A Much Needed Thaw in the Regulatory Gridlock
For many focused on opening up new avenues of capital formation for SME’s in the US, or expanding investment opportunities for non-accredited investors, 2014 has largely been a year of waiting, hoping – and ultimately frustration. Even the final word from the SEC this year on the state of the investor, from the perspective of the newly created SEC Office of Investor Advocate, contained nothing of hope for the average investor.
Specifically, the statutorily mandated year-end report of the SEC’s Office of Investor Advocate, quietly released on December 23, 2014, had no hint of any concern regarding regulatory impediments faced by an “ordinary” investor who seeks to join friends, family and even strangers to support a broad range of ventures, be it unregistered crowdfunded offerings or registered Regulation A+ offerings – those creatures which Congress hoped would come alive long ago, and along with it the new Facebooks and Googles that have made this country both proud and prosperous.
So although the “crowd” has spoken up early and often in 2014 to weigh in on regulatory issues in DC, sometimes with the support of the SEC Chair and other SEC Commissioners, it seems as though nothing has been able to move the needle forward in Washington. And included in the crowd are such folks as Senator Mark Warner, a Democrat from the adjoining Commonwealth of Virginia, as well as a long list of Republican Congressmen – whose party in January will find themselves in the majority in Congress. Many, including myself, have great expectations for 2015, however: a byproduct of regulatory gridlock which has lasted too long, a reconstituted 114th Congress, and the persistent voice of the crowd.
So what can we expect in 2015?
Industry and Legislative Trends
The Rise of Title IV’s Regulation A+. This newly rejuvenated avenue of capital formation for pre-IPO companies , courtesy of Title IV of the JOBS Act, will continue to attract attention, from issuers and industry stakeholders alike. Expect interest in Regulation A+ to be catapulted by SEC final rulemaking action early in 2015, which will strike an appropriate balance between allowing unaccredited investors being able to participate in smaller IPO’s, and right-sized regulatory requirements for smaller issuers – including freedom from state-by-state Blue Sky qualification requirements.
Interest will be fueled by a number of factors, including the current vacuum in the smaller IPO space, the interest of unaccredited investors in betting on companies who have demonstrated potential, but are not quite ready for listing on a national exchange, and the ability of Title II platforms and others to draw on growing investor bases and a hallmark of Regulation A+, enhanced by the ability of companies to “test the waters” for public interest in their offerings before investing large sums of up-front money in offering expensed, i.e. auditors, lawyers and investment professionals.
Broker-Dealer Registration of Title II Portals. 2015 will mark a growing shift from unregistered Title II portals, some with affiliations with independent third party broker-dealers, to an increasing number of Title II platforms which obtain broker-dealer licenses. At the end of the day there is a growing realization by newcomers to the industry that the absence of a broker-dealer license means that a Title II portal is barred from being compensated on a “transaction” basis – thus leaving money on the table.
This realization will grow as Title IV’s Regulation A+ becomes a functioning market, allowing Title II platforms to participate in transactions seeking raises up to $50 million with proper licensing. Ultimately, successful Title II portals which shun the regulatory burdens which accompany broker-dealer registration will merge with, or be acquired by, established broker-dealers.
Post JOBS Act Legislation. Though no one can predict the vagaries of political action in Washington, one thing is certain: the provisions of the JOBS Act of 2012 will be supplemented through new federal legislation in 2015. Here is a mere sampling of some of the many areas of expected activity:
• Title III Crowdfunding – Long delays in SEC rulemaking coupled with an increasing consensus on flaws in the original legislation are certain to result in some new legislation in 2015. However, because of intense lobbying pressure, the precise nature of this legislation is at best subject to educated conjecture at this point.
• Curation – The SEC has taken the rulemaking position that the ability of a portal to screen companies other than on the basis of broad objective factors, or obvious frauds, is impermissible under current law. Even the Dodd-Frank mandated SEC Investor Advisory Committee has recently recommended that portals should be given the freedom to curate investments, something the SEC believes would require portals to register as investment advisors under current law. So expect this to be one area where both investor advocates and crowdfunding supporters find agreement – and ultimately a legislative fix – allowing funding portals to screen investments based upon perceived quality.
