This is a letter Senator Jeff Merkley (D-Oregon) wrote to President Obama on July 26, 2012. I post it again here, as a reminder that this is complex stuff, and getting it right is not something that should be rushed, just as much as it should not be delayed.
Statement for the Recordof Senator Jeff Merkley RegardingCrowdfunding in Title III of H.R. 3606July 26, 2012
Mr. President, I rise today to discuss an issue that I and many of my colleagues are very excited about: crowdfunding, which allows startups and small businesses to harness the power of the Internet to pool investments from ordinary Americans intrigued by their ideas. These ideas can range from revolutionary new technologies to simple projects that can improve communities in need.
Introduction
If crowdfunding is going to take off, this new market needs to inspire confidence in both investors and small businesses. That is why in December of 2011, I introduced S. 1970 with Senators Michael Bennet and Mary Landrieu and in March of this year the bipartisan, compromise crowdfunding amendment with Senators Michael Bennet and Scott Brown. That amendment passed the Senate by a vote of 64 to 35 and was included in the JOBS Act, which passed the Senate and the House of Representatives and was signed into law by President Obama in April of this year.
In putting this legislation together, I was guided by two goals: 1) enabling this market to work for startups and small businesses and 2) protecting ordinary investors from fraud and deception. Fortunately, in many cases, these goals are aligned. The long-term ability for companies to efficiently raise capital will depend on investors’ confidence in the reliability of the marketplace. I believe that the legislation we produced sets the right framework for this marketplace to meet both goals. But, for success to be achieved, this framework must be filled in with smart, effective rules and consistent, conscientious oversight by the Securities and Exchange Commission (SEC), a professional and independent self-regulatory organization, and the State securities regulators.
The SEC is currently in the early stages of the rulemaking process required under the law. I seek to offer these comments today to add to the creative thinking going into that process. I explore several ways in which the law is designed to provide a streamlined and simplified crowdfunding process, as well as provide critical investor protections. I will touch on funding portal regulation, national securities association membership, target amounts, disclosures, accountability, aggregate caps, advertising and promotion, the relationship of crowdfunding to other capital raising, the public review period, the role of State securities regulators, and on-going review and adjustment.
Funding Portals
The law provides two regulatory options for firms seeking to provide crowdfunding services. A crowdfunding company under the “funding portal” option benefits from streamlined regulatory treatment but must be a neutral platform towards investors. Alternatively, a firm can register as a broker-dealer, in which case it can, through its website or otherwise, provide a broader range of investment guidance to investors. These two options provide a solid foundation for a crowdfunding marketplace with a range of business models.
Because both intermediary vehicles will be repeat players in the crowdfunding marketplace, the rules governing their activities are of paramount importance to the success of the marketplace. Registered broker-dealers are subject to a well-established set of regulations. The registered funding portal structure is, however, a new, streamlined approach. As such, attention should be given to how it can fulfill its promise of a streamlined regulatory approach while also providing the appropriate level of investor protection, as set forth in the law and otherwise.
The CROWDFUND Act is designed so that funding portals will be subject to fewer regulatory requirements than broker-dealers because they will do fewer things than broker-dealers. Among other limits, the law prohibits funding portals from engaging in solicitation, making recommendations, and providing investment advice. Relative passivity and neutrality, especially with respect to the investing public, are touchstones of the funding portal streamlined treatment.
The SEC will, of course, have to establish boundaries, and I encourage the Commission to consider several points:
Provided that funding portals are not subject to financial incentives that would cause them to favor certain companies or otherwise create a conflict of interest, funding portals should be able to exclude prospective issuers from their platform, whether that exclusion is based on the size of the offering, the type of security being offered, the industry of the business, the subjective quality of the issuer, the amount that the issuer would charge for its securities (e.g., the pricing of shares based on an evaluation of the company’s potential, or the interest rate on a debt security given a certain risk profile of the issuer as analyzed by the funding portal) or (almost) any other reason, including at the discretion of the platform. In short, a funding portal should not be forced, directly or indirectly, to conduct a crowdfunding offering of an issuer it doesn’t have faith in or on terms it doesn’t believe should be made available to its customers.
