It would be hard to downplay the popularity of crowdfunding in today’s Internet age. Now, however, this penchant for crowdfunding has found a new outlet: equity crowdfunding, or the online offering of securities to a group of people in exchange for investment. It was, it seems, an inevitability riding on the back of the Internet age, the visibility of high profile unicorns (startups that are valued at $1 billion or more), and the emergence of Kickstarter and other similar websites: startups need less and less money to begin operations, and raising money over the internet is both efficient and cheap. As a result, Congress took notice and, in 2012, passed legislation allowing companies to use crowdfunding to issue securities, otherwise known as the CROWDFUND Act, or Title III of the JOBS Act.
The JOBS Act itself makes it easier for companies to solicit accredited investors, but the CROWDFUND Act goes even further, allowing unaccredited investors to invest in startups without the same securities regulation provisions. What this essentially means is that startups and small businesses can raise up to $1 million in funds on crowdfunding platforms that are registered with the SEC. Early reactions were mixed, oscillating between hailing the CROWFUND Act for making it easier for Americans to be entrepreneurs and investors, and worrying that the funding platforms it provides for would turn into a market for low-quality startups and unsophisticated investors.
For four years, from 2012 until 2016, these reactions were merely theories, untested while the SEC finalized the rules surrounding Title III equity crowdfunding. Now, however, thanks to the finalized rules becoming effective in May 2016, some data about the Act’s efficacy and compliance is available.
As of December 31, 2016, only 169 companies had filed with the SEC to offer securities under Title III crowdfunding on 21 registered funding platforms. The median offering amount was $50,000, although almost all companies indicated that they would accept offers in excess of this amount, usually up to the cap: $1 million. Some companies have seen funding soar, including five companies that have reached the maximum $1 million in investments, and another five have raised over $500,000 to date. If that sounds small, consider this: if all the Title III crowdfunding securities offerings filed in 2016 are successful, the companies will raise around $110 million in new capital for their businesses.
For all its successes, there have been failures, too. Because Title III crowdfunding is subject to lower regulatory barriers, the SEC does not individually check whether issuing companies are complying with all the requirements. The result is a dearth in compliance among both platforms and issuers: CrowdCheck, a service that conducts due diligence on companies seeking investments, found that almost none of the companies that are listed on investment platforms are fully in compliance with SEC rules. Around 40% did not get their financial results audited or certified, as required. Similarly, the Drinker Biddle Crowdfunding Report, an open data set providing information on Title III issuers, found that compliance with 203(a)(3)(iii), which requires issuers to disclose the amount of securities sold in an offering no later than five days after the deadline, hovered around 15% within the five day period, and 43% without taking the period into account.
Perhaps the most high profile of these failures was the expulsion of uFindingPortal (UFP) from membership. UFP, as a funding platform, was required to have a reasonable basis for believing that issuers on its platform comply with applicable securities laws and rules under Rule 301(a). It allowed issuers on its platform even though none of these issuers had filed any of the requisite disclosures, including six companies that committed the more egregious sin of failing to disclose the names of all directors and officers with the SEC. FINRA ultimately found UFP guilty of violating 301(a) as well as other provisions, including, but not limited to: 301(c)(2) (requires funding platforms to deny access to its platform if it has a reasonable basis to believe that the issuer presents the potential for fraud), 200(c)(3) (prohibits funding platforms from including false, misleading, and untrue material facts on their platforms), 200(a) (requires funding platforms to observe high standards of commercial honor and just and equitable principles of trade), and 303 (requires platforms to make available all of the information supplied by the issuer). Luckily, the companies on the platform had raised less than $100 in the aggregate. uFundingPortal ultimately settled without admitting or denying any of the allegations.
On the issuer side, the SEC shut down Ascenergy, a company that raised $5 million on various crowdfunding sites to finance an oil and gas business, before the regulations even went into effect. It was able to rort the system (and skirt regulations) by allowing more sophisticated investors to invest in addition to the less sophisticated, a provision found in Title II of the JOBS Act. The majority of the money it had collected was promptly spent for the personal expenses of its founder before the SEC found that its various claims pertaining to the oil and gas business were baseless. It had been rejected by multiple platforms before being able to raise the $5 million from around 90 investors.
Theoretically, the Title III regulations were intended to stop companies like Ascenergy, that “scream fraud” from making it onto funding platforms, for it was perhaps the rejection of the company from several platforms that limited the damage somewhat. SEC rhetoric even changed: fraud and non-compliance on the part of the issuers should be stopped by the funding platforms, who, it was made clear, bear the responsibility according to the SEC regulations. However, despite these threats from the SEC, they never brought suit against or penalized the platforms that accepted Ascenergy. In response, some platforms are currently leading an effort to create industry standards when vetting potential investments, stopping companies like Ascenergy from ever getting past the gate. This has been met with some opposition, particularly from Wefunder, the funding platform that controls the most market share – currently around 70%.
Congress is currently considering legislation to amend the Crowdfunding Act. The House’s version, the Fix Crowdfunding Act, was passed on July 5, 2016, while the Senate version, the Crowdfunding Enhancement Act, was still in committee when the last Congress adjourned. Neither of these bills, however, address the lack of compliance in either the funding platform or issuer spaces, instead focusing on the use of special purpose vehicles (essentially aggregating all the investors into one group to make management easier) and registration exemptions. Given that the Senate bill is yet to be passed, it may fall on them to bless the current effort towards industry standards to protect these investors if, as the SEC has said, the funding platforms are to be the gatekeepers for Title III crowdfunding. This must, however, be met with greater enforcement by the SEC on both issuers and funding platforms, alike.