Mad Money: Rethinking PrivatePlacements

Table of ContentsI. Introduction 2255II. The Structure and Goals of Securities Regulation 2260A. Basic Elements of Federal SecuritiesRegulation 2261B. The Goals: Capital Formation and Investor Protection 22631. Capital Formation 22642. Investor-Choice Protection 22673. Paternalistic Investor Protection 22684. Populist Investor Protection 2274III. Private Placement Exemptions: Why and How? 2275A. Why Private Placement Exemptions? 2275B. How Private Placements Are Regulated 22771. Scaled-Disclosure Mechanisms 22782. Sorting Mechanisms 22793. Portfolio Mechanisms (Including Investment Caps) 2281IV. Evaluating the Mechanisms: In Theory and Practice 2284A. The Theoretical Appeal of Disclosure and Sorting (Smart Money) 22841. Smart Money in a Perfect World 22852. Investment Caps in a Perfect World 2289B. The Practical Problem of Universality 22901. Universality and the Failure of Scaled Disclosure 22902. Universality and the Failure of Sorting 22943. The Result: Counterproductive Smart-Money Approaches 2297C. The Case for Investment Caps (Mad Money) 2298V. A Proposal 2303A. The Scope 2303B. The Details 23051. A Diversification Test 23052. A Liquidity Test 2307C. Competing Proposals 2308D. Potential Objections 23111. Diversification to Lower Quality 23112. Death by a Thousand Cuts 23123. Asset Verification Problems 23124. Human Capital 23135. Empirical Uncertainty 23146. Why Protect the Rich? 2315VI. Conclusion 2316I IntroductionWhen President Obama signed the Jumpstart Our Business Startups Act (JOBS Act) into law, he deemed it a potential "game changer."1 Specifically, he commended the law for nurturing the next Facebook or Apple by easing restrictions on unregistered sales of stock, referred to as private placements.2 But bold predictions and plucky name aside, the law is mostly a continuation of stale approaches to regulating private placements. True, startup companies can now sell stock through third-party "crowdfunding" sites modeled after Kickstarter, but only after providing prescribed and costly information to investors.3 True, a startup company can now solicit investors through its own website, but only if it limits sales to wealthy investors deemed capable of making sound financial decisions.* * * 4 Like prior law, the JOBS Act primarily tries to protect investors by creating (through disclosure) and identifying (through investor qualification standards) the "smart money."5Congress's decision to double down on these smart-money approaches is puzzling. Regulators have struggled to identify information that investors actually value, as evidenced by disuse of exemptions conditioned on specified disclosure.6 Moreover, it is at best questionable whether wealth standards are a reasonable measure of investment capabilities-for example, a successful dentist may know little about hedge funds.7 For the JOBS Act, the unfortunate implications are that: (1) issuers and investors will steer clear of the crowdfunding exemption because of its rigid disclosure requirements, and (2) the JOBS Act's liberalized rules for sales to accredited investors leave wealthy but unsophisticated investors unprotected.8But despite the JOBS Act's broader failures,9 this Article finds something redeeming in one of the law's more obscure provisions. Buried deep in the new crowdfunding exemption is a building block for future exemptions-an "investment cap" limiting the amount any single purchaser can invest. …