David R. Burton
Capital formation and entrepreneurship improve economic growth, productivity and real wages.
Existing securities laws impede entrepreneurial capital formation. To
promote prosperity, Congress and a reconstituted Securities and Exchange
Commission need to systematically reduce or eliminate state and federal
regulatory barriers hindering entrepreneurs’ access to capital. The
regulatory environment needs to be improved for both primary and
secondary offerings by private and small public companies. Steps should
also be taken to improve small firms’ access to credit and to reduce the
regulatory burden on small broker-dealers.
Unfortunately, the list of reforms necessary to achieve these objectives is long. However, with a new Congress and a new administration, major constructive reforms are likely. This article is a highly abbreviated treatment of what needs to be done. In the next month or so, I will publish a Heritage Foundation backgrounder discussing the reforms outlined here in much more detail. In particular, it examines the evidence and literature bearing on the various issues and discusses the rationale underlying each proposed reform. In chapter 11 of a recent Mercatus Center published book, Reframing Financial Regulation, I have proposed substantial reforms to the securities disclosure regime that would make it simpler, more effective and more coherent. Lastly, I have another paper coming out that proposes major reforms to FINRA.
The reforms discussed below involve private placements (Regulation D and micro-offerings), crowdfunding, the small issues exemption (Regulation A), small public companies, secondary market reform, finders, and improved access to credit.
Private Offerings and Regulation D
Congress should establish a statutory definition of accredited investor that maintains the existing thresholds. Regulation D is the most important means of entrepreneurial capital formation today. Congress should prevent the SEC from reducing the number of Americans who have the opportunity to invest in private companies.
Congress should change the definition of an accredited investor for purposes of Regulation D to include persons who have met specific statutory bright line tests for whether an investor has the “knowledge and experience in financial and business matters” that the investor “is capable of evaluating the merits and risks of the prospective investment.” In practice, sophisticated investors without high incomes or net worth are unable to invest in the companies with the most profit potential. People that fall in this category are disproportionately young people. It also means that young entrepreneurs seeking to raise capital from their non-wealthy peers find it more difficult to raise capital. For example, Congress could provide that someone is an accredited investor for purposes of Regulation D who has (1) passed a test demonstrating the requisite knowledge such as the General Securities Representative Examination (Series 7), the Securities Analysis Examination (Series 86) or the Uniform Investment Adviser Law Examination (Series 65) or a newly created accredited investor exam, (2) met relevant educational requirements such as an advanced degree in finance, accounting, business or entrepreneurship, or (3) acquired relevant professional certification, accreditation or licensure, such as being a certified public accountant, chartered financial analyst, certified financial planner or registered investment advisor.
Congress should specify that the receipt by an issuer of a self-certification of accredited investor status constitutes taking “reasonable steps to verify that purchasers of the securities are accredited investors” for purposes of the JOBS Act. The regulations governing Rule 506(c) – Regulation D offerings involving general solicitation – effectively require very intrusive inquiries that make these offerings needlessly complex and less attractive.
Congress should stop the promulgation of Regulation D amendments proposed in July 2013 These proposed rules would substantially increase the regulatory burden on smaller companies seeking to use Regulation D and have no appreciable positive impact. They would require filing three forms instead of one and impose a variety of other burdensome requirements.
Congress should improve Regulation D by preempting blue sky registration and qualification requirements for Regulation D Rule 505 offerings (originally meant for smaller firms). This can be accomplished by defining Rule 505 securities as covered securities or by defining qualified purchaser to include all purchasers of Rule 505 securities or both.
Congress should amend the Securities Act to create a micro-offering safe harbor so that any offering (within a 12 month period):
Crowdfunding
Congress should repeal the requirement that crowdfunding issuers raising $500,000 or more have audited financial statements. These very small firms should not have to incur this cost when many much larger offerings using Regulation D or Regulation A do not. Congress should repeal restrictions on curation by funding portals. Curation protects investors. Congress needs to substantially reduce the complex initial and ongoing mandatory disclosure requirements on crowdfunding issuers. Congress should clarify that funding portals are not subject to the anti-money laundering, “Know Your Customer” and associated Bank Secrecy Act requirements. These very expensive rules will often make funding portals uneconomic and since funding portals are prohibited from holding customer funds, they are entirely inappropriate. FinCEN has proposed applying these rules to funding portals.
Congress should amend the Internal Revenue Code so that Title III crowdfunding and Regulation A investors are disregarded for purposes of determining whether an S Corporation has more than 100 shareholders. Otherwise, S corporations will be effectively barred from using crowdfunding and Regulation A because they will quickly exceed the 100 shareholder cap raising small amounts from a large number of investors.
