Crowdfunding Law

Let's Get Crowdfunding Right

Month: October, 2012

Real Investment Crowdfunding is Main Street–Not Goldman Sachs

When thinking about what is required to make investment crowdfunding work, I get the sense that not many people are thinking enough about what crowdfunding already is and how it got there.  This is a problem as regulators are attempting to define the landscape.  Maybe it is just an issue of timing, but I sense it is something more here.  The timing issue is that pending regulations that the lift the general ban on solicitation are certain to occur before Title III crowdfunding regulations are promulgated.  This lifting of the general ban on solicitation has an impact on investment crowdfunding, and enables crowdfunding for accredited investors, but it is certainly not limited to crowdfunding.  In fact, some of the more interesting applications of the ability to generally advertise private investment opportunities have nothing to do with the Internet or social networks. After all, just imagine if Y Combinator ran its next class as a reality TV show and at the end of the reality show accredited investors could actually invest in the class of new companies?  That is a pretty dramatically different world.  However, creating new mechanisms for the same types of companies to get essentially the same type of funding (as to size of the round and size of an individual investment) from essentially the same type of investor, is not crowdfunding to me—it is generally advertised Reg. D investment.

To me, genuine investment crowdfunding is something very different and it has its roots in what crowdfunding as an industry already has become.  Crowdfunding drew the attention of lawmakers because large amounts of money was getting contributed to help fund things that have never been privately funded before.  No better example exists than Kickstarter’s funding of independent films and music.  Genuine crowdfunding is more likely to occur when the Title III regulations are promulgated because Title III investments can be made by anyone who is old enough to enter into a contract.  This means that people who cannot easily invest in companies now will be able to do so.  It is investment for everyone.

Because anyone can invest and because Title III investments will be capped annually, both for issuers and investors, the investors and the investments are likely to be very different than what is realized by companies receiving outside investment today.  A standard Series A round for a tech company will exceed the $1 million annual cap for such a company.  While one can contest the propriety of the particular caps, the notion of investor caps helps create the true crowdfunding dynamic of smaller investments and larger numbers of investors.  Under Title III, I think mostly about communities funding a local coffee shop as opposed to mini Fred Wilsons looking to invest in the next Twitter.

Don’t get me wrong, there will be unconventional companies funded through new rules under Title II enabled 506 rounds as well as some genuine crowdfunding rounds under Title II.  There will also be some new Facebooks funded under Title III crowdfunding.  However, my on unofficial survey indicates that the bulk of the crowdfunding portal industry is gearing up for Title II “crowdfunding” and is aiming for larger rounds that will not fit under Title III.  For portals attempting to be as profitable as possible, that makes some sense.  The problem is that if regulators are only speaking to this group, there is no one at the table discussing what is necessary to make genuine crowdfunding work and pointing out what could be accomplished if the JOBS Act concept of a funding portal is actually realized.  These Internet investment bankers are not trying to make smaller offerings to companies not now being funded work.  They want to be investment bankers, so the cost of being broker-dealers is not particularly significant because larger investment rounds can absorb those costs and the activities they want to conduct require registration anyway.

Hopefully the regulators are thinking of how to make equity rounds as small as $50,0000 viable through funding portals.  These micro-rounds would be very enabling for many Main Street businesses because even SBA loans require some equity in the capitalization.  That is what genuine crowdfunding is about.  The JOBS Act was written with the understanding that this type of round cannot absorb the costs of broker-dealer compliance.  Further, this type of funding cannot absorb a burdensome registration or compliance program from FINRA that could be created for funding portals.  I hope these issues are getting full consideration by regulators because it really does not appear to me that crowdfunding industry groups really care about making small rounds viable.  It is these small rounds that will have tremendous impact for Main Street–like new coffee shops, landscaping businesses, bakeries, organic food stands, fitness centers and florists.  In a post recession world, capital is just not available for these businesses.  These proprietors no longer have home equity, let alone home equity lines of credit that formerly served to get them started.  This is not very interesting if you want to be an internet Goldman Sachs but the economy does not need more of that.  We need new investment from new investors and this is what crowdfunding is really about.  Even for tech companies, seed rounds like this can have a dramatic impact.  That is one thing that Y Combinator and Techstars have already proven–$50,000 can go a long way.

