Financing Transactions/Securities Offerings

An advisory committee set up by the SEC, as directed by the Dodd-Frank law, has issued a report with recommendations for changing the “accredited investor” definition used for purposes of determining investor qualifications to participate in Regulation D private offerings.  The report correctly identifies the flaws with a system that uses income and net worth as proxies for investment sophistication.  It goes on to make a series of recommendations for changes to the system that, in my view, are on the right track.

I wanted to focus for this post on a few specific recommendations that I found particularly noteworthy.

In Recommendation 2, the report advocates relying on more direct measures of financial literacy, such as having securities or financial planning credentials or passing a basic test.  There could be challenges in implementing something like this, but clearly we’d rather have a financial planner with a relatively modest income participating in private investments ahead of a 21-year old musician (not that there’s anything wrong with music) who just inherited a $1 million estate.

Recommendation 3 gets into possible limitations on amounts to be invested in private offerings if someone’s income or net worth barely meets the applicable thresholds.  This is akin to the limits on investments in the not-yet-enacted Title III crowdfunding rules.  This addresses one of the main goals of the securities laws, which is to try to prevent investors from losing a big chunk of their nest egg.  If someone who makes $200,000 per year wants to plunk $5,000 in a private investment with a lottery-like risk-reward profile, it may not be the most prudent thing to do, but it’s not going to ruin the investor, so it’s appropriate to regulate it lightly.

Finally, Recommendation 4 promotes third party verification of accredited investor status, which is a somewhat overlooked part of the new rules permitting general solicitation for all-accredited investor offerings.  Having trusted third parties in this role helps keep issuers out of the business of sifting through sensitive private financial information of their investors.

I blogged recently about an SEC crackdown on failure to make required filings under Sections 13 and 16 of the Exchange Act, and continuing with that theme, the SEC recently announced a enforcement program against several public companies for failure to disclose unregistered offerings of securities.

First, some background:  Any sale of securities by a company must either be registered under the Securities Act, or it must be sold under some exemption, such as a Regulation D private placement under Section 4(2) of the Securities Act.  The SEC’s concern is that all sales of any kind be effectively disclosed to the public, so investors are aware of dilution that may have recently occurred when making their investment decisions.  The public is aware of registered sales because the registration statement and prospectus filings are made via Edgar.  When the sales are unregistered, public companies are required to make a filing on a Form 8-K if the sale exceeds a certain threshold (5% of the outstanding common stock for smaller public companies), and otherwise on the next Form 10-Q or 10-K.

In the cases brought by the SEC, ten companies failed to report transactions on Form 8-K as required by these rules, and three of them also had faulty disclosure when they disclosed the transactions in a later report.  None of these companies is a household name.  The issue of disclosure of unregistered offerings is more likely to come up in the context of smaller public companies, since larger ones tend to have more flexibility to conduct registered offerings (takedowns from shelf registration statements, etc.), while their smaller counterparts rely on PIPEs and similar transactions, which trigger the disclosure requirement.  Often, these microcap public companies don’t rely on experienced or competent securities counsel in preparing their filings.  (Yes, that is a not-so-subtle pitch for my services.)

The broader point is that the SEC is well aware that certain of its disclosure requirements are not complied with religiously, and while the agency doesn’t have the budget to police each failure individually, it is attempting to send a message with these coordinated multi-company enforcement efforts that the rules shouldn’t be ignored.

Last month, the SEC issued a user-friendly guide for potential investors in avoiding fraudulent unregistered offerings.  I highly recommend the advice given here, but I have a few specific clarifications:

• In point 1, the SEC identifies promises of high returns with little risk as a red flag.  This is of course true, but one shouldn’t necessarily be concerned if a PPM contains projections of future financial results that look rosy, as long as there is appropriate risk disclosure included.  Particularly if the company is a startup without meaningful historical financials to disclose, you’re likely to see projections in the PPM, and even the most scrupulous and honest companies are not going to have projections that make the investment opportunity look like a sure-bad thing.
• Point 4 implies that you should be concerned if the offering doesn’t have a PPM, but as I’ve noted before, it’s not uncommon for private placements to go without a PPM for all-accredited investor offerings.  The other point made here about sloppy documentation is well-taken.
• Point 5 notes correctly that many exempt transactions rely on the accredited investor definition.  In such cases, as noted, it would be a red flag if the documentation did not ask about the investor’s accredited investor status.  However, the heading of this point could be interpreted to mean that you can’t participate in these offerings without the requisite net worth or income, but of course several of the exemptions permit a certain amount of non-accredited investors.
• Point 8 says it’s a red flag if the entity isn’t in good standing in its state of incorporation/organization.  It’s pretty common for smaller companies to be delinquent in franchise tax payments and therefore not in good standing pending the payment, and in the great majority of these cases, it’s probably more about inattention to detail than a scam.  A reasonable investor could deem such sloppiness to be a red flag, but not necessarily as an indicator that the promoter will abscond with the investor’s funds.