2015 NSBA Annual Meeting
Securities Law Section Seminar
A Discussion on Current Federal and State
Securities Law Issues
Prof. C. Steven Bradford, Mike Cameron, Stephanie Mattoon, Dan McMahon,
Amber Preston, Jeff Schaffart
October 7, 2015
Embassy Suites, La Vista
10/13/2015
Nebraska Securities Law Update
Mike Cameron
Legal Counsel—Securities
Nebraska Department of Banking and Finance
Legislative Update
 LB 226—Crowdfunding
 LB 252—One prospectus for registration by coordination
 LB 605—Prison Reform Bill
 Adjusts sentencing for Class IV Felonies
 Performance Audit Committee Interim Study
 May result in changes to the Administrative Procedures Act
1
10/13/2015
Crowdfunding
 Department has created a special page on its website
 Forms have been created
 Form NCF for issuers
 Form NPO for portal operators
 List of approved funding portals
 Frequently Asked Questions
Rules




Department is currently revising its rules.
Expect nearly all chapters to have some revisions.
Possibility of Additional Chapters.
Hearing(s) will likely occur late this year or early next year.
2
10/13/2015
Enforcement
 Number of cases is down
 The aftermath of 2008‐09 is winding down
 Criminal Cases (2014)
 4 convictions
 3 federal wire fraud
 1 state unregistered securities
 Administrative Cases (2014)
 10 Administrative Actions
 2 Individuals Barred
 $184,840 in fines and costs
Enforcement
 Areas of concerns





Oil and gas
Promissory notes
Rule 506 offerings
Suitability
Seminar advertising
3
10/13/2015
Department Initiatives
 Electronic File Depository (EFD)
 Rule 506 filings
 Voluntary system
 Receiving about 45% of Regulation 506 filings electronically  Increased resources for Investment Adviser Exams
 Investment Adviser Newsletters
 Quarterly newsletter to state registered IA’s
 Delivered electronically
 Archives will be on the Department’s website
Other Initiatives
 Cybersecurity
 Do our investment adviser understand their risks?
 Business continuity plan
 NASAA Guidance
4
10/13/2015
Seniors/Vulnerable Adults
 Elder abuse is a growing concern as the population of those over age 65 grows.
 FINRA approved the initiation of rulemaking on September 17, 2015
 Requires firms to use “reasonable efforts” to obtain a trusted contact at time firm opens
 Allows firms to put temporary holds on accounts if it suspects financial exploitation is occurring
 Formal notice and comment period is forthcoming
Seniors/Vulnerable Adults
 NASAA Model Legislation
 Available on www.nasaa.org
 Similar to the FINRA Rule
 Extends coverage to investment advisers
 Requires reporting of suspected financial exploitation
 Immunity for making the report, contacting the trusted person designated on account, delaying distribution
 Comments due on or before October 29, 2015
5
10/13/2015
Federal Securities Law Update
Daniel McMahon
Koley Jessen P.C., L.L.O.
JOBS Act – General Solicitation
Rule 506(b)
Rule 506(c)
Not engaged in public offering
General solicitation and advertising permitted Up to 35 non‐accredited investors
All accredited investors
“Check the box” generally permitted to verify accredited status Affirmative reasonable steps required to verify accredited status Additional proposed rules under
review 6
10/13/2015
What is “General Solicitation”
 General rule – a “substantive and pre‐existing relationship” by the issuer or its agent is a private offering.  Questions: how to apply this general rule to (1) historically gray areas (e.g., capital introduction programs, family office conferences, network or angel meetings, pitch or demo days), particularly in light of the new 506(c) path, and (2) websites/social media/online platforms.
 Commission Division of Corporation Finance Compliance and Disclosure Interpretations (Aug. 6, 2015), and Citizen VC, Inc.
(Aug. 6, 2015), seek to clarify these questions. Recent SEC Guidance – Establishing Relationships
 “Pre‐existing relationship” – one that the issuer has formed with a prospective investor prior to the offering. 

No waiting period required Issuer can rely on the relationship of a broker‐dealer or investment adviser
 “Substantive relationship” – one in which the issuer (or agent) has sufficient information to evaluate, and does, in fact, evaluate, an investor’s financial circumstances and sophistication.


“Check‐the‐box” alone is not sufficient Quality over quantity (e.g., time, questionnaires)  Issuer can establish a substantive, pre‐existing relationship indirectly through experienced, sophisticated investor networks (e.g., angel groups), or through capital introduction programs (e.g., pitch events or family office conferences) where program organizers have substantive, pre‐existing relationships with invitees.
7
10/13/2015
Recent SEC Guidance – Online
 Use of unrestricted website to offer or sell securities constitutes general solicitation.  Dissemination of “factual business information” does not constitute general solicitation. Do not include mention of the offering, or predictions, projections, forecasts, valuations about the issuer.  Offerings via protected online platforms that sufficiently pre‐screen investors in order to establish relationship do not constitute general solicitation.  Take away ‐ “Know it when you see it”
8
10/13/2015
Crowdfunding:
State and Federal Exemptions
C. Steven Bradford
College of Law
University of Nebraska‐Lincoln
Crowdfunding
Solicitation
WEB SITE
New Exemptions
• Securities Act § 4(a)(6)
• NEB. REV. STAT. § 8‐1111(24)
Public
BOTH: No federal or state registration
1
10/13/2015
Federal Crowdfunding Exemption
JOBS Act (2012)
Securities Act
§§ 4(a)(6), 4A
SEC regulations required
“very near term”
Section 4(a)(6)
Basic Requirements
1.
2.
3.
4.
Amount of Offering
Limits on Investors
Requirements for Intermediaries
Requirements for Issuers
2
10/13/2015
Offering Amount
$1 Million
within any 12‐month period
only crowdfunding sales count
Regulation of Investors • Anyone
– Not just accredited or sophisticated investors
3
10/13/2015
Regulation of Investors • Anyone
– Not just accredited or sophisticated investors
• Investor Education
– Disclosure/Investor Certification
– Questionnaire
• Restrictions on cancellation
• Difficult to resell
• Risky/can afford to lose money
Regulation of Investors • Anyone
– Not just accredited or sophisticated investors
• Investor Education
– Disclosure/Investor Certification
– Questionnaire
• Investment Limit
4
10/13/2015
Investment Limit
Net Worth and Annual Income
Both < $100,000
Either ≥ $100,000
Greatest of:
• $2,000
• 5% of Net Worth
• 5% of Annual Income
Greater of:
• 10% of Net Worth
• 10% of Annual Income
Maximum of $100,000
Regulation of Investors • Anyone
– Not just accredited or sophisticated investors
• Investor Education
– Provide information
– Questionnaire
• Investment Limit
• Resale Restriction: 1 Year
Exceptions
• Issuer
• Accredited investor
• Family member
• Certain Trusts
• Divorce or Death
5
10/13/2015
Intermediaries
• Must use intermediary
– No direct sales
– Off‐platform communications limited
• Broker or Funding Portal
• Bad‐Actor Disqualifications
– Exchange Act § 2(a)(39)
• Conflict‐of‐interest provisions
Regulation of Intermediaries • Enforce investor requirements
– Education and investment limits
6
10/13/2015
Regulation of Intermediaries • Enforce investor requirements
• Enforce issuer requirements
– Disclosure: Access 21 days before first sale
– Escrow provisions
• Target amount and target date
• Investor right to cancel
Regulation of Intermediaries •
•
•
•
Enforce investor requirements
Enforce issuer requirements
Communications channels
Steps to reduce fraud
– Background checks: issuers and principals
– Deny access if :
• “the issuer or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection”
7
10/13/2015
Issuers
• Only non‐reporting companies
• Only U.S. companies
• No investment companies
– or companies excluded by 3(b) or 3(c)
• “Bad Actor” Disqualifications
Issuer Disclosure
• File with the SEC and provide to investors
– Information about
• the offering
• the issuer, its capital structure, and its principals
• potential risks to investors
– Financial information
> $500,000
$100,000‐500,000
≤ $100,000
Audited Financial Reviewed by Certified by CEO
Statements
independent public +
accountant
Income Tax Returns
8
10/13/2015
Issuer Disclosure
• File with the SEC and provide to investors
– Information about
• the offering
• the issuer, its capital structure, and its principals
• potential risks to investors
– Financial information
– Annual reports to SEC and investors
Other Provisions
• “Substantial Compliance” Rule
– Good Faith Attempt
– No knowledge of intermediary non‐compliance
– “Insignificant with respect to the offering as a whole”
9
10/13/2015
Other Provisions
• “Substantial Compliance” Rule
• Exception to § 12(g) Reporting Company Trigger
• Liability: Securities Act § 4A(c)
– “Issuers”
• Directors; CEO; CFO; controller
• Anyone “offering or selling” in the offering
Neb. Rev. Stat. § 8‐1111(24)
• Piggybacks on intrastate offering exemption
– Securities Act § 3(a)(11)
– Rule 147
• Requirements
– Offering Amount
– Investors
– Intermediaries
– Issuers
10
10/13/2015
Offering Amount
Audited Financials Available?
No
Yes
$1 Million
$2 Million
Exclude sales to:
• Accredited investors
• 10% owners of any class
Offering Amount
• Subtract
– “all sales of securities by the issuer within the twelve months before the first offer or sale made in reliance on the exemption under this subdivision”
11
10/13/2015
Offering Amount
• Subtract
– “all sales of securities by the issuer within the twelve months before the first offer or sale made in reliance on the exemption under this subdivision”
Offering Amount
• Subtract
– “all sales of securities by the issuer within the twelve months before the first offer or sale made in reliance on the exemption under this subdivision”
12
10/13/2015
Offering Amount
• Subtract
– “all sales of securities by the issuer within the twelve months before the first offer or sale made in reliance on the exemption under this subdivision”
• “May not be used in conjunction with any other exemption . . . except for offers and sales to individuals identified in the disclosure document, during the immediately preceding twelve‐month period”
Regulation of Investors
• Nebraska residents (all offerees)
– Issuer must verify
• Investment limit: $5,000
– Doesn’t apply to accredited investors
• Certify understanding of risk
• Resale restriction
– No out‐of‐state sales—9 months
– Issuer: disclosure, legend, stop‐transfer
13
10/13/2015
Regulation of Intermediaries
• No direct offerings by issuer
• Registered crowdfunding portal
– Need not be broker‐dealer
• Limits on non‐brokers
– Bad‐actor disqualifications
Regulation of Intermediaries
•
•
•
•
•
•
No direct offerings by issuer
Registered crowdfunding portal
Recordkeeping
Limit access to Neb. residents
Can’t handle investor funds
Can’t invest in offerings
14
10/13/2015
Issuers
• Neb. Ties:
– Organized under Neb. Law
– Principal office
– 80% of gross revenues
– 80% of assets
– Use 80% of offering proceeds
Issuers
• Neb. Ties
• No reporting companies
• No investment companies
– or companies excluded by 3(c)
• Bad actor disqualifications—Rule 506(d)
15
10/13/2015
Regulation of Issuers
• Notice Filing/$200 Fee
• Disclosure Document
Issuer, history, and business plan
Use of proceeds
20% owners
Officers, directors, and other managers
Terms and conditions of securities
People assisting with offering
Litigation or regulatory actions
Other material information;
Significant risk factors
Regulation of Issuers
• Notice Filing/$200 Fee
• Disclosure Document
• Quarterly Reports
– Director and officer compensation
– Management analysis: business operations and financial condition
16
10/13/2015
Regulation of Issuers
•
•
•
•
Notice Filing/$200 Fee
Disclosure Document
Quarterly Reports
Escrow
– Target Amount/Date
– No $ until hit target amount
• Recordkeeping
Neb. Crowdfunding Exemption
vs.
Federal Crowdfunding Exemption
17
10/13/2015
C. Steven Bradford
College of Law
University of Nebraska‐Lincoln
sbradford.unl@gmail.com
18
CROWDFUNDING AND THE FEDERAL
SECURITIES LAWS
C. Steven Bradford*
Crowdfunding—the use of the Internet to raise money
through small contributions from a large number of
investors—could cause a revolution in small-business
financing. Through crowdfunding, smaller entrepreneurs,
who traditionally have had great difficulty obtaining capital,
have access to anyone in the world with a computer, Internet
access, and spare cash to invest. Crowdfunding sites such as
Kiva, Kickstarter, and IndieGoGo have proliferated, and the
amount of money raised through crowdfunding has grown to
billions of dollars in just a few years.
Crowdfunding poses two issues under federal securities
law. First, crowdfunding sometimes involves the sale of
securities, triggering the registration requirements of the
Securities Act of 1933. Registration is prohibitively expensive
for the small offerings that crowdfunding facilitates, and
none of the current exemptions from registration fit the
crowdfunding model. Second, the web sites that facilitate
crowdfunding may be treated as brokers or investment
advisers under the ambiguous standards applied by the SEC.
This article considers the costs and benefits of
crowdfunding and proposes an exemption that would free
crowdfunding from the registration requirements, but not the
* Earl Dunlap Distinguished Professor of Law, University of
Nebraska-Lincoln College of Law. An earlier draft of this paper was
presented in a colloquium at the University of Nebraska College of Law.
The author also discussed crowdfunding at the 2011 SEC GovernmentBusiness Forum on Small Business Capital Formation. The author writes
to thank the participants in both presentations for their helpful comments
and questions. The author also writes to thank Victor Peterson and Kevin
Davis for comments on an earlier draft. Finally, the author writes to
thank the research assistants who worked on this article: Daniel Hendrix
and, especially, Katharine Collins. Their work improved the final article
immeasurably and made the author’s work much easier.
2
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
antifraud provisions, of federal securities law. Securities
offerings for an amount less than $250,000–500,000 would be
exempted if (1) each investor invests no more than the greater
of $500 or 2% of the investor’s annual income; and (2) the
offering is made on an Internet crowdfunding site that meets
the exemption’s requirements.
To qualify for the exemption, crowdfunding sites would
have to: (1) be open to the general public; (2) provide public
communication portals for investors and potential investors;
(3) require investors to fulfill a simple education requirement
before investing; (4) prohibit certain conflicts of interest; (5)
offer no investment advice or recommendations; and (6) notify
the SEC that they are hosting crowdfunding offerings. Sites
that meet these requirements would not be treated as brokers
or investment advisers.
I.
II.
III.
Introduction .................................................................. 5
An Introduction to Crowdfunding ...............................10
A. What Is Crowdfunding?......................................... 10
B. Types of Crowdfunding.......................................... 14
1. Donation Sites .................................................. 15
2. Reward and Pre-Purchase Sites....................... 16
3. Lending Sites (Peer-to-Peer Lending).............. 20
a. Sites Not Offering Interest ......................... 20
b. Sites Offering Interest ................................ 21
4. Equity Sites ...................................................... 24
C. The Antecedents of Crowdfunding ........................ 27
Are Crowdfunding Investments Subject to the
Registration Requirements of the Securities Act? ......29
A. Are Crowdfunding Investments Securities? ......... 30
1. The Donation Model ......................................... 31
2. The Reward and Pre-Purchase Models ............ 32
3. The Equity Model ............................................. 33
4. The Lending Model........................................... 34
B. Registration and Exemption of Crowdfunded
Securities Offerings ............................................... 42
1. Registration ...................................................... 42
2. Possible Exemptions Under Current Law ....... 44
a. Section 4(2), Rule 506, and Section 4(5) ..... 45
No. 1:1]
IV.
V.
CROWDFUNDING AND SECURITIES LAWS
3
b. Rule 505 ...................................................... 47
c. Rule 504 ...................................................... 47
d. Regulation A ............................................... 48
The Status of Crowdfunding Sites Under Federal
Securities Law..............................................................49
A. Are Crowdfunding Sites Exchanges? .................... 50
B. Are Crowdfunding Sites Brokers? ......................... 51
1. Engaged in the Business .................................. 53
2. Effecting Transactions in Securities ................ 54
a. General Guidance ....................................... 54
b. Transaction-Based Compensation ............. 56
c. Involvement in the Transactions ............... 61
i. Providing Advice or
Recommendations.................................. 61
ii. Structuring the Transaction ................. 63
iii. Receipt or Transmission of Funds /
Continued Involvement after the
Financing ............................................... 63
iv. Involvement in Negotiations ................. 64
d. Solicitation and Advertising ....................... 64
e. For-Profit Status......................................... 66
3. Conclusion: Would Crowdfunding Sites Be
Brokers? ............................................................ 66
C. Are Crowdfunding Sites Investment Advisers? .... 67
1. The General Definition of Investment
Adviser .............................................................. 67
2. In the Business ................................................. 68
3. For Compensation ............................................ 69
4. Advice, Analyses, or Reports Concerning
Securities .......................................................... 69
5. SEC No-Action Letters ..................................... 73
6. The Publisher Exception .................................. 77
Proposals to Exempt Crowdfunding ............................81
A. The Sustainable Economies Law Center
Petition .................................................................. 81
B. The Small Business & Entrepreneurship
Council Proposal .................................................... 83
C. The Startup Exemption Proposal.......................... 84
D. The White House Endorsement ............................ 84
4
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
E. SEC Activity .......................................................... 85
F. The SEC’s Authority to Exempt Crowdfunding ... 87
G. The Congressional Response ................................. 88
1. House Bill 2930 ................................................ 89
2. Senate Bill 1791 ............................................... 91
3. Senate Bill 1970 ............................................... 94
VI. The Costs and Benefits of a Crowdfunding
Exemption ....................................................................98
A. Capital Formation: The Need for a
Crowdfunding Exemption ................................... 100
B. Investor Protection: The Effects of
Crowdfunding on Investors ................................. 104
1. The Risks of Small Business Investment ...... 105
2. The Financial Sophistication of the Crowd ... 109
3. Crowdfunding and Small Business
Investment Risk ............................................. 112
VII. A Crowdfunding Exemption Proposal .......................117
A. Restrictions on the Offering ................................ 118
1. Offering Amount............................................. 118
2. Aggregation/Integration ................................. 120
3. Individual Investment Cap ............................ 122
a. The Individual Cap Related to Existing
Exemptions ............................................... 123
b. How to Structure the Cap ........................ 126
4. Should There Be Company Size Limits?........ 132
B. Restrictions on Crowdfunding Sites.................... 133
1. Open Sites, Open Communication ................. 134
2. No Investment Advice or Recommendations . 136
3. Prohibition on Conflicts of Interests .............. 136
4. Notification to the SEC .................................. 137
5. Investor Education ......................................... 138
6. Funding Goals and Withdrawal Rights ......... 139
C. Other Possible Requirements.............................. 141
1. Non-Profit Versus Profit Status ..................... 141
2. Mandatory Disclosure by Entrepreneurs ...... 142
3. Restrictions on Resale .................................... 144
D. Preemption of State Law ..................................... 145
VIII. Conclusion ..................................................................149
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
I.
5
INTRODUCTION
Small businesses, especially startups, have a difficult
time raising money. The usual sources of business finance—
bank lending, venture capital, retained earnings—are
difficult to obtain for small and micro-businesses. Wealthy
individuals known as “angel investors” fill part of the
funding gap, but angel investing is limited, and even angel
investors tend to focus on larger investments.
Entrepreneurs who lack the personal resources needed to
finance their businesses turn to friends, family members,
and personal acquaintances, but those sources are often
insufficient. As a result, many potentially successful small
businesses do not get funded.
Crowdfunding, sometimes called peer-to-peer lending
when it involves debt financing, is a possible solution to the
small business funding problem. Crowdfunding, is, as its
name indicates, funding from the crowd—raising small
amounts of money from a large number of investors. Unlike
typical business financing, which comes primarily from
wealthy
individuals
and
institutional
investors,
crowdfunding raises money from the general public. In the
past, the transaction costs associated with raising small
amounts from a large number of investors would have made
crowdfunding unworkable, but the Internet has significantly
reduced those transaction costs. Web-based crowdfunding
services such as Kickstarter, Lending Club, Prosper,
ProFounder, IndieGoGo, and, the paragon of crowdfunding,1
Kiva have proliferated. Through these sites, entrepreneurs
have access to anyone in the world with a computer, Internet
access, and free cash. Billions of dollars have been raised
through Internet-based crowdfunding since its inception just
a few years ago—possibly the beginning of a revolution in
how the general public allocates capital.2
1
JEFF HOWE, CROWDSOURCING: WHY THE POWER OF THE CROWD IS
DRIVING THE FUTURE OF BUSINESS 247 (2008).
2
See KEVIN LAWTON & DAN MAROM, THE CROWDFUNDING REVOLUTION:
SOCIAL NETWORKING MEETS VENTURE FINANCING 3 (2010) (“[I]n the same
6
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
A recent campaign by two ad executives, Michael
Migliozzi II and Brian William Flatow, to raise $300 million
to buy Pabst Brewing illustrates the power of crowdfunding.3
They promised investors “certificates of ownership” and beer
with a value equal to the amount invested.4 According to
their lawyer, the two were only conducting an online
experiment and never actually intended to buy Pabst.5 But
they reportedly received $200 million in pledges from over
five million individuals in the six-month period before the
Securities and Exchange Commission (“SEC”) shut them
down for failing to register.6
As this example illustrates, crowdfunding does not mesh
well with federal securities regulation.
Entrepreneurs
seeking debt or equity financing through crowdfunding will
often be selling securities, and securities offerings must be
registered under the Securities Act of 1933 (the “Securities
Act”) unless an exemption is available. Registration would
be prohibitively expensive. A couple of peer-to-peer lending
sites have registered, but to do so, they substantially
restructured their operations in a way unlikely to prove
useful for most crowdfunding, particularly for equity
offerings.
The current exemptions from the registration
requirement also do not fit crowdfunding well. Crowdfunding
sites trying to fit within these exemptions have had to
restrict access either to sophisticated, wealthy investors or to
preexisting acquaintances of the entrepreneur seeking funds.
way that social networking changed how we allocate our time,
crowdfunding will change how we allocate capital.”).
3
See Michael Migliozzi II, Order Instituting Cease-and-Desist
Proceedings Pursuant to Section 8A of the Securities Act of 1933, Making
Findings, and Imposing a Cease-and-Desist Order, Securities Act Release
No. 9216 (June 8, 2011), available at http://www.sec.gov/litigation/admin
/2011/33-9216.pdf [hereinafter Migliozzi Cease-and-Desist Order]; Chad
Bray, Huge Beer Run Halted by Those No Fun D.C. Regulators, WALL ST.
J. L. BLOG (June 8, 2011, 4:05 PM), http://blogs.wsj.com/law/2011/06/
08/huge-beer-run-halted-by-those-no-fun-d-c-regulators/?mod=WSJBlog.
4
Migliozzi Cease-and-Desist Order, supra note 3, at 2.
5
See Bray, supra note 3.
6
Migliozzi Cease-and-Desist Order, supra note 3, at 3.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
7
Such restrictions eliminate the power of crowdfunding—
access to the public crowd of small investors. Securitiesbased crowdfunding is practicable only if a new exemption is
created.
Several proposals have been made to exempt
crowdfunding and certain other small business securities
offerings from the registration requirements of the Securities
Act. All of these proposals would cap both the dollar amount
of a crowdfunded offering and the amount that each
individual investor could invest.
But the Securities Act’s registration requirement is not
the only potential obstacle to crowdfunding. The web sites
that facilitate crowdfunding face their own regulatory issues.
If crowdfunding entrepreneurs offer securities on these sites,
the sites could be acting as unregistered brokers or
investment advisers under opaque SEC standards. Any
proposal designed to facilitate crowdfunding must deal with
these issues as well.
The White House recently endorsed a crowdfunding
exemption,7 and the SEC has promised to consider
crowdfunding as part of a general review of regulatory
constraints on capital formation. But Congress may not wait
for the SEC to act. The House has passed a bill to add a
crowdfunding exemption to the Securities Act and two bills
have been introduced in the Senate. Some of those bills
incorporate some of the recommendations made in this
article. According to one source, crowdfunding sites are
“gearing up for a boom” if a crowdfunding exemption passes.8
The CEO of one crowdfunding site, ProFounder, indicated in
7
See Press Release, White House Office of the Press Secretary issues
Fact Sheet and Overview for American Jobs Act (Sept. 8, 2011)
[hereinafter Fact Sheet and Overview for AJA], available at http:/
/www.whitehouse.gov/the-press-office/2011/09/08/fact-sheet-and-overview.
8
Angus Loten, Crowd-Fund Sites Eye Boom, WSJ.COM (May 12,
2011), http://online.wsj.com/article/SB100014240527487038063045762453
60782219274.html?mod=ITP_marketplace_4. The CEO of IndieGoGo, a
crowdfunding site, indicated that a regulatory change would “significantly
boost activity” on her site. Id.
8
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
May 2011 that she was “working with a legal team to lay the
groundwork for online equity sales.”9
The devil is in the details. Crafting a crowdfunding
exemption requires a careful balancing of investor protection
and capital formation. If the SEC leans strongly toward
investor protection, as it usually does, the resulting
exemption is likely to be too costly for many small
businesses. If, on the other hand, a crowdfunding exemption
ignores investor protection concerns entirely, the resulting
losses may create a regulatory and public relations backlash
that will set back crowdfunding for years.
This article argues for an exemption that would free both
crowdfunded offerings and the web sites on which they are
made from the regulatory requirements, but not the
antifraud provisions, of federal securities law. Under the
exemption, the total dollar amount of an entrepreneur’s
offerings would be limited to $250,000-$500,000 a year, with
individual investments limited to the greater of $500 or 2%
of the investor’s annual income. The offerings would have to
be made on publicly accessible crowdfunding web sites that,
among other things, meet conflict-of-interest standards and
do not provide investment advice.
Part II of this article is an introduction to the
crowdfunding phenomenon. It defines crowdfunding and
briefly explores its precursors: crowdsourcing and
microfinance. Part II also distinguishes among five different
models of crowdfunding: the donation model; the reward
model; the pre-purchase model; the lending model,
sometimes called peer-to-peer lending; and the equity model.
The models differ in what, if anything, contributors are
promised in return for their contributions.
Part III discusses whether crowdfunding investments are
securities subject to the Securities Act registration
requirements and concludes that the answer depends on the
particular form of crowdfunding.
Crowdfunding
contributions on donation, reward, and pre-purchase sites
are not securities. Crowdfunding investments on equity
9
Id.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
9
sites would be securities in the usual case where investors
are promised some investment return other than the return
of their capital. The answer with respect to lending sites is a
little less certain. If investors are promised interest on their
loans, those investments are probably securities. If no
interest is offered, lending sites would not be offering
securities.
Part IV discusses the regulatory issues faced by
crowdfunding sites. Even if crowdfunded offerings are
exempted from registration, the web sites that facilitate
crowdfunding could still be in violation of federal securities
laws.
They might be acting as unregistered brokers,
investment advisers, or, less likely, exchanges.
Part V discusses the various proposals to exempt
crowdfunding from federal securities law and also briefly
examines the SEC’s authority to exempt crowdfunding,
concluding that crowdfunding exemptions such as those
proposed would fall within that authority.
Part VI addresses the benefits and costs of crowdfunding.
Crowdfunding would help to ease the capital gap faced by
startups and very small businesses. It would extend the
geographical reach of small-business fundraising and make
capital available to poorer entrepreneurs whose family,
friends, and acquaintances have insufficient funds. But
these gains come at a potential cost. Crowdfunding exposes
relatively unsophisticated investors to the greater risks
associated with small business offerings—illiquidity, fraud,
business failure, and entrepreneurial self-dealing. Properly
structured, crowdfunding reduces, but does not eliminate,
those risks. However, investors are already exposed to those
same risks in the existing, non-securities models of
crowdfunding. A crowdfunding securities exemption would
increase those investors’ potential gains while mitigating
associated risks.
Part VII considers what a crowdfunding exemption
should look like.
10
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
II. AN INTRODUCTION TO CROWDFUNDING
A. What Is Crowdfunding?
The basic idea of crowdfunding is to raise money through
relatively small contributions from a large number of
people.10 Using the Internet, an entrepreneur can “in real
time and with no incremental cost . . . [sell] . . . to literally
millions of potential investors.”11 No intermediary such as a
bank or an underwriter is needed.12 Anyone who can
convince the public he has a good business idea can become
an entrepreneur, and anyone with a few dollars to spend can
become an investor.
The aspiring entrepreneur begins the process by
publishing a request for funding on a crowdfunding web site.
The request describes what the entrepreneur intends to do
with the money—the proposed product and a business plan.
It also indicates what, if anything, people who contribute
money to finance the business will receive in return for their
contributions.
Investors browse through entrepreneurs’
listings, and, if they find one (or more) that interests them,
they can contribute anything from a few dollars to the total
amount the entrepreneur is seeking. The web site on which
the funding request is published typically facilitates the
exchange of funds—the initial contributions from the
investors to the entrepreneurs and, if investors are to receive
money back, the payments from the entrepreneur back to the
investors.
10
See Paul Belleflamme, Thomas Lambert & Armin Schwienbacher,
Crowdfunding: Tapping the Right Crowd 2 (Center for Operations
Discussion and Research, Discussion Paper No. 2011/32, 2011), available
at http://ssrn.com/abstract=1836873.
11
Stuart R. Cohn & Gregory C. Yadley, Capital Offense: The SEC’s
Continuing Failure to Address Small Business Financing Concerns, 4
N.Y.U. J. L. & BUS. 1, 6 (2007). Crowdfunding can also be used for nonbusiness purposes, but this article focuses only on crowdfunding as a way
for businesses to raise money.
12
See Andrew Verstein, The Misregulation of Peer-to-Peer Lending, 45
U.C. DAVIS L. REV. (forthcoming 2012), available at http://ssrn.com
/abstract=1823763.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
11
Crowdfunding offerings are typically rather small. One
study found that the median amount raised was only
$28,583.13 But crowdfunding is not necessarily limited to
very small offerings. The largest amount raised in that same
study was over $82 million.14
And, in the aggregate,
crowdfunding is huge. As of December 2011, 600,000
different Kiva lenders had loaned more than $270 million
dollars to more than 700,000 entrepreneurs.15 Peer-to-peer
lending, just one form of crowdfunding, has alone been
responsible for more than $1 billion dollars in funding, and
some industry analysts believe peer-to-peer lending could
exceed $5 billion annually by 2013.16
The basic concept of crowdfunding is not new. Politicians
have been collecting small campaign donations from the
general public for generations.
That, in essence, is
17
crowdfunding.
But Internet-based crowdfunding is
relatively new. Kiva, the leading crowdfunding site today,
did not open for business until 2005,18 and the term
“crowdfunding” did not appear until 2006.19 In the brief time
since Internet-based crowdfunding appeared, it has grown
exponentially. It “is becoming a big business, with a steady
13
Belleflamme et al., supra note 10, at 32–33 tbl. 2. The mean was
$3.5 million. Id.
14
Id.
See also Armin Schwienbacher & Benjamin Larralde,
Crowdfunding of Small Entrepreneurial Ventures, in HANDBOOK OF
ENTREPRENEURIAL FINANCE (Douglas Cumming ed., forthcoming 2012),
available at: http://ssrn.com/abstract=1699183 (discussing plans of
Trampoline Systems, a British software company, to raise £1 million in
four tranches).
15
See About Us - Statistics, KIVA, http://www.kiva.org/about/stats (last
visited Mar. 5, 2012).
16
Verstein, supra note 12.
17
Crowdfunding has “been the backbone of the American political
system since politicians started kissing babies.” HOWE, supra note 1, at
253.
18
See About Us - History, KIVA, http://www.kiva.org/about/history
(last visited Mar. 5, 2012).
19
LAWTON & MAROM, supra note 2, at 66.
12
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
parade of services joining the fray.”20 Kiva is now so popular
that it sometimes exhausts its available lending
opportunities.21
Crowdfunding has been especially popular in the
entertainment industry,22 but there are crowdfunding sites
for all types of projects. Some crowdfunding sites are limited
to specific businesses or industries, such as book
publishing,23 gaming,24 music,25 journalism,26 or agriculture
20
Brian Oliver Bennett, Crowdfunding 101: How Rising Startups Use
the Web as a VC Firm, LAPTOPMAG.COM (July 9, 2011), http://blog.laptop
mag.com/crowdfunding-101-how-rising-startups-use-the-web-as-a-vc-firm.
21
See HOWE, supra note 1, at 248; Jilian Mincer, Microlending for
Microbankers, WALL ST. J., Mar. 20, 2008, at D2.
22
See Belleflamme et al., supra note 10, at 2–3; Tim Kappel, Ex Ante
Crowdfunding and the Recording Industry: A Model for the U.S.?, 29 LOY.
L.A. ENT. L. REV. 375, 375–76 (2009) (“[Crowdfunding] has been
increasingly used in the entertainment industry by independent
filmmakers, artists, writers, and performers.”).
Not surprisingly,
politicians have adapted their crowdfunding to the Internet as well.
Barak Obama used the Internet in his 2008 presidential campaign to raise
over $750 million from just under four million donors. Tahman Bradley,
Final Fundraising Figure: Obama’s $750M, ABC NEWS (Dec. 5, 2008),
http://abcnews.go.com/Politics/Vote2008/Story?id=6397572&page=1.
23
See, e.g., UNBOUND: BOOKS ARE NOW IN YOUR HANDS, http://www.
unbound.co.uk/ (last visited Mar. 5, 2012). See also Keith Wagstaff, Is
Crowdfunding the Future of Book Publishing?, THE UTOPIANIST (June 22,
2001),
http://utopianist.com/2011/06/is-crowdfunding-the-future-of-bookpublishing/ (discussing how crowd-funding works in book publishing).
24
See 8-BIT FUNDING, http://www.8bitfunding.com/index.php (last
visited Mar. 5, 2012). See also The Power of Crowd Funding, EDGE (June
20,
2011),
http://www.next-gen.biz/features/powertothepeoplefeature
(discussing how crowdfunding works in the video game industry).
25
See MY MAJOR COMPANY, http://www.mymajorcompany.co.uk/ (last
visited Mar. 5, 2012); SELLABAND, https://www.sellaband.com/ (last visited
Mar. 5, 2012). Crowdfunding works in the music industry “because most
of the market is controlled by a handful of risk-averse major labels and
there’s a huge underground that wants to break in.” John Tozzi, Scoring
Money from an Online Crowd, BLOOMBERG BUSINESSWEEK (Sept. 10, 2007,
8:15
AM),
http://www.businessweek.com/smallbiz/content/sep2007/sb
20070910_540342.htm (quoting Pim Tetist, one of the founders of
Sellaband).
26
See SPOT.US: COMMUNITY-FUNDED REPORTING, http://spot.us/ (last
visited Mar. 5, 2012).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
13
and ranching.27 Crowdfunding is even being used to fund
scientific research projects.28 Other sites are open to broader
categories, such as “creative projects”29 or “sustainable or
Fair Trade” projects.30 Others are directed at particular
types of entrepreneurs, such as women31 or the poor.32 Many
crowdfunding sites are open to entrepreneurial projects
generally.33
Crowdfunding is not just a U.S. innovation. There are
crowdfunding sites serving, among other countries and
regions, Great Britain,34 Hong Kong,35 Brazil,36 Germany,37
27
See HEIFER INTERNATIONAL, http://www.heifer.org/ (last visited Mar.
5, 2012).
28
See Thomas Lin, Scientists Turn to Crowds on the Web to Finance
Their Projects, N.Y. TIMES, July 11, 2011, at D3.
29
See Learn More, ROCKETHUB, http://rockethub.com/learnmore/intro
(last visited Mar. 5, 2012) (“creative products and endeavors”); Frequently
Asked Questions: Kickstarter Basics, KICKSTARTER, http://www.kick
starter.com/help/faq/kickstarter%20basics (last visited Mar. 5, 2012)
(“Kickstarter is focused on creative projects. We're a great way for artists,
filmmakers, musicians, designers, writers, illustrators, explorers, curators,
performers, and others to bring their projects, events, and dreams to life.”).
30
See THE HOOP FUND, http://www.hoopfund.com/learn.webui (last
visited Mar. 5, 2012).
31
See INUKA, http://inuka.org/ (last visited Mar. 5, 2012).
32
See How MicroPlace Works, MICROPLACE, https://www.microplace
.com/howitworks/what_we_do (last visited Mar. 5, 2012); About Us, KIVA,
http://www.kiva.org/about (last visited Mar. 5, 2012).
33
See, e.g., PROFOUNDER, https://www.profounder.com (last visited
Mar. 5, 2012); GROW VC, http://www.growvc.com/main/ (last visited Mar. 5,
2012); PEERBACKERS: CROWDFUNDING BIG IDEAS, http://www.peerbackers.
com/ (last visited Mar. 5, 2012); INDIEGOGO, http://www.indiegogo.com/
(last visited Mar. 5, 2012); MICROVENTURES, http://www.microventures.
com/ (last visited Mar. 5, 2012).
34
See MY MAJOR COMPANY, supra note 25; Company Information,
UNBOUND, http://www.unbound.co.uk/company (last visited Mar. 5, 2012).
See generally Catherine Burns, Small Firms Seek Crowd Funding, BBC
(May 26, 2011), http://www.bbc.co.uk/news/business-13569912.
35
See About, GROW VC, http://www.growvc.com/main/about/ (last
visited Mar. 5, 2012).
36
See Janet Gunter, Brazil: Crowdfunding Potential, GLOBAL VOICES:
ENGLISH (May 24, 2011, 1:15 PM), http://globalvoicesonline.org/2011/05/24
/brazil-crowdfunding-potential/.
14
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
the Netherlands,38 and sub-Saharan Africa.39 Some sites
claim to be global, open to investors and entrepreneurs
everywhere.40
Not surprisingly, given the international reach of the
Internet, some of those foreign sites also sell to U.S.
investors,41 and some of the investments they sell would
almost certainly qualify as securities under U.S. law. That
raises a host of jurisdictional issues,42 but this article focuses
on the issues posed by domestic crowdfunding sites—web
sites operated by U.S. companies that bring together U.S.
entrepreneurs and U.S. investors.
B. Types of Crowdfunding
One can categorize crowdfunding into five types,
distinguished by what investors are promised in return for
their contributions: (1) the donation model; (2) the reward
model; (3) the pre-purchase model; (4) the lending model;
37
See generally Karsten Wenzlaff, Crowdfunding is on the Rise in
Germany, CROWDSOURCING.ORG (June 27, 2011, 9:47 AM), http://www.
crowdsourcing.org/editorial/crowdfunding-is-on-the-rise-in-germany/4962.
38
See SYMBID, http://www.symbid.com/ (last visited Mar. 5, 2012);
About Us, SELLABAND, https://www.sellaband.com/en/pages/about_us (last
visited Mar. 5, 2012).
39
See Introducing Inuka, INUKA, http://inuka.org/ (last visited Mar. 5,
2012).
40
See, e.g., About, GROW VC, supra note 35 (“Grow Venture
Community (Grow VC) is the first global, transparent, community-based
platform dedicated to entrepreneurs and their needs. . . . We are located
all over the world and growing constantly. We wish to establish a
presence in all the most entrepreneurial countries on the planet.”); About
Us, KIVA, supra note 32 (“Kiva works with microfinance institutions on
five continents.”).
41
For instance, an in-depth study of Sellaband found that its
investors were concentrated in Europe and the eastern United States.
Ajay Agrawal, Christian Catalini & Avid Goldfarb, The Geography of
Crowdfunding 8 (NET Institution, Working Paper No. 10-08, 2010),
available at http://ssrn.com/abstract=1692661.
42
See generally 6 THOMAS LEE HAZEN, TREATISE ON THE LAW OF
SECURITIES REGULATION 403–21 (6th ed. 2009). The answers to these
questions are complicated by the Supreme Court’s recent decision in
Morrison v. National Australian Bank Ltd., 130 S. Ct. 2869 (2010).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
15
and (5) the equity model.
Some crowdfunding sites
encompass more than one model; it is especially common to
see the reward and pre-purchase models on a single web site.
Other sites rely on only a single model.
1. Donation Sites
The contributions on donation sites are, as the name
would indicate, donations. Investors receive nothing in
return for their contributions—not even the eventual return
of the amounts they contributed. However, although the
contributor’s motive is charitable, the recipient’s motive need
not be. Donations may fund for-profit enterprises.
Pure donation sites are rare, and those that exist focus on
requests by charities and other non-profit institutions,
rather than requests by businesses.43 Some of the reward
and pre-purchase sites also allow unrewarded requests for
donations,44 but one study found that only 22% of all
crowdfunding initiatives were requests for donations, with
no rewards offered.45
GlobalGiving is an example of a pure donation site.46 It
allows donors to direct contributions to development projects
around the world.47 The GlobalGiving Foundation, which
operates the site, takes a 15% fee48 and guarantees that the
remainder of the donation will reach the project within sixty
43
See, e.g., GLOBALGIVING, http://www.globalgiving.org/ (last visited
Mar. 5, 2012); DONORSCHOOSE.ORG, http://www.donorschoose.org (last
visited Mar. 5, 2012).
44
For example, IndieGoGo recommends, but does not require that
fundraisers offer what it calls “perks.” See Frequently Asked Questions:
Creating a Campaign, INDIEGOGO, http://www.indiegogo.com/about/faqs
(last visited Mar. 5, 2012).
45
Belleflamme et al., supra note 10, at 9.
46
GLOBALGIVING, supra note 43.
Another example is
DonorsChoose.org, which allows donors to donate to specific classroom
projects in public schools. See DONORSCHOOSE.ORG, supra note 43.
47
About Globalgiving, GLOBALGIVING, http://www.globalgiving.org/
aboutus/ (last visited Mar. 5, 2012).
48
Id.
16
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
days.49 However, GlobalGiving, like other pure donation
sites, is limited to non-profit organizations.50 None of the
leading crowdfunding sites available to business
entrepreneurs uses the pure-donation model.
2. Reward and Pre-Purchase Sites
The reward and pre-purchase crowdfunding models are
similar to each other, and often appear together on the same
sites. The reward model offers something to the investor in
return for the contribution, but does not offer interest or a
part of the earnings of the business. The reward could be
small, such as a key chain, or it could be something with a
little more cachet, such as the investor’s name on the credits
of a movie.51
The pre-purchase model, the most common type of
crowdfunding,52 is similar. As with the reward model,
contributors do not receive a financial return such as
interest, dividends, or part of the earnings of the business.
Instead, they receive the product that the entrepreneur is
making. For example, if the entrepreneur is producing a
music album, contributors would receive the album or the
right to buy the album at a reduced price upon completion.
Kickstarter53 and IndieGoGo54 are the leading reward/prepurchase crowdfunding sites.55 The two sites are similar.
49
How Global Giving Works, GLOBALGIVING, http://www.global
giving.org/howitworks.html (last visited Mar. 5, 2012).
50
See GlobalGiving is Always Looking for More Incredible Grassroots
Projects, GLOBALGIVING, http://www.globalgiving.org/non-profits/join-global
giving/ (last visited Mar. 5, 2012).
51
See, e.g., Kappel, supra note 22, at 376 (Patrons receive perks “such
as the use of their name in the film credits or album liner notes, advanced
autographed copies of the work, or backstage access at a performer’s
show.”).
52
Belleflamme et al., supra note 10, at 34–35 tbl. 3 (66.7% of
crowdfunding offerings not involving pure donations offered the right to
receive a product).
53
Kickstarter: A New Way to Fund & Follow Creativity, KICKSTARTER,
http://www.kickstarter.com/ (last visited Mar. 5, 2012).
54
INDIEGOGO, supra note 33.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
17
Kickstarter requires its projects to offer what it calls
“rewards,”56 typically of the pre-purchase variety. According
to Kickstarter, “Rewards are typically items produced by the
project itself—a copy of the CD, a print from the show, a
limited edition of the comic.”57 Typically, the “donation”
required to receive the product is below the planned retail
price. For example, Dan Provost and Tom Gerhardt, who
designed a tripod mount for the iPhone, offered one of the
mounts to anyone who donated $20.58 They planned to sell
the mount for a retail price of $34.95.59 But Kickstarter’s
rewards are not limited to pre-purchase. Other suggested
rewards include “a visit to the set, naming a character after
a backer, [or] a personal phone call.”60 The creators of the
iPhone tripod mount, for example, offered to dine with
anyone who contributed $250.61
IndieGoGo, unlike Kickstarter, does not require
campaigns to offer what it calls “perks,” although it does
recommend them.62 Many of the perks offered on the
IndieGoGo site follow the pre-purchase model, but some go
well beyond that. The table below lists some of the perks
55
There are a number of other rewards/pre-purchase sites. See, e.g.,
8-BIT FUNDING, supra note 24; PEERBACKERS, supra note 33; ROCKETHUB,
http://www.rockethub.com/ (last visited Mar. 5, 2012).
56
Frequently Asked Questions: Creating a Project, KICKSTARTER, supra
note 29.
57
Id.
58
Farhad Manjoo, Adopt a Genius: Kickstarter, the Brilliant Site that
Lets You Fund Strangers’ Brilliant Ideas, SLATE (Jan. 27, 2011, 3:44 PM),
http://www.slate.com/id/2282436.
59
See, e.g., TikTok+LunaTik Multi-Touch Watch Kits, KICKSTARTER,
http://www.kickstarter.com/projects/1104350651/tiktok-lunatik-multi-touc
h-watch-kits (last visited Mar. 5, 2012). For a twenty-five dollar pledge,
donors would receive a watch kit that will sell for $34.95. For a fifty dollar
pledge, donors would receive a watch kit that would sell for $69.95.
60
Frequently Asked Questions: Creating a Project, KICKSTARTER, supra
note 29.
61
Manjoo, supra note 58.
62
Frequently Asked Questions: Creating a Campaign, INDIEGOGO,
supra note 44.
18
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
that Josh Freese of the band Nine Inch Nails offered to help
fund an album. 63
TABLE 1: SELECTED PERKS FOR FUNDERS
Contribution
Amount
$7
$15
$50
Perk
Digital download of the album and videos
CD/DVD set and digital download
CD/DVD set
T-shirt
$75,000
A “Thank you” phone call from Josh
Signed CD/DVD
Digital download
T-shirt
Tour with Josh for a few days
Have Josh write, record and release a 5song EP about you and your life story
One of Josh’s drum sets
“Take shrooms and cruise Hollywood in
Danny from Tool’s Lamborghini OR play
quarters and then hop on the Ouija board
for a while”
“Josh will join your band for a month . . .
play shows, record, party with groupies,
63
See, e.g., Danae Ringelmann, Want Ideas for VIP Perks? Listen to
Nine Inch Nail’s Former Drummer, GOGO BLOG (Feb. 20, 2009, 7:23 PM),
http://www.indiegogo.com/blog/2009/02/want-ideas-for-vip-perks-listen-tonine-inch-nails-former-drummer.html. One hopes that at least a couple of
the listed perks are intended as jokes.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
Contribution
Amount
$75,000
19
Perk
etc. If you don’t have a band he’ll be your
personal assistant for a month (4-day work
weeks, 10 am to 4 pm).”
“Take a limo down to Tijuana and he’ll
show you how it’s done (what that means
exactly we can’t legally get into here)”
“If you don’t live in Southern California
(but are a U.S. resident) he’ll come to you
and be your personal assistant/cabana boy
for 2 weeks”
“Take a flying trapeze lesson with Josh
and Robin from NIN, go back to Robin’s
place afterwards and his wife will make
you raw lasagna”
Both Kickstarter and IndieGoGo take a cut of the money
collected. Kickstarter uses an “all-or-nothing” funding model
and does not allow projects to be funded unless they reach
their stated funding goal.64 If a project reaches its funding
goal, Kickstarter collects a 5% fee;65 if not, Kickstarter does
not charge a fee.66 IndieGoGo allows project creators to draw
on pledged funds immediately, whether or not the funding
goal is reached,67 but the fee depends on whether the funding
64
Frequently Asked Questions: All or Nothing Funding, KICKSTARTER,
supra note 29.
65
Frequently Asked Questions: Creating a Project, KICKSTARTER, supra
note 29.
66
Id.
67
Frequently Asked Questions, INDIEGOGO, supra note 44. However,
this requires that the entrepreneur elect the web site’s “Flexible Funding”
option. If an entrepreneur chooses the “Fixed Funding” alternative and
fails to reach her fundraising goal, the web site refunds all pledged
contributions.
20
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
goal is met. IndieGoGo charges a 4% fee if the funding goal
is reached68 and a 9% fee if it is not.69
3. Lending Sites (Peer-to-Peer Lending)
The lending model of crowdfunding is often called peer-topeer lending.
Peer-to-peer lending involves loans.
Contributors provide funds on a temporary basis, expecting
repayment. In some cases, investors are promised interest
on the funds they loan. In other cases, they are only entitled
to receive the return of their principal.
a. Sites Not Offering Interest
Kiva is, without a doubt, the leading crowdfunding site
using the lending model,70 and probably the leading
crowdfunding site of any type. One source calls Kiva “the
hottest nonprofit on the planet.”71
Kiva does not lend directly to entrepreneurs, but instead
partners with microfinance lenders around the world, which
Kiva calls “field partners.”72 The local institutions make
68
Frequently Asked Questions: General FAQs, INDIEGOGO, supra note
44.
69
Frequently Asked Questions: Creating a Campaign, INDIEGOGO,
supra note 44. However, an entrepreneur who elects the web site’s Fixed
Funding option and fails to reach the funding goal is charged no fee, and
all pledged contributions are refunded to investors.
70
See KIVA, http://www.kiva.org/ (last visited Mar. 5, 2012). Another
example of a lending site that does not charge interest is Inuka, which is
limited to requests from female entrepreneurs. See Introducing Inuka,
INUKA, supra note 31.
71
Jeffrey M. O’Brien, The Only Nonprofit That Matters, CNNMONEY
(Feb. 26, 2008, 11:31 AM), http://money.cnn.com/magazines/fortune/for
tune_archive/2008/03/03/103796533/index.htm?postversion=2008022611.
Kiva was originally not open to entrepreneurs in the United States. That
policy was changed in 2009. See Tamara Schweitzer, Microloans for All?,
INC. (June 10, 2009), http://www.inc.com/the-kiva-connection/2009
/06/microloans_for_all.html; Michael Liedtke, Kiva to Feed Cash-Starved
US Small Businesses, USA TODAY (June 10, 2009, 9:51 AM),
http://www.usatoday.com/tech/hotsites/2009-06-10-kiva_N.htm.
72
How Kiva Works, KIVA, http://www.kiva.org/about/how (last visited
Mar. 5, 2012).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
21
loans to entrepreneurs, often before the loan request is even
posted on Kiva.73 Each entrepreneur’s loan request is posted
on the Kiva web site, where potential lenders can browse the
requests and fund each one in any amount from $25 to the
full amount of the loan.74 Kiva collects and distributes this
money back to the field partners and credits lenders with
any repayments the entrepreneurs make.75 Lenders on the
Kiva site only receive their principal back; the field partners
use any interest received to cover their operating costs.76
b. Sites Offering Interest
Prosper and Lending Club are the two leading peer-topeer lending sites that offer interest.77 Not all of the loans on
these sites are for business purposes. Most of the loans are
for personal expenses,78 but the amount of the small business
lending on these sites is increasing.79
73
Id. See also Stephanie Strom, Confusion On Where Money Lent Via
Kiva Goes, N.Y. TIMES, Nov. 8, 2009, at B6 (noting that “[t]he person-toperson donor-to-borrower connections created by Kiva are partly fictional”
and that “most Kiva users do not realize this”).
74
How Kiva Works, KIVA, supra note 72.
75
Id.
76
Id.
77
PROSPER, http://www.prosper.com/ (last visited Mar. 5, 2012);
LENDING CLUB, http://www.lendingclub.com/home.action (last visited Mar.
5, 2012). See also Verstein, supra note 12 (Prosper and Lending Club
“dominate . . . [peer-to-peer lending] . . . in America.”). Other lending sites
that offer interest are Microplace and the Calvert Foundation. See
MICROPLACE, http://www.microplace.com (last visited Mar. 5, 2012);
CALVERT FOUNDATION, http://www.calvertfoundation.org/ (last visited Mar.
5, 2012).
78
See Angus Loten, Peer-to-Peer Loans Grow: Fed Up With Banks,
Entrepreneurs Turn to Internet Sites, WSJ.COM (June 17, 2011),
http://online.wsj.com/article/SB100014240527487034212045763311417799
53526.html?mod=ITP_marketplace_3 [hereinafter Loten, Peer-to-Peer
Loans]; Jonnelle Marte, Credit Crunch Gives ‘Microlending’ a Boost,
WSJ.COM (Sept. 26, 2010), http://online.wsj.com/article/SB10001424052748
703905604575514340314712872.html?KEYWORDS=credit+crunch.
79
Loten, Peer-to-Peer Loans, supra note 78. As of May 2011, about
7.5% of Lending Club’s loans and about 11% of Prosper’s loans were for
small business. Id.
22
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Prosper and Lending Club operate similar, but not
identical, platforms.80 Borrowers submit requests for loans
in amounts ranging from $1,000 to $25,000.81 Potential
lenders review those requests and decide which to fund.82
The minimum investment for each loan request is $25.83
When a loan receives sufficient commitments to close, the
borrower executes a three-year unsecured note for the
amount of the loan.84
The nature of investors’ participation in these loans has
changed since Prosper and Lending Club first launched.
Originally, borrowers on both sites issued notes directly to
the crowdfunding lenders, with the site maintaining custody
of the notes and servicing them for a 1% fee.85 Now,
however, lenders on the two sites do not make loans directly
to the underlying borrowers.86 Instead, lenders purchase
80
For a more detailed discussion of the operations of Prosper and
Lending Club, see generally Verstein, supra note 12 (describing the
operations of Prosper and Lending Club).
81
See Prosper Marketplace, Inc., Amendment No. 6 to Registration
Statement 8 (Form S-1) (July 13, 2009), available at http://www.
sec.gov/Archives/edgar/data/1416265/000141626509000017/prosper_s-1a6.
htm [hereinafter Prosper Registration Statement]; LendingClub Corp.,
Amendment No. 3 to Registration Statement 8 (Form S-1) (Oct. 9, 2008),
available at http://www.sec.gov/Archives/edgar/data/1409970/0000950134
08017739/f41480a3sv1za.htm [hereinafter Lending Club Registration
Statement].
82
All of the Lending Club lenders must meet suitability standards
based on gross income and/or net worth. Lending Club Registration
Statement, supra note 81, at 5. Prosper imposes suitability standards only
on lenders living in certain states. Prosper Registration Statement, supra
note 81, at 6.
83
Prosper Registration Statement, supra note 81, at 12; Lending Club
Registration Statement, supra note 81, at 48.
84
Prosper Registration Statement, supra note 81, at 8; Lending Club
Registration Statement, supra note 81, at 7. Prosper has said it plans to
vary the terms of its loans in the future, with a range between three
months and seven years. Prosper Registration Statement, supra note 81,
at 8.
85
Prosper Registration Statement, supra note 81, at 76; Lending Club
Registration Statement, supra note 81, at 89.
86
See Prosper Registration Statement, supra note 81, at 8; Lending
Club Registration Statement, supra note 81, at 7. The change resulted
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
23
notes issued by Prosper or Lending Club themselves, and the
sites use those funds to make loans through WebBank87 to
the underlying borrowers.88 Although the sites are the
issuers of the notes that the lenders purchase, the sites are
obligated to pay only if the underlying borrowers repay the
corresponding loans.89 In effect, the sites act as conduits for
borrower payments, taking 1% of the payments before
passing them along to the lenders.90 Both Prosper and
Lending Club also charge borrowers an origination fee on
each loan; the amount of the fee depends on the borrower’s
credit risk.91
Prosper and Lending Club set interest rates on the notes
(and on the underlying loans) differently. Lending Club
evaluates each borrower and sets an interest rate on each
loan based on the “loan grade” it assigns to the loan.92
Prosper also rates each potential loan,93 but those scores are
used only to set a minimum rate.94 The actual interest rate
is determined by an auction process. Each lender bids the
minimum percentage he is willing to accept,95 and the
interest rate on each loan (and on the notes issued by
directly from the SEC’s position that the sites were illegally offering
securities without registration. See Prosper Marketplace, Inc., Securities
Act Release No. 8984 (Nov. 24, 2008).
87
Prosper Registration Statement, supra note 81, at 5; Lending Club
Registration Statement, supra note 81, at 6.
88
Prosper Registration Statement, supra note 81, at 8; Lending Club
Registration Statement, supra note 81, at 7.
89
Prosper Registration Statement, supra note 81, at 8; Lending Club
Registration Statement, supra note 81, at 7–8. Each loan involves a
different series of note. The notes are registered pursuant to a Form S-1
shelf registration, and each loan requires a different prospectus
supplement. Verstein, supra note 12.
90
Prosper Registration Statement, supra note 81, at 5; Lending Club
Registration Statement, supra note 81, at 3.
91
Verstein, supra note 12.
92
Lending Club Registration Statement, supra note 81, at 37–43.
93
Prosper Registration Statement, supra note 81, at 12, 41–43.
94
Id. at 4.
95
Id.
24
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Prosper) is the minimum percentage acceptable to enough
lenders to fund the entire loan.96
4. Equity Sites
Equity crowdfunding offers investors a share of the
profits or return of the business they are helping to fund.
The equity model is the model that most clearly involves the
sale of a security. Because of the regulatory issues it raises,
the equity crowdfunding model is not common in the United
States. Equity crowdfunding is more common elsewhere,
however.97 One study found that one-third of all
crowdfunding sites that offered investor rewards offered
stock. 98
Until recently, ProFounder was the leading equity-model
crowdfunding site in the United States.99
However,
ProFounder announced in June 2011 that it would no longer
be offering securities on its site.100 The reason for the change
became apparent when the California Department of
Corporations subsequently issued a consent order barring
ProFounder from selling securities on its web site unless it
first registered as a broker-dealer under California law.101
96
Id.
Eric Markowitz, Coming Soon: More Cash for Start-ups?, YAHOO
SMALL BUSINESS ADVISOR (Dec. 8, 2011, 12:01 AM), http://smallbusiness.
yahoo.com/advisor/why-crowdfunding-bill-good-start-050100895.html.
98
Belleflamme et al., supra note 10, at 33–35 tbl. 3. Another 22%
offered direct cash payments other than dividends on stock. Id.
99
PROFOUNDER, supra note 33. See also Nikki D. Pope, Crowdfunding
Microstartups: It’s Time for the Securities and Exchange Commission to
Approve a Small Offering Exemption, 13 U. PA. J. BUS. L. 973, 978–81
(discussing a few direct Internet offerings not mediated through
crowdfunding sites).
100
See Jessica Jackley, Changes to Our Site, PROFOUNDER, THE BLOG
(June 27, 2011), http://profounderblog.wordpress.com/2011/06/27/changesto-our-site/. On February 17, 2012, ProFounder announced that it was
shutting down. ProFounder Shutting Down, PROFOUNDER (Feb. 17, 2012),
http://blog.profounder.com/2012/02/17/profounder-shutting-down/.
101
See ProFounder Fin., Inc., Cal. Bus., Transp. & Hous. Agency Dep’t
of Corps. Consent Order to Desist and Refrain (Aug. 31, 2011), available at
www.corp.ca.gov/ENF/pdf/2011/ ProFounder_CO.pdf.
97
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
25
As a result of this change, there are now no major, publicly
accessible equity crowdfunding sites in the United States,
although there are sites that facilitate private equity
offerings to sophisticated and accredited investors.102
When it was operating, ProFounder offered two different
types of investment, which it called “public rounds” and
“private rounds.”103 The types of offerings differed in two
ways: (1) the return offered to investors; and (2) the
investors allowed to participate. In public rounds, the
amount paid back to investors was limited to the amount
they contributed, without any return on their investment;
investors in private rounds could receive more than what
they invested.104 Public rounds were open to the general
public while private rounds were limited to friends, family
members and existing acquaintances of each entrepreneur—
an attempt to fit within the SEC’s Rule 504 exemption from
registration.105
Investors on ProFounder were promised a percentage of
the gross revenues of the businesses in which they
invested.106 The exact percentage of revenues to be paid to
investors and the period over which investors were to receive
those funds was left to the individual entrepreneur to
102
See MICROVENTURES, supra note 33; Terms, GROW VC, http://www.
growvc.com/main/tour/terms/ (last visited Mar. 5, 2012) (limited to
accredited investors).
103
See Matt Ferner, Financing for Ecommerce: ProFounder.com Can
Help Ecommerce Merchants Raise Money, PRACTICAL COMMERCE (Dec. 27,
2010), http://www.practicalecommerce.com/articles/2478-Financing-for-Eco
mmerce-ProFounder-com-Can-Help-Ecommerce-Merchants-Raise-Money.
104
See id.
105
See infra Part III.B.2.c.
106
David Lang, Entrepreneur—Read This First!, PROFOUNDER (Nov. 4,
2010),
http://support.profounder.com/entries/321128-common-questionsread-this-first (on file with author). ProFounder did not explain why
investors shared gross revenues rather than profits, but this was probably
an attempt to avoid creating a partnership between the entrepreneur and
the investors. Under the Uniform Partnership Act, profit-sharing is
presumptive evidence of the existence of a partnership. UNIF. P’SHIP ACT
§ 202(c)(3) (1997). Sharing gross returns is not. Id. § 202(c)(2).
26
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
determine,107 but the maximum payout period was five
years.108 This share of revenues was the only equity interest
investors received—they received no stock or any other
ownership interest.109
Entrepreneurs had to pay to list on ProFounder, but the
amount and structure of those payments is a little unclear.
According to the ProFounder web site, entrepreneurs had to
pay an initial fee of $100 to post a fundraising appeal.110
But, according to ProFounder’s CEO, the initial fee for a
private round was $1,000.111
For a public round, the
entrepreneur had to pay 5% of the amount raised if the
fundraising succeeded.112 If a private round was successful,
both the ProFounder web site and one interview of its CEO
indicated that the entrepreneur had to pay an additional
$1,000.113 But the CEO indicated in another interview that
no additional fee was charged for a private round—that
entrepreneurs paid a flat $1,000 fee, whether or not the
offering succeeded.114
Entrepreneurs had thirty days to raise the funds
needed.115 If entrepreneurs failed to reach their goal, they
107
Lang, supra note 106.
Id.
109
Investment Terms, PROFOUNDER, https://www.profounder.com/inve
stors/investment-terms/ (last visited Mar. 5, 2012).
110
FAQs, PROFOUNDER, http://www.profounder.com/entrepreneurs/faq
(last visited Mar. 5, 2012). See also Lang, supra note 106.
111
Is ProFounder in Violation of Any Securities Laws with Their
Crowdsourced Model for Funding Startups?, QUORA (Nov. 30, 2010),
http://www.quora.com/ProFounder/Is-ProFounder-in-violation-of-any-secur
ities-laws-with-their-crowdsourced-model-for-funding-startups.
112
Company Terms and Conditions for Services, PROFOUNDER,
https://www.profounder.com/legal/terms_and_conditions (last visited Mar.
5, 2012); Is ProFounder in Violation of Any Securities Laws with Their
Crowdsourced Model for Funding Startups?, supra note 111.
113
FAQs, PROFOUNDER, supra note 110. See also Lang, supra note
106; Ferner, supra note 103.
114
See Is ProFounder in Violation of Any Securities Laws with Their
Crowdsourced Model for Funding Startups?, supra note 111 (statement by
Jessica Jackley).
115
FAQs, PROFOUNDER, supra note 110.
108
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
27
received none of the pledged funds.116 Investors did not sign
term sheets or make any payments until the goal was met.
C. The Antecedents of Crowdfunding
Internet-based crowdfunding is a merger of two distinct
antecedents:
crowdsourcing
and
microfinance.117
Crowdsourcing is, quite simply, “collecting contributions
from many individuals to achieve a goal.”118 It divides “an
overwhelming task . . . into small enough chunks that
completing it becomes . . . feasible.”119 Wikipedia is probably
the most prominent example of crowdsourcing—an entire
encyclopedia consisting of articles written and edited by the
general public.120 Linux, the open-source computer operating
system, was developed through crowdsourcing, and other
software companies, including IBM, have adopted the opensource model.121 From astronomy to stock photography to
“prediction markets” to eBay, platforms based on the
116
Company Terms and Conditions for Services, PROFOUNDER, supra
note 112.
117
See Belleflamme et al., supra note 10, at 2 (stating that
crowdfunding is rooted in crowdsourcing); When Small Loans Make a Big
Difference, FORBES.COM (June 3, 2008, 4:08 PM), http://www.forbes.com/
2008/06/03/kiva-microfinance-uganda-ent-fin-cx_0603whartonkiva.html
(noting that crowdfunding is a merger of social networking and
microfinance); Nick Mendoza, How Filmmakers Use Crowdfunding to
MEDIASHIFT
(Sept.
21,
2010),
Kickstart
Productions,
PBS
http://www.pbs.org/mediashift/2010/09/how-filmmakers-use-crowdfundingto-kickstart-productions264.html (describing crowdfunding as a mix of
crowdsourcing, marketing and fundraising); Schwienbacher & Larralde,
supra note 14, at 5.
118
Tina Rosenberg, Crowdsourcing a Better World, N.Y. TIMES.COM
OPINIONATOR (Mar. 28, 2011, 9:15 PM), http://opinionator.blogs.
nytimes.com/2011/03/28/crowdsourcing-a-better-world.
119
HOWE, supra note 1, at 11.
120
See CHRIS ANDERSON, THE LONG TAIL: WHY THE FUTURE OF
BUSINESS IS SELLING LESS OF MORE 65–70 (2006); HOWE, supra note 1, at
56–61; DON TAPSCOTT & ANTHONY D. WILLIAMS, WIKINOMICS: HOW MASS
COLLABORATION CHANGES EVERYTHING 71–77 (2006).
121
See HOWE, supra note 1, at 47–70; CLAY SHIRKY, Here COMES
EVERYBODY: THE POWER OF ORGANIZING WITHOUT ORGANIZATIONS 237–43
(2008); TAPSCOTT & WILLIAMS, supra note 120, at 77–83.
28
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
collective contributions of a large number of people are
commonplace today.122 Even the all-pervasive Google search
system is crowdsourcing; Google’s algorithm captures the
sites that everyone collectively is linking to and visiting.123
The Internet significantly reduces the transaction costs of
decentralized group action124 and “opens . . . the economy to
The “rigid
new Linux-like projects every day.”125
institutional structures” previously required to organize
economic action are, in many cases, no longer necessary.126
The other antecedent of crowdfunding is microlending,
sometimes called microfinance.
Microlending involves
lending very small amounts of money, typically to poorer
borrowers.127 Microlending can be traced back to Irish loan
funds in the 1700s,128 but it became prominent in recent
times through the work of Muhammad Yunus and the
Grameen Bank.129 Yunus’s project began when he loaned $27
122
For a more detailed look at crowdsourcing, see generally HOWE,
supra note 1; TAPSCOTT & WILLIAMS, supra note 120.
123
YOCHAI BENKLER, THE WEALTH OF NETWORKS: HOW SOCIAL
PRODUCTION TRANSFORMS MARKETS AND FREEDOM 76 (2006). See also
JAMES SUROWIECKI, THE WISDOM OF CROWDS: WHY THE MANY ARE SMARTER
THAN THE FEW AND HOW COLLECTIVE WISDOM SHAPES BUSINESS,
ECONOMIES, SOCIETIES, AND NATIONS 16–17 (2004) (describing Google as an
example of the wisdom of the crowds).
124
BENKLER, supra note 123, at 3; SHIRKY, supra note 121, at 48.
125
TAPSCOTT & WILLIAMS, supra note 120, at 24.
However,
crowdsourcing predates the Internet. For example, since 1900, the
National Audubon Society has been organizing bird-watchers to do an
annual count of birds in the Western hemisphere. See Rosenberg, supra
note 118. The famous Pillsbury Bake-Off is a long-standing means of
crowdsourcing recipes. See id.
126
SHIRKY, supra note 121, at 21–22.
127
See Mincer, supra note 21.
128
Sarah B. Lawsky, Money for Nothing: Charitable Deductions for
Microfinance Lenders, 61 SMU L. REV. 1525, 1529 (2008).
