M&A is
11   probably just as efficient, if not more so, than IPO,
12   because scaling is much more efficient in a big
13   corporation.
14             So M&A in fact is a very efficient way of
15   scaling the businesses once it's incubated in a small
16   company.
17             And I think the capital formation is really
18   the key to growth.  And I think that's in fact the
19   charter of the SEC.
20             And I think two personal experience that's not
21   being discussed:  One is the -- in the good old days you
22   can walk into Cisco and you say, I want to develop this
23   technology.  And you can come out with an agreement
24   where you will be bought when your objective is
25   accomplished.  And you use that piece of paper to go out
0260
 1   and raise money.
 2             That can no -- that's no longer allowed
 3   because that's kind of external R&D funding.  So you
 4   have to write it off on your bottom line.  And that's a
 5   detriment to -- in terms of getting VC funding.
 6             And then the other one is the allocation of
 7   the R&D tax credit or tax loss.  Those are great
 8   incentives to attract investment capital into the
 9   startup community, and both of those are gone today.
10             So I think those are the systemic issue that
11   we can really sort of recommend to make a difference.
12             MR. GRAHAM:  You know, this -- you know, we
13   talked about scaling.  And it relates directly to
14   capital formation because we've got companies -- I mean,
15   there's a bigger hurdle than that, you know, with
16   companies like Charlie's who say they don't want to go
17   public. Nonetheless, that is -- that is a -- that does
18   provide headway for people who do want to at least
19   consider the IPO.
20             Then in terms of -- we talked about capital
21   formation, and kind of related to that is that if I can
22   save a million dollars in compliance costs, that's a
23   million dollars I can use in my company.
24             And it really -- you know, it really seems to
25   me that -- that when you think about how you can
0261
 1   accomplish this, that more and more we should be
 2   thinking in terms of the principles we apply in this
 3   context.  Because it seems to me that kind of a basic,
 4   you know, tenet of what we're dealing with here is
 5   disclosure and what is and what is not material.  And it
 6   seems to me like that materiality doesn't necessarily
 7   depend on market cap or revenue or how long you've been
 8   public.
 9             MR. CHANG:  I think I'm in 100 percent
10   agreement with Charles.  What he essentially said is
11   take it one inch at a time, five feet at a time.  That's
12   the back end.  The front end is the capital formation.
13             MR. GRAHAM:  Right.  But my question is in
14   context for anyone to respond to, investors in
15   particular:  What is out there in the way of compliance
16   that you see that you don't need?
17             MS. JACOBS:  Here's a question:  For those of
18   you that invest in public companies, is the disclosure
19   in and around conflict minerals going to be material?
20   That's a simple one, I think.  But you have to tell me
21   or -- because we had this discussion several months ago
22   when we even discussed the CD&A, pay-for-performance,
23   the frequency of pay-for-performance.  I mean, the list
24   goes on and on.
25             MR. CHACE:  I can tell you that the way we use
0262
 1   public documents, the research companies, the 10-Ks and
 2   the 10-Qs, for the numbers, for the business
 3   description, for the footnotes to financial statements,
 4   the management discussion and analysis which I think is relatively
 5   straightforward.
 6             (Outside noise.)
 7             The compensation disclosure is much less.  I
 8   think it's really (inaudible) put together.  It's not an
 9   area where we typically focus -- I can't speak for every
10   investor, obviously, but I think that we spend a lot of
11   time talking about it, try to gauge their motivations
12   from that.  Compensation is a part of that.  It really
13   is (inaudible).  We're looking for people that are
14   founders, inside owners as well.  (Inaudible) complex
15   pay structure.  Conflict minerals is (inaudible).
16             MS. JACOBS:  Okay.  So we got one.
17             MR. DENNIS:  I think the question on the
18   conflict minerals is, that’s in the law, right.  Congress
19   wrote that. It wasn't written for customer protection.
20             I think the question is to the SEC staff:  Do
21   we have any flexibility here?  Because the law is pretty
22   clear.  As I understood it, it said you will do this.
23   And so does the SEC staff have any ability to exempt
24   companies under a certain size?  I don't know the answer
25   to that.
0263
 1             MR. NALLENGARA:  The final rule, which was
 2   adopted late last month, didn't exempt any company.  And the
 3   reason for that is expressed in the final rule, is that
 4   the congressional mandate in Dodd-Frank didn't
 5   provide -- didn't contemplate anything other than all
 6   reporting companies have to do the -- have to do
 7   disclosure. There is some phasing provided for smaller
 8   companies.
 9             MR. DENNIS:  You know, it's like a
10   four-year --
11             MR. NALLENGARA:  Four-year.
12             MR. DENNIS:  So we got four years to get
13   Congress to change the law, kind of how I --
14             MR. NALLENGARA:  Well, it's not really four
15   years. After doing four years, they don't have to -- you
16   know, there's a varying -- without getting into -- and I
17   think we're all in painful detail of the rule, there are
18   some variances, there are some stages of work that a
19   company would have to do.  Whether you can certify and
20   get an audit saying that your stuff is conflict-free is
21   at one end.
