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SEC-NYU Dialogue on Securities Market Regulation: U.S. Securities-Based Crowdfunding - Closing Remarks

Commissioner Kara M. Stein

Feb. 28, 2017

Good afternoon. Thank you all for contributing to this inaugural SEC-NYU dialogue on securities crowdfunding. In particular, I would like to thank each of the panelists, SEC staff in the Divisions of Economic and Risk Analysis and Corporation Finance, and the NYU Salomon Center for the Study of Financial Institutions.

Today’s program has focused on federal crowdfunding. We are now able to observe the first tentative steps investors, entrepreneurs and intermediaries have taken in navigating this new landscape. From May 16, 2016, when crowdfunding went “live” to December 31, 2016, 21 funding portals registered with the SEC and FINRA. They facilitated 163 deals involving 156 distinct issuers. Moreover, as of the end of last month, 36 reported deals raised $11.3 million. These first steps hint at how small businesses will use federal crowdfunding.

The information presented today also hints at potential challenges. Three areas I believe deserve more thought and attention include (i) funding portals’ role as gatekeepers and facilitators of capital formation; (ii) the types of securities offered to retail investors in crowdfunding deals; and (iii) market concentration.

Funding Portals’ Role

Let’s start with the role of funding portals. From May 2016 through January 2017, 27 regulation crowdfunding offers were withdrawn. Sixteen of the withdrawn offers were hosted on a single funding portal, which was expelled by FINRA and withdrew its SEC registration. In essence, the portal had failed to uphold its most basic responsibilities. Allegedly, it ignored red flags and allowed suspect offers onto its platform. These offers did not appear to meet the issuer disclosure requirements specified in Regulation Crowdfunding.[1] For months prior to its expulsion, the funding portal allowed unsuspecting investors to invest in the 16 suspect offers. This incident provides us with the opportunity to examine the important role of funding portals as gatekeepers, as well as facilitators of capital formation. Are registered portals appropriately considering the companies and offers hosted on their platforms? When portals fail to conduct appropriate diligence, it adversely impacts both the investors who may become victims of a fraudulent offer, but just as importantly, it affects subsequent offers by other issuers. “Once-bitten-twice-shy” investors may be reluctant to fund the next business seeking financing through crowdfunding. Therefore, portals that are effective at vetting issuers and offers are important as both gatekeepers and facilitators of repeat investment.

To date, there has been some discussion within the crowdfunding industry about funding portals. Some have noted that funding portals have a spotty record of diligence. Some have registered concern at what may be a race to the bottom as portals compete for offers to host.[2] First of all, is this happening? If so, how should we address this? For example, should there be minimum and uniform standards for vetting companies seeking to be hosted on a portal? Should portals be ranked, and if so, based on what criteria and by whom? What else can be done to help portals be effective for the good of the entire marketplace?

Security-Types Offered

Another interesting observation from today’s program centers on the types of securities many retail investors are receiving in exchange for their crowdfunding investment. Thirty-six percent of crowdfunding offers were equity.[3] The second most common security offered, at 26%, were simple agreements for future equity or “SAFE” securities.[4] These so-called SAFE securities are contractual derivatives. The issuer promises to give the investor stock upon the occurrence of a contingent future event. The event is typically linked to a subsequent valuation event, such as securing an additional round of financing, a company sale, or an initial public offering. However, many small and emerging businesses will never attain the subsequent valuation event. As a result, a retail investor is left with little more than the paper on which the contract is written.[5] SAFEs arguably provide different rights and restrictions and more risk than what retail investors may typically expect.[6] Should we be looking more closely at these securities particularly for retail investors?[7] The funding portals that offer and promote SAFEs may have a role to play in this area. The Commission and FINRA should continue to pay close attention to this trend. In this regard, I support the Office of Investor Advocate and the Office of Small Business Policy in monitoring developments in this area.

Concentration in Crowdfunding

My final observation based on today’s discussion concerns concentration within the crowdfunding marketplace. The top five federal crowdfunding states, according to the data we have, account for 60% of offerings and over 90% of the total amount raised from completed offerings.[8] The location of registered portals is heavily concentrated in California, Texas, and along the East Coast. In addition, while crowdfunding may democratize capital-raising, it may not be reaching a varied enough base of entrepreneurs. We need to continue to examine the geographic and demographic trends regarding users of crowdfunding. Further outreach and education may be necessary to ensure crowdfunding opportunities are accessible to everyone from the businesswoman in Missouri to the immigrant in West Virginia.  Crowdfunding holds the promise of opportunity and access. What more needs to be done to support its equitable provision and use?

Conclusion

Overall, today’s presentations gave us good insight about the current state of crowdfunding. We are beginning to gather the critical data that will help inform our next steps. The challenges we see today are really opportunities for improvement going forward. I thank each of you for your contributions to this event and look forward to continuing our dialogue in the near future.

Thank you.

 

[1] See, e.g., SEC Regulation Crowdfunding Fact Sheet https://www.sec.gov/news/pressrelease/2015-249.html

[2] See, e.g., Nathaniel Popper, “Doubts Arise as Investors Flock to Crowdfunded Start-ups,” NY Times, Dealbook, Jan. 24, 2017 https://www.nytimes.com/2017/01/24/business/dealbook/crowdfunding-fraud-investing-startups.html?_r=0

[3] Division of Economic and Risk Analysis, Presentation at the SEC-NYU Dialogue on Securities Markets Securities Crowdfunding in the U.S., (Feb. 28, 2017).

[4]Id.

[5] See, e.g., Office of the Investor Advocate, SEC, Report on Activities, Fiscal Year 2016, 20-21 (2016), https://www.sec.gov/advocate/reportspubs/annual-reports/sec-investor-advocate-report-on-activities-2016.pdf (describing other contingencies that also may limit investors’ ability to receive a return on their investment).

[6] Id.

[7] See, e.g., Joseph M. Green & John F. Coyle, “Crowdfunding and the Not-So-Safe SAFE,” 102 Va. L. Rev. Online 168 (2016) http://ssrn.com/abstract_id=2830213 (questioning whether SAFEs are the right tool for channeling retail investment capital to crowdfunding companies.)

[8] See, e.g., Vladimir Ivanov & Anzhela Knyazeva, U.S. Securities-Based Crowdfunding Under Title III of the JOBS Act, DERA White Paper (2017), https://www.sec.gov/dera/staff-papers/white-papers/RegCF_WhitePaper.pdf.