The Deal: States Greet Crowdfunding With Hostility

NEW YORK ( The Deal) -- The crowdfunding industry is experiencing growing pains as entrepreneurs and operators of Web-based financing portals complain about a few hostile state securities agencies and the regulators grapple with an industry whose rules have yet to be written by the Securities and Exchange Commission.

While some states, like Georgia, Kansas and North Carolina, have welcomed the advent of Internet-based crowdfunding as a potential boost to their economies, with their own intrastate rules, others have taken a more skeptical and cautious approach.

SoMoLend Holdings LLC, a debt crowdfunding portal launched two years ago by entrepreneur and attorney Candace Klein, faces a public hearing on Oct. 17 and 18 on the Ohio Division of Securities' intention to issue a cease-and-desist order.

The Cincinnati-based crowdfunding portal, whose name is short for Social Mobile Lending, allows entrepreneurs to arrange loans from accredited investors over the Internet. SoMoLend raised about $2 million from investors and planned to arrange loans worth from $500 to $500,000.

The June 14 notice from the Ohio securities division alleges that Klein, who has since stepped down as CEO, and SoMoLend committed securities fraud by making false statements and engaging in other fraudulent activity geared toward investors for the purpose of selling SoMoLend securities.

The division said the statements and related activity include fraudulent financial projections; false and misleading statements regarding current and past performance, like the number of loans that had been transacted on the platform, the total value of those loans and the total revenue they generate; and false and misleading statements regarding SoMoLend's relationships with banks and other institutions.

"Respondents made the foregoing false statements and engaged in the fraudulent activity to dupe investors into believing that SoMoLend was an early and huge crowdfunding success," the notice said. SoMoLend and Klein "repeatedly stated they had already conducted millions of dollars of transactions on the SoMoLend Crowdfunding Platform by 2012, which they had not done and could not legally do pursuant to applicable securities laws and regulations at that time."

Although Klein declined to comment for this article, because the case is pending, a person familiar with their appeal told The Deal that Klein and SoMoLend reached out early and often to Ohio regulators for guidance on how to follow securities laws.

They submitted numerous documents being used to sell securities to investors, which the person said are now being used against them.

Klein and SoMoLend did so to avoid the fate of Prosper Marketplace Inc. and Lending Club, two peer-to-peer lending companies that were shut down in Ohio in 2008. Both remain active in other states.

The person said Klein and SoMoLend directly asked Ohio regulators about how they could avoid the fate of Prosper Marketplace and Lending Club in the state, to no avail.

Brian Hoyt, a spokesman for the Ohio Division of Securities, declined to comment, citing the pending nature of the case.

Charles Sidman, a retired professor at the University of Cincinnati and managing partner of venture capital fund ECS Capital Partners LLC, invested $10,000 in SoMoLend. He said that Ohio regulators have made themselves "a laughingstock" in the securities business.

"They have a beef with Klein because her enterprise is based on crowdfunding," Sidman said. "They're trying to make an example of her in the last few weeks that they're able to."

In September, new rules approved by the SEC will take effect that will give private-company managers, like Klein, more freedom to speak publicly about their companies' prospects without running afoul of securities laws.

In the past, communications that could be considered marketing of private company securities had to be limited to affluent "accredited" investors who are allowed to buy stock that isn't registered with the SEC.

Under Title II of the Jumpstart Our Business Startups Act, the SEC is now lifting the ban on what is referred to as "general solicitation" of private securities offerings. The end of the general solicitation ban is one of a number of provisions in the JOBS Act that are meant to make it easier for small companies to raise capital.

Sidman dismissed the Ohio securities division's case about false statements about financial projections as "complete nonsense and utter rubbish."

He said in speaking before the Greater Cincinnati Venture Association, Klein gave projections because she was asked to do so and would have been "dinged" if she hadn't.

Such projections "are made by every startup that looks for funding," Sidman said. "We all know it's speculation. These are all visions. And we ask: 'Why do you say that and what are the comparables?' Nobody was misled."

Sidman said if the division can prove Klein did something wrong, or misled someone and caused them harm, then its efforts will have been justified.

"But I've yet to meet a person who was injured," he added.

