Squalls in the safe harbor: investment advice & regulatory gaps in regulation crowdfunding.

AuthorOlson, Ethan
  1. INTRODUCTION II. BACKGROUND A. Crowdfunding in the Pre-JOBS Act Era 1. Crowdfunding Offerings as Securities 2. The Legal Status of Crowdfunding Sites B. The JOBS Act C. Funding Portals: What Are the Requirements? D. Regulation Crowdfunding 1. Limiting Offerings 2. Highlighting Issuers & Offerings 3. Providing Communication Channels 4. Various Other Activities III. ANALYSIS A. Investment Advice & the Investment Advisers Act of 1940 B. SEC Guidance & the Broad Construction of "Investment Advice" 1. Activeness 2. Level of Choice C. Regulation Crowdfunding Safe Harbor "Gaps" 1. Removal Provisions 2. Crowd Rating Systems IV. RECOMMENDATION A. The Crowd and Its Effectiveness as a Self-Regulating Body B. Venturing Outside the Safe Harbor 1. The SEC Should Allow Funding Portals to Implement Removal Provisions with Published Objective Criteria 2. The SEC Should Prohibit Portals from Creating Crowd Rating Systems for Offerings or Issuers V. CONCLUSION I. INTRODUCTION

    In recent years, the crowdfunding website Kickstarter (1) has risen in popularity. Since its launch in April of 2009, more than five million people have pledged more than one billion dollars to projects. (2) Hopefuls can list a proposed project on the website, with a funding goal and deadline, and if enough people pledge money to the project, it gets funding. (3) Other sites similar to Kickstarter, such as Indiegogo, (4) and RocketHub, (5) have also flourished. (6)

    The obama administration has recognized and stressed its belief that small startup businesses are an important part of the country's economic recovery after the financial crisis of 2008. (7) The purpose of the Jumpstart Our Business Startups Act (JOBS Act) is to assist small businesses by importing the crowdfunding model the above mentioned websites popularized, and "allow Main Street small businesses and high-growth enterprises to raise capital from investors more efficiently, allowing small and young firms across the country to grow and hire faster." (8) While Kickstarter operates on a "reward" model, (9) the JOBS Act's contemplated crowdfunding schemes operate on an "equity" model. (10) Eager issuers (11) post their offerings on crowdfunding sites, known as funding portals, (12) in the hopes of garnering enough attention from potential investors to reach their funding goals and start their businesses. While funding portals are subject to a host of regulations, (13) the JOBS Act also prohibits them from offering potential investors "investment advice." (14)

    The Senate passed the JOBS Act on March 22, 2012, after a bipartisan effort; the House of Representatives approved it on March 27, 2012. (15) President Obama signed the bill into law on April 5, 2012. (16) With its passage, the JOBS Act directed the Securities and Exchange Commission (SEC) to issue regulations to implement the JOBS Act's crowdfunding provisions within one year. (17) The SEC opened an initial public commenting period on the JOBS Act's crowdfunding provisions, but it did not issue any proposed rules until October 23, 2013. (18) The proposed rules provide no definition of "investment advice," though they do create a safe harbor for certain activities. (19)

    This Note examines the JOBS Act's various provisions and the proposed SEC rules. It then analyzes how the SEC has construed the term "investment advice" in the past and discerns two standards that the SEC appears to use in this context. This Note then applies these standards to two provisions that fall between the gaps of the safe harbor in the proposed rules: an offering removal provision and a crowd rating system provision, and then determines whether either would constitute investment advice under the prior SEC standards. This Note then argues that, because of the unique role the "crowd" plays in crowdfunding schemes and the tension between providing low-cost capital financing and investor protection, an activity that may constitute investment advice under traditional SEC analysis would not constitute investment advice if performed by a funding portal, and vice versa.

