On Monday, December 5, 2016, the U.S. House of Representatives passed the Creating Financial Prosperity for Businesses and Investors Act (H.R. 6427) with a vote of 392-0. This bill, consists of six Financial Services Committee measures aimed at increasing investment opportunities for American investors.
Now the bill moves to the Senate for consideration. With a change in government underway, it is unclear when, or even if, this bill will pass the Senate and head to the President’s desk. Nevertheless, these measures, if enacted, would have an effect on U.S. private capital markets.
Title I: the Small Business Capital Formation Enhancement Act - This act requires the SEC to respond to any findings and recommendations from the SEC’s annual Government-Business Forum on Small Business Capital Formation. This is a good requirement as the Forum is composed of industry participants that regularly make well thought out suggestions to the Commission. Responses to those recommendations will likely lead to refined regulatory goals for the SEC and a better regulatory environment overall.
Title II: the SEC Small Business Advocate Act - Title II creates both the Office of the Advocate for Small Business Capital Formation and the SEC Small Business Advisory Committee.
The Office of the Advocate for Small Business Capital Formation, headed by the Advocate for Small Business Capital Formation (the “Advocate”), will aid small businesses and their investors in resolving issues they have with the regulations of the SEC or rule of the various self-regulatory organizations, identify areas where small business and their investors would benefit from changes to existing regulations or rules, identify barriers to small businesses accessing capital, analyze existing and future impacts of regulations on small business capital formation, propose any changes in regulations the Advocate views as beneficial to small businesses and small business investors, and consult with the Investor Advocate on any such recommendation and other issues related to small business.
Additionally, the Advocate will be required to provide an annual report on his activities during the year to both the Senate Committee on Banking, Housing, and Urban Affairs and the House Committee on Financial Services.
The Act also creates a Small Business Capital Formation Advisory Committee to advise the Commission on how its rules, regulation, and policies relate to capital raising by emerging, privately-held business and smaller public companies (with less than $250,000,000 in public market capitalization), trading in securities of these companies, and public reporting and corporate governance requirements of emerging companies and smaller public companies. This committee would consist of the Advocate for Small Business Capital Formation, members who represent these types of companies, their advisors, and investors in emerging companies and smaller public companies.
Both the creation of the Office of the Advocate and the Small Business Capital Formation Advisory Committee will likely lead to the SEC focusing more on the issues around capital formation for smaller businesses. By having a dedicated office to focus solely on these issues, in addition to having to respond to the Government-Business Forum, the SEC will be able to more quickly react to changes within this market. This will allow the Commission to better accomplish two of its primary missions; maintaining fair, orderly, and efficient markets and facilitating capital formation. Additionally, the requirement that the Advocate provide annual reports to both the relevant committee in the Senate and the House of Representatives without input from the Commission will allow the Advocate to bring any concerns to the attention of legislators, without having to filter it through the commissioners.
Title III: Supporting America’s Innovators - Title III raises the investor limitation on companies exempt from registration as an investment company under section 3(c)(1) of the Investment Company Act from 100 persons to 250 persons for certain companies. In order for this new cap to apply, the company must fall into the new category of a “qualifying venture capital fund,” which is defined as any venture capital fund with no more than $10,000,000 in invested capital. While this is a positive change, it is unlikely to make a significant difference in the industry. First, “Venture Capital Fund” is a defined term in the regulations promulgated under the Investment Advisors Act, that has specific requirements which must be met. Second, most venture funds have more than $10,000,000 in invested capital. But for those funds that do fall within the definition and want to have a fund with less than $10,000,000 in invested capital, this change will allow them to raise funds from more people, which could lead to more access to venture funds for investors.
A more significant change would be to raise the investor limitation under 3(c)(1) from 100 persons to 250 persons for all potential investment companies. This limitation does come into play on occasion and cause consternation for all involved due to all the rules about who counts as a person for the purposes of the rule. Moving the limitation up to 250 for all potential investment companies would increase access to capital for such funds and likely allow for larger funds with lower minimum investments. This would allow smaller investors access to the potential offerings these funds have access to. That would be significant, but as for the proposed rule, its effect will likely be minimal.
Title IV: the Fix Crowdfunding Act - Title IV makes several changes to various statutes to attempt to fix some of the oversights in the original Reg CF. The most significant of these is the creation of the “crowdfunding vehicle.” One of the huge disadvantages with Regulation Crowdfunding, as enacted, compared to Regulation D private placements under 506(b) and 506(c) was that the issuer had to sell directly to the individual investors and could not use a special purpose vehicle. This meant that an issuer could end up with hundreds of small investors on its cap table for very little capital, which would likely hurt its chances for future funding from larger investors, such as angel groups or venture funds. The common solution to this problem under other exemptions is to use a special purpose vehicle, usually a LLC, to pool all of those investments and then make a single investment into the final issuer. This creates one large investment by a single investor with only one entry on the cap table.
