Criticizing Crowdfunding Under the JOBS Act — Do We Need a Do-Over?

It has been about six months since the passage of the JOBS Act that made, pending the issuance of SEC regulations, equity crowdfunding legal. Although the SEC is supposed to issue regulations pursuant to the equity crowdfunding section of the JOBS Act by the end of the year, it is clear to everyone that the SEC will miss that deadline — what is not clear is when the SEC will ever issue equity crowdfunding regulations. As such, perhaps it is time to take a look at whether the startup community is getting a good deal with the JOBS Act.

William Carleton, a startup lawyer and angel investor, recently published an editorial criticizing the equity crowdfunding legislation in the JOBS Act, blaming the Senate for mangling the bipartisan-supported equity crowdfunding bill passed in the House, introduced by Congressman Patrick McHenry. Carleton believes that equity crowdfunding as described by the JOBS Act is too ineffective and onerous to ever be successful. Instead, Carleton argues that a do-over may be necessary, by starting with the McHenry bill as a baseline and including some of the better provisions of the Senate equity crowdfunding proposal introduced by Senator Scott Brown, a better, more efficient equity crowdfunding mechanism may be arrived at.

It appears that Carleton’s two primary criticisms of equity crowdfunding in the JOBS Act are: (1) the requirement for funding portals to verify that investors are within their investment limits as prescribed by the Act; and, (2) not permitting a free-flow of information between issuers and investors, preferring the traditional (albeit perhaps somewhat simplified) model of information exchange through disclosure statements.

In my own review and analysis of the JOBS Act, I’ve pointed out the potentially onerous requirement for funding portals to verify that investors are within their investing limits as outlined in the JOBS Act. I argued that without some sort of central clearinghouse that records all crowdfunding transactions that portals could use to verify how much an individual has invested in crowdfunded companies, there would be no real way for portals or issuers to ensure that a prospective investor is investing within their limits. Absent a rather generous safe harbor provision, issuers and portals are taking a risk with every investor.

Carleton argues that an ideal equity crowdfunding law will ask investors to police themselves when it comes to their investment limits. To ensure that investors stay within those limits, Carleton proposes that investors lose their right to bring an action under the securities laws against any issuer to the extent that the investor exceeded his or her limit.

I was surprised by the amount of disclosure required from issuers by the JOBS Act; the SEC regulations would only presumably add to the amount of disclosures. Depending on the size of the offering, a startup could be looking at thousands or tens of thousands in lawyer, accountant, and other professional fees in order to comply with the disclosure requirements. Carleton argues that, as in the McHenry bill, portals should be required to give issuers and investors a mechanism to communicate with one another.

By having a communication mechanism, prospective investors will be able to ask the questions that matter to their analysis of the investment, rather than relying on a formulaic disclosure statement. This will also reduce the administrative burden on portals by not requiring them to collect any specific information from issuers. However, portals will obviously nonetheless choose to collect some information to allow them to review issuers. On that note, Carleton would also include the McHenry provision that allows portals to curate their issuer listings, so long as the methodology of curation is disclosures to prospective investors. This may be preferable to the JOBS Act, which prohibits portals from providing investment advice to investors — I questioned whether this provision would bar portals from rejecting or delisting offerings that, for example, appear to be a scam.

These provisions of Congressman McHenry’s bill that were excised by the Senate were largely tossed, ostensibly, in the name of investor protections. And if equity crowdfunding legislation were to be redone, despite the above provisions making crowdfunding more feasible, opponents would still cry “investor protections”. Carleton proposes that as a counter, investment limits could be lowered to the point that politicians are comfortable with having people lose on startup investments, where investor protections are not worth their cost to the market.

I would add to Carleton’s proposal, as I’ve written before, that portals should also undertake some investor education — the average person likely only has experience investing in the traditional equity markets and no experience investing in startups. Investing in startups requires a different mindset than investing in traditional equity markets. Whereas a person may only lose some of their money in the stock market, investing in a startup is almost always an all-or-nothing proposition — either the startup will be successful, or it will fail and probably cause its owners to lose their whole investment. In a perfect equity crowdfunding system, if people are still concerned about investor protections, then investors should be reminded, constantly, the likelihood that they will lose their entire investment, and should only invest what they can afford to lose.

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