Securities Regulation - an Sec-mandated Asset Verification System for Unaccredited Investors Must Be Added to the Proposed Regulatory Regime Under Title Iii of the Jobs Act

• Publication year: 2014

Securities Regulation - An SEC-mandated Asset Verification System for Unaccredited Investors Must Be Added to the Proposed Regulatory Regime Under Title III of the JOBS Act

Harrison Jones

SECURITIES REGULATION—AN SEC-MANDATED ASSET VERIFICATION SYSTEM FOR UNACCREDITED INVESTORS MUST BE ADDED TO THE PROPOSED REGULATORY REGIME UNDER TITLE III OF THE JOBS ACT

Introduction

Under traditional startup fundraising models, businesses in their infancy typically obtain financial support from a handful of seasoned investors capable of contributing millions.¹ Crowdfunding stands in diametric opposition to this tradition.² Put simply, crowdfunding is an emerging fundraising technique that generates capital by seeking smaller individual contributions from a larger number of people.³ Crowdfunding democratizes an entrepreneur's access point to the capital market by empowering the masses to financially contribute to ideas that they find intriguing.⁴ A recent addition to the JOBS Act is set to take crowdfunding, once perceived as the avant-garde cousin⁵ of traditional equity fundraising, and place it directly at the forefront of a revolution in small-business financing.⁶

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On October 23, 2013, the crowdfunding landscape changed dramatically.⁷ After more than fifteen months of delays, the Securities and Exchange Commission issued its formal proposal of Title III to the JOBS Act.⁸ Once enacted, Title III will lift the ban on general solicitation for securities purchases, allowing emerging growth companies⁹ to advertise their fundraising endeavors and engage in equity crowdfunding in an open market for the first time in more than eighty years.¹⁰

The ban was to be lifted in two parts, first with Title II, and second with Title III. Title II of the JOBS Act allowed emerging growth companies to advertise and solicit investments from accredited investors.¹¹ The SEC strictly regulates which entities can call themselves an "accredited investor," and reserves the category only for institutions such as banks, insurance companies and registered investment companies, as well as individuals with a net worth of more than $1 million, or an annual income above $200,000.00.¹² Once fully implemented, Title III of the JOBS Act will open the market further by allowing general solicitation of investments from the public at large. Anyone with access to a computer will now also have access to registered funding portals where they can request and receive capital.¹³ The most optimistic proponents of Title III estimate that it will unleash a new wave of capital into the U.S. investing market to the tune of $300 billion.¹⁴

I. Regulations to Prevent Fraud on the Market

There is a well-established body of scholarship that has voiced concerns over protecting unsophisticated investors from potential fraud in equity

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crowdfunding.¹⁵ The Securities and Exchange Commission no doubt shares these concerns, as the vast majority of the 568-page proposed Title III regulation deals with reporting and disclosure requirements aimed at minimizing the prevalence of fraud on the market.¹⁶

One key regulatory proposal to Title III of the JOBS Act addresses control over how much each unaccredited investor may invest in a twelve-month window. These investment caps are rooted in a bifurcated system based on net worth.¹⁷ An individual with a net worth of less than $100,000.00 may not contribute more than the greater of $2,000.00 or five percent of annual income.¹⁸ Individuals with a net worth greater than $100,000.00 may contribute 10% of their annual income so long as the total contribution does not exceed $100,000.00 in a twelve-month period.¹⁹

II. The Proposed Regulation's Deficiency

As currently written, the income-cap regulations for potential investors lack teeth. Nowhere in the regulation is there a provision that requires crowdfunding platforms to verify the income or assets of unaccredited investors. The system is based entirely on unchecked self-reporting by unsophisticated investors.²⁰ There is nothing that prevents an investor from lying about their assets, or making common mistakes in their calculation, such as including the value of their home in their net worth.²¹ This creates a troublesome scenario for the future of crowdfunding. The current scholarly discussion seems to be exclusively focused on protecting the unaccredited investors from the emerging growth company. This one-sided focus begs the question: should the Securities and Exchange Commission also be concerned about protecting unaccredited investors from themselves?

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III. The Need For SEC-Mandated Asset Verification for Unaccredited Investors

By failing to create an asset verification process for unaccredited investors, the Securities and Exchange Commission has created a strange dichotomy in its regulatory regime. When the first wave of solicitation restrictions was lifted under Title II of the JOBS Act, the SEC raised the level of diligence for companies when verifying the status of purchasers as accredited investors.²² Accompanying Title II of the JOBS Act was a newly-amended Rule 506(c), which requires companies to verify the assets of an accredited investor.²³ The new rule states that, "the issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under paragraph (c) of this section are accredited investors."²⁴ The Securities and Exchange Commission even goes as far as to provide a list of suggested methods to perform this verification.²⁵ To verify assets, the SEC suggests verifying bank statements, brokerage statements, statements of other securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties.²⁶ For liabilities, the commission suggests reviewing a consumer report from at least one of the...