November 11, 2011
Crowdfunding and Securities Fraud
Thomas Hazen has just posted an article opposing a federal securities law exemption for crowdfunding. His paper, Crowdfunding, Social Networks, and the Securities Laws—The Inadvisability of a Specially Tailored Exemption Without Imposing Affirmative Disclosure Requirements, is available here.
Crowdfunding, as I have explained before, is the use of the Internet to raise funds through small donations from a large number of people. For more on the crowdfunding phenomenon, see one of my earlier posts here. For a detailed examination and an explanation of why I think small businesses should be able to sell securities through crowdfunding without registering their offerings. see my article, to be published in the Columbia Business Law Review this spring.
Hazen argues that a crowdfunding exemption would result in more securities fraud. I have explained how a crowdfunding exemption can be structured to reduce the risk of fraud. Hazen doesn't really discuss those ideas, but Hazen’s basic point is right. If the SEC or Congress creates a crowdfunding exemption, there will be more fraud. That conclusion, however, tells us nothing.
Allowing more securities offerings of any type—whether they are registered offerings, private offerings, or crowdfunded offerings—will result in more securities fraud and other investor losses. The only way to protect investors from securities fraud is to ban all sales of securities. We don’t do that because the other costs of such a policy would exceed the gains in fraud protection.
Unfortunately, Hazen stops at investor protection. Having concluded that there will be more fraud if we adopt a crowdfunding exemption, he doesn’t ask the important question: will the benefits of a crowdfunding exemption exceed its costs, including the possibility of additional fraud? I think the answer to that question is yes.
As I explain in my article, small businesses face a significant capital gap. The existing exemptions are simply too expensive for very small offerings, leaving very small startups with no effective outlet for capital. Hazen claims that the existing securities exemptions are sufficient. That may be true for larger businesses, but it clearly isn’t true for offerings by very small startups. Securities law is an impassable obstacle for many small businesses. The expense to comply with the existing exemptions is simply too great relative to the size of the offering.
A properly constructed crowdfunding exemption will make new sources of capital available to small startups, and I think that gain will outweigh the potential losses. Moreover, the risk to any particular investor is minimized by limiting the amount each investor may invest. On the whole, I think the benefit of the exemption will exceed its cost.