Crowd Investing versus the SEC

by on September 26, 2011 at 12:47 pm in Economics, Law | Permalink

Crowdfunding has become well known thanks to popular websites like Kiva and Kickstarter so it may come as a surprise that crowd investing, investing in order to earn a return as opposed to “investing” for philanthropic reasons, remains essentially illegal. If a website like Kiva or Kickstarter tried to connect small investors with small firms it would run afoul of state and Federal laws regulating securities.  As Amy Cortese writes in the NYTimes:

Under those laws, crafted largely in the 1930s, the sites would have to either limit the fund-raising to wealthy investors, who the S.E.C. deems sophisticated, or go through a registration process that would prove too costly given the small sums being sought…

In the United States, these outdated laws are cutting off a huge pool of potential capital for small, private businesses that have been all but abandoned by banks and Wall Street.

…President Obama, as part of his jobs act, advocates an exemption for sums totaling up to $1 million. Representative Patrick McHenry, a Republican from North Carolina, has drafted legislation that would allow companies to obtain up to $5 million from individuals through crowdfunded ventures, with a cap of $10,000 per investor, or 10 percent of their annual incomes, whichever is smaller.

In Britain the regulations are less onerous:

For a glimpse of what is possible, look at Britain, where securities laws are helpful to crowdfunding and several start-ups are vying to be the Facebook of finance. The year-old Funding Circle, a business-lending site based in London, raises more than $2.3 million each month for small businesses from individuals who can invest as little as $30 and earn an average yield of roughly 7.3 percent after fees. Those are loans; two other start-ups are applying the model to equity shares in small companies.

Hat tip: Daniel Lippman.

John Hall September 26, 2011 at 12:53 pm

Interesting post. I just provided some funds to a youtube tv show via kickstarter. I recall reading in de Vany’s Hollywood Economics that a film is really no different than a firm set up to produce one product. So how is it not already illegal to get investors that start a business to make an online tv show?

Alex Tabarrok September 26, 2011 at 1:24 pm

The difference is that your investment doesn’t get you an ownership stake or potential financial return and so is considered a type of charity.

CMS September 26, 2011 at 1:29 pm

I have noticed though, at least with some Kickstarter projects, there are giveaways for those who contribute. Wouldn’t that be illegal under the current law?

John Hall September 26, 2011 at 2:25 pm

Yeah, the one I gave money to was full of possible contributions. I viewed it more as paying in advance for an HD copy of the series. I do think that is potential financial return, like a bond. I provide them with $x and receive in return an HD copy of the series back when it is made. It certainly isn’t like an equity investment.

It would be very easy for those people to just walk away with my money (they had raised like 80k over the weekend when I had submitted my own) if I were worried they would be dishonest.

Someone from the other side September 26, 2011 at 9:18 pm

Sounds more like donating money to the local opera and getting some free tickets in exchange?

Scott Leibrand September 26, 2011 at 3:16 pm

LendingClub seems to have done a good job working within the SEC rules to accomplish something similar. They do require investors to attest that they meet certain “sophistication” criteria, but they don’t actually check.

I’d love to see more reasonable regulations to encourage more similar sites.

Tony September 26, 2011 at 3:49 pm

“If … Kickstarter tried to connect small investors with small firms it would run afoul of state and Federal laws regulating securities.”

Then, I suppose it’s a good thing that isn’t at all what Kickstarter is trying to do. (Right?)

Jordan September 27, 2011 at 11:07 am

http://www.prosper.com/ seems to be doing what you describe, and I’m not sure how they get around these SEC rules.

Kirk Hartley September 27, 2011 at 11:48 am

Fascinating post. At a big picture level, might we conclude that well-intentioned SEC rules are part of how we have ended up with the mess of uber banks too big to let fail (they say) and uber crises. As the bansk and loands/investments have grown over the years, they encounter the Innovators Dilemma problems of only big scale matters, and good but little investments/loans etc become lost and ignored, thus leading to giant bets and giant failures, and the demise of small busienss that employs so many,often in socially responsible ways because employees are friends and not just datapoints. Therefore, to escape the problem, we need to pare back the SEC rules and foster/create new ways for “small” to happen, and incrementally (marginally) take power/leverage away from the massive. See below for other people’s words (see amazon book review) framing two of the lessons from the Innovators Dilemma by Christensen.

