Remarks before Los Angeles County Bar Association 47th Annual Securities Regulation Seminar
Commissioner Kara M. Stein
Los Angeles, California
Oct. 24, 2014
Thank you, John Hartigan, for that kind introduction. It’s a pleasure to be here in Los Angeles, and thank you to the Los Angeles County Bar Association for inviting me to be here with you today. Before I begin, I need to provide the requisite disclosure: the views I am expressing today are my own and do not necessarily reflect the views of the Commission, my fellow Commissioners, or the staff of the Commission.
It’s wonderful to be here this morning. When I have an opportunity to visit California, especially Los Angeles, I’m always amazed that anyone gets any work done around here, because the weather is just too gorgeous.
Today’s conference is appropriately just down the street from the historic Spring Street Financial District – once known as the “Wall Street of the West.” The connection between Wall Street and Hollywood is legendary, and includes enormous figures such as Joe Kennedy, who traded stocks, financed movies, and became the first chair of the Commission.
In fact, I recently learned that the first motion picture filmed in Los Angeles was about Spring Street. It was a 60-second film by Thomas Edison entitled “South Spring Street Los Angeles California,” and it showed the vibrancy of LA’s business and financial center -- okay, maybe just the horses, wagons, and a trolley -- circa 1898!
Hollywood has helped make the exchange trading floor the public image of our financial markets. While the New York Stock Exchange has garnered perhaps the most cinematic attention, the old Pacific Stock Exchange, based both here and in San Francisco, had its moment in the Hollywood sun too in the movie Quicksilver with none other than Kevin Bacon. The imagery of exchanges, a topic I will return to later, is powerful and helps us reflect on some of the broader questions we at the Commission are confronting regarding how we execute our mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.
This morning I want to talk about capital formation. I’d like to explore three ideas. First, I want to share how I think capital formation has changed in recent years and some of the consequences of those changes. Second, I want to suggest how we should organize the options available to make capital raising easier and better for businesses and investors alike. Finally, I want to share a few specific thoughts about one particular option, known as Regulation A+, which is where I will return to the idea of exchanges.
Speaking of exchanges, I want to express my condolences on the recent passing of Charles Rickershauser Jr., the first chair of the Pacific Stock Exchange and someone many of you in the room may have known. Mr. Rickershauser’s notable and impressive career included clerking for Supreme Court Justice William O. Douglas, who was also one of the first chairs of, and had a deep impact on, the Commission – an impact which continues to resound today.
It’s interesting to think about the Pacific Stock Exchange as embodying the arc of change in our markets. Formed from a combination of the San Francisco Stock and Bond Exchange and the Los Angeles Oil Exchange, each with roots back to the 1880s, the PCX was eventually purchased by the computer-driven platform Archipelago, which later merged with the New York Stock Exchange. What was once a regional platform for middle-market and growing companies became absorbed into the complex electronic markets of today. While there is no doubt that there are benefits to these new markets for capital formation, one also wonders whether a little something was lost in the ability for small and middle market businesses to tap the capital they need to grow and thrive.
Indeed, there has been a great deal of change in recent years in the process of capital formation. Until recently, entrepreneurs seeking to raise capital for businesses had a relatively simple set of options, going from being private to being public. Company founders used their own capital, tapped friends and family, and set out to achieve a new idea. As these small private companies grew, angel and venture networks or maybe credit from banks became options. Additional growth and a history of results provided a foundation for access to even more capital through the public markets.
This “continuum of capital formation,” as I like to call it, in large part tracked the growth path of a typical business organization, from an idea in a garage, to a small or mid-sized business, and eventually to a company that would go public.
In recent years, technology and creativity have been massive disrupters of so many old orders and ways of doing things. I use “disruption” in every sense of the term, good and bad.
Yesterday, I visited a technology venture accelerator at USC’s Viterbi School of Engineering called the Start-Up Garage. Impressive technology generated by smart and creative young engineers and business people, each a “disrupter” in his or her own way. Could one of the ideas being incubated at this patch of the “Silicon Beach” revolutionize some sector? I don’t doubt it. Will every idea succeed? No. But that’s what makes the American entrepreneurial spirit great – creative disruption bound with a drive to try and try again. Yet, for even the most promising idea to succeed, it needs funding, in an efficient way, which is where our capital markets come in.
