Investment Crowdfunding Beckons

Why Investment-Based Crowdfunding Will Succeed

(Reprint of article originally published in early 2013)

By R.P. Burrasca

(Part 1 of this white paper explains why in spite of the doubters in the established financial community, the successful advent of equity-based crowdfunding is assured. Part 2 explores the specific reasons why crowdfunding is good for America’s small investor, while Part 3 explores what’s happened to our economy over the past 40 years. Part 4 posits that the emergence of crowdfunding as a business finance tool is not only good for the small investor, but also absolutely essential to the revitalization of American capitalism and the U.S. economy. Lastly, in Part 5, we explore why hostility to the concept of crowdfunding currently exists among many finance professionals, regulatory authorities and investor protection groups). (Updated August 27, 2013).

Part 1

Some time ago, one of my clients asked me to join her at the taping of a half-hour radio show during which she and her organization were to be featured. Her goal in agreeing to the interview was to publicize a conference that she’s sponsoring, one of the key segments of which was a presentation on “crowdfunding,” a topic of considerable interest these days to her followers.

I was asked to join her so that I could answer any crowdfunding questions that might arise during the radio interview since I was the scheduled speaker for that segment of the client’s conference. I was surprised, however, when I found myself confronted by a hostile interviewer who, after derisively dismissing the concept of crowdfunding, felt compelled to add that he had once “worked for the Wall Street Journal.”

Well, this got me to thinking: is the host’s view one that is shared by many other members of the traditional financial community? That is, is the concept of investment-based crowdfunding a non-starter as far as this group is concerned? And, if so, what’s behind this refusal to see it as a viable alternative to more traditional sources of financing?

WHY INVESTMENT-BASED CROWDFUNDING IS INEVITABLE

The financial industry’s incredulity notwithstanding, the general public’s eventual acceptance of investment-based crowdfunding as a viable investment alternative is not only desirable, but inevitable. Quite simply, at present there is no other investment alternative to which this country’s small investors can turn to potentially obtain both assured and decent returns. This is so because of the following:

• Looking back over the past decade, the existing markets for publicly-traded equities have not been kind to individual small investors and thus are no longer trusted by them.
• Exchange-listed publicly-traded companies can no longer compete effectively with privately-held ones.
• The municipal bond markets are in crisis and, consequently, unreliable and the yields in corporate bonds are failing to protect investors even against inflation.
• Treasuries, money markets and bank cd’s and accounts, both savings and checking, are producing historically low returns and are ineffective as a hedge against inflation.
• The current flight to gold is an unrealistic strategy for the small investor.
• Investment activity in the real estate markets, both residential and commercial, is increasingly being dominated by large private equity funds to the detriment of the individual small investor.
• Existing “alternative” investments are dominated by professional traders and expert collectors, are already mature and fully-valued, and provide no upside for the foreseeable future.

Looking Back Over the Past Decade, The Existing Markets for Publicly-Traded Equities Have Not Been Kind to Individual Small Investors and Thus Are No Longer Trusted by Them:

According to the most recent reliable data available, the percentage of American households invested in domestic stocks, including directly or through any other vehicle (e.g., mutual funds or exchange-traded funds), was 44.4% in 2012 (source: “2013 Investment Company Factbook”, Investment Company Institute ). Most of this investment resides primarily in qualified retirement accounts, either in IRA’s or in employer direct contribution plans.

Unfortunately, for more than a decade, the market in publicly-traded stocks has been dominated by traders, either those who are professionals working in a financial institution or a corporation or those few individuals who are savvy enough to understand and successfully trade for their own accounts. These types of individuals share nothing in common with the average U.S. individual small investor. Rather, the individual small investor is someone who relies on third parties to oversee his or her individual investment account and who is forced because of the purpose of the account (i.e., to create a nest egg to retire on) to hold the securities in that account for the longer-term to take advantage of what use to be, at least historically, the inevitable appreciation in the value of the stock. This, of course, is done in order to ensure steady growth so that the money will be there when the investor retires. Thus, during the interim period, the small investor is subject to the ups and downs, vagaries, whims and caprices of a market dominated by both the professional and individual traders who have different goals (e.g., flipping hundred, thousands or even millions of shares to lock-in a nickel or a dime per share). (See, “Investors Covert Ops Often End in Defeat” (Investment News, Editorial, October 14, 2012, which you can find here) for an excellent discussion of the pitfalls that await individual small investors when they try, for the most part unsuccessfully, to turn to day trading for profits).

Coupled with this is the fact that for the individual small investor the stock markets have, over the past decade, been incredibly volatile and have produced meager, if any, “real dollar” returns. For example, between January 1, 2000 and January 1, 2010, the Average Annualized Return of the S&P 500 was -1.25% and the Cumulative Return of the S&P 500 for the decade was -11.85% (see figure 1 below) .

Figure 1 (source: Forecast-Chart.com; http://www.forecast-chart.com/)

The Dow Jones Industrial Average performed no better. During the almost five-year period between October of 2007 and July of 2012 the DIJA suffered a decline of 921 points (i.e., it was 13930 in October, 2007 and had slid to 13009 by July, 2012). The ten year average wasn’t any better (see figures 2 and 3 below).

Figure 2 (source: Forecast-Chart.com; http://www.forecast-chart.com/)

Figure 3 (Macrotrends; http://www.macrotrends.org/)

At the same time that these indexes were failing to perform, the NYSE Composite Index produced a shockingly bad return of -21% . . . The worst performing index during that period was the Nikkei 225 Index with a return of -51%. The median return for all stock market indexes during this time period was -8%. The average return for the indexes over the 5 years was -9%. See figures 4, 5 and 6 below.

Figure 4 (source: Forecast-Chart.com; http://www.forecast-chart.com/)

Figure 5 (Source: Stock Market USA; http://stockmarketusa.blogspot.com)

Figure 6 (Macrotrends; http://www.macrotrends.org/)

But, you say, what about the NASDAQ 100? Everyone knows that that index’s performance has been spectacular over the past five years.

The problem with the NASDAQ 100 is that it is disproportionately weighted in favor of only a handful (i.e., half dozen) spectacularly performing stocks like Apple and Google (See, figure 7 below and “Nasdaq 100 May Soon Be Held Hostage To Apple, Other Tech Behemoths”, Huffington Post: Tech, March 9, 2012, reporting on a previous Reuters story, which can be read here).

Specifically, in the case of Apple, because of its gargantuan size [Note: at the time of this blog entry, Apple had a share price above $650 and a market cap of $633 billion; see figure 8 below] it “is making it difficult for Wall Street to get a big-picture view of the earnings and margins for other American corporations. As a result, some equity analysts are cutting Apple out of the frame—and finding a dimmer outlook for the broader market.” “Apple’s Size Clouds Market”, The Wall Street Journal | Markets, February 15, 2012, which you can read here.

While it is certainly possible that an investor could have a portfolio comprised solely of NASDAQ 100 stocks, given the lack of such a portfolio’s diversification, it would be a high risk strategy. If the tech industry were to “fall out of bed” for whatever reason (for example, Apple’s most recent setbacks: see “Apple Stock Spanked for Low iPhone 5 Sales” here; “Biz Break: Apple Continues to Drag Technology Stocks Lower” here; “Apple CEO Apologizes for Maps Flaws, Recommends Rivals” here; “Google Maps Announces a 400 Year Advantage Over Apple Maps” here “After Apple’s Apology, What’s Next for iOS 6 Maps?” here; and “Apple’s Invincibility Fades on iPhone Miss, Global Woes: Apple Inc’s Biggest Success Has Become its Biggest Risk Factor” here), this index could struggle or even plummet, and would much more closely resemble its less successful brethren. [Update: since first publishing this blog entry, Apple’s stock has fallen almost 25%, making me appear to be (at least to myself, LOL!) a bona fide financial genius!]

Without putting too fine a point on the issue, the evidence of underperforming equities worldwide is legion; see such articles as “Shanghai Stock Market Shows No Ten-Year Gain” , The Epoch Times, English Edition, January 9, 2012, which you can read here; “Dead Stocks Walking”, Smart Money Magazine, October 24, 201which you can read here; and “What Happened to Berkshire Hathaway?”, The Motley Fool, May 8, 2012, which you can read here, among others.

The point here is that, consequently, the “take-away” for any individual small investor who thinks for more than a minute about (and has a sense of) what has happened over the past ten years to publicly-traded equities is that the existing markets for these securities are not set up for him and are, in fact, “rigged” against him.

“The slick TD Ameritrade advertisement running on television shows an animated figure in night-vision goggles, zooming over stock charts, making a midnight strike on the markets while the rest of the world sleeps. He is a “trading assassin,”and now that he’s made a killing in his pajamas and bunny slippers, he can turn out the light and sleep soundly. Hardly.

Enticing individual investors to trade on their own is a dangerous game, especially in this complex and convoluted marketplace. It is hard enough for professional investors to beat the market. To suggest that individuals can do it as well as, if not better than, the pros is at best misguided, at worst a recipe for disaster. But the financial business is full of ads from discount brokers encouraging investors to trade on their platforms . . . .

‘It would be great if a broker would [be] more of someone who protects you from the market, rather than one who encourages you to take risk,’ Mr. Sussman said. ‘But they would have to come up with a new business model.'”

“Investors’ Covert Ops Often End in Defeat” (Investment News, Editorial, October 14, 2012, which you can find here). Also, see “After Facebook, More Fear of Stock Market” (New York Times, May 28, 2012, which you can find here) and “Investors Seeking Alternative Investments as Stock/Bond Mix Fails to Excite” (Investment News, October 17, 2012, which you can find here).

Exchange-Listed Publicly-Traded Companies Can No Longer Compete Effectively with Privately-Held Ones:

Exacerbating this situation is the fact that exchange-listed publicly-traded corporations can no longer compete effectively with privately-held vehicles for investment dollars given the ease of administration and enhanced return on investment that privately-owned companies enjoy. For example, in an article last year in The Economist (“The Endangered Public Company: The Big Engine That Couldn’t”, May 12, 2012), the author points out that exchange-listed public companies have had a difficult decade, battered by scandals, tied up by regulations and challenged by alternative corporate forms –

“. . . [D]uring the past decade, the title of a 1989 essay, “Eclipse of the Public Corporation”, by Michael Jensen of Harvard Business School, has turned out to be prescient. In 2001-02 some of America’s most prominent public companies imploded. They included Enron, Tyco, WorldCom and Global Crossing, which, before their demise, were admired. Six years later Lehman Brothers collapsed and Citigroup and General Motors turned to the government for salvation . . .

. . . Meanwhile, SOEs were growing in emerging markets, challenging the idea that public companies are the biggest fishes in the sea. Private-equity firms flourished in the West, challenging the idea that public companies are the best managed. And the rise of the Asian economies, with their legions of family-owned conglomerates, challenged the idea that they are best equipped to advance capitalism’s geographical frontier.”

The number of public companies has dropped dramatically in the United States and Europe — 38% over the past 15 years in the United States and almost 50% in the UK’s primary markets. Initial public offerings in the U.S. dropped from around 300 a year in the two decades preceding the turn of the century to approximately 80 last year (see figure 9 below).

Figure 9

Being a publicly-traded business doesn’t have the same kind of allure these days that it once had. For example, the average length that a venture capital-financed business is in the VC’s portfolio prior to a sale or IPO of the business has grown from an average of four years to, in some instances, more than 10 (see, “Globalizing Venture Capital: Global Venture Capital Insights and Trends Report 2011”, pg. 12, Ernst & Young, 2012) . In addition, the extraordinary regime of regulatory and governmental hurdles that these companies have to overcome creates the need to incur greater and greater expense associated with hiring competent advisers, including investment bankers, lawyers and accountants.

“Lawyers and accountants are increasingly specialized and expensive; bankers are less willing to take them public; qualified directors are harder to find, since even ‘non-execs’ can go to prison if they sign false accounts.”

The Economist (“The Endangered Public Company: The Big Engine That Couldn’t”, May 12, 2012).

Also, eclipsing the corporate form in general is the renewed interest in setting up new businesses in the form of some of the newer variants of the traditional partnership. While, unlike traditional corporations, traditional partnerships provide no corporate veil and thus expose the (general) partners to unlimited liability, the newer forms of partnership, such as “limited liability partnerships”, “publicly-traded partnershps”, “limited liability companies”, etc., do not.

“Now, thanks to three decades of legal reforms, partnerships can offer most of the benefits of listing, such as limited liability and tradeable shares. In America they also boast a big tax advantage: partnerships are liable for only one lot of taxes, whereas companies must pay corporate taxes as well as taxes on dividends.”

The Economist (“The Endangered Public Company: The Big Engine That Couldn’t”, May 12, 2012)

The result is that now more than thirty percent of U.S.-based businesses report annually to the IRS on a tax form other than the traditional corporate ones. Also, when it comes to private-equity firms, with a few notable exceptions, most are still organized as partnerships, or more recently, as LLC’s. And, individual funds through which venture capitalists raise money are limited partnerships. There, managers are treated more like partners instead of employees and the rewards given to them take the form of partnership compensation rather than straight salaries or traditional bonuses. The Economist (“The Endangered Public Company: The Big Engine That Couldn’t”, May 12, 2012). For more on these evolving developments, see, “Decline of the ‘Publicly-Traded’ Corporation: Diminishing Value, Excessive Regulations, Viable Alternatives… Return to Private Enterprise,” Biz-Shifts-Trends, June 4, 2012; “Eclipse of the Public Corporation” and “The Staying Power of Public Corporation” both by Michael C. Jensen; and “Why is the Public Corporation in Eclipse,” by Larry Ribstein.

The Municipal Bond Markets are in Crisis and, Consequently, Unreliable and the Yields in Corporate Bonds are Failing to Protect Investors Even Against Inflation:

To some degree, the corporate bond markets suffer from the same malaise that infects the equity markets: institutional trading and day trading. But, additionally, and this is important to note, adding to the unattractiveness of the bond market in general (which is due primarily to (i) the low interest rates being paid on newly-issued bonds, both municipal and corporate (see, “What Record-Low Bond Yields Mean for Investors,” The Motley Fool, May 30, 2012; “Yield Vanishes, Inflation Lurks,” Michael Aneiro, Barron’s; “When Safe Bonds Don’t Yield Enough to Retire On,” Paul Sullivan, The New York Times, January 27, 2012) and (ii) the scarcity of quality high yield corporate bonds at an affordable price (see, “Junk Bonds – Getting Risky for a New Reason?“, AdvisorAnalyst.com, April 2, 2012; “Investor demand is . . . strong, with most new issues oversubscribed by a wide margin.” Prudential Fixed Income: 3rd Quarter 2012 Outlook; U.S. and European Corporate Bonds, July 2012), is the perception that many municipal bonds are in trouble because of out-of-control municipal operating costs (e.g., the salaries and underfunded benefits and retirement packages of public employees). This has led to a generally acknowledged belief that, ultimately, the credit quality of these bonds will be impacted (which will, of course, in turn impact their trading value) and has led some to believe that such excessive operating costs may even cause some bond-issuing municipalities to become insolvent, thereby forcing the need for bankruptcy filings and a concomitant significant diminution in the value of the bonds issued by those municipalities.

“Regular . . . readers are by now well versed in the perils of state and municipal finance. Simply put, vast unfunded liabilities (pensions and retiree health benefits) are bearing down on taxpayers who cannot afford to make up the shortfall. Consequently, a once placid and predictable market for state and municipal bonds is beginning to roil,“ John Ellis, Real Clear Policy, August 25, 2012.

Even more striking, is what Ken Volpert, head of Vanguard’s Taxable Bond Group has to say about bonds in general, including not only municipals, but corporate and Treasuries as well:

. . . [I]t is “somewhat astonishing that the yields on a broadly diversified basket of high-quality bonds (whether Treasury, corporate, or municipal securities) are often now below 2% or 3%. Given the rise in prices for food, health care and other select goods and services, such an environment can rightfully be thought of as ‘financial repression.'”

