In May, Regulation Crowdfunding (Reg CF or equity crowdfunding), an innovative law that opened the private capital markets to everyone, turned seven years old. In this short time, it has gone from regulatory stepsibling to regulatory success.
The journey has not been smooth.
From its start in the JOBS Act of 2012, critics including state and federal regulators, associations, and some politicians, attacked equity crowdfunding as an unwise and unneeded tool that would attract scammers whilst leaving John Q. Public holding the bag.
Indeed, the Securities and Exchange Commission so opposed Reg CF it took four years to produce the regulations, heaping loads more issuer requirements.
The SEC eventually saw Reg CF as a regulatory success
But after four years of relatively smooth sailing the SEC reversed course. In 2020, it acknowledged the predicted fraud tsunami had not occurred and loosened the rules, making the Reg more investor and founder friendly. This combined with rising interest in online investing because of the pandemic has meant seven years hence, Reg CF has become a regulatory success.
1.7 million investors have invested over $1.8 billion into over 4,100 startups and small businesses across 1,700 cities in the US.
Companies that have successfully raised via Reg CF are now valued at over $60 billion.
Reg CF has contributed approximately $4.7 billion to the overall economy through salaries, inventory, rent, professional services, and various operational expenses.
Besides the raw numbers, Reg CF has performed a social good by allowing entrepreneurs access to capital who were traditionally outside the venture capital pipeline. According to CCA, “women and minority entrepreneurs (that routinely struggle to access capital) have had greater success within Investment Crowdfunding and are raising up to 50% of the capital.”
Securities professionals help keep Reg CF a regulatory success
But Reg CF critics weren’t completely wrong. As with any investment endeavor, there are risks for founders and investors. Founders new to the startup grind may overpromise, choose the wrong security, or fail to disclose material information to investors. Ordinary people investing in startups for the first time may not realize the mechanics of liquidity, valuation, or disclosures. And of course, many startups fail, and investments are lost. If not properly configured, founders could face liability from both investors and authorities. In 2021, the SEC brought its first charges against an issuer and funding portal alleging fraud.
That is why it is so important for Reg CF companies to hire counsel to guide them through the process, file the proper paperwork and advise founders on issues of portal selection, financial instrument, valuation, disclosures, investor communications, and more.
The Reg CF revolution is just beginning. As more companies realize the benefits of democratizing capital raising to include their loyal customers and brand ambassadors, the numbers will keep growing. As younger generations already accustomed to transacting online become founders and investors themselves, the days of wooing Silicon Valley VCs in haughty boardrooms instead of one’s own crowd on Twitter or TikTok may end.
Wherever the Reg CF journey goes, its best days are ahead.
As Elizabeth Holmes, the disgraced founder of Theranos, tries to rehabilitate her image and stay out of jail, the story of her meteoric rise and fall keeps reverberating through startup world.
Wall Street Journal reporter John Carreyrou initially broke the story of Theranos’ shady practices in 2015. He later wrote the definitive account of the entire saga in the best seller Bad Blood.
For those familiar with the Theranos story, the book doesn’t provide any new revelations, but it does explain, in sharp detail, the many, and in hindsight, obvious, mistakes Theranos made during its short time as Silicon Valley’s hottest startup.
Here are five lessons startup founders should take from the downfall of Theranos and Elizabeth Holmes as described in Bad Blood.
Do the damn work: One obvious takeaway from Bad Blood was how far Holmes’s ambition exceeded her willingness to become proficient in her field. She majored in chemical engineering at Stanford, but famously dropped out after two semesters. When presenting to investors and later at conferences and talks with fawning attendees she spoke in airy terms about “changing the world.” This sentiment along with her arresting facial features and cultivated image worked most of the time. But on the rare occasions she pitched to technically competent audiences her charm quickly turned to hostility and the meetings abruptly ended. Of course, Theranos hired scores of technicians with impressive credentials, but Holmes never allowed them the time needed to produce the machine that would fulfill her vision (or even fully investigate whether it was technically possible.)
Choose your team carefully: Another obvious Bad Blood takeaway is the impossible management structure at Theranos. Holmes ran the startup with her erratic boyfriend and live-in lover Sunny Balwani. The couple apparently kept their relationship secret from the board of directors. Throughout the book, Carreyrou portrays Balwani as a toxic tyrant prone to sudden outbursts who fired people near daily. The poisonous management situation resulted in constant turnover where no one from upper management to low-level technicians was safe from unwarranted tirades. This atmosphere contrasts with the ‘we’re-saving-the-world’ sentiment expressed at company parties and all-hands meetings. Perhaps it would not have mattered in the end, but the unease Balwani’s omnipresence provoked negated any chance Theranos would ever fulfill its mission.
