July 10, 2013 was Christmas Day for felons and a dark day for investors. That’s when the SEC adopted a new rule allowing previously convicted felons and other bad actors to continue selling unregistered securities to so-called accredited investors (representing almost 10% of all U.S. households). The rule allows all the criminals and miscreants who have been convicted of the worst kinds of securities fraud and who have victimized untold numbers of investors in the past—including, for example, Bernie Madoff—to sell you securities.
Professor John Coffee, one of the most respected and quoted experts in the securities field, recently wrote an article in the New York Law Journal strongly criticizing the SEC’s decision. With a short but incisive legal analysis, he debunks the notion that the law tied the SEC’s hands and prohibited it from making the felon-ban retroactive. Professor Coffee then draws the inescapable conclusion that the SEC yielded to industry lobbying:
“If one were seeking to further tarnish an already compromised agency’s reputation and image, this would be the way to do it. So why did the SEC make this change, which was not in its original rule proposal? Commentators on the proposed rule had divided, with five suggesting that prior ‘bad actor’ disqualifying events should be covered on investor protection grounds, and 15 objecting that to do so would be unfair and unforeseen. But this 3-to-1 majority in favor of grandfathering prior ‘bad actor’ events proves only that law firms write more comment letters than do investors or public interest groups. Worse yet, counting the comment letters only incentivizes the industry to solicit more comment letters.”
The SEC’s terrible judgment matters more than some might think. Rule 506 allows issuers to raise unlimited amounts of money from investors who supposedly have the sophistication and money to make smart investments and absorb losses. These offerings have never been subjected to any significant regulatory oversight, so they’re extremely popular as a way of raising money—and also popular as vehicles for fraud and abuse. Making matters worse, along with the new “bad actor” rule, the SEC adopted another provision (mandated in the JOBS Act) that allows issuers to use “general solicitation” and advertising to attract investors in Rule 506 offerings. So, a fresh and almost unlimited wave of investors will be exposed to the risks in these largely unregulated offerings. And, as Better Markets argued in its comment letter filed on September 23, the SEC’s more recent rule proposals on Rule 506 do little to protect investors from the risks in these offerings.
One thing that the SEC could have and should have done to shore up regulation of Rule 506 offerings is provide some measure of protection with a strong bad actor rule. But the agency failed to do its job and investors will undoubtedly suffer.