May 28, 2013 by Tamara Piety
One of the sneaky little things that was built into the 2012 JOBS act (Jumpstart Our Business Start-Ups Act – don’t you just love these acronyms?) was a relaxation of the rule that firms wanting to raise private capital without registering with the SEC could engage in general advertising. You can take a peek at the regulation here.
Just to clarify, in the past a firm which wanted to raise capital from private investors but which didn’t want to have to comply with SEC regulations for public securities offerings could do so through what is known as a “private placement.” Only investors who met certain criteria could invest in private placements. And that rule is still in place.
But another condition was that the entity could not engage in “general advertising,” you know like you see on late night TV. “Invest now! This offer, which was previously only available to the elite investor now can be yours! Call our operators now standing by.”
This is a really terrible idea. If you think there is a huge potential for fraud through the sale of things like slicers and dicers, diet products, charitable subscriptions and the like, the potential with investments seems limitless because there the consumer does not get to “test” the product. Indeed, an investment by its very nature is expected to require time to pay off and so a delay of dividends can be expected. Of course this can also provide plenty of time for a boiler room to close up shop and get out of Dodge. To put this in perspective, I believe Bernie Madoff offered private placements.
Part of the impetus for this spectacularly bad idea seems to be to democratize the access to private placements, to develop a sort of Kickstarter for investors, to let the little guy in on the ground floor of start-ups or investments which might pay off far great returns than average. Of course, the risk is higher than average as well. Which is why only “qualified investors” may invest in private placements. “Qualified” means meeting certain net worth and income minimums. The danger is that these firms will engage in general advertising but then not do a very good job of screening investors, leaving private lawsuits to resolve the fallout.
Problem is, private lawsuits aren’t much of a deterrent for those who intend to commit a fraud since they cover their tracks and often, there won’t be any assets against which to attach a judgment (assuming that it is not cost-prohibitive to bring one).
The idea of “crowdsourcing” investments isn’t ridiculous. There is undoubtedly potential in the market to tap small investors. And it would be nice to democratize access to higher returns. The problem is whether the ordinary consumer is ready to become a sophisticated investor. I doubt it.
Professor Usha Rodriguez at the University of Georgia has published this piece on the new regs arguing that because of this potential for slippage between the advertising and the efforts at investor qualification, firms will not engage in this sort of advertising, and thus the aims of the JOBS Act will not be realized unless the SEC or Congress creates some “safe harbors,’ that is, clearly outlines what sort of controls on investor qualifications a company can put in place in order to insulate it against liability should the investment go south. ( you can see this blog post summarizing the article over on The Conglomerate)
I am not sure we need a safe harbor. I am inclined to think that crowdsourcing for investments is an idea that sounds better than it is. It sounds very democratic. There is undoubtedly a huge, untapped market. But it seems to me that the potential for this to become a huge source of fraud is too great. With Kickstarter, charitable and campaign contributions (at least for small contributors) the contributor knows they are not getting anything in return (or at best a small token of gratitude – a piece of artwork, a video, etc.). They don’t expect to hit the jackpot or double their money. Investing is an entirely different order of solicitation. With an investment the investor does expect to get returns on her money – sometimes, as at least this adviser suggests, she expects unreasonable returns. That sets up pressure for even honest business to steal from Peter to pay Paul in order to give investors what they want. That is a prescription for a Ponzi scheme. Indeed that is what Madoff claimed happened (even if you don’t believe him, that is what he said). To quote:
“Bernie Madoff claims that his decision to begin using new investor money to pay returns wasn’t his fault — he did it because he was under a lot of pressure from investors. But that’s exactly the point; all companies have pressure from their investors! Investors like good returns and in some cases they demand them, but they should only get paid if the company is generating positive returns. Just like children, investors sometimes have to be disappointed. Sophisticated investors understand this, and although unsophisticated or unaccredited investors probably don’t understand they should never be investing in start-up companies in the first place.”
Indeed. But removing the ban on general advertising seems like an invitation to Ponzi schemes. And we haven’t even yet discusses how the regulatory assessment of these ads would interact with this new and robust First Amendment, commercial speech doctrine. Looks like a potential car wreck to me. It may work out, but why take the chance in light of the massive investment frauds of recent years?
As Bette Davis might say, “Fasten your seat belts. It looks like it is going to be a bumpy ride.”