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From Securities Regulation Daily, June 3, 2015

SEC committee recommends crowdfunding measures, other relief for small businesses

By Anne Sherry, J.D.

The SEC Advisory Committee on Small and Emerging Companies met today to discuss public company disclosure effectiveness, crowdfunding, and broker-dealer registration exemptions for “finders,” among other agenda topics. The committee made several recommendations to the Commission, including a recommendation for formalizing the so-called Section 4(a)(1½) exemption for securities sales that do not qualify for the Rule 144 safe harbor and a recommendation that the SEC modernize Securities Act Rule 147 to complement state crowdfunding efforts.

The agenda items for the meeting were: public company disclosure effectiveness; intrastate crowdfunding and Securities Act Rule 147; the aforementioned “Section 4(a)(1½) exemption”; rules and market structure matters relevant to venture exchanges; and the treatment of “finders” who connect emerging companies with private investors.

Opening remarks. In her opening statement, SEC Chair Mary Jo White summarized some of the Commission’s recent efforts and touched on some of the topics on the committee’s agenda. She noted the agency’s recent adoption of Regulation A+ and reiterated that one of her priorities is to complete crowdfunding rulemaking this year. Modernizing Securities Act Rule 147 is also on the SEC’s radar. The rule, which issuers often rely on for intrastate offerings, was adopted in 1974 and did not contemplate the possibility of intrastate offerings using the Internet. Securities Act Rule 504 is another crowdfunding-related rule that could benefit from modernization, she said. She also noted CorpFin’s efforts to improve the effectiveness of the public company disclosure regime for both investors and companies.

Public company disclosure effectiveness. CorpFin Associate Director Karen Garnett provided an overview of the division’s efforts in this area, also referring to a speech that CorpFin Director Keith Higgins presented on the topic last October. The three major focuses of the division are on improving the principles-based requirements of Regulation S-K, reviewing Regulation S-X (including the disclosure regime for entities other than a registrant), and modernizing EDGAR. The latter issue is a years-long project, she said. One of the possibilities the Division is considering is allowing companies to put up a disclosure document that stays more or less static, with periodic updates to accommodate developments in the business but obviating the need for repeating the same disclosures year after year. Higgins agreed that the EDGAR modernization will take time, adding that there are some incremental improvements that could come sooner. Breaking apart a document into its component parts may be a long way off, he suggested, but there are other ways to make information easier for investors to find that will not require a full modernization.

M. Christine Jacobs, who sits on the board of McKesson Corporation, emphasized the cost of regulatory compliance for smaller companies. Small companies with a $75 million market capitalization have to comply with the same rules and regulations as Morgan Stanley and Disney, she pointed out: “One size does not fit all when we continue to absorb one new regulation after another.” She cited a real example of a NYSE-listed company with $80 million in revenue that paid (prior to Dodd-Frank) $4 million annually in compliance costs such as auditing, D&O insurance, and internal compliance-related salaries. If the burden were eased, she said, 100 new jobs could be created with the savings.

Shannon L. Greene agreed, and noted a list of disclosures that seem to be burdening small companies to unclear ends. Greene is the CFO of Tandy Leather Factory, which is listed on NASDAQ and has revenue and market capitalization of $85 million. She questioned whether anyone is using the company’s XBRL files — no one has ever asked her about them, she said —and is also trying to figure out how conflict minerals disclosure helps investors. As a CPA, Greene noted negative changes to the auditor-issuer relationship. “The auditor is now considered to be the guy with the big hammer while we as the client wait to be hit with it,” she said, remarking that her auditing firm more closely resembles a regulator than a business partner.

A general consensus with Sonia Luna’s client base is that there is a lot of disclosure with no value. Luna founded and heads Aviva Spectrum, a management consulting firm that advises on SOX compliance, internal audits, corporate governance, and risk management. She cited footnote disclosure as an example and suggested the SEC look into whether the company needs to provide duplicative narrative disclosure, for example in the MD&A, if the data is already in a footnote. Gregory C. Yadley, a partner at Shumaker, Loop & Kendrick LLP, picked up this thread, remarking that redundancy is a concern when there is a narrative disclosure as well as a footnote that has been reviewed by accountants. If you get an SEC staff comment letter asking you to expand on your narrative disclosure, that may affect your footnote, which the accountants do not want to change. But he acknowledged the SEC’s efforts in this area and issuers’ reluctance to leave anything out. Committee co-chair Stephen M. Graham likened the redundancy problem to the quip, “I’d have written you a shorter letter, but I didn’t have time.” Regardless, Graham believes that there is probably low-hanging fruit to cut before you get to the critical information that investors see as valuable.

Charles V. Baltic, a managing director at investment banking firm Needham & Company, agreed that reducing the burden of disclosure is an important goal. He said that he has clients who are enthusiastic about wanting to tell their story before raising capital, but quickly come to see disclosure as a burden and even come to fear it. He attributes this fear to several aspects of the disclosure regime: the technical compliance burden, litigation risk, the problem of creating expectations for future disclosure, and the potential for triggering staff comments, which can slow down the process of filing a Form S-1 or follow-on S-1.

