SEC Commissioner Kara M. Stein and Acting Chairman Michael S. Piwowar expressed optimism and concern over the future of the crowdfunding market. The discussion took place at the recent SEC-NYU Dialogue on Securities Market Regulation.
Acting Chairman Piwowar, who dissented from the adoption of the Commission’s crowdfunding rules in 2015, stated that “innovation, creativity, and job creation from small businesses are an essential component to fostering long-term economic growth.” He added that “capital formation through crowdfunding permits the investing public to allocate capital to its most productive use.” The acting chairman recognized that in its current state, the crowdfunding market may not appear to be a significant avenue to capital formation, but he pointed out that this is an entirely new funding channel that allows many entities to raise funds that otherwise may have had no access to capital.
He echoed his 2015 dissent, however, when he closed his remarks by stating that he was concerned about whether the final rules were too restrictive or too burdensome. In 2015, he objected to both the overall cap on annual investment and the annual income and net worth tests. He noted that even Warren Buffett or Bill Gates would be limited to investing no more than $100,000 during any 12-month period in all crowdfunding investments. In addition, he observed in 2015 that the income and net worth tests would “discourage legitimate companies from engaging in crowdfunding, while simultaneously encouraging less reputable actors to use affinity-based solicitation methods akin to multi-level marketing, a development that could stifle crowdfunding efforts.” The acting chairman once again called on the Commission to consider whether any further steps should be taken to improve the crowdfunding regulations, including the use of exemptive authority.
Commissioner Stein addressed three key challenges in the crowdfunding market. The first is the role of the funding portals as gatekeepers. She noted that through January 2017, issuers withdrew 27 crowdfunding offerings. Of these 27 offerings, 16 were listed on one funding portal, UFP, LLC.
In its investigation of the portal, FINRA found that UFP routinely violated the crowdfunding rules. UFP knew that many of its issuers failed to file required SEC disclosures, and also allowed issuers access to the portal despite the likelihood of fraud. In a particularly egregious example, 13 of UFP’s listed issuers, engaged in many different lines of business, listed identical amounts for their target funding requests, maximum funding requests, price per share, number of shares to be sold and equity valuation. UFP shut down its operations and withdrew from SEC registration.
Commissioner Stein suggested that it is appropriate to question the role of funding portals as gatekeepers, as well as facilitators of capital formation. One key problem is that funding portals may lack the resources to adequately perform due diligence on their listings. A robust due diligence program could involve company background checks, site visits, credit checks, cross checking with social media, account monitoring and more, which may be beyond the capabilities of thinly-staffed portals. A lack of appropriate diligence may not only impact investors in that particular offering, but can undermine the integrity of the crowdfunding market in general. “Once-bitten-twice-shy investors may be reluctant to fund the next business seeking financing through crowdfunding,” she stated.
The question becomes whether the current rules provide for adequate funding portal oversight, which is necessary to avoid a “race to the bottom” in this space. Possible options include minimum and uniform standards for vetting issuers, portal ranking and an SRO for portals.
She also expressed concern about the types of securities that retail investors are receiving in exchange for their crowdfunding investment. While 36 percent of crowdfunding offers involved equity securities, the second most common security offered, at 26 percent, were “simple agreements for future equity” or “SAFE” securities. A SAFE security is a contractual derivative, through which the issuer promises to give the investor stock upon the occurrence of a contingent future event. The obvious risk is that many small and emerging businesses will never attain the subsequent valuation event. Commissioner Stein asked if the SEC should look at further regulation of SAFEs sold to retail investors given that these instruments often provide different rights and restrictions and more risk than what retail investors may typically expect.
Finally, Commissioner Stein addressed concentration within the crowdfunding marketplace. One of the promises of crowdfunding was the democratization of the capital-raising process, but the market to date shows most activity is limited to a very few states, such as California, Texas and New York. She expressed concern that crowdfunding may not be reaching a varied enough base of entrepreneurs. She suggested that further outreach and investor education may provide a solution to the demographic and geographic concentration of the crowdfunding market.
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