  2. BACKGROUND

    At its most basic level, crowdfunding is a form of capital financing that utilizes relatively small investments drawn from a large group of people, usually facilitated through internet transactions. (20) The concept of crowdfunding as a capital financing scheme is not new, but it has recently gained popularity in the wake of the 2008 financial crisis. (21) The impetus driving the crowdfunding initiative is democratized access, both by small businesses to low-cost capital financing (22) as well as by the general public to input in emerging growth sectors and industries. (23) This democratizing impulse is apparent in crowdfunding schemes wherein "[a]nyone who can convince the public he has a good business idea can become an entrepreneur, and anyone with a few dollars to spend can become an investor." (24) This proposition rings even more true when one considers the ubiquity and importance of the Internet in connecting people together and sharing information and opportunities in today's society. (25)

    Crowdfunding has its conceptual origins in two distinct principles: crowdsourcing and microfinance. (26) Microfinance was developed in the late-1970s primarily to design a banking and credit system targeting the rural poor in developing nations, such as Bangladesh. (27) It traditionally involves issuing small, low-interest, unsecured loans (of about $50-$500), repayable in installments. (28) Grameen Bank is the most prominent microfinance platform, (29) disbursing more than $15 billion since its inception and currently servicing over 81,000 villages worldwide. (30) Crowdfunding is the conceptual "inverse of microfinance; instead of one institution making loans to thousands of individuals, crowdfunding allows thousands of individuals to make contributions to a single entrepreneur or business." (31)

    Crowdsourcing, like crowdfunding, draws on the power of a large and diversified group of contributors to undertake a task in a collaborative manner. (32) As opposed to crowdfunding, which contemplates monetary contributions, crowdsourcing asks the crowd to contribute labor to the project. (33) Generally, crowdsourced projects are completed online, and contributors tend not to be employees or contractors but instead work on a voluntary basis. (34) Well-known and successful examples of crowdsourcing efforts include Wikipedia, the online encyclopedia, and the user-generated restaurant reviewing site Yelp!. (35)

    Microfinance is defined in reference to its recipients: those without access to traditional banking and lending infrastructure. (36) Crowdsourcing is defined in reference to its contributors: a large and diversified "crowd" working together to further a common goal. (37) Crowdfunding is thus a synthesis of both of these concepts: a group of people working together to fund an emerging business that struggles to access traditional forms of capital financing. (38)

    1. Crowdfunding in the Pre-JOBS Act Era

      Prior to the JOBS Act's passage in early 2012, (39) crowdfunding occupied an indeterminate position in the federal securities laws. (40) The primary concern underlying the pre-JOBS Act crowdfunding schemes was the extent to which such schemes were subject to the various federal securities laws' stringent registration and reporting requirements. (41) The remainder of this section discusses this concern by examining whether crowdfunding schemes offered securities in the pre-JOBS Act era and crowdfunding schemes' organizational status at the time.

      1. Crowdfunding Offerings as Securities

        Section 5(c) of the Securities Act of 1933 (Securities Act) requires any business offering sale of securities to register those securities with the SEC or qualify under one of the available exemptions. (42) Thus, if crowdfunders did not offer crowdfunding investments as securities, there would be no breach of the Securities Act. As a result, the SEC would not require crowdfunders to register their offerings, and crowdfunding schemes could continue operating without fear of violating the Securities Act's registration requirements.

        Under the Supreme Court's test in SEC v. W.J. Howey Co., (43) an "investment contract"--a catch-all category in the Security Act's definition of "security"--is a "contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party." (44) Since Howey, the "solely" of the latter portion of the test has shifted to an analysis of the "undeniable significance" of a third-party promoter's actions. (45) Under this test, it is likely that any crowdfunding scheme offering equities (such as stocks) or operating on a peer-to-peer lending model (46) with investors expecting to make a profit (47) would fall under the Howey definition of "investment contract" and thus constitute a security. (48)

        Therefore, pre-JOBS Act crowdfunding schemes had to choose whether to register their offerings with the SEC or to seek refuge in one of the several exemptions to registration. The cost and time associated with registration prevent most small businesses from registering. (49) Indeed, the cost of registration (50) could exceed the target amount of capital being raised for many crowdfunded offerings, an impact that is doubly prohibitive considering that crowdfunded operations usually need to raise capital quickly. (51) Instead, any pre-JOBS Act crowdfunding offering would have had to find its way into one of several registration exemptions. (52)

        Most notably, sections 4(2) (53) and 4(5) (54) of the Securities Act, as well as Regulations D (55) and A (56) (and their attendant rules) could provide viable alternatives to crowdfunding registration. (57) Unfortunately, none of these are conducive to the crowdfunding model. Many of the exemptions preclude issuers from making general solicitations to the public...

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