Scholar argues that the SEC should protect investors by requiring greater disclosures for private offerings.
Federal securities law in the United States consists of many rules and regulations, but they all boil down to one simple concept: Knowledge is power. Investors with sufficient information can evaluate companies and make sound investment decisions. Those without enough information are left guessing if the businesses they invest in will succeed or fail.
The U.S. Securities and Exchange Commission (SEC) is supposed to protect investors by requiring companies to give investors the information they need to assess their risk before they invest. Yet for decades, the SEC has allowed companies to sell securities to certain investors without providing them with any information about the company.
In August 2020, the SEC expanded the group of investors who can buy securities without information. Andrew Vollmer, a scholar with the Mercatus Center at George Mason University, criticizes this decision in a recent paper. He argues that, rather than expanding the group of unprotected investors, the SEC should reverse its decades-old policy and require companies to provide every investor with a minimum level of information.
Companies sell securities, such as stocks and bonds, to raise money to start or expand their business. Historically, companies have offered securities in public markets, where anyone could buy them. Before offering securities to the public, companies must disclose extensive information to investors.
When the U.S. Congress passed the Securities Act of 1933, it created an important exception to this mandatory disclosure requirement. Under the exception, companies are allowed to avoid the expense of disclosing information to investors if they sell securities “not involving any public offering.” The U.S. Supreme Court interpreted this statute in SEC v. Ralston Purina to mean that companies can offer securities to investors without registering them or disclosing information in “private offerings” if the investors have access to enough information on their own to “fend for themselves.”
In his paper, Vollmer explains that the SEC has applied the Supreme Court’s decision by creating a category of investors known as “accredited investors.” Accredited investors are primarily wealthy investors who do not have access to any private information about the companies they invest in. The SEC allows companies to sell securities to accredited investors without providing them with more information because it considers accredited investors wealthy enough to “bear the risk of a loss.” In its August 2020 rulemaking, the SEC expanded the criteria for accredited investors to include not only wealth, but also financial sophistication based on education and professional experience—such as licensed brokers and portfolio managers at investment funds.
The SEC argues that it expanded the accredited investor exemption to include financially sophisticated investors because these investors have enough experience to fend for themselves and do not need mandatory disclosures to invest in private offerings. By allowing companies to sell securities to experienced investors in private offerings, those companies can raise capital without incurring significant costs to prepare mandatory disclosures for public offerings.
In his paper, Vollmer, a former deputy general counsel at the SEC, argues that the SEC’s entire accredited investor exemption strays too far from the Supreme Court’s intent in Ralston Purina and allows investors to participate in private offerings with too little information. He proposes that the SEC eliminate the exemption altogether and replace it with mandatory limited disclosures for private offerings.
Vollmer claims that Ralston Purina and subsequent federal court rulings only allow companies to offer securities to investors without providing disclosures if the investors have access to the same type of information they could get from mandatory disclosures. He argues that neither wealth nor financial sophistication can protect investors if they have insufficient information about a company.
Instead of allowing wealthy and financially sophisticated investors to invest in private offerings without any disclosures, Vollmer proposes that the SEC allow all investors to buy securities in private offerings with limited disclosures. Under this proposal, companies offering private securities would need to provide disclosures that are less comprehensive than public disclosures, but still sufficient to protect investors according to Ralston Purina’s “access to information” requirement.
These limited disclosures would be similar to the existing disclosure requirements for small and medium-sized companies that use crowdfunding. They would include essential information about the company, such as the type of business, material risk factors, and the structure of the securities offered. They would also cost less for companies to prepare than the extensive disclosures required for publicly traded securities.
Critics of Vollmer’s proposal may argue that allowing companies to raise capital from all investors through private offerings with limited disclosures would cause private markets to replace public markets entirely because companies would no longer need to make public offerings to gain access to capital from the general public. This could ruin public markets and the robust disclosures they require.
Vollmer addresses this concern by proposing that the SEC maintain other restrictions on private offerings that will continue to make them less attractive to companies than public offerings. Such restrictions include prohibitions on general solicitation, limiting the amount of money a company can raise each year through private offerings, and limiting who investors can trade securities with after buying them in a private offering. Vollmer anticipates these restrictions would be significant enough to discourage most publicly traded companies from switching to private offerings.
Another concern with Vollmer’s proposal is that eliminating the exemption would increase costs for privately financed businesses that currently do not have to provide investors with any disclosures. Vollmer addresses this issue by pointing out that most companies voluntarily choose to provide limited disclosures to investors during private offerings. Mandating limited disclosures would thus impose only a minor increase in compliance costs on companies, while increasing protection for investors trading private securities.
In exchange for this small expense, Vollmer claims, companies would gain access to a large group of potential investors who previously were not allowed to invest in private offerings because the SEC classified them as non-accredited. In addition, mandating limited disclosures for all private offerings would guarantee that every investor had access to adequate information to evaluate risk in an investment, enhancing investor protection for accredited investors who currently receive minimal or no disclosures.
By expanding the accredited investor definition to include financially sophisticated investors, the SEC has once again chosen to reject mandatory disclosures at the expense of investors. It is time, Vollmer argues, for the SEC to eliminate the accredited investor exemption and give those investing in private offerings the information they need to protect themselves.
