FacultyFaculty/Author Profile

Overview of 4(a)(2) and Regulation D


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ANNA T. PINEDO: So our first session of the day is an overview of 4(a)(2) and Regulation D, and we have three panelists joining. Dave Lynn, who is the co-chair of Jenner & Block securities Practice. Dave is based in the Washington DC office of Jenner, and he's also the co-editor of CorporateCounsel.net, which is an important resource for securities lawyers, both in-house and at law firms; coauthor of The Executive Compensation Disclosure Treatise and Reporting Guide; of course one of the thought leaders in securities; and prior to joining private practice served in various roles at the Securities and Exchange Division.

To his left, Lona Nallengara, who is a partner at Shearman & Sterling in the Capital Markets and Corporate Governance group. And Lona returned to Shearman in 2017 after having held various senior positions at the Securities and Exchange Commission. Most recently, he served as chief of staff to SEC Chair Mary Jo White and was her principal advisor on policy development, rulemaking, strategy, and management. Prior to having joined the SEC, he was formerly at Shearman as well.

And then to Lona's left, Marty Dunn. Marty is senior of counsel in Morrison & Foerster's Washington DC office. Prior to joining Morrison & Foerster, he spent over 20 years at the Securities and Exchange Commission, where among other positions he served as chief counsel and deputy director and acting director of the SEC's Division of Corporation Finance. With Dave, he is also actively involved in CorporateCounsel.net.

So I'm going to, before turning the panel over to Dave, Marty, and Lona, make sure that we just lay the groundwork and ask a question of our audience and our web listeners. And we'll be doing this throughout the day today with each panel. So maybe just a basic question. In your experience, have you noted a preference in recent years for relying on Section 4(a)(2) instead of Regulation D, namely rule 506, as a safe harbor? Maybe we can, just by show of hands, get a measure of the view in the room.

OK. Well, no opinion. I'm sure that the panelists will have a lot to say about 4(a)(2) versus Rule 506 or using them in conjunction. So I'm handing it off--

MARTIN P. DUNN: I'll start.

ANNA T. PINEDO: --to Marty.

MARTIN P. DUNN: Hey, everybody. Good morning. So I think the way we're going to go about this-- I'm just going to start by, in the first 10 minutes or whatever, level setting us on what the heck we're all talking about. Where does 4(2) fit? It really annoys me that in the JOBS Act they felt the need to add a 4(b). So that had to screw up all of our references to 4(1) and 4(2) and try to do research and figure out how-- and I get it wrong about half the time, so forgive me. You do it 30 years and you say it one way. It's tough to just change it.

So the opening we have here is the slide you see, is what basically is the '33 Act? How does it work? And one of the fun parts of the '33 Act is it's completely written out of order. Section 1 is like the name of this is the Securities Act-- or 1 or 2-- and then 3 and 4 are exemptions. Section 3 are what people call securities exemptions, and Section 4 is transactional exemptions. And that's well and good, but exemptions from what?

I mean, if you read the thing in order, you get definitions when you don't even know where they go, and then you get exemptions from something you don't know what it's about, and then you all the sudden get what you're exempt from in Section 5. I don't know why they chose to do it that way. Who the heck knows? But it works.

And then even more fun is in Section 5. Section 5 is completely out of order. Section 5(a) says you can't sell security-- it basically is you can't sell till it's effective. You can only offer this way in the middle, and you can't offer it all until you file. So it takes the timeline and reverses it. But again, we get there. I guess that makes it so we can have classes like this and go through it.

So what is the basic requirement of Section 5? The original name of the '33 Act was the Truth and Securities Act, and the reason for that was it's all about disclosure. And how do you get to disclosure? You get through disclosure through the registration requirement of Section 5.

And if you look at Section 5-- because now remember, we're reading it out of order. So if you just look at the basic requirement of Section 5, it can be summed up in one sentence, which I always find useful when we start these conversations, which is every offer or sale of security in the United States is either registered, exempt, or illegal. That's what it comes down to. And if you want to teach a law school class, you can break that sentence up and have different classes on each, and that's the whole thing, right?