• Audited Financial Statements – Though Congress has given the SEC the authority to eliminate the requirement of audited financial statements for issuers raising over $500,000, the SEC is thus far unwilling to eliminate this requirement for any offerings. Expect legislation which will remove the requirement of audited financial statements for offerings under $1 million.
• Ongoing Annual Disclosure – Title III currently requires extensive (as in expensive) ongoing annual reports following a successful crowdfunded raise. Expect legislation to whittle this down to disclosure that is size appropriate for small companies seeking raises below $1 million (or perhaps higher).
• Increased Annual Dollar Limits – Expect the current $1 million cap to be increased to at least $2 million, as some states have seen the need to broaden the dollar ceiling at the state level, with no apparent adverse impact on investors.
• Reduced Portal Liability – Look for Congress to clarify the provisions in Title III to make it clear that portals do not share the same liability as crowdfunding companies – a conclusion that the SEC is seemingly unable to come to in rulemaking, at least thus far.
• Testing the Waters – Look for legislation which would allow issuers to solicit potential interest in their company through public solicitation, prior to actual sales, without triggering more cumbersome crowdfunding regulations.
• Regulation A+ (Title IV) – Expect legislation to provide in Regulation A+ what Congress has already done for Title III: exclude shares sold in a Regulation A+ offering from counting towards the 500 unaccredited shareholder of record limit (and 2,000 shareholder limit), which when exceeded requires a company to be a fully reporting public company, with significant ongoing reporting obligations not well suited for smaller Regulation A+ companies.
• A More Effective SEC Rule 506(c) – Though most have focused on (perhaps obsessed in) “re-defining” who an accredited investor can be for purposes of participating in an unregistered private placement, expect attention to turn to better solutions to ensure that investors who participate in Rule 506 private placements involving general solicitation are indeed accredited.
Rule 506(c) now has a 1 year+ track record. Fears of the floodgates of fraud opening up have been overcome by the reality that fraud is an activity that best flourishes in the shadows – not in sunlight. There is also an understandable reluctance by both issuers and investors to utilize the vaguely defined, but mandatory, “reasonable accreditation procedures.” Failure to meet these standards currently has draconian penalties imposed on the issuer, ironically with no penalties on the investor. Investors are also understandably reluctant to provide sensitive financial information to an issuer – or even anonymous third parties. And non-US investors and their advisors are often even more reluctant to submit to third party verification solutions than their US counterparts.
So look for new ideas and proposals to surface in Congress amending Rule 506(c) which will place the burden of an investor misstating his or her financial status on the investor, rather than the issuer – with appropriate penalties for willful misstatements, perhaps akin to the “bad actor” provisions imposed by Dodd Frank on issuers and their affiliates. Also expect “the usual suspects” to strongly lobby against these proposals, under the banner of “investor protection.” Ultimately common sense will overcome fear – though not necessarily in 2015.
In sum, 2015 will be exciting, interesting and productive for entrepreneurs and SME’s seeking additional ways to access capital outside a small circle of friends and family. But make no mistake about it. As was the case with the JOBS Act in 2012, there will continue to be intense political forces in play in Washington.
When 2015 ends, no one’s wish list will have been completely fulfilled – but one can both hope and expect that the needle will have moved forward – for entrepreneurs, investors and the broader US economy.
Sam has more than 35 years of experience as a corporate and securities attorney and business advisor in private practice in New York and Los Angeles, including as an associate at Willkie Farr and Gallagher, a major New York based international law firm, a partner at the law firm of Ervin, Cohen and Jessup, in Los Angeles, and in the firm he founded in 1993, Guzik & Associates. http://www.guziklaw.com/
Mr. Guzik has represented public and privately held companies and entrepreneurs on a broad range of business and financing transactions, both public and private. Mr. Guzik has also successfully represented clients in federal securities litigation and SEC enforcement proceedings. Guzik has represented businesses in a diverse range of industries, including digital media, apparel, health care and numerous high technology based businesses.