Since the passage of the Jumpstart Our Business Startups (JOBS) Act,[1] and its endorsement of equity crowdfunding (ECF), capital markets observers have had another issue to debate. Investor protection advocates claim that investors in the capital markets will be hit with fraudsters trying to make a quick buck[2] while would-be capital raisers seek an efficient way to access funds for their businesses. [3] The costs and benefits of ECF bear analysis.

Generally, “crowdfunding” or “rewards crowdfunding” is a means of selling any product or service over the Internet to a broad group of consumers.[4] In an ECF transaction, an issuer makes a direct offer of securities to a large number of potential investors with the aim of raising a small amount from each one. The principles of ECF are a contrast to traditional methods of raising capital, where issuers turn to small groups of investors to complete the offering. The conduit of information from issuer to investor is a website, rather than an underwriter or intermediary.[5] The website contains information regarding the proposed project, the means by which investors can “buy in” or contribute to the project, and the issuer’s objectives.[6]

The absence of an underwriter may appear to be a significant disadvantage for the investor, and the unsophisticated investor especially. In any securities distribution, investors face costs from the acquisition, consolidation, evaluation and verification of the issuer’s information,[7] which usually require the employment of skilled persons such as underwriters, accountants and lawyers. Finally, investors seek to ensure that the information is credible; they rely heavily on underwriters to absorb the verification costs inherent in the fact-finding mission. The underwriter, together with a prospectus, serves to reduce these costs for investors and to make the information gathered readily available to investors.

Even though investors have neither a prospectus nor an underwriter in an ECF transaction, ECFs can be advantageous for them. As ECFs occur over the Internet, the costs of acquiring information are lower because investors do not need to rely on underwriters for information; rather, they can access it easily online from their homes. In order to ensure that the information on the Internet is consistently credible, securities regulators could mandate that securities must be distributed through a registered portal. The portal would enable the regulator to undertake a vetting process to ensure, for example, that only solvent issuers are able to issue securities via the portal and that the portal is a member of the country’s dealer’s association.[8] This stamp of approval provides information to investors – both sophisticated and unsophisticated – about the credibility of the issuer.

Further, ECF transactions can expand investor choice and “democratize” startup investing by allowing retail investors to participate in securities distributions to which they may not otherwise be privy. Schwartz argues that ECF is beneficial because it extends the ability to invest in potentially high reward startups to everyone, not just to the wealthy and well-connected.[9] While investing in startups is risky, some early investors can earn thousands of times their money by backing the right company.[10] ECF is a potential means to this end as it can expose investors to a wider range of investment opportunities than would otherwise be available.

For issuers, the cost savings are obvious: the issuer can raise capital more quickly than under the traditional prospectus method because it does not need to compile a lengthy disclosure document. Furthermore, the absence of an underwriter means that there is no “spread” (i.e., the net profit between the proceeds of the issue and the amount the issuer receives) payable to the underwriter. The issuer “speaks to” investors directly by selling its securities over the Internet.

A major objection to ECF is that it can lead to fraud and abuse.[11] Notably, however, the persistence of fraud in ECF has not been borne out by available evidence.[12] Mollick has undertaken an empirical study of Kickstarter projects in the Design and Technology category. He examined 381 successful projects, finding that only 14/381(0.37%) had stopped responding to funders “and could potentially have given up on delivering entirely.”[13] According to a UK report, the established evidence shows that little fraud actually occurs in crowdfunded transactions.[14] This is not to say that fraud in these transactions cannot or will not occur; it suggests only that the available data undermines the criticism that there are significant investor protection issues with these transactions because of the potential for fraud.

Remedies are available. The JOBS Act ensures that companies issuing ECF securities can be held liable by investors for making material misstatements concerning securities they have issued, or for omitting to disclose material information regarding those securities. In these situations, individuals who have purchased the issuer’s shares can bring legal action to recover their net losses: either in the form of consideration paid for the securities, if the securities are still owned, or damages if the securities are no longer owned.[15]

In short, ECF is not only an effective means for small and mid-size firms to raise capital, but also a viable avenue through which investors can access investment opportunities. Reviewing the costs and benefits of ECF, we can conclude that, on the whole, it is beneficial for, not harmful to, investors. Within certain regulatory boundaries, including the creation and monitoring of a registered portal, ECF can be consistent with the objectives of securities regulation and should be permitted to proceed as a means by which issuers can raise capital.