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Investment Crowdfunding in the U.S. is Dead Before Arrival

I was excited to attend the Dealflow Media Crowdfunding Conference in San Francisco Monday. However, what I heard about the regulatory process and the anticipated future rules from the SEC and FINRA sounded like most would-be investment portals have already raised the white flag to the regulators and the potential of the industry will not be realized.  Portals seem to have concluded that the regulators are going to effectively require them to register as broker-dealers even though the JOBS Act clearly was written to allow the creation of funding portals that do not have to deal with full broker-dealer compliance and costs.  I think this capitulation is the wrong approach, is contrary to the legislative intent of Title III of the JOBS Act and effectively kills true crowdfunding before it even begins.

The portal logic is two-fold.  Firstly the representatives of portals who have been meeting most with the regulators have determined that FINRA registration for internet portals will be close to as onerous as the requirements that exist for broker-dealers.  Having to deal with “80% of a broker-dealer’s obligations,” portals will then get virtually none of the broker-dealer’s licensed benefits.  Unlike broker-dealers, the JOBS Act appropriately limits the ability of internet portals to conduct certain activities and receive certain fees that are more commonly associated with broker roles.  The portals’ conclusion is apparently that dealing with the remaining 20% of the regulatory burden in order to receive 100% of the broker-dealer “benefits” and fee structures is a trade worth making.  I think this reaction imprudently focuses on the benefits of broker-dealer status without fully calculating the associated costs and burdens.

One of the roles that is prohibited to funding portals under the JOBS Act without broker-dealer registration is that of acting as an investment advisor.  The second assumption by portals seems to be that the SEC will classify so many things as “investment advice” that no workable portal will be able to operate without being a broker-dealer.  Some portals want to give the crowd what is clearly investment advice.  If you want to recommend to people how they should invest their money, you are not a funding portal and you certainly should be required to register as a broker-dealer.  Again, the JOBS Act was written with that simple logic and precludes funding portals from advising investors.

However, the potential problem is that the SEC has previously concluded that just about everything is “investment advice” in other contexts.  As I wrote before, what I heard from David Blass, Chief Counsel, S.E.C. Trading and Markets Division, regarding the SEC’s thoughts on some of these issues earlier this year was entirely reasonable.  However, if the SEC definition of “investment advice” in the funding portal context includes things as simple as allowing users to search companies based on their sector or even geography, banning sites from mechanically allowing offerings with more user interest to be more visible to other users and precluding portals from denying listing to any potential company, that is a real problem.  Some of this is silly.  The SEC would do well to hire a UI/UX developer as a consultant.  Helping users logically find what they themselves are looking for is sort of the point of web design and it is not really “advice” from the site if it is user directed and organically generated.  Listing a “Deal of the Week” is obviously a different matter.  If the SEC determines that funding portal “investment advice” is effectively everything required to simply run a workable website or that any discussion with companies as to how their offering can be hosted and structured on the site is investment advice, then there is no such thing as a funding portal under the JOBS Act despite the clear intention of the law to create one.

If either FINRA registration and compliance for funding portals is unreasonably burdensome or the SEC regs are overly broad on investment advice, then yes, all equity portals will be required to register as broker-dealers in order to function and, from what I heard in San Francisco, most portals are resigned to doing just that.  If so, true crowdfunding will never be realized in this country and the effort to democratize business finance in this country will remain broken unless and until Congress fixes the SEC and FINRA’s thinking.

