[Congressional Record Volume 158, Number 113 (Thursday, July 26, 2012)]
[Senate]
[Pages S5474-S5478]
From the Congressional Record Online through the Government Publishing Office [www.gpo.gov]
CROWDFUNDING
Mr. MERKLEY. Mr. President, I rise today to discuss an issue that I
and many of my colleagues are very excited about: crowdfunding, which
allows startups and small businesses to harness the power of the
Internet to pool investments from ordinary Americans intrigued by their
ideas. These ideas can range from revolutionary new technologies to
simple projects that can improve communities in need.
If crowdfunding is going to take off, this new market needs to
inspire confidence in both investors and small businesses. That is why
in December of 2011, I introduced S. 1970 with Senators Michael Bennet
and Mary Landrieu and in March of this year the bipartisan, compromise
crowdfunding amendment with Senators Michael Bennet and Scott Brown.
That amendment passed the Senate by a vote of 64 to 35 and was included
in the
[[Page S5475]]
JOBS Act, which passed the Senate and the House of Representatives and
was signed into law by President Obama in April of this year.
In putting this legislation together, I was guided by two goals: 1,
enabling this market to work for startups and small businesses and 2,
protecting ordinary investors from fraud and deception. Fortunately, in
many cases, these goals are aligned. The long-term ability for
companies to efficiently raise capital will depend on investors'
confidence in the reliability of the marketplace. I believe that the
legislation we produced sets the right framework for this marketplace
to meet both goals. But, for success to be achieved, this framework
must be filled in with smart, effective rules and consistent,
conscientious oversight by the Securities and Exchange Commission, SEC,
a professional and independent self-regulatory organization, and the
State securities regulators.
The SEC is currently in the early stages of the rulemaking process
required under the law. I seek to offer these comments today to add to
the creative thinking going into that process. I explore several ways
in which the law is designed to provide a streamlined and simplified
crowdfunding process, as well as provide critical investor protections.
I will touch on funding portal regulation, national securities
association membership, target amounts, disclosures, accountability,
aggregate caps, advertising and promotion, the relationship of
crowdfunding to other capital raising, the public review period, the
role of State securities regulators, and on-going review and
adjustment.
The law provides two regulatory options for firms seeking to provide
crowdfunding services. A crowdfunding company under the ``funding
portal'' option benefits from streamlined regulatory treatment but must
be a neutral platform towards investors. Alternatively, a firm can
register as a broker-dealer, in which case it can, through its website
or otherwise, provide a broader range of investment guidance to
investors. These two options provide a solid foundation for a
crowdfunding marketplace with a range of business models.
Because both intermediary vehicles will be repeat players in the
crowdfunding marketplace, the rules governing their activities are of
paramount importance to the success of the marketplace. Registered
broker-dealers are subject to a well-established set of regulations.
The registered funding portal structure is, however, a new, streamlined
approach. As such, attention should be given to how it can fulfill its
promise of a streamlined regulatory approach while also providing the
appropriate level of investor protection, as set forth in the law and
otherwise.
The CROWDFUND Act is designed so that funding portals will be subject
to fewer regulatory requirements than broker-dealers because they will
do fewer things than broker-dealers. Among other limits, the law
prohibits funding portals from engaging in solicitation, making
recommendations, and providing investment advice. Relative passivity
and neutrality, especially with respect to the investing public, are
touchstones of the funding portal streamlined treatment. The SEC will,
of course, have to establish boundaries, and I encourage the Commission
to consider several points:
Provided that funding portals are not subject to financial incentives
that would cause them to favor certain companies or otherwise create a
conflict of interest, funding portals should be able to exclude
prospective issuers from their platform, whether that exclusion is
based on the size of the offering, the type of security being offered,
the industry of the business, the subjective quality of the issuer, the
amount that the issuer would charge for its securities, e.g., the
pricing of shares based on an evaluation of the company's potential, or
the interest rate on a debt security given a certain risk profile of
the issuer as analyzed by the funding portal, or almost any other
reason, including at the discretion of the platform. In short, a
funding portal should not be forced, directly or indirectly, to conduct
a crowdfunding offering of an issuer it does not have faith in or on
terms it does not believe should be made available to its customers.
Subject to such limits as the SEC determines necessary for the
protection of investors and the crowdfunding issuers, funding portals
should be able to provide, or make available through service providers,
services to assist entrepreneurs utilizing crowdfunding, including, for
example, providing basic standardized templates, models, and
checklists. Enabling them to help small businesses construct simple,
standard deal structures will facilitate quality, low-cost offerings.
