By Carolyn A. Betts, Esq. with Catherine Austin Fitts, April 12, 2012
The following table compares the crowdfunding provisions enacted in Title 3 of the Jumpstart Our Business Startups Act (“JOBS Act”) (as well as a few expansions in the JOBS Act to Regulation A and Regulation D in Article 21) to currently-available registration exemptions under Regulation A and Regulation D. Although the SEC and state regulators maintain that flexibility provided by these exemptions are sufficient to permit the raising of equity funds by entrepreneurs, in practice, Regulation A filing requirements are expensive and cumbersome and restrictions on general solicitations under Regulation D make private offerings by issuers extremely cumbersome and in many cases unworkable. Those who characterize themselves as consumer advocates, as well as many regulators, were heard to object to proposed crowdfunding legislation on the grounds that legalizing crowdfunding will result in a proliferation of boiler-room operations targeting the elderly and unsophisticated members of the public who need the protections afforded by the laws and regulations that are relaxed under the JOBS Act.
We agree that there are significant risks that unscrupulous promoters may take advantage of the new law to widen the availability of their fraudulent schemes or meritless investment opportunities as the result of this blessing of Internet-based offerings by Congress. On the other hand, consider the following:
- Existing anti-fraud laws at both the state and federal level are in no way affected by the JOBS Act except that the JOBS Act adds enforcement and investor refund provisions for misstatements and omissions. It is still illegal to commit fraud in the offering of securities, to make misrepresentations in order to sell a security, and to fail to make disclosures to investors that, if made, might affect an investor’s decision whether to invest in a security. State antifraud rules are not preempted, so states can play a role in enforcement. If enforcement of these laws is insufficient, then the lack of enforcement, not the absence of regulation, is the problem.
- The JOBS Act requires the SEC to promulgate regulations covering crowdfunding offerings within 270 days and to consult with state and national securities association authorities that so request in developing such regulations. Among the matters that are to be included in such regulations are rules or guidelines interpreting the prohibitions on the provision of investment advice; the requirements that they take reasonable steps to reduce the risk of fraud; what “bad boy” disqualification provisions will apply and how the disclosure requirements may be satisfied.
- The SEC is notoriously underfunded by Congress, notwithstanding the fact that registration fees paid by securities issuers are sufficient to offset the costs of good regulation. In other words, the SEC is a cash cow for the federal government: failure of Congress to fund the regulator is itself a form of deregulation. The SEC also is notorious as a revolving door for big-firm securities lawyers in private practice and, as such, presents a conflict of interest in “protecting” the public from potential future clients of the regulators. The JOBS Act does not exacerbate this conflict.
- State lotteries are legal, and appeal to a broad spectrum of the public, including modest and low-income individuals, seeking a chance to build wealth, even though as an “investment” the lotteries present an almost certain opportunity for a 100% loss. The same may be said for the rapidly proliferating casinos and legal gambling operations. A better outlet for satisfying these investors’ appetites for a chance to build wealth is a much less risky small business investment.
- Most job generation comes from small businesses. The intentional use of complex regulation to create obstacles to legitimate financing mechanisms for small businesses leads to an economy dominated by franchises, big box stores and multinational corporations whose profits are not, for the most part, invested in local communities and whose potential for supporting job growth is severely limited.
- Under the law pre-crowdfunding, it has been almost impossible for non-accredited investors, people of modest means, to purchase any equity stake in community small businesses, even though many gambling opportunities are legally advertised on billboards and in radio and television. Under the JOBS Act, investors with incomes under $100,000 may purchase $2,000-a-shot equity interests in local businesses run by their neighbors, family members and other local residents whose activities they can understand, closely scrutinize and even personally patronize.
- In facilitating the creation of a readily-available infrastructure for offerings on Internet host websites by financial professionals and angel investment groups, it is just possible that the JOBS Act could play a role in educating non-institutional investors to perform due diligence and develop the skills to evaluate competing investment opportunities, thereby reducing the attractiveness of get-rich-quick schemes. This brings up the subject of financial literacy and the fact that US school curriculums routinely avoid teaching American kids that they need to know how to protect themselves against financial fraud and to understand their local and global financial ecosystems.
