This is really silly. First of all, I would recommend that if there is a short blog post that does nothing more but summarise an article, one should submit the article and not the blog post.
Second, the actual businessweek article is so silly it is laughable. It mentions that Dodd wants to connect the accredited investor metrics to inflation but admits that it does not know how that will happen. Then it makes a silly guess out of the blue how it may happen and and assumes that is how it will happen and then goes on to complain how it will be the end of the world. This is a classic straw man argument.
Here's the thing - politicians do not like to make drastic changes unless they are warranted. I guarantee you Dodd is not going to double the income and net worth requirements for accredited investors overnight. The requirements will probably be connected to inflation starting now, which means they will keep their current values when the law passes and will slowly increase with inflation in the future.
I'm with you. The article takes a tiny piece of the much larger financial reform regulation package which has been a bipartisan effort with Republican Richard Shelby very much involved, amplifies it through some hypothetical number crunching, and then attributes it all to Dodd.
The blog post then takes it a step further by adding a layer of incendiary drama. Might cause one to forget the whole point of financial reform which is to prevent the sort of economic crisis we just went through from happening again--a crisis that has surely done more damage to startups than the proposed legislation could ever do.
What's frustrating is-- this is an opinion piece (the guy's a professor, not a writer), and this opinion piece has no NONE, zip nada, link to the actual bill that Dodd is proposing. It's all just conjecture.
Drives me nuts that the media doesn't link to pieces of legislation when it's all online (and we at Sunlight work so hard to get it there).
I would not be too sanguine about what politicians beholden to the trial lawyers might or might not do in this sort of area. When you shrink the pool of accredited investors, you remove many of the avenues by which startups can raise capital in a manner by which they can be assured they are not violating securities laws. If the safe avenues are no longer there, the risks of lawsuits increase dramatically. It will all be done in the name of protecting investor rights, but the real beneficiaries here will be the trial lawyers and the losers will indeed be all early-stage companies that seek to raise capital.
Maybe it will happen quickly or maybe it will be gradual but the underlying motives here are pretty clear and have nothing to do with promoting the health of startups.
I express no opinion about the quality of the article posted here but it is a mistake to assume this legislation is benign for startups. It is not.
Really? That is a bit far-fetched to say the least. And don't you think one should actually check out what the inflation adjustment is going to be before crying foul? If it is the version that I suggested is most likely, I don't think it will have much of an effect at all.
The bill gives the SEC an open ticket to make the form of inflation adjustment it deems reasonable. In other words, if the SEC uses the statutory grant of authority to take this in a direction of radically scaling back the numbers of investors who qualify as "accredited," there is nothing anybody can do about it. In effect, we are at the mercy of the regulators.
This takes an area that has been defined by certainty and by a liberal view of what it takes to be "accredited" - no small benefit for the rise of startups over the past 30 years - and, in my view, gratuitously places a big question mark over it. You can take a sanguine view of what this means. I choose not to. Only time will tell which of us has the right instincts about it.
For the benefit of the startups I represent, I sincerely hope that you are right and I am wrong.
Well it is not surprising the SEC are getting that order, as they created the whole accredited investor stuff from whole cloth to begin with.
But I do not think you are correct that this is a grant of authority. The SEC have always had the authority to change those numbers; as I mentioned, they created them to begin with. This proposed law actually orders the SEC to raise the numbers to account for inflation, but it gives the SEC broad discretion on how to do it.
But it is worth noting that the SEC have not changed the numbers from 1982, although they had the power to. Also from various SEC papers I have read it seems very unlikely they will suddenly double the requirements. Most likely, they will start accounting for inflation in the future.
George, I am disappointed by the superficial assumptions which you make here, which I feel serve to obscure rather than clarify the issue.
(Before going on, grellas is a lawyer and one I respect due to his extensive experience, while I am not only not a lawyer, I have no qualifications of any kind on such matters and the following is nothing but my personal opinion. If you need guidance in this area then you should be consulting someone qualified to practice securities law instead of wasting your valuable time reading my upstart ideas.)
The relevant sections are #412 and #413, as follows:
SEC. 412. ADJUSTING THE ACCREDITED INVESTOR STANDARD FOR INFLATION.
The Commission shall, by rule—
(1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and (2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.
SEC. 413. GAO STUDY AND REPORT ON ACCREDITED INVESTORS.
The Comptroller General of the United States shall conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and shall submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study not later than 1 year after the date of enactment of this Act.
'Commission' here refers to the Securities and Exchange Commission. Accreditation criteria as they currently stand are set out in rule 501 of Regulation D of the SEC's rules, under the authority of the Securities Act 1933. You can read those criteria here: http://www.law.uc.edu/CCL/33ActRls/rule501.html
Now, to my argument.
First of all, the proposed bill lets the SEC itself recalculate the financial threshold for a natural person to be an accredited investor. As I am sure you are aware, the SEC proposed raising that threshold to $2.5 million in investment assets back in December 2006 (primarily as a prophylactic against fraud by hedge fund managers) but abandoned the idea following the feedback they received during the public consultation period. I fail to see how requiring the accreditation threshold to keep pace with inflation and tasking the GAO with a review of current practices - to which both attorneys and entrepreneurs will presumably contribute - is a bad thing.
