[House Hearing, 113 Congress]
[From the U.S. Government Publishing Office]
SEC'S CROWDFUNDING PROPOSAL: WILL IT WORK FOR SMALL BUSINESSES?
=======================================================================
HEARING
before the
SUBCOMMITTEE ON INVESTIGATIONS, OVERSIGHT AND REGULATIONS
OF THE
COMMITTEE ON SMALL BUSINESS
UNITED STATES
HOUSE OF REPRESENTATIVES
ONE HUNDRED THIRTEENTH CONGRESS
SECOND SESSION
__________
HEARING HELD
JANUARY 16, 2014
__________
[GRAPHIC] [TIFF OMITTED] TONGRESS.#13
Small Business Committee Document Number 113-050
Available via the GPO Website: www.fdsys.gov
U.S. GOVERNMENT PRINTING OFFICE
86-267 WASHINGTON : 2014
-----------------------------------------------------------------------
For sale by the Superintendent of Documents, U.S. Government Printing Office,
http://bookstore.gpo.gov. For more information, contact the GPO Customer Contact Center, U.S. Government Printing Office. Phone 202�09512�091800, or 866�09512�091800 (toll-free). E-mail, [email protected].
HOUSE COMMITTEE ON SMALL BUSINESS
SAM GRAVES, Missouri, Chairman
STEVE CHABOT, Ohio
STEVE KING, Iowa
MIKE COFFMAN, Colorado
BLAINE LUETKEMER, Missouri
MICK MULVANEY, South Carolina
SCOTT TIPTON, Colorado
JAIME HERRERA BEUTLER, Washington
RICHARD HANNA, New York
TIM HUELSKAMP, Kansas
DAVID SCHWEIKERT, Arizona
KERRY BENTIVOLIO, Michigan
CHRIS COLLINS, New York
TOM RICE, South Carolina
NYDIA VELAZQUEZ, New York, Ranking Member
KURT SCHRADER, Oregon
YVETTE CLARKE, New York
JUDY CHU, California
JANICE HAHN, California
DONALD PAYNE, JR., New Jersey
GRACE MENG, New York
BRAD SCHNEIDER, Illinois
RON BARBER, Arizona
ANN McLANE KUSTER, New Hampshire
PATRICK MURPHY, Florida
Lori Salley, Staff Director
Paul Sass, Deputy Staff Director
Barry Pineles, Chief Counsel
Michael Day, Minority Staff Director
C O N T E N T S
OPENING STATEMENTS
Page
Hon. David Schweikert............................................ 1
Hon. Yvette Clarke............................................... 6
WITNESSES
Jason Best, Principal, Crowdfund Capital Advisors, San Francisco,
CA............................................................. 2
Daniel Gorfine, Director, Financial Markets Policy, Milken
Institute, Washington, DC...................................... 4
Mercer Bullard, MDLA Distinguished Lecturer and Associate
Professor of Law, Director, Business Law Institute, University
of Mississippi, University, MS................................. 6
DJ Paul, Co-Chair, Crowdfund Intermediary Regulatory Advocates,
New York, NY................................................... 8
APPENDIX
Prepared Statements:
Jason Best, Principal, Crowdfund Capital Advisors, San
Francisco, CA.............................................. 28
Daniel Gorfine, Director, Financial Markets Policy, Milken
Institute, Washington, DC.................................. 76
Mercer Bullard, MDLA Distinguished Lecturer and Associate
Professor of Law, Director, Business Law Institute,
University of Mississippi, University, MS.................. 82
DJ Paul, Co-Chair, Crowdfund Intermediary Regulatory
Advocates, New York, NY.................................... 119
Questions for the Record:
None.
Answers for the Record:
None.
Additional Material for the Record:
None.
SEC'S CROWDFUNDING PROPOSAL: WILL IT WORK FOR SMALL BUSINESSES?
----------
THURSDAY, JANUARY 16, 2014
House of Representatives,
Committee on Small Business,
Subcommittee on Investigations, Oversight and
Regulations,
Washington, DC.
The Subcommittee met, pursuant to call, at 10:00 a.m., in
Room 2360, Rayburn House Office Building. Hon. David Schweikert
[chairman of the subcommittee] presiding.
Present: Representatives Schweikert, Chabot, Mulvaney,
Herrera Beutler, Rice, Clarke, and Chu.
Chairman SCHWEIKERT. Good morning. We will call our
Subcommittee hearing to order.
First, I would like to request that Mr. Mulvaney, the
member from South Carolina and a member of the Small Business
Committee, be able to participate in today's Subcommittee
hearing.
Without objection, so ordered.
Welcome, Mr. Mulvaney. Thank you for participating with us.
As we started to have a little bit of discussion before,
this is in regards to the crowdfunding portion of the JOBS Act
that was passed in April 2012. For some of us here, we have a
certain emotional investing to that JOBS Act. I was blessed to
have a couple sections of that that were a piece of legislation
that we had been working on for about a year. One of the great
thing about the JOBS Act, it was a truly bipartisan, bicameral
sort of piece of work. And we built a formula where everyone
from Maxine Waters, to Barney Frank, to Spencer Bachus, to even
myself, found a way to communicate and grind through a series
of small bills, and ideas for capital formation, where much of
my frustration is first. And look, we all know the dance that
the SEC has gone through the last two years with the chairman,
some of the membership, some of those things. But forgive me
for reaching down like this, in something that many of us had
been hoping would be sort of a smaller, egalitarian opportunity
for capital raising for the true beginning entrepreneurs,
literally, the ones that are coming out of their basement,
coming out of their garage, because we do have a cap of a
million dollars. This is the proposed rule set.
And when you start to analyze it, at least as we have from
our office, you are starting to see total costs by the time you
start to capitalize in your legal costs, your accounting costs,
other mechanics, when some of your money will have a 20, 30
percent load factor on that. At this point you are starting to
get into the point where should you be doing it on your credit
cards or should you be doing it with your neighborhood loan
shark. This was not our intention. This was supposed to be the
egalitarian access to capital because it did a couple things.
It helped create a proof of concept because of the
participation from either across the country or from within
your community, but also provided a level of optionality,
saying I need some capital up to the quarter million, up to
this, up to that, to start our idea and sell that idea using
today's modern society and Internet.
That is my great frustration. One of the things I am hoping
we will acquire from this hearing today is not only sort of an
analysis of what is within the rule sets, the proposed rule
sets that have come from the SEC, but understanding we have
only a couple more weeks for comments to go in. And much of the
testimony from here we intend as an office to package up and
send in also as comments. So I beg of you, even beyond your
written statements, when we hit Q&A, it is not only here is the
problem, but also maybe a suggestion that we could relate to
the SEC saying here is a way how you do it. Yes, you have
investor protections but you do not create a chilling effect
for what I am hoping is sort of the next generation of sort of
that beginning capital race.
Okay. When the ranking member shows up we are going to let
her do an opening statement. So what we are going to do is
actually go right now to our witnesses' opening statements.
Jason Best. Our first witness is Jason Best, co-founder and
principal of Crowdfund Capital Advisors (CCA), a consulting
advisory firm in San Francisco and co-author of the
Crowdfunding Investing Framework used in the original JOBS Act.
And actually, I remember parts of these documents coming across
my desk.
Prior to his work in crowdfunding investment, Mr. Best was
a successful healthcare technology entrepreneur, and most
recently was on the executive leadership team of Kinnser
Software, ranked by Inc. Magazine as one of the fastest growing
private companies in the U.S. He is co-author of the book,
Crowdfunding Investing for Dummies--you wrote that with me in
mind, did you not--and earned his MBA from the Thunderbird
School of Global Management in Arizona.
Mr. Best, five minutes.
STATEMENTS OF JASON BEST, PRINCIPAL, CROWDFUND CAPITAL
ADVISORS; DANIEL GORFINE, DIRECTOR, FINANCIAL MARKETS POLICY,
MILKEN INSTITUTE; MERCER BULLARD, MDLA DISTINGUISHED LECTURER
AND ASSOCIATE PROFESSOR OF LAW, DIRECTOR, BUSINESS LAW
INSTITUTE, UNIVERSITY OF MISSISSIPPI; DJ PAUL, CO-CHAIR,
CROWDFUND INTERMEDIARY REGULATORY ADVOCATES
STATEMENT OF JASON BEST
Mr. BEST. Chairman Schweikert, Ranking Member Clarke, and
members of the Committee, thank you very much for the
opportunity to discuss the value that crowdfunding can bring to
the American small business community, as well as share some
new data from the British and U.S. markets that should shed
some light on the magnitude of what is really happening in
crowdfunding and how the right kind of crowdfunding regulation
can enable a new chapter in American small business success.
I would like to thank the members of this Committee and
both parties within the House at-large for their bipartisan and
overwhelming support of crowdfunding.
As a co-author of The Startup Exemption Framework, I care
very deeply about how the market evolves and want to continue
to work with Congress and the SEC to create effective
regulation for this market. I want to thank the commissions and
staff of the SEC for their willingness to engage in a robust
conversation with CFIRA, the crowdfunding industry regulatory
organization, and I hope that CFIRA's active engagement was
able to demonstrate that the crowdfunding industry is focused
on creating an orderly market with access to capital, investor
protections, and appropriate regulatory oversight.
As a tech entrepreneur and a small business owner, I have
real experience in creating products and services raising
capital and creating jobs. There are a number of good elements
in the proposed regulation, but there is also a number of
troubling issues. One of the issues I want to highlight today
is the accounting requirements for a full CPA audit on firms
raising over a half million dollars. I believe this places an
unreasonable burden on entrepreneurs and small business owners
and may cause there to be a soft cap on raising money over
$500,000 due to the cost that this regulation would impose.
I understand the goal of the regulation. As the size of
capital raised increases, investors want increased disclosure
and validation of the state of the business, and we should work
to create different technology solutions that can help achieve
that. Additionally, if I have to spend 30 percent of what I
raise just to comply with the legal and accounting
requirements, as you said, Mr. Chairman, it is sort of like am
I going to use my credit cards or am I going to use this new
opportunity?
Now, I wanted to share, really moving to sort of looking at
the opportunities for crowdfunding particularly in two studies,
most recently a study that was done on the U.K., about the
British system, and an example of what light touch regulatory
environments can achieve and really what we hope it could
achieve here in the U.S. And secondly, one of the most
important questions I think is after a company raises the
capital, what happens then? What happens then to the business,
to follow-on investors, and to job creation?