Overall, Congress may want to simply start over and draft a new crowdfunding statute using Rep. McHenry’s original bill as the template.
The Small Issues Exemption and Regulation A
As it has done for Rule 506 and crowdfunding offerings, Congress should preempt state blue sky registration and qualification requirements for all Regulation A offerings. State anti-fraud laws should remain fully operative. Blue sky registration and qualification requirements are costly, cause long delays, introduce a high degree of uncertainty to any offering and do little if anything to protect investors. The fees they entail do, however, increase state regulators budgets.
Congress should codify the exemption from the section 12(g) holder of record limitations for Regulation A securities (as was necessarily done for crowdfunding). Congress needs to specify a better limited, scaled disclosure regime for Regulation A offerings. In particular, “Tier 1” Regulation A offerings must have reasonable requirements for offering statements and periodic disclosure. These provisions should be self-effectuating without having to wait for the promulgation of SEC regulations. The current Tier 2 requirements, which are the “price” of blue sky exemption for primary offerings, are similar to the burden imposed on smaller reporting companies and not feasible for most companies raising only a few million dollars. Congress should make it clear that investor limitations restricting the amount that investors may invest in Regulation A offerings, included by the SEC in its final rule, to no more than 10 percent of income or net worth are not permitted. This rule, while not objectively unreasonable for most people, is unreasonable for certain entrepreneurs and, more importantly, it establishes the precedent of the SEC starting to regulate the content of investor portfolio composition.
Congress also needs to preempt blue sky laws with respect to secondary sales of Regulation A securities (along with securities of reporting companies trading OTC). This will make these securities more liquid and attractive, helping investors to achieve a higher price at a lower cost and helping issuers raise capital because these securities will be more attractive to investors.
Finders and Private Placement Brokers
Congress should create a statutory exemption for small finders who are not “engaged in the business” of “effecting transactions in securities for the account of others” or of “buying and selling securities.” As an integral component of that exemption, it is necessary to create a bright-line “small finder” safe harbor such that small finders are deemed not to be engaged in the business of being a securities broker or dealer. Such a bright line safe harbor would eliminate much of the regulatory uncertainty associated with the use of finders.
Specifically, an exemption should be created for finders from the section 15 registration requirement providing a safe harbor such that a finder is deemed not to be engaged in the business of effecting transactions in securities for the account of others” if the finder meets one or more of the following criteria:
Congress should amend the law to preempt state regulation of broker-dealers except with respect to sales practices and fraud.
Secondary Market Reform
Congress should amend section 18(b) of the Securities Act to treat all securities as covered securities that (1) are traded on established securities markets and (2) have continuing reporting obligations as (a) a registered company, (b) pursuant to Regulation A or (c) pursuant to Regulation Crowdfunding. An established securities market should be defined to include those on electronic markets such as an SEC designated alternative trading system (ATS). This would probably be sufficient to allow venture exchanges to develop in the United States without having to adopt an alternative, separate regulatory framework for venture exchanges.
Congress should also establish an alternative regulatory regime for venture exchanges that would treat venture exchanges as national securities exchanges for purposes of blue sky preemption but more like ATSs for regulatory purposes.
Small Public Companies
Congress should increase the smaller reporting company threshold to $300 million and conform the accelerated filer definition. Congress should also make all emerging growth company advantages permanent for smaller reporting companies. Congress should provide a statutory, coherent and reasonable scaled disclosure regime for smaller reporting companies. And, as discussed above, Congress should exempt all reporting companies, including those not traded on exchanges, from blue sky laws other than the state anti-fraud statutes.
Improved Access to Credit
Small business access to credit is lagging. It is not entirely clear why. Congress should instruct the Government Accountability Office to investigate the cause of the decline in small business lending. Congress should repeal the arbitrary limit on credit union small business lending.
Congress should take steps to reduce regulatory impediments to small business peer-to-peer or FinTech lending. First, Congress should exempt peer to peer lending from the federal and state securities laws. Second, Congress should amend Title III of the JOBS Act to create a category of crowdfunding security called a “crowdfunding debt security” or “peer to peer debt security” whereby the issuer offering securities pursuant to Securities Act section 4(a)(6) – the crowdfunding exemption – would be exempt from much of the continuing disclosure requirements. Third, Congress could adopt an alternative regulatory regime for P2P lending. Such an approach has been proposed.
Conclusion
There is a lot to do. But we have the best opportunity in a very long time to improve the regulatory environment for entrepreneurial capital formation.
