NOTE to Participants: This relatively short essay (for an
anthology on entrepreneurship) is about politics, particularly the
encouraging innovation in a time of anxiety about jobs and economic
change. The focus is on the new-age excitement over crowdfunding,
but the essay also raises issues much beyond the usual confines of
securities regulation—touching briefly on, among other things, Hayekian
exuberance, gender equity in finance, the current state of public choice
theory, and the legacy of William O. Douglas.
The Politics of Entrepreneurial Capital-­‐Raising Donald C. Langevoort* Prologue: What Would WOD Do?
Before he was appointed to his long-lasting seat on the Supreme
Court, William O. Douglas (WOD to his entourage, apparently) was
Chairman of the Securities & Exchange Commission. His tenure was
productive and aggressive, taking on “the moneyed interests” harder
than either of his two New Deal predecessors.1 Two subsequent SEC
chairs, William Cary and Arthur Levitt, called Douglas their hero and
inspiration. In the 1990s, Levitt put Douglas’ quote committing the
SEC to be “the investor’s champion” against the forces of greed on the
home page of the Commission’s new website.2
Less well-known is that Douglas was the first chair to face
squarely the criticism from the small and emerging business community
(and its own champions) that the Securities Act of 1933 was choking
economic growth and job creation.3 Their words of complaint sound
remarkably contemporary. With pressure from the White House, the
SEC quickly responded: a first round of reforms was adopted in 1938
to jump-start small business capital-raising. That did not satisfy the
entrepreneurs, and the next seventy-five years brought a succession of
*
1
2
3
Thomas Aquinas Reynolds Professor of Law, Georgetown University Law Center.
JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET ch. 6 (3d ed., 2003).
Id. at 630.
Id. at 201-05.
1
partisan battles to redo the public-private boundaries.4 Though today
we think of the JOBS Act of 2012 as the apotheosis of this, other
significant statutory reforms (the Small Business Improvements Act of
1980 and the National Securities Markets Improvement Act of 1996)
were important skirmishes in the campaign, with many other smaller
statutory tweaks interspersed.
The SEC’s main rule-making
innovation—Regulation D in 1982—was thoroughly politicized, too.5
As a thought experiment, I recently posed the question to an
audience: What would WOD think about crowdfunding, the on-line
sourcing of entrepreneurial seed-capital from large numbers of small
investors, which the JOBS Act seeks to enable? It’s an odd question, of
course, given that the technology of finance that enables crowdfunding
hardly was imaginable in the late 1930s. Given his association with
being the investor’s champion, one might immediately think he’d be
horrified at leaving small investors so exposed. That was certainly the
opinion of many investor advocates in 2012.6
But it’s harder than that. Douglas had some of the instincts of a
western populist, and was a believer in economic opportunity. What
mainly drove his tenure as SEC chair was his distaste for Wall Street,
and to its chokehold (in so many different ways) on capital-formation
and investing. Douglas tried to persuade Franklin Roosevelt’s White
House to establish a series of government-owned and financed
industrial banks dedicated to helping businesses grow, shifting
economic power away from the large banks and securities firms so used
to collusion and cronyism to maintain power and privilege. That failed,
and toward the end of his term at the SEC (when he had no idea of his
4
See Robert B. Thompson & Donald C. Langevoort, Redrawing the Public-Private Boundaries in
Entrepreneurial Capital Raising, 98 Cornell L. Rev. 1573 (2013).
5
See Mark Sargent, The New Regulation D: Deregulation, Federalism and the Dynamics of
Regulatory Reform, 68 Wash. U.L.Q. 227 (1990).
6
In Congressional testimony, Jack Coffee memorably said that with unrestricted capital-raising,
“every barroom in America might come to be populated by a character, looking something like
Danny DeVito, obnoxiously trying to sell securities to his fellow patrons.” Testimony before the
Senate Committee on Banking, Housing and Urban Affairs, Dec. 1, 2011, at 10. Coffee was
speaking of the aspects of the proposal, later deleted, dealing with who could facilitate such
offerings.
2
forthcoming nomination to the Court) he seemed frustrated that he had
accomplished relatively so little in the battle to turn finance in the
direction of the public interest, ready to return to law teaching at Yale.
I suspect Douglas might be excited at the idea of the kind of
disintermediated, geographically diverse7 capital-raising atmosphere that
crowdfunding promises, free of the yoke of the securities industry. But
he would have warned to keep a wary eye on the industry players, who
would use their dark arts to destroy anything that might threaten their
expected revenues.
Who’s Fighting, and Why?
Crowdfunding and the other JOBS Act reforms pose an
interesting political puzzle. Ever since the 1930s, the significant costs
associated with entrepreneurial finance have been palpable; the
cumbersome registered public offering was then, and more so now,
unsuited for smaller offerings. To be sure, a completely deregulated
environment might not be in the best interests of reputable issuers
because of adverse selection: the familiar “lemons” problem. But some
deregulation was sorely needed, and became a legislative and regulatory
priority for business people with considerable political savvy and clout.
