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The JOBS Act of 2012: Balancing Fundamental Securities Law
Principals With the Demands of the Crowd
By Thomas A. Martin1
Table of Contents
I. Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
II. The JOBS Act. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
A. Crowdfunding. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Issuers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Intermediaries. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
B. Emerging Growth Companies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
C. Small Issues Exception. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
D. Reporting Company Threshold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
III. Principles Behind Securities Laws: Do the benefits of the JOBS Act exceed its burdens? . 17
A. Why Regulate? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Investor Protection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Market Stability and Lowering Systemic Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Integrity of Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
B. How do we balance the benefits with burdens of regulation? . . . . . . . . . . . . . . . . . . . 24
IV. Equity-Based Crowdfunding as a Unique Funding Model . . . . . . . . . . . . . . . . . . . . . . . . . . 25
A. The Crowd. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Accredited versus non-accredited. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Wisdom of Crowds. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
B. Low Investment Amount. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
C. Social Good Projects. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
V. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
1
J.D. Candidate 2012, Willamette University College of Law; with thanks to Professor Meyer
Eisenberg.
Electronic copy available at: http://ssrn.com/abstract=2040953
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I. Introduction
In 2012, Congress responded to a slow economic recovery by passing the Jumpstart Our
Business Startups Act (“JOBS Act”), a law designed to boost new company formation and create
jobs.2 Despite its clever name, however, the JOBS Act does little to directly spur job growth,
instead focusing its attention to deregulating the nation’s securities laws. The JOBS Act paints
with a rather broad brush in creating broad exemptions that exclude businesses from numerous
registration provisions contained in the post-depression securities laws, the Securities Act of
1933 (“1933 Act” or “Truth in Securities Act”),3 and the Securities Exchange Act of 1934
(“1934 Act” or “Exchange Act”).4 While purportedly intended to ease the regulatory burdens
placed on small, newly formed businesses that seek capital to get off the ground, the law exempts
a broad range of businesses, new as well as old,5 small as well as big.6
Despite the potential hazards on which examining the law’s specific provisions would
ostensibly shed light, Congress shared strong bipartisan support of the bill. The House version of
the bill, H.R. 3606, initially “sailed through the House . . . with 222 Republicans and 168
Democrats voting for it.”7 The Senate voted 73–26 to approve the bill on March 22, 2012,
2
H.R. 3606, available at http://thomas.loc.gov/cgi-bin/query/z?c112:H.R.3606:.
48 Stat. 74, codified at 15 U.S.C. § 77a et seq.
4
48 Stat. 881, codified at 15 U.S.C. § 78a et seq.
5
Nothing in the JOBS Act restricts an established corporation from creating a subsidiary issuer
that will be classified as an “emerging growth company,” although this classification only lasts
for up to five years, after which a company would have to create a “new” subsidiary for the
exemption to continue.
6
See id. The new “emerging growth company” classification exempts businesses with annual
revenue under $ 1,000,000,000 (One billion dollars).
7
Kathleen Pender, Financial Regulations Gutted in New Bill, SAN FRANCISCO CHRONICLE,
March 11, 2012, available at http://www.sfgate.com/cgibin/article.cgi?f=/c/a/2012/03/10/BUPU1NIGVF.DTL. The vote: 390–23, with all “no” votes
from Democrats.
3
Electronic copy available at: http://ssrn.com/abstract=2040953
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making amendments to add disclosure requirements.8 President Obama, who vocally supported
the bill’s passage, signed the JOBS Act into law on April 5, 2012.9 In an intensely divided
Congress sitting at the end of its 112th Session, whether the unusually strong popularity for the
JOBS Act was due to a sincere belief that deregulation will help spur job growth or a fear that
voters would equate opposition to a bill with “JOBS” in its title to opposition with the notion of
government helping the public obtain employment, remains unknown.
What is clear is that the JOBS Act will significantly reduce paperwork for corporations.
The dispute is over whether or not deregulation is a good idea at this time. Supporters of the
JOBS Act argue that because banks and investment companies have tightened credit lending to
small businesses in recent years, especially to relatively unpredictable startup ventures, our
financial system is starving for liquidity. The JOBS Act helps bolster our country’s financial
infrastructure by “ . . . deliver[ing] appropriate forms of capital and liquidity to entrepreneurs at
each stage of their growth . . . acheiv[ing] this goal by addressing 1) early stage capital
requirements through crowd funding, 2) liquidity for growing companies by raising the
shareholder limit, and 3) growth capital through the [Initial Public Offering (“IPO”)] on ramp
and the Reg A/Reg D provisions.”10 While House Minority Leader Nancy Pelosi voted for the
8
Edward Wyatt, Senate Passes Start-Ups Bill, With Amendment, N. Y. TIMES, March 22, 2012,
available at http://www.nytimes.com/2012/03/23/business/senate-passes-start-ups-bill-withamendments.html.
9
See C-SPAN, President Obama Signs the JOBS Act Into Law, http://www.cspan.org/Events/President-Obama-Signs-the-JOBS-Act-Into-Law/10737429665/ (links to video
of President Obama signing JOBS Act, as well as Senate and House passage of the bill).
10
Support HR 3606, The JOBS Act, NATIONAL VENTURE CAPITAL ASSOCIATION (“NVCA”), link
to document available at
http://nvcaccess.nvca.org/index.php/component/contentbloglist/?task=listmonth&year=2012&m
onth=3&section_id=6&id=6. The NVCA was active in private mobilization in business industry
support for the JOBS Act, exemplified in its sponsorship of a letter to the Senate containing 15
pages of signatures by “America’s Start Up Leaders” voicing support for the JOBS Act’s Senate
precursor, S.B. 1933.
Electronic copy available at: http://ssrn.com/abstract=2040953
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bill, she admitted that it was a “meager” effort at job-creation.11 Nevertheless, she agreed that it
would provide “small startups access [to] capital they need to grow and create jobs.”12
Opponents argue that the JOBS Act goes too far in exemption amount. For example, it
exempts a one-billion dollar per year business from registration, and does so on the basis that the
company is “small”.13 Columbia Law School Professor John Coffee has called the bill’s crowdfunding provision the “boiler room legalization act,” implying that the act will encourage market
schemes that use the internet to prey on unsophisticated investors.14
The Commissioner of the Securities and Exchange Commission (“SEC”), Luis Aguilar,
issued a statement in strong opposition to the JOBS Act, with arguments centering around two
main points. First, he pointed out that the JOBS Act reduces transparency, not only hurting
investors but also making enforcement more difficult.15 Second, the bill rests on the faulty
premise that reducing the regulatory burden on raising capital will lead to better capital
formation. Aguilar claims “regulatory compliance costs are not a principal cause of the decline in
IPO activity over the past decade.”16
11
Id. ¶ 8.
Id.
13
Robb Mandelbaum, In Latest Jobs Bill, a Billion-Dollar Business Is Now Small, N. Y. TIMES,
(March 13, 2012), available at http://boss.blogs.nytimes.com/2012/03/13/in-latest-jobs-bill-abillion-dollar-business-is-now-small.
14
Pender, supra note 7, ¶ 6. See also id. (Former SEC Chairman Arthur Levitt called the bill “a
disgrace”).
15
Luis Aguilar, SEC Commissioner, Investor Protection is Needed for True Capital Formation ¶
2 (March 6, 2012) (“True capital formation and economic growth require investors to have both
confidence in the capital markets and access to the information needed to make good investment
decisions.”)
16
Id. (adding “. . . there is significant research to support the conclusion that disclosure
requirements and other capital markets regulations enhance, rather than impede, capital
formation”); see also Frank B. Cross and Robert A. Prentice, The Economic Value of Securities
Regulation, 28 CARDOZO L. REV. 333 (2006).
