Remarks at the 2011 SEC Government-Business Forum on Small Business Capital Formation
Commissioner Daniel Gallagher
November 17, 2011
Thank you, Meredith, for your kind introduction. Thanks also to you and to Gerry Laporte and his staff in the Office for Small Business Policy for organizing this forum and assembling such a fantastic panel of folks to talk through the critical issues that face small businesses in trying to raise capital. Most importantly, I want to thank our panelists for giving their time today to lend their insights into these issues.
This is only my eighth day on the job, and I am incredibly excited to take on my new role as a Commissioner of the Securities and Exchange Commission. I am happy to tell Gerry that, in all my time as a Commissioner, this is the best event that I have ever attended.
At the risk of sounding pedantic, I think it is worth noting up front the Commission’s mission: to protect investors, ensure fair, orderly and transparent markets and promote capital formation. As the world economy continues to struggle to emerge from the doldrums of the last three years, and as U.S. regulators work to implement the Congressional response to the financial crisis of 2008 embodied in the Dodd-Frank Act, the Commission faces important questions about how to balance the sometimes competing priorities of investor protection and capital formation.
So I cannot think of a more timely opportunity to discuss these issues than at today’s forum, which brings together this group of owners, executives, advisers, investors and advocates for small businesses. Small businesses are truly the lifeblood of the American economy, yet they face a number of challenges in raising capital that may not be shared by their larger counterparts.
I know I am not the first person to recognize and I doubt that I am even the first person at this forum today to state that, if the American economy is to become vibrant once again, small business must be the driver that creates the jobs and economic growth that will lead the way.
A few brief statistics back this up. According to sources cited by the Small Business Administration, small firms – generally, firms having fewer than 500 employees:
- Employ about half of all U.S. private sector employees
- Pay 43% of total U.S. private payroll
- Have generated 65% of net new U.S. jobs over the past 17 years and
- Create more than half of the U.S. private gross domestic product.
If small businesses are to fulfill their role as the engines of economic and job growth, however, all regulators – and not least the SEC – must give them sufficient flexibility to raise capital, operate their businesses, innovate, take risks and otherwise take advantage of opportunities as they arise in the economy. This imperative is particularly true in light of the competition for capital and customers from international firms in places like India and China, which face far less restrictive regulations.
It is widely believed that the increased costs of being public as a result of the Sarbanes-Oxley Act and the Dodd-Frank Act have made it less attractive for smaller and growth-stage companies in the United States to be public, resulting in fewer IPOs and more companies considering going private. Some of these costs, like the unanticipated high costs associated with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act, are so significant and readily traced to a particular regulation that they attract significant attention, which fortunately can provide the impetus for some regulatory relief.
Others, however, are more incremental and less susceptible to easy measurement. Nevertheless, in part because the accumulation of a number of small requirements can ultimately result in meaningful burdens, these requirements can be just as costly to companies and, as a result, can have nearly as significant an effect on the willingness of companies to undertake a public offering. Some good examples of these requirements are the ever-expanding federally-mandated corporate governance requirements – such as director, audit committee and compensation committee independence requirements and mandated say-on-pay votes – as well as required disclosures of information that has little practical usefulness to real investors.
These costs and burdens can be difficult for any public company to bear, but clearly small companies, with their more limited human and financial legal resources, are often disproportionately affected.
For many of the rulemakings required by Dodd-Frank, the Commission may have little discretion. As we continue to implement the requirements of the Dodd-Frank Act, we should be very cognizant of the risks of chasing IPO candidates into private or offshore capital-raising transactions and look for opportunities to minimize burdens of being public, while remaining true to our mission of protecting investors. In addition to existing statutory requirements to consider the costs and benefits of our rules, some of the provisions of Dodd-Frank specifically charge the Commission with considering whether the required rules would have a disproportionate effect on smaller companies, and grant the Commission explicit authority to exempt smaller issuers. Furthermore, the Commission should use its general exemptive authority under the Exchange Act where appropriate.
