As Comment Period Closes, Debate Over Equity Crowdfunding Rules Rages On

The official period of public debate over equity crowdfunding is nearing an end, but don't breathe easy just yet. The controversy is hardly over.

When President Barack Obama signed into law the Jumpstart Our Business Startups Act, or JOBS Act, in April of 2012, he made equity crowdfunding legal for unaccredited investors and assigned the SEC to write rules to regulate it. 

After a long delay, the SEC released its first round of rules on Oct. 23, initiating a 90-day public comment period that officially ends on Feb. 3. 

Related:  The JOBS Act: What You Need To Know

In the almost three months since the provisional SEC rules were released, scores of public comments have been submitted to the SEC. The comments have been heated and, at times, completely contradictory.

At the heart of the debate is the concern that, by writing rules that regulate equity crowdfunding and protect unsophisticated investors from losing money, the spontaneity and fluidity that make crowdfunding attractive to upstart entrepreneurs will fade. In other words, by making equity crowdfunding safer, regulators run the risk of killing it.

Related:  SEC Releases Long-Awaited Rules on Crowdfunding

We have pulled a few comments that underscore the three most controversial pieces of the rules. To be sure, these are not nearly all of the public comments - which should, at the very least, make you glad that you are not the SEC.

INVESTOR LIMITS 
Investing in startups is risky business. A lot of entrepreneurs fail. Professional investors understand that; unprofessional investors may not. To protect Joe Shmo investors from dumping all their retirement savings into a startup and then being completely bankrupted if that startup fails, the SEC established limits on how much any individual can invest. No company can raise more than $1 million in any 12 month period. Investors are allowed to invest up to $2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000. If an investor's annual income or net worth is equal to or more than $100,000, then that investor can invest 10 percent of their annual income or net worth, whichever is greater. During any 12-month period, investors cannot buy more than $100,000 of securities through crowdfunding, the SEC said.

That cap is too low. Lawyer Michael Doud Gill III says that setting these limits prohibits crowdfunding from being as powerful a mechanism of finance as it could be. Gill wants those limits to be interpreted as the cap that any investor can put into any single company. If the rule is interpreted as being the cap that an investor can invest in total, in all companies, via crowdfunding, that "risks harming the nascent crowdfunding market," he writes. "If the SEC chose such an interpretation, it would signal the SEC's mistrust of the crowdfunding market by a conscious choice to limit the market's capital inflows."

There should be no cap. Another public comment indicates that it should be up to the individual to impose his or her own limits. "If I can spend my entire salary on penny stocks or at the casino, why can't I spend it on a project I believe in? I think these rules are good except for the limits. Some projects require more than a million dollars to get off the ground, and telling me I can't spend more than a couple thousand seems like overreach," says commenter Ryan Taylor. "Sure, check up on these companies, hold them responsible, but don't tell me I can't give a sizable sum of money if I want to."

Related:  What the U.S. Can Learn From the Netherlands About Equity Crowdfunding

SELF-ATTESTATION OF WEALTH
To determine what is safe for an individual to invest, the SEC has proposed capping the amount that an individual can invest based on his or her income and net worth. (That idea is, in and of itself, contentious, as seen above.) To determine what someone can spend then depends on what someone is worth. Requiring potential investors to go through an audit determining their net worth would grind the entire process to a halt, many argue, and so one alternative way to determine how much a potential investor is worth is to have that investor tell you. That concept is best known as "self-attestation" or "self-certification."

Potential investors have no incentive to be honest about their worth.  "It is our understanding that the commission is leaning toward permitting investor 'self certification' of financial status in most, if not all aspects of Title Ill," says David Benway, CEO of Verinvest Corporation, a company which provides investor accreditation. "This could lead to disastrous consequences and reckless behavior by investors and issuers alike." Benway says that in the excitement of hoping to strike it rich with the next hot-shot startup, "it is reasonable to question the compliance and discipline of a starry-eyed investment crowd." 

Related:  States Charge Ahead With Their Own Crowdfunding Laws

DISCLOSURE PAPERWORK
In the SEC's provisional rules, an entrepreneur looking to raise money would have to file certain paperwork with the SEC, including about officers, directors and anyone owning more than 20 percent of the company. Also, SEC documents would be required to describe the business, what the entrepreneur would elect to do with the raised funds, the financial condition of the company, tax returns and potentially an audit of the company's financial health by a third party.

The initial paperwork requirements are too expensive to prepare. "In our experience, these upfront costs (potentially hundreds of hours and $20,000-$50,000) will have a huge deterrent on those would seek to use crowdfunding. The majority of startups will have a tough time financing this level of upfront costs ahead of conducting a crowdfunding raise," says Kiran Lingam, a lawyer and the general counsel for SeedInvest, a crowdfunding platform that currently facilitates equity crowdfunding between entrepreneurs and accredited investors. "Additi onally, the few companies who are able to bootstrap these upfront costs will be severely dissuaded from proceeding given the lack of visibility as to the odds of successfully completing their crowdfunding round." Lingam proposes crafting a "Prospect Mode," where entrepreneurs are allowed to solicit feedback from the crowd and pre-emptively seek out funding, without having to submit SEC regulatory paperwork first. "This way companies will be able at least gauge their potential for success prior to spending $20,000-$50,000" on compliance expenses. 

Hiring an auditor is too expensive. Another stakeholder said that having to hire an auditor would be a dealbreaker. "We find the requirement for 'audited by an independent public accountant or auditor' to be the single item that would severely handicap the process and essentially nullify the intent of the Jobs Act. A required audit is the primary reason we were not able to offer shares in the first place under the current SEC regime," says entrepreneur Terry Reed, who has spent the past year raising $100,000 to launch internet taxicab service, www.directcabcall.com. "If you really want the Jobs Act provision for crowd source funding to work, you can't have an excellent overall structure, yet an entrance fee that keeps entrepreneurs from using it."

Having nonprofessionals do their own paperwork would be lead to untold amounts of error in the system. If hiring auditors and third parties is too expensive for startup entrepreneurs, another option would be to have crowdfunding campaign owners keep their own financial records. A stock transfer agent weighed in on this possibility. "We have experience assuming recordkeeping services for issuers who have, prior to hiring us, maintained their own shareholder records or arranged for a third party to do so. These records are typically kept in a basic spreadsheet form, and stock issuances, transfers, or other changes are recorded by deleting and editing line item entries. This type of rudimentary ledger system lacks any type of quality controls that would detect or prevent errors," says Kara Kennedy, the executive director of ClearTrust, an SEC-registered stock transfer agent. "Allowing anyone to maintain shareholder records, regardless of qualifications, experience, or quality control will create a wild west in the world of crowdfunding."

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