12
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In a debate over the “legalization”17 of equity-based crowd funding hosted by the WallStreet Journal, the proponent of deregulation points to the modern entrepreneur’s difficulty in
financing a project as “the majority of venture and angel funds are reserved for tech companies
with big growth potential.”18 Entrepreneurs who have less promising returns for investors are left
without funding. In this environment, Lavinsky claims “letting small firms sell equity online is
“angel investing on steroids.”19 The opponent, Dr. Torrens claims that the lack of angel
investment cuts the other way:
Many of these companies are not good candidates for equity capital––either from
angel investors or crowds. If angel investors have passed them by, there’s
probably a good reason. But those reasons may not be apparent to unsuspecting
crowds.20
Though crowdfunding is a very new financial model,21 the position taken both for and
against the JOBS Act is demonstrative of an older, more fundamental debate over the general
role of government in markets. The dispute lies between those who desire a laissez-faire
approach in which the government plays a minimalist regulatory role, deferring to Adam Smith’s
classical theory of the “invisible hand” to solve market problems, and by those who desire more
17
Despite the article inaccurately representing equity-based crowd funding as illegal, there has
never been a prohibition on such funding. Such means of financing are perfectly legal, though
they are admittedly somewhat cost-prohibitive due to the costs associated with pre-JOBS Act
registration.
18
Dave Lavinsky and John Torrens, Should Equity-Based Crowd Funding Be Legal?, WALL
STREET JOURNAL, ¶ 4, (March 18, 2012), available at
http://online.wsj.com/article/SB10001424052970203370604577265512766009938.html. Mr.
Lavinsky, who writes the proponent’s section, is president of Growthink, a business-planning
firm and investment bank. Dr. Torrens, writing for the opponent, is a professor of entrepreneurial
practice at Syracuse University’s Whitman School of Management.
19
Id.
20
Id. ¶ 29.
21
Crowdfunding, at least as we know it today, is approximately 5 years old. Kickstarter, one of
the most popular crowd funding websites, started in 2009.
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governmental involvement to correct certain market failures. As I will discuss below, these
warring ideologies cut to the core of the securities laws of the United States.
Since the 1930s, when Congress created the SEC to oversee the securities market,
proponents of these two fundamentally opposing ideologies have pushed and pulled the
securities laws between regulation and deregulation.22 In this context, the JOBS Act is the free
market theorist’s response to the burdens brought by the Sarbanes-Oxley and Dodd-Frank Acts.23
In Section II, I analyze the significant provisions of the JOBS Act. While these sweeping
provisions do promise a likely increase of liquidity and easing of the flow of capital into new
ventures, they also represent a move away from business transparency and away from investor
protections.
In Section III, I examine the principles behind the securities laws. The laws are clearly
costly and burdensome to the industry, and the system must justify its existence through its
benefits to society. The securities laws were born out of the destitute times surrounding the stock
market crash of 1929, and the establishment of the SEC represents the public’s direct response to
the fraudulent schemes that caused the crash.24 Purposes of the securities laws include protection
22
See e.g., The Banking Act of 1933 (“Glass–Steagall Act”), Pub. L. 73–66, 48 Stat. 162
(separated traditional banks from investment banks, but was repealed by the Gramm-LeachBliley Act of 1999). In 1987, President Reagan removed Paul Volcker from the Federal Reserve
Board and appointed Alan Greenspan as Chairman. See Nathan Gardels, Interview with Joseph
Stiglitz, The Fall of Wall Street is to Market Fundamentalism What the Fall of the Berlin Wall
Was to Communism, HUFFINGTON POST, available at http://www.huffingtonpost.com/nathangardels/stiglitz-the-fall-of-wall_b_126911.html (noting Greenspan’s free market economic
philosophy as central to President Reagan’s decision).
23
See Sarbanes–Oxley Act of 2002 (“Sarbanes–Oxley”), Pub. L. 107–204, 116 Stat. 745 (2002);
Dodd–Frank Wall Street Reform and Consumer Protection Act (“Dodd–Frank”), Pub. L. 111–
203, H.R. 4173 (2010).
24
See James M. Landis, SEC Chairman, 1935–1937, The Legislative History of the Securities
Act of 1933, 28 GEO. WASH. L. REV. 29, 30 (1959–1960) (The Senate Banking and Currency
Committee conducted an investigation into the causes of the Great Depression, and “indicted a
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of the investor, market stability, market integrity, and preventing and repairing damage caused
by free market failures. Despite, and perhaps because of, the currently lingering economic slump,
Congress enacted the JOBS Act, a remarkable shift away from the above-mentioned principles in
favor of a largely unregulated system.
In Section IV, I examine the unique financial model of crowdfunding. In a world where
everything has been done before, the method of a large number of people investing a relatively
small amount of money over the Internet is brand new. Its novel structure merits a close
inspection of the potential societal benefits that come from crowdfunding. Though the model’s
primary elements are in contrast with the traditional goals of the securities laws, particularly the
allowance for non-accredited investors to buy and sell securities more freely, Congress has
decided to weigh this risk against the potential societal gains from business growth, finding the
latter more persuasive. Growth in this fashion will almost undoubtedly be accompanied by a few
bad actors, and fraudulent practices. With a forecast of both growth and turmoil, the only
question may be whether this will result in going “one step forward, two steps back,” or if,
instead, the JOBS Act propels business two steps forward, one step back.
II. The JOBS Act
[The securities laws] should be limited to full and fair disclosure of the nature of the security
being offered and that there should be no authority to pass upon the investment quality of the
security. ––President Franklin D. Roosevelt25
The JOBS Act is a collection of several ideas focusing on different areas of the securities
laws, but they all have the overarching theme of deregulation and hence are logically bundled
system as a whole that had failed miserably in imposing those essential fiduciary standards that
should govern persons whose function it was to handle other people’s money”).
25
Id. at 34 (quoting President Roosevelt’s address before Congress to recommend enactment of
the Securities Act of 1933).
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into one act. While I discuss each of the main areas of the law in turn, namely crowdfunding,
emerging growth companies, and small issues, it is important not to view them as mutually
exclusive of each other. There is room for generous overlap among the provisions, and thus an
emerging growth company (Title I) can issue securities to a crowd via a funding portal (Title III)
while taking additional benefit from the amended § 3(b) small issues exemption (Title IV). The
combined result of the changes these provisions set in motion constitutes a license to unregulated
trading to an extent not allowed since before the crash of 1929.
A. Crowdfunding26
Evidently not satisfied with simple numerical ordering to denote the crowdfunding
provisions, Congress gave Title III of the JOBS Act an acronym, the “CROWDFUND Act”
(“Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012”).
Title III amends both the ’33 Act and the ’34 Act to prescribe means of crowdfunding, that is,
“the use of the internet to raise money through small contributions from a large number of
investors.”27
Issuers
Section 302 of the JOBS Act adds a crowdfunding transactional exemption as § 4(6) of
the 1933 Act.28 The aggregate amount sold to all investors under the § 4(6) exemption cannot
26
For a comprehensive overview of crowdfunding, see generally C. Steven Bradford,
Crowdfunding and the Federal Securities Laws, § II, 2012 COLUMBIA BUS. L. REV. 1 (2012).
27
Id. The JOBS Act does not define crowdfunding, but Professor Bradford’s definition is
accurate in a general sense to the extent that crowdfunding generally contains the two
components of (1) a large number of investors who invest in (2) relatively small amounts. The
internet is the presumed vehicle for trading due to its convenience and proclivity to connect
people, though Title III does not seem to limit crowdfunding to the internet (despite the acronym
presuming it is “Online”).
28
See also § 303 (exemption also applies to crowdfunding securities for purposes of registration
under § 12(g) of 1934 Act).
