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Speech by SEC Commissioner:
Facilitating Real Capital=20 Formation

by

Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

Council of Institutional Investors Spring = Meeting
Washington,=20 D.C.
April 4, 2011

Good morning. I am delighted to be here at the Council of = Institutional=20 Investors=92 Spring Meeting. I have appreciated that the Council = and its=20 members have been a strong voice working toward meaningful reform = in the=20 aftermath of the financial crisis. As these challenging times = continue, I=20 encourage you to continue to be a strong, proactive voice for = investors.=20 Before I begin my remarks this morning, I need to issue the = standard=20 disclaimer that the views I will express today are my own and do = not=20 necessarily reflect the views of the Commission, my fellow = Commissioners,=20 or members of the staff.

Today, I want to talk about capital formation. For over 30 = years, I=20 advised many clients as to their capital raising efforts in order = to grow=20 their businesses, and I worked with institutions that held = significant=20 stakes in companies who grew their operations by making better = products,=20 and selling more of them.

I have been growing increasingly concerned about the discussion = that is=20 taking place in our country regarding capital formation. This = discussion=20 seems to confuse the singular act of capital raising with = the much=20 broader concept of capital formation. Moreover, this = discussion=20 fails to take into account the importance of disclosure in helping = investors assess risks and make informed investment decisions. = Disclosure=20 leads to an informed investor - and informed investors are ones = who will=20 make investment decisions that collectively, in the aggregate, = will yield=20 productive benefits and growth to the real economy.

I know you understand exactly what I mean. The Council is an=20 association of members who have a long-term stake in the U.S = economy. You=20 are self-described as the =93patient capital=94 of the markets = because, in=20 general, you have =9330-year investment horizons and heavy use of = indexing=20 strategies.=94¹ You understand that for most = investments to make=20 money, the company generally requires organic or strategic growth = over a=20 period of time.

I share this long-term view.

At a time when too many people are facing tough economic = conditions in=20 our country, with persistently high levels of unemployment, we = need to=20 understand what is needed for investments to result in productive = uses.=20 With millions of Americans unemployed, and with those who are = employed=20 earning less,² our recovery will be anemic until all = Americans=20 can share in it and, by participating in the recovery, drive = economic=20 growth.

In particular, for this effort to be robust, the SEC must be = clear=20 about the benefits of regulation and how regulation has been, and = can=20 continue to be, a driver of informed investments and economic = growth. I am=20 concerned about the negative ramifications that will flow from = those who=20 refuse to face the reality that regulation and mandatory = disclosure are=20 essential to strong capital formation and to real economic = growth.³

I think that a focus on reality was a large part of what = President=20 Obama meant when earlier this year he issued an executive order on = regulation.⁴ I agree with President Obama when he = stated that=20 the purpose of =93the nation=92s regulatory system=94 is that it = =93must protect=20 public health, welfare, safety, and our environment while = promoting=20 economic growth, innovation, competitiveness, and job creation.=94 = In doing=20 so, the President made clear that regulation =93must be based on = the best=20 available science.=94

I plan to spend my time with you today discussing the = following:

The way that strong regulation facilitates capital formation = and=20 real economic growth and the science that supports it; and=20
My concern that the U.S. capital markets are being exploited = by=20 certain foreign companies, not only harming U.S. investors, but = also=20 negatively effecting the environment for capital formation.=20

The Real Economy and Capital Formation

Let me begin by talking about the real economy and the = essential and=20 positive role of securities regulation. By the =93real economy,=94 = I mean our=20 country=92s capacity to produce goods, to provide services, and = for our=20 citizens to earn a living wage. From my standpoint, one of the = most=20 important insights from the financial crisis was that deregulated = and=20 poorly regulated markets misallocated our country=92s capital and = other=20 scarce resources, resulting in trillions in mispriced assets, = devastating=20 the savings of American families, and resulting in painful levels = of=20 unemployment that persist to this day.⁵ As credit contracted, businesses saw = their=20 lending costs soar and hoarded cash in the face of weak = demand.⁶

The Reality About Capital Formation

As an SEC Commissioner focused on the real economy and on our = recovery=20 from the financial crisis, I am gratified that the SEC=92s mandate = includes=20 the consideration of capital formation. Facilitating capital = formation and=20 improving the real economy go hand in hand.

However, it is important that we define what facilitating = capital=20 formation means. When Congress included the consideration of = capital=20 formation in the SEC=92s mandate it did not define the = term.⁷ The term, however, has been around = for decades.=20 It is generally understood that capital formation is a = macroeconomic=20 benchmark that measures changes in the amount of productive = capital in the=20 economy as a whole.⁸ In essence, capital formation is = about all the=20 ways of creating productive capital in our economy, including but = not=20 limited to improving infrastructure, building plants, and hiring=20 workers.⁹

But, in the discussions about capital formation, it seems to = have=20 become synonymous with the ability to raise funds. Whatever makes = it=20 easier and cheaper for issuers to raise money seems to constitute = capital=20 formation.¹⁰ However, the singular act of raising = capital=20 does not necessarily result in capital formation.

Let me illustrate this with a prime example where a lot of = money was=20 raised from investors who received little to no information and = where, as=20 a result, fewer productive assets were produced. This example = involves=20 securitizations of asset-backed securities. It is true that = securitization=20 can lower borrowing costs and be an important way to facilitate = capital=20 formation, but we have learned that the process must be improved. = The vast=20 majority of asset-backed securities =96 especially the structured = finance=20 products that were key drivers of the financial crisis =96 were = sold in=20 private placements where no disclosure was required.¹¹ Moreover, for those securitizations = that were=20 sold in registered deals, ongoing public reporting generally = terminated=20 after one year.¹²

As the Financial Crisis Inquiry Commission observed, =93By the = time the=20 financial crisis hit, investors held more than $2 trillion of = non-GSE=20 mortgage backed securities, and close to $700 billion of CDOs that = held=20 mortgage-backed securities. These securities were issued with = practically=20 no SEC oversight. And only a minority were subject to the SEC=92s = ongoing=20 public reporting requirements.=94¹³ As the SEC said last year, = =93Securitization in=20 the private, unregistered market played a significant role in the=20 financial crisis.=94¹⁴ In fact, one might argue that we had = capital=20 destruction rather than capital formation.¹⁵

Additionally, if capital raising is the sole consideration to = define=20 capital formation, individuals who engage in Ponzi schemes could = be=20 considered the best facilitators of capital formation in the = business.=20 That simply cannot be right. Following this idea to its logical = conclusion=20 leads to capital destruction rather than capital formation.

