Non-accredited crowdfunding: a license to pillage the vulnerable, or democracy in action?

Monday, a friend sent me a link to a weekend New York Times editorial which strongly condemned the SEC's proposed rules under Title III of the JOBS Act.

However, unlike the criticism coming from those in the nascent non-accredited crowdfunding industry, the NYT editorial board faults the SEC's proposed rules, not for being unworkable, but for not being restrictive enough.

BjvXNWuIgAASow1I'll leave aside the Times' misconception that the faults lie in the agency's rulemaking rather than the legislation itself. In this regard, the editorial board makes the same mistake that non-accredited crowdfunding advocates, coming from the other direction, make. (Interestingly enough, at the ACA Summit last week in Washington DC, Rep. Patrick McHenry, the father of the original federal non-accredited crowdfunding bill, stated that Title III needed to be fixed legislatively, by Congress, not by rulemaking at the SEC.)

I'll also leave aside other aspects of the legislation and proposed rules which the NYT editorial board gets wrong.

Instead, I want to identify certain presumptions implicit in the NYT critique, for purposes of comparing and contrasting those presumptions with those underlying the critique of the very same proposed rules by non-accredited crowdfunding advocates:

Here are what I infer to be the NYT editorial board's presumptions:

  • People of modest means or on fixed incomes will be scammed out of money they can ill-afford to lose.
  • Even if a crowdfunded company turns out to be promising, later, more sophisticated investors will cheat the earliest investors out of fair returns.
  • Reliance on participant representations and self-policing is a recipe for fraud.

Non-accredited crowdfunding advocates approach the subject from a variety of different subcultures, you might say: some our tech start up oriented; others are community activists; others have a small business orientation. But these advocates share at least one or more of the following presumptions:

  • Startup and private company funding should be democratized in some meaningful way, and not remain the private preserve of the 1%.
  • Friends and family should not be shut out of legally investing in the business of a nephew, or a child, or an aunt, or a colleague.
  • More local dollars should circulate through local communities. Neighbors should be able to own a piece of the local restaurants, craft breweries, and other brick-and-mortar small businesses they support with their day-to-day commerce.
  • People are motivated to crowdfund for reasons other than Wall Street-like fixation on financial return.

So, which set of presumptions are correct?

Both sets are correct.

And herein lies the problem with non-accredited crowdfunding under Title III of the JOBS Act: it does not pick a consistent worldview, but instead hedges each feature of the exemption as though the fears of each camp are certain to be realized.

I happen to agree with the New York Times editorial board. For purposes of a federal law which preempts state law, crowdfunding should be limited to accredited investors. Accredited crowdfunding is supported by Title II of the JOBS Act, and the changes to Rule 506 that have been implemented by SEC regulation under Title II. There are transition headaches here, to be sure, but so far these accredited crowdfunding reforms are enabling (some would say, ratifying) significant changes in how angel deals are syndicated.

And I happen to agree with the aims of most of the non-accredited crowdfunding adovcates, though I believe Title III to be a lost cause, not worth fighting anyway because the proper place for non-accredited crowdfunding exemptions is at the state level, where rules can be scoped with local conditions in mind.

Photo: Rep. Patrick McHenry addressing the 2014 Angel Capital Association Summit last week.

Cherry blossoms

The Angel Capital Association 2014 Summit took me to Washington DC at the end of last week. I stayed over Saturday, mostly to take the opportunity to see Eddie Johnson play for the DC United football club at RFK Stadium, but also in the hope of seeing cherry blossoms at the Tidle Basin.

The cherry trees in DC were not in bloom.

But they are in full bloom back in my neighborhood in Seattle.

Cherry blossoms

SEC official to angel community: go ahead, develop your own verification methods!

Keith Higgins, the relatively new Director of the Division of Corporation Finance, delivered a speech at the closing session of the 2014 Angel Capital Association Summit - and was it a doozy!