Our capital markets are the most vibrant and robust capital markets in the world not only because of so many creative and entrepreneurial people, but also because we have built those capital markets on a foundation of trust and confidence, making them attractive to investors all over the globe.
It should be no surprise to anyone here today that technology, the pace of innovation, and changes in the law – long before but, including the JOBS Act – have also “disrupted” the old capital formation process. Over the years, exemptions and exclusions, and exclusions from the exemptions, have built up. Now, instead of a one-track progression, we have a jumble of overlapping and inconsistent options for both private and public capital-raising.
In the private markets, an incredible array of new options now exist. General solicitation changed the ground rules for Rule 506, which we have heard has made life potentially more challenging for angel and venture investors. At the same time, it appears that ostensibly private companies can now advertise for investors whenever and wherever they want – in front of senior citizen homes, during the Super Bowl, or all over the Internet, without any review by any regulatory agency. Moreover, trading of a company’s securities with large numbers of shareholders can now occur entirely on private trading platforms. Are these private or public markets?
Similarly, there is now a jumble of public or quasi-public options, with crowdfunding for small companies, “mini-offerings” through “Regulation A+” serving mid-size companies, and an “IPO On-Ramp” for some very large companies. The rules of the game have changed here too, and the old assumptions about what to do when may no longer apply.
As the paradigm changes, we need to change too. The patchwork quilt that is our system is becoming increasingly complex, at times irrational and contains gaps. In my view, this potentially inhibits efficient capital formation at some stages on the continuum, while needlessly exposing investors to undue risks at other stages. If we were building a system from scratch, no one would rationally do it this way. It doesn’t have to be this complicated. We can preserve flexibility and a palette of options for companies all the way up the capital raising continuum.
The good news is that, as with most disruption, there is destruction, but there are also opportunities for creative transformation. Healthy change often doesn’t happen by accident. It’s kind of like modern art: disruption upended the old painterly forms and opened new tableaus for creativity. Unlike the free flowing world of art, in the world of capital formation bounded by securities law and regulation, we won’t end up with Jackson Pollacks and Mark Rothkos by accident. It’s our job at the Commission – with your input and support – to put the pieces together into a coherent, rational whole. What we have to do is rationalize the capital- raising jumble and turn it into a palette of options available to companies at each stage in their growth and development – simple, easy to understand, and easy to use for both businesses and investors.
I can’t stand here today and predict exactly how each of these options and paths will be used. Flexibility and creativity are the hallmarks of American capital markets. If we are to develop a useful palette of options, we should ensure both logical consistency, and a path forward without large holes or contradictions in the process.
For example, how will a company progress from crowdfunding to Regulation A+? Is there a hole in the capital formation continuum that we could fill by improving the old Regulation A rather than leaving it intact as proposed? How do we make sure that general solicitation for ostensibly private offerings under Rule 506 doesn’t undermine the public markets? How do we ensure that investors receive fair treatment regardless of whether they invest in the private or public markets?
Conversely, how do we make sure that we do not undermine the simplicity and flexibility of the old Rule 506 offerings that angel and venture firms have relied on for so many years? Similarly, can we make crowdfunding and private offerings compatible, in a world where follow-on investors don’t want to deal with the 100 or 200 individuals on the company shareholder list, and where the individual retail investors may not be well-equipped to negotiate – or exercise – the standard investor protections a professional would insist on? The list goes on.
The Commission is grappling with these tough questions. And, we don’t have all the answers. That’s why getting your feedback is vital. As you provide such input, it’s important to think not just about the effects of rules on good actors. We at the Commission frequently see the underbelly of the capital markets, and bad actors are out there. Ideally, we want rules that are simple enough to catch bad actors in their tracks, while both allowing good actors to utilize them efficiently and in a way that helps ensure healthy outcomes for folks that want to do the right thing. Sometimes good advice from repeat players – the gatekeepers, like lawyers and accountants – can make the difference between a success for companies and investors or a failure for both.
