Change Crowdfunding Law

Campaign for an SEC regulatory exemption covering public securities offerings with individual investment capped at $100, and the people who love them.

CF Stuck in Senate / Upcoming Politico Ad / Heminway and Shelden

This Investment News article from Jan 1 (registration required) reports that the three crowdfunding exemption bills (H.R.2930, S.1791, and S.1970) are stalled in the Senate. On Jan 24th, it's still true.

To remedy this, a bunch of us will be launching a CF campaign soon to raise money to buy a full back-page advertisement in Politico, which is distributed in printed tabloid format in DC, and is reportedly read by congresscritters. According to Politico's rate card (PDF), a black-and-white full-page ad on the back cover will cost $13,680K.

Here's a draft (PDF below), still in need of a designer's touch.  Comments welcome, and please watch this space for when the campaign goes live.  Of course I hope you will contribute!  People in the Senate need to see that there is public interest and support for these proposals before venturing to consider them. That's not just our assumption-- DC sources have told us this.

Click here to download:
politico-ad-v4.pdf (94 KB)
(download)

Meanwhile, Joan MacLeod Heminway and Shelden Ryan Hoffman have published their final version of Proceed at Your Peril: Crowdfunding and the Securities Act of 1933 in the University of Tennessee Law Review.  It's comprehensive and current, and new tables in the back list and compare crowdfunding platforms worldwide-- a wonderful contribution.

Click here to download:
SSRN-id1986187.pdf (1.69 MB)
(download)

Two semi-random excerpt from Heminway and Hoffman's paper:

[...] it seems prudent to engage those involved in crowdfunding in the regulatory discussions in a meaningful way before Congress passes legislation that legalizes crowdfunded offerings of securities or the SEC publishes a rule proposal as part of the notice-and-comment process
 

Our approach encourages a balancing of issuer, investor, and regulatory interests in a manner similar to that involved in federal consumer protection regulation. The overall analogy to consumer protection is too complex to explore in any depth here. Suffice it to say, however, that there are both commonalities and differences in selling securities and other products at similar price points over the Internet.

On the latter point, I wonder if the newly-created Consumer Financial Protection Bureau
will have primary jurisdiction over CF, rather than the SEC.

 

 

Plug: MAKE Ultimate Kit Guide / More Grassroots Innovation and Economic Development

Make_sip_kits_cover_273x354
If you're interested in innovation (or just like to have fun) check out the MAKE Ultimate Kit Guide, which is available online (see below) or at newsstands nationwide. I may be biased since I worked on it, but it is an amazing document, like nothing you've seen before, and all of us at MAKE are so proud of it.

Many people aren't aware of this, but over the past couple of years there has been an explosion of artisan kit-makers creating wonderful, surprising, and innovative kits, particularly in electronics. The new kits scene has been drawing lots of young, enthusiastic electrical and mechanical engineering talent, and many successful grassroots startups have been growing out of it.  This special issue of MAKE (which is not included in a regular subscription) opens up this world by pulling the best of these kits together for the first time, and introducing you to some of the people behind them. You'll see 175 hands-on reviews and personal recommendations for electronics kits, crafts, robots, music, vehicles, food and beverage, science, sports, siege weapons, and more-- almost none of which you will find at the mall or in any other catalog.

In addition, the Ultimate Kit Guide has feature articles on the world’s worst and most dangerous kits, how you can build your own street-legal sports car, and how DIY medical kits are changing health care in the developing world. For Change Crowdfunding Law readers, I especially recommend the essay "Kits and Innovation" by MIT research fellow Michael Schrage on how kits drive technological innovation — and have since the dawn of the Industrial Revolution. Here’s Michael reading an excerpt from this revolution-minded essay, for your podcast-listening enjoyment.

I see kits as akin to crowdfunding as a medium for grassroots innovation and economic development-- but instead of aggregating human energy (money) around specific ideas, they aggregate human attention around specific sets of interconnecting and reconfigurable physical objects, and how they can be developed. More big companies are now beginning to see the value of "kit-ifying" their products by opening them up to user development, and as Michael Schrage's essay points out, the global DIY R&D brainpower that engages collaboratively with open standards and kits is far greater than the brainpower inside any secretive company department, no matter how many hot-shot engineers and designers they have hired.

Anyway, I apologize if you find this post too off-topic, but I'm excited about this magazine, think it would be interesting to most people who are drawn to crowdfunding, and I wanted to let you know!

