Facilitating Real Capital Formation

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s remarks at the Council of Institutional Investors Spring Meeting; the complete remarks, including footnotes, are available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today, I want to talk about capital formation. For over 30 years, I advised many clients as to their capital raising efforts in order to grow their businesses, and I worked with institutions that held significant stakes in companies who grew their operations by making better products, and selling more of them.

I have been growing increasingly concerned about the discussion that is taking place in our country regarding capital formation. This discussion seems to confuse the singular act of capital raising with the much broader concept of capital formation. Moreover, this discussion fails to take into account the importance of disclosure in helping investors assess risks and make informed investment decisions. Disclosure leads to an informed investor – and informed investors are ones who will make investment decisions that collectively, in the aggregate, will yield productive benefits and growth to the real economy.

I know you understand exactly what I mean. The Council is an association of members who have a long-term stake in the U.S economy. You are self-described as the “patient capital” of the markets because, in general, you have “30-year investment horizons and heavy use of indexing strategies.” You understand that for most investments to make money, the company generally requires organic or strategic growth over a period of time.

I share this long-term view.

At a time when too many people are facing tough economic conditions in our country, with persistently high levels of unemployment, we need to understand what is needed for investments to result in productive uses. With millions of Americans unemployed, and with those who are employed earning less, our recovery will be anemic until all Americans can share in it and, by participating in the recovery, drive economic growth.

In particular, for this effort to be robust, the SEC must be clear about the benefits of regulation and how regulation has been, and can continue to be, a driver of informed investments and economic growth. I am concerned about the negative ramifications that will flow from those who refuse to face the reality that regulation and mandatory disclosure are essential to strong capital formation and to real economic growth.

I think that a focus on reality was a large part of what President Obama meant when earlier this year he issued an executive order on regulation. I agree with President Obama when he stated that the purpose of “the nation’s regulatory system” is that it “must protect public health, welfare, safety, and our environment while promoting economic growth, innovation, competitiveness, and job creation.” In doing so, the President made clear that regulation “must be based on the best available science.”

I plan to spend my time with you today discussing the following:

  • The way that strong regulation facilitates capital formation and real economic growth and the science that supports it; and
  • My concern that the U.S. capital markets are being exploited by certain foreign companies, not only harming U.S. investors, but also negatively effecting the environment for capital formation.

The Real Economy and Capital Formation

Let me begin by talking about the real economy and the essential and positive role of securities regulation. By the “real economy,” I mean our country’s capacity to produce goods, to provide services, and for our citizens to earn a living wage. From my standpoint, one of the most important insights from the financial crisis was that deregulated and poorly regulated markets misallocated our country’s capital and other scarce resources, resulting in trillions in mispriced assets, devastating the savings of American families, and resulting in painful levels of unemployment that persist to this day. As credit contracted, businesses saw their lending costs soar and hoarded cash in the face of weak demand.

The Reality About Capital Formation

As an SEC Commissioner focused on the real economy and on our recovery from the financial crisis, I am gratified that the SEC’s mandate includes the consideration of capital formation. Facilitating capital formation and improving the real economy go hand in hand.

However, it is important that we define what facilitating capital formation means. When Congress included the consideration of capital formation in the SEC’s mandate it did not define the term. The term, however, has been around for decades. It is generally understood that capital formation is a macroeconomic benchmark that measures changes in the amount of productive capital in the economy as a whole. In essence, capital formation is about all the ways of creating productive capital in our economy, including but not limited to improving infrastructure, building plants, and hiring workers.

But, in the discussions about capital formation, it seems to have become synonymous with the ability to raise funds. Whatever makes it easier and cheaper for issuers to raise money seems to constitute capital formation. However, the singular act of raising capital does not necessarily result in capital formation.