ENDNOTES

[1] Jumpstart Our Business Startups Act Pub L No 112-106, §301-305, 126 Stat 306 (2012) [JOBS Act].

[2] See, for e.g., “Crowdfunding has a Place but it is a crazy way to Invest” The Globe and Mail (June 1, 2015) online at: http://www.theglobeandmail.com/report-on-business/rob-commentary/crowdfunding-has-a-place-but-its-a-crazy-way-to-invest/article24715364/.

[3] See publication by the Chairman of the Exempt Market Dealers Association. Brian Koscak, “Securities Law Considerations in Legalizing Equity Crowd Funding in Canada” (November 2012) online: New Brunswick Securities Commission http://www.nbsc-cvmnb.ca/nbsc/emag/2012_Making_HeadwayCrowd_Funding/pubData/source/MH-Newsletter-Crowdfunding-web-EN.pdf at 2.

[4] Rewards crowdfunding grew 81% to $2.7 billion in 2012, following a 64% growth in 2011. While rewards crowdfunding is the most widespread type of financing, equity crowdfunding is the fastest growing. See Kyie MacEllan, “Crowdfunding Market Grows 81 per cent in 2012” The Globe and Mail (8 April 2013), online: The Globe and Mail <http://www.theglobeandmail.com/report-on-business/small-business/sb-money/business-funding/crowdfunding-market-grows-81-per-cent-in-2012/article10841800/&gt; and Crowdsourcing LLC, “Crowdfunding Industry Report: Market Trends, Composition, and Crowdfunding Platforms” (May 2012), online: Crowdfunding.nl <http://www.crowdfunding.nl/wp-content/uploads/2012/05/92834651-Massolution-abridged-Crowd-Funding-Industry-Report1.pdf&gt;.

[5] See Ronald J Gibson & Reinier H Kraakman, “The Mechanisms of Market Efficiency” (1984) 70 Va L Rev 549 at 610 [Mechanisms] and discussion of the role of underwriters in online offerings in Anita Anand, “The Efficiency of Direct Public Offerings” (2003) 7 J Small and Emerging Business L 433.

[6] This return is usually a reward related to the proposed project. For instance, if the project is seeking to build a phone, the contributor might get a discounted or advanced copy of the phone in return for the donation.

[7] C. Steven Bradford, “Crowdfunding and the Federal Securities Laws” (2012) 10 Colum Bus L Rev 1.

[8] This endorsement of portal-based ECF follows from the JOBS Act, which permits equity crowdfunding via a licensed intermediary (in the U.S. called a broker-dealer) or via a registered portal. See JOBS Act, supra note 2 §304 discussed below.

[9] Andrew A Schwartz, “Crowdfunding Securities” (2013) 88 Notre Dame L Rev 1457.

[10] Ibid at 1475.

[11] Neil Gross, supra note 2.

[12] Ethan Mollick, “Crowdfunding: Promise or Peril?” (1 April 2013), online: Wharton Entrepreneurship Blog < http://beacon.wharton.upenn.edu/entrepreneurship/2013/04/crowdfunding-promise-or-peril&gt;.

[13] Ibid.

[14] Kathryn Curtis, “UK Group Targets Crowdfunding Compliance” (27 March 2013), online: Crowdex <http://crowdex.co/2013/03/27/uk-group-targets-crowdfunding-compliance/&gt;.

[15] See JOBS Act supra note 2 §4A(c). If the securities are still owned, the person charged with determining the extent of damages must also take into account not only profits received from the shares, but also interest.

The preceding post comes to us from Anita Anand Professor of Law and Academic Director, Centre for the Legal Profession, The University of Toronto, whose Twitter handle is @AnitaAnand2. This article is based on a longer piece by the author entitled “Is Crowdfunding Bad for Investors?” (2014) 55:2 Canadian Business Law Journal 215, which is available here.