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U.S. Securities and Exchange Commission

Testimony of
Brian Lane, Director, Division of Corporation Finance

Before the House Subcommittee on Government Programs and Oversight, Committee on Small Business, re: Providing Information to Small Businesses Concerning the Process of “Going Public”

October 14, 1999

Mr. Chairman, Members of the Subcommittee:

My name is Brian Lane. I am the director of the Division of Corporation Finance of the Securities and Exchange Commission ("SEC" or "Commission"). The Division of Corporation Finance, through its Small Business Office, is at the forefront of the Commission's efforts to help small businesses raise money from the public and comply with the federal securities laws. I am very pleased to have the opportunity today to testify on behalf of the Commission and share information about our efforts in this area.

I. The Commission's Small Business Initiatives

The Commission understands the importance of small business to the U.S. economy, and is committed to addressing the special concerns of small business. Over the years, the SEC has improved communications between the SEC and the small business community.

In its first Annual Report, in 1935, the Commission stated that it would provide informal guidance to the securities industry, both to foster improved compliance and to establish a spirit of cooperation with the public.1 This spirit continues to play an important role in the Commission's programs. The SEC works in partnership with industry, self-regulatory organizations and the public to protect investors and bolster market confidence while not burdening legitimate capital formation. Our efforts specifically to aid small business fall into two broad categories: (1) cutting through red tape and providing compliance assistance, and (2) reviewing existing and proposed rules for ways to reduce burdens on small business.

II. Cutting Through Red Tape and Providing Compliance Assistance

  • The SEC's Small Business Office:  The Office, which was created in 1979 and expanded significantly in 1996, serves as a liaison between the Commission and small business. The Office now directs the Commission's small business rulemaking initiatives, interpretations, and uniform review of disclosure in small business filings.

  • The SEC's Annual Government-Small Business Forum:  Begun in 1982, this forum is the only annual federal government-sponsored national small business gathering that offers small business the chance to tell federal and state government officials how the laws, rules and regulations impact their ability to raise capital. This year's Forum was held in Washington, D.C. while next year's Forum will be in Texas.

  • SEC Small Business Town Hall Meetings:  The Commission has held 13 "town hall" meetings with small businesses around the country since September 1996. The most recent meeting was in Kansas City, Missouri in June of this year; the next scheduled meeting is in Albuquerque, New Mexico on October 21. These meetings are designed to educate small businesses about the many opportunities to raise capital. They also help the Commission learn more about the problems small businesses face in raising capital, and design programs that meet small businesses' needs while protecting investors.

  • Working Relationship with the U.S. Small Business Administration:  The staff works closely with the U.S. Small Business Administration and their Office of Advocacy on all aspects of small business capital formation and other regulatory matters affecting small entities. We have jointly worked on the organization of our small business town halls and annual Government-Business Forum.

  • SEC Web Site (www.sec.gov):  The Commission operates a web site with special pages targeted to small businesses. These pages provide access to one of our most popular publications entitled "Q & A: Small Business and the SEC – A guide to help you understand how to raise capital and comply with the federal securities laws," proposed new regulations affecting small businesses, and information about specific issues of current interest. Copies of rules, forms and regulations relating to small businesses were recently added to our web site.

  • Public Inquiries:  Each major office of the Commission has staff who are available to answer questions from the public, including small businesses, by telephone and e-mail.

These programs have been remarkably successful. When the Small Business Regulatory Enforcement Fairness Act ("SBREFA")2 was passed, notably, Congress recognized the Commission as one of several agencies which "already have established successful programs to provide compliance assistance."3

III. Reviewing Existing and Proposed Rules for Ways To Reduce Burdens on Small Business

  • Plain English:  Nothing is more frustrating than trying to comply with regulations that are difficult to understand because they are written in jargon or legalese. The Commission has begun efforts to issue regulations and releases in "plain English." We also demand the same plain English from companies raising capital in public markets. People are more likely to invest their money in companies that clearly and simply describe what they are going to do with it.

  • Small Business Initiatives:  Beginning in 1992, the SEC launched a major regulatory initiative to make raising capital easier for small businesses. Rule changes arising out of this initiative simplified the process for registering securities of small business issuers for public sale; increased the dollar threshold for exemptions permitting unregistered public and private sales of securities; and simplified ongoing periodic reporting requirements of registered small issuers.

    In 1996 Congress enacted SBREFA, which requires agencies to publish small business compliance guides, to establish programs of informal guidance for small businesses, and to establish policies or programs to reduce or waive penalties for small entities. As mentioned above, the Commission developed compliance guides for small business such as the pamphlet – "Q&A: Small Business & the SEC" and the staff of each of the Commission's operational units provide informal advice over the telephone to members of the public. The Commission has an effective penalty-reduction policy for small businesses, providing them with the opportunity to demonstrate an inability to pay a penalty. Such penalties have frequently been lowered or not assessed in Commission proceedings based on a showing of inability to pay.