MAKE Ultimate Kit Guide 2012
At newsstands nationwide - $9.99
Buy at Maker Shed - print: $9.99 / PDF: $699

S.1970 Text and Analysis / The "Tech-Sync" Attempted CF Fraud Story

The text of S.1970 has been published, and William Carleton has a great critical analysis.  S.1970 caps total offerings at $1M with audited financials / $500K without, and it sets a lower individual investment cap than its competing bills: $500 or 1-2% of individual income, depending on income, plus a $2000 cap on people's total annual investment in CF-exempt securities.  It also requires that intermediaries register with SEC, include warnings and investor education, and do background checks, as determined by SEC.

I haven't fully digested how it treats reporting and preemption/integration with state requirements, both of which are important, and it seems too needlessly heavy on reporting requirements.  But the major, killing flaw I see in S.1970 is that it has no provision for an open discussion forum or other means of communication among potential investors.  This is essential for tapping the "wisdom of the crowd" for vetting, anti-fraud, etc. -- which is the whole point of crowdfunding, and is more adaptable and smarter than fixed, detailed reporting requirements. Here's the wording on this from H.R.2930:

"(10) makes available on the issuer's website a method of communication that permits the issuer and investors to communicate with one another;"

And here's S.1791, in its definition of "crowdfunding intermediary":

"(II) provides public communication portals for investors and potential investors;"

For a great specific example of how this works, here is an account by Andy Gelme of a fraudulent offer made on Kickstarter, for the "Tech-Sync Power System."  Long story short, someone claimed to have developed a replacement wall outlet that could communicate via wi-fi to iPhone and Android phones, plus Mac, Windows, and Linux PCs, for home automation use.  This seemed plausible and exciting, and 419 people ponied up $27,637 in pre-orders for the devices (even including installation, at higher "donation" levels).  But then some backers started reading the pitch more closely and saw red flags in both the technical claims made and the way the offering was structured. The discussed their concerns in the comments, and the collective intelligence changed its mind.  In the end, the offering was canceled, the offeror went AWOL, and no one lost any money.

For CF legislation, the Tech-Sync Power System episode underscores the need for a discussion forum (which should be open to everyone who registers interest, not just people who have already invested), and the value of a waiting period between investment and transfer to offeror during which open discusion can continue.

S.1970: Dem CF Bill in Senate / 14 Dec Hearing

I haven't seen the text yet, but last week Sen. Jeff Merkley (D-OR) introduced S.1970, the ambitiously-acronymed CROWDFUND Act (Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure) of 2011. Here is Merkley's press release; it sounds like it has a 1M cap on total offering, just like H.R.2930 and S.1719, and it was likewise referred to the Senate Banking Committee.  Co-sponsors are Michael Bennet (D-CO) and Mary Landrieu (D-LA).  Finally!  This is great news.

On Wednesday, the Senate Banking Committee will hold a hearing on "Examining Investor Risks in Capital Raising" and on Tuesday morning, the Small Business and Entrepreneurship Council is hosting a briefing "Crowdfund Investing: A Modern and Transparent Platform to Help Entrepreneurs Access Capital" at the law offices of Jones Day, featuring Woodie Neiss, Freeman White, and Karen Kerrigan.

Senate Banking Committee Hearing: Herstein and Coffee Recommendations

William Carleton liveblogged last Thursday's Senate Banking Committee hearing, "Spurring Job Growth Through Capital Formation While Protecting Investors," at which two participants at first seemed critical of a CF exemption: Jack Herstein, president of NASAA (the association of state securities regulators), and Prof. John Coffee, who had also participated in the SEC Small Business Forum on Nov 17th.  As mentioned previously, state securities regulators oppose H.R.2930 and S.1719 as written, which would remove their authority over federally CF-exempt securities.

But Carleton and David Fisher then read Herstein and Coffee's written testimonies, which were posted along with an archived video of the hearing, and found them more positive than the impressions they had gotten from their microphone time. Herstein's (PDF) states, "If regulatory authority is preserved for the states, NASAA will pursue the development of a model exemption for crowdfunding that uses many of the components of S. 1791." This is followed by proposed terms of a CF exemption.

