SEC Commissioner Caroline Crenshaw advocated for more stringent rules around private equity offerings to better protect investors from opaque, FTX-like offerings in a keynote address given to the Securities Regulation Institute on January 30.
A private placement is the sale of securities to pre-selected, accredited investors as opposed to an offering on public markets (such as via an IPO). Under the U.S. securities regime, private offerings amount to an exception to the broader rule that securities offerings attach significant disclosure obligations designed to protect investors. A private offering can be registered under the SEC’s Regulation D and avoid many of those obligations.
Regulation D was initially envisioned to give smaller businesses the ability to access capital without being burdened with onerous disclosure obligations that are more suited to public offerings done by larger institutions.
However, what initially started as an exception has, in recent decades, transformed into a well-trodden avenue for private companies of many kinds to raise large amounts of capital without having to comply with the most stringent requirements of U.S. securities law. As a result, private placements under Regulation D have exploded in comparison to their publicly traded counterparts: according to a 2019 report by McKinsey, private equity’s net asset value has grown twice as fast as public equities since 2002.
“Through decades of legal, regulatory and market developments, private companies now have access to increasing amounts of private capital, inflating their sizes and significance to investors and the economy, and all without the concomitant safeguards built into public markets,” Crenshaw said.
Such an exemption from the SEC’s rules has in the past been justified on the basis that the accredited investors who have access to such private offerings are of sufficient size and/or sophistication that protectionist disclosure rules aren’t needed. This assumption, stated Crenshaw, hasn’t been borne out by reality.
Indeed, some of recent history’s most infamous corporate malfeasances have arisen from companies funded via private placements. FTX will be top-of-mind, but the likes of Theranos and WeWork were also funded via private placement—funding secured by pulling the wool over the eyes of private investors.
“Consider FTX in particular,” Crenshaw said. “Despite the reported presence of many elite and sophisticated investors capable of negotiating for information and protections, FTX was nonetheless described by its court-appointed, post-bankruptcy CEO as marred by ‘a complete failure of corporate controls’ and a ‘complete absence of trustworthy financial information.’ Bankruptcy filings indicate that FTX didn’t even maintain an accurate list of its bank accounts or account signatories.”
According to Crenshaw, such failures were possible in part due to the exemptions allowed for private placements. To illustrate, the commissioner compared two registration statements that have recently been filed with the SEC: one under Regulation D and another under the regular public offering regime.
Of the Regulation D form, she said:
“The Form is 6 pages long (printed), and consists mostly of check the box answers. The company is seeking to raise over $300 million in funding. It lists whether the company’s year of incorporation was more or less than 5 years ago. It lists the principal place of business; it lists certain executives and directors; and it notes the types of securities offered. It declines to disclose its revenue or net asset value range; it shows no information about sales compensation nor the total number of investors. It’s signed by a deputy general counsel, and not a chief officer. That’s it. That’s all it says. Oh, and, if the issuer fails to file this form, there is really little to no consequence.”
The public offering registration, in contrast:
“…is 173 pages before appendices, and (as you all know), contains detailed, descriptive information about the business, the offering, the use of proceeds, risk factors, audited financial data, information on capitalization, dilution, board of directors and director independence, executive compensation, and related party transactions. It also includes the report of an independent registered public accountant, and it is signed by executive officers and directors.”
Crenshaw’s response to this disparity is to advocate for ‘incremental’ reforms to Regulation D:
“It is clear that the disparity in disclosure is great. But, acknowledging that the private markets have a place, and building on the fundamental successes that we have achieved in our public markets through this mandatory disclosure, oversight and investor protection, I propose incremental reforms to Reg D. There should be more transparency to ensure a basic level of disclosure that allows investors, even the most sophisticated, to make informed investment decisions. And other regulatory obligations should be tailored for size.”
Crenshaw proposed two potential reforms in particular. First, modify the registration form for private offerings to require “useful, substantive information” about the company. Additionally, impose consequences for failure to file correctly, such as prohibiting future attempts to rely on Regulation D for future offerings. The form should also be required to be signed by an executive officer who would be accountable for the accuracy of the information contained within it.
Second, Crenshaw proposes a two-tiered framework that would impose heightened obligations on larger issuers. For example, offerors of a certain size could be required to provide an independent financial audit as part of their filing, confirming that appropriate financial controls are in place.
“To my mind, this is a tailored solution that helps us fulfill our mandates,” she concluded.
“First it imposes heightened obligations on larger private companies. In so doing we would both acknowledge Reg D’s purpose in allowing reprieve to smaller businesses, and also help eliminate the benefit and effective subsidy being given to large private issuers on the backs of these same small businesses. Second, it provides broader disclosure to investors, which acknowledges again that, even among a set of accredited and sophisticated investors, private market investors are entitled to a certain basic set of information.”
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