The Anti-crowd Pleaser: Fixing the Crowdfund Act's Hidden Risks and Inadequate Remedies

• Jurisdiction: United States,Federal
• Publication year: 2013
• Citation: Vol. 63 No. 1

The Anti-Crowd Pleaser: Fixing the Crowdfund Act's Hidden Risks and Inadequate Remedies

David Mashburn

THE ANTI-CROWD PLEASER: FIXING THE CROWDFUND ACT'S HIDDEN RISKS AND INADEQUATE REMEDIES

ABSTRACT

A new form of startup financing is poised to turn the world of early-stage financing on its head. The Crowdfund Act—part of the Jumpstart Our Business Startups Act of 2012—will permit middle-class citizens to invest online in startups for the first time. After the SEC finishes its rulemaking, equity crowdfunding—modeled on the success of rewards-based crowdfunding websites, such as Kickstarter and Indiegogo—will allow startups and eligible small businesses to raise up to $1 million over a twelve-month period by issuing equity shares to mom-and-pop retail investors through online "funding portals."

A swelling tide of scholarship, media reports, and security industry publications warns about the risk of fraud inherent in the online selling of equity shares in startups to unsophisticated investors. However, this literature largely omits discussion of the problems with the new civil liability provision included in the Crowdfund Act—an express private action provision that will raise the transaction costs of crowdfunding and ensnare unwary issuers in its liability trap. In an attempt to address the fraud concern, Congress drafted this new civil liability provision as well as a detailed and extensive set of disclosure requirements for issuers to navigate. The new liability provision, which broadens the language of Section 12(a)(2) of the Securities Act of 1933, imposes liability on the issuer and its officers and directors for false or misleading statements or omissions in any written or oral communication. A plaintiff need only prove that an untrue statement or misleading omission occurred and that the defendant did not exercise reasonable care, even if loss causation, reliance, and scienter are not shown.

This Comment analyzes the hidden transaction costs in the Crowdfund Act, particularly the severe liability cost this provision imposes on issuers. Crowdfunded offerings present a new environment in which innocent but inexperienced entrepreneurs face increased risk of making a misstatement or misleading omission. Crowdfunded offerings confront a number of issues not faced by mature companies making public offerings, including the high failure rate of startups, the difficulty of working with emerging technology, the

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entrepreneurial psychological predisposition to risk, a lack of sophisticated disclosure assistance, and a dearth of due diligence.

This Comment argues that the new liability provision not only will sweep too broadly—indiscriminately catching negligent entrepreneurs and fraudsters in its swath—but will also fail to provide an effective remedy for defrauded investors. Given the relatively small amount of money in play in a crowdfunded offering and the expense and difficulty of bringing a class action securities lawsuit, plaintiffs' attorneys are unlikely to pursue cases involving fraudulent behavior. This Comment concludes that the best solution to both issues is to impose scienter as an element of the civil liability provision while also awarding attorneys' fees to plaintiffs' attorneys successful on the merits at trial. This solution will decrease the up-front and hidden transaction costs for issuers and will incentivize plaintiffs' attorneys to pursue issuers committing fraud. Finally, this solution continues the SEC's goal of balancing securities regulations to protect investors and the integrity of the market, while keeping transaction costs low enough to maintain the utility of the market as this revolutionary experiment in startup financing takes root.

INTRODUCTION..............................................................................................129

I. THE BACKGROUND OF CROWDFUNDING............................................135

A. The Evolution of Crowdfunding................................................. 136
B. The Startup Capital Funding Gap.............................................. 139
C. The Legislative History of the Crowdfund Act........................... 143

II. THE HIGH TRANSACTION COSTS OF CROWDFUNDING.......................146
III. LIABILITY PROVISION 4A(C)—DRACONIAN FOR ISSUERS AND AN INEFFECTIVE REMEDY FOR INVESTORS..............................................151

A. Current Section 12(a)(2) Elements and Applications................. 151
B. Crowdfunding's New Liability Dynamic.................................... 155

1. The Increased Risk of Material Misstatements or Omissions for Startups in a Crowdfunding Offering............ 157
2. The Likelihood of Plaintiffs' Attorneys Bringing Suit Under 4A(c).......................................................................... 165

