Equity Crowdfunding and The Road Not Taken – What Congress Could Learn From Kansas

It’s pretty easy to make a case against equity crowdfunding:

  • Startups are risky investments – most will fail, and investors will lose their money.
  • Crowdfunding will be a magnet for fraud, drawing phony and exaggerated investment schemes.
  • The goal of crowdfunding, job creation, is illusory – money will be wasted on businesses which ultimately will fail – assuming they even get off the ground – thwarting long term job creation.
  • Investing in “bite-sized” businesses diverts human resources and capital from larger, more efficient economic ventures.

And then there is the time tested wisdom of many successful Wall Streeters:  The real money is made by getting in before the crowd or even after the crowd, but definitely not with the crowd.  Warren Buffet summed it up with this credo:  “Be fearful when others are greedy and greedy when others are fearful.”

Then there was that pillar of Wall Street – Joseph Kennedy, father of President John F. Kennedy and the first Chairman of the SEC, who reportedly rescued his fortune from annihilation by selling all of his investment holdings shortly before the 1929 stock market crash.  His reason for liquidating his entire portfolio: when the market is so popular that a shoe shine boy is giving you stock tips, it’s time to take your money off the table and run.

The JOBS Act debate rose to a new level of visibility on March 3, 2013, when President Obama’s 2009 “Car Czar,” Steven Rattner, weighed in by way of an article entitled “A Sneaky Way to Regulate” in The New York Times, http://opinionator.blogs.nytimes.com/2013/03/03/a-sneaky-way-to-deregulate/?_r=0, where he railed against the JOBS Act in general, but saving his harshest criticism for the legalization of crowdfunding:

Picking winners among the many young companies seeking money is a tough business,even for the most sophisticated investors. Indeed, most professionally run venture funds lose money. For individuals, it’s pure folly. Buy a lottery ticket instead. Your chance of winning is likely to be higher.

As one might expect, Rattner’s New York Times article generated a firestorm of criticism among those leading the equity crowdfunding movement.  According to some critics, Rattner simply didn’t get what crowdfunding was really about.

Mr. Rattner attempted to clarify some of his statements shortly thereafter.  Two days later, according to a CNN article, http://tech.fortune.cnn.com/2013/03/05/crowdfunding-boosters-are-not-happy-with-steve-rattner/, Mr. Rattner advised a reporter:

Rattner also clarified that his biggest concern with equity crowdfunding is not fraud, but rather “stupid business ideas.” In a phone call with Fortune yesterday, Rattner said that he believes there are far better ways to invest money –like in the mutual funds or proven corporate stocks –than to invest in unproven entrepreneurs through crowdfunding.

Seems that Rattner is saying that the average individual investor is ill-equipped to make intelligent investment decisions, and that Wall Street insiders are better able to screen out “stupid business ideas.”  The author of the CNN article could not help but comment on the respect Mr. Rattner’s views deserved:

Rattner’s opinion certainly merits attention considering his role as lead negotiator in President Obama’s bid to restructure the auto industry back in 2009. He also boasts a long career in investment banking, including experience with firms like Lehman Brothers, Morgan Stanley and the Quadrangle Group, a private equity firm he co-founded in 2000.

Clearly Mr. Rattner is an individual who by all accounts, is extremely accomplished in the financial world – and whose opinions and ideas in the financial arena command a great deal of respect.  However, ironically, what the CNN story left out (what a lawyer might call a “material omission”) were allegations by both the SEC and the New York State Attorney General dating back to 2010, which if true, could easily be characterized as “stupid business ideas.”