Never lose sight of the mission: Elizabeth Holmes’s goal was to become famous, she wanted to be the female Steve Jobs—a force of nature whose sheer will could mesmerize crowds and whose ideas could change the lives of billions. In at least one respect, she got her wish. Whilst PhDs slaved away under Sunny Balwani’s tyrannical gaze, Holmes’ star rose. Particularly, after going “live” with the Walgreens partnership, her life seemed to consist of unending talks, glowing profiles, and conferences. Holmes, with a security detail fit for a president, constantly schmoozed VIPs. Celebrity can be intoxicating but unless it’s earned, it’s worthless. A founder’s main duty is to her investors/shareholders. Holmes treated this cohort as an expendable ATM. The Theranos board, despite numerous warnings, also failed to guard shareholders’ interests.
Don’t lie to people: Fraudsters exist in every industry. But the amount of lies that Holmes told was stunning. She lied about the technology, the reliability of the machines, the use of commercial analyzers, the patents she filed and so on. She and Balwani relied on NDAs, legal threats, and the omnipresent “trade secrets” whenever lies were exposed. The inability to level with anyone including shareholders, employees, media, business partners, regulators, and eventually medial patients was stunning. The mantra ‘fake it until you make it’ popular in Silicon Valley can’t mean blatantly lie to everyone and hope everything works out. The Theranos situation was worse than most because people’s actual lives were at stake, but a clean conscience is good policy for any founder.
Never run when you’re right. The last lesson applies to everyone who discovered the rampant deceit at Theranos. The media portrayed lab technicians Tyler Schultz and Erika Cheung as the heroes of the story. No doubt their courage in the face of unrelenting bullying by lawyer David Boise and his hatchet team deserves plaudits. But what is striking is how many people stood up to Holmes and Balwani. Holmes fired her CFO immediately when he warned her not to lie to potential investors. A lab manager and medical doctor provided the first proof to Carreyrou that something was awry. One scientist even committed suicide. Outside the company, as well, numerous people refused to be taken in by Holmes’s charm. A consultant hired by Walgreens repeatedly warned the company things did not add up. A regulator held his ground in the face of a four-star general who tried to fast-track Theranos machines to fields of combat. Even people at Theranos’ PR firm tried to warn their superiors. In the end, all these people came out of the affair with their integrity intact.
Will the Theranos debacle change anything? Probably not, larger investors may demand more proof before entrusting millions of dollars to charismatic, messianic founders. But then again maybe they won’t. As hype surrounding crypto reached a fever pitch, VCs lined up to back fraudsters like Sam Bankman-Fried and Do Kwon.
In the end, the human desire to be seen as virtuous combined with the human trait of greed will usually supplant the business need for boring, forensic due diligence. But that doesn’t mean individual startup founders can’t take the lessons of Theranos to heart, particularly if they’d prefer not to share a prison cell with her.
SEC Small Biz Committee: Liquidify the private markets
The SEC Small Business Capital Formation Advisory Committee (SBCFAC) has thrown down the gauntlet. Per the SEC’s website, the SBCFAC, was established by the SEC Small Business Advocate Act of 2016, and is designed to provide a formal mechanism for the Commission to receive advice and recommendations on Commission rules, regulations and policy matters relating to small businesses, including smaller public companies. It’s latest meeting produced a clear message: it’s time to start providing liquidity in the private markets.
The onus is now on the full commission, flush with two new members, Mark T. Uyeda and Jaime Lizárraga, to heed their advice. Ten years after President Obama signed the bipartisan Jumpstart Our Business Startups (JOBS Act of 2012) that invited everyday Americans into the lucrative private capital markets, the work remains half done at best. Two JOBS Act titles, Title III, which became Regulation Crowdfunding (Reg CF) and Title IV, which drastically improved Regulation A (Reg A+) have shown the success of deregulation. The two titles enabled a paradigm shift in private company investing by allowing startups and small businesses to accept investment from retail investors. Reg CF caters to smaller and younger companies with a 12-month offer limit of $5 million. More mature companies use Reg A+, which couples higher SEC scrutiny with a 12-month offer limit of $75 million.
SEC expanded the private markets in 2021, but it must do more
In March 2021, the Commission expanded JOBS Act provisions that freed more capital. But issues remain. First among them is the lack of liquidity in the secondary market—where initial purchasers resell shares. The SBCFAC tackled that problem this month by reviewing the lack of secondary trading state preemption for both Reg CF and Reg A+.
