Crowdfunding and the limits of the SEC

By now, every securities regulator and most others are familiar with Bernie Madoff and the gaggle of modern-era con men such as Allen Stanford and Marc Dreier, all of whom were ultimately caught by joint action from various law enforcement entities, including the SEC. They unearthed fraud in the hundreds of millions and billions of dollars collectively.  These are only some of the most high-profile cases prosecuted by the SEC, and there is little doubt that the SEC basks in the media glow as any enforcement agency does when it receives favorable press.

The problem with attention-grabbing prosecutions dealing in massive scams and huge financial losses is that it leads the public to believe that only the SEC is preventing fraud. In truth, the SEC is prosecuting criminal behavior after it has occurred.  This is an important distinction because prevention happens before, and prosecution happens after, a crime occurs. While successful prosecutions arguably have some deterrent effect on future scam artists, deterrence is only a part of crime prevention.

So, if the SEC and other government agencies are unable to stop Madoff, Stanford, and Dreier before the victims are soaked, how will the SEC prevent fraud in crowdfunding?

It likely won’t. Our federal government has developed expertise and drawn on deep resources to enforce the laws against criminals after the crime has been committed. But its track record at preventing financial crimes before they occur is spotty when viewed in the most favorable light. In fact, one could argue that the monumental frauds perpetrated by Madoff, Stanford, and Dreier actually expose the strict limits of the power of the SEC–only achieving colossal verdicts that speak to the failures of preventing these individuals from defrauding others.
It is probably not an overstatement to say that the fate of crowdfunding hinges on the the degree to which the SEC appreciates the limits of its powers at preventing financial crimes. Entrepreneurs, investors, and the public are all eagerly awaiting the verdict.


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The JOBS ACT and Kickstarter

An acquaintance recently asked why Kickstarter doesn’t have to comply with the restrictions set forth in the JOBS Act. Kickstarter is a platform that charges a commission for matching donors with young businesses and creative types who otherwise encounter difficulty funding their screen plays, independent films, unusual time pieces, and more.  The JOBS Act, with the help of the SEC, governs platforms that do the same thing as Kickstarter. The only substantive difference is one between donations and investments.  Donations are basically a gesture of good will with no possibility of financial returns while investments carry the expectation of profit.

So why doesn’t Kickstarter have to comply with investment limits, criminal background checks, consumer education, and other restrictions imposed by the JOBS Act?

The short answer is that the drafters of the JOBS Act want it to reflect public policy. Our politicians believe (rightly or wrongly) that fraud is more prevalent when people are acting in their own financial self-interest. Avarice, profit-motive, investment prudence . . . by whatever name it might be called, our public policy reflects enduring and overriding concerns that financial criminals prey on the financially self-interested.

A cash gift is fire-and-forget, no recourse, and lightly regulated (if at all). Try to buy a piece of a business because it appears to a be an attractive investment, on the other hand, and you and your intended recipient must pass a variety of hurdles to ensure it’s a legitimate deal, you have been provided adequate disclosures, you can afford to take the risk, and so on.

Whether there is a meaningful difference between con men who prey on the financially motivated vs. con men who take advantage of the charitable or philanthropic-minded is a discussion for another day. The mission of the SEC is strictly focused on boiler room operations and Ponzi-schemers, not  corrupt pastors, bogus documentary movie-makers, or other fake do-gooders busily fleecing the unwary.

Are Kickstarter and the like enjoying favorable treatment by our regulators? Are crowd-funding investments justifiably being held to a higher standard? Will public policy concerns drive potentially complex and costly new SEC regulations?

Stay tuned for word from the SEC.






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We’re from the Government & We’re Here to Help: Crowdfunding Investor Safeguards.