Perhaps your specific objection is to the suggestion that the SEC consider CPI in its reassessment of thresholds from the limits established in 1982. I would respond that pointing out that requiring consideration of the changes in CPI is very different from mandating their use as a metric, and only uses inflation as a rationale for future long-term maintenance of threshold amounts.
Incidentally, even if such thresholds were imposed by fiat tomorrow, are we really to believe that the risk of any given to investors is only 43% of that which it was in 1982? Is it logical to maintain a fixed dollar amount as the threshold for individual participation in offerings? Surely a period of inflation which further eroded the real value of that threshold would not in any way improve investors' collective security. I cannot fathom that invest...
Thank you for your thoughtful response, which I just upvoted for its very helpful content.
I must confess that some of my comments were indeed superficial but I did want to explain briefly why I have the perspective that I do. It is perhaps as much philosophical as anything else.
In this area, there has always been a continual tension between protecting investors (the very purpose of the securities laws) and giving people freedom to invest freely in ways that promote capital formation.
The Securities Act of 1933 imposes registration requirements upon the issuers of securities. The basic idea is that stock (and other securities) can be sold to the public only when accompanied by suitable disclosure materials such that a prospective investor can have a good understanding of the risks associated with the investment. Each state also has its own version of such laws, and these are known as "blue sky" laws. Thus, any issuer that desires to sell stock to public investors must register it with the SEC and also comply with the parallel blue-sky requirements.
Section 4(2) of the 1933 Act provides an exemption from these registration requirements for private placements. This is required for small-company capital formation because such companies would choke on the compliance costs involved with registration and, more importantly, in a private placement, the problems associated with selling stock to mass numbers of small and often unsophisticated public purchasers are just not present and it is overkill to apply the full force of the registration requirements to such situations.
The question is what is a "private placement"? Before Regulation D was adopted in 1982, this whole area was a mess. Did an offering to 5 people constitute a public offering? Or to 10? Or to 20? How about if stock were sold to 5, then another 5, then another and another, and so on, all in succession? At what point did such offerings cease to be private placements and become "public" offerings and hence illegal unless accompanied by suitable SEC registration? What if stock were sold to 15 people but were done via public forms of advertising? Did that make a difference? What if the investors numbered 50 or 500 but were all sophisticated investors capable of understanding the nature of the investment? Did that make a difference? What if they were given audited financials and similar forms of disclosure as part of the offering?
All such questions went all over the board prior to the enactment of Regulation D as courts struggled to make sense of the meaning of Section 4(2), and the result was a proliferation of litigation all over the nation that could easily ensnare issuers and their principals with large legal expenses and possible large judgments. And the penalties were not small. A violation of the 1933 Act by an issuer that does an improper unregistered offering meant that investors could rescind their stock purchases out to 3 years after their purchase and, moreover, could get their money back not only from the issuers but also from the principals who controlled them.
I remember this vividly. I clerked for a federal judge in the 1979-1980 period and saw firsthand the kinds of crazy cases that could wind up in court over such issues.
And here is the key point about such litigation: it could take all shapes and sizes because of uncertainty surrounding the meaning of what constituted a private placement. In other words, a company that sought to issue stock in a private placement could never know for sure (except in really extreme cases) whether investors could come back to bite the company and its principals simply because the company wound up failing. This set up all sorts of situations where lawyers could second-guess the offering even a long time after the fact because they could always point to this or that fact or circumstances that they would argue took the offering out of the 4(2) exempt category and subjected it to registration requirements. This uncertainty made it risky for companies to attempt to raise capital via private pla...
We basically agree on the purpose and utility of regulation D. By clearing defining what the safe harbor provisions are, it opens the doors to capital formation for small business without imposing hugely expensive compliance requirements, and I am heartily in favor of keeping capital formation a relatively simple process - especially in times like these when credit markets remain chilly and many otherwise healthy or promising businesses are unable to expand for lack of ready capital. I also agree that imposing stricter fiscal requirements for accreditation risks shrinking the liquidity pool and thus starving one of the most dynamic segments in the economy, with serious implications for job creation and economic growth.
Now, you mention that this legislation, if enacted pushes the SEC in a regulatory direction that will make this area more litigious, and here we differ, although I know I am presenting a rather flimsy theoretical opinion against your solid empirical one! It seems to me that you're assuming a shrinking liquidity pool will drive entrepreneurs to engage in increasingly risky behavior in order to develop their businesses; if the pool of accredited investors shrinks then capital will have to be sought from unaccredited ones, and uncertainty will ensue, followed by painful and expensive legal wrangling when a good portion of these ventures fail or underperform.
But is it not rather simplistic to assume that if the supply of investors is artificially constrained, the demand for investment will necessarily run towards the same uncertain and litigation-prone methods of capital formation that preceded the establishment of Regulation D? Might we not instead see an increase in the number of partnerships or directorships taken up as a condition of investment, but still in accordance with other safe harbor provisions of regulation D besides those based on the net worth of a natural person?
