Making Capital Formation Work for Smaller Companies and Investors

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s recent public statement; the full text, including footnotes, is 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.

Small businesses are vital to our nation’s economic growth and well-being. In fact, our nation’s small business owners create almost two out of every three new jobs and employ more than half of the U.S. workforce. It is therefore important to provide opportunities for entrepreneurs and investors to come together and put capital to productive uses through the development of new ideas, products, and services that make America stronger and create new jobs that bring financial security.

Ultimately, the success of small businesses depends on their ability to access capital. To that end, because many small businesses are thought to have more difficulty than established businesses in getting traditional loans, Congress has provided the Commission with authority to promulgate rules to facilitate access by small businesses to financing from the capital markets.

In order for these rules to be successful, and, just as critically, sustainable, the Commission is tasked with creating an ecosystem for capital formation that works for small businesses and investors alike. Thus, the challenge is to develop a system that enables businesses to raise capital in a cost-effective way and, at the same time, provide ways to benefit and protect investors. After all, without investors, there can be no capital formation.

Crowdfunding and Rules 147, 504, and 505

Today [Oct. 30, 2015], the Commission considers various rules to improve the capital formation process for small businesses. First, the Commission considers adopting new rules under Title III of the JOBS Act, so that small businesses can raise capital from investors in crowdfunding transactions. Second, the Commission proposes various amendments to Rules 147 and 504 to make them more efficient and usable. Lastly, the Commission is requesting comments on existing Rule 505 to assess how it is being used and whether it will still be needed if the proposed amendments are adopted.

I will first discuss Regulation Crowdfunding. This Regulation is designed to help startups and small businesses raise capital by providing an exemption from federal registration that will allow internet-based securities offerings of up to $1 million from investors over a 12-month period. To address the inherent risks associated with investments in startups and smaller businesses generally, and the uniqueness of creating a regulatory regime designed for internet-based offerings, today’s rules also include various investor protections. These include, among others, mandated disclosures and limits on what investors can put at risk (based on their income and net worth).

Importantly, Regulation Crowdfunding also provides a framework to govern how Crowdfunding intermediaries—such as a registered broker-dealer or a funding portal—can conduct securities offerings. Because these intermediaries essentially act as “gatekeepers” for these offerings, this framework should provide additional investor protection. Moreover, since these gatekeepers are indispensable for making Crowdfunding viable, it is critical for the registration regime for funding portals to be ready as soon as today’s Crowdfunding rules go into effect. It is my understanding that FINRA has already filed its proposed rule changes for funding portals, including the registration rules, and is waiting for Commission action. Accordingly, I urge the Commission and its staff to expedite the review of FINRA’s application.

In addition to adopting Regulation Crowdfunding, the Commission is also proposing amendments to Rule 147 under the Securities Act and Rule 504 of Regulation D, as well as requesting comments on Rule 505 of Regulation D.

Rule 147 has not been updated since it was first promulgated in 1974, and it is past time to consider how to revise the rule to reflect the reality of technological developments and the modern business environment. To that end, the proposed amendments provide additional flexibility for small businesses to raise capital while establishing appropriate safeguards for the purchasers of these securities.

In addition, the Commission is proposing to increase the offering limit under Rule 504 from $1 million in a 12-month period to $5 million in the same period, and is requesting comments on whether the Rule 505 exemption remains necessary in light of the amendments being proposed to Rule 504. Based on an analysis conducted by the staff of our Division of Economic and Risk Analysis (“DERA”), the use of the Rules 504 and 505 exemptions have been declining over time, and now constitute only a very small percentage of overall offerings based on the Regulation D exemptive regime. The hope is that today’s proposal will reinvigorate Rule 504. In the end, the total sum of the questions asked in today’s releases as to Rules 504 and 505 is whether the changes being proposed will breathe new life into Rule 504 in a way that will work for both issuers and investors, and, if so, whether Rule 505 will still have utility.

Three Essential Components of Capital Formation

In my view, there are three essential components to facilitating true capital formation by small businesses through securities offerings: first, an efficient and useful marketplace for small offerings; second, a vibrant secondary market for these securities; and third, an appropriate back-office infrastructure that facilitates this secondary market. These three components cover the issuance, trading, and clearance and settlement of trades in the securities of smaller issuers.

