When President Barack Obama signed the JOBS Act into law on April 5, 2012, Section 3(a) of the Securities Exchange Act of 1934 was amended to include a new definition for “funding portal.”1 Funding portals, along with brokers, are the lucky players through which all crowdfunding transactions must be conducted.2 But just how lucky are these intermediaries? Will they be overburdened by responsibilities imposed by the new rules? As Stephen Choi and A. C. Pritchard put it, these are the “gatekeepers” for crowdfunding.
Given the likely composition of the crowdfunding market, Congress had to contend with the problem that individual retail investors purchasing securities from relatively unknown startup companies would, at best, face highly risky investment choices without the information or sophistication to make informed decisions and, at worst, face a sea of fraudsters. Congress’s solution was to employ third party gatekeepers.3
Particularly in line with this notion of intermediaries serving as gatekeepers are their obligations to educate crowdfunding investors. Section 4A(a) of the Securities Act of 1933 outlines these obligations in subsections 3 & 4, which state that intermediaries engaged in crowdfunding shall:
(3) provide such disclosures, including disclosures related to risks and other investor education materials, as the Commission shall, by rule, determine appropriate;
(4) ensure that each investor—
(A) reviews investor-education information, in accordance with standards established by the Commission, by rule;
(B) positively affirms that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss; and
(C) answers questions demonstrating—
(i) an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers;
(ii) an understanding of the risk of illiquidity; and
(iii) an understanding of such other matters as the Commission determines appropriate, by rule.4
Although the SEC’s proposed rules provide slightly more guidance with regard to investor education materials than the JOBS Act, there still remains a mystery of what intermediaries are supposed to teach.
What form will these investor education materials take? Would it be too negative to point out that IPO investors in Facebook lost more than 25% of their value in the first week of trading after the IPO and that crowdfunding investors may potentially experience even greater losses? Should education materials report on the actual performance of all prior crowdfunding investments made through a specific broker or funding portal in the past year (including median, mean, and variance)? Or should the investor education materials simply contain platitudes about the fact that investments in equity are not as safe as putting money in an FDIC-insured bank account?5
Foster Swift Collins & Smith’s Iris Linder does not think the educational disclosures will be a big deal. “We do not believe that these proposed disclosure requirements are unduly burdensome to intermediaries. The intermediaries should be able to develop standard “boilerplate” disclosures, and then update them only periodically based upon new developments.”6 Eliza Sporn Fromberg and Michael Burwick of Day Pitney express a similar view, predicting that, “it is likely that the industry will develop a set of standardized educational materials for investors.”7
The new rules do not stop at simply requiring intermediaries to supply investor education materials, but also prescribe that the intermediaries ensure that the investors review and understand the materials, and answer questions demonstrating that understanding.8 Again, Choi & Pritchard question how this will be accomplished.
Should the questions on such a test include questions about the efficient capital markets hypothesis and basic knowledge on the time value of money? Should they be multiple choice? Once we go down the path of requiring investors to take tests, should the SEC centralize such tests, essentially licensing investors to participate in crowdfunding? Or can each broker or funding portal make up its own questions to test investors?9
The SEC has decided that it will not propose a model test. “Rather, the proposed rules would permit an intermediary to develop the representation and questionnaire in any format that is reasonably designed to demonstrate the investor’s receipt of the information and compliance with the other requirements under the proposed rules.”10 Although this may prove to be burdensome for intermediaries, perhaps it is vitally important for crowdfunding.
Stephen Temes, Co-founder and Chairman of EarlyShares, a funding portal, realized the necessity of truly educating the public on crowdfunding, which is one reason he embarked on a roadshow through 24 U.S. cities in 24 weeks, aimed at educating and raising awareness around crowdfunding.11 When asked whether there was a need for educational efforts to be made, Temes responded,
Oh, a huge need. You know, this is the first time in history that individual investors have been able to invest in companies directly. Usually, that’s been saved for the very wealthy or the institutions. So, this is a whole new way of investing. A lot of people have never been a part of this and they need to start learning what it really means.12
Anticipation grows, as people continue envisioning how funding portals are going to address the regulations surrounding crowdfunding. While there are certainly more worrisome requirements facing intermediaries conducting crowdfunding, the task of educating investors is not to be snuffed out. We tend to think of investors as people who read The Wall Street Journal and keep abreast of the markets, but now, investors include those who prefer The National Enquirer as their news source. Intermediaries serve an important role in educating people on the risks involved with investing; let’s hope funding portals do not turn into the new age slot machine.
Securities Exchange Act of 1934 § 3(a)(80), 15 U.S.C. § 78c(a)(80) (2012). ↩
Securities Act of 1933 § 4(a)(6)(C), 15 U.S.C. § 77d(a)(6)(C) (2012). ↩
Stephen J. Choi & A. C. Pritchard, Securities Regulation: Cases and Analysis 39 (3d ed. Supp. 2013). ↩
Securities Act of 1933 § 4A(a), 15 U.S.C. § 77d-1(a) (2012). ↩
Choi & Pritchard, supra note 3, at 39-40. ↩
Iris K. Linder, The SEC Proposed Crowdfunding Regulations: Investor Accounts for Platforms, Tech L. Blog (Jan. 13, 2014), http://www.michiganitlaw.com/SEC-Proposed-Crowdfunding-Regulations-Investor-Accounts-for-Platforms. ↩
Eliza Sporn Fromberg & Michael J. Burwick, So You Want to Be a Crowdfunding Portal? Top 10 Traps for the Unwary, VC Experts (Feb. 4, 2014), https://vcexperts.com/buzz_articles/1473. ↩
Securities Act of 1933 § 4A(a)(4), supra note 4. ↩
Choi & Pritchard, supra note 3, at 40. ↩
Crowdfunding, Securities Act Release No. 33-9470, Exchange Act Release No. 34-70741, 78 Fed. Reg. 66,471 (proposed Nov. 5, 2013) (to be codified at 17 C.F.R. pt. 227). ↩
Anton Root, Crowdfunding Investor Education: A Discussion with EarlyShares Chairman Stephen Temes, Crowdsourcing.org (June 21, 2012, 2:08 AM), http://www.crowdsourcing.org/editorial/crowdfunding-investor-education-a-discussion-with-earlyshares-chairman-stephen-temes/16014. ↩
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