I am not attempting to argue this as a debating point. Rather, I am seeking to understand why you anticipate one outcome rather than another. For example, is it your professional experience that angels are tolerant of risk but don't wish to shoulder the various obligations of a directorship, whether due to the burdens of compliance or because it might compromise their objectivity as investors? Is the distribution of wealth such that an increase - say, a doubling - of the financial barrier to accreditation necessarily halves the size of the capital pool, or shrinks it in direct proportion to the number of angels? In other words, if middling investors with more than a million but less than two all disappeared from the angel pool, what of the fact that no upper cap on the assets of wealthier angels exists - a newly imposed $2m threshold is of no material consequence to an angel with $10m to invest, whereas the middling investor's capital contribution is necessarily limited to less than the accreditation threshold. Finally, such restrictions might create opportunities for business development companies, not unlike YC, which are large enough to shoulder the burden of compliance and act as reliable brokers for high risk investors (eg a hedge fund manager who might wish to put 1% of his fund into high risk ventures with great upside potential and can easily offset the risk with more pedestrian investments, but lacks the time or expertise to seek out many tiny startups). The 'shotgun' approach of investing small sums in many disparate ventures with the understanding that only a few will yield significant returns could probably be formalized and maybe even simplify the capital formation process for startups, as YC seems to be doing. It seems to me that one of the most common and frustrating questions for new entrepreneurs is where to find an angel in the first place - for many people and industries, finding someone who can listen to and act upon your pitch is mysterious, so I feel there's an unmet demand here for business development as a kind of brokerage service.
1. Under existing law, startup companies can raise money easily and quickly from "accredited investors." There is no need for the companies or the investors to gain approval from any state or regulatory official.
2. This would change if Section 926 of the Dodd bill is included in any final reform legislation. That section would require, for the first time, companies seeking angel investment to make a filing with the Securities and Exchange Commission, which would have 120 days to review it. This would both raise the cost of seeking angels and delay the ability of companies to benefit from their funding.
Money quote: <i>Currently, a person must have a net worth of $1 million or an annual income of $200,000 if single or $300,000 if married (and filing jointly) to be an accredited investor. The senator's proposed bill doesn't say what inflation adjustment will be used to convert these numbers, established in 1982, to today's dollars. But if we use the Bureau of Labor Statistics inflation calculator to adjust these figures on the basis of the consumer price index, then the annual income requirements for accredited investor status would become $449,000 if the investor were single and $674,000 if the investor were married, while the net worth requirement would become $2.25 million.</i>
So, in other words, the bill's not even finished being drafted and they made some noise about maybe adjusting some figures, but they have CPMs to sell so they'll just assume "adjust" means "multiply by 2.25" and get the snappy headline.
That said, Dodd clearly shouldn't do anything to hurt actual startup investment.
- What problem does Dodd say this is going to solve? Is he trying to reduce the workload of the SEC?
- Whatever the problem is, is it a problem?
- Does this solve it?
- Who is paying/lobbying Dodd to do this? I imagine it wasn't on his radar until someone who stands to gain brought it to his attention. Is it just Tourette legislation?
- If the result will be as bad as the article says ... how/why do we let Congress get away with fucking things up?
It would increase the workload of the SEC, though only very marginally. The SEC proposed (but then retracted) a very similar change about 3 years ago. You can read about it here: http://www.sec.gov/rules/proposed/2006/33-8766.pdf their rationale is set out on pages 17-18.
tl;dr the SEC was worried that the explosion in house prices during the 90s (which raised many people's net worth above the accreditation threshold set in 1982) and the parallel increase in both the popularity and complexity of private investment offerings were tempting many people out of their financial depth. Large numbers of people borrowing against the value of their home to invest in hot deals without much understanding of the risks involved struck the SEC as a dangerous situation.
Arguably, the events of the last few years proved them correct. The SEC was not trying to strangle startups (nor was it blind to the the possibility of such a result), but to maintain a barrier between overconfident homeowners and glib fund managers whose only business case was that markets tend to rise over time.
I don't know enough about the legislation to comment on it specifically but I do know politics -- it appears the Republicans are pulling another HCR strategy here and simply letting the Democrats go forward on this unchallenged on substance in an attempt to score a political Waterloo 2 (since the first one didn't quite work) Pretty sad state of affairs I think. I'm willing to accept Dodd's bill isn't great (or even good) but the response of trying to make it purely a political issue with dishonest speculation of repealing it later is pure lunacy from the opposition. People are desperate to see some major financial reform so it will be extremely popular no matter what's actually in the bill. The political narrative of saying "the people who caused the meltdown oppose the fix" is political gold. As a committed liberal I'm actually a bit worried that the classic check & balance of right/left is getting out of whack due to the massive failure of the Republican party to put governing over politics. They need to come to the table with honest intentions and substance and try to be part of the solution.
When elected members of a political party find themselves in opposition, they are not paid to just sit on their hands and say 'fuck it'. They still have an obligation to their constituents to participate in the legislative process even if they don't expect to succeed. That's why we have a legislative branch instead of just an executive.
> When elected members of a political party find themselves in opposition, they are not paid to just sit on their hands and say 'fuck it'.
Remind me - did you complain when Dems did that to Bush? (Pre 2006)? You remember - "Disent is patriotic" and all that. Or is that somehow different?
Of cours, the Repubs actually do have proposals. You don't hear about them in the "tingly leg" media, so you'd have you'd have to look elsewhere. Or is that their fault too?
As a matter of fact, I have, though I have not been here on HN so long. This is hardly the place for a political argument, but I believe a pragmatic approach is entirely compatible with robust debate.