IV. Federal Securities Laws Requirements for “Going Public”

"Going public" in its common meaning is the offering of equity interests in a company to members of the public. How a company solicits interests in an opportunity of this nature can take many different forms. Besides simply selling its securities to the public – which is the most commonly thought of way – a company may, for example, decide to become a reporting company under the federal securities laws and provide its existing shareholders with the opportunity of selling their shares in a public market. Regardless of the method chosen, the provisions of the securities laws, both state and federal must be considered.

The Securities Act of 1933 ("Securities Act") requires companies to register their securities for sale to the public unless an exemption is available. Some securities – such as bank securities, and transactions – such as intrastate ones, are exempted from registration. The Commission has developed several exemptions designed for "small issues."4 For example, the Commission developed Rule 504 of Regulation D, the "seed capital" rule, which provides an exemption from Securities Act registration for limited offerings of securities of up to $1 million in a 12-month period (as long as the issuer is not an investment company under the Investment Company Act of 1940, a reporting company under the Exchange Act or a "blank check" issuer, that is, a company in the business of locating an unidentified business or assets.) While either public or private offerings are permitted under Rule 504, public offerings must be registered under a state securities registration provision requiring delivery of a disclosure document to prospective investors before sale,5 or be made under a state law exemption that limits sales to "accredited investors." The company need only file a Form D - a simple notification -with the SEC. Securities issued in a public offering under Rule 504 are freely tradable securities when held by a non-affiliate of the issuer.

Regulation A permits non-reporting U.S. or Canadian issuers to offer and sell to the public up to $5 million worth of securities in a 12-month period, without registration under the Securities Act (secondary offerings are restricted to no more than $1.5 million in the 12-month period). "Blank check" companies, investment companies, certain oil and gas/mineral rights issuers and disqualified persons are ineligible to use the exemption. Regulation A requires the company to prepare and file a disclosure document with the SEC and provide the offering circular to prospective purchasers. The required disclosure is less burdensome than that required in a full registration statement. For example, companies can use unaudited financial statements, prepared in accordance with U.S. generally accepted accounting principles. Advantages of using Regulation A include: avoiding strict Securities Act Section 11 liability; issuing freely tradable securities; and avoiding periodic and annual reporting obligations under the Exchange Act.

Regulation A also permits companies to gauge investors' interest, or "test the waters," before they incur the expense of preparing and distributing the required disclosure documents. The rule also permits companies to use written solicitation materials (so-called "free-writing") before filing the required disclosure documents, as long as they are truthful. "Testing the waters" is prohibited after the filing of the Regulation A offering statement. No sales may be effectuated until 20 days after the last publication of the "testing the waters" materials.

The exemptions provided by Regulations A and D provide that a company that made a good faith attempt to comply with all of the requirements of the exemption can defeat certain claims made by investors (but not a regulator) as long as the non-compliance item was not intended to protect the complaining party and the violation was not material to the offering as a whole. (Issuer eligibility, filing requirements and dollar limits are, however, always material.)

To simplify registration of securities under the Securities Act and periodic and annual reporting under the Exchange Act for small businesses, the Commission developed the concept of the "small business issuer". The small business issuer is one organized in the U.S. or Canada with revenues of less than $25 million in its most recent fiscal year and whose outstanding publicly held stock is worth no more than $25 million. About 3,000 public companies meet this test today.6 The Commission's Regulation S-B contains the core disclosure items for both Securities Act registration and Exchange Act registration and reporting purposes by small business issuers. Regulation S-B uses simple and non-legalistic language. In addition, small business issuers need to file certified GAAP financial statements, for only two rather than the three years required by larger issuers.

The Commission has significantly simplified the obligation of small business issuers to disclose certain accounting information. For example, Regulation S-B was the first system to provide for an automatic waiver from the audited financial statements requirements of significant acquired businesses.7 The experiment with small business issuers was so successful, the Commission now uses these tests for all companies.

Small business issuers may also do an initial public offering in the first quarter of their fiscal year without having to wait for the completion of the audit for the preceding year. In addition, selected financial data and supplementary financial information disclosure required by Regulation S-K – the comparable regulation for larger issuers – is not required.

Where a small business issuer has no operating revenues in each of the preceding three fiscal years, the company need only disclose its business plan, instead of the more detailed management's discussion and analysis.

The Commission also has developed special, simplified Securities Act registration forms for small business issuers. When these companies only offer up to $10 million worth of securities in any 12-month period, they may use Form SB-1. The form permits a company to use a question-and-answer format or the traditional Regulation A offering circular format for required disclosure. Unlike Regulation A filings, however, Form SB-1 requires audited financial statements.

