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Commentary

Crowdfunding 2.0: Where Will It Go?

Congress has created a set of rules that will make equity crowdfunding too cumbersome for most businesses, but there is still a chance to get it right.

In last spring's JOBS Act, Congress gave the SEC 90 days to enact rules for crowdfunding, a new type of Internet-based securities offering through which a large number of investors can buy shares in small businesses. The SEC probably has never adopted a rule in 90 days, and the underfunded agency is already way behind on dozens of rules required by the 2010 Dodd-Frank Act. But the logic of election-year politics has never been logical. Now Congress is shocked--shocked--that the SEC has not met the deadline.

After the crowdfunding rules are adopted, Congress will again be shocked--shocked--that they are excessively burdensome. No matter that it is Congress' requirements that are burdensome. It will still be amazed that the burdensome rules it asked for are precisely what it gets.

The JOBS Act is what happens when Congress crafts the details of regulatory innovation. You get a new category of "emerging-growth" issuers--an early example of which is 134-year-old Manchester United, a business that is creating jobs in the United Kingdom, not the United States. You get unregulated hedge funds being allowed to advertise alongside regulated mutual funds. And you get crowdfunding rules that are unworkable.

Equity crowdfunding has great promise as a model for disintermediating capital markets, a process that the SEC has steadily, albeit slowly furthered during the last three decades. But Congress has created a set of rules, for which it will ultimately blame the SEC, that will make equity crowdfunding too cumbersome for most businesses. This will likely lead to demands for Crowdfunding 2.0 and a second chance to fulfill or forsake crowdfunding's full potential.

Hey Sisyphus, Where's That Boulder Already?
Congress has assigned the SEC a task on which it cannot deliver. The crowdfunding bill's requirements ensure that SEC rules will not enable a workable crowdfunding marketplace. Indeed, the bill seems to have been intended to set up the SEC for failure.

Businesses seeking crowdfunding must file a registration statement that describes the financial condition of the business and includes financial statements that, for $100,000-plus offerings, must be certified by an independent public accountant and, for $500,000-plus offerings, must be audited.

Businesses must explain how the terms of securities offered may be modified and how the exercise of stock-purchase rights of principal shareholders may "negatively impact" purchasers. It must explain the risks "relating to minority ownership" and "corporate actions," including any follow-on sales of shares, sale of the business or its assets, and transactions with related parties.

Any small-business owner who could produce this information would do well on a corporate finance exam. However, it is not clear why Congress thought a condition of raising a measly $100,000 should require that a business owner take the first step toward obtaining a law degree.

This isn't the only schooling that Congress required. Crowdfunding intermediaries must "positively affirm" that each investor understands that he "is risking the loss of his entire investment." Toward that end, intermediaries must have investors take a quiz "demonstrating" an understanding of the risks entailed by: 1) investments in startups, emerging businesses, and small issuers, and 2) illiquidity. So it seems that both business owners and their investors will need advanced degrees in finance.

After conducting a background check on the business owner, the intermediary must affirm that each investor "could bear a loss" of their entire investment. These intermediary requirements will be supplemented by additional rules adopted by FINRA, the self-regulatory organization for broker-dealers. Intermediaries will have to register with the SEC and are prohibited from advising or soliciting investors and investing in issuers. An SEC Q&A for intermediaries lays out a decidedly unappetizing business model.

Even if crowdfunding makes sense for middlemen, it will not make sense for many businesses. One or more existing fundraising mechanisms--such as friends and family, private offerings under Rule 506 (especially once the SEC permits general solicitations and advertising), Reg A offerings (especially once the SEC raises the current $5 million limit to $50 million), and venture capital partnering--will usually offer a far more efficient alternative (at least one other securities lawyer agrees). The SEC has summarized the requirements for some of these alternative mechanisms here.

None of these mechanisms requires testing investors' sophistication or, for example, filing annual reports with the SEC. In contrast, Congress has required that crowdfunded businesses, like public companies, file annual reports that discuss their operating results and include, once again, financial statements. And crowdfunding will be subject to private claims under federal law that do not apply to private offerings.

Small businesses may instead choose to raise funds by borrowing rather than giving up an ownership stake. Notwithstanding all the hype surrounding equity crowdfunding, crowdfunded securities offerings have actually been around for years.

Debt crowdfunding sites such as Prosper, LendingClub, Kiva, Microplace, and Kabbage allow individuals to invest in business loans with almost no regulation. It is curious that equity-crowdfunding proponents virtually never point to their success. Perhaps they are too enamored of the cumbersome equity-crowdfunding rules they created, in contrast with the streamlined debt-crowdfunding rules created by the SEC that actually work. Or perhaps they are reluctant to publicize established debt-crowdfunding sites that may expand into the equity space and crush equity-only upstarts.

