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Three Things Broken in Investment Crowdfunding That SEC Regulations Won't Fix
© Image: Flickr.com / Norbert Löv
editorial

Three Things Broken in Investment Crowdfunding That SEC Regulations Won't Fix

Amy Cortese just wrote a wonderful piece for the New York Times about specific individuals who are this very day doing the clever, innovative and important work of making investment crowdfunding a reality in America.

The entrepreneurial financiers Amy profiled include Ryan Caldbeck and Rory Eakin, of CircleUp, and Candace Klein, of SoMoLend.

The persistence of these entrepreneurs - in a regulatory landscape inhospitable (to put it euphemistically) to innovations in finance for regular Americans - is to be lauded, and supported. They are working on filling the financing gap for small business growth, a function Jonathan Sandlund has shown is no longer served by conventional bank lending.

Regulatory constraints and the promise of the JOBS Act

We know that small, growing businesses are the engine of all net new job growth, and we also know small, growing businesses are starved for capital. Imagine the full impact CircleUp, SoMoLend and others might have on the broader US economy, were these financial innovators not artificially constrained by laws that restrict investment to accredited investors and institutions.* 

The JOBS Act was supposed to change this.

When he signed the legislation last year, President Obama said that the crowdfunding piece of the JOBS Act, Title III, would permit small business to access a new source of investment. He identified that new source of capital as "the American people."

As Amy prominently notes in her article, many who hope to see the President's statement become a reality are frustrated with the SEC's delay in circulating the regulations to implement Title III.

The fault lies not in SEC intransigence, but in the enabling legislation

I'm sorry to say that the hopes being placed on prospective SEC regulations are based on a false promise. There is little point in pushing the SEC, because Title III of the JOBS Act imposes constraints on crowdfunding which no set of regulations can fix.

It's not a matter of whether the SEC is willing to write workable rules. It's a core issue of administrative law, that regulations be delimited by the frame of enabling legislation. Whether SEC staffers are not friendly to investment crowdfunding, or are friendly, they cannot write implementing rules that contradict the imperatives of Title III.

Three things broken that rulemaking can't fix

Three things in the investment crowdfunding portion of the JOBS Act are broken and cannot be fixed by regulation. Any fix will require new legislation.

1. Title III of the JOBS Act takes the crowd out of investment crowdfunding

Representative Patrick McHenry's successful, bi-partisan investment crowdfunding bill didn't make it into the JOBS Act. It's a shame because, had it shaped the final legislation, at least one provision of the McHenry bill would have given sympathetic rulemakers a chance to keep the "crowd" in crowdfunding.

That essential, missing McHenry provision was a requirement that funding portals set up "a method of communication that permits the issuer and investors to communicate with one another."

The Senate struck that.

The Senate took that out, but didn't remain silent on the question of communication. Title III of the JOBS Act mandates that issuers "may not advertise the terms of the offering, except for notices which direct investors to the funding portal or broker." Contrast this prohibition with Title II of the JOBS Act, pertaining to crowdfunding for accredited investors: when it comes to offerings for accredited investors, Congress tells the SEC to lift the ban on general solicitation and general advertising.

In lieu of a lateral flow of information across portals and social media, in lieu of anything resembling accountability to investor-determined agendas, Title III substitutes a top-down, centralized disclosure paradigm that makes sure investors are passive (and does its best to take funding portals out of the business of making judgments, too; see point 2 below).

The strictures against communication are supposedly in the name of protecting against fraud, but I'd argue that Title III abandons any hope of meaningful investor protection. The design of the legislation appears instead to "protect" investors by making the exemption worthless. How else explain a flotsam of incongruous technical requirements that will keep the better ventures on the accredited crowdfunding side of the ledger. True, Title III might spawn a cottage industry of lawyers and consultants who will lead issuers and funding portals through pro forma exercises in "compliance," the kind followed by pink sheet companies.

Even if you think Congress meant well, you have to acknowledge that Title III looks more like a recycled, state limited offering registration scheme than anything resembling crowdfunding.

2. Funding portals aren't allowed the same flexibility to innovate that online angel platforms enjoy

To truly grasp how grudging Congress was about letting average Americans participate in the innovation economy, leave Title III and move back a title. In Title II, pertaining to accredited crowdfunding, Congress says that online angel platforms may offer, sell, purchase or negotiate with respect to securities, and may permit general solicitation and general advertising, all without requiring registration, as long as a few requirements are satisfied.

By contrast, Title III says that any funding portal for non-accredited investors must not "solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal."

The contrast doesn't end there.

Co-investment by the portal or persons associated with it? That's okay under Title II, but not Title III. Providing due diligence services and standard documents for the investment? Also okay if you are crowdfunding among angels, but not if you are crowdfunding among the American people at large.

Under Title II of the JOBS Act, angel platforms have three basic rules to follow: no commissions on the purchase or sale of securities; no possession of customer funds or securities; and no "bad actor"-type disqualifications.

No such flexibility for Title III funding platforms, which face regulations that look much more like those imposed on broker-dealers (if without the concomitant benefits).

To let a thousand flowers bloom and give the country the benefits of an honest experiment with investment crowdfunding, funding portals for non-accredited investment should be given the same flexibility to operate and innovate that online angel platforms enjoy.

3. Title III of the JOBS Act is too intrusive of investor privacy

Title III of the JOBS Act puts investment crowdfunding in a privacy conundrum.

In a well meaning attempt to protect investors by limiting how much they can risk in crowdfunded deals, the legislation requires funding portals "to ensure that no investor in a 12-month period has purchased securities . . . that, in the aggregate, from all issuers, exceed the investment limits."

If that suggests funding portals should share information, across platforms, about how much money crowdfunding investors make, keep in mind that Title III also requires funding portals to "protect the privacy of information collected from investors."

Here's a solution, one that sidesteps the privacy problem and, more significantly, provides the investor protection missing from Title III: Congress should establish the Individual Crowdfunding Account, or "ICA," putting the individual investor in charge of regulating it herself.

Under the Individual Crowdfunding Account concept, investors can invest money in a deal exempt under the investment crowdfunding law, but only from funds she has earmarked from a prior year and placed into her ICA. The ICA has a flat, annual contribution limit of $2,000 per year per person, so there is no need to verify income or net worth, or even to ask the question. For their part, issuers and funding portals must ensure that they only accept funds from a bona fide ICA.

The essential investor protection with the ICA? The cap on how much can be lost. That, plus the fact that no pressure or "hype" from a hot deal can motivate your decision to gather (or borrow) funds.

Conclusion

We need to stop wasting time pushing the SEC to write regulations to implement legislation that on its face isn't viable.

We need to build on the efforts of the heroes Amy Cortese profiles in her NYTimes piece and ask Congress to address the financing crunch small businesses are facing. One way to do this is to give the American people an opportunity to crowdfund investment dollars. That means leaving the comfort zone of state securities regulators and giving trailblazers ample room to iterate solutions.

Important footnote: Larry Baker and Charlie Tribbet of Bolstr are taking investment crowdfunding to non-accredited investors, by trying to automate the complexities of complying with Rule 504 of Reg D; that's important to watch, but significantly constrained by Rule 504 conditions.

-- 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, and check out his previous articles here

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