There was an air of euphoria in the crowdfunding community on October 23 when the U.S. Securities and Exchange Commission finally issued its proposed crowdfunding rules – a necessary step to implement equity crowdfunding, as dictated by Congress in the JOBS Act of 2012 (“Jumpstart Our Business Startups Act”). Though Congress had laid out a nine page roadmap creating an entirely new market structure, implementation was dependent on the SEC promulgating rules to implement the will of Congress – something the SEC was ordered to do by January 1, 2013. OK, so the proposed rules arrived a little late – 274 days to be exact. At least we have a Chairman at the SEC who appears committed to “getting stuff done,” whether or not it suits her views on a particular issue. Besides, the vote of the Commission on the proposed rules was unanimous, unlike the contentiousness which ushered in the Title II rules in July 2013. By all appearances it seemed that despite the worst fears of some Crowdfund proponents, the SEC was committed to get the job done – and done right. At least that was the hope.
The verdict surrounding the SEC’s proposed crowdfunding rules has thus far been mixed, generally falling into three categories:
Dismissive – Characteristic of staunch equity crowdfunding naysayers.
Determined – The proposed rules are a good start.
Disillusioned – With all the cost and complexity, why even bother with equity crowdfunding.
But the world looked a little different from my perspective – at least from the vantage point of a securities attorney, nestled in my office in Los Angeles.
Nearly two weeks after plowing through the proposed rules, reaching out to thought leaders in the crowdfunding community and surveying the myriad opinions of prognosticators on all sides of this issue, my conclusion is that despite the best efforts of the SEC, they still have not gotten it right.
The headline in USA Today says it all – albeit all wrong:
The SEC’s proposed rules on crowdfunding could bring investors an alternative to Wall Street’s monopoly on securities dealing, says USA TODAY’s business regulation columnist.
- The SEC proposes to let small companies offer shares without going through SEC registration
- Proposal strikes balance between protecting investors and letting process work
The last headline, striking a balance between protecting investors and letting the process work, was a view shared by many commentators. While the rules may have struck some sort of balance, if these rules are enacted as proposed the process may work – but it will not work well. And though the rules in large measure dutifully follow the dictates of Title III of the JOBS Act, as laid out by Congress, they are fatally riddled with the institutional biases embedded in our securities regulatory structure over the past 80 years. And while this structure has worked well for Wall Street, it has not met the needs of startups and other small and emerging businesses – something that the JOBS Act was intended to fix.
The end result are rules which have as their by-product:
- Complexity, and
- Conflicts of interest;
three factors that have dominated the securities landscape for decades – and which are anathema to equity crowdfunding as well as other innovations in the area of capital formation for small businesses which are much needed and long overdue. And although much of the blame for defects lies in the tenets that Congress laid down for the nascent crowdfunding industry, in my opinion the five SEC commissioners have a long way to go to make equity crowdfunding a vibrant, functioning market – they must think and act outside the regulatory box that the SEC has been trapped in for more 80 years – if crowdfunding and other innovative avenues of capital formation for small businesses are to succeed.
The SEC ought to heed the wisdom of one of the most renowned securities regulation scholars of our time, Joel Seligman, who 10 years ago summed up what is at stake in these few words:
“I want to urge that the caution of the SEC is not without cost. It is not simply that issues are not resolved, but rather that our markets remain less efficient; more beset by conflicts of interest; and ultimately, more vulnerable to international competition than they need to.”
Conflicts of Interest- Wall Street Versus Innovation – A Tilted Playing Field
Let there be no mistake about it. What Sherwood Neiss and Jason Best, the Godfathers of equity crowdfunding have accomplished by reason of gaining passage of Title III of the JOBS Act is nothing short of a miracle – new and innovative legislation creating an entirely new market structure, in a politically divided Congress – which goes against the grain of 80 years of regulatory history and creates an opening which is potentially disruptive to well established, and well represented Wall street interests. All of this was accomplished in a matter of months, and without spending millions of dollars for high priced “K” Street Washington lobbyists. But let’s face it – despite the catchy acronym of the JOBS Act, Jumpstart Our Business Startups Act, most of the bill’s provisions were an oversized Christmas present for vested Wall Street interests – not business startups. Whatever legislative momentum for the JOBS Act was provided by Congressman McHenry and crowdfunding proponents, Wall Street jumped on that bus, took control of the wheel, and pushed crowdfunding to the back of the bus. Other provisions which would have been immensely helpful to small business capital formation were thrown out the window – or in more colloquial terms – under the bus – never to see the light of day in Congress (more on that later).