As noted, there were many victories, to be sure, but to their
proponents they were slow in coming and inadequate, both in Congress
and at the SEC. 8 Crowdfunding is the current exemplar—no proponent
is happy with what they got out of the political process—but there are
others as well, as we shall see. The political question comes down to
who’s on the other side in these battles, and why.9 The standard answer
7
Diversity in gender, age and social orientation, too. See Andrew A. Schwartz, Inclusive
Crowdfunding, 2016 Utah L. Rev. (forthcoming).
8
E.g., Stuart Cohn, The Impact of Securities Laws on Developing Companies: Would the Wright
Brothers Haven Gotten Off the Ground?, 3 J. Small & Emerg. Bus. L 315 (1999).
9
For the JOBS Act, the Obama administration was strongly in favor from the beginning, though
probably with more enthusiasm for some portions of the pending bills (particularly the IPO on-
3
points to the forces of “investor protection,” but who is that, exactly?10
By most accounts, retail investors are too disorganized and distracted to
be a potent force. There are organized interest groups—the Consumer
Federation of America, AARP and unions—who do take positions
consistent with a protective, paternalistic stance in the face of aggressive
finance. But, whether then or now, that doesn’t seem like enough given
the organization and heft of the entrepreneurship side and the diffusion
of issues with which the investor-leaning groups are principally involved.
Especially today, in a post-Citizens United world of political hyperefficiency, this should be a rout. Although this is usually counted as a
Republican agenda item today, there are also some strong Democratic
connections here as well, largely through high-tech and hedge fund
donor communities.
Maybe the sticking point is the SEC. At least in times of
Democratic leadership, the Commission has largely resisted
deregulation, acting out its investor champion role. Perhaps this
reluctance is out of genuine belief that investors are at risk from capitalraising that takes place in the dark. There might also be predictable
bureaucratic biases, both perceptual and motivational. The
Commission sees a disproportionate number of bad actors, and may
extrapolate this too easily to the full range of capital-seekers.11 Or it
may be organizational identity: the agency’s historical mission is
investor protection, so protection is valued. That leads naturally to a
precautionary stance, and suspicion of the motives of those who might
threaten the status quo and with it, the agency’s reason for being.12
This no doubt explains some of the push-back, especially with
respect to rule-based reform. But again—especially in recent years—
ramp) than others. The Treasury Department and the White house jointly controlled efforts on
behalf of the administration.
10
For a good discussion of history and possible rationales underlying the malleable concept of
investor protection, see Michael Guttentag, Protection from What? Investor Protection and the
JOBS Act, 13 U.C. Davis Bus. L.J. 207 (2013).
11
Stephen Choi & Adam Pritchard, Behavioral Economics and the SEC, 56 Stan. L. Rev. 1
(2003).
12
Donald C. Langevoort, The SEC as a Lawmaker: Choices About Investor Protection in the
Face of Uncertainty, 84 Wash. U. L. Rev. 1591 (2006).
4
agencies like the SEC cannot prevent legislative reform without some
exogenous source of political muscle, and can be pressured to act
contrary to their natural protectionist habits. (There may have been a
time when the legacy of the New Deal among members of Congress—
like the legendary House Speaker Sam Rayburn, a long-time SEC
supporter, or later, powerful Congressman John Dingell—gave the
Commission extra clout, but those days are long passed). The JOBS
Act occurred with the SEC visibly excluded from the drafting process.13
To me, there are at least two additional stories to tell. One—too
complex to explore here in depth—is ideological. Small business
capital-raising is a stand-alone issue for business people, but also a
salient part of a bigger attack on the regulatory state.14 In purely
pragmatic terms, compromise to promote entrepreneurship might be
possible, but when proponents of reform seem energized by far greater
regulatory ambitions to eradicate bureaucratic paternalism, perhaps a
line gets crossed. In Congress, as we’ll see, this may have been one
source of crowdfunding’s de facto “defeat” via the layering on of
backdoor restrictions: some of crowdfunding’s most vocal (mainly
youthful) supporters made little effort to hide their Hayekian
enthusiasm. Elsewhere, I’m writing about the post-modern SEC, which
the pull of “publicness” is strong in opposition to a movement that so
prizes private economic freedom.15 The alliances are with others
threatened by that philosophy, whether or not they care much about
investor issues per se. The arousal is deep and instinctive, so that what
counts as a win or a loss isn’t just (or mainly) about the merits.
The other possible story is different, and my main interest here.
The idea that well-organized economic interests always trump diffuse
13
Itself part of a bigger story about administrative law. See Lisa Schultz Bressman & Robert B.
Thompson, The Future of Agency Independence, 63 Vand. L. Rev. 599 (2010).
14
See KIM PHILLIPS-FEIN, INVISIBLE HANDS: THE MAKING OF THE CONSERVATIVE MOVEMENT
FROM THE NEW DEAL TO REAGAN 3-4 (2009)(noting early antipathy to the SEC). Phillips-Fein
traces the fractures within conservatism between ideological libertarians and the business-oriented
pragmatists, especially the criticism that the latter are too willing to tolerate regulation and the
profit it generates as for the well-entrenched.
15
DONALD C. LANGEVOORT, CHASING THE GREASED PIG DOWN WALL STREET: THE ECONOMICS,
POLITICS AND PSYCHOLOGY OF INVESTOR PROTECTION (forthcoming, 2016).
