FTC Staff Comment Before the Securities and Exchange Commission Concerning Proposed Changes in Regulations Governing Registration and Reporting Disclosure of Small Business Issuers

V920011
"~'
.•..••.. Co 	Sta-ff 	of 	the 	Bureau of 	Economics
deral 	Trade Commission·
on
. 	',,'
Proposed.Changes 	in Regulation$
of 	the Securities and Exchange Commission
.. Gov.erning Registration and Rept;)rting Disclosures	. ". ~.:'
of 	Small 	Business 	Issuers 	,. . 	.
"(File S7-4-92) 	.
.: . ,: . .' . .~: .,:' .
.... ":
'......•. : 	.
'; 	. ."	~>.'.
* This 	comment contains 	the views of 	the 	staff 	of 	the 	Bureau
of Economics 	of 	the Federal Trade Commission, 	and does 	not
purport 	to 	represent the views 	of 	the Commission or of 	any
individual Commissioner. 	Please contact 	staff 	economist 	John C.
Hilke at 	(202) 	326-3483 	if you have any questions 	regarding this
comment.

I. 	INTRODUCTION
The 	Securities 	and 	Exchange 	Commission 	("SEC") 	has 	requested
comments 	on 	several 	proposed changes 	in 	regulations 	governing
registration 	and 	reporting 	disclosures 	for 	small 	business
issuers. 1 The 	proposed changes 	relate 	to 	Regulation 	A and 	Rule
504 	of 	Regulation D under 	the 	Securities 	Exchange Act 	of 	1934.
The 	changes 	are 	intended 	to 	"facilitate capital 	raising 	by 	small
businesses 	and 	reduce 	the 	compliance burdens 	placed on 	these
companies 	by 	the 	Federal 	securities 	laws" 	while 	maintaining
investor 	protection. 2 The 	staff 	of 	the 	Bureau 	of 	Economics
("BE") 	of 	the 	Federal 	Trade 	Commission 	("Commission" 	or 	"FTC")
appreciates 	this 	opportunity 	to 	submit 	the 	following 	comment 	in
response 	to 	the 	SEC's 	request.
The 	proposed changes 	to 	Regulation A include: 	(1) 	allowing
small 	firms 	to 	"test 	the 	waters" 	by circulating a 	written
statement 	to 	gauge 	investor receptiveness 	prior 	to 	a 	possible
public 	offering; 	(2) 	adopting 	a 	revised 	disclosure 	form 	that 	is
1 57 	Fed. 	Reg. 	9768 	(March 	20, 	1992). 	"Comment 	is 	requested
on 	the 	impact 	of 	the 	proposals 	from 	the 	point 	of 	view of 	the
public, 	as 	well 	as 	the 	entities 	or persons 	making 	filings 	with
the 	Commission." 	"The Commission 	further 	requests 	comment 	on 	any
competitive 	burdens 	that 	may 	result 	from 	adoption of 	the
proposals." 	57 	Fed. 	Reg. 	at 	9777.
2 57 	Fed. 	Reg. 	at 	9768. 	Aside 	from 	a 	general 	interest 	in
reducing 	capital 	costs, 	the 	SEC believes 	that 	these 	measures 	may
be 	particularly 	important 	at 	the 	present 	time. 	The 	SEC 	notes
that 	small 	businesses, 	an extremely 	important 	source 	of 	economic
growth 	and 	innovation 	in 	the 	u.S. 	economy, 	may be 	experiencing
increased 	difficulties 	obtaining capital 	due 	to 	recent
disruptions 	in 	the 	banking 	system. 	57 	Fed. 	Reg. 	at 	9768-70.
1

already 	in use 	in many 	states; 	and 	(3) 	increasing 	the 	size 	of 	the
issue 	ceiling 	for 	the 	exemption 	from 	$1.5 	million 	to 	$5.0
million. 	The 	proposed 	revisions 	to 	Rule 	504 	of 	Regulation 	D
include: 	(1) 	removing 	advertising 	restrictions; 	and 	(2) 	removing
resale 	restrictions 	on 	independent 	investors 	who 	purchase 	these
securities.
The 	staff 	of 	the 	FTC 	believes 	that 	the 	proposed changes 	for
Regulation A offerings 	may 	improve 	the 	efficient 	functioning 	of
capital 	markets 	by 	reducing 	the 	costs 	to 	small 	businesses 	of
complying with 	Federal 	securities 	laws 	without 	introducing
significant 	new risks 	for 	investors. 	The 	changes 	proposed 	for
Rule 	504 	of 	Regulation 	D also 	are 	likely 	to 	reduce 	the 	costs 	of
offering this 	type 	of 	issue. 	In monitoring 	fraudulent 	activity,
assuming 	the 	proposals 	are 	adopted, 	the 	SEC may wish 	to 	conduct 	a
separate 	evaluation concerning Rule 	504 	issues 	to 	avoid 	the
possibility that 	reduced disclosure 	and more 	liberal 	resale 	of
these 	issues 	might 	allow 	an 	increase 	in 	fraudulent 	activity.
Finally, 	the 	staff 	of 	the 	FTC 	suggests 	that 	the 	SEC may wish 	to
consider 	indexing 	the 	ceilings 	for 	these 	regulations 	to 	obviate
the 	need 	to 	revise 	the 	ceilings 	repeatedly 	to 	take 	inflation 	into
account.
II. 	FTC STAFF ANALYSES AHD COHHEHTS
The 	FTC 	is 	charged by 	statute with preventing 	unfair methods
of 	competition 	and 	unfair 	or deceptive 	practices 	that 	harm
2