Subject to such limits as the SEC determines necessary for the protection of investors and the crowdfunding issuers, funding portals should be able to provide (or make available through service providers) services to assist entrepreneurs utilizing crowdfunding, including, for example, providing basic standardized templates, models, and checklists. Enabling them to help small businesses construct simple, standard deal structures will facilitate quality, low-cost offerings. (If necessary, streamlined oversight of these may be appropriate, for example, by the relevant national securities association.)
Funding portals should be able to highlight for investors (such as through searches, requested email alerts, or profile “matches”) issuers according to objective criteria – for example, geographic, industry, trending (or not trending), amount an investor wants to pay for a security (or interest rate desired), or randomly.
Funding portals should be able to provide relevant factual information from third parties. For example, in the context of the sale of debt securities, this could be information from credit bureaus regarding the creditworthiness of issuers and their backers.
It is important to remember that nothing in the CROWDFUND Act prevents or limits a person independent of the funding portal from providing recommendations or investment advice to their clients. For example, Community Development Financial Institutions (CDFIs), with their mission-driven mandate and economic empowerment experience, may offer valuable insight for investors seeking to identify healthy, community-based investments.
Some have argued that discretion-based curation, such as highlighting certain companies on a home page for all investors, is important to the success of crowdfunding. However, the activity also comes very close to the line of making recommendations or providing investment advice, which are not permitted owing to the reduced duties that funding portals have compared to broker-dealers. Some of the CROWDFUND Act’s streamlining was precisely to enable small companies to successfully raise capital at modest cost, but some of those duties are also important investor protections. The SEC should carefully weigh these concerns and adopt practical, easy-to-manage solutions that facilitate successful crowdfunding for company, investor, and platform.
For example, it should be carefully considered whether organizing of the presentation of companies on the homepage facilitates success, especially by less sophisticated users, and so should be permitted. Of course, the funding portal should not match specific investors with specific companies and must not be compensated in a way that would cause them to favor certain companies or otherwise create a conflict of interest.
Indeed, some argue that discretion-based curation is essential to prevent fraudsters from gaming an objective system. On the other hand, some vigorously contest this point and identify it as creating a serious risk for pump-and-dump schemes.
One of the reasons I feel regulatory supervision of this space is so important – and fought for it so vigorously during the CROWDFUND Act debate – is because of the professional expertise regulators bring to addressing difficult technical issues.
In short, I urge the SEC and the relevant national securities association to consider competing views like these carefully. It should be remembered that crowdfunding comes with a number of investor protections, including the aggregate cap, and so may provide some space for modest experimentation, especially when done in partnership with investor protection advocates and industry participants acting in good faith, and with adjustments made based on actual performance and measurable data.
The SEC is and should feel fully empowered by the law to take actions to protect investors – and this is essential, especially at the early stages, when reputational risk to the crowdfunding market is very high. At the same time, I encourage it to approach this marketplace with a spirit of smart, careful experimentation and regular review and adjustment. In addition, I encourage the SEC to move swiftly to address potential concerns about timing for the registration of potential funding portals so that they can be ready to go when crowdfunding goes live.
National Securities Association
[first part of this is edited out due to FINRA already having been announced as the SRO for crowdfunding]
I encourage FINRA to work with new funding portals to keep bureaucracy, paperwork, and fees to a minimum, and to ensure funding portals can meaningfully participate in FINRA governance. Moreover, I urge FINRA to act quickly and in close coordination with the SEC to address potential timing concerns that may exist with respect to the relationship between registration and membership of funding portals and the effective date of crowdfunding. Prospective funding portals should not be disadvantaged in their ability to compete in the initial stages of the crowdfunding marketplace.
Target Amount
The law says companies can only access investor funds once they have raised an amount “equal to or greater than” their target amount. The goal of this provision is to ensure that disclosures provided are connected to the target amount (and any higher amount) while also enabling companies which attract more interest than they had expected to obtain the additional funds raised. For example, if an issuer sets its target amount at $50,000 and discloses that it needs the $50,000 for a set of ovens for a vegan bakery, if it only raises $35,000, an investor would have no way of knowing what the company would do with the money – and this is not permitted. However, if the issuer discloses it would buy a small oven if it raised $50,000 and a higher capacity oven if it raised $70,000, then that would give investors confidence that funds raised and distributed would go to their disclosed use. In short, the disclosures should be tied to the target amounts being raised, and issuers should provide some level of disclosure for how they will use funds above some reasonable percentage beyond their original target.
