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The Great Crowdfunding Train Wreck of 2013

The verb “to disrupt” in all its forms is rightly popular in the startup world.  To many entrepreneurs, few things are as personally satisfying (or as lucrative) as disrupting an entrenched, complacent, monopolistic, inefficient or stagnant market in ways that often empower consumers and producers alike.  Consumer Internet and mobile technology businesses continue to be rife with opportunities for disruption.

On March 8, 2012, the U.S. House of Representatives passed the JOBS Act, becoming the subject of much chatter at this year’s South by Southwest Interactive (SXSW) conference that began the following day.  This bill is the latest in a series of efforts and initiatives in recent years intended to disrupt the traditional methods and markets for investment in, and capitalization of, emerging growth businesses.  Boosters can be found all over the Web proclaiming a nascent crowdfunding revolution that will ensure prosperity for entrepreneurs and mom-and-pop investors alike.As a lawyer, advisor, investor, director and co-founder myself, I am an ardent advocate for entrepreneurs, startups, and the individuals and institutions that fund them.  Yet I simply can’t support crowdfunding, properly defined, for reasons I’ll get into below.  To cut to the chase, I believe it would lead to disastrous consequences for minimal gain, creating perverse incentives that would enrich the most “ethically challenged” hucksters, deplete the assets of those who can least afford it, while continuing to leave the most attractive investments to financial institutions and high-net-worth individuals—traditionally, venture capital firms and angel investors.

My colleague at Gust Blog, veteran angel investor Bill Payne, has written a series of outstanding posts on the subject already.  If you’re new to the subject, I highly recommend reading this post by Bill, which is more balanced than mine, neatly summarizing the pros and cons, risks and benefits.  I’d like to supplement his pieces with my own perspective, developed as an in-house and outside lawyer for startups and investors over the past 15 years.  In the course of my career, I’ve counseled clients in matters ranging from $10K friends-and-family convertible debt seed financing for new startups to overhauling a Nasdaq 100 company’s financial disclosure controls and securities compliance as Chairman of the Disclosure Committee in the wake of the Sarbanes-Oxley Act of 2002.

First, it’s important to define what we do and don’t mean by “crowdfunding.”  There are various ways of collectively funding new initiatives, such as pooling donations to a non-profit entity or facilitating collective sponsorship of creative projects as Kickstarter does.  There are also startups funded by a large number of individual angel investors or groups, all of whom meet the criteria for “accredited investors” under current U.S. securities law.  Those are all worthy pursuits that fall outside the scope of this discussion.

My definition of the type of crowdfunding contemplated by the JOBS Act — more accurately dubbed “crowd investing” — is the making available of equity shares in a for-profit business enterprise for investment in relatively small dollar amounts by a relatively large number of individual investors who do not meet the traditional “accredited investor” criteria.

Anyone in the securities industry will find this to be a familiar description.  It sounds virtually identical to something called an “initial public offering,” or IPO.  You can find Facebook’s regulatory filing for its upcoming IPO, known as a registration statement on Form S-1, on the SEC’s EDGAR website in all its 190 pages of glory.  (I previously published an analysis of the 22-page “Risk Factors” section in collaboration with Dan Rowinski of ReadWriteWeb.)  To “go public” involves filing this kind of registration statement under the Securities Act of 1933, subject to review by the SEC and amendment in response to its comments; preparing five years of historical financial information, to be reviewed and audited by an independent accounting firm and published in the registration statement; meeting both qualitative and quantitative listing criteria to be traded on a stock exchange; committing to governance standards such as having an audit committee comprised of independent directors; and committing to indefinite updating of the company’s public disclosures in the form of quarterly financial reports, annual audited financial statements with more extensive disclosure, and annual proxy statements in connection with the election of directors, as well as real-time reporting of significant events and transactions by insiders, among other things.

