On the JOBS Act, Market Transparency and the Search for Truth: A Lesson in Financial Market History & Current Events

“Those that fail to learn from history are doomed to repeat it.”                              George  Santayana, Winston Churchill.

Many financial market observers, including myself, have greeted the JOBS Act of 2012 with open arms, recognizing the promise it holds as both a driver of capital formation for small and emerging businesses and the democratization of investing.  No doubt, the regulatory sea change brought about by the JOBS Act, coupled with the power of the Internet, has resulted in a re-examination of the entire regulatory structure of the U.S. securities markets – something not seen since the imposition of a detailed and complex federal regulatory scheme in the early 1930’s.

Lest we forget, however, the imposition of this regulatory scheme did not occur in a vacuum. The financial exuberance of the 1920’s, fueled by easy money and a flood of new market participants, was a story that did not end well for most Americans or the U.S. economy.  In hindsight, a consensus of policymakers and legislators transformed itself into a regulatory scheme which had, as its cornerstone, providing investors with pertinent information which was both accurate and complete.

When it came to regulating the U.S. financial markets, after a number of pieces of groundbreaking securities regulations, surely we had learned our lesson. Or had we?

As many historians have noted however, history often repeats itself.  The modern day history of the U.S. financial markets has proven to be no exception.

The 2000 year millennium, a blip on the radar compared to the Crash of 1929, in some respects proved this adage.  The “dot com” bubble was yet another example of market exuberance which history records as not ending well.  Startups and IPO’s proliferated, achieving lofty valuations which brushed aside traditional financial yardsticks.  Fortunes were made overnight – and without warning, many fortunes evaporated – as market exuberance quickly faded away.

In 2008, however, the world financial markets were to learn a more painful lesson. The American dream of home ownership found a willing partner in Wall Street ingenuity – and greed.  Endless, unimaginable amounts of capital flowed into the U.S. debt markets, with a voracious appetite for new and exotic financial instruments – often not well understood by the best and brightest on Wall Street, institutional investors or the regulators charged with market regulation.  At the core of this misadventure were loans made to those who could not afford them, or did not understand their terms – peddled by commission-hungry sales persons.  This was in turn fueled by what seemed at the time to be an endless stream of capital, generated by “bundling” these loans into new and exotic financial instruments and selling them to the most sophisticated of investors – financial institutions around the globe.

At the core of what became one of the greatest financial meltdowns this world economy has ever seen was a market that lacked transparency and accurate information at all levels of the process, from loan origination to the dissemination of exotic financial instruments.  Both our regulators and our regulations proved ill-equipped to temper this exuberance.

Another Historical Accident Waiting to Happen – Led by a New “Bellweather” Index

So on February 4, 2015, when CNBC unveiled a host of new financial “crowdfinance” indices, its flagship being the Crowdfinance 50 Index, this triggered a PTSD flashback of sorts – to some of the not so good old days of yesteryear.

You see, this new Index purported to represent a composite real time index of “commitments raised” by the 50 hottest, live financial transactions – utilizing that new method of capital raising championed by Title II of the JOBS Act – unregistered publicly solicited raises to accredited investors for otherwise traditional “private placements.”  The Index was accompanied by a list of 50 companies, each showing the amount of dollars “raised” thus far – and the amount remaining available before an investor would be shut out of the offering.  Kinda like Home Shopping Network, but without a clock ticking down until these financial products were all gone.  Each Index company’s raise was linked to a deal page, provided by Crowdnetic, a crowdfinance industry data provider whose mantra is “transparency” and prides itself on the accuracy of its data.

Though, fortunately, the Index itself is not yet a traded financial instrument, the danger I saw lurking was to label something as “money raised” – or even  a “commitment” to invest – when there was often nothing to back it up – no investor funds – not even a legally binding commitment to provide funds.  Indeed, all that may have been represented by this data, was nothing more than a potential investor going on a site of one of the Index component platforms, registering on the site, and simply clicking on a mouse to show an indication of interest in a particular offering for a particular amount – simply put, “mouse money.” Often, these “commitments” are never backed up with real dollars, especially in “hot” deals, where investors will simply register their interest in order to get a place in line, and for any number of reasons simply never follow through.