If necessary, streamlined oversight of these may be appropriate, for
example, by the relevant national securities association.
Funding portals should be able to highlight for investors, such as
through searches, requested email alerts, or profile ``matches,''
issuers according to objective criteria for example, geographic,
industry, trending, or not trending, amount an investor wants to pay
for a security, or interest rate desired, or randomly.
Funding portals should be able to provide relevant factual
information from third parties. For example, in the context of the sale
of debt securities, this could be information from credit bureaus
regarding the creditworthiness of issuers and their backers.
It is important to remember that nothing in the CROWDFUND Act
prevents or limits a person independent of the funding portal from
providing recommendations or investment advice to their clients. For
example, Community Development Financial Institutions, CDFIs, with
their mission-driven mandate and economic empowerment experience, may
offer valuable insight for investors seeking to identify healthy,
community-based investments.
Some have argued that discretion-based curation, such as highlighting
certain companies on a home page for all investors, is important to the
success of crowdfunding. However, the activity also comes very close to
the line of making recommendations or providing investment advice,
which are not permitted owing to the reduced duties that funding
portals have compared to broker-dealers. Some of the CROWDFUND Act's
streamlining was precisely to enable small companies to successfully
raise capital at modest cost, but some of those duties are also
important investor protections. The SEC should carefully weigh these
concerns and adopt practical, easy-to-manage solutions that facilitate
successful crowdfunding for company, investor, and platform.
For example, it should be carefully considered whether organizing of
the presentation of companies on the homepage facilitates success,
especially by less sophisticated users, and so should be permitted. Of
course, the funding portal should not match specific investors with
specific companies and must not be compensated in a way that would
cause them to favor certain companies or otherwise create a conflict of
interest.
Indeed, some argue that discretion-based curation is essential to
prevent fraudsters from gaming an objective system. On the other hand,
some vigorously context this point and identify it as creating a
serious risk for pump-and-dump schemes. One of the reasons I feel
regulatory supervision of this space is so important--and fought for it
so vigorously during the CROWDFUND Act debate--is because of the
professional expertise regulators bring to addressing difficult
technical issues. In short, I urge the SEC and the relevant national
securities association to consider competing views like these
carefully. It should be remembered that crowdfunding comes with a
number of investor protections, including the aggregate cap, and so may
provide some space for modest experimentation, especially when done in
partnership with investor protection advocates and industry
participants acting in good faith, and with adjustments made based on
actual performance and measurable data.
The SEC is and should feel fully empowered by the law to take actions
to protect investors and this is essential, especially at the early
stages, when reputational risk to the crowdfunding market is very high.
At the same time, I encourage it to approach this marketplace with a
spirit of smart, careful experimentation and regular review and
adjustment.
In addition, I encourage the SEC to move swiftly to address potential
concerns about timing for the registration
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of potential funding portals so that they can be ready to go when
crowdfunding goes live.
The legislation requires firms offering crowdfunding services to join
a national securities association registered with the SEC, also known
as a self-regulatory organization, SRO. The vision of the SRO as a
genuine regulatory entity owes much to the leadership of SEC Chairman
William O. Douglas, the ``sheriff of Wall Street'' during the Great
Depression, who believed the SEC had a duty to establish strong
regulation in the public interest but that Wall Street itself was well
positioned--and should be obligated--to participate in the maintenance
of high standards of conduct. Accordingly, any such association must be
strictly independent and thoroughly professional, with a strong mandate
to operate in the highest forms of public interest and for the
protection of investors.
The legislation does not foreclose funding portals from developing
their own association. After consulting with the SEC and the Financial
Industry Regulatory Authority, FINRA, they may indeed decide such an
association would better serve their goals of a professional,
independent, high-quality SRO. Setting up an SRO is not easy, though,
and it may also make practical sense for funding portals to tap into
the architecture already present in FINRA. To facilitate that, I
encourage FINRA to work with new funding portals to keep bureaucracy,
paperwork, and fees to a minimum, and to ensure funding portals can
meaningfully participate in FINRA governance.
Moreover, I urge FINRA to act quickly and in close coordination with
the SEC to address potential timing concerns that may exist with
respect to the relationship between registration and membership of
funding portals and the effective date of crowdfunding. Prospective
funding portals should not be disadvantaged in their ability to compete
in the initial stages of the crowdfunding marketplace.