2) Small markets can not fulfil the growth need of large companies. For several reasons, growth is important for companies. Unfortunately, the bigger the company, the harder it is to continue growth. A small company (40 million sales) with a growth target of 20%, must achieve 8 million extra sales. A large company (4 billion sales), has to achieve 800 million of extra sales! Emerging markets often simply are not large enough to fulfil such growth needs. They can, however, fulfil the growth needs of new small companies.

3. Markets that do not exist can not be analysed. The ultimate applications of disruptive technologies can not be foreseen on forehand. Failure is an intrinsic unavoidable step to success.

ohwilleke September 27, 2011 at 10:45 pm

We can’t analyze markets that don’t exist, but we can analyze markets that used to exist and no longer do. There have been times in history when the regional stock exchanges had some vitality, and in the very early days of the big stock exchanges.

But, the more promising historical examples, in my mind, is the now greatly diminished small business bank sector developed before FDIC insurance made it imperative that commercial banks make absolutely safe loans. The transaction costs in extending and monitoring a bank loan to a small business are much lower than the costs involved in managing equity, and involve somewhat lower risks. Investors interesting in investing in these kinds of businesses can buy shares in the bank rather than the individual loans, thereby securing some diversification. The bank managers don’t have to worry about collective action problems and are sophisticated enough to know what kind of due diligence is required. Historically, these were an intermediary between investment banks and commercial banks that served businesses too small or stable to get venture capital funding in today’s business environment. They also often provided informal connections needed to secure small numbers of angel investors.

Tim Worstall September 27, 2011 at 12:34 pm

I had a long chat recently (about one of my own projects) with one of the UK platforms doing this. Real equity investment. Seems to be working alright, companies are getting funded. Too early to tell about snake oil of course……

But a decent plan has a very good chance of getting £50 k to £100 k in funding, enough to get a small one or three person business running. And that is the sort of amount of money which is horribly difficult to raise as well.

ohwilleke September 27, 2011 at 10:36 pm

You wouldn’t think that weak security laws would be that threatening to a nation’s overall well being. But, these turn out to have been some of the most vital laws to get right to avoid national scale catastrophy. Securities fraud very nearly brought down post-communist Albania and has been part and parcel of the really negative social and political developments we’ve seen in the former Soviet Unions with the development of the oligarchs, etc.

Perhaps the folks in the City, having a longer legacy of thinly regulated securities markets than anyplace else on Earth have enough private sector defenses built into their institutional memory to prevent things from spiraling out of control, but given that the UK seems to fair as poorly as anyplace else in the financial crisis, I’m not convinced.

ohwilleke September 27, 2011 at 10:28 pm

The current regime that limits crowd sourcing has a lot to be said for it.

Collective action problems involved in shareholder monitoring of action by publicly held companies is a serious problem even in largely publicly held companies that have individuals and institutional investors who have multimillion stakes in the companies to give them an incentive to monitor companies for misconduct.

Absent securities laws, the requirement that firms be transparent pretty much goes out the window, and no individual shareholder has enough of a personal financial stake in the company to make monitoring it economically efficient. Yet, it is much easier in a relatively small firm for insiders to divert value from equity holders than it is in a large firm, because profits are relatively small relative to relatively normal senior management salaries in small firms. Minority shareholders are very easy to screw over and have very few meaningful rights vis-a-vis management abuses of discretion (even for personal gain by management) due to corporate governance laws developed with large publicly held companies in mind. Most closely held firms deal with this problem by developing elaborate buy-sell arrangements or shareholder agreements to mitigate this risk.

