Is the JOBS Act Title II ecosystem being built around the art of the “con” by some Internet funding platforms and companies raising money on these platforms? The answer seems to be yes, judging by investment advice provided by Morningstar, FINRA, psychologists, and business world academics – and newly emerging practices of Internet platforms which are gaining widespread acceptance in the crowdfinance ecosystem.
Specifically, I refer to the widespread practice emerging in the wake of the JOBS Act of Title II Internet platforms prominently providing data regarding non-binding indications of interest, using such terms as “commitments” or even “funding”, without clearly and conspicuously disclosing the non-binding nature of these “commitments” and, almost universally, failing to provide any corresponding data reflecting binding investor commitments. Not only are these practices potentially misleading, but they may also violate existing federal and state securities laws and various consumer protection statutes.
Allow me to explain.
There can be little doubt that when Congress enacted Title II of the Jumpstart Our Business Startups Act of 2012 (the JOBS Act), this was a game changer for the U.S. financial markets by any measure. The ability of a company, particularly a private company, to be able to reach out beyond traditional capital markets – through general solicitation and advertising – was of enormous practical value to early stage companies. No longer would a private company with a “private” investment opportunity be restricted to sharing it with friends, family or the ephemeral “angel” investor.
With JOBS Act Title II in motion, the ability of a private company to attract investors seemed endless, especially when coupled with the broad reach of the Internet, and at little or no cost. The only barrier imposed in this new legislation was the requirement that all investors be “accredited” (measured by income or net worth) – and the company utilize reasonable procedures to ensure that investors met this requirement. The only missing ingredient: final SEC rules, which put this new market in play in September 2013.
This new private placement exemption was not borne without controversy. State securities regulators, led by the North American Securities Administrators Association (NASAA), were not sanguine with this new exemption. They pointed to statistical evidence indicating that the highest incidence of investment fraud occurred in private, unregistered transactions. And they noted that simply being “accredited” by reason of one’s financial wherewithal was not, ipso facto, a deterrent to investor fraud or misfortune.
- Urging the SEC to adopt rules which would require companies to file a public notice with the SEC before an offering commences; and
- re-crafting the definition of “accredited investor” to limit potential “victims” of high risk investments.
These issues remain very much in play – and the concerns they represent – investor protection – remain embedded in both federal securities regulation and the historic mission of the SEC.
What is More Interesting is What Has Gone Almost Entirely Unnoticed in the Title II Crowdfinance Ecosystem
Title II of the JOBS Act did much more than simply create a new tool for companies (“issuers” in SEC parlance) to raise capital. It laid the groundwork for an entirely new marketplace – with a new home (the Internet) and, as discussed below, new rules and new players. Indeed an entirely new ecosystem has rapidly developed around new equity finance markets on the Internet – driven to a large extent by technology, technologists, and with it a whole new set of players in this market place.
All good – right? Well, as with anything new, it’s not all good. No surprise there. As with any new market, there are unintended consequences – even in the hands of honest and well intentioned people. The surprise – for me – is that no one is talking about flaws developing – even embedded unnecessarily – in this new ecosystem – and correcting them before they become problematic.
So What’s So New about the Title II Crowdfinance Ecosytem? – New Players and a New Mindset
What has gone largely unnoticed in Title II of the JOBS Act is, in my opinion, generated to a large extent by the other substantive provision of Title II – inconspicuously embedded in Section 201(c) of the JOBS Act under the title “Explanation of Exemption.” This is somewhat of a (huge) misnomer. It is anything but an explanation of an exemption. Instead, it creates a whole new exemption – not for the companies seeking capital – but for people in the business of selling securities in this new market.
You see prior to Title II, indeed since the beginning of securities regulatory time, any person in the business of selling securities was generally required to register as a “broker-dealer” under federal and state law. Once registered, these broker-dealers fall under the rigorous regulatory umbrella of the self-regulatory organization today known as FINRA.
