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THE SECs ROLE IN CAPITAL FORMATION:

HELP OR HINDRANCE?

HEARING

BEFORE THE

SUBCOMMITTEE ON

OVERSIGHT AND INVESTIGATIONS

OF THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

FIRST SESSION

JUNE 26, 2001

Printed for the use of the Committee on Financial Services

Serial No. 107–29

(

(II)

HOUSE COMMITTEE ON FINANCIAL SERVICES

MICHAEL G. OXLEY, Ohio, Chairman

JAMES A. LEACH, Iowa

MARGE ROUKEMA, New Jersey, Vice Chair

DOUG BEREUTER, Nebraska

RICHARD H. BAKER, Louisiana

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware

PETER T. KING, New York

EDWARD R. ROYCE, California

FRANK D. LUCAS, Oklahoma

ROBERT W. NEY, Texas

BOB BARR, Georgia

SUE W. KELLY, New York

RON PAUL, Texas

PAUL E. GILLMOR, Ohio

CHRISTOPHER COX, California

DAVE WELDON, Florida

JIM RYUN, Kansas

BOB RILEY, Alabama

STEVEN C. LATOURETTE, Ohio

DONALD A. MANZULLO, Illinois

WALTER B. JONES, North Carolina

DOUG OSE, California

JUDY BIGGERT, Illinois

MARK GREEN, Wisconsin

PATRICK J. TOOMEY, Pennsylvania

CHRISTOPHER SHAYS, Connecticut

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

GARY G. MILLER, California

ERIC CANTOR, Virginia

FELIX J. GRUCCI, JR., New York

MELISSA A. HART, Pennsylvania

SHELLEY MOORE CAPITO, West Virginia

MIKE FERGUSON, New Jersey

MIKE ROGERS, Michigan

PATRICK J. TIBERI, Ohio

JOHN J. LAFALCE, New York

BARNEY FRANK, Massachusetts

PAUL E. KANJORSKI, Pennsylvania

MAXINE WATERS, California

CAROLYN B. MALONEY, New York

LUIS V. GUTIERREZ, Illinois

NYDIA M. VELA ́ ZQUEZ, New York

MELVIN L. WATT, North Carolina

GARY L. ACKERMAN, New York

KEN BENTSEN, Texas

JAMES H. MALONEY, Connecticut

DARLENE HOOLEY, Oregon

JULIA CARSON, Indiana

BRAD SHERMAN, California

MAX SANDLIN, Texas

GREGORY W. MEEKS, New York

BARBARA LEE, California

FRANK MASCARA, Pennsylvania

JAY INSLEE, Washington

JANICE D. SCHAKOWSKY, Illinois

DENNIS MOORE, Kansas

CHARLES A. GONZALEZ, Texas

STEPHANIE TUBBS JONES, Ohio

MICHAEL E. CAPUANO, Massachusetts

HAROLD E. FORD JR., Tennessee

RUBE ́ N HINOJOSA, Texas

KEN LUCAS, Kentucky

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

WILLIAM LACY CLAY, Missouri

STEVE ISRAEL, New York

MIKE ROSS, Arizona

BERNARD SANDERS, Vermont

Terry Haines, Chief Counsel and Staff Director

SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS

SUE W. KELLY, New York, Chair

RON PAUL, Ohio, Vice Chairman

PETER T. KING, New York

ROBERT W. NEY, Texas

CHRISTOPHER COX, California

DAVE WELDON, Florida

WALTER B. JONES, North Carolina

JOHN B. SHADEGG, Arizona

VITO FOSSELLA, New York

ERIC CANTOR, Virginia

PATRICK J. TIBERI, Ohio

LUIS V. GUTIERREZ, Illinois

JAY INSLEE, Washington

JANICE D. SCHAKOWSKY, Illinois

DENNIS MOORE, Kansas

STEPHANIE TUBBS JONES, Ohio

MICHAEL CAPUANO, Massachusetts

RONNIE SHOWS, Mississippi

JOSEPH CROWLEY, New York

WILLIAM LACY CLAY, Missouri

(III)

C O N T E N T S

Page

Hearing held on:

June 26, 2001 .................................................................................................... 1

Appendix:

June 26, 2001 .................................................................................................... 27

WITNESSES

TUESDAY, JUNE 26, 2001

Devine, Hon. Donald J., Vice Chairman, American Conservative Union ........... 8

Halpern, Gregory, Chairman and CEO, Circle Group Internet, Inc.,

Mundelein, IL ....................................................................................................... 6

Steinkirchner, James A., Co-Chairman, National Small Public Company

Leadership Council, Washington, DC ................................................................. 10

Sweeney, Joan, Chief Operating Officer, Allied Capital Corporation,

Washington, DC ................................................................................................... 5

APPENDIX

Prepared statements:

Kelly, Hon. Sue W. ........................................................................................... 28

Oxley, Hon. Michael G. .................................................................................... 30

Gutierrez, Hon. Luis V. .................................................................................... 32

Devine, Hon. Donald J. .................................................................................... 55

Halpern, Gregory .............................................................................................. 52

Steinkirchner, James A. ................................................................................... 69

Sweeney, Joan M. ............................................................................................. 40

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Kelly, Hon. Sue W.:

‘‘SEC Sleuths Beyond the Law?’’, Washington Times, June 26, 2001 .......... 29

Devine, Hon. Donald J.:

Written responses to questions from Hon. Sue W. Kelly .............................. 67

Gutierrez, Hon. Luis V.:

Executive Summary of ‘‘Modernizing the Regulation of Business Development Companies’’ .......................................................................................... 34

Sweeney, Joan M.:

Written responses to questions from Hon. Sue W. Kelly .............................. 49

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THE SEC’S ROLE IN CAPITAL FORMATION:

HELP OR HINDRANCE?

TUESDAY, JUNE 26, 2001

U.S. HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON OVERSIGHT AND INVESTIGATIONS, COMMITTEE ON FINANCIAL SERVICES, Washington, DC.

The subcommittee met, pursuant to call, at 9:35 a.m., in room

2128, Rayburn House Office Building, Hon. Sue W. Kelly,

[chairwoman of the subcommittee], presiding.

Present: Chairwoman Kelly; Representatives Cantor, Tiberi,

Gutierrez, Inslee, Moore, S. Jones of Ohio, and Shows.

Chairwoman KELLY. This hearing of the Subcommittee on

Oversight and Investigations will come to order. Without objection,

all Members’ opening statements will be made part of the record.

This morning, we are holding this subcommittee’s first hearings

on the issue of capital formation. Capital formation has been an

implicit responsibility of the Securities and Exchange Commission

since it was first created. In 1996, securities laws were amended

by the National Securities Market Improvement Act to explicitly

state that capital formation is an important responsibility of the

Securities and Exchange Commission. In 1995, in testimony before

the former Subcommittee on Finance and Hazardous Materials,

former Securities and Exchange Commission Chairman Arthur

Levitt stated, and I quote: ‘‘Existing law already requires the agency to give consideration to efficiency, competition and capital formation concerns whenever the Commission is required to make a

public interest determination.’’ Securities markets are the critical force behind our Nation’s

economy. It has been one of my long-standing goals in Congress to

eliminate obstacles to capital formation in those markets, especially for small businesses.

I am greatly distressed by the concerns that fundamental regulatory obstacles are inhibiting the flow of capital to and investor

participation in the small and middle market business sector. This

hearing is the subcommittee’s first step in determining how we in

Congress and the Commission can effectively eliminate those obstacles for all participants in our Nation’s capital markets.

Capital is the life blood of business, and efficient access to capital

is a crucial ingredient to a strong, growing economy. We have the

responsibility to closely examine the different structures the Securities and Exchange Commission has crafted for businesses to access the markets and to determine if these are practical and effective.

2

Businesses should be able to devote their energies toward their

customers and not be delayed by unnecessary requirements that no

longer reflect the realities of our new economy. In the Securities

and Exchange Commission’s work to ensure investor protection and

efficient capital formation, I believe the best service they can provide is to ensure transparency in disclosures and ensure fair play

through their enforcement division.

A September 2000 General Accounting Office report found that

the estimated average total cost needed to conduct a small business

IPO during 1994 to 1999 was about 10 percent of the total offering

proceeds, while the average total cost for a large business IPO was

about 8 percent. The Securities and Exchange Commission has a

few different processes for smaller businesses and smaller offerings

which were designed to reduce the regulatory burden for these

issuers. We will examine the effectiveness of some of these processes here today.

In addition, in 1996, the Securities and Exchange Commission

was given general exemptive authority to allow them to waive specific requirements on a case-by-case basis in order to give the Securities and Exchange Commission additional flexibility in assisting

businesses’ access to the capital markets. I intend for this subcommittee to take a close look at how that authority is being used.

