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LEGISLATION TO FURTHER REDUCE 

IMPEDIMENTS TO CAPITAL FORMATION 

HEARING 

BEFORE THE

SUBCOMMITTEE ON CAPITAL MARKETS AND 

GOVERNMENT SPONSORED ENTERPRISES 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED THIRTEENTH CONGRESS 

FIRST SESSION 

OCTOBER 23, 2013 

Printed for the use of the Committee on Financial Services 

Serial No. 113–46 

( 

(II) 

HOUSE COMMITTEE ON FINANCIAL SERVICES 

JEB HENSARLING, Texas, Chairman 

GARY G. MILLER, California, Vice Chairman 

SPENCER BACHUS, Alabama, Chairman 

Emeritus 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

SHELLEY MOORE CAPITO, West Virginia 

SCOTT GARRETT, New Jersey 

RANDY NEUGEBAUER, Texas 

PATRICK T. MCHENRY, North Carolina 

JOHN CAMPBELL, California 

MICHELE BACHMANN, Minnesota 

KEVIN McCARTHY, California 

STEVAN PEARCE, New Mexico 

BILL POSEY, Florida 

MICHAEL G. FITZPATRICK, Pennsylvania 

LYNN A. WESTMORELAND, Georgia 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

ROBERT HURT, Virginia 

MICHAEL G. GRIMM, New York 

STEVE STIVERS, Ohio 

STEPHEN LEE FINCHER, Tennessee 

MARLIN A. STUTZMAN, Indiana 

MICK MULVANEY, South Carolina 

RANDY HULTGREN, Illinois 

DENNIS A. ROSS, Florida 

ROBERT PITTENGER, North Carolina 

ANN WAGNER, Missouri 

ANDY BARR, Kentucky 

TOM COTTON, Arkansas 

KEITH J. ROTHFUS, Pennsylvania 

MAXINE WATERS, California, Ranking 

Member 

CAROLYN B. MALONEY, New York 

NYDIA M. VELA ́ ZQUEZ, New York 

MELVIN L. WATT, North Carolina 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

MICHAEL E. CAPUANO, Massachusetts 

RUBE ́ N HINOJOSA, Texas 

WM. LACY CLAY, Missouri 

CAROLYN MCCARTHY, New York 

STEPHEN F. LYNCH, Massachusetts 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

GWEN MOORE, Wisconsin 

KEITH ELLISON, Minnesota 

ED PERLMUTTER, Colorado 

JAMES A. HIMES, Connecticut 

GARY C. PETERS, Michigan 

JOHN C. CARNEY, JR., Delaware 

TERRI A. SEWELL, Alabama 

BILL FOSTER, Illinois 

DANIEL T. KILDEE, Michigan 

PATRICK MURPHY, Florida 

JOHN K. DELANEY, Maryland 

KYRSTEN SINEMA, Arizona 

JOYCE BEATTY, Ohio 

DENNY HECK, Washington 

SHANNON MCGAHN, Staff Director 

JAMES H. CLINGER, Chief Counsel 

(III) 

SUBCOMMITTEE ON CAPITAL MARKETS AND GOVERNMENT SPONSORED ENTERPRISES

SCOTT GARRETT, New Jersey, Chairman 

ROBERT HURT, Virginia, Vice Chairman 

SPENCER BACHUS, Alabama 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

RANDY NEUGEBAUER, Texas 

MICHELE BACHMANN, Minnesota 

KEVIN McCARTHY, California 

LYNN A. WESTMORELAND, Georgia 

BILL HUIZENGA, Michigan 

MICHAEL G. GRIMM, New York 

STEVE STIVERS, Ohio 

STEPHEN LEE FINCHER, Tennessee 

MICK MULVANEY, South Carolina 

RANDY HULTGREN, Illinois 

DENNIS A. ROSS, Florida 

ANN WAGNER, Missouri 

CAROLYN B. MALONEY, New York, 

Ranking Member 

BRAD SHERMAN, California 

RUBE ́ N HINOJOSA, Texas 

STEPHEN F. LYNCH, Massachusetts 

GWEN MOORE, Wisconsin 

ED PERLMUTTER, Colorado 

DAVID SCOTT, Georgia 

JAMES A. HIMES, Connecticut 

GARY C. PETERS, Michigan 

KEITH ELLISON, Minnesota 

MELVIN L. WATT, North Carolina 

BILL FOSTER, Illinois 

JOHN C. CARNEY, JR., Delaware 

TERRI A. SEWELL, Alabama 

DANIEL T. KILDEE, Michigan 

(V) 

C O N T E N T S 

Page 

Hearing held on: 

October 23, 2013 ............................................................................................... 1 

Appendix: 

October 23, 2013 ............................................................................................... 41 

WITNESSES 

WEDNESDAY, OCTOBER 23, 2013 

Abshure, A. Heath, Arkansas Securities Commissioner, on behalf of the North 

American Securities Administrators Association .............................................. 8 

Arougheti, Michael J., Chief Executive Officer, Ares Capital Corporation ......... 10 

Ertel, J. Michael, Managing Director, Legacy M&A Advisors, LLC ................... 11 

Frank, Alexander C., Chief Financial Officer, Fifth Street Management LLC .. 13 

Quaadman, Tom, Vice President, Center for Capital Markets Competitiveness, U.S. Chamber of Commerce ....................................................................... 16 

Weild, David, Founder, Chairman, and Chief Executive Officer, IssuWorks ..... 18 

Wunderlich, Gary K., Jr., Chief Executive Officer, Wunderlich Securities, 

on behalf of the Securities Industry and Financial Markets Association 

(SIFMA) ................................................................................................................ 14 

APPENDIX 

Prepared statements: 

Abshure, A. Heath ............................................................................................ 42 

Arougheti, Michael J. ....................................................................................... 58 

Ertel, J. Michael ............................................................................................... 64 

Frank, Alexander C. ......................................................................................... 104 

Quaadman, Tom ............................................................................................... 108 

Weild, David ...................................................................................................... 154 

Wunderlich, Gary K., Jr. .................................................................................. 174 

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Garrett, Hon. Scott: 

Letter to Representatives Garrett and Maloney from the Financial Services Roundtable ............................................................................................. 180 

Written statement of Joseph Ferraro, General Counsel, Prospect Capital 

Corporation .................................................................................................... 181 

Letter to Representative Elizabeth Esty from Michael F. Foley, former 

President and CEO, Reflexite Technology Corporation ............................. 183 

Letter to Representatives Garrett and Maloney from the Small Business 

Investor Alliance ........................................................................................... 185 

Letter to SEC Chair Mary Jo White from various companies ...................... 187 

Maloney, Hon. Carolyn: 

Letter to Representatives Garrett and Maloney from SEC Chair Mary 

Jo White ......................................................................................................... 191 

Sherman, Hon. Brad: 

Letter to Representatives Garrett and Maloney from the National Association of Federal Credit Unions ................................................................. 196 

(1) 

LEGISLATION TO FURTHER REDUCE 

IMPEDIMENTS TO CAPITAL FORMATION 

Wednesday, October 23, 2013 

U.S. HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON CAPITAL MARKETS AND

GOVERNMENT SPONSORED ENTERPRISES, COMMITTEE ON FINANCIAL SERVICES, Washington, D.C. 

The subcommittee met, pursuant to notice, at 2:28 p.m., in room 

2128, Rayburn House Office Building, Hon. Scott Garrett [chairman of the subcommittee] presiding. 

Members present: Representatives Garrett, Hurt, Royce, 

Huizenga, Grimm, Stivers, Mulvaney, Hultgren, Ross; Maloney, 

Sherman, Moore, Scott, Himes, Peters, Watt, Foster, Carney, Sewell, and Kildee. 

Ex officio present: Representative Hensarling. 

Also present: Representative Duffy. 

Chairman GARRETT. Good afternoon. The Subcommittee on Capital Markets and Government Sponsored Enterprises is hereby 

called to order. And I welcome the panel and their indulgence as 

we just concluded votes for the morning until the next series of 

votes. Before we go to the panel, we will have opening statements, 

and I will begin by yielding myself 3 minutes. 

Today’s hearing, as you all know, is on legislation to further reduce impediments to capital formation for who? For America’s 

small businesses. In a moment, I am going to recognize my colleagues for opening statements to introduce their legislative proposals. But first, I would like to briefly highlight a mixed bag, if 

you will, of recent developments in the area of small business capital formation. 

First, data continues to flow in on the early impact of the JOBS 

Act and the results are very encouraging. Thanks in large part to 

the law’s self-executing IPO on-ramp provisions, this is helping to 

shape up to be one of the best years for IPOs since 2007, and with 

more than 150 of them through the first three quarters and counting, it is a good track record. And so for our tech savvy crowd, I 

guess you could simply say with a hash tag the JOBS Act is working. 

Now, in addition, while the SEC’s statutory mission to promote 

capital formation has largely been ignored over the past 4 years, 

it does seem that the Commission is finally getting around to its 

responsibilities under the JOBS Act. Back in July, the SEC issued 

rules lifting the ban on general solicitation and advertising in connection with certain private security offerings to credit investors 

2 

and that was mandated by Title II of the JOBS Act. So this rule 

change was expected to be a milestone on the road to improving 

small business capital formation through the private securities 

market. 

Unfortunately, in Washington these days things are never as 

simple as they should be. Instead of following Congress’ straightforward and narrow mandate to lift the ban on general solicitation 

and advertising for certain private security offerings, the SEC also 

saw fit, over the objections of two Commissioners, to issue an additional, unrelated proposal to change the disclosure and filing requirements for these very same offerings. 

This proposal, which was not called for by the JOBS Act, is apparently intended to protect the already more sophisticated investors who may participate in these offerings. However, it is likely to 

impose additional new and significant costs and burdens on small 

businesses who are trying to seek to raise capital through private 

security offerings and thereby reduce the attractiveness of these offerings and thereby undermine the very purpose of the JOBS Act 

in the first place. 

So although Chair White wants the SEC to move expeditiously 

towards the adoption of this proposal, I would urge her and her colleagues on the Commission to seriously rethink whether it is the 

best option available to balance the SEC’s important duties both to 

protect investors and to promote small business capital formation. 

Indeed, it seems that the SEC too often forgets that an important 

part of protecting investors is ensuring that they have access to a 

variety of investment options. And so with respect to the remainder 

of the JOBS Act, earlier today the SEC voted in favor of issuing 

proposed rules to implement Title III, the crowdfunding provisions. 

And, frankly, I have not had a chance to review the crowdfunding 

proposals. I hope that this time the SEC has stayed true to the 

terms of the statute. I also hope that a proposal from the SEC on 

regulation A will follow before the end of the year. 

Now, on top of the JOBS Act, more can and should be done to 

help small businesses raise much-needed capital to grow and create 

jobs during this period of record-breaking government red tape, 

tepid economic growth, and persistently high unemployment. 

And so, finally, to that goal, I would like to recognize the great 

work of Representatives Maloney, Grimm, Velazquez, and 

Mulvaney on their bills addressing the regulations of business development companies (BDCs). Also, we have Representative 

Huizenga on his bill addressing the regulation of mergers and acquisition brokers. Additionally, we have over here Vice Chairman 

Hurt on his proposal to create a voluntary filing exemption for 

small companies, and you have Representative Duffy’s bill on his 

proposal to create the tick-size pilot program, and finally Representative Fincher on his proposals to improve Title I of the JOBS 

Act. 

And with that, I will look to some of those Members later on for 

their opening statements, but at this point I would like to turn to 

the ranking member of the subcommittee, the gentlelady from New 

York, for 4 minutes. 

Mrs. MALONEY. Thank you, Chairman Garrett, for holding this 

important hearing. And I want to particularly welcome Mr. Weild, 

3 

Mr. Arougheti, and Mr. Frank, who are all from the district that 

I am privileged to represent. This legislative hearing is the product 

of two informative hearings that this subcommittee held earlier 

this year, and I hope that this hearing will move our process forward. 

The United States has the deepest, most liquid, and most effective capital markets in the world. The United States stock market 

is 13 times larger than the British and 14 times larger than Germany’s. Simply put, the United States is where businesses come to 

raise money from investors. The sheer size of our stock market is 

attractive for investors because they know they will be able to sell 

their investment quickly if they need to. 

But, unfortunately, small businesses still have trouble raising 

funds in these markets. Between 1991 and 2007, the number of 

small companies that went public in our securities markets declined by 92 percent. Providing incentives for greater investment in 

our country’s businesses and our entrepreneurs will allow these 

companies to innovate, hire new workers, launch new products, 

and ultimately grow our economy. 

However, we also need to keep in mind that one of the main reasons the U.S. markets are the envy of the world is the transparency and trust that come from public disclosure. I have always 

said that our markets operate more on trust and confidence than 

on capital. 

That is why it is so important that we get the right balance between increased incentives for capital formation and healthy public 

disclosure that benefits all investors. We also need to make sure 

that any reforms we consider passing don’t harm the tremendous 

improvements our markets have made in the past 3 decades. 

As Chairman Garrett has noted, one of the big takeaways from 

the roundtable on market structure that he hosted earlier this year 

in New York was that today’s retail investors have better access to 

the markets and at lower costs than ever before. 

It is important not to lose sight of these benefits. And given what 

we went through with the financial crisis, it is also important that 

we put safety and soundness concerns first. As SEC Chair White 

has said, if there is a way to increase incentives for capital formation in a way that also protects the safety and soundness of the 

system, then we should work together towards that goal. 

The bills that we are considering today represent a good faith 

and sometimes bipartisan effort to improve our markets and grow 

our economy. I look forward to a very informative discussion of 

these bills from our distinguished panel. Thank you for being here. 

Chairman GARRETT. Thank you. 

Mr. Hurt is recognized for 2 minutes. 

Mr. HURT. Thank you, Mr. Chairman. Mr. Chairman, I want to 

thank you for holding today’s hearing on reducing barriers to capital formation. I am glad that this subcommittee is moving forward 

with additional proposals to increase access to capital for our small 

businesses and our startups. 

Our hearings over the summer have shown that while the JOBS 

Act has been successful, more still needs to be done to ensure that 

we remove or refine costly regulations, especially those disproportionately affecting small or public companies and those who are 

4 

considering accessing capital in the public markets. While a single 

regulation’s effect may appear insignificant, the combined costs of 

our regulatory climate produce exponential consequence. For that 

reason, I appreciate the subcommittee taking a holistic approach to 

examining our capital markets’ regulatory structure and its impact 

on innovative companies. 

One such requirement is related to the use of Extensible Business Reporting Language (XBRL), which was mandated by the SEC 

in 2009 and designed to lower the cost of capital for smaller companies and provide more efficient access to information for investors. 

While the SEC’s rule is well-intended, this requirement has become 

another example of a regulation where the costs outweigh potential 

benefits. Smaller companies expend tens of thousands of dollars or 

more complying with the regulation, yet there is evidence that less 

than 10 percentage of the investors actually use XBRL, further diminishing its potential benefits. That is why I am interested in legislation to provide relief from the disproportionate burdens of 

XBRL. 

The legislation under discussion would provide an exemption for 

emerging companies from complying with this regulation. It is important to note that nothing in the draft would preclude companies 

from utilizing XBRL for their regulatory filings with the SEC if 

they so choose. Rather, it allows these companies to assess whether 

the costs incurred with compliance are outweighed by any potential 

benefits from utilizing this technology. 

I believe the draft offers a practical step forward with XBRL requirements in line with the intent of the JOBS Act, ensuring that 

our regulatory structure is not disproportionately burdening smaller companies and disincentivizing innovative startups from accessing our public markets. 

I look forward to the testimony of our distinguished witnesses 

and thank them for their appearance before the subcommittee 

today. Mr. Chairman, I thank you, and I yield back the balance of 

my time. 

Chairman GARRETT. The gentleman yields back. 

The gentleman from California is recognized for 2 minutes. 

Mr. SHERMAN. Thank you, Mr. Chairman. 

We always have to balance on the one hand transparency and investor protection, which brings capital into our markets, with minimizing the costs of those companies trying to raise money. We 

should keep in mind that it is only for less than 2 centuries of 

human history that people invest with strangers, and they can do 

that only because we have a good and transparent accounting and 

financial reporting system that is reliable. 

We can provide more capital to the smallest businesses doing 

something that is outside the scope of today’s hearings, and that 

is allowing credit unions to make business loans. We bailed out 

banks that still aren’t making the small business loans that they 

ought to be making, some of the giant banks. Here we have credit 

unions who just want the U.S. Government to get out of the way 

and let them make business loans, and we should be acting on that 

bill. 

Finally, I want to recognize Mr. Quaadman of the Chamber for 

his work in preventing a grave threat to all business financings inVerDate Nov 24 2008 14:47 May 06, 2014 Jkt 086681 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 K:\DOCS\86681.TXT TERRI
5 

volving borrowing from a $100,000 bank loan to a multibillion-dollar bond indenture, and that is the proposal of the Financial Accounting Standards Boards to ‘‘capitalize leases.’’ This would add 

over $2 trillion to the liabilities listed on the balance sheets of 

unsuspecting businesses. Financial Accounting Standards Board 

exposure drafts are rarely on the front page of any newspaper, and 

so these businesses don’t know what is about to possibly hit them. 

But most businesses that borrow have loan covenants, which 

means that if they added to their liabilities, even if they added an 

equal amount to their assets, and even if that addition wasn’t a 

change in business but just a change in accounting principles, they 

would be in violation of their loan covenants and the money would 

be due immediately. That poses a risk to the financing of businesses that I hope this committee will look at separately. 

I yield back. 

Chairman GARRETT. The gentleman yields back. 

The gentleman from New York, Mr. Grimm, is recognized for 11⁄2

minutes. 

Mr. GRIMM. Thank you, Mr. Chairman. 

And thank you, Mr. Mulvaney. 

Chairman GARRETT. We appreciated the help from the gentleman 

for paying attention. 

Mr. GRIMM. Thank you for calling the hearing. I appreciate it because it is extremely important that we discuss several legislative 

proposals that would increase capital formation and further economic growth and job creation. I am very proud to have introduced 

one of the bills under consideration today, H.R. 1800, the Small 

Business Credit Availability Act. 

This commonsense legislation would increase the ability of business development companies, otherwise known as BDCs, to lend to 

small and midsized firms, the key drivers of new job growth in our 

economy. H.R. 1800 would allow BDCs to modestly increase their 

leverage, accurately reflect how their preferred stock is considered 

for regulatory purposes, and harmonize their securities issuance 

procedures with those of other registered firms. 

At a time when our economy is still struggling to create jobs and 

erase the damage done during the great recession, we must strive 

to do all that we can to ensure the flow of much-needed capital to 

Main Street businesses and make sure they are not interrupted. In 

the wake of the financial crisis, BDCs filled an important void in 

the economy by continuing to provide much-needed capital to small 

firms. It is crucial that we ensure that they are able to continue 

in this vital role. 

So I look forward to hearing from all the witnesses today. I 

would like their thoughts on BDCs and the other important legislation that is before us. And I yield back. 

Chairman GARRETT. The gentleman yields back. 

And Ms. Moore is recognized for 2 minutes. 

Ms. MOORE. Thank you, Mr. Chairman. It sure is good to be back 

at work. I think that this is an auspiciously timed hearing after the 

whole shutdown debt ceiling episode, a step in the wrong direction, 

to be trying to now look at legislation that might promote positive, 

sustainable, and widespread economic growth. 

6 

I think there are very varying degrees of merit to the many ideas 

that are coming before this committee today, but I do think that 

this is an opportunity for the authors, the sponsors of these drafts 

to help us come to some kind of consensus. 

I have not committed myself to any of these ideas, but I do think 

that proposals that my colleague from Wisconsin, Representative 

Duffy, on tick size, is of interest to me. The credit union business 

lending bill is of some interest to me. And I strongly encourage the 

sponsors to work with the SEC and State regulators on those proposals that impact the so-called accredited investors definition as 

a part of implementing the JOBS Act. 

After some of the more high profile cases, like Bernie Madoff, I 

think this is a really, really critical undertaking by the SEC, and 

the committee needs to work in sync and be mindful of that process. 

I thank you so much, Mr. Chairman and committee members, 

and I look forward to hearing from our witnesses. 

Chairman GARRETT. Thank you. The gentlelady yields back. 

Mr. Huizenga for 1 minute, please. 

Mr. HUIZENGA. Thank you, Mr. Chairman, and Ranking Member 

Maloney. 

Since 2006, the Securities and Exchange Commission has highlighted the merger and acquisition broker proposal as one of its top 

recommendations to help small businesses. However, 7 years 

later—count them, 7 years later—the SEC has not acted on this 

recommendation. I have been working with a constituent, Shane 

Hansen, who has been very involved in this, who had testified earlier, and that is why I, along with Representatives Brian Higgins 

and Bill Posey, introduced H.R. 2274, the Small Business Mergers, 

Acquisitions, Sales, and Brokerage Simplification Act. 

This bipartisan legislation would create a simplified SEC registration system for brokers performing services in connection with 

the transfer of ownership of smaller, privately held companies. It 

has been estimated that approximately $10 trillion, that is trillion 

with a ‘‘T,’’ of privately owned Main Street mom-and-pop type businesses will be sold or closed as baby boomers retire. We don’t want 

them closed, we want them sold so that they can continue. We 

must streamline and simplify the regulatory structure so small and 

midsized businesses are able to safely, efficiently, and effectively 

sell their companies while preserving and protecting jobs at these 

companies. 

Thank you, Mr. Chairman. I appreciate the time. 

Chairman GARRETT. The gentleman yields back. 

The gentleman from Georgia for 2 minutes. 

Mr. SCOTT. Thank you, Mr. Chairman. 

I think it is very important for us to understand why the BDCs 

were put together in the first place. Back in 1980, Congress created 

the BDCs as a specialized type of closed-end investment company 

whose primary goal is to invest in and provide managerial assistance to small and growing and financially troubled domestic businesses. Today, there are 68 active BDCs with the total assets of 

$53.7 billion, and the BDCs are required to invest 70 percent—70 

percent—of their funds in what are called eligible portfolio companies. These are private companies or publicly held companies with 

7 

a public float of less than $250 million, and an eligible portfolio 

company does not include mutual funds, hedge funds, or other private funds. But the BDCs do have a broader discretion regarding 

the remaining 30 percent of funds, so they are quite flexible. 

Another feature of the BDCs is that they are also required to 

provide significant managerial assistance to eligible portfolio companies, which can include providing guidance on management, 

business operation of the company, and exercising or controlling influence over the company. And because they are publicly traded, 

BDCs provide a unique opportunity for retail investors to invest in 

private companies. 

But I do have one concern here, and I hope that the committee, 

as we go forward on these three bills with our assessment of the 

BDCs and questions of how we can reduce barriers of capital formation through legislative means, that we must be mindful of how 

such adjustments that we might make might inadvertently divert 

capital away from the small growing businesses that the BDCs 

were originally created to help. As always, the hallmark of this 

committee is the delicate balance that we seek. 

Thank you, Mr. Chairman. 

Chairman GARRETT. And I thank the gentleman. The gentleman 

yields back. 

Mr. Mulvaney is recognized for 1 minute. 

Mr. MULVANEY. Thank you. 

As the chairman noted, the purpose of today’s hearing is to investigate the possibilities of reducing impediments to capital formation. And along those lines I am appreciative of the opportunity to 

include in the discussion today H.R. 1973, the Business Development Company Modernization Act, a fairly simple bill. For some 

reason back in 1980, the last time we changed this, we limited 

BDCs and their ability to invest in financial services companies. 

They can only invest 30 percent of their capital in those businesses. 

I imagine that might have made sense in 1980. I have no idea 

why it would make sense today. These are companies that we excel 

at as Americans, excel at in their ability to employ people, to grow 

businesses, and I am interested in trying to see us get rid of what 

is admittedly an arbitrary cap. So I appreciate several members of 

the panel today who have said favorable things about H.R. 1973. 

I look forward to continuing that discussion today because I think 

it is a great opportunity for us to do exactly what we have talked 

about, which is improving capital formation. 

With that, I thank the chairman for the opportunity. 

Chairman GARRETT. And I thank the gentleman for his legislation and for yielding back. 

And the last word on this will be Mr. Duffy for 11⁄2 minutes. 

Mr. DUFFY. Thank you, Mr. Chairman, and I appreciate the 

panel taking time out of their day to provide testimony to the committee. I have been working on legislation with the gentleman from 

Delaware, Mr. Carney, that would establish a pilot program that 

would allow emerging growth companies to trade at 5 and 10 cent 

increments. Why? We all know that America’s number one job creators, our small businesses, still need help. Congress put aside partisan differences last year and passed the JOBS Act, which removed a number of barriers to raising capital to start a business. 

8 

It is only logical that the next step is to help improve the liquidity 

of emerging growth companies once public. 

This is the main purpose of our proposal. It is no secret that the number of U.S.-listed IPOs raising less than $50 million has declined since the 1990s. Then, there were typically more than 100 

such IPOs. Last year, there were less than 10. 

Further, when the SEC implemented decimalization, larger companies saw an influx of investors, while our smaller companies saw 

their liquidity decrease. I believe that this issue can be partially 

remedied through reforms to our tick sizes for our small cap companies. 

I look forward to all of your comments on how we could create 

better liquidity with increasing our tick sizes. And with that, Mr. 

Chairman, I yield back. 

Chairman GARRETT. And the gentleman yields back, which concludes, I believe, the opening statements. 

And now we can get to the matter at hand. So before you all 

begin, let me just remind you that your full written testimony will 

be made a part of the record, and you will now be recognized for 

5 minutes. For those of you who have not been here before the committee before, you have a warning light that is in front of you: it 

is green when you start; yellow when it gets down to the last 

minute; and red when your time is up. 

I also will probably ask each and every one of you to make sure 

that you bring the microphone closer to you than it is for just about 

everyone right now, since the microphone is very sensitive to that. 

So with that being said, I now recognize Mr. Abshure, the Arkansas Securities Commissioner, testifying on behalf of the North 

American Securities Administrators Association. Thank you, and 

welcome to the panel. 

STATEMENT OF A. HEATH ABSHURE, ARKANSAS SECURITIES 

COMMISSIONER, ON BEHALF OF THE NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION 

Mr. ABSHURE. Good afternoon, Chairman Garrett, Ranking Member Maloney, and members of the subcommittee. I am Heath 

Abshure, Arkansas Securities Commissioner. Until earlier this 

month, I was also the president of the North American Securities 

Administrators Association, or NASAA, the association of State and 

provincial securities regulators. 

Prior to serving NASAA as president, I served as the chairman 

of both NASAA’s Special Committee on Small Business Capital 

Formation and NASAA’s Corporation Finance Section. In addition, 

since 2011, I have served as an observer member of the SEC’s Advisory Committee on Small and Emerging Companies, which has 

recently considered a number of the same questions that will be examined at the hearing today. 

I personally have a deep interest in small business finance and 

capital formation, and I am honored to testify for a second time before this subcommittee about these issues. In 2011, I testified before this subcommittee and expressed concern about many of the 

policies in the JOBS Act, including legislation directing the SEC to 

lift the ban on general solicitation in private securities offerings 

and to legalize equity crowdfunding. I remain deeply concerned 

9 

that some of the policies enacted under the JOBS Act, including in 

particular the lifting of the ban on general solicitation in Reg D, 

Rule 506 offerings, will be detrimental to investors and ultimately 

to the companies that rely on this method of capital formation. 

The SEC is currently considering a number of proposed amendments to the general solicitation rule adopted in July pursuant to 

Section 201 of the JOBS Act. State securities administrators 

strongly support many of the proposed amendments, and we consider it particularly essential that the Commission move swiftly to 

adopt the requirement that Form D be filed prior to the use of general solicitation. 

Today, the subcommittee is considering a number of new bills related to capital formation. NASAA’s view regarding this new collection of bills is mixed. NASAA supports a number of these proposals, especially the proposed Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act sponsored by Congressman Huizenga. NASAA also understands the need for some 

delay or regulatory forbearance for small businesses that may be 

struggling to meet the SEC’s requirement that certain filings be 

made using Extensible Business Reporting Language. 

At the same time, NASAA has concerns with other legislation 

pending before the committee today. Most notably, NASAA is troubled by the proposal to further expand what are basically new, untested regulatory carve-outs for emerging growth companies. 

NASAA is additionally dismayed by proposals to increase leverage 

limits with respect to the investment activities of business development companies and strongly opposed to allowing BDCs to invest 

in financial services companies, including investment advisers. In 

our view, such policies would invite problems such as conflicts of 

interest, dilution of common shareholders, and investment risk due 

to lack of transparency. These policies would turn BDCs into speculative hedge funds for unsophisticated, nonaccredited investors. 

In addition, NASAA cannot help but observe that competition 

from financial services firms will not benefit traditional BDC portfolio companies, meaning small operating companies that produce 

goods or provide services. If Congress were to enact such changes, 

the result would be that small businesses which create jobs in the 

real economy would be forced into competition with financial firms 

for BDC capital. This would frustrate the subcommittee’s goal of 

spurring job growth. BDCs were initially created for the purpose of 

providing capital to domestic small and medium-sized businesses 

that participate in the real economy and not jobs in the financial 

services industry. 

Finally, there are some bills before the subcommittee, including 

notably Congressman Duffy’s bill dealing with tick sizes, on which 

NASAA does not have a strong stakeholder interest. In discussing 

these bills, I will offer my own personal observations based on my 

experience as a securities regulator, as well as the many discussions I have had with other regulators, academics, and industry 

participants as part of my work on the Advisory Committee. 

Thank you again, Chairman Garrett and Ranking Member Maloney, for the opportunity to appear before the subcommittee today. 

I would now be pleased to answer any questions you may have. 

10 

[The prepared statement of Commissioner Abshure can be found 

on page 42 of the appendix.] 

Chairman GARRETT. And the gentleman yields back. Thank you. 

Mr. Arougheti is now recognized for 5 minutes. And welcome to 

the panel. 

STATEMENT OF MICHAEL J. AROUGHETI, CHIEF EXECUTIVE 

OFFICER, ARES CAPITAL CORPORATION 

Mr. AROUGHETI. Chairman Garrett, Ranking Member Maloney, 

and members of the subcommittee, thank you for the opportunity 

to testify today. I am Michael Arougheti, the CEO of Ares Capital 

Corporation, a BDC that has invested more than $14 billion in 

more than 450 small and medium-sized companies, creating tens of 

thousands of American jobs. 

Congress created BDCs in 1980 to encourage capital flows to 

small and medium-sized business at a time much like today when 

these businesses had limited options for securing credit. Uniquely, 

the BDC model allows ordinary investors to participate in this 

process, effectively Main Street funding Main Street. 

I have been asked today to testify on behalf of the BDC industry 

to express my support for the three pieces of proposed legislation, 

and I think it is important to note that the BDC industry is not 

seeking any government or taxpayer support or subsidy. 

Many of the challenges faced by BDCs arise out of their peculiar 

place in the regulatory framework. BDCs are more akin to operating companies and commercial finance companies than mutual 

funds. We are a proverbial square peg in a round hole. 

Three bills have been introduced into the House regarding BDCs. 

H.R. 1973, introduced by Congressman Mulvaney, offers welcome 

flexibility for BDC investment in financial institutions and finance 

companies. For example, a BDC investing in a growing leasing 

company might have to curtail useful lending to small business because of a limit that in context feels quite arbitrary. 

H.R. 31 and H.R. 1800 contain 4 nearly identical provisions 

which we believe illustrate the significant bipartisan support for 

these initiatives. First, both bills propose an increase in the BDC 

asset coverage test from 200 percent to 150 percent. We don’t believe that this introduces more risk. Rather, it should broaden the 

universe of potential borrowers and allow BDCs to invest in lower 

yielding, lower risk loans that don’t currently fit in our economic 

model. In fact, the current asset coverage test may ironically be 

forcing BDCs to invest in riskier, higher yielding securities in order 

to meet the dividend requirements of its shareholders. 

We also believe that this change will grant borrowers greater financing alternatives at a reduced cost and will benefit shareholders with more conservative diversified portfolios. This proposed 

change would apply to BDCs the same leverage ratio as small business investment companies, but unlike SBICs, without putting any 

government capital at risk. In fact, I also believe that this is extremely modest relative to typical bank leverage, which can exceed 

10 times or greater. Under the current asset coverage test, most 

BDCs currently operate at leverage significantly less than allowed. 

A prudent manager would likely continue this practice if the asset 

coverage were to change. 

11 

Second, both bills would allow BDCs to treat preferred stock as 

equity rather than as debt. Had BDCs been able to raise capital 

during the post-2008 period by issuing preferred shares as equity, 

many more loans could have been made and many more jobs created. 

Third, both bills direct the SEC to make specific technical 

amendments to certain securities offering rules that make raising 

capital cumbersome and inefficient. These rule changes aren’t controversial and would merely place BDCs on equal footing with nonBDC entities. 

And fourth, both bills would restore BDCs’ ability to own registered investment advisers, a right that was inadvertently structured away. 

Importantly, the first two provisions of these bills would become 

effective immediately upon passage. The other provisions will require action by the SEC. 

So in closing, we are encouraged by the bipartisan focus on this 

important initiative, and we look forward to working with Representative Grimm, Representative Velazquez, and Representative 

Mulvaney, as well as Chairman Garrett, Representative Maloney, 

and the rest of the committee in moving this important initiative 

forward. Thank you. 

[The prepared statement of Mr. Arougheti can be found on page 

58 of the appendix.] 

Chairman GARRETT. And I thank you. 

Mr. Ertel is recognized for 5 minutes. And welcome. 

STATEMENT OF J. MICHAEL ERTEL, MANAGING DIRECTOR, 

LEGACY M&A ADVISORS, LLC 

Mr. ERTEL. Chairman Garrett, Ranking Member Maloney, and 

members of the Capital Markets Subcommittee, thank you for this 

opportunity to explain how today’s one-size-fits-all system of regulating securities broker-dealers adversely impacts owners of privately held companies who seek professional advice and business 

brokerage services to sell, buy, or grow their small and midsized 

businesses through privately negotiated transactions. 

Public policy considerations supporting H.R. 2274 go back to at 

least 2005 and have been well-documented in the oral and written 

testimony submitted by Shane Hansen, securities law partner with 

Warner Norcross & Judd, who testified before this committee on 

June 12th. 

My testimony is based on my experience as co-chair of the Campaign for Clarity, a profession-wide effort to bring clarity to the 

regulation of M&A advisers and business brokers, which has been 

led by the Alliance of Mergers & Acquisitions Advisors and supported by at least 17 other regional, national, and international associations of M&A advisers, business brokers, and related professionals. My testimony is also based on my experience in providing 

business brokerage and M&A advisory services to sellers and buyers of privately held businesses since 2000 and being a small business owner myself. 

Since July 2011, I have been a registered representative with an 

SEC and State-registered broker-dealer and FINRA member, but I 

am not speaking for or representing that firm in my remarks 

12 

today. I became a registered rep because in 7 years of persistent 

appeals by the Campaign for Clarity, the SEC has yet to address 

this critical small business issue through rulemaking. 

For most business owners, the sale of their business is one of the 

largest personal financial transactions of their lives, but something 

they may do only once. While they may be experts at managing 

and growing their own business, they have little or no experience 

in preparing their company for sale and getting it sold and closed. 

While their attorneys and accountants will provide valuable advice, 

astute business owners recognize they may need an experienced 

professional to quarterback the entire multidisciplinary business 

sale process from start to finish. 

Most business sales start with the buyer preferring to acquire 

business assets and the seller preferring to receive all cash at closing. Such a transaction would be exempt from Federal and State 

securities regulation. But for a variety of legitimate business and 

personal reasons, the structure of the transaction may morph to 

one that involves the purchase, sale of the company’s stock or may 

include an earnout or a seller’s note, any of which could arguably 

convert this business sale to a securities transaction. The final deal 

structure is generally not known until very late in the business 

sale process, which can run for months or even years. 

In facilitating the sale of an ongoing business, M&A advisers and 

business brokers are not in the business of selling securities, nor 

do they raise capital, nor do they hold anyone’s funds or securities, 

nor do they invest funds for the account of others. Nonetheless, the 

current one-size-fits-all regulatory scheme requires business brokers and M&A advisers to hold the same FINRA classifications and 

comply with the same Federal and FINRA regulations as Wall 

Street investment bankers and retail securities brokers. 

The cost to organize and operate a FINRA member broker-dealer for the first 12 months has been estimated at $150,000 to $250,000. 

For most business brokers and M&A advisers, this is prohibitive. 

Since many business brokerage firms and M&A advisory firms do 

very few transactions per year, occasionally none in some years, 

and since not all transactions are subject to securities regulation, 

the cumulative cost attributable to an occasional securities transaction can be very, very substantial. Ultimately, these costs must 

be passed on to the business buyers and sellers. 

In summary, professional and cost-effective business brokerage 

services facilitate capital formation and promote economic growth, 

job preservation and creation by small and midsized businesses. 

H.R. 2274 would direct the SEC to create a simplified system of 

M&A broker registration through a public notice filing and would 

require disclosure to clients about the M&A broker similar to those 

required of investment advisers today. The bill would direct the 

SEC to review and tailor applicable rules to fit this business context. This directive from Congress to the SEC will ultimately free 

up resources to better protect our public markets and passive investors. 

I urge you to support H.R. 2274, and I look forward to your questions. 

[The prepared statement of Mr. Ertel can be found on page 64 

of the appendix.] 

13 

Chairman GARRETT. Thank you. 

Next, Mr. Frank. Welcome. You are recognized for 5 minutes. 

STATEMENT OF ALEXANDER C. FRANK, CHIEF FINANCIAL 

OFFICER, FIFTH STREET MANAGEMENT LLC 

Mr. FRANK. Thank you. Good afternoon, Chairman Garrett, 

Ranking Member Maloney, and members of the subcommittee, and 

thank you for the opportunity to speak today. My name is Alex 

Frank. I am the CFO and a partner in Fifth Street Management, 

with over $3 billion in assets under management and the SEC-registered investment adviser of two publicly traded business development companies. Our team has a 15-year track record financing 

small and midsized companies, primarily in connection with investments by private equity sponsors. 

BDCs like Fifth Street play an essential role in the new world 

of middle market lending. As traditional banks have pulled away 

from lending to small and midsized private businesses, alternative 

lenders like BDCs have filled the void, emerging as the primary 

conduit between banks and smaller companies that are noninvestment grade credits. Consider that 9 years ago, there were just four 

publicly traded BDCs. Today, there are roughly 10 times as many, 

and we estimate that within the next few years, BDC assets will 

exceed $100 billion. 

Despite the growing importance of BDCs in helping finance small 

and midsized companies in our economy today, the BDC industry 

is still operating with legacy regulations that cost the industry significant amounts of time and money each year. Since BDCs are 

pass-through vehicles, that cost is borne not just by BDC shareholders, but by small businesses we serve. 

Several aspects of H.R. 1800 and H.R. 31 could go a long way towards modernizing the BDC regulatory framework. Shell filing, incorporation by reference, and treating preferred equity as regulatory capital will bring parity to the industry vis-a-vis counterparts like REITs and MLPs. We also support allowing BDCs to own 

registered investment advisers as a shareholder-friendly step that 

would offer investors incremental fee-based revenue. 

As you can see, I join you today as a proponent of the proposed 

rule changes in virtually their entirety. However, as the CFO of a 

conservatively managed investment grade BDC, and having spent 

22 years working at Morgan Stanley, including serving as the 

firm’s global treasurer, I cannot endorse the move to a 2:1 leverage 

ratio. 

Today, the Securities and Exchange Commission does a highly effective job enforcing this leverage ratio. I believe the 1:1 ratio and 

strict SEC oversight contributes to a reputation for safety that is 

appreciated by both BDC investors and nationally recognized rating agencies alike. Permitting 2:1 leverage might compel investors 

to reevaluate the BDC model, and retail investors may not appreciate the higher level of risk they are taking. And as rating agencies adjust their models, downgrades could follow. Even those 

BDCs who adopt a more conservative approach could be penalized 

and a noninvestment grade credit rating would increase a BDC’s 

cost of capital. 

14 

I would like to conclude my testimony with a discussion of effective leverage, which takes into account on a look-through basis leverage of the underlying assets in which a BDC invests. In other 

words, it is important to recognize that BDCs often provide expansion capital to their portfolio companies, which are often heavily leveraged themselves. 

Effective leverage is an important concept because it shows the 

true risk in a BDC’s balance sheet. Wells Fargo Securities estimates the BDC peer group average at 3.5 times equity. But the 

most highly leveraged BDCs have effective leverage ratio estimates 

over 5.5 times. If the bills are enacted in their current form, BDCs 

with already high levels of effective leverage could essentially double their effective leverage up to 11 times. 

Not all BDCs are alike, and I am also not convinced that 1:1 leverage is precisely the right level. During this period of high 

growth and increasing small business reliance on BDCs, completely 

removing the safety rails should be reconsidered. Having reduced 

the amount of risk in the financial system by requiring banks to 

hold more capital to support the risks associated with lending to 

noninvestment grade companies, only to shift that risk to entities 

like BDCs already operating with less risk, could significantly undermine the long-term vision the bill set out to achieve. 

Thank you, Chairman Garrett, Ranking Member Maloney, and 

members of the committee for allowing me to present my views on 

this critically important topic. 

[The prepared statement of Mr. Frank can be found on page 104 

of the appendix.] 

Chairman GARRETT. And I thank you for your testimony. 

Mr. Wunderlich is now recognized, and welcome, for 5 minutes. 

STATEMENT OF GARY K. WUNDERLICH, JR., CHIEF EXECUTIVE 

OFFICER, WUNDERLICH SECURITIES, ON BEHALF OF THE 

SECURITIES INDUSTRY AND FINANCIAL MARKETS ASSOCIATION (SIFMA) 

Mr. WUNDERLICH. Chairman Garrett, Ranking Member Maloney, 

and members of the subcommittee, thank you for the opportunity 

to appear before you today to discuss various legislative proposals 

to promote capital formation and job creation. My name is Gary 

Wunderlich, and I am CEO of Wunderlich Securities. I am testifying today on behalf of the Securities Industry and Financial Markets Association. 

Wunderlich Securities is an independent investment firm and 

full service broker-dealer headquartered in Memphis, Tennessee, 

with 28 offices in 16 States employing over 450 people. We provide 

a full range of financial services to retail and institutional clients, 

including investment banking, institutional sales, trading, and research. 

So on behalf of SIFMA and its member firms, I am here to express our appreciation for this committee’s dedication to a review 

of the environment for capital formation. 

America’s success depends on a vibrant financial system that 

provides access to capital and credit at a reasonable price, and regional firms, such as the one I founded 17 years ago, play an inteVerDate Nov 24 2008 14:47 May 06, 2014 Jkt 086681 PO 00000 Frm 00020 Fmt 6633 Sfmt 6633 K:\DOCS\86681.TXT TERRI
15 

gral role in our financial services system, particularly to assist 

smaller issuers. 

Turning to the legislative proposals before us today, I would like 

to begin by discussing our views of one area of capital formation 

that has been frequently debated over the past few years: The impact of decimalization on liquidity of small cap and midcap issuers. 

Many have suggested that the move to decimalization has contributed to lower levels of liquidity in those stocks and that along with 

other factors has impeded capital formation for those companies. 

This question has been posed in a variety of forums of late, including Chairman Garrett’s recent roundtable, as well as the SEC 

roundtable on decimalization. 

SIFMA and its members have also been engaged in an active dialogue about the impact of decimalization on small and midcap 

issuers, and we generally believe that a pilot program which widens quote increments for small and midcap issuers would increase 

trading liquidity in those securities. 

SIFMA supports a carefully structured pilot designed with very 

clear metrics for determining success to increase liquidity in the 

small and midcap market and create a more fertile environment for 

small and emerging growth companies to access the public markets. We know that these companies can be an engine for economic 

growth, and Congressman Duffy is to be commended for considering new ways to incentivize interest in small cap issuers seeking 

growth. 

While SIFMA is supportive of a pilot that explores how a wider 

tick size could benefit small cap issuers, we do oppose any pilot 

program that would restrict trading within the spread as the current discussion draft contemplates. Any restriction against trading 

inside the quoting increment would be an unprecedented alteration 

of market practice and would prevent broker-dealers from providing price improvement to retail investors and deter the commitment of capital for market-making activities. 

With respect to market price, trading within the quoted spread 

has always been permitted. Before Reg NMS and before the establishment of the stock exchanges themselves, market participants 

have always been able to meet in the middle on a negotiation over 

price. Perhaps more importantly, a trading restriction would have 

a negative impact on Main Street savers and retail investors. A 

consensus of most every market structure discussion in recent 

months is that it has never been better to be a retail investor, as 

the options for routing trades have increased, and as a result trading costs have substantially decreased. 

Just a few years ago, the SEC considered and rejected a trading 

restriction when it adopted the current penny-wide quoting increment, concluding that such price improvement benefits retail investors and is in the public interest. The SEC’s conclusion that it is 

in the public interest to allow trading within the spread is as relevant in 2013 as it was in 2005. 

Moving on, I would note that SIFMA supports efforts to modernize regulation of business development companies as contemplated in the three bills we are discussing here today to better 

enable BDCs to fulfill their mission. The BDC structure was created to promote public vehicles as a means to bring capital to small 

16 

and medium-sized businesses, and by regulation 70 percent of 

BDCs’ investments must be in private and small cap companies. 

BDCs offer a critical source of capital to eligible companies not 

met in today’s environment by traditional lenders. In fact, 

Wunderlich Securities has supported the efforts of some 17 BDCs 

this year alone resulting in more than 1.3 billion in capital formation. 

Further, Congressman Fincher’s discussion draft, which would 

modify existing regulation of EGCs, is also laudable, and SIFMA 

supports each of the four provisions in the discussion draft. These 

modifications remove some technical inefficiencies to the JOBS Act 

on-ramp so as to reduce uncertainty in regulatory treatment and 

allow EGCs more flexibility to launch their offerings in a timely 

manner. 

In conclusion, SIFMA welcomes your continued interest in supporting capital formation through appropriate regulatory relief. 

Many in government often try to distinguish Main Street from Wall 

Street, but the capital allocation function provided by my firm and 

thousands of others across this country supports the creation and 

expansion of tens of thousands of small businesses which are truly 

the backbone of our economy and the best hope we have for robust 

job creation moving forward. 

Thank you for the opportunity to testify before you today, and I 

look forward to your questions. 

[The prepared statement of Mr. Wunderlich can be found on page 

174 of the appendix.] 

Chairman GARRETT. Thank you for your testimony. 

From the U.S. Chamber, Mr. Quaadman, welcome. 

STATEMENT OF TOM QUAADMAN, VICE PRESIDENT, CENTER 

FOR CAPITAL MARKETS COMPETITIVENESS, U.S. CHAMBER 

OF COMMERCE 

Mr. QUAADMAN. Thank you, Chairman Garrett, Ranking Member 

Maloney, and members of the subcommittee for the opportunity to 

testify before you today. I would also like to take this time to thank 

the subcommittee for its continued leadership in ensuring that the 

United States has the deepest and most efficient capital markets. 

And I think today’s release of the crowdfunding rules by the SEC, 

albeit a lot later than I think a lot of us would have liked, is a testament to the leadership of this subcommittee. 

A free enterprise system needs diverse capital markets. Capital 

is the fuel that drives our economic engine and different businesses 

have different financing needs. Filling those needs is a dynamic 

marketplace in response to an ever-changing economic, legal, and 

regulatory landscape. The 2008 financial crisis has had obvious impacts upon Main Street businesses. 

To take one example out of Dodd-Frank, there is going to be a 

comment period that closes next week on credit risk retention, that 

if the rule is not properly implemented, collateralized loan obligations, which finance businesses to the tune of $300 billion, could no 

longer be an attractive form of capital formation. Basel III is having direct impacts on business lending by small and midsized 

banks, and Basel III also specifically disincentivizes the extension 

of commercial lines of credit by banks. 

17 

The bipartisan legislation that is being presented here today by 

the committee, which the Chamber supports, is keeping pace with 

those dynamic markets and is not lagging behind it. 

Business development corporations are filling a void and are a 

growing source of financing for small and midsized businesses. As 

businesses are looking to be acquired rather than go public, the extension of reporting requirements and easing of reporting requirements for merger and acquisition brokers is key. The tick-size pilot 

program is an experiment to increase liquidity and look at regulatory innovations through factual evidence. The XBRL exemption, 

as well as security laws changes for emerging growth companies, 

are building upon the IPO on-ramp created by the JOBS Act. 

However, we do have suggested improvements to these bills. 

With business development corporations, as has been stated before, 

they are close-ended funds that are open to retail investors and not 

just accredited investors, and they have higher yields, as well as 

higher risks. We believe that the SEC, in developing implementing 

regulations, should be directed to reexamine disclosures so that investors know what they are investing in. 