5
ones in politics is fundamental to public choice theory. But an
important corollary of public choice is that battles over regulation are
not simply private versus public, but rather efforts by some organized
interests to gain advantages over their competitors or potential
competitors—in other words, rent-seeking (or rent-preserving) behavior.
Proponents of this say, somewhat compulsively, that legislation and
regulation is best explained by seeing what industry player stands best to
gain from heavy—maybe dysfunctional—regulation.16
I’m a skeptic of obsessive public choice explanations, partly
because I think ideology and symbols matter a lot in politics. The
perceived public interest is not a trivial explanatory category. But there
is no doubt that private interest groups are skilled enough to see
opportunities, and able to influence legislation and regulation to create
or expand burdens so long as the pain is felt by others. Sometimes this
characterizes entire regulatory projects; more often partisans just seek
out a provision or two to add or delete a few words in a lengthy bill that
does substantial harm to their competitors. Or it might involve giving
active support to other aspects of regulatory or deregulatory initiatives,
so long as they don’t touch the existing rents. The cover for all this is
easy, protecting investors from overreach. Paul Mahoney has used
public choice to explain how we got the Securities Act as we know it.17
For all the risks and burdens it imposes on capital-raising, it also
suppressed means of competition by aggressive upstarts. Wall Street’s
control over finance was strengthened, not reduced, something Douglas
sensed as he became increasingly frustrated many years ago.
That story is with us still. One of the dominating fact questions
that drove the JOBS Act was why we’re seeing noticeably fewer initial
public offerings today than in previous decades. Congress’ official
diagnosis was that the Securities Act imposed too heavy a disclosure
16
As applied to securities regulation, see SUSAN PHILLIPS & J.R. ZECHER, THE SEC AND THE
PUBLIC INTEREST (1981); Jonathan Macey, Administrative Agency Obsolescence and Interest
Group Formation: A Case Study of the SEC at Sixty, 15 Cardozo L.. Rev. 909 (1994). On private
markets in particular, see Zachary Gubler, Public Choice Theory and Private Securities Markets,
91 N.C. L. Rev. 745 (2013).
17
PAUL G. MAHONEY, WASTING A CRISIS: WHY SECURITIES REGULATION FAILS (2015).
6
burden on issuers, which it lightened with the new “on-ramp” for
registered public offerings by emerging growth companies. Apart from
reduced and delayed disclosure, the main reform was to enable the
more aggressive use of sell-side analysts in the public offering process,
notwithstanding their palpable conflicts of interest when connected to
the offering’s Wall Street underwriters. But the over-regulation
explanation for the drop in IPOs was questionable—a good bit of
academic research said that, while there surely was some inefficient
regulation, other factors probably dominated.18 Among these was the
cost of investment banking services, noticeably higher in the U.S. than
elsewhere. One might think, therefore, that reform might have at least
considered enhancing competition and innovation in underwriting,
perhaps by encouraging on-line auctions and other distribution
mechanisms.19 But that got no attention at all; the bankers even got
their analysts back in the game, potentially giving them even more
leverage in the offering.20 And while it’s too early to tell conclusively,
early post-JOBS Act empiricism casts doubt on whether are now getting
many more IPOs that we wouldn’t have had before under the right
economic conditions. But transparency apparently has diminished.21
Politics and Private Offerings
18
See Mark Abrahamson et al., Why Don’t U.S Issuers Demand European Fees for IPOs? 66 J.
Fin. 2055 (2011). There are many other explanations, including structural shifts in product
markets that favor size and scale and thus make growth via merger attractive. E.g., Xioshui Gao
et al., Where Have All the IPOs Gone?, 48 J. Fin. & Quant. Analysis 1663 (2013). An interesting
Canadian study traces the comparable drop there even though the regulation of IPOs is
considerably less burdensome. Bryce Tingle et al., The IPO Market in Canada: What a
Comparison with the United States Tells Us About a Global Problem, 54 Canadian Bus. L.J. 321
(2013).
19
For an exploration of the connection between this and other offering innovations, see Christine
Hurt, Pricing Disintermediation: Crowdfunding and On-line Auction IPOs, 2015 U. Ill. L. Rev.
217.
20
Donald C. Langevoort & Robert B. Thompson, IPOs and the Slow Death of Section 5, 102 Ky.
L.J. 891, 907-09 (2013-14).
21
See Susan Chaplinsky et al., The JOBS Act and the Cost of Going Public, working paper, 2014.
There was a noticeable increase in IPOs in 2013 and 2014, but under very changed economic
conditions from prior years. For preliminary evidence that the JOBS Act has reduced
underwriting fees somewhat, see Usha Rodrigues, The Effect of the JOBS Act on Underwriting
Spreads, 102 Ky. L.J. 926 (2013-14).