Facilitating true capital formation is about helping investors = and=20 other capital providers to make informed decisions. Almost all = investments=20 have risks, and while we all understand the need for investors to = take=20 risks, I want them to take informed risks. Capital formation is = about=20 ensuring that the companies with the best ideas, even if those = ideas are=20 risky, can get the financing to make those ideas a reality. The = goal is=20 for issuers to provide potential investors with appropriate = information so=20 that investors can assess the risk of investing their = capital.¹⁶ For that goal to be reached, we need = strong=20 and effective securities regulation that fosters appropriate = disclosures.=20

By comparison, just think about the recent financial crisis, as = well=20 the Great Depression, and you will see that poor securities = regulation=20 does not facilitate the formation of productive capital. In both = crises,=20 the savings of hard working Americans went into investments that = wound up=20 being worth little, if anything. And in many cases it was because = of a=20 lack of regulation and disclosures.¹⁷

In addition to the lessons of history, there are several recent = studies=20 that clearly demonstrate that capital formation is facilitated by = a=20 strong, mandatory disclosure regime.

The Best Available Science: Strong Securities Regulation is = Important=20 to the Real Economy

As those of us who took science in school will remember, in = science,=20 there is theory and there is empirical evidence. The theory of why = strong=20 mandatory disclosure drives capital formation is straightforward.=20 Disclosure improves the accuracy of share prices, and helps to = determine=20 which investment projects should receive society=92s scarce = capital. In=20 addition, disclosure assists shareholders in monitoring management = and in=20 proxy voting, which helps ensure that the projects that are=20 undertaken are managed better.

Disclosure also helps the broader public determine how best to = invest=20 capital. For example, imagine an entrepreneur contemplating entry = into the=20 telephone business. She learns from AT&T=92s segment = disclosures that=20 revenue from landline telephone service has declined by over 10% = each of=20 the last two years.¹⁸ It=92s not hard to imagine that this = entrepreneur may decide that a new startup aiming to improve = telephone=20 service should also consider whether it would be effective in a = wireless=20 or VOIP context. Venture capital investors would also look harder = at a=20 business plan whose profitability was based solely on landline = telephone=20 service. The public disclosure improves the quality of their = decision=20 making.

Economic theory explains not only why disclosure is valuable, = but also=20 why regulation is essential for adequate disclosure to be = provided. There=20 are a lot of reasons for this. One principal reason is that = disclosure is,=20 in economic terms, a =93public good=94 in that its benefits are = enjoyed=20 broadly by the public =96 across all investors, prospective = investors,=20 competitors, and other interested parties. However, because the = benefits=20 are shared broadly, there may not be any single group that will = fight for=20 disclosure at a level that benefits all. This includes companies. = Even the=20 best companies and their management who are focused on = high-quality=20 disclosure live in a world where the costs and inconvenience of = preparing=20 disclosure are borne by them but the disclosure benefits = shareholders and=20 other market participants. Without regulation requiring = disclosure,=20 management, especially with bad news to report, can be expected to = resist=20 disclosure.

Regulation also sets a level playing field by subjecting all = companies=20 to the same requirements. Without regulation mandating public = disclosures,=20 the widespread benefits of disclosure would not be achieved, and = investors=20 and the public would not receive the information they need. As a = result,=20 shareholders would be unable to judge how management is = performing, and=20 investors would be denied information to inform their investments=20 decisions. The public nature of the disclosure leads to decisions = that=20 allow our economy to be as strong as it can be.¹⁹

This theory has been evidenced in several empirical studies = over the=20 past decade that clearly show the positive effect of securities = regulation=20 and mandatory disclosure.²⁰ Let me briefly summarize just a few = of the=20 recent studies and their results:

First, a 2003 study that looked at the effect of the = Commission's rules=20 requiring management to discuss and analyze the company=92s = financial and=20 operating results, the so-called MD&A requirements. MD&A = was a=20 significant new disclosure rule when it was adopted. It required=20 management to reveal trends and risks that made the information = about the=20 company's current results more understandable. The study found = strong=20 evidence that MD&A disclosure resulted in more accurate and = informed=20 share prices =96 and that it contributed to a better functioning = real=20 economy.²¹

Second, a 2006 study that looked at what happened to = widely-held=20 companies that were traded over-the-counter after the securities = laws were=20 amended to require these companies to make disclosures specified = by the=20 SEC.²² The study found that the newly = required=20 disclosures created billions of dollars of value for shareholders = of the=20 OTC companies.²³ This study is strong evidence of the = benefits=20 that public disclosure provides.²⁴

One last study I want to draw to your attention to is quite = recent.=20 This 2010 study examined the effect on share price accuracy and = trading=20 arising from the SEC=92s rules requiring separate =93segment = reporting=94 or=20 =93line of business=94 reporting. These regulations required = issuers to=20 disclose the sales and net income derived from each of the lines = of=20 business in which they were significantly involved. The study = finds=20 =93strong evidence=94 that this disclosure did, in fact, increase = share price=20 accuracy and improve market liquidity.²⁵

There are many other economic studies that find public = disclosure is=20 valuable to the companies that make it, but more importantly to = the=20 economy as a whole.²⁶

Moreover, in addition to the economic arguments explaining how = strong=20 disclosure is beneficial to the real economy, we should not forget = that=20 disclosure also is supported by classic notions of investor = protection and=20 by the basic notion of fairness=96 that a capital provider, the = shareholder,=20 as principal, should know what its agent, the corporation and its=20 management, is doing. There is also a sense of marketplace = fairness that=20 is part of the fabric of this country: that a buyer shouldn=92t = pay more=20 than something is worth, especially because of a lack of = information.

Where would our economy be, and how much real, productive = capital would=20 our country have, if there had been better disclosures about = asset-backed=20 securities, about CDOs, and all the other securities that were = offered and=20 sold in poorly regulated markets? With trillions upon trillions of = dollars=20 being allocated in the capital markets, and with an economy that = is=20 increasingly sensitive to information, even small changes in = disclosure=20 can have a tremendous impact. That is the reality. And it is = important we=20 keep the facts in mind.