In Coffee's testimony (PDF) he states, "without some changes (which are essentially modest) [S.1791] could well be titled “The Boiler Room Legalization Act of 2011." Specifically, he recommends 1) prohibiting CF platforms from active solicitation, and 2) requiring anyone soliciting CF-exempt investments to be a registered broker-dealer. That's it-- modest indeed, and he even offers specific language to add to S.1719 to take care of the first point. In addition, Coffee makes the constructive suggestion that such an exemption should explicitly allow concurrence with offerings under Reg. D. This would make it possible to raise larger sums than the cap allows from both accredited and non-accredited investors without a 6-month wait in between-- something the SEC's "Integration Doctrine" would currently prohibit.

The bottom line is, people who have been seen as critical of a CF exemption are actually not against the idea-- they are just cautious about it, want it to be done right, and are actively thinking it through and offering suggestions for how to make it work.

Carleton's post about the written testimonies includes a great chart comparing H.R.2930, S.1719, and Herstein's proposal, as described in his written testimony.

Also at the hearing, Scott Brown of course advocated for a CF exemption in the form of his bill S.1719, which now co-sponsored by Senators Kelly Ayotte (R-NH) and Saxby Chambliss (R-GA).  Meredith Cross from the SEC recused herself from discussing the topic of crowdfunding, as a former advisor to the peer-to-peer platform Lending Club.  Scott Cutler from the NYSE said in his written testimony that he was open to the idea of a CF exemption it were limited, and Edward Knight from NASDAQ said he's interested in the concept, but hasn't formed an opinion yet.

Senate Banking Hearing / Dutch CF Policy Translation / Scott Brown Wired Editorial

The Senate Banking Committee is holding a hearing Dec 1 (today for most) called "Spurring Job Growth Through Capital Formation While Protecting Investors."  CF exemption bill S.1719 author Sen. Scott Brown (R-MA) will be testifying, along with Senators Mark Pryor (D-AR) and Kay Bailey Hutchinson (R-TX), Meredith Cross, Prof. John C. Coffee, and others.  The current crowdfunding exemption proposals will certainly be addressed, and I don't know who will be in favor of the idea (besides Scott Brown) or against it.  Will Sen. Mark Pryor convey criticism from Arkansas State Securities Commissioner Heath Abshure?

Reader Rob van Meijel reports that in April 2011, the DNB (Dutch Central Bank) and the AFM (Dutch Financial Markets authority) published a document explaining the country's new crowdfunding regulations, which permit CF investments.  You can find the original here (PDF), and Rob very kindly translated the document into English; see below.  It's a great reference, and if anyone knows of any think-tank reports or academic papers or theses written in either Dutch or English (or any other language) about how this policy has been working out in terms of economics, innovation, fraud, etc., please let me know!

Click here to download:
SEC vertaling van DNB AFM orienteren.pdf (65 KB)
(download)

 

Scott Brown wrote a great editorial for Wired, "Creating A Nation of Venture Capitalists Through Crowdfunding" (Nov 30) which advocates for a CF exemption and has sparked some lively comments.  Last week, NPR's All Things Considered ran a piece about the issue, The Deregulation Bill That's Drawing Crowds, and Rep. Patrick McHenry published a nice video from the Nov 17th rally.  My only criticism of the video is how it blurs the distinction between crowdfunding (which is already 100% legal when donation-based) and crowdfunded securities.  But Congressman McHenry's video people have real talent at making short, appealing videos-- which is gold.

SELC, ASBC Recommendations on Crowdfunding Legislation / S.1791 Review Soon

After discussions last week, Sen. Scott Brown's office (R-MA) asked the Sustainable Economies Law Center (SELC) and American Sustainable Business Council (ASBC) to submit their recommendations for S.1791, in descriptive form rather than changes to the bill's actual language. It's a great document-- see the whole thing below, and here's a summary:

Changes essential to success of legislation:

  • Individual investment cap at $1000 or 5% of annual income.
  • Exempt CF securities from state notice filings and fees.
  • Don't require an intermediary (crowdfunding platform) for exclusively local or in-state offerings.
  • Exempt intermediaries from both federal and state broker-dealer licensing requirements.
  • Allow individuals and regulated entities besides corporations to use CF exemption (S.1791 currently allows only corporations).
  • Guarantee SEC filing requirement for issuers to be just one page.

Other suggested changes, to improve legislation:

  • Require investors to declare that they aren't investing more than 10% of their income per year in CF-exempt offerings.
  • Add a lower-tier category with even easier compliance requirements for offerings capped at $100 individual investment.
  • Prohibit people who have been previously convicted of securities fraud from making offerings under CF exemption.
  • Limit offerings to one per person or entity year.
  • Require the formation of a non-profit governing body of intermediaries, presumably reporting to the SEC.

