Monday, May 30, 2011

SEC Officials Discuss General Solicitation Ban and 500-Shareholder Limit at House Hearings on Capital Formation

SEC Chair Mary Schapiro emphasized that the Commission is absolutely committed to seeing if the 500-shareholder limit still makes sense and intends to do a thorough and rigorous analysis of this threshold. In testimony before the House Oversight and Government Reform Committee, she noted that the review will require the gathering of economic data and analysis because the SEC needs to understand the characteristics of these companies and how their shareholders hold, whether in record name or in the name of the beneficial owner. The SEC Chair added that a staff review of the 500-shareholder test is front and center on the Commission’s agenda. The SEC staff is also reviewing the general solicitation ban as part of its overall review of capital formation regulations. Corporation Finance Director Meredith Cross noted that the staff is likely to recommend that the Commission issue a concept release on the general solicitation ban.

Enacted in 1964, Section 12(g) of the Exchange Act requires companies with more than $10 million in assets whose securities are held by more than 500 owners to file annual and other periodic reports with the SEC, which reports are then available to the public through the SEC's EDGAR database. While the $10 million threshold has been incrementally increased over the years from the $1 million level initially set in 1964, the 500 shareholder requirement has never been updated.

In prepared testimony, Chairman Schapiro noted that, shortly after the enactment of Section 12(g), the Commission adopted rules defining the terms held of record and total assets. The definition of “held of record” counts as holders of record only persons identified as owners on records of security holders maintained by the company in accordance with accepted practice. The Chair explained that the Commission used this definition to simplify the process of determining the applicability of Section 12(g) by allowing a company to look to the holders of its securities as shown on records maintained by it or on its behalf, such as records maintained by the company’s transfer agent.

But Chairman Schapiro observed that the securities markets have changed significantly since the enactment of Section 12(g). Also, since the definition of “held of record” was put into place, a fundamental shift has occurred in how securities are held in the United States. Today, the vast majority of securities of public companies are held in nominee or street name. This means that brokers that purchase securities on behalf of investors typically are listed as the holders of record. One broker may own a large position in a company on behalf of thousands of beneficial owners, she noted, but since the shares are all held in street name they are counted as being owned by one holder of record.

In response to concerns from Rep. Pat Meehan (R-PA) about carving sweat equity out of the 500-shareholer count, Corporation Finance Director Meredith Cross noted that, pursuant to an SEC rule adopted in 2007, options granted to employees don’t count towards the 500 shareholder number. In addition, Corp Fin staff have provided relief so that restricted stock units provided to employees do not have to be counted towards the 500 shareholder trigger. The Director said that the review of the Section 12(g) 500 limit will consider the question of whether employees should be counted at all. She also said that the SEC has heard that the 500 limit is an impediment to capital raising. The staff’s review will consider if 500 is the right number and is the counting being done correctly, that is, are the right people being included in the count

Rep. Patrick McHenry (R-NC) asked why there is a class of accredited investors. Director Cross explained that the notion behind the accredited investor, and if you have $1 million net worth you fit in the definition, is that sometime in the early 1980s it was decided that these investors can fend for themselves and do not need the protection of the securities laws, thus allowing them to participate in unregistered private offerings. In response to further comments from Rep. McHenry on the rationale for including accredited investors in the 500 shareholder count, the Director said that the staff, as part of its review, will consider if accredited investors should be eliminated from the count.

Responding to a question from Committee Ranking Member Elijah Cummings (D-MD) on what principles would guide the SEC staff review of the general solicitation ban and the 500-shareholder rule, and what factors would be considered, Director Cross said that, with regard to the 500-shareholder limit, the staff would like to know the investor makeup of these companies, and the characteristics of these companies. For example, whether they are trading in the dark market or are engines of growth in need of capital. It may turn out that different answers are needed for different companies, said the SEC official, such as for companies bumping up against the 500 limit who cannot get additional capital. There may have to be different tests for different types of companies.

With regard to the general solicitation ban, the Director said that the staff will want to be confident that, if the ban is eliminated and private offerings are allowed through publicity and advertising, the group getting sold to is the group that does not need the protection of the federal securities laws and are, in fact, accredited investors. If they don’t need protection, it may make sense to make it easier to reach them.

In offerings that are exempt from registration under Section 5, the extent to which an issuer may communicate publicly depends on the requirements of the exemption upon which the issuer is relying. One of the most commonly-used exemptions is Section 4(2) of the Securities Act, which exempts transactions by an issuer “not involving any public offering.” Currently, an issuer wishing to rely on Section 4(2) or its safe harbor, Rule 506 of Regulation D, is generally subject to a ban on the use of general solicitation or advertising to attract investors for its offering. The ban was designed to ensure that those who would benefit from the safeguards of registration are not solicited in connection with a private offering.

Rep. Trey Gowdy (R-SC) raised the question of whether the general solicitation ban is constitutional. He noted that the ban implicates a fundamental right and so must be under the strictest level of constitutional scrutiny and must be as narrowly drawn as it can be If the SEC concludes that the general solicitation ban does not pass constitutional muster, he added, there is some precedent for the SEC not to enforce the ban. Rather than not enforce the ban in that instance, replied Chairman Schapiro, the SEC would seek to change it. Chairman Schapiro recognized that the ban does limit speech to some extent and that the SEC staff study will be examining that issue, a First Amendment analysis will be part of the study. The issue is whether the protection of investors is appropriately balanced with the need for companies to effectively communicate in order to raise capital.