SEC Chair Jay Clayton Challenges Advisory Committee to Improve Private Offering Regulation
Commentary by Steven Lofchie
SEC Chair Jay Clayton urged the SEC Small Business Capital Formation Advisory Committee (the "Committee") to consider ways to facilitate investment opportunities for "Main Street" investors, and for small businesses to raise capital, through private placements.
In remarks before the Committee, Mr. Clayton advocated for a less costly and complicated approach to private offering regulation that would facilitate better opportunities for "Main Street" investors. According to Mr. Clayton, differences between the opportunities available to Main Street and institutional investors result in part from the current "overly complex and rigid" approach to private offering regulation. He said that this approach - which began 35 years ago and was implemented on a "patchwork basis" - relies on the wealth-based definition of "accredited investor," leading to only the wealthiest investors being able to invest in the private markets.
Mr. Clayton stated that businesses seeking to raise capital in the private markets typically favor institutional investors due to the cost of raising capital from Main Street investors. He said that the private capital markets do not sufficiently help small- and medium-sized companies raise capital. Further, most small- and medium-sized companies cannot grow beyond the start-up stage unless they have "established relationships with professional investors." Mr. Clayton advised the Committee to examine whether there are regulatory changes that would remedy this.
Commentary
The SEC just adopted Regulation Best Interest, which imposes a significant suitability obligation (and related potential legal liability) on a broker-dealer that sells securities to the most sophisticated natural persons; e.g., Warren Buffett. It is therefore not at all surprising that small investors are not given a chance to invest in private placements because it is too expensive to deal with such investors as compared to larger investors. See SEC Adopts "Retail Best Interest" Rulemaking Package.
One can either have rules that accept the possibility of small investors making decisions to invest money in risky startups; or one can have rules that shield small investors from those risks, at the cost of losing the opportunity to have significant payoffs. As a policy matter, both types of rules are potentially reasonable and defensible. But it is not possible to have it both ways. See Regulators Emphasize Importance of Capital Investment.
If our regulatory priority is on protecting small investors from any material investment risks, the logical result is that small investors will end up buying shares in diversified index funds, because it does not make sense for firms to take the economic risk of offering them a broader range of investment opportunities, which may very well go bad. The regulators should not be surprised at results that are the logical outcomes of their rulemakings. If there is to be some middle ground, perhaps it is in some revisions to the Investment Company Act that provide for a new type of semi-open-end fund, open to small investors, but run by professional managers, that can invest in most anything.
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