Regulators walk a tightrope when it comes to innovation, disruption

We may not have flying cars, as science fiction writers once promised, but we do have self-driving ones.

Cigarettes? Passé in a world of e-cigs and high-tech vaporizers. Hailing a cab is oh so 2015 with the spectacular growth of ride share services like Uber and Lyft. Lest cabbies think they can make up for lost fares with a few package deliveries, drones threaten to take over delivery logistics.

It was once an understood fact of life that regulators are reactive, not proactive, when it comes to rulemaking and industry standards. Now, with disruptive technology and sharing services evolving from quaint ideas to multi-billion- dollar enterprises, some are starting to shake off that reputation, albeit cautiously.

Click for cash

Two places where one usually doesn’t expect to see innovative thinking: Congress and the Securities and Exchange Commission. And yet, through the work of both entities, one of the biggest revolutions ever in private company capital-raising became a reality on May 15.

In October 2015, the SEC approved Regulation Crowdfunding, making good on a 2012 JOBS Act mandate to permit startups and small businesses to raise capital by offering and selling securities through crowdfunding.

Crowdfunding, although common on websites like Kickstarter, had not yet involved the offer of a share in any financial returns or profits from business activities. Doing so currently triggers the application of the full suite of federal securities laws, both for the issuers making the offerings and the brokers who intermediate them. The newly effective rule allows securities-based crowdfunding offerings to take place within a regulatory framework.

“Regulators must address how to prevent death from a thousand cuts by numerous state, federal and foreign regulators for FinTech firms that look to provide services across various financial market regulatory jurisdictions.”
J. Christopher Giancarlo, Commodity Futures Trading Commission

The approved framework establishes guidelines for investors and rules for issuers that want to raise up to $1 million a year through crowdfunding and not have to register those publicly offered securities. Whereas private companies are limited to seeking out accredited investors (with a net worth of $1 million or annual income of more than $200,000), crowdfunded ones could reach out to the unaccredited. They would not need to register those securities offerings with the SEC, but all offerings must be facilitated through either a registered broker-dealer or an online funding portal registered with the SEC and Financial Industry Regulatory Authority.

The final rule also requires financial statements prepared in accordance with U.S. GAAP for the issuer’s two most recently completed fiscal years (if they have been in business for that long). If the issuer proposes to offer $100,000 or less, then the financial statements must be reviewed and certified by the issuer’s chief financial officer. If the issuer is raising more than $100,000 and less than $500,000, the financial statements must be reviewed by an independent accountant. For amounts in excess of $500,000, financial statements must be audited.

If that sounds a lot more complicated than dropping $5 onto your niece’s GoFundMe site, it surely is. The complexity, in fact, is the end result of a Hobson’s choice that pitted the SEC against … well … pretty much everyone. Investor advocates see a treacherous landscape that threatens to fund bad companies on the backs of mom and pop investors. Congressional proponents see too many strings attached.

“That really explains why it took the SEC so long to come out with these rules,” says Debbie Klis, a partner with the law firm Ballard Spahr. “It was because of the complexity of actually making a usable program that was helpful to companies looking to raise money and yet still protects investors.” “The SEC had to come up with rules to protect investors from themselves,” she adds. “It was a real balancing act and I don’t fault the Commission for taking so long. It was probably a quite difficult thing to do.”

Keeping pace

In some areas, regulators are doing their best to keep pace with, if not stay ahead of, emerging technology.

In August 2015, Comptroller of the Currency Thomas Curry announced the development of a comprehensive framework that will improve his agency’s “ability to identify and understand trends and innovations in the financial services industry, as well as the evolving needs of consumers of financial services.”

The framework is intended to improve how the OCC evaluates innovative products and services that require regulatory approval while identifying potential risks associated with them. Those efforts were further detailed in a March paper, “Supporting Responsible Innovation in the Federal Banking System.”

“Innovation has been a hallmark of the national banking system since it’s founding in 1863 by President Lincoln,” the paper says. “That innovative spirit has been especially evident in recent decades as [banks] have led the way in developing and adapting products, services, and technology to meet the changing needs of their customers.” Among the guiding principles for the OCC’s approach:

Supporting responsible innovation

Fostering an internal culture receptive to responsible innovation

Encouraging banks of all sizes to integrate responsible innovation into their strategic planning

Collaborating with other regulators

That message resonates with J. Christopher Giancarlo of the Commodity Futures Trading Commission, an outspoken critic of regulatory overreach when it comes to FinTech innovations in the financial services sector. He champions a “do no harm” regulatory model.

Financial regulators should designate dedicated, technology savvy teams to work collaboratively with FinTech and blockchain companies to address issues of how existing regulatory frameworks apply to new products, services, and business models derived from innovative technologies, he said during a May 10 speech.

ALL ABOUT CROWDFUNDING

The following is from the Securities and Exchange Commission’s “Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers.”
Maximum offering amount of $1 Million
A company issuing securities in reliance on Regulation Crowdfunding is permitted to raise a maximum aggregate amount of $1 million in a 12-month period. In determining the amount that may be sold in a particular offering, an issuer should count:
Investors subject to limits
Individual investors are limited in the amounts they are allowed to invest in all Regulation Crowdfunding offerings over the course of a 12-month period:

If either of an investor’s annual income or net worth is less than $100,000, then the investor’s investment limit is the greater of: $2,000 or 5 percent of the lesser of the investor’s annual income or net worth.

