White Paper
February 10, 2016
Analysis of the JOBS Act to Recommend Reform to the Securities Markets
In Order to Provide Stability for Securities offered under Rule 506
Prodigious, LLC
5837 S. Gallup Street
Littleton, CO 80120
303-716-7234
Executive Summary
The JOBS Act
When Congress passed the Jumpstart Our Business Startups (the “JOBS Act”), it drastically
changed the landscape of how issuers can go about raising funds in primary offerings. The obvious
intent, as written in the text of the Act is “To increase American job creation and economic growth by
improving access to the public capital markets for emerging growth companies.” Four changes in the
JOBS Act will have the most profound effect:
1. Changed the language of 17 CFR 230.502(c) which removed the restrictions against the use of
general solicitation or general advertising for offers and sales of securities made pursuant to
section 17 CFR 230.506;
2. Created Regulation A+ which permits smaller companies to provide for two tiers of offering
levels - $20M and $50M, which will be exempt from registration as a public company;
3. Increased the minimum number of investors to 2,000 that triggers registration as a public
company (no more than 500 may be non-accredited investors”) for securities offered under
Regulation D; and
4. Increased the minimum number of investors to 2,000 required for registration as a public
company for issuers that are banks and bank holding companies.
©Prodigious, LLC 2016
The JOBS Act offered sweeping reform to the initial issuance of securities by small issuers but it
did not address the complexity of operations from a broker/dealer perspective or the operation of the
secondary or re-sale market for these securities. It is well understood that start-up and expanding
companies require cash. This means that a company may create an ongoing series of offerings. That
possibility disappears if there is no market value or the market value does not reflect true worth. It is also
well understood that securities sold in private placements must be held for a long period of time and that
the absence of a single market value has multiple repercussions, not the least of which is various
government agencies trying to impose artificial valuation mechanics.
The implementation of the JOBS Act has created a juggernaut but it has not taken into
consideration a viable platform for broker/dealers, Registered Investment Advisors, banks and other
entities to support, trade and report their secondary transactions. Without changes to the process to
encompass these requirements, the markets will continue to provide zero transparency and the ‘protection
of investors’ and the ‘public interest’ will continue to be ignored.
The purpose of this paper is to provide an overview of this marketplace; identify the weaknesses
and to ultimately propose changes to these markets.
The History of Alternative Investments
For more than thirty years, privately offered and exempt offerings have played an integral role
with investors and are securities which are often universally referred to as ‘alternative investments’.
These securities can include limited partnerships (“LPs”), Direct Participation Programs (“DPPs”), oil &
gas, private placements, Real Estate Investment Trusts (“REITs”), private offerings, 1031 Tax Exchanges,
Church Bonds, Tenants-In-Common (“TICs”), Business Development Companies (“BDCs”), Delaware
Statutory Trusts (“DSTs”), among other security types, and include a larger universe of thousands of
securities culminating in billions of dollars of investments. The majority of these securities are offered
pursuant to Rule 506 of Regulation D thus, these securities are not fully registered pursuant to the
Securities Act of 1933.
When one of these private offerings is created for sale, it is usually sold with a Private Placement
Memorandum (“PPM”) which identifies the necessary disclosures and risks associated with the offering.
Nearly 100% of the securities sold were done so as primary offerings and within nearly every PPM for
every offering there are three prominent disclosures that indicate certain risks associated with an
investor’s potential should their need to sell their security at a later date. The most common disclosures,
which are generally accepted, although the text of which may be altered, are included as follows:
1.
“There is no market for these securities and a market may never develop.”
2.
“As a result, purchasers of these securities may not resell or reregister them without providing a
legal opinion describing the validity of the transfer. It is unlikely there will be any market for resale of
the securities. As a consequence of these restrictions and limitations on resale, purchasers of securities
may have to bear the economic risk of their investment for an indefinite period of time.”
3.
“This means that you may receive little or no return on your investment and may be unable to
liquidate your investment due to transfer restrictions and lack of a public trading market. This could
result in the loss of your entire investment.”
What are issuers, regulators and the financial services industry telling investors with those kinds
of disclosures?
©Prodigious, LLC 2016
Similar to most all securities offerings, private offerings are meant to serve as a conduit by issuers
to raise funds for a private entity. The ultimate goal for the issuer is to utilize the newly raised funds for
its operations with the intent of ultimately making returns to the investors in the form of principal and
other residuals or financial benefits when the entity became profitable or able to return the funds without
hindering its ongoing operations. In theory, an investment in these securities is meant to be a ‘buy-andhold event’ as investors receive ownership, debt or equity interests in the issuer’s entity and hold their
investment until maturation. However, like most all other investments, many times investors are faced
with the need to liquidate their financial interests for a myriad of reasons.