129
See Mincer, supra note 21; Olivia L. Walker, The Future of
Microlending in the United States: A Shift from Charity to Profits?, 6 OHIO
ST. BUS. L.J. 383, 384 (2011); Kathleen Kingsbury, Microfinance: Lending
a Hand, TIME (Apr. 5, 2007), http://www.time.com/time/magazine
/article/0,9171,1607256,00.html.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
29
of his own money to 42 villagers in Bangladesh.130 He
subsequently established a multi-branch bank, the Grameen
Bank, that specialized in such loans.131 In 2006, Yunus and
the Grameen Bank shared the Nobel Peace Prize. Microlending has its detractors,132 but it has ballooned into a
multi-billion-dollar industry.133
Micro-lending is defined primarily by the recipient—very
small entrepreneurial ventures. Crowdsourcing is defined
primarily by the contributor—small contributions from a
large number of people to achieve a common goal.
Crowdfunding is just a combination of those two ideas—
small contributions from a large number of people to fund
small entrepreneurial ventures.
III. ARE CROWDFUNDING INVESTMENTS
SUBJECT TO THE REGISTRATION
REQUIREMENTS OF THE SECURITIES ACT?
Crowdfunding raises two different sets of issues under
federal securities laws. The first issue relates to the
offerings themselves: are the entrepreneurs raising funds on
crowdfunding sites offering securities subject to the
registration requirements of the Securities Act of 1933? The
second set of issues relates to possible violations of securities
laws by the crowdfunding sites that facilitate those offerings.
This section addresses the first issue; the next section
focuses on the securities law status of the crowdfunding
sites.
Section 5 of the Securities Act and the SEC rules
associated with Section 5 are a morass of prohibitions,
130
MUHAMMAD YUNUS, BANKER TO THE POOR: MICRO-LENDING AND THE
BATTLE AGAINST WORLD POVERTY 49–50 (2003).
131
Id. at 89–97.
132
See Kingsbury, supra note 129 (noting complaints that microcredit
does little to alleviate overall poverty, crowds out locally owned banks, and
can leave the poor drowning in debt).
133
See id. As of 2007, about 10,000 microfinance institutions held
more than $7 billion in outstanding loans.
30
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
exceptions, conditions, and exceptions to exceptions,134 but
the basic prohibitions are clear. Absent an exemption, an
issuer may not offer a security for sale until a registration
statement has been filed with the SEC.135 And an issuer may
not sell a security136 until that registration statement has
become effective.137 But the registration requirements apply
only if the entrepreneurs on crowdfunding sites are offering
securities.138 If crowdfunding investments are not securities,
the federal securities laws do not apply.
A. Are Crowdfunding Investments Securities?
Each federal securities statute has its own definition of
“security,” but the language of the various definitions, for
purposes of the issues raised here, is roughly the same.139
The most expansive part of the definition of security, the
catch-all category, is the term “investment contract.” In SEC
v. W. J. Howey Co., the Supreme Court defined an
investment contract as (1) an investment of money (2) in a
common enterprise (3) with an expectation of profits (4)
134
Consider, for example, Securities Act Rule 433. Whether a
communication falls within the Rule 433 safe harbor can depend on,
among other things: whether the issuer has filed a registration statement,
Rule 433(a); characteristics of the company issuing the securities, such as
its size and how long it has been a reporting company, Rule 433(b); the
content of the communication, Rule 433(b)(2)(i), (c); who is making the
communication, Rule 433(d), (f); where the information in the
communication originally came from, Rule 433(d)(1)(i)(B), (h)(2); whether
the information in the communication is otherwise available to the general
public, Rule 433(d)(8)(ii); and whether the issuer or anyone else associated
with the offering paid for the communication, Rule 433(b)(2)(i), (f)(1)(i).
135
Securities Act of 1933 § 5(c), 15 U.S.C. § 77e(c) (2010).
136
“Selling” includes entering into a contract of sale. See id. §
77b(a)(3).
137
Id. § 77e(a)(1).
138
Even if they are offering securities, an exemption may be available.
See infra Part III.B.2.
139
See 15 U.S.C. §§ 77b(a)(1), 78c(a)(10); Investment Company Act of
1940 § 2(a)(36), 15 U.S.C. § 80a-2(a)(36) (2010); Investment Advisers Act of
1940 § 202(a)(18), 15 U.S.C. § 80b-2(a)(18) (2010). For convenience, this
article generally refers to the Securities Act definition unless there is some
relevant difference.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
31
arising solely from the efforts of the promoter or a third
party.140 Both the Supreme Court and the lower courts have
refined the Howey test over the years, but its basic elements
remain unchanged—with one significant exception. The
word “solely” has been eliminated from the efforts-of-others
part of the test. Instead, the question is “whether the efforts
made by those other than the investor are the undeniably
significant ones, those essential managerial efforts which
affect the failure or success of the enterprise.”141
Crowdfunding offerings of the donation, reward, and prepurchase type clearly do not involve securities for purposes
of federal law. Crowdfunding sites organized on the lending
model probably are offering securities if the lender is
promised interest. Crowdfunding sites organized on the
equity model are usually offering securities.142
1. The Donation Model
Donation-model crowdfunding sites are not offering
securities to investors.
Contributors receive absolutely
nothing in return for their contributions, so they clearly have
no expectation of profits, a requirement for something to be
an investment contract under Howey. And contributors to
donation-model sites are offered nothing else, such as stock143
or notes,144 that would fall within the general definition of a
140
SEC v. W. J. Howey Co., 328 U.S. 293, 298–99 (1946).
SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir.
1973); accord SEC v. Koscot Interplanetary, Inc., 497 F.2d 473, 483 (5th
Cir. 1974).
142
Heminway and Hoffman have similarly concluded that at least
some crowdfunding offerings are securities under the Howey investment
contract test. See Joan MacLeod Heminway & Shelden Ryan Hoffman,
Proceed at Your Peril: Crowdfunding and the Securities Act of 1933, 78
TENN. L. REV. 879, 892–906 (2011).
143
See Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985) (holding
that ordinary corporate stock is a security).
144
See Reves v. Ernst & Young, 494 U.S. 56 (1990) (applying the
“family resemblance” test to determine whether a note is a security).
141
32
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
security.145 Gratuitous contributions, even to a business
entity, simply are not securities.
2. The Reward and Pre-Purchase Models
The reward and pre-purchase models also do not involve
securities under federal law, as long as the reward or the
pre-purchased product is all the investor is promised in
return for her contribution. The Supreme Court has drawn a
clear distinction between investment and consumption. An
investment contract is present only when an investor is
offered a financial return on his investment, such as capital
appreciation or a participation in earnings146 or even a fixed
rate of interest.147 If “a purchaser is motivated by a desire to
use or consume the item purchased . . . the securities laws do
not apply.”148 It does not matter that the contributor is
promised a lower price for the product than the general
public will pay.
Contributors on reward or pre-purchase sites are offered
no financial return of any kind. They are promised only a
product or service—a consumption item. Therefore, no
investment contract is being offered. And, because investors
on reward or pre-purchase sites are not offered stock, notes,
or anything else that falls within the definition of security,
federal securities law does not apply.
145
Securities Act of 1933 § 2(a)(1), 15 U.S.C. § 77b(a)(1) (2010).
United Hous. Found., Inc. v. Forman, 421 U.S. 837, 853 (1975).
147
SEC v. Edwards, 540 U.S. 389, 397 (2004).
148
United Housing Found., 421 U.S. at 852–53. It is possible that
these might be securities under state law. Some states use a risk capital
test to define securities. The risk capital test has three elements: “(1) an
investment, (2) in the risk capital of an enterprise, and (3) the expectation
of a benefit.” JOSEPH C. LONG, 12 BLUE SKY L. 2:80 (2011). The benefit
expected need not be an interest in profits, but can be any benefit that
motivates the investor to invest. Id. See also Silver Hills Country Club v.
Sobieski, 361 P.2d 906 (Cal. 1961) (finding a security where a country club
pre-sold club memberships to raise startup capital); HAZEN, supra note 42,
at 110.
146
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
33
3. The Equity Model
Equity-model crowdfunding would usually involve
securities. If investors receive ordinary corporate stock in
exchange for their contributions, they clearly are purchasing
securities. The definition of security includes “stock,”149 and
the Supreme Court has held that ordinary corporate stock is
a security, with no additional analysis required.150 Even if
crowdfunding investors are offered some participation in the
return of the business that does not involve corporate stock,
their investments would still be securities. Interests in
partnerships and limited liability companies, and other nonstock equity interests, are analyzed under the Howey
investment contract test.151 The interests offered to investors
on equity-model sites would clearly be investment contracts
under Howey.
Crowdfunding almost by definition involves a common
enterprise among many different investors. The whole point
of crowdfunding is to collect small amounts of money from a
number of different investors. The business pools these
investors’ funds, and the investors share in the returns of the
business. Although there is some disagreement among the
lower courts about what exactly constitutes a common
enterprise, all courts agree that horizontal commonality of
this sort meets the Howey test.152
Investors on equity-model sites would also have an
expectation of profits. Contributors are providing cash in
return for some sort of revenue- or profit-sharing.153 The
149
Securities Act of 1933 § 2(a)(1), 15 U.S.C. § 77b(a)(1).
Calling something stock is not alone enough to make it a security.
United Housing Found., 421 U.S. at 848. However, “[i]instruments that
bear both the name and all of the usual characteristics of stock seem to us
to be the clearest case for coverage by the plain language of the definition.”
Landreth Timber Co. v. Landreth, 471 U.S. 681, 693 (1985).
151
See, e.g., United States v. Leonard, 529 F.3d 83 (2d Cir. 2008)
(LLCs); Williamson v. Tucker, 645 F.2d 404 (5th Cir. 1981) (partnerships).
152
See HAZEN, supra note 42, at 98 (“Horizontal commonality clearly
satisfies the Howey common enterprise requirement.”).
153
Even if investors are offered a fixed return, rather than one that
depends on how well the business does, that would still meet the Howey
150
34
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
“public raise” type of funding offered by ProFounder154 would
not meet this requirement, however. Public-raise investors
are promised a share of the entrepreneur’s revenues, but
only until their original contributions are repaid. A person
who contributed $1,000 would receive, at most, only $1,000
back, no matter how well the business did. Since no profits
are expected, public-raise investments would not be
securities.
Finally, the profits expected are to come solely from the
efforts of the promoters or other third parties. Crowdfunding
investors will not usually be involved in the operation of the
business in which they invest, and, even if the crowdfunding
site allows them some minor role, the “essential managerial
efforts which affect the failure or success of the enterprise”155
will be those of the entrepreneur.
4. The Lending Model
The analysis is most complicated for lending-model
crowdfunding.156 The federal securities laws are not limited
to equity interests in businesses. The definition of security
encompasses some forms of debt,157 and an investment may
be a security even though the return consists of a fixed
requirement of an expectation of profits. See SEC v. Edwards, 540 U.S.
389 (2004) (holding that an agreement to pay investors $82 a month
constituted a security).
154
See supra text accompanying notes 107–09.
155
SEC v. Glenn W. Turner Enters., Inc., 474 F.2d 476, 482 (9th Cir.
1973).
156
Many lending sites offer consumer loans, and not just loans to
business entrepreneurs. The following discussion is limited to loans to
businesses and business projects. Loans for consumer purposes are less
likely to be treated as securities. See Verstein, supra note 12 (arguing that
consumer notes would not be securities under either the Howey or Reves
tests). For a general introduction to peer-to-peer lending, see Kevin E.
Davis & Anna Gelpern, Peer-to-Peer Financing for Development:
Regulating the Intermediaries, 42 N.Y.U. J. INT’L L. & POL. 1209 (2010);
Verstein, supra note 12.
157
The definition of a security includes, among other things, “notes,”
“bonds,” “debentures,” and “evidence of indebtedness.” See Securities Act
of 1933 § 2(a)(1), 15 U.S.C. § 77b(a)(1) (2010).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
35
payment or a fixed rate of interest.158 Howey is still relevant
but, if investors are offered notes, the Supreme Court’s
analysis in Reves v. Ernst & Young, discussed below, must
also be considered. Under that analysis, sites like Kiva that
offer investors no interest or other return, only a return of
their principal, are probably not offering securities, but, if
investors are promised interest, their investments probably
are securities.
Consider first whether crowdfunding sites offering
interest are selling investment contracts. Contributors are
investing money with an expectation of profits. A fixed rate
of interest, such as that which is offered on the Lending Club
and Prosper sites, would be “profit” for purposes of Howey.159
If more than one lender contributes to each business, there is
a horizontal common enterprise. And the profits are going to
result solely, or at least primarily, from the efforts of the
entrepreneur. Thus, investments made on lending sites that
offer investors interest would be investment contracts under
the Howey test. However, if the site, like Kiva, offers
investors only a return of their principal, without any
interest or other gain, investors would have no expectation of
profits.160 Consequently, the investment contract test would
not be met.161
158
Edwards, 540 U.S. at 397 (holding that an investment offering a
fixed return of $82 a month was an investment contract).
159
Id.
160
See Verstein, supra note 12 (setting forth a similar analysis). This
is why Kiva does not offer interest to investors. According to Matt
Flannery, a co-founder of Kiva, Kiva would like to offer investors interest.
Matt Flannery, Kiva and the Birth of Person-to-Person Microfinance, 2
INNOVATIONS 31, 53 (2007). Kiva decided not to offer interest after
Flannery had a conversation with an attorney in the SEC’s Office of Small
Business Policy and concluded that the key to avoiding SEC interference
was not to pay interest. Id. at 41.
161
See Global Dev. Co-operative, SEC No-Action Letter, 2011 WL
5013895 (Oct. 19, 2011) (granting no-action relief to a cooperative that
planned to sell interest-free notes to help fund capital investment projects
in developing countries). See also Davis & Gelpern, supra note 156, at
1241, 1258–59 (conceding that sites like Kiva are not offering securities
under current law, but arguing that such investments should be
regulated).
36
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Investments made through lending-model sites might
also involve notes, and thus be securities under another part
of the definition.162 Some of the lending sites, such as Kiva,
do not give investors a formal note in return for their
investments; others, such as Lending Club and Prosper, do.
The term “note” appears in the definition of a security,163 but
not all notes are securities.
The Supreme Court applies a different analysis, first
articulated in Reves v. Ernst & Young,164 to determine
whether a note is a security. Crowdfunding notes that
promise to pay interest to investors would probably be
securities under the Reves test. The Reves analysis, known
as the “family resemblance test,” begins with a rebuttable
presumption that every note is a security.165 It then looks to
a list of notes that are not securities, but crowdfunding loans
to businesses would not fit any of the categories on that
list.166 The final step of the Reves analysis is therefore
162
When an instrument is a note, the applicability of the Howey
investment contract analysis is a little unclear. Most courts have applied
the Howey investment contract test and the Reves note test in the
alternative with little analysis. See, e.g., SEC v. U.S. Reservation Bank &
Trust, 289 F. App’x 228, 230–31 (9th Cir. 2008); Resolution Trust Corp. v.
Stone, 998 F.2d 1534, 1539 (10th Cir. 1993); SEC v. Novus Tech., LLC, No.
2:07–CV–235–TC, 2010 WL 4180550 (D. Utah Oct. 20, 2010); In re Tucker
Freight Lines, Inc., 789 F. Supp. 884, 888–89 (W.D. Mich. 1991); Reeder v.
Succession of Palmer, 736 F. Supp. 128, 131–32 (E.D. La. 1990). See also
Dennis S. Corgill, Securities as Investments at Risk, 67 TUL. L. REV. 861,
900 (1993) (concluding that a note that is not a security under the Reves
test could still be a security under the Howey investment contract test).
But see Robert Anderson IV, Employee Incentives and the Federal
Securities Laws, 57 U. MIAMI L. REV. 1195, 1231 (2003) (arguing against
applying a second-stage investment contract analysis to something that is
not a security under Reves).
163
See Securities Act of 1933 § 2(a)(1), 15 U.S.C. § 77b(a)(1) (2010).
164
494 U.S. 56, 63–68 (1990).
165
Id. at 63.
166
Reves accepted the following categories of non-securities:
[T]he note delivered in consumer financing, the note
secured by a mortgage on a home, the short-term note
secured by a lien on a small business or some of its assets,
the note evidencing a ‘character’ loan to a bank customer,
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
37
decisive: applying a four-part test to determine whether
crowdfunding notes bear sufficient “family resemblance” to
the listed non-securities such that crowdfunding notes
should also not be treated as securities. The four factors are
(1) the motivations of the buyer and seller of the note; (2) the
plan of distribution of the notes; (3) the reasonable
expectations of the investing public; and (4) “whether some
factor such as the existence of another regulatory scheme
significantly reduces the risk of the instrument, thereby
rendering application of the Securities Acts unnecessary.”167
In applying this test, it is important to keep in mind that the
presumption is in favor of treating notes as securities.
The last factor is easily dismissed. Crowdfunding loans,
like the notes at issue in Reves, are uncollateralized and
uninsured, and no other federal regulatory scheme covers
them. They “would escape federal regulation entirely if
the . . . [federal securities laws] . . . were held not to apply.”168
The motivations factor supports treating interest-bearing
crowdfunding notes as securities.
The entrepreneur’s
purpose—or in the case of sites like Lending Club and
Prosper that issue their own notes to finance entrepreneurs,
the site’s purpose—“is to raise money for the general use of a
business,” a securities purpose.169 Investors are “interested
primarily in the profit the note is expected to generate,”170
with profit defined by the Court to include ordinary
interest.171 This is also a securities purpose. However,
investors on sites that offer no interest are not interested in
short-term notes secured by an assignment of accounts
receivable, . . . a note which simply formalizes an openaccount debt incurred in the ordinary course of business
(particularly if, as in the case of the customer of a broker, it
is collateralized), . . . [and] . . . notes evidencing loans by
commercial banks for current operations.
Id. at 65.
167
Id. at 67.
168
Id. at 69.
169
Id. at 66.
170
Id.
171
Id. at 68 n.4.
38
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
profit because no profit is expected.172 Their motivations are
of a more charitable nature, which cuts against security
status. This alone might be enough to keep the loans on
sites like Kiva from being securities.
The plan-of-distribution factor also appears to point
toward securities status. Some of the crowdfunding sites are
tied to trading markets where investors buy notes from, or
sell them to, other investors. Notes purchased on the
Lending Club and Prosper sites, for example, may be traded
on a platform maintained by FOLIOfn Investments, a
registered broker-dealer.173 But notes can meet the plan-ofdistribution test even if there is no trading market. After
first indicating that the plan-of-distribution factor depends
on whether “there is ‘common trading for speculation or
investment,’”174 the Reves opinion said that it was sufficient if
the notes are “offered and sold to a broad segment of the
public,” even if, as in Reves, there is no market to trade the
notes.175 Crowdfunding lending sites are open to the public,
and, by definition, crowdfunding involves investments by a
number of small investors. The number of investors will not
always be as many as the 1600 purchasers in Reves,176 but it
will typically be more than a few. Thus, notes sold on
crowdfunding sites could meet this part of the Reves test
even if there is no trading market.
The final factor to consider is the investing public’s
reasonable expectations. Reves said little about this factor,
other than to indicate that notes might be treated as
securities on the basis of such public perceptions, “even
where an economic analysis of the circumstances of the
particular transaction” would suggest otherwise.177
In
applying this factor, the Reves Court observed only that the
172
See Verstein, supra note 12 (setting forth a similar analysis).
See Prosper Registration Statement, supra note 81, at 11; Lending
Club Registration Statement, supra note 81, at 11.
174
Reves, 494 U.S. at 66 (citing SEC v. C.M. Joiner Leasing Corp., 320
U.S. 344, 351 (1943)).
175
Id. at 68.
176
Id. at 59.
177
Id. at 66.
173
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
39
notes were characterized as investments, and nothing “would
have led a reasonable person to question this
characterization.”178 The question, as analyzed in the lower
courts, seems to be “whether a reasonable member of the
investing public would consider these notes as
investments.”179 That, in turn, probably depends on whether
interest is offered and on whether or not the note is
presented to investors as an investment.180 If purchasers are
buying the notes for the interest they promise, they appear
to be investments, no matter how the crowdfunding site
characterizes them.181 Sites like Kiva that offer no interest
are less likely to meet this factor.182
As indicated earlier,183 Lending Club and Prosper have
changed their business models since their inception.
Originally, lenders on those sites made loans directly to the
underlying borrowers and received notes from those
borrowers in return. Now, Lending Club and Prosper issue
their own notes to lenders, and lenders are not directly
lending to the underlying borrowers.
As far as the
definitions of “investment contract” and “note” are
178
Id. at 69. See also Stoiber v. SEC, 161 F.3d 745, 751 (D.C. Cir.
1998) (describing this factor as a “one-way ratchet” that does not allow
notes that are securities under the other factors to escape the securities
laws).
179
McNabb v. SEC, 298 F.3d 1126, 1132 (9th Cir. 2002); accord SEC v.
Wallenbrock, 313 F.3d 532, 539 (9th Cir. 2002); Stoiber, 161 F.3d at 751.
180
Stoiber, 161 F.3d at 751 (“When a note seller calls a note an
investment, in the absence of contrary indications it would be reasonable
for a prospective purchaser to take the [offeror] at its word . . . .
Conversely, when note purchasers are expressly put on notice that a note
is not an investment, it is usually reasonable to conclude that the
‘investing public’ would not expect the notes to be securities.”) (quotations
omitted). But see Wallenbrock, 313 F.3d at 539 (noting that the failure of
the promoter to “use the term ‘investment’ to describe the notes is of little
import, given the nature of the transactions”).
181
See Wallenbrock, 313 F.3d at 539 (noting that the reasonable
expectations factor is closely related to the motivations factor and that the
failure to describe the notes as investments is “of little import”).
182
See Verstein, supra note 12 (setting forth a similar analysis).
183
See supra text accompanying notes 87–92.
40
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
concerned, this difference is irrelevant.184 Nothing in the
analysis above depends on who the issuer is.185
The SEC certainly believes that interest-bearing
crowdfunding notes are securities.
It has forced both
Lending Club and Prosper to register the notes they offer.186
Prior to that registration, the SEC entered a consent ceaseand-desist order against Prosper, finding that Prosper was
improperly selling securities without registration. 187 Both
companies’ registration statements indicate that it is
“reasonably possible” that the sites will be liable to lenders
for securities sold prior to registration,188 and Prosper is
currently fighting a class action lawsuit brought by preregistration lenders.189
184
See Prosper Marketplace, Inc., supra note 86 (taking the position
that the notes offered by Prosper, under its original model, were
securities).
185
The identity of the issuer might matter for purposes of registration.
If Lending Club and Prosper have no obligation on the notes they issue
and payment depends entirely on the success of the underlying borrower,
should the sites really be considered the issuers for purposes of
registration and the disclosure requirements? See Stefan J. Padfield, Peerto-Peer Lending: Who Is the Issuer?, BUS. LAW PROF BLOG (June 16, 2011),
http://lawprofessors.typepad.com/business_law/2011/06/peer-to-peer-lendin
g-who-is-the-issuer.html. See also Heminway & Hoffman, supra note 142,
at 922–27 (discussing whether the entrepreneur, the crowdfunding site, or
both are the issuer for purposes of registration).
186
See Prosper Registration Statement, supra note 81; Lending Club
Registration Statement, supra note 81.
187
Prosper Marketplace, Inc., supra note 86.
188
Prosper Registration Statement, supra note 81, at F-40; Lending
Club Registration Statement, supra note 81, at 90.
189
Prosper Registration Statement, supra note 81, at 75. A blog has
been set up to monitor and report on that case. See PROSPER CLASS ACTION
SUIT MONITOR, http://prosperclassaction.wordpress.com/ (last visited Mar.
5, 2012). Prosper has also entered into a settlement with the North
American Securities Administrators Association of regulatory claims
under state securities law and has agreed not to sell securities unless it
complies with state securities laws. See Prosper Registration Statement,
supra note 81, at 75; Prosper Marketplace Inc. Enters Settlement With
State Securities Regulators Over Sales of Unregistered Securities, N. AM.
SEC. ADM’RS ASS’N (Dec. 1, 2008), http://www.nasaa.org/5622/prosper-
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
41
The use of notes adds one additional complication. The
definition of a security in the Securities Exchange Act of
1934 (the “Exchange Act”) excepts notes with “a maturity at
the time of issuance not exceeding nine months, exclusive of
days of grace, or any renewal thereof the maturity of which
is likewise limited.”190 The Securities Act definition of
security includes no such exception. However, Section
3(a)(3) of the Securities Act exempts from some, but not all,191
of the Act’s requirements
Any note . . . which arises out of a current
transaction or the proceeds of which have been or are
to be used for current transactions, and which has a
maturity at the time of issuance of not exceeding
nine months, exclusive of days of grace, or any
renewal thereof the maturity of which is likewise
limited.192
Crowdfunders might try to avoid the application of
federal securities law by promising repayment within nine
months.193 However, both the Exchange Act exception and
the Securities Act exemption have traditionally been read to
cover only prime-quality commercial paper bought by
sophisticated traders.194 Four dissenters in Reves questioned
marketplace-inc-enters-settlement-with-state-securities-regulators-over-sa
les-of-unregistered-securities/.
190
Securities Exchange Act of 1934 § 3(a)(10), 15 U.S.C. § 78c(a)(10)
(2010).
191
See Securities Act of 1933 §§ 12(a)(2), 17(c), 15 U.S.C. §§ 77l(a)(2),
77q(c) (2010).
192
15 U.S.C. § 77c(a)(3).
193
It appears that no crowdfunding site currently requires repayment
within nine months. Prosper and Lending Club, for example, sell notes
with three-year terms. Prosper Registration Statement, supra note 81, at
8; Lending Club Registration Statement, supra note 81, at 7.
194
See HAZEN, supra note 42, at 460 (Exemption in Section 3(a)(3) of
the Securities Act “applies only to prime quality negotiable commercial
paper of a type not ordinarily purchased by the general public.”); Wendy
Gerwick Couture, The Securities Acts’ Treatment of Notes Maturing in Less
Than Nine Months: A Solution to the Enigma, 31 SEC. REG. L.J. 496, 505
(2003) (“Almost every court addressing the issue has held that the § 3(a)(3)
exemption and the § 3(a)(10) exclusion apply to the same notes.”).
42
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
this interpretation of the Exchange Act exception,195 but that
long-standing reading still stands. The risky debt issued by
startup entrepreneurs to the general public would not
qualify as commercial paper.196
B. Registration and Exemption of Crowdfunded
Securities Offerings
1. Registration
Offerings of securities must be registered with the SEC
unless an exemption is available.197
Unfortunately,
registration is not a viable option for early-stage small
businesses seeking relatively small amounts of capital.198 It
is too expensive and too time-consuming for crowdfunded
offerings.
First, the cost of registration will in most cases exceed the
amount small entrepreneurs want to raise.199 The direct
costs of preparing and filing the registration statement—
registration fees, accounting fees, legal fees, and printing
costs—can be hundreds of thousands of dollars, even
excluding underwriting costs.200 Smaller offerings are less
195
Reves v. Ernst & Young, 494 U.S. 56, 76 (1990) (Rehnquist, C.J.,
dissenting).
196
For a full discussion of the commercial paper test, see Couture,
supra note 194, at 512–31.
197
Section 5(c) of the Securities Act provides that no one may offer
securities until a registration statement has been filed with the SEC.
Securities Act of 1933 § 5(c), 15 U.S.C. § 77e(c) (2010). Section 5(a)(1) of
the Act prohibits sales of those securities until the registration statement
has become effective. Id. § 77e(a)(1).
198
See Cohn & Yadley, supra note 11, at 7–8; Jeffrey J. Hass, Small
Issue Public Offerings Conducted Over the Internet: Are They ‘Suitable’ for
the Retail Investor?, 72 S. CAL. L. REV. 67, 75 (1998); William K. Sjostrom,
Jr., Relaxing the Ban: It’s Time to Allow General Solicitation and
Advertising in Exempt Offerings, 32 FLA. ST. L. REV. 1, 8 (2004)
[hereinafter Sjostrom, Relaxing the Ban].
199
See Kappel, supra note 22, at 384.
200
A GAO report estimated the average cost for a $25 million
underwritten public offering to be $2.3 million, but much of that was
underwriting discounts and commissions. U.S. GOV’T. ACCOUNTABILITY
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
43
expensive to register than larger ones,201 but the cost is
disproportionately greater for smaller offerings.
Second, registration takes too much time.
Small
202
companies often need to raise capital quickly.
Today’s
rapid changes in technology result in “a compressed life-time
and a quicker requisite time-to-market.”203 A 1996 report
indicated that the average delay between filing and
effectiveness for an initial public offering on special,
simplified forms then available to small businesses was
103.7 days.204 That does not include the time required to
prepare for filing.
The total time from inception to
effectiveness can be six months—or even longer.205
Registration, however, is not impossible. Peer-to-peer
lenders Prosper and Lending Club register the notes they
offer, but they had to completely restructure their business
models to make it work. Instead of investors providing
OFFICE, GAO, GAO/GGD-00190, SMALL BUSINESS: EFFORTS TO FACILITATE
EQUITY CAPITAL FORMATION 23 (2000). The estimated cost included $9,914
for SEC registration fees, $160,000 for accounting fees and expenses,
$200,000 for legal fees and expenses, and $100,000 for printing fees and
expenses. Id. Another source provides the following estimates for a Form
S-1 public offering: underwriting fees 7–15% of the offering amount;
registration fees 1/29 of 1%; printing costs $2,500–75,000; engraving of
certificates $2,500–4,000; legal costs ¾–3% of the offering amount;
accounting costs $25,000–250,000; experts $300–15,000; state filing fees
$150–4,000 per state; and NASD filing fees $500–30,500. WILLIAM M.
PRIFTI, 24 SECURITIES: PUBLIC AND PRIVATE OFFERINGS § 1A:17 (2d ed.
2010). See also William K. Sjostrom, Jr., Going Public Through an
Internet Direct Public Offering: A Sensible Alternative for Small
Companies?, 53 FLA. L. REV. 529, 575–76 (2001) [hereinafter Sjostrom,
Going Public] (finding that legal, accounting, filing, and other fees for an
underwritten public offering generally range from $300,000 to $500,000).
201
Carl W. Schneider et al., Going Public: Practice, Procedure and
Consequences, 27 VILL. L. REV. 1, 32 (1981).
202
LAWTON & MAROM, supra note 2, at 37–38; Cohn & Yadley, supra
note 11, at 80.
203
LAWTON & MAROM, supra note 2, at 37.
204
SEC, REPORT OF THE ADVISORY COMMITTEE ON THE CAPITAL
FORMATION AND REGULATORY PROCESSES [1996-1997 Transfer Binder] Fed.
Sec. L. Rep. (CCH) ¶ 85,834, at 88,439 tbl. 2 (July 24, 1996), available at
http://www.sec.gov/news/studies/capform.htm.
205
See Cohn & Yadley, supra note 11, at 7.
44
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
money directly to the underlying entrepreneurs, investors
loan money to the sites themselves, and the sites issue nonrecourse notes dependent on payment by the underlying
borrower.206 Prosper and Lending Club each file a single
shelf registration statement for all of the notes they issue,
with each funding treated as a separate series requiring its
own prospectus supplement.207 This mechanism is costly,
burdensome, and does not translate easily to equity
crowdfunding.
2. Possible Exemptions Under Current Law
Companies selling securities on crowdfunding sites could
avoid registration if an exemption were available.208 Several
exemptions might possibly apply: the private offering
exemption in Section 4(2) of the Securities Act209 or its
regulatory safe harbor, Rule 506 of Regulation D;210 Section
4(5) of the Securities Act;211 Rule 504 of Regulation D;212 Rule
505 of Regulation D;213 or Regulation A.214 Unfortunately,
none of those exemptions is conducive to crowdfunding.215
206
See supra text accompanying notes 86–91.
See Verstein, supra note 12. This requires platforms to file two or
three times a day. Id. at 45–46. Each of those prospectus supplements
must contain all of the borrower information available on the platform, “no
matter how trivial.” Id. at 44.
208
These exemptions would only free entrepreneurs from the
registration requirements of the Securities Act. Entrepreneurs selling
securities would still be subject to the antifraud provisions of the
Securities and Exchange Act, including Rule 10b-5.
209
Securities Act of 1933 § 4(2), 15 U.S.C. § 77d (2) (2010).
210
Securities Act Rule 506, 17 C.F.R. § 230.506 (2012).
211
15 U.S.C. § 77d(5).
212
17 C.F.R. § 230.504.
213
17 C.F.R. § 230.505.
214
17 C.F.R. § 230.251 et seq.
215
See Cohn & Yadley, supra note 11, at 35 (“[S]mall companies are
hard pressed to find an exemption consistent with their timing, financing,
and marketing needs.”).
207
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
45
a. Section 4(2), Rule 506, and Section 4(5)
Section 4(2) of the Securities Act exempts “transactions
by an issuer not involving any public offering.”216 The exact
boundaries of this exemption are hazy,217 but the Supreme
Court held in Ralston Purina that the exemption’s
availability turns on whether offerees “need the protection of
the Act” or are “able to fend for themselves.”218 Subsequent
cases have focused on the sophistication of the offerees and
their access to information about the issuer.219
Crowdfunded offerings are not limited to sophisticated
investors. Most crowdfunding sites are open to the general
public—the whole point of crowdfunding is to appeal to this
“crowd.”
Because of that, Section 4(2) would not be
available.
The SEC has adopted a regulatory safe harbor for Section
4(2), Rule 506 of Regulation D,220 but that safe harbor would
also not be helpful. Purchasers in a Rule 506 offering must
either be “accredited investors” or meet a sophistication
requirement.221
Accredited investors are primarily
sophisticated institutions or individual investors who meet
wealth or income standards.222 Not all of the purchasers on a
216
Securities Act of 1933 § 4(2), 15 U.S.C. § 77d(2) (2010).
See HAZEN, supra note 42, at 573 (“[A]n issuer relying on the
statutory section 4(2) exemption . . . may be subjecting itself to a great
deal of uncertainty.”).
218
SEC v. Ralston Purina Co., 346 U.S. 119, 125 (1953).
219
See HAZEN, supra note 42, at 565.
220
Offers and sales that satisfy the conditions of Rule 506 “shall be
deemed to be transactions not involving any public offering within the
meaning of section 4(2) of the Act.” Securities Act Rule 506(a), 17 C.F.R. §
230.506(a) (2012).
221
17 C.F.R. § 230.506(b)(2)(ii). If a purchaser is not an accredited
investor, she or her purchaser representative must have “such knowledge
and experience in financial and business matters that [s]he is capable of
evaluating the merits and risks of the prospective investment.” Id. The
rule is satisfied even if the purchaser does not meet this standard, as long
as the issuer reasonably believes that she does. Id.
222
See 17 C.F.R. § 230.501(a).
217
46
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
publicly accessible crowdfunding site would meet these
requirements.
In addition, Rule 506 prohibits “general solicitation” and
“general advertising” of the offering.223 The SEC and its staff
take the position that any solicitation of an investor with
whom the issuer or its sales representatives do not have a
preexisting relationship violates the general solicitation
restriction.224 Offerings to the general public on crowdfunding sites would clearly violate this prohibition.225
Finally, sales under Rule 506 are limited to no more than
thirty-five non-accredited investors.226 Some crowdfunding
offerings might meet this limit on the number of purchasers,
but, given the small amounts contributed by each investor,
others would not.227
Section 4(5) of the Securities Act, until recently Section
4(6), is similar to Rule 506. 228 It allows offers and sales
solely to accredited investors provided that there is no
“advertising or public solicitation.”229 Thus, Section 4(5), like
Rule 506, is of little use to small businesses engaged in
crowdfunding.230
223
17 C.F.R. § 230.502(c).
See, e.g., Kenman Corp., Exchange Act Release No. 21,962, 32
S.E.C. Docket 1352 n.6 (Apr. 19, 1985). See generally HAZEN, supra note
42, at 540; Sjostrom, Relaxing the Ban, supra note 198, at 13–14.
According to Sjostrom, the SEC has indicated that a preexisting
relationship is not the only way to avoid the general solicitation ban, but it
has not granted any no-action relief where a preexisting relationship is
absent. Id.
225
See Heminway & Hoffman, supra note 142, at 918 (“The most
serious obstacle to the use of Regulation D to exempt crowdfunded
offerings from Securities Act registration is Regulation D’s overall
prohibition of general solicitation and general advertising.”).
226
See 17 C.F.R. § 230.506(b)(2)(i).
227
See Cohn & Yadley, supra note 11, at 12 (noting that small
companies are likely to need to sell to a large number of investors and
cannot do that within the numerical limits imposed by Rules 505 and 506).
228
Unlike Rule 506, Section 4(5) limits the amount of the offering to
$5 million. Securities Act of 1933 § 4(5), 15 U.S.C. § 77d(5), (2010).
229
Id.
230
See Cohn & Yadley, supra note 11, at 24.
224
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
47
b. Rule 505
Rule 505 exempts offerings of up to $5 million.231 Rule
505 is not restricted to accredited or sophisticated
purchasers, but it is subject to the same general solicitation
prohibition as Rule 506.232 Also, as under Rule 506, an issuer
may sell to no more than thirty-five non-accredited
investors.233 These conditions make Rule 505 unsuitable for
crowdfunding.
c. Rule 504
Rule 504 exempts offerings of up to $1 million,234 but Rule
504, like Rules 505 and 506, is subject to the general
solicitation restriction.235 The only exception is if the Rule
504 offering is subject to state registration requirements or
sold pursuant to a state exemption that limits sales to
accredited investors.236
One major crowdfunding site,
ProFounder, attempted to fit within this rule237 by limiting
access to friends, family members, and preexisting
acquaintances of each entrepreneur—in other words, those
231
17 C.F.R. § 230.505(b)(2)(i).
See 17 C.F.R. § 230.502(c).
233
See 17 C.F.R. § 230.505(b)(2)(ii) (permitting no more than thirtyfive purchasers); 17 C.F.R. § 230.501 (excluding accredited investors from
that limited number of purchasers).
234
17 C.F.R. § 230.504(b)(2).
235
17 C.F.R. § 230.502(c). The SEC eliminated the general solicitation
ban for Rule 504 offerings in 1992, but reinstated it in its current form in
1999. See Sjostrom, Relaxing the Ban, supra note 198, at 25.
236
See 17 C.F.R. § 230.502(c) (stating that Regulation D offerings may
not sell securities by solicitation or advertising “[e]xcept as provided in §
230.504(b)(1) . . .”); 17 C.F.R. § 230.504(b)(1) (exempting offerings sold in
one or more states requiring registration and delivery of a disclosure
document to investors or pursuant to a state exemption allowing general
solicitation in offerings limited to accredited investors).
237
See Lang, supra note 106 (“ProFounder facilitates compliance with
Regulation D, Rule 504.”). As previously discussed, ProFounder is no
longer selling securities. See supra text accompanying notes 100–03.
232
48
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
with whom the issuer has a preexisting relationship.238 This
may solve the general solicitation problem, but it eliminates
much of the value of crowdfunding. A publicly accessible
crowdfunding offering could not use Rule 504 unless the
offering was registered at the state level, and that state
registration would be prohibitively expensive.239
d. Regulation A
Regulation A is available to offerings by non-reporting
companies240 of up to $5 million.241 Unlike Regulation D,
Regulation A does not prohibit general solicitation. It does,
however, require issuers to file a disclosure document,242 and,
like Section 5 of the Securities Act, Regulation A includes
rather extensive limits on communications with investors,
tied to the filing and disclosure requirements.243 Regulation
A is, in effect, a “mini-registration,” a less expensive version
of what the Act itself requires absent an exemption.244
Regulation A is not cheap; the average cost of a Regulation A
offering in 1997 was $40,000–60,000.245 This is too expensive
for the very small offerings that crowdfunding attracts.246
238
Entrepreneurs were instructed to “invite investors who are friends,
family, or others who you know in your community.” Lang, supra note
106. Entrepreneurs were cautioned not to invite anyone with whom the
company “does not personally have a substantial, pre-existing personal
relationship.” Company Terms and Conditions for Services, PROFOUNDER,
supra note 112.
239
See infra Part VII.D. See also Heminway & Hoffman, supra note
142, at 919–20.
240
17 C.F.R. § 230.251(a)(2).
241
17 C.F.R. § 230.251(b).
242
17 C.F.R. §§ 230.251(d)(1)(i), 230.252.
243
See 17 C.F.R. § 230.251(d).
244
See HAROLD S. BLOOMENTHAL & SAMUEL WOLFF, 3A SECURITIES AND
FEDERAL CORPORATE LAW 6-67 (2011 rev.) (“The Regulation A procedures
are designed to emulate the procedures relating to the filing and
processing of registration statements with some insubstantial
exceptions.”); HAZEN, supra note 42, at 509 (calling Regulation A a “miniregistration”).
245
HAZEN supra note 42, at 512 n.20. See also PRIFTI, supra note 200,
at 1A:17 (listing costs of a Regulation A offering, including: filing fee $100;
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
49
IV. THE STATUS OF CROWDFUNDING SITES
UNDER FEDERAL SECURITIES LAW
The proposals to exempt crowdfunding focus primarily on
the offerings themselves and the need for an exemption from
Securities Act registration.247 But crowdfunding can function
effectively only through web sites that bring entrepreneurs
and potential investors together. The operation of those sites
raises a different set of issues under federal securities law.
If the investments offered on crowdfunding sites are
securities, crowdfunding site operators could be brokers
subject to regulation under the Exchange Act or investment
advisers under the Investment Advisers Act. They would
not, however, be regulated as exchanges.
underwriting costs 10–18% of the offering amount; printing costs $7,500–
15,000; engraving stock certificates $1,500; legal costs ¾–3% of the
offering amount; accounting costs $5,000–20,000; expert fees $300–5,000;
state filing fees $150–4,000 per state; and NASD filing fees $500 plus
0.01% of the offering amount).
246
See Rutheford B Campbell, Regulation A: Small Businesses’ Search
for ‘A Moderate Capital,” 31 DEL. J. CORP. L. 77, 111 (2006) (“On the small
offering end of the Regulation A spectrum . . . issuers are discouraged from
using Regulation A by the complexities of the filing, disclosure, and other
requirements and by the difficulties in many instances of meeting state
blue sky law requirements. Together, the costs of meeting these federal
and state requirements overwhelm any benefit a small business would
attain from utilizing Regulation A.”). See also BLOOMENTHAL & WOLFF,
supra note 244, at 6-49 (noting that small businesses do not use
Regulation A much); Sjostrom, Relaxing the Ban, supra note 198, at 26
(“Preparing a Regulation A offering statement can cost a small company a
significant amount of money and management time.”).
247
See, e.g., Letter from Woodie Neiss, Member, SBE Council Advisory
Committee, to Gerald J. Laporte, Chief, Office of Small Business Policy,
Division of Corporate Finance, SEC (Dec. 21, 2010), available at
http://www.sec.gov/info/smallbus/2010gbforum/2010gbforum-sbe.pdf
[hereinafter SBE Council Proposal]; Request for Rulemaking to Exempt
Securities Offerings Up to $100,000 With $100 Maximum Per Investor
From Registration, SEC, File No. 4-605, available at http://www.sec.gov
/rules/petitions.shtml; Factsheet and Overview for AJA, supra note 7;
About Us, STARTUP EXEMPTION, http://www.startupexemption.com/
?page_id=91#axzz1T9YWT6vM (last visited Mar. 5, 2012).
50
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Unfortunately, the definitions of “broker” and
“investment adviser” are ambiguous, so the status of
crowdfunding sites is uncertain. There is a strong possibility
that crowdfunding site operators would be brokers and a
somewhat smaller chance that they would be investment
advisers.
A. Are Crowdfunding Sites Exchanges?
At first blush, crowdfunding sites might seem to be
securities “exchanges” required to register under the
Exchange Act. Section 3(a)(1) of the Exchange Act defines
“exchange” as an “organization, association, or group of
persons” that “constitutes, maintains, or provides a market
place or facilities for bringing together purchasers and
sellers of securities or for otherwise performing with respect
to securities the functions commonly performed by a stock
exchange as that term is generally understood . . . .”248
Crowdfunding sites bring together investors buying
securities and the entrepreneurs selling them and facilitate
execution of the sales much as a securities exchange would.
In spite of this superficial resemblance, it is reasonably
clear that crowdfunding sites, unless they engage in
additional activities, would not be exchanges under federal
securities law. Rule 3b-16 provides that, to fall within the
definition of exchange, a trading system must, among other
things, “[bring] together the orders for securities of multiple
buyers and sellers.”249 In other words, for a system’s trading
of a particular security to make it an exchange, there must
be more than one person on each side of the transactions in
that security. The SEC made it clear that “systems in which
there is only a single seller, such as systems that permit
issuers to sell their own securities to investors, would not be
included within Rule 3b-16.”250
248
Securities Exchange Act of 1934 § 3(a)(1), 15 U.S.C. § 78c(a)(1)
(2010).
249
Exchange Act Rule 3b-16, 17 C.F.R. § 240.3b-16 (2012).
Regulation of Exchanges and Alternative Trading Systems, 63 Fed.
Reg. 70844-01, 70849 (Dec. 22, 1998) (to be codified at 17 C.F.R. pts. 202,
250
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
51
Crowdfunding sites fit this single-seller model, and
therefore are not exchanges. Although each company’s
security has a large number of buyers, meeting the multiplebuyer requirement, there is only one seller—the issuer itself.
Crowdfunding sites list the securities of a number of
different sellers, but the question is not whether there are
multiple sellers on the site, but whether there are multiple
sellers for a particular security. According to the SEC, “a
system that has multiple sellers, but only one seller for each
instrument, . . . would not . . . meet the ‘multiple parties’
requirement.”251 Unless crowdfunding sites get involved in
post-funding trading of listed company’s securities,252 none of
the securities offered would have multiple sellers. Therefore,
crowdfunding sites would not be exchanges.
B. Are Crowdfunding Sites Brokers?
Section 3(a)(4) of the Exchange Act defines a “broker” as
“any person engaged in the business of effecting transactions
in securities for the account of others.”253 The Exchange Act
provides no further guidance as to what it means to be
“engaged in a business” or “effecting transactions in
securities,” and the law in this area is uncertain.254 Whether
242), available at http://www.gpo.gov/fdsys/pkg/FR-1998-12-22/pdf/98-3329
9.pdf.
251
Regulation of Exchanges and Alternative Trading Systems, 63 Fed.
Reg. 23504-01, 23508 (Apr. 29, 1998) (to be codified at 17 C.F.R. pt. 242),
available at http://www.gpo.gov/fdsys/pkg/FR-1998-04-29/pdf/98-10945.pdf
(interpreting the proposed rule that became Rule 3b-16).
252
See infra Part VII.C.3 for a discussion of issues involving the resale
of crowdfunded securities.
253
Exchange Act § 3(a)(4), 15 U.S.C. § 78c(a)(4). The Exchange Act
distinguishes a “dealer,” who is “engaged in the business of buying and
selling securities for such person’s own account.”
Id. § 78c(a)(15)
(emphasis added). In other words, a dealer acts as a principal, trading for
herself, whereas a broker acts as an agent for someone else. However, the
distinction “often becomes blurred,” with cases and administrative
analyses indiscriminately using the two terms together. See DAVID A.
LIPTON, 15 BROKER-DEALER REGULATION 1-42 (2010).
254
See HAZEN, supra note 42, at 228 (“[I]t is not always easy to tell
when a finder’s activities would require broker-dealer registration.”);
52
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
an individual or entity is a broker is “one of the more
nebulous questions in U.S. securities regulation.”255
The case law is limited, so most of the guidance in this
area comes from SEC no-action letters.256 The SEC staff
“does not typically provide a rationale for its position” in
those letters, forcing the reader “to speculate which of
numerous facts recited in the response and/or letter of
inquiry triggered the staff reaction.”257 The analysis is
“extremely
flexible”258
and
therefore
inherently
unpredictable.
It is impossible to state definitively whether
crowdfunding sites would be brokers if they hosted securities
offerings. None of the major crowdfunding sites has received
NORMAN S. POSER & JAMES A. FANTO, BROKER-DEALER LAW AND
REGULATION 5-15 (4th ed. 2009) (indicating “some uncertainty” as to
whether finders who bring together two parties who wish to engage in a
securities transaction are brokers); Abraham J. B. Cable, Fending for
Themselves: Why Securities Regulations Should Encourage Angel Groups,
13 U. PA. J. BUS. L. 107, 136 (2010) (“[I]t is difficult to derive . . . a single,
comprehensible framework for evaluating broker-dealer status, and this
can be a source of frustration when trying to analyze the regulatory status
of new developments . . . .”).
255
John L. Orcutt, Improving the Efficiency of the Angel Finance
Market: A Proposal to Expand the Intermediary Role of Finders in the
Private Capital Raising Setting, 37 ARIZ. ST. L. J. 861, 903 (2005).
256
LIPTON, supra note 253, at 1-222. No-action letters express the
views of the staff and are not the official view of the SEC. 17 C.F.R. §
202.1(d). The SEC does not consider them binding precedent. Press
Release, SEC, Adoption of Section 200.81 (17 CFR 200.81), Concerning
Public Availability of Requests for No-Action and Interpretative Letters
and the Responses Thereto by the Commission’s Staff, and Amendment of
Section 200.80 (17 CFR 200.80) (Oct. 29, 1970), 1970 WL 10582, at *2.
“Nonetheless, as a practical matter, practitioners place significant reliance
on” them and “they clearly influence judicial opinions.” LIPTON, supra note
253, at 1-224.
257
LIPTON, supra note 253, at 1-226 (“Even comparing the facts cited
in one no-action letter with those in numerous other letters does not
necessarily indicate which factors were most persuasive for the staff
because the staff has placed different emphasis on the same factors at
varying times.”).
258
Id. at 1-48.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
53
no-action relief from the SEC.259 However, the SEC’s view of
what constitutes a broker is expansive, and crowdfunding
sites deviate in important ways from what the SEC has
allowed in other contexts. Because of this, there is a strong
possibility that sites hosting crowdfunded securities offerings
would be required to register as brokers.260
1. Engaged in the Business
Crowdfunding sites would satisfy the “engaged in the
business” part of the definition. To be “engaged in the
business,” one must be effecting securities transactions with
some regularity—a single, isolated transaction does not
make one a broker.261 However, securities transactions need
not be the sole, or even the primary, business of the
companies operating such sites.262 One can be a broker even
though securities transactions are “only a small part of . . .
[one’s] . . . business activity.”263
If the crowdfunding sites are effecting transactions in
securities, they undoubtedly are “engaged in the business” of
doing so. Their activity is regular; they match investors and
entrepreneurs on a continuous basis.
And, with the
exception of sites like Kiva that operate on a donation basis,
they do so for a business purpose—to earn a profit.264 Thus,
259
Prosper, one of the peer-to-peer lending sites, submitted a no-action
request shortly after its launch but withdrew it before the staff responded.
Verstein, supra note 12.
260
At least one state, California, has taken the position that a
crowdfunding site that sells securities is a broker for purposes of state law.
See ProFounder Fin., Inc., Consent Order to Desist and Refrain (Aug. 31,
2011), available at www.corp.ca.gov/ENF/pdf/2011/ProFounder_CO.pdf.
261
SEC v. Kenton Capital, Ltd., 69 F. Supp. 2d 1, 12 (D.D.C. 1998);
Mass. Fin. Servs., Inc. v. Sec. Investor Protection Corp., 411 F. Supp. 411,
415 (D. Mass.), aff’d, 545 F.2d 754 (1st Cir. 1976); HAZEN, supra note 42,
at 213; LIPTON, supra note 253, at 1-42.4–1-42.5; POSER & FANTO, supra
note 254, at 5-11.
262
UFITEC, S.A. v. Carter, 571 P.2d 990, 994 (Cal. 1977); LIPTON,
supra note 253, at 1-42.8; POSER & FANTO, supra note 254, at 5-11.
263
Kenton Capital, 69 F. Supp. 2d at 13.
264
See infra Part IV.B.2.e.
54
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
the real question is whether crowdfunding sites are effecting
transactions in securities.
2. Effecting Transactions in Securities
a. General Guidance
What exactly does it mean to effect transactions in
securities? The stereotypical stock broker who buys and
sells securities on a stock exchange for a customer’s account
is clearly covered,265 but crowdfunding sites do not fit that
stereotype. The definition also includes companies whose
involvement in securities transactions is less direct, “so long
as the person participates in significant stages or points of a
securities transaction, such as solicitation, structuring,
negotiation, and receipt or transmission of funds.”266 The
question, broadly phrased, is whether the person has “a
certain regularity of participation in securities transactions
at key points in the chain of distribution.”267
It does not matter how the site and its users characterize
the site’s services. One cannot avoid being a broker by
“describing the work . . . in terms which suggest a nonbroker-client relationship.”268 Therefore, statements such as
that on ProFounder’s web site that it “is not a broker, dealer
or underwriter of securities”269 have no effect.
265
Guide to Broker-Dealer Registration, SEC (Apr. 2008),
http://www.sec.gov/divisions/marketreg/bdguide.htm [hereinafter Guide to
Registration].
266
POSER & FANTO, supra note 254, at 5–14. See also HOWARD M.
FRIEDMAN, SECURITIES REGULATION IN CYBERSPACE 16–5 (3d ed. 2005)
[hereinafter FRIEDMAN, SECURITIES REGULATION].
267
Mass. Fin. Servs., Inc. v. Sec. Investor Protection Corp., 411 F.
Supp. 411, 415 (D. Mass.), aff’d, 545 F.2d 754 (1st Cir. 1976); accord SEC
v. Martino, 255 F. Supp. 2d 268, 283 (S.D.N.Y. 2003); SEC v. Nat’l Exec.
Planners, Ltd., 503 F. Supp. 1066, 1073 (M.D.N.C. 1980).
268
LIPTON, supra note 253, at 1-51. See also Martino, 255 F. Supp. 2d
at 284 (finding a broker even though the written agreements described the
work as “consulting services”).
269
Profounder Terms and Conditions for Services, PROFOUNDER, supra
note 112.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
55
The SEC has cautioned that the operators of web sites
that match investors with issuers need to consider
registration as brokers when those sites are not affiliated
with registered broker-dealers.270
Additionally, a guide
released by the SEC’s Division of Trading and Markets
warns that anyone finding investors for a company,
including venture capital, angel financings, and private
placements, may need to register as a broker.271 The guide
poses four questions and indicates that a “yes” answer to any
of the four questions may indicate a need to register. The
questions are:
(1) “Do you participate in important parts of a
securities
transaction,
including
solicitation,
negotiation, or execution of the transaction?”
(2) “Does your compensation for participation in the
transaction depend upon, or is it related to, the
outcome or size of the transaction or deal? . . . Do
you
receive
any
other
transaction-related
compensation?”
(3) “Are you otherwise engaged in the business of
effecting or facilitating securities transactions?”
(4) “Do you handle the securities or funds of others in
connection with securities transactions?”272
More specific guidance comes from a series of no-action
letters involving Internet- or computer-based matching
services that connect entrepreneurs seeking funds with
potential investors.273 The services granted relief in those
letters share a number of important features:
270
Use of Electronic Media, Securities Act Release No. 33-7856, 2000
WL 502290, at *12-13 (Apr. 28, 2000).
271
Guide to Registration, supra note 265.
272
Id.
273
See Angel Capital Elec. Network, SEC No-Action Letter, 1996 WL
636094 (Oct. 25, 1996); Mid-Atlantic Inv. Network, SEC No-Action Letter,
1993 WL 173768 (May 18, 1993); Private Investor Network, SEC NoAction Letter, 1987 WL 108869 (Nov. 2, 1987); VCN of Tex., SEC NoAction Letter, 1987 WL 108250 (June 18, 1987); Venture Match of N.J.,
SEC No-Action Letter, 1987 WL 108917 (June 11, 1988); Atlanta Econ.
56
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
(1) They were run by non-profit entities, and any fees
collected were used only to cover administrative
expenses.
(2) Fees did not depend on whether a successful
match occurred or whether the entrepreneur raised
the desired funds.
(3) The matching site’s role was essentially
completed when the entrepreneur and the investor
were introduced. From that point forward,
everything occurred off-site.
(4) The matching service was not involved in
negotiating or closing any transactions between the
entrepreneur and investors.
(5) The matching service did not handle any funds or
securities in connection with the financing.
(6) The matching service provided no advice to either
entrepreneurs or investors and did not assist them in
completing the financing.
b. Transaction-Based Compensation
Unlike the matching services in the no-action letters,
many of the crowdfunding sites charge fees that depend on
whether the financing is successful. 274 Kickstarter’s fee is
5% of the funds raised; however, if the fundraising is
unsuccessful, entrepreneurs pay no fee.275 IndieGoGo takes
4% or 9% of the funds raised, depending on whether the
entrepreneur meets her funding goal.276
Prosper and
Dev. Corp., SEC No-Action Letter, 1987 WL 107835 (Mar. 19, 1987);
Venture Capital Res., Inc., SEC No-Action Letter, 1985 WL 55644 (Nov.
25, 1985).
274
Kiva, however, operates exclusively on a donation basis. It does
not receive a fee from either entrepreneurs or borrowers, although it does
accept donations from its lenders. See About Us, KIVA, supra note 32.
275
See Frequently Asked Questions: Fees, KICKSTARTER, supra note 29.
276
See Pricing, INDIEGOGO, http://www.indiegogo.com/about/pricing
(last visited Mar. 5, 2012).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
57
Lending Club each charge a 1% fee.277 When ProFounder
was selling securities, at least part of its fee apparently
depended on whether the offering was successful.278
The SEC staff has indicated that transaction-based
compensation like this “is a key factor in determining
whether a person or entity is acting as a broker-dealer.”279
According to an American Bar Association Task Force,
“[t]ransaction-based compensation has come under intense
scrutiny by the SEC,”280 and the staff may be moving to a
position where transaction-based compensation in connection
with a securities transaction is alone sufficient to make one a
broker.281 The staff’s concern is apparently that transactionbased compensation would give the person “a ‘salesman’s
stake in the proposed transactions and . . . create heightened
incentive for . . . [the person] . . . to engage in sales efforts.”282
However, it is possible to receive transaction-based
compensation in connection with securities transactions
without being considered a broker. A recent district court
277
Prosper Registration Statement, supra note 81, at 5; Lending Club
Registration Statement, supra note 81, at 3.
278
See supra Part II.B.4.
279
See Guide to Registration, supra note 265 (“Does your
compensation for participation in the transaction depend upon, or is it
related to, the outcome or size of the transaction or deal? . . . Do you
receive any other transaction-related compensation?”). See also SEC v.
Margolin, No. 92 Civ. 6307 (PKL), 1992 WL 279735 (S.D.N.Y. Sept. 30,
1992) (listing transaction-based compensation as one factor); HAZEN, supra
note 42, at 210 (same); LIPTON, supra note 253, at 1-70.1 (same).
280
Task Force on Private Placement Broker-Dealers, ABA Section of
Business Law, Report and Recommendations of the Task Force on Private
Placement Broker-Dealers, 60 BUS. LAW. 959, 975 (2005). See also Orcutt,
supra note 255, at 908 (noting that transaction-based compensation has
“garnered substantial attention”).
281
Task Force on Private Placement Broker-Dealers, supra note 280,
at 977. See also POSER & FANTO, supra note 254, at 5–17 (noting that
transaction-based compensation “may be the determinative factor”).
282
Brumberg, Mackey & Wall, P.L.C., SEC No-Action Letter, 2010 WL
1976174 (May 17, 2010); 1st Global, Inc., SEC No-Action Letter, 2001 WL
499080 (May 7, 2001). See also Orcutt, supra note 255, at 910; John
Polanin, Jr., The “Finder’s” Exception from Federal Broker-Dealer
Registration, 40 CATH. U. L. REV. 787, 814 (1991).
58
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
case recognized that transaction-based compensation “is the
hallmark of a salesman,”283 but nevertheless held that an
individual who received transaction-based compensation for
merely bringing people together for a securities transaction
was not a broker.284 The SEC staff has also occasionally
granted no-action relief to finders who received transactionbased compensation. The most well-known of these noaction letters involved the entertainer Paul Anka, who
provided the names of potential investors to the Ottawa
Senators Hockey Club in return for a finder’s fee equal to
10% of the amount the investors invested.285
The Paul Anka letter and the other no-action letters
allowing transaction-based compensation involved finders
who were not involved in negotiations, consummation of the
financing, or transferring funds or securities to effect the
deal.286 Anka, for instance, only provided the names of
potential investors to the Club; he did not solicit or even
contact the potential investors and was not involved in
negotiations between the Club and the investors.287 David
Lipton reads these letters as allowing finders to receive
transaction-based compensation only if the finder is “totally
isolated from the process of selling the units.”288 In such
cases, the finder cannot act on the incentive “to engage in
283
SEC v. Kramer, 778 F. Supp. 2d 1320, 1334 (M.D. Fla. 2011).
Id. at 1336, 1338–39.
285
Paul Anka, SEC No-Action Letter, 1991 WL 176891 (July 24, 1991)
[hereinafter Anka No-Action Letter].
286
See Dana Inv. Advisers, Inc., SEC No-Action Letter, 1994 WL
718968 (Oct. 12, 1994); John DiMeno, SEC No-Action Letter, 1979 WL
13717 (Apr. 1, 1979) (reconsidering John DiMeno, SEC No-Action Letter,
1978 WL 12130 (Oct. 11, 1978)); Moana/Kauai Corp., SEC No-Action
Letter, 1974 WL 8804 (Aug. 10, 1974).
287
Anka No-Action Letter, supra note 285. Anka was doing this on a
one-time basis, so, even if he was effecting transactions in securities, he
arguably was not in the business of doing so, and would not be a broker for
this reason as well.
288
LIPTON, supra note 253, at 1-87.
284
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
59
abusive or sharp selling practices” that transaction-based
compensation might otherwise create.289
Finders who go beyond simple introductions risk being
treated as brokers if they receive transaction-based
compensation. Involvement in structuring or negotiating the
terms of a securities transaction would make one a broker
under the SEC’s analysis.290 If one receives transactionbased compensation, merely contacting investors and
describing the deal in general terms may cross the line
between broker and non-broker.291 Paul Anka had originally
proposed to contact the investors to describe the potential
investment and forward investors’ names to the Club only if
they expressed interest. The SEC staff granted the request
only after a follow-up letter limited Anka’s role to providing
names.292
The SEC staff may no longer accept even the limited
position it took in the Paul Anka letter.293 It currently views
the limited activity of introducing a potential buyer and
seller of securities “with skepticism when coupled with
transaction-based compensation.”294
289
Orcutt, supra note 255, at 911–12. See also LIPTON, supra note
253, at 1-87; Polanin, supra note 282, at 814.
290
See., e.g., Ram Capital Res., LLC, Exch. Act Release No. 34-60149,
96 S.E.C. Docket 459, 2009 WL 1723950 (June 19, 2009); Mike Bantuveris,
SEC No-Action Letter, 1975 WL 10654 (Sept. 23, 1975); May-Pac Mgmt.
Co., SEC No-Action Letter, 1973 WL 10806 (Nov. 20, 1973); Fulham & Co.,
Inc., SEC No-Action Letter, 1972 WL 9129 (Nov. 20, 1972).
291
See Richard S. Appel, SEC No-Action Letter, 1983 WL 30911, at *1
(Jan. 13, 1983) (denying a no-action request from a finder whose only role
would be to contact existing business associates and friends, describe
potential oil and gas investments in general terms, and provide the
approximate cost of drilling a well).
292
Anka No-Action Letter, supra note 285.
293
See Task Force on Private Placement Broker-Dealers, supra note
280, at 977 (“Based on staff comments at a recent Business Law Section
meeting, the SEC staff may . . . be reconsidering its position in the Paul
Anka letter situation and might not issue such a letter today.”).
294
Id. at 966.
60
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Consider, for example, the staff’s recent response in
Brumberg, Mackey & Wall, P.C.295 A law firm proposed to
introduce potential investors to a company seeking financing
in return for a percentage of the money raised from those
investors.
The firm was not going to be involved in
negotiations, provide the potential investors with any
information about the company, recommend or have any
responsibility for the terms of any agreement, or have any
other involvement in obtaining financing for the
transactions. In rejecting the request, the staff noted that
transaction-based compensation “is a hallmark of brokerdealer activity.
Accordingly, any person receiving
transaction-based compensation in connection with another
person’s purchase or sale of securities typically must register
as a broker-dealer or be an associated person of a registered
broker-dealer.”296
As discussed below, crowdfunding sites typically do more
than just bring entrepreneurs together with potential
investors. They solicit investors and are actively involved in
the resulting transactions. This, coupled with transactionbased compensation, puts them at serious risk of being
treated as brokers.
Unfortunately, a relatively recent district court case
muddies the water and casts doubt on the validity of the
SEC staff’s position with respect to transaction-based
compensation. In SEC v. M & A West, Inc.,297 the defendant
worked with the shareholders of private companies to
identify suitable public companies for reverse mergers,
actually prepared the documents for those transactions, and
coordinated among the parties.298 The defendant (or his
295
Brumberg, Mackey & Wall, P.L.C., SEC No-Action Letter, 2010 WL
1976174 (May 17, 2010).
296
Id. Even in this letter, it is hard to isolate transaction-based
compensation as the sole determining factor. The staff also believed that
the firm’s introduction of only contacts with a potential interest in the
company would necessarily involve some “pre-selling” of the company and
some “pre-screening” of potential investors. Id.
297
No. C-01-3376 VRW, 2005 WL 1514101 (N.D. Cal. June 20, 2005).
298
Id. at *3.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
61
nominees) received shares in the completed transactions for
his work299—clearly transaction-based compensation—but
the court nevertheless held that he was not a broker.
According to the court, although the defendant facilitated
securities transactions, his actions were not “effecting”
transactions in securities.300
c. Involvement in the Transactions
The extent of a site’s involvement in the actual securities
transactions is also important. The matching sites and other
finders approved in the favorable no-action letters merely
brought investors and entrepreneurs together. Once that
introduction was made, the matching site’s work was done.
The site “was not assisting the purchase or sale of specific
securities”301 and was not otherwise involved in the
transactions.302
Crowdfunding sites do more than just bring
entrepreneurs and investors together.
They provide a
platform for investors and entrepreneurs to negotiate; they
facilitate ongoing communications between investors and
entrepreneurs; and they transmit funds and investment
documents back and forth between investors and
entrepreneurs. That, coupled with the receipt of transactionbased compensation, could be enough to make them brokers.
i. Providing Advice or Recommendations
Providing advice or recommendations to investors is a
factor in deciding whether one is a broker,303 but most
crowdfunding sites provide only general advice, and do not
recommend or rate particular investment opportunities.
299
Id. at *3–4.
Id. at *9. The court granted summary judgment to the defendant
sua sponte.
301
LIPTON, supra note 253, at 1-100–1-101.
302
Id. at 1-102.
303
HAZEN, supra note 42, at 210; LIPTON, supra note 253, at 1-70.1;
POSER & FANTO, supra note 254, at 5–12; Task Force on Private Placement
Broker-Dealers, supra note 280, at 975.
300
62
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Kickstarter, for example, provides general advice to
investors about how to avoid fraud.304 Also, some of the sites
provide general advice to entrepreneurs about how to
structure a successful fundraising campaign.
The
Kickstarter site, for example, includes advice about how
much money to ask for and “the secret” to successful
fundraising.305 IndieGoGo and ProFounder offer general
advice about how to create a fundraising campaign and what
to offer in return for contributions.306
Other crowdfunding sites provide more specific advice to
entrepreneurs and investors.
Both Lending Club and
Prosper rate borrowers, effectively advising investors as to
the quality of the loans.307 ProFounder, before it quit offering
securities, helped entrepreneurs structure and complete
their offerings. It agreed to make a good faith effort “to
provide all documents necessary for compliance with
securities and other laws applicable to Company’s issuance
of securities and Investor’s PRIVATE investment,” although
it noted that compliance was ultimately the entrepreneur’s
responsibility.308 ProFounder also provided term sheets and
“compliance tools” to entrepreneurs309 and helped
entrepreneurs track compliance requirements and filing
fees.310
304
See Frequently Asked Questions, KICKSTARTER, supra note 29.
See Start Your Project, KICKSTARTER, http://www.kickstarter.com/
start (last visited Mar. 5, 2012).
306
See Frequently Asked Questions, INDIEGOGO, supra note 44; Lang,
supra note 106.
