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Steps for SEC to regulate crowdfunding

Concerns about fraud must be addressed so the

Concerns about fraud must be addressed so the emerging crowdfunding market of small investors can thrive without being spoiled by scams. Credit: iStock

Two months ago, President Barack Obama signed the JOBS Act into law, making equity-based crowdfunding legal for businesses that want to raise capital in smaller amounts than traditional venture capitalists or accredited investors supply.

Depending on who you ask, crowdfunding is either going to democratize access to capital and serve as a boon to small businesses across America, or it will be rife with con artists intent on bilking seniors out of their hard-earned savings.

Let's hope the former is true. But concerns about fraud must be addressed so the emerging market can thrive without being spoiled by fraud and scams.

The Securities and Exchange Commission is currently writing rules that will govern crowdfunding and, it's hoped, guarantee its success. To properly regulate crowdfunding without suffocating it at inception, the regulators at the SEC must strike the right balance between guarding against fraud and allowing the marketplace to work its will.

Here are five actions the SEC should take to help crowdfunding flourish:

Make crowdfunding easily searchable. Work with the industry and the applicable self-regulatory organization to create a standardized national database of crowdfunding intermediaries and businesses seeking crowdfunding that can be accessed by regulators and investors alike.

Define social-media boundaries. Provide detailed guidance as to how businesses seeking crowdfunding may use social media. Companies are allowed to give notice of their offering and direct investors to the "funding portal" where it is listed, but the nature of that notice is not spelled out. Can they post on Facebook and Twitter? What impact does it have to encourage people to "like" the investment on Facebook? Crowdfunding companies won't be filing a prospectus with the SEC when they're looking for funds, and information will be available through all sorts of different channels. Our new world needs new rules.

Allow crowdfunding portals to be selective. Thousands of wacky companies are going to spring up overnight, and portals have to be able to exercise judgment (for instance, declining groups that want to sell racist T-shirts). But if portals do exclude companies, they might be considered to be acting as "investment advisers" that have to be registered with the SEC. The SEC needs to give portals safe harbors to exercise common sense.

Let the private sector work. Acknowledge the important role that the private sector will play in policing crowdfunding. There are going to be companies that focus on due diligence and disclosure, like the one I cofounded, and others that try to measure the amount of risk involved. When such companies are performing a useful function in the market, they do not need to be regulated like a business seeking crowdfunding or a crowdfunding portal.

Don't smother start-ups. The SEC must recognize it's dealing with companies in the very early stages of development. That means it needs to accommodate the needs of start-ups. Start-up culture is disorganized and resource-poor. The SEC should focus on the overall picture and minimize the amount of information required for investors. For example, start-ups should be asked to provide a list answering the question "What are the specific risks you face?" as opposed to the detailed analysis that is more appropriate for more developed companies that trade on the New York Stock Exchange.

Sara Hanks is a corporate and securities attorney in Alexandria, Va. She recently stepped down as the general counsel of the Congressional Oversight Panel for TARP and is launching CrowdCheck.biz, a tool for entrepreneurs and investors looking for transparent crowdfunding investments.

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