This conference is part of the New Special Study of the Securities Markets (the “New Special Study”),[1] which is an ambitious effort to critically re-think how the securities markets should be regulated in the 21^st century. One important question to ponder is – if we were to start with a clean slate, would we design the securities laws in the same manner that we did nearly 90 years ago?

When the foundational securities laws were enacted in the early 1930s, there was a significant focus on the individual corporate issuer. Ideas such as the efficient market hypothesis and modern portfolio theory were not the widely accepted theories that they are today. The participation of retail investors in collective investment vehicles managed by financial professionals was significantly smaller. Today, it is not unusual for a retail investor, particularly those investors who are guided by financial professionals, to think more broadly about sector exposures, diversification, and uncorrelated returns with respect to their portfolios. The cost to execute trades has decreased dramatically. The securities markets are now more global in nature. But most importantly, the individual investors – who former SEC Chairman Jay Clayton liked to call Mr. & Mrs. 401(k) – are expected to provide for their own retirement by investing in securities, whether through a defined contribution plan, an individual retirement account or annuity, or a separately managed account.

I look forward to hearing the ideas that will come out of today’s conference, as well as the New Special Study. The original Special Study was published nearly sixty years ago.[2] I hope that the New Special Study will generate insights that are still relevant sixty years from now.

One theme of this conference is the general decline in the number of public companies over the past twenty-plus years. This trend directly affects a key part of the Commission’s mission – facilitating capital formation. In 1996, the number of companies listed on a U.S. stock exchange was slightly over 8,000.[3] By 2019, that number had fallen by nearly 50%.[4] I will discuss two aspects of this decline: (i) the factors contributing to the decline and how we can reverse the trend, and (ii) how the decline and outdated regulations adversely affect individuals’ ability to build wealth through investments.

Factors Contributing to the Decline and Reversing the Trend

The universe of public companies is driven by two events: initial public offerings (“IPOs”), the process of becoming a public company, and de-listings, the process of ceasing to be a public company. In the decade between 1990 and 2000, there were 4,194 IPOs by U.S. operating companies.[5] In the two decades from 2001 to 2021, there were only 2,276 IPOs.[6] As a securities attorney in private practice from 1995 to 2004, I saw first-hand the ups and downs of the IPO market and the burst of the dot-com bubble.[7]

There are a number of potential factors for the decline in IPOs. For instance, public companies may have acquired private companies before their potential IPO. Well-known examples include Google’s acquisition of YouTube and Facebook’s acquisitions of Instagram and WhatsApp. Another factor may be regulatory burdens. As with any business decision, private companies balance the benefits of being a public company – including liquidity for their shareholders, a potentially higher profile, and the ability to issue publicly-traded stock as employee compensation and as currency for acquisitions – against the costs of being a public company. While the Commission does not dictate market conditions, it can encourage capital formation by promulgating rules that: (i) are grounded in financial materiality and (ii) adequately consider smaller public companies’ ability to pay for the compliance costs.

Disclosure Rules Should Be Grounded in Financial Materiality

The Commission’s current regulatory agenda includes climate change, human capital, cybersecurity, and share repurchases, among other topics.[8] While some of these issues may be important to particular investors, the Supreme Court has held that materiality turns on an objective standard of the reasonable investor.[9] However, for the rulemakings where the Commission has issued proposals, the required disclosure is often one-size-fits-all and prescriptive. The disclosure requirements do not appear to be rooted in whether a reasonable investor would consider the information important in his or her decision to invest in a company’s stock. Receiving comments from market participants and the public on whether the Commission’s proposed rules sufficiently considered materiality is very important, and the Commission should evaluate and address any comments as part of any final rule.

When investing in securities, nearly all investors would agree that financial factors can affect their investment returns. Accordingly, there can be a reasonable investor standard for financial factors of quantitative or qualitative importance. However, it can be more difficult to reach consensus on disclosure without an apparent financial impact. This is because there may be significant differences among investors’ views of the importance of any given non-financial factor. As a result, it may be difficult to establish a reasonable investor standard for non-financial factors. The costs of providing such disclosure, however, are quite real.

