By Ryan Belanger-Saleh on Monday 17 October 2016
First, A Little History
The concept behind most financial instruments is old. Really old.
In some cases, as is the case with equity, it is many thousands of years old. The concept of regulating the issuance, sale, marketing and distribution of these instruments, however, is young. For the vast majority of the history of securities, normal business transaction law dictated what constituted a proper or improper transaction. There was no need for regulation as buying and selling securities was the business of the “sophisticated” elite who were considered savvy enough to make their own assessment of risk.
That was until the early 1900’s (in the USA). With the advent of mass communication methods like the telegraph, widely available mail delivery and higher literacy rates, the American securities industry was made available to the masses. Anyone with some savings was allowed to buy stock on hundreds of newly created exchanges and, in the spirit of American risk taking, we did, en masse.
By the 1920s, virtually every major American city saw the creation of stock exchanges that were controlled by brokers who would match the opportunistic and booming American middle class with new and novel companies which were riding the growth of the booming 1920s economy. All was well. The free market was working. The economy was growing. America now more than ever had become the land of social mobility, where a single savvy investment could rocket a hard working immigrant to the upper echelons of American society.
But like all boom times, trouble brewed under the surface and as the equities markets grew, fraud set in. There was no distinction between public or private companies in 1929. No need for reporting and financial auditing rules. Companies were free to mass market (generally solicit) their equity. With little more than a business plan, a company could get funding from hundreds of ordinary people and the brokers were allowed to sell anything to anybody with little liability.
We all know what happened next. 1929, the stock market crashed. 1933, Congress created the Securities and Exchange Commission and separated equities into those that are registered with the SEC (public companies), and those that are not registered, are not required to report, and can only be purchased by “sophisticated” investors (private companies).
While the industry would amend the law and cycle through several self regulating organizations over the next 80 years, the general spirit of The Securities Act has remained intact.
And then in 2012 the JOBS Act, or Jumpstart Our Business Startups Act (...we love our acronyms), was passed by congress. This law, more than 10 years in the making, was a massive deregulation of the securities industry, which aimed to use the internet and the availability of information that the internet put at our fingertips, to overhaul what the average person was allowed to invest in.
For example, several parts of the Act legalizes the mass marketing of securities, no longer requiring prior relationship between the seller of a stock and the buyer. Other parts allow offerings to be sold to “unsophisticated” investors (i.e. anyone).
But if you talk to members of the securities industry today and tried to sum up the collective opinion of JOBS Act in one word, it would be “caution”. The industry is waiting for enough funding to take place using these new rules to see what the true legal exposure and risk is, knowing that when the US economy takes its next downturn, people will lose money, lawsuits will come out of the woodwork and much of the law will be repealed, revised and clarified.
First, let’s discuss general solicitation, or the mass marketing of private securities legalized in the JOBS Act under Titles II, III and IV.
In a world where everyone has hundreds of social media connections, many of which they’ve never even met in person, defining what constitutes a pre-existing relationship will be virtually impossible for regulators. You cannot penalize the dissemination of information in the 21st century, so it’s safe to say that general solicitation is here to stay.
Next, we look at the selling of securities to unsophisticated (non-accredited) investors, legalized in the JOBS Act under Titles III and IV. Removing the minimum income or net worth requirement for investors in private companies is the largest single effect of the JOBS Act. Now issuers and brokers are free to advertise and sell securities to your average school teacher or mailman.
But are income and assets really a good measure of sophistication? You might have a 97 year old relative who, through years of frugality, has become accredited, and yet there are even financial analysts and investment bankers who are not accredited.
One problem with the JOBS Act is not in the removal of the accreditation requirement, but in the failure to replace it with a strong enough alternative.
Our hope is that regulators will instead replace the litmus test, the proof of accreditation, with something more indicative of sophistication. We believe the same investor protection could be achieved through stronger limits on the total amount of one’s salary that can be invested per year, proper risk disclosure requirements and a longer “cooling off period” so the investor can back out of the purchase within a number of weeks.
Now that we’ve discussed what they should do, it’s more important to discuss what regulators likely will do.
How will the JOBS Act look in ~2025? We think that general solicitation to accredited investors will live on and the Regulation D rule 506(c) will over time grow to replace rule 506(b), with the burdensome proof of accreditation standards eventually being lifted allowing traditional Reg D offerings to be generally solicited in emails, on social media and on listing websites.
We believe that Title III crowdfunding will remain a legal but small space (<$10,000,000 of total annual funding by 2020) allowing crowdfunding sites like Indiegogo and Kickstarter to sell a class of stock to large numbers of unaccredited investors, while avoiding major legal risk and offering early backers something more enticing than just the promise of receiving an early shipment of the company's product.
Lastly and perhaps sadly, we think that when the JOBS Act faces the scrutiny of congressional panels and SEC regulators, it will need a scapegoat. That scapegoat will come in the form of Regulation A tier 2 (Reg A+). This “IPO light”, legalized in the JOBS Act under Title IV, allows up to $50 million dollars of generally solicited equity to be raised from non-accredited investors. This fundraising mechanism bears the risk of attracting misrepresentation and fraud, and with one high-profile bust, we expect this regulation to be reviewed.
Whether the new exemptions live on or not, whether investor outcomes are improved or not, whether it was done for the right reasons or not, the JOBS Act is a progressive, forward thinking law that needed to be passed and will eventually lead to smarter, safer, more transparent, more tech-enabled, and more democratized capital markets.
Ryan Belanger-Saleh is a co-founder of Dealtable.com, a secure, private placement deal management platform that makes it easier for issuers, investors, advisors and intermediaries to source, market, diligence and close their transactions faster, while maintaining ultimate control over their data.