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Banking and Finance

The SEC on Capital Formation: Graded Incomplete – Commissioner Gallagher

 Last year the IPO market was overheating – a record number of initial offerings were conducted. Nevertheless, SEC Commissioner Daniel Gallagher gives the SEC a grade of “incomplete” in the area of capital formation in recent remarks. Commissioner Daniel M. Gallagher, “Grading the Commission’s Record on Capital Formation: A+, D, or Incomplete?” (March 27, 2015) (here).

Commissioner Gallagher explained his grade by starting with some kind words for his agency regarding the implementation of Title IV of the JOBS Act and what is being called Reg A+: “I am very pleased that the Commission was finally able to adopt changes to Regulation A . . . The cap on the size of the offering has been raised to the statutory minimum of $50 million, and offers and sales for so-called ‘Tier 2’ issuers preempt state blue sky law. The latter point is critical: issuers looking to make a nationwide offering need only have their offerings qualified by the SEC; they do not need to undergo the review processes, including merit review, of 50+ securities regulators. We’ve also given these issuers a conditional exemption from Section 12(g) of the Exchange Act, so that Tier 2 issuers have some breathing room to raise capital without triggering the burden of full Section 13 reporting . . .”

Yet the job is incomplete, according to the Commissioner. The cap should have been increased to $75 million. In addition, the semiannual reporting under the Rule should have been deemed to be “reasonably current” for Rules 15c2-11, 144 and 144A. Reporting issuers should also have been permitted to use the Rule the Commissioner noted. And, Regulation A is only targeted at primary issuance of securities, not the secondary markets. Venture exchanges – a topic the Commissioner has addressed before – can help solve secondary market liquidity.

Another key point revolves around the fact that the new Reg A Rules do little for Tier I issuers. Those companies are small issuers who still have to deal with state blue sky law qualification and SEC review and qualification. While the new NASAA coordinated review program appears to speed the process, the issuer still is required to undertake merit review.

Finally, for issuers who want to raise $5 million or under, the new rules are of little assistance. “Tier 1, with state qualification, remains too expensive; and Tier 2, with ongoing reporting, will likely be too expensive as well. This is unfortunate,” Commissioner Gallagher noted.

Another avenue for raising capital is crowdfunding. While this mechanism has been approved for accredited investors, it has not for others. “Crowdfunding to non-accredited investors under Title III of the JOBS Act is . . . still stuck in SEC rulemaking limbo. Not because the Commission lacks the will to move forward, but rather due to the weight of the accumulated, nanny state investor ‘protections’ thrown into the JOBS Act mandate by the Senate.” If crowdfunding is adopted as proposed it is likely to be too burdensome for the smallest of companies, according to Commissioner Gallagher.

Turning to Regulation D, the Commissioner focused on two points. First, for the most part the fundamental framework of the Regulation has not been updated since adoption in 1982. Given the substantial changes which have taken place since then it may be time to see if a new balance between access to capital and investor protection can be struck. Second, Rules 504 and 505 are little used. Those Rules permit, respectively, capital raises of up to $1 million and $5 million. Rule 504 permits a general solicitation of registered with the states. The provisions are little used probably because they lack state law preemption, Commissioner Gallagher noted. “To fix these rules, we need to better balance the costs and benefits of each of these exemptions” by considering, for example state preemption.

Other options also need to be considered. For many start-ups compliance with reporting as required for larger companies is simply too burdensome and expensive. The new study on disclosure being prepared by the Division of Corporation Finance “I hope and expect . . . will come out with an aggressive agenda for disclosure simplification . . . If that study simply affirms our existing disclosure regime, when there has been over a decade of unfinished efforts aimed at streamlining disclosures, it will have been a failure.”

Finally, the grade in these efforts for the Commission is an incomplete: “At best, our grade is ‘incomplete’ given the significant number of critical investor protection issues that need to be taken up in the near future. Yes, that’s right – capital formation and investor protections walk hand-in-hand. Rulemaking derided as ‘deregulatory’ may nonetheless help investors, if the costs of that disclosure, both direct, in terms of dollars diverted to compliance, and indirect, in terms of the opportunity costs of those dollars, are not outweighed by the benefits. I believe our rulebook is full of such rules, and hope we can take them on, and soon” declared Commissioner Gallagher.

 For more news and commentary on developing securities issues, visit SEC Actions, a blog by Thomas Gorman.

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