So first to the U.K. study. When we look specifically at
this U.K. study, they have had three years of equity and debt-
based crowdfunding up and running and a great deal of
experience. The U.K. government utilized a significantly light
touch approach, and it has been amazing to see what has
developed in that marketplace. The population of the U.K. is
about 61 million, so it is about 20 percent of the U.S.
population. The size of their crowd finance market doubled
nearly between 2012 and 2013. It grew from nearly $800 million
in size to over $1.3 billion. And this demonstrates a clear
willingness for both buyers and sellers, investors and
contributors, to want to engage in this kind of finance. Of
those 2013 totals of $1.3 billion, $314 million were
individuals lending to small business, and $45 million was
equity crowdfunding. That growth rate year over year was over
600 percent growth rate. And equity crowdfunding surpassed
rewards-based crowdfunding in the U.K. in 2013. That is pretty
amazing.
So collectively, in 2013, in the British system, over half
a billion dollars was delivered to early stage and small
businesses. That is over 5,000 businesses. And the report
predicts that in 2014 that will increase significantly. If you
were to equate that in the U.S. market, that would be 25,000
businesses receiving money across the country.
So looking at what businesses are doing post-funding, three
questions. One, does crowdfunding have a positive impact on
sales after you achieve your goal? And in fact, it does. We saw
a 24 percent increase in sales net of the crowdfunding raised
when they were successful. Two, were new employees hired? We
found that on average, 2.2 new employees were hired for
companies that successfully raised funds. So people are
creating jobs with this money. And finally, what about follow-
on investors? Will angel investors and VCs invest in these
companies after they have raised money through crowdfunding?
Resounding yes was the answer. Twenty-eight percent. Within 90
days of closing the round, 28 percent had already closed an
angel round of investment, and an additional 43 percent were,
in fact, in conversations with VCs or with angel investors.
And so that is the data I wanted to share this morning.
Again, I want to thank the Committee for this hearing and for
your overwhelming support of crowdfunding. I look forward to
your questions.
Chairman SCHWEIKERT. Thank you, Mr. Best.
Our next witness is Daniel Gorfine, director of Financial
Markets Policies and legal counsel in the Washington office of
the Milken Institute, an independent, economic think tank where
he researches and has written extensively on issues related to
crowdfunding provisions and the JOBS Act. Mr. Gorfine received
his B.A. in Economics and International Relations, Brown
University, and his law degree from the George Washington
University School of Law.
You have five minutes. And as you all know, five minutes.
And when you see yellow, just start talking faster.
STATEMENT OF DANIEL GORFINE
Mr. GORFINE. Chairman Schweikert, Ranking Member Clarke,
and members of the Committee, thank you for the opportunity to
testify on implementation of Title III of the JOBS Act or what
I will refer to as the crowd investing provisions.
My name is Daniel Gorfine, and I am the director of
Financial Markets Policy at the Milken Institute Center for
Financial Markets. Today's discussion fits squarely within a
number of pillars that guide our work, including expanding
access to capital and developing financial innovations. Indeed,
the ultimate goal of crowd investing is to responsibly increase
capital access for startups and small businesses, especially
within industries or regions disfavored by traditional sources
of capital.
In proposing Title III rules, the SEC has largely used its
discretion to positively advance that goal in the development
of this market. That said, it is an open question whether the
current crowd investing rules will significantly increase
capital formation for startups and small businesses. Investors
will need to consider whether the risk-reward dynamics are
sufficiently compelling and whether other factors, such as
personal interest and an affinity are a sufficient draw. And
for issuers and intermediaries there are concerns that the cost
of a Title III raise may exceed the benefit.
Based on these concerns, I will briefly discuss suggestions
that may foster the development of crowd investing while
limiting the downside risk to investors. This approach will
allow for the evolution of this market and an opportunity to
assess its central hypothesis that in an interconnected,
Internet-centric world there, is wisdom in the crowd.
Two principles from the law guide my suggestions today.
First, that this capital-raising tool is intended to be
relatively lost cost, and second, that the Internet can
facilitate a novel form of crowd-based due diligence in
investment. With these principles in mind, I believe as an
initial matter that the most efficient way to limit downside
risk is through emphasis on investor caps, at least until the
market is able to prove itself.
The SEC's current investor self-certification approach
properly imposes responsibility on investors. It should go
further, however, by requiring platforms to make investors
explicitly aware at the point of investment that the cap is not
something that can be ignored but rather is required by law and
intended to protect investors from the downside risk of early
stage investing. Additionally, the SEC should consider
precluding an investor who violates the investor caps from
bringing a lawsuit against an issuer. With investor caps
serving as the most effective way to limit downside risk, the
SEC should then minimize nonstatutory disclosure requirements.
The law already includes a number of baseline disclosure
requirements that will help investors make investment
decisions. But in aggregate, if additional disclosures are too
extensive and ongoing reporting requirements too onerous, then
the cost will exceed the benefit, especially given the
questionable value of such disclosure to investors.
The ultimate success of crowd investing hinges on the
effectiveness of new vetting methodologies and criteria
generated through the wisdom of the crowd, and evidence from
overseas demonstrates that discerning crowd investors are
likely to invest in what they know, existing companies with
known management teams or known businesses and products.
Accordingly, the SEC should first limit or require few, if any,
incremental disclosures beyond those already required by law,
and second, limit ongoing reporting requirements. A third
suggestion is to permit funding portals more leeway to select
and list offerings as well as to share data and information
with investors. The law does not allow a funding portal to
provide investment advice or recommendations. At its extreme
interpretation, this ban could require a platform to list all
offerings proposed by issuers.
In order to permit platforms some flexibility to decide on
which offerings they will list, the SEC proposes that a
platform can filter and select offerings based on objective
criteria. For example, by geographic region. It also creates a
duty for a platform to exclude offerings that could be
fraudulent or that raise investor protection concerns.
The rules, nevertheless, leave a gap where a platform could
have serious doubts about the viability of an offering but not
to the level that it is permitted to exclude the offering from
its platform. To require a platform to list an offering that it
has a strong conviction will fail is contrary to promoting
investor protection. Accordingly, portals should have the
ability to go further in deciding with whom they do business,
so long as they do not advertise that their platform has
somehow safer or better opportunities.
The SEC proposed rules may also prevent platforms from
sharing key data and information that could assist crowd
investors. As we have seen with the development of e-commerce
platforms, such as eBay and Amazon, there is significant
opportunity for intermediaries to glean and analyze data and
develop algorithms to detect fraud or best practices and also
collect user feedback. I would like to see the SEC explicitly
permit these types of activities for funding portals.
Finally, funding portals should be subject to reduced
liability exposure for issue or missteps, given the portals
limited promotional activities, limited ability to exclude
offerings, and design to serve simply as a bulletin board. The
SEC's initial contrary interpretation of the law would likely
decrease the number of intermediaries participating in this
market, as well as increase costs due to the risk of
litigation. If that interpretation holds, however, and a
platform can be on the hook for the missteps of an issuer, then
the platform should have greater discretion to decide on
whether to do business with that issuer.
I would like to thank the Committee again for having me
join you today and I look forward to answering any questions
that you may have.
Chairman SCHWEIKERT. Thank you, Mr. Gorfine.
I would like to yield to Ranking Member Clarke to introduce
the next witness.
Ms. CLARKE. I thank you, Mr. Chairman, and it is my honor
and privilege to introduce to everyone here today professor
Bullard. Professor Mercer Bullard is a securities law professor
at the University of Mississippi School of Law and founder and
president of Fund Democracy, a nonprofit investor advocacy
organization. He has appeared before congressional committees
on more than 20 occasions and is a member of PCAOB's Investor
Advisory Group and was a member of the SEC's Inaugural Investor
Advisory Committee. With prior experience as an assistant chief
counsel at the SEC and practicing securities lawyer, he is an
expert on the Commission's enforcement and rule-making
practices. He has a J.D. from the University of Virginia, a
Master's from Georgetown, and a B.A. from Yale.
I want to thank Professor Bullard for appearing before us
today and look forward to your testimony. Thank you.
STATEMENT OF MERCER BULLARD
Mr. BULLARD. Thank you, Ranking Member Clarke and Chairman
Schweikert and members of the Committee. It is a pleasure to
appear here today, especially a committee that is focused on
business, rather than securities, because what I spend most of
my time doing is teaching students how to solve business
problems.
The Committee has asked whether the SEC's proposal will
work for small businesses, and I am afraid the answer is
probably not, but it is hard to tell. But the question is
somewhat unfair because Congress did establish extremely
detailed disclosure and filing requirements that are going to
make up most of the burdens that will be imposed by
crowdfunding. And I also would add that I do not think the
solution is reducing those because I think they are appropriate
as investor protection measures to ensure this does not go the
way of the penny stock market in terms of the reputation that
crowdfunding develops.
As you may know from my prior testimony, my view is that
crowdfunding probably could work if investment minimums were so
low and the risk of loss was small so that virtually no
regulation at all would be required. It is not clear to me why
we could not allow any business to offer a $100 share to a
company or to an investor simply having provided a business
plan on the Internet, leaving only the anti-fraud provisions of
the securities laws and general consumer law to protect those
investors. But the current law is what we have, so I will turn
to some of the specific aspects of the SEC's proposal and their
effect on small businesses.
One issue that we talked about before the meeting is there
is a million dollar cap on what a crowdfunding issuer is
allowed to have sold and the statute clearly indicates that is
all securities. And the SEC has interpreted that to mean that
it does not include all securities. It includes only
crowdfunding securities. So what that means is somebody could
go out and raise $10 million or $100 million or a billion
dollars and then do a $1 million crowdfunding offering.
Congress imposed that $1 million cap because crowdfunding was
supposed to be for small issuers. It was supposed to be for
issuers raising small dollar amounts. It was supposed to be for
issuers that suffer from a perceived funding gap between them
and larger businesses. Under the SEC's approach, medium and
large businesses may fill the crowdfunding space, crowding out
the small businesses for which it was created.
Small businesses should also be concerned about the SEC's
position on certain investor protections. The reason is that if
it is easy for unscrupulous businesses to raise capital through
crowdfunding, the crowdfunding market may become equated, as I
mentioned, to the market for penny stocks, rather than the
thriving market for exciting investment opportunities that it
does have the potential to become.
