The JOBS Act at age two – prodigy or enfant terrible?
By Stuart Gittleman, Compliance Complete
NEW YORK, Apr. 3, 2014 (Thomson Reuters Accelus) - The financial services industry is still getting used to the two-year old JOBS Act, as funds gingerly begin to explore new general-solicitation freedoms and “crowdfunding” venues sort through the rules, speakers said at a Fordham Law School forum in New York.
As mandated by the JOBS – or Jumpstart Our Business Startups – Act enacted in April 2012, the Securities and Exchange Commission has adopted rules for general solicitations that became effective in September 2013, and is reviewing comments to a December 2013 set of proposed crowd-funding rules.
Before general solicitations were allowed, hedge funds were reluctant to have their personnel speak to the media, even to correct factual errors, to avoid potentially communicating with the general public and particularly non-accredited potential investors, the Hedge Fund Association’s Mitch Ackles said.
Under the new rules, funds have started “dipping their toes in the water” and there have been three advertisements so far, but almost all funds have been reluctant to participate in public marketing for fear that the SEC will pay “special attention” to funds that use general solicitation, Ackles added.
Also, the accredited investor test is flawed because its income and asset levels can become outdated faster than they can be updated and the levels’ correlation with financial sophistication is unproven. A better solution might be to test prospective investor for their financial knowledge, Ackles opined.
But it’s not just SEC rules that may be holding funds back from being more open, said James Jalil, a law partner at Thompson Hine. Mutual funds have structures and expectations that go further than the rules, and as they mature under their new freedoms, hedge funds will benefit by developing a similar infrastructure that encompasses more than just investor protection.
A key area of concern for mutual funds is how their competitors disclose their performance. The Investment Company Institute, a mutual fund trade group, is worried that hedge funds may be able to disadvantage their more established rivals by using different metrics to report their track record. The SEC rules’ inadequate content restrictions makes them too weak to prevent fraudulent misrepresentations and more fully protect investors, said ICI lawyer Robert Grohowski.
The SEC should require a standardized performance measurement and reporting methodology for both hedge and mutual funds, and should update the accredited investor income and asset thresholds that let funds charge performance fees in addition to asset-based compensation, Grohowski said.
After almost a decade of an loosely regulated “wild west” atmosphere the mutual fund industry welcomed Rule 482 under the Securities Act of 1933 as a way to standardize performance advertising to help prospective investors make apples-to-apples comparisons. This structure should apply to hedge funds too, Grohowski added.
Noting that hedge funds are embracing their new freedom cautiously, they should go even more slowly, said Andrew Donohue, the former director of the SEC Division of Investment Management.
The Commodity Futures Trading Commission has not updated its corollary rules, sections 206(1) and (2) of the Investment Advisers Act of 1940 allow fraud liability without evidence of scienter, and Rule 482 does not provide a total safe harbor, said Donohue, who is now at Goldman Sachs Asset Management.
The SEC proposal would create crowd-funding portals that would be a “lite” version of broker-dealers – with limited business opportunities but ones that require having chief compliance officer and anti-money laundering compliance officer functionalities.
Unless it is registered with the Financial Industry Regulatory Authority as a broker-dealer and its personnel are appropriately licensed, the portal will miss out on the revenues of investment banking or selling securities.
But the portal will have the costs of hiring or outsourcing a CCO and an AML CO, and these jobs will be more difficult because the portals are envisioned as internet-only operations. The portal will be required to know its customers as thoroughly as any B-D, no matter how little the customer has invested in “the next Facebook.”
Crowd-funding has been used in Australia and the UK to raise capital for companies but the social-media based fundraising method has not been used by securities issuers in the U.S. The portals envisioned by the SEC proposal could give budding entrepreneurs tools they can use to raise small amounts of capital on a do-it-yourself basis, said Alon Hillel-Tuch of Rockethub, which has raised fund for small business projects here, but ones that did not give contributors an interest in the business.
Crowd-funding can help entrepreneurs, but it will not outpace investments from friends and family, which annually exceed the investments by venture capitalists and angel investors, said Douglas Ellenoff, a law partner at Ellenoff Grossman & Schole. The SEC proposal would, however, protect investors through standardize disclosures under a regulated mechanism, he added.
A down side of the proposal is that it may capture portals as “issuers” under the Securities Act, which could make them liable under private rights of action, warned Joanne Rutkowski, of the SEC Division of Trading and Markets. A plus is that issuers may be able to pay their intermediaries with shares, she said.
The question of intermediary liability is unsettled, countered Ellenoff, who also gave a compliance and due diligence warning: documenting a firm’s know-your-customer procedures and its efforts to identify the IP address of the purported prospective customer may pay dividends in future exams.
The proposal envisions internet-only portals where quasi-brokers never meet investors and may also never meet issuers, so portal applicants should develop thorough compliance and supervisory policies and procedures to withstand probing – maybe even “proctological” – examinations by the SEC staff.
Some of the non -equity crowd-funding models charge low fees on an all-or-nothing basis, which coupled with the compliance and other costs may detract from the sector’s potential profitability and appeal.
A key plus in being an issuer or in operating a portal, whether or not the firm or its affiliate is a registered broker-dealer, is having “social capital” and a savvy knowledge of social media, but the most aggressive tweeters and Facebook and Instagram posters may cause regulatory disclosure alarms, said Hillel-Tuch.
But social media can also bring sunlight as a key, but information cuts both ways, panelists said. The crowd may promote the business proposition, even if it has been eschewed by the friends and family who know the people behind the float, and by experienced venture capitalists and optimistic angels. But the crowd may also ruthlessly perform due diligence on the proposed business and its owners, which can be more cutting than a regulatory exam.
(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. Compliance Complete provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Accelus compliance news on Twitter: @GRC_Accelus)