The Fix Crowdfunding Act creates the “crowdfunding vehicle,” a specific special purpose vehicle that may be used in Reg CF offerings. These vehicles will be exempt from the Investment Company Act. As a result, there would be certain restrictions on these vehicles. The most significant of these restrictions is that it must be current on ongoing disclosure requirements under Rule 202 of Reg CF and that it must be advised by a registered investment advisor. While these are significant requirements, they are not onerous. The allowance of the use of an SPV in Reg CF offerings solves one problem with Reg CF as enacted, but many other issues remain, including the $1 million cap on the offering, limitations on investments by individuals, and the real potential for fraud. Currently, making an offering under 506(c) exemption, or the traditional 506(b) exemption, remains the better option for most companies seeking capital (learn more about the booming Reg D market here).
Title V: Fair Investment Opportunities for Professional Experts - Title V amends the Securities Act’s definition of accredited investor. First, it adds the definitions for individual accredited investors (net worth or income) to the code, and also tacks those numbers to inflation. The way this will work is that the thresholds ($1 million for net worth and $200,000 of personal income or $300,000 of joint income) will be adjusted for inflation to the nearest $10,000 every five years. This was one of the many suggestions that had been put forward to update the definition of accredited investors both by the SEC and other participants in the securities industry. Those thresholds have not been adjusted since the 1980s, which led to the percentage of the population that qualifies as accredited increasing from 1.8% to 10.1%.[1] Going forward the thresholds will more closely align with inflation. This will likely mean that the population of investors accredited on the basis of income or net worth will not increase substantially. Additionally, by setting the adjustment to the nearest $10,000 every five years, Congress ensures that these adjustments are predictable and easy to implement for industry participants.
Second, Title V also introduces two new categories to the definition of “accredited investor.” The first is the category of registered individuals. As was suggested over a year ago by the SEC in its report on updating the definition of “accredited investor,” Congress added individuals who are licensed or registered as a broker or investment advisor by the SEC, FINRA (or other equivalent self-regulatory organization), or state securities division. This is a common sense change as these individuals have passed exams on complex financial instruments, including private placements, and work in the securities industry. One of the reasons for limiting private placements to accredited investors is to protect investors who may lack either the expertise to evaluate these offerings without the aid of the wider market or lack the assets to absorb a failure of these offerings. Theoretically individuals licensed by the SEC, FINRA, or a state securities division has the expertise to evaluate these offerings’ viability. As a result, they should be allowed to invest in private placements. Whether this is true or not, this change could be a positive one. Additionally, because whether an individual is registered or not is an objective fact, this addition to the definition will not complicate the analysis done by brokers like WealthForge as part of a 506(c) offering.
The second category of accredited investors added to the definition by Title V is the long called for “professional knowledge” category. The idea behind this category is that an individual with educational or professional knowledge of the industry being invested in, for example, a lawyer investing in a legal finance offering, should be allowed to make that investment. At first look, this makes sense. An expert would be able to evaluate the merits of an offering and protect himself or herself from making an unworthy investment in theory. But how does an issuer, or broker, conducting a 506(c) offering make the determination that someone is an expert? That determination is a subjective one and only adds risk that the 506(c) offering could be found to be invalid if challenged. Congress tries to solve this problem by requiring the SEC to make that determination and have FINRA, or another SRO, verify the individuals educational or professional background. Perhaps that will take the form of an exam or some sort of license, but until the SEC and FINRA actually promulgate regulations and rules, we will have to wait and see whether this addition is a positive or negative change.
Title VI: US Territories Investor Protection. Title VI removes the exemption from registration as an investment company for companies organized in Puerto Rico, the US Virgin Islands, or any other possession of the United States. Any companies exempt prior to enactment will remain exempt for three years after the date of enactment, with the SEC having the ability to extend it an additional three years. This brings those territories into alignment with the rest of the United States.
It is not yet certain that the Creating Financial Prosperity for Businesses and Investors Act will become law, as the Senate has yet to pass it and we are on the verge of a new administration with a new view of regulation. However, the changes to Reg CF and the definition of accredited investor, as well as the creation of the Office of the Small Business Advocate, do have the potential to increase access to capital in the US private capital markets and should be encouraged. At this point we remain hopeful that these changes, as well as further revisions to these rules, will continue to increase the transparency and efficiency of private capital markets.
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[1] Securities and Exchange Commission, Report on the Review of the Definition of “Accredited Investor”, 48 (December 18, 2015).