At yesterday’s meeting of the SEC’s Small Business Capital Formation Committee, the Committee discussed three topics: the SEC’s Harmonization Concept Release, the proposal to amend financial disclosure requirements relating to acquisitions and dispositions of businesses, and the proposal to amend the accelerated and large accelerated filer definitions. SEC Chair Jay Clayton emphasized that his goal was to find the right balance between making sure that investors receive the information they need and eliminating unnecessary costs and burdens. Several of the presentations to the Committee can be found here.
[Based on my notes, so standard caveats apply.]
Harmonization Concept Release. SEC staff members provided an overview of the Harmonization Concept Release, which is seeking public comment on ways to harmonize and streamline the patchwork universe of private placement exemptions and “to expand investment opportunities while maintaining appropriate investor protections and to promote capital formation.” (See this PubCo post.) Some of the key questions raised by the release were:
- How can small retail investors participate more in the private markets?
- Could the use of pooled investment vehicles with sophisticated intermediaries function as a mechanism to allow smaller retail investors to participate?
- Are there overlaps or gaps in the current system that create confusion or other problems?
- Is there a need to regulate offers and sales or would it suffice to regulate only sales?
- The current definition of “accredited investor” is binary—that is, if you are accredited you can participate in the transaction to any extent and if you are not accredited, you can’t participate at all. Would it be more appropriate to scale the level of investment permitted relative to the wealth of individual?
On the latter point regarding accredited investors, Corp Fin Director William Hinman said that the SEC planned to address the definition of “accredited investor” first; it is slated for consideration before the end of the year. Committee members advocated that just tinkering with the accredited investor definition won’t be enough to bring in the Main Street investor or to bring capital to non-traditional markets. Rather, the changes must be more holistic. SEC Chair Clayton suggested looking at, for example, a co-investment model, where non-accredited investors invest pari passus with sophisticated investors. (Take note that this pooled investment fund idea seems to be gaining traction.) One Committee member argued that investment funds would still be reluctant to include non-accredited investors—he thought there would still need to be incentives. Another member suggested that perhaps there should be different rules for eligibility to invest in an individual issuer as opposed to a pooled investment. The Committee is developing a framework to consider recommendations on the Concept Release.
Proposal to Amend Financial Disclosure Requirements Relating to Acquisitions and Dispositions of Businesses. The proposal, which affects Rules 3-05 and Article 11 of Reg S-X, as well as related rules and forms, is designed to “improve for investors the financial information about acquired and disposed businesses; facilitate more timely access to capital; and reduce the complexity and cost to prepare the disclosure.” As discussed in this PubCo post, the proposal would, among other things, revise the significance tests by modifying the investment test and the income test, with the goal of reducing the frequency of anomalous results; reduce the number of years of required financial statements for the acquired business; broaden the carve-out for asset acquisitions; eliminate the requirement to provide Rule 3-05 financial statements in registration statements and proxy statements once the acquired business is reflected in post-acquisition company financial statements for a complete fiscal year (as opposed to requiring that they have been included in an SEC filing), making it helpful in the context of IPOs; and require inclusion, as part of the pro forma financial information, of “disclosure of ‘Transaction Accounting Adjustments,’ reflecting the accounting for the transaction; and ‘Management’s Adjustments,’ reflecting reasonably estimable synergies and transaction effects.” The discussion was generally supportive of the proposal, particularly to the extent that it removed or reduced the disadvantages that smaller companies have in the M&A market. There was a fair amount of hesitation, however, with regard to the aspect of the proposal requiring disclosure of pro forma management adjustments. That type of information, panelists said, was typically uncertain and would likely not be a subject for accounting “comfort,” could involve sensitive disclosures, and could create target morale issues and an expectations gap. The Committee resolved to support the proposal, subject to suggestions that the SEC add more flexibility with regard to Reg A and make the management adjustments disclosure optional.
Proposal to Amend the Accelerated and Large Accelerated Filer Definitions. Its title notwithstanding, this proposal has much less to do with the timing of SEC filings and is really all about the SOX 404(b) auditor attestation requirement. Instead of proposing to raise the current threshold for status as an “accelerated filer” to be commensurate with the cap for “smaller reporting companies,” as was widely anticipated, the SEC instead proposed a narrowly tailored exception that attempts to thread the needle with regard to the controversy over exempting additional companies from SOX 404(b), viewed by some as a critical investor protection. The proposal would amend the accelerated filer and large accelerated filer definitions to provide a narrow carve-out from these definitions for companies that qualify as smaller reporting companies and reported less than $100 million in annual revenues in the most recent fiscal year for which audited financial statements were available. The proposed revision would mean that those companies qualifying for the carve-out would no longer be subject to the SOX 404(b) auditor attestation requirement, but higher revenue companies with public floats between $75 million and $250 million would still be subject to all of the accelerated filer requirements, including the auditor attestation requirement. (See this PubCo post.) Not surprisingly, this proposal fueled the most intense debate.
