Don’t Wait for the Crowd — Legalization of Crowdfunding Could Take a While
Crowfunding – raising money online to finance something – has obvious appeal in this era of social media and rapidly expanding Internet penetration. For companies seeking to raise investment dollars, however, crowdfunding is largely unavailable as a tool to attract investors based in the US Crowdfunding is currently impractical in the US because all securities offered to US investors must either be registered with the US Securities and Exchange Commission (SEC) or there must be an applicable exemption from registration. Registration with the SEC is very expensive and time consuming, and exemptions from registration are generally not available if the security is offered to the general public.
Fortunately, crowdfunding and the anachronistic restrictions on the public offerings of securities are receiving a lot of attention these days. After the President mentioned a proposal to exempt crowdfunding from registration requirements during his jobs speech a few weeks ago, the attention reached fever pitch. It even extended to Congress. Since the President’s speech, there have already been two Congressional hearings regarding an exemption and one bill has been introduced by a House Republican. The House bill is substantially aligned with the President’s proposal. Such bipartisan support is promising. The SEC is also exploring potential rule changes to exempt crowdfunded offerings that would not require legislative action.
Despite all the positive signs, however, the future of crowdfunding remains very uncertain. Three primary risks threaten the potential of crowdfunding to become a significant source of startup capital in the near future.
Risk 1: The voices opposed to a crowdfunding exemption win the day.
Support for a crowdfunding exemption is not universal. On September 21, Heath Abshure, a representative of the association of state securities regulators, testified before a House subcommittee regarding small business capital formation. In his wide-ranging testimony, Abshure made a strong case for investor protection and for the unique role state securities regulators play at the local level. The crowdfunding bill that was introduced in the House includes a state preemption clause, effectively exempting crowdfunded offerings from state registration requirements. As Abshure’s testimony indicates, this will likely be met with continued opposition from state securities regulators who have seen their scope of authority recede as federal regulation has increasingly preempted state securities laws.
The SEC also has expressed concerns about investor protection and may be reticent to carve out a significant exemption. In 1982, the SEC adopted Regulation D, which, among other things, included Rule 504, the “Seed Capital” exemption. Under Rule 504, small issuers (under $1 million) were allowed to offer and sell securities to an unlimited number of people regardless of sophistication; such issuers were exempted from delivering any specified information to investors; and such issuers were allowed to engage in general solicitation and advertising. After a number of abuses surfaced (facilitated by burgeoning Internet use), the SEC limited the scope of Rule 504. This history illustrates why the SEC may be risk averse in adopting a significant exemption regime for crowdfunding.
Risk 2: The final regulations are too narrow, gutting crowdfunding of its potential.
The SEC has voiced some guarded support for the principle of a de minimis exemption related to crowdfunded offerings. In a letter, SEC Chairman Mary Schapiro described one conception of crowdfunding as an offering of up to a maximum of $100,000 with individual investments capped at $100. The current House bill, meanwhile, would exempt crowdfunded offerings of up to $5 million and cap individual investments at $10,000. Abshure’s Congressional testimony echoed the SEC’s more restricted vision of crowdfunding. Referring to the limits included in the House bill, he stated that “the caps on these offerings are simply too high.” In support for this position, he argued that since more than half of households have less than $25,000 in savings and investments, a $10,000 loss would be “crippling” to most investors (but still not significant enough to reasonably pursue a private cause of action).
If legislation or SEC rule changes create a crowdfunding exemption at the $100,000 offering / $100 individual investment level, it will be an unrealistic source of real startup capital for most entrepreneurs. Most crowdfunding platforms intend to require a minimum commitment level in order for any funds to be invested and spent by the startup. With such low individual investment caps, very few deals would meet these minimums and actually get done. Furthermore, if the final exemption did not include state preemption, significant compliance costs would still fall on issuers. These results would relegate crowdfunding to a trivial role as a provider of startup capital for businesses.
The ultimate determination of aggregate offering and individual investment caps is of central importance. In my view, while a flat $10,000 cap on individual investments may be too high for many investors, it is certainly orthogonal to the policy goal of investor protection. A cap set as a percentage of income or wealth is more aligned with the goal of protecting a naïve investor from losing his shirt. It is also more flexible, allowing well-heeled investors to add larger infusions of capital to these markets. In any event, the success of a crowdfunding regime will be tied to these limits.
Risk 3: The process for adopting regulatory changes is slow, significantly delaying any exemption.
Any successful exemption regime, even if it includes the wish list of generous caps, state preemption, and other goodies, will likely take a long time. During her Congressional testimony on crowdfunding, SEC representative Meredith Cross was questioned as to the timeline for a decision. While she could not answer directly with respect to crowdfunding, she briefly discussed the timeline for an analogous inquiry that is instructive. In May of this year, Congressional hearings were first heard regarding potential changes to the 500-investor cap outlined in the Exchange Act’s section 12(g). Cross estimated that no decision would likely be made until “sometime in 2012.” Final regulations would likely not be released until much later.
A legislative solution is also likely to take time. With historic debt levels, continuing high unemployment and upcoming elections, Congress has a full plate. (Even just with respect to proposals related to capital markets). Nevertheless, it is possible that crowdfunding’s bipartisan appeal could position it for a realistic victory. But even in this best-case scenario, the clarity provided by final regulations would not come for some time.
Crowdfunding has a lot of promise, but the final contours of any regulatory regime are still unformed. These regulations could unleash the wisdom and wallets of the crowd in powerful ways, or could stifle a promising opportunity. Only time will tell. What does seem certain is that it will take a while.
Chris Hurtado wrote this post with some input from Bruce Campbell. Chris is working with Campbell Law Group as a law clerk during his final year of the JD/MBA program at Yale Law School and Yale School of Management. Prior to graduate school, he worked at the Bridgespan Group, where he advised private foundations and operating nonprofits on issues related to strategy, management, and organization. He started his career in corporate finance in the Silicon Valley.