The meeting opened with Commissioner remarks. Commissioner Hester Peirce spoke about how secondary market liquidity and investor protection complement, not oppose each other. “Secondary market liquidity marries capital formation and investor protection consideration. Issuer’s ability to raise capital turns in part on whether purchasers of their securities will enjoy strong secondary market liquidity.”
When presentations began, Ryan Feit, CEO and co-founder of crowdfunding portal SeedInvest relayed the frustration investors feel from their illiquid investments, even when values rise due to follow on rounds at higher per/share prices. “[W]hat happens is many startup and small business investors get burned out quickly. They make an investment or a few, and they’re excited about it, and then they actually realize that I might need to wait five to ten years to get any return out of this.” This ultimately leads to less capital for newer projects and ultimately good ideas not being funded.
SEC Small Biz committee members know stagnant secondary markets hurt the economy
Sara Hanks, a noted securities practitioner and SBCFAC member spoke about the tedious nature of complying with state-by-state regimes, which differ in fee structure, timing, notice requirements and the like. She mentioned possible solutions in the JOBS Act 4.0 Congress is currently considering.
Indeed, CEI filed comments in June on the JOBS Act 4.0 focusing on the importance of preempting state securities processes for secondary trading among a bevy of other proposals to improve private capital.
SEC Small Biz Committee member NASAA hates the private markets
Opposing any measure to provide private-market liquidity was a representative from the North American Securities Administrators Association (NASAA). This trade organization advocates for state-level securities agencies. The NASSA customarily opposes all access to private capital markets for retail investors and promotes additional burdens for accredited investors. It staunchly opposed the JOBS Act, filing numerous statements, comments, and press releases. At one point describing it as “an investor protection disaster waiting to happen.” Two members (Montana and Massachusetts) sued the SEC to stop implementation of Reg A+ with the NASSA in support as amicus curiae. They lost.
But this did not deter the committee, at least for Reg A+. They voted 9-1 in favor of a pilot program for Reg A+ to preempt state securities laws for secondary trading. The ball is now in the commissioners’ court. According to JD Alois of Crowdfund Insider, the committee should be “submitting a formal recommendation to the Commission in the coming weeks that outlines the need for preemption for Reg A+ securities.” The time has come for the SEC to act for small businesses. And Congress should complement this move by passing the JOBS Act 4.0.
The crypto world is recoiling under massive headwinds. Regulatory uncertainty and the current market downturn, including the spectacular crash of TerraUSD, has left the industry reeling. But while market corrections can shakeout unworthy projects and redirect capital more efficiently, unclear guidance about the rules is intransigent. Myopic federal guidance, particularly from the Securities and Exchange Commission (SEC) has hamstrung crypto development for years and hopes for a resolution exist but seem dim. Now the SEC kills crypto.
It didn’t have to be this way.
Four years ago this week, SEC Corporation and Finance Director Bill Hinman spoke at a San Francisco crypto summit and offered a path forward. Recognizing the emerging industry’s potential entanglement with securities laws, Hinman asked, “Can a digital asset that was originally offered in a securities offering ever be later sold in a manner that does not constitute an offering of a security?”
He tentatively said yes, if the project was sufficiently decentralized. “If the network on which the token or coin is to function is sufficiently decentralized – where purchasers would no longer reasonably expect a person or group to carry out essential managerial or entrepreneurial efforts – the assets may not represent an investment contract [security].”
Hinman halted the SEC killing crypto
Developers rejoiced dubbing his remarks the “Hinman Test.” Decentralization can be a messy concept that needs further clarity. But Hinman seemed to offer a way forward that captured crypto’s peer-to-peer ethos while prosecuting fraud.
Four years hence, crypto’s rules are less certain than ever and Hinman’s words are the subject of a vicious legal battle. The hope for a straightforward regulatory pathway for crypto is all but forgotten.
Even amid Hinman’s speech, then-SEC Chair Jay Clayton’s tenure lacked focus. A year after the Hinman Test, the SEC produced further crypto “guidance” so impenetrable Commissioner Hester Peirce likened it to a Jackson Pollock painting. Clayton also greenlit the Ripple/XRP litigation on his last day, which has become the SEC’s most arduous crypto battle.