7
In the history of deregulation of entrepreneurial capital-raising,
the adoption of Regulation D in 1982 was a watershed. (Not
surprisingly, it came in the wake of Ronald Reagan’s landslide
presidential victory and the appointment as SEC chairman of a strong
believer in free markets, John Shad). Prior to Reg D, the Supreme
Court’s Ralston Purina decision had cast a shadow over efforts to raise
funds other than from unambiguously sophisticated, informed
investors.22 After that, there was a clear way forward under new Rule
506 to raise unlimited funds without any disclosure obligations from
investors who were simply wealthy enough—those with an income of
more than $200,000 a year or a net worth of $1 million.23
Famously, however, there was a catch. Issuers could not search
for such accredited investors via any “general solicitation,” meaning no
advertising or other mass marketing techniques (including web-based
publicity). That was odd—why was it permissible to sell securities in an
unregulated transaction to those presumed able to fend for themselves,
but not go out searching for them? The Commission staff promptly
bolstered this oddity by ruling that, for all practical purposes, issuers
making this kind of Reg D offering had to utilize the costly services of
an intermediary to vet potential investors for accredited status well
before actually pitching any opportunity to them. This led the
entrepreneur community to attack the general solicitation ban as a
needless chill on capital-raising,24 an effort that failed consistently for
thirty years notwithstanding considerable political effort.
I suspect that this failure was less because the SEC was deeply
attached to the ban than because an industry of private placement
agents quickly filled the regulatory need and found Reg D offerings to
22
SEC v. Ralston Purina Co., 346 U.S. 119 (1953); see generally Rutheford B. Campbell, The
Plight of Small Issuers under the Securities Act of 1933: Practical Foreclosure from the Capital
Market, 1977 Duke L.J. 1139.
23
Reg D has other options that vary depending on the size of the offering and number of
purchasers, generally with some mandatory disclosure.
24
See, e.g., Patrick Daugherty, Rethinking the Ban on General Solicitation, 38 Emory L.J. 67
(1989).
8
pre-qualified accredited investors to be extremely lucrative. They had
no desire to see the ban relaxed and their services less needed. As
inflation and growth pushed more and more investors into accredited
status, their revenue stream grew considerably, giving them that much
more reason to seek protection, a classic example of public choice at
work. This issue was more important to them than to anyone else.
And they could hide behind investor protection advocates who liked
the ban not because it made any conceptual sense but because they
didn’t like Reg D from the start, and the ban was at least dampening its
use. No doubt this included some staff at the SEC, and numerous state
blue-sky securities officials.25 But they probably could not have held the
line for so long by themselves.
That takes us to the political economy of the JOBS Act, with its
bipartisan support. We’ve already seen the impact of the JOBS Act in
making IPOs easier to conduct. But today, even after the reforms, that
type of transaction is only for thriving private companies plausibly on
the verge of large-scale success. For earlier stage companies seeking
start-up capital, the markets are more limited—noticeably more so for
female entrepreneurs and those in geographic regions far away from
capital pools and angel clusters. The JOBS Act makes three important
deregulatory contributions for start-ups, each of which required SEC
rule-making for implementation: relaxing the ban on general
solicitations, Regulation A reform, and crowdfunding.26
Before turning to each of these, we should explore a bit more
about those who act as the salespeople for private offerings, because
there is immense diversity.27 Legally, any person or firm that is in the
business of assisting the purchase or sale of securities has to register as a
“broker.” That involves both direct SEC regulation and the “selfregulation” generated by FINRA, all in the name of promoting fair
dealing and the just and equitable principles of the trade. Finders and
25
Sargent, supra.
Thompson & Langevoort, supra, at 1604-21.
27
See John L. Orcutt, Improving the Efficiency of the Angel Finance Market: A Proposal to
Expand the Role of Finders in the Private Capital Raising Setting, 37 Ariz. St. L.J. 861 (2005).
26
9
placement agents who are registered as brokers use this regulation to
make a case for the virtue of intermediation—unlike issuers and
unregistered promoters, they are obliged to assure the suitability of the
private transaction for their customers, and conduct some due diligence
to see that the investment is a worthy one.
There is economic common-sense here, going back to adverse
selection. The challenge of entrepreneurial capital-raising is wellknown: start-ups have a dismally high rate of failure. Entrepreneurs are
often subject to overconfidence or diminished risk aversion,28 and in the
early stages, solid evidence from which on which outsiders can
reasonably estimate the likelihood of success is thin. Hence the risk is
hard to price. Expert “vouching” for the quality of the investment is
thus valuable, so that honest, diligent efforts by a broker can add great
value. This kind of reputational intermediation is common in financial
markets, and one reason why some people (including me) have
doubted that serious start-up financing can thrive without it or some
close economic substitute.29
So maybe all is well. This is an empirical question, but precisely
because private offerings are largely unregulated and have an illiquid
secondary market, we know relatively little about their value as
investments. The data necessary to measure average returns doesn’t
exist. However there are a number of areas involving non-public
investments that are more transparent and offer some clues. Indeed,
the pattern is remarkably similar. A “higher-end” of transactions
attracts more reputable brokers and agents, with access to a fairly
sophisticated clientele.
Not surprisingly, these deals pay-off
appropriately on a risk adjusted basis. To an extent, then, the
reputation market works. But as we go down the reputational hierarchy
among sales agents, both investor savvy and deal quality start to drop.
Toward the bottom, unfortunately, average returns are noticeably poor.
28
See Thomas Astebro et al., Seeking the Roots of Entrepreneurship: Insights from Behavioral
Economics, 28 J. Econ. Perspectives 49 (2014).
29
See also Jill Fisch, Can Internet Offerings Bridge the Small Business Capital Barrier?, 2 J.
