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Capital Unbound: Remarks at the Cato Summit on Financial Regulation

Commissioner Michael S. Piwowar

New York, New York

June 2, 2015

Thank you, Mark [Calabria], for that wonderful introduction. For years, Cato Institute scholars like Mark have served as important voices in the public policy debate about individual liberty, limited government, and the free markets. They are voices that are profoundly needed in the continuing discussion about regulation of the financial markets. Thank you, Mark, also for organizing this great conference. I enjoyed listening to the remarks this morning by my good friend CFTC Commissioner Chris Giancarlo, who is doing an outstanding job of ensuring that his agency acts in a thoughtful way, as well as those by Josh Rosner, co-author of Reckless Endangerment — the must-read book that exposes how misguided government housing policy and crony capitalism cost taxpayers trillions of dollars in bailouts and lost economic growth.

I am happy to be with you in New York City. When I have the opportunity to travel for meetings or to conferences such as this, I have fundamentally different conversations than when I am in Washington, D.C. In Washington, conversations frequently are scripted. Participants, who may be accompanied by trade association representatives and lawyers, use their talking points and have been coached to “stay on message.” Those discussions are undoubtedly meaningful as we at the Securities and Exchange Commission (“Commission” or “SEC”) engage in rulemaking and otherwise set policy.

But outside of Washington D.C., people generally want to talk about something else. They want to share their dreams and concerns about running their businesses. They want to show how their products, services, and innovations contribute to the economy, create jobs, and improve standards of living. And more importantly, they want to demonstrate how inside-the-beltway regulations are often focused on concerns that do not represent the biggest risks of harm to investors, customers, and businesses outside the beltway. I hear how regulations distract attention from the real risks and challenges of operating a business in globally competitive markets.

Compliance with securities laws and regulations is only one component of running a company. A business must also comply with laws on consumer protection, taxes, safety, employment, zoning, and the environment, to name only a few. If you have multiple locations — such as in New York, New Jersey, and Connecticut — you must deal with regulators in each jurisdiction. Soon, it may seem like you exist not to provide a good or service, but just to stay in compliance with the law.

With that in mind, now would be a good time to provide my own compliance disclaimer. My remarks today reflect my personal views and not necessarily those of the Commission or my fellow Commissioners.

“Bootleggers and Baptists”

Over thirty years ago, economist Bruce Yandle famously coined the term “Bootleggers and Baptists” to describe a public choice theory of economics, which observes that, for regulation to endure, groups that otherwise have opposite points of view choose a regulatory structure that results in private benefits for both but perhaps is suboptimal for society.[1] In Yandle’s illustration, Baptists support laws that shut down all bars and liquor stores on Sundays. Bootleggers are also in favor of such laws, but for entirely different reasons. If Sunday closing laws are in place, both parties get their preferred outcome, and the rules are easy to administer. But if the problem is consumption of alcohol, Sunday closing laws merely shift the production and distribution of alcohol from one group — bars and liquor stores — to bootleggers, while giving a false impression that the public interest is being served. No pun intended.

Yandle described this regulatory approach as making complete sense, when viewed from the regulator’s perspective. A regulator, Yandle reasoned, is most focused on minimizing its costs, rather than the overall costs of the regulation. One example is the regulator’s cost of enforcement. A regulator may be inclined to favor rules that minimize the number of circumstances in which a mistake can be made; for instance, unless a lawmaker confuses the day of the week, it is clear under a Sunday closing law whether a bar or liquor store is required to be closed. It is less costly for a regulator to adopt simple, across-the-board rules that are easy to monitor and enforce than alternatives that take into account economic efficiency and distributional effects — how costs and benefits are distributed among different groups. One area where we see this result is private securities offerings.

Accredited Investors

The theme of this conference is “capital unbound.” In contrast, the theme of the Securities Act of 1933 (“Securities Act”) could be characterized as “capital restricted.”[2] The Securities Act prohibits the use of any instrument of interstate commerce to offer or sell a security, unless pursuant to a registration statement declared effective by the government.[3] It is a blanket prohibition on raising capital unless you have the government’s authorization, or you can find an exemption.

