The "JOBS" Act and the Capital Raising Process (Crowdfunding and the Consequence of Gambling)

Crowdfunding embraces the notion that unaccredited investors with modest means should be allowed to invest in unregistered offerings.  The exemption, however, provides investors with little information about the company, often leaving them uninformed when they make the investment.  Some have likened the approach to gambling.  The saving grace was supposed to be that these investors could only invest a small amount of money and therefore wouldn't see their financial condition impaired in the event that the investment turned out to be fraudulent or quickly failed. 

But in fact, the crowdfunding exemption included in the JOBS Act is not limited to amounts that investors can afford to lose.  The provision allows those with an income or net worth of less than $100,000 to invest up to 5% of that amount or $5000 every year.  For those with a net worth or annual income above $100,000, they can invest up to 10% of that amount or up to $100,000 during any 12 month period.  The amounts will go up since the SEC is required to adjust them at least every 5 years in accordance with the Consumer Price Index.  See Section 4A(h) ("Dollar amounts in section 4(6) and subsection (b) of this section shall be adjusted by the Commission not less frequently than once every 5 years, by notice published in the Federal Register to reflect any change in the Consumer Price Index for All Urban Consumers published by the Bureau of Labor Statistics.").  In other words, investors over time will be allowed to invest annually more than $100,000.

Moreover, in computing income and net worth, the exemption contains no definition of the terms.  Instead, the exemption references the approach taken with respect to accredited investors.  Neither term is defined in Rule 501 of Regulation D.  Moreover, the SEC took a flexible approach with both terms, using high dollar thresholds for accredited investors as the primary mechanism for preventing abuse.  The same approach, however, does not work in the context of crowdfunding.   

While the term income is not defined, it was intended to apply to gross, rather than net, income.  As a result, the amount need not be reduced by the taxes paid or deductions taken.  See Securities Act Release No.  6389 (March 8, 1982) ("The test [for income] is no longer keyed to the federal income tax return. . . . Also, the term 'adjusted gross income' has been changed to 'income'. Use of the term 'income' will permit the inclusion of certain deductions and additional items of income which, as noted above, were excluded in the proposed concept of adjusted gross income.").  The term does not include for the most part unrealized capital appreciation but otherwise includes most if not all sources of income.  See Securities Act Release No. 6455 (March 3, 1983) (unrealized capital appreciation generally cannot be used in calculating income for purposes of the accredited investor standard). 

In other words, someone with $100,000 in gross income will be allowed to invest $10,000.  Yet the possibility that someone with a gross income of $100,000 can afford to lose $10,000 is small.  Moreover, the amounts used by investors of modest means to invest in crowdfunding ventures will probably result in other expenditures foregone.  Since rent, taxes, food, etc. cannot be eliminated, one has to wonder whether the amount invested in crowdfunding will result in a reduction in contributions to retirement plans.  Given the risks involved in crowdfunding (remember the analogy to gambling), swapping funds in this way will probably not be beneficial for investors of modest means in the long run.

But even those with income of far less than $100,000 will be eligible to invest $10,000 or more in crowdfunding ventures because the test turns not only on income but also on net worth.  Again, net worth is to be computed consistently with the approach used for accredited investors and again the term is not defined.  See Securities Act Release No. 9177 (Jan. 25, 2011) ("Neither the Securities Act nor our rules promulgated under the Securities Act define the term 'net worth.' The conventional or commonly understood meaning of the term is the difference between the value of a person's assets and the value of the person's liabilities.").  In adopting the net worth standard for accredited investors, the SEC allowed all assets to be included.  See Securities Act Release No. 6455 (March 3, 1983) ("Rule 501(a)(6) does not exclude any of the purchaser's assets from the net worth needed to qualify as an accredited investor."). 

In adopting a broad notion of net worth, the Commission deliberately decided not to take into account complicated issues surrounding the concept.  The Commission knew that this would allow investors to effectively overstate their real net worth but chose to address the concern through a high net worth amount.  See Securities Act Release No.  6389 (March 8, 1982) ("Some commentators, however, recommended excluding certain assets such as principal residences and automobiles from the computation of net worth. For simplicity, the Commission has determined that it is appropriate to increase the level to $1,000,000 without exclusions.").  

For persons with more modest means, however, this ability to "overstate" their net worth allows them to invest amounts that in fact they cannot genuinely afford to lose.  Thus, if they make $25,000 a year in gross income but have a net worth of $100,000, investors will be allowed to invest $10,000 in a crowdfunding venture.

How might someone with such modest income meet the $100,000 net worth standard?  They cannot use the appreciation in their principle residence.  Congress in Dodd Frank commanded that this amount be excluded from the calculation of net worth for accredited investors.  See Rule 501(a)(5) of Regulation D.  But as long as they borrow the equity appreciation (in the form of a second mortgage) more than 60 days before the purchase, they can count the loans as an asset.  Moreover, net worth can include their 401(k)/IRA, their car, their furniture, appreciation in property that is not a primary residence, and any other asset.  As a result, it will likely not be difficult for people with very modest means to have the ability to invest large amounts that they cannot afford to lose. 

In short, the dollar thresholds contained in the crowdfunding provision allow investors of very modest means to invest amounts that are beyond what they can afford to lose.  Moreover, the amounts invested may well result in a reduction in contributions to retirement plans, something that may have long term harmful consequences. 

J Robert Brown Jr.