SEC Wants All Investors to Access High Risk Investments.

In a startling about-face, Acting Securities and Exchange Commissioner Michael Piwowar called for allowing every investor to buy unregistered securities, regardless of their income, net worth, or ability to suffer the risk of loss.

The Issue

The discussion arises in the context of investing in private placements. Private placements are securities offerings of unregistered securities - they are not registered with the SEC and are generally not reviewed by any regulator before they are sold. Many of these offerings are high risk and the securities sold are typically illiquid.

It is because of that risk that companies are limited in who they can sell and solicit for these investments. Those restrictions generally work out so that firms do not accept investments from investors who are not "accredited." There are a number of types of accredited investors, but for individuals, they much have an annual income of $200,000 or more or a net worth of $1 million excluding their home. 

The accredited investor definition attempts to identify those persons whose financial sophistication and ability to sustain the risk of loss of investment or ability to fend for themselves remove the necessity for the protections of the '33 Act's registration provisions. While there are problems with the definition, the concept is sound. At the extremes, Bill Gates does not need to be protected in the same way your retired schoolteacher grandmother might be. 

Allowing companies to raise money without the costly registration process is fine - so long as the investors know and understand what the investment is, and what those risks are. The accredited investor definitions focus on financial information, and maybe a better test would be a review of actual investing experience, or maybe an investment test to qualify those sophisticated investors?

For now we are left with a financial test, which requires a balance. A narrow definition limits the number of investors and restrict the potential investor pool for business. A broad definition, would remove individuals who need the protection of the registration process, and would be nconsistent with the Commission’s investor protection mandate. It would also violate a basic tenet of the Securities Act by failing to provide investors in need of protection with adequate disclosures before they make an investment decision.

The Accredited Investor Definition

The definition of an accredited investor was introduced in 1982, and has not been changed, despite the effects of inflation over the years. However, the Dodd-Frank Act required the SEC to review the definition every 4 years.

The trend at the SEC is to limit the number of individuals who meet the requirements of an accredited investor, and, in theory, protect the investing public. For example, in December 2011, the SEC amended the definition to exclude the value of the investor's home, resulting in fewer investors meeting the net worth standard.

In December 2015 when the SEC Staff reviewed the definitions and made a number of recommendations, including the creation of new, additional inflation-adjusted income and net worth thresholds and to index all financial thresholds for inflation on a going-forward basis.

The SEC Chair's Comments

However, those changes may soon be coming to a halt. In a speech at a Practising Law Institute conference in Washington, Mr. Piwowar said that the restrictions on who can participate in private placements limits the returns and portfolio diversification of investors who are not defined as "accredited."

According to InvestmentNews.com, Mr. Piwowar said "[i]n my view, there is a glaring need to move beyond the artificial distinction between 'accredited' and 'non-accredited' investors," Mr. Piwowar also said. "I question the notion that non-accredited investors are truly protected by regulations that prevent them from investing in high-risk, high-return securities available only to the Davos jet-set."

While the definition certainly limits the investment choices of non-accredited investors, the reasoning behind the restriction remains sound. Or does it? It seems that Mr. Piwowar is claiming that the registration requirements of the securities laws for securities offerings do not do enough to protect investors. 

While I agree with him, that the registration requirements do little to protect investors and are a huge burden on small businesses and broker-dealers, is the answer to simply abandon investor qualifications and allow anyone to invest in high risk private placements? I like the concept of removing some of the paternalism that is inherent in the securities regulation web, but is this the position that the SEC should be taking? 

Conclusion

As InvestmentNews noted, democratizing the sale of unregistered securities can make investors with less financial werewithal vulnerable to losing money on the often risky ventures. Every review by the SEC Staff and Advisory Committees have recommending tightening the accredited investor definition, not removing it.

But here is Mr. Piwowar recommending changes to that Grandma can put her life savings into the latest technology private placement. Not a smart move by any stretch of the imagination.

Considering a Direct Private Placement?

As the markets and the economy recovers, we start to see more requests for assistance in capital raises, either for investments in hedge funds, private equity groups, or in issuers through private placements.

On occasion, we are contacted by business people who are interested in raising capital, but who want to do so without paying a fee to a brokerage firm, and who believe they can raise sufficient funds on their own, using their existing contacts.

The securities laws do in fact permit such an offering - a properly documented and structured Regulation D offering can be conducted by the officers and directors of the issuer. The question is not whether it is permitted, but rather, should it be done.

The process can be time consuming, and loaded with potential pitfalls and securities law violations. While the SEC has tried to make the capital raising process easier for small businesses, there has not been much success in practice. The simple fact is that business owners are business people, not securities sales people. They do not have the knowledge or business acumen to enable them to successfully, and legally, sell securities.

Additional issues arise in the structure of the offering. Many entrepreneurs learn that they were unable to raise sufficient capital, that they spent far too much time on the offering rather than operating their business, and, adding insult to injury, that the amount that they intended to raise was not enough to address their business needs.

For more detail on those issues, Professor William K. Sjostrom has published an excellent paper on the topic, Direct Private Placements, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2442522.

