Rebalancing Private Placement Regulation
| Publication year | 2012 |
I. INTRODUCTION
Regulating securities offerings entails balancing investor protection and capital formation.(fn1) Inevitably, this balance gets upset. As financial markets evolve, congress passes new legislation, the Securities and Exchange commission (SEc) adopts new rules, and the courts issue unanticipated opinions. These events upset the balance because they happen in an uncoordinated and haphazard manner and oftentimes produce unintended consequences.
Capital formation under the Securities Act of 1933(fn2) (Securities Act) occurs through private placements and public offerings, each of which is subject to a somewhat distinct securities regulatory regime. This Article focuses on the balance between investor protection and capital formation with respect to private placements. Specifically, I detail various rule changes that were implemented over the years to enhance capital formation. I also discuss other events that have occurred over the same timeframe and have weakened investor protection. Based on more than a decade of following, researching, and writing about private placement regulation, I fear that the latest round of capital formation enhancements has tilted the balance too far in favor of capital formation and away from investor protection, especially given the size of the private placement market today. The purpose of this Article is to draw attention to this potential imbalance so that it can be further studied and debated. Additionally, this Article puts forth a proposal for strengthening private placement investor protection. The proposal is meant to serve as a starting point for debate if policymakers conclude rebalancing is needed.
The Article proceeds as follows. To set the stage, Part II provides background on the Securities Act and describes the differences between public offerings and private placements. Part III explains why rebalancing private placement regulation may be warranted. Part IV offers proposed statutory language for a new civil liability provision in the Securities Act specifically for private placements. Part V concludes.
II. THE SECURITIES ACT
Congress enacted the Securities Act in the wake of the stock market crash of 1929.(fn3) The Act "was designed to provide investors with full disclosure of material information concerning public offerings of securities in commerce, to protect investors against fraud and, through the imposition of specified civil liabilities, to promote ethical standards of honesty and fair dealing."(fn4) The Securities Act contemplates two types of offerings-public and private.
Generally, a public offering is an offering of securities marketed to the public. Most public offerings must be registered with the SEC.(fn5) A company-or more precisely, the "issuer"-registers an offering by filing a registration statement. Pursuant to SEC regulations, a registration statement must set forth, or incorporate by reference, various disclosures about the issuer and the offering. These disclosures include audited financial statements, comparative selected financial information, and a detailed description of the issuer's business, properties, intended use of offering proceeds, transactions with management, legal proceedings, and executive compensation.(fn6) If the registration statement is for an issuer's initial public offering (IPO), the SEC carefully reviews and comments on it; however, the SEC may or may not review one for a non-IPO.(fn7) Regardless, with limited exceptions, no public offering may proceed until the SEC declares the underlying registration statement effective.
As part of the offering process, the issuer must make available to the public the prospectus for the offering.(fn8) A prospectus is a subpart of a registration statement, and it comprises the bulk of the required disclosures.(fn9) The policy behind the registration and prospectus requirements is to provide potential investors with a standard package of information about the issuer and offering so that they can make informed investment decisions.(fn10)
The registration requirement is negatively reinforced by sections 11 and 12(a)(2) of the Securities Act.(fn11) Under section 11, an investor in a public offering can sue the issuer, its chief executive officer, chief financial officer, directors, and the underwriters of the offering if it turns out that the issuer's registration statement contained a material misstatement or omission.(fn12) Likewise, under section 12(a)(2), an investor can sue the seller of securities if the prospectus contained a material misstatement or omission.(fn13) Neither claim requires a plaintiff to prove the defendant acted with a particular state of mind; however, with the exception of the issuer who is strictly liable, a defendant can avoid liability under both sections 11 and 12(a)(2) if he performed a reasonable investigation or due diligence of the issuer and the offering.(fn14) These civil liability provisions coupled with the due diligence defense are designed to deter erroneous disclosure, filter out marginal offerings, and provide a compensation avenue to wronged investors. They also supplement public enforcement of federal securities laws by enabling plaintiffs to serve as "private attorneys general," an important consideration given the resource constraints of the SEC.(fn15)
Note that section 11 and section 12(a)(2) liability overlaps when a material misstatement or omission appears in the prospectus, which is often the case given that the prospectus contains or incorporates by reference the bulk of the required substantive disclosure.(fn16) In other words, it is common for a defendant such as an underwriter to get sued under both sections.
Public offerings are undertaken by private companies that want the capital infusion and share liquidity that come with the transition to a public company through an IPo, and by public companies that want to raise additional capital by selling equity or debt securities to the public. Public offerings are typically marketed and sold to the public by a syndicate of underwriters.
A private placement or offering is an offering of securities made in compliance with an exemption from the registration requirements of the Securities Act that prohibits the issuer from marketing the securities to the general public. Private placements exist because Congress recognized that it did not make sense to require the registration of all securities of-ferings.(fn17) Thus, it included a number of registration exemptions in the Securities Act and empowered the SEC to adopt additional exemptions.(fn18)
Both public and private companies rely on private placement exemptions for a variety of offering types.(fn19) For public companies, offering types include sales of debt securities to institutional investors and convertible securities to PIPE(fn20) investors. For private companies, offering types include sales of common stock to angel investors, sales of preferred stock to venture capital funds, and issuances of stock options to employees.(fn21) Additionally, investment companies such as hedge funds and venture capital funds typically rely on private placement exemptions when selling interests in their funds to investors.(fn22) Finally, leading up to the recent financial crisis, special-purpose vehicles relied on private placement exemptions to sell billions of dollars of collateralized debt obligations (CDOs), otherwise known as toxic securities.(fn23)
Most private offerings are marketed to investors through an offering document prepared by the issuer and its counsel, typically called a private placement memorandum or PPM.(fn24) A PPM contains the same sort of disclosure found in a prospectus so that potential investors can make informed investment decisions.(fn25) A PPM, however, is not filed with or reviewed by the SEC.(fn26)
Oftentimes, especially in the private-company context, an issuer will hire an investment-banking firm to serve as "placement agent" on the deal.(fn27) Under this arrangement, the firm markets the offering to investors on behalf of the issuer in exchange for a commission.(fn28) The placement agent also assists the issuer in preparing the PPM.(fn29)
Private placement exemptions (or exclusions) include Rule 144A, which limits sales to "qualified institutional buyers";(fn30) Rule 701, which limits sales to employees and consultants of an issuer;(fn31) and Regulation S, which limits sales to non-U.S. buyers or securities markets.(fn32) By far, the most heavily utilized exemption is Rule 506 of Regulation D,(fn33) so I describe it here in more detail.
To fall within Rule 506, either an offering must be limited to accredited investors and no more than thirty-five unaccredited investors or the issuer must reasonably believe that there are no more than thirty-five unaccredited investors.(fn34) Rule 501(a) defines "accredited investors" as the following: banks, insurance companies, mutual funds, and certain other specified institutional investors;(fn35) individuals with net worth in excess of $1,000,000 (excluding the equity, if any, of the person's primary residence), annual incomes in excess of $200,000, or joint annual incomes in excess of $300,000; and executive officers and directors of the issuer.(fn36) Rule 506 also provides that...
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