The JOBS Act: An Investor Protection Disaster Waiting to Happen

The following post comes to us from Jack E. Herstein, president of the North American Securities Administrators Association and assistant director of the Nebraska Department of Banking & Finance, Bureau of Securities. Last week the U.S. Senate passed the JOBS Act, with some amendments from the version passed by the U.S. House of Representatives on March 8, 2012.

Congress and the White House are turning a blind eye to the unintended consequences of the Jumpstart Our Business Startups Act (H.R. 3606) by insisting on placing election-year politics over protecting the needs of both small businesses and “Main Street” investors.

The so-called JOBS Act is another example in a long history of good legislative intentions gone bad.

As Harvard Law School Professor John Coates said in his December 14, 2011 testimony before the Senate Banking Committee: “Whether the proposals will in fact increase job growth depends on how intensively they will lower offer costs, how extensively new offerings will take advantage of the new means of raising capital, how much more often fraud can be expected to occur as a result of the changes, how serious the fraud will be, and how much the reduction in information verifiability will be as a result of the changes. Thus, the proposals could not only generate front-page scandals, but reduce the very thing they are being promoted to increase: job growth.”

State securities regulators commend congressional desire to facilitate access to capital for new and small businesses. However, the version of the bill that passed the House is deeply flawed. These problems must be addressed by the Senate.

State securities regulators support efforts by Congress to ensure that laws facilitating the raising of capital are modern and efficient, and that Americans are encouraged to raise money to invest in the economy. However, it is critical that in doing so, Congress not discard basic investor protections. Investment fraud is real, and it can be particularly pervasive in small exempted offerings.

I join SEC Commissioner Luis Aguilar in his concerns that the JOBS Act, as currently written, is based on faulty premises and “would seriously hurt investors by reducing transparency and investor protection and, in turn, make securities law enforcement more difficult.”

Expanded access to capital markets for startups and small businesses can be beneficial, but only insofar as investors can be confident that they are protected, that transparency in the marketplace is preserved, and that investment opportunities are legitimate.

Small businesses are important to job growth, and to improving the economy. However, by weakening investor protections and placing unnecessary restrictions on the ability of state securities regulators to protect retail investors from the risks associated with smaller, speculative investments, Congress is on the verge of enacting policies that, although intended to strengthen the economy, will in fact only make it more difficult for small businesses to access investment capital.

Virtually every Title of the JOBS Act would benefit from greater scrutiny, but Title III of the Act, the Entrepreneur Access to Capital Act, poses the most urgent threat to retail, “Main Street” investors.

While intending to promote an Internet-based fundraising technique known as “crowdfunding” as a tool for investment, this title of the JOBS Act would needlessly preempt state securities laws and weaken important investor protections.

The concept of crowdfunding is appealing in many respects because it provides small, innovative enterprises access to capital that might not otherwise be available. Indeed, this is precisely the reason why states are now considering adopting a model rule that would establish a more modest exemption for crowdfunding as it is traditionally understood.

Our specific concerns with Title III are outlined below:

Section 301: Individual Investment Limit

Section 301 contemplates a hard-cap on individual crowdfunding investments that goes far beyond anything that is being contemplated by the states, or even by the overwhelming majority of advocates of crowdfunding. By setting an individual investment cap of 10 percent of annual income, or $10,000, Section 301 will create an exemption that will expose many more American families to potentially devastating financial harm.

For certain very wealthy individuals, or seasoned investors, a cap of $10,000 may make sense. Unfortunately, Section 301 fails to distinguish between these few wealthy, sophisticated investors, and the general investing public, imposing a $10,000 cap on both groups. Given that most U.S. households have a relatively modest amount of savings, a loss of $10,000 can be financially crippling.

A superior method of limiting individual investment amounts would be a scaled approach that would cap most investments at a modest level, but allow experienced investors, who can afford to sustain higher losses, to invest up to $10,000.

Section 301: Aggregate Offering Limit

Section 301 would also permit businesses to solicit investments of up to $2 million, in increments of $10,000 per investment. Such a high cap on aggregate investment makes the bill inconsistent with the expressed rationale for the crowdfunding exception.

