Facilitating General Solicitation at the Expense of Investors

Editor’s Note: Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s statement at a recent open meeting of the SEC; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

Today [July 10, 2013], among other things, the Commission considers amendments to Rule 506 of Regulation D, to remove the prohibition against general solicitation and advertising, if sales are made only to accredited investors. I do not support this action because both the process followed in proposing the amendments and the actual amendments being considered today come at the expense of investors and place investors at greater risk. I am particularly disappointed because this flies in the face of the Commission’s mission and did not have to be the case.

The Commission has both the Authority and the Obligation to Protect Investors in Implementing JOBS Act Section 201

Last year, Congress passed the Jumpstart Our Business Startups Act (“JOBS Act”). Section 201(a) of the JOBS Act requires the Commission to revise Rule 506 to remove the prohibition against general solicitation and general advertising, provided that all the purchasers in the offering are accredited investors.

It is without doubt the responsibility of the Commission to implement Section 201 of the JOBS Act. It is equally without doubt that this responsibility cannot be separated from the Commission’s duty to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Congress established the Commission as the independent agency with the expertise and authority to administer the federal securities laws. By statute, the Commission has the power to make, amend, and rescind the rules and regulations needed from time to time to carry out the provisions of such laws.

Nothing in the JOBS Act removes that broad authority. In fact, by tasking the Commission with implementing Section 201, Congress affirmed the Commission’s responsibility for administering the Securities Act of 1933. Congress did not need to delegate this action to the SEC; it could have acted directly to exempt from registration any offering in which sales are made only to accredited investors. But Congress declined to bypass the SEC. To the contrary, Section 201 expressly defers to the Commission’s rulemaking authority. The inescapable conclusion is that Congress intended the SEC, as a bipartisan Commission with broad rulemaking authority, to use its expertise to accomplish the goals of Section 201 in a manner consistent with the purpose of the Securities Act.

It is a false proposition to suggest that the Commission’s hands are tied—and that the JOBS Act prevents the Commission from protecting investors and safeguarding the integrity of the securities markets at the same time that it makes the changes required to Rule 506.

The need for the Commission to exercise its authority and protect investors is great, because general solicitation clearly has the potential to put investors at risk. In short, without additional protections, general solicitation makes fraud easier and enforcement more difficult.

Without Additional Protections, Permitting General Solicitation Will Put Investors at Risk

The record is clear that general solicitation will make fraud easier by allowing fraudsters to cast a wider net for victims. The potential risks associated with general solicitation are well understood. Many experienced observers, including law professors, state securities regulators, and investor advocacy groups, have submitted extensive comment letters documenting their concerns.

The Commission’s own actions today recognize those risks. Today’s accompanying release proposing ways to mitigate the damage of general solicitation is a testament to that increased risk. However, while I welcome efforts to protect investors, any benefits from such proposals will come far too late for the investors who are harmed.

Proponents of the current process say that we shouldn’t worry so much about fraud, because sales under Rule 506(c) are limited to accredited investors. The theory is that accredited investors are presumed to be knowledgeable about financial matters and otherwise able to fend for themselves. However, that argument is flawed in important ways:

First, the definition of accredited investor is not limited to experienced or sophisticated investors. An individual with annual income of $200,000 or net worth of $1,000,000 may be considered well-off, but those benchmarks are not necessarily correlated with financial expertise. In fact, the SEC’s Division of Economic and Risk Analysis estimates that only a small percentage of U.S. households meeting the definition of accredited investor have substantial direct holdings of individual securities, suggesting that their experience investing in securities may be limited.

Second, general solicitation provides fraudsters with key advantages over legitimate capital raisers: For one thing, the scam artist does not feel compelled to tell the truth—but can make the sales pitch as compelling as imagination permits. For another, unlike real investment funds and companies raising money for a legitimate purpose, the Ponzi-schemer only cares about raking in as much money as possible, and has an unlimited number of shares to sell. Thus, without common sense protections, general solicitation will prove be a great boon to the fraudster. Experience tells us that this will lead to economic disaster for many investors. In addition, a market tainted by accounts of fraud will also be damaging for legitimate companies seeking to raise capital under Rule 506(c).

The rulemaking record is replete with evidence raising these concerns. In fact, the Dodd-Frank mandated Investor Advisory Committee recognized these risks and acted unanimously last October to adopt a series of recommendations on general solicitation seeking to balance investor protection, capital formation, and market integrity. In so doing, the Committee urged the Commission to “carefully consider the potential harm to investors … and the alternatives available to minimize that harm.”

It is simply wrong for the Commission to brush these concerns aside and neglect its statutory responsibility to prevent fraud in the sale of securities sold in interstate commerce.

It is Reckless to Rush Forward with Adopting Rule 506(c), in the Hope that Investor Protections will be Added Later, Rather than Reproposing Now

Today, in addition to allowing general solicitation in Rule 506 offerings, the Commission is also considering a proposal to amend Regulation D and related rules to ameliorate the risks of general solicitation. While I support that proposal, I strongly question the timing of the Commission’s actions. The Commission is going ahead with the adoption of Rule 506(c), but only proposing the changes that would help to mitigate the harm to investors. The measures discussed in the accompanying proposal should have been considered as part of the amendments to allow general solicitation. I’m afraid the protections will simply come too late, if they come at all, for many investors. It is reckless to create a known risk today, with just the hope of a speculative remedy tomorrow.

