Crowdfunding in the United States

Crowdfunding Websites

by Christopher Cook (2012)

Will SEC regulation fuel or dampen enthusiasm for crowdfunding websites?

Since the IndieGoGo website was launched in 2008 to raise money for bone-marrow cancer research, it has become a leader in “crowdfunding” – the emerging economy of small-scale, do-it-yourself financing for charity and creative endeavors.

Crowdfunding websites enable visitors to peruse project proposals and donate to any they find deserving. By 2011, more than 40,000 people had used San Francisco-based IndieGoGo to raise millions of dollars for undertakings ranging from independent films to community gardens. The success of such websites soon caught the attention of entrepreneurs interested in expanding the idea to for-profit ventures. But there was a hitch: The cumbersome Securities and Exchange Commission requirements for publicly traded companies made it prohibitively expensive for smaller enterprises.

That changed in April when President Obama signed the JOBS Act (Pub. L. No. 112-106), which will enable crowdfunding of up to $1 million for business ventures. The act will open new investment paths as well as, some say, a passel of legal and business dilemmas. The new law, now in a 270-day rule-making process at the SEC, will allow registered brokers and Web-based “portals” like IndieGoGo to issue small-scale investment securities. Though Obama and others have called the law a “game-changer” for small business, many questions remain.

Disclosure requirements pose a significant concern. The crowdfunding law “punts everything to the funding portals,” says attorney Mark J. Seidemann. Details of what the portals must disclose about the source and solidity of investments offered remain unsettled. “In crowdfunding now, [disclosure] tends to be very brief,” says Seidemann, a partner with Cooper, White & Cooper in San Francisco.

Also, the new regulatory regime’s substantial costs could offset potential gains for investors. Portals will be on the hook for disclosure costs that can run $25,000 or more for legal and accounting fees.

Some securities industry groups opposed the new law on grounds that it would open the door to fraud. “States are concerned that the fraud and scammers will come out of the closets now and start using social networking sites to rip off investors,” Jack Herstein, president of the North American Securities Administrators Association, told Bloomberg Businessweek.

“There’s going to be a cost either way,” says Seidemann. “The less restriction you have, the more chance there is for fraud. But if restrictions are too high, you choke off opportunity.”

But Jenny Kassan, an attorney with Oakland’s Sustainable Economies Law Center and CEO of Cutting Edge Capital, is not worried. “It’s going to be pretty highly regulated. I’m not concerned about fly-by-night operations.” And the cost of registering an investment portal and providing full disclosures means “not just anybody is going to be able to do this,” she says.

The scale of a crowdfund offering may also affect which authorities enforce disclosure rules and prosecute fraud. Because smaller investments typically don’t rise to the SEC’s attention, state agencies may step in to regulate intermediaries and broker-dealers, says Keith Paul Bishop, a partner with Allen Matkins Leck Gamble Mallory & Natsis in Orange County and former commissioner of California’s Department of Corporations. “I think the states are going to have a significant enforcement role.”

One such example is the case of ProFounder, which the state Department of Corporations compelled last summer to stop issuing online securities. The crowdfunding website had allowed companies to receive funds from people with whom they had “substantial relationships” – but investigators determined that ProFounder hadn’t properly verified the investors’ identities, and thus sold securities without a license.