The SEC’s recent announcement that they are considering softening the rules for selling private company stock has brought out the pundits in force. Even my friend Fred Wilson has weighed in. The deeply-held views range widely, from “This is a force for democratization of ownership of private company stock; it is no longer simply a province of the wealthy” to “This is a weapon of mass destruction, providing yet another avenue for the unsophisticated to get fleeced.” I can certainly understand both positions. The bottom line is, however, that the accredited investor rules are and always have been a poor proxy for what really matters – understanding the investment opportunity at hand.
The accredited investor rules, as they currently stand, are as follows (as taken directly from the SEC.gov website):
Under the Securities Act of 1933, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The Act provides companies with a number of exemptions. For some of the exemptions, such as rules 505 and506 of Regulation D, a company may sell its securities to what are known as “accredited investors.”
The federal securities laws define the term accredited investor in Rule 501 of Regulation D as:
- a bank, insurance company, registered investment company, business development company, or small business investment company;
- an employee benefit plan, within the meaning of the Employee Retirement Income Security Act, if a bank, insurance company, or registered investment adviser makes the investment decisions, or if the plan has total assets in excess of $5 million;
- a charitable organisation, corporation, or partnership with assets exceeding $5 million;
- a director, executive officer, or general partner of the company selling the securities;
- a business in which all the equity owners are accredited investors;
- a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase;
- a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year; or
- a trust with assets in excess of $5 million, not formed to acquire the securities offered, whose purchases a sophisticated person makes.
These rules are focused on one thing: does the buyer have the financial capacity to lose their money, as opposed to asking if the buyer has the financial knowledge to make an educated investment decision. This strikes me as both odd and irrational. So, if you have (and/or make) enough money to make stupid decisions, it is your right to do so. However, if you are very educated about the markets and skilled in evaluating equity securities yet lack the income or net worth necessary to be an accredited investor, tough luck: no private stock for you. Let’s be honest: weakening the already-broken accredited investor rules would only lead to greater numbers of fools rushing in at precisely the wrong time. This is how the financial markets work: there are winners and losers. The winners generally have better information and are more savvy at playing the game, while losers lead with their heart (and not their head), get sucked into trends and are generally late on the entry and late on the exit.
Before considering changes to the current regulatory regime, we need to ask ourselves: what are we trying to accomplish? Protecting people from themselves? Preventing information asymmetry? Guarding against fraud?
I personally don’t think trying to protect people from making mistakes is healthy. Rich or poor, freedom of thoughts and actions (assuming they don’t hurt others) is part of the bedrock of our society. Legislating that if you are rich (at least by accredited investor standards) you can buy private company stock but if you are less than rich you cannot is unfair on its face. For this reason alone the accredited investor rules should be re-written or scrapped. However, preventing information asymmetry (as it relates to companies saying different things to different people and providing different levels of disclosure) is something worthy of regulation in my opinion. Further, protecting against fraud and ensuring truthful disclosures are important elements of vibrant and efficient markets. So, creating a level playing field with respect to information dissemination and legislating a common-sense package of disclosures (in conjunction with the Financial Accounting Standard Board) would seem to go a long way towards protecting investors from bad acts on the part of issuers, if not their own bad judgment.
Where things really get complicated is as follows: what is the difference between a private market and a public market? The breadth of ownership? The level of disclosures? The standards of honesty and transparency to which senior executives are held? If the SEC is seriously considering reducing the “ability to lose” standard and shrinking the difference in the ability to invest between private and public markets, then the level of disclosures and the responsibilities of managers and directors need to converge as well. If you want to broadly distribute unregistered securities, then I fail to see why the disclosures provided to investors should be materially different than those required by the public markets. At this point the difference between “private” and “public” become semantic; they both involve the broad distribution of securities. I have long felt that transparency is the key to fair markets: when viewing the public/private issue through this lens, there really isn’t much of a difference between the two.
So what are some conclusions that can be drawn from this discussion?
- The current accredited investor standards are nonsensical. If you want to create an appropriate barrier to investment in private securities with limited disclosures, it should be based on knowledge of investing and not on net worth or income.
- If the SEC wants to loosen the rules with respect to the breadth of distribution of private securities, then disclosure standards and the responsibilities and obligations of private company managements and boards needs to be increased.
- The asymmetry in required disclosures between private and public companies should shrink dramatically as broad distributions of private securities become a proxy for public offerings.
- To the extent that there is differing investor access to private and public securities, the rules should be biased towards prompting companies to go public in order to promote maximum liquidity and opportunity.
- There will always be edge cases (like Facebook). There should be a re-visiting of the 500 shareholder rule (given the number of employees and the fact that they are privy to a wealth of company information), and a non-employee number of owners determined that constitutes a public market proxy (and therefore requires public markets-like disclosures).
If these rules are created and administered properly, there should be no difference in the disclosures, management and board responsibilities, liquidity and access between public and broadly-distributed private offerings. There should not be opportunities for information and regulatory arbitrage by remaining private when in substance an enterprise is acting like a public company. However, the trick is in defining this threshold (500 non-employee shareholders?), setting appropriate disclosure requirements and re-visiting the accredited investor paradigm. This is a very textured issue that will likely be a magnet for lobbying dollars and political machinations. But the bottom line is transparency and self-reliance should be the guideposts of a sensible policy. Hopefully the SEC will take this to heart.
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