Title II changed all that with a stroke of the Presidential pen. Section 201(c) provides in part that no person:
shall be subject to registration as a broker or dealer . . . solely because— ‘‘(A) that person maintains a platform or mechanism that permits the offer, sale, purchase, or negotiation of or with respect to securities, or permits general solicitations, general advertisements, or similar or related activities by issuers of such securities, whether online, in person, or through any other means . . . or ‘‘(C) that person or any person associated with that person provides ancillary services with respect to such securities.
The term “ancillary services” specifically allows an unregistered “broker” to engage in such activities as providing investment advice, so long as a separate fee is not charged for this service, in addition to offering and selling securities.
Hence, since Title II of the JOBS Act became operative, we have seen a whole new group of players – unregulated Internet platforms often staffed entirely by unlicensed personnel. Though most, if not all, of these new players may be honest and well intentioned, more often than not they are not steeped in the culture or practices of the regulated financial industry, and often their backgrounds and strengths are in areas such as technology, marketing and sales.
So it ought to come as no surprise that there are new practices, and terminology, in this rapidly evolving ecosystem. Indeed, I noted in an earlier article:
In this new world of public crowdfinance, new procedures and new terminology are fast becoming part of the ecosystem. However, these new procedures and new terminology do not necessarily represent “best practices,”
Some of these new practices, though seemingly benign, give rise to unintended consequences when utilized in the context of a public, Internet-based crowdfinance market place, and arguably violate federal and state securities and consumer protection laws. And the potential negative impact of these practices on investors, issuers and the platforms becomes even more magnified in the context of an unregistered, and thus unreviewed, offering, under an exemption from SEC and state registration which has no express disclosure requirements – Rule 506 of SEC Regulation D.
Crossing the Line with Questionable Sales Techniques
As a young associate years ago working on an IPO I learned some basic lessons about the business of selling securities. Securities, as with most products, do not sell themselves. Yes, data is important in evaluating an investment opportunity. But it takes more than a good product and good data to clinch a sale.
Every investment decision starts with a “story” – best introduced with at least one bright shiny object intended to capture the attention, interest and imagination of the audience. Hence, the ubiquitous term “elevator pitch” – followed by a “pitch deck” – replete with graphics and attention grabbing subtitles.
Of course, there is nothing wrong with this. After all, a prospective investor typically will be provided with additional disclosure, and have questions answered, before an investment decision is made.
However, in the post-JOBS Act world of Internet platforms, what is beginning to emerge are tried and true sales techniques which often lead to decisions unconsciously influenced by emotion, and not rational analysis. And the impact of these practices and techniques, though perhaps more benign in non-digital settings outside the seeing and hearing distance of the crowd, are likely to be greatly magnified in both their intensity and impact in the context of a crowd finance environment. At least one of these practices appears to cross a line drawn by the “anti-fraud” provisions of the Securities Exchange Act of 1934 and corresponding state laws.
Incomplete Data Intended to Stimulate the Crowd
In my book, one of the most visible, prominent and widespread crowdfinance sales tactic utilized by Title II platforms is providing data regarding the amount of investor “commitments” an issuer has received to date in a live Title II raise. Typically this data is expressed both in terms of an absolute dollar amount and as a percentage of the total amount offered in the raise. Also typical of Title II platforms presenting this information is its prominence – usually on the initial “deal page” containing a thumbnail sketch of the offering and the issuer intended to whet the appetite of the investor.
So what’s the problem with presenting data about investor commitments? None, if what is being presented is information about legally binding commitments to invest a specific amount in an offering. However, almost universally, when the term “commitment” is used on a deal page of a Title II platform, it is anything but a binding legal commitment. Indeed, it initially reflects nothing more than a non-binding indication of interest by an investor in a particular company for a particular amount. Nothing to sign – not even a deposit. In social media parlance – the equivalent of clicking on a “like” button.
Some platforms, such as AngelList, have used a term other than “commitment” to represent a non-binding indication of investor interest – a “reservation” – somewhat more descriptive of a non-binding indication of interest – but equally non-binding.
So, one might ask, what is the danger to investor by prominently disclosing information regarding “non –binding investor commitments” or “reservations”?
