In his first public speech as SEC Chair, Jay Clayton outlined for the Economic Club of New York eight principles that he aims to guide his tenure as Chair. In discussing these principles and some ways in which he plans to put them into practice, Clayton seemed to stress the need to focus more intently on the various costs of regulatory compliance—in dollars, in time, in effort, in complexity and in economic impact. In particular, Clayton drew attention to a reduction in the number of public companies in recent years—a “roughly 50% decline in the total number of U.S.-listed public companies over the last two decades”—attributing the decline at least in part to the expansion of disclosure requirements, in some cases beyond materiality. To address this issue, he asserted, the SEC “should review its rules retrospectively” from the perspective of the cumulative effect of required disclosure, not just each incremental slice. Finally, he noted that the SEC “has several initiatives underway to improve the disclosure available to investors, “ including implementation of recommendations contained in the SEC staff’s Report on Modernization and Simplification of Regulation S-K (see this PubCo post). According to Clayton, the staff “is making good progress on preparing rulemaking proposals based on this report….”
Clayton began his remarks with an easy one: each tenet of the SEC’s three-part mission—(1) to protect investors, (2) to maintain fair, orderly, and efficient markets, and (3) to facilitate capital formation—is critical; together, they remain the SEC’s “touchstone.” In addition, the SEC will assess its performance of its mission by reference to the long-term interests of “the Main Street investor. Or, as I say when I walk the halls of the agency, how does what we propose to do affect the long-term interests of Mr. and Ms. 401(k)? Are these investors benefitting from our efforts? Do they have appropriate investment opportunities? Are they well informed? Speaking more granularly: what can the Commission do to cultivate markets where Mr. and Ms. 401(k) are able to invest in a better future? I am confident this is the right lens for our analysis; and the one the American people would want the Commission to use.”
Clayton also confirmed his belief that the materiality- and disclosure-based regulatory approach of the SEC (as opposed to merit regulation) was the right one for the SEC to continue to follow and, as result, the SEC “should continue to strive to ensure that investors have access to a well-crafted package of information that facilitates informed decision-making.” He also commended the other aspects of the SEC’s regulatory architecture, including regulation of SROs and various other market participants as well as the anti-fraud enforcement regime.
With regard to regulatory changes, Clayton emphasized the cumulative impact of new disclosure requirements. He observed that incremental changes “may not seem individually significant, but, in the aggregate, they can dramatically affect the markets. For example, our public company disclosure and trading system is an incredibly powerful, efficient, and reliable means of making investment opportunities available to the general public. In fact, this disclosure-based regime has worked so well that we—not just the SEC, but lawmakers and other regulators—have slowly but significantly expanded the scope of required disclosures beyond the core concept of materiality.” While regulators and lawmakers have justified those changes “often based on discrete, direct and indirect benefits to specific shareholders or other constituencies,” Clayton suggested that the severe decline in U.S.-listed public companies “forces us to question whether our analysis should be cumulative as well as incremental. I believe it should be. As a data point, over this period, studies show the median word-count for SEC filings has more than doubled, yet readability of those documents is at an all-time low.” Acknowledging that many factors drive the decision to go public, Clayton nevertheless argued that “increased disclosure and other burdens may render alternatives for raising capital, such as the private markets, increasingly attractive to companies that only a decade ago would have been all but certain candidates for the public markets. And, fewer small and medium-sized public companies may mean less liquid trading markets for those that remain public. Regardless of the cause, the reduction in the number of U.S.-listed public companies is a serious issue for our markets and the country more generally. To the extent companies are eschewing our public markets, the vast majority of Main Street investors will be unable to participate in their growth. The potential lasting effects of such an outcome to the economy and society are, in two words, not good.”
SideBar: At meetings of an SEC advisory committee and an SEC-sponsored forum, participants promoted a different view of the causes underlying the decline in public companies. Several indicated that the decline largely reflected acquisitions and delistings, as well as the significant extension of the timeframe to IPO; now, according to one participant, there is more concern with forcing companies to go public too early, and less mature companies tend not to be on the receiving end of calls from investment banks, as they may not yet be considered to be the caliber of company necessary to satisfy current market expectations.
One panelist reported that, when a number of CFOs were asked why they would decide not to go public, at the top of the list was the need to maintain decision-making control. In the private market, another panelist suggested, companies and investors have a kind of unspoken “pact” about long-term strategy. But, said one panelist, the rise of hedge-fund activism in tech and other product-cycle-driven public companies—a relatively recent phenomenon—has fueled concerns among founders and other management that they will be hampered in pursuing long-term strategic goals by activists with short-term perspectives. These companies fear that activity that may have significant long-term payout, but a near-term adverse price impact (e.g., M&A activity, change in product strategy, substantial investment in R&D), will draw scrutiny and intervention from hedge-fund opportunists.
