Thoughts on the Proposed Crowdfunding Regulations

 On October 23, 2013, the Securities and Exchange Commission issued proposed regulations to implement Title III of the JOBS Act, which will allow for the public sale of securities using crowdfunding under an exemption from registration under securities laws.

Since it has been some time since the regulations were proposed, I won’t attempt to summarize them in this post.  There are a number of great summaries of the regulations out there; here are two: (1) Kiran Lingam of SeedInvest’s summary and (2) Kevin Laws of Angelist’s summary.  In addition, all 585 pages of the proposed regulations can be found here.

Here are some of my thoughts on the proposed regulations.  I have six main points I’ll highlight in this post.  I’ve ordered the points from most optimistic/positive to more pessimistic/negative.  As you can see there is a lot to like and a lot to dislike.

  1. The SEC was not hostile to the concept of crowdfunding in its implementation of Title III.  My biggest fear was that the SEC, being hostile to the concept of deregulating securities markets, would make the crowdfunding regulations as difficult to use as possible.  The crowdfunding section of the JOBS Act is very poorly drafted, leaving many ambiguities.  The SEC could have, at every turn and every attempt to resolve these ambiguities, taken a more restrictive approach, but it didn’t.  For example, Sec. 302(a) provides for caps on the amount that an investor can invest in crowdfunding offerings in any 12-month period.  It is poorly drafted, making terrible use of the word “or,” causing the amount of the investment caps to be unclear in many situations.  The SEC resolved these ambiguities using interpretations that allow for larger rather than smaller amounts.  Another example is that the SEC had to decide whether to allow companies to use crowdfunding while also raising money through other types of offerings (i.e., using other exemptions, such as Rule 506).  The SEC decided to allow companies to raise money using crowdfunding and other exemptions simultaneously.[1]  These are just two of many examples showing that the SEC had real opportunities to make life more difficult for users of crowdfunding but declined to take advantage of them.
  2. The SEC may have improved upon Title III.  People who followed the passage of the JOBS Act know that the crowdfunding provisions were completely rewritten at the eleventh hour.  Prior to the rewrite, the crowdfunding provisions originally written by Rep. Patrick McHenry provided that funding portals had to provide communication channels to allow users of the site to discuss the offering.  The premise is that the “wisdom of the crowd” (i.e., the sheer number of people on the internet who would be willing to debate the merits of an investment) would help distinguish the good investments from the bad.  The version of the crowdfunding exemption that eventually passed omitted this provision.  However, in its proposed rules, the SEC has restored this provision, which arguably will help make the exemption more effective.
  3. Funding portals may actually have a workable business model…  One aspect of the proposed regulations that I found particularly surprising was that the SEC will allow funding portals to accept transaction-based compensation.  The SEC has long taken a hard line against anyone other than a registered broker-dealer taking compensation for raising capital if that compensation is contingent on money being raised or is proportionate to the amount actually raised.  Therefore, I fully expected the SEC to take the position that funding portals would not be permitted to accept such compensation.  Since startups would be very reluctant to pay a large fee for a capital raise that may or may not be successful if the fee wasn’t structured as some kind of contingent fee based on the amount raised, I previous had a lot of difficulty seeing how funding portals could actually make money.  To my surprise, the SEC has no issue with funding portals taking a percentage of the amount actually raised as a fee.  The SEC reasoned that funding portals actually are brokers under the Securities Exchange Act, but are not required to register as such because they can register as funding portals.  Since they are brokers, they can take the same fee that brokers customarily take: transaction-based compensation.