Often, these terms are used on platforms either without any specific disclosure of what these terms mean – or the disclosure is made in a less than conspicuous fashion. This is a potential area of confusion which is easily preventable with a prominent disclaimer.
However, a practice which is even more pervasive, and in my opinion, equally dangerous, is the practice of a vast number of Title II platforms prominently presenting data regarding non-binding commitments or reservations on an initial deal page, but without any corresponding disclosure as to either actual amounts funded – or even legally bound to be funded.
This common Title II platform practice has been further institutionalized and magnified exponentially by the recent introduction by CNBC of a daily ranking of the 50 hottest crowdfunding raises in progress – The CNBC Crowdfinance 50 Index. The accompanying rankings and deal profile information, intended to generate investor traffic to Title II portals, reflect non-binding investor commitments, with no corresponding data reflecting binding, funded subscriptions. Often these profiles are an investor’s first introduction to a particular investment opportunity – and serve as a hook to generate investment interest in a particular listed transaction.
So where is the danger to investors? Very often non-binding commitments are never actually funded by investors, for a variety of reasons, especially in “public deals requiring an investor to submit to verification procedures: they may fail to qualify as an accredited investor, or they may simply lose interest. Under the new Title II rules allowing general solicitation, an investor cannot simply represent that he or she is an accredited investor, as is the case with a traditional, non-public “private” placement. They must also submit to a verification process, proving up their income or net worth. Some are simply reluctant to submit to this process. Others fail to qualify. And often the attrition rate from a “commitment” to a funded investment is more pervasive in “hot” deals, where many rush to reserve a place in line – as no commitment of any kind is required.
Because real time data as to investor “commitments” is presented without any corresponding data as to investors who actually legally commit to an investment, prospective investors are missing out on receiving valuable data showing in real time how many of these “committed” dollars ever wind up in an escrow or issuer account. Investors who rush in to invest in a crowdfinanced transaction with the understanding that the transaction is almost fully “committed,” or even “funded,” may ultimately learn that the issuer barely succeeded in raising the minimum targeted offering amount, falling well short of the amount needed to effectively implement its business plan.
The overriding danger to investors in this practice of only providing “commitment” data, without any corresponding real time funding data – is that it is very likely to influence investor behavior – leading prospective investors to believe that interest is quickly building in a live raise. There is powerful subliminal messaging here: if others are quickly piling into this deal – then perhaps I need to take a closer look – and sooner rather than later.
On the other hand, if real time data is presented as to both non-binding commitments and actual amounts funded – a less compelling “emotional” case is presented for the investor to proceed in the early stages of a finance campaign – where there will typically be a disparity between a mere “like” by an investor, and a decision to write a check.
The Importance of Building Social Consensus in Crowdfunded Campaigns
So you say, where is the proof that only presenting partial data will unduly influence investors. Well the proof is called “social proof” – a powerful motivator in decision making in the crowd finance ecosystem.
Inherent in the power of crowdfunding, be it rewards based or investment crowdfunding, is the impact of building a social consensus – and the quicker a consensus is built the more likely it is that others will be willing to join in and create a successful campaign – something observed by an overwhelming number of crowdfunding experts in rewards-based crowdfunding.
And how is this social consensus built? There are a number of tools, including identifying key supporters, comments by investors, and disclosure of recent interest of the crowd. The most reliable predictor of a successful rewards based crowdfunding campaign has proven to be early, significant interest by the crowd. Where significant interest fails to evidence itself quickly after a campaign begins, the odds of a successful campaign decrease dramatically.
Indeed, recently one academician in the business community, commenting on crowd behavior in the context of crowdfinance, has concluded that building a “social consensus” or “social validation” is as important as the raw investment data itself:
“The pitch’s links to [the company’s] Facebook and Twitter, the stream of messages, “likes”, and “shares” and “comments” matter as much as the financials and key data. The social validation of a venture can make a casual observer become a curious investor, and then a self-appointed brand ambassador, passionately following the firm as it grows and into a possible IPO. This is the power of a networked, engaged crowd.”
