Crowdfunding for equity solutions series part 1: Investor protection

money-launderThis is Part 1 of a 10-part series.

CFIRA representatives have already met with the members of the Corporate Finance, Trading and Markets and Office of the Compliance Inspection Divisions of the SEC.

Our interest was to hash out new rules and regulations governing crowdfunding. The process is ongoing, and this meeting was just the start. In this series, we’ll lay out some of the important points covered, our concerns and suggestions.

Any workable crowdfunding regulation will require an investor protection mechanism. We advocate relying on transparency and fraud prevention mechanisms already in place for charities and reward-based markets as a starting point. This basic structure should then be augmented with additional protections such as: portal registry, background and securities enforcement history check, required investor education and due diligence requirements.

Some of the elements suggested to protect investors are:

1. Funding portal register, similar to Broker-Check. This should allow easy checking for registration status;

2. Whistleblower program similar to existing programs at the SEC, but scaled to the smaller amounts expected;

3. Third party escrow;

4. Due diligence requirements with these key components:

  • a. Background and history check for registrant, scaled to funding amounts;
  • b. Education of potential investors on crowdfunding generally;
  • c.  Survey investors individually to verify their understanding of the risk they are taking in general and on this particular deal;

As with all investment vehicles, the trick will be to balance regulation against the cost of compliance.

For this reason, many of our suggested practices need to be scaled to the expected market. Since one of the advantages of crowdfunding is a diverse investor base with small, but cumulative, investments at risk, the regulatory costs can quickly balloon and kill returns.

To avoid fatal regulatory hurdles for the industry, we recommend the burdens be placed generally on those issuing the investment opportunity and minimized for investors. There already exists a method to do this: the internet itself, where disclosures and information can be a simple click away and investment tracking (on both sides) can be automated.

By David Drake, founder and chairman of LDJ Capital, a New York City private-equity firm, and of The Soho Loft, a global financial media company with 3 divisions in Publishing, Conferences & Expos and Consulting. For more updates on the crowdfunding industry and information on alternative investment events, or if  you have comments about this article, you can comment here or reach out to me at [email protected] directly. Thank you.

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