Klein "has done what thousands of people have done before and after her, which is discuss her ideas publicly," he said. "She didn't pass out prospectuses. She did what Title II of the JOBS Act allows. She was never talking about selling securities.

"If this ever becomes definitive, it obviously will scare off further economic development" in Ohio, Sidman said. "If they are trying to attract business to their state, they could not have done anything worse."

While Ohio is thought to be the first state to bring an enforcement action against a crowdfunding portal, it is hardly the only state to express concern about crowdfunding over the past two years.

Under the JOBS Act, crowdfunding portals like SoMoLend may eventually be used by private companies to sell limited amounts of stock to small investors. That provision will not take effect, however, until the SEC makes rules to regulate crowdfunding. In the meantime, crowdfunding portals are facilitating securities sales to accredited investors.

Officials in Arkansas, California, Nevada and Washington have issued public warnings about the potential for fraud in crowdfunding. So has the National Association of State Securities Administrators.

Most recently, Massachusetts Secretary of State William Galvin formed a unit under the commonwealth's securities division to monitor crowdfunding websites and general solicitation of private placement financings.

Brian McNiff, a spokesman for Galvin, has said that the unit is an outgrowth of the SEC's recently proposed rule that would require private placement issuers to file solicitation and advertising documents with the SEC.

The commission announced the proposed rules on July 10 at the same meeting where it also voted to end the general solicitation ban.

Even under the new rules, private securities offerings under Rule 506 of the Securities Act will still mostly be limited to accredited investors. The new general solicitation rule also established a list of steps that private placement issuers can take to verify that investors are accredited.

The new unit of the Massachusetts Securities Division will consist of information technology staff and attorneys. It will be called I-CROWD, which stands for Internet Crowdfunding and Offerings Watch Department.

The I-CROWD unit will assess the impact of changes in the laws and rules that apply to unregistered offerings, according to Galvin's office. It also will gather data about the types and quantity of public advertising used for unregistered securities. In addition, the unit will track how issuers use the new rules allowing general solicitation and advertising, and compile information on how issuers verify the accredited status of their investors. The unit will monitor Web portals in Massachusetts with the intention of detecting fraud early and referring cases for enforcement action.

While "some states are doing everything they can to kill crowdfunding," others like Georgia, Kansas and North Carolina may be doing a better job of regulating crowdfunding than even envisioned by the JOBS Act, Sidman said.

"Georgia has a much better, smart and less onerous platform for regulating crowdfunding," he said. "It's a model much closer to the original Rep. Patrick McHenry crowdfunding proposal in the JOBS Act before it was watered down with so-called investor protections.

"I've been in this business a long time and I've lost some money and made some money and I've yet to see one instance where fraud was an issue," Sidman said. "I've never seen the fraud everybody talks about. When you're limiting it to the 1% who qualify as accredited investors, you're limiting it to people sophisticated enough to root out fraud."

While Sidman is skeptical of fraud, he is also skeptical that crowdfunding will ever be a source of real wealth creation for ordinary Americans.

"I don't view crowdfunding as a panacea for anything," he said. "Joe Q. Public doesn't have the experience to do this in a meaningful way."

The actions of Ohio and Massachusetts already have caught the attention of entrepreneurs and others in the crowdfunding business, said Douglas Ellenoff, a partner with the Ellenoff Grossman & Schole LLP law firm in New York.

"We are already getting calls from people in the crowdfunding industry seeking to better understand the meaning of the Ohio action," he said. "They're asking whether they should avoid such states."

While Ellenoff said he recognizes that states must monitor the activities of entrepreneurs to police capital markets and ensure compliance with securities laws, he said regulatory discretion is key to ensuring a healthy marketplace.

"Given that we are all figuring out the proper balance of how to operate under these new rules, I would encourage regulators to exercise restraint, where possible and appropriate, in not using unnecessary enforcement tools in order to remind the community at large of their responsibilities," Ellenoff said.

He said that one of the reasons such restraint is necessary is that crowdfunding has attracted many younger professionals, who have good intentions but need constructive guidance.

"Inevitably, there will be missteps along the way and we would suggest that regulators weigh the public interest in establishing a new industry that is good for their respective states with whether actual harm has taken place to investors and the need to weed out bad actors," Ellenoff said.