Let me illustrate this with a prime example where a lot of money was raised from investors who received little to no information and where, as a result, fewer productive assets were produced. This example involves securitizations of asset-backed securities. It is true that securitization can lower borrowing costs and be an important way to facilitate capital formation, but we have learned that the process must be improved. The vast majority of asset-backed securities – especially the structured finance products that were key drivers of the financial crisis – were sold in private placements where no disclosure was required. Moreover, for those securitizations that were sold in registered deals, ongoing public reporting generally terminated after one year.

As the Financial Crisis Inquiry Commission observed, “By the time the financial crisis hit, investors held more than $2 trillion of non-GSE mortgage backed securities, and close to $700 billion of CDOs that held mortgage-backed securities. These securities were issued with practically no SEC oversight. And only a minority were subject to the SEC’s ongoing public reporting requirements.” As the SEC said last year, “Securitization in the private, unregistered market played a significant role in the financial crisis.” In fact, one might argue that we had capital destruction rather than capital formation.

Additionally, if capital raising is the sole consideration to define capital formation, individuals who engage in Ponzi schemes could be considered the best facilitators of capital formation in the business. That simply cannot be right. Following this idea to its logical conclusion leads to capital destruction rather than capital formation.

Facilitating true capital formation is about helping investors and other capital providers to make informed decisions. Almost all investments have risks, and while we all understand the need for investors to take risks, I want them to take informed risks. Capital formation is about ensuring that the companies with the best ideas, even if those ideas are risky, can get the financing to make those ideas a reality. The goal is for issuers to provide potential investors with appropriate information so that investors can assess the risk of investing their capital. For that goal to be reached, we need strong and effective securities regulation that fosters appropriate disclosures.

By comparison, just think about the recent financial crisis, as well the Great Depression, and you will see that poor securities regulation does not facilitate the formation of productive capital. In both crises, the savings of hard working Americans went into investments that wound up being worth little, if anything. And in many cases it was because of a lack of regulation and disclosures.

In addition to the lessons of history, there are several recent studies that clearly demonstrate that capital formation is facilitated by a strong, mandatory disclosure regime.

The Best Available Science: Strong Securities Regulation is Important to the Real Economy

As those of us who took science in school will remember, in science, there is theory and there is empirical evidence. The theory of why strong mandatory disclosure drives capital formation is straightforward. Disclosure improves the accuracy of share prices, and helps to determine which investment projects should receive society’s scarce capital. In addition, disclosure assists shareholders in monitoring management and in proxy voting, which helps ensure that the projects that are undertaken are managed better.

Disclosure also helps the broader public determine how best to invest capital. For example, imagine an entrepreneur contemplating entry into the telephone business. She learns from AT&T’s segment disclosures that revenue from landline telephone service has declined by over 10% each of the last two years. It’s not hard to imagine that this entrepreneur may decide that a new startup aiming to improve telephone service should also consider whether it would be effective in a wireless or VOIP context. Venture capital investors would also look harder at a business plan whose profitability was based solely on landline telephone service. The public disclosure improves the quality of their decision making.

Economic theory explains not only why disclosure is valuable, but also why regulation is essential for adequate disclosure to be provided. There are a lot of reasons for this. One principal reason is that disclosure is, in economic terms, a “public good” in that its benefits are enjoyed broadly by the public – across all investors, prospective investors, competitors, and other interested parties. However, because the benefits are shared broadly, there may not be any single group that will fight for disclosure at a level that benefits all. This includes companies. Even the best companies and their management who are focused on high-quality disclosure live in a world where the costs and inconvenience of preparing disclosure are borne by them but the disclosure benefits shareholders and other market participants. Without regulation requiring disclosure, management, especially with bad news to report, can be expected to resist disclosure.

Regulation also sets a level playing field by subjecting all companies to the same requirements. Without regulation mandating public disclosures, the widespread benefits of disclosure would not be achieved, and investors and the public would not receive the information they need. As a result, shareholders would be unable to judge how management is performing, and investors would be denied information to inform their investments decisions. The public nature of the disclosure leads to decisions that allow our economy to be as strong as it can be.

