When the U.S. Securities and Exchange Commission passed Regulation A+ of the JOBS Act last April, it provided companies with new ways to raise money and ease their state filing obligations. In many ways, the new rules were a win for startups and other small businesses, and we’re already seeing companies take advantage of the legislation.
Regulation A+ capped the amount of capital that companies could raise at $5 million, and it prevented them from taking on unaccredited investors. Regulation A+ lifted the cap to $50 million and opened investment opportunities to those outside of the accreditation thresholds. Accredited investors must have a $200,000 annual income or $1 million net worth. These standards precluded many would-be investors from participating in small business growth prior to Regulation A+.
The SEC also implemented a two-tier system under Regulation A+ in response to criticisms from the North American Securities Administrators Association. The tiered structure was not only designed to address NASAA’s concerns about decreased state oversight, but it also allows companies to gauge investors’ interests and go to market more effectively.
By these measures, Regulation A+ brought positive change to the investment landscape. But it also created a number of unintended consequences that the SEC and the financial community need to address.
The most significant of these include:
An emphasis on crowdfunding: The biggest news to come out of Regulation A+ revolved around the crowdfunding guidelines that opened the market to unaccredited investors. Because Title III rules haven’t been finalized, organizations see Regulation A+ as an opportunity to broaden their general solicitations to a greater pool of potential investors.
Under rule 506(c) of Regulation D, companies can advertise or solicit to anyone, but they can only accept accredited investors from general solicitation. That said, retail investors are now able to participate via Reg A+. Many firms interpreted Regulation A+ as a replacement for Title III of the JOBS Act, even though the former is more cost-prohibitive. The market participants and regulators need to continue to refine these new investment models going forward.
Outdated 15c2-11 requirements: Regulation A+ mandates that companies file publicly for inclusion in the Financial Industry Regularity Authority over-the-counter bulletin board within 12 months of their offerings. Companies typically manage their 15c2-11 filings with a market-maker who secures a listing for them on the OTC bulletin board or a public equivalent.
But market-makers cannot charge for 15c2-11 filing services, so their only motivation for ensuring companies are listed is to capture order flows from trading activity once created. Given the lack of liquidity in these arrangements, it’s very hard for market-makers to regain lost revenue. There’s little upfront incentive to do in-depth due diligence, creating a garbage in, garbage out situation. Each additional market-maker who adds the stock to trade “cuts and pastes” the limited, sub-standard data from the original filing instead of doing the proper research and updating the listing.
With so many new participants expected to utilize Regulation A+, this antiquated process needs an overhaul. The SEC should allow market-makers to charge a fee for 15c2-11 filings, which would improve the quality of information put into the system and increase investor protection.
A decline in reverse-merger strategies: A strategy for private companies historically obtained their shareholder listings by reverse merging into existing public shells. Now, organizations can opt for a Regulation A+ offering and 15c2-11 filing, a process that allows them to come out on the other side as clean-listed companies on the bulletin board for the over-the-counter market. The industry may see a significant drop in the demand for reverse mergers, as well as a decrease in the costs to procure a publicly traded shell.
With each consequence, investors and regulators need to think about where they want the financial market to go and how they want to implement these lessons into upcoming legislation.
The Future of Financial Legislation
The financial market is a living entity that shifts constantly in response to market trends. The industry must treat regulations as living entities as well, updating and revising them as new products and technologies emerge. Technology is disrupting society on a mass scale, and it’s exposing the inefficiencies of the current securities market. Innovative solutions for distribution, transparency, archiving, and other essential functions will become increasingly accessible, democratizing the investment industry.
But investors and regulators can’t cede oversight to financial algorithms or computer systems, regardless of their sophistication. Technology enhances and improves regulation and management, but it can’t replace human beings who understand the implications of different securities practices.
Groups like the Crowdfund Intermediary Regulatory Advocates have taken the lead on raising important regulatory questions. But the SEC, NASAA, and FINRA will play pivotal roles in engaging with all of the relevant parties throughout the rule-making process.
We need more securities experts and market participants involved in consulting with legislators during the drafting of regulations. There have been tremendous nuances in the industry because, as each new regulation is created, market participants have to remember to apply the legislations of before. And when practitioners are excluded from advising during the writing of regulations, we see problems like the ones listed above. This will always happen when the people creating the policies don’t fully understand the dynamic or depth of the marketplace.
The future of the financial industry depends on a continuous evolution of our regulatory body of work. As we engage further in this new frontier of technology and social media, continued synergy between market participants and regulators will devolve these unintended consequences.