For over eighty years, US security laws have focused on mandating disclosures to protect investors. The efficacy of this strategy has been hotly debated for decades. Equity crowdfunding as it was initially introduced to Congress could have been a new opportunity for a natural experiment in voluntary disclosure, but Regulation Crowdfunding as promulgated by the SEC turned out to be yet another mandatory-disclosure regime. Perhaps there is an opportunity for legal theorists to explain how our developing understanding of crowd capital and the digital shareholder may challenge the assumptions on which mandatory-disclosure theory rests.
The foundations of mandatory-disclosure theory begin around 1913, when the highly-influential jurist Louis D Brandeis famously wrote in his article What Publicity Can Do: ‘[s]unlight is said to be the best of disinfectants’. Brandeisian thinking pervaded the New Deal legislation, including the 1933 Securities Act and the 1934 Securities Exchange Act, which require companies to disclose extensive financial information in order to sell stock to investors. This includes requirements to make detailed disclosures annually (see Form 10-K), quarterly (see Form 10-Q), and whenever there is a material change in the firm’s financial condition or operations (see Form 8-K). As recently as 2003, the SEC has reaffirmed its self-image as a ‘full disclosure’ agency whose primary mission is to close information asymmetries.
The costs of mandatory disclosures really add up. PwC reported that going public costs $5.7 million and being public costs about $1.5 million per year. In my article Democratizing Startups I argue that these massive costs discourage many companies from going public, and empirical evidence clearly demonstrates that more and more large companies are staying in the shadows of private finance. Basically, it is not worth going public if there are cheaper ways to raise the same amount of money.
The benefits of mandatory disclosures are harder to quantify. On the side favoring mandatory disclosure, scholars argue that publicly traded companies will not voluntarily produce the optimal amount of disclosures. For example, Allen Ferrell points out in The Case for Mandatory Disclosures in Securities Regulation Around the World that empirical evidence is consistent with the theory that demanding disclosure increases competition in capital markets and reduces the agency costs associated with concentrated ownership structures. It is worth noting, however, that Professor Ferrell himself acknowledges that the US and the UK have dispersed ownership structures. Scholars opposing mandatory disclosures argue that firms will voluntarily disclose private information because doing so signals quality. For example, Roberta Romano argues that by eliminating mandatory disclosures, firms become able to compete on the basis of disclosure, with higher-quality firms making more disclosures in order to reduce their cost of raising capital.
Equity crowdfunding as implemented in the US follows the Brandeisian quest for sunlight. Rule 201 requires companies raising more than $500,000 to provide a litany of expensive-to-produce documents, including audited financial statements (see Form C). How expensive are these requirements? SeedInvest estimates that the cost of Regulation Crowdfunding is so high that some successful offerings result in negative cashflow! Raising $1,000,000 may cost $250,000 or more, which is an astonishing (and unaffordable) cost of capital. Clearly, our obsession with sunlight has left equity-crowdfunding firms in the dark.
My latest article attempts to disrupt the conventional cost-benefit analysis on mandatory disclosures by considering the latest crowd-science research. In short, crowd-science theorists have identified conditions where crowd sourcing results in good or bad decisions. The wisdom of the crowd shines through when its members contribute their private information to the collective knowledge in a process called information aggregation. But crowds fail when its members ignore their own private information and instead merely mimic others’ actions in a process called information cascading.
The crowd-science problem with Regulation Crowdfunding is that it requires firms to produce information that is not only costly to produce but also costly to interpret. Analyzing audited financial statements and the other SEC-mandated disclosures is difficult and time consuming. Crowdfunding members will be rationally apathetic to the mandatory disclosures, so they will not develop their own private information with regard to them, but will merely rely on public information, such as trending companies, as a heuristic. The massive expense of these mandatory disclosures crowds out additional voluntary disclosures (or signals provided by the lack thereof) that may be more useful to investors.
A better approach to crowdfunding may be to let fundraising companies and the portals on which they raise funds to set their own disclosure requirements. This would make crowdfunding affordable enough to be potentially useful and, moreover, it would allow crowdfunding entities to experiment with voluntary disclosure regimes, which may create the conditions necessary for crowds to aggregate information about disclosures and investment opportunities.
In short, if we are to create a new market for crowd-sourced investment, we must not subject this emerging market to the constraints of our old system. Rather, we should engineer the crowdfunding system flexibly enough for the wisdom of the crowd to shine though. In this way, crowds may truly find ‘a place of their own’ in the market for equity investments.
Seth Oranburg is an Assistant Professor of Law at the Duquesne University School of Law.