A huge issue for angel investors is the "reasonable steps to verify" accredited status that is part of new Rule 506(c), which permits issuers to engage in "general solicitation." The issue was a focus of at least two breakout sessions at the Summit, including one Thursday moderated by ACA policy chair Mike Eckert that I participated in with the gifted lawyers Peter Rosenblum and Rob Rosenblum (not related), and an excellent breakfast briefing Friday from K&L Gates lawyers Gary Kocher and Kevin Gruben.

1842308438_83cb923365_oThe reason for such attention is the anxiety caused by the non-exclusive verification "safe harbors" set out in Rule 506(c). These verification methods contemplate that, going forward, an issuer is going to have to demand personal financial information from investors, or engage third party verification services to do so. To many readers of the new rule, including a majority of securities lawyers, the safe harbors - in spite of the "non-exclusive" label - feel destined to prove de facto requirement.

But Higgins said that needn't be the case.

In his speech (the full text of which you can access on the SEC's website), Higgins emphasized that if any verification standard might be core under Rule 506(c), it is the flexible, "principles-based" approach laid out in the inital release proposing the new rule:

"These [applications of the principles-based method] are all part of a deliberate effort by the Commission to provide issuers with an alternative to the clear but highly prescriptive list of verification methods included in the rule. In fact, it is ironic that this list of verification methods is being viewed by some as the primary way to verify a purchaser’s accredited investor status when, in fact, the Commission originally proposed the principles-based approach as the way issuers would comply with the rule’s verification requirement and added the list of specific verification methods only in response to address the concerns of commenters who wanted more certainty."

As Gary Kocher explained plainly in his breakfast briefing earlier in the day, lawyers are a conservative bunch, and naturally are going to navigate to the safe harbors. But, Gary stated he believed that the staff meant what they said in the rule and in the release, that the principles-based approach was viable. I think Higgins' speech completely validates Gary's view.

All of this portends well for verification methods based on the Angel Capital Association's Established Angel Group guidance, which would not require the turning over of sensitive financial information to issuers or their vendors.

As for seeking express SEC staff blessing of particular applications of the principles-based method of verification? Higgins seemed to say that was both not likely to be forthcoming anytime soon, and also beside the point:

"On that note, we have had recent inquiries asking whether the staff would provide guidance – presumably on a case-by-case basis – confirming that a specified principles-based verification method constitutes 'reasonable steps' for purposes of the rule’s requirement.  The notion of the staff reviewing and approving specific verification methods seems somewhat contrary to the very purpose of a principles-based rule and I am not yet convinced of the need for this type of staff involvement. Rather, this is an area where issuers and other market participants have the flexibility to think about innovative approaches for complying with the verification requirement of the rule and use the methods that best suit their needs. While the staff may not be in a position at this point to provide guidance on what constitutes 'reasonable steps' under particular circumstances, I also believe the staff will not be quick to second guess decisions that issuers and their advisers make in good faith that appear to be reasonable under the circumstances."

I should note that the angels I spoke to at the Summit, and the questions they posed in the breakout sessions, were more precisely focused on the definition of general solicitation and the activities at pitch events and the like that might push a company from 506(b) territory into 506(c) territory. But let's step back a second and look at the problem from just a story or two higher: to the extent that verification under 506(c) becomes more manageable, then the general solicitation issue becomes somewhat less of an existential distinction. (There may yet be reasons to avoid publicly soliciting investors - but that is another topic.)

Success for principles-based verification approaches will not be self-executing. Angels and their entrepreneurs will have to insist on them, and will have to make sure they have enough rigor to acquire respect. In the right circumstances, lawyers for a given deal might, just might, go along.

Drawing: "Principles Mound" by Paul Downey / Flickr.

Again, which kind of crowdfunding?

Over breakfast, I flipped the pages of a newsprint version of The New York Times and came across an article by Michael J. de la Merced, about a startup crowdfunding portal, called Junction Investments, that is focusing on Hollywood film financing.