“Today’s Bonds are ‘Financial Repression: Bond Investors Need to be Prepared for What Lies Ahead — Namely Small to Negative Returns“, Ken Volpert, AdvisorOne, September 10, 2012. See, also, “Warren Buffet Dumps Muni Bonds,” The American Interest, August 22, 2012; “State of the States,” Andrew Bary, Barron’s, August 25, 2012; “Buffet’s Muni-Bond Move Raises a Red Flag,” Jeff Roggo interviewing Colin Barr, Wall Street Journal Live, August 21, 2012, which you can view here, and “Investors Seeking Alternative Investments as Stock/Bond Mix Fails to Excite,” Investment News, October 17, 2012, which you can find here.

Treasuries, Money Markets and Bank CD’s and Accounts, Both Savings and Checking, Are Producing Historically Low Returns and Are Ineffective as a Hedge Against Inflation:

Rates on certificates of deposit have never been lower, according to a recent rate roundup by Bankrate.com. At that time, the average rate on a 1-year CD was 0.34% and 1.14% on a 5-year CD. Even worse is the fact that those rates are below the prevailing rate of inflation, which has been running at about 3%. For the average investor, that means if he or she were to walk into a bank on the day those rates prevailed and bought a CD, the real interest rate on it would have been negative. “Unfortunately, Ben Bernanke’s not throwing any bones,” says Bankrate senior analyst Greg McBride. “The Fed intends to keep interest rates low for the next couple of years.” (See, Bankrate.com at http://www.bankrate.com/).

Of course, the above should not come as a revelation to anyone; investors have seen massive decline in interest rates for quite a few years now and, consequently, at the present time it’s hard to find lower interest rates than those currently prevailing on money market funds and accounts. To put things in fresh perspective, I noted that the day before the date of this blog entry, CD’s ranged from a low of 0.18% on 1-month certificates (all percentages indicated are per annum) to a high of 0.39% on 6-month CD’s. At the same time, the yield on Treasuries ranged from a low of 0.10% on 4-week Treasury bills to a high of 2.79% on 30-year maturities (source: H.15 (519) Selected Interest Rates, August 24th, which you can find here). See, “U.S. Treasuries: Rock-Bottom Yields Leave Little Room for Improvement in 2012,” Thomas Kenny, 2012 Bond Market Outlook, About.com: Bonds). When you look at money market funds and bank checking and savings accounts for the same period, the picture is even bleaker.

For money market funds, the highest interest rate being paid on August 24th was 1.10% at UFB Direct (see DepositAccounts.com here), while the highest rate on that date for bank checking and savings accounts was 1.5% on checking accounts at Apple Federal Credit Union and 1.0% on savings accounts at Barclay’s (see DepositAccounts.com at here and here).

The Current Flight to Gold is Unsustainable and an Unrealistic Strategy for the Small Investor:

As to current trends, with the exception of securities issued by a half-dozen tech giants’ that dominate the NASDAQ 100 (Apple and Google come to mind, for instance), it is into gold, not stocks and bonds, that many of the current better-heeled individual investors are fleeing.

Andrew Osterland, in his article “There’s gold in them thar fields,” (Investment News, August 26, 2012), explores the recent investor clamor to possess, and even bury, the precious metal by interviewing several experts in the field, among them Paul Lee, an adviser with UBS Financial Services Inc. and David John Marotta, a registered investment advisor in Charlottesville, Virginia:

“A strong case can be made for investing in gold in general. After all, the price of the world’s favorite precious metal has roughly doubled since the beginning of 2009 . . . Since the beginning of 2000, however, gold is up about 400%, versus a flat market in stocks . . . “

Of course what makes sense for the ultra-rich, may not make sense for the average small investor.

“’I believe gold has a place in everyone’s portfolio, but unless you’re ultra-affluent, it’s a lot easier to get exposure to it through ETFs rather than by buying gold coins,’ said Paul Lee, an adviser with UBS Financial Services Inc.”

However, in contrast, Mr. Marotta shares that,

“I have clients who want nothing to do with gold ETFs,” he said. “For them, gold is not an investment, it’s a hedge against the end of the world. . . . Personally, I don’t need to buy a couple of bars of gold. But if you think the world is going to implode, then you should consider an allocation to bullion.”

But, for the average small investor, is the purchase of gold bullion even remotely close to being a realistic strategy? First of all, the available supply of gold in the world is way too small to satisfy the needs of all the small investors in the U.S. who might want to purchase some:

“There isn’t enough gold around in the world to [support the flight to gold for the majority of U.S. investors] at current gold prices. Rough back of the envelope calculations show that the Fed’s holdings of gold, assuming that it is unencumbered and not lent out, is worth around $200 billion at current prices. Remember that the U.S. Federal Reserve is one of the larger central bank holders of gold in the world.”

“Why A Gold Standard Is A Bad Idea,” Cam Hui, Daily Market, December 30, 2008. Moreover, if everyone in the U.S. held gold in their retirement accounts based on the amount of gold available to the United States and the amount of currency currently in circulation in the U.S. economy,

“The arithmetic would be daunting . . . to clients. The United States holds gold reserves of 261 million ounces, the world’s largest. The monetary base – cash in circulation plus banks’ deposits at the Federal Reserve – is nearly $2.7 trillion. [Exchanging paper money for gold] would require a gold price of about $10,000 an ounce compared with today’s price of roughly $1,600 . . .”

“New gold standard not practical,” Robert Samuelson, The Orange County Register, August 29, 2012

Thus, in light of the above, you can quickly see that this “flight to gold” strategy would prove disastrous if pursued by a small investor given his financial inability to purchase any significant quantities of gold at its current trading price, let alone a price that would reflect a mass exodus to gold by the vast majority of the American small investor community.

To further complicate the prospect of owning gold, there are some unique tax problems associated with its ownership. Mr. Marotta has to continually warn his clients that, unlike stocks and bonds, physical gold is considered a collectible by the IRS and as such is subject to a 28% capital gains tax; this may explain why some clients may want to buy gold with cash and hide it in their basement. “I talk them out of it by asking them if they want to be charged with tax evasion,” says Mr. Marotta.

And last of all, the effect of a massive flight to gold (similar to the effect that re-instituting the gold standard would have) would spell real problems for our currency-based monetary system and, thus, in turn, would work to significantly undermine the interests of the middle class, to which our average small investor belongs. See “Paul Krugman: Gold Standard Would Ruin U.S. Economy,” Bonnie Kavoussi, The Huffington Post, August 27, 2012.

Investment Activity in the Real Estate Markets, Both Residential and Commercial, is Increasingly Being Dominated by Large Private Equity Funds:

Moving on to real estate, residential real estate investing by solo individuals “flipping” houses in reliance on the perception that the housing market would continue to increase in value forever has collapsed. What’s replaced it are private equity funds amassing huge portfolios of single family homes to hold as rental properties. See “Private Equity Funds Target Foreclosed Homes as Rental Play,” Beth Mattson-Teig, National Real Estate Investor, August 22, 2012; “Big-Money Funds Buy Foreclosures — to Rent,” Marilyn Kalfus, The Orange County Register, August 30, 2012.

This development is coupled with the troubling fact that “vulture” funds have been set up by the major investment management companies to buy up bank positions on scores of mortgages on commercial ground leases. As has been widely reported in the financial press, huge numbers of these types of mortgages are scheduled to expire in the next two to three years (where there’s no hope for bank refinancing due to the banking industries new tighter, more risk adverse, loan underwriting rules) solely for the purpose of ultimately (after the ground lessor’s default on the associated mortgage) securing “the keys” to the “real estate”, i.e., the ground lessor’s position. In Dr. Kenneth Rosen’s recent whitepaper, entitled “The Current State of the Housing, Mortgage, and Commercial Real Estate Markets …” he states:

“The fundamentals for nearly all commercial property types are still eroding, as vacancy rates rise and rents fall. Consequently, values have plunged between 25-50% from peak levels of 2007. As NOI declines, delinquency rates on commercial mortgages are rising substantially. Additionally, many owners that bought at the peak of the market between 2005 and 2007 are unable to refinance maturing loans on properties that are now worth substantially less than the value of the mortgage. . . . [C]urrent valuation levels on the $779 billion of mortgages that were created [during the boom period] will make refinancing difficult. . . .

“We estimate that between $800 billion and $1 trillion of losses to commercial real estate equity and debt will be realized over the next few years. The annual volume of commercial mortgage maturities is expected to increase each year through 2013, meaning that losses for banks, life insurance companies, CMBS holders and other investors will continue to mount unless borrowers are able to find alternate funding sources.”

“The Current State of the Housing, Mortgage, and Commercial Real Estate Markets: Some Policy Proposals to Deal with the Current Crisis and Reform Proposals to the Real Estate Finance System,” pg. 3; Dr. Kenneth T. Rosen, Chairman, Fisher Center for Real Estate and Urban Economics, University of California, Berkeley. Also, see, “PwC: Current State of the Commercial Real Estate Market,” Korpacz Real Estate Investor Survey™, PricewaterhouseCoopers LLP and “Commercial Real Estate Outlook: Top Ten Issues in 2012,” pg. 9, Bob O’Brien, Deloitte & Touche, LLP.

This development, of course, spells trouble not only for ground lessors but for small business owners who are their tenants. These tenants are already struggling to make ends’ meet in the U.S.’s very slowly-recovering consumer economy. They can ill afford substantial increases in rent once the economy does recover and the vulture funds that previously assumed ownership of these ground leases (through foreclosure against the original ground lessors) start trying to exact exorbitant rentals from these same small business owners.

Existing “Alternative” Investments Are Dominated by Professional Traders and Expert Collectors, Are Already Mature and Fully-Valued, and Provide Only an Uncertain Upside for the Average Small Investor:

Lastly, all other existing investment alternatives, e.g., commodities trading, hedge funds, derivatives, collectibles, etc. are dominated by institutional traders or extremely sophisticated individual traders/collectors (and thus are not suitable investments for the average American small investor). Here’s what Investopedia has to say about “alternative investments.”

“An ‘alternative investment’ is an investment that is not one of the three traditional asset types (stocks, bonds and cash). Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regulations and relative lack of liquidity. Alternative investments include hedge funds, managed futures, . . . commodities and derivatives contracts, among other things.

“Many alternative investments also have high minimum investments and fee structures compared to mutual funds and ETFs. While they are subject to less regulation, they also have less opportunity to publish verifiable performance data and advertise to potential investors.

“Alternative investments are favored mainly because their returns have a low correlation with those of standard asset classes. Because of this, many large institutional funds such as pensions and private endowments have begun to allocate a small portion (typically less than 10%) of their portfolios to alternative investments such as hedge funds.

“While the small investor may be shut out of some alternative investment opportunities . . . commodities such as precious metals are available [although carry significant amounts of risk]. “

“Alternative Investment,” Investopedia, 2012

Additionally, these are extremely narrow investment niches that are both mature and, at present, fully-valued without a reasonably safe and secure upside (i.e., the upside is extremely speculative) for the average small investor.

Summing Up

As you can clearly tell from the above, there aren’t many (if any) opportunities among the traditional categories of investments where the average small investor can earn a return on his or her money which is both relatively safe and, at the same time, decent (say, something in the order of 7% and above) to boot. So, what’s the average investor to do????

In Part 2 of this blog entry and in the other parts which follow, we’ll explore the ways in which investment-based crowdfunding will be, for the average U.S. small investor, a superior way to invest, and how, in addition to enriching the average small investor, it can enrich the U.S. economy as a whole. In addition, we’ll explore what’s behind the rejection of this new avenue for investment by so many existing investment professionals.

Why Investment-Based Crowdfunding Will Succeed: Part 2

In the first part of this blog entry, I explored why, moving forward, existing traditional investments are ill-suited for the average small investor and how they have failed (and will continue to fail) to provide both safe and adequate returns to the average investor.

In this part and in succeeding parts, I’ll explore:

• Why I (and others) believe that crowdfunding is good for the average small investor

• Why I (and others) believe that crowdfunding is essential to revitalizing American capitalism and in reviving the flagging U.S. economy
• The real reasons behind the existing financial community’s resistance to the idea of crowdfunding as a viable channel for future investments

WHY CROWDFUNDING IS GOOD FOR THE AVERAGE SMALL INVESTOR

In his article, “3 Reasons Crowdfunding is Good for Investors” (Seeking Alpha, April 12, 2012, which you can read here), Ryan Caldbeck, founder and CEO of CircleUp Network, Inc., touches on several important features of crowdfunding that will appeal to the individual small investor. He argues these features will cause crowdfunding to gain adherents, thereby building traction and ultimately ensuring the success of crowdfunding as a viable financing alternative.

First, he points to the fact that the internet has been responsible for bringing sellers and buyers together in a variety of ways that both reduce costs and increase efficiency:

“As with markets for new retail goods (Amazon), used items (eBay), and, more recently, personal services (TaskRabbit), aggregated platforms reduce search costs and transaction costs, allowing for increased participation in the market.”

Turning to the “entry cost” for investments in early-stage companies, Caldbeck underscores the fact that with the existing channels, the individual investor has limited options:

“The investor . . . [can (i)] identify a company directly and manage the investment alone; [ii] join an ‘Angel Group’, or [iii] invest passively through a professional venture firm. Because of rules surrounding general solicitation, it is very difficult for investors to identify companies directly. Private companies are not permitted to announce when they are fundraising. As a result, individuals require significant networking to find companies in which they might like to invest . . . Access to [angel groups and] venture capital firms for individual investors is extremely limited . . . [in addition,] few of the top venture capital funds will even accept investments from individuals.”

while, at the same time, paying a high price:

“The price an investor pays for access to early-stage companies via venture capital is steep, as most firms charge investors an annual fee of 2% of capital under management and take 20% of investment profits as well. By contrast if an individual was able to invest $100,000 in a VC fund that had a gross return of 2x invested capital [author’s note: a very, very real possibility given how venture capital firms of late have been badly under performing when it comes to their previously promised rate of return], the investor would only receive $170,000 once fees and the firm’s share of profits (i.e. carried interest) were netted out.”

For contrast, he posits an alternative investment in ten separate crowdfunded vehicles at $10,000 a piece where the same rate of return results:

” . . . a $100,000 [aggregate] venture investment [in] ten separate $10,000 investments through crowdfunding, where there is a 2x return on capital, is truly $100,000 of profit in an individual investor’s pocket.”

Caldbeck also points out the crowdfunding platforms significantly reduce the costs of fundraising, thereby enhancing the crowdfunded company’s return from its crowdfunding effort and consequently indirectly providing a better return for the investor:

“Costs of transaction items such as legal diligence, equity document preparation, background checks, finders’ fees and more can run into the high six figures on an equity investment of just a few million dollars. These costs don’t scale down much, as a similar 75 pages of a stock purchase agreement are needed whether you make a $1 million or $100 million investment.

By way of contrast, well-run crowdfunding platforms remove these high costs from the process for individual investors, as they standardize legal documents, background checks, and many of the other expensive process points that make it prohibitively expensive for an individual to invest in a few deals per year. Because crowdfunding sites facilitate raises by many different companies, they recognize the benefits of scale and are able to amortize costs across many companies, so the individual investor pays [very little toward these types of expenses].”

Second, based on the above and other factors, Caldbeck presses home the point that at present, early stage investing is inefficient in that many of the industries that venture capital firms and angels tend to overlook (i.e., virtually everything but startups in the technology sector) are underserved when it comes to start-up financing, despite the fact that these sectors consistently outperform the overall economy as a whole:

“Crowdfunding opens up under served markets like consumer and retail to individual investors. In 2011, just over 4% of venture capital funds went to consumer products companies, even though the consumer sector accounts for 15% of the broader economy and, in the public markets, has significantly outperformed the S&P 500 over the last four years. VC firms, however, continue to focus on the high-tech sectors that the industry grew up with, as experience and connections in this sector generates further investment dollars.”

