Rob Weiss on Thomas Klein's call for regulatory competition: this may not be the best way to fix equity crowdfunding

Note from Bill: The following is a guest post by Robert Weiss, a finance and securities lawyer based in New York City. We met at the Docracy "Equity Crowdfunding Dissected" event in Brooklyn, and in the week since have been exchanging thoughts (including comments on the "Individual Crowdfunding Account" idea). Follow Rob on Twitter or connect with him on Linkedin.

This post is a response to an exciting post by Thomas Klein published at VCExperts.

In that post, Mr. Klein argues that truly effective reform of US securities regulation would result from creating competition between state legislators and securities regulators, on the one hand, and the US Congress and the SEC, on the other hand.

Muni regulationsThe “competition” would be over issuers (or perhaps more precisely over filing fees, taxes or other kinds of revenue a jurisdiction, whether it be state or federal, would raise from securities issuances under its authority).

Drawing on empirical research regarding the salutary effects of regulatory competition in the corporate law context, Mr. Klein concludes that regulatory competition in the securities context would benefit both issuers and investors by (1) improving the quality of both regimes and (2) providing maximum flexibility for issuers of securities.*

Among other areas, Mr. Klein directs his argument to the JOBS Act, and specifically the new law's crowdfunding provisions, which he finds to be unworkable because too restrictive. We are more likely to find. he argues, a workable solution through regulatory competition between state and federal regulatory regimes.

Mr. Klein’s argument does indeed address problems inherent in the JOBS Act’s structure and provisions. It probably is folly to expect that, by piling on "more of the same" from the tried and true paradigm of additional disclosure, a meaningful crowdfunding exemption can result.

But I have a couple of counter-points I think we should consider.

(1)  Corporate law may not be the right analogue to equity crowdfunding.

Mr. Klein (and others) present strong evidence that regulatory competition in corporate law has benefited both companies and, at least with respect to public companies, their investors.

The research also points out that most public company equities are held by institutional investors that are likely to be more sophisticated than the SEC itself. (Many people advocating for less regulation make this point.) This distinction is critical to getting the benefits from regulatory competition in corporate law: smart investors prefer investing in companies subject to good corporate governance regimes, and states want to attract successful companies so as to increase franchise or corporate tax revenues; accordingly, states have an incentive to have good corporate governance regimes so as to attract those kinds of companies.

It’s not clear, though, that less sophisticated investors (e.g., small investors participating in equity crowdfunding) could or would impose the kind of market discipline necessary to make regulatory competition worthwhile in equity crowdfunding. Other industries, where there are greater asymmetries among participants, may be more analogous to equity crowdfunding, and regulatory competition in those areas has not always been beneficial. 

Consider the insurance industry. Each US state regulates insurance business conducted within its borders. There is no federal insurance regulator or regulatory regime (though the federal government has imposed regulation in certain areas, most recently with the Affordable Care Act and Dodd-Frank). Now, insurance seems far afield from securities regulation. After all, insurance companies must be licensed ex ante to do business in each state; except for those states whose blue-sky laws include merit board reviews (which are few and dwindling), complying with the securities laws is a disclosure matter, and problems are resolved ex post. But the first and foremost purpose of insurance regulation is to protect policyholders, who are almost always at a distinct disadvantage in understanding the terms of insurance policies.

Similarly, one of the hard problems in crowdfunding is whether and to what extent we are willing to expose potentially unsophisticated investors to extremely opaque, and highly risky, investments. At least as far as protecting investors who may not be informed or sophisticated, insurance regulation may be a better analogue than corporate law.

The benefits of regulatory competition in insurance regulation for policyholders are not clear. Opinions differ, of course, but there is evidence that having over 50 separate regulatory regimes (1) imposes substantial cost on insurers that want to do business in multiple state, and, more importantly for this analysis, (2) pressures legislatures and regulators to deregulate in order to attract business to the state, a regulatory “race to the bottom” that puts state revenues, rather than policyholders, first. (See, for example, Professor Daniel Schwarcz’s article “Regulating Insurance Sales or Selling Insurance Regulation?: Against Regulatory Competition in Insurance”, 94 Minn. L. Rev. 1707 (2010).)

To combat these effects, insurance regulatory regimes have converged on certain key points; associations of regulators like the National Association of Insurance Commissioners have created model rules and forms that diminish the costs of operating in multiple states while attempting to ensure minimum levels of policyholder protections. In other words, an important result of regulatory competition in insurance is the convergence of state standards toward a single set of common rules that arguably serves its primary purpose (protecting policyholders) less well than it otherwise might.

(2)  Who would pay for it? 

Nearly all the states are struggling to handle their current corporate, tax and other administrative burdens. Few states currently have both (a) securities laws and regulations robust enough to address all of the issues raised in modern securities issuances and (b) enforcement authorities large, expertised and resourced enough to handle an upsurge in issuances. Requiring the states (whether directly or indirectly) to take on securities regulation would impose tremendous new burdens on them.

Who would pay for this?

Some commentators argue that those states that don’t want to incur great expense here could simply instantiate federal law. But why would we recreate the wheel? If we ended up with 50 state regimes that more or less mimicked the current federal regime, what would we have achieved?

There are fundamental issues with the JOBS Act, as Bill and others have described at great length. It’s important for us to resolve those questions, and I think many are resolvable. (For example, as noted above, we need to decide under which conditions we’re willing to expose non-sophisticated investors to ultra-high risk investments.) In theory, having 50 different problem-solvers each taking its best shot at resolving them would be great. But given the other constraints on time and resources, and the questionable value of regulatory competition in the crowdfunding context, it seems better, at least in my opinion, to address them at the federal level.

*Legal scholars have made comprehensive arguments for and against regulatory competition in the securities context.  Mr. Klein cites an especially good article in support of regulatory competition by Professor Roberta Romano of Yale Law School that I recommend if you are interested in the topic.  The article is “Empowering Investors: A Market Approach to Securities Regulation”, 107 Yale L.J. 2359 (1997-1998).

Photo: Frank Farm / Flickr.


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