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Title:

Crowdfunding and Securities Laws: What the Americans Are Doing and the Case for an Australian Crowdfunding Exemption

Author: Matt Vitins EAP Date (approved for print): 15 July 2013 DOI: 10.5778/JLIS.2013.22.Vitins.1

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Crowdfunding and Securities Laws: What the Americans Are Doing and the Case for an Australian Crowdfunding Exemption
MATT VITINS* Introduction
Crowdfunding is one of the more interesting things happening online at the moment. As a basic definition, crowdfunding involves funding a project by collecting small contributions from a large number of people, using the internet.1 Crowdfunding can be used to finance films, games, scientific research, social causes, businesses, journalism all manner of products and projects. As is often the case with disruptive new things from the internet, crowdfunding does not sit well with an existing body of law. Securities laws designed to protect investors from making bad decisions are capping the cultural and economic potential of crowdfunding. As it stands in both Australia and United States, crowdfunding promoters can accept donations or offer perks as an incentive to fund, but can not offer equity or debt (investment crowdfunding) without complying with a dense set of disclosure rules. The costs of compliance with these rules is prohibitive for many of the small-scale operations that have the most to gain from investment crowdfunding. Crowdfunding is doing quite well on the simple perk or patronage model, but investment crowdfunding could materially improve how we raise and allocate capital. The regulatory response to crowdfunding in the United States is set to change. In April 2012, the Jumpstart Our Business Startups Act2 (JOBS Act) was signed into law and, amongst other things, will create a new exemption under the Securities Act of 1933 (Securities Act) for investment crowdfunding. The exemption will become available when the Securities and Exchange Commission (SEC) adopts implementing rules, expected sometime in 2013. Australian authorities have acknowledged crowdfunding but have not taken any steps towards substantive law reform. The Australian Securities and Investments Commission (ASIC) issued guidance on crowdfunding in August 2012, noting that some types of crowdfunding could involve activities regulated by the Corporations Act 2001 (Cth) (Corporations Act).3 However, no specific

Matt Vitins is admitted as a lawyer in New South Wales and recently completed a masters at Harvard Law School. Matt would like to thank Victoria Jane Moore, Matthew Tracey and the anonymous reviewers that read this piece for their thoughtful comments, and Anna Lord, in general. Any errors of fact, law, style or etiquette are of course the authors own. There are at least a few definitions of crowdfunding that circulate in the literature. Mary Schapiro, then Chair of the SEC, described crowdfunding as a method of capital formation where groups of people pool money, typically comprised of very small individual contributions, to support an effort by others to accomplish a specific goal: Response Letter from SEC Chair Mary Schapiro to House Oversight Committee Chair Darrell Issa, 6 April 2011, in James Hamilton, Jumpstart Our Business Startups Act (CCH, 2012), 161. This definition is repeated in US Congressional reports and SEC documents. Another early definition provided by Lambert and Schwienbacher characterises crowdfunding as an open call, essentially through the Internet, for the provision of financial resources either in the form of donation or in exchange for some form of reward and/or voting rights in order to support initiatives for specific purposes quoted in Armin Schwienbacher and Benjamin Larralde, Crowdfunding of Small Entrepreneurial Ventures (28 September 2010) <http://ssrn.com/abstract=1699183>, 4. The definition above paraphrases Ethan Mollick in The Dynamics of Crowdfunding: Determinants of Success and Failure (23 April 2013) SSRN <http://ssrn.com/abstract=2088298>. Public Law No 112-106, 126 Stat 306 (2012). Australian Securities & Investments Commission (ASIC), ASIC Guidance on Crowd Funding, 12-196MR, 14 August 2012.

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accommodations have been made for crowdfunding and questions remain about how crowdfunding fits under Australian law. This paper argues that there is a case for an Australian crowdfunding exemption. Part I surveys the world of crowdfunding. It discusses the cultural and economic promises of crowdfunding and why getting the regulatory settings right on this could be important. Part II gives an overview of relevant US and Australian securities laws and how they affect crowdfunding. Part III describes the crowdfunding provisions of the JOBS Act and what the Americans are doing. As noted, these provisions are yet to be implemented. It is not yet clear what effect the legislation will have or how the practice of crowdfunding will develop in response to the new regulatory scheme. However, this paper suggests that the scheme has some apparent shortcomings. Congress took a very securities-centric approach in regulating crowdfunding. It understood crowdfunding as a form of securities offering, and designed a regime consistent with the formal, professional and stylised cultural traditions of securities laws. This makes sense at the higher levels of crowdfunding, where large amounts are involved and investment opportunities can resemble a traditional equity or debt offering. However, crowdfunding operates on a spectrum. At the lower levels, crowdfunding is a social activity more than a financial one. This paper discusses some of the cultural dynamics of crowdfunding and how these dynamics provide relevant investor protections. This leads to the conclusion that the JOBS Act could have done more to liberate crowdfunding from the strictures of the Securities Act. Nonetheless, the crowdfunding exemption in the JOBS Act, and the extensive commentary it has generated, represent experience and thinking that can guide the design of an Australian crowdfunding exemption. Part IV sketches out the form of an Australian exemption and how it could be implemented.

Crowdfunding A Survey

Crowdfunding typically involves an intermediary (a crowdfunding platform) connecting potential contributors (funders, backers or investors) to those seeking funding for their projects (proposers or issuers). The platforms provide a catalogue of projects put forward by various proposers, and funders browse through and contribute to the projects they like. Social media often provides an important overlay in directing people to particular projects, announcing contributions and broadcasting project updates. From this point the world of crowdfunding divides into a number of categories and subcategories.

1.1 Projects Funded


One of the principal divisions is the type of project funded on a particular platform. Kickstarter, one of the most prominent crowdfunding platforms, is dedicated to creative projects.4 Another well-known site, Indiegogo, positions itself as a more general platform that will allow campaigns for anything.5 A number of crowdfunding platforms are dedicated to social causes, others to healthcare, scientific research, education, startups and small businesses.6 Gaming is a particularly popular category, both on general sites and on gaming focused platforms.7 Citizen journalism has also been the focus of some

The Kickstarter Project Guidelines note that the site will not host charities, businesses, fund my life projects, or projects endorsing a political candidate. Examples of a fund my life project, include projects to pay tuition, go on vacation or buy a new camera. Kickstarter, Project Guidelines <http://www.kickstarter.com/help/guidelines>. One of the sites co-founders has claimed: We had a baby crowdfunded on Indiegogo (referring to a campaign for in vitro fertilisation): Bernadette Tansey, Indiegogo Bucks Trend Toward Niche Crowdfunding Xconomy (11 December 2012), <http://www.xconomy.com/san-francisco/2012/12/11/indiegogo-bucks-trend-towardniche-crowdfunding/>. Ryan Kim, A GigaOM Guide to Kickstarter <http://gigaom.com/2012/11/28/kickstarter-copycats/>. Wannabes GigaOM (28 November 2012)

Crowdsourcing.org, Crowdfunding Year in Review: Top Grossing Projects of 2012 (17 December 2012) <http://www.crowdsourcing.org/editorial/crowdfunding-year-in-review-top-grossing-projects-of2012/22671>.

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crowdfunding activity and commentary,8 particularly given continuing concerns about who is going to pay to produce news once the last hardcopy paper has closed. This list is not exhaustive. The world of crowdfunding is diverse. The model can be used to raise capital for almost any (legal) enterprise.

1.2 Patronage and Investment Crowdfunding


Another useful division focuses on what promoters offer as an incentive to fund. Following this analysis, Bradford has helpfully outlined five basic crowdfunding models: (1) the donation model, (2) the reward model, (3) the pre-purchase model, (4) the lending model, and (5) the equity model.9 1.2.1 Patronage Crowdfunding The first three categories can be grouped together under the heading patronage crowdfunding.10 This type of crowdfunding limits funding incentives to either nothing or perks. The donation model involves a simple gift in support of a project (for instance, a charity) without any further incentive beyond feeling good. The reward model has promoters offering perks that is, things or experiences often based on the amount contributed. This is typically a copy of the album, film, or book produced, but funders can get quite creative. Artists sometimes offer private shows, thank you phone calls, access to events and so forth.11 The first project to raise a million dollars on Kickstarter (the iPhone Elevation Dock) and the most successful project to date (the Pebble Wrist Watch) are both examples of the prepurchase model.12 In each case the promoters posted designs, sought funding to go into production, and promised contributors one or more docks or watches depending on the amount contributed. Patronage crowdfunding is the dominant form of crowdfunding at the moment at least in part for regulatory reasons. This type of crowdfunding does not involve an offer of any financial incentives (such as interest payments or an opportunity for profit participation) and, as such, will not ordinarily be subject to securities regulation. 1.2.2 Investment Crowdfunding Investment crowdfunding covers categories (4) and (5). This type of crowdfunding may involve offering debt, equity or some other financial interest and, depending on where you are and the terms of the offer, may be regulated under securities laws. This is generally the case in the United States and Australia. However, some jurisdictions are more permissive. Crowdcube operates out of the United Kingdom and provides a platform for funding start-ups and other businesses. As a case study promoted on the site, the Rushmore Group, which runs the exceptional cocktail bar Milk & Honey, raised 1,000,000 through Crowdcube selling 10 per cent of its equity to 143 separate investors. This is an example of a relatively sophisticated offering, but there are lower order forms of investment crowdfunding. A number of crowdfunding platforms are structured around financial incentives and

See, eg, Leah Betancourt, Is Crowdfunding the Future of Journalism? Mashable (16 July 2009), <http://mashable.com/2009/07/16/crowdfunded-news/>; also see: Narrative.ly, <http://narrative.ly> (funded in part through Kickstarter), and Spot.us <http://spot.us> (a page dedicated to community-funded reporting). C Steven Bradford, Crowdfunding and the Federal Securities Laws (2012) (2012)(1) Columbia Business Law Review, 14. Edan Burkett, A Crowdfunding Exemption? Online Investment Crowdfunding and U.S. Securities Regulation (2011) 13 Tennessee Journal of Business Law 63, 66. Indiegogo has shared research suggesting that having a US $25 perk is the level at which campaigns make an optimum amount of money: Kat Popiel, 5 Rookie Mistakes in Crowdfunding (1 May 2012) <http://blog.indiegogo.com/author/kat-popiel/page/2>; Kickstarter notes four common reward types: (1) copies of the thing; (2) creative collaborations (ie a funder appears as a character in the film, book, etc); (3) creative experiences (a visit to the set, a phone call); (4) creative mementos (ie polaroids, sketches, slides), Kickstarter School <http://www.kickstarter.com/help/school>. Ryan Kim, Kickstarter Comes of Age as a Big-Time Funding Platform GigaOM (10 February 2012) <http://gigaom.com/2012/02/10/kickstarter-comes-of-age-as-a-big-timefunding-platform/>.

