The Securities and Exchange Commission—as readers undoubtedly know—has a three-fold mission: to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. Critics often lament that pursuit of the third objective comes at the expense of the first.
The rise of SEC-sanctioned crowdfunding is a poster child for those concerns. Over time, however, reviews of those business practices have the potential to encourage a fresh look at investor protections. New approaches to that first prong of the SEC’s mission are already afoot.
“Achieving the goals of crowdfunding is not without challenges,” says Acting SEC Commissioner Michael Piwowar. “Without sound protection of investors from fraud, it is unlikely that capital formation through crowdfunding will thrive.”
In 2012, Congress passed—with bipartisan support—the Jumpstart Our Business Startups (“JOBS”) Act. It required the Commission to rethink traditional methods of capital formation and investor protection.
Among the results was Regulation Crowdfunding, effective May 2016. It allowed for a large number of retail investors to be solicited on the Web and through social media to purchase unregistered securities of small private companies. Additionally, the rule establishes a new type of intermediary—funding portals—that bring buyers and sellers together online.
Funding portals facilitate the sale of crowdfunded securities, provide investors with information and communications channels, and are tasked with implementing measures to reduce fraud.
To date, 21 funding portals have emerged to facilitate these transactions, with 163 deals initiated, of which 33 have completed their fundraising. Approximately $10 million of new capital has been raised since Regulation Crowdfunding became effective.
Among the deep dives into crowdfunding successes and failures was a Feb. 28 symposium held jointly by the SEC’s Division of Economic and Risk Analysis and New York University’s Salomon Center for the Study of Financial Institutions. A recurring theme was the challenges and tradeoffs of protecting investors in crowdfunded transactions.
Among the speakers was Paul LaPorte, CEO of MF Fire. One of the first crowdfunded companies under the new rule, it specializes in wood-burning stove technologies.
“Crowdfunding fills a critical gap,” he said. “We just didn’t fit the traditional funding model. This has really opened up a lot of business foundation that would not otherwise be there.”
The process was hardly worry-free. LaPorte describes concerns about his company’s legitimacy and the validity of the offering. A CPA audit, although simple and basic, was one tool for establishing trust throughout the $200,000 capital raising campaign. The money raised helped seed additional funding and finish products needed for testing by the Environmental Protection Agency.
There have been numerous success stories thanks to Regulation Crowdfunding space, and all kinds of companies—from craft breweries to high tech—are raising funds, said Sara Hanks, co-founder and CEO of CrowdCheck, a firm that provides due diligence, disclosure, and compliance services for online capital formation.
An attorney with more than 30 years of experience in the corporate and securities field, Hanks was previously general counsel of the bipartisan Congressional Oversight Panel, overseer of the Troubled Asset Relief Program.
“There are good things and bad things about some of the rules the SEC adopted,” Hanks, co-chair of the SEC’s Advisory Council on Small and Emerging Companies, said. The original JOBS Act legislation was “all or nothing.” Companies set a monetary target (up to $1 million). If they failed to reach the goal, they couldn’t get any of the money.
“Crowdfunding fills a critical gap. We just didn’t fit the traditional funding model. This has really opened up a lot of business foundation that would not otherwise be there.”
Paul LaPorte, CEO, MF Fire
There was also, however, an allowance for over-subscription. That means companies can set a minimum raise of, for example, $20,000, to ensure a completed campaign, while angling for more money from additional participants.
“That’s good from the point of view of companies that are desperate for money, but not good for investors if the company really did need a larger amount of money for what it was doing,” Hanks says. Among the risks: the initial fundraising target was really only enough cash to keep the enterprise afloat for a few weeks.
Hanks also laments that disclosure compliance “is fairly inconsistent.”
“When I say ‘inconsistent,’ I am being hugely tactful,” she said. Research indicates that 100 percent compliance is reached by only about 15 percent of the companies raising funds; there are some items of disclosure where compliance is less than 20 percent.
That metric may be “pathetic” but it, and other problems, “can be solved by proper investor education and by platforms taking a more active role as gatekeepers,” she said.
Platforms can help police, at least to a degree, communications rules, unsupported valuations, and non-GAAP financial reporting. The problem: Portals are overworked and under-sourced, even as regulators expect them to serve as gatekeepers.
General crowdfunding concerns, according to Marc Sharma, chief counsel of the SEC’s Office of the Investor Advocate, are that the securities investors receive are frequently illiquid, with provisions that lock up their funds for a year or more. There is often limited disclosure, especially when compared to what might be expected from a public company in terms of quality and frequency.
“It is in no one’s best interest to have a huge blow-up in this space,” Sharma says. “It could really harm not just investors but this nascent market. But there is a lack of professional guidance. You don’t typically have angel investors shepherding a new company, or venture capital representation on the board that is going to help guide this company to success.”
Sharma agrees that portals can, and should, take a greater role in investor education. “There is a general lack of financial literacy among many retail investors out there,” he says. “Do they know how to analyze a potential investment opportunity? Education in this area could really help them understand the risks and rewards.”
In a statement, SEC Commissioner Kara Stein addressed the importance of keeping a watchful eye on funding portals. There are cases, she said, where portals have ignored red flags and allowed suspect offers onto their platform. For months prior to its expulsion, one particular funding portal allowed unsuspecting investors to invest in the 16 suspect offers.
The following is from “Remembering the Forgotten Investor,” a speech made by Acting SEC Chairman Michael Piwowar at the Practising Law Institute’s SEC Speaks conference in Washington, D.C. on Feb. 24.
The accredited investor threshold, or how the other half lives
[Consider] the registration requirements under the Securities Act of 1933 (the “Securities Act”) and the various exemptions therefrom, including Regulation D.
