In January 2011, President Obama unveiled the Startup America Initiative which included the Jump-Start Our Business Startups (“JOBS”) Act. The JOBS Act was designed to help raise capital for small and new businesses in today’s rough economic times. Yet, certain provisions of the JOBS Act have received scrutiny from members of the financial services industry. Specifically, recent actions by the Securities and Exchange Commission (“SEC”) have taken heat due to the proposition of a rule, as mandated by the JOBS Act, that would make it easier for private securities to be sold without the oversight given to publicly traded securities. This rule could have severe consequences for fund managers, registered representatives and broker/dealers engaged in the sale of private securities to investors.
Overall, the JOBS Act contains numerous provisions that will significantly impact the financial services industry. For example, the JOBS Act provides a new exemption from the requirement to register public offerings with the SEC, mainly for smaller offerings. More controversial is the provision of the JOBS Act that will lift the current bank on general solicitation and advertising of securities sold through private placements, which the SEC proposed through revisions to the Securities Act Rule 506. Currently, Rule 506 allows issuers to sell securities to accredited investors without any limitations on the dollar amounts raised or number of accredited investors, without going through the burdens of registering the offering with the SEC, if in exchange, the issuer agreed, in part, not to engage in general solicitation of its offering. Under the revised Rule 506, as proposed by the SEC, the ban on general solicitation of private placement offerings has been lifted so long as the purchasers are accredited investors. Therefore, so long as the actual investors are accredited, there will be nothing to prevent the issuers of private placements from advertising to non-accredited investors.
In prior years, before recent FINRA rule changes, investors had been able to qualify as accredited investors based upon their home value when their liquid assets were nowhere near the amount necessary to be able to sustain the possible losses that often occur from securities sold through private placements. This resulted in many individuals losing millions of dollars due to investments that were unsuitable but for the fact that the investors’ home value qualified their accreditation. If issuers of private placements are now allowed to advertise their offerings to non-accredited investors, there will be an increased risk that investors are not truthful on their applications in order to qualify as accredited for the purpose of investing in private placement offerings. This will require many members of the financial services industry to pay closer attention to their clients, namely how their qualify as accredited, to ensure they are not lying on their application documents.
Furthermore, even if a client qualifies as an accredited investor, it is still necessary to assure that the offerings are suitable for the client based upon concentration and amount invested criteria. Essentially, the proposed revisions to Rule 506 will open the door to private placements being offered to a new group of clients who may be motivated to conceal the truth about their financial status in order to qualify for advertised investments. In today’s investment market, it is very easy for clients to be deceptive as to their true financial status in order to reap the benefits of high risk investments such as private placements. Consequently, this is quite dangerous as these clients can in turn make suitability or misrepresentation claims against their financial advisors and firms when said investments do not work out as planned.
While it is true that the JOBS Act and the proposed revisions to Rule 506 could help jump-start the economy and allow small, new businesses to raise the capital necessary to succeed in today’s market, they could also open the door to new investors who will do all they can to be afforded the opportunity to invest in private offerings they learned about through general advertisements and solicitations. Likewise, these changes could also subject fund managers, registered representatives and broker/dealers to additional claims when those investors do not see the returns they hoped for on their investments and reveal that they really were not accredited investors as defined by the rules. As a result, financial industry members need to do all they can to make sure they fully know their clients who are contemplating private placement investments and properly document everything in the event such investment decisions turn into lawsuits or arbitration claims if the investments turn south.