The Wisdom of the Crowd

Regulators should not let a fear of crowdfunding losses stifle legitimate businesses.

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I plan to open up an online bakery, but need some funds. My family and friends aren't coming through and my credit cards are maxed out, so I'll turn to the Internet to raise the $70,000 or so I need to get the virtual doors open. The investors solicited over the Internet will put money into the enterprise up front in exchange for a piece of the sweet profits my bakery will soon be generating.

"Not so fast!" says the government. No, it's not Mayor Bloomberg running in to confiscate my sugar stockpiles. It's the Securities and Exchange Commission stopping foolhardy would-be investors from entrusting yours truly with a penny of their hard-earned cash. I can currently raise money on the Internet without running afoul of the SEC, but only if I retain all the profits and the funders' only reward is a few muffins from my bakery. All that is about to change – maybe.

Last week, the SEC voted to propose a new crowdfunding regulatory framework. Start-ups and other small companies will be able to raise money in small amounts from investors who generally aren't rich enough to buy securities through private offerings. Current securities laws prevent most non-wealthy investors from purchasing securities in offerings that are not registered with the SEC. The rationale is that only wealthy investors have, or can pay for, the savvy necessary to make good investment choices. They also can afford to lose money if they make bad choices.

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Included in the JOBS Act of 2012 was the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure ("Crowdfund") Act, which directed the SEC to set up a regulatory framework for crowdfunding. As the act's clever name suggests, the statute included a number of restrictions to deter fraud.

For example, there is a $1 million annual limit on the amount a company can raise via crowdfunding. There are caps on investors' participation based on income or net worth. Money must be raised through a registered funding portal or broker. Companies must make specified disclosures about the company and the offering. The SEC's 600-page proposal fills in the details of how the crowdfunding framework would work in practice and adds more requirements. As formulated by the SEC, for example, two potentially costly provisions are the financial statement requirements and the mandatory filing of annual reports with the SEC.

Public comments in response to the proposal are already pouring in. Many of them urge the SEC to trim back requirements that threaten to make crowdfunding so costly as to be unsuitable for financially strapped start-ups. On the other hand, some worry that the requirements are not tough enough. SEC Commissioner Kara Stein argued, for example, that the rule might not do enough to protect seniors and others on fixed incomes from incurring losses. Reflecting similar concerns, the SEC's proposal asks many questions about whether requirements should be tougher.

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The SEC is rightly concerned that unscrupulous purported bakers might use the funds they raise to charter a plane to Hawaii for an all-expenses-paid, five-star vacation. Or, as will happen more often, a well-intentioned baker will find that running an online bakery entails a lot more than she had envisioned. Her bakery will be a flop and her investors will not get their investment back, let alone make a profit.

The appropriate response to these concerns is not to pad the crowdfunding regime with so many restrictions that it becomes unusable. Rather, the SEC should encourage this newly empowered set of investors to exercise judgment, not to assume that every investment opportunity is a sure path to riches, and to be rationally skeptical as they weigh investment opportunities.

Crowdfunding will only work if the SEC starts telling investors to think for themselves, rather than encouraging them to rely on the SEC for safety. Confidence in our capital markets should rest on the fact that legions of private investors are independently exercising skepticism, not on the empty promise that regulation can prevent investors from getting ripped off or otherwise losing their money. In order to get my online bakery off the ground, I should have to convince an inquisitive crowd of funders that my business plan has more merit than all the other businesses vying for their money. As the SEC moves to finalize its crowdfunding framework, it should take care not to displace the wisdom of the crowd with a set of rules that only reflect its own wisdom.

Hester Peirce is a senior research fellow at the Mercatus Center at George Mason University.

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