Director Hinman said the question was whether to pursue the SEC’s more nuanced approach or to just conform the non-accelerated filer definition with the SRC definition? Is an attestation worthwhile for companies with public floats over $75 million? According to Hinman, the reason the SEC proposed the narrowly tailored exception for low-revenue companies—“fine-tuning” as Hinman characterized it—was that the DERA analysis was more supportive of that approach: the DERA analysis showed that the risk of problems was greater for companies with revenues in excess of $100 million. In any case, even without the auditor attestation, the auditors still need to review the quality of the controls as part of the audit, he noted, and the management is still required to perform a SOX 404(a) assessment of internal controls. And there are certainly costs associated with the attestation, especially “system upgrades” that are needed when the attestation process commences. A number of comments received on the proposal argued that, while an attestation can add to the company’s cost, it also saves funds by reducing the cost of capital. As structured, the proposal allows low-revenue companies to make that decision.
Chair Clayton observed that, first, it was important to emphasize that high-quality financial statements are the bedrock of our system. But, with more than a decade of experience with SOX 404(b) and over five years of experience with the JOBS Act and its exemption from 404(b) for EGCs, he suggested, the market is telling us something. With many EGCs now starting to “age out” of that exemption, is the market just “rubbing its hands” in anticipation of 404(b) attestations for these post-EGC companies? He wasn’t seeing it (and some of the company representatives later indicated that, although they were aging out of EGC status, their investors were not asking for 404(b) attestations). Was there a “Wild West” premium for non-accelerated filers?
The representative of the National Association of Manufacturers presented the case for raising the accelerated filer public float threshold to $250 million, commensurate with the cap for SRCs. As currently structured, the proposal would benefit primarily biotechs, but most manufacturing companies with public floats between $75 million and $250 million and revenues over $100 million are still small businesses, he urged. For example, 98% of manufacturers have fewer than 500 employees and 75% have fewer than 20. The median revenue for companies with public floats between $75 million and $250 million was $228 million. If they did not have to incur the cost of a 404(b) attestation, the cost savings would be substantial, and these manufacturers wanted to invest the savings to benefit their workforces through, for example, additional training. Whether or not to incur the cost of an attestation for companies of this size, he argued, should be optional. The JOBS Act has shown, he said, that companies make these choices appropriately; when the market demands that companies comply with otherwise optional accounting provisions, companies tend to do so. If companies believed that the absence of auditor attestations would lead to lower valuations, they would go forward with auditor attestations.
Representatives of biotechs, as the main beneficiaries of the proposal, were certainly in favor of it, but some suggested going further by raising the revenue cap and/or using a rolling three-year average (to account for the variability in revenue arising out of, e.g., milestone payments). They noted the high cost of compliance—generally many $100,000s more than the SEC’s estimates—and the better use of those funds for R&D purposes. Because biotechs need to raise such significant dollars to develop and bring a new drug to market, they maintained, biotechs tend to go public early to access the substantial funding available in the public markets. But they often age-out of EGC status well before they have earned any real revenue. Because they have low revenue, they also tend to have much less complex financial statements. What’s more, for investors, biotechs are “all about the science.”
Representatives of audit firms and investors argued that the attestation provides significant value, giving investors more confidence in their investments. Absent the attestation, one contended, he would reexamine the distinction between his holdings of accelerated and non-accelerated filers: he might not want to pay for that much risk. An auditor on the panel observed that, in his experience, lots of companies with public floats below $250 million have very complex financial statements and would benefit from the 404(b) attestation. On the other hand, a banker on the Committee contended that scale matters and that the cost of compliance with 404(b) could be prohibitive for companies with public floats below $250 million. Several panelists also noted the difficulty of compliance in light of the complexity of the proposal.
In the end, the Committee voted to express support for the proposal as a baseline, but suggested that the SEC continue to explore a higher revenue threshold for accelerated filer status as well as a three-year rolling average revenue threshold and solicit the views of institutional investors with regard to whether all SRCs should be treated as non-accelerated filers (i.e., raising the public float threshold to $250 million, commensurate with the SRC cap).