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In Crowdfunding, Who is Responsible for Preventing Fraud?

February 5, 2014
URL: http://www.entrepreneur.com/article/231283

Who is responsible in the case that an investor loses his or her money to a fraudster in equity crowdfunding? That is the question that is at the root of much of the debate over how to regulate this new financial tool.

On the last day that public comments for proposed regulation for equity crowdfunding were accepted by the Securities and Exchange Commission, almost fifty letters were submitted with recommendations on how to change the rules. (Let’s be honest, we don’t stop procrastinating after college.)

Related: States Charge Ahead With Their Own Crowdfunding Laws

The comment letters came from a wide variety of sources, from small-business advocacy groups to equity-crowdfunding portals to various members of the legal, regulating community to professional crowdfunding trade organizations. But many of the letters brought up one common concern: that the websites administering equity crowdfunding (or the “portals”) will be saddled with so much responsibility, they won’t be able to effectively function.

The SEC, which was assigned to write rules to regulate this newly legalized equity crowdfunding, released a preliminary set of rules on Oct. 23. That initiated a 90-day comment period which ended on Monday of this week. Regulatory issues brought up earlier in the comment period included appropriate investor caps, how an investor’s wealth ought to be determined and calculated, and the appropriate amounts of financial disclosure paperwork that ought to be required.

Related: As Comment Period Closes, Debate Over Equity Crowdfunding Rules Rages On

Here is a breakdown of the latest hot-button issue: how to regulate the portals.

The regulation squeeze: The proposed SEC rules consider crowdfunding portals “issuers,” and that means that the portals are held liable for the entrepreneurs raising money on their sites. If an entrepreneur’s campaign to raise money is fraudulent, then the portal would be held responsible. At the same time, portals are not allowed to give “investment advice.” That means portals are responsible for investors losing money, but can’t give any advice. “The proposed rules put funding portals between a rock and a hard place,” said Kiran Lingam, general counsel for Seed Invest, an equity crowdfunding platform which currently deals only with accredited investors, in a letter to the SEC.

As a result, only a few portals would survive the regulatory environment: The combination of regulatory burdens will result in a very limited pool of portals, according to letter submitted to the SEC by the Small Business and Entrepreneurship Council, an advocacy group with over 100,000 members. “The combined regulatory and liability risks are far too great under current proposed regulations to expect a vibrant funding portal marketplace. That means less choice for issuers, as well as higher costs. Fixing the proposed regulations to provide clarity when it comes to liability and discretion on the funding portal’s part will allow for innovation, competition and accountability in the portal space,” said Karen Kerrigan, president and CEO of the SBE Council in her letter to the SEC. Having fewer portals is a negative for the industry. “Greater choices of funding portals will benefit investors and the entrepreneurs who will be using these platforms,” Kerrigan says.

Kerrigan says the SEC has estimated that it could cost as much as $400,000 just to meet required regulatory hurdles to open an equity crowdfunding portal. That’s a lot of money for financial platforms whose revenue streams are built by taking a cut of relatively small investments.

Related: What the U.S. Can Learn From the Netherlands About Equity Crowdfunding

“Under the SEC's proposing release, a portal would need to demonstrate affirmative ‘due diligence’ efforts as a defense to an investor suit for a material misstatement or omission by the issuer of the securities appearing on the funding portal's site. Because funding portals operating under Title III will present only small offerings of less than one million dollars, the cost to conduct an extensive review of each offering would be high relative to the small offering size,” said John Hamilton, the president of City First Enterprises, a Washington D.C.-based community development center.These due diligence costs would make it challenging for portals to post offerings that could not support fees large enough to cover the costs, limiting the number of potential investment opportunities and shrinking the amount of capital made available through crowdfunding. This in turn would diminish the job creation sought by the legislation.”

So, what’s gives? Some of the regulatory burden has to be removed from the portals. As written, portals are in an “untenable catch-22,” said House Small Business Committee Chairman and Representative Sam Graves (R, Mo.) in a letter to the SEC. “In order to achieve the appropriate balance of creating a usable crowdfunding model for small businesses while providing adequate protections for investors, the Commission should remove the liability placed on funding portals in the proposed rules or permit them to curate offerings. Otherwise it is highly improbable that any rational business would establish a web portal in the heads-you-win, tails-I-lose environment. And without web portals, there is no crowdfunding, which directly contravenes the statutory mandate from Congress in Title III of the JOBS Act.”

How then, should investors be protected? Portals should be given the authority to reject any campaign owner they consider unfit for investing, according to Charles Sidman, president and chair of the Crowdfunding Professional Association in his letter to the SEC. While Sidman agrees that giving crowdfunding portals the authority to rank entrepreneur campaigns does constitute a level of “investment advice” that portal operators should not have, they should be allowed to reject any applicant they feel untrustworthy carte blanche, he says. 

Related: Crowdfunding Seen Providing $65 Billion Boost to the Global Economy in 2014 (Infographic)