Daily Journal – By Mark Ankcorn
Soon, the airwaves, Internet and print media may be filled with ads soliciting the opportunity to buy into starts-ups, hedge or private equity funds.
Consumers have been spared these pitches for years under Regulation D (Rule 506) of the Securities Act of 1933. But unfortunately, the Securities Exchange Commission recently voted to lift this more than 80-year-old ban on public solicitation of investments in private companies, which means that hedge funds and start-ups can now advertise publicly for funding.
Under the new Rule 506(c), companies will now be able to “generally solicit” to prospective investors. The new rule will be added as a new subsection (c) to existing Rule 506.
The rule, which passed earlier last month by a 4-1 vote of the commission, is the first one mandated by last year’s Jumpstart Our Business Startups (JOBS) Act to be completed by the SEC. The regulations are likely to take effect in September.
Now, startups and other small companies can use advertising to raise unlimited amounts of money. At first blush, it seems like a good idea. Why should early-stage investments be limited only to “qualified investors” who have more than $1 million in assets? Why can’t regular folks pool their money to back a good idea or a new technology? After all, it’s been a revolutionary and effective tool for interesting devices, video games, movies and other projects on crowdfunding sites like Kickstarter.
On a deeper analysis, however, this recent ruling creates many opportunities for massive fraud at a grassroots level. In short, the ban on advertising was originally established with very good reason — to protect investors. The biggest potential downside of the new ruling: fraudsters who dupe consumers into pouring the money into bad funds.
In fact, lifting the ban will enable sophisticated financial swindlers to target regular people. Instead of the oversight provided by a company like Kickstarter, which zealously polices its projects to eliminate even a trace of swindle, under the new JOBS Act rules the only watchdog will be the SEC. This is concerning, as the overburdened SEC is already deluged with schemes and frauds.
Proponents hope the ruling will fuel the economy with new sources of capital. “As we fulfill our mission to facilitate capital formation and maintain fair and efficient markets, the Commission must always focus on strong investor protections,” said Mary Jo White, chair of the SEC, in a press release. “We want this new market and the private markets in general to thrive in a safe and efficient manner, and these rules we adopt and propose are designed to facilitate that objective.”
But Democratic Commissioner Luis Aguilar, the lone dissenter, warned that the new rule “will prove be a great boon to the fraudster” and could “lead to economic disaster for many investors.”
In fact, many are deriding the decision — and calling for follow up regulation — and the Department of Justice and Federal Trade Commission are bracing themselves for an onslaught of complaints when the ban is officially lifted next month.
According to Tim France with the U.S. Postal Inspection Service, the impact of lifting the ban will be a “giant tsunami” of fraud. “So-called ‘entrepreneurs’ can now just set up a website and advertise for investors to put even $50 into a project, getting only equity in return,” France said.
The biggest area to watch for fraud is medical/biotech schemes. Anyone promising “advanced research” into a cure for autism or breast cancer or diabetes will find a willing list of thousands eager to have some kind of good news, no matter how remote.
Here’s an example of how that might happen: A newly formed LLC with no assets and no product uses carefully targeted Google ads and late night infomercials to tout its “advanced research” into a cure for autism. The fraudsters frequent online forums and discussion groups — pretending to be parents of an autistic child who have heard about this “breakthrough therapy.” They claim that this struggling company can’t find regular investors and needs our help, so “we’re investing now so we can be guaranteed a spot for our child.” Wouldn’t you do the same?
It’s sad and it’s frightening, but swindlers have long preyed on the fears and hopes of people in difficult circumstances and are more than willing to take the money of the most vulnerable members of society.
The new rules will fundamentally change the way that private offerings have to date been conducted by opening up a new universe of potential investors — from a wide range of social media forums such as LinkedIn, Facebook and Twitter.
For all of these reasons and more, carefully thought out follow-up regulation is key. In the meantime, expect an onslaught of financial scammers, consumer complaints — and litigation.
Mark Ankcornis an attorney with San Diego-based Casey Gerry Schenk Francavilla Blatt & Penfield LLP and a member of its class action litigation practice team. He is currently the lead plaintiffs’ counsel in national class actions against some of the world’s largest financial services corporations.