The language of the prohibition, though, does not simply prohibit capital raising transactions, or sales of securities. It also prohibits offers, which the law defines as “every attempt or offer of, or solicitation of an offer to buy, a security or interest in a security, for value.”[4] And the Commission broadly construes the term “offer” to encompass any public statements that might “condition the market” or arouse interest in an issuer.[5]

Fortunately, the statute and regulations are not so draconian as to require government permission for each and every private securities offering; there are a number of exemptions. Still, the burden remains with the issuer to prove its eligibility to use an exemption. One of the most noteworthy exemptions is contained in what we call Regulation D, which is a safe harbor for private offerings. Commission data shows that Regulation D offerings are the most popular type of exempt offerings when compared to other exemptions.[6] I suspect that, despite recent SEC rulemakings intended to improve other exemptions, such as Regulation A, issuers are likely to continue to favor Regulation D for the foreseeable future.

Regulation D is based on a provision in the Securities Act, which states that the obligation to register with the government will not apply to any “transactions by an issuer not involving any public offering.” The Supreme Court addressed the definition of public offering in 1953.[7] The Court offered the following interpretation: the exemption should turn on whether “the particular class of persons affected needs the protection” of the securities laws and should be only utilized by persons who can “fend for themselves.”[8]

Yet, consistent with Bruce Yandle’s theory, the desire for regulatory simplicity resulted in the need to draw bright lines. In 1982, the Commission did so when it adopted Regulation D. It essentially divided the world of private offering investors into two arbitrary categories of individuals — those persons accorded the privileged status of being an “accredited investor” and those who were not. In short, if you made $200,000 or more in annual income or had $1 million or more in net worth, then you were in the privileged class and could choose to invest in the full panoply of investments, whether public or private. If not, the government decided that, for your own protection, you were restricted access to these private investments.

One of the few provisions of the Dodd-Frank Act that I can strongly support authorized the Commission to undertake a study of the definition of accredited investor as it applies to natural persons to determine whether it should be adjusted or modified.[9] I welcome this review, and am pleased that staff in our Division of Corporation Finance is currently working on the study.

The $200,000 income test has not been updated since 1982, even though, due to the effects of inflation, $200,000 in 2015 dollars represents a different amount of purchasing power than in 1982 dollars. The net worth test was revised as part of the Dodd-Frank Act to disallow equity in one’s residence from being counted, but otherwise remained unchanged. In my view, there is an obvious need to revisit these thresholds.

As the Commission’s Investor Advisory Committee has pointed out, simply adjusting the tests for inflation may not be the right answer.[10] We do not know, for instance, if the levels set in 1982 were right to begin with. Were they too high or too low? Further, a single national threshold might be both under-inclusive and over-inclusive at the same time: earning $200,000 a year in rural Iowa is quite different than making $200,000 here in New York City.

Moreover, the income and net worth tests can create different results depending on how an investor has structured their own personal balance sheet. As one early commenter pointed out, “[s]omeone who rents and has $1,000,001 in declared net worth is accredited” while someone “who has prudently paid off the value of a home which could be of net worth of $975,000 and has $750,000 of additional assets for a total net worth of $1,725,000 is not accredited.”[11]

Another commenter observed that the current tests also unnecessarily inject age into a determination of investor sophistication. Older investors, “who have had a long time to [accumulate] wealth, do [not] necessarily possess better investment acumen” than younger investors, “who have not had the time to build up substantial liquid wealth.”[12]

I want to move beyond the artificial distinction between so-called “accredited” and “non-accredited” investors and challenge the notion that non-accredited investors are “being protected” when the government prohibits them from investing in high-risk securities. Here, I appeal to two well-known concepts from the field of financial economics. The first is the risk-return tradeoff. Because most investors are risk averse, riskier securities must offer investors higher returns. This means that prohibiting non-accredited investors from investing in high-risk securities is the same thing as prohibiting them from investing in high-return securities.

