Friday, April 08, 2011

Responding to Issa Letter, SEC Chair Schapiro Calls for Review of Capital Formation Regulations and 500-Shareholder Rule

In response to a letter from Rep. Darrell Issa (R-CA), Chair of the House Oversight Committee, SEC Chair Mary Schapiro said that the Commission will review its capital formation regulations with an eye to reducing the burden of unnecessary regulations on companies seeking access to the US capital markets. In addition, she said that the SEC is forming a new Advisory Committee on Small and Emerging Companies that will give input to this regulatory review. The SEC Chair said that the Commission will review the 500-shareholder rule that triggers a company’s SEC reporting obligation. In addition, the SEC staff is examining the policy issues around special purpose vehicles holding company securities. The staff is also exploring several approaches to the new capital formation strategy of crowdfunding, which occurs when groups of people pool money, typically small individual contributions, to support an effort by others to accomplish a specific goal. An example of crowdfunding described to the SEC staff is to conduct an offering of up to a maximum of $100,000 of equity securities of a company, with individual investments capped at $100.

With regard to the Facebook offering, which was a private offering limited to investors outside the US, the SEC Chair emphasized that at no point did the SEC staff advice or instruct Facebook or Goldman Sachs that the offering could not be conducted in the US. Moreover, in 2007 the SEC indicated that the proper analysis of whether a general solicitation occurred should focus on whether the investors participating in the offering were actually solicited through the activities that could be viewed as a general solicitation of if, for example, the investors were existing clients or those with whom a pre-existing relationship existed.

Chairman Schapiro recognizes that some people see the general solicitation ban as a significant impediment to capital raising and some believe that it is not necessary because offerees who might be located through a general solicitation, but who do not buy the security, would not be harmed by the solicitation. But at the same time, the general solicitation ban is supported by others because it helps prevent securities fraud by making it more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market.

The Issa letter referenced the IPOs of Google and Go Daddy Group and said that the quiet period rules delayed the Google IPO and may have resulted in Go Daddy cancelling its IPO. The SEC Chair clarified that Commission staff did not impose any cooling off period or otherwise delay the Google offering as a result of an article interviewing the company’s founders. It is important to also note that had the SEC’s 2005 offering communications rules been in effect at the time, even if the article was published before Google’s offering period for the auction had closed, Google’s IPO would not have been delayed.

Citing unfavorable market conditions, Go Daddy withdrew its IPO less than three months after filing its registration statement. Although the SEC staff does not have additional first-hand information on the reasons why the company cancelled its IPO, noted the SEC Chair, a posting on the blog of the company’s CEO cited the quiet period rules, among other things, as the reason for the decision to cancel the IPO. Apparently, the CEO’s objections to the quiet period rules were partially fueled by his understanding that the rules restricted his ability to conduct his weekly radio show. In fact, said Chairman Schapiro, SEC communication restriction rules would not have prevented the CEO from conducting his show, but would have prevented him from using the show to promote the offering.

In liberalizing the communications rules in 2005, explained the Chair, the SEC determined that in the case of IPOs investors should be provided a prospectus before issuers are allowed to make an offering on radio or TV in order to assure a balanced presentation.

Regarding the Congressman’s questioning about a cost benefit analysis of the quiet period rules, Chairman Schapiro said that the First Amendment implications of the quiet period rules, or for that matter any regulation, are best considered in context. No-action letters and exemptive requests allow consideration of both the regulation at issue and the circumstances of the offering, she said, and also allow SEC staff to tailor a response to accommodate the interests at stake. And specific rulemakings allow for a more concrete context in which to consider the interests at issue.

The Chair also assured Rep. Issa that economic and cost-benefit analyses are fundamental components of the rulemaking process and an essential part of the staff’s work. The SEC engages in an extensive collaberative process on cost-benefit analysis of a regulation. Once senior staff of the SEC division primarily responsible for the rule and the Commission economists in Risk Fin have reviewed the cost-benefit information, each Commissioner reviews and comments extensively on the draft proposing release.

Compliance costs alone do not explain the choice by the average global company doing an IPO not to list in the US, noted Chairman Schapiro, adding that the reasons a company goes public are varied and complex and are based on the company’s own situation and market conditions at the time. Recognizing that the cost and benefits of SEC regulations can impact a decision to do an IPO, the SEC seeks to minimize the cost of being a US public company and provide a regulatory environment that encourages IPOs while at the same time providing investor protection..

While the IPO market is not as robust as it has been in some periods in the past, or as robust as we would like it to be, acknowledged the Chair, it is difficult to precisely identify why any particular company decides to undertake an IPO or declines to undertake an offering.

