House hearings focused on the implementation of the recently-enacted JOBS Act demonstrated a consensus that the SEC regulations implementing the Title III crowdfunding provisions will be critical in determining the efficacy of crowdfunding as a capital-raising mechanism. The hearings were held before the Financial Services Subcommittee of the House Oversight Committee, chaired by Rep. Patrick McHenry (R-NC), who authored the House version of Title III, which was replaced by a Senate version in the enacted JOBS Act. Chairman McHenry said that the Senate version of Title III contains imperfect language. He said that the Senate inserted provisions complicated crowdfunding and made sections of the Act ambiguous and inconsistent.
On the day the House concurred with the Senate Amendment to the JOBS Act, Chairman McHenry said that the Senate changes to Title III were ill-conceived and burdensome and misguided in seeing crowdfunding as simply unregulated activity. He pledged to work in a bi-partisan way to fix the legislation. (Cong. Rec., Mar 27, 2012, p. H1590).
At the hearing, Chairman McHenry noted that the SEC holds a great deal of discretion over the Title III implementing regulations and questioned whether this discretion could place at risk the viability of using crowdfunding. He spoke about using light-touch regulation in the area of crowdfunding.
Professor C. Steven Bradford, University of Nebraska Law School, said that there is a potential that regulatory cost could make crowdfunding not feasible to use. The professor urged that the SEC regulations implementing Title III be as light-handed and unobtrusive as possible. Chairman McHenry said that, while the disclosure piece is important, there is concern over the cost of compliance.
Ranking Member Mike Quigley (D-IL) said that Title III is a welcome step forward. He also noted that the regulatory restrictions rolled back by the JOBS Act were put in place for a reason. He acknowledged a fear of fraud. While Congress correctly judged that there were too many hurdles to raising capital, he observed, the SEC has to protect investors. The Ranking Member also emphasized that the regulations implementing the JOBS Act should not be placed before regulations implementing the Dodd-Frank Act.
Professor Bradford said that crowdfunding has the potential to spark a revolution in small business financing. Whether that happens will depend a great deal on the regulatory burden in that the SEC implementing regulations will determine the future usefulness of crowdfunding under Title III. Professor Bradford believes that regulations should be imposed on the crowdfunding intermediaries and not the entrepreneurs raising the funds. Brokers and funding portals can spread regulatory costs over a large number of offerings, he reasoned, and they will be more heavily capitalized than almost all of the entrepreneurs using the crowdfunding sites. By contrast, the small companies and entrepreneurs most likely to engage in crowdfunding are poorly capitalized and legally unsophisticated.
Professor Bradford also urged the SEC to adopt a substantial compliance rule to protect those who inadvertently violate a regulation so that a minor technical violation will not cause the loss of the exemption. Given the complexity of the exemption’s requirements, he noted, inadvertent violations are likely and the consequence of even a minor violation is drastic. He added that other Securities Act exemptions include substantial compliance rules that protect issuers if they fail to comply with the exemption in certain insignificant ways.
While acknowledging that nothing in the JOBS Act itself specifically authorizes the SEC to enact a substantial compliance rule, Professor Bradford noted that Section 302(c) of the JOBS Act gives the SEC blanket authority to issue such rules as the Commission determines may be necessary or appropriate for the protection of investors to carry out Sections 4(6) and 4A of the Securities Act.
He observed that the SEC has even broader authority in both the Securities Act and the Securities Exchange Act to exempt any person, security, or transaction from any provision of the statutes if the Commission determines that such exemption is necessary or appropriate in the public interest and is consistent with the protection of investors. Professor Bradford said that the Commission could use this authority to specify that an issuer that reasonably believed it met the requirements of Section 4(6) or that substantially complied with Section 4(6) would still be entitled to the exemption, in spite of the noncompliance.
Former SEC General Counsel Brian Cartright noted that the JOBS Act calls for SEC rulemaking to address 15 separate matters, in addition to necessary FINRA rulemaking. How all the rulemaking is crafted, noted the former GC, will help determine whether Title III assists capital formation for small ventures or becomes a dead letter. The former SEC official urged the Commission to rigorously analyze the anticipated compliance costs for relying on Title III.
In evaluating the costs, advised the former General Counsel, the SEC should include such items as the costs an intermediary will incur to build and maintain a compliance infrastructure sufficient to survive SEC and FINRA inspections, as well as any costs to address the heightened risks arising from the higher standard of liability Title III carries compared to other private offerings. The SEC should then determine the estimated fraction of the proceeds that would be consumed by those costs at varying offering sizes allowed by Title III. If, after a rigorous cost analysis, the SEC decides that those costs could render impractical the use of Title III, it should state this in order to alert Congress so that legislators can consider if additional legislation is needed.