Crowdfunding involves offering the same kind of securities to the same kind of public buyers with precisely none of the above.  The lack of transparency is justified by limiting the amount of capital any one investor can lose, and/or the amount the company can raise, to figures small enough to meet someone’s arbitrary standard of relative harmlessness.  If that sounds reasonable to you, I’d be happy to confiscate $100 apiece from 10,000 readers to walk away a millionaire while leaving you with no recourse.  (Libertarians are outraged when the government does that in the form of taxation.)

Securities regulation in the United States is a disclosure-based system.  The SEC does not pass on the merits of any particular investment per se.  The primary purpose of securities laws and regulations, and their enforcement, is to protect investors from fraudulent and deceptive practices in a situation of radical information asymmetry.  The people running a company know literally everything about it; outsiders know literally nothing except what is disclosed, either voluntarily or through government coercion.  Even then, as investors, we have no guarantee that what is disclosed by the company resembles the truth — a lesson bitterly learned through destruction of untold billions of dollars of shareholder value by Enron, WorldCom and their ilk.  Sabanes-Oxley was passed out of desperation when it became clear that even the very largest NYSE-traded companies with blue-chip auditing firms were able to get away with massive accounting fraud by reporting figures that were manipulated and distorted.  Our trust, as it turned out, was misplaced.

In the lexicon of economics, this is a variety of principal-agent problem in which a moral hazard exists for a company to take more risk than its investors would take under the same circumstances.  (If you find the term “moral hazard” muddies the waters, simply replace it with the concept of gambling with “other people’s money” rather than your own.  This very concept of spreading risk widely enough that it’s unrecognizable by the investors taking it turned out to be at the heart of the subprime mortgage crisis.)  There is no reason to assume that these problems will magically go away with respect to companies below a certain size, or raising an amount of capital less than $X, or in purchases of less than $Y from any single investor.  In fact, as I’ll explain, the risks are exacerbated and amplified by orders of magnitude as a consequence of basic economic principles and a recent U.S. Supreme Court decision.

One of the fundamental tenets of investing is that risk and return are positively correlated.  The more risky an investment, the more it must pay investors to find that risk acceptable.  The “invisible hand” of market forces described by Adam Smith makes this so.  Setting aside the theory, anecdotally, any early stage investor has examples of worthless stock written off after a bad investment as well as (hopefully) spectacular returns from the home-run hitters.  The portfolio approach followed by VCs and angels arrives at an outcome that should ultimately be a healthy rate of return in the long run at the cost of great short-term volatility and illiquidity.

Valuation of private companies is more of an art than a science.  Sophisticated institutional investors with decades of experience can and do regularly disagree about the fair pre-money valuation of a startup.  Nevertheless, existing securities law treats these investors as “grown-ups.”  Through exemptions such as Regulation D under the Securities Act, accredited investors can invest in a startup without putting the company through the onerous disclosure and governance requirements described above for public companies, which would be prohibitive.  The only reason this makes any sense is that investors typically have both economic incentive and bargaining leverage to conduct thorough due diligence reviews, negotiate protective provisions and investor rights, get a seat on the Board of Directors (or at least an observer seat, affording them access to the same flow of detailed inside information that the Board receives), and so on.  Even so, the best investors get it wrong much of the time, like Hall-of-Fame baseball players who still miss more pitches than they hit.

Small investors, as in crowdfunding, have neither the economic incentive nor the leverage to do any of the above.  They are therefore expected to make investment decisions involving the riskiest of investments in a near-total information vacuum.  Common sense suggests that in this kind of scenario, the little guys need more protection in the form of regulations mandating certain types of financial and other disclosure.  Unsurprisingly, the existing exemption most commonly used by startups (Rule 506 of Regulation D) requires exactly that!  The primary reason most startups won’t allow non-accredited investors (other than founders) to invest is that Reg. D requires them to prepare fairly extensive disclosure materials to be delivered to those non-accredited investors.  While less onerous than going public, it’s a headache that most early stage startups want or need to avoid.

