If you've been following the debate in the Senate over the JOBS Act, you know that "crowdfunding" has become a huge issue and potential obstacle to passage:
Crowdfunding will likely become the new law of the land, but not as soon as its advocates had hoped.
The JOBS Act passed the House easily on March 8 by a 390-23 vote, and its supporters hoped it would sail through the Senate. But today the Act has been delayed in the Senate by new arguments and amendments. ...
Strong editorial opposition to the House version of JOBS has come from the likes ofBloomberg and The New York Times, where editorials predict that the Act will usher in a new era of scams and bilking as regulations for capital-raising in small companies are scaled back; the comparison is often made to the formation of the SEC after the 1929 stock market crash, which was caused, in part, by an under-regulated securities market that accelerated out of control and became doomed to pop, taking consumer nest-eggs with it.
I'll be blogging on crowdfunding over the next few days. Let's start today with a brief description of what crowdfunding is.
Crowdfunding is a neologism for the process of raising very small investments from a large number of investors. The process has been facilitated by development of Crowdfunding websites. A prospective entrepreneur can establish a profile on one of these websites, describing the project in some detail. Anyone with Internet access thus is a prospective investor. Crowdfunding thus differs dramatically in terms of scope from traditional models of angel financing, in which the entrepreneur raises start up capital from his friends and family. Because crowdfunding has a strong social networking component of crowdfunding, moreover, the project basically gets free advertising at an extremely early stage in development.
Crowdfunding can loosely be classified into four distinct models: (1) the donation model, (2) the reward model, (3) the pre-purchase model, and (4) the equity model.
Under the donation model, contributors make a donation to support some project without receiving anything tangible in return. This type of crowdfunding really doesn’t raise significant securities law issues, because it’s more akin to a charitable donation than an investment. Donors do not receive any form of classic security such as stock, bonds, or notes. Because the donors have no expectation of profit, moreover, there is no investment contract.
Under the reward model, supporters make a monetary contribution in return for a reward of some sort. The rewards can be wholly intangible, such as mere credit as a supporter. In other cases, however, supporters receive a tangible reward. For example, a student of mine who wrote a research paper on crowdfunding (from which I’m borrowing some) identified the example of a company that makes wallets out of vintage ties and gives financial supporters custom neck-tie wallets made from the contributor’s own neck-ties. As another example, an independent filmmaker might give supporters tickets to the premiere. Again, there is no stock or other classic security involved. Although some cases involve a tangible reward, it’s hard to argue that a reward like a vintage wallet amounts to the sort of profit required for an investment contract to exist.
A somewhat related model is the pre-purchase model, in which the financial contribution is essentially a conditional pre-purchase of the entrepreneur’s planned product. If the project is successful, contributors are sent the actual product. The contributor’s reward may be being first in line to get the product, a discount on the price, and/or a special limited edition. Again, there is no stock or other classic security involved. Although contributors do get something in return, assuming the project succeeds, the purchase aspect makes the financial aspect of this model look less like an investment than a consumption act. So there really is no basis for finding an investment contract.
There simply is no security present in the first three models and, accordingly, no hook for federal regulation. Under current law, the SEC should not (and does not) regulate such activities. Whatever ends up happening with crowdfunding legislation, Congress should not drag these types of crowdfunding into the regulatory net. To the extent they require regulation, Congress should leave it to contract and fraud law.
Under the equity model, investors receive an interest in the profits of the business that they are helping fund. This is the sort of crowdfunding that raises securities law concerns.
Under current law, it’s quite clear that equity model crowdfunding involves the sale of a security and is therefore subject to the federal securities laws. Even if the crowdfunding enterprise does not issue shares of stock, bonds, notes, or other classic securities, there almost certainly is an investment contract and, accordingly, a security as defined by federal law.
In SEC v. Howey, the US Supreme Court defined an investment contract as a vehicle via which a person invests money in a common enterprise and is lead to expect profits from the efforts of another.
In equity crowdfunding, investors contribute money in exchange for either a share in the profits generated by sales. There is a common enterprise, because both horizontal and vertical commonality are satisfied by a scheme in which funds are pooled from multiple investors to fund an project whose returns are all contingent upon the success of the project. Under the equity model, it is clearly the expectation of profits that drives the investor to invest, as they are promised nothing else in return for their contributions. Finally, these profits are generated solely by the entrepreneur that proposed the project, as investors essentially pay, then sit back and wait to see if the project is successful.
Some equity crowdfunding projects can qualify for exemptions from the burdensome requirements associated with raising capital by selling securities, but many do not, because the use of public websites constitutes prohibited general advertising.
The question before Congress thus is whether to create new exemptions to facilitate crowdfunding. I’ll take up that issue in a future post.
For a great treatment of crowdfunding, which includes detailed treatment of the four models, and oin which my student's paper relied, see Steve Bradford's article, Crowdfunding and the Federal Securities Laws (March 09, 2012). Columbia Business Law Review, Vol. 2001, No. 1, 2012. Available at SSRN: http://ssrn.com/abstract=1916184