Lindsey Anderson Smith*
President Obama signed into law the Jumpstart Our Business Startups Act ("JOBS Act") on April 5, 2012. Title III of the Act, the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act, amended Section 4 of the Securities Act of 1933 (“1933 Act”) to exempt capital raising crowdfunding from registration. Crowdfunding targets unaccredited investors primarily through offerings over the Internet. The provision reduces traditional protections under the securities laws but imposes an annual cap on the amount investors can invest (and lose).
These investment caps are computed on a sliding scale based upon the individual investors’ income or net worth. The caps, however, raise a number of concerns. For one thing, their enforcement will be difficult. Under the JOBS Act, Internet portals are required to monitor investments to ensure that investors do not exceed these limits. Nonetheless, there is no centralized system for organizing and maintaining accurate investment records among investors.
More importantly, however, the investment caps fail to adequately protect investors. They do not restrict investors to an amount they can truly afford to lose. This is particularly the case with respect to the limits based upon net worth. The JOBS Act borrowed the definition of net worth from the standard for accredited investors. Net worth in that context, however, has an entirely different purpose from the investment caps imposed in connection with crowdfunding. Use of this definition ensures that many unaccredited investors will be able to invest a significant portion of their wealth in high-risk offerings sold over the Internet.
This paper will review Title III of the JOBS Act and the newly adopted crowdfunding exemption. Part I will provide a brief historical background of the accredited investor standard and the net worth requirement. Part II will examine the legislative impetus behind the crowdfunding provision in the JOBS Act, particularly the net worth test. Finally, the paper will address the challenge the SEC must overcome in striking the correct balance between opening the doorway to legitimate crowdfunding offerings while adequately protecting investors.
The 1933 Act requires the registration of shares sold to the public. The Act, however, includes a number of exemptions from registration. Specifically, Section 4(a)(2) permits the private placement of shares, a type of offering generally limited to sophisticated investors.
To address regulatory uncertainties in connection with this exemption, the Securities and Exchange Commission ("SEC") adopted Regulation D. Regulation D was intended to “simplify and clarify existing exemptions, to expand their availability, and . . . to facilitate capital formation consistent with the protection of investors.” Rule 506 provided a safe harbor for offerings under Section 4(a)(2). Under the Rule, issuers could sell securities to an unlimited number of accredited, and up to thirty-five unaccredited, investors.
Congress defined an accredited individual investor in the Small Business Investment Incentive Act of 1980 as “any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters.” To bring greater certainty to the definition, the SEC later adopted a definition in Rule 501(a) of Regulation D. Accredited investors included natural persons with an income in excess of $200,000 individually or $300,000 jointly over the most recent two years and with a reasonable expectation of similar income levels in the current year. Alternatively, an individual investor could qualify as accredited if he or she possessed a net worth of at least $1 million. These tests eliminated any need to determine an investor’s actual sophistication.
Rule 501 did not define net worth. The term, however, was traditionally treated as the excess of assets over liabilities. No assets were excluded from the calculation other than the primary residence. Net worth, therefore, included illiquid assets, such as real property, and liquid assets, such as interests in certain retirement plans.
Crowdfunding involves the raising of capital through modest investments from a large pool of investors primarily over Internet portals. Crowdfunding has so far been used for fundraising on a non-equity basis. Websites invited large numbers of individuals with a common interest to make small contributions a charity or project. Contributors sometimes received nothing in return and other times a nominal gift. For example, Amanda Palmer raised over $1,000,000 for her band Grand Theft Orchestra over Kickstarter in only one month in return for free downloads, signed albums, or books, depending upon the contribution levels.
Crowdfunding in the context of capital raising seeks to provide a fundraising avenue to small businesses. Using the Internet, companies unable to borrow from banks or tap traditional equity markets can seek modest contributions from large numbers of ordinary investors in return for shares or other securities. Crowdfunding offerings of equity, however, must conform to the requirements of the state and federal securities laws. These were addressed in the JOBS Act.
