(Article from Registered Funds Alert, May 2017)
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President Donald Trump campaigned heavily on promises to reform federal regulations. On May 3, 2017, the Senate confirmed the President’s nominee for Chair of the Securities and Exchange Commission (“SEC”), Jay Clayton. Chair Clayton has indicated that he intends to play a key role in helping President Trump fulfill those promises to deregulate. Chair Clayton joins a short-handed SEC, which has been operating with only two Commissioners since January, when former Chair Mary Jo White resigned, and has lost a number of senior staff members since the election, including the heads of multiple divisions and offices within the SEC.[1]
During Chair Clayton’s nomination hearing on March 23, 2017, before the Senate Banking Committee, he was questioned by senators about his views on a wide range of matters, including his philosophy regarding enforcement and rulemaking, and his potential conflicts of interest. In this Alert, we will focus on a particular theme that dominated Chair Clayton’s testimony—access to capital markets.
In his prepared remarks and in many of his responses, Chair Clayton laid out his vision for clearer and leaner regulation, focusing on the thesis that complexity creates confusion and inflates the cost of compliance for companies. Throughout his testimony, Chair Clayton repeatedly stated his belief that the complexity and upfront costs of initial public offerings (IPOs), as well as continuing compliance costs, are the main factors discouraging companies from going public. Chair Clayton also said that the fixed-cost nature compliance creates a disproportionately heavy burden for smaller and early-stage companies, and that these regulatory-driven costs make public offerings less attractive to those companies. He concluded that well-functioning capital markets benefit all Americans, and that all Americans should have the opportunity to participate in our markets. In other words, when younger companies have IPOs, the general investing public gets to participate in the growth of the company to a greater extent than when companies go public after they are more mature.
While Chair Clayton did not specifically discuss registered funds and asset managers in relation to his vision for capital markets reform, they could be critical facilitators of capital markets access. According to the 2017 Investment Company Fact Book (“Fact Book”) published by the Investment Company Institute (“ICI”), more than 93 million Americans (44% of U.S. households) have invested over $19 trillion in mutual funds and exchange-traded funds (“ETFs”). Registered funds and their managers operate under heavy regulatory burdens that have only increased in recent years. Accordingly, Chair Clayton’s stated principle of ensuring that all Americans have the opportunity to participate in capital markets certainly would be furthered by supporting reforms for registered funds.
Reduce Burdens on ETFs
One possible set of reforms for Chair Clayton to consider relates to exemptive relief requirements and listing standards for ETFs. ETFs are one of the fastest growing types of registered funds, with total net assets increasing almost eight-fold in the past ten years, to nearly $4 trillion according to recent reports. However, much of that growth has been concentrated in a handful of key industry players, at least partially as a result of the high regulatory barrier to entry into the marketplace caused by existing regulations.
One significant barrier to entry is that ETFs currently require exemptive relief from the SEC in order to operate. Historically, most ETFs that received exemptive relief have tracked a specific index of securities (such as the S&P 500). More recently, the SEC has granted relief for actively managed ETFs that meet certain conditions. The exemptive order process can be expensive and time consuming. While the SEC proposed some rules to govern ETFs in 2008, no rules were ever adopted. The time is ripe for the SEC to adopt exemptive rules that would allow ETFs that generally meet the conditions in typical ETF exemptive orders to operate without obtaining an exemptive order.
Another key regulatory burden for ETFs relates to listing standards. As ETFs are listed on securities exchanges, they must meet the listing standards of an exchange in order to list. The SEC has approved generic ETF listing standards for various exchanges that allow listing of index ETFs, and recently, actively managed ETFs, that meet the generic standards at the time of listing. For ETFs that do not meet the generic standards, an exemptive order must be obtained from the SEC in order for the ETF to list. However, in 2016 several securities exchanges approached the SEC for approval of continuous listing standards, which impose ongoing requirements for ETFs. Industry advocates failed to convince the SEC that many of the ongoing requirements would impose significant new compliance burdens on ETFs, which would be difficult to implement and likely would raise the cost of ETFs. In addition to increasing the cost of investing in existing ETFs, the new continuous listing standards may add another barrier to entry for new ETFs. The continuous listing standards go into effect later this year.
Given the increasing extent to which retail investors have demonstrated familiarity and comfort with the structure of ETFs, reducing barriers to entry into the space would clearly further Chair Clayton’s goal of improving access to capital markets.
Increase Retail Investor Access to Private Companies
Another way for Chair Clayton to expand retail investor access to growing companies would be to make it easier for them to seek investment exposure to private companies. Currently, retail investors can gain access to investments in private companies through registered funds that invest in hedge funds and private equity funds, but the SEC generally requires that such funds only be offered to “accredited investors.” Individual investors must have earned $200,000 in annual net income in the past two years or hold $1 million in net worth, excluding their primary residence, to meet the accredited investor standard. While it is understandable that the SEC would want to ensure that investors in such funds are sophisticated enough to understand, and wealthy enough to bear, the risks associated with the types of investments that hedge and private equity funds make, this high qualification hurdle obviously reduces the ability of retail investors to gain exposure to private companies through registered funds of hedge funds and private equity funds.
We acknowledge that while simply lowering the bar for retail investors to invest in funds that invest in hedge funds and private equity funds is one way to improve access to private companies, the SEC may have significant concerns about appropriate safeguards to prevent end runs around the statutory constructs for private funds. That said, the SEC also could make it easier for retail investors to invest in private equity or hedge-like investments without raising such concerns. Specifically, by permitting registered funds to co-invest more efficiently in transactions alongside private funds, the SEC could meet Chair Clayton’s goal of providing access to retail investors to younger companies while not undermining important investor protection concerns. Currently, SEC no-action guidance allows registered funds to co-invest alongside private funds if the only term being negotiated in the transaction is price. In any other scenario, including most types of investments in private companies, a registered fund may need an exemptive order from the SEC, which is a costly and time-consuming proposition. An exemptive rule under Section 17 of the Investment Company Act of 1940, as amended (“1940 Act”), allowing additional types of co-investments, or even codifying the exemptive relief that has been granted to several companies, would immediately enhance retail investor access to private companies. Because the existing exemptive relief requires that funds not be disadvantaged vis-à-vis private funds with which they co-invest, such a change would also be consistent with the SEC’s mission to protect investors, maintain fair, orderly, and efficient markets and facilitate capital formation.
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These are just two potential ways that Chair Clayton’s goal of increasing access to capital markets could tie in with reforms for registered funds. Indeed, we believe that, given the role of registered funds in the savings, retirement and investment accounts of retail investors, the SEC would be well-served to focus on registered funds in the coming years as a primary driver to bring Chair Clayton’s goals to fruition.
[1] On May 9, 2017, Chair Clayton filled the first of those vacancies, the position of Director of Corporation Finance, with retired Simpson Thacher partner William Hinman.