IV. RECOMMENDATIONS FOR CONGRESS AND ISSUERS ...........................169

CONCLUSION..................................................................................................173

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INTRODUCTION

When startup Pebble Technology founder Eric Migicovsky needed additional funding to take his invention, a "smartwatch" that pairs with smartphones and runs apps, from prototype to production, he started off on the traditional road—he pitched his idea to the established venture capital firms in Silicon Valley.¹ But, as is frequently the case, the traditional venture capital firms turned Migicovsky down.² Migicovsky's startup then took a new, but increasingly common, approach: it turned to "the crowd" for funding. In April 2012, Pebble Technology posted a funding pitch on Kickstarter, a crowdfunding website, estimating delivery of a Pebble Watch by september to each person who contributed $115 or more to the venture.³ Pebble Technology set its funding goal at $100,000.⁴ Within about twenty-eight hours, Pebble Technology had raised $1 million.⁵ Within thirty-seven days, Pebble Technology had raised $10,266,845—more than 102 times its goal—without ceding any ownership in the company to investors.⁶

The biggest problem for crowdfunded ventures, such as Pebble Technology? Living up to their own promises. Pebble Technology shipped the first of its black smartwatches in late January 2013, missing its estimated delivery date by four months.⁷ Most of Pebble Technology's color smartwatches shipped during spring 2013, although supporters that ordered white smartwatches were still awaiting delivery in July 2013⁸ Even with this delay of more than ten months for certain smartwatch backers, Pebble Technology actually came closer to meeting its estimated delivery date than many large crowdfunded projects on Kickstarter.⁹ This problem—failing to

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achieve production timetables and delivery promises—is endemic among technology startups on Kickstarter and exemplifies the risks and obstacles startups face.¹⁰

Despite these issues, crowdfunding possesses enormous potential for revolutionizing startup financing and jumpstarting the lagging U.S. economy.¹¹ Kickstarter is an example of a reward crowdfunding site where donors receive rewards, such as products or small perks, in exchange for donations as seen in the Pebble Watch story. Now, a new type of crowdfunding is in the works—equity crowdfunding. In the spring of 2012, congress passed, and President Obama signed, the Jumpstart Our Business Startups Act of 2012 (JOBS Act).¹² A central provision in the JOBS Act, Title III: Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (Crowdfund Act), mandates that the Securities and Exchange Commission promulgate rules creating a registration exemption to the Securities Act of 1933 (Securities Act) for crowdfunded offerings sold to retail investors, meaning individual, small investors, via registered online funding portals or brokers.¹³ In equity crowdfunding, the investor receives equity, meaning a share of the company, instead of simply a reward or product.¹⁴ Until the SEC promulgates these rules—most likely in early 2014—equity crowdfunding will remain illegal.¹⁵

Securities regulations do not apply to reward crowdfunding sites, such as Kickstarter, which allows them to operate sans SEC oversight.¹⁶ But what if a Pebble Watch scenario occurred in the forthcoming SEC-regulated equity crowdfunding? Thanks to the new civil liability provision in the JOBS Act, Eric Migicovsky and Pebble Technology would be on the hook for all the

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money raised, plus interest, if Migicovsky or any Pebble Technology officer, director, or partner made a material misstatement or omission in a written or oral communication to the SEC or to Pebble Technology's investors.¹⁷ This liability applies even if the misrepresentation was "merely negligent, not intentional,"¹⁸ such as setting the September 2012 shipping date, for example. This Comment will closely examine the new civil liability provision in the JOBS Act.

The JOBS Act is, as its name suggests, intended to jumpstart economic development and job creation by easing restrictions on startups seeking to raise capital.¹⁹ Based on the obvious and inevitable risk of fraud inherent in an online funding system involving unsophisticated investors,²⁰ Congress drafted detailed, extensive, and complicated disclosure requirements for issuers using crowdfunding.²¹ These hurdles will increase the transaction costs associated with raising a relatively small sum of money through crowdfunding.²² Along with the substantive disclosure requirements, Congress also drafted a new liability provision—referred to as Section 4A(c) throughout this Comment—that borrows almost verbatim from the language of Section 12(a)(2) of the Securities Act.²³ Section 12(a)(2), at least in theory, imposes civil liability on issuers for false or misleading statements or omissions in an oral statement or in a prospectus for a public offering.²⁴ This Comment argues that Section 4A(c) sweeps too broadly, raises further the already high transaction costs in

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