22             And a smaller company can for four years
23   effectively say they haven't been able to determine
24   whether it's conflict-free.  So it's still work for them
25   to do, but it's a part of -- it's part of an elaborate
0264
 1   transition mechanism, smaller companies have a longer
 2   transition.
 3             So I mean, this is -- and I don't think
 4   anyone, at least -- I'm from the staff perspective, I
 5   think the Commissioners, I don't think anyone is
 6   thinking this is disclosure that an investor determining
 7   whether they're going to buy or sell its security is
 8   looking for.  This is not that.  This is -- I mean,
 9   that's not what the purpose -- I don't think that's what
10   the purpose of -- if you look at Dodd-Frank, that wasn't
11   the intended purpose.
12             So when you look at materiality, it's probably
13   not the best lens to be looking at this Act, because I
14   don't think that was the lens that anyone who --
15             MR. DENNIS:  But I think it does show a
16   dangerous trend of Congress using this organization as a
17   way to social engineer something that is not in its
18   mandate, not in its charter.  And I don't expect you to
19   comment.
20             MR. NALLENGARA:  No, no, and I'm grateful it's
21   not webcast, so --
22             MR. DENNIS:  We can make a recommendation
23   that -- maybe the recommendation, Christine, is that we
24   try to seek congressional action on this in some way. 
25   That's probably the answer to this.  Maybe that's how we
0265
 1   form our recommendation.
 2             MS. JACOBS:  Well, okay.  That's one
 3   suggestion. But then I'll throw another one out to the
 4   folks that are investors.  XBRL.
 5             MR. CHACE:  I am not certain how much we use
 6   it directly.  I mean, the word -- and we use basically
 7   the filings to plug in our own numbers.  It's not clear
 8   to me how XBRL makes my life better.  We do use a lot of
 9   financial information providers that probably benefit
10   from XBRL that we use to download data.  So they have
11   some secondary positive effect on us, but not
12   day-to-day.
13             MR. LEZA:  Can we get back to jobs, get back to
14   access to capital, which is basically why this group was
15   formed for.  I like to separate it in two ways here to
16   make a comment, one from the private side, and one from
17   the public side.
18             From the private side, I was involved in
19   startups in six companies.  One of them failed, five
20   were acquired in M&A.  Okay.  And there was three
21   things that you looked at.  And the animal has changed
22   from IPOs, the way I see it.
23             Okay.  The first thing you look at, risk.  You
24   look at risk.  And you kind of evaluate what my options
25   are going public or what my options are going M&A.
0266
 1             The second thing you look at is, what kind of
 2   money am I going to get based on IPO and based on M&A?
 3             If you look at it, M&A has been swinging to
 4   where they used to have a multiple one or two, and now
 5   they're paying seven or eight.  Now, so you kind of look
 6   at it and say, I mean, I can get seven or eight.  I'm
 7   not tied up.  There's no locking.  I can -- my stock can
 8   be, you know, liquid in no time.  And since it's a big
 9   corporation, I can sell immediately because I don't hold
10   that much of a percentage based on the large
11   corporation.  So the animal has changed from the private
12   side.
13             So a lot of the companies that you see, they
14   look at risk, they look at how much money.
15             And then the other problem that they look at,
16   and I think this is one big problem, is all of a sudden
17   you've got two things.  From the private side you go in
18   and you look at it, and all of a sudden it becomes
19   performance quarter to quarter.  They don't care about
20   the long-term.  It's quarter to quarter.  And people do
21   not like working like this.  When you're private, you're
22   looking at three to five years, and you're making
23   decisions in three to five years.
24             And this thing about, I need to be looking at
25   it quarter to quarter, you spend so much time doing that
0267
 1   and trying to see what you need to little tweak and
 2   stuff.  And you look at this and say, hey, it's a choice
 3   here.  It's not that -- you know, I can understand some
 4   of the presentations and some of the stuff, but I think
 5   the pendulum has changed.
 6             From the public side, being involved with
 7   public companies and market cap all the way from I would
 8   say, you know, 70 million all the way to 450 million,
 9   you look at that from the private side.
10             And I can understand SoX, you know.  And like
11   I said before, when we implemented SoX, for the first
12   two years the expense went up, and it went up quite a
13   bit, you know.
14             But then within the next two or three years,
15   there was certain things that were implemented, and we
16   brought the cost right back to where it was before.
17   Okay.
18             So I don't think that that is something that
19   prevents things from creating a bigger company or adding
20   jobs or stuff like this.  I think regulations, yeah,
21   they're an irritation, but I don't think that that's
22   something that keeps the people from thinking
23   differently.
24             I still think the focus -- what becomes
25   important is that access to capital.  I need to get more
0268
 1   money to do more things.  And a lot of times what
 2   happens is you're in the public company, you've gone
 3   public and you've got money, and it depends how you look
 4   at it.
 5             In a semiconductor company, we had a company
 6   that was sitting there, we were growing double digits,
 7   but -- you know, and we had $250 million in cash and we
 8   were doing something like -- our revenue was like $80
 9   million, and, you know, we were public.
10             But then another company came in and said,
11   look, if we consolidate, we can buy and do this, do
12   that.  The numbers were right, so we said, okay, let's
13   do it.  It's not that we didn't want to be public; it's
14   just that the economy and the choice became greater by
15   consolidating and selling out.