Certain Foreign Companies Abusing U.S. Capital Formation = Process

With that foundation, I would like to highlight a disturbing = trend that=20 seems to have challenging implications for capital formation and = investor=20 protection. In recent years, we have seen a spike in private = companies=20 merging with a public shell company as a way of going public. = While it is=20 Chinese companies that have grabbed recent headlines, the problems = coming=20 to the forefront would not necessarily be limited to companies = based in=20 China.

There are a lot of different ways for companies to access the = public=20 markets, but not all of them are equal. They differ in the quality = of the=20 disclosures,the time investors and the SEC typically = have to=20 consider them, and the protections that investors have against = false and=20 fraudulent statements.

The traditional IPO remains the gold standard. In a traditional = IPO,=20 the SEC and the public receive robust disclosures, along with the = time to=20 review and consider them, backed up by real liability that puts = the risk=20 of false statements on the people in the best position to ensure = accuracy,=20 not on the investors. In addition, underwriters and auditors = engage in due=20 diligence which enhances the disclosure quality.

Another way to access the public markets is Exchange Act = registration=20 of a class of securities, rather than through registration of a = public=20 offering. For example, when the company reaches a certain size and = has a=20 class of equity securities that is considered widely-held because = of its=20 number of shareholders, it is required to provide public = disclosures.=20 However, unlike a traditional IPO, there is no underwriter = performing due=20 diligence.

A common but lesser known way of accessing the public markets = is the=20 reverse merger into a public shell, or where a public shell merges = into a=20 private company, a so-called =93backdoor registration.=94²⁷ For those of you not familiar with = these types=20 of mergers, what typically happens is a private company seeking to = go=20 public merges with a public shell company. Before the transaction, = the=20 public shell company no longer has substantive operations, but its = public=20 company registration remains in effect. The transaction gives the = formerly=20 private company the credibility and access to capital of being = registered=20 as a public company, without any of the vetting from underwriters = and=20 investors that companies undergo when they perform a traditional = IPO.

Since January of 2007, there have been over 600 backdoor = registrations.=20 Over 150 of these have been by companies from China and the China=20 region.²⁸ Notwithstanding the SEC rulemaking = of a few=20 years ago to respond to abuses involving shell companies,²⁹ we are seeing increasing problems. = While the=20 vast majority of these Chinese companies may be legitimate = businesses, a=20 growing number of them are proving to have significant accounting=20 deficiencies or being vessels of outright fraud.³⁰

As just one example of this phenomenon, two companies that were = numbers=20 1 and 2 on the Investor=92s Business Daily 100 have now been shown = to have=20 significant issues.³¹ One of these companies had to = restate its=20 earnings and was delisted just last week.³² The other has admitted that at the = very least=20 two of its manufacturing contracts didn=92t actually exist.³³ Just last Friday, the SEC suspended = trading in=20 another Chinese company that became public in the United States = through a=20 shell.³⁴ This was the second SEC trading = suspension=20 imposed on Chinese companies in this situation in the month of = March=20 alone.³⁵ Additionally, NASDAQ and NYSE Amex = have=20 recently suspended trading in several of these companies.³⁶

I support all of the efforts to address these problems. The SEC = staff=20 has been working collaboratively and tirelessly with many others = to=20 investigate and shed light on this situation. It has been widely = reported=20 that the SEC set up an internal task force to investigate fraud in = overseas companies with listings on U.S. exchanges, with = particular=20 emphasis on companies engaging in these mergers to achieve = backdoor SEC=20 registration. The staff=92s hard work has yielded, and will = continue to=20 yield, results.

In the world of backdoor registrations to gain entry into the = U.S.=20 public market, the use by Chinese companies has raised some unique = issues,=20 even compared to mergers by U.S. companies. Two important ones = are:

First, there appear to be systematic concerns with the = quality of=20 the auditing and financial reporting; and
Second, even though these companies are registered here in = the U.S.,=20 there are limitations on the ability to enforce the securities = laws, and=20 for investors to recover their losses when disclosures are found = to be=20 untrue, or even fraudulent.=20

I am worried by the systematic concerns surrounding the quality = of the=20 financial reporting by these companies. In particular, according = to a=20 recent report by the staff of the Public Company Accounting = Oversight=20 Board (PCAOB), U.S. auditing firms may be issuing audit opinions = on the=20 financials, but not engaging in any of their own work.³⁷ Instead, the U.S. firm may be = issuing an=20 opinion based almost entirely on work performed by Chinese audit = firms. If=20 this is true, it could appear that the U.S. audit firms are simply = selling=20 their name and PCAOB-registered status because they are not = engaging in=20 independent activity to confirm that the work they are relying on = is of=20 high quality. This is significant for a lot of reasons, including = that the=20 PCAOB has been prevented from inspecting audit firms in China.

Moreover, the PCAOB noted that these issues were layered on top = of=20 other factors that may have a negative impact on the audit, = including:=20

The need to understand the local language;=20
The use of local audit firms or personnel from an outside = audit firm=20 to complete a portion of the audit work;=20
Additional travel time and expense; and=20
The need to understand the local business environment in = which the=20 client operates.

An additional problem with these backdoor registrations is that = there=20 may be difficulty in prosecuting violations. Enforcement against=20 falsehoods in the context of these companies is difficult. The = documents=20 and people who have the information about the company and whether = there=20 was misconduct are often outside the reach of subpoena power. = However,=20 notwithstanding these obstacles, our staff is committed to doing=20 everything they can with the resources we have. The SEC has = already=20 brought cases and will continue to do so.

Nonetheless, investors should still be aware that the SEC and = private=20 plaintiffs may have a more difficult time enforcing their remedies = and=20 that recovery for investor losses could be limited. For one thing, = the=20 persons to punish and the assets that could satisfy a judgment may = be=20 located outside of the United States and harder to access. In = addition,=20 remedies obtained in the United States may not be enforceable in = foreign=20 countries, where the bulk of the assets might reside.

