The Future of Capital Formation
Craig M. Lewis, Chief Economist and Director of the Division of Economic and Risk Analysis
April 15, 2014
MIT Sloan School of Management’s Center for Finance and Policy’s Distinguished Speaker Series
Good morning. It is a pleasure to be here and I am honored to be part of the Distinguished Speaker series. But no matter how distinguished my remarks attempt to be, I must make clear to you that they are my own and do not necessarily reflect the views of the Commission, Commissioners, or of SEC staff.
Today I’d like to talk about capital formation – one part of the Commission’s tri-partite mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. There is much to be said about the Commission’s efforts to facilitate capital formation. But because I’m an economist, today I will focus in particular on some of the economic fundamentals that I believe can be considered when thinking about capital formation.
The notion of encouraging capital formation has been particularly salient over the past year or so, since the passage of the Jumpstart Our Business Startups Act in 2012. The stated goal of that legislation is “[t]o increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.” The JOBS Act, as it is called, provides a variety of approaches to capital formation, including via new channels of capital raising, such as crowdfunding, exempting certain offerings of up to $50 million of securities, and lifting the ban on general solicitation.
As the Commission works to propose and adopt rules to implement the JOBS Act, my Division has performed extensive economic analysis of the potential impacts of each of these new capital raising opportunities as part of the rulemaking process. As part of its rulemakings, the Commission is often required by another statute, the National Securities Markets Improvement Act of 1996, to “consider, in addition to the protection of investors, whether the action will promote efficiency, competition and capital formation.” Thus, in most of its rule releases, the Commission will, as part of its consideration of the economic impacts of a particular policy choice, also take into account the effects on efficiency, competition, and capital formation. Or as we call it at the SEC, “ECCF.”
Combining the two statutory directives described above, in the context of JOBS Act rulemakings, my Division has considered whether rules facilitating capital formation do, indeed, promote capital formation. As part of those efforts, we have been able to develop a better understanding of the types of capital raising activities that characterize the current market and how these practices may change over time.
For example, in the crowdfunding proposing release, we document that from 2009 through 2012, there were more than 20,000 private offerings to sophisticated or accredited investors for less than $1 million. Under the proposed rules, these issuers may have been eligible to issue their securities to retail investors through regulated funding portals or brokers, and with less burdensome requirements relative to registered offerings.
We also know that the private offering market contributes a substantial amount of capital to businesses of all size and status. During the last calendar year, more than a trillion dollars was raised through private channels, including by operating companies, venture capital and private equity funds. In fact, initial offers of sales by operating companies totaled more than $100 billion, which is greater than the total amount raised through Initial Public Offerings during the same period.
I’d like to step back a little, though, and think about the underlying economics of what we are seeing in the markets. Specifically, what challenges do and will small companies and entrepreneurs face as they think about capital raising now and in the future.
Among the impediments to capital formation that may constrain small companies’ access to capital markets are those related to what economists refer to as “informational frictions” in financial markets. For example, there are frictions associated with the efforts of companies and investors to find each other – what we call “search costs.” Similarly, potential investors may face challenges becoming adequately informed regarding the merits of a particular company’s prospects.
Smaller companies cannot solve these informational frictions as easily as larger companies. Large companies often have a sufficient capital base to merit an exchange listing. This allows investors and analysts to lower their search costs by converging on a single location to evaluate potential investment opportunities. Larger companies may also have a greater ability to absorb the costs of complying with SEC registration and reporting requirements. These mandated disclosures provide potential investors not only with information regarding particular companies, but also comparable information across companies, allowing for easier assessment of the relative prospects (and risks) of these various investment opportunities.
The JOBS Act in part focuses on lowering these informational frictions in novel and creative ways. For example, crowdfunding seeks to reduce search costs by allowing a new financial intermediary (a “funding portal”) or a registered broker to connect small businesses and entrepreneurs to retail investors, subject to certain limitations. Moreover, under the crowdfunding rules proposed by the Commission, these issuances would not be subject to certain SEC reporting costs that, as I noted above, can be more burdensome for smaller companies. Once the Commission adopts rules to implement crowdfunding, crowdfunding intermediaries could serve to process capital that was previously sourced through, for example, unstructured loans from friends, families, and local communities. Moreover, capital raised through crowdfunding intermediaries could provide an alternative to small business bank lending, which is often unavailable to small business borrowers because of collateral requirements, and by some accounts has fallen precipitously since 2008, with less than one-third of small businesses having reported a bank loan.
Another rule rooted in the JOBS Act, the proposed expansion of Regulation A, allows a larger amount of capital to be raised, up to $50 million, also without the full SEC registration and periodic reporting requirements, but with greater disclosure requirements than what was proposed for crowdfunding issuances. With access to retail investors, Regulation A-issued securities could provide an attractive alternative to private offerings that are primarily limited to sophisticated or accredited investors. Indeed, during the last calendar year, more than 10,000 Regulation D offerings fell within the offering limits of the proposed Regulation A. Regulation A issued securities could also provide an alternative to a traditional IPO, with such issuers weighing the tradeoff between the benefits of reduced disclosure requirements and potential costs from a loss of secondary market liquidity that may result from an issuer’s inability to have its securities quoted on platforms available only for Exchange Act-registered securities.
Finally, the removal of the ban on general solicitation mandated by the JOBS Act allows issuers of private offerings to use new channels of communication to reach accredited investors, with the specific intent to lower search costs. While this could increase the supply of capital from accredited investors and lower the cost of capital for issuers, broader dissemination of investment opportunities could also increase the likelihood of participation by unaccredited investors, either inadvertently or by design to the extent that promoters of fraudulent schemes could more easily reach potential investors. Since the effective date of the removal of the ban on general solicitation, September 23 of last year, fewer than 10% of offerings and less than 5% of capital raised – approximately $10 billion – is by issuers claiming the new 506(c) exemption, which permits general solicitation. To better understand how the private offering market is likely to develop under the new rules, the Commission is currently considering amendments to Form D, the primary collection tool for statistics on private offerings, to include additional information about the number and types of investors participating in these offerings, and the types of solicitation and verification methods being used.