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profit participation short of formal equity or debt.13 Appbackr, for instance, provides a platform where investors can support the development of a mobile app in exchange for a copy of the app and some minor level of profit participation.14 Contributions on Appbackr are typically well below US $100. As another example, Sellaband allows funders to support music projects, with a percentage revenue share available as a standard incentive alongside copies of albums and other rewards.15 This paper uses the term investment crowdfunding to refer to crowdfunding offerings of a financial nature, including equity and debt, and a range of financial interests that look something like equity or debt. 1.2.3 The Basic Crowdfunding Models The following table sets out the basic crowdfunding models described in this section. These categories are important as the line between patronage crowdfunding and investment crowdfunding, although hard to draw with precision, can be used as shorthand for those types of crowdfunding that are mostly left alone by securities regulators, and those that are properly within the scope of applicable securities laws. Patronage Crowdfunding (1) donation Investment Crowdfunding (4) lending (5) equity (a financial interest)

(2) reward (3) pre-order


Table 1: basic crowdfunding models.

1.3 State of the Industry


A series of research reports published through Crowdsourcing.org has crowdfunding platforms distributing approximately US $1.5 billion in 2011 and US $2.7 billion in 2012.16 The first of these


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Anyone searching for clear definitional lines here is likely to be disappointed. Heminway refers to these sorts of incentives as unequity a particular category of crowdfunding investment that occupies a space in-between debt and equity. That is, a financial interest that provides profit-sharing or revenue-sharing on a short-term basis, without any accompanying governance rights (Appbackr and Sellaband provide examples). As Heminway notes, this type of interest is a security (within the definition set out in the Securities Act), but is neither debt (as there is no repayment obligation) nor equity. Joan MacLeod Heminway, What is a Security in the Crowdfunding Era? (2012) 7 Ohio State Entrepreneurial Business Law Journal 335, 360. Also see Burkett, above n 10, 74-5. Appbackr <www.appbackr.com>. Public Enemy used Sellaband to finance their two most recent albums, with mixed success. Pioneers in crowdfunding, as in hip-hop, Public Enemy launched a campaign in 2010 seeking US $250,000, but lowered this target to US $75,000 after a slow start. The band commented on its Sellaband page: We have learned that the fan funding model is still not fully developed and, as a result, a $250,000 fund raising effort, while possible, will take too long to accomplish. Sellaband Public Enemy <https://www.sellaband.com/en/projects/publicenemy>. The two crowdfunded albums were delivered in 2012. Wikipedia notes positive reviews for both, <http://en.wikipedia.org/wiki/Most_of_My_Heroes_Still_Don't-_Appear_on_No_Stamp>; and <http://en.wikipedia.org/wiki/The_Evil_Empire_of_Everything>. Massolution, Crowdfunding Industry Report (May 2012) and 2013CF The Crowdfunding Industry Report (April 2013), both reports and certain summary data are available at <http://www.crowdsourcing.org>. At time of writing, Kickstarter has funded 35 million-dollar plus projects and some 631 projects at between US $100,000 and US $1 million. Games dominated the million dollar plus category with 21 out of the 35 million dollar plus projects funded. Film and Video, Design and Technology are also well-funded categories. Kickstarter keeps statistics (such as these) on Kickstarter Stats <http://www.kickstarter.com/help/stats>.

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reports, published last year, identified 452 active crowdfunding platforms as at April 2012.17 These numbers suggest growth, but also some early hype. We should expect a level of consolidation and turbulence in coming years that will hopefully give way to a more mature phase for the industry in the years that follow.18 The idea that crowdfunding is simply another fleeting internet moment has been voiced and is possible. However, there would seem to be some cultural and economic value associated with the crowdfunding model that will help it to establish its place.

1.4 Promises of Crowdfunding


1.4.1 Cultural At the professional level, the business of producing films and other cultural products is expensive. Hollywood was organised on high production values and high up front capital costs, then broad distribution to a mass-audience. That is, expensive blockbusters in theatres everywhere. Similar rules have tended to apply for journalism, television, music and video games.19 A consequence of this model is that production decisions are centralised and risk averse. Projects have to clear a number of gatekeepers before getting made, with studios, distributors and financiers providing sign-off. The system accordingly inclines towards safe bets. Crowdfunding can supplement and circumvent this mode of cultural production. The fundraising conducted for the video game Double Fine Adventure provides a useful (and explicit) example.20 As part of a Kickstarter pitch the games producers explained: Big games cost big money To finance the production, promotion, and distribution of these massive undertakings, companies like Double Fine have to rely on external sources like publishers, investment firms, or loans. And while they fulfill an important role in the process, their involvement also comes with significant strings attached that can pull the game in the wrong directions or even cancel its production altogether Crowd-sourced fundraising sites like Kickstarter have been an incredible boon to the independent development community. They democratize the process by allowing consumers to support the games they want to see developed and give the developers the freedom to experiment, take risks, and design without anyone else compromising their vision. Its the kind of creative luxury that most major, established studios simply cant afford 21


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Massolution, Crowdfunding Industry Report (May 2012), above n 16. The liberalisation of crowdfunding regulation through the JOBS Act will probably extend the hype for a while through 2013, but may also lend some credibility to the crowdfunding model. That is, once crowdfunding is sanctioned by a set of SEC rules, it may be seen as a more legitimate way of raising capital. A set of historical and economic factors explain why this model of cultural production became established across different media. As each of these industries developed they were shaped by then existing limitations in distribution, including limited broadcasting capacity, limited screen and shelf-space, and difficulties aggregating geographically dispersed niche audiences. This led to mass cultural products designed to have wide appeal. See Chris Anderson, The Long Tail 12.10 Wired (October 2004), <http://www.wired.com/wired/archive/12.10/tail.html>; also see Yochai Benkler, The Wealth of Networks (Yale University Press, 2006) 31-32. For a description of how newspapers and broadcast media became organised around high-cost/high-volume production model and how the internet offers an alternative, see Yochai Benkler, From Consumers to Users: Shifting the Deeper Structures of Regulation Towards Sustainable Commons and User Access (2000) 52 Federal Communications Law Journal 561, 563. Double Fine Adventure hit its initial target of US $400,000 in around eight hours. It raised over US $3 million in total and was the second million-dollar plus project on Kickstarter. Kim, above n 12; Double Fine Adventure Kickstarter Project Page <http://www.kickstarter.com/projects/doublefine/double-fine-adventure>. Double Fine Adventure Kickstarter Project Page, above n 20.

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This sums things up well. It is also worth noting the different relationship between the consumer and producer in this setting. Double Fine Adventure had some 87,000 backers on Kickstarter curious to see what the games producers could do. The producers established a Double Fine Adventure website that gave detailed information about the project, including where money is being spent, and updates on art, character, storyboard and programming.22 Backers also had access to private forums where they could interact with the producers and comment on game development. This is very deliberate communitybuilding. Double Fine Adventure is an example of a project that was entirely crowdfunded. However, crowdfunding can also act as a stepping-stone and supplement to more traditional sources of funding. Crowdfunding can prove an audience for unorthodox projects. It can also provide initial or early-round capital, taking a project to a level where networks, distributors or arts funding bodies will provide support. For instance, the Australian production company Aquarius Films partly funded one of its current projects through the crowdfunding portal Pozible.23 The producers had reportedly secured a letter of intent from Screen Australia for the feature film The Second Coming, but faced a shortfall.24 Their Pozible campaign raised AU $75,000 in effect providing gap-financing. As a small-scale (but typical) example, the producers of the short animation Cabbit raised a few thousand dollars through Kickstarter, while also relying on personal funds and private support.25 Crowdfunding therefore carries two important cultural promises. It democratises production decisions and it develops connections between audiences and creators. We can see these effects in projects ranging from the cottage-level (Cabbit) to mid-range and multi-million dollar productions (The Second Coming, Double Fine Adventure).26 The next time someone complains about what is on at the cinema, think about crowdfunding as an alternative to traditional funding models. 1.4.2 Economic Access to capital is both important and difficult for small businesses. The basic sources of capital (bank lending, angel investors, venture capitalists) are not always easy to access. One reason for this is an issue of scale. The transaction costs associated with a professional-grade investments are such that angel investors and venture capitalists are unlikely to be bothered dealing in small amounts.27 A second reason relates to information asymmetries between small businesses and potential investors. 28 As Black


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Double Fine Adventure <http://www.doublefine.com/dfa>. The Second Coming Pozible Project Page <http://www.pozible.com/project/6904>. Michell Hammond Acquarius Films Offers On-Set Role in $200,000 Pozible Fund Raising Startupsmart (September 11, 2012) <http://www.startupsmart.com.au/funding/aquarius-films-offers-on-set-role-for$200000-pozible-fund-raising/>. Cabbit Kickstarter Project Pages <www.kickstarter.com/projects/thesoogie/cabbit-y-tutelary-a-short-film-bysoogie (Phase I), and <www.kickstarter.com/projects/thesoogie/cabbit-y-tutelary-phase-ii-0> (Phase II). The animation is available here: http://vimeo.com/55738572. Look for Nora Vitins (the authors mother) in the credits. As a recent and well-documented example of the type of large-scale, commercial cultural production that is starting to appear on Kickstarter, the campaign for the new Veronica Mars movie (to be produced by Warner Bros.) raised $2 million in 11 hours, breaking various crowdfunding records. The campaign ultimately raised $5.7 million from over 91,000 backers. The Veronica Mars Movie Project <http://www.kickstarter.com/projects/559914737/the-veronica-mars-movie-project>. Of course, not all crowdfunding campaigns are successful (even those promoted by celebrities). Zosia Mamets campaign to raise $30,000 to produce a folk music video with her younger sister crashed and burned and has inspired bitchy commentary: see, for example, Sophie Heawood Zosia Mamet: the Trouble with Crowdfunding The Guardian (31 May 2013); Ellen Gamerman, The Trouble With Kickstarter The Wall Street Journal (21 June 2013). Bradford, above n 9, 100-101. See generally: Michael Jensen and William Meckling, Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure (1976) 3 Journal of Financial Economics 305; Andy Cosh, Douglas J Cumming and Alan Hughes, Outside Entrepreneurial Capital (August 17, 2007) Economic Journal <http://ssrn.com/abstract=663841>.

