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.