The reason crowdfunding is dead if only registered broker-dealers can do it is that it will not be economical for either issuers or portals to conduct Title III transactions.  The trend over the last year has been toward new regulations that have saddled broker-dealers with more costly reporting and compliance requirements.  Even before these increased costs of business, the pressure on broker-dealer firms has been toward larger transactions as increased costs have made smaller transactions unworkable.  Against this backdrop, crowdfunding sites think they can run a business that is cost-effective to issuers and themselves while absorbing the cost of broker-dealer status.  Good luck.  Broker-dealers know better.  Higher regulation and compliance costs may be appropriate for genuine broker-dealer activities but that is precisely why Congress created the notion of funding portals for crowdfunding. Those portals are not intended to have the high cost of compliance and they are not supposed to be doing anything other than hosting offerings in a passive role.

Being a broker-dealer may work in some online applications.  AngelList will be able to absorb the costs of broker-dealer compliance because they are geared to do general solicitations with accredited investors.  Other broker-dealers with a good retail clientele will be successful doing general solicitations under Title II.  I think that approach will be very successful and will be a great resource for companies that most likely would have likely gotten venture or angel backing anyhow.  The rounds will be larger and the valuations will be better and that is a good thing for tech companies in Silicon Valley.  Accredited investors will invest who may have never invested before and that will increase early stage capital and it is a step toward the better.  But make no mistake, this is just a new vehicle for more funding for the same companies that have always been funded–this is not the vehicle to get funding to main street businesses that have never been, and will never be, attractive to the existing private investment model.

If regulations effectively require funding portals to be registered broker-dealers, $1 million dollar capped rounds under Title III don’t make economic sense and true investment crowdfunding is dead.  Portals will likely need to charge up to half of the money raised (perhaps more) for smaller offerings in order to offset the huge costs of compliance.  Everyday Americans will not be able to participate in early stage finance because portals will not be able to economically conduct suitability determinations for investments of less than $2,000.  Even if they wanted to do so, E&O insurers will probably not permit it.  Title III protects these investors by placing arbitrary caps on annual investment.  It does not create a nanny-state response of asking a broker to determine that a small investment is suitable for that particular investor.  Companies that would not have otherwise gotten angel or institutional investment will not have a vehicle through crowdfunding to find it and the dream of democratizing capital finance for Main Street is dead again–all apparently without much of a fight from would-be funding portals.

Dealflow Media has made the audio of the conference available here if you are interested in hearing the panel comments on broker-dealer registration.

Crowdfunding Under Rule 506: Is the SEC Intentionally Undermining the Intention of the JOBS Act?

Last week I tweeted out a link to a very insightful Law 360 article written by Joseph McLaughlin of Sidley. I simply sent the tweet without posting comment because McLaughlin’s article speaks for itself in a very eloquent way. What I failed to realize is that the Law 360 article is behind a paid registration wall. Sorry about that.  If you have a subscription, the article is here.  If not, have no worry because McLaughlin has now publicly commented on the SEC’s proposed rule 506 changes designed to implement the JOBS Act’s elimination of the prohibition against general solicitation.  You can find his equally insightful letter to the SEC here.  If you have any interest in preserving the possibility that the JOBS Act will realize the Congressional intention to open up capital from accredited investors, you should read his letter because the proposed regs may well be an SEC attempt to undermine that legislation.

As proposed, Rule 506(c) would require companies to take “reasonable steps” to verify that investors are accredited investors.  That seems harmless enough on its face.  However, the rule does not provide any clarity on what such “reasonable steps” should be.  Therefore, companies cannot have any assurance that the steps they have taken are sufficient in the circumstances. Furthermore, even if they were “reasonable,” there is no assurance that a disgruntled investor will not sue just to cause a problem or blackmail the company with the prospect of bad publicity and large legal expenses.  McLaughlin persuasively suggests that all this uncertainty is not likely an accident but represents an intentional effort to circumvent provisions of the JOBS Act that the SEC actively argued against.  This could be the first evidence that the SEC has an agenda to impose its own will over the clear legislative intent of the JOBS Act.  Stay tuned.

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