In the event of a violation, he said that regulators should ask themselves whether it really serves the public interest to be "heavy handed when a less severe means of enforcing compliance" might be available.

Similarly, Ellenoff said it is incumbent on entrepreneurs to understand that crowdfunding is subject to traditional securities laws and regulations.

"No one in the crowdfunding industry benefits if a fraudster who cheats investors out of their hard-earned money isn't prosecuted, criminally and civilly," he said.

However, not everyone in the market believes that some state regulators are off base in their wariness of crowdfunding.

"We welcome having some oversight from states as well as the SEC" and the Financial Industry Regulatory Authority, said Bruce Lipnick, CEO of Asset Alliance Corp., a New York-based alternative investment manager that launched its own crowdfunding portal called Crowd Alliance USA. "A lot of people are new to this business and don't know what they can and can't say."

Some of the states are a little tougher, like Ohio, Massachusetts and Illinois, but others have been welcoming, Lipnick said.

For example, Lipnick said Crowd Alliance is working on a partnership with the state of Hawaii called Five M Bloom, which will allow Hawaii's entrepreneurs to raise money through crowdfunding that will be matched by the state.

They want "to allocate capital, dollar for dollar, to develop new companies in the state of Hawaii," he said.

Lipnick said Crowd Alliance is looking for investors for Five M Bloom. He declined to comment on how much Five M Bloom plans to raise. He said it would start small with low dollar amounts.

Crowd Alliance also is negotiating with representatives of New York Gov. Andrew Cuomo on a similar partnership in the Empire State.

Lipnick said the states have been understandably cool to crowdfunding because it is such a new business whose rules have yet to be written by the SEC.

"We're optimistic that once the rules are solidified, the states will be more receptive," he said. "They realize they have to create jobs. Let's do it the right way."

The right way to regulate crowdfunding remains a work in progress, according to Jilliene Helman, the CEO of RealtyMogul, a Beverly Hills, Calif.-based portal for real estate deals.

"To some extent, oversight is wonderful and we welcome it," she said. "We're going to hold ourselves accountable to our investors and customers."

The problem with Ohio's enforcement action against SoMoLend is that it cites behavior that's been going on for years, she said.

"There's been rampant general solicitation going on for 10 years at pitch events," Helman said. "What's not smart is a state going after things that have been happening for a long time, especially when the rules are going to change in a month.

"To use taxpayer money to go after people who have been trying to follow the rules doesn't seem like a good use of time," she said. "What would be better would be to establish a working relationship with the portals to make sure they get crowdfunding right, like the SEC did with peer-to-peer lending players like Lending Club and Prosper Marketplace."

Ultimately, Helman said that state regulators are probably not in the best position to efficiently regulate crowdfunding.

"I'm 100% for watchdogs, but I'd rather see it at the federal level," she said. "I think it's bad for portals to have individual state oversight."

Having to meet each state's filing requirements can be expensive, Helman said. States' filing requirements can cost as little as $50 per investor and as much as $1,300 per investor.

A $1 million capital raise through a portal may cost $4,000 to $5,000 in filing fees, she said.

"The U.K. has a much wiser approach," Helman said. There, a single agency, the Financial Conduct Authority, oversees crowdfunding.

That assessment was shared by Judd Hollas, the founder and CEO of EquityNet LLC, a Fayetteville, Ark.-based portal.

So far, Hollas said EquityNet's interaction with the state of Arkansas has been fairly benign.

"We had an engagement with Arkansas regulators and we went through a review and no action was taken," he said.

Hollas described the Arkansas regulators as "very objective" and "not adversarial." He said the regulators asked a lot of questions and requested a lot of information.

"I didn't think it was problematic," Hollas said. "It was just part of doing business."

Other states have been a "mixed bag" for crowdfunding portals, he said.

"My hope is that it doesn't create an overwhelming amount of red tape for us," Hollas said. "I would not want to see a situation where I have to deal with federal and state regulators."

He characterized some state regulators' hostility to crowdfunding and the industry's concerns about state regulation as "growing pains" for the crowdfunding market.

Given the dramatic shift in the ability of private companies to raise capital that crowdfunding represents, Hollas said "these kinds of growing pains are to be expected."

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