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explains, investors do not know and cannot easily verify the quality of information provided by a business seeking funding.29 This is especially true in the early phases, where a business has no stable track record or audited financial statements. Attracting capital under these conditions is difficult. It requires a leap of faith by investors or lenders. The levels of risk involved also mean that lenders or investors will demand relatively high returns either in the form of higher interest rates or a greater percentage of the business in order to provide funding.30 The result of all this is that entrepreneurs will tend to start out with internal sources of funding personal savings, credit cards, friends and family, available cash-flow before turning to external debt or equity.31 In short, small businesses face a capital funding gap; and some good ideas do not get funded. Crowdfunding offers at least a partial solution to these problems. It cuts the transaction costs associated with small-scale loans and investments, providing a lower first step on the capital-raising ladder than existing alternatives. Issues of information asymmetry persist, but the social aspect of crowdfunding can add a layer of trust that makes information asymmetries less significant to an investment decision. The crowdfunding model may also help to connect small businesses with less demanding investors or, by providing access to an alternative source of funding and a larger pool of potential investors, may reduce disparities in leverage between those seeking and providing capital.32 There are some good reasons then both cultural and economic for legislatures and regulators to be interested in crowdfunding, and some good reasons to ensure regulation does not unnecessarily restrict the practice.

Securities Laws

2.1 History and Philosophy


The Securities Act governs the initial offer and sale of securities in the United States. This legislation was adopted to respond to fraud in the securities industry, which was thought to have contributed to the stock market crash of 1929 and the Great Depression.33 The law aims to promote public confidence in capital markets by requiring full and fair disclosure of material information about securities offered for sale, and by prohibiting misrepresentations and fraud in the sale of securities.34 The Securities Act is sometimes referred to as the truth in securities law.35 The foundational philosophy of the Securities Act is investor protection through disclosure. Companies can offer all manner of exotic, high-risk and plain awful securities, provided that they properly disclose the risks involved and the information necessary for an investor to make an informed decision about whether to invest. This has resulted in a relatively complex set of rules that define what proper disclosure looks like and how and when the details of an offer may be communicated.


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Bernard S Black, Information Asymmetry, the Internet and Securities Offerings (1998) 2 Journal of Small & Emerging Business Law 91, 91. Daniel Isenberg, The Road to Crowdfunding Hell Harvard Business Review Blog Network (23 April, 2012) <http://blogs.hbr.org/cs/2012/04/the_road_to_crowdfunding_hell.html>. Cosh, Cumming and Hughes, above n 28, 2: Although they discuss a number of exceptions and qualifications, the authors note a standard pecking order theory, in that firms prefer to finance new projects with internal cash flows first, and then if necessary, thereafter seek external debt capital and lastly seek external equity capital. See also Bradford, above n 9, 101; Schwienbacher and Larralde, above n 1, 8-9. A draft research paper by Ethan Mollick further suggests that crowdfunding could alleviate some geographic and gender biases associated with the way venture capitalists look for signals of quality: Ethan Mollick Swept Away by the Crowd?: Crowdfunding, Venture Capital, and the Selection of Entrepreneurs (25 March 2013) <http://ssrn.com/abstract=2239204>. Ted Trautmann and James Hamilton, 2007 US Master Federal Securities Law Guide (CCH, 2007), 13. SEC, The Laws that Govern the Securities Industry <http://www.sec.gov/about/laws.shtml>. Ibid.

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The Australian Corporations Act adopts a similar disclosure focused approach in its regulation of the fundraising activities of Australian companies. The Corporations Act requires a disclosure document for most Australian securities offerings. In the ordinary course, a disclosure document must contain all information an investor (or their professional advisors) would reasonably require to make an informed assessment of the securities offered.36 As in the United States, the Corporations Act and rules determined by ASIC are relatively prescriptive about the form, substance and timing of disclosure documents, and how securities offerings may be promoted. A picture is hopefully starting to develop around the legal cultural traditions of securities laws. These are formal and detailed laws, designed to regulate sophisticated instruments and billion dollar transactions. Although complex, securities laws are appropriate and well adapted for their purpose. These laws do serious work. They defend the integrity of significant capital markets. In one of the nicer pieces of writing on securities regulation, Black explains: The United States is not the only country with a successful securities market, but it surely has one of the best. The United States markets are, for many countries, a source of envy Its magical, in a way. People pay enormous amounts of money for completely intangible rights. Internationally, this magic is pretty rare. It does not appear in unregulated markets.37 As Black suggests, securities laws are important in maintaining public confidence in capital markets. This confidence means businesses have an easier time raising capital and it needs to be carefully protected. It is not clear, however, that the regulatory framework established for such serious investments is appropriate for crowdfunding. The following paragraphs look at how United States and Australian securities laws affect crowdfunding. This background helps to explain why the Americans felt a crowdfunding exemption was a good idea, and why an equivalent might also be a good idea in Australia.

2.2 Securities Laws and Crowdfunding in the United States


2.2.1 Securities As a threshold matter, crowdfunding will not activate federal securities laws in the United States unless it involves an offer of a security.38 The donation, reward and pre-order forms of patronage crowdfunding described above do not typically involve any offer of a security and therefore escape out of the regulatory regime established under the Securities Act.39 The story is different where a crowdfunding campaign promises a financial return. Crowdfunding will most likely involve the offer of a security if an investor is offered interest on a debt;40 or some form of participation in the profits or revenue of an enterprise.41 Examples of investment crowdfunding where there is an actual allotment of


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Corporations Act s 710 (the general disclosure test). Black, above n 29, 92. A security is broadly defined in s 2(a)(1) of the Securities Act. The definition sets out a non-exhaustive list of securities, including any certificate of interest or participation in any profit sharing agreement, any investment contract or any interest or instrument commonly known as a security. Burkett, above n 10, 80; Bradford, above n 9, 31. Whether a debt interest will be a security for the purposes of the Securities Act will most likely turn on an analysis under the family resemblance test put forward in Reves v Ernst & Young 494 US 56 (1990). As Heminway and Hoffman explain, Crowdfunding interests structured in the form of interest-bearing notes or similar debt instruments are likely to be classified as securities under the Reves test: Joan Macleod Heminway and Shelden Ryan Hoffman Proceed at your Peril: Crowdfunding and the Securities Act of 1933 (2011) 78 Tennessee Law Review 879, 891. See also Heminway, above n 13, 353-356; and on the application of the Reves test: Bradford, above n 9, 34-42. A crowdfunding offering that involves revenue or profit-sharing arrangements will most likely be classified as an investment contract and a type of security under the test proposed in SEC v WJ Howey Co. 328 US 293. For

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shares or notes (like the Rushmore Group fundraising discussed above) would clearly come within the scope of the Securities Act if conducted in the United States. In summary, some crowdfunding offerings are securities offerings. 2.2.2 Registration Section 5 of the Securities Act prohibits the offer or sale of a security without an effective registration statement, unless an exemption applies. An offer must be registered or exempt. The registration process is typically expensive and time-consuming. The direct costs of registration include registration fees and the professional fees incurred by lawyers and accountants in preparing relevant disclosure documents. The extent of these costs will depend somewhat on the size and complexity of the offering, but range in the hundreds of thousands of dollars.42 This makes registration prohibitively expensive when raising small amounts of capital. The costs of registration may even exceed the amount of capital sought by small businesses or for small projects, and registration would rarely (if ever) make sense in such circumstances. 2.2.3 Exemptions The consensus of academic commentary is that none of the current exemptions in US federal securities laws could be used to support investment crowdfunding.43 Section 4(a)(2) of the Securities Act creates an exemption for transactions not involving any public offering. This exemption allows private placements of securities to a limited number of sophisticated investors.44 The private placement exemption is relevant for certain forms of online fundraising,45 but could not accommodate garden variety investment crowdfunding for a few reasons. Crowdfunding tends not to be exclusively focused on sophisticated investors. The private placement exemption is also at odds with the crowd aspect of crowdfunding, and could not be used to put out an open call for funding through the internet.46 Another set of exemptions from registration are available under the SECs Regulation D, but are similarly unhelpful.47 Subject to a minor exception, offerings under Regulation D may not use any form


detailed analysis of crowdfunding and the Howey test see Heminway and Hoffman, above n 40, 885-906. In Howey, the Court held that a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a third party is an investment contract, quoted in Burkett, above n 10, 80. Note the similarity with the definitions of a financial product and managed investment scheme under the Corporations Act (discussed below).
42

As a guide, Bradford cites a US Government Accountability Office estimate of the average cost of US $2.3 million for a US $25 million underwritten public offering, but notes that much of this would be underwriting discounts and commissions. Bradford, above n 9, 42 n 200. Burkett, and Heminway and Hoffman also put their estimates in the hundreds of thousands of dollars. Burkett, above n 10, 82; Heminway and Hoffman, above n 40, 908-909. For present purposes it is enough to say that registration will often be impossibly expensive for businesses seeking small amounts of capital. Thomas Lee Hazen Crowdfunding or Fraudfunding? Social Networks and the Securities Laws Why the Specially Tailored Exemption Must be Conditioned on Meaningful Disclosure (2011-2012) 90 North Carolina Law Review 1735, 1744-50; Heminway and Hoffman, above n 40, 912; Bradford, above n 9, 44-49; Burkett, above n 10, 84-88. See Heminway and Hoffman, above n 40, 912-916, for a discussion of the Supreme Courts interpretation of s 4(a)(2) in SEC v Ralston Purina Co. 346 US 119 (1953) and the parameters of the sophisticated investor requirement. For instance, AngelList operates a platform connecting sophisticated/accredited angel investors with start up companies. See AngelList <http://angel.co/>. Public advertising and the general solicitation of investors would be inconsistent with a claim of a private offering, Heminway and Hoffman, above n 40, 916; Hazen, above n 43, 1745. The exemptions in Regulation D are set out in rr 504, 505 and 506 each of which is subject to different requirements. Rules 504 and 505 are designed for small offerings (capped at US $1 million and US $5 million within a twelve-month period respectively). Rule 506 is not subject to a dollar limit.

