Donald J. Devine

FREEING THE SMALL BUSINESS CAPITAL MARKET
September 25, 2000

Summary

Freeing the small business capital market is essential for continued prosperity. Recent actions by the Securities and Exchange Commission to restrict one of the major sources of this prosperity could end that boom. SEC Rule 504 was liberalized during the Ronald Reagan and George H.W. Bush administrations to allow small public firms to raise capital more cheaply and efficiently. After years of success in supporting this burst of economic growth, the SEC became concerned with fraud under the rule. While admitting that it was not widespread, the agency drastically restricted use of the rule to private companies, excluding the public companies responsible for much of the growth. It also required complicated filing and approval procedures under stricter standards that forced many non-fraudulent firms into bankruptcy and restricted the access to efficient stock exchanges for many others. A review of the facts suggests that the SEC has over-reacted. Suggestions for proper reform of the small public company market are presented to correct this deficiency.

The Continuing Prosperity

Why has the current prosperity lasted so long? Except for a few months in 1992, the United States has experienced a continuous prosperity since 1982, the year that President Reagan's reforms became fully effectuated. Although Bill Clinton likes to take credit for the longest period of uninterrupted growth in history covering 108 months, 21 of those months took place under his predecessor, George H.W. Bush. Not only was the Reagan expansion longer, including the months under his successor, but the few months of interruption were inconsequential. The Reagan boom effectively spanned the whole period.

The supply-side tax cuts, the trimming of government spending and even the psychological effect resulting from the example of management leadership provided by his refusing to buckle to the air controllers' union strike, are well known as the policy that turned the economy from double-digit inflation, extremely high capital costs and uncontrolled government spending to prosperity. Less heralded, was an obscure rule passed by the Securities and Exchange Commission that same critical year of 1982. But this rule, empowering small business to raise essential capital, may have had as much effect in creating the nearly two decade era of the boom as any of its more well-known contributing factors.

The Capital In Capitalism

It is the ability to raise and wisely invest capital that has been the major economic factor allowing capitalism to bury its socialist competitors. Even in capitalist nations, government is notorious in its inability to raise long-term, capital funds. Politicians in a democracy respond to short-term demands of constituents. They follow John Maynard Keynes' famous maxim "In the long term, we all are dead." Yet, if one does not plan for the long term, it does not make sense to invest in the future. For example, in the United States, there long has been a great deal of discussion over the need to privatize the air traffic control system so that it could raise the capital necessary to end the persistent delays and even to save the whole system from crashing. The Federal Aeronautics Administration has planned for the necessary equipment upgrade and replacement for years but Congress just cannot convince itself to grant the many billions needed. It can always be delayed one more year.

The capital markets for large private sector corporations in the United States are the most efficient imaginable. A public firm that can be listed on the New York Stock Exchange can raise the funds it needs, whatever the level, as long as it can convince investors that its future will be as successful as the present or even better. The secret is the easy availability of information. The same may be said of the NASDAQ national and small capital markets and, probably, a reorganized American Stock Exchange. The situation is not as favorable for the millions of small firms that are forced to rely upon the NASDAQ Over The Counter (OTC) Bulletin Board, the private National Quotation Bureau's "pink sheet" markets, or the private funds raised from friends, relatives and neighbors (often unfairly characterized as the "three F's"--friends, family and fools).

Small Business Is Unique

While small business has the most difficulty in raising capital, it is clear that it is the most dynamic part of the business market. It creates the overwhelming number of new jobs and it is the source of much of the innovation that makes the U.S. business sector so dynamic. As shown in Table 1, a bit more than half of all employees work for firms with fewer than 500 employees. Equally important, these firms produce 47 percent, or almost half, of the business receipts of all firms.

Table 1. Importance of Small Business

Firm Size Employees (1995) Receipts (1995) Net New Jobs (1992-1996)
Under 500 Employees 52,653,000 $7.4 billion 11,827,000
Over 500 Employees 47,662,000 $8.3 billion -645,000
Source: Small Business Administration, Small Business Answer Card. 1998, pp 1,3.

