Wednesday, December 14, 2011

Senate Crowdfunding Legislation Would Allow Internet Capital Raising with Investor Protection

Two measures have been introduced in the Senate to permit crowdfundng efforts to raise capital over the Internet with investor protections. Senator Jeff Merkley (R-OR) introduced the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act, S 1970, which would legalize and regulate the raising of start-up capital for small businesses on the internet. According to Senate Merkley, the promise of crowdfunding is that investments in small amounts made through transparent online forums can allow the “wisdom of the crowd” to provide funding for small, smart companies. The legislation would provide an alternative to the process under which a company seeking financing from the public must register a security with the SEC and providing detailed disclosures by allowing companies to raise up to $1 million annually through crowdfunding on registered internet websites

S 1970 contains requirements for intermediaries under which a person engaged in the business of effecting crowdfunding transactions in securities for the account of others must register with the SEC as a broker or a funding portal as defined in Section 3(a)(80) of the Securities Exchange Act. The intermediary must register with any applicable SRO and provide such disclosures, including disclosures related to risks and other investor education materials, as the SEC determines appropriate.

The intermediary must also ensure that each potential investor reviews investor-education information, in line with standards established by the SEC and positively affirm that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss and answers questions demonstrating an understanding of the level of risk generally applicable to investments in startups and small issuers;) an understanding of the risk of illiquidity; and an understanding of such other matters as the SEC determines appropriate.

The Merkley bill would also implement basic marketplace protections for the ordinary investors seeking to take advantage of this new marketplace. Web sites seeking to list companies must register with the regulators and provide investors the basic information about the companies they list. Also, crowdfunded companies themselves must provide basic disclosures to investors and regulators.

The Democratizing Access to Capital Act, S 1791, introduced by Senator Scott Brown (R-MA) would exempt small investments of $1,000 per investment, with total size of the stock offering capped at $1,000,000 while at the same time providing strong investor protections. The legislation limits the risk to individual investors to $1,000 per person per issue per year. According to Senator Brown, this amount greatly limits potential investor exposure to fraud. The Senator noted that this bipartisan jobs bill seeks to replace outdated restrictions so that small businesses have new ways to access capital and can more effectively compete in the global marketplace. In addition, the legislation also includes a role for the states in providing oversight and regulation of intermediaries.

Crowdfunding offerings can be aggregate investment offerings of $1 million or less in any six month period. Companies seeking to raise larger amounts already have access to other funding methods. The Brown legislation exempts crowdfunding offerings and investments made through an intermediary from certain SEC requirements. Many of these costly requirements are prohibitive for startups, said Senator Brown, deter offerings altogether, and have little positive impact on smaller investment offerings.

The measure requires companies raising capital through crowdfunding to disclose risk, incorporate pursuant to state law, and register with the SEC. It also requires crowdfunding intermediaries to positively identify issuers and conduct background checks on their principals. Further, cash-management must be performed by a qualified third party such as a federally-insured bank or a traditional broker-dealer. Records must be kept to SEC standards.

Crowdfunding offerings would also be subject to the bad actor provision of the Dodd-Frank Act, which prevent known bad actors from participating in securities markets. More broadly, S 1791 establishes trust in the marketplace by ensuring that regulated crowdfunding sites do not engage in activities that pose a conflict of interest. Intermediaries are prohibited from offering investment advice, and their employees are prohibited from having any interest in any offering made through their firm.

S 1791 also provides a complaint process for investors and a variety of dispute resolution avenues. Finally, the legislation provides one nationwide standard for crowdfunding so that investors can depend on the same rules anywhere they invest in the country. Regulations that are understandable and credible to all parties are essential to the development of any market, emphasized Senator Brown.

The House of Representatives has earlier overwhelming passed bi-partisan legislation designed to enhance capital formation. The Entrepreneurial Access to Capital Act, HR 2930, sponsored by Rep. Patrick McHenry (R-NC) would allow crowdfunding to finance new businesses by allowing companies to accept and pool donations of up to $1 million, or $2 million in some cases, without registering with the SEC.

1 comment:

RLSeattle said...

Hey Jim,

Great article. There are so many crowd funding bills making it through the system nowadays it will be interesting to see what it looks like when/ if one successfully makes it through.

Do you have any insight on what kind of SEC regulation you would expect on one of these bills? I understand there is a period post passing that the SEC would have to impose specific regulatory requirements on both crowd funding companies as well as the platforms acting as intermediaries. Do you have any insight on what you would expect to see here?