Penny wise, pound foolish? If you are looking to take on investors, hire a securities lawyer to assist you in the process, and retain an experienced broker-dealer to conduct the offering for you. You can concentrate on running your company, and your professionals can run your offering.

Related Articles

Introduction to Private Placements

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Questions? Comments? Considering a private placement? Call me to see how we can help - 212-509-6544 or send me an email - mja@sallahlaw.com

Stock Offerings on the Rise

While the smaller cap public offering market has been depressed for many years, we may be seeing an increase in those offerings. Wile we have been experiencing an increase in inquiries regarding private placements, some investment firms are reporting significant increases in their underwriting activity.

This week Jefferies Group said profit rose 68% as stock underwriting more than doubled and investment- banking revenue reached a record. The firm reported a 47% increase in investment-banking revenue on the equity-underwriting gains. Global corporate-bond underwriting jumped 58% to $1.08 trillion in Jefferies’s fiscal fourth quarter from the previous three months, and global equity underwriting rose 77% to $221.1 billion, according to data compiled by Bloomberg.

For more information - Jefferies Net Income Increases 68% as Underwriting Gains
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The attorneys at Sallah Astarita & Cox  have decades of experience in all aspects of securities law and regulation. Mark Astarita, one of our partners, is the author of two popular introductory articles  - Introduction to the Federal Securities Laws and Introduction to Private Placements, which are available at SECLaw.com.

For more information about raising capital, and the SEC's new CrowdFunding proposals, call him at 212-509-6544 or at email us

In December FINRA’s new Rule 5123 went into effect.  The Rule requires members selling securities issued by non-members in a private placement to file the private placement memorandum, term sheet or other offering documents with FINRA within 15 days of the date of the first sale of securities, or indicate that there were no offering documents used. The Regulatory Notice, which includes the text of the rule is available here - Private Placements of Securities SEC Approves New FINRA Rule 5123 Regarding Private Placements of Securities.

Related articles

 

• FINRA Issues Guidance for Private Placement Filings
• Introduction to Private Placements 
• FINRA Issues Helpful Materials to Aid Members with their Private Placement Notice Filings
• 'Rich Man's Crowd Funding'

Introduction to Private Placements

Is the economy picking up?  One of SECLaw's most popular articles is getting hits like crazy. Here

Accredited Investor Definition

The question keeps coming up, so I thought a new blog post was in order. The question - what is the definition of an accredited investor for purposes of Reg D?
For years, the definitions that most are familiar with are:

• a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; OR

• natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year

The confusion apparently stems from a 2011 amendment to the definition under Dodd Frank which excluded the value of the investor's home from the calculation of net worth. An investors' home is no longer included in the calculation.

The earnings definition remains the same, despite the passage of time, but the Commission is now required to review the accredited investor definition in its entirety every 4 years.

The original release is at SEC Adopts Net Worth Standard for Accredited Investors Under Dodd-Frank Act; 2011-274

The definition itself is contained in Rule 501(a) of the Securities Act of 1933.

SEC Charges Executives at Clean Coal Technology Company for Misstatements to Investors

The SEC charged the former CEO and CFO at a Minnesota-based clean coal technology company for making false and misleading statements to investors. The SEC separately charged a network of brokers who sold the company’s securities without being registered with the SEC to do so. Bixby Energy Systems raised at least $43 million from more than 1,800 investors through a series of purported private placement offerings of stocks, warrants, and promissory notes during a nine-year period. The company used this capital raising activity to help fund operations, pay salaries, and pay commissions to brokers that sold Bixby securities.

The SEC alleges that Bixby’s former CEO and former CFO made repeated misstatements both verbally and in writing to investors about the company’s core product – a machine that supposedly produced synthetic natural gas through a proprietary clean coal technology. They told investors that Bixby’s coal gasification machine was proven and operating when in fact it had substantial technological defects, did not function properly, and was at risk of self-destruction. The CEO and CFO never disclosed these problems to investors.

SEC Charges Executives at Clean Coal Technology Company for Misstatements to Investors

More Private Placements Under Fire

FINRA has announced that it fined Pacific Cornerstone Capital Inc. and its former chief executive, Terry Roussel, a total of $750,000 for making misleading statements and, in some cases, omitting facts in connection with the sale of two private placements.

Private Placements are coming under increased scrutiny. These offerings, with limited registration and regulatory oversight have been the cornerstone of private capital raising for decades. In the past year or so the SEC and FINRA have been investigating numerous private placements  and bringing enforcement actions.

According to press reports Pacific Cornerstone sold two deals, Cornerstone Industrial Properties LLC and CIP Leveraged Fund Advisors LLC, from January 2004 to May 2009. FINRA also says that both offerings were affiliated businesses of Pacific Cornerstone and raised close to $50 million from about 950 investors.

Those investors are undoubtedly looking for securities attorneys to represent them in litigation over these deals, and other broker-dealers should be reminded that due diligence in Reg D offerings is not simply part of the deal, it is the part of the deal that may keep your firm out of the firing line when the business model does not work out as expected.

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