It is not hard to understand why Wall Street by and large has no burning desire to lead the charge on equity crowdfunding. First and foremost, size matters, especially on Wall Street. Large financings yield large commissions-small deals earn small commissions. And very small deals, ala crowdfunding, yield very small commissions. And those institutional types who show any sort of interest in crowdfunding are likely enchanted by the prospect of a new vehicle that will allow them to skim the few attractive deals off the top – and away from the crowd.
So if size matters so much to Wall Street, why were they so involved in the legislative process leading up to the enactment of Title III. It’s called protecting your turf. While Wall Street has no interest in bite sized financings, the domain of curating transactions has been an area long reserved to SEC licensed broker-dealers and are regulated by FINRA, the only financial industry SRO in this country. Any encroachment on that turf could lead to a whole new breed of financial transaction facilitators, and financial transactions. With the intersection of the internet, social media and technological innovations, creating a crowdfunding transaction which put FINRA broker-dealers at a disadvantage – could be the beginning of a slippery slope which would threaten the FINRA monopoly – with even larger transactions – and disrupt the established financial community.
Separate But Equal is Inherently Unequal – But Separate and Unequal Will not Work Well for Crowdfunding
Okay, let’s look at who will be running the equity crowdfunding platforms. Title III creates two classes of intermediaries (platforms) – licensed broker-dealers and “funding portals”, the latter being an invention borne in Title III. Both types of portals must be regulated by a national securities association, with all of its attendant rules – which in this case is FINRA – since FINRA is the only game in town.
But embedded in the statute is a structure that makes a viable business model for a non-FINRA portal an iffy proposition – funding portals will be subject to a regulatory maze that is very different from the “broker-dealer light” that Wood and Best had hoped for – with all of its attendant costs and complexity. However, unless a funding portal teams up with a broker-dealer (i.e. splits its fees), it will be unable to take an equity kicker in the transaction, and will be unable to dish out any investment advice to the crowd.
So be it for the statute itself. The SEC’s proposed rules take the statute a couple of steps closer to the cliff of extinction, at least for funding portals.
First, Congress dictated that funding portals (i.e. non broker-dealers) could not offer investment advice or recommendations. Even assuming, arguendo, that one is a staunch believer of the “wisdom of the crowd”, why bother going to a portal that reads more like an unfiltered Craig’s List bulletin board, as opposed to a menu of carefully curated investment opportunities. Broker-dealers have a leg up over funding portals from the get go, both from the company (issuer) perspective and the investor prospective. Though, in my opinion, Title III of the JOBS Act does not, ipso facto preclude funding portals from presented a list of carefully curated investments, the SEC in its 585 tome has clearly precluded funding portals from doing so – even if they have on their staff a licensed broker-dealer, certified public accountant, or Certified Financial Planner. The JOBS Act (but not the proposed rule) appears to allow room for a funding portal to apply its own qualitative listing standards as a condition to listing – so long as, once listed, the funding portal does not play favorites by making investment recommendations.
We leave crowdfunding in risky startups to the “wisdom of the crowd”, but don’t allow licensed funding portals to make a quality cut for its portal – it must take on all comers unless they detect the aroma of fraud or the company’s management have a “record.” Who does the SEC think it is protecting by this rule. Certainly not investors!