A. The Early Versions
Efforts in Congress to exempt crowdfunding from the registration requirements began in 2011. Congressman Patrick McHenry (R-NC) introduced the “Entrepreneur Access to Capital Act” on September 14, 2011. H.R. 2930 originally provided an exemption from registration for offerings of not more than $5 million during any twelve-month period. With no requirements that investors be sophisticated or accredited, the proposed legislation limited equity investments in each offering to the lesser of $10,000 or 10% of an investor’s annual income. Income verification was to be determined through “certifications provided by investors.”
The version adopted by the House, however, made significant changes to the bill. The offering size was reduced to $1 million (or $2 million if the issuer met certain disclosure requirements). Internet portals were subjected to a number of requirements designed to protect investors. The cap on investments was retained, with individuals allowed to invest no more than the lesser of $10,000 or 10% of their income in each offering. The language providing that income could be determined through investor self-certification was removed. The bill passed on November 3, 2011 by a vote of 407-17.
Concerns regarding investors’ exposure to fraud prompted the North American Securities Administrators Association (“NASAA”) among others, to issue a letter pointing out that fundraising efforts online would disproportionately place the risk of speculative business ventures on unsophisticated investors unable to financially handle the potential loss of the investment. These concerns were reflected in S. 1970, “Capital Raising On-Line While Deterring Fraud and Unethical Non-Disclosure Act of 2011,” crowdfunding legislation introduced in December 2011 by Senator Merkley and co-sponsored with Senators Landrieu, Gillibrand, and Bennet.
The proposal included an investment cap significantly more restrictive than the one included in the House version. Annual investments in all crowdfunding ventures were limited to $500 for those earning less than $50,000, 1% for those with income below $100,000, and 2% for those with income over that amount. Senator Merkley noted in the Congressional Record that the caps were an important safeguard and that, without them, “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.”
B. Crowdfunding and the JOBS Act
The JOBS Act initially included the House version. The Senate, however, completely rewrote the provision. On March 13, 2012, Senators Merkley, Brown and Bennet introduced S. 2190, (“CROWDFUND Act”) as an amendment to the JOBS Act. The amendment included a number of provisions designed to protect investors. Internet portals were required to register with both the SEC and an “applicable” self-regulatory organization. They had to provide disclosure about the risks of the investment in a question and answer format and take steps to prevent fraud, including conducting background checks on officers, directors, and 20% shareholders. Issuers were also required to provide investors with certain specified information.
Mostly, however, investors were protected through the adoption of an annual investment cap. S 2190 computed the cap based not only upon an investor’s income but also upon net worth. Moreover, the amendment provided a definition of net worth and income. The terms were to be taken from the definitions used in connection with accredited investors. The amendment also assigned to Internet portals the task of monitoring the investment limits. The amendment did not, however, specify how this would occur, a particular concern given the possibility that investors could use multiple portals. The Senate approved S 2190 on March 22, 2011 by a vote of 73-26. The provision remained in the final version of the JOBS Act that was signed by President Obama.
III. Implementation and Suggestion
Crowdfunding offerings are inherently risky. They may involve fraud. Startup companies have a high failure rate. Moreover, the offerings are available to unaccredited investors who may lack the sophistication and expertise needed to understand the risk or may not have resources sufficient to acquire the necessary expertise.
The riskiness of the investments was not lost on Congress. Crowdfunding contained a number of provisions designed to protect investors, including modest disclosure requirements. Mostly, though, the JOBS Act sought to protect investors through the imposition of an annual cap on the amount that could be invested. Unaccredited investors could participate in the offerings but could not invest more than they could afford to lose.
The investment cap, however, does not achieve the intended goal. First, the cap allows for the investment of a significant portion of an unaccredited investor’s wealth. This is particularly true because the cap is computed not only based upon income but also net worth. Net worth includes all assets other than the primary residence. Thus, the computation takes into account everything from cars and furniture, to real property and interests in small businesses.