With XBRL, we believe that the rule 406T grace period should 

be extended for 2 years for large issuers and 5 years for smaller 

issuers. We also believe that there should be a requirement for an 

annual SEC report to Congress on the SEC’s progress on XBRL, 

the cost to businesses for XBRL implementation, the use of XBRL 

by investors, and that there should also be a report by the SEC to 

periodically report to Congress on the retrospective review of obsolete and unnecessary disclosures. 

To give one example that I have in my testimony, one Federal 

agency, working under the auspices of President Obama’s regulatory reform executive order, took 120 outdated regulations off the 

books on May 17th, and that was the Federal Communications 

Commission, some of those regulations dating back to the 1930s. 

With tick size, we believe that there should be a safe harbor from 

litigation so that as directors and management decide on a tick 

size, it is recognized that they are operating within their fiduciary 

duty for the best interests of the corporation and that they should 

not be subject to unnecessary litigation. 

With emerging growth companies, we believe that Rule 701 

should be modernized so that the dollar limit on private offerings 

may conform to the JOBS Act section 12(g) changes. So while the 

JOBS Act changed the number of investors that could be subject 

to private offerings, the $5 million limit that was put in place by 

the SEC in 1988 no longer is indicative of the market forces, so if 

you even just change that for inflation, that number today would 

be $10 billion. 

There is a cost of inaction if these bills are not passed. If these 

bills are not passed, we will see continued economic underperformance, sluggish job growth, and business caution. If these bills are 

passed, combined with the implementation of the JOBS Act, we can 

break that cycle and stoke the smoldering engines of growth. 

Thank you, Mr. Chairman. I am happy to take any questions you 

have. 

[The prepared statement of Mr. Quaadman can be found on page 

108 of the appendix.] 

18 

Chairman GARRETT. And I thank you, Mr. Quaadman. 

And finally, Mr. Weild is recognized for 5 minutes. And welcome 

to the committee as well. 

STATEMENT OF DAVID WEILD, FOUNDER, CHAIRMAN, AND 

CHIEF EXECUTIVE OFFICER, ISSUWORKS 

Mr. WEILD. Thank you, Mr. Chairman. Chairman Garrett, Ranking Member Maloney, and members of the subcommittee, thank 

you for inviting me to speak today on legislation to further reduce 

impediments to capital formation. My name is David Weild. I am 

chairman and CEO of IssuWorks Holdings, which was recently 

founded to develop technologies to improve capital formation in the 

public markets. I was formerly vice chairman of the NASDAQ stock 

market with responsibility for all of its listed companies, and I ran 

the equity new issues business at Prudential Securities back when 

Prudential Securities was one of the 10 largest underwriters in the 

United States. 

Improving access to equity capital in the United States is simply 

one of the most important needs for our economy. It fuels job 

growth and innovation, which in turn enables free markets to solve 

problems from poverty to unemployment to finding cures for cancer, global warming, and many of the other challenges that this 

generation and every other generation will face. 

I would like to start by thanking you for the terrific bipartisan 

work that culminated with the signing into law of the JOBS Act 

on April 5th of 2012, but while the JOBS Act created the so-called 

on-ramps to facilitate companies getting public, it did nothing to 

improve the after-market for these companies and their investors. 

So one might legitimately ask, have we created the on-ramp to nowhere? 

We are generally supportive of all of the bills in this group and 

our specific comments are contained in our written testimony. We 

have included other recommendations on capital formation and job 

growth in our written testimony and we hope that this committee 

will take it under advisement. However, I would like to focus on 

Mr. Duffy’s bill because it speaks to after-market support, and 

without after-market support for small cap equities, the U.S. economy will languish. 

Our listed stock markets are in the midst of a protracted collapse, and I call your attention to data which is contained in our 

statement that was recently compiled by the CFA Institute’s Jason 

Voss. The United States today has fewer publicly listed companies 

than at any point since all the way back to 1975. In fact, we have 

fewer than 4,900 publicly listed companies. We have lost half of 

them from the markets. And we should have, if we hadn’t done 

anything to market structure in the 1990s, closer to 13,000 publicly 

listed companies. 

We published a study for the Organization of Economic Cooperation and Development in July, and in it we found that the United 

States has the lowest after-market incentives of any of the 26 largest IPO markets in the world. Very simply, we are starving our 

markets. Consumer activists who promote low-cost trading in 

stocks are promoting fool’s gold. There is no free lunch. In fact, lowcost trading in illiquid stocks harms consumers by depriving them 

19 

of higher disposable incomes while wreaking havoc on the lowest 

socioeconomic classes of our society. It also seems obvious that the 

great growth companies of tomorrow, those very companies that 

will find the cure to Alzheimer’s and global warming and advance 

the technologies for sourcing renewable energy, need a United 

States IPO market that is as vibrant as it used to be when companies like Intel, Microsoft, and Amgen went public. We are doing 

135 IPOs since the end of the dot-com bubble. We were doing over 

500 a year before the dot-com bubble, and on a GDP-weighted basis 

we should be doing closer to 900 IPOs a year today. 

So we not only support this bill, we hope that this bill will, in 

addition to 5 and 10 cent tick-size increments within nano-cap 

stocks defined as stocks under $100 million in market value, consider a 20 cent tick option. The bill should require that trading be 

done only at a minimum tick-size increment, not within the tick 

size. 

And I am going to take issue actually with the SIFMA testimony 

in this regard because much of that is a view that is proffered by 

dark pool interests with the larger firms. You have to be very careful not to gut the tick-size incentives and takeaway by allowing 

people to trade within the economic incentive and to actually take 

away the inventive for smaller firms to provide value, which is research, capital, commitment, and sales support to these stocks. 

There should also be no payment for water flow allowed that would 

make a mockery of the intent of this structure. 

Higher after-market incentives through higher tick sizes will 

lead to more liquidity, which will bring more institutional investment, which will raise stock prices in smaller stocks, and lead to 

more IPOs and more job creation that will grow the U.S. economy. 

Today, there are already fewer than 3,700 operating companies in 

the Wilshire 5000 index. 

So with this in mind, we urge Congress to come together and get 

behind this bill and give Americans an on-ramp to prosperity. 

Thank you, Mr. Chairman. 

[The prepared statement of Mr. Weild can be found on page 154 

of the appendix.] 

Chairman GARRETT. And thank you for your testimony. 

I welcome everyone, and thank you all for your testimony. At 

this point, we will turn to questions, and I will recognize myself for 

5 minutes. I will just start with Mr. Abshure. 

Do you see any benefits, either in jobs or benefits to the economy, 

for financial services investment companies, financial institutions? 

Mr. ABSHURE. I guess I am— 

Chairman GARRETT. I say that, because your opening comments 

were opposed to the legislation that is before us today that would 

expand for the asset classes the type of assets that they may invest 

in? 

Mr. ABSHURE. The type of asset classes that BDCs could invest 

in. 

Chairman GARRETT. Yes. 

Mr. ABSHURE. Do I see a benefit of BDCs investing in financial 

services companies? 

20 

Chairman GARRETT. Do financial services companies not provide 

the economy with growth to the economy? Do they not provide the 

economy with new jobs and the like? 

Mr. ABSHURE. They invest in companies that do that. But if you 

already have— 

Chairman GARRETT. But they don’t provide them jobs and what 

have you in amongst themselves? 

Mr. ABSHURE. Not in the way that BDCs were designed. You 

have a carve-out specifically for BDCs that was designed for small 

companies, startup companies, and financially distressed companies. And then you have that mechanism for unaccredited investors 

to invest in those companies. Financial services are something different. And my point is, if you allow BDCs to invest in financial 

services companies that are, in turn, going to be a conduit for that 

capital to go somewhere else, you have just inserted a second step 

that provides no benefit but more cost. If BDCs can invest in what 

a financial services company can invest in, why do they need to be 

there? 

Chairman GARRETT. Okay. I see your point. You are suggesting 

that we are not getting any benefits from those financial institutions in and amongst themselves. I would disagree with that. 

Turning to the questions that Mr. Weild was talking about, you 

seem fairly passionate about the issue of the—I guess on the Duffy 

language and the trade-out rule. In your testimony, you said trading should be done only at the ‘‘outer bounds of minimum tick size 

increments, not within the tick increment.’’ And you go on to say 

this may be controversial. 

First, why do you say that may be controversial? 

Mr. WEILD. We don’t trade stocks, so we don’t have a horse in 

this race. I can step back and I think be objective. 

There are lots of interests right now that provide so-called price 

improvement to investors, a tenth of a penny, something that is 

relatively trivial. Large cap markets can perform very well because 

there are lots of buyers to offset sellers. There is a network effect. 

It is what academics will call symmetrical order book markets. But 

in small cap markets, which are asymmetrical—big buyer, no seller; big seller, no buyer—somebody has to provide value capital, and 

they have to provide salesmen to find the other side of the order. 

So you need an economic incentive to do that, and the minute they 

start trading within the tick size, the market devolves and it starts 

competing exclusively on price, so the whole thing starts to fall 

apart again. 

So I don’t think it will work, Chairman Garrett, in my view, and 

I think that if you give people a real nickel, and everybody trades, 

say at 10 by 1005, then what it will do is it will cause the firms 

to think about how to provide value to attract order flow, to create 

order flow, and it will start to bring capital into these micro-cap 

markets, lift them, which will then make them more attractive to 

move market IPOs into. 

Chairman GARRETT. So if we do something along the lines of setting—I will open this to you and other members, Mr. Wunderlich, 

if you wanted to join in—if we do something along the lines of setting of a pilot program, are there ways to do it such that you could 

set up measurement matrices to actually measure what you are 

21 

talking about, and also measure liquidity in the marketplace on 

this? 

Mr. WEILD. Sure. You could set up different baskets of stocks 

where you actually test where you have pull sanctity to the tick 

size, where you allow maybe even, it has been said trade at one 

price point within the tick size so that, for instance, if it was a 

nickel tick, you can trade at 2.5 cents, but that is it. And then, sort 

of the status quo. And you could test three buckets. 

You have to be careful though because Wall Street sometimes 

can be very crafty and they can ‘‘paint the tape,’’ to use an old 

term. 

Chairman GARRETT. What do you mean? 

Mr. WEILD. Meaning that you can have some interest that if you 

have a basket of 100 stocks, that if they want to demonstrate that 

there is more volume in one particular size, they may actually push 

volume through one pile, which could be very careful to control. 

Chairman GARRETT. Yes, okay. 

Mr. Wunderlich, do you want to join in on that? 

Mr. WUNDERLICH. Our position, SIFMA’s position is that there is 

value in the off-exchange pools and there is price improvement that 

we think is very demonstrable. Any restriction or prohibition on 

trading, on free market trading, we think would be a deterrent and 

distort actual market valuation and efficiency. 

I can speak on behalf of Wunderlich Securities. In my firm, we 

are market makers. Our market-making activities have come way 

down from when decimalization was put in place. And a part of it 

is, so it is not, ‘‘Wall Street trying to make more money,’’ it is managing risk. And so if I know now I have to trade at a nickel, or 

a dime, or even 20 cents, I am less likely to commit as much capital to market-making activities as I would if I knew that I could 

negotiate a price as a buyer and seller. 

Mr. Weild is right in that it can be a somewhat inefficient market, certainly without market makers. There are large buyers at 

some times and a few sellers, and there are large sellers and sometimes a few buyers. And market-making activities which we would 

undertake are to facilitate those orders. We could potentially take 

one side of that trade in order to facilitate an order from a customer who had a position, whether buying or selling. But we are 

less likely to do that if we are being prohibited or restricted on how 

we can liquidate that position. 

Chairman GARRETT. How you do the trade—yes? I can keep on 

going on this, but my time is up. And before I yield to the 

gentlelady from New York, I would just like to recognize the former 

chairman of the Financial Services Committee, who is not only 

looking at me in the face now, but is also looking over my shoulder 

as well, and welcome Chairman Oxley. 

It is good to be with you again. 

And of course I should point out that he is one of the reasons 

why I am even on this committee here in the position I am in 

today, so thank you for that as well, Mr. Chairman. 

At that, I will yield to the gentlelady from New York. 

Mrs. MALONEY. I likewise would like to recognize the gentleman 

who is literally on the wall, usually in the chairman’s seat. It is 

22 

very good to see you again, Chairman Oxley. It is wonderful to see 

you. 

I would like to start with Mr. Frank. You testified that basically, 

allowing BDCs to double their leverage would magnify the risk to 

shareholders, which are often retail investors. Mary Jo White, the 

Chair of the SEC, shares your concern in a letter that arrived 

today, and I would like to ask unanimous consent to make that letter a part of the record. 

Chairman GARRETT. Without objection, and it should be indicated that this is a letter with which I am familiar. This is a letter 

from Ms. White in her individual capacity and not from the SEC. 

Mrs. MALONEY. Right. 

Chairman GARRETT. Without objection, it is so ordered. 

Mrs. MALONEY. Thank you. 

And I would like to know, do any other panelists agree with Mr. 

Frank’s position on this issue? Does anybody else agree with him? 

No one else does? Does anyone disagree with him, and would they 

like to give their position? Mr. Arougheti? 

Mr. AROUGHETI. I would be happy to, for a counterpoint. 

First of all, representing the BDC industry today, to my knowledge, I think Fifth Street is the only member of this growing industry who has come out in opposition of an increase in leverage or 

a change in the asset coverage ratio. I have difficulty reconciling 

that with the fact that they also signed a letter of support for the 

proposed legislation with a host of other industry participants that 

came from the SBIA to the SEC a couple of weeks ago. 

In order to really understand this, I think it is important to just 

maybe take a step back and understand how the assets that BDCs 

invest in are already getting leveraged in the market and how the 

market participants are thinking about the increased risk. 

First, I think it is also worth clarifying that about 40 percent of 

investors in BDC stocks today are sophisticated institutions and 

not retail, and it may be a misconception that retail investors are 

driving growth in the BDC space. 

If you look at BDC balance sheets today, BDCs, depending on 

who you are, pursue different business models. Some BDCs invest 

in riskier mezzanine loans, which on their face are not leverageable 

due to their higher risk, and to use Mr. Frank’s language, have a 

higher effective leverage and therefore will not command leverage 

at the portfolio level. Other BDCs, such as ourselves, pursue a less 

risky strategy focusing on senior secured loans, which by definition 

carry less risk and therefore can command greater leverage. So the 

idea of leverage of loan collateral is something that is well-documented and already in practice in the BDC space in the financial 

services industry generally. 

To put a finer point on that, leverage in the BDC industry today 

is about 50 percent provided by banks. To use Ares as an example, 

we have about $2 billion of leverage that we get from the banking 

community, from notable lenders such as JPMorgan, Merrill Lynch, 

and Bank of America, et cetera, and we have 50 percent of our leverage that comes from the institutional debt markets. 

If you drill down into how the underlying documents work for 

these loan agreements, you will see that there are actually borrowing bases that are already in place where the bank lending 

23 

community has assigned different risk to different asset classes 

that BDCs invest in, and based on that perception of risk have a 

willingness today, as does the institutional market, to either increase leverage on lower-risk assets or decrease leverage on higherrisk assets. 

So I think the mechanisms are already in place. The overarching 

constraint is the regulatory restriction on leverage. So I don’t believe that leverage in and of itself means increased risk. I think the 

markets have reached a level of complexity and sophistication 

today to handle the differentiation between low-risk assets and 

high-risk assets. I think to not allow a change in the asset coverage 

ratio flies in the face of the policy mandate that BDCs were created 

for today, which is to make sure that we can get capital to small 

companies and grow jobs. 

Mrs. MALONEY. Mr. Abshure? 

Mr. ABSHURE. I just wanted to make sure, apparently I didn’t 

nod my head sufficiently vehemently enough. State securities regulators share the concerns voiced by both Mr. Frank and Chair 

White in her letter. However, I don’t feel that I could put those concerns anywhere near as eloquently as Mr. Frank and Chair White 

did. 

Mrs. MALONEY. Mr. Quaadman? 

Mr. QUAADMAN. Ms. Maloney, I think one is the change in leverage from 1:1 to 2:1 is actually a modest change in leverage. If you 

look at a well-capitalized bank, obviously there are different companies, but a well-capitalized bank has a leverage ratio of 7 or 8 

to 1. So one is, that change actually will allow BDCs to provide 

more liquidity. The SEC also has a number of different tools at its 

disposal to see if the BDC is acting properly, is being an appropriate, active participant. And that is also one of the reasons why 

we ask for more disclosures for investor protection. 

Mrs. MALONEY. Mr. Chairman, my time has expired, but may I 

ask for a few seconds for Mr. Weild to respond? His hand was in 

the air. 

Mr. WEILD. Thank you. We actually commented on this in our 

written testimony, and we just said that a higher leverage ratio my 

boost yields to investors and result in an increase in share price 

values. And we had actually called for some scenario analysis, 

some stress test analysis. Because these are already fairly highly 

leveraged businesses. It is the mezzanine debt finance market, debt 

plus warrants, and to understand in an inverted yield curve environment to where, in a deep recessionary environment how these 

portfolios are going to perform, I think would be only prudent. We 

are not averse to going to 1.5:1, but we would just like more information on how the portfolios would perform. 

Mrs. MALONEY. My time has expired. Thank you. 

Chairman GARRETT. All right. And I would just ask you to maybe 

provide us some measurement tools on how you would do that, how 

we would gather that information. 

But with that, I will yield now to Mr. Hurt for 5 minutes. 

Mr. HURT. Thank you, Mr. Chairman. 

I want to thank each of you for your testimony here today and 

for the work of our colleagues in trying to improve access to our 

capital markets. 

24 

My questions relate, as I said in my opening statement, to the 

XBRL. And I want to say how much I appreciate the useful comments made by the Chamber as it relates to this issue. 

With that in mind, Mr. Quaadman, I was wondering if you could 

talk a little bit about what the benefits are of XBRL in the big picture? You point out in your testimony that perhaps a 2-year delay 

in the compliance might be a good idea. I am wondering, what are 

the benefits and how would a delay be consistent with those benefits? 

Mr. QUAADMAN. Sure. There would be a number of different benefits with a delay. One is that XBRL is still a work in progress, 

and the whole theory behind XBRL is that you are going to move 

away from a paper-based system to a digital-based system, and 

then investors can pick and choose what information they want to 

analyze a company with. 

The problem is the SEC has, quite frankly, had a number of different problems with getting this off the ground. Some of the exemptions that we are talking about actually allow companies that 

are in XBRL to furnish instead of file reports under XBRL, and 

that is important because if it is furnished there is no liability; if 

they are filed, there are. 

So the reason why we are asking for a delay is, one, is to get the 

SEC’s house in order, to get the system up and running as best as 

they can. The other issue, and this is the reason why we asked for 

reports, is it is also important for Congress and the SEC to know 

how exactly are investors using XBRL, are they using it or not, and 

currently they really aren’t. 

Mr. HURT. Right, and why is that? 

Mr. QUAADMAN. Because they think there are a number of different sources that are out there that investors can use to access 

information if they like. It is available in a number of different 

sources and formats. Theoretically, if you can get them all in under 

XBRL at the SEC, it will make it easier. It will be one-stop shopping. That just hasn’t existed. So it is sort of the savvy investor 

who knows where to find the information can get it now; others 

can’t. 

Mr. HURT. Okay. And you mentioned this, I think there is a 

study that shows that less than 10 percent of investors use the system at all. 

Mr. QUAADMAN. That is correct. 

Mr. HURT. And I think it must go without saying that there is 

already an obligation. To the extent that SEC should promote 

transparency, I think we would all agree that is one of the cornerstones of our capital markets and the SEC’s fundamental mission. 

But with that said, these issuers have that responsibility going 

forward. It is not like they can, without XBRL, somehow have some 

added incentive or added ability to hide information. Is that a fair 

statement? 

Mr. QUAADMAN. That is correct. And the challenge that has existed, and there has been a frustration in the issuer community on 

this, the SEC has had a concept release out now for over 3 years 

on how to overhaul proxy plumbing systems. And this actually goes 

back to XBRL as well, because all of the systems in terms of how 

you report these issues, the disclosures, the corporate governance 

25 

issues, they are all rooted in a 1930s technology, and the SEC has 

sort of just allowed this to languish. So XBRL to some degree is 

a little bit of a symptom, but there is a disease out there, and we 

need to overhaul these systems into the 21st Century. 

Mr. HURT. The Chair of the SEC has talked about disclosure 

overload. We think about the benefits and what we hope that 

XBRL will bring, or what the SEC hopes it will bring to the table, 

but there are real costs to this for issuers and potential issuers. 

That is what we have heard certainly through our work on this as 

we have talked to folks about this issue. Would you agree with 

that? 

Mr. QUAADMAN. Yes. The disclosure overload harms both investors and issuers. So if you look at disclosures today, they are well 

over 100 pages and probably at least double what they were 15 

years ago. And if you looked at disclosures in the 1950s, you could 

have had a concise report that was 6 pages long. So the problem 

is, it is more difficult for companies to communicate with their investors. The investors just have information dumped on them and 

it is difficult for them to sort through what they think is actually 

material or not. 

And that actually gets to the core of the issue, is that the SEC— 

and this is what Chair White was also referencing in her speech— 

has moved away from what is material to investors. And the more 

we have moved away from that, the more inefficient the capital 

markets become. So we need to reorient the reports in a readable 

format, we need to make the information in there more material, 

and therefore there can be actual real communications between 

companies and their investors. 

Mr. HURT. Excellent. Thank you for your answers. My time has 

expired. 

Chairman GARRETT. The gentleman’s time has expired. 

The gentleman from California is recognized for 5 minutes. 

Mr. SHERMAN. Thank you, Mr. Chairman, and thanks for this series of hearings because it is very important that we get capital, 

particularly to small business. 

Without objection, I would like to enter into the record a letter 

from NAFCU, the National Association of Federal Credit Unions, 

dealing with the role that they can play in financing small businesses if we were to make a few changes in the laws regulating 

credit unions. 

Chairman GARRETT. Without objection, it is so ordered. 

Mr. SHERMAN. Previously entered into the record is a letter from 

the Chair of the SEC, and I would like to highlight on page 4 of 

that letter a statement that two of the bills, one of which would 

amend Section 60 and permit BDCs to purchase securities issued 

by registered investment advisers, and another one that would direct the Commission to revise certain rules under the Securities 

Act of 1933 to put BDCs on parity with other issuers that are required to file certain reports with the SEC under the 1934 Act. The 

chairman says that in her view these provisions do not raise significant investor protection concerns, so we should congratulate the 

authors of those two bills. 

Mr. Frank, there are two possible changes dealing with BDCs 

that would increase the upside and downside risk to those who inVerDate Nov 24 2008 14:47 May 06, 2014 Jkt 086681 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 K:\DOCS\86681.TXT TERRI
26 

vest in the common shares of the BDC. One would open the door 

to more issuance of preferred stock. The other would allow greater 

leverage. And I can see how you wouldn’t want to harm the brand 

name of BDCs among retail investors. They are looking for a moderate level of risk and here is an opportunity to have more risk, 

both upside and downside. 

Should we create a new designation, the high-leverage BDC, that 

would be allowed to get the benefit of those preferred share 

issuances and the higher leverage, and in that way just let investors know that you can invest in a regular, old-fashioned BDC or 

you can invest in the Ferrari that might crash? Would that solve 

the problem allowing some BDCs to go Ferrari style and some to 

be, what should I say, a Volvo with lots of air bags? 

Mr. FRANK. No, I don’t think it would. But first, I would just like 

to say that I think that allowing BDCs to include in their capital 

structure some level of preferred equity, which had the appropriate 

characteristics around capital permanence, is not something that 

we would think is necessarily imprudent and probably there is a 

place in the capital structure for that. 

Mr. SHERMAN. But you would object to the idea of having highleveraged BDCs identified as such, allowed to have different coverage ratios than regular BDCs? You would object to that? 

Mr. FRANK. I would, yes. I think that would introduce a level of 

complexity in the industry that would—it is already a fairly complex structure for investors, particularly retail investors to understand, and I also think that— 

Mr. SHERMAN. I have to reclaim my time because I have other 

questions on other issues. We are dealing with so many issues 

here. 

Mr. Quaadman, XBRL software, why does it cost $20,000 per filing for even a small company to use that software? 

Mr. QUAADMAN. I don’t know the reason for why it costs that 

much. But— 

Mr. SHERMAN. Excel is free. 

Mr. QUAADMAN. I think you just made the point right there. 

Mr. SHERMAN. Could the solution to this be to not exempt smaller companies from using it, but to make sure that the charge for 

using it is closer to $1,000 a filing rather than $20,000 a filing? 

Mr. QUAADMAN. I would hope that with the length of time that 

can be done to get this right, we would have costs that are much 

more realistic. We need to go to some digital-based form of reporting, but we need to do it right and the SEC needs the time to get 

it right. 

Mr. SHERMAN. So we might have a circumstance where we would 

delay a requirement due to the difficulty of government getting the 

computer technology right. That is interesting. Thank you. 

Mr. QUAADMAN. Sure. 

Mr. SHERMAN. I yield back. 

Chairman GARRETT. Yes, there we go. That is right. 

Mr. Huizenga for 5 minutes. 

Mr. HUIZENGA. Thank you, Mr. Chairman. I appreciate that. 

And I would like to kind of open it up on a couple of different 

fronts to a few of you. Under our existing system, there is a onesize-fits-all approach with SEC registration for the brokers, and I 

27 

am curious why you believe the SEC should be more tailored in its 

registration system for M&A brokers. I know Mr. Abshure and Mr. 

Ertel and a few others had talked specifically about our bill here. 

But, Mr. Ertel, do you want to start off, maybe, and Mr. 

Abshure? 

Mr. ERTEL. Having been through the process of getting the 

FINRA certifications to be a registered rep, they really bear little 

resemblance to the work that I do in helping a business owner get 

his business ready to sell, take it to market confidentially, sort 

through the various offers, and work with the various advisers to 

get that deal closed. So it poses an inordinately burdensome level 

of regulation on a transaction for which historically there have 

been very few bad actors, there have been very few cases where 

anybody has been injured. 

Mr. HUIZENGA. And we have had testimony before this committee—Shane Hansen, whom I mentioned in my opening statement, Alliance of Merger and Acquisition Associates, I believe that 

you are advisers, you are familiar with him, he had said setup and 

compliance-related costs often exceed $150,000. I think you had 

said $150,000 to $250,000 in your testimony, correct? And then ongoing compliance often exceeding $75,000 per year. Talk a little bit 

about that impact for a smaller M&A person. 

Mr. ERTEL. A lot of business brokerage firms and M&A advisory 

firms are very small shops—many sole practitioners, many firms of 

just two or three practitioners. So if you take that cost and spread 

it over the few transactions that they do a year, it is a very significant burden per transaction. 

Mr. HUIZENGA. Mr. Abshure? 

Mr. ABSHURE. Yes, I think if you go back and look at the historic 

definition of a broker under the securities laws, which is—and see 

that buy securities for its own account and for the—on the account 

of others, and you look at the existing system of regulation, both 

at the SEC and State level and also FINRA, you will learn that the 

system of regulation and the requirements is not really designed 

for the business in which an M&A broker engages. And I believe 

in your opening remarks you point—or perhaps Mr. Ertel pointed 

that out—that oftentimes an M&A deal, how it is structured is determined by the tax treatment. The M&A broker goes in, looks at 

the financial statements of the entity to be sold, helps clean that 

up, and makes some management advice. And then you get ready 

to do the deal, you look at the tax treatment, and decide whether 

it is an asset deal or a stock deal. If it is an asset deal, he is not 

a broker. If it is a stock deal, he is a broker. So it doesn’t really 

make sense. 

Mr. HUIZENGA. Even though that is the exact same transition 

and transaction, basically? 

Mr. ABSHURE. True M&A brokers are business advisers that specialize in the business of advising a company that is looking to 

change management, is putting itself on the market. And as long 

as they stay within that narrow frame, I think that the States are 

fine with creating alternative registration and compliance systems 

for those. 

The problem is that it is a very thin line between changing ownership and just selling a large block in connection with a capitalVerDate Nov 24 2008 14:47 May 06, 2014 Jkt 086681 PO 00000 Frm 00033 Fmt 6633 Sfmt 6633 K:\DOCS\86681.TXT TERRI
28 

raising transaction. So we would have concerns that the distinctions are clearly drawn. 

Mr. HUIZENGA. All right. I have around a minute-and-a-half here. 

Under my bill, H.R. 2274, M&A is exempt from FINRA, while subject to some of these SEC rules relevant to the limited nature of 

what M&A broker activities are. But should FINRA regulate M&A 

brokers? Anybody care to comment on that? 

Mr. ABSHURE. No. 

Mr. HUIZENGA. Excellent. Okay. 

Mr. ERTEL. I would agree. 

Mr. HUIZENGA. I am curious why, if you want to elaborate. 

Mr. ABSHURE. It goes back to why you are talking about exempting or changing the structure of M&A brokers. The entire FINRA 

system, regulatory system, is set up to govern brokers that are in 

the business of buying securities either for their own accounts or 

for the accounts of their client. That is not what these guys do. So 

there is no reason—and plus the numbers are so much smaller 

than what we are going to see from a regular broker-dealer standpoint—there is no reason, it would be extremely inefficient to set 

up a third level of regulation for business brokers considering the 

very narrow nature of their business. 

Mr. HUIZENGA. This is government we are talking about, so there 

is not always a concern about efficiency. But there is from this 

member, and I know from many members of this committee. And 

ultimately, I will part on this, who ultimately bears the cost of the 

fees associated with registration and compliance associated for the 

M&A brokers? I think we probably all know the answer, but if anybody cares to jump in? 

Mr. ERTEL. It ultimately passes through to the buyer and seller 

of the business. I have made the statement that if the deal was all 

cash and you marked the bills that were brought to closing, the 

buyer brings all the money and the broker takes home some of it. 

So a lot of it falls to the buyer. Some of it falls to the seller. 

Mr. HUIZENGA. Right, thank you. My time has expired. I appreciate that. I just wish Mr. Hensarling was here, our Chairman 

Hensarling was here to hear again how important that this bill is. 

But I am glad he was here for opening statements. So, thank you. 

Chairman GARRETT. Okay. The gentleman from Georgia is recognized for 5 minutes. 

Mr. SCOTT. Thank you, Mr. Chairman. This is certainly a fascinating hearing. 

I have two lines of questions. First of all, it seems to me we are 

sort of turning the BDCs on their head here, and so I think it is 

important that the first question I want to ask is that by permitting the BDCs to invest all of these funds in financial firms instead 

of the nonfinancial small businesses, would not that divert capital 

from the small, growing businesses that the BDCs were originally 

created to help? Am I off base there? Do you all have any concerns 

that might be happening? 

Mr. ABSHURE. The State securities regulators share your concern. 

Mr. SCOTT. And I am also concerned about the fact of the other 

thing. Right now, it is prohibited in the hedge funds. And would 

BDCs and their allowing them to invest entirely in private funds, 

29 

including hedge funds, would not that allow the BDCs to circumvent the general prohibition on selling interest in private funds 

to retail investors? 

Mr. ABSHURE. If you will recall, in my opening remarks I said 

that in the State securities regulators’ opinion, the changes in the 

BDC laws that are being proposed would effectively allow hedge 

funds for unaccredited investors. 

Mr. SCOTT. Okay, thank you. And would not this turning this on 

its head eliminate all of the provisions intended to protect preferred stock investors? Holders of preferred stock could find that 

dividends not paid during lower earnings periods are never paid, 

even if the BDC subsequently prospers. Is that not a true statement? Shouldn’t we be concerned about that, that these investor 

protections would be lost here? 

Mr. AROUGHETI. If I may, I think we may be talking about apples 

and oranges. And there was testimony introduced into the record 

by Prospect Capital around some of these issues. I think it is important to differentiate between finance companies and financial 

services companies. My understanding of the dialogue is in regard 

to traditional commercial finance structures such as equipment 

leasing companies, commercial finance companies, and franchise finance companies, all of whom occupy a very important role in the 

capital formation for small companies. 

Under current regulations, BDCs are actually prohibited from investing in those types of businesses, and it is those types of businesses that are part of the formula for getting capital to small business. When we are talking about structures like private equity 

funds and hedge funds, to Mr. Abshure’s point, I do think that 

could be worthy of further reflection and discussion insofar as those 

are fund structures, not operating companies. And I think it is important to make a very clear distinction between those two types 

of structures. 

Mr. SCOTT. Okay. Now, let’s go to the tick sizes. There is a tick 

size that is being advocated of 5 cents or 10 cents. There are even 

some who want the continuation of the 1 cent or the penny. So 

there is not a unified position in the community on what size this 

split should be, which there should be. So my point is, given that 

there are some who want 5, there are some who want 10, there are 

some who want a penny, and some even want less than that, my 

question is would it be appropriate to enshrine the tick sizes in the 

statute with this split and difference in your community? 

Mr. WEILD. May I take a shot at that, Congressman? Any increase in tick sizes for small micro-cap stocks is going to be a step 

in the right direction. I think then it is a question of how we actually implement it. And I share this view with Professor James 

Angel from the University of Georgetown, who was a proponent of 

the issuer choice tick size model, because we think that what will 

happen is, by discussing what the appropriate tick size is with the 

securities firms, the investment banks, the value providers, and the 

institutional investors, that the companies will figure out an appropriate tick for the share price. A 5 cents tick size in a $10 share 

price is twice the value of a 5 cent tick size in a $20 share price. 

So it is not going to be a one-size-fits-all. Where we came out was 

let the market decide, let individuals get into a discussion, and that 

30 

we would start to see liquidity bands and we would start to see individual ticks sort of gravitate to certain underlying liquidity bands 

as a result of market input. 

Mr. SCOTT. One quick point and I am through, Mr. Chairman. 

But is everybody in agreement that a penny and a subpenny tick 

size is central to the decline of the U.S. IPO market over recent 

years? 

Mr. QUAADMAN. Mr. Scott, if I could just take a stab at that. 

Number one, decimalization actually lowered costs for investors 

and actually provided for price discovery. What we are having now 

is a debate about whether or not, if you are going to have a pilot 

program on tick size changes, is that going to help drive liquidity 

to smaller issuers? So I think we need to differentiate different 

parts of the market from the other. 

The other point to your first question is, I think it is important 

to leave it in the hands of the companies to decide, if there is a 

pilot program, decide what is best for the company, but then it is 

really going to be incumbent on the SEC to really research it in 

terms of, is it providing that liquidity to those companies, is it allowing people to look at smaller companies in a closer way than 

they are now, but also what is it doing in terms of cost to investors? So is it helping retail investors go to invest in smaller companies? What does it mean for mutual funds? Is it going to increase 

cost or lower cost for mutual funds? Is it going to have them become a bigger investor in smaller companies? 

So I think the SEC, if there is a pilot program, needs to look at 

this holistically to see if this program is going to work, and then 

we should all come back and decide what the next step should be. 

Mr. SCOTT. Thank you, Mr. Chairman, for that extra time. It was 

very helpful. Thank you. 

Chairman GARRETT. Mr. Grimm? 

Mr. GRIMM. Thank you, Mr. Chairman. 

Mr. Arougheti, we are hearing a lot of different opinions on the 

role of BDCs and the impact that it could have. So I wanted to 

hone in on a few things regarding the kind of BDCs that you specialize in, like yours. What is their current ability, the kind of firms 

that BDCs like yours finance, the ones that you are providing capital to, what is their current ability to access capital to grow either 

via a bank or the other capital markets? 

Mr. AROUGHETI. Thank you, Mr. Grimm. Maybe just to take a 

quick step back to understand the ecosystem that we operate in 

and to really understand the critical role that BDCs play, if you 

think about the traditional financing alternatives available to a 

small and growing company, there are community banks and local 

banks that can meet the needs of small businesses as they grow, 

with government subsidy or without government subsidy. However, 

they are limited in the flexibility of their product. Oftentimes, they 

are limited in their risk tolerance. Many times, they are limited in 

the size of capital commitment that they can give to a growing 

company. 

So the BDC industry really begins to become relevant at the 

point in which the needs of a small and growing business outgrow 

the traditional small company alternatives, and we grow with that 

business all the way up to the point at which they can access the 

31 

debt or equity capital markets. That goes hand in hand with the 

policy mandate that we provide strategic and managerial assistance to these companies. So one of the ways I have always thought 

about BDCs, and it is inherent in the growth in the industry, is 

we effectively grow with these companies as they graduate through 

the capital markets ecosystem. 

When you look at the type of companies that we lend to, we will 

lend to venture companies that are investing pre-revenue and precash flow in new technology and innovation, all the way up to more 

mature companies. But the borrowers that find their way to the 

BDC space find their way to us for a reason, because their needs 

are being unmet by traditional alternatives. 

Mr. GRIMM. And right now, just approximately last year, say, 

how many in loans did you provide capital for? 

Mr. AROUGHETI. Ares is the largest industry participant, and we 

committed about $4 billion in new capital into the middle market. 

Mr. GRIMM. And if this bill were to pass and the leverage ratio 

was increased, which I think is a very modest increase, from $1 to 

$2, how much do you think you would be able to increase your capability of loaning money to these small and midsized firms? 

Mr. AROUGHETI. Significantly, and it goes back to my prior commentary. I think the increase in leverage will actually encourage 

BDCs to seek out lower-risk borrowers in a part of the ecosystem 

that they currently can’t serve. When you look at the BDC structure as a pass-through entity, the yield requirement on BDC dividends for the more conservative players like us is 8 percent, and 

some of the ‘‘riskier players’’ the market is already differentiating 

with yields in excess of 11 or 12 percent. My expectation is that 

with a modest increase in leverage you would see the ability of 

BDCs to further meet the needs and serve the needs of their existing customer base. 

I would also highlight, if I may, if you look at the SBIC debenture program, which has been very successful and is a very good 

indicator of the underlying performance of these types of loans, to 

put that in perspective, in Fiscal Year 2012, the SBIC debenture 

program extended about $3.1 billion in loans, and I would highlight 

that the SBIC debenture program currently allows for leverage of 

2:1, consistent with the proposed legislation, as opposed to the 1:1 

under the existing BDC regulation. 

Mr. GRIMM. I apologize. I really want to get this in with 1 minute 

left, so please be as concise as you can because I think this is important. What level of losses would a BDC like yours need to experience to wipe out its equity at these ratios, the proposed ratios? 

Mr. AROUGHETI. Commissioner White had in her letter a description of increased risk, saying that the loss rate would have to go 

from 50 percent to 33.3 percent to harm BDC shareholders. I think 

it is worth pointing out that the BDC industry over the last 10 

years has experienced actual realized loss rates of about 60 basis 

points and some of the more conservative structures like Ares have 

actually had positive realizations, i.e., no net losses. So as we come 

off of the experience of the great recession and see how these middle market companies and this middle market collateral have performed, I struggle to craft a scenario where we— 

32 

Mr. GRIMM. Did any BDCs fail in the 2008 crises because of too 

much leverage? 

Mr. AROUGHETI. There have been no BDCs that have failed or 

gone bankrupt. 

Mr. GRIMM. Thank you. I yield back. 

Chairman GARRETT. The gentleman yields back. 

Mr. Foster is now recognized. 

Mr. FOSTER. Thank you, Mr. Chairman. 

In Mr. Abshure’s testimony he notes that one of his concerns 

with the BDC bills is the proposal that would allow them to invest 

in investment adviser firms. And his concern was that it might create a potential conflict of interest for the investment advisers to 

recommend to their clients that they invest in the BDC or their 

portfolio companies. And I was wondering if any of the other witnesses have a comment on this potential conflict-of-interest concern? 

Mr. QUAADMAN. I would just add, I think that is one of the issues 

that the SEC can look at. I think that is what Mr. Sherman was 

sort of driving at, is that if you go forward with this legislation, you 

allow them to become bigger liquidity providers in the market and 

you provide for more investor protections, if you know that there 

are different types of strategies that are involved, the SEC has the 

tools, through stress tests and others, to see if they are acting appropriately and the like. So I think there are ways to monitor that 

and then to come back and see if more needs to be done. 

Mr. FOSTER. Is anyone willing to venture a guess as to what fraction of BDC holdings might be expected to flow into investment advisers if the restrictions are lifted? Is this going to be a little pimple on the whole industry or does this have the potential to be a 

dominant component? Any feeling at all? All right. 

If I can move to tick size, would it be a good idea if the tick-size 

experiments were conducted both with and without bans on trading 

between the ticks? Is that an interesting element of the pilot proposals? Because there is sort of a different opinion as to how big 

an effect that would be and whether it would effectively vitiate the 

tick-size proposals. 

Mr. WEILD. I think that was a recommendation we made way 

back at the February 5th roundtable on decimalization, and if you 

really want to create a pilot you can segregate different groups of 

stocks and you can extract interesting comparable information. 

Mr. Wunderlich’s comment, I agree and I don’t agree with the 

comment about market makers, risk taking. There are 53 different 

trading venues in the United States now so markets are structurally very different from the days when we had over-the-counter 

market makers, when we did control risk by essentially being able 

to put stock out within the bid and the ask side of the market. So 

it is not clear that is actually going to be the way that market 

makers control risk today given that a dark pool might siphon off 

just mounds and mounds of liquidity as investors are searching out 

lowest possible price as opposed to value provision. 

I just honestly think we have to get started and try some stuff 

and we have to keep doing it and keep trying it because the problems are so extreme and the impact on the economy is so extreme 

that the upside for the American people is extraordinary. And so 

33 

we may not get it right the first shot, but doesn’t mean that we 

don’t take a second or third shot at getting it right. 

Mr. FOSTER. Is it anticipated that the tick-size changes would result primarily in changes in the amount of technical trading or research-based trading or sales commission-based trading? And 

which is the kind of trading and liquidity that you are trying to encourage here? 

Mr. WEILD. Real liquidity is when there is no order and somebody goes out and creates an order to offset a buyer or offset a seller. And that usually takes human beings to do. Machines don’t do 

that. And there has to be an economic model to incent somebody 

to get on the phone. Right now there is no economic model to do 

that. 

Mr. FOSTER. But that could be based on a statistical analysis of 

previous price points, which I would consider to be technical trading, or based on actually a study of the fundamentals of the company. And I am just trying to figure out which one you are trying 

to incent mainly, or which will you end up incenting mainly with 

the tick-size changes. 

Mr. WEILD. We would be incenting real brokers, human beings, 

talking to institutional investors or retail investors about stocks 

and creating visibility in those names, in those stocks, which is activity for the most part which is going out of the market today. 

We would also hope to be incenting capital commitment to facilitate the positioning of a block of stock before they find a buyer that 

is real liquidity on the other side for that block of stock. So we 

would expect that if these pilots were structured appropriately that 

one of the metrics you would look at is block liquidity. If block liquidity starts to go up 5,000 shares—right now things are put 

through the electronic mixmaster and you are looking at 100-share, 

150-share trades ad nauseam, and if you start seeing the numbers 

creep up in terms of size of the trade, I think that is a sign that 

this system is having its intended effect. 

Mr. FOSTER. Right. Thank you. My time is up. I yield back. 

Chairman GARRETT. Thank you. The gentleman yields back. 

Mr. Duffy is recognized for 5 minutes. 

Mr. DUFFY. Thank you, Mr. Chairman. And again, I appreciate 

all of the conversation around tick sizes and maybe the benefits or 

drawbacks that you guys all have provided your opinions on. 

First, I want to thank Mr. Quaadman for bringing up the issue 

of a safe harbor. I think that is a good point. If we are going to 

have a successful tick-size pilot program, we want to make sure 

there is no liability. And I think that is a conversation we want to 

pursue. But I appreciate you bringing that point up. 

And I want to be clear, we don’t have any interest, I am not trying to engage in the larger argument between our dark pools and 

exchanges, and I think we have entered into a space that has some 

people excited. We truly are trying to create more liquidity for 

small cap companies. That is the true intent here. And I know that 

people are looking down the road and it might take some signaling 

of our proposal that we are trying to have a greater impact on a 

market structure, and that is not the intent. 

34 

But maybe to Mr. Wunderlich, if we allow just a quote at, aren’t 

we really undermining the purpose of a tick-size bill? We don’t get 

the full impact of this experiment, this pilot program? 

Mr. WUNDERLICH. Yes and no, in that it does seem sort of 

counterintuitive, right, that you are going to quote it in nickels and 

dimes and then you are going to trade it maybe in between. So 

maybe it does seem a little counterintuitive. But the issue, it is sort 

of, I guess, I would go back to a point in history when we tried to 

do it in 8ths and 16ths. We always traded between the bid and the 

ask. It has been done historically. And I think liquidity in our experience was a lot better before decimalization in small and midcap 

stocks; not necessarily the case in larger cap stocks. 

The other issue is, from where I sit from a market-making standpoint we do think that it is taking more risk if you are committing 

to basically having to trade in larger increments. And the other 

side it is just sort of market valuation and efficiency. Markets, liquid markets are very efficient over time as far as where things 

should or shouldn’t be priced. And I don’t want to say it is manipulation or price fixing, but in a sense you kind of are, if you are 

mandating you have to be at this dime or this nickel or 20 cents. 

That being said, I will reiterate, we are for the pilot, again, but 

we think we ought to be able to trade between the bid and the ask. 

Mr. DUFFY. And we are creating a financial incentive here, aren’t 

we? That is the purpose. 

Mr. WUNDERLICH. I’m sorry, I didn’t hear you. 

Mr. DUFFY. We are trying to create a financial incentive here. 

Mr. WUNDERLICH. That is correct. 

Mr. DUFFY. And that incentive may be diminished if we allow 

more price improvement, trading between the ticks. Yes? 

Mr. WUNDERLICH. No, sir. I think I would go the other way. The 

incentive is for whom? Right? Is it for the investor or is it for the 

brokerage firm, is it for the issuer? There are several constituents 

involved. And one is for us to have an incentive to even traffic in 

these stocks. And if we view that to an outsized business risk 

where we are mandated to have to take a price, then we are less 

likely to commit capital to something like that than if we were able 

to trade freely between the bid and the offer. Did that answer your 

question? 

Mr. DUFFY. Kind of. Maybe we can talk about it a little more 

later. 

Mr. Weild, do you agree with that? Do you think we diminish the 

pilot program, our tick-size pilot program if we allow trading between the ticks? 

Mr. WEILD. I think we do on the margin. Step back for a second 

and look at the study that we did on the 26 foreign IPO market, 

the 26 largest. And we have a convention in this country where we 

don’t allow—most brokerage firms don’t allow brokers to solicit 

stocks or put them on margin if they are under $5 a share. So it 

arbitrarily keeps our stock prices high. So the United States has 

zero stock, zero percent stocks that have a 1 percent or higher tick 

size that are sub-500 million that are micro-cap or smaller, whereas the high IPO-producing countries, which are countries like 

Singapore, Australia, Canada, weighted for GDP, 70 percent or 

more of their micro-cap stocks have 1 percent or higher tick sizes 

35 

because they split the stocks down to levels where a penny, at 50 

cents, a penny can make 2 percent difference incentive. 

I do believe that a nickel or a dime and having some integrity 

to the tick size will ultimately cause the market to compete on providing sales, capital, value support, and it won’t let the market 

compete on price, which is the problem in micro-cap markets. 

I totally agree with the point of view, I think Tom said this earlier, large cap stocks that are innately liquid stocks actually become more liquid with smaller tick sizes, but the academic literature clearly shows that innately illiquid stocks become less liquid with smaller tick sizes. So the reverse of that, which is increase 

the tick and respect the tick size, will bring liquidity to these 

stocks. 

Mr. DUFFY. And, Mr. Wunderlich, do you agree with that? 

Mr. WUNDERLICH. Yes, I do. 

Mr. DUFFY. Thank you, I yield back. 

Chairman GARRETT. The gentleman yields back. 

For the last word, Mr. Carney is recognized. 

Mr. CARNEY. Thank you, Mr. Chairman, and thank you for holding the hearing today. Thank you to all the witnesses. I have been 

working with Mr. Duffy on this tick-size issue, so I have been listening very carefully to the discussion over the last three questioners. 

And our objective is pretty simple, Mr. Duffy laid it out, is to 

drive more liquidity, more activity to the smaller cap companies. 

And do I interpret everybody to say that you are for a pilot of some 

kind. Mr. Wunderlich? Mr. Quaadman? The last three had the 

most discussion, right? 

Mr. WUNDERLICH. Yes. 

Mr. CARNEY. So the question is, how to get it right. I was interested in the suggestion that Mr. Foster had about having both 

maybe a quote at and trade at provision in the pilot. Does that 

make sense? I will start with you, Mr. Wunderlich. You have a 

problem with our current approach, so what about the approach of 

having both? 

Mr. WUNDERLICH. Clearly, and let me speak for myself and 

maybe not SIFMA here— 

Mr. CARNEY. Sure, sure. 

Mr. WUNDERLICH. I will speak for SIFMA in this regard. One, we 

need to have very clear metrics. And I think Mr. Weild said earlier, 

we want to make sure that if you do something on it, we want to 

compare apples to apples, and it needs to be very clear. 

Mr. CARNEY. And by the way, that is my last question, and that 

would be the metrics in terms of the evaluation of this pilot. So to 

the extent that you independently can provide us with something 

in writing about what they ought to be, you have mentioned some 

of those, that would be much appreciated. Please. 