Under Section 12(g) of the Exchange Act, companies with more than $10 million in assets whose securities are held by more than 500 owners must file annual and other periodic reports with the SEC. While the $10 million threshold has been incrementally increased over the years from the $1 million level initially set in 1964, the 500 shareholder of record requirement has never been updated. Regarding the 500-shareholder rule, the SEC Chair said that the vast majority of the securities of public companies are held in nominee or street name, which means that brokers who purchase securities on behalf of investors are typically listed as the holders of record. One broker may own a large position in a company on behalf of thousands of beneficial owners, noted the Chair, but because the shares are held in street name they are counted as being owned by one holder of record.

This means that much of the individual shareholder base of public companies is not counted. Conversely, the shareholders of most private companies generally hold their shares directly and are counted as holders of record. This has required companies with more than $10 million in total assets and that cross the 500-shareholer barrier because the number of holders of record actually represents the number of shareholders to register and begin SEC reporting. Chairman Schapiro called for an examination of both the question of how shareholders are counted and how many shareholders should trigger registration. She noted that Congress has given the SEC the requisite authority to revise the 500-shareholder threshold.

The Issa letter also raised concerns about Rule 12g5-1(b)(3), which is an anti-circumvention rule stating that if an issuer knows that the form of holding securities of record is primarily used to circumvent Section 12(g) the beneficial owners will be deemed the record owners. Noting that the rule has been used sparingly, Chairman Schapiro said that Rule 12g5-1(b)(3) is not designed to create uncertainty for issuers.

Rather, the rule is intended to prevent companies that would otherwise be subject to registration from evading important investor protections by using artificial means to keep the number of investors below the thresholds requiring registration, such as by creating holding companies or other special purpose entities.

Chairman Issa also asked the SEC about the use of special purpose vehicles to allow investors to access investments in companies that have not yet completed IPOs. The SEC staff has also noted this recent trend, said Chairman Schapiro, and has been exploring a variety of issues raised by it. For example, special purpose vehicles may be formed by firms unaffiliated with the issuer and without issuer involvement because the sponsor believes that there is a demand for exposure to the issuer that cannot be met with shares available in the market.

According to Ms. Schapiro, special purpose vehicles that hold company securities raise a number of policy questions. For example, should SEC rules count the holders of the special purpose vehicle in determining if registration under Section 12(g) should be required and should that be the case only if the issuer is involved in forming the special purpose vehicle. There is also the policy issue of whether not counting special purpose vehicle investors undermines the legislative goals of Section 12(g). She queries if SEC rules should be amended to provide additional certainty or require registration without regard to the purpose of the special purpose vehicle.

The Chair said that the SEC staff is currently monitoring secondary trading on a number of online platforms, many of which are facilitating the trading of the stock of private companies. Trading on online platforms can be beneficial in that it can provide much needed liquidity to investors, noted the official, but this benefit must be balanced with investor protection concerns that can be raised when investors lack information about these private companies. In the absence of an informed market, cautioned the Chair, securities pricing could be influenced by conflicted market participants buying and selling for their own account and facilitating transactions for other buyers and sellers.

The Issa letter discusses crowdfunding as a popular new method of capital formation. The SEC understands crowdfunding to be a form of capital formation whereby groups of people pool money, typically small individual contributions, to support an effort by others to accomplish a specific goal. This strategy was first developed to fund things like books and films, with investors akin to contributors who were donating funds. Since there was no profit participation, these initial crowdfunding efforts did not raise securities law issues. But crowdfunding came on the SEC radar screen when investors were offered an ownership interest in a developing business and an opportunity for return on investment capital. An example of crowdfunding described to the SEC staff is to conduct an offering of up to a maximum of $100,000 of equity securities of a company, with individual investments capped at $100.

Crowdfunding proponents seek a registration exemption, noted the Chair, and the SEC staff has been exploring several approaches to this new capital formation strategy. In considering if a registration exemption is appropriate for crowdfunding, said Chairman Schapiro, the SEC will be mindful of its dual duties to facilitate capital formation and protect investors.

While the limits on individual investment and offering amounts in crowdfunding may reduce incentives for abuse, noted the Chair, the widespread use of the Internet for these funding strategies may present additional challenges to investor protection compared to those presented when Rule 504 was revised in 1999. Before its revision, Rule 504 allowed a public offering to investors for securities offerings of up to $1 million with no mandated disclosures and no resale limitations. Rule 504 was amended in 1999 in light of investor protection concerns about fraud in the market. Chairman Schapiro believes that in developing any exemption for crowdfunding, it will be important to consider the Rule 504 experience and build in investor protections.