For example, the Commission would permit investors to offer
investors who invest early a larger share of any
oversubscription amount. The stampede effect that this promotes
is precisely why such first come, first serve tender offers are
prohibited under the Williams Act. What kind of businesses are
going to allocate oversubscriptions on a first come, first
serve basis in order to stampede investors to make commitments?
It will be the less scrupulous ones that honest businesses
should not want in their crowdfunding marketplace. The
Commission would permit issuers to use financial statements
that are 16 months stale. That means that you could start a
business in December of year one, you could do a crowdfunding
offering in April of year three, and your financial statements
would cover one month at the beginning of the life of the
business covering only one out of a 17 month lifespan.
The Commission would permit crowdfunded issuers that have
failed to file their annual report the only post-offering
obligation they have for up to 23 months to go ahead and make
another crowdfunding offering. What kind of businesses are
going to take advantage of the opportunity to file financial
information that is 16 months stale or are willing to violate
the law by failing to file their annual report? And I believe
it is the unscrupulous businesses that honest businesses should
not want in their crowdfunding marketplace.
Small businesses should also be concerned about investors
suffering financial distress as a result of investment, which
is more likely due to certain SEC positions. For example, the
Commission would permit investors to self-certify the financial
qualifications. And this will result, for example, in some
investors mistakenly believing they can count their home toward
their net worth, in which case their crowdfunding investment
may end up representing a large part of their savings.
Small businesses should be concerned about this issue
because the defining feature of the crowdfunding market may end
up being the high frequency of investments going to zero and
how that plays out. Estimating conservatively, one quarter of
crowdfunding investments are going to be worthless in three
years. The data suggest the failure rate may be closer to one
half. Imagine the reputation of a family of mutual funds in
which one-quarter to one-half of the funds lost 100 percent of
their value every three years.
So how will this narrative play out? Will the losses be
only a small part of an investor's portfolio, money they can
afford to lose? Or is the narrative going to be about investors
who lost money they could not afford to lose their life savings
perhaps. You can stack up a pile of filings and disclosure as
high as the sky, but the bottom line is the success or failure
of crowdfunding is likely to turn onto the losses that
investors suffer and there are going to be a lot of total
losses that they can afford.
Thank you, and I would be happy to take questions that you
might have.
Chairman SCHWEIKERT. Our next witness is DJ Paul, co-
founder of Crowdfund Intermediary Regulatory Advocates. You
could not have come up with a shorter name? A trade association
for crowdfunding web portals. He is also the co-chief strategy
officer with GATE Impact based in New York, where he develops
solutions to facilitate and expand private and alternative
asset transactions. Prior to joining GATE, Mr. Paul co-founded
Crowdfunder, a Los Angeles-based crowdfunding intermediary
platform. Mr. Paul earned a B.A. in Philosophy from Brown
University.
Well, please wax philosophy towards us. Five minutes, Mr.
Paul.
STATEMENT OF DJ PAUL
Mr. PAUL. Chairman Schweikert, Ranking Member Clarke, and
other members of the Committee, thank you for the opportunity
to testify today. It is an honor to be here.
Given the limited time for testimony, I will confine my
comments to four salient issues. These four issues are
certainly representative of the kinds of concerns which some of
the industry have with respect to the proposed regulations but
they are by no means exhaustive.
First, auto requirements, which Mr. Best was good enough to
touch on; pooled investment restrictions; intermediary
participation restrictions; and funding portal liability.
Auto requirements. As currently proposed, there are three
tiers of financial disclosure requirements for Title III
offerings, corresponding roughly to the amount raised. First
tier is 0 to $100,000; second tier is $100,000 to $500,000; and
the third tier is from $5,000 to $1,000,000.
The first tier requires disclosure of financial statements
certified by an executive officer of the company. The second
tier requires the financial statements reviewed by an
accountant. However, the third tier requires CPA-audited
financials. Furthermore, these requirements for such CPA-
audited financials are on an ongoing basis. Such audited
financials to be provided to investors every year following a
Title III raise over $500,000.
It is worth noting that these disclosure requirements for
the third tier are actually more onerous and exhaustive than
the current requirements for Regulation D offerings, which does
not mandate audited financial statements for issuers, nor
ongoing annual audited disclosures. These overly onerous
requirements for third tier security crowdfunding offerings may
have the unintended effect of pushing potential issuers away
from doing Title III entirely and towards perhaps Regulation D
offerings which might be more attractive to potential issuers.
This seems clearly inconsistent with the spirit of the
original legislation, and in effect, creates a donut hole
between $500,000 and $1,000,000, where offers do not utilize
Title III at all. And in addition to creating an artificial
market irregularity, this will also have the unfortunate effect
of making these offerings unavailable to unaccredited investors
since Regulation D, which is the most viable alternative
obviously does not permit investment by unaccredited investors.
Moving on to pool of investment restrictions. The proposed
regulations exclude funds from utilizing Title III to raise
capital, in effect requiring all crowdfunding investments to be
direct investments. This rule would restrict pool of
investments for hedge funds, private equity, from raising money
through crowdfunding. While most of us can agree that most
funds are not suitable issuers for crowdfunding, we believe
that this restriction may be overbroad as it appears to
restrict the fund-raising of special purpose vehicles or single
purpose entities, investing only in a single operating company
that would otherwise qualify as an eligible Title III issuer.
This restriction does not serve to protect investors, but
rather, this restriction actually succeeds in denying
crowdfunding investors some of the advantages and protections
afforded to other investors and institutions in other asset
classes, particularly those utilized in Regulation D.
Moving on to intermediary participation restrictions.
Current proposed regulations would restrict intermediaries from
holding interests in the companies conducting Title III
offerings on their platforms. This serves to restrict
intermediaries from participating alongside their investors in
these offerings. Rather than diminishing a theoretical conflict
of interest between intermediaries and investors, as a
practical matter this restriction effectively forbids alignment
of interests between investors and intermediaries. This concept
is often described as ``skin in the game.'' We believe that
intermediaries who invest in issuers make for better alignment
of interests.
We believe that allowing such co-investment by
intermediaries would have two very desirable benefits from
investors. First, an investor may take comfort in knowing that
the intermediary facilitating the transaction is investing in
the same deal and on the same terms in the investment that they
are considering. And second, when the intermediary has such
skin in the game, that fact itself may encourage the
intermediary to take more seriously their assigned roles in the
marketplace.
I see that I am running out of time, so I will just very
quickly skip to funding portal liability just so that I will
have an opportunity perhaps to answer some questions that you
might have with respect to that.
As the regulations are currently written of proposed, it
may be subject to the interpretation that intermediaries are
considered issuers within the context of the liability of any
omissions that might be made by an issuer. This would have a
rather bizarre effect of making an intermediary responsible,
effectively a guarantor, of any offering that appeared on its
platform. I think that it is pretty obvious that that would be
problematic on its face, and it is something that we need to
address in the next several weeks and certainly before these
regulations become finalized.
I will end there, and I will look forward to your
questions. Thank you again for the opportunity to testify.
Chairman SCHWEIKERT. Thank you, Mr. Paul.
And I was going to turn to Ranking Member Clarke and let
her share with us her opening statement.
Ms. CLARKE. I thank you, Mr. Chairman. And I welcome our
witnesses and thank them for their testimony here this morning.
With traditional capital access avenues still relatively
constrained an increasing number of entrepreneurs are turning
to crowdfunding to launch their enterprises. In 2012 alone,
crowdfunding injected $2.7 billion into new ventures, a figure
that will likely increase moving forward. In accordance with
the Jumpstart Our Business Startup or JOBS Act of 2013, the SEC
published its proposed rule for implementing the crowdfunding
provisions in October of last year. While the SEC's
crowdfunding disclosure requirements are aimed at providing
enough information to the public to facilitate prudent
investment decisions and minimize fraud, there is some concern
that some of the disclosure requirements will make crowdfunding
offerings cost prohibitive.
The SEC, for example, has estimated that it could initially
cost $15,000 in listing fees and regulatory compliance
expenditures to raise $50,000, thus taking resources away from
business expansion and working capital. While these costs are
likely to decrease over time as equity crowd funding becomes
more popular, it is vital that Congress monitor the SEC's
crowdfunding rollout and make changes if necessary to improve
access to capital for small businesses, while preventing bad
actors from defrauding the public.
I would like to thank our witnesses for lending their
expertise and insights to this second examination of today's
subject matter, the rule, and the SEC's crowdfunding proposal.
And with that, Mr. Chairman, I yield back.
Chairman SCHWEIKERT. Thank you, Ranking Member Clarke.
I am going to turn to Mr. Mulvaney for the first five
minutes of questions.
Mr. MULVANEY. Sure. Just a couple of random questions to
the various members of the panel. Thank you, gentlemen, again
for doing this. And thank you for participating. I do not think
a lot of folk realize how important this is because it helps
drive the national debate on the issue. So I appreciate your
time.
Mr. Paul, we will start with you, just because you said a
couple things that stood out. You said that because of the
audited financial requirements to Tier III offerings, it is
actually technically easier of cheaper to use a Reg D offering.
What does a CPA audit cost these days?
Mr. PAUL. There is some debate about this. I mean, it could
be $10,000. It could be $20,000. It could be $5,000. It is not
going to be insignificant. There is some discussion about
whether or not it will be streamlined. The cost of audited
financials, obviously, are going to be contingent to some
extent on how much activity the business--how far along it is
in its business cycle. A startup, it would be more readily--a
company that has no history, pretty much all that you are
buying there is the CPA's license.
Mr. MULVANEY. And before I get to the Reg D question, how
do you audit a company that does not exist?
Mr. PAUL. I am not smart enough to answer that question.
That would be a challenge. I agree.
Mr. MULVANEY. If Mr. Schweikert and I have an idea, my
understanding is that this is actually being used in the music
industry a good bit. If he and I want to do a record together,
we want to cut an album, it sounds like I would be completely
excluded from the Tier III because I cannot audit something
that does not exist, can I?
Mr. PAUL. You certainly could have an accountant look at
what you do not have and say I am certifying that you do not
have the thing that you said you do not have.
Mr. MULVANEY. Do not have it. Yeah, that is probably true.
How much can I raise at a Reg D offering?
Mr. PAUL. There is no limit.
Mr. MULVANEY. So if it is easier to do Reg D than it is to
do a Tier III, you wonder why anybody would do a Tier III.