16             The thing that we have to look at is that both
17   private and public companies create jobs when they have
18   access to capital, and I think that's the thing that we
19   gotta look at more closely and see what we can do to
20   relieve some of the constraints so that people are more
21   freely picking up capital and being able to grow in a
22   faster rate than we can have.
23             MR. GRAHAM:  Right.  Can't disagree with that.
24             MR. SUNDLING:  I think one of the key points
25   in there if I can chime in that I think that can't be
0269
 1   lost in this discussion is those multiples and how it's
 2   swung.  So I remember -- this is not being webcast,
 3   right?
 4             MS. ZEPRALKA:  It's being recorded.
 5             MR. GRAHAM:  Recorded.
 6             MR. SUNDLING:  Oh, it's being recorded.  Oh. 
 7   Well, then, I won’t go through that example, but --
 8             There was an event back in around the dot-com
 9   boom days.  And, you know, we had an offer on the table.
10   And at the time, right, it's exactly what you said, is
11   M&A, the multiples were pretty modest.  You know, there
12   were 3X, and there were -- there were, though, these
13   ridiculous dot-com deals happening.
14             But on the M&A side, you could expect a
15   reasonable return, but there was no limit on an IPO
16   because you'd have -- and there were a couple
17   companies -- won't name their tickers, but one of my
18   favorites had 63 million in revenue and a market cap was
19   $16 billion, right.  And so everybody -- you know, we
20   all knew deep down that wasn't going to last, but that's
21   what you were going after.
22             Now it's all about the alternatives.  So, you
23   know, we had some nice offers, and we turned them down,
24   which today, these offers would be -- you know, you'd
25   jump on in a second, right.  But it was because of the
0270
 1   alternative opportunity and an IPO was worth the risk
 2   and all the other things that come with it, because it
 3   was just ridiculously different what you could do if you
 4   had a successful IPO you -- taken out early.
 5             And that's changed, right.  So now it's more
 6   about those multiples are up, because look at who the
 7   buyers are.  Just check the balance sheets of all these
 8   big -- they're sitting in aggregate hundreds of billions
 9   of dollars in cash looking for something to do.  They're
10   all on buying frenzies, right.  They're taking all the
11   components they need to grow these massive companies.
12             And on the other side, you've got this crazy,
13   regulated, painful thing called being public.  You know,
14   it's a pretty easy choice, right.  And so I'll leave
15   that one alone.
16             I promised Lona I'd complain about one more
17   thing before I left, which is this accredited investor.
18   Okay.  Time to do that?  Just so we can get some
19   specific recommendations.
20             MR. NALLENGARA:  Sure, yeah, any -- yeah. 
21   More complaining is good.
22             MR. LEZA:  With recommendations.
23             MR. NALLENGARA:  Yeah, yeah, if you're going
24   to complain, yeah.
25             MR. SUNDLING:  Around 506 which -- so the good
0271
 1   news is these reforms around 506 are phenomenal, right. 
 2   To actually be able to tell somebody that you're selling
 3   stock, that's pretty good, right?  And we did a PPM and
 4   we had to go through all this stuff, and then you get to
 5   this notion of accredited investor and who is it.  And
 6   whatever the -- 200,000 now a year, expecting it for the
 7   next year or a million in net assets exclusive of real
 8   estate.
 9             MR. NALLENGARA:  Of your house, your home.
10             MR. SUNDLING:  Of your primary residence?
11             MR. NALLENGARA:  Yeah.
12             MR. SUNDLING:  Okay.  So the measurement
13   you're looking for is a sophisticated investor that can
14   evaluate risk, right.  I think nobody would argue that
15   just because you have a million bucks in the bank or you
16   make $200,000 a year doesn't necessarily make you a
17   sophisticated investor.  And if there are a lot of
18   people -- you can have a Harvard MBA graduating that's
19   making, you know, 90K doing some analysis work down the
20   road that knows more about your market and your business
21   than anybody else on earth, and you can't take a $10,000
22   check from him, it just doesn't seem like that's the
23   measurement, right.
24             That maybe these things were thrown out there
25   because somebody needed to -- you had to have some kind
0272
 1   of measurement, but what can we do to ease that? Because
 2   when you talk about -- someone in here mentioned, I
 3   think it was this young man here, cutting off access and
 4   limiting investment to certain people.  I would argue --
 5             MR. GRAHAM:  You can still take money from
 6   that Harvard professor, you just can't rely on Reg D.
 7             MR. SUNDLING:  Okay.
 8             MS. SMITH:  He can be part of your crowd
 9   funding.
10             MR. SUNDLING:  Yeah.  So anyhow, some look at
11   making that a little smarter on identifying what exactly
12   is an accredited investor.
13             MR. GRAHAM:  Okay.  I want to make sure
14   everyone has a chance to comment before we run out of
15   time.  I haven't heard from Karen or Catherine or
16   Kathleen.
17             MS. MOTT:  I just wanted to just maybe
18   summarize what I thought when I read all this material
19   and after listening today is that I think there's an
20   amalgam of factors that are contributing to the issues
21   we're dealing with in the marketplace.  And obviously
22   things need to be addressed.