On January 7, 1997 the Securities and Exchange Commission (the “SEC” or “Commission”)
approved the self-regulatory organization Financial Industry Regulatory Authority (“FINRA”) rules
(formerly known as the National Association of Securities Dealers or “NASD”) permitting the quotation
of DPPs. 1 In Notice to Members (“NTM”) 97-8 it states, “Ninety billion dollars worth of DPP securities
have been purchased by approximately 10 million investors over the past 15 years.” According to the
SEC, in 2014 issuers raised $2 trillion in unregistered offerings. The SEC’s data is derived from Form D
filings and likely does not include offerings that were not filed requesting an exemption under Regulation
D.
Within 97-8 FINRA also received a private letter ruling from the Internal Revenue Service
(“IRS”). In their letter dated October 7, 1996, the IRS wrote, “IRS Notice 88-75 provides that a
secondary market or the substantial equivalent thereof exists if investors are readily able to buy, sell, or
exchange their partnership interests in a manner that is comparable, economically, to trading on
established securities markets.” It is interesting that nearly 20 years ago the IRS indicates it is plausible
to report transactions so long as an established securities market exists. Yet if an investor were to look for
the “established securities markets” for these securities, they would not be able to find one and depending
on how that established market operates, it violates other sections of this same rule not addressed in the
private letter ruling.
In NTM 97-8 FINRA also wrote, “The NASD’s determination to include DPPs in the OTCBB
and to require the reporting of DPP transactions by NASD members is in response to this existing
secondary market for DPP securities.” Today, broker/dealers are required to report their secondary
transactions via the ORF system (OTC Reporting Facility) which is owned and operated by FINRA.
It is very apparent that the drafters of the JOBS Act understood the impact the aforementioned
changes would have on the existing marketplace. And because of the changes which created a more
relaxed regulatory environment, the intentions of the JOBS Act will be met and the sheer volume of these
types of offerings and their associated dollar raises will increase exponentially. Obviously this can be
viewed as a win for Congress, small American businesses and the issuers but without the appropriate
regulatory and operational support the potential for failure has also increased.
Weaknesses of the Marketplace
1.
MSRP: The Car Dealer Theory
When someone buys a new car from a dealership it is a well-known fact that the moment the car
is driven off the lot its value decreases by about 10%... but why? If an investor purchases a private
offering they should expect their investment to maintain, at least, the value for which they invested. But
1
NASD Notice to Members 97-8. http://www.finra.org/sites/default/files/NoticeDocument/p004903.pdf
©Prodigious, LLC 2016
in most situations, with these types of investments, that isn’t always accurate. Issuers are similar to car
dealers in that their securities are priced as the Manufacturers’ Suggested Retail Price or “MSRP” and
their securities are not always priced accordingly. Most often they are a price predicated upon nonauditable and other non-standardized factors.
2.
A Market May Never Develop
Regardless of the JOBS Act, investors that purchase alternative investments are often stuck with
their investment without the possibility of re-selling their investment in a secondary market. To those
detractors that defer to the disclosures mentioned above and profoundly say these are not tradable
securities, one only needs to look at the evolution of municipal securities or government agencies or
treasuries or corporate debt or mutual funds and so on. Neither an issuer nor regulator can demand that an
investor be stuck with their purchase because it simply doesn’t coincide with the concept of a market
economy system that has long been established in the financial services industry. In fact, there are ATS
platforms that have attempted to address this concern, but without an appropriate understanding of the
securities in this sector, they cannot adequately perform for the space.
Although the disclosures strongly suggest there are no secondary markets, Financial Industry
Regulatory ‘Authority’ says otherwise, “…in response to this existing secondary market for DPP
securities…” But if one were to query regulators or the most seasoned Wall Street veterans as to where to
find the secondary market for DPP securities the questioner would be greeted with blank stares and
stammering. In all of the rules and regulations that have ever printed, there is no virtual, electronic or
tangible central marketplace where broker/dealers on behalf of buyers and sellers can come together to
sell alternative investments.
While it is clearly obvious FINRA and the entire securities industry recognizes the secondary
market, no centralized (regulated) marketplace exists for secondary trading of these securities. In its
current format, the secondary market for private offerings is a loosely held unorganized group of
registered and unregistered individuals buying and selling these securities. In most instances, these
securities are bought and sold away from the regulated environment.
