Written By: Phil Feigin
Without much fanfare, Mary Jo White’s reign as chairman of the Securities and Exchange Commission has begun in earnest. The first regulatory Gordian knot, of the sort that stymied Mary Schapiro’s Commission into an administration with all the innovation of Herbert Hoover’s presidency, has been untied. Ms. White’s SEC proposed new rules to govern money market funds. It well might be argued that the seeds of these consensus proposals were sown a year earlier, when Ms. Schapiro championed bold reform efforts in the face of ardent opposition.
The Commissioners’ consensus and unanimous vote on the money market fund proposals beg the questions: how many more regulatory logjams at the SEC will be broken, and when? Will the JOBS Act initiatives be next? Will it be crowd funding (the purist in me still precludes me from treating it as one word), the populist and ill-conceived notion for bringing capital formation to the common man—a financial version of the hula hoop and pet rocks (about as useful but much more dangerous)? I doubt it.
Or will it be the change called for in the JOBS Act that the professionals are waiting for, the Congressionally mandated SEC amendments to Rule 506 to allow public solicitation to verified accredited investors? While crowd funding drew a lot of consternation from regulators and consumer protection activists, it is the prospect of public solicitation of Rule 506 deals that is of greatest concern. This is where the real fraud and harm will be centered.
Entrepreneurs and their counsel view the regulatory resistance to public solicitation as some troglodyte, Neanderthal, mindless, Flat Earther reaction to innovation and positive change. Allow me to peel some layers off the onion to explain my concerns (my law partners will never accuse me of having left my regulatory roots far behind). Perhaps these concerns are representative of those of my former colleagues in the investor protection trenches.
First and foremost, regulators only see the worst of the worst private placements. They see them in investigations and enforcement cases. Without any scientifically validated evidence to support the conclusion, any enforcement guy will tell you there is an uncanny correlation between private placements that are being publicly solicited illegally and those rife with abuse and fraud. QED—show them an unregistered deal being publicly solicited and you show them a fraud. That connection has been hard-wired into the enforcement DNA for more than 100 years.
Second, anyone can make a private placement offering. Anyone can pull down a PPM from the Net and edit it to fit their deal. They do not need the resources necessary to register an offering, to deal with the lawyers, accountants and broker-dealers and the regulators. All they need is a computer and an Internet connection. As a result, in addition to fraudsters, shaky private placement offerings can also be made by starry-eyed entrepreneurs who have no hope of succeeding in anything except perhaps convincing some other unsophisticated people they can turn their dream into profitable reality. Whether to a bungling amateur or a slick con man, lost life savings can be just as harmful to unsuspecting victim investors. Enforcement personnel have to deal with all too many errant dreamers who publicly solicit too.
Setting those very real, experience-based factors aside, the real core issue is that the long-standing limitation imposed on private placement issuers allowing them to solicit only those persons with whom they have a pre-existing business or personal relationship carries with it a sense of issuer maturity, of seasoning. Only those issuers who have developed a loyal following of persons over years, people who know them, whose trust they have earned, and are willing and able to support their capital needs based on their history of success and accomplishment, are those issuers who ought to be raising money through private placements. That’s the way it’s supposed to work.
On the other side of the coin are the entrepreneurs, particularly those less established entrepreneurs, who believe to the last fiber of their being that they will succeed in raising the capital they need if only given the chance to publicly solicit. Nature of the beast. They believe that, given the opportunity to share their ideas with others, these strangers will be convinced of the prospects as well, and will support the entrepreneur’s efforts. Sure, the entrepreneurs are willing to make disclosures about their ideas, just as long as they don’t have to pay lawyers to put together a private placement memorandum no one reads anyway. But a prohibition on reaching out to people who might want to share in the dream is downright un-American. But for the prohibition, their dream could become reality and all involved would benefit. [1]
I have long supported Internet-based matching services where potential issuers can post their ideas for vetted angels to peruse undisturbed at their leisure. Those who wish to pursue investing may contact the issuer directly. That should not constitute “public solicitation” for Rule 506 purposes and the website hosts should not be classified as broker-dealers when they take an equity stake in the funded companies. The JOBS Act pretty much mandated implementation of both ideas, and those changes are long overdue.