Current Chair Gary Gensler has replaced Clayton’s vacillation with outright hostility. Gensler has unleashed a torrent of legal actions against crypto project developers like LBRY and doubled down on the Ripple case,projects with happy user bases and no hint of fraud. He’s called for plenary authority over crypto and hired scores more attorneys to evaluate each project under the vague and famously malleable Howey test. And he’s threatened virtual marketplaces like Coinbase, while forcing BlockFi and Celsius into fines and settlements to avoid protracted legal battles.
Gensler’s SEC kills crypto
Cynics claim Gensler’s “enforcement only” approach and attendant industry ire is worth the trouble to bolster his profile for ever higher government posts. Regardless of motivation, the results have immensely damaged this century’s most promising technology.
Observers inside and outside the Commission have offered alternatives to the Clayton-Gensler quagmire. Commissioner Peirce has suggested a regulatory sandbox. Academics have offered various solutions including a state-led regime. Senators Kirsten Gillibrand (D-NY) and Cynthia Lummis (R-WY) proffered a legislative solution. None seem likely to be enacted soon.
For now, the judiciary offers the only refuge from the SEC’s regulatory onslaught. Ripple along with individual defendants Brad Garlinghouse and Christian Larsen have cornered the SEC into unforced errors and shifting justifications as discovery battles intensify before trial.
Ripple case shows SEC crypto hostility
Most prominently, the SEC’s turn from Hinman’s speech and the SEC’s unwillingness to reveal the intra-office machinations surrounding it has begot Amber Heard-like court performances. Magistrate Judge Sarah Netburn has grown increasingly frustrated with the SEC’s obduracy.
At one point during a hearing last week she sarcastically directed the SEC lawyer to pull up the speech and explain which parts were Hinman’s personal opinion and which were SEC policy, as the commission darts to-and-fro to avoid yielding information to opposing counsel.
Ripple has the resources to fight a protracted battle that may end at the Supreme Court. The Commission rarely faces spirited opposition, as years-long investigations followed by expensive litigation crush adversaries well before a ruling on the merits.
SEC is losing Ripple crypto case
For once the SEC seems to have the losing hand and not just in the Ripple litigation. Mr. Gensler’s reportedly abrasive style has caused a mass exodus of top-level personnel. The Fifth Circuit recently ruled its administrative law judge system of adjudication that denies defendants a federal court venue is unconstitutional in certain circumstances.
For the crypto world building the next generation economy, the SEC’s troubles are its gain. The industry should use the Crypto Winter to exert maximum pressure on Gensler. Reviving the Hinman Test – and actually applying it consistently – would be a start.
The attention of financial regulators in the US and globally seems focused on issues far afield from the core mission at a time when turmoil is roiling global markets. Inflation is at 40-year highs and the public is overwhelmingly concerned with pocketbook issues. Yet financial regulators seem fixated on carbon emissions and potential global temperatures decades hence. They should refocus on their core mission and leave environmental concerns to the political branches.
In one sense, the dodge is understandable. To discuss the current inflation crisis is to expose the embarrassing faux pas of those tasked with financial stability. Both Treasury Secretary Janet Yellen and Federal Reserve Chair Jerome Powell have meekly backtracked on prior statements about inflation’s cause and their expertise in containing it.
Conversely, discussing carbon-emission risks to the financial system that may materialize in the distant future yields glowing press and applause at international conferences.
Treasury Secretary Janet Yellen focuses on climate not finance
Secretary Yellen has taken the lead in her role as chair of the Financial Stability Oversight Council (FSOC), a product of the Dodd-Frank law. The council has extraordinary power to bypass Congress and act unilaterally to address “emerging threats” to US financial stability. In her first FSOC meeting Yellen called climate change an “existential threat.” And she urged a “rapid transition to a net-zero carbon economy.”
Federal Reserve chair Jerome Powell echoed Ms. Yellen’s sentiment, “One of our goals is to make climate change a part of our regular financial stability framework.”
Global Financial Regulators Fetishize Climate
Global financial regulators agree. In a July 11 speech Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision for the Bank for International Settlements (BIS), the global central banking authority, spoke in strikingly similar terms. Mr. Hernández de Cos described “a growing consensus that climate change is the most existential [challenge]” the world now faces. He too pushed for “Net Zero” carbon emissions citing the Glasgow Financial Alliance for Net Zero and the Net-Zero Banking Alliance.
The consequences of inaction would be dire warned Mr. Hernández de Cos. This includes a 1.5-degree Celsius rise in temperatures this century. He concluded his remarks citing the critical need for global cooperation and the necessity to hear from “a broad set of external stakeholders.”
