Alan R. Palmiter
Professor of Law
June 30, 1999
Document e-mailed to:
Mr. Jonathan G. Katz
Secretary, U.S. Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, DC 20549
Re: File No. S7-30-98Dear Mr. Katz:
Please find attached comments concerning the Commission's "Aircraft Carrier" proposal. Securities Act Rel. No. 7606A, 63 Fed. Reg. 67,174 (Dec. 4, 1998), available at <http://www.sec.gov/rules/proposed/337606a1.txt>
Alan R. Palmiter
Box 7206, Reynolda Station
Winston-Salem, NC 27109
336-758-5711 (voice) / 336-758-4496 (fax)
Professor of Law, Wake Forest University
June 30, 1999
Thank you for the opportunity to comment on the Commission's proposed reforms to the rules governing securities offerings -- the so-called "Aircraft Carrier" proposal.
Over the last twenty years, the Commission by rule and informal agency action has made available streamlined registration formats and greater disclosure options in securities offerings. The "Aircraft Carrier" proposal, ostensibly meant to allow greater speed and flexibility in securities offerings, may actually reverse this salutary direction. The proposal's retrenchment reveals apparent concerns that deregulation must be slowed and even undone. But these fears, only vaguely explored in the proposal, seem unfounded. Capital formation in this country has increasingly found ways to function, effectively and fairly, outside the traditional regulatory framework. Recent experience, particularly for investors in smaller issuers, powerfully suggests that mandatory pre-transaction rules governing the offering and disclosure process have become unnecessarily costly. In short, the Commission's proposal threatens to impose, without sufficient study, unjustified costs on our nation's capital formation.
Regulation of securities offerings has been the bedrock of the Commission's historic role. The original Securities Act of 1933 commanded the Commission to regulate the disclosure in securities offerings, if any investors lacked the capacity to "fend for themselves." But no longer. Congress, recognizing the maturation and technological changes in securities markets, now demands that the Commission consider the costs of its regulation. The National Securities Markets Improvement Act of 1996 clarifies that "investor protection" should not be the exclusive focus of the Commission's rulemaking. Under new Section 2(b) of the Securities Act, the Commission is to "consider efficiency, competition, and capital formation" when it engages in Securities Act rulemaking under a "public interest" standard. The House Report accompanying the Improvement Act specifically calls on the Commission to "analyze the potential costs and benefits of any rulemaking initiative."
Would investors, if they negotiated the terms of disclosure in a securities offering, be willing to pay for the proposed "Aircraft Carrier" rules governing timing, issuer qualification, information delivery and participant liability? It is hard to know. The Commission did not approach the proposal on this basis. Yet, given the favorable experience with the Commission's many recent deregulatory initiatives, widely embraced by issuers and investors, it seems doubtful investors would have sought to re-regulate the securities offering process. The Commission's proposal gives us (and Congress) only conclusory assurances that the new mandates and restrictions, if adopted, will be worth the costs they will impose on capital formation.
The Commission has many important regulatory functions. One hopes the Commission will have the wisdom and courage to question whether increased pre-transaction regulation of securities offerings should be one of them. Adding new mandatory burdens to the process of capital formation, as the proposal often does, lacks cogent justification. Recent empirical research, as well as a wealth of market experience, suggests the glory days of Securities Act regulation are over. We should allow this magnificent regime a graceful exit.
This short comment makes three points:
Over the last two decades, a fundamental rethinking of the federal laws that govern securities offerings has eroded the mandatory nature of securities regulation. The new reality is that issuers, in burgeoning contexts, can raise investment capital without subjecting themselves to the Commission's full-blown disclosure requirements or the heightened antifraud standards of the Securities Act of 1933.
Underlying this regulatory transformation has been
a subtle, but powerful rethinking of the twin tenets that have animated
securities regulation for more than half a century -- namely, manager informational
shirking and investor helplessness. No longer can managers, operating in
sophisticated and well-intermediated capital markets, unilaterally dictate
the disclosure that their
firms provide investors when raising capital. More important, the prototype investor is no longer our vulnerable grandmother, but has become instead our well-connected rich uncle.
Deregulatory initiatives. The Securities Act has proved itself a malleable vessel into which the Commission has poured its deregulatory philosophy. The Commission, laudably cognizant of the regulatory costs of its disclosure rules, now permits issuers to choose from among a richly-layered set of disclosure levels and methods in offering their securities to investors.
For example, the safe-harbor Rule 506 (unlike the statutory exemption) permits offers to unqualified investors, so long as solicitations are not made widely and unqualified investors do not purchase. The rule specifies categories of qualified investors and equates wealth with investment sophistication and insider status. Wealthy investors, whether individuals or institutions, are treated as having the sophistication of institutional investors and the information access of insiders. Unsophisticated, nonwealthy investors can be qualified if they number fewer than 35 and are assisted by a sophisticated representative. In short, the Commission has accepted that sophisticated intermediation can, at less cost, replicate the protections of full-blown registration.
As issuers have moved from public offerings to private equity placements, the Commission has facilitated the movement. Rule 144A permits trading markets (such as the PORTAL system) in securities placed with institutional investors. The Commission staff has permitted private placements in which the issuer promises to exchange the restricted securities with new registered securities at a future date -- so-called A/B or Exxon Capital exchanges. By permitting issuers to reduce the illiquidity discount usually present in private offerings, the Commission has accepted the market's desire to avoid the costs of full-blown registration and its preference for institutional intermediation and ownership.
In particular, the Commission's deregulation now encourages small issuers to raise capital -- with the least regulatory demands. Responding to congressional commands to reduce the regulatory costs for small businesses, the Commission has created a panoply of exemptive rules for small and limited offerings, cutting away significant layers of regulatory protection. And, ironically, for those issuers with the least market following and investors with the least professional assistance, the Commission's regulatory dispensations have been the greatest.