I do not care for the zero-sum outcomes which often result from or are promoted by the adversarial nature of our political system. But I learned very early in life that no matter how bitter a competition becomes, almost all the spectators are united by a disdain for the referee.
> This is hardly the place for a political argument, but I believe a pragmatic approach is entirely compatible with robust debate.
Interestingly enough, your "pragmatic approach" involves chiding Repubs for not making proposals even though they actually did.
Why are you blaming Repubs for your ignorance of their proposals? (I'm not saying that it's necessarily wrong to blame them - I'm asking why you are doing so.)
btw - You do realize that the fellow with the pipe is a smug parasite, right? Snark, while "cool", isn't actually productive. It's a way to feel superior without actually doing anything that justifies the feeling.
Nothing wrong with holding them responsible or voting them out if that's what the people decide. I just believe if you get elected to govern it's really irresponsible to spend your time running for re-election the whole time. If they don't stop focusing exclusively on making everything "his Waterloo!" the American people won't trust them to govern. I don't want to see a one party system but it seems like we're heading in that direction due to their political miscalculations. Even the hype now around November is pretty unrealistic. There just aren't really enough weak Democrats up for re-election in the Senate to "repeal it!" so they're setting themselves up for a big political failure 8 months before an election they might actually do well in otherwise.
Why do investors need to be accredited at all? If I, someone with savings and income far below those thresholds, want to invest a large portion of my net worth into a startup I really believe in, why should the government stop me? It's so risky that it's a horrible idea, but don't I have a right to be stupid?
Because of scams. Of course you are going to say that you should have the right to fall for scams if you want to, but some scams become so prevalent they actually have an effect on the economy, or can crash the stockmarket.
I also have to say that the accredited investor rules do not exactly prohibit you from investing in startups. Or from owning stock. They are part of a complex securities regulation framework and it is difficult to explain in a quick message board post exactly where they fit in.
But the result of the rule is that submillionaires can't invest in YC-like companies, but they can still lose all their money (and whatever additional amount banks will loan them) on...
- day-trading
- real-estate-speculation
- investing in 'safe' public stocks like Enron, Fannie Mae, Lehman, and GM
- trading forex following rules they learned from late-night-informercials
- gambling in licensed casinos offering rigged games
- buying state lottery tickets
All these often-negative-expectation activities are allowed. So what, exactly, do the 'accredited investor' limits prevent a gullible person from doing? A fool will be parted from his money; these rules just change the form of the transactions that will be used.
Meanwhile, the limits prevent wise-but-poor people from being shareholders in small businesses that they actually have some expertise about, and which are more likely to be positive-expectation than the above activities.
The laws obviously cannot prevent all fraud. But the least they can do is make fraud relatively difficult. Some of the examples you provided were fraud, but they were relatively difficult to pull off, as opposed to what would happen if there were no securities laws. (Some of your examples, were not fraud but just stupid decisions.)
For example Enron had to work hard to fool all those accountants, and as a result one of the largest accounting companies in the world went under and many of its partners are still mired in lawsuits. The banks created a very convoluted system to mislead investors as to the value of their securities, which involved a lot of new legislation, somehow tricking or corrupting the ratings agencies, controlling markets, etc.
So scams happen, but they are not as easy. Of course I think securities laws could stand improvement.
But we do not have the case where there are so many scams on the stock market that everybody assumes that everything is a scam and nobody invests, so the stock market is essentially useless. This is the case for many (actually most) countries.
First, wise-but-poor people will be able to invest in small businesses as you describe, but will have to satisfy other non-financial criteria in order to do so. (these criteria already exist, and apply if you don't meet the current accreditation thresholds.)
Second, to turn your argument on its head, why not get rid of the limits altogether? Let anyone invest in anything, whether or not the investment vehicle is registered with or reports to the SEC. Sounds great, right? Unfortunately, historical experience with this approach is that people get ripped off left, right and center, and taxpayers end up holding the bag.
True, taxpayers end up holding the bag for a lot of things anyway. I'm not sure how to fix this, but I'm pretty sure that removing all limits on the size of bags ain't it.
We float in a sea of fraud. The investment laws are not about stopping it, they are about giving Goldman Sachs a percentage of every fraud. Goldman would implode tomorrow if random assholes could just cheat each other directly. Take the fucking red pill, Neo.
The historical evidence is that complete fraud control produces water empires that are destroyed by the first barbarian to ride into town. The destruction is generally so complete that a dark age follows. Forget taxpayers holding the bag, you need archeologists to figure out what happened from the bits of that society that would not burn.
Conversely, the Western Enlightenment showed that you can get growth and prosperity undreamed by the kings of old even in the face of pervasive investment fraud. What counts is a culture of liberty, optimism, and a commitment to basic policing. Or to put it another way, it's worth the life savings of a lot of senile grandmothers if the wild-eyed schemer sometimes actually delivers a goose that lays gold eggs.
wise-but-poor people... have to satisfy other non-financial criteria
...which limits them to a tiny fraction of the private investment opportunities available to millionaires. Why make things harder on the wise-but-poor? Or those who have wise-but-poor friends-and-family?
...to turn your argument on its head, why not get rid of the limits altogether...
That's not the argument on its head -- that's the argument itself! Net-worth-based discrimination has no place in securities regulation.