A committed libertarian might shrug at all of this and suggest investors should be expected to bear risks and reap rewards on their own, keeping government out of it.  Regardless of the merits of that view, crowdfunding law as proposed would be a bizarre distortion that turns it on its head.  If investors are to be left to fend for themselves, it should logically be with respect to investments in the largest, Fortune 500-type companies that offer far more disclosure voluntarily and whose stock prices are far less volatile.  Instead, JOBS Act-style crowdfunding legislation is a form of targeted deregulation of the financial markets aimed exclusively at investors who by definition have assets or income placing them squarely in the middle class and are making investments so small that in reality they have neither the leverage nor the economic incentive to demand adequate disclosure by issuers.  An economics professor could hardly dream up a better textbook example of guaranteed market failure.  (Law professor Barbara Black has also written on the subject.)

Many investments become worthless.  People will make bad or uninformed decisions, or invest on the basis of misleading, deceptive or fraudulent information.  In the case of crowdfunding, when this happens, who will they blame?  The answer is not themselves; our culture simply doesn’t work that way in this litigious age.

What about intermediaries who could impose some order on the chaos, disclosure standards, and so forth?  The inherent trade-offs are insurmountable:  The more transparency and accountability required of issuers, the more the entire point of being crowdfunded disappears.  With a less transparent, unregulated market, more investors will inevitably be deceived, misled or defrauded.  This goes hand-in-hand with the liability question.  Securities litigation has been a thorn in the sides of technology companies for decades.  (It’s often jokingly said that a rite of passage for any publicly traded tech company is its first securities class action or derivative suit.)  For a private company, increasing the number of shareholders by orders of magnitude will also increase the probability of litigation by orders of magnitude, unless Congress acts to specifically shield crowdfunding issuers from liability.  So naturally that kind of immunity has been floated in some of the proposals currently on the table.  Without it, proponents argue, companies would be afraid to try crowdfunding.  Adding immunity to the mix takes a situation from bad to worse, where the nearly-unaccountable become totally unaccountable.  This starts to sound like sheer insanity.

It gets better.  Add the concept of adverse selection and we have the makings of a Microeconomics 101 final exam.  Adverse selection is the concept that “bad” inefficiencies result when parties have asymmetric information (see a pattern here?).  For example, people with enormous appetites gravitate to an all-you-can-eat fixed-price buffet while light eaters are more likely to stay away, costing the restaurant more than expected.  Such is the case with a funding mechanism that is designed from the ground up to leverage a large number of individual investors with minimal bargaining power under circumstances involving minimal disclosure, toothless corporate governance and little-to-no liability to shareholders.  What sort of business operators can we predict will be disproportionately drawn to using this kind of fundraising mechanism?

Finally, even if Congress were to refuse to limit or eliminate liability from securities litigation against crowdfunded companies, the U.S. Supreme Court might well do it for them under its recent AT&T Mobility decision.  To understand why, it’s important first to distinguish between individual lawsuits and class actions.  Litigation is expensive.  If I invest $100,000 in a company that deceives or defrauds me, it might well be worth suing individually, particularly if I can find a plaintiffs’ lawyer to take my case on contingency (e.g., 40% of the proceeds).  If I invest $1,000, not so much.  In the real world, this means companies will never get sued for securities fraud except (1) by individual shareholders with large stakes that make it worthwhile (usually hedge or pension funds), or (2) by numerous shareholders bundled together in a class action lawsuit—usually instigated by the lawyers, it should be noted, not the shareholders—on behalf of everyone similarly situated.

This individual-versus-class action distinction becomes critical in many contexts, including consumer protection and employment as well as securities, where there may be a large number of people with relatively small claims that wouldn’t be worth litigating individually but multiply out to a large total dollar amount.  States such as California, siding with consumers, have restricted companies’ ability to eliminate class actions in their contracts as AT&T tried to do in its cell phone service contract.  That is a controversial subject and a separate discussion in itself, but the point here is that the U.S. Supreme Court struck down California’s law in the AT&T Mobility case, restoring companies’ ability to require as a condition of doing business that customers agree to waive any right to class action litigation and/or agree to 1-on-1 arbitration with the company.  If you wonder who would ever insist on spending the time and money to go to arbitration for a $150 dispute with AT&T over a cell phone bill, you see exactly why this matters.

