September 08, 2012 4788 VIEWS


September 8, 2012 / Jason Zweig  / WJS
In the bull market that has suddenly broken out for stocks, you might have missed the bull market emerging in another commodity: regulatory irony.
The likely outcome will be wide access to formerly exclusive securities—and a greater risk of fraud and abuse.
On Aug. 29, the Securities and Exchange Commission proposed a rule permitting issuers to promote private offerings to the general investing public for the first time.
The very next day, the US SEC issued a report on financial literacy, which concluded—and I paraphrase here, but not by much—that members of the general investing public can barely tie their own shoes.
So what led the nation's leading financial regulator into this absurd contradiction? Congress, of course.
Under the Dodd-Frank financial-overhaul law of 2010 and the JOBS Act of 2012, Congress required the US SEC to study how knowledgeable the investing public is and, at the same time, to allow companies to market their private securities to anyone they care to pitch to.
The end result: rules that make some of the biggest changes to the investment world in more than a quarter of a century.
The new regulations will ease capital-raising for many legitimate companies. But they also could subject unwary and vulnerable investors to deals that offer limited financial disclosures and even less liquidity.
"Because the promoters are being supplied with much larger nets to try to catch their investors, there's going to be much more possibility of fraud and abuse," says Robert Robbins, a partner at the law firm of Pillsbury Winthrop Shaw Pittman in Washington.
Once the rule goes into effect, probably in a few months, every Tom, Dick and Harry can be pitched on stakes in hedge funds and other exclusive investment pools, as well as oil-and-gas partnerships, real-estate securities and a host of other offerings that long have been sold privately under an exemption to the federal securities laws known as Regulation D.
So-called Reg D securities aren't listed on an exchange and rarely trade, and their issuers don't have to file financial statements publicly with the US SEC.
The agency estimates that companies raised more than $1 trillion through such offerings in 2011 alone. To put that in perspective, it is triple the total raised in all initial stock offerings on U.S. public markets over the past 10 years, according to Renaissance Capital, a research firm in Greenwich, Conn.
Until now, companies generally could market private securities only to wealthy investors with whom they (or their representatives like stockbrokers and the like) had "pre-existing relationships." The new rule, as directed by Congress, enables private securities to be marketed anywhere, by any means.
Wayne Souza, general counsel at Walton International Group, a global real-estate development company that frequently has issued private securities, doesn't expect to see hedge-fund or partnership ads on billboards or blimps. Private issuers want to reach wealthy clients, he says, "and the bulk of sophisticated investors, unless they're insomniacs, aren't up at 2 a.m. watching infomercials."
But Mr. Robbins isn't so sure. "You could see ads on the Shopping Channel or the checkout screen at your neighborhood nail salon," he says.
Under the new rule, in order to buy into a publicly marketed private offering you must verify that you have at least $1 million in net worth, excluding the value of your home. The SEC, so far at least, is leaving it mostly up to companies and brokers to determine how they will verify the net worth of prospective investors.
Hugh Makens, a former federal and Michigan state securities regulator who is now an attorney at Warner Norcross & Judd in Grand Rapids, is concerned that elderly investors might be specifically targeted to invest in private deals.
He points out that many investors worth more than $1 million are afflicted with Alzheimer's or other forms of dementia—and are thus especially prone to having their money pried out of them by the promotions the new law makes possible.
The latest rule also could escalate the risk of "affinity fraud" through church groups, country clubs and other social networks, Mr. Makens warns.
If you are approached to invest in a private deal, pay special attention to how the broker verifies your net worth.
A few cursory questions might imply the broker cares more about grabbing a quick commission than making sure the deal is appropriate for you. Be sure you understand how much you will pay in fees and what financial updates will be available on your investment.
Above all, ask yourself why you have suddenly been offered this exclusive opportunity. "Think of all the smart pairs of eyes that comb through every possible deal," says Joshua Brown, a former stockbroker who works as a fee-only financial adviser at Fusion Analytics in New York. "By the time a private deal gets to some retail stockbroker in a strip mall, is there any way it's still worth doing for you?"
Related Articles
August 27, 2012 7483 VIEWS
August 27, 2012 3711 VIEWS
August 24, 2012 3950 VIEWS
August 21, 2012 2235 VIEWS