April 18, 2011
Crowdfunding and the SEC
Last week, Mary Schapiro, the Chairman of the SEC, announced that the SEC plans to review the impact of its regulations on capital formation for small businesses. We discussed that announcement here and here.
Among other things, Chairman Schapiro’s letter promised to address crowdfunding. Crowdfunding, sometimes known as micro-finance, raises capital through very small contributions from a large number of investor. For example, the Sustainable Economies Law Center has petitioned the SEC to create a new Securities Act exemption for offerings of $100,000 or less, provided that no single investor invests more than $100. The SEC has filed this proposal and is receiving comments on it here. [Confession: Until I began working in this area, I didn't realize one could petition the SEC to adopt an exemption.]
Crowdfunding is already widely used in contexts arguably not involving the sale of securities. For example, the website Kickstarter allows people to solicit money for “creative projects” like films, technology, or music. Contributors don’t receive any equity interest in the projects, but rewards such as a copy of the CD produced, a visit to the set, film credit, and so on. Another site, Kiva, uses crowdfunding to make loans to projects around the world.
A crowdfunding exemption from the registration requirements of the Securities Act would allow entrepreneurs to give investors an equity interest in return for such capital contributions.
Such web sites are impossible under current law. The closest thing I have seen in the United States is ProFounder, which does offer a share of revenues in return for investors’ contributions. ProFounder tries to fit its offerings within the SEC’s Rule 504 exemption by limiting the size of any offering to $1 million or less and by limiting access to friends, families and others with whom the entrepreneur has a preexisting relationship. (The latter restriction is designed to avoid the exemption’s prohibition of general solicitation.) ProFounder also limits the number of investors in any given state, in an attempt to use state limited offering exemptions to avoid state registration requirements.
What’s the argument for a crowdfunding exemption? Obviously, an offering isn’t any safer just because a large number of people invest small amounts. And people who invest small amounts aren’t necessarily sophisticated enough to protect themselves; in fact, smaller investors are probably less sophisticated on average. The policy rationale, to the extent there is one, is that, even if it’s a bad deal, each investor won’t lose much. The loss is tolerable.
This argument for an exemption if investors can afford to lose the money isn’t as novel as it sounds. It essentially underlies Regulation D’s designation of investors as “accredited” if they meet specified income or net worth limits.
I have been working on an article on crowdfunding and hope to have a draft completed in the next month or two, depending on how exam-grading goes. I will post an SSRN link on the blog when it’s available.
April 18, 2011 | Permalink
There are some interesting sites specifically geared toward raising money for up and coming music bands. Most of these sites are based in Europe. You can invest money and be eligible to receive a portion of the band's profits. Some of the sites include slicethepie.com and bandstocks.com among others. I remember doing some research for my securities law class a few years ago regarding the legality of such websites under securities laws.
Posted by: Gustav | Apr 19, 2011 7:47:51 AM
The key is "in Europe." Those sites are clearly selling securities under the Howey test, and I have no doubt they would be illegal in the United States.
Posted by: Steve Bradford | Apr 19, 2011 9:10:24 AM
you're late to the party. prosper.com was doing this a while back and got dinged for unregistered offering. There are also weird sites like Indiegogo which let you donate to "causes" but for mushier reasons than cold-cash profit, so they might not be securities.
Posted by: Jarrod Melson | Apr 19, 2011 11:50:16 AM
Jarrod, I'm familiar with Indiegogo, but donations clearly don't involve securities. The point of the proposed exemption is to allow this fundraising method to be used by small businesses to sell securities. Not late to the party-I've been following this at least since Muhammad Yunus won his Nobel prize for micro-lending. Just trying to usher the SEC into the modern world and extend the party to securities law.
Posted by: Steve Bradford | Apr 19, 2011 1:14:46 PM
My "late to the party" comment was ill spoken. My apologies. I am only recently familiar with Indiegogo, and was dubious for two reasons. First, my past work on prosper (not as counsel) made me dubious of crowdfunding generally. Second, I cannot understand why someone would want to fund another person's dream of becoming a reality TV star or the other silliness I've seen there, if not for profit. Looking forward to reading your paper.
Posted by: Jarrod Melson | Apr 19, 2011 1:35:43 PM
@Steve I agree that they would be in violation of Section 5 in the U.S. The interesting question is whether they are being offered and sold in the U.S. because the website is accessible by U.S. persons. I assume you'd get into the whole sliding scale type of analysis as one would when dealing with personal jurisdiction based on website access and the degree of interactivity of the website. I may be off on this as I am reaching way back in my mind to remember what went on in civ pro class years ago not being a courtroom attorney type.
Posted by: Gustav | Apr 20, 2011 6:27:57 AM
That is an interesting question that, among other things, would require one to get into the complexities of Regulation S. I wonder what kind of screening they do.
Posted by: Steve Bradford | Apr 20, 2011 9:01:42 AM
How wuold you compare crowdfunding with the investors of small Grameen (rural) Banks of Bangladesh?
Posted by: G S Prasad | Apr 21, 2011 6:36:48 AM
G.S., Kiva is essentially an attempt to meld the Grameen Bank microloan concept with crowdfunding--to collect small donations from "investors" and use those funds to make microloans around the world. The two ideas aren't necessarily connected. Grameen Bank involves small amounts on the borrower's side of the transaction, but there's no theoretical reason why the source of that capital has to be crowdfunding instead of huge donors. Similarly, crowdfunding involves small amounts on the investor's side, but there's no theoretical reason why crowdfunding couldn't be used to finance a larger business.
Posted by: Steve Bradford | Apr 21, 2011 8:41:17 AM
Well thank you for the idea, but that's already so huge in Uganda where the a group of so many people with a common interest or work together, save together ( Sacco s )and the same members in the Sacco are lent these funds for start-ups or emergencies or any need.
Posted by: N.J | Apr 28, 2011 8:42:47 AM
N.J.: In some ways, things are much easier without the SEC. :)
Posted by: Steve Bradford | Apr 29, 2011 2:56:50 PM