JOBS Act

Accredited Investors-Here Comes Direct Solicitation

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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

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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.