Crowdfunding is becoming a reality, but the question is whether it will thrive or become largely a vehicle for fraud.
If it does turn out to be a disaster, don’t blame the Securities and Exchange Commission. The agency was merely following orders when it was told to adopt rules for crowdfunding.
Last week, the regulator proposed rules governing crowdfunding in a 568-page release. The idea behind the proposal — mandated by the 2012 Jump-start Our Business Start-ups Act, or JOBS Act — is born of our penchant for the kinds of popular ideas that emerge at TED talks. In the case of crowdfunding, the concept is that small companies can obtain the financing they need through the “wisdom of crowds.” The crowd in this instance will use the Internet to collectively pick the best investment. It is a win for all involved, particularly small companies that are starved for financing.
There are reasons to be skeptical, however.
For one, the experts in investing in start-ups — venture capitalists — are not terribly successful. According to the National Venture Capital Association, 40 percent of venture capital investments fail, 40 percent break about even and only 20 percent have a decent to high return.
Crowdfunding investors, that is, you or me, are likely to lack the diversification of venture capitalists, meaning that crowdfunding investors will not have the successes to even out the overwhelming majority of failures. Moreover, the crowd’s ability to pick winners may not be as good as the venture capitalists, meaning an even higher rate of failure.
Then there is the second problem associated with crowdfunding: fraud. Without proper identification, anyone can put a nifty sounding idea out there: Elaine from “Seinfeld” was right; we need to bring back the sponge! Or how about brushless toothbrushes! In the worst situation, the entrepreneur could take the money and run. Even without outright fraud, once the money comes in, there is no oversight. So entrepreneurs can fritter it away on their own expenses.
Take a recent campaign on Kickstarter, the crowdfunding site where companies raise money in exchange for products or services instead of shares. Some people compare the crowdfunding process of raising capital to what goes on at Kickstarter. In this case, an entrepreneur raised more than $122,000 on Kickstarter, preselling versions of a board game, the Doom that Came to Atlantic City, termed “a Lovecraftian game of urban destruction.” Months later, the entrepreneur canceled the project, having spent the money on things like moving to Portland, Ore. Atlantic City survived, and the only thing destroyed was the crowd’s money.
With crowdfunding, even if a company were successful, there is probably no way to exit or even control the company. As the S.E.C. acknowledged in its release last week, these companies are extremely unlikely to go public.
It all means that you will have better odds at the casino than investing in crowdfunded companies.
When Congress was considering the JOBS Act, the legislation that made crowdfunding possible, the S.E.C. was strongly opposed. Mary L. Schapiro, then the chairwoman of the agency, said that the law would “weaken important protection” for investors.
Congress largely ignored those concerns and dumped the rule-making for crowdfunding in the lap of the S.E.C. So the regulator has swallowed hard and tried to make the best of this situation.
The S.E.C. did not respond to requests for comment.
The final rules are a reflection of Congress and another force — Eugene Scalia.
Mr. Scalia, a partner at the law firm of Gibson, Dunn & Crutcher, has made a successful practice of challenging S.E.C. rules in the United States Court of Appeals for the District of Columbia. His most prominent success so far has been persuading the court to overturn the agency’s rules that would permit shareholders to nominate directors directly, known as proxy access. The court found that the S.E.C.’s cost-benefit analysis of the proxy access was so poor as to be arbitrary.
The decision has given ammunition to opponents of the agency to challenge every rule as arbitrary. Because the court implied the need for statistical proof to justify a rule, it has set a high bar for the S.E.C. to overcome.
The decision has also had some unfortunate and unintended side effects. The lengthy release on its crowdfunding rules is a product of the S.E.C.’s attempt to meet the appellate court’s challenge. The result is not better analysis, but rather simply more words on the page as the agency strains to justify every decision to show it has proper empirical proof.
The court opinion has also led the commission to adopt a bunker mentality. Rather than risk yet another rule being overturned, the S.E.C. has instead preferred to adhere to the most conservative view of Congress’s dictates. The result has been less innovation.
In the case of crowdfunding, the agency largely parroted what Congress did without addressing its own concerns about investor safety. That would be a problem in any circumstance, yet Congress adopted these rules without any real thought.
The JOBS Act raced through Congress and was initially supposed to be about reviving the market for initial public offerings. But forces in favor of private markets pushed for a new section to permit crowdfunding. This was never intended to be included by the group of venture capitalists and other industry groups who first proposed the JOBS Act.
In the wake of concerns about the potential for fraud in crowdfunding, new provisions were added to the legislation that required that crowdfunding be done through third-party portals or brokers. In addition, requirements for financial statements for companies and background checks on executives were added.
For example, Congress required that if more than $100,000 were raised, then the company’s financial statements must be reviewed by an independent accountant. If the amount were more than $500,000, then the financial statements must be audited. Most companies will probably sidestep this requirement by raising less than $100,000. This means that small companies will predominate and the chance of fraud will only increase.
Crowdfunding could have been a chance to experiment, to try different ways to see which method raised capital best for companies with a minimal amount of fraud. The S.E.C. could have started by creating different markets with different rules. Or perhaps investing could have been done through funds that allow for diversification.
Instead, because of Congress’s straitjacket and the S.E.C.’s fear of innovation, we have a proposal that seems likely to have significant problems, if not with fraud than simply with how investors will get their money back, let alone make money.
The rules are merely proposals, and comments are due in 90 days. The agency made almost 300 requests for comment on various issues. But the rules are unlikely to change much.
The S.E.C. has resisted crowdfunding and might not have ever gone along with any effort to endorse the practice. But the agency is hamstrung, afraid to do what it could have to make crowdfunding work better for investors. That’s a shame generally, but maybe more so for the people who invest in these small companies and lose everything.