THE JOBS ACT – Is it Securities Regulation that Really Hurts Small Business? Part Five of Five

Written by: Phil Feigin

REPEAL FIVE:  Crowd funding—the Repeal of Common Sense

And then there’s crowd funding (I am still not able to bring myself to accept it as a new, single word), the concept that would turn traditional investing and capital formation into a national Tupperware party. State securities regulators are up in arms over the prospects for disaster, and rightly so. The least sophisticated issuers will be allowed to raise money from the least sophisticated investors, and thousands of them, with almost no regulatory oversight, through intermediaries who may not have much more sophistication than the issuers or investors. How is a start-up enterprise supposed to manage a shareholder list numbering in the thousands? Oh, and in addition to managing a hoard of shareholders, the issuers will be subject to section 12(a)(2) liability, and the states are preempted from regulating the deals.

As a general premise of traditional investing, an investor buying stock has three options:  (i) hold it and wait for dividends; (ii) try to sell it to someone else for more than they paid for it (the “greater fool” theory); or (iii) frame the stock certificate and hang it on the wall as a memento of a “great opportunity” gone to dust. While the crowd funding issuers we will see in 270 days or so (when SEC rules are due) may actually succeed in raising some money, the investors will have virtually no chance of doing anything but searching for a suitable frame. Market professionals, private equity firms, venture capital firms and broker-dealers are unlikely to touch one of these companies, ever. Ever! Too many questions and complications. This will be the Internet version of Glenn Turner, but without the tent.

At the end of the day, won’t we ever learn that the market is generally efficient, particularly at its extremes. An investor will always be able to buy or sell shares of Apple and Microsoft. At the other extreme, shares of companies with no track record and no generally and professionally analyzed information, i.e., shares of most small companies (and I mean start-ups and really small companies) are more than illiquid; they are nearly frozen solid. With rare exceptions, they are all “frame” material. Banks usually won’t touch lending to them. Friends and family are usually already tapped out, as are the owner’s credit cards. We all know that at least nine out of ten will fail within a year or two.

When state legislatures and, more importantly, Congress, react to tough economic times, they haul out the “small business is the engine of our economy and job creation” speeches, come up with hastily and poorly thought out legislature or regulatory proposals to gut some provision or other in the securities law, label them “jobs” initiatives, and we’re off the races. SECURITIES REGULATION IS NOT THE PROBLEM! It’s just an easy target.

Congress cannot make investors invest, cannot make banks lend money, and cannot make employers hire employees. Each must be confident they will benefit from doing so, and without unacceptable risk. If they don’t have the information they need, they will not write the check. If the risks of loss are too great and the opportunity for reward too remote, they will not wire the funds. No one likes laying off employees.

If Congress truly wanted to promote small business, they would provide the funding outright, or incentivize investors to invest, and banks to lend, and employees to hire, through federal grants, insurance and tax breaks sufficient and efficient enough to make the risks and illiquidity worthwhile. Community banks shy away from SBA loans because the process is simply too complicated. Federal banking regulators (OCC, Fed and FDIC) have imposed such onerous capital requirements on community banks that lending to small business has virtually been made illegal. Anyone in the truly small business community knows this to be the case. Local banks can’t lend because the regulators won’t let them. Without the money, businesses can’t afford to hire new people.

Ironically, federal banking regulators, fearful of allowing further failures and Congressional scorn, take the position that bank failures are not going to happen on their watch, so much so that we now have very stable, liquid, well-capitalized banks that are lending mostly to those who probably don’t need the money in the first place. If small business is the engine that drives America, community banks are the engine that drives small business. But the engine has been starved for fuel.

It is thus ironic that, with crowd funding, Congress has foisted off on private investors, and unsophisticated private investors, the opportunity to invest in the riskiest and most untested investments. Congress is unwilling to allow federally insured banks and the SBA to take the risk of lending or guaranteeing loans to these small companies, but Congress seemingly has no compunction at all about exposing investors, with meager resources and potentially less information, to the ventures, all with the fanfare of “democratizing” American investing and job creation, no less.

