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Does the U.S. Equity Crowdfunding Legislation Need a "Do-over"?
editorial

Does the U.S. Equity Crowdfunding Legislation Need a "Do-over"?

A few days ago I posted a rewrite of Rep. Patrick McHenry's famous equity crowdfunding bill, the bipartisan success that forced the U.S. Senate to humor the idea that non-accredited individuals should be able to invest in startups.

Below the surface, the prospect of equity crowdfunding was onerous to the Senate. So onerous that, come game time, senators singled out Rep. McHenry's bill for attention. Not the IPO on-ramp, not the lifting of the ban on general solicitation for Rule 506 offerings to accredited investors, not the federal broker dealer exemption for angel platforms - the Senate had knives out only for McHenry. Adopting the rhetoric of equity crowdfunding proponents, the Senate substituted a cynical hodgepodge of conflicting mandates, virtually impossible to implement. McHenry's honest and earnest experiment ended up eviscerated.

House leadership caved on the Senate's gutting of Rep. McHenry's bill, presumably for the sake of getting the rest of the JOBS Act, otherwise in the form in which it passed the House, into a final act of Congress. Sen. Scott Brown, who had earlier introduced a workable equity crowdfunding bill, looked ahead to his reelection and sided with McHenry's adversaries.

And so the JOBS Act which the President signed does not actually contain the text of the equity crowdfunding legislation for which Rep. McHenry is famous.

My rewrite goes back to the McHenry bill as a baseline, simplifies it in a few respects, and adds improvements from the Brown bill.

The form of the proposal is pedagogical. It is written as though Title III of the JOBS Act never became law. It "turns back the clock," Groundhog Day-style, as though we and Rep. McHenry could have a "do-over."

The proposed do-over is short and (relatively) easy to read.

But let me help the cause of viable non-accredited equity crowdfunding further by summarizing how the do-over would fix the schizophrenic equity crowdfunding provision actually in the JOBS Act.

Investor protection

The bedrock investor protection mechanism of the McHenry do-over is simple. In any 12 month period, no investor is allowed to invest more than $1,000 in a single issuer, or more than $5,000 in equity crowdfunding deals in the aggregate.

Paternalism is fully embraced. No need for a prospectus, audited financial statements, new and untested causes of civil action against entrepreneurs, rescission rights, and other hardware from the kitchen sink of state blue sky regulation. Instead, a bright line: "you are not allowed to lose more than this amount annually."

Bargaining tip for Rep. McHenry: the second anyone starts to call for additional investor protections, knock a zero off the two investment limits. Make the single offering limit $100, and the annual aggregate limit $500. Say, "if the experiment works at this modest level, we can consider increasing the levels in a few years." There simply has to be an amount which reasonable people can agree are so modest that protections - which are a boon to lawyers but a tax on utility - are not worth their cost.

Entrepreneur protection

Entrepreneurs are protected in the McHenry do-over by putting the onus of annual investment limit compliance on the investors themselves. No need for entrepreneurs (or funding portals) to collect investor W-2s to verify income, then stress on how to meet the concomitant privacy regulations. The investor must self-police. If she invests in excess of the limits, she is forever barred from bringing claims under the Securities Act against the entrepreneurs to whom she made false reps.

If regulators insist that investors may be confused by the responsibility, then require this mandatory disclosure:

Prospective investors please note: you are likely to lose everything that you invest in this offering. Don't invest anything that you can't honestly regard as play money. And it's even worse than that in the following respect: if we do something wrong, you can only go after us legally if you have kept your equity crowdfunding investment under the annual limits imposed by law. It's not our job to police whether you have exceeded your annual limits. It's your job, and you exceed them at your peril.

Funding portal protection

The very biggest mistake the Senate made in cutting McHenry's equity crowdfunding bill was in removing the provision that funding portals and issuers "make available a method of communication that permits the issuer and investors to communicate with one another."

Essentially, the Senate stripped the crowd out of crowdfunding. In lieu of an experiment with wholly transparent and free-flow communication, the Senate doubled down on the pre-Internet paradigm of disclosure that brings you such models of investor fairness as the Facebook IPO.

(Editorial comment: I am not sure that crowdsourced information sharing is any less prone to insider abuse than centralized, top-down disclosure, but I do think McHenry was willing to experiment to find out, and that's healthy.)

The McHenry do-over would restore the ability of investors and entrepreneurs to communicate with one another. In fact, the do-over would say that funding portals *must* provide a means for this.

That requirement "protects" the funding portals insofar as it obviates the need to require them, as a matter of regulation, to do anything else.

Moreover, the McHenry do-over would expressly permit funding portals to curate their listings, as long as they disclose the methodology or process used in the curation.

Funding portals would not have to register with the SEC or any other agency or body.

More to come: in a subsequent post, I may tackle a provision-by-provision listing of the features of the McHenry do-over.

-- William Carleton is with the firm of McNaul, Ebel, Nawrot & Helgren. He also has experience as a startup lawyer and angel investor. Follow him on Twitter @wac6.

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  • Antone Johnson Antone Johnson Oct 10, 2012 09:45 pm GMT

    William, I like the sound of "a method of communication that permits the issuer and investors to communicate with one another." My concern is whether crowdfunded issuers would be obligated to respond to every inbound inquiry. With a large crowd, CEOs could be embroiled in continual discussions with hundreds of individual investors — an onerous obligation leaving them little time to actually build the business. (This is a serious issue already for entrepreneurs with a relatively large number of private shareholders; I can't think of a client CEO in that category who *hasn't* complained at times about how much of his or her bandwidth is taken up dealing with shareholders.) If not, how would they decide where to draw the line?

    Typical lawyerly risk aversion would ordinarily lead me to counsel clients (1) not to leave any shareholder communication unanswered, and (2) to make identical disclosure to every shareholder in all material respects. Otherwise, in the event of the usual 20/20-hindsight securities litigation, selective disclosure to investors would be a neatly wrapped shiny gift to the plaintiffs' bar, creating a mountain of discoverable evidence about what facts were disclosed to shareholder X but not to Y, or not at the same time, etc. In practice, given the low dollar limits that you've recommended, so many of these issues seem to ride on the question of whether investors in equity crowdfunding deals could be required to waive the right to a class action, to agree to arbitration, or whether some kind of special safe harbor could be extended to equity crowdfunding issuers. Curious to hear your thoughts.

  • William Carleton William Carleton Oct 20, 2012 11:57 pm GMT

    Antone, apologies for not seeing your comment earlier! Thank you very much for reading and for your thoughtful response.

    I think there is no question that equity crowdfunding is impossible to pull off under the current regulatory paradigm of centralized, carefully managed disclosure, from the inside to the outside. For it to work, the founders are going to have to be free to have an informal kind of give and take as occasions present themselves and as time permits. For equity crowdunding to work, the shareholders will have to take ownership of the disclosure. In other words, equity crowdfunding should be set up to experiment with the idea that the necessary information can be crowdsourced, and/or that the crowd can do the disseminating of all available information.

    From the perspective of the existing paradigm, you might say that all investors would be deemed to have knowledge of anything and everything a founder says about the company in any online forum that is open (I guess that makes Facebook a problem). You'd defeat the problem of selective disclosure by not recognizing any disclosure as other than thoroughly public, thoroughly findable.

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