consumers. J The 	staff 	of 	the 	Commission provides, 	upon 	request,
comments 	to 	federal, 	state, 	and 	local 	legislatures 	and
administrative 	agencies 	on matters 	concerning competition 	and
consumer 	protection 	issues. 4 In 	addition, 	the 	staff 	of 	the
Commission monitors 	the 	truthfulness 	of 	advertising 	of 	goods 	and
services 	such 	as 	art 	work, 	rare 	coins, 	and precious 	metals, 	and
conducts 	investigations 	and 	recommends 	enforcement 	action 	against
possible 	deception where 	appropriate. 5 BE 	staff 	also 	has
prepared 	reports 	examining prospective 	benefits 	and 	costs 	of
various 	regulations 	affecting competition 	in capital 	markets 	and
investor welfare. 6
J 15 	U.S.C. 	S45.
4 Examples 	include: 	"Comment 	of 	the 	Staff 	of 	the 	Bureau 	of
Economics 	of 	the 	Federal 	Trade 	Commission 	in 	the 	Matter of
Advanced Television Systems 	and 	their 	Impact 	upon 	the 	Existing
Television Broadcast 	Service," 	MM 	Docket 	No. 	87-268, 	submitted 	to
the 	Federal 	Communication Commission, 	January 	31, 	1992; 	Comments
of 	the 	Division of 	Credit 	Practices 	of 	the 	Federal 	Trade
Commission Concerning Proposed Revision 	to 	Regulation 	Z, 	the
Implementing Regulation of 	the 	Truth 	in Lending Act, 	Regarding
Home 	Equity Lines 	of 	Credit," 	submitted to 	the 	Board of 	Governors
of 	the 	Federal 	Reserve 	System, 	February 	28, 	1992; 	and 	"Comments
of 	the 	Staff 	of 	the 	Bureau 	of 	Economics 	on Proposed Regulations
of 	the 	SEC Governing 	the 	Payment 	of 	Asset-Based 	Sales 	Loads 	by
Registered Open-End Management 	Investment 	Companies," 	File No 	S7
10-88 	(rule 	12b-1), 	submitted 	to 	the 	Securities 	and 	Exchange
Commission, 	September 	19, 	1988.
5 The 	Bureau 	of 	Consumer Protection of 	the 	FTC 	is
responsible 	for 	FTC 	investigative 	activity 	in 	this 	area.
6 	See Hilke, 	J., 	Minimum Duality Versus 	Disclosure
Regulations: 	State 	Regulation of 	Interstate Opened-End
Investment 	Company 	and Common Stock 	Issues, 	Washington, 	D.C.:
FTC, 	1987 	(revised 	and published as 	"Mandatory Government
Investment 	'Advice': 	The 	Effects 	on 	Investors 	of 	State Merit
Regulation of 	Mutual 	Funds 	and Common Stocks," 	Research 	in Law
and 	Economics 	Vol. 	14, 	1991, 	pp. 	113-190); 	and Hilke, 	J., 	~
(continued .•. )
3

A. 	Background
The 	SEC 	regulates 	sales 	of 	new 	public 	offerings 	of
securities 	under 	the 	Securities 	Act 	of 	1933 	and 	the 	Securities
Exchange Act 	of 	1934. 	The 	SEC 	normally 	requires 	prospective
public 	issuers 	of 	securities 	to 	file 	a 	complete 	set 	of 	disclosure
documents 	with 	the 	agency 	and 	to 	agree 	to 	make 	periodic
additional 	public 	disclosures 	of 	financial 	statistics. 	Once 	the
disclosure 	documents 	are 	completed, 	the 	issuer may 	register 	the
issue with 	the 	SEC 	and begin 	selling 	the 	security. 	The
individual 	states 	also 	regulate 	new 	offerings.]
Complying with 	these 	regulations 	involves 	several 	costs 	that
do 	not 	vary 	in 	proportion 	to 	the 	size 	of 	the 	issue. 	These 	costs
can be 	substantial 	and 	fall 	disproportionately on 	small
offerings. 8 To 	diminish 	the 	disproportionate 	compliance 	costs
6( ••• continued)
Size 	and Regulatory Compliance 	Costs: 	The 	Case 	of 	LIFO
Regulations, 	Washington, 	D.C.: 	FTC, 	1984.
] The 	regulations 	of 	the 	SEC 	coexist with the 	regulations 	of
the 	individual 	states. 	Issuers 	interested 	in 	selling 	in two 	or
more 	states 	must 	comply with 	the 	registration 	regulations 	of 	each
such 	state 	as 	well 	as 	with those 	of 	the 	SEC.
Nearly all 	states 	have 	some 	type 	of 	disclosure 	regulations
governing 	securities 	issues, 	as 	well 	as 	fraud 	provisions.
Several 	states 	also 	have minimum quality regulations 	termed
"merit 	review." 	Firms 	that 	have 	neither 	registered 	a 	security 	in
a 	state 	nor 	qualified 	for 	an exemption may 	not 	offer the 	security
for 	sale 	in 	that 	state.
8 The 	SEC 	indicates 	that 	compliance 	costs 	for 	small
businesses 	may 	exceed 	$200,000 	per 	issue. 	57 	Fed. 	Reg. 	at 	9769.
Prior SEC 	studies 	have 	found 	that 	the 	costs 	of making 	an 	initial
public 	offering 	are 	larger 	for 	larger offerings, 	but 	that 	these
costs 	are 	disproportionately 	high 	for 	small 	offers. 	See Simmons,
G., 	Cost 	of 	FlotAtion 	of 	Registered 	Issues, 	1971-72, 	Washington,
D.C.: 	SEC, 	1974, 	particularly page 	17.
4