Significantly, however, net worth presumably includes assets in at least some retirement plans. Individuals with modest income may, therefore, have a significant net worth as a result of these savings. For example, one study found that the median amount saved in retirement accounts by individuals between ages forty-five and fifty-four was $101,000. Retirees in particular have a substantial net worth. Those aged sixty-five to sixty-nine have a median net worth of $137,346. As a result, they may invest significant amounts in crowdfunding offerings.
Second, the focus on net worth does not distinguish between liquid and illiquid assets. Unaccredited investors may have a significant net worth because of illiquid assets such as farmland. To actually participate in crowdfunding offerings, however, investors will need to access assets that can be readily transformed into cash. Retirement plans are a prime example. Many plans allow holders to withdraw money before retirement, some without penalty. The typical 401(k) permits account holders to borrow against a portion of their balance. Thus, those with high net worth because of illiquid assets may disproportionately use retirement funds as a source for investments in crowdfunding offerings.
Third, the JOBS Act took the definition of “net worth” from the accredited investor standard. Net worth in the accredited investor context is meant to establish a threshold that determines sophistication. As a result, the net worth standard looks to all assets (except the primary residence). Having achieved the required measure of wealth, investors are deemed to be capable of protecting themselves when acquiring shares in risky ventures.
In the context of crowdfunding, however, net worth is not a threshold but a measure used to determine an amount that investors can invest and, by extension, afford to lose.
In this context, consideration of all assets is not appropriate. For example, an unaccredited investor typically cannot afford to lose his retirement savings. Retirement savings, for example, are not an amount that an unaccredited investor can typically afford to lose. Yet in determining net worth in the crowdfunding context, the Commission cannot take the type of asset into account. So long as assets are included in the net worth standard for accredited investors, they must be included in the standard for crowdfunding.
Fourth, the cap will be hard to enforce. The responsibility for monitoring investment caps rests with the funding platforms. Investors may use multiple portals or accounts, making it difficult to determine the amount invested. Moreover, the net worth of the investor will change constantly and need to be calculated at the time of each purchase.
One intermediary suggested that the most secure way to enforce the caps is to require individual portals to monitor investor activity on their own platform and then report such activity directly to the Commission. Investors would make individual representations to their funding portal regarding any securities purchased via other platforms during the prior twelve months and the portals would be required to keep the data confidential. Another suggested the development of a private or public database accessible to portals where individual investments could be crosschecked. Each individual investor would be provided a unique number after providing specific personal data including his or her name, social security number and date of birth.
Central systems for monitoring ownership currently do not exist. To the extent the portals rely on self-certification, the concept was originally included in the legislation introduced by Congressman McHenry but ultimately taken out. Such an approach would in many cases render the investment cap ineffective. As Congresswoman Waters noted in the context of offerings under Rule 506, investors attracted by the excitement or hyperbole of an offering would have an incentive to misstate the amount actually invested in order to qualify for additional investments.
Crowdfunded offerings will often be risky. Some of the risk, however, can be mitigated if investors are subject to meaningful investment limits. The caps contained in the JOBS Act, however, do not sufficiently protect investors. They allow for amounts to be invested that are beyond what some unaccredited investors can afford to lose. One solution would be to provide additional protections for investors. The SEC could, for example, require significant additional disclosure by issuers and impose on portals meaningful requirements designed to educate investors about the risks associated with crowdfunding and to ensure that offerings are not fraudulent.
Another possible reform is to lower the cap. Because the definition of net worth is fixed in the statute, there is little leeway for the SEC to tamper with the cap under the current formulation. An amendment to the JOBS Act by Congress could, however, allow the SEC to define net worth. With the authority, the Commission could adopt a definition that focuses on an amount that investors can generally afford to lose.
*. J.D. Candidate 2013, University of Denver Sturm College of Law.