I recall from back in the days of the penny stocks here in Denver, at least at the beginning of the craze, the federal government was not overly concerned about penny stocks. The shares were not traded on traditional exchanges, and they did not really impact the national economy. The penny stock operators had devised the perfect crime. They had figured out a way to steal $100 from everyone in America. No one complained very loudly, and the crooks made off with billions.

I don’t foresee that crowd funding will precipitate the kinds of colossal losses as did the penny stock craze, but grand statistics only matter if it’s not your money that was lost. Everyone from crooks to the hopelessly naïve will hit the crowd funding bandwagon. The offerings are limited to $1 million per year. How will anyone but the issuer (and perhaps his offshore bank) know when they reach the $1 million limit? I know there is supposed to be a registered funding portal and escrow account. Do they really seem like insurmountable obstacles for crooks to you?

In pondering the impact of securities regulation on legitimate small businesses and the difficulties they have in raising the capital, I learned what I believe is a valuable lesson as a regulator through the Small Corporate Offering Registration (“SCOR”) program adopted by the states. SCOR requires small businesses to fill out a fairly granular but straightforward disclosure form to raise up to $1 million with no restrictions on the wherewithal of the investors. Over the years, we registered several such offerings in Colorado. Once registered, the SCOR issuers were free to advertise the deal to their heart’s content, in newspapers, radio, wherever, and they could call anyone in the state with their proposal.

The registered SCOR offerings all but universally failed. It was not securities regulation that was inhibiting these small businesses from raising capital—it was the inability of the promoters to reach likely investors. The ability to publicly solicit and advertise did not make any difference.

The deals failed because no brokerage firms were involved. One way to look at it is that investments are more sold than bought. Again, it takes relationships and trust to invest. Brokerage firms did not get involved because of the inherent risks in start-up ventures, and there wasn’t enough money to be made. It simply wasn’t worth it. Their clients could lose their principal, and even if the company grew, it would be years before any secondary market offered the opportunity for a profit. Thus, I do not see crowd funding going anywhere after the initial fad wears off. Unless brokers get involved, I do not see many Rule 506 offerings getting any further than they got before. The new Reg. A deals hold the greatest promise for issuer and investors because the numbers may be significant enough to warrant the interest and participation of a hungry brokerage and underwriting industry. It is that sector that is the fuel injector of the small business engine.

Crowd funding will not be the undoing of our economy. It will neither create many jobs nor be the birth of the next Apple. Thousands of people are likely to lose millions of dollars, to both scammers and innocent, unsophisticated, well-intentioned dreamers until this latest Internet/social media “hoola hoop” drops to the ground to be stored in the garage, along with all those framed stock certificates. It is just a naïve, dumb idea, meant for headlines more than assembly lines.

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THE JOBS ACT – Is it Securities Regulation that Really Hurts Small Business? Part Four of Five

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 5^th, 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.

THE JOBS ACT – Is it Securities Regulation that Really Hurts Small Business? Part Three of Five

Written by: Phil Feigin

The remaining changes to the securities world in the JOBS Act have the potential to be much more impactful on daily investor lives. It’s one thing to talk in the abstract about financial reporting companies with $1 billion in annual revenue (are there even any in Colorado? Coors maybe) and Wall Street analysts touting stocks, but that’s not as palpable as getting a cold call at dinner from a private placement salesman, or an emailed pitch from someone you’ve never heard of. That’s more my beat.

REPEAL NUMBER THREE:  Regulation A

Regulation A had become a trick question on a law school securities test. A “mini-registration” process with the SEC, the $5 million cap did not expand with the times. Add full state registration (and merit) review and preemption of Rule 506 offerings, and Reg. A had reduced to a regulatory relic. The JOBS Act breathes new life into the provision and process, by raising the offering limit from $5 million to $50 million, and preempting the states from reviewing the offering statements (they are not called prospectuses). The SEC, and perhaps FINRA and underwriters, will be the only things standing between the issuers and prospective investors. Shares purchased will be freely tradable (not that any kind of market is assured). My old penny stock joints are aching at the prospects.