Then, in a separate article written for Forbes Magazine, Ryan Caldbeck further points out that under Fed Chairman Ben Bernanke’s “quantitative easing” program (Note: Not to long ago, Bernanke announced a third round of quantitative easing (QE3), which came in the form of an open-ended commitment by the Fed to purchase $40 billion of mortgage debt per month until the job market improves), “the Fed’s accommodative monetary policy significantly distorts both returns and risk in the public markets, the two opposing forces that any investor must consider when constructing” his or her portfolio, providing an excellent opportunity for investors to allocate a portion of their portfolio to equities of crowdfunded companies. He expands on this thought further:

“When the Fed pours money into the system with the purchase of mortgage-backed securities, combined with guidance from the Federal Open Market Committee that the federal funds rate will remain near zero at least through mid-2015, it depresses yields on debt instruments. In turn, investors pour money into public equities in search of returns they can no longer access in the debt markets. The value of a company should be based on the value of its future free cash flows discounted at its cost of capital. However, since the Fed is holding down interest rates and thus companies’ cost of capital, the discount rate to calculate the value of a company is artificially lower resulting in higher company values than might be implied by a company’s fundamentals.”

He continues:

“However, it’s not just the returns portion of the risk-return equation that is out of whack . . . The current yield on three-month Treasury bills, often considered to be the “risk-free” rate, stands at just 0.10%. However, given the cycle of funds from the left pocket of the U.S. government—the Fed—to the right pocket—the Treasury selling T-bills—is the risk-free rate really risk-free? Nobody can know for sure what would happen to T-bill yields if the Fed’s buying binge ended, but one thing that’s certain is this: the risk-free rate would rise, as demand for our T-bills dropped. In short, risk is being distorted in today’s markets too.

So, what does that all mean to . . . an investor? It means that at some point in time, when unemployment improves to a level that Ben Bernanke considers acceptable, QE3 will end, and public equities may be headed for a plunge.”

“Ben Bernanke’s QE3: The Best Thing for Crowdfunding Since the JOBS Act,” Forbes Magazine, October 2, 2012, which you can read here.

Meanwhile, Chance Barnett, co-founder & CEO of Crowdfunder.com, in his own Forbes article, provides a compatible view on why crowdfunding is good for the small investor. However, he does so from a “leveling-the-playing-field” or egalitarian perspective:

“A key part of [the] transformation [wrought by crowdfunding and the JOBS Act] focuses on closing the gap in securities law between two types of investors: accredited and non-accredited . . . individuals . . . deemed “accredited” . . . means they’re graced with investment opportunities that aren’t available to the rest of the population.

The only distinction between these two groups is personal wealth. Not enough Americans know about this distinction or what it really means. Here are two important implications:

1) If you’re non-accredited (not a wealthy person), it’s illegal for you to be presented with investment offerings in private businesses unless you already know the founder.

2) If you’re trying to raise money for your company, it’s illegal for you to publicly broadcast that fact in an effort to attract investors. You can’t use your social network to find investors. If you don’t already know investors, which most Americans don’t, then good luck.

In short, our securities laws leave about 80% of Americans (non-accrediteds) standing on the sidelines in the wealth creation cycle of early-stage investing, while wealthy Americans enjoy exclusive access to participate. It was 1933 when the first of these laws were created to protect vulnerable Americans from losing what little money they still had in the aftermath of 1929. But the world has changed dramatically since then. Giving Americans equal economic opportunities based on their wealth or income isn’t just a political imperative. It’s a moral imperative.”

“Community-Based Investing: A Higher Evolution of Crowdfunding,” Forbes Magazine, September 27, 2012 (read it here).

Ryan Caldbeck confirms Barnett’s views on this when he notes:

“Today, startup investing is reserved for the 1%. Less than 1% of Americans are ‘Angel’ investors and less than 1% of all small businesses receive outside equity investment. (This despite significant investor returns, according to the Angel Investment Performance Project). Within this narrow band, the distribution tightens further – a majority of all Angel investments go to technology driven industries. And, 80% of Angel investors are men. As a result, a vast majority of the economy – entrepreneurs, investors, and whole industries – are left out of this virtuous cycle.”

“How The JOBS Act Could Change Startup Investing Forever,” CircleUp, March 16, 2012.

In a similar vein, Dave Lavinsky, President of Growthink, a business-planning firm and investment bank, answers an emphatic “YES” to the question posed by The Wall Street Journal, “Should Equity-Based Crowd Funding Be Legal? ” (The Wall Street Journal, U.S. Edition, March 18, 2012, which you can read here), calling crowdfunding “angel investing on steriods”:

“Crowdfunding holds a big advantage for the funders . . . It lets them participate in angel investing, whose returns have outpaced every other significant asset class over the past decade.”

Alon Hillel-Tuch, co-founder and CFO of RocketHub, adds his voice to the chorus when he points out that:

“Crowdfunding portals and regulators are able to drive standardized and understandable terms across offerings. This allows crowdfunding investors to become educated and aware of the offering terms and risks. Investors in crowdfunding offerings are able to clearly see the terms and success of an offering, and are able to directly communicate with the issuer and other investors.”

“Comments Before SEC,” Alon Hillel-Tuch, June 25, 2012.

In responding to critics of crowdfunding, Paul Spinrad of Crowdfundinglaw.com explains that, unlike traditional private placements and other private equity investments, crowdfunding offers additional protections to the investor:

“Scammers rely on isolating and pressuring their marks for large amounts of money, but crowdfunding solicitations ask for peanuts, and they are open, driven by word-of-mouth, and widely-seen. They originate within an offeror’s personal connections or community of interest, and potential supporters are free to research and discuss the pitches on their own time, using any tools at their disposal.”

“Equity Crowd Funding: A Good Idea Whose Time Is Now,” The American (online magazine of the American Enterprise Institute), March 22, 2012.

Then, there’s Sarah Lacey, Senior Editor for TechCrunch, one the tech industry’s leading daily publications, who, after some initial doubts, says she’s sold on the JOB’s Act, crowdfunding included. Here’s what she says, in particular, about the locavesting aspect of crowdfunding and the additional non-monetary benefits that investors can expect from this type of crowdfunding:

“Part of this isn’t about a return, it’s about letting fans of a company be the owners. On a public company level, wanting to own a piece of something you love was what made the Netscape IPO such a retail investor phenomenon. It’s why people own Disney and hang the stock certificates in their kids’ rooms. And it’s a big reason Apple is one of the most valuable companies on the planet. Disseminating that on a neighborhood level is a cool idea.”

“After Some Initial Doubts, I’m Sold On The JOBS Act“, PandoDaily, March 17, 2012, which you can read here.

Lastly, when it comes to the issue of transparency, it is clear that on this issue, crowdfunding stands “head-and-shoulders” above all other avenues for company funding:

“Crowdfunding will increase, not decrease, transparency in this market. Today, as nearly every entrepreneur will tell you, the early stage investing process is isolated and opaque. Companies share information to one investor after another, all in separate private meetings, all with the goal of telling the ‘right story’ for that particular investor. Crowdfunding brings this process into a broader community space. A well-regulated crowdfunding platform prevents fraud by requiring companies to share their information widely, by conducting third-party background checks on entrepreneurs, and by providing the transparency necessary to allow for greater scrutiny from a diverse audience of investors. The “crowd” acts as a collective due diligence tool – each person contributing an independent view on the merit of the investment. Fraud thrives in the shadows, not in the light of a vibrant open market system.

Crowdfunding is the antithesis of the financial practices of the last decade. There are no credit default swaps, leverage multiples, or obscure fund structures standing between company and investor. It is direct. It is personalized. Investors actively seek out the companies they believe in, evaluate the merits of the investment on a case-by-case basis, and make an investment.”

“How The JOBS Act Could Change Startup Investing Forever,” CircleUp, March 16, 2012.

Because of this aspect, as well as the other aspects explored above, crowdfunding’s ultimate acceptance by the small investor is assured. As financial professionals, our job is to accelerate its acceptance by revealing, as often as we can, its merits to any and all who will listen, and to do so sooner, rather than later.

Along this line, the next part of this blog entry will explore why doing so is so important, and not only for the small business person looking for funding and for the small investor looking for a decent return, but for our society as a whole.

Why Investment-Based Crowdfunding Will Succeed: Part 3

Investment-based crowdfunding will ultimately succeed because, in addition to being good for both the entrepreneur and the average small investor, it is also good for America as well as being essential for revitalization of the U.S. economy.

However, in order for the reader to be able to understand why this is so, we need to spend some time revisiting the last four decades of U.S. economic history. This Part 3 of the blog entry does just that.

HOW WE GOT TO WHERE WE ARE

Prelude

By the early 1970’s, problems (viewed at that time, surprisingly, as opportunities) were starting to roil the public markets. Here’s what was happening back then:

“The 1970s started [with] William McChesney Martin stepping down at the Federal Reserve and [being] replaced by . . . Arthur Burns . . . When Burns came in, the approach immediately tended toward “easing,” [and] the Fed funds rate plummeted. This produced a decent recovery in 1971-1972, which helped Nixon get re-elected in 1972. . . . Various commodity markets boomed.

Most people . . . including most professional stock market investors, assumed that they were still in the prosperous 1960s, enjoying the Great Bull Market that had begun more than twenty years earlier. The ‘Go Go Years’ were still in play, although the DJIA hadn’t made a new high since 1965, when it peeked over 1000 intraday but did not close above that level.

“Then, it happened. Toward the end of 1972, the DJIA broke the 1000 level and made new highs . . . the DJIA topped out at around 1050, or about 5% above its 1965 high. On January 1, 1973, Barron’s published its famous Roundtable interviews with big-name professional investors. The title was ‘Not a Bear Among Them,’ . . . the Fed Funds Rate, as of the end of December 1972, was — 5.33%.”

But then, predictably, the bears set in:

“And that was it: the market started heading down, and as the already-existing inflation intensified in 1973 and 1974, the DJIA collapsed to under 600. In terms of gold, the DJIA went to about three oz. of gold (600 with the dollar at $200/oz.). For comparison, at the absolute lows of 1932, the DJIA was worth two ounces of gold. Thus, although the ‘headline’ decline in the DJIA was about 45%, the ‘real’ decline was more like 90%.”

“The End of the 1972 Bull Market,” New World Economics, December 25, 2006, which you can read here.

Today, the DJIA is again near its historical high, although with gold at $1700/oz. it is only worth about 7.7 oz. of gold. At the peak in 1965, it was worth about 28 oz. of gold, so in actuality — adjusting for devaluation of the dollar — the DJIA is well beneath its high point of almost 50 years ago.

The 1970’s: Strike-Suit Lawyers and Corporate Raiders

The collapse of the stock market after 1972 created new possibilities for economic opportunists in the form of corporate strike-suit litigation. Feeding off of a flurry of SEC enforcement activity occasioned by the precipitous drop in stock prices and involving mutual funds (account churning), REIT’s (overvaluations of real estate perpetuated by scam artists working cooperatively with regional or local banks) and publicly-traded companies (which had made material misstatements or had omitted to state material facts in their disclosure documents), the private securities bar began deluging the federal and state courts with dozens upon dozens of “extortion”-style lawsuits aimed at extracting a settlement from the offending target entities.

I had an opportunity to see this development up close since my first career position was working for one of these strike-suit lawyers who, not surprisingly, had an office on 47th Street in Manhattan, just off of the old Times Square, then a hotbed of adult book stores, strip clubs and sex industry workers. The typical scenario involved, first, reading in the New York Law Journal (the legal profession’s trade magazine for the metro New York area) that the SEC had commenced a new enforcement action against yet another mutual fund or corporation. Then, it was a race by my firm’s paralegals to the courthouse to get a copy of the SEC’s complaint and to claim “lead counsel” status before any other firm could. After that, it was the lawyers in the firm rummaging around the Rolodex to find a suitable owner of the target’s shares who could be “put up” as a class representative for the allegedly injured class. The objective, of course, was to extract a settlement from the offending target and for the “lead counsel” (sometimes a role which was shared by two or more law firms) to walk away with a disproportionate share of the settlement. Very rarely did these lawsuits actually make it to trial and very rarely did the “injured” class actually get any real restitution.

While this “golden goose” didn’t last for very long (the federal courts started administering some strong medicine to the strike-suit bar given what the courts saw as the excessive greed of the competing plaintiff law firms), starting in the late 1970’s a new group of economic opportunists known as the “corporate raiders” appeared on the scene. Here’s what Wikipedia has to say about the corporate raids which started in the 70’s:

“In business, a corporate raid refers to buying a large stake in a corporation and then using shareholder voting rights to require the company to undertake novel measures designed to increase the share value, generally in opposition to the desires and practices of the corporation’s current management. The measures might include replacing top executives, downsizing operations, or liquidating the company.

“Corporate raids were particularly common in the 1970s and 1980s in the United States. By the end of the 1980s, management of many large publicly traded corporations had adopted legal countermeasures designed to thwart potential hostile takeovers and corporate raids, including poison pills, golden parachutes, and increases in debt levels on the company’s balance sheet.”

“Corporate raid,” Wikipedia, October 20, 2012.

Wikipedia goes on to describe the “freshmen class” of the corporate raider community:

“Corporate raids became the hallmark of a handful of investors in the 1970s and 1980s. Among the most notable corporate raiders of the 1980s were Carl Icahn, Victor Posner, Nelson Peltz, Robert M. Bass, T. Boone Pickens, Harold Clark Simmons, Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and Asher Edelman. These investors used a number of the same tactics and targeted the same type of companies as more traditional leveraged buyouts and in many ways could be considered a forerunner of the later private equity firms. In fact, it is Posner, one of the first ‘corporate raiders’ who is often credited with coining the term ‘leveraged buyout’ or ‘LBO'”.

As was the case with their earlier opportunistic brethren, I again found myself with a front-row seat to this new development. In 1979 I was working as the corporate securities specialist for a small, NYSE-listed medical device manufacturer. One day, Victor Posner telephoned the company’s CEO to advise him that Posner had purchased a 9% interest in the company’s outstanding shares and that he was on the sidelines “watching”. Predictably, management was panicked and determined to take any and all steps necessary to defend itself against this unwanted suitor. A series of “shark repellant” measures were adopted, including proposals made to the shareholders to approve staggering the company’s board (to disable Posner from changing the board in single annual election of directors) and to increase voting requirements on material corporate transactions to super majority level, both things permitted under New York corporation law, the law under which this particular company was formed.

Regarding Mr. Posner here’s what Wikipedia has to say about him, in particular:

“Victor Posner, who had made a fortune in real estate investments in the 1930s and 1940s, acquired a major stake in DWG Corporation in 1966. Having gained control of the company, Posner used it as an investment vehicle that could execute takeovers of other companies. Posner and DWG are perhaps best known for the hostile takeover of Sharon Steel Corporation in 1969, one of the earliest such takeovers in the United States. Posner’s investments were typically motivated by attractive valuations, balance sheets and cash flow characteristics. Because of its high debt load, Posner’s DWG would generate attractive but highly volatile returns and would ultimately land the company in financial difficulty. In 1987, Sharon Steel entered Chapter 11 bankruptcy protection.”

Of course, Victor Posner was not alone in his pursuit of profit from these types of activities. As indicated above, there were many other raiders who inflicted equal or greater damage on the companies they acquired (or, in some cases, threatened to acquire unless “extortion money” was paid to buyout their interests at a premium over what the stock was trading for at the time of the threat) and, indirectly, on the economy as a whole. Here’s what Wikipedia has to say about one of them, Carl Icahn:

“Carl Icahn developed a reputation as a ruthless “corporate raider” after his hostile takeover of TWA in 1985.The result of that takeover was Icahn systematically selling TWA’s assets to repay the debt he used to purchase the company, which was described as ‘asset stripping’.”