If an unwise or gullible person can throw their entire net worth -- and then some, via leverage -- into a single risky real-estate transaction, or risky options trade, or risky loan to an unreliable acquaintance, or risky superbowl wager -- then there's no rational basis for preventing them from buying private securities.
Some will be burned, and learn (and teach others via their example). They'll do better the next time -- as with all the other expensive failures we let people experience with their own money.
Fraud can be prosecuted under existing fraud laws. And the majority of honest entrepreneurs and wise-but-poor investors will have many, many more opportunities to explore the small-business solution-space with angel capital.
I can't help feel you're responding to individual bits of my reply rather than the whole thing. As for the rational basis of such rules, I invite you to consider why the securities act of 1933 was created in the first place, and the circumstances which led up to that.
Whatever good was in the depression-era securities regulations, other parts were an overreaction, just like SarbOx has been. Now, much of their paternalism is obsolete. Non-millionaires of 2010 have knowledge and resources far beyond that of depression-era barons.
And irrational exuberance, not fraud, is how the masses lost the bulk of their money -- then and now.
We just lost trillions in real estate value. Should non-millionaires be prohibited from buying real estate, by law, because circumstances have shown they're just too feeble-minded to make such investments? That would be a modern equivalent to 'accredited investor' rules originating from depression-era biases.
I couldn't agree more. The fact that non-accredited investors are permitted to open an options trading account and only receive a statement disclosing that options trading is risky is an indication that these rules represent more of an exercise in regulatory capture that protects incumbents than a real mechanism that protects investors. An inexperienced investor would be much more likely to lose money trading options than to fall prey to hedge fund scams.
True...but do we want to burden startups with the compliance requirements of public securities trading?
While grellas and I disagree upthread about the intent and ramifications of this proposed change, we concur that the alternative (of an unspecific regulatory environment) is messy, unpredictable, and expensive. Libertarians often point out that disputes are inevitable are best resolved on their individual merits in a court rather than via pre-emptive regulation. This is a fine ideal, but my limited experience as a party to a few legal disputes is that going to court erodes commercial productivity like nothing else.
It reduces the burden on entrepreneurs by freeing them from the complex and expensive filing requirements of the SEC for making a public offering similar to an IPO. Basically the accredited investor can say 'I am sufficiently wealthy and well-informed that if I lose all my money I will not run to the authorities crying that you encouraged me to take financial risks that were beyond my ability to understand'.
If you wish to solicit funds from the general public for a profit-seeking enterprise, you have to include a huge number of disclaimers and warnings with your offering and pay a very expensive securities lawyer to evaluate and sign off on your compliance with SEC regulations, or you face a very high likelihood of getting prosecuted for mail fraud and multiple other offences.
You may be a smart individual or an ethical entrepreneur, but the empirical evidence is that the general public is rather naive, poorly informed about risk assessment and financial engineering, and there are a lot of people out there eager to exploit this fact.
It would be nice if we could do without police and fire departments and pay less tax as a result, but crime and outbreaks of fire are annoying realities whose costs typically exceed those of professional emergency responders.
Step 1. Make private investment difficult and costly. Step 2. Save the day with gov small business investment. 3. Pick winners based on political agenda.
There's more than one way to build a command economy...
36 comments
[ 3.3 ms ] story [ 86.1 ms ] threadSecond, the actual businessweek article is so silly it is laughable. It mentions that Dodd wants to connect the accredited investor metrics to inflation but admits that it does not know how that will happen. Then it makes a silly guess out of the blue how it may happen and and assumes that is how it will happen and then goes on to complain how it will be the end of the world. This is a classic straw man argument.
Here's the thing - politicians do not like to make drastic changes unless they are warranted. I guarantee you Dodd is not going to double the income and net worth requirements for accredited investors overnight. The requirements will probably be connected to inflation starting now, which means they will keep their current values when the law passes and will slowly increase with inflation in the future.
The blog post then takes it a step further by adding a layer of incendiary drama. Might cause one to forget the whole point of financial reform which is to prevent the sort of economic crisis we just went through from happening again--a crisis that has surely done more damage to startups than the proposed legislation could ever do.
Drives me nuts that the media doesn't link to pieces of legislation when it's all online (and we at Sunlight work so hard to get it there).
Maybe it will happen quickly or maybe it will be gradual but the underlying motives here are pretty clear and have nothing to do with promoting the health of startups.
I express no opinion about the quality of the article posted here but it is a mistake to assume this legislation is benign for startups. It is not.
This takes an area that has been defined by certainty and by a liberal view of what it takes to be "accredited" - no small benefit for the rise of startups over the past 30 years - and, in my view, gratuitously places a big question mark over it. You can take a sanguine view of what this means. I choose not to. Only time will tell which of us has the right instincts about it.
For the benefit of the startups I represent, I sincerely hope that you are right and I am wrong.
But I do not think you are correct that this is a grant of authority. The SEC have always had the authority to change those numbers; as I mentioned, they created them to begin with. This proposed law actually orders the SEC to raise the numbers to account for inflation, but it gives the SEC broad discretion on how to do it.
But it is worth noting that the SEC have not changed the numbers from 1982, although they had the power to. Also from various SEC papers I have read it seems very unlikely they will suddenly double the requirements. Most likely, they will start accounting for inflation in the future.
