Remarks at the Los Angeles County Bar 55th Annual Securities Regulation Seminar

Good morning. Thank you for the invitation to address the 55^th Annual Securities Regulation Seminar of the Los Angeles County Bar Association (LACBA). It is nice to return to being an in-person event after having been conducted virtually for the past several years-even if we are not in the traditional venue of the Biltmore Hotel.

This gathering is special to me. After graduating law school in 1995 and working a year in private practice in Washington, D.C., I came back to my Southern California roots and spent the next seven years as a transactional attorney a couple of blocks over with O'Melveny & Myers LLP. I ended up renting an apartment for that entire time on Bunker Hill and I was one of the few lawyers who would walk to work.[1] My thinking was that I would rather commute to fun on the weekends than commute every day to work on the freeway.

During this period, I joined LACBA and eventually became part of its committee responsible for organizing this seminar. Also serving on the committee was John Hartigan of Morgan, Lewis, and Bockius, who is a proud alumnus of the SEC's Division of Enforcement and a past leader of the Association of SEC Alumni.

Staff from the SEC's Pacific Regional Office (now the Los Angeles Regional Office) and the California Department of Corporations (now the California Department of Financial Protection and Innovation) participated with the LACBA committee. As a result, I came to know the SEC's regional directors in Los Angeles, starting with Randall Lee, Rosalind "Roz" Tyson, and Michelle Layne, each of whom I subsequently worked with when I was on the SEC's executive staff. The DOC was often represented by Gabriel Eckstein, who would later join the SEC's Division of Corporation Finance back in Washington, D.C. Today, Gabriel serves as one of my counsels.

Sensing a theme here? The road to Washington often runs through L.A. But more importantly, it familiarized me with the operations and tremendous efforts of regulators on a state and regional basis.

Today, I would like to focus my remarks on three interrelated matters: the benefits of properly functioning capital markets; the challenges to capital formation for smaller private companies; and the concerns with regulation by enforcement. These remarks reflect my individual views as a Commissioner and not necessarily the views of the full Commission or my fellow Commissioners.

Properly Functioning Markets - Where Ideas Meet Funding

As the number of securities rules and regulations grows ever larger, we must keep in mind the purpose for that regime: it is to support and advance the capital markets. Properly functioning markets facilitate capital formation and provide a powerful catalyst to our economy.[2] This means increased gross domestic product, jobs creation, and innovation. Capital markets accomplish this by funding ideas that result in new goods or services, which contribute to our prosperity.

Of course, not all ideas succeed. The capital markets do not guarantee success, but rather offer the opportunity to be a success or a failure. It is up to market participants-not the government-to determine that. This results in decentralized decision making that tends to be immediate and responsive.[3] In other words, the marketplace efficiently allocates capital based on supply and demand set by investor perceptions and expectations. This is far superior to central government planning and it is why the capital markets can play a much more dynamic role in business formation that is separate from the banking system.

For capital markets to function properly they must share the following characteristics. First, there must be a cost-effective regulatory framework that provides investors with the relevant disclosure needed to make informed investment decisions. But a disclosure framework works only when the information disclosed is material and accurate. It must be coupled with regulations that require market intermediaries to provide their services with honesty and integrity and remove bad actors and fraudsters from the marketplace.

Second, capital markets must be open to anyone with a good idea. Barriers to entry function as barriers to prosperity.[4] Barriers to entry also limit competition. In the capital markets, barriers can be imposed when overly restrictive regulations limit capital raising or capital market intermediation.

Government regulators, however, are not expert investment managers. Developing talent and spotting investment opportunities are areas where the private sector has a comparable advantage. And do not let higher education credentials fool you as some of America's largest companies were started by college dropouts operating from their garages, but were able to obtain funding from investors willing to take certain risks. For ideas to flourish, we must cultivate a regulatory culture that effectively allocates risk and encourages innovation, leading to increased prosperity for society.

Capital Formation in the Private Markets

Capital, however, can be difficult to obtain. For many entrepreneurs and companies, a public offering of securities pursuant to a registration statement filed with the SEC is not practical. Thus, these companies need to find investors that are willing to accept the risk that accompanies an investment in a startup company. But small companies face an additional challenge-our complex regulatory regime for private offerings.

To raise capital without filing a registration statement, an issuer has a number of potential exemptions available. These include the statutory private offering exemption, Regulation D, Regulation A, Regulation Crowdfunding, rule 504, the intrastate exemption, and the coordinated exemption in Regulation CE, which works in conjunction with Section 25102(n) of the California Corporations Code.[5] Each exemption has its own set of requirements. While having choices is normally a good thing, even seasoned securities lawyers often need a chart to keep track of the differing requirements of each exemption.[6]

To improve the complex regulatory regime for exempt offerings, one should first consider streamlining the number of exemptions. For example, rather than having the current laundry list of exemptions, we should have offering exemptions tailored to common capital raising scenarios. This was recently illustrated to me when a partner at a small venture capital firm asked "what is the exemption for the friends and family round?" As you might surmise, there is not an easy answer to that question.

Exemptions for common capital raising scenarios means that the requirements to raise capital for the early "friends and family" round of common stock should be different from the requirements for the pre-IPO, late-stage funding round of preferred stock. Similarly, the conditions for an operating company seeking money for working capital should be different from the conditions for a pooled investment vehicle seeking subscriptions for the fund.

