How the SEC's crowdfunding rules for funding portals save the two-headed snake: drawing the proper balance between integrity and cost.

• Author: Archambault, Patrick

"Has not the famous political Fable of the Snake, with two Heads and one Body, some useful Instruction contained in it? She was going to a Brook to drink, and in her Way was to pass thro' a Hedge, a Twig of which opposed her direct Course; one Head chose to go on the right Side of the Twig, the other on the left, so that Time was spent in the Contest, and before the Decision was completed, the poor Snake died with thurst." (1)

1. INTRODUCTION

   On October 30, 2015, the Securities and Exchange Commission (SEC) adopted final rules to implement equity crowdfunding under Title III of the Jumpstart Our Business Startups Act (JOBS Act). (2) The SEC approved the final rules, named Regulation Crowdfunding, by a three to one vote, establishing the regime under which small businesses and startups can raise capital from individual investors online. (3) For the first time, unaccredited investors can invest a relatively small dollar amount of capital in securities, which private businesses offer over the Internet. (4)

   Crowdfunding is gaining wide-scale attention because of its seamless capacity to raise capital online. (5) The Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act (CROWDFUND Act), which is Title III of the JOBS Act, provides a crowdfunding exemption that allows the public to invest in small businesses. (6) The CROWDFUND Act requires entrepreneurs and investors to exchange capital through an intermediary, which is an online website. (7) The CROWDFUND Act requires intermediaries--or "gatekeepers"--to register with the SEC as either a broker or a funding portal. (8) Thus, intermediaries are the lynchpin of the CROWDFUND Act because they provide essential and early-stage investor protection. (9)

   For many small entrepreneurs, starting a new business is a risky endeavor. (10) Often, a startup business struggles to procure investors and financing, especially when the business has no operating profit. (11) Largely due to the significant risk associated with starting a new business, the usual sources of funding--loans from family and friends, bank loans, venture capital, and retained earnings--are not commonly available to small startups. (12) This funding gap means many potentially successful business ventures fail because they are unable to procure adequate funding. (13)

   Like with crowdsourcing, pooling from the public to finance startups and small businesses offers an opportunity to close this funding gap. (14) By definition, crowdsourcing is an exchange and procurement of ideas or content through the request of contributions from large groups online. (15) Equity crowdfunding is a new concept originating from nonequity forms of crowdfunding, often referred to as reward crowdfunding. (16) Unlike reward crowdfunding, equity crowdfunding donors do not receive a product in exchange for their financial contributions. (17) The issuing startup, instead, provides donors with unregistered securities. (18) A security is an interest in a company that provides that security holder with the right to share profits. (19) In 2012, Congress signed the equity model of crowdfunding for unaccredited investors and small businesses into law as the CROWDFUND Act. (20)

   The CROWDFUND Act required the SEC to adopt rules to facilitate equity crowdfunding. (21) Although the final rules do not go into effect until 180 days after publication in the Federal Register, preliminary observations can be made. (22) Both the CROWDFUND Act and the SEC's final rules impose restrictions for intermediaries, particularly for the newly introduced funding portals. (23) These restrictions raise the question of whether or not the SEC's rules create an appropriate balance between adequately protecting unaccredited investors and allowing funding portals to act as gatekeepers. (24) The specific concern to investors in donating capital to these funding portals is that investments may be subject to fraud. (25) Due to funding portals' novelty, this Note pays special attention to funding portals in the context of the SEC's final rules. (26)

   This Note argues that the SEC's rules for funding portals are well founded because the rules cost-effectively solidify funding portals' gatekeeping function as legitimate, in establishing the new, low-cost entity known as the Form Funding Portal (Form FP). (27) Form FP will allow funding portals to initiate and operate business at lower costs than operating business using the more traditional Form Broker-Dealer (Form BD) because the Form FP will allow funding portals to charge issuers lower prices than those normally charged to brokers asking for service fees. (28) Further, this Note argues that the SEC's rules for intermediaries--particularly funding portals--adequately protect investors by ensuring the crowdfunded startups seeking investments are bona fide issuers and legitimate operators. (29) The SEC granted funding portals broad discretion for cancelling issuers that present a risk of fraud, which emphasizes the SEC's desire to establish funding portals as an integrity-enhancing conduit. (30) The SEC's rules for funding portals also strengthen investor protection by requiring funding portals to provide communication channels, to transmit funds to issuers and investors through third parties, and to mandate investor education. (31)