. See Troy A Paredes, On the Decision to Regulate Hedge Funds: The SEC’s Regulatory Philosophy, Style, and Mission, 2006 U. Ill. L. Rev. 975, 997 (noting that the Commission has prioritized wealth over sophistication as the essential component of assessing accredited investors).
. See Net Worth Standard for Accredited Investors, Securities Act Release No. IC-29572, 100 SEC Docket 147 (Jan. 25, 2011) (“Neither the Securities Act nor our rules promulgated under the Securities Act define the term ‘net worth.’ The conventional or commonly understood meaning of the term is the difference between the value of a person's assets and the value of the person's liabilities.”).
. See Interpretive Release on Regulation D, Securities Act Release No. 33-6455, 1983 WL 409415 (Mar. 3, 1983) (“Rule 501(a)(6) does not exclude any of the purchaser's assets from the net worth needed to qualify as an accredited investor.”).
. See 17 C.F.R 230.501(a)(5)(i)(A). The exclusion of the primary residence was mandated in Dodd-Frank. See Net Worth Standard for Accredited Investors, Securities Act Release No. IC-92891, 2011 WL 6415435 (Dec. 21, 2011).
. The JOBS Act provided that these offerings could be made through either a broker or portal. See Jumpstart Our Business Startups Act, Pub. L. 112-106, 126 Stat. 306 (2012), sec. 302, § 77d(4)(a)(6)(C).
. See Amanda, Palmer, Amanda Palmer: The New Record, Art Book and Tour, Kickstarter, http://www.kickstarter.com/projects/amandapalmer/amanda-palmer-the-new-record-art-book-and-tour (last visited October 3, 2012).
22. See Entrepreneur Access to Capital Act, H.R. 2930, 112th Cong. (2011) (noting that the legislation suggested that the cap applied only for each individual offering. The provision specified the amount that an individual issuer could raise then stated that “
individual investments in the securities are limited” to the lesser of $10,000 or 10% of annual income.).
The intermediary must (1) warn investors of the speculative nature generally applicable to investments in startups, emerging businesses, and small issuers; (2) warn investors that there are restrictions on the re-sale of the securities; (3) take reasonable measures to reduce the risk of fraud with respect to the transaction; (4) provide the Securities and Exchange Commission (SEC) with information about the intermediary; (5) provide the SEC with continuous investor-level access to the intermediary's website; (6) require each investor to answer questions demonstrating a basic understanding of the nature of the securities offered; (7) require the issuer to state a target offering amount and withhold capital formation proceeds until the aggregate capital raised from investors other than the issuer is greater than or equal to 60 percent of the target offering amount; (8) carry out background checks on the issuer's principals; (9) provide the SEC with information about the issuer and offering; (10) outsource cash-management functions to a qualified third party custodian; (11) maintain such books and records as the SEC deems appropriate; (12) allow for communication between the issuer and investors; and (13) not offer investment advice.
H.R. Rep. No. 112-262, at 9 (2011), available at http://www.gpo.gov/fdsys/pkg/CRPT-112hrpt262/pdf/CRPT-112hrpt262.pdf.
. The only amendment referencing the caps adjusted them for inflation. See H. Amdt. 852 (amending Entrepreneur Access to Capital Act, H.R. 2930, 112th Cong. (2011)) available at http://beta.congress.gov/amendment/112th-congress/house-amendment/852.
. See Letter from Jack Herstein, NASAA President, to John Boehner, Speaker of the House of Representatives and Nancy Pelosi, Minority Leader of the House of Representatives (November 3, 2011), available at http://www.nasaa.org/wp-content/uploads/2011/11/NASAA-Letter-on-HR-2930.pdf.
. See CROWDFUND Act, S. 1970, 112th Cong. (2011), available at http://www.govtrack.us/congress/bills/112/s1970/text. An earlier proposal had been introduced in the Senate by Senator Brown. See Democratizing Access to Capital Act of 2011, S. 1791, 112th Congress (2011), available at http://thomas.loc.gov/cgi-bin/query/z?c112:S.1791:.
