The dark side of JOBS

THE JUMPSTART Our Business Start- ups bill likely will jump-start additional responsibilities for investment advisers. That is because one of its provisions could leave investors, especially those who are inexperienced and unsophisticated, vulnerable to scam artists pushing hot-stock deals.

Investment advisers, and all those working with individual investors, would have to fine-tune their anti-fraud radar to pick up on the additional attempted fraudulent stock deals this bill likely will produce.

Rolling back elements of the Sarbanes-Oxley law, the JOBS bill will make it easier for small and midsize companies — those with annual revenue of up to $1 billion — to raise money through initial public offerings.

The bill, which awaits President Barack Obama's signature, will allow crowd funding — or small companies' raising up to $1 million annually from the sale of small amounts of stock to individuals without having to register the shares with the Securities and Exchange Commission. In addition, it would raise the threshold for private firms to 2,000 shareholders, from 500, allowing companies that wanted to avoid registering with the SEC to do so for longer.

It is easy to see the opportunities for fraud arising from these provisions.

Small companies also would be able to forego some accounting rules, external audits of their internal controls (considered unreasonably expensive for small firms) and disclosure of executive pay for up to five years.

The objective is to encourage more startups and to help existing small firms raise the capital needed to grow, to reduce the cost of going public and to reduce the cost of being a public company for small firms in the expectation that this will stimulate job creation.

Unfortunately, the eased regulations will provide plenty of opportunities for criminals to take advantage of investors. The bill raises the probability that small investors will be lured by unscrupulous promoters into “private-equity” and “venture capital” deals whose only real prospect is to make the promoters wealthy.

RIPE FOR THE PICKING

Conditions are especially ripe for unsophisticated investors to be seduced by such investment opportunities, given the poor results produced by the stock markets in the past decade and the frequent reports of institutional investors' increasing their involvement in private-equity deals, especially VC deals. “Private equity” and “venture capital” sound cutting-edge and can be presented as a diversification that reduces risk.

Although institutional investors such as pension funds, endowments and foundations have been pouring billions of dollars into private-equity investments and might be tempted by some of the small companies affected by the new rules, they have sophisticated analysts to help them vet any opportunities.

Presumably, the SEC, which has opposed many provisions of the bill, will step up its surveillance of small private companies raising money from individual investors.

But for individual investors, the advisers and brokers who serve them must be a strong second line of defense. Unfortunately, bucket shops dealing in fraudulent or worthless investments often reach such investors out of sight and hearing of advisers through phone calls.

Legitimate advisers and brokers will have to be in frequent contact with clients, warning them about the possibilities of fraud and urging them to get an expert opinion about investment opportunities. Otherwise, instead of JOBS' offering opportunities, it may be increasing the number of fraud victims.