Mr. PAUL. Well, you might do it for several reasons. First
of all, it is not clear that it is going to be necessarily less
expensive. This is one specific requirement that exists in the
Tier III of Title III offerings of crowdfunding that does not
exist in Regulation D. There are other requirements in
Regulation D as well. However, again, Regulation D is limited
to accredited investors. And there are certain ideas, certain
ventures, perhaps your record idea, that might be more
appealing from an investor base of unaccredited investors. So
that might be a motivating factor to not go up to Reg D.
Mr. MULVANEY. Thank you, Mr. Paul.
Mr. Gorfine, you said something regarding limited
promotional activities. What are you not allowed to do as a
portal?
Mr. GORFINE. So funding portals are quite restricted in
what they can do with the offerings that are listed on their
site. So they cannot be going out and soliciting for that
offering or sending out messages saying we have got this great
offering on our platform. You should come check out your new
record album company. So they really are the idea behind the
funding portals as opposed to a registered broker dealer
platform which would have more ability to kind of provide
advice and recommendations. A funding portal is envisioned to
be a bulletin board. It is a Craigslist for offerings. So
really you just go to the platform. You will be directed to the
platform where you can then sort through the different
offerings but the portals themselves cannot do anything further
to be promoting those offerings on their site.
Mr. MULVANEY. Gotcha. Finally, Dr. Bullard, I am all for
solving problems. I am a little concerned about creating
problems that do not exist. If I have just raised a billion
dollars in the public markets, why would I raise $250,000 on a
crowdfunding site?
Mr. BULLARD. The reason is that I would certainly think
Twitter, when it was private, would think it would be a great
social media strategy to do a million dollar funding through
crowdfunding to reach out to its users who are accredited
investors. So I think there are a lot of instances.
But the issue is not necessarily whether it is a billion or
$10 million or whatever. The idea is this space will be used
more often by larger companies if you allow really large
companies to participate. So if you allow companies that are
raising $10 million into the space, it is going to have the
effect of squeezing out or at least they will be competing with
all the small business that it is purportedly designed for. So
I do not know if a million is the right cap, but having no cap
at all will leave the space open to whoever can pay the most
for the services.
Mr. MULVANEY. Right. And I guess I just look at the numbers
of it and the math of it. This is fairly expensive money in the
greater scheme of things. And that is one of the reasons we are
having the hearing. It is not as easy and efficient and as
cheap as we had hoped it would be to raise money through
crowdfunding. So I guess I am struggling with why I would go
raise $250,000, very expensive money, when I just raised some
of the cheapest $100 million, billion dollars that I possibly
could. So I recognize there are challenges. I am wondering if
that is one of the ones we actually spend a lot of our time on.
Anyway, I appreciate the Chairman's time. I yield back.
Chairman SCHWEIKERT. Thank you, Mr. Mulvaney.
Ranking Member Clarke.
Ms. CLARKE. Thank you, Mr. Chairman. I am going to yield
the tile to Representative Chu at this time.
Chairman SCHWEIKERT. Ms. Chu, five minutes.
Ms. CHU. Thank you so much for yielding.
I am a member of the Intellectual Property Subcommittee on
the Judiciary Committee, and so I am concerned about
intellectual property and I know the protection of intellectual
property is one of the challenges of crowdfunding. So I have a
question for anybody on the panel.
Once an idea is out, the startup of small business runs the
risk that the idea will be stolen or copied, how can inventors
and artists protect themselves from those consequences, let us
say for instance that a tech startup has a new technology that
has not been patented but they use crowdfunding to raise
capital for their venture, should intermediaries be required to
advise or educate issuers on IP protections before a campaign
is posted or disclosed?
Mr. PAUL. The same risks exist whenever one raises money.
Whether or not intermediaries should be required to advise
issuers as to that, it is certainly something that I do not
believe that the intermediaries that are part of our
organization would have any objection to that being something
that we would want to do. There are certainly going to be some
ideas that maybe are not welcome or suited to the broad raising
of capital through this because of intellectual property
concerns. But the majority of the ideas, I think, can be
protected. You mentioned patented. And of course, there are
other ways of protecting ideas, and it will encourage, we hope,
issuers to be organized and get their intellectual property, as
well as their other issues in order prior to doing a raise in
this manner.
Ms. CHU. Mr. Best?
Mr. BEST. In addition to Mr. Paul's comments, I think that
what we are also seeing on a mechanical basis and
implementation are the fact that many crowdfunding platforms,
and I would assume all, will have deal rooms, online deal
rooms, where there is a public facing amount of information
that anyone can see but that any IP, anything that would
restrict it, the viewer would need to gain an additional level
of access from the entrepreneur that they could pass through
some sort of screen that the entrepreneur could determine this
is a serious investor. This is someone who actually wants to
make an investment in my business and I will allow that to
happen. The same thing that occurs in the offline world through
many 506 offerings.
Mr. BULLARD. Yeah. If I could just add, I would say to
answer the question about liability, I think we need to leave
intermediaries to just what legal rights the issuers would have
under current law. There may be some duties that they would be
impliedly having in that scenario, but I certainly would not
make it any kind of statutory or rule-based requirement.
Mr. GORFINE. Yeah. I would agree that this is not
appropriate to put the requirement on a platform necessarily to
educate the entrepreneur or the issuer, but I think it raises
an important question which is how do we make sure that issuers
and entrepreneurs are educated about some of the risks of a
crowdfund or a crowd raise? So I think that education for
issuers and entrepreneurs is going to be very important, and
one suggestion I would have is that the SEC actually has an
investor.gov website that has a lot of great information for
investors. Perhaps through the education side of the SEC's
organization, you could create some information for issuers and
entrepreneurs that they could consult before they go ahead and
do a crowd raise. So I think that the education component is
important.
Ms. CHU. Thank you for that.
Professor Bullard, given the inherent riskiness of small
business investing and the lack of investor sophistication in
individual retail investors, it was mentioned today that the
best way to limit downside risk is through an emphasis on the
investor caps. However, the proposed rules do not require
crowdfunding platforms to verify the income and net worth
stated by the investors. What are the implications of this and
furthermore, what mechanism should be used to ensure the
compliance of the investor caps?
Mr. BULLARD. Well, there are really two problems here. One
is the very real possibility that people will lose a
significant amount of money that they cannot lose. And
obviously, that will have happened only because something has
gone wrong in the application of the Act. One of the really
great things the Job Act did was actually to impose percentage
limits, so that implies that you can only put a certain amount
of risk, which is a great defense to allowing people to take
those kinds of risks.
But people will slip through the cracks. It is inevitable.
And something more needs to be done than simply to allow an
investor to go on a website on an unguided basis and just say I
have got a million dollars of net worth. And I can tell you,
most investors are going to think that their house is included
in that, which it is not, and most investors are going to
neglect the fact that they do not own their house; the bank
actually does. So you could have people investing perhaps all
of their savings in an offering because of that confusion. You
cannot go out and sit down in a room with an investor and go
over all their qualifications.
But on the other hand, Mr. Gorfine suggests that we
actually sue investors who violate the provision. Well, you
cannot violate the provision. The provision does not say that
investors are required to be X. It says that issuers are not
allowed to sell to those people. The obligation is on the part
of the issuer and the intermediary, and they are the ones who
are really responsible. So the SEC needs to step it up a little
bit, but we all know that it cannot be sending lots of papers
that have to be reviewed on a detail basis.
Ms. CHU. I see my time has run out so I will yield back.
Chairman SCHWEIKERT. Thank you for that.
Mr. Rice, five minutes.
Mr. RICE. I will yield.
Chairman SCHWEIKERT. And who do you want to yield to?
In that case I get to. And what is always dangerous here,
and Ms. Clarke and I have teased over this in the past and I am
trying to do questions without too much in tirades, but I do
need to actually just sort of throw a personal philosophic
sharing, particularly for my philosophy major at the end, as
much of the political side and the latest political discussion
is income disparities. But yet, in many ways we have diced up
part of our opportunity within our society saying I am a
qualified investor so I am part of this fraction of a fraction
of a fraction represent of my U.S. population. You get to
participate. You get to know what is going on. You get to take
risk. But the vast majority of our society and population, you
are walled off from opportunities. And yes, people lose money.
But as we have all had in our experiences, we invest in three
things. One we do okay in and actually over time we do well in
it. The other two go nowhere, but that is how we have built our
nest egg for our retirements and our future.
And as some of the rule sets become more paternalistic, my
fear is we just expanded that income and inequality by sort of
almost a financial apartheid where we say if you have this
wealth you get to participate; if you do not, you do not get to
even know. So I do have an underlying belief system here that
we have sort of this egalitarian obligation to reach out. If
you are an electrical engineer and you are an expert but you do
not have the million dollars in the bank, but damn it, you have
$2,000 and you are an expert. Should you be allowed to invest
it? And that was actually one of my great hopes underneath the
crowdfunding is how do I really create an opportunity society
and not one that is walled off where you have it so you get to
continue to participate.
And this sort of makes the circle back to Mr. Paul, back to
sort of the question. My fear was in some of the reading our
office did within the proposed rule sets that a platform, an
intermediary, may actually find itself within the tree of
liability. Do they get to sort of choose who they post up? If
so, do they now start to sort of only choose opportunities that
they feel are perfectly safe or do they have to post up
anything within their general box and geographic or these
things, and do they end up carrying liability for a failed
disclosure of someone's bad act?
Mr. PAUL. There are a few questions in there, so let me
start with what I think was the first one.
Understand that, and I am sure you do because I know you
participated in the creation of the statute itself, but
investment advice is not permitted to be given by funding
portals to investors. So the question that you are asking about
whether or not a portal can pick and choose which offerings it
puts up gets close to the line of whether or not that in effect
if you exclude something and you include something, if that
constitutes investment advice.
CFIRA, the organization I work with, has been working with
the SEC to fine tune that a little bit, put a little bit more
shape on exactly what that is so that we do not have a
situation where all portals have to list everything, which
would be a bulletin board and not really in keeping with what
the intent was. Nor can they be quite so selective that it is
pretty obvious that they are picking the winners because they
cannot offer the investment advice. So I think that might be
responsive to the first part of your question.
Chairman SCHWEIKERT. Okay. Go onto the second part
because----
Mr. PAUL. In terms of the liability. Yeah. The definition
of issuer as it relates to Title III offerings is broad enough
now to include not just the issuer itself but to include the
portal. And then the liabilities that the issuer quite rightly
has for being truthful and disclosing accurately, if the portal
is considered an issuer then the responsibility and the
liability would then fall to the portal. That seems overbroad.