Text at the bottom of the first column of the piece startled me into diverting more of my attention from my French toast to the paper:

"Perhaps [the] most notable change [brought by the JOBS Act] was that it blessed crowdfunding. Groups of so-called accredited investors – people who either make $200,000 a year or . . ."

Unexpectedly, I have been handed a coda to the discussion yesterday opening the 2014 Thompson Reuters Online Financial Symposium. At that event, we panelists had debated the right use of the "crowdfunding" term, with some of us eschewing it altogether as risqué; others of us applying it precisely to one subset of crowdsourced financing or another; and still others allowing the term to embrace almost everything, using adjectives to narrow its scope as necessary.

Here was a news article using the term "crowdfunding" to denote Title II crowdfunding limited to accredited investors. A sign, I thought, that an insurgent message (which I approve) is getting traction.

But what the first column inflated, the top of the second column deflated:

" . . . have a net worth of more than $1 million, excluding their home – can band together to buy up to $1 million of a company's equity."

Sigh. That confusion again, conflating JOBS Act Title II accredited crowdfunding with JOBS Act Title III non-accredited crowdfunding.

There is no $1 million limit under Title II, of course, anymore then there is any limit at all on what can be raised under a Rule 506 deal. The $1 million cap is a feature of Title III, still not implemented.


Again, which kind of crowdfunding?

What exactly is crowdfunding?

This morning I took part in a panel at the Thompson Reuters 2014 Online Financial Services Symposium.

Moderated by Suzanne Barlyn of Thomson Reuters, the topic was "disruptive alternatives," including crowdfunding and peer-to-peer lending.

Bjkz7mTIQAEPKAkThe audience is made up of financial services professionals who manage online trading and other retail financial services on a massive scale. As I blog this, a panel is getting into the nitty-gritty of trade execution. A later panel will talk about user interface design and new ways to engage both self-directed and managed investors (and how the categories are blurring).

So I hope that lends context. The panel I took part in was to discuss new classes of investing that might be around the bend for the mainstream online financial services industry.

6a01156e3d83cb970c01a3fcde8425970b-580wiSomething big that I learned in the course of the morning is that peer-to-peer lending is something not far off into the future, like Title III non-accredited crowdfunding, but a phenomenon already here and even embraced by policy makers at the Federal Reserve. Ron Suber (pictured) of Prosper, a San Francisco based marketplace matching consumer borrowers with lenders, captured everyone's imagination with his vision of disintermediating banks in the consumer credit space. He calls it an investable asset class, and emphasized the pains taken to qualify would-be borrowers (eighty percent of applicants are turned down, he said).

Closer to the world with which I am more familiar - equity financing provided by accredited investors to startups - Michael Raneri of Venovate, another San Francisco-based company, described a sweet spot for online activity that is post-seed stage (later than AngelList or FundersClub), but still very much emerging growth. His company is part broker, part part portal, part VC fund (or maybe fully all three). He does not appear to like the term "crowdfunding," however, for the connotations it brings of Title III.

BjlGgPNIUAAnRkwTim Baker, Global Head of Content Strategy at Thomson Reuters, reminded all that angel and venture financing is relatively small - only about $25 billion a year. He cited historical precedents which suggest to him that, if crowdfunding on the equity side is going to take off, it will take 5 years or so to catch on.

If Tim is right, I imagine that, in that span of time, people will get comfortable with the idea that some kind of clearinghouse will standardize accreditation. When that happens, the 506(b)/506(c) distinction - so very existentially critical in this moment of transition - won't be as big a deal. 

So debt crowdfunding at a retail level is here already. And accredited crowdfunding (Tito Singh of Thomson Reuters terms it "elite crowdfunding") is finding its footings and will likely impact angel investing as we know it. What about equity crowdfunding for everyone?