So there are important parts of that. Even when I was doing training at the SEC, the first day you get the younger folks or the newer folks in there, you talk about the "every" part. And if you look at a transaction that has multiple parts, sometimes there are multiple offers and sales in there, and you have to say have I registered each part? Have I registered each offer, or do I have an exemption for one? And that's really important, and I think it's useful in analyzing this stuff.

But if you look at "every," that not only means every public distribution. That means if I sell you a stock for $1, I need an exemption for that or I have to register. Now we have exemptions for it. And when you go back into the exemptions, basically 99.9% are exempt.

But you have to start the analysis and figure out how to think about it in the context of let me go through this transaction. Do I have an offer or sale? Do I have a security? Am I in the US? In which case, have I registered, or do I have an exemption? And I know that sounds really simplistic. I can't tell you how many times people will screw up because there's a series of transactions and they missed something in the middle of it.

Similarly, when I say "every," that includes resales, which we're not going to focus on this morning but is a big part of this. And so when I'm looking at resales, do I have an exemption for it? Well, let's go through the four main exemptions that we're going to worry about.

4(a)(1) is for any sale by anybody who's not an issuer, underwriter, or dealer. OK. Well, that wipes a lot out, right? And plus, dealers have their own exemption in 4(3). So everything that's not an issuer or underwriter, OK? Well, we'll talk underwriter later.

But the notion of resales and me asking if I'm an underwriter-- the basic definition of an underwriter includes I purchased with an intent to distribute. Well, how do you figure out what somebody's intent was? It is very difficult. So you have to go through the analyses there and you have to figure that out.

And at the same time, that leads me to one of-- it leads me to my two least favorite phrases that people use to misstate the securities laws. One is oh, that's a registered security. Doesn't mean anything. It's offers in sales, not securities. It's of securities, but you don't register the security. You register the offer on sale.

So when people walk up and say-- no, that meant in a transaction at some point in the past that transaction was registered, but I have a new transaction I have to figure out now, and do I have an exemption? It most likely is going to be 4(a)(1) because if it's a resale or if it's something afterwards. But you can't just say "registered security." Drives me nuts.

The other one is when people say oh no, these are freely tradeable. There's no such-- look for "freely tradeable" in the '33 Act. You're not going to find it, right? It's not there.

And so what they mean when they say "freely tradeable" is it was sold in a transaction such that it's not a restricted security under 144. That's what they really are meaning to say, except they don't really know what they're talking about. And so they say it that way because that's what everybody told them before. So no such thing. Even though it's a resale, even though everything was complied with before, look each time.

As an example of that, I will use a phrase that my friend Michael Hyatt told me 25, 28 years ago. We used to answer 144 questions in the chief counsel's office, and back then it was with a rotary phone, so your finger would slip off and you'd go crazy because you had to make 100 calls a day. And I would get a 144 question, which is very detailed. And I would go to Michael Hyatt because he was the 144 guy. I would ask him the question. He'd tell me the answer.

I'd walk back. I'd call them and tell them the answer. And then they'd say well, what if-- and they'd change literally one fact in the entire thing. I'd be like, yeah, I don't know. Right? And so I'd go back to Michael and ask him again.

And finally after this kept happening, I asked what I thought was a good question, and I said Michael, why can't I understand Rule 144? Why do I have to keep coming back to you? And his very Michael response was, well, to understand Rule 144, you have to understand the Securities Act, and you don't. Fair point.

So I set about making it as simple as I can so I can understand it when I have to figure it out. So that is my big advice on-- the first big piece of advice on looking at the '33 Act is remember to look at "every." Even if you think-- even if you know deep down I have an exemption, remember there is a transaction there you have to think about. So that's the big thing.

So I have to think about all the transactions. Well, why don't I have to register them all? And that goes back to what we're going to talk about pretty much the rest of the day and a good bit of tomorrow, which is the exemptions from that. 4(3) and 4(4), 4(a)(3) 4(a)(4), are for brokers and dealers, and they're pretty set forth. They're not what we're talking about today, right?

4(a)(1) is issuers-- everybody who's not an issuer or underwriter or dealer. OK. So I can worry about whether I'm an underwriter. 4(a)(2) is the exemption for issuers, and it is the exemption for transactions not involving a public offering-- private placements. And so that leaves us with the challenge of what's a private placement that Dave is going to talk about in just a minute. But it also leaves us with how do we figure these things out.

