Statement of Sen. Carl Levin to the Committee on Banking, Housing and Urban Affairs


Committee Hearing on Spurring Job Growth Through Capital Formation

December 1, 2011 – (RealEstateRama) — Today’s hearing is intended to examine several bills that are now being characterized as small business “jobs” or “capital access” bills. Each of these bills is designed to address a perceived challenge facing small or private businesses, but all of them would eliminate or diminish aspects of the federal securities laws. I thank the Chairman for holding today’s hearing, which I hope will explore many of the issues raised by these bills.

These bills, as drafted, reduce investor protections and increase regulatory blind spots. Put simply, the unsubstantiated promise of job creation is being used to justify a weakening of investor protections and regulatory oversight. Some bills can be improved and some cannot.

Collectively, the bills seek to expand the tools businesses have at their disposal for raising capital. The bills approach the issue from four different angles:

Regulation A. The Tester-Toomey bill (S.1544) and its House-passed counterpart would make it easier for companies to conduct public offerings using a streamlined version of the regular SEC registration process called Regulation A, by raising the cap on the dollars that can be raised from $5 million to $50 million. The Reg A process has been effectively abandoned in recent years, and these bills are attempts to revive it as a less-burdensome alternative for smaller issuers.

Raising the threshold to $50 million may be a reasonable method to revive the usage of Reg A, while still ensuring, because of its relatively small size, that it is not abused by large companies seeking to avoid the normal public registration process.

However, in addition to raising the cap, the Tester-Toomey bill also creates a routine process through which the cap would very likely be raised every two years, with no limit. In fact, if the SEC declined to raise the cap, it would have to report its reasons for doing so to the appropriate committees of jurisdiction. The bill language could even be read to remove the discretion of the SEC to lower the cap in the future.

This procedure would allow the cap to be raised well above a level appropriate for small business. Allowing companies to raise well in excess of the proposed cap using the streamlined Reg A process would undermine the normal registration process and the additional protections it provides to investors. Although the SEC could raise the cap now, that authority has not been utilized and companies have completed only a handful of Reg A offerings in recent years.

Congress should ensure that the bill provides an alternative registration process for only smaller offerings, and is not used by larger companies to evade normal investor protections.

Accordingly, the bill should be revised to safeguard the integrity of the Reg A process and retain its focus on small offerings.

A second issue involves the question of liability. Section 11 of the Securities Act of 1933 generally provides strict liability for issuers that make misstatements or omissions of material facts in their prospectuses. Those who aid in the prospectuses’ preparation may also be found liable. Some have raised the concern that it is unclear whether this liability would apply to misstatements or omissions made in Reg A filings. The bill should be revised to clarify that the same liability standards apply to Reg A offerings.

I support raising the cap for Reg A offerings to $50 million, but I believe that we should protect the integrity of Reg A and retain its focus on providing an easier alternative for small offerings.

Crowd-Funding. A second set of bills would authorize so-called “crowd-funding,” which would essentially allow companies to use the internet and potentially unregulated intermediaries to raise funds from ordinary investors. Most crowd-funding proposals would allow a corporation to advertise itself on a third party “intermediary” website, and solicit small investments from a large number of retail, meaning unsophisticated, investors, without the normal burdens of registering with the SEC.

These intermediary websites typically provide a list of several different investment options. This approach is similar to the approach used in philanthropy and micro-loan operations in which artistic endeavors, charities, or small entrepreneurs use the Internet to advertise their projects and solicit a large number of small donations.

The current House and Senate versions of this proposal would create a “crowd-funding” exemption from federal and state securities laws, which would allow small businesses to advertise publicly on the Internet and raise money from a large number of investors.

Both versions would significantly weaken federal and state securities laws by opening up a huge loophole for securities offerings to the investing public. Regulators, practicing securities lawyers, and others have expressed concerns about whether the bills retain adequate protections for ordinary investors. They note that these types of small, unregistered investments are precisely the same types of instruments used by unscrupulous fraudsters in “boiler room” cases over the decades. As currently drafted, these bills could end up sanctioning an online investment casino generating huge losses for small investors.

My key concerns with the House bill in particular include the following.

It would create a new unregulated class of broker-dealers. The “intermediaries” that operate the websites or otherwise facilitate investments in the companies would be acting much like an SEC-registered broker-dealer, but would not be required to register or operate like one. There would be virtually no SEC or state oversight of the websites or the companies that run them. Yet, these intermediaries are the only entities who can perform basic due diligence to ensure that the companies seeking funding are real business enterprises, and not shams.
The proposed investment and income restrictions are inadequate. The bill would allow a company to accept investments of as much as $10,000 or 10% of an investor’s income. A person losing $10,000 or 10% of his annual income would be a very meaningful loss. Yet, both because of their newness and their relative freedom from regulation, companies using this crowd-funding exemption could easily fail. There are also no safeguards to prevent an investor from plowing $10,000 or 10% of their income into several crowd-funded companies. This is of particular concern given that the intermediaries typically would allow users to view and invest in a large number of companies. In addition, as we saw during the financial crisis, investors may certify that they have greater incomes than they do, but the bill contains no effective requirement for income verification.
Investing in new companies is often a high-risk proposition that is not suitable for many investors. Federal securities laws and the rules of the self-regulatory organizations currently prohibit broker-dealers from selling customers investments that are “unsuitable” for the investor. For unsophisticated investors, investments in these early-stage companies, which are among the riskiest of all investments, are unlikely to be “suitable,” but this bill would circumvent that investor protection. Even worse, the disclosures mandated by the bill are inadequate to meaningfully warn potential investors of the inherent risks.
The bill would also preempt state securities regulatory protections, an approach that the recent financial crisis has shown was ill-advised. State securities regulators often have the best information and sensitivity to investment frauds harming their residents. They are much-needed cops on the beat, and we should not unnecessarily limit their abilities to protect their citizens.