Integrity in the Marketplace for Small Offerings

The foundation of our capital markets rests on the notion that those who are interested in acquiring capital and those who are interested in providing it can meet in a marketplace where the exchange of capital takes place. Facilitating true capital formation is about ensuring that companies with the best ideas—even if those ideas are risky—can get the financing needed to make those ideas a reality. However, it is equally critical to a successful capital formation environment that investors are provided appropriate protections.

Today’s Crowdfunding rules and the proposed amendments to Rules 147 and 504 reflect the Commission’s ongoing efforts to create more available options for small businesses to access the capital markets. Previously, the Commission has adopted Congressionally-mandated amendments to existing exemptive regimes under both Regulation A (also known as “Regulation A-plus”) and Regulation D.

A reality of these new Commission rules, and various other provisions statutorily required by the JOBS Act, is that in combination they will result in companies having many more shareholders without the need to register under the federal securities laws as publicly-traded companies.

In essence, companies will be able to sell their securities to a wider swath of the public and remain outside of the registration and disclosure provisions of the Exchange Act for longer periods of time. This reality raises a host of potential problems. In particular, unlike larger, more well-established publicly-owned companies that receive market attention as a result of their public disclosures, these smaller issuers will face a lack of an active secondary market for their securities. Obviously, this has been a long-standing problem for smaller companies, but, in light of these new developments, it is clear that the problem is only going to get worse.

A Strong Secondary Market for Small Issuers

There is no question that for a capital market to thrive it needs a vibrant secondary market, where previously issued securities can be bought and sold. It is important to consider the need for such a secondary market in the context of adopting and proposing rules to facilitate exemptive transactions because, under the new or recently-amended exemptive regimes, the vast majority of these widely-offered securities become freely-tradable immediately upon issuance or after a short holding period. These exemptive regimes include Crowdfunding, Regulation A, Rule 506 of Regulation D, and the proposed versions of Rules 147 and 504.

Accordingly, another reality of the combined impact of these exemptive rules is that they will result in a very large number of shareholders needing to find liquidity in the secondary markets. And another reality is that these securities will undoubtedly be purchased by investors that face a secondary market that is less fair, less liquid, and less transparent than the secondary market for listed securities.

The coming tsunami of unregistered and unlisted shares requires new solutions for an active secondary market to take hold, and I am going to mention two ideas—ideas that I have previously discussed at greater length in other settings.

First, the Commission should examine whether the challenges that have thwarted prior efforts to develop venture exchanges can be overcome in ways that benefit investors. Yet the Commission cannot stop there, for there may well be other, potentially better paths to a robust secondary market for these securities. Some avenues worth exploring include determining whether exchanges could develop new listing tiers for these securities, or whether these securities could trade on alternative trading systems. These potential solutions may implicate especially thorny regulatory issues, but I am confident they could be overcome.

Second, the Commission should reform Exchange Act Rule 15c2-11, with a specific focus on the rule’s so-called “piggy-back” exception. Rule 15c2-11 is widely used by broker-dealers to trade in unlisted securities, such as those that will likely result from sales under today’s Crowdfunding rules. Under the rule’s “piggy-back” exception, broker-dealers are permitted to publish quotations for a security without complying with the rule’s due diligence and information requirements if any other broker-dealer has published regular and frequent quotations for that security. Accordingly, a broker-dealer can “piggy-back” on either its own or another broker-dealer’s prior quotations. The existing problems with this current rule are well-known, and they boil down to an opaque and loosely overseen trading regime that too often wholly fails investors.

As I’ve said in a prior speech, possible solutions to the Rule 15c2-11 problem include: (1) eliminating or amending the broker-dealer “piggy-back” exception for small business securities; (2) requiring broker-dealers that publish quotations to obtain and review current information about an issuer at least annually; and (3) enhancing investor access to the information collected, reviewed, and maintained by the broker-dealer about the issuer. While the need to fix Rule 15c2-11 has been well known, and while the staff has thrice proposed changes to Rule 15c2-11, no action has been taken to fix the rule.