And the SEC went through a really good series of rulemakings in the late '70s, early '80s where they tried to create safe harbors so people didn't have to just go by opinion and go by subjective criteria and the like. And what they did under Section 4(a)(2) is they created-- it had been a series of exemptions under the 100, like Rule 146, and these things were all over there. But instead they combined them into one set of exemptions, safe harbor exemptions. And it said if you comply with the safe harbor, you do not have a public offering and you have the exemption under 4-- what then was (2), 4(a)(2).

But they said it's not exclusive. So at the same time as you can have the safe harbor, just like you can have 144, you can always make the argument that under the statute I have it. So it's nonexclusive. You always discuss 4(a)(2) and Reg D, because they both-- one doesn't trump the other. god, I wish I hadn't said that. It just came out.

And what Reg D does, very interestingly, is it sets up rule 501 to 508. I guess it's 500 to 508 now, because we used to have a note, and somebody in the government GPO decided you can't have notes anymore. It has to have a rule number. Who knows? I'm sure it's vital decision making.

And so what you have is 500 to 508. 500 explains it, and you've got definitions in there, and then basically the exemptions are what used to be in 504, 505, and 506. 505 became-- you remember 15 years ago, 10 years ago, there used to be S1, S2, S3 for registrations under the '33 Act? And then S2 got kind of squeezed out because S1 got bigger and S3 got smaller, and it squeezed out that middle ground. Well, that's what happened with 504, 505 and 506, is 504 got bigger, 506 got split into two, and 505 became useless.

So you've got a different set there of how this all works. But the key to know is if you comply with Reg D, then you've got an exemption and you're good to go. Where the rubber meets the road on Reg D is really rule 506 now. And so that's kind of setting it all up, and I'll let Dave start with 4(2).

DAVID M. LYNN: All right. Well, as Marty made clear, 4(a)(2) is the granddaddy of private placement exemptions. I mean, it is really what so many transactions are done on. They're either directly under the statute or pursuant to the safe harbor under 506, as Marty mentioned. So 4(a)(2) is definitely the most fundamental and important notion to what constitutes a private placement.

As Marty mentioned, it is a transactional exemption. It's in the four series of transactional exemptions. It's specifically an issuer exemption. It's available to issuers only. Obviously we'll talk later in the program about 4(a)(1-1/2), which looks a lot like 4(a)(2) but is involved for the exempting resale transactions. But when you look at 4(a)(2) itself, it's really only talking about issuer transactions.

I mean, one of the things that I think is always somewhat troubling about the amount of offerings that go on under 4(a)(2) is 4(a)(2) is just a few words. It's "a transaction not involving a public offering," and that's all we have to go on. Back in those days, I guess people felt much more comfortable writing legislation that was very brief. And so really the development of 4(a)(2) over the many years has been through the courts and the case law that has developed and through the way the SEC has looked at it, both in terms of guidance we may get dribbling out from time to time on issues under 4(a)(2) but also when looking at it through the lens of the safe harbors that were adopted in order to protect people who are seeking to do offerings under 4(a)(2).

And then as Marty also mentioned, these transactions result in securities that are deemed restricted securities. Really when you think about it, because what you're trying to do in a 4(a)(2) offering is de-issue or selling securities to another party for investment purposes and not for the purposes of effectuating a distribution indirectly to the public. So the securities are restricted in the sense that they are sold to those purchasers and then ultimately come to rest with them before they decide to sell them on to others.

MARTIN P. DUNN: And that's why you get reps and warranties in those transactions. You get a representation, I'm purchasing this to hold it. Because the issuer has to take some step to make sure that they, as Dave said, come to rest. And that's why you get legends and everything else on there.