The consequences of the growing problems in this area has real=20 significance, because it has been reported that billions of U.S. = savings=20 and investment dollars have been entrusted with these = companies.³⁸

Finally, and to return to our earlier topic of capital = formation, it=92s=20 important to see the connection between capital formation and = strong=20 enforcement of securities laws. We have seen clearly that capital=20 formation is improved with solid disclosures =96 but what happens = when the=20 disclosures are lies? That=92s when we need strong enforcement. = Capital=20 formation is strengthened when investors have confidence that the = laws=20 will be obeyed and that, when they=92re not, that the fraudsters = will be=20 made to pay. Moreover, strong enforcement =96 by providing = deterrence -=20 helps to ensure the disclosure is truthful and complete in the = first=20 place. Where savings and investments are allocated under = inadequate or=20 false information the environment for capital formation is = negatively=20 affected. That is why I=92ve been a consistent advocate for a = robust=20 enforcement program and an adequately funded SEC. My hope is that=20 potential fraudsters are scared into telling the truth to avoid = the=20 consequences.

Conclusion

With our country in an anemic recovery, with persistent = unemployment=20 and underemployment, we must facilitate real capital formation. = There is=20 compelling evidence that securities regulation must be strong. We = need to=20 take the lessons learned in the crisis and the findings from = high-quality=20 empirical analysis and use them to improve our regulations and the = economy.

How we move forward will set the tone for future economic = growth in=20 this country. It is important that all of us continue to fight for = effective regulation. As I said in the beginning, the Council has = been a=20 strong advocate of investors, and I know you will continue to be = actively=20 engaged.

Thank you for having me here today. I have enjoyed being with = you. Best=20 wishes for an outstanding conference.

Endnotes

¹http://sec.gov/cgi-bin/goodbye.cgi?www.cii.org/about.

²See, e.g., Catherine Rampell, = Higher-Paying=20 Jobs Lost, but Lower-Paying Jobs Gained, New York Times, = Economix,=20 February 23, 2011. (Observing that =93the private sector job = market still=20 has a long way to go before it returns to its previous peak. = Worse, those=20 jobs that have been created in the last year typically pay = less=20 than the jobs they=92re replaced.=94)(emphasis original.) http://sec.gov/cgi-bin/goodbye.cgi?economix.blogs.nytimes.c= om/2011/02/23/higher-paying-jobs-lost-but-lower-paying-jobs-gained/.<= /P>

³Some have called on the SEC to permit = public=20 offerings without public disclosures by repealing the prohibition = on=20 general solicitations in private placements. Others have called on = the SEC=20 to permit companies to be held by an increasing number of = shareholders=20 before public disclosures are required to be made.

⁴See, Executive Order 13563 of January = 18, 2011,=20 76 FR 3821 (January 21, 2011). Although this order applies to = executive=20 agencies, it does not apply to independent agencies such as the = Securities=20 and Exchange Commission. However, the SEC is seeking public = comment on how=20 its regulations may be modified to improve the economy. See = Reviewing Regulatory Requirements to Ensure They Continue to = Promote=20 Economic Growth, Innovation, Competitiveness, and Job Creation, http://sec.gov/spotlight/regulatoryreviewcomments.shtml= =20 (stating that =93Given that our mission includes the facilitation = of capital=20 formation, we are seeking suggestions from the public on = modifying,=20 streamlining, expanding or repealing our existing rules to better = promote=20 economic growth, innovation, competitiveness and job creation =85 = .=94).

The SEC is generally required by statute to consider the = effect=20 on capital formation of its rules, and this is an important=20 responsibility. However, Congress intended investor protection to = remain=20 the foremost mission of the SEC. See, Report of the House = Committee=20 on Commerce, H.R.Rep. 104-622 at 39 (stating that =93Section 106 = requires=20 the Commission to consider efficiency, competition, and capital = formation=20 when it engages in rulemaking or reviews SRO-proposed rules = pursuant to=20 the Securities Act, the Exchange Act, or the Investment Company = Act under=20 a =91=91public interest=92=92 standard. The new section makes = clear that matters=20 relating to efficiency, competition, and capital formation are = only part=20 of the public interest determination, which also includes, among = other=20 things, consideration of the protection of investors. For 62 = years, the=20 foremost mission of the Commission has been investor protection, = and this=20 section does not alter the Commission's mission.=94)(emphasis=20 added).

⁵See, e.g., Benjamin M. Friedman, The = Failure of=20 the Economy & the Economists, New York Review of Books (May = 28, 2009)=20 (observing that, "By now there are few people who do not = acknowledge that=20 the major American financial institutions and the markets they = dominate=20 turn out to have served the country badly in recent years. The = surface=20 evidence of this failure is the enormous losses=97more than $4 = trillion on=20 the latest estimate from the International Monetary Fund=97that = banks and=20 other lenders have suffered on their mortgage-related investments, = together with the consequent need for the taxpayers to put up = still larger=20 sums in direct subsidies and guarantees to keep these firms from = failing.=20 With nearly 9 percent of the labor force now unemployed and still = more=20 joining their ranks, industrial production off by 13 percent = compared to a=20 year ago, and most companies' profits either falling rapidly or = morphing=20 into losses, it is also evident that the financial failure has = imposed=20 huge economic costs.") http://sec.gov/cgi-bin/goodbye.cgi?www.nybooks.com/articles= /22702.=20

⁶See, Simon H. Kwan, Financial = Crisis and Bank=20 Lending, Federal Reserve Bank of San Francisco Working Paper = Series=20 (May 2010) (=93This paper focuses on the extent and the mechanism = of credit=20 tightening during the recent financial crisis. The main findings = of this=20 study are the following. As of 2010:Q1, the [=93commercial and = industrial=94]=20 loan rate spread over the federal funds rate was about 66 basis = points=20 higher than its long-term average. Because lending terms were = unusually=20 loose just prior to the eruption of the crisis, the increase in = the loan=20 rate spread from the trough in 2007:Q2 to 2010:Q1 was almost one=20 percentage point. [Moreover, I do not find evidence that smaller=20 bank-dependent borrowers, proxied by loan size, suffered more from = bank=20 tightening than large borrowers.]=94), http://sec.gov/cgi-bin/goodbye.cgi?www.frbsf.org/publicatio= ns/economics/papers/2010/wp10-11bk.pdf.

