How to Harm Investors; Proposed crowdfunding rules by the Securities and Exchange Commission need to be thoroughly reworked

How to Harm Investors

By THE EDITORIAL BOARDMARCH 29, 2014

Before Facebook paid $2 billion last week to buy Oculus VR, a virtual reality headset maker, 9,500 people donated $2.4 million via Kickstarter, the crowdfunding website, to get Oculus off the ground. Those early donors got thank-you notes, T-shirts or prototype headsets, but not a piece of the company. Donations through Kickstarter are just that, donations, not investments.

Oculus’s success, however, has stoked broad public interest in crowdfunding as a way to invest for profit. Currently, only high-net-worth, high-income investors can legally invest in start-ups through crowdfunding sites. But soon, legislative and regulatory changes will open the sites to everyone.

That is where the Securities and Exchange Commission, with its explicit mission to protect investors, is supposed to come in. But the agency’sproposed crowdfunding rules, to be finalized in the months ahead, are a joke. Here’s how this happened. In an election-year sop to special interests, Congress passed a law in 2012 to end or loosen many bedrock investor protections, on the grounds that deregulation would make it easier for companies to raise money. Among its changes, the law, deceptively named the JOBS Act, called for the S.E.C. to write rules to establish a crowdfunding marketplace where companies could raise up to $1 million a year without having to meet disclosure and accounting standards that had long applied whenever private ventures raised money from the public. Perhaps the law’s one and only saving grace was that it also required the S.E.C. to put in place new safeguards against the heightened potential in crowdfunding for big losses from fraudulent or unsuitable offerings.

In the law’s most basic safeguard, Congress instructed the S.E.C. to limit the amount individuals can invest each year through crowdfunding as a way to limit the likely losses on inherently high-risk start-up investments. It gave the S.E.C. leeway to determine that limit, within certain parameters, based on an investor’s income and assets. In its proposal, the agency opted for the most expansive formula possible. For example, a retiree with $25,000 in annual Social Security income and a nest egg of $100,000 would be allowed to invest up to $10,000 a year. That is way too much. If the agency had used the least expansive formula possible, the retiree’s maximum would be $2,000 a year, which is still very risky.

The law also required crowdfunding “intermediaries,” that is, the sites, to take steps to prevent fraud by start-ups featured on the sites. But the S.E.C.’s proposed rules basically let intermediaries satisfy the antifraud obligation by relying on the companies’ own representations.

And under the proposed rules, investors could end up with next to nothing even if they invested in the next big thing. Sophisticated investors often negotiate complex terms to ensure that they are amply rewarded for early-stage investments, even if later investors put up more money. The S.E.C. has acknowledged that everyday investors “might not” be able to negotiate the same terms — which include “anti-dilution provisions,” “superior liquidation preferences” and other arcana. But its proposal only requires companies to disclose how early investments may be “limited, diluted or qualified.” It should instead require that shares issued through crowdfunding incorporate the terms that sophisticated investors routinely demand.

The proposed crowdfunding rules need to be thoroughly reworked. If the five commissioners and their staffs cannot agree on a worthy set of protections, a majority on the commission should refuse to finalize the rules that emerge.