The most interesting statistic, however, is their affect on new job growth. As noted, firms of over 500 employees actually had a net decrease in jobs over the period of 1992 to 1996. If all of America were large firms, employment would look like that of Europe, stagnant. But the greater number of small firms in the U.S. has been the source of its greater dynamism. Firms of under 500 employees have created all of the net new jobs during the boom years. Indeed, most of the jobs were created by firms of five or fewer employees.

Surprisingly, most of the funds are raised privately from the "three F's" or on private credit sources. About 75 percent of small firms seek credit, mostly from traditional or commercial loans or from personal or business credit cards. But those firms that wish to grow more substantially generally must ultimately raise funds publicly. It is just not possible to grow larger without raising funds in the securities markets, whether the firm is private or public. And there one comes into contact with the government regulation of securities and exchanges.

The Securities and Exchange Commission Regulatory Structure

Securities have been regulated in the United States since 1933. The Securities Act of that year required that companies give investors "full disclosure" of all "material facts" that investors would need to make an investment decision, to register investor information with the SEC, which declares the investment "effective" (but not safe or good) if they satisfy its disclosure rules. The Exchange Act of 1934 requires public companies to disclose information about their business operations, financial activities and management to the SEC and, in some cases, to investors. Over the years, filing and information production requirements have grown more complex and more expensive. It is virtually impossible for the average businessman to keep up with requirements. Indeed, the SEC itself recommends the use of an attorney to avoid possible penalties.

In an effort to help small businesses without great staff support, the SEC opened a Small Business Office in 1979 to provide assistance. Yet, it was forced to deal with the existing, complex process and could only assist at the margins. By then, the basic filing form had become very complex indeed. Basic Form S-1 became infamous for its difficulty, cost and density--frustrating the openness originally sought by the acts. A form SB-1 was added to allow transaction under $10 million by small (less than $25 million in revenues and stock worth no more than $25 million) firms in a simpler question and answer format. SB-2 followed for any size transaction with specific criteria in plain language to be followed. They helped a bit but still require professional assistance. Other forms were equally complex. The lack of clear guidance causes innocent error that can lead to administrative or legal problems.

In response to public and business complaints, both the SEC and Congress have, over the years, provided some exemptions from the more onerous requirements, although even these are properly subject to the anti-fraud provisions of the law. There is an interstate exemption for transactions within a state (Section 3(a)(11)), although it is almost impossible to meet since if even one share is offered or resold out-of-state the exemption can be lost. Private offerings are exempted under Section 4(2) but the purchaser must be a "sophisticated investor" and no advertising or public solicitation may be used. Significantly, even the SEC admits that the precise limits of a non-public offering are "uncertain." Section 3(b) authorized the SEC to exempt small securities offerings and this led to a Regulation A affecting offerings of $5 million or less in a 12-month period. They do not need to be audited. Still, the company must file an offering statement with the SEC for review and a statement similar to the traditional prospectus must be given to investors. The review process is long--perhaps several months, during which time conditions change--and expensive with lawyers, accountants, consultants and the rest.

Regulation D offers some other alternatives. Its Rule 505 offers an exemption for offers and sales up to $5 million in 12 months to any number of investors--but they must be "accredited" (except for 35 other persons), i.e. sophisticated and registered, and the instruments are "restricted, i.e. they " cannot be resold for at least a year without registration. Financial statements must be made available and certified. Rule 506 is a safe harbor for the private offering exemption. It at least provides some protection from arbitrary prosecution by spelling out (to some degree) what information is needed. There is also a general accredited investor exemption (Section 4(6)), for sales for employee benefits (Rule 701), and qualified purchasers in California (Rule 1001). But the only generally useful exemption that was created was Rule 504.

