Technology: Delay in crowdfunding rulemaking creates questions and opportunities

Despite a lack of regulations, existing crowdfunding companies give the SEC a chance to “beta test” the concept

On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startup Act, or “JOBS Act,” which exempted certain “crowdfunding” activities from the registration requirements of the Securities Act. The Securities and Exchange Commission (SEC) was supposed to promulgate rules by Jan. 5, which—subject to statutory boundaries—would implement the crowdfunding exemption. It failed to do so. Six months later, the SEC has not even issued initial proposed regulations. In the meantime, public comments to the SEC on the need and specifics of crowdfunding continue to roll in, and the small business community stamps its foot impatiently.

Mary Jo White, who was confirmed as the SEC Commissioner on April 8, has repeatedly stated that completing JOBS Act rulemaking is amongst her top priorities. The delay in rules implementation, however, suggests that balancing the various priorities in the crowdfunding regulation is proving a tough nut to crack. The stated purpose of the JOBS Act was “to increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.” The term “crowdfund,” however, is not used in the act to refer to access to capital, but instead is used as an acronym for fraud avoidance—“Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure.” The act thus neatly identifies the conflict the SEC’s regulations must resolve: How can we tap into the power of millions of Internet denizens and their social media and online connections to drive business investment while simultaneously ensuring those same investors are not defrauded in the process? The Internet is both the solution and the problem; it provides access to the Internet mob for investment, but does so immediately and without personal interaction, supplying the means for anonymous third parties to bilk potential investors of hard-earned money under the guise of a failed business venture.

The comments on the crowdfunding portion of the JOBS Act at the SEC demonstrate significant interest in the regulations. As of the date of this article, the agency has received more than 390 different comments, and the agency lists more than 50 different meetings it has held on the regulations with companies knowledgeable about crowdfunding. Yet, none of those comments or meetings is likely to result in a concrete solution to entirely eliminate the potential fraud for crowdfunding investment. The ability to raise funds from individual investors directly presents too great an opportunity for fraud, and people are, in the end, human beings subject to influence and persuasion. Fraud will happen, and the SEC likely knows this fact. So, the question is, why the delay in implementing the rules? Is the SEC waiting for a solution that does not exist?

Perhaps the answer to the SEC’s delays lies in the potential information it is already gaining from existing crowdfunding platforms. Rewards-based crowdfunding has been around for several years, with prominent companies such as Kickstarter and Indiegogo funding thousands of products and raising millions of dollars. More recently, the SEC has begun issuing “No-Action” letters to equity funding portals as well, including FoundersClub Inc. and AngelList LLC, finding their business models acceptable. As these funding systems are deemed acceptable, more and more crowdfunding options are made available to the public, and more and more real-world experience can be imparted to the SEC. The SEC has already consulted many of these companies in the rulemaking process, suggesting strongly that the agency is watching the companies’ success (or lack thereof), in hopes of providing the framework for a successful implementation of the JOBS Act regulations.

The lessons learned from these existing portals regarding fraud avoidance will likely shape the SEC’s regulations. Kickstarter is a good example. Per its FAQs, Kickstarter does not screen the projects on its site aside from ensuring they meet a short set of project guidelines, it does not have an equity stake in the projects, and – once a project is funded – Kickstarter disclaims any responsibility for ensuring that it is completed . It steadfastly refuses to refund funds to project backers. Thus, for fraud prevention, it places the onus entirely on the project creator and the Internet community, asserting that its sign-up process creates a legal responsibility to follow through on the project once funded, and that the reputational impact of a failed Kickstarter project acts as a deterrent to fraud.

The combined effect of legal responsibility and reputational impact appears to be substantially successful. Since 2009, Kickstarter has launched nearly 105,000 projects, raising nearly $700 million in the process. Of that amount, about 10 percent ($75 million) of the dollars raised were for projects that were funded but that, for whatever reason, were not successfully completed. Although Kickstarter does not archive projects that fail to be funded, it does keep projects that were unsuccessful available for searching. Thus, if a creator fails to complete a project, its failure is available via a simple search on the site or a search engine.

A 90-percent success rate suggests Kickstarter’s system works. It enables a reputational review by ensuring transparency as to project expectations, creator identity and historical success. It then makes that information available to the Kickstarter community. Through this process, the Kickstarter community (and sometimes Kickstarter itself) has identified and caused the cancellation of numerous potentially fraudulent projects. The community has been able to identify fraud through unrealistic stated expectations, copying of photographs and other materials in the project description, and departure of the project creator, amongst other information. The combination of a strong and interested community with the transparent information above provides an avenue for the community to police the creators.

Because Kickstarter is project-based, its success rate is easier to define than it would be for an equity return on investment. After all, it is easier to identify whether a particular design project was actually made than it is to navigate the challenging confluence of accounting practices, tax laws and business practices that relate to business valuation to determine company growth. But, where the identity of the party issuing the equity is ensured and made transparent and where historical information is made available to the relevant public, the ability of a company to mislead or defraud investors is greatly inhibited.

As the SEC gains more knowledge from the real-world crowdfunding projects, it gains knowledge into practices that successfully foster investment while protecting investors. Hopefully, it has already gained enough knowledge to at least issue preliminary regulations for the crowdfunding portion of the JOBS Act in the near future. Other companies have shown crowdfunding works for limited investors and rewards-based investing. It is time to take those lessons and apply them to equity-based crowdfunding and truly jumpstart our business startups.

Contributing Author

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Jake Koering

Jake Koering is a partner in the Litigation and Intellectual Property practice groups at Freeborn & Peters. A long-time technology addict, both professionally and personally,...

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