Currently, the most commonly used exemption is Regulation D's rule 506(b) under the Securities Act. Its popularity is due both to its requirements and to market practice. Between July 1, 2022 and June 30, 2023, over 17,000 offerings relied on rule 506(b) to raise about $259 billion in proceeds.[7] The second most commonly used exemption, under Regulation D's rule 506(c), was relied on for slightly more than 2,200 offerings and raised about $16 billion in proceeds.[8] Other exemptions from registration under Regulation A, Regulation Crowdfunding, and rule 504 accounted, in the aggregate, for just over 1,500 offerings, raising about $2 billion in offering proceeds.[9]

To rely on the exemption under rule 506(b), a company can sell to accredited investors and up to 35 non-accredited investors.[10] But selling to non-accredited investors means a company must provide disclosure equivalent to that required in a Regulation A offering.[11] Due to this requirement, companies relying on rule 506(b) often exclude participation by non-accredited investors.[12] In fact, about 95% of rule 506(b) offerings did not include non-accredited investors. Yet when they desire to do so, non-accredited investors cannot invest in private companies, even if they are able to assess the risks and rewards of making such investments.

The accredited investor definition requires a natural person to exceed $1 million net worth or $200,000 annual income thresholds.[13] These thresholds have not changed since they were introduced in 1982, other than to exclude the value of the principal residence for the net worth calculation. In 2020, the accredited investor definition was expanded to include individuals holding a Series 7, 65, or 82 license.[14]

While the net worth and annual income tests were revolutionary at the time of their introduction, the Commission should consider whether there are new approaches that should be taken. One approach is using a sliding scale that would allow any individual to invest at least a modest amount in private investments over the course of a year.[15] This approach contrasts with the current "all or nothing" accredited investor definition, which prevents a person from investing in an offering if he or she falls one dollar short of the net worth or income threshold.

The approach also recognizes that investments in private, venture-stage companies that have a higher risk and a higher reward, may be beneficial as part of an investor's diversified portfolio. These investments may be particularly suitable for those investors that have less need for liquidity, a longer investment horizon, and greater risk tolerance. It also avoids the paternalistic policies of the current accredited investor definition. Preventing investors that do not meet the current income or net worth thresholds from investing in private offerings under the guise of investor protection, may ultimately harm those individuals by depriving them of investment opportunities and could reduce their ability to manage risk through diversification.

By limiting certain investors from private offerings, the accredited investor definition could also be viewed as a form of merit regulation, with the government substituting its risk tolerance for that of investors.

Investing in private offerings can carry a high level of risk. They may have unproven business models and there may be little liquidity for the security. But we should not equate the risk of unsuccessful business ideas with fraud-and we should not impose draconian restrictions as a remedy. This will cause far greater harm by preventing legitimate businesses from starting than eliminating bad actors from the marketplace.

Regulation D, including the accredited investor definition, remains on the Commission's rulemaking agenda.[16] The Commission should consider how changes to Regulation D will impact investors and entrepreneurs, particularly those from historically underrepresented backgrounds.

While on the subject of rulemaking, I would like to turn to a related topic-regulation by enforcement.

Regulation by Enforcement

Regulatory provisions should convey a sense of expected standards of conduct by those persons who are subject to them. Our rules are often principles-based, because it is impossible to create a rule for every potential situation. Thus, an important function that a regulator can play is to provide clarity to market participants applying the rules to particular facts and circumstances. When the Commission resorts to enforcement actions before providing needed clarity, it is setting regulatory policy through enforcement actions and in the process creating new definitions or interpretations.

Rulemaking generally requires that a federal agency engage in a process called "notice and comment." This consists of giving notice of the proposed rulemaking and soliciting comment from interested parties on the proposed rules.[17] But enforcement actions are not subject to notice and comment, which denies the public a chance to provide input. The only persons in the room are SEC enforcement staff and the prospective defendants. Moreover, enforcement actions are not well-suited to providing guidance, since they are post hoc in nature and do not provide affected persons with the opportunity to comply.

One area to highlight for regulation by enforcement is cryptocurrencies and digital assets. There has been a lack of regulatory guidance in the crypto space. Instead, regulatory policy has been promulgated through settled enforcement actions and positions taken in litigation. In my view, it would have been preferable for the Commission to have considered proposing rules or issuing interpretive guidance before resorting to enforcement.

One key issue to resolve is whether the cryptocurrency or digital asset at issue is a security. Making this determination can be difficult for both practitioners and the courts, who must often analyze under the investment contract test described in the SEC v. W.J. Howey Co.[18]decision. That decision held that an investment contract means a contract, transaction, or scheme whereby a person invests money in a common enterprise and is led to expect profits from the efforts of the promoter or a third party.

Rather than proactively contributing to the creation of a body of law regarding cryptocurrencies and digital assets by setting definitional parameters ex ante, the SEC is instead pursuing a case-by-case approach through enforcement actions. As a result, it will take years to reach any type of legally binding precedent, as cases will need to wind their way through the judicial system before reaching a court of appeals. That type of delay is not helpful to either investors or innovators.

Conclusion

Our capital markets require a cost-effective regulatory framework that allows investors to make informed investment decisions, and facilitates capital formation for anyone with an idea. This supports a vibrant start-up ecosystem that funds ideas leading to new goods and services, which will accelerate economic growth, create jobs, and increase our standard of living. Such economic growth will be needed to support the record amount of public debt that has been issued over the last four years. Overly paternalistic policies in the regulation of private markets will only serve as barriers to investors and entrepreneurs, depriving society of economic growth while giving less meaning to investor protection.

Capital markets can thrive when they are accompanied by regulation that sets clear expectations on disclosure and standards of conduct so that law-abiding market participants can comply. Instead of using enforcement actions to set regulatory policy, the SEC should provide greater transparency with respect to how it applies its own rules, especially in developing areas like cryptocurrencies and digital assets.

Thank you for listening and enjoy the rest of the Seminar.

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