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exceed $1,000,000 over a 12-month period.29 This is a generous amount, given that most
crowdfunding projects have a much smaller target amount. For example, the popular
crowdfunding site Kickstarter had an average project size during the 2011 year of only $8,390.30
Though the original H.R. 3606 passed by the House did not require the issuer to register
with the SEC (unless the issuer was proceeding without an intermediary as allowed by the
previous version of the bill), the Senate amendments added a registration requirement for
crowdfunding issuers. The issuer must provide the following to the Commission, the
intermediary, and potential investors:
(A) [basic identifying information of issuer] (B) names of the directors and
officers . . . and each person holding more than 20 percent of the shares of the
issuer; (C) a description of the business of the issuer and the anticipated business
plan . . . (D) a description of the financial condition of the issuer . . . (E) a
description of the stated purpose and intended use of the proceeds of the offering
sought by the issuer with respect to the target offering amount; (F) the target
offering amount, the deadline . . . and regular updates regarding the progress of
the issuer in meeting the target offering amount; (G) the price to the public of the
securities . . . [and] each investor shall be provided in writing the final price and
all required disclosures, with a reasonable opportunity to rescind the commitment
to purchase the securities; (H) a description of the ownership and capital structure
of the issuer . . .31
29
Id. § 4(6)(A). The original version of H.R. 3606 allowed a $2,000,000 exempted offering if the
issuer provided an audited financial statement.
30
Kickstarter Blog, 2011: The Stats, http://www.kickstarter.com/blog/2011-the-stats. In 2011,
Kickstarter had $99,344,382 pledged to 11,836 successful projects. Id. The difference between
the $1,000,000 dollar amount Congress chose for the exemption and the average project size is a
large gap, although admittedly Kickstarter’s data will differ from an equity-based crowdfunding
site, because Kickstarter uses a “rewards” model where the issuer pays the customer in a good or
service, rather than in gains from a security interest. Crowdcube, the world’s first (and perhaps
only) equity-based crowdfunding site, has raised £ 2,832,000 since it opened in February 2011.
Crowdcube, Crowdcube Infographic, http://www.crowdcube.com/infographic. With 15 projects
or “pitches” funded, that equals an average amount of £ 188,800 per project. This is also well
below the $1,000,000 amount allowed under the section 4(6) exemption, although the largest
Crowdcube offering was £ 1,000,000 for a 10% stake in a London–based chain of bars and clubs.
See Crowdcube, The Rushmore Group, Ltd., http://www.crowdcube.com/investment/therushmore-group-ltd-10449. This larger offering amount could be a glimpse of what is to come.
31
§ 4A(b)(1).
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Regarding disclosure of the issuer’s financial condition under subsection (D), the law takes a
sliding scale approach by requiring issuers who seek a greater target offering amount to disclose
more information, while those issuers who seek less capital do not have to disclose as much. An
issuer that seeks $100,000 or less must only disclose its income tax returns for the most recently
completed year, if any, and financial statements certified by the principal executive officer.32 If
the target offering amount is between $100,000 and $500,000, the issuer must disclose financial
statements reviewed by an independent public accountant according to standards and procedures
established by the SEC.33 Only if the issuer seeks more than $500,000 does it have to disclose an
audited financial statement. Furthermore, the issuer must disclose additional financial
information to be determined by the Commission “not less than annually”.34
Intermediaries
The § 4(6) exempted transaction must be conducted through a registered broker or
“funding portal”.35 The intermediary must also register with any applicable self-regulatory
organizations, and it must conduct certain due diligence procedures “to reduce the risk of fraud”,
including background and securities enforcement regulatory history check on issuers and their
principal officers.36
While most of the requirements for crowdfunding intermediaries are in line with the
broker-dealer role elsewhere, Congress also charges crowdfunding intermediaries with the duty
of educating investors, to:
(4) ensure that each investor—
32
Id. at sub. (1)(D)(i).
Id. at sub. (1)(D)(ii).
34
Id. at § 4A(b)(4).
35
Id. § 4(6)(B).
36
§ 4A(a).
33
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(A) reviews investor-education information, in accordance with standards
established by the Commission, by rule;
(B) positively affirms that the investor understands that the investor is
risking the loss of the entire investment, and that the investor could bear such a
loss; and
(C) answers questions demonstrating—
(i) an understanding of the level of risk generally applicable to
investments in startups, emerging businesses, and small issuers;
(ii) an understanding of the risk of illiquidity; and
(iii) an understanding of such other matters as the Commission
determines appropriate, by rule . . .37
One can assume that the purpose of this rule is to screen out investors who are ill-fitted with
securities investment, and the intermediaries are arguably in the best position to conduct this
function. However, it is unclear how Congress intends the intermediary to conduct this screening
process. Will simple boilerplate provisions inserted into a website’s terms and conditions be
sufficient for the intermediary to claim it “ensured” that the investor was knowledgeable of the
risks involved? If so, does Congress really expect investors to read and understand the terms and
conditions? On the other hand, if Congress desires more oversight, is the intermediary required
to test the knowledge of an investor under some rubric, wherein one who fails the test cannot
invest? Hopefully the SEC will expand upon how an intermediary complies with this
requirement, or else the law will remain in its ambiguous state.
Regarding the issue of who can be an “intermediary” that is allowed to trade in
crowdfunding securities, Congress created a new category of intermediary called a “funding
portal”.38 A funding portal is defined as the following:
. . . any person acting as an intermediary in a transaction involving the offer or
sale of securities for the account of others, solely pursuant to section 4(6) of the
Securities Act of 1933 (15 U.S.C. 77d(6)), that does not—
(A) offer investment advice or recommendations;
37
Id.
The other class of crowdfunding intermediary is a traditional “broker” and is not discussed in
this paper.
38
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(B) solicit purchases, sales, or offers to buy the securities offered or
displayed on its website or portal;
(C) compensate employees, agents, or other persons for such solicitation
or based on the sale of securities displayed or referenced on its website or
portal;
(D) hold, manage, possess, or otherwise handle investor funds or
securities; or
(E) engage in such other activities as the Commission, by rule, determines
appropriate.39
The restrictions on the funding portals activities serve to protect the investor. The funding portal
is prohibited from offering investment advice in subsection (A), which corresponds to a similar
prohibition on broker-dealers, and (B) prohibits the funding portal from actively pushing more
profitable securities on investors, e.g., by utilizing aggressive solicitation tactics. Moreover, the
prohibition on compensating employees “commissions” for selling securities in subsection (C)
destroys an incentive for the portal’s employees to sell junk securities. The prohibition on
handling funds in subsection (D) lessens opportunities for fraud.
Funding portals have a limited exemption from registration under section 15(a)(1) of the
1934 Act.40 The funding portal must be a member of a national securities association registered
under section 15A.41 The SEC may place conditions on this exemption.42
Investors43
Perhaps with the goal of investor protection in mind, Congress placed a limit on the
amount that an investor can invest under the § 4(6) exemption. If either the investor’s net worth
or annual income is less than $100,000, then he may not invest an amount more than the greater
39
JOBS Act, § 304(a)(1).
Id. (amending Securities Exchange Act of 1934).
41
Id. The term “broker or dealer” in sections 15(b)(8) and 15A of the ’34 Act now includes a
“funding portal” under the § 304.
42
Id.
43
Though it is beyond the scope of my paper, it is worth noting that the issuer is liable for
material misstatements and omissions, and § 4A(c) of Title III gives the investor a private right
of action in such circumstances.
40
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of $2,000 or 5% of his annual income.44 If either the investor’s net worth or annual income is
equal to or more than $100,000, he may invest not more than $100,000 or 10% of his annual
income or net worth, whichever is less.45 There is some overlap in prescribing an allowable
investment for some investors, such as one whose net worth is above $100,000, and whose
annual income is below this mark. If my net worth is $105,000 and my annual income is
$60,000, am I limited to investing the maximum allowed $2,000 under subsection (i), or may I
invest $6,000, 10% of my annual income, under subsection (ii)? There is additional vagueness on
whether net worth includes homeownership, the inclusion of which would push many lowincome individuals over the $100,000 amount in net worth.