Mr. WUNDERLICH. And now I have forgotten your question. I 

apologize. 

Mr. CARNEY. The question was, the pilot that included both a 

quote at and a trade at, so that you have two different looks at 

trading within the spread. 

Mr. WUNDERLICH. And I will speak for myself and Wunderlich 

Securities severally. I do believe that being able to trade between 

36 

the bid and the—between tick sizes would be better. That being 

said, ultimately, I am for a pilot in some way, shape, or form. And 

if it means having two pilots then I would be personally, and I will 

speak for myself and Wunderlich Securities here, I would be for 

that, versus not having a pilot at all. 

Mr. CARNEY. Okay. 

Mr. Quaadman, do you have a view of that? 

Mr. QUAADMAN. Let me take it in reverse order. 

Mr. CARNEY. Sure. 

Mr. QUAADMAN. We are supportive of a pilot program. We think 

there needs to be exhaustive metrics on that. 

Mr. CARNEY. And you have a view of what things ought to be? 

Mr. QUAADMAN. Yes. We will work with both you and Mr. Duffy 

on that. 

As to your last point, I think there is some attraction to that, and 

I want to think about that some more and get back to both you and 

Mr. Duffy on that. 

Mr. CARNEY. Okay, sure. 

Mr. Weild, do you want to take both of those pieces? 

Mr. WEILD. We have done some work already on what we think 

the metrics should be. There is also a committee that has been advising Treasury, an ad hoc committee that includes some institutional investors that has done some work. So let me pull that together and I will just get it back to you on what we think metrics 

should be. 

Clearly, the things that require people investments, on a shortterm pilot people are not going to make long-term investments in 

research and things like that, but when you look at the trading 

characteristics, you will get a sense, I think pretty quickly with the 

right metrics, whether or not it is working. And so, I think this is 

eminently— 

Mr. CARNEY. So we have a duration in the bill. Any comment on 

the duration? A 5-year duration is too long, too short, about right? 

Mr. WEILD. I think longer is better, and then if it proves to be 

working, then just make it permanent. Because the problem with 

a short-term pilot is people might game it. If it is a 1-year pilot, 

which I think has been recommended in some circles, like in the 

Citigroup article that came out in the Wall Street Journal today, 

I think they recommended a year, I think that is too short. 

Mr. CARNEY. Mr. Quaadman, you look like— 

Mr. QUAADMAN. I think a 5-year pilot is fine, but I would recommend that the SEC come out with some interim report either at 

2 or 3 years so you get a snapshot early on. 

Mr. CARNEY. Any comment on the definition of companies that 

would be eligible either in terms of total cap size or other? Right 

now the definition pretty much tracks the emerging growth company definition in the JOBS Act, I believe. So is that too limited, 

too expansive? Any comments on that? 

Mr. QUAADMAN. No, I actually think that is the right way to go, 

because that is a defined universe that Congress has already 

picked out, and it makes sense to go with that universe for this 

pilot program. 

Mr. CARNEY. Okay. Are there other comments? 

Mr. WUNDERLICH. I would agree. 

37 

Mr. WEILD. We would agree. I would also in our testimony, page 

11, just call your attention to just show you, if you just use this 

one metric, sub-$2 billion market value companies, they only represent 6.6 percent of total market value. Said another way, you 

could trade yourself silly in the large cap markets, and that is the 

vast majority of market value, and these small stocks are just fundamentally different. About 81.1 percent of all listed companies are 

sub-$2 billion in market value, the institutional definition of small 

cap, and they represent only 6.6 percent of aggregate market value. 

You are comparing apples to oranges structurally. So, EGC definition is fine, gets to the same, close to the same place. 

Mr. CARNEY. I want to thank each of you for your help, and your 

testimony today, and I thank my colleague from the other side. I 

yield back. 

Chairman GARRETT. The gentleman yields back. 

And we have been joined by Mr. Mulvaney for the last questions. 

Mr. MULVANEY. Mr. Chairman, I apologize to both you and the 

panel for having to run back out and back in. It has just been that 

kind of day. 

Mr. Abshure, I was here for your testimony, but I was not here 

for some of the follow-up questions. But as I understand it, you 

have a difficulty with retail investors being exposed to investments 

in hedge funds and private equity. Is that correct, sir? 

Mr. ABSHURE. Yes. 

Mr. MULVANEY. Okay. And I guess in theory I can sympathize 

with that a little bit, but don’t pension funds face the same issue? 

And aren’t there other instruments out there already that expose 

retail investors to investments in hedge funds and private equity 

funds? 

Mr. ABSHURE. I don’t think so on the levels that you are talking 

about here. You are talking about unaccredited, unsophisticated investors having access. 

Mr. MULVANEY. Unaccredited, unsophisticated investors. Does 

that not describe most pensioners who work for CalPERS? 

Mr. ABSHURE. Sure. 

Mr. MULVANEY. Don’t they invest in hedge funds and private equity funds? 

Mr. ABSHURE. No. 

Mr. MULVANEY. They don’t? Pensions funds don’t invest in hedge 

funds and private equity funds? 

Mr. ABSHURE. No. Unaccredited investors can invest in pension 

funds, but unaccredited investors cannot invest in hedge funds. 

Mr. MULVANEY. Okay. Don’t the managers of both of those types 

of entities, of pension funds— 

Mr. ABSHURE. The difference is you have a manager. 

Mr. MULVANEY. I’m sorry? 

Mr. ABSHURE. The difference is you have a manager in a pension 

fund as opposed to an unaccredited or an unsophisticated investor 

deciding to invest in the BDC all on his own, and then that BDC 

making decisions. 

Mr. MULVANEY. I have never invested in a BDC. I have invested 

in a closed-end mutual fund before and it was readily apparent to 

me what the closed-end mutual fund had invested in. Is that same 

information available to somebody who invests in a BDC? If I want 

38 

to know what they are investing in before I buy a share of a BDC, 

do I get to know what they are investing the money in? 

Mr. ABSHURE. No. 

Mr. MULVANEY. That is a secret. 

Mr. ABSHURE. I don’t think a registered BDC is going to disclose 

all of its investment on the front end— 

Mr. MULVANEY. Mr. Arougheti, help me out here. Do you tell 

your investors what you invest in? 

Mr. AROUGHETI. Just a minor correction. By regulation, BDCs 

are required to have a detailed investment listing of every single 

security and investment. 

Mr. MULVANEY. Okay. That is not a minor clarification. That is 

the exact opposite of what Mr. Abshure just said. 

Mr. AROUGHETI. No, every quarter BDCs, by regulation, are required to provide a detailed investment listing by security that 

they hold on their balance sheet. 

Mr. MULVANEY. Okay, Mr. Abshure, so is he wrong? 

Mr. ABSHURE. No. You provide that every quarter after the purchase has been made, correct? 

Mr. MULVANEY. Go ahead. You can respond, Mr. Arougheti. 

Mr. AROUGHETI. Correct. We have full transparency as to what 

resides— 

Mr. ABSHURE. So if I am a BDC owner on January 1st, I am 

going to learn what you did with my money at the end of that 

quarter. 

Mr. MULVANEY. But you are also going to know on the day that 

you purchased the stock where that money is invested, correct? 

Mr. ABSHURE. But in terms of what happens on day number 2 

then, I will know at the end of the quarter. 

Mr. MULVANEY. I didn’t stay in the State government long 

enough to participate in that State pension, but a lot of my friends 

have. I have teachers in the South Carolina retirement system. 

How are they treated any differently than your hypothetical BDC 

investor? Do they know when they put money away for their pension where that money is going on a daily basis or do they get regular updates? 

Mr. ABSHURE. No. 

Mr. MULVANEY. They don’t know, do they? There is no difference 

here. I guess what I am trying to get at is, why would we treat 

BDCs any different from pensions when it comes to hedge funds 

and private equity funds? 

Mr. ABSHURE. I think there are many differences between BDCs 

and pension funds. 

Mr. MULVANEY. And I am asking you for some of them. 

Mr. ABSHURE. I think just the entire structure, the entire goal 

behind the pension funds, the required payouts of the pension 

funds, the way that pension funds are structured to provide payments over time, the way that pension funds are constantly monitored to make sure that they have assets to meet the payout responsibilities. 

Mr. MULVANEY. And there is another difference, which is a lot 

of times, for example, if I am a teacher in South Carolina I don’t 

even get the choice to participate or not, I have to participate. So 

39 

there are actually certain areas where it is actually worse to be in 

a pension. 

Let me ask you this, because the SEC raised similar questions. 

I think it was a lot more well-articulated than what we have been 

through today. But, Mr. Arougheti, aren’t there ways to handle 

this? That is really the concern. If there is legitimate concern that 

you don’t want to end up with these entities being pass-through entities to simply fund hedge funds, aren’t there ways to deal with 

that? 

Mr. AROUGHETI. Yes, Mr. Mulvaney. I apologize, in prior commentary I thought that it was worth making the distinction between finance companies and funds. And as I said earlier, I do believe that there are parts of the financial ecosystem—leasing companies, franchise finance companies, et cetera—that are a valuable 

provider of capital, that are very distinct in the way that they operate and bring capital than the hedge funds and private equity 

funds. 

Mr. MULVANEY. So to the extent Mr. Abshure’s questions are legitimate, let’s assume for the sake of discussion that they are, we 

can fix that, can’t we? 

Mr. ABSHURE. Absolutely. 

Mr. MULVANEY. Thank you. 

I yield back the balance of my time. 

Chairman GARRETT. The gentleman yields back. And I think that 

was the last word. 

So at this point I want to, again, thank you all on the panel. And 

I ask unanimous consent to put 3 letters into the record from the 

Financial Services Roundtable, Reflexite, and Prospect, and also 

from SBIA. They are letters with regard to today’s hearing, so they 

are put into the record. Without objection, it is so ordered. 

Now, I can say thank you all for coming and for your testimony, 

which has been very illuminating and educational. And if we had 

any questions that we threw out to you that we didn’t get back, we 

would appreciate you responding in writing for the record. 

The Chair notes that some Members may have additional questions for this panel, which they may wish to submit in writing. 

Without objection, the hearing record will remain open for 5 legislative days for Members to submit written questions to these witnesses and to place their responses in the record. Also, without objection, Members will have 5 legislative days to submit extraneous 

materials to the Chair for inclusion in the record. 

So with that, I again thank you all. And this committee is hereby 

adjourned. 

[Whereupon, at 4:30 p.m., the hearing was adjourned.] 

(41) 

A P P E N D I X 

October 23, 2013 

42 


86681.001

Testimony of A. Heath Abshure 

Arkansas Securities Commissioner 

and 

Immediate Past-President of the North American Securities 

Administrators Association, Inc. 

Before the 

House Committee on Financial Services 

Subcommittee on Capital Markets and Government Sponsored 

Enterprises 

"Legislation to Further Reduce Impediments to Capital Formation" 

October 23, 2013 

Washington, DC 
43 


86681.002

Introduction: 

Good morning Chairman Garrett, Ranking Member Maloney, and members of the 

Subcommittee, I'm Heath Abshure, Securities Commissioner for the State of Arkansas. 

Until earlier this month, I was also the President of the North American Securities 

Administrators Association, Inc. ("NASAA"),l the association of state and provincial 

securities regulators. 

Prior to serving as NASAA president, I served as the chairman of both NASAA's 

Special Committee on Small Business Capital Formation, and NASAA's Corporation 

Finance Section. In addition, since 2011, I have served as an observer member of the 

SEC's Advisory Committee on Small and Emerging Companies, which has recently 

considered many of the same questions that will be examined at the hearing today. 

I, personally, have a deep interest in issues related to small business finance and 

capital formation, and I am honored to testify for a second time before this Subcommittee 

about these issues. 

Securities regulation is a complementary regime of both state and federal 

securities laws, and the states work closely together to uncover and prosecute securities 

law violators. State securities regulators have protected Main Street investors for the past 

100 years, longer than any other securities regulator. State securities regulators continue 

to focus on protecting retail investors, especially those who lack the expertise, 

experience, and resources to protect their own interests. 

The securities administrators in your states are responsible for enforcing state 

securities laws by pursuing cases of suspected investment fraud, conducting 

investigations of unlawful conduct, licensing firms and investment professionals, 

registering certain securities offerings, examining broker-dealers and investment advisers, 

and providing investor education programs and materials to your constituents.2 

Ten of my colleagues are appointed by state Secretaries of State, five are under 

the jurisdiction of their states' Attorneys General. Some, like me, are appointed by their 

Governors and Cabinet officials. Others, work for independent commissions or boards. 

In addition to serving as the "cops on the beat" and the first line of defense against 

fraud for "mom and pop" investors, state securities regulators serve as the primary 

I The oldest international organization devoted to investor protection, the North American Securities 

Administrators Association, Inc. (NASAA) was organized in 1919. Its membership consists of the 

securities administrators in the 50 states, the District of Columbia, Canada, Mexico, Puerto Rico and the 

U.S. Virgin Islands. NASAA is the voice of securities agencies responsible for grass-roots investor 

protection and efficient capital fonnation. 

2 States are also the undisputed leaders in criminal prosecutions of securities violators. In 2012 alone, state 

securities regulators conducted nearly 6,000 investigations, leading to nearly 2,500 enforcement actions, 

including 339 criminal actions. Moreover, in 2012, 4,300 licenses of brokers and investment advisers were 

withdrawn, denied, revoked, suspended, or conditioned due to state action, up 28 percent from the previous 

year. 

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86681.003

regulators of most small company securities offerings. As such, state securities 

regulators regularly work with and assist local businesses seeking capital to grow their 

companies. 

The states are committed to fostering responsible capital formation which in tum 

strengthens investor confidence and leads to job growth. At the same time, and as I 

testified to the Subcommittee in 2011, capital formation will be impeded when investors 

are not adequately protected. 

Advisory Committee on Small and Emerging Companies 

For over two years, I have had the privilege of serving as NASAA's designated 

member of the SEC Advisory Committee on Small and Emerging Companies ("Advisory 

Committee"). 

The Advisory Committee was established on Oct. 4, 2011, for a term of two 

years, and reauthorized for a second term earlier this month. Since the Committee was 

established, it has provided recommendations to the Commission regarding rules, 

regulations, and policies related to emerging companies, capital raising through private 

placements and public securities offerings, and reporting requirements for small and 

emerging publicly traded companies. 

Some of the policies enacted last year by the JOBS Act were based on 

recommendations of the Advisory Committee. In 2011, I testified before this 

Subcommittee and expressed concern about many of the policies in the JOBS Act, 

including legislation that directed the SEC to lift the ban on general solicitation in private 

securities offerings, and to implement rules to legalize "equity" crowdfunding. 

I remain deeply concerned that some of the policies enacted under the JOBS Act, 

including in particular, the lifting of the ban on general solicitation in Regulation D, Rule 

506 offerings, will be detrimental to investors and ultimately to the companies that rely 

on this method of capital formation. 

The SEC is currently considering a number of proposed amendments to the 

general solicitation rule adopted in July pursuant to Section 201 of the JOBS Act. 

NASAA strongly supports these proposed amendments.3 It will be essential that the 

Commission move swiftly to adopt many of these proposed amendments, especially the 

proposed requirement that "Form D" be filed prior to the first sale that occurs in any 

Regulation D offering that uses general solicitation. 

3 See NASAA Comments in Response to Release Nos. 33-9416, 34-69960, IC- 30595 (File No. S7-06-13), 

"Amendments to Regulation D, Fonn D and Rule 156 under the Securities Act." 27 September, 2013. 

Accessible at: http;//www.nasaa.orglwp-contentluploadsl2011/07INASAA-Comment-Letter-re-Fonn-D.pdf 

3 
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86681.004

Overview of NASA A Perspective on Today's Legislation 

Today, the Subcommittee is considering a number of new bills related to capital 

formation.4 These include proposals to (i) streamline registration requirements of socalled "merger and acquisition brokers;" (ii) further ease reporting requirements 

applicable to "Emerging Growth Companies" or EGCs; (iii) and relax portfolio strictures, 

leverage limits, and other regulations for business development companies (BDCs). They 

also include common-sense proposals to reduce "red tape" that adds to the compliance 

costs of small and startup businesses, such as the SEC's requirement that certain filings 

be made using eXtensible Business Reporting Language (XBRL).5 

NASAA's view regarding this new collection of bills is mixed. NASAA supports 

a number of these proposals; especially the proposed Small Business Mergers, 

Acquisitions, Sales, and Brokerage Simplification Act of 2013 sponsored by 

Congressman Huizenga, but ha<; concerns with other legislation pending before the 

Committee today. Most notably, NASAA is troubled by the proposal to further expand 

what are basically new, untested regulatory carve-outs for EGCs as well as proposals that 

would increase leverage and conflicts of interests in the BDC space. There are some bills 

before the Subcommittee on which NASAA does not have a strong stakeholder interest. 

For those bills, I will simply offer my own personal observations based on discussions I 

have had with others as part of my work on the Advisory Committee. Insofar as that 

latter category of bills does not pertain directly to state securities regulation, NASAA 

neither supports nor opposes their enactment. 

Streamlining Registration for Mergers & Acquisitions Brokers 

State securities administrators generally support the targeted, well-balanced 

provisions ofH.R. 2274, the Small Business Mergers, Acquisitions, Sales, and Brokerage 

Simplification Act of2013, H.R. 2274. This legislation would establish a simplified and 

streamlined registration process for broker-dealers engaged solely in the business of 

effecting the transfer or sale of privately held companies (i.e., "M&A brokers"). NASAA 

is optimistic that this legislation will encourage registration and regulatory compliance by 

M&A brokers. 

The registration process is an integral part of an overall regulatory regime at the 

state and federal level that is designed to promote responsible business practices among 

broker-dealers and to help protect investors. Generally, broker-dealers engage in the 

buying and selling of securities either for their own account or for the accounts of others. 

Broker-dealers may also engage in other businesses such as underwriting securities 

4 At least one of the discussion draft bills before the Subcommittee is modeled on a recommendation of the 

Advisory Committee. See U.S. Securities and Exchange Commission. Advisory Committee on Small and 

Emerging Companies. Recommendations Regarding Trading Spreads for Smaller Exchange-Listed 

Companies. February 1,2013. Accessible at http://www.sec.gov/info/smallbus/acsec!acsecrecommendation-032I 13-spread-tick-size.pdf 

5 While NASAA is supportive of reasonable statutory or regulatory forbearance for compliance with XBRL 

requirements for small businesses, as explained elsewhere in this testimony. we consider that the $1 billion 

annual revenue threshold contemplated by the discussion draft is far too high. 

4 
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86681.005

offerings and the making of markets for new and emerging companies. The current 

registration process is well suited to the vast majority of these broker-dealers. However, 

these registration requirements may not be as well suited to a limited number of brokerdealers engaged exclusively in the business of mergers and acquisitions (M&A Firms). 

M&A Firms, as defined in H.R. 2274, would be limited to those firms engaged 

solely in the business of affecting the transfer of ownership of certain eligible privately 

held companies. As a result, the traditional registration process for broker-dealers is not 

particularly well suited for the M&A Firms. Furthermore, individuals who work for 

these firms and earn commission-based compensation in M&A deals have the additional 

burden of affiliating with a registered broker-dealer firm in order to obtain registration. 

The expense and compliance with the registration requirements has led many M&A 

firms, particularly those handling small M&A deals where firms typically pass on the 

cost of regulatory compliance to their clients, to forego registration and compliance 

requirements altogether. There is no public record of these unregistered firms or 

individuals, or the fees they earn for their services. There is no regulatory body (whether 

a government regulator or a self-regulatory organization) confirming that clients receive 

appropriate disclosures such as conflicts of interest and a list of employees and affiliates. 

Investor protection is best served when regulatory necessity and transparency is 

balanced sensibly with the practicalities inherent in any business model. In the case of 

M&A brokers, H.R. 2274 strikes an appropriate balance. The bill reduces the standard 

regulatory requirements applicable to traditional broker-dealer firms and provides M&A 

brokers of privately held companies (as defined therein) with a simplified registration 

regime that provides sufficient oversight to these firms without diminishing the authority 

of state or federal regulators. 

The M&A industry has worked with NASAA in developing the proposal that is 

contained in H.R. 2274. We welcome its introduction and look forward to supporting the 

legislation in the I 13th Congress. 

Notwithstanding our general support for H.R. 2274, NASAA does object to one 

provision - (a)(13)(G)(iii) State Law Preemption - that references Section 15(i)(J) of the 

Securities Exchange Act of 1934 (Exchange Act). Section 15(i)(1) governs capital, 

margin, books and records, bonding and reporting requirements of the Exchange Act, and 

the limitations on any conflicting or superfluous requirements under state law. NASAA 

posits that adding Section (a)(13)(G)(iii) in H.R. 2774 creates an unnecessary and 

confusing addition to an otherwise seamless bill governing M&A brokers. Section 

13(G)(iii) titled "State Law Preemption" provides as follows: 

Subsection (i)(l) shall govern the relationship between the requirements 

applicable to M&A brokers under this Act and the requirements applicable to 

M&A brokers under the law of a State or a political subdivision of a State. Except 

as provided in such subsection, this paragraph shall not preempt the law of a State 

or a political subdivision of a State applicable to M&A brokers. 

5 
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86681.006

This "preemption" paragraph in fact refers to a limited preemption already in the 

Exchange Act addressing books and records, and reporting requirements. NASAA has 

worked with the M&A industry to obtain their support for withdrawing this language, and 

we ask that Representative Huizenga and the Committee consider removing this 

redundant, and arguably confusing, paragraph from the bill. 

Business Development Companies 

The Subcommittee is presently considering several bills that contemplate 

relaxation of the portfolio strictures and other limitations on the ability of Business 

Development Companies (BDCs) to invest in financial companies. 

Three bills pending before the Subcommittee - H.R. 31, H.R. 1800, and H.R. 

1973 would repeal the provisions of the Investment Company Act of 1940 (lCA) that 

limit the ability of a BDC to invest in investment advisers. Two of these bills, H.R. 31 

and H.R. 1800, would additionally ease the leverage limits for BDCs established by the 

ICA, allowing such firms to maintain a greater ratio of debt to asset valuation on their 

balance sheets, and would direct the SEC to revise its forms and filing instructions for 

"shelf registrations" to permit BDCs to incorporate by reference in their shelf 

registrations subsequent financial reports. The most radical change contemplated by any 

of the bills before the Subcommittee occurs under H.R. 1973, which would redefine 

financial services companies as "eligible portfolio companies," thereby obviating all 

existing limitations on the ability of BDCs to invest in financial companies6

• 

Before I address these changes, it may be helpful for me to provide the 

Subcommittee with some background information on BDCs in general. BDCs are 

regulated, closed-end investment firms that invest in small, developing, or financially 

troubled companies. As entities that combine the capital of many investors to finance a 

portfolio of operating businesses, BDCs are governed by the Investment Company Act of 

1940 (lCA). BDCs are unique, however, in that they enjoy a number of important 

exemptions from the ICA that have allowed them in recent years to step into the role that 

regional commercial banks largely vacated during the financial crisis-lending to 

companics that may not otherwise get financing. 

BDCs are attractive to many investors for three primary reasons. First, investors 

are drawn to the very high rate return that BDCs offer - sometime in excess of eight 

percent.7 Second, under normal market conditions, BDCs also provide investors with 

liquidity comparable to that of other publicly traded investments. In contrast, investors in 

open-end investment companies or traditional mutual funds may only sell and buy shares 

directly to and from the fund itself. The third reason many investors invest in BDCs is 

6 As contemplated by H.R. 1973, fmancial companies would include not only finns that deal in securities, 

but also depository institutions like banks and credit unions, insurance companies, credit card companies, 

and a host of other entities that primarily derive their revenue from financial transactions and the sale of 

financial products. 

7 Notably, BDCs are also required to distribute at least 90% of their taxable earnings in the fonn of 

dividends. 

6 
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86681.007

simply access because investors do not need to meet the higher income, net worth or 

sophistication criteria that are imposed on private equity investments. 

By virtue oftheir unique treatment under the ICA, BOCs enjoy a number of 

regulatory advantages relative to traditional investment funds. BOCs are permitted to use 

more leverage than a traditional mutual fund, up to and including a I-to-l debt-to-equity 

ratio. BOCs can also engage in affiliate transactions with portfolio companies. BOC 

managers also have access to "permanent capital" that is not subject to shareholder 

redemption or the requiremcnt that capital be distributed to investors as returns on 

investments are realized. Moreover, managers ofBOCs may immediately begin earning 

management fees after the BOCs have gone public and, unlike other registered funds, 

charge performance fees. 

In exchange for considerable regulatory latitude, BOCs adhere to certain portfolio 

strictures not applicable to other registered funds. Most prominently, BOCs have an asset 

coverage ratio of200%, at least 70% of which must be in "eligible" investments.s In 

addition, the ICA prohibits a BOC from acquiring more than 5% of any class of equity 

securities or investing more than 5% of its assets in any company that derives more than 

15% of its revenues from securities-related activities, including acting as a registered 

investment adviser. It is this part of the regulatory bargain that today's BOC bills attempt 

to renegotiate. 

State securities regulators question the rationale for further relaxing the 

leverage limits applicable to BDCs, as contemplated by H.R. 31 and H.R. 1800. 

As I just mentioned, the current asset coverage ratio applicable to BOCs is 200%. 

This means that every dollar of a BOC's debt must be "covered" by two dollars of BOC 

assets. In other words, it effectively limits a BOC's leverage ratio to 50% of assets, 

which is meant to make BOCs safer and more stable for investors. Excessive leverage by 

some of our largest financial institutions, as you might recall, was at least part of the 

problem we faced as part ofthc most reccnt financial crisis and many other crises before 

it. Moreover, the BOC asset coverage ratio has already been adjusted to balance sponsor 

and investor need, reduced from thc initial threshold of 300% for closed-end funds, down 

to 200%.9 While BDCs may desire the higher fees they could generate from their 

increased leverage, that desire is not a compelling justification for increasing leverage 

and risk to investors, especially unsophisticated retail investors. In the absence of such a 

justification, NASAA is disinclined to support the measure. 

8 Eligible investments include: (I) privately issued securities purchased from "eligible portfolio 

companies," (2) securities of eligible portfolio companies that are controlled by a BDC and of which an 

affiliated person of the BDC is a director, (3) privately issued securities of companies subject to a 

bankruptcy proceeding, or otherwise unable to meet their obligations, (4) cash, government securities or 

high quality debt securities maturing in less than one (5) facilities maintained to conduct the business of the 

BDC, such as office furniture and equipment, interests in real estate and leasehold improvements. 

9 Under the Investment Company Act of 1940 the asset coverage requirement for closed-end funds is 300% 

for debt securities and 200% for preferred stock. 1be Small Business Investment Incentive Act of \980 

reduced the asset coverage ratio for BDCs to 200% from the 300% applicable to non-BDC investment 

companies under sec. \8(a)(\)(A) of the ICA. 

7 
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86681.008

Another change contemplated by H.R. 31 and H.R.lSOO that NASAA does not 

fully understand and, therefore, does not support is the proposal to allow BDCs to issue 

multiple classes of debt securities and senior equity securities. The effects of this 

provision on common shareholders, retail investors in every one of your districts, and 

many senior investors, could be quite harmful. Specifically, allowing BDCs to issue 

preferred stock is inviting them to dilute the value owned by holders of common stock. 

Moreover, by allowing preferred stock to count on the equity side of the ratio, the effect 

of the change would be to permit BDCs to issue greater amounts of debt, potentially 

placing the holders of common shares in a position where they could be wiped out in the 

event the BDC incurred losses. This would not serve BDC investors well. 

State securities regulators have significant concerns about provisions in H.R. 

31, H.R. 1800, and H.R. 1973 that would remove existing prohibitions on the ability 

ofBDCs to invest in investment advisers. 

Conflicts of Interest and Business Development Companies 

While the foregoing changes are problematic, NASAA's primary concern with 

the BDC bills is the proposal that would allow BDC investment in IA firms. That 

proposal would create a significant conflict of interest. If an advisory firm were among a 

BDC's portfolio of companies, an incentive would exist for the investment adviser to 

recommend, or even push, their clients toward investments in the BDC or its other 

portfolio companies, even if such investments were not in the client's best interest. 

Such conflicts could be even more troublesome in the context of an adviser's 

discretionary or "managed" accounts, where the adviser is delegated authority to make 

investment decisions on behalf of the client. As BDC directors also owe a fiduciary duty 

to their shareholders, if the proposed change were enacted, it would increase the 

likelihood that BDCs will acquire interests in advisory firms for the express purpose of 

accessing the advisory firm's pool of investible capital. This conflict could be 

exacerbated in the event that a BDC's portfolio company underperforms and the captive 

advisory firm is seen as a way to shore up the struggling company with additional capital. 

No such conflicts of intcrest exist now, and NASAA urges Congress not to allow 

for such a conflict of interest to arise as it considers reforms to the BDCs portfolio 

strictures. 

Transparency and Business Development Companies 

Beyond the conflict of intcrest inherent in the repeal of restrictions on BDC 

investments in advisory firms, NASAA is concerned that such repeal would cause a 

significant loss of transparency. 

BDCs that are registered with the states have limited transparency in a number of 

respects. State securities regulators usually see them in state registration as startups, or as 

S 
50 


86681.009

businesses with a very limited history of operations. They are frequently "blind pool" 

offerings in which investors have little or no aceess to information regarding the 

investments the BDC will make. Disclosure documents deseribing eligible portfolio 

companies can be vague, broad, and limited. For example, a BDC might disclose that it 

primarily intends to invest in debt and equity securities of small to middle market private 

U.S. companies. Such vague disclosure as to the use of proceeds grants broad discretion 

to BDC managers while reducing transparency to investors. 

Investors must place their reliance and trust in the management ofthe BDC to 

select appropriate companies for the BDC to lend to. Many BDCs have made a niche in 

lending to companies that have recently struggled with bank financing. Allowing 

investments in investment advisers adds an additional layer of opacity for BDC investors. 

NASAA believes BDC investors should continue to receive adequate disclosure about the 

income producing assets of the investment adviser. 

Impact on Shareholders and Job Creation of Business Development Companies 

Finally, NASAA cannot help but observe that competition from finaneial services 

firms will not benefit traditional BDC portfolio companies - i.e., small businesses. 

BDCs were initially created for the purpose of providing capital to domestic small 

and medium-sized businesses that participate in the real economy. Since their creation, 

BDCs have enjoyed relaxed regulatory requirements to further this goal; this is the reason 

financial firms have traditionally been excluded as eligible portfolio companies. Under 

the proposed legislation, however, these small businesses will presumably face new and 

greater difficulty obtaining BDC financing because BDC's will reallocate some of their 

limited resources to investment advisers and other financial firms. Such an outeome 

may frustrate the Subcommittee's goal of spurring job growth. 

Moreover, NASAA is not aware that investment advisory firms have any real 

need for BDC financing, especially as compared to the smaller real economy firms that 

BDCs were designed to benefit. 

State securities regulators understand and support sensible modernization of 

regulations applicable to BDCs and other companies. 

While most of the proposals set forth in the BDC bills have issues from a state 

and investor protection perspective, NASAA does support the proposal to extend the 

relaxed regulatory requirements available to Well Known Seasoned Issuers ("WKSI") 

and eertain other large public filers to BDCs. BDCs operate similarly to large public 

companies in regard to eommunieations with the public and the filing offorms with the 

Commission. 

Under the amendments contemplated by H.R. 1800 and H.R. 31, BDCs would be 

eligible for WKSI status and would be eligible to file automatic shelf registrations on 

forms S-3 or N-2. Automatic shelf registrations are automatically effective upon filing 

9 
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86681.010

and receive no SEC review. To be eligible, BDCs would be required to have a class of 

securities with at least $700 million in public float or have completed a public issuance of 

at least $1 billion. Some state-registered non-traded BDC offerings have already reached 

this threshold and would be eligible for automatic shelf registration with limited 

information and incorporation by reference. 

NASAA did not oppose incorporation by reference for real estate investment trust 

(REIT) offerings a number of years ago, and NASAA similarly does not oppose 

amending the ICA to permit incorporation by reference for BDCs today. 

In summary, NASAA considers that small and mid-size companies that produce 

goods and services in the real economy have a greater need for BDC loans, and are better 

positioned than financial companies to use the capital from these loans to create jobs and 

improve the economy. Repeal of the provisions that limit BDC investment in financial 

services companies, as contemplated by H.R. 1973, or even investment advisers only, as 

contemplated by all three of the bills, will, at best, serve to dilute the impact ofBDC 

investment capital as a source of job creation. Such policies might also create incentives 

for BDCs to help financial services companies design their business strategies, with the 

main goal of aiding the financial services sector, not building small businesses in other 

sectors of the economy. 

Further Reduction of Publicly Available Information about Emerging Growth 

Companies 

NASAA is also concerned about discussion draft legislation that would further 

relax reporting requirements for so-called emerging growth companies (EGCs). 

Under the proposed discussion draft, EGCs would benefit from a dramatic 

shortening of the window of time between the completion of a confidential filing with the 

SEC and the beginning of the "road show" marking its initial public offering (IPO). 

While NASAA recognizes that from the standpoint of the issuer, the shortening of the 

required waiting period from 21 days to 5 days may be beneficial, as it reduces the 

likelihood of external events impacting the offering, the 21 day period is already a 

relatively short window of time. Moreover, non-EGC companies seeking to go public do 

not even enjoy an opportunity for confidential review. Like many of the provisions in the 

discussion draft, this change raises questions about how far Congress is willing to extend 

favorable treatment to a particular class of companies, and who exactly stands to benefit 

from such changes. 

In addition, whereas the JOBS Act authorized EGCs to submit registration 

documents to the SEC for review on a confidential basis prior to an IPO, the proposed 

legislation would permit EGCs to enjoy this same "confidential review" privilege for 

follow-on offerings of securities issued after the IPO. When Congress established the 

mechanism for EGCs to obtain confidential SEC review of registration documents under 

the JOBS Act, its expressed purpose was to encourage companies to go public. It is not 

10 
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86681.011

clear why the privilege should now be extended to companies that, by definition, have 

already successfully completed an IPO. 

Similarly, the bill requires that EGCs be permitted to file registration documents 

for confidential SEC review that "omit financial information for historical periods 

otherwise required by regulation." Time and again, accounting scandals have shaken 

public confidence in the markets and demonstrated the critical importance of complete 

and accurate financial reporting. Such an omission runs counter to the interests of 

investors, the public, or our capital markets. 

The Securities Act of 1933 reflects the principle that "sunlight is the best 

disinfectant."Io In fact, during the signing of the bill President Roosevelt emphasized that 

a well-functioning capitalist system must be built upon a foundation that requires the full 

disclosure of accurate information to investors: 

Events have made it abundantly clear that the merchandising of securities 

is really traffic in the economic and social welfare of our people. Such 

traffic demands the utmost good faith and fair dealing on the part of those 

engaged in it. If the country is to flourish, capital must be invested in 

enterprise. But those who seek to draw upon other people's money must 

be wholly candid regarding the facts on which the investor's judgment is 

asked. 

To that end this Bill requires the publicity necessary for sound investment. 

It is, of course, no insurance against errors of judgment. That is the 

function of no Government. It does give assurance, however, that, within 

the limit of its powers, the Federal Government will insist upon 

knowledge of the facts on which alone judgment can be based. I I 

The ink is barely dry on the JOBS Act and we do not yet know what impact Title 

I will have on the number ofIPOs. More importantly, we do not yet know whether it will 

affect investors' willingness to invest in the emerging growth companies that are so vital 

to our economy. Despite these uncertainties, the discussion draft would go even further 

than Title I by reducing the information that is available to investors and giving them less 

time to digest it. 

NASAA respectfully urges the Subcommittee to reject further changes to Title I, 

at least until the full impact of Title I on investors and securities markets can be observed 

and evaluated. Until such time, the potential costs and benefits of further expanding Title 

I will be impossible to determine. 

10 ""[PJublicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the 

best of disinfectants.... The potent force of publicity must. .. be utilized in many ways as a continuous 

remedial measure." Louis D. Brandeis, Other People's Money 62 CR. Abrams ed. 1967}. 

IlPresident Franklin D. Roosevelt. "Statement on Signing the Securities Bill," 27 May, 1933, 

available at http://www.presidency.ucsb.edulwsl?pid=14654 

11 
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86681.012

Tick Sizes and the Small Cap Liquidity Reform Act 

Proposals to promote greater liquidity for EGCs or other thinly traded stocks by 

experimenting with changes to the "tick sizes," or minimum increment for quoting 

shares, for certain smaller public companies, raise interesting policy questions. However, 

from a standpoint of public and market-regulatory policy, such proposals also raise a 

number of concerns. 

The proposal that is before the Subcommittee today would direct the SEC to 

establish a pilot program that would increase the spread between bid and offer prices for 

EGCs, boosting profits for market-makers. The sponsors of the proposal evidently expect 

that the increased revenue realized by such market makers from the widened spreads will, 

in tum, support additional research or "coverage" of the stocks in question. Greater 

coverage ofEGC stocks by analysts, the thinking goes, will in tum lead to more initial 

public offerings and greater liquidity for EGC shares following their initial offering. 

NASAA appreciates that there is less analyst coverage of many smaller company 

stocks than their shareholders might like; however, we question whether changing the 

mechanics of the securities market in the hope of subsidizing artificial interest in and 

coverage of such securities is something Congress should pursue. 

There can be little question but that broker-dealers and others who serve as 

market makers for EGC stocks have a financial incentive to support such a change. It is 

also understandable that EGCs, and their managers, perceive in such a program the 

prospect ofincreased research coverage of their securitics, and by extension, greater 

liquidity. 

However, it is far from clear how any of these changes will stand to benefit the 

investing public. Indeed, quite to the contrary: increasing the spread between bid and ask 

prices for shares ofEGC securities will systemically strip value from the holders of the 

securities and reallocate it to broker-dealers and others who act as market makers in these 

s.ecurities. 

Moreover, as a matter of basic economics, it is evident that by manufacturing 

additional, artificial transaction costs for the exchange of EGC securities, the proposed 

pilot program would have the effect of diminishing rather than increasing overall 

marketplace efficiency. 

NASAA believes that, as general matter, Congress should exercise great caution 

anytime it considers a policy that would make securities or other markets more costly and 

less efficient. 

12 
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86681.013

There are many valid and important reasons why in some instances thc 

government should undertake actions, consistent with the interests of the investing 

public, which may have the effect of decreasing marketplace efficiency - for example, to 

protect investors from fraud and abuse, to prevent excessive speculation, or to prevent 

market panic. In this instance, however, the proposed pilot program appears to offer 

little, if any, of these benefits to the investing public while increasing their transaction 

costs. 

eXtensible Business Reporting Language (XBRL) 

eXtensible Business Reporting Language (XBRL) is an international standard 

used for exchanging and reporting business information. XBRL makes use of 

"interactive data" to indentify trends and patterns that would not otherwise be 

recognizable or accessible. 

XBRL allows for the automated processing of business information by computer 

software, cutting out laborious and costly processes of manual re-entry and comparison. 

This is highly useful for financial regulators such as the SEC, since the SEC's computers 

can recognize information filed in XBRL format, analyze it, store it, and ultimately 

compare it on an "apples to apples" basis with other filings to obtain an extremely precise 

and highly useful picture of market participants and market activities.12 Interactive data 

also allows investors and others to pinpoint facts and figures within often lengthy 

disclosure documents.13 

In early 2009, the SEC published three final rules requiring XBRL tagging of 

certain disclosure information for operating companies, mutual funds, and credit rating 

agencies. One of the bills before the Subcommittee today would effectively repeal this 

requirement for firms with total annual revenues of less than $1 billion. Under the bill, 

roughly three in every four public companies would be exempt from providing this 

meaningful information. 

As a general matter, NASAA shares the view of other advocates for transparency, 

from the SEC's Investor Advisory Committee to the Chairman of the House Committee 

on Oversight and Government Reform, in supporting the use ofXBRL and other filing 

protocols that maximize meaningful disclosure that benefits the investing public. 14 

Accordingly, NASAA does not believe that Congress should, at this time, repeal the 

XBRL reporting requirement for all public companies with less than $1 billion in annual 

revenues. 

l2 Federal Financial Institutions Examination Council. Report entitled: "Improved Business Process 

Through XBRL: A Use Case for Business Reporting" 31 January, 2006. Accessible at 

http://www .xbrl.orglBusiness/Regulators/FFIEC-White-Paper-31 Jan06. pdf. 

13 Securities Exchange Commission. http://www.sec.gov/spotlightlxbrllwhat-is-idata.shtml. 

14 Letter from House Oversight and Government Reform Committee Chainnan Darrell E. Issa to SEC Chair 

Mary Jo White regarding SEC implementation and enforcement of the Interactive Data to Improve 

Financial Reporting Rule 0[2009. 10 September, 2013. Accessible at http://oversight.house.gov/wpcontentluploads/20 13/09120 13-09-1 O-DEI-to-White-re-Interactive-Data-Rule.pdf. 

13 
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86681.014

At the same time, state securities regulators are very sensitive to the compliance 

cost that XBRL may be placing on some truly small companies, and in the case of such 

companies, we would hope that Congress and the SEC would afford filers with a more 

limited exemption, or forbearance, to minimize any excessive cost or burden associated 

with this new filing protocol. 

Other Ideas for Spurring Capital Formation Through Pro-Investor Reforms 

NASAA shares the goal of Congress to improve the United States economy by 

spurring private investment in businesses. However, we are concerned that the 

Committee may be attempting to reach this goal through a strictly one-sided approach 

namely, by eliminating regulations that appear to be burdensome to businesses who want 

to raise capital. We encourage the Committee to take a more balanced approach and to 

consider reforms that will restore investor confidence in the markets. What we need is 

smarter regulation, not merely deregulation. 

A Gallup survey in June 2002 found that 67 percent of Americans O\vned a 401(k) 

or otherwise invested in individual stocks, bonds, or mutual funds. Earlier this year, that 

number was down to 54 percent. 15 If this Subcommittee wants to spur economic 

development through capital formation, it should focus on giving that missing 13 percent 

the confidence to re-enter the marketplace. 

The reasons for investor nervousness seem obvious. Many Americans lost a big 

share of their retirement savings during the economic meltdown and now view the stock 

market as a "casino" that is riggcd by insiders and high frequency traders. These 

investors also hear about computer errors and false news stories that cause flash crashes, 

and they understandably wonder whether the markets are sufficiently stable to invest their 

retirement savings. 16 

Of course, this is not the first time in our history that investors need their faith in 

the markets restored. The original Securities Act of 1933 was not meant to punish Wall 

Street for the stock market crash of 1929, but rather to lift the country out of the resulting 

depression by restoring investor confidence and spurring new capital formation. Felix 

Frankfurter, a principal drafter of the Sccurities Act, spoke of the strain on our markets at 

that time: 

The great and buoyant faith in capitalism, in the competitive system, is 

largely deflated, and ... it is not only a question of whether the system is 

just, but whether it works. When you have a system which is questioned 

15 See http://www.gallup.comfpollfI47206/stock-market-investments-Iowest-1999.aspx. 

16 In the past several years, major market disruptions that have not been adequately explained, but which 

appear to be linked to electronic trading, include the May 6, 2010 "Flash Crash," the BATS IPO, and the 

Knight Capital "fat finger" incident. 

14 
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by the masses, that system cannot last unless it wins back the loyalty and 

allegiance of the doubters .... I7 

Today, investors need a similar boost of confidence in the securities markets. It is 

counterproductive to capital formation when Congress continually chips away at the 

protections that investors have come to expect, and Congress could help small businesses 

more effectively by looking for reforms that will make investors comfortable investing 

again. NASAA has not yet come to firm conclusions about reforms that would provide a 

cure to investor cynicism, but we are intrigued by a few ideas that seem worthy of further 

study by this Committee. 

First, we believe that Congress should study the impact of high frequency trading 

and take steps to ameliorate any harm to retail investors. According to Charles Schwab, 

high frequency traders flood the market with orders to evaluate the market, then cancel 

90 percent or more of the orders and retain only the advantageous trades.18 To curb these 

abuses, some European governments have proposed transaction taxes on all orders that 

are placed in the markets, but Mr. Schwab has suggested a narrower approach that would 

probably be less controversial and more effective a penalty on excessive 

cancellations. 19 

Another innovative effort to combat high frequency trading has been undertaken 

by ParFX and EBS, two international currency trading platforms. They use a randomized 

pause so that the first order placed in the system queue is not necessarily the first to be 

executed.2o According to Larry Tabb, founder of the TABB Group, "In the equities 

market, it's going to be pretty tough for an exchange to introduce randomization because 

the regulations have been interpreted to be very time-price specific.,,21 Therefore, 

Congress might consider amending the laws to allow this type of reform in the United 

States equities marketplace. 

17 L. Baker. Felix Frankfurter 146 (1969) (taken from a Frankfurter speech delivered at Smith 

College, Feb. 22,1933). The Securities Act of 1933 was successful in encouraging investors to 

reenter the capital markets. The issuance of new corporate securities had grown from $6.5 billion 

in 1927 to $9.4 billion in 1929, but it fell off dramatically after the stock market crash to $644 

million in 1932 and $380 million in 1933. Bureau of the Census, Historical Statistics of the 

United States: Colonial Times to 1970 1006 (1975). However, after adoption of the Securities Act 

of 1933, new corporate securities issues quickly increased to over $2.5 billion in 1935 and over 

$4.3 billion in 1936. Goldschmidt, Registration under the Securities Act of 1933. 4 Law & 

Contemp. Probs. 19, 28 (1937). 

l8 Charles Schwab and Walt Bettinger, Why Individual Investors Are Fleeing Stocks, Wall Street Journal 

Editorial, July 10,2013, available at 

http://online.w~j.com/news/articIes/SB I 000 1424 I 2788732358290457848481 0838726222?mod~dist_smart 

brief. 

191d. 

20 Eric Onstad, Analysis: 'Slow Frequency' Technology Faces Tough Shift from FX to Stock Markets, 

Reuters. October 2. 2013, available at http://www.reuters.com/articIe/2013/l 0/02/us-hft-curbs-analysisidUSBRE99I OPJ20 131 002. 

211d. 

15 
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Congress could also study the numerous electronic "glitches" that have plagued 

the markets with market shutdowns and price instability. Many have called for 

mandatory "kill switches" to stop trading when problems occur, but we believe more 

aggressive steps should be taken to ensure that our markets are protected. If such havoc 

can be wrought from innocent errors by companies who have every incentive to get 

things right, then we worry what could be done by someone with a malicious intent to 

harm the markets or the country. 

Improving Investment Adviser Oversight and Preserving Investor Choice 

Finally, state securities regulators continue to support legislation introduced in the 

House by Ranking Member Maxine Waters that would authorize the SEC to collect "user 

fees" from federally registered investment advisers, and to use the revenue derived from 

these fees to fund more frequent examinations of such advisers. We would also like to 

congratulate Congressman Keith Ellison for introducing the Investor Choice Act of 2013, 

H.R.2998. This bill preserves an investor's right to access the court system if the 

investor has a dispute against a broker or investment adviser. H.R. 2998 is a direct 

response to the longstanding practice in the broker-dealer industry, and most recently 

among investment adviser firms (despite advisers' fiduciary duty), of including 

mandatory pre-dispute arbitration agreements in client contracts. Retail investors deserve 

a choice, not a mandate, when it comes to disputes affecting their financial portfolios. 

Taken together, these two bills constitute major steps that Congress could take 

today to restore investor confidence in the fairness and soundness of our securities 

markets, and those who they trust to invest their retirement and savings in these markets. 

Thank you again, Chairman Garrett and Ranking Member Maloney, for the 

opportunity to appear before the Subcommittee today. I would be pleased to answer any 

questions that you may have. 

16 
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TESTIMONY OF 

MICHAEL J. AROUGHETI 

CHIEF EXECUTIVE OFFICER 

ARES CAPITAL CORPORATION 

BEFORE THE 

HOUSE SUBCOMMITTEE ON CAPITAL MARKETS AND 

GOVERNMENT SPONSORED ENTERPRISES 

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ON 

"LEGISLATION TO FURTHER REDUCE IMPEDIMENTS TO CAPITAL FORMATION" 

OCTOBER 23, 2013 
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I. Introdnction 

Chainnan Garrett, Ranking Member Maloney and members of the Sub-Committee, thank you for 

the opportunity to testify today. My name is Michael Arougheti and I am the Chief Executive 

Officer of Ares Capital Corporation, an SEC registered Business Development Company, or 

"BDC", and one of the largest non-bank providers of capital to small- and medium-sized 

American companies - the backbone of the U.S. economy. Ares Capital Corporation is publiclytraded on the NASDAQ National Market and is currently the largest BDC by both market 

capitalization and assets. Since our IPO in 2004 through June 30, 2013, we have invested more 

than $14 billion in more than 450 small and medium sized American companies, in the process 

creating tens of thousands of new jobs and providing capital to growing businesses who were 

unable to access capital through commercial banks or other traditional financing sources. 

