Selling Private Placements

Why aren’t people buying crowdfunding? That question has people flocking to conferences and spending a lot on so-called experts looking for the reason that most equity crowdfunding campaigns fail to raise the money that they want.  Let me save you some money and a week on the road by stating the obvious: people are not buying crowdfunding offerings because no one is selling them.

I recently had a conversation with an entrepreneur who was funding his business on a crowdfunding website. I had viewed his offering and asked for more information. He sent me an e-mail and we scheduled a phone call.

He was professional throughout the conversation.  He was knowledgeable about his product, his customers and his competition. His sales projections were realistic and he seemed to have a good team in place.

What he lacked was any real sales skill. He had certainly spoken with dozens of potential investors before he got to me. It was obvious that he did not know how to close the sale.

Compare that with a professional stockbroker. Stockbrokers sell private placements and they are highly incentivized to do so. Private placements pay brokers higher commissions than almost any other financial product.

One of the first things that I learned when I started working on Wall Street was that people do not buy investments, rather people are sold investments. That is the lesson that the crowdfunding industry does seem ready to learn.

People are often surprised to learn that far more money is raised through private placements than public offerings every year. The JOBS Act which enabled crowdfunding to compete with mainstream stockbrokers actually made it easier for the brokers to sell the same private placements in direct competition with the crowdfunding platforms.

When the SEC adopted Regulation D in 1982 to provide a safe harbor for these private, non-registered offerings it defined a class of accredited investors, wealthy individuals with $1,000,000 in net worth or $200,000 in annual income. At the time this was a relatively small group of people. Due mainly to inflation this group has grown substantially since 1982. Many accredited investors who might consider investing in a start-up already have a stockbroker.

By the end of the 1980s there were a number of brokerage firms that specialized in selling private placements and many companies that packaged these investments for them. Most of these private placements were for various types of real estate or oil and gas investments. That is still true today.

A lot of these investors were baby boomers because they had money to invest and many were retirees or near retirement age. These people were specifically looking for investments that would provide steady income to help offset their retirement expenses.  Many private placements were sold based upon projections of monthly or quarterly income.

Selling an investment that throws off a substantial monthly check should not be that difficult, but it is. Virtually every security offered through a private placement has a substantial risk that the investor will suffer a complete loss of their investment.

In part because the universe of individuals who might want to take that risk is limited, the brokerage industry charges a hefty commission to sell these investments. Even the largest firms that package real estate or oil and gas investments as private placements frequently pay a 10% commission to the brokerage firms that sell them.

When you add legal, due diligence and marketing costs, the up-front expenses for a private placement can often add up to 15% or more. Those syndication costs are taken out of the offering proceeds. Some private placements also burden investors with pre-arranged exit costs if the property is sold.  I have seen real estate syndications where the property needed to appreciate by 30% for the investors to break even.

Reg. D offerings were not supposed to be “public” offerings and brokers were constrained to sell them only to people with whom they had a prior business relationship. Advertising a private placement or what is called “general solicitation” was always prohibited.

Given the high commissions that rule was often overlooked. It was not uncommon for a broker to hold a seminar where a sponsor would present the details of an offering that had just closed.  At the end of the presentation, the participants would be invited to sign up if they wanted to be notified when the next offering became available.

Attendance at a seminar was probably not the SEC’s idea of a prior business relationship but these went on for years.  The sponsors paid for the seminars and compliance directors at the brokerage firms looked the other way.

The JOBS Act eliminated the rule against general solicitation. That opened the door for general advertising of private placements. The only condition was that they could only be sold to accredited investors. Advertising of these offerings to accredited investors has exploded.

The JOBS Act was supposed to offer investors the opportunity to invest on-line through websites that did not charge commissions. Eliminating that commission cost should have created better economics and better deals and given the crowdfunders a leg up. Sadly, that has not been true.

Rather than up their game, the crowdfunding industry seems content to list offerings for companies with half-baked ideas, inexperienced management and unpatented products and processes. Add to that a fair amount of out and out fraud because the offerings are un-vetted and it is easy to see why the mainstream brokerage industry has little to fear from the crowdfunders.