307
See e.g., Prosper Ratings, PROSPER, http://www.prosper.com/invest/
how-to-invest/prosper-ratings/ (last visited Mar. 5, 2012).
308
Company Terms and Conditions for Services, PROFOUNDER, supra
note 112.
See also Lang, supra note 106 (“ProFounder facilitates
compliance with Regulation D, Rule 504.”).
309
See Why Crowdfund?, PROFOUNDER, http://www.profounder.com/
entrepreneurs/why_crowdfund (last visited Mar. 5, 2012).
310
See Lang, supra note 106.
305
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
63
ii. Structuring the Transaction
Involvement in structuring a securities transaction is
another factor pointing toward broker status.311 Prosper and
Lending Club each specify the terms of the loans on their
sites.312 Other sites restrict the structure of the resulting
transaction. IndieGoGo and ProFounder, for example, limit
how long a funding request may remain open.313 ProFounder
required quarterly payments to investors and imposed a fiveyear limit on how long an entrepreneur could share returns
with investors.314 ProFounder also allowed entrepreneurs to
exit their commitments early, but only if they paid investors
twice their investment.315
iii. Receipt or Transmission of Funds /
Continued Involvement after the
Financing
The receipt or transmission of funds or securities is
another criterion considered in determining whether
someone is a broker.316 All of the major crowdfunding sites
actually collect funds from investors and forward them to the
entrepreneurs.317
The sites where entrepreneurs offer
311
See Orcutt, supra note 255, at 904–05; Guide to Registration, supra
note 265.
312
See generally Prosper Registration Statement, supra note 81;
Lending Club Registration Statement, supra note 81.
313
Frequently Asked Questions: Creating a Campaign, INDIEGOGO,
supra note 44 (120-day limit); FAQs, PROFOUNDER, supra note 110.
314
Lang, supra note 106.
315
Id. However, this early repayment option is not done through the
ProFounder web site. Id.
316
LIPTON, supra note 253, at 1-43. See also SEC v. Margolin, 1992
WL 279735 (S.D.N.Y. Sept. 30, 1992) (“possessing client funds and
securities”); POSER & FANTO, supra note 254, at 5-12 (“taking custody of
clients’ funds and securities”); Guide to Registration, supra note 265 (“Do
you handle the securities or funds of others in connection with securities
transactions?”).
317
See, e.g., Frequently Asked Questions: Pledging, KICKSTARTER,
supra note 29; How Kiva Works, supra note 72; Frequently Asked
Questions, INDIEGOGO, supra note 44; Lang, supra note 106 (ProFounder).
64
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
financial rewards also transfer those funds back to
investors.318 Sites are also involved in other ways after
completion of the transaction.
At ProFounder,
entrepreneurs had to report their revenues on a quarterly
basis and even upload their tax returns each year to verify
the reported revenues.319
Similarly, Kickstarter and
IndieGoGo encourage entrepreneurs to post project
updates.320
iv. Involvement in Negotiations
Another relevant factor is involvement in negotiations
between investors and entrepreneurs. A person involved in
the negotiation of securities transactions is “virtually
always” treated as a broker.321 Crowdfunding sites are not
actively involved in negotiations between the entrepreneurs
who list on the sites and potential investors.
The
communications portals on crowdfunding sites obviously
facilitate negotiations, but merely facilitating the exchange
of information or documents is not sufficient to make one a
broker.322
d. Solicitation and Advertising
Another factor relevant to broker status is whether the
person is actively advertising or otherwise soliciting
Solicitation is defined fairly broadly. The
investors.323
318
See, e.g., How Kiva Works, supra note 72; Lang, supra note 106.
See Lang, supra note 106.
320
See Frequently Asked Questions: Project Updates, KICKSTARTER,
supra note 29; Frequently Asked Questions: Creating a Campaign,
INDIEGOGO, supra note 44.
321
LIPTON, supra note 253, at 1-74. See also HAZEN, supra note 42, at
210 (listing involvement in negotiations as a factor pointing towards
broker status); POSER & FANTO, supra note 254, at 5-12 (same).
322
Task Force on Private Placement Broker-Dealers, supra note 280,
at 978.
323
See SEC v. Margolin, No. 92 Civ. 6307 (PKL), 1992 WL 279735, at
*5 (S.D.N.Y. Sept. 30, 1992); SEC v. Nat’l Exec. Planners, Ltd., 503 F.
Supp. 1066, 1073 (M.D.N.C. 1980); HAZEN, supra note 43, at 210; LIPTON,
319
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
65
question is whether the possible broker is contacting
investors with whom it has a preexisting relationship or is
instead actively identifying previously unknown third
parties; the latter qualifies as a solicitation.324 A public web
site, by definition, is engaged in continued public solicitation,
even if it does not otherwise advertise. Moreover, “mere
repeated advertising to purchase or sell securities would
trigger the broker-dealer registration requirement.”325
However, the SEC staff has approved several web-based
electronic matching systems, so a web presence alone is not
sufficient to make one a broker. The line between acceptable
and unacceptable solicitation and advertising is hazy. The
SEC “has not provided much guidance on what activities
constitute solicitation or advertising sufficient to trigger
broker-dealer registration . . . .”326 For example, the SEC
staff granted no-action relief to Venture Capital Resources,
Inc., which planned to publicize its system through one-onone discussions with potential investors, contacting the
clients of accountants and attorneys, a “selected mailing
program,” press releases, advertisements, and the
distribution of
brochures
through
local
financial
institutions.327 The SEC also granted relief to a non-profit
matching service that planned to publicize the system
through accounting firms, law firms, local universities, and
non-profit organizations interested in economic development,
as well as by distributing pamphlets and brochures to
interested individuals and groups.328 But the SEC has
indicated that a for-profit web site would be a broker
because, among other things, it “actively solicits investors to
supra note 253, at 1-42.13; POSER & FANTO, supra note 254, at 5-12; Task
Force on Private Placement Broker-Dealers, supra note 280, at 975.
324
Orcutt, supra note 255, at 914.
325
LIPTON, supra note 253, at 1-42.13.
326
Task Force on Private Placement Broker-Dealers, supra note 280,
at 979.
327
Venture Capital Res., Inc., SEC No-Action Letter, 1985 WL 55644
(Oct. 25, 1985).
328
Atlanta Econ. Dev. Corp., SEC No-Action Letter, 1987 WL 107835
(Feb. 17, 1987).
66
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
purchase oil and gas interests (for example, by targeting
potential investors with direct mailings and follow-up email).”329
e. For-Profit Status
Finally, many crowdfunding sites are for-profit entities.
Almost all of the no-action letters have involved “state
instrumentalities, private non-profit corporations, and quasigovernmental organizations,”330 and the staff has generally
required representations that these systems would be run
solely on a cost-recovery basis, and not for profit.331 Forprofit status does not automatically make one a broker. The
SEC staff has granted no-action relief to a few private
matching sites. However, none of those sites received
transaction-based compensation, and in all those cases the
securities transactions were negotiated and completed, and
funds were transferred, off the site.332
3. Conclusion: Would Crowdfunding Sites Be
Brokers?
Given the messy state of the law, no definitive answer is
possible, but there is a strong possibility that crowdfunding
sites would be considered brokers if they listed offerings of
securities. The crowdfunding sites’ receipt of transactionbased compensation, continued involvement in the investorentrepreneur relationship, public advertising, and for-profit
329
Oil-N-Gas, Inc., SEC No-Action Letter, 2000 WL 1119244 (June 8,
2000).
330
Cf. Polanin, supra note 282, at 821.
Id.
332
See Investex Inv. Exch. Inc., SEC No-Action Letter, 1990 WL
286331 (Apr. 9, 1990); Petroleum Info. Corp., SEC No-Action Letter, 1989
WL 246625 (Nov. 28, 1989); Internet Capital Corp., SEC No-Action Letter,
1997 WL 796944 (Dec. 24, 1997). But see OilOre.com, SEC No-Action
Letter, 2000 WL 546573 (Apr. 21, 2000) (denying no-action relief to a forprofit entity that was to receive compensation contingent on the investor
making an investment).
331
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
67
status may cumulatively be too much to allow them to avoid
broker status.
C. Are Crowdfunding Sites Investment Advisers?
Crowdfunding sites might also be investment advisers
within the meaning of the Investment Advisers Act of 1940.
Unfortunately, the definition of “investment adviser” in this
context is as unclear as the definition of “broker”—if
anything, there is less guidance available on the investmentadviser question. Two issues must be addressed. First, do
crowdfunding sites fall within the general definition of
“investment adviser”? Second, if so, do they qualify for the
“publisher” exception in that definition?
1. The General Definition of Investment Adviser
The basic definition of investment adviser, in Section
202(a)(11) of the Investment Advisers Act,333 has two parts,
either of which suffices to make one an investment adviser.
First, a person is an investment adviser if she, “for
compensation, engages in the business of advising others,
either directly or through publications or writings, as to the
value of securities or as to the advisability of investing in,
purchasing, or selling securities.”334 Alternatively, a person
is an investment adviser, if she, “for compensation and as
part of a regular business, issues or promulgates analyses or
reports concerning securities.”335 Under either part of the
definition, three basic requirements must be met:
(1) The person must be providing advice or issuing
reports or analyses concerning securities;
(2) The person must be in the business of doing so;
and
333
Investment Advisers Act of 1940 § 202(a)(11), 15 U.S.C. § 80b2(a)(11) (2006).
334
Id.
335
Id.
68
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
(3) The person must be doing so for compensation.336
Though crowdfunding sites clearly meet the last two
requirements, it is unclear whether they satisfy the first.
2. In the Business
The business requirement is phrased slightly differently
in the two parts of Section 202(a)(11). The first alternative
uses the phrase “engages in the business” and the second
alternative requires that the analysis be given “as part of a
regular business,”337 but the SEC interprets the business
element of both parts identically.338
Some regularity is required—isolated instances of
investment advice do not make one an investment adviser.339
But investment advice does not have to be the person’s
principal business, as long as the advice is given on a regular
basis.340 Crowdfunding sites would undoubtedly meet this
regularity requirement. If their services constitute securities
advice or analysis, they are providing that service on an
ongoing, regular basis.
As with broker status, transaction-based compensation is
important. The SEC has indicated that a person meets the
“business” requirement if she “receives transaction-based
compensation if the client implements the investment
336
Applicability of the Investment Advisers Act to Financial Planners,
Pension Consultants, and Other Persons Who Provide Investment
Advisory Services as a Component of Other Financial Services, 52 Fed.
Reg. 38400-01, 38402 (Oct. 16, 1987) (to be codified in 17 C.F.R. pt. 276)
[hereinafter Investment Advisers Release]. See also United States v.
Elliott, 62 F.3d 1304, 1309–10 (11th Cir. 1995).
337
15 U.S.C. § 80b-2(a)(11).
338
Investment Advisers Release, supra note 336, at 38402.
339
Id. See also Zinn v. Parrish, 644 F.2d 360 (7th Cir. 1981); HAZEN,
supra note 42, at 29.
340
Investment Advisers Release, supra note 336, at 38402; HAZEN,
supra note 42, at 27; THOMAS P. LEMKE & GERALD T. LINS, REGULATION OF
INVESTMENT ADVISORS 5 (2011).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
69
advice.”341
Thus, it is reasonably clear that for-profit
crowdfunding sites would meet the “business” requirement.
3. For Compensation
For one to be an investment adviser, analysis or advice
must be provided for compensation.342 Any economic benefit
is sufficient to meet this requirement; the adviser does not
have to charge a separate fee for the advisory portion of the
services.343 Most crowdfunding sites charge a fee of some
kind, usually either a flat fee, a percentage of the amount
raised, or interest.344
This satisfies the compensation
requirement.345
4. Advice, Analyses, or Reports Concerning
Securities
Most crowdfunding sites are not offering advice “as to the
value of securities or as to the advisability of investing in,
341
According to the SEC, a person is in the business if “(i) [he] holds
himself out as an investment adviser or as one who provides investment
advice, (ii) receives any separate or additional compensation that
represents a clearly definable charge for providing advice about securities,
regardless of whether the compensation is separate from or included
within any overall compensation, or receives transaction-based
compensation if the client implements in the investment advice, or (iii) on
anything other than rare, isolated and non-periodic instances, provides
specific investment advice.” Investment Advisers Release, supra note 336,
at 38402 (emphasis added).
342
See HAZEN, supra note 42, at 29 (“The rendering of investment
advice without compensation is likely to take the person rendering the
advice out from under the purview of the Investment Advisers Act.”).
343
Investment Advisers Release, supra note 336, at 38403. See also
Thomas v. Metropolitan Life Ins. Co., 631 F.3d 1153, 1164 (10th Cir.
2011); United States v. Elliott, 62 F.3d 1304, 1311 (11th Cir. 1995); LEMKE
& LINS, supra note 340, at 4.
344
Kiva is an exception. It funds itself through donations.
345
FRIEDMAN, SECURITIES REGULATION, supra note 266, at 17-5 (“If a
website offering investment advice grants access only to those who pay a
subscription fee, clearly its sponsor is receiving compensation for
investment advice.”). Friedman notes that the question would be more
difficult if the web site were funded only by advertisements. Id.
70
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
purchasing, or selling securities.”346 They may, however, be
issuing “analyses or reports concerning securities,”347
assuming that securities are being offered on the site. The
case law and guidance from the SEC are simply too
uncertain to offer a definitive conclusion.
Consider first the advice portion of the definition. Most of
the existing crowdfunding sites do not advise investors as to
the merits of particular opportunities, or evaluate or rate the
potential investments. Advice does not have to relate to
specific securities to make one an investment adviser.348 A
discussion of the relative advantages of investing in
securities rather than other investments would suffice,349 but
crowdfunding sites typically do not even do this.
The obvious exceptions are Prosper and Lending Club,
which assign ratings to individual loans. If Prosper and
Lending Club were selling those loans directly to lenders, as
they did prior to registration, the case for investment adviser
status would be strong.
Their current pass-through
programs cloud the analysis. Now they are, in effect,
commenting on the value of their own notes, not advising
investors as to securities issued by others. Almost every
issuer of securities discusses the value of the securities it
issues. If that were enough to make one an investment
adviser, then every company would be an investment
adviser. Thus, as long as the SEC continues to treat Prosper
and Lending Club as the “issuers” of these securities, it is
difficult to see them as investment advisers.
For the other crowdfunding sites, the problem, if there is
one, comes under the second part of the definition.
Crowdfunding sites may be issuing “analyses or reports
concerning securities.” The SEC staff has indicated that
someone providing investors with statistical data on
companies or a listing of investment opportunities is not
issuing analyses or reports if (1) the information is readily
346
See Investment Advisers Act of 1940 § 202(a)(11), 15 U.S.C. § 80b2(a)(11) (2006).
347
Id.
348
Investment Advisers Release, supra note 336, at 38402.
349
Id. See also LEMKE & LINS, supra note 340, at 6–7.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
71
available to the public in its raw state; (2) the categories of
information presented are not highly selective; and (3) the
information is not organized or presented in a manner that
suggests the purchase, holding, or sale of any security.350
These requirements seem problematic for crowdfunding
sites.
The entrepreneur’s information is not readily
available to the public other than through the crowdfunding
site. And the whole point of the listing is to suggest that
investors purchase a security by investing in the
entrepreneurs’ companies.
However, the SEC staff has granted no-action relief to
several matching services, which, like crowdfunding sites,
are created to promote the purchase of entrepreneurs’
securities and typically provide non-public information. Like
crowdfunding sites, those matching services are created to
promote the purchase of entrepreneurs’ securities, and the
information provided by those small business entrepreneurs
is not typically publicly available.
No cases directly address whether crowdfunding sites are
investment advisers, but other investment-adviser cases
support treating crowdfunding sites as investment advisers.
Two cases have held that general partners’ financial reports
to limited partners on the status of the partnerships’
investments constituted investment advice for purposes of
the definition.351 Those reports, like the company reports
available to investors on some crowdfunding sites, included
financial statements and a calculation of investors’
returns.352 Even though the defendants were not offering the
limited partners any actual advice in these reports—they
350
See, e.g., Angel Capital Elec. Network, SEC No-Action Letter, 1996
WL 636094 (Oct. 25, 1996); Mo. Innovation Ctr., Inc., SEC No-Action
Letter, 1995 WL 643949 (Oct. 17, 1995); Media Gen. Fin. Servs., Inc., SEC
No-Action Letter, 1992 WL 198262 (July 20, 1992); Investex Inv. Exch.
Inc., SEC No-Action Letter, 1990 WL 286331 (Apr. 9, 1990); Charles St.
Sec., Inc., SEC No-Action Letter, 1987 WL 107616 (Jan. 28, 1987). See
generally FRIEDMAN, SECURITIES REGULATION, supra note 266, at 17-3;
LEMKE & LINS, supra note 340, at 7.
351
See Abrahamson v. Fleschner, 568 F.2d 862, 870 (2d Cir. 1977);
SEC v. Saltzman, 127 F. Supp. 2d 660, 669 (E.D. Pa. 2000).
352
See Fleschner, 568 F.2d at 866; Saltzman, 127 F. Supp. 2d at 669.
72
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
were only providing performance data—the courts concluded
that the Investment Advisers Act applied because the
limited partners would use the reports to decide whether to
continue their investments in the partnership.353 Similarly,
even though crowdfunding sites are not advising investors to
invest in a particular company, they are providing the
reports that the investors will use to make investment
decisions.
Most crowdfunding sites, however, do not independently
generate reports on the companies listed. They merely post
funding requests and other information produced by the
entrepreneurs themselves. Because they function as mere
conduits for information and do not create anything
themselves, they arguably are not providing any “advice” or
“analyses” or “reports” at all. However, at least two cases
have rejected this “mere conduit” argument. In SEC v. Wall
Street Transcript Corp.,354 the defendant published a weekly
tabloid containing verbatim reprints of reports on securities
issued by brokers. The court concluded that “there can be no
doubt that, for purposes of the . . . [Investment Advisers Act],
. . . [the defendant] . . . ‘issues’ analyses and reports
concerning securities . . . . That a publication acts as a mere
conduit for investment advice written by others obviously
does not insure against the possibility that the publisher will
engage in the fraudulent activities the Act was designed to
prevent.”355 Similarly, in Zinn v. Parrish,356 a sports agent
occasionally transmitted to one of his clients securities
recommendations made by others.357 The court held that the
agent was not “in the business” of offering investment
353
In those cases, the general partners were also actually making
investment decisions for the partnership, but both courts seemed to see
the reports themselves as sufficient to make one an investment adviser.
354
454 F. Supp. 559 (S.D.N.Y. 1978).
355
Id. at 565. However, after finding that the defendant fell within
the general definition of investment adviser, the court concluded that the
exception in that definition for publishers was available. Id. at 567. See
infra Part IV.C.6 (discussion of the exception for publishers).
356
644 F.2d 360 (7th Cir. 1981).
357
Id. at 364.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
73
advice, but noted that, if the agent had passed along such
recommendations more regularly, he might be an investment
adviser.358
5. SEC No-Action Letters
The primary source of guidance on the investment adviser
issue comes in the form of SEC no-action letters. The SEC
staff has issued a large number of no-action letters to
companies that either attempt to match investors and
entrepreneurs359 or merely present investment opportunities
for investors’ unguided choice.360 The SEC staff has dealt
with so many no-action requests in this area that it no longer
responds to them “unless they present novel or unusual
In granting these requests, the staff has
issues.”361
emphasized a number of features of these services without
358
Id.
See Angel Capital Elec. Network, SEC No-Action Letter, 1996 WL
636094, at *1 (Oct. 25, 1996); Capital Res. Network, SEC No-Action
Letter, 1993 WL 164600, at *1 (Apr. 23, 1993); Tech. Capital Network,
Inc., SEC No-Action Letter, 1992 WL 175694, at *1 (June 5, 1992);
Heartland Venture Capital Network, Inc., SEC No-Action Letter, 1987 WL
108286 (June 7, 1987); Venture Capital Network of N.Y., Inc., SEC NoAction Letter, 1986 WL 67371, at *1 (Nov. 10, 1986); Univ. of Ark., SEC
No-Action Letter, 1986 WL 67354, at *1 (Oct. 27, 1986); Inv. Contacts
Network, SEC No-Action Letter, 1986 WL 68350 (Sept. 24, 1986); Venture
Capital Exch., Inc., SEC No-Action Letter, 1986 WL 66613, at *1 (Mar. 24,
1986); Indep. Inst. for N.Y. Bus. Ventures, Inc., SEC No-Action Letter,
1986 WL 65138, at *1 (Jan. 10, 1986); Venture Capital Res., Inc., SEC NoAction Letter, 1985 WL 55644, at *1 (Nov. 25, 1985); Venture Capital
Network, Inc., SEC No-Action Letter, 1984 WL 45334, at *1 (May 7, 1984).
360
See Mo. Innovation Ctr., Inc., SEC No-Action Letter, 1995 WL
643949, at *2 (Oct. 17, 1995); Investex Inv. Exch. Inc., SEC No-Action
Letter, 1990 WL 286331, at *1 (Apr. 9, 1990); Petroleum Info. Corp., SEC
No-Action Letter, 1989 WL 246625, at *1 (Nov. 28, 1989); Richmond
Venture Capital Network, Inc., SEC No-Action Letter, 1989 WL 246296, at
*2 (May 12, 1989).
361
See Envtl. Capital Network, SEC No-Action Letter, 1995 LEXIS
1030, at *8 (Dec. 28, 1995); Colo. Capital Alliance, Inc., 1995 WL 271123,
at *2 (May 4, 1995); Mo. Innovation Ctr., Inc., SEC No-Action Letter, 1995
WL 643949, at *4 (Oct. 17, 1995); Capital Res. Network, SEC No-Action
Letter, 1993 WL 164600, at *5 (Apr. 23, 1993).
359
74
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
explaining why those particular features matter.362
features include the following:
(1) The network is operated by
organization.363
Those
a non-profit
(2) The network does not give any advice on the
merits or shortcomings of particular investments364
and does not otherwise endorse, analyze, or
recommend the listed investment opportunities.365
(3) The network receives only a small application fee,
typically used to offset administrative costs,366 and no
employees of the network will receive any
compensation based on the outcome of investment
transactions.367
(4) The network is not involved in negotiating any
purchase or sale368 and will not provide any
362
Almost all of the letters share these common features. The
following notes cite letters in which the staff expressly noted the feature in
granting relief.
363
Capital Res. Network, SEC No-Action Letter, 1993 WL 164600, at
*1 (Apr. 23, 1993); Venture Capital Exch., Inc., SEC No-Action Letter,
1986 WL 66613, at *1 (Apr. 23, 1986). But see Tech. Capital Network, Inc.,
SEC No-Action Letter, 1992 WL 175694, at *8 n.2 (June 5, 1992) (nonprofit status “is not solely determinative” of whether a company is an
investment adviser).
364
Angel Capital Elec. Network, SEC No-Action Letter, 1996 WL
636094, at *1 (Oct. 25, 1996); Venture Capital Exch., Inc., SEC No-Action
Letter, 1986 WL 66613, at *1 (Apr. 23, 1986); Venture Capital Res., Inc.,
SEC No-Action Letter, 1985 WL 55644, at *1 (Nov. 25, 1985).
365
Mo. Innovation Center, Inc., SEC No-Action Letter, 1995 WL
643949, at *10 (Oct. 17, 1995).
366
Capital Res. Network, SEC No-Action Letter, 1993 WL 164600
(Apr. 23, 1993); Venture Capital Res., Inc., SEC No-Action Letter, 1985
WL 55644 (Nov. 25, 1985); Heartland Venture Capital Network, SEC NoAction Letter, 1986 WL 65138, at *1 (Mar. 26, 1987) (indicating that the
fee need not be a one-time fee; a renewal fee is acceptable).
367
Capital Res. Network, SEC No-Action Letter, 1993 WL 164600, at
*2 (Apr. 23, 1993); Tech. Capital Network, Inc., SEC No-Action Letter,
1992 WL 175694, at *7 (June 5, 1992).
368
Angel Capital Elec. Network, SEC No-Action Letter, 1996 WL
636094, at *2 (Oct. 25, 1996); Capital Res. Network, SEC No-Action
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
information concerning
transaction.369
how
to
complete
75
a
(5) The network does not handle any funds or
securities involved in completing a transaction.370
Thomas Hazen reads these no-action letters as allowing
the use of “passive” bulletin boards that merely post
information about securities as long as two conditions are
met: (1) the bulletin boards are not involved in any
negotiations regarding investments arising from using of the
bulletin board; and (2) the board operator gives no advice
“regarding the merits or shortcomings of any particular
trade.”371 Thomas Lemke and Gerald Lins add a third
condition: the bulletin board operator may not “receive
compensation in connection with the purchase or sale of any
stock listed on the bulletin board.”372
Crowdfunding sites differ from these approved matching
networks in several ways that make it more likely that they
will be treated as investment advisers. Crowdfunding sites
typically are operated for profit, not by a non-profit
institution.
They often charge transaction-based fees.
Although the site operator does not directly participate in
negotiations, negotiation and completion of the transactions
occur on the crowdfunding site, rather than directly between
the investor and the entrepreneur. Also, crowdfunding sites
do handle funds and securities, since both the initial
investments and the returns paid to investors flow through
the site. Whether these differences from approved services
are enough to make crowdfunding sites investment advisers
is unclear.
However,
one
important
distinction
between
crowdfunding sites and matching services points in the
Letter, 1993 WL 164600, at *2 (Apr. 23, 1993); Venture Capital Res., Inc.,
SEC No-Action Letter, 1985 WL 55644 (Nov. 25, 1985).
369
Venture Capital Res., Inc., SEC No-Action Letter, 1985 WL 55644,
at *2 (Nov. 25, 1985).
370
Id.
371
7 HAZEN, supra note 42, at 30.
372
LEMKE & LINS, supra note 340, at 10.
76
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
opposite direction. Matching services, by definition, attempt
to match investors with suitable offerings. By making a
match, the service is, in effect, “advising” the investor that
the particular offering fits the investor’s needs.
Crowdfunding sites, by contrast, do not typically screen
investment opportunities in this way. Investors can see all
of the opportunities available on the site, and it is up to the
investor to screen them to determine which is appropriate.
The element of “advice or “analysis” being provided by the
site is thus arguably missing.
The SEC staff has in fact granted no-action relief to
several sites that merely posted available opportunities, with
no attempt to match investors to those opportunities.373
However, those sites differed in other important ways from
crowdfunding sites. Moreover, only one no-action letter
suggests that this distinction is important for the SEC’s
purposes. In its response to Venture Capital Network,
Inc.,374 the staff indicated that a matching network was
issuing analyses or reports concerning securities, and
therefore met the criteria to be an “investment adviser,”
because it “represents that, on the basis of the investors’
responses to the questionnaire drawn up by VCN and the
information provided by the entrepreneurs in response to
questionnaires drawn up by VCN, the information provided
by VCN concerns an investment opportunity in a company or
companies which satisfy the investors’ indicated investment
criteria.”375
Crowdfunding sites do not usually pick
opportunities for investors or attempt to match them to
“appropriate” opportunities. However, given the SEC letter’s
limited discussion, it is unclear if this distinction from the
373
See Mo. Innovation Ctr., Inc., SEC No-Action Letter, 1995 WL
643949, at *4 (Oct. 17, 1995); Investex Investors Exch. Inc., SEC NoAction Letter, 1990 WL 286331, at *2 (Apr. 9, 1990); Petroleum Info.
Corp., SEC No-Action Letter, 1989 WL 246625, at *2 (Nov. 28, 1989);
Richmond Venture Capital Network, Inc., SEC No-Action Letter, 1989 WL
246296, at *1 (May 12, 1989).
374
Venture Capital Network, Inc., SEC No-Action Letter, 1984 WL
45334 (May 7, 1984).
375
Id. at *2.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
77
matching services is sufficient to keep crowdfunding sites
from being investment advisers.
6. The Publisher Exception
Section 202(a)(11) of the Investment Advisers Act
contains several exceptions to the general definition of
investment adviser. One of those exceptions, the subsection
(D) exception for “the publisher of any bona fide newspaper,
news magazine or business or financial publication of
general and regular circulation,”376 might apply to
crowdfunding sites. The exception covers “publications,” but
it is “clear that the exclusion for publishers is not limited to
publications or paper media.”377 It has been applied to web
sites,378 Internet postings,379 electronic messages,380 and a
private video information network.381
Consequently,
Internet-based crowdfunding sites could potentially use the
exception.
The Supreme Court outlined the parameters of the
subsection (D) exception in 1985, in Lowe v. SEC.382
According to the Court, in passing the Investment Advisers
Act, Congress “was primarily interested in regulating the
business of rendering personalized investment advice.”383
Communications that “do not offer individualized advice
376
Investment Advisers Act of 1940 § 80b-2(a)(11)(D), 15 U.S.C. § 80b2(a)(11)(D) (2006).
377
FRIEDMAN, supra note 266, at 17-7.
378
SEC v. Park, 99 F. Supp. 2d 889, 900–02 (N.D. Ill. 2000) (rejecting
the application of the subsection (D) exception for other reasons).
379
See id. at 894–96 (rejecting the application of the subsection (D)
exception for other reasons).
380
See SEC v. Terry’s Tips, Inc., 409 F. Supp. 2d 526, 530–32 (D. Vt.
2006) (holding that the publisher exception applies to non-personalized email, but nevertheless finding the defendants to be investment advisers);
Mr. Russell H. Smith, SEC No-Action Letter, 1996 WL 282564, at *2 (May
2, 1996) (noting that a person providing advice through electronic mail
could qualify for the publisher exception).
381
See Reuters Info. Servs., SEC No-Action Letter, 1991 WL 176539,
at *1–3 (Jan. 17, 1991).
382
472 U.S. 181, 203–11 (1985).
383
Id. at 204.
78
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
attuned to any specific portfolio or to any client’s particular
needs” are not within the purpose of the Act384 and are at
least presumptively within the subsection (D) exclusion.385 A
few lower court cases since Lowe have concluded that
publications offering non-personalized advice to investors are
not investment advisers.386
The SEC staff derives three requirements from Lowe.
The publication must (1) offer only impersonalized advice,
i.e., advice not tailored to the individual needs of a specific
client or group of clients; (2) be “bona fide” or genuine, in
that it contains disinterested commentary and analysis as
opposed to promotional material; and (3) be of general and
regular circulation, i.e., not timed to specific market activity
or to events affecting or having the ability to affect the
securities industry.387
Crowdfunding sites clearly do not offer personalized
investment advice. Everyone who enters a publicly available
crowdfunding site receives exactly the same information. In
384
Id. at 208. Prior to Lowe, courts made no distinction between
personal and impersonal investment advice in applying subsection (D).
See Lani M. Lee, The Effects of Lowe on the Application of the Investment
Advisers Act of 1940 to Impersonal Investment Advisory Publications, 42
BUS. LAW. 507, 507 (1987).
385
Lowe might be interpreted to require that one offer personalized
advice to be an investment adviser at all, but the majority opinion clearly
indicates that “on its face, the basic definition applies to petitioners.”
Lowe, 472 U.S. at 203–04. Thus, the better reading is that the distinction
between personalized and impersonal advice relates to the publisher
exception. See David B. Levant, Financial Columnists as Investment
Advisers: After Lowe and Carpenter, 74 CAL. L. REV. 2061, 2093 (1986).
See also SEC v. Park, 99 F. Supp. 2d 889, 894–95 (N.D. Ill. 2000) (holding
that publications that do not offer personalized advice could still be
investment advisers if the publications are not bona fide).
386
See Compuware Corp. v. Moody’s Investors Servs., Inc., 273 F.
Supp. 2d 914, 916 (E.D. Mich. 2002); SEC v. Wall St. Publ’g Inst., 664 F.
Supp. 554, 555 (D.D.C. 1986).
387
Nito GmbH, SEC No-Action Letter, 1996 WL 473433, at *1–2 (Aug.
9, 1996). See also, e.g., Mr. Russell H. Smith, SEC No-Action Letter, 1996
WL 282564, at *2 (May 2, 1996); InTouch Global, LLC, SEC No-Action
Letter, 1995 WL 693301, at *2 (Nov. 14, 1995); David Parkinson, Ph.D.,
SEC No-Action Letter, 1995 WL 619930, at *1 (Oct. 19, 1995).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
79
fact, unlike most of the electronic matching services, most
crowdfunding sites do not even attempt to collect information
about investors that would allow them to match investors to
particular offerings.
Therefore, crowdfunding sites would fall within the
publisher exception if they are “bona fide” and “of general
and regular circulation.”388
These two requirements,
according to Lowe, are designed to eliminate “hit and run
tipsters” and “touts” from using the exception.389 In the
Court’s view, the exception is intended for publications that
“contain disinterested commentary and analysis as opposed
to promotional material disseminated by a ‘tout.’”390
Crowdfunding sites are not designed to tout particular
stocks or issues; rather, they are open to any entrepreneur
who wishes to raise money. Moreover, they are not “personal
communications masquerading in the clothing of” general
publications.391 Every investor who logs on receives exactly
the same content. However, the materials on crowdfunding
sites are not “disinterested commentary”—they are intended
to be “promotional.” The whole point of the entrepreneurs’
postings is to convince people to invest in their businesses,
and the crowdfunding sites themselves, which receive
transaction-based compensation, have a pecuniary interest
in investors following that “advice.” This alone may be
sufficient to preclude application of the publisher
exception.392
388
See Investment Advisers Act of 1940 § 80b-2(a)(11)(D), 15 U.S.C.
§80b-2(a)(11)(D) (2006).
389
Lowe, 472 U.S. at 206.
390
Id.
391
Id. at 209.
392
See SEC v. Laurins, No. 89-16708, 1991 WL 57933, at *2 (9th Cir.
Apr. 16, 1991) (where the publisher of an investment report had an
undisclosed pecuniary interest in the advice contained in the report, the
publication was not bona fide, and the publisher therefore was an
investment adviser); SEC v. Park, 99 F. Supp. 2d 889, 894 (N.D. Ill. 2000)
(publication may not be bona fide, and therefore may not be entitled to the
publisher exception, where the defendants were promoting stocks “in
which they either had an interest or for which they were being paid to
recommend without revealing their interests”).
80
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Unfortunately, the case law in this area is somewhat
confused. One district court opinion has essentially read the
“bona fide” requirement out of the Lowe opinion, holding that
publications not offering individualized advice were not
investment advisers, even though they “do not contain
completely disinterested commentary, and do contain
promotional material.”393 Another district court held that a
magazine was a bona fide publication that fit within the
exception, even though much of the magazine’s content was
provided by featured companies and their public relations
agents.394
To fall within the publisher exception, crowdfunding sites
must also be of general and regular circulation. Web sites
are, by definition, continually published, and crowdfunding
sites are open to the general public. But the Supreme Court
indicated in Lowe that a publication is not regular if its
publication is “timed to specific market activity, or to events
affecting or having the ability to affect the securities
industry.”395 It is not clear exactly what this means in the
context of a web site. Although crowdfunding sites are
continually available, they are changed each time an
entrepreneur posts a new fundraising request. Thus, in a
sense, each “new edition” of the site is timed to specific
market activity—a new securities offering by an
entrepreneur. The SEC might seize on this to argue that
crowdfunding sites are timed to specific market activity, and
therefore do not qualify for the exception.
393
SEC v. Terry’s Tips, Inc. 409 F. Supp. 2d 526, 532 (D. Vt. 2006).
The court still held that the defendants were investment advisers because
of individualized advice they gave to individual investors in phone calls
and e-mail. Id.
394
See SEC v. Wall St. Publ’g Inst., Inc., 664 F. Supp. 554, 555 (D.D.C.
1986), rev’d on other grounds, 851 F.2d 365 (D.C. Cir. 1988). The
magazine is described in an earlier opinion, SEC v. Wall Street Publishing
Institute, 591 F. Supp. 1070, 1075–77 (D.D.C. 1984), stayed, No. 84-5485,
1984 WL 21133, at *1 (D.C. Cir. Aug. 10, 1984).
395
Lowe, 472 U.S. at 209.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
81
V. PROPOSALS TO EXEMPT CROWDFUNDING
As crowdfunding has grown, proponents of crowdfunding
have, not surprisingly, turned their attention to federal
securities law and the possibility of selling securities through
crowdfunding. The result has been several proposals to
exempt crowdfunding from Securities Act registration. Even
the White House has endorsed a crowdfunding exemption.
Some of these crowdfunding exemption proposals are
sketchy. At best, they represent bare frames on which an
exemption could be erected. But all of the proposals share
two common features: (1) an overall cap on the dollar amount
of the offering; and (2) a limit on the amount each investor
may invest.
The SEC, under pressure from Congress, had agreed to
look at crowdfunding even before the White House
announcement. But the White House endorsement definitely
raises the ante and makes it more likely that the SEC will at
least consider rule-making. However, Congress may not wait
for SEC action. Three bills have been introduced that would
create statutory crowdfunding exemptions, and one of those
bills has passed in the House.
A. The Sustainable Economies Law Center Petition
The first exemption proposal came in 2010.
The
Sustainable Economies Law Center petitioned the SEC to
exempt offerings of up to $100,000, provided that no single
investor contributed more than $100.396
The proposed
exemption includes additional limitations: (1) the offerors
must be individual U.S residents, not entities;397 (2) each
offeror may make only one offering at a time; and (3) all
396
Sustainable Economies Law Ctr., Request for Rulemaking to
Exempt Securities Offerings Up to $100,000 With $100 Maximum Per
Investor From Registration, SEC File No. 4-605, at 2 (July 1, 2010),
available at http://www.sec.gov/rules/petitions/2010/petn4-605.pdf.
397
Id. at 7. The Center argues that allowing only individuals, and not
companies, to use the exemption would limit fraud because the identity of
each offeror could be verified and no one could “hide behind a corporate
shell.”
82
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
offering materials and communications must include a
disclaimer “stating the possibility of total loss of the
investment, and the necessity of careful evaluation of each
offeror’s trustworthiness.”398
The petition itself is an
illustration of the power of crowdfunding: it was funded by a
campaign on the crowdfunding web site IndieGoGo.399
The SEC dutifully logged the petition400 and began
accepting comments. Aided by a mention on the blog
BoingBoing,401 the petition has generated dozens of
individual comments, almost all supportive, plus almost one
hundred form comments.402 The petition even has its own
website.403 Moreover, the final report of the 2010 SEC
Government-Business Forum on Small Business Capital
Formation recommended a similar exemption, although the
398
Id.
See LAWTON & MAROM, supra note 2, at 187–88; Crowdfunding
Campaign to Change Crowdfunding Law, INDIEGOGO, http://www.indiego
go.com/Change-Crowdfunding-Law (last visited Mar. 5, 2012).
400
See Request for Rulemaking to Exempt Securities Offerings Up to
$100,000 With $100 Maximum Per Investor From Registration, SEC, File
No. 4-605, available at http://www.sec.gov/rules/petitions/2010/petn4-605.p
df.
401
See Paul Spinrad, Crowdfunding Exemption Action: File No. 4-605,
BOINGBOING (July 3, 2010, 3:26 AM), http://www.boingboing.net/2010/07
/03/sec-crowdfunding-exe.html.
402
See Comments on Rulemaking Petition: Request for Rulemaking to
Exempt Securities Offerings up to $100 from Registration Under Section 5
of the Securities Act of 1933, SEC, File No. 4-605, available at
http://www.sec.gov/comments/4-605/4-605.shtml. Some of those comments
proposed raising the maximum offering amount and the maximum
individual investment. See, e.g., the comments of Michael Sauvante (Nov.
9, 2010); James J. Angel (Sept. 21, 2010); Andres La Saga (Aug. 24, 2010),
Comments on Rulemaking Petition: Request for Rulemaking to Exempt
Securities Offerings up to $100 from Registration Under Section 5 of the
Securities Act of 1933, SEC, File No. 4-605, available at
http://www.sec.gov/comments/4-605/4-605.shtml. See also Pope, supra
note 99, at 997 (discussing the SELC proposal and arguing that the perinvestor cap should be increased to $1,000 and the aggregate offering limit
should be increased to $250,000).
403
See
Change
Crowdfunding
Law,
CROWDFUNDINGLAW.COM
http://crowdfundinglaw.com/ (last visited Mar. 5, 2012).
399
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
83
recommendation does not specifically name the Center as its
source.404
B. The Small Business & Entrepreneurship Council
Proposal
Near the end of 2010, the Small Business &
Entrepreneurship Council proposed a similar exemption.405
The Council’s exemption was also included in, but not
directly endorsed by, the final report of the 2010 SEC
Forum.406
The maximum offering amount under the Council’s
proposal would be $1 million, and the maximum for any
individual investor would be either $10,000 or 10% of the
person’s “stated income” for the prior year.407 Offerings could
be made on SEC-approved web sites.408 To participate in
such an offering, an investor would be required to take an
online test, but if the Council’s single proposed question for
this test is representative, the test would be more of an
interactive disclaimer than a test of investment
sophistication.
The question asks whether investors
understand that all of their capital is at risk.409 The
Council’s proposed exemption would not completely free
issuers from SEC disclosure requirements. Issuers would
404
2010 ANNUAL SEC GOVERNMENT-BUSINESS FORUM ON SMALL
BUSINESS CAPITAL FORMATION, FINAL REPORT 21 (2011), available at
http://www.sec.gov/info/smallbus/gbfor29.pdf (recommending that the SEC
“exempt from 1933 Act registration aggregate offerings of up to $100,000,
where each individual may invest no more than a certain maximum
amount, say $100 per individual”).
405
See SBE Council Proposal, supra note 247.
406
See 2010 ANNUAL SEC GOVERNMENT-BUSINESS FORUM ON SMALL
BUSINESS CAPITAL FORMATION, supra note 404, at 29–30.
407
SBE Council Proposal, supra note 247, at 4. It is not clear from the
proposal exactly what “stated income” means or whether the individual
limit is supposed to select the greater or the lesser of the two amounts.
408
Id. at 5. The Council’s proposal suggests that the organizations
hosting such sites could vet the issuers and investors, a process that might
create issues under the Investment Advisers Act. That aspect of the
Council’s proposal is not discussed here.
409
See id.
84
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
have to provide disclosure on something similar to the Small
Company Offering Registration (“SCOR”) form used by the
states.410
C. The Startup Exemption Proposal
Entrepreneur Sherwood Neiss411 has created an online
petition in favor of another crowdfunding exemption.412 The
petition calls for a $1 million exemption, available only to
businesses with annual gross revenues of less than $5
million during the prior three years.413 All investors would
have “to complete a questionnaire to determine their
aptitude to participate . . . and answer a series of
disclosures” to demonstrate that they have sufficient
knowledge and experience to invest.414
Unaccredited
investors would not be able to invest more than $10,000.415
The platforms hosting these offerings would be required to
register with the SEC but would not need a broker’s
license.416 Offerings pursuant to the exemption would also be
exempted from state registration requirements but would
have to file a notice with the states.417
D. The White House Endorsement
On September 8, 2011, the White House released a “Fact
Sheet and Overview” detailing President Obama’s proposed
410
See id. at 4. See also SCOR Forms, NASAA, http://www.nasaa.org/
industry-resources/corporation-finance/scor-overview/scor-forms/
(last
visited Mar. 5, 2012).
411
See About Us, STARTUP EXEMPTION, http://www.startup
exemption.com/about-us#axzz1idaRGVy9 (last visited Mar. 5, 2012).
412
See STARTUP EXEMPTION, http://www.startupexemption.com (last
visited Mar. 5, 2012).
413
See Exemption Framework ¶ 1, STARTUP EXEMPTION,
http://www.startupexemption.com/exemption-framework#axzz1idaRGVy9
(last visited Mar. 5, 2012).
414
Id. ¶ 3.
415
Id. ¶ 2.
416
Id. ¶¶ 6, 8.
It is unclear exactly what requirements this
registration would entail.
417
Id. ¶ 5.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
85
job-creating measures.418 Buried in that ten-page document
is a single sentence about crowdfunding: “The administration
also supports establishing a ‘crowdfunding’ exemption from
SEC registration requirements for firms raising less than $1
million (with individual investments limited to $10,000 or
10% of investors’ annual income) . . . .”419 The release
provides no further details. The proposed offering and
individual investment limits match those in the Small
Business & Entrepreneurship Council proposal, but the
release neither acknowledges that proposal nor indicates
whether the President supports the other requirements in
that proposal.
E. SEC Activity
The SEC has not yet proposed a crowdfunding exemption
or officially responded to any of the exemption proposals
detailed above. It has, however, agreed to consider some
kind of special treatment for crowdfunding. On March 22,
2011, Congressman Darrell Issa, Chairman of the House
Committee on Oversight and Government Reform, sent a
seventeen-page letter to Mary Schapiro, Chairman of the
SEC, criticizing the SEC’s treatment of private capital
formation and posing numerous questions about regulation
of the capital formation process.420 Congressman Issa’s letter
specifically asked whether the SEC had considered creating
exemptions for crowdfunding.421
Chairman Schapiro responded to Congressman Issa on
April 6, 2011.422 In her letter, she informed him that she was
418
Fact Sheet and Overview for AJA, supra note 7.
Id. at 2.
420
Letter from Darrell E. Issa, Chairman, House Comm. on Oversight
& Gov’t Reform, to Mary L. Schapiro, Chairman, SEC (Mar. 22, 2011),
available at www.knowledgemosaic.com/resourcecenter/Issa.041211.pdf
[hereinafter Issa Letter].
421
Id. at 11.
422
Letter from Mary L. Schapiro, Chairman, SEC, to Darrell E. Issa,
Chairman, House Comm. on Oversight & Gov’t Reform (Apr. 6, 2011),
available
at
www.sec.gov/news/press/schapiro-issa-letter-040611.pdf
[hereinafter Schapiro Letter].
419
86
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
creating a new Advisory Committee on Small and Emerging
Companies and that the SEC staff was “taking a fresh look
at our rules to develop ideas for the Commission about ways
to reduce the regulatory burdens on small business capital
formation.”423 She noted the Sustainable Economies Law
Center proposal for a crowdfunding exemption,424 said that
the SEC staff had been discussing crowdfunding,425 and
promised a staff review of “the impact of our regulations on
capital formation for small businesses,” specifically including
“the regulatory questions posed by new capital raising
strategies.”426
This promise, made prior to President Obama’s
endorsement, should not have caused undue optimism
among crowdfunding’s supporters. The SEC often pays lip
service to small business needs, but it seldom acts on those
concerns.427 The annual forum it holds on small business
issues has produced “repeated and strongly-worded
recommendations from small business advocates to lessen
the SEC’s regulatory burdens on raising capital . . . [, but]
with rare exception, the SEC has turned a deaf ear to the
However,
Forum’s recommendations and concerns.”428
President Obama’s subsequent endorsement may make a
crowdfunding exemption more likely.
At the House
subcommittee hearing, Meredith Cross, director of the SEC’s
Division of Corporation Finance, indicated that she expects
the SEC to consider crowdfunding in the near future.429
423
Id. at 1.
Id. at 22 n.77.
425
Id. at 22–23.
426
Id. at 24.
427
See Cohn & Yadley, supra note 11, at 64 (“Despite the SEC
profession of interest in small business, there has been a great deal more
smoke than fire.”).
428
Id. at 3–4.
429
Yin Wilczek, SEC Under Pressure to Allow Crowdfunding; Agency
to Consider Issue Soon, Official Says, 43 SEC. REG. & L. REP. (BNA) 1872
(Sept. 19, 2011).
424
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
87
F. The SEC’s Authority to Exempt Crowdfunding
The SEC clearly has the authority to exempt
crowdfunding from the registration requirements of the
Securities Act and to exempt crowdfunding web sites from
registration as brokers or investment advisers.
Two
separate provisions of the Securities Act are possible sources
of authority for the SEC to exempt crowdfunding from the
Act’s registration requirements.
Section 3(b) of the
Securities Act430 authorizes the SEC to exempt offerings of
less than a specified dollar amount, currently $5 million.431
To authorize a Section 3(b) exemption, the SEC must find
that “enforcement . . . with respect to such securities is not
necessary in the public interest and for the protection of
investors by reason of the small amount involved or the
limited character of the public offering.”432 The SEC has
used its Section 3(b) authority rather extensively: Rules 504
and 505 of Regulation D are both Section 3(b) exemptions,433
as is Regulation A.434
The SEC’s authority under Section 28 of the Securities
Act is even more extensive, authorizing the SEC to exempt
“any person, security, or transaction, or any class or classes
of persons, securities, or transactions,” from any provision of
the Act or associated rules.435 Unlike Section 3(b), Section 28
430
Securities Act of 1933 § 3(b), 15 U.S.C. § 77c(b) (2010).
The Sustainable Economies Law Center petition points to Section
3(b) as a potential source of authority. See Request for Rulemaking to
Exempt Securities Offerings up to $100,000 with $100 Maximum per
Investor from Registration, supra note 400, at 8–9. The Center also
argued that its proposed exemption could be a safe harbor for Section 4(2)
of the Securities Act. See id. at 9. But cf. supra Part III.B.2.a (suggesting
that it is doubtful that the Center’s proposed exemption could be a safe
harbor for Section 4(2) given how the section has been interpreted).
432
Request for Rulemaking to Exempt Securities Offerings up to
$100,000 with $100 Maximum per Investor from Registration, supra note
400, at 8–9.
433
See Securities Act Rules 504(a) and 505(a), 17 C.F.R. §§ 230.504(a),
230.505(a) (2012).
434
See 17 C.F.R. § 230.251.
435
15 U.S.C. § 77z-3.
431
88
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
does not limit the dollar amount of exempted offerings. To
use its Section 28 exemption authority, the SEC must find
that the “exemption is necessary or appropriate in the public
interest and is consistent with the protection of investors.”436
The SEC has similar authority to exempt those who
would otherwise be regulated as brokers under the Exchange
Act or regulated as investment advisers under the
Investment Advisers Act. Section 36(a) of the Exchange Act
authorizes the SEC to “conditionally or unconditionally
exempt any person, security, or transaction, or any class or
classes of persons, securities, or transactions” from any
provisions of the Act.437 To adopt such an exemption, the
SEC would have to find that it “is necessary or appropriate
in the public interest, and . . . consistent with the protection
Section 202(a)(11) of the Investment
of investors.”438
Advisers Act, which defines “investment adviser,” authorizes
the SEC to exclude “other persons not within the intent of
[the definition].”439 More broadly, Section 206A of the
Advisers Act authorizes the SEC to “conditionally or
unconditionally exempt any person or transaction, or any
class or classes of persons, or transactions,” provided that
the exemption “is necessary or appropriate in the public
interest and consistent with the protection of investors and
the purposes fairly intended by the policy and provisions of
this [Act].”440
G. The Congressional Response
Congress may not give the SEC an opportunity to develop
a crowdfunding exemption.
The House has passed a
crowdfunding bill, and a similar bill has been introduced in
436
Id.
Securities Exchange Act of 1934 § 36(a), 15 U.S.C. § 78mm(a)
(2010). The exception to the SEC’s authority involving government
securities and government securities brokers is provided at 15 U.S.C. §
78mm(b). This exception would not apply to crowdfunding.
438
15 U.S.C. § 78mm(a).
439
Investment Advisers Act of 1940 § 202(a)(11)(G), 15 U.S.C. § 80b2(a)(11)(G) (2006).
440
15 U.S.C. § 80b-6a.
437
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
89
the Senate. Thus, it is possible that there will soon be a
statutory crowdfunding exemption.
1. House Bill 2930
On November 3, 2011, the House passed House Bill 2930,
the Entrepreneur Access to Capital Act, introduced by
Congressman Patrick McHenry.441 The bipartisan 407–17
vote came shortly after the Obama administration released a
statement supporting the bill.442 The bill, which would add to
the Securities Act a new statutory exemption for crowdfunding, incorporates many of the policy recommendations
made in this article.443
House Bill 2930 allows sales of securities either directly
by the issuer or through intermediaries.444 Intermediaries
who meet the requirements of the exemption are protected
from treatment as brokers under the Exchange Act.445
The maximum offering amount allowed by the bill is $1
million, or $2 million if the issuer provides investors with
audited financial statements.446 The aggregate amount sold
to any investor in a twelve month period may not exceed the
lesser of $10,000 or 10% of the investor’s annual income.447
441
See Entrepreneur Access to Capital Act, H.R. 2930, 112th Cong.
(2011).
442
See Executive Office of the President, Statement of Administration
Policy (Nov. 2, 2011), available at www.whitehouse.gov/sites/default/files/
omb/legislative/sap/112/saphr2930r_20111102.pdf (“The Administration
supports House passage of H.R. 2930.”).
443
A draft of this article was publicly available on the Social Science
Research Network long before any of these bills was introduced. The
author had an extensive discussion with a member of Congressman
McHenry’s legislative staff after Congressman McHenry first introduced
his bill. The original bill was rather spartan; the bill that passed the
House added many of the provisions recommended in this article.
However, the author was not directly involved in drafting the bill.
444
H.R. 2930 § 2. Certain issuers are disqualified from using the
exemption. See id. § 2(d).
445
Id. § 2(b).
446
Id. § 2(a). These limits are for a twelve month period.
447
Id.
90
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
However, the issuer and any intermediary may rely on
investors’ self-certifications of income.448
Investors who purchase crowdfunded securities generally
may not resell them for one year, except in limited
circumstances.449
In addition, those investors are not
counted as record shareholders for purposes of Exchange Act
registration requirements.450
House Bill 2930 includes a number of disclosure-related
provisions.
To qualify for the exemption, issuers (or
intermediaries if the issuer is selling through an
intermediary) must451:
(1) warn investors about the speculative nature of
the securities, the risk of illiquidity, and the
restriction on resale;
(2) require investors to answer questions
demonstrating an understanding of the risk,
including the risk of illiquidity, and any other
matters that the SEC adds by rule;
(3) provide the SEC with limited information about
the intermediary, if one is used;
(4) provide the SEC and potential investors with
information about the issuer, its principals, the
purpose of the offering, the target offering amount,
and the deadline for reaching that amount;452 and
(5) when the offering is completed, provide the SEC
with a notice of the aggregate offering amount and
the number of purchasers.
If the offering is being made directly by the issuer, the
issuer must also disclose its interest in the offering.453 If an
intermediary is used, the intermediary must do a
448
Id. § 2(b).
Id.
450
Id. § 3.
451
See id. § 2(b).
452
Issuers may not draw on the pledged funds until investors have
pledged at least 60% of the target amount. Id. § 2(b).
453
Id.
449
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
91
background check on the issuer’s principals.454 The issuer or
the intermediary must also take “reasonable measures to
reduce the risk of fraud with respect to such transaction,”
although the bill provides no guidance as to what this
requires.455
The bill also includes several structural requirements.
Investors and issuers must be able to communicate with
each other on the web site used for the offering.456 The SEC
must be granted investor-level access to the site.457 Cashmanagement functions must be outsourced to a third-party
custodian, such as a registered broker-dealer or an insured
depository institution.458
The issuer or intermediary
(depending on whether it is a direct or intermediated
offering) must maintain such books and records as the SEC
deems appropriate.459 Finally, neither the issuer nor the
intermediary may offer investment advice.460
House Bill 2930 preempts state offering registration
requirements, but otherwise leaves state authority intact.461
In addition, the SEC must make the information it receives
pursuant to the exemption available to state securities
administrators.462
2. Senate Bill 1791
On November 2, 2011, Senator Scott Brown introduced
Senate Bill 1791, the Democratizing Access to Capital Act of
Senator Brown’s bill, like House Bill 2930,
2011.463
454
455
456
457
458
459
460
461
462
463
(2011).
Id.
Id.
Id.
Id.
Id.
Id.
Id.
Id. § 4.
Id. § 2.
Democratizing Access to Capital Act of 2011, S. 1791, 112th Cong.
92
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
incorporates
several
of
this
article’s
policy
recommendations.464
Senate Bill 1791, unlike House Bill 2930, would allow
offerings to be conducted only through a crowdfunding
intermediary.465 The annual offering amount would be
capped at $1 million, with individual investments limited to
$1,000 or less.466 To qualify for the exemption, issuers would
have to file such notice with the SEC as it shall require and
“disclose to investors all rights of investors, including
complete information about the risks, obligations, benefits,
history, and costs of offering.”467 As in House Bill 2930,
resale of crowdfunded securities would be restricted for one
year,468 and crowdfunded securities-holders would not count
as record shareholders for purposes of Section 12(g) of the
Exchange Act.469
Most of the conditions in Senate Bill 1791 are imposed on
crowdfunding intermediaries as requirements to obtain an
exemption from regulation as brokers.470
Some of the
disclosure-related requirements471 mirror those in House Bill
2930. The intermediary must:
(1) warn investors about the investments’ speculative
nature, the problem of illiquidity, and the one-year
restriction on resale;
(2) require every potential investor to answer
questions demonstrating competency as to the level
464
Id. § 2. The author had no direct contact with anyone on Senator
Brown’s staff prior to the introduction of his bill, and the author was not
involved in its drafting. The author has, however, had discussions with
several other Senate staff members.
465
Id. As in H.R. 2930, certain issuers would be disqualified from
using the exemption under disqualification provisions to be determined
from the SEC. Id.
466
Id.
467
Id.
468
Id.
469
Id. § 3.
470
Id. § 7.
471
See id. § 6.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
93
of risk, the risk of illiquidity, and other areas as
determined by the SEC;
(3) provide information to the SEC about the
intermediary and its employees; and
(4) provide a notice to the SEC that includes
information about the issuer, its principals, the
purpose of the offering, the intended use of proceeds,
and the target offering amount.
In addition, as in House Bill 2930, the intermediary must
do a background check on the issuer’s principals and take
“reasonable measures to reduce the risk of fraud.”472
Senate Bill 1791 also imposes various structural
requirements on crowdfunding intermediaries. They must473:
(1) be open to the public and provide investor-level
access to the SEC;
(2) provide public communication
investors and potential investors;
portals
for
(3) prohibit their employees from investing in the
offerings or having any financial interest in issuers
posting offerings;
(4) refrain from offering investment advice or
recommendations;
(5) require the issuer to state a target offering
amount and withhold funds from the issuer until at
least 60% of that target amount has been raised;
(6) outsource cash-management functions to a thirdparty custodian, such as a broker or an insured
depository institution;
(7) maintain such books and records as the SEC
requires; and
(8) provide a complaint-resolution mechanism for
investors.
472
473
Id. § 6.
Id.
94
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Senate Bill 1791 would preempt state offering
registration requirements.474 However, the issuer’s state of
organization and any state in which the purchasers of 50% or
more of the offering amount reside could still collect fees and
require that any documents filed with the SEC also be filed
with the state securities commission.475
3. Senate Bill 1970
On December 8, 2011, Senator Jeff Merkley introduced
Senate Bill 1970, the Capital Raising Online While
Deterring Fraud and Unethical Non-Disclosure Act of
2011.476 Senator Merkley’s bill also incorporates several of
the policy recommendations made in this article.477
Senate Bill 1970 requires that the securities be sold
through a broker or an intermediary that meets specific
criteria.478 The bill makes it very difficult for a non-broker to
facilitate crowdfunding. Non-broker intermediaries must
register with the SEC as “funding portals,”479 and are subject
to regulation by the SEC.480 These funding portals may not
solicit purchases or sales and may not handle investor funds
or securities.481 They also may not compensate employees or
third parties for solicitation or based on the sale of securities
Finally, funding portals may not offer
on the site.482
investment advice or recommendations to investors.483
474
Id. § 4.
Id. § 6.
476
Capital Raising Online While Deterring Fraud and Unethical NonDisclosure Act of 2011, S. 1970, 112th Cong. (2011).
477
The author had an extensive discussion with members of Senator
Merkley’s staff prior to the introduction of Senator Merkley’s bill.
However, the author was not directly involved in drafting the bill.
478
S. 1970 § 2.
479
Id.
480
Id. § 4.
481
Id.
482
Id.
483
Id.
475
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
95
Senate Bill 1970 caps the annual offering amount at $1
million,484 and also includes investor limits, but the investor
limits are more complicated than in the other bills. For a
single offering, the limit is the greater of $500 or an amount
that depends on the investor’s annual income.485 If the
investor’s annual income is between $50,000 and $100,000,
the limit is 1% of income.486 If the investor’s annual income
is more than $100,000, the limit is 2% of income.487 The bill
provides no alternative limit for investors whose income is
$50,000 or less, so presumably their investment limit is the
$500 alternative.
These limits are for a twelve-month period for a single
issuer.488 The bill also includes cumulative annual limits for
all crowdfunded offerings in which a given investor
participates.489 Crowdfunding intermediaries are required to
take such steps as the SEC deems appropriate to verify that
no investor has purchased securities from all crowdfunding
issuers that exceed the greater of $2,000 or an income-based
limit, in any twelve-month period.490 The income limit would
be 4% of income for those investors in the $50,000–$100,000
range and 8% of income for those with incomes greater than
$100,000.491
Senate Bill 1970 does not allow issuers to advertise their
offerings, except to direct people to the intermediary,492 and
also imposes fairly substantial filing and disclosure
requirements on issuers. Crowdfunding issuers must file
with the SEC, and must provide to investors and potential
investors, among other information493:
484
485
486
487
488
489
490
491
492
493
Id. § 2.
Id.
Id.
Id.
Id.
Id.
Id.
Id.
Id.
Id.
96
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
(1) the names of the issuer’s officers and directors,
and of persons owning more than 20% of the issuer’s
shares;
(2) a description of the business of the issuer and its
anticipated business plan;
(3) financial statements reviewed by an independent
public accountant, and audited for offerings of more
than $500,000;
(4) a description of the purpose of the offering and
the intended use of the proceeds; and
(5) “a description of the ownership and capital
structure of the issuer, how the securities being
offered are being valued, what the rights of the
securities are, and how rights may be exercised by
the issuer and shareholders.”494
Issuers must also provide investors and the SEC with
regular updates about the issuer’s progress toward meeting
the target offering amount, as well as quarterly reports on
operations and financial statements.495
Crowdfunding intermediaries, including brokers, must
also
meet
certain
disclosure-related
requirements.
Intermediaries must provide SEC-required disclosures and
investor education materials and must “ensure” that each
investor (1) reviews those materials; (2) “positively affirms”
her understanding that her entire investment is at risk and
that she could bear such a loss; and (3) answers questions
demonstrating an understanding of the risk, including the
risk of illiquidity, and such other matters as the SEC deems
appropriate.496 In addition, at least one month prior to any
offering, the intermediary must provide, in writing, to both
the SEC and investors, any information that has been
provided by the issuer pursuant to the issuer’s filing
requirements.497 Intermediaries are also required to take
494
495
496
497
Id.
Id.
Id.
Id.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
97
such measures as the SEC requires to reduce the risk of
fraud, including criminal background checks and securities
enforcement regulatory checks on the issuer’s officers and
directors, and on holders of more than 20% of the issuer’s
shares.498
Senate Bill 1970 includes a number of other structural
restrictions on intermediaries. Intermediaries may not allow
issuers to draw on offering funds until the capital
contributed by investors is equal to the target offering
amount, and must allow investors to cancel their
commitments to invest under rules to be adopted by the
SEC.499 The directors, officers, partners, and employees of an
intermediary may not have a financial interest in any of the
issuers using the intermediary.500 The intermediary may not
compensate promoters, finders, or others for finding
potential investors.501 Finally, intermediaries must take
steps to protect investors’ privacy, as mandated by SEC
rules.502
Senate Bill 1970 adds a miscellany of other conditions.
Certain issuers, brokers, and other intermediaries are
disqualified from using the exemption.503
Resales are
restricted for two years, with certain exceptions.504 The SEC
is allowed, but not required, to exclude crowdfunding
investors from the calculation of record shareholders for
purposes of Section 12(g) of the Exchange Act.505 Senate Bill
1970 also requires the SEC to periodically review the
exemption’s effects on investor protection.506 Furthermore,
the bill adds a special liability provision making
498
499
500
501
502
503
504
505
506
Id.
Id.
Id.
Id.
Id.
Id.
Id.
Id.
Id. § 5.
98
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
crowdfunding issuers and their officers and directors liable
for materially false and misleading statements.507
Unlike the other bills, Senate Bill 1970 does not preempt
state securities law. It does, however, require that the SEC
make the information it receives pursuant to the exemption
available to state securities regulators.508
VI. THE COSTS AND BENEFITS OF A
CROWDFUNDING EXEMPTION
A crowdfunding exemption, like any securities law
exemption, requires a complicated balancing of two
sometimes conflicting goals: investor protection and capital
formation.509 The SEC has long seen its mission as “investor
protection in the sense of remedying information
asymmetries and rooting out fraud,”510 but all of the SEC’s
foundational statutes require it to consider, “in addition to
the protection of investors, whether the . . . [SEC’s] action
will
promote
efficiency,
competition,
and
capital
formation.”511 Balancing those competing interests is “a
fundamental challenge of securities regulation,”512 and the
507
Id. § 2.
Id.
509
See generally C. Steven Bradford, Transaction Exemptions in the
Securities Act of 1933: An Economic Analysis, 45 EMORY L.J. 591 (1996)
[hereinafter Bradford, Transaction Exemptions] (discussing the costs and
benefits of registration and the justifications for exemptions from the
registration requirement).
510
Troy A. Paredes, On the Decision to Regulate Hedge Funds: The
SEC’s Regulatory Philosophy, Style, and Mission, 2006 U. ILL. L. REV. 975,
1005 (2006). See also Stephen Choi, Regulating Investors, Not Issuers: A
Market-Based Proposal, 88 CALIF. L. REV. 279, 280 (2000) (“Securities
regulation in the United States revolves around investor protection.”).
511
Investment Advisers Act of 1940 § 203(c), 15 U.S.C. § 80b-2(c)
(2010); Investment Company Act of 1940 § 2(c), 15 U.S.C. § 80a-2(c)
(2010);. Securities Act of 1933 § 2(b), 15 U.S.C. § 77(b) (2010); Securities
Exchange Act of 1934 § 3(f), 15 U.S.C. § 78c(f) (2010).
512
Paredes, supra note 510, at 1005.
508
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
99
SEC usually tilts the balance in favor of investor
protection.513
A crowdfunding exemption would undoubtedly facilitate
capital formation.
Very small businesses, particularly
startups, have an unmet need for capital that securities
crowdfunding would help to meet.
The investor-protection consequences of a crowdfunding
exemption, however, are less clear.
Small business
investments are inherently risky, posing not only greater
risks of business failure, but also of fraud and overreaching
by controlling entrepreneurs. A crowdfunding exemption
would expose members of the general public to those risks
without ensuring that they have the financial sophistication
necessary to deal with them. The structure of crowdfunding
might, to some extent, ameliorate those risks, but investors
would still face a significant chance of loss.
But this risk of loss is inherent in small business
startups. The only way to completely eliminate it would be
to bar small business financing altogether. Crowdfunding
exemption proposals are structured so that losses to any
single investor would be relatively small and bearable.
Moreover, the public is already contributing billions of
dollars to non-securities crowdfunding, and those
crowdfunding investments are subject to the same risks as
securities crowdfunding.
A securities crowdfunding
exemption would, therefore, not open investors to new risks,
but merely allow entrepreneurs to offer a higher return to
offset those risks.
The net effect on investors could,
therefore, be positive.
513
Id. at 1006.
According to Paredes, now himself an SEC
commissioner, securities regulators “have an exaggerated concern over
fraud and investor losses and, at least by comparison, a dulled sensitivity
to the costs of greater investor protection.” Id. at 1009. Recently, several
of the SEC’s rules have been overturned because of the Commission’s
failure to adequately consider the cost of the rules. See Bus. Roundtable v.
SEC, 647 F.3d 1144 (D.C. Cir. 2011); Am. Equity Inv. Life Ins. Co. v. SEC,
613 F.3d 166 (D.C. Cir. 2010); Chamber of Commerce v. SEC, 443 F.3d 890
(D.C. Cir. 2006); Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir.
2005).