This theory has been evidenced in several empirical studies over the past decade that clearly show the positive effect of securities regulation and mandatory disclosure. Let me briefly summarize just a few of the recent studies and their results:

First, a 2003 study that looked at the effect of the Commission’s rules requiring management to discuss and analyze the company’s financial and operating results, the so-called MD&A requirements. MD&A was a significant new disclosure rule when it was adopted. It required management to reveal trends and risks that made the information about the company’s current results more understandable. The study found strong evidence that MD&A disclosure resulted in more accurate and informed share prices – and that it contributed to a better functioning real economy.

Second, a 2006 study that looked at what happened to widely-held companies that were traded over-the-counter after the securities laws were amended to require these companies to make disclosures specified by the SEC. The study found that the newly required disclosures created billions of dollars of value for shareholders of the OTC companies. This study is strong evidence of the benefits that public disclosure provides.

One last study I want to draw to your attention to is quite recent. This 2010 study examined the effect on share price accuracy and trading arising from the SEC’s rules requiring separate “segment reporting” or “line of business” reporting. These regulations required issuers to disclose the sales and net income derived from each of the lines of business in which they were significantly involved. The study finds “strong evidence” that this disclosure did, in fact, increase share price accuracy and improve market liquidity.

There are many other economic studies that find public disclosure is valuable to the companies that make it, but more importantly to the economy as a whole.

Moreover, in addition to the economic arguments explaining how strong disclosure is beneficial to the real economy, we should not forget that disclosure also is supported by classic notions of investor protection and by the basic notion of fairness– that a capital provider, the shareholder, as principal, should know what its agent, the corporation and its management, is doing. There is also a sense of marketplace fairness that is part of the fabric of this country: that a buyer shouldn’t pay more than something is worth, especially because of a lack of information.

Where would our economy be, and how much real, productive capital would our country have, if there had been better disclosures about asset-backed securities, about CDOs, and all the other securities that were offered and sold in poorly regulated markets? With trillions upon trillions of dollars being allocated in the capital markets, and with an economy that is increasingly sensitive to information, even small changes in disclosure can have a tremendous impact. That is the reality. And it is important we keep the facts in mind.

Certain Foreign Companies Abusing U.S. Capital Formation Process

With that foundation, I would like to highlight a disturbing trend that seems to have challenging implications for capital formation and investor protection. In recent years, we have seen a spike in private companies merging with a public shell company as a way of going public. While it is Chinese companies that have grabbed recent headlines, the problems coming to the forefront would not necessarily be limited to companies based in China.

There are a lot of different ways for companies to access the public markets, but not all of them are equal. They differ in the quality of the disclosures, the time investors and the SEC typically have to consider them, and the protections that investors have against false and fraudulent statements.

The traditional IPO remains the gold standard. In a traditional IPO, the SEC and the public receive robust disclosures, along with the time to review and consider them, backed up by real liability that puts the risk of false statements on the people in the best position to ensure accuracy, not on the investors. In addition, underwriters and auditors engage in due diligence which enhances the disclosure quality.

Another way to access the public markets is Exchange Act registration of a class of securities, rather than through registration of a public offering. For example, when the company reaches a certain size and has a class of equity securities that is considered widely-held because of its number of shareholders, it is required to provide public disclosures. However, unlike a traditional IPO, there is no underwriter performing due diligence.

A common but lesser known way of accessing the public markets is the reverse merger into a public shell, or where a public shell merges into a private company, a so-called “backdoor registration.” For those of you not familiar with these types of mergers, what typically happens is a private company seeking to go public merges with a public shell company. Before the transaction, the public shell company no longer has substantive operations, but its public company registration remains in effect. The transaction gives the formerly private company the credibility and access to capital of being registered as a public company, without any of the vetting from underwriters and investors that companies undergo when they perform a traditional IPO.

Since January of 2007, there have been over 600 backdoor registrations. Over 150 of these have been by companies from China and the China region. Notwithstanding the SEC rulemaking of a few years ago to respond to abuses involving shell companies, we are seeing increasing problems. While the vast majority of these Chinese companies may be legitimate businesses, a growing number of them are proving to have significant accounting deficiencies or being vessels of outright fraud.

