House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises Hearing
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Introduction:
Good morning Chairman Garrett, Ranking Member Maloney, and members of the Subcommittee, I'm
Prior to serving as NASAA president, I served as the chairman of both
I, personally, have a deep interest in issues related to small business finance and capital formation, and I am honored to testify for a second time before this Subcommittee about these issues.
Securities regulation is a complementary regime of both state and federal securities laws, and the states work closely together to uncover and prosecute securities law violators. State securities regulators have protected
The securities administrators in your states are responsible for enforcing state securities laws by pursuing cases of suspected investment fraud, conducting investigations of unlawful conduct, licensing firms and investment professionals, registering certain securities offerings, examining broker-dealers and investment advisers, and providing investor education programs and materials to your constituents. n2
Ten of my colleagues are appointed by state Secretaries of State, five are under the jurisdiction of their states' Attorneys General. Some, like me, are appointed by their Governors and Cabinet officials. Others, work for independent commissions or boards.
In addition to serving as the "cops on the beat" and the first line of defense against fraud for "mom and pop" investors, state securities regulators serve as the primary regulators of most small company securities offerings. As such, state securities regulators regularly work with and assist local businesses seeking capital to grow their companies.
The states are committed to fostering responsible capital formation which in turn strengthens investor confidence and leads to job growth. At the same time, and as I testified to the Subcommittee in 2011, capital formation will be impeded when investors are not adequately protected.
For over two years, I have had the privilege of serving as NASAA's designated member of the
The Advisory Committee was established on
Some of the policies enacted last year by the JOBS Act were based on recommendations of the Advisory Committee. In 2011, I testified before this Subcommittee and expressed concern about many of the policies in the JOBS Act, including legislation that directed the
I remain deeply concerned that some of the policies enacted under the JOBS Act, including in particular, the lifting of the ban on general solicitation in Regulation D, Rule 506 offerings, will be detrimental to investors and ultimately to the companies that rely on this method of capital formation.
The
Overview of NASAA Perspective on Today's Legislation
Today, the Subcommittee is considering a number of new bills related to capital formation. n4 These include proposals to (i) streamline registration requirements of so-called "merger and acquisition brokers;" (ii) further ease reporting requirements applicable to "Emerging Growth Companies" or EGCs; (iii) and relax portfolio strictures, leverage limits, and other regulations for business development companies (BDCs). They also include common-sense proposals to reduce "red tape" that adds to the compliance costs of small and startup businesses, such as the
NASAA's view regarding this new collection of bills is mixed. NASAA supports a number of these proposals; especially the proposed Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2013 sponsored by Congressman Huizenga, but has concerns with other legislation pending before the Committee today. Most notably, NASAA is troubled by the proposal to further expand what are basically new, untested regulatory carve-outs for EGCs as well as proposals that would increase leverage and conflicts of interests in the BDC space. There are some bills before the Subcommittee on which NASAA does not have a strong stakeholder interest. For those bills, I will simply offer my own personal observations based on discussions I have had with others as part of my work on the Advisory Committee. Insofar as that latter category of bills does not pertain directly to state securities regulation, NASAA neither supports nor opposes their enactment.
Streamlining Registration for Mergers & Acquisitions Brokers
State securities administrators generally support the targeted, well-balanced provisions of H.R. 2274, the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of 2013, H.R. 2274. This legislation would establish a simplified and streamlined registration process for broker-dealers engaged solely in the business of effecting the transfer or sale of privately held companies (i.e., "M&A brokers"). NASAA is optimistic that this legislation will encourage registration and regulatory compliance by M&A brokers.
The registration process is an integral part of an overall regulatory regime at the state and federal level that is designed to promote responsible business practices among broker-dealers and to help protect investors. Generally, broker-dealers engage in the buying and selling of securities either for their own account or for the accounts of others. Broker-dealers may also engage in other businesses such as underwriting securities offerings and the making of markets for new and emerging companies. The current registration process is well suited to the vast majority of these broker-dealers. However, these registration requirements may not be as well suited to a limited number of broker-dealers engaged exclusively in the business of mergers and acquisitions (M&A Firms).
M&A Firms, as defined in H.R. 2274, would be limited to those firms engaged solely in the business of affecting the transfer of ownership of certain eligible privately held companies. As a result, the traditional registration process for broker-dealers is not particularly well suited for the M&A Firms. Furthermore, individuals who work for these firms and earn commission-based compensation in M&A deals have the additional burden of affiliating with a registered broker-dealer firm in order to obtain registration. The expense and compliance with the registration requirements has led many M&A firms, particularly those handling small M&A deals where firms typically pass on the cost of regulatory compliance to their clients, to forego registration and compliance requirements altogether. There is no public record of these unregistered firms or individuals, or the fees they earn for their services. There is no regulatory body (whether a government regulator or a self-regulatory organization) confirming that clients receive appropriate disclosures such as conflicts of interest and a list of employees and affiliates.
