Securities Regulation Daily Senate Banking Committee seeks to produce bipartisan capital formation package
Thursday, February 28, 2019

Senate Banking Committee seeks to produce bipartisan capital formation package

By Mark S. Nelson, J.D.

A Senate Banking Committee hearing considered reviving JOBS Act 3.0 from the last Congress with additional emphasis on diversity, angels, insiders, proxy advisers, and private equity firms.

The Senate Banking Committee heard from three witnesses on a range of capital formation issues. The specific legislative proposals that formed the basis for the hearing consisted mostly of bills previously introduced in the last Congress as JOBS Act 3.0 plus legislation on proxy advisers. From this now familiar legislative package emerged several discussion threads, a few of them not part of JOBS Act 3.0, that focused on diversity, angels, insiders, proxy advisers, and private equity firms,

Senate capital formation plan. Senate Banking Committee Chairman Mike Crapo (R-Idaho) and Ranking Member Sherrod Brown (D-Ohio) set the tone by framing the over arching question to be addressed by the hearing in mostly the same way: Is capital formation good for everyone or just for Wall Street? The two leaders, however, offered divergent answers. Senator Crapo said yes. Senator Brown suggested Wall Street comes out ahead of workers in this context. The differences between the two committee leaders, though, belie the many bipartisan bills at the heart of JOBS Act 3.0, which Sen. Crapo noted was being considered for the first time by the Senate at today’s hearing.

As for the Senate Banking Committee’s course going forward, Sen. Crapo put it thus in his prepared remarks: "While there are bills for consideration today that I have previously expressed concerns with, as well as a number that Senator Brown has stated concerns with, I believe this is the fairest way to consider all of the legislative proposals that remain outstanding from last Congress." One bill that was part of JOBS Act 3.0 that may not be re-introduced, however, is the Encouraging Public Offerings Act of 2017 (H.R. 3903S. 2347) because the SEC, on its own initiative, recently proposed (press release) to allow all public companies (not just emerging growth companies) to engage in test-the-waters activities in advance of initial public offerings.

This review of the Senate Banking Committee’s Capital Formation hearing will focus on only a few of the topics covered by JOBS Act 3.0. For a detailed discussion of the entirety of JOBS Act 3.0 as introduced in the last Congress, see this white paper.

Diversity. Diversity has become one of the most discussed financial topics in Washington, D.C. in recent months, in part, spurred by California’s board room diversity law. Recently, Sen. Robert Menendez (D-NJ) and Rep. Gregory Meeks (D-NY) introduced bills (S. 360H.R. 1018) that would require public companies to disclose data on diversity. The SEC also recently updated its Compliance and Disclosure Interpretations (C&DIs) to provide guidance on how companies should handle disclosures regarding the consideration of self-identified director diversity characteristics.

Senator Menendez prefaced his questions regarding diversity to the panel by noting that the SEC’s 2009 amendments to Regulation S-K, the same one’s addressed by the updated C&DIs, did not define the term "diversity." Heather Slavkin Corzo, director of Capital Markets Policy at AFL-CIO and senior fellow at Americans for Financial Reform, told the committee that diverse corporate leadership begets greater corporate diversity and that more diverse companies tend to enjoy better investment performance.

Thomas Quaadman, executive vice president at the Center for Capital Markets Competitiveness within the U.S. Chamber of Commerce, observed that some business lag on diversity issues while others have done well. Quaadman said the best practices set forth in the Menendez-Meeks bills could potentially spur slower companies to do more on diversity. The Chamber of Commerce recently praised the Menendez-Meeks bills for avoiding quotas and providing for private sector consultation.

The SEC’s 2009 rule amended Item 407(c) of Regulation S-K to require companies to explain how they consider diversity in identifying board nominees. The adopting release also cited public comments that suggested corporate diversity disclosures would allow investors to better evaluate corporate culture and related governance practices. The SEC said other comment letters suggested that diversity can lead to better financial performance.

With respect to not defining "diversity," the 2009 release said the following: "We recognize that companies may define diversity in various ways, reflecting different perspectives. For instance, some companies may conceptualize diversity expansively to include differences of viewpoint, professional experience, education, skill and other individual qualities and attributes that contribute to board heterogeneity, while others may focus on diversity concepts such as race, gender and national origin. We believe that for purposes of this disclosure requirement, companies should be allowed to define diversity in ways that they consider appropriate. As a result[,] we have not defined diversity in the amendments."

Angels. Perhaps a prefatory remark on a somewhat different topic (human capital) made later in the hearing by Sen. Mark Warner (D-Va) could also function to set up the discussion of angel investors. According to Sen. Warner, 20th century finance can be characterized as having produced too much labor and not enough capital; by contrast, 21st century finance has, so far, produced the opposite scenario of an abundant capital supply but too few qualified laborers.

Catherine Mott, CEO of BlueTree Capital, suggested in her opening remarks that capital issues for angel investors are a bit more nuanced than the abundant capital theory might imply. In her view, the supply of capital on America’s east and west coasts is sufficient, but the rust belt and other areas of middle America face a dearth of capital. Angel investors, said Mott, provide $25 billion in investments to far more companies than do traditional venture capital firms, although angel investments to individual companies tend to be on a much smaller scale.

Mott said two bills under consideration would aid angel investors: the Helping Angels Lead Our Startups (HALOS) Act (H.R. 79S. 588) and the Fair Investment Opportunities for Professional Experts Act (H.R. 1585). Both bills were part of JOBS Act 3.0 in the last Congress.