Congress created BDCs in 1980 in a period similar to what we saw following the "Great 

Recession". Specifically, after a period of rapid growth, a downturn caused banks to retrench 

from lending and left small and medium sized businesses with limited options for securing 

credit. The stated objective of BDCs was to encourage the establishment of new market vehicles 

to invest in, and increase the flow of capital to, private businesses. By mandate, BDC's are also 

required to provide managerial assistance to their portfolio companies. Uniquely, the BDC 

model allows ordinary investors exposure to start-up and small companies - effectively "Main 

Street funding Main Street". 

Today, the middle market employs two out of every three workers in the private sector.! Based 

on data from ADP, small- and medium-sized businesses have lost a combined 843,000 jobs since 

the beginning of 2008. 2 In contrast, many companies funded by the BDC industry during that 

same period have been able to increase hiring and grow their respective businesses. 

The impact ofBDC's on small- and medium-sized businesses has been tangible and meaningful. 

By way of example, in 2004 Ares Capital Corporation made an initial investment in Reflexite, an 

employee-owned producer of optical components and films for the Safety, Lighting, 

Instrumentation and Display markets based in Avon, CT. Reflexite needed to raise capital to, 

among other things, expand product lines and seed new businesses. However, Reflexite was at a 

stage in its life cycle where neither a traditional senior debt provider nor a private equity finn 

was the right fit to provide what Rcflexite was looking [or. Traditional senior debt providers 

were not a good fit as their proposed capital was inflexible, they had low tolerance for risk as 

Reflexite grew new businesses and they could not provide a sufficient amount of 

capital. Similarly, private equity sources were not a good match as they wanted to be able force 

liquidity within a certain time frame, which was incompatible with a private company that 

wished to preserve autonomy and invest in growth over the long tenn. Because BDCs such as 

ARCC are "pennanent capital" vehicles, they often have a longer investment horizon and can 

provide more flexible capital to companies like Reflexite. Ares Capital Corporation not only 

provided capital, but also took seats on Reflexite's board of directors and provided valuable 

strategic advice and support to the company as it grew. 

I Source: ADP National Employment Report - September 2013. Nonfarm private sector employment for 

companies with 1 to 49 employees and companies with 50 to 499 employees. 

2 Source: ADP National Employment Report - September 2013. Sum of small- and medium· sized businesses. 

Small businesses defined as less than 50 employees. Medium businesses defined as 50 to 499 employees. 
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Today there are over 40 publicly-traded BDCs with an aggregate market capitalization of more 

than $25 billion and approximately $40 billion in assets. While all BDC's do not look alike with 

respect to criteria such as size of investments, size of portfolio companies and industry focus, all 

BDCs do share a common investment objective of improving capital access. As traditional 

lending institutions have been inconsistent in providing loans to small and medium size 

companies, BDCs now find themselves in a very similar position as they were in 30 years ago -

at the forefront of the effort to address the unmet capital needs of small business. 

While the BDC industry continues to grow, I strongly believe that we can expand our scope and 

do more to fulfill our policy mandate. To that end, I am here today on behalf of the BDC 

industry to express support for current proposed legislation that seeks to make straightforward, 

prudent changes to the Investment Company Act of 1940 in order to enable BDCs to more easily 

raise and deploy capital to small and medium size businesses. It is important to note that 

BDCs are not seeking any government or taxpayer snpport or subsidy. The BDC industry is 

simply asking Congress to modernize their regulatory framework so that BDCs can more easily 

fulfill their Congressional mandate. 

II. Policy Challenges I Proposed Policy Solutions 

BDCs are heavily regulated and appropriately, the activities of BDCs are fully transparent to 

regulators, investors and portfolio companies. Specifically, publicly-traded BDCs are subject to 

the disclosure requirements of the Securities Act of 1933 and the Securities Exchange Act of 

1934 and are also subject to additional regulations imposed by the Investment Company Act of 

1940. BDC's fall under the supervision ofthe SEC's Division ofInvestment Management. 

Ironically, many of the challenges faced by BDCs in increasing both the scope of borrowers and 

the amounts that BDCs can invest arise out of their place in this regulatory framework. Given 

that BDCs are more akin to operating companies such as banks and other commercial lenders 

than to mutual funds, BDCs must often play the part of the proverbial "square peg being in a 

round hole". 

So, the question then becomes how to enable BDCs to fulfill their Congressional mandate of 

being an active provider of capital to small and medium sizcd companies, while remaining 

appropriately regulated? 

The answer - begin the process of modernizing the regulatory framework with a handful of 

modest, common sense changes. Clearly, the world is a much different place than it was in 1980 

when Congress created BDCs. 

During the "Great Recession", we all learned a number of lessons which hopefully will be taken 

to heart as the economy continues to improve. One of the important lessons learned by BDCs 

was that during a downturn, structural constraints in the existing regulatory framework are 

punitive not only to BDCs but also to the many small and medium sized companies they serve. 

Three bills have been introduced in the House to modernize the regulatory framework for BDCs 

2 
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and to mitigate/eliminate many of the issues faced in 2008, thereby ensuring that BDCs can 

continue to fulfill their Congressional mandate today and in the future. 

The first two, H.R. 31 (Velasquez) and H.R. 1800 (Grimm), relate directly to the issue of capital 

formation and, ultimately, capital flows to small and medium sized businesses through modest, 

common sense amendments to the Securities Act of 1933 and the Investment Company Act of 

1940. In short, they seek to enable BDC's to "do more" than they are currently able to in terms 

of the number of companies that they can lend to, the types of investments they can make and the 

amount of capital that they can raise and deploy. 

These two bills contain four nearly identical provisions, which we believe illustrates the 

significant bipartisan support for these changes. 

• First, both bills propose an increase in the BDC asset coverage test from 200% to 150%, 

thereby broadening the universe of potential borrowers that can access loans from a BDC. 

We do not believe that the proposed change introduces more risk. Rather, it should allow 

BDC's to invest in lower-yielding, lower-risk assets that don't currently fit their 

economic model. In fact, the current asset coverage test actually forces BDC's to invest 

in riskier, higher-yielding securities in order to meet the dividend requirements of their 

shareholders. This potential "de-risking" is further supported by the strong underlying 

performance of the loan asset class. For example, during the period from our IPQ 

through June 30, 2013, ARCC's non-accrual rate on first lien senior secured loans was 

0.8% while the average default rate of the S&P LSTA Leveraged Loan Index for first lien 

senior secured loans for that same period was 2.49%.3 Similarly, since inception BDCs 

have generated a cumulative gain / loss rate of negative 62 bps, outperforming banks by 

186 bps. 4 We believe that this proposed change will benefit borrowers through greater 

financing alternatives and a reduced cost of capital and will also benefit shareholders by 

enabling BDCs to construct more conservative, diversified portfolios. 

In addition, this proposed change would apply to BDCs the same leverage ratio as the 

leverage ratio for Small Business Investment Companies but, unlike SBICs, without 

putting any government capital at risk. This seems prudent, consistent with other 

legislation that this sub-committee has passed and, as I noted, benefits both small and 

medium-sized companies and shareholders without any government or taxpayer subsidy. 

An increase in this ratio will also provide additional "cushion" given the requirement 

that BDC's must "mark to market" their loans each quarter. Specifically, in the event of 

falling asset values in the overall market as we saw during the Great Recession, unlike 

banks and other commercial finance companies BDCs are generally required to write 

down the value of certain of their otherwise performing assets. Currently, most BDCs 

have an average leverage ratio of 0.5x-0.75x, reflecting a desire and a practical need to 

maintain adequate "cushion" in the unprecedented, unlikely event of a sudden and steep 

3 Source: S&P LCD data for LSTA Leveraged Loan Index ("LLI"). Calculated as the average of LTM rolling 

monthly default rates over the period from October 2004 through June 2013. 

4 Source: TPG Specialty Lending: 2013 Wells Fargo BDC Leadership Forum Rating Agency Concerns about 

BDCs 

3 
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86681.021

drop in asset values. However, the maintenance of such a cushion has the unintended 

effect of reducing the ability of BDCs to raise and invest capital, thereby frustrating the 

original intent of Congress. This additional cushion would provide BDCs with the ability 

to deploy more capital in the ordinary course and through market cycles. 

This proposed change is extremely modest given that banks customarily incur leverage of 

10: 1 and greater. Further, contrary to those commentators who would suggest otherwise, 

a decrease in the asset coverage test will not result in an automatic, immediate increase in 

risk. BDCs will still need to act prudently for the reasons noted above and the "'market", 

including lenders and debt investors, will ultimately make the determination as to "how 

much leverage is too much". 

Finally, given the transparency required of BDCs in their SEC disclosure documents, 

shareholders will be clearly informed (as they are now) of the amount of leverage that 

BDCs can incur and any potential risks to them associated with such leverage. This 

applies equally to retail investors as well as institutional investors, who comprise 

approximately 40% ofBDC shareholders.s 

• Second, both bills would allow BDCs to treat preferred stock as equity rather than as debt 

and eliminate the requirement that holders of preferred stock have board representation. 

Many BDCs were challenged during the last downturn, in particular with respect to 

issuing common equity at a price below net asset value. Had BDCs been able to raise 

capital during the post 2008 period by issuing preferred shares as equity, many more 

loans could have been made to cash-starved companies to enable them to retain 

employees and, in some instances, to remain in business. 

• Third, apart from a handful of minor differences, both bills direct the SEC to make 

specific technical amendments to certain securities offering rules applicable to BDCs. 

Currently, despite the need for regular access to the capital markets, BDCs are the only 

seasoned issuers required to comply with certain provisions of the 1933 Act which, in 

tum, makes raising capital cumbersome and inefficient. These rule changes would 

merely place BDCs on equal footing with non-BDC's without any accompanying 

decrease in transparency or shareholder protection. 

• Fourth, both bills would allow BDCs to own registered investment advisers, which as a 

technical matter is currently prohibited under the 1940 Act. Apart from viewing these as 

attractive investment opportunities, investments in RIAs enable money to be raised from 

third party investors which, in tum, can be deployed to small and medium-sized 

companies. Under prior rules, an investment adviser did not have to register if it had less 

than 15 clients and, accordingly, it could be owned by a BDC. The recent removal of this 

exemption, without any corresponding rulemaking to address the technical glitch caused 

by such removal, has left BDCs in the uncomfortable position of (I) simply not investing 

in RIAs at all or (2) for BDCs with existing RIA subsidiaries or portfolio companies, 

engaging in a fire sale if the SEC doesn't grant pennission for such BDCs to continue 

5 Source: Wells Fargo SDC Leadership Forum materials. 

4 
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ownership of an RIA post-registration. Currently the SEC has been granting exemptive 

relief from this rule on a case by case basis; this amendment will eliminate this often 

lengthy and expensive process. 

The modest asset coverage ratio increase and change in treatment of preferred stock contained in 

both H.R. 31 and H.R. 1800, would become effective immediately upon passage. The other 

provisions will require action by the SEC. Accordingly, we would urge the Sub-Committee to 

work with the SECto make these proposed changes in a timely manner. 

Last but not least, H.R. 1973 introduced by Congressman Mulvaney, offers welcome flexibility 

for BOC investment in financial institutions currently limited by the 30% basket. For example, a 

BOC investing in a growing leasing company might have to curtail useful lending because of a 

limit that in context feels quite arbitrary. 

III. Closing Remarks 

In conclusion, we believe that the time is right to modernize the BOC sector and pass legislation 

which would allow BOC's to increase capital flows to America's small and medium size 

companies, spur economic growth and create. We are encouraged by the bi-partisan focus on 

this important initiative, and look forward to working with the Committee in moving these bills 

forward. 

On behalf of the entire BOC sector, I'd like thank Representatives Grimm, Velazquez and 

Mulvaney for their efforts and urge the sub-Committee to act favorably on a BOC modernization 

bill. Again, I appreciate the opportunity to testify today and would be pleased to answer any 

questions. 

5 
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86681.023

United States House of Representatives Committee on Financial Services 

Subcommittee on Capital Markets and Government Sponsored Enterprises 

Hearing Entitled: 

"Legislation to Further Reduce Impediments to Capital Formation" 

Room 2128 Rayburn House Office Building 

October 23, 2013 

Written Statement by 

J. Michael Ertel, Managing Director 

Legacy M&A Advisors, LLC 

Submitted for and on behalf of the 

Alliance of Merger & Acquisition Advisors 

200 East Randolph Street, 24th Floor 

Chicago, Illinois 60601 

With respect to H.R. 2274 

The Small Business Mergers, Acquisitions, 

Sales, and Brokerage Simplification Act of 2013 
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Introduction 

Written Statement by 

J. Michael Ertel, Managing Director 

Legacy M&A Advisors, LLC 

Submitted for and on behalf of the 

Alliance of Merger & Acquisition Advisors 

200 East Randolph Street, 24th Floor 

Chicago, Illinois 60601 

With respect to H.R. 2274 

The Small Business Mergers, Acquisitions, 

Sales, and Brokerage Simplification Act of 2013 

October 23, 2013 

Chairman Garrett, Ranking Member Maloney, members of the Capital Markets 

Subcommittee, thank you for this opportunity to explain how today's "one-size-fits-all" system 

of regulating securities broker-dealers adversely impacts owners of privately held companies 

who seek professional advice and business brokerage services to sell, buy, or grow their smalland mid-sized businesses through privately negotiated mergers, acquisitions, sales, and other 

business combination transactions ("M&A transactions"). 

Public Policy Considerations 

Public policy considerations supporting H.R. 2274, the Small Business Mergers. 

Acquisitions, and Sales Brokerage Simp/[/ication Act of 2013, date back to the 2005 American 

Bar Association, Report and Recommendations of the Private Placement Broker-Dealer Task 

Force, I and the 2006 Final Report of the Advisory Committee [to the SEC} on Smaller Public 

Companies,2 as documented in the oral and written testimony submitted by Shane Hansen, a 

securities law partner with Warner Norcross & Judd LLP, who testified about H.R. 2274 at a 

hearing before this Subcommittee on June 12,2013.3 

1 Available on the SEC's website at www.sec.gov/info/smallbus/2009gbforum/abareport062005.pdf. 

2 Available on the SEC's website at www.sec.gov/info/smallbus/acspc/acspc-finalreport.pdf. 

J "Reducing Barriers to Capital Formation," available on the Subcommittee's website at http://financialservices. 

house.gov/calendar/eventsingle.aspx?EventlD~336906 . 

Page 1 of8 
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Representing Legacy Advisors & AM&AA 

My testimony is based on my personal experience as Co-Chair of the Campaign for 

Clarity, a profession-wide effort to bring clarity to the regulation of M&A advisors, 

intermediaries, and business brokers ("M&A brokers"), led by the Alliance of Mergers & 

Acquisitions Advisors (AM&AA), and supported more than 16 other international, national and 

regional professional associations of M&A brokers and related professionals.4 It is also based on 

my personal experience in providing business brokerage and M&A advisory services to sellers 

and buyers of privately held businesses since 2000, and being a small business owner myself. 

Since July 20 II, I have been registered as a representative of an SEC- and state-registered 

broker-dealer and member of the Financial Industry Regulatory Authority ("FINRA"), but I am 

not speaking for or representing that brokerage firm in my remarks today. I became registered 

with a fully-registered broker-dealer in order to comply with today's "one-size fits all" regulatory 

scheme because, in seven years of persistent efforts by the AM&AA and the supporting 

professional associations, the Securities and Exchange Commission ("SEC") has not addressed 

this critical small business issue through rulemaking. 

The Business Context 

For most business owners, the sale of their business is one of the largest personal 

financial transactions of their lives, but something many will likely do only once. It represents 

their best opportunity to reap the financial rewards of their work, time - for some a lifetime -

and money. While business owners may be experts at managing and growing their own 

businesses, they generally have little or no experience in preparing their business for sale; 

identifying and screening prospective buyers; assembling, packaging, and presenting information 

relevant to prospective buyers; valuing their business, its assets, and its income streams; 

assessing the pros, cons, and quality of purchase offers; structuring the transaction; managing the 

pre-purchase due diligence process; guiding the transaction through unexpected operational and 

human resource obstacles; preparing for the transition of ownership and management; and 

4 See the list in Exhibit 1 to this "Titten statement. 

Page 2 of8 
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completing the transaction. While their attorneys and accountants provide valuable legal, tax, 

and accounting advice, astute business owners recognize they may need an experienced 

professional intermediary to quarterback the entire business sale process from start to finish, 

since they will not get a second chance to get a successful outcome. 

For example, most private business owners plan and file their corporate tax returns to 

legitimately minimize their taxes, such as by accelerating deductions and deferring income 

recognition. Often, tax-driven business planning fails to reveal the true market value of their 

business. Consequently, financial statements and related records must be carefully analyzed and 

presented to better reflect the value of the business to prospective buyers and to fully support the 

business sale process. Many private business owners need and turn to the professional services 

of an M&A broker to facilitate these processes. 

M&A transactions involving privately owned businesses may have a variety of different 

legal structures depending on many factors, principally driven by the business objectives of the 

parties. Regardless of the M&A transaction's legal structure, the parties' common objective is to 

conveyor combine ownership and control of an existing business so that the enterprise can 

continue to operate and grow, to preserve existing jobs, and to create new jobs. There are many 

reasons for sellers to seek an M&A transaction. M&A transactions occur when, for example, 

one or more private business owners want to exit the business or retire by selling his or her stake 

in the company. Sometimes owner want to sell part or all of the business to its employees. 

Sometimes the business needs more or different skill sets to take it to the next level. Sometimes 

a larger company wants to divest the business conducted by a division or a subsidiary. 

The legal structure and the process required to complete an M&A transaction is affected 

by many factors including, for example, the size of the business, the nature of its operations and 

assets, the business risks, the industry type, the industry participants, the historical financial 

performance, the operating capital requirements, the business development stage (e.g., start-up or 

mature), the human resources, the intellectual property, the market for its products or services, 

and the applicable regulatory requirements. Some prospective buyers may prefer to acquire the 

Page 3 of8 
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business' assets for a variety of reasons, including considerations such as taxes and business risk 

mitigation. Sellers commonly prefer to receive all cash at closing. Cash-for-assets transactions 

are usually outside the jurisdiction of federal and state securities laws, though under some 

circumstances contract terms such as an "earn-out" or a buyer's promissory note issued to the 

seller may subject the transaction, the parties, and the M&A broker to securities law and 

regulation. In many instances it may be undesirable or impractical to structure an M&A 

transaction as cash-for-assets because there are income tax advantages for the sellers to prefer 

cash-for-stock or stock-for-stock exchanges, which are within the jurisdiction of federal and state 

securities laws. The final legal structure of an M&A transaction may not be known until late in 

the sale process, which can span many months or even years. While all of these transaction 

structures result in the sale of the business, some of these legal structures are subject to federal 

and state securities laws, including broker-dealer regulation of the M&A broker, while other 

legal structures are not subject to securities regulation at all. 

Selling a privately owned business requires knowledge of multiple disciplines affecting 

all aspects of that business. Smaller businesses mayor may not have in-house expertise, and 

mayor may not be able to afTord consultants or specialists, in the relevant disciplines. 

Accordingly, an M&A broker serving smaller businesses often needs to be a competent 

generalist and "jack of all trades", knowing when and where special expertise is needed. M&A 

brokers educate the seller on the selling process; help prepare the business for sale; analyze 

company's financials and its business; perform or coordinate valuation; advise on potential 

capital sources and capital structure; understand the business operations; prepare business 

offering information packages; identify, market, and screen qualified potential buyers; assist in 

organizing and facilitating the buyer's due diligence; and coordinate communications with the 

parties' lawyers, accountants, and other consultants, An M&A broker's knowledge and 

experience with these and other business factors are critically important to thc success of an 

M&A transaction. 

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Regardless of legal structure, in M&A transactions the prospective buyers conduct their 

own extensive due diligence investigation into the seller's business, financial performance, 

management, operations, assets, liabilities, and business risks. The prospective buyers will 

control and run the businesses after the transaction's closing. Commonly, the prospective buyers 

have substantial business experience, employ their own knowledgeable operational and financial 

officers and managers, and are advised by their own lawyers, accountants, commercial bankers, 

and consultants. Sometimes the prospective buyers are larger, more sophisticated companies or 

private equity groups. The buyer's duc diligence team has complete access to the seller's 

business, which the buyer will ultimately own, control, and run. The parties negotiate their 

contractual representations, warranties, covenants, rights, and remedies, and may enforce their 

rights in court, rather than merely relying upon the antifraud protections and remedies in federal 

and state securities laws that are important to passive, non-controlling investors. Commonly, the 

parties' lawyers close the M&A transactions and control the exchange of the purchase 

consideration. In effecting the sale of a privately owned business, M&A brokers are not in the 

business of selling securities to passive investors; they are not raising capital; they are not 

holding either party's funds or securities; they are not investing funds for account of others. 

Not all M&A transactions that start are successfully closed. Commonly, M&A brokers 

are primarily paid for their services with a contingent success fee so, apart from reimbursement 

of expenses, the seller does not incur the cost of these services unless the transaction is 

completed. While this compensation structure helps to align the interests of the seller and the 

M&A broker, it also means that the M&A broker may commit a substantial amount of time -

often many months and sometimes several years - to working on behalf of the seller without 

current pay checks. M&A transactions fall apart frequently for a variety of reasons unrelated to 

the M&A broker or its services. For example, a prospective buyer may be unable to get 

financing, the buyer's discovery in due diligence of unacceptable business risks such as offbalance sheet liabilities, or the parties' inability to negotiate a satisfactory purchase price or 

contractual representations, warranties, indemnifications, and other remedies. An M&A broker 

Page 50f8 
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may have to find and screen multiple prospective buyers to ultimately sell a business, or may 

have to walk away from a sell-side engagement without compensation if no M&A transaction is 

closed. Most M&A brokers are themselves small businesses. High fixed overhead costs, 

including the cost of maintaining today's complex broker-dealer compliance infrastructure, are 

difficult to sustain when an M&A broker's compensation for services rendered is neither 

periodic nor predictable. 

Today's Compliance 

The current one-size-fits-all regulatory scheme requires M&A brokers to comply with the 

same SEC and FINRA regulations that govern Wall Street investment bankers and retail 

securities brokers. This requires registration with and extensive regulation by the SEC and 

FINRA, as well as compliance with various state securities laws, real estate brokerage laws, and 

business brokerage laws. The vast preponderance of existing federal regulation has been 

designed and enhanced to better protect our public markets and passive investors, and so imposes 

burdensome and complex requirements that are largely irrelevant in the context of private M&A 

transactions. 

The 2006, 2007, 2008, 2009, 2010, and 2011 Final Reports and Recommendations of the 

Government-Business Forum on Small Business Capital Formation hosted by the SEC have 

recommended that the SEC take the lead in clarifying and simplifying the complex, overlapping, 

and unduly burdensome securities regulations that presently regulate M&A brokers.5 In 2011, 

former SEC Chairman Schapiro acknowledged to Members of Congress6 the need for the agency 

to review the application of existing rules to M&A brokers in the privately negotiated sale of a 

business context, but no rulemaking has been undertaken and, since the enactment of the DoddFrank Act, there have been other Congressionally-mandated priorities. 

5 These reports are available on the SEC's website at http://www.sec.gov/info/smallbus/sbforum.shtml. 

6 Ms. Schapiro's letter is among the exhibits to Mr. Hansen's written slatement available on the Subcommittee's 

website at http://financialservices.house.gov/ calendarieventsingle.aspx?EventlD= 336906 . 

Page 6 of8 
71 


86681.030

Cost of Compliance 

Almost all M&A brokers operate as very small firms. For a typical small M&A broker to 

organize itself as a registered broker-dealer, the initial cost to organize and operate for the first 

twelve months of operations has been estimated to exceed $2S0,000? Annual fixed compliance 

costs are estimated to exceed $75,000 regardless of the number of M&A transactions handled or 

closed during the year. Because M&A brokers are commonly compensated by a contingent 

success fee, they must carry the entire cost of operations, including compliance, until each M&A 

transaction's closing. 

Since most M&A brokers close a very small number of transactions per year-sometimes 

none-and since not all of those transactions are even subject to securities regulation, the initial 

and on-going compliance cost required to handle a very small number of securities transactions 

is disproportionately burdensome to these small firms. Ultimately, these costs must be passed on 

to the business owners in order for the M&A broker to remain in business. 

Need to Act Now 

Various authors8 have observed that as the baby boomer generation reaches retirement, 

millions of small businesses affecting millions of employees will be transitioning to the next 

generation of owners. To better protect these senior business owners who frequently have up to 

90% of their net worth tied up in their businesses through direct investment and personal 

guarantees, many will need the assistance of an M&A broker. The perception of public 

protection through today's "one-size fits all" broker-dealer regulation is illusory, because there 

are thousands of small, unregistered M&A brokers across the country, who are either unaware 

that their activities require broker-dealer registration and regulation, or have chosen to ignore this 

requirement due to the extraordinarily high cost and lack of rclevance to the professional services 

they provide. The parties rely upon their negotiated contractual representations, warranties, 

7 See Exhibit 2, Estimate of Pro Forma Broker-Dealer Compliance-related Costs, and Exhibit 3, FINRA Gross 

Income Assessments and Various Registration Fees, for some of these compliance-related costs. 

8 Richard Jackim, Peter Christman, The $10 Trillion Opportunity, Exit Planning Institute (2006); Robert Avery, 

Cornell University. 

Page 70f8 
72 


86681.031

covenants, rights, and remedies drafted by their own attorneys for their own protection, rather 

than on the general antifraud prohibitions and protections designed for passive investors. 

The Impact ofH.R. 2274 on Economic Growth 

Capital formation, economic growth, and jobs preservation and creation by small and 

mid-sized businesses are all facilitated with cost-effective M&A advisory and business 

brokerage services.9 H.R. 2274 would direct the SEC to create a simplified system of M&A 

broker registration through a public notice filing. The bill would direct the SEC to review and 

tailor rules relevant to the context in which M&A brokers provide professional services. The bill 

would direct the SEC to work with state securities regulators to develop appropriate client 

disclosures about the firm and its professional staff, services, fees, and conflicts of interest 

(conceptually similar to those required from investment advisers), and professional 

qualifications. No new federal preemption of state laws would be created by H.R. 2274. State 

securities laws would continue to apply to M&A brokers. State securities regulators would 

continue their role in providing important protections for business sellers buyers. Appropriately 

scaling federal securities regulation of M&A brokers in view of the foregoing considerations 

would ultimately free-up the SEC's and FINRA's resources to bcttcr protect our public markets 

and passive investors. 

This written statement is accompanied by a number of exhibits with supporting 

information, which are incorporated here by reference. 

Conclusion 

I urge you to support H.R. 2274 and look forward to your questions. 

9 See Exhibit 4, A Bipartisan Small Business Fix, Michael Nail, AM&AA Founder, October 8, 2013 posted to the 

Hill.com. 

Page 80f8 
73 


86681.032

Exhibit 1 

Exhibit 2 

Exhibit 3 

Exhibit 4 

Exhibit 5 

Exhibit 6 

Exhibits Accompanying 

Written Statement by 

J. Michael Ertel, Managing Director 

Legacy M&A Advisors, LLC 

October 23, 2013 

List of Professional Association Supporters 

Estimate of Pro Fonna Broker-Dealer Compliance-related Costs 

FINRA Gross Income Assessments and Various Registration Fees 

A Bipartisan Small Business Fix, Michael Nail, AM&AA Founder, October 8, 2013, 

posted to the Hill.com. 

J. Michael Ertel Biography 

"Truth in Testimony" Disclosure Fonn 
74 


86681.033

Exhibit 1 

Supporting Professional Associations 
75 


86681.034

AM&AA Campaign for Clarity 

Supporting Professional Associations 

As of October, 2013 

• Alliance of Merger & Acquisition Advisors (AM&AA) 

• MidMarket Alliance (formerly Alliance for Corporate Wealth (ACW» 

• Midwest Business Brokers & Intermediaries (MBBI) 

• International Business Brokers Association (IBBA) 

• M&A Source (MAS) 

• Business Brokers of Florida (BBF) 

• Colorado Association of Business Intermediaries (CAB I) 

• Mid Atlantic Business Intermediaries Association (MABIA) 

• Texas Association of Business Brokers (TAB B) 

• California Association of Business Brokers (CAB B) 

• Institute of Certified Business Counselors (ICBC) 

• Arizona Business Brokers Association (AZBBA) 

• Georgia Association of Business Brokers (GABB) 

• Michigan Business Brokers Association (MSSA) 

• Carolina Virginia Business Brokers Association (CVBBA) 

• Nevada Business Brokers Association (NBBA) 

• Alliance for Corporate Growth (ACG) 

The Campaign for Clarity is also supported by numerous individuals and firms. 
76 


86681.035

Exbibit2 

Estimate of Pro Forma Broker-Dealer Compliance-related Costs 

86681.036

AI; antQitntllliff 

'feWR, 

Estimate of Pro Forma Broker-Dealer Compliance-related Costs 

Subject BO: ABC Capital Markets. LLC 

Broker-Oealer's basic required Net Capital fO'r an Investment Banking firm Is typically $5,000, but depends 9n how th" firm is set-up.lt could be 85 much a

(busineullnes to push a firm to' the $100,000 requirement MProprietary Trading, Firm Commitment Underwritings, Market Making) 

FINRA requires enough capital to' cover 12 months of anticipated expenses with nO' revenues (you may get bv with 6 months if you show you can put more 

The New FINRA NMA fees start at $7,500 and range up to' $55,000 depending on the size. and permiSSions of the firm. 

Calculated at the end 9f the Calendar year. Formula based on number of representatives, branch offices and gross revenues from securities transactions, 

Based on percentage of gross revenues - .25% of net operating r&venue. 

M&A Only can be as low as $10klyearfor a $1MM policY, for PrlYate Placements up to $60klyear if you're provided a quote at all 

This number can range in muhiples higher when the firm is larger 

Based on number representatiVQs, branch offices and net capital requirement 

If no FINOP in-house and services are outsourced monthly 

Estimated number, may be more or less based on complexity of business 
78 


86681.037

Exhibit 3 

FINRA Gross Income Assessments and Various Registration Fees 
79 


86681.038

1~ 'Wi '" q" 

1.~~ItIa~(J)I0~ .(J)~il~ , m~', 

Regulatory Pricing Changes 

SEC Approves Changes to the Personnel Assessment 

and Gross Income Assessment Fees 

Effective Date: January 1, 2010 

Executive Summary 

The SEC has approved changes to FINRA's regulatory pricing structure as 

originally outlined in Regulatory Notice 09-56 (September 2009). Effective 

January I, 2010, FINRA will implement a new Personnel Assessment rate 

structure and a revised calculation for the Gross Income Assessment.1 

The text of the amendments to Schedule A of the FINRA By-laws is set 

forth in Attachment A. 

Questions concerning this Notice should be directed to: 

~ Finance at (240) 386-5397; or 

~ the Office of General Counsel at (202) 728-8071. 

Background and Discussion 

FINRA's primary pricing structure consists of the following fees; the 

Personnel Assessment (PA). the Gross Income Assessment (GIA). the 

Trading Activity Fee and the Branch Office Assessment. These fees are 

used to fund FINRA's regulatory activities, including its examination 

and enforcement programs. The SEC has approved a rule change that 

restructures the PA and the GIA to allow FINRA to continue to effectively 

discharge its regulatory obligations in a fiscally prudent way. while 

reducing its vulnerability to another market downturn. 

November 20{)9 
80 


86681.039

The GIA currently is assessed through a seven-tiered rate structure with a minimum GIA 

of $1,200. Under the current pricing structure, firms are required to pay an annual GIA 

as follows: 

(1) $1,200 on annual gross revenue upto $1 million; 

(2) 0.1215% of annual gross revenue greater than $1 million up to $25 million; 

(3) 0.2599% of annual gross revenue greater than $25 million up to $50 million; 

(4) 0.0518% of annual gross revenue greater than $50 million up to $100 million; 

(5) 0.0365% of annual gross revenue greater than $100 million up to $5 billion; 

(6) 0.0397% of annual gross revenue greater than $5 billion up to $25 billion; and, 

(7) 0.0855% of annual gross revenue greater than $25 billion. 

The rule change amends Schedule A ofthe FINRA By-Laws to assess a GIA ofthe greater 

of (1) the amount that would be the GIA based on the existing rate structure (current 

year GIA) or (2) a three-year average of the GIA to be calculated by adding the currentyear GIA plus the GIA assessed on the firm over the previous two calendar years, 

divided by three. For a newer firm that has only been assessed in the prior year, 

FINRA will compare the current year GIA to the firm's two-year average and assess 

the greater amount. 

Otherwise, the existing GIA rate structure and phase-in implementation through 

2010 remain the same. Thus, for 2010, the current year GIA would remain subject to 

the cap set forth in Regulatory Notice 08-19 (ApriI200B), which describes the new 

funding structure that resulted from the consolidation of NASD and the member 

regulation, enforcement and arbitration functions of NYSE Regulation into FINRA. 

FINRA states in the Notice that it will apply a 10 percent cap on any increase or decrease 

of a firm's 2010 current year GIA resulting from the new pricing structure implemented 

in January 200B.' 

Firms should note that FINRA is committed to its practice of providing rebates to 

firms when revenues exceed the expenditures necessary to discharge its regulatory 

obligations. 

The rule change also increases the PA to better align FINRA's revenues with its costs. 

The PA is currently assessed on a three-tiered rate structure: firms with one to five 

registered representatives and principals are assessed $75 for each registered person; 

6 to 25 registered persons, $70 each; and 26 or more registered persons, $65 each. 

The rule change increases those rates to $150, $140 and $l30, respectively, based on 

the same tiered structure. 

Implementation 

The rule changes are effective January 1, 2010. 

Regula+ory Notice 
81 


86681.040

Endnotes 

See Exchange Act Release NO.6] 042 

(November 20, 2009), 74 FR 62616 

(November 30, 2009) (Order Approving 

SR-FINRA-2009-05 7). 

Regulatory Notice 

three-year average-will be used to calculate 

the current~year assessment and the resulting 

number would be used to calculate the 

three-year average. 
82 


86681.041

Attachment A 

Below is the text of the rule (hange. New language is underlined; deletions are in brackets. 

SCHEDULE A TO THE BY-LAWS OFTHE CORPORATION 

Assessments and fees pursuant to the provisions of Article VI of the By-laws of the 

Corporation shall be determined on the following basis. 

Section 1 - Member Regulatory Fees 

(a) through (b) No Change. 

(c) Each member shall pay an annual Gross Income Assessment equal to the 

greater [totalJ of: 

4 

(1) the total of: 

[(l)]!£Il $1,200.00 on annual gross revenue up to $1 million, 

[(2)]l!ll 0.1215% of annual gross revenue greater than $1 million upto $25 

million; 

[(3)](0 0.2599% of annual gross revenue greater than $25 million up to 

$50 million, 

[(4)]!Ql 0.0518% of annual gross revenue greater than $50 million up to 

$100 million, 

[(5)]ill. 0.0365% of annual gross revenue greater than $100 million up to 

$5 billion, 

[(6)]ill. 0.0397% of annual gross revenue greater than $5 billion up to $25 

billion; and 

[(7)]~ 0.0855% of annual gross revenue greater than $25 billion[.];JlI 

(;2l The average Gross Income Assessment from the preceding three calendar 

years to be determined by adding the Gross Income Assessment calculation 

pursuant to paragraph (clUl to the actual Gross Income Assessment in the 

preceding two calendar years then dividing by three. 

Regula:ory Notice 
83 


86681.042

The rate structure set forth in paragraph Iclill [aboveJ will be implemented 

over a three year period beginning in 2008 in such manner as specified by FINRA. 

For the purpose of paragraph Ic)(l) [El!:ach member is to report annual gross 

revenue as defined in Section 2 of this Schedule[,J for the preceding calendar year. 

(d) Each member shall pay an annual Personnel Assessment equal to: 

(1) [$7SJll2.Q.00 per principal and each representative up to five principals and 

representatives as defined below; 

(2) [$70J$140.00 per principal and each representative for six principals and 

representatives up to twenty-five principals and representatives as defined below; 

or 

(3) [$6SJ$12.Q.00 per principal and each representative for twenty-six or more 

principals and representatives as defined below. 

A principal or representative is defined as a principal or representative in the 

member's organization who is registered with FINRA as of December 31st of the 

prior fiscal year. 

Regulatory Notice 
84 


86681.043

RegistrationlExam Fee Schedule - FINRA 

Flnra?" 

Industry Professionals:> Compliance:> Registration;:. eRD:> FlImg & GUidance 

2013 Registration Fees 

The infonnation provided below includes fee changes and their effective dates, which were approved by the U$. 

Securities and Exchange Commission in June 2012 as noted in Regulatory Notice 12-32. 

Membership Fee 

Effective 7/23112 

The New Member Application (NMA) fee structure assesses fees ranging from $7,500 to $55,000 depending on the 

size of the new member applicant, as outlined in the tables below. The fee structure also assesses an additional 

$5,000 surcharge for a new member firm applicant that intends to engage in clearing and carrying activities. 

Number of Registered Persons 

Associated With Applicant 

Tier 1 

Tier 2 

Tier 3 

Application Fee per Tier 

Tier 1 

Tier 2 

Tier 3 

General Registration Fees 

Effective 1/02113 

Fee 

$100.00 

$45.00 

Small Medium Large 

1-10 151-300 501-1,000 

11-100 301-500 1,001-5,000 

101-150 NIA >5,000 

Small Medium Large 

$7,500 $25,000 $35,000 

$12,500 $30,000 $45,000 

$20,000 N/A $55,000 

Description 

Registration Fee - for each initial Form U4, The foUowing discounts apply to 

Forms U4 filed to transfer the registration of representatives/principals in 

connection with acquisition of all/part of a member's business by another 

member: 

* 1,000-1,999 registered personnel transferred - 10% discount 

2,000-2,999 registered personnel transferred - 20% discount 

~ 3,000-3,999 registered personnel transferred - 30% discount 

rn 4,OOD-4,999 registered personnel transferred - 40% discount 

5,000 and over registered personnel transferred - 50% discount 

Annual Web eRD Processing Fee 

Disclosure ProceSSing Fee (U4, U5 & amendments) - for all registration, transfer 

$110.00 or termination filings with new or amended disclosure information or that require 

certification as weI! as any amendment to disclosure information. 

$100.00 for the first day, $25 for Late Disclosure Fee 

each subsequent day, up to a 

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Page I of3 

10/23/2013 
85 


86681.044

RegistrationlExam Fee Schedule - FINRA 

maximum of 60 days. $1,575 

max 

$40.00 

$80.00 

Termination Fee 

Late Termination Fee 

Branch Office Registration Fees 

Fee Per Branch Office 

$75 

$20 

Notes about Branch Office Fees: 

Description 

Branch Office Initial Registration Fee 

Branch Office System Processing Fee 

iii FINRA will continue to waive the Initial Registration Fee for one branch per firm . 

• FINRA will continue to waive the System Processing Fee for one branch per firm. 

Branch Office Annual Registration Fees (Renewal) 

Effective 1/02/13 

# of Branch Offices 

1-250 

251-500 

501-1000 

1001-2000 

2001+ 

Notes about Branch Office Fees: 

Fee Per Branch Office 

$175 

$150 

$125 

$100 

$75 

FINRA will continue to waive the Annual Registration Fee (renewal) for one branch per firm. 

" In addition to the Annual Registration Fee, FINRA will continue to assess a $20 Annual System Processing Fee 

(renewal) per branch office. 

" FINRA will continue to waive the Annual System Processing Fee (renewal) for one branch per firm. 

Fingerprint Processing Fees 

Effective 1102/13 

Electronic Submission - covers processing and posting to Web CRD 

Fee Per Submission 

$29.50 

$15.00 

$29.50 

Description 

Initial Submission 

Second Submission for a first fingerprint submission that was deemed illegible 

by the FBI 

Third Submission 

Paper Card Submission - covers processing and posting to Web CRD 

Fee Per Card Description 

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Page 2 of3 

10/23/2013 
86 


86681.045

RegistrationlExam Fee Schedule - FINRA 

$44.50 

$30.00 

$44.50 

Initial Submission 

Second Submission for a first fingerprint submission that was deemed illegible 

by the FBI 

Third Submission 

Qualification Examination Fees are listed on the FINRA Administered Qualification Examinations table. 

Last Updated 11/2112012 

©2013 FINRA. AU rights reserved. FINRA is a registered trademark of the Financial Industry Regulatory Authority, Inc. 

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Page 3 of3 

10/23/2013 
87 


86681.046

Page I of7 

Fln~ Print 

Section 4 - Fees 

(a)(1) Each member shall be assessed a registration fee of $75.00 and a branch office system processing fee of 

$20.00 upon the registration of each branch office, as defined in the By-Laws. 

(2) FINRA shall waive, for the first branch office registered by a member, payment of the $75.00 registration fee 

and the $20.00 branch office system processing fee (where such fees have been assessed pursuant to paragraph (a) 

(1)). 

(3) Each member also shall be assessed: 

(A) an annual registration fee of: 

(i) $175, for each of the first 250 branch offices registered by the member; 

(ii) $150, for each of branch offices 251 to 500 registered by the member; 

(iii) $125, for each of branch offices 501 to 1,000 registered by the member; 

(iv) $100, for each of branch offices 1,001 to 2,000 registered by the member; 

(v) $75, for every branch office greater than 2,000 registered by the member; and 

(B) an annual branch office system processing fee of $20.00 per registered branch. 

(4) FINRA shall waive, for one branch office per member per year, payment of the $175 annual registration fee 

(where such fee has been assessed pursuant to paragraph (a)(3)(A)(i) and the $20.00 annual branch office system 

processing fee assessed pursuant to paragraph (a)(3)(B). 

(b) FINRA shall assess each member a fee of: 

(1) $100.00 for each initial Form U4 filed by the member with FINRA for the registration ofa representative or 

principal, except that the following discounts shall apply to the filing of Forms U4 to transfer the registration of 

representatives or principals in connection with acquisition of all or a part of a member's business by another member: 

Number of Registered Discount 

Personnel Transferred 

1,000-1,999 10% 

2,000-2,999 20% 

3,000-3,999 30% 

4,000-4,999 40% 

I 5,000 and over I 50% I 

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88 


86681.047

Page 2 of7 

(2) $40.00 for each initial Form US filed by the member with FINRA for the termination of a registered 

representative or registered principal, plus a late filing fee of $80.00 if the member fails to file the initial Form US within 

30 days after the date of termination; 

(3) $110.00 for the additional processing of each initial or amended Form U4, Form US or Form SO that includes 

the initial reporting, amendment, or certification of one or more disclosure events or proceedings; 

(4) $15.00 for processing and posting to the CRD system each set of fingerprints submitted electronically by the 

member to FINRA, plus any other charge that may be imposed by the United States Department of Justice for 

processing each set of fingerprints; 

(5) $30.00 for processing and posting to the CRD system each set of fingerprint cards submitted in nonelectronic format by the member to FINRA, plus any other charge that may be imposed by the United States 

Department of Justice for processing each set of fingerprints; 

(6) $30.00 for processing and posting to the CRD system each set of fingerprint results and identifying 

information that have been processed through another self-regulatory organization and submitted by a member to 

FINRA; 

(7) $45.00 annually for each of the member's registered representatives and principals for system processing; 

and 

(8) 10% of a member's final annual renewal assessment or $100, whichever is greater, with a maximum charge 

of $5,000, if the member fails timely to pay the amount indicated on its preliminary annual renewal statement. 

(c) The following fees shall be assessed to each individual who registers to take an examination as described below. 

These fees are in addition to the registration fee described in paragraph (b) and any other fees that the owner of an 

examination that F1NRA administers may assess. 

Series 

4 

Series 

6 

Series 

Series 

Series 

17 

~ 

~ 

G2:Jeries 

23 

Registered Options Principal 

Investment Company ProductsNariable 

Contracts Representative 

General Securities Representative 

Supervisor -

s SupervisorSupervisory Analyst 

Limited Registered Representative 

Direct Participation Programs 

Representative 

$75 

$95 

F===============ip===~1 General Securities Principal Sales 

Supervisor Module 

$95 

L-__________________ ~L ____ ~I 

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89 


86681.048

28 

37 

38 

39 

Series 

42 

Series 

51 

52 

Series 

72 

~ 

~ 

I Series I 82 

~ 

~ 

Series 

87 

Series 

99 

General Securities Principal 

Canada Module of S7 (No Options 

Required) 

Direct Participation Programs Principal 

Registered Options Representative 

Municipal Fund Securities Limited 

Principal 

Municipal Securities Representative 

Municipal Securities Principal 

lted Representative -Eq1uity Trl 

ecurities Limited 

Government Securities Representative 

Investment Banking Qualification 

Examination 

Limited Representative - Pri 

Securities Offering 

Research Analyst - Analysis 

Research Analyst - Regulatory 

Operations Professional 

Page 3 of7 

$95 

$175 

$175 

$120 

$105 

$175 

$125 

$125 

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86681.049

Page 4 of7 

(1) Persons for whom any qualification examination is waived pursuant to Rule 1070 shall be assessed as an 

application fee the examination fee for each qualification examination so waived. 

(2) There shall be an additional service charge of $15.00 for any examination or Regulatory Element session 

taken in a test center located outside the territorial limits of the United States. 

(3) There shall be a service charge equal to the examination or Regulatory Element session fee assessed to 

each individual who, having made an apPointment for a specific time and place for computer-based administration of 

an examination listed above or Regulatory Element session, fails to timely appear for such appointment or cancels or 

reschedules such apPointment within two business days prior to the apPointment date. 

(4) There shall be a service charge equal to one-half of the examination or Regulatory Element session fee 

assessed to each individual who, having made an apPointment for a specific time and place for computer-based 

administration of an examination listed above or Regulatory Element session, cancels or reschedules such 

appointment three to 10 business days prior to the appointment date. 

(d) In the event a member believes it should not be required to pay the late filing fee, it shall be entitled to a hearing in 

accordance with the procedures set forth in the Rule 9640 Series. 

(e)(l) In addition to any dues or fees otherwise payable, each applicant for membership shall be assessed an 

application fee, based on the number of registered persons proposed to be associated with the applicant at the time 

the application is filed, as outlined in the tables below: 

Number of 

Registered Persons 

Associated with Applicant 

Tier 1 

Tier 2 

Tier3 

Application Fee per 

Tier 

Tier 1 

Tier 2 

Tier 3 

(2) Each applicant for membership also shall be assessed an additional $5,000 if the applicant will be engaging 

in any clearing and carrying activity. 

(f) There shall be a session fee of $100 assessed as to each individual who is required to complete the Regulatory 

Element of the Continuing Education Requirements pursuant to FINRA rules. 

(g)(l) Unless a specific temporary extension of time has been granted, there shall be imposed upon each 

member required to file reports, as deSignated by this paragraph ("DeSignated Reports"), a fee of $100 for each day 

that such report is not timely filed. The fee will be assessed for a period not to exceed 10 business days. Requests for 

such extension of time must be submitted to FINRA at least three business days prior to the due date; and 

(2) Any report filed pursuant to this Rule containing material inaccuracies or filed incompletely shall be deemed 

not to have been filed until a corrected copy of the report has been resubmitted. 

(3) List of DeSignated Reports: 

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86681.050

(A) SEA Rule 17a-5 - Monthly and quarterly FOCUS reports and annual audit reports; 

(6) SEA Rule 17a-lO - Schedule I; 

Page 5 of7 

(C) FINRA Rule 4140 - any audited financial and/or operational report or examination report required 

pursuantto Rule 4140; and 

(0) FINRA Rule 4521 - any report, notification or information required pursuant to Rule 4521. 

(h) FINRA shall assess each member a fee of $100.00 on the first day and $25.00 for each subsequent day, up to a 

maximum of $1 ,575, that a new disclosure event or a change in the status of a previously reported disclosure event is not 

timely filed as required by FINRA on an initial Form U5, an amendment to a Form US, or an amendment to a Form U4, with 

such fee to be assessed starting on the day following the last date on which the event was required to be reported. 

(i)( 1) In addition to any dues or fees otherwise payable, each applicant submitting an application for approval of 

a change in ownership, control, or business operations shall be assessed an application fee, based on the number of 

registered persons associated with the applicant (including registered persons proposed to be associated with the 

applicant upon approval of the application) at the time the application is filed and the type of change in ownership, 

control, or business operations, as outlined in the tables below: 

Number of 

Registered Persons 

Associated with Applicant 

Tier 1 

Tier 2 

Tier 3 

Application Fee 

per Tier 

Merger 

Tier 1 

Tier 2 

IF"" Material Change 

Tier 1 

Tier2 

Tier 3 

Ownership 

Change 

I Transfer of Assets I 

I 

I 

I 

I II 

Small 

$7,500 

$12,500 

$20,000 

$5,000 

$10,000 

$15,000 

$5,000 

$5,000 

Medium Large 

Jl $50.000 

$75,000 

I N/A $100,000 

I 

II $20.000 I $35,000 

I $25,000 II $50,000 I N/A $75,000 

$10,000 $15,000 

$10,000 I $15,000 I 

II II I 

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Page 60f7 

Acquisition $5,000 II $10,000 II $15,000 II 

(2) If an applicant's application for approval of a change in ownership, control, or business operations involves 

more than one type of application identified in the "application fee per tier and application type" table in paragraph (i) 

(1) of this section, the application fee shall be the highest amount of the applicable fees (e.g., the application fee for 

an applicant associated with 1-10 registered persons filing an application involving a merger and material change 

would be $7,500). 

