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The SEC’s Proposed Crowdfunding Rules Promise Benefits, Raise Concerns

| Nov 7, 2013 | News

The Securities and Exchange Commission’s (SEC) recently proposed rules on crowdfunding are sure to draw crowds.  The agency’s proposal, which would allow startups to solicit investors over the Internet, would open up investment opportunities now dominated by Wall Street firms and wealthy individuals.

SEC buildingThe vote followed months of SEC debate on how to balance the needs of cash-strapped startups with the desire to protect unsophisticated investors from fraud.  Those businesses or startups deemed too small or risky to attract funding from banks or venture capitalists are expected to benefit from equity crowdfunding.  On the other hand, critics of the SEC’s crowdfunding proposal warn that small investors will be vulnerable to fraud or big losses, especially with the high failure rates of small businesses.

Under the proposed rules, companies will be able to raise a maximum aggregate amount of $1 million in a 12-month period through crowdfunding offerings.  Individuals may invest, according to their net worth and income, from $2,000 to $100,000 annually.  The proposal mandates that crowdfunding transactions must take place through an SEC-registered intermediary, either a broker-dealer or a funding portal.

The proposed rules, mandated by Congress, are part of the SEC’s effort to implement the Jumpstart Our Business Startups (JOBS) Act, which was passed in 2012 to make it easier for small businesses to raise money, grow, and hire more workers.

Crowdfunding has garnered broad interest because it opens the benefits of direct investing to everyone regardless of their income or net worth.  Currently, entrepreneurs can offer equity in their companies through the marketplaces only to accredited (or wealthy) investors.

Additionally, crowdfunding provides an opportunity for startup businesses to raise money while avoiding the costs of the initial public offering process provided for under federal securities law.  With crowdfunding, these businesses can obtain the financing they need through the “wisdom of the crowd.”  Collectively, the crowd can use the Internet to pick the best investment.

Under the JOBS Act, a company that wishes to raise capital must post their offering on a website operated by a broker registered with the SEC or a “funding portal” registered with the SEC. Brokers and portals will be regulated by the SEC and the Financial Industry Regulatory Authority (FINRA), according to POLITICO.  Following the SEC’s crowdfunding proposal, FINRA has invited prospective crowdfunding portals to file with the organization.

The SEC has estimated that 50 portals will participate initially in the market once the rules are adopted, as reported by Bloomberg.  Portals are not permitted to recommend deals or give investment advice.  The funding portals will serve as key communication points between companies and potential investors.

Daniel Gorfine, a director of financial markets policy at  DC-based think tank the Milken Institute, reportedly said the SEC’s plans for funding portals reveal that the agency understands how crowdfunding differs from traditional funding.  Crowdfunding, as popularized by websites like Kickstarter, relies upon a collective effort of individuals to pool resources to fund projects and causes.  Connecting to the spirit of crowdfunding, the portals allow interested individuals to “share their views and opinions with one another on these offerings.”

According to the National Venture Capital Association, 40 percent of venture capital investments fail, 40 percent break about even with moderate returns and only 20 percent have a decent to high return.  Critics warn that connecting unsophisticated companies with unsophisticated investors to purchase equity in those companies will likely lead to investors losing money.

Some SEC commissioners acknowledged the potential risks involved in equity crowdfunding and asked the public for feedback before the rules are finalized.   The proposal offers great promise to provide capital to small businesses, but also may provide great risks to investors.  SEC Commissioner Kara M. Stein explained “[g]etting the balance right will likely take time and careful refinement.  If we don’t get it right, I fear that the promise of crowdfunding will be lost.”

The proposed crowdfunding rules would place requirements on companies hoping to make a crowdfunding offering to raise capital.  Companies raising less than $500,000 would have to file with the SEC and make available to potential investors financial statements and income-tax returns.  Companies offering more than $100,000, but not more than $500,000, are required to file with the SEC and provide to potential investors financial statements reviewed by an independent public accountant.  A business looking to raise above $500,000 would have to provide audited financial statements.

SEC Chair Mary Jo White noted that the intent of the JOBS Act is to make it easier for startups and small businesses to raise capital from a range of investors and to open opportunities for investors.

“There is a great deal of excitement in the marketplace about the crowdfunding exemption, and I’m pleased that we’re in a position to seek public comment on a proposal to permit crowdfunding,” said Chair White.  “We want this market to thrive in a safe manner for investors.”

The JOBS Act called for the SEC to issue equity-based crowdfunding rules within 270 days, but nearly twice that much time passed before the 585-page draft rules were unveiled.  Having already delayed the crowdfunding rules, the debate over investor protections is likely to continue.

Commissioner Kara Stein reportedly said “[b]ecause this [equity crowdfunding] has not been done before, we know very little about the dynamics of how this financial innovation will work.”  Commissioner Stein went on to explain that the characteristics of who will invest, how much will be invested, what types of businesses will use the portals, or what type of fraudulent activity to expect are still unknown.  According to Commissioner Stein, “[w]e still have a lot to learn.”

The five-member SEC commission unanimously voted to propose the crowdfunding rules, which are a major update to securities regulations dating back to the 1930s.  The SEC is seeking public comment on the proposed rules for a 90-day period following their publication in the Federal Register.



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