September 23, 2011
Harmonizing the Federal Securities Laws’ Treatment of Small Businesses
The Securities Act treats small businesses in a fundamentally different way than the Securities Exchange Act. Harmonizing those two statutes would go a long way towards solving the problem of small business capital formation in the United States.
The Mandatory Disclosure Requirements
Both statutes impose mandatory disclosure requirements on American businesses. The Securities Act requirement is episodic. When a company offers securities, it must file a registration statement with the SEC and make a prospectus available to investors. The mandatory disclosure in the Exchange Act requirement is periodic. Companies must file annual and quarterly reports (Forms 10-K and 10-Q), and also report on certain important events occurring between those regular filings (Form 8-K). The Securities Act disclosure protects investors at the entry level; the Exchange Act disclosure protects existing investors.
Small Business Under the Exchange Act
The two federal statutes treat small businesses very differently. The Exchange Act absolutely and categorically exempts small businesses from the mandatory disclosure requirements. Unless a company’s securities are traded on a national securities exchange or the company has both $10 million in assets and a class of equity securities with more than 500 record holders, it usually doesn’t have to worry about Exchange Act registration.
Small Business Under the Securities Act
The Securities Act does not categorically exempt small business offerings from its registration requirement. In fact, the Securities Act doesn't exempt small business offerings at all. The registration requirement applies regardless of the size of the offering or the size of the company making the offering. (The statute exempts non-public offerings, but the Supreme Court held long ago that the private offering exemption depends primarily on the character of the offerees, not the dollar amount of the offering.)
The Securities Act does authorize the SEC to create exemptions for smaller offerings, and the SEC has adopted several such exemptions, but all of those exemptions add non-trivial restrictions and conditions. There is no unconditional exemption for small offerings or small companies.
It is almost universally recognized that, because of economies of scale, the cost of registering smaller offerings is prohibitive. The Securities Act’s registration requirement therefore imposes a serious burden on small business capital formation.
A Proposal for a Categorical Securities Act Exemption
Why not just follow the approach of the Exchange Act and free all smaller companies from the Securities Act registration requirement as well? The SEC usually points to the higher risk of fraud in small business offerings and argues that registration, or at least some limitations on the offering, are needed to protect investors from that fraud.
It’s true that small businesses are riskier, and that includes a disproportionate risk of fraud. But that risk exists whether the small business is engaged in an offering of securities or just dealing with its existing investors on a day-to-day basis. If the offerees in small business offerings need the protection of one-time mandatory disclosure, then the investors in small businesses equally need the protection of periodic mandatory disclosure. The fraud argument, if you accept it, works for both statutes.
Requiring small companies to file annual and quarterly reports would, of course, be silly. The enormous cost of Exchange Act reporting clearly outweighs any possible gain to the investors. Requiring a company with a total value of only $200,000 to file Exchange Act reports would quickly bankrupt the company.
But the same is true under the Securities Act. Assume that a new business startup wants to raise $100,000 by selling securities. The most that the investors in that offering could possibly lose is $100,000, so the maximum possible benefit of registration is $100,000. (That assumes investors would lose everything without registration and that registration would completely prevent such losses.) Registering that offering would clearly cost more than $100,000, so it doesn’t make economic sense to require registration, no matter how risky the offering is. In short, for the same reason a categorical Exchange Act exemption makes sense, a categorical Securities Act exemption makes sense.
How about adding something like this to the Securities Act:
Section 5 of this Act shall apply only to offerings by an issuer that
(a) has, or will have after the offering, a security traded on a national securities exchange;
(b) has, or will have after the offering, total assets in excess of $10 million.”