From Viral Videos on Youtube to Viral Stock Transactions on Crowdfunding Portals: Is Crowdfunding the Modern Thirst-Quencher for America’s Obsession with Gambling in the Stock Market?
- Introduction: The Importance of Crowdfunding 1
- Overview of the JOBS Act 2
III. Crowdfunding 4
- What is Crowdfunding? 4
- Crowdfunding Looking Forward 4
- Crowdfunding and Securities Regulation 5
- Definition of Security 6
- Types of Crowdfunding 7
- The Crossroad 7
- Crowdfunding Exemption 9
- Crowdfunding and pre-JOBS Act Exemption Rules 9
- Crowdfunding and the Amendment of Rule 506 9
- Crowdfunding Exemption 10
- Crowdfunding Exemption’s Likely Impact 11
- Conclusion 12
- Introduction: The Importance of Crowdfunding
What do Spike Lee, Zach Braff, and James Franco have in common these days? Besides being millionaires, celebrities, and fans of Mike Tyson, they are all raising money for projects on crowdfunding websites. In turn, accelerating the hype of this relatively recent method to raise money. To date, all forms of crowdfunding are merely variations of charitable contributions or the purchase of a product or a service. But, when the so call Crowdfunding Exemption becomes effective a whole new ball game begins. To be clear, I am not concerned about Mr. Accredited Investor, who is already dabbling with investment crowdfunding. I am concerned about Mr. Blue Collar. The same guy that during the late 80’s picked up investment advice from the back of an auto repair magazines just before dialing Jordan Belfort’s direct number. However, this time it might be worst. The importance of crowdfunding goes beyond its likely negative impact. Instead, its importance lies in the viral nature of the crowdfunding method. In turn, intensifying exponentially any impact—whether positive or negative—that the Crowdfunding Exemption may have.
- Overview of the JOBS Act
Securities regulation is an economic necessity. The absence of securities regulation and regulation oversight has proved detrimental to the United States’ economy. For instance, the enactment of the Securities Act of 1933 and the Securities Exchange Act of 1934 was the result of Senate hearings triggered by the market crash of 1929. This Senate hearings unveiled gross speculation and manipulation of the securities markets by issuers and Wall Street intermediaries.
On the other hand, securities regulation increases the cost of capital formation, and hence discourages business from raising capital in the securities markets. Indeed, the Securities and Exchange Commission (“SEC”) concedes that “[c]ost-effective access to capital for companies of all sizes plays a critical role in our national economy, and companies seeking access to capital should not be hindered by unnecessary or overly burdensome regulations.” Based on this premise, on April 5, 2012, Congress enacted the Jumpstart Our Business Startups Act (“JOBS Act” or “the Act”).
In a nutshell, the JOBS Act makes it easier for private companies to raise capital by selling securities to investors by reducing regulatory requirements and government oversight. The JOBS Act promulgates various major changes to federal securities laws. For instance, “section 201(a) of the JOBS Act requires the SEC to eliminate the prohibition on using general solicitation under Rule 506 where all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verify that the purchasers are accredited investors.” In addition, section 302(a) of the JOBS Act amends section 4 of the Securities Act of 1933, adding a new type of transaction to the list of transactions exempted from registration and disclosure obligations under section 5 of the Securities Act of 1933, this exemption is referred to as the Crowdfunding Exemption.
As mentioned in the introduction, the JOBS Act’s most important modification to securities laws is, perhaps, the Crowdfunding Exemption. Because crowdfunding—as a method of raising capital—has enormous potential for rapid proliferation, the impact of the Crowdfunding Exemption would be magnified. But, what is crowdfunding? What is the Crowdfunding Exemption? Why was the Crowdfunding Exemption enacted? And, what is the likely impact of the Crowdfunding Exemption, which would be magnified?
- What is Crowdfunding?
Crowdfunding is a method of raising money online. The basic premise of crowdfunding is to raise money through relatively small contributions from a large number of people. Indeed, a crowdfund contribution usually does amount to just a few dollars, and rarely surpasses one thousand dollars. However, a single crowdfund project easily surpasses one thousand backers. In fact, The Veronica Mars Movie Project—which raised more than five million dollars—received contributions from over ninety thousand backers.
Entrepreneurs that need to raise relatively small amounts of money to grow their business find a cost effective and simple alternative in crowdfunding websites. To start the crowdfunding process, the entrepreneur simply publishes a request for funding on a crowdfunding website, along with information concerning, a business plan, and what—if anything—people who back the project will receive in return for their contributions. Moreover, crowdfunding websites charge a relatively small fee for their service.
- Crowdfunding Looking Forward: Exponential Proliferation
The funds raised through crowdfunding are typically small amounts. In fact, most projects aim to raise only a few thousand dollars. However, this trend is starting to change. The most funded project on Indiegogo, for example, aimed to raise thirty-two million dollars.