The Reagan Small Public Company Reforms of Rule 504

Inspired by the overwhelming victory of President Reagan in 1980 and the renewed interest in entrepreneurship and growth this generated around the world, as opposed to learning to live with malaise and limits to growth, the SEC adopted a major reform in 1982. Rule 504 was specifically adopted to allow small businesses to more easily raise capital without the red tape and cost associated with regulatory bureaucracy. Small business was recognized as the growth-generator and the need to liberate it seemed manifest.

Rule 504 allowed private and public stock offerings of up to $500,000 (later raised to $1 million) to be sold within 12 months to an unlimited number of investors without a prospectus and without regard for the investors' "sophistication" or amount of knowledge, as long as the offering was filed under state law. These so-called blue sky laws generally required a disclosure document but with less information and fewer costly administrative hurdles. Approval was possible within 30 days by most states at a modest cost. Section 504 immediately became the offering tool of choice among small public and, especially, private company stock offerings. It unquestionably, became one of the engines for the growth of the stock market, especially, internet and technology stocks and the prosperity that they inspired and led.

Rule 504 was further liberalized in July of 1992. All federal restrictions other than fraud were removed and all offerings under the rule offerings were subject only to state regulations. General solicitations and advertising were allowed and offerings were not "restricted" for resale by non-affiliates of the issuer. Whatever slowdown there was in 1991 quickly turned to furious growth, especially in the small public company area which relied upon these 504 liberalizations to raise the capital necessary for their growth and that of the economy generally.

The Concern With "Microcap" Fraud

No good deed goes unpunished and deregulation of the small capital market was no exception. While recognizing that the Reagan reforms generally operated effectively and fairly, with the large growth in these markets, instances of fraud became more apparent. Although the evidence was spotty, the SEC began in 1997 to be concerned with exploitation of the Rule 504 exemption. In a few cases, the lack of state regulation in New York was used by dealers resident there to avoid any regulation at all. Securities were placed with dealers who used cold-calling to sell securities at ever-increasing prices to unknowing investors. Worse, when the inventory of shares was exhausted, the principals allowed the artificial demand to collapse, selling short or taking paper loses to offset gains, with investors losing their investment, in a scheme called "pump and dump." The SEC believed that the fraud was limited to sales in the secondary, i.e. resale, market.

The SEC originally proposed to close the New York "loophole" and to restrict all re-sales for a period of one year. Objections from dealers and others, however, led it to do the former but instead of the latter limited Rule 504 to private offerings only--which it claimed were the vast majority of transactions anyway--plus state regulation. But this left public offerings without the 504 flexibilities and this low-cost means to raise capital. And they had to report and register with the SEC as a regular, non-504 firm. On top of this, NASDAQ, which also has regulatory authority, ruled that only reporting companies could now have access to its exchanges, including the OTC Bulletin Board. The OTC was used by many of the small public companies utilizing 504 before they had to report to the SEC. At the same time, NASDAQ and the other exchanges raised the standards for reporting and qualifying for each of the hierarchy of exchanges. In addition, the SEC was considering a rule to require not only the market-maker to do due diligence on a stock offering but for all additional sellers to do so too. Objections from brokers and SEC commissioner Norman Johnson have held up this regulation but it still causes concern in creating markets nonetheless.

Hurting the "Good Guys"

The result of these changes was that three thousand firms were thrown off the OTC Bulletin Board into the more turbulent pink sheet market, forcing a liquidity crisis that pushed many into insolvency. This was the case even while the SEC acknowledged that the "scope of the abuse is small." Many could not meet the high costs for qualifying for reporting status. In addition, with the large number of companies required to file, the SEC approval process choked from the new paperwork. So, even firms that could comply were delayed. In the raucous chase for capital, time is essential and many firms were driven out of business when they could not raise capital because they still had not received approval.

