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Prominent figures in the crowdfunding industry continue to lavish praise on the JOBS Act, which President Obama signed into law on April 5, but the legislation is not without its detractors. One notable critic of the Act is securities lawyer Jeffrey Rubin. A partner at international law firm Hogan Lovells, Rubin is chair of the federal regulation of securities committee for the business law section of the American Bar Association. Rubin is most concerned about the crowdfunding exemption embedded in the Act, which will legalize crowdfund investing in the United States when it goes into effect in early 2013. Below, Rubin and I discuss the potential perils of crowdfund investing and the JOBS Act.
Eric Blattberg, Crowdsourcing.org: To start, can you give me a bit of background on yourself and your current position?
Jeffrey Rubin: I’m a partner at the U.S. and global law firm Hogan Lovells. I practice corporate securities law. In addition, I am chair of the federal regulation of securities committee of the business law section of the American Bar Association. The committee has over 2,600 members and it is the principle liason between the American Bar Association and the Securities and Exchange Commission. The comments that I’m making, however, are purely my own and don’t represent either Hogan Lovells or the ABA.
I’d like to first hear your general impression of the JOBS Act. As far as I’m aware, you’re a fairly harsh critic of its content.
I’m a harsh critic of certain of the aspects. Other aspects I think are likely to be very helpful to companies and investors. I think it’s also fair to say that my criticisms aren’t all in the area of “harsh” — some of them are more nuanced.
Well I’d love to hear the whole spectrum of your thoughts, so dive in wherever you want to start.
Let me start first by commenting that prior to the final enactment of the JOBS Act, SEC Chairwoman Mary Schapiro wrote a letter to Congress expressing concerns that certain provisions of the JOBS Act could serve to erode various investor protections that have been available for many, many years. To the extent that the SEC’s statutory mandate is to promote capital formation, to maintain fair and orderly markets, and to provide investor protection, she expressed that some significant investor protection concerns could be affected by the JOBS Act.
From my perspective, the area where I have the most concern relates to crowdfunding. Crowdfund [investing], as you know, provides an exemption from federal registration and also preempts state law in connection will small offerings of securities subject to certain limitations, both as to the amount of money and the amount any individual investor can invest in crowdfunding ventures. It also imposes a number of qualifications on intermediaries. Congress adopted the crowdfunding provision with a sensitivity to investor protection concerns. My concern, though, is that it may potentially be subject to abuse.
Among other things, this is intended for smaller companies that don’t have the money to hire lawyers to do a full due diligence, to do a full document package and things of that sort. It remains to be seen whether the investors in these matters will be given a sufficient amount of high-quality information that will enable them to make an informed investment decision about the company, including all the risks and things of that sort. Secondly, although the crowdfunding provision requires companies to continue to report to investors and the SEC about their progress, in many cases the SEC has difficulty in requiring public companies to continue reporting; many simply go dark. It remains to be seen how effective the crowdfunding provisions will be. If a company doesn’t succeed, the likelihood is somebody will turn off the lights, pull out the plugs, and move on to something else, and there well may be nobody to report to the issuers.
Do you think it would be more effective if another organization came to assist with that process to take some of the burden off the SEC?
Well I don’t think the SEC is going to be doing a lot of substantive review of this because I just don’t think they have the manpower. My concern is that, historically, there has been abuse of the securities laws to take advantage of investors. When you have a smaller offering, you have the confluence of an offering so small that the private litigation bar — or the SEC enforcement staff — will simply not consider a particular matter to involve enough money to justify their getting involved.
In other words, if somebody has raised $800,000, how many resources can a private plaintiff attorney or the SEC devote to an investigation and litigation of the matter? The enforcement costs may exceed the amount raised. Secondly, many of the investors in crowdfunding will be amongst the most vulnerable investors and require the most amount of investor protection. I’m concerned that the most vulnerable investors will be left without adequate protections.
Will it create jobs? I don’t know. It’s touted as a jobs bill, but I just simply don’t know. I’m also concerned as to whether people who have a history or an inclination of exploiting weaker investors might consider this to be an opportunity. You could see a promoter who raises $800,000, all of which he pays himself in salary, declares the company not to be viable, pulls the plug and then moves on to another venture. If somebody were to sue the person, it’s not clear they would be entitled to recovery, because that person may have undertaken efforts to have that business succeed.
It’s not as if they’re going to necessarily get a smoking gun of somebody who has actively engaged in fraud. Fraud may be very difficult to prove. The person may say, “I rented this office, I hired staff, I paid myself salary, I really wanted to have a go of it. I had this correspondent that suggested that the business had some prospects and it didn’t work out.” And so the person goes onto the next venture, and the next one, and the one after that, leaving in his or her wake a number of investors who will never see their money back.
Well, a number of people have made the argument that it might be difficult to crowdfund a second or third fraudulent venture given one’s potentially low credit score or scrupulous history. Supposedly all these platforms are going to have to communicate with each other…
Well that’s not in the statute as far as I recall, but I know that there are groups trying to encourage that kind of communication. This will all depend upon the ability and success of these platforms to basically vet quality. I know that some groups are talking about branding, background financial and criminal checks on promoters — and if that works, it’s fine. But the problem is, you’re walking a tightrope, because many of the crowdfunding companies are engaged in this to minimize the cost associated with raising capital, and the more things you do, the more likely it is that costs will increase. If there is a sweet spot as to where the crowdfunding enterprises’ willingness to pay with what the market could reasonably do to assure quality, that would be a good thing to find.
