February 14, 2007
After reading the the proprosed rule changes several times, it seems that the staff's concerns regarding inadequate investor protection in pooled investment vehicles come as a result of some infamous hedge fund failures. Many of these appear to have involved plain old garden variety fraud. Others, particularly those involving so called "hedge funds" that utilized proprietary "black box" trading algorithms or otherwise provided little or no transparency to their investors,were apparently caused by fund managers who bet on highly leveraged and effectively under hedged directional trades that went awry. In neither case would the proposed revisions to the safe harbor provisions of Reg D have provided any protection to investors.
As quoted in footnote 34, "the availability of the private offering exemption turns on the knowledge of the offerees and is limited to situations in which the offerees have access to the kind of information afforded by
registration under section 5 of the Securities Act." One might also add that such offerees have the requisite experience or expertise to enable them to make a fair evaluation of the risks and the potential rewards of a proposed investment. These principles are currently applied in Reg D where "accredited investors" are presumed to to have "such knowledge and experience in financial
and business matters that they are capable of evaluating the merits and risks of the prospective investment." Up to 35 unaccredited investors may still invest in private placements provided they are provided with disclosure materials and have the requisite knowledge and experience.(See notes 37 and 41). The perceived "problem" with hedge funds seems to stem from a lack of transparency, not from the lack of sophistication of investors. Setting a minimum standard for income or net worth is a convenient salve, not a rational substitute for determining whether an investor has sufficient experience and knowledge to evaluate the merits of and can afford to bear the risk of loss from an investment in an unregistered security. Under the proposed rules, many investors having the requisite experience, knowledge and capability would be arbitrarily prevented from investing in placements that relied upon the Reg D safe harbor, notwithstanding the fact that the issuer might be perfectly willing to provide disclosure documents and afford investors the opportunity to ask questions and otherwise perform due diligence. I also find the definition of "investment" to be vague. For example, where an individual has made a number of small investments in the shares of private companies (including his own) that have continued to grow and have become profitable, how is an issuer to determine the "fair value" of these small private investments? May the investor "certify" as to their values? Does one need to receive an independent appraisal of each individual investment in order to be protected from a later enforcement action?
Contrary to the statements in the proposal, most Reg D private placements do not involve "complicated strategies." They are straight forward offerings that provide investors with the opportunity to decide whether to invest in a targeted business or new venture.
The proposed rule could have a very chilling affect on the ability of start-ups to raise capital, as most get money from small angel groups (e.g "friends family" groups who often invest through a single partnership or LLC), not large VC firms that rely primarily on institutional investors and would meet the only proposed definitional exception.
Moreover, the lack of any grandfathering provision will put many of these existing individual angel investors in early stage companies at a disadvantage by effectively taking away their preemptive rights to participate in future investment rounds. These preemptive rights allow small investors to maintain their relative ownership positions as a company successfully meets its milestones and raises larger amounts of capital from institutional investors prior to a planned IPO or ultimate sale. Failing to grandfather existing investors, who are accredited under current rules but may not be under the proposed rules, will prevent them from participating in future rounds, which are typically done at substantially higher valuations as companies pass their proof of concept stage. Thus the proposed rule would deprive them of much of their investment opportunity. This strikes me as a pure taking by regulation. Small investors would thus face a perverse affect from the proposed rule- they could be prevented from realizing the bulk of their opportunities for gain from succesful early stage investments while their struggling early stage ventures find it much more difficult to raise continuing operating capital, thus jeopardizing their chances for success. That doesn't sound like investor protection.
If investor protection is the goal, put the onus on the issuer/sponsor to provide appropriate disclosure and continuing adherence to its investor approved strategies. Arbitrarily raising the bar to investment may protect some sponsors from litigious investors, but doesn't protect any investors from the fraud or malfeasance of fund managers.