April 4 (Bloomberg) — Mark L. Morze knows a good investment opportunity when he sees one, but he hasn’t pursued his fortunes quite the way the rest of us have. Morze, 61, hung his hat for 4 1/2 years at federal prisons in Lompoc and Boron, California, after pleading guilty to two counts of fraud for cooking the books at the infamous carpet-cleaning company ZZZZ Best in the 1980s.
He says he’s baffled that President Barack Obama plans to sign a law tomorrow that amounts to an open invitation for fraud. “I wish legislators would consult with people like me before they write something like this,” he says, sounding dead serious about the offer. “I could tell them, ‘I know what your intent was with this wording, but we can get around it so easily, it cracks me up.”’
I’m sure the last thing U.S. lawmakers were looking for in their zealous bipartisan push for the Jumpstart Our Business Startups (JOBS) Act was the inconvenient feedback of a seasoned investment fraudster — albeit one who says he’s rehabilitated and now lectures on the techniques scammers use. Though the JOBS Act was packaged as a plan to streamline rules to help small companies crank out jobs, even its cheerleaders have come up with scant evidence the law will boost employment much, if at all. In an election year when pragmatic politicians are laboring to come off as allies of deep-pocketed business donors, the JOBS Act is a slapdash attempt at securities-law deregulation, plain and simple.
The new law has 22 pages of gems that include new ways for securities analysts to tout their firms’ public offerings, and cool opportunities to avoid rules that force companies to supply audited financial statements. In the end, though, the law that Morze tags as having “real potential for abuse” boils down to two features that don’t bode well for small investors: It lets a lot of companies reveal less about themselves when they sell stock, and, for the first time, it lets companies flog their shares on the Internet.
The Securities and Exchange Commission still has to figure out how the new JOBS rules will read, which just means the unsightly lobbying to diminish investor protection hasn’t yet ended.
There is a lot to dislike about the law, and we will all learn soon enough which ill-advised provisions in the JOBS Act have done the most harm to smaller investors. For the moment, though, the law’s approval of something called “crowdfunding” looks like the most toxic of all.
I wrote about crowdfunding this time last year, having noticed that celebrity Whoopi Goldberg had promoted the idea on her Facebook page, where she continued to plug crowdfunding as recently as last month. Crowdfunding is a way to raise money, as tech types put it, “from the crowd” on the Internet. It became popular when musicians and other artists began using it to solicit online donations for underwriting music tours and films.
Crowdfunding comes with some heart-warming benefits. Families have crowdfunded to raise money for a loved one’s expensive medical procedure, for example. But it was only a matter of time before sharp-eyed investment types spotted the benign Internet fund-raising technique as a way to sell shares to the public.
There was a hitch, though. They had to find a way around those irritating SEC rules that force you to slog through extensive registration requirements. Now that the hurdle has been removed by the JOBS Act, companies will be able to peddle as much as $1 million in shares a year that investors can access with a click on their shiny new iPad 3s.
Even before JOBS came along, we were at little risk of running out of financial scams to worry about. At the Federal Bureau of Investigation in Washington, Unit Chief for Financial Crimes Aaron Seres says investors continue to get fleeced by boiler-room operators who hype shares of microcap companies, and that’s without the viral fraud possibilities that Internet IPOs would add. His fear is that unsophisticated investors will be lured into online scams and learn too late, as Seres puts it, that “Lo and behold, there’s no business in the first place.”
It will take months for the SEC to get those new rules in place, but Morze figures that the sleaze set is already doing prep work to line up refuse to sell on the new crowdfunding sites, which are known as portals.
“My guess is they’re setting up dummy companies,” he says, speculating that crowdfunding will appeal to “small investors who are a little intimidated by bigger marketplaces.”
Investors with annual income or net worth of less than $100,000 will be allowed to invest as much as $2,000 a year in a company that offers shares via crowdfunding. People with net worth or income of more than $100,000 can invest as much as 10 percent of their annual income or net worth, up to $100,000.
From what I can tell, crowdfunding’s supporters mostly are well-meaning boosters of entrepreneurialism who simply don’t have much understanding of how a swindler’s mind works. They have suggested fraud-thwarting measures such as a self- regulatory organization to keep things honest, and there is nothing wrong with trying that, though SROs have been no cure for the fraud we already have in the markets.
Fans of the idea have also found solace that when an entrepreneur makes a claim online about his or her company, readers can signal that the assertion is sound by pushing the “like” button. Unexplained in all this is why we wouldn’t expect that some sleazy stock promoter couldn’t arrange for his cronies to be gathered in an Internet cafe pushing the same button over and over again on some worthless fraud.
The JOBS regulatory easing coincides with a soaring caseload for law enforcers. The FBI had a record 726 pending corporate-fraud investigations in the fiscal year ended Sept. 30. It had 1,800 pending commodities and securities-fraud investigations for the same period, also a record.
History suggests that when you strip away regulators’ authority, you set the stage for more fraud and a spike in the number of investors who want nothing to do with financial markets. After Congress passed the 1996 National Securities Markets Improvement Act — what’s with these titles that say the opposite of their intent? — state regulators shifted from stopping fraud before it happened to mopping up the mess after investors had been bilked. Joseph Borg, the securities commissioner in Alabama, says investors have suffered “billions of dollars of losses” since that law stripped state regulators of their ability to vet private deals known as Regulation D 506 offerings.
“We used to call them up and ask questions about this or that or the other thing, and we’d never hear from them again — they’d just go away,” says Borg, referring to the shady characters who tried to sell garbage under the Regulation D exemptions from full securities-law registration. Today, Borg and his colleagues in other states usually settle for filing enforcement actions against Reg D crooks after the money is gone. State regulators have brought 580 enforcement actions against violators of Reg D’s exemption over the past three years.
The JOBS Act similarly denies states any say over crowdfunding offerings, but does honor them with the booby prize of having the authority to bring fraud charges.
And who might be the victims in the wacky new world of securities crowdfunding? Maybe not who you think.
The quest for financial literacy among smaller investors is a laudable goal pursued by consumer advocates in recent years, but it turns out that knowing the basics doesn’t mean you have what it takes to ward off investment criminals. Anthony Pratkanis, a professor of psychology at the University of California in Santa Cruz, told me he worked on a project where researchers got their hands on real-life tapes of crooks pitching victims on the telephone.
Perhaps it isn’t a surprise that victims often had unusual stress in their lives – divorce, job loss, or other difficulties — that made them more vulnerable. The crooks would “tailor the investment advice to whatever was needed,” Pratkanis said.
But Pratkanis said he didn’t expect to discover this attribute in many of the investors who lost: they tended to score highest on a quiz of eight basic questions about investing, which signaled to the research team that financial literacy offered little protection. Equally surprising was that victims were more likely to be male, married, wealthy and educated.
John Lawlor, a Long Island, New York-based lawyer who has practiced securities law for 27 years, told me the target of choice for scamsters who peddle worthless private securities over the telephone is the same group that the hapless JOBS law says it is trying to help: small businesses.
“It’s always small-business owners, usually outside of major metropolitan areas,” he said. “That’s who is on the cold-calling lists.” Regulators figure the same bad operators who scam over the phone will be exploiting the new online opportunities, too.
Morze has a good idea, JOBS law or no JOBS law. When someone gets caught, make it hurt, he says. “Prison really helps deter white-collar guys,” he said. Let’s hope lawmakers and regulators hear that.
(Susan Antilla, who has written about Wall Street and business for three decades and is the author of “Tales From the Boom-Boom Room,” a book about sexual harassment at financial companies, is a Bloomberg View columnist. The opinions expressed are her own.)