What I see in the future is the mainstream stockbrokerage industry establishing crowdfunding sites where potential investors can browse offerings after being solicited by advertisements. Once there, the websites will make the potential investors presence known for licensed registered representatives to follow up and close the sale.

This is not what many of the crowdfunders had in mind when they lobbied for the JOBS Act.  Some believed that the crowd was capable of making intelligent decisions about investing in start-ups and that many people would want to put their money into these small companies.  Neither assertion was ever true.

I am probably alone in suggesting that crowdfunding will make a better adjunct to a traditional brokerage firm than a replacement for it. I suspect that it will not be long before others begin to see what I see and the “contact for more information” button on a crowdfunding site will go to a licensed stockbroker who will close the sale and be paid a commission.

There is a difference between marketing or solicitation and selling. Selling is what the crowdfunding industry needs in order to ultimately be a successful tool for corporate finance.

 

Can Lawyers Trust Their Clients?

It was a simple case and a simple request. The case involved an older gentleman whose stockbroker had over concentrated his portfolio in real estate securities. When the 2008 real estate crash came the portfolio tanked. I was retained to recover his losses.

I drafted the claim and sent it to the client for his comments. I included simple instructions, “review it carefully and tell me if I have set out the facts correctly. At the hearing you will be asked to swear that this is true”.

One of the facts included in the claim was something the gentleman had told me at our first meeting; that he had never invested in real estate securities before.  This became important when the stockbroker being sued filed his answer. He said that the client had told him that he had previously invested in real estate securities and had lost money and therefore understood the transactions and the risk.

“Never happened” my client told me.

Sure enough, on cross examination, the defense attorney reminded my client that when he first became this broker’s client, years earlier, it was because the previous broker had recommended that he invest in securities that were very similar to the ones he was now complaining about.  Apparently, he had deposited a small check that he had received from a class action over a defunct real estate deal into the account early on.

The next question: “if you lost money in this type of securities before, why did you accept the broker’s recommendation to buy them again?” effectively dooming the case because the client did not have a good answer. I had not prepared him to answer the question that I never thought he would be asked.

I could attribute this to the client’s bad memory but that does not factor into every situation.

In another case, a different client revealed for the first time during cross examination that he had been accused by his wife during their divorce proceeding of molesting his own children. There was apparently enough truth to the allegation that he had been formally charged and sentenced to probation.

I always ask about past lawsuits and criminal matters at my first meeting with any client who is likely to take the witness stand. I believe that a lot of lawyers do so as well. This client did not think that it was important to tell me the truth. We did not win that case, either.

These client omissions resulted in lost cases and a fair amount of lost time.  Most lawyers do not lose too much sleep over it. There are a lot of things that can go wrong with any case. Every time two lawyers go into a courtroom, someone loses. Trial lawyers develop a thick skin.

Corporate lawyers with untrustworthy clients can get into more significant trouble. Lawyers who prepare the offering documents for the sale of securities take on a considerable amount of personal liability. Most of the big law firms that write the prospectuses for IPOs carry substantial liability insurance policies. And these firms usually do a pretty good job of getting the facts straight.

Still, if the offering is deficient and the investment fails anyone connected with the offering, including the lawyers are likely to get sued.

When I was a young lawyer learning how to prepare offering documents I attended a few seminars. One instructor offered an example of an attorney who had failed to do what he should have done and had gotten into a lot of legal difficulty.

The example went something like this:

An older gentleman who owned about $100 million worth of commercial real estate, mostly small office buildings with street level retail storefronts, wanted to retire and sell out. His son, who had no cash, wanted to continue to receive lucrative management fees and arranged a private placement to buy out his father.

Many of the tenants had been there for years and the father gave many of them long term lease extensions as he was preparing to sell. The leases were collected and reviewed by the lawyer who was preparing the private placement. These were reduced to a schedule which showed the current and projected rent roll for the buildings that was included in the private placement memorandum (PPM).

What was not disclosed was the fact that the father had also provided side letters to many of the tenants who he considered to be his friends allowing them to terminate their leases on short notice if market conditions deteriorated, which of course they did a few years later. Several tenants vacated and several more asked for rent reductions threatening to vacate based upon the side letters that had never been disclosed.

The investors sued and won. The state securities commissioner alleged fraud and the attorney was lucky to settle the case and retain his license to practice.

