Crowdfunding has become a popular new way for entrepreneurs, small businesses, and philanthropists to raise capital by obtaining small contributions from a large number of individuals over the Internet. Online platforms like Kickstarter and IndieGoGo allow individuals to contribute to projects and causes in exchange for some sort of gift or recognition. Title III of the Jumpstart Our Business Startups Act (the “JOBS Act”), which was passed in 2012 but has yet to go into effect, takes crowdfunding one step further, by allowing startups to use crowdfunding campaigns to offer investors something beyond mere gifts—actual shares in the company. (Before the passage of the JOBS Act, investment-based crowdfunding was only legal with accredited investors—people who can verify that their net worth is at least US$1 million, or that they make at least US$200,000 a year.)
Investment-based crowdfunding is a game changing development which may prove to be a mixed blessing. On the one hand, crowdfunding can provide startups and small businesses with a cost-effective way to raise capital, outside of the traditional banking and venture capital industries. It allows eligible companies to avoid the high costs of “going public” that are paid by companies that have to meet the registration requirements of the Securities Act.
On the other hand, crowdfunding is particularly vulnerable to money laundering and financial crimes. Crowdfunding offers investors low-priced securities, which are naturally more susceptible to fraud, market manipulation, and insider trading. There is also potential for crowdfunding to be used to launder illegally acquired assets—in the past, thieves have used crowdfunding websites to funnel stolen assets to their own bank accounts.
Title III of the JOBS Act was an attempt to strike a balance between the potential benefits and risks, allowing investment-based crowdfunding while at the same time laying out provisions to protect investors. In order to permit investment-based crowdfunding, Title III of the JOBS Act added provisions to the Securities Act, including an exemption allowing crowdfunding issuers to sell securities without registering these offerings, a list of necessary disclosures for crowdfunding issuers, and requirements for the online platforms that list these investment opportunities. TheSecurities Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”) both issued proposed rules on October 28, 2013 to implement these statutory provisions.
The SEC’s proposed rules mostly apply to the issuers of a crowdfunding offering, and hew closely to the provisions in the JOBS Act. They specify that a crowdfunding offering is only exempt from registration if the aggregate amount of sales to investors in a 12-month period is less than US$1 million, and the aggregate amount sold to any particular investor in a 12-month period is limited to US$2,000 or 5% of the investor’s annual income or net worth if the investor’s annual income is under US$100,000—10% if the investor’s annual income is over US$100,000. The exemption does not apply to issuers that are not registered as corporate entities in the United States, to investment companies, or to hedge funds. Crowdfunding issuers are required to file certain disclosure documents, including their business plan, financial condition, intended use of proceeds of the offering, results of operations, and financial statements. Under the proposed rules, only one online platform can be used to crowdfund an offering and that platform can only offer the investment opportunity over the Internet. The platform must also disclose how it is being compensated by the crowdfunding issuer.
The SEC’s proposed rules also apply some of the Bank Secrecy Act’s requirements to crowdfunded investments, requiring the establishment and maintenance of anti-money laundering and customer identification programs, the filing of suspicious activity reports, and compliance with the Financial Crimes Enforcement Network’s (“FINCEN”) requests for information.
FINRA has been charged with regulating the online crowdfunding platforms, referred to in their proposed rules as “funding portals.” FINRA’s proposed rules subject funding portals to less stringent requirements than those applied to broker-dealers. FINRA’s proposed rules require, among other things, that the funding portal register with the SEC and FINRA, report disciplinary actions to FINRA, apply a “just and equitable principles of trade” standard for dealing with customers, establish and maintain a supervisory structure, comply with anti-money laundering rules, maintain a fidelity bond, and keep certain records.
The public comments period for the SEC and FINRA proposed rules ended in February 2014. Many of the submitted comments focus on the restrictiveness of the caps on how much an individual can invest in a crowdfunded offering, and the costliness of preparing all the disclosures required by the SEC’s proposed rules. There exists uncertainty and disagreement as to how the SEC should determine an individual’s net worth to see what their investment cap should be—while audits of potential investors would be incredibly time-consuming, allowing investors to self-certify their net worth may lead to dishonesty from overeager investors. Similarly, there is some debate as to whether the SEC should require an auditor to prepare disclosures—one comment argued that having to hire an auditor to handle the disclosures would “severely handicap the process and essentially nullify the intent of the Jobs Act,” while another comment argued that auditors should be a necessity, stating that “[a]llowing anyone to maintain shareholder records, regardless of qualifications, experience, or quality control will create a wild west in the world of crowdfunding.” The SEC and FINRA have yet to issue their final rules.
Some are already disappointed with the federal investment-based crowdfunding laws, even though they have not yet gone into effect. Last month Congressman Patrick McHenry, who championed the original crowdfunding legislation, introduced a draft bill proposing several revisions to Title III of the JOBS Act, including raising the individual investor cap to US$5 million, allowing individual self-worth to be self-certified for issuances under US$500,000, and removing certain liability provisions for crowdfunding issuers and online platforms.
In the meantime, eleven states have legalized investment-based crowdfunding since 2011—Washington became the most recent one just last month. The results of these state laws may go a long way toward demonstrating the benefits of crowdfunding to the nation at large. However, these state laws come with natural limitations: companies can only raise money from residents of the same state, and according to the SEC, cannot use social media to raise awareness of their crowdfunded offerings, given that these communications tools extend beyond state boundaries.
Federal investment-based crowd-funding won’t be beholden to such limitations. However, startup entrepreneurs hoping to take advantage of it will have to wait for more guidance. Given the myriad conflicting opinions on the best way to balance the encouragement of startups and the protection of investors, it may be some time before the final federal regulatory framework is hammered out.