Thursday, December 01, 2011

Senate Banking Committee Examines Capital Formation Legislation

In the wake of the House passage of bi-partisan capital formation legislation, the Senate Banking Committee conducted hearings on a number of companion pieces of capital formation legislation, including crowdfunding, raising the Regulation A exemption threshold, and raising the 500 shareholder threshold. The Senate legislation also has strong bi-partisan support.

Chairman Tim Johnson (D-SD) said that it is important to encourage capital formation and job creation while at the same time protecting investors. Senator Richard Shelby (R-ALA), the Committee’s Ranking Member, noted that small business is bogged down with burdensome regulations. He said that the federal securities laws and regulations should be amended to make it easer for companies to raise capital. For example, companies could be permitted to raise money from a greater number of investors without having to incur the substantial reporting costs of registering with the SEC. Since nearly all new businesses are private companies, he reasoned, these types of reforms could help reduce one of the primary obstacles all entrepreneurs face. Another way to increase the availability of funding is to make it easier for companies to access the public markets. Presently, small businesses that want to go public have to overcome a one-size-fits-all regulatory approach that requires them to bear disproportionate costs.

Senator Shelby cited a recent report by the IPO Task Force, which was much discussed during the hearing, for the finding that the cumulative effect of a sequence of regulatory actions, while mostly aimed at protecting investors from behaviors and risks posed by the largest public companies, have driven up costs for emerging growth companies looking to go public. The IPO Task Force estimates that the average cost for a company to go public is $2.5 million, and the annual cost to stay public is $1.5 million.

According to Senator Shelby, these costs make the public markets unaffordable for thousands of small companies. As a result, regulation can deprive funding for companies at exactly the moment they want to expand and create new jobs. While US securities laws have helped to preserve US capital markets as the largest and deepest in the world, he said, they need to strike the right balance between protecting investors and ensuring that companies can raise funds. It is becoming apparent that we do not have the right balance, the Senator emphasized, adding that the securities laws need to consider the real world costs of complying with regulations, especially those borne by small businesses.

Senators Kay Bailey Hutchinson (R-TX) and Mark Pryor (D-ARK) testified on their legislation raising the 500 shareholder threshold for community banks and bank holding companies. Senator Hutchinson described S 556 as a common sense bill with bi-partisan support that would enhance the community banking system and allow them to bolster their balance sheet to comply with the capital requirements of Dodd-Frank. The legislation would raise the 500 shareholder threshold for SEC public reporting to 2000 shareholders. Senator Pryor mentioned that banks are already heavily regulated and the legislation is only for banks and bank holding companies and not other companies.

Bi-partisan legislation introduced by Senators Pat Toomey (R-PA) and Tom Carper (D-DE) would raise the 500-shareholder threshold for SEC reporting for private companies. The Private Company Flexibility and Growth Act (S 1824) would raise the current shareholder limit, which was set in 1964, from 500 to 2,000 for community banks and small companies and would exclude employees from this cap. The legislation is designed to give small businesses the flexibility to focus on long-term growth, job creation and creating better environments for their employees. This legislation is intended to be especially helpful to start-ups and young companies who need to raise capital in order to grow but cannot afford the compliance costs of the current regulations. Senators Mike Johanns (R-Neb.) and Mark Warner (D-Va.) are co-sponsors of S 1824.

The 500-shareholder threshold was much on the minds of the committee members and the witnesses. Meredith Cross, SEC Director of the Division of Corporation Finance, said that companies like the certainty of record ownership, which makes it easier to count the shareholders. Counting beneficial owners by broker look throughs makes it harder to have certainty. Currently the statute refers to holders of record, she noted. If it is determined to look through to beneficial owners, said the Director, the shareholder numbers get much larger and the threshold would definitely have to be increased.

The SEC official testified that securities markets have changed significantly since the enactment of Section 12(g) and the Commission’s adoption of the definition of held of record. Today, the vast majority of securities of publicly-traded companies are held in nominee or street name rather than directly by the owner. This means that the 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 because the shares are all held in street name, those shares count as being owned by one holder of record. This change in the way securities are held means that for most publicly-traded companies, much of their individual shareholder base is not counted under the current definition of held of record. Conversely, the shareholders of most private companies, who generally hold their shares directly, are counted as holders of record under the definition.

