The era of “unicorn” companies operating without the requirement of audited financial statements may be coming to an end, as SEC Commissioner Caroline Crenshaw warns that regulations have failed to keep up with the fast-growing private markets.
Crenshaw, a Democrat appointed by former President Donald Trump, emphasized in a speech that the current Rule 506 of Regulation D, which exempts private issuers from disclosing information to the public, is outdated. This rule was put in place in 1982 when private companies were much smaller and sophisticated investors were considered to have access to the necessary information. However, with many startups now raising billions of dollars from a broad range of investors, the current system needs an update.
“Like the children’s book, the Very Hungry Caterpillar, unfettered access to capital through Rule 506 has had a bloating effect on private issuers,” she said. In prior decades, small private issuers who grew had to turn to the public markets to sate their capital needs, now Reg D, among other legal and regulatory mechanisms, has allowed for the development of pools of private capital sufficient to satisfy the needs of even the largest private issuers.
Crenshaw suggests revamping Reg D to resemble Regulation A, a tiered system where reporting requirements increase with the size of the offering. She said that private companies have grown in size and significance to investors and the economy, and they should have the same safeguards in place as public companies. The SEC has already announced its intention to consider changes to Regulation D as part of its rulemaking agenda.
The clearest evidence of a need for change may be the mere existence of the once-mythical (but now ubiquitous) “unicorns” – private issuers valued at over a billion dollars. When the term was first coined in 2013, there were 43 unicorns. There are now more than 1,200.
“And, relevant here, these unicorns have consistently relied on Rule 506 of Reg D to raise billions of dollars in U.S. capital,” Crenshaw said. “Make no mistake, Reg D has helped pave the way for the advent of the unicorn. Not only can the companies rely on Reg D to raise capital as small businesses, but they can keep raising capital, and keep growing, indefinitely while staying in private markets. The exception is no longer narrow.”
There are consequences when issuers are allowed to grow so large without any of the requirements of registration.
Chief among them is investor protection, Crenshaw said.
Investors are simply not protected in the same ways in the private markets as they are in the public markets. The Rule 506 safe harbor provides insulation from state blue sky laws and from the registration provisions of federal securities laws.
“The current logic for that exemption, more or less, is that if investors are accredited, there is no need for any baseline regulatory disclosure obligations,” Crenshaw said. “Many would say, in fact, that large private issuers are backed by the most sophisticated investors in the world and don’t need the SEC to impose disclosure or corporate governance protections. I am concerned, though, that sophistication is not quite the safeguard it’s presumed to be.”
The relevant question perhaps should be whether investors have the information needed to bring “their sophisticated knowledge of business affairs to bear in deciding whether or not to invest,” Crenshaw said.
As private companies have gained increasingly large market power and as the pool of accredited investors has expanded – including venture capital, private equity funds, mutual funds, pension funds, and individuals that meet the requisite wealth thresholds – the de facto presumption that accredited investors need no disclosure isn’t panning out.
