At a hearing of a House Financial Services subcommittee on Wednesday, the voice of dissent was Donald Langevoort, a professor of law at Georgetown University, who questioned the wisdom of sacrificing some investor protections so that private companies would have an easier time attracting equity investors.
“We should beware of reforms driven by the desire to attract capital from less sophisticated investors simply because there are so many of them and they might be more excitable and less demanding,” said Langevoort at a hearing of at the Subcommittee on Capital Markets and Government Sponsored Enterprises on Wednesday. “That story will not end well.”
Many the JOBS Act’s provisions are still up in the air. But it’s a certainty that private securities offerings will be more widely promoted, and possibly sold, to less-sophisticated investors.
Investor protection groups have been most vocal about Title III of the JOBS Act, popularly known as “crowdfunding.” Title III permits start-ups to raise as much as $1 million from non-accredited investors without registering with the Securities and Exchange Commission.
But sections of the JOBS Act that remove regulatory barriers for larger capital offerings of more mature companies also present opportunities for fraud and abuse. U.S. companies can cast a wider net to attract equity investors in private placements, but will not have the same disclosure requirements that come with SEC registration.
Langevoort said an investor’s trust in the genuineness of an investment opportunity, for which they require credible information, is closely tied to capital formation and economic growth. “If [investor trust]] hits some horrible tipping point and recedes because there is too much perceived risk of opportunism and abuse, capital formation will be damaged by poorly crafted innovations, not enhanced,” he said in prepared remarks. “For all the honest entrepreneurs who deserve a better shot at low-cost funding, there are opportunists as well who not only threaten the financial well being of targeted — sometimes vulnerable — investors but take funds away from legitimate enterprise.”
Under the JOBS Act, more potentially “vulnerable” investors may receive solicitations for private securities sales. Title II of the JOBS Act removes a ban against widespread promotion and advertising of private placements under Rule 506 Regulation D. A company can broadcast its offering as long as only accredited investors — institutions, or individuals that meet a minimum net worth test — ultimately take part in the offering.
Even though accredited investors may be more sophisticated than the average securities buyer, additional rules regarding the promotional content of an offer are needed, said SEC Commissioner Louis Aguilar in September. At the time, Aguilar suggested requiring promotional materials for private placements include a balanced presentation of risks and rewards and display a warning note about the riskiness of investing in private securities deals. He also recommended establishing a mandatory “cooling off” period during which an investor can terminate these kinds of securities purchases.
In Regulation D offerings, the accredited investor class may also encompass a wider universe of investors than regulators foresee. The minimum net worth for accredited-investor status, for example, may be reached with retirement savings. “Wealth tests (for example, $1 million for accredited investor status , or $100,000 for enhanced participation in crowd-funding) may seem large at first glance, but not so much if that is all there is for a lengthy retirement except for Medicare and Social Security,” Langevoort said in his statement.Coulson says, without running afoul of regulators. The JOBS Act also mandates certain kinds of financial statement disclosures related to private placements.
For example, the JOBS Act revision to Regulation A offerings —an exempt class of small-dollar public issues of stock — strengthens disclosure standards. Regulation A issuances can now be as large as $50 million annually, up from $5 million. But the issuer will also have to file annual, audited financial statements with the SEC and comply with any additional rules the SEC devises in its final rules.
In his prepared statement prior to the House Financial Services hearing, David Weild of Grant Thornton’s capital markets practice said those additional requirements may include “that the issuer distribute or make available to investors an offering statement and post-offering periodic disclosures regarding its business operations, financial condition, corporate governance principles and other matters.”
In other ways, however, the final JOBS Act rules could lower investor protections for Regulation A capital-raising. For one, the SEC’s final regulations could exempt Reg A offerings from state Blue Sky laws, which protect investors against securities fraud. In addition, some securities dealers are calling for the SEC to expand the universe of investors that would be qualified to purchase Regulation A shares.
“Qualified purchasers should include financially sophisticated individuals that may not have obtained the wealth to be accredited investors, such as employees of the issuer and those that meet the current requirements applied to broker-dealer customers trading stock options,” said Coulson in his prepared statement.
Grant Thornton and others are pushing the SEC to move on the revisions to Regulation A, by calling for the U.S. Senate to pass a version of H.R. 701. The bill, already passed by the House of Representatives, would require the SEC to finalize rulemaking for Regulation A by October 31.
OTC Markets’ Coulson did not discount that the JOBS Act reforms “present a risk of abuse, as with any new rule making.” However, he said, “that risk can be addressed when it arises.” Langevoort said regulatory reform efforts should continue, but removal of regulatory barriers needs to be done “with due regard for investor protection.”
At the close of his prepared statement, Langevoort expressed what he called “an uncomfortable truth”: The main impediment to small-business capital raising is not the regulatory burden but the economics of such arrangements. “Small businesses are very very risky. Entrepreneurs rarely find the cost of equity or debt that rationally prices this risk to be particularly attractive,” he said.