The rich guy’s version of crowdsourcing, in which basically passive investments (mostly real estate investments, oil and gas development once oil has already been struck, private equity funds and hedge funds) are funded with private offerings to wealthy individuals has a number of checks and balances that this model wouldn’t. First, rather than having illusory control through a right to vote that can’t be exercised effectively, private offering financed ventures tend to (1) have non-voting members, (2) predictable and not amenable to the need or possibility of widespread management discertion, (3) strictly limit management compensation by contract to a percentage of the fund’s profits, (4) require large investments by relatively modest numbers of sophisticated investors who have the incentives and means to seriously monitor their investments, and (5) is faciliated by sophisticated and highly regulated professional brokers and lawyers, some of whom owe fiduciary duties to the investors and others of which have powerful reputational stakes in deals going smoothly. Even then, big swindles or immense suprises aren’t all that uncommon. This is a quite litigious field when deals go bad and an equity investment model that requires not infrequent litigation to keep honest might not work as well at a wholesale level.

Private equity offerings in active businesses are generally workable in practice only with very high levels of interpersonal contacts between the investors. Typically, the biggest players are current or former players in the same or related industries and serve on the Board of Directors, the management has personal relationships at least as business colleagues with the investors, and the entire marketplace of investors many of whom are in multiple ventures with relatively big dollar investments each communicates frequently, share a lot of norms about the business decisions that management will have to make, all know each other reasonably well, and are in a geographic area typically not much bigger than a metro area. The social capital that investors and managers have with each other is critical to developing the trust needed to make a situation prone to abuse fly. Usually, for example, these companies have an unwritten rule setting a presumptive price for shares, investors sell only when they must, they buy if they can to let another investor who needs to get out out, and they ignore ordinary indica of actual FMV in interinvestor transactions. The number of closely held businesses organized on the ordinary shareholder of a corporation model where it takes more than a dozen people to command a majority to act is exceedingly small. Civic organizations and cooperatives manage large groups of voting stakeholders mostly by having other laws that impose strict limits on privatge inurement to bolster a lack of an incentive to monitor management.

A crowdsourced bond offering with an indenture trustee wouldn’t be as catastrophically prone to abuse as an equity offering, particularly given the capacity of shareholders to utilize the threat of 10b-5 lawsuits and perhaps Dun & Bradstreet credit ratings to ascertain capacity to pay, and the likelihood that intermediaries might develop to satisfy the demand for a modicum of due diligence. But, even then, something a bit like a donor advised fund of a community foundation, or a mutual fund, where an umbrella organization provides outsiders with opportunities to buy into ventures indirectly through their own offerings tied to particular incubated firms in exchange for taking responsibility for conducting minimal due diligence seem far more likely to work without becoming cesspools of fraud than a truly unregulated system.

I see a deregulation of crowdsourcing investments start to look a lot like the quite disreputable penny stock markets, but worse. While crowdsourcing sounds bright and glittering, without intermediaries to facilitate collective action and monitoring, it really doesn’t make a lot of practical sense as a financing mechanism, at least without far more legal regulation than existing corporate governance law provides.

NAME REDACTED September 28, 2011 at 3:30 am

Crowd investing /IS/ what a stock market started out to be and what it is supposed to be.

Unfortunately stock market regulation has since been captured.

conchis September 28, 2011 at 3:48 am

Interesting that some of the British players actually appear to be in favour of more regulation in the sector: http://www.p2pfinanceassociation.org.uk/

human mathematics September 30, 2011 at 2:09 am

Yeah, you can try, but in the end, you’re just gonna lose, bigtime, because the world is run by The Man.

- Who ?
- The Man.

Oh, you don’t know The Man ? Well, he’s everywhere. In the White House, down the hall. Miss Mullins, she’s The Man.

[D]on’t waste your time trying to make anything cool or pure or awesome. The Man’s just gonna call you a fat, washed-up loser and crush your soul.

So do yourselves a favor and just give up !

-Jack Black

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