S.1791 is expected to be reviewed by the Senate Banking Committee before year's end.  If it passes (I think it will), then it will be need to be reconciled with H.R.2930.

Click here to download:
SELC-ASBC-comments-HR2930-S1791.pdf (64 KB)
(download)

SEC Forum Reports: Carleton, Priore / S.1791 Recommendations TK

William Carleton and Ken Priore both posted great reports on the SEC Small Business Forum last Thursday.  A crowdfunding exemption was definitely on the menu, and a couple of people expressed astonishment that the idea had come so far so quickly.  My favorite line is from Columbia Law professor John Coffee, paraphrased by Carleton: On crowdfunding: "A catchy, fashionable idea, tweeting for investors." As drafted now, should it pass, then we will see, every night in every bar in America, a Danny DeVito-figure hawking securities. "It would add some stigma to the securities marketing process."  (This sounds good to me, on all counts!)

I haven't heard how the rally outside the SEC went, but suspect that in terms of media attention, Occupy Wall Street's declared day of coordinated global demonstrations unfortunately took up all the reporters covering the outside-demonstrations beat.  It's too bad none dared branch out to learn about another grassroots revolution, but there was plenty of attention paid to crowdfunded securities inside the SEC that day.

Meanwhile, staff from the office of Sen. Scott Brown (R-MA) have been consulting on possible revisions to S.1791, hoping to appeal to "the other 99 Senators," as they put it.  They are of course well aware of the overwhelming majority with which H.R.2930 passed the House.  I hope to post some recommendations on S.1791 soon that I have read and am very excited about-- they're very well thought-through and inspiring. (I feel like such a wonk saying that.)

The Wall Street Journal and The Economist have articles; nothing new for readers of this blog, but good to see what's getting out there-- and the WSJ article has some lively discussion in the comments.

Here's a wonderful essay by Michael Shuman that I should have posted earlier (d'oh!): "Don't Occupy Wall Street, Ditch It."

And here's Steve Bradford's slide deck, from his SEC presentation last Thurs-- I linked to it before, but nicer to embed:

Click here to download:
sbforum111711-materials-bradford.pdf (368 KB)
(download)

McHenry at SEC Rally Tomorrow! (Please Support) / Hazen On S.1791, and New Draft / Fraud vs. Failure

Great news if you're going to Woodie Neiss's Rally To Make Crowdfund Investing Legal in front of the SEC tomorrow morning -- Rep. Patrick McHenry (R-NC), who introduced H.R.2930 and heroically shepherded it through to near-unanimous success in the House on Nov 3rd, will be speaking at the event!  If you're in DC, check it out tomorrow morning 8am-10am and then attend the SEC Small Business Forum in the afternoon.  (If the Forum format is the same as last year, the morning is all presentations, and the afternoon is where the discussion with the public happens.)

UPDATE: One of the morning presentations (slide deck) at the SEC will be by Steve Bradford, based on his paper "Crowdfunding and Federal Securities Law," which was posted here earlier.

If you can't attend the rally, please help support it, and talk it up!

Meanwhile, Prof. Thomas Lee Hazen sent a nice response to my recent comments on his article, along with a revised version of it (below), which includes discussion of H.R. 2930 and S.1791.  He writes:

Thanks for your comments.  I believe we are on the same page.  The House Bill as I understand it, like most of the proposals to date have virtually no or too little disclosure requirements.  The Senate Bill on the other hand seems to address the disclosure issues.  I have no problem with an exemption  conditioned on meaningful disclosure on the nature of the business and attendant risks.  The fact that investor risk is limited by setting a cap on the investment justifies a lower level of disclosure than would apply in a registered public offering.  However, it does not justify an exemption without any meaningful disclose requirements.

Feel free to post this on your blog.

Thanks Tom, I agree-- we are on the same page.  Lower investment should mean lower level of required disclosure, and higher for higher. His revised article, "Crowdfunding or Fraudfunding? Social Networks, and the Securities Laws – Why any Specially Tailored Exemption Should be Conditioned on Meaningful Disclosure" (below), gives some background on the House Bill and then argues:

The problem with the House Bill is that like the other proposals, the exemption is not conditioned on meaningful disclosure. In contrast, the proposed crowdfunding exemption found in Senate Bill 1791 would be conditioned on disclosure “to investors all rights of investors, including complete information about the risks, obligations, benefits, history, and costs of offering.” The proposed exemption would allow a maximum $ 1,000 investment per investor and further would be conditioned on an offering of no more than $1 million per year. This is clearly a step in the right direction. A viable crowdfunding exemption should include not only disclosure of the “risks, obligations, benefits, [and] history” of the offering but also meaningful disclosure of the nature of the business sufficient to enable investors to evaluate the merits of the securities being offered.

