May 11, 2012
In regards to Sec. 4A(a)(3): provide such disclosures, including disclosures related to risks and other investor education materials, as the Commission shall, by rule, determine appropriate
This implies that the Commission will state precisely what disclosures must be provided and as in other rules that have been promulgated, provide model text for those disclosures.
As funding portals will be web based and not have brick and mortar offices at which investors may obtain investor education materials, the rules should specifically state what materials must be provided, in what form, and how those must be distributed or made available. Again, if the Commission desires educational pamphlets or brochures, model text should be made available to brokers and funding portals so that everyone is on the same page. This requirement may be better stated as investor-education information (see Sec. 4A(a)(4)(A) below) for which the Commission could draft model text and which could be made available for delivery over the Internet in a number of ways.
In regards to Sec. 4A(a)(4)(A): reviews investor-education information, in accordance with standards established by the Commission, by rule
A review in accordance with standards established by the Commission by rule indicates that the Commission will in fact state specifically what investor-education information is required, how it is to be presented to investors, and how such a review is to be evidenced and documented.
In regards to Sec. 4A(a)(4)(B): positively affirms that the investor understands that the investor is risking the loss of the entire investment, and that the investor could bear such a loss
The term understands in this provision and the provisions that follow is a very subjective term. It is difficult to know how a broker or funding portal can positively affirm that any investor truly understands any of the concepts presented in the investor-education information. The broker or funding portal can positively affirm that the information regarding the risk of losing the entire investment and that the investor would bear that loss was presented and affirmatively acknowledged, but they cannot attest to the level of understanding. Presumably such information would be presented at a level of readability equivalent to a small town newspaper such that it is easily understood by the average person, by most in our country. But there is no means by which a broker or funding portal can positively affirm any level of understanding. This should be clarified in the rules.
In regards to Sec. 4A(a)(4)(C)(i-iii): answers questions demonstrating—
(i) an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers
(ii) an understanding of the risk of illiquidity and
(iii) an understanding of such other matters as the Commission determines appropriate, by rule
Adding to the comments on Sec. 4A(a)(4)(B) above, it is unclear what types of questions would actually demonstrate a particular level of understanding of the risks that are of concern here. It is a simple matter to force investors through a required disclosure or a page of investor-education information and require that they positively affirm having been through that page. It is even possible to require that they positively affirm that they understand the information with questions that essentially restate these requirements like:
Do you understand that investments in startups, emerging businesses, and small issuers represent a level of risk much greater than other types of investments? Yes or No
Do you understand that it may be difficult to sell the securities you purchase from startups, emerging businesses, and small issuers? Yes or No
These questions do not demonstrate any level of understanding however.
The only questions that would actually demonstrate an understanding would be test questions over the information presented. While it is certainly possible, it seems unlikely that investors would be required to study the information and disclosures and then be required to pass a quiz of sorts before being allowed to invest.
A better requirement might be to answer questions that positively affirm they have been given the information and disclosures, have had the opportunity to read everything, have had the opportunity to review frequently asked questions about those disclosures and the information provided, have had the opportunity to pose additional questions to the broker or funding portal, and fully understand the risk. Again, this does not demonstrate an understanding, but prompts the investor to investigate and ask questions and affirms that the investor has a level of understanding he or she is comfortable with. Alternatively, investors may be quizzed after receiving the disclosures in such a way that the answers are revealed after they are answered so that they know they got a question right, and if not, they are presented with the correct response and an explanation.
In regards to Sec. 4A(a)(5): take such measures to reduce the risk of fraud with respect to such transactions, as established by the Commission, by rule, including obtaining a background and securities enforcement regulatory history check on each officer, director, and person holding more than 20 percent of the outstanding equity of every issuer whose securities are offered by such person
The term background check is not defined in the law. A background check can encompass many things, can take considerable time, and can cost considerable money. Presumably, this would involve a regulatory cost that would be passed on by brokers and funding portals to the issuers. For a startup in particular, the expense of this could be prohibitive.
Further, this provision is unclear as to what is required of brokers or funding portals. The measures mentioned are actions taken by broker/dealers and funding portals to investigate the issuers and others. This seems to assume that the risk of fraud is sufficiently reduced merely by obtaining the background check and securities enforcement regulatory history on these individuals. It is not clear whether the Commission will expect each broker and funding portal to merely report the findings of these checks and allow the crowd of investors to determine the legitimacy of any issuer or individual and whether to take the risk, or whether the Commission will expect brokers and funding portals to pass judgment on the issuer or principals and deny the offering on some basis. The difference here is whether brokers and funding portals will perform the checks and list everything for the crowd to judge, or whether the issuer will essentially be applying to be listed with a broker or on a funding portal and that entity will accept or reject the applicant. This raises many other issues.
First, if the broker or funding portal performs the required checks and lists everyone, what information is to be made available and to what degree or level of detail? It seems clear that almost any record of securities fraud would disqualify someone, but what about misdemeanor conviction for something 6 years prior? Is that relevant to the likelihood of success of the business or business expansion? Full disclosure of details might unnecessarily preclude many from even trying to crowdfund a business. Conversely, if the brokers and funding portals are put in the position of making listing decisions, what standards will be in place to make certain that issuers are treated fairly and consistently? Will the listing entity be required to send letters of denial stating the specific reasons for denial and what steps must be taken to be listed? As mentioned earlier, these checks that must be performed might involve significant cost that will undoubtedly be passed on to the issuer. If the issuer has paid attorneys and others to set up a corporation and issue the stock, then pays a broker or funding portal for the background and securities history checks and is denied, what then? Pay again to another broker hoping for a different decision?
This also presumes that the Commission will have readily available electronically to brokers and funding portals upon inquiry the securities enforcement regulatory history of all those individuals in the system.