Kathleen M. Kahle and Ren=E9 M. Stulz, Financial Policies, = Investment,=20 And The Financial Crisis: Impaired Credit Channel Or Diminished = Demand For=20 Capital?, Fisher College of Business Working Paper Series = (February=20 2011) (=93The conventional view of the financial crisis is that = bank losses=20 from toxic assets led to fire sales by banks and a bank credit = contraction=20 (see Brunnermeier (2009) and Shleifer and Vishny (2010)). These = toxic=20 assets were mostly securities backed by subprime and related = mortgages, so=20 their loss in value had little to do with the performance of = industrial=20 firms, making the credit contraction an exogenous event for these = firms.=20 Research in finance, including research on the recent financial = crisis,=20 shows that exogenous credit contractions have real effects on = firms by=20 forcing them to reduce investment. However, an exogenous = contraction in=20 the supply of credit was not the only adverse development in the = recent=20 crisis. Credit contracted endogenously as well because of a demand = shock=20 that led to lower cash flows, loss of investment opportunities, = and weaker=20 balance sheets. Further, risk increased sharply in the fall of = 2008,=20 making firms less credit worthy and leading to a flight to quality = that=20 increased risk premia. Most of the evidence is inconsistent with = the view=20 that the direct impact of the bank credit supply shock on firms = was the=20 dominant factor. Contrary to the predictions of the exogenous = credit=20 supply shock hypothesis, net debt issuance does not fall during = the first=20 year of the crisis and firms most likely to be bank dependent = decrease=20 their net equity issuance rather than increase it. After September = 2008,=20 net debt issuance drops sharply, but firms hoard cash, and firms = more=20 likely to be bank dependent do not decrease capital expenditures = more than=20 other firms. Overall, our evidence shows that the demand shock, = the=20 resulting endogenous credit contraction, and the reaction of = [operating=20 companies] to the increase in risk play a dominant role in = explaining=20 firms=92 financial and investment policies.=94), http://sec.gov/cgi-bin/goodbye.cgi?papers.ssrn.com/sol3/pap= ers.cfm?abstract_id=3D1754660.

⁷The mandate to consider capital = formation in=20 connection with certain rulemaking was added to the federal = securities=20 laws in the National Securities Markets Improvements Act of 1996. =

⁸See, e.g., Simon Kuznets, Capital = in the=20 American Economy: Its Formation and Financing (Princeton = University=20 Press 1961), at 15-16 and 389 (=93In modern society, capital is = the stock of=20 means, separable from human beings and legally disposable in = economic=20 transactions, intended for use in producing goods or income. =85 = Capital in=20 the hands of various units within a country=97households, business = firms,=20 nonbusiness associations, governments=97may take the form of goods = (tangible=20 assets) or claims (financial assets or intangibles). The claims = may be=20 domestic, against residents of the country, or foreign, against = residents=20 of other countries. In totaling the stock of capital of the = country,=20 domestic claims are exactly offset by domestic obligations, and = only the=20 net balance of foreign claims remains. Nationwide capital, by = definition,=20 therefore, consists of the stock of goods within the country and = the net=20 balance (positive or negative) of foreign claims. Capital = formation,=20 strictly speaking, denotes additions to the stock of = tangible goods=20 within the country or to foreign claims. These additions are = usually taken=20 on a net basis, which means that for some owner or user groups, = for some=20 periods, or for some types of goods or claims, there may be = subtractions=20 rather than additions, declines rather than rises. We should, = then, speak=20 of capital dissolution or reduction. But it has become customary = to use=20 the term capital formation for all changes in the stock of goods = or=20 claims, whether positive or negative, and to use the latter as = qualifying=20 adjectives. Thus, nationwide capital formation is a sum of the net = changes=20 in the stock of goods within the country and in the net balance of = foreign=20 claims. For some purposes, changes in the stock of durable = (long-lived)=20 capital goods are estimated on a gross basis: capital goods = consumed are=20 not subtracted from the total additions to stock. And gross = capital=20 formation is distinguished from net in that it, too, is gross of = the=20 allowance for current consumption.=94 Id. at 15-16). (=93By = capital=20 formation we mean diversion of part of the current [national] = product for=20 use as capital, that is, goods to produce other goods or = income.=94 Id. at=20 389.) http://sec.gov/cgi-bin/goodbye.cgi?www.nber.org/books/kuzn6= 1-1.

⁹Over time, economically efficient = capital=20 raising would be expected to effectively facilitate capital = formation.=20

¹⁰While capital raising and capital = formation=20 are not the same, the financing environment affects capital = formation.=20 See, e.g., Benjamin M. Friedman, Financing Corporate Capital = Formation=20 (University of Chicago Press 1986) (collecting papers and = noting the=20 =93The central importance of capital formation to the economy=92s = further=20 growth and development is broadly recognized, and physical = investment=20 decisions and their financial counterparts are fundamentally=20 interdependent. The financial environment therefore influences = both the=20 amount and the composition of the capital formation that an = economy like=20 that of the United States undertakes.=94 Id. at 1.) Available = online at=20 http://www.nber.org/books/frie86-1.

¹¹Technically, disclosure is not = required in=20 Rule 506 transactions under Regulation D except to investors who = are not=20 accredited. Offers and sales of asset-backed securities to = non-accredited=20 investors was essentially non-existent. See, Release No. 33-9117,=20 Asset-Backed Securities, 75 FR 23327 (May 3,2010)(stating that = =93Except for=20 a few types of ABS, we believe that investors in privately issued=20 asset-backed securities typically would qualify as accredited = investors,=20 and therefore, issuers would not be required to provide the = prescribed=20 information to them in order rely on Rule 506 of Regulation D for = the sale=20 of the securities.=94). http://sec.gov/rules/proposed/2010/33-9117.pdf. =

¹²Section 942(a) of the Dodd-Frank = Wall Street=20 Reform and Consumer Protection Act addressed the concern regarding = ongoing=20 reporting following registered offerings of asset-backed = securities. See=20 also, Release No. 34-63652 (proposing rules to implement this=20 provision).

¹³FCIC report at 169.

¹⁴Release No. 33-9117, Asset-Backed = Securities,=20 75 FR 23327 (May 3, 2010). http://sec.gov/rules/proposed/2010/33-9117.pdf. =

¹⁵The Dodd-Frank Wall Street Reform = and Consumer=20 Protection Act sought to improve the asset-backed securities = market. In=20 addition to the provision discussed above in note 12, another = example is=20 Commission rulemaking pursuant to Section 943 of the Dodd-Frank = Act, which=20 requires certain disclosures in respect of registered as well as=20 unregistered asset-backed securities. See, Release No. 33-9175 (76 = FR 4489=20 January 26, 2011].