Attorneys who participate in the issuance of securities are obligated to conduct a reasonable investigation of the facts to make certain that what they disclose is accurate and complete.  This lawyer just accepted what his client told him at face value and suffered the consequences. That was the lesson that was being taught. Lawyers cannot trust their clients.

A few months ago I was approached by a small company that needed a private placement memorandum in order to crowdfund about $600,000. The company had already spent about $250,000 developing its product and was now getting ready to buy inventory and kick–off the business.

They did not want me to write the document. They had prepared it themselves using a software package that asked a lot of questions and spit out a private placement memo. All they wanted from me was to review the document and to “bless it”.  They had budgeted $1500 a legal review because they reasoned it could not take an attorney that long to read the document.

They told me that the software package was recommended as the best by several prominent bloggers and websites.  The software package was popular so they were confident that the resulting document would be fine.

Software templates for private placement memos have been around for a long time. There are dozens available today. For an attorney working without a secretary or paralegal, they certainly might have some utility.

Allowing a company to use a software template to write its own PPM without an attorney is like handing a child a loaded gun. Someone is going to get hurt. In most cases, it is probably going to be the investors.

I told the company what I would charge to review the document, make changes as needed and conduct a reasonable investigation to make certain that the facts were properly disclosed. It was more than $1500. They chose to find what they wanted elsewhere.

Several weeks later I came across the offering on one of the less expensive crowdfunding platforms.  I accessed the documents and saw that the PPM was mediocre at best. It just did not read very well.

They had removed some of the standard risk factors that I would have included for any startup. The prior work histories of the key executives were uneven. Some went back 10 years; others 5 years. There apparently was no marketing study and no discussion of the competition.  The PPM stressed how successful the company was going to be without a realistic discussion of what might go wrong.

The sales and profit projections were questionable.  They were projecting explosive growth in short order even though the company had not yet made its first sale. The company had nothing to support that projection except its own hopes and dreams.

I assume that some lawyer took their $1500 and signed off on the PPM as they presented it.  Some of the crowdfunding platforms require an attorney to review the PPM; some do not.

Most of the lawyers that I have met or corresponded with in the crowdfunding arena and the mainstream financial markets would insist on a reasonable investigation of the facts in any offering that they prepared. In most cases, you cannot do an investigation for a startup correctly for $1500.

I think it fair to question why the founders of a startup who are planning to get rich cannot budget more for a competent attorney than they do for pizza. I appreciate that lawyers have a bad reputation, but at the very least there should be some agreement that we are a necessary evil if the company is going to seek funding from investors.

The investigation is done partially to protect the lawyers from their own clients. It may not be what the entrepreneurs want to hear, but lawyers are not expected to trust their clients and the markets are safer and more efficient for it.

 

FINRA looks at Wall Street’s Corporate Culture – It should look at its own.

The Financial Industry Regulatory Authority (FINRA) has announced that as part of its 2016 member firm audits it will look into what it calls the firm’s culture of compliance and supervision. The idea is laudable until you put it into context.

Registered representatives (stockbrokers) are routinely incentivized to open more accounts, bring in more money and make more trades. Many successful stockbrokers gain their clients’ trust by presenting themselves as financial advisers when they are not. They are salespeople not analysts or advisers.

That is the culture of the industry. It is demonstrable without an audit.

As someone who has brought arbitration claims against hundreds of stockbrokers, I can tell you that the miscreants among registered representatives are a small minority. Most stockbrokers do not get out of bed thinking “who can I screw today”. More frequently problems arise from advice they are not qualified to give or even more often from financial products that should not be sold in the first place.

The most conflicted advice that is routinely given by FINRA Broker/Dealer firms is for customers to stay in the market no matter what. If the market crashes, which it periodically does, registered representatives routinely tell customers that they did not see it coming and then “don’t worry, the market always comes back.”

Ask yourself: if your stockbroker did not see the market crash coming, how do they know that the market will come back?

My own adviser (an independent Registered Investment Advisor) has been bearish since last summer. After a long bull market he called the collapse of oil prices a “shot across the bow” for the markets and started selling positions and accumulating cash. He has raised more cash of late because he uses stop losses. He believes that protecting a client’s portfolio is part of his job. If your adviser thinks differently or does not use stop losses, send me an e-mail and I will gladly refer you to mine. (I receive no fee for any referral).