DAVID M. LYNN: Absolutely. And I think in terms of what the framework is that we operate under today, the Ralston Purina case is probably the most frequently cited piece of decision-making made around 4(a)(2). It really set forth the factors that the court looked at in analysis and analytical framework, where the focus really is on the offerees. To have the availability of the exemption, you're focused on who you're offering to and not necessarily the actual purchasers of the securities. You're not looking at any sort of specific numerical test. You may be able to have a good 4(a)(2) offering to a relatively large group of individual or institutional investors, and you can't just draw a bright line around the number. And that gets again reflected in the safe harbor in 506(b), where you can offer to an unlimited number of accredited investors.

And also the focus again shifted, as subsequently reflected in the SEC's rulemaking on the wherewithal of those investors to make decisions about investing in the securities without the benefit of a registration process. And registration process provides specific disclosure in the form of the SEC's prescribed forms. It provides the SEC staff's oversight of the registration process, and it provides a liability regime that is specific to registered offerings. So really from the court's perspective and from subsequent courts' perspective, you're really focused on are these folks that are buying in this offering, or institutions, are they the type of persons that don't really need those protections and can make their own judgments about the investor itself? And also, another thing that the court looked at in this case was the access to information that people had-- that individually the investors might be in a situation really to access information about the issuer, whether through contractual negotiation or otherwise in a way that would then allow them to make an informed investment decision. So with that to go on, thus sprang forth the vast majority of private placements being done under either 4(a)(2) or Rule 506 of Reg D.

When you look at the comparative of 4(a)(2) to other offering exemptions, there's nothing in the statute itself or in the subsequent consideration in the courts that would limit the amount offered. Unlike in other provisions that we'll talk about, exempted provisions we'll talk about, we're not limited in any way by amount of offering. It's really available to any sort of issuer. It's not limited to only public issuers. Someone who has no reporting obligations, who's never registered with the SEC, can do a 4(a)(2) offering, as can a public company.

The notion of who the investors are again really focuses on the sophistication of the investors, their ability to make their own investment decisions and fend for themselves without the benefit of a registration process. Obviously, as Lona will talk about, that evolved into, under Regulation D, a notion of accredited investor. But you don't have to be an accredited investor to buy in a 4(a)(2) offering, unlike if you were relying on 506(b)-- then you either have to be an accredited investor or a non-accredited investor who has access to information that's specified in the rule.

MARTIN P. DUNN: And you know, Dave, I've always found it interesting in Ralston that they came up with the question of what is not a public offering. And the SEC had always given some notion that it had to do with the number of offerees or the number of purchasers or some number concept. And the court totally tossed that out. Reg D brought it back, in a way.

But the court totally tossed it out and went to who needs the registration? Who can fend for themselves? And I always thought that was an interesting distinction. I don't know where they got it. But on general solicitation and everything, they barely touch on that, and say for a nonpublic offering it depends on who you're selling to or offering to. But I don't think anybody thinks that under 4(a)(2) there's a notion of you can float a billboard out there, and so long as you only sell to rich people, you're OK.

DAVE LYNN: (LAUGHING) Right.

MARTIN P. DUNN: That's not what 4(a)(2) is about. There is still the notion of how are you offering it that I think you just can't read out of the statute.

DAVID M. LYNN: Yeah, absolutely. And I think that notion of that it's not public offering comes down to the fact that while I may use an intermediary who has access to investors through their own clientele or I may engage in some marketing efforts investor by investor based on preexisting relationships, either with the intermediary or with the issuer, I'm going to do this in a way that's not going to be perceived as public. I think over the years what exactly constitutes something that's public has changed a lot because sort of everything is public now. So it's much harder to, I think, find that line sometimes in looking at 4(a)(2) offerings as a result.

LONA NALLENGARA: Dave, how do issuers typically determine or get comfortable at some "sophisticated investor"? How complicated is that?

DAVID M. LYNN: Yeah. I think generally people rely on representations from the investors. And often, again, it leans towards why using an intermediary can be particularly helpful, because the intermediary has their own obligations to know their clients. And so when you're talking about selling, particularly to institutional-- or not to institutional investors, but to individual investors in a 4(a)(2) offering, I think those kind of protections are necessary. The vast majority of 4(a)(2) offerings involve institutional investors-- investments involving funds and the like-- and so there sometimes I think it's much easier to make that judgment in that context.

AUDIENCE: [INAUDIBLE]

DAVID M. LYNN: Yes, sir?