Small & Emerging Bus. L. 57 (1998).
10
There we are seeing more crafty salesmanship than reputational
intermediation. Empirical studies demonstrate this pattern in the PIPE
market,30 with respect to reverse mergers,31 and perhaps most
suggestively, for placement agents in private equity deals.32 It’s hard to
believe that it is not the case in private offerings to accredited investors.
As Jennifer Johnson has shown in her writings on the subject, there is at
least a circumstantial case to fear considerable low-end abuse, especially
ones targeting senior citizens whose retirement nest egg deems them
able to fend for themselves.33
The industry is awfully prickly about any sort of regulatory
intrusion into their dark spaces, too. In the last few years, to its credit,
FINRA has sought to shed more light on private placement brokerage
activity, with new filing requirements and warnings about suitability.
But beaten back, by a sustained political effort, were attempts to require
the disclosure and filing of a much greater range of deal-related
information and to put limits on the commissions that brokers can
charge for their efforts.34 Regulators lack the ability to monitor private
placements on a real-time basis, which is probably the most valuable
step toward investor protection that could be taken in this space.35 The
political refrain used to lobby successfully was predictable: all these
regulatory steps are intolerably costly, and the costs are passed on in the
form of lower returns, a burden felt by both issuers and investors. The
public suffers, too, they said, via less innovation and job creation.
Note how interesting the politics get here. High-end brokers and
agents feel justified in complaining and point out these adverse
30
See Na Da et al., The Quality and Price of Investment Banks’ Service: Evidence from the PIPE
Market, 39 Fin. Mgt. 585 (2010).
31
See Ionnis Floris & Travis Sapp, Shell Games: On the Value of Shell Companies, 17 J. Corp.
Fin. 850, 855-56 (2011).
32
Matthew Cain et al., Intermediation in Private Equity: The Role of Placement Agents, working
paper, April 2015.
33
Jennifer Johnson, Fleecing Grandma: A Regulatory Ponzi Scheme, 16 Lewis & Clark L. Rev.
993 (2012); see also Jennifer Johnson, Private Placements: A Regulatory Black Hole, 35 Del. J.
Corp. L. 151 (2010).
34
See Jennifer Johnson, Private Placements: Will FINRA Sink the Sea Change?, 82 U. Cinn. L.
Rev. 465 (2013).
35
Thompson & Langevoort, supra, at 1624-27.
11
consequences, genuinely believing that the regulatory threat is an
overreach. They’ve arguably solved the lemons problem by reputationbuilding with a savvy-enough clientele. But if they succeed politically,
they gain protection for others on down the line as well. Because the
clienteles do not strongly overlap, there is no competitive advantage in
trying to disable to low-end brokers and agents who might exploit a very
different set of investors. And because the lower-end brokers will also
be on the political warpath to counter any challenge to those particular
rents, the alliance is fairly stable.
So now back to the JOBS Act as it relates to private and exempt
offerings. Brokers took a blow with the elimination of the ban on
general solicitations for accredited investor-only deals, in the sense that
direct, aggressively marketed, un-intermediated private placements by
issuers are now lawful. But they also gained the ability to be more
aggressive themselves in approaching potential clients. And there is an
interesting back-story. The language of the ban’s elimination (reflected
in new Rule 506(c)) has a curious difference from what was in the old
rule (now 506(b)), to which the ban still attaches. The latter required
the broker to have a reasonable belief that the investor was accredited.
Under new 506(c), however, there has to be a reasonable effort to verify
that status.
The difference may seem technical, but it produced a firestorm
when the SEC went to write the implementing rules. The issue is not
hard to see, and plays right into the brokers’ hands. The only sure way
to verify accredited investor status is to gain access to customer tax
returns and bank or brokerage statements. Can you imagine any
sensible investor willingly turning over such documentation to a beer
company doing an internet-based marketing blitz in search of growth
capital?
Brokers, on the other hands, routinely obtain such
information, and strong federal privacy rules protect customer
confidentiality. The stricter the verification requirements, the more this
plays to brokers’ advantage. The SEC was being pushed by investor
advocates to make this obligation very strict, while the capital-raising
12
community was asking for a generous formulation, lest the value of the
relaxation be lost.36 The SEC responded with a middle-ground
approach, satisfying no one. And while it is still too early to assess, new
Rule 506(c) has not thus far gotten significant traction, with many
blaming the uncertainty over verification. The brokers and placement
agents are still in the game. I can’t tie broker lobbying to this outcome
with any fingerprints, much less stronger forensic evidence. The
standard account blames (or credits) the consumer and investor
advocates, who clearly were front-stage. But if we take sophisticated
public choice seriously, it’s easy to imagine the muscle behind the
efforts to be from those who covet the rents from controlling the
solicitation process.
A similar inference might be drawn from another battle, over
Regulation A. Reg A allows for a simplified public offering process for
small capital-raising transaction. Before the JOBS Act the cap was $5
million, which was too low to make “mini-registration” attractive.37 The
Act gave the SEC the authority to raise that cap to $50 million, with
some additional regulatory protections, a reform that was quickly
nicknamed Reg A+.