Aggregate Caps
The law puts in place aggregate caps on an individual’s crowdfunding investments in a given year. Without aggregate caps, someone could in theory max out a per-company investment in a single company and then repeat that bet ten, a hundred, or a thousand times, perhaps unintentionally wiping out their entire savings. The challenge is that crowdfunding is a new framework to provide small companies, including many start-ups, opportunities to raise capital. The risks that are present in this space are not amenable to ordinary means of mitigation through diversification. Angel and venture capital funds, whose mission is to invest in the start-up sector, tend to invest in perhaps one out of one hundred opportunities presented and assume that ninety-five percent of investments will fail entirely. Their profits commonly emerge out of only a handful of big winners. Even with the investor education mandated under the law, ordinary investors might not fully appreciate these risks. Aggregate caps can help address this problem.
Because caps scale up as investors can bear greater risk, an important investor protection is the cap ($2000, to be adjusted for inflation) for persons of lower income. One way to ensure that the investor protection inherent in the scaled approach is meaningfully implemented might be to only require persons seeking to qualify for the higher investment amounts make showing regarding their income, but then make that showing slightly higher than simply “checking a box.” This approach could protect less sophisticated investors from opting into the higher limits accidentally or due to potentially misleading promptings from a less scrupulous intermediary, while retaining ease of use for the majority of participants utilizing the default amount of $2000. Some have expressed concern about how to implement the aggregate amounts across platforms.
A data sharing regime is one way to do that, but the SEC might also consider whether to pair it with a presumption that ordinary investors that remain within an amount below the default aggregate, for example $500, on any one platform are also presumed compliant across other unaffiliated platforms. This streamlining may be particularly useful for those seeking to make small investments and for those that want to engage in community-based crowdfunding, including those serving the CDFI community. As the market develops, the SEC should carefully evaluate how these caps are working from perspectives of investors, issuers, and intermediaries.
Disclosures
The bipartisan Senate approach to crowdfunding provides critical disclosures that should help investors make intelligent investment choices. These include core financial information, basics about the business of the issuer, information about major owners, and other key basics any investor needs to know before investing. Disclosures should be designed specifically for the crowdfunding market, enabling start-ups and small businesses to present basic, accurate information appropriate to the amount of money being put at risk by each investor and raised overall by the issuer.
With respect to financial information, the law allows companies raising smaller amounts of money to provide financial information appropriate to the amount of capital being raised—but all companies must provide something. If, for example, an issuer wants to raise $90,000 to develop a prototype project but it is a new company without any previous revenue, that is fine—under the law, it just has to, for example, certify that the company has not yet filed tax returns and provide a CEO-certified set of financial statements displaying the appropriate zeroes. I want this process to work for all kinds of startups and be reasonably tailored to the amount of capital being raised.
The law mandates strong disclosures about capital structure and risks of dilution. Crowdfunding is available for both equity and debt securities, but the more complex the security or capital structure is, the greater the need is for strong disclosure. The goal with the strong disclosure mandate in the law to push issuers towards easy-to-understand, investor-friendly approaches, while also permitting more complex approaches if the appropriate disclosures are made. It was envisioned that the SEC might even adopt safe harbors for simple, investor-friendly structures. It may wish to convene an advisory committee specifically designed to evaluate these issues, as well as also to seek input from the Office of the Investor Advocate.
The legislation also provides for annual reports by issuers to investors. This should be a similarly streamlined approach that allows startups and small businesses to provide basic information to investors about business performance and future prospects, as well as other basic, relevant information that may be important for investor decision-making (e.g., related party transactions and conflicts of interest).
We urge the SEC to consult with the advisory committee noted above, as well as market participants and investors to develop a properly tailored approach. Consumer testing may be a useful tool as well, and the SEC should not be shy about adjusting its approach based on how they work in the marketplace.
Accountability
When selling securities to the public, companies and the key players involved have a special obligation to provide truthful information. When they do not, the law properly holds them accountable. This is an essential civil right that has long been a critical tool ensuring U.S. markets are the deepest and most reliable capital markets in the world.
Here too, the law seeks to adopt a fair, practical approach. The CROWDFUND Act sets forth a “due diligence” standard for accountability, which is essentially a “do your homework” standard. This is a standard that was reached after considerable bipartisan effort as well as consultation with legal experts, and I believe it is and can be workable and effective for this marketplace.