Placing the crowdfunding exemption in section 4, regarding exempt transactions, as
opposed to section 3, regarding exempt securities, implies that Congress means to restrict the
resale of securities sold under this exemption. Indeed, section 4A(e) restricts resale of securities
sold under the crowdfunding exemption, albeit narrowly, for a one year period, during which the
investor may sell the securities back to the issuer, an accredited investor, a family member, or as
part of a registered offering. The SEC may further limit resale of these securities, though the
statute’s limited restrictions on resale allow a secondary market to emerge for crowdfunding
securities over one year old.
B. Emerging Growth Companies
Title I of the JOBS Act creates a new term, an “emerging growth company” (“EGC”),
which is defined as “an issuer that had total annual gross revenues of less than $1,000,000,000 . .
44
45
1933 Act § 4(6)(B)(i).
Id. at (ii).
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. during its most recently completed fiscal year.”46 An EGC retains such status unless and until
the fifth anniversary of its IPO, it issues more than $1,000,000,000 in non-convertible debt over
a three year period, or it becomes a “large accelerated filer” under Rule12b–2.47 It is clear that
the $1,000,000,000 annual revenue ceiling will cover most start up companies.
With the knowledge that most young companies will be able to benefit from status as an
emerging growth company, what specific benefits does such status actually confer? First, EGC’s
are exempt from certain executive pay disclosure requirements under the 1934 Act48 and the
Investor Protection and Securities Reform Act of 2010.49 Congress enacted the executive pay
disclosure rules after wide public criticism of undisclosed “golden parachutes” for executives.50
Reporting these executive payment plans may appear to be another burdensome disclosure
requirement to the reporting corporation, but the new provision reduces corporate transparency
in an area of great public interest.
Second, EGC’s are exempt from a host of accounting requirements, including the
following: an EGC must present (not more than) 2 years of audits in its IPO registration
statement;51 exemption from reporting “selected financial data” under Rule 301 (17 C.F.R. §
46
1933 Act § 2(a)(19). See also 1934 Act § 3(a) (defining an emerging growth company for
purposes of the 1934 Act).
47
Id.
48
JOBS Act, § 102 (amending ’34 Act § 14A(e)).
49
Id. (amending Investor Protection and Securities Reform Act of 2010 § 953(b)(1) (Pub. L.
111–203; 124 Stat. 1904)).
50
See Noam Noked, Examining the Largest Golden Parachutes, THE HARVARD LAW SCHOOL
FORUM ON CORPORATE GOVERNANCE AND FINANCIAL REGULATION (February 26, 2012),
http://blogs.law.harvard.edu/corpgov/2012/02/26/examining-the-largest-golden-parachutes
(discussing “golden parachutes” that allowed some executives to reap large financial gains, many
in the form of bonuses, while employed at failing financial institutions).
51
1933 Act § 7(a), (15 U.S.C. § 77g(a)).
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229.301);52 a wholesale exemption from section 404(b) of the Sarbanes–Oxley related to internal
controls auditing;53 and an exemption from a mandatory audit firm rotation.54
Third, classification as an EGC means that the EGC enjoys relaxed rules regarding
communication to investors. An EGC will now be able to communicate openly with potential
investors, so long as they are qualified institutional buyers or accredited institutional investors.55
The JOBS Act instructs the SEC to modify its rules to state that the prohibition against general
solicitation and general advertising does not apply to Rule 506 offerings to accredited
investors.56 The SEC is also instructed to modify Rule 144A to allow an issuer to offer securities
to persons other than qualified institutional buyers, including by general solicitation, so long as
sales are made only to persons the issuer reasonably believes is a qualified institutional buyer.57
Additionally, section 105 allows the broker-dealer to publish and distribute a “research
report” that will not be considered an offer for sale or offer to sell a security.58 A research report
is “a written, electronic, or oral communication that includes information, opinions, or
recommendations with respect to securities of an issuer or an analysis of a security or an issuer,
52
1934 Act § 13(a).
15 U.S.C. 7262(b). Aguilar calls section 404(b) an “important mechanism for enhancing the
reliability of financial statements.” Supra, note 15, ¶ 15. Yet it “currently applies only to
companies with a market capitalization above $75 million,” and so the JOBS Act does away with
an auditing requirement that only affects large companies who would be able to bear the costs of
auditing with ease.
54
Id. § 103(a)(3). The SEC may adopt additional rules if it determines such requirements are
“necessary or appropriate in the public interest, after considering the protection of investors and
whether the action will promote efficiency, competition, and capital formation.” JOBS Act, §
104.
55
JOBS Act, § 105(c) (amending ’33 Act § 5 (15 U.S.C. § 77e)).
56
Id. § 201(a)(1).
57
Id. § 201(a)(2).
58
Id. § 105(a) (amending 1933 Act § 2(a)(3), (15 U.S.C. 77b(a)(3))).
53
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whether or not it provides information reasonably sufficient upon which to base an investment
decision.”59
C. Small Issues Exemption
Title IV of the JOBS Act outlines an expanded exemption under section 3(b) of the 1933
Act.60 Under Regulations A61 & D,62 the previous safe harbors for section 3(b) offerings, the
exemption was limited to an offering amount of $5,000,000 per 12-month period.63 Title IV
expands this amount ten-fold, to $50,000,000.64 The securities sold under this exemption may be
offered and sold publicly, and they are unrestricted, essentially meaning that they may be resold
to anyone at anytime.65 The only restraints include a requirement that the issuer file audited
financial statements annually, and comply with other terms to be decided by the SEC, including,
e.g., providing an offering statement to prospective investors.66
D. Reporting Company Threshold
Title V of the JOB Act raises the threshold at which a company must report to the SEC
for purposes of the 1934 Act.67 The amount that triggers a duty to report under the 1934 Act is
raised from $1,000,000 to $10,000,000.68 The size of the class of equity security held of record is
59
Id.
JOBS Act, § 401 (amending 1933 Act § 3(b) (15 U.S.C. 77c(b))).
61
Regulation A offerings still require the issuer to file a disclosure document with the SEC, and
is therefore a type of “mini-registration”. Bradford, supra note 26, at 48.
62
Rule 505 restricts sales to 35 non-accredited investors and also prohibits general advertising,
and is therefore “unsuitable for crowdfunding”, where the issuer needs to solicit and sell to a
large number of non-accredited investors. See Bradford, supra note 26, at 47.
63
Rule 251(b); Rule 505(b).
64
1933 Act, § 3(b)(2)(A).
65
§ 3(b)(2)(B)–(C).
66
JOBS Act, § 3(b)(2)(F)–(G).
67
Id. § 501 (amending 1934 Act § 12(g)(1) (15 U.S.C. § 78l(g)(1))); see also Rule 12g–1.
68
JOBS Act, § 12(g)(1)(A). Another benefit to being a non-reporting company is an availability
to offer securities through the Regulation A small issues exemption, although Regulation A may
fall into disuse with the new JOBS Act small issue exemption.
60
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raised from 750 to 2,000 or 500 persons, depending on whether they are accredited or nonaccredited, respectively.
III. Principles Behind Securities Laws: Do the benefits of the JOBS Act exceed its burdens?
If there is any one thing that has grown out of the times of adversity in which we have been
recently living, it is the desire to make common cause against the problems that confront us.
There is now a singleness of purpose in our united efforts such as we could not have hoped for in
the days of easy prosperity. And beyond the accomplishment of our immediate purposes there is,
I sincerely believe, a hope and determination that we learn how to build more soundly in the
future; that we shall profit by our experience. Of major importance in this concerted drive is the
Securities Act [of 1933]. ––Hon. Garland S. Ferguson, Jr,69
With the near unanimous Congressional support of the JOBS Act, a law that alters the
very foundation on which our securities laws were built, it is necessary to revisit the principals
that support such a system. If the securities laws are burdensome and produce no social benefit,
then why regulate at all? Indeed, that seems to be the approach of some of the more libertarian
thinkers sitting in Congress—society should just get rid of the bureaucracy and let the market
work things out. But, on the other hand, if the laws do produce some social benefit, then we
should weigh this against whatever burden is placed on reporting parties. Because the majority of
people agree that there is indeed some benefit to the securities laws, including those who drafted
the Securities Act of 1933, and the Securities Exchange Act of 1934, we should begin by
examining the answers to the question, “why regulate?” Second, we should analyze how to
balance the burdens imposed on securities markets with the benefits distributed to and through
this same system.