It’s far from certain whether the AT&T Mobility precedent will extend to matters outside consumer protection, such as securities litigation, but much of the legal community is mobilized to push things in that direction and test its boundaries.  We should expect contracts that involve high-volume, low-dollar-amount transactions to require a class action waiver in every conceivable setting unless and until the Supreme Court sets a clear boundary.  Crowdfunding is a perfect application for this change, and I would therefore be shocked if every subscription or purchase agreement for a crowdfunding deal under the new law (if it passes) doesn’t contain such a waiver.  That would have the practical effect of eviscerating any legal remedy for securities fraud against unscrupulous businesses using crowdfunding.

If you’re still reading at this point, it should be clear that the very attributes that make crowdfunding an attractive tool for raising capital also comprise a disaster waiting to happen.  One person’s barriers to investment are another’s indispensible safeguards.  There is a cost to transparency and accountability which small enterprises are understandably reluctant to bear.  Nevertheless, eliminating those things while throwing the doors open to members of the general public who are less able to bear the complete loss of an investment than accredited investors, would have trouble valuing an investment even in the face of perfect information but in fact receive almost none (and of dubious veracity), and are left with no legal recourse if defrauded, seems like a dream come true for predatory con artists and hucksters.

 
This article is for general informational purposes only, not a substitute for professional legal advice. It does not result in the creation of an attorney-client relationship.

Written by Antone Johnson

user Antone Johnson Founding Principal,
Bottom Line Law Group

Antone is a business lawyer and executive advising technology and media companies, entrepreneurs and investors in corporate, commercial and intellectual property matters. Johnson is Founding Principal of Bottom Line Law Group, a business and IP law firm and was the former VP and head of worldwide legal affairs at eHarmony.

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Comments

14 thoughts on “The Great Crowdfunding Train Wreck of 2013”

  1. Bingo, Antone. Memes are great for pop culture but disastrous for investments. Right now there are inadequate protections against price manipulation and equity-grabbing schemes. History shows there are dozens of ways to defraud investors and it’s not clear that there are guards for the chicken coop. For example, what happens if one of the owners attempts a coup using a debt-to-equity conversion? Unlike other countries, the SEC does not require a third-party analysis nor does it take into account the relationship between the note holder and the stockholders at large. Myself, I think there shouldn’t be a statute of limitations protecting advisers who use their knowledge of securities law to engage in “pump and dump” and other fraudulent conveyances.

  2. Bill Payne says:

    GREAT analysis, Antone.  Thanks for taking the time to detail this for all of us!

  3. David Israel says:

    This is a topic that entrepreneurs are talking about, however they do not understand the implications.  Well written and well analyzed.

  4. Ryan Tanaka says:

    Nice post. Helped me get a clearer picture on what was happenimg

  5. Anonymous says:

    How do you explain that literally none of the apocalyptic scenarios of bogeymen waiting in the night to rob us blind have transpired in countries where crowd funding is legal?Crowdcube in the UK nor any of the various Dutch platforms havent had case of fraud. Their market hasn’t collapsed. The truth is crowdfunding is going to transform startup financing by putting terms in the hands of the entrepreneurs. I have a very strong feeling this violent opposition to it has more to do with investors fearing their loss of the stranglehold on an industry or conversely the view that individuals without a high net worth are somehow inherently less intelligent.

  6. If you read my article, nowhere will you find any insinuation that “individuals without a high net worth are somehow inherently less intelligent.”  I agree that would be an abhorrent, stereotypical view.  The best arguments for limiting risky early stage investments to accredited investors are that (1) they have both the resources and the incentive to conduct effective due diligence, insisting on greater transparency, and (2) they generally invest in a larger number of deals, allowing the risk of this kind of investment to be diversified across a portfolio.

    Regarding your main question, I think the answer is one or more of the following:  Fraud and deception aren’t being measured and reported accurately; government regulators in those countries are more active in policing securities markets than the SEC; and it’s just a matter of time.  How long has Crowdcube been around?  Market collapse isn’t the relevant concept; if only 5 or 10 percent of crowdfunding deals were fraudulent, that might be acceptable to the general public, but the investors unlucky enough to be swindled would still lose 100%.