That seems like it is going to dissuade would-be portals from
participating in the process.
Chairman SCHWEIKERT. Can I put a hold on you at that point?
Mr. PAUL. Certainly.
Chairman SCHWEIKERT. Does everyone on the panel agree that
a clean reading of sort of the proposed rule set does that
cascade of liability?
Mr. BULLARD. What Mr. Paul is talking about is there is
liability for violating Section 5, which basically means you
have not complied with the exemption. As it turns out, it was
not available. And generally, issues, the intermediaries are
not going to be subject to that, and to the sense that they
might be, that is certainly a legitimate concern.
Chairman SCHWEIKERT. Okay.
Mr. BULLARD. And then there is the secondary liability,
which you are also talking about, which is material
misstatements, and they are squarely in the crosshairs on that.
And Congress specifically put 12(a)(2) in the act, so there is
no question there.
Chairman SCHWEIKERT. Mr. Gorfine, do you agree?
Mr. GORFINE. I would say the SEC has interpreted the Title
III to potentially impose that liability on funding portals. I
think that there is something think it is not clear from the
statute though whether a funding portal should fall within the
purview of that type of liability because they are not able to
fully decide who they are listing on their platform, and there
is a limited promotional aspect of what they are doing. There
is a limited solicitation aspect of what they are doing, which
raises questions. How can you be held liable for the
misstatement of an issuer or an admission of an issuer if you
did not have the ultimate discretion of whether to list that
offering on your platform or not.
So I view this on a bit of a sliding scale. To the extent
that platforms do not have the discretion to decide with whom
they do business, it seems like a poor outcome for them to be
liable.
Chairman SCHWEIKERT. Mr. Best?
Mr. BEST. I think from my perspective we believe that the
portals should have the ability to decide who is and is not on
their platform because then it becomes more than a bulletin
board.
Chairman SCHWEIKERT. But on the taking liability for if----
Mr. BULLARD. I agree. There is a significant disagreement
we have not covered.
Mr. MULVANEY. I am going to come back to you, Mr. Paul,
because there were a couple things in your written testimony
that were actually very interesting.
Mr. Paul?
Mr. PAUL. Yes, sir.
Chairman SCHWEIKERT. I interrupted you when I went on my
tirade.
Mr. PAUL. Yes, I was not sure if that was a tirade or you
were just looking for confirmation.
Chairman SCHWEIKERT. Actually, believe it or not, within
your written testimonies I have a bit of a split on the
discussion of does the portal--what level of liability it takes
for a screwed up offering or someone forgetting a disclosure.
And so that is what I am trying to----
Mr. PAUL. It will always get back down to when there is a
claim, if there is a claim, you know, what did the portal know
and when? And the liability could be significant. I mean, it
could be significant enough that effectively, and I mentioned
this very briefly in my oral testimony, but it is in my written
testimony, in the broadest interpretation the portal could be
100 percent liable for reimbursing an investor, even after the
investor perhaps does not even own the security any longer,
which would effectively make the portal a guarantor for
everything that is listed on the platform.
Chairman SCHWEIKERT. And I am concerned about the potential
chilling effect and just cleaning up that language.
Professor, you actually had--you sort of brushed alongside
this. Can I throw a scenario at you and have you sort of game
theory this with me?
There are actually a group of friends and supporters, it is
a Korean business association. At one time, if it was a few
years ago, they were trying to put up a community bank but the
difficulties and the capital that is required to that, and they
have been looking at the idea of, hey, if we could produce a
portal and we could reach out to the Southwest and the
California market and help folk within our association group
have basic capital raise and their level of comfort because
these are often folks, either they know reputation wise or they
know the industries, do I have problems with something that
borders on a fraternal or business or chamber or specialty
organization, setting up a portal saying this is what we are
going to fund? That is the first question. Do you see anything
there in a portal being that specific to its charter?
Mr. BULLARD. Yeah. The disagreement is that there is no
restriction on your ability to say no to issuers. That is
simply incorrect. To be fair to the SEC, the investment advice
issue, that goes to the communications with the public, the
investor. Deciding who is going to list is a communication with
the issuer.
Chairman SCHWEIKERT. Okay. So my Korean business
association----
Mr. BULLARD. So that is not an issue.
Chairman SCHWEIKERT. Instead of a community bank, this is
how we are going to help folks in our community.
Mr. BULLARD. So there should be no problem.
Now, you cannot say you should invest in these affinity
entities because you will get better returns. But you can say
you can invest in these affiliated entities and you can
probably say because we think they have values that we share.
But there is no conceivable possibility that you chose the
group on that basis or you went out and you only accepted
issuers you thought would be 10-baggers that you would be
liable for that. That is simply not realistic.
Chairman SCHWEIKERT. Well, as a professor of securities
law, as you probably remember a decade or two ago, there was a
movement to try to create specialty community banks to be able
to deal with underserved populations. Do you see where some of
this model could actually be part of that opportunity?
Mr. BULLARD. Yes. But we talked before the hearing about
the issue of whether you can actually do bricks and mortar
selling, and I am still not totally clear on that. But I think
that to the extent the SEC has put----
Chairman SCHWEIKERT. Could you explain that for everyone
else here because this one actually could be a bottleneck.
Mr. BULLARD. Right. Well, the SEC talks about kind of an
online-only approach, and if I am correct, that would preclude
you from running an offering out of your bank. You would still
have to have a website, but you would not be limited to the
website. Then I think that would severely handicap what is
really the sweet spot of crowdfunding. That is the community
business that somebody might want to start up based on local
relationships. For example, the organization you mentioned.
Chairman SCHWEIKERT. Okay.
And Mr. Best, as the professor was just touching on, is not
the second part of the beauty within sort of the crowd
sourcing, crowdfunding concept, is just that? It is a proof of
concept?
Mr. BEST. Absolutely.
Chairman SCHWEIKERT. It is not only maybe raising money in
my community but also an A&B test of not only I can access some
money but I can also access folks that have enthusiasm for the
concept?
Mr. BEST. Absolutely, Mr. Chairman. I think what we are
seeing, there are a number of angel investors who now are
beginning to look at crowdfunding as a qualifying step before
they will look at a deal because do you have a customer for
your product? Do you have a customer for your service? And
being able to, whether it be through awards or through equity
or debt, being able to establish that does several things. It
is proof of concept of your product. It is proof of concept of
you as an entrepreneur, the ability to execute, and your
ability to raise capital, both very important aspects.
Chairman SCHWEIKERT. Mr. Gorfine, in that sort of model,
let us say I actually need a few million dollars for my
concept, but I am going to use crowdfunding to raise $499,000.
And we will discuss whether ultimately I have a soft cap, a
small raise because in that population, most likely I am not
going to have many people able to invest over $2,000, and at
some point we really do need to talk that there are these
investment caps already built into here to limit someone's
downside. But I use that as my proof of concept. Then I take my
proof of concept, and can I then go to my qualified investors
and raise my next $2 million and then go to more institutional
money to round out my fund-raise?
Mr. GORFINE. Yeah, I think that is right. And the SEC, I
think, did a great job in clarifying that point. That you would
be able to use Title III alongside or before, subsequent to,
certain other exemptions. So if you think about this in its
totality, what I like about the JOBS Act vision is that it
creates this kind of seamless capital access pipeline, if
implemented effectively, so that you can go from each stage of
the development of a company and be able to access capital that
suits your needs at whatever stage of development you are at so
that you could certainly start with Title III and then
potentially use that to move up to a Title IV, you know, Reg A-
Plus type raise.
Chairman SCHWEIKERT. Thank you. That was one of the
concepts I wanted to make sure we addressed.
Ranking Member Clarke.
Ms. CLARKE. Thank you, Mr. Chairman.
Mr. Paul, the SEC has estimated that commissions to
intermediaries will account for about 5 to 15 percent of the
crowdfunding issuance, higher than other funding sources such
as public stock offerings or bond issuances. Do you expect this
higher cost to come down and become competitive with
traditional forms of capital as crowdfunding expands? And then
I will open it up to the rest of the panel.
Mr. PAUL. I think it is going to be a competitive
marketplace, so if you are asking if over time that these
commissions, there will be some sort of competition, I think
the answer is probably yes. I would, however, note that
comparing the commissions for crowdfunding offerings to IPOs or
public markets is perhaps not the most apt analogy. I mean, it
is an appropriate one, but there are other types of securities
that exist that might be a closer analogy. For example,
Regulation D or 506, which is another type of private
placement. And in that universe, these proposed commissions are
fairly consistent. Maybe a touch higher but not quite as many
multiples higher as the private-public markets.
Ms. CLARKE. Would you agree with Mr. Paul's assessment?
Mr. BEST. I would. Yes.
Ms. CLARKE. Okay. Professor Bullard, the rule outlines a
number of investment limits based on an investor's income
level. However, you invest concerns that the rule lack an
income verification scheme. What risk does this pose for
investors interested in crowdfunding?
Mr. BULLARD. The risk is not that they will invest in
accordance with the rules. I think the rules are good rules,
particularly that they limit the percentage with respect to
that person's income or net worth. This is a slip-through-the-
cracks problem, and is most likely to happen when you put the
entire analysis in the investors' hands and you do not give
them clear markers as the things they need to look out for.
So, for example, one obvious one would be they should not
be allowed to self-certify if there has not been a button they
had to push saying I have not included the value of my home.
They should not accept that they have read the investor
education material which is required unless there are a couple
screens where a box has said in big, bold letters the
percentage of small businesses that fail to really drive home
the point that this happens. Instead, what the SEC suggested is
you can just click on a box that says ``I have read this'' and
the thing is not even there or something you would have to
scroll down 20 pages. And we all check that box all the time
saying we read it, but we are lying, are we not? Right? But it
is also crazy to think anybody is going to read these things.
So the SEC has always been unwilling to say, well, you know,
the literal letter of the law is the only path we can go down
with no requirement. Just be creative and say, look, there are
four or five boxes with big fat letters that will lay out the
key things they need to think about and that should do it. That
is the kind of thing we need to deal with but I think
submitting a paystub should be a requirement. That is just too
easy. Or some electronic verification of income, for example.
Ms. CLARKE. So discuss that ambiguity in a rule that could
allow large companies to raise $1 million through crowdfunding
while simultaneously raising more via other public offerings.
Can you elaborate on how this will impact startups and small
businesses that are experiencing a funding gap and want to seek
crowdfunding?