The crowdfunding bill was drafted by crowdfunding advocates who were more interested in getting a law enacted than creating workable rules. Members of Congress spent more time thinking about naming the "JOBS Act" than about its contents. Now the SEC is stuck codifying the mess that Congress created, fully aware that it will be blamed for doing exactly what it is required to do.

To be fair, the SEC deserves some of the blame. It stood by passively while the bill worked its way through Congress, with only a brief, 11th-hour note of tepid opposition coming from then-SEC chairman Mary Schapiro. Now new SEC chairman Mary Jo White will have to decide how to handle the inevitable demands for Crowdfunding 2.0.

Crowdfunding 2.0
It is not too late for the SEC to get off the sidelines and restore sanity to equity crowdfunding. After delivering the dysfunctional set of rules that Congress has demanded, the agency should seize the initiative and create a separate crowdfunding regulatory regime that actually works. Crowdfunding 2.0 is going to happen. The SEC should make sure that this time we get it right.

A form of "Reg A Lite" may hold out the greatest potential for equity crowdfunding. Regulation A already permits the general solicitation of investors and investment by investors regardless of their wealth or sophistication (and is used by real estate crowdfunder Fundrise). A properly modified Reg A offering, including a "covered security" exemption from state registration and a plain-English registration statement, could entirely supplant Congress' burdensome crowdfunding model.

Another alternative would be to create an equity version of the existing debt-crowdfunding regime. This might entail a standardized capital-structure format that approximates the simplified structure of a standard loan that has made debt crowdfunding a less complex challenge. It is not clear, however, that a genuine equity investment can be adequately simplified without compromising its intrinsic ownership qualities. As a legal and business matter, a promise to pay interest is just fundamentally different from promising a piece of the profits.

An innovative interim step might be to authorize debt-crowdfunding sites to offer single-class, perpetual-life, participating preferred stock that operated like debt while offering a limited degree of profit participation and protection from economic dilution. In layman's terms, this would mean the business was not required to make payouts, but when it did, a minimum, fixed amount would have to be paid to the preferred shareholders before other equity owners received anything.

The problem common to these approaches, however, is that they attempt to stuff crowdfunding into the existing regulatory model for securities offerings. That shoe will never really fit. The best alternative may be to create an equity-crowdfunding model in which offering regulation can be jettisoned altogether.

The core of such an approach would be capping individual investments at a truly de minimis amount, with higher limits on each investor's aggregate annual investments. Some investor advocates and regulators may not like this approach because it protects investors primarily by limiting their losses. But there is a point at which the amount of money at risk just doesn't justify the costs of offering regulation. General securities fraud and consumer protection rules would still apply. And other versions of Crowdfunding 2.0--which is coming one way or another--are likely to be far worse.

Crowdfunders may cry about lower individual investment limits, but if the genius of crowdfunding really is, as its apostles claim, the tapping of the wisdom of crowds, then why shouldn't it be bona fide crowds that are doing the investing? Ten investors each investing $10,000 toward a $100,000 crowdfunding is not a crowd. One thousand investors each investing $100 is.

Offerings would be preceded by an SEC filing 21 days prior to the first offering that states: 1) the amount of the offering, 2) the name and physical address of the issuer and its principal owner, 3) the issuer's form of organization and the jurisdiction in which it is organized, and 4) the business in which it is engaged. Such a prior-notice filing (already required by the JOBS Act) would provide enforcement officials an opportunity to preview offerings by fraudsters attempting to use crowdfunding as a screen to engage in plain-vanilla theft.

Finally, broker-dealers who only engage in crowdfunding should be functionally regulated as broker-dealers. The SEC (or FINRA) should substantially downsize broker-dealer rules to reflect the greatly reduced risks presented by de minimis crowdfunding investments. Limited soliciting, generic advice, and co-investing could be permitted; these activities are currently banned under the JOBS Act.

In short, with de minimis investment limits, a 21-day notice, and functional regulation of intermediaries, crowdfunding should be allowed with no securities regulation other than general antifraud rules. No registration statement. No investor sophistication test. No annual reports. No financial statements. No tutorials on capital structure, liquidity risk, or financial statements. No JOBS Act regulation.

The SEC should go even further by working toward a global standard under which investors, wherever they are, could support tiny businesses, wherever they are. Capital-raising will one day be regulated on a truly global basis, but to date, the stakes have been too high (among other reasons) for truly global standards to take hold. In contrast, low-stakes crowdfunding offers a unique opportunity to build a truly global funding model. But it would be enough for now to start with a workable model under which a small U.S. business in Pocatello, Idaho, or Poughkeepsie, N.Y., could raise $50,000 over the Internet without running a regulatory gantlet.