The second economic concept is modern portfolio theory. By holding a diversified portfolio of assets, investors reap the benefits of diversification; that is, the risk of the portfolio as a whole is lower than the risk of any individual asset. I do not have the time today to give a full lecture on the mathematics and statistics of portfolio diversification, so I will just assure you the correlation of returns is key. When adding higher-risk, higher-return securities to an existing portfolio, as long as the returns from the new securities are not perfectly positively correlated with (move in exactly the same direction as) the existing portfolio, investors can reap higher returns with little or no change in overall portfolio risk. In fact, if the correlations are low enough, the overall portfolio risk could actually decrease.

These two concepts show how even a well-intentioned investor protection policy can ultimately harm the very investors the policy is intended to protect. Moreover, restricting the number of accredited investors in the “privileged class” can have additional (or what economists call “second-order”) effects. The accredited investors may enjoy even higher returns because the non-accredited investors are prohibited from buying and bidding up the price of, high-risk, high-return securities. Remarkably, if you think about it, by allowing only high-income and high-net-worth individuals to reap the risk and return benefits from investing in certain securities, the government may actually exacerbate wealth inequality.

Outsourcing Critical Enforcement Monitoring

Turning to a different issue, hundreds of SEC employees, including me, work hard every day to advance the Commission’s investor protection mandate. I am proud to say that we do an incredibly good job policing that beat. But, at the same time, I believe investors should have a healthy dose of skepticism about the government’s ability to protect them in connection with their financial investments. The SEC sometimes enlists help, and that raises significant concerns.

In both settled and litigated cases, the Commission and courts frequently require issuers and regulated entities to retain independent consultants or monitors (“consultants”) to promote compliance with regulatory obligations and agreed-upon undertakings.[13] A consultant will review the firm’s procedures and report to both the firm and Commission staff any weaknesses in controls or operations, as well as recommendations for modifications and improvements.[14] These undertakings usually require the firm to respond in writing to the consultant’s recommendations, representing either that the firm will implement the recommendations, or offering alternative solutions to address weaknesses the consultant has identified. The undertakings also typically include provisions regarding the costs of the consultant, the deadlines for submitting reports and responses, requirements for the consultant’s independence, and other details of the engagement.

To the extent there is an undertaking in an enforcement action for an independent consultant, Commission staff plays a limited role in the process of engaging that third party. The staff evaluates the specific person and, in rare cases, selects or recommends to a court someone to serve as the independent consultant. The final choice must not be unacceptable to the staff.

I am sure there are well-intentioned historical reasons for the Commission’s practice on independent consultants. But we need to reassess whether this is the correct approach. We need to question the appropriate level of involvement and responsibility of the Commission when it comes to overseeing remedial compliance efforts by regulated entities.

As Bruce Yandle noted, one of the risks that a regulatory agency faces is making a mistake. Therefore, by limiting our involvement to the procedural aspects — determining whether a consultant is independent and not otherwise unacceptable — and avoiding making the hard decisions about the substance, the Commission is walking away from its statutory obligations. In the course of carrying out our duties, our agency, like any other person, may make a mistake. But it is a far better course of action to tackle the challenge head on, rather than shirk and shield ourselves from responsibility by outsourcing critical functions to third parties.

Waivers for Forward-Looking Statements

Next, I would like to discuss the issue of waivers, which has recently generated a lot of press for the SEC. The Commission has the authority to grant waivers to certain persons that would otherwise be ineligible to utilize various provisions of the securities laws.[15] There are four main types of waivers: first, status as a well-known seasoned issuer, or WKSI;[16] second, a prohibition from acting as an investment adviser or depositor of any registered investment company;[17] third, disqualification from using Rule 506 under Regulation D;[18] and fourth, the ability to rely on the statutory safe harbor for forward-looking statements.[19]

Today, I will focus only on the fourth type of waiver — forward-looking statements. The federal securities statutes dictate that an issuer can lose the ability to use the forward-looking statement safe harbor if, during the preceding three year period, it has been convicted of certain felonies and misdemeanors or has been made the subject of a judicial or administrative proceeding involving violation(s) of the antifraud provisions of the securities laws.[20] Thus, enforcement matters unrelated to an issuer’s corporate disclosure can render the issuer ineligible to use the forward-looking statement safe harbor, unless the issuer requests and is granted a waiver by the SEC. In responding to forward-looking statement waiver requests, Commission staff generally evaluates a number of factors, such as whether the disqualifying event involved disclosure for which the issuer was responsible or that calls into question the ability of the issuer to produce reliable disclosure currently and in the future.[21]

