November 18, 2015 Practice Points

    Congress and SEC Implement the Use of Crowdfunding to Spur Economic Growth

    By Leonard Wills

    On March 27, 2012, Congress passed the Jumpstart Our Business Startups (JOBS) Act to provide an alternative method for startup companies (startups) to raise capital by selling securities through crowdfunding platforms. The JOBS Act builds on the same principle as a crowdfunding business model, which allows the general public to invest in startups by purchasing securities. Crowdfunding consists of online platforms used by an entity or individual to raise capital from the general public or "crowd" for a particular venture. President Obama called the JOBS Act a "potential game changer" because for the first time, "ordinary Americans will be able to go online and invest in entrepreneurs they believe in" and, in the process, create economic growth.

    Three years after Congress authorized the Securities and Exchange Commission (SEC) to set rules to implement the new law, the SEC approved the final rules (also known as 'Regulation Crowdfunding'), to allow equity crowdfunding, by a 3 to 1 vote under Section 4(a)(6) of Title III of the JOBS Act. Congress added Section 4(a)(6) to the Securities Act of 1933 (Securities Act) to allow a startup's offering and sale of securities through a crowdfunding platform to be exempt from registration with the SEC—an expensive and time-consuming process.

    Section 4(a)(6) contains two key regulations. First, startups can now sell securities to the general public through a crowdfunding platform. Startups can raise a total of $1 million each year through an "SEC-registered intermediary, either a broker-dealer or a funding portal." Second, for the first time in history, the general public can purchase securities from a company during its early stages. Investors must thoroughly research these startups before making an investment—if they hope to yield large returns. However, along with the possibility of large returns, investors can experience huge losses or even investment fraud.

    The SEC acknowledges the possible occurrence of investment fraud and set measures in place to guard against it. To protect investors, Section 4(a)(6) provides regulatory measures such as: investment caps and required disclosure statements from startups. Investment caps aim to prevent a person from squandering her lifesavings on investments, which are inherently risky. The investment cap, under Section 4(a)(6) permits investors to invest up to $2,000 or up to 5–10 percent of their annual income in a 12 month period—whichever is greater. In addition, startups must file disclosure statements with the SEC. Disclosure statements contain details about the company, including but not limited to: the company's officers and directors, a business description, the company's public offerings, and the company's financial condition. The SEC reviews the statements before disseminating it to the public, which uses the statements to make investment decisions.

    Despite these regulatory measures, some critics argue that the new rules do not provide enough protection for the general public. Investing in startups remains an inherently risky activity—startups have a 75 percent failure rate. An SEC study on the financial literacy of investors found that many "investors do not understand the most elementary financial concepts… [and] that investors lack critical knowledge" that would protect them against "investment fraud."

    Crowdfunding takes place over the internet, an inherently "impersonal structure" that prevents investors from access to "the information and tools used by professional venture capitalists." Subsequently, investors without this access are more susceptible to investment fraud and making poor investments. Venture capital firms, on the other hand, engage in risk management, fundamental analysis, and market research to discern which companies have a likely chance to succeed in the market place. Unlike the general public, these firms also have access to the startups' management team and spend hours interviewing them about their company before making an investment decision.

    Congress enacted the JOBS Act to provide a less expensive means for entrepreneurs to raise capital, and to create economic growth. Only with the passage of time can Congress, investors, startups, venture capitalists, and others judge whether the JOBS Act adequately protects investors from fraud and lives up to its name—to jumpstart the creation of small businesses and thereby create economic growth.

    Keywords: minority trial lawyer, litigation, SEC, crowdfunding, JOBS Act

    Leonard Wills is with the U.S. Department of Homeland Security Federal Emergency Management Agency in Philidelphia, Pennsylvania.

    The views in this article neither represent the official views of the United States government nor does the United States government endorse the views in this article.

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