(Before going on, grellas is a lawyer and one I respect due to his extensive experience, while I am not only not a lawyer, I have no qualifications of any kind on such matters and the following is nothing but my personal opinion. If you need guidance in this area then you should be consulting someone qualified to practice securities law instead of wasting your valuable time reading my upstart ideas.)
First, the relevant material we're talking about. The text of the bill is to be found here: http://banking.senate.gov/public/_files/ChairmansMark31510AY...
The relevant sections are #412 and #413, as follows:
SEC. 412. ADJUSTING THE ACCREDITED INVESTOR STANDARD FOR INFLATION.
The Commission shall, by rule— (1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and (2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.
SEC. 413. GAO STUDY AND REPORT ON ACCREDITED INVESTORS. The Comptroller General of the United States shall conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and shall submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study not later than 1 year after the date of enactment of this Act.
'Commission' here refers to the Securities and Exchange Commission. Accreditation criteria as they currently stand are set out in rule 501 of Regulation D of the SEC's rules, under the authority of the Securities Act 1933. You can read those criteria here: http://www.law.uc.edu/CCL/33ActRls/rule501.html
Now, to my argument.
First of all, the proposed bill lets the SEC itself recalculate the financial threshold for a natural person to be an accredited investor. As I am sure you are aware, the SEC proposed raising that threshold to $2.5 million in investment assets back in December 2006 (primarily as a prophylactic against fraud by hedge fund managers) but abandoned the idea following the feedback they received during the public consultation period. I fail to see how requiring the accreditation threshold to keep pace with inflation and tasking the GAO with a review of current practices - to which both attorneys and entrepreneurs will presumably contribute - is a bad thing.
Perhaps your specific objection is to the suggestion that the SEC consider CPI in its reassessment of thresholds from the limits established in 1982. I would respond that pointing out that requiring consideration of the changes in CPI is very different from mandating their use as a metric, and only uses inflation as a rationale for future long-term maintenance of threshold amounts.
Incidentally, even if such thresholds were imposed by fiat tomorrow, are we really to believe that the risk of any given to investors is only 43% of that which it was in 1982? Is it logical to maintain a fixed dollar amount as the threshold for individual participation in offerings? Surely a period of inflation which further eroded the real value of that threshold would not in any way improve investors' collective security. I cannot fathom that invest...
I must confess that some of my comments were indeed superficial but I did want to explain briefly why I have the perspective that I do. It is perhaps as much philosophical as anything else.
In this area, there has always been a continual tension between protecting investors (the very purpose of the securities laws) and giving people freedom to invest freely in ways that promote capital formation.
The Securities Act of 1933 imposes registration requirements upon the issuers of securities. The basic idea is that stock (and other securities) can be sold to the public only when accompanied by suitable disclosure materials such that a prospective investor can have a good understanding of the risks associated with the investment. Each state also has its own version of such laws, and these are known as "blue sky" laws. Thus, any issuer that desires to sell stock to public investors must register it with the SEC and also comply with the parallel blue-sky requirements.
Section 4(2) of the 1933 Act provides an exemption from these registration requirements for private placements. This is required for small-company capital formation because such companies would choke on the compliance costs involved with registration and, more importantly, in a private placement, the problems associated with selling stock to mass numbers of small and often unsophisticated public purchasers are just not present and it is overkill to apply the full force of the registration requirements to such situations.
The question is what is a "private placement"? Before Regulation D was adopted in 1982, this whole area was a mess. Did an offering to 5 people constitute a public offering? Or to 10? Or to 20? How about if stock were sold to 5, then another 5, then another and another, and so on, all in succession? At what point did such offerings cease to be private placements and become "public" offerings and hence illegal unless accompanied by suitable SEC registration? What if stock were sold to 15 people but were done via public forms of advertising? Did that make a difference? What if the investors numbered 50 or 500 but were all sophisticated investors capable of understanding the nature of the investment? Did that make a difference? What if they were given audited financials and similar forms of disclosure as part of the offering?
All such questions went all over the board prior to the enactment of Regulation D as courts struggled to make sense of the meaning of Section 4(2), and the result was a proliferation of litigation all over the nation that could easily ensnare issuers and their principals with large legal expenses and possible large judgments. And the penalties were not small. A violation of the 1933 Act by an issuer that does an improper unregistered offering meant that investors could rescind their stock purchases out to 3 years after their purchase and, moreover, could get their money back not only from the issuers but also from the principals who controlled them.
I remember this vividly. I clerked for a federal judge in the 1979-1980 period and saw firsthand the kinds of crazy cases that could wind up in court over such issues.
And here is the key point about such litigation: it could take all shapes and sizes because of uncertainty surrounding the meaning of what constituted a private placement. In other words, a company that sought to issue stock in a private placement could never know for sure (except in really extreme cases) whether investors could come back to bite the company and its principals simply because the company wound up failing. This set up all sorts of situations where lawyers could second-guess the offering even a long time after the fact because they could always point to this or that fact or circumstances that they would argue took the offering out of the 4(2) exempt category and subjected it to registration requirements. This uncertainty made it risky for companies to attempt to raise capital via private pla...