(3) FINRA shall waive the fee assessed pursuant to paragraph (i)(1) for a continuing membership application 

where FINRA determines that such application is proposing less significant changes that do not require substantial 

stalf review. For example, a continuing membership application may qualify for a fee waiver under this paragraph (i) 

(3) where the proposed change: 

(A) does not make any day-to-day changes in the applicant's business activities, management, 

supervision, assets, or liabilities, and the applicant is only proposing a change in the: 

(i) applicant's legal structure (e.g., changing from a corporation to an LLC); 

(ii) equity ownership, partnership capital, or other ownership interest in an applicant held by a 

corporate legal structure that is due solely to a reorganization of ownership or control of the applicant 

within the corporate legal structure (e.g., reorganizing only to add a holding company to the corporate legal 

structure's ownership or control chain of the applicant); or 

(iii) percentage of ownership interest or partnership capital of an applicant's existing owners or 

partners resulting in an owner or partner owning or controlling 25 percent or more of the ownership interest 

or partnership and that owner or partner has no disclosure or disciplinary issues in the preceding five 

years; or 

(6) is filed in connection with a direct or indirect acquisition or transfer of 25 percent or more in the 

aggregate of the applicant's assets or any asset, business, or line of operation that generates revenues 

composing 25 percent or more in the aggregate of the applicant's earnings, measured an a railing 36-month 

basis, where the applicant also is ceasing operations as a broker or dealer (including filing a Fonn BOW with the 

SEC); and there are either: 

(i) no pending or unpaid settled customer related claims (including, but not limited to, pending or 

unpaid settled arbitration or litigation actions) against the applicant or any of its associated persons; or 

(Ii) pending or unpaid settled customer related claims (induding, but not limited to, pending or unpaid 

settled arbitration or litigation actions) against the applicant or its associated persons, but the applicant 

demonstrates in the continuing membership application its ability to satiSfy in full any unpaid customer 

related claim (e.g., sufficient capita! or escrow funds, proof of adequate insurance for customer related 

claims). 

Amended by SR-FINRA-2013-015 elf. Feb. 5, 2013. 

Amended by SR-FINRA-2012-030 elf. Jan. 2, 2013. 

Amended by SR-FINRA-2012-031 elf. Jan. 2, 2013. 

Amended by SR-FINRA-2012-031 elf. July 23, 2012. 

Amended by SR-FINRA-2012-009 elf. Apr. 2, 2012. 

Amended by SR-FINRA-2011-042 elf. Oct. 17,2011. 

Amended by SR-FINRA-2011-026 elf. Sept. 1,2011. 

Amended by SR-FINRA-2010-016 elf. April 9, 2010. 

Amended by SR-FINRA-2008-067 elf. Feb. 8, 2010. 

Amended by SR-FINRA-2009-071 elf. Jan. 4, 2010. 

Amended by SR-FINRA-2009-056 elf. Nov. 2, 2009. 

Amended by SR-FINRA-2oo8-053 elf. Jan. 2, 2009. 

Amended by SR-FINRA-2008-001 elf. Jan. 1, 2008. 

Amended by SR-FINRA-2008-035 elf. July 30,2007. 

Amended by SR-NASD-2006-065 elf. July 3, 2006. 

Amended by SR-NASD-2005-133 elf. Jan. 1, 2006. 

Amended by SR-NASD-2005-132 eff. Jan. 1, 2006. 

Amended by SR-NASD-2004-145 elf. Jan. 1,2005. 

Amended by SR-NASD-2004-087 elf. June 7, 2004. 

Amended by SR-NASD-2004-049 elf. Mar. 30, 2004. 

Amended by SR-NASD-2003-192 elf. Feb. 11, 2004. 

Amended by SR-NASD-2004-115 elf. Jan. 1,2004. 

Amended by SR-NASD-2003-148 elf. Oct. 3, 2003. 

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Amended by SR-NASD-2003-109 eft July 10, 2003. 

Amended by SR-NASD-2002-182 eff. Dec. 24,2002. 

Amended by SR-NASD-2002-147 elf. Oct. 18,2002. 

Amended by SR-NASD-2002-1 00 elf. July 25, 2002. 

Amended by SR-NASD-2002-98 elf. July 24, 2002. 

Amended by SR-NASD-00-39 elf. Sept. 10,2001. 

Amended by SR-NASD-99-38 elf. Sept. 15, 1999. 

Amended by SR-NASD-99-43 elf. Sept. 7, 1999. 

Amended by SR-NASD-98-77 elf. Jan 1, 1999. 

Amended by SR-NASD-98-95 eft Dec 21, 1998. 

Amended by SR-NASD-96-53 elf. Jan 3, 1997. 

Amended by SR-NASD-95-32 elf. July 26. 1995. 

Amended by SR-NASD-95-23 elf. July 1,1995. 

Amended by SR-NASD-94-58 elf. Dec. 9, 1994. 

Amended by SR-NASD-94-06 elf. Feb. 9, 1994. 

Amended by SR-NASD-94-05 elf. Jan. 21, 1994. 

Schedule A, Sec. 2 amended elf. May 20, 1975; May 30, 1979; Oct. 1, 1979; Nov. 23, 1982; 

Oct. 1, 1985; Aug. 14, 1987; Apr. 4,1990 (elf. May 1, 1990); May 3,1990; Aug. 13, 1990; 

Mar. 1, 1991; July 16, 1991; Nov. 4,1992; July 13, 1993. 

Selected Notices: 95-59, 98-89; 99-75, 01-54, 04-25, 08-61, 09-67, 09-71, 11-36, 12-16, 

12-32,mJ· 

©2013 FINRA All rights reserved. 

Page7of7 

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FINRA Administered Qualification Examinations - FINRA Page I of 4 

Fln~ Industry" Professionals> Compliance> Registration >- Qualifications & Exams 

FINRA Administered Qualification Examinations 

Study outlines for some exams may be accessed by clicking on the Series number(s) listed below. Please click on the 

Series 63, 65, and 66 links to access study outlines available on the NASAA website, the Series 56 link to access the 

study outrine available on the CBOE website and the Series 3 link to access the study outline available on the NFA 

website. 

Series Examination Questions Time Prerequisite Cost 

(minutes) 

National Commodity 120 150 None $115 

Futures (CR) 

Registered Options 125 180 57, or 562 with $100 

Principal (OP) 842,517,537 

or 538 

Investment 100 135 None $95 

Company 

ProductsNariable 

Contracts 

Representative (IR) 

General Securities 250 360 None $290 

Representative (GS) 

General Securities 55 go 87 $75 

Sales Supervisor 

(Options Module 

(FINRA-SU) 

10 General Securities 145 240 57 $120 

Sales Supervisor 

General Module 

(FINRA-5U) 

11 Assistant 50 60 None $75 

RepresentativeOrder Processing 

(AR) 

14 Compliance Officer 110 180 None $335 

(NY5E-CO) 

16 Supervisory Analyst Each Part 50 90 Part 1 None $230 

(NYSE-8A) [one or 

Effective 10128113 two parts depending 120 Part 2 

on NYSE 

requirements] 

htt!):1 Iwww.finra.org/lndustrv ICom!)liancelRegistrationiQuali ficationsExams/!)O II 096 10123/2013 
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FINRA Administered Qualification Examinations - FINRA Page 2 of 4 

17 limited Registered 100 150 FCA $75 

Representative (IE) Registration 

22 Direct Participation 100 150 None $95 

Programs 

Representative (DR) 

23 General Securities 100 150 S8, S9/10, or $95 

Principal Sales 812 

Supervisor Module 

(GP) 

24 General Securities 150 225 87, 817,837, $115 

Principal (GP) S38, 862, S79 

orS82 

26 Investment 110 165 86 or 87 $95 

Company 

ProductsNariable 

Contracts (IP) 

27 Financial and 145 210 None $115 

Operations Principal 

(FN) 

28 Introducing 95 120 None $95 

Broker/Dealer 

Financial and 

Operations Principal 

(FI) 

30 NFA Branch 50 60 None $75 

Managers 

Examination 

31 Futures Managed 45 60 None $75 

Funds Examination 

32 limited Futures 35 45 None $75 

Exam~Regulations 

34 Retail Off-Exchange 40 60 None $75 

Forex Examination 

37 Canada Module of 90 150 CAN $175 

S7 (CD) [Options Registration 

Required] 

38 Canada Module of 45 75 CAN $175 

S7 (CN) [No Options Registration 

Required] 

39 Direct Participation 100 135 822 or 87 $90 

Programs Principal 

(DP) 

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FINRA Administered Qualification Examinations - FINRA Page 3 of 4 

42 Registered Options 50 90 872 or 862 $70 

Representative (OR) 

51 Municipal Fund 60 90 S24 or 526 $155 

Securities Limited 

Principal (FP) 

52 Municipal Securities 115 210 None $180 

Representative (MR) 

53 Municipal Securities 100 180 852 or 57 (if $165 

Principal (MP) passed prior to 

1117111) 

55 Limited 100 180 57.517.837. $105 

Representative- 538. or 562 

Equity Trader 

Examination (ET) 

56 Proprietary Trader 100 150 None $195 

Examination (PT) 

62 Corporate Securities 115 150 None $90 

Limited 

Representative (CS) 

63 Uniform Securities 60 75 None $115 

Agent State law 

Exam (AG) 

65 NASAA-Investment 130 180 None $155 

Advisors Law Exam 

(RA) 

66 NASAA~Uniform 100 150 57 $145 

Combined State Law 

Exam (AG and/or 

RA) 

72 Government 100 180 None $105 

Securities 

Representative (RG) 

79 Limited 175 300 None $290 

Representative -

Investment Banking 

82 limited 100 150 None $90 

RepresentativePrivate Securities 

Olferings (PR) 

86 Research Analyst 100 240 S7 • 517. S37. $175 

(RS) Part I or 538 

Analysis Module 

httll:llwww.finra.orgL}ndus!;!:y/ComllliancelRegistrationlQualificationsExams/QOll 096 10/23/2013 
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86681.056

FfNRA Administered Qualification Examinations - FINRA Page 4 of4 

87 Research Analyst 50 90 S7 ,S17, S37, $125 

(RS) or $38 

Part Ii 

Regulations Module 

91 FDIC Risk 100 240 $140 

Management 

Technical EValuation 

92 FDIC Compliance 100 240 $140 

Technical EValuation 

93 FDIC Division of 100 240 $125 

Resolutions & 

Receivership 

Technical Evaluation 

99 Operations 100 150 None $125 

Professional (OS) 

Last Updated: 8/28/2013 

©2013 FINRA. All rights reserved. FINRA is a registered trademark of the Financial Industry Regulatory Authority, Inc. 

http://www.finra.org/lndustry/CompliancelRegistration/QualificationsExams/pOll096 10/23/2013 

86681.057

SRO/Jurisdiction Fee and Setting Schedule· Web CRD 

Fees As Of 10/412013 

= 

______ 

Current change(s) in (" Gleen) 

86681.058

IndfvidualFee$ " !ndiv!duaISettings SO Fees and 

8R Renewal Fee Form BR Dual BR 

AmdFee Office Fee 

J!l:ilv/dul>l T",mmll!IQn f"'" f-INiIA a ".)(1 '1)", Ill' mfJh.,d'lzJ 1 

CUlrent change(s) !O (" Oft-en) 

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100 


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Exhibit 4 

A Bipartisan Small Business Fix, 

Michael Nail, AM&AA Founder 

Posted to the HiII.com 

October 8, 2013 
101 


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A bipartisan small business fix - The Hill's Congress Blog 

l'HEj.,flILL 

~'()il~~lr~'~~~~~~,~~==~==== \ nWI~' lawmakel's {'OI11{' III hlo~ 

A bipartisan sm all business fix 

By Michael Nail - 10/08/13 09:00 AM ET 

Page I of3 

As Congress confronts issues of tremendous policy and political implications in the next few weeks 

including a continuing resolution to keep the government open, federal debt ceiling debates, and 

numerous healthcare, immigration, and energy proposals, one bill is quietly making its way through 

Congress which is bipartisan, pro-small business, pro-job growth, and a long overdue fix for 

professionals who work in the sale of private businesses. 

HR 2274, the Small Business Mergers, Acquisitions, Sales, and Brokerage Simplification Act of20\3 

is an excellent bipartisan bill, one whose time has come, and Congress should get it done before the 

end of the year. It's not a sexy bill, not one that prime-time TV will be talking about, and not one that 

will evoke a question in the next presidential debates, but it's a bill that does have teeth and it is a 

serious and substantive piece of small business legislation. 

HR 2274 would simplify and reduce the costs offederal securities regulation in privately negotiated 

mergers and acquisitions. The bill would apply to M&A transactions involving the sale of private 

companies with earnings of less than $25 million (earnings are defined as EBITDA which stands for 

Earnings Before Interest, Taxes and Depreciation) and revenue ofless than $250 million to active 

buyers. 

The key words here are 'private companies' and 'active buyers.' It would direct the SEC to create a 

simplified system of registration through a public notice filing that would he available on the SEC's 

website, and it would require appropriate client disclosures from the M&A broker. H.R. 2274 would 

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A bipartisan small business fix - The Hill's Congress Blog Page 2 of3 

also direct the SEC to tailor its rules governing M&A brokers in light of the limited scope of their 

activities, the nature of privately negotiated M&A transactions, and the active involvement of buyers 

and sellers in those transactions. 

The current one-size-fits-alllaw treats the sale of a small, privately held business the same as a Wall 

Street investment banker selling securities of a public company. For instance, a sale of a local candy 

store with seller financing can technically be considered a securities transaction requiring brokerdealer registration with the SEC. 

There is a big difference between the sale of a small business to a buyer who will be active in 

managing the business after the sale and the sale to passive investors of securities of a publicly-traded 

company on the New York Stock Exchange. 

Current law does not distinguish between these two activities and it should. It's time for 

Washington to define the differences. 

HR 2274 does just that. 

2274 would help small business owners reap the benefits of their entrepreneurial efforts of starting, 

building, and running ajob creating private enterprise. For many of these owners, sale of their 

business is their retirement nest egg. 2274 also helps entrepreneurs and managers buy an existing 

business and build it up to the next level. 

Compliance costs for small businesses associated with these current regulations can easily exceed 

$75,000 per year; costs that could result in either non-compliance or expenses passed on to the small 

business owners. 

2274 would lower costs, increase compliance, and better serve buyers and sellers of small businesses. 

It is a bill that promotes economic development, job creation, and provides important, immediate, and 

substantial relief of regulatory burdens on small business professionals in the critical M&A industry. 

In this red hot partisan atmosphere, perhaps Congress can take a day to identify and pass some truly 

bipartisan small business bills. Such an act would show America that, while major philosophical 

differences and contentious proposals are being hammered out on high-profile issues on Capitol Hill, 

at the same time, positive initiatives can still being considered and passed in a bipartisan fashion; laws 

that can make a real and immediate difference in the lives of many Americans. 

It is a smart bill and one that deserves consideration through a straight-up vote or through inclusion in 

any other jurisdictional bills moving through Congress that address small business, jobs or regulatory 

reform. 

We encourage Congress to look at 2274 as a perfect example of where Congress can come together in 

a bipartisan effort to show that things are still getting done for the American small business 

community in Washington. 

Nail is the president ()fThe Alliance of Merger & Acquisition Advisorsifi) (amaaonline.org) which is 

the international organization serving the the middle market M&A industry. 

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A bipartisan small business fix - The Hill's Congress Blog Page 3 of3 

Source: 

htlp:llthehill.comlblogs/congress-blog/economy-a-budgetl326999-a-bipartisan-small-business-fix 

The contents of this site are © 2013 Capitol Hill Publishing Corp., a subsidiary of News Communications, Inc. 

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Congressional Testimony H.R. 1800 AND H.R. 31 

Written 

Legislation to Further Reduce Impediments to Capital Formation 

Small Business Credit Availability Act (H.R. 1800) 

Next Steps for Credit Availability Act (H.R. 31) 

Alexander C. Frank 

As Chief Financial Officer and Partner of Fifth Street Management llC, I appreciate the opportunity to 

testify on the implications of H.R. 1800 and H.R. 31. Fifth Street is an alternative asset manager with 

over $3 billion in assets under management and the SEC-registered investment adviser of two publiclytraded business development companies. Our team has a 15 year track record financing small and midsized companies, primarily in connection with investments by private equity sponsors. 

BDCs like Fifth Street play an essential role in the new paradigm of middle market lending. As traditional 

banks have shied away from lending to small and mid-sized private businesses, alternative lenders like 

BDCs have filled the void, emerging as the primary conduit between banks and smaller companies that 

are non-investment grade credits. Consider that nine years ago, there were just four publicly-traded 

BDCs. Today, there are roughly ten times as many-or approximately 40 publicly-traded BDCs-and we 

estimate that within the next few years, BDC assets will eclipse $100 billion. 

Despite the growing importance of BDCs in helping finance small and mid-sized companies in our 

economy today, the BDC industry is still burdened by legacy regulations that create an uneven playing 

field while needlessly costing the industry significant amounts of time and money each year. Since BDCs 

are pass-through vehicles, that cost is borne not just by BDC shareholders, but by the small businesses 

BDCs serve as well. 

Several aspects of both H.R. 1800 and H.R. 31 could go a long way towards "modernizing the BDC 

regulatory framework." First, allowing BDCs to own interests in registered investment advisers is a 

shareholder-friendly step that would offer investors incremental fee-based revenue. Second, permitting 

BDCs to issue preferred equity that would be considered regulatory capital could be viewed as equally 

favorable-BDCs would gain a new source of funding, while investors would benefit from less dilution 

from additional issuance of common equity shares. Finally, if SEC registration is streamlined, BDCs 

should become more agile, tapping the capital markets more quickly and having the ability to pursue 

opportunities as they arise. The latter two provisions, in particular, will bring much-needed parity to the 

BDC industry vis a vis counterparts like REITs and MlPs. 

Collectively, such modernization would represent a positive development for an industry that is playing 

an increasingly important role in financing underserved small and mid-sized U.S. companies. However, 
105 


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when it comes to reducing asset coverage requirements-which would allow for more aggressive 

balance sheet leverage-H.R. 1800 and H.R. 31 may not be appropriate in all cases, or for all asset 

classes, and I believe requires further review. Prudently-managed BOCs with efficient operations simply 

are not challenged by a lack of capital today. In fact, the BOC industry as a whole witnessed a multitude 

of securities issuances in 2012 and that trend has continued into 2013. 

Investment grade rated BOCs issued close to $1.3 billion in public equity for the full 2012 calendar year, 

a 300% increase compared with all of 2011.' With ample capital to deploy, well-run BOCs easily 

maintained leverage levels below statutory minimums-the industry's average debt/equity ratio stood 

at approximately O.4x equity last year. According to Fitch Ratings, unsecured debt issuances totaled $1.9 

billion across six rated BOCs in 2012 and 1Q13, versus just $545 million across three rated BOC issuers in 

2011. 2 

In reality, the single biggest hurdle that prevents a BOC from attracting new capital is having a stock 

price that trades below net asset value (NAV), or book value. BOCs are not permitted to sell shares 

below net asset value without shareholder approval. Approval notwithstanding, the invisible hand of 

the market serves as a natural constraint against BOCs with discounted NAVs. It is difficult to 

successfully raise equity when one's stock (or, at times, the entire sector) is out of favor. 

A number of factors influence a BOC's NAV, including dividend policy, the prospect for dilutive equity 

raises and above all, the credit performance of a BOC's underlying portfolio. On the latter front-under 

the existing leverage rules-the industry'S overall track record has been strong. Cumulative realized and 

unrealized losses for the BOC industry average at a rate of around 70 basis points annualized, which 

compares favorably to a 257 basis points annualized rate for commercial banks.3 Thus, while banks may 

gravitate toward more liquid assets, BOCs have demonstrated relatively superior credit performance. 

Yet, there have still been notable exceptions. At the peak ofthe credit cycle in 2006-2007, two 

prominent BOCs overextended their debt capacity as a means of fueling aggressive portfolio growth. 

Unfortunately, the timing was disastrous. A series of write-downs led to violations of credit facility 

covenants, which resulted in restructurings and the eventual cessation of dividend payments. In the 

end, equity investors suffered considerable losses. 

Several lessons can be learned from this cautionary tale. First, a few high-profile mistakes can tarnish 

the entire industry. This is especially true in a sector that tends to be viewed as a monolith-as 

evidenced by the fact that Virtually the entire BOC industry trades in a narrow range in terms of price-tobook. The misguided decisions of two players who borrowed imprudently in pursuit of growth still haunt 

the industry today. As well-managed BOCs shake off the lingering pall of investor misconceptions, it 

would be counterproductive to raise the specter of expanded leverage. 

1 "BOC Unsecured Issuance Bolstering Funding Flexibility," April 9, 2013. Fitch Ratings. 

2 Ibid, 

3 "The SDC Almanac-Part Deux," January 23, 2013. Welts Fargo Securities, 
106 


86681.131

The second key lesson is the importance of having diversified sources offunding. Today, large BOCs 

enjoy multiple pockets of funding. This diversification reduces the likelihood of a potential liquidity 

squeeze. However, smaller BOCs may not be able to afford the luxury of varied funding sources. Even 

so, under current asset coverage requirements, it might still be feasible for a smaller BOC to approach 

the public equity markets to replace funding from a pulled credit line. Under the newly proposed 

guidelines, however, the potential hole could be too large to fill. 

The final lesson that can be gleaned is that BOC investors place a high premium on stability. Investors in 

BOCs are attracted to the potential for healthy dividend yields with low leverage. It is that combination 

that makes the BOC model uniquely compelling: robust current income without undue risk. Because 

BOCs pay dividends based on the taxable income they earn, investors generally feel secure knowing that 

dividends are supported by relatively stable, predictable cash flows. 

Today, the Securities & Exchange Commission does a highly effective job enforcing the current leverage 

ratio. In our view, the 1:1 ratio-and its strict SEC oversight-contributes to a reputation for safety that 

is appreciated by both BOC investors and nationally recognized rating agencies alike. Altering the 

leverage profile in the BOC model would inevitably lead to higher default risk-to the detriment of the 

investment calculus. 

Investors are not the only ones who would likely feel compelled to re-evaluate the BOC model if 

leverage beyond the traditional 1:1 requirement is permitted. Rating agencies-instrumental in helping 

BOCs become a more entrenched institutional asset class-would likely view the development as 

unfavorable, too. 

As nationally recognized ratings agencies incorporate the higher risk of defaults into their models, 

downgrades could follow. Even those BOCs who adopt a more conservative approach could be 

penalized, as agencies would need to account for potential competitive pressures to expand leverage. 

A change in position could not come at a worse time for the industry. New risk-based capital weightings 

under Basel I!! are likely to mandate that banks increase equity capital reserves for leveraged loans. 

While many view this as a positive development for BOCs-assuming decreased bank competitiveness in 

the middle market space-potential credit downgrades could undercut any upside. 

At best, a non-investment grade credit rating would increase a BOC's cost of capital on bank credit 

facilities. At worst, it could make institutional investors less receptive to BOCs at a time when an uptick 

in unsecured debt issuances is enhancing BOCs' funding diversity. 

In short, credit downgrades would be an unwelcome surprise at a time when BOCs should be capitaliZing 

on the tailwinds of supportive capital markets for unsecured debt and increased market share potential 

due to Basel!!1. 

This discussion would not be complete without mentioning "effective leverage", which takes into 

account, on a look-through basis, leverage ofthe underlying assets in which a BDC invests. In other 
107 


86681.132

words, it's important to recognize that BOCs often provide expansion capital to their portfolio 

companies who are often heavily leveraged themselves. 

Effective leverage is an important concept because it shows the true risk in a BOC's balance sheet. Wells 

Fargo Securities, llC estimates the BOC peer group average at 3.Sx, but the most highly levered BOCs 

have effective leverage ratio estimates over S.5X.4 If H.R. 1800 or H.R. 31 is enacted in its current form, 

BOCs with already high levels of effective leverage could essentially double their effective leverage up to 

llx. 

Not all BOCs are alike-and 1:1 leverage may not be precisely the right level. Yet, a drastic move from 

1:1 to 2:1 leverage in one step might benefit a handful of BOCs while working to the detriment of the 

vast majority. Ouring this period of high growth and increasing small-business reliance on BOCs, 

completely removing the safety rails does not seem judicious. Having reduced the amount of risk in the 

financial system by requiring banks to hold more capital to support the risks associated with lending to 

non-investment grade companies-only to shift that risk to entities already operating more 

responsibly-appears imprudent and could significantly undermine the long-term vision that the bills set 

out to achieve. 

The BOC industry stands at a crossroads: BOCs are considered an emerging asset class and the industry is 

growing swiftly. In fact, industry analysts see parallels between BOCs and two other investment 

vehicles, Real Estate Investment Trusts (REITs) and Master limited Partnerships (MlPs), which also 

started out as relatively obscure, niche investments. Now, REITS and MlPs are highly successful, wellestablished asset classes. All indications are that BOCs could continue to provide very good investment 

opportunities-provided the industry avoids reputational damage and other hurdles that could 

undermine its prospects. 

Many BOCs would welcome either H.R. 1800 or H.R. 31 as it is currently written, and three provisions 

seem both prudent and beneficial. However, from a fiduciary perspective and the protection of 

shareholder capital, increasing the leverage threshold potentially risks shrinking the pool of capital 

available to BOCs and choking off liquidity to the "young, rapidly growing companies" it is designed to 

help. 

4 {Wells Fargo Securities, The Q3 2013 BDC Scorecard, June 14, 2013, page 50) 
108 


86681.063

ON: 

TO: 

BY: 

DATE: 

Statement 

of the 

U.S. Chamber 

of Commerce 

Legislative Proposals to Reduce Barriers to Capital 

Formation 

The Subcommittee on Capital Markets and Government 

Sponsored Enterprises 

Tom Quaadman, Vice President of the Center for Capital 

Markets Competitiveness 

October 23, 2013 

Th~~ C!umhcr's misslno is to ad\'~nc(' hunun 

political and social sysH'm based on 

inccmiyc, initiatin:, opportunity and responsibility. 
109 


86681.064

1be u.s. Chamber of Commerce is the world's largest business federation 

representing the interests of more than 3 million businesses of all sizes, sectors, and 

regions, as well as state and local chambers and industry associations. The Chamber is 

dedicated to promoting, protecting, and defending America's free enterprise system. 

More than 96% of Chamber member companies have fewer than 100 

employees, and many of the nation's largest companies are also active members. We 

arc therefore cognizant not only of the challenges facing smaller businesses, but also 

those facing the business community at large. 

Besides representing a cross-section of the American business community with 

respect to the number of employees, major classifications of American business--e.g., 

manufacturing, retailing, services, construction, wholesalers, and finance-are 

represented. The Chamber has membership in all 50 states. 

The Chamber's international reach is substantial as well. We believe that global 

interdependence provides opportunities, not threats. In addition to the American 

Chambers of Commerce abroad, an increasing number of our members engage in the 

export and import of both goods and services and have ongoing investment activities. 

The Chamber favors strengthened international comperitiveness and opposes artificial 

U.S. and foreign barriers to international business. 

Positions on issues are developed by Chamber members servmg on 

committees, subcommittees, councils, and task forces. Nearly 1,900 businesspeople 

participate in this process. 

2 
110 


86681.065

Chairman Garrett, Ranking Member Maloney and Members of the Capital 

Markets and Government Sponsored Enterprises subcommittee, my name is Tom 

Quaadman and I am Vice President of the Center for Capital Markets 

Competitiveness ("CCMC") at the U.S. Chamber of Commerce ("Chamber"). The 

Chamber is the world's largest business federation, representing the interests of more 

than three million businesses and organizations of every size, sector and region. I 

appreciate the opportunity to testify before the Subcommittee today on behalf of the 

businesses that the Chamber represents. 

Before I address the subject of the hearing, I would like to thank Chairman 

Garrett, Ranking Member Maloney and the Members of the Capital Markets and 

Government Sponsored Enterprises Subcommittee for your tireless efforts to 

improve capital formation opportunities for ,,\merica's small and mid-size businesses. 

These efforts resulted in the enactment of the bi-partisan Jumpstart Our Business 

Startups Act ("JOBS .Act") last year, and we hope that your current exertions ",,;II 

culminate in a JOBS Act II becoming law. 

I. Need for Diverse Forms of Capital in a Free Enterprise System 

In 2011, the Chamber released a study by Professor Anjan Thakor of 

Washington University entided, Sources ofCapitaJ and Economic Growth: 

Interconnected and Diverse Markets Driving U.S. Competitiveness ("Thakor 

Study"). The Thakor Study found that a key factor for small business success and 

resulting growth and job creation is their ability to access flnancing. The Thakor 

Study had flve key conclusions: 

1. A robust, efflcient and diverse flnancial system facilitates economic growth; 

2. In terms of their flnancing choices individual entrepreneurs are largely limited 

to debt flnancing for raising capital; 

3. As businesses f:,>fOW they can access both debt and equity flnancing and the mix 

of these two, called d1e "capital structure" decision, is an important choice 

every business makes; 

4. A rich diversity of flnancing sources is provided by the U.S. financial system; 

and 

5. The U.S. financial system is highly connected and what happens to one 

flnancing source causes spillover effects in other parts of the system. So for 

example, if excessive regulation restricts access to, or the operation of, the IPO 

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and secondary markets for publicly traded companies, the resulting loss of 

liquidity will act as a disincentive to private equity and venture capital activity as 

well. 

Therefore, the better the fInancial system functions, the more new companies 

are launched, the larger the number of publicly listed companies, the better overall 

management of risk and greater availability of consumer credit. In other words, a 

diverse, well-developed and effIcient system of capital formation is necessary for 

robust economic growth and increased employment. 

Over the past several years we have seen our capital markets lose effIciency 

with a resulting decline in the number of businesses becoming public companies, as 

well as a sharp drop in the number of public companies overall. Many reasons exist 

for these outcomes-the fmancial crisis, stale regulatory systems that fail to keep up 

with the needs of a 21 st century economy, and legislative and regulatory initiatives that 

are changing fundamental practices that have been in place for decades. 

What has not changed is the need for new businesses and growing businesses 

to acquire capit.al. However, if those capital needs are not met, the next big idea or 

next successful business will simply wither on the vine and blow away with the wind. 

These bi-partisan bills are an important step in removing some of the 

roadblocks that are inhibiting grO\vth by.America's Main Street businesses. The 

Chamber supports these bills and I will offer some constructive changes as I discuss 

these legislative proposals in greater detail. 

II. Legislative Proposals 

a. Bills Regarding Business Development Companies 

I would like to address the proposed legislation on Business Development 

Companies ("BOCs"), H.R. 31 offered by j\1s. Velazquez, H.R. 1800 offered by 

Messer's. Grimm and Graves, and H.R. 1973 offered by Mr. Mulvaney, together as 

one package. 

BOCs are a unique form of fmancing, similar to private equity, venture capital 

or Real Estate Investment Trusts. They have become increasingly popular as the 

credit cycle and regulatory reaction to the fmancial crisis have made accessing debt 

fInancing more challenging. It is important to keep in mind that BOCs are open to 

retail investors and not just accredited investors. BOCs tend to have higher yields, 

but also greater risks than fLxed-income products. 

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The passage ofH.R. 31, H.R. 1800, and H.R. 1973 would increase the capital 

available to BDCs and increase their ability to provide small and mid-size businesses 

with the funding needed to grow. Additionally, these bills would remove barriers for 

BDCs to become more active participants in the marketplace. For example, some 

BDCs could be treated as "well known seasoned issuers" and thus be permitted to 

issue securities more quickly. BDCs would be able to use a modestly higher level of 

leverage, which would permit them to invest more capital to portfolio companies. 

BDCs would also have more flexibility in their investments. 

A combination of events and forces- Basel III, changes in risk tolerances, a 

zero rate interest environment-have deprived small and mid-size businesses of 

previously available forms of capital. This has prevented the creation of new 

businesses and constrained the ability of existing businesses to grow. Passage of H.R. 

31, H.R. 1800, and H.R. 1973 would allow existing market trends towards BDCs to 

grow and fIll a void that has caused serious economic harm. 

Although BDCs are currently required to describe the risk factors involved in 

their submissions to shareholders and the Securities and Exchange Commission 

("SEC"), the Chamber is concerned that investors may not fully comprehend the 

nature of the risks involved in BDCs. In promulgating implementing regulations, 

SEC should reexamine the required disclosures to insure that investors are properly 

aware of the risks. 

h. Small Business Mergers, Acquisitions, Sales and Brokerage 

Simplification Act 

H.R. 2274, introduced by Rep. Huizenga, would establish a notice-filing 

registration procedure for mergers and acquisition brokers ("M&A brokers"). This 

bill would permit M&A brokers, to the extent that these brokers limit their activities 

to transactions involving the transfer of ownership or the assets of an "eligible 

privately held company," to electronically register with SEC, and not be subject to all 

the requirements imposed on a full service broker under the Securities Exchange Act 

of 1934. While it would simplify the registration of these brokers, it contains a 

number of safeguards to prevent abuses. This bill would circumscribe the activ;.ties of 

an M&A broker. The bill would not exempt M&A brokers from tl'le existing 

prohibitions designed to block securities law violators, criminals, and other bad actors 

from entering the business. It would also require disclosure of relevant information 

to clients and to the owner of an eligible privately held company who is offered a 

stock for stock transfer. 

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This is a common sense reform that should help entrepreneurs avail themselves 

of expert assistance in selling their business and realizing the full value of their 

enterprise, thereby providing further incentives for aspiring entrepreneurs to push 

forward with their ideas. By facilitating M&A activity, it would provide another 

source of capital for smaller companies. 

c. XBRL Exemption for Small Public Companies 

An efficient flow of information to investors is critical to efficient capital 

markets. While our securities laws are still largely rooted in a paper based system, 

eXtensible Business Reporting Language ("XBIU/') provides machine-readable 

financial statements in a consistent format, making information more user-friendly for 

investors. Investors can quickly download information to spreadsheets without 

manually re-inputting the data. Investors can also search SEC filings more quickly in 

order to find promising investments. Clearly, digital disclosures are the way of the 

future and XBRL is the first step down that road. 

Currently, all issuers have to furnish, but not officially "file" financial 

statements in XBlU~, which limits issuer's liability for honest mistakes. Under the 

current rule 406T, scheduled to expire on October 31, 2014, issuers \vilI not be liable 

for mistakes as long as the issuer makes a good faith effort to comply. 

Despite the advantages of digital disclosure, the Chamber supports a temporary 

XBRL exemption for two reasons: 

1) XBRL has been a work in progress and has undergone a number of gro\Vwg 

pains. This system will undergo series of changes and adjustments as 

various stakeholders demand changes and become better acclimated with 

the system. It is better that small businesses not have to deal with a work in 

progress and instead concentrate on issues of more importance-the 

growth of the company. Smaller issuers should be required to use XBRL 

only after the bugs have been worked out and compliance costs have fallen 

to the point where they are less than the benefits. 

2) The JOBS Act exempts small public companies from certain financial 

reporting obligations and other disclosure requirements. An exemption 

from XBIU~ reporting for smaller companies would be consistent with the 

other exemptions in the JOBS Act. 

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While XBRL and digital disclosures will gradually become a larger part of the 

information flow for capital markets, smaller public companies need not be subject to 

some of the hiccups. Smaller fIrms are less able to bear the development costs of the 

evolution ofXBRL. 

The Chamber would recommend that the discussion draft be changed to 

include a requirement for SEC to report to Congress on an annual basis on the 

progress it has made on XBRL and the use of digital disclosures to facilitate the flow 

of information to investors and the marketplace. The report should include estimates 

of the costs of compliance with the XBRL mandate and the use of XBRL by 

investors. This information would be useful in determining whether it would be cost 

effective to extend the XBRL mandate to smaller companies. 

In addition, the Chamber recommends that the grace period in current SEC 

Rule 406T should be extended for all issuers for two years and for smaller issuers for 

at least fIve years. 

The Chamber also agrees with the recent statements by SEC Chair White that 

there is a "disclosure overload."t A voluminous amount of obsolete and immaterial 

disclosures have effectively disenfranchised retail investors and forced investors to 

wade through a clutter of information at their own peril. The discussion draft could 

also include a requirement for SEC to periodically report to Congress on its 

retrospective review of obsolete and unnecessary disclosures. As an example, the 

Federal Communications Commission recently undertook such a retrospective review 

and removed over 120 regulations that were deemed to be obsolete and outdated.2 

The SEC should be able to do the same. 

d. Pilot Program for Tick Size of Stocks 

The move to decimalization in stock quoting and trading at the turn of the last 

century was a landmark moment for retail investors. Decimalization refIned price 

discovery, tightened spreads, and lowered costs. However, trading in pennies has 

impacted the available liquidity in some thinly traded stocks, including many small-cap 

stocks. The optimal tick may not be the same for all companies, and a pilot 

experiment would gather useful data for examining this. Accordingly, we believe that 

the draft legislation proposed by Representative Duffy would help ensure that we 

have a market structure that supports capital formation for all public companies. This 

1 See October 3, 2013 speech by Chair \);Jrute entitled, The Importance of Independence and October 15, 2013 speech 

entitled, The Path Forward OD .Disclosure. 

2 See May 17, 2013 Federal Communications Commission press release entitled FCC Lifts Unneeded Telecom Rules, 

Frees ~fillions for Investment. 

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legislation would pennit scientific evidence-based rulemaking, which, in or opinion, is 

the best kind. Also, the ability to have issuers select their own tick size is reasonable. 

We believe that an optional pilot program is warranted to see if such an 

innovation would achieve its purpose. Rulemaking should be based on solid scientific 

evidence, and a well-designed pilot program would gather the appropriate data for 

sound rulemaking. If it is successful then Congress and SEC can determine what next 

steps should be taken. 

However, the Chamber believes that a provision should be added to provide a 

safe harbor to insulate management and directors from liability in exercising the 

option to choose a tick size. Unfortunately, we have seen all too often that some ""ill 

attempt to use the courts for gain, at the expenses of investors. This is true with nonbinding advisory say on pay executive compensation votes despite the intent of 

Congress that such actions not be subject to lawsuits. A safe harbor would recognize 

that directors and management are exercising their fiduciary duties in the best interest 

of the company and prevent resources from being dissipated at the expense of the 

company and investors. 

Without such a safe harbor, companies may not avail themselves of the 

opportunity to participate in the pilot program and an opening to help smaller public 

companies may be lost. 

e. Amend Certain Securities Laws for Treatment of Emerging Growth 

Companies 

The Chamber supports this discussion draft, offered by Representative Fincher. 

One of the most important contributions of the JOBS Act was that it removed many 

of the practical obstacles to an IPO for Emerging Growth Companies ("EGCs"). 

The draft legislation would build on this. It would enable more EGCs to pursue the 

registration process without incurring the significant costs that can be associated with 

this process. It would facilitate subsequent offerings of securities to the investing 

public. Importandy, it would promote EGC access to dle capital markets without 

denying investors with important real time infonnation on which to base their 

investment decision. 

The Chamber would also recommend that an addition to this discussion draft 

be included to modernize Rule 701. 3 The JOBS Act contains a provision that updated 

3 See June 11,2013 letter from the Chamber to Chairman Scott Garrett and Ranking !llember Carolyn Maloney of the 

Subcommittee on Capital :Markets and Government Sponsored Enterprises 

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12(g) employee registration exemptions that assist privately-held companies that want 

to provide employees with the option of increased employee ownership. To 

compliment these changes to the 12(g) employee registration exemptions, SEC should 

update Rule 701 by raising the $5 million disclosure threshold requirements. 

In 1988, SEC adopted Rule 701, which allows private companies to sell 

securities to employees without incurring the costs of registration for offers and sales 

of securities under certain compensatory benefit plans or written agreements relating 

to compensation. As a result, private companies were able to offer their employees 

the benefits of ownership without undertaking the costly registration process that is 

generally intended to protect publicly-traded securities. Under its current form, Rule 

701 mandates disclosures that treat employee sales above $5 million more like capitalraising than compensation. These disclosures raise the cost of providing these 

securities and require private companies to risk the disclosure of confidential fmancial 

information. Moreover, this now-dated approach is one that does not account for the 

JOBS Act's 12(g) employee exemption or the effects of inflation. 

The Rule 701 threshold should be raised and/or adjusted for inflation and 

updated to reflect the JOBS Act revisions. This adjustment would allow the 

employees working for privately-held businesses ranging from relatively new start-ups 

to mature companies to take full advantage of the JOBS Act 12(g) employee 

shareholder provisions. 

III. Consequences of Inaction and Action 

If these bills are not passed and if the JOBS Act is not fully implemented, 

economic growth and job creation will continue to underperform and stagnate for 

years to come. 

The problem that has existed before, during and after the fmancial crisis is that 

our securities regulations reflect a pre-World War II economy at worst or the 

stagflation economy of the mid-1970's at best. 

In other words our current regulatory apparatus for capital formation is at least 

two to four generations removed from the realities of today's economy and wholly 

unprepared for the competitive demands for the next decade. 

Furthermore, this situation has been exacerbated by the unforeseen 

consequences of the regulatory initiatives undertaken as a result of the Dodd-Frank 

Act, the G-20 and the Basel Capital Accords. 

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Entrepreneurs may need access to credit cards and bank flnancing, small 

businesses access to debt markets, and growing businesses the ability to enter public 

company capital markets. Since 2008, we have seen a greater concentration of our 

banking system that slowly erodes the ability of smaller businesses to access capital, 

and the application of the Basel III capital accords upon smaller and mid-size banks 

has constrained the flow of resources to smaller businesses. 

In effect we are prohibiting the financial sector from taking reasonable risks on 

the risk takers who grow our economy. 

If this situation is to continue, then these bills would allow other entities to fill 

the void, open up our public company markets and give businesses greater flexibility 

to access capital. Passage of these bills would help to meet those demands and allow 

America to compete. 

But let me also state a word of caution. While these bills are a step in the right 

direction, they are only a step. Because of the avalanche of regulations that are not 

geared to investor protection or competition and what SEC Chair White called 

disclosure overload, investors are increasingly turning away from the public company 

as a profltable investment. The bills today are geared towards increasing IPOs and 

early stage financing, but more should also be done to address the precipitous and 

relentless decline of the number of public companies in the United States. The 

Subcommittee's hearing on proxy advisory flrms this past June is one example of 

rebalancing the pendulum. 

The SEC must undertake a review and action to address policies and 

regulations that are obsolete in a 21 st century economy. As we have seen with the 

JOBS Act and with the proposed legislation that is the subject of today's hearing, 

Congress sometimes has to direct SEC to take action that it may not want to do, but 

that it should do. 

We stand ready to work with members of both parties to address these longterm issues and we believe this Subcommittee is the catalyst for such action. 

IV. Conclusion 

The Chamber views these bills, along with our proposed improvements, as 

critical steps to preserve the diverse capital structure our free enterprise system needs 

and to allow for the dynamic changes the market place demands in order to provide 

the life blood necessary for entrepreneurs to start a business and for small and midsize businesses to grow into larger ones. This has been the formula for success that 

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has allowed the United States economy to grow at unprecedented levels throughout 

its history. More importantly, these bills, along with the full implementation of the 

JOBS Act are necessary for American businesses to succeed in an ever increasing 

competitive global economy. 

I am happy to take any questions that you may have at this time. 

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CENTER FOR CAPITAL MARKETS 

OMPETITIVENESS 

Interconnected and Diverse 1\1I~lrkj""t<:: 
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CENTER FOR CAPITAL MARKETS 

COMPETITIVENESS 

Since its inception, the U.S. Chamber's Center for Capital Markets Competitiveness (CCMC) has led a 

bipartisan effort to modernize and strengthen the outmoded regulatory systems that have governed our 

capital markets. Ensuring an effective and robust capital formation system is essential to every business 

from the smallest start-up to the largest enterprise. 
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SUh,~i\AAHY ....................................................................................................................... , ••.••... 2 

!NTPODUCTlON ..................... , ........................... . ............... 4 

.. ................. , .......... 6 

The Conceptual Link Between the Financial System and Economic Growth .. .............................. 6 

The Services the Financial System Provides and How They Help Economic Growth ................. 8 

HI. AN OF ................. 11 

Debt Versus Equity and Use by Consumers and Businesses ........ . . ........................................ 13 

Individual/Consumer Financing ............ 14 

Business Financing: Equity ....... .. .. ..... 15 

Internal Equity Financing ................................................. . .. ......................................... 15 

External Equity Financing .. .. ............ 16 

Intermediated Equity Capital ................. . .. ............. 17 

Business Financing: Debt .............................. . .. ...... 21 

Nonmarket, Intermediated, and Direct Debt.. ......................... . . .................. 21 

Public Debt .. .. ............................................................. 23 

............................ , ...................... , ........ 25 

u·~'''Lu0,L''~ ...................... . ................. 30 
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This paper provides a broad overview of 

the U.S. financial system. It describes the variety 

of financing sources available to both individual 

consumers and businesses, and the considerations 

that lead a consumer or a business to choose a 

specific financing source. It then discusses how 

this variety of financing sources provides benefits 

to the economy. Five main conclusions emerge 

from this analysis. 

sources include family and friends, credit cards, 

home equity loans, and other types of bank loans. 

Consumer credit provided through these diverse 

sources is a large segment of our economy. The 

major providers of consumer credit-commercial 

banks, finance companies, credit unions, the federal 

government, savings institutions, and nonfinancial 

businesses-provided over $2.4 trillion of consumer 

credit as of year-end 2010. The efficient availability 

of this credit is critical in an economy so dependent 

First, a robust, efficient, and diverse on domestic consumption. It is important to note 

financial system facilitates economic growth. that for many smaller businesses, especially startResearch has shown that the !evel of financial devel- ups, these consumer credit products are often the 

opment is a strong predictor of economic growth. only available sources of new or even working capiThis research is based on a study of a large number tal. Entrepreneurs often rely on access to personal 

of countries. Even with the unprecedented economic 

crisis, the growth in the U.S. financial services indus~ 

try has been accompanied by a robust growth in our 

economy, as measured by growth in gross domestic 

product (GDP). The financial system facilitates economic growth by providing four basic services: 

facilitating trade; 

facilitating risk management for various individuals and businesses; 

mobilizing resources; and 

obtaining information, evaluating businesses 

and individuals based on this information, 

and allocating capital. 

It is through the provision of these services that the 

financial system ensures that investment capital is 

channeled most efficiently from the providers of cap~ 

credit, including credit cards and home equity loans, 

to launch their new businesses. 

Third, as businesses grow they can 

access both debt and equity financing, and the 

mix of these two, called the "capital structure" 

decision, is an important choice every business 

makes. Three broad categories of financing sources 

are available to businesses for either debt or equity 

capital. One source of capital involves raising funds 

without using any intermediaries like banks or going 

to the publlc capital market. Included in this category are family and friends, employee ownership, 

retained earnings generated by the operating profits of the business, customers and suppliers, and 

angel investors. A second category is intennediated 

ital to the users of capital, so that both the economy finance that does not involve going to the capital 

and employment grow. market. Included in this are loans from intermediaries like banks and insurance companies, funding by 

Second, in terms of their financing private-equity firms and venture capitalists, small 

choices, individuals are largely limited to debt business investment companies that provide Smallfinancing for raising capital. For individuals, these Business-Administration-sponsored financing, and 
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factoring companies that provide financing against financing would decline as well. Hence, assessing the 

receivables. While all these financing sources are risks associated wah regulatory changes in the finanimportant, venture capital has played an especially cial system is a notoriously difficult task. This often 

vital role in helping launch new businesses: venture leads to unintended consequences when changes are 

capital financing accounts for 21 % of GOP. Many introduced in some part of the financial system. Oisfamous companies like Apple were financed in their turbing examples of this can be found in the impact of 

infancy by venture capital. For more mature busj- the Sarbanes-Oxley Act and the lITigation environment 

ness, bank loans are an essential source of finance. faced by U.S. companies. These changes have conIn 2009, U.S. banks made more than $7 trillion in tributed to a slowdown of the rate at which new public 

loans. The third category of financing available to companies are formed and an increase in the rate at 

businesses is direct capital market access, whereby which existing public companies are leaving the marthe firm uses an investment bank and sells debt ket, leading to a substantial decline in the number of 

or equity claims directly to capital-market inves- publicly listed U.S. companies. 

tors. These include commercial paper, initial public 

offerings (IPOs), bond sales, and secondary equity 

offerings. 