69
The Securities Act of 1933: Its Powers and Administration, 1 FED. B. ASS’N J. 23, 23 (1931–
1933).
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A. Why Regulate?70
Investor Protection
Possibly the strongest argument for regulating securities is to protect investors from
fraud. When one purchases a security, the investor often pays immediately, often in the form of
cash, for an interest in something, the underlying security. Because securities are by their nature
intangible, they are susceptible to deceit. For example, in a completely unregulated market, the
issuer may issue a piece of paper to the investor stating a 10% interest in Company XYZ in
exchange for $1,000. Once the investor pays, the issuer disappears, leaving the investor with a
10% interest in a possibly fictitious company.
What of the “buyer beware” argument? Many would claim the investor should know
what he or she is investing in, and shouldn’t make risky bets investing in Company XYZ. The
buyer beware argument is flawed for several reasons. One very significant point is that most
investments are handled through an agent. The average layperson who wishes to invest relies on
someone with more experience to handle that investment. They do not know precisely what they
are investing in, but rely on their agent to make a wise decision. Moreover, pension funds and
401(k)s are pools of employee assets managed by a representative. Even when the agent has a
duty to make wise investment decisions, it is unrealistic to expect investors to be able to recoup
all of their losses from a negligent agent.
Second, the “buyer beware” argument assumes that investors have access to information
that will shed light on the true value of the company in which they are investing. A phenomenon
known as information asymmetry results in the buyer being unaware of critical information to
70
See JOHN C. COFFEE, JR. SECURITIES REGULATIONS, 1–10 (11th ed. Foundation 2009)
(discussing justifications for regulating securities markets). Coffee provides additional
justifications to regulate securities markets, such as informational need of investors, inadequate
incentives to disclose, corporate governance and agency costs, and allocative efficiency.
Page 19 of 34
the transaction.71 Clearly, investors need to know how much an asset is worth in deciding
whether to buy it, and when buying a traditional good the buyer can engage in self-help. Coffee
visualizes this as “kick[ing] the tires” at a dealership or “squeez[ing] the tomatoes” at the grocery
store.72 In a securities market, it is harder to engage in self-help due to the inherently intangible
nature of the good sold.
As a result of the buyer’s inability to pursue self-help, there is a stronger imbalance
between the knowledge of the buyer and seller. There ensues a greater reliance on information
given by the seller, often the only source of information about the security. Yet in any
transaction, the seller has a strong incentive to hide or otherwise fail to inform the investor of any
negative information having a propensity to devalue the asset. In the case of a mortgage backed
security, for example, the seller has every incentive to hide information about the quality of the
underlying mortgages, statistics regarding the rate of default, or anything that might cause the
buyer to question the price of the asset. Not only is negative information held back, but any
positive information about the asset is trumped up.73 Buyer beware fails to work in securities
trading, because the buyer doesn’t know the true value of the security.74
71
See George A. Akerlof, The Market for Lemons: Quality Uncertainty and the Market
Mechanism, THE QUARTERLY JOURNAL OF ECONOMICS (1970). Akerlof, Michael Spence, and
Joseph Stiglitz jointly received The Sveriges Riksbank Prize in Economic Sciences in Memory
of Alfred Nobel 2001 for their work on the analysis of markets with asymmetric information.
Nobelprize.org, Prize in Economic Sciences 2001,
http://www.nobelprize.org/nobel_prizes/economics/laureates/2001/.
72
Coffee, supra note 70, at 4.
73
This includes the seller bolstering its reputation via a credit rating. Standard & Poor’s,
Moody’s, and Fitch have come under a lot of criticism for their role in overvaluing institutions
and their securities. See Richard Tomlinson, David Evans, CDO Boom Masks Subprime Losses,
Abetted by S&P, Moody’s, Fitch, BLOOMBERG (May 31, 2007), available at
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ajs7BqG4_X8I; see also
Financial Crisis Inquiry Commission Report, available at
http://www.gpo.gov/fdsys/search/pagedetails.action?packageId=GPO-FCIC (“We conclude the
Page 20 of 34
We have just seen how a lack of information can distort an asset’s true value. A securities
market with a rigorous disclosure system helps information flow from companies to investors,
and thereby ensures the accuracy of securities prices.75 An “accurate” stock conforms to the
fundamental value of the companies traded, and requiring disclosure lessens information
asymmetry that would otherwise distort value.
Market Stability and Lowering Systemic Risk
A second argument in favor of regulating the securities markets is to foster market
stability and lower systemic risk. The SEC is the “financial overseer” of any financial institution
that registers as a broker-dealer.76 “[T]he SEC is charged with ensuring their capital adequacy[,]
monitoring their safety[,] soundness and risk management practices.”77 The insolvency of any of
these institutions can jeopardize others, and can ultimately have “externalities that potentially
can destabilize the economy as a whole.”78 In simple terms, the failure of a “bad” institution that
takes up too much risk can lead to the failure of “good” institutions.79 As is evident from the
recent crisis, even people who are entirely outside the realm of the financial sector may see
failures of credit rating agencies were essential cogs in the wheel of financial destruction. The
three credit rating agencies were key enablers of the financial meltdown”).
74
Coffee, supra note 70, at 5 (discussing the inadequate incentives to disclose).
75
Id. at 6.
76
Id. at 7; see 1934 Act, § 3(a)(5)(A), codified at 15 U.S.C. § 78c(a)(5)(A) (defining “dealer” as
“any person engaged in the business of buying and selling securities for such person's own
account through a broker or otherwise”); id. at § 3(a)(4)(A) (defining “broker” as “any person
engaged in the business of effecting transactions in securities for the account of others”); Robert
L.D. Colby, What is a Broker-Dealer?, Davis Polk & Wardwell, LLP, available at
http://www.davispolk.com/files/Publication/ccc2422e-8266-4acf-9e4c3236a64aaf8f/Presentation/PublicationAttachment/172ca422-8d7d-4b84-9880354bd4f98e1a/lschwartz.rcolby.broker-dealerreg.pli.sep10.pdf.
77
Coffee, supra, note 70, at 7.
78
Id. (citing the recent financial crisis as such an episode).
79
NOURIEL ROUBINI AND STEVEN MIHM, CRISIS ECONOMICS: A CRASH COURSE IN THE FUTURE
OF FINANCE (Penguin Press HC, 1st ed. 2010). (examining the systemic failure of the financial
sector, including how the actions of a few bad actors threatened the entire market).
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ramifications of Wall Street’s malfeasance in the form of home foreclosures and job layoffs, as
the confidence in the market turns south and sends shockwaves through the economy.80
Integrity of Markets
A third reason for regulation, ensuring the integrity of our markets, is related to the
market stability argument. At a 1972 address to the American Bar Association’s Section of
Corporation, Banking and Business Law, then SEC Chairman William J. Casey gave the
following statement:
If I had to sum it up in a phrase the task in which the Commission and the Bar
have a common interest and a common task, I would say it is to assure the
integrity of our securities markets. The vitality of a priceless national asset, the
best capital market in the world, depends not only on our doing that task well but
also on the public perception that the fairness and the integrity of our securities
markets have indeed been maintained.81
Notwithstanding the recent recession, the United States retains its position as the world’s reserve
currency.82 Additionally, foreign investment in the United States has remained strong.83 This
lasting soundness of the financial system in the United States is due in no insignificant part to the
integrity of U.S. markets. If I buy ten shares of Apple stock today, I am confident that what I pay
80
“We conclude there was a systemic breakdown in accountability and ethics.
