Legal Aspects of Crowdfunding

Today, I would like to discuss regulatory aspects of crowdfunding. There are several proposals now that aim to change existing regulation to provide small businesses with easier access to capital markets.

One such proposal comes from the Sustainable Economies Law Center (SELC). In July 2010, SELC proposed to the SEC to exempt from registration requirements of Section 5 of the Securities Act securities offerings up to $100,000 in total amount raised with a $100 maximum investment limit per investor. Investors can be only individuals and must be either U.S. citizens or permanent residents. Investors cannot participate in multiple offerings at the same time. Petition is available at www.sec.gov/rules/petitions/2010/petn4-605.pdf.

In my opinion, the SELC proposal is not practical in limiting investment amount to only $100 per investor. A $10,000 limit is much more reasonable, and if lost, would unlikely lead to investor’s bankruptcy. Also, the rationale for limiting investors only to one offering at a time is unclear. After all, if they are choosing to participate in risky investments, then they have to be prepared to bear the risks (especially, if the investments are limited to $100).

Another proposal is called the “Startup Exemption”. The petition (that presently has 1,803 signatories) is based on an idea by a group of entrepreneurs led by Sherwood Neiss. It calls for creating a “funding window” to raise up to $1 million over the life of a business, to be used by small businesses with less than $5 million in revenues during the last three years. Each individual investment would be limited to a maximum of $10,000. Investors would be required to fill out a questionnaire demonstrating their willingness to accept risks related to the investment. The Startup Exemption also proposes to eliminate the 500-shareholder rule limitation and the broker-dealer licensing requirements and preempt state regulation of such offerings similarly to Rule 506. Finally, the petition calls to repeal the ban on general solicitation if the offering is conducted through one of registered platforms, where like on crowdfunding sites, ideas can be vetted, discussed, and peer reviewed. Such platforms would then report to the SEC regarding their customers and offerings. More information is available at www.startupexemption.com.

This seems to be a better proposal as it addresses important issues like state regulation, the 500 shareholder rule, and proposes a more reasonable $10,000 per investment limit. Also, reporting requirements by registered platforms that would be reviewed by the SEC, as well as review of companies and offerings by peers, provide some investor protection and transparency.

I identify two paramount issues in all the discussions about the need for new exemptions. First, there is an acute need to protect investors from scams and fraud that may be directed at them once/if general solicitation on the Internet is allowed. It seems inevitable that at some point in the future the SEC will relax the ban on solicitation and advertising given the proliferation of social media and the current state of technological progress. However, this also may open a floodgate of fraudulent offerings and schemes, and the SEC needs to put safeguards in place before it relaxes rules relating to solicitation and advertising.

Second, one of the main complaints regarding the current private placement exemptions is the onerous state regulation of private offerings. The only private offerings that are preempted from state regulation by the National Securities Markets Improvement Act of 1996 (the “1996 Act”) are the Rule 506 offerings. State regulation is based on the number of investors in each state. So, a private offering of securities to investors from ten or so states may fall under regulation of all ten states, thus leading to high legal fees which may make a small offering cost-prohibitive. There is a need to expand the reaching of the 1996 Act to other Regulation D offerings (Rule 504 and 505 offerings) as well as other private placement exemptions.

In the April 6, 2011 26-page long letter to the Chairman of the Committee on Oversight and Government Reform, Mary Shapiro, the Chairman of the SEC, expressed the understanding and the urgency for legal reform to enable small company investing. The SEC is currently reviewing the impact of the regulations on capital formation for small business, with the focus on (i) restrictions on communications in IPOs, (ii) adequacy of a ban on solicitation and advertising in light of current technologies and capital-raising trends, (iii) the 500 shareholder trigger for public reporting, and (iv) the questions presented by new capital raising strategies. The SEC staff is familiar with crowdfunding and the desire by many startups to use it to conduct securities offerings (i.e., offer equity or profit sharing or another arrangement to investors).

So, stay tuned, as the Congress and the SEC address issues relating to capital formation of small businesses.