Hedge funds and other companies seeking private investments will be allowed to advertise publicly for funding under a rule approved today by the U.S. Securities and Exchange Commission.
The rule, which passed under a 4-1 vote, is the first one mandated by last year’s Jumpstart Our Business Startups Act to be completed by the SEC. A deadline for the regulation set by Congress lapsed more than a year ago.
The rule will ease 80 years of advertising restrictions intended to help ensure small investors aren’t lured into taking inappropriate risks. Under the measure, startups and other small companies would also be able to use advertising to raise unlimited amounts of money.
“Given the explicit language of the JOBS Act as well as the statutory deadline which passed last July, the commission should act without any further delay,” SEC Chairman Mary Jo White said. “This does not mean, however, that the commission should not take steps to pursue additional investor safeguards if and where such measures become needed.”
The rule affects how companies raise money through private offerings, which are exempt from requirements to publicly report financial statements. Private offers are restricted to investors with a net worth of at least $1 million excluding their primary residence, who are considered better positioned to take the risks of investing with less information.
“It changes the whole paradigm of who you can talk to,” said Brian J. Lane, a former division director at the SEC and now a partner at Gibson, Dunn & Crutcher LLP in Washington. “Hedge funds will benefit because they have the most restrictions on their ability to communicate more broadly about different funds coming to market.”
Raising Capital
Companies raised $899 billion through private offers last year, compared with $228 billion through registered sales of stock and $976 billion through sales of public debt, according to the SEC. Firms raising capital through private offers decide what information to share with investors.
State securities regulators say private offers were the most common product leading to enforcement actions in 2011. The North American Securities Administrators Association protested the SEC’s plan for lifting the advertising ban after it was proposed in August. The state regulators said the SEC’s plan failed to provide guidance to companies about appropriate advertising and didn’t include any investor protections.
The rule proved controversial at the five-member commission. Democratic Commissioner Luis A. Aguilar, who voted against the rule, said it leaves investors unprotected against a greater risk of fraud.
“Without common-sense protections, general solicitation will prove be a great boon to the fraudster,” Aguilar said in a statement prepared for today’s meeting. “Experience tells us that this will lead to economic disaster for many investors.”
Fellow Democratic Commissioner Elisse B. Walter voted for the rule, saying the SEC will scrutinize how advertising is used and will pursue additional investor protections in a separate rule.
“Technology has rapidly and permanently altered the ways in which we communicate with each other,” Walter said. “Congress recognized that and directed us to update” the regulation by removing the advertising ban.
Changes Recommended
An SEC advisory committee recommended in October that the commission rewrite the proposal while seeking to ensure better compliance with a required form that tracks the initial offer. The committee also said the SEC should restrict the number of people eligible to invest by refining the definition of an “accredited investor,” or those considered rich enough to understand the risks and withstand an adverse outcome. About 7.4% of U.S. investors meet the definition.
“They have decided to allow blast marketing of private offerings without any meaningful adjustments to the regulatory structure,” said Mercer E. Bullard, a professor of law at the University of Mississippi and founder of investor advocacy group Fund Democracy. “It’s a complete repudiation of virtually all of the concerns expressed by two Democratic commissioners and the SEC’s own investor advisory committee.”
Two Methods
The SEC’s rule specifies two methods for companies to verify a person is qualified to participate, while giving them flexibility to determine other ways. Companies can review federal-tax documents to check the income of the purchaser or get confirmation of a person’s income or wealth from a registered broker, investment adviser, licensed attorney or certified public accountant.
The limit to sell only to accredited investors explains why many hedge funds probably won’t respond to the rule change by taking out print and television ads seeking new investors, said David S. Guin, a partner at Withers Bergman LLP whose clients include hedge funds.
Instead, the rule may free up hedge-fund managers to communicate more freely at conferences and to offer more information about fund performance on their websites, Guin said in a phone interview.
“You wouldn’t expect the type of person who is typically sought as an investor to be investing off of an ad in a newspaper or magazine,” Guin said.
Operating Companies
Operating companies also will be able to advertise for investors after the ban is lifted. They’ll benefit because they’ll be able to reach “a much broader audience than they would be able to with their own contacts,” Guin said.
In an effort to address questions about deception, the commission approved a new proposal, on a 3-2 vote, that seeks to monitor how advertising is used and whether it contributes to more fraud. The SEC also approved a rule that blocks felons and others found culpable of securities-law violations from marketing private offers, which are more lightly regulated than public offers of stock or debt.
The three-step process allows White to complete the required rulemaking before two new commissioners replace Walter and Commissioner Troy A. Paredes later this summer. Paredes and fellow Republican Commissioner Daniel M. Gallagher voted to lift the ban.
“We want this new market and the private markets in general to thrive in a safe and efficient manner, and the rules we adopt today are designed to achieve that objective,” White said.
Paredes and Gallagher voted against the proposal to add new rules to private offers, saying it would restrict their role in capital formation.
“The proposal, if adopted, would undermine the JOBS Act goal of spurring our economy and job creation,” Paredes said.
Under the proposal, advertising would have to include cautionary statements about the risk of the investment and a disclosure that the offer is open only to accredited investors.
Companies raising money through private offers also would be required to file a required statement, known as Form D, to the SEC 15 days before the offer closes. The form would include information on the type of advertising used. Companies would have to update the information contained in the form within 30 days of completing the offer.
Companies that failed to comply with the form requirements would be disqualified from conducting a private offer for one year.
Sales Literature
The proposal also would alter SEC guidance to make private funds such as hedge funds accountable for fraudulent or misleading sales literature. Investor advocates such as the Consumer Federation of America have expressed skepticism about whether the proposal will ever be adopted.
“I don’t think it’s a hopeless exercise but there are a lot of examples where the SEC just can’t get proposals to fruition,” Bullard said in a phone interview. “To be fair, it was either do something now or wait probably at least two or three months after the new commissioners are in place.”