Advertising and Promotion
The promise of crowdfunding is that centralized platforms and social media can allow the “wisdom of the crowd” to help direct capital to deserving start-ups and small businesses in a cost-effective, efficient manner that provides fair returns. Critical to the success of the venture is the reliability of the information and commentary presented. While the Internet can be a tremendous tool for transparency, that is not always the case. The CROWDFUND Act seeks to provide a reliable, transparent marketplace by centralizing information about the offering on a registered intermediary that maintains strong standards.
Off-platform advertising is limited to pointing the public to the registered intermediary. Whether on or off the intermediary, persons paid or financially incentivized to promote (including officers, directors, and 20 percent shareholders) must clearly disclose themselves each and every time they engage in a promotional activity. Furthermore, the limitation on off-platform advertising is intended to prohibit issuers (including officers, directors, and 20 percent shareholders) from promoting or paying promoters to express opinions outside the platform that would go beyond pointing the public to the funding portal. Such paid testimonials and manufactured excitement would represent a prohibited form of off-site advertising if those disclosures were not present. Whether on or off the platform, paid advertising must clearly be disclosed as such. In short, the investor deserves a transparent medium for making healthy
decisions.
These limits will help to ensure that ordinary investors can rely on the information they encounter online and accurately gauge a company’s level of public support, while also helping to ensure that honest startups can compete for investors without hiring armies of paid promoters or engaging in manipulative tactics.
Relationship to Other Capital Raising and Governance Matters
Another important issue the SEC will need to address is the relationship of crowdfunding to other capital raisings, and in particular to Regulation D offerings. This is a difficult issue, especially as Regulation D’s restrictions on general solicitation have been loosened by Title II of the JOBS Act. I believe that careful study and attention needs to be paid to how the two should interact in various contexts, including with respect to integration.
Although crowdfunding is a public offering, it is unlike other public offerings, and, absent evidence of problems, most likely should be able to proceed parallel to a Regulation D private offering, provided the appropriate protections are put in place (and the SEC adjusts them as necessary based on their performance in the real world). It is critical, though, that the now-looser solicitation rules for a post-JOBS Act Regulation D offering not be permitted to undermine the centralized transparency protections of crowdfunding’s restrictions on advertising.
One solution could be to provide a safe harbor from integration rules only where the Regulation D offering followed the pre-JOBS Act approach on Regulation D. Naturally, the Regulation D offering and the crowdfunding offering would have to provide the same information to investors. With respect to subsequent offerings, crowdfunding should be flexible enough to fit into the start-up ecosystem, and the SEC should carefully investigate this question. However, crowdfunding investors will likely face a higher risk of unfair dilution than ordinary angel investors. The disclosures mandated in the CROWDFUND Act should be helpful. But, should issuers seek to engage in private offerings within only a short period after a crowdfunding, which would normally not be permitted under Regulation D, the SEC should consider whether it can be possible for these offerings can proceed if they are especially protective of investors – along the lines of how an angel investor might protect himself or herself from unfair dilution or other problems arising from near-term subsequent offerings.
This may require the SEC to adopt approaches more substantive than is normally the case. For example, dilution might only be permitted to the same or lesser extent than the directors, officers, and major shareholders, or the crowd would have to be bought out at a profit disclosed in the original offering. Again, for the success of the crowdfunding marketplace, the SEC should ensure that crowdfunding fits into the start-up ecosystem but should do so in a way that ensures crowdfunding investors are treated fairly.
Similar issues may arise with respect to other corporate governance matters and relationships with other aspects of securities law, such as managing the large number of investors in a crowdfunded company. In these instances, the SEC should look to find ways to ensure that investors are properly protected – in many instances, by ensuring that they are aligned with the interests of the directors, officers, and major shareholders – while also being practical and ensuring that crowdfunding can function within the start-up ecosystem.
Public Review Period
Two important investor protections in the CROWDFUND Act are the public review period and withdrawl rights. They are designed to allow investors the chance to carefully consider offerings, permitting the “wisdom of the crowd” to develop, rather than perhaps just the “excitement of the crowd.”
