In the previous blog post, I detailed the reasons behind why there haven’t been very many funding portals. ((Jackson Colton, Where are the Funding Portals, Mich. Bus. and Entrepreneurial L. Rev. (2018), http://mbelr.org/where-are-the-funding-portals/.)) This blog post will propose an idea that would allow many more companies to register as funding portals. This would hopefully allow small companies more access to regulation crowdfunding offerings, and place the number of funding portals more in line with the SEC’s expectations.
One of the major detriments to operating a funding portal is regulatory cost, including the costs of registration. In order to fully comply with the registration requirements and to comply with the requirements of an intermediary, the SEC estimated that a funding portal would face an initial cost of $167,000, with an ongoing cost of $50,000. ((Regulation Crowdfunding, Securities Act Release No. 33-9974; 34-9974; File No. S7-09-13, 446 (Oct. 9, 2015), https://www.sec.gov/rules/final/2015/33-9974.pdf [hereinafter, Crowdfunding].)) $167,000 would require around forty successful offerings to break even, or 25% of the Regulation Crowdfunding offerings in 2016. ((Colton, supra note 1.)) This places a large regulatory burden on funding portals, and is likely a reason behind why there haven’t been as many funding portals as the SEC estimated.
One possible solution to the lack of funding portals is to remove the registration requirements as imposed by the SEC (or at least make them fairly minimal). This would eliminate an estimated $100,000 of the initial cost of setting up a funding portal, and an estimated $10,000 of the ongoing regulatory cost ((Crowdfunding at 446.)), a significant barrier to entry. In the year 2016, the removal of these costs would mean that a funding portal would only need around twenty offerings to break even on the regulatory costs. Removing the registration requirements for securities intermediaries is also not unprecedented. For example, the SEC issued a no-action letter in 2014 that removed the registration requirement for M&A brokers that only serve private companies. ((Private Company M&A Brokers Don’t Need to Register with the SEC as Broker-Dealers, Morrison & Foerster (Feb. 6, 2014), https://media2.mofo.com/documents/140206-private-company-ma-brokers.pdf.)). However, M&A brokers face a number of criteria in order to qualify for non-registration. ((Id. at 2 (listing ten different criteria that an M&A broker must meet).))
There are a number of issues that may make the SEC cautious about, or even opposed to, removing the registration requirement. The first is that funding portal registration is already an exemption from broker dealer registration, and was intended to be a facilitation of the normal registration requirements. ((Laura Anthony, The Payment of Finders’ Fees – An Ongoing Discussion, Securities Law Blog (July 5, 2017), http://securities-law-blog.com/2017/07/05/the-payment-of-finders-fees-an-ongoing-discussion/; see also Crowdfunding, at 245-46 (“We proposed to establish a streamlined registration process under which a funding portal would register with the Commission by filing a form with information consistent with, but less extensive than, the information required for broker-dealers.”).)) Funding portals file a separate form, Form Funding Portal, and do not need to make the same disclosures as a broker-dealer. As a result, funding portals already have a much lower compliance cost than a broker dealer. ((Crowdfunding, at 445 (Broker-dealers were estimated to have an initial registration cost of $275,000, with ongoing costs of $50,000).)) Removing, or significantly limiting, the registration requirements of a funding portal could be seen by the SEC as inconsistent with the compromise that the SEC already reached. In other words, the SEC already tried to balance the imposition of regulatory costs with investor protection, and concluded that the current funding portal requirements were the best balance of the two conflicting issues. In addition, the SEC would likely prefer not to change registration status with only one year of data on Regulation Crowdfunding.
Second, the SEC might be worried that removing or significantly limiting the registration requirements could increase the amount of fraud in the Regulation Crowdfunding market. One of the major reasons for registration requirements is protecting investors from fraud. ((See Internet Fraud, SEC: Fast Answers (June 25, 2013), https://www.sec.gov/fast-answers/answersinternethtm.html (telling investors to check whether a securities promoter is registered as a broker dealer with the SEC in order to avoid securities fraud); cf. Registration under the Securities Act of 1933, SEC: Fast Answers (Sept. 2, 2011), https://www.sec.gov/fast-answers/answersregis33htm.html (The SEC accomplishes [the objective to provide investors with information and to “prohibit deceit, misrepresentations, and other fraud in the sale of securities”] primarily by requiring that companies disclose important financial information through the registration of securities).)) Removal of the registration requirement could make it difficult for investors and for issuers to know which entity claiming to be a Regulation Crowdfunding intermediary is trustworthy. This is especially true for start-up intermediaries, who would not have a transaction history to prove their trustworthiness.
However, Regulation Crowdfunding does not appear to have created a desirable market for fraudsters. In 2016, FINRA only brought one enforcement action against a funding portal (implying a low rate of fraud in the Regulation Crowdfunding market) for, among other violations, a failure to adequately screen issuers. ((Marc A. Leaf et al., Crowdfunding Report—FINRA’s First Enforcement Action and Updated Data Analysis, Drinker Biddle (Jan. 30, 2017), https://www.drinkerbiddle.com/insights/publications/2017/01/crowdfunding-report. But see Nathaniel Popper, Doubts Arise as Investors Flock to Crowdfunded Start-Ups, N.Y. Times: DealBook (Jan. 24, 2017), https://www.nytimes.com/2017/01/24/business/dealbook/crowdfunding-fraud-investing-startups.html (implying that the crowdfunding market is not adequately screening for frauds, and criticizing the FINRA enforcement for being too slow).)). Moreover, non-Regulation Crowdfunding platforms, such as Kickstarter and Indiegogo, which have no registration requirements, have astonishingly low rates of fraud. ((See Douglas Cumming et al., Disentangling Crowdfunding From Fraudfunding Max Planck Inst. for Innovation & Competition, Research Paper No. 16-09, 1, 18 (2016), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2828919## (finding, from 2010 to 2015, 197 cases of fraud on Kickstarter out of 110,000 successful projects, and ten cases of fraud on Indiegogo, out of 275,000 successful projects, compared to a 14% fraud rate of US publicly traded companies); see also GoFundMe: A Safe Place to Give, GoFundME, https://pages.gofundme.com/protection/?lang=en-gb (reporting a fraud rate of less than .1%).)). Although the SEC may have significant concerns about fraudsters in Regulation Crowdfunding, the data seems to support that the Regulation Crowdfunding market is not a desirable location for fraud.
Removing or significantly limiting the registration requirement could help the growth funding portals to act as intermediaries for Regulation Crowdfunding. By eliminating a significant barrier to entry for funding portals, the SEC could help the growth of the Regulation Crowdfunding market in an area that is not commonly used for fraud.