According to the SEC’s civil complaint filed against Rattner in November 2010, the Commission charged Rattner, a former managing principal of the private equity firm Quadrangle Group, with “entering into undisclosed quid pro quo arrangements .  .  .”  in order to secure up to $150 million of investment funds for Quadrangle from the New York State Retirement Fund (what the SEC described as “pay-to-play”).  http://www.sec.gov/litigation/litreleases/2010/lr21748.htm.  The SEC alleged that Quadrangle secured $150 million in investments after arranging for a Quadrangle affiliate to distribute the DVD of a low-budget film, and by agreeing to pay more than $1 million disguised as a “sham” “finders” fee, and without disclosing these transactions to the Retirement Fund’s investment community.

The SEC’s charges were ultimately settled without Rattner admitting or denying the allegations.  However, Rattner consented to the entry of a judgment that permanently enjoins him from violating Section 17(a)(2) of the Securities Act of 1933 and ordered him to pay approximately $3.2 million in disgorgement and a $3 million penalty – a status which would have barred him from taking advantage of some of the JOBS Act provisions under the“bad actor” exclusions, as they were then proposed by the SEC – proposals which would have barred him from utilizing the  new federal exemption allowing general solicitation of investors in Regulation D private placements.  Perhaps this explained the seemingly incongruous and dismissive criticism by Rattner of the JOBS Act  that “.  .  . the most successful private equity and hedge funds can already raise all the capital they can efficiently manage without advertising.”

The SEC’s allegations of impropriety against Rattner also attracted the attention of the New York State Attorney General.  This matter was put to rest in December 2010 in a settlement whereby Rattner agreed to pay $10 million to settle civil charges that he engaged in a kickback scheme involving New York state’s pension fund.  He did not admit any wrongdoing.

What a Difference One Hundred Years Makes

Okay, so what does Kansas have to do with federal crowdfunding.  After all, in 1911 Kansas earned the distinction of being the first state in the U.S. to enact stringent Blue Sky laws requiring the registration of sales of securities to the general public.  However, Kansas was the first to do an  about face 100 years later – enacting what can fairly be called the first equity crowdfunding law in the U.S.  It was done without an act of Congress, or even the Kansas State legislature, and without a great deal of fanfare and red tape.  It was done by the order of a man named Jack – Aaron Jack –  the now former Securities Commissioner of the State of Kansas.  Apparently the Commissioner had some firsthand experience raising capital and working with broker-dealers.  Seems that in a prior life he was West-Central Zone Director for New York Life, where he presided over 3,200 registered representatives and was the first director in the history of New York Life to raise $1 billion in new assets for its investment management subsidiary. http://www.fed-soc.org/doclib/20120813_JackEngage13.2.pdf.

On May 11, 2011, the then Securities Commissioner Jack formally submitted for public comment the proposed regulations known as the “Invest Kansas Exemption”, exempting from state registration sales of securities in Kansas to an unlimited number of unaccredited investors.  Commissioner Jack’s proposal came with a 60 day public comment period, with a public hearing set on July 19, 2011.   On August 12, 2011, the “Investment Kansas Exemption,” referred to officially as “IKE,” was the law of the State of Kansas, months before the earliest version of the JOBS Act was even introduced as a bill in Congress.

There has been a great deal of hype surrounding equity crowdfunding – both before and following the passage of the federal JOBS Act.  Seems that in Kansas some things are simpler – and quieter.  With the proposed regulations came a simple statement of purpose:

The proposed exemption will allow Kansas companies to raise capital without going through the registration process. A company could spend approximately $15,000 to $25,000 to properly register a $1 million securities offering. The costs would include a filing fee of $500, legal and accounting fees, due diligence costs, and other expenses associated with a securities offering. Most of these costs could be avoided if the company takes advantage of the new exemption, which has no filing fee and is designed to be used with minimal legal assistance. Because of the high expenses associated with registration, few companies actually use the registration process for small offerings.

