Half-Loaf for State Regulators, Still Poison for Entrepreneurs & Angels

A spokesperson for the North American Securities Administrators Association (NASAA) is quoted in Investment News as saying that the Association “didn’t get what it wanted” in Monday’s new version of Sen. Dodd's financial regulatory reform bill.

The implication is that the language in Sen. Dodd’s substitute proposal, attacking angel financing, is somehow a backing off, a compromise, from language in an earlier version of the bill.

That analysis might make sense to the NASAA, but from the perspective of a entrepreneur or an angel investor, Sen. Dodd’s new tack may be worse than his first.

What the NASAA wanted was for Sen. Dodd to altogether rescind federal preemption of state regulation over offerings exempt from registration requirements under Rule 506 of Regulation D. Outright repeal of federal preemption appeared to be in the first bill.

What happened instead this second go-round looks like one of those mish mashes of incoherence that occurs when someone doesn't understand the underlying purpose of what she or he is messing with.

Dodd's new language says the SEC must review filings under Rule 506 of Regulation D within 120 days. If the SEC does not undertake the review in such time, then the states are free to intervene (either because the security is no longer "covered," or because a state regulator undertakes a review and somehow determines that the SEC filing is okay -- it's confusing, but the supposition seems to be that a state may step in and play a review role comparable to the one the SEC failed to play during the 120 days (though it would seem a state might just as well decline that "invitation" and go right to regulating the offering under its own standards)). Alternatively, the SEC can bail on the responsibility altogether, and let states go directly to regulating a certain class of offerings, where the SEC determines that the size and scope of such offerings are too small for SEC consideration (er, make that, "too small to merit federal exemption from state purview"). 

Depending on SEC rulemaking under Dodd's legislation, this could mean the end of federal preemption over seed financings and smaller offerings that meet Reg D requirements, and a quagmire of uncertainty for offerings that ostensibly are large enough for the SEC to retain authority over.

The quagmire is in the 120 day wait. As Joe Wallin put it on his blog, "The concept of waiting 120 days for the SEC to clear an all accredited investor offering is truly an amazing thing to ponder."

So how would one plan in this new regime? The prudent issuer that, in the past, would have relied on Reg D, raised initial funds, then filed, will, under Dodd's legislation, probably need to go ahead and comply up front with state requirements. Given the chance that the SEC might default to the states anyway at the end of 120 days, the issuer had better get all relevant state review processes running concurrently. How else can the issuer reasonably hope to get the offering cleared in less than half a year? The only issuers who dare not "cover all bases" in this manner would be those that have all the time in the world to wait for regulatory clearance (there aren't many of those).

To summarize, Dodd would now both (a) leave the door open for the SEC, by rule, to gut federal preemption for smaller seed financings or other angel financings, and (b) cripple the self-policing nature of the current exemption regime, even if/where it still would exist, by requiring filers to wait (up to 120 days for SEC review, longer if SEC inaction by default pushes review out to the states).

Just how absurd this all is was put well by Dave (no last name given) in a comment to the TechFlash piece from earlier this week:

"All this does is massively increase the cost and time burden for rule following companies and it will reduce capital raised. Regardless of the rule changes, federal and state governments do not have the resources to effectively review all public and private offerings of securities. Ultimately, the exemption framework largely sets out the rules for companies that follow the rules and provides the mechanism for recourse when rules were not followed. No exemption typically means a strict liability remedy for violations of state securities or "blue sky" laws in addition to other penalties. That is what the rules do. The system is not designed to have a substantive review of every single financing in the country." 

Dave goes on to point out that this system for private financing, with self-policing up front and dire consequences and rights of regulatory and private action following just behind, works well, and would appear to be more effective than the system of public registration and disclosure that didn't do anything to stop Madoff or Lehman Brothers.

For a future post: what a real compromise might look like.