We basically agree on the purpose and utility of regulation D. By clearing defining what the safe harbor provisions are, it opens the doors to capital formation for small business without imposing hugely expensive compliance requirements, and I am heartily in favor of keeping capital formation a relatively simple process - especially in times like these when credit markets remain chilly and many otherwise healthy or promising businesses are unable to expand for lack of ready capital. I also agree that imposing stricter fiscal requirements for accreditation risks shrinking the liquidity pool and thus starving one of the most dynamic segments in the economy, with serious implications for job creation and economic growth.
Now, you mention that this legislation, if enacted pushes the SEC in a regulatory direction that will make this area more litigious, and here we differ, although I know I am presenting a rather flimsy theoretical opinion against your solid empirical one! It seems to me that you're assuming a shrinking liquidity pool will drive entrepreneurs to engage in increasingly risky behavior in order to develop their businesses; if the pool of accredited investors shrinks then capital will have to be sought from unaccredited ones, and uncertainty will ensue, followed by painful and expensive legal wrangling when a good portion of these ventures fail or underperform.
But is it not rather simplistic to assume that if the supply of investors is artificially constrained, the demand for investment will necessarily run towards the same uncertain and litigation-prone methods of capital formation that preceded the establishment of Regulation D? Might we not instead see an increase in the number of partnerships or directorships taken up as a condition of investment, but still in accordance with other safe harbor provisions of regulation D besides those based on the net worth of a natural person?
I am not attempting to argue this as a debating point. Rather, I am seeking to understand why you anticipate one outcome rather than another. For example, is it your professional experience that angels are tolerant of risk but don't wish to shoulder the various obligations of a directorship, whether due to the burdens of compliance or because it might compromise their objectivity as investors? Is the distribution of wealth such that an increase - say, a doubling - of the financial barrier to accreditation necessarily halves the size of the capital pool, or shrinks it in direct proportion to the number of angels? In other words, if middling investors with more than a million but less than two all disappeared from the angel pool, what of the fact that no upper cap on the assets of wealthier angels exists - a newly imposed $2m threshold is of no material consequence to an angel with $10m to invest, whereas the middling investor's capital contribution is necessarily limited to less than the accreditation threshold. Finally, such restrictions might create opportunities for business development companies, not unlike YC, which are large enough to shoulder the burden of compliance and act as reliable brokers for high risk investors (eg a hedge fund manager who might wish to put 1% of his fund into high risk ventures with great upside potential and can easily offset the risk with more pedestrian investments, but lacks the time or expertise to seek out many tiny startups). The 'shotgun' approach of investing small sums in many disparate ventures with the understanding that only a few will yield significant returns could probably be formalized and maybe even simplify the capital formation process for startups, as YC seems to be doing. It seems to me that one of the most common and frustrating questions for new entrepreneurs is where to find an angel in the first place - for many people and industries, finding someone who can listen to and act upon your pitch is mysterious, so I feel there's an unmet demand here for business development as a kind of brokerage service.
I don't mean this as an en...
1. Under existing law, startup companies can raise money easily and quickly from "accredited investors." There is no need for the companies or the investors to gain approval from any state or regulatory official.
2. This would change if Section 926 of the Dodd bill is included in any final reform legislation. That section would require, for the first time, companies seeking angel investment to make a filing with the Securities and Exchange Commission, which would have 120 days to review it. This would both raise the cost of seeking angels and delay the ability of companies to benefit from their funding.
So, in other words, the bill's not even finished being drafted and they made some noise about maybe adjusting some figures, but they have CPMs to sell so they'll just assume "adjust" means "multiply by 2.25" and get the snappy headline.
That said, Dodd clearly shouldn't do anything to hurt actual startup investment.
- Whatever the problem is, is it a problem?
- Does this solve it?
- Who is paying/lobbying Dodd to do this? I imagine it wasn't on his radar until someone who stands to gain brought it to his attention. Is it just Tourette legislation?
- If the result will be as bad as the article says ... how/why do we let Congress get away with fucking things up?
tl;dr the SEC was worried that the explosion in house prices during the 90s (which raised many people's net worth above the accreditation threshold set in 1982) and the parallel increase in both the popularity and complexity of private investment offerings were tempting many people out of their financial depth. Large numbers of people borrowing against the value of their home to invest in hot deals without much understanding of the risks involved struck the SEC as a dangerous situation.
Arguably, the events of the last few years proved them correct. The SEC was not trying to strangle startups (nor was it blind to the the possibility of such a result), but to maintain a barrier between overconfident homeowners and glib fund managers whose only business case was that markets tend to rise over time.
If Democrats left to their own devices do dumb things, why should we want to let them stay in power?
What's wrong with holding Democrats responsible for their proposals?
Remind me - did you complain when Dems did that to Bush? (Pre 2006)? You remember - "Disent is patriotic" and all that. Or is that somehow different?
Of cours, the Repubs actually do have proposals. You don't hear about them in the "tingly leg" media, so you'd have you'd have to look elsewhere. Or is that their fault too?
I do not care for the zero-sum outcomes which often result from or are promoted by the adversarial nature of our political system. But I learned very early in life that no matter how bitter a competition becomes, almost all the spectators are united by a disdain for the referee.
This cartoon humorously summarizes my worldview; I like that fellow with the pipe. http://i171.photobucket.com/albums/u316/sisdecadence/subgeni...
Interestingly enough, your "pragmatic approach" involves chiding Repubs for not making proposals even though they actually did.