At the bottom of the CFO list of reasons not to go public was the burden of regulatory compliance. As one academic on the panel explained, while regulatory cost has been the dominant narrative, that narrative ignores the impact of deregulation of private-capital raising—it’s now much easier not only to raise private capital (e.g., changes to Reg D) but also to stay private (e.g., changes to the Exchange Act registration threshold). With low interest rates, debt has also been an attractive option for funding in lieu of an IPO. In addition, markets have provided more opportunities for liquidity through secondary trading of privately held shares. The panelist also argued that private companies enjoy the benefit of information asymmetry relative to public companies, which are subject to much more significant disclosure requirements. Changes in the market were also cited as a cause for the decline, including the growth of passive index funds. (See this PubCo post.)
Clayton also urged that the SEC must keep up with the disruptions of technology “to ensure that our rules and operations reflect the realities of our capital markets,” as well as to exploit the opportunities that technological disruption provides. For example, the SEC now applies “sophisticated analytic strategies to detect companies and individuals engaging in suspicious behavior.” However, the SEC should not ignore the costs—of systems, personnel, legal advice and adaptation to regulatory changes—that companies incur in building systems of compliance to implement regulatory change; “[s]hareholders and customers bear these costs, which is something that should not be taken lightly, lest we lose our credibility as regulators.”
With respect to rulemaking, the SEC obtains public input and performs rigorous economic analyses in both proposing and adopting rules; however, Clayton argues, the SEC “should not stop there. The Commission should review its rules retrospectively. We should listen to investors and others about where rules are, or are not, functioning as intended. We cannot be shy about being introspective and self-critical.”
In addition, Clayton suggested that the economic analyses conducted as part of the rulemaking process should also include the “practical costs” of demonstrating compliance. SEC rules, Clayton stressed, should be written clearly “so that those subject to them can ascertain how to comply and—now more than ever—how to demonstrate that compliance.” As an example of practical costs, Clayton looked at the requirement for CEO certifications; in performing its economic analyses, Clayton maintained, the SEC should take into account that, by imposing responsibility, these certifications will necessarily “be supported through the chain of command in a demonstrable manner. This can be an expensive practice that goes well beyond a prudent management and control architecture; when third parties, such as auditors, outside counsel, and consultants, are involved, the costs—financial costs and, in many ways more important, the cost in terms of time—can skyrocket. This may be the appropriate regulatory approach, and to be clear, in some areas I think it is. However, the Commission needs to make sure at the time of adoption that we have a realistic vision for how rules will be implemented as well as how we and others intend to examine for compliance.”
Finally, Clayton noted the importance of the SEC’s coordination with other federal, state and international regulatory bodies to ensure a “well-functioning regulatory environment.” For example, the regulatory scheme governing over-the-counter derivatives requires close coordination between the SEC and CFTC. In addition, cybersecurity requires coordination and information-sharing among financial regulators to react appropriately to cyber threats.
Clayton then highlighted several areas regarding implementation of these principles. With regard to enforcement, in addition to deploying SEC enforcement resources to root out fraud, Clayton commented on the need for “proportionality” in enforcement in connection with cybersecurity: “Public companies have a clear obligation to disclose material information about cyber risks and cyber events. I expect them to take this requirement seriously. I also recognize that the cyber space has many bad actors, including nation states that have resources far beyond anything a single company can muster. Being a victim of a cyber penetration is not, in itself, an excuse. But, I think we need to be cautious about punishing responsible companies who nevertheless are victims of sophisticated cyber penetrations. Said another way, the SEC needs to have a broad perspective and bring proportionality to this area that affects not only investors, companies, and our markets, but our national security and our future.”
With regard to capital formation, Clayton remarked that he has heard from many companies about the attractive alternative offered by the private markets and believes that the attractiveness of the public capital markets must be increased without adversely affecting the availability of capital from the private markets. The JOBS Act, he observes, has been instructive. By policy, the SEC has just extended to non-EGCs the process for confidential submission of draft registration statements, first permitted by the JOBS Act only to EGCs. (See this PubCo post and this PubCo post.) Interestingly, he also notes approvingly the JOBS Act’s phase-in provisions, permitting EGCs to comply with their reporting obligations gradually. (Will extension of those provisions to non-EGCs in IPOs be the SEC’s next step? That’s anyone’s guess.) Noting the “clear appeal” of these provisions to EGCs, Clayton expressed his hope that the extension of the confidentiality provisions would encourage private companies “to find the prospect of selling their shares in the U.S. public markets more attractive generally, and at an earlier stage in their development.”
He also reminded companies about the availability of Rule 3-13 of Reg S-X, under which companies can request modifications to their financial reporting obligations where they believe that the required disclosures are burdensome but not material to the total mix of information available to investors. Clayton encouraged companies to consider these requests “in connection with their capital raising activities,” and stressed that the “SEC staff is placing a high priority on responding with timely guidance.” Note that Rule 3-13 was also mentioned in the announcement extending the confidentiality provisions (see this PubCo post), which might imply that they really mean it. We’ll have to wait to see how that turns out.