Companies that sell their shares to the public constantly disclose all sorts of details about their operations under the watchful eye of regulators, a time-consuming and expensive process that’s meant to help investors make sound decisions.
But firms that raise money solely from sophisticated private investors can skip all that — if they refrain from soliciting the general public. Hedge funds, for instance, can advertise offerings only to wealthy individuals, who can presumably withstand potential losses.
Now, that market tenet is about to be turned on its head. Congress has directed the Securities and Exchange Commission to lift the ban on general solicitation, in effect allowing companies to mass-market their private offerings for the first time since the 1930s. The goal is to help start-ups and small businesses raise capital more easily.
Technology has forced the issue. Decades ago, solicitation of the wealthy involved making cold calls or sending letters to country club members. Today, it’s much tougher to keep a private offering under wraps. The free flow of information through e-mail, Facebook, Twitter and other Web sites makes it difficult to control who learns about investment opportunities, a factor that policymakers have acknowledged for years.
Investor advocates are complaining loudly about the upcoming change. They say it will leave investors more vulnerable to fraud and high-pressure sales tactics, a position embraced by at least one SEC commissioner. As the SEC prepares to roll out the rules needed to lift the ban, consumer groups want the agency to mandate investor safeguards.
But the private-equity industry says Congress has adopted a common-sense approach that relieves firms of onerous constraints that stifle entrepreneurship. Those who want the ban lifted are pressing the SEC to stop dragging its feet. The agency was supposed to have acted by July 4, but all it has done is put out a proposal last August that has yet to be finalized.
As Congress instructed, the proposal will allow firms to advertise to whomever they want. But only “accredited investors” with a certain net worth or income will be permitted to make a purchase — the same restriction that’s been in place for decades.
The industry says it’s silly to limit who can know about a private offering. It’s far more important to restrict who can buy it, said Stuart Kaswell, general counsel of the Managed Funds Association, which represents hedge funds. In other words, why ban consumers from window-shopping at Tiffany’s just because they can’t afford the goods?
“The complicated rules about how to communicate and who can know may have made sense once upon a time, but not anymore,” Kaswell said.
18 Rabbits, limited investors
The ban has been frustrating for entrepreneurs such as Alison Bailey Vercruysse, a maker of granola-based foods.
When Vercruysse launched her company, 18 Rabbits, in 2008, her products attracted a loyal following, she said. But she could not tap those fans for capital as she tried to grow her firm.
“People would come up to me in different places and say: ‘I’m interested in investing in your company. How can I do that?’ ” Vercruysse said. “I couldn’t say we were trying to raise money. I’d end up saying things like; ‘Buy our granola. That would help us.’ ”
Instead, Vercruysse tapped her friends and family, as permitted by law, raising about $175,000. She then traveled the country meeting private-equity firms and “angel investor” groups. In 2009, a cash infusion from one investor saved the company from ruin, she said. An additional $500,000 followed when her firm was featured on CircleUp, an online platform that matches consumer product start-ups with accredited investors.
Without a solicitation ban, a firm like 18 Rabbits could simply put a message on its packaging telling passionate supporters how they could help the company expand, said Rory Eakin, co-founder of CircleUp. “It would democratize the access instead of directing all the deal flow to known angel investors,” he said.
But if a company runs afoul of the solicitation law, the consequences can be dire. A hedge fund or any other firm that relies on private offerings would be exposed to regulatory sanctions and suffer damage to its reputation, Kaswell said. Perhaps most important, the firm’s investors could rescind their money or sue the company for its failure to abide by federal securities law.
“It’s like a scarlet letter,” said Phillip Goldstein, co-founder of a group of hedge funds in New Jersey called Bulldog Investors.
Years ago, Bulldog responded to an e-mail from a Massachusetts man who wanted to know more about the company. In the response, it shared some information about its long-term financial performance. Massachusetts regulators went after the firm for violating state securities law, which tracks the federal solicitation ban.
