The Jumpstart Our Business Startups (JOBS) Act took effect this week and the SEC tweeted an Investor Alert focused on the lifting of the ban on advertising and “general solicitation” on qualifying private placements. This provision has been the focus of criticism from the likes of former SEC chairman Arthur Levitt – a staunch and effective proponent of investor protection – and professor William Black, a financial crime expert who was responsible for uncovering Congressional fraud in the Savings & Loan scandal.
The JOBS Act is intended to make it easier for small start-up businesses to raise money, especially using private placements. Flexibility afforded by the Act includes exemption from requirements of SEC registration for qualifying companies, including exemption from making certain required regulatory disclosures in connection with an IPO, and a longer five year phase-in of the already reduced small-company requirements of Sarbanes Oxley (those pesky rules Congress introduced to prevent the massive accounting fraud that sunk companies like Enron and WorldCom). The JOBS Act also increases both the number of shareholders and the amount of capital that can be raised privately, giving start-up companies a longer runway before they have to register with the SEC.
What Could Go Wrong?
The SEC Alert highlights certain risks of investing in private placements, including the possible loss of your entire investment – a pretty common outcome with smaller private offerings – and the lack of a liquid market, which means you may have to hold your investment forever – another common result. Remember that a private placement by definition does not trade, meaning you can’t get your money out at all until there is an IPO. The reduced filing obligations under the Act mean companies will provide less information. The Commission says “companies have more discretion in what information to disclose to you” and emphasizes “Pay particular attention to any risk factors that are described,” with the very strong implication that companies can get away with sweeping stuff under the carpet, and that therefore any risks they feel compelled to disclose must be really risky.
Isn’t there any protection left to the individual investor? you ask. Well, in order to take your money, the company still has to verify that you are an Accredited Investor.
Should I Feel Better Now?
Regulation D, which governs private placements, identifies certain investors as “Accredited,” meaning they are deemed both sufficiently sophisticated, and financially suitable to assume the risks of a private placement investment. The list includes banks, insurance companies, mutual funds, registered investment advisers… and individuals with $200K in annual income ($300K jointly with spouse) or $1 million in net worth. This financial standard was introduced in 1982. Since then, lots of things have changed – but the financial test for Accredited Investor has not.
You don’t have to have a PhD in economics to reckon that a million dollars in 1982 is different from a million dollars today. Thankfully, the value of your primary residence is excluded from the calculation, but other stuff is included – like your 401(K) and your IRA accounts – meaning that “net worth” is not at all the same as “cash.” In other words, you could be Accredited, be a millionaire, and still have a hard time making your mortgage and tuition payments.
Just for a lark, we ran $1 million 1982 dollars through the CPI Inflation Calculator on the Bureau of Labor Statistics website, which says that the 2013 equivalent is $2,423,595.85. This means that even under the old Reg D restrictions the number of Accrediteds has grown tremendously. Accrediteds now represent a higher percentage of the general population but they are a lot less rich than when the standard was introduced. Being a millionaire just ain’t what it used to be, a reality that everyone gets except Congress and the government agency charged with protecting the investing public.
Are you worried yet?
While easing the path to investment capital sounds positive and pro-growth and overall beneficial to America, direct-to-investor advertising is not an unmitigated societal good. It makes us think of direct-to-consumer marketing of pharmaceuticals – outlawed in every country but New Zealand and the US – which is often viewed as an end run around regulation, designed to make people clamor for new drugs they may not need, or for off-label uses of existing drugs.
In the age of Facebook and Twitter, direct solicitation is inevitable, so it is legitimate to view the JOBS Act as Congress trying to get in front of an unstoppable event and to start making regulations around it. But one of the Act’s most important and up-to-date objectives has so far gone nowhere; open crowdfunding of start-ups was supposed to be implemented by the end of last year. The SEC hasn’t even begun drafting rules covering crowdfunding, perhaps waiting to first view the carnage from Open Season on retail investors. A lot of firms invested in crowdfunding technology, and many have shifted to launch their own private placement platforms – sort of “speed dating for retail investors” – in order not to lose out completely on their investment.
There was massive press hype in the lead-up to the Facebook IPO. So much so that Goldman Sachs, Facebook’s bankers, withdrew lucrative private tranches it had just offered to its partners and to key investors. Goldman was concerned that the SEC would construe all the media attention as “constructive advertising” and charge Goldman under Reg D. After the fact, the SEC said they would not have gone after Goldman over the final private pieces of the Facebook offering – but there is no way of actually knowing what the Commission might have done. The Act now makes it moot. You are now really, truly, and completely on your own. It’s a no-brainer to predict that the initial stages of advertising and marketing private placements directly to investors will see substantial damage to individuals’ net worths before the dust settles. We urge you not to be counted among the fallen.
Of Things To come…
One bright point in all this is our fantasy of what mass advertising for high-risk private placements will look like. We imagine a television commercial with scantily-clad women swooning over a supremely confident guy in an expensive sportscar. “What sort of man buys private placements?” asks the announcer. One look tells you all you need to know. The 30-second spot will leave you panting for the kind of success that only private placements offer. “Chernham & Burnham Private Bankers, Ltd.,” croons the announcer. “Let us handle your privates.”
Looks like Wall Street is going to be fun again after all. Watch yourselves.
By Moshe Silver
Moshe Silver is a Managing Director at Hedgeye Risk Management and author of Fixing a Broken Wall Street.