Written by: Phil Feigin
REPEAL NUMBER FOUR: Public Solicitation and Advertising of Rule 506 Offerings
This is the one that gives the former regulator in me the biggest heartburn. Under Rule 506 as it stands today and until the SEC issues new rules, in less that 90 days now, an issuer can sell securities to an unlimited number of accredited investors (and to a maximum of 35 non-accredited but “sophisticated” investors) and raise an unlimited amount of money, provided they have a pre-existing business or personal relationship with the people they solicit and to whom they sell the investments. In other words, the promoters cannot solicit strangers or publicly, generally advertise their offerings. Over the years, these limitations have driven many issuers and prospective issuers nuts. To them, if they could only reach out more broadly to find investors, their offerings would be fully subscribed and they would be able to move forward with their projects.
Congress has now directed the SEC to adopt changes to Rule 506. Issuers of (soon only so-called) “private placement” offerings made under Rule 506 of Regulation D have their long sought wishes fulfilled. They will be permitted to publicly solicit and advertise their offerings, as long as they sell exclusively to people they can verify are “accredited investors.” The bounds of this new latitude are left for the SEC to define in rules promulgated within 90 days of April 5th, the day the President signed the Act.
Unless things have changed an awful lot since I left regulation in 2000, this change will really stick in the craw of securities regulators federal and state, particularly the enforcement types. There has been no academic study of which I’m aware on the subject, but it is nonetheless a widely held belief among enforcement people that over the last 30 years and more, there has been a frighteningly high correlation between private offerings whose promoters advertise or cold call for investors, and those that prove to be fraudulent. The current (but now short-lived) ban on public solicitation dates as far back as 1953 and earlier, based on court and staff interpretations of ’33 Act section 4(2), and what is meant by the term “not involving a public offering.” If a private offering issuer was found offering to strangers or advertising, the deal could be stopped on registration violation grounds right then and there. At that point, further investigation usually revealed other, more serious problems. Thus, the prohibition on solicitation and advertising served as a sort of trip wire, enabling regulators to stop many such illicit deals before they could victimize many unwitting investors. With that early warning system gone in 90 days or so, I suspect my former colleagues are girding for the worst.
However, I hasten to add that a corollary change brought about in the JOBS Act is long overdue, and I applaud its arrival. The SEC Staff has long taken the view that Internet-based “matching services,” i.e., Web-based sites where private offerings could be posted and made available for pre-screened “angels” to review, had to be registered as “brokers” under the Securities Exchange Act of 1934. The states generally followed suit. A good deal of the position was based on the fact that in most cases, given their shortage of cash, the promoters had to compensate the webhost with securities in their company. Thus, the host had a “salesman’s stake” in the deals they hosted. That meant they were brokers and registration was required.
Provided that the web host had no contact with angels regarding the deal, and handled no customers funds or securities, I always thought this “broker” position was short-sighted and heavy-handed. It was an innovation unique to the Internet to which the Staff simply chose not to adapt. In fact, I spoke with an SEC staffer from Trading and Markets about two years ago, in the midst of the Dodd-Frank debate and with Madoff and Stanford still ringing in their ears. I was calling on behalf of a client that wanted to serve as a matching service in the hi-tech space. I asked the staffer if there had been any change in the Staff’s position about matching services being “brokers,” given the recession and freeze in capital formation. The staffer did not dispute my reasoning, but told me “Now is not the time for the SEC to be seen as easing regulations.” How this can change in just two short years.
Under the JOBS Act, these Internet host intermediaries will be excluded from the definitions of “broker” or “dealer” under the ’34 Act. Some reasonable limitations are imposed. Now, we will see if the intermediary idea works in matching private placements with accredited investors.
My overall concern about public solicitation and advertising by private placement issuers is that too much faith is placed on the premise that the purchasers must be accredited investors and that issuers must verify the claim. Supporters of the lifting of the ban on solicitation and advertising argue that mere offers never hurt anyone, and regulators and private investors both, even prosecutors, can take action against issuers if they sell to investors who do meet the accredited investor standards. The problem with that premise is that government and private investors can and do bring those actions today, in an environment where solicitation and advertising are banned yet prolific among the scammers. But it is almost always too late. The money is gone.
Perhaps the predicted increase in fraudulent deals is somehow offset by the prospect for more fully funded legitimate and job producing offerings. I think the idea that more offerings will be funded now that issuers can publicly solicit and advertise is pie in the sky. I have never received a call from any investor, in 20 years as a regulator and 12+ years in private practice, to complain that the investor could not find anywhere to invest his/her money. It is the rare “angel” who is not networked into a group that, one way or another, gets access to or is contacting by interesting (and some not so interesting) private offerings in any community. Such investments are made based on trust and networking and relationships. Given the lack of the overarching regulatory structure of markets and involvement of regulated brokers, such investments tend to be more local in nature. Major investment decisions by savvy, sophisticated investors are not made off cold calls or newspaper ads. Overall, I fear the trade-off will prove to be lopsided. There will be many more frauds and money lost and investor lives significantly harmed than there will be real deals, let alone will the deals result in new jobs.