Goldstein fought back and took his case to the state’s top court. He lost each step of the way. The U.S. Supreme Court declined to hear the case. Given the change in the law, he has now asked the state to overturn its decision so the firm can wipe its record clean.
“Our big crime is that we responded to the e-mail and we had a Web site that was not protected by a password,” Goldstein said. “It really makes no sense.”
State authorities did not respond to a request for comment.
Thresholds from 1982
Congress instructed the SEC to get rid of the ban as part of a broader mandate set by the Jumpstart Our Business Startups Act, or JOBS Act, of 2012. Investor advocates say they recognize that the agency is simply following its marching orders from Congress. But that doesn’t mean it should pump out rules devoid of investor protections, they say.
For starters, the thresholds that define an accredited investor are ridiculously low — they haven’t been adjusted for inflation since they were set in 1982, said Barbara Roper, a lobbyist at the Consumer Federation of America.
The new SEC proposal will keep the current thresholds in place. Anyone with a net worth of more than $1 million (with or without a spouse) or an income exceeding $200,000 (or $300,000 with a spouse) qualifies. A person’s primary residence is not part of the net worth calculation because of a recent change in the law.
“Still, I don’t think anyone who is being honest about it really thinks that income of $200,000 means you are either financially sophisticated or wealthy enough to withstand losses,” Roper said. “It’s a joke.”
Another misconception is that the solicitations will be out in the open and therefore easy to police for fraud, she said. That may be true for radio or television ads, but less so for e-mails and cold calls from telemarketers. Roper also said the commission lacks resources to track the marketing.
The North American Securities Administrators Association, which represents state securities regulators, reported that states brought more than 200 enforcement actions in 2011 for fraud related to private offerings that weren’t registered with the SEC.
The group expects fraud cases to climb once private placements are widely broadcast, said Heath Abshure, NASAA president and Arkansas Securities Commissioner.
Currently, start-ups or hedge funds that want to reach well-to-do investors typically hire broker dealers to find them, Abshure said. Those broker dealers are obligated to do some due diligence on the company and make sure it’s a good fit for the investor.
But under the new rules, companies that don’t pass muster with broker dealers will be able to directly access a broad group of investors through solicitations, Abshure said. The new law says only that companies must take “reasonable steps” to verify that they are exclusively soliciting accredited investors.
Abshure said the approach is sure to backfire. The deluge of ads about to be unleashed on the public is bound to shake investor confidence in the market, he said.
“How will legitimate offers be heard over the din if every time you turn on your computer, open a magazine, look at a billboard or flick on your TV, there is somebody selling securities and promising the next greatest thing?” Abshure said. “Nobody will trust the market, and if nobody trusts the market, nobody invests.”
‘Not for everyone’
Even the SEC’s staff has weighed in to warn that broadcasting these private offerings widely could create problems. “These offerings are not for everyone and carry a very high degree of risk,” Lori Schock, who heads the SEC’s office of investor education and advocacy, said in June. “For every successful venture, there are more numerous failed ventures.”
Against that backdrop, observers are parsing the public statements of the SEC’s four commissioners, evenly split between Democrats and Republicans, for clues as to what might happen next.
The agency tried to rush the rules last summer, but it succumbed to pressure from Roper and other investor advocates who demanded that the SEC slow down. Mary Schapiro, who was chairman at the time, opted to gather public comment before finalizing the rules.
Republican SEC commissioners Dan Gallagher and Troy Paredes favored the fast track, and both voted for the proposal that was presented to the public for comment in August.
SEC Commissioner Luis Aguilar (D) did not, saying it lacked adequate investor protections.
Now, all eyes are on Elisse Walter, who took over as SEC chairman last month.
Walter voted for the proposal, with hesitation. In public statements, she has acknowledged that the solicitation ban needs to be modified because technology has changed the way people communicate. But she also said that lifting the ban is a “profound change” that could have “unintended consequences.”
In recent public remarks, Walter said the agency must consider ways to mitigate potential harm to investors while preserving the rules’ intended benefits.