With the JOBS Act, The Private Funding Market Gets Its Chance

In mid-July, the Securities and Exchange Commission approved groundbreaking regulations that will change the way companies interact with, and raise money from investors. The Commission voted -- nearly one year past its deadline from Congress -- to implement a key section of the JOBS Act by lifting a decades-old ban on mass marketing private securities offerings.

According to the SEC, private markets already raise considerably more money for companies than their public counterparts, with $1.7 trillion raised privately compared to $1.2 trillion raised publicly in 2012. In addition to being able to engage wealthy friends and family, it will now be possible for companies and investment funds to advertise private securities to the general public via the Internet or social media platforms such as Facebook or Twitter. Provided that the ultimate buyers are qualified institutions or one of the country's 8.7 million "accredited" investors, these securities do not have to go through the costly and time-consuming process of being registered with the SEC.

In voting to lift the ban, the SEC opted to propose -- but not yet adopt -- a number of additional disclosure requirements and investor safeguards that would signify an attempt by the agency to begin regulating what has been a largely unregulated private market. While this approach drew fire from both consumer and free-market advocates, the SEC's decision to open the door to mass marketing of private securities and temporarily hold off on new regulations sets the stage for a crucial experiment of whether private capital markets are able to police themselves and ensure market integrity.

Once the new rules take effect in September, if incidences of fraud are low and the new regime allows American companies to increase their access to capital, pressure will mount on the SEC to embrace other 21st century tools and technologies that directly connect companies and investors. Earlier this year, the SEC already allowed public companies to issue corporate disclosures to investors through social media. And the SEC is currently working on regulations that will legalize public securities crowdfunding, which will permit unregistered sales of small equity and debt offerings to the general public through the Internet.

On the other hand, if the new climate opens a Pandora's Box of investment scams, abuses, and boiler rooms this will likely lead to significant new regulation, which would almost certainly include raising the bar to qualifying as an accredited investor by demanding higher income or net asset thresholds. The SEC would also likely increase regulatory burdens on a nascent public crowdfunding industry.

So, how will the online marketplace likely develop in the coming months? For companies raising funds through private markets, many will opt to advertise their offerings on web-based investment platforms that help to aggregate and verify accredited investors, as well as facilitate efficient transactions. Investors would look to these platforms for quality-control, standardization, and filtering of opportunities to match an investor's preferences.

Self-policing has its precedents, and has become more effective as technology has improved. eBay, for example, has shown the ability to ensure market integrity with its online auction marketplace and vigilant user-base; so too has PayPal, which created algorithms to detect internal fraud, instead of relying on law enforcement. If private capital markets follow similar paths, then we should expect that investors ultimately will be attracted to a limited number of platforms with strong reputations for vetting companies. Effective platforms will also have to be transparent in communicating to investors the risks involved in investing in startup and small businesses.

Alternatively, regulators will likely react with concern if the marketplace instead fragments into a chaotic structure, with individual companies pitching investors directly without relying on reputable investment platforms to serve as intermediaries. In this scenario, investors would be bombarded with investment solicitations with little standardization in how information is presented and transactions facilitated.

Hopefully, the wisdom of the SEC's regulatory restraint will be justified by forces of market innovation that result in larger yet sound private capital markets. By holding off on new regulations, the SEC can observe how the industry will develop and experiment with creative new approaches to offering and selling securities to investors. It may well be that additional investor safeguards are required, but it is nearly impossible to prescribe those safeguards before first allowing a new, dynamic internet-based industry to develop.

Given the attention that private capital markets will receive from regulators as they await comment on their new proposed regulations, the industry does not have long to demonstrate that it can take care of itself and its investors. If it succeeds in doing so, however, internet-based democratization of finance will only gain momentum. Success with accredited investors could bode well for the SEC's treatment of public securities crowdfunding as well, which is still waiting for Commission action.

Daniel Gorfine is the Washington-based Director of Financial Markets Policy & Legal Counsel for the Milken Institute.