Once again, a skirmish broke out as the Commission went to
work on rule-making. The start-up community wanted greater
liberalization than just cap-raising, pointing out the transparency
associated with close SEC monitoring of these kinds of deals. Most of
all they wanted preemption of state blue sky law registration, which
added a considerable burden, which they saw as duplicative of the
SEC’s efforts. Back in 1996, Congress had preempted such registration
for Rule 506 offerings under Reg D; here, the case seemed all the
stronger. And indeed, the SEC did provide for preemption when it
adopted the revisions in early 2015. State securities regulators in
36
Yin Wilczek,SEC’s Rule 506 Verification Approach Divides Attorneys, Market Participants, 44
Sec. Reg. & L. Rep. (BNA) 1945 (Oct. 22, 2012).
37
See Rutheford B. Campbell, Regulation A: Small Business’ Search for “A Moderate Capital,”
31 Del. J. Corp. L. 77 (2006).
13
Massachusetts and Montana promptly filed suit to attack the SEC’s
action.38
The private placement brokers and agents are unseen in this
story, and perhaps not part of it. But so-called Reg A+ was getting
attention as a truly promising way to raise capital especially in the $20 to
$50 million range, one that replaces high transparency for the darkness
that previously characterized deals for that kind of money. It would
change the nature (and economics) of the solicitation process, and
perhaps invite a new set of competitors, more familiar with SEC
supervised transactions, into the mix. If so, there was good reason for
the incumbents to feel threatened, and thus to try to undermine the
reform through lobbying or litigation. It seems odd that budgetstrapped state regulators would undertake an expensive lawsuit to
preserve their involvement in what is SEC-supervised, even if they had
genuine doubts about the reform. Their ability to enforce for fraud
and related misbehavior in these offerings remained untouched. Once
again, there is reason to ask who really wants A+ dead.
What’s my point? The common view of entrepreneurial politics
is a battle between capital-raisers and investor-protectors. Those on the
start-up side tend to portray the investor protection side (and their
champions at the SEC) as old-age thinkers, unable to grasp to benefits
to everyone, including investors,39 of a more vibrant entrepreneurial
setting. While I suspect there is some truth to this depiction, it’s
overstated. The campaign for more entreprenurial freedom needs to
recognize better who its friends are, and who might be feigning support
for more robust tools but actually working to make sure that their costly
hold over the process remains. Some wolves have large wardrobes of
sheep suits.
There is also a lesson here for academics. At one point, public
choice theory and its sibling, the efficient markets hypothesis, were
38
Montana, Massachusetts Sue SEC Over Reg A Preemption of State Law, 47 Sec. Reg. & L.
Rep. (BNA) 1066 (June, 1, 2015).
39
See Usha Rodrigues, Securities Law’s Dirty Little Secret, 81 Fordham L. Rev. 3389 (2013);
Kelli Alces, Legal Diversification, 113 Colum. L. Rev. 1977 (2013).
14
embraced by progressives as well as conservatives suspicious of bigbusiness rent-seeking and interference with relatively well-functioning
markets. Today, by contrast, progressives tend to view both with
suspicion, if not contempt, and largely associated with right-leaning
ideology. While some of the suspicion might be warranted empirically,
the taint is probably unfortunate. With respects to efficient markets,
Ron Gilson and Reinier Kraakman recently pointed out that the EMH
was effectively high-jacked by ideologues and big business, its teachings
stretched beyond what was ever descriptively plausible.40 So, too, with
public choice: the suspicion it casts over all regulation goes much too
far, and political science has moved on to more nuanced theories of
lawmaking. To be sure, capture theory and other public-choice
explanations come naturally when we think that there is too little
regulation. Sophisticated public choice wisely reminds us to also look
for instances where business’ distaste for too much competition
produces bad regulation masquerading as good. Beating back
deregulation might be cause to cheer, or not.
Crowdfunding
Many smart people have written that what became the headline
JOBS Act reform—crowdfunding—was probably mortally wounded in
the legislative wrangling even before enactment.41 Crowdfunding is an
exemption from registration for small capital-raisers (capped at $1
million), who surely can’t afford the cost of much regulation.
Originally, the main investor protections—controversial, to be sure—
were limits on how much any one investor could put into crowdfunded
securities, and transparency via internet-based funding portals that
40
Ronald Gilson & Reinier Kraakman, Market Efficiency after the Financial Crisis: It’s Still a
Matter of Information Costs, 100 Va. L. Rev. 313, 315 (2014).
41
E.g., Joan Heminway, How Congress Killed Investment Crowdfunding: A Tale of Political
Pressure, Hasty Decisions and Inexpert Judgments that Begs for a Happy Ending, 102 Ky. L.J.
865 (2014); Others are more optimistic. E.g., Schwartz, supra. See also Hurt, supra, who notes
that social-value entrepreneurs may be most likely to find a way forward.
15
would allow “the crowd” to vet deals in advance, posting warnings or
endorsements based on private information or evaluations. Some
Democratic members of Congress balked at this, and demanded the
layering on of additional disclosures and liability. To preserve the
widespread bipartisan support the Act had received and sustain its
momentum, the bill’s handlers agreed.
