Crowdfunding – Not Yet Legal

by Herrick K. Lidstone, Jr. and Theresa M. Mehringer

There has been quite a bit written about “crowdfunding” since President Obama signed the JOBS Act in April 2012.  Crowdfunding has been around for a number of years, and sometimes involves the offer and sale of a security and sometimes does not.  If a particular crowdfunding activity involves the offer and sale of a security, the JOBS Act provides an exemption that only becomes effective upon SEC rulemaking which the JOBS Act mandates to be completed by early January 2013.  The SEC has already said that this timing is not likely to be achieved.

What is crowdfunding? 

Although the JOBS Act contemplates crowdfunding, it does not define it.  Wikipedia defines crowdfunding as follows:

Crowd funding or crowdfunding describes the collective effort of individuals who network and pool their resources, usually via the Internet, to support efforts initiated by other people or organizations. Crowd funding is used in support of a wide variety of activities, including disaster relief, citizen journalism, support of artists by fans, political campaigns, startup company funding, movie or free software development, and scientific research.

Crowdfunding may, or may not, involve the offer and sale of a security.

The term “security” is defined in federal and state law.  Where a security is involved in crowdfunding (or in any other manner of capital formation), the offer and sale must be registered under federal and applicable state law (pursuant to a time-consuming and expensive process) or the offer and sale must be exempt from registration.

  • While there are a number of nuances to the definition, a security is generally involved when a person (the entrepreneur) proposes to use other people’s money (the investor’s money) for her own business and has promised to deliver to the investor a return or a profit from the business.
  • Where crowdfunding is associated with disaster relief, support of artists, support of political campaigns, or other activities and there is no promise of a return to the investor (except the good feeling for having helped a good cause), the offer and sale of a security is not likely involved.

Previous examples of crowdfunding. 

In 2008, the entity attempted to sell fractional shares in a minor league baseball player (Randy Newsom) until the SEC said that it sounded like selling securities and Major League Baseball said it sounded like gambling. (By the way, Newsom is still in the minor leagues.)

Also in 2008, the novelist Tao Lin sought financial support through a public solicitation over the Internet for his (then unwritten) book, Richard Yates, saying (here):  “I am selling 6 shares (of 10% of the U.S. royalties of my second novel) for $2000 per share.  For each share you own you will receive 10% of the U.S. royalties of my second novel.  This includes all U.S. serial, reprint, textbook, and film (and other performance) royalties.”  For securities lawyers, this sure sounds like the offer of a security, but Mr. Lin sold the six shares and no complaints were filed.  Would it have made economic sense for Mr. Lin to have hired an attorney and complied with the securities laws for a $12,000 offering?  Probably not.  Was compliance (through registration or the establishment of an exemption) required?  Yes.

In the past, the SEC has taken the position that a microbrewery that included a share of stock in each six pack had engaged in the offer of a security and would have to discontinue that practice.  On the other hand, the sale of a share of the Green Bay Packers that included no economic or voting rights (but just the Packer logo on an engraved certificate) was not the offer or sale of a security.

Does crowdfunding involve the offer and sale of a security if, in exchange for a cash investment the promoter promises the investor free software, movie tickets, an autographed book or a copy of the CD being created, or other consideration of nominal value?  Perhaps, but enforcement would be rare.

Current status of crowdfunding.

Crowdfunding has been institutionalized at where the introduction to the publicly available website says:

At this very second, thousands of people are checking out projects on Kickstarter. They’re rallying around their friends’ ideas, backing projects from people they’ve long admired, and discovering things that make them laugh and smile.  Every project is independently crafted, put to all-or-nothing funding, and supported by friends, fans, and the public in return for rewards.”

According to the website, rewards can include things like a copy of what’s being made, a limited edition, or a custom experience related to the project.”  Similarly, www.upstart.comadvertises on its website that it:

“lets you raise money in exchange for a small share of your income for ten years.  It’s an investment in you, not your idea or your business.”  [Upstart also contemplates that the investor may mentor the entrepreneur, provide networking opportunities or make other connections for the entrepreneur.]

From a securities lawyer’s perspective, whether these and other available crowdfunding mechanisms involve the offer or sale of a security will depend on the facts of each transaction.  Where the offer or sale of a security is involved, whether an exemption under federal or state law is available will also be fact dependent.  Perhaps the opportunity provided in to provide mentoring or networking opportunities is sufficient to avoid the classification as a “security” since the profit will not be “solely from the efforts of others.”  Under existing case law, however, the investor’s contribution has to be “significant” or “meaningful.”

The JOBS Act and crowdfunding.

The JOBS Act has taken these thoughts and has attempted to codify them in federal law and to preempt state law where state law would be inconsistent.  To implement crowdfunding as a federal policy, the JOBS Act provides for a new exemption from registration for offerings by domestic non-reporting companies (but not investment companies) for offerings up to $1,000,000 during a twelve month period, but delays the effectiveness of the legislation until implemented by SEC rulemaking (which will not occur until 2013, at the earliest).  After the SEC rules become effective,

  • Crowdfunding offerings must be conducted either by a registered broker or through a special online portal;
  • Persons desiring to engage in crowdfunding will have to meet certain disclosure and other obligations; and
  • Investors with a net worth or annual income of less than $100,000 will be able to invest up to the greater of $2,000 or 5% of the investor’s annual income or net worth in a crowdfunding solicitation.  (Investors with a net worth or annual income in excess of $100,000 will be able to invest larger amounts.)

Crowdfunding securities will generally be subject to a one year holding period. Advertising will generally not be permitted, except for notices directing potential investors to the applicable funding portal or broker.  The JOBS Act also contemplates some minimal disclosure requirements for the crowdfunding exemption to be available, which will undoubtedly be expanded by the SEC in its rulemaking activities so that that all prospective investors have sufficient information to make a fully informed investment decision.

Federal law permitting crowdfunding in the offer or sale of a security is not effective until the issuance of final SEC regulations. When effective, though, federal law will preempt any state law to the contrary, and crowdfunding (in a manner complying with the published regulations) will (in my opinion) become the next national pastime, and will likely result in a large number of people losing money.  Perhaps there should be crowdfunding exemptions for small investments in startup businesses where the expected investment and reward do not merit an expenditure even for modest legal fees – microinvestment.  The risk is, however, the less regulation the greater the opportunity for fraud on the investor.

We will see how the SEC’s rules on crowdfunding balance investor protection and capital formation.