This particular episode of Icahn’s adventures served as the basis for director Oliver Stone’s 1987 film, Wall Street, a fictional account of what had been occurring on Wall Street at the time of the movie’s premiere. In the movie, Michael Douglas, as the character Gordon Gekko, tells his young apprentice, Bud Fox, played by the actor Charlie Sheen, that “greed is good”. Despite Stone’s feeling that the audience would recoil from the Gekko character, quite the opposite actually occurred; instead of dismay at Gekko’s lack of moral restraint and excessive greed and overarching narcissism, Gekko’s “greed is good” creed became the marching anthem of an entire generation of U.S. finance professionals (as well as subsequent generations of finance professionals in the U.S.). The wide acceptance of this as a mantra for success in America explains, to a large extent, what has happened to the U.S. economy in the intervening years leading to the present.

The 1980’s: Raiders, LBO’s and Shark Repellents

The general perception that stocks were undervalued and did not accurately reflect the value of the underlying company assets drove much of the raider and leveraged buyout firm activity during the 1980’s.

However, one of the unintended consequences of the advent of corporate raids, was a whole slew of counter-measures that corporate CEO’s and company boards of directors began considering in order to defend themselves against unwarranted pressure from coercive hostile takeovers. Some of the counter-measures that resulted were justified at the time on the basis that they provided a company’s directors with some much-needed breathing room in order to more fully consider the merits of a particular offering, focusing exclusively during that process on the best interests of the shareholders. Others were clearly intended simply to ensure the continued entrenchment of the then current management, irrespective of their past performance and thus their value to the company’s shareholders.

At the time, I happened to be employed by a multinational advertising agency whose CEO had engineered two separate anti-takeover measures. The first one consisted of the repurchase of a significant number of company shares and their subsequent deposit into a company-sponsored ESOP (the trustees for which included the CEO and several of his cronies, some of whom also served as outside advisers to the company). The second consisted of the issuance to the CEO (and two other company executives, both of whom received a much smaller percentage of the same type of shares as a token to demonstrate that the CEO’s move to have the shares issued to him was not simply an act of self-aggrandizement) of an exotic preferred stock which siphoned value off of the common shareholders’ per share book value on a periodic basis.

These and other types of “shark repellant” measures were routinely devised by “creative” outside counsel in those days and then quickly deployed by fearful corporate managements. In fact, one of the most controversial of these measures, the “poison pill,” was heavily promoted by one of the named partners of the same law firm that had previously been very active in the plaintiffs strike-suit bar. This transformation from corporate ambulance-chaser to prominent champion of the anti-takeover movement was nothing short of miraculous.

It was during the latter half of the 1980’s that these stories became personal for me. At that time I was working as in-house counsel for mergers & acquisitions at a major pulp and paper company. Corporate management was anxious to rapidly grow the size of the company in order to both make it less attractive to hostile acquirers, as well as to accomplish their strategy of significantly increasing shareholder value by investing in additional pulp and paper assets utilizing the tremendous amount of cash that the company’s ultra-efficient and extremely low-cost manufacturing facilities were generating. We looked at dozens and dozens of deals, flying from place to place on corporate jets, and dealing with the entire gamut of Wall Street investment banking firms who we, or others, had retained to represent us/them in these high-profile deals.

During the process we dealt with one of the more prominent corporate raiders, Sir James Goldsmith (this particular raider served as the inspiration for the film character “Sir Larry Wildman,” played by Terence Stamp in the movie Wall Street) who acquired an old and well-established West Coast paper company in a spectacular and very public hostile takeover bid which involved a triggering of the company’s “poison pill” by the raider and a break-up of the company and sell-off of its assets (other than its land holdings) once the mess from the triggering of the pill had been cleaned up. While we were unsuccessful in this particular instance, we later succeeded in doing two back-to-back deals with one of the largest of the leveraged buyout funds at the time, Kohlberg, Kravis & Roberts, paying well over $1.25 billion for the two deals (which, we subsequently learned, was approximately $400 million more than what the rest of our competitors for those deals were willing to pay; a tip of the hat for that to our then investment bank, Smith Barney for that!). In the end, although we acquired both these companies, we did it (1) by borrowing an enormous amount of money, and (2) changing our corporate policy of “sticking to our knitting” and “plain vanilla” to “flexing our financial muscle.” This change in corporate policy, coupled with our “success” in overpaying on these two deals, put us on the pulp & paper industry’s radar. This, coupled with the view that we had acquired some industry-coveted assets, caused us to become the target of yet a larger pulp and paper company, which ultimately made an “all cash” hostile tender offer for our company’s shares, to which we succumbed after a bitterly contested six-month battle to remain independent.

The really distressing part of this latter experience was how our company’s ex-chairman (i.e., who had retired several years before the takeover) fared as a result of the takeover. This ex-chairman, who had devoted most of his professional life to building the company (and who, at one point, had refused a measly special bonus of $80,000 from the company’s board for extraordinary accomplishments in the building of a world-class “greenfield” pulp mill in the deep South, relying exclusively on tax credits and the company’s own cash flow and some Industrial Revenue Bonds, claiming that such a bonus would be “waste of shareholder assets,”) did not benefit anywhere near to the same degree when the takeover succeeded as our then current company chairman did. In addition, both he and the current chairman did not benefit anywhere near to the same degree that the acquiring company’s chairman did when he sold the combined company several years later to one of the U.S.’s largest privately-held companies. And, the most ironic part about all of this is that, with the exception of one of our divisions (out of a total of six), all of our company’s assets were stripped-off and sold by the acquiring company prior to its sale to the privately held firm. So, the bottom line here is that the takeover was a dismal failure and, yet, the engineer of the takeover, who was at the helm of the combined company at the time of its sale to the privately-held firm, literally “made out like a bandit”.

To give the reader some perspective on how all this worked out, let’s say our old chairman, counting both the stock he already owned as well as the stock he obtained by virtue of his exercise of low-priced options previously granted to him, received, as a result of the takeover, a total of $1 million. Based on that assumption, our then current chairman received $10 million and the other company’s chairman, upon his sale of the combined company to a third-party, received $100 million. So, when you sort it all out, our old chairman received essentially 1% of the amount received by the other company’s executive. This “100-to-1” ratio, where those who create catastrophes receive the lion’s share of the rewards, has been a dominant theme in our financial sector ever since. Despite the protestations of the politically conservative right to the contrary, the truth about that period in the U.S.’s economic history is that it was undeniably the “Decade of Greed”, and I got to witness it, up close and personal.

Of course, such excess always leads to a correction. Thus, it was no surprise to anyone when the stock market tanked in October of 1987. In the days between October 14 and October 19, 1987, the major equity indexes dropped more than 30%. Then, on October 19, 1987 (aptly named “Black Monday”), the Dow Jones Industrial Average plummeted 508 points, losing over 20% of its total value. Likewise, the S&P 500 dropped more than 20% as well, falling from 282.7 to 225.06. Up to that point in time, this was the greatest one-day loss Wall Street had ever suffered. Almost twenty years later, the Fed commissioned a study to ascertain precisely what had caused the run-up to Black Monday and subsequently. Here’s what Mark Carlson had the to say about that period:

“During the years prior to the crash, equity markets had been posting strong gains. Price increases outpaced earnings growth and lifted price-earnings ratios; some commentators warned that the market had become overvalued . . There had been an influx of new investors, such as pension funds, into the stock market during the 1980s, and the increased demand helped support prices . . . Equities were also boosted by some favorable tax treatments given to the financing of corporate buyouts, such as allowing firms to deduct interest expenses associated with debt issued during a buyout, which increased the number of companies that were potential takeover targets and pushed up their stock prices.”

“A Brief History of the 1987 Stock Market Crash with a Discussion of the Federal Reserve Response,” Mark Carlson, Board of Governors of the Federal Reserve, November, 2006.

The report issued by Mr. Carlson raises two very important points, not previously touched upon, about that period: first, the effect of the decade long transformation of corporate retirement plans from “defined benefit” to “defined contribution” and, second, the effect on the corporate landscape of allowing firms to deduct interest expense associated with debt issued during a takeover or other buyout.

The first development, i.e., companies freezing or dropping defined benefit plans (i.e., pension plans) in favor of defined contribution plans (i.e., 401(k)’s), resulted from the realization by many companies that their previously adopted defined benefit plans were significantly underfunded. This resulted from overly optimistic actuarial assumptions about plan earnings posited by actuaries in prior decades, i.e., most plan actuaries had assumed a rate of return of more than 8%, while the reality turned out to be significantly less. This problem plagued many companies, some of which were blue-chip Fortune 500 corporations.

The second issue, the allowance of deductible interest in connection with borrowings associated with corporate takeovers, skewered the playing field, giving an acquirer substantial financial leverage in any takeover contest. Congress attempted to do something about this imbalance immediately prior to the 1987 Crash. In fact, more than one commentator attributed the Crash to this development, i.e., if takeover-related debt was no longer deductible less takeovers would occur and the excessive valuations of companies’ equities being driven by the prospect of a takeover would evaporate.

The End of the 80’s – Michael Milken Helps to Make LBO’s Respectable, the Ascendency of Goldman Sachs and MLPs

Something that provided extra fuel for the takeover fire, was the arrival of Michael Milken, whom the media proclaimed to be the “Junk Bond King,” on the scene, sometime in the 1980’s:

“Many of the corporate raiders of the 1980s were onetime clients of Michael Milken, whose investment banking firm, Drexel Burnham Lambert, helped raise blind pools of capital which corporate raiders could use to make . . . attempts to take over companies and provide high-yield debt financing of the buyouts.”

When the corporate raiders first appeared, there was general consensus that they were outliers, villainous and unconcerned about anything other than making a profit, and certainly oblivious to the harm they were creating for the employees of the companies they raided and for the general economy as a whole. However, with the help of Michael Milken, by the time the 1980’s ended, leveraged buyouts had become respectable, with junk bonds and highly leveraged companies going mainstream. In fact, in spite of their inherent destructive tendencies and structural defects, leveraged buyouts came to be looked upon as a way to save the economy from inefficient and out-of-touch, “old boy” corporate managements. Lost on everyone was the fact that these buyouts were being accomplished with dollars borrowed from banks whose account holders were not benefiting in the slightest from the risky behavior in which the banks were engaging. Some of the more outrageous incidents ultimately ended up being reported in such stories as “Barbarians at the Gate: The Fall of RJR Nabisco” (both a book and a movie), “Den of Thieves” (a book), “The Predators’ Ball: The Inside Story of Drexel Burnham and the Rise of the Junk Bond Raiders” (a book) and “Liar’s Poker” (also a book).

Simultaneously, something else was happening. Goldman Sachs, which had been able to insinuate itself into the Reagan Presidency, started having greater and greater influence and cachet on Wall Street. I know, because they were our investment banker at the time of the takeover of my company in 1990. Positioning themselves as both the purveyor of innovative new financial products as well as a storehouse of financial wisdom, they also promoted themselves as the “pro-management” investment bank during the takeover wars of the 1980’s. The problem with the latter arrangement is that they always stood to gain more financially from the loss of the company they were supposedly defending than from actually succeeding in keeping it independent.

That wasn’t all, however. While I didn’t fully appreciate how insidious it was at the time, one of the “innovative” products that Goldman attempted to foist off on us was the concept of a “master limited partnership”. As I recounted above, our Chairman/CEO at the time was interested in “flexing our financial muscle” and, consequently, was more than little receptive to new approaches to accomplishing that goal. We had a brand new pulp mill in the South (the one, in fact, mentioned above with respect to which our board had tried to award a bonus to our former CEO, which he had, of course, rejected) that had experienced a significant level of success due to the quality of the pulp it was producing and the clamoring from non-integrated paper mills abroad for the product it produced, i.e., extraordinarily bright and strong pulp. Goldman suggested that we put that pulp mill into one of these new master limited partnerships so that we could create some liquidity for the parent company, i.e., redeploy some its value into other areas of our business, as well as at the same time, keep it off of the parent company’s balance sheet.

This master limited partnership concept was a concept that was embraced with a vengeance by the management of Enron several years later, and we all know how that story turned out.

The Roaring ’90’s: “Rightsizing” and the Rise and Fall of the Dot.Com Nation

In the late 1980’s, massive job losses started to occur among mid- to upper-level white collar workers, mostly due to the corporate consolidations, liquidations and subsequent deleveraging that followed as a result of the excesses of the early and mid-80’s. Once again, I was able to observe this development first hand.

By the end of the 80’s, the company for which I had worked for most of that decade had succumbed to a hostile corporate takeover but I, unlike so many others in my situation, was lucky enough, through a friend’s efforts, to secure new employment with a subsidiary of one of America’s premier consumer products company. Earlier in the decade this subsidiary had itself been a target of a hostile raid by a second, different multinational consumer products company. However, unlike the situation affecting my prior employer, this subsidiary’s management, which was violently-opposed to being acquired by the raider, found consolation in the arms of a “white knight,” which turned out to be my new employer.

As a result of this job change, in 1990 I moved to Westport, Connecticut, a suburb of the Greater New York Metropolitan Area and populated by a sprinkling of the truly rich, but mostly by members of the white-collar working class, including upper-level corporate managers, lawyers, accountants, stock brokers and investment bankers. Westport is both close enough to New York City, and to Boston and Providence, Rhode Island, to serve as a barometer of what was happening in the Northeastern U.S. in general (where many corporate offices were located), and by analogy what was happening in all of the geographic centers of corporate power throughout the nation.

For example, immediately prior to the 1987 Crash, the house that I ultimately bought in 1990 was valued at 200% of what I paid for it. The job losses hit Westport particularly hard since unlike the communities which surrounded it (i.e., Greenwich, Darien, New Canaan, etc., all of which are tonier, with more “old money” than Westport), Westport was much more ethnically diverse and more closely reflected the middle and upper middle-class white-collar working class, much like their brethren in corporate centers throughout the country.

The deplorable employment opportunities landscape that existed at the beginning of the ‘90’s continued unabated through the first half of the 1990’s and only started improving when Netscape Corporation revolutionized the internet with its new browser and the major software industry companies started following suit with their own brand of browser. The result was the dot.com boom of the late 90’s, reaching fever pitch in 1999, before imploding in early 2000. Again, I had a front row seat.

During the latter part of the 1990’s (due to a divorce and a relocation to California to be closer to my parents and siblings, all of whom had relocated to California several years earlier), I found myself working for the Silicon Valley office of a San Francisco-based law firm. In late 1999, just before the dot.com phenomenon self-detonated, I was advised by the managing partner of another firm that, typically, the time-lapse between three typical Standford University graduate students coming up with an idea and the IPO of the company they formed to implement the idea was 18 months!! Eighteen months between concept and IPO!

When you think about this phenomenon for more than a millisecond, you begin to realize that what was happening was that venture capital firms were snapping up new companies left and right, pumping up the prospects for these companies with cash and with “creative” accounting methods, and then dumping them on an unsuspecting American public after pocketing a hefty profit in the process. This happened over and over and was done without any consideration or investigation of the true merits of the business model being proposed. While some new companies did emerge, Amazon, eBay and Yahoo among them, the vast majority of them either failed outright or continued to limp along supported by subsequent rounds of private equity financing, i.e., in order not to appear to have failed miserably, some of the vc firms started throwing good money after bad. However, when the “IPO window” finally shut, it came down with a bang!

The result? Subsequent tides of layoffs, consolidations and bankruptcies. In fact, the law firm where I worked, as most full-service corporate law firms do, had a “three-legged stool” strategy for their corporate business model: first, company formations, then company growth (including regulatory work and corporate M&A transactions), and finally, at the end of the party, bankruptcy reorganizations or liquidations. Thus, I went from working on startups, to working on deals for mature companies purchasing smaller ones, to working with the firm’s bankruptcy lawyers in connection with reorganizations or straight liquidations of some of the firm’s client companies. And, despite ex-President Clinton’s claim of creating 23 million jobs during his administration, the truth is that, looking at it from a longer-term perspective, only a fraction of those jobs actually continued to exist after the dot.com crash and the events of September 11, 2001.