AUDIENCE: So with 4(a)(2), if you were doing a deal that would typically look like a 506(b) but you wanted to bring in, say, a finance professor who didn't make the accredited investor standards-- didn't have the income or the net worth-- could you bring him in under 4(a)(2) and say, hey, this is a sophisticated person who knows what they're doing? Even though they may not meet the accredited investor standards under Reg D, we've got a 4(a)(2) for this person.

DAVID M. LYNN: Yeah. I think in that context--

MARTIN P. DUNN: Dave, you want to repeat it a little bit?

DAVID M. LYNN: Oh, I'm sorry. You're doing an offering, and you want to involve someone who's a finance professor, for instance, who doesn't meet the accredited investor definition. Could you include them under 4(a)(2)? And I think that's the flexibility that 4(a)(2) provides, that you can make that judgment as to whether that person could be deemed as a sophisticated enough investor for the purposes of the offering.

MARTIN P. DUNN: Yeah. I agree, Dave. The way I would walk through it in my head is do I have 506(c)? Let's say no, because this person would not be an accredited investor, and I can't take-- no matter how many reasonable steps I take, I can't verify that he is, right? So I can't use (c).

Can I use (b)? Well, (b) has this funky thing in (b), where it basically comes down to you can have 35 sophisticated, but not accrediteds. It's not in the rule, but it's in how you count investors. It's very bizarre. And so I think I could probably figure out that this person was sophisticated, so I could rely on (b). But if I couldn't get comfortable for whatever reason-- I'm not sure why I couldn't-- then you fall back to 4(a)(2). So I would walk backwards through it. But certainly you could do it under 4(a)(2), or you could look to 506(b) and see if you fit.

AUDIENCE: If you relied on (b) there, would you have to provide them [INAUDIBLE]?

MARTIN P. DUNN: I mean, there are parts to that. At the same time, to do a 4(a)(2) without some kind of offering materials, although it wouldn't be the required-- again, you walk through the steps and you walk backwards, and ultimately you get to the statute, which the same goes for 144 and 4(a)(1).

AUDIENCE: [INAUDIBLE]

MARTIN P. DUNN: I'm sorry, where?

AUDIENCE: You have a blue sky problem too, because if you don't use Reg D, you don't have [INAUDIBLE].

MARTIN P. DUNN: I mean, you have to look at blue sky. You have to look at blue sky. But most blue skies have an accredited investor exemption, and you can probably squeeze into something at the state level. But you do have to look if you don't have preemption. You're exactly right.

LONA NALLENGARA: Practically speaking, your intermediary may be a little uncomfortable with having your finance professor participate in your offering. You can always squeeze them to make exceptions, but I've found that there's some discomfort in adding that random-- one of Marty's 35 in your otherwise good offering.

DAVID M. LYNN: I think we covered most of the rest of these topics in terms of the documentation. There may or may not be an offering memorandum, as Marty said. From a blue sky perspective, you do have to do your blue sky analysis because you don't have the benefit of preemption, but the state exemptions are often available.

And just to wrap up on my comments, I did want to just talk a little bit more about the bad actor disqualification provision, because I think when you line up 506 and 4(a)(2) now today, the most stark difference between the two really comes down to the bad actor disqualification provisions. Where in 4(a)(2) there is none-- nothing in the statute refers to bad actor disqualification-- while as in 506, beginning about five years ago, the SEC adopted rules that impose a bad actor disqualification. Those rules generally provide that-- similar to some of the other exemptions that you look at, like in Regulation A and Regulation Crowdfunding and the like-- when you have specific offering participants involved in any sort of the very specific types of disqualifying events, then the exemption isn't available as a result.

And in terms of who the covered persons are for bad actor disqualification, you're looking at the issuer-- any director, executive officer, or other officer participating in the offering process; general partner or managing members of the issuer; beneficial owners of 20% or more of any class of voting equity securities; investment managers to an issuer that's a fund of any director, executive officer participating in the offering; the general partner or managing members; promoters that are connected to the issuer at the time of sale-- persons who are basically paid solicitors in connection with the offering; and the directors, executive officers, and officers participating in the offering at those paid solicitors.