Before us today, we are honored to have a distinguished panel

of witnesses to share their thoughts and observations with us on

these issues. I thank all of you for taking the time out of your busy

schedules to spend some time discussing these issues with us

today, and I would let Members of the subcommittee and staff

know that it is my intention to enforce the 5-minute rule, and I

would appreciate their cooperation in this.

I am now going to recognize my friend from Chicago, Mr. Gutierrez, distinguished Ranking Member for this subcommittee, for his

opening statement.

Mr. Gutierrez.

[The prepared statement of Hon. Sue W. Kelly can be found on

page 28 in the appendix.]

Mr. GUTIERREZ. Well, good morning, Chairwoman Kelly, and

thank you for holding this hearing. I would like to welcome all of

the panelists who have come here today to share their views on the

important issue of capital formation.

The mission of the U.S. Securities and Exchange Commission is

to protect investors and promote efficient capital formation. Challenges facing the Commission in accomplishing its mission are no

different today than the challenges that existed in 1933 when the

U.S. Federal Government first began regulating the issuance of securities. The premise of the 1933 Act is that full and fair disclosure

would most effectively promote efficient and fair functioning in the

process of capital formation.

We are here today to study and discuss possible changes to the

existing regulatory structure to facilitate capital formation for

small businesses and all market participants. Small businesses are

an important source of economic growth and creation; they account

for 50 percent of the gross domestic product and the majority of

new jobs.

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Access to capital is a critical issue for small businesses. Without

sufficient capital, small businesses are unable to develop new products and services or grow to meet new demands. Insufficient liquidity is frequently cited as a cause of small business failure. Small

firms are heavily dependent on bank float, trade credit and informal sources of financing such as personal savings, credit cards,

home equity loans and loans from family and friends.

Steps have been taken by both the Federal securities regulators

and State governments in an attempt to reduce some of the regulatory burden and costs for small businesses seeking equity capital

financing in the regulated securities market. One of the steps

taken by the Federal securities regulators has been simplifying

Federal registration of securities offerings and exempting certain

small businesses’ securities offerings from several requirements,

Regulation D, in an attempt to reduce the regulatory burden and

the cost for small businesses in equity capital formation.

One of these exceptions, Rule 504 under Regulation D, is intended to allow companies to raise seed capital. A company may

privately sell up to $1 million in securities in a 12-month period

to any investor without registration as long as there is no public

solicitation or advertising or resale of the share; and resale of the

share is restricted. A company may sell the same amount of securities using public solicitation if it has registered the securities in a

State that requires: one, public filing of a registration statement

with the State and; two, the delivery of disclosure documents to investors.

From 1992 to 1999, the Securities and Exchange Commission

dropped the State registration requirement from Rule 504. They

then experienced a substantial increase in the number of complaints they received from investors who have been defrauded by

operations selling shares under Rule 504. The Securities and Exchange Commission found that fraudulent operations had developed that would go to States that had no substantive registration

requirements and sell securities to residents in those States. This

resulted in substantial incidence of fraudulent sales to the general

public of securities for which no information was publicly available.

Another step taken by the Securities and Exchange Commission

to minimize the regulatory costs of raising equity capital has been

permitting small businesses’ issuers to use simplified, small business forms, so-called SB-1 and SB-2, in filing registration. Small

business issuers are those with less than $25 million in revenue in

the last fiscal year and outstanding stock of $25 million or less.

Even though these forms save an issuer up to approximately

$125,000 an average offering, small business issues are viewed unfavorably by many investment bankers because they are too small

in size to be profitable. Also, small offerings are commonly distributed by small investment banks that lack the market recognition

which can be an impediment to attracting investors.

These problems show that even though many positive steps have

been taken to help small businesses gain access to equity capital,

more needs to be done. By passing the capital promotion tools in

the National Securities Market Improvement Act in 1996, we

sought to enhance the Commission’s role in promoting capital formation and efficiency with the appropriate investor protections. It

4

is crucial then that the Securities and Exchange Commission balance the burden placed on small businesses against the purposes

of investor protections under the securities law.

I look forward to hearing all of the testimonies and thank you,

Madam Chairwoman, once again.

[The prepared statement of Hon. Luis V. Gutierrez can be found

on page 32 in the appendix.]

Chairwoman KELLY. Thank you very much, Mr. Gutierrez.

Mr. Cantor, have you an opening statement?

Mr. CANTOR. No, Madam Chairwoman.

Chairwoman KELLY. Mr. Tiberi.

Mr. TIBERI. No.

Chairwoman KELLY. Thank you.

Well, then, if there are no more opening statements, we will

begin with our first panel. Before us today we have Ms. Joan M.

Sweeney, the Managing Director and Chief Operating Officer for

Allied Capital. Before her work with Allied Capital, Ms. Sweeney

was an accountant with the Securities and Exchange Commission’s

Enforcement Division.

Next, we have Gregory Halpern, the Chairman and CEO for Circle Group Internet Incorporated. In 1998, Mr. Halpern distinguished Circle Group Internet by raising $2.5 million as the first

and only company to orchestrate a complete end-to-end Regulation

A offering over the internet without the assistance of outside brokerage.

In addition, we have Mr. Donald J. Devine, the Vice Chairman

of the American Conservative Union, who is the former Director of

the U.S. Office of Personnel Management, Grewcock Professor of

American Values at Bellevue University, a Washington Times columnist, a writer, and an Adjunct Scholar at the Heritage Foundation. And if you don’t mind, Mr. Devine, we are all enjoying this

column of yours that appeared in the newspaper today. And I am

going to, with your permission, sir, and the permission of the subcommittee, I am going to include this in the record. If anybody

hasn’t read this, you should get the Washington Times, take a look

at it.

Mr. DEVINE. Well, thank you.

Chairwoman KELLY. If you don’t have enough time today, at

least this clarifies your position, along with a very good cartoon.

[The article referred to can be found on page 29 in the appendix.]

Finally, we have Mr. James A. Steinkirchner, the Co-Chairman

of the National Small Public Company Leadership Council. Mr.

Steinkirchner is listed as an NSAD trader since 1996 and is currently the Vice President of McGinn, Smith & Company of Atlanta,

Georgia.

We thank you all for joining us here today to share your

thoughts on these issues. Without objection, your written statements will be made part of the record, and you will each be recognized now for a 5-minute summary of your testimony, and I would

like to begin with you, Ms. Sweeney.

5

STATEMENT OF JOAN M. SWEENEY, CHIEF OPERATING

OFFICER, ALLIED CAPITAL CORPORATION

Ms. SWEENEY. Thank you, Madam Chairwoman. Members of the

subcommittee, my name is Joan Sweeney, and I am the Chief Operating Officer of Allied Capital, a public business development

company. Today, I am pleased to share our thoughts about improvements to the Federal securities regulatory framework as it

impacts capital formation.

Allied Capital has invested in growing businesses for over 40

years. We operate the oldest SBIC license and we have financed

thousands of small businesses. We provide mezzanine debt and equity capital, and our portfolio today is just shy of $2 billion.

We constantly see challenges faced by companies seeking capital.

As a business development company, we are a successful conduit

for bringing public investment dollars to small businesses, but we

too are burdened with a cumbersome regulatory regime. I was a

member of the Securities and Exchange Commission’s Division of

Enforcement, and I fully support the Securities and Exchange

Commission’s role as ‘‘cop on the street.’’ However, the authority

and activities of the Securities and Exchange Commission staff

need a fresh look if the goal is to encourage capital formation as

well.

There are three areas I would like to discuss related to improving capital access. First, it is time to embrace the internet. Financial markets are moving at the speed of light and financial information is only a click away. The fact that the Securities and Exchange Commission does not consider information to be publicly

disclosed when it is presented on a company’s website seems out

of touch with the realities of the millennium. This is especially true

when online disclosure is required through EDGAR filings. We

need to think outside the box and outside the four corners of the

prospectus to come to a virtual prospectus that incorporates a company’s website.

Second, the Securities and Exchange Commission needs to challenge low value-add activity. Under a 70-year-old system, too much

of the Securities and Exchange Commission’s activity centers

around the review of registration statements. This is cumbersome

and low value-added. The law is the law, and the registrant and

their lawyers and the registrant’s underwriters and their lawyers

all know the law, are responsible for it and are liable with respect

to compliance with the law. Why, then, is a 30-day review period,

often undertaken by an unseasoned examiner, necessary? Legal

fees mount, often in response to questions raised only from a lack

of experience. More seriously, the delay of this process can result

in a missed market window.

The reality is, public offerings are not sold off registration statements. Plain English improves disclosure, but prospectuses are still

not read. The majority of public securities are sold to mutual funds,

and fund managers research far beyond the registration statement,

ironically, using the registrant’s website and the internet. To further the irony, individual investors use websites and internet chat

boards to get the real plain-English scoop. Why not focus staff time

on regulating information in channels that investors really use,

6

rather than allocating limited resources to the review of outdated

registration forms?