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of general solicitation or general advertising.48 This language is broad enough to prohibit offers conducted through an open investment crowdfunding platform.49 Some of the Regulation D exemptions also limit the number of un-accredited investors that may participate, again inconsistent with the concept of the crowd.50

2.3 Securities Laws and Crowdfunding in Australia


Australian law in this area largely tracks the regime in the United States, although the central definitions are a bit different. The US Securities Act progresses on a broad understanding of a security. The Australian Corporations Act breaks this up into financial products (flexibly defined) and securities (shares and debentures). As ASIC notes in its guidance, crowdfunding may be regulated in a number of ways under the Corporations Act.51 A crowdfunding offering may amount to an offer of a financial product, an interest in a managed investment scheme (a type of financial product) or an offer of securities. The regulatory consequences that follow depend on which of these definitions applies. 2.3.1 Financial products The definition of a financial product The term financial product is the subject of a multi-layered definition in the Corporations Act.52 Notably, a financial product includes a facility through which a person makes a financial investment53 A financial investment is when (a) an investor provides a contribution, (b) someone uses, or attempts to use, the contribution to generate a financial return, and (c) the investor has no dayto-day control over the use of the contribution to generate that financial return.54 At the end of all this, we come out somewhere reasonably close to the analysis under US federal law that draws a line around the payment of interest or promise of revenue- or profit-sharing.55 A crowdfunding offering that promises a financial return could quickly be classified as a financial product and regulated under the Corporations Act.


48

17 CFR 230.502(c). There is some movement on this front, although nothing too revolutionary. The JOBS Act will permit advertisements to accredited investors for offerings under r 506: JOBS Act, 201(a)(1), SEC Proposed Rule Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and 144A Offerings [Release No 33-9354; File No S7-07-12] 77 (No 172) Fed Reg, (September 5, 2012). Heminway and Hoffman, above n 40, 919. See also Hazen, above n 43, 1745-49. Hazen also discusses the exemption available under Regulation A, which provides for offers under US $5 million and allows general solicitation, but requires a disclosure document. As Hazen notes, associated compliance costs limit Regulation As utility for crowdfunding: at 1746; see also Bradford, above n 9, 48. Rule 505 and 506 offerings are largely limited to accredited investors (the number of un-accredited investors under either rule can not exceed 35), 17 CFR 230.502-506. In calculating the number of investors that may be sold to under r 505 and 506 look at 17 CFR 230.501(e), which exempts relatives and accredited investors (amongst others). ASIC, above n 3. For discussion see Kevin Lewis When is a Financial Product Not a Financial Product (2004) 22 Company & Securities Law Journal 103. Corporations Act s 763A(1). Section 764A of the Corporations Act sets out a list of things that are definitely within the definition, including securities (shares and debentures), derivatives, various insurance products, retirement savings accounts. Section 765A of the Corporations Act sets out a list of things that are not financial products, such as health insurance. Ibid s 763B. See footnotes 40 and 41 above on the application of the Reves and Howey tests.

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51 52

53

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Managed Investment Schemes An interest in a managed investment scheme is a type of financial product under the Corporations Act.56 In its guidance on crowdfunding, ASIC commented that a crowdfunding project could be a managed investment scheme depending on the type of reward offered (and other factors).57 The basic definition of a managed investment in the Corporations Act is a scheme where: (a) people contribute money, (b) contributions are pooled or used in a common enterprise to produce financial benefits or benefits consisting of a right or interest in property for members, and (c) members do not have day-to-day control over the operation of the scheme.58 This reference to financial benefits or benefits consisting of rights or interests in property is broad language.59 It could incidentally catch a range of innocent crowdfunding incentives including incentives offered within the patronage crowdfunding model. A determination that a crowdfunding project is a managed investment scheme would be fatal in most instances. The operations of a managed investment scheme are heavily regulated and subject to detailed compliance requirements under Chapter 5C of the Corporations Act.60 It would not be practicable to run a crowdfunding project as a managed investment scheme except in extraordinary circumstances, and for highly capitalised projects. Product Disclosure Statements An offer of a financial product (including a managed investment scheme) will ordinarily need to be accompanied by a product disclosure statement.61 A product disclosure statement is a detailed document and must contain such information as might reasonably be expected to have a material influence on a decision to acquire the product.62 The Corporations Act establishes strict liability for false, misleading or deceptive statements made in a product disclosure statement.63 As a result, product disclosure statements are carefully prepared by professional advisors and are accordingly expensive. 2.3.2 Securities Disclosure Documents An offer of securities (shares or debentures) is prohibited in Australia without a disclosure document, although this general rule is subject to exceptions.64 There are a few types of disclosure document under the Corporations Act. A prospectus is the standard full-disclosure document and the most common.65 A


56 57 58 59

Corporations Act s 764A(1). ASIC, above n 3. Corporations Act s 9 (definition of managed investment scheme). Note that property means any legal or equitable estate or interest (whether present or future and whether vested or contingent) in real and personal property of any description. Corporations Act s 9 (definition of property). A managed investment scheme with twenty or more members (a hostile number in the context of crowdfunding) generally needs to be registered with ASIC and must be conducted through a public company with an Australian financial services license. Corporations Act ss 601ED, 601FA. The scheme must have a compliance plan (Corporations Act s 601H) and must have a compliance committee if less than half of the directors of the responsible entities are external directors (Corporations Act s 601JA). Corporations Act s 1012B(3). See general ASIC, Regulatory Guide 168: Disclosure: Product Disclosure Statements (and Other Disclosure Obligations), 6 September 2010. Corporations Act s 1013E. Ibid s 1041E (false or misleading statements), 1041H (misleading or deceptive conduct civil liability), 1041I (civil cause of action). Ibid ss 708, 727. Ibid s 705. There are three types of disclosure document: a prospectus, a profile statement, and an offer information statement: Corporations Act s 9 (definition of disclosure document). A profile statement, is a short document that may be used alongside a prospectus where approved by ASIC: Corporations Act s 709(2). However, ASIC has not approved any uses for profile statements at time of writing: ASIC, Raising Funds in

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prospectus must contain certain specific disclosures as well as all information that investors and their professional advisors would reasonably require to make an informed assessment of the securities offered.66 The Corporations Act includes provisions dealing with misleading or deceptive statements and omissions in disclosure documents.67 The result of these requirements which should by now be familiar is that prospectuses and other disclosure documents are complex and expensive to prepare.68 Exemptions The Corporations Act sets out some exemptions to the general disclosure document requirement. As in the United States, none of the current exemptions in Australian law could support the classic form of investment crowdfunding. There are two main situations where a disclosure document is not required in an Australian securities offering: offers made to sophisticated investors and small-scale offerings. The sophisticated investor exemption allows offers of AU $500,000 and above; and offers made to investors that can prove at least AU $2.5 million in net assets or AU $250,000 in annual income.69 A further exemption exists for professional investors, including investors that control more than AU $10 million in assets.70 The thresholds for these exemptions are inconsistent with crowdfunding. The class of qualified investors is too limited to constitute a crowd. The small-scale offerings exemption has different limitations that are similarly problematic for investment crowdfunding. A personal offer of securities in Australia will not require disclosure to investors provided that no more than 20 investors participate and no more than AU $2 million is raised in any 12-month period.71 An offer under the small-scale offerings exemption may not be advertised.72 Again, this exemption is too limited for most types of investment crowdfunding. An open crowdfunding page and promotion through social media could conflict with the advertising restriction, and twenty investors is not a crowd. However, a modified version of the small-scale offerings exemption exists under a Class Order determined by ASIC and has been used to interesting effect. 2.3.3 ASIC Class Order 02/273 It is worth a detour into some regulatory history. In 1997, the Productivity Commission issued a report on Informal Equity Investment. The report noted concerns about the availability of funds through formal capital markets for small businesses but that informal investment (by private investors) was a major source of capital.73 The report documented the emergence of services that aimed to facilitate informal


Australia <http://www.asic.gov.au/asic/asic.nsf/byheadline/Raising+funds+in+Australia?openDocument>. An offer information statement may be used instead of a prospectus for securities offerings of less than AU $10 million: Corporations Act s 709(4). An offer information statement is a lighter document than a prospectus but still detailed and still subject to the liability regime for disclosure documents. Corporations Act ss 715, 728, 729. Corporations Act s 710 (general disclosure test) s 711 (specific disclosures). Ibid ss 728, 729. Andrew J Serpell The Future of Financial Services Regulatory Reform in Australia: Conduct and Disclosure Obligations (2008) 5 Macquarie Journal of Business Law 329, 340. A short-form prospectus may refer to material lodged with ASIC and may be used in place of a full prospectus. Corporations Act s 712. A transaction specific or special prospectus may be used for continuously quoted securities. Corporations Act s 713. These rules may reduce paperwork for public companies that regularly file with ASIC, but will not assist a new crowdfunding project. Corporations Act s 708(8)(c), Corporations Regulations 2001 (Cth) reg 6D.2.03. The annual income test requires proof of gross income for each of the last two financial years. Corporations Act ss 9 (definition of professional investor), 708(11). Ibid s 708(1)-(3). An exception is also available for small scale offerings of certain financial products that might otherwise require a product disclosure statement. Corporations Act s 1012E. Corporations Act s 734(1). Productivity Commission, Informal Equity Investment, Industry Commission Information Paper, 22 April 1997, iii.

