In October 2017, the U.S. Department of the Treasury issued a report to President Trump entitled “A Financial System That Creates Economic Opportunities; Capital Markets” (the “Treasury Report”). The Treasury Report was issued in response to an executive order dated February 3, 2017. The executive order identified Core Principles and requested the Treasury Department to identify laws, treaties, regulations, guidance, reporting and record-keeping requirements, and other government policies that promote or inhibit federal regulation of the U.S. financial system in a manner consistent with the Core Principles. In response to its directive, the Treasury Department is issuing four reports; this one on capital markets discusses and makes specific recommendations related to the federal securities laws.
The Core Principles are:
- Empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth;
- Prevent taxpayer-funded bailouts;
- Foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry;
- Enable American companies to be competitive with foreign firms in domestic and foreign markets;
- Advance American interests in international financial regulatory negotiations and meetings;
- Make regulation efficient, effective, and appropriately tailored; and
- Restore public accountability within federal financial regulatory agencies and rationalize the federal financial regulatory framework.
This blog will summarize key portions of the 232-page report that directly affect the small and lower middle equity markets. In addition to the areas discussed in this blog, the report covers business development and investment companies, Title III crowdfunding, the bond and treasury markets, securitization, derivatives and multiple other topics. For those interested, the entire Report, and especially the beginning Executive Summary, is well written and thought-provoking. Exhibit B to the Report contains a succinct table of all recommendations broken by category.
Summary of Recommendations and Findings
The U.S. equities market represents $29 trillion in publicly traded U.S. stocks, with an average daily volume of over $270 billion. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), together with state securities regulators, are responsible for regulating U.S. markets. Further self-regulatory organizations such as the Financial Industry Regulatory Authority (FINRA) oversee parts of the markets and its participants.
Encouraging Going Public Transactions
There are many benefits to a going public transaction. As summarized by the Treasury Report:
Access to the public equity markets means obtaining a source of permanent capital, usually at a cost lower than other alternatives. Proceeds from IPOs can be used to hire employees, develop new products and technologies, and expand operations. Furthermore, IPOs give institutional and other early stage investors an exit, allowing them to reallocate their capital and talent to other ventures. IPOs also have important implications for employees, who may have accepted pre-IPO compensation in the form of options and stock grants. After an IPO, an employee can monetize his or her compensation by selling into the market. This feature can incentivize employee job performance and work commitment.
As I’ve written about several times, the U.S. economy has experienced an extremely slow recovery since the latest financial crisis, though fortunately, that seems to be improving dramatically over the last year. However, over the last 20 years, the number of public companies in the U.S. has declined by nearly 50%. Many factors have been cited for the decrease in IPO’s, including: (i) compliance costs and risk related to regulations, including Sarbanes-Oxley and Dodd-Frank; (ii) changes in equity market structure, such as decimalization, fragmentation of the market and a decline in small and mid-sized investment banks; (iii) nonfinancial disclosure requirements based on social and political issues; (iv) shareholder litigation risk; (v) shareholder pressure to prioritize short-term returns over long-term growth; (vi) inadequate oversight and accountability of proxy advisor firms; and (vii) lack of research coverage for smaller public companies. At the same time, the availability of private equity funds has increased.
The Treasury Department’s recommendations include numerous measures to encourage IPO’s, including eliminating duplicative requirements, liberalizing pre-initial public offering communications (testing the waters), and removing non-material disclosure requirements. he Report makes several recommendations to assist all public companies, including amending the $2000 holding requirement for shareholder proposals and amending resubmission thresholds for repeat shareholder proposals.
Removal of Non-Material Disclosure Requirements
Materiality is an objective standard meant to provide disclosure that would be important to a “reasonable investor” as opposed to a subjective standard meant to serve varied special interest groups. However, Dodd-Frank added special interest disclosure requirements, including those related to conflict minerals, mine safety, resource extraction and pay ratio. The Treasury Report notes that the securities laws are not equipped to deal with social issues and that requiring such disclosures for public companies and not private companies not only undermines the overall social aspect of the goals but creates an incentive to remain private.
The Treasury Report recommends eliminating each of these disclosure requirements (conflict minerals, mine safety, resource extraction and pay ratio). I note that the Financial Choice Act eliminates these provisions as well.
Eliminate Duplicative Disclosures
The Treasury Report recommends that the SEC proceed to amend Regulation S-K to eliminate duplicative, overlapping, outdated or unnecessary disclosures. The Report mentions that the SEC has been working on this, but doesn’t give real credit to the progress made. I’ve written about the SEC Disclosure Effectiveness Initiative on numerous occasions, including a review of the October 11, 2017 proposed rule amendment to simplify and modernize disclosure requirements.
Permit Additional Pre-IPO Communications
Historically all offers to sell registered securities prior to the effectiveness of the filed registration statement have been strictly regulated and restricted. Communications made by the company during the IPO process, beginning with the pre-registration filing period, depending on the mode and content, result in violations of Section 5 of the Securities Act. Communication-related violations of Section 5 during the pre-filing and pre-effectiveness periods are often referred to as “gun jumping.” For a more complete discussion of allowable communications during the IPO process.
