S.E.C.’s Delay on Crowdfunding May Just Save It

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The New York Times Dealbook by Steven Davidoff Solomon | November 18, 2014

Image c/o Harry Campbell, The New York Times

Image c/o Harry Campbell, The New York Times

While the Securities and Exchange Commission dawdles, states are rushing to adopt their own crowdfunding rules. Ironically, it may just be the thing that rescues crowdfunding from a regulatory death grip.

In 2012, President Obama signed the Jumpstart Our Business Start-ups Act, otherwise known as the JOBS Act. The law was an odd creature. It purported to open up the capital markets and create jobs by loosening regulations on initial public offerings and allowing for crowdfunding. Yet there was little evidence to support that watering down of any of these regulations would create jobs. Instead, the bill mainly appeared to be catering to special interests and was intended to show that Congress was doing something, anything, to create jobs. Crowdfunding in particular was pushed by a number of special interests that — you guessed it — wanted to start crowdfunding sites.

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Crowdfunding was also the most controversial part of the bill. The S.E.C., led by Mary Schapiro at the time, submitted a letter in opposition. The reason was basically fraud. Let’s face it, in a world where a potato salad party can raise more than $50,000 on Kickstarter, people may not be investigating their investments particularly well. The S.E.C. feared that crowdfunding would instead serve as an easy vehicle to defraud people.

More important perhaps was the idea that these investments would create zombie companies — companies that weren’t frauds but that investors simply couldn’t get profit from. The S.E.C.’s protests led to some last-minute revisions to the bill, including a requirement that a crowdfunding company include audited financials when raising more than $500,000.

Congress gave the S.E.C. a deadline of December 2012 to enact the new rules. For those keeping score, that was almost two years ago. But the S.E.C. has flouted that deadline and has yet to give a green light to crowdfunding. Its only action thus far was to issue proposed rules about a year ago. Hundreds of comments later, and nothing has happened.

See also: Canada’s National Crowdfunding Association Applauds Regulators for Setting the Stage for Crowdfunding Success

For some who think that crowdfunding is an invitation to fraud, this is the best outcome, for the S.E.C. to simply ignore the law.

But the crowdfunding industry is eager for guidelines. And so it has started to go to the states to work around the S.E.C.’s inertia. Under the securities laws, an offering made in a state by company from that state is exempt from the S.E.C. rules on securities offerings. This was intentional when the Securities Act of 1933 was passed. The idea was that individual states should maintain jurisdiction of offerings limited to their borders because only their residents would be affected.

Armed with this exemption, 13 states have so far enacted crowdfunding rules. As might be expected, these states have different approaches.

The S.E.C. has been focused on minimizing fraud and has pushed for strict requirements, including that issuers prepare and file with the agency audited financials and extensive disclosure. But with the S.E.C. dragging its feet on approving the rules, national crowdfunding has stalled. In the meantime, the S.E.C. has been actively bringing litigation to shut down crowdfunding platforms that are operating despite the lack of rules.

For good or bad, the states don’t seem to care as much about the fraud issue.

Related: United States: Ten Things You Need To Know Before Engaging In Accredited Crowdfunding

Consider Texas, which last month proposed its own crowdfunding rules that are deliberately more liberal than those proposed by the S.E.C. The Texas rules require no audited financials and no extensive disclosure. Instead, a Texas company can raise up to $1 million in any 12-month period, and it only has to do so through a privately run portal that vets the companies. And unlike the S.E.C.’s proposed rules, there are no annual filing requirements. Michigan, Indiana and other states that have adopted their own crowdfunding rules have similarly relaxed requirements.

The proposed S.E.C. rules, particularly those requiring audited financials and annual reporting, have been criticized as detrimental to crowdfunding because compliance costs have been estimated to consume more than 15 percent of the offering. The result is that few expect the S.E.C. to adopt regulations that allow companies to use crowdfunding effectively.

Had the S.E.C. acted in a timely fashion, it would have ended the matter because its rules would have effectively pre-empted the states from acting. But the S.E.C.’s delay has given states room to offer more viable alternatives.

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