Investor protection is best served when regulatory necessity and transparency is balanced sensibly with the practicalities inherent in any business model. In the case of M&A brokers, H.R. 2274 strikes an appropriate balance. The bill reduces the standard regulatory requirements applicable to traditional broker-dealer firms and provides M&A brokers of privately held companies (as defined therein) with a simplified registration regime that provides sufficient oversight to these firms without diminishing the authority of state or federal regulators.
The M&A industry has worked with NASAA in developing the proposal that is contained in H.R. 2274. We welcome its introduction and look forward to supporting the legislation in the 113th
Notwithstanding our general support for H.R. 2274, NASAA does object to one provision - (a)(13)(G)(iii) State Law Preemption - that references Section 15(i)(1) of the Securities Exchange Act of 1934 (Exchange Act). Section 15(i)(1) governs capital, margin, books and records, bonding and reporting requirements of the Exchange Act, and the limitations on any conflicting or superfluous requirements under state law. NASAA posits that adding Section (a)(13)(G)(iii) in H.R. 2774 creates an unnecessary and confusing addition to an otherwise seamless bill governing M&A brokers. Section 13(G)(iii) titled "State Law Preemption" provides as follows:
Subsection (i)(1) shall govern the relationship between the requirements applicable to M&A brokers under this Act and the requirements applicable to M&A brokers under the law of a State or a political subdivision of a State. Except as provided in such subsection, this paragraph shall not preempt the law of a State or a political subdivision of a State applicable to M&A brokers.
This "preemption" paragraph in fact refers to a limited preemption already in the Exchange Act addressing books and records, and reporting requirements. NASAA has worked with the M&A industry to obtain their support for withdrawing this language, and we ask that Representative Huizenga and the Committee consider removing this redundant, and arguably confusing, paragraph from the bill.
Business Development Companies
The Subcommittee is presently considering several bills that contemplate relaxation of the portfolio strictures and other limitations on the ability of Business Development Companies (BDCs) to invest in financial companies.
Three bills pending before the Subcommittee - H.R. 31, H.R. 1800, and H.R. 1973 - would repeal the provisions of the Investment Company Act of 1940 (ICA) that limit the ability of a BDC to invest in investment advisers. Two of these bills, H.R. 31 and H.R. 1800, would additionally ease the leverage limits for BDCs established by the ICA, allowing such firms to maintain a greater ratio of debt to asset valuation on their balance sheets, and would direct the
Before I address these changes, it may be helpful for me to provide the Subcommittee with some background information on BDCs in general. BDCs are regulated, closed-end investment firms that invest in small, developing, or financially troubled companies. As entities that combine the capital of many investors to finance a portfolio of operating businesses, BDCs are governed by the Investment Company Act of 1940 (ICA). BDCs are unique, however, in that they enjoy a number of important exemptions from the ICA that have allowed them in recent years to step into the role that regional commercial banks largely vacated during the financial crisis--lending to companies that may not otherwise get financing.
BDCs are attractive to many investors for three primary reasons. First, investors are drawn to the very high rate return that BDCs offer - sometime in excess of eight percent. n7 Second, under normal market conditions, BDCs also provide investors with liquidity comparable to that of other publicly traded investments. In contrast, investors in open-end investment companies or traditional mutual funds may only sell and buy shares directly to and from the fund itself. The third reason many investors invest in BDCs is simply access because investors do not need to meet the higher income, net worth or sophistication criteria that are imposed on private equity investments.
By virtue of their unique treatment under the ICA, BDCs enjoy a number of regulatory advantages relative to traditional investment funds. BDCs are permitted to use more leverage than a traditional mutual fund, up to and including a 1-to-1 debt-to-equity ratio. BDCs can also engage in affiliate transactions with portfolio companies. BDC managers also have access to "permanent capital" that is not subject to shareholder redemption or the requirement that capital be distributed to investors as returns on investments are realized. Moreover, managers of BDCs may immediately begin earning management fees after the BDCs have gone public and, unlike other registered funds, charge performance fees.
In exchange for considerable regulatory latitude, BDCs adhere to certain portfolio strictures not applicable to other registered funds. Most prominently, BDCs have an asset coverage ratio of 200%, at least 70% of which must be in "eligible" investments. n8 In addition, the ICA prohibits a BDC from acquiring more than 5% of any class of equity securities or investing more than 5% of its assets in any company that derives more than 15% of its revenues from securities-related activities, including acting as a registered investment adviser. It is this part of the regulatory bargain that today's BDC bills attempt to renegotiate.