We commonly analyze these rules from the perspective of issuers of securities, with a view to promoting capital formation in the United States. But what if we were to consider these rules from the perspective of the Forgotten Investor?
The Securities Act prohibits the use of any instrument of interstate commerce to offer or sell a security, unless pursuant to a registration statement declared effective by the Commission. It also prohibits “every attempt or offer of, or solicitation of an offer to buy, a security or interest in a security, for value,” defining “offer” broadly to encompass any public statements that might “condition the market” or arouse interest in an issuer.
Of course, the Commission has extended certain exemptions from this system, prominently including Regulation D’s safe harbor for private offerings. Regulation D is based on a provision of the Securities Act that exempts “transactions by an issuer not involving any public offering,” an exemption that the Supreme Court has held turns on whether “the particular class of persons affected needs the protection” of the securities laws.
Distinguishing investors who can fend for themselves from those who cannot is a line-drawing exercise fraught with peril.
The Commission did just that in 1982 when it adopted Regulation D, dividing the world of private offering investors into two categories: those persons accorded the privileged status of “accredited investor” and those who are not. Like something out of the ancien régime, investors lucky enough to earn $200,000 or more in annual income or with a net worth of more than $1 million have available to them myriad investment choices, both public or private.
By contrast, les Misérables on the other side of the line are severely restricted in their investing options. The $200,000 income test has not been updated since 1982, whereas the net worth test was revised by the Dodd-Frank Act to disallow the counting of home equity, raising the bar even higher to qualify as an “accredited investor.”
In my view, there is a glaring need to move beyond the artificial distinction between “accredited” and “non-accredited” investors. I question the notion that non-accredited investors are truly protected by regulations that prevent them from investing in high-risk, high-return securities available only to the Davos jet-set.
Here, I appeal to two well-known concepts from the field of financial economics to show that, in maintaining an “accredited” status in our regulatory structure, we may have forgotten—and in fact disadvantaged—a set of investors. The first is the risk-return tradeoff. Because most investors are risk averse, riskier securities accordingly offer higher returns. Therefore, prohibiting non-accredited investors from investing in high-risk securities amounts to a blanket prohibition on their earning the very highest expected returns.
The second concept is modern portfolio theory. By holding a diversified portfolio of assets, investors reap the benefits of diversification. That is, the risk of the portfolio as a whole is lower than the risk of any individual asset. The correlation of returns is the mathematical key. When adding high-risk, high-return securities to an existing portfolio, so long as the returns from the new securities are not in perfect positive correlation with the existing portfolio, investors may reap higher returns with little to no change in overall portfolio risk. In fact, if the correlations are low enough, the overall portfolio risk can even decrease. As such, excluding certain investors from diversification options deprives them of important risk mitigation techniques.
These two basic concepts of economics demonstrate how even a well-intentioned policy of investor protection can do more harm than good, for instance, by exacerbating inequalities of wealth and opportunity.
“When portals fail to conduct appropriate diligence, it adversely impacts both the investors who may become victims of a fraudulent offer, but just as importantly, it affects subsequent offers by other issuers,” Stein said. “Once-bitten-twice-shy investors may be reluctant to fund the next business seeking financing through crowdfunding. Therefore, portals that are effective at vetting issuers and offers are important as both gatekeepers and facilitators of repeat investment.”
“To date, there has been some discussion within the crowdfunding industry about funding portals. Some have noted that funding portals have a spotty record of diligence. Some have registered concern at what may be a race to the bottom as portals compete for offers to host,” Stein added.
Should there be minimum and uniform standards for vetting companies seeking to be hosted on a portal?
Should portals be ranked, and if so, based on what criteria and by whom?
What else can be done to help portals be effective for the good of the entire marketplace?
The security types offered in crowdfunding campaigns are another concern for Stein. The second most common security offered are simple agreements for future equity or “SAFE” securities.
These so-called SAFE securities are contractual derivatives. The issuer promises to give the investor stock upon the occurrence of a contingent future event. The event is typically linked to a subsequent valuation event, such as securing an additional round of financing, a company sale, or an initial public offering.
“However, many small and emerging businesses will never attain the subsequent valuation event,” Stein said. “As a result, a retail investor is left with little more than the paper on which the contract is written. SAFEs arguably provide different rights and restrictions and more risk than what retail investors may typically expect.”
A big push in the direction of investor protection will come later this week when the SEC’s Office of the Investor Advocate launches a new investor research initiative (one that goes far beyond crowdfunding alone).
The effort is dubbed ‘POSITIER’, for Policy Oriented Stakeholder and Investor Testing for Innovative and Effective Regulation. It seeks to inform the rulemaking process with evidence obtained from surveys and specific testing projects.
Under this initiative, the SEC’s Office of the Investor Advocate has launched a specific study program to examine the topic of Retail Disclosure Effectiveness. This study seeks to identify and test interventions that increase investor awareness of key investment features and, in turn, improve investment outcomes.
“With this new tool, we can gain better insights into the potential benefits to investors from proposed rule changes, and we will be able to help identify the best options amongst competing policy choices,” Investor Advocate Rick Fleming said.
At the Practising Law Institute’s SEC Speaks conference, Fleming elaborated on his vision.
“I suggest three ways that the Commission should enhance its understanding of investors: through direct outreach to investors, increased use of investor research, and greater engagement with the Investor Advisory Committee,” he said. “I believe this type of research has the potential to transform the way the SEC approaches rulemaking and, in turn, to enhance the overall effectiveness of regulation. We still have a long way to go to make investor research a routine part of our rulemaking process, but I am gratified by the support we have received so far in this initiative.”