Simplifying things for businesses of all sizes also requires us to be even smarter about investors. We already recognize in our laws a distinction between sophisticated and unsophisticated investors. We need to be thinking about what types of investment decisions different types of investors can meaningfully make, and our capital formation continuum needs to take that into account. The SEC’s Investor Advisory Committee earlier this month put out a proposal on the definition of “accredited investor.” I’d like to get your feedback on it, as it appears to me to offer the potential to better align the opportunities and risks that various types of investors might want. We should also be doing more investor testing to better understand how different types of investors think and how disclosures can meaningfully assist such investors in making reasonable decisions. There is a lot more thinking that needs to occur in this space.
We also must be realistic about the limits of our regulators. The Commission has been weighed down for a number of years now with a range of costly burdens, and it can only do so much with the resources it has. Why can’t we leverage the expertise, accessibility, and resources of our state securities regulators with respect to smaller and regional offerings? Just like regional exchanges, regional regulation seems to make a lot of sense.
So, as I call for a comprehensive review and rationalization of our capital formation tools, let’s start by taking a look at how we might make Regulation A+ under the JOBS Act work smoothly.
First, we can admit that the old Regulation A clearly hadn’t worked. It was rarely used. How could it evolve? When I was working for the U.S. Senate as staff director for the Subcommittee on Securities, Insurance, and Investment, we heard testimony that raising the $5 million threshold in old Regulation A could provide a capital raising opportunity that relied on public markets and the protections of exchanges. Some suggested that this provision would enable a new, vibrant set of regional growth exchanges to fill an important gap in access to capital.
It’s interesting to note that much of the debate around the Commission’s proposed rules implementing Regulation A+ centers around the role of the state securities regulators. But this controversy somewhat puzzles me. I think that half of the problem is already solved, and the rest can be resolved in a simple, modest way.
First, for those who emphasize the importance of federal preemption to making Regulation A+ work, it’s already there: Congress provided for preemption for Reg A+ securities listed on a national securities exchange. Why did Congress do that? I suspect because the federal securities laws have long recognized the benefits for retail investors that come with an exchange listing. These protections include, for example, listing standards and reputational checks, as well as the secondary market liquidity that is facilitated by an exchange.
Given the investor protections already built into exchanges, could regional exchanges play a stronger role in building out the palette of options that companies and investors have when seeking to raise or deploy capital? It’s definitely a question worth thinking about. And to the extent those markets are not emerging, we should be thinking about why that is the case.
But what about securities not listed on exchange? I recognize that a 50-state blue sky approach has long been seen as complex and costly. In part, I think that the compliance challenges of a 50-state approach actually helps keep in check the public circulation of over-the-counter securities, which can be hotbeds for fraud. Given the powerful imagery of exchanges in the minds of investors, a more diverse and robust set of regional exchanges may be much preferable to thousands of OTC securities subject to no listing standards and with very limited secondary market liquidity.
Moreover, the state securities regulators have evolved and modernized. Just this year, the North American Securities Administrators Association (NASAA) put in place a streamlined review regime for Regulation A offerings with a single point of contact for all states, time limits on regulatory review, and a one-shot approval – meaning sign off for one and all. This unified regime is designed to review smaller offerings in a fast, efficient way. State regulators really are – or should be – the best equipped and most logical overseers for these mostly smaller, regional businesses and the investments in them.
And where one or another state isn’t participating, I would not be opposed to using SEC preemptive authority to ensure that the new NASAA one-stop shop process applies to all states. The result would be two options for a simple, nation-wide system for small and middle market offerings under Regulation A: exchange-listed offerings would be subject to federal review; and OTC offerings would be reviewed in a fast, efficient state-coordinated process.
However, this is just one idea. I’m open to developing other creative ways to make this new capital raising tool work and firmly place it on the palette of options along the capital-raising continuum. You have ideas. You’ve seen what works and what doesn’t. We need your best thoughts.