For a fuller exposition of what really took place during the 1990’s, the reader is referred to Joseph Stiglitz’s book “The Roaring Nineties” a work of non-fiction with a publication date of October 1, 2003. A recent review of the book states:

” . . [M]uch of what we understood about the prosperity of the 1990s is wrong. Although jobs were created, technology prospered, inflation fell and poverty was reduced . . . this decade actually laid the foundations for the economic problems we now face . . . [and] that the theories that have been used to guide world leaders and anchor key business decisions were fundamentally outdated. Trapped in a near-ideological commitment to free markets, policymakers permitted accounting standards to slip, carried deregulation further than they should have, and pandered to corporate greed. These chickens, this book demonstrates, have now come home to roost.”

And, that, reader, is the way things really were and that’s precisely what happened.

The 2000’s: After the Stock Market Crashes, the Housing Bubble Begins

I left the San Franciso-based law firm in 2003. However, for at least a year before I left, I was working on closing binders for CMO’s (for the uninitiated, that’s “collateralized mortgage obligations”; yes, that’s right, the stuff that sank the economy starting in 2008), doing, on average, at least two binders a week. The stuff was being generated at a frenetic pace out of both the firm’s New York and San Francisco offices and, even then, when I looked at it, it seemed impossible that the stuff was selling, but selling it was.

Shortly after leaving the law firm, I relocated to Colorado and took up my current life with a new wife in one of Colorado’s Front Range suburbs, where I currently reside. As I watched the first decade of the new Millennium unfold, mostly from an observer’s perspective (as opposed to the vantage point of an active participant as I had been in the three prior decades), a couple of financial themes emerged, about which I observed the following:

1. During the decade following the dot-com implosion, job creation was dismal. Contrast, for example, the situation in September of 2009 when, on a seasonally adjusted basis, there were the same number of private, nongovernmental U.S.-based jobs as there were in June 1999 (you can see that information for yourself here by checking “nonfarm private.”). In other words, the private sector failed in a spectacular fashion to create any new real jobs, despite the adoption of policies by the Bush administration specifically intended to do that. The population grew 9 percent during those years, from 282 million in 2000 to 308 million, but not more than a handful of additional jobs were created.
2. The stock market performance has already been discussed in the Part 1 of this blog entry. One of the commentators said that it was behaving “like somebody running on a treadmill” (“The Lost Decade – Why the Last 10 Years Have Been an Economic Disappointment for Most Americans,” Slate, November 11, 2009). To reiterate, stocks went nowhere, despite slashed capital gains and dividend tax rates, historically low interest rates and the bailing out of more than half of Wall Street.
3. At the same time (reasonably so given the paltry results over the course of the decade), ordinary folks in the U.S. seem to have lost interest in investing. During the 1990’s, for example, U.S. households owning mutual funds increased from 24.4 to 49 percent. At the same time, U.S. household equities ownership rose by more than 30%. In fact, George W. Bush even suggested at the beginning of his presidency that investing in equities could provide a solution to a whole host of societal issues, ranging from the fact of Social Security’s long-term insolvency to resolving the crisis in health care. Instead, the percentage of the U.S. population that continued to own stocks and bonds fell by more than 15% (see, for example, the securities industry’s Equity Ownership in America 2008 report.).
4. Lastly, at end of the Lost Decade, Americans didn’t have much cash left over to invest in the stock market. Incomes, terminally stagnant during the decade, failed to keep pace with the cost increases being experienced in education, health insurance, energy, all of which spiked. Median household income was at $50,303 in 2008, which was below what it was in 1998. At the same time, the number and the percentage of people living below the poverty line rose, from 11.9 percent in 1999 to 13.2 percent in 2009 (see this report from the Census Bureau).

Daniel Gross, in his 2009 article on the Slate website discussed the factors behind these developments:

“Many factors explain the sluggish performance. Globalization, the continuing information technology revolution, and the offshoring of manufacturing and service jobs kept employment in check. But at root, it turned out that the policies enacted by the folks running the system—low interest rates, cutting taxes aggressively, disempowering unions, empowering Wall Street, deregulating the financial system—just didn’t work as advertised. Meanwhile, policymakers neglected some important areas that can help support financial stability—such as health insurance. Between 1999 and 2008 . . . the population of the United States rose 9 percent, but the uninsured population of the United States rose 19.5 percent.”

“The Lost Decade – Why the Last 10 Years Have Been an Economic Disappointment for Most Americans,” Slate, November 11, 2009.

2008 to the Present: “Inside the Meltdown”, “Inside Job” and Moore (no, not “more,” Moore)

Of course, finally in September of 2008, the “man behind the curtain” (to borrow from a scene in the 1939 film, “The Wizard of Oz“) was finally revealed. Our economy took a nose dive into the deep end of the pool, the financial system unraveled and the American taxpayer had to bail out the system to save it from the excesses and mistakes of those “Masters of the Universe” who had been running it for more than 35 years. Here’s what Janet Tavakoli, author of “The New Robber Barons” has to say about some of the more prominent of those “masters”:

” . . . [A]ll the major former investment banks and large bank holding companies participated in fraud during the subprime mortgage crisis, but the public—and even the financial community itself—remains uninformed about their role.

“‘There’s been a lot of lying, and the lying has been so good that many people in the business aren’t fully aware of the big picture of what happened,’ Tavakoli says. What the lies of which Tavakoli speaks are attempting to obscure is ‘widespread massive fraud for which people have not been indicted,’ and an additional barrier to justice has been Wall Street’s ‘shills in the financial media. It’s as if they’re taking dictation,’ Tavakoli says.

“As an example of what she calls this ‘campaign against the truth,’ Tavakoli cites a recent Columbia School of Journalism expose of CNBC financial reporter Maria Bartiromo and contributor Bethany McClean on a report about Goldman Sachs avoiding a Justice Department indictment. Former regulator Bill Black, also on the taped CNBC segment, attempted a vigorous case against Goldman, but ‘he has been marginalized; these ladies were laughing at him.’ Yet ‘despite this reprehensible behavior [securities fraud], they are a bank as of 2008, they can now borrow from the Fed,’ Tavakoli says.

“Besides Wall Street and the media, Tavakoli . . . is no less critical of Washington’s role in covering up financial fraud. ‘The Treasury and the Fed have manipulated the narrative by, for instance, saying we need money [for] TARP; we need money [for] AIG. Any reasonable liquidator would have clawed back that money’ [on collateral calls made to Goldman, SocGen and others], she says.

“Tavakoli wants to see too-big-to-fail banks broken up, but says even that is insufficient. ‘We have to look into the practices. We do have too many regulators, but they’re failed regulators. We could rid ourselves of two-thirds of the people in the system. We have the wrong kind of regulators. In fact we have anti-regulators-incompetent and venal people unable to do their jobs. . .

“’Obama appointed people from the Bush Administration who are failed regulators,’ she continued, citing SEC Chairwoman Mary Schapiro as a prime example. ‘She’s the antichrist of investor advocacy,’ Tavakoli says, pointing to her record as head of FINRA in the Bush administration. ‘The record is along the lines of I-banks 100, investors zero,’ she adds. ‘The fish rots from the head. Based on her track record at FINRA, she shouldn’t be in the regulatory system at all.’”

“‘Antichrist’ at SEC, Dimon, Bush Among Villains of Financial Crisis: Tavakoli,”AdvisorOne, August 29, 2012, which you can read here.

Here’s what another commentator has to say about the period between 2008 and today and about the period immediately prior to it:

“Over the last few decades legislators have changed the landscape that has created a shift in wealth in America. The bailouts, tax loopholes, subsidies and monetary policy have created a funnel from the middle and lower class, going into the cup of the top.

“In the late summer and early fall of 2000 the Internet bubble popped, which lead to a recession. The monetary and fiscal response to this recession was the tipping point for a noticeable shift in wealth from the middle to the top. The Federal Reserve and its former Chairman Alan Greenspan responded to this recession and the 9/11 attacks with an unprecedented amount of easy money aimed at lifting asset prices.

“Fiscally, President George W. Bush inherited what looked like a good hand, but it quickly unraveled. The White House’s response was a broad tax cut, aimed mostly at the upper brackets, capital gains, dividends and estate taxes. From both sides, monetary and fiscal, starting in 2001, stimulus and aid has been mostly aimed toward the wealthiest. At the same time the government spends more on entitlement programs to mask the bigger issue of the top getting most of the ‘redistribution’ . . .

“When we had the financial crisis in 2008 created by the Fed, excessive risks, big banks and insurance companies, we could have done nothing and let the rich take their hits. But our legislators failed us again and created TARP, shifting even more wealth over to the top. Since the Fed had been way to loose in the last cycle taking interest rates to 0 percent this time, was not enough to stabilize the price of long dated assets.

“They decided to try quantitative easing and we are now four years into the Fed expanding its balance sheet almost $3 trillion. They have created and taken $3 trillion in bad debt from the big banks that received TARP. The people who directly caused the meltdown have received almost $5 trillion dollars worth of aid since 2008. The fiscal aid, aimed toward non-banks is less than a trillion dollars, since 2008. Currently the Fed is handing over $85 billion of taxpayer money, every month, to large banks that created the financial crisis.

“When people tried to get help on their adjustable rate mortgages, most were turned away because the money was allocated to the banks, instead. The mortgage owner is the middle class. The bank is the upper class. It is that simple. That is how the shift in wealth has transferred.”

“Shift in Wealth in America Adds to Social Unrest,” Voxii, September 26, 2012, which you can read here.

Much (too much, in fact) has been written about this period in our financial history and I’m not interested in providing any more ink to the discussion other than those which appear above. Instead, I refer the reader to three excellent and compelling narratives that explain precisely and, in the most minute detail, exactly what happened during that period. They are:

• The PBS Frontline special, “Inside the Meltdown,” which you can view here;
• The independently-produced film, “Inside Job,” which won an Academy Award, which you can find here; and
• Despite the strange title, the Michael Moore movie, “Capitalism: a Love Story,” which you can find here. There’s nothing that I can add to their discussion that would improve, in any way, the story of what happened to our economy as it unfolds in their narratives.

Why Investment-Based Crowdfunding Will Succeed: Part 4

Crowdfunding is Good for America and Essential for Revitalization of the U.S. Economy

Financial and legal writers commenting on crowdfunding are equally divided between singing its praises and decrying its defects. While we’ll explore the detractors reasons for being so critical in Part 5 of this blog entry, in this Part 4 we’re going to spend some ink exploring the sentiments of those on the other side of the issue.

U.S. House Representative Patrick McHenry, a Republican from the state of North Carolina, is the person most responsible for making legally-compliant, investment-based crowdfunding a reality. A day after introducing the initial House crowdfunding bill, Representative McHenry convened a House subcommittee hearing to discuss crowdfunding and invited several prominent representatives of the various constituencies that needed to be consulted in order for investment-based crowdfunding to move forward. Representative McHenry, in his opening remarks, stated:

“In an economic environment in which lending to job creators and entrepreneurs remains dismal, we must find new and modern means for capital formation to ignite our sputtering economy . . . An existing and innovative means to connect investors and job creators is crowdfunding . . .

“In today’s fast-paced world of innovation and innovators, all Americans, rather than just banks and venture capitalists and so-called qualified investors, [i.e.,] high net worth individuals, should be able to invest in the next Google, Apple, Facebook, their local coffee shop or their favorite beer company.”

Remarks of U.S. Representative Patrick McHenry, “Crowdfunding: Connecting Investors and Job Creators,” Hearing Before the Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs of the Committee on Oversight and Government Reform, House of Representatives, One Hundred Twelfth Session, September 15, 2011 (hereinafter referred to as the “McHenry Crowdfunding Hearing”).

Dana Mauriello, Co-Founder and President of ProFounder, one of the first investment-based crowdfunding portals to be formed, followed with these remarks:

“It is important that crowdfunding exist because it democratizes access to start-up capital. Capital exists in people’s communities and it just can’t be accessed. Anyone who is bright, driven, and has a great idea can gather a supportive community around himself. Crowdfunding allows that entrepreneur to turn his community into a capital source.”

Remarks of Dana Mauriello, McHenry Crowdfunding Hearing.

Dana Mauriello eloquently laid out the case for “community-based” crowdfunding and its value to this nation in her further testimony before the McHenry Crowdfunding Hearing:

“The idea for ProFunder came to us when we saw two classmates who were starting a business get investment interest from dozens of fellow classmates.

“When these entrepreneurs asked their lawyers to structure this investment deal, they were told that it is impossible for their classmates to invest even $1K each because they are unaccredited investors. When pushed, the lawyers spent months and tens of thousands of dollars to structure a deal that would include only 35 of these classmates.

“We were struck by the incredible inefficiency of this arrangement; available capital existed in the community, but there were tremendous legal and administrative barriers to accessing it.” Remarks of Dana Mauriello, McHenry Crowdfunding Hearing.

Michael H. Scuman, author of The Small Mart Revolution: How Local Businesses Are Beating Global Competition, has stated that:

“Crowdfunding has the potential to deliver jobs Americans have been longing for. We know that small businesses, especially locally owned ones, are key for expanding the nation’s employment, and these businesses comprise (by output and jobs) more than half the private economy. And yet almost none of the $30 trillion we have in our long-term investments (stocks, bonds, pension funds, mutual funds, insurance funds) touches these businesses. This is a colossal market failure, driven by obsolete securities laws. Moving even a few percentage points of our capital into local, small businesses could affect a stimulus home run.”

Scuman, Michael, The Small Mart Revolution: How Local Businesses Are Beating Global Competition (Berrett-Koehler Publishers, Inc., 2006).

Here’s what Ryan Caldbeck in a recent Forbes article had to say about the comparative advantages of crowdfunding compared to traditional channels of investment:

“. . . [W]e believe the Fed’s accommodative monetary policy significantly distorts both returns and risk in the public markets, the two opposing forces that any investor must consider when constructing her portfolio, and provides a great opportunity for investors to allocate a portion of their portfolio to private market assets like crowdfunding.

“When the Fed pours money into the system with the purchase of mortgage-backed securities, combined with guidance from the Federal Open Market Committee that the federal funds rate will remain near zero at least through mid-2015, it depresses yields on debt instruments. In turn, investors pour money into public equities in search of returns they can no longer access in the debt markets.

“The value of a company should be based on the value of its future free cash flows discounted at its cost of capital. However, since the Fed is holding down interest rates and thus companies’ cost of capital, the discount rate to calculate the value of a company is artificially lower resulting in higher company values than might be implied by a company’s fundamentals.

“However, it’s not just the returns portion of the risk-return equation that is out of whack . . . The current yield on three-month Treasury bills, often considered to be the “risk-free” rate, stands at just 0.10% . . . [G]iven the cycle of funds from the left pocket of the U.S. government—the Fed—to the right pocket—the Treasury selling T-bills—is the risk-free rate really risk-free? Nobody can know for sure what would happen to T-bill yields if the Fed’s buying binge ended, but one thing that’s certain is this: the risk-free rate would rise, as demand for our T-bills dropped. In short, risk is being distorted in today’s markets too.

“So, what does the all mean to . . . an investor? It means that at some point in time, when unemployment improves to a level that Ben Bernanke considers acceptable, QE3 will end, and public equities may be headed for a plunge.

“Nobody knows when the music will stop, but the distortion of risk-reward in the public markets makes this an ideal time for investors to consider their portfolio allocation in private markets.

“Private markets certainly carry risks too; however, investors can take comfort knowing that when they invest in a high-growth $1 million revenue organic food company, there is no meaningful distortion of the company’s value due to QE3. The value drivers for high-growth consumer companies [for example] tend to be driven by execution – distribution expansion, new product development, sales and marketing, not macro-economic issues. There are significant risks, but they are more idiosyncratic to the company, rather than to distortionary monetary policy.”