And in terms of the disqualifying events for this purpose, you're looking at certain criminal convictions, court injunctions, and restraining orders; final orders from state regulators, like securities, banking, and insurance and federal regulators; disciplinary orders that the SEC puts out against brokers, dealers, municipal securities dealers, investment advisors, and the like; SEC cease and desist orders; SRO suspensions; SEC stop orders and orders suspending a Reg A offering; and US postal service false representation orders.

So what has changed a lot about the private placement process is now that when 506 is relied upon because of the applicability of these disqualification events, a lot more diligence has to go into determining whether you may have some sort of bad actor disqualification situation. And I think that certainly changes the dynamic between should I do a 4(2) and a 506, just based on the type of the offering and the circumstances which the offering is undertaken.

LONA NALLENGARA: Dave, does the conduct disqualifying event have to have related to a private placement?

DAVID M. LYNN: Not specifically. And I would also mention too that there is a waiver process for this, and the SEC has put out some specific guidance as to the type of factors that they consider in the waiver process. So people should always think about that ahead of time or go back and check to make sure a waiver hadn't been obtained, particularly when dealing with intermediaries.

MARTIN P. DUNN: So one question I know was a big one when this was adopted is you can do a continuous offering under Reg D, right? You can do anything under Reg D or 4(a)(2). And so if I have a deal that goes on-- say I have a fund that goes on for two years. How often do people recheck, as a practical matter? When it first came out, people were saying probably six months. They weren't sure. Is that settled anywhere? I still keep hearing six months, but I don't know what people actually do.

DAVID M. LYNN: Yeah. I still have heard the six months, but I think it's going to depend on the nature of the offering.

MARTIN P. DUNN: Sure. And going back one step on, well, how does it make sense that Reg D is a safe harbor under 4(2)? 4(2) makes no mention anywhere of bad actors. So why is it in Rule 506? It wasn't in Reg D for years. How do we survive, right? Why did we all the sudden need this? Were there a lot more bad actors? Where did it come from?

And in looking at it, the very first proposal to add bad actor in I worked on just before I left the commission. That was about 10 years ago. They adopted well after I left. And that was a debate I had with the person who was holding the job that actually you hold. The chief of staff to the chairman sent me a kind of unpleasant email one afternoon just as I was leaving that said exactly the question I asked-- not as gently as I just asked it, but it was there.

And so I didn't answer that day. I thought about it overnight, the next morning came in and read up on it. And the reason it's in Reg D now and didn't have to be before is when Reg D was initially adopted, 4(2) was always there. When Reg D was adopted as a safe harbor under it, it didn't have bad actor. But remember, they weren't covered securities at the time, and every state had a bad actor provision-- virtually every state, enough to make it so it was regulated, right?

And so when covered securities came into the vernacular, all the sudden the state blue sky provision wasn't going to hold up a deal, and now the feds weren't going to hold it up either. And so it created this kind of a vacuum where there was no bad actor provision where the state side of it had been assumed for years. And so that's why the feds had to come up and write it into Reg D because of covered securities.

So that's why, although it doesn't seem to fit quite right with 4(a)(2) and Reg D, and says right there on Dave's slide "not applicable to 4(a)(2)." That's how that worked out and why it changed. And there was a problem there in the middle, particularly in Texas, where a lot of bad actors were getting a couple of lawyers who would write any opinion to anything, and it needed to be stepped up and dealt with. That's why you have the differences there.

Sorry, I like to ramble. It's what I do.

LONA NALLENGARA: So let's take a few minutes to talk about accredited investors. So when we look at Rule 506, as Dave and Marty have talked about, the critical piece of 506 is who you can sell to. And 506(b) or 506(c) allows you to sell to an unlimited number of accredited investors. And "accredited investor" in Rule 501 provides a definition. Lots of different categories, lots of different institutional categories. A bunch of regulated entities-- banks and savings and loans, broker-dealers-- all fall within the scope of accredited investor.

Then there's a bunch of other entities that have a $5 million asset level. Those are considered accredited investors. Executive officers and directors of the issuer are also considered accredited investors.