for 	small 	firms 	(which 	usually 	seek 	to 	raise 	relatively 	small
amounts 	of 	capital), 	the 	SEC 	established Regulation A.
Regulation A dispenses 	with 	registration, 	but 	imposes 	disclosure
requirements, 	albeit 	a 	reduced 	set 	of 	disclosures. 	Regulation 	A
is 	currently 	limited 	to 	issues 	of 	up 	to 	$1.5 	million 	per year. 9
The 	SEC 	also 	established Regulation 	D, 	Rule 	504. 	Under 	this
rule, 	very 	small 	public 	issues 	(less 	than 	$1 	million per year)
are 	not 	required 	to 	make 	disclosures 	other 	than 	those 	found 	in
Form 	D. 10 Currently, 	Regulation 0, 	Rule 	504, 	offerings 	cannot
be 	advertised 	and 	resales 	are 	subject 	to 	restrictions. 11
The 	SEC 	has 	long been 	aware 	of 	and concerned 	about 	the 	costs
to 	small 	firms 	of 	complying with 	its 	regulations. 12 Regulation
9 	Evidence 	suggests 	that 	exemptions 	from 	SEC 	registration
requirements 	provide 	net 	benefits 	for 	the 	eligible 	firms. 	For
example, 	when 	simplified 	registration 	form 	S-18 	became 	available
to 	small 	firms 	in 	lieu of 	the more 	elaborate 	form 	S-l, 	more 	than
90% 	of 	small 	firms 	utilized 	the 	exemption. 	See 	FOrm 	S-18: 	A
Monitoring Report 	on 	the 	First 	18 	Months 	of 	Its 	Use, 	Washington,
D.C.: 	SEC, 	1981, 	Appendix A.
10 Form 	D discloses 	the 	intent 	to make 	an 	offer 	and 	the
intended use 	of 	the 	proceeds, 	but 	does 	not 	provide 	financial
disclosures.
11 	Resales 	by 	unaffiliated 	holders 	are 	subject 	to 	delays
unless 	the 	issue 	is 	registered with 	the 	relevant 	state(s) 	or 	(if
state 	registration 	is 	not 	applicable) 	the 	holders 	undertake 	a
separate 	SEC 	registration. 	57 	Fed. 	Reg. 	at 	9770.
12 See, 	for 	example, 	Costs 	of 	Flotation 	for 	Small 	Issues,
1925-1929 	and 	1935-1938, 	Washington, 	D.C., 	SEC, 	1940;
"Statistical 	Series 	Release 	No. 	572," 	Washington, 	D.C., 	SEC,
1941; 	"Statistical 	Series 	Release 	No. 	715," 	Philadelphia: 	SEC,
1942; 	"Cost 	of 	Flotation of 	Registered 	Issues, 	1945-1949,"
Washington, 	D.C.: 	SEC, 	1951 	; 	Sameth, 	E., 	"Privately-Placed
Securities 	- 	Cost 	of 	Flotation" 	(covering 	1947-1950), 	Washington
D.C.: 	SEC, 	1952; 	"Cost of 	Flotation of 	Corporate 	Securities,
1951-1955," 	Washington, 	D.C.: 	SEC, 	1957; 	Simmons, 	C., 	and S.
( continued ... )
5

A and Regulation D, 	Rule 	504, 	represent 	previous 	efforts 	to
reduce 	the 	disproportionate 	costs 	borne 	by 	small 	firms. 	The
present 	proposals 	are 	an extension of 	this 	longstanding 	concern
and 	an 	effort 	to 	reduce 	compliance 	costs 	still 	further.
B. 	FTC 	Staff 	Experience 	with Other Regulations
Staff 	of 	the 	FTC 	has 	conducted research on 	the 	costs 	of
complying with other 	financial 	and 	disclosure 	regulations 	that
tends 	to 	support 	the 	SEC's 	belief 	that 	its 	disclosure 	regulations
entail 	proportionately higher compliance 	costs 	for 	small 	firms.
The 	appendix contains 	a 	summary of 	the 	results 	from 	these
studies. u
C. 	Framework of 	Analysis
This 	comment 	addresses 	the 	following 	question: 	Can
compliance 	costs 	be made 	less 	burdensome 	for 	small 	firms 	without
imposing more 	than 	compensating 	costs 	on 	investors?
12( ••• continued)
Muller, 	Cost 	of 	Flotation of 	Registered 	Issues. 	1971-72,
Washington, 	D.C.: 	SEC, 	1974; 	Sumanski, 	J., 	"Study of 	Regulation A
Issues," 	Washington, 	D.C.: 	SEC, 	1975; 	and 	Form S-18. 	A Monitoring
Report 	on 	the 	First 	18 	Months 	of 	Its 	Use, 	Washington, 	D.C.: 	SEC,
1981. 	Both 	the 	Simmons 	and Muller 	and 	the 	Sumanski 	studies
report 	compliance 	costs 	by 	size 	of 	offering and 	find 	that 	smaller
offers 	involved 	a 	higher 	proportion of 	compliance 	costs 	relative
to 	the 	proceeds 	of 	the 	offer.
13 	See 	Hilke, 	J., 	Firm Size 	and 	RegulatokY Compliance 	Costs:
The 	Case 	of 	LIFO Regulations, 	Washington, 	D.C.: 	FTC, 	1984, 	and
Boyle, 	J., 	"Survey 	of 	the 	Mortgage Banking 	Industry Concerning
Costs 	and 	Benefits 	of 	Regulations," 	Washington, 	D.C.: 	FTC, 	1982.
6