Kansas Crowdfunding and the JOBS Act Exemption Compared

Here are some of the highlights of the Kansas crowdfunding exemption, compared to the JOBS Act provisions:

  • Limit on Amount Raised – The primary thing IKE has in common with Title III of the JOBS Act is the limit of $1 million raised in 12 months under this exemption – and there is an exclusion for money invested by controlling persons.
  • Limitation on Amount Invested – There are limitations on how much an investor can invest: unaccredited investors are limited to $5,000 per company; there are no limits on an investor who is “accredited” under SEC Regulation D.
  • Advertising – Unlike the JOBS Act, where general solicitation of unaccredited investors is prohibited, general solicitation is expressly permitted.
  • Manner of Sale – Unlike the JOBS Act, which requires an intermediary – either a broker-dealer or an SEC registered portal which becomes subject to FINRA rules governing broker-dealers, there is no requirement that a company use a registered portal to raise money.  Companies have the flexibility to raise money on their own website, or with a registered broker dealer.
  • Disclosure –  There is no particular form of disclosure required.  However, any information provided must be truthful and free of material omissions.
  • Disclosure Standards – Sales and advertising literature must be free of false or misleading statements:
  • Sales and advertising literature shall be deemed to be false and misleading if it contains any exaggerated statements, emphasizes positive information while minimizing negative information, or compares alternative investments without disclosing all material differences between the investments, including expenses, liquidity, safety, and tax features.

So What is IKE Missing?

Because Kansas’ IKE is an exemption from registration under Kansas Blue Sky laws, its scope by its terms is limited geographically to Kansas:

  • Offers and sales only to Kansas residents.
  • The issuer must be organized under Kansas law
  • All persons responsible for the management of the issuer’s operations or properties must be Kansas residents.

Apart from the limited geographic scope of IKE, its most striking feature is its simplicity.  IKE fits on one page – the JOBS Act crowdfunding provisions run nine pages – and that is before tacking on the unknown number of pages comprising the labyrinthian regulations yet to be adopted by the SEC .

IKE is also missing a crowdfunding exemption which mandates the use of an intermediary, such as a broker-dealer or an SEC/FINRA registered portal.  Unlike the JOBS Act, a company is free to set up its own crowdfunding campaign on its website – or to use a broker-dealer to assist it in the offering.

IKE is also missing the hype and the fanfare.

Statutes similar to IKE have been adopted in Georgia and are under consideration in North Carolina and Washington State.  And although IKE does not address all of the equity crowdfunding issues, and is itself not a perfect model for federal legislation, it is certainly a simpler starting point – and one more easily capable of implementation, even at the federal level.

What Congress Can Learn From Kansas and its Blue Sky Laws – They Don’t Know “Jack”

Our Congress could learn something from Kansas and its Securities Commissioner Jack.  The appropriate acronym is not a new one: “KISS” (keep it simple stupid), one that will never sell on Capitol Hill.  But when it comes to the equity crowdfunding debate, nothing is simple or straightforward. There are a great deal of competing ideas inexorably steeped in various conflicts of interest.  In this regard I agree with Mr. Rattner in at least one respect – when he says that the federal JOBS Act legislation in the form ultimately passed was more a function of Washington politics than sound economic or regulatory policy.

The JOBS Act equity crowdfunding provisions are a hodgepodge of ideas more representative of the special interests behind the legislation, primarily those who want to be in the business of equity crowdfunding, rather than sound economic or regulatory policy.  And while I am enthusiastic about equity crowdfunding on a conceptual basis – opening up more channels for businesses in need of capital to raise money – it is imperfect in its present form – and I believe it is likely that the multitude of SEC regulations which will put meat on the bones of the Title III of the JOBS Act will highlight and even accentuate some of these imperfections.

I suggest that while the crowdfunding community is intently focused on the long overdue SEC regulations – a community thus far comprised largely of those who have a vested interest in the business of crowdfunding – those who are interested in seeing equity crowdfunding succeed in raising capital for entrepreneurs ought to be looking ahead to the amendments to the JOBS Act which will inevitably follow, and/or consider other avenues of financing which are permissible under current laws and SEC regulations.

About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies.  For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.

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