I participate on two different committees (one for the American Bar Association, the other for the Washington State Bar Association) that are tasked with analyzing and commenting on proposals for crowdfunding legislation. I spent this past weekend digging into the various alternatives that are now making their way through Congress and various state and federal administrative bodies.
I thought it might be worth sharing my observations about the major issues — highlighting both the areas of general consensus and the areas of significant difference. My aim here is not only to inform readers, but also to refine my own thinking.
The Idea Behind Crowdfunding
The general idea of crowdfunding is for a “sponsor” to raise funds by obtaining small contributions from a large number of sources. By this definition, charities and political campaigns are effectively crowdfunded, and have been so for many years. We just didn’t call it that.
One should not be surprised to learn that entrepreneurs have ported this traditional notion of “crowdfunding” to the Internet. They have given it a name, expanded its uses, and encouraged its growth through social media.
Thus, there are now sites for crowdfunding charities (e.g., globalgiving), crowdfunding loans (e.g., kiva), crowdfunding creative projects (e.g., kickstarter), and, soon, crowdfunding business opportunities (e.g., wefounder).
The business models for these sites vary.
For some, the contributors make a pure donation to the sponsor. For others, the contributors receive a “reward,” such as a pre-purchase discount on whatever the sponsor proposes to develop with the proceeds. But so far, in the United States at least, none currently allow contributors to receive an “equity stake” in the sponsored project.
Our securities laws stand as an obstacle.
The Securities Laws
State and federal securities laws tightly regulate the “offer or sale” of securities. A “security” is broadly defined to include any investment opportunity whose outcome depends on the efforts of others. See SEC v. Howey Co, 328 U.S. 293, 298-299 (1946). Crowdfunding in exchange for an equity interest in a sponsored project plainly runs afoul of this definition, and is therefore subject to regulation.
These regulations, as constructed now, do not permit an easy path (any path?) for crowdfunding investment opportunities. The alternative of “registering” each deal with the SEC ahead of time is plainly cost-prohibitive — running in the tens if not hundreds of thousands of dollars. And because crowdfunding involves a large number of investors (many not “sophisticated,” much less “accredited”) who likely have no pre-existing relationship to the sponsor, the existing regulatory exemptions for deals involving accredited investors and a limited number of fairly sophisticated investors, all with pre-existing relationships to the sponsor, simply do not apply.
As if that were not enough, the securities laws would also trigger fairly onerous licensing requirements for the sites acting as deal intermediaries, as the securities laws would likely require their registration as a broker-dealer. And finally, because the deals would involve a large number of investors once completed, any company closing a crowdfunding deal could be deemed “public” and thereafter be subject to onerous periodic reporting requirements.
So, what to do?
On the federal level, the SEC regulates the securities market, including “issuers” and “broker-dealers.” The SEC has, within its existing authority, the ability to exempt crowdfunding from the registration requirements of the Securities Act. It could do so, for example, under Section 3(b) of the Securities Act, which permits the SEC to exempt offerings of less than $5 million if it finds that “enforcement … is not necessary in the public interest and for the protection of investors by reason of the small amount involved or the limited character of the public offering.” The SEC has similar authority to exempt brokers under Section 36(a) of the Exchange Act, which authorizes the SEC to create such an exemption by finding that it “is necessary or appropriate in the public interest, and … consistent with the protection of investors.”
While the SEC has such authority, thus far it has not exercised it. It presently has before it at least one petition formally seeking rule making on the issue — in respect of which the SEC has already received dozens of comments. In her testimony before Congress on May 11 2011, SEC Chairman Mary Schapiro confirmed that the SEC is studying the issue. And since then, the SEC created an Advisory Committee on Small and Emerging Committees that is tasked with making recommendations on a number of issues involving small companies, including crowdfunding.
Still, it is difficult to say whether any of this will yield a viable crowdfunding exemption anytime soon.
The Legislative Proposals
The initiative to create a crowdfunding exemption enjoys significant bipartisan support. In September 2011, even President Obama weighed in on the concept, advocating its adoption among many of his proposed job-creating measures. And Congress listened.
In the House, Congressman Patrick McHenry introduced H.R. 2930 — the Entrepreneur Access to Capital Act. H.R. 2930 proposes an exemption for offerings of up to $1 million (or, with audited financial statements, up to $2 million) in any 12-month period where each individual investor invests no more than the lesser of $10,000 or ten percent of such individual’s annual income. H.R. 2930 passed the House with an overwhelming 407-to-17 vote, but has not yet been acted on in the Senate.
Meanwhile, Senator Scott Brown introduced a crowdfunding bill of his own, which he calls the “Democratizing Access to Capital Act of 2011.” His bill, S. 1791, proposes an exemption for offerings of up to $1 million in any 12-month period where each individual investor invests no more than “an aggregate annual amount of $1,000.” Also in the Senate, Senator John Merkley introduced S. 1970, a bill whose ridiculous title is far too long to mention but whose acronym spells “CROWDFUND.” S. 1970 proposes an exemption for offerings of up to $1 million in any 12-month period where each individual investor invests no more than $500 or, if greater, no more than either one or two percent of the individual’s annual income depending on whether such income is more or less than $100,000. To date, neither Senate bill has advanced for consideration beyond a one-day committee hearing on S. 1791.
The hearing on S. 1791 brought out its opponents, with Professor John Coffee of Columbia University leading the charge. He declared that the Bill should be “called the Boiler Room Legalization Act of 2011,” warning that the worst kind of fraudsters will begin hawking fictional investments to those in our society least able to understand or afford them.
Jack Herstein, President of the North American Securities Administrators Association (the “NASAA”), joined in. NASAA is an organization composed of state securities regulators. For years NASAA has waged a back-and-forth battle in opposition to the increasing federalization of securities regulation. Not unexpectedly, then, Mr. Herstein insisted in his testimony that regulating “small offerings” is ideally left to the states. He declared that his organization had the capacity and desire to implement a workable regulatory regime of its own.
Late last week, NASAA made good on its promise by circulating an early draft to its members. Besides retaining state oversight, NASAA’s proposed “Model Crowdunding Exemption” contemplates a coordinated exemption for securities sold in any participating state where the offering amount does not exceed $500,000 in any 12-month period and no single investor buys more than $1000 worth of the offered securities.
The Key Issues
So where does this leave us?
Well, we have four different concrete proposals: HR 2930, S. 1791, S. 1970, and NASAA’s “Model Crowdfunding Exemption.” We do not yet have any proposed rule making from the SEC — which is indeed unfortunate, for the SEC itself is probably best positioned to craft a truly workable crowdfunding solution. In its absence, however, we might benefit by reviewing the existing proposals against the following key areas of concern:
- maximum offering amount;
- maximum individual investment amount;
- restrictions on advertising and general solicitation;
- required disclosure documents and warnings;
- required use of an intermediary;
- escrows and closing conditions;
- restricted securities and holding period;
- disqualifying circumstances;
- notice filings and fees; and
- preemption of state law.
I’ll take these up in Part 2.