As I’ve described, these innovative ways for smaller issuers to access capital may lessen certain informational frictions, particularly those related to search costs. On the other hand, if there is insufficient disclosure regarding these methods of capital raising, investors may not in all cases have access to information that will permit an adequate assessment of the risks of these offerings. This can, in turn, impact capital formation if the increase in perceived risk by investors raises the cost of capital to a point where issuers’ investment opportunities are no longer profitable when funded at those levels. This may also have an impact on investor protection. As I said last year, it is far from clear to me that “investor protection” is much different from considering the economic impacts of a rule, particularly on efficiency, competition, and capital formation. For example, if rules are inefficient or anti-competitive, they could allow for an environment which incentivizes fraudulent or nefarious behavior at the cost of investors. But if the markets are working, with adequate disclosures and an even playing field, both investors and companies will be well served.
Another important consideration is whether these new capital raising methods will increase the total capital invested in the markets by accessing sources of previously unavailable capital. Put another way, will investors who are already putting their money into the capital raising efforts of companies simply redeploy that capital into other opportunities, or will new investors enter the markets, bringing an influx of new capital?
You can see why this will make a difference to the net effects of these new capital raising methods. If future JOBS Act issuers could have otherwise accessed capital from already-existing sources, then the impact of the JOBS Act will be mainly redistributive in nature. In other words, the effect on capital formation could simply result in a shift from one offering method to another.
This is not to say that the impact would not be beneficial. Indeed, the positive effects of this type of redistribution could be potentially significant, enhancing the allocative efficiency of capital formation by providing issuers with less costly access to capital. For example, standardized funding methods that could be offered through crowdfunding intermediaries could lower the administrative burdens and contracting complexities to entrepreneurs and their potential investors that would otherwise use a more customized loan or security issuance agreement. Alternatively, an issuer that has access to capital from accredited investors in the private offering market might elect to raise capital under proposed Regulation A if a broader retail investor base is willing to supply capital at a lower cost.
On the other hand, if future JOBS Act issuers are now better able to access new and under-utilized sources of capital – such as from families, friends, neighbors, and local communities – there could be a positive impact on overall capital formation.
Unfortunately we cannot fully predict the magnitude of these effects before the final rules are adopted and put into practice. In fact, this is one of the key challenges that economists at the Commission face when they construct an economic analysis. We can, however, think about the kinds of trade-offs that new investors may take into account as they consider various investment opportunities. For example, the attractiveness of securities issued through the new offering methods – for example crowdfunding or under expanded Regulation A – may be impacted by the extent to which investors can easily exit their securities. Because, as I noted above, it is likely that these issuances may not reach a national market exchange, other exchange venues may ultimately develop to facilitate the necessary liquidity to encourage primary investment. If they do not, and if investors feel that they will not be able to easily divest, or if the securities are not designed to self-liquidate, then investors may be reluctant to invest in the first place.
Similarly, small issuers will also face trade-offs as they consider how to raise capital. For example, small issuers may increasingly elect to seek capital through private offerings, particularly now that the ban on general solicitation has been lifted. Of course, only accredited investors can participate in these offerings, thus potentially limiting the supply of capital. On the other hand, this limitation may be offset by the ability to raise capital without limit, and without registration and ongoing reporting requirements.
These are only a few significant considerations to think about regarding the effects these new capital raising methods will have on capital formation. And certainly when the Commission weighs whether to adopt a rule, many factors – including the importance of protecting investors – must be taken into account. But I hope that I’ve been able to provide at least an entry point to thinking about what capital formation looks like now and how it may look in the future. Thank you again for the invitation.
 The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues upon the staff of the Commission.
 Pub. L. No. 112-106, 126 Stat. 306 (2012).
 Id. See also Release No. 33-9470, Crowdfunding (Oct. 23, 2013), http://www.sec.gov/rules/proposed/2013/33-9470.pdf; Release No. 33-9415, Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings (July 10, 2013), http://www.sec.gov/rules/final/2013/33-9415.pdf; Release No. 33-9497, Proposed Rule Amendments for Small and Additional Issues Exemptions Under Section 3(b) of the Securities Act (Dec. 18, 2013), http://www.sec.gov/rules/proposed/2013/33-9497.pdf.
 Pub. L. No. 104-290, 110 Stat. 3416 (1996).
 See 15 U.S.C. 77b(b); 15 U.S.C. 78c(f); 15 U.S.C. 80a-2(c).
 See Division of Risk, Strategy, and Financial Innovation and Office of the General Counsel, Current Guidance on Economic Analysis in SEC Rulemakings (March 16, 2012), p14-15 (noting the value of presenting an integrated economic analysis combining consideration of economic effects and the effects on efficiency, competition, and capital formation), http://www.sec.gov/divisions/riskfin/rsfi_guidance_econ_analy_secrulemaking.pdf.
 The Kauffman Foundation, 2013 State of Entrepreneurship Address (Feb. 5, 2013), available at http://www.kauffman.org/uploadedFiles/DownLoadableResources/SOE%20Report_2013pdf.pdf. The report cautions against prematurely concluding that banks are not lending enough to small businesses as the sample period of the study includes the most recent recession.
 See Craig M. Lewis, “Investor Protection Through Economic Analysis” (May 23, 2013), http://www.sec.gov/News/Speech/Detail/Speech/1365171575422.