Crowd funding, a capital-raising mechanism designed to help small businesses, could become the next Regulation D-like rip-off, according to state regulators.
Investment advisers also are wary of the process, citing the inherent risks of investing in unproven businesses and weak regulatory oversight.
But proponents of crowd-funding legislation, which could be signed into law by President Barack Obama as early as this week, assert that the measure would help launch more startups by enabling entrepreneurs to sell shares in small increments online.
Advocates contend that it is a badly needed way to raise capital and democratize investing — letting investors claim a stake in everything from the next Google Inc. to a favorite coffee shop.
REG D COMPARISON
In a letter to senators last month, however, Jack Herstein, president of the North American Securities Administrators Association Inc. and assistant director of the Nebraska Department of Banking and Securities, drew parallels between crowd funding and Regulation D Rule 506, under which accredited investors can buy restricted securities.
In each case, states are pre-empted from reviewing offerings before they are made to the public. Between 2007 and 2010, Reg D violations were the source of 580 state enforcement actions, and they were the leading regulatory problem in 2010.
Mr. Herstein contends that Reg D history will repeat itself with crowd-funding.
“Based on the [Securities and Exchange Commission's] previous track record and their limited resources, this is a mandate the agency is not in a position to fulfill and hence an investor protection disaster waiting to happen,” he wrote.
Mr. Herstein isn't alone.
WORST PARTS OF REG D
“I think it's absolutely another Reg D,” said Heath Abshure, Arkansas' securities commissioner. “What this bill potentially does is take the worst parts of Reg D, make them worse and apply them to crowd funding.”
Under the bill approved by Congress last Tuesday, fledgling companies can raise up to $1 million online annually without having to register with the SEC, though they have to provide the regulator with basic information, such as financial statements and a list of officers and directors.
The House and Senate passed the measure by overwhelming majorities. In addition to crowd funding, it would ease other SEC registration requirements, such as allowing general solicitation for Reg D offerings and exempting emerging companies with less than $1 billion in revenue from many SEC rules.
SEC Chairman Mary Schapiro expressed concerns about the bill. A last-minute effort by several Senate Democrats to increase investor protections in the bill resulted in some crowd-funding changes.
The amount that an individual can invest in an online offering is capped at $2,000, or 5% of annual income or net worth if either is less than $100,000. The limit rises to 10% if either is more than $100,000.
The Senate also inserted language that requires crowd-funding websites to register with the SEC as brokers or as funding portals.
State regulators failed to get state pre-emption removed.
Unlike Reg D offerings, a broker-dealer need not be involved in crowd-funding transactions, which means that suitability analysis is absent, state regulators said.
“Investors are going to be bombarded with offers to invest,” Mr. Abshure said. “There's going to be so much noise in this marketplace that legitimate companies are not going to be heard.”
"TRAIN WRECK'
Allan Katz, president of Comprehensive Wealth Management Group LLC, said that he would not recommend crowd-funding investments.
“It's a train wreck waiting to happen. People can't put their emotions aside,” Mr. Katz said.
“They have a hard time seeing through the clutter, deciding what's legitimate and what's not. You're not going to be able to ascertain all the risks when you're hearing the pie-in-the-sky upside without a downside,” Mr. Katz said.
By contrast, Carroll Hayes Jr., principal at Charles Carroll Financial Partners LLC, embraces the crowd-funding concept, saying that it is an exciting alternative investment at a time when traditional stock and bond markets have become “too rigid.”
“For many of my clients, this is the approach they're looking for. They're becoming disenchanted with the marketplace,” Mr. Hayes said.
“They think the interest rate environment is invented, it's artificially controlled,” he said. “This could be a game changer.”
BRING SOME SKEPTICISM
Investors must bring the same amount of skepticism to crowd-funding as they do to any other investment, but not necessarily more, Mr. Hayes said, noting that the MF Global and Bernard Madoff collapses occurred in a “highly regulated” part of the industry.
A crowd-funding consultant anticipates that the market could involve billions of dollars in offerings in the next 18 months, after the SEC writes the implementing regulations.
David Marlett, founder and chief executive of CrowdFund Securities LLC, acknowledged that investors will sometimes be vulnerable. But like many proponents, he said that the wisdom of the crowd will help mitigate the problems.
Bad actors can be drummed out of online communities, Mr. Marlett said. “The Internet is a wicked place when it comes to reputation,” he said. “It's a dangerous place for the hucksters because they can be smoked out quickly. We need to take the risks seriously, but we don't need to get all bent out of shape about them.”
Startups will be able to get a seal of approval before they are placed on crowd-funding portals if they submit to a background check by a due-diligence company such as the newly formed CrowdCheck Inc.
“It provides a level of assurance that you don't get if you just go with the requirements in the statute,” said Sara Hanks, the company's chief executive.
Some advisers, such as Ray Benton of Lincoln Financial Advisors Corp., are still not convinced. “It's definitely going to be a high-risk type of thing,” he said.
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“I think it's absolutely another Reg D.”
Heath Abshure
Arkansas securities commissioner
