Senator Dodd’s financial regulation proposal (pdf) is just now beginning to make the rounds in Congress, and predictably his idea to house a new “Consumer Financial Protection Agency” inside the Federal Reserve is attracting the most attention. But lurking deeper within the proposal is another idea that is generating anxiety in the startup and angel investment community.
By way of background, a company wanting to raise capital by issuing securities must first register the offering with the Securities and Exchange Commission (the “SEC”) or otherwise qualify the transaction for an exemption as a”private placement.” As the cost of completing a registered offering runs in the hundreds of thousands of dollars, finding an applicable exemption is critical to the success of the overwhelming majority of deals.
But states in our federal system of government also have a say, and many states have imposed their own sets of rules for registering or exempting securities offerings made to residents in their states. Many of these laws go so far as to allow regulators to conduct a “merit review” and deny any offerings the regulators do not consider to be fair, just, and equitable.
Obviously qualifying for a federal exemption while simultaneously complying with the separate rules of every state in which an offering is made places a significant burden on raising private equity capital. It is nowhere near the cost of registering an offering, but burdensome nonetheless. In 1996 Congress mitigated this burden by essentially preempting all but the notice and fee provisions of state securities regulations for what is known as “covered” securities. Among securities defined as “covered” are those offered in compliance with the exemption described in Rule 506 of Regulation D, which imposes these basic requirements on an “issuer” of securities:
- the issuer may not advertise the offering or otherwise make a general solicitation of prospective investors;
- those whom the issuer actually solicits must generally be “accredited”;
- the issuer must disclose all the facts material to an investment decision; and
- the issuer must file a Form that notifies the SEC of the private offering.
Presently the SEC only concerns itself with the fact of, and not the “merits” of, any offering made under Rule 506, thus leaving it entirely to investors to fend for themselves. The theory is that accredited investors (that is, those meeting specific “wealth” requirements) have the resources to investigate the merits of an investment and the means to withstand any losses that result from their own poor judgment. As it has evolved since 1996, small companies now routinely obtain small amounts of capital from wealthier individuals (that is, “angels”) who invest in new ideas at their most premature stage. As a result of Rule 506, the “merits” of these offerings are seldom, if ever, questioned by any regulator.
Not surprisingly, the preemption of state securities laws never sat well with state securities regulators, most of whom believe that smaller private offerings for premature companies are right in their “wheel house.” The North American Securities Administrators Association has never made much of a secret of its view, as typified by this relatively recent policy release:
Although Congress preserved the states’ authority to take enforcement actions for fraud in the offer and sale of all “covered” securities, including Rule 506 offerings, this power is no substitute for a state’s ability to scrutinize offerings for signs of potential abuse and to ensure that disclosure is adequate before harm is done to investors. In light of the growing popularity of Rule 506 offerings and the expansive reading of the exemption given by certain courts, NASAA believes the time has come for Congress to reinstate state regulatory oversight of all Rule 506 offerings by repealing Subsection 18(b)4(D) of the Securities Act of 1933.
Senator Dodd’s proposal gives NASAA a lot of what it wants. First, the proposed legislation authorizes the SEC to consider and adopt a rule that will exclude to-be-specified offerings (based on “size” of the offering and the number and location of prospective investors) from being deemed a “covered security” under Rule 506. While we will need to await the completion of the rule-making process to know what that might portend, it would hardly be surprising to see the outright exclusion of the type of offerings that virtually define angel investments: less than $1,000,000 sourced from multiple smaller investors for companies still in the ideation phase.
Beyond that, the legislation also contemplates that the SEC will start examining each Form D presumably (although unclear) before closing the first sale in an offering, not after, as is the case now. The SEC would have 120 days from the date of the filing of the Form affirmatively to act, and barring action within that time frame, the offering would not be deemed “covered” under Rule 506, unless state regulators make a contrary determination (and why would they?). That means that even if an offering might be “covered” and therefore potentially not subject to state regulation, an issuer won’t know for sure until after the SEC acts — a process that by law might take up to 120 days. The proposal thus introduces both potential delay and uncertainty in not only the smallest deals, but in any private offering seeking the safe harbor of Rule 506.
No doubt state regulators’ concerns about the abuse of Rule 506 is genuine. Scam artists will forever search for the path of least resistance in which to ply their trade. The problem, though, is that closing the loophole to scammers in the manner proposed in the legislation comes at a significant cost to the entrepreneurial community, best put by Fred Wilson awhile back:
The angel funding mechanism is potentially the single most important funding mechanism in startup land. Most entrepreneurs get their first real investments from angels, not VCs. If you lower the amount of angel capital in startup land, you’ll end up lowering the number of entrepreneurs who can get their projects off the ground.
It may well be that the current system is subject to abuse. But squeezing the life out of a vibrant entrepreneurial and angel investment community by returning to a patch-work of securities regulation is not the answer we should accept. Congress should search for a different answer.