In the past four months, the Securities and Exchange Commission laid the groundwork for two major initiatives that give the masses a chance to play a larger role in the investing world.
But the initiatives fail to protect mom-and-pop investors from themselves in significant ways, according to investor advocates who closely track the issues.
This week, the commission unanimously approved a proposal that would allow fledgling businesses to raise small sums online from a large number of people. Through this “crowdfunding” method, entrepreneurs can raise up to $1 million a year from investors and give these people a stake in the company.
Anybody could invest. But investors would be limited in how much they chip in — anywhere from $2,000 to $100,000 annually, depending on their income and net worth. They can even invest their last $2,000. But the goal is to cap how much they can lose.
Here’s the catch: The firms are not required to verify the investors’ income or net worth.
Instead, the money will be raised through funding portals and other intermediaries that can simply rely on the information given to them by potential investors.
“The argument is that if [investors] lie, they’re not deserving of legal protection,” said Mercer Bullard, an associate professor at the University of Mississippi and founder of Fund Democracy, an investor advocacy group. “But people are going to be getting a hard sell, and they’ll be excited about the possibilities and might misrepresent their actual income or net worth.”
The funding portals do not have to accept a potential investor’s word if they have reason to question the information, said SEC spokesman John Nester. The portals are also required to educate investors and to reduce the risk of fraud.
This type of crowdfunding was mandated by the Jumpstart Our Business Startups Act, a broad bipartisan measure enacted last year that aims to make it easier for companies to raise money and grow.
The SEC approved another initiative in July, also spurred by the Jobs Act, which allowed hedge funds and other private firms to raise money by advertising to the public for the first time in decades via e-mails, billboards or even Facebook.
Under that initiative, which took effect in September, firms can solicit whomever they want, although only “accredited investors” with a certain net worth or income can make a purchase.
But the SEC rules give the firms significant flexibility, saying only that they must take “reasonable steps” to verify that the investors are accredited.
That’s not what alarms investor advocates the most.
They’re more concerned that the thresholds that define who qualifies as an accredited investor are far too low. The thresholds haven’t been adjusted for inflation since 1982, and Congress has barred the SEC from making adjustments until July 2014, said Barbara Roper, a director at the Consumer Federation of America.
Anyone with a net worth of more than $1 million (with or without a spouse) or an income exceeding $200,000 (or $300,000 with a spouse) would qualify as accredited. A person’s primary residence is not part of the net-worth calculation because of a recent change in law.
The SEC is likely to revisit the definition come July 2014, an agency spokesman said.
But the agency could go either way, depending on what happens in the marketplace, said Daniel Gorfine, director of financial market policy at the Milken Institute.
“If they see lots of examples of fraud or boiler rooms pushing questionable offerings, the SEC might tighten the definition,” Gorfine said. “But if things go well, and it’s an orderly marketplace with credible players, there may be the opposite pressure.”