66 67 68

69

70 71

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direct investment by introducing businesses and potential investors.74 It suggested possibilities for a significant expansion of informal investment through the development of broader networks of business advisors, investors and businesses.75 The report continued: This could be facilitated by the expansion in Australia of the use of the Internet, or by using some other more specific computer-based network 76 Sometime later in 1997, ASIC issued Class Order 97/2329, which provided exemptive relief from certain provisions of the Corporations Law for business introduction or matching services including those operating through bulletin boards and the Internet.77 The 1997 Class Order evolved into Class Order 02/273, which remains in effect.78 Class Order 02/273 allows information about small-scale offerings to be circulated to potential investors in particular circumstances, provided that clear warnings about the risks of investment are also provided. That is, it liberalises advertising restrictions on small-scale offerings (subject to conditions). The Class Order also creates exemptions for issuers and other actors that effectively lift the ceiling for small-scale offerings to AU $5 million where such offerings are conducted through an introduction service.79 The Class Order is drafted such that the 20 investor limit remains in place for small-scale offerings (whether under the Corporations Act or the Class Order), except to the extent that other exemptions in the Corporations Act are available.80 So, for example, the exemption available under the Class Order could be combined with the sophisticated or professional investor exemptions. The Australian Small Scale Offerings Board The 1997 Class Order and its successors set foundations for a limited form of investment crowdfunding in Australia. The Australian Small Scale Offerings Board (ASSOB) operates a business introduction platform at assob.com.au, relying on a combination of exemptions available under the Corporations Act and Class Order 02/273.81 The site conforms to the basic crowdfunding style. It lists companies seeking funding. However, from this point ASSOB ratchets up a few levels. ASSOB conducts due diligence on companies seeking to list. It also requires that companies engage an approved sponsor (professional business advisor) to assist with the listing process. As an overlay to existing requirements under the Corporations Act (ASSOB only lists companies), the ASSOB Rules of Admission set out certain governance and reporting requirements, including that company directors sign a solvency statement, that the company appoint an auditor, and that companies report material information that would affect shareholder interests.82


74 75 76 77 78

Ibid, 49. Ibid, 55. Ibid. ASIC, Regulatory Guide 129: Business Introduction or Matching Services, 4 February 1998. ASIC, ASIC Class Order- Business Introduction or Matching Services, CO 02/273, 5 March 2002 (Class Order 02/273). Class Order 02/273, note the First Exemption and Second Exemption. Also note that the Class Order may be used for small-scale offerings of securities or scheme interests. Class Order 02/273, Second Exemption, 2(d). Ibid. When read together, sub-ss 708(1) and (3) of the Corporations Act (which set out operative parts of the small-scale offerings exemption) say that the exemption is lost if the number of people to whom securities have been issued exceed 20 in a twelve-month period. The preferred reading here is that it would not be possible to add together the 20 investors allowed under sub-s 708(1) and the 20 investors allowed under the separate exception in Class Order 02/273. Note, however, that offers made to sophisticated investors or professional investors or under some other exception under s 708 are not counted for the purposes of either limit: Corporations Act s 708(1)(5), Class Order 02/273, Second Exemption, 3(b)(A). ASSOB Rules of Admission <http://www.assob.com.au/entrepreneurs.asp?page=5>.

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ASSOB is working effectively within the parameters set by the Corporations Act. At time of writing, ASSOB has raised something in the order of AU $130 million,83 and the average amount of capital raised in a successful ASSOB offering is around half a million dollars.84 This puts ASSOB at the sophisticated end of crowdfunding and capable of tolerating the complex regulatory environment in which it finds itself. ASSOB also needs to be understood as a very light version of crowdfunding. The continuing 20-investor limitations in the Corporations Act and Class Order 02/273 mean that the platform is neither designed nor permitted to engage in crowdfunding as it is generally understood. Nonetheless, ASSOB provides an interesting example of what equity crowdfunding could look like.85

2.4 Securities Laws and Crowdfunding in Review


In review, the position in the United States (pending the implementation of relevant provisions of the JOBS Act) is that investment crowdfunding is constrained. A crowdfunding campaign that promises interest on a debt or some form of profit participation may amount to an offer of a security. A security may not be offered or sold except pursuant to a registration statement or where an exemption applies. The exemptions available in the Securities Act are generally incompatible with crowdfunding, with relevant exemptions limiting general solicitation and the number and nature of participating investors. A principal issue for crowdfunding in Australia is that its position under applicable laws is ambiguous. ASICs guidance on crowdfunding and relevant statutory definitions indicate that some forms of patronage crowdfunding, and most forms of investment crowdfunding, could be regulated under the Corporations Act. ASIC gives some reassurance in its guidance that: If the people providing the funds are making a donation or are only told they may receive some asset of nominal value which is not itself a financial product, regulation under the Corporations Act may not apply.86 This makes it tolerably clear that basic patronage crowdfunding is okay. However, it is vague reassurance at best and leaves a cloud over the types of incentives crowdfunding promoters may offer even within the patronage model. Where a crowdfunding offering amounts to a managed investment scheme or an offer of some other financial product some heavy regulation kicks-in. Similarly, where a crowdfunding offering amounts to an offer of securities, the issuer must prepare complex disclosure documents, backed by an intimidating liability regime for misstatements and omissions, or navigate through some narrow exemptions in the Corporations Act. Although ASSOB has pushed through a complex regulatory environment to find some sunlight, its effectiveness has been constrained by limitations on advertising and on the number of investors that may participate in an offering. In short, the Corporations Act does not comfortably accommodate investment crowdfunding. The following section looks at how crowdfunding might be more appropriately regulated. It reviews what the Americans have done with the JOBS Act and provides some commentary. The paper then moves on to consider the high-level design of an Australian crowdfunding exemption.


83 84

A running counter is presented on the front page of the ASSOB website <http://www.assob.com.au/>. Australian Small Scale Offerings Board Limited, Financial Report for the Year Ended 30 June 2012, 28 September 2012, 4, <http://www.nsxa.com.au/announcements_list.asp?nsxcode=AOB>. ASSOB was cited in Forbes as an example of the type of equity crowdfunding platform that might emerge in the United States once the JOBS Act is implemented. Alan Hall An Interview with Carl Esposti, Crowdfunding Industry Research Forbes (May 14, 2012) <http://www.forbes.com/sites/alanhall/2012/05/14/an-interview-with-carl-esposti-crowdfunding-industryresearch/>. ASIC, above n 51.

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How to Exempt Crowdfunding out of Securities Laws (and to What Extent)

3.1 Background
A capital funding gap for small businesses exists and remains inadequately addressed. This issue was compounded by the global financial crisis, particularly in the United States, when bank lending became more conservative. The financial crisis and the slow recovery that followed created circumstances under which US politicians became interested in crowdfunding as an innovative form of financing.87 In a report on predecessor legislation to the JOBS Act, the US House of Representatives Committee on Financial Services explained: Capital formation is necessary for job creation and is essential for any lasting economic recovery. Without access to capital, businesses cannot expand. Without regulatory certainty, capital disappears. Companies obtain capital thought borrowing or equity financing. Because banks have tightened their lending standards in the wake of the economic crisis, there is less credit available to fund growth... Crowdfunding is an increasingly popular method of capital formation88 The House Committee continued to note that securities regulations impeded crowdfunding. In light of the above, following some amendments by the Senate, Congress passed the JOBS Act.

3.2 The JOBS Act


3.2.1 The Exemption The JOBS Act includes a new exemption from registration for crowdfunding offerings. The exemption, set out in section 4(6) of the Securities Act, is available for securities transactions where: (a) the aggregate amount sold to all investors does not exceed US $1 million in any 12 month period; (b) the aggregate amount sold to any one investor does not exceed: i. ii. US $2000 or 5 per cent of the annual net worth of the investor (where the annual income or net worth of the investor is less than US $100,000); or 10 per cent of the annual income or net worth of the investor, up to a maximum aggregate amount of US $100,000 (where the annual income or net worth of the investor is equal to or more than US $100,000); the transaction is conducted through a registered crowdfunding portal that complies with certain specified obligations; and

(c)

(d) the issuer complies with certain specified disclosure and other obligations.89


87 88 89

House Report No 112-262, 31 October 2011, 4. Ibid. Securities Act 4(6).

