WSJ: Inventive Funding Deserves Creative Regulation
The SEC should tread lightly regarding the social-media approach to venture capital.
January 31, 2013 -
By ZACHARY J. GUBLER
Crowdfunding has the potential to revolutionize the financing of small business, transforming millions of users of social media such as Facebook into overnight venture capitalists, and giving life to valuable business ideas that might otherwise go unfunded. Entrepreneurs have already used this fundraising technique on popular crowdfunding websites such as Indiegogo, Kickstarter and Startsomegood to get their ideas off the ground—including a device to track a person's daily activities, an art book about the Dead Sea, and an effort to support poor communities in Bangladesh.
Though crowdfunding is still in its infancy, the ability to raise capital via the Internet may in time become a significant spur for economic growth—to say nothing of giving ordinary investors the opportunity to get in on the ground floor of the next big idea.
Last year Congress passed the JOBS Act—for Jumpstart Our Business Startups—to remove the barriers in securities laws that prevent entrepreneurs from using crowdfunding to sell equity to ordinary investors and let companies raise up to $1 million through the Internet. President Obama signed the law this past April, and the Securities and Exchange Commission is tasked with implementing its provisions. But the agency has been slow to adopt new regulations and is asking for more time. The delay has been attributed to the complexity of the issues and the need to get the rules right.
Yet it might be wishful thinking to believe that the SEC can get these rules right, at least on the first try, because the effects of the regulations are hard to predict in such a new investing realm. If we require companies that raise more than $500,000 through crowdfunding to provide investors with audited financial statements (a rule that the SEC is considering), will that substantially reduce the incidence of fraud? Or will it undermine crowdfunding by imposing an impossible requirement on companies that don't yet have any financials to audit?
Crowdfunding raises dozens of such thorny questions for which there are no reliable answers because of the untested waters. Instead of trying to get the rules right on the first try, why not take an approach that will maximize the probability of getting it right a few years down the road?
A regulatory experiment might do the trick. Specifically, the SEC, in adopting its rules, could treat crowdfunding with a relatively light regulatory touch: for example, by not requiring audited financials but specifying that the rule will expire after three to five years. If the evidence over that period suggests the incidence of fraud is high, then the agency might impose stricter and more permanent requirements.
True, an agency or Congress can always change its rules or laws after the fact in light of experience. But that's not always so easy. A sunset provision, however, forces a regulator to overcome the inertia of the status quo. Particularly with crowdfunding, the SEC can take positive steps to gather the relevant information that will be necessary when it revisits the rules after the test period.
An experimental approach isn't free of obstacles. Interest groups that favor a particular rule or regulation will, everything else being equal, strongly prefer that their approach be adopted on a permanent basis. Federal courts, especially the D.C. Circuit Court of Appeals, have in recent years required the agency to make a more thorough case that the benefits outweigh a rule's costs. This requirement could be a problem for rules that are deliberately experimental.
Still, the hurdles might be overcome. On the political front, experimental crowdfunding rules might be precisely what is needed to reach consensus and to prevent gridlock and legal challenges. It would give those who favor light regulation a limited period to see what happens. And it would give those who favor strict regulations the evidence they need to make the case. Federal courts might also give their blessing to a regulatory approach designed to generate the data necessary to satisfy cost-benefit analysis.
If crowdfunding really is the innovation that many anticipate, investors should be allowed to take advantage of it sooner rather than later. We may end up with a better, more robust system for raising small business capital than endlessly agonizing over the unprovable "right rules." An experimental approach to regulation might be the way to get the JOBS Act to start producing jobs.
Finally, there would be a satisfying symmetry in getting to the optimal regulatory regime by using the type of innovation and experimentation that characterizes the very business startups the JOBS Act is designed to help.
Mr. Gubler is professor of law at Arizona State University's Sandra Day O'Connor College of Law.
Read this article at the Wall Street Journal website here.