The integrity of our financial markets and the public’s trust in those markets are
essential to the economic well-being of our nation. The soundness and the
sustained prosperity of the financial system and our economy rely on the notions
of fair dealing, responsibility, and transparency.”
Financial Crisis Inquiry Commission, supra, note 73, at xxii. (examining the causes of the recent
financial crisis).
81
SEC’s Strategy for Increasing Investor Confidence, 28 BUS. LAW. 537, address given at the
Section’s annual meeting in San Francisco on August 15, 1972.
82
See, e.g., Antwerp Facets, Dollar in Decline, But Retains Global Trading Power,
http://www.antwerpfacetsonline.be/nc/articles/single/article/dollar-in-decline-but-retains-globaltrading-power (a Belgium diamond dealer discussing dollar’s enduring popularity, “because it is
known and trusted by businesses across the world”).
83
See generally Foreign Investment in U.S. Rises 49%, CHICAGO TRIBUNE/CNN,
http://articles.chicagotribune.com/2011-06-20/business/chi-foreign-investment-in-us-rises-4920110620_1_foreign-investment-foreign-firms-direct-investment (discussing foreign investment
in the United States, $194 billion in 2010).
Page 22 of 34
for those shares is a fairly accurate representation of my stake hold in the company. Aside from
the minor under- and over- stock valuations from which some speculating traders make their
living, the NYSE and the NASDAQ are accurate markets. This reliability rests on the fair
valuation of U.S. companies and their assets.
How does a company build and maintain its reputation of having an accurately valued
stock? In contrast to some foreign countries, American companies are held to strict accounting
standards––commonly referred to as Generally Accepted Accounting Principles (“GAAP”)––that
require adherence to honest methods of asset valuation and thereby ensure an accurate stock
price. Because adhering to higher accounting standards increases administrative costs to private
firms, as they must hire knowledgeable accountants to comply with GAAP, the government
assumes firms will not voluntarily engage in these higher accounting standards. Therefore, the
federal government forces firms to comply with statutes and regulations prescribing GAAP
standards. Congress and administrative bodies, with notable assistance from the Financial
Accounting Standards Board (“FASB”),84 may set the bar at an appropriate level, recognizing the
importance of transparent and accurate accounting methods without placing the standard so high
as to unduly constrain business through a cost-prohibitive process.
Generally, business interests advocate for lowering the bar to reduce accounting costs. It
is logical that businesses want to save money where they can, but in calculating costs associated
with regulatory compliance, they may fail to take into account benefits of compliance that are
less obvious to their bottom line. While it may be difficult to place a precise dollar amount in
valuing macroeconomic integrity, it is clearly an asset. This intangible value associated with
84
To read more about the FASB’s authority and independent structure, visit its website at
http://www.fasb.org/jsp/FASB/Page/SectionPage&cid=1176154526495.
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integrity may account for William J. Casey’s observation that integrity in the securities markets
is a common interest of business and government.85
To illustrate the importance of accounting standards to the integrity of the markets, the
scandals at WorldCom and Enron provide solid evidence that the lack of compliance with such a
standard is damning to the entire industry.86 Even before the true impact of the Enron scandal
was realized, Arthur Levitt said the following in a March, 2002 interview with PBS:
If investors lose confidence in the reliability of numbers that are presented to
them, our markets will suffer grievously. It will be more difficult to raise money.
It will be more difficult to maintain public interest in our markets. The source of
capital will dry up. It will have very severe economic and political consequences.
Our markets have already suffered a very serious blow. And whether they recover
from that, whether they can restore the kind of public confidence that is essential
to America's markets, depends on how our policymakers deal with these issues.
The Enron story was a story not just of the failure of the accounting firm, but also
the traditional gatekeepers: the board, the audit committee, the lawyers, the
investment bankers, the rating agencies. All of them had a part in this. ...
I don't personally believe that Andersen is any worse than any of the other firms. I
can't speak to fraud, because we don't know the dimensions of that at this point.
But in terms of how they deal with their clients, I think the kinds of problems
Andersen has had, have developed and will develop in other firms in probably
precisely the same way.87
Regarding the WorldCom scandal, Judge Cote examined the due diligence standard, finding that
the underwriters failed to respond to red flags in financial statements of WorldCom’s auditor,
Arthur Anderson, that “would suggest to an investor of ordinary intelligence the probability that
85
See supra, note 81.
See In re Worldcom, Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004); United
States v. Causey, Indictment CR–No. H–04–25, (S.D. Texas 2004), available at
http://news.findlaw.com/legalnews/lit/enron/index.html (charging the Arthur Anderson employee
with nineteen counts of Securities Fraud, including the construction and use of manipulative
financial devices in reporting Enron’s financial statements). Richard Causey pled guilty and
cooperated with the government in its prosecution of Enron executives Kenneth Lay and Jeffrey
Skilling. Id. FindLaw provides links to numerous internal documents of Enron and its
accountant, Arthur Anderson, as well as criminal, civil, and bankruptcy filings related to the
Enron scandal. Id.
87
Hedrick Smith, Interview with Arthur Levitt, PBS FRONTLINE, available at
http://www.pbs.org/wgbh/pages/frontline/shows/regulation/interviews/levitt.html.
86
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she has been defrauded.”88 The integrity of our markets is so important that neither the
government nor businesses can allow accounting methods to reign free and unchecked.
Congress responded to Enron and WorldCom by passing Sarbanes–Oxley,89 which
reformed accounting standards and called for greater corporate transparency. This transparency
may increase administrative costs to business, but it also ensures the integrity of our securities
markets.
B. How do we balance the benefits with burdens of regulation?
Over time, the securities laws have moved back and forth from regulation to
deregulation, ebbing and flowing like the sea. There is obvious tension between individual
businesses and greater society, and the JOBS Act may be evidence that business interests are
currently winning the tug-of-war with regulators. But the debate is not so polarized. As William
Casey’s statement suggests, there are times when interests align and the right level of regulation
can be beneficial to all. The search to find the right level of securities regulation is not unlike the
broader search for the best form of government. Is Thoreau’s motto correct, that “that
government is best which governs least,”90 or does a strong governmental involvement in society
protect special interests from being overpowered by more dominant forces? In a democratic
society, the bar that denotes the level of regulation does (as perhaps it should) fluctuate between
the two extremes of anarchy and totalitarianism, hopefully without reaching the shores of either.
In Section IV, I examine the unique aspects of crowdfunding, and analyze whether these
aspects make crowdfunding more or less appropriate to looser regulations.
88
In re WorldCom, supra, note 86, at 673, quoting LC Capital Partners, L.P. v. Frontier Ins.
Group, 318 F. 3d 148, 154 (2d Cir. 2003).
89
Supra, note 23.
90
Henry David Thoreau, CIVIL DISOBEDIENCE (1848).
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IV. Equity-Based Crowdfunding as a Unique Funding Model
Economic progress, in capitalist society, means turmoil. ––Joseph A. Schumpeter91
What is different about crowdfunding from regular securities trading? The crowdfunding
model has several somewhat unique aspects to its structure, including the following: (1) the
“crowd”, a large investment class with no necessary distinction between accredited and nonaccredited investors; (2) relatively low investment amounts that are pooled together; (3) as a
result of “crowd” preferences, a natural bias towards popular projects, a large portion of which
are focused towards social good. I will examine each in turn. After examining the uniqueness of
crowdfunding, I will conclude by questioning whether the model deserves special treatment, as
the JOBS Act has bestowed on it a generous exemption to registration under the securities laws.
A. The Crowd
Accredited versus non-accredited
First, we should address the elephant in the room, which is the fact that many
crowdfunding investors are not accredited. To those in the securities law industry, especially
regulators, it is understandable that the mention of a large group of non-accredited investors
giving money to start-up companies produces a gut-wrenching reaction. Fraud appears imminent.