Another concern with the lack of a viable secondary market platform for these securities is the
support required not only for the current level of investors and issuers but also for the volume expected to
enter the marketplace with the creation of the JOBS Act.
3.
Waning Creditability
Prior to the JOBS Act the volume of private offerings was substantial. In accordance with their
customer’s wishes, broker/dealer firms would purchase these offerings as there was a seemingly endless
supply of inventory. The JOBS Act has increased the volumes of securities offerings and in turn, it will
leave millions of investors holding securities for which there is no recognizable secondary market.
There are hundreds of banks, broker/dealers and registered investment advisers with thousands of
clients that own alternative investments but do not permit their registered representatives (salespersons) to
trade them on their behalf. The primary concern of senior executives in legal and compliance at
broker/dealer firms is the lack of a viable and nationally recognizable marketplace which allows for fluid
transparency and a firm’s ability to meet regulatory standards. We believe an additional primary concern
is that the financial services industry is unable to have minimal forms of control as to the receipt and
delivery of securities, as well as the identification in handling of unregistered persons participating in the
marketplace.
©Prodigious, LLC 2016
4.
Reporting Trades for a Market that Doesn’t Exist
FINRA Rule 6622 (Supplementary Material)(.01) identifies the procedure for broker/dealer firms
to report their transactions. The process can best be described as arduous. As previously mentioned,
firms are required to report secondary transactions via the ORF system which is operated through a
registered ATS. In order to input a trade into the ORF system, the security must have a CUSIP number.
However, more than 90% of these securities do not have CUSIP numbers. CUSIP was created by the
American Banker’s Association when banks were the primary transfer agent on behalf of public
companies. CUSIP may be the source for verification of a securities existence chosen for this model, this
choice comes with a lack of control for the alternative investment space. CUSIP themselves stated that
until recently, they did not even have the ability to categorize a security as a REIT, the most common
security type traded in the alternative investment secondary market. The issuance of symbols for these
securities within an equities system regularly causes transactions to occur when no actual transaction
takes place likely causing damages for investors. Rule 6620 is written for equity securities and “restricted
securities” and it is unreasonable to include DPPs as they are neither ‘OTC equities’ nor ‘restricted
securities’ and because of the manner in which they trade and the lack of a centralized marketplace – it is
a “work around” rule placement.
It is estimated that less than 10% of member firms report their transactions. The ORF system was
designed for firms to report transactions in equity securities. Therefore, inputting a transaction on behalf
of an alternative investment in the ORF system is difficult because of the different and unconventional
fields. For a sector that is creating trillions of dollars of securities, it makes more sense to have a properly
established conduit.
It is nearly impossible for FINRA to logically determine and demonstrate how any transaction is
reported. The rule requires that transactions be reported “…no later than 10 seconds after execution…”
This requisite could only be met if both firms are reporting the transaction but that is rarely the case.
There is also confusion regarding regulatory language stating only the ‘sell-side’ is required to report.
There is no definition of “execution” in this very manual trading process and no part of the process is
automated to provide guidance with meeting this 10 second requirement. So how is FINRA able to
regulate this activity? They don’t.
As stated, most firms do not know of the regulations nor understand or acknowledge the reporting
requirements. This is also one of the reasons firms choose to not participate in the secondary market.
There is no uniform reporting conduit specifically established for alternative securities although the
mandates are in place, and therefore, there is no transparency available to the investing public or the
broker/dealers participating in this marketplace. There is no effective market economy platform which
allows for the free trade of alternative investments, and therefore, broker/dealers and their investors
wishing to liquidate their positions are essentially navigating in the dark with their hands tied behind their
back. FINRA’s requirement for firms to utilize the ATS has failed and it is a fact that cannot be
disputed. Creating additional regulation expanding this conduit will not solve the problem.
We all agree that the secondary market exists yet with respect to price and value there is nearly
zero transparency between member firms nor does any transparency exist for the investing public. There
is confusion and no clear guidance for reporting, so most broker/dealer firms simply do not make any
attempt to report their transactions.
Currently, there are multiple government agencies requiring price or value assignments to these
securities during many different steps of the process. FINRA requires values placed on specific securities
utilizing one methodology and a separate methodology for other securities. Within FINRA’s framework
of reporting, as discussed previously, these transactions are known to be secondary market executions.