The Public Cares about Finance not Climate
Those stakeholders apparently do not include the public, which must bear the brunt of the global climate push. The most obvious current stakeholders are the protesting Dutch farmers whose livelihoods are jeopardized from climate-related regulations.
In a recent poll, Americans placed economics at the fore of their concerns. The AP/University of Chicago poll found the top five concerns: 1. Inflation; 2. Gas prices/energy costs; 3. Gun issues; 4. Immigration; and 5. The Economy. Environment/climate change placed seventh at 17 percent—a four percent drop since December.
Financial Regulators’ Climate Fetish distracts from Crypto
Regulators’ climate fetish also threatens cryptocurrencies, which authorities already view suspiciously because of their decentralized, private nature. Earlier this month, researchers at the European Central Bank opined the European Union will likely ban Bitcoin. Even though assumptions about this topic usually come littered with fallacies. Financial regulators should focus on their core mission of financial stability and leave climate concerns to the political branches. As Agustín Carstens, head of the BIS stated last year, financial regulators core mission is to “do no harm” to their country’s monetary system or the citizens within it. Yet financial regulators’ climate fetish is doing just that at a time when their attention is urgently needed elsewhere.
Crypto insiders lauded Gary Gensler’s nomination to chair the Securities and Exchange Commission (SEC) last February. The MIT professor who had taught blockchain classes would bring an enlightened approach to crypto compared to the scattershot, perplexed style of his predecessor Jay Clayton. But a year in the professor gets an F in crypto guidance and leadership. He has encouraged the worst bureaucratic instincts of the federal government, deepened regulatory confusion, and thwarted any hope of progress during his tenure—all whilst claiming the mantle of little-guy defender and public-interest protector.
Cynics contend this cabal comprise his real audience; those that can help the uber ambitious Gensler climb the bureaucratic ladder to Treasury Secretary or beyond. But even without questioning his motives, his tenure related to crypto has been a farce.
Gensler analogizes his role to that of football referees. “Imagine a football game without referees. Without fear of penalties, teams start to break rules. The game isn’t fair and maybe after a few minutes, it isn’t fun to watch.” Yet the dystopian present he has fomented invites a different analogy: The referees are the only ones who know the rules, won’t tell the teams what they are, but still call a penalty on every play—the players discovering ex post facto the play was verboten.
Former acting Comptroller of the Currency, Brian Brooks, described the scene recently in Congressional testimony: “What happens in the United States is you have a new crypto project and you walk into the SEC and you describe it in great detail and you ask for guidance and they say we can’t tell you and you list it at your own peril.”
Crypto doesn’t want Professor Gensler’s protection
This is particularly disheartening when the teams have plays the fans want to see. Although Gensler couches crypto edicts in protecting the populace against scams, many high-profile cases the SEC has prosecuted during his (and his predecessor’s) tenure had active, happy user bases. Kik, Telegram, and ongoing cases against LBRY and XRP/Ripple focused on selling “unregistered” securities via a security type (investment contract) absent in the federal code and defined through a three-part test by the Supreme Court a year after WWII ended.
Lawyer James Burnham opines the current Supreme Court zeitgeist would likely preclude such broad administrative diktat on crypto absent new Congressional mandate. But such agency reprimand would require a company spend gargantuan legal fees and endure years of litigation for even the chance to argue the case. The Commission understands its ability to bleed belligerents dry and force settlements before they obtain meaningful judicial review. As it stated in its 2018 budget request: “[T]he SEC’s litigation efforts also help the SEC obtain strong settlements in other cases by providing a credible trial threat and making it clear that the SEC will go deep into litigation and to trial, if necessary, in order to obtain appropriate relief.”
For his part, Gensler has directed the Enforcement Division to discourage meetings with investigatory targets and eliminate “unnecessary process.”
Professor Gensler is not serving the public interest
Commissioner Hester Peirce described a previous era of “broken windows” theory compliance at the SEC as the “Sanctions” and Exchange Commission. Now it may better be labeled the “Sanctions and Enforcement” Commission.
Under Gensler, the SEC has declared a permanent crypto war. It has refused to approve any Bitcoin spot Exchange Traded Products despite myriad applications, new projects are refused guidance and told to take their chances, and the Chair recently gave a speech one commentator called the “the most aggressive and hostile stance re U.S. crypto regulation to date from the SEC.” An SEC this stroppy to crypto innovation may serve entrenched interests in Washington and other global financial destinations. It does nothing, however, for the American public. Those that think otherwise should go back to school.
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