A FINRA audit is often performed by an inexperienced auditor (not a CPA) who is thinking about spending a few years at FINRA and then getting a more lucrative job in the industry. Rarely, if ever, do FINRA auditors ask the hard questions.

Trillions of dollars worth of transactions are placed by FINRA firms every year that are perfectly legitimate and need little scrutiny. FINRA would do better to spend time and energy reviewing those transactions that yield the most problems.

Hundreds of FINRA firms and thousands of registered representatives specialize in selling private placements to non-institutional customers. Private placements pay higher commissions than most other financial products and are therefore always a concern for potential abuse. Private placement losses are a multi-hundred billion dollar problem that affects many seniors and retirees, many of whom should never have been offered these investments in the first place.

FINRA has explicit rules about how firms should perform due diligence on private offerings. Failure to conduct a due diligence investigation on private offerings has been a leading cause of investor losses and the reason that a significant number of FINRA firms went out of business when the market corrected in 2008.

Private placements are sold with shiny marketing brochures that are supposed to be reviewed by compliance departments but frequently are not. Do FINRA auditors routinely review the marketing materials for private placements at the firms that they audit to see if they are appropriately reviewed and not misleading? They do not.

FINRA would do well to examine its own culture.

It has never been my practice to file complaints with FINRA’s enforcement branch, in part because they are consistently ineffectual. Some time back, I did file a complaint on behalf of an 80 year old client who had been sold a particularly ugly private placement for a building in the mid-West.

The sponsor, who was also the master tenant responsible to make payments to the investors claimed to be a college graduate who had previously owned a seat on one of commodity exchanges. He also claimed to have been a successful real estate developer.

In fact, the sponsor had never graduated from college, never owned a seat on any commodity exchange and his only prior development had filed for bankruptcy protection leaving many sub-contractors unpaid. I submit that no competent due diligence officer who actually investigated this offering would have approved it. That did not stop dozens of FINRA firms from selling this and other private placements offered by the same sponsor.

The investors ultimately lost the building to foreclosure because the roof leaked badly and needed expensive repairs. The due diligence officer at the FINRA firms that sold this private placement had never seen an inspection report on the building and it is doubtful that a building inspection was performed before it was syndicated to investors. The sales brochure that every investor received described this as a great building and a great investment.

The FINRA enforcement officer that looked into the complaint had never performed a due diligence investigation himself nor was he trained in any way as to what a reasonable due diligence investigation might entail. I know this because I spoke with him more than once. He pronounced the due diligence investigation on this offering to have been fine and on his recommendation FINRA took no action against the member firm.

I took the claim to arbitration and the panel rescinded the transaction giving the customer all of his money back with interest. It certainly helped that the registered representative who had sold the offering to the customer testified that he would not have made the sale if he had known that the firms’ due diligence had been so minimal. If the arbitrators and the registered representative could see that the due diligence was inadequate, why could FINRA’s own enforcement staff not see the obvious?

In another case involving a complex, highly leveraged derivative I asked the branch office manager who had approved the trade to explain the investment to the arbitration panel. After he had embarrassed himself with a clearly incorrect explanation the claim settled. I doubt that many FINRA auditors could have adequately understood this particular financial product well enough to ask questions about it.

Regulatory compliance in the financial services industry is not rocket science. Every supervisor should be able to spot a bad trade if it hits their desk. Compliance does take time and can be expensive.

If the firm has one compliance officer for thousands of salespeople or one due diligence officer reviewing dozens of offerings every month FINRA does not need to delve into the corporate culture. It is a safe bet that adequate compliance is not happening.

I know that more than a few regulators and compliance professionals read my blog. I would appreciate your thoughts and comments.

What The Crowdfunders Forgot ….The Crowd

My own interest in Crowdfunding goes back only about one year but there are few old timers like me in this now exploding corner of the capital markets. By now I have now read hundreds of articles and studies, spoken and corresponded with people who were instrumental in getting the JOBS Act passed and people who work in the Crowdfunding market every day.