Third, there needs to be more staff time allocated to exemptive

orders and new rulemaking. There are many inefficiencies in the

system that could be readily fixed if the staff had the time and authority.

For instance, you may not be familiar with BDCs, such as Allied

Capital, and our role in capital formation. BDCs were created by

Congress 20 years ago to encourage the flow of public capital to

small, private companies. Yet today, the BDC industry is still barely visible. I believe this is largely because operating within the

cumbersome yoke of the 1940 Act discourages new entrants.

For example, efficient access to the public markets through integrated disclosure is not available to BDCs. Unlike other public

companies, we cannot use our Forms 10-K and 10-Q to update our

shelf registration statements. This situation is time consuming and

costly and, we believe, results from a mere oversight in the law

that could be easily remedied.

We submitted a letter to the staff in July of 1998 to address our

integrated disclosure issue by requesting a no-action position. After

3 years of waiting for their answer, last week we were told that

under the current regulatory framework, the staff could not grant

the relief we were seeking. Instead, we were told to pursue rulemaking, with no guarantee of immediate attention. We essentially

waited 3 years to learn we must pursue a different bureaucratic

process. This is clearly inefficient.

The staff needs to allocate its resources to foster capital formation through interpretive positions, exemptive orders and rulemaking. I am certain that if they had the time and authority to act,

we would not have waited 3 years to find ourselves back at square

one.

I believe the changes that I have suggested would improve capital formation as well as enhance investor protection.

Thank you.

[The prepared statement of Joan M. Sweeney can be found on

page 40 in the appendix.]

Chairwoman KELLY. I thank you very much Ms. Sweeney. I really appreciated reading your testimony last night as well. So we will

get into that more.

Now we move on to Mr. Halpern.

STATEMENT OF GREGORY HALPERN, CHAIRMAN AND CEO,

CIRCLE GROUP INTERNET, INC.

Mr. HALPERN. Madam Chairwoman, Members of the subcommittee, thank you for inviting me to this hearing. I am Greg

Halpern, founder and CEO of Circle Group Internet. We are a

funding and consulting source for emerging technology companies,

based in Mundelein, Illinois.

Now, I represent 21 million small business professionals who create half the jobs in America who are not here today, because today

is a work day and for them, every day is a work day. My written

testimony is going to address most of my issues in detail, but let

me summarize.

7

Small businesses like ours produce more than half of America’s

private gross domestic product. As you know, by 2005, we will create 60 percent of the new jobs in this country, and these figures

are provided by the United States Government so they are not

rhetoric, they are reality.

Small businesses struggle to succeed despite often unreasonable

and misguided regulations, taxes and very little representation. We

face regulations that make raising capital difficult, if not impossible. At today’s hearing our concern is with the Securities and Exchange Commission.

Now, the Great Depression, as we know, created the need for the

Securities and Exchange Commission, and it has served its purpose. Nearly a century later, however, the Securities and Exchange

Commission has failed to keep pace as markets and the global

economy have evolved. Now, I am not here to propose increased

limitations on the Securities and Exchange Commission’s power.

Let’s help the Securities and Exchange Commission continue its

mission and at the same time assist small business.

Today, the process to register with the Securities and Exchange

Commission is so time consuming, expensive and subjective that

many small businesses either drop out during registration or avoid

it altogether. The Securities and Exchange Commission regularly

fails to comply with the Act of the Congress, which we have talked

about, known as the National Securities Market Improvement Act

of 1996, which concerns competition, efficiency and capital formation in the Securities and Exchange Commission’s rulemaking activities.

Hundreds of companies retired from the Securities and Exchange

Commission’s registration process in 2000. The opportunities

missed by just these companies represented billions and billions of

dollars that could have gone toward jobs, the economy and tax dollars to the Treasury. Was the next Home Depot, Dell, or Yahoo

among them? We will never know.

Small businesses register their securities under Regulation SB.

The SB, as you know, stands for ‘‘small business,’’ and it is supposed to mean a much simpler and friendlier way to enter the capital market based on objective criteria. In reality, though, SB often

predisposes the staff against the very companies it is supposed to

be serving.

The Securities and Exchange Commission often mistakenly loses

sight of its simple, objective mission, which is to ensure full disclosure and then send the companies off to market. Instead, many

companies are drained needlessly of time, money and resources, answering endless rounds of questions and waiting for the slow process to resolve itself.

Another issue that affects many small businesses is the Investment Act of 1940, which requires public companies to hold no more

than 40 percent of their value in securities of other companies.

This hurts firms like ours, because as we fund other emerging companies and their securities increase in value, we find ourselves out

of compliance. This means we are becoming victims of our own success.

At the end of the day, this is not about the 1940 Act or Regulation SB, though; it is quite simply about the larger issues of the

8

Securities and Exchange Commission’s role in capital formation.

The Securities and Exchange Commission was told in the last century to support capital formation, and it really needs to learn how

to work with small businesses in this new century.

Small businesses need relief now. The processes are actually in

place; the Securities and Exchange Commission just needs to let

them work.

Additionally, I am proposing the creation of a department in the

Securities and Exchange Commission to be known as the Small

Business Advocacy and Liaison Office. This office should serve

small business ventures that require special assistance in reaching

the capital markets. It would fall under the Division of Corporate

Finance and represent the nineteenth office in the Commission.

The office would advise small businesses how to meet the regulations and requirements of the Securities and Exchange Commission. It would monitor processing of applications and provide quick,

reasonable responses. The office would establish a schedule to better prepare businesses for their Securities and Exchange Commission experience, and it would also respond with clear and concise

information regarding any difficulties or irregularities with its constituent applicant companies.

And finally, the Small Business Advocacy and Liaison Office

would provide an annual review of the Securities and Exchange

Commission rules and regulations related to all small business entities and make recommendations to Congress for changes in those

policies that may unfairly encumber small businesses.

I thank you, Madam Chairwoman and the rest of the subcommittee, for the opportunity to take a day off and come to Washington to discuss the concerns of 21 million of my fellow small business professionals. I know there is a genuine willingness on your

part to help and together we can solve these problems and get on

with the task of building our businesses, and the Nation as well.

Thank you.

[The prepared statement of Gregory Halpern can be found on

page 52 in the appendix.]

Chairwoman KELLY. Thank you very much, Mr. Halpern.

I am very sorry, having read your testimony, that your company

has had such a problem in dealing with simple things like phone

calls not even being returned by any kind of a Federal Government

agency.

Now, we turn to you, Mr. Devine.

STATEMENT OF HON. DONALD J. DEVINE, VICE CHAIRMAN,

AMERICAN CONSERVATIVE UNION

Mr. DEVINE. Thank you very much, and I would like to thank

you very much for holding this hearing.

I think it is a critical question as to whether the agencies and

the bureaucracy—and I used to be the chief bureaucrat for 4 years

as Director of the Office of Personnel Management—that they actually follow the law. This subcommittee and its predecessor have

gone through an enormous amount of activity to try to get the Securities and Exchange Commission to follow the law.

I think when the former Chairman and Mr. Oxley wrote the Securities and Exchange Commission and got its reply, the reply

9

clearly showed that the Securities and Exchange Commission did

not understand what it was supposed to do under the law—in order

to take into account its other obligations, other than fighting fraud,

which is certainly a very important obligation. But that is not the

only obligation under the very law under which they operate.

I think we saw this very clearly when they amended Rule 504,

under which small companies secured small amounts of capital. It

was a critical element in their raising capital. Effectively, the Securities and Exchange Commission took public companies out of the

regulated market so that they could raise small amounts of capital

with limited bureaucratic review. In my opinion, it is a sad situation, a public scandal really, that this critical legal avenue is not

open to small business anymore.

Several tables are in the formal testimony, but I have a larger

version here. You see what happened when the Securities and Exchange Commission adopted Rule 504. The market went up and up

and up, for years in fact. This is, in fact, the plot from one of these

automatic computer programs for it. I didn’t fit it in that line.

Now other things were happening. There were tax cuts and

things. I am not saying it is the only thing, but clearly that is what

happened after those initial Rule 504 reforms.

Now we see in a second chart what happened after the Securities

and Exchange Commission made the 1999 change. And this one

really amazed me when I looked at it, and again, the computer

fitted the lines. It is almost as if there is a perfect correlation. As

a former Professor at the University of Maryland and now at Bellevue University, I know this doesn’t happen very often. I was just

bowled over by it.

But the fact of the matter is that when the Securities and Exchange Commission rule went into effect on April 7th, 1999, the

market dropped. It was unstable during the whole period of the

OTC registration process. When the OTC registration process

ended, it dropped again enormously; and, at the same time, the

regular market kept going up. I had that on there too, but it is too

confusing to add it.

I have all of the details in my formal testimony here. But, to me,

that is the proof. The Securities and Exchange Commission is supposed to pay attention to capital formation. I think their former response to this subcommittee shows they do not.

As I tried to outline in detail in my testimony, the Rule 504 process did not find them taking capital formation into consideration.

