Crowdfunding & investor education: empowering investors to mitigate risk & prevent fraud.

• Author: Friesz, Cody R.

"I also requested that the staff think creatively about what the SEC can do to encourage capital formation, particularly for small businesses, while maintaining important investor protections." (1)

1. INTRODUCTION

   Small businesses are imperative in the United States economy. (2) Small businesses make up 99.7 percent of all employer firms in the United States. (3) These firms employ nearly fifty-five million individuals and provide 42.6 percent of the nation's private-sector payroll. (4) In addition, small businesses are job creators. (5) Between 1993 and 2013, small businesses accounted for 14.3 million net new jobs, sixty-three percent of net new jobs during that period. (6) Further, these firms are responsible for sixty percent of the net new jobs created since the most recent recession. (7) Additionally, in March 2011, about 900,000 self-employed individuals were unemployed the prior year. (8)

   Small businesses, despite their prominence in the economy, account for the vast majority of firm failures. (9) One cause of these failures is inadequate capital. (10) The lack of capital is caused, in part, by the small business capital gap. (11) In order to strengthen the small business environment, the United States economy must bridge this gap.12 One way to address the disparity between small business capital demand and supply is through the further development of crowdfunding. (13)

   Crowdfunding is the raising of small amounts of capital from a large number of people, the "crowd." (14) It is a combination of crowdsourcing and microfinancing, and a number of crowdfunding models have emerged: donation, reward, pre-purchase, lending, and equity. (15) The crowdfunding models are explained below in Part II.A. (16) To date, these crowdfunding models have raised billions of dollars. (17) Equity crowdfunding, however, has been significantly underutilized. (18) This underutilization is due to the lack of certainty concerning crowdfunding and its interplay with current securities laws. (19) The Securities and Exchange Commission's (SEC's) proposed regulations have helped create some certainty and could aid in closing, or at least shrinking, the capital gap. (20) Certainty alone, however, is not enough; the regulations must also find a balance between investor protection and capital formation. (21) This Note discusses how incorporating a stronger investor education mechanism into the regulations could achieve the appropriate balance. (22)

   Part II of this Note will examine the historical aspect of this issue. (23) It begins by describing crowdfunding, its different models, and its evolution in the United States. (24) Part II goes on to discuss the Securities Act of 1933 ('33 Act), including the rationale motivating the adoption of United States securities laws. (25) This discussion will include an analysis of the relevant provisions of the '33 Act. (26) Finally, Part II will culminate with an explanation of the framework for regulating crowdfunding provided by the Jumpstart Our Business Startups Act (JOBS Act) and the SEC's proposed crowdfunding rules. (27)

   Part III will discuss how the SEC can balance investor protection with capital formation by strengthening the regulation's investor education component. (28) By strengthening the educational requirements, the SEC could relax other regulations without compromising investor protection. (29) Further, Part III suggests that a regulatory system built on disclosure, such as this, is not meaningful if investors are not provided the education needed to understand and utilize the disclosures. (30) Lastly, Part IV summarizes the major themes in this Note and solidifies the importance of a balanced and responsible approach toward regulating crowdfunding. (31)

2. HISTORY

   To better appreciate the challenges in regulating crowdfunding, it is important to first develop a basic understanding of the crowdfunding phenomena and the United States securities laws. (32) This section first discusses the evolution of crowdfunding--where it evolved from and the forms it takes today. (33) Next, it will look at the history of the United States securities laws and outline provisions relevant to this discussion. (34) By describing both crowdfunding and the securities laws, this section will highlight the unique challenges that crowdfunding creates for securities regulators. (35)

   1. Crowdfunding

      Crowdfunding is the process of raising money from a large number of contributors who typically contribute small amounts through the use of the Internet or social media. (36) It evolved from the combination of two other practices: crowdsourcing and microfinancing. (37) Crowdsourcing is the process of taking on an overwhelming task by farming out small, manageable tasks to the "crowd." (38) Microfinancing is the lending of small amounts of money to an individual or enterprise in need. (39) Thus, together, crowdsourcing and microfinancing create crowdfunding: raising small amounts of money- microfinancing--from a large number of people--crowdsourcing. (40)