This thing could be over before it begins. Recent commentary on crowdfunding in the New York Times is consistent with our view of the sausage-making process that is hailed as legislative progress today. The 11th hour Senate amendment intended to beef up so-called fraud protection risks crippling the crowdfunding portion of the JOBS Act: ” . . . Congress made the provisions hard to use. Crowdfunding companies will have to raise money through Internet platforms in small individual amounts, less than $2,000 for most Americans. If a company raises more than $500,000 it will have to prepare audited financials. This is a huge expense that will discourage most companies from resorting to crowdfunding for significant amounts of capital.” CrowdFunds agrees.

We  previously expressed our dismay at some of the sloppy thinking behind the mish-mash of provisions clumped together under the banner of “fraud protection” and have not changed our view.  Essentially, our elected officials do not delineate between:

  1. steps designed to protect you from bad guys engaged in financial crime and/or remedy investment fraud that has already occurred; and
  2. the distinct possibility that you will lose the entire value of your investment by betting on businesses that are young, under-capitalized, speculative, unproven, and sometimes plain wacky.

Effort to promote #1 is good if it lowers the cost of identity verification, aids the speedier administration of SEC investigation and enforcement, establishes a restitution fund for victims of financial crime, and otherwise makes life difficult for con artists.  But effort to protect you from yourself under #2 is a fool’s errand, ripe for abuse by investors and extremely difficult to enforce.

Consider the laughs and industry responses that would follow preposterous legislative attempts to protect you from your sometimes dumb investments:

  1. Pretend you were only permitted to invest 10% of your annual income up to $10,000 in the purchase of a house, which until very recently enjoyed the perception of a sound investment.  The real estate lobby would be marching on Washington if this ever happened.
  2. Imagine you were admitted entrance to a casino as long as you promised not to gamble more than $2,000 in a year.  Gaming interests would be grinding their teeth as they fired lobbyists and worked to replace congress en masse.
  3. Suppose you have to register with your state of residence and were capped on the purchase lottery tickets based on your income.  This could starve your state of a necessary income stream and . . . Hold on. That is just too crazy to contemplate.

Now we return to reality and the SEC rule-making process, with the distinct possibility things could in fact worsen for crowdfunding.  We shall see.

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Congress Risks Snatching Crowdfunding Defeat from the Jaws of Victory

As crowdfunding supporters hold their collective breath for Congress to send a bill to the President for his signature, some are reminded of the cautious advice about second marriages representing the triumph of hope over experience.

What could go wrong? For starters, the proposed crowdfunding legislation is gestating in fear and distrust. Bernie Madoff’s massive fraud is still fresh in our minds. The reputation of Wall Street is slightly ahead of North Korea (maybe). Media reports of corporate accounting scandals and other shenanigans at shareholder expense are legion. There are no limits to the lengths our politicians will go in order to protect the public from itself–or at least appear to be protecting the little guy from market meltdowns.

The problem is that crowdfunding isn’t about fear and distrust. Startups are full of promise, a refreshing departure from the general skepticism of financial markets. Crowdfunding thrives on fundamental optimism: that a startup will one day make it big, new jobs will be created, a ground-floor investment will defy sometimes long odds, and so on. It’s the frothy Springtime to the dull Winter of big business.

Treating grownups as if they need an extra layer of protection in a crowdfunding environment is a product of fear and distrust, and one that appears to be wildly misplaced if the instances of crowdfunding fraud in the UK and elsewhere are any indication.

A second problem is that the proposed crowdfunding bills suffer from unnecessary complexity, a failure of the “simplicity test” described by Davis Wright Tremaine LLP attorney Joe Wallin. Others have commented on the messy process and potential for ineffective legislation, so we’ll have to wait and see whether the our politicians view the Internet as terra incognita that must be tamed, or another avenue for streamlined risk capital.

As Patrick Ruffini writes, “Crowdfunding shouldn’t be — and actually isn’t — controversial, yet some politicians are trying to stand in the way. For too many in Washington, the Internet is still a foreign land — one to be regulated and held at bay. Instead of the enormous potential for new small business growth, some politicians are demagoging the potential for fraud . . . ” Will fear and distrust prevail? Stay tuned.

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