The only specific amount they mentioned was a $30,000 registration fee, which is a very small part of costs. I estimate that cost

alone is about 10 percent, or $250,000, of an offering of about a

million dollars. I presented some GAO figures for higher offerings

in my formal testimony.

So I just can’t say how pleased I am that the subcommittee is

looking into this, that they are going to presumably question the

Securities and Exchange Commission and ask them why they

aren’t following the law. I recommend that you also apply consideration of capital formation to their rule for oversight of private exchanges, that the Securities and Exchange Commission try to find

a new way for public companies to use Rule 504 or a different rule.

It doesn’t matter what rule it is, but some way to raise capital.

10

Also, I would encourage giving more control to stockholders. They

are the ones that really can keep fraud from happening.

And that is my time. Thanks for having me.

[The prepared statement of Hon. Donald J. Devine can be found

on page 55 in the appendix.]

Chairwoman KELLY. Thank you very much, Donald Devine. We

appreciate very much hearing from you.

Next we have some more testimony that I read last night from

Mr. Steinkirchner. Mr. Steinkirchner, thank you so much for your

testimony; and thank you for appearing here today. Please proceed.

STATEMENT OF JAMES A. STEINKIRCHNER, CO-CHAIRMAN,

NATIONAL SMALL PUBLIC COMPANY LEADERSHIP COUNCIL

Mr. STEINKIRCHNER. I would like to thank Madam Chairwoman

Kelly and Ranking Member Gutierrez and other Members of the

subcommittee for the opportunity to testify on critical issues facing

small business.

I am testifying today as the Co-Chairman of the National Small

Public Company Leadership Council and on behalf of the small

business marketplace we represent.

The Leadership Council, based in Washington, DC., seeks to educate and inform Members of Congress about the economic contributions of small emerging growth companies. Although the Government has made great strides in the right direction, the Leadership

Council believes that more cost-benefit analysis needs to be conducted on how it affects small business before laws and regulations

are passed.

In my written testimony, I address 10 key issues affecting small

business. Today, I will address four.

In 1982, Mr. Devine covered the Rule 504-C exemption. In 1999,

the Government amended Rule 504 to a point where nobody would

really want to use it. Also, the Securities and Exchange Commission and the press have created a stigma relating Rule 504 to

fraud. I doubt very seriously if it ever will be used again in its current form.

Instead, my proposal would be to create a new Rule 509 offering.

It is kind of like a quasi-public offering. It would be available to

both public and private companies, be able to raise up to $10 million.

Some key points to address. Investor protections, I would mandate that an NASD underwriter would have to be used in this type

of offering, can advertise the offering, can use only line road shows,

use the modernization that Ms. Sweeney addressed earlier in her

testimony.

Abuses of the current short sale rules are depriving individual

investors of essential investor protections. They also are making it

more expensive for companies to raise capital.

Some possible solutions to the illegal short-selling abuses are:

apply the uptick rule to both the NASDAQ small cap and the bulletin board issues; develop a mechanism for tracking short sales;

identify 5 percent or more holders of the outstanding stock or 10

percent of the public float; and create a new Rule 13S which would

be filed with the Securities and Exchange Commission. Those that

have beneficial ownership must currently use a 13D if they earn

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over 5 percent. Why not make those holding substantial short positions report also?

Some other issues I would like to address are: one, minimum

stock price listing requirements for some of the exchanges. When

a company stock price approaches or drops below minimum listing

requirements, it actually fosters fraud and unethical practices by

imposing an artificial guideline in a free market mechanism. A

company’s management has limited options to keep itself from

being delisted. It could create artificial demand by issuing press releases, hiring promoters or reverse splitting its stock. All these efforts are usually offset or exceeded by the short sellers.

Another problem that we have in our industry right now is what

is called a ‘‘toxic convertible’’ or a ‘‘death spiral convertible.’’ These

instruments have exploded over the last 5 years from $274 million

to $3.2 billion last year. Private Investment in Public Equity, or

another name it is called, PIPE, deals have become a major source

of capital for public companies. PIPE deals do have their place in

the markets, but it is their offspring, the ‘‘toxic convertible,’’ that

needs to be regulated. In simple terms, the ‘‘toxic convertible’’ is a

private placement that enables investors to convert their securities

at a discount to the current market price usually with no floor as

to how low the conversion can go.

An investor who buys common stock of an issuer in a toxic convertible loses, on average, 34 percent of his investment 1 year after

a toxic convertible is issued. In the year 2000, there were 220 toxic

convertibles done, and only five were at a higher price than before

the offering. It is obvious the common stock investor is getting

burned by these convertibles.

Thank you. I would like to go into a little more. I guess I ran

out of time. I would like to thank the Leadership Council and

thank you.

Chairwoman KELLY. We thank you, Mr. Steinkirchner. You have

a little more time because we will ask you questions.

[The prepared statement of James A. Steinkirchner can be found

on page 69 in the appendix.]

Chairwoman KELLY. I would like to begin the questioning by

asking all of you one general question, and I want a very succinct

answer, please, because I, too, have a time limit.

My question is, I want to know how you think that we can use,

or you can use, the internet more effectively to get information

there to the Securities and Exchange Commission and to make the

disclosures. You have all mentioned the internet. There is a reason

that I am sure you want to do that. So, very quickly, if you could

all just chime in here. Thank you.

Ms. SWEENEY. I guess I will start.

I think the thing that we see, we invest in companies every day,

so we are an investor ourselves, is that you can use a company’s

website to do everything a registration statement does and in a

much more plain English, dynamic disclosure means. So why not

set out what are the disclosure requirements that the Securities

and Exchange Commission and the law requires and ask companies to comply with them by keeping that information updated on

a quarterly basis right on their own website?

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I don’t know if you have pulled down information from EDGAR

recently, but EDGAR is a very, very cumbersome system. There are

a lot of private sector systems like 10-K Wizard, and other things

that do a lot of things better than does EDGAR, but companies on

their own website are really the best at telling their own story. So

I think you use the website as the virtual prospectus.

Chairwoman KELLY. Thank you, Ms. Sweeney.

As you were talking about that, you brought up the issue of registration. I just want to quickly ask you one question about that.

Since you worked over there, is the registration process used by the

staff to leverage extract concessions from a registrant like on a related or an unrelated matter? Is that part of what is happening

with the registration process?

Ms. SWEENEY. I don’t think so. I think what it just simply is, is

cumbersome. I brought, just so you could see, Allied Capital’s registration statement. This is our Form N-2, OK? No one reads this.

It is impossible. Look at the depth of the print. I mean, what individual shareholder is going to pore through this? They are not

going to.

What is the problem in the registration statement process, is

that it is an outdated medium of communication. Plain English,

didn’t really do anything. It made it so you could maybe read it,

but still there are tables in here that defy the average shareholder

to understand. I mean, it doesn’t make any sense. So I think that

is the real problem. I don’t think necessarily that even the staff understands what is required in a registration statement.

Chairwoman KELLY. Thank you. I want to go on and ask my first

question on down, but thank you very much.

I have more questions, but we have been called to a vote. I am

going to finish my questions, then I am going to take a break, and

with the subcommittee’s indulgence we will be back here—can I

give everybody just 10 minutes to come back, or do you want a

standard 15? We will be back in 10 minutes, but please answer the

question.

Mr. HALPERN. The current question?

Chairwoman KELLY. The first question.

Mr. HALPERN. Sure. Certainly, I would second everything Ms.

Sweeney said, and I would add a couple of fundamental things.

As you had said, we had the distinction of doing the first endto-end stock offering on the internet, and I actually thought that

it was quite a novel approach, we worked closely with the staff of

the Securities and Exchange Commission to clear it and we

thought it could be an outstanding model for companies to use in

the future.

What we did was, we had the risk disclosure shown first; and it

was a simple two pages of risk disclosure that the user could read.

After that, they were forwarded on to the downloading of the prospectus; and, finally, if they passed through that, they could see

the marketing material and then subscribe online. It was done

quite efficiently, in a matter of a week’s time we raiseed several

million dollars. I thought it would be a great opportunity for small

businesses to have access to capital markets.

But the other caveat that I would put in there, which camps on

to what was just said, is that if people were to read the registration

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statements cover to cover and really understand it, they probably

wouldn’t invest in anything. So that is the reality of it. I think that

the idea of full disclosure is an important one, because it basically

says, if we have junk, we are telling you we have junk, and you

can make a decision if you like junk and you want to invest in it.

But, beyond that, the process becomes entirely subjective. Because

if somebody doesn’t like any aspect of the business, then it becomes

a subjective process, and that can go on for some extended period

of time.

Chairwoman KELLY. Thank you.

Mr. Devine.

Mr. DEVINE. Well, these people in Government deal much more

in this on a practical level. In my experience in the Government,

it is very hard for the bureaucracy to do anything new to keep up.