      While the phenomena has become prevalent in recent years, the underlying concept behind crowdfunding has been around for some time. (41) In fact, crowdfunding theory has its roots in the eighteenth century when Alexander Pope used the basic concept to finance his endeavor to translate ancient Greek poetry into English. (42) Although the idea of crowdfunding is not new, its utilization of the Internet and social media is. (43) The concept moved to the Internet in the mid-1990s. (44) Two of today's more notable crowdfunding sites, Indiegogo and Kickstarter, however, were not launched until 2008 and 2009, respectively. (45)

      Crowdfunding has grown significantly since 2009. (46) In 2009, global crowdfunding platforms raised approximately $530 million. (47) Since then, the amount raised through these platforms has grown by nearly 950%. (48) The 2013 estimate for global funds raised through crowdfunding platforms exceeds five billion dollars. (49) The phenomenon is excepted to continue to grow; in fact, a World Bank report estimates that crowdfunding in the developing world could raise ninety to ninety-six billion dollars a year by 2025. (50)

      Five different methods of crowdfunding have evolved in recent years: donation, reward, prepurchase, lending, and equity. (51) In the donation model, contributors give money to a cause and receive nothing in return. (52) This does not mean the cause needs to be charitable in nature. (53) For-profit ventures can use the donation model to raise funds, but as a practical matter, most donation model activity is from charities and other nonprofit organizations. (54)

      The reward and prepurchase models are similar and treated together. (55) In both models, contributors receive something in return for their contribution, but not an interest or share in business earnings. (56) In the reward model, donors often receive a nominal gift, such as a key chain or their name listed as a project contributor, but the reward can be more extravagant, for example, dinner with a celebrity or a trip to see a band play live. (57) The prepurchase model is similar, but instead of receiving a reward, contributors receive the product the business is raising money to manufacture or create. (58)

      In the lending model of crowdfunding--sometimes referred to as peer-topeer lending--contributors give funds with the expectation that they will be repaid. (59) This model takes two forms. (60) In one form, contributors are repaid only the principal amount--the amount they loaned to the recipient. (61) In the other form, contributors receive the principal amount plus interest. (62)

      The final crowdfunding model is equity crowdfunding. (63) Here, donors make contributions to entrepreneurs and in turn expect a share in the profits of the business. (64) To date, there are no major equity crowdfunding sites in the United States that are publicly accessible, largely due to the uncertainty over how the practice relates to securities laws. (65) Most crowdfunding models do not raise securities regulations concerns. (66) Securities laws, however, likely have implications on equity crowdfunding and that model will be the focus of this Note. (67)

   2. Securities Laws

      Following the stock market crash of 1929 and during the ensuing Great Depression, Congress adopted the '33 Act and the Securities Exchange Act of 1934 ('34 Act). (68) In developing these Acts and the regulations that followed, Congress and the SEC had two competing interests in mind: protecting investors and facilitating capital formation. (69) For the purposes of this Note, only the '33 Act is addressed. (70)

      The '33 Act, to effectuate its competing underlying policy interests, requires securities issuers to make certain disclosures and creates liability for noncompliance, material misstatements and omissions, and fraud. (71) First, section five prohibits offering or selling securities until such securities are registered with the SEC and the registration statement becomes effective. (72) Certain securities and offerings, however, are exempt from the registration requirement. (73) To register securities, the issuer--the company selling the securities--must submit a registration statement to the SEC. (74) That statement must include operating and financial disclosures about the issuer, information about the securities being offered, and details about the plan of distribution for the securities. (75) The registration process is time consuming and often extremely expensive. (76) In many cases, the registration costs, which can exceed $100,000, may outweigh the benefit of offering securities, particularly for companies raising limited amounts of capital. (77) Thus, the registration requirements have the effect of excluding small and startup businesses from the public capital market. (78) The practical exclusion of small and startup businesses from the public capital market is why many have advocated for a...