Why Washington Gets Crowdfunding Wrong

Dear Early Investor,

Can Washington get crowdfunding right this time?

Only if it begins to worry about everyday investors as little as it seems to worry about our country’s wealthy investors.

Last week, Representative Patrick McHenry, R-N.C., introduced a bill called the Equity Crowdfunding Improvement Act of 2014.

This is familiar turf for McHenry. He submitted the original House version of the JOBS Act back in September 2011.

Why is he revisiting the equity crowdfunding space, especially when there’s legislation already in place (and still being rolled out)?

I just saw The Wolf of Wall Street. This flawed movie offers a big clue.

The main character, Belfort, wasn’t a great investor. But he was a great salesman. He’d pick up the phone, and in three minutes flat, he would have sold a few thousand dollars’ worth of shares of some crappy company.

The movie doesn’t mind misleading the viewer in that it portrays an extreme version of both Wall Street (its lack of ethics) and the average investor (his lack of caution or overabundance of naiveté).

Please don’t cast  me as a defender of Wall Street. It’s overrun with “wheelers and dealers” looking for any edge they can.  Sometimes they get carried away. It’s no coincidence that their respect for the law is just as spotty as the government’s enforcement.

But the consequences of Wall Street’s inconsistent respect for the law is

where perception and reality part company. It’s playing havoc with the current national debate over equity crowdfunding. And plays a direct role in Washington coming up with all the wrong answers to such important questions as…

Should equity crowdfunding be tightly or loosely regulated? Should investors be restricted and, if so, on what grounds? Their level of income? Personal assets? How much they’ve invested in the past? Their risk tolerance?

All of the above or none of the above?

Right now, any discussion is useless. Why? Because it’s based on a big fat lie.

Preying On the Rich and Vulnerable

Wall Street is about big money. Win big (David Tepper of Appaloosa Management took home $3.5 billion last year).

Lose big ($9 billion fund Coatue Management lost almost $1 billion this past April alone).

And then there’s scam big.

The vast majority of big winners and big losers operate outside the scams. But it’s the juicy, ill-begotten gains of cheats and scamsters that periodically fill the press and raise a hue and cry for reform.

What’s forgotten (or conveniently ignored) is that the victims of scams tend to fall into  two camps. They’re wealthy individuals. Or they’re institutional investors. Consider that…

  • Bernie Madoff stole $18 billion from both groups.
  • Goldman Sachs deliberately filled its securities with bad mortgage loans, then sold them to some of its most loyal institutional customers.
  • Back in the 1990s, Sam Israel’s Bayou Hedge Fund Group stole $450 million from its trusting wealthy investors.

I could go on and list dozens more examples. But what has really hurt wealthy investors is the same thing that has killed small investors. Big market plunges. Hundreds of hedge funds shut their doors in 2008. Likewise, small investors also suffered from the fallout of the global financial crisis.

I’m not saying the rich are more gullible than the lesser off, but to set them apart as a group far less susceptible to big promises that never materialize seems a big stretch to me.

The idea that wealthy investors are well equipped to fend off cheaters… that they’re somehow too “smart” or “sophisticated” to be easily scammed… is pure myth, and unsupported by the facts.

Now throw into the mix the new legislation called the JOBS Act. More than any other previous piece of financial legislation, it is a product of this big fat lie.

And that means trouble…

In the Name of the Small Investor

The JOBS Act has plenty of protective provisions.

The pump-and-dump scheme featured in The Wolf of Wall Street, for example, would not have been possible, because the Act requires a one-year holding period on purchased shares. No buying low one month and selling high the next.

Other preventive measures call for…

  • Third-party escrow agents that prevent “paper companies” from heading for the hills with newly raised money.
  • Background checks on share issuers.
  • Issuers going through online intermediaries.

Overall, though, the wealthy (or “accredited”) investors get less protection than the non-wealthy (or “non-accredited”) investors.

For example, the warnings on the speculative nature of early-stage equity funding are scaled up for the less wealthy. And the audit and reporting requirements are scaled down for accredited investors.

The message is unequivocal. The “little guy” needs the government to protect him. But the math doesn’t support such a conclusion.

If an accredited investor loses $200,000 and a non-accredited investor loses $20,000 – both representing 40% of their investible savings – who has taken the bigger loss?

It’s not clear. And if the better-off person’s loss is not 40% but 50% and the less wealthy person’s loss is not 40% but 30%, then it’s even less clear.

Yet the JOBS Act allows accredited investors to invest as much as they want and therefore potentially lose as much as they’re worth. But if you fall into the lower-income categories, you’re only allowed to invest a max of 5% to 10% of your yearly income (according to the last round of proposed regulations).

McHenry’s bill reduces the restrictions on non-accredited investing. It brings how non-wealthy investors can invest in startups closer to how accredited investors can invest. It also retains the key preventive measures applicable to both groups of investors, like disclosures, escrow agents and required online intermediaries.

But it doesn’t go nearly far enough in treating non-accredited investors “like adults,” as my colleague Adam Sharp says in this article posted earlier. Mike Norman, a co-founder of startup portal Wefunder, says the government’s efforts to protect non-accredited investors “has made it so difficult for companies to raise money from them that the best ones may choose not to. And that’s the worst outcome I can think of.”

Listen, Wall Street will always have its share of scams. Equity crowdfunding may eventually see a couple. But so far, so good. Reward-based crowdfunding has been around for more than half a decade and it’s been free of scams to date. Kickstarter, begun in 2009, has funded $1 billion in projects without any scandals.

The government should have one set of rules for all investors. If I made $200,000 in the last two years, I’m smart enough to invest with minimal restrictions. But if I make $150,000 this year, I guess I’ve taken stupid pills and need more protection. REALLY?

This is sheer nonsense. Give us a “one size fits all” regulatory regime, because everybody is prey, rich fools and poor fools alike. And everybody also deserves a chance to hit it big, making investments they feel they can afford.

Correlating our intelligence, risk tolerance and investing acumen to the thickness of our wallet is the worst kind of elitism and plain stupid to boot.