Perhaps helping to level things out, a perhaps less noticed provision of the Act breathes new life into another near vestigial provision of the Securities Act of 1933, section 12(a)(2). The relevance of this section was reduced significantly by the Supreme Court in Gustafson v. Alloyd, 513 U.S. 561 (1995). Under the provision, buyers can sue sellers for making untrue statements or omitting material facts in making the sales. In Gustafson, the Court held that the relief was limited to public offerings (registered or unregistered and illegal) because those are the only offerings that involve a “prospectus.” This had the effect of depriving investors in private placement offerings of a fraud remedy under the ’33 Act. Their only recourse was an action under Rule 10b-5, with its culpable mental state, reliance and causation requirements, or state law.

Under the JOBS Act changes, “sellers” of securities under the new Reg. A can now be sued by buyers under section 12(a)(2). This is more a negligence standard than the steeper hills to climb in a Rule 10b-5 action. The sellers of Reg. A offerings will ignore this new reality at their private liability peril. Plaintiffs’ and defense counsel alike are going to have to dig into the vaults to unearth their 12(a)(2) memos, briefs and case law from 17 years ago and brush up on a cause of action returned from the dead.

The transactional upshot of the Reg. A changes are that this (sort of) registration exemption is likely to go from worst to first among small companies seeking capital. Just as the popularity of Rule 506 skyrocketed after the states were preempted from regulating them in 1995, it is not hard to envision a similar impact in Reg. A, especially when coupled with the 1,000% increase in the amount that can be raised. Reg. A may prove to be even more attractive and useful than Rule 506 in some circles, given that there are no investor minimum qualifications like the accredited or “sophisticated” investor restrictions in Rule 506. Much will depend on the process the SEC develops for review of the offerings. SEC examiners at Corp Fin may review the new deals “vigorously” knowing they are the only line of government defense, with the states out of the way, but they do not impose merit review requirements on the offerings.

It remains to be seen how new Reg. A offerings will be sold. Will underwriting and secondary market broker-dealers, analysts and investors have any interest in this new tier of securities? In my mind, that is the “$64,000” question (shouldn’t we lobby Congress to adjust the old “$64,000” standard for inflation? What would it be now, in today’s dollars?).

THE JOBS ACT – Is it Securities Regulation that Really Hurts Small Business? Part Two of Five

Written by: Phil Feigin

So what does the JOBS Act really do? I don’t profess to be a Wall Street/NYSE economic and public company expert. In my career, I have generally dealt with the other end of the corporate spectrum when it comes to securities regulation and business, with Ponzi schemes, penny stocks, start-up businesses and “man-on-the-street” sort of stuff. I know enough about the exchange world to agree with more sophisticated pundits and reporters that the first two changes brought about in the JOBS Act are of significant concern.

REPEAL NUMBER ONE:  Emerging Growth Companies

It is hard to forget the voodoo accounting at Tyco and Enron and Worldcom and a dozen other firms only a decade ago. They all led to economic calamity. In turn, that led to Sarbanes-Oxley and stricter reporting requirements and accountability.

However, Congress and the President apparently succeeded in doing just that:  forgetting. Under our new JOBS Act, companies with less than $1 billion in annual revenue are freed from filing quarterly and annual reports with the SEC, as long as they have fewer than 2,000 shareholders. Apparently, they are of the view that the cost of preparing and filing these reports was too great. I suppose the idea is that these companies will use the money saved by not having to file these bothersome reports to hire new employees. However, without readily available public information attested to and filed by corporate executives under penalty of perjury and vetted by independent analysts, the value and liquidity of company stock may also suffer. 

REPEAL NUMBER TWO:  Analysts

 In the go-go years of the dot.com boom, a lot of investors listened to the glowing projections of guru analysts and sucked up one hot new issue after another, only to find out later many of their recommendations were perhaps, shall we say, less than objective. Under the new JOBS Act regime, analysts at brokerage firms and investment banks underwriting new offerings by the newly classified “emerging growth companies” will once again be allowed to participate in marketing efforts. I wonder if this go-round, prospective investors will remember that, when they hear an analyst tout a stock in road shows and in other market hyping, if the analyst is secretly thinking the stock and the company are really “doo-doo”?