State securities regulators question the rationale for further relaxing the leverage limits applicable to BDCs, as contemplated by H.R. 31 and H.R. 1800.
As I just mentioned, the current asset coverage ratio applicable to BDCs is 200%. This means that every dollar of a BDC's debt must be "covered" by
Another change contemplated by H.R. 31 and H.R.1800 that NASAA does not fully understand and, therefore, does not support is the proposal to allow BDCs to issue multiple classes of debt securities and senior equity securities. The effects of this provision on common shareholders, retail investors in every one of your districts, and many senior investors, could be quite harmful. Specifically, allowing BDCs to issue preferred stock is inviting them to dilute the value owned by holders of common stock. Moreover, by allowing preferred stock to count on the equity side of the ratio, the effect of the change would be to permit BDCs to issue greater amounts of debt, potentially placing the holders of common shares in a position where they could be wiped out in the event the BDC incurred losses. This would not serve BDC investors well.
State securities regulators have significant concerns about provisions in H.R. 31, H.R. 1800, and H.R. 1973 that would remove existing prohibitions on the ability of BDCs to invest in investment advisers.
Conflicts of Interest and Business Development Companies
While the foregoing changes are problematic, NASAA's primary concern with the BDC bills is the proposal that would allow BDC investment in IA firms. That proposal would create a significant conflict of interest. If an advisory firm were among a BDC's portfolio of companies, an incentive would exist for the investment adviser to recommend, or even push, their clients toward investments in the BDC or its other portfolio companies, even if such investments were not in the client's best interest.
Such conflicts could be even more troublesome in the context of an adviser's discretionary or "managed" accounts, where the adviser is delegated authority to make investment decisions on behalf of the client. As BDC directors also owe a fiduciary duty to their shareholders, if the proposed change were enacted, it would increase the likelihood that BDCs will acquire interests in advisory firms for the express purpose of accessing the advisory firm's pool of investible capital. This conflict could be exacerbated in the event that a BDC's portfolio company underperforms and the captive advisory firm is seen as a way to shore up the struggling company with additional capital.
No such conflicts of interest exist now, and NASAA urges
Transparency and Business Development Companies
Beyond the conflict of interest inherent in the repeal of restrictions on BDC investments in advisory firms, NASAA is concerned that such repeal would cause a significant loss of transparency.
BDCs that are registered with the states have limited transparency in a number of respects. State securities regulators usually see them in state registration as startups, or as businesses with a very limited history of operations. They are frequently "blind pool" offerings in which investors have little or no access to information regarding the investments the BDC will make. Disclosure documents describing eligible portfolio companies can be vague, broad, and limited. For example, a BDC might disclose that it primarily intends to invest in debt and equity securities of small to middle market private U.S. companies. Such vague disclosure as to the use of proceeds grants broad discretion to BDC managers while reducing transparency to investors.
Investors must place their reliance and trust in the management of the BDC to select appropriate companies for the BDC to lend to. Many BDCs have made a niche in lending to companies that have recently struggled with bank financing. Allowing investments in investment advisers adds an additional layer of opacity for BDC investors. NASAA believes BDC investors should continue to receive adequate disclosure about the income producing assets of the investment adviser.
Impact on Shareholders and Job Creation of Business Development Companies
Finally, NASAA cannot help but observe that competition from financial services firms will not benefit traditional BDC portfolio companies - i.e., small businesses.
BDCs were initially created for the purpose of providing capital to domestic small and medium-sized businesses that participate in the real economy. Since their creation, BDCs have enjoyed relaxed regulatory requirements to further this goal; this is the reason financial firms have traditionally been excluded as eligible portfolio companies. Under the proposed legislation, however, these small businesses will presumably face new and greater difficulty obtaining BDC financing because BDC's will reallocate some of their limited resources to investment advisers and other financial firms. Such an outcome may frustrate the Subcommittee's goal of spurring job growth.
Moreover, NASAA is not aware that investment advisory firms have any real need for BDC financing, especially as compared to the smaller real economy firms that BDCs were designed to benefit.
State securities regulators understand and support sensible modernization of regulations applicable to BDCs and other companies.
While most of the proposals set forth in the BDC bills have issues from a state and investor protection perspective, NASAA does support the proposal to extend the relaxed regulatory requirements available to Well Known Seasoned Issuers ("WKSI") and certain other large public filers to BDCs. BDCs operate similarly to large public companies in regard to communications with the public and the filing of forms with the Commission.
