5 Regulatory Changes That Would Benefit the Private Placement Marketplace
by Chris Rohde
1. Verification of accredited investors
For an offering exempt from registration under Rule 506(c), the issuer must take reasonable steps to verify that the purchasers are accredited under the definitions in 17 CFR 230.501. This can be done in one of several ways, including verifying the subscriber’s income through reviewing tax documents, verifying net worth through assets and liabilities, or in many cases, receiving a letter from an attorney, CPA, RIA, or broker-dealer attesting to the accredited status of the subscriber. While this process is sound, there are a few improvements that would make the verification far easier.
First, letters from CPAs, attorneys, RIAs, and broker-dealers only last three months under the rule, no matter how the subscriber meets the requirement. The disconnect here is that if a subscriber is accredited based on income and provides tax returns, the issuer can rely on those returns until the new returns are available. However, if the subscriber provides an accreditation letter, the issuer can only rely on it for three months. Having to require an investor who is accredited based on income to get a new letter every three months is an unnecessary and arbitrary requirement. As a result, the rule should be adjusted to allow letters attesting to accreditation based on income to be relied on until the next set of tax returns are available.
Second, the SEC should consider providing further guidance on the types of evidence an issuer can rely on in accrediting subscribers that are not individuals, which is a very common occurrence. Subscribers regularly invest through trusts, LLCs, and occasionally other types of entities. Generally, accrediting these entities is pretty self-explanatory, but further guidance to provide a uniform approach would be a net benefit for the industry. For example, what type of documentation would be acceptable to evidence the assets of a corporation, trust, or other entity?
2. Expand the definition of accredited investor to include a sophistication test
The current definition of an accredited investor dates back to the mid-1980s and is in need of significant updating. This is not news to individuals and firms that work in the Regulation D space. Even the SEC has noted the need for an update. While there are many suggestions for adjustments to the accredited investor definition, one in particular would aid the market at large: the addition of accreditation based on passing a test of sophistication. As we have discussed previously, an individual with expertise in investing, such as a financial advisor or broker, or in the subject-matter, such as a doctor or biochemist investing in a medical company’s offering, may be better qualified to determine whether a potential investment is worthwhile or not than someone who happens to make $200,000 a year or have a net worth of $1 million. Having a high net worth or high income does not necessarily make one sophisticated enough to evaluate the risks of an investment or even guarantee that one can weather the failure of an investment. But a sophistication test would allow individuals who are currently not accredited, but have the requisite knowledge to evaluate the risks of the investment, to become accredited. This influx of sophisticated investors can only increase the quality and quantity of potential investors in the Reg D space.
3. Increase cap on Reg CF
Since Regulation Crowdfunding (Reg CF) went into effect in May 2016, issuers have raised approximately $45M under that exemption according to nextgencrowdfunding.com. Meanwhile, our own research shows that in the same period, offerings under Reg D raised more than $1T. While proponents of Reg CF maintain that it will continue to increase in popularity, the current cap on CF offerings at $1 million appears to have hamstrung that exception so far. This is similar to the effect the initial cap on Reg A had on the use of that exemption, which has abated with the passage of the new Reg A+ regulations. WealthForge believes that raising the cap from $1 million to $5 million would likely have a similar effect on the use of Reg CF. Without a doubt, an increase in the possible offering size may attract more quality issuers and allow for greater amounts to be raised, having a greater impact on overall capital markets and capital formation. In addition to raising the cap, Reg CF will continue to need further refinement, and may remain an exemption that is best utilized by early stage companies that are not quite ready or generally do not fit the profile for venture capital funding rounds.
4. Allow brokers to advertise targeted returns for real estate offerings
FINRA Rule 2210 governs broker-dealer’s communications with the public. This rule contains various requirements depending on the type of communication, to whom the communication is directed, and how long the broker-dealer has been in business. However, no matter where in those categories the communication falls, certain content rules always apply to any communication with the public. One such rule is contained in 2210(d)(1)(F), which states “Communications may not predict or project performance, imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast; provided, however, that this paragraph (d)(1)(F) does not prohibit.” While there are exceptions to this rule, this generally prohibits broker-dealers from advertising any sort of prediction or projection of returns, including anticipated or targeted internal rate of return for an investment. While this rule makes sense in the context of the general securities, there is one sector that this rule significantly impedes: real estate. This rule currently serves as a significant impediment to real estate developers or funds using broker-dealers to conduct their offerings because anticipated/targeted IRR is a major factor in the decision to invest for potential investors in these products. Additionally, in the private placements market, the general assumption is that the investors can fend for themselves. An exception for real estate offerings or a more advanced rule allowing predictions or projections under certain circumstances would increase access to information for potential investors and promote a more transparent market. Based on these factors, WealthForge, in response to a request for comment on a potential new exception to this rule, argued for investments into real estate to be exempt from this rule since those IRR estimates are generally based on both historic performance and actual measurable and implementable changes to the property.
5. Enforce Form D filing requirement and verify Form D information for better transparency
Rule 503 of Regulation D requires the issuer to file a Form D with the SEC. This filing is submitted online through the SEC’s EDGAR filing system. While this is a requirement, there is ample evidence that the SEC does not police these filings. For example, last year a filing was made for a $999,000,000,000 fund. This was clearly a typo. Additionally, our research shows that many issuers fail to even make the required filing. Inaccurate reporting and failure to file leads to confusion about both the market and the individual offerings, which can actually harm investors. The SEC should first make it clear that Form D filings are a requirement and that failure to complete them will lead to fines, loss of the exemption, etc. Additionally, the SEC should regularly review these filings and follow-up on outliers. Both of these recommendations would lead to a more transparent marketplace for all participants.
An In-Depth Look at Form D Filing Activity in 2016
Download our comprehensive analysis of private capital raise activity in 2016 to learn about important trends in private capital markets.
Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.