The SEC’s rulemaking [has not yet been completed], and it is
again much too early to see if the predictions that this is a non-starter
are so. Still, we might ask the same question: are the broker/agent
lobbyists’ fingerprints on this, too? Brokers in the small-cap space
might think of new-age portals with the same antipathy as their larger
underwriter brethren imagining on-line auctions of IPOs. (If so, they
again hedged their bets, via an odd statutory provision that seems to
invite brokers to engage in eligible transactions without using portals42).
Those are reasonable suspicions, but we have to be cautious
here. How important sub-million dollar transactions are to brokers is
unclear; maybe that was mainly “friends and family” territory. On the
other hand, if crowdfunding were to succeed without exhibiting severe
investor protection problems, there would soon be strong pressure to
raise the cap, so that the exemption would start siphoning off deals the
brokers do covet. So maybe they did play a role. If so, however, they
would have had numerous allies in the effort to quash. Establishment
players—including elite lawyers—were critics, and venture capital and
angel investor groups seemed nervous and hence ambivalent about this
radical experiment in democratization of start-up financing. Nor did
proponents handle themselves well, politically. There were loud
voices, especially among portal innovators, confidently proclaiming
their ability to be disrupters. And, going back to something said earlier,
this reform is where the libertarianism was particularly jarring, no doubt
sending a loud signal that this was a signature effort to start removing
the government from the start-up capital markets entirely. That alone
42
Section 4(a)(6)(C).
16
was enough to provoke reactance. If a killing it was, this was a little like
Murder on the Orient Express, with the knife passed from many hands.
That politicization is unfortunate, because crowdfunding has an
appeal. (Indeed, there was already a total exemption in Reg D for submillion dollar offerings, so that this issue, too, was mainly about
preempting residual state blue sky registration.) Others have written
about this at length, but what differentiates crowdfunding from
conventional private placements, aside from wagering limits, is the
transparency of the funding efforts. A small, well-regulated set of
portals would have reputational incentives to police for the worst of
abuses, and on-line transparency makes government surveillance much
easier. While I have my doubts about how wise crowds are,43 I have a
strong preference for light instead of dark. Push away the extraneous
politics and I think thoughtful advocates on both sides could find a
healthy compromise fairly easily. It wouldn’t be perfect in avoiding
abuses44, but that’s not the question. We’ve long conceded that
entrepreneurship deserves a well-placed thumb on the scales.45 And as
Joan Heminway points out, some kind of crowdfunding is inevitable, a
project in motion in other countries (and many individual U.S. states
on a localized basis) on which we probably can’t afford to be a national
laggard.46 Crowdfunding should have a better fate.
Jobs
43
See Thompson & Langevoort, supra, at 1606-07.
Nor would it solve the rational actor problems in linking investors to entrepreneurs without the
kinds of protections angels and venture capitalists employ at the time of investing and with respect
to later rounds of financing. See Darian Ibrahim, Equity Crowdfunding: A Market of Lemons?, 100
Minn. L. Rev. (forthcoming, 2016); see also Arjay Agrawal et al., Some Simple Economics of
Crowdfunding, in 14 INNOVATION POLICY AND THE ECONOMY, (Josh Lerner & Scott Stern, eds,
2014). Still, there are ways this might be crafted to overcome these problems. E.g., John
Wroldsen, The Social Network and the Crowdfund Act: Zuckerberg, Saverin, and Venture
Capitalists’ Dilution of the Crowd, 15 Vand. J. Ent. & Tech. L. 583 (2013). One promising idea,
utilized in Europe, is to privilege those crowdfunding efforts where there is an initial large
experienced investor with common interest with subsequent smaller investors and a commitment
to hold the securities.
45
See D. Gordon Smith & Darian Ibrahim, Law and Entrepreneurial Opportunities, 98 Cornell L.
Rev. 1533 (2013).
46
Heminway, supra.
44
17
“Make Reagan more simple, the PR executives recommended,
saying he should talk about jobs, not capital formation.”
47
No discussion of the politics of entrepreneurial capital-raising
can ignore the rhetoric of job creation. Predictably, the spin was
intense before and after the JOBS Act. One example was advocacy for
the on-ramp for emerging growth company IPOs, where estimates were
put forward—then endlessly repeated in Congressional hearings and the
press—that a sufficiently liberalized marketplace could create 10-20
million new private sector jobs. Academic analysis using more
conservative (i.e., non-ludicrous) assumptions brought that projection
down by at least 90%.48
There is still some connection, of course; academic research
clearly supports the idea that most new private-sector jobs come from
new enterprises, and IPOs are usually followed by more jobs at the
company.49 But the complications are not hard to spot. What is far
more interesting is net job creation or loss, because successful
innovators engage in creative destruction, eliminating jobs elsewhere
even as they add their own.50 Amazon has risen to be a big employer,
but probably an even bigger job destroyer on main streets, in shopping
malls, and elsewhere. (The drop off in retail start-ups over the last two
decades has been dramatic, for reasons having nothing to do with
finance.) Nor does anything guarantee that any jobs created will be
domestic ones, as globalization accelerates.
47
Phillips-Fein, supra, at 248, about refining Reagan’s 1980 campaign message.
Testimony of Jay R. Ritter, Cordell Professor of Finance, University of Florida, before the
Senate Committee on Banking, Housing, and Urban Affairs, March 6, 2012.