As just one example of this phenomenon, two companies that were numbers 1 and 2 on the Investor’s Business Daily 100 have now been shown to have significant issues. One of these companies had to restate its earnings and was delisted just last week. The other has admitted that at the very least two of its manufacturing contracts didn’t actually exist. Just last Friday, the SEC suspended trading in another Chinese company that became public in the United States through a shell. This was the second SEC trading suspension imposed on Chinese companies in this situation in the month of March alone. Additionally, NASDAQ and NYSE Amex have recently suspended trading in several of these companies.

I support all of the efforts to address these problems. The SEC staff has been working collaboratively and tirelessly with many others to investigate and shed light on this situation. It has been widely reported that the SEC set up an internal task force to investigate fraud in overseas companies with listings on U.S. exchanges, with particular emphasis on companies engaging in these mergers to achieve backdoor SEC registration. The staff’s hard work has yielded, and will continue to yield, results.

In the world of backdoor registrations to gain entry into the U.S. public market, the use by Chinese companies has raised some unique issues, even compared to mergers by U.S. companies. Two important ones are:

  • First, there appear to be systematic concerns with the quality of the auditing and financial reporting; and
  • Second, even though these companies are registered here in the U.S., there are limitations on the ability to enforce the securities laws, and for investors to recover their losses when disclosures are found to be untrue, or even fraudulent.

I am worried by the systematic concerns surrounding the quality of the financial reporting by these companies. In particular, according to a recent report by the staff of the Public Company Accounting Oversight Board (PCAOB), U.S. auditing firms may be issuing audit opinions on the financials, but not engaging in any of their own work. Instead, the U.S. firm may be issuing an opinion based almost entirely on work performed by Chinese audit firms. If this is true, it could appear that the U.S. audit firms are simply selling their name and PCAOB-registered status because they are not engaging in independent activity to confirm that the work they are relying on is of high quality. This is significant for a lot of reasons, including that the PCAOB has been prevented from inspecting audit firms in China.

Moreover, the PCAOB noted that these issues were layered on top of other factors that may have a negative impact on the audit, including:

  • The need to understand the local language;
  • The use of local audit firms or personnel from an outside audit firm to complete a portion of the audit work;
  • Additional travel time and expense; and
  • The need to understand the local business environment in which the client operates.

An additional problem with these backdoor registrations is that there may be difficulty in prosecuting violations. Enforcement against falsehoods in the context of these companies is difficult. The documents and people who have the information about the company and whether there was misconduct are often outside the reach of subpoena power. However, notwithstanding these obstacles, our staff is committed to doing everything they can with the resources we have. The SEC has already brought cases and will continue to do so.

Nonetheless, investors should still be aware that the SEC and private plaintiffs may have a more difficult time enforcing their remedies and that recovery for investor losses could be limited. For one thing, the persons to punish and the assets that could satisfy a judgment may be located outside of the United States and harder to access. In addition, remedies obtained in the United States may not be enforceable in foreign countries, where the bulk of the assets might reside.

The consequences of the growing problems in this area has real significance, because it has been reported that billions of U.S. savings and investment dollars have been entrusted with these companies.

Finally, and to return to our earlier topic of capital formation, it’s important to see the connection between capital formation and strong enforcement of securities laws. We have seen clearly that capital formation is improved with solid disclosures – but what happens when the disclosures are lies? That’s when we need strong enforcement. Capital formation is strengthened when investors have confidence that the laws will be obeyed and that, when they’re not, that the fraudsters will be made to pay. Moreover, strong enforcement – by providing deterrence – helps to ensure the disclosure is truthful and complete in the first place. Where savings and investments are allocated under inadequate or false information the environment for capital formation is negatively affected. That is why I’ve been a consistent advocate for a robust enforcement program and an adequately funded SEC. My hope is that potential fraudsters are scared into telling the truth to avoid the consequences.