Second, all crowdfunding platforms, including a funding portal, are required to take “such measures to reduce the risk of fraud . . . as established by the Commission by rule, including obtaining background checks on officers, directors and 20% stockholders. The Commission’s proposed rules appear to take this one step further to the cliff of funding portal extinction – by creating an ambiguous obligation on the part of platforms to ferret out fraud – something the statute may permit, but certainly does not require. The Commission, in effect, has created a schizophrenic business paradigm for funding platforms – a business model which imposes the risks/liability attendant to being a broker-dealer – but without the ability to use the broker-dealer compensation model – or even to create value for a different compensation model (remember, the SEC has said no curation for platforms unless registered as a broker-dealer).
And to make matters worse for funding portals, broker-dealers will have a built-in head start over funding portals – as funding portals must first be registered with both FINRA and the SEC – a process that takes time – and cannot even be started until both FINRA and the SEC promulgate final rules.
If the SEC adopts its rules as proposed, say syonara to non broker-dealer funding portals playing in the equity crowdfunding space. It is no wonder that the Kickstarter and their like have greeted the proposed regulations with a mix of caution and disinterest.
Thus, notwithstanding the headlines, the SEC’s rules, as proposed, have left the “Wall Street Monopoly” intact. It’s the back of the bus for crowdfunders. So much for robust competition in this marketplace.
The Elephant in the Room – Cost and Complexity
Okay, so you say you can live with the Wall Street monopoly. Unfortunately, this is probably the least of the impediments to making equity crowdfunding a vibrant market. The proposed rules add an unhealthy dose of cost and complexity.
With all due respect to the concerns as to cost expressed by Sherwood Neiss in his testimony before Congress on October 30, 2013, this issue is only the tip of the iceberg for a crowdfunding company hoping to raise up to $1 million. Yes there will be costs – there is always a cost for money – and the higher the risk, the higher the cost. There is nothing anyone can or should do about that. This is, after all, a rational economic principal. And yes, there are some costs that could be avoided – such as by only requiring reviewed financial statements, rather than audited financial statements (as is required by the JOBS Act for raises over $500,000). But the biggest deal killer is complexity – which not only adds to the financial cost – but complexity that, instead of allowing crowdfunding to be a magnet for would be entrepreneurs and small businesses with fundable business models, will have the opposite effect – serving as a fatal repellent to even starting down the equity crowdfunding road at all.
Some Unnecessary Complexities Courtesy of the SEC
Cost and complexity will kill equity crowdfunding before it even has a chance to prove itself – if the SEC’s proposed rules are allowed to stand. Dara Albright, Managing Director of Crowdnetics, a vocal supporter of equity crowdfunding, had this to say one week after the proposed rules were issued:
“after reading the proposed rules . . . I’m struggling to understand why issuers would opt for this type of financing structure over other more attractive crowdfinance methods.
For instance, why would an issuer raising $1M subject itself to a financial audit, additional form filings and advertising limitations when it can just as easily complete a PIPR (“Private Issuers Publicly Raising”) financing under the 506c exemption [private offerings to accredited investors using public solicitation] where there are no offering limits, no advertising restrictions, no audit requirements and no ongoing filing obligations? (Information on PIPRs can be found on Dow Jones’ MarketWatch in the “Education Section” of Private Offerings).
While I remain a staunch supporter of interstate securities crowdfunding, my fear is that Title III crowdfunding (as will make the cost of raising small amounts of capital too high for most emerging businesses proposed) will have difficulty finding mainstream adoption. The additional regulatory burdens. And when capital is too expensive, neither issuers nor shareholders stand to benefit.”
This is a far cry from the optimism Ms. Albright exuded only eight months ago:
“Most people don’t realize that crowdfund Investing is guided by the very same principles that transformed America from a vast farmland into the greatest economic engine that the world had ever encountered. Enacted with the proper blend of decorum and incentives, crowdfunding has the ability to inspire a similar economic revolution. But, imagine the possibilities of one that fosters social consciousness in addition to prosperity.
In other words, based upon what the SEC has dished out, “why even bother.” With unnecessary complexity brings unnecessary financial costs – and unnecessary complexity will sound the death knell for equity crowdfunding before it can even get off the ground. And Ms. Albright is not alone with her prognosis.