Unfortunately, the list of reforms necessary to achieve these objectives is long. However, with a new Congress and a new administration, major constructive reforms are likely. This article is a highly abbreviated treatment of what needs to be done. In the next month or so, I will publish a Heritage Foundation backgrounder discussing the reforms outlined here in much more detail. In particular, it examines the evidence and literature bearing on the various issues and discusses the rationale underlying each proposed reform. In chapter 11 of a recent Mercatus Center published book, Reframing Financial Regulation, I have proposed substantial reforms to the securities disclosure regime that would make it simpler, more effective and more coherent. Lastly, I have another paper coming out that proposes major reforms to FINRA.
The reforms discussed below involve private placements (Regulation D and micro-offerings), crowdfunding, the small issues exemption (Regulation A), small public companies, secondary market reform, finders, and improved access to credit.
Private Offerings and Regulation D
Congress should establish a statutory definition of accredited investor that maintains the existing thresholds. Regulation D is the most important means of entrepreneurial capital formation today. Congress should prevent the SEC from reducing the number of Americans who have the opportunity to invest in private companies.
Congress should change the definition of an accredited investor for purposes of Regulation D to include persons who have met specific statutory bright line tests for whether an investor has the “knowledge and experience in financial and business matters” that the investor “is capable of evaluating the merits and risks of the prospective investment.” In practice, sophisticated investors without high incomes or net worth are unable to invest in the companies with the most profit potential. People that fall in this category are disproportionately young people. It also means that young entrepreneurs seeking to raise capital from their non-wealthy peers find it more difficult to raise capital. For example, Congress could provide that someone is an accredited investor for purposes of Regulation D who has (1) passed a test demonstrating the requisite knowledge such as the General Securities Representative Examination (Series 7), the Securities Analysis Examination (Series 86) or the Uniform Investment Adviser Law Examination (Series 65) or a newly created accredited investor exam, (2) met relevant educational requirements such as an advanced degree in finance, accounting, business or entrepreneurship, or (3) acquired relevant professional certification, accreditation or licensure, such as being a certified public accountant, chartered financial analyst, certified financial planner or registered investment advisor.
Congress should specify that the receipt by an issuer of a self-certification of accredited investor status constitutes taking “reasonable steps to verify that purchasers of the securities are accredited investors” for purposes of the JOBS Act. The regulations governing Rule 506(c) – Regulation D offerings involving general solicitation – effectively require very intrusive inquiries that make these offerings needlessly complex and less attractive.
Congress should stop the promulgation of Regulation D amendments proposed in July 2013 These proposed rules would substantially increase the regulatory burden on smaller companies seeking to use Regulation D and have no appreciable positive impact. They would require filing three forms instead of one and impose a variety of other burdensome requirements.
Congress should improve Regulation D by preempting blue sky registration and qualification requirements for Regulation D Rule 505 offerings (originally meant for smaller firms). This can be accomplished by defining Rule 505 securities as covered securities or by defining qualified purchaser to include all purchasers of Rule 505 securities or both.
Congress should amend the Securities Act to create a micro-offering safe harbor so that any offering (within a 12 month period):
-
to people with whom the issuer (or its officers, directors or 10
percent or more shareholders) has a substantial pre-existing
relationship;
-
involving 35 or fewer other persons; or
-
of less than $500,000
Crowdfunding
Congress should repeal the requirement that crowdfunding issuers raising $500,000 or more have audited financial statements. These very small firms should not have to incur this cost when many much larger offerings using Regulation D or Regulation A do not. Congress should repeal restrictions on curation by funding portals. Curation protects investors. Congress needs to substantially reduce the complex initial and ongoing mandatory disclosure requirements on crowdfunding issuers. Congress should clarify that funding portals are not subject to the anti-money laundering, “Know Your Customer” and associated Bank Secrecy Act requirements. These very expensive rules will often make funding portals uneconomic and since funding portals are prohibited from holding customer funds, they are entirely inappropriate. FinCEN has proposed applying these rules to funding portals.
Congress should amend the Internal Revenue Code so that Title III crowdfunding and Regulation A investors are disregarded for purposes of determining whether an S Corporation has more than 100 shareholders. Otherwise, S corporations will be effectively barred from using crowdfunding and Regulation A because they will quickly exceed the 100 shareholder cap raising small amounts from a large number of investors.
Overall, Congress may want to simply start over and draft a new crowdfunding statute using Rep. McHenry’s original bill as the template.