100
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
A. Capital Formation: The Need for a Crowdfunding
Exemption
Small businesses face a capital funding gap.514 Some
estimates indicate that the financial markets fall $60 billion
short each year “in meeting the demand of small companies
for early-stage private equity financing.”515 Equity capital is
“widely viewed as less accessible and more costly per dollar
raised for small businesses compared with large
businesses.”516 Finding funding is particularly difficult for
businesses seeking to raise funds in the $100,000 to $5
million range.517
Many entrepreneurs with promising
projects may go unfunded as a result, costing the United
States an unknown number of jobs and innovations.518
Early-stage entrepreneurial activity in the United States is
steadily declining, and the United States has lost its lead
over other innovation-driven economies.519
514
See Cable, supra note 254, at 108; Jill E. Fisch, Can Internet
Offerings Bridge the Small Business Capital Barrier?, 2 J. SMALL &
EMERGING BUS. L. 57, 59–64 (1998); Darian M. Ibrahim, The (Not So)
Puzzling Behavior of Angel Investors, 61 VAND. L. REV. 1405, 1417 (2008).
515
Sjostrom, supra note 198, at 3.
516
GAO Report, supra note 200, at 2. See also Fisch, supra note 514,
at 63 (small business funding “is often viewed as inadequate”); Sjostrom,
supra note 198, at 586 (financing options available to small companies “are
generally viewed as inadequate”).
517
Ibrahim, supra note 514, at 1417 (amounts above $100,000); GAO
Report, supra note 200, at 12–13 ($250,000–$5 million); Cable, supra note
254, at 108 ($500,000–$5 million).
518
Curtis J. Milhaupt, The Small Firm Financing Problem: Private
Information and Public Policy, 2 J. SMALL & EMERGING BUS. L. 177, 178
(1998); Sjostrom, supra note 198, at 3.
519
Abdul Ali et al., 2009 National Entrepreneurial Assessment for the
United States of America: Executive Report, GLOBAL ENTREPRENEURSHIP
MONITOR, 2009, at 1, 7, http://www.gemconsortium.org/docs/download/666
[hereinafter National Entrepreneurial Assessment]. The amount of total
early-stage entrepreneurial activity in the United States dropped from
10.6% in 2005 to 6.9% in 2009. Id. at 7. Nascent entrepreneurial activity
declined from 8.7% of the U.S. population in 2005 to 4.9% in 2009. Id. at
33.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
101
The small business financing problem has at least two
causes. The first cause is informational inefficiency—a
failure to match potential sources of capital with potential
investment opportunities.520 Even if money is available, it
will not be utilized if the entrepreneur who needs it fails to
connect with the investors who have it. Not surprisingly,
investments by the major sources of small business capital
tend to be concentrated in certain geographical areas, such
as Silicon Valley.521 Crowdfunding allows an entrepreneur to
publish her request for funding to the entire world,
“mak[ing] it . . . easier to harness spare capital and route it
to those who need it most.”522
The second element of the capital gap is the
unavailability of traditional sources of small business
financing—bank lending, venture capitalists, and angel
investors—to most startups and other very small businesses.
Entrepreneurs typically begin new ventures using personal
funds, including savings, credit card debt, second mortgages,
and money from friends and family.523 Some entrepreneurs
might raise $100,000, or even $500,000, from those personal
sources,524 but many entrepreneurs with good ideas,
particularly those who are not in the upper and middle
classes, have very little access to funds.
520
Sjostrom, supra note 198, at 3–4.
See GAO Report, supra note 200, at 3 (venture capitalists); SIMON
C. PARKER, THE ECONOMICS OF ENTREPRENEURSHIP 249–50 (2009) (angel
investors).
522
HOWE, supra note 1, at 248. A study of Dutch crowdfunding site
Sellaband found that only 13.5% of successful crowdfunders’ capital came
from investors within fifty kilometers of the entrepreneur. Almost 40% of
the amounts received came from investors more than 3,000 kilometers
away. Ajay Agrawal, Christian Catalini & Avi Goldfarb, The Geography of
Crowdfunding 22 tbl. 2a (NET Institute Working Paper No. 10-08, 2011),
available at http://ssrn.com/abstract=1692661.
523
Fisch, supra note 514, at 60; National Entrepreneurial Assessment,
supra note 519, at 8; Sjostrom, supra note 198, at 5. See also PARKER,
supra note 521, at 250 (“Families are the most commonly used source of
business loans in the USA after banks and other financial institutions.”).
524
See Cable, supra note 254, at 108; Ibrahim, supra note 514, at
1417.
521
102
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Furthermore, when those personal resources are
exhausted, funding is difficult to find. Other common
sources of business financing are not available to small
startups. Bank loans are one possible source of capital, but
most small startups do not have the collateral, the cash flow,
or the operating history to qualify for bank loans in the
amount needed.525
Venture capital funds are another possible source of
funding,526 but venture capitalists tend to focus on companies
that have passed the initial startup phase and are seeking to
grow further.527 Less than a quarter of venture capital
investments are for early-stage funding.528 Venture capital
funding is also not available in the relatively small amounts
that new companies need,529 and the problem is worsening as
the average minimum amount invested by venture capital
funds increases.530 A typical venture capital investment
averages between $2 million and $10 million.531 Venture
capitalists sometimes provide smaller amounts,532 but high
transaction costs usually make smaller investments
impractical.533 These investments also tend to focus on
specific industries534 and on firms with potential for rapid
525
See Cable, supra note 254, at 121; George W. Dent, Jr., Venture
Capital and the Future of Corporate Finance, 70 WASH. U. L. Q. 1029, 1032
(1992); Fisch, supra note 514, at 60; Sjostrom, supra note 198, at 5.
526
For a good, short introduction to the venture capital industry, see
Cable, supra note 254, at 112–15.
527
Fisch, supra note 514, at 62; Ibrahim, supra note 514, at 1416.
528
GAO Report, supra note 200, at 21.
529
See id. at 3. See also Cohn & Yadley, supra note 11, at 80–81;
Ibrahim, supra note 514, at 1416.
530
GAO Report, supra note 200, at 13. One source claims that the
total amount of venture capital funding has also declined recently, from
$106 billion in 2000 to $40 billion in 2001 and $30.5 billion in 2007.
PARKER, supra note 521, at 238.
531
Ibrahim, supra note 514, at 1416.
532
See GAO Report, supra note 200, at 11 (amounts ranging from
$250,000 to $5 million).
533
Dent, supra note 525, at 1080.
534
GAO Report, supra note 200, at 3.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
103
growth.535 Furthermore, venture capitalists are extremely
selective, rejecting 99% of the business plans submitted to
them.536
So-called “angel investors,” wealthy individuals with
substantial business and entrepreneurial experience,537 are
the other major possibility for initial funding.
Angel
investors often invest on a smaller scale than venture capital
firms,538 and they are usually more willing to invest in
startup companies.539 A typical financing round for an angel
investor ranges from $100,000 to $2 million.540 Some angel
investors may be willing to provide as little as $25,000,541 but
one source indicates that the minimum deal size for most
angel investors in the United States is about $1 million.542
Also, like venture capitalists, angel investors generally look
for “high-growth, high-return investment opportunities,”543 so
many small companies would not qualify. Angel investors by
themselves are not currently filling the small business
funding gap.544
Crowdfunding makes new sources of capital available to
small businesses.545 It opens business investment to smaller
535
Fisch, supra note 514, at 62; GAO Report, supra note 200, at 10.
Fisch, supra note 514, at 20; GAO Report, supra note 200, at 20.
537
Sjostrom, supra note 198, at 5.
538
Cable, supra note 254, at 115; Fisch, supra note 514, at 62.
539
GAO Report, supra note 200, at 10; Ibrahim, supra note 514, at
1406. According to Amatucci and Sohl, the percentage of angel deals
involving the seed and startup stages of business was 45% in 2004, 52% in
2003, and 50% in 2002. F. M. Amatucci & J. E. Sohl, Business Angels:
Investment Processes, Outcomes and Current Trends, in A. ZACHARAKIS &
S. SPINELLI, JR., 2 ENTREPRENEURSHIP: THE ENGINE OF GROWTH 87, 88
(2007).
540
Ibrahim, supra note 514, at 1418; Sjostrom, supra note 198, at 6.
See also Amatucci & Sohl, supra note 539, at 88 (average angel investment
of $470,000 in 2004).
541
GAO Report, supra note 200, at 10.
542
PARKER, supra note 521, at 249.
543
GAO Report, supra note 200, at 10.
544
See generally Cable, supra note 254 (suggesting regulatory changes
to enable more angel investing).
545
See Heminway and Hoffman, supra note 142, at 931 (arguing that
crowdfunding “enables entrepreneurs to more quickly and easily identify
536
104
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
investors who have not traditionally participated in private
securities offerings. Those investors have less money to
invest, so they would be willing to fund smaller business
opportunities that the venture capitalists and angel
investors would not touch. Crowdfunding also gives poorer
entrepreneurs whose friends and family lack the wealth to
provide seed capital somewhere else to turn.
But what about the other benefits that venture capitalists
and angel investors provide to small business entrepreneurs?
In addition to the capital they invest, venture capitalists and
angel investors typically provide companies with managerial
and monitoring services.546 If startups turn to passive,
unsophisticated public investors, they will not receive the
collateral services provided by sophisticated venture
capitalists and angel investors.547 However, crowdfunding is
not a substitute for venture capital or angel investing; it is
aimed at entrepreneurs who do not have access to such
funding.
The entrepreneurs most likely to engage in
crowdfunding would not, in any event, have access to the
other services that venture capitalists and angel investors
provide.
Crowdfunding is not a panacea for small businesses’
financing issues. It will not completely eliminate the capital
gap. It will, however, open investment to new sources of
capital and provide a platform that allows investors with
unused capital to connect with entrepreneurs who need it.
B. Investor Protection: The Effects of Crowdfunding on
Investors
Crowdfunding sites make it possible for relatively
unsophisticated members of the general public to invest in
particularly risky ventures. Investor protection is, therefore,
supporter-investors who are willing and able to fund their businesses or
projects”).
546
PARKER, supra note 521, at 239–40; Fisch, supra note 514, at 84;
Ibrahim, supra note 514, at 1419; GAO Report, supra note 200, at 11.
547
See Fisch, supra note 514, at 86 (arguing that if angel investor
funding were “replaced by dispersed passive public investors, the
collateral monitoring and managing services are likely to be eliminated”).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
105
an important issue. A crowdfunding exemption, properly
structured, can ameliorate some, but not all, of the risk. But
investments in small businesses, whether or not those
investments are facilitated through crowdfunding, are
inherently risky.
Crowdfunding possesses no magical
properties that prevent investors from losing money just like
other investors.
However, at the margin, the cost to investors of a
crowdfunding exemption is likely to be low. Investors are
already contributing substantial amounts of money to
unregulated crowdfunding offerings, although not for
securities. Those crowdfunding investments are subject to
the same risk of loss as crowdfunded securities, but do not
offer the upside potential of a securities investment.
Allowing crowdfunding entrepreneurs to sell securities
would, therefore, be a net gain to investors, increasing the
possibility of gains without any increase in the risk.
1. The Risks of Small Business Investment
Investing in small businesses is very risky. Small
business investments are illiquid, and small businesses,
especially startups, are much more likely to fail than are
more established companies.548 Losses due to fraud and selfdealing are also much more likely.549
Small business investments expose investors to a
disproportionate risk of fraud.550 The abuses in the penny
stock market in the 1980s “typify the securities fraud
potential associated with direct marketing of microcap
securities to individual investors.”551 The SEC’s experience
when it eased the requirements of the Rule 504 small
offering exemption in the 1990s also illustrates the potential
fraud associated with unregulated small offerings. The
changes freed Rule 504 offerings from federal mandatory
disclosure requirements even when those offerings were not
548
549
550
551
Id. at 58. See also Sjostrom, supra note 198, at 586.
Fisch, supra note 514, at 58; Sjostrom, supra note 198, at 586.
Fisch, supra note 514, at 58; Sjostrom, supra note 198, at 586.
Fisch, supra note 514, at 82.
106
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
registered at the state level. In New York, which has no
state registration requirement, “Rule 504 was being used by
nefarious promoters to distribute up to $1 million of
securities in New York to a select favored group, followed
promptly by boiler-room promotions that artificially drove up
the secondary market price until such time as the initial
purchasers could sell their shares at a handsome profit,
leaving the gullible crop of new investors with suddenly
deflated shares and irrecoverable losses.”552
Even absent fraud, investors in small businesses must
deal with the potential agency costs and problems of
opportunism that arise from uncertainty and information
asymmetry.553 Uncertainty is inherent in startup businesses.
At the time of investment, “virtually all of the important
decisions bearing on the company’s success remain to be
made, and most of the significant uncertainties concerning
the outcome of the company’s efforts remain unresolved.”554
Entrepreneurs typically have a business plan laying out a
strategy but, at the startup phase, that plan is little more
than a “best guess.”555 At that point, many major strategic
decisions remain to be made556, and they will be made by a
management whose quality is unknown to investors.557 The
entrepreneur’s intentions and abilities are both “not easily
observable by an investor and difficult for an entrepreneur to
communicate credibly.”558 In the case of high-technology
companies, there may also be uncertainties about the
technology itself, including whether the product works and
552
Cohn & Yadley, supra note 11, at 71–72. See also Revision of Rule
504 of Regulation D, the “Seed Capital” Exemption, Securities Act Release
No. 7644, 1999 WL 95490, at *2 (Feb. 25, 1999).
553
See Cable, supra note 254, at 121–22 (2010); Ronald J. Gilson,
Engineering a Venture Capital Market: Lessons from the American
Experience, 55 STAN. L. REV. 1067, 1076–77 (2003); Ibrahim, supra note
514, at 1407.
554
Gilson, supra note 553.
555
Cable, supra note 254, at 121–22.
556
Id. at 122.
557
Gilson, supra note 553, at 1077.
558
Cable, supra note 254, at 122. See also Gilson, supra note 553, at
1077.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
107
can be viably and widely adopted. The entrepreneur is
almost certain to understand those issues better than most
investors.559
In short, the entrepreneur holds all the cards. Investors
have little information about what is to come and little
control over what the entrepreneur does. This presents
entrepreneurs with opportunities for self-dealing, excessive
compensation, misuse of corporate opportunities, and
dilution of investors’ interests—issues similar to those faced
by investors in closely-held corporations.560
Sophisticated venture capital funds deal with these
problems by negotiating control rights and negative
covenants requiring investor approval for certain actions.561
Staged financing complements these protections.562
Entrepreneurs and investors “recognize that the company
will need additional rounds of financing” requiring the
cooperation of the venture capitalists.563 The need to go back
to investors for future funding should constrain self-dealing,
opportunistic behavior by the entrepreneur.
Most crowdfunding investors will not have the
sophistication to understand the need for or benefits of
control rights or protective covenants. Even if they were
sophisticated enough to seek such protection, it is unclear
how they would negotiate for it, or whether it would be worth
their effort.
The small amount invested by each
crowdfunding investor and the remote, impersonal nature of
crowdfunding preclude any meaningful negotiations.564
559
Gilson, supra note 553, at 1077.
See Dent, supra note 525, at 1052–57.
561
See Dent, supra note 525, at 1035, 1044–61; Gilson, supra note 553,
at 1074; Ibrahim, supra note 514, at 1407.
562
Gilson, supra note 553, at 1074.
563
Dent, supra note 525, at 1065.
564
Belleflamme et al., supra note 10, at 26–27 (“From a more general
perspective, crowdfunding practices raise questions with respect to
corporate governance and investor protection issues if most individuals
only invest tiny amounts. Crowdfunders are most likely offered very little
investor protection. This may lead to corporate governance issues, which
in turn may turn into reputation concerns if some cases of fraud or bad
governance are uncovered. Crowdfunders have very little scope to
560
108
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Even in the absence of fraud or self-dealing, many
crowdfunded small businesses will fail. The small startups
to which crowdfunding appeals pose a disproportionate risk
of business failure.565 Approximately 80% of new businesses
“either fail or no longer exist within five to seven years of
formation . . . .”566 Even the small businesses selected for
investment by sophisticated venture capital funds are
predominantly failures. One-third of those companies end
up in bankruptcy, while another third meet their expenses
but are unable to go public or pay significant dividends.567
Investors in startups also face liquidity risk, because
there is no ready public market in which to resell their
investments.568 Crowdfunding sites will not provide such a
trading market because, if they did, they would risk having
to register as exchanges or alternative trading systems.569
Therefore, crowdfunding investors may have to wait quite
some time to realize any return.570
Some existing
crowdfunding sites require repayment within a few years,571
which limits the illiquidity problem but may exacerbate the
risk of business failure because entrepreneurs could be
forced to repay investments before their business has
intervene to protect their interests as stakeholders. Moreover, the fact
that their investment is small is likely to create a lack of incentive to
intervene.”).
565
See Fisch, supra note 514, at 58; Howard M. Friedman, On Being
Rich, Accredited, and Undiversified: The Lacunae in Contemporary
Securities Regulation, 47 OKLA. L. REV. 291, 306 (1994); Sjostrom, supra
note 198, at 586.
566
GAO Report, supra note 200, at 19.
567
Dent, supra note 525, at 1034. See also GAO Report, supra note
200, at 19 (“[O]nly about ten percent of venture capital investments meet
their expected rate of return.”).
568
Cable, supra note 254, at 122; Fisch, supra note 514, at 79.
569
Crowdfunding sites that facilitate resales would bring together
multiple buyers and sellers, increasing the likelihood that they would be
exchanges. See supra Part IV.A.
570
See Cable, supra note 254, at 122 (An investor in a startup “can
expect to wait more than five years for any return on the investment.”).
571
See, e.g., Prosper Registration Statement, supra note 81, at 4
(three-year notes); Lending Club Registration Statement, supra note 81, at
3 (three-year notes); Lang, supra note 106 (maximum of five years).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
109
developed sufficiently to do so. And, if startups take time to
become profitable, such short repayment periods may
preclude meaningful profit-sharing.
2. The Financial Sophistication of the Crowd
The risks associated with crowdfunding ventures would
be a less significant concern if crowdfunding investors were
sophisticated enough to protect themselves.
But
crowdfunding is open to the general public, and many
members of “the crowd” are not that financially wellinformed.572 In one study, 34% of American adults gave
themselves a “C” grade or below on their knowledge of
personal finance, and only 22% awarded themselves an
572
Annamaria Lusardi & Olivia Mitchell, Financial Literacy and
Retirement Planning: New Evidence from the Rand American Life Panel 4
(Michigan Retirement Research Center, Working Paper 2007-157, 2007),
available at http://ssrn.com/abstract=1095869 (“Financial literacy surveys
in many developed nations show that consumers are poorly informed
about basic economic and financial concepts.”). See also B. Douglas
Bernheim, Financial Illiteracy, Education, and Retirement Savings, in
LIVING WITH DEFINED CONTRIBUTION PENSIONS: REMAKING RESPONSIBILITY
FOR RETIREMENT 38, 42 (Olivia S. Mitchell & Sylvester J. Schieber, eds.,
1998) (“Collectively, existing studies paint a rather bleak picture of
Americans’ economic and financial literacy.”).
For specific survey results, see APPLIED RESEARCH & CONSULTING LLC,
FINANCIAL CAPABILITY IN THE UNITED STATES: INITIAL REPORT OF RESEARCH
FINDINGS FROM THE 2009 NATIONAL SURVEY (Dec. 1, 2009), available at
http://www.finrafoundation.org/web/groups/foundation/@foundation/docum
ents/foundation/p120536.pdf; NAT’L COUNCIL ON ECON. EDUC., WHAT
AMERICAN TEENS AND ADULTS KNOW ABOUT ECONOMICS (Apr. 26, 2005),
available at http://www.councilforeconed.org/cel/WhatAmericansKnowAbo
utEconomics_042605-3.pdf; NAT’L FOUND. FOR CREDIT COUNSELING, THE
2010 CONSUMER FINANCIAL LITERACY SURVEY: FINAL REPORT (Apr. 2010),
available at www.nfcc.org/newsroom/FinancialLiteracy/files2010/2010Con
sumerFinancialLiteracySurveyFinalReport.pdf; Bernheim, supra note 572;
Marianne A. Hilgert, Jeanne M. Hogarth & Sondra G. Beverly, Household
Financial Management: The Connection Between Knowledge and Behavior,
Federal Reserve Bulletin 309 (July 2003); Annamaria Lusardi, Financial
Literacy: An Essential Tool for Informed Consumer Choice?, 26–30 (Paolo
Baffi Centre Research Paper No. 2009-35, June 2008), available at http://
ssrn.com/abstract=1336389; Lusardi & Mitchell, supra note 572, at 26–30.
110
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
“A.”573 Self-assessment is probably not the best way to
measure financial knowledge, but people’s self-assessments
are strongly correlated with their actual financial
knowledge.574
Many Americans are not financially literate. In a survey
of 3,512 adults and 2,242 high school students in 2005, only
17% of the adults and 3% of the students scored an “A” on a
twenty-four-question financial literacy quiz.575
Sixty-six
percent of the adults and 91% of the students had grades of
“C” or worse.576
In 2009, respondents in a survey of
American adults answered an average of only 2.72 out of 5
financial literacy questions correctly.577 Forty-eight percent
of those respondents did not understand that investing in a
mutual fund generally provides a safer return than investing
in a single stock.578 Thirty-five percent missed a very simple
question about calculating compound interest.579 Seventynine percent did not understand the relationship between
573
NAT’L FOUND. FOR CREDIT COUNSELING, supra note 572, at 9. But
see APPLIED RESEARCH & CONSULTING LLC, supra note 572, at 37 (70% of
American adults rated their overall financial knowledge in the top three
levels on a seven-point scale. Only 13% put themselves in the bottom
three levels.)
574
Bernheim, supra note 572, at 48.
575
NAT’L COUNCIL ON ECON. EDUC., supra note 572, at 44.
576
Id. There was a positive correlation between students’ grade level
and their scores, indicating that the students were learning over time. Id.
at 48.
577
APPLIED RESEARCH & CONSULTING LLC, supra note 572, at 41.
578
Id. at 40. See also NAT’L COUNCIL ON ECON. EDUC., supra note 572,
at 42 (only 44% of adults and 15% of high school students understood that
diversification was a reason for preferring mutual funds to individual
stocks).
579
APPLIED RESEARCH & CONSULTING LLC, supra note 572, at 39. See
also Bernheim, supra note 572, at 44 (in a 1993 survey of American adults
aged twenty to forty-seven, nearly one-third indicated that $1,000 left in
the bank for thirty years with compound interest of 8% would earn less
than $5,000; the correct answer is more than $10,000); Lusardi & Mitchell,
supra note 572, at 21 (in a survey of American adults, only 75% correctly
answered a multiple-choice question about compound interest).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
111
interest rates and bond prices.580 Another survey asked
Americans aged fifty or older three questions about
compound interest, the relationship between investment
return and inflation, and the value of diversification.581 Only
one-third of the respondents were able to answer all three
questions correctly.582
This financial ignorance extends beyond general
principles of finance to more specific questions about
economic facts.
In a 2001 survey, only 52% of the
respondents knew that mutual funds do not pay a
guaranteed rate of return; only 33% knew that not all
investment products purchased at a bank are federally
insured; and only 56% knew that, over the long term, stocks
offer the highest rate of return.583
Still, the numbers are not totally disheartening. A large
percentage of American adults do get many basic financial
literacy questions right.584 In one recent survey, two-thirds
of the respondents correctly answered most basic questions
about the function of stock markets, mutual funds,
diversification, and risk.585 However, these respondents were
relatively highly-educated and wealthy, so the results
580
APPLIED RESEARCH & CONSULTING LLC, supra note 572, at 38. See
also Lusardi & Mitchell, supra note 572, at 22 (noting that, in a survey of
American adults, only 37% knew the relationship between bond prices and
interest rate.).
581
See Lusardi, supra note 572, at 5. The questions were as follows:
(1) Suppose you had $100 in a savings account and the interest rate was
2% per year. After 5 years, how much do you think you would have in the
account if you left the money to grow: more than $102, exactly $102, less
than $102? (2) Imagine that the interest rate on your savings account was
1% per year and inflation was 2% per year. After 1 year, would you be
able to buy more than, exactly the same as, or less than today with the
money in this account? (3) Do you think that the following statement is
true or false? “Buying a single company stock usually provides a safer
return than a stock mutual fund.”
582
Id. at 6.
583
Hilgert et al., supra note 572, at 313.
584
See Lusardi & Mitchell, supra note 572, at 21.
585
See Lusardi, supra note 572, at 8–10, 26.
112
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
probably “overstate the level of financial literacy in the
general population.”586
The precise numbers are irrelevant, however. It is clear
that a significant portion of the American public lacks basic
financial literacy. Since crowdfunding sites are usually open
to the general public, at least some of the people investing in
crowdfunding offerings will not have the basic financial
knowledge required to understand the risks.
3. Crowdfunding and Small Business Investment
Risk
Crowdfunding offers relatively risky investments to
relatively unsophisticated investors. Some of its features
may reduce the risk of loss, and a crowdfunding exemption
could be structured to provide additional investor protection.
But, no matter how an exemption is framed, many
crowdfunding investors will lose money.
The risks
associated with crowdfunding cannot be completely
eliminated.
Consider first the effect of crowdfunding on the risk of
fraud. No matter how the exemption is structured, there will
be fraud. “[N]o amount of technical exemption requirements
will hinder the fraud artists from their endeavors.”587 But, of
course, registration itself does not completely eliminate
fraud. The question is a comparative one: whether Internetbased crowdfunding will increase the incidence of fraud, and,
if so, by how much.
Paul Spinrad, who proposed the first crowdfunding
exemption, argues that fraudsters will not find crowdfunding
appealing because of the small amounts involved and the
open, public nature of crowdfunding.588 It is not clear if that
586
Lusardi & Mitchell, supra note 572, at 5.
Cohn & Yadley, supra note 11, at 72.
588
Scott Shane, Let the Crowd Buy Equity in Private Companies,
BLOOMBERG BUSINESSWEEK, May 3, 2011, available at http://www.
businessweek.com/smallbiz/content/may2011/sb2011052_710243.htm. See
also SBE Council Proposal, supra note 247, at 4 (arguing that the
companies that would use its proposed rule “are small enough and
transparent enough to prevent fraud”).
587
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
113
is true. On the one hand, the Internet allows fraudulent
offerings to be distributed widely at low cost,589 so
crowdfunding sites are an obvious target for fraudsters. On
the other hand, fraud is “more detectable on the Internet,”590
especially when it must be mediated through an independent
crowdfunding site that is open to the public. The net effect is
indeterminate. However, it is important to remember that a
crowdfunding exemption would not legitimize fraud or
protect fraudulent offerings from the antifraud rules in the
securities statutes. The SEC and private parties would still
have the usual remedies for any fraud.
The crowdfunding structure does have some features that
could help limit some of the risks of investing in small
business ventures. First, like venture capital, crowdfunding
sometimes involves staged financing.591 The need to come
back for additional funds could moderate entrepreneur
behavior, especially if prior-round investors are able to
comment publicly on the crowdfunding site about the
entrepreneur’s behavior.
Second, investors could use
crowdfunding discussion boards to point out problems with
proposed ventures, to coax concessions from entrepreneurs
prior to investing, and to monitor investments after they
invest. Lenders on peer-to-peer (“P2P”) lending sites “show a
remarkable propensity to shoulder the burden of monitoring
underlying loan debts. Web forums and message boards are
replete with the adventures of [a] P2P lender qua detective,
ferreting out frauds that have been overlooked by the
platform.”592
589
Fisch, supra note 514, at 58.
Id. at 81.
591
See, e.g., Frequently Asked Questions (FAQs), INDIEGOGO,
http://www.indiegogo.com/about/faqs (last visited Mar. 5, 2012) (indicating
that fundraising can be continued after the close of a campaign by starting
a new campaign); Creating a Project, KICKSTARTER, http://www.
kickstarter.com/help/faq/creating%20a%20project#StarAProj (discussing
splitting funding for a project into stages). See also LAWTON & MAROM,
supra note 2, at 112 (noting that with crowdfunding, the discrete rounds of
financing are being replaced with the “rolling close,” which provides
continuous funding).
592
Verstein, supra note 12, at 15.
590
114
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
Under the right conditions, crowdfunding could benefit
from “the wisdom of crowds,”593 the notion that “even if most
of the people within a group are not especially well-informed
or rational . . . [the group] can still reach a collectively wise
decision.”594
The knowledge gap that once separated
professionals from the general public has shrunk as
information has become more readily accessible through the
Internet.595
Moreover, investment expertise does not
necessarily translate into success, and experts often make
extraordinarily poor judgments.596 One of the lessons of
crowdsourcing is that a diverse group of less-expert decisionmakers can often make better choices than an expert
working individually.597
It is at least possible that
crowdfunding investors will do a better job compared to
venture capitalists and angel investors than their relative
lack of sophistication would predict.598
Additionally, unsophisticated crowdfunding investors are
likely to become more sophisticated over time.599 A study of
593
See SUROWIECKI, supra note 123.
Id. at xiii–xiv.
595
See HOWE, supra note 1, at 39–40.
596
See DAN GARDNER, FUTURE BABBLE: WHY EXPERT PREDICTIONS ARE
NEXT TO WORTHLESS (2011). James Surowiecki quotes Wharton professor
J. Scott Armstrong, who surveyed expert forecasts and analyses in a
number of fields and concluded that he “could find no studies that showed
an important advantage for expertise.” SUROWIECKI, supra note 123, at 33.
597
See HOWE, supra note 1, at 131–45.
598
Even so, crowdfunding investors may not necessarily enjoy higher
investment returns. Venture capital funds and angel investors are highly
selective, and venture capitalists especially tend to focus on larger, highgrowth companies that are past the startup phase. See supra Part VI.A.
Crowdfunding sites appeal to entrepreneurs who cannot otherwise obtain
adequate funds—those, in other words, who could not attract funding from
venture capitalists and angel investors. Even if crowdfunding investors
are better at discriminating among available investments, they are
picking from a different, more risky pool than venture capitalists and
angel investors.
599
See Seth Freedman & Ginger Zhe Jin, Do Social Networks Solve
Information Problems for Peer-to-Peer Lending?
Evidence From
Prosper.com 3 (Net Inst., Working Paper No. 08-43, 2008), available at
http://ssrn.com/abstract=1304138 (“[M]any Prosper lenders make mistakes
594
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
115
lenders on Prosper.com found that, over the two-year period
studied, lenders moved from lower-performing loans to loans
with a higher rate of return.600 However, crowdfunding is
still relatively young and has not been exhaustively studied.
Only more experience will demonstrate its success in
protecting investors from risk.
Critics have argued that a crowdfunding exemption will
result in increased fraud and investor losses.601
This
argument is overstated. It supposes a horde of bicephalous
con men eager to violate the antifraud rules but unwilling to
violate the offering registration requirements. It is unlikely
that fraudsters are so selective in their willingness to violate
the law.
Nevertheless, the argument that fraud and investors’
losses will increase is surely correct. The investors on
crowdfunding sites, like other small-business investors, will
suffer significant losses.602 Fraudsters will use crowdfunding
sites to deceive investors and take their money.
Entrepreneurs will take advantage of their control to benefit
themselves at the expense of outside investors.
Unsophisticated investors will make ill-advised investments.
But the argument that fraud and investor losses will
increase is trivial. More securities offerings of any kind—
whether those offerings are registered, pursuant to a
crowdfunding exemption, or pursuant to some other
exemption—are going to result in more fraud and greater
in loan selection and therefore have a negative rate of return on their
portfolios, but they learn vigorously and the learning speeds up over
time.”).
600
Freedman & Jin, supra note 599, at 25.
601
See, e.g., Jay Hancock, Businesses Also Seek “Crowdfunding,” so
Watch Out, BALT. SUN, Nov. 14, 2011, available at http://articles.baltimore
sun.com/2011-11-14/business/bs-bz-hancock-crowdfunding-danger-2011111
2_1_small-business-crowdfunding-business-plan; Thomas Lee Hazen,
Crowdfunding or Fraudfunding? Social Networks and the Securities
Laws—Why any Specially Tailored Exemption Should be Conditioned on
Meaningful Disclosure, N. C. L. REV. (forthcoming 2012) (manuscript at
18–22), available at http://ssrn.com/abstract=1954040.
602
See LAWTON & MAROM, supra note 2, at 180 (finding that numerous
losses will occur, either through fraud, or, more likely, business failure).
116
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
investor losses. The real question is whether the benefits of
a crowdfunding exemption outweigh these costs.
The structural features mentioned above and the
presence of a neutral intermediary will help reduce the risk
to investors. In addition, each of the proposed exemptions
limits the maximum amount a single investor may
contribute and therefore limits each investor’s possible
loss.603 Such limits ensure that even if investors do lose
money, those losses are unlikely to be catastrophic.
Investors are already investing substantial amounts in
non-securities crowdfunding. Those investments are as risky
as securities crowdfunding.
People who make pure
donations to entrepreneurs are guaranteed to “lose” all of
their money and receive nothing in return. People who
contribute to crowdfunding appeals in return for small
rewards or to pre-purchase a product might never receive the
promised reward, or the reward or product may not be as
valuable as they anticipated. People who make no-interest
loans on Kiva may never recover their principal.
Securities crowdfunding increases the potential gains to
these investors. Instead of making a donation or settling for
some reward, investors in crowdfunded securities can receive
interest or a share of the entrepreneur’s profits. They may
not receive the promised return, but even the possibility of
interest or profit is better than no financial return at all.
The risk of fraud or self-dealing is the same in the nonsecurities crowdfunding context as in the securities
crowdfunding context. The gain to the fraudster or the selfdealing entrepreneur depends on the amount invested, not
on the type of return offered to investors.
A $1,000
contribution provides the same opportunity for diversion
whether the offering is for a non-interest loan on Kiva, a prepurchase on Kickstarter, or a purchase of stock on a
securities crowdfunding site. The absence of any serious
fraud problem in non-securities crowdfunding (at least as far
as we know) is reassuring.
603
See supra Part V.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
117
VII. A CROWDFUNDING EXEMPTION PROPOSAL
A crowdfunding exemption could be beneficial, but the
exemption must minimize investor losses as much as
possible without destroying its utility to entrepreneurs
raising capital. However, investor protection and capital
formation are, to some extent, incompatible goals. It is not
possible to maximize both. Adding additional requirements
to protect investors will in most cases impose an additional
cost on small business issuers using the exemption. Subpart
A, below, discusses the requirements an exemption should
impose on crowdfunded offerings. Subpart B discusses the
requirements an exemption should impose on sites hosting
those offerings.
The locus of any regulation should be the crowdfunding
sites, not the entrepreneurs making the offerings. The small
companies and entrepreneurs most likely to engage in
crowdfunding
are
poorly
capitalized
and
legally
unsophisticated.
They do not have and cannot afford
sophisticated securities counsel to guide them through a
labyrinth of complex regulations.604 Too much complexity at
the entrepreneurial level will produce a host of unintended
violations and destroy the exemption’s utility.
Crowdfunding sites, in contrast, are repeat players. They
can spread any regulatory costs over a large number of
offerings.
They are better capitalized than the
entrepreneurs using their sites and can afford securities
counsel. Crowdfunding sites are also much more visible to
the SEC for regulatory enforcement purposes.
Thus,
crowdfunding sites are a more desirable locus for any
conditions necessary for investor protection.
Conditions may be imposed on the offerings or on the
companies making the offerings, but those restrictions
should be enforceable at the site level, with the
crowdfunding sites acting as gatekeepers to enforce the
restrictions. For example, a crowdfunding site can easily
monitor and enforce a restriction on the dollar amount of
604
The cost of securities counsel could easily exceed the amount being
raised in smaller offerings.
118
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
crowdfunding offerings, since the money flows through the
site. But the entrepreneur’s off-site activities are not as
easily monitored. If, for example, the available amount is
affected by fundraising the entrepreneur does off-site, the
site has no effective means to enforce the limit.
A. Restrictions on the Offering
The dollar amount of offerings qualifying for the
crowdfunding exemption should be limited, as should the
amount that any single investor may invest. It is not clear
what the exact amounts of those limits should be; there is no
magic number. This article proposes an annual offering
limit of $250,000 to $500,000, with an annual limit on
individual contributions equal to the greater of $500 or 2% of
the investor’s annual income. Integration and aggregation
concepts should not be applied to the offering limit. A limit
on the size of companies eligible to engage in crowdfunding
offerings is not necessary, but if the SEC believes such a
limit is appropriate, limiting the exemption to non-reporting
companies would do little damage. Finally, crowdfunding
should be exempted only if it occurs on a crowdfunding site
that meets the requirements specified in subpart B below.
1. Offering Amount
An absolute, unconditional exemption of smaller offerings
from Securities Act registration requirements makes
sense.605 The cost to register a relatively small offering
605
For a more detailed discussion of this point, see C. Steven
Bradford, Securities Regulation and Small Business: Rule 504 and the
Case for an Unconditional Exemption, 5 J. SMALL & EMERGING BUS. LAW 1
passim (2001) [hereinafter Bradford, Securities Regulation and Small
Business]. The argument for a Securities Act exemption for smaller
offerings is just a specific case of the more general economic argument for
small business exemptions. See C. Steven Bradford, Does Size Matter? An
Economic Analysis of Small Business Exemptions from Regulation, 8 J.
SMALL & EMERGING BUS. LAW 1, 17–20 (2004) [hereinafter Bradford, Does
Size Matter?].
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
119
exceeds any benefit that registration could provide.606 This is
true even if fraud is more likely in smaller offerings.
Although the likelihood of fraud affects the dollar amount
below which offerings should be exempted, it does not affect
the case for such an exemption.607 Economies of scale make
registration inefficient for smaller offerings, even if
registration creates a net benefit for larger offerings.608
For example, consider an attempt to raise $20,000. The
maximum amount investors could lose in that offering is
$20,000. Even if registration could reduce the probability of
any loss to zero, the maximum possible benefit of
registration would only be $20,000. The cost to register an
offering is substantially more than $20,000, so requiring
registration of the offering costs more than allowing
investors to bear the risks of an unregistered offering.
The case for exempting a $20,000 offering is thus fairly
obvious, but the exact level at which registration ceases to be
cost-effective is less clear. If the exemption is not absolute—
if it includes requirements designed to protect investors—a
higher limit makes sense.609 The proposed limits in the
various crowdfunding exemption proposals range from
$100,000 to $2 million.610 There is no magic number. Given
606
See Bradford, Securities Regulation and Small Business, supra
note 605, at 29–33.
607
Assume, for example, that the average loss in smaller offerings for
all reasons, including fraud, is 60% of the amount invested. Now make the
unlikely assumption that registration would prevent all those losses. If
the total cost of registering a $100,000 offering is $70,000, it still makes
sense to exempt such offerings. In the absence of registration, the average
loss will be $60,000, but registration imposes an even greater cost of
$70,000. Society is better off exempting such offerings. See id. at 39–47
(calculating the optimal exemption amount, given various assumptions
about fixed costs, the proportion of losses, and the proportion of losses
prevented by registration).
608
See Bradford, Securities Regulation and Small Business, supra
note 605, at 24–27; Bradford, Does Size Matter?, supra note 605, at 5–15.
609
See Bradford, Transaction Exemptions, supra note 509, at 618–22
(explaining the efficiency of intermediate, conditional exemptions).
610
See supra Part V.
120
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
the cost of registering an offering,611 the case for exempting
offerings of less than $250,000 to $500,000 is solid. A
plausible case can be made for exempting larger offerings,
particularly with a strong limit on the amount of each
person’s investment. But an exemption limit above $500,000
requires stronger assumptions about the cost of registration,
the risk of loss, and the extent to which registration reduces
that risk.612
2. Aggregation/Integration
Any proposal for a Securities Act exemption must deal
with the frustrating problem of integration—that is, whether
two offerings that are ostensibly separate should be treated
as part of the same offering.613 The integration doctrine was
developed by the SEC “to prevent issuers from artificially
dividing a single, non-exempt offering into two or more parts
in an attempt to obtain an exemption for one or more of the
parts.”614 Integrating two offerings could result in the loss of
each offering’s exemption. Unfortunately, the integration
doctrine is an uncertain, confusing mess.615 Scholars have
proposed its elimination616 or substantial modification,617 and
the SEC itself has created several safe harbors that protect
against application of the doctrine.618
611
See supra Part III.B.1.
For a set of hypothetical calculations, see Bradford, Securities
Regulation and Small Business, supra note 605, at 47.
613
For a general introduction to integration, see Bradford,
Transaction Exemptions, supra note 509, at 649–57.
614
Id. at 649. See also Darryl B. Deaktor, Integration of Securities
Offerings, 31 U. FLA. L. REV. 465, 473 (1979).
615
See Bradford, Transaction Exemptions, supra note 509, at 651–52
(discussing the lack of clarity in SEC releases that detail the standard for
integrated offerings).
616
See Rutheford B. Campbell, Jr., The Overwhelming Case for
Elimination of the Integration Doctrine Under the Securities Act of 1933,
89 KY. L.J. 289 (2001).
617
See C. Steven Bradford, Expanding the Non-Transactional
Revolution: A New Approach to Securities Registration Exemptions, 49
EMORY L.J. 437 (2000).
618
See Bradford, Transaction Exemptions, supra note 509, at 652–57.
612
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
121
Even if two offerings are not integrated, the related
concept of aggregation can pose problems for small issuers.
The aggregation provisions in Regulation A and Rules 504
and 505 of Regulation D reduce the maximum amounts
available under those exemptions by the amount of certain
other offerings.619 The $1 million limit in Rule 504 would, for
example, be reduced if the issuer had completed a Regulation
A offering in the previous twelve months.620
The dollar limit of any crowdfunding exemption should be
applied on an aggregate basis to all crowdfunding within any
twelve-month period by the same issuer. If the limit is
$500,000, the total an entrepreneur raises through
crowdfunding should not exceed $500,000 in a year, even if
the entrepreneur conducts multiple, separate rounds of
fundraising. Securities sold in non-crowdfunded offerings
should not count against the exemption’s limit. This is
consistent with the SEC’s approach in Regulation A. Rule
251(b) limits the offering amount in Regulation A offerings to
no more than $5 million in any twelve-month period, but
only offerings pursuant to Regulation A are counted against
that limit.621
The concepts of integration and aggregation should not be
applied beyond that. Small business entrepreneurs seeking
to raise money through crowdfunding cannot afford the legal
expertise needed to navigate the integration doctrine. These
entrepreneurs can count how much money they receive
619
See Securities Act Rule 251(b), 17 C.F.R. §§ 230.251(b)
230.504(b)(2), 230.505(b)(2)(i) (2012). See generally Bradford, Transaction
Exemptions, supra note 509, at 657–58 (explaining the concept of
aggregation).
620
The available aggregate offering amount is reduced by “the
aggregate offering price for all securities sold within the twelve months
before the start of and during the offering of securities under . . . [Rule
504] in reliance on any exemption under section 3(b) . . . .” 17 C.F.R. §
230.504(b)(2). Regulation A is a Section 3(b) exemption. See 17 C.F.R. §
230.251.
621
17 C.F.R. § 230.251(b). Other exemptions with dollar limits use a
similar twelve-month period, although the amounts charged against those
limits include other specified offerings. See 17 C.F.R. §§ 230.504(b)(2),
230.505(b)(2)(i).
122
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
through crowdfunding, but they are not in a position to
consider the effect of other fundraising efforts on the
availability of crowdfunding—whether, for example, the
private solicitation of money from Aunt Agnes will count
against the crowdfunding limit.622
They also cannot
anticipate their future capital needs623 or the potential
retroactive application of integration to destroy their
crowdfunding exemption. The incorporation of integration
concepts into the crowdfunding exemption would function as
a trap for unsophisticated, unwary entrepreneurs.
Integrating or aggregating non-crowdfunded offerings is
also inconsistent with the idea of crowdfunding sites as
gatekeepers. Crowdfunding sites can monitor how much
each entrepreneur raises through crowdfunding since the
money passes through their portal. However, they cannot
easily ascertain how much entrepreneurs have raised
through other, outside sources.
Two of the proposed bills have provisions that might be
construed as protecting against integration. Both House Bill
2930 and Senate Bill 1970 provide that nothing in the
exemption “shall be construed as preventing an issuer from
raising capital through methods not described under” the
exemption.624
3. Individual Investment Cap
All of the crowdfunding exemption proposals limit not
only the total amount of the offering, but also the amount
that each investor may invest. Such a limit is sensible.
622
The Wall Street Journal provides an excellent example. Bronson
Chang raised $54,000 on ProFounder from family members, friends, and
customers. He then sought another $60,000 through a “public raise” on
ProFounder. Emily Maltby, Tapping the Crowd for Funds, WALL ST. J.
(Dec. 8, 2010), http://online.wsj.com/article/SB1000142405274870349350
4576007463796977774.html. It is likely that Chang never even considered
whether his subsequent offering negatively affected the status of his
earlier Rule 504 “private raise.”
623
See Cohn & Yadley, supra note 11, at 50 (stating that small
companies’ capital needs “are often sporadic and immediate”).
624
H.R. 2930, 112th Cong. § 2 (2011); S. 1970, 112th Cong. § 2 (2011).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
123
Small business offerings are very risky and losses are
likely.625 A properly set cap on the amount an individual
may invest eliminates the possibility of catastrophic loss and
limits losses to what each investor can bear.626 As with the
offering amount, there is no magic number. This article
proposes that each investor be able to invest annually in
crowdfunding no more than the greater of $500 or 2% of the
investor’s annual income.
a. The Individual Cap Related to Existing
Exemptions
None of the current exemptions limit the amount an
individual investor may invest. Many of the exemptions cap
the total dollar amount of an offering,627 but as long as the
total offering amount does not exceed the cap, the amount
that any single investor purchases does not matter. The
exemption would be available even if a single investor
purchased the entire offering.
However, some of the existing exemptions do consider an
investor’s ability to bear losses in a less direct way. Both
Rule 506 of Regulation D and Section 4(5) of the Securities
Act restrict the purchasers to whom sales may be made.628
Section 4(5) of the Securities Act limits sales to accredited
investors.629 Rule 506 limits sales to purchasers who either
are accredited investors or who have “such knowledge and
experience in financial and business matters that . . . [they
625
See supra Part VI.B.1.
See Request for Rulemaking to Exempt Securities Offerings up to
$100,000 with $100 Maximum Per Investor from Registration, supra note
400, at 7 (arguing that the proposed $100 individual investment limit
would prevent investors “from incurring significant financial risk” because
“[e]ven a total loss of $100 is unlikely to be financially crippling for
anyone”).
627
See Securities Act Rule 251(b), 17 C.F.R. § 230.251(b) (2012) (cap of
$5 million); 17 C.F.R. § 230.504(b)(2) (cap of $1 million); 17 C.F.R. §
230.505(b)(2)(i) (cap of $5 million).
628
See Securities Act Rule 506(b)(2)(ii), 17 C.F.R. § 230.506(b)(2)(ii);
Securities Act § 4(5), 15 U.S.C. § 77d(5) (2010).
629
Securities Act of 1933 § 4(5), 15 U.S.C. § 77d(5) (2010).
626
124
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
are] . . . capable of evaluating the merits and risks of the
prospective investment . . . .”630
Rule 506 is a safe harbor for Section 4(2) of the Securities
Act, and the sophistication requirement is consistent with
the Supreme Court’s analysis of the Section 4(2) exemption
in Ralston Purina. In Ralston Purina, the Court indicated
that the availability of the Section 4(2) exemption turns on
whether the offerees “need the protection of the Act” or are
“able to fend for themselves.”631 But under Rule 506, sales
may be made even to unsophisticated investors, as long as
they are accredited.632
Some of the categories of accredited investors are
individuals
or
institutions
who
are
undoubtedly
“sophisticated.”633 In those cases, accredited status is merely
a more objective proxy for sophistication. Other parts of the
accredited investor definition focus solely on an investor’s
wealth or income. Any individual whose net worth, either
alone or with a spouse, exceeds $1 million is accredited,634 as
are corporations, partnerships, and certain other entities
with total assets in excess of $5 million.635 An individual is
also an accredited investor if she has had an income of
630
17 C.F.R. § 230.506(b)(2)(ii). Even if a non-accredited investor does
not meet the sophistication requirement, the exemption is still available if
the investor is represented by someone who meets the requirement or if
the issuer reasonably believes that the purchaser meets the sophistication
requirement. Id.
631
SEC v. Ralston Purina Co., 346 U.S. 119, 125 (1953). See also 1
HAZEN, supra note 42, at 565.
632
See 17 C.F.R. § 230.506(b)(2)(ii) (requiring “each purchaser who is
not an accredited investor” to meet a sophistication requirement).
Moreover, the information requirements that would otherwise apply in a
Rule 506 offering do not apply to sales to accredited investors. See 17
C.F.R. § 230.502(b).
633
For example, the definition includes registered securities brokers
or dealers, registered investment companies, banks, and insurance
companies. See 17 C.F.R. §§ 230.215(a), 230.501(a)(1). Directors and
executive officers of the issuer, who ordinarily have access to information
about the issuer, are also accredited investors.
See 17 C.F.R. §§
230.215(d), 230.501(a)(4).
634
See 17 C.F.R. §§ 230.215(e), 230.501(a)(5).
635
See 17 C.F.R. §§ 215(c), 230.215(c), 230.501(a)(3).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
125
$200,000, or a joint income with her spouse of $300,000, over
the two previous years, provided she reasonably expects to
reach the same income in the year of the offering.636
Many people who are accredited investors solely because
of wealth or income are unsophisticated investors.637
Consider, for example, the high school dropout who wins $10
million in a lottery.638 She would be an accredited investor,
even though the way in which she accumulated her wealth
does not demonstrate that she is capable of evaluating the
merits and risks of investing in the offering.
The SEC’s reasons for including wealthy but
unsophisticated investors in the definition of “accredited
investor” are unclear. One possibility is that wealth and
income are just extraordinarily imperfect proxies for
sophistication. 639 A more plausible reason, though, is that
wealthy investors can afford to lose the money.640
636
See 17 C.F.R. §§ 230.215(f), 230.501(a)(6).
See Choi, supra note 510, at 311 (stating that the definition of
accredited investor may include “financial neophytes”); Friedman, supra
note 565, at 299 (stating that wealthy investors are “easy prey for
securities sales personnel”); Manning Gilbert Warren III, A Review of
Regulation D: The Present Exemption Regimen for Limited Offerings
Under the Securities Act of 1933, 33 AM. U. L. REV. 355, 382 (1984)
(“Experience indicates that the wealthy often do not have the
sophistication to demand access to material information or otherwise to
evaluate the merits and risks of a prospective investment.”).
638
This example is derived from a problem in JAMES D. COX, ROBERT
W. HILLMAN & DONALD C. LANGEVOORT, SECURITIES REGULATION: CASES
AND MATERIALS 270–71 (6th ed. 2009). See also Wallis K. Finger, Note,
Unsophisticated Wealth: Reconsidering the SEC’s “Accredited Investor”
Definition Under the 1933 Act, 86 WASH. U. L. REV. 733, 754 (2009).
639
See Finger, supra note 638, at 747 (noting that the SEC’s goal in
Regulation D was to use wealth as a proxy for whether an investor is
capable of fending for herself); C. Edward Fletcher, III, Sophisticated
Investors Under the Federal Securities Laws, 1988 DUKE L.J. 1081, 1124
(1988) (arguing that “the SEC assumes either that wealthy investors are
always sophisticated or that they, no matter how naïve, do not need the
protection of the . . . registration provisions”); Friedman, supra note 565,
at 301; Marvin R. Mohney, Regulation D: Coherent Exemptions for Small
Businesses Under the Securities Act of 1933, 24 WM. & MARY L. REV. 121,
165 (1982) (noting that “the SEC has equated wealth with sophistication
and with access to information”); Warren, supra note 637, at 381 (noting
637
126
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
If that is the rationale, the existing exemptions do not fit
it well. Neither Section 4(5) nor Rule 506 limits the amount
that any single investor may invest in the offering.641 Thus,
an individual with a net worth of only $1 million could invest
all of his wealth in a single risky offering, and a total loss on
that one investment would leave the investor penniless. And
an investor whose accredited status is based solely on net
income could actually be insolvent at the time of purchase.642
The crowdfunding exemption proposals focus on the
investor’s ability to bear the loss in a much more coherent
way.
b. How to Structure the Cap
Unfortunately, some of the crowdfunding exemption
proposals leave questions about the individual investment
limit unanswered. Should the limit be applied on a peroffering basis or applied cumulatively across all of a person’s
that the SEC presumes that these investors can fend for themselves). See
also Susan E. Satkowski, Rule 242 and Section 4(6) Securities Registration
Exemptions: Recent Attempts to Aid Small Businesses, 23 WM. & MARY L.
REV. 73, 81 (1981) (noting that Rule 242, the predecessor to Regulation D,
attempted to dispense subjective criteria of sophistication and access to
information with more “definitive and objective standards”).
640
See Friedman, supra note 565, at 299–300 (suggesting that the
basis for making wealthy but unsophisticated investors accredited is “the
ground that they can afford to lose money”). Edward Fletcher also seems
to believe that this basis underlies the accredited investor categories. He
asks, “Should the law presume that wealthy investors, who can bear
investment risks, are sophisticated investors, and treat them as such, no
matter how financially naive they may be?” Fletcher, supra note 639, at
1123 (emphasis added).
641
This has not always been the case. When Regulation D was
adopted, an investor was accredited if she purchased at least $150,000 of
the securities being offered and if the purchase price did not exceed 20% of
the purchaser’s net worth. See Revision of Certain Exemptions from
Registration for Transactions Involving Limited Offers and Sales,
Securities Act Release No. 6389 (Mar. 8, 1982). See also Mohney, supra
note 639, at 135; Warren, supra note 637, at 369. Presumably, this 20%
floor “assures . . . [investors] . . . are able to bear the risk of the
investment.” Mahoney, supra note 639, at 136.
642
See Warren, supra note 637, at 382.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
127
crowdfunding investments? Should it be an annual limit or
a cap on the total amount of all outstanding crowdfunding
investments? Should the limit be a uniform dollar amount
or a percentage of each person’s wealth or income? Most
importantly, what should the limit be? The proposals range
from $100 to $10,000 per person, and some of the proposals
add an alternative cap based on the investor’s income.643
This article proposes to limit each investor’s annual
crowdfunding investments to the greater of $500 or 2% of the
investor’s annual income.
Consider first whether the investment limit should be the
same for all investors or should vary depending on the
investor’s financial circumstances. A fixed limit of, for
example, $500 per person would be simple and easy to apply.
But a uniform limit, unless it is very small, does not
necessarily limit all investors to an amount they can afford
to lose.
Many investors have very little savings or
uncommitted income.644 A loss of even $500 could be
catastrophic to those investors.
A limit tailored to the particular investor’s wealth or
income would better fit the policy rationale. For example, an
individual investor might be limited to investing no more
than 5% of her net worth or annual income. But this type of
limit would make the exemption more costly and more
difficult to administer. Either the crowdfunding site or the
issuer would have to determine the investor’s income or net
643
See supra Part V.
A 2010 survey found that 30% of all adults had no savings
(excluding retirement savings). NATI’L FOUND. FOR CREDIT COUNSELING,
supra note 572, at 5. See also Hilgert et al., supra note 572, at 310 (earlier
survey finding that only 80% of the respondents had a savings account).
Another survey found that fewer than half of American adults had an
emergency fund that would cover expenses for three months. APPLIED
RESEARCH & CONSULTING LLC, supra note 572, at 16. Forty-nine percent
of those respondents found it difficult merely to pay all of their bills each
month. Id. at 15. But see Hilgert et al., supra note 572, at 310 (finding
that 63% of the respondents had some emergency fund and that 49% of the
respondents set aside money out of each paycheck).
644
128
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
worth before allowing the investor to invest.645 Because
crowdfunding depends on small contributions from a large
number of investors, the number of such income and wealth
determinations could be prohibitively expensive.
There are two ways to incorporate an income- or wealthbased limit without unduly increasing administrative costs.
One option, adopted by House Bill 2930, is to allow the
issuer (and, presumably, the crowdfunding site as well) to
rely on the investor’s self-certification of income.646 The site
or the issuer would still have to collect and track income
figures for each investor, but no verification would be
required. Once the investor stated an income, the site’s work
would be complete.
However, a self-certified income
standard is essentially the same as no standard at all.
Investors who want to invest more would quickly learn to
exaggerate their income.
The second, preferable option is to state the limit per
investor in the alternative—as the greater of a specified
dollar amount or a percentage of the person’s income.
Senate Bill 1970 takes this approach.647 Under such a
standard, crowdfunding sites would not be required to check
or verify anyone’s income. Since the limit is the greater of
the two, sites could simply limit investments to the specified
645
Both the Small Business & Entrepreneurship Council petition and
the White House proposal provide alternative individual investor limits:
either $10,000 or 10% of the investor’s income. See supra Parts V.B and
V.D. Neither proposal indicates how the limit will be applied if an
investment is within one of those limits but not the other. In House Bill
2930, the limit is the lesser of $10,000 or 10% of the investor’s annual
income. See supra Part V.G.1.
646
House Bill 2930 provides that “an issuer or intermediary may rely
on certifications as to annual income provided by the person to whom the
securities are sold to verify the investor’s income.” H.R. 2930, 112th Cong.
§ 2 (2011). It is unclear what would happen under this proposal if the
issuer knows or reasonably should know that the investor’s selfcertification is false. What if, for instance, the investor states one income,
then changes it when she wants to invest more money?
647
S. 1970, 112th Cong. § 2 (2011).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
129
dollar amount.648
An income determination would be
required on a case-by-case basis only if the site chose to allow
a particular investor to contribute more than that dollar
limit. It would, therefore, be left to the site to decide
whether to incur the additional costs of determining an
investor’s income.649
Both the dollar amount and the income percentage should
be low enough that most people could afford to lose that
amount. Neither theory nor empirical analysis can specify
the precise amount, but an investment limit of around $500
per person seems reasonable.650 This amount is more than
648
If, as in some of the other exemption proposals, the limit is the
lesser of the two alternatives, crowdfunding sites would still have to
determine each investor’s income in order to know which of the two
numbers is smaller.
649
If a site does choose to use the income-based limit, it should only
have to establish a reasonable belief that the investor qualifies. The
easiest way to do this would be to obtain the first two pages of the
investor’s federal tax return.
650
See Heminway & Hoffman, supra note 142, at 948 (proposing an
individual limit of $100 to $250 per offering); Shane, supra note 588
(arguing that allowing people to invest only $100 “doesn’t seem to impose
a significant risk of financial loss on individuals”).
The limit could be applied individually or on a household basis. An
individual limit would be easier to administer because neither the site nor
the issuer would have to determine who belongs to the same family or
household. However, risk is typically borne by a household as a whole; if
one family member loses money, the entire family suffers. The dollar limit
should be adjusted to account for the individual-versus-family choice. If
the limit is applied on an individual basis, the limit can be slightly less. If
it is applied on a household basis, it can be slightly more.
The author’s colleague, Steve Willborn, suggests a mandatory
diversification requirement—requiring investors to spread the maximum
in smaller amounts across several different offerings. He points out that
this could reduce some of the company-specific risk, and thus reduce the
expected loss. However, the question is not what the average, expected
loss will be, but how much of a loss the investor can bear. Diversification
would not eliminate the risk of a complete loss, so the question is still the
maximum amount an investor can afford to lose.
Moreover, a
diversification requirement would increase the cost of using the exemption
in two ways. First, enforcing the diversification requirement would
increase the administrative cost. Second, a diversification requirement
would reduce the average investment amount in each offering, and thus
130
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
some investors could afford to lose, but, at some point,
potential investors must be trusted to decide for themselves
what they can afford. The $10,000 individual limit in some
of the proposals seems excessive; it is doubtful whether most
investors could afford an annual loss of that magnitude.651
The alternative limit in the exemption proposals varies
from 1% to 10% of the investor’s annual income.652 Again,
there is no magic number. How much an investor can afford
to lose depends on a number of factors other than annual
income. An investor whose wealth is tied up in illiquid
assets and who has little free income can afford to lose very
little of her income. A cap of 10% seems too high for most
people. A more cautious cap of 2% makes more sense, at
least until investors have some experience with the
exemption. Thus, an investor should be able to invest no
more than the greater of $500 or 2% of the investor’s annual
income.653
increase the number of purchasers, increasing the cost of making an
offering under the exemption.
651
Pope proposes a limit of $1,000 per investor, arguing that “many
consumers already spend [that much] on items such as laptop computers
and tablets, designer footwear and high-definition televisions.” Pope,
supra note 99, at 997. That may be true of some people, but $1,000 would
be a catastrophic loss to some investors, particularly when considered on
an annual basis.
652
See supra Part V.
653
Heminway and Hoffman suggest limiting the cap to investors who
are not accredited or sophisticated, and allowing accredited and
sophisticated investors to invest without any limit. See Heminway &
Hoffman, supra note 142, at 953. Issuers can already offer securities to
accredited and sophisticated investors using Rule 506 of Regulation D.
The author’s proposal would preclude integration of any Rule 506 offerings
with offerings pursuant to the crowdfunding exemption. See infra Part
VII.A.2. Therefore, the only thing that would preclude simultaneous, sideby-side Rule 506 and crowdfunding exemption offerings on the same web
site is Regulation D’s general solicitation restriction. See supra text
accompanying notes 225–27. The author would prefer that the SEC
eliminate the general solicitation restrictions for all Rule 506 offerings
rather than carve out an exception in the crowdfunding exemption for
sales to accredited and sophisticated investors.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
131
Whatever the limit, it should be applied to all of an
individual’s crowdfunding investments in any given year, not
on a per-offering basis. Otherwise, an investor could quickly
invest more than she could afford to lose by investing the
maximum amount in a large number of offerings—$500 in
offering A, $500 in offering B, $500 in offering C, and so on.
An investment limit fits the policy argument only if it is
applied on an aggregate basis.654
Only crowdfunding investments should be considered in
applying this annual cap. Other investments, even other
securities investments, should not count.
People have
numerous other investments with various levels of financial
risk—mutual funds, houses, cars, friends’ businesses. All of
a person’s assets and liabilities are relevant in assessing the
risk that a particular investment adds to the person’s
portfolio, but the SEC has to draw a line somewhere. The
SEC is not a general risk protection agency, and going
outside the crowdfunding exemption to calculate the limit
would make the exemption unworkable.655
Finally, the limit should be an annual one. An investor
who invests $500 in 2012 should be free to invest another
$500 in 2013, even if she still holds the 2012 investment.
The amount of the cap obviously should be lower for an
annual limit than it would be for a cumulative limit, but an
annual limit is much easier to administer. A cumulative cap
would have to account for withdrawals of money, dividends,
and bankruptcies, and could pose difficult computational
issues.656
654
The only proposal that clearly takes this approach is Senate Bill
1970. It imposes investor limits both for each offering and for all offerings
collectively. See supra Part V.
655
See also supra Part VII.A.2 (rejecting application of integration and
aggregation concepts).
656
If, for example, an investor loses her entire $500 investment, would
or should she be forever barred from again investing in crowdfunding?
She has, after all, lost the total amount it was determined she could afford
to lose. One might want to bar her on the theory that she is a bad
investor, but given the high percentage of startup failures, a total loss does
not necessarily reflect negatively on that person’s capabilities as an
investor.
132
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
4. Should There Be Company Size Limits?
The proposed crowdfunding exemption is designed to help
very small businesses raise capital.
Should larger
businesses therefore be excluded from using it? The SEC
already limits the use of the Regulation A and Rule 504
exemptions to non-reporting companies.657 Heminway and
Hoffman suggest that any crowdfunding exemption should
be similarly limited.658 However, the justification for small
offering exemptions depends on the size of the offering, not
on the size of the company making the offering.659 There is
no reason to prevent larger companies from using the
exemption, but such a limit, if imposed, would be relatively
easy to administer and would have no dramatic effect on the
use of the crowdfunding exemption.660
Larger businesses are unlikely to use the exemption even
if they are allowed to. Most large businesses are unlikely to
seek external funding for such small amounts, particularly
given the cost of raising money through investments of $500
or less. Big companies usually have enough cash to meet
small funding requirements internally. Apple Computer, for
instance, had $11.2 billion in cash and cash equivalents at
the end of its 2010 fiscal year.661 The Buckle, Inc., a much
smaller company, reported over $116 million in cash and
cash equivalents at the end of its most recent fiscal year.662
657
See Securities Act Rule 251(a)(2), 17 C.F.R. §§ 230.251(a)(2),
230.504(a)(2) (2012).
658
See Heminway & Hoffman, supra note 142, at 948. They also
propose to exclude foreign issuers and investment companies. Id.
659
See supra text accompanying notes 592–95.
660
If, however, the rule’s exception is expressed in terms of a
company’s total or net assets, crowdfunding sites would have to review
documentation from each issuer to verify that it does not exceed the cap.
The cost of administering the restriction would be higher.
661
Apple Inc., Annual Report (Form 10-K), at 47 (Oct. 27, 2010),
available at http://www.sec.gov/Archives/edgar/data/320193/00011931251
0238044/d10k.htm#tx37397_2.
662
The Buckle, Inc., Annual Report (Form 10-K), at 31 (Mar. 30,
2011), available at http://www.sec.gov/Archives/edgar/data/885245/000115
752311001807/a6663779.htm#statements.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
133
These companies are not going to be using a crowdfunding
exemption.
Larger non-reporting companies have another reason to
avoid the crowdfunding exemption.
Companies in the
United States with more than $10 million in total assets and
a class of equity security held of record by 500 or more people
must register with the SEC under the Exchange Act.663
Selling equity to a large number of investors in small
amounts would increase the number of equity holders and
could trigger Exchange Act reporting requirements.
B. Restrictions on Crowdfunding Sites
Offerings that fall within the limitations discussed above
should be exempted only if they are sold through
crowdfunding sites that meet standards designed to protect
investors. Crowdfunding sites should be open to the general
public
and
should
provide
publicly
accessible
communications portals that allow potential investors to
communicate about each offering. Investors should be
allowed to invest on those sites only after viewing a brief
investor education video or taking a short quiz.
Entrepreneurs posting on those sites should be required to
specify a funding goal and should be allowed to close an
offering only if that goal is reached. Until then, investors
should be free to withdraw their commitments.
Crowdfunding sites should not be allowed to recommend or
rate investment opportunities, or to advise investors about
those opportunities, unless they are willing to register as
brokers or investment advisers. Neither the crowdfunding
sites nor their employees should be able to invest in any of
the offerings that appear on the site.
Crowdfunding sites that meet these standards and notify
the SEC that they are engaged in crowdfunding should not
be required to register as brokers or investment advisers
663
See Securities Exchange Act of 1934 § 12(g)(1)(B), 15 U.S.C. §
78l(g)(1)(B) (2010) (requiring the registration of companies with more than
$1 million in total assets and 500 or more record holders of a class of
equity security); Rule 12g-1 (raising the asset amount to $10 million).
134
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
unless they also engage in activities other than their
crowdfunding activities that would make them such.
1. Open Sites, Open Communication
Crowdfunding sites that want to take advantage of the
proposed exemption should be open to the general public and
should be required to provide some means, such as an
electronic bulletin board, that allows investors to
communicate freely and openly about each offering. These
requirements will allow crowdfunding sites to take
advantage of “the wisdom of crowds” that is the foundation of
crowdsourcing, including crowdfunding.664
An open communications platform will help to prevent
fraud by allowing investors with particular knowledge about
an offering or an issuer to communicate it to other investors.
Investors who are aware of a particular entrepreneur’s shady
business background can communicate that knowledge to
others. Investors with local knowledge of facts inconsistent
with the entrepreneur’s claims can inform others. For
example, if the entrepreneur falsely claims to own a facility
in North Platte, Nebraska, people in North Platte can expose
the fraud.
In addition to preventing fraud, open communication will
lead to better-informed investors. Investors with knowledge
of the particular industry or type of product can share that
knowledge with other potential investors. Investors who are
also potential customers can explain why the proposed
product or service will or will not succeed and can suggest
modifications of the product or service. Investors with
business or accounting expertise can point out problems in
the entrepreneur’s business plan or projections. Investors
with legal expertise can point out regulatory issues the
664
See SUROWIECKI, supra note 123, at 230 (peer monitoring is a
fundamental part of the virtual world); Schwienbacher & Larralde, supra
note 14, at 12 (although crowdfunders might not have any special
knowledge about the industry in which they are investing, they can be
more efficient as a crowd than a few equity investors alone). See also
Freedman & Jin, supra note 599, at 2.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
135
entrepreneur has not considered. Not only would these
communications provide investors with more and better
information, they might even help the entrepreneur refine
her business plan.
