Private Offerings and Public Ends: Reconsidering the Regime for Classification of Investors Under the Securities Act of 1933

To achieve a growing number of public, social, civic goals, we draw on the power of financial markets.  Parents who can afford to save for the cost of their children’s college education rely on the market when they put money into college savings plans like New York’s 529 College Savings Program, for example, and so do workers counting on pension funds to provide income in retirement.

As long as these investments produce the needed return, all is well, but when they do not, they undermine the public end they were supposed to serve. The riskiness of investments made in service of a public goal matters.

There are different ways to limit how much risk an investor takes on.  One is to impose a fiduciary duty on a fund manager, for example, requiring that the level of risk be consistent with the goals of the future retiree.  My article addresses another method:  Restricting investment in securities more likely to be high-risk and, consequently, less certain to produce the return needed to achieve the goal of financially secure retirement.

The article addresses securities sold in private offerings, which are exempt from the formal registration requirements imposed by federal securities laws.  Federal regulations require buyers to be wealthy and/or sophisticated investors.  The reasoning is simple:  These are investors who can take care of themselves.  So stated the Supreme Court in the widely taught case, Securities and Exchange Commission v. Ralston Purina Co.: “An offering to those who are shown to be able to fend for themselves is a transaction ‘not involving any public offering.’”

This rationale offers cold comfort to those depending on the decisions of one of these wealthy and ostensibly sophisticated investors–say, a private equity fund in which a public pension fund in turn invested–to provide retirement income. But an investor’s institutional mission is not a factor in the analysis of eligibility to invest in a private offering.

Rather, accessibility of private placements turns on easy-to-measure, objective criteria, including wealth, income, and assets under management. (To learn more, look at 17 C.F.R. §230.501(a), here, and §506(b)(2)(ii), here.) A good number of scholars have criticized this categorical approach to assessing whether a particular individual or entity should be allowed to invest in a private placement.

To be clear, it is not necessarily the case that unregistered securities are always riskier than the publicly traded kind. They just could be. Consider: The financial crisis that began in 2008, which showed that putatively savvy and sophisticated institutions actually did not know better than to bet that real estate prices were immune to gravity, did not spare public pension funds.  One way that public pension funds were exposed to declines in real estate prices was through securities purchased in private placements. Private equity and hedge funds have wooed public pension funds to buy in private offerings.  Some pension funds have since decided the risk is not worth the return.  CalPERS, for example, has moved away from investing in hedge funds, though to reduce costs – fees are high – as well as risk.

Imposing limits on institutions whose investments serve certain public goals, like providing income to retirees, has an intuitive appeal.  The more important the public mission of an investment, the better that investment should be insulated from an adverse outcome, so that the goal can be achieved.

In a sense, this argument builds on the thesis of prior work, which proposed adjusting the pleading standards confronting plaintiffs who allege securities fraud. I summarized the argument here.  My focus in that project was the advantage conferred by the pleading standards on investors in private offerings relative to those who bought on public exchanges.  That article considered remedies for investors ex post, while this one considers measures that could apply ex ante.

One obvious challenge to restricting investments by what I am calling public-serving entities is figuring out whom to apply them to.  Perhaps public pension funds present the easy case, at one of the spectrum, but what about other entities on whom vulnerable third parties rely?  To what extent do insurance companies, for example, perform a public mission, because their operations help mitigate harm otherwise suffered by policyholders?

The term “public” is itself looking more slippery, and that is part of the challenge. In the context of securities, the word does not have quite – or only – the meaning given by the dictionary. Scholars like Hillary Sale, Donald Langevoort and Robert Thompson have suggested a sophisticated understanding of what it means for a company to be public, going beyond a definition resting on its ownership structure.  After all, companies that are privately held can have broad effects on the public through their business conduct. All I suggest is that an investor’s goal also should be relevant to assessing publicness.

A good place to start is the name and mission statement of the investing entity, then. Again, public pension funds, whose mission statements typically spell out their raison d’etre, are an easy case. Assessing other types of investing institutions might require more analysis, and presumably a number of them would resist a classification that would limit their investment activity. But this seems a more fruitful exercise to pursue than attempting to assess actual investing acumen or raising the dollar amounts currently in Rules 501 and 506.  The nature of the investing mission should matter.

The preceding post comes to us from Jonathan D. Glater, Assistant Professor of Law at the University of California Irvine School of Law. It is based on his article, which is entitled “Private Offerings and Public Ends: Reconsidering the Regime for Classification of Investors Under the Securities Act of 1933,” forthcoming in the Connecticut Law Review and available here.