That said, very few deals at any level are sold on the basis of disclosure information sitting on some website waiting to be perused. There is an old adage that securities are not bought, they are sold. That means brokers, salesmen, guys on the phone pitching, and pitching hard. It is here I predict the private placement enforcement cases of the future will lie: unregistered brokers and agents and their fraudulent solicitations.
As a general rule, issuers make lousy securities salesmen. It is the track record of the seasoned, successful issuers that attracts their loyal following to their next deal. Any sales effort is minimal. If those issuers had to expand their market to solicit new, unknown prospective investors, their chances of failure to raise capital would soar.
Issuers don’t want to sell their securities, they just want the money. It is natural that they have in the past and will in the future turn to those who are in the business of selling. The JOBS Act did virtually nothing to amend the Securities Exchange Act of 1934 or Rule 3a4-1 in this regard. Those who engage in the business of selling securities are and will continue to be brokers.
The SEC has been uncharacteristically active of late in pursuing unregistered broker cases. Further, and ironically, the opportunities that will be presented by the ability of issuers to publicly solicit for accredited investors coincides with the advent of the most extreme restrictions in decades on registered broker-dealers getting involved with private placements.
In the wake of several recent, highly visible, national private placement frauds, many broker-dealers that were willing to market private placements that (perhaps unwittingly) marketed the fraudulent securities went out of business. Those that continued to market other private placement issues have been faced with intensive regulatory examinations and skepticism. More recently, FINRA has imposed its Rule 5123, requiring much more of broker-dealers that elect to market private placement securities. With the ranks of those firms willing to market private placements thinned by attrition, these new factors are not likely to help replenish the ranks and attract member firms to the private placement market in the future.
That leaves us with the rogues. Private placement issuers that turn to public solicitation in the absence of a ready market for their securities will find out quickly that merely posting the opportunities on websites, or advertising in newspapers, or even via spots during Star Trek or infomercials between late night movies will not attract the investors they need. That is when some will turn to the “placement agents,” “finders” and the like who, through their own websites and other ads, purport to have access to eager accredited investors for private placement issuers. There are far too many of these illicit operations and operators out there today. Their numbers will only increase once the new Rule 506 public solicitation rules are effective.
There is no bright line test to separate those few legitimate, true finders from the far more common illicit, unregistered brokers. It will take a massive diversion of resources for federal and state securities regulators even to make a dent in the hoard of illegal operations and operators who are bound to spring up. Fraudulent private placement issuers will use their own pitchmen. Unsuspecting issuers will retain unregistered firms, and hire unlicensed people to sell their offerings in even greater proportions than they do today. Enforcement efforts will have to be far more “after the fact” than the tripwire that mere public solicitation is today.
Advocates of limited regulation have used the requirement that the SEC conduct a cost-benefit analysis prior to promulgating rules to great advantage in testing and defeating SEC proposals of late (would that legislation enacted by Congress was subject to the same analytic gauntlet.) Contrary to the belief of some entrepreneurs and their market advocates that, but for the ban on public solicitation, they could find investors for their private placement offerings, I fear the lifting of the ban will precipitate far more illicit conduct and investor losses to fraud than any legitimate investing, let alone job creation. Professional investors are not likely to be located by means of ads, cold calls and websites. And make no mistake—there will be a flood of such solicitations. True investors find their investments through networking, through trusted channels of people with whom they have dealt for years. The fraud that will trace its roots to now allowed public solicitation of purported Rule 506 deals will far outweigh any benefit derived from allowing it. The extent of the fraud will boil down to how long public solicitation is allowed before everyone comes to their senses.
[1] However, I note that, in my 34+ years of securities regulation and practice, not once has an investor called and complained to me that they could not find an investment to invest in.
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