23             Where I see critical issues in my industry,
24   because we're at a point where we invest -- we expect
25   VCs to follow on and invest in some of our companies.
0273
 1   And in the two areas are life sciences, biotech, I put
 2   them together, and clean tech that are very capital
 3   intensive.  They're going to require VC money.
 4             And when you have a contraction of the
 5   industry, what we're seeing is that a lot of these
 6   companies aren't getting appropriately funded, and that
 7   could really make a difference because there's no
 8   incentive, the IPO incentive has been taken away.  Or
 9   not taken away, but it has diminished.
10             So we have great concerns about when we're
11   making our investment decisions, wow, this is clean
12   tech, maybe we should not invest in this because we
13   don't think we're going to get the follow-on funding
14   that is going to be required for this company.
15             So my concerns, of course, are how much that's
16   going to impact those kinds of companies.
17             And my other concern is something else I'm
18   seeing, is in the M&A market.  One of our local
19   companies got 40 million in VC funding, was acquired
20   by –- it was called Renal Solutions.  It was a home dialysis
21   kit.  Acquired by Fresenius in Germany.  Fresenius
22   shelved the company because it was going to disrupt the
23   marketplace.  So they paid $200 million to shelve it. So
24   it didn't create jobs, some people made some money, and
25   it made no difference in the marketplace.  So, and it
0274
 1   could have made a difference in people's lives.  So
 2   that's a concern.
 3             My third concern is we can't be sitting here
 4   with blinders on and not be concerned about what's
 5   happening in China, people with lots of money.  And I
 6   was at a demo, a demo day in my own little town of
 7   Pittsburgh, and there were representatives from China
 8   there looking to invest in companies and build these
 9   companies.  And that surprised me because we're not
10   Boston, we're not Silicon Valley.
11             So let's say they find a Charlie, Charlie's
12   company is going to China.  Who's going to create -- the
13   wealth that's going to be created is going to be in
14   China, not here, you know, not in my backyard, if that
15   happens.  So those are the kinds of things I'm concerned
16   about if we do not address the IPO market.
17             MR. GRAHAM:  Kathleen.
18             MS. McGOWAN:  I just wanted to talk about life
19   sciences and the biotech industry.  There are two sides
20   to the story:  to stay private and then to look for an
21   M&A transaction.  When you're talking about developing
22   drugs, you're talking about clinical trial studies,
23   which could be hundreds of millions dollars.  And then
24   you've got a lot of big pharmaceutical companies.  And
25   their R&D organizations have been shut down, so
0275
 1   purchasing of -- M&A -- of smaller companies with certain
 2   expertise is the way to go and the ability to buy them.
 3             So IPOs may not always be an exit.  You know,
 4   you may not raise all the funds you need to continue
 5   clinical trials.  It may not be even an exit for the
 6   current investors, but, you know, that might be one way
 7   of -- one way that's stopping some of the IPOs.
 8             But I still think that if you could
 9   potentially get an IPO in the market, raise some money,
10   get some big milestones and possibly do a secondary,
11   there's another option of getting additional funds, and
12   then other funding to fund your clinical trials is
13   another option.
14             I think a lot of the JOBS Act will help with
15   reducing some of the required reporting.  Because you
16   have to think, some of these small companies have less
17   than 20 people.  You can't possibly get all the
18   reporting and all the things up to speed.  Yet they
19   still may have a lot of controls in place already to
20   make it, you know, a viable company and to, you know, be
21   reporting similar to what you need to do, which does not
22   have all the head count required and the cost associated
23   with it.  Like you said, you know, that money can go
24   into R&D or additional clinical trial, which is to go
25   into reporting.
0276
 1             And then I just had some questions on the
 2   tick, the size of the tick, which -- size that David was
 3   mentioning in, you know, the pilot program and how do
 4   you go ahead and do the piloting.
 5             Are the back office operations able to
 6   handle -- like if you had two different markets and how
 7   you would handle different tick sizes in those markets.
 8   Kind of getting the – devil is in the details in how
 9   would those things work.  Those are things I'm not
10   familiar with.  So those would be questions that I have.
11             But basically, you know, you have private
12   markets and potential M&A exit and then IP exit -- IPO
13   exit, what those possibilities were.  And if it would
14   help smaller companies get into the IPO market,
15   potentially raise additional funds to do clinical
16   trials, I think that that's well worth the effort.  But
17   I still have a lot of questions after everything today
18   on, you know, how do you go about doing that.
19             MR. GRAHAM:  Well, the good news is that this
20   committee only has to make recommendations.
21             MS. McGOWAN:  Right.  And I don't know a lot
22   of that.  Some of the things David brought up, I don't
23   know some of the back office of how you physically do
24   these things.  Are they almost more -- you know, I don't
25   know the logistics behind it.
0277
 1             MR. GRAHAM:  Right, right.
 2             MR. DENNIS:  Steven, on that -- at one point
 3   we talked about making a recommendation on the high tech
 4   companies with very simple operational structures, but
 5   large market cap structures.  Is that something that
 6   we're going to --
 7             MR. GRAHAM:  I'm sorry.  I'm not recalling.
 8             MR. DENNIS:  Okay.  Maybe I'm thinking of a
 9   different group or something.  But, you know, I think --
10   you know, we've exempted Sarbanes -- we've exempted
11   small companies from Sarbanes-Oxley.  And there's this
12   group of companies that are high tech, large market caps
13   and very simple operational structures that are not
14   exempted from SoX 404, and does that make sense to
15   recommend something around that?