The SEC is currently conducting a study on the 500-shareholder threshold. In response to Senator Shelby’s question of how soon the SEC would be able to deliver the study to the committee, Director Cross replied that the SEC is deep into the data gathering stage of the study and is preparing to seek public comment. She estimated that the study would be completed during 2012. The SEC official also noted that, given the timeframe of the study, possible SEC regulatory action raising the 500-shareholder threshold would be more than a year away. Senator Toomey found that to be disappointing. The Director also said that the passage of legislation raising the 500-shareholder limit would not preclude the SEC from adopting regulations on how to count the shareholders.

Senators Jon Tester (D-Mont.) and Pat Toomey have introduced legislation cutting regulatory burdens on small businesses and expanding their access to much-needed capital. The bipartisan Small Company Capital Formation Act, S 1544, makes it easier for small startup companies to raise capital through public offerings by amending SEC Regulation A to allow companies to sell up to $50 million in shares without filing lengthy paperwork. Currently, businesses can only raise $5 million under Regulation A, a limit many businesses consider insufficient. The legislation will also improve the transparency of these offerings, providing investors with access to additional information.

Senator Tester, chairman of the Senate Economic Policy Subcommittee, and Senator Toomey, have been working on the Small Company Capital Formation Act for many months after hearing from constituents about the potential of startup companies to create jobs and spur economic growth.

Senator Tester said that Congress must ensure that small businesses have access to capital, and that means taking a closer look at updating Regulation A. Senator Toomey said that the Regulation A threshold of $5 million, which has not been updated in 20 years, is too low to be valuable in raising capital. He noted that the legislation raising the threshold contains a number of safeguards, including that the company must file audited financial statements with the SEC. Senator Toomey noted that President Obama and Senate Minority Leader Mitch McConnell (R-KY) both support the legislation.

Senator Tester noted that the Securities Act gave the SEC exemptive authority. Director Cross said that Regulation A was adopted under Section 3(b) of the Act, and that the SEC could use the general exemptive authority under Section 28 to raise the cap under the statutory standard of Sec. 28 that the action be necessary or appropriate in the public interest, and consistent with the protection of investors. Noting that the Tester-Toomey legislation would require the SEC to review the Regulation A threshold every two years and raise it as the Commission determines appropriate, the Director said that she would expect that the SEC would use the Section 28 general exemption standard in determining if raising the cap was appropriate under the legislation.

The hearings also discussed crowdfunding legislation introduced by Senator Scott Brown (R-MA). The Democratizing Access to Capital Act, S 1791, is similar to legislation passed earlier by the House of Representatives. The Entrepreneurial Access to Capital Act, HR 2930, sponsored by Rep. Patrick McHenry (R-NC) would allow crowdfunding to finance new businesses by allowing companies to accept and pool donations of up to $1 million, or $2 million in some cases, without registering with the SEC. The legislation was approved by a vote of 407 to 17. Crowdfunding describes a form of capital raising whereby groups of people pool money, typically comprised of very small individual contributions, to support an effort by others to accomplish a specific goal.

State securities regulators are concerned about state preemption provisions in both the House and Senate crowdfunding bills. In testimony before committee, Jack Herstein, President of the North American Securities Administrators Association (NASAA), noted that both HR 2930 and S 1791 would prevent state securities regulators from reviewing investment opportunities made on websites before they are offered for sale to the public. Instead of preempting the states, he urged Congress to allow the states to take a leading role in implementing an appropriate regulatory framework for crowdfunding.

Mr. Herstein told the committee that if regulatory authority is preserved for the states, NASAA will continue to pursue the development of a model exemption for crowdfunding that would allow one-stop filing in the state of the issuer’s principal place of businesses. He also suggested that Congress direct the SEC to work with the states to develop a federal exemption in tandem with a state model rule. He added that state securities regulators are best positioned to provide an efficient regulatory framework to enable new and small businesses to raise investment capital and provide safeguards for investors.