Kickstarter’s statistics show the popularity and rapid growth of the crowdfunding industry. Since lunching in 2009, Kickstarter has served as platform for more than 142,000 projects. In fact, nearly six million individuals have contributed money to projects on Kickstarter. And, to date the funds pledged through Kickstarter surpass one billion dollars. Indeed, while in 2012 nearly two million backers pledged $606.76 per minute, in 2013 nearly three million backers pledged $913 per minute. Moreover, the incursion in crowdfunding of celebrities such as Spike Lee and Zach Braff, as well as the notoriety of projects such as The Veronica Mars Movie Project make crowdfunding every day more popular.
- Crowdfunding and Securities Regulation: Finding the Crossroad
The main objective underlying securities regulation is the protection of investors. Securities regulation offers protection to investors via two primary cornerstones: (1) mandatory disclosure and (2) liability for fraud. This protection extends to any transaction that involves a security, and not to transactions that do not involve a security. Therefore, crowdfunding would be subject to securities regulation if it involves a securities transaction. Thus, absent an exemption, crowdfunding would be subject to the stringent registration and disclosure duties imposed by section 5 of the Securities Act of 1933. But, not all crowdfunding transactions operate equally. Consequently, whether crowdfunding falls within the scope of securities regulation depends on the application of the definition of security to the different types of crowdfunding activities.
- Definition of Security
Section 2(a)(1) of the Securities Act of 1933 defines security as any of a laundry list of financial instruments including note, stock, bond, debentures, and transferable shares, as well as catchall terms such as investment contract. Courts have wrestled with the interpretation of the statutory definition of security. However, two Supreme Court cases have served as the basis to put this struggle to rest. First, the Court in SEC v. W.J. Howey Co. formulated the so-called Howey test to determine whether a certain type of investment qualifies as investment contract. Under Howey, a transaction is an investment contract if: (1) a person invests money; (2) in a common enterprise; (3) is led to expect profits; and (4) solely from the efforts of others. Second, in Reves v. Ernst & Young the Court adopted the family resemblance test to determine whether a note is a security in a particular context. In summary, the family resemblance test provides that a note is a security, unless it falls in a category of instruments that are not securities.
- Types of Crowdfunding
Crowdfunding is typically categorized depending on “what investors are promised in return for their contributions.” First, the contributors in a donation model of crowdfunding are promised—and receive—nothing in return for their contribution. Second, in a reward model of crowdfunding the contributor is promised something in return for its contribution, but never a financial return such as interest, dividends, or part of the earnings of the business. Third, crowdfunding sites such as Lending Club offer contributors—lenders—interests in return for loans. Conversely, crowdfunding sites such as Kiva do not offer contributors interests in return for loans. Finally, equity crowdfunding sites like Crowdfunder offer investors a share of the profits of the business they are helping to fund.
- The Crossroad
Absent an exemption, crowdfunding transactions that involve a security are subject to the obligations imposed by section 5 of the Securities Act of 1933. Under section 5 of the Securities Act of 1933, an issuer may not market or sale a security before a registration statement is filed or sale a security before the registration statement becomes effective. In addition, once the registration statement becomes effective sales of securities are permitted, but purchasers must receive a prospectus that complies with certain requirements.
The donation model clearly does not involve a security because contributors are not promised anything in return for their contribution, thus they are not “led to expect profits” as required under the Howey test. Similarly, the reward model also does not involve a security because reward crowdfunding sites offer consumable products or services in return for contributions—and nothing else. The Court has clarified that securities laws do not apply “when a purchaser is motivated by a desire to use or consume the item purchased,” and not by an expectation of profit as required by the Howey test.
The lending model of crowdfunding that does not involve an offer of interests does not qualify as a security under Howey, simply because there is no expectation of profit. And, it does not qualify as a security under the family resemblance test adopted in Reves because the transaction involves a note that resembles an ordinary consumer-lending note, which under Reves is within the family of non-security notes. Conversely, the lending model of crowdfunding that does offer interests involves a security under Howey because it involves the investments of money in a common enterprise with the expectation of profits resulting solely from the efforts of others.
Finally, the equity model of crowdfunding clearly involves a security—the shares offered in return for money. Moreover, it meets the elements of Howey because it involves the investments of money in a common enterprise with the expectation of profits resulting solely from the efforts of others.
As mentioned above, the registration and disclosure duties imposed by section 5 of the Securities Act of 1933 substantially increase the cost of capital formation. Therefore, crowdfunding transactions that involve a security become financially impracticable, unless the transaction qualifies for an exemption under section 3(b) of the Securities Act of 1933 or section 4 of the Securities Act of 1933.
