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From Securities Regulation Daily, February 28, 2017

SEC-NYU dialogue on crowdfunding suggests the ‘crowd’ can keep fraud at bay

By Anne Sherry, J.D.

A half-day SEC-NYU Dialogue on Securities Markets examined the trends in crowdfunding, the dangers of some of the securities in play, and the role of the crowd in warding off fraud. Remarks from SEC Acting Chairman Michael Piwowar and Commissioner Kara Stein bookended the discussion.

Crowd before funding. Although one might expect an SEC symposium to focus on the "funding" side of "crowdfunding"—and that topic got its due—many of the panelists stressed the importance of the "wisdom of the crowd." Ethan Mollick (Wharton School, University of Pennsylvania) observed that a large enough crowd is likely to select high-quality projects, reducing the risk of fraud and failure. Michele Schmipp (Small Business Administration) noted that this is especially important as less-sophisticated investors become increasingly involved.

Mollick said that the community element is really what distinguishes crowdfunding from other types of capital-raising. People tend to support projects they are passionate about, whether that be craft beer or the Oculus Rift. There is evidence that people are taking their communities with them when, for example, a project that begins on a reward-based crowdfunding platform like Kickstarter moves to an equity portal. Sara Hanks (CrowdCheck) agreed in the importance of gathering a base of support. People aren’t going out looking for a project to sink money into; you have to find them. She added that if she had the opportunity to change the law, she would create a mechanism for testing the waters so startups could build a crowd prior to making the offering.

Funding issues also arise. On the funding side of the equation, several panelists focused on the type of securities investors receive in exchange. Vladimir Ivanov (DERA) noted that about a third of crowdfunding offerings are for equity, but 26 percent involve Simple Agreement for Future Equity, or SAFE, instruments. Marc Sharma (SEC Office of the Investor Advocate) explained that these resemble warrants, but they do not earn interest or mature at a particular date. Instead, investors must wait for a liquidity event to convert the instrument to equity. Sharma observed that SAFE instruments originated in Silicon Valley and were designed for tech startups likely to raise institutional venture capital at some point. It may be a Procrustean fit for non-tech offerings like the craft brewery or local bakery, he posited. Commissioner Stein echoed these comments in her closing remarks. Many small and emerging businesses will never obtain the subsequent valuation event, she said, leaving retail investors with little more than the paper on which the contract is written.

Hanks also brought up one quandary in Regulation Crowdfunding: the requirement that companies establish a minimum and a maximum funding target. Because funding is an all-or-nothing proposition, there is an incentive to set a small minimum of about $20,000 to $50,000 and leave the ceiling at the regulatory maximum of $1 million. This may work from the point of view of a company desperate for money, Hanks said, but it may not be as good for investors if the company really did need a large amount of money to do what it wanted to do. Paul LaPorte earlier spoke of how his company, CF Fire, set an ambitious floor of $250,000. They ended up falling short of that raise even after extending the campaign by a month, but the success they did have allowed the company to go out and seek bigger funding.

Fraud prevention is critical to the model. The prospect of fraud in crowdfunding was on many panelists’ (and audience members’) minds. In response to an audience question, Douglas Ellenoff (Ellenoff Grossman & Schole LLP) said that it is just too early in crowdfunding to get a clear picture of the fraud landscape. He did note that in one campaign, fraud was discovered and about half the funds were recovered. The importance of the crowd to a campaign’s success is a disincentive to commit fraud, Mollick said. If you defraud your customers, they won’t become investors.

Sharma stressed that fraud is not just bad for investors, it’s bad for the model as a whole. Stein echoed this concern. The fraud incident raised by Ellenoff provides the opportunity to ask funding portals if they are appropriately considering the companies and offers hosted on their platforms. When they fail to conduct appropriate diligence, it harms investors as well as offers by other issuers. Once-bitten, twice-shy investors will be unlikely to fund the next business, she said.

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