The law says companies can only access investor funds once they have
raised an amount ``equal to or greater than'' their target amount. The
goal of this provision is to ensure that disclosures provided are
connected to the target amount--and any higher amount--while also
enabling companies which attract more interest than they had expected
to obtain the additional funds raised. For example, if an issuer sets
its target amount at $50,000 and discloses that it needs the $50,000
for a set of ovens for a vegan bakery, if it only raises $35,000, an
investor would have no way of knowing what the company would do with
the money--and this is not permitted. However, if the issuer discloses
it would buy a small oven if it raised $50,000 and a higher-capacity
oven if it raised $70,000, then that would give investors confidence
that funds raised and distributed would go to their disclosed use. In
short, the disclosures should be tied to the target amounts being
raised, and issuers should provide some level of disclosure for how
they will use funds above some reasonable percentage beyond their
original target.
The law puts in place aggregate caps on an individual's crowdfunding
investments in a given year. Without aggregate caps, someone could in
theory max out a per-company investment in a single company and then
repeat that bet ten, a hundred, or a thousand times, perhaps
unintentionally wiping out their entire savings. The challenge is that
crowdfunding is a new framework to provide small companies, including
many start-ups, opportunities to raise capital. The risks that are
present in this space are not amenable to ordinary means of mitigation
through diversification. Angel and venture capital funds, whose mission
is to invest in the start-up sector, tend to invest in perhaps one out
of one hundred opportunities presented and assume that ninety-five
percent of investments will fail entirely. Their profits commonly
emerge out of only a handful of big winners. Even with the investor
education mandated under the law, ordinary investors might not fully
appreciate these risks. Aggregate caps can help address this problem.
Because caps scale up as investors can bear greater risk, an
important investor protection is the cap--$2000, to be adjusted for
inflation--for persons of lower income. One way to ensure that the
investor protection inherent in the scaled approach is meaningfully
implemented might be to only require persons seeking to qualify for the
higher investment amounts make showing regarding their income, but then
make that showing slightly higher than simply ``checking a box.'' This
approach could protect less sophisticated investors from opting into
the higher limits accidentally or due to potentially misleading
promptings from a less scrupulous intermediary, while retaining ease of
use for the majority of participants utilizing the default amount of
$2000.
Some have expressed concern about how to implement the aggregate
amounts across platforms. A data sharing regime is one way to do that,
but the SEC might also consider whether to pair it with a presumption
that ordinary investors that remain within an amount below the default
aggregate, for example $500, on any one platform are also presumed
compliant across other unaffiliated platforms. This streamlining may be
particularly useful for those seeking to make small investments and for
those that want to engage in community-based crowdfunding, including
those serving the CDFI community.
As the market develops, the SEC should carefully evaluate how these
caps are working from perspectives of investors, issuers, and
intermediaries.
The bipartisan Senate approach to crowdfunding provides critical
disclosures that should help investors make intelligent investment
choices. These include core financial information, basics about the
business of the issuer, information about major owners, and other key
basics any investor needs to know before investing. Disclosures should
be designed specifically for the crowdfunding market, enabling start-
ups and small businesses to present basic, accurate information
appropriate to the amount of money being put at risk by each investor
and raised overall by the issuer.
With respect to financial information, the law allows companies
raising smaller amounts of money to provide financial information
appropriate to the amount of capital being raised--but all companies
must provide something. If, for example, an issuer wants to raise
$90,000 to develop a prototype project but it is a new company without
any previous revenue, that is fine--under the law, it just has to, for
example, certify that the company has not yet filed tax returns and
provide a CEO-certified set of financial statements displaying the
appropriate zeroes. I want this process to work for all kinds of
startups and be reasonably tailored to the amount of capital being
raised.
The law mandates strong disclosures about capital structure and risks
of dilution. Crowdfunding is available for both equity and debt
securities, but the more complex the security or capital structure is,
the greater the need is for strong disclosure. The goal with the strong
disclosure mandate in the law to push issuers towards easy-to-
understand, investor-friendly approaches, while also permitting more
complex approaches if the appropriate disclosures are made. It was
envisioned that the SEC might even adopt safe harbors for simple,
investor-friendly structures. It may wish to convene an advisory
committee specifically designed to evaluate these issues, as well as
also to seek input from the Office of the Investor Advocate.
The legislation also provides for annual reports by issuers to
investors. This should be a similarly streamlined approach that allows
startups and small businesses to provide basic information to investors
about business performance and future prospects, as well as other
basic, relevant information that may be important for investor
decision-making--e.g., related party transactions and conflicts of
interest.
We urge the SEC to consult with the advisory committee noted above,
as well as market participants and investors to develop a properly
tailored approach. Consumer testing may be a useful tool as well, and
the SEC should not be shy about adjusting its approach based on how
they work in the marketplace.
When selling securities to the public, companies and the key players
involved have a special obligation to provide truthful information.