In the May 19, 2012 Print Edition of The Economist, the writer decries the decline of the publicly-traded corporation, hinting that the antidote to much of what ails our economy is a new profusion of businesses who’s ultimate goal is to become widely-held by a fully-engaged and very much interested general public (precisely what crowdfunding in its most vibrant and successful form promises):

“ . . . [T]here are reasons to worry about the decline of an organizational structure that has spread prosperity for 150 years… Fewer IPOs mean fewer chances for ordinary people to put their money in growth companies. The rise of private-equity and spread of private markets are returning power to a club of privileged investors. All this argues for a change in thinking– especially among the politicians who heap regulations onto publicly traded corporations, blithely assuming that business have no choice but to go public in the long run. Many firms now go (or stay) private to avoid red tape. The result is that ever more business is conducted in the dark, with rich insiders playing a more powerful role. The publicly traded company has long been the locomotive of capitalism. Governments should not derail it . . . ”

In his Forbes article on community-based crowdfunding, Chance Barnett, a regular Forbes contributor on crowdfunding says:

” . . . Giving Americans equal economic opportunities based on their wealth or income isn’t just a political imperative. It’s a moral imperative . . .

Those who oppose crowdfunding laws under the JOBS Act would have you believe that non-accredited investors can’t be trusted to make their own financial decisions and thus shouldn’t have the opportunity to invest in private companies. They argue that ordinary Americans are naïve and don’t have adequate experience to be allowed to invest.

What crowdfunding opponents conveniently overlook is that ordinary Americans have a history of investing in private companies with whom they have a personal connection, and are allowed to do so under current law at a rate of up to 35 non-accredited investors per company.

If you know anything about investing in small businesses, you know the decision to invest is as much about the people in whom you’re investing as it is about the idea. Yet opponents talk about crowdfunding in a vacuum, as though it’s about some cold and impersonal ‘stock market.’ . . .

Under the JOBS Act, changes in securities laws will create a new market for business crowdfunding that gives everyone – regardless of income or net worth – the opportunity to invest in early-stage startups and small businesses . . .

[And] [w]hat I predict will be the most socially transformative part of crowdfunding will come from the power of local or community-based investing . . .

Not only does investing in local businesses appeal to this new class of non-accredited investors, it can and will often take place within existing relationships and communities of people who know, respect and trust one another. The outcome? Stronger communities and stronger local economies.”

“Community-Based Investing: A Higher Evolution of Crowdfunding,” Forbes, September 27, 2012.

Hear what Sherwood Neiss and his collaborators on “Startup Exemption” (which you can read here) have to say about the benefits of crowdfunding:

” . . . [T]he traditional capital that our nation’s entrepreneurs used prior to the financial meltdown has disappeared – I know I tried to raise capital for 2 ideas I have and I’m a seasoned three-time INC500 entrepreneur.

There’s a solution . . . [it’s] . . . based on Crowdfunding where entrepreneurs pitch their ideas to average Americans and let them decide which ideas they would back with a few dollars in exchange for an equity stake in the company.

This form of investment is illegal in the USA because it breaks 80 year-old Security Laws on public solicitation and accreditation. However, American’s today are more sophisticated than they were 80 years ago, they have seen the financial crisis firsthand and are more skeptical than ever before freely giving away their hard earned cash. Go ahead, try and ask a group of 1,000 people for $50 each and see how successful you are . . .

. . . [U]pdat[ing] the security laws to make equity-based Crowdfunding . . . legal . . . can put the power in the hands of the American people to decide which of their community entrepreneurs they want to back and those that they do not. The ones that rise to the top will not only have access to a small amount of critical seed capital that doesn’t exist in the markets, but knowledge, experience and marketing power from their supporters. Think about it. If you own Apple stock chances are you have an iPhone and rave about it. Subsequently, if you want to back your friends Korean BBQ Food Truck or Internet Startup, chances are you will not only be a consumer but an advisor and marketing agent for them as well.

Direct ownership will not only increase the chance of success (as social networks have time and again shown the ability of the crowd to rally behind an idea) but first-hand ownership will help entrepreneurs succeed thru shared knowledge and experience. More small successes will lead to an increase in consumer confidence, which is a direct economic indicator.”

Lastly, Jared Iverson, a self-described “former Big Law securities attorney” who currently serves as the CEO and Co-founder of Healthfundr, an online funding platform for health, wellness and medical companies, has this to say about crowdfunding:

“. . . [D]espite some challenges, the potential for good far outweighs the dangers . . . [here are] just a few of the benefits crowdfunding presents . . .

• While crowdfunding entails investment risk, risk is not the same thing as fraud, and crowdfunding makes it more difficult for entrepreneurs to commit fraud
• VCs consistently deny funding to companies that would have otherwise thrived
• Crowdfunding will galvanize America’s culture of innovative mavericks and risk-takers
• Crowdfunding is a natural extension of the historical trend toward greater access to capital” “Why Crowdfunding is Good for America,” The Crowdfund Lawyer, August 31, 2012. Iverson goes on to add: ” . . . [O]ver emphasizing the risks while glossing over the benefits will only serve to stifle American ingenuity. The benefits crowdfunding offers to investors and entrepreneurs alike are many. The crowd is anxious to invest in innovation and the markets have already spoken – Crowdfunding is a success and it’s here to stay. . . . “ Before concluding our examination of why crowdfunding is good for America, I’d like to explore several of Iverson’s points in greater depth. Crowdfunding Makes It More Difficult for Entrepreneurs to Commit Fraud: It’s a given that a startup entrepreneur engaged in a crowdfunding campaign will be subjected to far greater scrutiny than is the case with current funding models. This is so because there will be a significantly greater number of prospective investors (and other interested parties) merely because of the online nature of, and ease of access to, the crowdfund offering itself. As a consequence, where, in those rare instances, a fraud is being perpetrated, the fraud will be detected far more quickly than is the case with non-crowdfunding models, such as offline private placements, small DPO’s and venture and angel capital, among others. Also, and separately, crowdfunding portals will provide direct access to the entrepreneur, something unavailable in most IPO’s and DPO’s. This, coupled with the superior communication tools available through funding portals, will result in far more transparency in discussions with CEO’s and their CFO’s (e.g., FAQ and Q&A chat rooms and spaces on the crowdfunding offering website, open to both prospective investors and members of the financial press). “Opponents of crowdfunding will try to cite high failure rates of crowdfunded companies as evidence of fraud. Correlating fraud with the high-risk nature of early-stage investing would be disingenuous and misguided . . . Creating something that hasn’t previously been created is never accomplished free of mistakes or initial failures. [Some of the s]tartups seeking crowdfunding [will be] in the business of disruptive, innovative progress and are, consequently, highly risky. Many will fail. But even those failures will add to society’s accumulated knowledge and will benefit other innovators.” “Why Crowdfunding is Good for America,” The Crowdfund Lawyer, August 31, 2012. VCs Consistently Deny Funding to Companies That Would Have Otherwise Thrived: Even though we will be examining the reasons for the animus against crowdfunding in Part 5, Jared Iverson provides some early insight: “Some pundits claim that our current model is sufficient and if entrepreneurs aren’t being funded by VCs, then they’re not suitable for crowdfunding. I don’t know if that argument is rooted in naïveté or a desire to shield current funding models from competition.” Venture capitalists turn away viable startups all the time. Why? Principally, because the startup doesn’t fit the narrow profile that the VC has created for those businesses in which he or she will consider investing. For example, many VCs invest solely in technology companies; few invest in consumer product companies even though the products produced by those types of companies constitute 14% of our consumer economy. Also, given the historical failure rate of the vast majority of the companies in which VCs invest, some companies can’t possibly promise the type of returns that VCs require in order to provide balance and protection against the results from the ones that will fail. In order to reduce the risk to their investors, VCs tend to invest only in those companies in industries with which members of the VC firm have familiarity or those with respect to which the firm has, as they like to say, “domain expertise.” Thus, the reasons why VCs pass on companies that could have achieved success are varied and involve factors that are unique to each individual venture capital firm’s investment profile. Crowdfunding Will Galvanize America’s Culture of Innovative Mavericks and Risk-Takers: Whether an innovation can be truly disruptive and can potentially constitute a significant improvement on existing products in a particular market can never be predicted with certainty. The strength of America’s economy has always been due to the pace of innovation and the willingness to depart from the past in order to secure the future. Consequently, the single most important way to revitalize the U.S. economy lies through encouraging and supporting both inventors and innovators. As Jared Iverson has so elegantly articulated: “America needs more innovators, risk-takers and leaders willing to step into the dark uncertainty of the startup world. It’s these entrepreneurial individuals who push back the boundaries of our collective knowledge and bring substantive advancements that benefit society. It’s these individuals who drive job creation and improve economies. Crowdfunding will empower these innovators that our current capital-distribution models have failed to reach.” “Why Crowdfunding is Good for America,” The Crowdfund Lawyer, August 31, 2012. Crowdfunding is a Natural Extension of the Historical Trend Toward Greater Access to Capital: Finally, as Jared Iverson correctly points out, capital will flow freely through crowdfunding portals in the future, despite the efforts of Wall Street (and their supporters in the financial, legal and accounting communities), investor protection groups and federal and state securities administrators to restrain it. Crowdfunding is part and parcel of a democratization process that is currently underway and that is profoundly impacting traditional institutional structures, both in this country and abroad, many of which have failed to adequately address and protect the needs of the constituents to which they are answerable. The clear and unmistakable failure of many of our existing financial institutions to perform in a reasonable and rational manner, and their failure to protect the interests of those to whom they should owe a loyalty, has led inexorably to the emergence of new avenues of investment, including crowdfunding, to set matters right. “It’s inevitable in our information age that [even the average small] investor[ ] will become increasingly more aware of startups. And those who wish to support those startups will find a way to invest despite the overly paternalistic . . . attempts of regulators. “Just like water always finds a way to flow downhill, capital will find its way to productive entities. Regulators can try to dam up the flow, but the market will find a way to get the necessary capital to creative individuals.” The successful implementation of crowdfunding will free-up capital and put it to use in a more direct and efficient way than conventional channels. It will also do so in a much more transparent and revealing way and thus take some of the artificially-manufactured “mystery” out of capital raising in the U.S. Importantly, regulators should recognize this fact and should not insist on subjecting the new system to the mercy of those same old malefactors who view their clients as “muppets” and who have failed miserably to honor their obligations to their clients in the past. Turning crowdfunding over to the broker-dealer crowd, with their “accredited investor” personal contacts and their “insider and old-boy” networks will interfere with the optimal development of this new channel. The small investor who has been ignored by the traditional channels needs to be allowed to reclaim control over his or her investments without interference by the established financial community and to redeploy those funds in a manner more suited to meet his or her own objectives, rather than the objectives of a far-away Wall Street or the established large corporations community.

Why Investment-Based Crowdfunding Will Succeed: Part 5

Why Is the Wall Street-Centric Crowd Dismissive of Crowdfunding?

In this, the last part of our examination of investment-based crowdfunding and why it will succeed, we explore why Wall Street (along with existing private equity, both venture capital and angel group investing) is so strongly and almost universally dismissive of non-accredited investment-based crowdfunding. Additionally, we consider why their supporters, i.e., corporate finance and securities lawyers, “Big 4” accounting firms and their smaller imitators and the existing investor protection groups and regulatory authorities, i.e., the SEC, FINRA and the NASAA (the North American Securities Administrators Association), are also so vehemently opposed to this development.

Wall Street, Sand Hill Road and Angel Group Investors:

Why are Wall Street, venture capitalists and angel groups, and their professional advisers and support staffs, all opposed to investment-based crowdfunding? The answer is quite simple: “fear” and “greed”, and, in some quarters, “arrogance”.

The Venture Capital Community

While there are certainly some enlightened beings among the venture capital community (Fred Wilson, of Union Square Ventures in New York City, comes to mind; see Forbes interview, “Fred Wilson and The Death of Venture Capital,” Forbes (Online) May 5, 2012)), the vast majority of the “movers and shakers” in the venture capital community are opposed to investment-based crowdfunding because of the possibility that it will (i) initially, diminish their influence and power in attracting the best new deals (since quality deal flow is already a problem for the established venture capital community), and (ii) secondly, screw-up their ability to fund subsequent rounds of financing that these young companies might require in order to grow their businesses. Regarding the former, here’s what the interviewer reported after speaking with Wilson during his Forbes interview:

. . . [T]here is simply too much money [chasing deals that could qualify for venture capital financing]. Although $30 billion continues to flow unabated into venture-backed companies annually in the U.S., venture capital as an asset class hasn’t outperformed the market since the early 90’s – back when only $10 billion was put to work. Things look even bleaker when you add in the $10 billion or so that angel investors now dish out (three to five times more than just five years ago), growing interest from places like Russia and the Middle East (think Yuri Milner and Prince Alwaleed’s Twitter investment), the rise of accelerator programs (YCombinator and TechStars) and non-equity financing options like Kickstarter. The prospect of equity-based crowdfunding, as legalized by the JOBS Act, may present an even graver threat . . . The problems with venture capital now are dwarfed by the potential problems down the line . . .”

“Fred Wilson and The Death of Venture Capital,” Forbes (Online) May 5, 2012.

For a sample of VC antipathy to crowdfunding, consider the remarks of Jonathan Aberman, a venture capitalist with Amplifier Ventures:

“the idea that crowd funding is going to change the startup industry in a positive way is just silly …

. . . the reason why most startup investing occurs through direct interactions and professional management is that there is a risk reducing function that is performed by the VC or the experienced Angel. I know that comment could touch off a firestorm of comments, so . . . [s]uffice it to say that wealthy people tend to believe this, as do the professional managers of endowments and pension funds . . .

. . . most investors are not sufficiently financially literate to evaluate an adjustable rate mortgage, much less a startup . . .”

This view ignores the fact that if you look at the historical averages (as reported by the venture capital industry itself) of even the best, most diligently-run venture capital firms you’ll find an average success rate (according to the National Venture Capital Association, the trade group for the industry) of about 30%. Which means that even if you believe the results touted by NVCA and the venture capital industry, on average, venture capitalists are wrong in their assessments of the companies they choose to invest in, and thus fail, 70% of the time.

Furthermore, according to The Wall Street Journal, even these numbers over-inflate the actual success of the industry:

” . . . there is evidence that venture-backed start-ups fail at far higher numbers than the rate the industry usually cites . . . [In actuality,] [a]bout three-quarters of venture-backed firms in the U.S. don’t return investors’ capital, according to recent research by Shikhar Ghosh, a senior lecturer at Harvard Business School . . . Compare that with the figures that venture capitalists toss around . . . [For example,] [t]he National Venture Capital Association estimates that 25% to 30% of venture-backed businesses fail.

Mr. Ghosh chalks up the discrepancy in part to a dearth of in-depth research into failures. “We’re just getting more light on the entrepreneurial process,” he says. His findings are based on data from more than 2,000 companies that received venture funding, generally at least $1 million, from 2004 through 2010. He also combed the portfolios of VC firms and talked to people at start-ups, he says. The results were similar when he examined data for companies funded from 2000 to 2010, he says.

Venture capitalists “bury their dead very quietly,” Mr. Ghosh says. “They emphasize the successes but they don’t talk about the failures at all . . . “

“The Venture Capital Secret: 3 Out of 4 Start-Ups Fails,” The Wall Street Journal, U.S. Edition, September 19, 2012.

In particular, over the past 10 years the track record of even the most prestigious venture capital funds has been abysmal. The Ewing Marion Kauffman Foundation, one of the most respected entrepreneurial-support organizations in the United States, has this to say about venture capital’s performance over the past decade:

“Venture capital (VC) has delivered poor returns for more than a decade. VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC. Speculation among industry insiders is that the VC model is broken, despite occasional high-profile successes like Groupon, Zynga, LinkedIn, and Facebook in recent years.