I think that, as a concept, crowdfunding is very compelling. Why shouldn’t a small entrepreneur be able to raise money without getting involved in a thicket of federal regulation? But on the other hand, if this becomes a playground for sponsors who will exploit the lack of regulation, then it becomes a very tainted marketplace. It’s going to remain to be seen — say, a year or two after [crowdfund investing] becomes a reality — whether the returns on crowdfunding will be compelling. It will be interesting to see what percentage of crowdfunded companies simply don’t thrive, and even those that do, to see how many of them actually justify the risk involved in the investment.
Many people would say that investing in the startup ecosystem in general is inherently very risky.
Well, it has a lot of sex associated with it. I mean, if you could have invested in Woz and Steve’s young business when it was in a garage, you’d own a big island in the Caribbean right now. The idea of getting in on the ground floor of a business is very compelling. My concern is that most of the people that are going to be investing in crowdfunding are not sophisticated investors.
It’s not like people are born sophisticated investors, though. Don’t you think giving people a chance to play in these pools might be educational? You know, putting $50 here, $100 there, and seeing how those investments play out.
I wish I could say yes to that, but if you follow message boards on microcap companies — and many of these are public companies — you realize how uninformed and influenced by rumor many people are. You also realize how many companies (especially in the microcap area) have questionable financials, questionable business models. I’m not saying all, many of them are perfectly fine, but a not insignificant number of them. I think the SEC’s office of investor education is doing a fabulous job of trying to put out information that would be useful to investors in trying to evaluate risk and trying to understand what’s involved in microcaps. They do it through publications, town meetings, a number of other things; it’s just that, I’m concerned about how many people are actually getting it.
And you had mentioned if people are putting down $50 or $100… I’m really not concerned if people want to pay $50 or $100. I think they might expect to lose it all. I’m worried about the people who are getting up to the maximum of what is permitted, or even people who for one reason or another, will misrepresent their other crowdfunding investments. And once you start getting into the multi-thousand dollar range — especially if you’re dealing with vulnerable investors — you’re dealing with people whose losses may constitute significant events in terms of their own lifestyles. Many people have food to put on the table, kids to educate, mortgages to pay off, and I’m concerned that the prospect for these people losing everything in crowdfunding ventures is significant. You know, the whole reason the securities laws are in place is to offer investor protection. I’m concerned that we’re depriving folks of those investor protections.
The other side of the coin is you’ve got a company that’s not bankable, has no history, that’s got a good idea and the people are ethical, so what are they to do? Why embroil them in a ton of red tape in order for them to raise money? I’m sympathetic to that, too. And certainly there have been lots of friends and family deals where people know each other and they reach out to their relatives, friends and business associates [through crowdfunding]. I’m sympathetic to that. But when you start turning it into an industry, you plant forms where there is no connection between the investor and the sponsor. I just have concerns about what will ensue.
After a year or two, if 95 percent of the companies that raised money crowdfunding are either insolvent or otherwise not operating, then it will turn out to be a pretty significant scam. I know that, in that instance, people will turn to the SEC and say, “What were you doing?” And I think the SEC, first of all, tried to warn Congress about these prospects. They’ll also say, “We just don’t have the resources to bring federal securities law claims against the corner restaurant that just didn’t make a go of it.”
Then again, I think proponents of the Act might argue — well, not might, they certainly have argued — that this “local-vesting” aspect of crowdfunding is so important to any campaign getting off the ground that the guy randomly soliciting strangers will have a very hard time actually raising that capital at all, as opposed to the people who start with their social networks — their friends and family — and retain that trusted base as they branch out.
Right. Let me say now that I’m not wishing doom on crowdfunding, I’m not wishing losses for investors, I’m not wishing that people invest more than they can afford. I’m just concerned that against so many of the penny stock manipulations, so much fraud that exists in that area, so much fraud that the SEC enforcement people have identified in connection with Internet securities fraud, that I think crowdfunding could just become another playground for some of the people who have been involved in some of these other issues.
Let’s get more granular. I’m a company. I’m trying to raise money by crowdfunding. Presumably, I’m not acting as an individual, but I’m doing it in some form of corporate or LLC entity. That means that I have created a legal vehicle to raise the money. If I’m incorporated then I should have a capital structure that will include the securities to be issued — in other words, if I’m authorized to sell 100 shares, and I issue 2,000 shares through crowdfunding, then I violated my charter. Presumably, I will also have bylaws that govern how the entity is operated, and I will operate that entity in accordance with the charter and the bylaws. And this is before we even get to the offering.
Many of these small entities are lax about even hiring a lawyer, let alone a lawyer who is going to, among other things, make sure the organizational documents are right for the entity. If there are a number of existing shareholders putting together a shareholder’s agreement — well, is it a concern of investors if the chief executive simply walks? Should there be an employment agreement, and if so, for how long? Because if there’s no employment agreement, the guy can simply say, “Eh, it’s not going well, I’m going to collect my salary and quit.” And somebody who is an investor doesn’t have any ability to restrain that. Is there a non-compete provision in the employment contract? If the person is starting to do something really good, they can simply leave the company and go to somebody else who is going to pay them even more, leaving all the investors in the dark.
These are things that business lawyers deal with all the time, and I think it may be unrealistic to expect that entities created to raise money through crowdfunding — hence the avoidance of recourse through appropriate legal services — will put in those same protections. The whole system seems to be structured to make it easy to raise money, but I’m concerned the quality of the investment vehicle.
If you were to have, for example, an accredited investor who is presumably sophisticated in investing, virtually every accredited investor will require certain things. They’re putting in good money so they’ll make the charter and bylaws are there, they’ll make sure there’s an employment contract with a non-compete for any significant employee, they’ll make sure that the offering is consistent with what the company can legally do. I’m concerned that in a crowdfunding situation, none of that will occur.
Stay tuned for part two of my discussion with Jeffrey Rubin of Hogan Lovells later this week.