©Prodigious, LLC 2016
However, in FINRA’s own requirement of use of price and value, in some instances secondary market
executions are specifically not allowed to be utilized, removing a cost effective method to value from the
horizon and since these prices are visible to the general public, causing confusion with the investors who
compare their broker dealer statement value or issuer reported value to the reported secondary market
executions. FINRA also requires a methodology which differs again for broker-dealer financial
operations reporting. IRS requires Fair Market Value (“FMV”) to be assigned, which is a fourth
methodology, to these securities and that value may or may not be utilized in two separate reporting
requirements. IRS also requires ERISA value, very similar to FMV methodology to be utilized within
qualified plans. The amount of confusion and increased expense to manage these pricing and value
requirements, not to mention the expense passed on to investors for the multiple levels of pricing/value
currently required seems to have no satiation point.
5.
Lack of Structure
Secondary markets for more traditional securities offer several key features that are not currently
present to support securities issued under the JOBS Act provisions. In a public offering a security, the
cycle begins with an underwriter and a selling group. While some alternative investments will be
acquired through a selling group, it is not the same type of selling group traditionally found within the
equities markets. The selling group for alternative investments lacks an underwriter, who through their
activities, which typically has a financial and vested interest in the success of the offering. The additional
selling group members may also have a financial and vested interest in this success. The typical selling
group for an alternative investment has individual brokers and a few firms which may have an interest in
seeing securities they sold perform within acceptable expectations. Within the secondary support
structure of the equities markets, there are specialists on the trading floor as well as market makers within
the trading framework. These parties typically have a vested interest in ensuring the performance of a
security is stabilized and priced accordingly in the secondary market. These securities are often followed
by research analysts who analyze the company’s operations and prospects.
The alternative space, and its existing secondary market, has none of these support mechanisms.
Rather, there is absolutely no party with an interest in how the security performs within the market
structure. There is usually no entity, outside of the issuer and investors, with a vested interest in the
ongoing performance at any level. Securities sold under the JOBS Act provisions are and will become
“orphans” in the sense they are bought and held and investors rarely have access to liquidity.
There is no market structure of any kind for these security types within the currently accepted
exchange or trading platform environment. For instance, short selling is permitted within equities’
markets but short selling within alternative investments could destroy the price of a security, thus making
it worthless. Short sellers have little concern for the real viability of the underlying entity and short
selling is not possible due to the fact that it cannot be supported from the issuer perspective and the
operations of broker/dealer. An inept understanding of the mere structures and those implications for
these securities in a trading environment could cause dramatic damage to the securities themselves as well
as the investors.
Unlike the traditional markets, the full manual nature of the function of alternative investments must be
realized. There are no execution and clearance functions automated for this market sector. The room for
error without appropriate understanding could be disastrous. There are additional concerns that must be
placed on understanding the security sector and recognizing the differences within the many structures for
these security types which come with their own sets of requirements for how they can be traded, volume
constraints and what types of activity can adversely affect the existing shareholders as well as the issuer.
An understanding of regulation from all government agencies is at the forefront. The process is not as
©Prodigious, LLC 2016
simple as forcing this round peg to fit into the framework of the square hole that exists, the existing
framework is not capable of dealing with these security types.
If the volume increases because of the JOBS Act and a formalized secondary market is not
established, the credibility of these securities, their issuers and the financial services community will most
certainly end up with a black eye and the potential for a public relations nightmare.
6. Limitations of an Automated Trading System (“ATS”)
An ATS is a broker-dealer registered trading platform which is governed by FINRA and the SEC.
While it adheres to regulation issued by those entities, it does not typically take into consideration all
regulation issued by other government entities which should be considered with respect to the trading,
reporting and operations. It does not typically have the knowledge base to deal with the repercussions
that occur when operating without understanding these regulations. In the current environment, most
ATS who are considering offering assistance within this market sector are not dedicated to this market
sector. With the deep knowledge base required for this market sector, this is a weakness.
An ATS, in many instances, is run by an entity that has an interest in trading themselves. This is
not conducive to arms-length transparency. By operating an exchange, as opposed to an ATS, to support
this market sector, regulators, participants and the investing public has assurances of fair play that may
not always be present within the ATS environment.
An ATS allows for trading and trade reporting of securities which typically are listed on a
recognized exchange. If an ATS enters into this sector of the market, along with not having the support
for the securities outlined earlier in this document, it will also be lacking any protections or support
offered by an exchange.
An ATS is not a self-regulatory body, thus is unable to be as flexible in its operations and must
operate under more limited specific guidelines. As such, an ATS doesn’t have the ability to expand and
grow within its marketplace at the same level of an exchange, thus making it inefficient. With an
exchange, the market sector needs could be addressed through membership rules quickly with the
authority to disallow participants who do not adhere to those rules.
