The Dark Side of Safe Harbors

Safe harbors are useful and nifty. Consider the SEC’s accredited investor safe harbor under Rule 506 of Regulation D, which allows private securities offerings to sufficiently wealthy investors. Rule 506 facilitates capital formation and promotes efficient markets. Yet it also does more than it acknowledges. Accredited-investor private offerings largely occupy the field – even though the rule doesn’t prohibit other private offerings.

As I argue in a new article,  safe harbors have an unacknowledged dark side. On its face, a safe harbor only protects described facts and does no more. But in practical application, a safe harbor often acts as a bright-line rule that, in effect, penalizes situations beyond the safe harbor line. A safe harbor does not say that it prohibits non-safe-harbor behavior, but in practical effect it often has a silent implication that prohibits non-safe-harbor behavior.

A safe harbor’s silent implication causes collateral damage to non-safe-harbor facts. An example is the de facto exclusion of non-accredited investors from participation in private offerings. Sometimes, although rarely, that silent implication is illegal. For instance, the accredited investor safe harbor would produce an illegal result if the securities law statute made it illegal to block less wealthy investors from private offerings. If the practical effect of a safe harbor is illegal and the lawmaker intends or controls that illegal result, then a plaintiff who suffers collateral damage should be able to persuade a court to invalidate the safe harbor.

Safe harbors solve a problem of limited information and resources. One doesn’t need to know everything about a field of regulation to make a safe harbor. One only needs to be confident that the facts within the safe harbor satisfy the law. This is a great fit for expert agencies like the SEC. They can set  rules for known and repeated situations while leaving other parts of the regulatory field open to later rulemaking by other institutions, like courts. Meanwhile, regulated parties generally get two things they most want from safe harbors: a good answer, and a certain one.

The SEC’s accredited investor safe harbor as a practical matter not only protects accredited investors but also excludes non-accredited investors from private placements, despite other provisions that plainly allow private placements by non-accredited investors in some cases. The Title IX “substantial proportionality” safe harbor, which emerged in the 1990s to measure gender equity in college athletics, not only boosted women’s rowing but also reduced men’s wrestling. A 2004 Texas Education Agency announcement, which promised it would not scrutinize school districts with 8.5 percent or fewer students receiving special education services, protected some school districts from audit scrutiny while denying some students services they were entitled to under federal law.

There is a discontinuous jump from a 0 percent chance of penalty to a positive possibility of penalty at the line a safe harbor draws. Because of this discontinuity, as I wrote in 2016, behavior converges at the safe harbor line. As I argue in my current paper, when an intermediary is involved – like a private-offering issuer, a university athletic department, or a Texas school district – the tendency toward this convergence increases.

Intermediaries decide how to implement safe harbors on behalf of their owners, lenders, employees, students, and other stakeholders. A classic intermediary is a corporate compliance department, charged with enforcing the law within the corporation. A core goal of compliance is to avoid government enforcement – and higher penalties – by preventing misconduct internally. Accordingly, compliance department intermediaries are by design risk averse. This makes the safe harbor advantage of zero compliance risk particularly attractive and increases the likelihood that a safe harbor will be treated as a bright-line rule.

Intermediaries also have monitoring costs. They seek to ensure that employees properly implement compliance policy. This factor, too, leans in favor of treating safe harbors like bright-line rules. The uncertainty of questions where a safe harbor is silent – such as whether unaccredited investors can participate in private offerings – may not translate easily to clear internal policy.

Finally, intermediaries have multiple stakeholders. When an intermediary implements a safe harbor as a bright-line rule, it can choose to impose collateral harm on weaker stakeholders. In the Title IX substantial proportionality example, universities cut nonrevenue men’s teams, like wrestling and swimming, to move toward compliance. They did not cut football.

The SEC’s accredited investor safe harbor apparently has overwhelmed the private offering landscape. Accredited investor offerings appear to make up the overwhelming majority of private offerings – even when other exemptions might also apply. Yet the collateral harm of discouraging non-accredited investor private offerings doesn’t mean that the accredited investor safe harbor should be invalidated. The possibility of invalidation should only come into play if it were illegal to bar less wealthy investors from private offerings, and if the SEC intended that result or controlled the intermediary that produced it.

To create the possibility for such an invalidation, in some situations a person injured by the bright-line application of a safe harbor should be able to sue not only the intermediary that directly caused harm, but also the government that indirectly caused harm. If a safe harbor causes an intermediary to act, the government can be made a defendant under third-party causation standing doctrine. For instance, the Fourth Circuit concluded that cut male athletes had standing to sue the federal Department of Education, as well as their university, in a challenge to Title IX substantial proportionality guidance. The athletes lost when the court decided that the guidance complied with the statute and with the Constitution’s Equal Protection Clause. But the case still shows that plaintiffs can sometimes sue the government if they are harmed when an intermediary treats a safe harbor as a bright-line rule.

In the case of the Texas Education Agency, the safe harbor promised immunity from further scrutiny for school districts with 8.5 percent or fewer special education designations, against a starting backdrop of about 12 percent. In this case, a plaintiff could likely have established a causal connection between the agency guideline and the denial of services. Then, the plaintiff could have sued both the agency and the school district. In such a suit, a court should have invalidated the 8.5 percent guidance. Federal law requires that every eligible student receive special education services, so the guidance caused an illegal result. Further, the result appears to have been intended, and the education agency exerted control over the intermediary school districts because of state control over local law.

A lawsuit was not necessary in the Texas special education case. Instead, a 2018 letter from the federal Department of Education  persuaded Texas to pull the policy. But in similar rare cases when a safe harbor produces an illegal result intended or controlled by the lawmaker, invalidation can be an appropriate remedy.

In other cases, when a safe harbor produces collateral but not illegal harm, lawmakers might consider whether and how to mitigate that harm. It may not be illegal to exclude unaccredited investors from private offerings. Nevertheless, one proposal encourages the SEC to assist individuals unsure of whether they are accredited investors — by creating yet more safe harbors.

This post comes to us from Professor Susan C. Morse at the University of Texas at Austin School of Law. It is based on her recent article, “The Truth About Safe Harbors,” forthcoming in the Tennessee Law Review and available here.

1 Comment

  1. Bruce E. Methven

    I am puzzled. Rule 506(b) is a private-offering safe harbor that allows up to 35 non-accredited but sophisticated investors. Are you proposing a different approach?

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