In April 2012, the JOBS Act was enacted which created emerging growth companies (EGC’s) and provided provisions to allow EGC’s to communicate with qualified institutional buyers (QIB’s) and institutional accredited investors during the pre-filing period. The JOBS Act also allows EGC’s to file confidential registration statements with the SEC. It is thought that testing the waters, together with the ability to file a confidential registration statement, reduces the risk of an IPO by allowing a company to gauge investor interest without having exposed its financial and business information to the public and competitors.
On June 19, 2017, the SEC expanded to the ability to file confidential registration statements to all companies completing an IPO and for some follow-on secondary offerings. The Treasury Report recommends that all companies be allowed to test the waters with QIB’s and institutional accredited investors.
Not only do I agree with this recommendation, but I think it should be taken one step further and that testing the waters, to the extent allowed in a Regulation A offering, should be allowed for all companies completing an initial IPO under a certain dollar limit such as $100 million. Regulation A allows for pre-filing and pre-qualification indications of interest as long as no funds are solicited or accepted and proper disclaimers are provided. Regulation A does not limit solicitation recipients and all forms of solicitation and advertising are permitted, subject to the disclaimer requirements and antifraud provisions.
One of the SEC and regulator concerns with gun jumping is that it will create an illusory market interest or prime the market in an unsustainable fashion. One of the reasons why such solicitation is allowed in a Regulation A offering is that it is thought that companies engaging in such offerings, with a high end limit of $50 million, will be smaller and less likely to create overwhelming market interest. In addition, with the offering limitation, it is less likely that the offering marketing will result in an unsustainable initial market price.
Just as all companies can now file confidential registration statements, I think all companies should be allowed to engage in public test-the-waters communications, subject to investor protections through disclaimers, rules against accepting funds, requiring the delivery of a filed prospectus once filed, and subject to offering dollar limitations.
Shareholder Rights and Dual Class Stock
Generally corporate governance and shareholder rights are a matter of state law. Under state law, a corporation may have multiple classes of stock with differing rights, including voting rights. A class of stock may have voting control, regardless of the number of shares or holders of public or common stock.
The Treasury Report recommends that corporate governance, including stock classes, remain under state law. I agree. In fact, I think the Report only addresses this topic because it has been debated recently, especially following the Snapchat IPO, whose public offering only included non-voting stock.
Exchange Act Rule 14a-8 allows shareholders to include proposals in a company’s proxy materials. The rule requires the company to include the proposal unless it falls within a list of allowable exclusions and provided that the shareholder follow the procedural requirements. To submit a proposal, a shareholder must have held, for at least one year, either (i) company securities with a value of $2,000 or more, or (ii) at least 1% of the outstanding voting securities.
The Treasury Report states that “According to one study, six individual investors were responsible for 33% of all shareholder proposals in 2016, while institutional investors with a stated social, religious, or policy orientation were responsible for 38%. During the period between 2007 and 2016, 31% of all shareholder proposals were a resubmission of a prior proposal.”
Shareholder proposals are an oft-debated topic as they cost companies tens of millions of dollars and significant time and management resources. The SEC often issues guidance on proposals, including recently in November 2017, about which I will write more in the future. Prior guidance was published in January 2015.
The Treasury Report recommends that the $2,000 holding requirement, which was instituted over 30 years ago, be substantially increased, and adding additional eligibility requirements. The Treasury Report also recommends substantial changes to the resubmission thresholds.
Smaller Public Companies
Smaller public companies face additional challenges, including just by virtue of complying with regulatory requirements with fewer economic and human resources. Furthermore, institutional investors generally favor invest larger companies.
The Treasury has identified opportunities to ease challenges for smaller public companies, including amending the definition of a “smaller reporting company” to increase the public float threshold from $75 million to $250 million and increasing scaled disclosure requirements. Moreover, the Report recommends extending the length of time a company may be considered an emerging growth company (EGC) to up to ten (10) years based on revenue and public float thresholds.
The Treasury Department also recognizes that liquidity remains an issue for smaller public companies. In that regard, the Report recommends increasing “tick size” and making changes to the practices at ATS’s (which would include OTC Markets).
Amend the Definition of a Smaller Reporting Company
Currently a smaller reporting company (SRC) is defined as one that: (i) has a public float of less than $75 million as of the last day of their most recently completed second fiscal quarter; or (ii) a zero public float and annual revenues of less than $50 million during the most recently completed fiscal year for which audited financial statements are available. SRC’s have the benefit of scaled disclosure requirements and are not required to comply with Sarbanes-Oxley Section 404(b), requiring independent auditor attestation of management’s assessment on internal controls.
Consistent with SEC proposals, the Treasury Report recommends increasing the threshold for an SRC to $250 million of public float. The Report does not mention the revenue threshold. The SEC has proposed rules to amend the definition of a SRC, which rule change is slated for action this year. For a review of the proposed rule amendment.
