True crowdfunding has worked really well in numerous documented cases where ordinary people (and by ordinary I mean tech savvy people) looked to help other ordinary people complete a project. Sometimes it’s a personal project like raising money to pay medical bills (over $143,000 for a victim of the Aurora Colorado shooting), while other times it’s a business project to raise money to build a better mouse trap (over $2,000 for a dry composting toilet). In the former case, the donor may get back a warm and fuzzy feeling; in the latter case a donor may get back a right to buy the better mousetrap (or dry composting toilet) at a discount (if its ever produced), or some other tchotchke to thank the donors for their money. That all works really well thanks to the Internet and tech savvy ordinary people. Of course, we don’t know if there really is a sick person or better mousetrap (dry composting toilet) involved at all, and there is no cop (or plumber) on the beat to check.
Before the JOBS Act (Jumpstart Our Business Startups Act), one could not offer the crowdfunding donors an ownership or equity interest in a business project in exchange for their money because that “interest” is considered to be a “security,” the offer or sale of which is heavily regulated by federal and state law. With the JOBS Act, however, Congress sought to create a securities law crowdfunding exemption that permits the use of the Internet to raise a limited amount of capital from an unlimited number of ordinary people who then get back an equity ownership interest in the business project. But the devil is in the details and those details have doomed equity crowdfunding in my view.
For example, the intermediary requirement to use a registered broker-dealer or “funding portal” is a kiss of death. It’s hard to imagine many registered broker-dealers becoming crowdfunding intermediaries in view of the small dollar amounts involved. Moreover, the restrictions, reporting requirements and affirmative duties imposed on funding portals are so onerous that it's unlikely many, if any, will emerge. In this regard, funding portals will be required to undertake a measure of due diligence to positively affirm that each and every of the ordinary people investors understands the risks of the investment, can bear the loss of the entire investment, and is otherwise educated in similar investment transactions. In addition, before a funding portal is permitted to sell securities under the crowdfunding exemption, the funding portal must first conduct a background and securities enforcement regulatory history check on each officer and director of the business project issuer, as well as each holder of more than 20 percent of the equity ownership of the business project issuer. The funding portal must also ensure that the proceeds from the crowdfunding are not sent to the business project issuer until the specified target offering amount has been reached.
Further, similarly onerous are the pre-sale disclosure obligations imposed on the business project issuer (that must be filed with the SEC), as well as annual SEC disclosure filing obligations. In addition to the names, addresses and ownership interests of the officers and directors of the business project issuer, description of the business project and use of proceeds, and description of the ownership and capital structure of the business project issuer, the business project issuer must also provide a description of its financial condition, including its tax returns for offerings under $100,000 and audited financial statements for offerings over $500,000. Again, it seems unlikely that many business project issuers will go to the trouble and expense to provide all of that information for a relatively small capital raise using the equity crowdfunding exemption.
Time will tell, but until the SEC and Financial Industry Regulatory Authority (“FINRA”) propose and adopt rules defining the crowdfunding exemption, there is nothing to tell – it’s still illegal to sell securities using a crowdfunding technique.
Nevertheless, on January 10, 2013, FINRA invited prospective funding portals to voluntarily submit information to it, at no cost and on a confidential basis, about their proposed business models, activities and operations. The purpose of the information collection on FINRA’s “Interim Form for Funding Portals,” is to help FINRA become more familiar with the funding portal community and to assist it in developing rules specific to funding portals. Completion of the Interim Form will not result in FINRA membership or the ability to legally intermediate crowdfunding transactions. Voluntary filers of the Interim Form will still need to complete a new membership application form once the SEC and FINRA rules are proposed and become effective.