Crowdfunding. Michael Pieciak serves as the NASAA observer on the committee. Pieciak, deputy commissioner of the Vermont Securities Division, presented a snapshot of the current efforts in state-based crowdfunding. He sees the field of emerging companies as comprising two types of businesses: those with a potential for high growth, whose investors are looking to maximize profits and those that have a social or community component, such as a local grocery store. Pieciak said he’s given a lot of thought to the federal crowdfunding rules and concluded that regulatory compliance will differentiate state and federal crowdfunding. Vermont’s crowdfunding approach permits raising up to $1 million without audited financial statements, $2 million with financial statements, and higher individual investments. States are comfortable with higher numbers because they are more involved with the offerings that come through their door, he said.

Pieciak also discussed the possibility of regional crowdfunding standards. Particularly in a small area like New England, he said, a regional approach makes sense. Economic patterns may also argue for such an approach; for example, many people who work in Boston live in New Hampshire. All of the New England states are attempting to meet and discuss regional standards, he said, clarifying that this would not create an additional exemption or roll the standard up into Rule 504.

The committee members also discussed the “80 percent rule” under Rule 147. The Rule 147 safe harbor to Securities Act Section 3(a)(11) requires that 80 percent of the issuer’s revenues, its assets, and the net proceeds of the offering all be within or derive from the state of operation. This is a difficult rule to stay within and even to calculate, Pieciak noted, as some businesses don’t know where their customers are located. Sara Hanks, CEO of CrowdCheck, added that it’s so easy for customers to use a VPN or proxy so that online businesses cannot truly discern where a customer is located. As a result, the rules will have to allow customers to self-certify their location to the issuer, she said.

In response to his own call for a recommendation, Graham suggested that modernizing Rule 147 is a noncontroversial measure that would be very important to facilitate capital formation and support state crowdfunding efforts. The committee formally adopted his recommendation.

Venture exchanges. David Shillman, associate director of Trading & Markets, addressed a few misconceptions about venture exchanges. One question he says he gets asked is why the SEC prohibits venture exchanges. Venture exchanges are not broadly prohibited, but these questioners are applying the term broadly to include other firms such as alternative trading systems (ATS). The real issue is not whether the Commission should permit venture exchanges, he said, but how to make them more viable.

The thrust of the market structure regulatory initiative over the last two decades was to increase regulation: Regulation ATS created a new type of trading venue, decimalization fostered price competition among dealers, and order handling rules made sure best prices were publicly available. But legitimate questions have been raised as to whether these changes have benefited small-cap stocks, Shillman said. The real challenge for venture exchanges is attracting liquidity providers because small-cap securities tend to be thinly traded and market makers would be required to follow the security to ensure the quotes remain reasonable. This requires a lot of effort for limited potential profit. The trick would be in designing an attractive value proposition, perhaps through larger minimum quoting increments or monopoly trading rights, so that makers would be willing to make a continuous market in securities that don’t trade much. All of this has tradeoffs, Shillman added.

Treatment of “finders.” Finally, the committee discussed the problem of “finders,” referring to matchmakers who connect companies, for a fee, with potential investors but do not register as broker-dealers. Yadley noted that between 2009 and 2012, only 13 percent of Regulation D offerings involved a financial intermediary. He attributes this to issuers feeling that there isn’t interest in them from broker-dealers and the risks of using unregistered broker-dealers is too high, so there isn’t a robust field of intermediaries. This is a particular problem in more remote areas of the country where angel investors tend not to congregate. Catherine Mott, CEO of several Pittsburgh-based investors and angel groups, agreed, giving the example of a great company in the middle of her state that had been tainted by the work of a local attorney unfamiliar with the securities laws, causing potential investors to back out when they saw the state of the documents. Mott said that, as much as the industry sometimes frowns on people getting paid to raise money, there are a lot of pockets of the U.S. without incubators or other support that could benefit from finders.

The SEC’s M&A-broker no-action letter is a start in this area, Yadley said. Although it involved a specific set of facts, it made a general, salutary statement of what someone could do to help private businesses be bought and sold. The staff concluded that it would not recommend enforcement action for violating the broker-dealer registration rules in connection with transfers of privately held companies to a buyer who will actively operate the post-merger company. Congress is considering a similar exemption and several states have also followed suits, while others are not on board. Yadley suggested that NASAA may help coordinate state efforts. He also identified several criteria in creating a sort of finder exemption. The first agenda item would be to see who is actually out there acting as a finder. Next, there would need to be some restrictions, such as a prohibition on holding customer funds. Most people who want to see the exemption happen are willing to restrict purchasers to accredited investors, he said, and there would have to be bad actor disqualifications. Most importantly, he said, there needs to be some grandfathering because if the form asks when you first started conducting activities in securities, no one will register if they have to write down that it was one or two years ago. Written disclosure about the finder and the basis for compensation would also be important and membership in FINRA or another self-regulatory organization would be required. Finally, antifraud rules would continue to apply.

Graham suggested asking the SEC to take the lead on figuring out how to legitimize finders through a combination of exemptions and regulation. However, the committee decided to table the recommendation until after it had examined the issue more fully.

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