The safe harbor provision for forward-looking statements was added as part of the Private Securities Litigation Reform Act in 1995 and was enacted on a bipartisan basis over a veto from President Clinton.[22] The purpose of this safe harbor, as set forth in the Conference Report, was that “abusive litigation severely affects the willingness of corporate managers to disclose information to the marketplace” and that “fear that inaccurate projections will trigger the filing of securities class action lawsuit has muzzled corporate management.”[23] Therefore, the conference committee sought “to enhance market efficiency by encouraging companies to disclose forward-looking information.”[24] The safe harbor was intended to provide certainty that forward-looking statements will not be actionable by private parties under certain circumstances.

Academic research has long shown that stock prices respond to quantitative information conveyed in management earnings forecasts as well as management revisions of future earnings estimates.[25] Recent academic studies have found that investors strongly respond to qualitative and non-earnings disclosures as well, resulting in greater changes in analyst forecast accuracy.[26] Moreover, when managers are more uncertain about the future, they are less likely to use quantitative and earnings-related disclosures and more likely to use qualitative and non-earnings-related forward-looking statements.[27] Thus, forward-looking statements provide critical information to investors to help them make informed decisions.

So why, then, would we want to reject waivers and thus reduce incentives for companies to provide forward-looking statements? It has been asserted that it may be appropriate for the Commission to refuse to grant waivers if a company has too many enforcement actions, regardless of whether those violations relate to corporate disclosure. I disagree. A policy that discourages companies from providing forward-looking information harms investors, leads to unfair, disorderly, and inefficient markets, and discourages capital formation. This result is antithetic to all three parts of our statutory mission. As some have observed, because a company’s value is best judged by future prospects, rather than historical performance, reduced use of forward-looking statements is especially concerning from the perspective of allocative efficiency.[28]

There is an even stronger case for large, complex financial institutions to disclose forward-looking statements. A few weeks ago, I called for “market-based prudential regulation,” especially with respect to banks.[29] Simply stated, exposing banks to the disclosure-oriented focus of market-based regulation would provide better protection to the financial system than relying on banking regulators who think they should have the right to discard decisions made by individual participants in the capital markets. One of the important lessons from the financial crisis was that bank investments and exposures were not adequately disclosed and the market had difficulty assessing an accurate value of those financial institutions. This was the direct result of a flawed bank regulatory framework. Moreover, greater volatility with respect to banks and other financial institutions was specifically identified as an area of concern in the Dodd-Frank Act.[30] If banks were not making forward-looking statements, the dearth of information would be even more severe.

Let me make one last point about waivers. There are factors that are inappropriate to use when evaluating a particular waiver request. We should not be considering whether an issuer is “too big to fail.” Indeed, with respect to the Commission staff’s waiver policy for WKSIs, the original approach was to consider “the issuer’s significance to the markets and its connectedness to other market participants,” thereby enshrining the too big to fail concept as a factor in waiver consideration.[31] Last year, when the staff sought to revise their policy statement on WKSI waivers, I successfully fought to remove the “too big to fail” factor as a consideration. The issue for forward-looking statement waivers is the same — company size should be inconsequential. The right question is whether a company can reliably produce disclosures. We should avoid considerations that are not relevant to this analysis.

Promoting a Healthy Dose of Investor Skepticism

Finally, I want to address the notion that the Commission should “promote investor confidence.” That is a nebulous concept and, in any event, promotes the wrong incentives. Does promoting investor confidence mean that an investor can stop doing due diligence thanks to the efforts of the government to keep the markets safe? Does it mean that an investor need not educate himself or herself about the fundamentals of investing? Does it mean that an investor can avoid engaging in comparison shopping when it comes to fees and expenses charged by investment advisers, mutual funds, and broker-dealers? I think not.