- Requirements that crowdfunding financial statements be audited or reviewed by independent accountants (offerings > $100K) or certified by a chief financial officer (offerings < $100K) provide an identifiable target for enforcement authorities in the case of fraudulent offerings. Public accountants can be expected to impose client certification requirements as a condition to the issuance of reviews, opinions or audits and AICPA or other accounting groups can be expected to weigh in on appropriate accounting procedures.
- Pre-crowdfunding, establishing a start-up business of any size is an almost insurmountable challenge for all but the most well-capitalized, financially sophisticated and highly risk-tolerant entrepreneurs. In fact, many entrepreneurs finance their new businesses with credit card debt at outrageously high interest rates and predatory terms, because conventional bank financing of small businesses is almost non-existent.
- Funding start-ups with debt increases the likelihood of failure. Equity financing and limited leverage allows new businesses to weather economic downturns without crushing fixed debt service expenses and to expand during good times through the reinvestment of profits.
There are many statutory requirements for crowdfunding: opponents cannot seriously portray this legislation as “deregulation” or elimination of investor protections in the context of small business and start-up funding. Perhaps the cries of “foul” by consumer advocates would be more appropriately hurled at the provisions of Title 1 of the JOBS Act, which relieves “emerging growth companies” of up to $1B in annual revenues from many of the investor protection “burdens” imposed by Sarbanes-Oxley and Dodd-Frank, for example:
- Proxy solicitation requirements to gain investor approval for golden parachutes are eliminated
- Compensation disclosures are scaled back from top five to top three principals
- Exemption is given from CEO pay v. performance and pay ratio disclosure (which isn’t even in effect under Dodd-Frank yet)
- Independent auditors are not required to issue audit attestation reports on management control over internal financial reporting
- Exemption is given from any audit rotation rules that may be issued in the future
- The SEC initial public offering review process is streamlined and emerging growth companies are permitted to file initial registration statements on a confidential basis without their going public on EDGAR until SEC comments are received
- Prohibitions of pre-IPO underwriter research reports by underwriters are lifted
In addition, Title I prohibits the SEC from adopting rules that restrict communications between management and analysis and institutional investors in connection with IPOs.
Perhaps the most uncomfortable aspect of this legislation is its context: the implicit understanding that now that America has been sucked dry of capital by a combination of government and central bank policies that have encouraged, facilitated or even blessed criminal activities by private investors at the expenses of taxpayers and citizens, capital will now be brought back onshore to buy up ownership and control of resources at low cost. The pump and dump goes on and there is nothing being done to stop it. If anything, this legislation will help facilitate that process.
Nevertheless, we do need a legal structure that allows capital to flow to start-ups and small business. So let’s see if we can take a step in the right direction despite the corruption now endemic throughout our society.
1Article 2 also makes similar changes to the exemption under Rule 144A, but in the interests of time, we have not included the chart all of the existing rules for exemption under Rule 144A. Suffice it to say that the JOBS Act removes the prohibition on general solicitations for Rule 144A for offerings limited to qualified institutional investors.
2Note that multiple offerings by the same issuer may be “integrated” for this purpose if of the same type of security and for the same general purposes. [See chart]
3The term “accredited investor” as defined in Rule 501 of Regulation D includes in pertinent part an individual (a) with an income of $200,000 per year (or $300,000 with a spouse) in the last two years and an expectation of the same in the current year or (b) with a net worth of at least $1MM (excluding the individual’s primary residence). It also includes certain insiders of the issuer, companies or institutions with assets of at least $5MM; entities comprised solely of accredited investors and certain institutional investors. [See chart]
4In this context, “sophisticated” means the investor, alone or together with an investment representative (not the issuer or anyone receiving a commission for the sale) must have sufficient knowledge and experience in financial and business matters to make him or her capable of evaluating the merits and risks of the prospective investment. [See chart]
5But in the case of a limited partnership, the issuer may provide audited financial statements prepared under federal income tax laws. [See chart]
6“Bad boy” disqualifications limit access of the provision to issuers who (and whose insiders) have not gotten into trouble in the past, as defined in the particular disqualification provision. The Regulation A disqualification provisions are found in Rule 262. [See chart]
7A “blank check company” is a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person. [See chart]
- Text of the JOBS Act: http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf
- The Economist: http://www.economist.com/node/21551481
- Orrick, Herrington & Sutcliffe summary: http://www.jdsupra.com/post/documentViewer.aspx?fid=80d3d517-b727-42a7-9bef-052cc68ddfea