Under the amendments contemplated by H.R. 1800 and H.R. 31, BDCs would be eligible for WKSI status and would be eligible to file automatic shelf registrations on forms S-3 or N-2. Automatic shelf registrations are automatically effective upon filing and receive no
NASAA did not oppose incorporation by reference for real estate investment trust (REIT) offerings a number of years ago, and NASAA similarly does not oppose amending the ICA to permit incorporation by reference for BDCs today.
In summary, NASAA considers that small and mid-size companies that produce goods and services in the real economy have a greater need for BDC loans, and are better positioned than financial companies to use the capital from these loans to create jobs and improve the economy. Repeal of the provisions that limit BDC investment in financial services companies, as contemplated by H.R. 1973, or even investment advisers only, as contemplated by all three of the bills, will, at best, serve to dilute the impact of BDC investment capital as a source of job creation. Such policies might also create incentives for BDCs to help financial services companies design their business strategies, with the main goal of aiding the financial services sector, not building small businesses in other sectors of the economy.
Further Reduction of Publicly Available Information about Emerging Growth Companies
NASAA is also concerned about discussion draft legislation that would further relax reporting requirements for so-called emerging growth companies (EGCs).
Under the proposed discussion draft, EGCs would benefit from a dramatic shortening of the window of time between the completion of a confidential filing with the
In addition, whereas the JOBS Act authorized EGCs to submit registration documents to the
Similarly, the bill requires that EGCs be permitted to file registration documents for confidential
The Securities Act of 1933 reflects the principle that "sunlight is the best disinfectant." n10 In fact, during the signing of the bill
Events have made it abundantly clear that the merchandising of securities is really traffic in the economic and social welfare of our people. Such traffic demands the utmost good faith and fair dealing on the part of those engaged in it. If the country is to flourish, capital must be invested in enterprise. But those who seek to draw upon other people's money must be wholly candid regarding the facts on which the investor's judgment is asked.
To that end this Bill requires the publicity necessary for sound investment. It is, of course, no insurance against errors of judgment. That is the function of no Government. It does give assurance, however, that, within the limit of its powers, the Federal Government will insist upon knowledge of the facts on which alone judgment can be based. n11
The ink is barely dry on the JOBS Act and we do not yet know what impact Title I will have on the number of IPOs. More importantly, we do not yet know whether it will affect investors' willingness to invest in the emerging growth companies that are so vital to our economy. Despite these uncertainties, the discussion draft would go even further than Title I by reducing the information that is available to investors and giving them less time to digest it.
NASAA respectfully urges the Subcommittee to reject further changes to Title I, at least until the full impact of Title I on investors and securities markets can be observed and evaluated. Until such time, the potential costs and benefits of further expanding Title I will be impossible to determine.
Tick Sizes and the Small Cap Liquidity Reform Act
Proposals to promote greater liquidity for EGCs or other thinly traded stocks by experimenting with changes to the ''tick sizes,'' or minimum increment for quoting shares, for certain smaller public companies, raise interesting policy questions. However, from a standpoint of public and market-regulatory policy, such proposals also raise a number of concerns.
The proposal that is before the Subcommittee today would direct the
NASAA appreciates that there is less analyst coverage of many smaller company stocks than their shareholders might like; however, we question whether changing the mechanics of the securities market in the hope of subsidizing artificial interest in and coverage of such securities is something
There can be little question but that broker-dealers and others who serve as market makers for EGC stocks have a financial incentive to support such a change. It is also understandable that EGCs, and their managers, perceive in such a program the prospect of increased research coverage of their securities, and by extension, greater liquidity.
However, it is far from clear how any of these changes will stand to benefit the investing public. Indeed, quite to the contrary: increasing the spread between bid and ask prices for shares of EGC securities will systemically strip value from the holders of the securities and reallocate it to broker-dealers and others who act as market makers in these securities.
Moreover, as a matter of basic economics, it is evident that by manufacturing additional, artificial transaction costs for the exchange of EGC securities, the proposed pilot program would have the effect of diminishing rather than increasing overall marketplace efficiency.
NASAA believes that, as general matter,
There are many valid and important reasons why in some instances the government should undertake actions, consistent with the interests of the investing public, which may have the effect of decreasing marketplace efficiency - for example, to protect investors from fraud and abuse, to prevent excessive speculation, or to prevent market panic. In this instance, however, the proposed pilot program appears to offer little, if any, of these benefits to the investing public while increasing their transaction costs.
eXtensible Business Reporting Language (XBRL)
eXtensible Business Reporting Language (XBRL) is an international standard used for exchanging and reporting business information. XBRL makes use of "interactive data" to indentify trends and patterns that would not otherwise be recognizable or accessible.