These fundamental changes will surely lower costs and ease restrictions on “emerging growth companies” in the short term, but may undermine values in the long run. At least lawmakers and regulators will have good models to review in reaction if history repeats itself.

THE JOBS ACT – Is it Securities Regulation that Really Hurts Small Business? Part One of Five

Written by: Phil Feigin

The news came Thursday morning Las Vegas time, March 22^nd, as dozens of securities and corporate lawyers trekked around the oceanic acreage that is the Caesar’s Palace conference center, searching for meeting rooms. The Senate had passed the JOBS Act. Panelists making presentations on securities and small business issues at the ABA’s Business Law Section Spring Conference scrambled to make last minute changes to their prepared remarks. Comments about what the new Act would mean had to be wedged into earlier prepared talking points aimed at deciphering still unsettled questions raised in Dodd-Frank.

Mark your calendars and circle April 5, 2012. That’s the day President Obama signed the JOBS Act into law. Proponents of the Act hope it will inject new life and reinvigorate the economy. As a former state securities administrator, I fear April 5^th is also the day that thousands of gallons of deregulatory gasoline were poured on the destructive flames of investment fraud.

The dot.com boom and bust gave us Sarbanes-Oxley and analyst reform. The collapse of mortgage-backed securities, derivatives and swaps gave rise to Dodd-Frank. We have never fully implemented Sarbanes-Oxley, and have yet to fully digest and implement Dodd-Frank. Now we have the JOBS Act, weakening or reversing many of the reforms brought about in Sarbanes-Oxley, and more. Added to the pile of Dodd-Frank rules the SEC is still trying to plow its way through, to say nothing of the Commission’s own agenda (remember 12b-1 reform?), the SEC is now tasked with promulgating at least 12 more rules by my count, either completely new rules or amendments to rules already in place (and a bunch more if you count rules they are merely empowered to adopt). Once again, the SEC must try to make regulatory sense of the jumble Congress has created in this most recent spasm of politically motivated economic and regulatory legerdemain.

The JOBS Act is touted by its proponents as a means to jumpstart the economy, to make it easier for small businesses, the purported engines of prosperity and job creation, to raise capital, go and remain publicly traded, and generally get the economy moving again. This is to be accomplished by easing (gutting?) rules deemed too burdensome to small business. Will it work? No one knows, and don’t believe anyone who says they think they do. I argue we have relied to excess on people who profess to know what the future holds. See Alan Greenspan, Standard & Poor’s and Moody’s.

The Franklin Delano Roosevelt administrations of 1932-1940 brought about many fundamental changes that we now take for granted, like Social Security and federal bank deposit insurance. However, the alphabet soup of other programs that comprised the New Deal, meant to pry the U.S. economy out of the Great Depression, probably didn’t work all that well in achieving their overall purpose. It is rather well accepted that the ultimate turnaround came with the end of the economic cycle and the advent of the Second World War, and not the government programs. (Even so, try telling that to the legions of men and women who were able to put bread on their families’ tables given the Civil Conservation Corps, projects of the Works Progress Administration, the Tennessee Valley Authority and more.) The programs and “safety nets” made some difference, and eased the most extreme distress, but were no panacea. It took a long time and a lot of factors to precipitate the Depression, and a long time and a lot of factors to work our way out of it.

So it is and will be, I believe, with this recession, the creeping rebound and all the efforts to spur it. Looking back in later years, we will never know if the JOBS Act or any of the other Congressional and Presidential efforts to induce our economy to robust recovery had any real effect, or if we simply had to endure the trough and upswing of another economic cycle. We can’t run the “tape” again, this time without the programs and laws, to see if they made much of a difference. However (in full recognition of my dissing of prognosticators in general above), I predict the JOBS Act will do much more harm than good, and I will describe why in my next blog.