Market incentives to disclose. Yet not all is disclosure avoidance. Despite the availability of wide disclosure options, there is strong evidence that investors' informational demands exercised through intermediated markets often propel issuers to provide disclosure at levels beyond that mandated -- as a private, contractual matter. For example, issuers in private offerings generally prepare materials that are nearly identical in presentation and substance to registration statements. Empirical studies of earnings disclosures prior to issuers accessing capital markets suggest that investor demands impose disclosure discipline beyond that created by regulation.
The Commission has implicitly noted this phenomenon, as well. In proposing the "Aircraft Carrier" rules, the Commission commented, "We have had six years of successful experience with the small business issuer disclosure system. Our experience indicates that small business issuers have incurred less cost, time and burden in preparing disclosure documents . . . without reducing investor protection. See 63 Fed. Reg. at 67,202. This observation is borne out by studies of the litigation experience for smaller public IPOs, which account for fewer fraud claims on average than do larger public IPOs.
The Commission's "Aircraft Carrier" proposal would undertake the most significant revision of the securities offering process since 1933. The proposal would change disclosure requirements in registration statement forms, prospectus delivery rules, rules governing pre-offering communications, rules governing the integration of private and public offerings, and periodic disclosure requirements.
Recognizing the costs of its current regulation, the Commission makes some proposals that would provide salutary deregulation. For example, Form B issuers would be permitted to choose the form and style of disclosure given investors during the offering period, thus giving issuers "greater freedom . . . to cut some boilerplate disclosure and to omit non-material disclosure from the prospectus." 63 Fed. Reg. at 67182-83.
But the proposal is a minefield of potentially harmful consequences, intended and unintended. In the name of reducing the costs, delays and uncertainties of the current registration scheme, the Commission proposes to add significant new conditions and liability risks that would add new burdens to the securities offering process -- these new costs ultimately borne by investors. Consider the following sampling of additional new requirements:
Issuers. Issuers would be required to --
The Commission's proposal assumes without explanation, for example, that unseasoned issuers cannot be expected to disclose at adequate levels. But this adherence to "accuracy enhancement" (at whatever the cost) obscures the importance of a "prudent investor" rationale for mandatory disclosure - what buyers want and are willing to pay for. As the Commission has long recognized, disclosure rules that compel revelation of competitively-sensitive information may actually injure investors, outweighing the value to accurate pricing and constraints on management irresponsibility.
The "Aircraft Carrier" proposal, far from easing the current regulatory overhang for public offerings, threatens to add rigidity and costs to the offering process. If adopted in its current form, the proposal would create offering delays both for seasoned and unseasoned issuers, increase liability risks for issuers using streamlined Form B registration, and reduce the availability of highly-popular sales methods, such as at-market offerings using delayed shelf registration and private Rule 144A offerings made pursuant to A/B exchanges.
Noticeably absent from the voluminous release proposing the new rules is empirical analysis of the likely benefits and costs of particular new rules. The Commission points out only that overall direct compliance costs for the private sector will fall from $5.6 billion per year under the current regime to $5.4 billion under the new regime, without any discussion of how these figures are derived. See 63 Fed. Reg. at 67,251 & n.586. More disturbing, the proposal does not consider the impact on securities offerings as issuers' capital costs rise because of greater regulatory burdens. For example, while acknowledging that more than a third of recent IPOs have been pursuant to an A/B exchange (in which an issuer offers securities privately and shortly afterward registers substantially identical securities in exchange for those privately placed) and without citing to any abuses in these transactions, the Commission proposes to eliminate the flexibility of these offerings based on unsupported "views regarding . . . the need for additional protections for non-QIBs in offerings by these smaller issuers." Id. at 67,208.
Consider the new restrictions
and conditions the proposal would impose, and the unanswered questions
upon which the proposals hinge:
To the extent the Commission has relied on actual empirical observation, the information cited tends to raise doubts about the efficacy of the current registration system. For example, the Commission observes: "We have had six years of successful experience with the small business issuer disclosure system." Id. at 67,202. Yet small business issuers disclose at lower levels than larger public issuers, have fewer large institutional shareholders, and are followed by fewer analysts.
In short, the "Aircraft Carrier" promises that regulatory fine-tuning will benefit investors, but this "dog don't hunt."
"Disclosure, more disclosure and yet more disclosure!" The refrain still rings in our ears, ever since our earliest inculcation in the Securities Act's wondrous labyrinth of "truth in securities." And from the beginning we accepted the refrain's subtext -- "mandatory disclosure, more and yet more."
Times are changing. The assumptions upon which mandatory disclosure rest, particularly in securities offerings, have become less convincing. The Commission's deregulatory agenda, pursued intelligently and in earnest over the last two decades, has proved a success. Many of the "Aircraft Carrier" proposals, however, shrug off this experience -- unnecessarily and without adequate cost-benefit analysis. Despite the significant (and admirable) effort that has gone into building the "Aircraft Carrier," the failure to adequately consider and justify the costs that would be imposed on capital formation by many of the proposed rules (easily exceeding the purported "direct compliance" cost savings of $200 million a year) suggests that much of the proposal will not withstand judicial challenge.
Capital formation in
this country, which will bear the consequences of costly over-regulation,
is too precious to be subjected to glib assumptions that government control
is preferable to none. The Commission and its staff have worked hard and
faithfully in seeking to overhaul the regulation of securities offerings.
Sometimes hard work, however, is not enough. Congress has admonished the
Commission to really stop, look and listen before imposing costs on our
capital markets. Investors deserve no less.