Rather, the Commission should, as I said before, promote a healthy dose of investor skepticism in order to better fulfill our investor protection mandate. Instead of promoting government dependence, the Commission should be promoting self-reliance and empowering investors to ask why and how. Why is an intermediary charging this fee? How is the investment generating cash to return dividends or repayments? By asking why and how, we create a more informed marketplace that, in turn, promotes more accurate valuations, whether it be for a security, investment advice, or an investment-related service; more efficient allocation of capital; and better economic growth.

* * *

Thank you for your kind attention. Enjoy the rest of this great conference.

[1] Bruce Yandle, Bootleggers and Baptists—The Education of a Regulatory Economist, Regulation: AEI Journal on Government and Society (May/June 1983), at 12.

[2] See 15 U.S.C. § 77a et seq.

[3] Section 5 of the Securities Act.

[4] Section 2(a)(3) of the Securities Act.

[5] Securities Act Release No. 3844 (Oct. 4, 1957), 22 F.R. 8359 (Oct. 24, 1957) (“the publication of information and statements, and publicity efforts, generally, made in advance of a proposed financing, although not couched in terms of an express offer, may in fact contribute to conditioning the public mind or arousing public interest in the issuer or in the securities of an issuer in a manner which raises a serious question whether the publicity is not in fact part of the selling effort”).

[6] Vladimir Ivanov and Scott Bauguess, Capital Raising in the U.S.: An Analysis of Unregistered Offerings Using the Regulation D Exemption, 2009-2012 (July 2013), available at

[7] SEC v. Ralston Purina Co., 346 U.S. 119 (1953).

[8] Id. at 125.

[9] Section 413 of the Dodd-Frank Act.

[10] Investor Advisory Committee, Recommendation of the Investor as Purchaser Subcommittee and the Investor Education Subcommittee: Accredited Investor Definition (Oct. 9, 2014), available at

[12] Letter from Mark A. Buffington (Aug. 14, 2010), available at

[13] See, e.g., In the Matter of Feltl & Company, Inc., Exchange Act Release No. 65838 (Nov. 28, 2011).

[14] See, e.g., In the Matter of In the Matter of AXA Advisors, LLC, Exchange Act Release No. 66206 (Jan. 20, 2012); In the Matter of Financial Industry Regulatory Authority, Inc., Exchange Act Release No. 65643 (Oct. 27, 2011).

[15] The Commission has granted delegated authority to the staff to grant such waivers, but waiver requests can be “called up” for consideration by the full Commission.

[16] Rule 405 under the Securities Act.

[17] Section 9(c) of the Investment Company Act of 1940.

[18] Rule 506(d)(2)(ii) under the Securities Act.

[19] Section 27A(b) of the Securities Act and Section 21E(b) of the Securities Exchange Act of 1934.

[20] Id.

[21] Commission staff has not issued specific guidance regarding forward-looking statements. The staff has issued guidance for other waivers, such as eligibility to maintain WKSI status. See Division of Corporation Finance, Revised Statement on Well-Known Seasoned Issuer Waivers (Apr. 24, 2014), available at

[22] Pub. L. 104-67, 109 Stat. 737 (1995).

[23] House Report 104-369 (Nov. 28, 1995) at 42-43.

[24] Id. at 43.

[25] Zahn Bozanic, Darren T. Roulstone, and Andrew Van Buskirk, Management Earnings Forecasts and Other Forward-Looking Statements, working paper (May 2015), available at

[26] Id.

[27] Id.

[28] See Amanda M. Rose, The Multienforcer Approach to Securities Fraud Deterrence: A Critical Analysis, 158 U. Pa. L.Rev. 2173, 2185-86 (2010).

[29] Michael S. Piwowar, Remarks Before the Exchequer Club of Washington, D.C. (May 20, 2015), available at

[30] See Section 112(a)(1) of the Dodd-Frank Act (describing one purpose of the Financial Stability Oversight Council — to identify risks to financial stability that could arise from material financial distress or failure, or ongoing activities, of large, inter-connected bank holding companies).

[31] Division of Corporation Finance, Statement on Well-Known Seasoned Issuer Waivers (July 8, 2011), available at

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