In effect, the CNBC Index did not provide reliable financial data. At best it was a measure of investor sentiment for publicly offered, non-registered raises – what some might view as an index of market exuberance. In the end, this Index, and the long list of companies which followed it, was little more than a commercial lure to this fledgling market – and an incomplete and misleading one at that.

Though certainly the Index was great PR for CNBC, data provider Crowdnetic and the companies lucky enough to make the Top 50, as a securities attorney and a student of financial market history – the dangers to both the integrity of this fledgling JOBS Act market for private placements publicly raised, not to mention unsuspecting investors, was apparent.  Certainly, it was not appropriate to show money as being “raised” in a live ongoing offering, when in fact it had not.  And, in my opinion, it was also inappropriate to present data reflecting non-binding indications of interest as “commitments” without also presenting corresponding real time information quantifying actual dollars invested in a particular raise.

And the dangers were very real, in my opinion – especially in the context of a crowdfinanced offering.  After all, the target market for this Index was not Angel Investors or VC’s. Perhaps an investor, concluding that time was “running out,” might be unduly influenced by this messaging.  And an investor who plunked down real money, believing that an offering was nearly maxxed out might someday learn that the offering was ultimately closed with only the minimum target raised, leaving the company with insufficient funds to fully implement its business plan.

It seemed to me that CNBC, with data “powered by Crowdnetic,” had crossed a line – from providing accurate and transparent data – to providing data which was misleading and incomplete. Instead of reading data contained in Morningstar or the Wall Street Journal, unsuspecting viewers found themselves lured by something more akin to a sensational headline – a la The National Enquirer – lured by a few kernels of “fact” – unless and until one took the time to both read and understand all of the fine print.

A collegial letter to Crowdnetic’s securities counsel, Covington and Burling, sent by me one day after the CNBC Index hit the air on February 4, pointing out these issues and the potential dangers, had some salutary effect. Within hours of its transmission, the Index-listed companies no longer displayed the dollar amounts for each of the listed offerings as money “raised.” Instead, the Index-listed companies now reported money “committed” for each of the Indexed companies – a step in the right direction.

So problem solved? Not really.

As the expression goes:  “Garbage In – Garbage Out.” You see, the Index, apart from being more of a marketing ploy masquerading as a somewhat dubious indicator of market exuberance (what CNBC refers to as “a pulse reading”), is simply the tip of an iceberg of sorts, reflecting a much more ominous evil – as the Index merely mirrors data of a type reported by many of the 18 underlying securities platforms on their websites: investor “commitments” or in some cases “reservations,” more often than not a mere non-binding indication of interest – terms used liberally by intermediaries in their marketing materials to attract interest from the public in live, ongoing offerings.  Missing from this information in most cases is any data reflecting how much money was actually raised. In some cases, missing from the communication is a clear message that these commitments are non-binding indications of interest. And information which is either incomplete or misleading, by regulatory or business standards, is not healthy, either for investors or the integrity of this nascent, newly emerging market place.

These Internet marketing practices, conducted by a large number of Internet intermediaries, were called out, and detailed, in two prior Crowdfund Insider articles, one primarily addressing the CNBC Index, entitled “The CNBC Crowdfinance 50 Index – When an Investor “Commitment” is Just a Kiss”(February 19, 2015), and the other addressing marketing practices by Internet platforms, entitled “The JOBS Act, Crowdfinance & Building Social Consensus: Are Investors Unnecessarily at Risk”  (February 24, 2015).

The Morning After – The Industry Reaction Which Followed These Articles

Feedback I received on these articles from industry leaders around the globe was nothing less than fully supportive of the concerns I shared over Internet marketing practices premised upon incomplete or potentially misleading information – especially feedback regarding the second article. By way of example, Australian crowdfunding pioneer Paul Niederer, founder and CEO of the Australian Small Scale Offerings Board, noted for its extremely low incidence of fraud and business failures, remarked:  Awesome, awesome article. At ASSOB we only display investment once the cheque has cleared! Anything else is misrepresentation in my view and I’m sure you’d agree Sam?” Yes, Paul, I surely agree.

