State regulators are up in arms about efforts to expand online offerings of private placements.
They contend that a bill pending in Congress to open up on-line offerings to more investors — a concept also supported by President Barack Obama in his jobs plan — would open the door wider for fraudsters to attract victims through the Internet.
Last week, the House Financial Services Committee approved, on a bipartisan basis, a bill that would ease the way for more so-called crowd-funded offerings.
Crowd funding has gained prominence as a way to raise money for social networks, charities and, increasingly, private businesses.
The House bill was expected to go to the full floor this week.
Sponsored by Rep. Patrick McHenry, R-N.C., it would limit crowd-funded deals to $1 million in size, or $2 million if the issuer filed an audit. Issuers couldn't accept more than $10,000 per investor or 10% of an investor's annual income, whichever were smaller.
The $1 million limit tracks what Mr. Obama proposed in his jobs plan.
But state regulators think that easing up on current limits would let bad actors advertise deals on the Internet and suck in unsophisticated investors.
The SEC exemption known as Regulation D, under which private placements are sold, doesn't allow public solicitation, and limits the amounts sold to nonaccredited investors.
Using the Internet to open crowd-funded deals to anyone would erode those protections, according to state securities cops.
“A million or two sold on the Internet through a huge public system that requires no [disclosure] information? We're re-creating the Wild West,” said Heath Abshure, Arkansas securities commissioner.
Mr. Abshure is chairman of a new small-business capital formation committee assembled this month by the North American Securities Administrators Association Inc. in response to the House bill.
“If I'm a crook, I'd be licking my chops over this,”said Jack Herstein, NASAA's president and assistant director of the Nebraska Department of Banking and Finance.
Proponents of crowd funding downplay the danger and assert that technology can minimize fraud while giving small businesses access to capital.
“Wall Street and the banks aren't stepping in, so let the [Internet] community do it,” said Sherwood Neiss, an entrepreneur who founded Startup Exemption, an organization that has been pushing Congress and the White House to ease up on crowd-funded securities offerings.
State regulators are simply afraid of the Internet community's “infringing on their territory,” he said.
Small crowd-funding deals — currently done via de minimus exemptions — involve family and friends, Mr. Neiss said.
That minimizes any chances of fraud.
Such talk makes state regulators nervous. Reg D offerings continue to account for most of their enforcement cases, even after several major fraud cases came to light two years ago.
Stanford Financial Group was alleged to have raised $7 billion through fraudulent certificates of deposit through a Reg D offering. And two allegedly fraudulent private deals from Medical Capital Holdings Inc. and Provident Asset Management LLC have taken down a number of independent broker-dealers.
Medical Capital sold $77 million in notes, and Provident issued $485 million of preferred stock and limited-partnership interests.
Between 2007 and 2010, there were 580 state enforcement actions related to Reg D offerings, according to NASAA spokesman Bob Webster.
Last year, state regulators brought 256 cases related to private offerings.
The House bill retains state regulators' authority to enforce anti-fraud provisions, said Ryan Minto, an aide to Mr. McHenry.
“And we still have very strong investor protections in the bill, so hopefully, [state regulators] will be able to get behind it,” Mr. Minto said.
Last week, the bill was amended to prohibit any individual convicted of securities fraud from using the exemption. And it now requires that issuers make a so-called notice filing with the SEC, which will be available to state regulators.
But state regulators complain that notice filings are just bare-bones alerts that someone is raising money, not a full disclosure document.
Although the Securities and Exchange Commission hasn't taken a position on the bill, Meredith Cross, director of the SEC's Division of Corporation Finance, told a House subcommittee last month that crowd-funding investors may have limited investment experience and information, and little ability to negotiate for protections.
She noted that a 1992 exemption that allowed public offerings of up to $1 million to nonaccredited investors, with no prescribed disclosures, was scaled back in 1999 due to concerns about fraud.
“There was a tremendous amount of manipulation and fraud activity that emanated from that mistake,” said Hugh Makens, of counsel at Warner Norcross & Judd LLP.
An SEC spokesman had no further comment.
Although it isn't part of the House legislation, Mr. Neiss envisions a crowd-funding platform ensuring that deals are sold to family and friends, where active participants can vet issuers, who would have to submit to a background check. Investors would be warned of the risks.
“Yes, fraudsters will try to use it, but they'll fail because the [Internet] crowd will see through them,” he said.
DISMISSING THE IDEA
Mr. Abshure dismisses that idea as Pollyannaish.
“That's just a move back to "buyer beware,'” he said.
“The idea that the people doing the talking [online] somehow get to the truth is silly. The person doing the talking is the fraudster,” Mr. Abshure said.
The minute he gets the money, it's wired offshore and it's gone,” he said.
Crowd funding “may be a gem of an idea, but it isn't a wonderful solution to make capital available,” Mr. Makens said. “What you really need is more broker-dealer firms able and willing to raise money for small companies.”
In the aftermath of the MedCap and Provident messes, however, broker-dealers have pulled back from private offerings.
States could build an exemption process that streamlined crowd-funding efforts and would be in a better position to help local issuers and investors, Mr. Abshure said.
Small crowd-funding issuers won't call the SEC for help, he said.
“They're going to call the states,” he said.
Email Dan Jamieson at firstname.lastname@example.org