The SEC Investor Advisory Committee (IAC), in a September 21, 2023 open meeting, welcomed five panelists to discuss Regulation D with emphasis on Rule 506. The SEC commissioners and IAC staff members were particularly interested in panelist recommendations on how to bring the 1982-initiated regulation into the 21st Century to balance capital formation with investor protection, given today’s exploding multi trillion-dollar private offering market.
Christopher Mirabile, the IAC Chief, kicked off the conversation by stating that while it is important to protect investors participating in these low disclosure Rule 506 offerings, this should not be done at the expense of capital formation, especially by small start-up companies, because the private offerings these startups make can, among other things, result in immense job growth for the U.S. population. And because of this potential job growth, the SEC should not immediately shut down a startup simply because it does not have the resources to fully comply with SEC requirements at the pre-offering stage; they will have more information to better comply after they make the offering. Mirabile did, however, advocate for the startups to file Form D. Most interestingly, at the end of the meeting, the IAC asked the panelists to help staff draft the Regulation D Rule 506 recommendations. Leslie Van Buskirk, Wisconsin’s Securities Administrator, moderated the panel.
Opening remarks. SEC Chair Gary Gensler and Commissioner Hester Peirce provided the opening remarks. Gensler relayed the history of the U.S. financial markets dating back to the Great Depression, with the inception of the SEC and the federal Exchange and Securities Acts that later led to the Ronald Reagan era initiation of Regulation D, including Rule 506. He pointed out that Regulation D has served as an important exemption outside of public offering registration by providing full, fair, and truthful disclosure to investors in the private market.
Peirce remarked upon the private market escalating into a primary source for capital, making the Regulation D and accredited investor topics comprising today’s open meeting central to the Commission’s mission to facilitate capital formation while simultaneously protecting investors. Although Peirce emphasized that enhanced access to private capital is a positive development not only for companies but for investors, and that a robust private market contributes to the health of our economy, she said the SEC should not look to impose public-market-style regulations on private markets; instead, she declared the Commission should look for ways to reduce the costs companies face in going and staying public. Peirce further proclaimed that many investors have access only to the public markets, a problem that could be rectified by increasing opportunities for retail funds to access private investments. Lastly, Peirce turned to two draft recommendations the IAC will consider later today, namely (1) a human capital management disclosure recommendation; and (2) an open-end fund liquidity risk management and swing price recommendation. For each recommendation she posed a number of questions for the IAC to consider.
Commissioners Carolyn Crenshaw and Jaime Lizarraga also weighed in by pointing out that, ironically, the very regulation created to protect retail investors in the private market may now be undermining them by requiring no more than bare bones disclosures, which are not enough to help these investors weigh the benefits against the risks to determine whether to invest or not. Crenshaw also emphasized that a Rule 506 issuer’s Form D information is not certified by the SEC even though the Form contains a Commission logo, possibly leading investors to mistakenly believe the SEC has or will oversee the information. Crenshaw, therefore, calls for gatekeepers, auditors, and other means of SEC oversight to protect Rule 506 investors from fraud.
Commissioners Carolyn Crenshaw and Jaime Lizarraga also weighed in by pointing out that, ironically, the very regulation created to protect retail investors in the private market may now be undermining them by requiring no more than bare bones disclosures, which are not enough to help these investors weigh the benefits against the risks to determine whether to invest or not. Crenshaw also emphasized that a Rule 506 issuer’s Form D information is not certified by the SEC even though the Form contains a Commission logo, possibly leading investors to mistakenly believe the SEC has or will oversee the information. Crenshaw, therefore, calls for gatekeepers, auditors, and other means of SEC oversight to protect Rule 506 investors from fraud.
Panelists. Like Chair Gensler, the panelists delved into various aspects of the history of federal securities regulation, but their most important contribution consisted of recommendations made to the IAC and commissioners.