Fourth, a rich diversity of financing 

sources is provided by the U.S. financial system. 

This diversity helps U.S. consumers and businesses 

to better manage their risks and lowers their cost of 

and increased 

A well-developed financial system goes handcapital. Diversity enables consumers and businesses in-hand with robust economic growth and increased 

to effectively match their financing needs to the employment. The better the financial system funcfinancing sources, with each financing source pro- tions, the more new companies are launched, the 

viding a different set of services. Since the needs of larger the number of publicly listed companies, the 

those seeking financing differ, it is beneficial to have better the overall management of risk, the greater the 

specialized financiers catering to different needs. The availability of consumer credit, and the higher aggreresult is better risk management and higher invest- gate investment. 

ment in the economy, leading to an increase in GOP 

and employment. 

Fifth, the U.s. financial system is highly interconnected. What happens to one financing source 

typically affects a host of other financing sources as 

well as those seeking financing. These spillover effects 

cause any change in the part of the system to be 

propagated through the entire system, often in ways 

that are difficult to predict. For example, if our public equity markets were to diminish in the future-say 

due to excessively onerous regUlation-it is very likely 

that the supply of private equity and venture capital 
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I. Introduction 

In the early 19805, the financial services 

industry accounted for about 10% of total corporate profits in the United States. In 2007, it was 40%. 

Some have used statistics like this to argue that financial services are becoming excessively important at 

the expense of other parts of the economy, such as 

manufacturing and services that produce obviously 

tangible economic value. However, nothing could be 

further from the truth. Given the economic crisis we 

have witnessed over the past three years, it is easy to 

forget that growth in financial services over the past 

two decades was also accompanied by some of the 

most spectacular economic growth we have ever witnessed, In the 19805, U.S. gross domestic product 

(GDP). the most commonly used measure of the size 

of the economy, stood at under $3 trillion. In 2007, 

when the share of total corporate profits accounted 

for by financial services was four times as large as 

in the 1980s. it was around $14 trillion. Today the 

U.S. financial services industry employs more than 

5.77 million people, about 6% of total private nonfarm employment, and this number is projected to 

grow to 12% by 2018. The wealth generated by the 

financial services industry contributed nearly 6% 

($828 billion) to U.S. GDP in 2009.' 

In the wake of the recent financial crisis, some 

have argued that the economic growth we witnessed 

was merely an unsustainable bubble, and that when 

the bubble burst, the economy came crashing down. 

While the causes of this crisis are not the topic of 

this paper, it is worth noting that the crisis was a 

consequence of a variety of factors in the United 

States: an excess supply of liquidity due to a global 

1 u.s. Financial Services Industry: Contributing to a More Com· 

petitive U.S. Economy, SIFMA, http://www.ita.doc.gov/td/flnance/ 

publicationslU.S.%20Financial%20Services%20Indushy.pdf, 

(July 2010). 

liquidity-imbalance, an easy-money monetary policy, 

a political desire for widespread home ownership, 

and various developments in the financial sector. 

All of these factors need attention if we are to have 

a well-regulated, transparent, efficient, and robust 

financial system consisting of a diversity of financing sources. Thus, financial reform must go hand 

in hand with a strong financial services sector. The 

recently passed Dodd-Frank Wall Street Reform and 

Consumer Protection Act tackles a variety of financial 

reform issues, but many of the specific regulations 

have yet to be written, so time will tell about how 

effectively the Act will deal with the causes of the 

crisis. Nonetheless, an important point to remember 

is that the data show a strong correlation between 

economic growth and strength of financial services. 

Financial markets and the 

financial service firms that 

in those markets 

individuals and businesses raise 

of various sorts, as 

channel mOlley from savers to 

those with investment ideas. 

It was not a coincidence that the U.S. economy grew so rapidly during a time that financial 

services grew in importance. Financial markets and 

the financial service firms that operate in those markets help individuals and businesses raise capital of 

various sorts, as they channel money from savers to 

those with investment ideas. The more well developed 

the financial system, the better lubricated this channe!, and the lower the transactions costs and other 

impediments to investment and economic growth. 
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Indeed, one of the roadblocks to economic of financing sources available to them, and the 

growth in the former eastern-block Communist coun- financial instruments/contracts that are used to raise 

tries in Europe, such as Romania, has been the lack capitaL Section IV discusses how different parts of 

of developed financial systems. The fact that the U.S the financial system are connected and the role of 

financial system is well developed and innovative has the large diversity of financing sources in making the 

been a big boon to individuals and businesses, as financial system deep and vibrant, and facilitating 

they have been able to access a variety of financing economic growth. 

sources to raise relatively low-cost capital to grow. 

Even within the United States, the number one reason 

When small businesses 

do succeed and create 

and an 

Imvw,,,,]! factor in their success 

is access to the 

needed to 

for the failure of small businesses is lack of access 

to funding. Put differently, when small businesses 

do succeed and create employment and growth, 

an important factor in their success is access to the 

financing needed to support growth. The strength of 

the financial system has also been a significant factor in the creation of prominent new firms that have 

been launched in the past 25 years and have gone on 

to become global powerhouses. Starbucks, Yahoo, 

Google, and eBay are but a few examples. No other 

country in the world can match this, in large part 

because no other country in the world has such a 

deep and vibrant financial system. 

What is the U.S. financial system composed 

of and how does it work? What makes it so deep and 

vibrant? These are the main questions addressed in 

this research paper. Section II discusses the role of 

the financia! system in promoting economic growth. 

Section III provides an overview of the financial system and addresses the question of how the financial 

system functions. The focus is on the types of businesses that are involved in raising capital, the types 
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Role of Financial System Economic Growth 

There is a rich body of research on the role of hand, is patient and would not mind giving her money 

the financial system in promoting economic growth, to someone now in exchange for a larger payment in 

much of it from comparisons of different countries. the future. However, she does not know Peter well and 

For example, in a study of 56 developing countries, is concerned that he might be a crook who will simply 

the level of financial development in 1960 was a abscond with her money if she lends it to him. 

strong predictor of economic growth over the next 

30 years, after controlling for a variety of economic Without a financial system in this community, 

and political factors. 2 This and other studies provide Peter will be limited to planting whatever apple trees 

ample evidence that robust financial development is he can using his own seeds and labor, but without any 

followed by healthy economic growth. This section fertilizer or farm equipment. Suppose he can plant a 

will discuss this research to develop an understand- few trees and harvest 500 apples a year. That then 

lng of what the facts say and why they say what they defines his economic output. 

say. But first, it is useful to understand the basic economics behind how the financial system promotes Now suppose the community's financial syseconomic growth. tern includes a bank and a financial market where 

financial securities are traded. Now Peter can go to 

the bank and request a loan that would be repaid from 

future sales of apples. The bank will conduct a credit 

analysis and determine whether Peter is a good credit 

risk. The bank will also monitor Peter to make sure 

A simple example illustrates this link. Sup- that he is not a crook who absconds with the bank 

pose we have a community in which four people own loan. With the assurances provided, Mary will be willproductive resources: Mary, Peter, Paul, and Sally. lng to deposit her money in the bank. This is better 

Mary has saved some money that she keeps in a for her than keeping the money idle in a safe in her 

safe in her house. Peter owns an orchard and some house and earning zero interest. With the bank loan, 

apple seeds that he can plant to grow trees and har- Peter will buy some fertilizer from Paul and some farm 

vest apples. Paul has a farm on which he naturally equipment from Sally on a cash-on-purchase basis. 

produces fertilizer. Sally owns some farm equipment He can now plant more trees to produce more apples, 

that can be used for tilling the land and digging holes so he ends up with 10,000 apples rather than 500. The 

for planting trees. economic output of this economy has gone up due to 

the financial market. A further increase in economic 

Neither Paul nor Sally is willing to sell any output may arise from the fact that Paul and Sally 

goods or services for the promise of a future return. may use the money Peter pays them to produce more 

They will sell only if they get paid now. But Peter has fertilizer and farm equipment. This output may have 

no money to pay anyone now. Mary, on the other uses in other parts of the economy, leading to further 

increases in economic output, and so on (see figure 1). 

2 See Levine (199S). 
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This simple example illustrates three important ways in which the financial system contributes to 

economic growth: 

it increases trade and the flow of goods and selVices; 

it increases the rate of physical capital accumulation; and 

it increases the efficiency of combining capital and labor in production. 

Figure 1: How the Financial System Promotes Growth 

Peter uses fertilizer and farm equipmen1 to generate greater efficiency 

of labor in production and thereby produces more apples. 
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to move money from one party to the other and often 

across national boundaries. Without these systems, 

companies would be greatly impeded in their ability to do business with each other, and economic 

There are four basic services provided by growth would suffer. 

financial systems that help spur economic growth3 

(see figure 2). The Financial System Facilitates Risk 

Management: Financial systems help individuals 

The Financial System Facilitates Trade: and businesses improve their management of variIn primitive economies, trade was based on barter, ous sorts of risks. This is important for economic 

something that Peter and Paul could not do in our growth because increased risk reduces investment. 

example because Peter had no apples in his inven- In our example, Peter faces some risk when he buys 

tory to trade. The invention of money minimized the fertilizer and farm equipment to increase his apple 

Figure 2: The Basic Services Provided by a Financial System 

need for barter trade, thereby increasing commercial crop. If it does not rain as much as Peter expects, he 

transactions and trade. In modern economies, it is not may have a lean harvest and be unable to fully repay 

enough to have money to facilitate transactions-this his bank loan. This may cause him to lose his farm 

money needs to be moved around. Financial systems, to the bank. Or there may be enough rain, but new 

with the appropriate hubs and spokes for recording apple orchards may spring up in neighboring comand clearing multilateral financial transactions, help munities and the market may be flooded with apples, 

pushing the price of apples well below normal. These 

3 See levine (1996). risks may cause Peter to cut back on how much 
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he invests in buying fertilizer and farm equipment. 

A financial system prices risk and provides mechanisms for pooling, ameliorating, and trading risk. It 

provides producers like Peter a way to manage risks. 

For example, Peter could use the financial system to 

purchase insurance against a low harvest or could 

hedge apple price risk in the futures market. The 

financial system also gives investors like Mary better 

risk management opportunities. For example, Mary 

may be concerned about liquidity risk if she lends 

directly to Peter. Once the money is loaned, Mary 

may be unable to get any of it back until the apples 

are harvested and sold. But what jf a medical emergency arises and Mary needs the money before then? 

With a financial system, Mary would simply withdraw her deposit from the bank when she needs it. 

Thus, a financial system, by facilitating improved risk 

management for both borrowers and savers, spurs 

long-run investments that fuel economic growth. 

A financial by 

borrowers and savers, spurs 

long-run investments that fuel 

economic 

The Financial System Mobilizes Resources: As our 

example shows, without a financial system, Mary's 

savings would have stayed locked up in her safe. It 

took a financial system to mobilize those resources 

and get them to Peter, who could put them to pro-

"We have entirely lost the idea that 

any undertaking likely to pay, and seen to be 

likely, can perish for want of money; yet no 

idea was more familiar to our ancestors, or is 

more common in most counties. A citizen of 

Long in Queen Elizabeth's time ... would have 

thought that it was no use inventing railways 

(if he could have understood what a railway 

meant), for you would not have been able to 

collect the capital with which to make them. 

At this moment, in colonies and in all rude 

countries, there is no large sum of transfer~ 

able money, there is not fund from which you 

can borrow, and out of which you can make 

immense works." 

What Bagehot was referring to was the ability of the financial system to mobilize resources that 

would permit the development of better technologies 

that lead to economic growth. 

The Financial System Obtains and 

Processes Information and Allocates Capital: Individual savers, like Mary, may not have the 

resources or expertise to evaluate firms, projects, 

and managers before deciding whether to invest in 

them. Financial intermediaries, like banks and investment banks, have a cost and expertise advantage in 

collecting and processing such information, and then 

helping the capital-allocation process based on that 

information.s This, in tum, encourages investors to 

supply capital to these intermediaries, which channel 

the capital to businesses that make investments that 

fuel economic growth. 

For example, imagine that someone comes ductive use. Almost 150 years ago, the famous 

economist Walter Bagehot described how the finan- to you and asks for a loan to finance a new restaurant. 

cial system helps to mobilizes resources and spur While you have the money to lend, you are not sure 

this is a good investment for you. But if your friend 

goes to a bank for the loan, the bank can gather the economic growth:4 

4 See 8agehot (1873), reprinted 1962, as noted by Levine (1996). 5 See Greenbaum and Thakor (2007). 
130 


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necessary information about potential future income In summary, the financial system provides 

and the assets purchased with the loan that can four key services - facilitates trade, facilitates risk 

be used as collateral, conduct the necessary credit management, mobilizes resources, and acquires and 

analysis with this information, and decide whether to processes information that helps in the allocation of 

lend and how to structure the loan. Such expertise capital. These key services help to increase the flow 

is part of the bank's business skill set. Knowing that of goods and seNices, increase the rate of physical 

the bank will do this, you may be willing to deposit capital accumulation, and increase the efficiency of 

your money so that the bank can, in turn, use it to combining capital and labor in production. The result 

make loans. is more economic growth. 

In a different context, venture capitalists are 

also information-processing experts. When a venture 

capita! firm like Sequoia Capital evaluates a startup firm, it uses its expertise in assessing the firm's 

growth potential and odds of success on the basis of 

the finn's business pian. It then uses this assessment 

to decide whether to provide financing. Promising 

new ventures that survive this screening are able to 

obtain more financing than they might receive from 

family and friends. 

Figure 3: The U.S. Financial System: Individuals/Consumers 

__ --------- Familyand 

Friends 

Credit Cards 

Bank and Other 

Loans 

Nonbank Loans 
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III. Overview of 

Financial System Works The U.S. financial system is a complex mosaic of institutions, markets, investors (businesses and 

individuals), savers, and financial contracts, all of which are interconnected. Before we can understand the 

role played by each part of the financial system, it is necessary to understand some key distinctions between 

the contracts by which financial capital is raised and the differences between individuals/consumers and 

businesses with respect to how these financing contracts are used. 

Figure 4: The U.S. Financial System: Businesses Raising Equity Financing 

Private and Public 

Placements of Equity 

Family and Friends 

Employee Ownership 

Retained Earnings 

Angel Investors 

Customers and Suppliers 

Corporate Parents 

..- Debt and Equity 

Investors 

Pension Funds, 

_ 1-- Endowments, Insurance 

Companies. Individuals 

and Families 

Private and Government 

Investors Provising 

...- Small-Business 

Administration {SBA}~ 

Sponsored Financing 
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Figure 5: The U.S. Financial System: Businesses Raising Debt Financing 

Depositors (Individuals 

and Businesses) and 

Those Who Buy Bank 

Equity 

Policyholders, 

individuals, and 

Businesses 

Factoring Companies' 

Investors 

- Taxpayers 

Suppliers 

Capital Market Investors 

Providing Commercial 

Paper and Public Bond 

Financing 
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shareholders can be paid. In our example, if Peter 

finances with a bank loan, he must first use all of the 

profit from semng apples to repay the bank, even 

Although a highly developed financial sys- before he pays taxes. Only after he repays the bank 

tem like the United States has a plethora of financial and pays his taxes can he keep what is left over 

contracts, the contracts by which individuals and for himself as the owner of his business. 

businesses raise capital can be divided into two main 

groups: equity and debt. 

With an equity contract, a business wishing 

to raise capital would sell an ownership stake in the 

Consumel's finance 

with debt contracts. 

business to investors, who would provide the exter- Consumers finance primarily with debt con~ 

nal financing the business needs. In the example tracts. Bank loans, home mortgages, and credit card 

discussed earlier, Peter might go to Mary and offer borrowing are all forms of debt contracts. There is 

her a 30% ownership share in his apple business in a good reason why equity is not used in consumer 

order to raise the money to buy fertilizer and farm financing. A loan taken by a consumer is essentially a 

equipment, rather than taking a bank loan. How financial claim by the lender on the borrower's future 

much money Mary would make on her investment labor income. It is relatively easy for the borrower to 

would depend entirely on the profitability of the busi- simply withhold the supply of this labor income-for 

ness. If Mary invested $100,000 for a 30% ownership example, by quitting work-and make the lender's 

share and Peter made a profit of $15,000 in the first claim worthless. A debt contract, with a requireyear after paying off aU his operating expenses, Mary ment to repay by a certain date and penalties for not 

would be entitled to receive 30% of that, which is repaying, provides better incentives for the borrower 

$4,500. If Peter's business made a profit of $50,000, to repay. 

Mary would get $15,000 in the first year alone, and 

if the business made no profit in the first year, Mary Businesses finance with both debt and 

would get nothing in the first year. Each year, Mary equity_ In fact, the mix of debt and equity financing 

would receive 30% of the profits, assuming all profit is an important decision for any business. Equity 

is distributed as dividends. Moreover, Mary's investment has no stated maturity. That means Peter never 

has to return her original investment of $100,000 to 

her as a lump sum. The only way for Mary to recover 

that original investment is to sell her ownership stake 

to someone else. 

With a debt contract-for example, a bank 

loan -the lender is promised a repayment of the 

Businesses finance with 

both debt and In fact, 

is an 

decision for any business. 

ori9inalloan amount plus some interest. A debt claim financing is viable for businesses because the finanhas both a stated maturity and priority over equity. cial system provides corporate governance to keep 

"Stated maturity" means that the lender must be managerial actions roughly aligned with the interests 

fully repaid by a certain date. "Priority over equity" of the financiers of the business. Further, businesses 

means that debt holders must be fully repaid before have powerful incentives to keep producing profits, 
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so they are unlikely to withhold the supply of produc- Of course, once you take the loan, you will be faced 

tive inputs like labor. 

Consumers can tap a variety of sources for 

financing, most of which is in the form of debt (see 

figure 3). 

with additional monthly payments on the loan. 

Before the subprime financial crisis, home 

equity loans were a significant source of finance for 

many consumers. The average U.S. homeowner 

extracted 25-30 cents for every dollar increase in 

home equity during 2002-2006, and home-equitybased borrowing was equal to 2.8% of GOP every 

Friends and family provide a potentially year from 2002 to 2006.6 

significant source of capital. Often these loans have 

vaguely defined maturity with specific purposes, for 

example, a student loan that will be repaid sometime 

after graduation or a car loan. Many people rely on 

this form of financing in emergencies or for purposes 

for which bank loans are difficult to get. 

Credit card financing is unsecured debt, 

which means there is no specific collateral backing the loan. Since it is largely used as a means of 

transaction financing, the issuer expects to be repaid 

Bank and other loans represent a significant 

portion of the financing available to individuals. These 

loans include borrowing from commercial banks, 

finance companies (e.g., car loans), credit unions, the 

federal government, and so on. The amount of this 

borrowing is huge. As of year-end 2010, consumer 

credit outstanding was $2.41 trillion, having grown at 

an annual rate of 2.5% in the fourth quarter of 2010 

(see table 1). 

from the borrower's income within a relatively short 

time. Interest rates and late-payment fees tend to Nonbank loans are provided by a wide array 

of lenders. Perhaps the biggest nonbank financial 

be high to encourage prompt payment. The viabil- intermediary is the U.S. government. From Fannie 

ity of credit card financing rests on a well-developed 

financial system with a high leve! of trust and a deep Mae and Freddie Mac to Sally Mae (the Student Loan 

Marketing Association), the amount of credit provision that involves the U.S. government dwarfs that 

by any bank. 

financial market in which banks can raise financing by securitizing their credit card receivables and 

selling the claims to investors. The volume of credit 

card finance, and hence the enormous paymenttransactions convenience afforded to consumers, 

both decline exponentially as one moves fram welldeveloped financial systems (like the United States) 

to less-developed financial systems. 

Various other lenders also exist on the 

"periphery" of the financial services industry and 

serve as "bankers" to the poor and the excluded. 

Pawnbrokers are one such group of lenders. Pawnbraking is a form of asset-backed (secured) lending. 

Home equity loans are a convenient way for The lender makes a loan that typically is small, 

say $50-$100, for a few weeks or months, and is consumers to borrow against the price appreciation 

in their homes. For example, say you need $75,000. secured with merchandise (e.g., jewelry, electronics) 

Your home is worth $300,000 and you owe the that has a resale value roughly twice the debt. Interbank $200,000. Then your home equity is $100,000 est rates tend to be high, roughly 25-30% per month 

($300,000 minus $200,000), and you can borrow in some states. Default rates range between 10% 

the $75,000 you need against the home equity. 5 See Mian and Sufi (2010). 
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Table 1: Consumer Credit 

Source: Federal Reserve Statistical Release, February 7,2011. 

and 30%. In 2004, there were 15,000 pawnbrokers remain with the borrower while the loan is outstandin the United States.7 lng and repossess it only upon default. 

Payday lenders represent another source Attention will be turned next to business 

of nonbank credit. They provide unsecured, short- financing. While for purposes of discussion, it is useterm loans to customers. The loan arises in one of ful to create a clean separation between consumer 

two ways. The first is a "traditional" payday loan, in and business financing, in practice this dividing line 

which the borrower writes a post-dated (or undated) is often fuzzy. In particular, many individuals will use 

personal check to the lender, and the lender makes their access to consumer financing to raise the money 

a loan equal to the check amount minus a finance they need to invest in their businesses. For example, 

charge. The lender usually deposits the check and someone may charge a business purchase to a pergets paid the day the borrower receives his pay. The sonal credit card or use a home equity loan to make 

second involves the lender directly debiting the bor- the investment needed to expand the business. 

rower's bank checking account on a future date for 

the amount of the loan plus the finance charge. The 

typical loan has a two-week maturity. Payday lending 

is legal and regulated in many states, but is illegal or 

infeasible given the law in some states. 

Title lenders are similar to payday lenders, 

the difference being that title lenders make secured 

loans rather than unsecured loans. That is, the title 

holder (lender) holds collateral against the loan. Car 

title loans are quite common, and in this case the 

lender holds the title to the borrower's car until the 

Businesses can raise equity financing from a 

richly diverse set of sources (see figure 4). 

Internal Equity Financing 

Family and friends represent an important 

financing source for start-up businesses. The typical family or friend investor is someone who has 

been successful in his own business and wishes to 

invest both to help a family member or friend andlor 

loan is repaid. Title lending is an extension of pawn- because someone had made a similar investment in 

broking. A key difference is that while a pawnbroker his business when it was a start-up. For example, a 

keeps possession of the collateral during the term of health care private equity firm was launched about 

the loan, the title lender may permit the collateral to 10 years ago in St. Louis, MO, with financing provided 

7 See Greenbaum and Thakor (20D?). 

entirely by family and friends because the founders 

discovered that no Wall Street firm was willing to 
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provide start-up financing to a group of individuals growth prospects and some synergies with their 

who had operating experience in the industry but no own businesses, and operate in an industry that the 

private-equity experience. Similarly, Facebook was individuals have successfully worked in or are bulllaunched from a Harvard dorm room and eventually ish about. Angel financing is quite often tapped by 

expanded with family and friends financing. Typically, early-stage companies that have yet to establish 

family and friends will invest up to $100,000 each. a track record of revenues or earnings that would 

enable them to obtain institutional financing from 

Employee ownership is another way in venture capital firms or banks. In our apple-orchard 

which firms can raise equity financing. Employee example, if Peter cannot get a bank loan to buy ferstock ownership plans (ESOPs) give employees the tmzer and farm equipment, he might seek out angel 

opportunity to become shareholders in the company. investors (typically investors who, unlike Mary, know 

As shareholders, employees can experience increased him and something about his business) to provide 

pride and security, and may become more productive. the financing in exchange for an (equity) ownership 

Employees can participate via stock purchases, by stake in the business. 

receiving a portion of their compensation as stock 

rather than cash, and sometimes by providing personal assets to the business. There are more than 

11,500 ESOPs in place in the United States, covering 10 million employees (10% of the private-sector 

workforce). The total assets owned by U.S. ESOPs 

were estimated at $901 billion at end of 2007.8 

Retained earnings represent a vital source 

of internal equity financing for businesses. When a 

firm makes a profit at the end of a year after settling 

all its expenses, paying creditors, and paying taxes, it 

will typically payout a portion of the profits as a diviestablish a track record of 

revenues or that 

would enable them to obtain 

institutional fl'Om 

venture firms or banks. 

dend to its shareholders. The amount remaining after Angel financing is often quite expensive. 

the dividend payment is called reta;ned eam;ngs, and Capital from angel investors can cost the entrepreit augments the firm's equity. Retained earnings may neur anywhere from 10% to 50% of the ownership 

be viewed as a "sacrifice" made by the shareholders in the business. In addition, many angel investors 

in the sense that they forgo some dividends in order charge a monthly management fee. 

to build up the firm's equity, Companies generally 

retain 30% to 80% of their after-tax profit every year. 

External Equity Financing 

Angel financing involves raising equity 

capital from individual investors, known as "angels." 

These individuals look for companies that have high 

8 The ESOP Association Industry Statistics, http://www,esopassociation.org/mediaJmedia .. statistics.asp {March 2011). 

Businesses can sometimes raise equity 

financing from customers~ suppliers~ and sales 

representatives. These parties may be motivated to 

provide financing because they believe that the business has growth potentia! that may not be realized 

without the financial support provided by the equity 

input, and also that the equity position may become 

a profitable investment down the road. For example, 

Growth 
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IBM once invested enough in Intel to own 20% of 

Intel's equity. It made this investment to financially 

boost Intel, a key supplier whose microprocessors 

were used in all IBM personal computers. 

Corporate parents represent another significant financing source for some institutions. A 

holding company may provide its subsidiary with 

capital rather than incurring the cost of raising exter- professionals serve as general partners, and invesnat capital. For example, when ABN-Amro, the Dutch tors serve as passive limited partners and provide 

banking giant, acquired LaSalle Bank in Chicago in the capita!. The PE firm usually collects a manage~ 

1979, it infused $300 million of capital into its newly ment fee of 2% or less plus 20% of the capital gain 

acquired subsidiary. 

Intermediated Equity Capital 

Thus far we have discussed non jntermefrom the investment. Many PE firms deliver attractive 

returns to their investors, net of these charges. 

The largest PE firm in the world is Kohlberg 

Kravis Roberts & Co. (KKR), which had more than 

diated sources of equity capital, in which the user $230 billion in completed and pending acquisiobtains capital directly from the investors (who represent the sources of capital). Other forms of equity tions during 2005-2010. Other big PE firms include 

capital involve financial intermediaries that help to the Blackstone Group LP, Carlyle Group, Cerberus, 

Clayton Dubilier and Rice, Goldman Sachs Capital link the sources and users of capital. Partners, Bain Capital, TPG Capital, and Permira. 

The first of these is private equity. The term While these are the largest PE firms, they represent 

a mere fraction of the total number of PE firms in private equity (PE) is used to refer to a firm whose the business. There are more than 2,500 PE firms equity is not publicly traded on a stock exchange or 

capital that is not quoted on a public exchange. PE worldwide, and they raise many billions of dollars in 

capital every year. In 2006, PE firms bought 654 U.S. 

firms specialize in buying firms, some of which may companies for $375 billion, and U.S.-based PE firms 

be publicly owned, and holding them as part of a raised $215.4 billion in investor commitments.9 

portfolio of privately-owned firms. After they improve 

the management of these firms, the PE firms either 

sell them to other firms or take them publlc through a PE firms use a variety of strategies to acquire 

sale of stock in the market. For example, the Black- firms: leveraged buyouts (LBO), growth capital, distressed investments, mezzanine capital, and venture stone Group's PE unit recently acquired theme park 

operator Busch Entertainment Corp. (previously capital. In a typical LBO deal, the PE firm acquires 

owned by the Anheuser-Busch Corp.) and renamed majority control of an existing or mature firm and 

it SeaWorld Parks & Entertainment. Blackstone also finances the acquisition with a relatively high amount 

acquired frozen-foods maker Birds Eye Foods in a of debt. The assets of the acquired firm serve as collateral for the debt used by the PE firms to acquire it. PE transaction. 

PE firms are typically organized as limited 

partnerships to hold investments in which investment 

9 Robert J. Samuelson, The Private Equity 800m, Washington Post, 

http://www.washingtonpost.comlwp·dyn/contentlarticle/2007/03/14I 

AA2007031402177.h!ml(March 17,2007). 
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Over time, the cash flows generated by the acquired the successful launch of so many new companies in 

firm help to payoff the debt used for the acquisition. the United States. Numerous famous firms, such as 

Apple, Google, and Microsoft, were launched with 

Venture capital will be discussed shortly as the help of VC financing. 

a distinct source of equity capital because there are 

also specialized venture capitalists that do not do VC-backed companies account for 21 % of 

private equity deals. Growth capital refers to equity U.S. GDP and thus playa vita! role in job creation 

investments, quite frequently minority investments, in our knowledge economy. Two million new busimade by PE firms in mature companies that are nesses are created every year in the United States, 

seeking capital to expand or restructure operations of which about 600 to 800 get VC funding. 10 

or fund some other major investment. By obtaining 

this capital from a PE firm, the firm that acquires 

the capital avoids the dilution in the capita! market 

that would occur if it were to issue equity. There 

is ownership dilution with a PE firm as well, but 

the minority ownership of the PE firm represents a 

(monolithic) block ownership as opposed to a more 

diffused dilution in the capital market. 

Distressed investments are investments 

(either debt or equity) that PE firms undertake in 

financially distressed companies. Occasionally, PE 

firms will take more senior positions than equity in 

either distressed or healthy firms. These may be subordinated debt or preferred stock (which has seniority 

over common equity but is junior to debt). The objecVC financing is provided by both government-sponsored and private entities. In fact, an initial 

step in the development of this industry was the passage of the Smaff Business Investment Act of 1958, 

which allowed the SBA to license private "Small Business Investment Companies" (SBICs) to help fill the 

gap between the availability of VC and the needs of 

small businesses in start-up and growth situations. 

The structure of the program is unique in that SBles 

are privately owned and managed investment funds, 

licensed and regulated by SBA, that use their own 

capital plus funds borrowed at favorable rates with 

an SBA guarantee to make equity and debt investments in qualifying small businesses. 

tive in taking such positions would be to reduce the There is also a SUbstantial institutional VC 

PE firm's risk exposure. industry in the United States. These privately owned 

financial intermediaries typically invest in high-growth 

Mezzanine capital refers to a subordinated companies that are capable of reaching sales of at 

debt or preferred equity claim on the firm's assets least $25 million in five years. According to recent 

that is senior to the firm's common equity, but junior estimates based on surveys from the National Vento other claims. Such capital has a lower return but ture Capital Association, U.S. venture capital firms 

less risk for the PE firm providing the financing. invest between $5 billion and $10 billion per year. 

Since 1970, VC firms have reportedly invested in 

Venture capital (Ve) is an enormously more than 27,000 start-ups to the tune of $456 bilimportant source of finance for start-up companies. lion. Some of the major VC firms include Sequoia 

The fact that the United States has the most well- Capital, Benchmark Capital, Mitsubishi UFJ Capital, 

developed VC market in the world - with Silicon and Kleiner, Perkins, Caufield & Byers. 

Valley setting the "gold standard" for a VC community-has often been singled out as a key reason for 
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VC firms raise their own financing from inves- even public firms take advantage of private placetors (sources of capital). These include pension funds ment, because it helps to raise equity capital without 

(42% of funds), insurance companies (25% of funds), additional information disclosure of the kind required 

endowments (21 % of funds), individuals and families for a public offering. This can be beneficial for firms 

(10% of funds), and others (2% of funds). VC firms that wish to protect the confidentiality of product 

typically stay invested in their portfolio companies for information or technology. 

five to eight years before selling them off. 

Facebook is a good example of how private 

Investment banks a!so act as intermediaries placement of equity can help a firm raise financthat help businesses raise capital from a variety of ing for growth. A relatively new company that is at 

sources. An investment bank is a financial institution the vanguard of the social-network phenomenon, 

that assists individuals, corporations, and govern- Facebook's initial equity funding came from privatements in raising capital by underwriting andlor acting equity placements with Peter Theil (co-founder of 

as the client's agent in the issuance of securities. An PayPal), Acce! Partners, and Greylock Partners. The 

investment bank may also help companies involved in first round of private-equity investment in Facebook 

mergers and acquisitions by providing a host of ser- came in September 2004 when Peter Thiel invested 

vices, such as market making, trading of derivatives, $500,000 (valuing the company at $5 million). Since 

bonds, equity, foreign exchange, and commodities. then, PE firms have continued to invest in Facebook. In early 2011, a fund organized by Goldman 

Unlike commercial banks, investment banks Sachs invested more than $1 billion in Facebook. 

do not finance themselves with deposits, although General Atlantic recently agreed to purchase 0.1 % 

most major Wall Street investment banks have of Facebook from its employees at a price that valbecome parts of Bank Holding Companies since ues Facebook at $65 billion. 

the subprime financial crisis. Investment banks 

may have VC subsidiaries that provide VC financing In terms of public offerings of equity. investto businesses. ment banks help to take private firms public through 

initial public offerings (IPOs) of stock. An IPO 

Investment banks also help businesses with involves the sale of common stock to the public for 

private placements of equity, whereby new equity the first time. Through the IPO, part of the ownership 

capital can be raised without having to issue equity of the company transfers from the entrepreneur(s) 

on the public stock exchanges. A firm that wishes who launched the company to capital-market investo raise equity hires an investment bank to locate tors. In exchange, the firm is able to raise hard cash 

institutional and individual investors who wish to as it sells its shares to investors. The firm will typiinvest in the company. These investors purchase the cally hire an investment bank to help with the IPO. 

equity being offered for sale in privately arranged Among the many services the investment bank protransactions. For a private firm, the benefit of this is vides are the pricing of the IPO, the "road shows" 

obvious-because it is not publicly listed, a private during which the company is publicized to potential 

placement allows it to raise equity capital beyond investors prior to the IPO, and the actual underwhat is available from retained earnings. The addi- writing of the equity issue. The investment bank 

tional capital can help to finance expansion, business receives a percentage of the proceeds of the IPO as 

growth, and additional employment. But sometimes compensation for its services. 
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A number of large IPOs have been in the 

news. AT&T Wireless did a $10.6 billion IPO in 2000, 

and in 2010 General Motors re-emerged from post 

bankruptcy privatization with a $23.1 billion IPO. We 

all remember Go09le's IPO in 2004, which turned 

its 1,000 employees (who were shareholders) into 

instant millionaires, and its founders, Sergey Brin and 

Larry Page, into billionaires. Moreover, with its publicly traded stock from the IPO serving as currency, 

Google was able to acquire video-sharing service 

YouTube in 2006 for $1.6 billion. 

from a short rebound of 

a couple of years before tile 

IPO volume ilas 

since 2004. 

equity capital after they have already gone public. 

Companies rely on these secondary equity offerings (SEOs) when they need equity capital beyond 

what is provided by retained earnings. For example, 

Figure 6: The Decline in Publicly Listed U.S. Companies 

9000 

8000 

7000 

6000 

5000 

4000 

3000 

2000 

1000 

0~~1=~~1~-1~9~~.,-J~19~g5-J~19~W~~19~9~9~~2~OO~'~~2~OCC=-~2JOO~5-L-2J.OO-7-L~200~9 

Source: Letter by James Angel, dated January 14, 2011, to the Securities and Exchange Commission. 

Apart from a short rebound of a couple of in 2009 many U.S. banks made secondary equity 

years before the subprime crisis, IPQ volume has offerings to raise equity capital to satisfy regulabeen declining since 2004. There was also a decline tory capital requirements, because their equity was 

prior to 2004, in part due to the more stringent and depleted during the crisis. 

costly corporate governance stipulation contained in 

the Sarbanes-Oxley Act. IPOs are one of many indi- IPOs and SEOs allow publicly traded compacators of the competitiveness of U.S. capital markets. nies to raise capital, grow, and increase employment. 

The number of publicly traded companies and the 

In addition to IPOs, investment banks also amount of capital that they raise are both good indihelp publicly traded companies raise additional cators of the health of the economy and the prospects 
141 


86681.096

for future employment. From this standpoint, recent the cash-on-hand that is needed to pay suppliers, 

developments in U.S. capital markets cause con- support inventories, and pay other daily bills. Intercern. The number of domestic U.S. companies listed mediate-term and long-term debt-financing take 

on our exchanges has been declining for the past 15 the form of bank-term loans. These are the stanyears or so, At the end of 1997, about 8,000 domes- dard commercia! loans with fixed interest rates, set 

tic companies were listed on the New York Stock maturity dates, and monthly or quarterly repayment 

Exchange (NYSE), American Exchange (AM EX), and schedules. 

NASDAQ, This number had dropped to fewer than 

5,000 by the end of 2009, and there are now fewer Intermediate-term loans usually have a 

than 4,000 companies in the Wilshire 5000 index of maturity of three years or less. They are generally 

U.S. public companies (see figure 6).11 This decline, repaid in monthly installments (in some cases with 

combined with the sputtering volume of U.S. IPOs, balloon payments) from the cash flows generated by 

suggests that we are creating new public companies the sale of goods and services and the collection of 

at a slower rate than before and that existing public cash. In our apple orchard example, Peter would pay 

companies are vanishing at a higher rate than new off an intermedfate~term loan by selling apples and 

public companies are being created. Although many collecting cash from his customers. 

factors are contributing to this decline, the litigation 

environment and regulatory and compliance burdens A long-term loan typically has a maturity of 

faced by U.S. companies, as well as the passage of between three and ten years. These loans are secured 

Sarbanes-Oxley Act, are significant issues. (collateralized) by some assets in the business. OperNonmarket, Intermediated, and Direct Debt 

ating cash flows are still relied on for making either 

monthly or quarterly repayments. 

In 2009, U.S. banks made more than $7 tril~ 

Businesses raise large amounts of financing lion of commercia! and industrial, real estate, and 

from debt from a variety of sources. Commercial consumer loans, as weI! as other loans and leases. 

banks are traditionally an important source of debt 

financing. For example, Avalon, an aircraft leasing (see figure 7). This is a very important source of debt 

group, announced in January 2011 that it had raised financing for businesses. 

$2.5 billion in debt since May 2010, the latest coming in the form of $465 million debt raised from a 

consortium of three leading U,S. banks: Wells Fargo 

Securities, Cltl, and Morgan Stanley. Businesses use 

banks to obtain short-term, intermediate-term, and 

long-term debt financing, 

Short-term bank financing (typically with 

loan maturities under one year) is used by businesses to finance working capital needs, that is, 

In addition to making loans, banks also make 

loan commitments to businesses. In a bank loan 

commitment, a bank promises to lend the borrower 

up to a predetermined amount at a contractually 

determined interest rate in the future. Typically, commitments are provided for specific uses, such as 

meeting working capital financing needs or financing an acquisition. As of March 2001, outstanding 

(unused) bank loan commitments to U.S. corporations stood at $1.6 tnmon, so this is a large source 

of financing. 
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86681.097

Insurance 

loans because 

are interested in 

need to balance the risk of their 

nUk"nUv0, like life insurance tJv,,'-"'~'-', 

Institutional/enders, such as commercial- long-term investments in manufacturing plants (such 

finance companies like GE Capital and insurance as Ford or Caterpillar), networks {such as AT&n, and 

companies, have been a major source of long-term so on. These investments produce cash flows over 

debt financing for U.S. businesses. Institutional lend- a long time horizon. The risks in these investments 

ers make loans that may be more than 10 years in are best managed by financing them with relatively 

maturity and thus fill a need at the longer end of the long-maturity liabilities, such as loans from insurance 

debt maturity spectrum (term loans are typically less companies. Absent such loans, the management of 

than 10 years in maturity). Insurance companies are risks inherent in long-term investments would not be 

interested in making long-maturity loans because as efficient. 

they need to balance the risk of their long-maturity 

liabilities, like life insurance policies. By making such The factoring of accounts receivables is 

long-term loans available to companies, insurance another source of debt financing that is available 

companies help their borrowers improve their risk to businesses. Every business that sells to custommanagement. For example. many companies make ers on credit-the customer purchases the good or 

Figure 7: U.S. Aggregate Lending: Commercial Banks (Seasonally Adjusted) 
143 


86681.098

selVice but pays at a later date-generates "accounts Public Debt 

receivables" when it makes sales. In our apple orchard Thus far we have discussed nonmarket, interexample, Peter might sell $1,000 of his apples to the mediated, and direct (non intermediated) forms of 

school in his town but the school may not pay Peter debt. Companies that have publicly traded debt can 

until three weeks later. Peter would then record $1,000 

as a sale on his income statement and $1,000 as an 

account receivable on the asset side of his balance 

sheet. The problem with accounts receivables is that 

even though a sale has been recorded, there is no cash 

coming in at that time. Sometimes, a company wi!! 

"factor" its receivables. Specialized factoring companies will provide cash to the manufacturer against that 

manufacturer's accounts receivables, with a reselVe 

payment set aside, that is, the factoring companies 

purchase the receivables. After the manufacturer's 

customers have paid, the factor pays the manufacturer the balance minus an amount representing the 

factor's discount and interest on the funds originally 

paid to the manufacturer. 

also directly access the capital market for borrowing 

by issuing public debt with the help of investment 

banks. Two main forms of public debt are available 

to U.S. firms: commercial paper and long-term debt. 

that have 

traded debt can also 

for 

market 

debt with the 

investment banks. 

Commercial paper is usually short-maturity 

(less than one year) unsecured debt financing that 

Accounts payable is a similar source of is available only to the highest-credit-quality firms, 

financing provided by the firm's suppliers. Most firms It is typically used for financing accounts receivable 

do not pay their suppliers as soon as they receive the and inventory. This is a huge market, with almost $1 

goods. It is fairly common practice for firms to pay trillion in outstanding commercial paper predicted 

their suppliers within 30 days of receipt of the goods for 2011. At the end of 2009, there were more than 

(e,g., Dell has followed this practice), but some com- 1,700 commercial paper issuers in the United States. 

panies take even longer, For example, AB-Inbev, the Commercial paper is available in a variety of denomibeer company, has a gO-day payment policy for its nations and usually ranges in maturity from 2 to 270 

suppliers, Whenever a company purchases some- days. It is relatively low-cost (currently, commerthing but does not pay for it right away, it records the cia! paper rates are less than 0.5% per annum) and 

purchase as an expense on its income statement and hence attractive to companies that can access the 

the amount yet to be paid as a liability, called accounts commercia! paper market. For these companies, it is 

payable, on its balance sheet This liability is essen- often an alternative to a short -term bank loan. Howtial1ya form of short-term debt. ever, it is also risky because its availability and cost 

The U.S. Small Business Administration 

(SBA) provides another source of debt financing. The 

SBA offers long-term financing for purchasing fixed bond fund, said that General 

assets. Typically these loans require a personal guarantee from any investor with a stake in the business 

exceeding 5%. foreseeable future." GE's stock price fell 
144 


86681.099

the announcement.12 More recently, when the credit In both cases, commercia! paper as well as 

market experienced stress during the subprime cri- long-term debt, investment banks help firms with the 

sis, the commercial paper market was one of the first process of issuing debt to capital market investors. 

to dry up. 

Commercial paper is usually a very safe 

investment because the issuer's financial condition 

can be reliably predicted over a short time horizon 

and because only companies with relatively high credit 

ratings issue commercial paper. The typical denomination for a commercial paper issue is $100,000 or more, 

which makes direct investment in commercial paper 

difficult for retail investors. To deal with this, money 

market mutual funds have emerged that invest in commercial paper, allowing investors to invest indirectly by 

purchasing shares in the mutual fund. 

Long-term debt involves bond issues with 

maturities exceeding one year. While commercial 

paper is typically used to satisfy short-term liquidity 

needs of the firm (e.g., financing inventories), longterm debt is used to finance the purchase of fixed 

assets like machines or acquisitions of other companies. Companies rely on long-term bond financing 

for a variety of uses and typically pay higher interest rates than on commercial paper. For example. 

McKesson, the biggest U.S. drug distributor, issued 

$1.7 billion of 5-year, 1 D-year and 3D-year bonds. as 

reported in its February 23, 2011, filing with the SEC. 

Tracking the upward-sloping yield curve, the interest 

rates were 3.25% on the 5-year bonds, 4.75% on the 

10-year bonds, and 6% on the 3D-year bonds.13 As 

of 2007, the amount of U.S. corporate bonds outstanding exceeded $5 trillion. 

12 CNNMoney. "GE Drops on Gross Comments", http://money. 

cnn.com/2002/03/21/News/companies/ge/indexllndex.htm 

(March 21, 2002). 

13 McKesson Corp. Form 8-k, EdgarOnline, http://yahoo.brand. 

edgar-online.com/displayfilinginfoaspx?FilingID= 7757832-4769-

12827 &typeoosect&dcn",OOO0950123-11-019414. 
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86681.100

IV. The Interconnectedness 

Financial System 

Two important messages emerge from the 

description of the financial system. One is that there 

is a great diversity of financing sources available to 

individuals and businesses seeking financing. And 

the other is that the different components of the 

financial system are interconnected. 

Why do we need such a diverse set of financing sources? The simple reason is that the greater 

the diversity, the more effectively the financial system 

can meet the needs of individuals and businesses. 

For example, suppose that the only mortgages available were 30-year fixed rate mortgages. These might 

meet the needs of individuals who wish to lock in an 

interest rate for a long period of time. But what about 

the person who believes interest rates might fall in the 

future or whose financial condition is likely to improve 

over time so he would be able to afford higher interest rates in the future? Such a person would prefer 

a variable or adjustable rate mortgage, in which the 

interest rate fluctuates with market rates, or one that 

that has a lower initial rate and a higher subsequent 

rate. A greater variety of mortgages accommodates 

a greater variety of individual preferences and needs. 

Why do we need such a 

diverse set of hnc)n",nn 

the Illore the financial 

can Illeet the needs of 

individuals and businesses. 

The reason that firms such as Microsoft and Merck, 

which have intellectual property to protect, tend to 

use relatively low amounts of debt is that an increase 

in debt financing brings with it a higher likelihood that 

the firm will be unable to meet its repayment obligation or violate certain debt covenants. For example, 

as we saw in the subprime crisis, homeowners who 

defaulted on their mortgages were those who had 

higher loan-to-value ratios than others, because 

higher indebtedness meant larger monthly mortgage payments and hence a lower ability to make 

the payments when faced with a decline in income. 

The same is true for companies. When there is a covenant violation or default on a repayment obligation, 

Like individuals, businesses have a diverse the firm may be forced to either sell assets (some 

set of needs, Some face a great deal of uncertainty which may have valuable intellectual property) or 

in their core business model and prefer to finance declare bankruptcy (in which case ownership of the 

largely with equity in order to limit the bankruptcy intellectual property might transfer to the creditors). 

risk associated with debt. Other firms invest heavily in R&D and have substantial intellectual property Even within the spectrum of a specific form of 

that they wish to protect. Such firms will also tend to financing like equity or debt, diversity plays an imporfinance primarily with equity to minimize bankruptcy tant role. Consider equity first. Some firms prefer to 

risk. Microsoft is one example. Other examples are finance primarily through retained earnings because 

drug companies such as Merck that invest heavily in it is important for them to avoid the ownership diluR&D. These firms tend to have low debt/equity ratios tion associated with issuing equity. Yet others, 

in their financing mix. 
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86681.101

find that relying solely on internally generated equity These employees understand that if they work hard 

is not enough to support their growth. Such firms and provide the best customer service, Starbucks' 

will wish to use external equity financing. And in this stock price will go up. Such employee stock ownerrespect, the more diverse the sources of external ship is valued more by employees when they can sell 

equity finance, the better. For example, a firm may be their stock in a liquid public market than when it is 

seeking equity to help finance its growth in a market privately held. 

in which it is selling a product for which it has developed a proprietary technology_ Such a firm may not Diversity of financing sources is also 

wish to issue equity in the public market because it important for businesses seeking debt financing. 

would have to disclose sensitive information about Sometimes firms have short-term borrowing needs. 

its technology, due to the information disclosure They would tend to satisfy these needs through 

requirements of the securities exchange. While the accounts payable financing, accounts receivable facinformation is disclosed primarily for investors, it is toring, or bank loan commitments. Larger firms with 

also necessarily revealed to competitors at the same impeccable credit ratings may choose to augment 

time. To avoid this, the firm may wish to use a private these short-term financing sources with commercial 

placement of equity to raise external equity capital. paper financing. The availability of diverse short-term 

If the private placement option were not available, financing sources permits firms to match quite prethe firm might prefer to forgo issuing equity and cisely their speclfic needs to the financing source. 

expanding in order to protect the confidentiality The result is that more short-term financing needs 

of its proprietary technology. It is easy to think of are met than would be possible with fewer financing 

examples. Facebook raised private equity at a time sources. Consequently, firms invest more. 

when it would have found it difficult to raise public equity. Similarly, Intel raised private equity from At other times, firms have longer-term debt 

IBM, a customer, rather than issuing public equity. financing needs. A firm may be investing in a new facAlthough IBM has divested most of its holdings in tory that has an anticipated economic life of 20 years. 