Strange as it may sound to securities professionals, but the non-accredited investor’s general
response to a prohibition on buying securities is outrage.92 The laws are such that only the
wealthy can invest. Not only does this shield the relatively “poor” middle class American from
fraud, but it also prohibits him from making a profit from investing in a profitable company. To
91
CAPITALISM, SOCIALISM AND DEMOCRACY, 42 (Harper & Row, 1942).
See generally Scott Shane, Scrap the Accredited Investor Rule, THE AMERICAN MAGAZINE
(July 20, 2011), available at http://www.american.com/archive/2011/july/scrap-the-accreditedinvestor-rule.
92
Page 26 of 34
many middle-class people, the securities laws might be seen as patronizing, trying to protect the
assumedly uneducated investor from himself.
The crowdfunding model turns this idea on its head. By allowing the average person to
invest in equity capital, you are empowering them with the choice of whether or not equity
investment is right for them. Some investors will reap huge profits and some will lose all that
they invest, but this is no different from the investments of accredited investors. Crowdfunding
simply gives people the option to decide for themselves whether to take on this risk.
Unfortunately, the law calculates accreditation based on net worth rather than knowledge
of the financial system. The result is that some accredited investors lack the experience and
knowledge needed to make wise investment decisions, while others may have some knowledge
of the financial system yet lack accreditation. For example, even if an accredited doctor cannot
tell the difference between a stock and a bond, the market doors remain wide open because of his
net worth. If the accreditation argument is to have more merit, we should base it on financial
competency rather than net worth.
The JOBS Act expands the allowance for non-accredited investments, but it does not
grant an outright exemption to all non-accredited investments. The crowdfunding provisions
allow a transactional exemption for up to 2,000 investors, up to 500 of whom may be
nonaccredited.93
The expansion of non-accredited investing does not mean we should abandon educating
people on making wise financial decisions. Rather, it may lend itself towards an argument for
more widespread education and dissemination of financial information. Although crowdfunding
93
See also Kickstarter, supra, note 30.
Page 27 of 34
rules under the JOBS Act prevents a funding portal from giving financial advice,94 as
crowdfunding increases in popularity, so too should the flow of basic financial information95
increasingly reach a larger section of the public. Furthermore, investing is not for everyone, and
those who lack financial knowledge as well as the desire to learn, should simply not invest.
Wisdom of crowds
In a recent article condemning the JOBS Act, Barbara Roper, the Director of Investor
Protection at the Consumer Federation of America, themed her arguments around Charles
Mackay’s idea that crowds make awful decisions, and therefore should not be trusted to make
wise financial decisions.96 This is not an uncommonly held view, that public opinion is driven
like herds of buffalo by the media and other forces, often over cliffs. However, some writers
suggest that collective intelligence may make wiser choices than an individual. James
Surowiecki,97 argues just that. He claims collective intelligence can make up for an individual’s
94
This protects investors from an unethical situation where a funding portal is recommending a
particular investment and the funding portal stands to benefit from that investment.
95
By “financial information” I refer not just to specific financial documents of issuers, but
general education materials that increase public knowledge of basic financing methods. See e.g.
Yahoo! Finance, Education Center, http://finance.yahoo.com/education/begin_investing; Inc.,
http://www.inc.com/ (providing free information that educates the public, often in layman’s
terms, on how to invest, how to start a business, how markets work, etc.). Regarding financial
information of the issuer, even if the issuer is exempt from providing certain information to the
purchasers, the purchasers may demand certain information, and so this voluntary disclosure and
maintenance of fundamental transparency may be in the issuer’s best interest.
96
Barbara Roper, Extraordinary Popular Delusions and the Madness of Crowd (Funding), CQ
TODAY (March 6, 2012), discussing CHARLES MACKAY, EXTRAORDINARY POPULAR DELUSIONS
AND THE MADNESS OF CROWDS (1841) (“Men, it has been well said, think in herds; it will be
seen that they go mad in herds, while they only recover their senses slowly and one by one”).
97
THE WISDOM OF CROWDS: WHY THE MANY ARE SMARTER THAN THE FEW AND HOW
COLLECTIVE WISDOM SHAPES BUSINESS, ECONOMIES, SOCIETIES AND NATIONS (Doubleday,
2004). Surowiecki is a journalist at The New Yorker, and has also written articles for The Motley
Fool, Foreign Affairs, The New York Times, The Wall Street Journal, Slate, and Wired.
Page 28 of 34
lack of sophisticated cost-benefit calculations, as we can pool our knowledge, and in the
aggregate make wiser, well-informed choices.98
This theory has substantial potential for application to the crowdfunding model. Under
the “Wisdom of the Crowd” theory, Crowdfunding may actually lead to wiser decisions than a
few venture capitalists. Although it may seem like comparing apples and oranges, as successful
venture capitalists will doubtlessly have a business background and a strong financial acumen,
but the crowd has something a single venture capitalist does not—purchasing power. The crowd
not only represents potential investors, but it also represents consumers. This means that a
successfully funded crowdfunding campaign launches its business with the knowledge that it has
fairly broad public support.
For example, if I wanted to start up a brewery in Portland and chose the angel investment
route, I would have one or two highly skilled individuals who would hopefully put time as well
as money into my business. Assuming I successfully obtain this angel investment, I would be in
capable hands, although possibly with a large portion of my equity gone. And although a good
angel could connect me to marketing and advertising people, this would be an extra step and an
extra expense to the business.
In contrast, if I wanted to start up a brewery in Portland and chose an equity-based
crowdfunding route, I have several advantages over the angel route. First, I probably have kept
more of my equity, as the issuer presumably has more leverage in the crowdfunding site, as he
sets his own terms for investment.99
98
Id. at xiv.
Because crowdfunding is so new, this presumption may equate to speculation. Once a
successful U.S. equity-based crowdfunding site is launched, we will probably see a websitefunding portal that allows the issuer to state the terms of the security issue, and investors may or
may not have room to negotiate terms of the issue. Presumably, this will be more favorable than
99
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Second, if I have, e.g., five hundred investors, I can assume that I have approximately
five hundred customers. Of course, it is possible that teetotalers have invested in my business
because they know the Portland market and have a hunch that my beer will sell well. But
crowdfunding sites such as Kickstarter have shown that the crowd usually invests in something
they want for themselves.100 Therefore, I may assume that at least most of my investors are beer
drinkers, and will support my business from day one. It is better than free advertising, because I
am actually making money, in exchange for equity under the terms of the contract, of course.
Third, the crowd literally has a vested interest in drinking my beer rather than the
competitor’s. They want the company to succeed, because they own it. A portion of every beer
they buy is returning to their own pockets. It also creates a free albeit novel advertising
opportunity, because if Ted invests in my company, he wants to tell his friends, come have a beer
at “my” place. Perhaps this argument is exaggerated, because it might not be too different than
one who owns a share of Coca-Cola ordering a Coke. However, under the JOBS Act, no more
than 2,000 people have invested in my brewery over a 12-month time, so it is more of a local
cooperative than a shareholding experience. This argument probably has more weight in a
community setting than a large business. If the crowd is too large or a person owns too little of
the company, then it may lose the “come to my brewery” appeal.
the venture capitalist scenario, as the angel often wants a large stake hold in the company as well
as voting rights.
100
See e.g. Kickstarter, The Cosmonaut: A Wide-Grip Stylus for Touch Screens,
http://www.kickstarter.com/projects/danprovost/the-cosmonaut-a-wide-grip-stylus-for-touchscreens?ref=live. The Cosmonaut is a pen that one can use on any touch screen, such as an iPad
or a Samsung Galaxy Tab. Over 6,000 “backers” contributed over $130,000 (more than twice the
amount sought by the entrepreneurs) for project revolving around a very simply designed, $25
pen. The crowd invested because they wanted the product, which was the reward for
contributing.