The HALOS Act would help to clarify the legal status of demo days events. Mott said the bill could eliminate confusion over whether these events are general solicitations. In reply to questions from Sen. Patrick Toomey (R-Pa), Mott explained that many start-ups choose to conduct offerings under Securities Act Rule 506(c) to be on the safe side. The Jumpstart Our Business Startups (JOBS) Act of 2012 amended Rule 506 to allow for both traditional Regulation D offerings and Regulation D offerings with general advertising and general solicitation. The potential problem with the Rule 506(c) variant is the need for companies to verify the accredited investor status of investors. Senator Toomey had asked whether, assuming the legislation he plans to re-introduce with Sen. Kyrsten Sinema (D-Ariz) becomes law, an investor would still have to be an accredited investor in order to participate in demo days events. (Mott answered "Yes.)

Mott also said she backed the Fair Investment Opportunities for Professional Experts Act, although with one caveat. The bill would expand the definition of who may be an accredited investor to include certain professionals who have the educational and work experience to become involved in risky investments. However, Mott noted that the legislation also would subject the numerical accredited investor thresholds to periodic inflation adjustments, which she said could cause some accredited investors to lose their accredited investor status. Mott suggested that this result could be avoided if the legislation was amended to include "hold-harmless" or "grandfathering" provisions.

Insiders. One of the first financial bills passed by the House in the new Congress focuses on curbing abuses in Rule 10b5-1 plans used by corporate insiders to trade company stock without running afoul of the SEC’s anti-manipulation rules. House Financial Services Committee Chairwoman Maxine Waters (D-Cal) and Ranking Member Patrick McHenry (R-NC) reintroduced the Promoting Transparent Standards for Corporate Insiders Act (H.R. 624), which passed the full House by a vote of 413-3 in January.

Senators Chris Van Hollen (D-Md) and Deb Fischer (R-Neb) recently introduced the Senate version of the bill. "This bipartisan legislation will help ensure that corporate insiders are following the same rules as everyone else. By studying and modifying SEC Rule 10b5-1, the SEC can make changes that will ensure this rule can’t be used by individuals to shield themselves from liability when they do trade on insider information. I urge action on the bill without delay," said Van Hollen in a press release.

In reply to multiple questions from Sen. Van Hollen, Slavkin Corzo expressed support for the bill. By contrast, Quaadman was more cautious, although he conceded that "insider trading hurts everybody." Quaadman also noted that the Chamber of Commerce did not comment to the House prior to passage of the Promoting Transparent Standards for Corporate Insiders Act in January.

Moreover, Sen. Van Hollen observed that the bill, as drafted, would allow the SEC to engage in rulemaking after conducting a study. However, the senator floated the possibility of altering the bill text to require the SEC to obtain evidence regarding Rule 10b5-1 abuses before it could engage in rulemaking.

Proxy advisers. Senator Thom Tillis (R-NC) inquired about regulating proxy advisory firms. Lawmakers’ concerns about these firms arise from the dominance of two major proxy advisory firms and the potentially excessive reliance by smaller funds on proxy advisers which, in some lawmakers’ view, can result in robo-voting based on proxy advisers’ recommendations that smaller funds cannot verify due to the lack of resources to conduct independent research.

In the last Congress, two legislative options emerged. A more comprehensive bill (H.R. 4015) sponsored by Rep. Sean Duffy (R-Wis) would have given public companies an unprecedented look behind the scenes at how proxy advisers make their recommendations. By contrast, a more tailored bill (S. 3614) sponsored by Sen. Jack Reed (D-RI) would have provided for some regulation of proxy advisers. Within the past year, the SEC accomplished on its own part of what the House bill would have required by withdrawing two no-action letters regarding the use of proxy advisory firm recommendations (see, Egan-Jones Proxy Services, May 27, 2004 and Institutional Shareholder Services, Inc., September 15, 2004).

In reply to questions from Sen. Tillis, Quaadman addressed the differences between the House and Senate versions of proxy adviser regulation. Specifically, Quaadman said the Senate bill needed stronger language regarding conflicts of interest, fiduciary duties, and on how proxy advisers make recommendations.

Private equity firms. Senator Brown had begun the day’s questioning by asking Slavkin Corzo whether there is enough transparency in private equity markets. Slavkin Corzo explained in her opening statement that the private equity field employs five million U.S. workers and that pensions are heavily invested in private equity firms but at a significant cost. In reply to Sen. Brown, Slavkin Corzo suggested that the SEC could use its authorities to expand disclosures currently required on Form ADV and Form PF to capture more information about private equity firms.

Senator Catherine Cortez Masto (D-Nev) later revived the private equity line of questions. Specifically, Sen. Cortez Masto wanted to know about how leveraged buyouts are used by private equity to develop portfolios of operating companies. Slavkin Corzo explained that many of these deals are accomplished with very little cash and often leave the targeted operating companies laden with debt. From Slavkin Corzo’s view, this may be fine during good economic times, but can result in private equity firms’ operating companies cutting workers and limiting pensions when the economy falters.

Slavkin Corzo also said none of the bills being considered by the Senate Banking Committee would address transparency at private equity firms. For example, she said more could be done to ensure disclosure of the fees and expenses paid by investors to general partners at private equity firms and payments by operating companies to private equity firms. Slavkin Corzo also said disclosure about the performance results at private equity firms is lagging.

Companies: BlueTree Capital; AFL-CIO; Americans for Financial Reform

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