Openness like this can also lead to better monitoring after
an investment is made. From a purely economic standpoint,
it makes little sense for someone who has invested a couple
hundred dollars to devote a substantial amount of time and
effort to monitoring. But the social aspects of crowdfunding
and other crowdsourcing applications often lead people to
contribute inordinate amounts of time and effort to the
enterprise.665 A crowdfunding site that facilitates open
communication allows these monitors to share their findings
with other investors.
Open communication is not an unmitigated positive. It
can also lead to group-think. Deliberative discussion “is the
enemy of collective intelligence because it reduces
diversity.”666 James Surowiecki, promoter of “the wisdom of
crowds,” notes that group judgment is most likely to be
accurate if each person’s opinion is not determined by the
opinions of those around them.667 According to Surowiecki,
“The more influence a group’s members exert on each other,
and the more personal contact they have with each other, the
less likely it is that the group’s decisions will be wise ones.”668
If people can see what others have done before they act, they
tend to follow the actions of others, creating an “information
cascade” problem.669
There is also a risk that these open forums will be the
target of spammers or advertisements, or that users will post
fraudulent comments. Crowdfunding sites should not be
665
“In many cases, the financial return seems to be of secondary
concern for those who provide funds. This suggests that crowdfunders care
about social reputation and/or enjoy private benefits from participating in
the success of the initiative.” Belleflamme et al., supra note 10, at 27.
666
HOWE, supra note 1, at 175.
667
SUROWIECKI, supra note 123, at 10.
668
Id. at 42.
669
Id. at 63–64.
136
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
liable for the content of the comments and should be free to
remove irrelevant or fraudulent material.
2. No Investment Advice or Recommendations
A key determinant of whether a person is a broker or an
investment adviser is whether she offers recommendations
or investment advice to investors.670 Unless crowdfunding
sites are willing to register as brokers or investment
advisers, they should not recommend or rate the offerings
that appear on the sites and should not advise investors
about the merits or risks of those offerings. Without this
restriction, a crowdfunding exemption could become a way to
circumvent the regulation applicable to ordinary brokers and
investment advisers. If crowdfunding sites act as anything
other than a neutral intermediary, they should have to face
the regulatory consequences. Similarly, if crowdfunding
sites set up a secondary trading market for crowdfunded
securities, the crowdfunding exemption should not free them
from having to register as exchanges or alternative trading
systems if such registration would otherwise be required.
3. Prohibition on Conflicts of Interests
Crowdfunding sites and their employees should not be
allowed to invest in the offerings on their sites, or to have
any financial interest in the companies posting offerings on
the site. Some of the SEC no-action letters involving
matching services condition relief on the non-participation of
the site and its employees in any of the posted offerings.671
Although typically unstated by the SEC staff, its concern is
presumably conflicts of interest. If the site and its employees
participate in advertised offerings, they will have a financial
interest in favoring or promoting particular offerings.672 If
670
See supra Parts IV.B.2.c(1) and IV.C.4.
See, e.g., Angel Capital Elec. Network, SEC No-Action Letter, 1996
WL 636094, at *1 (Oct. 25, 1996); Atlanta Econ. Dev. Corp., SEC NoAction Letter, 1987 WL 107835, at *1 (Feb. 17, 1987).
672
The receipt of transaction-based compensation already gives
crowdfunding sites a financial incentive to promote all of the offerings
671
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
137
recommendations and other investment advice are
prohibited, the potential dangers of such conflicts are
reduced.
Nevertheless, a conflict-of-interest prohibition
would eliminate any remaining incentives to manipulate the
system to promote or favor particular offerings. Such a
condition would also prevent an issuer from setting up a
sham site to promote the issuer’s own securities. Whether or
not it is necessary, a conflict-of-interest prohibition like this
could enhance the public reputation of crowdfunding sites.673
Such restrictions seem relatively harmless, and the cost to
the site of imposing such a policy would be small.674
4. Notification to the SEC
Crowdfunding sites that meet the requirements of the
exemption should not have to register as brokers, investment
advisers, or exchanges, and no other special registration
should be required. However, sites should have to notify the
SEC that they are acting as crowdfunding sites pursuant to
the exemption. The SEC, understandably, will want to
monitor how the crowdfunding exemption is being used and
whether sites are in compliance. It can do that only if it
knows where crowdfunding is occurring. A simple notice
containing the site’s name and URL would be sufficient to
make the SEC aware of sites that are engaged in
crowdfunding under the exemption. Since the sites will be
open to the public, including the SEC, the SEC will have
access to all of the information being provided to investors.
collectively. The concern here is the incentive to promote particular
offerings in which the site’s operators have invested or plan to invest.
673
Of course, if that is the case, individual sites have a competitive
incentive to impose and promote such policies, whether or not the SEC
requires them.
674
No employer can guarantee that its employees will abide by any
conflict-of-interest policy. If the crowdfunding site has a conflict-ofinterest policy, informs its employees of its policy, and makes a good faith
effort to enforce the policy, it should qualify for the exemption. The site
should not be liable if an employee, without its knowledge or complicity,
invests in one of the site’s offerings—for example, through a false identity.
138
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
This notice should not trigger any other regulatory
requirements. The more the SEC requires from these sites,
the greater the cost that will be passed along to
crowdfunding entrepreneurs, and the less effective the
crowdfunding exemption will be.
5. Investor Education
Many of the investors on crowdfunding sites will be
The participation of so many
unsophisticated.675
unsophisticated investors offers a rare investor-education
opportunity. Before she is given access to any offerings, each
crowdfunding investor should be required to complete a brief
investor-education video or quiz prepared by the SEC.676
This article is not suggesting that the SEC certify
whether investors are qualified to invest or that the
education be in the form of a full course on investment.677
Such requirements would unduly burden crowdfunding and
chill its development. This article merely suggests the use of
a brief educational film or quiz with feedback that would
take no more than five or ten minutes to complete. Such a
short presentation would not make crowdfunding investors
sophisticated, but it would allow the SEC to warn them of
the potential pitfalls and risks associated with small
business investments.
The mechanics would be relatively simple.
When
investors first register with the crowdfunding site, they could
be linked to the SEC material; they would be returned to the
crowdfunding site when the educational video or quiz is
675
See supra Part VI.B.2.
See SBE Council Proposal, supra note 405 (proposing that investors
be required to take an online test prior to investing).
677
Others have suggested certification of investors. See, e.g., Choi,
supra note 510, at 310–11 (proposing that investors be licensed); Finger,
supra note 638, at 759–62 (2009) (proposing that investors be licensed).
See also Hass, supra note 198, at 112 (arguing that unseasoned issuers
should have to make a suitability determination before selling securities to
unsophisticated retail investors).
676
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
139
completed.678 There is no easy way to guarantee that
investors actually pay attention—or, in the case of a video,
even watch it. However, this requirement would at least
give unsophisticated investors an opportunity to learn
something. Those who choose not to take advantage of this
opportunity have only themselves to blame.
Heminway and Hoffman propose to accomplish the same
objective in a slightly different way—by requiring each
crowdfunding web site to include cautionary language and
certain other limited disclosures.679 This is a plausible
alternative, but the proposal set forth above has two
advantages. First, it allows a disinterested party—the
SEC—to control the disclosure and the context in which it is
presented. Second, cautionary language and mandatory
disclosures tend to be ignored, as anyone who has dealt with
the detailed scroll-down licenses on the Internet can attest.
Under this proposal, investors would be forced to engage on
some level with a non-graded quiz, even if they breeze
through it.
6. Funding Goals and Withdrawal Rights
Entrepreneurs should be required to include a funding
goal in their online proposals and should not be allowed to
close offerings unless and until investors have pledged at
least that amount. Until then, investors should be free to
change their minds and withdraw their pledges.
These requirements allow the social networking aspect of
crowdfunding to work fully. Investors can communicate with
each other while the offering is open and withdraw their bids
678
Crowdfunding sites would not be required to present the SEC
material to investors or to endorse the SEC educational materials as their
own, only to limit access to investors who have viewed such material.
Therefore, any claim that the exemption compels speech in violation of the
First Amendment seems weak. See generally ERWIN CHEMERINSKY,
CONSTITUTIONAL LAW: PRINCIPLES AND POLICIES 1001–02 (4th ed. 2011)
(discussing the compelled speech issue under the First Amendment);
RONALD ROTUNDA & JOHN E. NOWAK, TREATISE ON CONSTITUTIONAL LAW:
SUBSTANCE AND PROCEDURE 63–64 (4th ed. 2008) (same).
679
See Heminway & Hoffman, supra note 142, at 957–59.
140
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
if they conclude, based on the information shared, that the
offering is not a suitable investment. The all-or-nothing
condition also protects the most optimistic and foolhardy
investors from their own improvidence.
Unless the
entrepreneur can convince other, more rational, investors to
participate, the foolhardy are not at risk.680
The all-or-nothing condition also forces the entrepreneur
to carefully consider her financing needs before posting her
proposal. Since overreaching could cause the offering to fail,
the entrepreneur has an incentive to request only the true
minimum amount needed to fund the project. This should
lead to more careful budgeting before the funding request is
posted.
Some of the existing crowdfunding sites already impose
all-or-nothing requirements,681 and such requirements are
common in other areas of securities regulation. Some
securities offerings include minimum sales conditions.682
Completing an offering when that minimum is not met
680
This all-or-nothing restriction “‘imposes a lot of market discipline . .
. . You can see whether an artist or organizer can get sufficient attention
to a project.’” Tina Rosenberg, On the Web, A Revolution in Giving, N.Y.
TIMES (Mar. 31, 2011), http://opinionator.blogs.nytimes.com/2011/03/31/onthe-web-a-revolution-in-giving/ (quoting Ethan Zuckerman, senior
researcher at Harvard’s Berkman Center for Internet and Society).
681
See, e.g., Kickstarter Basics, KICKSTARTER, http://www.kickstarter.
com/help/faq/kickstarter%20basics#AlloFund (last visited Mar. 5, 2012);
Company Terms and Conditions for Services, PROFOUNDER, supra note 112
(“If the aggregate value of pledges that Company receives in its Raise does
not meet Company’s Raise Goal within the time period allotted,
ProFounder will no longer continue to support the making or collection of
pledges for that particular Raise, pledges will not be converted to
Investments and funds distributed to Company, and no money will change
hands on the Website.”). But cf. Frequently Asked Questions, INDIEGOGO,
http://www.indiegogo.com/about/faqs (last visited Mar. 5, 2012) (follow
“Creating a Campaign” hyperlink) (“With Flexible Funding you still keep
the money you raise with your campaign. You will be charged a 9% fee on
the money you raise, despite the unmet funding goal. With Fixed Funding,
IndieGoGo will refund all your campaign’s contributions if your goal is
unmet, and you will not be charged any fees.”).
682
See Regulation S-K, Item 501(a)(8)(ii), Example B, 17 C.F.R. §
229.501(a)(8)(ii) (2012) (requiring that any such conditions be disclosed on
the front cover of the registration statement).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
141
constitutes securities fraud.683 Since no contract of sale is
allowed before a registration statement is effective,684
investors who express interest before that time are free to
change their minds and withdraw their offers. Similarly,
shareholders whose shares are subject to a tender offer are
free to withdraw their tenders at any time prior to closing of
the offer.685 Crowdfunding investors should receive similar
protection.686
C. Other Possible Requirements
1. Non-Profit Versus Profit Status
Crowdfunding sites should not be required to have nonprofit status.
The SEC no-action letters applying the
definitions of broker and investment adviser to Internet
matching sites have often focused on the provider’s nonprofit status.687 A for-profit provider obviously has a stronger
incentive to push investors and entrepreneurs to complete
the proposed transactions, even if those transactions are not
in the investors’ best interests.688 This is especially true
683
Exchange Act Rule 10b-9(a)(2), 17 C.F.R. § 240.10b-9(a)(2) (2012).
See also In the Matter of Richard H. Morrow, Exchange Act Release No.
40,392 (Sept. 2, 1998) (violation to sell securities after the deadline set in
the offering document for raising the required minimum amount).
684
See Securities Act of 1933 § 5(a)(1), 15 U.S.C. § 77e(a)(1) (2010).
685
Exchange Act Rule 14d-7(a)(1), 17 C.F.R. § 240.14d-7(a)(1) (2012).
686
Another possibility would be to impose a minimum time period that
offerings must be open before they may close, similar to the minimum
offering period the SEC requires for tender offers. See 17 C.F.R. §
240.143-1(a). In many cases, it will take time for the entrepreneur to
convince sufficient investors to meet the entrepreneur’s funding goal; no
regulatory minimum is needed in such cases. But a regulatory minimum
would insure that investors have time to consider the offering and
communicate with each other even in the most popular offerings. The
author does not advocate such a minimum limit, but, if it is sufficiently
short, it would not substantially burden issuers using the exemption.
687
See supra Part IV.B.2.e and text accompanying note 363.
688
See Verstein, supra note 12, at 18 (arguing that peer-to-peer
lending platforms “have an incentive to encourage lending . . . while
lenders bear the brunt of the loss if the lending is imprudent”).
142
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
when the site operator’s compensation depends on
completion of the transaction, as in the case of many existing
crowdfunding sites.
But that profit motive also gives companies incentives to
establish crowdfunding sites in the first place and to develop
and improve those sites.689 With the exception of Kiva
(admittedly a big exception), for-profit sites have driven
business-related crowdfunding. Limiting crowdfunding to
non-profits would seriously restrict its development. Some of
the proposed restrictions on crowdfunding sites, such as the
prohibition of investment advice and the conflicts-of-interest
bar, should temper some of the adverse effects of the profit
motive. Reputational constraints should also moderate a
site’s interest in pushing investors toward inappropriate
investments; a site that develops a reputation for losing
investments will suffer a loss of customers as investors move
to more reputable sites.690
2. Mandatory Disclosure by Entrepreneurs
Senate Bill 1970 imposes extensive mandatory disclosure
requirements as a condition of the exemption. It would
require detailed standardized disclosure about the issuer, its
business and business plan, its ownership and capital
structure, the offering, the rights of the securities being sold,
and even financial statements prepared by independent
accountants and audited in some cases.
Mandatory
disclosure requirements like those will unduly increase the
cost of crowdfunding.691 Entrepreneurs will need to hire
689
See Olivia L. Walker, The Future of Microlending in the United
States: A Shift from Charity to Profits?, 6 OHIO ST. BUS. L.J. 383, 393–95
(2011) (arguing that, for microlending to succeed in the United States, it
needs to be transformed into a for-profit industry).
690
See Verstein, supra note 12, at 14 (arguing that peer-to-peer
lending platforms “have long-term incentives to cultivate impressive
returns to gain customers”).
691
Heminway and Hoffman concede that one of “[t]he major
disadvantage[s] of this type of disclosure requirement [is] its cost.”
Heminway & Hoffman, supra note 142, at 959. Broad, ambiguous
disclosure requirements are equally dangerous. Senate Bill 1791, for
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
143
attorneys and accountants to comply, and the increased cost
will
drive
away
small,
marginal
entrepreneurs.
Crowdfunding site operators might help entrepreneurs to
complete the required disclosure, but that does not eliminate
the cost, and such advice increases the likelihood that the
site operator will be treated as a broker or investment
adviser.692 A better option for crowdfunding filings would be
the very simple notice filing required by House Bill 2930.693
The proponents of strong mandatory disclosure
requirements are missing one of the important facets of the
argument for small business exemptions. For offerings
below a certain size, the cost of any regulatory
requirements—even a minimal disclosure requirement—
exceeds the benefit.
For those small offerings, an
unconditional exemption makes sense.694 No matter how
attractive registration and standardized disclosure seem in
the abstract, they make no economic sense for the very small
offerings that crowdfunding facilitates.
Although it allows easier comparisons among investment
opportunities and therefore has some value to investors,695
standardization of disclosure is a bad idea for another
reason. Crowdfunding is still in a very early stage of
development.
Standardization of what appears on
crowdfunding sites could discourage experimentation and
instance, requires issuers to disclose “all rights of investors, including
complete information about the risks, obligations, benefits, history, and
costs of offering.” S. 1791, 112th Cong. § 2(b)(1)(A) (2011). What does it
mean to provide “complete” information about all the risks of the offering?
This uncertain requirement merely provides fodder for subsequent
investor lawsuits against issuers who were not advised by sophisticated
securities counsel.
692
See supra Parts IV.B.2.c.1 and IV.C.4.
693
See H.R. 2930, 112th Cong. § 2(b) (2011) (requiring information
about the issuer, its principals, the purpose of the offering, the target
offering amount, and the deadline for reaching that target).
694
The author explains this point in much greater detail elsewhere.
See Bradford, Securities Regulation and Small Business, supra note 605,
at 29–33; Bradford, Transaction Exemptions, supra note 509, at 614–22.
695
See Heminway & Hoffman, supra note 142, at 938–39 (arguing that
standardization promotes efficiency).
144
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
freeze its development. Instead of forcing all crowdfunding
sites into a federally mandated standard disclosure model,
regulators should allow them to search for the format that
investors find most useful.
3. Restrictions on Resale
The three bills outstanding in Congress all restrict the
resale of crowdfunded securities.696 Heminway and Hoffman
argue that such restrictions are necessary because a resale
market may not provide new investors with direct access to
the information available on the crowdfunding site itself, so
resales are more conducive to fraud.697
Restrictions on resale are neither necessary nor desirable,
although their presence will not unduly chill use of the
exemption. The existing crowdfunding sites do not maintain
trading markets, and they cannot easily establish such
markets without registering as exchanges or alternative
trading systems.698 If crowdfunding platforms do establish
their own trading platforms, information about the
entrepreneur and the offering is available on-site. Given the
small amounts invested, active trading markets are unlikely
to develop outside the crowdfunding site.699
Resale restrictions are likely to serve only as a trap for
the unwary. Unsophisticated investors, who are unlikely to
understand or even be aware of such restrictions, would be
exposed to liability whenever they sell their crowdfunded
securities to Uncle Ernie or Aunt Emma. And, if resale
restrictions are given any teeth, such resales could cause
696
See supra Part V.G.
See Heminway & Hoffman, supra note 142, at 954.
698
See supra Part IV.A.
699
However, the notes offered by Prosper and Lending Club are traded
on a platform maintained by FOLIOIfn, a registered broker-dealer. See
Prosper Registration Statement, supra note 81, at 11; Lending Club
Registration Statement, supra note 81, at 11. It is not clear how actively
those notes are traded.
697
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
145
issuers to lose their exemptions.700 Given the limited danger,
resale restrictions are undesirable.
D. Preemption of State Law
Securities regulation in the United States is a polycentric
combination of federal and state regulation. Issuers offering
securities must deal not only with the registration
requirements of the federal Securities Act, but also with the
registration requirements in all of the states in which they
offer the securities.
Congress has preempted state
registration requirements for the offering of certain
securities,701 but the securities sold by small issuers on
crowdfunding sites do not fall within the preempted
categories.
Even if the SEC adopts a crowdfunding
exemption, the states would remain free to regulate
crowdfunding.702
State securities laws also require the registration of
brokers and other agents engaged in securities activities.703
Exempting crowdfunding sites from federal regulation as
brokers or investment advisers would not protect them from
similar state regulation. The Exchange Act limits the power
of states to regulate brokers and their associated persons,704
but, as explained earlier, crowdfunding sites would not be
brokers under the proposed crowdfunding exemption. The
700
Heminway and Hoffman recognize this issue. They note that “any
regulatory solution should address the manner in which investor
violations of any resale prohibition impact the issuer’s exemption.”
Heminway & Hoffman, supra note 142, at 954 n.367.
701
See Securities Act of 1933 § 18, 15 U.S.C. § 77r(a)–(b) (2010).
702
Cohn & Yadley, supra note 11, at 13 (“Even when the issuer is able
to qualify for exemption from the 1933 Securities Act, there is no
guarantee, other than Rule 506, that the offering will be exempt from
state securities regulation.”). A crowdfunding site could avoid the
application of a particular state’s securities law by not selling in that
state. Most states have adopted an exemption for Internet offerings when
(1) the offer specifically indicates it is not being offered to the residents of
that state; (2) no offer is specifically directed to anyone in that state; and
(3) no securities are sold in that state. See Sjostrom, supra note 198, at 30.
703
See generally 12A LONG, supra note 148, at 8-3−8-6.
704
Securities Exchange Act of 1934 § 15(i), 15 U.S.C. § 78o(i).
146
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
states would be free to construe the term “broker” more
broadly than under federal law. However, the SEC probably
could effectively preclude state regulation of crowdfunding
sites as investment advisers. The Investment Advisers Act
provides that states may not require the registration,
licensing or qualification of advisers excepted from the
federal definition in Section 202(a)(11) of the Act,705 and one
of the exceptions in 202(a)(11) is for advisers designated by
the SEC.706
States could develop coordinated exemptions that would
also free crowdfunded offerings from state regulatory
requirements. This would not be unprecedented. Many
states, for example, have adopted a Uniform Limited
Offering Exemption (“ULOE”) that coordinates with Rule
505 of Regulation D.707 However, states have been unwilling
to extend the ULOE to Rule 504,708 and it is unlikely they
will extend it to any other exemption for offerings to
The North
unaccredited, unsophisticated investors.709
American Securities Administrators Association is working
on a model crowdfunding rule, but it has not yet been
705
Investment Advisers Act of 1940 § 203A(b)(1)(B), 15 U.S.C. § 80b3a(b)(1)(B) (2010).
706
Investment Advisers Act of 1940 § 202(a)(11)(G), 15 U.S.C. § 80b2(a)(11)(G) (2010).
707
There are actually two versions of the Uniform Limited Offering
Exemption. See 12B LONG, supra note 148, apps. C, C-1. For a general
discussion of the ULOE, see 12 LONG, supra note 148, 7-85–7-107.
708
Only four states have exemptions for offerings under Rule 504, and
at no time has there been any serious effort to coordinate the ULOE with
Rule 504. 12 LONG, supra note 148, at 7-199.
709
Most states have adopted a uniform private offering exemption
that exempts offerings to no more than a few people in the state. See 12
LONG, supra note 148. That exemption is unlikely to work for most
crowdfunded offerings. It focuses on the number of offerees in the state,
not the number of purchasers, effectively precluding publicly advertised
offerings. Id. Some states have altered their versions of the exemption to
focus on the number of purchasers, but even some of those states still put
an outside limit on the number of offerees. Id. Other states read a
sophistication requirement into the exemption, which would preclude
public offerings. Id.
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
147
publicly released.710 Even if a model rule is developed, its
success would depend on uniform adoption by all the states,
and the history of other state-coordinated exemptions is not
encouraging.
Because of state securities law, a federal crowdfunding
exemption would not by itself allow entrepreneurs to avoid
the cost of regulation. Unless state law was preempted, a
federal exemption would merely shift the cost to another
level in the federal system. Absent corresponding state
exemptions, a federal exemption would therefore accomplish
little.711
Compliance with state regulation alone is
“prohibitively costly if companies are seeking to raise only
small amounts of money.”712 Therefore, states should be
preempted from requiring the registration of offerings that
comply with the proposed crowdfunding exemption.713
The most effective way to preempt state law is through
congressional action.714
Congress could simply add
crowdfunded securities to the existing list of preempted
offerings.715 This is precisely what House Bill 2930 proposes
710
See NASAA Completes Draft of Model Crowdfunding Rule, Sec. L.
Daily (BNA) (Dec. 5, 2011). The model rule apparently would not exempt
issuers from filing a state disclosure document. Id.
711
Rutheford Campbell argues that requiring federally exempted
small business offerings to comply with state registration requirements is
inconsistent with the SEC’s reckoning of the appropriate balance between
investor protection and capital formation and imposes an “unwarranted
drag on capital formation.” Rutheford B. Campbell, Jr., Blue Sky Laws
and the Recent Congressional Preemption Failure, 22 J. CORP. L. 175, 208
(1997) [hereinafter Campbell, Blue Sky Laws]. More recently, Campbell
has called for the complete preemption of all state registration
requirements. See Rutheford B. Campbell, Jr., Federalism Gone Amuck:
The Case for Reallocating Governmental Authority Over the Capital
Formation Activities of Businesses, 50 WASHBURN L.J. 573 (2011).
712
Shane, supra note 588.
713
Others agree that any crowdfunding exemption should preempt
state law. See Heminway & Hoffman, supra note 142, at 960; Pope, supra
note 99, at 1000.
714
See Cohn & Yadley, supra note 11, at 82 (calling for congressional
action to preempt state registration requirements for all federally
exempted offerings except the intrastate exemption).
715
See Securities Act of 1933 § 18, 15 U.S.C. § 77r (2010).
148
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
to do. However, even House Bill 2930 preempts only state
offering registration requirements.716 It leaves the states
free to regulate crowdfunding intermediaries as brokers.
Another possibility is intriguing, but it is less likely.
Section 18(b)(3) of the Securities Act preempts state
securities requirements “with respect to the offer or sale . . .
[of securities] . . . to qualified purchasers, as defined by the
Commission by rule.”717 The statute itself does not define
“qualified purchaser;” instead, it says that the SEC “may
define the term . . . differently with respect to different
categories of securities, consistent with the public interest
and the protection of investors.”718 The SEC could define the
term “qualified purchaser” to include everyone who
purchases in a federally exempted crowdfunding offering,
thereby exempting crowdfunding offerings from state
registration requirements.719
This would not solve the
“broker” or “investment adviser” issues under state law, but
it would exempt the offerings themselves from registration.
However, it is reasonably clear that when Congress added
this provision to the Securities Act, in the National
Securities Market Improvement Act of 1996, it intended
“qualified purchaser” to encompass only “sophisticated
investors, capable of protecting themselves in a manner that
716
Senate Bill 1791 takes a slightly more conservative approach. It
preempts state offering registration requirements, but allows the issuer’s
home state, and any state in which the purchasers of more than 50% of the
offering amount reside, to require notice filings and charge fees. See supra
Part V.G.2.
717
Securities Act of 1933 § 18(b)(3), 15 U.S.C. § 77r(b)(3) (2010).
718
Id.
719
Others have made similar suggestions.
Shortly after these
preemption provisions were added by the National Securities Markets
Improvement Act of 1996, Campbell proposed that the SEC define
“qualified purchaser” to include all purchasers in offerings pursuant to the
Rules 504, 505, 147, and Regulation A exemptions. Campbell, Blue Sky
Laws, supra note 711, at 207. See also Sjostrom, supra note 198, at 587–
88 (noting this as a possible solution to the problem state regulation poses
to Internet offerings).
No. 1:1]
CROWDFUNDING AND SECURITIES LAWS
149
renders regulation by State authorities unnecessary.”720
Rutheford Campbell argues that this legislative history
should not limit the SEC,721 but the SEC proposal to
implement Section 18(b)(3), still not adopted, equates the
term qualified purchaser with the term “accredited investor”
in Regulation D.722 Because most crowdfunding investors are
not accredited investors, the SEC is unlikely to include them
within the definition of “qualified purchaser” for purposes of
preemption.
VIII. CONCLUSION
The SEC should adopt an exemption to facilitate
crowdfunded securities offerings. That exemption should
include the basic features outlined above. Issuers should be
able to raise a maximum of $250,000–$500,000 each year
without registration or other information requirements,
provided that each investor invests annually no more than
either $500 or 2% of the investor’s annual income, whichever
is greater. Those crowdfunded offerings should include a
funding goal and should not close until that goal is met.
Until then, investors should be free to withdraw from the
offering.
The exemption should also require that the offering be
made on a crowdfunding site that:
720
H.R. Rep. No. 622-104, pt. 1, at 31 (1996). See also S. Rep. No. 293104, at 10 (1996).
721
Campbell, Blue Sky Laws, supra note 711, at 207–08. Campbell
notes that the statute itself contains no such restriction and states that
the legislative history is “so disjointed and confusing as to be essentially
worthless.” Id. at 208. Section 18 requires the SEC to define the term
“consistent with the public interest.” Securities Act of 1933 § 18(b)(3), 15
U.S.C. § 77r(b)(3) (2010). Campbell also points out that, in considering
what is in “the public interest,” the SEC must consider not only investor
protection, but also “whether the action will promote efficiency,
competition, and capital formation.” Campbell, Blue Sky Laws, supra note
711, at 207.
722
See Defining the Term “Qualified Purchaser” Under the Securities
Act of 1933, Securities Act Release No. 33-8041, SEC Docket S7-23-01
(Dec. 19, 2001).
150
COLUMBIA BUSINESS LAW REVIEW
[Vol. 2012
(1) notifies the SEC that it is facilitating
crowdfunding offerings under the exemption;
(2) is open to the general public;
(3) provides a communication portal that allows
investors to communicate about each offering;
(4) requires investors to fulfill a simple education
requirement before investing;
(5) does not invest, and does not allow its employees
to invest, in the site’s offerings; and
(6) does not offer investment advice.
The enactment of a crowdfunding exemption would be no
panacea. None of the requirements that this article proposes
will guarantee that investors receive their expected returns.
None of these requirements will protect investors from the
losses often incurred by investors in small businesses. None
of these requirements will prevent fraud. That is not the
point of the proposed crowdfunding exemption.
Instead, the proposed crowdfunding exemption is an
attempt to promote small business capital formation by
exempting offerings where the cost of registration clearly
exceeds any possible benefits. The proposed exemption
allows smaller, unsophisticated investors to act as capitalists
and to learn by doing, while protecting those investors from
catastrophic losses they cannot bear. Finally, the proposed
exemption attempts to bring securities regulation into the
modern world of social networking and the Internet—to
reconcile the regulatory requirements of 1933 with the
realities of the twenty-first century.
The New Federal Crowdfunding
Exemption: Promise Unfullled
By C. Steven Bradford*
On April 5, 2012, President Barack Obama signed into law a new
federal securities law exemption for crowdfunded securities oerings.
Crowdfunding—the use of the Internet to raise small amounts of money
from a large number of contributors—has become incredibly popular
outside the securities context. But the use of crowdfunding to sell securities has been stymied by federal securities regulation. Securities Act
registration is simply too expensive for small, crowdfunded oerings,
and, until now, none of the registration exemptions t crowdfunding
well. Moreover, the web sites that facilitate crowdfunding could be
considered brokers if they hosted securities oerings, imposing additional regulatory costs.
The new crowdfunding exemption attempts to resolve both of those
regulatory problems—by exempting crowdfunded oerings from the
registration requirement of the Securities Act and by providing that
crowdfunding sites that meet certain requirements will not be treated
as brokers. However, the new exemption imposes substantial regulatory costs of its own and, therefore, will not be the panacea crowdfunding supporters hoped for. The regulatory cost of selling securities
through crowdfunding may still be too high.
This article analyzes the requirements of the new crowdfunding
exemption and discusses its aws.
I. Introduction
On April 5, 2012, President Barack Obama signed into lawthe
Jumpstart Our Business Startups (JOBS) Act,2 which amends federal
*Earl Dunlap Distinguished Professor of Law, University of Nebraska-Lincoln
College of Law. I have presented some of the ideas and analysis in this paper on several occasions: at a faculty colloquium at the University of Nebraska-Lincoln College
of Law; at the 2011 SEC Government-Business Forum on Small Business Capital
Formation; in a presentation to the Securities Regulation Committee of the New York
State Bar Association; in a colloquium sponsored by the Center for Entrepreneurship
at the University of Nebraska-Lincoln College of Business Administration; and in a
webinar sponsored by the National Council of Entrepreneurial Tech Transfer. My
thanks to the participants in those presentations, and to the many people who called
or e-mailed me afterwards, for their helpful questions and comments. My thanks also
to Katharine Collins and Benjamin Herbers for their invaluable research assistance.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
Electronic copy available at: http://ssrn.com/abstract=2066088
195
Securities Regulation Law Journal
securities law in ways intended to benet small to medium-sized
businesses. Title III of the JOBS Act, known as the CROWDFUND
Act,3 creates a new federal securities law exemption for crowdfunded
securities oerings.
Crowdfunding is the use of the Internet to raise money through
small donations from a large number of people—the “crowd” in
crowdfunding.4 An entrepreneur, or anyone else who needs money,
publishes an appeal for funds on a publicly accessible web site, and
that appeal is communicated to the general public through the site.
People who want to participate can contribute any amount from a few
dollars to the entire amount the person needs.5
Internet-based crowdfunding is a recent phenomenon. Kiva, today's
leading crowdfunding site, started in 2005,6 and the term crowdfunding rst appeared in 2006.7 But crowdfunding has become a billiondollar industry.8 One recent oering on the Kickstarter crowdfunding
site raised over $10 million.9
Crowdfunding oers signicant promise for small business issuers,
who face a capital funding gap.10 Traditional sources of business
nancing—bank lending, venture capital, and angel investors—are
unavailable to many startups and other very small oerings. 11
Fundraising is even more dicult for issuers located away from the
major sources of capital because small business investors tend to
focus on local investments.12 Crowdfunding connects entrepreneurs
who would not otherwise get nancing to a new source of capital—
public investors who would not traditionally be investing in smallbusiness startups.13
But crowdfunding is not an unmitigated positive. It involves a
potentially dangerous combination of investment risk and relatively
unsophisticated investors. Crowdfunding involves sales to the general
public, not just sophisticated or accredited investors, and many
members of the general public are remarkably unsophisticated
nancially.14 And investing in small business, particularly at the
startup stage, is inherently risky. The potential for fraud and selfdealing is high,15 and, even in the absence of wrongdoing, small businesses are much more likely to fail than more established companies.16
Illiquidity is also a signicant concern.17
Until now, issuers wishing to sell securities through crowdfunding
have had to deal with two formidable obstacles under federal securities law. First, absent an exemption, those oerings would have to be
registered under the Securities Act of 1933.18 Registration is simply
too expensive for the small oerings to which crowdfunding appeals,
and none of the traditional exemptions from the registration requirement ts crowdfunding well.19 Second, crowdfunding web sites hosting
196
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
Electronic copy available at: http://ssrn.com/abstract=2066088
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
oerings of securities could be required to register as brokers under
the Securities Exchange Act or as investment advisers under the
Investment Advisers Act.20
Because of these regulatory issues, most crowdfunding sites in the
United States have stuck with fundraising techniques that do not
involve securities. In some cases, contributors merely donate money
and receive nothing in return.21 Other fundraising is done through
pre-purchases, where, in return for the contribution, the contributor
is promised a copy of the product the entrepreneur is developing.22
Other entrepreneurs oer various types of non-nancial rewards to
contributors; for example, an entrepreneur making a movie might
promise to put people's names in the credits if they contribute more
than a specied amount. 23 None of these types of crowdfunding
involves a security, so federal securities law is not an issue.24
But donations, pre-purchases, and non-nancial rewards can only
attract a limited number of investors. Crowdfunding can fulll its
promise as a capital-formation tool only if issuers are able to oer
nancial returns to investors—either interest on the funds invested or
a share of the business's prots—and those types of investments would
clearly be securities.25
The CROWDFUND Act attempts to facilitate the use of crowdfunding to sell securities by adding a new Section 4(6) oering registration
exemption to the Securities Act.26 Section 4(6) exempts oerings of $1
million or less, provided that no investor exceeds an individual investment cap based on the investor's annual income and net worth. The
securities must be sold through an intermediary that meets the
requirements of new section 4A(a) of the Securities Act, and the issuer must meet the requirements of new section 4A(b).27 Resales of securities sold pursuant to the crowdfunding exemption are restricted.28
(For the reader's convenience, the full text of sections 4(6) and 4A appears in Appendix A.).
The CROWDFUND Act includes a number of additional provisions.
It creates a new category of regulated entity known as a “funding
portal”; crowdfunding intermediaries that are not brokers must register as funding portals. 29 It preempts most state regulation of
crowdfunded oerings and funding portals. 30 And it creates an
important new liability provision for fraud or negligent misstatements
in connection with section 4(6) oerings.31
In an earlier article, I explained why a crowdfunding exemption
makes sense32 and how such an exemption should be structured.33 A
reader who wants a full discussion of the policy arguments can turn
to that article and to the articles others have written on the subject.34
The key, as in all securities regulation, is to balance the capital forma© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
197
Securities Regulation Law Journal
tion benets of crowdfunding against the cost of allowing those oerings, including possible investor losses.35 To minimize investor losses
without unduly increasing the cost to issuers, investors should be
protected not through complicated, expensive mandatory disclosure
requirements, butthrough less costly structural requirements.36
The new crowdfunding exemption is disappointing. It is poorly
drafted, leaving many ambiguities and inconsistencies for the SEC or
the courts to resolve. Its mandatory disclosure requirements are too
complicated and expensive for the small oerings it is designed to
facilitate. Its individual investment limits are too high, exposing investors to more risk than many of them can aord. Its regulation of
crowdfunding intermediaries is haphazard, unnecessarily disadvantaging non-broker intermediaries, but failing to include a crucial investor protection provision. Its failure to include a “substantial compliance” provision to protect innocent and immaterial violations, coupled
with its complicated regulatory requirements, makes inadvertent
violations likely. And the new liability provision the Act adds is fairly
draconian and will expose innocent but unsophisticated entrepreneurs
to unexpected liabilities.Because of these and a number of other
problems, the promise of crowdfunded securities oerings remains
unfullled. The new exemption is not the regulatory panacea
crowdfunding supporters hoped for, and it is unlikely to spawn a
crowdfunding revolution.
Part II of this article is a brief legislative history of the crowdfunding exemption. Part III is a detailed analysis of the specic requirements of the exemption and the other provisions in the CROWDFUND
Act. In Part IV, I discuss some of the new exemption's shortcomings.
II. A Brief Legislative History37
The crowdfunding exemption has a surprisingly short history. The
rst proposal to exempt crowdfunding from federal securities law
came in 2010, when the Sustainable Economies Law Center petitioned
the SEC to exempt oerings of $100,000 or less, provided that no
single investor contributed more than $100.38 Other exemption proposals followed,39 but the SEC took no public action. In April, 2011, in an
exchange with Congressman Darrell Issa,40 SEC Chairman Mary
Schapiro indicated that the SEC sta had been discussing crowdfunding41 and promised to “[take] a fresh look” at ways to reduce the
regulatory burdens on small business capital formation.42 But, as it
turned out, the SEC never had the opportunity to act.
In September, 2011, the White House publicly supported a
crowdfunding exemption. The following sentence appeared in a tenpage “Fact Sheet and Overview” discussing President Obama's
proposed job-creation measures: “The administration . . . supports
198
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
establishing a ‘crowdfunding’ exemption from SEC registration
requirements for rms raising less than $1 million (with individual
investments limited to $10,000 or 10% of investors' annual income)
. . ..”43
The rst crowdfunding bill, House Resolution 2930, was introduced
in Congress on September 14, 2011, by Representative Patrick
McHenry, a Republican from North Carolina.44 That proposal was
endorsed by President Obama45 and passed the House on November 3,
2011, by a bipartisan 407-17 vote.46
On November 2, 2011, Senator Scott Brown, a Republican from
Massachusetts, introduced another crowdfunding bill, Senate Bill
1791, in the Senate.47 On December 8, 2011, Senator Je Merkley, a
Democrat from Oregon introduced a third crowdfunding bill, Senate
Bill 1970.48 The Senate took no immediate action on any of these bills.
After a brief lull, legislative activity accelerated in March. On March
8, 2012, the House passed the Jumpstart Our Business Startups
(JOBS) Act, which incorporated Congressman McHenry's original
crowdfunding bill with some minor changes, by a 390-23 vote.49 On
March 13, 2012, Senators Merkley and Brown, along with Senators
Mary Landrieu and Michael Bennet, introduced a compromise
crowdfunding bill, Senate Bill 2190.50 When the JOBS Act came to the
Senate oor, Senators Merkley, Brown and Bennet introduced an
amendment, Senate Amendment 1884, to replace Representative
McHenry's crowdfunding provisions. 51 The Senate agreed to the
amendment by a 64-35 vote and passed the JOBS Act by a 73-26
vote.52 The House accepted the amendment on March 27, 2012 by a
380-41 vote53 and President Obama signed the amended JOBS Act,
which became Pub. L. No. 112-106, on April 5, 2012.54
III. A Tour through the New Crowdfunding Exemption
(a) Basic Structure55
The basic crowdfunding exemption is in new section 4(6) of the Securities Act, but that section draws heavily on new section 4A. Section
4(6) contains four requirements: (1) a limit on the amount of the oering; (2) a limit on the amount that each investor may invest; (3) a
requirement that the oering be conducted through an intermediary
that complies with section 4A(a) of the Act; and (4) a requirement
that the issuer comply with section 4A(b) of the Act.56 In addition to
the basic exemption, the CROWDFUND Act adds several other
important provisions: (1) disqualication provisions precluding certain
issuers and intermediaries from participating in section 4(6) oerings;
(2) a restriction on the resale of crowdfunded securities; (3) provisions
preempting state securities law; and (4) a new liability section for
people involved in section 4(6) oerings. All of these requirements are
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
199
Securities Regulation Law Journal
discussed below.
(b) Oering Amount
The maximum amount that an issuer may sell in any 12-month period is $1 million.57 It is a little unclear if that limit includes all securities sold by the issuer, or just securities sold pursuant to the section
4(6) exemption. The Act says that the aggregate amount sold “to all
investors” by the issuer may not exceed $1 million, but it only
expressly includes sales in the past 12 months in reliance on the section 4(6) exemption,58 so sales pursuant to other exemptions arguably
do not count against the $1 million cap.59 Sales pursuant to other
exemptions would, however, raise oering integration issues.60
The oering limit only looks backwards in time, so subsequent sales
pursuant to other exemptions do not aect the section 4(6) dollar
limit. Those subsequent sales could raise potential integration issues,61 but, absent integration, they would not retroactively reduce
the section 4(6) limit.
(c) Requirements Imposed on Investors
The new crowdfunding exemption imposes three limits on investors:
(1) a limit on the amount each investor may invest in a single
crowdfunded oering; (2) a limit on the aggregate amount each investor may invest in all crowdfunded oerings; and (3) an investoreducation requirement. The two investment limits depend on the
investor's annual income and net worth and, in some cases, the statutory limit is unclear.
(i) The Single-Issuer Investment Limit
The limit on the amount an investor may invest with a single issuer
depends on the investor's net worth and annual income, with both
calculated in accordance with SEC rules concerning such calculations
for accredited investors.62
E Both net worth and annual income less than $100,000. If the
investor's annual income and the investor's net worth are both
less than $100,000,63 the limit is the greatest of three numbers:
$2,000, ve percent of the investor's annual income, or ve
percent of the investor's net worth.64
E Both net worth and annual income equal to or greater than
$100,000. If the investor's net worth and annual income are both
equal to or greater than $100,000, the statute says the limit is
“10 percent of the annual income or net worth,” subject to a
maximum of $100,000.65 The statute does not say whether the
limit is the greater or the lesser of the two 10% gures.66 Assume, for example, that the investor's annual income is $150,000
and the investor's net worth is $200,000. Is the cap $15,000 or
200
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
$20,000? The language is ambiguous, but the best interpretation
is probably the lesser of the two amounts. The statute requires
that the aggregate amount sold “not exceed . . . (ii) 10 percent of
the annual income or net worth of such investor, . . .”67 If the
amount invested exceeds either one of the two, this requirement
would not be met.
E One equal to or greater than $100,000; one less than $100,000.
The statute is also ambiguous about what happens when one of
the two gures—either net worth or annual income—is equal to
or greater than $100,000 and the other is less than $100,000.
Subsection 4(6)(B)(i), the lower limit, would apply in this case. It
applies “if either the annual income or net worth of the investor
is less than $100,000.”68 However, subsection 4(6)(B)(ii), the
higher limit, would also apply. It applies “if either the annual
income or net worth of the investor is equal to or more than
$100,000.”69 Thus, if net worth is greater than $100,000 and annual income is less than $100,000, or vice versa, both limits
apply. Unless the SEC or Congress claries this ambiguity, the
only safe action is to limit investors to the lower amount.
This investment limit apparently only includes an investor's
purchases pursuant to the section 4(6) exemption, although the Act is
a little unclear.Section 4(6)(B) says that “the aggregate amount sold
to any investor by an issuer, including any amount sold in reliance on
the exemption provided under this paragraph during the 12-month
period preceding the date of such transaction” may not exceed the
limit.70 When an issuer sells securities to an investor pursuant to the
section 4(6) exemption and also sells securities to that same investor
pursuant to some other exemption, does the “aggregate amount sold
to any investor by the issuer” means the aggregate amount of all
sales to that purchaser, or only the aggregate amount of the section
4(6) sales?
Read in context, this language may mean only the amount sold pursuant to the exemption. The subsequent reference to purchases in the
prior 12 months “in reliance on the exemption” supports this reading.
But that clause says only that the sales to be counted include those
earlier section 4(6) purchases, not that section 4(6) purchases are the
only ones to be considered. However, the aggregate investment limit
discussed below clearly includes only section 4(6) sales,71 so the singleissuer limit should probably be interpreted similarly.72
(ii) The Aggregate Investment Limit
The second investment limit is applied on an aggregate basis,
considering all of an investor's crowdfunding purchases, not just those
from a single issuer. This limit is not in section 4(6), but in section
4A(a), which requires crowdfunding intermediaries to “make such ef© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
201
Securities Regulation Law Journal
forts as the Commission determines appropriate, by rule, to ensure
that no investor in a 12-month period has purchased securities oered
pursuant to section 4(6) that, in the aggregate, from all issuers, exceed
the investment limits” discussed above.73 The dollar limit is the same
as the single-issuer limit, but the aggregate limit includes the aggregate amount the investor buys from all issuers in any 12-month
period. Section 4A(a) says that no investor may “[purchase] securities
oered pursuant to section 4(6)” that exceed the limit, so only
purchases pursuant to section 4(6) are counted.
An investor's violation of this aggregate limit would aect the
exemption dierently than an investor's violation of the single-issuer
limit. If an issuer sells more to an investor than the single-issuer
limit allows, the exemption would be lost; section 4(6)(B) conditions
the exemption on the amount sold to the investor not exceeding the
limit.74 The exemption is not conditioned on the investor's satisfaction
of the aggregate limit, only on the intermediary taking the SECmandated steps to enforce the limit. If the crowdfunding intermediary
made the requisite eort to enforce the aggregate limit, but an investor nevertheless exceeded it, the requirements of section 4A(a) would
be met and the exemption would survive.
It is unclear what the SEC will require intermediaries to do to
enforce this aggregate limit. The intermediary's records will show how
much each investor has purchased through its site, but investors
might also have purchased in section 4(6) oerings on other sites. The
intermediary could ask the investor how much he has invested on
other crowdfunding sites, but the answer might be intentionally or
unintentionally incorrect. The only totally eective solution would be
to establish a central recordkeeping system and require intermediaries to report every section 4(6) purchase. But a system like that would
be expensive. Self-reporting by investors may be the only cost-eective
method.
(iii) Investor Understanding/Education Requirements
To participate in a section 4(6) oering, investors must also review
investor-education information, although exactly what that information will be is left to the SEC.75 Investors must also answer questions
demonstrating an understanding of
E the risk of investments in startups and other small businesses;
E the risk of illiquidity; and
E any other matters the SEC deems appropriate.76
Finally, investors must positively arm that they understand they
are risking their entire investment and that they can bear such a
loss.77
(d) Requirements Imposed on the Issuer
To qualify for the section 4(6) exemption, issuers must comply with
202
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
the requirements in section 4A(b) of the Act.78 Section 4A(b) imposes
rather extensive disclosure requirements and also limits the issuer's
solicitation of investors. The statute also limits the companies that
may use the crowdfunding exemption79 and requires the SEC to enact
additional disqualications by rule.80
(i) Eligible Companies
To use the section 4(6) exemption, an issuer must be organized
under the law of a U.S. state or territory or the District of Columbia81
and may not be a reporting company under the Exchange Act.82 Investment companies, or companies that would be investment companies
but for the exclusions in section 3(b) or 3(c) of the Investment
Company Act, are also ineligible to use section 4(6),83 and the SEC is
authorized to add other categories of ineligible issuers.84 An issuer is
also ineligible to use the section 4(6) exemption if it is subject to the
disqualication provisions discussed later in this article.85
(ii) Issuer Disclosure Requirements
The Act imposes extensive disclosure requirements on issuers using
the section 4(6) exemption. Issuers must le the required information
with the SEC, and provide it to investors, potential investors, and the
crowdfunding intermediary through which the oering is made.86 The
following categories of information must be disclosed.87
a. General Information about the Company
The issuer must disclose:
E Its name, legal status, physical address, and website address;88
E The names of its directors and ocers and anyone with a similar
status or function;89 and
E A description of its business and its anticipated business plan.90
b. Financial Information
The issuer must provide “a description of the nancial condition of
the issuer.”91 This must include nancial statements, but the exact
requirement depends on the size of the oering.92
E $100,000 or less. If the target amount of the oering is $100,000
or less, the issuer must provide income tax returns for the most
recent year, as well as nancial statements certied by the issuer's principal executive ocer to be true and complete in all
material respects.93
E $100,000-$500,000. If the target amount of the oering is between $100,000 and $500,000, the issuer must provide nancial
statements reviewed by an independent public accountant, “using professional standards and procedures for such review or
standards and procedures established by the Commission” for
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
203
Securities Regulation Law Journal
this purpose.94
E More than $500,000. If the target amount of the oering is more
than $500,000, the issuer is required to provide audited nancial
statements.95
Nothing in the new exemption precludes an issuer from raising
more than the specied target amount of the oering. Thus, an issuer
might specify a target amount of $100,000, but actually raise more
than $100,000. Since the required disclosure depends on the target
amount, not the amount sold, this should not change the issuer's
disclosure obligation.
c. Ownership and Capital Structure
The issuer must provide a description of its “ownership and capital
structure.”96 This information must include all of the following:
E The terms of each class of the issuer's securities, including the
class being oered, and a summary of the dierences between
the dierent classes;97
E A discussion of how the terms of the securities may be modied
and how the rights of the securities being oered could be materially limited, diluted, or qualied by the rights of other classes;98
E A description of how the exercise of rights held by the principal
shareholder of the issuer could negatively aect the purchasers
of the securities being oered;99
E The names of each person holding more than 20% of the issuer's
shares;100
E The name and ownership level of each existing shareholder who
owns more than 20 percent of any class of shares;101
E How the securities being oered are being valued, “and examples
of how such securities may be valued by the issuer in the future,
including during subsequent corporate actions”;102 and
E The risks to purchasers relating to minority ownership and future
corporate actions, including additional issues of shares, a sale of
the company or its assets, and transactions with related parties.103
d. Disclosure Concerning the Oering
The issuer is required to disclose certain information about the offering itself:
E The purpose of the oering and the intended use of the proceeds;104
E The target oering amount and the deadline to reach that target;105 and
E The price of the securities being oered or the method for
determining the price.106 Prior to sale, the nal price must be
disclosed to the investor in writing, and the investor must be
204
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
given a reasonable opportunity to rescind the commitment to
purchase.107
e. Annual Reporting Requirement
In addition to the disclosures required at the time of the oering, issuers must le annual reports with the SEC and provide those reports
to investors.108 Those reports must include such information on the
result of operations and nancial statements as the SEC shall
require.109 The SEC is authorized to make exceptions to the annual
reporting requirement and to specify a date after which the reporting
obligation terminates.110
(iii) Restrictions on Solicitation
Section 4A(b) also imposes restrictions on solicitation by the issuer
or others acting on its behalf. The issuer may not advertise the terms
of the oering, other than directing investors to the intermediary
through which the oering is conducted.111 And the issuer is prohibited
from compensating anyone for promoting the oering “through communication channels provided by the intermediary,” unless it complies
with SEC rules requiring disclosure of such compensation.112
(iv) SEC Authorized to Add Additional Requirements
The Act authorizes the SEC to add to the required disclosure any
other information it feels is necessary “for the protection of investors
and in the public interest.”113 The statute also allows the SEC to
impose other requirements on the issuer “for the protection of investors and in the public interest.”114
(e) Regulation of Crowdfunding Intermediaries
Section 4(6) oerings must be conducted through a registered broker or funding portal that complies with section 4A(a) of the Securities Act.115 Certain brokers and funding portals are disqualied from
participating in section 4(6) oerings.116 Section 4A(a) imposes a
number of requirements on eligible intermediaries.117 Among other
things, they must make sure that the issuer's disclosure is provided to
investors, enforce the investor education requirements, and limit the
issuer's access to investor funds. All of these requirements, and others, are discussed below.
(i) Registered Broker or “Funding Portal”
Crowdfunding intermediaries using the section 4(6) exemption must
register with the SEC, either as brokers or as funding portals.118 They
must also register with any applicable self-regulatory organization.119
The requirements that brokers register and belong to a self-regulatory
organization are obviously not new.120 But the “funding portal” category is new, created by the Act.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
205
Securities Regulation Law Journal
The Exchange Act denes a “funding portal” as “any person acting
as an intermediary in a transaction involving the oer or sale of securities for the account of others, solely pursuant to section 4(6).”121
Funding portals may not
E “oer investment advice or recommendations;”122
E “solicit purchases, sales, or oers to buy the securities oered or
displayed on its website or portal;”123
E “compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced
on its website or portal;”124
E “hold manage, possess, or otherwise handle investor funds or
securities.”125
The SEC is authorized to impose additional restrictions on the
activities of funding portals.126
Funding portals are not subject to the same requirements as
brokers. The Act requires the SEC to exempt registered funding
portals from registration as brokers or dealers under section 15(a)(1)
of the Exchange Act, provided that the funding portal “remains subject
to the examination, enforcement, and other rulemaking authority of
the Commission.”127 However, the exemption for funding portals may
be conditional, and the SEC may impose “such other requirements
. . . as the Commission determines appropriate.”128
Funding portals are not exempted from the requirement of membership in a national securities association.129 In fact, the Act specically
conditions exemption from treatment as brokers on the portal's
membership in a national securities association registered under section 15A of the Exchange Act.130 However, the national securities association to which the funding portal belongs may apply to the funding portal only rules “written specically for registered funding
portals.”131
(ii) Disclosure and Enforcement of Investor Requirements
Crowdfunding intermediaries must provide to potential investors
any disclosures required by the SEC, including investor education
materials and disclosures related to risks.132 Crowdfunding intermediaries are required to enforce the investor education requirements
discussed earlier, 133 ensuring that investors review the required
investor-education information, answer the required questions, and
make the required armations about risk.134 The intermediary must
also take such steps to enforce the aggregate investor limits as the
SEC shall mandate.135 Curiously, there is no analogous provision
requiring the intermediary to enforce the $1 million oering limit applicable to the issuer.
206
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
At least 21 days prior to the rst day on which an issuer sells securities to any investor, the crowdfunding intermediary must provide
the issuer's disclosure to potential investors.136 As a result of this
requirement, a 21-day waiting period is automatically built into every
crowdfunded oering.
(iii) Risk Reduction Steps
Crowdfunding intermediaries must “take such measures to reduce
the risk of fraud” in section 4(6) transactions as the SEC shall establish by rule.137 These steps must include background and securities
enforcement regulatory history checks on the issuer's ocers, directors, and persons holding more than 20% of the issuer's outstanding
equity.138
(iv) Use of Proceeds
The intermediary must ensure that the issuer receives the oering
proceeds only when the amount of capital raised equals or exceeds the
issuer's stated target oering amount. Until then, investors must be
allowed to cancel their commitments to invest, in accordance with
rules to be adopted by the SEC.139
As explained earlier, issuers must disclose both a target oering
amount and a deadline for reaching that target.140 Although section
4A(a) requires the intermediaries to enforce the target amount, it
says nothing about the deadline. If the issuer does not reach the
target amount by the specied deadline, the statute does not prohibit
the intermediary from allowing the issuer to continue the oering and
draw on the funds if it subsequently hits the target. However, failure
to comply with the stated deadline could constitute fraud, since the
deadline could be construed as a representation that the issuer will
not continue the oering beyond the deadline if the goal is not reached.
The statute does not prohibit the issuer from changing either the
deadline or the target amount mid-oering.141 Nor does the statute
prevent the issuer from setting an articially low target amount to
ensure that the target is met, then accepting tenders of more than the
target amount.
(v) Privacy
Crowdfunding intermediaries must take steps to protect the privacy
of information collected from investors. The exact requirements are
left to the SEC.142
(vi) Compensation of Promoters
Crowdfunding intermediaries may not compensate “promoters, nders, or lead generators” for providing the personal identifying information of any potential investor.143
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
207
Securities Regulation Law Journal
(vii) Conict of Interest
The intermediary must prohibit its directors, ocers, and partners
(or any similar persons) from having any nancial interest in any issuer using the intermediary.144 This provision does not prohibit the
intermediary itself from having such an interest, so intermediaries
could own equity in issuers using their sites.
(viii) Other Requirements
The statute gives the SEC the authority to impose other requirements on crowdfunding intermediaries “for the protection of investors
and in the public interest.”145
(f) Disqualication Provisions
The Act requires the SEC to adopt rules disqualifying certain issuers, brokers, and funding portals from participating in section 4(6)
oerings.146 Those rules must include disqualications “substantially
similar” to those in Rule 262 of the Regulation A exemption.147 Rule
262 contains a number of “bad actor” disqualications relating to the
issuer, its predecessors, and aliates;148 directors, ocers, general
partners, and 10% benecial owners of the issuer;149 promoters;150 underwriters of the securities being oered;151 and partners, directors, or
ocers of the underwriters.152 These disqualication provisions bar
people who have been involved in various kinds of wrongdoing, mostly
securities-related.
The Act adds other disqualications in addition to those specied in
Rule 262. One of those disqualications applies to persons subject to
certain nal orders of state securities commissioners; state banking,
savings and loan, or credit union regulators; state insurance commissioners; federal banking regulators; or the National Credit Union
Administration. 153 A person is also disqualied if he “has been
convicted of any felony or misdemeanor in connection with the
purchase or sale of any security or involving the making of any false
ling with the Commission.”154
Rule 262 allows the SEC to waive the Regulation A disqualication
for good cause.155 Presumably, since the JOBS Act calls for “substantially similar” disqualication provisions, the SEC could include a
similar waiver in the section 4(6) disqualication rule. However, the
JOBS Act does not provide for a waiver of the specic disqualication
provisions it includes, so it is not clear the SEC would have authority
to waive those disqualications.156
(g) Resale Restrictions
Purchasers in a section 4(6) oering may not resell the securities
for a year from the date of purchase.157 There are ve exceptions to
this prohibition on resales:
208
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
sales back to the issuer;158
sales to accredited investors;159
sales in a registered oering;160
sales to a member of the purchaser's family “or the equivalent;”161
or
E sales in connection with the death or divorce of the purchaser “or
other similar circumstances.”162
The SEC is also authorized to impose other limitations on resales.163
(h) Preemption of State Law
E
E
E
E
(i) State Oering Registration Requirements
Securities sold pursuant to the section 4(6) crowdfunding exemption
are “covered securities” under section 18(b)(4) of the Securities Act.164
As a result, states may not require the registration or qualication of
section 4(6) oerings, or regulate section 4(6) oering documents.165
For some categories of covered securities, section 18(c) of the Securities Act allows states to require the ling of documents led with the
SEC, as well as annual or periodic reports on the value of securities
sold within the state.166 The states may also in some cases require issuers to pay ling or registration fees.167 The drafters of the new
crowdfunding exemption clearly did not intend to allow the states to
require such lings or fees for section 4(6) oerings, with two
exceptions: (1) the state in which the principal place of business of the
issuer is located; and (2) any state in which the purchasers of 50
percent or more of the dollar amount of the oering reside. 168
Unfortunately, there's a drafting error in the JOBS Act.169 The JOBS
Act adds a new subsection section 18(c)(2)(F) to the Securities Act
that applies to securities that are covered securities pursuant to
subsection (b)(4)(B).170 The drafters clearly intended for subsection (F)
to cover section 4(6) securities—the heading of subsection (F) is “FEES
NOT PERMITTED ON CROWDFUNDED SECURITIES.” 171 But
crowdfunded securities are covered securities under subsection
18(b)(4)(C), not (B). Section 18(b)(4)(B) covers securities in transactions that are exempt pursuant to section 4(4) of the Securities Act,172
which has nothing to do with crowdfunding. The statutory crossreference is just wrong.173
The JOBS Act preemption of state law “relate[s] solely to State
registration, documentation, and oering requirements, . . . and . . .
[has] . . . no impact on other State authority to take enforcement action with regard to an issuer, funding portal, or any other person or
entity using the . . . [section 4(6) exemption].”174 States retain authority in section 4(6) transactions with respect to fraud or deceit or
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
209
Securities Regulation Law Journal
unlawful conduct by a broker, dealer, funding portal, or issuer.175 And
the Act requires the SEC to make the disclosure provided by section
4(6) issuers and crowdfunding available to the states,176 which should
facilitate state antifraud enforcement.
(ii) State Regulation of Crowdfunding Intermediaries
State regulation of crowdfunding intermediaries is also aected by
the new crowdfunding provisions. The Act does not disturb state
authority over brokers, even if those brokers are operating as
crowdfunding intermediaries. 177 But new section 15(i)(2) of the
Exchange Act provides, with one exception, that states may not
“enforce any law, rule, regulation, or other administrative action
against a registered funding portal with respect to its business as
such.”178 There is a limited exception for the state which is the funding portal's principal place of business,179 but the principal place of
business may not impose any requirement that is “in addition to or
dierent from the requirements for registered funding portals
established by the Commission.”180
(i) The New Liability Section
Sales of securities pursuant to the section 4(6) exemption are subject
to the same Securities Act and Exchange Act liability rules as other
oers and sales, but the CROWDFUND Act adds a new liability provision applicable only to section 4(6) oerings. New section 4A(c) of
the Securities Act imposes liability for false or misleading statements
and omissions in “any written or oral communication, in the oering
or sale of any security in a transaction exempted by the provisions of
section 4(6).”181 Fraud is dened similarly to other federal securities
law fraud provisions, such as Rule 10b-5182 and section 17 of the Securities Act:183 a communication that “makes an untrue statement of a
material fact or omits to state a material fact required to be stated or
necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading.”184
Any person “who purchases a security in a transaction exempted by
the provisions of section 4(6)” may bring an action under section
4A(c).185 Presumably, this limits the action to those who actually
purchased from the issuer in the oering and would bar subsequent
purchasers, since they would not have purchased the security in the
section 4(6) transaction.186 Plaintis who prove a violation may tender
the security and recover the consideration paid with interest, “less the
amount of any income received thereon.”187 If the plainti no longer
owns the security, the plainti may recover damages;188 the statute
does not say how to calculate those damages.
The plainti is not required to prove that the fraud caused the
plainti's loss. Section 4A(c) incorporates the negative causation
defense of section 12(b) of the Securities Act, which places the loss
210
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
causation burden on the defendant.189 A defendant may avoid liability
for all or part of the amount that would otherwise be recoverable by
showing that the depreciation in value resulted from something other
than the fraud.190
Plaintis also do not have to prove that the defendant acted with
scienter, but defendants may avoid liability by proving that they “did
not know, and in the exercise of reasonable care could not have known,
of such untruth or omission.”191 This language is identical to the
language in section 12(a)(2) of the Securities Act,192 and presumably
will be interpreted in the same way. Section 4A(c), like sections 11
and 12(a)(2) of the Securities Act,193 expressly bars plaintis who
themselves had knowledge of the untruth or omission from recovering.
Section 4A(c) imposes liability on “issuers,”194 but the term issuer is
broadly dened to include not only the actual issuer, but also
any person who is a director or partner of the issuer, and the principal
executive ocer or ocers, principal nancial ocer, and controller or
principal accounting ocer of the issuer (and any person occupying a
similar status or performing a similar function) that oers or sells a security in a transaction exempted by the provisions of section 4(6), and
any person who oers or sells the security in such oering.195
This denition raises several issues. First, it is unclear if the
parenthetical “(and any person occupying a similar status or performing a similar function)”196 applies only to the controller or principal accounting ocer or applies to all the categories listed prior to the
parenthetical.197
Second, it is unclear if the listed directors, partners, and ocers
must themselves oer or sell the securities to be “issuers.” The phrase
“that oers or sells a security in a transaction exempted by the provisions of section 4(6)”198 appears to modify the word “issuer,” so the
listed individuals do not themselves have to oer or sell securities to
be liable, only be connected to an issuer that oers or sells pursuant
to section 4(6). But the “oers or sells” clause could be read to modify
all of the listed defendants, requiring them to oer or sell the securities to be liable. However, the listing of directors and ocers would
then be redundant, since “issuer” already includes “any person who
oers or sells the security” in a section 4(6) oering.199 The terms “offer” and “sell” are not dened in section 4A, so the usual Securities
Act denitions200 would presumably apply, incorporating the Supreme
Court's analysis of “seller” for purposes of section 12 in201
Finally, it is unclear if the non-issuer issuers are liable only for
their own fraud, or also for the issuer's fraudulent statements. Clearly,
the listed defendants would be liable for false and misleading statements they personally make in connection with the issuer's oering.
If, for example, the issuer's CEO directly made a material misstate© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
211
Securities Regulation Law Journal
ment to an investor, the CEO could be liable for that statement. If
that is all section 4A(c) does, its eect will be limited. In many cases,
the issuer's directors, ocers, and others covered by the denition of
“issuer” will not make any statements directly to crowdfunding investors, especially given the Supreme Court's recent restrictive interpretation of what it means to “make” a statement.202
But section 4A(c) could be read to make the non-issuer issuers liable for statements made by the issuer, even if they did not personally
make any statements. The argument is that “issuer” consists of all
the listed people collectively and whenever the collective “issuer”
makes a false statement everyone in that collective “issuer” is liable.
This interpretation would explain how directors, partners, and ocers
could be liable as issuers, even if they did not oer or sell any
securities.
The section 4A(c) cause of action is subject to the same statute of
limitations in section 13 of the Securities Act that would apply to an
action under section 12(a)(2).203 Under section 13, an action must be
brought “within one year after the discovery of the untrue statement
or the omission, or after such discovery should have been made by the
exercise of reasonable diligence,” but in no event later than three
years after the sale in question.204
(j) Interaction with Other Oerings
A section 4(6) crowdfunded oering cannot always be considered in
isolation. The issuer might have already sold securities, or may
subsequently sell securities, pursuant to some other exemption. If so,
the issuer needs to consider how those other oerings aect the
crowdfunding exemption, and vice versa. Sales by other companies
controlled by, or under common control with, the issuer could also
present a problem.
(i) Determining the Aggregate Oering Price
One potential problem has to do with limits on the amount of securities sold. Section 4(6) limits issuers to $1 million in any 12-month
period.205 As previously discussed, although the statute is a little
unclear, that $1 million limit probably does not include securities sold
pursuant to other exemptions unless the two oerings are
integrated.206
Amounts sold pursuant to the section 4(6) exemption would also not
aect the aggregate oering price limits in other exemptions as those
exemptions are currently worded. The primary Securities Act exemptions with aggregate oering price limits are Regulation A and Rules
504 and 505 of Regulation D. Regulation A's $5 million limit is reduced
only by the amount of other Regulation A sales.207 The Rule 504 and
505 limits, $1 million and $5 million respectively, are reduced by
212
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
sales of securities “in reliance on any exemption under section 3(b) [of
the Securities Act], or in violation of section 5(a) of the Securities
Act.”208 The new crowdfunding exemption, created by Congress, is not
a section 3(b) exemption.209 And, if an oering complies with section
4(6), the sales would be exempted from section 5210 and would not
violate section 5(a). Therefore, sales pursuant to the new section 4(6)
exemption would not aect the dollar amounts available under these
other small oering exemptions.
(ii) Integration Issues
Integration is another possible problem for section 4(6) oerings. To
avoid registration under the Securities Act, an issuer's entire oering
must meet the requirements of a single exemption; the issuer may not
use two or more exemptions to cover parts of what is essentially a
single transaction.211 Section 4(6), like other Securities Act exemptions, exempts “transactions,” so the entire transaction must fall
within the exemption.212 If the issuer sells securities outside of section
4(6), the question is whether those other sales would be considered
part of the same transaction and destroy the section 4(6) exemption.
The SEC uses a ve-factor test to determine when to integrate
ostensibly separate oerings and treat them as part of the same
oering. The ve-factor test asks whether (1) the dierent oerings
are part of a single plan of nancing; (2) the oerings involve the
same class of security; (3) the oerings are made at or about the same
time; (4) the same type of consideration is paid for the securities sold;
and (5) the oerings are for the same general purpose.213
Application of the integration doctrine is dicult, to put it mildly.