But where the real discussion has focused, particularly over the last few years, is on the individual and what individuals, like Ted's professor, whether the individual qualifies as an accredited investor. And there's two categories that individuals can fall under. One is if the natural person has a net worth in excess of $1 million, and the second category is whether their income exceeds $200,000 in the last two years with an expectation of it in the current year. And together with their spouse, that $200,000 level gets to $300,000 level. When you look at the net worth, there's some exclusions from that. You exclude your primary residence. And so that single asset that many people have as their primary asset would be excluded from your net worth calculation.

So that's the basic parameters of the accredited investor definition. And what it's intended to capture, at least what the rule describes it's intended to capture, is trying to capture financial sophistication and the ability to sustain some kind of loss. So that's what it's intended by the definition, that you're trying to get financial sophistication and the ability to sustain a loss.

MARTIN P. DUNN: Going back to Ralston, fend for yourself.

LONA NALLENGARA: Absolutely. But when you look at the individual level, they're really only talking about dollar amounts, right? They're talking about income level and they're talking about net worth level. Certainly that is a surrogate. I don't know if it's a good one, but it's certainly a surrogate for your ability to sustain a loss. But it doesn't necessarily indicate whether you've got financial sophistication. Lots of people have lots of money who have no sense whatsoever, so we have to make sure. So when there's discussion about the accredited investor definition, a lot of the focus is on have we really captured financial sophistication as part of the accredited investor definition.

And then this definition hasn't really changed since 1982, right? These are dollar amounts and categories that were set in 1982, and lots has changed since there. The pool of accredited investors that fit within that category has exploded. It's a much bigger number than it was then.

The way people communicate has changed, the way people get information. Back in 1982, you couldn't go on the worldwide web and figure out what a company does or who the people are or do background checks and understand what a company can do. So thinking about someone's financial sophistication in 1982 is maybe different than you'd consider financial sophistication. I have a 12-year-old son who knows more about investing in the stock market than I do. I'm not sure he's financially sophisticated, but he's certainly more financially sophisticated than I am.

So there are concerns on both sides of the accredited investor definition, on whether it's overinclusive or underinclusive. Some think that those dollar thresholds-- if you think about the dollar threshold, that $1 million net worth test and the $200,000 income test, if you put those 1982 dollars into 2018 dollars, you're talking about a net worth test of $2.5 million and a net income test of $500,000 to $600,000. That's a real difference than what we're talking about now. So those dollar thresholds haven't been adjusted for inflation at all since then. Some commentators have indicated at the very least we should be adjusting these dollar amounts for inflation.

And then on the underinclusive side, it comes back to the financial sophistication. No one's really focused on true indicia of financial sophistication when you look at the definition.

So what are some ideas? And there's been lots of discussion around this. In the Dodd-Frank Act, there was a requirement for the SEC every-- four years?

ANNA T. PINEDO: Four years.

LONA NALLENGARA: Four years to review the definition of accredited investor. And that was done-- the first review was required in 2015, and I think the report came out. The SEC did a report on the definition. It's a great read-- December 2015. I think you can get it on the website. It gives you a whole history of all the stuff that Dave and Marty talked about, talks about. And then it goes into the long detail about how we got to where we got to on accredited investor, and then a bunch of different ideas about how we can change accredited investor.

As you look at the pulls and tugs on the different interests on the accredited investor definition, I think one key fact you have to keep in mind is that there's going to be extreme resistance to changing anything that reduces the number of accredited investors, the aggregate number of accredited investors. There's always going to be pressure, because you're going to have-- and even with the SEC, they have their own struggle.

As you look at their mission, they've got a three-part mission. Two of them come in contact when you look at accredited investor. They want to protect investors. They want to make sure that the definition of accredited investor is adequately protecting investors. But at the same time, they have to facilitate capital formation. If you just adjust for inflation these dollar thresholds from $1 million net worth to $2.5 million net worth, you're going to reduce the available number of accredited investors and you're going to have one side of the aisle in Congress going crazy. But if you don't address the inflation, you're going to have-- you're likely going to have some others being concerned that we haven't addressed those dollar thresholds in a meaningful way.

