More than a year after Congress passed the Jumpstart our Business Startups Act (JOBS Act), the SEC released long-awaited proposed rules on Crowdfunding Regulation. The new law regulates and legalizes equity-based crowdfunding – the ability for the general public to invest in promising startups through Internet-based crowdfunding platforms.
In passing the Act, Congress’ two most important concerns were (1) the lack of sophistication of investors. Indeed, even when venture capitalists cherry-pick startups, many startups fail. Such odds are likely to be even more unfavorable to inexperienced investors, which they should be informed of. And (2) preventing frauds. Without regulations in place, anybody could claim funding to a wonderful idea without any intention of making good on his or her promises.
The JOBS Act and the SEC rules addressed these concerns by requiring crowdfunding platforms to:
I. Educate Investors.
II. Confirm Investors understand the crowdfunding rules of the game and risks.
III. Take measures to prevent fraud.
I. Educate Investors.
Crowdfunding platforms are required to educate investors. The educational materials must be written in “plain language” and include a laundry list of items pertaining to the basic terms of a crowdfunding transaction – the list can be found in the postscript of this article.
Importantly, the educational material should highlight:
(1) The risks associated with the type of share available for sale. In that context, the SEC went out of their way to mention share dilution. ((If a startup issues additional shares after the crowdfunding rounds and that you, the crowdfunding investors, do not have preemptive rights, or otherwise possess other anti-dilution protection, your proportional ownership in that company, and your shares’ value, are reduced. This is called dilution)) It should be clear to investors whether the shares up for sale on a crowdfunding platform are of the type whose worth can later be diluted, and whether those shares include voting rights.
(2) Investors can cancel an investment commitment for any reason until 48 hours before the deadline set for the given startup; and
(3) Investors must be told that, in most cases, they won’t be able to resale the stocks for a full year and also provide other information about resale restrictions.
II. Confirm Investors understand the risks and rules of the game.
Giving educational material to investors is only part of the story. Crowdfunding platforms must also obtain from investors their specific acknowledgement that (1) they have reviewed such material, (2) they understand their investments could be all lost, and that (3) they are financially capable of bearing such loss.
In addition to receiving such acknowledgments, the platforms must run the investors through a series of questions to ensure they understand the three items mentioned under Section I. (risks involved in crowdfunding transactions; restrictions on cancelling investment commitment; and difficulty to resell stocks.)
All in all, the SEC implemented the JOBS Act pragmatically and efficiently. But when it comes to investor acknowledgment of risk, the SEC rules fall short of what the Act requires. The Act stressed that investors must answer questions demonstrating their understanding “of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers.”
All the SEC rules ever says on that issue is: crowdfunding transaction involves risk and investor should not invest unless they can afford to lose it all. Of course investments involve risks and of course you can lose it all. That is true of virtually all investments! Information about the level of risk was required and that, the SEC failed to provide for. Receiving confirmation from investors that they understand that most startups fail, as they do, would have aptly fulfilled the level of risk requirement. But that is not what the rules say.
Nevertheless, even without a specific SEC rule about the level of risk, it is unclear whether crowdfunding platforms can get away with only applying the narrower SEC rules. Because the level of risk obligation is in the statute and that the SEC rules are additions to the Act, not in replacement of it, making sure investor understands that most startups fail is likely to be required regardless. ((Under subsection (c) of the same provision, Congress expressly left it up to the SEC to come up with other rules in addition to the JOBS Act. This gives ample room for someone to eventually argue that the SEC rules arise from that subsection and do not displace the level of risk requirement of the statute.))
Affirmation Required For Each Investment.
Further, per the SEC rules, obtaining from investors the acknowledgment of risks set forth above is required not just when investors makes their first investment but every time they invests.
III. Take measures to prevent fraud.
The two main obligations of crowdfunding platforms, regarding fraud monitoring, consist of the following:
(1) The crowdfunding platforms must have a reasonable basis for believing that a startup seeking to offer its shares complies with the JOBS Act and SEC Rules; and
(2) The crowdfunding platforms must have a reasonable basis for believing that a startup has established means to keep accurate shareholder records of the shares purchased through crowdfunding.
If a crowdfunding platform cannot form a reasonable basis as to both of these, the platform must reject the startup – note that these duties continue past the initial approval of the given startup so that, even if the startup has raised one million dollar, if the crowdfunding platform learns of new facts casting doubts on either the startup’s failure to comply with the rules or its inability to keep accurate shareholder records, the startup must be disqualified.
Fortunately, the crowdfunding platforms can easily protect themselves thanks to a generous inference. They can rely on startups’ statements as to their own compliance with the law, and their adequate means to keep accurate records. This means that simply obtaining from startups statements affirming they do both of these would be enough for the platforms to cover themselves. This is surprising because the crowdfunding platforms are the first line of defense to prevent fraud. But if they can simply take startups’ word for it, it is doubtful fraud will be aptly policed.
That said, the SEC rules do make clear that relying on the startups’ own word is only available when the crowdfunding platforms do not otherwise know of adverse information. In fact, the platforms are required to:
(1) Perform background checks on the startups’ owner, directors and employees;
(2) Reject a startup when a crowdfunding platform is unable to assess the risk of fraud; and
(3) Reject a startup if they believe it presents the potential for fraud or otherwise raises concerns regarding investor protection. ((In that regard, the SEC, at footnote 366, gave an interesting example: Say a startup director lied on his resume and on that basis a crowdfunding platform determines that the misrepresentation was intentional and would in some way indicate that the startup presents potential for fraud; the crowdfunding platform would then be required to deny access to the startup. This example illustrates well that crowdfunding platforms have a duty to reject startups not just when there is blatant evidence of fraud but also when there is unethical conduct that only indicate fraud.))
In deciding to allow crowdfunding platforms to rely on the startups’ own statements, the SEC counted on the Internet doing what it does best: bringing forth transparency. Indeed, the crowdfunding platforms must allow investors to comment on startups within their platforms, and make those comments available to the general public (without having to log into the platforms). Further, the platforms are prohibited from moderating such comments – except for obvious instances of fraud or spam. Some have proposed a rating system à la Ebay to convey startup trustworthiness to the general public and prevent fraud. The Ebay analogy is not perfect but is a remarkable example of how to build trust in the online marketplace; something crowdfunding platforms should seek to emulate. Because, like Ebay, the crowdfunding platforms have strong, market-based incentive to fight fraud and other bad behaviors, there are reasons to believe they will aptly deal with fraud, even in the absence of onerous fraud-protection provisions.
- The process for investing on the intermediary’s platform.
- The risks associated with crowdfunding securities.
- The types of securities that may be offered on the intermediary’s platform and the risks associated with each, including dilution (note that the intermediary may be deemed not to have met this criterion if an issuer sells a securities product not previously explained in its education materials).
- Restrictions on resale.
- The type of information that an issuer is required to deliver annually, and that such information may cease to be provided in the future.
- Investor limit amounts.
- The circumstances in which an investor may cancel an investment commitment.
- Limitations on the investor’s right to cancel an investment commitment.
- The need for an investor to consider whether crowdfunding securities are appropriate for him or her.
- That at the end of the offering, there might not be any ongoing relationship between the issuer and the intermediary.