I admit that I am fascinated by Crowdfunding. I see it as especially beneficial to smaller companies who can now raise capital in a regulated environment. Much of the literature focuses on the benefits of that capital to those companies and the benefits of those small companies to the general economy.

Very little seems to have been written on how this market will attract investors. If anything, there seems to be an attitude that suggests that ”if we build it, investors will come”.

Up until now, Crowdfunded offerings could only be purchased by “accredited investors”, wealthier people who are supposedly sophisticated enough to evaluate a private offering themselves and who are presumed to be wealthy enough to accept a loss if the investment tanked.

Before Crowdfunding accredited investors were sought out for private placements offered under Regulation D. Reg. D offerings are generally made through regulated brokerage firms where professional salespeople sell them to investors and are sometimes motivated by high commissions.

Crowdfunding is attempting to compete with these live salespeople using mostly passive portals and social media. It is not the same. Social media is just a tool. What Crowdfunding needs to embrace is a message that these investors want to hear.

A significant number of Reg. D offerings are real estate or oil and gas production syndications. In a great many of these offerings investors are promised a share of the rents or royalties or some other monthly or quarterly income stream. Some of these offerings offer tax benefits that are attractive to wealthy investors.

There are many established sponsors in the Reg. D market. These companies fund project after project through private placements. The larger sponsors can often point to a track record of success. By success I mean that prior investors were able to cash out for more than they invested.

Crowdfunding is too young for any company to post a similar track record. Crowdfunding counts its successes by how many companies get funded. As Crowdfunding matures it needs to judge its success by how many investors make money.

Only a small portion of the people who qualify as accredited investors actually invest in private placements. What exactly is the Crowdfunding industry doing to lure these private placement investors to Crowdfunding websites? The short answer is: not nearly enough.

The Securities and Exchange Commission (SEC) has recently opened Crowdfunding to all investors. Many smaller investors will be restricted to investing no more than $2000 on Crowdfunding portals each year. The SEC understands that with any Crowdfunded offering there is a high risk that the investors will could lose their entire investment.

Since we are speaking of only $2000 of non-essential income, it would seem more logical that people might opt to take that amount money to Las Vegas and put one dollar at a time into a slot machine. Statistically, slot machines pay out about 97% of the money that people put into them. Whether you ultimately win or lose has a lot do with when you stop. If you play a slot machine for long enough the casino is likely to buy you a beverage.

Investing that same $2000 in a small business through a Crowdfunding portal would have a significantly higher risk of loss and demonstrably less entertainment value. I see a lot of ads for Crowdfunded offerings and to date none has included a drink coupon.

The allure of Crowdfunding to any investor is the chance to cash out big. For the vast majority of Crowdfunded businesses that is very unlikely to happen even if the funded company is successful.

To date, there is no meaningful secondary market for Crowdfunded offerings. An investor who invests in a company that does well may still not get their money back to spend or invest in other offerings.

What will the Crowdfunding portals offer to entice any investor to bring money?

There is a lot in the Crowdfunding literature regarding the use of social media campaigns to sell offerings. This reliance upon social media actually highlights a weakness in the Crowdfunding system.

Investors who are solicited by a single company because they are suppliers or customers of that company or friends of the management have no reason to evaluate any other offering on the same portal or other portals. The portals should not expect these investors to become repeat customers.

If an investor does not get interest or a regular share of the profits, cannot cash out and has worse odds of success than at a slot machine, it is easy to see that the Crowdfunding industry still has will have some work to do. Once the “newness” of Crowdfunding wears off investors will need better deals and better incentives for investors.

 

Reg. A+ Assessing the True Costs

From the laptop of Irwin G. Stein, Esq.Many small and mid-sized companies seem to be assessing their option to raise equity capital using the SEC’s new Regulation A+, which was promulgated under the JOBS Act. The regulation allows companies to register up to $50 million worth of their shares with the SEC and then offer them for sale to members of the general public.

Until now, companies seeking equity capital at this low end of the market could only seek funds from wealthy, accredited investors using a different regulation; Reg. D, the private placement rule.

The upfront costs of preparing a private placement offering will always be less than the costs of a Reg. A+ offering. In both cases competent securities attorneys will prepare the prospectus. Reg. A+ requires that the company’s books be audited as well. This is an added expense. The true costs however, will be determined by who sells the offering and how it is sold.