I know there are people in the nascent non-accredited crowdfunding industry, who see non-accredited crowdfunding of startups as a asset class. That is a mistake. In fact, part of why I like the state crowdfunding alternatives (alternatives to JOBS Act Title III) is that they seem to take more of the approach that people want to back small companies for reasons that are as compelling or more compelling than the prospect of financial return.

Picture credits: first two, Lauren Young of Thomson Reuters (from her tweet stream); third is picture I took from the dais of Suzanne Barlyn before she took the podium.

Twitter and idleness

In preparation for my trip to the East Coast next week (I'll be speaking at the Thomson Reuters Online Financial Services Symposium in New York City, and then at the 2014 Angel Capital Association Summit in Washington DC; details in this post from earlier this week), I'm reading Charles Simic's beautiful little volume about Joseph Cornell.

9781590174869_jpg_200x450_q85It's a series of prose poems, I guess you could say, about Cornell's art, but really about Cornell's daily habits, wandering around New York City. Reading Simic interpreting Cornell as an existential presence, you really track how living within the circumference of New York was more than sufficient for Cornell's artistic and reflective life. The outside world reached in through pictures, objects, references, stuff that travelled into the city - like minerals from other planets - and were lost there, for Cornell to find and curate.

Simic picks up on how a life of calculated idleness can engender emotions of the rawest authenticity and, through that meditation and suffering, art of the purest conceptual order.

And somehow all this makes me think of Twitter. (Twitter as proxy for social media, I think.)

My friend Joe Wallin joked some years back that exposing oneself on Twitter and/or social media generally was "a cry for help." I think he was joking, but I appreciate the point and it had a certain ring of accuracy back then.

Not now. Those who may have once been craving attention now want to slice through the noise to get you to buy something, or buy into them.

To use Twitter now other than to promote or advertise is to use it idly, for no real purpose.* Which raises the possibility: is there a Joseph Cornell-like art that can be tweeted to?

But is the idleness of using Twitter (not for PR, and thus, necessarily, by my measure anyway, to use it without direct purpose) analogous to the idleness of wandering around the streets and towers and theaters and basements of New York? Does it, might it, yield discovery, or nurture attitude that might pressure those discoveries into diamonds?

Or is Twitter more like watching cable TV?

It may depend on who you follow in your tweet stream.

*Maybe that's not true; maybe some people have relationships with others that are mediated at just the right equipoise of intimacy and distance through Twitter. I suppose I am necessarily talking about how Twitter seems to function or present possibilities to to me.

2014 ACA Summit Coming Up!

Next week, I will be joining more than 700 of my colleagues at the largest gathering of angel investors in the world. I have been invited to present at this conference session: The New SEC Regulations - Practical Interpretation and Guidance for Angel Group Management Activities.

2014 Summit MastheadThe session I'm participating in will be chaired by Mike Eckert, ACA Policy Chair and of the NO/LA Angel Network, and my fellow panelists will be Peter Rosenblum of Foley Hoag, and Robert Rosenblum of K&L Gates.

Here's a description, from the conference agenda, of what Mike, Peter, Rob and I will cover;

'Leaders of angel groups continue to deal with confusion, uncertainty and misunderstanding as related to the recently passed SEC regulations about General Solicitation. The questions ”what should my group be doing or not be doing?”, “which rule is effective and when did it become effective?”, “which is not effective?”, “what kind of guidance should my group be providing to entrepreneurs, startups, accelerators/incubators, colleges and universities about General Solicitation and Reg D/Form D?”, “what is and what is not General Solicitation?”, “has anything really changed?”, and “how do I protect my group, its members and the companies presenting to it?” are pervasive. The objective of this session is to provide further guidance and where possible clarity such that ACA members and member groups can make continued informed decisions about these issues in their day-to-day real-world activities, and be key sources of knowledge about these in their respective markets.'

If you’re not already attending the ACA Summit March 26-28th in Washington DC, I invite you to learn more about it at www.angelcapitalassociation.org/2014summit.