SEC sta interpretations of the test in no-action letters have been
confusing and inconsistent.214 Even experts have diculty applying
the doctrine: “Everyone seems to agree that these criteria are nearly
impossible to apply, principally because neither the Commission nor
the courts have ever adequately articulated how . . . [the ve factors]
. . . are to be weighed or how many factors must be present in order
for integration to occur.”215 For this reason, an issuer who sells other
securities outside the section 4(6) exemption cannot be sure the
exemption is available.
Issuers using other Securities Act exemptions can avoid the vefactor integration test by using integration safe harbors within those
exemptions.216 Section 4(6) has no such integration safe harbor, or at
least nothing styled as such. Section 4A(g),with the heading “Rule of
Construction,” provides: “Nothing in this section or section 4(6) shall
be construed as preventing an issuer from raising capital through
methods not described under section 4(6).”217 The purpose of section
4A(g) is unclear, but, if it was intended to protect section 4(6) oering
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
213
Securities Regulation Law Journal
from integration with other oerings, its language is incredibly vague
in carrying out that intention. Absent a very generous interpretation
of section 4A(g), issuers who have oered or sold securities outside
section 4(6) must look to the ve-factor test to determine the eect of
those other oers and sales on their section 4(6) oerings.
(iii) The “Control” Language and Issuer Integration
Sales of securities by other companies controlled by, or under common control with, the issuer could also be problematic. The SEC
sometimes integrates oerings by legally separate, but related,
companies.218 If, for example, Issuer A and Issuer B are related
companies and they each oer securities at roughly the same time,
the SEC might treat those two sales as a single oering. Section 4(6)
includes some puzzling language that might accomplish a similar
result.
Section 4(6) exempts oers or sales “by an issuer (including all entities controlled by or under common control with the issuer) . . ..”219
The purpose and meaning of the parenthetical are unclear, but it
could be interpreted to require that the oerings of two issuers be
integrated if they are in a control relationship, even though each issuer is oering its own, separate security. At a minimum, it should
include within the oering sales by the other entity of the section 4(6)
issuer's securities.
Sales by those other companies could aect the section 4(6) exemption in two ways. First, those sales could apply to the issuer's $1 million limit. Second, to the extent that the controlled company's sales
are treated as the issuer's for purposes of section 4(6), an investor's
purchases from the controlled company would be counted against the
individual investment limits.
The “control” parenthetical could aect the exemption even in situations where the company controlled by or under common control with
the issuer is not selling securities. For example, do the issuer
disclosure requirements in section 4A(b) incorporate this control relationship idea, so that an issuer must disclose information about
companies controlled by, or under common control with, the issuer?
Does the control language sweep these aliates into the provision of
section 4A(c) imposing liability on “issuers,”220 making them also
potentially liable? The answer to these questions is unclear.
(k) Exclusion from Exchange Act § 12(g)
The CROWDFUND Act contains one nal, important provision. An
issuer's obligation to register and le reports under the Exchange Act
sometimes depends on the number of record holders of the issuer's
securities.221 The CROWDFUND Act requires the SEC to “conditionally or unconditionally” exclude section 4(6) purchasers from the count
214
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
of record holders.222 Once the SEC adopts the required rule, issuers
need not worry about crowdfunded sales triggering Exchange Act
registration.223
(l) SEC Rulemaking
Many of the requirements of the new crowdfunding exemption turn
on compliance with rules to be adopted by the SEC. Until the SEC
adopts those rules, there is no eective exemption.224 The Act requires
the SEC to issue all required rules no later than 270 days after enactment of the statute.225 President Obama signed the bill on April 5,
2012, so the deadline for rulemaking is December 31, 2012. The SEC
has already begun to solicit public comments on these and other rules
required by the JOBS Act,226 but it is unclear if it will meet the
deadline.227 It still has not completed the rulemaking required by the
Dodd-Frank Act, even though the deadlines for those rules have long
since passed.228
In addition to the required rulemaking, the Act in many places
authorizes the SEC to modify the exemption's requirements. The Act
also includes a general authorization of “such rules as the Commission determines may be necessary or appropriate for the protection of
investors.”229 Appendix B lists all the areas in which SEC rulemaking
is specically required or permitted.
The SEC's rules could toughen the requirements of the statutory
exemption. SEC Chairman Mary Schapiro and Commissioner Luis
Aguilar both spoke against the JOBS Act prior to its passage.230 And
the Act requires the SEC, in the course of its crowdfunding rulemaking, to consult with state securities regulators and any relevant
national securities association.231 The North American Securities
Administrators Association, the organization of state securities regulators, was critical of the JOBS Act,232 so the state regulators will probably be active participants in the regulatory process.
IV. A Selective Critique of the New Exemption
I have already pointed out a number of specic problems with the
new crowdfunding exemption. In this section, I will oer several more
general criticisms.
(a) The New Exemption is Not Well Drafted
The crowdfunding exemption includes a number of ambiguities,
internal inconsistences, and outright drafting errors. These problems
introduce unnecessary complexity into the exemption and will increase
the cost to small business issuers using the exemption.
The most obvious drafting error is in the preemption provisions,
where the drafters included a careless cross-reference to the wrong
subsection of the Securities Act.233 The other glaring drafting mistake
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
215
Securities Regulation Law Journal
appears in the individual investment limits, where the statute applies
both the lower limit and the higher limit in some cases.234
Many of the drafting problems are less blatant, involving ambiguities rather than obvious mistakes. The individual investment limits
provide an example of this type of problem. For wealthier investors,
the limit is “10 percent of the [investor's] annual income or net worth,”
but the Act does not say whether the limit is the greater or the lesser
of those two gures.235 The drafters clearly knew how to deal with this
issue; the limit for less wealthy investors is “the greater of” three
amounts. They just failed to take equal care in drafting the limit for
wealthier investors.
At several places, the Act includes troublesome language whose
meaning is unclear. For example, what exactly is the purpose of the
parenthetical, “(including all entities controlled by or under common
control with the issuers)” at the beginning of section 4(6)?236 What is
the eect of including other people in the denition of “issuer” for
purposes of liability under section 4A(c)?237
The statute is also internally inconsistent in places. That is not necessarily a problem, if the inconsistency was intentional, but most of
the inconsistencies appear to be unintentional. Consider, for example,
the issuer disclosure requirements of section 4A(b). At one point, the
statute requires the issuer to disclose the names of every person owning more than 20 percent of its shares.238 But, elsewhere, the issuer is
required to disclose the names of each person owning more than 20
percent of any class of its shares.239 The two are not, of course,
identical.
This example illustrates another persistent problem in the statute—the assumption that issuers will be corporations. Many small issuers using the section 4(6) exemption will be limited liability
companies, partnerships, or even sole proprietorships. Those entities
must translate the language of the exemption into non-corporate
equivalents.
These drafting issues are not surprising. The substitute crowdfunding amendment was introduced on March 21, 2012, the day before the
Senate agreed to the amendment and approved the JOBS Act. Senate
Bill 2190, the original Merkley-Brown compromise bill on which the
amendment was based, was not introduced until March 13, 2012. Neither bill was subjected to committee hearings or markup. The Act
clearly could have benetted from more thorough consideration and
markup. The SEC and users of the exemption now have to deal with
the consequences.
(b) The Exemption is Too Complicated and Expensive
To be useful to small business issuers, a crowdfunding exemption
needs to be relatively simple and inexpensive. Regulatory cost is, after
216
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
all, why registration is not a viable option for these oerings.240 The
largest section 4(6) oering will only be for $1 million and many oerings could be for much less than that. For oerings that small, it will
not take much regulatory cost to eliminate crowdfunding as an option.
In addition, any regulatory requirements that are imposed on issuers need to be relatively simple and easy to comply with.241 The
entrepreneurs behind these small startup companies often lack legal
and nancial sophistication. And complicated ling and disclosure
requirements invariably demand lawyers and accountants, increasing
the expense of using the exemption.
The issuer disclosure requirements in the new crowdfunding exemption are neither simple nor inexpensive. Issuers must furnish full
nancial statements for even the smallest oerings. Those nancial
statements must be reviewed by independent public accountants if
the oering is for $100,000 or more, and audited if the oering is for
more than $500,000.242 And, unlike other small business exemptions,
the crowdfunding exemption imposes continued, annual reporting
requirements even after the oering is completed.243
Not only is the amount of disclosure excessive, some of the
disclosure items require a rather sophisticated understanding of
corporate law and nance. Consider, for example, sections
4A(b)(1)(H)(iv) and (v) of the statute. Subsection (H)(iv) requires the
issuer to explain “how the securities being oered are being valued,
and examples of methods for how such securities may be valued by
the issuer in the future, including during subsequent corporate
actions.”244 Subsection (H)(v) requires the issuer to explain “the risks
to purchasers of the securities relating to minority ownership in the
issuer, [and] the risks associated with corporate actions, including additional issuances of shares, a sale of the issuer or of assets of the issuer, or transactions with related parties.”245 To comply with these
two requirements, a budding entrepreneur must have the foresight to
predict the future transactions in which the business might engage
and the knowledge of corporate nance needed to describe how securities might be valued in those transactions and the risks those future
transactions could present to security holders. The entrepreneur must
also have the legal knowledge necessary to explain the pitfalls of
minority ownership.
The detailed disclosure requirements in the Act, coupled with the
new liability section, are a liability trap for unwary, unsophisticated
entrepreneurs. Some issuers are bound to bungle the extensive,
complicated disclosures required by the exemption. Since the new liability section has no scienter requirement, those issuers will be liable
even if their failure to disclose properly was merely negligent, not
intentional.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
217
Securities Regulation Law Journal
(c) The Individual Investment Limits are Too High
The limits on how much each investor may invest in crowdfunded
securities oerings are an important investor protection feature. Small
business oerings are risky and investor losses are likely.246 Unsophisticated investors may not adequately understand or evaluate that
risk.247 Appropriate investment limits eliminate the possibility of a
catastrophic loss and limit losses to what each investor can bear.248
The limits in section 4(6) are too high to fulll that policy goal.
Anyone, regardless of their net worth or annual income, may invest
$2,000 per year.249 That is more than some people can aord to lose,
especially on an annual basis. And, if the investor's annual income or
net worth is higher, the investor may invest ve or ten percent of that
annual income or net worth, and continue to invest that amount year
after year.250 It is doubtful that most people, especially those in the
lower income categories, have sucient free cash ow or savings to afford to lose ve or ten percent of their net income. Although there is
no magic number, and reasonable people can disagree as to the appropriate investor limit, the limits in the Act seem excessive.
(d) The Exemption Needs a “Substantial Compliance” Rule
To qualify for the crowdfunding exemption, both issuers and
crowdfunding intermediaries must comply with a number of detailed
requirements. Compliance with all of those requirements is a condition of the exemption.251 If the crowdfunding intermediary fails to
comply with any of the requirements of section 4A(a) or if the issuer
fails to comply with any of the requirements of section 4A(b), the
exemption is unavailable. It does not matter how important or trivial
the violation is, nor does it matter whether the issuer or the intermediary reasonably believed they were in compliance—the exemption is
conditioned on compliance with all of the requirements and any violation results in the loss of the exemption.
If, for example, the issuer sells more than $1 million worth of securities in a 12-month period, the exemption would be lost for all of the
sales, not just those that put the issuer over the limit. If the intermediary fails to properly qualify some of the investors by requiring them
to answer the investor education questions, the exemption would be
lost as to all investors.
If the statute is read literally, the loss of the exemption might even
be retroactive. One of the conditions of the exemption is that the issuer le post-oering annual reports.252 If the issuer failed to le a
required annual report sometime after the oering, the issuer would
not meet all of the requirements of section 4A(b), and section 4(6)
would not exempt the oering.
The consequence of even a minor violation is drastic. Absent an
exemption, section 5(a)(1) of the Securities Act makes it unlawful to
218
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
sell a security unless a registration statement is in eect.253 If the offering does not meet the requirements of section 4(6), no exemption
would be available, and all of the sales in the oering would violate
section 5(a)(1). The issuer would be liable to all of the purchasers for
rescission under section 12(a)(1) of the Securities Act.254
Both the Regulation A exemption and the Regulation D exemption
now include “substantial compliance” rules that protect an issuer
even if the issuer failed to comply with the exemption in certain insignicant ways.255 Regulation D also includes several provisions that
protect the issuer if it reasonably believed the requirements of the
rule were met, even if they actually were not.256
Section 4(6) needs a similar substantial compliance rule. In the
absence of such a rule, the exemption's mix of complicated requirements and relatively inexperienced issuers could prove fatal. Inadvertent violations are likely, and the consequence of any violation, no
matter how minor, will be loss of the exemption and liability to all of
the investors for the full amount invested.
(e) Problems with the Regulation of Funding Portals and
Other Crowdfunding Intermediaries
The new exemption's regulation of crowdfunding intermediaries poses a couple of problems. First, the exemption omits one of the primary antifraud components of crowdfunding—an open, public web
site. Second, the Act seriously handicaps non-broker funding portals
as crowdfunding intermediaries. The Act does not adequately protect
them from the risk that they will be treated as brokers or investment
advisers and the Act imposes other unnecessary restraints on funding
portals that will give brokers a competitive advantage.
(i) Crowdfunding Sites Should Be Public and Oer an
Open Communication Forum for Each Oering
The new exemption omits a crucial element of crowdfunding—an
open, public communications channel allowing potential investors to
communicate with the issuer and each other.257 Openness of this sort
would allow crowdfunding sites to take advantage of “the wisdom of
crowds,”258 the idea that “even if most of the people within a group are
not especially well-informed or rational . . . [the group] can still reach
a collectively wise decision.”259 Open communication channels can help
protect investors from both fraud and poor investment decisions by allowing members of the public to share knowledge about particular
entrepreneurs, businesses, or investment risks.260 Open communication channels also allow investors to monitor the enterprise better after the investment is made.
Congressman McHenry's and Senator Brown's bills each required
open communication channels,261 but that requirement was excluded
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
219
Securities Regulation Law Journal
from the crowdfunding exemption that was eventually enacted. The
new crowdfunding exemption does not even require that crowdfunding sites be open to the public. Crowdfunding sites may be open to the
public and provide communications channels to investors, but the Act
does not require it.
(ii) Funding Portals as Brokers or Investment Advisers
Non-brokers may operate section 4(6) crowdfunding sites and the
statute makes it clear that operating such a site does not make one a
broker.262 However, to avoid being a broker, the crowdfunding site
must be a registered funding portal,263 and “funding portal” is dened
as a person that acts as an intermediary in transactions “solely pursuant to section 4(6).”264 If a crowdfunding intermediary handles a
transaction that is not “pursuant to section 4(6),” it will not qualify as
a funding portal and will lose the broker registration exemption. Given
the complexity of the new exemption, failed section 4(6) oerings are
likely, and each failed oering puts the funding portal's regulatory
status at risk.
Crowdfunding intermediaries could also be “investment advisers”
required to register under the Investment Advisers Act. 265 The
CROWDFUND Act does not protect funding portals from being treated
as investment advisers. In fact, the restrictions the Act imposes on
funding portals exacerbate the problem.
Funding portals may not “oer investment advice or
recommendations.”266 The meaning of investment advice under the
Advisers Act is murky at best,267 and the CROWDFUND Act does
nothing to clarify that uncertainty. If, for example, a funding portal
places a few oerings in a “featured oerings” section, would that constitute a recommendation or investment advice and violate this prohibition? Funding portals that stray into the uncertain area of investment advice now face not one, but two, negative consequences: (1)
they will be violating the Exchange Act restrictions on funding portals;
and (2) they could be acting as unregistered investment advisers in
violation of the Advisers Act.
Even funding portals that do not “oer investment advice or recommendations” could still be investment advisers. The Investment Advisers Act has a two-part denition of investment advisers. First, anyone
who, “for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling
securities” is an investment adviser.268 Presumably, a funding portal
that complied with the new Exchange Act prohibition on “investment
advice or recommendations” would not fall within this prong of the
denition.
220
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
But the denition of investment adviser has a second part. Anyone
who, “for compensation and as part of a regular business, issues or
promulgates analyses or reports concerning securities” is also an
investment adviser.269 One who merely provides information about
companies and investment opportunities can be an investment adviser
under this part of the denition even if no formal recommendation is
made.270 The SEC sta has indicated in several no-action letters that
providing investors with information of this type falls outside the definition of investment adviser only if certain conditions are met.271
It is not clear that one who falls within the second part of the investment adviser denition would be oering investment advice or recommendations within the meaning of the restriction on funding portals.
Thus, a crowdfunding site might meet the requirements to be a funding portal and still risk being treated as an investment adviser.
The SEC could harmonize the two denitions by adding an additional restriction prohibiting funding portals from “issuing reports
or analyses concerning securities.” The denition of funding portal
grants the SEC the power to prevent funding portals from “[engaging]
in such other activities as the Commission, by rule, determines
appropriate.”272 This approach would make the two denitions mutually exclusive, but it would not solve the underlying problem. Funding
portals would still need to determine what constitutes “investment
advice” or “analyses or reports concerning securities.” An “investment
advice” safe harbor specifying exactly what is and is not allowed would
be helpful.
(iii) Other Restrictions on Funding Portals
Two other restrictions on funding portals pose interpretive issues
under the Act and place funding portals at a disadvantage compared
to brokers. First, a funding portal is not allowed to “solicit purchases,
sales, or oers to buy the securities oered or displayed on its web
site or portal”273 or to “compensate employees, agents, or other persons
for such solicitation.”274 Read literally, this could prevent funding
portals from operating crowdfunding sites at all, since issuers' listings
on crowdfunding sites are soliciting purchases and oers to buy the issuers' securities. Since the statute clearly allows funding portals to
operate crowdfunding sites,275 the listings themselves cannot violate
this prohibition. But what else would the prohibition on solicitation
cover? Could a funding portal advertise its site? If so, would it be
barred from mentioning particular oerings in those advertisements?
Could it contact prospective investors by e-mail and provide a link to
the site? Could it do anything more than just provide that link? Even
if such communications did not solicit people to buy particular securities, they would be soliciting people to purchase “the securities oered
or displayed on its web site.” However the restriction on solicitation is
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
221
Securities Regulation Law Journal
interpreted, crowdfunding sites operated by funding portals will be at
a disadvantage compared to sites operated by brokers, who are not
subject to this restriction.
A second restriction on funding portals is also problematic. Funding
portals may not “hold, manage, possess, or otherwise handle investor
funds or securities.”276 Because of this restriction, securities and funds
must be exchanged either directly between issuers and investors or
through an independent third party. And since crowdfunding
intermediaries must “ensure that all oering proceeds are only
provided to the issuer when the aggregate capital raised from all
investors is equal to or greater than a target amount,”277 the only effective solution is to use a third party escrow agent to handle collection and disbursement.278 This gives an advantage to brokers, who are
not subject to such a restriction.
V. Conclusion
Crowdfunding is a promising possibility for small business
startups—a chance for underfunded small businesses to use modern
technology to connect to new sources of capital. But that promise
remains unfullled. Congress could have used crowdfunding as an opportunity to reexamine some of the basic premises of securities regulation of small businesses and to seriously rethink how the Internet can
be used to protect investors in less traditional, less expensive ways.
Instead, it threw together a poorly drafted regulatory bundle of old
ideas that is complicated, expensive, and unlikely to have much of an
eect on the small business capital gap.
Ironically, the most important provision in the JOBS Act for
Internet oerings by small businesses is not in the CROWDFUND
Act and is not specically aimed at either small businesses or Internet
oerings. The JOBS Act requires the SEC to eliminate the prohibition
against general solicitation and general advertising from the Rule 506
exemption in Regulation D, provided that all purchasers are accredited investors.279 The prohibition on general solicitation has eectively
precluded public Internet oerings because the SEC sta interprets it
to prohibit oers to anyone with whom the issuer or persons selling
on the issuer's behalf do not have a preexisting relationship.280
The elimination of the general solicitation restriction will make it
possible to oer securities in a Rule 506 oering on an Internet site
that is open to the general public. Those securities could only be sold
to accredited investors,281 but without almost all of the regulatory
restrictions in the crowdfunding exemption. The issuer would not
have to sell through a broker or funding portal, or, for that matter,
through any intermediary. The dollar amount of the oering would be
unlimited, as would the amount that each investor could purchase.
The issuer would avoid any signicant mandatory disclosure require222
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
ments,282 and there would be no annual reporting requirement. Resales
would be restricted,283 but the holding period for Rule 506 would be no
longer than that under the crowdfunding exemption.284 And, as with
crowdfunding, state disclosure and registration requirements would
be preempted.285
Hence, Congress may have taken a great leap forward for Internet
oerings by small businesses, just not in the portion of the JOBS Act
specically aimed at those oerings.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
223
Securities Regulation Law Journal
APPENDIX A Sections 4(6) and 4A of the
Securities Act (as amended)
Section 4. Exempted transactions
The provisions of section 5 of this Act shall not apply to ***
(6) transactions involving the oer or sale of securities by an issuer
(including all entities controlled by or under common control with the
issuer), provided that—
(A) the aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the exemption provided
under this paragraph during the 12-month period preceding
the date of such transaction, is not more than $1,000,000;
(B) the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption provided
under this paragraph during the 12-month period preceding
the date of such transaction, does not exceed—
(i) the greater of $2,000 or 5 percent of the annual income or
net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than
$100,000; and
(ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate
amount sold of $100,000, if either the annual income or
net worth of the investor is equal to or more than $100,000;
(C) the transaction is conducted through a broker or funding portal
that complies with the requirements of section 4A(a); and
(D) the issuer complies with the requirements of section 4A(b).
Section 4A. Requirements with respect to certain small transactions.
(a) REQUIREMENTS ON INTERMEDIARIES.—A person acting
as an intermediary in a transaction involving the oer or sale of
securities for the account of others pursuant to section 4(6)
shall—
(1) register with the Commission as—
(A) a broker; or
(B) a funding portal (as dened in section 3(a)(80) of the
Securities Exchange Act of 1934);
(2) register with any applicable self-regulatory organization
(as dened in section 3(a)(26) of the Securities Exchange
Act of 1934);
(3) provide such disclosures, including disclosures related to
risks and other investor education materials, as the Commission shall, by rule, determine appropriate;
224
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
(4) ensure that each investor—
(A) reviews investor-education information, in accordance with standards established by the Commission, byrule;
(B) positively arms 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;
(5) take such measures to reduce the risk of fraud with respect to such transactions, as established by the Commission, by rule, including obtaining a background and securities enforcement regulatory history check on each ocer,
director, and person holding more than 20 percent of the
outstanding equity of every issuer whose securities are offered by such person;
(6) not later than 21 days prior to the rst day on which securities are sold to any investor (or such other period asthe
Commission may establish), make available to the Commission and to potential investors any information
provided by the issuer pursuant to subsection (b);
(7) ensure that all oering proceeds are only provided to the
issuer when the aggregate capital raised from all investors is equal to or greater than a target oering amount,
and allow all investors to cancel their commitments to
invest, as the Commission shall, by rule, determine appropriate;
(8) make such eorts as the Commission determines appropriate, by rule, to ensure that no investor in a 12-month period has purchased securities oered pursuant to section
4(6) that, in the aggregate, from all issuers, exceed the
investment limits set forth in section 4(6)(B);
(9) take such steps to protect the privacy of information collected from investors as the Commission shall, by rule,
determine appropriate;
(10) not compensate promoters, nders, or lead generators for
providing the broker or funding portal with the personal
identifying information of any potential investor;
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
225
Securities Regulation Law Journal
(11) prohibit its directors, ocers, or partners (or any person
occupying a similar status or performing a similar function) from having any nancial interest in an issuer using
its services; and
(12) meet such other requirements as the Commission may, by
rule, prescribe, for the protection of investors andin the
public interest.
(b) REQUIREMENTS FOR ISSUERS.—For purposes of section
4(6), an issuer who oers or sells securities shall—
(1) le with the Commission and provide to investors and the
relevant broker or funding portal, and make availableto
potential investors—
(A) the name, legal status, physical address, and website
address of the issuer;
(B) the names of the directors and ocers (and any
persons occupying a similar status or performing a
similarfunction), and each person holding more than
20 percent of the shares of the issuer;
(C) a description of the business of the issuer and the
anticipated business plan of the issuer;
(D) a description of the nancial condition of the issuer,
including, for oerings that, together with all other
oerings of the issuer under section 4(6) within the
preceding 12-month period, have, in the aggregate,
target oering amounts of—
(i)
$100,000 or less—
(I) the income tax returns led by the issuer
for the most recently completed year (if
any); and
(II) nancial statements of the issuer, which
shall be certied by the principal executive
ocer of the issuer to be true and complete
in all material respects;
(ii)
more than $100,000, but not more than
$500,000, nancial statements reviewed by a
public accountant who is independent of the issuer, using professional standards and procedures for such review or standards and procedures established by the Commission, by rule,
for such purpose; and
(iii) more than $500,000 (or such other amount as
the Commission may establish, by rule), audited nancial statements;
226
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
(E) a description of the stated purpose and intended use
of the proceeds of the oering sought by the issuer
with respect to the target oering amount;
(F) the target oering amount, the deadline to reach the
target oering amount, and regular updates regardingthe progress of the issuer in meeting the target
oering amount;
(G) the price to the public of the securities or the method
for determining the price, provided that, prior tosale,
each investor shall be provided in writing the nal
price and all required disclosures, with a reasonable
opportunity to rescind the commitment to purchase
the securities;
(H) a description of the ownership and capital structure
of the issuer, including—
(i)
terms of the securities of the issuer being offered and each other class of security of the issuer, including how such terms may be modied, and a summary of the dierences between
such securities, including how the rights of the
securities being oered may be materially
limited, diluted, or qualied by the rights of
any other class of security of the issuer;
(ii)
a description of how the exercise of the rights
held by the principal shareholders of the issuer could negatively impact the purchasers of
the securities being oered;
(iii) the name and ownership level of each existing
shareholder who owns more than 20 percent of
any class of the securities of the issuer;
(iv) how the securities being oered are being
valued, and examples of methods for how such
securities may be valued by the issuer in the
future, including during subsequent corporate
actions; and (v) the risks to purchasers of the
securities relating to minority ownership in
the issuer, the risks associated with corporate
actions, including additional issuances of
shares, a sale of the issuer or of assets of the
issuer, or transactions with related parties;
and
(I) such other information as the Commission
may, by rule, prescribe, for the protection of
investors and in the public interest;
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
227
Securities Regulation Law Journal
(2) not advertise the terms of the oering, except for notices
which direct investors to the funding portal or broker;
(3) not compensate or commit to compensate, directly or
indirectly, any person to promote its oerings through communication channels provided by a broker or funding portal,
without taking such steps as the Commission shall, by rule,
require to ensure that such person clearly discloses the
receipt, past or prospective, of such compensation, upon
each instance of such promotional communication;
(4) not less than annually, le with the Commission and
provide to investors reports of the results of operations and
nancial statements of the issuer, as the Commission shall,
by rule, determine appropriate, subject to such exceptions
and termination dates as the Commission may establish, by
rule; and
(5) comply with such other requirements as the Commission
may, by rule, prescribe, for the protection of investors and
in the public interest.
(c) LIABILITY FOR MATERIAL MISSTATEMENTS AND
OMISSIONS.—
(1) ACTIONS AUTHORIZED.—
(A) IN GENERAL.—Subject to paragraph (2), a person
who purchases a security in a transaction exempted
by the provisions of section 4(6) may bring an action
against an issuer described in paragraph (2), either
at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any
income received thereon, upon the tender of such security, or for damages if such person no longer owns
the security.
(B) LIABILITY.—An action brought under this paragraph shall be subject to the provisions of section
12(b) and section 13, as if the liability were created
under section 12(a)(2).
(2) APPLICABILITY.—An issuer shall be liable in an action
under paragraph (1), if the issuer—
(A) by the use of any means or instruments of transportation or communication in interstate commerce or
of the mails, by any means of any written or oral
communication, in the oering or sale of a security
in a transaction exempted by the provisions of section 4(6), makes an untrue statement of a material
fact or omits to state a material fact required to be
228
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
stated or necessary in order to make the statements,
in the light of the circumstances under which they
were made, not misleading, provided that the purchaser did not know of such untruth or omission;
and
(B) 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.
(3) DEFINITION.—As used in this subsection, the term “issuer” includes any person who is a director or partner of
the issuer, and the principal executive ocer or ocers,
principal nancial ocer, and controller or principal accounting ocer of the issuer (and any person occupying a
similar status or performing a similar function) that oers
or sells a security in a transaction exempted by the provisions of section 4(6), and any person who oers or sells the
security in such oering.
(d) INFORMATION AVAILABLE TO STATES.—The Commission
shall make, or shall cause to be made by the relevant broker or
funding portal, the information described in subsection (b) and
such other information as the Commission, by rule, determines
appropriate, available to the securities commission (or any
agency or oce performing like functions) of each State and territory of the United States and the District of Columbia.
(e) RESTRICTIONS ON SALES.—Securities issued pursuant to a
transaction described in section 4(6)—
(1) may not be transferred by the purchaser of such securities
during the 1-year period beginning on the date of purchase,
unless such securities are transferred—
(A) to the issuer of the securities;
(B) to an accredited investor;
(C) as part of an oering registered with the Commission; or
(D) to a member of the family of the purchaser or the
equivalent, or in connection with the death or divorce
of the purchaser or other similar circumstance, in
the discretion of the Commission; and
(2) shall be subject to such other limitations as the Commission shall, by rule, establish.
(f) APPLICABILITY.—Section 4(6) shall not apply to transactions
involving the oer or sale of securities by any issuer that—
(1) is not organized under and subject to the laws of a State or
territory of the United States or the District of Columbia;
(2) is subject to the requirement to le reports pursuant to sec© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
229
Securities Regulation Law Journal
tion 13 or section 15(d) of the Securities Exchange Act of
1934;
(3) is an investment company, as dened in section 3 of the
Investment Company Act of 1940, or is excluded from the
denition of investment company by section 3(b) or section
3(c) of that Act; or
(4) the Commission, by rule or regulation, determines
appropriate.
(g) RULE OF CONSTRUCTION.—Nothing in this section or section 4(6) shall be construed as preventing an issuer from raising capital through methods not described under section 4(6).
(h) CERTAIN CALCULATIONS.—
(1) DOLLAR AMOUNTS.—Dollar amounts in section 4(6) and
subsection (b) of this section shall be adjusted by the Commission not less frequently than once every 5 years, by notice published in the Federal Register to reect any change
in the Consumer Price Index for All Urban Consumers
published by the Bureau of Labor Statistics.
(2) INCOME AND NET WORTH.—The income and net worth
of a natural person under section 4(6)(B) shall be calculated
in accordance with any rules of the Commission under this
title regarding the calculation of the income and net worth,
respectively, of an accredited investor.
230
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
APPENDIX B Required and Optional
SEC Rulemaking
Type of Regulation
Such rules as necessary or appropriate
for the protection of investors to carry
out sections 4(6) and 4A
Disqualication provisions for issuers
and crowdfunding intermediaries
Disclosure required by crowdfunding intermediaries
Standards for investor-education information to be reviewed by investors
Other matters that investors must demonstrate an understanding of
Measures to be taken by intermediaries
to reduce the risk of fraud
Alternative period prior to oering by
which intermediaries must make available to the SEC and potential investors
information provided by the issuer
Cancellation of commitment to invest
prior to issuer reaching target
Eorts required by intermediaries to
ensure that no investor has exceeded the
12-month aggregate crowdfunding cap
Steps by intermediaries to protect the
privacy of information collected by investors
Other requirements imposed on
intermediaries for the protection of
investors and in the public interest
Professional standards and procedures
for review by independent accountants
of issuer nancial statements for oerings in the $100,000-500,000 range
Alternate amount of oering for which
audited nancial statements are
required
Other information to be led and
disclosed by the issuer
Statutory Authority
JOBS Act § 302(c)
JOBS Act § 302(d)
Securities Act § 4A(a)(3)
Securities Act
§ 4A(a)(4)(A)
Securities Act
§ 4A(a)(4)(C)(iii)
Securities Act § 4A(a)(5)
Securities Act § 4A(a)(6)
Securities Act § 4A(a)(7)
Securities Act § 4A(a)(8)
Securities Act § 4A(a)(9)
Securities Act § 4A(a)(12)
Securities Act
§ 4A(b)(1)(D)(ii)
Securities Act
§ 4A(b)(1)(D)(iii)
Securities Act
§ 4A(b)(1)(I)
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
231
Securities Regulation Law Journal
Type of Regulation
Steps required to ensure that persons
compensated by the issuer for promoting
its oerings through communication
channels provided by crowdfunding intermediaries disclose that compensation
upon each communication
Contents of annual reports on results of
operations and nancial statements to
be led by crowdfunding issuers, and
exceptions and termination dates for the
annual reporting requirement
Other requirements imposed on issuers
for the protection of investors and in the
public interest
Other information that crowdfunding
intermediaries must make available to
state securities regulator
Circumstances similar to death or
divorce in which crowdfunded securities
may be resold within the one-year period
after purchase
Other limitations on resales
Other issuers not eligible to use the
crowdfunding exemption
Adjustment of dollar amounts for
changes to CPI
Conditional or unconditional exemption
of section 4(6) securities from section
12(g) of Exchange Act
Conditional or unconditional exemption
of registered funding portals from the
requirement to register as brokers or
dealers
Other requirements for registered funding portals to be eligible for exemption
from the requirement to register as
brokers or dealers
Extent to which the term “broker or
dealer” shall not include registered funding portals for purposes of section
15(c)(8) and 15A of the Exchange Act
Other activities that funding portals
may not engage in
232
Statutory Authority
Securities Act § 4A(b)(3)
Securities Act § 4A(b)(4)
Securities Act § 4A(b)(5)
Securities Act § 4A(d)
Securities Act
§ 4A(e)(1)(D)
Securities Act § 4A(e)(2)
Securities Act § 4A(f)(4)
Securities Act § 4A(h)(1)
Exchange Act § 12(g)(6)
Exchange Act § 3(h)(1)
Exchange Act § 3(h)(1)(C)
Exchange Act § 3(h)(2)
Exchange Act
§ 3(a)(80)(E)
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
NOTES:
2
Jumpstart Our Business Startups Act, Pub. L. 112-106, 126 Stat. 306 (2012)
[hereinafter, “JOBS Act”].
3
JOBS Act, Pub. L. No. 112-106, §§ 301-305, 126 Stat. 306 (2012). “CROWDFUND” is an acronym for “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure.” Id., § 301.
4
See Paul Belleamme, Thomas Lambert & Armin Schwienbacher, Crowdfunding:
Tapping the Right Crowd 2 (Center for Operations Discussion and Research, Discussion Paper No. 2011/32, 2011), available at http://ssrn.com/abstract=1836873.
5
See Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus.
L. Rev. 1, 10 (2012).
6
SeeAbout Us—History, KIVA, http://www.kiva.org/about/history (last visited
Mar. 5, 2012).
7
KEVIN LAWTON & DAN MAROM, THE CROWDFUNDING REVOLUTION:
SOCIAL NETWORKING MEETS VENTURE FINANCING 66 (2010).
8
According to one study, crowdfunding raised $1.5 billion worldwide in 2011. See
Natalie Huet, European Start-Ups Court Crowds for Cash, REUTERS, May 9, 2012,
available at http://www.reuters.com/article/2012/05/09/nance-crowdfunding-idUSL5
E8G50RB20120509.
9
See Angela Moscaritolo, Pebble Smartwatch Sells Out, Collects $10 Million on
Kickstarter, PCMag.com (May 10, 2012), http:// www.pcmag.com/article2/0,2817,
2404295,00.asp.
10
See Cable, Fending for Themselves: Why Securities Regulations Should Encourage Angel Groups, 13 U. Pa. J. Bus. L. 107, 108 (2010); Fisch, Can Internet Oerings
Bridge the Small Business Capital Barrier?, 2 J. Small & Emerging Bus. L. 57, 59–64
(1998); Ibrahim, The (Not So) Puzzling Behavior of Angel Investors, 61 Vand. L. Rev.
1405, 1417 (2008).
11
See Bradford, supra note 4, at 100–104.
12
See id., at 101.
13
See id., at 104.
14
See id., at 109–112 (discussing a number of studies of nancial sophistication).
15
See id., at 106–107, and sources cited therein.
16
See id., at 108, and sources cited therein.
17
See id., at 108–109, and sources cited therein.
18
Absent an exemption, it is unlawful to sell securities unless a registration statement is in eect as to those securities. Securities Act of 1933 § 5(a)(1), 15 U.S.C.A.
§ 77e(a)(1) (2010).
19
See Bradford, supra note 4, at 42–49.
20
See id., at 51–80.
21
Seeid., at 15–16.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
233
Securities Regulation Law Journal
22
See id., at 16-19.
23
Id.
24
Id., at 31–33.
25
See Bradford, supra note 4, at 33–42.
26
Securities Act of 1933 § 4(6), JOBS Act, Pub. L. 112-106, § 302(a), 126 Stat. 306
(2012) (to be codied at 15 U.S.C. § 77d(6)).
27
See Securities Act of 1933 § 4A(a),(b), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a),(b)).
28
See Section III.G, infra.
29
See Section III.E.1, infra.
30
See Section III.H, infra.
31
See Section III.I, infra.
32
See Bradford, supra note 4, at 98–117.
33
See id., at 117–149.
34
See Heminway and Homan, Proceed at Your Peril: Crowdfunding and the
Securities Act of 1933, 78 Tenn. L. Rev. 879 (2011); Pope, Crowdfunding Microstartups: It's Time for the Securities and Exchange Commission to Approve a Small Oering Exemption, 13 U. Pa. J. Bus. L. 973, 978-81 (2011); Burkett, A Crowdfunding
Exemption? Online Investment Crowdfunding and U.S. Securities Regulation, 13
Transactions 63 (2011); Thomas Lee Hazen, Crowdfunding or Fraudfunding? Social
Networks and the Securities Laws—Why any Specially Tailored Exemption Should
be Conditioned on Meaningful Disclosure, N. C. L. REV. (forthcoming 2012), available
at http://ssrn.com/abstract=1954040.
35
See Paredes, On the Decision to Regulate Hedge Funds: The SEC's Regulatory
Philosophy, Style, and Mission, 2006 U. Ill. L. Rev. 975, 1005–1006 (2006) (discussing
the need to balance investor protection and capital formation in securities regulation).
36
For a discussion of what I think those structural requirements should be and
their justications, see Bradford, supra note 4, at 117–150.
37
I consulted with House and Senate sta members who drafted the legislation
discussed in this section. However, I was not directly involved in drafting or lobbying
for any of the bills.
38
Sustainable Economies Law Ctr., Request for Rulemaking to Exempt Securities
Oerings Up to $100,000 With $100 Maximum Per Investor From Registration, SEC
File No. 4-605, at 2 (July 1, 2010), available at http://www.sec.gov/rules/petitions/
2010/petn4-605.pdf.
39
See Letter from Woodie Neiss, Member, SBE Council Advisory Committee, to
Gerald J. Laporte, Chief, Oce of Small Business Policy, Division of Corporate
Finance, SEC (Dec. 21, 2010), available at http://www.sec.gov/info/smallbus/2010gbfor
um/2010gbforum-sbe.pdf; STARTUP EXEMPTION, http://www.startupexemptio
n.com (last visited Mar. 5, 2012).
40
See Bradford, supra note 4, at 85–86.
41
Letter from Mary L. Schapiro, Chairman, SEC, to Darrell E. Issa, Chairman,
House Comm. on Oversight & Gov't Reform 22-23 (Apr. 6, 2011), available at www.se
c.gov/news/press/schapiro-issa-letter-040611.pdf.
42
234
Id., at 1.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
43
See Press Release, White House Oce of the Press Secretary issues Fact Sheet
and Overview for American Jobs Act 2 (Sept. 8, 2011), available at http://www.whiteh
ouse.gov/the-press-oce/2011/09/08/fact-sheet-and-overview.
44
See Entrepreneur Access to Capital Act, H.R. 2930, 112th Cong. (as passed by
House, Nov. 3, 2011). For a full discussion of this bill, see Bradford, supra note 4, at
88–91.
45
See Executive Oce of the President, Statement of Administration Policy (Nov.
2, 2011), available at www.whitehouse.gov/sites/default/les/ omb/legislative/sap/112/s
aphr2930r20111102.pdf (“The Administration supports House passage of H.R.
2930.”).
46
157 CONG. REC. H7311 (Nov. 3, 2011).
47
Democratizing Access to Capital Act of 2011, S. 1791, 112th Cong. (2011). For a
full discussion of S. 1791, see Bradford, supra note 4, at 91–93.
48
Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure
Act of 2011, S. 1970, 112th Cong. (2011). For a full discussion of S. 1970, see Bradford,
supra note 4, at 94–97.
49
Jumpstart Our Business Startups Act, H.R. 3606, 112th Cong. (as passed by
House, Nov. 3, 2011). See 158 CONG. REC. H1288 (Mar. 8, 2012).
50
Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure
Act of 2012, S. 2190, 112th Cong. (2012).
51
Senate Amendment 1884, 112th Cong. (2012).
52
158 Cong. Rec. S1976-1977 (Mar. 22, 2012).
53
158 Cong. Rec. H1598 (Mar. 27, 2012).
Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306
(2012).
55
For the convenience of the reader, the new sections 4(6) and 4A of the Securities Act, as added by the JOBS Act, appear in Appendix A.
56
Securities Act of 1933 § 4(6), JOBS Act, Pub. L. No. 112-106, § 302(a), 126 Stat.
306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)).
57
Securities Act of 1933 § 4(6)(A), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(A)).The SEC is required to
adjust this dollar amount at least every ve years to reect changes in the Consumer
Price Index for All Urban Consumers. Securities Act of 1933 § 4A(h)(1), JOBS Act,
Pub. L. No. 112-106, § 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A.
§ 77d-1(h)(1)).
58
New section 4(6)(A) provides that “the aggregate amount sold to all investors by
the issuer, including any amount sold in reliance on the exemption provided under
this paragraph during the 12-month period preceding the date of such transaction”
may not exceed the cap. Securities Act of 1933 § 4(6)(A), JOBS Act, Pub. L. No. 112106, § 302(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(A)). (emphasis
added).
59
Sales by companies controlled by, or under common control with, the issuer
could also count against the issuer's $1 million limit. See Section III.J.3, infra.
60
See Section III.J.2, infra.
61
See id.
62
Securities Act of 1933 § 4A(h), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(h)). Currently, the only such
54
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
235
Securities Regulation Law Journal
rules are Rules 215 and 501 under the Securities Act. Under those rules, a spouse's
income and net worth are included when calculating a person's annual income and
net worth. See Securities Act Rules 215(e),(f); 501(a)(5),(6), 17 C.F.R. §§ 230.215(e),(f);
501(a)(5),(6) (2012). The value of an investor's primary residence is excluded in
calculating net worth. See Securities Act Rules 215(e), 501(a)(5), 17 C.F.R.
§§ 230.215(e), 230.501(a)(5) (2012).
63
The SEC is required to adjust the $100,000 barrier at least every ve years to
reect any changes in the Consumer Price Index for All Urban Consumers. See Securities Act of 1933 § 4A(h)(1), JOBS Act, Pub. L. No. 112-106, § 302(b), 126 Stat. 306
(2012) (to be codied at 15 U.S.C.A. § 77d-1(h)(1)).
64
Securities Act of 1933 § 4(6)(B)(i), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)(i)).
65
Securities Act of 1933 § 4(6)(B)(ii), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)(ii)).
66
Subsection 4(6)(B)(i) clearly says that the limit is “the greater of” the alternatives. Securities Act of 1933 § 4(6)(B)(i), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)(i)). But subsection 4(6)(B)(ii)
contains no such language. See Securities Act of 1933 § 4(6)(B)(ii), JOBS Act, Pub. L.
No. 112-106, § 302(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)(ii)).
67
Securities Act of 1933 § 4(6)(B)(ii), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)(ii)) (emphasis added).
68
Securities Act of 1933 § 4(6)(B)(i), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)(i)).
69
Securities Act of 1933 § 4(6)(B)(ii), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C. § 77d(6)(B)(ii)).
70
Securities Act of 1933 § 4(6)(B), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)) (emphasis added).
71
See Section III.C.2, infra.
72
Sales of securities by companies controlled by, or under common control with,
the issuer could also be counted against the single-issuer limit. See Section III.J.3,
infra.
73
Securities Act of 1933 § 4A(a)(8), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(8)) (emphasis added).
74
See Section III.C.1, supra.
75
A crowdfunding intermediary is required to ensure that each investor “reviews
investor-education information, in accordance with standards established by the
Commission.” Securities Act of 1933 § 4A(a)(4)(A), JOBS Act, Pub. L. No. 112-106,
§ 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(4)(A)).
76
Securities Act of 1933 § 4A(a)(4)(C), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(4)(C)).
77
Securities Act of 1933 § 4A(a)(4)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(4)(B)).
78
The section 4(6) exemption is available only “provided that . . . the issuer
complies with the requirements of section 4A(b).” Securities Act of 1933 § 4(6)(D),
JOBS Act, Pub. L. No. 112-106, § 302(a), 126 Stat. 306 (2012) (to be codied at 15
U.S.C.A. § 77d(6)(D)).
236
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
79
See Securities Act of 1933 § 4A(f), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(f)).
80
See JOBS Act, Pub. L. No. 112-106, § 302(d), 126 Stat. 306 (2012).
81
Securities Act of 1933 § 4A(f)(1), JOBS Act, Pub. L. No.
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(f)(1)).
82
Securities Act of 1933 § 4A(f)(2), JOBS Act, Pub. L. No.
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(f)(2)).
83
Securities Act of 1933 § 4A(f)(3), JOBS Act, Pub. L. No.
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(f)(3)).
84
Securities Act of 1933 § 4A(f)(4), JOBS Act, Pub. L. No.
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(f)(4)).
85
See Section III.F, infra.
86
Securities Act of 1933 § 4A(b)(1), JOBS Act, Pub. L. No.
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)).
112-106, § 302(b), 126
112-106, § 302(b), 126
112-106, § 302(b), 126
112-106, § 302(b), 126
112-106, § 302(b), 126
87
Rather than follow the order of the statute, I have in certain places reorganized
the information into more useful categories.
88
Securities Act of 1933 § 4A(b)(1)(A), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(A)).
89
Securities Act of 1933 § 4A(b)(1)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(B)).
90
Securities Act of 1933 § 4A(b)(1)(C), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(C)).
91
Securities Act of 1933 § 4A(b)(1)(D), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(D)).
92
The SEC is required to adjust these dollar amount categories at least every ve
years to reect any changes in the Consumer Price Index for All Urban Consumers.
Securities Act of 1933 § 4A(h)(1), JOBS Act, Pub. L. No. 112-106, § 302(b), 126 Stat.
306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(h)(1)).
93
Securities Act of 1933 § 4A(b)(1)(D)(i), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(D)(i)).
94
Securities Act of 1933 § 4A(b)(1)(D)(ii), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(D)(ii)). An issuer in
this category is not required to provide its tax returns.
95
Securities Act of 1933 § 4A(b)(1)(D)(iii), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(D)(iii)). No tax returns
are required.
96
Securities Act of 1933 § 4A(b)(1)(H), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)).
97
Securities Act of 1933 § 4A(b)(1)(H)(i), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(i)).
98
Id.
99
Securities Act of 1933 § 4A(b)(1)(H)(ii), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(ii)). “Principal
shareholder” is not dened.
100
Securities Act of 1933 § 4A(b)(1)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(B)).
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
237
Securities Regulation Law Journal
101
Securities Act of 1933 § 4A(b)(1)(H)(iii), JOBS Act, Pub. L. No. 112-106,
§ 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(iii)). This
requirement and the previous requirement come from separate parts of the statute.
Although similar, they are not necessarily the same. If the issuer has two classes of
shares outstanding, one who owns 20% of one class doesn't necessarily own 20% of all
of the issuer's outstanding shares.
102
Securities Act of 1933 § 4A(b)(1)(H)(iv), JOBS Act, Pub. L. No. 112-106,
§ 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(iv)).
103
Securities Act of 1933 § 4A(b)(1)(H)(v), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(v)).
104
Securities Act of 1933 § 4A(b)(1)(E), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(E)).
105
Securities Act of 1933 § 4A(b)(1)(F), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(91)(F)). The issuer must
also provide “regular updates” on its progress towards meeting that target. Id. See
Section III.E.4, infra, for a discussion of the eect of the target amount and deadline.
106
Securities Act of 1933 § 4A(b)(1)(G), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(G)).
107
It is unclear from the statute if this nal price disclosure and opportunity to
rescind applies in all cases or only when the price is not set in advance (i.e., when
only the method for determining the price is specied).
108
Securities Act of 1933 § 4A(b)(4), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(4)).
109
Id.
110
Id.
111
Securities Act of 1933 § 4A(b)(2), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(2)).
112
Securities Act of 1933 § 4A(b)(3), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(3)). This restriction undoubtedly reects a concern that issuers might pay people to tout the oerings on
crowdfunding websites.
113
Securities Act of 1933 § 4A(b)(1)(I), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(I)).
114
Securities Act of 1933 § 4A(b)(5), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(5)).
115
Securities Act of 1933 § 4(6)(C), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(C)).
116
See Section III.F, infra.
117
See Securities Act of 1933 § 4A(a), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)).
118
Securities Act of 1933 § 4A(a)(1), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(1)).
119
Securities Act of 1933 § 4A(a)(2), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(2)).
120
238
See Securities Exchange Act of 1934 § 15(a),(b), 15 U.S.C.A. § 78o(a),(b) (2010).
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
121
Securities Exchange Act of 1934 § 3(a)(80), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)).
122
Securities Exchange Act of 1934 § 3(a)(80)(A), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(A)).
123
Securities Exchange Act of 1934 § 3(a)(80)(B), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(B)).
124
Securities Exchange Act of 1934 § 3(a)(80)(C), JOBS Act, Pub. L. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(C)).
125
Securities Exchange Act of 1934 § 3(a)(80)(D), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(D)).
126
Securities Exchange Act of 1934 § 3(a)(80)(E), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(E)).
127
Securities Exchange Act of 1934 § 3(h)(1), JOBS Act, Pub. L. No. 112-106,
§ 304(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(h)(1)). The rules
providing for such an exemption must be issued no later than 270 days after enactment of the Act. JOBS Act, supra, § 304(a)(2).
128
Securities Exchange Act of 1934 § 3(h)(1)(C), JOBS Act, Pub. L. No. 112-106,
§ 304(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(h)(1)(C)).
129
Section 15(b)(8) of the Exchange Act requires brokers to belong to a national
securities association registered pursuant to section 15A of the Exchange Act. See Securities Exchange Act of 1934 § 15(b)(8), 15 U.S.C.A. § 78o(b) (2010). New section 3(h)
of the Exchange Act provides that, for purposes of sections 15(b)(8) and 15A, the term
“broker or dealer” includes funding portals. Securities Exchange Act of 1934 § 3(h)(2),
JOBS Act, Pub. L. No. 112-106, § 304(a), 126 Stat. 306 (2012) (to be codied at 15
U.S.C.A. § 78c(h)(2)).
130
See Securities Exchange Act of 1934 § 3(h)(1)(B), JOBS Act, Pub. L. No. 112106, § 304(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(h)(1)(B)).
131
Securities Exchange Act of 1934 § 3(h)(2), JOBS Act, Pub. L. No. 112-106,
§ 304(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(h)(2)).
132
Securities Act of 1933 § 4A(a)(3), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(3)).
133
See Section III.C.3, supra.
134
See Securities Act of 1933 § 4A(a)(4), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(4)).
135
Securities Act of 1933 § 4A(a)(8), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(8)). For a discussion of these
limits, see Section III.C.2, supra.
136
Securities Act of 1933 § 4A(a)(6), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(6)). The Act allows the SEC
to change the 21-day period. Id.
137
Securities Act of 1933 § 4A(a)(5), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(5)).
138
As previously discussed, the statute sometimes refers to the holders of 20% of
any class of security and sometimes refers to the holders of 2% of the overall equity.
See Section III.D.2.c, supra. The reference here is to all of the outstanding equity, not
to any particular class.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
239
Securities Regulation Law Journal
139
Securities Act of 1933 § 4A(a)(7), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(7)).
140
See Section III.D.2.d, supra.
141
The issuer could avoid fraud claims by notifying investors of the amendment
and giving them an opportunity to withdraw.
142
Securities Act of 1933 § 4A(a)(9), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(9)).
143
Securities Act of 1933 § 4A(a)(10), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(10)).
144
Securities Act of 1933 § 4A(a)(11), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(11)).
145
Securities Act of 1933 § 4A(a)(12), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(12)).
146
JOBS Act, Pub. L. No. 112-106, § 302(d), 126 Stat. 306 (2012).
147
See Securities Act Rule 262, 17 C.F.R. § 230.262 (2012).
148
See Securities Act Rule 262(a), 17 C.F.R. § 230.262(a) (2012).
149
See Securities Act Rule 262(b), 17 C.F.R. § 230.262(b) (2012).
150
See id.
151
See Securities Act Rule 262(b),(c), 17 C.F.R. § 230.262(b),(c) (2012).
152
See Securities Act Rule 262(b), 17 C.F.R. § 230.262(b) (2012).
153
JOBS Act, Pub. L. No. 112-106, § 302(d)(2)(B)(i), 126 Stat. 306 (2012). A person
is disqualied if such an order bars the person from associating with a regulated
entity; engaging in the business of securities, insurance, or banking; or engaging in
savings association or credit union activities. The person is also disqualied if the order is a nal order “based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the 10-year period ending on the
date of ling of the oer or sale.” Id., § 302(d)(2)(B)(i)(II). It is unclear from the
language of the statute whether the violation or only the order has to be within 10
years of the section 4(6) oering, although the better reading is probably that the
conduct constituting the violation has to be within 10 years.
154
JOBS Act, Pub. L. No. 112-106, § 302(d)(2)(B)(ii), 126 Stat. 306 (2012).
155
Securities Act Rule 262, 17 C.F.R. § 230.262 (2012).
156
Section 302(c) of the Act grants the SEC the authority to “issue such rules as
the Commission determines may be necessary or appropriate for the protection of
investors to carry out sections 4(6) and section 4A,” JOBS Act, Pub. L. No. 112-106,
§ 302(c), 126 Stat. 306 (2012), but it's not clear that an exception to what Congress
has expressly required would fall within this language. However, section 28 of the Securities Act authorizes the SEC to “conditionally or unconditionally exempt any
person, security, or transaction, or any class or classes of persons, securities, or
transactions, from any provision or provisions of this subchapter or of any rule or
regulation issued under this subchapter, to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of
investors.” Securities Act of 1933 § 28, 15 U.S.C.A. § 77z-3 (2010). Perhaps section 28
would give the SEC the authority to waive the JOBS Act disqualications.
157
Securities Act of 1933 § 4A(e)(1), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(e)(1)).
240
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
158
Securities Act of 1933 § 4A(e)(1)(A), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(e)(1)(A)).
159
Securities Act of 1933 § 4A(e)(1)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(e)(1)(B)).
160
Securities Act of 1933 § 4A(e)(1)(C), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(e)(1)(C)).
161
Securities Act of 1933 § 4A(e)(1)(D), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(e)(1)(D)). The statute
provides no clue as to what the “equivalent” of a family member is.
162
Id. The statute does not say what other circumstances might be similar—
presumably other involuntary transfers. The SEC's authority under this portion of
the statute is also ambiguous. The exception is for sales “to a member of the family of
the purchaser or the equivalent, or in connection with the death or divorce of the
purchaser or other similar circumstance, in the discretion of the Commission.” Id.
(emphasis added). It is unclear if the SEC's discretion is only to dene “other similar
circumstances,” or if the SEC has discretion to decide whether to allow resales in any
of the categories covered in subsection (D).
163
Securities Act of 1933 § 4A(e)(2), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(e)(2)).
164
See JOBS Act, Pub. L. No. 112-106, § 305(a), 126 Stat. 306 (2012) (adding a
new category in § 18(b)(4)(C) for securities exempt from registration pursuant to section (4)(6)).
165
Securities Act of 1933 § 18(a)(1),(2),(3).
166
Securities Act of 1933 § 18(c)(2)(A), 15 U.S.C.A. § 77r(c)(2)(A), as amended by
JOBS Act, Pub. L. No. 112-106, § 305(c), 126 Stat. 306 (2012).
167
Securities Act of 1933 § 18(c)(2), 15 U.S.C.A. § 77r(c)(2), as amended by JOBS
Act, Pub. L. No. 112-106, § 305(c), 126 Stat. 306 (2012).
168
See Securities Act of 1933 § 18(c)(2)(F), 15 U.S.C.A. § 77r(c)(2)(F), as amended
by JOBS Act, Pub. L. No. 112-106, § 305(c), 126 Stat. 306 (2012).
169
See Keith Paul Bishop, How Many Errors Can You Make in 9,000 Word, More
or Less?, California Corporate and Securities Law (Apr. 17., 2012), http://calcorporate
law.com/2012/04/how-many-errors-can-you-make-in-9000-words-more-or-less/.
170
New subsection (F) restricts state lings and fees “with respect to any security
that is a covered security pursuant to subsection (b)(4)(B) or will be such a covered
security upon completion of the transaction.” Securities Act of 1933 § 18(c)(2)(F), 15
U.S.C.A. § 77r(c)(2)(F), as amended by JOBS Act, Pub. L. No. 112-106, § 305(c), 126
Stat. 306 (2012).
171
See Securities Act of 1933 § 18(c)(2)(F), 15 U.S.C.A. § 77r(c)(2)(F), as amended
by JOBS Act, Pub. L. No. 112-106, § 305(c), 126 Stat. 306 (2012).
172
Securities Act of 1933 § 4(4), 15 U.S.C.A. § 77d(4) (2010).
173
A court might correct this mistaken cross-reference. See U.S. v. Coatoam, 245
F.3d 553, 557–558, 2001 FED App. 0092P (6th Cir. 2001) (correcting a statutory
cross-reference where legislative intent was clear, and reading the cross-reference
literally would produce an absurd result and render part of the statute mere
surplusage). But see U.S. v. Moore, 136 F.3d 1343, 1344 (9th Cir. 1998) (refusing to
correct a statutory cross-reference retroactively, even though Congress subsequently
amended the statute to correct its mistake).
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
241
Securities Regulation Law Journal
174
JOBS Act, Pub. L. No. 112-106, § 305(b)(1), 126 Stat. 306 (2012).
175
Securities Act of 1933 § 18(c)(1)(B), 15 U.S.C.A. § 77r(c)(1)(B), as amended by
JOBS Act, Pub. L. No. 112-106, §§ 305(b)(2), 305(d)(2), 126 Stat. 306 (2012).
176
Securities Act of 1933 § 4A(d), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(d)).
177
The Securities Exchange Act already preempts certain state regulation of securities brokers. See Securities Exchange Act of 1934 § 15(i), 15 U.S.C.A. § 78o(i), as
amended by JOBS Act, Pub. L. No. 112-106, § 305(d)(1), 126 Stat. 306 (2012).
178
Securities Exchange Act of 1934 § 15(i)(2)(A), 15 U.S.C.A. § 78o(i)(2)(A), as
amended by JOBS Act, Pub. L. No. 112-106, § 305(d)(1), 126 Stat. 306 (2012).
179
Securities Exchange Act of 1934 § 15(i)(2)(B), 15 U.S.C.A. § 78o(i)(2)(B), as
amended by JOBS Act, Pub. L. No. 112-106, § 305(d)(1), 126 Stat. 306 (2012).
180
Id.
181
Securities Act of 1933 § 4A(c)(2)(A), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(2)(A)). The statute
includes an interstate commerce requirement: the liable person must make “use of
any means or instruments of transportation or communication in interstate commerce or of the mails.” Id.
182
Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5 (2012).
183
Securities Act of 1933 § 17(a), 15 U.S.C.A. § 77q(a) (2010).
184
Securities Act of 1933 § 4A(c)(2)(A), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(2)(A)). The “required to
be stated” language does not appear in Rule 10b-5, section 17, or section 12(a)(2) of
the Securities Act. It would impose liability for failure to disclose any material fact
required to be disclosed pursuant to the exemption, whether or not that omission
rendered any other statements made to investors materially misleading.
185
Securities Act of 1933 § 4A(c)(1)(A), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(1)(A)).
186
Compare section 11 of the Securities Act, which grants a cause of action to
“any person acquiring such security,” such security being the security sold in a
registered oering. See Securities Act of 1933 § 11(a), 15 U.S.C. § 77k(a) (2010).
Under section 11, anyone who can trace the securities they own back to the registered
oering whose registration statement was fraudulent may assert a cause of action,
even if they did not purchase directly from the issuer or underwriter in that oering.
See, e.g., Hertzberg v. Dignity Partners, Inc., 191 F.3d 1076 (9th Cir. 1999).
187
Securities Act of 1933 § 4A(c)(1)(A), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(1)(A)).
188
Id.
189
Securities Act of 1933 § 4A(c)(1)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(1)(B)).
190
See Securities Act of 1933 § 12(b), 15 U.S.C.A. § 77l(b) (2010).
191
Securities Act of 1933 § 4A(c)(2)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(2)(B)).
192
See Securities Act of 1933 § 12(a)(2), 15 U.S.C.A. § 77l(a)(2) (2010).
193
242
See Securities Act of 1933 §§ 11(a), 12(a)(2), 15 U.S.C.A. §§ 77k(a), 77l(a)(2)
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
(2010).
194
Securities Act of 1933 § 4A(c)(2), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(2)) (“An issuer shall be liable
. . ..”).
195
Securities Act of 1933 § 4A(c)(3), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(3)). The “partner of the issuer” language is ambiguous. It is probably intended to make partners liable when
the issuer is a partnership, but it could also be read to cover people with whom the
issuer is in partnership.
196
Id.
197
Elsewhere in the Act, a similar parenthetical modies ocers and directors.
Section 4A(b)(1)(B) requires the issuer to disclose “the names of the directors and ofcers (and any persons occupying a similar status or performing a similar function),
. . .” Securities Act of 1933 § 4A(b)(1)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(B)).
198
Subsection 4A(c)(3) says:
As used in this subsection, the term “issuer” includes any person who is a director or
partner of the issuer, and the principal executive ocer or ocers, principal nancial ocer,
and controller or principal accounting ocer of the issuer (and any person occupying a similar status or performing a similar function) that oers or sells a security in a transaction
exempted by the provisions of section 4(6), and any person who oers or sells the security in
such oering.”
Securities Act of 1933 § 4A(c)(3), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(3)).
199
Id.
200
See Securities Act of 1933 § 2(a)(3), 15 U.S.C.A. § 77b(a)(3) (2010).
201
Pinter v. Dahl., 486 U.S. 622 (1988) (holding that “seller” for purposes of section 12(a)(2) of the Securities Act includes not only the person who passes title to the
buyer, but also anyone who solicits the purchaser to serve his own nancial interests
or the interests of the title-passing seller).
202
See Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296,
2303, 180 L. Ed. 2d 166 (2011) (For purposes of Rule 10b-5, a person makes a false
statement only if the person has legal authority over its content and how to communicate it.). Janus Capital was interpreting only Rule 10b-5, so its holding would
not apply directly to the new section 4A(c). However, section 4A(c) uses essentially
the same language and was adopted after Janus, so there is a strong argument for
the same interpretation.
203
Securities Act of 1933 § 4A(c)(1)(B), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(c)(1)(B)).
204
Securities Act of 1933 § 13, 15 U.S.C.A. § 77m (2010).
205
Securities Act of 1933 § 4(6)(A), JOBS Act, Pub. L. No. 112-106, § 302(a), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(A)).
206
See Section III.B, supra. I discuss the integration issues in Section III.J.2,
infra.
207
Under Regulation A, the aggregate oering price “shall not exceed $5,000,000,
. . ., less the aggregate oering price for all securities sold within the twelve months
before the start of and during the oering of securities in reliance upon Regulation
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
243
Securities Regulation Law Journal
A.” Securities Act Rule 251(b), 17 C.F.R. § 230.251(b) (2012) (emphasis added).
208
See Securities Act Rule 504(b)(2), 17 C.F.R. § 230.504(b)(2) (2012); Securities
Act Rule 505(b)(2)(i), 17 C.F.R. § 230.505(b)(2)(i) (2012).
209
Section 3(b) authorizes the SEC to create regulatory exemptions for oerings of
$5 million or less. See Securities Act of 1933 § 3(b), 15 U.S.C.A. § 77c(b) (2010), as
amended by JOBS Act Pub. L. No. 112-106, § 401(a), 126 Stat. 306 (2012).
210
See Securities Act of 1933 § 4, 15 U.S.C. § 77d (2010) (“The provisions of section 5 of this Act shall not apply to . . ..”).
211
Bradford, Expanding the Non-Transactional Revolution: A New Approach to
Securities Registration Exemptions, 49 Emory L.J. 437, 460 (2000).
212
Securities Act of 1933 § 4(6), JOBS Act, Pub. L. No. 112-106, § 302(a), 126 Stat.
306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)).
213
See Non-Public Oering Exemption, Securities Act Release No. 4552, 1 Fed.
Sec. L. Rep. (CCH) ¶¶ 2770-83 (Nov. 6, 1962).
214
See Bradford, supra note 210, at 463 and authorities cited therein.
215
Campbell, Jr., The Plight of Small Issuers (and Others) Under Regulation D:
Those Nagging Problems That Need Attention, 74 Ky. L.J. 127, 164 (1985-86). See
also Subcommittee on Partnerships, Trusts and Unincorporated Associations, Integration of Partnership Oerings: A Proposal for Identifying a Discrete Oerings, 37 Bus.
Law. 1591,1605 (1982) (No-action letters dealing with integration are “dicult to reconcile even when dealing with similar fact situations involving the same subject
matter.”).
216
See Securities Act Rule 147(b)(2), 17 C.F.R. § 230.147(b)(2) (2012); Rule 251(c),
17 C.F.R. § 230.251(c) (2012); Rule 502(a), 17 C.F.R. § 230.502(a) (2012).
217
Securities Act of 1933 § 4A(g), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(g)). This provision was also in
H.R. 2930, the rst crowdfunding bill introduced. See H.R. 2930, 112th Cong. § 2(b)
(as passed by House, Nov. 3, 2011) (proposed section 4A(f)(2) of the Securities Act).
218
See, e.g., S.E.C. v. Murphy, 626 F.2d 633 (9th Cir. 1980).
219
Securities Act of 1933 § 4(6), JOBS Act, Pub. L. No. 112-106, § 302(a), 126 Stat.
306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)).
220
See Section III.I, supra.
221
Prior to passage of the JOBS Act, Section 12(g)(1) of the Exchange Act, as
modied by Rule 12g-1, required an issuer to register any class of equity security held
of record by 500 or more shareholders if the issuer has total assets exceeding $10
million. See Securities Exchange Act of 1934 § 12(g)(1)(B), 15 U.S.C.A. § 78l(g)(1)(B)
(2010), amended by JOBS Act, Pub. L. No. 112-106, §§ 303(a), 501, 601(a) 126 Stat.
306 (2012) (total assets exceeding $1 million and a class of equity security held of record by 500 or more persons); Exchange Act Rule 12g-1, 17 C.F.R. § 240.12g-1 (2012)
(increasing the total assets threshold to $10 million). The JOBS Act changed the record holder threshold to 2,000 persons or 500 persons who are not accredited investors.
See JOBS Act, Pub. L. No. 112-106, § 501, 126 Stat. 306 (2012).
222
Securities Exchange Act of 1934 § 12(g)(6), JOBS Act, Pub. L. No. 112-106,
§ 303(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78l(g)(6)). The SEC must
issue the required rule within 270 days of the Act's enactment. Id., § 303(b).
223
244
Even this simple provision raises questions. If a crowdfunding purchaser
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
resells the security, does the exclusion carry over or does the holder then count for
purposes of the Exchange Act registration requirement?.
224
See SEC, Information Regarding the Use of the Crowdfunding Exemption in
the JOBS Act (April 23, 2012), available at http://www.sec.gov/spotlight/jobsact/crowd
fundingexemption.htm (reminding issuers that oerings in reliance on the crowdfunding exemption are unlawful until the SEC adopts implementing regulations).