¹⁶See, e.g., George A. Akerlof, The = Market=20 for "Lemons": Quality Uncertainty and the Market Mechanism, = The=20 Quarterly Journal of Economics (August 1970) (discussing the = market for=20 used cars, for medical insurance for those over 65 years old, and = others=20 to demonstrate how a lack of adequate information about the = quality of an=20 item being purchased can drive a market out of existence: =93There = may be=20 potential buyers of good quality products and there may be = potential=20 sellers of such products in the appropriate price range; however, = the=20 presence of people who wish to pawn bad wares as good wares tends = to drive=20 out the legitimate business. The cost of dishonesty, therefore, = lies not=20 only in the amount by which the purchaser is cheated; the cost = also must=20 include the loss incurred from driving legitimate business out of=20 existence.=94).

¹⁷Regarding the Great Depression, see, = e.g.,=20 H.R. Rep. No. 1383, 73d Cong. 2d Sess. at 11 (1934) (stating that: = =93No=20 investor, no speculator, can safely buy and sell securities upon = the=20 exchanges without having an intelligent basis for forming his = judgment as=20 to the value of the securities he buys or sells. The idea of a = free and=20 open public market is built upon the theory that competing = judgments of=20 buyers and sellers as to the fair price of a security brings about = a=20 situation where the market price reflects as nearly as possible a = just=20 price. Just as artificial manipulation tends to upset the true = function of=20 an open market, so the hiding and secreting of important = information=20 obstructs the operation of the markets as indices of real value. = There=20 cannot be honest markets without honest publicity. Manipulation = and=20 dishonest practices of the market place thrive upon mystery and = secrecy.=20 The disclosure of information materially important to investors = may not=20 instantaneously be reflected in market value, but despite the = intricacies=20 of security values truth does find relatively quick acceptance on = the=20 market. That is why in many cases it is so carefully guarded. = Delayed,=20 inaccurate, and misleading reports are the tools of the = unconscionable=20 market operator and the recreant corporate official who speculate = on=20 inside information. Despite the tug of conflicting interests and = the=20 influence of powerful groups, responsible officials of the leading = exchanges have unqualifiedly recognized in theory at least the = vital=20 importance of true and accurate corporate reporting as an = essential cog in=20 the proper functioning of the public exchanges. Their efforts to = bring=20 about more adequate and prompt publicity have been handicapped by = the lack=20 of legal power and by the failure of certain banking and business = groups=20 to appreciate that a business that gathers its capital from the = investing=20 public has not the same right to secrecy as a small privately = owned and=20 managed business. It is only a few decades since men believed that = the=20 disclosure of a balance sheet was a disclosure of a trade secret. = Today=20 few people would admit the right of any company to solicit public = funds=20 without the disclosure of a balance sheet.=94).

Regarding the recent financial crisis, see the FCIC report.

¹⁸See, Form 10-K of AT&T Inc., = Exhibit 13,=20 Selected Financial and Operating Data, Wireline Segment Results, = at 9. http://sec.gov/Archives/edgar/data/732717/00007327171100001= 4/ex13.htm.=20

¹⁹See, e.g., Merritt B. Fox, Retaining = Mandatory=20 Securities Disclosure: Why Issuer Choice Is Not Investor = Empowerment, 85=20 U. Va. L. Rev. 1335 (1999).

²⁰There are studies that find = otherwise. For=20 example, two earlier studies (Stigler 1964 and Bentsen 1973) = purported to=20 find no significant positive effect from mandatory securities = disclosure=20 arising from the passage of the Securities Exchange Act of 1934. = These=20 studies have been criticized on methodological grounds and, for = one study,=20 the data appear to actually support the opposite conclusion. = See,=20 Retaining Mandatory Securities Disclosure: Why Issuer Choice Is = Not=20 Investor Empowerment, referenced above at note 20.

²¹See, Merritt B. Fox, Randall Morck, = Bernard=20 Yeung, and Artyom Durnev Law, Share Price Accuracy, and = Economic=20 Performance: The Empirical Evidence, , 102 Mich. L. Rev. 331 = (2003)=20 (the conclusion that more accurate and informed share prices = contribute to=20 the real economy referenced (i) Jeffrey Wurgler, Financial Markets = and the=20 Allocation of Capital, 58 J. Fin. Econ. 187 (2000) and Artyom = Durnev et=20 al., Value Enhancing Capital Budgeting and Firm-specific Stock = Return=20 Variation, 58 J. Fin 64 (2004), Id. nn 86 and 87.).

²²Exchange Act Section 12(g) was = adopted in the=20 Securities Act Amendments of 1964. [Pub. L. 88=96467 (August 20, = 1964)]

²³See, Michael Greenstone, Paul Oyer, = and=20 Annette Vissing-Jorgensen, Mandated Disclosure, Stock Returns = and the=20 1964 Securities Acts Amendments, Quarterly Journal of = Economics, May=20 2006 (stating that the =93results imply that the 1964 Amendments = created=20 $0.5 to $1.0 billion (1963$) or $3.2 to $6.2 billion (2005$), of = value for=20 stockholders=94 after excluding Royal Dutch Company to =93avoid = potentially=20 overstating the effects.=94) A summary version of the paper is = available at=20 http://sec.gov/cgi-bin/goodbye.cgi?www.stanford.edu/group/s= iepr/cgi-bin/siepr/?q=3Dsystem/files/shared/pubs/papers/briefs/policybrie= f_jan06.pdf.=20

²⁴See also, Allen Ferrell, Mandated = Disclosure and Stock Returns: Evidence from the Over-the-counter=20 Market, 36 J. Legal Studies 1 (2007). An earlier draft is the = John M.=20 Olin Center for Law, Economics, and Business Discussion Paper No. = 453=20 (December 2003). http://sec.gov/cgi-bin/goodbye.cgi?www.law.harvard.edu/facu= lty/fferrell/pdfs/Ferrell-MandatedDisclosure2.pdf.=20

²⁵Durnyev, Fox, Morck and Yeung, = The=20 Effectiveness of Mandatory Disclosure: An Empirical Test of the = Line of=20 Business Regulations (June 23, 2010 Draft on file)(=93These = results are=20 useful in two regards. First, taken together, they constitute very = strong=20 evidence that the LOB Regulations, one of the most important = reforms in=20 the history of the U.S. mandatory disclosure regime, had effects = on how=20 the shares of the issuers to which they applied were priced and = traded.=20 They provide a substantial basis for believing that these effects = included=20 both improved liquidity and increased share price accuracy. = Second, they=20 advance our still imperfect understanding of the way that = information=20 relevant for predicting firms=92 future cash flows is created, = distributed=20 among investors and used in trading and, in this connection, of = the role=20 that mandatory disclosure plays in the determination of share = price=20 accuracy and liquidity.=94).