. See 158 Cong. Rec. S5476 (2012) available at http://www.gpo.gov/fdsys/pkg/CREC-2012-07-26/pdf/CREC-2012-07-26-pt1-PgS5474-3.pdf#page=3 (comparing crowdfunding investment to venture financing and noting that investors may not fully realize the level of risk involved, despite investor education. Therefore, such safeguards are vital.)
. 15 U.S.C.A 77d-1(h)(2) (West 2012) (“The income and net worth of an investor under section 77d(a)(6) of this title shall be calculated the same as income and net worth for accredited investors under Rule 501.”).
. 15 U.S.C.A. 77d-1(a)(8) (West 2012) (intermediary must “make such efforts as the Commission determines appropriate, by rule, to ensure that no investor in a 12-month period has purchased securities offered pursuant to section 77d(a)(6) of this title that, in the aggregate, from all issuers, exceed the investment limits.”).
. See Laws Provide Con Artists with Personal Economic Growth Plan, NASAA (August 21, 2012), http://www.nasaa.org/14679/laws-provide-con-artists-with-personal-economic-growth-plan/.
. See Scott Shane, Startups Consistently Fail, Forbes (Aug. 17, 2011, 4:16 AM), http://www.forbes.com/sites/scottshane/2011/08/17/start-ups-consistently-fail/ (noting that “…nearly two-thirds [fail] within a decade”).
. See Laura Shin, Retirement Savings by Age, How do You Compare?, Daily Finance (Nov. 14, 2012, 11:57AM), http://www.dailyfinance.com/2012/11/14/retirement-savings-by-age-how-do-you-compare/ (providing self-reports of retirement savings).
. See Alfred O. Gottschalck, Net Worth and the Assets of Households: 2002, U.S. Census Bureau 11 (Apr. 2008) http://www.census.gov/prod/2008pubs/p70-115.pdf (detailing net worth changes over the last decade by age. Other statistics provided show a net worth of $128,800 for those seventy-five and older.).
. See Rich White, Don’t Fear the 401(k) Loan, Forbes (Sept. 2, 2008, 6:00 PM), http://www.forbes.com/2008/09/02/401k-loan-borrowing-pf-education-in_rw_0902investopedia_inl.html (stating that takers could face a 10% penalty on the unpaid balance if younger than age 59 ½).
. See Tapping Your 401(k) Before You Retire, Smart Money (June 29, 2010), http://www.smartmoney.com/retirement/planning/tapping-your-401k-before-you-retire-7924/ (providing a guide for users wishing to borrow money from their 401ks).
. See Jumpstart Our Business Startups Act Frequently Asked Questions About Crowdfunding Intermediaries, U.S. Securities and Exchange Commission (May 7, 2012), http://www.sec.gov/divisions/marketreg/tmjobsact-crowdfundingintermediariesfaq.htm (SEC stating that portals are required to monitor the individual investment caps, specifically to "make efforts to ensure that no investor in a 12-month period has purchased crowdfunded securities that, in the aggregate, from all issuers, exceed the investment limits set forth in section Title III of the JOBS Act”).
. See SEC comment letter from RocketHub (Oct. 2012), http://www.sec.gov/comments/jobs-title-iii/jobstitleiii-179.pdf.
. See SEC comment letter from RocketHub (May 2012), http://www.sec.gov/comments/jobs-title-iii/jobstitleiii-39.pdf.
. Unsurprisingly, some have challenged the use of investor representations as a means of ensuring enforcement with the cap. NAASA, for example, noted that investor self-reporting would be insufficient to meet the “reasonable steps to verify” standard in Rule 506 and therefore suggested that, at a minimum, the issuer should be required to obtain proof that a given investor had at least $1,000,000 in assets. See SEC comment letter from Jack Herstein, NAASA President (July 3, 2012), http://www.sec.gov/comments/jobs-title-ii/jobstitleii-40.pdf.