A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation

Transactions: The Tennessee Journal of Business Law, Dec 2011

By Edan Burkett, Published on 10/01/11

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A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation

TRANSACTIONS: THE TENNESSEE JOURNAL OF BUSINESS LAW 0 J.D., Brigham Young University, J. Reuben Clark Law School EDAN BURKETT* In recent years, artists, entrepreneurs, and nonprofits (collectively “promoters”) have tapped the collaborative power of the online crowds to fund a wide range of charities, creative projects, and even investment opportunities. This phenomenon is called “crowdfunding,” or sometimes “crowd financing” or “crowdsourced capital.”1 This Article first examines the intractable conflict between investment crowdfunding and traditional U.S. securities laws and then explores possible solutions that would enable small companies to more easily raise capital through the online crowds. INVESTMENT CROWDFUNDING AND U.S. SECURITIES REGULATION INTRODUCTION crowdfunding platforms, promoters are usually given the chance to pitch their ideas to potential funders, who then choose which projects to support.3 In exchange for a contribution, most current crowdfunding sites only allow promoters to reward funders with nominal perks or “thank-you” gifts.4 Because the contributions are effectively donations, this is called “patronage crowdfunding.”5 If promoters reward funders with something more than a thank-you gift, such as an equity share in the project itself, it is “investment crowdfunding.”6 The principal reason most promoters do not reward their online patrons with equity shares, or any other security, is the danger of getting entangled in complicated securities laws.7 While the United States is “[b]y far the biggest and most sophisticated country supporting [various forms of financial investment] . . . [f]ederal law seems to rule out . . . online marketing for investment in return for debt or equity.”8 For instance, it is illegal in the United States to offer or sell a “security” without either complying with arduous registration requirements or wading through the difficult process of obtaining an exemption.9 Promoters legitimately worry that any investment opportunity in their project could be a security known as an nor do they have the potential for a large enough exit. And second, there are too few venture capitalists versus the masses of entrepreneurs who need money.”). 3 Barbara Ortutay, Raising funds? Many turn to the Web for help, PRESS OF ATLANTIC CITY, Sept. 21, 2010, at B1, available at 2010 WLNR 18760546. 4 Kappel, supra note 1, at 376 (“In return, financial contributors typically receive ‘patronage perks’ such as 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.”). 5 See Kappel, supra note 1, at 376. 6 This Article adopts “investment crowdfunding,” as opposed to “equity crowdfunding,” because funders might get a debt-based security, or funders might not get actual equity but merely an investment contract—e.g., Grow VC, discussed later, gives subscribers a cut of the profits, but not equity per se. 7 See Kappel, supra note 1, at 376-77; C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2011 COLUM. BUS. L. REV. (forthcoming 2011) (manuscript at 4-5), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184. 8 Fellow Crowdfunders – What’s Holding You Up?, CROWDFUNDING CENTRAL (May 30, 2010), http://www.crowdfundingcentral.com/blog_holdup. “investment contract.”10 Being subject to securities requirements may spell the end of a small enterprise because the costs of registration, or even obtaining the exemption from registration, may exceed the total capital needed for the project.11 This Article is one of the first to examine the conflict between investment crowdfunding and U.S. securities laws and to consider the circumstances under which these laws might be changed to permit this new form of grassroots investment. While it is clear that patronage crowdfunding is not subject to securities regulation, most investment crowdfunding schemes are investment contract securities, which are subject to federal and state securities laws.12 Furthermore, standard exemptions from federal registration requirements are inadequate or inappropriate for most types of investment crowdfunding.13 Given these problems, it is worthwhile to consider the merits of the current proposal for a Securities and Exchange Commission (“SEC”) rulemaking to create a crowdfunding exemption. The current proposal disregards many of the fundamental principles of the modern securities framework, and this Article explores other possible proposals and considers the ultimate viability of SEC action altogether. While SEC Chairman Mary Shapiro promised Congressman Darrell Issa that the SEC would consider a crowdfunding exemption,14 it is by no means clear that the SEC has the time, resources, or desire to draft what is sure to be a complicated exemption and to see it through the long rulemaking process. Ultimately, legislating a crowdfunding exemption may be easier than obtaining an exemption through the rule (...truncated)


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Edan Burkett. A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation, Transactions: The Tennessee Journal of Business Law, 2011, pp. 63, Volume 13, Issue 1,