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Fourth, if a crowdfunding campaign is unsuccessful, then perhaps it won’t be a successful
business.101 If you cannot build enough public support for your product or service, then maybe
your business isn’t as needed as you thought it might be. The crowd functions as a quasi–market
research tool, a forum to test the waters for responsiveness of your idea.102 This process works to
filter out bad ideas from good, and could save the would-be business-owner a lot of time and
money.
B. Low Investment Amount
Rather than one or two individuals investing a large amount into a start-up, the crowd
pools its assets together to support a particular project. Although the JOBS Act allows projects
up to $1,000,000, it places limits on the amount any particular investor may invest. This protects
the investor from “betting the house”, although the amount is substantial enough to allow
significant losses if a novice investor doesn’t research the company in which he invests.
C. Social Good Projects
Thus far, crowdfunding sites are extremely successful to raise money for “social good”
projects. Kiva is a well-established peer-to-peer lending site where investors lend a small microloan to an entrepreneur who is located in a less-developed country. Although Kiva’s “field
partner”, the loan servicer, collects a small interest payment to cover administrative costs,
lenders do not earn any interest. The real reason behind Kiva is to loan money to relatively
101
Kickstarter and Crowdcube do not allow partially funded projects, and investments are put
into escrow until the funding period (usually between 30 and 90 days) is completed. If your
target amount is to raise $500,000 and you only raise $200,000, then the money is returned to
investors and the project fails. Only projects that reach the target amount, i.e., projects that are
popular enough, raise the target amount, at which point the funding succeeds and the issuer can
get to work.
102
On the other hand, this same function could have adverse consequences. If people post halfbaked ideas just to test the market, with no real intention of carrying out the proposed business
idea, they may be surprised to find their project completely funded.
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impoverished people. Rather than donating to a charity, for example, one may loan money, and
once it is paid back they have the option of re-loaning that amount, acting in effect as a perpetual
donation to a charitable cause.
Kickstarter also has many social good projects. It does not allow real charities, that is,
501(c)(3)’s, from soliciting donations. Nevertheless, many projects are community-based, such
as transforming an abandoned trolley tunnel on Manhattan’s Lower East Side into an
underground public space.103 Additionally, it has a plethora of art-focused projects such as
documentaries, music projects, photography, etc.
V. Conclusion
The purpose of the legislation I suggest is to protect the public with the least possible
interference to honest business. ––President Franklin D. Roosevelt104
It is easy to picture the world without equity–based crowdfunding, as the concept is
entirely new. Without the JOBS Act, equity-based crowdfunding could not gain a foothold in the
U.S. The registration costs would simply be too expensive, in large part because of the smaller
average project size of a crowdfunded venture. Funding models such as Kiva and Kickstarter
would still be up and running, as they rely on peer-to-peer lending and a unique rewards system,
respectively. But equity crowdfunding would not exist.
As a result, society should decide whether or not whether to accept or reject this model.
Do its benefits outweigh its burdens? If so, Congress has made a great decision in passing the
JOBS Act. If not, the bipartisan bill was a mistake.
103
Kickstarter, LowLine: An Underground Park on NYC’s Lower East Side,
http://www.kickstarter.com/projects/855802805/lowline-an-underground-park-on-nycs-lowereast-sid?ref=live.
104
Address to Congress regarding the Securities Act of 1933, quoted by Harold F. Lusk, The
Federal Securities Act of 1933, 7 AM. L. SCH. REV. 1162, 1163 (1930–1934).
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There are certain exemptions to securities registration, such as the small issues
exemption, that Congress has passed because it viewed its benefits to outweigh the burdens.
Corwdfunding is similar to the small issues exemption, though arguably more “radical” because
of its attitude towards allowing a much greater number of non-accredited investors to participate.
Crowdfunding admittedly goes against some of the policies of the securities laws.
Investors are exposed to fraudulent issuers who are allowed to openly solicit their ideas. If
crowdfunding becomes popular, a large number of bad investments could trigger a loss of
confidence in the market, and the risks could spread to traditional markets. Additionally, though
I do not address it in my paper, the secondary market for crowdfunding securities, those that pass
their one-year birthday and may be resold without restrictions, could have terrible consequences.
This is simply a big question-mark, an unknown that I do not believe anyone can competently
address at this moment.
On the other hand, crowdfunding has potential to open a new market of opportunity,
growth, and could help thousands of start-ups with capital they need to get their business off the
ground. In the aggregate, this could boost our economy, and, though secondary to helping
businesses, could improve employment numbers as businesses grow and hire more employees.
Furthermore, the “bad investment” argument is a red herring, because the government is
in the business of protecting investors from bad investments, only those that are fraudulent or
misrepresenting the company’s true value.105 In short, if an issuer wants to sell junk, it can, so
long as it tells you it is junk. The securities laws simply guide the process towards greater
105
See Hon. Garland S. Ferguson, Jr., The Securities Act of 1933: Its Powers and Administration,
1 FED. B. ASS’N J. 23, 24 (1931–1933) (“[N]either the Commission nor the Attorney General is
empowered by the law to pass upon the quality or the investment value of any security. Neither
the issuer’s right to offer nor the public’s right to buy a security may be limited under this act on
account of its speculative, unsound or hazardous character”).
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transparency, so one can separate the good investments from the junk. Although crowdfunding
will have less transparency as a result of the new section 4(6) exemption, it still must provide
limited disclosures to investors.106 These disclosures represent a compromise between the
business industry and investor protection advocates—it will no longer be cost-prohibitive to
issue crowdfunding securities, but the fundamental safeguards will be there.
The fraudulent investment argument is probably overstated. Crowdcube, the U.K.
crowdfunding site, reported zero fraud claims after a year in business.107 In the event there is a
fraudulent act, deceit, or other similar unlawful conduct, the SEC and state governments retain
all avenues of civil and criminal justice ordinarily pursued under the law. The JOBS Act also
expressly grants a private right of action against a company engaging in crowdfunding based on
material written or oral misstatements or omissions in connection with an offering.108
Nouriel Roubini recently chastized the passive role taken by regulators during the past
several years, likening the government to a doctor who allows a patient to smoke for years, only
to treat them for lung cancer.109 If we accept this analogy as accurate, the argument almost
certainly cuts the other way than how Roubini sees it. Yes, it is in the individual’s best interest,
and also that of society, if the doctor pulls the cigarette from the patient’s mouth. But we
currently live in a society that allows people to make their own decisions regarding their health,
even if those decisions are harmful. We simply recognize, however irrational it may seem to
some, the freedoms of individual choice over outside control over that choice. Likewise, we may
106
These disclosures were enhanced in the Senate amendments in response to concerns raised by
SEC Chairman Mary Schapiro and others.
107
Tim Rowe, CEO, Cambridge Innovation Center, testimony before Senate Committee on
Banking, Housing, and Urban Affairs (March 6, 2012), video and text available at
http://www.cictr.com/blog/2012/03/tim-rowe-testifies-before-the-senate-banking-committee/.
108
JOBS Act, § 302(c).
109
See Roubini, supra, note 79.
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choose to allow the market to fluctuate, even if there are controls we could take to even out the
highs and lows, at least until the patient gets cancer, or until the market becomes unstable.
Whether or not one believes crowdfunding is an appropriate model for investing, the
securities laws are about economic tradeoffs that are realized politically by balancing constituent
interests. It remains impossible to foster economic growth without taking some measure of risk.
We could, for example, place regulations at such a level that all illegal financial activity stops in
its tracks, but such stifling regulation would also stall our entire financial markets. Or we could
remove the regulatory dam and allow capital to flow wild and free, but this extreme measure
would certainly destroy the integrity and stability of our markets. Therefore, we need to find
some middle ground. Though the provisions of the JOBS Act can and should be continually
improved upon, it achieves this balancing of interests quite well, by allowing a crowdfunding
exemption while imposing duties and responsibilities on the issuer and broker-dealer. Only time
will tell how successful or disastrous the JOBS Act may prove to be, but now that the doors to
crowdfunding are open, we should focus on making it work.