That is why, in general, the fewer regulations the better. And certainly it just makes fundamental sense to bring the Securities and

Exchange Commission into the 21st century here and use the internet. It is just so elemental, common sense.

Chairwoman KELLY. Mr. Steinkirchner.

Mr. STEINKIRCHNER. The Securities and Exchange Commission

has already issued quite a few no-action letters; and Mr. Halpern,

I believe, received one relating to the internet. The problem here

is it has taken so much time to get the Securities and Exchange

Commission no-action letters, and basically what they do is they

test the waters with these Securities and Exchange Commission

no-action letters. This started way back in 1995, and we are already in the year 2001, and we still don’t have a general ruling on

internet road shows, things of this nature, offering prospectuses online, signature requirements online. You could go on and on.

I believe right now that in the public arena you will find that

probably 90-something percent have a website right now. So it is

not like people don’t have access to these companies.

I think you could get the private market to embrace the internet

also by providing financials, and Mr. Devine says I would like to

see them get into the 21st century.

Chairwoman KELLY. Good. That is wonderful. Thank you very

much for answering and being, all of you, all four of you, being very

clear about it.

We are going to take a break so that everyone can go to the floor

and vote, and we will see you back here in 10 minutes.

[Recess.]

Chairwoman KELLY. Mr. Gutierrez.

Mr. GUTIERREZ. Thank you very much.

Professor Devine, the dramatic growth of the internet has provided a new medium for fraudulent operators to reach a much larger audience than was ever possible over the telephone. Mr. Devine,

you obviously disagree with the approach that the Securities and

Exchange Commission has taken to prevent fraud and ensure that

adequate public information is available to investors about small

business insurers of securities. What would you do to protect investors from fraud in these markets?

Mr. DEVINE. Well, it is not so much me that thinks that. It was

Congress in 1996 that passed the law saying that beside taking

into account questions of fraud, that the Securities and Exchange

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Commission should also consider efficiency, competition, and capital effects. And that is what I think they need to do to make a balanced judgment, as the law requires them to do. I am not sure that

the internet does, in fact, open things up to more people than the

telephone. I would suspect more people have a telephone than have

a computer or are hooked up to the internet. So, I don’t think it’s

a question of broader opportunities for fraud. I think, in their rulemaking, as opposed to their enforcement action, they need to take

into account these other activities.

The Securities and Exchange Commission has had—and they

haven’t asked for any major changes in the fraud statutes and regulations themselves—they have sufficient powers to pursue fraud.

So I don’t think it is a question of neglecting fraud. When it happens, they should go after it and prosecute it, and they do and they

should continue to do that. I just think it is a question in their

rulemaking. They should consider these other important things,

and not so much because I say it—although I happen to agree with

it—but it also happens to be the law.

Mr. GUTIERREZ. Mr. Halpern, if you could just follow up on what

Mr. Devine just said and answer the question. And also, your company has successfully raised capital over the internet in 1998, but

dropped out of the registration process in the year 2000. Could you

tell us a bit more about how you were successful in 1998 and why

you dropped out in the year 2000 and what has changed and

maybe talk a little bit concerning the question I raised with Mr.

Devine?

Mr. HALPERN. Yes, sir. Well, to follow on to what Mr. Devine, I

think, put well, there are many good rules already to protect investors. Yet many investors still lose most, if not all their investments.

I mean, we legalize gambling, for example, and let people go lose

all of their money. And in essence, you know, investing in the market is a form of legalized gambling. But again, there are many good

rules to protect the investors. What I am calling for in that score

is if we want to protect investors, then let’s protect all investors,

including those who have already invested in small business. You

see, there is this space in small business where a lot of people don’t

want to invest because it is risky. And most of these newer businesses, these emerging businesses get their humble beginning from

anywhere from credit card financing to their friends and family to

get started. Well, after that it is hard for a lot of investors to want

to participate, because they don’t see where the liquidity is going

to come from.

One of the ways, a tremendous stimulation to the economy, is to

give investors a greater degree of confidence in these emerging

companies, which is—our acronym is advanced small business. It

is a business which is growing much faster than businesses used

to. In other words, in 3 to 5 years the company is going to hit $100

million. It couldn’t do that, you know, 10 years ago. It could only

hope a much smaller fraction of that. So I am saying let’s protect

all investors.

In my case, I already had almost 500 investors in the Regulation

A offer I conducted successfully online, and I thought—I think you

might have just stepped out when I started to say that I thought

that was a very novel process. I was very proud of fact that we had

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done it online because it worked so well. And I thought, wouldn’t

this be novel in a lot of small businesses that have a difficult time

in getting access to the capital markets. And with Rule 504 and all

the OTC things that you hear that are so negative, wouldn’t it be

great if they had a novel process the way Ms. Sweeney said, to use

the internet to produce commerce and investment capital in their

business at a minimal amount of effort and a minimal amount of

cost. We could essentially create a lot more opportunity for our society. But, you know if we will give investors the confidence to invest in early stages that they are going to achieve liquidity, I believe we are going to dramatically stimulate the economy, and I

think new investment capital in that space is sadly lacking.

So the other thing I wanted to say about any negativity about

protecting the investor, there are a lot of investor protections. But

we must remember that while we can’t legislate risk out of existence, we can legislate the future of small business out of existence.

And in my own process, all that really happened, Congressman

Gutierrez, was that when we did the Reg A we said this is very

novel. And by that time the Securities and Exchange Commission

was looking at a lot of companies raising money online and saying

‘‘this is making us nervous.’’ We didn’t see that it would really

work. And so when we went back in the process with another selfunderwriting, which was the SB2, the small business regulation, I

firmly believe, although again I don’t blame anybody. I feel that it

would almost be a relief for the Securities and Exchange Commission if it had an easier way to cope with small emerging businesses. I don’t believe they have a way to cope with it. So they

have to move you from point A to point B until someone else says,

well, you release it. Well, no I don’t want to. You do it. And I think

that is a huge problem.

Mr. GUTIERREZ. Well, following up on that, I would like Ms. Joan

Sweeney to wrap up, because I am over my time. We have an Executive Summary of ‘‘Modernizing the Regulation of Business Development Companies.’’ I would like to ask that this be entered into

the record of this hearing and ask Ms. Sweeney when she thinks

the report will be done.

[The information can be found on page 34 in the appendix.]

Chairwoman KELLY. Without objection.

Mr. GUTIERREZ. And give us just a brief overview of the report

and when you think it will be done.

Ms. SWEENEY. Sure. We, Allied Capital, are a member of something we call the Committee for Modernization of BDC Regulation.

And there are a handful of BDCs out there who also share our

views that it is just very difficult to operate within the 1940 Act.

I don’t know how much time any of you have spent with the 1940

Act, but it is a very cumbersome piece of legislation. The subcommittee is now circulating a report within the committee to

make sure that everyone agrees that these are the issues, things

that need to be done, very, very simple things to modernize BDC

regulation. I touched on one in my testimony, which is integrated

disclosure.

I mean, that is somewhat of a no-brainer when you get down to

it. That is just simply allowing us to do what other companies can

do on their Form S-3 registration statement. The other things that

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we are looking to do is, for instance, break down some of the barriers with respect to affiliated transactions.

The Investment Company Act of 1940 is set up to prevent bad

external managers from doing bad things to shareholders of mutual

funds. That is a noble purpose and there are bad fund managers.

For instance, if you know, the management company is external;

it could have cross purposes with the fund. A business development

company is usually internally managed. There is no way the business development company is going to disadvantage itself dealing

with itself. It is the same entity.

And there is a whole cadre of rules within Section 57 of the Investment Company Act of 1940 that is set up to essentially prevent

an activity that really wouldn’t happen in any operating company.

So there are various things like that that are really simple fixes

to the operation that we think could encourage the flow of public

company capital to small businesses.

You know, the hardest thing about investing in a small business—Mr. Halpern touched on it—isn’t even necessarily the risk, it

is the liquidity. You are a company with a market cap of less than

$100 million. People will not invest in you simply because you are

illiquid. You know getting in and getting out of the stock can cause

problems. BDC has fixed that. If you look at Allied Capital, we are

about a $2.2 billion market cap BDC. We have huge liquidity. People can invest in Allied Capital, get a nice 8 percent dividend because we pass our earnings to our shareholders. Come in and out

of us, while we put money into illiquid companies. Our portfolio to

date is about 125 companies that have gotten their investment capital from public investors, but in a liquid format. So we think BDCs

are a great thing that should be really studied and embraced.

Mr. GUTIERREZ. Thank you. Thank you very much.

Chairwoman KELLY. We turn now to Mr. Shows.

Mr. SHOWS. No.

Chairwoman KELLY. No questions?

Mr. SHOWS. No.

Chairwoman KELLY. All right. Since there seems to be a bit more

to be discussed here I think we will go into—with the indulgence

of the panel—a second round of questioning, if that is all right.