Mr. BULLARD. This is the issue Representative Mulvaney
raised, and I agree that the $1 million cap on the total
offerings that a crowdfunding issuer is allowed is too low, but
I think as a business matter--this is not an investor
protection issue at all--but as a business matter, if you
really want crowdfunding to work, I think that larger issuers
are going to squeeze out smaller issuers. And you all know in
the regulatory space who calls the shots. In the regulatory
space, it is going to be the largest regulated entities. So if
you let larger entities in this regulatory space, they are
going to have more influence with the SEC and the rules are
going to reflect their interests. So definitely, I think the $1
million is not high enough. I do not think the SEC has the
authority to do what it is doing because the statute is so
unambiguous, but the fact that somebody can be very successful
raising significant amounts elsewhere, they should not be
allowed to use crowdfunding because I think the way it is going
to work is they will squeeze out the small businesses.
Ms. CLARKE. Let me open this up to the rest of the panel. I
saw, I guess, a glimmer in our eye, Mr. Paul. Would you like to
share your thoughts?
Mr. PAUL. It might have been a glimmer.
Yeah. With all due respect to Professor Bullard, I just do
not agree. I do not think that the larger issue--if the larger
issuers, or whatever, larger entities are allowed to do
crowdfunding offerings, that it is going to squeeze anybody
out. It will simply make it a more diverse marketplace. I am
trying to think of a large corporation that might choose to
utilize Title III almost as a marketing opportunity or a way of
extending their brand. It is still going to be limited to a
million, at least for the time being. Why would we restrict
that? Why is that a bad thing? Why not allow the opportunity to
invest for unaccredited investors that would not otherwise have
had that opportunity? I am cognizant, of course, that this is
the Small Business Committee, and so we want to foster small
businesses, and certainly Professor Bullard's comments are
consistent with that. However, the other side of the rationale
for Title III was to democratize wealth creation as well. So it
is not just democratizing the capital formation, but also
democratizing the opportunity for investors to participate in
the types of investments that they might not otherwise, and
previously did not otherwise have. So I do not see the need to
restrict them.
Ms. CLARKE. Mr. Gorfine? Mr. Best?
Mr. BEST. Well, in talking to a couple major corporations
about this who have been interested in crowdfunding--their
interest really is more on the reward side because of the
rewards crowdfunding, like Kickstarter or using services like
that because it allows them to raise capital--there are no
limits, and far fewer restrictions. And knowing how general
counsels at corporations tend to work, that would be the way
that a marketing department might have a better chance at
actually executing one of these campaigns.
So I do not believe it will crowd out small businesses. I
think that those major corporations will utilize other means,
rewards or otherwise.
Mr. GORFINE. Yeah, I mean, just to add, I tend to agree
with that. I think let the marketplace determine what the crowd
wants to invest in. And I think more opportunities, more
offerings and options is not necessarily a bad thing.
And if I may, can I come back to the investor cap question
that you were asking before? I do want to just clarify one
thing. By no means do I think the SEC should be going after
investors with lawsuits if they violate the cap. So I actually
do agree to a significant extent with Professor Bullard that
this idea of how do we make sure investors just understand what
these caps are all about. So what I would propose is just
literally at the point that an investor is about to click their
commitment, there can be a popup that explains the rule and how
you calculate what your cap may be, and just explains why that
is important. So I do agree with the self-certification aspect
of it, but it could just be an explicit popup that occurs at
the point of the commitment that explains what the parameters
are.
And my point on the lawsuits is if an investor violates
that cap, you could consider whether they should not have the
right to bring a cause of action against an issuer. That is
what I was bringing up in terms of lawsuits. Just to help
enforce the importance of that cap.
Ms. CLARKE. Very well. Thank you.
Just one final question, and I am going to start with
Professor Bullard.
The SEC cost estimates for crowdfunding do not look
promising for small issuers. Are there ways the SEC could
reduce the cost without impacting investor protection?
Mr. BULLARD. That depends on to what extent the SEC
believes it can disregard what was expressly required in the
statute. And the SEC has shown a great willingness to do that
in its proposal. So if that is what it is going to do, then
yes. And one example that really stands out is the requirement
that you explained how you valued the shares and how you are
going to value them in the future, which you do not have to do
anything similar for an IPO. And it is also sort of in
contravention of the general rule that you are trying to sell
things for the highest price you can get. Although ironically,
in IPOs you are often trying to sell them for less than you can
get in order to have an effect on the aftermarket. So that
should go away. It is unreasonable. The very detailed
instructions when explaining your capital structure should go
away. The very detailed explanations on a dilution. What they
need to know is you can make subsequent offerings of shares and
it can result in reducing the value of our shares. And we have
the authority to do that.
So a lot of the things just are not the kinds of things
that are going to go to the real issue here, which is that
there are going to be a lot of losses. And who are the people
who suffered those losses going to be? Right? And I do not
think this is going to be about disclosure, but the cost is
certainly going to go to disclosure and the perceived liability
is going to go to that as well.
Ms. CLARKE. Thank you, Professor.
Is there anyone else who would want to? Mr. Best?
Mr. BEST. Just one thing about education. I think that is
one of the good things in the statute, was the requirement for
robust investor education. And we have already begun seeing
some of the portals who are going to be implementing solutions
that look very much like what Professor Bullard was talking
about, whether they be a video, much like the seatbelt video
you watch when you get on the airplane, or something that has
large check boxes and really requires much more engagement.
There were other solutions that used to require you to spend a
certain amount of time on the page and sort of monitor that.
Also, because all this is happening on websites, everything
is tracked. And so there will be a digital footprint of
everything that was done by that investor on those sites. And
so you will know how many minutes they spent on each page of
disclosure, how many times they watched the video, how many
times they did everything. And so it will provide much more
transparency than we have ever had before about what people are
doing when they are reviewing documents.
Ms. CLARKE. Very well. I yield back, Mr. Chairman. Thank
you all for your expertise today.
Chairman SCHWEIKERT. Thank you, Ranking Member Clarke.
And I am going to go to Mr. Rice, but Professor, I want to
chime in on this one just quickly. I actually see substantially
more benefits for its larger organizations. From their
standpoint, they get to do a proof of concept, but I actually
also saw that as they would have the resources to have good
documentation, good video, good information, maybe a nice blog
that explains what they are doing. And it is a way of their
resources helping introduce hopefully this next class of
investor to this concept. And as we keep saying, education,
education, education. Well, I would love to exploit some of
their resources to do that. So that is where I have some
optimism.
Mr. Rice, five minutes.
Mr. RICE. I was a tax lawyer and a CPA for 25 years before
I came to Congress, and I represented a thousand small
businesses. And I have seen the effect of federal securities
laws on their ability to raise capital. For a truly small
business, it simply is out of reach. Banks being the primary
source of capital, the new Dodd-Frank regulations are certainly
going to limit that even further. So this is an incredibly
important concept, very innovative concept. Could solve a big
problem of growing small businesses. I totally agree.
I would ask each one of you for one suggestion. We cannot
make this so complex and complicated and expensive that it,
like the rest of the federal securities laws, is out of reach
of the average small business. So I would ask each one of you
for one concrete change or suggestion that we could do with
these regulations in this law to make it more accessible.
And I will start with you, Mr. Best.
Mr. BEST. I think it would be to modify the requirement of
a full CPA audit at above a half million to potentially the CPA
review that was required in the $100,000 to half a million
range.
I would say in the same vein, I would limit any
nonstatutory disclosure requirements, and that also includes
limiting some of the ongoing compliance requirements. I would
just add to the point on audits above $500,000, for a Reg A
offering up to $5 million, we do not have that same financial
audit requirement. So you want to kind of square how these
different exemptions fit together.
Mr. RICE. Mr. Best, at what level would you require an
audit?
Mr. BEST. I do not have the benefit of 25 years of tax CPA
experience. I just come at this as a small business person, as
a small business owner. I think there is some level, but I
think if you wanted to say that maybe at the end of year one,
after you were successful at raising the capital at the end of
year one and you wanted to then provide something back, to
deliver back to those people. I think one of the things, too,
is that these investors, because they are investing most of the
time, historically the data we have to date is that 80 percent
of the time these are people who are first or secondary
connections to the small business owner who are making these
either investments or contributions. And so these are people
they have ongoing relationships with. And so there will be a
lot of mandated disclosure, but what we are seeing is the
people who are successful are the people who provide ongoing
sort of fulsome disclosure in the course of doing business
because that is what people want to know.
Mr. RICE. Well, do not get me wrong. I hold a CPA, but I
agree with you that an audit is an onerous requirement for a
small business, particularly when it has been ongoing for five
years and never had an audit. And so to go back and redo all
that from ground zero to establish a starting point is
ridiculously expensive and would prohibit any small business
from being able to utilize this. So I agree with you and I
think that that threshold, if there is not going to be an audit
required, should be very high because it is going to cost so
much to get the money it is not going to be worth it.
Mr. Bullard?
Mr. BULLARD. I guess the one change I would make would be
to have a $100 investment maximum and then strip everything out
except for the requirement to do it through a mediary and the
requirement to have some business plan that is at least 500
words.
Mr. RICE. I think 100 would be too small, but I hear what
you are saying.
Mr. BULLARD. A thousand times 100. There is your 100,000.
Mr. RICE. Mr. Paul?
Mr. PAUL. My suggestion would be addressing--it may seem
indirect, but addressing the portal liability issue is rather
crucial to a facilitating small business's ability to raise
money. If it is not clear, we may end up with perhaps the more
gun-slinging actors participating in a market that we really do
not want to be perceived that way.
Just getting back to the audit question, the only reason
that was not my choice was because it had already been
mentioned. I think an audit should be required when it is
required by the owners. I think when the market says, you know
what? We are not comfortable with you, the investors, we want
to see how you got here. When that happens then I think the
company should be required to, but I think setting an arbitrary
cut with respect to how much is raised feels, well, arbitrary
and it should be based more on necessity and the desire of the
shareholders.
Mr. RICE. Thank you very much for your time. I completely
agree that the way this is proceeding is going to make this
pretty much useless to small businesses unless we make changes.
I appreciate your input. I like the idea of limiting investment
but I think $100, it needs to be significantly higher than
that.
Thank you, Mr. Chairman.
Chairman SCHWEIKERT. And thank you, Mr. Rice.
They are about to call votes. I think that still gives us a
few minutes because as we have all learned around here the
first 15 minute vote means a half an hour.
Mr. Mulvaney, you had a couple.