When the Commission’s disclosure rules move away from financial materiality, they potentially impose significant costs on companies to produce the disclosure but provide limited or no use to a reasonable investor making an investment decision. To the extent that disclosures that are not financially material are added at the whims of the Commission, companies, over time, will face a collection of immaterial topics that will need to be disclosed and that will be subject to litigation. The costs to prepare such disclosure and defend any litigation will likely be passed on to the companies’ investors in the form of lower investment returns or to their customers in the form of higher prices. Such costs may also disincentive private companies from going public. Moreover, the mere possibility that new, burdensome and immaterial disclosure requirements may be imposed in the future could similarly cause private companies to think twice about going public.

Regulatory Burdens on Smaller Public Companies

The decline in public companies and IPOs has been more pronounced among smaller companies. From 1998 to 2017, the percentage of listed companies with less than $100 million in revenue decreased by approximately 60%.[10] Between 1990 and 2000, the percentage of IPOs involving a company that had less than $100 million in revenue in the trailing twelve months was 72%.[11]Since 2001, that percentage has declined to 55%.[12] Unsurprisingly, smaller companies with less revenue and less gross profit have fewer resources to pay for the increasing compliance costs of being a public company.

In 2007, the Commission consolidated the scaled disclosure requirements for smaller companies in Regulation S-K and introduced the term “smaller reporting company.”[13] Initially, a company qualified as a smaller reporting company based solely on its public float, if it had one.[14] If it did not, then a company qualified based on its revenues.[15] In 2020, the Commission revised the qualification requirements to include a revenue test if the company’s public float is less than $700 million.[16] In that situation, a company qualified as a smaller reporting company if it has less than $100 million in revenues.[17] A company could also qualify as a smaller reporting company if its public float is less than $250 million.[18]

Public float measures the value of the public’s investment in a company. It does not measure a company’s ability or resources to pay the attorneys, accountants, consultants, and internal staff to prepare Form 10-Ks, proxy statements, and other filings or to otherwise comply with the Commission’s disclosure rules. Instead, a test based on revenue or gross profit, either in addition to, or in lieu of, public float is better suited to determine whether a company can qualify for the ability to provide scaled disclosure. Gross profit may be more appropriate than revenue because it somewhat neutralizes the impact of the company’s industry and better reflects the company’s ability to pay its “below the line” compliance costs from a financial statements perspective. The Commission should further consider how companies can qualify as a smaller reporting company. Additionally, the starting point for any disclosure rule should be to allow for some degree of scaled disclosure for smaller reporting companies.

To further reduce compliance burdens, smaller reporting companies should, by default, have delayed compliance dates of at least one year on any new disclosure rule. This allows smaller companies to benefit from the legal, consulting, and accounting work received by larger companies on new rules. These new rules can be complex and raise issues not clearly addressed in the rulemaking. Professionals will typically spend most of their time analyzing the rule and drafting the required forms and disclosures in the first year after a rule is effective. Accordingly, the compliance costs in the first year are likely the highest. If smaller public companies can benefit from implementation efforts by larger companies, then smaller companies might be able to significantly reduce their compliance costs associated with new rules.

Less Access to Growth-Stage Companies by Main Street Investors

The decline of IPOs indicates that companies, and especially smaller companies, no longer see them as a cost-effective method of raising capital. Instead, IPOs have largely been used by more mature companies as liquidity events for their insiders, including founders and venture capital investors. This trend is concerning. Additionally, as IPOs have declined, so has the pool of potential growth-stage investments available to Main Street investors. The result is that Main Street investors – but not wealthy investors or venture funds – lose out on the ability to participate in the potential upside associated with some growth-stage companies and the diversification that investments in such companies can provide. We need to re-think how Main Street investors can have exposure to growth-stage companies that go beyond efforts to force those companies to undertake some form of public offering. So long as the burdens of being a public company remain significant, limiting companies’ ability to raise capital in the private markets, or otherwise increasing the costs to be a private company, will not result in them going public. Rather, such restrictions could prevent new companies with innovative ideas from being started in the first place.

