What entrepreneurs need to know

By Neil Hare

When most of us think of the Securities and Exchange Commission (SEC), we think of a government agency created to ensure that publicly traded companies provide investors with accurate information, that employees who have access to “inside information” do not trade on it, and that investment professionals do not exploit, misinform or defraud the average investor in Main Street, USA. We certainly do not view the SEC as a tool for broadly regulating private companies trying to raise capital, especially during a downturn in the economy that many believe is headed for a recession.

President Ronald Reagan famously answered his rhetorical question of what the nine most terrifying words in the English language are like, “I’m from the government and I’m here to help.” While we can take that notion with a grain of salt, the truth is that the SEC is one of the most powerful government agencies you may know the least about, and under its current leadership it is aiming for a dramatic increase in its oversight. , regulatory requirements and enforcement by all US companies, including increasingly private companies.

The Great Depression spawned the SEC

The SEC was created by Congress in the aftermath of the Great Depression through the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. In short, one of the reasons for the stock market crash of 1929 was that public companies false and misleading information to investors. To restore public confidence in the securities markets, Congress created the SEC with a mandate to ensure that companies make truthful statements and that brokers, dealers and exchanges treat investors fairly and fairly.

The SEC is considered an independent agency, meaning that while it is part of the executive branch, it has regulatory and regulatory authority outside of presidential control. This is largely because the president’s ability to fire the bureau chief or a commissioner is limited. The SEC may also take civil enforcement action to issue court orders to prevent future violations and civil fines and payout of illegal profits. The SEC cannot take criminal action, but it does work closely with the Department of Justice in support of criminal enforcement or securities violations.

The SEC is also intended to be bipartisan, requiring three of the five commissioners to be from one party and two from the other. Commissioners are appointed by the president and confirmed by the Senate. SEC rules or regulations have the same force as federal law. Other comparable independent agencies include the Central Intelligence Agency, the Consumer Financial Protection Bureau, and the Commodity Futures Trading Commission.

Private companies survive and thrive on debt

For private companies, small or large, access to debt is one of the most important drivers of growth and critical to running a business effectively. For decades, studies have shown that access to capital is the number one concern of American entrepreneurs.

Many private companies would prefer to secure capital through debt rather than equity investment for a number of reasons. First, most business owners don’t want to dilute their ownership in the company they founded or give up management control over the entity unless absolutely necessary. Second, and related, investors don’t want to make equity investments in companies, small or large, that may not scale sufficiently or fast enough for a significant return on investment, or in companies that they would have little to no control over.

Therefore, private companies often look for debt instruments from lines of credit or loans from their bank, SBA loans, crowdfunding debt, or by issuing debt instruments, also known as bonds. It is this last type of debt that the SEC has decided to regulate without much reason or by soliciting feedback from the public, as usually happens in the regulatory process.

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SEC attempts to regulate private company debt securities How did the SEC achieve this feat? They did this by taking a rule designed to protect investors who trade in the over-the-counter securities market, known as “pink sheets” or penny stocks, and deciding that it also applied to this debt offered by private companies. The rule they used is 15c2-11, which came into effect in 1971 to protect investors from being bullied into buying worthless penny stocks from unscrupulous and nefarious cold callers posing as stockbrokers. You can watch the movies Boiler room or The wolf of Wall Street to get a picture of this phenomenon.

In 2020, the SEC decided it was necessary update Rule 15c2-11 correspond to technological advancements that have changed the way people invest. Many investors no longer even have landlines to accept cold calls, instead participating in chat rooms on Reddit and other social media sites to make investment decisions – often bad ones. This signaled a need for change.

However, in a surprise move a year later, SEC staff declared that the requirements of Rule 15c2-11 also applied to privately issued debt instruments, and in December 2021, the SEC reaffirmed this position. In addition, the SEC did not follow the typical regulatory process of allowing time for public comment on the proposed amendment. On November 30, 2022the SEC stated that enforcement of the new rule will take effect in January 2025.

It is important to note that one of the main reasons companies remain private is that they do not have to disclose their financial information and bear the accounting and legal costs of doing so under SEC regulations. Rule 15c2-11 is an exception to SEC Rule 144A, which exempts private companies from filing public financial filings, such as companies that are publicly traded. Debt securities issued by private companies under Rule 144A can generally only be purchased by qualified institutional buyers (QIBs), which are institutions with more than $100 million in assets under management.

The average investor on the street cannot buy these securities. QIBs can request financial information from companies that issue this debt, but they are not required to disclose it to the general public. In addition, there is currently no proposed rule change to allow retail investors to purchase this debt. So instead of following its mandate to protect investors, by changing this rule the SEC could have a chilling effect on private companies accessing capital during a volatile time in our economy.

Is the SEC overstepping its authority?

Whether you own a private company, work for a public company, or invest in the securities markets, you should be aware of the SEC’s role in regulating these fundamental aspects of our economy, which is the strongest in the world.

The SEC is crucial to transparent and fair markets, but that doesn’t mean it should overstep its authority. Certainly, imposing the same disclosure requirements and regulatory burdens on private companies as they do on public companies is an area that needs close scrutiny.

About the author

Neil Hare is a lawyer and president of GVC strategies, where he specializes in small business policies, advocacy and communications campaigns; follow him on Twitter @nehare and further LinkedIn. See more articles by Neil and the full bio at AllBusiness.com.

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