State regulators battle for grip over crowdfunding

Tue Nov 1, 2011 3:39pm EDT

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(Reuters) - State regulators are inching closer to having some influence over securities offered through "crowdfunding," a strategy they say has the potential to spawn a wave of investment frauds.

U.S. lawmakers on Wednesday revised a bill to allow crowdfunding, a capital-raising strategy that lets investors buy small stakes in start-ups through Internet sites.

Changes include requiring issuers to give notice to the Securities and Exchange Commission about new offerings. The SEC would then pass those details along to state regulators, a measure that could help protect investors against scams.

Crowdfunding isn't a major problem for regulators yet because securities typically aren't sold through the sites. But allowing those sales would likely attract con artists, said regulators.

The changes are encouraging to state regulators, who say they could use the details to ferret out bogus deals. However, the North American Securities Administrators Association, or NASAA, says it still doesn't give states enough authority.

The bill, proposed by Republican Representative Patrick McHenry, would continue to bar state regulators from requiring the offerings to be registered first. Registration would let regulators review offerings to see if they meet standards for sale in their states.

"There would at least be a gatekeeper before they unleashed it on the public," said Joseph Borg, director of the Alabama Securities Commission.

BATTLING FOR AUTHORITY

Crowdfunding is another chapter in state regulators' fight against a 15-year-old law that exempted some securities, including private placements often issued by start-ups from state registration laws. The National Securities Markets Improvement Act of 1996, or NSMIA, aimed to streamline the registration process for those securities, since navigating 50 different state laws and processes can be unwieldy.

"The argument that complying with state regulation is expensive and inconvenient is a poor argument," said Heath Abshure, commissioner of the Arkansas Securities Department. Small business investment usually involves local projects, he said. Investors often call state regulators if there's a problem, he said.

State regulators have been on the front lines in dealing with investor losses in scams involving private placements, another unregistered security that was exempted from state registration laws, he said. Still, the safety net is stronger since private placement investors have to meet certain income and net-worth thresholds that won't apply in crowdfunding, said Abshure.

The House bill, which would allow small businesses to receive up to $2 million and investors to donate up to $10,000, now heads to the full House of Representatives. NASAA is hoping for other changes there that will give states more clout. Lawmakers are continuing to discuss the state's concerns.

FREE YOGA CLASSES

For regulators, the effort is more preemptive than reactive. Most crowdfunding sites are not yet in the business of offering investments for financial return. They started as a way to ask many people for small amounts of money - as little as $10 - to fund everything from documentaries to community projects.

A person typically posts a project on a crowdfunding website such as Peerbackers or Kickstarter for several weeks or months and sets a fundraising goal. Backers, often friends, send money through the sites, and typically receive a gift for their support. That gift is usually a small token thank-you, often a gadget or service, such as a free yoga class.

But sites are slowly garnering more notice and inquiries from backers interested in making money off the "investment", according to Sally Outlaw, president of Peerbackers, a crowdfunding site based in Jupiter, Florida.

Many sites are already discussing future fraud prevention measures to protect investors, such as conducting background checks of issuers, Outlaw said. The deals also happen in a "very public forum," with information about issuers and their investors available on the sites, she said.

Safeguards from site owners won't be enough, said Borg, the Alabama securities regulator, who likens the investor risk to online phishing scams, where fraudsters use official corporate logos to make requests for personal details look legitimate.

"It'll be like someone saying, "But they had the Citibank logo when they asked me for my password,'" he said.

(Reporting by Suzanne Barlyn; Additional reporting by Alexandra Alper; editing by Jennifer Merritt and Walden Siew)

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