Protecting Us From Opportunity

Securities laws are supposed to protect us from harm, but the rules that govern privately placed investments can end up shielding potential investors, not from fraud or theft, but from opportunity.

Federal laws were written after the Crash of 1929 to protect investors, particularly individuals with small portfolios, who got caught up in the mania of the Roaring Twenties and lost everything, often on investments they did not fully understand. The goal was to force companies to provide thorough and accurate data so that investors could make informed decisions. Not necessarily successful ones; the law recognized that investments will always have risk and many are not going to work out. The idea was that investors are entitled to know, in advance, exactly what they are getting into.

Today, however, this perfectly reasonable principle is producing patently unreasonable consequences. Because of U.S. securities regulations, Americans will be the only ones not allowed to invest in Facebook, an American company; a hedge fund is in legal trouble in Massachusetts for creating a website explaining its investment philosophy; and financial advisors who direct very large portfolios for clients may be unable to participate in similar investments themselves, even if clients would prefer that the advisor eat what he cooks.

The reason Americans will not be able to invest in Facebook is, paradoxically, because the public learned too much about the deal. Regulators consider investments in closely-held companies, such as Facebook, to be riskier because such companies are under less scrutiny from the Securities and Exchange Commission. Except for the smallest transactions, offerings can only be made privately to “sophisticated” investors who, based on the size of their investment portfolios, are presumed to have the experience and smarts to size up investments on their own or the cash to hire someone to do it for them.

The Facebook offering was nominally private, but the deal gained a great deal of attention in the general media, reaching members of the public who ordinarily would not be privy to such eyes-only information. Goldman Sachs, worried that regulators might decide the media attention constituted an offering to non-sophisticated investors, preemptively limited the offering to non-Americans. The company said in a statement, “Goldman Sachs concluded that the level of media attention might not be consistent with the proper completion of a U.S. private placement under U.S. law.”

Goldman Sachs was not being unreasonable in thinking that the publicity might cause regulatory problems. In 2007, the Commonwealth of Massachusetts sanctioned a hedge fund for giving information about itself on a publicly accessible website, claiming that the website constituted an illegal public offering. The hedge fund, Bulldog Investors, did not make any untruthful claims, nor did it directly encourage viewers of the website to invest. It simply gave a transparent account of its strategy and track record.

Nevertheless, the state argued that “even though not couched in terms of a direct offer,” information on a website still might “condition the public mind or arouse public interest in the particular securities.” In other words, information must be kept away from the masses, who might not be intelligent enough to handle it without becoming “aroused” and making rash investments. Bulldog fought back and legal action is ongoing.

Of course, no matter how much small-time investors’ interests were piqued by the media coverage of the Facebook deal or by Bulldog’s website, they still wouldn’t have been able to take any real action regarding those opportunities. In addition to restricting the flow of information to those not considered “sophisticated” enough to make complex investments, securities regulations also outright prohibit most people from taking part in these deals.

The Facebook shares would have been offered only to “qualified purchasers,” and, no matter who read its website, Bulldog was permitted to enroll only “accredited investors.” Both of those words, “qualified” and “accredited,” mean wealthy. To be a “qualified purchaser” an individual must have an investment portfolio of at least $5 million. The standard is lower for “accredited investors.” A person might be considered adequately sophisticated to make an investment one day, and then, due to an overall drop in the stock market, lose that mark of sophistication the next day. Financial advisors who use their expertise to evaluate investments for wealthy clients are prohibited from using that same expertise in managing their own portfolios.

There is a fine line between preventing con artists from taking advantage of ordinary investors and blocking individuals from making their own decisions about what risks to take. The line is currently drawn in the wrong place. Moving it back to where it belongs will require two major adjustments to the Depression-era laws.

First, information that is accurate and not misleading should never be illegal, no matter how widely it is disseminated. The current suppression of information creates an unfair advantage for certain investors. People who have no idea what kinds of deals and terms are being offered to the most sophisticated investors are likely to accept much less favorable terms themselves. We see a lot of deals offered to moderately wealthy investors that bigger players would never touch.

Second, the criteria for becoming a “qualified purchaser” or “accredited investor” should be based on the size of an investor’s portfolio in relation to the potential investment, rather than simple net worth. A qualified purchaser might be defined as someone for whom the investment would not represent more than, say, 3 percent of a portfolio. An accredited investor might be someone for whom the investment would not exceed perhaps 5 or 10 percent. The total exposure in a small portfolio to nonpublic investments could be limited to something like 10 or 20 percent.

Usually, a private company can include up to 100 accredited investors or 500 qualified purchasers. Because of this limit on the number of investors, all but the smallest deals are likely to have steep enough minimum investments that these percentage-based limits would keep out most mom-and-pop participants. But the percentage limits would still permit small investors to at least participate, in a modest way, in some of the same types of opportunities that bigger players get.

Securities laws were intended to guarantee investors fair treatment, which is an achievable goal. While it might be “fair” in some people’s minds to prohibit all Americans, including the wealthiest, from participating (wisely or otherwise) in Facebook’s forthcoming offering, it certainly misses the point. The securities laws have drifted off target. It’s time to get them pointed in the right direction again.