Why are you blaming Repubs for your ignorance of their proposals? (I'm not saying that it's necessarily wrong to blame them - I'm asking why you are doing so.)
btw - You do realize that the fellow with the pipe is a smug parasite, right? Snark, while "cool", isn't actually productive. It's a way to feel superior without actually doing anything that justifies the feeling.
I also have to say that the accredited investor rules do not exactly prohibit you from investing in startups. Or from owning stock. They are part of a complex securities regulation framework and it is difficult to explain in a quick message board post exactly where they fit in.
- day-trading
- real-estate-speculation
- investing in 'safe' public stocks like Enron, Fannie Mae, Lehman, and GM
- trading forex following rules they learned from late-night-informercials
- gambling in licensed casinos offering rigged games
- buying state lottery tickets
All these often-negative-expectation activities are allowed. So what, exactly, do the 'accredited investor' limits prevent a gullible person from doing? A fool will be parted from his money; these rules just change the form of the transactions that will be used.
Meanwhile, the limits prevent wise-but-poor people from being shareholders in small businesses that they actually have some expertise about, and which are more likely to be positive-expectation than the above activities.
For example Enron had to work hard to fool all those accountants, and as a result one of the largest accounting companies in the world went under and many of its partners are still mired in lawsuits. The banks created a very convoluted system to mislead investors as to the value of their securities, which involved a lot of new legislation, somehow tricking or corrupting the ratings agencies, controlling markets, etc.
So scams happen, but they are not as easy. Of course I think securities laws could stand improvement.
But we do not have the case where there are so many scams on the stock market that everybody assumes that everything is a scam and nobody invests, so the stock market is essentially useless. This is the case for many (actually most) countries.
Second, to turn your argument on its head, why not get rid of the limits altogether? Let anyone invest in anything, whether or not the investment vehicle is registered with or reports to the SEC. Sounds great, right? Unfortunately, historical experience with this approach is that people get ripped off left, right and center, and taxpayers end up holding the bag.
True, taxpayers end up holding the bag for a lot of things anyway. I'm not sure how to fix this, but I'm pretty sure that removing all limits on the size of bags ain't it.
We float in a sea of fraud. The investment laws are not about stopping it, they are about giving Goldman Sachs a percentage of every fraud. Goldman would implode tomorrow if random assholes could just cheat each other directly. Take the fucking red pill, Neo.
The historical evidence is that complete fraud control produces water empires that are destroyed by the first barbarian to ride into town. The destruction is generally so complete that a dark age follows. Forget taxpayers holding the bag, you need archeologists to figure out what happened from the bits of that society that would not burn.
Conversely, the Western Enlightenment showed that you can get growth and prosperity undreamed by the kings of old even in the face of pervasive investment fraud. What counts is a culture of liberty, optimism, and a commitment to basic policing. Or to put it another way, it's worth the life savings of a lot of senile grandmothers if the wild-eyed schemer sometimes actually delivers a goose that lays gold eggs.
...which limits them to a tiny fraction of the private investment opportunities available to millionaires. Why make things harder on the wise-but-poor? Or those who have wise-but-poor friends-and-family?
...to turn your argument on its head, why not get rid of the limits altogether...
That's not the argument on its head -- that's the argument itself! Net-worth-based discrimination has no place in securities regulation.
If an unwise or gullible person can throw their entire net worth -- and then some, via leverage -- into a single risky real-estate transaction, or risky options trade, or risky loan to an unreliable acquaintance, or risky superbowl wager -- then there's no rational basis for preventing them from buying private securities.
Some will be burned, and learn (and teach others via their example). They'll do better the next time -- as with all the other expensive failures we let people experience with their own money.
Fraud can be prosecuted under existing fraud laws. And the majority of honest entrepreneurs and wise-but-poor investors will have many, many more opportunities to explore the small-business solution-space with angel capital.
And irrational exuberance, not fraud, is how the masses lost the bulk of their money -- then and now.
We just lost trillions in real estate value. Should non-millionaires be prohibited from buying real estate, by law, because circumstances have shown they're just too feeble-minded to make such investments? That would be a modern equivalent to 'accredited investor' rules originating from depression-era biases.
While grellas and I disagree upthread about the intent and ramifications of this proposed change, we concur that the alternative (of an unspecific regulatory environment) is messy, unpredictable, and expensive. Libertarians often point out that disputes are inevitable are best resolved on their individual merits in a court rather than via pre-emptive regulation. This is a fine ideal, but my limited experience as a party to a few legal disputes is that going to court erodes commercial productivity like nothing else.
If you wish to solicit funds from the general public for a profit-seeking enterprise, you have to include a huge number of disclaimers and warnings with your offering and pay a very expensive securities lawyer to evaluate and sign off on your compliance with SEC regulations, or you face a very high likelihood of getting prosecuted for mail fraud and multiple other offences.
You may be a smart individual or an ethical entrepreneur, but the empirical evidence is that the general public is rather naive, poorly informed about risk assessment and financial engineering, and there are a lot of people out there eager to exploit this fact.
It would be nice if we could do without police and fire departments and pay less tax as a result, but crime and outbreaks of fire are annoying realities whose costs typically exceed those of professional emergency responders.
There's more than one way to build a command economy...