Written by: Phil Feigin
REPEAL FIVE: Crowd funding—the Repeal of Common Sense
And then there’s crowd funding (I am still not able to bring myself to accept it as a new, single word), the concept that would turn traditional investing and capital formation into a national Tupperware party. State securities regulators are up in arms over the prospects for disaster, and rightly so. The least sophisticated issuers will be allowed to raise money from the least sophisticated investors, and thousands of them, with almost no regulatory oversight, through intermediaries who may not have much more sophistication than the issuers or investors. How is a start-up enterprise supposed to manage a shareholder list numbering in the thousands? Oh, and in addition to managing a hoard of shareholders, the issuers will be subject to section 12(a)(2) liability, and the states are preempted from regulating the deals.
As a general premise of traditional investing, an investor buying stock has three options: (i) hold it and wait for dividends; (ii) try to sell it to someone else for more than they paid for it (the “greater fool” theory); or (iii) frame the stock certificate and hang it on the wall as a memento of a “great opportunity” gone to dust. While the crowd funding issuers we will see in 270 days or so (when SEC rules are due) may actually succeed in raising some money, the investors will have virtually no chance of doing anything but searching for a suitable frame. Market professionals, private equity firms, venture capital firms and broker-dealers are unlikely to touch one of these companies, ever. Ever! Too many questions and complications. This will be the Internet version of Glenn Turner, but without the tent.
At the end of the day, won’t we ever learn that the market is generally efficient, particularly at its extremes. An investor will always be able to buy or sell shares of Apple and Microsoft. At the other extreme, shares of companies with no track record and no generally and professionally analyzed information, i.e., shares of most small companies (and I mean start-ups and really small companies) are more than illiquid; they are nearly frozen solid. With rare exceptions, they are all “frame” material. Banks usually won’t touch lending to them. Friends and family are usually already tapped out, as are the owner’s credit cards. We all know that at least nine out of ten will fail within a year or two.
When state legislatures and, more importantly, Congress, react to tough economic times, they haul out the “small business is the engine of our economy and job creation” speeches, come up with hastily and poorly thought out legislature or regulatory proposals to gut some provision or other in the securities law, label them “jobs” initiatives, and we’re off the races. SECURITIES REGULATION IS NOT THE PROBLEM! It’s just an easy target.
Congress cannot make investors invest, cannot make banks lend money, and cannot make employers hire employees. Each must be confident they will benefit from doing so, and without unacceptable risk. If they don’t have the information they need, they will not write the check. If the risks of loss are too great and the opportunity for reward too remote, they will not wire the funds. No one likes laying off employees.
If Congress truly wanted to promote small business, they would provide the funding outright, or incentivize investors to invest, and banks to lend, and employees to hire, through federal grants, insurance and tax breaks sufficient and efficient enough to make the risks and illiquidity worthwhile. Community banks shy away from SBA loans because the process is simply too complicated. Federal banking regulators (OCC, Fed and FDIC) have imposed such onerous capital requirements on community banks that lending to small business has virtually been made illegal. Anyone in the truly small business community knows this to be the case. Local banks can’t lend because the regulators won’t let them. Without the money, businesses can’t afford to hire new people.
Ironically, federal banking regulators, fearful of allowing further failures and Congressional scorn, take the position that bank failures are not going to happen on their watch, so much so that we now have very stable, liquid, well-capitalized banks that are lending mostly to those who probably don’t need the money in the first place. If small business is the engine that drives America, community banks are the engine that drives small business. But the engine has been starved for fuel.
It is thus ironic that, with crowd funding, Congress has foisted off on private investors, and unsophisticated private investors, the opportunity to invest in the riskiest and most untested investments. Congress is unwilling to allow federally insured banks and the SBA to take the risk of lending or guaranteeing loans to these small companies, but Congress seemingly has no compunction at all about exposing investors, with meager resources and potentially less information, to the ventures, all with the fanfare of “democratizing” American investing and job creation, no less.
I recall from back in the days of the penny stocks here in Denver, at least at the beginning of the craze, the federal government was not overly concerned about penny stocks. The shares were not traded on traditional exchanges, and they did not really impact the national economy. The penny stock operators had devised the perfect crime. They had figured out a way to steal $100 from everyone in America. No one complained very loudly, and the crooks made off with billions.
I don’t foresee that crowd funding will precipitate the kinds of colossal losses as did the penny stock craze, but grand statistics only matter if it’s not your money that was lost. Everyone from crooks to the hopelessly naïve will hit the crowd funding bandwagon. The offerings are limited to $1 million per year. How will anyone but the issuer (and perhaps his offshore bank) know when they reach the $1 million limit? I know there is supposed to be a registered funding portal and escrow account. Do they really seem like insurmountable obstacles for crooks to you?
In pondering the impact of securities regulation on legitimate small businesses and the difficulties they have in raising the capital, I learned what I believe is a valuable lesson as a regulator through the Small Corporate Offering Registration (“SCOR”) program adopted by the states. SCOR requires small businesses to fill out a fairly granular but straightforward disclosure form to raise up to $1 million with no restrictions on the wherewithal of the investors. Over the years, we registered several such offerings in Colorado. Once registered, the SCOR issuers were free to advertise the deal to their heart’s content, in newspapers, radio, wherever, and they could call anyone in the state with their proposal.
The registered SCOR offerings all but universally failed. It was not securities regulation that was inhibiting these small businesses from raising capital—it was the inability of the promoters to reach likely investors. The ability to publicly solicit and advertise did not make any difference.
The deals failed because no brokerage firms were involved. One way to look at it is that investments are more sold than bought. Again, it takes relationships and trust to invest. Brokerage firms did not get involved because of the inherent risks in start-up ventures, and there wasn’t enough money to be made. It simply wasn’t worth it. Their clients could lose their principal, and even if the company grew, it would be years before any secondary market offered the opportunity for a profit. Thus, I do not see crowd funding going anywhere after the initial fad wears off. Unless brokers get involved, I do not see many Rule 506 offerings getting any further than they got before. The new Reg. A deals hold the greatest promise for issuer and investors because the numbers may be significant enough to warrant the interest and participation of a hungry brokerage and underwriting industry. It is that sector that is the fuel injector of the small business engine.
Crowd funding will not be the undoing of our economy. It will neither create many jobs nor be the birth of the next Apple. Thousands of people are likely to lose millions of dollars, to both scammers and innocent, unsophisticated, well-intentioned dreamers until this latest Internet/social media “hoola hoop” drops to the ground to be stored in the garage, along with all those framed stock certificates. It is just a naïve, dumb idea, meant for headlines more than assembly lines.