Intel, at one time it owned 20% of the company. For such a Iong-tenn investment, it will seek a long-term 

loan. If only short-term debt financing were available, 

By contrast, other firms might be more lnter- the firm might pass up the investment opportunity. 

ested in a public sale of equity-either through an 

IPQ or an SEQ-because publicly traded equity Firms sometimes finance acquisitions with 

provides greater liquidity and typically has a lower debt. For example, InBev's purchase of Anheuser 

cost of capital associated with it than private equity. Busch, the largest U.S. beer manufacturer, was 

Moreover, public equity also helps with employee financed predominantly with debt. In such cases, the 

motivation and retention. For example, having pub- firm may wish to match the maturity structure of its 

!icly traded equity allows companies like Microsoft debt with the pattern of cash flows it anticipates genand Starbucks to compensate their employees with erating after the acquisition. This, too, typically calls 

shares of stock. When Microsoft's stock price was for long-term debt financing. 

rising rapidly in the 1990s, this was very attractive to 

its employees and it allowed Microsoft to attract and A diverse set of financing sources also 

retain high-quality talent. Starbucks takes stock own- enables firms to strike the appropriate balance 

ership right down to the employees in its retail stores. between the cost of debt financing and liquidity 
147 


86681.102

A diverse set of 

sources also enables firms to 

strike tile balance 

between the cost of debt 

f;n'onr';nr. and risk. 

they will eventually exit by taking these firms public 

and selling off their ownership shares. If our public 

equity markets were to diminish in the future, perhaps because of excessively onerous regulation, it 

is very likely that the supply of PE and VC financing would decline as well. Without the attractive 

"exit option" provided by the public equity market, 

PE and VC firms would view their investments as 

risk. Since long-term debt financing is usually more lacking the potential to be "liquefied" in the future 

expensive than short-term debt financing, pure cost via an IPO, and would therefore scale back on their 

considerations would push the firm in the direction investments. Clearly, some capita! market regulation 

of short-term debt Hke commercial paper or a short- is necessary to ensure transparency and integrity, 

term bank loan. But short-maturity debt also exposes and this improves the efficiency and attractiveness 

the firm to liquidity risk because It may not be able to of the market But when it becomes excessive, it can 

roll over its short-term debt. A recent example of this drive firms away. Thus, more onerous capital market 

is Bear Stearns, the investment bank. It was financing regulation might reduce investment in small and miditself with debt of one-month maturity that was rolled sized companies and lower aggregate employment. 

over every 30 days, When concerns about its hedgefund losses became sufficiently grave, this 3D-day Similarly, good public equity and debt mardebt financing evaporated, and the bank was on the kets allow banks to raise debt and equity capital to 

brink of insolvency before its government-assisted support their own growth. This, in turn, enables banks 

takeover by JPMorgan Chase. Firms are constantly to extend loans that support the financing needs and 

trying to balance the cost of borrowing against liquid- growth plans of individuals and businesses. If burity risk, and a diverse set of financing sources helps densome new regulatory requirements made bank 

them to achieve the right balance, capital more expensive, bank lending would decline. 

The consequence would be lower GDP growth and 

A greater diversity of financing sources employment. 

helps individuals and businesses to: 

Indeed, given the interdependence between 

improve their management of risk and achieve banks, markets, and among the different compo~ 

a better balance between the cost of financing nents of the market, if one financing source were to 

and risk; and disappear, it would have potentially devastating conincrease investments, and thus employment sequences for other parts of the fInancial system. 14 

in the economy. This can be seen most vividly in emerging markets. 

When Romania converted from a centrally planned, 

It is useful to note that the different parts of Communist-run economy to a free-market economy, 

the financial system are intimately interconnected, the housing market was underdeveloped. It was 

For example, venture capital and private equity are difficult to jump-start this market even in the new 

available in part because we have such deep and free-market economy because banks were reluctant 

relatively efficient capital markets. PE and VC firms to lend to consumers to buy houses, This reluctance 

make their investments with the expectation that 

14 See Song and Thakor (201 0). 
148 


86681.103

arose from the inabll1ty of banks to securitize home in about defaults on home mortgages, and many of 

mortgages because the securitization market did not the securities being used as collateral in repos were 

exist in Romania the 1990s.15 Thus, the absence of mortgage-backed securities. Thus, what happened 

the securitization market stunted the growth of the in home mortgages affected short-term credit availhome mortgage market. ability to financial firms, which then spilled over into a 

general decline in the credit available to businesses 

Even within the United States, we have seen and individuals. 

numerous examples of this. Many U.S. corporations, 

especially non-depository financial companies, rely Imagine what would happen to U.S. credit 

onthe repo market for their short-term funding needs. card lending if the market for credit card securitizaThe repo market, whose precrisis size is estimated at tion were to disappear. Millions of consumers would 

between $10 trillion and $20 trillion, involves a firm find themselves without access to credit cards. Simjtakjng a short-term loan (typically overnight loans) larly, imagine what would happen to entrepreneurs 

from another firm under a repurchase agreement in if venture capita! were to disappear. Scores of new 

which eligible securities are used as collateral. So, 

I might have $100 worth of marketable securities 

against which 1 might borrow $100 from you for, say, 

a day. When I repay the loan, I get my securities back 

(I "repurchase" them). If I default, you keep the securities. Repos have "haircuts" associated with them. If 

I can borrow $100 against $100 worth of securities, 

the haircut on the repo is O. If I can borrow only $90 

against $100 worth of securities, the haircut is 10%. 

and so on. It is estimated that between early 2008 and 

early 2009, the haircut on repos went from 0 to 45%.16 

If one takes the simple average of these two numbers 

as the average haircut during this period, then one 

can estimate that about $2.25 trillion in short-term 

borrowing capacity vanished fairly quickly from the 

market as companies were now able to borrow that 

much less using the same collateral as before. This 

led to a significant decline in lending to individuals 

and businesses, as a major part of our financial system found itself to be liquidity constrained. 

businesses would fail to be launched. 

When the rnrnr)f,"fC'nT'O of 

the financial system are so 

even small 

and manifest as 

eventual rh,:mr10Q 

of 

The "theory of unintended consequences" 

says that it is difficult to predict how the financial 

system will react if one of its components is tinkered 

with via regulatory changes. When the components 

of the financial system are so interconnected, even 

small initial changes in one part of the system can 

reverberate through the entire system and manifest 

This example illustrates both interconnect- as big eventual changes. For example, when the 

edness and the danger in making changes in one Federal Reserve injected substantial liquidity into 

part of the financial system. One reason that repo the economy from 1995 through 2005, it was hard to 

haircuts went up is that bad news began to trickle imagine that this would contribute to a housing price 

15 See Meyendorff and Thakor (20Q2). 

16 See Gorton and Metrick (2010). 

bubble and crisis. Such unintended consequences 

are also encountered in other parts of the economy. 
149 


86681.104

For example, not many would have predicted that the legal liability on credit rating agencies for "rating mis-

"cash for clunkers" stimulus initiative would have the 

unintended consequence of hurting automobile parts 

suppliers and putting many of them out of business. 

Interconnectedness magnifies the errors embedded 

in regulatory missteps and increases the uncertainty 

generated by them. 

The effects of this interconnectedness can 

spill over into different types of financing. For example, suppose that banks find their equity capital has 

been depleted because of credit and trading losses 

such as those that we witnessed during the recent 

crisis. At the same time, it might be more difficult 

to access public equity markets for more capital 

because the market is stressed and investors are 

averse to purchasing additional equity in banks. A 

consequence of this would be a decline in bank lending, similar to the 7.5% decline in U.S. bank lending 

witnessed in 2009.17 Another consequence would be 

a decline in new lines of credit (or loan commitments) 

extended by banks. Because companies use lines of 

credit from banks extensively to back up commercial paper issues, U.S. corporations would suffer a 

"double whammy" in the sense that they would not 

only have diminished access to bank loans, but also 

lesser access to the public debt market. In this way, 

adverse developments for banks in the market for 

bank equity capital can spill over into the debt market 

for other firms. Aggregate investment, employment, 

and GOP suffer as a result. 

This interconnectedness is one of the main 

reasons why regulatory intervention in one part of the 

financial system so often generates unpredictable 

and undesirable consequences in some other part 

of the financial system. Consider what happened 

when the Dodd-Frank Act effectively expanded the 

17 Statement of Martin J. Gruenberg. Vice Chairman FD!C, on 

Condition of Small Business and Commercial Real Estate lending !n 

Loca! Markets. FD!C, http://www.fdlc.gov/newsJnewsJspeeches/others/spfeb261O.html (February 26,2010). 

representation." The three major U.S. credit rating 

agencies responded by asking debt issuers to not 

use their ratings. However, by SEC regulation, these 

debt issues needed ratings, so the market for these 

issues essentially froze for a few months. Scores of 

debt issuers were denied access to much needed 

funds. Such are the workings of the theory of unintended consequences. 

This interconnectedness 

is one of the main masons 

why intervention 

of the financial 

so often generates 

and 

undesirable consequences 

in some other of the 

financial 
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86681.105

V. Conclusion 

This paper has surveyed the U.S. financial access includes going directly to the capital market 

system from the standpoint of the various types to raise money, such as through a commercial paper 

of financing sources available to individuals and or public debt issue. 

businesses and the different types of financing 

arrangements (contracts) by which capital is raised. Fourth, a rich variety of debt and equity 

The main messages emerging from this discussion financing sources is available in the United 

are as follows. States. This diversity is crucial for helping our economy to keep its competitive edge because it enables 

First, the financial system helps economic businesses to improve their management of risk and 

growth. This is achieved through the provision of lower their cost of capital, so that both investment 

four basic services: facilitating trade; facilitating risk and employment increase. 

management for various individuals and businesses; 

mobilizing resources; and processing information Finally, the U.s. financial system is highly 

about individuals and businesses and allocating interconnected. This interconnectedness means 

resources. that any changes in one part of the financial system-either through a shock like a crisis or through 

Second, individuals (consumers) are regulatory intervention-can reverberate throughout 

largely limited to debt financing for raising capital. the entire system, often in unpredictable ways. As a 

Nonetheless, consumers can use a large number result, well-intentioned initiatives may produce more 

of sources to raise this financing, including banks, harm than good. 

finance companies, and the federal government. 

This paper has not addressed some quesThird, businesses regularly access both tions. What does the future hold for financial 

debt and equity capital, and the appropriate services? What effect wi!! the Dodd-Frank Act have 

mix of debt and equity, called the "capital struc- on the financial services industry? Will the industry 

ture" decision, is a key strategic choice for any experience an increase or decrease in the diversity of 

company. Businesses have three basic sources of financing sources in the future? How will the regulacapital: private, intermediated sources, and public tory structure evolve? These are interesting questions 

markets. These three categories exist for both debt to ponder, and the answers will not only influence how 

and equity capital. In private non-intermediated we deal with global challenges but also determine the 

sources, the firm raises financing outside the public magnitude of future economic growth because of the 

capital market without using a financial intermediary close relationship between financial system developlike a bank. Induded in this are sources like friends ment and economic growth, discussed in this paper. 

and family, cash generated from the firm's operating The world's population is growing and is likely to hit 

profits, customers, and suppliers. Private interme- 9 billion in this century. This growth will put substandiated sources include bank loans, borrowing from tially greater stress on the natural resources needed 

finance companies and insurance companies, and to support this population-food, water, and energy. 

loans from the parent company. Public market Innovations of all sorts will be needed to optimize the 
151 


86681.106

use of limited resources and harness new resources. 

These innovations will need to be financed. A vibrant 

and robust financial system in the United States wlll 

play a critical roie in supporting these innovations 

and helping them to become commercial successes. 

The Microsofts, Googles, Genentechs, and Facebooks of tomorrow will rise from the commitment to 

innovation that will be fueled by the financial services 

sector in the United States and elsewhere. Financial 

markets in emerging countries like India, China. and 

Brazil wi!! continue to grow and challenge the preeminence of U.S. financial markets. Already, two-thirds 

of the world's equity market capitalization is outside 

the United States. Global competition among financia! markets is sure to intensify even further. Thus, 

business wi!! go to the most transparent and wellregulated markets, and will flow away from markets 

that are more onerously regulated and involve higher 

costs of capital. As long as economically sensible 

regulation supports the transparency and health 

of the U.S. financial system, the economic growth 

that will follow the wave of future innovation wi!! be 

accompanied by growth in the depth and size of the 

U.S. financial services industry and the economic 

value provided by it. 
152 


86681.107

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154 


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Hearing on Legislation to 

Further Reduce Impediments 

to Capital Formation 

Statement of David Weild, Founder, Chairman & CEO of IssuWorks Holdings LLC, 

before the U.S. House of Representatives Financial Services Committee, Capital Markets 

and Government Sponsored Enterprises Subcommittee, October 23,2013. 

David.Weild@IssuWorks.com· (212) 705-8731 • www.IssuWorks.com 
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Contents 

Introduction 

Specific responses to legislative proposals 

Call for a JOBS Act 2 (Significant ways Congress can help the U.S. economy) 

Conclusion: IPOs lead to job growth 

Additional materials 

About David Weild 

About IssuWorks Holdings 

Hearing on Legislation to Further Reduce Impediments to Capital Formation 

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Introduction 

Chairman Garrett, Ranking Member Maloney and members of the Subcommittee, thank you for 

inviting me to speak today about an issue of great importance to many Americans: "Legislation 

to Further Reduce Impediments to Capital Formation: 

My name is David Weild. I am the Chairman & CEO of IssuWorks Holdings ("lssuWorks"), which 

was recently founded to develop technologies to improve capital formation in the public markets. 

I was formerly vice chairman of The NASDAQ Stock Market with responsibility for all of its listed 

companies, and I ran the equity new issues business of Prudential Securities, back when 

Prudential Securities was one of the ten largest underwriters of new issues equities in the 

United States. 

Improving access to equity capital in the United States is one of the most important needs for 

our economy. Access to equity capital fuels job growth and innovation, which, in turn, enables 

free markets to solve problems from poverty and unemployment to finding cures to cancer, 

global warming and many of the other challenges that this generation, and every other 

generation, will face. 

I'd like to start by thanking you for the terrific bipartisan work that culminated with the signing 

into law of the JOBS Act on April 5, 2012. I know what an integral part so many of you played in 

making the JOBS Act a reality. But, while the JOBS Act created so-called "On-Ramps" to 

facilitate companies getting public, it did nothing to improve the aftermarket for these companies 

and their investors. One might legitimately ask, "Have we created the "On-Ramp to Nowhere?" 

So with this in mind, I would like to convey my view that we have much more work to do. The 

American people will need the equivalent of a JOBS Act 2 and 3 if we are really going to restore 

the innovation and job creation engine to the US economy that once made US stock markets 

the envy of stock markets the world over. 

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Specific responses to legislative proposals 

H.R. , To amend the Securities Exchange Act of 1934 to provide for an optional 

pilot program allowing certain emerging growth companies to increase the tick 

sizes of their stocks. (Mr. Duffy) 

This is the most important Bill in this package for its potential to improve capital formation 

broadly and to create jobs in the United States. Our listed stock markets are in the midst 

of a long-term and protracted collapse which has been self-inflicted. As seen from recent 

data compiled by the CFA Institute's Jason Voss, the United States today has fewer 

publicly listed companies than we did at any point since 1975 (see Figure 1). 

Figure 1: U.S. stock market listings have collapsed since 1997 

The United States has fewer than 4,900 listed companies when it should be 

approaching 13,000. 

Sources: Jason Voss, CFA Institute (cited by Bloomberg Finance, Oct. 11,2013) and IssuWorks 

In fact, we have less than 4,900 publicly listed companies, when we should have closer to 

13,000 public companies, but for the fact that changes to market structure gutted the 

aftermarket support model in 1997 with the implementation of the Order Handling Rules 

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followed by the shift to electronic markets in 1998 with Regulation A TS (Alternative 

Trading Systems) and one-size-fits-all penny stock trading in 2001 with "Decimalization" 

(see Figure 2). 

Consumer activists that promote low cost trading in innately illiquid (small-, micro- and 

nano-cap) stocks are trafficking very bluntly in "Fool's gold." Low cost trading in illiquid 

stocks perversely harms consumers by depriving them of higher disposable incomes while 

wreaking havoc on the lowest socioeconomic classes of our society. 

Low-income groups which are disproportionately made up of minorities, single mothers, 

blue collar workers, many union workers, older Americans, and kids graduating from 

college are not day trading stocks.' None of these groups benefit from this market 

structure. Indeed, they are all harmed by this market structure inasmuch as it deprives 

them of employment opportunities and higher disposable income. 

Figure 2: The acceleration to electronic markets in 1998 (Reg. A TS) triggered a 

wholesale the collapse in economic incentives to support small cap stocks which, 

in turn, gutted the small/PO market. 

101.1% 

Sources: IssuWorks and Dealogic. 

Data includes corporate IPOs as of Dec. 31, 2012, excluding dosed-end funds, RE!Ts, SPACs and lPs 

1 For example, according to statistics from the Economic Policy Institute on asset ownership by race and ethnicity, the 

average dollar value of stocks owned by Black and Hispanic households was $12,300 and $10,800, respectively, in 2010. 

while the median dollar value of stocks owned by both groups was $0. See http://sta1eofworkingamerica.org/chartJswawealth-table-6--8-average-median-assetst. 

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It takes no great leap to understand that the loss of the so-called "Multiplier effect" in job 

creation, where as many as five service sector jobs are created for every technology job2

, 

is exacerbating the disparity between the "haves" and "have nots" of our society. Poor 

people don't day trade stocks, but they do need a robust economy that will create jobs. 

People at the lower end of the economy are the "UFOs" in our job market: Last in, first 

out. When we have a slack economy, they suffer most. 

It also takes no great leap to understand that the great growth companies of tomorrow, the 

great innovators of tomorrow, those very companies that will find the cure to Alzheimer's 

and global warming and advance the technologies for sourcing renewable energy, need a 

United States IPO market that is as vibrant as it used to be when companies like Intel, 

Microsoft and Amgen went public. 

In our work for the OECO comparing the top 26 IPO markets in the World, it became 

crystal clear that the IPO market in the United States collapsed from what today should be 

on the order of 900 IPOs per year to levels which have averaged 1351POs a year since 

2000. Today, of the top 26 IPO markets, the United States is ahead of only Mexico and 

Brazil in GOP-weighted smalilPO production. 

Today, the United States has the lowest aftermarket incentives of any market as 

measured by how many micro-cap stocks offer tick size incentives that are greater than 

1 % of the share price. In the United States, zero (0) micro-cap stocks have tick sizes 

greater than 1 % of share price while stock markets that dramatically outproduce the 

United States in smalilPOs on a GOP weighted basis - including Australia, Canada, 

Hong Kong, Malaysia and Singapore (see Figure 3) - have fully 71% of their micro-cap 

stocks with tick sizes in excess of 1 % of share price. 

Figure 3: The U.S. has the lowest aftermarket incentives of any market in the world 

Percent of small stoek$ with large 

aftennarket incentives 

0% 

United States 

Hong 

Malaysia, 

tPO output ratio ,,' -, -, ,,~~-

0.4 

United States 

(average) 

We have been penny wise and pound foolish in our efforts to save consumers money on 

transaction costs, and if we do nothing to improve the aftermarket, we have built an "IPO 

2 Moretti, Enrico, Professor of Economics, University of Cali fomi a, Berkeley, The New Geography of Jobs, 2013 

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On-Ramp to Nowhere." We not only support this bill, we believe that this Bill needs to go 

further: 

In addition to 5 cent and 10 cent tick size options, we believe that nano-cap stocks 

- defined as stocks under $100 million in market value - may need a 20 cent tick 

size option. 

• We believe the Bill should require that trading be done only at the outer bounds of 

minimum tick size increments (not within the tick increment) 

We believe that there should be no payment for order flow allowed that would 

make a mockery of the intent of this structure. 

While this may be controversial, the fact is that in an "Issuer choice of tick size" model, 

investors are invited to "Vote with their feet." They don't have to invest in these stocks if 

they don't want to. And, the vast majority of equity market value that is large-cap will still 

trade at penny tick size increments - thus satiating special trading interests. 

Too many people on Wall Street fight to increase their slice of the pie without working to 

grow the size of the pie. These changes are essential to growing the pie. They will lead 

to more liquidity ... which will bring more institutional investment... which will raise stock 

prices in smaller stocks ... leading to more IPOs and more job creation that will grow the 

economy. 

However, one thing is clear, that at current rates of decline in the IPO market, if we do 

nothing, investors will have fewer and fewer choices in public companies: Today, there 

are already fewer than 3,700 operating companies in the Wilshire 5000 index. 

We urge Congress to come together in the same bipartisan manner that brought us the 

JOBS Act, to finish the job and develop the essential "JOBS Act 2" that will restore 

aftermarket support and brings U.S. IPO markets back to where once again, the United 

States stock markets will rightfully be the envy of stock markets the World over and 

Americans may be put back to work. 

Business Development Companies (H.R. 1973, 1800 and 31 broadly) 

We generally support the thrust of these three bills. 

Business Development Company ("BDC") rules are antiquated and should be 

modernized to support streamlined filing practices, including shelf registrations, that are 

the customary practice for operating companies. BDCs typically lend money to 

businesses, and, in a world where banks are required to maintain higher regulatory 

capital ratios, there is a public interest to be served by streamlining the capital raising 

activities of BDCs (to use shelf registrations as is indicated by H.R. 1800) and widening 

their scope of investment (as is indicated by H.R. 1973) to make financial services 

companies, including community banks, leasing companies, factoring firms, and 

automobile financing companies so-called "Qualifying" investments. 

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A policy that limits BOC investments to no more than 30% of small- and medium-sized 

financial services companies runs counter to the objective of helping attract capital for 

the benefit of small- and medium-sized American companies, since these financial 

institutions may in turn lend money to other businesses. In fact, we could easily foresee 

BOCs that are dedicated exclusively to investing in financial institutions as being 

something clearly in the public interest in light of the aftereffects of the Financial Crisis 

of 2007-2008. 

However, since BOC shares are widely held by retail investors, and both both H.R. 1800 

and H.R. 31 would increase the ability to leverage BOCs, from a current ratio of $2 of 

assets to every $1 of equity to $1.5 of assets to every $1 of equity, we would like to see 

portfolio stress tests before we endorse any increase to leverage limits. A higher 

leverage ratio may boost yields to investors and result in an increase in share price 

values which would allow BOCs to raise more equity capital. Increased leverage 

applied to these portfolios, while increasing the potential for return, will also increase 

downside risk, and we believe that the Sub-Committee would be wise to understand 

fully how BOCs might perform when fully leveraged in a variety of environments that 

include inverted yield curves (where short-term liabilities of such funds are higher than 

the yields of long-term assets) and periods of higher corporate defaults, financial crisis 

(such as the Financial Crisis of 2007-2008) and recession. 

H.R. 2274, Small Business Mergers, Acquisitions, Sales, and Brokerage 

Simplification Act of 2013 

We support H.R. 2274 because it creates clarity in the regulation of the M&A market. M&A 

advisory firms that took the conservative approach of registering with FINRA have been 

frustrated by those many firms that transact in the M&A market without a FINRA registration. 

Most types of M&A, especially in private markets, pose very little risk to the public: 

Transactions are negotiated among professionals and/or business owners who conduct their 

own due diligence. It is widely accepted that these transactions should be held to what has 

been called a "Broker-dealer lite" standard. For the reason that all partiCipants should 

adhere to the same set of rules and that these rules should not be unduly burdensome, we 

support the formation of a new regime, overseen by the SEC, as contemplated by H.R. 2274. 

However, we believe that the Bill should explicitly state that FINRA-Registered Broker 

Dealers could also file with the Commission under H.R. 2274 as an M&A Broker and that 

qualifying transactions would be subject to no additional review by FINRA. 

H.R. , To direct the Securities and Exchange Commission to revise its 

regulations relating to requiring the use of eXtensible Business Reporting 

Language for periodic reporting to exempt smaller public companies from 

such requirements. (Sponsor Not Named) 

I helped organize the first demonstration of XBRL while vice chairman of NASDAQ. 

We did this for a group of semiconductor companies. We generally applaud the intent 

of XBRL. However, requiring smaller issuers to bear the costs of services that largely 

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benefit investors, especially large ones, is not fair and will only cause companies to 

avoid going public. We believe that the cost is better borne by investors and not the 

companies. We also believe that a transaction tax model, or subscription to XBRL 

model, would better serve the purpose of acquiring funds to pay for the cost of XBRL 

tagging of smaller companies' data. Smaller issuers need reduced costs to incentivize 

them to go public. Absent an alternative, we support exempting smaller public 

companies from the requirement to file XBRL-enabled financial statements. 

H.R. ,To amend certain provisions of the securities laws relating to the treatment 

of emerging growth companies. (Mr. Fincher) 

8 

We support this Bill as it creates generally greater optionality for issuers without altering the 

ultimate level of required disclosure to investors. This Bill is in keeping with the philosphy that 

underlies Title I of the JOBS Act and the creation of safe harbors such as "Testing the waters" and 

"Confidential filings." We believe, for example, that providing issuers with the ability to file without 

full financial statements will cut issuer time-to-market which is beneficial in mitigating market risk 

and speeding access to capital. 

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Call for a JOBS Act 2 (Significant ways 

Congress can help the U.S. economy) 

We take this opportunity to offer a range of ideas to improve the long-term effectiveness of the 

JOBS Act: 

Title I of the JOBS Act - Emerging Growth Companies 

9 

We continue to believe that the single most critical impact on capital formation in the United 

States will be had by improving aftermarket incentives so that small-, micro- and nano-cap 

market makers will compete on the provision of value (e.g., capital commitment, sales coverage, 

and research coverage) and not on price. Whether this is done by increasing tick sizes (and 

eliminating incentives to engage in price competition through such practices as payment for 

order flow, rebates and price improvement by trading within the tick), or the wholesale creation 

of new market structures, is less important than the realization that current market structure has 

had a catastrophic impact on capital formation and the U.S. economy. 

Please see views expressed above in the section entitled, "Specific responses to legislative 

proposals" where we generally endorse the Bills intended: 

"To amend the Securities Exchange Act of 1934 to provide for an optional pilot program 

allowing certain emerging growth companies to increase the tick sizes of their stocks." 

(Mr. Duffy) 

"To amend certain provisions of the securities laws relating to the treatment of emerging 

growth companies." (Mr. Fincher) 

Title III of the JOBS Act - "Crowdflmding" 

Professor John Coffee of Columbia University, in riveting testimony before the Senate, dubbed 

Crowdfunding the "Boiler room act of 2011." This understandably caused concern. 

We submit that Crowdfunding Portals should be thought of differently, and treated separately, 

from broker-intermediated offerings under Title III of the JOBS Act. Crowdfunding Portals 

represent a paradigm shift in how securities, products and causes will be vetted and sold. The 

collective intelligence and scrutiny of the "Crowd" will result in dramatically lower rates of fraud, 

for example, than the tradtitional broker-intermediated sales process. One need only recall that 

when peer-to-peer auction markets such as eBay came into being, there were similar concerns 

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over the risk of fraud. The portal (eBay), in order to grow, had to master quality control, which it 

did by being responsive to its users and harnessing the power of the Crowd. 

We also believe that Crowdfunding has the potential to transform access to capital for small 

business. For these reasons, we recommend that Congress: 

Eliminate the $1 million cap on Crowdfunding that takes place on Portals. There are 

already limits in place on the amount that an investor can commit to anyone 

investment. Two layers of protection are unnecessary in our view. 

• Consider tax credits for investment in minority- and women-owned businesses, 

businesses where minorities and women make up a majority of employees, and 

businesses that are concentrated in targeted development zones. We believe that 

Crowdfunding and entrepreneurship, combined with tax incentives could be a powerful 

mechanism to incentivize "haves" to invest in "have nots" and thereby use free markets 

as a way to transform some of the structural challenges facing our society. 

Title IV of the JOBS Act- Popularly known as "Reg. A+" 

Need for a Reg A+ Blue Sky Exemption - Background - Reg. A+ is a stripped down 

(documentation) form of IPO for smaller offerings (a maximum of $50 million in proceeds) where 

public investors are solicited under a private placement exemption and where shares may be 

traded freely in the aftermarket (subject to State or "Blue Sky" limitations). Under Title IV of the 

JOBS Act, the cap on this exemption was raised from $5 million in proceeds to $50 million in 

proceeds. "Bad Actor" prohibitions and certain reporting and disclosure enhancements (e.g., 

audits) were added. However, the concern is that this Title (the SEC still has not issued the 

rules) will not find widespread use unless a Blue Sky (state filing) exemption is permitted. (notethe increase in aftermarket economic incentives through an increase in tick sizes or other 

structural change will be critical to Reg. A+ transactions working as well). 

Possible legislative mechanism - Congress could make Title IV securities "Covered 

securities" under Section 18(b)(4) of the Securities Act of 1933 which would exempt these 

Securities Offerings under Title IV of the JOBS Act from State regulation. This small change 

would help ensure that Reg. A+ would fulfill its promise. 

Creating a Core Competency to Protect and Sustain Small Company 

Markets 

The drive to create one-size-fits-all stock markets with low transactional costs to benefit stock 

purchasers is at the heart of the collapse of the I PO and listings markets in the United States. 

Small-, micro- and nano-cap markets are fundamentally different in nature from large 

capitalization markets and yet their interests are often drowned out of the discussion for the 

simple reason that while they make up 81.1% of all listed companies, they only account for 

6.6% of total market value. Market value is concentrated in larger (large-cap and mid-cap) 

stocks while capital formation, growth and innovation is concentrated in smaller stocks. 

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Sources: IssuWorks and CapltallQ 

Includes NASDAQ, NYSE (including AMEX) and OTe listings. Corporate issuers only, excluding holding companies, funds, MLPs, SPACs, 

REITs and other trusts. 

Sources: IssuWorks and Capital 10 

Includes NASDAQ, NYSE (including AMEX) and OTC listings. Corporate issuers only, excluding holding companies, funds, MlPs, SPACs, 

REITs and other trusts. 

We recommend the creation of a horiziontally-integrated small capitalization division 

within the SEC. This division would include under one roof, all three major disciplines 

including: 

Corporation Finance 

Trading and Markets 

• Enforcement 

Small cap markets are neglected because there is insufficient dedicated representation of the 

needs of small cap market structure. Prior to Reg. ATS, the stock exchanges performed this 

function by protecting market structures that would support capital formation and small cap 

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stocks. At NASDAQ, it was through the dealer system and higher spreads. At the NYSE, it was 

through the allocation system (specialists were forced to subsidize liquidity and support small 

cap stocks that were assigned to their "Book."). With the flood of new entrants from Reg. ATS 

and the competition that ensued after the advent of Decimalization and Regulation NMS 

(National Market System), the one-size, hyper-competitive trading model caused the stock 

exchanges to lose the ability to effectively fight to preserve market quality for small-cap stocks. 

Today, neither the SEC nor the Stock Exchanges provide a holistic discipline focused on 

nurturing the small-, micro- and nano-cap ecosystems. At the SEC, to the best of our 

knowledge, only the Division of Corporation Finance has a formal small company discipline. 

Without control over market structure and enforcement, that discipline has proven to be 

ineffectual. 

By creating a horizontally integrated small-, micro- and nano-cap discipline at the SEC, with 

authority to optimize market structure for the benefit of the broader ecosystem of investors, 

intermediaries and issuers, market structure would avoid again being led down a path that 

compromised U.S. economic growth. 

I have had occasion recently to present to the Investor Advisory Committee of the SEC. Again, 

I am struck by the fact that this committee is made up of mostly large-cap oriented, quantitative 

and index-oriented investors that have little-to-no direct experience in the fundamenal investing 

in, and trading of, small and micro-cap stocks. We believe that the SEC needs an Investor 

Advisory Committee made up exclusively of fundamentally-oriented investors in small-, microand nano-cap stocks. 

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Conclusion: IPOs lead to job growth 

A capital market is a multi-layered, complex ecosystem of competing and related interests. Each 

of the numerous constituents must be govemed by rules and encouraged by incentives. The 

markets that succeed in balancing these many interests are the markets that will go the furthest 

in facilitating capital formation. Efficient markets need to do more than create rock-bottom 

trading costs for market speculators - they also need to improve the allocation of capital and 

enhance long-term economic growth. 

If the rules become too burdensome, or if the incentives become diminished for any party, the 

ecosystem operates far below its potential efficiency. Companies have difficulty reaching new 

investors, innovation and job creation slows or stops altogether, and the macro economy 

suffers. 

A vibrant capital market is the engine of a healthy economy that creates jobs. We estimate that, 

if not for the scarcity in public offerings, 3.1 million to 9.4 million additional U.S. jobs might have 

been created by companies after going public. If we assume a multiplier effect where higher IPO 

activity accounts for a like-kind number of jobs created in the private market (a conservative 

effect of only one for one), the range of 3.1 million to 9.4 million jobs created jumps to between 

6.2 million and 18.8 million. 

A major contributor to employment 

In fact, the so-called multiplier effect may be much larger than we estimate above. Enrico 

Moretti has estimated that as many as five local service sector jobs - ranging from doctors and 

teachers to wait staff and sales clerks - are created for every one technology and 

biotechnology sector job produced"These are the very industries that once sought out public 

offerings as their preferred strategy to raise capital (and exit). This five-to- one ratio of job 

formation has served to increase the number of employment opportunities at all skill levels and, 

ultimately, the U.S. standard of living. 

, Ibid. 

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Congressional support is needed 

Congress has the power to help reverse our current situation and bring back the stock market 

that was once the envy of economies throughout the world for its ability to foster U.S. economic 

leadership. To grow the IPO markets currently the key exit path putting pressure on access 

to capital in private markets - we need Congress to focus its attention on the so-called 

"Aftermarket support model" - the incentives required to sustain visibility and institutional 

liquidity in small-, micro- and nano-cap stocks, 

We understand that it will not be easy. There are many entrenched interests that would prefer 

to argue over how to increase their share of the "pie" rather than to focus on how to grow the 

"pie" for all Americans, Unfortunately, those that can least afford to bear the brunt of a soft 

economy have been dealt the harshest blow by the folly that is one-size-fits-all stock markets, 

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Additional materials 

The collapse in economic incentives to support small-, micro- and nano-cap stocks precipitated 

a collapse in the ecosystem of investment banks that acted as book running managers in 1994 

verus 2012. Firms in red from 1994 (see below) were no longer in business in 2012. The 

number of book-running managers (so called "On-ramps') contracted dramatically. 

Tick sizes r'bankable spread») $0.25 per share $0.01 per share ·96% 

Retail commissions $250 PEl'r trade $5 per trade ·91l% 

Investment banks (acting as a bookrunner) 161 {1994} 39 (2006) ·17% 

Small company IPOs 2,990 (1001-1997) 233 (2001-2007) ·92% 

AB Capital & Investment 

Advest Inc 

AG Edwards & Sons Inc 

Allen &Co LLC 

Americorp Securities Inc 

Anderson & Strudwick 

AR Baron & Co Inc 

AT Brod & Co Inc 

Auerbach Pollak Richardson 

Bane of America Securities 

Baraban Securities Inc 

Barber & Bronson Inc 

Baring Securities 

Barington Capital Group 

Barron Chase Securities Inc 

Beacon Securities Inc 

Bear Stearns & Co Inc 

Brenner Securities Corp 

1994 

Harriman Group Inc 

Harris Nesbitt Gerard Inc 

HJ Meyers & Co Inc 

Howe Barnes Investments Inc 

tAR Securities Inc 

ING Barings 

International Assets Advisory 

Investec Inc 

Investors Associates Inc 

J Gregory & Co Inc 

James Capel & Co 

Janney Montgomery Scott 

JC Bradford & Co 

Joseph Stevens & Co lP 

Josephthal & Co 

JP Morgan Securities LLC 

JW Charles Securities Inc 

Keane Securities Co Inc 

Paragon Capital Markets Inc 

Pari bas Capital Markets 

Parker/Hunter Inc 

Patterson Travis Securities 

Paulson Investment Co Inc 

Piper Jaffray & Co 

PrinCipal Financial Securities 

Prudential Securities Inc 

RAF Financial Corp 

RAS Securities Corp 

Raymond James 

Redstone Securities Inc 

Rickel & Associates Inc 

RJ Steichen & Co 

Robert W Baird & Co 

Robertson Stephens 

Robinson-Humphrey Co 

Rocky Mountain Securities 

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Allen & Co LLC 

Ameriprise Financial Inc 

BofA Merrill Lynch 

Barclays Capital Inc 

BMO Capital Markets 

Capitol Securities Mgmt 

Chardan Capital Markets 

Citigroup Global Markets 

Cowen & Co LLC 

Credit Suisse Securities 

Dawson James Securities 

Deutsche Bank Securities 

Dominick & Dominick Inc 

EarlyBird Capital Inc 

FBR Capital Markets & Co 

Goldman Sachs 

Janney Montgomery Scott 

Jefferies & Co Inc 
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Chase H&Q 

CIBC World Markets 

Citigroup Global Markets 

Commonwealth Associates 

Comprehensive Capital Corp 

Craig-Hallum Group 

Credit Suisse First Boston 

D Blech & Co 

Oain Rauscher Wessels 

Daiwa Securities America 

Dean Witter Reynolds Inc 

Deutsche Bank Securities 

Deutsche Morgan Grenfell 

DHBlair 

Dickinson & Co 

Dillon·Gage Securities Inc 

Donaldson Lufkin & Jenrette 

Equity Securities Investment 

Evere" Securities Inc 

FAC/Equities 

FEB Investments Inc 

First Asset Management 

First Equity Corp of Florida 

First Hanover Securities Inc 

First Marathon 

Friedman Billings Ramsey 

Gilford Securities Inc 

GKN Securities Corp 

Glaser Capital Corp 

Global Capital Securities Corp 

Goldman Sachs 

Grady & Hatch & Co Inc 

Greenway Capital Corp 

Hamilton Investments Inc 

Hampshire Securities Corp 

Hanifen Imhoff Inc 

Kennedy Mathews Landis HealyRodman & Renshaw Inc 

Kensington Wells Inc Roney Capital Markets 

Kidder, Peabody & Co Inc Roth Capital Partners 

Kleinwort Benson Securities Royce Investment Group Inc 

Ladenburg Thalmann & Co Inc RvR Securities Corp 

Laidlaw Global Securities Inc Ryan Lee & Co Inc 

Lam Wagner Inc Salomon Brothers Inc 

Lazard Freres & Co LLC Sands Brothers & Co Ltd 

LC Wegard & Co Inc Schneider Securities Inc 

Legg Mason Wood Walker Schroder & Co 

Lehman Brothers SG Cowen & Co LLC 

LH Alton & Co Smith Barney Inc 

Mabon Securities Corp Spectrum Securities Inc 

Marleau Lemire Securities Inc Spelman & Co 

Mathews Holmquist & Assoc, Stephens 

McDonald Investments Inc Sterling Foster 

Merrill Lynch & Co Sterne Agee & Leach Inc 

MH Meyerson & Co inc Strasbourger Pearson Tulcin 

Miller Johnson & Kuehn Stratton Oakmont Inc 

Montgomery Securities Summit Investment Corp 

Morgan Keegan & Co Inc Texas Capital Securities Inc 

Morgan Stanley Thomas James Inc 

Murchison Investment Bankers Toluca Pacific Securities Corp 

NatCity Investments Inc Tucker Anthony Inc 

NatWest Securities Corp UBS Securities Inc 

Needham & Co Inc VTR Capital Inc 

Neldiger Tucker Bruner Inc Wachovia Capital Markets 

Nesbitt Burns Inc Wedbush Morgan Securities 

Nomura SeCUrities Inti Wells Fargo Securities LLC 

Norcross Securities Inc Werbel~Roth Securities tnc 

Oak Ridge Investments Inc Wertheim Schroder & Co 

Oppenheimer & Co Westfield Financial Corp 

Oscar Gruss & Son Inc Whale Securities Co 

Pacific Crest Securities LLC William Blair & Co LLC 

Pacific Growth Equities LLC Yamaichi Securities 

PaineWebber Inc Vee Desmond Schroeder Allen 

16 

JP Morgan Securities LLC 

Keefe, Bruyette & Woods 

KeyBanc Capital Markets 

Lazard Capital Markets 

Leerink Swann LLC 

Macquarie Capital 

Maxim Group LLC 

MDB Capital Group LLC 

Morgan Stanley 

Nuveen Investments 

Oppenheimer & Co 

Paulson Investment Co 

Piper Jaffray & Co 

PrinceRidge Group 

Raymond James 

RBC Capital Markets 

Robert W Baird & Co 

Sandler O'Neill & Partners 

Santander Investment 

Stephens 

Stifel 

SunTrust Robinson Hum 

UBS Securities LLC 

Wellington Shields Co LLC 

Wells Fargo Securities 

William Blair & Co LLC 

July 2013, Making Stock Markets Work to Support Economic Growth (OECD Corporate 

Governance Working Papers) 

September 2013, The trouble with small tick sizes: Larger tick sizes will bring back 

capital formation, jobs and investor confidence 

June 20,2012, testimony to the U.S. House of Representatives Financial Services Committee, 

Capital Markets and Government Sponsored Entities Subcommittee 

June 8,2012, presentation to SEC's Advisory Committee on Small and Emerging Companies 

June, 2010 Market structure is causing the fPO crisis - and more 

November 2009, A wake-up call for America 

November 2008, Why are IPOs in the leU? 

Wall Street Journal Op-ed entitled, "How to revive small-cap IPOs," October 27,2011 

Hearing on Legislation to Further Reduce Impediments to Capital Formation © 2013 IssuWorks Holdmgs LlC, AJI Rights Reserved 
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About David Weild 

David is the Chairman & CEO of IssuWorks, which he recently founded to create technologies to 

improve equity capital formation and aftermarket support. IssuWorks owns Weild & Co. 

(formerly Capital Markets Advisory Partners or CMA Partners), a FINRA-registered brokerdealer. 

Experience 

David is an internationally recognized expert in how market structure affects capital formation. 

His work has been cited by academics, regulators and lawmakers in the US and overseas and 

the IPO Task Force Report to the U.S. Treasury. He was the former vice-chairman and 

executive vice-president of The NASDAQ Stock Market, with oversight of the more than 4,000 

listed companies. Prior to NASDAQ, he spent 14 years at Prudential Securities in a number of 

senior management roles, including president of eCommerce, head of corporate finance, head 

of technology investment banking and head of equity capital markets in New York, London and 

Tokyo. He worked on more than 1,000 IPOs, follow-on offerings and convertible transactions 

and was an innovator of new issue systems and securities underwriting structures, including the 

use of Form S-3s to mitigate risk for small capitalization companies raising equity and 

convertible debt capital. He created the Market Intelligence Desk - or MID - while at 

NASDAQ to support issuers in their quest to better understand what was impacting trading in 

their stocks. 

Education 

David holds an MBA from the Stern School of Business and a BA from Wesleyan University. He 

has studied on exchange at The Sorbonne, Ecole des Haute Etudes Commerciales and The 

Stockholm School of Economics. 

Industry participation 

David has participated in the NYSE's and National Venture Capital Association's Blue Ribbon 

Regional Task Force to explore ways to help restore a vibrant IPO market and keep innovation 

flourishing in the United States, and is Chairman of the International Stock Exchange 

Executives Emeriti (ISEEE) Small Business Financing Crisis Task Force. He has spoken at the 
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18 

OECD (Organisation for Economic Co-operation and Development) with the 35 member nations 

in attendance, plus the European Commission and IOSCO. David testified before the CFTCSEC Joint Panel on Emerging Regulatory Issues in the wake of the May 2010 flash crash, and 

has spoken at the SEC a number of times, including the SEC Small Business Forum, the SEC 

Advisory Committee on Small and Emerging Companies and the SEC Roundtable on 

Decimalization. David is often interviewed by the financial news media. He has served as a 

Director of the National Investor Relations Institute's New York chapter, and he is the Chairman 

of the Board of Tuesday's Children, the non-profit that serves 9/11 families, and recently 

expanded its charter to make its long-term programs available to first responders, wounded 

warriors, families of the fallen and those touched by other acts of political and apolitical terrorism 

(e.g., Newtown). 

Publications 

David and Edward Kim have co-authored a number of studies, including The trouble with small 

tick sizes: Larger tick sizes will bring back capital fonnation, jobs and investor confidence (Grant 

Thomton) (with Lisa Newport) in 2012 and Why are IPOs in the leU? (Grant Thomton) in 2008. 

Released in the fall of 2009, Market structure is causing the IPO crisis (Grant Thomton) 

(updated by Market structure is causing the IPO crisis - and more in 2010) and A wake-up call 

for America (Grant Thornton) have been entered into the Congressional Record and the Federal 

Register. They also authored Making Stock Markets Work to Support Economic Growth (OEeD) 

(with Lisa Newport) and the chapter, Killing the Stock Market That Laid the Golden Eggs (FT 

Press) in the recent book on high frequency and predatory practices entitled, Broken Markets, 

by Sal Arnuk & Joseph Saluzzi, published in May 2012. 

Hearin9 on Legislation to Further Reduce Impediments to. Capital Formation © 2013 ISSllWorks Holdings LLC, All RightS Reserved 
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19 

About Issn 

IssuWorks is the software and service firm focused on leveraging recent shifts in technology to 

create next generation platforms that will improve new issue performance and revitalize capital 

formation. IssuWorks' goal is to help investment banks, issuers, and the venture capital and 

private equity communities drive superior results by reducing the cost and complexity of new 

issue preparation while improving the distribution and aftermarket support of new issues. The 

combined effect will keep IPO "windows" open longer, resulting in higher throughput (more new 

issues). IssuWorks has a key strategic partnership with Netroadshow, the global standard for 

online roadshows for both public and private companies. IssuWorks is the exclusive computerbased marketing provider for Netroadshow, and they are our exclusive roadshow partner. Weild 

& Co., a wholly-owned subsidiary of IssuWorks, is a FINRA-registered broker-dealer. 

Hearing on Legislation to Further Reduce Impediments to Capital Formation © 2013 !ssul/Vorks Holdings LlC, Ai! Rights Reserved 
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Written Testimony of Gary K. Wunderlich, Jr. 

Chief Executive Officer, Wunderlich Securities 

Before the House Subcommittee on Capital Markets and Government Sponsored Enterprises 

On behalf of the Securities Industry and Financial Markets Association 

Octo her 23, 2013 

Chairman Garrett, Ranking Member Maloney and members of the Subcommittee, thank you for the 

opportunity to appear before you today to discuss various legislative proposals to promote capital formation 

and job creation. My name is Gary Wunderlich, CEO of Wunderlich Secutitles, and I am testifying today on 

behalf of the Securities Industry and !'inancial Markets AssociationI \V'underlich Securities is an independent 

investment firm and full service broker/dealer headquartered in Memphis with 28 offices in 16 states. We 

provide a full range of financial services to retail and institutional clients including investment banking, 

instltutional sales and trading and research. 

srFMA and its member firms appreciare tills Committee's dedicatlon to a review of the environment 

for capital formation, and we are committed to working with you to evaluate and offer constructive 

recommendations to improve the wide-range of proposals that you are considering. America's success 

depends on a vibrant financial system that provides access to capital and credit at a reasonable price. The 

capital markets provide funding to people across I\merica allowing them to build on their dreams of opening 

a small business, saving to send their children to college, buying their first home or saving for retlrement. 

Our capital markets have changed dramatically in just the past few years so it is wholly appropriate for 

extensive public debate about what is working or not working in today's marketplace. 

Changes in our economy and markets warrant evaluation and modernization of securities regulation 

in a manner that continues to protect investors, ensures the competitiveness of our markets and provides the 

efficient flow of capital to the nlany corners of our changing economy. In that regard, we welcome the 

opportunity to he here today. 

1 The Securities Industry and Financial Markets Association (SIFt-.LA..) brings together the shared interests of hundreds of securities 

firms, banks and asset managers. SIFMA's mission is to support a strong financial industry, investor opportunity, capiml formation, 

job creation and economic growth, while building trust and confidence in the financial markets. SIFi\iA, with offices in New York 

and Washington, D.C, is the u.s. regional member of the Global Financial 11arkets Association (GFMA). For more information. visit 

http://www.sifina.org. 

1 
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Tick-Size Pilot Discussion Draft (Rep. Duffy) 

One area of capital formation that has been frequendy debated over the past few years is d,e impact 

of decimalization on liquidity of small-cap and mid-cap issuers. Some have suggested dlat the move to 

decimalization has contrihuted to lower levels of liquidity in those stocks and that along ,,~th other factors, 

has impeded capital formation for those companies. Congress brought dus issue into focus last year in 

passing the "JOBs Act". Section 106 of the ':JOBS Act" directed d,e Securities and Exchange Commission 

(SEC) to conduct a study examining the effects of decinlalization on initial public offerings (IPOs) and the 

liquidity of small and middle capitalization companies. The SEC submitted its report to Congress last July 

and included a literature review of a number of studies dlat had been conducted on the issue. The SEC 

recommended not proceeding ,,~th specific mlcmaking to increase tick sizes, but rather considering additional 

steps dlat may be needed to determine whedler mlemaking should be undertaken in the future. Since then, 

the topic has been discussed in a number of public forums, including Chainnan Garrett's Equity Market 

Structure Roundtable this past May and an SEC Roundtable in February. 