It is not unusual for a private placement being sold under Reg. D to have an upfront load of 15% of the total amount of the offering or more. The issuing company only receives 85% or less of the funds that are raised by the underwriter.

One percent of the load might repay the company’s costs of preparing the offering. Another one percent might cover the underwriter’s marketing and due diligence costs. The rest is the sales commission and other fees that the underwriter is charging for selling the private placement.

Many accredited investors are currently purchasing Reg. D offerings and paying the 15% or more front-end load. There is no incentive for the brokerage industry to charge Reg. A+ issuers any less.

When you purchase shares in a private placement you generally cannot re-sell them. Even if the company does well at first, if it fails in later years, you still lose your money.

With Reg. A+ the shares are supposed to be freely trade-able, except that they are not. The market in which they are supposed to trade is not yet fully developed. It may not develop for quite some time.

How much will the underwriters charge for a fully underwritten Reg. A+ offering? The rule of thumb has always been that commissions go up as the risks go up. Shares issued under both Reg. D and Reg. A+ are speculative investments.

Since both regulations will yield securities that are speculative investments that cannot be re-sold, it is reasonable that underwriters will charge the same for both types of offerings.

Some companies will attempt to sell their shares under Reg. A+ directly to the public without an underwriter. Investors who purchase these shares will get more equity for their investment. That does not necessarily mean that they will get greater value. If many issuers can self-fund without an underwriter it might cause downward pressure on loads and commissions that underwriters can charge.

If commissions on Reg. A+ offerings turn out to be substantially less, many accredited investors may shift to the Reg. A+ market. More likely, some brokerage firms will sell both Reg. D and Reg. A+ offerings side by side. If they do, the commission structure and total load on each should be similar.

Accredited Investors-Here Comes Direct Solicitation

The JOBS Act required the SEC to permit issuers of certain common private placements to greatly expand their marketing efforts. Issuers using the Reg. D exemption had been prohibited from using any form of “general solicitation” or “general advertising” to market their interests. The SEC has amended its rules to lift that prohibition.

“General solicitation” and “general advertising” were not defined terms, but the rule states that these may include, “any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.”

A private placement offering is frequently structured to be sold to accredited investors only. This includes banks and insurance companies and retail customers provided the latter have either a $1 million net worth or earn $200,000 per year.

Under the old rule, a stockbroker could not address a stranger with a solicitation for a private placement. There needed to be a pre-existing business relationship between the stockbroker and the potential investor. This was always a chicken and egg problem for the brokerage industry. Many brokerage firms and issuers found interesting ways to comply with the rule and still attract “new” customers.

Under the new rules, accredited investors will likely be bombarded with advertisements for Reg. D offerings of every kind. There will be print and website ads, U-Tube videos and infomercials. Seminars will be less informational and more focused on making sales.

This rule change is likely to launch billions of e-mails. Mailing lists with e-mail addresses for accredited investors are currently available from list brokers. The lists can be sorted geographically and will identify people who previously invested in Reg. D offerings.

If these advertisements emanate from FINRA brokerage firms there is at least a presumption of compliance with the rules that require the advertisements not to be misleading. If the ads emanate from the issuers themselves, there is less oversight.

More likely than not there will be more abuses. In the last cycle, we saw issuers put out glossy brochures offering interests in “Class A” office buildings that were not “Class A” and ads for oil drilling programs with “proven reserves” that were not “proven”.

Some ads will likely target seniors. It is not hard to imagine an advertisement for a Reg. D offering that asks: could you use more monthly income? I should not have to tell you that scam artists will be especially active.

The interests sold in Reg. D offerings are speculative investments. The ideal customer for a Reg. D offering is an accredited investor who is willing to take the risk of these investments and who can afford to take the loss if it occurs. They should be sophisticated enough to understand the offering materials and to make an informed decision whether or not to invest.

General advertising will cast a much wider net. It will undoubtedly bring more investors and more capital into this market. It will also bring more investors into the market who will not understand the offering documents or be able to accurately assess the risks.

Advertising appeals to our emotional nature. Emotions are never a good tool for evaluating risky investments.