- Crowdfunding Exemption
Before the JOBS Act, only nonpublic offerings and secondary offerings, as well as certain small issues were exempt from section 5 of the Securities Act of 1933. The JOBS Act created two exemptions for crowdfunding transactions that involve a security, one of which is already effective.
- Crowdfunding and pre-JOBS Act Exemption Rules
Under the authority of Section 3(b)(1) of the Securities Act of 1933, SEC created Regulation A, which provides that offerings not exceeding an aggregate of five million dollars in a continuous period of twelve months are exempt from registration if the issuer uses an offering circular and complies with filing and circular delivery requirements. Because Reg-A has no general solicitation limitation it has been found suitable for crowdfunding. However, compliance costs limit Reg-A’s practical utility for crowdfunding.
On the other hand, Rule 506—which is a safe harbor provision for the private placement exemption of section 4(2) of the Securities Act of 1933—allows issuers to sell unlimited amounts of securities to an unlimited number of accredited investors, and to no more than thirty-five non-accredited investors. However, before it was amended by the JOBS Act, Rule 506 did not permit general advertising or general solicitation, making this exemption unsuitable for crowdfunding.
- Crowdfunding and the Amendment of Rule 506
To comply with the requirement of section 201(a) of the JOBS Act, “SEC adopted paragraph (c) of Rule 506. Under Rule 506(c), issuers can offer securities through means of general solicitation, provided that: (1) all purchasers in the offering are accredited investors; (2) the issuer takes reasonable steps to verify their accredited investor status; and (3) certain other conditions in Regulation D are satisfied.”
The amendment of rule 506 operates as a crowdfunding exemption for issues sold to accredited investors only, but advertised to the public at large. In fact, equity crowdfunding sites such as Crowdfunder currently operate under this exemption. Crowdfunder clearly indicates that “unlike other . . . crowdfunding sites . . . Crowdfunder allows [contributors] to become . . . shareholders in a company” and that presently only accredited investors may invest in the projects posted on the Crowdfunder site.
- Crowdfunding Exemption
Section 302 of the JOBS Act—contained in title III of the Act—amends section 4 of the Securities Act of 1933, adding a new type of transaction to the list of transactions to which “provisions of section 5 [of the Securities Act of 1933] shall not apply.” The new type of exempt transactions is limited to sales of securities not exceeding one million dollars in a twelve-month period. And, it limits individual investors from investing more than two thousand dollars or five percent of the investors income or net worth in a period of twelve months if the income or net worth of the investor is less than one hundred thousand dollars; or more than ten percent of the investors income or net worth, not to exceed one hundred thousand dollars, if the net worth of the investor is one hundred thousand dollars or more.
The SEC has warned issuers that title III of “the Act requires the Commission to adopt rules to implement a new exemption that will allow crowdfunding. Until then, . . . any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.” On October 23, 2013, the SEC issued a 585-page rule proposal on crowdfunding. The proposal opened the door to a ninety-day comment period that ended February 3, 2014. However, SEC has not issued the final rule.
- Crowdfunding Exemption’s Likely Impact
The Crowdfunding Exemption might open the door for viral fraud schemes and gross misconduct from crowdfunding issuers. Crowdfunding transactions that involve a security and non-accredited investors soon will be exempt from registration and disclosure requirements. Nonetheless, these transactions will be subject to securities anti-fraud provisions. But, the viral nature of crowdfunding will represent a problem for enforcement. Admittedly, the SEC has “limited resources to investigate and prosecute misconduct.” Thus, the SEC has failed to discharge its enforcement duties satisfactorily with respect to large-scale fraud schemes. The Madoff scandal is a good example of the SEC’s inadequate enforcement response. Therefore, a greater margin of enforcement failure is likely with respect to crowdfunding, which given its viral nature might prove very elusive.
Moreover, the private remedies available might be inadequate to protect crowdfunding investors. For instance, crowdfunding issuers are subject to liability under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, which have a private right of action. However, plaintiffs in private 10(b) and 10b-5 actions have the burden of proving scienter. And, scienter is often difficult to prove. If scienter is a problem, plaintiffs may bring an action under section 11 of the Securities Act of 1933, which does not require scienter. But, this remedy is not available to crowdfunding investors because it is limited to misrepresentations made in registration statements of public offerings.
Finally, section 302 of the JOBS Act amends section 12 of the Securities Act of 1933 to create a cause of action for crowdfunding investors. However, crowdfunding investors face practical considerations that might prevent them from bringing an action, even under this provision. First, crowdfunding investors—by definition—are low-income investors. Thus, crowdfunding investors probably will not have the money to fund litigation. Second, crowdfunding offerings are caped at one million dollars in a period of twelve-months. Thus, law firms probably will not take on crowdfunding litigation on a contingency basis because of cost-benefit considerations.