Small business issuers may register an unlimited dollar amount of securities using Form SB-2 under the Securities Act. The form may be used not only for initial public offerings but any subsequent offering for as long as the issuer is a small business issuer.8

Regulation S-B also contains the disclosure items for Exchange Act Forms 10-SB, 10-QSB and 10-KSB, which are used for registration, quarterly and annual reporting, respectively, by small business issuers in our continuing disclosure system. These forms also contain instructions that are designed specifically for small business issuers transitioning from non- reporting to reporting status and offer both the question-and- answer format and the traditional disclosure format from Regulation A. Transitioning small business issuers filing on Form 10-SB may provide audited financial statements for just the latest fiscal year unless two years worth of financial statements are available. A transitioning issuer would continue to satisfy its reporting obligation with this type of information until the issuer:

  • registers more than $10 million for sale in a single 12-month period;

  • elects to use the regular small business issuer disclosure system; or

  • is no longer a small business issuer.

V. Pending Commission Proposals for Small Business

The process of "going public" imposes significant restrictions on the way the company selling its securities can communicate with those it wants to sell them to. Under the Securities Act, the "statutory prospectus" must accompany or precede any other writing – all such writings must be consistent with that prospectus. Oral communications are permitted but they must be truthful and consistent with the prospectus. This process minimizes high pressure sales tactics and permits investors to consider the investment using the prospectus as the basic, if not most essential guide. The Commission has proposed to permit more freedom in communications with investors. These proposals carefully consider investor needs and protections. Small business issuers could enjoy significant relief from some of these communication restrictions during registration for offerings to "qualified institutional buyers" and to existing securityholders, among other specific offerings.9

Under proposed Rule 167, all communications made by or on behalf of any issuer that take place during a specified period before it files a registration statement would not violate these restrictions on communications. Generally, free communications would be allowed more than 30 days before filing a registration statement. This approach would apply to small business issuers that file registration statements on Forms SB-1 and SB-2. Under this proposal, the issuer, underwriter and participating dealer must take all reasonable steps within their control to prevent further distribution or re-publication of the communication during the 30 day period immediately before the registration statement is filed.

In a second proposal, companies could discuss factual business information at any time. "Factual business communications" would include, for example, advertisement of the issuer's products or services; factual business or financial developments with respect to the issuer; and dividend notices. Factual business communications would not include information about the registered offering itself or forward-looking information.

In addition to factual business information, reporting companies could continue to publish regularly released forward- looking information. In order to come within this safe harbor, the issuer must have customarily released this type of information in its ordinary course of business for the last two fiscal years (and any portion of a fiscal year) immediately before the communication. The time, manner and form in which the information is released must be consistent with past practice.

In order to facilitate effective communication after a registration statement is filed, companies would be allowed to make offers and disseminate offering information in any form, without each communication having to be a "statutory prospectus." This proposal would permit issuers to prepare presentations and disclose information in a variety of formats, available to all investors. Through these changes, we seek to have sellers augment the information available to investors and thereby enhance investors' knowledge of the company and its securities.

Issuers are sometimes faced with difficult decisions about unregistered offerings that are properly exempted from the registration requirements of the Securities Act. This difficulty may affect the smallest of issuers most. We have made a number of proposals in this area.

Generally, private offerings do not need to be registered with the Commission. Sometimes, issuers change their minds about how they want to raise capital – publicly or privately. Certain rules are in place, so that investors are protected and do not participate in offerings for which they are not qualified. An unregistered private offering that occurs before or after a registered offering may raise "integration" issues under the Securities Act. "Integration" occurs when two or more apparently separate, exempt securities transactions are in fact one offering that should be registered. For example, if a private offering is considered part of an earlier or subsequent registered offering, the exemption for the private offering could be lost because there might be no reason for the investors in the so-called private offering not to have the same protections the purchasers in the registered one got. In such a case, the issuer could be liable to investors for the purchase price they paid.

We adopted Securities Act Rule 152, which provides a safe harbor from integration when an issuer makes a non-public offering exempted under Securities Act Section 4(2) and then decides to make a public offering and/or file a registration statement. Many questions have been raised about Rule 152 over the years. Our proposal significantly revises the safe harbor to clarify and broaden it.

Under the proposal, an issuer could under specific conditions abandon an ongoing private offering and then file a Securities Act registration statement at any time, before it files the registration statement. If the issuer had offered the securities in the private offering to a person ineligible to purchase the securities, it also must wait at least 30 days from abandoning the private offering before filing the registration statement. The proposed conditions are designed to ensure that offerees in the private offering are treated the same as offerees and purchasers in the registered offering.

