Secondary trading environment critical for small businesses

Emerging companies are considered to be the drivers of U.S. economic activity, innovation and job creation. Their ability to survive and prosper depends on ready access to capital, particularly in the private markets. The SEC Advisory Committee on Small and Emerging Companies met to discuss ways in which the secondary trading environment for the securities of small businesses can be improved. It is an issue that needs to be solved quickly in view of a projected increase in those securities.

Smaller companies are important to the U.S. economy, and it will be important to support a market structure that promotes the capital formation for them, while also providing robust investor protections, said SEC Chair Mary Jo White, in her opening remarks for the meeting, which focused on a number of important related topics, including Regulation A+, secondary market liquidity and the definition of accredited investor, all of which are quite timely for the commission's ongoing work in those areas.

ACCREDITED INVESTOR DEFINED

The committee's first order of business related to the definition of accredited investor. As the members had discussed in earlier meetings, they did not believe the income threshold and net worth requirements underlying the current definition of accredited investor should be raised significantly, reasoning it would materially decrease the pool of capital available for smaller businesses.

Since any modifications should help expand, not contract, the pool of accredited investors, the committee recommended adding "those investors who meet a sophistication test, regardless of income or net worth."

That addresses what many have considered an omission in the definition, since net worth doesn't always equate to financial sophistication and knowledge.

Other related recommendations forwarded to the SEC were: to take into account the effect of future inflation, on a going forward basis, and adjust the accredited investor thresholds according to the consumer price index; focus on enhanced enforcement efforts and increased investor education; and continue to gather data on that subject for ongoing analysis.

MAKING REG A ATTRACTIVE

Recognizing that an IPO isn't always the best route for all small companies in need of capital, the SEC proposed a rule that sets up a two-track approach to Reg A. The first track would be limited to offerings of up to $5 million and would pretty much follow the course of the current Reg A rules, which is seldom used. The second track, dubbed Regulation A+, is being proposed to increase the cap to $50 million, preempt state securities reviews and impose stricter investor protections. (See BioWorld Today, Nov. 13, 2013.)

Despite all its good intentions of helping small companies access capital, its use by companies has been virtually non-existent, noted Michael Pieciak, North American Securities Administrators Association (NASAA) observer, at the meeting.

Instead of going the Reg A route, companies have, in the main, opted for private offering exemption Rule 506 of the commission's Regulation D. The committee, in fact, presented data showing that in 2013, issuers utilizing Rule 506 raised more than $1 trillion, comparing favorably to the $1.3 trillion raised in public offerings that year.

To remove some of the administrative burden of Reg A filings, Pieciak presented a NASAA-developed, streamlined, multistate coordinated review program for Regulation A and Regulation A+ offerings to ease regulatory compliance costs on small companies seeking to raise capital. Through that program, launched in May 2014, the filings are made in one place and distributed electronically to all states. Lead examiners will be appointed as the primary point of contact for a filer and each state will be given 10 business days for review. The lead examiners alone will interact with the issuer to resolve any deficiencies. The process is designed to speed up the filing of company offerings.

Currently, 46 states have signed on to the program, and Pieciak said NASAA is in negotiations with the remaining states.

The SEC has proposed exempting small companies and start-ups raising capital under Regulation A from state blue sky laws and, following discussion of the issues, the committee members voted in favor of that proposal.

In summing up the debate, Stephen Graham, co-chair of the committee, noted that preemption does make sense with a consensus on this from committee members. It certainly takes the friction out of the system, he added.

VENTURE EXCHANGES

Although existing venture exchanges have had their fair share of problems in terms of liquidity and volatility, they have been suggested as a way to foster an active secondary market for small company stocks and the commission has been urged to approve establishing one or more of them.

In his comments to the committee, SEC Commissioner Luis Aguilar said that since the private equity market is growing rapidly, the SEC should carefully examine new solutions to "the coming tsunami of unregistered and unlisted shares." Looking at the reasons such exchanges have run into difficulties in the past may lead to more innovative solutions for the future.

David Weild, of Weild & Co., provided some valuable insights on the current situation and the need for a venture exchange. He pointed out that since 1998 to the present, the U.S. has fallen from first place to 12th position in terms of the number of small IPOs (less than $50 million raised) completed. In the period leading up to the dot.com era, annual IPOs numbered about 500; now that number has averaged only 150 per year from 2001 onward.

In addition, the U.S. has witnessed a decline in listed companies during that period, from 9,000 to about 5,000. The consequence is a loss of economic growth that those companies can afford.

Weild argued that the dramatic numbers speak in favor of the creation of a venture exchange. It will require a bold initiative to create a "regulation venture exchange," but it would go a long way to repairing what he views as a dysfunctional financial ecosystem for small companies looking to raise capital currently.

Although the committee spent considerable time debating some of the issues relating to a venture exchange no recommendations were developed and the issue was tabled until the next meeting in June.

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