So let me sum up. The continuum of capital formation has changed dramatically, and it’s incumbent upon us at the Commission to comprehensively review all the exemptions and exclusions that have built up over the years, and to organize this patchwork quilt into a coherent, rational framework that works for the range of businesses that might use them and for all the different types of investors whose confidence enables businesses to thrive. . We need to do this, and we need to do it soon. Waiting is not good for anyone. But I think we should be able to walk and chew gum at the same time: we can and should engage in this capital formation review while we move forward expeditiously on fulfilling the statutory mandates we have on items like Regulation A+ and crowdfunding, among others.
I come to work each day at the Commission thinking about whether I am doing all I can to ensure that businesses can obtain the capital they need, in a marketplace where investors have confidence they are being treated fairly. But I can’t do it alone. I hope you will join in this important conversation. Please, reach out and contact my office. I’m optimistic that together we can move forward on this project, quickly, and open up and organize better options for bringing those who need the capital together with those who have it.
And on that note, let me just say I wish I were staying the weekend here at the “Silicon Beach” rather than hopping on a plane back to Washington! Thank you, and I look forward to a continuing dialogue on these important issues.
# # #
 Program Chair, Los Angeles County Bar Association.
 David Kipen, “First movie ever made of LA was of traffic … with no traffic jams!” Southern California Public Radio, Oct. 31, 2013, available at http://www.scpr.org/programs/offramp/2013/10/31/34452/first-movie-ever-made-of-la-was-of-traffic--with-n/.
 David Colker, “Charles Rickershauser, Jr. dies at 86; lawyer led Pacific Stock Exchange,” Los Angeles Times, Oct. 10, 2014, available at http://www.latimes.com/local/obituaries/la-me-charles-rickershauser-20141011-story.html.
 “Trading Floor’s Final Day At Pacific Stock Exchange,” New York Times, May 25, 2001, available at http://www.nytimes.com/2001/05/26/business/trading-floor-s-final-day-at-pacific-stock-exchange.html; “New York Stock Exchange/Archipelago Holdings Merger Complete,” PR Newswire, March 7, 2006, available at http://www.prnewswire.com/news-releases/new-york-stock-exchangearchipelago-holdings-merger-complete-55269462.html.
 “Recommendation of the Investor Advisory Committee: Accredited Investor Definition,” SEC Investor Advisory Committee, Oct. 9, 2014, available at http://www.sec.gov/spotlight/investor-advisory-committee-2012/investment-advisor-accredited-definition.pdf.
 See Scott Cutler, Testimony before Sen. Comm. On Banking, Housing, and Urban Affs. Hearing on Spurring Job Growth Through Capital Formation While Protecting Investors, Dec. 1, 2011, available at http://www.banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=a96c1bc1-b064-4b01-a8ad-11e86438c7e5&Witness_ID=39539e91-3e17-472f-950c-d8f813a0c8ec.
 See Edward Knight, Testimony before Sen. Comm. On Banking, Housing, and Urban Affs. Hearing on Spurring Job Growth Through Capital Formation While Protecting Investors, Dec. 1, 2011, available at http://www.banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=a96c1bc1-b064-4b01-a8ad-11e86438c7e5&Witness_ID=08f5ca07-51c7-4193-a5ce-2ccb41a6e532.
 JD Alois, “Nine Senators Submit Letter to SEC Opposing State Blue Sky Preemption,” Crowdfund Insider, Aug. 12, 2014, available at http://www.crowdfundinsider.com/2014/08/46617-nine-senators-submit-letter-sec-opposing-state-blue-sky-preemption/.
 Section 18(b)(4)(D) of the Securities Act of 1933 (as amended), added by section 401(b) of the Jumpstart Our Business Startups (JOBS) Act, available at http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf.
 “Regulation A Offerings NASAA’s Coordinated Review Program for Regulation A Offerings,” North American Securities Administrators Association, available at http://www.nasaa.org/industry-resources/corporation-finance/coordinated-review/regulation-a-offerings/; see “NASAA Members Approve Streamlined Multi-State Coordinated Review Program,” North American Securities Administrators Association, Mar. 11, 2014, available at http://www.nasaa.org/29699/nasaa-members-approve-streamlined-multi-state-coordinated-review-program/.