  4. …or they may not.  Funding portals may be subject to considerable potential liability that, over the long run, may make it too expensive for them to stay in business.  Rule 301 of the proposed regulations requires that funding portals have a reasonable basis for believing that an issuer seeking to offer and sell securities in reliance on the crowdfunding exemption through the funding portal’s platform complies with the requirements of the exemption.  It also requires funding portals to deny access to its platforms to issuers when the platform “[b]elieves that the issuer or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection.”  In addition, if a funding portal becomes aware of information after it has granted access to its platform that causes it to believe that the issuer or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection, the funding portal must remove the offering from its platform.  Thus, the proposed rules require funding portals to take an active role in screening for fraud and impose upon them a duty to protect investors.  At the same time, under the JOBS Act, funding portals are prohibited from offering investment advice.  The SEC has interpreted this to limit the ability of funding portals to curate the offerings conducted through their sites.  The SEC has further interpreted the regulations as imposing liability on funding portals for fraud.  Thus the SEC is asking them to use a significant amount of discretion to protect investors (and to face liability if they fail to do so), but at the same time is prohibiting them from having much discretion in the first place.  All of this could put funding portals in a no-win situation. If all of these items remain in the final rule, funding portals may find that the mere risk of operating is just too high.
  5. There is an awful lot of disclosure required.  The JOBS Act itself requires that issuers (and consequently intermediaries) provide a significant amount of disclosure to potential investors, including narrative descriptions and discussions of the issuer’s business plan, financial condition, intended use of proceeds, and capital structure.  The SEC further added to this burden by requiring disclosure of other small items such as biographical information about the issuer’s officers and directors.  The regulations also flesh out the required disclosure items listed in the statute.  Upon reading these it becomes quite apparent that a crowdfunding offering will have a lot more required disclosure than your typical small Rule 506 or Rule 504 offering.  This equates to potentially high legal bills.  This isn’t really the fault of the SEC, as most of this is mandated by Congress, but reading the proposed regulation really hammers home that the use of this exemption will not be simple and routine (as many who advocate for crowdfunding hope).
  6. This whole thing may still prove to be too expensive to make it worth anyone’s while.  My main concern about the crowdfunding exemption has always been that the cost of compliance with the exemption may not be justified by its benefits.  This still remains the case after the release of the proposed regulations.  Kiran Lingam of SeedInvest posted a really great spreadsheet that illustrates this point.  It can be found here.  Kiran essentially has tallied up all of the costs associated with using the crowdfunding exemption, such as commissions, legal fees, accounting fees, insurance, and other costs, so that a potential issuer can see the amount of proceeds the offering will actually yield and how much of the proceeds will be used to incur the additional expenses associated with pursuing a crowdfunding campaign.  The results are not pretty.  Let’s say a issuer wanted to raise $100,000.  Under Kiran’s calculations, it would actually cost more than $100,000 to raise the money.  Under his projections a $500,000 offering would net around $351,650, which would mean that about 42% of the proceeds will ultimately be used for expenses.  At $1,000,000, his calculations estimate that 25% of the proceeds will be used for expenses.  If true, this really limits the utility of crowdfunding and places an unacceptably high cost of capital on startups using it.  I can’t quibble with Kiran’s estimates, as he works at a crowdfunding site, and I don’t think he’s overestimated the expenses to “be conservative,” given that he estimates only $5,000 in initial legal costs (see point 5 above on why the legal costs won’t be insignificant).  He estimates a 10% commission going to the funding portal.  Perhaps some platforms will offer a lower commission.  At the same time, since compliance work that is required to be done in future years is included in his costs, there may be some economies of scale realized by having multiple rounds of $1,000,000 raised using crowdfunding over a period of years.

The comment period on the proposed regulations is open until February 3, 2014.  Given their complexity, I would expect we will not have a working crowdfunding exemption in place until late summer of 2014 at the earliest and most likely not until fall 2014.


Footnotes

[1] However, the SEC did caution that the exemptions could not be used in clearly incompatible ways.  For instance, if a company were to engage in a crowdfunding campaign and simultaneously engage in a Rule 506(b) offering, which cannot make use of public advertising, it couldn’t accept investors into the Rule 506(b) offering who were found through the crowdfunding campaign.

Alexander Davie

Read more articles by Alexander Davie at Strictly Business, a business law blog for entrepreneurs, emerging companies, and the investment management industry.

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