16             MR. GRAHAM:  I'm not sure if we discussed that
17   in this group, or if it was one of the times I was
18   sleeping.
19             MR. DENNIS:  Okay.  I'm sorry.  I'm brain
20   dead.  I must have thought about it -- it must have been
21   somewhere else.
22             MR. GRAHAM:  But I do think that one of the
23   things that we have to be thinking about in terms of
24   this recommendation is kind of the way things have
25   played out where now we have -- we have -- you know,
0278
 1   people essentially kind of acknowledge that the scaling
 2   can be a good thing.  I mean, it's going to make sense
 3   in a lot of contexts.  And that's given us smaller reporting companies
 4   portion of money.  And it's given us the emerging
 5   growth company.
 6             But, you know, within that are, kind of
 7   overlooked, kind of orphans I think in this whole
 8   process, are the companies like Chris's company where it
 9   doesn't -- it doesn't qualify for any of this stuff. But
10   if she had an IPO with her company and with all the
11   characteristics necessary to qualify as an emerging
12   growth company, she does IPO on December 8, she would
13   qualify for all the benefits.  But if she had done an
14   IPO on December 7, she wouldn't.
15             So there's -- not sure how that really kind of
16   plays out in terms of, you know, protection for
17   investors.
18             But I think, you know, certainly a part of
19   this kind of goes back to, you know, kind of the notion,
20   to what extent does it make sense to have, you know,
21   multiple markets?  I think that might go to what
22   Kathleen was saying as well.
23             I certainly -- I certainly think that what
24   relief that we have provided for some companies probably
25   could be extended to others.  And I also probably made clear that
0279
 1   I think it makes some sense in terms of coming up with
 2   kind of another market to operate kind of alongside the
 3   markets we currently have in place.  Definitely might
 4   make things easier.
 5             Just conceptually or intuitively, I feel if we
 6   had a market and it was geared only to accredited
 7   investors and so all the disclosure was simplified
 8   accordingly, but nonetheless, who was that you -- you
 9   were going to have access to in fact every accredited
10   investor in the world, that you could probably build
11   something.  But that's just -- I mean, it seems to me
12   those are -- those are things that we're going to need
13   to explore.
14             Yes.
15             MR. BORER:  It's hard to make a recommendation
16   that they should study the fact that we're all really
17   worried about the IPO market being dead and being unfair
18   out there for small companies.
19             One thing I think that makes a lot of sense to
20   some of the stuff that has been talked about today seems
21   to be recommendation that the SEC studies this or it
22   actually looks at regulation can do this as opposed to
23   legislation.
24             But I think making all the companies who are
25   already public subject to similar reporting requirements
0280
 1   that were created in the JOBS Act for that first five
 2   years seems like a no-brainer.  It absolutely seems like
 3   a no-brainer.  Why somebody didn't say, hey, why are we
 4   putting shackles on these people already because they
 5   were dumb enough to already get public and letting these
 6   others, you know, run without that problem, that seems
 7   like a very easy recommendation.  And it's not just
 8   because I'm sitting next to Chris.
 9             The other thing with respect to -- David is
10   gone now -- Wall Street and the indicting statistic up
11   there today was how many book running managers were
12   there ten years ago versus how many there are today? And
13   it doesn't have anything to do with the fact there's
14   high speed trading taking up the gap.  They don't bring
15   companies, you know, public.  Morningstar is not
16   bringing companies public.  That's just a
17   misunderstanding in the market.
18             If there's anything that can be done to create
19   more H&Qs, Alex Browns, Behrman Sells, Sutros, Adbest,
20   Tucker Anthonys, you know, all these guys, we should try
21   to do it, or else the government is going to have to
22   step in with something like Community Reinvestment Act
23   and say to these big brokerage firms, unless you guys do
24   these 20 small IPOs a year, we're not going to let you
25   do business with the treasury, okay, in the market.  And
0281
 1   I don't think that would make sense. It didn't work with
 2   big banks, it's not going to work with brokerage.
 3             Pick up something specific.  If it's tick
 4   size, I don't see any downside to it.  It may be
 5   politically unpopular because people would say, well, if
 6   mom and pop investor might by paying another -- you
 7   know, a higher commission than they did through -- they
 8   are right now through Scottrade.  Scottrade at 5.95 isn't
 9   giving them any service.  It's a wonderful execution
10   platform, but there's no service.  And it's dried up the
11   small end of the market, not only for the IPOs, because
12   those firms don't exist anymore to bring them, but also
13   the execution and follow-on.
14             It was -- this morning I think it was David
15   said, he's been on desks, he's run desks.  I'm not going
16   to put up $10 million to take a block of stock because I
17   can't pay 25 cents.  I can make 1 cent on the upside and
18   $2 on the downside as far as per share.  It just won't
19   happen.