Let me use a transportation-related analogy to help put this into perspective:

Imagine that a new locomotive would allow trains to go much faster. I believe that a responsible way to proceed would be to examine the railroad tracks to see if they could handle that faster speed. We would probably find a lot of places where trains could safely go much faster. But there would also be curves and grade crossings where the faster speed would be dangerous, and we would need to adopt safeguards to help prevent accidents. Of course, some of us might differ about how to implement such precautions, but all of us would want to make sure that the railroads were safe at the new speeds, before they started hurtling through our towns.

By the same principle, lifting the ban on general solicitation can and should be done in a manner that concurrently promotes investor protection, and provides regulators with the tools they need to police the market effectively. Adopting Rule 506(c) today, while relying on speculative future actions to implement the common sense improvements needed to protect investors, is no way to run a railroad.

I hope that the Regulation D enhancements we propose today—together with needed improvements to the definition of accredited investor—will be adopted promptly, but experience tells me I shouldn’t hold my breath. The Commission has proposed many rules that linger indefinitely without going into effect.

The Rulemaking Process Was Fatally Flawed

So, how did we get here? Unfortunately, I believe the Commission’s process for this rulemaking was fatally flawed from the beginning.

The primary error was the Commission’s failure to even consider any alternatives when the removal of general solicitation was proposed. It is standard practice in Commission rulemakings for the proposing release to request comment on both the terms of the rule proposed and any alternatives to the proposed rule. In fact, I cannot recall any substantive rulemaking during my terms as a Commissioner—and certainly no rulemaking as significant as this one—in which the release did not expressly solicit comments on potential alternatives.

But in this case all such requests for comment were pointedly excluded. That was a slap in the face to investors. More importantly, since the proposing release excluded any substantive discussion of the various suggestions to mitigate risk from general solicitation that were raised by commenters prior to the issuance of the proposal, the Commission was prevented from considering such suggestions at the adopting phase of the rulemaking. That is why I have consistently called for reproposal of the rule.

Numerous alternatives to the stripped-down version of the rule adopted here today are in the record, but—instead of considering them as part of the process of removing the ban on general solicitation, when it mattered most—the majority dismissed them out-of-hand, without data, without analysis, and without any substantive explanation.

This is bad policy for a regulatory agency. The Commission has a responsibility to fulfill its statutory duty to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation—and, as one court has noted, it must do so “on the basis of empirical data and sound analysis.” By law, such analysis must include adequate consideration of reasonable alternatives.

Identification of alternative regulatory approaches, together with an evaluation of the benefits and costs, both quantitative and qualitative, of the main alternatives, is also required by the guidance on economic analysis recently published by the SEC’s staff. Yet, this too was ignored.

The Commission’s failure to adequately consider any alternatives to the version of the rule adopted, and to evaluate the effect of such alternatives on investor protection, including the costs to investors and other market participants of any increase in fraud resulting from general solicitation, is a fatal flaw in the rule that the majority of the Commission votes to adopt today.

The Commission also failed to adequately assess the economic effects of the new rule. The economic analysis in the adopting release includes numerous unsupported conclusions, and unexplained contradictions, and fails to respond to substantial problems raised by commenters. Moreover, the adopting release acknowledges repeatedly that the Commission’s data on the Rule 506 market is unreliable or incomplete, but then dismisses the impact of this lack on the Commission’s economic analysis, without explanation.

These failures cry out for reproposing a balanced rule that implements Section 201(a) in a manner consistent with the Commission’s other statutory responsibilities. Failure to do so risks delay, uncertainty, and damage to the Commission’s important mission by insisting on the adoption of an unbalanced and deficient rule.

For all these reasons, I cannot support this rule.

Lastly, I appreciate that, after a lengthy delay, the Commission is finally acting to fulfill its obligation under the Dodd-Frank Act to prevent felons and other “bad actors” from being involved in Rule 506 offerings. However, the Bad Actor rule is not a panacea that will solve the problems created today. For example, a Bad Actor rule can do nothing to protect investors from fraudsters who have yet to be caught and identified.


Obviously, I am disappointed and saddened by the reckless adoption of the amendments to Rule 506 without appropriate safeguards. I know that many on the staff share my concerns. I want to encourage you to fight on behalf of investors. They will need you now more than ever.

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One Comment

  1. Amy M.
    Posted Thursday, July 11, 2013 at 4:33 pm | Permalink

    This opinion is totally flawed. It’s clear that Commissioner Aguilar has never launched or tried launching a company requiring outside private capital.

    If all SEC investment rules were held up to his standards, then many other kinds of now legal investing opportunities should be illegal or barred as well.

    As a founder’s POV, that ban on general solicitations did nothing other than prevent entrepreneurs from reaching potential investors and enriching private placements firms.