   Part II of this Note inspects the background and history of equity crowdfunding, with a focus on the incorporation of intermediaries in securities law. (32) Further, Part II discusses the legislative history of the JOBS Act and the rationale for amending the Securities Act of 1933 ('33 Act). (33) The pinnacle of Part II examines the most crucial aspects of the SEC's rules for funding portals. (34) Part II.A focuses primarily on the legislative history and purpose of the JOBS Act and CROWDFUND Act. (35) Part II.B.1 then focuses on the CROWDFUND Act requirement for funding portals. (36) Part II.B.2 focuses on the SEC's final rules. (37)

   Part III argues that the SEC's rules properly and efficiently regulate funding portals. (38) The SEC demonstrates mindfulness and commitment to balancing both funding portals' economic interests with Form FP and investor protection by way of mandatory investor education. (39) Further, Part III suggests the SEC's rules for funding portals facilitate openness and transparency through communication channels, which will likely reduce fraud. (40) Finally, Part IV summarizes the SEC's rulemaking dilemma for balancing the interests of business with investor protection. (41)

2. HISTORY

   1. A Background of JOBS Act's Crowdfunding Provision

      1. The CROWDFUND Act Exemption

         The legislative purpose of the JOBS Act is to increase American jobs and foster economic growth in broadening small companies' access to the public capital markets. (42) Permitting equity crowdfunding is one of several JOBS Act initiatives designed to advance this objective. (43) Crowdfunding law diverges from the long-settled laws for public offerings of securities. (44) A featured principle of crowdfunding is that public, online crowds of possible investors may examine small businesses' proposed offerings and provide contributions. (45) Generally, whenever a company (whether a large corporation or a small startup) offers the public exchange of securities, the company's securities must register with the SEC unless it satisfies an exemption. (46)

         Small startup companies seeking only a relatively small amount of capital normally find it burdensome to register with the SEC because it consumes too many resources. (47) Accordingly, the CROWD FUND Act aims to rectify this burden by balancing efficient and affordable oversight while reducing the risk of fraud for unaccredited investors. (48) Although smaller offerings are less burdensome to register than larger offerings, smaller offerings are still likely to face excessive costs. (49) To alleviate this capital-raising shortcoming for small businesses and startups, the CROWDFUND Act amends Section 4 of the '33 Act by exempting transactions from registration where the total amount an issuer sells to all investors is not more than $1,000,000. (50) This exemption is targeted at increasing small businesses' access to capital, without imposing burdensome regulations on small businesses and intermediaries. (51)

      2. Bipartisan Support, Economic Revitalization, and Democratizing Securities

         The JOBS Act received strong bipartisan support, with the House of Representatives passing the bill 390 to 23 and the Senate passing it 73 to 26. (52) Although Congress designed the CROWDFUND Act to boost economic activity, some lawmakers and commentators argued it leaves unaccredited investors vulnerable due to their unfamiliarity with investing. (53) Other critics claim that the CROWDFUND Act invites unaccredited investors to make risky investments in highly speculative businesses with large chances of illiquidity. (54) Lawmakers intended, however, to rebut these claims through protecting unsophisticated investors with modest income from fraud and overinvesting by restricting the amount one may invest per year and by requiring preinvestment education for all crowdfunding donors. (55) Furthermore, unsophisticated investors, despite critical speculation, had already been investing in unregulated crowdfunding offerings, albeit not in exchange for equity. (56)

         The JOBS Act purported to revitalize a languid economy by allowing small businesses to gain capital from broader, public contributions. (57) The JOBS Act's major goals were to increase job creation and entrepreneurial activity and to promote economic growth, through public access to capital markets for startups. (58) More specifically, Congress designed the CROWDFUND Act to help reduce both the funding gap and regulatory restraints that startups and small businesses encounter when seeking to obtain capital in relatively low dollar amounts. (59) Congress was eager to boost economic growth in light of...