And the subliminal impact of displaying only data as to investor interest, without any corresponding data as to amounts funded, is often amplified by prominent display of other data on a Title II platform, intended to appeal to emotional factors. By way of example, a recent visit to the AngelList home page prominently exhibited a list of “Ten Top Investments,” ranked by “money raised” in the past seven days. Two of these deals were tagged as “hot in the last 24 hours.”
It is widely known that two classic sales tactics commonly employed, in both legitimate and illegitimate deals, are the use of “social consensus” (if others are piling in, so should I) and the “scarcity tactic” (hurry, quantities are limited). They are used because they are proven, effective psychological triggers to motivate a person to invest. So says FINRA; so says the SEC; and so says Morningstar, in discussing what is refers to as a “herding” mentality.
Moreover, by a platform having a practice of showing only indications of interest, without information as to actual funding, it is very tempting for a campaign supporter to “manufacture” social proof by simply registering on a site and weighing in with a hefty non-binding commitment of “mouse money,” with absolutely no intention of following up with funding. It is virtually impossible to police this type of “emotional” manipulation – the only practical anecdote is to also report binding, funded commitments with equal prominence to non-binding commitments.
“Success in investing doesn’t correlate with I.Q. once you’re above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.”
So Who is at Risk by Presenting Incomplete Data as to Investor “Commitments”?
Well, aside from the investor itself who may be unduly influenced by incomplete data evidencing a rapidly gathering social consensus, most at risk is the issuer raising funds who makes information available reflecting mere non-binding indications of interest, unless corresponding real time data reflecting binding commitments is displayed with equal prominence. Even though Title II of the JOBS Act and SEC Rule 506 allows an issuer to engage in general solicitation to accredited investors without presenting any specific type of disclosure, the “anti-fraud” provisions of both federal and applicable state law continue to apply. These provisions prohibit “material omissions” and other deceptive practices and have not been pre-empted by the JOBS Act provisions. And aside from securities laws, many states have consumer protection statutes prohibiting misleading or deceptive business practices which may be broad enough to encompass this practice of providing partial data. And as for the platforms themselves, they too expose themselves to the wrath of regulators by providing incomplete data.
So What is the Solution?
There is a simple solution for both platforms and issuers who wish to lawfully provide information regarding investor interest in order to build social consensus: Either provide complete data, i.e. data regarding both investor interest and binding investor commitments, with a conspicuous disclosure of what a non-binding investor “commitment” or “reservation” is – or forego providing any quantitative data regarding interest in the offering, binding or non-binding. Doing anything less, in my opinion, is far from being in line with “best practices” and may ultimately lead a portal or an issuer into unnecessary encounters with federal and state regulators.
Samuel S. Guzik, a Senior Contributor to Crowdfund Insider, is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience in private practice. A nationally recognized authority on the JOBS Act, including Regulation D private placements, investment crowdfunding and Regulation A+, he is and an advisor to legislators, researchers and private businesses, including crowdfunding issuers, service providers and platforms, on matters relating to the JOBS Act. As an advocate for small and medium sized business he has engaged with major stakeholders in the ongoing post-JOBS Act reform, including legislators, industry advocates and federal and state securities regulators. In 2014, some of his speaking engagements have included leading a Crowdfunding Roundtable in Washington, DC sponsored by the U.S. Small Business Administration Office of Advocacy, a panelist at the MIT Sloan School of Business 2014 Crowdfunding Roundtable, and a panelist at a national bar association event which included private practitioners, investor advocates and officials of NASAA. His articles on JOBS Act issues, including two published in the Harvard Law School Forum on Corporate Governance and Financial Regulation, have also served as a basis for post-JOBS Act proposed legislation. Recently he was cited by SEC Commissioner Daniel M. Gallagher in a public address for his advocacy on SEC regulatory reform for small business. He is admitted to practice before the SEC and in New York and California. Guzik has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies. He also frequent blogger on securities and corporate law issues at The Corporate Securities Lawyer Blog.