Mr. MULVANEY. I did. Thank you.
And I forgot, Mr. Best, you actually opened your testimony
by talking about the British system and the theory that good
ideas can come from anyplace. Would you just give us a quick
summary of where you think the significant difference are
between the British system and the one we have adopted and
maybe someplace where it might be better, someplace where our
system might be a little better?
Mr. BEST. What is interesting about the British system is a
lot of it has sprung up in the absence of strong regulation.
And it is only this year that the British government will be
issuing more formalized crowdfunding and crowd lending
regulation.
Mr. MULVANEY. The caps that we are talking about, the
disclosure requirements, the liability rules are nonexistent?
They are organic? What are they in the British system?
Mr. BEST. Well, they are much less structured in the
British system. And so what we are seeing is you are seeing a
wide range of investors and lenders. Now, I will say that the
products of choice in the U.K. tend to be the loan products,
the debt-based products. That is about 10 times more crowd-debt
as there is equity. I think there is a degree to which that is
cultural, as well as the fact that for a lot of small
businesses who will never have an IPO or a 10X multiple, asking
the question where is my exit on this investment. If it is a
debt-based product, I know that I am going to get my loan
payment every month over the next four years. So that makes
sense as well.
Mr. MULVANEY. To the chairman's issue on democratization of
investment, you said that there is a wide array of investors in
the British system. Tell us who they are. Who is participating
in this, not on the issuer's end but on the investor's end?
Mr. BEST. Well, on the largest debt-based platform in the
U.K., it is called Funding Circle, they have now raised over
180 million British pounds. That is over a quarter billion
dollars through their platform. And they have, I believe, it is
65,000 investors that have invested individuals into small
businesses. And they come from a wide range of folks. And if
you look at the average investment, it is about the average of
about $3,000 USD. And so these are people who are not investing
large amounts of money but are investing a few thousand dollars
into a local business that they are familiar with. And I think
that is a size of investment that, number one, we did research
a couple years ago before the law passed just to ask people,
what do you think your investment would be if you had this
opportunity? And the number was between $3,000 and $4,000. So
we are seeing, at least in the British system, those numbers
are somewhat consistent. And so I think that while the limits
may be up to 10 percent of someone's restrictions, what we are
seeing in the U.K. after tens of thousands of people have used
this system, that people are going into this fairly carefully.
Mr. MULVANEY. I heard Professor Bullard mention in his
testimony that he was concerned that something between a
quarter and a half of these issuers, if I got that right, might
fail. Do you happen to know the failure rate in the British
system so far or not?
Mr. BEST. No, sir. I do not know the British system. I can
give you some data from Australia. I think that there will be
failure. Absolutely. Businesses fail. We have never run away
from that in this entire conversation about this.
In the Australian system, they have had crowdfund
investing, a form of it for now almost eight years, and the
platform there is called the Australian Small-Scale Offering
Board. And they have run about 145 companies through that
platform, through that crowdfunding platform. One of the
interesting things is that the survival rate of those
businesses who have used that system has been 86 percent. That
is kind of a very surprising high number. And when asked about
that, the CEO of the platform has said he does not have the
exact reason but certainly believes that adding structure and
transparency to a business earlier than it typically would have
as a startup, because you have to sort of have a lot more
structure around your business because you are now offering
this security out to the public, and also the transparency of
having to make regular engagement with your investors, whether
it be informally or formally, provides people with better
decision-making opportunities and more transparency. I am doing
this on stage. I have to do a better job. I have to live up to
the expectations of the public.
And so we will see if that plays out in U.K. system and in
the U.S. system, but it is an interesting data point.
Mr. MULVANEY. Fascinating.
Thank you, Mr. Chairman. I appreciate it, gentlemen.
Chairman SCHWEIKERT. Thank you, Mr. Mulvaney. And thank you
for joining us.
Just one last, a takeoff of where you were, Mr. Best, or
anyone that wants to participate. Let us articulate so we have
it on the record. What are the caps? It is $2,000?
Mr. BEST. Two thousand dollars above $50,000--$50,000 to
$100,000 in income. It is up to 5 percent of your annual income
or net worth, and above $100,000 it is 10 percent of your
annual income or net worth excluding the value of your home.
Chairman SCHWEIKERT. Professor.
Mr. BULLARD. There is actually a flat contradiction in the
statute, so we do not really know the answer to that, which is
it says if you are either at 100 or below as to income or net
worth, you are subject to the lower limit. And then the next
provision says if you are either at 100 or more.
Also, it is not clear what the 5 percent applies to. There
I think the SEC should interpret it to be the greater of.
Chairman SCHWEIKERT. And Professor, did not the SEC sort of
broach that in their rule set?
Mr. BULLARD. Right. But they took the investor protection
ambiguity and they ruled against more investor protection,
allowing someone to invest more. But as a practical matter,
what that means is someone who has $100,000 in savings would be
able to invest $10,000 instead of $5,000. It is not going to be
the end of the world but I do not think the SEC, when there is
such a clear ambiguity, should be erring on the side of higher
investments when this is an investment protection provision.
Chairman SCHWEIKERT. Last thing I wanted to share, and this
was actually something--and those of you who have actually been
involved in intermediaries, I am from sort of the world that
believe that crowdsourcing of data information and
crowdsourcing of money and other things, there is a purifying
effect of information, sunlight, and the fact of the matter is
having seen--because I have looked at some of the ones
actually, the Netherlands, Sweden, Great Britain. And many of
them actually had blogs running alongside of it saying, ``We go
to Mary's Bakery. We like this. That is why we are willing to
put 1,000 pounds into this.'' It was a narrative that came with
not only the posting in the investment.
Do you believe U.S. portals will actually make sure that
they also, if they are asking for egalitarian participation,
democratization of investment as you have used the term, will
also be doing democratization of information and comments?
Mr. PAUL. I think absolutely. I think that it will be in
both senses, in the example that you gave of Mary's Bakery,
customers will talk, ``This place is great and they make great
scones.'' And there will be a discussion about that. But I
think that there will also be blogs or a running dialogue about
the offering itself where certain people will say, ``All right.
So I looked at the offering and this thing does not totally
make sense to me. Does anybody have any clarity on that?'' And
then a dialogue, someone will respond, perhaps even the
principal. And so I do think that there will be that level of
transparency.
Chairman SCHWEIKERT. Would anyone disagree with me that
particularly in this investor class, that is the ultimate type
of regulation? Because we are all comfortable going to Yelp and
others to get portions of information. As long as they have
built the mechanics within there to avoid the scamming, that
access to information has an ultimate regulator?
Mr. PAUL. I think it is a great contributing factor to that
level of regulation, and I think that it may come to pass that
it actually ends up being something that is expected in other
asset classes. I think it is going to be very successful on
Title III, and I think 5, 10 years from now that might be one
of the legacies of this entire legislation, is that that level
of transparency is actually required for other things, which
will be great.
Chairman SCHWEIKERT. And now we do the scamper to go vote.
Thank you for your participation today. Your testimony has
helped us to better understand how the SEC proposal will affect
the future of crowdfunding. As I shared with you earlier, I am
a bit emotionally invested in this, and I really do want to
move to this democratization of access to capital where all of
our U.S. citizens have the opportunity to take risks but also
benefit from that participation and risk.
I will ask unanimous consent to have five legislative days
to submit statements and supporting materials for the record.
Do understand our office also intends to take portions of this
and turn it into the SEC as part of sort of a comment coming
from us.
Without objection, the hearing is adjourned.
[Whereupon, at 11:28 a.m., the Subcommittee was adjourned.]