Accordingly, at my request, the staff has included a discussion in the Crowdfunding release about Rule 15c2-11. In brief, it states that the staff is directed to evaluate promptly Rule 15c2-11 in light of the rule’s historical application and recent market developments—such as today’s Regulation Crowdfunding, Regulation A-plus, etc.—to assess how the rule is meeting regulatory objectives and to determine whether any changes are necessary. Separately, as part of a broader review of Regulation Crowdfunding that the staff plans to undertake within three years of the effective date of these rules, the staff will also assess the development of the secondary market trading in Crowdfunding securities and will report to the Commission whether further actions are necessary with respect to Rule 15c2-11. Finally, I urge the staff to intensify its efforts to police compliance with Rule 15c2-11. Prior efforts to enforce this important rule have fallen short. I urge the Office of Compliance Inspections and Examinations to build upon its recent sweep of a limited number of broker-dealers for Rule 15c2-11 compliance, and to prioritize Rule 15c2-11 in its risk-based exam selection process going forward.

It is critical that a viable secondary trading environment exists for unregistered and unlisted securities of small businesses, and one that promotes a fair and transparent market for these securities. Such an approach is necessary to protect investors and promote the growth and success of small businesses.

A Robust Clearance and Settlement Infrastructure for Small Issuers

Finally, a secondary trading market for unregistered and unlisted securities of small businesses cannot thrive unless there is a workable system for the clearance and settlement of trades that permits the efficient transfer of securities ownership. In today’s large and complex securities markets, however, much of these back-office responsibilities have shifted to central securities depositories (“CSDs”)—the world’s largest of which is the Depository Trust Company (“DTC”)—which were developed to allow for the efficient transfer of securities ownership between buyers and sellers. Today, central securities depositories provide critical custody and recordkeeping services using an electronic “book-entry” system. This system permits the efficient electronic transfer of an issuer’s securities rather than the exchange of actual paper stock certificates. Such an electronic trading infrastructure is critical for an active and functioning secondary market for securities.

For most issuers, however, access to this electronic “book entry” system first requires that the securities be deemed eligible for DTC services, meaning that the securities satisfy certain criteria established by DTC. I am concerned that, as the Commission provides new fundraising options for smaller issuers, an unintended consequence may be to enable an avalanche of small issuer securities to enter the capital markets without having access to DTC’s electronic “book entry” system—because they will fail to meet DTC’s criteria or for other reasons.

Many market participants simply see the burden of dealing with physical stock certificates as impractical and/or costly, and, as a result, may charge additional fees to handle these transactions. In fact, trading in paper certificates is nearly non-existent, and, in recent years, accounted for just one-tenth of one percent of daily trading volume. Yet, this small marketplace niche of paper certificate trading is widely believed to be dominated by retail investors, and is thus vital to the capital formation process of smaller companies. Accordingly, the Commission should explore ways to work with DTC or otherwise facilitate or incentivize the development of an alternative electronic “book entry” system that can be made available to smaller issuers and their investors.

The success of the Commission’s efforts to facilitate capital formation for smaller businesses will be substantially impacted by the lack of an efficient and reliable way for investors in smaller businesses to transfer their shares. I am hopeful that 21st Century technology can bring a cost-effective solution to this problem.

To this end, I recently had a discussion with a very senior officer at The Depository Trust & Clearing Corporation (“DTCC”)—the parent company of DTC—who agreed to look into this issue and to determine what DTCC can do to help perform these back-office functions for smaller issuers.

I urge the staff of the Division of Corporation Finance and the Division of Trading and Markets to follow-up on this issue. And to do so with urgency and speed.

Let’s Stop Delaying and Fix the Problem

Before becoming a Commissioner, I spent much of my professional career as a practitioner involved in capital formation through public and private offerings. I worked with companies—big and small—that grew their businesses by making better, smarter, and more innovative products, and selling more of them. It has been my experience, in both the private and public sectors, that effective common sense regulation—and one that offers investor protection—is necessary to foster a viable environment for true capital formation. It has also been my experience that the sooner you address and resolve known problems, the more likely you can prevent them from becoming unmanageable and destructive catastrophes. The continuing and well-known difficulty of trading small issuer securities is such a problem that requires our immediate attention.


In closing, today’s rules reflect a well-thought out approach to capital formation that takes into account the need to protect investors. For these reasons, I will support both the adopting release for Crowdfunding and the accompanying proposing release and request for comments.

I would like to thank the staff from the Division of Corporation Finance, the Division of Trading and Markets, the Division of Economic Research and Analysis, and the Office of the General Counsel for their work on this rulemaking. I appreciate your dedication and the important work that you do to protect investors.

Thank you.

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