The Continual Dismantling of the Mandatory Disclosure Framework — The SEC’s Inaction

Marc I. Steinberg is the Rupert and Lillian Radford Chair in Law and Professor of Law at Southern Methodist University. This post is based on his recent piece.

In a recent speech, SEC Commissioner Caroline Crenshaw focused on the sparsity of  disclosure in Rule 506(b) offerings.  Pointing out that more funds are raised in private than registered offerings for over a decade, companies are electing to stay private than undertake the rigorous disclosure and regulatory mandates of public company status.  The result is the growing number of unicorns — privately-held companies (currently, approximately 1,200 such companies) with values exceeding $1 billion — with minimal disclosure required.  As Commissioner Crenshaw implicitly acknowledged, the current Commission thus far has done nothing to address this situation.  To her credit, Commissioner Crenshaw set forth a number of potential reforms, including a heightened disclosure regimen for such larger private issuers (resembling the Regulation A—Tier 2 disclosure requirements) and the reconstitution of the Form D to provide meaningful information. (Crenshaw, “Big Issues in the Small Business Safe Harbor: Remarks at the 50th Annual Securities Regulation Institute” (Jan. 30, 2023)).

As Commissioner Crenshaw acknowledged, the divide between the disclosure required in Securities Act registered offerings contrasted with private offerings is huge.   And, this divide becomes wider when the continuous Exchange Act disclosure mandates are triggered once an issuer elects to go public.   Securities Act registration statements and Exchange Act periodic reports call for a wide spectrum of information, with specificity and detail that critics assert result in information overload.  The SEC’s current focus on ESG disclosure likely will exacerbate this dilemma.

Indeed, it is ironic that the current Commission’s focus on ESG and other regulatory mandates induces privately-held enterprises to maintain their status rather than enter the publicly-held company arena.  So long as funds can be adequately raised with minimal disclosure in private Rule 506(b) offerings, a strong incentive exists to maintain that status. While recognizing this situation, the SEC declines to act.  As this subject is a primary issue impacting the securities markets and investors, one would posit that this Commission under a Democratic administration, with an active Chair, would have addressed this anomaly in an expeditious and thorough manner.  Yet, now into the third year of the current Administration, the SEC has done nothing to rectify this unacceptable situation.

Hopefully, the Commission soon will act on Commissioner Crenshaw’s possible reforms. Analogizing to Regulation A—Tier 2, issuers that seek to raise annually over $20 million in such an offering must provide investors with extensive disclosure, including audited financial statements, and are subject to a continuous reporting regime.  Although reasonable minds differ on whether these precise requirements should apply to Rule 506 offerings, it is clear that, at some point, substantive disclosure (including audited financial statements) should be mandated.  Certainly, it is unacceptable that billion dollar enterprises (unicorns) are raising funds from investors without being required to disclose important information to their investors, with this omission occurring both at the offering stage and on a continuous basis.

The Form D also needs to be promptly amended by the Commission.  Currently, the Form is not required to be filed with the SEC until 15 days after the first sale.  Rather, the Form D should be required to be filed prior to the making of any offer or sale pursuant to Regulation D and at the conclusion of the offering.  Moreover, as Commissioner Crenshaw set forth, substantive information should be provided in the Form D, including the issuer’s “size, (by assets, investors, and employees), its operations, its management, its financial condition and revenues, and the volume and nature of the securities offerings.”    And, of course, there should be meaningful consequences for noncompliance with the Form D filing requirement, including enforcement actions with appropriate sanctions instituted against violators.

The SEC’s inaction with respect to requiring substantive disclosure in the Rule 506 (and particularly the unicorn) setting is not the only failure in this context.  As I emphasized in my award-winning Oxford University Press book Rethinking Securities Law (awarded Winner Best Law Book of 2021 by American Book Fest), the SEC has done nothing with respect to reforming the financial threshold for an individual to qualify as an accredited investor.  In adopting the 2020 amendments, the Commission made clear that increasing these financial thresholds“ could have disruptive effects on the Regulation D market, [possibly resulting] in a higher cost of capital for companies.” (Securities Act Release No. 10734 (2020)).  Hence, while the SEC has been willing to raise the issuer offering amounts with respect to several of the exemptions from Securities Act registration (e.g., the Rule 504, Regulation A and crowdfunding exemptions), it has refused since Regulation D’s adoption in 1982 to increase the financial requirements for an individual to be an accredited investor. (Note that, pursuant to the Dodd-Frank Act of 2010, Congress excluded one’s principal residence from an investor’s net worth calculation.)  To say that an individual who has a net worth of $1 million (exclusive of primary residence) or who earns $200,000 annually (or $300,000 with one’s spouse or spousal equivalent) irrefutably has financial sophistication and has access to registration-type information belies reality. In view of the perpetration of investor fraud in the Regulation D Rule 506 setting (including elder fraud), remedial action should be expeditiously undertaken.  Unfortunately, the SEC’s favoritism for capital raising interests over those of investors (and, with some frequency, uninitiated investors) is incompatible with its mission of investor protection.

In 2021, with the seeming presence of Commissioners more receptive to investor interests under the leadership of Chair Gensler, it was believed that this deficiency would be promptly remedied.  Yet, here we are two years afterwards, with no action taken on either the unicorn disclosure problem or the individual accredited investor financial threshold.  Although the SEC has focused on a number of meritorious subjects, including SPAC offerings and the treatment of virtual currencies, it has been sidetracked by subjects that are tangential to the Commission’s core objectives, most particularly ESG issues.

Urgency should be the Commission’s focus at this time.  And, that signifies that the SEC should undertake immediate rulemaking action with respect to enhancing disclosure in the Rule 506 setting, especially with respect to unicorns and raising (based on inflation) from 1982 dollars to 2023 dollars the financial threshold for an individual to qualify as an accredited investor.

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