20             And you can regulate all you want, but if the
21   regulation makes it so that the people you're regulating
22   have no incentive to take the risk unless you force them
23   to take that risk through some mandate, they won't do
24   it, we go home.  I think that's what's taking place.
25             So either investigating or actually
0282
 1   implementing something, even if it's on a test or trial
 2   basis with this tick size, voluntary or algorithmic or
 3   otherwise, it's -- you know, it's a little expression,
 4   light one candle, you know, as opposed to cursing the
 5   darkness.  Because if we just say, let's encourage more
 6   small brokerage firms to get in business and see if they
 7   do IPOs, we're going to be too old to see the results.
 8   It won't happen.
 9             So those are two specific things I would
10   suggest we take a look at.
11             MR. GRAHAM:  Agreed, agreed.
12             MS. JACOBS:  Feel the same?
13             MS. SMITH:  I totally agree with everything
14   John said.  I think he's spot on.
15             MR. GRAHAM:  You got to give us more than
16   that, Karen.
17             MS. SMITH:  Well, I --
18             MS. JACOBS:  We'll take the I agree.
19             MS. SMITH:  No, I appreciate it because, I
20   mean, I've been struggling today with what is our
21   mandate, like what this committee’s mandate, now given the
22   changes that happened since we first met around this
23   time last year because the JOBS Act, all the things that
24   have transpired since then.  So I appreciate John
25   articulating it in the way he did.  I think those are
0283
 1   two very concrete recommendations that we could actually
 2   make.
 3             MS. GREENE:  I'll jump in real quick.  I know
 4   we're out of time.  But I absolutely agree with what he
 5   said on both counts.  The exemptions and things that
 6   were done with the JOBS Act doesn't help me, doesn't
 7   help Chris, doesn't help existing companies because we
 8   were dumb enough to go public, whatever.
 9             So but even more so than saying, okay, take
10   all those exemptions and apply them, let every company
11   take them.  Well, but I want them longer than five years
12   if I can't get my market cap or my revenue or my assets
13   or whatever up over some amount.
14             So as Chris said at the beginning where that
15   75 million market cap, which I really appreciate right
16   now, because we're under that, but if we crowd -- if we
17   get close to that number, my incentive to stay under
18   that market cap is going to be really high, which works
19   totally against investors, because I don't want to do
20   404(b).  I don't want to do all those things.
21             So, as Chris said, where 75 million dollar market
22   cap came from as far as exemptions or small
23   reporting companies, I think that needs to be --
24   certainly needs to be increased.  Whoever said the
25   market cap $787 million is 94 percent of the total
0284
 1   public company value, and so everybody under -- you know
 2   how far away a $787 million market cap is for us?  It
 3   will never happen in the lifetime of me and the next ten
 4   generations, I suspect.  So, but that's only 6 percent
 5   of the total public company value.  And we're -- you
 6   know, we help the little companies under 75 million.
 7             So I will jump out there and say I like what
 8   John said, but I would make that -- those small company
 9   exemptions -- set the market cap so if I still don't hit
10   whatever the market cap is in five years, I don't fall
11   off that exemption thing and go, oh, now you're there.
12   So -- based on what Chris said.
13             Some of the things that Charlie said, and
14   these are just -- I wrote them down so I wouldn't ramble
15   too much.  So there is no -- as Charlie said, the
16   perception of being public, there's no payoff for that for a
17   small company. Whether that's reality or not, that's the
18   perception. And I don't hear any small public companies
19   talking about how great it is to be public, because
20   there is no -- there's no payoff.
21             Making the IPO process -- and I don't know
22   which one of you guys said it -- making it more
23   attractive doesn't solve the lack of post IPO support
24   for small companies.  So you go out and, you know, you
25   do this great IPO, but if you're not -- if you're not
0285
 1   the billion dollars or whatever, there's no money in it
 2   for the guys that actually used to provide that
 3   support -- that support in terms of research and
 4   investment banks and whatever.
 5             I can't tell you how many investment banks I
 6   talked to.  I have no deal for you.  Well, they're not
 7   going to make -- I mean, we trade 5,000 shares a day.
 8   They're not going to go for that.  I mean, there's
 9   nothing -- there's nothing that our company's doing that
10   would incentivize anybody to put any support in, make
11   the phone calls to the brokers, whoever said all that.
12   There's no money there.
13             So until there's money there, and maybe that's
14   tick size, until there's some financial incentive for
15   those guys that used to support public companies,
16   small public companies -- until there's some financial incentive, I don't
17   think -- I don't think anything is ever going to be
18   solved.  Companies are not going to go public because
19   they can't get the aftermarket support.  Nobody in --
20   out of the goodness of their heart is going to spend a
21   bunch of time trying to support very small companies,
22   because we're all in everything we do to make money.
23             So I think -- I think tick size is the most
24   concrete suggestion I've heard.  And I don't understand
25   it exactly either.  I don't know -- if you came to me
0286
 1   and said, what do you think your tick size is?  I don't
 2   know.  But why not try it?  I mean, it can't get any
 3   worse, right?  I mean, for us it can't get any worse.
 4   For Chris, it probably can’t get worse.  So why not try
 5   it.  It's a concrete suggestion.  Let's -- why not throw
 6   it out there.
