December 22, 2014

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Equity Crowdfunding: Why Did The SEC Leave It Out Of New Rules?

New SEC rules expand the pool of potential investors for private placements, but leave the general public in limbo over equity crowdfunding. But some want to keep it that way.

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By Francesca Rheannon

This summer, I’ve been renting a spare bedroom in my home to total strangers.

So far, the experience has been 100 percent positive: I’ve made some new friends, had some great conversations, and even arranged for my mother’s archives (she was a multimedia artist, dancer and choreographer) to be taken by the perfect library collection, thanks to a couple I hosted who were archivists and who suggested the library and gave me the relevant contact. Every guest has been polite, quiet, responsible and neat.

Trust & The Crowd

Why would I trust my safety and home – on a few occasions I have been away when my guests arrived – to perfect strangers? Because I use Airbnb – and the internet home hosting service has made it easy for me to feel secure. Guests and hosts are vetted through reviews, security deposits are taken by the service, and there is a $1 million insurance policy.

Airbnb is part of the new sharing economy, but it’s also part of a broader range of transactions that use the web’s crowd-accessing capability to do business. These include Etsy and Ebay, which bring small producers and sellers together with buyers.

The internet has also opened opportunities for investors on a limited basis. Anybody can sign up with microlending sites like Kiva to loan small sums to microentrpreneurs. And for startups looking for capital, there is crowdfunding through platforms such as Indigogo and Kickstarter, where donations are solicited in return for rewards and perks.

The key element encouraging crowd participation in such sites is trust. Through a variety of airbnbmechanisms – most notably consumer reviews that allow the kind of vetting possible in the past only in small communities – these sites promise a kind of transparency that reassures users.

Equity Crowdfunding’s Trust Problem 

But will crowdfunding work for investors seeking to buy an equity stake in startup ventures?

Many in the business community are hoping the crowdfunding model can make the leap from reward/donation to this higher level called equity crowdfunding. With banks still hanging back on lending, startups are hungry for capital, expecially in the tech industry.

So far, only crowdfunding in return for rewards or through straight donations has been allowed, but some are reading the tea leaves in a recent SEC ruling and forecasting a tectonic shift to equity crowdfunding. That’s because the JOBS Act, which President Obama signed into law in 2012, gives its stamp of approval to equity crowdfunding in Title III.

But before Title III can go into effect, the SEC needs to create a crowdfunding exemption to the 1933 Securities Act – and that’s something it has shown itself exceedingly reluctant to do. The ruling on July 10th applies only to private placements to accredited investors (covered under Title II of the JOBS Act,) not the general public. For the first time, it allows private placements to advertise widely, including on the Internet, as long as they accept only accredited investors. 

But the equity crowdfunding rules in Title III were required to be finalized by December 31, 2012. It’s now more than six months beyond the deadline and the SEC hasn’t even come up with a proposal. The stumbling block most often cited is trust – or the lack thereof.

Brian Korn, securities lawyer at Pepper Hamilton, LLP in New York, told CSRwire:

My belief is that there are quite a few people at the SEC who don't believe crowdfunding should be a viable corporate finance tool. The potential for fraud is great and because crowdfunding is going to be extremely procedurely complicated, the theory is that only those deals that can't get done through a private placement will opt for crowdfunding.

What you have there is the riskiest slice of start-up transactions -- even more risky than the start-up universe as a whole, because you're taking out the transactions that can't get mainstreamed through accredited investor or venture capital funding and you're laying them at the doorstep of Mom and Pop investors who are generally the most protected class of investors that we have.”

Transparency Delayed Is Transparency Denied

But Mom and Pop may lose some of those protections if Title III goes into effect. Matt Taibbi of Rolling crowdfundingStone, who has been writing a searing slew of articles on how “Everything Is Rigged” on Wall Street condemned the JOBS Act in general and its promotion of equity crowdfunding in particular when the JOBS Act was signed into law:

One could say this law is not just a sweeping piece of deregulation that will have an increase in securities fraud as an accidental, ancillary consequence. No, this law actually appears to have been specifically written to encourage fraud in the stock markets.

He cites the provision in the law exempting startups from independent accounting for five years:

…how does letting www.investonawhim.com go to market (and stay on the market for five years!) without publishing real numbers actually help the industry attract more financing in general, when the whole point of all of these controls is to make investment a less risky experience for the investor?

And he fears that the law creates an unequal playing field that will burden ethical companies:  

...it puts an honest company at a severe disadvantage, because now it has to compete against other, less scrupulous companies that can simply make their projections up on the backs of envelopes.

Can Equity Crowdfunding Enhance Investor Protections Through Self-regulation?

Alon Goren, CEO and Co-founder of InvestedIn, which describes itself as “a revenue generating platform that specializes in social fundraising and Crowdfunding,” disagrees with Taibbi and others who fear that the practice will promote fraud.

“Fraud is actually not a real concern for people who understand the space,” Goren told CSRwire.

“Crowdfunding for the general public is something that has been legal in places like Australia and the U.K. for several years now and there has been virtually no fraud there. I have been in the internet technology field for 10 years and I would say there is so much more fraud in just normal e-commerce transactions than any sort of crowdfunding transaction. Fraud is more of a stalling tactic for lobbyists and for the government. At the end of the day it is going to be legal.”

As a techie, Goren would “love to see it completely open:”

"I think it will self-regulate very quickly. When Ebay first launched, people were freaking out that there was going to be fraud. ‘You're doing person-to-person transactions online? People are going to take money and run!’ And that happened a little bit. But then Paypal was born out of that and there's virtually none of that anymore. Because if I buy something from you online with Paypal and you don't deliver, I get my money back. So in the short term, I think that it'll regulate itself and it'll become a very efficient business."

Simple Risk vs. Fraud

However, it's unlikely that investors will be getting their money back from losses in equity crowdfunding, as even Goren ackowledges. But he says that’s a risk investors already take, in a investedinuniverse where nine out of 10 startup companies go out of business.

“I think very quickly people will realize how risky it is, that it is a gamble, and they will invest accordingly. At the end of the day, it's not any riskier than a lot of other investments. Gambling is legal.”

But, while risk is an accepted part of investor expectations, fraud is not – and the rub comes in knowing whether losses stem from fraud or simple misfortune. If independent audits can be bypassed for five years, how will investors know whether they've lost their money to bad luck or skullduggery? By the time the reviews roll in, it will be too late for caveat emptor.

Democratizing The Investment Pool

There are some protections built into Title III that limit investor losses. The law restricts investments to 5 percent of income for those with annual incomes less than $100,000 and to 10 percent for those with more than $100,000. But there is little provision for due diligence – that will be up to investors or the crowdfunding dealerships that are proliferating to serve them.

Allowing the general public to be start-up investors will hugely widen the pool of potential capital to small companies, Goren pointed out, democratizing access to funds. Such crowdfunding, Goren says, could boost local economies by allowing investors from the general public anywhere to invest in them.

Whether it will be such a good deal for the investors though, will depend on writing rules to enhance transparency and accountability.

The ball is in the the SEC’s court – now, they just need a racquet.

The opinions, beliefs and viewpoints expressed by CSRwire contributors do not necessarily reflect the opinions, beliefs and viewpoints of CSRwire.

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