Crowdfunding Bill Paves Way for Fraud: NASAA

House panel to allow voting on bill exempting crowdfunding from state oversight

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Entrepreneurs are ecstatic. State regulators, not so much. Rep. Patrick McHenry, R-S.C., introduced a bill touted as a job creator that would allow would-be business founders to finance their startups through crowdfunding, a medium that has been used for thousands of projects already, albeit predominantly for such artistic ventures as new CDs or films—with financiers contributing small amounts and often getting nothing larger than a CD or t-shirt, if anything, in return for their investments.

H.R. 2930, the Entrepreneurial Access to Capital Act, however, could change all that—and already the alarm bells are ringing. The bill, introduced in September, was approved by the House Financial Services Committee and is heading for a vote, but its controversial removal of an SEC rule that makes it more difficult for companies to raise money through small contributions has state regulators seething.

Under the terms of the legislation, new business entities could use crowdfunding to raise and combine donations of up to $1 million and not have to register with the SEC.

McHenry, who sponsored the bill, said of the measure in a report in The Hill, "Outdated regulations are getting in the way of innovative ideas making it from the dinner table to the production line. This legislation will give small businesses and entrepreneurs access to the capital they need to expand, compete and—most importantly—hire."

The North American Securities Administrators Association (NASAA), however, is not so sure, and says that while the committee did beef up the investor protection provisions of the bill, "it left a massive hole in the investor protection safety net by refusing to remove Section 4 of the bill, which specifically and unnecessarily pre-empts state law for the new crowdfunding exemption created under the legislation."

NASAA President Jack Herstein said in a statement, “The key to protecting investors is to be able to act before a fraudulent offering is made, not after the fact when the con artist and the investor’s money have disappeared. From an investor protection standpoint, the best solution is to simply drop Section 4 from the bill.”

Herstein pointed to what he calls a similar mistake in the approval of the National Securities Markets Improvement Act of 1996, which pre-empted states from reviewing private placement investments made under SEC Rule 506 of Regulation D.

The use of the exemption in Rule 506 has increased substantially, he said, and so has the danger to investors. He likened H.R. 2930 to the NSMIA, and said that state regulators were far better positioned to regulate small businesses like those expected to use crowdfunding.

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