Expanded access to capital markets for startups and small businesses can be beneficial if done reasonably, and only if investors are confident that they are protected, that transparency in the marketplace is preserved and that investment opportunities are legitimate.
The desire to facilitate access to capital for new and small businesses is commendable. But the approach taken by H.R. 3606 is deeply flawed.
The JOBS Act has many red flags for Main Street investors, but two of its provisions pose the most urgent risks: preempting states from reviewing crowdfunding investment offers and allowing advertising for highly speculative and risky private placement offerings.
The White House promotes crowdfunding, an Internet-based fundraising technique as a new tool for raising money for small and startup businesses. State securities regulators do not object to the concept of crowdfunding, which could provide small, innovative enterprises access to new sources of capital. States are currently working on a model rule that would permit crowdfunding while preserving a state’s ability to prevent scam artists from exploiting Main Street investors.
The JOBS Act would prohibit states from requiring disclosures or reviewing crowdfunded investment offerings before they are sold to the public. This authority is critical to the ability of states to get “under the hood” of an offering to make sure that it is what it says it is.
Congress made a similar mistake when it approved the National Securities Markets Improvement Act (NSMIA) in 1996 and preempted state authority to review private offerings made under SEC Regulation D Rule 506.
Companies meeting certain standards can use this rule to raise an unlimited amount of money without registering the offering with the SEC. NSMIA prohibited state securities regulators from reviewing Regulation D, Rule 506 offerings to screen out bad actors, making this exemption a haven for investment fraud.
These offerings were the most frequent source of enforcement cases handled by state securities regulators, according to the 2011 enforcement survey of the North American Securities Administrators Association. Allowing state securities regulators to take action only after a fraudulent sale is made offers little comfort to investors who have seen their money vanish.
Congress can avoid making the same mistake with crowdfunding. Instead of preempting states, Congress should allow the states to take a leading role in implementing an appropriate regulatory framework for crowdfunding.
State securities regulators have a well-earned reputation for spotting and stopping investor abuse, from the penny-stock and micro-cap stock frauds of the 1980s to day trading in the 1990s and auction rate securities within the past decade.
States are the only regulators in a position to effectively police the small emerging crowdfunding market and protect its participants.
Another troubling provision would abandon the SEC’s ban on general solicitation, or advertising, of the Regulation D Rule 506 offerings. This would enable scammers to cast a wider net to trap more fish for their fraudulent schemes.
Unlike other types of Regulation D offerings, where the size of the offering is capped, the amount of money that an issuer can raise under Rule 506 is unlimited, presenting an opportunity for fraud on a massive scale.
Securities regulators, legal scholars, investor advocates and others have cautioned the Senate about the impact H.R. 3606 could have on investors and capital markets. But in an election year, neither the White House nor Congress wants to be painted as anti-business.
Unless corrected by the Senate, the JOBS Act, which currently contains a provision that one expert, Columbia Law School Professor John Coffee, calls “The Boiler Room Legalization Act,” will hurt legitimate small businesses by undermining investor confidence.
Boiler rooms are heating up in anticipation of the JOBS Act’s passage.
Jack Herstein is president of the North American Securities
Administrators Association and assistant director of the Nebraska
Department of Banking & Finance, Bureau of Securities.