Society raises red flags on SEC’s crowdfunding regs

By:
CHRIS GAETANO
Published Date:
Mar 6, 2014
The NYSSCPA expressed some concern that a proposal from the Securities and Exchange Commission (SEC) regarding crowdfunding—a fundraising tactic in which small amounts of capital are solicited from a large number of sources—could reduce transparency and security and may ultimately open up numerous avenues for fraud by unscrupulous entrepreneurs.

The Society sounded the note of caution in a Jan. 21 comment letter drafted by members of its Litigation Services Committee. The letter was in response to the proposal “Rules Governing the Offer and Sale of Securities Through Crowdfunding Under Section 4(6) of the Securities Act of 1933,” which the SEC created at the behest of Congress and released last July.

The proposal supplies a road map for implementing Title III of the 2012 Jumpstart Our Business Startups Act (JOBS Act), which was intended to encourage funding of small businesses in the United States by easing various securities regulations.

Given the document’s considerable length—it spans some 176 pages—the Society opted to comment on select portions of the measure that the authors felt were relevant to the CPA community, particularly where risk management is concerned.

For example, one part of the proposal allows for exemptions to traditional requirements in the issuance of securities used in crowdfunding. While most crowdfunding today tends to give in-kind compensation to investors (such as a deluxe copy of a computer game under development or lunch with a celebrity), the proposal would allow for actual securities to be offered without the formal accreditation and registration that is ordinarily required.

The provision does have certain limitations. To remain eligible for the exception, no more than $1 million may be raised within a 12-month period and the aggregate amount sold to any investor by an issuer cannot exceed $2,000 or 5 percent of annual income (whichever is greater), or 10 percent of annual income or net worth in the event it exceeds $100,000. Moreover, the transaction must be conducted through a single SEC-approved intermediary and must take place exclusively through that intermediary’s web site or other online platform.

Excluded from the proposal’s scope are those issuers that are not recognized in the U.S.; those already subject to SEC reporting requirements; investment companies as defined by the Investment Company Act of 1940 and those that were excluded under that definition under that same act; any issuer that hasn’t filed with the commission and provided investors with ongoing reports required by the crowdfunding regulation during the two years immediately preceding the filing of the required new offering statement; any issuer that has no specific business plan or has indicated that it intends to engage in a merger or acquisition with an unidentified business or company; hedge funds; and anyone else the SEC deems appropriate.

If a startup, for example, meets all of these requirements and does not have any disqualifying aspect, it can offer securities through a crowfunding mechanism online, provided that it files proper disclosures and regular reports with the SEC.

Overall, the NYSSCPA was concerned that the proposal as the SEC is currently offering it paves the way for risks for investors. This reduction in regulatory oversight, the Society said, would come at the expense of security and transparency, which can lead to dangerous situations.

“We urge the SEC to consider the many recent financial events rooted in fraud and dereliction on the part of a reporting company when it evaluates the level of oversight of the crowdfunding investment vehicle,” the Society said.

For instance, the Society pointed to a section of the proposal that says that a person “may find it impractical in view of the limited nature of that person’s activities and business to register as a broker-dealer and operate under the full set of regulatory obligations that apply to a broker-dealer.”

The Society took issue with the characterization of the quality of service and integrity of securities being offered as a business decision that can be weighed in cost/benefit analysis and said that “if an operator finds it impractical to be regulated under prescribed rules, we challenge the SEC to identify a reason why such an operator would find it practical to self-regulate.”

 Yigal Rechtman, a member of the Litigation Services Committee and one of the comment letter’s authors, said that he wanted to make clear that the Society has not come out against crowdfunding in general, but on the proposed implementation of this particular regulation.

“The comment letter addresses solely the risks of fraud, calling the regulators’ attention not only to the large constituency of the ‘good players’ who will abide by the rules, but also noting that there will be a small group of ‘bad players,’’’ Rechtman said. “Regulators should have a pragmatic approach when designing and implementing regulations, and unfortunately, some of this pragmatism has to bode towards the issue of ‘bad players,’ i.e. fraudsters.”

The Society also noted areas where the regulations could defeat their own purpose. For example, the required use of intermediaries are, according to the SEC, meant to increase transparency for investors, as the intermediaries will keep investors informed of developments in the crowdfunding effort. However, the Society questioned why putting more layers between the issuer and the investor would increase transparency rather than doing the opposite, as “multi-layered agents increases the opaqueness of the investment vehicle and reduces the security of the investors and creditors in it.” Transparency, the NYSSCPA said, is achieved by disseminating accurate, reliable and meaningful information in an understandable way and so questioned that adding further layers of intermediaries would have an effect on that.

“The risk of fraud cannot be regulated, rather regulators should be aware of it as they balance the needs of investors for safety and the needs of the market to evolve,” Rechtman said. “We have no agenda beyond the wish to find the sweet spot of the two groups of stakeholders.” 

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