Securities Law Prof Blog

Editor: Eric C. Chaffee
Univ. of Toledo College of Law

Sunday, November 13, 2011

Crowdfunding Legislation : Answer to Entrepreneurs’ Prayers or Nightmare for Small Investors?

On November 9, 2012, the House of Representatives, by a 407-17 vote, passed The Entrepreneur Access to Capital bill (H.R. 2930), which, according to its sponsors, will allow small businesses to raise capital without burdensome regulation and thus promote job growth.  The Obama Administration supported House passage of H.R. 2930 because it will “make it easier for entrepreneurs to raise capital and create jobs.”  The legislation has been introduced in the Senate. 

H.R. 2930 creates a “crowdfunding” exemption from registration under the Securities Act of 1933 and allows the offering of securities up to $1 million annually ($2 million if the  issuer provides audited financial statements), so long as individual investments are limited to the lesser of $10,000 or ten percent of the investor’s annual income.   The securities may be sold with or without the services of an intermediary, who would not be deemed a broker under the securities laws solely by reason of participating in such a transaction.  It is expected that offerings will take place over the internet.

The crowfunding exemption does not require disclosure about the issuer and its business plans.  This is in contrast to existing exemptions that involve general solicitation of investors (apart from the intrastate exemption).  Instead, investors must be warned about:

• the speculative nature generally applicable to investments in startups, emerging businesses and small issuers, including risks in the secondary market related to illiquidity; and
• that they are subject to restrictions on resale.

Potential investors need not be sophisticated, but will have to answer questions demonstrating competency in:

• Recognition of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers;
• Risk of illiquidity; and
• Other areas that the SEC may determine appropriate.

Intermediaries, or issuers if an intermediary is not used, are required to:

• Take reasonable measures to reduce the risk of fraud with respect to such transaction;
• State a target offering amount and withhold proceeds until the aggregate capital raised from investors is no less than 60 percent of the target offering amount; and
• Outsource cash-management functions to a qualified third-party custodian.

Intermediaries, or investors, cannot offer investment advice.

If an intermediary is used, it is required to carry out a background check on the issuer’s principals.

Securities sold pursuant to this new exemption cannot be resold for a one-year period from the date of purchase, except to the issuer or an accredited investor.

The legislation requires the SEC to issue implementing rules not later than 90 days after enactment and explicitly directs the SEC to carry out the cost-benefit analysis required under section 2(b) of the Securities Act.  The legislation also directs the agency to establish disqualification provisions for ineligible issuers and intermediaries substantially similar to those contained in regulations adopted pursuant to section 926 of the Dodd-Frank Act.

Holders of securities issued pursuant to this new exemption shall not be counted for purposes of determining the number of shareholder s of record under section 12(g)(5) of the Securities Exchange Act (500) that triggers the reporting requirements.

Finally, securities issued pursuant to this new exemption are “covered securities” under section 18(b)(4) of the Securities Act and therefore exempt from state regulation.

According to press reports, SEC Commissioner Elisse Walter supports a crowdfunding exemption within limits – “if it is too big, it will become a haven for fraud and it will backfire.”  Previously, in Congressional testimony, Meredith B. Cross, Director of the SEC’s Division of Corporation Finance, noted the SEC’s responsibilities both to facilitate capital formation and to protect investors and cited the agency’s experience under the small public offering exemption (Rule 504) and the investor protection concerns that led to significant revision of that Rule in 1999.  Further, Ms. Cross stated:

Although the business venture may have a well formulated plan and a committed entrepreneur, potential investors may have little information about the plan, its execution, or the entrepreneur behind the business. Investments in small businesses can be open to opportunism created by this information asymmetry. Sophisticated investors generally negotiate protections for themselves and may provide their funding over time to protect their investment, but due to the nature of crowdfunding ventures, crowdfunding investors may have limited investment experience, limited information upon which to make investment decisions, and almost no ability to negotiate for protections. While the small amount of any potential crowdfunding investment should generally limit the extent of any individual’s losses, these issues are among those that would need to be considered as a part of the cost-benefit analysis that the Commission would consider in connection with any future proposal.

Similarly, NASAA has urged Congress to balance the need for investor protection with the need to help small businesses raise capital.  In  Congressional testimony on behalf of NASAA, Arkansas Securities Commissioner Heath Abshure cited state regulators’ experience under SEC Rule 506 after Congress preempted states from reviewing private placement offerings:

Today, the exemption is being misused to steal millions of dollars from investors through false and misleading representations in offerings that provide the appearance of legitimacy without any meaningful scrutiny of regulators.

As Professor Thomas Hazen has argued in a forthcoming article(available on SSRN), “it is naïve to assume that limiting offerings to small amounts per investor will deter scammers from taking advantage of investors via crowdfunding.”  Moreover, $10,000 or ten per cent of the investors’ annual income is not a de minimus amount for small investors.   While the national economy needs incentives to promote job growth, it cannot be at the expense of investor protection.  I agree with Professor Joan Heminway and Sheldon Hoffman, who state in their forthcoming article (also available on SSRN) that “[w]e do not find it acceptable … that a regulatory exemption for crowdfunding leave those who invest a small dollar value in a venture to fend for themselves.”  

Accordingly, I agree with Professor Hazen’s conclusion that “there should be no special carve-out for crowdfunding efforts unless the exemption is conditioned on disclosures necessary to enable even unsophisticated investors to make an informed investment decision.”

(Thanks to Professor Margaret V. Sachs for calling my attention to H.R. 2930)

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Very informative materials; I would only add that the 1999 amdnements to Rule 504 (in rolling back on "general solicitation" and by (re)-defining the securities as "restricted securities)-- were enacted NOT becasue of Issuer fraud, but rather secondary market microcap "pump and dump" schemes (NASD-registered)brokers were engaged in: i.e. market manipulation of prices. -- [SEE SEC Rel. No. 7644.]

Posted by: Steve Turner | Jan 2, 2012 3:25:13 PM

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