In sum, will investment crowdfunding result in fraud? Definitely. Will wrongdoers in the investment crowdfunding arena escape liability? Probably yes. Does the incentive to capital formation created by the Crowdfunding Exemption warrants the relaxation of investor protections? Maybe. Do investors want to be protected? Perhaps no. The premise underlying the evolving crowdfunding frenzy is the same premise that stood behind the promises that gave Blue Sky Laws their name in the 1920’s. Its is the same premise that stood behind Jordan Belfort’s promise to blue collar investors in the early 90’s. And, indeed, the same premise that stood behind valet parking guys that bought million dollar homes in Kendall during the real estate bubble that lead to the 2008 financial meltdown. I am referring to the promise of everything for nothing. I mean, who said that you must actually work to get a Ferrari, right? America has always been thirsty for it, and until today it is still not enough. However, like Vegas gambling or Candy-Crush, investment crowdfunding is engaging and entertaining, as well as legal. Therefore, it might encounter the same type luck.
. Jamie Farrell, The JOBS Act: What Startups and Small Businesses Need to Know [Infographic], Forbes (Sept. 21, 2012, 12:21 PM), http://www.forbes.com/sites/work-in-progress/2012/09/21/the-jobs-act-what-startups-and-small-businesses-need-to-know-infographic.
. General solicitation includes—but is not limited to—“[a]ny advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio.” 17 C.F.R. § 230.502(c)(1) (2013).
. 15 U.S.C. § 77d (2012); Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings: A Small Entity Compliance Guide, U.S. Sec. & Exchange Commission, http://www.sec.gov/info/smallbus/secg/general-solicitation-small-entity-compliance-guide.htm (last modified Sept. 20, 2013) [hereinafter Eliminating the Prohibition Against General Solicitation].
. Let’s Get Together: Crowdfunding Portals Bring in the Bucks, Deloitte 1 (2013), http://www.deloitte.com/assets/Dcom-Shared%20Assets/Documents/TMT%20Predictions%202013%20PDFs/dttl_TMT_Predictions2013_LetsGetTogeather.pdf.
. See, e.g., Discover Projects, supra note 25. For instance, only eighteen out of nearly 150,000 projects on Kickstarter have raised more than one million dollars. Id. Interestingly, the most funded project on Kickstarter aimed to raise one hundred thousand dollars, but ended up raising more than ten million dollars. Pebble: E-Paper Watch for iPhone and Android, Kickstarter, https://www.kickstarter.com/projects/597507018/pebble-e-paper-watch-for-iphone-and-android?ref=discovery (last visited Apr. 16, 2014).
. The Best of Kickstarter 2012, Kickstarter, https://www.kickstarter.com/year/2012?ref=footer (last visited Apr. 16, 2014); The Year in Kickstarter 2013, Kickstarter, https://www.kickstarter.com/year/2013/?ref=footer (last visited Apr. 16, 2014).
. The Newest Hottest Spike Lee Joint, Kickstarter, https://www.kickstarter.com/projects/spikelee/the-newest-hottest-spike-lee-joint?ref=live (last visited Apr. 16, 2014); Wish I Was Here, Kickstarter, https://www.kickstarter.com/projects/1869987317/wish-i-was-here-1?ref=live (last visited Apr. 16, 2014); The Veronica Mars Project, supra note 26. “Spike Lee brought three decades of fans to Kickstarter . . . and to the thousands of other projects that are funding on Kickstarter.” Similarly, the Zach Braff and Veronica Mars projects “brought thousands of new people to Kickstarter who have since pledged more than [one] million [dollars] to [six thousand] other projects.” Perry Chen et al., The Truth About Spike Lee and Kickstarter, Kickstarter, https://www.kickstarter.com/blog/the-truth-about-spike-lee-and-kickstarter-0 (last visited Apr. 16, 2014).
. Bradford, supra note 56, at 15. Crowdrise, for example, is a crowdfund site dedicated to donation crowdfunding. About Crowdrise, Crowdrise, http://www.crowdrise.com/about (last visited Apr. 16, 2014).
. Id.; see also Thomas Lee Hazen, Crowdfunding or Fraudfunding? Social Networks and the Securities Laws—Why the Specially Tailored Exemption Must Be Conditioned on Meaningful Disclosure, 90 N.C. L. Rev. 1735, 1746 (2012).
. Information Regarding the Use of the Crowdfunding Exemption in the JOBS Act, U.S. Sec. & Exchange Commission, http://www.sec.gov/spotlight/jobsact/crowdfundingexemption.htm (last visited Apr. 16, 2014).
. See Matt Taibbi, Why Didn’t the SEC Catch Madoff? It Might Have Been Policy Not To, RollingStone (May 31, 2013, 5:20 PM ET), http://www.rollingstone.com/politics/blogs/taibblog/why-didnt-the-sec-catch-madoff-it-might-have-been-policy-not-to-20130531.