When an issuer decides to switch from a public offering to a private one, a different analysis and set of problems result. The filing of a registration statement for a specific securities offering constitutes a general solicitation for that offering. Thus, when an issuer wishes to convert an offering begun as a registered public offering into a private offering, or follow it soon after abandonment with a private offering, the non-public or limited offering exemptions may not be available. Issuers currently in this situation must wait a full six months to be certain that the public offering under the registration statement would not be integrated with the private offering. We proposed to expand Rule 152 to shorten or eliminate that wait.

Under our proposal an issuer could more easily withdraw or abandon a Securities Act registration statement and then conduct an unregistered private offering if certain conditions are met. Additional conditions are applied to any issuer that starts the private offering within 30 days after the public offering is withdrawn or abandoned. In that case, the issuer and any underwriter also must agree to accept liability for material misstatements or omissions in the offering documents used in the private offering under the standards of Section 11 and Section 12(a)(2) of the Securities Act.

This proposal may be particularly attractive to small business. If the issuer discovers limited interest in its securities, it may withdraw its public offering and shortly thereafter sell securities in a private offering to persons who were solicited in the public offering. The small issuer will have incurred significant costs and time to prepare and file its registration statement. If it discovers weak demand for its securities after filing the registration statement, it will be able to switch to a private offering, sell securities to persons solicited in the public offering, and obtain some amount of funding.

VI. Conclusion

The Commission has long been sensitive to the needs of small business in their capital-raising activities. It must also protect investors. The Commission has always strived to keep the balance set between these two, apparently competing goals. The two, in fact, complement each other: the public is likely to invest more if they believe their interests are protected. The Commission's small business disclosure and exemptive system currently in place and as proposed to be revised, strikes this balance. It has been a pleasure to take this opportunity to put it on display.


1SEC, 1 Annual Report 9-10 (1935).

2Pub. L. No. 104-122, title II, 110 Stat. 857 to 874 (Mar. 29, 1996), codified at 15 U. S. C. 657, 5 U. S. C. 801-808.

3"Small Business Regulatory Enforcement Act – Joint Managers' Statement of Legislative History and Congressional Intent," 142 Cong. Rec. S3234, S3243 (daily ed. Mar. 29, 1996)

4A number of Commission exemptions created under this provision for small businesses are not really suitable for "going public." For example, under Rule 505 of Regulation D, an issuer may undertake a limited private offering of its securities in an amount of up to $5 million in a 12-month period. Purchasers must be accredited investors and sales may be made to an unlimited number of these persons, as well as to an additional 35 persons who do not need to be sophisticated investors. Non-accredited investors must be provided with disclosure that is comparable to that required in a registered transaction. Investment companies and certain disqualified persons are not allowed to use the exemption. Securities issued in a Rule 505 transaction are "restricted" as to resale for one year. A Form D notification is required to be filed with the Commission. Rule 505 is a coordinated exemption with the North American Securities Administrators Association Inc.'s Uniform Limited Offering Exemption ("ULOE"), which has been adopted by more than 30 states.

Rule 701 permits a non-reporting company to compensate its employees and others with company securities. The exemption was designed for small businesses and is particularly helpful to start-up companies that are strapped for cash. Under the exemption, any qualifying company may issue up to $1 million worth of securities in a 12-month period. The rule provides formulas to determine whether a greater amount may be issued based upon the calculation of 15% of the company's assets or outstanding securities. If more than $5 million worth of securities would be issued, the company must provide disclosure to the employee-investors.

5Form U-7 of the North American Securities Administrators Association (also referenced as ULOR or SCOR) is designed to satisfy the public offering requirement in Rule 504.

6The Commission has proposed to raise the revenue ceiling to $50 million and eliminate the public float test. Our studies indicate that 1,100 more public companies would become eligible to use the small business disclosure system.

7Where the acquisition(s) do not account for more than 20 percent of the issuer's total assets, the audited requirement is waived. Where the acquisition(s) does not account for more than 40 percent of the issuer's total assets, then an automatic waiver of one year's (the year preceding the latest fiscal year) worth of audited statements is granted. These waivers are only available if these financials are not readily available and any available unaudited statements are furnished.

8The Commission has proposed to introduce incorporation by reference concepts into Form SB-2 for seasoned companies. Under the proposal, after two years of filing reports the small business issuer could refer to its Exchange Act reports for much of the information now contained in a Form SB-2 prospectus rather than reprinting it as presently is the case.

We also have proposed a special small business form for business combination transaction, Form SB-3. This proposal would simplify and streamline the applicable disclosure requirements.

Another proposal that would be beneficial to small business issuers contemplating the registration of their securities for public sale involves the ability to defer payment of the registration fee until shortly prior to effectiveness. By this technique, some savings could be had where an offering does not go forward or the amounts of securities offered become reduced subsequent to initial filing.

9Other offerings include offerings of investment grade, non-convertible securities and market making transactions by broker-dealers affiliated with an issuer. There would be no pre-filing communications restrictions and free communications after filing a registration statement.