Efficiently 	functioning 	capital 	markets 	facilitate
competition and economic 	growth. 	As 	the 	SEC 	notes, 	small
businesses 	contribute 	to 	innovation 	and employment 	growth 	in many
markets. 14 	From disrupting pricing cartels 	to 	introducing new
technologies, 	small 	firms 	bolster 	the 	efficiency 	and 	progress 	of
the 	economy.
The 	costs 	of 	complying with 	regulations 	are 	a 	factor 	that
may 	discourage 	firms 	from 	entering new markets. 	The 	costs 	of
complying with 	regulations 	may 	represent 	a 	particular obstacle
for 	small 	firms 	because 	these 	costs 	are 	likely 	to 	represent 	a
higher 	proportion of 	total 	costs 	for 	small 	firms 	than 	for 	large
firms. 	Changes 	in 	regulations 	that 	reduce 	costs 	of 	complying
generally, 	and 	reduce 	their disproportionate 	impact 	on 	small
firms 	in particular, 	can encourage entry 	and may 	lead 	to 	reduced
prices, 	improved quality, 	and, 	a 	broader range 	of 	consumer
choices.
As 	the 	SEC 	suggests, 	the 	costs 	of 	complying with 	the 	SEC's
disclosure 	regulations 	are 	a 	form 	of 	sunk cost. 15 To make 	a
public 	securities 	offering, 	a 	firm 	must 	incur 	the 	costs 	of
filling 	out disclosure 	forms, 	hiring counsel, 	and conforming
sales 	efforts 	and 	advertising 	to 	required 	formats. 	These 	costs
cannot 	be 	recovered 	by 	the 	issuer 	if 	the 	issue 	fails 	to 	attract
14 57 	Fed. 	Reg. 	at 	9768-9.
u 57 	Fed. 	Reg. 	at 	9769.
~
7

investors. 16 	The 	SEC 	further 	indicates 	that 	the 	total 	cost 	of
at 	least 	some 	of 	the 	steps 	in current 	disclosure 	procedures 	do
not 	depend on 	the 	size 	of 	the 	issue, 	so 	the 	costs 	of 	small 	issues
are 	disproportionately 	higher. 17
The 	current 	SEC 	disclosure 	regulations 	are 	designed 	to
protect 	against 	the 	potential 	detrimental 	effects 	associated 	with
insufficient 	or 	inaccurate 	investor 	information. 	The 	benefits
traditionally 	associated with disclosure 	requirements 	are 	better
informed decision-making 	and 	reduced 	incidence 	of 	fraud.
However, 	if 	other 	regulations 	could be 	equally effective 	in
protecting 	investors, 	yet 	involve 	lower 	costs 	and 	improved
information 	for 	market 	participants, 	then adopting 	these 	revised
regulations 	will 	directly 	improve 	investor welfare 	and 	indirectly
improve 	consumer welfare. 	In this 	instance, 	the 	SEC 	seeks 	to
determine 	whether 	less 	costly and more 	flexible 	disclosure
16 The 	costs 	may also 	be 	unrecoverable 	if 	the 	offer 	attracts
investors, 	but 	the 	new 	firm 	exits 	the 	industry 	in 	the 	near 	future
before 	the 	costs 	are 	amortized.
The 	importance 	of 	sunk costs 	in decisions 	to 	open 	new
businesses 	is 	described 	in Baumol, 	W., 	J. 	Panzar, 	and R. 	Willig,
Contestable Markets 	and 	the 	TheokY of 	IndustkY 	Structure, 	New
York: 	Harcourt, 	Brace 	and 	Javanovich, 	1982; 	Sharkey, 	W., 	~
TheokY of 	Natural 	Monopoly, 	New York: 	Cambridge 	University 	Press,
1982; 	and 	Baumol, 	W., 	J. 	Panzar, 	and R. 	Willig, 	"On 	the 	Theory of
Perfectly-Contestable Markets," 	Stiglitz, 	J., 	and G. 	Mathewson,
Eds., 	New Developments 	in 	the 	Analysis 	of 	Market 	Structure,
Cambridge, 	Mass.: 	MIT 	Press, 	1986. 	Also 	see 	the 	1992 	Merger
Guidelines 	jointly 	released by the 	Department 	of 	Justice 	and 	the
Federal 	Trade 	Commission on April 	2, 	1992. 	See, 	in particular,
Sections 	1.3 	and 	3.0.
17 	In effect, 	the 	SEC's 	disclosure 	regulations 	may 	have
created an economy 	of 	scale, 	i.e., 	a 	relative competitive
advantage 	(lower 	unit 	costs) 	for 	large 	firms, 	that 	would 	not
exist 	but 	for 	the 	regulations.
8

requirements 	for 	small 	issues 	would be 	sufficient 	to 	maintain 	the
benefits 	of 	investor 	protection 	in 	the 	case 	of 	small 	firms, 	where
the 	compliance 	costs 	of 	current 	regulations 	are 	believed 	to 	be
particularly 	high.
D. 	Individual 	Proposals
1. 	Allow 	Issuers 	to 	"Test 	the 	Waters" 	with 	a 	Prospective
Offering Announcement: 	This 	proposal 	is 	likely 	to 	reduce 	the
costs 	of 	complying with Regulation A by permitting 	these 	costs 	to
be 	incurred 	after 	information 	about 	the 	likely 	success 	of 	an
offer has 	been 	gathered. 	Under current 	regulations, 	small 	firms
must 	undertake most 	compliance 	costs 	associated with an 	offering
before 	they 	have 	received much 	information 	about 	investor
interest 	in 	the 	offer. 	Allowing 	small 	firms 	to 	test 	the waters
with 	a 	prospective 	offering notice 	before 	undertaking 	the 	costs
of 	required 	disclosures 	is 	likely 	to 	reduce 	uncertainty 	about 	the
prospects 	of 	making 	a 	successful 	offer. 	This 	may 	lead more 	small
firms 	to 	decide 	to 	raise 	capital 	and enter new markets 	if
investors 	do 	demonstrate 	interest. 	In addition, 	earlier 	notice
of 	the 	potential 	availability of 	a 	new 	issue 	should 	allow
investors 	more 	time 	to 	assess 	the 	issuer before 	the 	issue 	comes
~ 	to 	market.
Under 	this 	proposal, 	small 	firms 	that 	make 	actual 	securities
sales 	under 	Regulation A will 	continue 	to 	deliver 	to 	purchasers
an offering 	circular containing 	financial 	statements 	and 	other
required 	disclo8ures. 	In 	addition, 	the 	prospective offering
9