225
JOBS Act, Pub. L. No. 112-106, § 302(c), 126 Stat. 306 (2012).
226
See SEC, Public Comments on SEC Regulatory Initiatives under the JOBS
Act, http://www.sec.gov/spotlight/jobsactcomments.shtml (April 18, 2012).
227
See Yin Wilczek, Much Work Lies Ahead of the SEC In Implementing JOBS
Act, Attorneys Say, Bloomberg BNA Securities Law Daily (Apr. 20, 2012), available
at http://news.bna.com/sdln/SDLNWB/splitdisplay.adp?fedd=25859584&vname=sl
dbulallissues&jd=a0d1p0y9k6&split=0 (“[A]ttorneys who have been closely following
the legislation say the SEC is not likely to make the mandated deadlines”). Before the
legislation was passed, SEC Chair Mary Schapiro indicated that 18 months was a
more realistic deadline. See Yin Wilczek, Schapiro Faults JOBs Bill for Gaps In
Investor Protection, Short Deadlines, Bloomberg BNA Securities Law Daily (March
15, 2012), available at http://news.bna.com/sdln/SDLNWB/splitdisplay.adp?fedd=
24828096&vname=sldbulallissues&jd=a0d0z7t7f8&split=0.
228
See Dan Froomkin, SEC Stall Leaves Key Dodd-Frank Rules More than a Year
Overdue, Hungton Post: Business, http://www.hungtonpost.com/2012/04/17/sec-do
dd-frank-rules-year-overduen1432839.html (April 17, 2012).
229
JOBS Act, Pub. L. No. 112-106, § 302(c), 126 Stat. 306 (2012).
230
See David S. Hilzenrath, Jobs Act Could Remove Investor Protections, SEC
Chair Mary Schapiro Warns, The Washington Post, March 14, 2012, available at htt
p://www.washingtonpost.com/business/economy/jobs-act-could-open-a-door-to-investm
ent-fraud-sec-chief-says/2012/03/14/gIQA1vx1BSstory.html; Luis A. Aguilar, Investor Protection is Needed for True Capital Formation, The Harvard Law School Forum
on Corporate Governance and Financial Regulation (Mar. 25, 2012), http://blogs.law.h
arvard.edu/corpgov/2012/03/25/investor-protection-is-needed-for-true-capital-formati
on/.
231
JOBS Act, Pub. L. No. 112-106, § 302(c), 126 Stat. 306 (2012).
232
See, e.g., NASAA: The JOBS Act an Investor Protection Disaster Waiting to
Happen, http://www.nasaa.org/11548/nasaa-the-jobs-act-an-investor-protection-disast
er-waiting-to-happen/ (March 22, 2012).
233
See Section III.H.2, supra.
234
See Section III.C.1, supra.
235
See id.
236
See Section III.J.3, supra.
237
See Section III.I, supra.
238
See Securities Act of 1933 § 4A(b)(1)(B), JOBS Act, Pub. L. No. 112-106,
§ 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(B)).
239
See Securities Act of 1933 § 4A(b)(1)(H)(iii), JOBS Act, Pub. L. No. 112-106,
§ 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(iii)).
240
See Bradford, supra note 4, at 42–43.
241
See Bradford, supra note 4, at 117.
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
245
Securities Regulation Law Journal
242
See Section III.D.2.b, supra.
243
See Section III.D.2.e, supra.
244
Securities Act of 1933 § 4A(b)(1)(H)(iv), JOBS Act, Pub. L. No. 112-106,
§ 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(iv)).
245
Securities Act of 1933 § 4A(b)(1)(H)(v), JOBS Act, Pub. L. No. 112-106, § 302(b),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(b)(1)(H)(v)).
246
See Bradford, supra note 4, at 104–109.
247
See id., at 109–112.
248
Bradford, supra note 4, at 123. See also Request for Rulemaking to Exempt
Securities Oerings Up to $100,000 With $100 Maximum Per Investor From Registration, SEC File No. 4-605, available at http://www.sec.gov/rules/petitions/2010/petn4605.pdf (arguing that a proposed $100 individual investment limit would prevent
investors from incurring a crippling nancial risk).
249
If an investor's net worth and annual income are each less than $100,000, the
limit is the greater of $2,000, ve percent of annual income, or ve percent of net
worth. See Securities Act of 1933 § 4(6)(B)(i), JOBS Act, Pub. L. No. 112-106, § 302(a),
126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(B)(i)).
250
See Section III.C, supra.
251
Section 4(6) exempts “transactions involving the oer or sale of securities by
an issuer . . . provided that” the listed requirements are met. Securities Act of 1933
§ 4(6), JOBS Act, Pub. L. No. 112-106, § 302(a), 126 Stat. 306 (2012) (to be codied at
15 U.S.C.A. § 77d(6)) (emphasis added). The required conditions include the
intermediary's compliance with section 4A(a) and the issuer's compliance with section
4A(b). See Securities Act of 1933 § 4(6)(C),(D), JOBS Act, Pub. L. No. 112-106,
§ 302(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d(6)(C),(D)).
252
See Section III.D.2.e, supra.
253
Securities Act of 1933 § 5(a)(1), 15 U.S.C.A. § 77e(a)(1) (2010). Section 4(6) is
an exemption from section 5 of the Act. See Securities Act of 1933 § 4, 15 U.S.C.A.
§ 77d (2010) (“The provisions of section 5 of this Act shall not apply to — . . ..”).
254
Securities Act of 1933 § 12(a)(1), 15 U.S.C.A. § 77l(a)(1) (2010). See Schneider
and Zall, Section 12(1) and the Imperfect Exempt Transaction: The Proposed I & I
Defense, 28 Bus. Law. 1011 (1973) (proposing a defense where an issuer's failure to
comply with a registration exemption was innocent and immaterial).
255
See Securities Act Rule 260, 17 C.F.R. § 230.260 (2012) (Regulation A); Securities Act Rule 508, 17 C.F.R. § 230.508 (2012) (Regulation D). See also Schneider, A
Substantial Compliance (“I&I”) Defense and Other Changes are Added to SEC Regulation D, 44 Bus. Law. 1207 (1989) (discussing the addition of Rule 508 to Regulation
D).
256
See Securities Act Rules 501(a), 17 C.F.R. § 230.501(a) (2012) (reasonable
belief that investors are accredited investors); 501(h) (reasonable belief that purchaser
representatives meet the requirements to serve as purchaser representatives);
505(b)(2)(ii), 17 C.F.R. § 230.505(b)(2)(ii) (2012) (reasonable belief that there are no
more than 35 purchasers); 506(b)(2)(i), 17 C.F.R. § 230.506(b)(2)(i) (2012) (reasonable
belief that there are no more than 35 purchasers); 506(b)(2)(ii), 17 C.F.R.
§ 230.506(b)(2)(ii) (2012) (reasonable belief that non-accredited purchasers meet a
sophistication requirement).
257
246
See Bradford, supra note 4, at 134–136 (arguing for public crowdfunding sites
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
with open communication platforms).
258
See generally JAMES SUROWIECKI, THE WISDOM OF CROWDS: WHY
THE MANY ARE SMARTER THAN THE FEW AND HOW COLLECTIVE WISDOM
SHAPES BUSINESS, ECONOMIES, SOCIETIES, AND NATIONS (2004).
259
Id., at xiii-xiv. See also Armin Schwienbacher & Benjamin Larralde,
Crowdfunding of Small Entrepreneurial Ventures, at 12, in HANDBOOKOF
ENTREPRENEURIAL FINANCE (Douglas Cumming ed., forthcoming 2012), available at: http://ssrn.com/abstract=1699183at 12 (although crowdfunders might not
have any special knowledge about the industry in which they are investing, they can
be more ecient as a crowd than a few equity investors alone).
260
See Bradford, supra note 4, at 134–136.
261
See H.R. 2930, 112th Cong. § 2(b) (as passed by House, Nov. 3, 2011); S. 1791,
112th Cong. § 6 (2011).
262
See Section III.E.1, supra.
263
Securities Exchange Act of 1934 § 3(h)(1), JOBS Act, Pub. L. No. 112-106,
§ 304(a), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(h)(1)).
264
Securities Exchange Act of 1934 § 3(a)(80), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)).
265
For a full discussion of this issue, see Bradford, supra note 4, at 67–80. This
problem aects primarily crowdfunding intermediaries who are not brokers. The
Investment Advisers Act excepts from the denition of investment adviser “any broker or dealer whose performance of such services is solely incidental to the conduct of
his business as a broker or dealer and who receives no special compensation therefor.”
Investment Advisers Act of 1940 § 202(a)(11)(C), 15 U.S.C.A. § 80b-2(a)(11)(C) (2010).
If the operation of a crowdfunding site is part of the conduct of a broker's ordinary
business, the broker would not be an investment adviser, as long as the broker
received no special compensation for any advice.
266
Securities Exchange Act of 1934 § 3(a)(80)(A), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(A)).
267
See Bradford, supra note 4, at 69–73, and authorities cited therein.
268
Investment Advisers Act of 1940 § 202(a)(11), 15 U.S.C.A. § 80b-2(a)(11) (2010).
269
Id.
270
See Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977) (General partner
providing nancial reports on the partnership's investments to limited partners.);
S.E.C. v. Saltzman, 127 F. Supp. 2d 660, 669 (E.D. Pa. 2000) (same). The general
partners in both cases were also making investment decisions for the partnerships,
but the courts apparently held that the reports alone were sucient to make the
partners investment advisers.
271
The information provided must readily available to the public in its raw state;
the categories of information presented may not be highly selective; and the information may not be organized or presented in a manner that suggests the purchase, holding, or sale of any security. See, e.g., Angel Capital Elec. Network, SEC No-Action
Letter, 1996 WL 636094 (Oct. 25, 1996); Mo. Innovation Ctr., Inc., SEC No-Action
Letter, 1995 WL 643949 (Oct. 17, 1995); Media Gen. Fin. Servs., Inc., SEC No-Action
Letter, 1992 WL 198262 (July 20, 1992); Investex Inv. Exch. Inc., SEC No-Action
Letter, 1990 WL 286331 (Apr. 9, 1990); Charles St. Sec., Inc., SEC No-Action Letter,
1987 WL 107616 (Jan. 28, 1987). See generally HOWARD M. FRIEDMAN, SECURI-
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
247
Securities Regulation Law Journal
TIES REGULATION IN CYBERSPACE 17-3 (3d ed. 2005); THOMAS P. LEMKE &
GERALD T. LINS, REGULATION OF INVESTMENT ADVISORS7 (2011).
272
Securities Exchange Act of 1934 § 3(a)(80)(E), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(E)).
273
Securities Exchange Act of 1934 § 3(a)(80)(B), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(B)).
274
Securities Exchange Act of 1934 § 3(a)(80)(C), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(C)).
275
See Securities Act of 1933 § 4A(a)(1)(B), JOBS Act, Pub. L. No. 112-106,
§ 302(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(1)(B)) (allowing
funding portals to act as intermediaries in section 4(6) oerings).
276
Securities Exchange Act of 1934 § 3(a)(80)(D), JOBS Act, Pub. L. No. 112-106,
§ 304(b), 126 Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 78c(a)(80)(D)).
277
Securities Act of 1933 § 4A(a)(7), JOBS Act, Pub. L. No. 112-106, § 302(b), 126
Stat. 306 (2012) (to be codied at 15 U.S.C.A. § 77d-1(a)(7)).
278
Some of the earlier crowdfunding bills required this. See H.R. 2930, 112th
Cong. § 1(b) (as passed by House, Nov. 3, 2011) (in proposed section 4A(a)(10) of the
Securities Act, requiring intermediaries to outsource cash-management functions to
third-party custodians); S. 1791, 112th Cong. § 7(a) (2011) (in proposed section
3(a)(4)(G) of the Exchange Act, a similar requirement).
279
JOBS Act, Pub. L. No. 112-106, § 201(a)(1), 126 Stat. 306 (2012). The SEC
must act on this requirement within 90 days of the Act's enactment. Id. Prior to this
change, Rule 502(c) prohibited oering or selling securities in most Regulation D offerings “by any form of general solicitation or general advertising.” Securities Act
Rule 502(c), 17 C.F.R. § 230.502(c) (2012). Certain Rule 504 oerings are excluded
from this prohibition. See id.
280
See, e.g., In the Matter of Kenman Corp., Exchange Act Release No.21962, 1985
WL 548507 (Apr. 19, 1985). The sta has softened this prohibition by allowing brokers
to solicit and pre-qualify potential investors and then invite them to participate in
subsequent Regulation D oerings. See, e.g., Bateman Eichler, Hill Richards, Inc.,
SEC No-Action Letter, 1985 WL 55679 (Dec. 3, 1985); E. F. Hutton, SEC No-Action
Letter, 1985 WL 55680 (Dec. 3, 1985).
281
JOBS Act, Pub. L. No. 112-106, § 201(a)(1), 126 Stat. 306 (2012).
282
The information requirements of Regulation D apply to a Rule 506 oering
only when the issuer sells to non-accredited investors. Securities Act Rule 502(b)(1),
17 C.F.R. § 230.502(b)(1) (2012).
283
See Securities Act Rule 502(d), 17 C.F.R. § 230.502(d) (2012).
284
Under Rule 144, the resale safe harbor applicable to Regulation D restricted
securities, the holding period is six months for the securities of reporting companies
and one year for non-reporting companies. See Securities Act Rule 144(d)(1), 17
C.F.R. § 230.144(d)(1) (2012). Small businesses using Rule 506 would presumably be
non-reporting companies, but, if so, the one-year holding period would be identical to
that in the crowdfunding exemption.
285
Securities sold pursuant to Rule 506, a safe harbor for section 4(2) of the Securities Act, are “covered securities.” Securities Act of 1933 § 18(b)(4)(E), 15 U.S.C.A.
§ 77r(b)(4)(E), as amended by JOBS Act, Pub. L. 112-106, § 305(a), 126 Stat. 306
(2012). (This category was formerly in subsection (D), but the JOBS Act amendments
248
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
[Vol. 40:3 2012] The New Federal Crowdfunding Exemption: Promise
Unfulfilled
changed it to subsection (E).) State registration requirements are generally preempted
for oerings of covered securities. See Securities Act of 1933 § 18(a), 15 U.S.C.A.
§ 77r(a) (2010).
© 2012 Thomson Reuters E Securities Regulation Law Journal E Fall 2012
249
SHOOTING THE MESSENGER:
THE LIABILITY OF CROWDFUNDING INTERMEDIARIES
FOR THE FRAUD OF OTHERS
C. Steven Bradford*
I. INTRODUCTION
Crowdfunding may soon be used to sell securities in the United
States. Congress has provided an exemption from registration under the
Securities Act and the SEC has proposed rules to implement that
exemption. But liability concerns may cripple the new exemption.
Unless Congress amends the antifraud rules, crowdfunding
intermediaries face a significant risk of liability that could make
crowdfunded securities offerings unfeasible.
Crowdfunding is the use of the Internet to raise money through small
contributions from a large number of people—the “crowd.” 1 In the
business context, an entrepreneur seeking funds publishes a solicitation
on a publicly accessible Internet site. The funding request describes
what the entrepreneur intends to do with the money and what, if
anything, contributors will receive in return for their contributions. The
hope is that, although individual contributions may be small, their total
will equal or exceed the entrepreneur’s goal. 2
Businesses and others use crowdfunding to raise money in a number
of contexts that do not involve the sale of securities. 3 But the cost of
Securities Act registration and the absence of any suitable exemption
have, for the most part, precluded its lawful use to sell securities. 4
The CROWDFUND Act, included in the JOBS Act passed in 2012,
included a new registration exemption for crowdfunded securities
offerings. 5 That exemption, in § 4(a)(6) of the Securities Act, 6 is not yet
* Earl Dunlap Distinguished Professor of Law, University of Nebraska-Lincoln College of
Law. This paper was presented at the 27th Annual Corporate Law Center Symposium at the University
of Cincinnati College of Law. My thanks to those at that symposium for their thoughtful comments and
questions. My thanks also to Brad Pesicka and Stephen Knudsen for their excellent research assistance.
1. C. Steven Bradford, The New Federal Crowdfunding Exemption: Promise Unfulfilled, 40
SEC. REG. L. J. 195, 196 (2012) (hereinafter Bradford, The New Exemption).
2. See C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 COLUM.
BUS. L. REV. 1, 10 (2012) (hereinafter Bradford, Crowdfunding).
3. See id., at 14–27 (discussing different types of crowdfunding).
4. See id., at 42–48 (discussing the federal securities law obstacles to crowdfunded securities
offerings).
5. See Jumpstart Our Business Startups Act, tit. III, Pub. L. 112-106, 126 Stat. 306 (2012)
(hereinafter JOBS Act). The term “crowdfunding” has also been applied to offerings to accredited
investors pursuant to Rule 506(c) of Regulation D, also mandated by the JOBS Act. See Securities Act
Rule 506(c), 17 C.F.R. § 230.506(c). The JOBS Act does not refer to such offerings as crowdfunding.
371
372
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
available; the SEC has proposed, but not yet adopted, the rules required
to implement the exemption. 7 Once the new rules are in place, issuers
will be able to sell up to $1 million of securities each year through
crowdfunding, provided that the amount sold to each investor does not
exceed a cap based on the investor’s annual income and net worth.8
However, those securities may be sold only through a broker or funding
portal that complies with § 4A(a) of the Securities Act and the
associated SEC rules. 9
I have previously written articles arguing for a crowdfunding
exemption 10 and discussing in detail the requirements of § 4(a)(6). 11 I
will not repeat that discussion here.
This article focuses on the liability of crowdfunding intermediaries—
the brokers and funding portals through which crowdfunded securities
must be sold—for false or misleading statements made on their
crowdfunding sites. Those intermediaries are, without a doubt, liable
for their own fraudulent statements, but the focus of this article is on
their liability for information provided by others.
Both the
CROWDFUND Act and the SEC’s proposed rules require crowdfunding
intermediaries to post detailed disclosure provided by issuers. 12 The
proposed rules also require crowdfunding intermediaries to create
communication channels—essentially Internet discussion boards—
where prospective investors and others may post comments. 13 Thus, a
great deal of the information on crowdfunding platforms will be
provided by people other than the intermediary. Unfortunately, neither
the statute nor the proposed rules have much to say about the
See JOBS Act, supra, § 201. I will use the term to mean only offerings pursuant to the crowdfunding
exemption in section 4(a)(6) of the Securities Act, 15 U.S.C. § 77d(a)(6).
6. The CROWDFUND Act actually places the exemption in section “4(6)” of the Securities
Act, ignoring a prior amendment that added lettered subsections to section 4. It has been codified as
subsection (a)(6) in the United States Code, so I will refer to it as section 4(a)(6).
7. See SEC, Crowdfunding, Securities Act Release No. 9470, 78 Fed. Reg. 66,428 (Oct. 23,
2013) (hereinafter SEC Proposal). The deadline for comments expired on February 3, 2014. Id. at
66,428.
8. Securities Act of 1933 § 4(a)(6)(A),(B), 15 U.S.C. § 77d(a)(6)(A),(B).
9. Securities Act of 1933 § 4(a)(6)(C),(D), 15 U.S.C. § 77d(a)(6)(C),(D). Funding portals are a
new type of regulated entity whose only role is to host offerings pursuant to the section 4(a)(6)
crowdfunding exemption. See Securities Exchange Act of 1934 § 3(a)(80), 15 U.S.C. § 78c(a)(80).
10. Bradford, Crowdfunding, supra note 2. For additional perspectives on crowdfunding and
securities law, see Thomas Lee Hazen, Crowdfunding or Fraudfunding? Social Networks and the
Securities Laws—Why the Specially Tailored Exemption Must be Conditioned on Meaningful
Disclosure, 90 N.C. L. REV. 1735 (2012); Joan MacLeod Heminway & Shelden Ryan Hoffman,
Proceed at Your Peril: Crowdfunding and the Securities Act of 1933, 78 TENN. L. REV. 879 (2011).
11. Bradford, The New Exemption, supra note 1. For another perspective on the statute, see
Stuart R. Cohn, The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 64 FLA.
L. REV. 1433 (2012).
12. See Part II.A.1, infra.
13. See Part II.A.2, infra.
2014]
SHOOTING THE MESSENGER
373
intermediary’s obligation to verify that information or the intermediary’s
liability if that information is false or misleading.
I argue in Part III that crowdfunding intermediaries should be liable
for fraudulent statements made by others on their sites in only three
circumstances: (1) if they know the posted material is fraudulent; (2) if
they deliberately ignore red flags that should have alerted them to the
fraud; and (3) if they recommend a particular security or issuer without
an adequate investigation. It is not clear under the current antifraud
rules that crowdfunding intermediaries would always be liable in these
circumstances or that they would be liable only in these circumstances.
Parts IV through VII discuss crowdfunding intermediaries’ possible
liability under the various antifraud rules. One of those rules, the
crowdfunding liability provision in § 4A(c) of the Securities Act, 14 is
new. Others, such as Rule 10b-5 15 and §§ 12(a)(2) 16 and 17(a) 17 of the
Securities Act, are familiar. One of the liability provisions I discuss, §
9 18 of the Exchange Act, is not new, but seldom used.
To determine the potential liability of crowdfunding intermediaries,
one must address a number of perplexing questions that have arisen
under the antifraud rules in the last twenty years. What does it mean to
“make” a false statement? What is required to “offer or sell” a security?
And, most importantly, what do the standards of care under those
liability sections—scienter or negligence—require crowdfunding
intermediaries to do?
The law on many of these questions is unresolved. Crowdfunding
intermediaries might be able to avoid liability to investors even if they
know the information posted by others is fraudulent. On the other hand,
they could be liable for failing to investigate offerings even if they had
no reason to suspect fraud. Neither of those alternatives is acceptable.
Crowdfunding intermediaries should not be able to knowingly facilitate
fraud, but they must be protected from excessive liability if the
crowdfunding exemption is going to be practicable. An amendment to
the statute is needed because the case law under the existing antifraud
rules is simply too uncertain and risky. I offer a proposed amendment in
Part IX and the Appendix.
My focus is on civil liability under federal securities law, but Part
VIII briefly mentions two other possibilities: federal criminal liability
and liability under state securities law.
14.
15.
16.
17.
18.
Securities Act of 1933 § 4A(c), 15 U.S.C. § 77d-1(c).
Securities Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5.
Securities Act of 1933 § 12(a)(2), 15 U.S.C. § 77l(a)(2).
Securities Act of 1933 § 17(a), 15 U.S.C. § 77q(a).
Securities Exchange Act of 1934 § 9, 15 U.S.C. § 78i.
374
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
II. THE INTERMEDIARY’S OBLIGATIONS UNDER THE
CROWDFUNDING EXEMPTION
The proposed crowdfunding rules require intermediaries to post two
types of information provided by others: disclosure furnished by issuers;
and comments by prospective investors and others on public
communication channels. The proposed rules also specify steps
crowdfunding intermediaries must take to prevent fraud. Crowdfunding
intermediaries who fail to comply with these requirements could be
liable in an action brought by the SEC and might also be liable to
investors in actions pursuant to § 12(a)(1) of the Securities Act.
A. Posting Information Provided by Others
1. The Issuer’s Disclosure
Both the statute and the proposed rules require issuers in § 4(a)(6)
offerings to provide detailed disclosure about the company, the offering,
and the securities being sold. 19 The statute requires crowdfunding
intermediaries to provide that issuer disclosure to the SEC and
investors. 20 Proposed Rule 303 21 enforces that statutory requirement. It
provides that the issuer’s information must be made available to the
SEC and “must be made publicly available on the intermediary’s
platform,” accessible even by people who have no account with the
intermediary. The required information must be available at least 21
days before the intermediary begins accepting investment commitments
and must be in a form that potential investors can save or download.
2. Public Communication Channels
Proposed Rule 303(c) adds an additional requirement that does not
appear in the statute: crowdfunding intermediaries must provide publicly
accessible communication channels that allow investors and prospective
investors to “communicate with one another and with representatives of
the issuer about offerings made available on the intermediary’s
platform.” 22 Only investors who have opened an account with the
19. See Securities Act of 1933 § 4A(b)(1), 15 U.S.C. § 77d-1(b)(1); Proposed Rule 201, in SEC
Proposal, supra note 7, at 66,552–54.
20. Securities Act of 1933 § 4A(a)(6), 15 U.S.C. § 77d-1(a)(6). This information must be made
available at least 21 days prior to the first sale. Id.
21. Proposed Rule 303(a), in SEC Proposal, supra note 7, at 66,557.
22. Proposed Rule 303(c), in SEC Proposal, supra note 7, at 66,557.
2014]
SHOOTING THE MESSENGER
375
intermediary may post on these communication channels.23
Representatives of the issuer may post on these channels only if they
disclose their relationship to the issuer. The intermediary must require
that any person posting a comment “clearly and prominently disclose
with each posting whether he or she is a founder or an employee of an
issuer engaging in promotional activities on behalf of the issuer, or is
otherwise compensated, whether in the past or prospectively, to promote
the issuer’s offering.” 24
The proposed rules do not require the intermediary to verify the
accuracy of these posts or to take action if it becomes aware of
fraudulent comments. Under the rules, intermediaries may, but are not
expressly required to, remove fraudulent posts. 25
B. Anti-Fraud Measures
The statute also
intermediaries to
imposes
an
obligation
on
crowdfunding
take such measures to reduce the risk of fraud with respect to such
transactions, as established by the Commission, by rule, including
obtaining a background and securities enforcement regulatory
history check on each officer, director, and person holding more
than 20 percent of the outstanding equity of every issuer whose
securities are offered by such person. 26
The SEC has proposed several requirements to implement this
statutory mandate. 27
1. Compliance with the Exemption
Under proposed Rule 301(a), the intermediary must have a
“reasonable basis” for believing the issuer has complied with the
23. Proposed Rule 303(c)(3), id. Presumably, this restriction does not apply to the issuer and its
representatives, although they are not expressly excepted.
24. Proposed Rule 303(c)(4), id.
25. Both Rule 303(c) and the rules regulating funding portals bar funding portals from
participating in the communications on these channels “other than to establish guidelines for
communication and remove abusive or potentially fraudulent communications.” Proposed Rules
303(c)(1); 402(b)(4)(i), in SEC Proposal, supra note 7, at 66,557, 66,560. However, neither one of these
rules actually requires funding portals to remove such communications and neither rule applies to
crowdfunding intermediaries that are brokers.
26. Securities Act of 1933 § 4A(a)(5), 15 U.S.C. § 77d-1(a)(5).
27. I will not discuss one requirement—that the intermediary reasonably believe that the issuer
has “established means to keep accurate records of the holders of the securities” it is selling—because it
has little relevance to the issues dealt with in this article. See Proposed Rule 303(b), in SEC Proposal,
supra note 7, at 66,556.
376
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
requirements of § 4A(b) of the Securities Act and related regulations.28
Section 4A(b) includes, among other things, the issuer’s disclosure
requirements. 29 In most cases, the intermediary’s burden under Rule
301(a) will be minimal; the rule allows the intermediary to rely on the
issuer’s representations that the issuer has fully complied “unless the
intermediary has reason to question the reliability of those
representations.” 30
2. Enforcing the Disqualification Provisions
One way the crowdfunding exemption attempts to reduce the
incidence of fraud is by excluding past wrongdoers. Proposed Rule 503
bars issuers from using the exemption if they or certain related parties
are subject to a variety of disqualifications. 31 Proposed Rule 301(c)(1)
requires crowdfunding intermediaries to deny access to an offering if the
intermediary “has a reasonable basis for believing that” the issuer, its
officers or directors, or any beneficial owners of 20 percent or more of
the issuer’s voting equity securities fall within any of the Rule 503
disqualifications. 32
An intermediary may not rely on the issuer’s certification that it is not
disqualified. Intermediaries must, “at a minimum,” conduct checks on
the background and securities enforcement regulatory history of each
such person. 33 Neither the rule nor the SEC release says what would be
a sufficient background check. Additionally, the “at a minimum”
language is troublesome; it raises the possibility that intermediaries may
be required to do more than background checks without specifying
exactly what is required.
3. Protecting Against the Potential for Fraud
The broadest, and potentially most burdensome, rule is proposed Rule
301(c)(2). An intermediary must deny access to an offering if it
“believes that the issuer or the offering presents the potential for fraud or
otherwise raises concerns regarding investor protection.” 34
28. Proposed Rule 301(a), in SEC Proposal, supra note 7, at 66,556.
29. See Securities Act of 1933 § 4A(b)(1), 15 U.S.C. § 77d-1(b)(1).
30. Proposed Rule 301(a), in SEC Proposal, supra note 7, at 66,556.
31. See Proposed Rule 503, in SEC Proposal, supra note 7, at 66,562–563.
32. Proposed Rule 301(c)(1), in SEC Proposal, supra note 7, at 66,556.
33. Id.
34. Proposed Rule 301(c)(2), id. If the intermediary initially grants access to the issuer, then later
becomes aware of information that causes it to believe there is such a concern, it “must promptly
remove the offering from its platform, cancel the offering, and return (or, for funding portals, direct the
return of) any funds that have been committed by investors in the offering.” Id.
2014]
SHOOTING THE MESSENGER
377
This language is ambiguous in two ways. First, when exactly is a
“potential” for fraud present? Every small business offering presents a
“potential” for fraud, but the rule can’t be read that broadly, or no
offering would qualify. If the intermediary knows the offering is
fraudulent, Rule 301(c)(2) would clearly apply, but what level of
suspicion short of actual knowledge triggers the rule? Second, the
intermediary must also deny access to any offering that the intermediary
believes “otherwise raises concerns regarding investor protection.”
Absent a potential for fraud, what other investor protection concerns
would trigger Rule 301(c)(2)? For example, would an intermediary
have to bar an issuer if there were no provisions in place to protect
investors from dilution? 35 The SEC release provides no guidance.
Setting these interpretive questions aside, this language would appear
to deny access to an offering only if the intermediary is aware of
something that flags a potential problem. But, unfortunately, proposed
rule 301(c)(2) goes on to provide that the intermediary must deny access
to the offering “if it believes that it is unable to adequately or effectively
assess the risk of fraud.” 36 This second sentence arguably requires the
intermediary to thoroughly investigate the issuer and the offering since
the intermediary cannot “adequately or effectively assess the risk of
fraud” without full, accurate information. Absent an investigation, the
intermediary would not have an adequate basis to assess the risk of
fraud, and would therefore have to bar the offering, even if it was
unaware of any potential problems.
C. The Consequences of Violating These Requirements
A crowdfunding intermediary that violates these requirements would
be subject to liability in an action by the SEC. Section 20 of the
Securities Act authorizes SEC actions for injunctive relief or civil
penalties against anyone who violates any provision of the Securities
Act or any rule or regulation under the Act. 37
It is less clear if intermediaries would be liable to investors if they
violate these rules. Investors clearly would not have a private right of
action under the crowdfunding rules themselves. Nothing in the Act or
in the rules grants such a private right of action 38 and courts are unlikely
35. See John S. Wroldsen, The Social Network and the Crowdfund Act: Zuckerberg, Saverin, and
Venture Capitalists’ Dilution of the Crowd, 15 VAND. J. ENT. & TECH. L. 583, 616–19 (2013)
(discussing the need of crowdfunding investors for protection from dilution).
36. Proposed Rule 301(c)(2), in SEC Proposal, supra note 7, at 66,556.
37. Securities Act of 1933 § 20(b),(d), 15 U.S.C. § 77t(b),(d). Section 21 of the Exchange Act
gives the SEC similar authority to enforce that statute and its rules and regulations. Securities Exchange
Act of 1934 § 21(d)(1),(3), 15 U.S.C. § 78u(d)(1),(3).
38. Section 4A(c), an antifraud provision, is the only express liability provision added by the
378
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
to imply one. 39 However, crowdfunding intermediaries might be liable
under § 12(a)(1) of the Securities Act if they fail to fulfill their
responsibilities under the exemption.
Section 12(a)(1) makes anyone who “offers or sells a security in
violation of section 5” of the Securities Act liable to purchasers of that
security. 40 It is not clear if crowdfunding intermediaries would be
“offering or selling” for purposes of § 12; I deal with that issue later.41
If they are, crowdfunding intermediaries could be liable under § 12(a)(1)
if they violate the crowdfunding rules.
The availability of the crowdfunding exemption is conditioned on the
intermediary’s compliance with the requirements of § 4A(a), 42 and one
of those requirements is that the intermediary take the measures the SEC
specifies to reduce the risk of fraud. 43 If the intermediary does not
comply with Rule 301, it has not complied with § 4A(a), and the
crowdfunding exemption is therefore unavailable. If the exemption is
unavailable, the offering would violate § 5, which makes it unlawful to
offer or sell a security without registration, 44 and that in turn would
result in liability under § 12(a)(1).
However, one of the proposed crowdfunding rules would preserve the
exemption, in spite of the intermediary’s failure to comply, as long as
the failure to comply was “insignificant with respect to the offering as a
whole” and the issuer was unaware of the intermediary’s
noncompliance. 45 If the requirements of this rule were met, the
intermediary’s violation of the rules would not destroy the exemption,
and § 12(a)(1) would not apply.
CROWDFUND Act. See Part V, infra.
39. “[P]rivate rights of action to enforce federal law must be created by Congress.” Alexander v.
Sandoval, 532 U.S. 275, 286 (2001). Absent statutory intent to create a private remedy, “a cause of
action does not exist and courts may not create one, no matter how desirable that might be as a policy
matter.” Id., at 286-87. The focus is on the language of the statute itself, Touche Ross & Co. v.
Redington, 442 U.S. 560, 568 (1979), although the absence in the legislative history of any suggestion
of an intent to create a private right of action reinforces the decision not to imply one. Id., at 571.
Nothing in the CROWDFUND Act or its limited legislative history evidences any intent to create a
private right of action for regulatory violations.
40. Securities Act of 1933 § 12(a)(1), 15 U.S.C. § 77l(a)(1).
41. See Part V.B, infra.
42. Securities Act of 1933 § 4(a)(6)(C), 15 U.S.C. § 77d(a)(6)(C).
43. Securities Act of 1933 § 4A(a)(5), 15 U.S.C. § 77d-1(a)(5).
44. Section 5(c) of the Securities Act makes it unlawful to offer a security unless a registration
statement has been filed. Securities Act of 1933 § 5(c), 15 U.S.C. § 77e(c). Section 5(a)(1) of the Act
makes it unlawful to sell a security unless a registration statement is effective. Securities Act of 1933
§ 5(a)(1), 15 U.S.C. § 77e(a)(1).
45. Proposed Rule 502(a), in SEC Proposal, supra note 7, at 66,562.
2014]
SHOOTING THE MESSENGER
379
III. WHEN SHOULD CROWDFUNDING INTERMEDIARIES BE LIABLE?
Parts IV through VII will examine whether crowdfunding
intermediaries would be liable under the various antifraud rules for
fraudulent information posted by others. But, before embarking on that
discussion, let us first consider what their liability should be. Liability is
appropriate if the intermediary knows the posted information is false or
is aware of red flags that cast doubt on the accuracy of the posted
information. But an innocent intermediary, who neither knows of the
fraud nor is aware of any red flags that should alert it to the fraud,
should only be liable if it recommends the offering to investors without
an adequate investigation. Crowdfunding intermediaries should have no
general obligation to investigate the offerings appearing on their
platforms.
A. When the Intermediary Is Aware of the Fraud
A crowdfunding intermediary that knowingly allows its platform to
be used for fraudulent purposes should be liable. If a crowdfunding
intermediary discovers that information on its site is fraudulent and does
not remove it, it is complicit in the fraud. It could have prevented harm
to investors at a very low cost—the slight cost of removing the
fraudulent offering or the fraudulent post. Imposing liability in this case
does not force the intermediary to investigate offerings or to institute
any costly procedures to catch fraud, only to act on the information it
already has. If it does not, the intermediary cannot complain about
liability.
B. When the Intermediary Is Aware of Red Flags
Liability is also not particularly troublesome where the intermediary
has no actual knowledge of the fraud but is aware of red flags indicating
that fraud is probable. An intermediary that ignores obvious signs of
fraud is almost as blameworthy as one that has actual knowledge of the
fraud. An investigation to determine if the offering really is fraudulent
might be costly to the intermediary, but that cost will only be incurred in
cases where fraud is probable and the risk of investor losses is high.
Further, the intermediary does not have to incur that cost if it does not
want to. If the intermediary believes that the cost of investigating
further is too high, it can avoid liability by removing the questionable
offering or post. If the intermediary is aware of facts which point to
fraud and proceeds without further investigation, it has voluntarily
chosen to bear the risk of liability.
380
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
C. The Innocent Intermediary
Consider now the innocent intermediary, which has no actual
knowledge of the fraud and no reason for suspicion. Such an
intermediary should not be liable solely because it failed to investigate
the issuer and the offering—or, in the case of a fraudulent post on a
communication channel, solely because it failed to investigate the
accuracy of the post.
Imposing a due diligence requirement on crowdfunding
intermediaries will significantly increase the cost of using the
exemption. Only non-public companies may use the crowdfunding
exemption, 46 and many of those companies will be small startups unable
to obtain financing anywhere else. 47 Their operating history will be
limited and little public information will be available, increasing the cost
of an investigation.
Given the limited information available about those companies and
their principals, an investigation will in many cases be fruitless, even if
the offering is fraudulent. Due diligence might expose some fraudulent
offerings, but the cost would be incurred for all offerings, since the
intermediary would not know in advance which offerings are fraudulent
and which are not.
This cost will be passed on to issuers, making the crowdfunding
exemption significantly more expensive to use. 48 Section 4(a)(6)
offerings are limited in size; an issuer may sell no more than $1 million
a year. For those small offerings, regulatory cost is a major concern,
and the cost of complying with the exemption is already too high. 49
Adding a due diligence burden could make the exemption unfeasible.50
46. Securities Act of 1933 § 4A(f)(2), 15 U.S.C. § 77d-1(f)(2).
47. See David Mashburn, The Anti-Crowd Pleaser: Fixing the Crowdfund Act's Hidden Risks
and Inadequate Remedies, 63 EMORY L. J. 127, 157–58 (2013) (“Crowdfunding . . . is designed for
startups—businesses still in their infancy.”).
48. See Christine Hurt, Pricing Disintermediation: Crowdfunding and Online Auction IPOs,
unpublished manuscript, available at http://ssrn.com/abstract=2406205 (Mar. 7, 2014) (to compensate
for the cost of due diligence and liability, crowdfunding portals will have to charge issuers more,
increasing the cost to issuers).
49. See Mary M. Shepro, Keeping the Crowd at Bay: The Practical Implications of the SEC's
New
Crowdfunding
Exemption,
unpublished
manuscript,
at
5,
available
at
http://ssrn.com/abstract=2433225 (May 5, 2014) ("The costs of complying with the federal securities
laws—both pecuniary and nonpecuniary—are simply too high for equity crowdfunding to be
worthwhile or attractive for most startups."); Hurt, supra note 48, at 47 (“No one disagrees that the . . .
crowdfunding exemption in Section 4(6) will be burdensome on both issuers and portals. . . . The
economies of scale will not be there for most issuers.”); Bradford, The New Exemption, supra note 1, at
222 (2012) (“The crowdfunding exemption “is complicated, expensive, and unlikely to have much of an
effect on the small business capital gap.”).
50. See Mashburn, supra note 47, at 165 (2013) (given the small sums of money involved in
crowdfunding, “expensive and lengthy due diligence is not practical”); Daniel Isenberg, The Road to
Crowdfunding
Hell,
HBR
BLOG
NETWORK
(Apr.
23,
2012),
available
at
2014]
SHOOTING THE MESSENGER
381
That would, of course, eliminate fraud, but only by eliminating all
crowdfunded offerings—fraudulent or not.
If the intermediary recommends the security or the issuer to
investors, 51 an investigation requirement is less troublesome. A
recommendation implies that the intermediary has evaluated the
offering. 52 Recommending a particular security or company without
sufficient information is reckless at best. And imposing liability on
intermediaries who make recommendations without sufficient due
diligence will not be an insuperable obstacle to crowdfunding. If
intermediaries think the cost is too high, they can simply forebear from
making recommendations. If they choose to make recommendations,
they voluntarily assume the concomitant risk of liability.
An innocent intermediary that does not recommend an offering is merely
acting as a conduit for the transfer of information from the issuer to
potential investors—in essence, an electronic bulletin board. Just as mail
carriers or messengers are not liable for the content of what they deliver, the
innocent intermediary should not be liable for the content of the
information the crowdfunding exemption requires it to post on its
platform. 53
The federal antifraud rules, unfortunately, do not protect the innocent
intermediary from liability. The law is unsettled, but even innocent
intermediaries who make no recommendations risk liability if they fail
to investigate the offerings on their platforms. It is also possible that
intermediaries who were aware of the fraud could avoid liability to
injured investors. Let us turn now to those antifraud rules.
IV. LIABILITY UNDER RULE 10B-5
Consider first Rule 10b-5, the most commonly used antifraud rule in
http://blogs.hbr.org/2012/04/the-road-to-crowdfunding-hell/ (due diligence for crowdfunding offerings
is “financially prohibitive, as well as impractical”). See also Joan MacLeod Heminway, The New
Intermediary on the Block: Funding Portals Under the CROWDFUND ACT, 13 U.C. Davis Bus. L. J.
177, 191 (2013) (the burdens the CROWDFUND Act imposes on crowdfunding intermediaries may
make it difficult for funding portals to develop a profitable business model).
51. Only brokers will be able to do this. Funding portals are barred from recommending
securities or offering investment advice. Securities Exchange Act of 1934, 15 U.S.C. § 3(a)(80)(A), 15
U.S.C. § 78c(a)(80)(A).
52. Hanly v. SEC, 415 F.2d 589, 596–97 (2d Cir. 1969).
53. FINRA’s proposed regulation of funding portals takes the right approach. Under the
proposed FINRA rules, funding portals are not responsible for “any communication on the funding
portal member’s website that is prepared solely by an issuer” unless the funding portal “knows or has
reason to know” the communication is false or misleading. See Proposed Rule 200(c)(3), in Financial
Industry Regulatory Authority, Funding Portal Rules 17 (2013), available at http://www.finra.org/web
/idcplg?IdcService=SS_GET_PAGE&ssDocName=p369763.
382
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
federal securities law. 54 Crowdfunding intermediaries are unlikely to be
liable under Rule 10b-5 for fraudulent material posted by others, but
liability cannot be completely ruled out. Intermediaries are more likely
to be liable in an action by the SEC for aiding and abetting the fraud, but
only if the SEC can prove that they acted with scienter.
Rule 10b-5 has three subsections, and the requirements for liability
under each subsection are not the same, so I will discuss them
separately. Part IV.A discusses liability under Rule10b-5(b); Part IV.B
discusses subsections (a) and (c).
A. Liability under Rule 10b-5(b): Would Crowdfunding
Intermediaries Be “Makers”?
Rule 10b-5(b) makes it unlawful, in connection with the purchase or
sale of a security, “[t]o make any untrue statement of a material fact or
to omit to state a material fact necessary in order to make the statements
made, in the light of the circumstances under which they were made, not
misleading.” 55 Crowdfunding intermediaries would be liable under Rule
10b-5(b) only for statements they “made,” not for statements made by
others. 56 The Supreme Court in Janus Capital held that the term
“make” focuses on legal authority: “the maker of a statement is the
person or entity with ultimate authority over the statement, including its
content and whether and how to communicate it.” 57
Crowdfunding intermediaries would probably not be the makers of
statements posted by others on their platforms. The maker of the
issuer’s required disclosure would be the issuer itself. The makers of
the posts on communication channels would be the authors of those
posts. They have the ultimate authority over the content of that material
and whether and how to communicate it. The intermediary is not a
maker merely because it posts someone else’s material on its web site;
one of the non-maker defendants in Janus did exactly that. 58 It also
shouldn’t matter if the intermediary advises issuers about the content of
their disclosures or even helps them draft disclosures. According to
Janus, “[o]ne who prepares or publishes a statement on behalf of
another is not its maker.” 59 As long as the posted material is properly
attributed, 60 crowdfunding intermediaries should not be liable under
54.
55.
56.
57.
58.
59.
60.
Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5.
Exchange Act Rule 10b-5(b), 17 C.F.R. § 240.10b-5(b).
Janus Capital Group Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2301 (2011).
Id., at 2302.
Id., at 2312 (Breyer, J., dissenting).
Id., at 2302.
“[I]n the ordinary case, attribution within a statement or implicit from surrounding
2014]
SHOOTING THE MESSENGER
383
Rule 10b-5(b).
Liability cannot be completely ruled out, however. Two post-Janus
cases have held that one who merely distributes the statements of others
can be a maker. In In re National Century Financial Enterprises,61
Credit Suisse was the initial purchaser and placement agent for an issue
of notes by National Century. The court held that Credit Suisse was a
maker of the private placement memoranda used in the offering because
“Credit Suisse . . . took these statements and put them into investors’
hands.” 62 Similarly, the court in SEC v. Garber 63 stated that the nonattorney defendants were makers of attorneys’ opinions prepared at their
behest and used by them to resell penny stocks. The court believed the
defendants had sufficient control “over whether and how to
communicate” those opinions to be makers under Janus. 64 Both of these
cases seem inconsistent with Janus, but they nevertheless create
uncertainty and pose a risk to crowdfunding intermediaries.
A recent Fourth Circuit decision, Prousalis v. Moore, 65 raises another
issue. Prousalis held that Janus is limited to implied private rights of
action and does not apply to criminal actions under Rule 10b-5(b).66
The Prousalis argument could also be extended to SEC enforcement
actions, 67 although ‘[m]any lower courts have applied Janus to SEC
enforcement actions, at least ‘arguendo.’” 68 I have argued elsewhere
that Prousalis is an incorrect interpretation of Janus, 69 but, unless the
circumstances is strong evidence that a statement was made by—and only by—the party to whom it is
attributed.” Id., at 2302.
61. In re National Century Financial Enterprises, 846 F. Supp.2d 828 (S.D. Ohio 2012).
62. Id., at 861. The court, perhaps missing the point of Janus, noted that “[i]t is fraud to
knowingly provide false information to another person, regardless of who originally drafted the words.”
Id. However, Credit Suisse also helped draft the memoranda, its name was on them, and there was
evidence that it exercised control over their content. Id. Therefore, its control was significantly greater
than the control a crowdfunding intermediary would typically exercise when it posts an issuer’s
disclosure.
63. SEC v. Garber, 2013 WL 1732571 (S.D.N.Y. Apr. 22, 2013).
64. Id., at *5.
65. Prousalis v. Moore, 2014 WL 1799803 (4th Cir. May 7, 2014).
66. Id., at *3–*5.
67. The holding in Prousalis was also based on deference to congressional control of criminal
liability, id. at *5–*6, a rationale that would not apply to SEC enforcement actions.
68. Donald C. Langevoort, Lies Without Liars? Janus Capital and Conservative Securities
Jurisprudence, 90 WASH. U. L. REV. 933, 939 (2013). See also Andrew P. Arnold, Two Faces of
Janus in the District Courts: Is Liability for Securities Fraud Under Section 17(a) Limited to Actors
With Ultimate Authority Over Untrue Statements, 91 N.C. L. Rev. 1054, 1063 (2013) (“although the
decision in Janus was premised in part on the need to limit the private right of action, it is apparent from
the plain language of the opinion that the ultimate authority requirement also applies to claims brought
by the SEC”).
69. C. Steven Bradford, The 4th Circuit’s Two-Headed Interpretation of Janus Capital is Wrong,
Business Law Prof Blog, available at http://lawprofessors.typepad.com/business_law/2014/05/the-4thcircuits-two-headed-interpretation-of-janus-capital-is-wrong.html.
384
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
Supreme Court overrules it, crowdfunding intermediaries might be
liable under Rule 10b-5(b) in criminal and SEC enforcement actions
even if they are not makers.
B. Scheme Liability under Rule 10b-5(a) and (c)
Crowdfunding intermediaries are unlikely to be liable for so-called
“scheme liability” under the other two subsections of Rule 10b-5. Rule
10b-5(a) makes it unlawful “to employ any device, scheme, or artifice to
defraud.” 70 Rule 10b-5(c) makes it unlawful “to engage in any act,
practice, or course of business which operates or would operate as a
fraud or deceit upon any person.” 71
Neither of those subsections uses the word “make,” and most of the
courts considering the issue have held that Janus does not apply to
subsections (a) or (c)—a defendant can be liable under Rule 10b-5(a)
and (c) even if he didn’t make a false statement. 72 However, courts
generally “reject any attempt to by-pass Janus and use scheme liability .
. . to ensnare activity which in essence is comprised primarily of public
misrepresentations and/or omissions.” 73 If the claim is based solely on
fraud that could form the basis of a claim under Rule 10b-5(b),
subsections (a) and (c) are unavailable. 74
70. Exchange Act Rule 10b-5(a), 17 C.F.R. § 240.10b-5(a).
71. Exchange Act Rule 10b-5(c), 17 C.F.R. § 240.10b-5(c).
72. See SEC v. Monterosso, 2014 WL 815403, at *5 (11th Cir. Mar. 3, 2014); SEC v. Garber,
959 F. Supp. 2d 374, 380 (S.D.N.Y. 2013); SEC v. Pentagon Capital Management PLC, 844 F. Supp. 2d
377, 422 (S.D.N.Y. 2012), aff'd in part and rev'd in part, 725 F.3d 279 (2d Cir. 2013); SEC v. Mercury
Interactive, LLC, 2011 WL 5871020, at *2 (N.D. Cal. Nov. 22, 2011); Hawaii Ironworkers Annuity
Trust Fund v. Cole, 2011 WL 3862206, at *5-7 (N.D. Ohio Sept. 1, 2011), reconsideration denied, 2013
WL 3147974 (N.D. Ohio June 19, 2013). See also Alan R. Bromberg, Lewis D. Lowenfels and Michael
J. Sullivan, 5 BROMBERG & LOWENFELS ON SECURITIES FRAUD § 7:306.59 (2d ed. Nov. 2013
rev.) (the trend to date indicates that Janus does not apply to scheme liability); Anthony Sallah, Scheme
Liability: Conduct Beyond the Misrepresentations, Deceptive Acts, and A Possible Janus Intervention,
45 U. TOL. L. REV. 181, 198 (2013) (criticizing the application of Janus to scheme liability claims).
But see SEC v. Kelly, 817 F. Supp. 2d 340, 344 (S.D.N.Y. 2011) (holding that Janus also applies to
scheme liability claims).
73. 5 BROMBERG, LOWENFELS, & SULLIVAN, supra note 72, § 7:306.59. See also SEC v.
Benger, 931 F. Supp. 2d 904, 913 (N.D. Ill. 2013) (“The holding in Janus cannot be skirted simply by
artful pleading and rechristening a 10b-5(b) claim as a claim under 10b-5(a) and (c)”); In re Smith
Barney Transfer Agent Litigation, 884 F. Supp. 2d 152, 161 (S.D.N.Y. 2012) (Scheme liability cannot
be used as a back door into liability for those who help others make a false statement or omission in
violation of Rule 10b-5(b)); Louisiana Municipal Police Employees Retirement System v. KPMG, LLP,
2012 WL 3903335, at *5 (N.D. Ohio 2012) ("after Janus, the Court cannot believe Supreme Court
precedent intends to render a situation whereby a misstatement defendant is liable pursuant to Rule 10b–
5(a) and (c) but is not liable pursuant to 10b–5(b), the subsection that deals specifically with
misstatements”).
74. See, e.g., Public Pension Fund Group v. KV Pharmaceutical Co., 679 F.3d 972, 987 (8th Cir.
2012); WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1057 (9th Cir. 2011);
Lentell v. Merrill Lynch & Co., Inc., 396 F.3d 161, 177 (2d Cir. 2005).
2014]
SHOOTING THE MESSENGER
385
To be liable under Rule 10b-5(a) or (c), crowdfunding intermediaries
would have to engage in manipulative or deceptive conduct that goes
beyond the other person’s misrepresentation, 75 and the plaintiffs would
have to rely on the intermediary’s deceptive conduct, not just on the
underlying misrepresentation. 76 A claim that an intermediary knew of
another person’s fraud 77 or failed to disclose it would not suffice.78
Merely assisting someone who makes a fraudulent statement or
participating in another person’s fraudulent scheme does not make one
liable on the basis of scheme liability. 79 Thus, if the only wrongful
conduct is the fraudulent statement posted by someone else on the
crowdfunding platform, the intermediary would not be liable.
C. Aiding and Abetting
It is questionable if crowdfunding intermediaries would be directly
liable under Rule 10b-5 for the fraudulent statements of others. But they
could still be liable for aiding and abetting the fraud of the person
posting the fraudulent material. There is no private right of action for
aiding and abetting a violation of Rule 10b-5, 80 but the SEC may bring
an action against any person who “knowingly or recklessly provides
substantial assistance to another person in violation of” any Exchange
Act rule, including Rule 10b-5. 81 The underlying violation would be the
other person’s fraudulent post. The intermediary would be providing
substantial assistance by allowing its web site to be used to facilitate the
fraud. The critical question would be the issue discussed in the next
75. See, e.g., SEC v. St. Anselm Exploration Co., 936 F.Supp.2d 1281, 1298 (D. Colo. 2013);
SEC v. Brown, 740 F.Supp.2d 148, 172 (D.D.C. 2010); SEC v. Berry, 580 F.Supp.2d 911, 923 (N.D.
Cal. 2008); In re Alstom SA Securities Litigation, 406 F.Supp.2d 433, 474 (S.D.N.Y. 2005). See also
Anthony Sallah, supra note 72, at 190 (courts require inherently deceptive conduct distinct from any
alleged misstatement); Robert A. Prentice, Scheme Liability: Does It Have a Future after Stoneridge?,
2009 WISC. L. REV. 351, 395 (2009) (same).
76. See Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 159-60
(2008).
77. SEC v. Patel, 2009 WL 3151143, at *13 (D. N.H. Sept. 30, 2009).
78. See WPP Luxembourg Gamma Three Sarl v. Spot Runner, Inc., 655 F.3d 1039, 1057 (9th
Cir. 2011); SEC v. Benger, 931 F. Supp. 2d 904, 915 (N.D. Ill. 2013); Stichting Pensioenfonds ABP v.
Merck & Co., Inc., 2012 WL 3235783, at *10 (D.N.J. Aug. 1, 2012); SEC v. Lucent Technologies, Inc.,
610 F. Supp. 2d 342, 360 (D.N.J. 2009); Lautenberg Foundation v. Madoff, 2009 WL 2928913, at *12
(D. N.J. Sept. 9, 2009).
79. See SEC v. Goldstone, 952 F. Supp. 2d 1060, 1203 (D.N.M. 2013); In re Smith Barney
Transfer Agent Litigation, 884 F. Supp. 2d 152, 161 (S.D.N.Y. 2012); SEC v. Patel, 2009 WL 3151143,
at *7 (D. N.H. Sept. 30, 2009); In re Royal Dutch/Shell Transport Securities Litigation, 2006 WL
2355402, at *8 (D. N.J. Aug. 14, 2006); In re Alstom SA Securities Litigation, 406 F. Supp. 2d 433, 475
(S.D.N.Y. 2005).
80. See Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994).
81. Securities Exchange Act § 20(e), 15 U.S.C. § 78t(e).
386
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
section: whether the intermediary acted knowingly or recklessly.
D. The Scienter Requirement
Intermediaries would be liable under Rule 10b-5 only if they acted
with scienter: 82 their participation must be intentional 83 or reckless. 84 If
the intermediary knew that the posted statement was fraudulent, this
standard would clearly be satisfied. It is less clear when an intermediary
with no actual knowledge of the fraud would be acting with scienter.
“[T]he case law [defining recklessness] is in a state of disarray. The
trial courts are all over the board; even different panels within individual
circuits vary in their approaches.” 85
The courts have defined recklessness in this context as “carelessness
approaching indifference,” 86 “an extreme departure from the standards
of ordinary care, . . . which presents a danger of misleading buyers or
sellers that is either known to the defendant or is so obvious that the
actor must have been aware of it.” 87 Recklessness in this sense is closer
to a “lesser form of intent than merely a greater degree of ordinary
negligence.” 88
An intermediary could be reckless if it deliberately ignores red flags
or warning signs that should have alerted it to the fraud. 89 However,
depending on the facts, ignoring warning signs of fraud may constitute
82. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976); Aaron v. SEC, 446 U.S. 680 (1980).
83. See Ernst & Ernst v. Hochfelder, 425 U.S. at 193 n. 12 (defining scienter as “a mental state
embracing intent to deceive, manipulate or defraud”).
84. The Supreme Court has not determined whether recklessness satisfies the scienter
requirement. See Ernst & Ernst v. Hochfelder, 425 U.S. at 193 n. 12 (noting that, in some areas of the
law recklessness is considered intentional conduct, but not addressing whether recklessness is sufficient
under Rule 10b-5). But “the vast majority of the circuit and district court decisions have found that
recklessness is sufficient.” Thomas Lee Hazen, 4 TREATISE ON THE LAW OF SECURITIES
REGULATION 12 (6th ed. 2009). See also Samuel W. Buell, What is Securities Fraud?, 61 DUKE
L.J. 511, 549 (2011) (“the federal appellate courts have uniformly held that recklessness can establish
scienter under Rule 10b-5”).
85. Ann Morales Olazabal, Defining Recklessness: A Doctrinal Approach to Deterrence of
Secondary Market Securities Fraud, 2010 WIS. L. REV. 1415, 1442 (2010).
86. Hoffman v. Estabrook & Co., Inc., 587 F.2d 509, 516 (1st Cir. 1978).
87. E.g., Sundstrand Corp. v. Sun Chemical Corp., 553 F.2d 1033, 1045 (7th Cir. 1977); Broad
v. Rockwell Intern. Corp., 642 F.2d 929 (5th Cir. 1981); Rolf v. Blyth, Eastman Dillon & Co., Inc., 570
F.2d 38, 47 (2d Cir. 1978). See also Olazabal, supra note 85, at 1442 (“every circuit’s definition of
recklessness can ultimately be traced back to the definition found in the Seventh Circuit’s Sundstrand
Corp. v. Sun Chemical Corp.”).
88. Sanders v. John Nuveen & Co., Inc., 554 F.2d 790, 793 (7th Cir. 1977). See also Olazabal,
supra note 85, at 1424 n. 44-45 (collecting cases to this effect).
89. See, e.g., New Mexico State Investment Council v. Ernst & Young LLP, 641 F.3d 1089,
1102 (9th Cir. 2011); PR Diamonds, Inc. v. Chandler, 91 F.App’x. 418, 431 (6th Cir. 2004); Novak v.
Kasaks, 216 F.3d 300, 308 (2d Cir. 2000); Katz v. Image Innovations Holdings, Inc., 542 F. Supp. 2d
269, 275 (S.D.N.Y. 2008).
2014]
SHOOTING THE MESSENGER
387
only negligence, and not recklessness. 90 A finding of recklessness is
more likely where there are “multiple, obvious red flags.” 91 The
question is whether, given the warning signs, the danger of fraud was so
obvious that the intermediary must have been aware of it—that is,
whether the intermediary egregiously refused “to see the obvious or
investigate the doubtful.” 92
If the intermediary was unaware of any red flags that should have
alerted it to the fraud, a mere failure to investigate is probably at most
ordinary negligence and not recklessness. 93 “It is not enough to show
that [the] defendant failed to detect certain material facts when he had
no reason to suspect their existence.” 94 However, it could be considered
reckless if the innocent intermediary recommends a security without an
investigation. Some courts have held that securities professionals who
recommend a security to clients without an adequate basis for the
recommendation are liable under Rule 10b-5. 95
90. See Ziemba v. Cascade Intern., Inc., 256 F.3d 1194, 1211 (11th Cir. 2001); Iowa Public
Employee's Retirement System v. Deloitte & Touche LLP, 919 F.Supp.2d 321, 336 (S.D.N.Y. 2013); In
re Satyam Computer Services Ltd. Securities Litigation, 915 F. Supp. 2d 450, 480 (S.D.N.Y. 2013). See
also Yates v. Municipal Mortg. & Equity, LLC, 744 F.3d 874 (4th Cir. 2014) (holding that the red flags
alleged were “not insubstantial” but did “not give rise to a strong inference of scienter”).
91. Ricker v. Zoo Entertainment, Inc., 534 F.App’x. 495, 499 (6th Cir. 2013); Louisiana School
Employees' Retirement System v. Ernst & Young, LLP, 622 F.3d 471, 482 (6th Cir. 2010); SEC v.
Delphi Corp., 508 F.App’x. 527, 532 (6th Cir. 2012).
92. Louisiana School Employees' Retirement System v. Ernst & Young, LLP, 622 F.3d 471, 482
(6th Cir. 2010); In re Cardinal Health Inc. Securities Litigations, 426 F.Supp.2d 688, 765 (S.D. Ohio
2006).
93. E.g., In re Colonial Bancgroup, Inc. Securities Litigation, 2014 WL 1259658, at *6 (M.D.
Ala. Mar. 27, 2014); Iowa Public Employee's Retirement System v. Deloitte & Touche LLP, 919
F.Supp.2d 321. 332 (S.D.N.Y. 2013); In re CBI Holding Co., Inc., 419 B.R. 553, 567 (S.D.N.Y. 2009);
In re Ikon Office Solutions, Inc. Securities Litigation, 66 F. Supp. 2d 622, 629 (E.D. Pa. 1999); Griffin
v. McNiff, 744 F. Supp. 1237, 1251 (S.D.N.Y. 1990). See also South Cherry Street, LLC v. Hennessee
Group LLC, 573 F.3d 98, 112 (2d Cir. 2009) (no scienter where no allegation of anything that would
have put the defendant on alert, merely an allegation that if the defendant had investigated, it would
have uncovered the fraud); Newman v. Family Management Corp., 748 F.Supp.2d 299, 310–11
(S.D.N.Y. 2010) (same). But see SEC v. Kelly, 545 F.Supp.2d 808, 812 (N.D. Ill. 2008) (sales agent’s
failure to investigate claims made by promoter could constitute scienter for purpose of a claim under
section 17(a)(1) of the Securities Act).
94. Cohen v. Franchard Corp., 478 F.2d 115, 123 (2d Cir. 1973); The Limited, Inc. v. McCrory
Corp., 683 F. Supp. 387, 394 (S.D.N.Y. 1988).
95. See SEC v. Blavin, 760 F.2d 706, 712 (6th Cir. 1985) (publisher of investment newsletter
acted recklessly by not investigating the information upon which his recommendations were based);
Hanly v. SEC, 415 F.2d 589, 596–97 (2d Cir. 1969) (violation of Rule 10b-5 for a securities salesperson
to recommend stocks without an adequate basis for doing so); SEC v. Randy, 38 F. Supp. 2d 657, 67072 (N.D. Ill. 1999) (recklessness for a broker to recommend a security without an adequate basis for the
recommendation). According to Hanly, a securities dealer
implicitly represents that he has an adequate basis for the opinions he renders. . . . He cannot
recommend a security unless there is an adequate and reasonable basis for such
recommendation. . . . By his recommendation he implies that a reasonable investigation has
been made and that his recommendation rests on the conclusions based on such investigation. .
. . A salesman may not rely blindly upon the issuer for information concerning a company,
388
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
V. LIABILITY UNDER SECTIONS 4A(C) AND 12(A)(2) OF THE SECURITIES
ACT
The CROWDFUND Act adds a new liability provision, § 4A(c) of
the Securities Act, 96 that applies only to offerings pursuant to the §
4(a)(6) crowdfunding exemption. Section 4A(c) allows crowdfunding
purchasers to recover from an “issuer” if the issuer
by any means of any written or oral communication . . . makes an
untrue statement of a material fact or omits to state a material fact
required to be stated or necessary in order to make the statements,
in the light of the circumstances under which they were made, not
misleading, provided that the purchaser did not know of such
untruth or omission. 97
Section 4A(c) broadly defines the term “issuer” to include “any
person who offers or sells the security in such offering.” 98 Section
4A(c) is modeled on Section 12(a)(2) of the Securities Act, which
imposes liability on anyone who “offers or sells a security . . . by means
of a prospectus or oral communication” which is false or misleading. 99
The applicability of §§ 4A(c) and 12(a)(2) to crowdfunding
intermediaries is uncertain. Intermediaries would be liable under either
section only if they were offering or selling the securities posted on their
platforms. An intermediary that merely posts the required information
without recommending the offering or urging investors to purchase the
particular security might not be covered. It is also unclear if
crowdfunding intermediaries would be liable under § 4A(c) for
statements made by others. Finally, because of the Supreme Court’s
interpretation of the word “prospectus” in § 12(a)(2), a weak, yet
colorable, argument could be made that § 12(a)(2) does not apply to
crowdfunding offerings at all.
If §§ 4A(c) or 12(a)(2) do apply, liability is much stricter than under
Rule 10b-5, because the standard of care is negligence rather than
scienter. Crowdfunding intermediaries could avoid liability only if they
proved that they “did not know, and in the exercise of reasonable care,
could not have known,” of the fraud. 100 Under this standard,
although the degree of independent investigation which must be made by a securities dealer will
vary in each case. Securities issued by smaller companies of recent origin obviously require
more thorough investigation.
Hanly v. SEC, 415 F.2d at 596–97.
96. Securities Act of 1933 § 4A(c), 15 U.S.C. § 77d-1(c).
97. Securities Act of 1933 § 4A(c)(2)(A), 15 U.S.C. § 77d-1(c)(2)(A).
98. Securities Act of 1933 § 4A(c)(3), 15 U.S.C. § 77d-1(c)(3).
99. Securities Act of 1933 § 12(a)(2), 15 U.S.C. § 77l(a)(2).
100. Securities Act of 1933 §§ 4A(c)(2)(B), 12(a)(2), 15 U.S.C. §§ 77d-1(c)(2)(B), 77l(a)(2).
2014]
SHOOTING THE MESSENGER
389
intermediaries could be liable if they failed to investigate the offering,
even if they had no reason to suspect the fraud.
A. Does Section 12(a)(2) Even Apply to Section 4(a)(6) Offerings?:
The “Prospectus” Requirement
Section 12(a)(2) may not apply to crowdfunded offerings at all,
although it probably does. To be covered by § 12(a)(2), the fraud must
be “by means of a prospectus or oral communication.” 101 An offering
posted on an intermediary’s crowdfunding site would seem to qualify
under the statutory definition of “prospectus,” 102 but the Supreme
Court’s opinion in Gustafson v. Alloyd Co. 103 interpreted the word
narrowly to include only “documents related to public offerings by an
issuer or its controlling shareholders.” 104
Gustafson did not define “public offering” for purposes of § 12, but
cases since Gustafson have generally applied the Ralston Purina criteria
used under § 4(a)(2) of the Securities Act. 105 Under Ralston Purina,
whether an offering is public turns on whether the offerees “[need] . . .
the protection of the Act. An offering to those who are shown to be able
to fend for themselves” is not a public offering. 106
Section 4(a)(6) offerings would, without question, be “public
offerings” within the meaning of Ralston Purina. They are made on
publicly accessible web sites and are not limited to offerees who,
because of their sophistication or access to information about the issuer,
are “able to fend for themselves” without Securities Act registration.
The fact that § 4(a)(6) offerings are exempt from the registration
101. Securities Act of 1933 § 12(a)(2), 15 U.S.C. § 77l(a)(2).
102. Section 2(a)(10) of the Securities Act defines “prospectus” to include “any . . .
communication, written or by radio or television, which offers any security for sale. . . . ”
Crowdfunding issuers are by definition offering to sell their securities. See Securities Act of 1933
§ 2(a)(3), 15 U.S.C. § 77b(a)(3) (defining “offer to sell” as “every attempt or offer to dispose of, or
solicitation of an offer to buy, a security or interest in a security, for value”). An Internet posting would
be considered a written communication. The term “written” is defined to include “any means of graphic
communication,” Securities Act § 2(a)(9), 15 U.S.C. § 77b(a)(9), and the SEC has defined “graphic
communication” to include “all forms of electronic media, including, but not limited to, . . . Internet
Web sites.” Securities Act Rule 405, 17 C.F.R. § 230.405.