The Core of the Complexity – The SEC’s Disclosure Model is Broken
From the vantage point of a securities lawyer, what is at the core of the (unnecessary) complexity are the disclosure requirements outlined in 10 of the 585 pages of proposed regulations – which mandate what disclosure a crowdfunding company must make – and how it must make it – coupled with what is not in the proposed regulations – how to meaningfully educate the crowd leveraging the crowdfunding process.
According to USA Today, preparation of disclosure documents under the new rules ought to be a snap:
“Ancillary service providers such as CrowdCheck are already working to help vet potential investments and provide disclosure a lot more helpful than those voluminous prospectuses of legal mumbo jumbo that no normal investor can read or understand.”
My suggestion – don’t believe everything you read in the national media. While CrowdCheck is a fine company, staffed by some of the best and the brightest – it certainly hasn’t been providing any disclosure services to any U.S. equity crowdfunders – at least not under the proposed SEC rules.
Second, while there will always be some third party service provider willing to step up to help a crowdfunder complete the mandatory disclosure with an API template– at varying costs – the daunting 10 pages of disclosure regulations will unnerve the average entrepreneur, no matter how seasoned – again, discouraging crowdfunders from even going down this road.
Even from the perspective of a securities lawyer who has prosecuted a fair number of SEC registrations, although the proposed rules give a company the flexibility to determine how the required disclosures are made, the proposed disclosure rules have the look and feel of registration type disclosure. Yes, there is no registration review process – but yes, there certainly is registration – which must be filed through the SEC’s electronic “EDGAR” system. And at the end of the day, if Chair White means what she says when she says that “We want this market to thrive, in a safe manner for investors,” it is the responsibility of the SEC to provide a workable disclosure framework, and not leave this task to intermediaries and/or the lowest bidder amongst a sea of unregulated third party service providers. Moreover, (and beyond the scope of this article), is the potential (and unnecessary) legal risk created for the crowdfunding company that fails to follow these detailed rules to the letter. If the proposed rules are left standing, I for one would echo the sentiment of Dara Albright – why even bother, when Rule 506 is available. Unfortunately, if this becomes the final judgment of potentially crowdfunded companies, scores of startups and small businesses will never get off the ground – too small, or too uninteresting – to appeal to the Rule 506 crowd of investors.
If disclosure is the name of the game (indeed the only game) for investor protection, at least from the SEC’s vantage point (which I fully expect and understand), the disclosure must be “right sized” for the dollar amounts involved and in a format that is truly meaningful to an investor.
If there is anything the SEC must do before it completes the rulemaking process – it MUST devise simple, meaningful disclosure in a format which is tailored to the process by which the crowd will absorb and analyze information. Instead, the SEC has gone overboard, and taken the entire crowdfunding market with it. And not surprisingly – as disclosure is the principal tool of the SEC’s historical regulatory power – and historically, more disclosure has been viewed as better than less. Nonetheless, if an equity crowdfunding market is to develop, crafting a simple, suitable disclosure model will be mandatory.
The SEC Fails to Leverage the Power of the Crowd
One of the more glaring deficiencies in the proposed rules is the failure to tailor an effective disclosure regime to the crowdfunding process. I do not necessarily believe in “the wisdom of the crowd” any more than I believe in the wisdom of the VC or any other type of investor. In every market there are winners and losers – and no one has yet devised a foolproof investment model. However, what crowdfunding brings to the investment process is allowing the crowd to ask questions directly to the crowdfunding company, and to allow investors to discuss the merits and risks of an investment in an open and transparent forum. Though the proposed rules certainly open up these channels of communication – and create a permanent electronic record of the information provided, the SEC has stopped short of leveraging the power of the crowd, many of whom will be relatively unsophisticated.
Though the proposed rules provide for intermediaries to provide educational materials to an investor when they open an account on the platform, the SEC has missed an opportunity to think outside of its regulatory box – and provide effective guidance to investors.
In the first instance, it ought to be the responsibility of the SEC to educate investors on the risks of investing. The SEC has avoided taking on this responsibility and left this to chance – adding to the casino type atmosphere that many believe will define equity crowdfunding. The SEC is more than capable of coming up with educational materials which will explain to an investor, in plain English, not only what are the risks in investing, but how to minimize these risks.
