The availability of risk capital for early-stage ventures has proven itself to be remarkably resilient. It has overcome the cycles and uncertainties of our economy, as well as the myopic tax policies perpetuated by our partisan politics. But I foresee a fresh challenge to the startup ecosystem on the horizon—and it is the direct result of bad brokers, disingenuous dealers, unprincipled promoters and iniquitous issuers.
The “bad actors” are the fraudsters who make confidence a career by peddling perilous product to unwitting investors. More often than not, they camouflage their chicanery under the cover of Regulation D.
“Reg D” provides for some companies to offer and sell their securities without having to register the securities with the SEC and consequently makes access to the capital markets possible for small companies that could not otherwise bear the costs of a normal SEC registration mandated under the Securities Act of 1933.
It is a success story that began when the SEC created the exemption in 1982 with the intent of simplifying capital-raising for small business owners to launch or expand their ventures. Subsequently, Reg D has enabled literally hundreds of thousands of new businesses to efficiently find financing.
But, private placements offered under Reg D have endured a checkered history beginning with the Prudential Securites Inc. offering that devoured $1.4 billion from 100,000 investors back in the late 1980s.
Private placement pilferings were conducted via the virtual absence of gatekeeper protection or regulatory oversight provided under the cover of Reg D. Regulators and lawmakers are rightly concerned, particularly with the private placements of limited partnerships that have been capitalized by offerings to “accredited” individual investors through independent broker-dealers reaping commissions as high 10%.
Though initially intended to enable entrepreneurship and small business financings, the legitimate users of Reg D have been eclipsed by the scamsters.
Considering the responsibility of lawmakers to protect unwary investors from unscrupulous promoters and the readiness of regulators to expand their regimes, private investments that claim to be exempt from SEC registration are a torrid topic these days.
Alas, therein lies the rub. There were 11,000 Reg D deals filed in 1996, but that number swelled to a reported 26,485 in 2009 when estimated offerings exceeded $609 billion. Regulators are ill-equipped and lack the proper resources to evaluate the thousands of oil and gas ventures and real estate partnerships that file under Reg D each year.
“Investors have been exposed to far more risk in private placement offerings than Congress could have imagined,” exclaims Denise Crawford, former president of the North American Securities Administrators Association (NASAA) and the Texas Securities Commissioner, adding as “Reg D offerings receive virtually no regulatory pre-screening at any level of government.” Not surprisingly, she and many others have been lobbying for a rollback of the federal statutes in an effort to return the pre-empted authority back into the hands of the state regulators. In turn, they hope to close the oversight gaps that Ponzi scheme operators tend to gravitate toward to engage in their duplicitous dealings.
I fear that former Banking Committee Chair Chris Dodd’s efforts last year to gut Reg D will resurrect itself with the sincere intent of “protecting investors,” but the unintended consequence of stymieing startups that depend upon the provision for risk capital.
Last March, the Angel Capital Association noted in a letter to Dodd, “the angel investment arena has been virtually complaint-free in terms of fraud. Accredited angel investors make their own decisions to invest directly into small businesses, without securities dealers or investment advisors.” That point needs to resonate with our lawmakers who tend to be notoriously nescient with respect to nuance. More effective oversight is desperately needed to protect investors from the multi-million dollar private placement scams—so why not simply start there?
Funds, limited partnerships or series of funds that solicit investments from individual investors (as opposed to qualified purchasers) that collect north of $100 million from investors should be required to register as private fund advisors to provide regulators at the state and federal level with the transparency required to identify potential pockets of capital at risk. If there is a compelling case as to why limited partnerships that solicit hundreds of millions of dollars from individual investors should be exempt from oversight, someone needs to step up and make that case.
If regulators prove their ability to properly police these pools, oversight can later be mandated to begin at lower thresholds. But, leave Reg D as is for the startup and small business. Private investment is the sine qua non of startups and early-stage ventures. Leave the entrepreneurs alone.