Ms. Sweeney, you had mentioned a couple of things that I—one

thing in particular I would like to ask you about. I would like to

know how the regulatory process can be used to impose unduly

burdensome requirements on a company. Can you give us some examples of that?

Ms. SWEENEY. Sure. You know, I think, as I say, there are some

pretty simple things and probably the most burdensome process

any public company can undertake, whether it is in the initial public offering or in registering securities a second time, third time,

fourth time around, is the registration process. That is probably

where the average public company touches the Securities and Exchange Commission most frequently. That process is so antiquated

and outdated, and it causes huge delays. This is where you will get

questions on whether we should be using the word ‘‘such’’ items

versus ‘‘certain’’ items. OK, that is a comment. To spend the legal

time addressing that comment adds little value, if any, to the registration process.

17

I don’t know if any of you have spent an all-nighter at a financial

printer with an army of lawyers responding to a litany of staff

questions, largely in plain English. But I can tell you it adds a lot

of cost and burden to the process.

The other thing is, I don’t think necessarily the level of examiner

you get within the Division of Corporation Finance, or other divisions within the Securities and Exchange Commission, really have

the business savvy to understand the magnitude of some of their

information requests. For instance, we took a company private in

the fourth quarter of 2000. This was a company that really couldn’t

access the public markets, unloved, low market cap. It is our job

as a BDC to fund these companies. We took it private and we had

to do it through a merger. We actually issued Allied Capital stock

to complete the transaction, a very innovative way of using a BDC

capital to do something good for another public company. In that

process we were floored to find out that, because it was a merger

in form and a going private transaction, that there was a requirement in the rules that we had to actually file and disclose board

presentations that were done to effect the merger. We are talking

about a company’s trade secrets, the internal works of the board

of directors, as they evaluated why the merger was good, taking

their projections and filing it with the public. Now, that is kind of

stepping over the bounds of disclosing trade secrets that most likely really wasn’t necessary for those shareholders to make an educated decision on the proxy that they were being presented to decide, whether or not they were getting an adequate premium over

their market price. There is fairness opinions done by the investment banks. Shareholders can make their own decisions. Shareholders can call management. Understand this: There is no need to

take the inner workings, you know, that is pretty confidential information of the board of directors, and file it. So those are the types

of things that are just huge, time consumers and also maybe overreaching in terms of disclosure through kind of a registration process.

Chairwoman KELLY. I thank you very much, Ms. Sweeney. One

other question that I had was the question about the shelf registration. You mentioned in your testimony that there is a question in

my mind about the fact that you can’t use information that is already provided to the public through the different forms, the 10-

Ks and the 10-Qs. Could you speak about that just a little bit,

please?

Ms. SWEENEY. Yes. This is what we think is pretty much an

oversight for BDCs. BDCs are required to file 1940 Act forms. So

we re-file our registration statement on a Form N-2 every time we

post new quarterly information. So, once a quarter we have to update this thing, and fully, all the way through, and refile it and

subject ourselves to staff review, once a quarter. If we were CocaCola, any other company out there, public company, that doesn’t

file under the 1940 Act, that files their shelf on something called

an S-3, which most companies file, they don’t have to do that. They

put their S-3 up at the Securities and Exchange Commission and

they are allowed to have integrated disclosure. Form 10-Qs and

Form 10-Ks update their shelf registration statements. So we have

a kind of mechanism that doesn’t work, where companies that file

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on N Forms aren’t allowed to do that. Companies that file on S

Forms are. A very simple fix would allow those on N Forms to do

the same thing.

So this is the thing we have been waiting on for about 3 years

to try to solve.

Chairwoman KELLY. Well, good. I am glad we at least had a

chance to discuss it. Thank you.

Mr. Steinkirchner, I wanted to just quickly ask you one question,

and if you would just fill me in on your thoughts and the new Rule

509 legislation that you had proposed. Could you, sir, please pull

the microphone closer to your mouth so we can all hear you?

Thanks.

Mr. STEINKIRCHNER. OK. Rule 509 is actually a rebirth of Rule

504 almost. But it adds some more investor protections in there.

And basically what I wanted to do with Rule 509 is create a modernization type instrument where you could use online road shows,

put your financials up on the site, offer a prospectus all online, because using the internet is cost effective. I mean, it is just much

less costly to use the internet. So the Securities and Exchange

Commission has allowed it in certain circumstances and it has all

worked out relatively well. They haven’t revoked anybody’s Securities and Exchange Commission no-action letter, so I would say that

the online no-action letters that have been approved to date have

been working quite effectively.

But I also wanted to create a new investor class that could get

involved in private offerings. Currently, the Securities and Exchange Commission segregates investors into two classes, nonaccredited and accredited, and what I wanted to do is create a

semi-accredited. It is an investor class that is in between these two.

Last year, there were five million Americans that qualified as credited investors. Out of that five million, 250,000 contributed about

$60 billion to the private marketplace to fund small businesses.

And if we could create a new investor class that has the financial

sophistication—I mean, I deal with these people on a day-to-day

basis. They want to get involved in these private transactions, but

are restricted under these requirements. And by adding a layer of

protection by making sure that an NASD member underwriter is

the only type of underwriter that can underwrite this type of security, what you are doing is you are effective putting the investor

under all the NASD scrutiny that both the broker dealers and the

issuers have to deal with. So I am kind of covering the investor

protection rule there and making sure that the client is suitable for

the investment.

Some other issues are I would like to put a cap on it of $10 million, but I also wanted to have a minimum contingency of $2 million, and that the money had to be escrowed in an escrow account.

Although this is a little more costly, I think it will protect the investor a lot more. More importantly, by putting a minimum contingency, this will ensure, hopefully, in a lot of cases, that there is

enough money for the business to progress.

And I could go over numerous other examples, but the bottom

line, Rule 509 is kind of like a quasi-public offering. What you have

right now is you have public offerings that are doing private offerings, which are called pipe deals, and we are talking hundreds of

19

billions of dollars have been done in these pipe deals. It is a quick,

effective way for public companies to raise money. And now, by

using the internet, you have private companies offering over the

internet. So effectively they are becoming public offerings. So instead of having two separate classes, why don’t we just put it right

in the middle? In a way, it is like a quasi-public/private offering.

But it would open it up to another 12.8 million Americans, would

afford them investor protection. It would give small business an instrument that is cost effective.

I will give you an example. In the State of Georgia, where I reside, over the last 5 years there were roughly 200-and-something,

low 200s, Rule 504 offerings filed with the Secretary of State.

There were only 32 offerings that were completely subscribed, and

out of that 32, 80 percent of them used an underwriter. The bottom

line is that even if you do get through and you put a registration

statement together using Rule 504 and you are a private company

and you submit it with your State regulator and they approve it,

these aren’t people where their profession is raising capital. And

the problem is they get through this whole process and at the end

of the day, they find that they haven’t raised the money. And I

think in order for small business to have a way of raising capital,

I think they need to use a professional.

Thank you.

Chairwoman KELLY. Thank you very much.

Mr. Gutierrez.

Mr. GUTIERREZ. Thank you very much. You just, real quickly,

commented that, well, there probably are more phones than people

hooked up to the internet. The fact is that people are using the

internet a lot more than phones, especially to make investments.

Senior citizens are a growing group of people that are using the

internet.

So while you might have more phones than internet, the internet

is the vehicle of use for making investments. All you have to do is

turn on the TV to see all the different companies who are making

offerings and competing with one another for $9.95 a trade, $19.95

a trade. It is an explosion, and it is all on the internet. They don’t

say ‘‘call this phone number.’’ They say ‘‘get on the internet and

make these trades.’’ It is the quick way to do it. And especially senior citizens we have noticed have an increased—and I am surprised, because I am 47, so I am hoping the next 20 years go quickly so I can become an internet user, too, given that at the age of

47 it appears that older folks and younger folks than me, I think

it is the people in the middle that don’t know how to use the computer. If you are young or if you are older, it seems like that is

what you are doing.

So that was kind of where I was going with my questions. But

I thank you, Doctor, for your answer and for the security questions.

I do want to ask a couple of questions, another one of Mr. Devine.

During the period before Rule 504 was—I am sorry. I need to

also get glasses—was put into law, how many companies took advantage of it and how much money was raised?

Mr. DEVINE. I don’t think anybody really knows the answer to

that question. At least I haven’t been able to find it. The anecdotal

assumption is that a very large proportion of the capital for small

20

public firms was raised through Rule 504. Since these were only required to be listed in States—and in New York didn’t have to be

listed at all, and I think the Securities and Exchange Commission

correctly got rid of that exemption—nobody really knows. But, at

least anecdotally, it was a very large proportion of the funding of

small public companies.

Mr. GUTIERREZ. OK. I have a question, another question, for my

fellow Illinoisan. You expressed in your testimony another issue

that affects particularly advanced small businesses such as yours

in the Investment Act of 1940, which requires public companies to

hold up to a maximum of 40 percent of their values in the securities of other companies. How do you think this law can be amended

and/or improved to better serve the current needs of companies

such as yours?

