Now that the comment period has closed on the SEC's proposal to allow hedge funds and private-placement issuers to advertise their offerings, the agency should listen to its critics and go back to the drawing board to come up with a plan that has safeguards in it to minimize the very real dangers facing the investing public.
To be fair, the Securities and Exchange Commission is between a rock and a hard place. Right now, private-placement issuers and hedge funds can raise money from accredited investors but can't advertise their offerings to the general public.
Under the Jumpstart Our Business Startups Act, the SEC has been directed to lift its advertising ban, even though the only people who will be allowed to invest in these offerings still will be accredited investors. However, the SEC has the wherewithal — in fact, some say it has the duty — to put guidelines in place that accomplish that goal while at the same time protecting ordinary investors.
Critics of the plan, which include SEC member Luis Aguilar, the Consumer Federation of America and the North American Securities Administrators Association Inc., have taken issue with the commission's proposal for its failure to adopt standards to verify that those who purchase these offerings are accredited investors. Instead, it requires merely that issuers have a “reasonable basis” for thinking that the people buying their investments are accredited.
Financial advisers also are concerned. In a recent InvestmentNews survey (see Page 18), 69% of them said that hedge funds shouldn't be allowed to advertise to the general public.
Their concern is well-founded. No one knows what will happen once the advertising ban has been lifted.
Will ads now appear in personal-finance magazines such as Money and Kiplinger's? How about popular investment websites such as TheStreet.com?
And what about infomercials on late-night TV, where the sales pitches regularly run for a half-hour or more?
Given these wide-ranging advertising vehicles, the potential to create greater demand for private offerings will be evident. That is why critics are insisting that the SEC set effective standards to make sure that only accredited investors are allowed to participate in these markets.
The first thing that the SEC must do is redefine an accredited investor. Right now, it broadly defines such an investor as one with a net worth of at least $1 million or an annual income of $200,000 — $300,000 for a couple — in each of the past two years.
Observers have noted that these thresholds are hopelessly outdated and should be adjusted. Set in 1982, they have never been reset for inflation.
Under the existing guidelines, many wage earners who would never describe themselves as wealthy or even well-off might qualify as accredited investors.
Adjusted for inflation, the net-worth requirement today more likely would be about $2.25 million. The annual-income benchmark would be $450,000 for individuals and $674,000 for couples.
Although wealth is one way to define an accredited investor, it alone doesn't guarantee that an individual is educated or sophisticated enough to evaluate private offerings. Some have suggested that individuals should need to demonstrate actual investment experience to complement the wealth benchmarks.
Apart from redefining what an accredited investor is, the SEC must come up with ways to make sure that issuers have procedures in place to verify the accuracy of the information they are relying on to determine investor accreditation.
Perhaps, the SEC should require a third party, such as a broker or adviser, to sign off on the investor's documentation. At the very least, the issuer should be forced to get the SEC to approve its protocol for accredited-investor verification.
The bottom line is that the SEC shouldn't adopt its proposal as originally issued. Although by law it has to follow the dictates of the JOBS Act, it also has to make sure that it isn't opening the floodgates to future investor fraud.