The public review period commences upon the date 21 days prior to when the securities are “sold” to any investor. This means that when the offering is made available to the public (“potential investors”) to consider investing (i.e., it is put up on the platform) – which is the point at which information is made available to regulators and is also the point when a notice filing is made with the relevant state securities regulator – the public has 21 days to review it. At the end of that, the offering can close and the securities can be “sold” to investors. The 21-day period does not reset for each and every potential investor who might look at the offering – which is why the language specifically says “potential investors.” For example, when a potential investor considers investing on the seventeenth day the offering has been up on the platform, the offering can still close four days later whether that person invests or not. The SEC must also provide appropriate ways for investors to cancel commitments to invest.
State Securities Regulators
The law envisions an important role for State securities regulators. The State securities regulators are the “50 cops on the beat” that have time and again proven crucial for policing smaller offerings, such as those envisioned under crowdfunding.
One way the law has been designed to empower them is through the 21-day public review period for all offerings. When combined with the notice filings to the State securities regulator of the principal place of business of the issuers (and states where more than 50 percent of investors are located) and the anti-fraud authority preserved for them, the 21-day public review period is designed to provide the State securities regulators with practical ability to assist in policing the marketplace.
In addition, State securities regulators have examination and enforcement power for funding portals headquartered in their states. Although they will be limited to enforcing federal rules, this oversight authority is an important tool, especially for smaller crowdfunding portals that may emerge in particular states. Of course, oversight should be coordinated with the SEC and the relevant national securities association to the greatest extent possible.
I also encourage the SEC and the relevant national securities association to work closely with state regulators in crafting the rules and learning from their on-the-ground experience.
Community Development Financial Institutions
We have also heard recently from the CDFI community with ideas about how crowdfunding can support their work bringing growth and job creation to underserved communities. CDFIs are lenders and partners to businesses in underserved communities. They tend to obtain low rates of return on mission-driven investments, and frequently encounter financing gaps that might be filled through mission-driven crowdfunding – much the way such investing occurs in certain segments of the non-security-based crowdfunding universe today.
I believe that the overall structure of our bill offers CDFI’s powerful tools to support their jobcreation work, while protecting ordinary investors from undue risk of fraud and loss. In addition, some in the CDFI community have suggested to us that because of the types of businesses CDFI’s work with, the types of low returns that might be derived, and the particular financing gaps that might be filled through crowdfunding, that mission-driven, CDFI-supported crowdfunding may yield better results for investors and positive job creation for communities if the rules reflect the particular work they do. Suggestions include ensuring crowdfunding can fill the financing gap for projects supported by federally-regulated, 501(c)3 CDFIs, a clarification to ensure that CDFIs and issuers can make sure investors understand the mission and charitable aspects of investments, and fast treatment from the SEC and FINRA related to registration and membership.
The SEC should be receptive to concepts CDFIs may bring that could aid in accomplishing the job-creating goals of the legislation, while protecting investors. It should consult with CDFI’s and the CDFI Fund at the Treasury Department on how best to maximize the social and jobs potential for investing through crowdfunding and CDFI’s.
Review and Adjustment
Although it was not included in the final legislation for procedural reasons, I would encourage the SEC and the relevant national securities association to engage in regular reviews and reports regarding developments in the crowdfunding marketplace, including thorough coordination and consultation with State securities regulators. Should problems arise, these authorities should act quickly, including use of their full rulemaking and enforcement authorities. Crowdfunding holds great potential, but it is also experimental and presents risks. For it to succeed long-term, it will require careful oversight, especially during the early stages.
I also urge the SEC and the relevant national securities association to speed the publication of final rules. Crowdfunding cannot get started until rules fill out the framework to make the law effective.
Conclusion
I believe the features outlined above are essential if crowdfunding is going to succeed. Success should be judged both on returns to and satisfaction of investors, and the growth and development of new and exciting companies. I am excited about the potential of this new market, but also cognizant of its risks. It won’t be without its hiccups in the short run, but done properly, I believe this framework has the potential over the long run to help millions of new startups get the funding they need to grow their businesses and create jobs, and provide investors with opportunities for meaningful returns and community involvement.
I would like to extend my heartfelt thanks to the hard work and cooperation of my fellow senators, especially Michael Bennet, Mary Landrieu, and Scott Brown. I would also like to acknowledge the hard work of our staffs, who did so much to get the original legislative idea into law in strong, responsible form.
Mr. President, I yield the floor.
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