Mr. HALPERN. Well I think that is an excellent question, and Ms.

Sweeney, I think, made a good point about the Investment Act.

And just really the purpose of the Investment Act was to manage

and regulate the mutual fund industry. And we clearly are an advanced small business, as we had said earlier. I mean, these are

companies that have grown much quicker and are trying to help

companies in a much earlier stage and have very little to do with

public investing and mutual funds. I think that the Investment Act

of 1940—not the Investment Act, but the NMSIA, the 1996 National Market Securities Improvement Act, clearly gives some latitude. It gives latitude to allow companies to be exempt from some

of those processes, and when we go through that department, what

happens is they really don’t know what to do with us. I get that

feeling. I don’t get the feeling that there is somebody there that is

antagonistic. They are just saying ‘‘How do we fit you into that

mold from 1940?’’ And since they can’t figure it out, every time we

reinvent ourselves to try to suit it they say, ‘‘Well, gee, then you

have a problem with accounting.’’ And if we change the accounting

by restating financial statements, then they say, ‘‘Well, then you

have a problem with the Investment Act.’’ And then, if you have

a problem with the Investment Act, but you are operating as an

Investment Act company, and you do that for an extended period

of time, then you have to go the enforcement department and have

an enforcement action because you are out of compliance.

So these processes are neither effective or economical for anybody

in the Government. And I generally—if I were—I am trying to put

myself in a staff member’s shoes and say, well, if I was them looking at me I would say all I have got is oranges and apples in my

bowl and you are a kiwi. Well, there are a lot of kiwis now and

they need a bowl.

And I don’t know if this helps you, but I think something that

is a very good point here is, I think this subcommittee and the Securities and Exchange Commission have an opportunity to do for

the Securities and Exchange Commission and to do for small business what was done a few years back for the IRS, where if you

think about it, you know, if you are already collecting upward of

40 percent of someone’s hard-earned income and in addition you

are taking 20 percent of their after-tax family budget in hidden

regulatory costs, you would think that it pays to be very nice to

those people, because they are working hard so the money can be

21

distributed, so the Government can proliferate and do a good job

managing its interests.

But I think that in the case of the Securities and Exchange Commission, it is like an accident out on the highway. Two cars crash,

nobody knows whose fault it was—and I am not here to say it is

anybody’s fault, because I don’t think there is any fault. I just

think we have a process which clearly doesn’t work. And if you ask

me to summarize, what I would tell you is, it could work, but somebody there at the staff has to let it work. They don’t know it is OK

to let it work.

No-action letters? Well, those are irrelevant, because everyone

has a disclaimer at the bottom that says ‘‘By the way, if we change

our mind later, then this doesn’t apply any more.’’ And those disclaimers are continuously put into every single process at the staff.

I don’t think it is from the intent to harm small business, I think

it is the reality of the regulatory machine that has built itself up

into a corner and put a lot of tape around it. And so they can’t see

a clear way to do this.

But I clearly represent the 21 million small business professionals who have businesses, and many of them avoid altogether,

or once in the process, drop out because it is too costly, it is too

time-consuming, it doesn’t produce the desired result. So I am calling for a process to assist the Securities and Exchange Commission

in continuing on with its mission to protect investors.

I think Mr. Steinkirchner made some excellent points about how

investors could be protected in the smaller markets, but give more

stimulation. And I think what you get then is like we said with the

IRS. Now if you call the IRS, you get a friendly process. A few

years ago that wasn’t the case. I think there should be a spirit of

cooperation and a friendly process that we can participate in and

grow these economies of scale and produce, as was mentioned earlier, a transparent process using what the other panelists have

quite accurately said, the internet process.

Mr. GUTIERREZ. I think that we will be delving into that issue.

Let me say the only Federal regulator I have to deal with is the

Federal Election Commission in terms of keeping my reports, and

we have gone online. And since we have gone online it certainly

has helped us and everybody gets to know what I am doing and

the information, and it has worked pretty well. But they are not—

they haven’t been particularly cumbersome over there. I mean, if

they raise a question about a $10,000 contribution to the Democratic Party of the State of Illinois, we kind of write them back. But

that is where I spend my money, my legal money, dealing with

the—unfortunately I have to spend money, because they raise an

issue and, of course you don’t want your opponent to raise it later

on and you want to be within the law—only to find out that they

were wrong, that I could indeed give that $10,000 to the State

Democratic Party and that they made a big thing. But in this particular case, don’t worry. All the Democrats in Illinois gave the

same $10,000. So we all got the same letter. So we figured if we

are in trouble we are all in trouble together.

But it does cause anxiety. I mean, the anxiety that it causes is

something that I want to relieve for investors out there that are

developing businesses that I don’t—it causes—you know, your lawVerDate 11-MAY-2000 07:55 Nov 13, 2001 Jkt 000000 PO 00000 Frm 00025 Fmt 6633 Sfmt 6633 73742.TXT HBANK1 PsN: HBANK1
22

yer calls you, ‘‘call your lawyer.’’ It is like everybody is in a panic

that you have done something wrong and illegal, and I want to

make sure that we can get through that process in a manner in

which investors can—especially that are trying to run companies,

especially small businesses. They have got a lot of other things to

deal with than a lawyer calling them panicked that they are out

of regulation, that somebody is going to come down hard on them.

And so, thank you so much to all the panelists for coming here

on behalf of the minority. Thank you very much.

Chairwoman KELLY. Mr. Shows.

Mr. SHOWS. Thank you, Madam Chairwoman.

Mr. Halpern, I was reading your testimony, and Mississippi has

a lot of startup small businesses going even though we are a small

State. And one of the questions I would like to ask you in your

statement, and I will read the question first, is what do you think

the main factor affecting the responsiveness of the Securities and

Exchange Commission to the needs of small business—this probably is outdated laws, and maybe undertrained personnel or disorganized regulatory structure or maybe a tracking system. But

your statement says here, when you were trying to get your money

and raise capital, you said ‘‘staff members continue to contact our

service, saying they still do not understand the nature of our business.’’ I find that true in dealing with reporters sometimes, in that

when you try to explain—as a Highway Commissioner back in Mississippi, I tried to explain a project to a reporter, who may be a

young reporter, who didn’t really understand what I was trying to

tell them and I didn’t know how to break it down where you didn’t

make them feel bad about asking that question. And I know that

is probably the same problem that you have.

How do you explain to the Securities and Exchange Commission

what you are trying to do and yet get it to where they can understand where they can write the guidelines for you to perform like

you would want to? And that is what I am interested in, is trying

to let small business be able to come in and work with the Securities and Exchange Commission and so we still have the—and I

guess what everybody else is talking about—you know, simplify it

enough so that the company doesn’t get like you did, so disheartened with the system that you almost throw the paper up and walk

out the door. And we need to turn that around. And what would

you say would be the thing that we need to do to the Securities and

Exchange Commission to help them to help small business?

Mr. HALPERN. Well, I think that is an excellent point that you

are raising, and it brings back to mind two of the different approaches that we have discussed here. One is that in the short

term I would like to see the processes that are in place be used the

way I believe that they were intended to be used. In other words,

in the National Market Security Improvement Act of 1996, clearly

that is an act of Congress which said the Securities and Exchange

Commission will consider efficient competition and capital formation in its rulemaking activities. But I don’t think there is any spirit of cooperation there, because as the internet evolved there became a sort of fanaticism within the staff that there must be a lot

of scams there. In fact, I attended one of these Securities and Exchange Commission meetings, an enforcement meeting in New

23

York early-on, about 2 years ago, and one of the marketing people

from the staff got up and said, ‘‘Well, you know, people think that

you know we are not on it. We don’t have enough people to keep

track of all the scams out there. But actually we are way ahead of

it. We have hired hundreds and hundreds of new people, and we

are on it all the time.’’ And what I think it became was a fishing

expedition. And again, you know, not with the intent, but the idea

that, well, with the internet evolving there must be all these

scams. And sure, there are scams. But as I said before, and I want

to reestablish this point, you cannot legislate risk out of existence.

But you can legislate the future of small business out.

So that was the first point. The point was let the systems that

are in place do what they were intended to do. First, you need a

person in there that says, ‘‘Now wait a minute, we have a process

that could work.’’ Regulation SB was designed, and it was released in 1992, because in the late 1980s, banks started tying up the coffers on lending to small, new, emerging companies. And you have seen this. So

they said we are not going to lend. So in response, Congress said

let’s do Regulation SB. And so SB was designed for small business

to have an easier and friendlier process. The problem is, it is not

an easier and friendlier process. In fact, if you go in and say ‘‘I am

a small business,’’ they say, ‘‘Ooh, I don’t know what that means

to me, other than I don’t have a bowl to put you in.’’ So you will

have to go around and around the staff. In our case, the first registration process was successful, but the second one wasn’t because

it took too long to get through. And by that time, most of my competitors had lost 98 percent of their initial value of a year earlier.