    The burden of proof, frankly, should be the other way around.  There is no investment market in the history of the world that has experienced zero fraud, deception, or manipulation.  I’d be happy to read a cogent explanation for why crowdfunding is immune from unethical behavior.  I don’t see that immunity magically arising as a result of using a buzzword rather than the less catchy traditional terminology of securities law (“general solicitation and sale to the public of unregistered securities”).

  7. Thanks, Ryan.  It’s interesting to probe people’s views on that subject.  How much is too little money to worry about throwing away?  It’s tough to come up with a principled answer to that question.  Gambling is one thing — people are paying for entertainment, not investing for long-term financial gain — but even that is tightly regulated.  Regardless of the legal regime, it seems to me that the success of crowdfunding is likely to vary tremendously based on the person(s) running a given startup and the trust they’ve earned in the community as well as the size of investments being sought.

  8. Deanwermer says:

    As Antone notes, a significant problem with these bills are that, in an age of significant income inequality, they “leave the most attractive investments to financial institutions and high-net-worth individuals.” Ordinary Americans will continue, as a practical matter, to be out-of-luck in getting access to private investments in companies such as Facebook, Twitter, etc.  Nor will ordinary Americans be able to get fair and equitable access to shares allocated in the IPO’s of these companies.  By and large, the financings these bills will enable likely will be bottom of the barrel quality.  Legislative effort would be better focused on (a) reducing the expense of both Regulation D offerings and IPO’s to small and mid-sized companies, (b) exploring sensible ways to give ordinary americans access to better quality private offerings (rather than excluding them from high risk returns altogether under the guise or protecting them from losses), and, most importantly in my view, (c) introducing basic financial education (personal finance and basic economic principles) early on in K-12 education so that educated americans would be more likely to make sensible financial decisions, decisions that are critical to personal well being.
    On the other hand, we live in a society where ordinary americans are free to make all sorts of terrible and ruinous investments, from 0% down (often teaser interest) home loans to large student loans for the pursuit of degrees that provide poor economic prospects.  People are free to gamble away their entire life savings.  Indeed, state governments are happy to assist (lotteries/casinos).  And people can run up ruinous credit card debt on ordinary consumer purchases or otherwise live way beyond one’s means.  So, the question I always come to when I consider these bills and reforms in our rather dated securities laws, why ban ordinary americans from this select group of investments?  Isn’t it fundamentally troubling to discriminate amongst americans on the basis of wealth in this manner?  Is it right, it sure does not feel that way, that millionaires and billionaires will make gazillions in the Facebook IPO, but, except for the admittedly important class of Facebook employees, ordinary americans are shut out, except at post-IPO market valuations?

  9. There’s always a flip side to things, everything has its pros and cons and we all have a right to our opinion(s). However, I don’t personally believe it’s all doom and gloom, in fact I firmly believe the JOBS act can and will have a very positive impact when it comes to creating new jobs and opportunities. Sometimes people simply fear change and focus too much on the worst possible outcome rather than the many benefits that certain changes like this can have. That’s just my opinion though, only time will tell how this new legislation will effect the bigger picture.

  10. Unregulated equity crowdfunding could be awful. In the UK it’s not unregulated, and Seedrs, the only equity platform to have been officially approved by regulators, does cover off most of the issues you raise above.

    Crowdfunding as a concept should be welcomed by business angels and VCs; they so often don’t recognise a valid new disruptive business, having the same herd instincts of most of the human race, and are thus inclined to go with the latest buzz. Social/location-based/coupon mobile app anyone? 😉

    My own start-up, when explained to the people from the target (paying) markets is warmly welcomed in the great majority of cases; but established investors and VCs struggle with it because it’s nowhere near the buzz and is up against very established companies and technologies. Companies more or less as established as it gets in WWW terms…

    But the target customers get it, not just for their own use but for other people like them; many of them are middle class and have a little capital; so they are willing to back it if given the opportunity. That initial investment gets the first wave of traction, and proves the business model, de-risking the investment for the professional investor (and getting me a decent valuation in that round of investment at the same time!).