It would be easy to minimize the consequences of smaller and emerging companies choosing not to undertake public offerings in the United States. Like the “dog that didn’t bark,” however, the economic significance of companies systematically deciding to defer IPOs, to forego U.S. IPOs altogether in favor of raising capital in private transactions or in foreign markets, and of venture capitalists seeking “M&A” exits rather than public offering exits from early-stage investments, should not be ignored.
To the extent that regulations tend to push issuers and investors away from U.S. public offerings:
- Ordinary American investors will have fewer opportunities to seek higher returns by investing in growth stage companies
- Issuers raising capital, and early round investors seeking an exit, will receive less for shares sold in private transactions because private investors are not willing to pay as much for illiquid investments. This lower return on investment, in turn, dissuades entrepreneurs and investors from pursuing these ventures in the first place, depriving our economy of entrepreneurship and innovation and
- Investors in these private transactions will be deprived of many of the protections afforded by the Commission’s robust disclosure and other rules.
Furthermore, just as we should avoid chasing issuers away from the U.S. public markets, we must also be careful not to insert ourselves into private transactions in inappropriate ways that hinder, discourage or penalize private deals. Private transactions can be a particularly important financing tool for smaller and growth-stage businesses that have not yet tapped the public markets. Clearly, private transactions can provide a number of benefits for both issuers and investors – in particular the ability to close a deal quickly and to agree upon whatever terms the parties deem most appropriate under the circumstances.
Nevertheless, there clearly is some role for federal regulation even of private transactions. Most notably, the anti-fraud provisions of the federal securities laws have always applied to securities transactions, whether registered or not.
Indeed, as my predecessor Kathleen Casey noted, the emergence of trading platforms for shares of private companies is largely an outgrowth of the phenomenon of private, growing companies delaying going public for as long as possible, driven in part by the high cost of being public. As Commissioner Casey and others have also noted, however, while these markets provide much sought-after liquidity for private company investors, they also raise a number of questions about whether investors that purchase shares on these markets require the protections afforded by the federal securities laws.
In addition, our regulations set forth detailed criteria for private transactions to be exempt from the registration requirements of the Securities Act. These criteria are intended to limit private transactions to instances where the need for the protections of the federal securities laws and regulations is diminished, such as where investors are sophisticated or have sufficient resources to fend for themselves.
The Dodd-Frank Act restricts or requires the Commission to adopt rules that restrict private placements in some measure. These provisions include the exclusion of “bad actors” from reliance on Rule 506 under Regulation D and the elimination, for purposes of determining whether a natural person is an “accredited investor,” of the value of a person’s primary residence from the calculation of his or her net worth. The Commission proposed rules relating to these provisions before I started, and I am reviewing these proposals and the public comments on these releases with great interest as I consider what rules I believe we should ultimately adopt.
In addition to carefully considering the impact of any new regulations that we adopt, we should, where appropriate, also consider whether there are existing regulations that are unduly restrictive. I am happy to say that there have been a few bright spots to point to over the last year or so in this regard.
In the Dodd-Frank Act, Congress appropriately, in my view, exempted smaller issuers from compliance with the auditor attestation requirements contained in Section 404(b) of the Sarbanes-Oxley Act. The benefits of the rule to investors simply were not worth the compliance costs.
I am also very pleased that both Congress and the Commission are considering ways to make private capital markets more robust, including consideration of:
- easing the limitation on general solicitations in the private placement exemptions
- increasing the offering size limitations under Regulation A
- creating an exemption from registration under the Securities Act for so-called “crowd-funding” transactions and
- raising the 500-shareholder threshold for registration under the Exchange Act.
Certainly, these proposals raise a number of issues that we must understand and address. Nevertheless, I believe these proposals represent a strong step in the right direction. It is also notable that the Commission is considering a process for conducting retrospective reviews of our existing rules – given my background, I could list several for you off the top of my head. I hope that all of these considerations will result in improvements in securities laws and recommendations for Commission action that will help small businesses to raise capital, consistent with the Commission’s mission to protect investors and facilitate capital formation.
With that, I will relinquish the microphone to Meredith to kick off the next panel discussion about Initial Public Offerings and Securities Regulation Involving Smaller Public Companies. Thanks once again to our panelists today for their contributions to this important event, and I very much look forward to seeing the recommendations that emerge from today’s forum.