The Kauffman Foundation investment team analyzed our twenty-year history of venture investing experience in nearly 100 VC funds with some of the most notable and exclusive partnership “brands” and concluded that the Limited Partner . . . investment model is broken . . . . .Limited Partners — foundations, endowments, and state pension fund — invest too much capital in under-performing venture capital funds on frequently misaligned terms. Our research suggests that investors like us succumb time and again to narrative fallacies, a well-studied behavioral finance bias . . .

. . . The cumulative effect of fees, carry, and the uneven nature of venture investing ultimately left us with sixty-nine funds (78 percent) that did not achieve returns sufficient to reward us for patient, expensive, long-term investing.”

“We Have Met the Enemy and He is Us: Lessons Learned From Twenty Years of the Kauffman Foundation’s Investments in Venture Capital Funds and the Triumph of Hope Over Experience” (The Ewing Marion Kauffman Foundation, May 2012). Also see, “The Venture Capital Secret: 3 Out of 4 Start-Ups Fails,” The Wall Street Journal, U.S. Edition, September 19, 2012.

Can the ordinary small investor do much worse than that, especially when they’re dealing with their own money (as opposed to VC’s who are typically gambling with someone else’s money) and when they’re not receiving either a fee for managing the portfolio nor a carried interest for which they have not paid. No, simply put, because the average small investor will have more “skin-in-the-game,” he or she will be that much more involved. Aberman’s argument simply doesn’t hold water; half-way intelligent human beings, under similar circumstances, will, on average, do better. And those who, for one reason or the other, lack the capacity to do so, will, over time, simply leave the market.

Angel Groups

Among the various groups opposed to crowdfunding, a segment that is second only to state securities administrators in the intensity of their opposition to crowdfunding, is the segment known as “angel” groups.

Angel groups first became a factor in seed and early-stage start-up financing following the withdrawal of the venture capital community from investing in that sector following the dot-com meltdown and the uncertainty created by the events of September 11, 2001. And, the 2008 meltdown has only accelerated this trend.

With venture capital hard to come by, and the rise of many dot-com-era newly-minted millionaires, angel investing changed dramatically. Extremely well-heeled accredited investors started to band together, stepping into the shoes traditionally worn by venture capitalists, in order to secure for themselves (without having to pay a fund manager a 2% annual fee and a 20% carried interest) the types of returns on their money that had been denied to them prior to their entry into the “millionaires (and billionaires) club”.

But, unlike the venture capital industry, the “angel group investing” segment has major structural defects that make managing group angel investments considerably more difficult, not only for the companies being funded but for the investors themselves:

“The angel market is much less efficient than established venture capital. According to the Angel Capital Association, most angel investments happen locally – sometimes because of a desire to be close to the entrepreneur, but often because the deal was sourced through word-of-mouth, or even to support their local community. Sourcing is very difficult, in part because of the historical ban on general solicitation . . . . Angel investments have historically been conducted through personal networks . . . . The typical Angel process includes lots of meetings and introductions – without a central location for buyers and sellers to come together . . . [P]roprietary deal flow is still a hallmark of the industry, and leaves newer funders with less established track records in a weak position.

“. . . The democratization of early-stage investing through crowdfunding has the potential to level the playing field, disrupt the Angel industry, and in the process provide huge new benefits to entrepreneurs and investors. It will likely make early-stage investing more efficient [as opposed to Angel-financing which is currently inefficient], and increase the total funded capital of start-ups.”

“Why Crowdfunding is Disruptive to Angels, but not to VCs,” TID *Start Up*,
November 22, 2012.

Thus, although the angel community shares a dislike of crowdfunding with the venture capital community, and for the some of the same reasons that the venture capital community does, i.e., loss of deal flow and difficulties in providing additional capital to post-crowdfunded companies, in the case of angel groups there is an added reason for the hostility, i.e., angel groups cannot compete effectively against crowdfunding due to the inherent inefficiencies present in the angel group investing model. Here’s what Ryan Caldbeck, CEO of CircleUp, had to say about the inherent disadvantage in angel investing in groups:

“Six months ago I called the Director of Business Development for a well-respected angel group in California and told him about my company, CircleUp, an equity-based crowdfunding platform that would allow his angels to invest into private companies. He had no interest in talking, saying “our angels wouldn’t be interested in something like this.”

30 days later, several of “his” angels invested through our platform (they had heard of CircleUp through word of mouth). As it turned out, his angels loved us because we gave them access to quality deal flow they would not have otherwise seen.”

“Why Crowdfunding is Disruptive to Angels, but not to VCs,” TID *Start Up*,
November 22, 2012.

On a personal note, this apparent hostility to crowdfunding by angel groups was confirmed to me during my participation at the SEC Government-Business Forum on Small Business Capital Formation, held on November 15, 2012. During the Crowdfunding Breakout Group session, a very prominent (and vocal) attorney for several angel groups stated, categorically, that “angel groups are hostile to crowdfunding.”

Given the clear attitude of this adviser (who was allegedly speaking on behalf of his clients), as well as the experiences of the others who have personally witnessed displays of this hostility, perhaps, in the final analysis, it’s the managers and advisers to these angel groups who are opposed, rather than the angels themselves. After all, if angels start investing through crowdfunding, instead of through these angel groups, these managers and advisers stand to lose not only influence but, perhaps, even money in the process. Time will tell.

Wall Street

When I write about Wall Street here, I’m referring to that crowd consisting of the remaining large investment banks (and their distribution channels in the established broker-dealer networks), the large commercial banks (to the extent they still exist as independent entities apart from the investment banks and are involved, in some meaningful way, in start-up financing), a big chunk of the membership of FINRA, and various middle men and support professionals who assist the major players in ensuring that the giant whirlygig known as “Wall Street” continues to go round and round without, in the slightest, even slowing down.

When it comes to Wall Street, the hostility toward crowdfunding is absolute. This, despite the fact that, strangely and paradoxically, the opposition to it here appears, at least on the surface, more subdued. Perhaps this is due to the fact that, like much of Wall Street’s activities, its opposition to crowdfunding is being carried on in the dark and, as is so often the case, through purchased proxies, lobbyists among them.

For this group, as is the case with the radio show host (mentioned in Part 1 of this blog), their hostility to crowdfunding comes more from their disdain of, and disbelief that, any alternative capital formation and maintenance system could compete effectively with the one to which they are currently committed. They hold to the current system despite its negative impact on new capital formation (e.g., the paucity of IPO’s for smaller, not-so-easily scalable, companies) and its repeated failures to provide even a modicum of value to the average American investor from whom so much has already been taken. After all, the folks who lead Wall Street, even more than their brethren in private equity, have been able to irresponsibly and systematically wreck our economy, while at the same time both raking in billions of dollars and simultaneously escaping virtually all of the consequences of their bad acts. So, given the current system that works so wonderfully for those who feed off of it, why bother to give any serious consideration to a competing system which, as improbable to them as it now appears, might just contain the seeds of a viable alternative, thus posing a danger to the established order. See, “Dodd-Frank Lobbyists Delaying JOBS Act Implementation,” Institutional Investor, October 12, 2012, which you can read here.

Mike Masnick, in his article “Corruption Laundering: The Art Of Manipulating Regulations To Block Innovation” (Innovation by TechDirt, December 11, 2012; you can read that article here), writing in general about what has been referred to as “soft corruption,” addresses the phenomenon of existing businesses using existing regulatory schemes in an attempt to block new companies with “disruptive” business models. The insights he shares seems to apply equally to Wall Street and its attitude toward crowdfunding:

“. . . There’s a myth out there that businesses hate regulations. That’s only partially true, and it’s only true in limited cases. In many industries — especially highly regulated ones — the incumbents often love regulations because (a) they have enough power to control the regulations, (b) they know their way around those regulations better than anyone else, (c) those regulations quite frequently limit competition, and (d) those regulations quite frequently effectively block out any form of disruptive innovation by stopping it entirely.”

Elsewhere in the article he observes:

“. . . [H]ow [is] . . . it . . . possible for people to explain away the corruption in each case as having a legitimate basis[?] That’s what’s really pernicious here . . . we’re generally not talking about overt corruption, the kind where someone is handing briefcases full of cash over to politicians. It’s much more subtle. What you get are legacy companies who fear disruption — and they are able to make the case that the ‘disruption’ should be illegal because it’s scary to the incumbent. That is . . . ‘we need to carefully regulate industry z, because if we don’t they’ll take advantage of customers!’

. . . [I]t’s done through this regulatory framework to make it look, sound and (in some cases) feel perfectly legit to many people, making it much easier to keep those regulations in place. The corruption is ‘cleaned’ of its dirty connotations because it can be wrapped in a cloth (though bogus) of . . . ‘protecting your safety.’ It is corruption, but the truly nefarious part is that the corruption is done in such a way that there is plausible deniability over whether or not it is truly corrupt. And that’s what makes it so difficult to root out . . . It’s all been white-washed in a way to have a plausible explanation, even as the pace of important innovation suffers drastically.”

On a parallel track, here’s what Dara Albright, the founder of NowStreet Media, has to say about the well-heeled and well-positioned (many of whom participate in the Wall Street shell game) and suggesting another reason that might be behind their opposition to crowdfunding:

“Once Wall Street stopped risking its own capital and starting “guaranteeing” returns for its institutional clients, as seen with certain PIPE financings, was when the markets began to dismantle. Look how much the Street has changed since the dot-com bubble burst – most broker dealers no longer commit capital to their banking deals or their trading desks. They act strictly on an agency basis. Many investment bankers even demand upfront retainers, eliminating any risk whatsoever . . .

. . . Because small investors are legally prohibited from investing in private companies, they have been forced to become the “exit strategy” for those who are allowed. I will never understand the logic behind laws that permit average citizens to purchase stocks only when “sophisticated” investors are ready to dump them . . .”

Supporters of the Wall Street Crowd:

What about the supporters of the Wall Street crowd, i.e., the corporate finance / securities bar and the established players in the accounting profession? What motivates their opposition to crowdfunding, as evidenced by the countless articles and whitepapers prepared by these supporters to criticize, discredit, and point out the supposed defects with, crowdfunding.

As mentioned above, for many of them, the answer is quite simple: “arrogance” and “cynicism.” For the rest, the answer is blind allegiance to the prevailing capital formation and maintenance culture, as well as unthinking, uncritical and non-objective loyalty to their clients, driven mostly by their need to protect their own livelihoods, irrespective of the social costs.

Enough said.

The Federal and State Regulatory Authorities

In the case of both federal and state securities regulators, they claim their opposition to crowdfunding arises from their concern that the average small investor is too stupid and too naive to be capable of fending for him- or herself. But the facts suggest that there may be other reasons at work as well.

To understand the stated view of the securities administrators regarding crowdfunding, consider the words of the SEC’s Chairman, Mary Schapiro, in her written testimony submitted to the U.S. Senate as they considered the proposed federal crowdfunding exemption:

“. . . Too often, investors are the target of fraudulent schemes disguised as investment opportunities . . . As you know, if the balance is tipped to the point where investors are not confident that there are appropriate protections, investors will lose confidence in our markets, and capital formation will ultimately be made more difficult and expensive . . .”

The sentiment behind Schapiro’s testimony has been echoed in statements by other securities regulators, at both the state and federal level, in the form of testimony during the hearings leading up to the enactment of the legislation, as well as subsequent numerous “official” pronouncements issued after it became law (some of which are discussed under the heading “NASAA and the State Securities Regulators” which appears below).

But is this their real concern or merely a mask for some deeper, more, as Mike Masnick writes, “pernicious” motivation?:

“. . . [The] regulatory framework . . . make[s] it look, sound and (in some cases) feel perfectly legit to many people, making it much easier to keep those regulations in place. The corruption is ‘cleaned’ of its dirty connotations because it can be wrapped in a cloth (though bogus) of . . . ‘protecting your safety.’ It is corruption, but the truly nefarious part is that the corruption is done in such a way that there is plausible deniability over whether or not it is truly corrupt . . . It’s all been white-washed in a way to have a plausible explanation, even as the pace of important innovation suffers drastically.”

“Corruption Laundering: The Art Of Manipulating Regulations To Block Innovation” (Innovation by TechDirt, December 11, 2012).

FINRA and the SEC: Mary Schapiro’s Opposition to Crowdfunding

In order to understand the current opposition to crowdfunding by securities regulators at the federal level, i.e., the Securities and Exchange Commission (SEC) on the one hand, and the Financial Regulatory Authority (FINRA) on the other, it’s important to examine the career and views of Mary Schapiro, who not only served as the SEC’s chairperson at the time of the initial consideration in Washington of a crowdfunding exemption,, but also as FINRA’s Chairman and CEO immediately prior to her appointment as SEC chair.

To start with, Mary Schapiro served in various roles as a financial services regulator under Ronald Reagan, George Bush, Sr. and Bill Clinton. Those administrations, collectively, have been credited with allowing the dismantling, with Wall Street’s full support and complicity, of much of the regulatory oversight infrastructure that might have prevented, or at least significantly mitigated, the financial meltdown of 2008.

Second, Wikipedia reports that prior to her appointment by President Obama as the SEC’s Chairperson, Schapiro served, from 2006 to early 2009, as the Chairman and CEO of FINRA (see “Mary Schapiro“, Wikipedia, here). It was during Schapiro’s tenure at FINRA, in the period betweem 2006 and 2007, that FINRA’s “fines against Wall Street shriveled.” See, “Dump FINRA and the SEC,” Forbes.com, September 10, 2009, which you can find here, as well as my prior blog entry on the subject, which you can find here.

Coincidentally, nine months after President Obama appointed Schapiro as the new permanent SEC Chairman, Bernie Madoff, in an interview reported at NYDailyNews.com, referred to Schapiro as a “dear friend” (“Bernie Madoff Baffled by SEC blunders; Compares Agency’s Bumbling Actions to Lt. Colombo,” (NYDailyNews.com, October 30, 2009; in the same interview, Madoff referred to Elisse Walter, Schapiro’s replacement as SEC Chairman, as a “terrific lady” whom he knew “pretty well”; you can read the Daily News report of that interview here).

But, assuming that there actually was such a friendship and that Bernie Madoff wasn’t lying, how important was this “friendship”? Important enough for Schapiro to ignore the substantial “red flags” and allegations of wrongdoing that had been previously leveled against Madoff? Does the existence of such a relationship, if it truly existed, signify anything at all, or is it merely a coincidence?

Not entirely unrelated to this line of inquiry, Wikipedia reports (in the article previously cited above) that in 2008, her last year at FINRA, Schapiro earned a regular compensation package of $3.3 million. Additionally, on her departure from FINRA, she received additional lump sum retirement benefit payments that brought her total package to just under $9 million in 2008 (source: “WHOA: FINRA Paid Mary Schapiro $9 Million In 2008”. Courtney Comstock, Business Insider (October 11, 2010), which you can read here).

In light of the above, it’s interesting to note that, along with other allegations, an allegation was made after her departure from FINRA that Schapiro’s FINRA compensation, as well as the compensation of certain highly-placed executives of FINRA, was “excessive”. This claim, among others, was asserted by one of FINRA’s members, Amerivet Securities, Inc., in a letter to FINRA’s Board dated December 4, 2009.

In response to the Amerivet letter, an investigation was undertaken and at the conclusion of the investigation a final report was issued. The report, entitled “Report of the Amerivet Demand Committee of the Financial Industry Regulatory Authority, Inc.,” (which, if you’re even interested, you can read here) (the “Report”), exonerated the FINRA Board and top FINRA management with respect to all the issues raised in the Demand Letter. However, the Report’s conclusions have been disputed by Amerivet (which subsequently decided to pursue its own lawsuit against the organization, its management and its board) and, additionally, have been widely criticized by the financial press; see, for example, “Finra, First Heal Thyself” Barron’s, March 8, 2010; (“In 2007-08, regulators at FINRA were so distracted with empire-building and lining their pockets, they overlooked the world’s two largest Ponzi schemers: Bernie Madoff and . . . R. Allen Stanford . . .“; you can read that article here or here) and “Mary Schapiro, Whose Pay Was Benchmarked To CEOs Of Investment Banks And The NYSE, Received A Farewell Payment From FINRA Of $8,985,334.02” Zero Hedge, October 11, 2010, which you can read here.