²⁶See, e.g., Frank B. Cross and Robert = A.=20 Prentice, The Economic Value of Securities Regulation, 28 = Cardozo=20 L. Rev. 333 (2006)(surveying empirical research regarding = securities=20 regulation, conducting an examination of the effects of mandatory=20 disclosure on the equity markets and concluding that =93Our = findings=20 consistently show a positive effect for securities law on equity = markets=20 in models with high levels of statistical significance, and that = the=20 effect of securities is frequently an independently statistically=20 significant one. As we better capture the full effect of = securities law,=20 the association becomes stronger, providing substantial evidence = of the=20 benefits of such laws. When these results are combined with the = prior=20 cross-country research, the historical research, and other = empirical=20 studies discussed in the prior section, the case for strong = securities=20 regulation, particularly mandatory disclosure rules, seems = exceedingly=20 strong.=94).

See also, Lambert, Leuz and Verrechia, Accounting = Information,=20 Disclosure, and the Cost of Capital, Journal of Accounting = (May 2007)=20 (=93We demonstrate that the quality of accounting information = influences a=20 firm=92s cost of capital, both directly by affecting market = participants=92=20 perceptions about the distribution of future cash flows, and = indirectly by=20 affecting real decisions that alter the distribution of future = cash flows.=20 The direct effect occurs because the quality of disclosures = affects the=20 assessed covariances between a firm=92s cash flow and other = firms=92 cash=20 flows. This effect is not diversifiable in large economies. Our = finding=20 provides a direct link between the quality of a firm=92s = disclosures and=20 accounting policies and its cost of capital. In addition, it = extends prior=20 work in the estimation risk literature. =85 Finally, we briefly = comment on=20 the impact of mandated disclosures or accounting policies on = firms=92 cost=20 of capital. Based on our model, increasing the quality of mandated = disclosures should generally reduce the cost of capital for each = firm in=20 the economy (assuming that the expected cash flow of each firm and = the=20 covariance of that firm=92s cash flow with the market have the = same=20 sign).=94); Leuz, Triantis and Wang, Why Do Firms Go Dark: = Causes and=20 Economic Consequences of Voluntary Deregistration, 2006 (=93We = examine a=20 comprehensive sample of SEC deregistrations from 1998 to 2004 = where public=20 companies =93go dark=94, i.e., cease filing with the SEC, but = continue to=20 trade in the OTC market. =85 We also document a large negative = abnormal=20 return to going dark, even when firms already trade in the OTC = market and=20 there is no need to change trading venue. =85 We find that many = firms go=20 dark in response to poor future prospects, financial distress and=20 increased compliance costs after SOX. But we also find evidence = suggesting=20 that some controlling insiders take their firms dark to protect = their=20 private control benefits and decrease outside scrutiny, = particularly when=20 corporate governance is weak and outside investors are less = protected.=94);=20 Leuz and Verrechia, The Economic Consequences of Increased=20 Disclosure, Journal of Accounting Research, Vol. 38, = Supplement:=20 Studies on Accounting Information and the Economics of the Firm = (2000)=20 (=93Economic theory provides compelling arguments that a = commitment by a=20 firm to increased levels of disclosure should lower the = information=20 asymmetry component of the firm's cost of capital. Documenting = this=20 relationship, however, has been difficult empirically. In this = paper, we=20 study a sample of German firms that have adopted IAS or U.S. GAAP=20 accounting standards in their consolidated financial statements. = This=20 international reporting strategy commits firms to substantially = increased=20 levels of disclosure but has no immediate tax or dividend = implications.=20 Moreover, the disclosure levels in Germany under German GAAP have = been=20 characterized as being low. For these reasons, the experimental = setting of=20 our study seems particularly suited to document the economic = consequences=20 of increased disclosure. Our evidence is consistent with the = notion that=20 firms committing to increased levels of disclosure garner = economically and=20 statistically significant benefits. We show in a cross-sectional = analysis=20 that an international reporting strategy is associated with lower = bid-ask=20 spreads and higher share turnover when we control for various firm = characteristics (e.g., performance, firm size, and foreign = listings) as=20 well as selection bias. Additional sensitivity analysis supports = the=20 robustness of our findings. A subsequent "event study" around the = switch=20 to international reporting produces corroborating results.=94). =

²⁷See, Release No. 33-8587, (July 15, = 2005) [70=20 FR 42233] (stating that =93These transactions generally take one = of two=20 forms: In the most common type of transaction, a =93reverse = merger,=94 the=20 private business merges into the shell company, with the shell = company=20 surviving and the former shareholders of the private business = controlling=20 the surviving entity. In another common type of transaction, a = =93back door=20 registration,=94 the shell company merges into the formerly = private company,=20 with the formerly private company surviving and the shareholders = of the=20 shell company becoming shareholders of the surviving entity.=94). =

See also, Release No. 33-8407 [69 FR 21650]. at note 54 (citing = interpretive letter by SEC staff to Lisa Roberts, Director of = NASDAQ=20 Listing Qualifications (Apr. 7, 2000), and explaining that = although SEC=20 staff took the position that =93back-door registration=94 did not = constitute a=20 succession of the surviving entity to the rights and obligations = of the=20 reporting shell company, =93nevertheless, the staff permitted = nonreporting=20 acquiring companies to file Form 8-K reports and enter our = reporting=20 system, so long as specified information was included, rather than = requiring these companies to file registration statements under = Section 12=20 of the [Exchange] Act to become reporting companies.=94).

²⁸See, Public Company Accounting = Oversight=20 Board, Activity Summary and Audit Implications for Reverse Mergers = Involving Companies from the China Region: January 1, 2007 through = March=20 31, 2010, Research Note # 2011-P1 (March 14, 2011).