The Small Issues Exemption and Regulation A
As it has done for Rule 506 and crowdfunding offerings, Congress should preempt state blue sky registration and qualification requirements for all Regulation A offerings. State anti-fraud laws should remain fully operative. Blue sky registration and qualification requirements are costly, cause long delays, introduce a high degree of uncertainty to any offering and do little if anything to protect investors. The fees they entail do, however, increase state regulators budgets.
Congress should codify the exemption from the section 12(g) holder of record limitations for Regulation A securities (as was necessarily done for crowdfunding). Congress needs to specify a better limited, scaled disclosure regime for Regulation A offerings. In particular, “Tier 1” Regulation A offerings must have reasonable requirements for offering statements and periodic disclosure. These provisions should be self-effectuating without having to wait for the promulgation of SEC regulations. The current Tier 2 requirements, which are the “price” of blue sky exemption for primary offerings, are similar to the burden imposed on smaller reporting companies and not feasible for most companies raising only a few million dollars. Congress should make it clear that investor limitations restricting the amount that investors may invest in Regulation A offerings, included by the SEC in its final rule, to no more than 10 percent of income or net worth are not permitted. This rule, while not objectively unreasonable for most people, is unreasonable for certain entrepreneurs and, more importantly, it establishes the precedent of the SEC starting to regulate the content of investor portfolio composition.
Congress also needs to preempt blue sky laws with respect to secondary sales of Regulation A securities (along with securities of reporting companies trading OTC). This will make these securities more liquid and attractive, helping investors to achieve a higher price at a lower cost and helping issuers raise capital because these securities will be more attractive to investors.
Finders and Private Placement Brokers
Congress should create a statutory exemption for small finders who are not “engaged in the business” of “effecting transactions in securities for the account of others” or of “buying and selling securities.” As an integral component of that exemption, it is necessary to create a bright-line “small finder” safe harbor such that small finders are deemed not to be engaged in the business of being a securities broker or dealer. Such a bright line safe harbor would eliminate much of the regulatory uncertainty associated with the use of finders.
Specifically, an exemption should be created for finders from the section 15 registration requirement providing a safe harbor such that a finder is deemed not to be engaged in the business of effecting transactions in securities for the account of others” if the finder meets one or more of the following criteria:
-
the finder does not receive finder’s fees exceeding $300,000 in any year;
-
the finder does not assist an issuer in raising more than $10 million in any year;
-
the finder does not assist any combination of issuers in raising more than $20 million in any year; or
-
the finder does not assist any combination of issuers with respect to more than 15 transactions in any year.
Congress should amend the law to preempt state regulation of broker-dealers except with respect to sales practices and fraud.
Secondary Market Reform
Congress should amend section 18(b) of the Securities Act to treat all securities as covered securities that (1) are traded on established securities markets and (2) have continuing reporting obligations as (a) a registered company, (b) pursuant to Regulation A or (c) pursuant to Regulation Crowdfunding. An established securities market should be defined to include those on electronic markets such as an SEC designated alternative trading system (ATS). This would probably be sufficient to allow venture exchanges to develop in the United States without having to adopt an alternative, separate regulatory framework for venture exchanges.
Congress should also establish an alternative regulatory regime for venture exchanges that would treat venture exchanges as national securities exchanges for purposes of blue sky preemption but more like ATSs for regulatory purposes.
Small Public Companies
Congress should increase the smaller reporting company threshold to $300 million and conform the accelerated filer definition. Congress should also make all emerging growth company advantages permanent for smaller reporting companies. Congress should provide a statutory, coherent and reasonable scaled disclosure regime for smaller reporting companies. And, as discussed above, Congress should exempt all reporting companies, including those not traded on exchanges, from blue sky laws other than the state anti-fraud statutes.
Improved Access to Credit
Small business access to credit is lagging. It is not entirely clear why. Congress should instruct the Government Accountability Office to investigate the cause of the decline in small business lending. Congress should repeal the arbitrary limit on credit union small business lending.
Congress should take steps to reduce regulatory impediments to small business peer-to-peer or FinTech lending. First, Congress should exempt peer to peer lending from the federal and state securities laws. Second, Congress should amend Title III of the JOBS Act to create a category of crowdfunding security called a “crowdfunding debt security” or “peer to peer debt security” whereby the issuer offering securities pursuant to Securities Act section 4(a)(6) – the crowdfunding exemption – would be exempt from much of the continuing disclosure requirements. Third, Congress could adopt an alternative regulatory regime for P2P lending. Such an approach has been proposed.
Conclusion
There is a lot to do. But we have the best opportunity in a very long time to improve the regulatory environment for entrepreneurial capital formation.
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