A P P E N D I X
[GRAPHIC] [TIFF OMITTED] T6267.001
[GRAPHIC] [TIFF OMITTED] T6267.002
[GRAPHIC] [TIFF OMITTED] T6267.003
[GRAPHIC] [TIFF OMITTED] T6267.004
[GRAPHIC] [TIFF OMITTED] T6267.005
[GRAPHIC] [TIFF OMITTED] T6267.006
[GRAPHIC] [TIFF OMITTED] T6267.007
[GRAPHIC] [TIFF OMITTED] T6267.008
[GRAPHIC] [TIFF OMITTED] T6267.009
[GRAPHIC] [TIFF OMITTED] T6267.010
[GRAPHIC] [TIFF OMITTED] T6267.011
[GRAPHIC] [TIFF OMITTED] T6267.012
[GRAPHIC] [TIFF OMITTED] T6267.013
[GRAPHIC] [TIFF OMITTED] T6267.014
[GRAPHIC] [TIFF OMITTED] T6267.015
[GRAPHIC] [TIFF OMITTED] T6267.016
[GRAPHIC] [TIFF OMITTED] T6267.017
[GRAPHIC] [TIFF OMITTED] T6267.018
[GRAPHIC] [TIFF OMITTED] T6267.019
[GRAPHIC] [TIFF OMITTED] T6267.020
[GRAPHIC] [TIFF OMITTED] T6267.021
[GRAPHIC] [TIFF OMITTED] T6267.022
[GRAPHIC] [TIFF OMITTED] T6267.023
[GRAPHIC] [TIFF OMITTED] T6267.024
[GRAPHIC] [TIFF OMITTED] T6267.025
[GRAPHIC] [TIFF OMITTED] T6267.026
[GRAPHIC] [TIFF OMITTED] T6267.027
[GRAPHIC] [TIFF OMITTED] T6267.028
[GRAPHIC] [TIFF OMITTED] T6267.029
[GRAPHIC] [TIFF OMITTED] T6267.030
[GRAPHIC] [TIFF OMITTED] T6267.031
[GRAPHIC] [TIFF OMITTED] T6267.032
[GRAPHIC] [TIFF OMITTED] T6267.033
[GRAPHIC] [TIFF OMITTED] T6267.034
[GRAPHIC] [TIFF OMITTED] T6267.035
[GRAPHIC] [TIFF OMITTED] T6267.036
[GRAPHIC] [TIFF OMITTED] T6267.037
[GRAPHIC] [TIFF OMITTED] T6267.038
[GRAPHIC] [TIFF OMITTED] T6267.039
[GRAPHIC] [TIFF OMITTED] T6267.040
[GRAPHIC] [TIFF OMITTED] T6267.041
[GRAPHIC] [TIFF OMITTED] T6267.042
[GRAPHIC] [TIFF OMITTED] T6267.043
[GRAPHIC] [TIFF OMITTED] T6267.044
[GRAPHIC] [TIFF OMITTED] T6267.045
[GRAPHIC] [TIFF OMITTED] T6267.046
[GRAPHIC] [TIFF OMITTED] T6267.047
[GRAPHIC] [TIFF OMITTED] T6267.048
[GRAPHIC] [TIFF OMITTED] T6267.049
[GRAPHIC] [TIFF OMITTED] T6267.050
[GRAPHIC] [TIFF OMITTED] T6267.051
[GRAPHIC] [TIFF OMITTED] T6267.052
[GRAPHIC] [TIFF OMITTED] T6267.053
[GRAPHIC] [TIFF OMITTED] T6267.054
[GRAPHIC] [TIFF OMITTED] T6267.055
[GRAPHIC] [TIFF OMITTED] T6267.056
[GRAPHIC] [TIFF OMITTED] T6267.057
[GRAPHIC] [TIFF OMITTED] T6267.058
[GRAPHIC] [TIFF OMITTED] T6267.059
[GRAPHIC] [TIFF OMITTED] T6267.060
[GRAPHIC] [TIFF OMITTED] T6267.061
[GRAPHIC] [TIFF OMITTED] T6267.062
[GRAPHIC] [TIFF OMITTED] T6267.063
[GRAPHIC] [TIFF OMITTED] T6267.064
[GRAPHIC] [TIFF OMITTED] T6267.065
[GRAPHIC] [TIFF OMITTED] T6267.066
[GRAPHIC] [TIFF OMITTED] T6267.067
[GRAPHIC] [TIFF OMITTED] T6267.068
[GRAPHIC] [TIFF OMITTED] T6267.069
[GRAPHIC] [TIFF OMITTED] T6267.070
[GRAPHIC] [TIFF OMITTED] T6267.071
[GRAPHIC] [TIFF OMITTED] T6267.072
[GRAPHIC] [TIFF OMITTED] T6267.073
[GRAPHIC] [TIFF OMITTED] T6267.074
[GRAPHIC] [TIFF OMITTED] T6267.075
[GRAPHIC] [TIFF OMITTED] T6267.076
[GRAPHIC] [TIFF OMITTED] T6267.077
[GRAPHIC] [TIFF OMITTED] T6267.078
[GRAPHIC] [TIFF OMITTED] T6267.079
[GRAPHIC] [TIFF OMITTED] T6267.080
[GRAPHIC] [TIFF OMITTED] T6267.081
[GRAPHIC] [TIFF OMITTED] T6267.082
[GRAPHIC] [TIFF OMITTED] T6267.083
[GRAPHIC] [TIFF OMITTED] T6267.084
[GRAPHIC] [TIFF OMITTED] T6267.085
[GRAPHIC] [TIFF OMITTED] T6267.086
[GRAPHIC] [TIFF OMITTED] T6267.087
[GRAPHIC] [TIFF OMITTED] T6267.088
[GRAPHIC] [TIFF OMITTED] T6267.089
[GRAPHIC] [TIFF OMITTED] T6267.090
[GRAPHIC] [TIFF OMITTED] T6267.091
Congressional Testimony of
David J. Paul
Co-Chair and Co-Founder of CfIRA
(Crowdfunding Intermediary Regulatory Advocates)
Chief Strategy Officer of Gate Global Impact
before the United States House of Representatives
Committee on Small Business
Subcommittee on Investigations, Oversight and Regulations
For the Hearing:
``SEC's Crowdfunding Proposal: Will it work for small
business?''
January 16, 2014
To Chairman Schweikert, Ranking Member Clarke, and other
honorable members of the Committee:
As all of you are aware, Congress passed the Jumpstart Our
Business Startups Act (the JOBS act) on March 27, 2012 which
was signed into law on April 5, 2012.
Very shortly thereafter, on April 20, 2012, I organized
what may have been the first meeting between representatives of
the crowdfunding industry and the Security and Exchange
Commission. Since that first meeting, CfIRA has enjoyed an
ongoing and productive dialog with both the SEC staff and the
commissioners up to, and subsequent to, the release by the SEC
of the proposed Title 3 crowdfunding regulations on October 23,
2013.
While it would be difficult to say that the crowdfunding
industry speaks with a singular voice, it is fair to say that
the overall consensus among the industry is that the SEC has
done a diligent and thoughtful job creating the proposed
regulations. In general, we remain hopeful that Title 3
crowdfunding, when it comes online later this year, will prove
to be an effective and robust new asset class, matching small
businesses with individual investors in a safe and productive
marketplace.
With that said, there are certain aspects of the proposed
regulations which may be amiss and which we hope to address and
modify. Some of these concerns will be the subject of my
testimony.
Given the limited time for testimony, I will confine my
comments to four salient issues. These four issues are
certainly representative of the kinds of concerns which the
industry has with respect to the proposed regulation, but these
are by no means exhaustive: Audit Requirements, Pooled
Investment Restrictions, Intermediary Participation
Restrictions, and Funding Portal Liability.
Audit Requirements
As currently proposed, there are three tiers of financial
disclosure requirements for Title 3 offerings, corresponding to
the amount raised:
First Tier: $0 - $100,000
Second Tier: $100,000 - $500,000
Third Tier: $500,000 - $1 million
The First Tier requires disclosure of financial statements
certified by an executive officer of the company. The Second
Tier requires financial statements reviewed by an accountant.
However, the Third Tier requires CPA audited financials.
Furthermore, the requirement for such CPA audited financials is
on an ongoing basis, with such audited financials to be
provided to investors every year following a Title 3 raise of
over $500,000.
It is worth noting that these disclosure requirements for
the Third Tier are actually more onerous and exhaustive than
the current requirement for Regulation D offerings which does
not mandate audited financial statements for issuers, nor
ongoing annual audited disclosures.
These overly onerous requirements for the Third Tier of
security crowdfunding offerings may have the unintended effect
of pushing potential issuers away from doing Title 3
crowdfunding offerings above $500,000 entirely, and instead
will make Regulation D offerings more attractive to potential
issuers.
This seems clearly inconsistent with the spirit of the
original legislation. In effect, this may create a `donut hole'
between $500,000 and $1 million where offerors do not utilize
Title 3 at all.
In addition to creating an artificial market irregularity,
this will also have the unfortunate effect of making these
offerings unavailable to unaccredited investors, since
Regulation D offerings utilizing Title 2 are not available for
investment by unaccredited individuals.
Pooled Investments Restrictions
The proposed regulations exclude funds from utilizing Title
3 to raise capital, in effect, requiring all crowdfunding
investments to be direct investments. This rule would restrict
pooled investments, or hedge funds and private equity funds
from raising money through crowdfunding.
While we may agree that most funds may not be suitable
issuers for crowdfunding, we believe that this restriction is
overbroad as it appears to restrict the fundraising of Special
Purpose Vehicles or Single Purpose Entities (SPE's) investing
only in a single operating company that would otherwise qualify
as an eligible Title 3 issuer.
This restriction does not serve to protect investors, but
rather this restriction actually succeeds in denying
crowdfunding investors some of the advantages and protections
afforded to other investors and institutions in other asset
classes, particularly those utilized in Regulation D offerings.
Intermediary Participation Restrictions
Current proposed regulations would restrict intermediaries
from holding interests in the companies conducting Title 3
offerings on their platforms. This serves to restrict
intermediaries from participating alongside their investors in
these offerings.
Rather than diminishing a theoretical `conflict of
interest' between intermediaries and investors, as a practical
matter this restriction effectively forbids alignment of
interests between investors and intermediaries.
This concept is often described as ``skin in the game.'' We
believe that intermediaries who invest in issuers make for
better alignment of interests. We believe that allowing such
co-investment by intermediaries would have two very desirable
benefits for investors. First, an investor may take comfort in
knowing that the intermediary facilitating the transaction is
invested in the same deal and on the same terms in the
investment they are considering. Second, when an intermediary
has such ``skin in the game'' that fact itself will encourage
intermediaries to take more seriously their assigned role in
the marketplace.
While we are aware that an intermediary's investing in a
deal may be perceived by an investor as a tacit endorsement of
that deal (perhaps to the exclusion of others in which the
intermediary has not committed its firm's capital) and that
this tacit endorsement may itself be construed as ``investment
advice'', we do not believe that this is necessarily the case.
But even if such a determination were to be made, we
believe that this ``investment advice'' restriction should not
be applied to all intermediaries. At most, this restriction
should be limited to Funding Portals and not to Broker-Dealers
conducting Title 3 crowdfunding offerings, as Broker-Dealers
are not restricted from offering investment advice in Title 3
crowdfunding offerings.
It is also worth noting that Broker-Dealers are not
restricted from owning positions in other types of offerings in
which they support, including Title 2 Regulation D offerings.
So the restriction on Broker-Dealer financial participation
triggered by Title 3 offerings may have the undesired effect of
disencouraging Broker-Dealers from bringing Title 3 offerings
at all.
Funding Portal Liability
Section 4A(c)(2) of the Securities Act provides that an
``issuer'' will be subject to liability if it fails in either
of the following two criteria: (1) if an issuer makes an untrue
statement of material fact or omits to state a material fact;
(2) if an issuer does not sustain the burden of proof that such
issuer did not know, and in the exercise of reasonable care
could not have known, of such untruth or omission.
While this may seem reasonable and proper for companies
issuing securities, as written, the regulations suggest that
funding portals themselves can be broadly included in the
definition of issuers.
If this interpretation proves accurate, then a funding
portal as well as each of its directors, principal executive
officers and other employees involved in an offering, may
potentially have personal liability for every transaction
conducted on its platform.
The proposed consequence for a violation under this
provision is to allow an investor to recover the amount of his
or her investment, even if he or she no longer holds the
security.
To put a fine point on this, this would mean that if the
platform does one hundred $1 million deals, then each of a
portal's affiliated persons would have $100 million in personal
exposure. A portal effectively becomes a guarantor for every
single statement in every offering document of every offering
on its platform.
To say that this liability issue may have a chilling effect
on anyone considering creating a portal may be something of an
understatement. Indeed, each employee of a funding portal will
have to make a decision as to whether they are comfortable
exposing themselves, and potentially their families, because of
the personal liability involved.
It is not hard to imagine this liability potential
resulting in an adverse selection, where conservative market
players are scared away and only aggressive players are willing
to take on this risk. Clearly, this would not be in the best
interests of the market as a whole.
Respectfully submitted,
David J. Paul
Co-Chair - CfIRA
CSO - Gate Global Impact