Over the past decades, private securities offerings have grown at a significantly faster rate than public offerings, a growth that has been facilitated by Reg D and other legal mechanisms, noted SEC Commissioner Caroline Crenshaw. The offerings’ ballooning size and significance to investors signals regulatory reforms are needed to keep pace, she said.
Addressing the topic of big issues in small business at the 50th Annual Securities Regulation Institute on Monday, Crenshaw pointed out there are now some 1,205 “unicorns,” or private issuers purportedly valued at over a billion dollars. When the term was first coined in 2013, there were 43, she said.
Impact on small business. “The unintended and perverse consequence of the unlimited nature of Reg D is that it may actually be hurting small businesses it was designed to help,” said Crenshaw. “The fact that unicorns and large private issuers are able to continue to raise capital through Reg D, even after they have far outgrown the small business moniker, means that the capital going to large private issuers is locked up.”
In addition, “the de facto presumption” that accredited investors in private offerings don’t need disclosure isn’t panning out, she said.
Safe harbor protection. Rule 506 safe harbor provides insulation from state blue sky laws and the registration provisions of the federal securities laws. The current logic for that exemption, she said, is that baseline regulatory disclosure obligations are not needed for large, sophisticated investors.
However, “I am concerned, though, that sophistication is not quite the safeguard it’s presumed to be.” Crenshaw said. “History tells a different story,” she said. “We saw this, for example, in the 2008 financial crisis, and have many recent examples of the continued phenomenon with companies such as FTX, Theranos and WeWork.”
“Consider FTX in particular—despite the reported presence of many elite and sophisticated investors capable of negotiating for information and protections, FTX was nonetheless described by its court-appointed, post-bankruptcy CEO,” John J. Ray III, as marred by “a complete failure of corporate controls” and an absence of trustworthy financial information, she said.
Valuations hazy. In addition, private markets have certain immutable characteristics that have lent themselves to concerns surrounding valuation, Crenshaw said. Investors may not receive complete or reliable information and securities can be illiquid. With limited price discovery means trading can be expensive and investors are not guaranteed the best available prices.
Inconsistent governance. Finally, research has shown private companies that use their market power can distort traditional corporate governance protections, Crenshaw said. That can include dual-class share structures, inconsistent disclosure across investors and conditions that create lax or deficient systems of internal controls, she said.
Suggested revisions. To counter some of these drawbacks, Crenshaw suggested revisions to current practices, including:
- Changing Form D. The form, which is filed with a Reg D offering, should provide essential information to private investors, public markets and regulators. For example, a description of a private company’s size (by assets, investors and employees), its operations, its management, its financial condition and revenues, and the volume and nature of the securities offerings. The form should be signed and certified by an executive officer, who would bear accountability for the statements. The current Form D is six pages long and consists mostly of check-the-box answers, she noted.
- Imposing heightened obligations on large private issuers and large capital raises. Crenshaw also suggested a two-tiered framework that would impose heightened obligations on larger private issuers and issuances. For example, Tier 1 and Tier 2 issuers would file an offering circular, subject to review, along with two years of financial statements. But Tier 2 offerings—for larger raises—would be subject to heightened requirements.