103. Gustafson v. Alloyd Co., 513 U.S. 561 (1995).
104. Id., at 56.
105. See, e.g., Maldonado v. Dominguez, 137 F.3d 1, 8 (1st Cir. 1998); Hyer v. Malouf, 2008 WL
4427941, at *3 (D. Ut. Sept. 25, 2008); West v. Infotrac Corp., 463 F.Supp.2d 1169, 1176 ( D. Nev.
2006); In re Enron Corp. Securities, Derivative & “ERISA” Litigation, 310 F.Supp.2d 819, 861–66
(S.D. Tex. 2004); Sloane Overseas Fund, Ltd. v. Sapiens Intern. Corp., N.V., 941 F. Supp. 1369, 1376
(S.D.N.Y. 1996). See also J. William Hicks, 17A CIVIL LIABILITIES: ENFORCEMENT AND
LITIGATION UNDER THE 1933 ACT § 6.17 (2013) (arguing for the application of the Ralston Purina
criteria to determine whether an offering is public for purposes of Gustafson).
106. SEC v. Ralston Purina, 346 U.S. 119, 125 (1953).
390
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
requirement does not matter; exempt offerings can still be public. 107
Section 4(a)(6) offerings are also public in a broader sense discussed
in Gustafson. Gustafson noted that the term “prospectus” refers to
“documents of wide dissemination” 108 and documents “soliciting the
public to acquire securities from the issuer.” 109 The information posted
on crowdfunding sites would be soliciting the general public to purchase
the issuers’ securities.
However, another aspect of Gustafson complicates the analysis.
Gustafson also indicated that the term prospectus “is confined to a
document that, absent an overriding exemption, must include the
‘information contained in the registration statement.’” 110 Offerings of
securities exempted by § 3 of the Securities Act are clearly covered by §
12(a)(2), 111 but Gustafson “seems to establish that liability under § . . .
[12(a)(2)] . . . can attach only to a transaction registered pursuant to § 5 .
. . , a transaction that should be registered, or a transaction exempt
from registration by reason of § 3.” 112 Justice Ginsburg’s dissent in
Gustafson reads the majority opinion this way. According to her, “the
Court’s definition of a public offering . . . encompass[es] both
transactions that must be registered under § 5, . . . and transactions that
would have been registered had the securities involved not qualified for
exemption under § 3.” 113
Crowdfunded offerings are not registered and, because of the §
4(a)(6) exemption, are not required to be registered. They are not
exempted by § 3 of the Act; the crowdfunding exemption is in § 4.
Thus, under this narrower reading of Gustafson, § 12(a)(2) would not
apply to crowdfunded offerings. 114 However, there is almost no case
law to support this reading, because, until now, § 4 exempted primarily
the types of offerings Gustafson expressly says are not covered by § 12:
107. See William K. Sjostrom, Jr., Rebalancing Private Placement Regulation, 36 SEATTLE U.
L. REV. 1143, 1155 (2013); 2 HAZEN, supra note 84, at 284–85.
108. Gustafson v. Alloyd Co., 513 U.S. 561, 575 (1995).
109. Id.
110. Id., at 569 (emphasis added).
111. Id., at 579.
112. Elliott J. Weiss, Securities Act Section 12(2) After Gustafson v. Alloyd Co.: What Questions
Remain?, 50 BUS. LAW. 1209, 1219-20 (1995). See also Stephen M. Bainbridge, Securities Act
Section 12(2) After the Gustafson Debacle, 50 BUS. LAW. 1231, 1260 (1995) (“one can read
Gustafson as limiting prospectus to selling documents used in connection with an offering required to be
registered and those offerings exempted from registration by virtue of section 3.”).
113. Gustafson v. Alloyd Co., 513 U.S. 561, 596 (1995) (Ginsburg, J., dissenting).
114. Bainbridge notes that “the exemptions created by section 3 differ little from those created by
section 4,” Bainbridge, supra note 112, at 1262, but concludes that the “overriding exemption” language
in Gustafson only includes section 3 exemptions. Id., at 1264. See also Janet E. Kerr, Ralston Redux:
Determining Which Section 3 Offerings are Public Under Section 12(2) After Gustafson, 50 SMU L.
REV. 175, 190 (1996) (the “overriding exemption” language in Gustafson “expressly includes within
Section [12(a)(2)] only those offerings that are exempted under Section 3, not Section 4”).
2014]
SHOOTING THE MESSENGER
391
sales by issuers and controlling persons in private offerings, which are
exempted by § 4(a)(2), and resales by non-controlling persons, which
are exempted by § 4(a)(1). Courts have not had occasion to determine if
a public offering by the issuer exempted by § 4 would fall within §
12(a)(2). 115
The courts may treat § 4(a)(6) offerings like they treat offerings
pursuant to the Rule 144A exemption for resales to qualified
institutional buyers. 116 Rule 144A is, in essence, a safe harbor for a § 4
exemption, § 4(a)(1) of the Securities Act. 117 “[L]ower courts now
routinely hold 144A placements not subject to Section 12(a)(2) liability
under Gustafson,” 118 but they do so by focusing on the public/private
distinction, not by automatically assuming all § 4 exemptions are
excluded. 119 If courts take the same approach to § 4(a)(6), § 12(a)(2)
will clearly apply because crowdfunding undoubtedly involves a public
offering.
This “public offering” issue does not arise under § 4A(c), the
crowdfunding liability section. Section 4A(c) substitutes “written
communication” for the word “prospectus,” 120 and expressly grants a
cause of action to any “person who purchases a security in a transaction
exempted by the provisions of § 4(a)(6).” 121
B. Are Crowdfunding Intermediaries “Offering or Selling” the
Securities Listed on Their Platforms?
Crowdfunding intermediaries are liable under §§ 4A(c) and 12(a)(2)
only if they are “offering or selling” the issuer’s securities. The SEC
115. Section 4(a)(6) is not the only other issuer exemption in section 4. Section 4(a)(5) exempts
sales to accredited investors where there is no public solicitation or advertising. See Securities Act
§ 4(a)(5), 15 U.S.C. § 77d(a)(5). It was added in 1980, so it was in the statute [as section 4(6)] when
Gustafson was decided. See Pub. L. No. 96-477, 94 Stat. 2275 (1980).
116. See Securities Act Rule 144A, 17 C.F.R. § 230.144A.
117. See Securities Act Rule 144A(b), 17 C.F.R. § 230.144A(b) (persons other than issuers or
dealers selling pursuant to the rule are deemed not to be underwriters for purposes of the section 4(a)(1)
exemption).
118. Natasha S. Guinan, Nearly a Decade Later: Revisiting Gustafson and the Status of Section
12(a)(2) Liability in the Courts—Creative Judicial Developments and a Proposal for Reform, 72
FORDHAM L. REV. 1053, 1075 (2004).
119. See, e.g., In re Refco, Inc. Securities Litigation, 503 F. Supp. 2d 611, 625–27 (S.D.N.Y.
2007); In re Enron Corp. Securities, Derivative & "ERISA" Litigation, 310 F. Supp. 2d 819, 861–66
(S.D. Tex. 2004); American High-Income Trust v. Alliedsignal, 329 F. Supp. 2d 534, 542–43
(S.D.N.Y. 2004).
120. Securities Act of 1933 § 4A(c)(2)(A), 15 U.S.C. § 77d-1(c)(2)(A).
121. Securities Act of 1933 § 4A(c)(1)(A), 15 U.S.C. § 77d-1(c)(1)(A). See Mashburn, supra
note 47, at 154 (because of the elimination of the prospectus language from section 4A(c), it “will
certainly cover all disclosure statements filed with the SEC and provided to investors, and it will likely
cover all additional statements related to the offering or selling of the securities").
392
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
believes they will be; the crowdfunding release states that “it appears
likely that intermediaries, including funding portals,” would be offering
or selling securities for purposes of § 4A(c). 122 But the law is uncertain.
Intermediaries who recommend, or urge investors to purchase, a
particular security would be covered, but it is unclear whether
intermediaries would be offering or selling in the absence of such a
recommendation.
Section 4A(c) uses the same “offers or sells” language as §
12(a)(2), 123 so presumably the two sections will be interpreted
identically. The Supreme Court in Pinter v. Dahl 124 explained what it
means to offer or sell for purposes of § 12(a)(1) of the Securities Act,
and the lower courts have applied that analysis to § 12(a)(2) as well.125
Under Pinter, a “seller” is not only the person who transfers title to the
purchaser, but also anyone who solicits the purchase “motivated at least
in part by a desire to serve his own financial interests or those of the
securities owner.” 126
Crowdfunding intermediaries would clearly meet the “financial
interests” part of the definition.
The intermediaries’ financial
motivation would be the fees or commissions they expect to receive
when they sell the securities. Even if they received no fee or
commission, their motivation would be to facilitate the offerings and
serve the financial interests of the issuer. But, under Pinter, it is not
enough that the defendant receives a financial benefit from the sale; the
defendant must also be soliciting. 127 Even brokers or sales agents, the
prototypical sellers, 128 are not covered by § 12(a)(2) unless they solicit
the purchases. 129
A crowdfunding intermediary would not be a seller merely because it
122. SEC Proposal, supra note 7, at 66,499.
123. See Securities Act § 12(a)(2), 15 U.S.C. § 77l(a)(2).
124. Pinter v. Dahl, 486 U.S. 622 (1988).
125. The Supreme Court in Pinter took no position on whether its analysis under section 12(a)(1)
also applies to section 12(a)(2). Pinter v. Dahl, 486 U.S. at 642, n. 20. But the lower courts have held
that it does. See, e.g., Craftmatic Securities Litigation v. Kraftsow, 890 F.2d 628, 635 (3d Cir. 1989);
Moore v. Kayport Package Exp., Inc., 885 F.2d 531, 536 (9th Cir. 1989); Crawford v. Glenns, Inc., 876
F.2d 507, 510 (5th Cir. 1989) (same); Capri v. Murphy, 856 F.2d 473, 478 (2d Cir. 1988).
126. Pinter v. Dahl, 486 U.S. at 647.
127. Smith v. American National Bank and Trust Co., 982 F.2d 936, 941 (6th Cir. 1992); In re
CNL Hotels & Resorts, Inc., 2005 WL 2291729, at *5 (M.D. Fla. Sept. 20, 2005).
128. According to Pinter, “It long has been ‘quite clear,’ that when a broker acting as agent of one
of the principals to the transaction successfully solicits a purchase, he is a person from whom the buyer
purchases within the meaning of § 12 and is therefore liable as a statutory seller.” Pinter v. Dahl, 486
U.S. 622, 647 (1988) (emphasis added).
129. See Ryder International Corp. v. First American National Bank, 943 F.2d 1521, 1531 (11th
Cir. 1991); In re CNL Hotels & Resorts, Inc., 2005 WL 2291729, at *5 (M.D. Fla. Sept. 20, 2005). See
also, 2 HAZEN, supra note 84, at 299–300 (“not all activity by brokers will per se qualify them as
sellers under section 12”).
2014]
SHOOTING THE MESSENGER
393
participated in an offering and facilitated an issuer’s solicitation, 130 even
if the intermediary was a substantial factor in causing the sale to
occur. 131 To be a seller under Pinter, a defendant must directly and
actively participate in solicitation of the sale. 132 Unfortunately, “[t]he
courts have had a great deal of difficulty in defining precisely how much
active participation is required.” 133
Several courts have read Pinter to require that the defendant must
urge or persuade the investor to buy the particular security. 134 A
crowdfunding intermediary would clearly be a seller if it recommended
that investors purchase one of the securities listed on its site. But a
general solicitation of business, such as soliciting investors to visit the
crowdfunding site, is probably not enough. 135
In a broad sense, “the mere act of having a web platform available to
the public on which issuers can list their offering could be viewed as . . .
solicitation.” 136 But it is unclear if merely posting an issuer’s offering
material or a user’s post would be a solicitation by the intermediary
130. See Shaw v. Digital Equipment Corp., 82 F.3d 1194, 1216 (1st Cir. 1996) (mere participation
in activities relating to the sale does not make one a seller); Ackerman v. Schwartz, 947 F.2d 841, 845
(7th Cir. 1991) (lawyer not a seller merely because his opinion letter “played an important role in
making the units marketable”); Pullins v. Klimley, 2008 WL 85871, at *15 (S.D. Ohio Jan. 7, 2008)
(neither participation in activities relating to the sale nor the fact that the defendant was a substantial
factor in the purchase is sufficient to make the defendant a seller); Fox v. First BanCorp., 2006 WL
4128534, at *6 (D. Puerto Rico Nov. 6, 2006) (“neither involvement in preparation of a registration
statement or prospectus nor participation in ‘activities’ relating to the sale of securities” is sufficient to
establish seller status). See also 17A HICKS, supra note 105, § 6.96 (“to become a statutory seller, a
person must do more than merely assist in another’s solicitation efforts”).
131. Under Pinter, one does not become a seller merely because one is a “substantial factor” in
causing the sale to occur. Pinter v. Dahl, 486 U.S. at 648–53. According to the Court, such a test
“would extend liability to participants only remotely related to the relevant aspects of the sales
transaction.” Id., at 651.
132. Craftmatic Securities Litigation v. Kraftsow, 890 F.2d 628, 636 (3d Cir. 1989); In re
Thornburg Mortgage, Inc. Securities Litigation, 695 F. Supp. 2d 1165, 1220 (D.N.M. 2010), clarified,
2010 WL 2998471 (D.N.M. Jul. 5, 2010), partially reconsidered, 824 F. Supp. 2d 1214 (D.N.M.
2011), aff'd, Slater v. A. G. Edwards & Sons, Inc., 719 F.3d 1190 (10th Cir. 2013); Pullins v. Klimley,
2008 WL 85871, at *15 (S.D. Ohio Jan. 7, 2008); Pierce v. Morris, 2006 WL 2370343, at *3 (N.D. Tex.
Aug. 16, 2006); 2 HAZEN, supra note 84, at 290; 17A HICKS, supra note 105, § 6.96.
133. 2 HAZEN, supra note 84, at 290.
134. See Ryder International Corp. v. First American National Bank, 943 F.2d 1521, 1531 (11th
Cir. 1991); Pullins v. Klimley, 2008 WL 85871, at * 15 (S.D. Ohio Jan. 7, 2008); VT Investors v R &
D Funding Corp. 733 F.Supp. 823, 839–40 (D. N.J. 1990); Chin v. Shiu, 1990 WL 70520, at *3 (N.D.
Ill. May 15, 1990). See also Sheldon Co. Profit Sharing Plan and Trust v. Smith, 828 F.Supp. 1262,
1280 (W.D. Mich. 1993) (plaintiffs must allege that the broker, “acting as agent of the principal to the
transaction, solicited . . . [the investor] . . . to buy certain stocks”); 17A HICKS, supra note 105,
§ 6.96 (a person is more likely to be soliciting “where the defendant touts the investment directly to the
purchaser”).
135. See Ryder International Corp. v. First American National Bank, 943 F.2d 1521, 1534 (11th
Cir. 1991); Montcalm County Bd. of Com'rs v. McDonald & Co. Securities, Inc., 833 F. Supp. 1225,
1234 (W.D. Mich. 1993); 2 HAZEN, supra note 84, at 299–300.
136. SEC Proposal, supra note 7, at 66,485 (noting the position of one commenter).
394
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
under the Pinter test. A couple of cases have held that mailing or
disseminating offering documents does not make one a seller. 137 But a
role in circulating the offering materials has been found important in
other cases. 138 Professor Hicks argues that an offering participant
should be a seller “if he uses the issuer’s disclosure in communications
with offerees and presents them with the information that is needed to
finalize the sale.” 139 Some cases, however, have held that defendants
with even more substantial contact with investors were not sellers. 140
It is also unclear how other activities, such as helping issuers prepare
disclosure documents or structure offerings, would affect the seller
status of crowdfunding intermediaries. Most courts have held that
participation in the preparation of offering documents does not by itself
make one a seller, 141 but that conclusion is not unanimous. 142 Several
137. See Wilson v. Saintine Exploration and Drilling Corp., 872 F.2d 1124, 1126 (2d Cir. 1989)
(mailing a copy of the private placement memorandum); In re CNL Hotels & Resorts, Inc., 2005 WL
2291729, at *5 (M.D. Fla. Sept. 20, 2005) (disseminating the offering documents). See also 17A
HICKS, supra note 105, § 6.96 (“Solicitation does not include ministerial acts, such as mailing an
offering document at the seller’s request.”).
138. See Rosenfeld v. Parentcare Ltd., 1993 WL 427422, at *3 (S.D.N.Y. Oct. 15, 1993) (letter
from the defendant enclosing a subscription agreement and offering to call in a few days to see if the
plaintiff was interested sufficient to survive a motion for summary judgment); Martin v. EVP Second
Corp., 1991 WL 131176, at *2 (S.D.N.Y. July 9, 1991) (allegation that defendant received a sales
commission of 8% and distributed the offering materials sufficient to survive a motion to dismiss). See
also Harelson v. Miller Financial Group, 854 F.2d 1141, 1142 (9th Cir. 1988) (in holding that the
defendant was a seller under Pinter, noting that defendant’s “use of a company brochure was typical of
any salesman offering a product”).
139. 17A HICKS, supra note 105, § 6.96 (2013).
140. See In re Gas Reclamation, Inc. Securities Litigation, 733 F. Supp. 713, 723 (S.D.N.Y.
1990), reconsidered, 741 F. Supp. 1094 (S.D.N.Y. 1990), appeal dismissed, Abish v. Northwestern Nat.
Ins. Co., 924 F.2d 448 (2d Cir. 1991) (defendant attended a sales presentation, instructed investors how
to fill out documents, and spoke with several investors about the deal); Pullins v. Klimley, 2008 WL
85871, at *16 (S.D. Ohio Jan. 7, 2008) (defendant told plaintiff “what a great company it is and we
should invest”); Brody v. Homestore, Inc., 2003 WL 22127108, at *5 (C.D. Cal. Aug. 8, 2003)
(defendant arranged road shows, met with potential investors, and presented information about the
company).
141. Hazen indicates that “[e]ven substantial involvement in the preparation of registration and
offering materials will not create liability unless there is also active involvement in the negotiations
leading to the sale in question.” 2 HAZEN, supra note 84, 206. See Shaw v. Digital Equipment Corp.,
82 F.3d 1194, 1216 (1st Cir. 1996); Craftmatic Securities Litigation v. Kraftsow, 890 F.2d 628, 636 (3d
Cir. 1989); Moore v. Kayport Package Exp., Inc., 885 F.2d 531, 536–37 (9th Cir. 1989); Wilson v.
Saintine Exploration and Drilling Corp., 872 F.2d 1124, 1125 (2d Cir. 1989); Federal Housing Finance
Agency v. Stanley, 2012 WL 5868300, at *4 (S.D.N.Y. Nov. 19, 2012); In re Thornburg Mortgage, Inc.
Securities Litigation, 695 F. Supp. 2d 1165, 1220 (D.N.M. 2010), clarified, 2010 WL 2998471 (D.N.M.
Jul. 5, 2010), partially reconsidered, 824 F. Supp. 2d 1214 (D.N.M. 2011), aff'd, Slater v. A. G.
Edwards & Sons, Inc., 719 F.3d 1190 (10th Cir. 2013); Fouad v. Isilon Systems, Inc., 2008 WL
5412397, at *7 (W.D. Wash. Dec. 29, 2008); Lopes v. Vieira, 543 F.Supp.2d 1149, 1170–71 (E.D. Cal.
2008); Fox v. First BanCorp., 2006 WL 4128534, at *6 (D. Puerto Rico Nov. 6, 2006); In re CNL
Hotels & Resorts, Inc., 2005 WL 2291729, at *5 (M.D. Fla. Sept. 20, 2005); In re Gas Reclamation, Inc.
Securities Litigation, 733 F. Supp. 713, 724 (S.D.N.Y. 1990), reconsidered, 741 F. Supp. 1094
(S.D.N.Y. 1990), appeal dismissed, Abish v. Northwestern Nat. Ins. Co., 924 F.2d 448 (2d Cir. 1991);
2014]
SHOOTING THE MESSENGER
395
courts have cited such activities as one factor in determining that a
defendant was a seller. 143
In short, the case law is murky, but the statute itself may provide a
definitive answer. Section 3(a)(80) of the Exchange Act, added by the
JOBS Act, severely restricts the activities of funding portals—among
other things, they may not “solicit purchases, sales, or offers to buy the
securities offered or displayed on . . . [their] . . . website[s] or
portal[s].” 144 Funding portals are allowed to serve as crowdfunding
intermediaries, 145 and crowdfunding intermediaries are required to
provide the issuer’s disclosure to investors. 146 This is consistent with §
3(a)(80) only if posting the issuer’s disclosure is not solicitation. The
proposed crowdfunding rules indicate that some of an intermediary’s
other activities would also not constitute solicitation. Proposed Rule
402 provides that it is “consistent with the prohibitions under Section
3(a)(80)” for a funding portal to provide the required communication
channels and “[a]dvise an issuer about the structure or content of the
issuer’s offering, including assisting the issuer in preparing offering
documentation.” 147 Activities that are not solicitation for purposes of §
3(a)(80) also should not be solicitation for purposes of Pinter.
Therefore, unless the intermediary recommends a particular security, it
should not be liable under §§ 4A(c) or 12(a)(2).
C. Are Crowdfunding Intermediaries “Making” the
Fraudulent Statements?
The language of § 4A(c) raises an additional issue that does not arise
under § 12(a)(2). An “issuer,” including one who offers or sells the
security, is liable under § 4A(c) only if it “makes an untrue statement of
a material fact or omits to state a material fact required to be stated or
Marshall v. Quinn-L Equities, Inc. 704 F.Supp. 1384, 1388-1389 (N.D. Tex. 1988).
142. See In re Charles Schwab Corp. Securities Litigation, 2010 WL 1445445, at *5–*6 (N.D.
Cal. Apr. 8, 2010); Suppa v. Montano, 1989 WL 69883 (W.D. Mo. Feb. 28, 1989).
143. See In re American Bank Note Holographics, Inc. Securities Litigation, 93 F. Supp. 2d 424,
439 (S.D.N.Y. 2000); In re Vivendi Universal, S.A., 381 F. Supp. 2d 158, 187 (S.D.N.Y. 2003),
reconsideration denied, 2004 WL 2375830 (S.D.N.Y. Oct. 22, 2004); Dorchester Investors v. Peak
Trends Trust, 2003 WL 223466, at *2 (S.D.N.Y. Feb. 3, 2003). See also Capri v. Murphy, 856 F.2d
473, 478 (2d Cir. 1988) (defendants were sellers where they prepared and circulated the prospectus and
another person communicated with investors on their behalf); 17A HICKS, supra note 105, § 6.96
(2013) (“factors pointing in the direction of solicitation for purposes of the Pinter test include control
over the amount and content of information to be provided to potential investors and control over the
persons to be contacted for possible sales”).
144. Securities Exchange Act of 1934 § 3(a)(80)(B), 15 U.S.C. § 78c(a)(80)(B).
145. See Securities Act of 1933 § 4A(a)(1), 15 U.S.C. § 77d-1(a)(1).
146. Securities Act of 1933 § 4A(a)(6), 15 U.S.C. § 77d-1(a)(6).
147. Proposed Rule 402(b)(4),(5), in SEC Proposal, supra note 7, at 66,560.
396
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
necessary in order to make the statements, in the light of the
circumstances under which they were made, not misleading.” 148 This
use of the word “make” raises the same issue I already discussed under
Rule 10b-5: would crowdfunding intermediaries be “making” the false
statements posted by others? 149 If courts apply the Janus Capital
definition of “maker to section 4A(c), the result would be the same as
under Rule 10b-5. However, there are two arguments for reading §
4A(c) more broadly.
First, § 4A(c), unlike § 10(b) of the Exchange Act or Rule 10b-5,
creates an express private right of action. The majority opinion in Janus
noted “the narrow scope that we must give the implied private right of
action.” 150 A few courts have focused on that as one reason not to
extend Janus beyond private rights of action under Rule 10b-5.151
However, except for one case involving criminal liability under Rule
10b-5, those cases involved claims under § 17(a) of the Securities Act,
which does not use the word “make.” Janus focused on a textual
analysis of the word “make,” 152 and § 4A(c) uses the same language.
The distinction between express and private rights of action should not
trump the use of identical language.
The second possible way around Janus arises from an ambiguity
within § 4A(c). As previously discussed, § 4A(c) makes “issuers”
liable, but then provides its own broad definition of issuer that includes
people other than the literal issuer of the securities. 153 In defining
liability, § 4A(c)(2) uses the word “issuer” twice. It says “[a]n issuer
shall be liable . . . if the issuer—(A) . . . makes an untrue statement of a
material fact or omits to state a material fact required to be stated or
necessary in order to make the statements . . . not misleading.” 154 If the
statute is referring to the same “issuer” both times, then a crowdfunding
intermediary would be liable only for false statements it made. But if
the “issuer” in the first appearance of the term can be different from the
“issuer” in the second appearance, then the intermediary could be liable
for false statements made by someone else.
Assume, for example, that Intermediary Corporation, a crowdfunding
148. Securities Act of 1933 § 4A(c)(2)(A), 15 U.S.C. § 77d-1(c)(2)(A).
149. See Part IV.A, supra.
150. Janus Capital Group, Inc. v. First Derivative Traders, 131 S.Ct. 2296, 2303 (U.S. 2011).
151. See Prousalis v. Moore, 2014 WL 1799803, at *4–5 (4th Cir. May 7, 2014) (Janus does not
apply to criminal actions for violations of Rule 10b-5); SEC v. Stoker, 865 F. Supp. 2d 457, 465
(S.D.N.Y. 2012) (Janus does not apply to actions under section 17(a) of the Securities Act); SEC v.
Daifotis, 2011 WL 3295139, at * 5–6 (N.D. Cal. Aug. 1, 2011) (Janus does not apply to actions under
section 17(a) of the Securities Act).
152. Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. at 2302–03.
153. See note 98, supra, and accompanying text.
154. Securities Act of 1933 § 4A(c)(2), 15 U.S.C. § 77d-1(c)(2) (emphasis added).
2014]
SHOOTING THE MESSENGER
397
intermediary, is listing securities offered by Startup, Inc., and the
disclosure documents posted by Startup are fraudulent. Assume, for the
sake of argument, that Intermediary is offering or selling Startup’s
securities and is therefore an “issuer” for purposes of § 4A(c). The first
possible interpretation of § 4A(c) would say Intermediary (an issuer) is
liable only if Intermediary (the issuer) makes a false or misleading
statement. The alternative interpretation would also impose liability on
Intermediary (an issuer) if Startup (the issuer) makes a false or
misleading statement.
The text could be read either way, 155 and nothing in the limited
legislative history helps. 156 But, if the courts accept the broader
interpretation, it doesn’t matter whether the intermediary made a
fraudulent statement within the meaning of Janus, as long as some
“issuer” did.
This issue does not arise under § 12(a)(2). Section 12(a)(2) does not
require that the defendant “make” a false or misleading statement, only
that the defendant offer or sell “by means of” a false or misleading
statement. The Supreme Court has already indicated in Pinter who is
liable under § 12(a)(2); unless and until the Court says otherwise, lower
courts are highly unlikely to superimpose a “maker” requirement on top
of that. 157
D. Aiding and Abetting
Aiding and abetting claims cannot be used to circumvent the seller
and maker issues arising under §§ 4A(c) and 12(a)(2). The courts have
generally rejected aiding and abetting claims under § 12(a)(2).158 The
outcome will almost certainly be the same under § 4A(c). The Supreme
Court’s rejection of aiding and abetting under Rule 10b-5 took a very
simple approach—since the text of the statute does not expressly
provide for aiding and abetting liability, it does not exist. 159 The text of
155. Note especially the distinction between “an” issuer in the first use of the term and “the”
issuer in the second use. Is “the” in the second use meant to delimit it to the same issuer we’re talking
about in the first use? Or is it meant to limit the second use to the literal issuer of the securities as
opposed to “an issuer”—meaning any issuer—in the first use?
156. See Alan R. Palmiter, Pricing Disclosure: Crowdfunding's Curious Conundrum, 7 OHIO ST.
ENTREPRENEURIAL BUS. L. J. 373, 402 (2012) (Section 4A(c) “received scant attention”).
157. A number of cases have held that Janus does not apply to actions pursuant to section 17(a),
which also does not use the word “make.” See Section VI.A, infra. Their analysis should apply with
equal force to section 12(a)(2).
158. See 17A HICKS, supra note 105, § 6.28, and cases cited therein; 2 HAZEN, supra note 84,
at 207.
159. “We reach the uncontroversial conclusion, accepted even by those courts recognizing a
§ 10(b) aiding and abetting cause of action, that the text of the 1934 Act does not itself reach those who
aid and abet a § 10(b) violation. Unlike those courts, however, we think that conclusion resolves the
398
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
§ 4A(c) also does not provide for aiding and abetting liability, nor is
there anything in the legislative history that indicates it was intended.
Therefore, courts are unlikely to allow it.
E. Reasonable Care Defense
Even if a crowdfunding intermediary is a proper defendant under §§
4A(c) and 12(a)(2), it can avoid liability by proving it “did not know,
and in the exercise of reasonable care could not have known, of such
untruth or omission.” 160 A crowdfunding intermediary who knew that
the posted statements were false could not avoid liability, because lack
of knowledge is part of the defense (“did not know”). Beyond that, the
law is uncertain, 161 in part because there is little federal appellate law on
the issue 162 and in part because what constitutes reasonable care depends
on the facts of the particular case. 163
An intermediary that is aware of red flags that cast doubt on the
truthfulness of the statements posted by others probably could not
establish reasonable care. As previously discussed, some courts
interpreting Rule 10b-5 have held that ignoring red flags constitutes
recklessness 164 and many courts that have not found recklessness have
said that ignoring red flags would constitute ordinary negligence. 165
But what if there were no red flags? Is it enough that the
intermediary neither knew nor suspected that the statements were false?
Or, to establish reasonable care, would the intermediary have to show it
investigated both the offering and the posted information? 166 The
case.” Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 177
(1994).
160. Securities Act of 1933 § 4A(c)(2)(B), 15 U.S.C. § 77d-1(c)(2)(B); Securities Act of 1933
§ 12(a)(2), 15 U.S.C. § 77l(a)(2). The two sections are worded identically, so presumably the same
standard will apply under section 4A(c) as under section 12(a)(2). Bradford, The New Exemption, supra
note 1, at 211.
161. See David B. Gail, Uncertain Future: Liability Concerns Surrounding the Application of
Section 12(a)(2) of the Securities Act of 1933 to Free Writing Prospectuses After the Enactment of the
SEC's Recently Reformed Offering Rules, 60 SMU L. REV. 609, 633 (2007) (noting "significant
uncertainty in the securities bar with respect to the level of due diligence-like investigation required in a
section 12(a)(2) case").
162. Committee on Federal Regulation of Securities, Report of the Task Force on Sellers' Due
Diligence and Similar Defenses Under the Federal Securities Laws, 48 BUS. LAWYER 1185, 1195
(1993).
163. Therese Maynard, The Affirmative Defense of Reasonable Care under Section 12(2) of the
Securities Act of 1933, 69 NOTRE DAME L. REV. 57, 86 (1993); Committee on Federal Regulation of
Securities, supra note 162, at 1232.
164. See notes 89,91, supra, and accompanying text.
165. See note 90, supra, and accompanying text. See also SEC v. Hughes Capital Corp., 124 F.3d
449, 454 (3d Cir. 1997) (defendant was negligent for purposes of section 17(a) “in ignoring clear
indicators of questionable behavior”).
166. If the intermediary does conduct a reasonable investigation and does not discover the fraud,
2014]
SHOOTING THE MESSENGER
399
answer is unclear. There is no per se obligation to investigate, 167 and
many authorities, including the SEC, say that the reasonable care
defense is less demanding than the “reasonable investigation” required
to show due diligence under § 11 of the Securities Act. 168 But others
say the reasonable care defense is similar or essentially the same as the
reasonable investigation requirement in § 11. 169
If the intermediary recommends the particular security, or expresses
an opinion on the security or the issuer, an investigation would probably
be required. Several cases say that a broker or sales agent who makes
such a recommendation has an obligation to investigate the issuer in
order to establish reasonable care. 170
If the intermediary makes no recommendation, the law is less certain.
Some cases say that a broker who neither solicits the sale nor
recommends the security has a minimal duty to investigate, if any. 171 At
least one case has indicated that even a sales agent who solicits
purchasers does not have to show an investigation to establish
reasonable care. 172
On the other hand, cases have held that
underwriters, who purchase from the issuer and sell to the public, have a
duty to investigate, whether or not they make a recommendation.173
the reasonable care defense would protect it. 2 HAZEN, supra note 84, 273.
167. Id., at 271.
168. See In re Fuwei Films Securities Litigation, 634 F. Supp. 2d 419, 435 n. 10 (S.D.N.Y.
2009); In re Worldcom, Inc. Securities Litigation, 346 F. Supp. 2d 628, 663 (S.D.N.Y. 2004); SEC,
Securities Offering Reform, Securities Act Release No. 8591 2005 WL 1692642, at *79 (July 19, 2005)
(“We believe . . . that the standard of care under Section 12(a)(2) is less demanding than that
prescribed by Section 11 or, put another way, that Section 11 requires a more diligent investigation than
Section 12(a)(2).”); Comment, "Reasonable Care" in Section 12(2) of the Securities Act of 1933, 48 U.
CHI. L. REV. 372, 388 (1981) (most of the commentary has concluded that the section 11 defense is
“more stringent” than the section 12(a)(2) defense).
169. See In re Software Toolworks Inc., 50 F.3d 615, 621 (9th Cir. 1994); Sanders v. John
Nuveen & Co., Inc., 619 F.2d 1222, 1228 (7th Cir. 1980); Weinberger v. Jackson, 1990 WL 260676, at
*2 (N.D. Cal. Oct. 11, 1990). See also Ernest L. Folk, III, Civil Liabilities under the Federal Securities
Acts: The BarChris Case: Part II: The Broader Implications, 55 VA. L. REV. 199, 207–15 (1969)
(arguing that the reasonable care standard under section 12(2) is essentially the same as the reasonable
investigation standard under section 11(b)(3)(C)). But see John Nuveen & Co., Inc. v. Sanders, 450
U.S. 1005, 1007–09 (U.S. 1981) (Powell, J., dissenting from denial of cert.) (arguing that an
independent investigation should not be required under § 12(2)).
170. See Junker v. Crory, 650 F.2d 1349, 1361 (5th Cir. 1981); Quincy Co-op Bank v. A.G.
Edwards & Sons, Inc., 655 F. Supp. 78, 86 (D. Mass. 1986); Canizaro v. Kohlmeyer & Co., 370 F.
Supp. 282, 289–90 (E.D. La. 1974), aff'd, 512 F.2d 484 (5th Cir. 1975). See also Maynard, supra note
163, at 122.
171. Quincy Co-op Bank v. A.G. Edwards & Sons, Inc., 655 F. Supp. 78, 86 (D. Mass. 1986);
Canizaro v. Kohlmeyer & Co., 370 F. Supp. 282, 290 (E.D. La. 1974), aff'd, 512 F.2d 484 (5th Cir.
1975).
172. See Adams v. Hyannis Harborview, Inc., 838 F. Supp. 676, 689 (D. Mass. 1993), aff'd,
Adams v. Zimmerman, 73 F.3d 1164 (9th Cir. 2009).
173. The Seventh Circuit has held that the relationship between the underwriter and the issuer
implicitly involves a favorable recommendation of the security, “and since the underwriter is
400
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
Crowdfunding intermediaries fall somewhere between brokers who
merely execute unsolicited trades for clients and underwriters who
purchase and resell in a registered public offering.
The Sixth Circuit in Davis v. Avco Financial Services identified five
factors relevant to the reasonable care analysis under § 12(a)(2), 174 but
those factors do not provide a clear, categorical answer. The first factor
is “the quantum of decisional (planning) and facilitative (promotional)
participation, such as designing the deal and contacting and attempting
to persuade potential purchasers.” 175 The planning and promotional
activities of crowdfunding intermediaries will vary. They are allowed to
be involved in planning offerings, including drafting offering
documents, but they are not required to be. Their web sites promote the
offerings and the promotional activities of broker-intermediaries may go
beyond that—recommending particular offerings. The second Davis
factor is “access to source data against which the truth or falsity of
representations can be tested.” 176 Crowdfunding intermediaries do not
have ready access to source data to test the truth or falsity of the
representations; that data is within the control of the issuer. But, of
course, they have greater access to that data than investors. The third
factor is “relative skill in ferreting out the truth.” 177 Intermediaries will
have greater skill in ferreting out the truth than most of the small,
unsophisticated investors likely to invest in crowdfunding. The fourth
unquestionably aware of the nature of the public’s reliance on his participation in the sale of the issuer,
the mere fact that he has underwritten it is an implied representation that he has met the standards of his
profession in his investigation of the issuer.” Sanders v. John Nuveen & Co., Inc., 524 F.2d 1064 (7th
Cir. 1975), vacated and remanded on other grounds, John Nuveen & Co., Inc. v. Sanders, 425 U.S. 929
(1976), on remand, Sanders v. John Nuveen & Co., Inc., 619 F.2d 1222 (7th Cir. 1980). It subsequently
held that the underwriter was required to conduct a reasonable investigation to satisfy the reasonable
care defense in section 12(a)(2). Sanders v. John Nuveen & Co., Inc., 619 F.2d 1222, 1228 (7th Cir.
1980). See also SEC v. Dain Rauscher, Inc., 254 F.3d 852, 857-58 (9th Cir. 2001) (holding that an
underwriter’s failure to investigate an offering of municipal securities could be negligent for purposes of
section 17(a)); Quincy Co-op Bank v. A.G. Edwards & Sons, Inc., 655 F. Supp. 78, 86 (D. Mass. 1986)
(citing Sanders for the proposition that “an underwriter who purchases and resells all of an issuer’s
securities is held to a more rigorous duty of care in investigating the security”).
174. Davis v. Avco Financial Services, Inc., 739 F.2d 1057, 1068 (6th Cir. 1984). See also Picard
Chemical Inc. Profit Sharing Plan v. Perrigo Co., 1998 WL 513091, at *15 (W.D. Mich. June 15, 1998)
(stating that the Davis factors are “potentially relevant . . . [but] not by themselves determinative”);
Riedel v. Acutote of Colorado, 773 F. Supp. 1055, 1063 (S.D. Ohio 1991), appeal dismissed, 947 F.2d
945 (6th Cir. 1991) (citing the Davis factors); 2 HAZEN, supra note 84, at 273. Compare University
Hill Foundation v. Goldman, Sachs & Co., 422 F. Supp. 879, 900 (S.D.N.Y. 1976) (what is required to
establish reasonable care depends on “a close consideration of the facts of the relationship between . . .
[the issuer and the defendant], the latter’s access to information, the nature of the data it relied upon and
the presence or absence of ‘warning signals’ . . . to . . . [the defendant] . . . that something more
might be in order”).
175. Davis v. Avco Financial Services, Inc., 739 F.2d at 1068.
176. Id.
177. Id.
2014]
SHOOTING THE MESSENGER
401
factor is “pecuniary interest in the completion of the transaction.” 178 If
crowdfunding intermediaries receive a percentage fee, they clearly have
a pecuniary interest in completing the transaction. The fifth and final
Davis factor is “the existence of a relationship of trust and confidence
between the plaintiff and the alleged ‘seller.’” 179 No relationship of
trust and confidence will exist between investors and crowdfunding
intermediaries.
The SEC’s crowdfunding release is not particularly helpful in
resolving the uncertainty about what constitutes “reasonable care.” The
release indicates that an intermediary’s steps to establish reasonable care
under § 4A(c) should include “a review of the issuer’s offering
documents, before posting them to the platform, to evaluate whether
they contain materially false or misleading information.” 180 The word
“review” could mean merely reading the issuer’s documents carefully or
it could be interpreted more broadly to require an investigation to check
what the documents say. An investigation would probably be necessary
to seriously “evaluate whether . . . [those documents] . . . contain
materially false or misleading information.”
However, the proposed rules themselves could be interpreted to
relieve crowdfunding intermediaries of any duty to investigate.
Proposed Rule 301(a) says that an intermediary must have a reasonable
basis for believing that the issuer is in compliance with the requirements
of both § 4A(b) of the statute and the regulation itself. 181 The issuer’s
requirements would include, of course, the disclosure requirement. But
Rule 301(a) says that the intermediary “may rely on the representations
of the issuer concerning compliance with these requirements unless the
intermediary has reason to question the reliability of those
representations.” 182
Since full compliance with the disclosure
requirements would require truthful and complete disclosure, 183 Rule
301(a) arguably allows the intermediary to rely on the issuer’s
representation that its disclosure is not misleading unless it has some
reason to doubt that representation. No further investigation is required.
The SEC probably did not intend for Rule 301(a) to be used to satisfy
the reasonable care requirement, and the success of the argument is
doubtful. In any event, Rule 301(a) would not protect intermediaries
178. Id.
179. Id.
180. SEC Proposal, supra note 7, at 66,499.
181. Proposed Rule 301(b), in SEC Proposal, supra note 7, at 66,556.
182. Id.
183. See SEC v. Manor Nursing Centers, Inc., 458 F.2d 1082, 1098–99 (2d Cir. 1972) (holding
that an issuer has not complied with the requirement to deliver a prospectus if the prospectus is
materially misleading). But see SEC v. Southwest Coal & Energy Co., 624 F.2d 1315, 1318–19 (5th
Cir. 1980) (rejecting the Manor Nursing Centers analysis).
402
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
from liability for fraudulent posts on communication channels; such
posts do not involve a requirement imposed on the issuer.
VI. LIABILITY UNDER SECTION 17(A) OF THE SECURITIES ACT
Crowdfunding intermediaries might also be liable under § 17(a) of the
Securities Act, although only in actions brought by the SEC. Section
17(a) makes it unlawful for any person in the offer or sale of securities
(1) to employ any device, scheme, or artifice to defraud, or
(2) to obtain money or property by means of any untrue statement
of a material fact or any omission to state a material fact necessary
in order to make the statements made, in light of the circumstances
under which they were made, not misleading; or
(3) to engage in any transaction, practice, or course of business
which operates or would operate as a fraud or deceit upon the
purchaser. 184
This language is similar to that of Rule 10b-5, because Rule 10b-5 was
However, the two provisions are not
modeled on § 17(a). 185
coextensive, and the differences between them would affect the potential
liability of crowdfunding intermediaries.
A. Relevant Differences between Section 17(a) and Rule 10b-5
Section 17(a) and Rule 10b-5 differ in three important ways. First,
“the overwhelming majority of decisions since 1975 hold that there is no
private remedy under § 17(a).” 186 Therefore, only the SEC could bring
an action under § 17(a) against crowdfunding intermediaries.
Second, § 17(a) may reach a broader range of defendants. Section
17(a)(2), unlike Rule 10b-5(b), does not use the word “make.” It only
requires that the defendant act “by means of” a misleading statement.
Most, but not all, courts that have considered the issue have concluded
that Janus does not apply to § 17(a) and, therefore, liability is not
limited to “makers.” 187
184. Securities Act of 1933 § 17(a), 15 U.S.C. § 77q(a).
185. See 3 HAZEN, supra note 84, at 521 (Rule 10b-5 was patterned on section 17(a));
BROMBERG, LOWENFELS, & SULLIVAN, supra note 72, § 2:18 (Rule 10b-5 was a graft of section
17(a) and section 10(b) of the Exchange Act).
186. 2 HAZEN, supra note 84, at 272 n. 45. See, e.g., Maldonado v. Dominguez, 137 F.3d 1, 7
(1st Cir. 1998), and cases cited therein (“In recent years, every circuit to have addressed the issue has
refused to recognize a private right of action under section 17(a), including four circuits which originally
had held otherwise.”).
187. See, e.g., SEC v. Benger, 931 F.Supp.2d 904, 906–07 (N.D. Ill. 2013); SEC v. Garber, 2013
WL 1732571, at *4 (S.D.N.Y. Apr. 22, 2013); SEC v. Stoker, 865 F. Supp. 2d 457, 464 (S.D.N.Y.
2014]
SHOOTING THE MESSENGER
403
Many courts apply the Pinter v. Dahl test to determine who is liable
under § 17(a). 188 Under Pinter, crowdfunding intermediaries would be
liable only if they are offering or selling the securities on their sites, an
issue that I already discussed. 189 But a few courts say that § 17(a) is
broader than § 12(a)(2). Section 12(a)(2) covers only defendants who
“offer or sell,” whereas § 17(a) imposes liability on any person who, “in
the offer or sale of any securities,” engages in the prohibited conduct. 190
A defendant who is not an offeror or seller could still engage in fraud
“in the offer or sale.” The Fifth Circuit noted this argument in Meadows
v. SEC, 191 but ultimately decided that the defendant was a seller under
the Pinter standard, so it did not have to resolve the issue. 192 However,
a few district court cases have embraced this broader interpretation of §
17(a). 193 Under this interpretation, crowdfunding intermediaries could
be liable even if they are not actively soliciting investors and therefore
are not “sellers” under Pinter.
The third relevant difference between § 17(a) and Rule 10b-5 is the
standard of care. Although scienter is required for liability under §
17(a)(1), negligence is sufficient under §§ 17(a)(2) and 17(a)(3),194
equivalent to the “reasonable care” required by § 12(a)(2) of the
Securities Act. 195 I have already discussed the application of a
2012); SEC v. Pentagon Capital Management PLC, 844 F. Supp. 2d 377, 422 (S.D.N.Y. 2012), aff'd in
part and rev'd in part, 725 F.3d 279 (2d Cir. 2013); SEC v. Mercury Interactive, LLC, 2011 WL
5871020, at *3 (N.D. Cal. Nov. 22, 2011); SEC v. Daifotis, 2011 WL 3295139, at *5–*6 (N.D. Cal.
Aug. 1, 2011). See also Arnold, supra note 68, at 1068-76 (arguing that Janus should not apply to
section 17(a)); Langevoort, supra note 68, at 955 (arguing that Janus should not apply to section 17(a)).
However, two cases have held that Janus applies to claims under section 17(a), so only “makers” are
liable. See SEC v. Perry, 2012 WL 1959566, at *8 (C.D. Cal. May 31, 2012); SEC v. Kelly, 817 F.
Supp. 2d 340, 345 (S.D.N.Y. 2011).
188. See SEC v. JB Oxford Holdings, Inc., 2004 WL 6234910, at *3 (C.D. Cal. Nov. 9, 2004),
and cases cited therein (holding that Pinter determines who is a seller for purposes of section 17(a));
Buford White Lumber Co. Profit Sharing and Savings Plan & Trust v. Octagon Properties, Ltd., 740 F.
Supp. 1553 (W.D. Okla. 1989) (holding that Pinter applies to section 17(a) claims). See also SEC v.
Druffner, 353 F. Supp. 2d 141, 152–53 (D. Mass. 2005) (holding that only “sellers” are liable under
section 17(a) and looking to cases under section 12 to define “seller,” but stating that it does not intend
to imply that “seller” has the same meaning under both sections).
189. See Part V.B, supra.
190. See SEC v. Durgarian, 477 F. Supp. 2d 342, 356 (D. Mass. 2007), aff’d, SEC v. Papa, 555
F.3d 31 (1st Cir. 2009) (noting this difference).
191. Meadows v. SEC, 119 F.3d 1219, 1224 (1997).
192. Id., at 1224-25.
193. See SEC v. Durgarian, 477 F. Supp. 2d at 356 (rejecting the argument that a defendant is not
liable under section 17(a) unless it is an offeror or seller); SEC v. Shapiro, 2008 WL 819945, at *4 (E.D.
Tex. March 25, 2008) (noting that “little case law exists on this precise question,” but relying on
Meadows to deny a motion to dismiss that argued the defendants were not offerors or sellers); SEC v.
Morris, 2005 WL 2000665, at *7 (S.D. Tex. Aug. 18, 2005) (noting that “little case law exists on this
precise question,” but following the “broad interpretation” in Meadows).
194. Aaron v. SEC, 446 U.S. 680, 697 (1980). See also 2 HAZEN, supra note 84, at 331–32.
195. The only difference lies in the burden of proof. Under sections 4A(c) and 12(a)(2),
404
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
negligence standard to crowdfunding intermediaries. 196
B. Aiding and Abetting
Crowdfunding intermediaries could also be liable for aiding and
abetting other people’s violations of § 17(a), but only if they acted with
scienter. Section 15(b) of the Securities Act authorizes the SEC to bring
an action against “any person that knowingly or recklessly provides
substantial assistance to another person in violation of a provision of . .
. [the Securities Act].” 197 I have already discussed liability for aiding
and abetting violations of Rule 10b-5; 198 the standard under § 15(b) is
the same, so I will not repeat that discussion here.
VII. LIABILITY UNDER SECTION 9 OF THE EXCHANGE ACT
Crowdfunding intermediaries might be liable under § 9 of the
Exchange Act. Section 9(a)(4) of the Exchange Act makes it unlawful
for any person offering or selling any security “to make, . . . for the
purpose of inducing the purchase or sale of such security, . . . any
statement which was at the time and in light of the circumstances under
which it was made, false or misleading with respect to any material fact,
and which that person knew or had reasonable ground to believe was so
false or misleading.” 199 If a crowdfunding intermediary violated §
9(a)(4), the SEC could bring an action under § 21(d) of the Exchange
Act. 200 In addition, § 9(f) creates a private right of action against
anyone who “willfully participates” in a violation of § 9(a)(4). 201
Section 9 originally applied only to exchange-traded securities, but
the Dodd-Frank Act expanded it to reach unlisted securities as well,202
reasonable care is a defense, and the burden is on the defendant. See Securities Act of 1933
§§ 4A(c)(2)(B), 12(a)(2), 15 U.S.C. §§ 77d-1(c)(2)(B), 77l(a)(2).
196. See Part V.E, supra.
197. Securities Act of 1933 § 15(b), 15 U.S.C. § 77o(b).
198. See Part IV.C, supra.
199. Securities Exchange Act of 1934 § 9(a)(4), 15 U.S.C. § 78i(a)(4).
200. Securities Exchange Act of 1934 § 21(d)(1),(3), 15 U.S.C § 78u(d)(1),(3) (authorizing civil
actions by the SEC to obtain injunctive relief or money penalties for violations of the Exchange Act).
201. “Any person who willfully participates in any act or transaction in violation of subsections
(a), (b), or (c) of this section, shall be liable to any person who shall purchase or sell any security at a
price which was affected by such act or transaction, and the person so injured may sue in law or in
equity in any court of competent jurisdiction to recover the damages sustained as a result of any such act
or transaction.” Securities Exchange Act of 1934 § 9(f), 15 U.S.C. § 78i(f). Section (f) was formerly
section 9(e). See 15 U.S.C. § 78i (2000), amended by DODD–FRANK WALL STREET REFORM
AND CONSUMER PROTECTION ACT, Tit. IX, § 929X, Pub. L. 111-203, 124 Stat 1376, 1870 (July
21, 2010).
202. See 15 U.S.C. § 78i (2000), amended by DODD–FRANK WALL STREET REFORM AND
CONSUMER PROTECTION ACT, Tit. IX, § 929X, Pub. L. 111-203, 124 Stat 1376, 1870 (July 21,
2014]
SHOOTING THE MESSENGER
405
so it would apply to crowdfunding. However, the case law under §
9(a)(4) is sparse and the remedy provided by § 9(f) has not often been
invoked successfully. 203 The application of § 9 to crowdfunding
intermediaries raises a couple of issues already discussed: whether
intermediaries would be “offering or selling” the securities listed on
their sites; and whether intermediaries must “make” the false statements
to be liable. If intermediaries are covered by § 9, they would be liable
only if they acted with scienter. In addition, a private investor suing
under § 9(f) would have to show that the fraud affected the price, and it
is unclear exactly what that means in the crowdfunding context.
A. Would Crowdfunding Intermediaries Be Proper
Defendants under Section 9?
Section 9(a)(4) imposes liability on “a dealer, broker, security-based
swap dealer, major security-based swap participant, or other person
selling or offering for sale or purchasing or offering to purchase the
security.” 204 Non-broker intermediaries, and possibly brokers as well, 205
would be liable only if they were offering or selling the issuer’s
securities. There are no cases interpreting this language, but it is similar
to the “offers or sells” language in § 12(a)(2) of the Securities Act, so
the Pinter test might apply. 206
Section 9(a)(4) also requires that the defendant “make” a false or
misleading statement, so the restrictive Janus definition of “maker”
could apply. 207 However, as previously discussed, some courts have
argued that Janus should be limited to implied private rights of
action. 208 Section 9(f) grants an express private right of action for
violations of § 9(a)(4), so the “make” language in § 9(a)(4) might be
read more broadly.
2010). See also Arnold S. Jacobs, DISCLOSURE AND REMEDIES UNDER THE SECURITIES
LAWS § 4:4 (2014 rev.).
203. See JACOBS, supra note 202, § 4:4.
204. Securities Exchange Act of 1934 § 9(a)(4), 15 U.S.C. § 78i(a)(4). See also Robbins v.
Banner Industries, Inc., 285 F. Supp. 758, 761 (S.D.N.Y. 1966) (the false or misleading statement must
“be made by the purchaser to the seller or vice versa”).
205. It is not clear if the “offering or selling” requirement applies to brokers, or only to persons
other than dealers, brokers, swap dealers, and swap participants. Prior to its amendment by the DoddFrank Act in 2010, section 9(a)(4) applied to “a dealer or broker, or other person selling or offering. . . .
” See 15 U.S.C. § 78i (2000), amended by DODD–FRANK WALL STREET REFORM AND
CONSUMER PROTECTION ACT, Tit. IX, § 929X, Pub. L. 111-203, 124 Stat 1376, 1870 (July 21,
2010). This construction arguably excludes dealers and brokers from the “selling or offering”
requirement.
206. See Part V.B, supra.
207. See Part IV.A, supra.
208. See text accompanying notes 65–69 and 150–52, supra.
406
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
Even if § 9(a)(4) is limited to Janus-type makers, there is still an
argument that other defendants would be liable under § 9(f), which
imposes liability on anyone who “willfully participates” in a violation of
§ 9(a)(4). Crowdfunding intermediaries who allow others to post
fraudulent statements on their sites may be willfully participating in the
fraud, even if they do not themselves “make” any fraudulent
statements. 209 However, it is unclear that the “participates” language
in § 9(f) was intended to impose secondary liability on defendants who
do not themselves violate § 9(a). Most cases say that § 9(f) merely
“creates an express private remedy for violations of § 9(a),” 210 and a
California state case has rejected the use of a California blue sky
provision patterned on § 9(f) to impose such secondary liability. 211 No
federal cases have directly addressed this question, so it is possible that
a court would read § 9(f) to extend liability to secondary participants. If
so, crowdfunding intermediaries could be liable even if they did not
make any fraudulent statements themselves.
B. The Scienter Requirement
Although the case law is limited, a crowdfunding intermediary would
probably be liable under § 9 only if it acted with scienter.212 At least
one court has indicated that under § 9(a)(4), unlike Rule 10b-5,
recklessness is not sufficient. 213 I have already discussed the application
209. See Sara Hanks & Andrew Stephenson, Online Securities Offerings, 33 No. 2 Banking &
Fin. Services Pol’y Rep. 1, 13 (2014) (“the inclusion of any person who ‘willfully participates’ in a
false or misleading statement may reintroduce secondary liability to securities intermediaries that was
eliminated from Rule 10b-5 liability by the decision in Janus Capital Group”).
210. Chemetron Corp. v. Business Funds, Inc., 682 F.2d 1149, 1156-57 (5th Cir. 1982), vacated
on other grounds, 460 U.S. 1007 (1983) (Section 9(e) [now 9(f)] creates an express private remedy for
violations of section 9(a)). See also Walck v. American Stock Exchange, Inc., 565 F. Supp. 1051, 1063
(E.D. Pa. 1981), aff’d 687 F.2d 778 (3d Cir. 1982) (“Section 9(e) [now 9(f)] . . . provides an express
remedy to persons injured by conduct constituting a violation of § 9(a)(2)”).
211. California Amplifier, Inc. v. RLI Ins. Co., 94 Cal. App. 4th 102, 113 Cal. Rptr. 2d 915
(2002). The court rejected the argument that California section 25500, which imposes liability on “any
person who willfully participates in any act or transaction in violation of Section 25400,” extends
liability to people who do not themselves violate section 25400, but only participate in someone else’s
violation.” California Amplifier, Inc. v. RLI Ins. Co., 94 Cal. App. 4th at 112.
212. See Chemetron Corp. v. Business Funds, Inc., 682 F.2d 1149, 1161 (5th Cir. 1982), vacated
on other grounds, 460 U.S. 1007 (1983); Perry v. Eastman Kodak Co., 1991 WL 629728, at *6 (S.D.
Ind. Apr. 22, 1991). See also Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480 F.2d 341, 398 (2d
Cir. 1973) (indicating that liability under section 9(e) [now 9(f)] for violations of section 9(a)(4) is
limited to “willful and intentional misrepresentation”); AnchorBank, FSB v. Hofer, 649 F.3d 610 (7th
Cir. 2011) (scienter required to show a violation of § 9(a)); JACOBS, supra note 202, § 4:4 (scienter is
an element of a claim under section 9(f)). See also Ernst & Ernst v. Hochfelder, 425 U.S. 185, 209 n.
28 (1976) (indicating that section 9(e) [now 9(f)] “contains a state of mind condition requiring
something more than negligence”).
213. Chemetron Corp. v. Business Funds, Inc., 682 F.2d at 1162.
2014]
SHOOTING THE MESSENGER
407
of the scienter requirement to crowdfunding intermediaries 214 and will
not repeat that discussion here.
C. For Liability under Section 9(f), the Misrepresentation Must
“Affect” the Price
Crowdfunding intermediaries would be liable under § 9(f) only to
investors who purchased “at a price which was affected by” the fraud.215
It is not enough that the defendant made a fraudulent statement to the
plaintiff 216 or that the fraud touches on the reason for the security’s
ultimate decline in value. 217 The fraud must affect the price the plaintiff
pays for the security. 218 Only a couple of cases have discussed this
requirement, and it is unclear exactly what it means in the crowdfunding
context. The price in a crowdfunded offering is neither negotiated nor
the result of informed market trading; it is set by the issuer on a take-itor-leave-it basis. Is it enough to show that, if the truth had been known,
some or most of the investors would not have purchased at the posted
price? If that is sufficient, how is a plaintiff to prove that?
VIII. OTHER POSSIBLE LIABILITY
This article focuses on civil liability under federal securities law, but
crowdfunding intermediaries might also be liable under federal criminal
law or under state blue sky laws.
A. Federal Criminal Liability
Crowdfunding intermediaries could be criminally liable for violations
of federal securities law. Both the Securities Act and the Exchange Act
authorize criminal sanctions against anyone who willfully violates any
provision of the securities statutes or the rules and regulations adopted
pursuant to those statutes. 219 A general federal criminal provision also
imposes liability on anyone who aids or abets a criminal violation, 220 so
214. See Part IV.D, supra.
215. Securities Exchange Act of 1934 § 9(f), 15 U.S.C. § 78i(f).
216. Rosenberg v. Hano, 121 F.2d 818, 821 (3d Cir. 1941) (a misrepresentation made privately to
the plaintiff was not actionable where the plaintiff paid the market price for the stock and the
misrepresentation did not affect that market price).
217. Chemetron Corp. v. Business Funds, Inc., 682 F.2d 1149, 1162 (5th Cir. 1982), vacated on
other grounds, 460 U.S. 1007 (1983).
218. Id., at 1162; Rosenberg v. Hano, 121 F.2d at 821.
219. Securities Act of 1933 § 24, 15 U.S.C. § 77x; Securities Exchange Act of 1934 § 32, 15
U.S.C. § 78ff.
220. 18 U.S.C. § 2(a).
408
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
intermediaries might be liable for aiding and abetting fraud by the issuer
and others.
B. Liability under State Law
Crowdfunding intermediaries might also be liable under state
securities law. The crowdfunding exemption preempts state registration,
qualification, and offering requirements, 221 but the states retain authority
with respect to fraud, deceit, or unlawful conduct by the issuer and
crowdfunding intermediaries. 222
State securities law is in some cases more expansive than the
corresponding federal liability provisions. Some states, for instance,
reject the Pinter “seller” test, imposing liability on anyone who was a
“substantial factor” in causing a sale to take place. 223 In some states,
aiders and abettors are liable in civil actions. 224 Scienter may not be
required for liability. 225 Thus, crowdfunding intermediaries might be
liable under state law even when they are not liable under federal law.
IX. CONCLUSION
Crowdfunding intermediaries face a significant risk of liability for the
fraudulent statements of issuers and others posted on their platforms.
Unfortunately, the exact extent of their liability is unclear. The law
needs to be clarified in two ways.
First, crowdfunding intermediaries should be liable if they have actual
221. Securities sold pursuant to the section 4(a)(6) exemption are “covered securities.” Securities
Act of 1933 § 18(b)(4), 15 U.S.C. § 77r(b)(4). State registration, qualification, and offering
requirements are preempted with respect to offerings of covered securities. Securities Act of 1933
§ 18(a), 15 U.S.C. § 77r(a).
222. Securities Act of 1933 § 18(c)(1)(B), 15 U.S.C. § 77r(c)(1)(B). In addition, the JOBS Act
leaves undisturbed the states’ authority to regulate brokers, even if those brokers operate as
crowdfunding intermediaries. See Securities Exchange Act of 1934 § 15(i), 15 U.S.C. § 78o(i).
However, state authority to regulate non-broker funding portals is limited. See Securities Exchange Act
of 1934 § 15(i)(2)(A),(B), 15 U.S.C. § 78o(i)(2)(A),(B). See also Bradford, The New Exemption, supra
note 1, at 210.
223. See, e.g., Hoffer v. State, 776 P.2d 963, 964–65 (Wash. 1989) (rejecting Pinter and holding
that one who is a “substantial contributive factor” in causing the sale to take place is liable).
224. See Kirchoff v. Selby, 703 N.E.2d 644, 652 (Ind. 1998) (rejecting the application of Pinter
and Central Bank and holding that Indiana law imposes liability on one who “materially aids in the
conduct creating liability); State v. Diacide Distributors, Inc., 561 N.W.2d 369, 373–75 (in a state
enforcement action, noting that aiders and abettors are liable to injured purchasers). However, there are
not many aiding and abetting cases under state securities law, and the results are mixed. Joseph C. Long,
12A BLUE SKY LAW § 7:76.19 (2013). See also Robert N. Rapp, 2 BLUE SKY REGULATION
§ 13.02[2][c], at 13–58 (2d ed. 2013) (“secondary liability in many Blue Sky Laws is prescribed in
terms of materially aiding or participating in a violation”).
225. See 2 RAPP, supra note 224, at 13-21 to 13-22 (in Uniform Act states, courts have held that
defrauded purchasers do not have to show that the seller acted with fraudulent intent).
2014]
SHOOTING THE MESSENGER
409
knowledge that statements posted by others on their platforms are false
or if they are aware of red flags that should make them aware of the
fraud. But, given the confusion about whether intermediaries would be
“sellers” and whether they would be “making” the statements on their
platforms, it is unclear if they would be liable to investors even when
they acted knowingly or recklessly. The law should be clarified to
expressly impose such liability.
Second, under the existing case law, liability might be imposed on
innocent intermediaries, who were unaware of the fraud and did not act
recklessly, merely because they failed to investigate the offering and the
accuracy of the statements posted by others. Imposing such a duty to
investigate on innocent intermediaries will significantly increase the cost
of operating crowdfunding platforms and make the crowdfunding
exemption even less viable than it already is. 226 The law should clarify
that innocent intermediaries are not liable unless they recommend the
particular security without an adequate investigation.
Given the uncertainty in the case law, the only sure way to achieve
these results is by amending the statute. The most sensible place for
such an amendment would be § 4A(c) of the Securities Act, since that
section deals specifically with crowdfunding liability.
I have included a proposed amendment in the Appendix. The
proposed amendment clarifies that crowdfunding intermediaries are
sellers for purposes of § 4A(c) and deems them “makers” of the
statements posted on their platforms. However, it also limits their
liability for information provided by others. It allows for liability where
the intermediary knew of the fraud or ignored red flags that made the
fraud apparent, or where the intermediary recommended a particular
security or issuer. Except for those specific carve-outs, the intermediary
would not be liable—civilly, criminally, or administratively; under
federal law, state law, or FINRA rules—for false statements made by
others, even if it did not investigate the accuracy of those statements.
226. It is possible, of course, that litigation, and thus the risk of liability, will be limited. The SEC
might have higher enforcement priorities. Hazen, supra note 10, at 1757; Palmiter, supra note 156, at
375. And the small amount of money involved may make private litigation, even class actions, unlikely.
Mashburn, supra note 47, at 165–66; Thomas G. James, Far From the Maddening Crowd: Does the
JOBS Act Provide Meaningful Redress to Small Investors for Securities Fraud in Connection with
Crowdfunding Offerings?, 54 B.C. L. REV. 1767, 1769–70 (2013); Palmiter, supra, at 375 (2012). But
class actions might be brought for their quick settlement value, Mashburn, supra, at 166–67, and there is
always the risk that the SEC or state regulators would take an interest.
410
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83
APPENDIX
PROPOSED AMENDMENT TO SECTION 4A(C) OF THE SECURITIES ACT
Add the following two subsections at the end of Section 4A(c):
(4) Status of Crowdfunding Intermediaries. For purposes of section
4A(c) only, a crowdfunding intermediary shall be deemed to be an
“issuer” as to any offering made on the intermediary’s platform,
notwithstanding anything to the contrary in the definition in section
4A(c)(3). All statements posted on a crowdfunding intermediary’s
platform shall be deemed to be made by the crowdfunding intermediary.
“Crowdfunding intermediary,” for purposes of subsections (c)(4) and
(c)(5) means a broker or funding portal acting as an intermediary in a
transaction involving the offer or sale of securities pursuant to section
4(a)(6) of this Act.
(5) Limitation of the liability of crowdfunding intermediaries.
a. “Liability under federal securities law” for purposes of subsection
(c)(5) includes civil or criminal liability under any provision of this
Act or the Securities Exchange Act of 1934, any rule or regulation
issued under the authority of either act, or any rule or regulation
issued by any self-regulatory organization (as defined by section
3(a)(26) of the Securities Exchange Act of 1934).
b. Except as provided in subsections (c)(5)c and (c)(5)d, no
crowdfunding intermediary shall have any liability under federal
securities law for (1) any information provided by the issuer of the
security and required to be made available by the crowdfunding
intermediary pursuant to section 4A(a)(6) of this Act or associated
regulations; or (2) any information posted on a communication
channel provided by the crowdfunding intermediary, except for
information posted by the crowdfunding intermediary or persons
acting as its employees or agents.
c. Subsection (c)(5)b shall not affect the liability of a crowdfunding
intermediary where:
(1) the intermediary recommends, or expresses an opinion on, a
particular security or issuer; or
(2) the intermediary knew, or based on facts known to the
intermediary, was reckless in not knowing, that the particular
information included an untrue statement of a material fact or
omitted to state a material fact necessary in order to make the
2014]
SHOOTING THE MESSENGER
411
statements, in the light of the circumstances under which they were
made, not misleading.
d. (1) Subsection (c)(5)b shall not affect the obligation of the
intermediary to comply with the requirements of section 4A(a) of the
Securities Act or any rule or regulation issued under the authority of
section 4A(a).
(2) Except in the circumstances specified in subsection (c)(5)c, the
SEC may not require, as a condition of the exemption provided by
section 4(a)(6) of this Act, or pursuant to its authority under
section 4A(a) of this Act, that a crowdfunding intermediary
investigate:
(a) any information provided by the issuer and required to be
made available by the crowdfunding intermediary; or
(b) any information posted on a communication channel
provided by the crowdfunding intermediary, except for
information posted by the crowdfunding intermediary, or
persons acting as its employees or agents.
e. No state or political subdivision of a State may impose liability on
a crowdfunding intermediary inconsistent with subsections (c)(5)b
and (c)(5)c. For purposes of this subsection (c)(5)e, “State” includes
the District of Columbia and the territories of the United States.
412
UNIVERSITY OF CINCINNATI LAW REVIEW
[VOL. 83