With our country in an anemic recovery, with persistent unemployment and underemployment, we must facilitate real capital formation. There is compelling evidence that securities regulation must be strong. We need to take the lessons learned in the crisis and the findings from high-quality empirical analysis and use them to improve our regulations and the economy.

How we move forward will set the tone for future economic growth in this country. It is important that all of us continue to fight for effective regulation.

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  1. Wayne Isaacks
    Posted Monday, April 25, 2011 at 1:13 pm | Permalink

    Let’s have sighted regulation rather than blind regulation. We may need more freedom for the SEC to place warnings, and to require more or even unique disclosures from companies with certain “smell test” issues. I would favor an SEC alert regarding listed companies with little or no enforcement recourse due to out of jurisdiction people and property, or hard to reach assets, or inadequate assets.

    What is the rationale for permitting a market in listed shells? Really, shouldn’t this be eliminated, or at least require something like registration disclosues in such mergers? Why keep listed shells that have no significant operations? It seems to have more opportunity for abuse than good.

  2. Ami de Chapeaurouge
    Posted Thursday, April 28, 2011 at 4:45 am | Permalink

    Dear Commissioner Aguilar,

    As the Private Equity (PE) movement grapples with additional liquidity events and exit channels to assuage their at times disgruntled LP constituency, we have discussed internally the usefulness of SPACs and, conceptually not far afield, the combo of reverse IPOs with PIPE financings as potential liquidity providers. In Germany, where I spend part of my professional time apart from Asia and the U.S., the regulatory gap between effecting such reverse merger and actually going to market is much shorter than in the U.S., about 14 days instead of 90 – 120 days in the U.S. before the SEC declares the prospectus effective and going to market – under certain conditions: You need to structure a capital increase/secondary below 10% of the outstanding publicly traded stock to do without a prospectus; and you need not wait for a BaFin (the German SEC equivalent) declaration of effectiveness therefore, if such a PIPE is appropriately structured. As a result, the discount needn’t be as steep as it customarily is in the U.S. markets. I am much impressed with the paper by Floros and Sapp “On the Information Content of Repeated PIPE Offerings” in its March 4, 2010 version. I believe in their central thesis that via hedge fund financings, a quasi-public parallel equity market has sprung to life in the U.S. for lower quality issuers that would not otherwise be in a position to access capital; but not yet in other mature jurisdictions, though increasingly popular with Chinese and Indian potential issuers. It remains to be seen whether PE will avail itself of such a financing route as a potential exit much at all. I am currently speaking to PEs and investment bankers and if your are interested, I would make availble our slides on such exit alternatives (the Blog sponsors have my details). Interestingly enough, even SPACs with much higher regulatory thresholds than reverse IPOs cum PIPEs are not permitted in Hong Kong (they are allowed in Korea).
    As far as the 150 Chinese issuers in the last couple of years are concerned that you are making mention of in your remarks, I am fully with you: We get about an inqury a week from potential Indian, Russian, Chinese or otherwise South East Asian issuers about a Frankfurt Stock Exchange listing, oftentimes with respect to the segment with the lowest regulatory hurdles such as the Entry Standard. But even understanding for and complete compliance with that standard, much less the composition of a detailed and semi-sophisticated strategic Business Plan that might in future form the backbone of such potential issuer’s Equity Story, is very hard to come by. These issuers find it very hard to come to grips with strategic thought and frequently regard a Going Public as a one-time event, without fathoming the continuing reporting requirements of Being Public. Unpopular as it may be, with such lower quality issuers, a deluge of reverse IPOs would seem to me to posit some real dangers to the integrity of the capital markets, in the U.S. or, for that matter, in the U.K. and in Europe Continental. One commentator before me wishes to discourage or outlaw reverse IPOs altogether, presumably for information asymmetry reasons. I wouldn’t go that far, but draw a distinction between domestic U.S. market participants and those lower quality overseas issuers afflicted by the dual shortcomings of a complete lack of understanding of (or even respect for?) our capital markets and the ‘tyranny of distance’, both spatial and timewise.