XBRL allows for the automated processing of business information by computer software, cutting out laborious and costly processes of manual re-entry and comparison. This is highly useful for financial regulators such as the
In early 2009, the
As a general matter, NASAA shares the view of other advocates for transparency, from the
At the same time, state securities regulators are very sensitive to the compliance cost that XBRL may be placing on some truly small companies, and in the case of such companies, we would hope that
Other Ideas for Spurring Capital Formation Through Pro-Investor Reforms
NASAA shares the goal of
A Gallup survey in
The reasons for investor nervousness seem obvious. Many Americans lost a big share of their retirement savings during the economic meltdown and now view the stock market as a "casino" that is rigged by insiders and high frequency traders. These investors also hear about computer errors and false news stories that cause flash crashes, and they understandably wonder whether the markets are sufficiently stable to invest their retirement savings. n16
Of course, this is not the first time in our history that investors need their faith in the markets restored. The original Securities Act of 1933 was not meant to punish
The great and buoyant faith in capitalism, in the competitive system, is largely deflated, and . . . it is not only a question of whether the system is just, but whether it works. When you have a system which is questioned by the masses, that system cannot last unless it wins back the loyalty and allegiance of the doubters. . . . n17
Today, investors need a similar boost of confidence in the securities markets. It is counterproductive to capital formation when
First, we believe that
Another innovative effort to combat high frequency trading has been undertaken by ParFX and EBS, two international currency trading platforms. They use a randomized pause so that the first order placed in the system queue is not necessarily the first to be executed. n20 According to
Improving Investment Adviser Oversight and Preserving Investor Choice
Finally, state securities regulators continue to support legislation introduced in the House by Ranking Member Maxine Waters that would authorize the
Taken together, these two bills constitute major steps that
Thank you again, Chairman Garrett and Ranking Member Maloney, for the opportunity to appear before the Subcommittee today. I would be pleased to answer any questions that you may have.
n1 The oldest international organization devoted to investor protection, the
n2 States are also the undisputed leaders in criminal prosecutions of securities violators. In 2012 alone, state securities regulators conducted nearly 6,000 investigations, leading to nearly 2,500 enforcement actions, including 339 criminal actions. Moreover, in 2012, 4,300 licenses of brokers and investment advisers were withdrawn, denied, revoked, suspended, or conditioned due to state action, up 28 percent from the previous year.
n3 See NASAA Comments in Response to Release Nos. 33-9416, 34-69960, IC- 30595 (File No. S7-06-13), "Amendments to Regulation D, Form D and Rule 156 under the Securities Act."
n4 At least one of the discussion draft bills before the Subcommittee is modeled on a recommendation of the Advisory Committee.
n5 While NASAA is supportive of reasonable statutory or regulatory forbearance for compliance with XBRL requirements for small businesses, as explained elsewhere in this testimony, we consider that the
n6 As contemplated by H.R. 1973, financial companies would include not only firms that deal in securities, but also depository institutions like banks and credit unions, insurance companies, credit card companies, and a host of other entities that primarily derive their revenue from financial transactions and the sale of financial products.
n7 Notably, BDCs are also required to distribute at least 90% of their taxable earnings in the form of dividends.
n8 Eligible investments include: (1) privately issued securities purchased from "eligible portfolio companies," (2) securities of eligible portfolio companies that are controlled by a BDC and of which an affiliated person of the BDC is a director, (3) privately issued securities of companies subject to a bankruptcy proceeding, or otherwise unable to meet their obligations, (4) cash, government securities or high quality debt securities maturing in less than one (5) facilities maintained to conduct the business of the BDC, such as office furniture and equipment, interests in real estate and leasehold improvements.
n9 Under the Investment Company Act of 1940 the asset coverage requirement for closed-end funds is 300% for debt securities and 200% for preferred stock. The Small Business Investment Incentive Act of 1980 reduced the asset coverage ratio for BDCs to 200% from the 300% applicable to non-BDC investment companies under sec. 18(a)(1)(A) of the ICA.
n10 "[P]ublicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants.... The potent force of publicity must...be utilized in many ways as a continuous remedial measure."
n11 President
n12
n13
n14 Letter from
n15 See http://www.gallup.com/poll/147206/stock-market-investments-lowest-1999.aspx.
n16 In the past several years, major market disruptions that have not been adequately explained, but which appear to be linked to electronic trading, include the
n17
n18
n19 Id.
n20
n21 Id.
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