Many private companies raise capital by relying on Rule 506(b), which is a safe harbor for the Section 4(a)(2) private placement exemption from registration. The Commission adopted Rule 506(b) and the concept of accredited investors in 1982.[19] An individual can qualify as an accredited investor if he or she satisfies one of two financial tests. First, his or her income exceeds $200,000, or $300,000 jointly with the individual’s spouse, in each of the two most recent years with expectation for the same in the current year.[20] Second, his or her net worth, or joint net worth with the individual’s spouse, exceeds $1 million, excluding the individual’s primary residence.[21]

In 2020, the Commission expanded the accredited investor definition to include holding a Series 7, 65, or 82 license.[22] In expanding the accredited investor definition, the Commission recognized that relying solely on financial thresholds as an indicator of financial sophistication is not ideal because it may restrict access to investment opportunities for individuals who are able to evaluate the risks of an investment based on their knowledge and experience, but lack the income or wealth. Moreover, it seemed inconsistent to allow a person subject to a best interest or fiduciary standard to recommend the purchase of an investment to a client, but to not allow that person to purchase for himself or herself.

However, it is worth considering whether there are alternatives to the binary “all or nothing” approach to accredited investors introduced more than forty years ago. For instance, if a person earns $200,001, that person can invest an unlimited amount into a single private offering. Yet, if that person makes a dollar less, he or she cannot invest in any private placement limited to accredited investors. To provide investment exposure to growth-stage companies for Main Street investors, consideration should be given to allowing an individual to invest a certain percentage of his or her income or net worth in one or more private companies during a year. The Commission has previously used this concept for crowdfunding. In such offerings, a company can sell to any person if the aggregate amount of securities sold to such person by all companies in reliance on the crowdfunding provisions during the prior 12-months does not exceed a certain percentage of the person’s income or net worth.[23] We may want to also consider the role, if any, that financial professionals and collective investment vehicles might play in providing exposure to growth-stage companies for Main Street investors.

A financial threshold for accredited investor qualification based solely on income or net worth amounts can be problematic for other reasons. First, it does not account for cost of living differences throughout the country. For example, a person living in Manhattan with an income of $200,001 can maintain the same standard of living in Cleveland for slightly over $82,000.[24] If he or she is able to maintain the same, or have a better, standard of living making less than $200,001 in Cleveland, shouldn’t that person be able to invest a portion of his or her income in growth-stage companies? Furthermore, companies seeking capital may be more likely to be located in cities where they have access to that capital. If most individuals who qualify as an accredited investor live in relatively higher-cost and higher-income coastal cities, then that may also concentrate startups in those same areas and away from more rural parts of the country.

Second, a financial threshold qualification based solely on income or net worth disadvantages younger people. Younger people may not have had the time or opportunities to exceed a $200,000 income level or build up more than $1 million of net worth. However, younger people may have less need for liquidity, longer investment horizons, and greater risk tolerance as compared to a person nearing retirement – and who may be more likely to satisfy the income or net worth test. Denying younger people the opportunity to invest a portion of their income or net worth in growth-stage companies, particularly as fewer of them go public, may have adverse consequences for their wealth accumulation over the long run.

Third, a financial threshold qualification based solely on income or net worth ignores the investment diversification opportunity that private, growth-stage companies can provide. Due in part to their limited liquidity and relatively short operating history, these companies are often a high-risk, high-reward investment. However, that type of investment may be appropriate in a diversified portfolio. The need for diversification applies regardless of whether an individual is an accredited investor. By denying this diversification opportunity, the Commission may be undercutting its investor protection mission.

Conclusion

To conclude, the answer to fewer companies going public is not to overregulate the private markets through prescriptive disclosure and governance requirements. The Commission should create a regulatory environment that appropriately balances the costs and benefits associated with any required disclosures, while considering its investor protection mission. This starts by ensuring that the Commission’s disclosure regime mandates information only if it is financially material. Additionally, recognizing the fewer resources available to smaller companies, the Commission should consider providing more opportunities for scaled disclosure and staggered compliance dates.

Founders and venture funds should not be the only ones that have the opportunity to invest in private, growth-stage companies and financially benefit from IPOs. We ought to collectively think whether there are ways that Main Street investors can also gain access to these investments.

Thank you to the Columbia Law and Business Schools’ Program in the Law and Economics of Capital Markets for hosting this conference and conducting the New Special Study of the Securities Markets. There will be four thoughtful panels today, and I look forward to the discussions being ultimately reflected in the New Special Study’s final report.

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