announcement 	will 	be 	subject 	to 	the 	antifraud provisions 	of 	the
securities 	laws. 	These 	safeguards 	seem to 	forestall 	the
possibility that 	this 	proposal 	inadvertently could 	reduce
investor 	protection 	or 	increase 	investment 	fraud.
2. 	Accept 	State 	Disclosure 	Forms 	in 	Lieu 	of 	Current 	SEC
Forms: 	The 	proposal 	to 	allow 	small 	businesses 	to 	use 	the 	same
form 	to 	comply with both 	state 	and 	federal 	securities 	disclosure
requirements 	is 	also 	likely 	to 	reduce 	compliance 	costs 	and
improve 	the 	efficiency of 	capital 	markets. 	Savings 	are 	likely 	to
come 	from 	simply reducing 	the 	number of 	different 	formats 	in
which 	disclosure 	information must 	be 	recorded, 	from 	a 	minimum of
two 	forms 	(SEC 	form 	and 	the 	uniform 	state 	form) 	to 	one. 18
According 	to 	the 	SEC, 	the 	state 	form may provide 	small 	businesses
with 	a 	reduced 	cost 	option, 	while 	maintaining 	investor
protection. 19
18 The 	SEC's 	proposal 	also 	would 	allow 	firms 	the 	choice 	to
continue 	to 	use 	the 	current 	SEC 	form. 	Therefore, 	the 	costs 	would
not 	increase 	for 	firms 	that 	would 	not 	otherwise 	be 	completing the
state 	form, 	and would 	use 	the 	familiar 	SEC 	form.
In 	addition, 	the 	SEC's 	adoption of 	the 	state 	form 	(Form U-7)
developed 	by 	the 	North American Security Administrator's
Association 	(NASAA) 	may 	encourage more 	states 	to 	adopt 	this 	form.
If 	so, 	the 	SEC's 	action may potentially reduce 	compliance 	costs
further 	for 	those 	firms 	that wish 	to 	sell 	issues 	in 	these 	states.
Further, 	SEC 	adoption of 	Form U-7 	may encourage 	firms 	to 	sell
their 	issues 	in more 	states 	since 	the 	incremental 	cost 	of
completing disclosures 	in 	states 	that 	have 	adopted Form U-7 	would
decrease. 	Firms 	that 	would 	have 	floated 	their 	issue 	only 	in
states 	where 	the 	Federal 	form was 	sufficient may 	now meet 	both
the 	federal 	disclosure 	requirements 	and 	those 	in most 	states 	by
completing one 	form.
19 	57 	Fed. 	Reg. 	at 	9771.
10

,
3. 	Increase 	the 	Ceiling 	for 	Regulation A Offers 	and 	The
Possibility of 	Indexing 	the 	Small 	Firm Exemption Criteria: 	The
SEC 	proposes 	to 	increase 	the 	ceiling on Regulation A issues 	to 	$5
million 	from 	$1.5 	million. 	This 	will 	lift 	the 	level 	of 	the
ceiling to make 	it 	more 	consistent with continued 	inflation 	and
reduce 	relative 	compliance 	costs 	for 	a 	larger 	number 	of
• 	20
~ssuers.
The 	SEC may wish 	to 	consider 	adjusting 	the 	exemption ceiling
for 	small 	firms 	under Regulation A (and under 	Regulation 	0, 	Rule
504) 	on 	a 	regular 	basis 	to maintain a 	ceiling 	that 	is 	consistent
in 	inflation 	adjusted 	terms 	over 	time. 	For example, 	the 	SEC
might 	calculate 	an 	increase 	in 	the 	ceiling 	for 	exemptions 	on 	an
annual 	basis 	that 	corresponds 	to 	the 	percentage 	increase 	in 	the
prior year's 	consumer 	price 	index. 	This 	approach, 	called
indexing, 	may 	help 	to 	reduce 	regulatory uncertainty 	about
prospective eligibility 	for 	some 	potential 	applicants 	as 	well 	as
reduce 	the 	likelihood 	that 	the 	SEC will 	need 	to 	spend 	future
resources 	revisiting 	the 	ceiling 	for 	small 	business 	exemptions.
4. 	Remoye 	Adyertising 	Restrictions 	on Small 	Issues 	Sold
Under Rule 	504. 	Efficient 	capital markets 	require 	that 	potential
investors 	be 	adequately 	informed about 	investment 	options. 21
20 The 	$1.5 	milllon ceiling was 	adopted 	in 	1978. 	One
million 	five 	hundred 	thousand dollars 	in 	1978 	dollars 	is
equivalent 	to approximately 	$3.2 	million 	in current 	dollars.
21 	The 	.tatf 	ot 	the 	PTC 	regularly evaluates 	mandatory
disclosures 	and 	re.trictlons 	on advertising 	in connection with
(continued ... )
11

