(click here to see the full abstract of Mr. Eric Finseth’s presentation at the Symposium) While Silicon Valley tech companies and VC firms did not have any clear hand in contributing to the recent financial crisis, several new regulations may nonetheless present new burdens on their industry. While exemptions were written throughout most of the Dodd Frank act to prevent VC firms from the obligations imposed on other financial institutions, some “collateral damage” has unfortunately manifested itself (in preventing relatively small companies from financing themselves through the “friends and family” channel).
Live Blogging at the Dodd-Frank Symposium: Recognizing the Costs of New Regulations on VC Funds
SEC Attempting to Correct Incentives for Risk-taking that Underlie Executive Compensation Structures
The SEC recently proposed a rule that would require greater disclosure of performance-based compensation structures for broker-dealers and investment advisers at companies that manage greater than $1 billion in assets. In addition, the rule would enable SEC regulators to prohibit compensation schemes that it believes promote inappropriate risk-taking and regulators may even require partial deferral of incentive-based compensation for up to three years (for companies managing greater than $50 billion in assets).
This rule is just one of many that the SEC, in collaboration with various other regulatory agencies, has been empowered to implement under the Dodd-Frank Act in order to correct incentive structures which many believe contributed to the recent financial collapse. Many financial institutions (and non-financial institutions, for that matter) pay their employees and executives based on their individual, as well as on the company’s, performance in a given period of time. These compensation structures enable firms to overcome various principal-agent problems that may otherwise exist between shareholders and company executives (as well as between company executives and lower-level employees). The problem with this scheme is that it incentivizes individuals to take risks, particularly risks that pay off in the short term, as the employees stand to benefit tremendously if the risks pay off and yet are not faced with the prospect of personally losing the money that is invested if the risks don’t pay off. The result of this incentive structure is that broker-dealers and investment advisors may end of taking excessive risks, in pursuit of the high yields that fuel their own personal compensation.
Rules are good, but who’s going to enforce them?
Since the Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in July, many federal agencies, including the Securities and Exchange Commission, the Federal Reserve Board, and the Office of the Treasury, have been tasked with creating new rules that will govern the future of America’s financial institutions. The Act contains some 300 provisions and may necessitate promulgating upwards of 243 regulations. However, many agencies are now facing an important question: where is the money to properly enforce these new regulations going to come from? Heated debate has raged about appropriate funding for agencies like the SEC and CFTC, whose 2010 funding levels are set to expire March 4.
SEC Chairman Mary Shapiro recently raised the issue before the Senate. Ms. Shapiro has stated that “[t]he real crunch comes after the rules are in place and [the SEC] has to operationalize them. We lack the resources to do that.” Congress’ failure to pass a budget that would have given the SEC an 18% funding increase puts that agency and other regulatory agencies in a bind. If unsuccessful, Shaprio has stated that the SEC will have to cut some 600 employees and would be unable to implement the rules and studies required by the Act.
To help mollify the situation, on January 26, 2011, the Federal Bar Association Securities Law Committee Executive Counsel wrote a letter to members of Congress imploring them to vote for more funding for the SEC. The letter asks Congress for “a substantially increased appropriation for the SEC” through registration fees at no cost to the American taxpayer, and “the adoption for the SEC of the same funding model that Congress has used successfully for decades for the nation’s banking regulators.” In response to the fiscal stalemate, Senator Barney Frank, one of the authors of Dodd-Frank Act, introduced an amendment last week to increase the SEC’s funding by $131 million.
Has Sarbanes-Oxley Reduced IPOs?
The Sarbanes-Oxley Act was enacted in 2002, setting higher standards for all U.S. public company board, management and public accounting firms. The Act mandated reforms to enhance financial disclosures and corporate responsibility. Since the enactment of Sarbanes-Oxley, a debate has ensued about whether or not overregulation has deterred foreign companies from listing in the United States. In response, the SEC reduced regulatory requirements on foreign and public companies, making compliance easier. Public companies now face lighter regulations as a result of Supreme Court decisions and requirements that have been eliminated through the Dodd-Frank Act. The Supreme Court made it significantly harder to sue public companies for securities fraud in several cases and the Dodd-Frank Act eliminated the requirement that auditors must certify the validity of company’s internal controls for companies with a market value of less than $75 million.
A study by Berkeley Law Professor Robert Bartlett, however, found that a majority of companies bought by private equity firms still voluntarily complied with the requirements of Sarbanes-Oxley. Professor Bartlett’s study corrects a significant bias in the hypothesis that the compliance costs associated with Sarbanes-Oxley resulted in an increase of firms going private. His study provides considerable evidence to show that the wave of going-private was not driven by the compliance costs.