SIFMA and its members have also been engaged in an active dialogue about the impact of 

decimalization on small and mid cap issuers, and we generally believe that a pilot program which widens 

quote increments for small and mid cap securities could increase trading liquidity in d,ose securities. 

I ncreased liquidity in the small and mid cap market will create a marc fertile environment for small and 

emerging growth compauies to tap d,e public markets, ~th broader market participation in the sector and the 

potential for increased research coverage to better inform and educate investors on both the opportunities 

and risks. \vc know that these companies can be an engine for economic growth, and the sponsors of these 

proposals are right to consider additional ways to ensure entrepreneurs have access to the capital they need. 

\X,l111e SIP!\-fA is supportive of a pilot that explon~s how a wider tick size could benefit to small cap 

issuers, we oppose any pilot program that would prohibit trading \V'ithin the wider quoting increments, as the 

current Discussion Draft contemplates. A prohibition on trading inside the quoting increment would be an 

unprecedented alteration of market practice and would prevent broker-dealers from providing price 

improvement to retail investors. 

With respect to market practice, trading within d,e quoted spread has always been permitted. Before 

Regulation NMS and before the establishment of the stock exchanges themselves, market participants have 

always been able to meet in the middle on a negotiation over price. This includes periods when stocks were 

still traded in fractions instead of decimals (e.<~., l/Sths of a dollar, instead of the current penny pricing). It is 

difficult to understand how such an alteration in market practice would facilitate the goal of increasing 

2 
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liquidity for small-cap and mid-cap issuers. To our knowledge, there is no evidence to suggest that the goal 

of a tick size pilot to increase liquidity would be advanced by prohibiting trading within the wider quoting 

increments. 

Perhaps more importandy, a trading restriction would have a negative impact on Main Street savers 

and retail investors. A consensus of most every market structure panel discussion or roundtable in recent 

months is that it has never been better to be a retail investor, as the options for routing trades have increased 

and as a result, trading costs have substantially decreased. Trading inside the spread allows broker-dealers to 

provide price substantial improvement at pricing increments within the established quoting increments. This 

happens routinely today when investors' trades are e.xecuted in non-exchange venues, allowing investors to 

"buy lower" and "sell higher" than they would otherwise. Just a few years ago, the SEC considered and 

rejected a trading restriction when it adopted the current penny-wide quoting increment, concluding tbat sucb 

price improvement benefits retail investors and is in the public interest. At that rime, tile SEC determined 

tbat trading in sub-penny increments does not raise the same concerns as sub-penny quoting, that sub-penny 

executions do not decrease depth at tile posted quote (i.e .. do not reduce liquidity), and that suh-penny 

executious due to price improvement are generally beneficial to retail investors. 111e SEC's conclusion that it 

is in the public interest to allow trading \\~thin the spread is as relevant in 2013 as it was in 2005. 

As with any market, free and open competition among trading venues has created pricing efficiencies 

for the end user - here, tbe retail investor - who benefits direcdy from lower trading costs. We are 

concerned that a restriction on trading increments would tilt the playing field in favor of certain venues over 

others, impair the robust competitiveness of this market, and accordingly, elin1inate those price improvement 

opportunities that broker-dealers currendy give their customers. 

In addition, for any possible pilot program to be a success, it is critical to establish clearly stated 

metrics for use in evaluating tile results of the pilot. And while SIFMA generally supports a pilot for 

widening quoting increments in small and mid cap securities, ideally we would like to see such a study take 

place as part of a broader review of U.S. market structure. Such a review should include the regulatory 

structure around exchange and off-exchange trading venues, the future of self-regulation, and a consideration 

of whether the comparative regulatory benefits and obligations facing exchanges and broker-dealers should 

be adjusted to reflect today's market realities. As SEC Commissioner Gallagher has noted at SIFMA's 

previous two market structure conferences, this review should have "no sacred cows." 

Business Development Company Regulation (H.R. 31, H.R.1800 and H.R. 1973) 

SIFMA supports efforts to modernize regulation of Business Development Compauies (RDCs) as 

contemplated in the three bills we are discussing today. Since their creation, BDCs have been subject to 

3 
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regulation under the Investment Company Act of 1940 subjecting them to certain statutory safeguards 

covering such areas as diversification, leverage, compliance and valuation. The BDC structure was created to 

promote public vehicles as a means to bring capital to small and medium sized businesses and by regulation, 

70% of BDCs investments must be in ptivate or small cap companies. 

The JOBs Act provided for an onramp for Emerging Grov.'lh Companies (EGCs) to access the IPO 

market and has also created a framework for crowdfunding to bring capital to early stage entrepreneurs in 

much srnaller increments. !vfoee can be done, however, to promote the flow of capital to private companies 

that are big enough to need larger amounts of capital to reach the next stage of their development but are still 

years away from an IPO. nDCs offer one such critical source of capital to eligible companies. BDC's have 

been active issuers in the last few years as they see opportuniry to bring funds to attractive companies that arc 

struggling to find capital at a reasonable cost from other sources. 

Unfortunately much of the modernization of securities regulation that occurred in 2005 by way of 

Securities Offering Reform largely did not apply to BDCs. As a result, SIFMA believes that many 

unnecessary obstacles remain in place today so that BDCs are unable to efficiently access the markets and, in 

turn, provide much needed capital to middle market companies. We support efforts to aligu regulation for 

nDCs more closely with tllat of other puhlic companies. 

Since most BDCs are tax RICs (Regulated Investment Companies) and as a result are required to 

dividend out substantially all of their net income for tax purposes, BDCs are required to come to the public 

markets more regularly to raise capital in order to grow. The inability to utilize some of tl,e built- in 

efficiencies in securities regulation for frequent corporate issuers, such as incorporating previously filed 

infotn1ation by reference, creates unnecessary burdens. Moreover, since nDCs are generally unable to sell 

their shares below NAV (absent a shareholder vote among other things), they are even more sensitive to the 

need to access markets when conditions arc favorable and so the inability for larger BDCs to qualify as Wellknown Seasoned Issuer (\VKSls) and realize the benefits of automatically effective registration statements is 

also harmful. These types of hurdles inlpede BDCs in their mission to bringing much needed capital to the 

middle markets in a cost effective and efficient manner. 

Lastly, SIFMA believes some incremental flexibility in the asset coverage ratio should be provided to 

BDCs to allow them to better fulfill their mission while at the same time maintaining sufficient safeguards to 

protect investors such as enhanced disclosure requirements, capital structure limitations, corporate 

governance and compliance requirements, affiliate transaction limitations and restrictions on leverage, all of 

which are applicahle to BDCs by virtue of their being subject to compliance with the '40 Act and which are 

incremental to the safeguards applicable to other public companies. 

4 
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Emerging Growth Company Discussion Draft (Rep. Fincher) 

Congressman Fincher's discussion draft which would modify existing regulation of EGCs is also 

laudable and SIFMA supports each of the four provisions in the discussion draft. 

Section 1 amends the Securities Act of 1933 to reduce the quiet period requirements from 21 days to 

5 days for public filing prior to public offerings by EGC's. Currently, an BGC must file its registration 

statement publicly and must refrain from marketing the securities through its underwriters or otherwise for 

21 days. In theory, this requirement allows for the dissemination, access and review of such information 

across the broader marketplace before a broker-dealer begins to actively market and solicit orders. In our 

experience however, this 21-day period is excessively long given the ready online access the public now 

possesses to such filings. 11,e volatility in our markets can narrow the window of opportunity for an IPQ to 

launch and price successfillly and a 21-day quiet period inordinately and unnecessarily restricts an BGC's 

ability to come to market in a timely manner. We support a significant reduction in the quiet period as 

contemplated in the bill. 

Sections 2 and 3 of the Discussion Draft add clarity and efficiency to two areas of securities 

regulation without impairing investor protection. Section 2 prO\~des a grace period for a change in status of 

an EGC by allo"'~ng an issuer that qualifies as an EGC at the time of the filing of its confidential registration 

statement for review to continue to be treated as an EGC through the date on which it conswnmates its 

initial public offering. The limitation of the current regulatory construction, which would require the issuer to 

qualify as an EGC both at the time of confidential submission of the registration statement and at the time 

the registration statement is publicly flIed, risks disincentivizing fast growing companies that could grow out 

of EGC status in the months required to essentially complete SEC review and make public the registration 

statement - despite having started the process with the SEC as an EGe. 

Section 3 is designed to simplify the financial statement disclosure requirements for EGC's, 

Currently an BGC must include the previous two years of audited fmancials when it flies its registration 

statement for review. The time required for SEC review could however cause the EGC to roll into a new 

fiscal year before it launches its IPO, and as such the relevant two-year period may change. For example, an 

EGC may f1le its registration statement in the third or fourth quarter of 2013, and accordingly include in tllat 

filing full audited financial statements (and related Management Discussion and Analysis) for 2011 and 2012. 

If, however, the IPQ does not launch until 2014, the 2011 audited fmanci.1 statements generally would no 

longer be required for the offering. The cost and effort to create audited fmancial statements (and related 

narrative disclosures) for IPO issuers are significant, and is an entirely unnecessary burden for thetn where 

those financial statements will not be required to be included in a preliminary prospectus or fmal prospectus 

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distributed to investors. It is our understanding that other securities regulators (for example, the UK FSA) 

currently permit tl,e suggested approach. 

The last provision in ilie bill extends the ability for EGC's to fue a confidential registration statement 

not only for their initial public offering but also for a follow-on offering. The JOBS Act provided this 

confidential filing with a recognition iliat EGC's do not want to make proprietary information public too 

early or otherwise prematurely disclose tl,eir intention to make an offering-and thereby inlpair their 

competitive standing if there is risk that market dynamics or the tinle required for SEC review may force 

them to delay (or abandon) an offering. The new provision extends that same reasoning to follow-on 

offerings so that EGC's are able to derive a sin,ilar benefit for those offerings and thus encourage them to 

engage in further capital raising or sales on behalf of their founding investors. 

Conclusion 

SIFMA welcomes your continued interest in supporting capital formation through appropriate 

regulatory relief. Many in government often try to distinguish Main Street from Wall Street but the capital 

allocation function provided by my Memphis, Tennessee finn and thousands of otl,ers across tills country 

supports the creation and expansion of tens of tllOusands of small businesses who are truly the backbone of 

our economy and the best hope we have for robust job creation moving forward. Again referring to 

Commissioner Gallagher's quote that there should be no sacred cows as we evaluate how our markets have 

evolved and what more can be done to inlprove tI,eir function, SIFMA strongly supports ti,e work of this 

Committee to facilitate capital formation and create jobs and we look forward to continued constructi,-e 

engagement throughout tI,is process. 

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October 22, 2013 

The Honorable Scott Garrett 

Chairman 

House Financial Services Committee 

Capital Markets & Government 

Sponsored Enterprises Subcommittee 

Washington, D.C. 20515 

1001 PENNSYLVANIA AVE., NW 

SUITE 500 SOUTH 

WASHINGTON, DC 20004 

TEL 202-289-4322 

FAX 202-628-2455 

The Honorable Carolyn Maloney 

Ranking Member 

House Financial Services Committee 

Capital Markets & Government 

Sponsored Enterprises Subcommittee 

Washington, D.C. 20515 

Dear Chairman Garrett and Ranking Member Maloney: 

The Financial Services Roundtable is writing to express our support of the "Next Steps for Credit 

Availability Act (H.R. 31)"; "Small Business Credit Availability Act (H.R. 1800)"; and the "Business 

Development Company Modernization Act (H.R. 1973}." These bills will make it easier for Business 

Development Companies (BDC) to lend to small and mid-sized businesses. BDC's are designed to 

facilitate capital formation for small and middle-market companies. BDC's playa vital role in funding 

the businesses that keep the economy stimulated. 

We request your support in moving these bills forward. 

Please contact me at 202 589-2416 if you have any questions. 

Best Regards, 

Scott Talbott 

Senior Vice President of Public Policy 

Financial Services Roundtable 
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Testimony Submitted by Joseph Ferraro, 

General Counsel, Prospect Capital Corporation 

before 

The House Subcommittee on Capital Markets 

and Government Sponsored Enterprises 

on 

"Legislation to Further Reduce Impediments to Capital FormationOctober 23, 2013 

Mr. Chairman, Ranking Member Maloney, and Members of the Committee, thank you for 

the opportunity to submit this written testimony. My name is joseph Ferraro and I am 

General Counsel to Prospect Capital, a leading provider of capital to job-creating small and 

medium-sized companies in the United States. 

Prospect is a publicly-traded business development company, or BDC. Our company 

completed its initial public offering in july 2004, and since then we have invested more 

than $5.5 billion in over 175 small and medium-sized companies to expand their 

businesses, hire workers, construct factories, and achieve other important objectives. Our 

capital has helped create thousands of American jobs over the years, and our capital is 

much needed in this critical period of high unemployment and economic uncertainty. 

In 1980, Congress enacted amendments to the Investment Company Act of 1940 

authorizing BDCs to facilitate financing of small and medium-sized businesses. Deciding 

which of these businesses to finance requires rigorous credit analysis and significant and 

time consuming due diligence. These activities are uneconomical for traditional banks to 

perform and involve transaction sizes too small for many other capital providers. 

Put simply, a BDC is a lender to and investor in small and medium-sized businesses that 

might not otherwise receive financing. 

As I testified in june of this year, our industry believes that modest changes to our 

securities laws can greatly enhance the ability of BDCs to serve the capital needs of small 

and medium-sized companies without undermining investor protections. These changes 

have been recommended by bills introduced by Representatives Mulvaney, Velazquez, and 

Grimm. 

While my june testimony described in some detail the benefits of each of these measures, 

today I want to focus on H.R. 1973. 

Under current law a BDC must invest at least 70% of its assets in so-called "eligible assets" 

- namely public micro-cap and private companies. But current law excludes financial 

services companies from qualifying as "eligible portfolio companies." Thus, no more than 

30% of a BDC's assets can be invested in financial services companies. 

10 East 40th Street. 44th Floor New York. NY 10016. Tel 212-448-0702. Fax 212-448-9652 • www.prospectstreet.com 
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2 

This outdated limitation makes no sense. The financial services sector encompasses a wide 

array of companies including community banks, leasing companies, factoring firms, and 

automobile financing companies. BDC investments in small- to medium-sized American 

financial services businesses are consistent with the principal purpose for which Congress 

created BDCs - to provide capital and assistance to small, developing businesses that are 

seeking to expand and create American jobs. The law should not artificially limit a BDC's 

ability to provide capital to such companies. H.R. 1973 would remove this artificial 30% 

cap on these types of investments. 

In its October 21, 2013 letter to Chairman Garrett and Ranking Member Maloney, the SEC 

has raised two concerns regarding the scope of H.R. 1973. Specifically, the SEC raised 

concerns that removing the cap on investments in private equity and hedge fund 

investments could allow a BDC to become a conduit for non-accredited retail investors to 

invest in such financial entities. The Committee can address such concerns by tightening 

the language in H.R. 1973 to retain the existing law limitations on such investments 

contained in paragraphs (1) and (7) of section 3(c) of the Investment Company Act of 1940. 

This modification to H.R. 1973 would fully address the SEC's concerns while retaining the 

general intent of the legislation. 

Additionally, in explaining its understanding of the original purpose for excluding financial 

service entities from the definition of "eligible portfolio company", the SEC generally 

paraphrases the legislative history behind the 1980 amendments to the Investment 

Company Act of 1940 creating BDCs. The SEC describes this limitation as "intended to 

encourage a BDC to focus its investment activities on operating companies that directly 

produce goods or provide services rather than on other financial institutions that serve 

primarily as conduits of capital." Thirty-three years later, many of the investments that 

H.R. 1973 would treat as eligible investments are not mere passive "conduits of capital", 

but rather are themselves active, developing and expanding small- and middle-market 

companies that provide an array of critical services to other small- and middle-market 

companies - exactly the kind of "operating companies" in need of the small business 

investment BDCs are incentivized to provide. Thus, the changes recommended by H.R. 

1973 are consistent with the BDC mission of making capital available to small and middlemarket companies. 

Lastly, I want to address a misunderstanding about how BDCs raise and deploy capital. 

Any suggestion that if a BDC were to make larger investments in financial service 

companies it would have fewer assets to invest in other types of companies presumes that 

a BDC has a finite amount of capital to deploy. That is simply not the case. BDCs regularly 

raise capital in the markets and look for opportunities to make new investments. It is the 

availability of quality investments that dictate how much capital a BDC can raise and invest. 

Thus, expanding the pool of eligible investments does not mean a BDC will merely 

reallocate or divert existing capital. Instead, enacting H.R. 1973 means BDCs will be able to 

expand capital access to the very companies that BDCs were created to serve. 

Again, we appreciate the Committee's consideration of legislation to reduce impediments 

to capital formation. We believe that modernizing the rules that govern BDCs will help to 

expand capital access for small and middle-market companies. 
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<> Reflexite 

AN ORAFOL COMPANY 

The Honorable Elizabeth Esty 

509 Cannon House Office Building 

Washington, O.c. 20515 

Dear Representative Esty: 

Reflexite Technology Center 

120 Darling Drive 

Avon, CT 06001-4217 USA 

860676-7100, fax 860 676-7155 

www.reflexite.com 

Michael F. Foley, PhD 

President and CEO 

I am writing this letter in support ofthe BOC model as a means for raising funds to support the capital 

needs of middle market growth companies. I was an executive at Reflexite Corporation (in Avon, CT) for 

the last 16 years, most recently serving as the CEO until my retirement this year. Reflexite produces 

optical components and films for Safety, Lighting, Instrumentation, and Display Markets. You may not 

have heard of our company, which was on track to sell $180M in product this year, but you would 

certainly know our products. For instance, we make friend or foe 10's for the US military, diffusers for 

more energy efficient lighting systems, lens arrays for solar power generation, and traffic control 

products for nighttime safety on our roads. Before we sold the company in 2011, we were an employee 

owned company and were named one of the Wall Street Journal's Top 15 Small Workplaces in America 

in 2007. 

There are times when companies need to raise money away from the limitations of traditional senior 

debt providers or private equity firms. In our case, Reflexite needed to raise capital to facilitate the 

buyout of my predecessor and to grow new product lines. Traditional bank sources were not a good fit 

as their proposed capital was inflexible, they had low tolerance for risk as we grew new businesses, and 

they could not meet the size ofthe capital commitment we needed. Similarly, private equity sources 

were not a good match as they wanted to be able force liquidity within a certain time frame. This is 

fundamentally incompatible with a private company who wishes to preserve autonomy and to invest in 

growth. Our company was majority owned by its employees and our shareholders enjoyed a return in 

excess of 12% compounded over the last 30 years. We did not want to sell the company until we felt it 

was ready, which was on our own timetable, not one that was provided by our bankers. 

The BOC model is one of "permanent capital" because the money is raised on the public market there 

is no fixed timeframe for liquidity. And because BOC's distribute the profits of their companies back to 

shareholders as dividends, BOC's present an attractive alternative for value/long term/fixed income 

investors who don't want to see their returns compromised by short term thinking. Ares Capital became 

our partner and offered many advantages beSides a long term orientation. A number of senior 

executives of Ares spt on our Board of Directors and provided invaluable strategic advice and counsel as 

our firm grew and changed. 
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86681.143

We did eventually sell the company, when we got to a point where we needed to be part of an even 

bigger company to continue to succeed in the marketplace. But in the meantime, we enabled the 

American dream for many in our workforce, the vast majority of whom are still employed with the 

company years after the sale. Many of our hourly factory floor workers retired with stock accounts 

worth more than $1 million. I can honestly say that we could not have achieved our success without the 

help from Ares Capital and the BOC model. 

Sincerely, 

REFLEXITE CORPORATION 

M~~i% President and CEO (retired) 

cc: 

The Honorable Jeb Hansarling 

Chairman 

Subcommittee on Capital Markets and Government Sponsored Enterprises 

U.S. House of Representatives 

Washington, DC 20515 

The Honorable Maxine Waters 

Ranking Member 

Subcommittee on Capital Markets and Government Sponsored Enterprises 

U.s. House of Representatives 

Washington, DC 20515 
185 


86681.144

The Honorable Scott Garrett 

Chairman 

House Financial Services Subcommittee 

on Capital Markets and GSEs 

2129 Rayburn House Office Building 

Washington, D.C. 20515 

October 23, 2013 

The Honorable Carolyn Maloney 

Ranking Member 

House Financial Services Subcommittee 

on Capital Markets and GSEs 

B301C Rayburn House Office Building 

Washington, D.C. 20515 

Dear Chairman Garrett, Ranking Member Maloney, and Members of the Subcommittee, 

On behalf oflhe Small Busiuess Investor Alliance (SBIA), the nation's premier organiz.ation oflower 

middle market investors, thank you for holding this hearing to consider "Legislation to Further Reduce 

Impediments to Capital Formation." We appreciate the opportunity to make our comments available to 

the Committee as part of the hearing record. 

SBIA has examined the regulatory landscape for BDCs and concluded that the current regime hinders, not 

promotes, healthy and competitive private markets for small businesses accessing capital. Current BDC 

regulations are outdated and unnecessarily burdensome - making the BDC capital raising process less 

flexible, less efficient, and more expensive than necessary. This lack of modernization particularly hurts 

smaller BDCs investing in smaller businesses. The SBIA supports the reforms in H.R. 1800 and H.R. 31 

and we look forward to working with the Committee to make any improvements stemming from this 

hearing in preparation for a markup. The SBIA believes elements ofH.R. 1973 would improve current 

law, but we have concerns about negative consequences relating to some of the language. We would 

welcome the opportunity to work with the Committee to make needed improvements to the bill prior to a 

mark up. 

The SBIA spearheaded a letter' to the Securities and Exchange Commission (SEC) on October 7, 2013, 

requesting the modernization ofBDC regulations and the opportunity to discuss policy changes affecting 

the asset coverage ratio. 24 BDCs signed the letter, representing almost half of the BDCs in the 

marketplace today. We again attach this letter because it clearly defines specific problems facing small 

business investors and outlines our support for the regulatory modernizations included in H.R. 31 and 

H.R. 1800. These commonsense reforms, most of which should have been corrected in 2005 when the 

SEC adopted final rules related to Securities Offering Reform, would streamline the registration and 

1 Petitions for Rulemaking Submitted to the SEC; File No. 4-667; Request for rulemaking to modernize the 

regulations of Business Development Companies; Submitted by Brett Palmer, Small Business Investor Alliance; 

October 7, 2013. 
186 


86681.145

offering process by allowing BOCs to incorporate already filed information by reference; allowing BOCs 

to obtain well-known seasoned issuer status; permitting BDCs to use free writing prospectuses; and 

allowing BDCs to pre-file shelf registration statements for continuous or delayed offerings. We know of 

no objections to these reforms. Even the Chair of the SEC, Commissioner White, wrote in her letter to 

this Committee on October 21,2013 that the regulatory modernization provisions contained in H.R. 31 

and H.R. 1800 "do not raise significant investor protection concerns." However, without Congressional 

action we do not believe that the SEC will make any reforms, even these reforms that would ultimately 

benefit small businesses. 

Chairwoman White's letter to the Committee expressed her concerns about potential changes to the asset 

coverage ratio. However she does not mention that, even the most strident critics of changing the asset 

coverage ratio believe there may be certain circumstances where greater flexibility under the asset 

coverage ratio might be appropriate. We encourage the SEC to seriously consider the BDC industry's 

request to discuss proposals to prudently modifY the asset coverage ratio instead of dismissing the issue 

without discussion. The SBIA supports the bills but also has viable alternatives worthy of discussion and 

would welcome the opportunity to work with the Committee and the SEC to consider all options for 

providing prudent flexibility for the asset coverage ratio. 

H.R. 31, H.R. 1800, and H.R. 1973 all would allow BDCs to own investment advisers. Since passage of 

Dodd-Frank, several BDCs have sought and received exemptive relief to own registered investment 

advisers subject to certain conditions. Each exemptive application requires a BOC to prepare an 

individualized filing, typically with the assistance of legal counsel, to be made to the SEC. Upon receipt 

of the BDC's filing, the SEC may take months or even years to grant the requested relief. Adopting this 

provision would level the playing field between the BDCs who have received exemptive relief and those 

that are in the process of attempting to obtain such relief. 

The "eligible portfolio company" provision ofH.R. 1973, as currently written, is major change that is 

overly broad that will have adverse effects on the BDC industry if adopted in its current fonn. We stand 

ready to help the Committee correct this language in order to prudently expand the eligible portfolio 

company definition. 

Thank you again for holding this important hearing and we look forward to working with you to reduce 

regulatory barriers to capital formation. 

Sincerely, 

Brett Palmer 

President 

Small Business Investor Alliance 
187 


86681.146

Octqber 7,2013 

The Honorable Mary 10 White 

Chairwoman 

U.S. Securities and Exchange Commission 

100 F Street, NE 

Washington, DC 20549 

Dear Commissioner White: 

As an industry we formally request that the SEC modernize the regulatory burdens on Business 

Development Companies. 

Business Development Companies (BDCs) were created by Congress in 1980 to encourage the 

establishment of public vehicles to increase the flow of capital to small, growing U.S. businesses, 

a critical component of the U.S. economy. BDCs make direct investments in smaller, developing 

American businesses thereby providing access to capital to the middle market that is not 

otherwise available through traditional funding sources such as banks or the public equity capital 

markets. Despite the critical role BDCs perform, current BDC regulation has made it extremely 

difficult for BDCs to deliver on their mission to fund small and medium sized small businesses 

starved of growth capital. 

Rationalizing BDC regulations will support American jobs and foster economic growth by 

improving access to the public capital markets for BDCs to invest in emerging growth 

companies. By any standard, BDCs provide more disclosure and are subject to more regulation 

than other traditional public companies. The current restrictions on BDCs make the capital 

raising process for BDCs less flexible, less efficient, and more expensive than necessary- which 

ultimately reduces each BDC's ability to invest in growing U.S. businesses. 

In late 2005, the SEC adopted final rules relating to Securities Offering Reform, which were the 

most sweeping liberalization and modernization of the registered offering process under the 1933 

Act in decades. The majority of these updates did not apply to BDCs. At the time the rule 

revisions were implemented, the Commission promised to consider reforms for BDCs at a later 

date - this never happened. Consequently BDCs have been left behind on an uneven playing field 

with other public companies seeking to access the capital markets. 

Despite this arcane regulatory framework, the number ofBDCs operating today has more than 

doubled since Securities Offering Reform was enacted, and over that time the industry has 

invested billions of dollars into growing U.S. businesses, thus creating or supporting thousands 

of U.S. jobs. This alone demonstrates the significant demand for growth capital that BDCs are 

filling - but much more could be accomplished. With a modem regulatory framework, the BDC 

industry could further expand, fill the market demand, and provide billions more in growth 

capital to small and medium-sized businesses. 

We formally ask the SEC to modernize the regulation ofBDCs. The BDC industry respectfully 

requests the following: 
188 


86681.147

• Include BDC regulatory modernization as a major agenda item of the SEC's Forum on Small 

Business Capital Formation this November and in future years. 

• Take formal action to modernize how BDCs raise capital by making applicable to BDCs the 

rules that apply to traditional public companies, specifically: 

o Allow BDCs to incorporate already-filed information by reference into current 

registration statements with the Commission as other public companies do; 

o Allow BDCs to file automatic shelf registration statements and therefore be afforded 

ready access to the capital markets by permitting qualification for BDCs under the 

definition of "Well-Known Seasoned Issuer" (WKSI) as other public companies do; 

o Permit BDCs to release factual and forward-looking business information by using 

free-writing prospectuses, as other public companies do; 

o Allow BDCs to communicate with investors more freely during the preparation and 

filing periods for a registration statement, as other public companies do; 

o Allow broker-dealers and other providers of market research more flexibility to 

disseminate research, thereby providing more information to the market and 

shareholders; 

o Provide a safe harbor to BDCs for disseminating additional information during an 

offering, as other public companies do; 

o Allow a BDC to file a shelf registration statement for continuous or delayed offerings 

on the same form used by other public companies; 

o Synchronize BDC prospectus filing requirements with those of other public 

companies, which Congress contemplated in 1980 when the BDC model was 

created; 

o Provide regulatory parity by relieving BDCs of the requirement to provide written 

confirmations of sales, notifications of allocation. and deliveries of securities; and 

o Allow preferred stock to be treated as equity, not debt. 

• We believe that BDCs should be permitted to own or acquire securities or other interests in 

registered investment advisers or other advisers to investment companies. This 1940 Act 

prohibition serves no obvious policy purpose. In fact, the Commission has routinely provided 

exemptive relief to BDCs to permit the ownership of investment advisers in the last several 

years. Formalization of this position would permit BDCs more flexibility in their business 

models and structures without changing the important policy protections of the 1940 Act. 

• BOCs are significantly limited as to their use of borrowings such that they may not excced a 

1-to-1 debt to equity ratio. We believe there may be circumstances under which greater 

flexibility might be appropriate. The Commission should immediately engage the BOC 

industry to review and propose changes to the asset coverage ratio under which BDCs must 

operate, specifically focusing on the benefits of a modest reduction in such ratio and any 

appropriate market safeguards that should be required. 

We ask for your prompt consideration of these matters. Please contact Brett Palmer, President, 

Small Business Investor Alliance, regarding the Commission's response to this letter. Mr. 

Palmer can be contacted by mail at 1100 H St., NW, Suite 610, Washington, OC 20005; by 

phone at (202) 628-5055; or by email at bpalmer@sbia.org. 
189 


86681.148

Sincerely, 

Curtis Hartman 

SBIA, BDC Committee Chairman 

Senior Managing Director and 

Chief Credit Officer 

Main Street Capital Corporation 

Lawrence E. Golub 

Chief Executive Officcr 

Golub Capital 

Todd Huskinson 

Chief Financial Officer 

Stellus Capital Investment Corporation 

Steven C. Lilly 

Chief Financial Officer 

Triangle Capital Corporation 

Alvin Murstein 

Chairman and Chief Executive Officer 

Medallion Financial Corp. 

Brook Taube 

Chairman and CEO 

Medley Capital Corporation 

Steve Gardner 

President and CEO 

NGP Capital Resources Company 

Howard Levkowitz 

Chairman and CEO 

TCP Capital Corp. 

David Gladstone 

Chairman and CEO 

Gladstone Investment Corporation 

Gladstone Capital Corporation 

Manuel A. Henriquez 

Chairman and CEO 

Hercules Technology Growth Capital, Inc. 

Theodore L. Koenig 

Chainnan and CEO 

Monroe Capital 

B. Hagen Saville 

President and CEO 

MCG Capital Corporation 

James K. Hunt 

Chairman and CEO 

THL Credit, Inc. 

Bernard D. Berman 

President 

Fifth Street Finance Corp. and Fifth Street 

Senior Floating Rate Corp. 

Timothy J. Keating 

Chairman and CEO 

Keating Capital, Inc. 

Robert A. Hamwee 

President and CEO 

New Mountain Finance Corporation 
190 


86681.149

Allen F. "Pete" Grum 

President and CEO 

Rand Capital Corporation 

Edward H. Ross 

Chairman and CEO 

Fidus Investment Corporation 

Art Penn 

Chief Executive Officer 

PennantPark Investment Corporation and 

PennantPark Floating Rate Capital 

Christian L. Oberbeck 

Chairman and CEO 

Saratoga Investment Corp. 

cc: 

Douglas W. Jamison 

Chairman and CEO 

Harris & Harris Group, Inc. 

Brian Chase 

Chief Financial Officer 

Garrison Capital Inc. 

Nicholas Radesca 

Chief Financial Officer 

Business Development Corporation of 

America 

Joseph B. Alala, III 

President and CEO 

Capitala Investment Advisors, LLC 

The Honorable Luis A. Aguilar, U.S. Securities and Exchange Commissioner 

The Honorable Daniel M. Gallagher, U.S. Securities and Exchange Commissioner 

The Honorable Kara M. Stein, U.S. Securities and Exchange Commissioner 

The Honorable Michael S. Piwowar, U.S. Securities and Exchange Commissioner 

The Honorable Jeb Hensarling, Chairman, U.S. House Committee on Financial Services 

The Honorable Maxine Waters, Ranking Member, U.S. House Committee on Financial Services 

The Honorable Tim Johnson, Chairman, U.S. Senate Committee on Banking, Housing and 

Urban Development 

The Honorable Mike Crapo, Ranking Member, U.S. Senate Committee on Banking, Housing and 

Urban Development 
191 


86681.150

UNITED STATES 

SECURITIES AND EXCHANGE COMMISSION 

WASHINGTON, D.C. 20549 

THE: CHAIR: 

The Honorable Scott Garrett 

Chairman 

Subcommittee on Capital Markets and 

Government Sponsored Entcrprises 

U.S. House of Representatives 

Washington, DC 20515 

October 21,2013 

The Honorable Carolyn Maloney 

Ranking Member 

Subcommittee on Capital Markets and 

Government Sponsored Enterprises 

U.S. House of Representatives 

Washin!,>ton, DC 20515 

Dear Chairman Garrett and Ranking Member Maloney: 

I understand that the Capital Markets Subcommittee of the House Financial Services 

Committee will be discussing at an upcoming legislative hearing three bills that would amend 

provisions of the Investment Company Act of 1940 (Act) concerning business development 

companies (BDCs): H.R. 31 (the Next Steps for Credit Availability Act); H.R. 1800 (the Small 

Business Credit Availability Act); and H.R. 1973 (the Business Development Company 

Modernization Act). I wTite to briefly provide background on BDCs and to draw your attention 

to certain features of these bills. Please note that the views expressed in this letter are my own 

and do not necessarily reflect the views of the full Commission or any Commissioner. 

As of June 30, 2013, there were 68 active HDCs with aggregate total assets of $53.7 

billion. While BDCs account for a small percentage of the asscts managed by all regulated 

investment companies, assets managed by HDCs have grown rapidly over the past decade from 

net assets of just $5 billion at the end of2003. Much of this growth is from newly organized 

HDCs sponsored by large private capital managers. Most HDCs sell a fixed number of shares in 

periodic offerings and most (about 85%) provide investors with liquidity by listing their shares 

on a stock exchange. Significantly, most securities issued by HDCs, whether traded or not, are 

held by retail investors. 

Congress created BDCs in 1980 as a specialized type of closed-end investment company 

(i.e., a fund that is not required to repurchase or redeem its securities) whose principal activities 

consist of investing in, and providing managerial assistance to, small, growing, or tinancially 

troubled domestic businesses. To this end, the Act generally requires a BDC to invest at least 

70% of its portfolio assets in cash (or high quality, short-term debt securitics), securities issued 

by financially troubled businesses, Of certain securities issued by domestic companies that: 

• do not have a security listed on a national securities exchange (i.e., are private 

companies), or have a security listed on a national securities exchange but have less 

than $250 million of common shares outstanding; 

• are not investment companies; and 
192 


86681.151

The Honorable Scott Garrett 

The Honorable Carolyn Maloney 

Page 2 

• would not be investment companies but for an exclusion from the definition of 

"investment company" in section 3(c) of the Act. 

The remaining 30010 of a BOC's portfolio assets are not limited by these investment restrictions 

and can be invested freely. 

Under the Act, BOCs enjoy greater operating flexibility than mutual funds or other 

closed-end funds. A BOC, for example, may issue long term options and warrants, may issue 

multiple classes of debt securities, and may issue approximately 50010 more debt securities as a 

percentage of capital than other investment companies. As discussed below, H.R. 31 and H.R. 

1800 would ease that regulatory structure by permitting a BOC to double its permitted 

borrowings and issue an unlimited amount of preferred stock, thereby increasing the risk of loss 

from such leverage for BOC shareholders and holders of senior securities issued by BOCs. 

H.R. 31 and H.R. 1800 

Both H.R. 31 and H.R. 1800 would amend section 61(a) of the Actto: (a) reduce the 

asset coverage for senior securities representing indebtedness from 200% to 150%; and (b) make 

inapplicable the 200% asset coverage requirement for senior securities that are stock, t e., 

preferred stock, and other provisions of the Act intended to protect holders of preferred stock. I In 

my view, this increase in the ability ofBOCs to use leverage, and the elimination of provisions 

of the Act intended to protect holders of preferred stock issued by a BOC, gives rise to investor 

protection concerns, particularly because most BOC shareholders are retail investors. 

The Act's asset coverage requirements exist for the protection of both a BOC's 

sharebolders on one hand and investors in its senior securities on the other.2 Leverage amplifies 

both negative and positive portfolio performance. As the percentage of a BOC's capital from 

senior securities increases, the greater is the amplification. Increased leverage increases earnings 

volatility. At the same time, the risk increases that the BOC will lack the resources to pay 

I Asset coverage is the ratio of total assets less liabilities other than senior securities to senior securities. The asset 

coverage requirement for senior securities issued by a BOC is 200%. For other closed-end funds, the asset coverage 

requirement is 300",1, for debt securities and 200",1, for preferred stock. An asset coverage of 300% is approximately 

equivalent to a debt to equity ratio of I :2; an asset coverage of 200% is approximately equivalent to a debt to equity 

ratio of 1:1. 

2 When Congress enacted the Act, the higbly capitalized and simplified capital structure that the Act imposes on 

investment companies was regarded as being of central importance to the protection of investors. Prior to 1940, the 

use of excessive leverage and complex capital structures by certain closed-end funds led to personal gain for insiders 

at the expense of public security holders. In some instances, debt and preferred stock sold to the public accounted 

for a disproportionate amount of a fund's capital, but common stock concentrated in the bands of insiders controlled 

the fund. AIthougb a fund's assets migbt be insufficient to liquidate the senior securities, insiders could induce the 

fund to pay distributions with respect to the common stock or repurchase common stock. See Investment Trusts and 

Investment Companies pt 3, H.R. Doc. No. 279, 76th Cong., 1st Sess. 1001, 1582-97 (1939). In this regard, section 

l(b) of the Act identifies "excessive borrowing and the issuance of excessive amounts of senior securities [i.e., 

preferred stock or debt securities]" as one of the principal abuses the Act was designed to address. 
193 


86681.152

The Honorable Scott Garrett 

The Honorable Carolyn Maloney 

Page 3 

promised interest or dividends, or the principal or liquidation preference, to the holders of its 

senior securities. 

The risk that a BDC will be unable to make timely payments to senior security holders is 

in my view, of particular concern in view of the illiquid types of investments that BDCs make. ' 

The asset coverage provisions act as a circuit breaker. If a BDC's asset coverage of its senior 

securities is less than 200% (after giving effect to the distribution, issuance or repurchase), the 

BDC may not make cash distributions to shareholders, issue additional senior securities, or 

repurchase common stock and must retain for the BDC's use cash that the BDC otherwise would 

pay to its shareholders as distributions.3 

Both H.R. 31 and H.R. 1800 would permit a BDC to significantly increase its leverage in 

two specific ways. First, the amendments to the Act proposed in those bills would reduce the 

asset coverage requirement for debt securities to 150% from 2000/0, thereby increasing the debt 

to equity ratio from approximately 1:1 to 2:1. By way of example, under current law, a BDC 

with $100 in equity could borrow $100 (equal to $200 total assets). If that BDC's assets lost 

50% of their value, its shareholders would experience a total loss on their equity investment. 

Reducing the required asset coverage to 150% would permit the same BDC to borrow $200, 

effectively doubling its leverage. A BDC's assets would only have to lose 33 1/3% of their value 

before exposing shareholders to a total loss of their investment. 

Second, the proposed amendments would allow a BDC to issue an unlimited amount of 

preferred stock, effectively eliminating the Act's limitations on leverage. Because the proposed 

amendments would treat the issuance of preferred stock as the equivalent of the issuance of 

common stock for purposes of calculating asset coverage, a BDC could increase its leverage by 

issuing preferred stock and thereby actually increase its capacity for issuing additional debt 

securities. 

Both H.R. 31 and H.R. 1800 also would eliminate all of the provisions in the Act 

specifically intended to protect the holders of preferred stock issued by a BDC.4 A potential 

, Debt securities issued by a BDC also provide that if: (a) asset coverage declines to less than )00".41 for one year 

then the holders of those securities have the right to elect a majority of the BDe's directors; or (b) asset coverage 

declines to less than 100% for 24 consecutive months then a default shall be deemed to have occurred. Failing to 

meet the asset coverage requirements, however, is not a violation of the Act, and the BDe is not forced to sell assets. 

• The Act provides that holders of preferred stock, voting separately as a class, are entitled to: (a) elect at least two 

directors at all times; (b) elect a majority of the directors if at any time dividends on the preferred stock have been in 

arrears for two full years; (c) approve or disapprove any plan of reorganization adversely affecting their interests; 

and (d) approve or disapprove certain other major corporate events, such as converting to a mutual fund format. 

These voting rights help balance the sometimes conflicting interests of the holders of the common stock and the 

holders of the preferred stock issued by the same fund. Under the Act, a BDC may not issue different classes of 

preferred stock, i.e., classes with different priorities as to the payment of dividends or liquidation preference. In 

liquidation, if the value of a BDC's assets is insufficient to satisfY the claims of all security holders, holders of a 

class with a higher priority have a clear advantage. Absent liquidation, that priority can influence the market value 

of a security, particularly during times when a particular BDe's prospects dim. Retail investors might find a junior 

class of preferred stock with a high dividend rate attractive but fail to appreciate the risks in the event that the BDC 
194 


86681.153

The Honorable Scott Garrett 

The Honorable Carolyn Maloney 

Page 4 

consequence is the sale to retail investors of preferred stock with a confusing mix of 

characteristics and rights. Under the Act, for example, preferred stock has "complete priority" 

over the common stock as to payment of dividends, and dividends are cumulative. This 

provision prohibits the sale of participating preferred stock or preferred stock that is preferred 

ouly as to assets in liquidation but not as to dividends. But for these provisions, holders of 

preferred stock could find that dividends not paid during lower earnings periods are never paid, 

even if the BDC subsequently prospers. 

The two bills also would: (a) amend section 60 of the Act to permit a BDC to purchase 

securities issued by registered investment advisers; and (b) direct the Commission to revise 

certain rules under the Securities Act of 1933 to put BDCs on parity with other issuers that are 

required to file certain reports under the Securities Exchange Act of 1934. In my view, these 

provisions do not raise significant investor protection concerns. 

H.R.1973 

By amending the Act's definition of "eligible portfolio company" to include currently 

excluded financial institutions, H.R. 1973 would change the definition and stated purpose of 

BDCs. The Act defines "business development company" as a closed-end fund that is "operated 

for the purpose of making investments in securities" issued by small or financially distressed 

companies, generally companies that meet the Act's definition of "eligible portfolio company." 

This definition requires that, with one exception,s an eligible portfolio company be neither an 

investment company, as defined in Act, nor a company that is excluded from the definition of 

investment company solely by section 3(c) of the Act, i.e., financial institutions such as hedge 

funds, private equity funds, brokers and consumer finance companies. The Act, however, does 

not prohibit a BOC from investing in financial institutions or other companies that are not 

eligible portfolio companies; under the Act, a BDC can invest up to 30% of its portfolio in 

securities issued by these companies . 

. The explicit exclusion of investment companies and other financial institutions from the 

definition of "eligible portfolio company" was intended to encourage a BDC to focus its 

investment activities on operating companies that directly produce goods or provide services 

rather than on other financial institutions that serve primarily as conduits of capital. Congress 

created BOCs in response to "the slowing of the flow of capital to American enterprise, 

particularly to smaller, growing businesses.,,6 To the extent that a BDC concentrates its 

experiences financial reversals. A BOC in financial distress, for example, might eliminate dividend payments to 

holders of a junior class of preferred stock but continue dividend payments to holders of a senior class. 

S The one exception allows an eligible portfolio company to be a small business investment company (SBIC) 

licensed by the Small Business Administration that is a wholly owned subsidiary of a BOC. A SBIC makes 

investments that are consistent with the purpose of BDCs. 

• H.R. Rep. No. 1341, 96th Cong., 2d Sess. 20 (1980). The House Report stales that "[tJhe importance of these 

businesses to the American economic system in terms ofinnovation, productivity, increased competition and the 

jobs they create is, of course, critical.» Id 
195 


86681.154

The Honorable Scott Garrett 

"tbe Honorable Carolyn Maloney 

Page 5 

investments in other financial institutions, it would divert capital from small, growing businesses 

that BDCs were originally created to help. 

While Congress obviously can choose to change the purpose ofBDCs in this manner, of 

particular concern is the prospect of a BDC concentrating its investments in hedge and other 

private funds because of the riskier strategies associated with some of these funds. This raises 

potential investor protection concerns, as it would allow non-accredited investors to invest in a 

BDC comprised entirely of private funds. As such, BDCs could be used to circumvent the 

general prohibition on selling interests in private funds to retail investors. 

I hope that this information is helpful to you and to the other members of the 

Subcommittee. Please do not hesitate to contact me at (202) 551-2010, or have your staff contact 

Tim Henseler, Director of the Office of Legislative and Intergovernmental Affairs, at (202) 551-

2015, if I can be of any further assistance. 

cc; Chairman Jeb Hensarling 

Ranking Member Maxine Waters 

Sincerely, 

~~w~ 

Mary Jo White 

Chair 
196 


86681.155

~ I 

313810thStreetNorth 

Arlington, VA 22201·2149 

P: 703.842.2234 

NAFCU ~~~~t~~;~~~.~;: National AssociatIon of Federal Credit Unions I www.nafcu,org 

October 22, 2013 

The Honorable Scott Garrett 

Chairman 

House Financial Services Subcommittee on 

Capital Markets & GSEs 

United States House ofRepl'esentatives 

Washington, D.C. 20515 

Carrie R. Hunt 

Senior Vice President of Government Affairs 

and General Counsel 

The Honorable Carolyn Maloney 

Ranking Member 

House Financial Services Subcommittee on 

Capital Markets & GSEs 

United States House of Representatives 

Washington, D.C. 20515 

Dear Chairman Garrett and Ranking Member Maloney: 

On behalf of the National Association of Federal Credit Unions (NAFCU), the only national 

trade association that exclusively represents the interests of our nation's federal credit unions, I 

write in conjunction with the subcommittee hearing being held tomorrow entitled, "Legislation 

to Further Reduce Impediments to Capital Formation." Credit unions and their 96 million 

members urge your additional consideration of legislation that would reduce impediments to 

capital for our nation's small businesses by allowing credit unions to better assist in lending 

efforts. 

As you know, there was a severe reduction in the availability of capital during the financial 

crisis. This credit crunch is still being felt by many small business owners today. As the economy 

recovers, credit unions continue to serve as an important resource for small businesses to obtain 

capital oftentimes in the cvent that they have been turned away from other financial service 

providers. While credit unions are equipped to help small businesses, their efforts, unfortunately, 

are severely hindered by the arbitrary credit union member business lending cap. This cap is 

denying mU'nation's small businesses all the tools they need to grow and spur economic activity 

such as job creation. With this in mind, Representatives Ed Royce and Carolyn McCarthy 

introduced bipartisan legislation, the Credit Union Small Business Jobs Creation Act of 2013 

(H.R. 688) to raise the arbitrary credit union member business lending cap. Both the Treasury 

Department and the National Credit Union Administration (NCUA) have signed-off on this 

proposal that would create johs without spending a single dime of taxpayer funds. 

Another impediment to credit unions providing much needed capital is their inability to access 

supplemental forms of capital. Under cunent law, a credit umon's net worth ratio is determined 

solely on the basis of retained earnings as a percentage of total assets. Because retained earnings 

often cannot keep pace with asset growth, otherwise healthy growth can dilute a credit union's 

regulatory capital ratio. Representatives Peter King and Brad Sherman have introduced 

bipm1isan legislation, the Capital Access for Small Businesses and Jobs Act of 2013 (H.R. 719), 

that would address this problem by authorizing the NCUA to allow credit unions to access 

supplemental forms of capital that do not alter then' cooperative nature. This wonld fi1l1her 

minimize the probability of credit union insolvency, ensure they are able to maximize lending to 

small busincsscs, and allow them to grow to rMet the needs of their members. 

NAFCU I Your Direct Connection to Education. Advocacy & Advancement 
197 


86681.156

We urge you and your colleagues to consider and support these two bipartisan commonsense 

legislative proposals. Enacting these bills would help reduce impediments to capital formation at 

our nation's small businesses. If you have any questions or require additional infOlmation, 

please contact me or Jillian Pevo, NAFCU's Director of Legislative Affairs, at 703-842-2836 or 

jpevo@nafcu.org. 

Sincerely, 

cc: Members of the House Financial Services Subcommittee on Capital Markets and GSEs 

o