Kenisha Nicholson, Special Counsel for the Office of Small Business Policy at the Division of Finance within the SEC, pointed out the need for Regulation D changes because of data showing that Rule 506, particularly 506(b), has brought in trillions of dollars more than other exemptions such as Rule 504, Regulation A Tier 2, federal Regulation crowdfunding, state crowdfunding, and even public offerings/IPOs. Moreover, issuers including start-up companies gravitate to Rule 506(b) over the other exemptions because it’s the easiest to put in place: it can be used anytime and without the disclosures the other private offering exemptions or public registrations mandate. Another important point she made is that the Commission states Form D should be filed but is not required to be filed and, further, is only mentioned to be filed at the start of the offering—within 15 days after the first sale—and not at any other point including at the offering’s termination. As a result, federal and state securities regulations do not have data on how the offering progressed or how much money it made by the end of its life cycle…so they may not know the full extent of any fraudulent dealings or significant investor losses until it is too late to get full restitution for the victims. Thus, she advocates for more disclosure requirements, including post-sale and post-offering termination disclosures.
Craig McCann, Principal, SLCG Economic Consulting, was the panelist who presented all of the charts and graphs on what Rule 506(b) data has revealed. The most telling point he made was that data compiled by even the SEC and relied upon by Commission staff and other federal and state regulators may be grossly inaccurate. In one case, he pointed out that one of the ten largest Rule 506 revenue-producing companies overstated to the SEC the capital it raised by billions of dollars—all because that enormous dollar figure on SEC-filed documents was actually the amount in another country’s currency, say Indian rupees; in short, the Indian company either intentionally or unintentionally entered the much lower rupee amount in U.S. dollars on the filing, making the SEC believe the company made much more money on the offering than it actually did. And according to McCann, the Commission never corrected this gross error leading data analysts and regulators looking at the chart to believe that much more money was raised from these large company private offerings than was actually raised.
Yet another chart showed that most of the Reg D Rule 506 offerings are made in pooled investment funds, but there is hardly any data on what industries these funds invest in, whether in construction, technology, or pharmaceuticals for example, that investors might want to know before investing.
Sarah Hanks, CEO of Crowdcheck made a fundamental point: that small start-up companies often fall back on a Rule 506 simply to keep the company doors open and the lights on; that it’s the only offering they can make because the other private exemptions and public registrations are way too expensive and mandate many more disclosures than the start-ups can provide. Hanks said that as result of this intense reliance on 506 coupled with the fact that a Form D filing is not required for them, the amount of even accidental fraud occurring especially to unaccredited retail investors from these many start-up companies can spiral into thousands or millions of dollars in total investor losses. She, therefore, recommends: (1) a link be placed on Regulation D for investors to click on and read the standard risks of this investment; (2) mention on Form D that the issuer-provided information is self-reporting, meaning that the SEC does not oversee it even though the Commission logo is on the form; and (3) provide a legend of risks on all issuer communications to investors—even on Tik Tok communications for the many young investors out there.
Amanda Senn, Director of the Alabama Securities Commission, emphasized how state securities regulators across the country are frustrated by not seeing data on Regulation D Rule 506 offerings by providing more than bare bones disclosures on Form D to glean whether the disclosures are, in fact, effective at preventing fraud. She advocates four proposals: (a) require issuers to file Form D before they solicit investors; (b) require issuers to file an amendment at the close of the offering to see how much money was actually raised and view other factors about the offering, e.g., price, investor demographic, assets, etc. that occurred after the initial filing; (c) amend the “accredited investor” definition to eliminate the value of an investor’s permanent residence and 401(K) retirement account from the calculation for deciding whether the investor qualifies to participate in the Rule 506 offering; and (4) index an investor’s funds for investing by inflation, which may disqualify them from the offering if the funds, indexed for inflation, should have less money than they should have for the offering.
Alexandra Thorton, Senior Director, Financial Regulator, The Center of American Progress, mentioned a severe, unintended consequence of the exploding Regulation D Rule 506(b): that so much of the money raised in this market is not by the small start-up companies Rule 506 was created for (50 percent of whom drop out by failing to raise the needed funds); instead, the bulk of the money raised is by large companies with public company characteristics who avoid making public company disclosures by undertaking private offerings, which do not mandate them. Thornton, therefore, strongly recommended that the IAC staff and SEC commissioners turn these large private companies into publicly reporting companies.
