On Crowdfunding and Other Threats

Editor’s Note: a great article appeared in the WS Journal entitled “On Crowfunding and Other Threats.” While the title did not grab me, the first few lines of the story did – -“Attention, investors: Congress has a deal for you! Thanks to the JOBS Act of 2012, you soon will have new ways to drop your money into high-risk start-ups, private offerings, hedge funds and maybe even your neighborhood gelato shop.” I saw many similarities to cases involving abusive tax schemes. I think the advice is great. Here’s the article.

Attention, investors: Congress has a deal for you!

Thanks to the JOBS Act of 2012, you soon will have new ways to drop your money into high-risk start-ups, private offerings, hedge funds and maybe even your neighborhood gelato shop.

The changes are intended to help small businesses raise funds more easily, but regulators and consumer advocates warn they could also unleash an explosion in investment scams. Last month, the North American Securities Administrators Association, an association of securities regulators, said it is especially concerned that two provisions could “unwittingly open a floodgate of fraud.”

Leading the group’s list of top investor threats: “crowdfunding,” or using the Internet to sell securities to individuals. Under the new law, small businesses will be able to offer up to $1 million in debt or equity through crowdfunding, selling either through a broker or a regulated third-party website.

Risky Start-Ups

Rules are expected to be hammered out next year. Still, even when such investing is simplified, putting money into start-ups will remain highly risky, since many fail, says Jack E. Herstein, a Nebraska securities regulator and past president of the regulators’ association.

A second JOBS Act provision will allow widespread advertising and marketing of private offerings, formerly restricted to wealthy investors. About $900 billion was raised last year in private offerings allowed under an exemption in federal securities laws, which includes everything from venture capital to energy partnerships.

While many private offerings are legitimate, they constitute the most common type of fraud state regulators see. “It’s a little bit like the red-light district of the investment community,” says Andrew Stoltmann, a Chicago securities lawyer.

A third provision allows private companies to have up to 2,000 investors before they must make public filings, up from 500 previously. While that might benefit a hot tech start-up, it also could open the door to much larger investment schemes.

So how can you protect yourself from smooth-talking promoters, skilled at seducing you with their “special opportunities?” Here are the questions to ask.

Is that yield possible? The most notable selling point of these offerings is a big return, all the more enticing now that the Federal Reserve is planning on keeping interest rates low into 2015. But how can hotels or natural-gas properties regularly return 10% or 15% a year when nothing else does? And if it is such a good deal, why aren’t wealthier, more sophisticated investors snapping it up?

Masters of Persuasion

Con artists “are masters of persuasion,” determined to “make you believe an opportunity is both good and true,” says Gerri Walsh, vice president of investor education for Finra, the securities industry regulator. It can be hard to see that a pitch is too good to be true.

Why me? Brokers are supposed to vet private offerings and sell them only to accredited investors, or those who make at least $200,000 a year or who have at least $1 million in net worth, excluding their home. They also should ensure that the investment is suitable for you. So quiz them: How does this fit into your portfolio? Do you really have enough to invest to take a risk like this?

What is the commission and management fee? Some private placements include 10% commissions for the broker and another 5% in upfront fees, meaning only 85% of your money is going to the investment. Hedge funds often charge 2% of assets and take 20% of the profits. In other words, you will have to earn a lot just to break even.

What is the broker’s and management’s background? Do an Internet search of their names, looking for lawsuits, fines and investor complaints. You can also see if the broker has ever been sanctioned by state or federal regulators by checking with your state securities office or Finra’s BrokerCheck. Any penalties should concern you, since, as Ms. Walsh says, “There is a fair amount of recidivism when it comes to fraud.”

Can I get the audited results? Professional investors expect an audit by an accounting firm, but many private placements don’t bother to report audited results.

Where is the money going? Read the “risk factors” section of the private-placement memorandum. If management says it may make loans to affiliates, or transfer money between them, it probably will. And if it says it may pay dividends from investor proceeds, it probably will do that, too.

What do my advisers think? If you are serious about the investment, show it to your accountant or lawyer. It’s worth paying a few hundred dollars for their professional assessment, especially since the minimum investment typically is $25,000 or more.

How do I get out of this? There rarely is a secondary market for private placements, and you may not be able to get your money out until the debt matures or the assets are sold, which could be years, if at all.

If you think you will need the money, you should hang on to it. In fact, you shouldn’t invest money in a private offering or start-up unless you can afford to lose it all.