COMMISSIONER AGUILAR ON CAPITAL FORMATION AND REGULATION

The relationship between capital formation, effective regulation and how this is being thwarted by certain foreign issuers were the subjects of SEC Commissioner Luis Aguilar’s remarks to the Council of Institutional Investors at their Spring Meeting on April 4, 2011 (here). Much of the current discussion confuses capital formation with capital raising while failing to consider the importance of regulation and disclosure the Commissioner noted in setting the theme for his remarks.

In the current economic climate effective capital formation is critical. Capital formation concerns the ways of creating productive capital for the economy. This includes improving infrastructure, building plants, and hiring workers. Simply raising money is not necessarily capital formation This point is well illustrated by the market crisis from which the country is recovering. By the time that financial crisis unfolded investors held more than $2 trillion of non-GSE mortgage backed securities and close to $700 billion of CDOs that held mortgage-backed securities, according to the Financial Crisis Commission. Those securities were issued with little oversight by the SEC. Securitization in the private unregulated markets clearly raised money but also played a significant role in the financial crisis. If “capital raising is the sole consideration to define capital formation, individuals who engage in Ponzi schemes could be considered the best facilitators of capital formation . . .” the Commissioner noted. That is obviously incorrect.

Rather, “[f]acilitating true capital formation is about helping investors and other capital provides to make informed decisions . . . Capital formation is about ensuring that the companies with the best ideas, even if those ideas are risky, can get the financing to make those ideas a reality.” It is thus critical that investors have appropriate information. Public disclosure improves the quality of decision making and thus price discovery in the markets. It also levels the playing field for all companies.

To achieve this goal strong and effective securities regulation is necessary. Viewed in this context, “[w]here would our economy be, and how much real, productive capital would our country have, if there had been better disclosure about asset-backed securities, about CDOs, and all the other securities that were offered and sold in poorly regulated markets . . .” Commissioner Aguilar asked.

A current trend of concern is the increasing number of reverse mergers being used by Chinese companies to go public. This deprives the markets of the kind of information required by an IPO. This trend is causing significant difficulties. The PCAOB has recently commented on it (here). The SEC’s Enforcement Division is conducting an investigation of overseas companies with listings on U.S. exchanges with a particular focus on those that became public through reverse mergers. There are also serious concerns about the auditing of these companies since the work may be done by local affiliates of the U.S. firm and the results cannot be confirmed.

Overall it is important to focus on the “connection between capital formation and strong enforcement of securities laws.” For this reason, Commissioner Aguilar concluded by endorsing a strong enforcement program.