SEC Officials Discuss General Solicitation Ban and 500-Shareholder Limit at Hearing on Capital Formation

Chair Mary Schapiro, in testimony before the House Oversight and Government Reform Committee, advised that the Commission is committed to seeing if the 500-shareholder limit which triggers an issuer’s periodic filing obligation still makes sense. The SEC intends to do a thorough and rigorous analysis of the threshold, which she said will require the gathering of economic data and analysis. The SEC needs to understand the characteristics of these companies and whether their shareholders hold their securities in record name or in the name of the beneficial owner.

Schapiro said the staff review of the 500-shareholder test is front and center on the Commission’s agenda. The staff is also reviewing the general solicitation ban as part of its overall review of capital formation regulations. Corporation Finance Director Meredith Cross noted that the staff is likely to recommend that the Commission issue a concept release on the general solicitation ban.

Section 12(g) of the 1934 Act, which was enacted in 1964, requires companies with more than $10 million in assets whose securities are held by more than 500 owners to file annual and other periodic reports with the SEC. The reports are then available to the public through the SEC’s EDGAR database. While the $10 million threshold has been increased incrementally over the years from the $1 million level initially set in 1964, the 500 shareholder requirement has never been updated.

In her written remarks, Schapiro noted that, shortly after the enactment of Section 12(g), the Commission adopted rules to define the terms “held of record” and “total assets.” The definition of held of record counts only persons identified as owners on records of security holders maintained by the company in accordance with accepted practice. Schapiro explained that the Commission used this definition to simplify the process of determining the applicability of Section 12(g) by allowing a company to look to the holders of its securities as shown on records maintained that it maintains or that are maintained on its behalf, such as records maintained by the company’s transfer agent.

Schapiro observed that the securities markets have changed significantly since the enactment of Section 12(g). Since the definition of held of record was put into place, a fundamental shift has occurred in how securities are held in the U.S. Today, the vast majority of securities of public companies are held in nominee or street name. Brokers that purchase securities on behalf of investors typically are listed as the holders of record. One broker may own a large position in a company on behalf of thousands of beneficial owners, but since the shares are all held in street name they are counted as being owned by one holder of record.

In response to concerns from Rep. Pat Meehan (R-PA) about carving sweat equity out of the 500-shareholder count, Cross noted that, pursuant to an SEC rule adopted in 2007, options granted to employees do not count towards the 500 shareholder number. In addition, the staff has provided relief so that restricted stock units provided to employees do not have to be counted towards the 500 shareholder trigger. Cross said the review of the Section 12(g) limit will include the question of whether employees should be counted at all. The SEC has heard that the 500 shareholder limit is an impediment to capital raising. The review will consider whether 500 is the right number and whether the counting is being done correctly to include the right people in the count.

Rep. Patrick McHenry (R-NC) asked why there is a class of accredited investors. Cross explained that sometime in the early 1980s, a determination was made that investors with $1 million in net worth can fend for themselves and do not need the protection of the securities laws, which allows them to participate in unregistered private offerings. Cross said the staff will consider whether accredited investors should be eliminated from the count as part of its review.

In response to a question from ranking member Elijah Cummings (D-MD) about which principles would guide the staff review of the general solicitation ban and the 500-shareholder rule, and what factors would be considered, Cross said that, with regard to the 500-shareholder limit, the staff would like to know the investor makeup and the characteristics of these companies. For example, the staff will look at whether they are trading in the dark market or are engines of growth in need of capital. It may turn out that different answers are needed for different companies, such as companies bumping up against the 500 limit which cannot get additional capital. There may have to be different tests for different types of companies, according to Cross.

With regard to the general solicitation ban, Cross said that the staff wants to be confident that, if the ban is eliminated and private offerings are allowed through publicity and advertising, the group to whom the securities are sold is the group that does not need the protection of the federal securities laws and that they are, in fact, accredited investors. If they do not need protection, it may make sense to make it easier to reach them, she said.

In offerings that are exempt from registration under Section 5, the extent to which an issuer may communicate publicly depends on the requirements of the exemption upon which the issuer is relying. One of the most commonly used exemptions is Section 4(2) of the 1933 Act, which exempts transactions by an issuer that do not involve any public offering. Currently, an issuer that wishes to rely on Section 4(2) or its safe harbor, Rule 506 of Regulation D, is generally subject to a ban on the use of general solicitation or advertising to attract investors for its offering. The ban was designed to ensure that those who would benefit from the safeguards of registration are not solicited in connection with a private offering.

Rep. Trey Gowdy (R-SC) raised the question of whether the general solicitation ban is constitutional. He noted that the ban implicates a fundamental right. It must be under the strictest level of constitutional scrutiny and must be as narrowly drawn as possible. If the SEC concludes that the general solicitation ban does not pass constitutional muster, Gowdy said there is precedent for the SEC not to enforce the ban. Schapiro replied that, the SEC would seek to change it rather than not enforce the ban. She acknowledged that the ban limits speech to some extent and said the staff study will examine that issue. A First Amendment analysis will be part of the study. Schapiro said the issue is whether the protection of investors is appropriately balanced with the need for companies to effectively communicate in order to raise capital.