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Reg. A+ – Exuberance and Reality

The JOBS Act mandated the creation of new rules to help smaller companies obtain funds for development and expansion. One result is the SEC’s new Reg. A+.

Many people see the new regulation as an opportunity for small companies to gain access to the capital markets. It has created a fair amount of excitement and a plethora of seminars and experts.

There are groups prepared to assist businesses owned by women and minorities to take advantage of new sources of capital. There are bio-tech companies with patents (and those still developing their patents) looking for funds. There are consultants pitching Reg. A+ to the cannabis industry.

The sales pitch for Reg. A+ goes something like this: small investors will help to fund small companies that Wall Street ignores. Reg. A+ is a way for companies that could not get funded elsewhere to raise money from Main Street investors.

Some people seem to suggest that thousands of small companies will be able to take advantage of this new regulation. They seem to believe that there is a vast pool of underutilized capital eager for this type of speculative investment.

Reg. A+ will permit companies to raise a maximum of $50 million. Many of the offerings will be smaller; some a lot smaller. These are unlikely to attract the attention of any of the large investment banks. There will be some brokerage firms that will occupy this space, but they too are likely to be smaller.

The anticipation seems to be that many issuers will try to sell the shares to the public themselves without the help of an underwriter. Direct to the public securities offerings have been around for 20 years. Raising a relatively small amount of money from family, friends, suppliers and customers has always been an option.

The up front costs of a new Reg. A + offering are likely to be high. Lawyers and accountants who take companies public are specialists and frequently expensive ones. How little a Reg. A+ offering raise and still justify those costs has yet to be determined.

Underwriters provide essential services to every offering. Underwriters conduct due diligence about the issuer and the offering. Underwriters participate in preparing the registration statement. They make the important pricing decisions and provide research and aftermarket support. All of these tasks will still need to be performed if the company decides to go it alone.

All of this will fall to the issuers, their attorneys and accountants. Issuers who do not use an underwriter will need to assemble an experienced team from scratch. The attorneys and accountants are not going to be much help in the effort to sell the shares. That is what the underwriters do best.

Liability under the federal anti-fraud statutes will rest with the issuers as well. Insurance companies are already advising management that raising funds from public investors without appropriate coverage is fool-hardy.

Proponents are looking to social media to create interest in these offerings. Reg. A+ has a provision allowing a company to use a preliminary prospectus akin to a red herring to obtain indications of interest before the offering becomes final.

As a practical matter, potential purchasers will likely be directed to a website that will allow them to read the preliminary prospectus and which will likely contain a video about the company. The latter is a modern version of what used to be called the “dog and pony show”.

The lawyers who are moving the registration statement through the SEC are likely to make certain that those videos are toned down. That does not mean that a company cannot generate some real excitement in a video. It means that the videos will need to be compliant with the regulations anbd offer a balanced presentation including the fact that investors could lose all the money that they invest.

Given the reach of social media, the video might be viewed by a great many potential investors. Success of a direct to the public offering may hinge upon how many people are excited enough to direct their friends and contacts to the website. At least with an underwriter the offering is likely to be funded.

Any investor willing to assume the risk will be able to purchase shares offered in a Reg. A+ offering. That is the point. Mom and pop can help fund a small business that might eventually turn out to be big. Investors will further benefit because sales made directly by the company will not be subject to sales commissions.

Institutions and accredited investors (wealthier individuals with $1 million net worth or $200,000 in income) are also expected to invest. Angel investors and professional venture capital funds may invest as well. These investors are currently purchasing offerings being made under Regulation D which frequently have substantial loads and commission costs. Direct from the company offerings that are commission free will certainly appeal to some accredited and professional investors.

Unlike Reg. D, investors in a Reg. A+ offering come away with freely trade-able shares, just like they would in an IPO, but not quite. The Reg. A+ market is brand new. Reg. A+ shares may be legally trade-able but if you wish to sell them the question will be: to whom? It may take a while for a truly liquid secondary market for these shares to develop.

Certainly there will be successful offerings made under Reg. A+ both underwritten and direct from the issuer. How many there will be and how much money they will raise remains to be seen.

One thousand Reg. A+ offerings per year at the maximum of $50 million each would add only $50 billion to this end of the market. I suspect that the actual amount of funds raised under this rule will be less.