When they do not, the law properly holds them accountable. This is an
essential civil right that has long been a critical tool
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ensuring U.S. markets are the deepest and most reliable capital markets
in the world.
Here too, the law seeks to adopt a fair, practical approach. The
CROWDFUND Act sets forth a ``due diligence'' standard for
accountability, which is essentially a ``do your homework'' standard.
This is a standard that was reached after considerable bipartisan
effort as well as consultation with legal experts, and I believe it is
and can be workable and effective for this marketplace.
The promise of crowdfunding is that centralized platforms and social
media can allow the ``wisdom of the crowd'' to help direct capital to
deserving start-ups and small businesses in a cost-effective, efficient
manner that provides fair returns. Critical to the success of the
venture is the reliability of the information and commentary presented.
While the Internet can be a tremendous tool for transparency, that is
not always the case. The CROWDFUND Act seeks to provide a reliable,
transparent marketplace by centralizing information about the offering
on a registered intermediary that maintains strong standards.
Off-platform advertising is limited to pointing the public to the
registered intermediary. Whether on or off the intermediary, persons
paid or financially incentivized to promote--including officers,
directors, and 20 percent shareholders--must clearly disclose
themselves each and every time they engage in a promotional activity.
Furthermore, the limitation on off-platform advertising is intended to
prohibit issuers--including officers, directors, and 20 percent
shareholders--from promoting or paying promoters to express opinions
outside the platform that would go beyond pointing the public to the
funding portal. Such paid testimonials and manufactured excitement
would represent a prohibited form of off-site advertising if those
disclosures were not present. Whether on or off the platform, paid
advertising must clearly be disclosed as such. In short, the investor
deserves a transparent medium for making healthy decisions.
These limits will help to ensure that ordinary investors can rely on
the information they encounter online and accurately gauge a company's
level of public support, while also helping to ensure that honest
startups can compete for investors without hiring armies of paid
promoters or engaging in manipulative tactics.
Another important issue the SEC will need to address is the
relationship of crowdfunding to other capital raisings, and in
particular to Regulation D offerings. This is a difficult issue,
especially as Regulation D's restrictions on general solicitation have
been loosened by Title II of the JOBS Act. I believe that careful study
and attention needs to be paid to how the two should interact in
various contexts, including with respect to integration.
Although crowdfunding is a public offering, it is unlike other public
offerings, and, absent evidence of problems, most likely should be able
to proceed parallel to a Regulation D private offering, provided the
appropriate protections are put in place--and the SEC adjusts them as
necessary based on their performance in the real world. It is critical,
though, that the now-looser solicitation rules for a post-JOBS Act
Regulation D offering not be permitted to undermine the centralized
transparency protections of crowdfunding's restrictions on advertising.
One solution could be to provide a safeharbor from integration rules
only where the Regulation D offering followed the pre-JOBS Act approach
on Regulation D. Naturally, the Regulation D offering and the
crowdfunding offering would have to provide the same information to
investors.
With respect to subsequent offerings, crowdfunding should be flexible
enough to fit into the start-up ecosystem, and the SEC should carefully
investigate this question. However, crowdfunding investors will likely
face a higher risk of unfair dilution than ordinary angel investors.
The disclosures mandated in the CROWDFUND Act should be helpful. But,
should issuers seek to engage in private offerings within only a short
period after a crowdfunding, which would normally not be permitted
under Regulation D, the SEC should consider whether it can be possible
for these offerings can proceed if they are especially protective of
investors along the lines of how an angel investor might protect
himself or herself from unfair dilution or other problems arising from
near-term subsequent offerings.
This may require the SEC to adopt approaches more substantive than is
normally the case. For example, dilution might only be permitted to the
same or lesser extent than the directors, officers, and major
shareholders, or the crowd would have to be bought out at a profit
disclosed in the original offering. Again, for the success of the
crowdfunding marketplace, the SEC should ensure that crowdfunding fits
into the start-up ecosystem but should do so in a way that ensures
crowdfunding investors are treated fairly.
Similar issues may arise with respect to other corporate governance
matters and relationships with other aspects of securities law, such as
managing the large number of investors in a crowdfunded company. In
these instances, the SEC should look to find ways to ensure that
investors are properly protected--in many instances, by ensuring that
they are aligned with the interests of the directors, officers, and
major shareholders--while also being practical and ensuring that
crowdfunding can function within the start-up ecosystem.
Two important investor protections in the CROWDFUND Act are the
public review period and withdrawl rights. They are designed to allow
investors the chance to carefully consider offerings, permitting the
``wisdom of the crowd'' to develop, rather than perhaps just the
``excitement of the crowd.''