Kenisha Nicholson, Special Counsel for the Office of Small Business Policy at the Division of Finance within the SEC, pointed out the need for Regulation D changes because of data showing that Rule 506, particularly 506(b), has brought in trillions of dollars more than other exemptions such as Rule 504, Regulation A Tier 2, federal Regulation crowdfunding, state crowdfunding, and even public offerings/IPOs. Moreover, issuers including start-up companies gravitate to Rule 506(b) over the other exemptions because it’s the easiest to put in place: it can be used anytime and without the disclosures the other private offering exemptions or public registrations mandate. Another important point she made is that the Commission states Form D should be filed but is not required to be filed and, further, is only mentioned to be filed at the start of the offering—within 15 days after the first sale—and not at any other point including at the offering’s termination. As a result, federal and state securities regulations do not have data on how the offering progressed or how much money it made by the end of its life cycle…so they may not know the full extent of any fraudulent dealings or significant investor losses until it is too late to get full restitution for the victims. Thus, she advocates for more disclosure requirements, including post-sale and post-offering termination disclosures.
Craig McCann, Principal, SLCG Economic Consulting, was the panelist who presented all of the charts and graphs on what Rule 506(b) data has revealed. The most telling point he made was that data compiled by even the SEC and relied upon by Commission staff and other federal and state regulators may be grossly inaccurate. In one case, he pointed out that one of the ten largest Rule 506 revenue-producing companies overstated to the SEC the capital it raised by billions of dollars—all because that enormous dollar figure on SEC-filed documents was actually the amount in another country’s currency, say Indian rupees; in short, the Indian company either intentionally or unintentionally entered the much lower rupee amount in U.S. dollars on the filing, making the SEC believe the company made much more money on the offering than it actually did. And according to McCann, the Commission never corrected this gross error leading data analysts and regulators looking at the chart to believe that much more money was raised from these large company private offerings than was actually raised.
Yet another chart showed that most of the Reg D Rule 506 offerings are made in pooled investment funds, but there is hardly any data on what industries these funds invest in, whether in construction, technology, or pharmaceuticals for example, that investors might want to know before investing.
Sarah Hanks, CEO of Crowdcheck made a fundamental point: that small start-up companies often fall back on a Rule 506 simply to keep the company doors open and the lights on; that it’s the only offering they can make because the other private exemptions and public registrations are way too expensive and mandate many more disclosures than the start-ups can provide. Hanks said that as result of this intense reliance on 506 coupled with the fact that a Form D filing is not required for them, the amount of even accidental fraud occurring especially to unaccredited retail investors from these many start-up companies can spiral into thousands or millions of dollars in total investor losses. She, therefore, recommends: (1) a link be placed on Regulation D for investors to click on and read the standard risks of this investment; (2) mention on Form D that the issuer-provided information is self-reporting, meaning that the SEC does not oversee it even though the Commission logo is on the form; and (3) provide a legend of risks on all issuer communications to investors—even on Tik Tok communications for the many young investors out there.
Amanda Senn, Director of the Alabama Securities Commission, emphasized how state securities regulators across the country are frustrated by not seeing data on Regulation D Rule 506 offerings by providing more than bare bones disclosures on Form D to glean whether the disclosures are, in fact, effective at preventing fraud. She advocates four proposals: (a) require issuers to file Form D before they solicit investors; (b) require issuers to file an amendment at the close of the offering to see how much money was actually raised and view other factors about the offering, e.g., price, investor demographic, assets, etc. that occurred after the initial filing; (c) amend the “accredited investor” definition to eliminate the value of an investor’s permanent residence and 401(K) retirement account from the calculation for deciding whether the investor qualifies to participate in the Rule 506 offering; and (4) index an investor’s funds for investing by inflation, which may disqualify them from the offering if the funds, indexed for inflation, should have less money than they should have for the offering.
Alexandra Thorton, Senior Director, Financial Regulator, The Center of American Progress, mentioned a severe, unintended consequence of the exploding Regulation D Rule 506(b): that so much of the money raised in this market is not by the small start-up companies Rule 506 was created for (50 percent of whom drop out by failing to raise the needed funds); instead, the bulk of the money raised is by large companies with public company characteristics who avoid making public company disclosures by undertaking private offerings, which do not mandate them. Thornton, therefore, strongly recommended that the IAC staff and SEC commissioners turn these large private companies into publicly reporting companies.