Views on improving the integrity of global capital markets
21 February 2014

US Crowdfunding Takes Major Step Forward: Let’s Get This Right for Investors

Posted In: US SEC

Crowdfunding — the new capital-raising mechanism mandated by the Jumpstart Our Business Startups Act (JOBS Act) through contributions using the Internet — has come one step closer to becoming a reality in the United States. Through regulations proposed by the US Securities and Exchange Commission (SEC) , smaller issuers and startup companies could soon raise up to $US 1 million in a 12-month period without having to comply with the requirements of registered securities offerings.

Safeguarding the Investor While Supporting the Startup

Crowdfunding is intended to allow issuers with early stage ideas and ventures to gain funding from investors who are able to communicate with each other through the Internet and thus vet the project before committing to invest. Participating issuers would be required to meet various requirements and provide a range of disclosures to potential investors, including information about their business plans, financial condition, and intended use of proceeds. Interested investors would be limited to the amount they could invest, based on annual income or net worth.

Of concern to investor advocates is the high risk to individual investors by these untested new offerings that are exempt from the registration and disclosure requirements that apply to registered offerings with which investors are familiar. And given that a significant number of startups fail, investors stand to lose substantial portions of their investments, prompting investor advocates to call for heightened investor protections for crowdfunding transactions.

In response, the SEC proposes to require offering documents to contain legends alerting investors to the fact that investing is risky and that they should not invest unless able to afford losing the entire investment. Investors also may cancel their investment commitments for any reason up until 48 hours before the offering deadline and must reconfirm their investment commitments in writing if material changes are made to the offering. Issuers and intermediaries are subject to a range of disclosure requirements and prohibitions, including those related to promotional activities, aimed at preventing investor confusion and conflicts of interest.

Whether the proposed safeguards will be enough to protect investors from unprecedented risky investing and accompanying losses remains to be seen.

CFA Institute Weighs in

While CFA Institute supported many aspects of the proposal that appear to balance the need for incentives that support capital formation with investor protections, it nonetheless recommended additional provisions aimed at alerting potential investors to the risks of investing in startups. For example, among other things, it suggested a “quiet period” between promotional activities of offerings that rely on differing exemptions to avoid investor confusion, additional disclosures by issuers related to the effect of market risk on their businesses, and heightened prominence of the warnings that issuers must provide in offering documents relating to the risks of investing.

The SEC has indicated approval of a final rule is on a short track; many expect completion of the rule-making process this spring.

FINRA Enters the Crowdfunding Arena

As contemplated by the SEC proposal, actual crowdfunding transactions will be conducted through intermediaries: either registered brokers or a new entity called “funding portals.” These funding portals would fall under the oversight of the Financial Industry Regulatory Authority (FINRA), which has proposed its own set of regulations applicable to the portals. CFA Institute also commented on this proposal.        

Other Jurisdictions Are Not Far Behind

While the United States looks to be on a determined course to implement crowdfunding regulations, other countries may not be far behind. Italy has created a framework for crowdfunding, the United Kingdom has proposed to allow crowdfunding in equity securities, and the European Union recognizes a limited application. Then there is the International Organization of Securities Commissions (IOSCO) paper noting the growth of crowdfunding venues. And in an interesting twist, this report notes that while not currently so, crowdfunding could actually pose systemic risks in the future.

The unknown nature of this investing vehicle and the potential widespread interest leaves one wondering about future headlines. Will crowdfunding transactions allow investors to tap into new wealth afforded by intriguing business ventures or result in a loss of investor money and confidence that ultimately will undermine crowdfunding’s current appeal? The outcome appears to lie in the hands of regulators as they face the challenge of balancing meaningful investor protections with incentives for economic growth. Let’s hope they get it right.


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Photo credit: iStockphoto.com/Tashatuvango

About the Author(s)
Linda Rittenhouse, JD

Linda Rittenhouse, JD, is a director of capital markets policy at CFA Institute. She focuses primarily on issues related to investment products and investment regulation. Rittenhouse holds a JD degree.

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