On March 22, 2011, U.S. House Oversight Committee Chairman Darrell Issa (R., Calif.), sent a sharply worded letter to Chairman Mary Schapiro of the Securities and Exchange Commission (the “SEC”), in which he demanded that the SEC justify several of its rules regarding raising capital, including the “quiet period” that restricts a company’s communications ahead of an initial public offering (“IPO”) and the rules that limit the number of investors in private companies to 499. The immediate impetus of this letter (the “Issa Letter”) appeared to be the recent decision by Facebook to issue shares exclusively to non-U.S. investors due to the requirement for a private company to file financial statements with the SEC once it has more than 499 U.S. equity holders, as well as the general decline of the overall IPO market in the U.S.
The Issa Letter accuses the SEC of stifling capital creation and causing the decline of the IPO market in the U.S. by clinging to obsolete and inflexible laws and regulations. Chairman Issa asks whether the decline in public equity listings and issuances have been driven by the expansion and complexity of SEC regulations, the expansion of personal liability under the Sarbanes-Oxley Act of 2002, the new uncertainty surrounding regulations to be issued pursuant to the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), securities class action lawsuits and the expansion of other regulatory, legal or compliance burdens. Chairman Issa railed against the prohibition on promotional statements made between the time that a registration statement has been filed and the time it becomes effective as a violation of an issuer’s rights under the First Amendment. Chairman Issa further finds fault in the inability of the SEC to fashion rules to permit effective early stage capital formation, accuses the SEC of certain conflicts of interest and ineptitude in its staff, and suggests that “sophisticated” investors, regardless of whether they satisfy the “accredited” investor standard, should be permitted to invest in private placements.
On April 6, 2011, Chairman Schapiro responded to Chairman Issa in a detailed and heavily footnoted tome (the “Shapiro Letter”) that sought to correct some of the basic misunderstandings in the Issa Letter. The Schapiro Letter provides an interesting and brief history of the development of private offerings, the development of the private markets, the IPO process, the rationale behind public reporting, and the SEC’s views towards capital raising strategies. Much of this discussion is either relevant to investment fund managers or directly on point with their businesses, and certainly worth a read.
Chairman Issa raises some interesting points and the combative tone of his letter should not be a reason to simply dismiss his concerns. There are, however, two interesting questions that Chairman Issa could have raised with the SEC, but did not, the answers to which may have been even more productive to the discussion.
First, does the SEC believe that if it was self-funded, it would be more responsive to the needs of the capital markets and be able to better balance its dual mandates of creating efficient capital markets and protecting shareholders? It should be noted that early drafts of the Dodd-Frank Act stated that the SEC was to be self-funded, but that language was later removed when our two political parties agreed on specific budget numbers for the SEC, which they believed would permit the SEC to meet its significant new and continuing obligations. Once the Dodd-Frank Act became law, a bi-partisan Congress promptly ignored these funding mandates and has continued to impede the effectiveness of the SEC through the budget process.
Second, does the SEC believe that significantly increasing the number of investors to which a private company can sell shares, without providing full and fair disclosure, would shrink the public markets, make fewer investment opportunities available to ordinary investors, and accelerate the wealth divide that is threatening to destabilize the U.S.? The securities laws were meant to level the playing field among investors, and the SEC over the years has attempted to enforce this mandate through the registration process and its enforcement actions. Larry Ribstein provides a thoughtful view of this dilemma here.
The balance between effective regulation for investor protection and efficient capital markets to encourage responsible investment is a delicate one that we can expect to be treated quite indelicately in the current political climate.