If both annual income and net worth are equal to or more than $100,000, then the investor’s limit is 10 percent of the lesser of their annual income or net worth.
During the 12-month period, the aggregate amount of securities sold to an investor through all Regulation Crowdfunding offerings may not exceed $100,000, regardless of the investor’s annual income or net worth.
Spouses are allowed to calculate their net worth and annual income jointly. 
Transactions conducted through an intermediary
Each Regulation Crowdfunding offering must be exclusively conducted through one online platform. The intermediary operating the platform must be a broker-dealer or a funding portal that is registered with the SEC and FINRA.
Disclosure by issuers
Any issuer conducting a Regulation Crowdfunding offering must electronically file its offering statement on Form C through the Commission’s EDGAR system and with the intermediary facilitating the crowdfunding offering.
The instructions to Form C indicate the information that an issuer must disclose, including: information about officers, directors, and owners of 20 percent or more of the issuer; a description of the issuer’s business and the use of proceeds from the offering; the price to the public of the securities or the method for determining the price, the target offering amount and the deadline to reach the target offering amount, whether the issuer will accept investments in excess of the target offering amount; certain related-party transactions; and a discussion of the issuer’s financial condition and financial statements.
 
Source: SEC

Regulators should also foster a regulatory environment that spurs innovation and allows “space to breath” when developing and testing innovative solutions. “Regulators must address how to prevent death from a thousand cuts by numerous state, federal and foreign regulators for FinTech firms that look to provide services across various financial market regulatory jurisdictions,” he said.

Also count Edith Ramirez, chairman of the Federal Trade Commission among the regulators embracing innovation. In a recent speech at Fordham Law School, she set her sights on the so-called “sharing economy.”

The proliferation of peer-to- peer Internet platforms is creating new sources of supply for products and services ranging from ride-sharing to short-term rentals to micro- lending, she said.

The FTC, Ramirez said, is “particularly well suited to consider the various issues raised by the sharing economy” and “enforcers and policymakers have to strike a balance.” “We must allow competition and innovation in the form of these new peer-to- peer business models to flourish,” she said. “At the same time, where necessary, targeted regulatory measures may be needed to ensure that these new business models have appropriate consumer protections; but they should be no greater than necessary to address those concerns.”

The challenge: “sharing economy platforms raise regulatory issues for policymakers not previously seen.” Nevertheless, her agency has cautioned state and local governments “not to impose legacy regulations on new business models simply because they happen to fall outside of existing regulatory schemes.”

“The threshold question for policymakers examining new peer-to- peer businesses should be whether there is a public policy justification for regulating the service at all, either through an expansion of existing regulatory schemes or entirely new ones,” Ramirez said. “If there is no public policy rationale justifying regulation, policymakers should allow competition to proceed unfettered.”

That approach, if the FTC sticks to it, is exactly what Robert Shannon, a partner with law firm Hinshaw & Culbertson, advocates. As tensions flare among traditional and emerging industries, regulators find themselves taking on a Solomonic role. He calls for “a new era of regulatory statesmanship.”

All of this will be much easier said than done. Cab and limo drivers continue to fight ride-sharing services that avoid the fees and rules they are subjected to. States are also increasingly battling with home-sharing sites like Airbnb over lost lodging taxes. The Federal Aviation Administration is in a quandary over how to let companies like Amazon use aerial drones for deliveries.

Regulating for the sake of regulation

On May 5, a blow for one disruptive technology was meted out by the Food and Drug Administration when it finalized a rule extending its authority to all tobacco products, including e-cigarettes and vaping products. The requirements include registering manufacturing establishments and providing product listings to the FDA; reporting ingredients; and requiring premarket review and authorization of new tobacco products.

The inevitable lawsuits have already begun, including one by Nicopure Labs, a Florida- based e-liquid manufacturer. On May 10, it was the first company of its kind to challenge the FDA rule in the U.S. District Court for the District of Columbia. In its court filing Nicopure Labs contends the FDA’s rulemaking process violated the Administrative Procedure Act, and that the deeming rule violates the First Amendment.

“The government’s role is not to regulate for the sake of regulation; regulation must be based on sound science and robust procedure, and it must accomplish certain public health goals,” says General Counsel and Chief Compliance Officer Patricia Kovacevic. As for those self-driving cars, prepare for the regulatory equivalent of a traffic jam. Sixteen states introduced legislation related to autonomous vehicles in 2015, up from 12 states in 2014, nine states and D.C. in 2013, and six states in 2012, according to the National Conference of State Legislatures.

The good news, for proponents of the technology, is that most of that legislation sets the stage for the legal use of autonomous vehicles on public roads. One bill, proposed in the Michigan State Legislature, would also limit the liability of vehicle manufacturers in a product liability suit resulting from modifications made by a third party. Another, in Nevada, allows “driver” smartphone use as “these persons are deemed not to be operating a motor vehicle for the purposes of the law.”

And, of course, money talks. In January, at the North American International Auto Show in Detroit, U.S. Transportation Secretary Anthony Foxx announced a commitment of nearly $4 billion over the next 10 years to accelerate the development and adoption of safe vehicle automation.

Also, later this year, National Highway Traffic Safety Administration is expected to propose industry guidance. Leading the charge to influence that work is the Self-Driving Coalition for Safer Streets, a lobbying group that includes Uber, Lyft, Ford, Google, and Volvo.