The requirements for listing were increased substantially. The listing requirement and the necessity of SEC approval was the main reason small public firms were forced off the OTC Bulletin Board market. Small firms do not come close to qualifying for The New York Stock Exchange so their only real choices are the OTC or NASDAQ. The requirements for their major markets are listed in Table 2. The assets required for initial listing are substantial and, for continued listing, they are even higher. More importantly, the requirements were raised substantially from the old listing before the regulatory change to the new ones that now apply. For the NASDAQ National Market, the asset requirement was increased 50 percent. The new SmallCap Market began at the old National level and almost doubled the net revenue requirements. The raising of the requirements and the SEC backlog caused the greatest burden and the requirements still provide a barrier to entry today. Moreover, many additional reporting and informational requirements are obligatory both for entry and continued listing.

Table 2. Requirements for Access to Capital Market Exchanges (initial listing, pre and post "reform")

Assetts Float Value Income/Revenue
NASDAQ National Market, old $4 million $1 million $400,000 (net)
NASDAQ National Market, new $6 million $8 million $75 million
NASDAQ SmallCap Market, old $4 million $1 million $400,000 (net)
NASDAQ SmallCap Market, new $4 million $5 million $750,000 (net)
Source: The Nasdaq Stock Market, Inc. Listing Qualifications (updated)

There is no question that many good companies were harmed by the implementation and by the new requirements. Yet, there is still broad support for access to capital for small public companies. Small public companies are the future giants and producers of jobs and wealth. There is a serious question whether giants like Microsoft or Home Depot, which both started a private, then moved to small public company status, could have sold their second product or opened its second store without access to the OTC Bulletin Board. Under today's requirements, they would have not met the minimal levels and could have failed, with all of the loss of wealth, service and jobs. Some future producer of wealth and jobs will be deterred by these higher requirements.

The whole idea of chasing the small public companies off the OTC exchange for not meeting arbitrary filing requirements must be questioned. The SEC itself recognized that only a few bad apples were causing the fraud. Yet, 3,000 firms were destroyed and many more harmed in the attempt to get a few. The pink sheet market is just too difficult for any but the most sophisticated to utilize. Even if its plans to put quotations on line do progress, it will take time. Until then, the small public companies need some relief.

Reforming the Small Public Company Market

The answer is to return to the Reagan reforms in a manner that will also reduce fraud. The problem in the 504 market was the lack of reporting. There was not sufficient availability of information to the small public investor in initial offerings and investors and stockholders in secondary offerings. The solution is to retain the section 504 freedom from registration but to require reporting and approval from stockholders in issuing additional stock. Closing the New York "loophole" was enough to stop the worst abuses.

This is what needs to be done:

1) Raise Transaction Level to $5 Million. Since Rule 504 is now reserved for private offerings, it probably makes sense to keep it restricted to private ones under the existing conditions. The amount of allowable transactions, however, should be raised to $5 million in any one year. For all 504 firms

2) Create a New Rule 504(a) for Public Offerings for Small Business. Since all small businesses that have survived the SEC transition now report, all existing small caps already have the higher standards requested by the regulators. All that must be accomplished now to restore the Reagan reforms is to allow small public companies to raise the funds without the additional requirements. Small public companies need the flexibilities and lower costs of 504 protections.

3) Stockholder Approval of Stock Issuance. The real way to control pump and dump fraud is to require that stockholders approve issuance of stock, for they have the necessary interest not to dilute its value. Stockholders should be in control of their firms in any event.

4) Only Fraud and Civil Liability Federal Requirements. Both 504 and 504(a) should be reformed to only require fraud and civil liability redress under Federal statutes. This merely returns to the pre-reform status quo. States are the proper forum for this regulation. With stockholders in charge and states overseeing the process for fraud, no further SEC control is required.

5) Stockholder Control of Fraud. The worst fraud occurs when an owner and small board of directors dilutes the stock while protecting themselves or even gaining in the transaction. The solution, again, is to put stockholders in charge. Any board or chief executive decision that would have the affect of diluting the stock by 20 percent or more should require stockholder notice and approval.

6) Review the Higher Standards for Exchange Access. The standards for access to the various exchanges were set arbitrarily. There should be a review of these requirements with substantial input to NASDAQ from small business.