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3.2.2 Intermediaries The obligations that apply to intermediaries seeking to rely on the new crowdfunding exemption are set out in s 4A(a) of the Securities Act. The section provides that crowdfunding intermediaries must register with the SEC and any applicable industry self-regulatory body.90 It then sets out a series of requirements directed at investor education. Intermediaries must provide investors with whatever warnings, disclosures and materials the SEC determines to be appropriate.91 Intermediaries must ensure that investors positively affirm they understand they could lose their investment, and answer questions demonstrating an understanding of investment risks and such other matters as the SEC may determine.92 The intermediary must take steps to address fraud, including conducting background and regulatory history checks on the directors, officers and major shareholders of the issuer.93 The SEC may require further anti-fraud measures in its implementing rules.94 Intermediaries are responsible for ensuring that the information required of issuers is provided to investors and the SEC at least 21 days prior to the first sale of securities, slowing things down a bit.95 Further slowing things down, intermediaries may not pay out funds to an issuer until the target amount for the offering is met or exceeded.96 3.2.3 Issuers The obligations that apply to crowdfunding issuers are set out in s 4A(b) of the Securities Act. An issuer must provide investors with information including its name and address, names of directors, officers and significant shareholders, descriptions of its business, financial condition, ownership and capital structure, and its intended use of proceeds of the offering.97 Consistent with existing crowdfunding practice, an issuer must state a target amount and the deadline to reach that target, and must provide investors with regular progress updates.98 Further disclosure obligations and other requirements may be determined by the SEC for the protection of investors and in the public interest.99 The legislation takes a tiered approach on required financial documentation. The documentation an issuer must provide depends on the target amount of the offering. For offerings that, together with any offerings in the preceding 12 months, have an aggregate target amount of: US $100,000 or less, the issuer must provide its income tax return for the previous year (if any), and financial statements certified by management to be true and correct; US $100,000 US $500,000, the issuer must provide financial statements reviewed by an accountant who is independent of the issuer; and
Ibid 4A(a)(1)-(2). The Financial Industry Regulatory Authority (FINRA) is the only relevant self-regulatory body at time of writing. Securities Act 4A(a)(3). Ibid 4A(a)(4). Ibid 4A(a)(5). This will presumably connect with rules to be developed by the SEC establishing issuer disqualification provisions (bad actor provisions): JOBS Act 302(d)(1). Securities Act 4A(a)(5). Ibid 4A(a)(6). Ibid 4A(a)(7). This legislates for a particular form of crowdfunding. The JOBS Act insists on an all-or-nothing funding approach (the model adopted by Kickstarter). On this model, funds are distributed only when a project reaches its target. If a project does not reach its target before its stated deadline, no money is collected from funders. There are other models out there. Indiegogo, for instance, allows promoters to keep funds raised, even if they do not meet their stated goal. Also note that under s 4A(a)(7), investors must be allowed to cancel their commitment to invest in circumstances to be determined by the SEC. Securities Act 4A(b)(1)(A)-(E), (H). Ibid 4A(b)(1)(F). Ibid 4A(b)(1)(I), 4A(b)(5).


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US $500,000 US $1 million, the issuer must provide audited financial statements.100

The issuer must provide annual reports to the SEC and investors setting out results of operations and financial statements, with further details and exceptions to be determined by the SEC.101 An issuer may not advertise the terms of the offering except for a notice directing investors to the relevant crowdfunding intermediary.102 This last restriction is significant. It was argued on the floor of the House of Representatives that this would mean a company could not tweet the fact theyre trying to raise capital.103 This is probably too strict an interpretation of the final text the rule is only that a company may not advertise the terms of the offer. However, it means that crowdfunding issuers will have to be cautious in their public communications. 3.2.4 Liability The JOBS Act creates a private right of action for investors in crowdfunding transactions affected by a material misstatement or omission by an issuer.104 The issuer will escape liability if it can show that it did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.105 If the action is successful, the investor can return the security and claim back whatever consideration they paid (with interest, less any income received), or may claim damages if they no longer hold the security.106 3.2.5 SEC Rulemaking The crowdfunding exemption will not take effect until the SEC has adopted implementing rules. As indicated through the paragraphs above, the SEC has broad latitude to shape the ultimate form of the exemption. Congress has set up a framework, but the SEC has been left to provide important details. The JOBS Act required that the SEC deliver its rules within 270 days of enactment.107 This deadline passed on January 1, 2013. It is not clear when rules will be forthcoming, although they are expected later this year.108

3.3 Capital Formation and Investor Protections


The crowdfunding provisions in the JOBS Act are the product of a negotiation between two competing interests. The purpose of the legislation was to increase economic growth by improving access to the public capital markets.109 That is, to facilitate capital formation. Against this, Congress sought to


100 101 102 103 104 105 106 107 108

Ibid 4A(b)(1)(D). Ibid 4A(b)(4). Ibid 4A(b)(2). Congressional Record, 112th Congress, Second Session, 27 March 2012, H1581. Securities Act 4A(c)(1). Ibid 4A(c)(2)(B). Ibid 4A(c)(1)(A). JOBS Act 302(c). Notably, then SEC Chair, Mary Schapiro, had sought 18 months to adopt final rules (responding to a 180 day timetable proposed in an early version of the JOBS Act): Letter from SEC Chair Mary Schapiro to Senate Banking Committee on HR 3606 (13 March 2012) in Hamilton, above n 1, 185. The SEC is yet to propose draft rules on crowdfunding, suggesting it may be some time before final rules are adopted. This said, such rulemaking has been identified as a priority of the incoming Chair of the SEC, Mary Jo White. In testimony before the Senate Banking Committee, White has stated: The SEC needs to get the rules right, but it also needs to get them done. To complete these legislative mandates expeditiously must be an immediate imperative for the SEC. Testimony of Mary Jo White, Nominee for Chair of the US Securities and Exchange Commission, before the United States Senate Committee on Banking, Housing and Urban Affairs, March 12, 2013. Preamble to the JOBS Act.

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balance the ever-present concern of investor protection that has motivated securities laws since the 1930s. There are risks here that need to be acknowledged. Crowdfunding makes it possible for relatively unsophisticated members of the general public to throw money at particularly risky enterprises.110 Small businesses often fail. People who can not afford it may lose money. There is scope for fraud. We could add a secondary concern that if investor protections are inadequate, the public may lose confidence in capital markets and capital formation will become generally more difficult and expensive.111 Any exemption for investment crowdfunding must accordingly be conditional and limited. However, it is easy to overstate risks to investors and to over-regulate in response.112

3.4 The Balance in the JOBS Act


When broken into constituent parts, there is not too much to criticise about the new crowdfunding exemption. The structure of the exemption makes sense. Crowdfunding offerings must be conducted through an intermediary. Intermediaries must be registered with the SEC and must provide warnings to investors. Issuers must comply with a set of disclosure obligations supported by a private right of action establishing liability for misstatements and omissions. All of this is fine. However, the requirements at each stage are both too many and too prescriptive. The crime in the JOBS Act is one of excess. The SEC also has broad rule-making authority to add obligations at each stage of the process, and there is a risk the SEC will add a substantial layer of detail to an already complex regime.113 A number of the investor protections in the final crowdfunding exemption were introduced by the Senate.114 These amendments addressed commentary on early drafts of the crowdfunding legislation which had expressed concerns about a lack of investor protections and forecast increases in fraud and bad investment decisions.115 Some subsequent commentary has suggested that the Senate went too far in response that the complexity of the new rules will prove overwhelming and will limit the utility


110 111

Bradford, above n 9, 104. Letter from then SEC Chair Mary Schapiro to Senate Banking Committee on HR 3606 (13 March 2012), in Hamilton, above n 1, 185; Statement of Professor John C Coffee Jr (Adolf A Berle Professor of Law, Columbia University Law School) at Hearings Before the Senate Committee on Banking, Housing and Urban Affairs, December 1, 2011; Black above n 29, 92. As Paredes concludes: The bottom line is that securities regulators, as well as the public and the media, often have an exaggerated concern over fraud and investor losses and, at least by comparison, a dulled sensitivity to the costs of greater investor protection. Troy A Paredes, On the Decision to Regulate Hedge Funds: The SECs Regulatory Philosophy, Style and Mission (2006) 5 University of Illinois Law Review 975, 1009; also quoted in Bradford, above n 9, 99. Also note Dombalagian, Securities regulation is generally advanced under the rubric of investor confidence or investor protection The goals of economic efficiency and capital formation, where they appear in the federal securities laws, serve as decidedly secondary considerations. as cited in Heminway, above n 13, 338. Although note that concerns about overregulation are starting to get some play in the press and in academic literature. Schwartz, for example, writes, This Essays core message to the SEC, and incoming Chairman White is this: keep the rules and regulations governing securities crowdfunding as light and simple as possible: Andrew A Schwartz, Keep it Light, Chairman White: SEC Rulemaking Under the CROWDFUND Act (2013) 66 Vanderbilt Law Review En Banc 43, 62; University of Colorado Law Legal Studies Research Paper No 13-8 <http://ssrn.com/abstract=2269072>. The requirement that intermediaries register with the SEC, a number of additional disclosure obligations and the private right of action for misstatements and omissions all came from the Senate. The Senate amendments also substantially expanded the matters to be addressed in the SECs rules. Entrepreneur Access to Capital Act (H.R. 2930) (the House Bill) cf Title III of the JOBS Act (the legislation as passed). See, eg, Statement of Professor John C Coffee Jr, above n 111: Although we all want to be Internet-friendly, S.1791 (an early Bill), in its present form, seems likely to invite a significant amount of fraud that could, over the longer run, stigmatize those attempting to market smaller offerings.

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of the exemption.116 Congressman Patrick McHenry, author of the House crowdfunding bill, offered the following comments: Rather than recognizing that crowdfunding could create new markets and opportunities for small businesses and start-ups, these misguided Senators simply saw crowdfunding as unregulated activities. This misperception caused them to design a crowdfunding title that is riddled with burdens on issuers, investors, and intermediaries and limits general solicitation and enhances SEC rulemaking authority.117 There is force to these criticisms. As captured in the Congressmans comments, what started as an exercise in deregulation was taken as an opportunity to re-regulate an emerging practice.

3.5 The Crowdfunding Spectrum


The Senate amendments follow from a very securities-centric way of thinking about how to regulate crowdfunding. The new exemption sees crowdfunding as a species of securities offering and regulates accordingly. This is not all bad. The line between investment crowdfunding and a traditional securities offering becomes increasingly blurred when large amounts are involved. The new exemption is roughly appropriate for the more sophisticated and securities-like crowdfunding offerings. At these higher levels, offerings raise sufficiently large amounts of capital for issuers to absorb the costs of preparing financial statements and other disclosures. The percentages paid through to crowdfunding platforms are also probably large enough to underwrite the platforms costs associated with registration with the SEC and conducting basic diligence on issuers. Crowdfunding, however, operates on a spectrum. The compliance costs associated with the new scheme mean that it will not be useful for smaller-scale investment crowdfunding. In this, the exemption fails to create sufficient space under the Securities Act for some of the more innovative lowerlevel forms of investment crowdfunding that are emerging and should be encouraged. The Senate dropped the weight of traditional securities regulation onto all tiers of crowdfunding, which was not a sufficiently nuanced approach.118 At the lower and intermediate levels, crowdfunding is quite different from a traditional securities offering in terms of cultural framing, expectations and risks.

