A few months ago, in the heat of debate over the JOBS Act in Congress, I penned an in-depth critique of the portion of the JOBS Act seeking to legalize equity crowdfunding in the United States. As I argued, the version of the JOBS Act initially approved by a bipartisan majority in the House of Representatives was a brash experiment in targeted radical deregulation of financial markets that would have come on the heels of one of the worst economic disasters in American history — itself attributable to deregulation with inadequate oversight — while the asthmatic U.S. economic recovery continued to wheeze and stumble through the smoldering wreckage of once-mighty financial institutions.
As background, JOBS Act-style crowdfunding legislation — which would more properly be dubbed “crowd investing” or “equity crowdfunding” to differentiate it from other models such as Kickstarter, a funding platform for creative projects — is a form of market deregulation aimed exclusively at investors who by definition have assets or income placing them squarely in the middle class and are making investments so small that in reality they have neither the leverage nor the economic incentive to demand adequate disclosure by issuers. As I wrote previously, an economics professor could hardly dream up a better textbook example of market failure for a final exam.
In a world populated by human beings rather than saints, this dismal outcome is not merely possible; it is inevitable, a classic “race to the bottom” propelled by the invisible hand of profit maximization. A confidence crisis created by widespread losses and disillusionment among investors can cause catastrophic market collapse (as seen in 1929), with protracted macroeconomic misery until that confidence is restored. It’s no coincidence that Congress passed the Securities Act in 1933 and the Securities Exchange Act in 1934. Crowdfunding in its purest form would shred both of those laws under the presumed theory that if the amounts invested are small enough, it simply doesn’t matter if individuals choose to gamble in a wholly unregulated market.
Unsurprisingly, I wasn’t alone in expressing criticism in this vein. In Senate hearings, my own securities law professor, Jack Coffee — still teaching at Columbia decades later — lambasted the proposed equity crowdfunding legislation, dubbing it “The Boiler Room Legalization Act of 2011.” Former SEC Chairman Arthur Levitt opined in a Forbes interview that “The bill is a disgrace.” Former New York Attorney General and governor Eliot Spitzer, perhaps responsible for the successful prosecution of more securities fraud cases than any other person in modern times, wrote a piece for Slate in which he branded the JOBS Act the “Return Fraud to Wall Street in One Easy Step Act.” Corporate governance expert Eleanor Bloxham at CNN Money wrote that “The bill is a hypothesis without the tests or the results. Perhaps, you’ll see more ads for forensic accountants, criminologists and plaintiffs’ lawyers.” Nevertheless, the JOBS Act sailed through the Senate by a comfortable 73-26 vote on March 22, 2012. Those curious to see how the sausage was made can read some commentary at The Business Journals.
In my view, the single most significant development was the Senate’s approval of an amendment to the JOBS Act referred to as “Merkley-Brown” that virtually rewrote the entire section on crowdfunding, adding a host of provisions intended to protect investors. Relying on a mix of industry self-regulation, intermediary (platform) accountability and SEC regulation, the law goes a long way toward addressing the panoply of market failures, perverse incentives and other risks that I described in my critique. A detailed summary of the final JOBS Act signed into law by President Obama can be found here. In a nutshell, the Merkley-Brown amendment — and therefore the final bill signed into law — bolsters transparency and accountability in the following ways:
- Transparency. Issuers will need to make basic information available to the SEC and the public, including the names of directors and officers, a description of the business, anticipated business plan, and the financial disclosures described below.
- Financial disclosure. Companies raising less than $100,000 will need to make available income tax returns and unaudited financial statements certified by the CEO as accurate. For companies seeking to raise between $100,000 and $500,000, the financials must also be reviewed by an independent public accountant. Companies seeking to raise over $500,000 will need audited financial statements.
- Intermediaries. Either a broker-dealer or “funding portal” must be used. Funding portals may not gjve investment advice, make solicitations, or pay compensation based on sales. Funding portals will be registered following a more streamlined process than standard broker-dealer registration.
- Tiered investment caps. The amount an equity crowdfunding issuer can sell to an individual investor in any 12-month period is limited to the maximum of (A) the greater of $2,000 or 5% of the annual income or net worth of an investor, if either the investor’s net worth or annual income is less than $100,000; or (B) 10%, not to exceed $100,000, of annual income or net worth of an investor, if either the investor’s annual income or net worth is equal to or greater than $100,000.
- Civil liability. The JOBS Act specifically authorizes an investor in a crowdfunding transaction to bring a civil action against an issuer for material misstatements or omissions in disclosures provided to investors.
The trade-off is both clear and inexorable between making capital raising more expedient and accepting a higher rate of losses by investors stemming from reasons that are wholly independent of pure investment risk. As Tim Worstall put it at Forbes, “There is always a delicate balance between getting new ventures funded and people being ripped off by the pretence of new ventures getting funded.” Some commentators are suggesting that crowdfunding will be most effective for more conventional businesses such as construction or retail rather than the kind of high growth, market-disrupting startups typically funded by VCs and angel investors. As I have argued before, those businesses are unlikely to be successful in more traditional methods of capital raising but may meet with a receptive audience if marketed effectively through the right crowdfunding platform.
The market failures and incentives I described still exist. What remains to be seen is whether the investor protections mandated by the law will land us in the “sweet spot” of the curve at a point where the risk of abuse is acceptably low, yet the benefits to entrepreneurs are sufficiently clear that they pursue crowdfunding as a viable funding source. If there’s an escape from this stark tradeoff, it may come in the form of intermediaries — that is, crowdfunding platforms — that assume much of the responsibility for policing the area. Whether those platforms can be viable businesses, facilitating a large volume of small-dollar-amount transactions while being deputized by the SEC to perform certain oversight functions, remains to be seen. I remain skeptical, but would be happy to be proven wrong. Meanwhile, the experiment will be placed on hold for a few months while the SEC implements its congressional mandate to formulate the rules of the road (or the railway, so to speak). There may be no wreck after all, but at a minimum it will be a while before the crowdfunding train is cleared by safety inspectors to leave the station.