The reported numbers may understate the number of = =93transactions that=20 are structured differently, but with the result being similar to a = [China=20 reverse merger].=94 As explained by PCAOB staff, =93there may be = unidentified=20 reverse merger transactions that occurred =85 because no Form 8-K = Item 5.06=20 was required to be filed, such as those transactions involving = special=20 purpose acquisition companies, or that did not involve a shell = company. In=20 addition, the research excluded reverse merger transactions = involving=20 foreign private issuer shell companies filing Form 20-F.=94 Id. at = 3.

²⁹See Release No. 33-8587 [72 FR 42234 = (July 21,=20 2005)]. See also, Release No. 33-8407, 69 FR 21650 (a proposal = designed to=20 =93protect investors by deterring fraud and abuse in our = securities markets=20 through the use of reporting shell companies,=94 this release also = discussed=20 the SEC=92s history of combating =93the fraudulent methods used to = manipulate=20 the market in highly speculative securities,=94 and the ways in = which=20 transactions involving public shell companies have been = problematic.).=20

³⁰See, e.g., SEC Files Fraud Charges = Against=20 China Energy Savings Technology, Inc. and Others; Court Orders = Asset=20 Freeze. http://www.sec.gov/news/press/2006/2006-200.htm.

³¹See, James Surowiecki, Don=92t Enter = the Dragon,=20 The New Yorker, January 31, 2011.

³²See, NASDAQ Delisting Chinese = Manufacturer=20 Fuqi, Jewelers=92 Circular Keystone, March 29, 2011. http://sec.gov/cgi-bin/goodbye.cgi?www.jckonline.com/2011/0= 3/29/nasdaq-delisting-chinese-manufacturer-fuqi.=20

³³See, James Surowiecki, Don=92t Enter = the Dragon,=20 The New Yorker, January 31, 2011.

³⁴See Release No. 64164, April 1, 2011 = (announcing suspension of trading in the securities of China = Changjiang=20 Mining & New Energy Co., Ltd.).=20 http://sec.gov/litigation/suspensions/2011/34-64164.pdf.

³⁵See Release Nos. 64164, referenced = above in=20 note 34, and Release No. 64101, March 21, 2011 (announcing = suspension of=20 trading in the securities of Heli Electronics Corp.). http://sec.gov/litigation/suspensions/2011/34-64101.pdf= .=20

³⁶See Press Release, NASDAQ OMX, = NASDAQ Halts=20 China Agritech, Inc. (March 14, 2011), http://sec.gov/cgi-bin/goodbye.cgi?www.globenewswire.com/ne= wsroom/news.html?d=3D216129;=20 Press Release, NASDAQ OMX, NASDAQ Changes Trading Halt Status of = China=20 MediaExpress Holdings, Inc. (March 14, 2011), http://sec.gov/cgi-bin/goodbye.cgi?www.globenewswire.com/ne= wsroom/news.html?d=3D216199;=20 Press Release, NYSE Euronext, NYSE Amex to Halt Trading in the = Securities=20 of China Century Dragon Media, Inc. (March 21, 2011), http://sec.gov/cgi-bin/goodbye.cgi?www.nyse.com/press/13007= 01752438.html;=20 Press Release, NYSE Euronext, NYSE Amex Halts Trading in the = Securities of=20 China Intelligent Lighting and Electronics, Inc. (March 24, 2011), = http://sec.gov/cgi-bin/goodbye.cgi?www.nyse.com/press/13009= 63610692.html;=20 Press Release, NYSE Euronext, NYSE Amex Halts Trading in the = Securities of=20 NIVS IntelliMedia Technology Group, Inc. (March 24, 2011), http://sec.gov/cgi-bin/goodbye.cgi?www.nyse.com/press/13009= 63610893.html;=20 Press Release, NYSE Euronext, NYSE to Suspend Trading in Duoyan = Printing,=20 Inc. (March 28, 2011) (suspension to take effect prior to the = opening on=20 Apr. 4, 2011), http://sec.gov/cgi-bin/goodbye.cgi?www.nyse.com/press/13013= 07616164.html;=20 Press Release, NASDAQ OMX, NASDAQ Halts China Electric Motor, Inc. = (March=20 31, 2011), http://sec.gov/cgi-bin/goodbye.cgi?www.globenewswire.com/ne= wsroom/news.html?d=3D217571.

³⁷See Public Company Accounting = Oversight Board,=20 Activity Summary and Audit Implications for Reverse Mergers = Involving=20 Companies from the China Region: January 1, 2007 through March 31, = 2010,=20 Research Note # 2011-P1 (March 14, 2011) (discussing Audit Alert = 6, where=20 =93the Board=92s inspection staff observed audit quality concerns = in certain=20 audits in which U.S. registered accounting firms performed audits = of=20 companies with substantially all of their operations in another = country.=20 In some situations it appeared that U.S. firms provided audit = services by=20 having most or all of the audit performed by another firm or by = assistants=20 engaged from outside the firm without complying with PCAOB = standards=20 applicable to using the work and reports of another auditor or = supervising=20 assistants. =85 For example, in one instance described in the = Alert, a U.S.=20 registered accounting firm retained an accounting firm in the = China=20 Region, and the audit procedures performed by the other firm = constituted=20 substantially all of the audit procedures on the issuer's = financial=20 statements. The U.S. firm's personnel did not travel to the China = region=20 during the audit, and substantially all of the audit documentation = was=20 maintained by the firm in the China Region. As noted in the Alert, = AU sec.=20 543 does not contemplate an auditor taking responsibility for the = work of=20 another auditor that has audited an issuer's financial statements=20 substantially in their entirety.=94).

³⁸See, Bill Alpert and Leslie P. = Norton, Beware=20 This Chinese Export, Barron=92s, Aug. 30, 2010 (reporting that the = combined=20 capitalization of the companies entering the U.S. public markets = through=20 backdoor registrations at their peaks exceeded $50 billion, but = has=20 dropped by $20 billion, or 60%. By comparison, the value of = Chinese=20 companies who became listed in the U.S. through more traditional = ways, not=20 involving a backdoor registration, has increased 60%. Chinese = reverse=20 merger companies have also performed poorly compared to small U.S. = listed=20 companies generally, =93lagging behind the Russell 2000 index of = small-cap=20 stocks by 66%.=94 Id.).

http://www.sec.gov/news/speech/2011/spch040411laa.htm

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Speech by SEC Commissioner:Facilitating Real Capital=20 Formation

by