Will Rule Change Place You at Greater Risk for Investment Scams?

By D. Russell Stroud, Fall 2013 Student Intern

As part of the Jumpstart Our Business Startups Act (the “JOBS Act”), the Securities and Exchange Commission (SEC), has enacted changes to Rule 506 of Regulation D under the Securities Act of 1933.  The SEC passed the amendment, which took effect on September 23, 2013, in an effort to reduce some of the previous constraints on companies seeking to raise capital through private placements – an offering of company securities not registered with the SEC or offered via a public exchange such as the NYSE or NASDAQ.  In this post, we briefly address the prior rule and its recent change.  But, most importantly, we discuss what this change means for you and how you can protect yourself as an investor.

Rule 506…in a nutshell.

As previously designed, Rule 506 afforded companies attempting to raise significant capital a safe harbor in order to avoid the full requirements and necessary disclosures inherent in a standard public offering on a national exchange.  The safe harbor permitted companies to make targeted offerings to accredited investors – those with a net worth in excess of $1,000,000, or earned income for each of the last two years in excess of $200,000 for individuals or $300,000 together with a spouse.  The catch was that these offerings could only be conducted through private placements directed specifically at previously identified individuals meeting the accreditation or, in limited cases, sophistication, requirements.  This meant general solicitation and advertising were off limits to the companies as a means of reaching potential investors with these offerings.

accredited investor

The recent amendment to Rule 506 as passed by the SEC, while not altering the requirements defining an accredited investor, now allows companies seeking private funding to engage in general, or open, solicitation and advertising to attract potential investors without losing the registration and filing safe harbor protections under Regulation D.  The issuer must merely observe two requirements:

(1)   The issuer may not sell to non-accredited investors; and

(2)   The issuer must make a reasonable determination that each investor meets the accredited investor standards.

 So what does this mean for you?

While the onus remains on the company making the offering to ensure that transactions are completed only by accredited investors, with the doors now being opened to the general public market, even those individuals who do not meet the accredited investor standards will likely be exposed to these offerings.  As such, there are two essential points that you as the well informed investor must keep at the front of your mind:

(1)   Because these types of private placements are not required to register with the SEC, often very limited information is made available pertaining to the company, its officers, current capital structure, financial history, or the offering itself.  You want to be sure you do not blindly get wrapped up in something.  Absent or incomplete information may obscure potential risks with the company or offering.

(2)   There is no readily available public market for these investments and issuers are generally not required to repurchase the securities from you, thus making it extremely difficult to get your money out of the company when you are ready to sell.  Your money could be tied up longer than you desire or you may simply not be able to readily withdraw if the investment begins to decline in value.

money mogulWhile this by no means suggests one should never invest in a private placement, it does require that you be very careful and do your homework before pursuing such an opportunity.  Know what you are investing in and be very clear as to any limitations in getting your money out of the investment down the road.  Keep in mind, if financial liquidity is a concern, it is probably best if you steer clear of private placements and stick with publicly traded products.

 Be a Knowledgeable Investor.

FINRA has prepared a brief guide for navigating private placements highlighting a number of key tips to help determine if the investment opportunity is right for you.  If you are considering investing in a private placement, be sure to follow these important steps:

  • Research the company and the industry in which it operates.
  • Collect as much information as you can on the offering particulars – dollar amount required to complete the placement, exit opportunities for individual investors, whether there are additional capital contribution requirements, etc.
  • Ask yourself if you are comfortable receiving limited information during the course of your investment.
  • Consult your broker and discuss how the private placement fits in with your overall investment strategy and portfolio make-up.
  • Ask and check.  Ask if the party pitching the investment is registered with FINRA or the SEC.  Then check to see if this in fact the case.
  • Watch out for phishing.  Be extremely cautious with opportunities presented through spam emails or unsolicited phone calls.

fishing for dollars

For more information on ways to protect yourself as an investor, visit the free investor education tools and materials on FINRA’s website as well as the resources on SaveAndInvest.org.