So too from Kevin Laws, COO of AngelList, reputed to be the largest crowdfinance platform for private placements in the U.S., and according to CNBC, one of the Index’s reporting platforms:  Nice article on Crowdfund Insider. You probably won’t be surprised that we at AngelList completely agree. .   .   . I’m supportive of anything that brings true transparency to the market.” Mr. Laws further indicated that AngelList would be revisiting and revising marketing practices in the coming weeks.  His reaction was not surprising, given AngelList’s widely known reputation as an industry leader striving for regulatory perfection – a recent, favorable SEC ruling even bearing AngelList’s name.

Also in accord, Søren Stenderup, Director of CrowdCube Denmark: when promoting to retail investors one must have particularly high standards when it comes to providing balanced and not misleading information.” And Mr. Stenderup appropriately called my attention to the regulatory standards for Internet crowdfinance marketing set by the UK’s counterpart to the SEC, the FCA, which has issued a number of detailed, comprehensive reports focusing on the importance of marketing practices, and balanced information, when offering crowdfinanced securities on the Internet and elsewhere.

And Where There is Smoke – There Often is Fire!

As I concluded in my February 24 article:

“There is a simple solution for both platforms and issuers who wish to lawfully provide information regarding investor interest in order to build social consensus:  Either provide complete data, i.e. data regarding both investor interest and binding investor commitments, with a conspicuous disclosure of what a non-binding investor “commitment” or “reservation” is – or forego providing any quantitative data regarding interest in the offering, binding or non-binding. Doing anything less, in my opinion, is far from being in line with “best practices” and may ultimately lead a portal or an issuer into unnecessary encounters with federal and state regulators.”

So it came as no surprise to me, when I attended and spoke at CrowdfundBeat’s Silicon Valley Crowdfunding Conference on March 5, 2015, and heard international crowdfunding icon Richard Swart tell the nearly 200 conference attendees that a number of U.S. Internet platforms had received letters from the SEC during the prior week inquiring as to their marketing practices. Undoubtedly someone at the SEC had read my articles – and saw the same smoke rising as I did. Nor did it come as a surprise to me when CNBC shortly thereafter begrudgingly revised the description of the CNBC Crowdfinance 50 Index (for the second time):

“To get a pulse reading on the emerging equity crowdfunding market, take a look at the CNBC Crowdfinance Index. It is the daily average index of the 50 largest capital commitments raised  by private U.S. companies listed on Crowdnetic’s data platform” [CNBC Change marked to show deletion of the word “raised”]

Perhaps it was the pitter-patter of regulatory feet which caused CNBC to, once again, rethink the narrative of its CNBC Crowdfinance 50 Index. Perhaps for the sake of this industry CNBC ought to instead consider an Index which simply measures real dollars received by investors.

Some Closing Thoughts

If this nascent industry of Internet platforms (and issuers) raising money publicly in unregistered “private” placements, is to survive – and thrive – anything less than full transparency and accurate, complete information for potential investors simply does not suffice – and is an accident waiting to happen.  History has repeatedly shown the U.S. financial markets that exhibit a lack of transparency, coupled with mislabeled or incomplete financial information – is a recipe for financial disaster of varying proportions that will ultimately cause the demise of the market itself.

On a positive note, as I have pointed out in the second of the two cited articles, these newly emerging post-JOBS Act Internet platforms, many not licensed as broker-dealers under the jurisdiction of the U.S. self-regulatory body, FINRA, though often not steeped in the nuances of federal securities laws or prevailing financial industry practices in the regulated bricks and mortar finance world, are mindful of the importance of adhering to “best practices.”  After all, these first movers of this post-JOBS Act world are the industry. And without adherence to these standards, this nascent industry will simply cease to exist – or will succumb to reflexive overregulation. Initial positive industry reaction to my recent articles provides some tangible evidence for this conclusion.

So personally I am hopeful that with a little bit of sunlight on post-JOBS Act marketing practices which have gone askew, accelerated by the power of Internet media, both best practices and this developing crowdfinance market will both survive – and prosper.

History alone will ultimately record the outcome.


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