October 28, 2013

The Wisdom of the Crowd

Hester Peirce

Former Senior Research Fellow
Summary

I plan to open up an online bakery, but need some funds. My family and friends aren't coming through and my credit cards are maxed out, so I'll turn to the Internet to raise the $70,000 or so I need to get the virtual doors open. The investors solicited over the Internet will put money into the enterprise up front in exchange for a piece of the sweet profits my bakery will soon be generating.

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I plan to open up an online bakery, but need some funds. My family and friends aren't coming through and my credit cards are maxed out, so I'll turn to the Internet to raise the $70,000 or so I need to get the virtual doors open. The investors solicited over the Internet will put money into the enterprise up front in exchange for a piece of the sweet profits my bakery will soon be generating.

"Not so fast!" says the government. No, it's not Mayor Bloomberg running in to confiscate my sugar stockpiles. It's the Securities and Exchange Commission stopping foolhardy would-be investors from entrusting yours truly with a penny of their hard-earned cash. I can currently raise money on the Internet without running afoul of the SEC, but only if I retain all the profits and the funders' only reward is a few muffins from my bakery. All that is about to change – maybe.

Last week, the SEC voted to propose a new crowdfunding regulatory framework. Start-ups and other small companies will be able to raise money in small amounts from investors who generally aren't rich enough to buy securities through private offerings. Current securities laws prevent most non-wealthy investors from purchasing securities in offerings that are not registered with the SEC. The rationale is that only wealthy investors have, or can pay for, the savvy necessary to make good investment choices. They also can afford to lose money if they make bad choices.

Included in the JOBS Act of 2012 was the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure ("Crowdfund") Act, which directed the SEC to set up a regulatory framework for crowdfunding. As the act's clever name suggests, the statute included a number of restrictions to deter fraud.

For example, there is a $1 million annual limit on the amount a company can raise via crowdfunding. There are caps on investors' participation based on income or net worth. Money must be raised through a registered funding portal or broker. Companies must make specified disclosures about the company and the offering. The SEC's 600-page proposal fills in the details of how the crowdfunding framework would work in practice and adds more requirements. As formulated by the SEC, for example, two potentially costly provisions are the financial statement requirements and the mandatory filing of annual reports with the SEC.

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