Providing 	investment 	information to 	investors 	reduces 	the
investors' 	cost 	of 	evaluating 	the 	expected 	risk 	and 	return,
reduces 	uncertainty, 	and, 	therefore, 	increases 	both the 	value 	of
the 	issue 	to 	investors 	and 	the 	net 	proceeds 	to 	the 	offering 	firm.
Advertising often 	is 	a 	lower cost method of 	disseminating
investment 	information than other 	available 	methoqs, 	such 	as
using 	commissioned 	agents 	to 	make 	individual 	contacts 	with
investors 	by mail, 	phone, 	or 	in-person visits.
The 	SEC's 	proposal 	to 	lift 	the 	advertising ban on 	small
firms 	raising capital 	under Regulation 0, 	Rule 	504, 	appears
likely 	to 	reduce 	costs 	by 	allowing 	the 	offering 	firm 	to 	use
advertising 	to 	disseminate 	information 	about 	the 	offer 	instead of
other 	potentially higher 	cost 	methods. 	The 	proposed changes
would 	lower 	the 	relative 	costs 	of 	information dissemination 	for
21 ( ... continued)
the 	FTC's 	consumer 	protection mission and 	its 	competition
advocacy program. 	The 	staff 	of 	the 	FTC 	has 	been actively
involved 	in 	research, 	regulations, 	cases, 	and comments 	in 	the
area of 	restrictions 	on 	truthful 	advertising. 	The 	staff's
research 	on 	advertising 	restrictions 	includes: 	"Comments 	of 	the
Staff 	of 	the 	Bureaus 	of 	Consumer Protection and 	Economics 	of 	the
Federal 	Trade 	Commission on Proposed Rulemaking Regarding 	Food
Labeling," 	Food 	and 	Drug Administration, 	Docket No. 	91N-0384,
submitted on 	February 	25, 	1992; 	P. 	Ippolito 	and A. 	Mathios,
Health 	Claims 	in 	Adyertising and Labeling: 	A Study of 	the 	Cereal
Market, 	Washington, 	D.C.: 	FTC, 	1989; 	J. 	Lacko, 	Product 	Ouality
and 	InfOrmation 	in 	the 	Used Car Market, 	Washington, 	D.C.: 	FTC,
1986; 	A. 	Masson 	and 	R. 	Steiner, 	Generic 	Substitution and
Prescription 	Drug 	Prices: 	Economic 	Effects 	of 	State 	Drug 	Product
Substitution Laws, 	Washington, 	D.C.: 	Federal 	Trade 	Commission,
1985; 	W. 	Jacobs 	at 	al., 	Improving Consumer Access 	to Legal
Services: 	The 	Cale 	for 	Removing Restriction on Truthful
Advertising, 	washington, 	D.C.: 	Federal 	Trade 	Commission, 	1984;
and R. 	Bond ~ Al., 	·Self 	Regulation 	in Optometry: 	The 	Impact 	on
Price 	and 	Quality,· 	Low 	And Human 	Behavior 	7:2 	(1983), 	pp. 	219
234.
12

small 	issues. 	Lower costs 	are 	likely 	to 	increase 	the 	level 	of
information 	available 	to 	investors 	and 	thereby 	improve 	capital
market 	efficiency and 	investor welfare 	and open new 	investment
opportunities 	for 	small 	firms.
On 	the 	other hand, 	allowing 	advertising 	of 	these 	issues 	may
entail 	an 	increased 	risk 	that 	misleading 	information will 	be
disseminated. 	Notably, 	however, 	nothing 	in 	the 	proposed
regulations 	relaxes 	the 	fraud 	statutes 	that 	the 	SEC 	applies 	to
securities 	advertising. 22 If 	this 	proposed change 	is 	adopted,
the 	SEC may wish to monitor securities 	advertising 	to 	ensure 	that
its 	revised Rule 	504 	regulations 	do 	not 	lead 	to 	an 	increase 	in
the 	incidence of 	misleading claims.
5. 	Lift 	Resale 	Restrictions 	on Rule 	504 	Issues: 	Legal
restrictions 	on resale of 	small 	issues, 	such as 	the 	current 	Rule
504 	provisions,23 	increase an 	investor's 	cost of 	holding a
security, 	because 	the 	investor cannot move 	capital 	readily 	to
another 	area of 	opportunity. 	Investors 	will 	demand a 	higher 	rate
of 	return 	from 	restricted issues, 	and 	the cost 	of 	capital 	for
these 	small 	firm 	issuers 	therefore will 	be 	higher.
22 	57 	Fed. 	Reg. 	at 	9770, 	9773.
n 	Resellers 	of 	large registered 	issues 	are 	not 	under 	this
restriction. 	Registered 	issues 	disclose 	financial 	performance
information as 	part of the 	registration process 	and report
updated performance 	information to 	the 	SEC 	on 	a 	regular basis.
13

The 	SEC 	proposes 	to 	remove 	restrictions 	on 	resales 	that
apply 	to 	securities 	issued 	under 	Rule 	504 	of 	Regulation 	0. 24
Increased 	liquidity 	for 	Rule 	504 	resales 	might 	make 	investors
willing 	to 	accept 	lower 	expected 	rates 	of 	return. 	This 	would, 	in
turn, 	reduce 	the 	costs 	of 	issues 	for 	small 	firms, 	increasing 	the
likelihood of 	entry 	and expansion.
While 	the 	proposed 	relaxation of 	resale 	restrictions 	may
L
t·
reduce 	the 	costs 	of 	illiquidity 	that 	fallon 	both 	investors 	and
small 	firms, 	the 	proposals 	might 	raise 	concerns 	about 	fraudulent·
resales 	of 	504 	offerings. 	For example, 	a 	marketing operation
might 	buy up 	a 	Rule 	504 	offering and 	then 	resell 	the 	issue 	at 	a
much 	higher price while making 	fraudulent 	claims 	about 	its
prospects. 	Targets 	of 	the 	fraudulent 	operator might 	find 	it
harder 	to 	check 	on 	the 	truthfulness 	of 	claims 	because 	there 	would
be 	no 	disclosures 	on 	file 	with 	the 	SEC 	subsequent 	to 	the 	initial
sale 	to 	the 	marketer.~
The 	staff 	of 	the 	FTC 	deal 	frequently 	with allegations 	of
fraud 	in 	the 	reaale 	of 	investment-like products 	such 	as 	art 	work,
24 	Resales 	by 	affiliates 	of 	the 	issuer would continue 	to 	be
restricted.
~ The 	SEC 	indicat •• 	that 	many of 	the 	same 	conditions
proposed 	for 	Rule 	504 	of 	Regulation 0 	already prevail 	under 	Rule
257 	of 	Regulation 	A for 	i.sues 	under 	$100,000. 	The 	SEC
indicates, 	however, 	that 	very 	few Regulation A issues 	take 	place
under Rule 	257 	(" 	,~. 	aeg. 	at 	9773 	n. 	90), 	hence 	the 	SEC 	has
relatively 	little date on which 	to 	base 	an 	evaluation. 	SEC 	staff
has 	indiCAted 	lnforaal1y 	to Commission 	staff 	that 	Rule 	257 	issues
are 	not 	disproportloftetoly 	associated with 	frauds. 	(Conversation
on April 	15, 	ltt2.)
14