The Report’s exoneration of Mary Schapiro notwithstanding, one can’t help but wonder whether the extraordinary level of compensation paid to Schapiro (as the Report acknowledged, set at the levels existing for executives at some of the most profitable investment banking and financial services organizations on Wall Street), along with her alleged coziness with Bernard Madoff (remember, he said she’s a “dear friend”) somehow relates to how rigorously (or not) she pursued cases against the “bad actors” among FINRA’s membership. While, in actuality, there may be no connection, nevertheless the attendant circumstances certainly could give one pause.

Alright, but how is the above in any way relevant to the issue of Schapiro’s views on crowdfunding? The answer is quite simple: even after her departure from FINRA, Schapiro continued to have a strong connection to that organization and its top brass. This, coupled with her continuing loyalty to those among its members whom she may have viewed as “good friends” (remember Bernie Madoff’s comment), could cause her to want to help protect their vested interests, for which crowdfunding could, over time, present a serious competitive challenge.

From her perch atop the SEC she undoubtedly saw how introducing unworkable regulations for equity-based crowdfunding would have the effect of undermining this new, more democratic way to raise capital. By successfully lobbying the Senate to inject a largely unworkable regulatory overlay on the crowdfunding piece of the JOBS Act (before investment-based crowdfunding ever had an opportunity to demonstrate its viability in the marketplace), Schapiro may have sought to nip this new development in the bud. Remember, “[t]he SEC openly opposed crowdfunding prior to the JOBS Act, including pointed criticism by SEC Chairwoman Mary Schapiro that crowdfunding would weaken investor protection and be ‘a step backwards.’ See “Will Crowdfunding Live Up to the Hype?” PEHub, April 28, 2012, which you can find here.

Is Mike Masnick’s extraordinarily perceptive insight that regulations are both enacted and maintained to protect the established order operative in this case?:

“. . . [The] regulatory framework . . . make[s] it look, sound and (in some cases) feel perfectly legit to many people, making it much easier to [put] those regulations in place. The corruption is ‘cleaned’ of its dirty connotations because it can be wrapped in a cloth (though bogus) of . . . ‘protecting [investors’] safety.’ It is corruption, but the truly nefarious part is that the corruption is done in such a way that there is plausible deniability over whether or not it is truly corrupt . . . It’s all been white-washed in a way to have a plausible explanation, even as the pace of important innovation suffers drastically.”

“Corruption Laundering: The Art Of Manipulating Regulations To Block Innovation” (Innovation by TechDirt, December 11, 2012).

Of course, specifics and some additional explanation are in order here. By providing testimony and recommendations to the Senate during their deliberations on crowdfunding, Schapiro’s words, given in her capacity as the top federal cop on the securities beat, carried great weight. Consequently, Schapiro was able to have inserted in the Senate version (primarily, she claimed, as “protection for investors”), the concept of “required intermediaries.” [Note: It should be noted here that this concept of intermediaries as part of the crowdfunding process was merely an option, not a requirement, under the original McHenry proposal]. Additionally, she was able to have inserted, as a corollary to the requirement for regulated intermediaries, a second requirement that all such intermediaries be subject to regulatory oversight either by FINRA or by some new “other,” still to be established and currently non-existent, self-regulatory organization (SRO).

At the time she advocated adding this SRO wrinkle, however, Schapiro was already aware that the concept of a new SRO to regulate crowdfunding portals would never fly because (i) it would require separate governmental funding as well as the imposition of additional costs upon the members of the fledgling crowdfunding industry in the form of membership dues; and (ii) she knew that a proposal to set up a similar SRO to regulate investment advisers under the proposed Investment Adviser Oversight Act of 2012 (H.R. 4624) had already been taken up by Congress and rejected. (NOTE: for a sample of the views presented in opposition to this proposed new SRO, see, for example, a submission made subsequently in the form of a letter dated May 29, 2012 from Angela Canterbury, Director of Public Policy for Project on Government Oversight to House Committee on Financial Services, which you can find here; the opposition in that case, understandably, wanted responsibility for oversight of investment advisers to remain with the SEC and not be delegated away to yet another new and ineffectual SRO).

Consequently, as Schapiro already knew, FINRA, dominated by the existing member organizations with their own broker-dealer networks, would be the one to step into the breach and become the regulatory authority to which the new crowdfunding “funding portals” would be answerable. Thus, with some quick and deft flourishes allegedly needed to protect “unsophisticated” investors, Schapiro was able to effect a situation where the new “hen house” of crowdfunding is now to be guarded by the “foxes” of the old, established order. Subsequent events (e.g., infant crowdfunding portals now attaching themselves to existing broker-dealer networks and essentially conceding regulation of themselves to oversight by FINRA) have proved this to be the case.

One last tidbit about Shapiro and her attempts to destroy or delay the actual introduction of investment-based crowdfunding. Recently, Schapiro has been criticized by Representative McHenry for refusing to issue, prior to her departure on December 14th of last year (apparently because of a concern by her about her “legacy”) proposed final rules for that section of the JOBS Act dealing with general solicitation in connection with offerings made exclusively to “accredited investors”:

“. . . Documents that the Commission provided to the Committee are disconcerting as they imply that you personally intervened to delay implementation of the law in an effort to appease special interest groups and out of concern for your legacy as Chairman . . .”

“Letter, dated November 30, 2012, from U.S. Representative Patrick McHenry, Chairman, Subcommittee on TARP et al. to Mary Schapiro, Chairman, Securities and Exchange Commission,” which you can read here.

The “special interest” to which Representative McHenry refers in his letter is Barbara Roper, a registered lobbyist with the Consumer Federation of America (CFA). In an article entitled, “Schapiro’s Boss” which appeared in The Wall Street Journal on December 6, 2012 (U.S. Edition, pg. A16; you can read the online version of the article here), Roper is referred to as the ” . . . lobbyist . . . who plays Tonto to the tort bar …”.

Or course, delaying proposed final rules for this section of the JOBS Act also, coincidentally, delays the issuance of proposed final rules for Title III of the JOBS Act, dealing with non-accredited crowdfunding. A fine “Christmas present” for her friends at FINRA and a momentary defeat for the forces in support of investment-based crowdfunding.

Whether or not, in actuality, there were motives behind the SEC’s and FINRA’s and, in particular, Mary Schapiro’s, opposition to crowdfunding, other than the stated ones of “investor protection,” there’s certainly enough “smoke” here to indicate that regulators are not necessarily immune from the influences of the marketplace that they are charged with regulating.

NASAA and State Securities Regulators

In his article released to the media, Jack E. Herstein, assistant director of the Nebraska Department of Banking & Finance, Bureau of Securities and President of the North American Securities Administrators Association, speaking on behalf of the NASAA membership, has declared “The JOBS Act: An Investor Protection Disaster Waiting to Happen,” The Harvard Law School Forum on Corporate Governance and Financial Regulation, March 26, 2012 (which you can read here).

Herstein’s pronouncement has been followed by numerous “fear mongering” releases by NASAA and by individual NASAA members. Here are just a few:

• “NASAA Fires Off Warning as Crowdfunding Accelerates,” AdvisorOne, December 7, 2012;
• “Top Investor Traps,” Wyoming Secretary of State Website, Investing, Investor Information, 2013;
• “State warns of future scams capitalizing on ‘crowdfunding’ trend,” Wisconsin State Journal, August 22, 2012;
• “Small Business Advisory: Crowdfunding,” North American Securities Administrators Association Website, June 2012;
• “Letter dated August 8, 2012 from William F. Galvin, Secretary of the Commonwealth of Massachusetts, to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission,” reported here;
• “Crowd funding could come back to bite broker-dealers,” InvestmentNews, October 25, 2012;
• “Massachusetts’ Action Reveals the Dangers of Crowdfunding Investments,” Investment Fraud Lawyer Blog, December 12, 2012.

NASAA’s (and its members’) opposition to crowdfunding as envisioned by Title III of the JOBS Act, (“federal crowdfunding”) is far more nuanced than the opposition to it mounted by the other constituencies mentioned earlier in this article and than that which is being mounted by the various investor protection groups. It requires some understanding of the relationship that has developed over the years between the SEC and the federal system, on one hand, and the NASAA membership and the various state systems, on the other, for regulating the offering of securities.

First and foremost, is NASAA’s and the state securities administrators’ (collectively referred to hereinafter as the “state administrators”) very strong opposition to the concept of federal preemption in the regulation of securities and securities offerings.

As background to the preemption issue, it’s important to note that even before adoption by Congress of the federal securities laws in 1933, virtually every state (the notable exception being Nevada) had a regime in place for regulating the offering of securities. These state statutes were commonly referred to as “blue sky” laws because in the minds of regulators and others, company offerings sometimes consisted of nothing more than a promise to share ownership in a “patch of blue sky”.

There is a significant difference, however, between most of the state statutes that were enacted and the federal securities laws. The federal securities laws are based on the concept of “full and fair disclosure”, i.e., full disclosure of all material information that a reasonable investor would require in order to make up his or her mind about the potential investment. However, historically, most of the state laws were (and, in many cases, continue to be) based on the concept of “merit”, i.e., the imposition of a so-called “merit review” wherein the state regulator looks to see if the proposed offering meets specific, qualitative requirements. If not, then the company simply will not be allowed to do a registered offering in that state, no matter how fully its faults are disclosed in the prospectus.

The problem arises from the fact that when Congress enacted the first federal securities act (the Securities Act of 1933), it left existing state securities laws in place. The result: unless an offering was confined exclusively to purchasers in a single state, any proposed securities offering would have to jump through multiple legal hoops; once at the federal level and then again at the state level for each and every state in which an offering was proposed to be made.

In the mid-1990’s, however, there was a momentous change. Congress enacted the National Securities Markets Improvement Act of 1996 (“NSMIA”):

“Historically, the federal securities laws and the state blue sky laws complemented and often duplicated one another. [However,] [m]uch of the duplication, especially with regards to registration of securities and the regulation of brokers and advisors, was largely preempted by the Securities and Exchange Commission [once Congress enacted] the National Securities Markets Improvement Act of 1996 (NSMIA).

This act . . . left some regulation of investment advisors and much of the fraud litigation under state jurisdiction. [However,] in1998, [the Securities Litigation Uniform Act was adopted and] state law securities fraud claims were expressly preempted from being raised in [class action lawsuits] by investors, even if not filed [initially] as class actions.”

The experience of state administrators under both NSMIA and SLUA has been, to say the least, less than optimal. In the words of Denise Voigt Crawford, former NASAA President and Texas Securities Commissioner:

“As the regulators closest to investors, state securities regulators provide an indispensable layer of protection for Main Street investors . . . Our presence did not contribute to the [2008] crisis; rather, the fact that our regulatory and enforcement roles [under NSMIA and SLUA] had been eroded was a significant factor in the severity of the financial meltdown.

Calls for preemption of state regulatory authority or for more authority for self- regulatory organizations defy common sense… The evidence clearly demonstrates that the state-federal regulatory structure actually works for the investor . . .”

While there are certainly voices strongly expressing a view diametrically opposed to the sentiments expressed by Commissioner Crawford (see, for example, “Federalism Gone Amuck:The Case for Reallocating Governmental Authority over the Capital Formation Activities of Businesses,” Washburn Law Journal, Vol. 50, No. 573, 2011; and,”Wall Street Reform Bill Issues – Performance of State Securities Regulators,” Hedge Fund Law Blog, July 5, 2010), nevertheless, it seems to be more than mere coincidence that precisely after the creation of the national market system under NSMIA and SLUA, and the further preemption of state law in the securities regulation area resulting from that change, that we have experienced the most dramatic and devastating scandals and adverse investment outcomes since the Great Depression.

Thus, it is against this backdrop that one begins to understand the basis for the state administrators strong opposition to federal crowdfunding, particularly since it preempts the states from any prior review of a crowdfunding offering and leaves them only with enforcement rights to clean up the mess after an offering disaster has occurred. This development potentially impacts the states adversely in so many unpleasant ways: first, there is the weakening of the importance of the state “prior review” function since it is anticipated that there will be many more crowdfunding offerings than traditional ones. Then, the shriveling of the state review function will adversely impact staffing and funding for the various state securities divisions precisely at a point in time when additional staffing and funding (for enforcement purposes) will be required. With most states experiencing a drastic shortfall in general operating revenues these days, the resulting confluence of events could trigger, at least in the minds of the state securities administrators, a “perfect storm” of securities internet fraud, resulting in substantial losses to those folks (i.e., the average small investor) least able to afford it.

Another factor in their opposition to federal crowdfunding is that prior to adoption of the JOBS Act by Congress, the state administrators were proposing their own version of crowdfunding. Several commentators have written that the states’ approach to crowdfunding could have proven itself to be superior to the one actually adopted, provided that the “uniform offering” format being proposed had actually been adopted by each state’s legislature and a single state was set up for each crowdfunding offering, regardless of how many states in which the offering was made (for a discussion of this proposed state alternative, see “NASAA Proposes Model Crowdfunding Exemption,” Jim Hamilton’s World of Securities Regulation, January 25, 2012, which you can read here). Unfortunately, at least for the foreseeable future, this alternative is dead.

For the reasons set forth above, expect NASAA and the various state securities administrators to continue to speak out against crowdfunding and, at every opportunity, to label any ill-conceived offering, crowdfunding or not, as yet another “crowdfunding disaster”.

Investor Protection Groups / Institutional Investors

The last group opposing crowdfunding are certain investor protection groups (consisting of such entities as the Consumer Federation of America, AARP and the AFL-CIO) and various institutional investors who would prefer that things stay exactly as they’ve been, unchanged, for the past several decades.

What motivates these various groups in their opposition to crowdfunding? Quite simply, the fear of change. Any kind of change from the existing order has the potential to disrupt and threaten the power that each of these groups currently wields. Loss of power means lose of relevance; loss of relevance means lose of members, money and influence. If crowdfunding actually does work the way its advocates and supporters say it will, power, money and influence will, quite naturally, be decentralized, especially if neither the SEC nor the existing SRO (i.e., FINRA), derail it with outrageously onerous and punitive rules and regulations.

Ironically, not one of these groups was at the forefront of calling out the bad actors as they were actually in the process of committing their frauds prior to 2008. None of them did a thing to prevent the frauds in the first place and none of them have the power to stop it in the future. They are irrelevant to real investor protection and instead use the phrase as a cloak to wield personal power for their own ends and without benefiting either their constituencies or society as a whole.

CONCLUSION

In the final analysis, it’s irrelevant who or what opposes crowdfunding. In the end it will succeed and in so doing will completely rewrite the landscape of capital formation and maintenance.

For example, David Thorpe, writing recently in Forbes tells us that crowdfunding will explode in 2013:

“The world of entrepreneurial finance is changing rapidly; we are at a tipping point that will make what seems like a vibrant part of our global economy today seem small in one year’s hindsight.

Whether you are a service provider, social entrepreneur, angel investor, venture capitalist, or one of the millions of people ready to become a small-scale start up financier, it is time to pay attention.

Estimates for annual crowdfunding transactions go as high as $500 billion annually compared to 2011’s $1.5 billion (anticipated to be $3 billion in 2012). If crowdfunding even begins to approach that scale, it will completely change the landscape for start-up financing.”

“Why Crowdfunding Will Explode In 2013,” Forbes, October 15, 2012, which you can read here.

Imagine an earthquake at sea. It’s just erupted and the resulting tsunami is on its way to shore. Until it arrives, the illusion that everything is as it was continues. But once it hits the shore, it changes everything. That’s crowdfunding and that’s its potential.