 

Due Diligence and Reg. D

Due diligence was originally a judicial construct that provided a defense for underwriters who were jointly and severally liable for fraud perpetrated by the companies they brought to market. If the underwriter could not have discovered the fraud after a diligent investigation of the issuer, then the courts reasoned that there was not much more that the underwriter could do.

The due diligence investigation fell to the lead underwriter who was well paid for its efforts and upon whom other members of the selling group could rely. The underwriter’s due diligence investigators would consult with the issuer’s attorneys and accountants, pour over legal documents, ledgers and spreadsheets and visit factories, properties and sales offices. A good due diligence investigation included a look at the company’s customers, suppliers and competition, as well.

Due diligence has been a staple for underwriters for more than 40 years. The SEC has acknowledged the process in its new crowdfunding rules. Every legitimate brokerage firm underwriting new issues of securities employs some kind of acceptable due diligence process with one glaring exception: firms that underwrite Reg. D offerings sold to retail accredited investors. .

FINRA has codified the requirement of a diligent investigation by member firms selling private placements under Reg. D. The FINRA standard is specific; the member firm should verify the facts that are being given to investors. In a great many cases, a diligent investigation just does not happen.

When Reg. D was enacted, in the early 1980s, the vast majority of private placements were purchased by large institutional investors. These firms had the ability to review and analyze the offerings by themselves. Institutional purchasers would send their own lawyers and accountants to the issuing company before they sent their money.

Reg. D allowed wealthy individuals to invest in private placements as well. The rule set the threshold for “wealthy” investors at above a $1 million net worth. Wealthy individuals, it was reasoned could afford to sustain the losses if they occurred. Reg. D calls these wealthy individuals accredited investors. At the time there were fewer than 1 million millionaires in the US. Today there are 10s of millions.

A due diligence investigation of a company seeking to raise capital from investors is not difficult. My partner and I conduct due diligence investigations for VC funds, angel investors, family offices and broker/dealers. Individual investors, unless they are making a large investment, rarely call us.

The SEC estimates that $800 billion dollars worth of private placements are now sold every year, a very significant the vast majority of the funds coming from individual accredited investors. Experience has shown that some brokerage firms, including those that sell billions of dollars of private placements to individual accredited investors, do not diligently investigate the offerings that they sell. Hundreds of billions of dollars in investor losses are directly attributable to that fact.

After the credit market crash in 2008, many companies that had used Reg. D to raise billions of dollars were shown have been frauds. More than a few were Ponzi schemes. The latter, in many cases, were facades that had no business, just a good story about how investors were going to get paid high returns.

In some cases, more than 100 FINRA broker/dealers signed on to raise money for these Ponzi schemes. If they had done any investigation of these companies, they would have seen that the represented business did not exist. Selling a Ponzi scheme is usually a prima facie example of a firm that did not conduct a diligent investigation and probably conducted no investigation at all.

FINRA, the SEC and the state regulators did not impose significant penalties against firms that sold Ponzi schemes to investors. Civil recoveries by investors against the brokerage firms that sold the Ponzi schemes have been negligible. There is nothing in the market to incentivize a brokerage firm to conduct a real due diligence investigation; nor anything detrimental if they fail to do so.

The Dodd-Frank Act requires the SEC to re-consider the threshold for accredited investors every four years. If the SEC raised the threshold for net worth to $5 million, it would simply be an adjustment for inflation during the 30 plus years since the $1 million figure was set. It would also reduce the number of potential investors and the amount of capital that is available to this market.

The SEC seems intent upon expanding the amount of capital available to this market rather than contracting it. The Commission has already approved a change to Reg. D that makes it easier for firms to solicit potential Reg. D investors. No new protections for individual accredited investors seem to be forthcoming.

Many real estate and energy companies are serial issuers; they fund project after project using Reg. D. You can spot these professional sponsors at meetings and conferences where they wine and dine brokerage firm executives to get their offerings noticed and sold.

Brokerage firms will continue to give lip service to due diligence investigations but not perform them diligently. Ponzi schemes and other fraudulent offerings will continue to be sold to investors under Reg. D. Individual accredited investors will continue to bear the brunt of the losses.

Some things about the future of markets are easier to predict than others.