The public review period commences upon the date 21 days prior to
when the securities are ``sold'' to any investor. This means that when
the offering is made available to the public--``potential investors''--
to consider investing: i.e., it is put up on the platform which is the
point at which information is made available to regulators and is also
the point when a notice filing is made with the relevant state
securities regulator the public has 21 days to review it. At the end of
that, the offering can close and the securities can be ``sold'' to
investors. The 21-day period does not reset for each and every
potential investor who might look at the offering--which is why the
language specifically says ``potential investors.'' For example, when a
potential investor considers investing on the seventeenth day the
offering has been up on the platform, the offering can still close four
days later whether that person invests or not.
The SEC must also provide appropriate ways for investors to cancel
commitments to invest.
The law envisions an important role for State securities regulators.
The State securities regulators are the ``50 cops on the beat'' that
have time and again proven crucial for policing smaller offerings, such
as those envisioned under crowdfunding.
One way the law has been designed to empower them is through the 21-
day public review period for all offerings. When combined with the
notice filings to the State securities regulator of the principal place
of business of the issuers--and States where more than 50 percent of
investors are located--and the anti-fraud authority preserved for them,
the 21-day public review period is designed to provide the State
securities regulators with practical ability to assist in policing the
marketplace.
In addition, State securities regulators have examination and
enforcement power for funding portals headquartered in their states.
Although they will be limited to enforcing federal rules, this
oversight authority is an important tool, especially for smaller
crowdfunding portals that may emerge in particular states. Of course,
oversight should be coordinated with the SEC and the relevant national
securities association to the greatest extent possible.
I also encourage the SEC and the relevant national securities
association to work closely with state regulators in crafting the rules
and learning from their on-the-ground experience.
We have also heard recently from the CDFI community with ideas about
how crowdfunding can support their work bringing growth and job
creation to underserved communities. CDFIs are lenders and partners to
businesses in underserved communities. They tend to obtain low rates of
return on mission-driven investments, and frequently encounter
financing gaps that
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might be filled through mission-driven crowdfunding--much the way such
investing occurs in certain segments of the non-security-based
crowdfunding universe today.
I believe that the overall structure of our bill offers CDFI's
powerful tools to support their job-creation work, while protecting
ordinary investors from undue risk of fraud and loss. In addition, some
in the CDFI community have suggested to us that because of the types of
businesses CDFI's work with, the types of low returns that might be
derived, and the particular financing gaps that might be filled through
crowdfunding, that mission-driven, CDFI-supported crowdfunding may
yield better results for investors and positive job creation for
communities if the rules reflect the particular work they do.
Suggestions include ensuring crowdfunding can fill the financing gap
for projects supported by federally-regulated, 501(c)3 CDFIs, a
clarification to ensure that CDFIs and issuers can make sure investors
understand the mission and charitable aspects of investments, and fast
treatment from the SEC and FINRA related to registration and
membership.
The SEC should be receptive to concepts CDFIs may bring that could
aid in accomplishing the job-creating goals of the legislation, while
protecting investors. It should consult with CDFI's and the CDFI Fund
at the Treasury Department on how best to maximize the social and jobs
potential for investing through crowdfunding and CDFI's.
Although it was not included in the final legislation for procedural
reasons, I would encourage the SEC and the relevant national securities
association to engage in regular reviews and reports regarding
developments in the crowdfunding marketplace, including thorough
coordination and consultation with State securities regulators. Should
problems arise, these authorities should act quickly, including use of
their full rulemaking and enforcement authorities. Crowdfunding holds
great potential, but it is also experimental and presents risks. For it
to succeed long-term, it will require careful oversight, especially
during the early stages.
I also urge the SEC and the relevant national securities association
to speed the publication of final rules. Crowdfunding cannot get
started until rules fill out the framework to make the law effective.
I believe the features outlined above are essential if crowdfunding
is going to succeed. Success should be judged both on returns to and
satisfaction of investors, and the growth and development of new and
exciting companies. I am excited about the potential of this new
market, but also cognizant of its risks. It won't be without its
hiccups in the short run, but done properly, I believe this framework
has the potential over the long run to help millions of new startups
get the funding they need to grow their businesses and create jobs, and
provide investors with opportunities for meaningful returns and
community involvement.
I wish to extend my heartfelt thanks to the hard work and cooperation
of my fellow senators, especially Michael Bennet, Mary Landrieu, and
Scott Brown. I would also like to acknowledge the hard work of our
staffs, who did so much to get the original legislative idea into law
in strong, responsible form.
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