3.6 The Nature of Crowdfunding


3.6.1 Social Systems In its basic form, crowdfunding is a social activity. The call for funding is pushed through social networks and provides an opportunity to support a friend or associate in what they are doing. At the next level, funding is driven through geographic communities or communities of interest. As we saw with Double-Fine Adventure, crowdfunding can establish deep connections between project promoters and a disparate community of funders. This social dimension and community-building can provide relevant investor protections. Endorsement systems A draft research paper by Ethan Mollick of Wharton indicates that the social networks of crowdfunding promoters are a key determinant of whether a project will attract funding.119 This underlines the social


116

Stuart R Cohn, The New Crowdfunding Registration Exemption: Good Idea, Bad Execution (2012) 64 Florida Law Review 1433, 1438. Congressional Record, 112th Congress, Second Session, 27 March 2012, H192. Heminway arrives at a similar conclusion in considering whether certain crowdfunding offerings should be defined as securities under the Securities Act. In her words, The regulation of financial interests, instruments and offerings can and should be rethought with the less sophisticated interests and instruments in mind, as well as the more sophisticated interests and instruments. Heminway, above n 13, 362. Mollick, above n 1.

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nature of crowdfunding and intuitively makes sense. An important vote of trust in a project and promoter is expressed by each person that posts a link on their Facebook timeline or Twitter feed. This process of people vouching for a project radiates out to second and third level supporters, acting as a form of social endorsement that identifies worthwhile and legitimate projects. Where a project has high levels of support amongst those with first-hand knowledge of the promoters, or amongst a community familiar with their work, external investors can proceed with increased confidence. We can see evidence of this in Kickstarters funding statistics. If a project crosses 30 per cent of its funding goal, it will usually go on to be successfully funded.120 As noted in one analysis of Kickstarter data, this is often the threshold at which people outside the promoters immediate network start to contribute to a campaign.121 Conversely, the vast majority of projects that fail do so at the early stages and at lower levels of funding.122 These statistics suggest that endorsement systems may work to filter out bad projects. Social obligations The further importance of the social nature of crowdfunding is that social obligations and expectations attach where an issuer has called on their extended network to raise funds. It means that reputational consequences follow where a crowdfunding issuer behaves badly. As explained by one of the cofounders of Indiegogo: A person who wanted to commit fraud by raising money and running would have to be willing to destroy their reputation and social graph connections across the web to succeed.123 Effects These systems of social endorsement and accountability appear to be quite effective in preventing fraud and compelling good faith conduct on the part of promoters. While there has been a lot of noise about the risks of fraud in crowdfunding, we are not seeing any widespread reports about actual fraud effected through crowdfunding sites.124 This takes us back to Mollicks research which has identified little, if any, outright fraud 125 In addition, while finding that many crowdfunding projects were delayed (and some seriously delayed), Mollick has reported that very few projects did not appear to be making a good effort to fulfill their obligations.126


120

Michael Wolf, Analyzing Kickstarter: What Succeeds, By How Much and How Often GigaaOm (28 June 2012) <http://gigaom.com/2012/06/28/analyzing-kickstarter-what-succeeds-by-how-much-and-how-often/>. Wolf puts the threshold at 30 per cent. Kickstarter suggests that a slightly lower threshold might apply, noting 81 per cent of projects that cross 20 per cent go on to be fully funded: Kickstarter Stats, above n 16. Wolf, above n 120. Kickstarter Stats, above n 16. Notably, around 11 per cent of projects do not receive any pledges. Danae Ringlemann quoted in Tom Harnish, Cloud Funding Offers More than Pennies from Heaven Crowd Source Capital (3 August 2010) <www.openforum.com/idea-hub/topics/money/article/cloud-funding-offersmore-than-pennies-from-heaven-1/>. Also quoted in Burkett, above n 10, 73 n 61. In an interview with Forbes, Justin Kazmark of Kickstarter offered the following comments on the fraud issue: This is something were thinking about. More than 32,000 projects have launched and succeeded, and fraud is not something that were experiencing. The way that Kickstarter works, its not a one-to-one relationship where its easy to pull the wool over peoples eyes. Although there have been projects that have made claims that are lofty, people have called them out and they dont get funding. The internet asks questions. Thats how the system works. Theres a difference between failure and fraud, and were not seeing fraud quoted in Suw Charman-Anderson, Kickstarter: Dream Maker Or Promise Breaker? Forbes (30 November 2012) <http://www.forbes.com/sites/suwcharmananderson/2012/11/30/kickstarter-dream-maker-or-promisebreaker/>. Mollick, above n 1. Mollick also notes a direct failure rate well below five per cent. Mollick, ibid.

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3.6.2 Information systems A further difference between crowdfunding and a traditional securities offering has to do with information systems. The nature of crowdfunding as a social activity, and one that happens online, affects how information circulates in a crowdfunding offering. This is important from a regulatory perspective. The central philosophy of Australian and US securities laws is investor protection through disclosure. Securities laws operate to ensure that investors have all information required to make informed investment decisions. The way this has traditionally been done has been to require issuers to file complete and authoritative documentation, threatened into pedantic accuracy by strict liability. While this model is effective, it is not necessarily appropriate for smaller crowdfunding offerings. Over-disclosure There is a relationship between the size of an investment and the value of full disclosure. It may be efficient for a professional investor to spend time closely reviewing disclosure documents before putting down a million dollars in a way that does not hold for a crowdfunding investor about to risk a hundred or a thousand dollars. That is, for crowd level investments, detailed or prescriptive disclosure requirements may not be an efficient way to ensure investors have relevant information. Such requirements put issuers to the expense of preparing documentation that investors, acting rationally, would not spend the time to read or understand. Adding to this issue, one of the problems with the formal disclosure regimes outlined above is that issuers tend to over-disclose in order to avoid liability for omissions.127 The question then, is how to ensure investors have access to relevant information. In considering the issue of over-disclosure, Lumsden hints at a solution by wondering whether to approach the problem from the investor in rather than the issuer out.128 The traditional securities disclosure framework is a classically top-down method of providing information. It involves a one-way, broadcast communication from the issuer to investors. As an online activity, crowdfunding naturally inclines towards a dialogue. Communications flow between issuers and investors and from investor to investor. There is still a need for disclosure by issuers. This starts the conversation. However, it is relevant that crowdfunding sites provide a forum where information supplied by issuers can be questioned, tested and discussed.129 Through such dialogue, investors can also guide issuers on the type of information that is important. In this manner it may be possible to get to a better calibrated level of disclosure where over-disclosure is limited and investors are provided with information that is important to them in the context of a particular project or offering. 130 Negotiating disclosure One of the ways in which issuers and investors negotiate disclosure is simply through the decision to fund. An offering that is not supported by adequate documentation or information will be less likely to find funding.131 A paper by Ahlers, Cumming, Gnther and Schweizer is informative here. The paper


127

Heminway, above n 13, 348-349; Andrew J Lumsden, Son of Wallis Disclosure for the 21st Century (9 November 2009) [39], <http://ssrn.com/abstract=1502451>; Serpell, above n 68, 342. Lumsden, above n 127. For discussion of the importance of open communication systems in crowdfunding, see Bradford, above n 9, 134-135. Crowdfunding intermediaries are part of this process. Interestingly, Kickstarter has started to require that promoters outline Risks and Challenges associated with their project a very informal version of the risk factors set out in standard disclosure documents. See Perry Chen, Yancey Strickler and Charles Adler, Kickstarter is not a Store Kickstarter Blog (20 September 2012) <http://www.kickstarter.com/blog/kickstarter-is-not-a-store>. As ASSOB notes on its site, The more relevant the information and documentation an application has to support a companys profiling on our Platform, the easier it will be to build a credible investment opportunity for showcasing and the more incentive a Funder has to invest.

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looked at how start-ups signalled value to investors in equity crowdfunding. The data set was based on offerings conducted through ASSOB, and so focused on higher-level crowdfunding where more formal disclosure is likely to be appropriate. The authors found that presenting financial projections and roadmaps, and internal governance factors such as proper board structure and more highly qualified board members, increased the likelihood of funding.132 The paper concluded: Our data also highlight the fact that the crowdfunding market operates in a largely rational manner, even among retail investors who are arguably less sophisticated. Crowdfunding investors seem to pay a great deal of attention to the financial and governance material that firms provide.133 What is interesting here is that, in territory where good disclosure is not exhaustively defined by regulation, investors are quite effectively calling for information that is relevant to them (financial and governance information). It is also interesting to note that this type of information does not form part of the disclosure commonly provided at the lower levels of investment crowdfunding. The disclosure provided by developers on Appbackr, for instance, tends to be a few paragraphs and some screen shots. In contrast, the amounts involved on Crowdcube and ASSOB are substantially higher and the disclosure documentation is commensurately more detailed. In summary, (a) there are some wide variations in what amounts to appropriate disclosure in investment crowdfunding; and (b) left to their own devices, issuers and investors are sorting out what appropriate disclosure looks like. 3.6.3 Limitations Crowdfunding is a new practice, where norms, economic models and relationships between issuers and investors are still being be defined. The social pressures and information systems described above are interesting, but should not, by themselves, be expected to provide sufficient investor protections. These cultural dynamics are fragile and may fail. They will also operate more or less effectively across different types of crowdfunding activities. Crowdfunding directed at professional level investments in for-profit businesses, for example, is not likely to become characterised by social connections between issuers and investors in the same manner as crowdfunding for films, video-games and other cultural products. The social dimensions of crowdfunding and online information systems are relevant but unreliable regulators. The point of the discussion in this section is not that crowdfunding should be left unregulated. It is that crowdfunding is (or can be) something quite different to a traditional securities offering; and, as a follow-on conclusion, certain forms of crowdfunding may not need to be as aggressively or prescriptively regulated as a traditional securities offering.

