Over the last few weeks, many commentators have written about the potential for widespread fraud and abuse in connection with Rule 506 offerings in which general solicitation is used. Some of these commentators have noted that if general solicitation is permitted, additional safeguards should be implemented in order to protect accredited investors. The argument seems to go more or less as follows: the securities laws prevented general solicitation from being used in connection with private offerings made to sophisticated purchasers and mandated that where general solicitation was permitted (i.e., public offerings), certain disclosure standards had to be met in order to ensure that investors had adequate information on which to base their investment decision. And, the argument continues: if general solicitation is permitted in connection with certain exempt offerings, then the accredited investor standard should be revisited and certain disclosures should be mandated in order to protect investors.
We have a little trouble following these arguments. Indeed, an exemption from registration has always been available in the case of certain private offerings made to a limited number of financially sophisticated investors that have some relationship to each other and to the issuer, have access to information about the issuer, and no general solicitation is used. It was determined that in the case of such offerings, financially sophisticated investors could fend for themselves. Was their ability to fend for themselves dependent on the fact that no general solicitation was used? If general solicitation is used, would it render otherwise financially sophisticated investors unable to fend for themselves? We’ll come back to this question.
A bit of history first: the notion of deregulating offers (relaxing the ban against general solicitation) is not a new idea that was rashly suggested and was not given careful consideration. Relaxing the prohibition against general solicitation and general advertising has been suggested and considered for the better part of twenty years. Not sure we would say that taking two decades to effect this change is “rushed.”
The proposed rules regarding Rule 506 offerings using general solicitation do require that additional steps be taken to verify the status of those investors that are actually purchasing securities. This is intended to address the concerns raised by certain legislators in connection with their consideration of the JOBS Act. Issuers (or the broker-dealers acting on their behalf) will be required to evidence the steps they took to verify the status of investors. On this basis, it is difficult to understand how investors that are subjected to general advertising or solicitation efforts but do not participate in offerings are harmed. One might be able to understand that certain classes of TV viewers might be harmed by watching advertisements for sugary cereals or “jumbo-sized” meal deals (although someone, presumably older and more nutritionally-aware, still has to make the decision to visit a store and make the purchase decision) or by being exposed to excessively violent television programs. However, it is a little harder to draw parallels with investing. Is the point that listeners will be de-sensitized to hearing about investment opportunities? Or, that merely listening will do harm? Not everyone that listens to a compelling or aggressive sales pitch for a security will qualify as an accredited investor, or will be deemed to be a customer for which the investment is appropriate based on investment objectives and other criteria.
A couple of commentators have also noted that it is the “accredited investor” standard that may be deficient. For some time now, we have relied on the utility of the “accredited investor” threshold as one that is useful in identifying a class of investors that has the financial wherewithal to make certain investments and that possess, either on their own or with the assistance of a purchaser representative, the ability to make investment decisions. It is true that the “accredited investor” definition uses financial tests as a proxy for assessing sophistication, and, perhaps, that’s a crude and imprecise test. We have never implemented investor standards that require testing or screening for financial literacy. Does the fact that general solicitation will be permitted really require revisiting of all of our investor standards? And, if we were to revisit the “accredited investor” test, then should we revisit the other investor standards contained in the securities laws? If we don’t believe that accredited investor self-certification is reliable, would it be reasonable to rely on the accuracy and reliability of any “financial literacy” test? Don’t the know-your-customer and suitability obligations mitigate any potential risks that securities would be recommended to customers for which such purchases would be inappropriate?
Some have suggested that it may be useful to require a “warning label” on the offered securities, or impose a “cooling off” period during which investors who were generally solicited (and presumably vetted and determined to be accredited) could re-consider their investment decision. This is not the first time that a “cooling off” period has been suggested in connection with securities offerings. In fact, we’ve seen this suggested in connection with mortgage-backed and asset-backed offerings, as well as with accelerated book build transactions marketed principally to institutional investors. The rationale given is that the marketing of transactions moves too quickly to permit careful consideration of investment opportunities—so, we should slow down the pace of the market, but facilitate capital formation? Interesting.