More importantly, the SEC can take investor education one step further and explain to investors in plain English what questions to ask of a crowdfunding issuer, and why it is important for an investor to ask these questions. This simple step will not only effectively unleash the power of the crowd to vet an investment opportunity – thereby leveraging a benefit of the crowdfunding model – but will go a long way towards the SEC meeting its responsibility to protect investors in a meaningful way. After all, isn’t this exactly what the SEC does when it reviews a full blown registration statement – ask questions of the issuer of the securities? Let the crowd ask the questions in a transparent setting, and arm the crowd with information which will assist them in determining what questions to ask and why they should ask them.
This simple step ought to also allow the SEC to more effectively craft simplified disclosure rules for crowdfunding companies and allow them to provide this information in a more simplified format – in effect, shifting some of the disclosure burden to the crowd – with a corresponding benefit to both the crowdfunding company and the crowd. This approach would go a lot farther towards meeting the Congressional intent of establish a vibrant crowdfunding market. A “one size fits all” approach, modeled after traditional disclosure regimes, while safe and cautious, will kill the market before it gets started.
After all, the donor based crowdfunding model has worked well, with minimal instances of fraud, without any type of mandatory disclosure whatsoever!
Apparently thus far I have few supporters in the chorus of commentators that have greeted the Title III regulations – by calling out the SEC for its dismal failure on the disclosure side – something it cannot blame on Congress, or even hide behind the mantra of investor protection. Notwithstanding the headlines and proclamation of “balanced” rules, I submit that in the disclosure rules alone lay the seeds not of capital creation, but rather capital market stagnation.
Even Sherwood Neiss seemed to miss the importance of this issue in his recent testimony before Congress, content to leave the disclosure burden squarely on the shoulders of crowdfunding companies. In his opening remarks to Congress, Mr. Neiss stated:
“[E]ntrepreneurs need to approach this opportunity with eyes wide open. There is a great deal of disclosure and compliance required in this opportunity and it is advised that they take the time to study and learn everything about crowdfunding and the proposed rules before moving forward.”
In fact, the only fly in the ointment that Mr. Neiss testified to on the issue of disclosure was what he believed was the burdensome requirement of disclosing three years of business experience for officers and directors. Either he has drunk the KoolAid – or he took political correctness too far as he stood before members of Congress – perhaps reserving his concerns for the SEC rulemaking comment process sometime in the next 90 days. Although, Mr. Neiss effectively laid out the case for equity crowdfunding in his testimony – he missed the boat on this one – a potentially fatal mistake.
And apparently the voluminous and unnecessarily complex disclosure was not the only thing that appears to have caught Mr. Neiss by surprise. At the very moment that Neiss was testifying before Congress and citing by name the importance of third party service providers such as Crowdnetics to the Title III in implementing the crowdfunding disclosure regime, Crowdnetics’ Managing Director, Dara Albright, was pivoting away from the Title III regime – essentially asking the crowd: why bother with all that nasty disclosure, both at the time of the initial raise – not to mention the ongoing annual follow-up filings?
What Needs to be Done and How it Can Get Done
There are too many naysayers, especially lawyers, who have pronounced equity crowdfunding dead on arrival – but who come with no solutions.
The good news is that, even by adhering to the somewhat imperfect parameters set by Congress in Title III of the JOBS Act, with some modification of the proposed regulations, the equity crowdfunding market will have an opportunity to provide a valuable niche in the large void that currently exists for startups and small businesses.
In my next article in CrowdfundInsider, I will share my opinions on what can and should be done by crowdfunding supporters to fix the problems – and how to do it. It will take a large and vocal crowd – and the wisdom and political will of the SEC to implement it.
The caution of the SEC is not without cost. Hopefully the SEC will listen.
Let’s get it done – and done right – Chairman White.
Samuel S. Guzik is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience. He is admitted to practice before the SEC and in New York and California. 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