49
Moreover, IPOs are associated with a drop in innovation after the financing is done. Shai
Bernstein, Does Going Public Affect Innovation?, 70 J. Fin. 1365 (2015). To be sure, they might
incentivize innovation to the extent that the anticipated IPO exit is the big pay-day reward for prepublic success. But there are other exit paths, ones that are increasingly preferred. See Gao, supra.
50
Researchers also point out that given the high rate of entrepreneurial failure, jobs that are
created may not last long, and create substantial dislocation once lost.
48
18
The technology connection is crucial. We are in the midst of a
rapid acceleration in the ability of technology to substitute for human
brainpower. Technological innovation is supported by financial
innovation, particularly in the sequence from venture capital financing
to an exit transaction like an IPO or trade sale. Economists (and the
public, increasingly) debate the employment effects of rapid
technological innovation51—do advances in artificial intelligence threaten
most everyone’s career? Even if not, what is the effect on opportunity
and wealth inequity if only a segment of the population has the skill and
motivation to ride the wave forward?
I couldn’t possibly answer either of those questions (both of
which make me very uneasy), yet quite sure that entrepreneurial finance
and securities regulation will get caught up in the political maelstrom if
conditions turn in a more populist direction out of growing fear and
resentment. Imagine, as I’ve posed the question elsewhere, if a
substantial segment of the public comes to believe that our financial
system brought us the new companies that developed the robots that
put material success out of the reach of most? If I had to venture a
guess, I would say that future technological innovation will increasingly
be funded by institutional private equity—already the exclusive domain
of the well-to-do—thus further leveraging the risk of resentment if
conditions move in that direction.52
My point here shouldn’t be misunderstood. Innovation—
including the creative destruction kind—can be valuable, indeed
necessary, in a world of ever-increasing threats and opportunities.
Better that creative destruction occur here than the creativity elsewhere
and only the destruction here. What I am posing is just the question of
whether the jobs connection to entrepreneurial finance isn’t two-edged,
51
E.g., Joel Mokyr et al., The History of Technological Anxiety and the Future of Economic
Growth: Is this Time Different?, 29 J. Econ. Perspectives 31 (2015).
52
See Jerold Zimmerman, The Role of Accounting in the 21st Century Firm, 45 Acct’g & Bus.
Res. 1 (2015), pointing out that innovation raises confidentiality and agency costs issues not easily
solvable in the public company. Another explanation for the disappearing IPO is the willingness
of institutional investors (including private equity) to step into the shoes of the venture capitalists
in a series of private transactions.
19
promising something that if not delivered will ultimately be turned
against those who first claimed it. Our financial markets have long
taken advantage of the perceived coupling of innovation with the
sustained growth of the middle class over most of the last century and a
half. Take away that perception and the political ecology reconfigures
completely, just as it did during the last great disillusionment in the
early 1930s, out of which came the federal securities laws.
Conclusion
In a world populated by careful, mindful investors, we probably
need some securities regulation beyond a well-policed antifraud
prohibition, but not all that much. That is true for entrepreneurial
finance, too. Market-based solutions, reputational intermediaries in
particular, can carry a lot of the load in the promotion of start-ups so
long as investors are paying enough attention. When investors don’t,
however, they are at risk of exploitation, without either competition or
market efficiency necessarily coming to their aid. For aggressive
promoters in these markets, rents are there for the taking.
The big flash points in investor protection today are about
responding to the exploitation that occurs in the still-dark portions of
the financial marketplace. The securities laws given to us in the 1930s
largely assumed the widespread need to protect the naïve or the
overwhelmed from their own inadequacy. But starting almost the same
time was a libertarian, business-driven reaction that took decades to
take root, but thrives today. The legitimate role of the government in
protecting investors is deeply contested. And as political markets have
gotten so much more efficient, there is more and more information,
money and power on deregulatory side.
That seeming portends victory for that side, especially when the
seekers can invoke the romance of entrepreneurship and the lure of
20
job creation in an increasingly anxious society. But many business
interests are ambivalent about regulation, not always reliable
ideologues. The incumbency of the regulatory state is vastly powerful,
too, and the social Darwinism that once was vivid in the libertarian
world-view surfaces often enough to prompt nervousness on the part of
ordinary folk for whom freedom might not be enough for a secure
future. So we live in a divided world, both sides increasingly confident
in their righteousness and compromise harder to find. Political battles
about the registration of securities seem far removed from these
divisions, but the ideological spillovers are visible if you look closely
enough.
Meanwhile, those who simply want to make money can subtly
play both sides amidst all the noise, taking advantage of the wrangling
and the rhetoric to find an edge through more regulation, less
regulation, or some of both. Those committed to investor protection,
to entrepreneurial innovation, or to some happy medium should keep
a wary eye out for those from the industry who may appear as
momentary allies on some issue or other. Maybe even cooperate with
each other to stand up to piggishness. The rents are there, and
marketplace incumbents have no intention of easily giving them up.53
In the game of finance, WOD would warn us, they are never the
suckers.
53
In some contexts, perhaps, regulation might be structured to empower some interest group as a
way of countering incursions by some even more threatening group. See Adam Levitin, The
Politics of Financial Regulation and the Regulation of Financial Politics: A Review Essay, 127
Harv. L. Rev. 1992 (2014).
21