Will Title III Impact Private Capital Markets in the Same Way as Title II?

Over the past few years, the JOBS Act’s potential benefits have been thoroughly examined in press, blogs, and in well-researched whitepapers published by various firms connected to private capital markets. The Act’s goal was to liberate private capital, to fund small business, but chiefly to create jobs in a stagnant economy. Interestingly, according to a recent Fortune article, the JOBS Act’s full implementation occurs at a time when the US is at full employment.

The JOBS Act did not create new accredited investors—not one. It did not create new ‘investable’ capital. It did not change regulation that provided incentive or disincentive for an investor to invest differently.

Accredited investors influenced by macro motivations make investments largely for three fundamental reasons: to make a profit, to shelter tax liability, or to participate in an interesting project that might add social value.

The JOBS Act at its core, created opportunity for existing capital to be directed at an asset class – unregistered securities, specifically, small businesses seeking pre IPO capital. Remember, the capital already existed, so really the intent was to reallocate that capital from status quo to active, or put it to work.

To achieve its goals, the JOBS Act addressed the three areas that a market requires:

• Opportunity
• Awareness
• Efficiency

An opportunity is a project. Something needs to get done. An entrepreneur has an idea but needs capital to execute. A real estate developer has a vision for a tract of land or an urban renewal effort and needs equity to support conventional financing. At the time the Act was passed, many opportunities existed, but much capital was idle and on the sidelines.

Awareness, in this case, is the ability for an investor to know about an opportunity. Arguably this is the greatest impact of the JOBS Act. Unregistered securities are no longer required to be a secret shared by a select few. Utilizing the Reg. D 506(c) registration exemption, companies may raise an unlimited amount of capital in full public view. Revising the long existing Reg. A restricted public offering, from a limit of $5M to $50M, made the expense associated with creating the offering at least justifiable. The last portion of the Act, also known as the FINRA regulated ‘Funding Portal’ to be implemented May 16th, embraces the Internet’s ability to distribute smaller offerings to the masses, allowing non-accredited investors to participate.

To be certain, the accredited investor’s ability to find private offerings meeting his investment objectives is greatly improved. By corollary, their capital, given that they must also be sophisticated, will find the most worthy projects to finance.

For the unaccredited investor investing through a Funding Portal, he now will have access to opportunities that formerly would not receive wide exposure.

Market efficiency, popularized in Eugene Fama’s hypothesis, says that no individual can outperform the market since a stock’s market price reflects all information available at all times. However, in private markets, historically, there is no efficiency because there is no transparency— no comparative insight, no true market. By allowing transparency and public view, the JOBS Act enables an efficiency gain in private markets which is absolutely essential for that market to function, attract capital and deliver the wash, rinse, repeat cycle that fuels public markets.

On May 16th, Reg. CF will allow companies to raise capital from non-accredited investors through public offerings of restricted securities via intermediaries, or Funding Portals. Investors are limited by regulation in the amount that they are allowed to invest, and with strict controls on what is communicated to them by the issuer. The intermediary is regulated by FINRA, the issuer is not.

The non-accredited, unsophisticated investor may now invest his money in Reg. CF public offerings. However, this opportunity does not have the benefit of the market efficiency and transparency that determines public market pricing. Reg. CF offerings like Reg. D offerings are very risky. The reward to the investor may be high, but perhaps more often is the case that the investor’s funds are not returned.

And on the topic of regulation, a Funding Portal, while regulated, is not held to the same standard as a broker-dealer in many regards.

• Offering Structure – The Funding Portal may provide advice on the structure of an offering, but is not required to have any certification credentials to verify, or at least establish a valid basis for their recommendation, to the issuer. There is no required principal or supervisory oversight of that recommendation before it is distributed.
• Suitability – Funding Portals have no obligation to determine whether an offering is suitable with regard to the investor’s investment objectives. Conversely, broker-dealers must evaluate suitability and understand the attributes of the offering and the investment objectives of the investor before administering the transaction.
• Anti Money Laundering – Funding Portals have no obligation to perform Anti Money Laundering analysis of either issuer or investor. No issuer wants a terrorist on their cap table, or to accept funds from an OFAC restricted country; doing so increases the issuer’s risk of having the offering proceeds rescinded.
• Investment Funding – Similarly, Funding Portals are free to determine how purchases are to be funded—debit card, credit card, or even Paypal account. This may increase the issuer’s risk that an investor will opt out of his investment by having the credit card company deduct the payment from their operating account.
• Escrow – Funding Portals may not handle funds or securities and are required to utilize a qualified third party (e.g., bank, broker-dealer, or credit union) to hold the funds, but not to act as an independent escrow agent.
• Scope – CF offerings are limited to $1M in aggregate per year, and Funding Portals may not conduct Reg. D or other restricted security offerings.
• Transaction – If an offering has a material change while underway, a funding portal is required to give notice and wait five days for the investor to recommit the investment. In a Reg. D offering, a material change to an offering while open requires the broker-dealer to refund all funds to the investor and for new subscription documents be executed.
• Communication – Funding Portals are not allowed to solicit sales of Reg. CF securities nor are the issuers of those securities allowed to communicate with investors except through the communication method provided by the portal. Broker-dealers are typically very engaged in the sale of the securities they represent, and are trained continually on how to do so in a compliant manner.

Investment capital seeks its best use and the opportunity that has the best potential to satisfy the motivation of the investor—profit, tax avoidance, or interesting/socially motivated/altruistic endeavors. Title II has already provided more transparency into private capital markets, leading to historical growth in 2015. Will Title III do the same? At WealthForge, we believe where capital goes, progress follows.

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Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.