Now, we had the distinction of funding 10 companies in that process. And today our 10 companies stand tall, have strong beating

hearts and have grown and thrived in a down market, which I

think says something about we are more of a traditional style of

business rather than the dot.com that, you know, selling buzzwords

such as B2B, B2C infrastructure. But with your small businesses

that are in your home State I think it is critically important that

they have a process.

Maybe the Rule 509 prepared by my collegue would be an earlier

stage process. They must be inspired though, no matter what the

process, to follow the process that should work. And when the company gets in the process, I think they should be embraced. If you

come here to Washington to the Securities and Exchange Commission and you say ‘‘I am a small business,’’ I think you should have

a red carpet thrown out and say, ‘‘You are going to create more jobs

and more money for our staff to run itself and take care of real

problems. So therefore, we embrace you.’’

But it is really not that way. It is more of a mean-spirited approach, saying ‘‘We don’t really understand, therefore we will shuffle you around and see what happens.’’ And you know, I survived

it. OK. I am here on my dime to come here because you were willing to take your time and listen. But I think it is a critically important issue. And I think, step one, let’s make the processes that are

already in place work. They have latitude. Let’s give latitude. Let’s

get rid of these things. Let’s give latitude to this BDC. Let’s give

latitude to investors and let’s make them work. My second phase

24

will give the Small Business Advocacy and Liaison Office, the 19th

office in the Commission, a long-term latitude, a long-term communication process that would allow us to keep track of what is going

on and make sure that there is a special interest group within the

staff that always says no matter what rules are going on, you

know, we have a process to help the small business get through so

it can become a big business some day and create more jobs and

more economy and more value.

Mr. SHOWS. But don’t you think that is the intent of Congress,

but the mindset of some of the Securities and Exchange Commission is still set this way and not initially the intent of Congress?

We would like for it to work. Like you said, it is in place. Now, why

isn’t it working? Is it because some of the people have been there

so long their mindset is set in that fashion?

Mr. HALPERN. Yes.

Mr. SHOWS. And they are locked in and they don’t feel like they

are going anywhere?

Mr. HALPERN. Yes. I think it is as frustrating for the staff as it

is for us out here. You know, they may not be aware of it, because

they will go home and come back every day, you know, going to the

same job, not being concerned in the least with what the outcome

is. But we are concerned because it is our business. I think this is

an issue where we all can say yes, we get it. We have to figure out

a way to help small business and achieve the desired result. And

I think given that opportunity the staff would say, ‘‘OK, give us

some clear instructions on how to handle these other entities and

we will do it.’’ Mr. SHOWS. Thank you.

I appreciate it, Madam Chairwoman.

Chairwoman KELLY. Thank you, Mr. Shows.

Mrs. Jones, have you questions?

Mrs. JONES. Yes.

Good morning. I missed some of your presentation and I am trying to quickly read through your statements to kind of catch up

here. I also sit on the Small Business Committee, so the combination of these two works very well. I am trying to, in my second

term in Congress, improve. I come from the City of Cleveland and

we are always looking for more capital investment in Cleveland. So

if you don’t have any investment in Cleveland—I don’t have a company, but please come on in and do some work because we need

it.

Let me also say, I think that small businesses are key to creating

stronger communities throughout this country. We have had great

success in building new homes in Cleveland in many communities,

but we need some businesses to go with those new homes to really

create a community.

Ms. Sweeney, I am looking at your statement, and you speak

about not being able to use an integrated disclosure for purposes

of your shelf registration statement and other things. Are there

other examples of improvements that you can suggest that the Securities and Exchange Commission could do in order to assist small

business in working its way through the process?

Ms. SWEENEY. Yes. I will answer that and also follow up on some

of the points Mr. Halpern made.

25

Mrs. JONES. No problem.

Ms. SWEENEY. I have kind of got an interesting background myself, because I was with the staff of the Securities and Exchange

Commission.

Mrs. JONES. I read that.

Ms. SWEENEY. In the Enforcement Division, and I have got to tell

you, there are lot of bad people out there and there does need to

be a very strong Securities and Exchange Commission that does

protect the widows and orphans, because there are a lot of scam

artists out there. So regulation, I think, is a good thing.

What I think has happened to our Securities and Exchange Commission, and I think it has happened more in the decade of the

1990s than you saw in the 1980s, is there has been a misplacement

of emphasis and a misplacement of leadership at the core of the Securities and Exchange Commission to focus time on interpretive positions, rulemaking, and exemptive orders, because we are dealing

with a body of law that is 70 years old. The capital markets move.

Law can’t possibly keep pace with the speed of the capital markets.

Death spiral preferred is a classic example. This is a preferred

stock instrument that is killing common shareholders. How can

people at the Securities and Exchange Commission stay on top of

that if their time is spent in low value-add activities like reviewing

registration statements?

There is a ton of very, very talented staff members at the Securities and Exchange Commission that have the capabilities to spend

their time thinking of interpretive positions, rulemaking and ways

to increase access to capital. But when their hours, their daily work

hour is spent pouring through these—do you know I have to file

one of these every quarter and someone has to review it? I mean,

when that time is spent doing that, how can they have time to

think of the bigger picture and think about how to push access?

So it really is a very simple change. It is a change in emphasis

from low value-add to maximum value-add, and that is really all

that needs to happen.

Mrs. JONES. OK.

Mr. Devine, or Mr.—want to pronounce that for me?

Mr. STEINKIRCHNER. Steinkirchner.

Mrs. JONES. Steinkirchner. Would either of you like to add anything based on what we have discussed before my time is up?

Mr. DEVINE. On the question of the Securities and Exchange

Commission itself, I will speak as somebody with some background

in Federal personnel, being in charge of it at one time. Bureaucracies aren’t known for quick response. I mean, that is kind of the

nature of bureaucracy. And the Securities and Exchange Commission is no better or no worse than probably any other bureaucracy,

maybe a little better than most. But the problem is that changing

ways of thinking in a bureaucracy is enormously difficult. And I

think the history of the 1996 Act, in Chairman Oxley, and former

Chairman Bliley’s attempt to get the Securities and Exchange

Commission to respond, in the kind of response that in my opinion

was enormously inadequate, you can see right there reading it— that they are not responding—or in reading the cost-benefits section of the change to Rule 504. I mean, you can see they just don’t

get it. And I don’t think it is necessarily a bad spirit; but they just

26

don’t get it. And that is why these hearings, to me, are so important.

The Congressman from Mississippi—I am afraid, unlike Mr.

Gutierrez, I am already old, so I can’t read his name. I apologize.

Mrs. JONES. Shows. Ronnie Shows.

Mr. DEVINE. He asked, ‘‘Congress didn’t intend.’’ And that is very

clear. Congress intended the Securities and Exchange Commission

to look at the broader picture. And in my experience in this business, the only way you can do it is you keep going back and telling

them again and again. That is why my every other word is thanking you for having this hearing.

Mrs. JONES. Do I have a moment to allow the last gentleman to

respond?

Chairwoman KELLY. Of course.

Mr. STEINKIRCHNER. Thank you. Well, I will give you two conviction solutions, one a standardization of the offerings. The reason

why that book is as big as it is is because the Securities and Exchange Commission asks you to put what is pertinent that investors should know. But that is all they say. They don’t tell you exactly what is needed to be put in that document. And I think if

they found what was necessary for investor protection to put into

a document of that nature, that would go down dramatically, and

I think Ms. Sweeney would probably agree with me.

Two, education. If we want people to stop getting burned over

the internet or through whatever, we need to educate the public a

lot more about private and public offerings, and that is the number

one way. I mean, we have been harping for—I don’t know, 20 or

30 years, to use seatbelts and now people are using seatbelts. And

I think if we harp on them that, ‘‘Hey, I think you should get a

registration document, here are 10 things that you should look at

before you place money in a private company,’’ or a public company

or whatever, and harp this continually, I think you will cut down

the amount of scams and frauds that are occurring over the internet, through the mails, and over the telephone.

Mrs. JONES. Thank you.

Chairwoman KELLY. Thank you very much, Mrs. Jones.

If there are no more questions I am going to note that some

Members may have additional questions and they may wish to submit them in writing. So without objection, the hearing record is

going to remain open for 30 days for Members to submit written

questions to these witnesses and to place their responses in the

record.

I really thank this panel. You have been extraordinarily patient

with us. We do have more questions I am sure. You have also been

very interesting in your responses, and we do thank you for your

indulgence in allowing us a second round of questions here.

This panel is excused with our great thanks, the subcommittee’s

great thanks, and appreciation for your time. This hearing is adjourned.

[Whereupon, at 11:15 a.m., the hearing was adjourned.]

(27)

A P P E N D I X

June 26, 2001

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