Click here to download:
Hazen crowdfunding draft rev1 ssrn nov 16.pdf (502 KB)
(download)

Another important point is that in typical early stage investing, honest failure is a much greater source of loss than fraud is.  Woodie Neiss and Kevin Lawton make a great argument about this here. So I think the question is, would this continue to hold true under a new crowdfunding exemption, or would such an exemption inspire significantly more people to commit successful fraud, lifting it to a comparable threat level as failure? The answer will of course depend on how the exemption is designed.

A couple of readers noted that the ATM argument in my last post is flawed, because each bank doesn't know about any other bank transactions.  Good point!  Such a scheme would require a global database variable for each individual (maintained by whom-- the SEC?) that updates their total no matter what actor or financial institution it originated from-- so yes, it's certainly doable, but not as simple as the check that ATM systems do on just the banks' own withdrawals.

Hazen Paper / Per Annum Invest Cap?

Thomas Lee Hazen at UNC Chapel Hill recently published a draft paper entitled "Crowdfunding, Social Networks, and the Securities Laws – The Inadvisability of a Specially Tailored Exemption Without Imposing Affirmative Disclosure Requirements."  You can check it out below or at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1954040.

Hazen is critical of recent crowdfunding exemption proposals because they dramatically reduce disclosure requirements. After citing several, he asks, "If the exemption is conditioned on limiting amounts from each investor, who monitor[s] investors’ claims that they meet the exemption’s qualifications?" He repeats the question later:

If, as the proposals suggest, the limited dollar exposure of each investor is a precondition of the exemption, who will monitor this? Will crowdfunding operations have to do their due diligence to assure than investors in fact qualify? If not, what is to prevent an investor from making multiple investments that are not in compliance with the exemption’s limitations?

I can't pretend to be a lawyer, but as an former software engineer, Hazen's question strikes me as akin to asking a retail bank, "If you limit the daily amount that I can withdraw from an ATM, what prevents me from going to an ATM multiple times and withdrawing more than the limit allows?"  The answer, I would assert, is a simple software check designed to prevent disallowed transactions.  Such a check might fail in the instance of an eager investor with multiple identities and SSNs, each having their own bank accounts-- but such an individual would be in violation of federal law already.

Hazen also suggests that "limiting investments to small amounts from each investor does little if anything to provide meaningful investor protection without either sophistication or disclosure requirements." He later elaborates:

Why does a small amount of money from many investors present less of an investor protection threat than more significant amounts of money from fewer investors? While the argument that the limited risk exposure per investor warrants less regulation may have some surface appeal, a deeper analysis does not support this as the primary basis for a specially tailored exemption.

In my reading of Hazen's article, this assertion seems unsupported. Consider an individual investment cap of $10, for example, or $0.01. If Hazen concludes that the possibility of losing $0.01 does not present "less of an investor protection threat" than the possibility of losing $10,000, I would like to see more of his deep analysis.

Having said that, Hazen's heart is clearly in the right place, and he brings up a point that did change my opinion, which I appreciate.  In a footnote citing some of his earlier work on gambling, he points out:

It has been suggested that people who cannot afford the risk are lured to gambling as a chance to hit it big in order to exit from their dire economic circumstances.

To me, this suggestion evokes the scenario of a big-hearted soul with little money but ample trust and optimism, who might come to ruin by repeatedly investing in ill-conceived (or fraudulent) schemes presented by various members of his or her community.  That's bad.  To mitigate this, I think there should be a cap not just on individual investment in a crowdfunded offering, but also a cap on an individual investor's total annual investment in exempted crowdfunded securities, perhaps three or four times the individual investment cap.  What do you think?

I do agree with Hazen that transparency and disclosure are important for any investment offering, no matter how limited. I just believe that the specific requirements for such can be lighter (as they are in H.R.2930 and S.1791) if only small-dollar investments are allowed, and that open communication will foster transparency and disclosure where it is most needed.

Click here to download:
SSRN-id1954040.pdf (520 KB)
(download)