 7             Investor interest, it is about increasing
 8   shareholder value, which is increasing stock price. That
 9   is the result of earnings and growth.  Cost to be
10   public, million dollars, whatever.  You take that out of
11   your earnings, the pressure on earnings to continue to
12   grow in order to increase your shareholder value, in order
13   to keep investors interested, it's very circular.  And
14   the more money you spend on stuff, cost to being public,
15   whatever, reduces earnings.  If you're not growing
16   earnings, then the investors aren't interested in you.
17   Again, they're in it to make money, they're not in it
18   because they're feeling generous today.
19             SarbOx, somebody said, had a very small
20   impact.  I adamantly disagree with that.  But that may
21   be perception now more than anything.  SarbOx, the
22   idea why public companies don't -- or why private
23   companies don't want to go public.  SarbOx is a huge
24   issue.  And whether that's reality or not, the
25   perception is it's a huge issue.  I don't want to deal
0287
 1   with the SarbOx stuff, so --
 2             And then even if the original reason for
 3   wanting to go public is to raise capital, don't we all
 4   want to get -- and I throw this out.  I'm tired and
 5   maybe this doesn't make sense.  But don't we all want to
 6   get to where we don't need to raise money?  I mean,
 7   don't we want to grow our companies to where they're
 8   organically growing to support or growing enough that we
 9   can support our growth internally with organic cash flow
10   and all that, as opposed to having to go back out to the market
11   to garner more -- to raise more capital?
12             So capital formation may be -- or capital
13   raising may be a viable reason to go public to start
14   with.  But I know, in my mind, I would eventually want
15   to outgrow that anyway.  Once you outgrow that and you
16   don't need to raise money, as Richard said, we have so
17   much cash on the balance sheet, then you have no deal
18   for anybody to do anything for you, so, you know, again
19   it's circular.  There's no support.
20             MS. JACOBS:  So then why go public?
21             MS. GREENE:  Yeah.  I mean --
22             MS. JACOBS:  You can’t get out, you’re going to get sued --
23             MS. GREENE:  Or you're going to leverage your
24   company so bad to get out that -- yeah.  So
25   recommendation is raise the $75 million market cap on
0288
 1   small reporting companies up to -- I don't know, I mean,
 2   787 million sounds like a great number, but, you know,
 3   I'll take 500 million or whatever.  I think that's a
 4   great recommendation.
 5             Tick size.  The only concrete thing, I mean,
 6   that I've really heard that might help the aftermarket
 7   support for those people that can actually do something
 8   with your stock, the market makers and the traders and
 9   all that, why not recommend that and see what the SEC
10   comes up with?
11             MS. JACOBS:  Any other -- any discussion
12   around the 787 million market cap?
13             DR. RITTER:  I've got a catchy acronym.  We
14   call it the "BOEING" amendment.
15             MR. DENNIS:  The problem with -- if you go up
16   to 787 million, and I'm trying to remember the
17   statistics we looked back four, five years ago, Gerry. 
18   But the 75 million, I believe, came from, it was 1
19   percent of the market cap, is where that -- I thought
20   that's where we kinda came up with that recommendation. 
21   Because it was 25 million at one point.  The 787
22   million, although it's 6 percent of the market cap, it's
23   something like 80 percent of the number of public
24   companies.
25             So if you exempt 80 percent of the public
0289
 1   companies out there from Sarbanes-Oxley, and you've kind
 2   of done an end run around Congress and the law, and I think
 3   you get -- I think it's easy to say.  I think it's hard
 4   to go down and say, Congress adopted a law that said
 5   public companies have to do this and the SEC is going to
 6   exempt 80 percent of the public companies out there.
 7             MS. GREENE:  Well, I think lower the number,
 8   then. Go to, I don't know, go to 75 million.
 9             MR. LEZA:  Go to 250 million, like I said
10   before.
11             MR. DENNIS:  I'm just saying it's harder than
12   just that.  But --
13             MS. JACOBS:  Right.  But the law -- but
14   Congress itself has exempted companies up to a billion
15   in revenue, which I don't consider emerging, but that's
16   how they've identified them.
17             MR. DENNIS:  First five years of their
18   existence, right.
19             MS. JACOBS:  That's right.
20             MR. GRAHAM:  Yeah.
21             MS. JACOBS:  Yeah.
22             MR. GRAHAM:  So you've raised a very good
23   point. And I think that one of the reasons why we
24   frequently have issues is that people kinda don't
25   normally -- they're really unable to foresee the
0290
 1   unforeseen consequences.  And I think that's one of the
 2   things that I want to make sure that we do as a
 3   committee, make recommendations, perhaps raise certain
 4   issues that were raised.
 5             We are past time to -- wrap things up.  Has
 6   everyone had a chance to comment?
 7             (No audible response.)
 8             MR. GRAHAM:  What I would like to -- I've
 9   heard -- again, there are a number of things that we
10   talked about.  And I think that there is -- the seeds
11   have been planted, I think, for a number of
12   recommendations. Certainly there are two or three things
13   that are relatively concrete on the table.  And that is
14   the tick size. One has to do with expanding the -- expanding
15   the relief that was provided under the JOBS Act for a
16   broader group of small public companies, which just
17   happen to have gone public before December 8 and -- am I
18   missing one?