One of the concerns with creating an exchange for this market sector are the current regulations
in place governing the ability for a security to be registered on an exchange. In the Securities Exchange
Act of 1934, Section 12 (c) reads, “If in the judgment of the Commission any information required under
subsection (b) of this section is inapplicable to any specified class or classes of issuers, the Commission
shall require in lieu thereof the submission of such other information of comparable character as it may
deem applicable to such class of issuers.” This demonstrates a willingness of the Commission to work
within the specific needs of a security class to develop and allow for disclosure of information appropriate
to the market sector thereby supporting the Commission’s mission statement of protecting investors and
working toward public interest. The alternative investment market sector, as discussed at length in this
document, is riddled with caveats and structural differences that make the current market support
structures inadequate. There is no difference in that dilemma with respect to filing requirements and it is
an item that must be addressed to appropriately support the market.
In the Securities Exchange Act of 1933 (“the Act”), Section 2(b) reads, “CONSIDERATION OF
PROMOTION OF EFFICIENCY, COMPETITION, AND CAPITAL FORMATION.—Whenever pursuant
to this title the Commission is engaged in rulemaking and is required to consider or determine whether an
action is necessary or appropriate in the public interest, the Commission shall also consider, in addition
©Prodigious, LLC 2016
to the protection of investors, whether the action will promote efficiency, competition, and capital
formation.” In the Act there are 27 separate instances of the phrase “protection of investors” and 33
separate instances of the phrase “public interest”.
7.
Additional Government Overlap and Contradiction
A final point is that the Department of Labor has new regulation up for consideration which could
add to the confusion and contradicting requirements for dealing with alternative investments. The
proposed regulation makes no indication of its awareness of the secondary market. In fact, the restrictions
it places on allowing these securities to be sold to qualified plan holders are for reasons which should not
be a consideration for a functioning secondary market as it will mirror other types of exempt securities,
such as equities. The reasons cited are specific to these securities within the primary offering period and
by not making the distinction or addressing the secondary market, they may be effectively not allowing
the sale of the securities within a qualified plan of these securities for reasons which specifically do not
apply. If we can imagine the added illiquidity this would add; a cited issue within most regulatory
concerns from all parties, to the existing holders of these securities and the inability of an investor to
choose the platform from which they prefer to invest personally.
The Solution
We believe the opportunity for a well regulated centralized marketplace or exchange is necessary
in order to better serve the investing public and to maintain a market economy system. The benefit of
such secondary marketplace will create transparency, better regulation, tighten the controls in which the
financial services industry serves the investing public and create liquidity. Because of its vast experience
in this sector of the financial services industry, Prodigious has created proprietary software and is able to
offer unique services. It is because of its staff, experience, relationships and computing technology,
Prodigious believes it can spearhead the task of creating a virtual electronic exchange that would service
the secondary market for alternative investments for the financial services industry on behalf of the
investing public.
We strongly believe creating an exchange will be a valuable solution to the investing public and
broker/dealer firms that will:
1.
2.
3.
4.
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establish a virtual conduit/platform to report transactions
mandate member firms to either participate
create more time-sensitive transparency with respect to value
propagate better due diligence and the sharing of information
understand and consider structural requirements for securities
provide adequate support for the marketplace and create trust within the investing public
prevent mini tender offers that are priced far below the market
allow firms that are currently on the sidelines to engage the marketplace
provide stronger regulatory oversight while creating systemic regulation and tightening controls
make it more difficult for less ethical issuers to enter the market
incorporate competition in a regulated marketplace which is key to achieving realistic values
The exchange would only permit secondary market activity in the alternative investment space.
If a security is listed on a second exchange, it could not remain listed on the alternative exchange. The
volume of the market sector would be safeguarded. We believe the exchange will essentially remove the
wide value disparities that currently exist thus making the market tighter. It will establish a more
articulate economic framework with respect to participation and pricing which should create a fairer
©Prodigious, LLC 2016
marketplace. Finally, we believe the new standards will ultimately alienate the “rogue” issuers and
increase the confidence of the investing public.
About Prodigious
Prodigious, LLC was formed in 1993 and has been assisting in the transfers and information
requirements of Limited Partnerships, Private Placements, Non-Listed REITS and other forms of nonexchange assets since that time.
Prodigious provides several classes of transfer, pricing, reconciliation and research services to the
financial community which includes some of the largest banks and broker/dealers in the country. Our
commitment to our clients is to provide fast, efficient, and cost-effective outsourcing solutions. This is
accomplished by a knowledgeable staff with long-standing relationships with some of the largest
broker/dealers and banks in the financial services industry. Prodigious is affiliated with a secondary
market trading desk operating exclusively within this market sector since 1992.
©Prodigious, LLC 2016