Paternalism and Securities Law
The Securities and Exchange Commission just published rules to lift the ban on advertising for private placements under Title II of the JOBS Act, which is expected to take effect in September 2013. Jonathan Wilson of Taylor English Duma LLP provides another perspective on the SEC’s actions.
In some recent posts I’ve covered the rules that the SEC is required to issue under the JOBS Act to implement interstate securities-based crowdfunding as well as the rules the SEC issued under Title II of the JOBS Act to remove the ban on general solicitation and general advertising for certain private placements under Rule 506 of Regulation D.
The concepts of crowdfunding and private placements work together but also have an interesting conflict in their underlying public policies.
The Securities Act of 1933 and the Securities Exchange Act of 1934 were both Congressional reactions to thegreat stock market crash of 1929. The thinking at the time was that the markets had become overheated, in part, because of an influx of new, small investors who had been solicited by unscrupulous brokers. Among the other reforms contained in the 1933 Act and the 1934 Act was a general prohibition on sales of securities unless those securities had been registered with the SEC or were subject to an exemption.
The statutory exemptions to the general obligation to register securities are primarily set forth in Sections 3 and 4 of the 1933 Act. Statutory exemptions include everything from sales of stock in certain banks to sales of stock in purely intrastate transactions (i.e., Section 3(a)(11)) of the 1933 Act). Section 4(2) of the 1933 Act exempts sales of securities in a transaction that does not involve a public offering.
This last exemption is somewhat vague, since the statute does not define “public offering”. To eliminate the ambiguity, the SEC eventually adopted Regulation D, a set of regulations that provide clarity as to what is a “public offering” and that create safe harbors for certain kinds of non-public transactions. Among those safe harbors is a safe harbor for private sales of securities to an “accredited investors” who is defined in Rule 501 of Regulation D to include an individual person with either (a) income of $200,000 or more for two or more consecutive years ($300,000 if married and filing jointly) and with the expectation of achieving at least that level of income in the current year, or (b) a net worth of $1 million or more (excluding the individual’s primary residence).
The paternalism in this definition is obvious. Individuals who meet the income test or the net worth test are free to invest in unregistered offerings, others are not. The policy behind this definition is that millionaires and high income-earnings are capable of making investment decisions (or capable of bearing the risk of bad decisions) but others are not.
In the Dodd-Frank Wall Street Reform Act Congress directed the SEC to take another look at its definition of “accredited investor” and commissioned the Government Accountability Office to study the definition and alternative means of determining an accredited investor. The GAO issued its report last week.
The GAO’s report is underwhelming. It is primarily a survey of the beliefs of market participants on what criteria should be used to define “accredited investor”. In conducting this survey the GAO interviewed a grand total of 31 market participants, that were either attorneys with experience in private placements, accredited investors, other investors who were not accredited, and broker/dealers. That’s right, just 31 participants. You could walk into a bar in Manhattan at 5pm on most business days and run into more than 31 investors, broker/dealers and securities lawyers.
And what was the conclusion of the GAO’s report? It concluded that the SEC should “consider alternative criteria” for meeting the accredited investor standard. It cited remarks by some survey participants (a handful of folks out of the 31 surveyed) who thought it would be better to look at an individual’s liquid investments.
Wow. How much did we spend (in tax dollars) for this piece of insight? A far more meaningful study would have examined (a) why it is that high income or net worth should be a pre-condition for the right to invest, and (b) whether education or professional experience should be an alternative criteria for the right to invest.
Compare, for example, the kinds of transactions that individuals often enter into without any inquiry as to their experience, knowledge or ability to tolerate financial risk. Individuals may buy a house, borrow money to purchase a house, buy gold or silver as an investment, buy cars, artwork and other items as an investment, and purchase life insurance, open an IRA or stock brokerage account, all without having to demonstrate their ability to understand what they are doing or their ability to handle the financial risk they are taking.
What makes investing in a private placement more risky that taking down a mortgage loan to buy a house? In 2008 and 2009 the news was full of stories of individuals who had been flipping single family homes on a leveraged basis who lost their shirts when the housing market hit bottom. I don’t remember any stories of individuals who were bankrupted because their investment in a private placement went bad.
The idea behind crowdfunding, as expressed in Title III of the JOBS Act, is a rejection of the paternalism behind the accredited investor definition and the way it has been institutionalized in Regulation D. Crowdfunding was intended to empower individuals to make their own investment decisions in unregistered offerings of securities based on the availability of information over the Internet. As crowdfunding develops, the conflict between the policy behind it and the paternalistic policy behind the idea of “accredited investors” will become even more apparent and even harder to justify.
Jonathan B. Wilson is a member of Taylor English Duma LLP’s Corporate & Business practice group and his practice includes corporate securities, corporate finance and governance, mergers and acquisitions and intellectual property. He has represented both Fortune 100, middle-market and start-up companies in transactional matters for roughly 20 years. This article reprinted with permission. Mr. Wilson also is a member of CFIRA. Feature Image (c) Crestock.com under license.