While crowd-funding proposals sound enticing, Congress should be leery of weakening bedrock investor protections, and make sure that this niche funding opportunity does not open the floodgates to fraud. I understand that Senators Merkley and Bennet may be working on a proposal that may permit crowd-funding with more appropriate investor safeguards, and I look forward to evaluating it.

Shareholder Ceiling. Currently, companies with more than $10 million in assets and 500 or more shareholders must register and make periodic filings with the SEC, which also means that they must comply with Sarbanes-Oxley financial controls and other federal securities laws. A third set of bills would increase the number of shareholders that private companies may have before being required to go public and register with the SEC from 500 to up to 2,000 shareholders, depending upon the bill.

Some have argued that high registration and compliance costs, along with low investor demand for smaller public offerings, make it difficult for companies at or near the 500 shareholder limit to go public. Some very large companies that are near the 500 shareholder limit may buy-back their shares or engage in other transactions so as to ensure they don’t hit the trigger. These corporations would like to raise the shareholder limit to make it easier for them to avoid having to comply with filing requirements and other regulatory protections.

H.R.2167 would raise the trigger from 500 to 1000 shareholders. The bill would also exclude from the count all accredited investors, such as pensions, insurance companies, university endowments, hedge funds and mutual funds, and employees of the issuing company, which would mean that most shareholders would not be counted at all. A similar Senate bill would also raise the trigger from 500 to 2000 shareholders. Another, much more limited version (S.556), which was introduced by Senators Hutchison and Pryor, would raise the shareholder number trigger to 2,000 solely for banks or bank holding companies.

It is unclear how helping corporations with large numbers of shareholders avoid federal securities laws would help create jobs or help small businesses.

Venture capitalists have said that they do not think that raising the shareholder limit would be especially helpful to startup companies. And the research indicates that the costs associated with SEC registration and Sarbanes-Oxley compliance are not major factors when businesses decide whether or not to go public. Far from helping the IPO market, some have expressed concerns that this bill could further inhibit the return of a healthy IPO market.

I have not heard from any small businesses seeking to raise the cap on all companies. Rather than being a small business concern, there is substantial evidence to suggest proposals to increase the thresholds for all companies are being pressed by larger private companies that are seeking to avoid SEC registration. The trading platforms where large “private” issues are now being traded outside of regulated exchanges are also pushing for this bill. And some experts suggest that as many as half of all public companies might be able to fall under a raised cap.

It is difficult to imagine how helping large businesses avoid federal oversight, transparency, and investor protections produces jobs or assists small business. In fact these bills may be counterproductive in that they will make our markets less transparent and less attractive for investment. One of the great strengths of our markets is its transparency.

Further, a substantial debate is going on over how to count the number of shareholders, including how to count investment pools or securities held in street name, which may allow firms to evade the limits. The SEC staff is currently studying this issue and there is no reason to jump the gun before they come out with their findings.

Setting the appropriate thresholds for when a company is large enough, and has enough shareholders, so that it should register with the SEC and provide basic levels of financial transparency is critical to healthy capital markets. These issues deserve thoughtful study and informed debate, which we have not yet had. The bills to raise the shareholder threshold are premature, and threaten harmful consequences for US capital markets and investor protections.

Advertising. The fourth and final set of bills relate to advertising issues. Regulation D is designed to exempt small private offerings from SEC registration so long as the issuer sells the securities to only accredited investors, such as wealthy individuals, pensions, insurance companies, mutual funds, and hedge funds. Sales to non-accredited investors are strictly limited.

When relying on Reg D, issuers are prohibited from “general solicitation,” in other words, publicly advertising the offering of their securities. H.R.2940 would allow issuers relying on Reg D to publicly advertise their securities so long as the resulting sales are to accredited investors.

While this concept sounds sensible, loosening the general solicitation prohibition was tried before and failed. Ultimately, the SEC re-imposed the restriction because the increased leniency was “abused by perpetrators of microcap fraud.” Some would suggest that Congress should ignore this real-life test of the importance of the general solicitation prohibition. We shouldn’t.

This proposal could open the door for Internet solicitations, billboards along the highway, and mass mailings promoting risky, opaque investments to the masses. It is an invitation to fraud and there is no evidence to suggest that it would promote jobs or small business.

I thank Chairman Johnson for holding this hearing today and for the opportunity to share my concerns. I look forward to working with my colleagues on ways to promote small businesses and job creation while maintaining investor protections and oversight of our financial markets.


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