Title III of the JOBS Act, known as the CROWDFUND Act, authorizes the “crowdfunding” of securities, defined as selling securities online to many investors, each of whom contributes only a small amount.  See this post and paper.  The Act was signed into law in April 2012, but cannot go into effect until the SEC promulgates rules and regulations to govern the new marketplace for crowdfunded securities.

In “Keep it Light, Chairman White:  SEC Rulemaking Under the CROWDFUND Act,” I offer friendly advice to the SEC as to how to exercise its rulemaking authority in a manner that will enable the Act to achieve its goals of creating an ultralow-cost method for raising business capital and democratizing the market for speculative business investments.

The whole crowdfunding project depends on a very simple and inexpensive process for offering securities, so it is vital that the SEC not burden the CROWDFUND Act with any more rules and regulations than are absolutely necessary.  The SEC must avoid its usual practice of requiring extensive disclosure and should rely primarily on the existing statutory scheme, especially the novel aggregate annual cap on crowdfunded securities which acts as a structural protection against losing one’s life savings to a crooked crowdfunder.

Congress was highly attentive to the possibility of fraud in crowdfunding and included in the Act a private right of action for defrauded investors as well as preserved the power of the SEC and state regulators to bring enforcement actions against wrongdoers.  Beyond these traditional techniques, however, Congress also included an innovative structural protection for investors, specifically a strict annual cap on the aggregate amount that a person may invest in any and all crowdfunded securities.

For most people, this cap will be five percent of their annual income, up to $5,000 per year.  So, for a person with the median American income of about $50,000, her maximum annual investment would be $2,500 per year.  Were she to invest the maximum and lose everything to a judgment-proof con artist, it would be unfortunate, but affordable.

This annual investment cap is designed to shield investors from losses of devastating magnitude.  It is practically impossible to lose one’s “life savings” in crowdfunding, no matter how unwise or unlucky one’s choices may be.  By contrast, an investor can lose her life savings—quickly, easily, and legally—by investing in the stock market, gambling at a casino, or playing the state lottery.

The CROWDFUND Act’s investment cap differs from the usual type of regulation found in federal securities laws.  The usual way that federal law tries to protect investors is by mandating extensive public disclosure, both at the IPO stage and regularly thereafter.  And indeed, the Act includes a number of disclosure requirements—and invites the SEC to add more.  But for the SEC to mandate a great deal of additional disclosure does not make sense in the crowdfunding context for two reasons.

First, experience in the IPO market has shown that mandatory disclosures can easily push the cost of a securities offering out of reach for offerings of modest size.  For the type of small offerings authorized by the Act (under $1 million), extensive disclosure is simply not an economically viable option.  The only way that crowdfunding can work is if the process is exceedingly inexpensive.

Second, most crowdfunding investors are unlikely to read or take notice of required disclosures in any event.  In the context of registered, publicly traded companies, professional securities analysts read and analyze the disclosures they make and then convey the information in plain English to investors.  But crowdfunding companies will be far too small to warrant professional analysis, so investors will be on their own to read and understand any disclosures they make.  Furthermore, ample experience with consumer contracting teaches that online disclosures (such as “terms of service” to which one must click “I agree”) are ignored by almost everyone.

The full paper is available here.