Investment crowdfunding is a young industry, but it holds great potential to channel desperately needed capital to the nation’s small businesses. However, this potential has been stunted by outdated federal securities regulations and the SEC’s reluctance to fully implement the JOBS Act. As a result, equity crowdfunding is predominantly restricted to a small percentage of the population: the 8.5 million Americans that meet the wealth requirements of today’s accredited investor standards. And the SEC is considering revisions that may cut that number by at least half.
In response, a growing number of states have enacted laws allowing for “intrastate” crowdfunding, where companies based in a state can raise capital from any resident of the state, regardless of their net worth or income. As a result, many states now offer broad opportunities for small businesses to tap into their local communities for capital. However, the intrastate crowdfunding platforms are very new, don’t offer liquid investments, and consequently have very low volume.
How can crowdfunding be made a viable part of the small business capital landscape without opening the doors to fraud and unnecessary risk?
The most powerful step would be for the SEC to fully implement the crowdfunding regulations called for by the JOBS Act, in a way that is sufficiently flexible to allow more capital flow from investors to small businesses. In the meantime, the best way forward might be to make it easier for people to invest through intrastate crowdfunding. One way to do that—as I proposed in a white paper I authored for R Street Institute earlier this year—is by using a legal framework that already exists: the 401(k) account.
A new regulation would establish a “safe harbor” for up to 10% of an investor’s account, if used to buy liquid securities that are properly regulated by the state.
Most small investors do their investing through employer-sponsored 401(k) plans—Americans hold more than $4 trillion in such accounts. 401(k) plans offer a regulatory and administrative structure that allows average investors to access relatively complex investments easily. In addition, plan administrators and sponsoring companies are required by ERISA (the Employee Retirement Income Security Act) to be fiduciaries—any investment options they provide must meet the “prudent investor” rule.
In practice, this usually means investing in SEC-registered securities like stocks, bonds, or mutual funds. (If you set up your own self-directed 401(k) or IRA, you can invest in many other things including crowdfunding; but doing so is expensive and cumbersome, and most people don’t want the hassle.) So there needs to be a way for crowdfunding to satisfy the Prudent Investor Rule; otherwise, plan administrators won’t take the risk of being sued if people lose money in an “imprudent” investment.
Here’s how it would work. A new regulation would establish a “safe harbor” for up to 10% of an investor’s account, if used to buy liquid securities that are properly regulated by the state. A safe harbor means that any investments that satisfy the regulations can be presumed to be prudent, freeing administrators from legal jeopardy if the investment goes bad. That way, we can neatly sidestep the SEC’s intransigence (although it would require cooperation from the Department of Labor, which administers ERISA, and possibly the IRS).
Note that such a rule change requires that the investments be regulated by the state, and that they be liquid. At the moment, almost no intrastate crowdfunded investments have a secondary market (although Michigan passed a law allowing their creation).
Practically speaking, it would take some time for the first dollar of 401(k) assets to be directed to a local crowdfunded security, even if the rule change were to take effect immediately. Plan administrators need to set up investment vehicles that allow their participants to invest easily. Even then, the magnitude of direct investments is likely to be small. Early adopters likely would not be the largest plan administrators like Fidelity or Vanguard, but niche administrators seeking to appeal to employers owned by crowdfunding or local investing enthusiasts.
Yet such a rule change could have a profound ripple effect. It would encourage state officials and private companies to improve their intrastate markets and infrastructure, allowing for more liquidity. We would likely see the emergence of mutual funds focused on local, intrastate securities. And improved regulatory frameworks would allow investors to better screen for high-quality companies.
Once again, the states could be the laboratories of democracy—enabling the creativity and experimentation that are at the heart of the American Dream.
Of course, this proposal may be just a stopgap until federal regulators catch up with reality. The American crowdfunding industry is already falling behind that of the United Kingdom, which has far more reasonable crowdfunding regulations and a broad marketplace of investments to which ordinary people have access (including from their retirement accounts).
Still, allowing 401(k) plans to invest in state-regulated crowdfunding would be a start. And besides, as readers of this site well know, investing in local businesses has its own virtues. Perhaps we will soon see the return of thriving local securities exchanges, where ordinary people can once again put their savings to work in their own communities.
Dr. Oren Litwin is an associate fellow of the R Street Institute. He has worked in financial advising and investment management for more than a decade, most recently as part of the AIG Advisor Group. He currently teaches at the United States Naval Academy in Annapolis, MD.
Main photo courtesy of gotcredit.com.