Tuesday, November 19, 2013

506c and Securities Regulation

The new Reg D, Rule 506c is a major change in securities regulation.

Let us get a perspective on all this.

One of the major hidden concepts in securities regulation is prior restraint. In a world without any securities regulation, anyone would be allowed to immediately offer securities with any level of disclosure and advertising.  No securities regulator would review the offer, no filing of any kind would have to be made.

Imagine turning on your television and watching a 30 minute infomercial on American Widget common stock. The company was formed last week by some people who are on parole for fraud but they don't have to tell you that. Anyone, no matter how unsophisticated, can buy, even if they cannot afford the loss. The buyer calls in and a former used car salesman gives the investors a hard sell to get all the money they have.

Instead of prior restraint, society would have to rely entirely on prosecutors who come in and punish those who defraud, but they would act only after the fact, after investor losses and after discovery of the fraud that caused the losses.

What we have for initial public offerings is a system that requires prior review by the SEC. Prior restraint but no review of the merits of the offering.

In some instances bad boys are not allowed to offer securities, but with an IPO, they are allowed if their acts are disclosed.

You can advertise an IPO but only with a tombstone ad.

Now for private offerings, we have 506c which allows advertising. There is no prior review of the offering documents, but you do have to file a Form D. Only accredited, sophisticated investors can buy. There is no limit on the dollar amount. Bad boys can play if disclosed.

Compare the pending crowdfunding rules. Advertising is limited to portals. Anyone can buy but only to a certain dollar limit. No prior review of the offering materials.

Most of all, in both 506c and crowdfunding, there is no guaranteed exit strategy. What is the value of an investment you cannot liquidate? Public companies using 506c do present an exit strategy, but private companies do not.

The small investor is barred from the 506c offerings, but can gamble on startups, most of which will fail.

The startup company has to choose between 506c and crowdfunding. Can they survive scrutiny by accredited investors?

There is no federal merit review in 506c or crowdfunding, unless you count the bad boy provisions.

Consider merit review used by some states. The rules are generally based on having the promoters invest a reasonable portion of the entire capitalization, reasonable pricing in some fashion, and the promoters cannot rapidly cash out. Bad boys may be barred.

Some of these merit reviews may help even though they may hurt the promoters. affected by these elements. Does the amount of money invested by promoters actually affect the success of the enterprise? The pricing of the deal may affect the investor's return. Bad boys often do not learn their lesson but many do reform. What is the sense of barring those, but how do we select out the reformed bad boys before they perform? Keeping the promoters from cashing out fast can focus them on long term results which benefit investors.

As a society we have to weigh the burden of regulation with the benefits of open finance. Congress in its wisdom has chosen 506c and crowdfunding as the new tools of finance. Time will tell.