Crowdfunding: Where Regulators and Investors Collide
Crowdfunding is a bit like the Wild West of investing right now. It’s (relatively) new, interesting, not fully understood, not fully regulated, and the sky appears to be the limit.
It’s important to draw a distinction between different types of crowdfunding. The term itself can mean different things to different people. To an artist and some entrepreneurs, it may mean donation- or reward-based crowdsourced funding for a project vis-a-vis a platform like Kickstarter. For those with philanthropic intentions, crowdfunding can be conducted through Crowdrise (Slogan: “If you don’t give back no one will like you”).
To an investor, though, crowdfunding means something different: participating in the financing (or refinancing) of a business. It means pooling money into a business loan, such as through SoMoLend, or trading dollars for equity, such as through Crowdfunder.
These last two categories are where most of the attention has fallen recently. There appears to be significant and growing demand for loan- and investment-based crowdfunding, but the regulatory infrastructure surrounding the market is still young and in some cases nonexistent.
In the United States, the regulation surrounding crowdfunding is in a sort of limbo, and for the time being, certain crowdfunding activities exist in a legal gray area. The Securities and Exchange Commission is the gatekeeper of securities transactions in the U.S., and the markets are waiting on a decision — due in 2014 — about loan- and investment-based crowdfunding.
There have been some developments to date, though, that can serve to illuminate some of the regulatory landscape here. The story ostensibly begins with the Securities Act of 1933, which says that all securities offerings in the U.S. must be registered with the SEC. This, of course, means navigating a jungle of bureaucracy that many small businesses and startups can’t afford to do.
Enter Regulation D, a clause within the Securities Act that spells out the conditions under which a company can qualify for exemption from the rule requiring SEC registration in order to sell securities. Regulation D allows companies to sell securities but puts various restrictions on the offering. The offering is usually required to be limited in scope, with certain information required to be disclosed, and — most relevant to this conversation — it requires that there be no “general solicitation” of the offering.
The general solicitation restrictions on Regulation D pretty much made the idea of investment crowdfunding impossible. By definition, seeking investment-based crowdfunding constitutes a general solicitation for the offering.
In April 2012, President Barack Obama signed the Jumpstart Our Business Startups Act (JOBS Act) into law. The act gained some fame recently because it granted Twitter (NYSE:TWTR) the ability to first file its S-1 prospectus confidentially, which allowed it to “test the waters” before moving forward with its initial public offering.
Title III of the JOBS Act deals explicitly with crowdfunding, but the legislation is still pending. However, much to the delight of the crowdfunding community, the SEC recently proposed a set of rules to govern crowdfunding that are not totally ridiculous. The rules would allow startups and small businesses to raise money at a small scale without having to jump through regulatory hoops.
The proposed rules would allow companies to raise up to $1 million in equity through crowdfunding each year, although any company raising more than $500,000 would have to file more detailed information with the SEC. Any company engaged in crowdfunding must provide detailed information to investors so that they understand what they are getting into.
Additionally — similar to some byzantine investor accreditation rules already on the table — investors with net annual income of less than $100,000 would only be able to invest up to $2,000 every year, or 5 percent of their income. Those earning more than $100,000 would be able to invest up to 10 percent of their income.
The rules proposed by the SEC are similar to the crowdfunding rules proposed by the United Kingdom’s Financial Conduct Authority. The key proposals from the authority are:
- In the retail market, the firms can only promote these platforms to:
– Sophisticated investors, high-net-worth investors, retail clients who receive regulated investment advice or investment management services from an authorized person; or
– Retail clients who certify that they will not invest more than 10 percent of their portfolio (i.e., excluding their primary residence, pensions, and life cover) in unlisted shares or unlisted debt securities. This reflects the fact that most investments in startup businesses result in a 100 percent loss of investment (between 50 percent and 70 percent of new businesses fail in the early years).
- For non-advised clients, firms must assess appropriateness before allowing them to invest through the platform.
- The restrictions the FCA has placed on the marketing of unregulated collective investment schemes, or UCIS, will apply to platforms that offer these investments.
- In addition, while most platforms will simply be providing an introduction to an investment, they will need to think carefully about whether any supporting information they provide (such as a star rating or “investment of the week” award) amounts to advice. If it does, the firm will need to apply to FCA for permission to advise on investments.