Designing an Australian Crowdfunding Exemption

A couple of things need to happen for Australian law to better accommodate crowdfunding. As a starting point, it would be helpful to get further clarification on how patronage crowdfunding will be treated by ASIC. A more detailed regulatory guide could provide some certainty on the dividing line between those forms of crowdfunding that are and are not regulated. The next step would be to develop a limited exemption from certain aspects of the Corporations Act for investment crowdfunding. The following paragraphs set out some considerations that could inform the design of such an exemption.


<http://www.assob.com.au/entrepreneurs.asp?page=3>. Heminway and Hoffman similarly observe that, Investors typically will not fund unknown risks. Heminway and Hoffman, above n 40, 955.
132

Gerrit K C Ahlers, Douglas J Cumming, Christina Guenther and Denis Schweizer, Signaling in Equity Crowdfunding (14 October 2012), <http://ssrn.com/abstract=2161587>. Ibid.

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4.1 The JOBS Act Template


The US template suggests an exemption with the following basic attributes: aggregate and individual investment limits; intermediary obligations, including a registration requirement; and issuer disclosure and reporting obligations.

These regulatory settings may be dialled-up or down to find an appropriately balanced exemption. Investment Limits The crowdfunding exemption in the JOBS Act is subject to both overall and individual investment caps.134 An overall limit is necessary so that the crowdfunding exemption does not pollute or subsume how traditional securities offerings are conducted (and regulated).135 The individual investor limits in the JOBS Act were designed so investors could not lose their life savings in one fell swoop.136 There is something patronising about this, but it is not a bad idea.137 The individual investment limit helps to contain the crowdfunding exemption to offerings that can properly be considered crowdfunding. It is consistent with the idea of collecting small amounts from a large number of people. A low individual investment limit could also be reconciled with occasional, larger investments, by excluding sophisticated or professional investors from the cap. Tiers The further value of such limits is that they can be used to create regulatory partitions. As noted, crowdfunding operates on a spectrum. The crowdfunding exemption in the JOBS Act is roughly appropriate for the more sophisticated tiers of investment crowdfunding that look like a traditional securities offering. It falls down when applied to smaller-scale investment crowdfunding. Arguably, Congress felt it necessary to regulate up to a high-watermark due to the thresholds adopted in the JOBS Act. As explained by Cohn: The problem with selecting one million dollars as the authorized amount is that Congress then felt impelled to surround the exemption with numerous requirements that might not have been necessary had an exemption been created for smaller offerings in lieu of or in addition to the one million dollar exemption.138 Cohns comment suggests a tiered approach to regulating investment crowdfunding. The JOBS Act started to do this with its requirements on financial statements (recall that audited financial statements are only required for offerings above US $500,000, management accounts may be used for smaller offerings), but it could have pushed the concept further. The obligations on intermediaries and issuers could be dramatically simplified for offerings below AU $100,000 (or even less than that), stepped up for offerings at an intermediate level, and set at something heading towards the JOBS Act for offerings above half a million dollars. These levels are arbitrary and would need to be more precisely set,


134

The JOBS Act sets the aggregate amount that may be raised by an issuer that relies on the Crowdfunding exemption at US $1 million in any twelve-month period. Securities Act 4(6). The SEC has to adjust the dollar amounts in s 4(6) at least every five years: Securities Act 4A(h). Another potential limitation would be to restrict crowdfunding offerings to companies that have less than a certain amount in annual gross-revenues. This would limit the exception to small businesses: Bradford, above n 9, 84. Securities Act 4(6)(A). Senator Jeff Merkley, Congressional Record, 21 March 2012, S1887, as quoted in Hamilton, above n 1, 37. For further discussion on the value of individual caps, see Schwartz, above n 113, 50-51. Cohn, above n 116, 1438.

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weighing the costs of compliance against the amount of capital to be raised. For the time being it is enough to note that regulatory tiers can and should be established based on the size of an offering. Intermediary Obligations Gatekeepers Another sensible aspects of the JOBS Act is that it requires crowdfunding platforms to register with the SEC, and requires investment crowdfunding offerings to be conducted through a registered platform. This introduces a gatekeeper into the process, and one with a deep interest in limiting fraud and in the general success of crowdfunding conducted through its platform.139 As repeat players, and presumably well-resourced (at least compared to issuers), crowdfunding platforms are also well positioned to take on some compliance obligations.140 While there are costs associated with introducing an intermediary these are worth weighing against the advantages of a level of adult supervision. Disclosure At least some mandatory disclosures are appropriate at all levels of crowdfunding. The identity of the issuer and basic details of the offer, for instance, are always important.141 At the higher levels of crowdfunding, we might start to ask about capital structure and corporate governance arrangements.142 However, legislators and regulators need to fight against the traditional securities law habit of promulgating a long list of required disclosures.143 There should be space for issuers and investors to come to their own understanding of what constitutes good disclosure. As discussed above, the information that is useful to investors can vary widely according to context and the type of crowdfunding involved. 144 One way forward here could be to rely on soft law, such as guidelines issued by a regulator, instead of enforceable rules. This connects with the discussion above on the cultural dynamics of crowdfunding. Crowdfunding remains a new practice, where norms and relationships between participants are being defined. Guidelines would influence the practices that develop around investment crowdfunding towards particular forms of disclosure, while allowing space for continuing innovation. The proposal


139

This paper does not suggest a liability regime for crowdfunding intermediaries, as exists for gatekeepers in traditional securities offerings (Securities Act, 11, Securities Exchange Act of 1934, 10(b) and r 10b-5). The cost of conducting due diligence and establishing a due diligence defence is such that would be problematic for the smaller capital raisings that should be the proper focus of a crowdfunding exemption. For further discussion of gatekeeper liability, see Reinier H Kraakman, Corporate Liability Strategies and the Costs of Legal Controls (1983-1984) 93 Yale Law Journal 857, 888-896. For an update to theories on gatekeeper liability and a useful overview of the literature, see Andrew F Tuch, Multiple Gatekeepers (2010) 96 Virginia Law Review 1583. For instance, platforms can monitor investment limits and provide investor warnings without too much difficulty: Bradford above n 9, 117; Heminway and Hoffman, above n 40, 957-9. This sort of information can be obtained through a simple form with required fields and drop-down menus established by the intermediary. Heminway and Hoffman note that a minimal amount of information necessary for monitoring and enforcement would be required as a threshold matter. Heminway and Hoffman, above n 40, 957. Establishing the identity of an issuer will also be a pre-condition to the bad actor disqualification provisions that are to be developed by the SEC: Jobs Act, s 302(d)(1). In terms of subject matter, Palmiter has persuasively argued that pricing disclosure would be highly material to investment crowdfunding. That is, issuers should be required to disclose the valuation methods and assumptions used to price an offering (the price per share for equity or interest rate set for debt). Subject to concerns about limiting the set of required disclosures for crowdfunding offerings, and containing such disclosure to higher-order crowdfunding, this sounds reasonable. Alan R Palmiter, Pricing Disclosure: Crowdfundings Curious Conundrum (2012) 7 Ohio State Entrepreneurial Business Law Journal 373, 427. Schwartz, above n 113, makes this point in counselling the SEC to show restraint in its forthcoming rulemaking on crowdfunding: at 46. Heminway notes that mandatory disclosure may be ineffective or inefficient in this respect: Mandatory disclosure rules may be under-inclusive (failing to adequately anticipate and require disclosure of relevant or important information) and over-inclusive (requiring the disclosure of irrelevant or unimportant information): Heminway, above n 13, 349.

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then, would be a very light minimum tier with guidelines proposing fuller disclosure as offerings move up in sophistication.145

4.2 Implementation
A crowdfunding exemption could be implemented by ASIC or by legislation. ASIC has the power to create exemptions or modify obligations under certain Chapters of the Corporations Act.146 Class Order 02/273 was made relying on these powers. ASIC could implement a reasonably complete crowdfunding exemption by declaring a new Class Order. If investment crowdfunding becomes commonplace, however, legislation may be necessary. There will be some tricks in properly synchronising investment crowdfunding with the deeper structures of the Corporations Act. In particular, a proprietary company (the preferred corporate form for small business) must have fewer than 50 non-employee shareholders.147 This will be an uncomfortable cap on equity crowdfunding, but is an important organising line in the Corporations Act. Parliament may ultimately need to resolve how to fit crowdfunding within this framework.

Conclusion

The cultural and economic promises associated with crowdfunding are such that the practice should not be constrained by a hostile regulatory environment. There is a strong case for exempting investment crowdfunding out of those parts of the Corporations Act that were designed to regulate traditional securities offerings. On the form of such an exemption, Australian law-makers have the benefit of an instructive body of work coming out of the United States. The negotiation of the JOBS Act through Congress, and the many pages of subsequent commentary across the internet and academic journals, represent some well-developed thinking on how crowdfunding should be regulated. This paper has suggested an exemption for investment crowdfunding based on a tiered approach that would more heavily regulate crowdfunding offerings involving large amounts, while providing fuller exemptive relief for smaller offerings. As noted, any crowdfunding exemption must be conditional and limited. A tiered approach would allow for continuing innovation at a safe level, without affecting the functioning of traditional capital markets. There is significant potential upside to investment crowdfunding. The risks look manageable. We should start work on an Australian crowdfunding exemption.


145

Note that the disclosure requirements will connect with the liability regime that is built in to any new exemption. From an issuers perspective, the worst-case scenario would be to require detailed disclosure coupled with a strict liability misstatements and omissions. The JOBS Act allows an issuer to escape liability for misstatements and omissions made in connection with an offering where the issuer did not know, and in the exercise of reasonable care, could not have known, of the untruth or omission: Securities Act 4A(c)(1)(B). That is, liability can be established for negligent misstatements and omissions. This creates a level of risk and demands increased caution for issuers, which may increase the costs of an offering, but is hard to avoid. Limiting required disclosures, however, reduces this risk in that it limits the information that must be produced and verified by an issuer. Corporations Act ss 238GA, 741, 992B, 1020F. Ibid s 113. This was not so much of an issue in the United States, where the threshold at which private companies must report like public companies is set at 500 shareholders (and US $10 million in assets): Securities Exchange Act of 1934, 12(g).

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