So one idea is to address the dollar thresholds in a number of different ways. One is to just increase it. Others would suggest putting an inflation adjustment. A interesting idea that the SEC discussed in the report was adding a investment cap-- so keeping the thresholds the same or increasing the thresholds, but also putting investment caps so you can invest up to 10% of your net worth or 10% of your income on an annual basis.

But I think the real interest is finding other indicia of being an accredited investor, and that would be looking at your knowledge base. There's a number of ideas about putting in qualification of being accredited investor if you passed a variety of different financial literacy courses or financial license exams-- series 7, series 82. The question is if I can advise somebody to buy a security, that you have to be an accredited investor. I should be able to-- I should be knowledgeable enough to buy it on my own.

So that's one. And another idea is to create an accredited investor test that a broker-dealer could administer. So if you can pass a basic test that includes some of these things, that would be a way to qualify as an accredited investor.

So we're running short on time, but I encourage you to read the SEC's report. Congress is also interested in this area, as you would expect. They're largely sort of focusing on not changing dollar thresholds, because I think that's probably a little bit difficult to navigate both sides of the aisle on that. But I think they're really focused on the different indicia of financial sophistication.

MARTIN P. DUNN: Yeah. I want to be respectful of next panel's time as well, because I'm on it. But the two things I would say on the accredited investor debate, it's been going on since it was adopted about the dollar thresholds. And the answer that I always heard from the people who said it doesn't need to be changed-- because people are like, oh my god, it's so different then than now; 30 years of inflation, all this-- is anybody who doesn't want it changed says show me that people are getting ripped off because of the definition of accredited investor, which is prove the negative, right? And so that's the challenge.

And the other is on the create a test part. I actually wrote an op-ed a little while ago that the last thing if I was at the SEC I'd want is to be telling people they're financially in a position where they can make investments on their own and don't need us, because then you start-- as soon as they start losing money, they point fingers at you. That's a bit of a challenge.

ANNA T. PINEDO: So maybe a question for you all before we wrap up. In a significant number of private placements that are being done under 4(a)(2)-- so good 4(a)(2) unquestionably going to institutional investors only, no individuals-- many law firms have been resistant to giving good private placement or the typical no registration opinion if it's not done under the 506 safe harbor. Do you have views on whether it should be possible to give a legal opinion, whether you'd have pause about giving a legal opinion if you weren't relying on a safe harbor?

DAVID M. LYNN: Do you guys want to start, or--

MARTIN P. DUNN: Yeah. Go ahead, Dave.

DAVID M. LYNN: Yeah. I've always been comfortable that if you have a good 4(a)(2) you have a good 4(a)(2). And I guess I'm not sure why there would be resistance. It's not an exclusive safe harbor. There's a well-developed body of law. So to me, applying law to the facts, you can usually make that determination.

MARTIN P. DUNN: I was going to say the same thing. And I've always been more willing to look at the statute and give exemptions. A lot of people will say the SEC doesn't like that. But since we were all there so long, we know the SEC doesn't really care. If you got a good exemption, you got a good exemption. That's the way it goes. [INAUDIBLE]

ANNA T. PINEDO: [INAUDIBLE]

LONA NALLENGARA: No, I agree. If I can rely on the safe harbor, I'm always, of course, to do that. But I don't see a problem with that either.

ANNA T. PINEDO: And do you think that there are-- this sort of trend of bad actor diligence being viewed as a real stumbling block or as an impediment to Reg D? Do you think we're over that now that, as Dave said, we're quite a number of years into it?

DAVID M. LYNN: Yeah. I think initially that was very much a concern, and I think that was something the SEC acknowledged. And people were concerned that we'd been doing it for so long one way, to change it midstream was going to be very difficult. But I guess my impression has been that generally procedures have been established at placement agents, procedures have been established for issuers through their law firms and other advisors, and so now you don't really have as much of a reason not to do a 506 offering just because of the bad actor disqualification.

I would say the other difference too between 4(a)(2) and Reg D that we didn't talk about is with Reg D you have to follow Form D. Now sometimes people don't file the Form D, but there is sort of a disclosure element to it that's different if you're actually relying on Reg D.

ANNA T. PINEDO: All right. Well, thanks so much for that great introduction to--

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