    So we should all warmly welcome crowdfunding as a model for funding startups. Although not unregulated…

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  12. John LaBarge says:

    As you admit above, the SEC has been incapable of preventing con artists and hucksters from defrauding investors in the public market from time to time, Enron is a good example.  With the exception of government bail-outs no one is forcing people to invest.  And its not as if small equity investments would be the only way that middle class individuals could be defrauded.  With a complicit government Wall Street continues to work out new ways to do so, of late are sub-prime mortgages and the devaluation of the currency.  Not only is it discriminatory, elitist and plain un-American to prevent people from investing their own money because they aren’t at particular net-worth, I personally would trust the free market to do its own vetting of hucksters and con-artist far more than I would our Federal Government. 

  13. Kevin Frei says:

    Deanwermer, you are absolutely correct. The libertarian wisdom on this matter is twofold: 1. There are market mechanisms for regulating these securities that are far more efficient and nuanced than the SEC. A totally free securities market would give birth to multiple exchanges, many of them specialized, all competing based on reputation. They have every incentive to regulate the securities they list in a way that maximizes gains. 2. A certain fraction of any market is bound to be dysfunctional. The question is whether the SEC succeeds suppressing dysfunction in the securities market (i.e. fraudulent issuers on one side and naive investors on the other) below the natural rate enough to justify the costs in both efficiency and equity in the system. My suspicion is that much of the gains in consumer protection are probably offset by the ignorance imposed upon them by barring their access to any legal markets for private securities. But more importantly, the economic cost of imposing so much friction on these markets is enormous. As everyone knows, when you want less of something, tax and regulate it. The idea that we regulate the flow of capital to entrepreneurs (and the flow of created value back to investors) so heavily defies logic. Total deregulation would likely result in only a small uptick in net fraud as most people would learn very quickly that it’s a dangerous world and it’s smart to only invest in businesses you understand on exchanges you trust. You can’t sell someone a stock they don’t want to buy. Most consumers intuitively understand information asymmetry which is why markets produce things like money-back guarantees, trusted vendors (in this case exchanges), etc. Given that the SEC doesn’t do much to police private issuers ex-ante anyway, it can continue to punish fraud ex-post without also lumping in charges about whether the offer was conducted properly. Now, all that said, I’m not an expert and I won’t be surprised if someone crushes me with a really good rebuttal, but that’s how I see the issue, anyway.

  14. Kevin, thanks for your thoughtful comment. I agree in principle with the “libertarian wisdom” that you describe. No doubt we’ll see all kinds of creative approaches to building credibility by platforms that compete for crowdfunding business. The final version of the JOBS Act places a lot of responsibility on these intermediaries.

    That said, I’m concerned that crowdfunding is uniquely difficult to keep in check because the dollar amounts involved are so small, relatively speaking, and spread so thin. You’re absolutely right that policing of private issuers is weak; with finite resources, the SEC focuses enforcement efforts on public markets, where (1) the stakes are much higher in dollar terms, (2) “mom and pop” retail investors participate, and (3) the flow of information from the company is vast under the ’33 and ’34 Acts.

    Do retail investors read and analyze an S-1 before deciding to buy? Of course not. The flow of information to analysts, state and federal regulators, and plantiffs’ class action attorneys should be a powerful enough incentive to keep issuers honest such that consumers can have a reasonable degree of confidence in the market. Remove #3 above and the difficulty of any kind of enforcement jumps by an order of magnitude. Remove #1 and the potential rewards of any public or private enforcement diminish significantly. Equity crowdfunding does exactly that, while keeping #2. In a nutshell, my concern is that the cost-benefit of any enforcement with respect to all but the very largest crowdfunding deals simply won’t pencil out, and therefore won’t exist. I very much hope to be proven wrong as events unfold.