Registration and filing requirements at both the state and federal level exist to protect investors. A company that is sufficiently large to warrant the raising of $2 million in investment capital is also a company that can afford to comply with the applicable registration and filing requirements at both the state and federal level.

Section 303: Preemption of State Law

Section 303 would preempt state laws requiring disclosures or review of exempted investment offerings before they are sold to the public. The authority to require such filings 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.

Moreover, as a matter of principle and policy, the review of offerings of this size should remain primarily the responsibility of the states. State regulators are closer, more accessible, and more in touch with the local and regional economic issues that affect both the issuer and the investor in a small business offering.

Congress would be rash to preempt states from regulating crowdfunding. Preempting state authority is a very serious step and not something that should be undertaken lightly or without careful deliberation, including a thorough examination of all available alternatives.

In this case, preemption for a very new and untested concept to raise capital, without a demonstrable history of reliability, is especially unwarranted, as the states have far more experience with crowdfunding than Congress or the SEC, and as the states have historically been the primary “cops on the beat” in the regulation of all areas of small business capital formation.

For a clear example of the dangers of preempting state securities regulators, look no further than the effect of the National Securities Markets Improvement Act (NSMIA). As a result of this Congressional action, private offerings receive virtually no regulatory scrutiny. State securities regulators are prohibited from reviewing these offerings prior to their sale to investors, and federal regulators lack the resources to conduct any meaningful review, so the offerings proceed unquestioned.

Today, the exemption is being misused to steal millions of dollars from investors through false and misleading representations in offerings that provide the appearance of legitimacy without any meaningful scrutiny of regulators.

These offerings are the most frequent source of enforcement cases handled by state securities regulators, according to NASAA’s 2011 enforcement survey. In essence, the private offering provisions of Rule 506 are being used by unscrupulous promoters to evade review and fly under the radar of justice. 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.

Instead of preempting states, Congress should allow the states to take a leading role in implementing an appropriate regulatory framework for crowdfunding. Based on the small size of the offering, the small size of the issuer, and the relatively small investment amounts, it is clear that the states are the only regulators in a position to police this new market and protect its participants.

In closing, I return to the Senate testimony of Professor Coates, who noted the “entirety of the crowdfinancing concept suggests nothing to me so much as a catchy, high-risk, and very possibly fraudulent investment scheme. It might work. It might turn out to be a neat new thing. Or it might turn out to be mostly a cheaper, better vehicle for fraud, with negative spillover effects on the current person-to-person lending and crowdfunding project sites.”

As the securities regulators closest to the investing public, and in light of their distinguished record of effective regulation, states are the most appropriate regulator in this area. State securities regulators are not only capable of acting, but, indeed, are acting in this critical area, and Congress should continue to allow the states to do so.

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  1. John Baker
    Posted Monday, March 26, 2012 at 2:46 pm | Permalink

    This is based entirely on the crowdfunding provisions that were in the House version of the bill. The Senate replaced those with an entirely different version of Title III, and it is the Senate version that is expected to become law. I am disappointed, since I was looking forward to reading an analysis based upon the final version of the bill.

  2. Hector Sanchez
    Posted Wednesday, April 11, 2012 at 4:59 pm | Permalink

    My thoughts exactly…the Crowdfunding bill that became LAW overcomes many of the objections listed by the writer. For example, investors are limited to crowdfunding investments which, in aggregate, cannot exceed 10% of their annual income or assets; 5% if the investor has less than $100K in assets or income. So, it’s impossible for Grandma to be duped into losing her lifesavings in a high-risk venture.

    Therefore, I would now like to see the writer’s comments on the final version of the law.

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  1. […] full article………via The JOBS Act: An Investor Protection Disaster Waiting to Happen — The Harvard Law School Forum on …. Share OptionsPrintEmailMoreFacebookLinkedInStumbleUponTwitterPinterestRedditDiggTumblrLike […]

  2. […] So, that being said, the question about the JOBS Act isn’t whether it will create new jobs. The question is whether it will improve capital markets by removing needlessly cumbersome regulations and lead to the optimal allocation of capital, or whether it will cry havoc and unleash the dogs of warrantless deregulation upon the unwitting masses of potential fraud victims.  (I’m pretty sure these are the only two options, judging by the rhetoric of the bill’s supporters and detractors.) […]