19             MR. DENNIS:  Conflict minerals.  Let's put
20   conflict minerals.  I mean, I'd put it on just because I
21   think conflict --
22             MS. JACOBS:  I don't think we have a thing to
23   lose.
24             MR. DENNIS:  Well, I think Congress doesn't
25   read these reports.
0291
 1             MS. JACOBS:  Yes, no.
 2             MR. GRAHAM:  We'll make recommendations to the
 3   SEC, so I'm not sure.
 4             MR. DENNIS:  I don't know how we word it,
 5   but --
 6             MR. GRAHAM:  I'm not sure if our mandate says
 7   to do that.
 8             MS. JACOBS:  But I think we can go on record
 9   as recommending --
10             (Talking simultaneously.)
11             MR. GRAHAM:  (Inaudible.)
12             MS. JACOBS:  -- an exemption.
13             No, that's an action.  It's not going against
14   the law, right?  Can't we recommend -- can't we say
15   something about an exemption?
16             MR. LEZA:  As long as you define it as a
17   recommendation, you can say whatever you want.
18             MS. JACOBS:  Exactly.
19             And I have one follow-on for Leroy.
20             Leroy, there are several studies out there,
21   one in particular is a high state and the couple of
22   others that have defined small reporting companies, and
23   they range from 250 million to 700 million, and maybe
24   what we could do is sort of hold to find out a
25   propensity of what that market cap should be.
0292
 1             MR. DENNIS:  Yeah, you can --
 2             MS. JACOBS:  You understand?
 3             MR. DENNIS:  Yeah.  There's all kinds of
 4   statistics out there, so what number of companies you're
 5   going to impact.
 6             MR. GRAHAM:  What I was about to say was we
 7   might do kind of thinking about maybe doing what we did last
 8   year with respect to what is that -- what is the
 9   recommendation that we said we approved telephonically?
10             MS. ZEPRALKA:  That was Reg D.
11             MR. GRAHAM:  Was that Reg D?  I'm thinking
12   about when we can have our next meeting.  And obviously
13   next month is October, which means into the holidays. 
14   Not going to do anything next month, November, December.
15   But it might make some sense to formulate some
16   recommendations around these few items, then get them
17   out to the group.
18             MS. JACOBS:  Oh, well, there's some very
19   practical reasons.  Because those of us that are public
20   in January of 2013, several of these exemptions,
21   Say-on-Pay, frequency of Say-on-Pay, we have no
22   reprieves, so we are under a deadline as public
23   companies.
24             MR. GRAHAM:  So we're going to make a
25   recommendation.  That's not going to be changed by that.
0293
 1             MS. JACOBS:  No, but really nice to have a
 2   place card holder out there.  Correct?  We're up against
 3   deadlines January 2013, those of you that aren't public.
 4             MR. GRAHAM:  Okay.  Ladies and gentlemen,
 5   thank you very much.
 6             MS. JACOBS:  Thank you.
 7             (Whereupon, at 4:17 p.m., the meeting was
 8   concluded.)
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0294
 1                   PROOFREADER'S CERTIFICATE
 2   In The Matter of:   MEETING OF SEC ADVISORY COMMITTEE ON
 3                       SMALL AND EMERGING COMPANIES
 4   File Number:        OS-265-27
 5   Date:               Friday, September 7, 2012
 6   Location:           San Francisco, CA
 7   
 8             This is to certify that I, Donna S. Raya,
 9   (the undersigned), do hereby swear and affirm that the
10   attached proceedings before the U.S. Securities and
11   Exchange Commission were held according to the record
12   and that this is the original, complete, true and
13   accurate transcript that has been compared to the
14   reporting or recording accomplished at the hearing.
15   
16   _______________________       _______________________
17   (Proofreader's Name)          (Date)
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0295
 1   STATE OF CALIFORNIA                          )ss.
 2                                                ) 
 3   CITY OF COUNTY OF SAN FRANCISCO              ) 
 4   
 5             I, SUZANNE I. ANDRADE, CSR NO. 10682, a
 6   Certified Shorthand Reporter of the State of California,
 7   do hereby certify:
 8                That the foregoing proceedings were taken
 9   before me at the time and place herein set forth; that a
10   verbatim record of the proceedings was made by me using
11   machine shorthand which was thereafter transcribed under
12   my direction.
13             I further certify that I am not interested in
14   the outcome of said action nor connected with, nor
15   related to, any of the parties in said action.
16             IN WITNESS WHEREOF, I have hereunto set my
17   hand and affixed my signature this 13th day of
18   September, 2012.
19                     ________________________________
20                    SUZANNE I. ANDRADE, CSR NO. 10682
21                    STATE OF CALIFORNIA
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 1   Diversified Reporting Services, Inc.
 2   1101 Sixteenth Street, N.W.
 3   2nd Floor
 4   Washington, DC  20036
 5   
 6   In the Matter of:   MEETING OF SEC ADVISORY COMMITTEE ON
 7                       SMALL AND EMERGING COMPANIES
 8   File Number:        OS-265-27
 9   Date:               Friday, September 7, 2012
10   Location:           San Francisco, CA
11   
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