coins, 	and precious 	metals. 26 A review 	of 	a 	sample 	of 	FTC 	case
files 	indicates 	that 	investors 	frequently 	rely 	on 	the 	sales
agent's 	persuasiveness, 	sense 	of 	urgency, 	persistence 	and
misrepresentations 	about 	likely 	risks 	and 	returns 	from 	these
"investments.,,27 	Law 	enforcement 	proved 	necessary 	to 	reduce 	the
problems 	posed by 	these 	fraudulent 	operators.
If 	the 	resale 	restrictions 	are 	lifted, 	the 	staff 	of 	the
Commission 	suggests 	that 	the 	SEC monitor 	the 	type 	and 	level 	of
frauds 	in 	securities 	resales 	to 	ensure 	against 	an 	increase 	in
fraudulent 	activity. 	If 	fraudulent 	activity escalates, 	the 	SEC
may wish 	to 	increase 	enforcement 	activity, 	or 	reinstate 	some 	or
all 	restrictions 	on 	resale.
26 	The 	states, 	the 	FTC, 	the 	SEC, 	and 	the 	Commodity 	Futures
Trading Commission 	(CFTC) 	all 	engage 	in 	some 	enforcement
activities 	to 	curtail 	investment 	frauds 	in off-exchange
transactions. 	Consistent with our experience, 	the 	SEC 	indicated
several 	years 	ago 	that 	its 	enforcement 	efforts 	in 	fraud 	cases
occur 	primarily where 	the 	transaction 	is 	closely 	related 	to
transactions 	on 	the 	exchanges. 	Written 	Statement 	of 	John M.
Fedders, 	Director, 	Division of 	Enforcement, 	of 	the 	SEC, 	Before
the 	Permanent 	Subcommittee on 	Investigations 	of 	the 	Senate
Committee on Governmental 	Affairs, 	Regarding Trading 	in 	Precious
Metals, 	March 	21, 	1984. 	The CFTC 	has 	also 	concentrated 	its
enforcement 	efforts 	on 	practices 	on 	the 	exchanges.
27 	This 	section 	of 	the 	comment 	is 	derived 	largely 	from 	an
intensive 	review 	of 	a 	sample 	of 	FTC 	fraud 	cases 	conducted by 	Paul
Pautler, 	a 	member of 	the 	staff 	of 	the 	FTC's 	Bureau 	of 	Economics.
Fraudulent 	operators 	in 	areas 	covered by 	the 	FTC 	frequently
ignore 	all 	the 	applicable 	laws. 	(One 	exception appears 	to 	be 	the
California 	laws 	requiring 	telemarketers 	to 	notify 	the 	state 	that
they 	have 	operations 	based 	in California. 	Compliance with 	this
registration 	procedure, 	however, 	has 	not 	prevented subsequent
fraudulent 	activity 	by 	some 	registrants.) 	If 	this 	observation
describes 	the 	SEC's 	experience 	as 	well, 	it may 	imply 	that
relaxation of 	the 	disclosure 	regulations 	would be 	unlikely 	to
increase 	substantially 	the 	incidence 	of 	investment 	fraud
involving 	securities 	issued by 	small 	businesses.
15

III. 	CONCLUSION
The 	SEC's 	proposals 	to 	revise 	Regulation A would 	allow 	a
small 	firm 	interested 	in 	issuing 	securities 	to 	test 	the 	waters
with 	a 	prospective 	offering announcement 	and 	allow 	small 	firms 	to
utilize 	a 	widely 	used 	state 	disclosure 	document 	in 	lieu 	of 	the
SEC's 	disclosure 	form. 	These 	proposals 	seem 	likely to 	reduce
capital 	costs 	for 	small 	businesses 	and 	thereby enhance
competition and 	the 	efficiency of 	capital 	markets. 	The 	SEC 	may
wish 	to 	provide 	greater temporal 	consistency 	in 	the 	pool 	of 	firms
eligible 	for 	Regulation A by 	indexing 	the 	ceiling under which
firms 	can qualify 	for 	Regulation A.
The 	SEC's 	proposals 	to 	revise 	Rule 	504 	of 	Regulation D by
removing 	advertising 	and resale 	restrictions 	on qualifying 	issues
are 	also 	likely 	to 	reduce 	the 	cost 	of 	capital 	for 	small 	firms.
These 	benefits 	of 	revising Rule 	504 	may, 	however, 	be 	accompanied
by 	increased 	risk 	of 	the 	dissemination of 	misleading 	information
or 	fraudulent 	resales 	of 	these 	issues. 	The 	SEC may wish 	to
monitor 	the marketing practices 	of 	newly 	eligible Rule 	504
issuers 	(and 	resellers) 	to 	ensure 	against 	such behavior.
16

