Today’s Policy Paper of the Day [PPD] comes courtesy of the CATO Institutes’ Center for Monetary and Financial Alternatives.
Recently, Thaya Brook Knight published a policy analysis entitled “Your Money’s No Good Here: How Restrictions on Private Securities Offerings Harm Investors.” Knight was an associate director of financial regulation studies at CATO, and she is an attorney with extensive experience in this specific are of the law.
The argument put forward by Knight provides quite a compelling case for why current SEC regulations governing private securities offerings are in need of revamping.
Below is a summary of her argument, but her analysis can be read in full at the link at the end of this post.
Public vs Private Offerings
Let’s start from the top.
Businesses that seek to offer and sell securities (stock in their company) must register their offerings with the Securities Exchange Commission. This process is very burdensome, as it requires companies to spend large amounts of money to ensure that they are acting in compliance with lengthy federal regulations, wait extensive periods of time, and publicize sizable amounts of information pertaining to their operations and overall financials.
However, federal codes, under Rule 506 of Regulation D, provide an exemption from this process if companies’ securities sales do not involve “any public offering.”
Thus, an important distinction is drawn between those offerings which are public and those which are private.
As Knight explains, Congress, the SEC, and even the Supreme Court have all struggled to define the very nature of this distinction. While the definition of private has shifted over the course of nearly a century, currently, the definition relies on an “accredited investor” model from several decades ago when evaluating whether a company’s offerings are public or private.
Hence, a company can receive an exemption from the aforementioned burdensome process if it sells “its securities to an unlimited number of ‘accredited investors’ and up to 35 other purchasers,” (in accordance with Rule 506[b]’s conditions) or if “the investors in the offering are all accredited investors” (in accordance with Rule 506[c]’s conditions).
What separates an “accredited investor” from a normal investor? Knight provides a one word answer: money.
Formally, the SEC defines an accredited investor as, among other possible entities, a “person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000 … [or a] person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year.”
The Problem With The SEC’s Current Accredited Investor Model
As Knight argues in her analysis, the SEC’s accredited investor model rests on false assumptions.
First, the model assumes that private offerings are inherently riskier than public offerings and are thus in need of a more restricted class of investors.
While such offerings are not accompanied by the same access of information that a public offering provides, anyone with a basic understanding of investment can attest to the fact that risk is a determination relative to one’s entire portfolio of investments, it is not always an inherent quality of a single investment.
Even in the specific circumstances in which a private offering would be a risky investment, Knight importantly points out that limiting the class of investors in the private market not only limits those who can take on risk but also caps those who can profit from high rewards:
Investors are compensated for risk with the chance at higher returns. If some investors are categorically excluded from a type of investment specifically because it presents a greater risk, then they are not just protected from exposure to the potential downside; they are also prevented from realizing the potential upside.
Second, the model assumes that wealthy individuals are inherently capable of both understanding the potential risk of private offerings and withstanding the possible failure of a private offering better than individuals beneath the wealth cut off established within Regulation D.
One can persuasively put to rest any serious consideration of these two assumptions through a series of hypotheticals, just as Knight does in her analysis.
For example, if Person A has a net worth of $1 million and Person B has a net worth of $80,000, then Regulation D, upon no other considerations, prohibits the latter from investing in private offerings and welcomes the former into the same market.
Let’s first assume that both would be willing to offer $10,000 to a new start up company that is seeking to produce unique medical equipment and is in search of additional funds through a sale of private securities. Is Person A always more capable of understanding the risks associated with this investment than Person B?
Both of these individuals may not have access to the information on the company that would otherwise be mandatorily accessible in a public offering, but Person A is by no means inherently more capable than Person B of persuading someone to provide him/her with such information. After all, both of them would be willing to provide the same amount of funding.
In fact, Person B may have career experience that would greatly suit him/her to fully understand the risk of investing in this company. He/she may be a nurse practitioner, a medical assistant, or a health-insurance agent that could grasp the impact of the company’s product within the medical industry. Maybe he/she is even an investment advisor who would certainly comprehend such an investment decision.
On the other hand, Person A may have amassed their wealth through luck, inheritance, or a field completely outside of the realm of this company’s industry, placing him/her at a disadvantage to Person B’s expertise.
Let’s now assume that Person A is willing to offer $930,000, and Person B is willing to offer the same $10,000 as before. Is the former necessarily more capable than the latter of withstanding the financial loss if this company were to fail?
Of course not, and Knight writes the following on this legal conundrum: “Under current law … [a non-accredited investor] would be barred from making even a very modest investment whereas [an accredited investor] could freely wipe out a life’s savings.”
It should go without saying, however, that none of the above is a guarantee. Plenty of wealthy individuals are fully capable of making smart investment decisions in the private securities market. A primary point of this analysis is that individuals should not be judged by their net worth alone, so one should not read this post or Knight’s paper as being antagonistic against those individuals who are currently qualified to be accredited investors.
Rather, one should takeaway, as Knight correctly points out in her hypotheticals, that this type of paternalism from the SEC makes very little sense and is hardly present in any other commercial setting in our economy today.
Why does any of this matter?
Those who are serious about addressing the wealth inequality in our country should take into consideration the above and the following.
As cited in Knight’s analysis, the market for public offerings has been in decline for quite some time now. For the reasons stated at the start of this post, many companies are delaying the process of offering public securities, which keeps non-accredited investors away from the major growth periods that many start-up companies and developing companies proceed through, and other companies are outright forgoing the sale of such securities.
Private companies, on the other hand, have recently provided wealthy individuals with great money making opportunities.
Airbnb, Spotify, and Uber have collectively raised roughly $6 billion through private funding; as Knight writes, “to put that in context, the median size for an initial public offering (IPO) in 2016 was about $95 million.”
To be fair, even if the SEC were to fully democratize Rule 506 of Regulation D and permit anybody to partake in the sale of private securities offerings, certain private companies may still decide to only seek investments from high net worth individuals.
Nevertheless, that is a choice that ought to be left to the autonomous decision-making of private companies, not the federal government.
The SEC should not be playing the role of a restrictive crossing guard between the markets of private and public securities offerings, permitting wealthy investors to cross whenever they wish and stopping other investors from venturing outside of a lane which has historically been shrinking and providing smaller sized rewards.
When fully understood, Knight’s analysis makes clear that while the SEC has claimed that its policies are protective of the less wealthy, Rule 506 of Regulation D is in fact nothing but subjective in favor of our nation’s most wealthy.
Those who would like to see more economic mobility ought to support the elimination of the artificial “Do Not Enter” signs that the federal government has placed along our nation’s pathways to prosperity.
Read Thaya Brook Knight’s full analysis here: Your Money’s No Good Here: How Restrictions on Private Securities Offerings Harm Investors.