Increase Time to Qualify for Emerging Growth Company Status
An EGC is defined as a company with total annual gross revenues of less than $1,070,000,000 during its most recently completed fiscal year that first sells equity in a registered offering after December 8, 2011. An EGC loses its EGC status on the earlier of (i) the last day of the fiscal year in which it exceeds $1,070,000,000 in revenues; (ii) the last day of the fiscal year following the fifth year after its IPO; (iii) the date on which it has issued more than $1,070,000,000 in non-convertible debt during the prior three-year period; or (iv) the date it becomes a large accelerated filer (i.e., its non-affiliated public float is valued at $700 million or more).
The primary benefits of an EGC include scaled-down disclosure requirements both in an IPO and periodic reporting, relief from the auditor attestation requirements in Section 404(b) of the Sarbanes-Oxley Act, confidential filings of registration statements, certain test-the-waters rights in IPO’s, and an ease on analyst communications and reports during the EGC IPO process. The first of emerging growth companies (“EGC’s”) will begin losing EGC status as the five-year anniversary of the creation of an EGC has now passed. For a discussion of EGCs and the impact of losing EGC status.
The Treasury Report recommends increasing the time a company may be considered an EGC to up to 10 years.
Research Analyst Rules
In 2003 and 2004, SEC enforcement settlements with some of the major broker-dealers and investment banks required the firms to separate their research analysts from investment banking. The JOBS Act eased restrictions on research analyst communications during the IPO process. In addition, several changes in legislation have been proposed, with many passing either the House or Senate, but not becoming law. Included in that is the Financial Choice Act, which recommended expanding the exclusion of research reports from the definition of an offer for or to sell securities under the Securities Act.
The Treasury Report recommends a complete overhaul of the rules related to research reports, including harmonizing the 2003 and 2004 enforcement settlements within those new rules.
Regulation A/A+ Amendments
Like research reports, multiple changes in legislation have been proposed, and passed either the House or Senate, including the Financial Choice Act, which would increase the limits for Regulation A to $75 million. Additionally, there have been many proponents, including myself, who advocate for allowing companies that are subject to the Exchange Act reporting requirements to use Regulation A.
Supporting Regulation A, the Treasury Report recommends expanding the eligibility to use Regulation A to include Exchange Act reporting companies and increasing the Tier 2 offering limits to $75 million.
Encouraging Private Funding
Being public is not the right choice for all companies, especially earlier-stage entities, and as such, the Treasury Report discusses the state of private equity and ways to encourage private funding and access to capital for these vital companies as well. In an effort to support private capital-raising efforts, the Report makes recommendations for the modification of the “accredited investor” definition, creating a regulatory structure for finders, and modifying rules for private equity funds, including allowing more investments by unaccredited investors under Rule 506.
Regulation of Finders
The regulation of finders, or lack thereof, has been a topic I have written about many times, and is one of the most deficient areas of guidance in the federal securities laws. I have been vocal about my recommendations, including that I would recommend a regulatory framework that includes (i) limits on the total amount finders can introduce in a 12-month period; (ii) antifraud and basic disclosure requirements that match issuer responsibilities under registration exemptions; and (iii) bad-actor prohibitions and disclosures which also match issuer requirements under registration exemptions. For a review of the SEC Advisory Committee on Small and Emerging Companies recommendations related to finders, and a discussion of my own views.
The Treasury Report recommends that the SEC, FINRA and states propose a new regulatory structure for finders and other intermediaries in capital-forming transactions. The report generally suggests a “broker-dealer lite” structure; however, it makes no specific recommendations and anything broker-dealer-related will likely not resolve the issues or fix this broken area of the system.
Increase Eligible Investors in Regulation D Offerings
The definition of an accredited investor is another relevant topic to our private (and public) capital markets. On December 18, 2015, the SEC issued a report on the definition of an “accredited investor” and it is expected that new proposed rules amending the definition will be issued this year. For a review of the SEC report and more information on the background of the definition of an accredited investor.
The definition of “accredited investor” has not been comprehensively re-examined by regulators since its adoption in 1982; however, in 2011 the Dodd-Frank Act amended the definition to exclude a person’s primary residence from the net worth test of accreditation. Generally, natural persons can qualify as an accredited investor if they have a net worth of at least $1 million, excluding their primary residence, or have income of at least $200,000 ($300,000 together with a spouse) for each year for the last two years with a reasonable expectation to continue such income in the current year. Certain legal entities with over $5 million in assets are accredited investors, while certain regulated entities such as banks, broker-dealers, registered investment companies, BDC’s, and insurance companies are automatically designated as accredited investors.
The Treasury Report recommends expanding the definition of an accredited investor to include additional sophisticated investors, including, for example, registered representatives working with broker-dealers, investment advisors, financial professionals, and investors that are advised as to the merits and risks by a licensed individual.