Appendix
Research Results 	Concerning Regulatory Compliance 	Costs
Study 	of 	the 	Costs 	of 	Complying with LIFO 	Regulations
BE 	staff 	studied 	in 	detail 	the 	costs 	of 	complying with 	the
Internal 	Revenue 	Service's 	(IRS) 	regulations 	governing 	Last 	In
First 	Out 	(LIFO) 	accounting, 	as 	part 	of 	a 	project 	reviewing
regulatory compliance 	costs 	generally.28 	Use 	of 	LIFO 	leads 	to
more 	efficient 	inventory decisions, 	particularly 	in 	a 	period 	of
inflation. 	But 	if 	LIFO 	regulations 	are 	complex 	and
disproportionately costly 	for 	small 	firms 	to 	implement 	in
comparison with 	large 	firms, 	small 	firms, 	including potential
entrants, 	may be 	less 	likely 	to 	adopt 	LIFO. 	Such 	firms 	are
likely 	to 	misevaluate 	inventory options 	and make 	inefficient
production 	and 	investment 	decisions, 	including entry decisions,
during 	inflationary periods. 29
BE 	staff 	found 	that 	small 	firms 	were, 	in 	fact, 	significantly
less 	likely 	than 	large 	firms 	to 	adopt 	LIFO even 	during 	a 	period
of 	relatively 	high 	inflation. 	More 	than 	three 	quarters 	of 	small
28 Hilke, 	J., 	Firm 	Size 	and Regulatory Compliance 	Costs: 	The
Case 	of 	LIFO Regulations, 	Washington, 	D.C.: 	FTC, 	1984.
Regulations 	permitting 	firms 	to 	switch to 	LIFO 	had been 	in 	place
for 	several 	years 	before 	inflation 	increased enough 	in 	the 	late
1970s 	to 	make 	access 	to 	LIFO a 	significant economic 	concern.
29 	Detailed examination of 	the 	cost 	reports 	suggests 	that
relatively 	small 	changes 	in 	the 	regulations 	could eliminate 	large
portions 	of 	the 	compliance 	costs, 	thereby 	ameliorating 	the 	cost
disadvantage 	of 	small 	firms 	without 	creating additional
compliance 	problems.
17

r:
...,;.
firm 	survey 	respondents 	(those with 	sales 	under 	$5 	million 	per
year) 	cited costs 	of 	complying with 	the 	IRS's 	rules 	for 	switching
to 	LIFO 	as 	an 	"important" 	or 	"very 	important" 	reason why 	they 	had
not 	adopted LIFO. 	Respondents 	that 	used LIFO 	provided data 	on
their 	costs 	of 	complying with 	the 	regulations. 	The 	reported
costs 	are 	listed 	in 	Table 	1.
Table 	1
Stratified Sample Means 	of 	Sales 	and
First 	Year LIFO Compliance 	Costs
Mean 	Total
Annual 	Total 	LIFO 	Costs
Mean 	Sales 	LIFO 	as 	% of
Group 	N 	($ 	millions) 	Costs 	Sales*
Whole 	Sample 	199 	43.02 	$35,583 	.083
Sales 	Less 	Than
$5 	Million 	58 	2.96 	$26,292 	.888
Sales 	Between
$5 	and 	$10
Million 	53 	7.33 	$23,422 	.320
;:.
* 	Ongoing 	annual 	compliance 	costs 	are 	$23,242, 	65% 	of 	the 	total.
Total 	LIFO costs 	are 	equal 	to 	2.9, 	30.6, 	and 	11.0 	percent 	of
profits 	respectively 	for 	the 	three 	groups. 	Source: 	Quarterly
Financial 	Reports. 	1977-1981, 	Federal 	Trade 	Commission, 	1982,
Table 	2.
Source: 	Tables 	5 	and 	8 	in Hilke, 	J., 	Firm 	Size 	and Regulatory
Compliance 	Costs: 	The 	Case 	of 	LIFO 	Regulations, 	Washington, 	D.C.:
FTC, 	1984.
18

Study of 	the 	Costs 	of 	Complying with 	Disclosure 	Regulations 	under
the 	Truth-in-Lending 	Act
A study of 	the 	costs 	of 	complying with 	the 	Truth-in-Lending
Act,30 commissioned 	by 	the 	FTC 	in 	response 	to 	a 	request 	from 	the
Joint 	Economic 	Committee 	of 	Congress, 	indicated that 	although
compliance 	costs 	vary 	considerably 	from 	firm 	to 	firm, 	small 	firms
on 	average 	incurred compliance 	costs 	approximately 	three 	times
those 	of 	larger 	firms. 	Table 	2 	shows 	the 	average 	compliance
costs 	for 	different 	firm-sizes 	measured on 	a 	cost 	per 	$1,000
loaned basis.
Table 	2
Average Annual 	Regulatory Compliance 	Costs
By 	Size of 	Mortgage 	Banking Company
(1981)
Average
Average 	Average 	Regulatory
Group 	N Loan Volume
($1,000s) Regulatory
Costs Cost 	per
$1000 	Loaned
Small 	119 	020,044 	$ 	17,839 	$ 	.89
Medium 	060 	085,622 	$ 	46,236 	$ 	.54
Large 	022 	276,343 	$ 	80,139 	$ 	.29
Source: 	Tables 	7 	and 	8, 	Boyle 	(1982).
30 The 	Truth-in-Lending Act 	is 	Title 	1 of 	the 	Consumer
Credit 	Protection Act 	of 	1968 	(P.L. 	90-321). 	The 	study 	is:
Boyle, 	J., 	"Survey of 	the 	Mortgage 	Banking 	Industry Concerning
Costs 	and Benefits 	of 	Regulations," 	Washington, 	D.C.: 	FTC, 	1982.
19