Judging by the left’s response to the passage of the JOBS Act last week, the United States is now once again safe for fraud, Wall Street shenanigans, and old-school ’90s style dot-com flim-flam. The basic take is that the bill signed into law by President Obama on April 5 proves that we’ve learned nothing since reckless financial “innovation” plunged the world into a massive recession. Instead of tightening the screws, we’re loosening them. A bill that is supposed to make it easier for startups to get funded and grow (and create jobs) is actually just an invitation for Big Capital to be as reckless as they wanna be.
The critique may well hold true for large deregulatory swathes of the new law — it didn’t generate massive Republican support for nothing, after all. But there’s one piece that’s getting unfairly castigated and it just happens to be something that could have enormous progressive potential. It’s the piece called “crowdfunding”: the Internet-enabled aggregation of lots of small sums of cash as way to raise capital for individuals or enterprises who would otherwise face an uphill battle getting the attention of banks or well-heeled investors.
The democratization of Wall Street could be a very good thing, especially if you’re looking for ways to invest your capital in local businesses that you value and want to succeed. The basic principle is not so hard to understand. New technological innovations can offer new ways of doing things. Last November, in my article “A Declaration of Independence from Wall Street,” I quoted the Federal Reserve Bank of San Francisco’s Ian Galloway as he painted an enticing picture of the not-too-distant crowdfunding future.
“I can imagine a world not too far down the road,” says Galloway, “where you can walk down the street and pass a blighted piece of property, take a photo of it with your smartphone, click your CDFI [Community Development Financial Institution] app and have that photo geo-coded and sent to the local CDFI with your $25 investment in the predevelopment loan that would cause that property to be redeveloped.”
Sounds nice, no? But there was one major obstacle preventing the realization of that scenario. Securities regulations dating all the way back to the 1930s made it very difficult for anyone but the wealthiest Americans to invest in private companies and prevented online crowdfunding facilitators from offering any kind return on one’s investment — unless they jumped through an expensive series of regulatory hoops. Popular crowdfunding pioneers like Kiva and Kickstarter make do with donations, not investments.
The JOBS Act loosened those regulations. Now private startups will be able to raise as much as a million dollars through crowd-funding — although individual investments will be limited to a maximum of $10,000 or 10 percent of one’s net worth. The goal is open a whole new channel of funding that avoids the heavy-handed mediation of the big banks. You want to help that indie bookstore down the block expand its operations? Head to your nearest crowdfunding portal and plunk down some bucks.
But according to the critics, if you follow that urge, you’re a fool: the new legislation’s main result weill be a new generation of marks lining up to be fleeced by scamsters. Crowdfunding, writes economist Robert Reich, is just a means “by which people whose net worth is less than $100,000 can gamble away (invest) up to 5 percent of their annual incomes in any get-rich-quick scam (start-up) that any huckster (entrepreneur) may sell them…. ” Jack E. Herstein, NASAA president and assistant director of the Nebraska Department of Banking & Finance, Bureau of Securities, declares that the relaxation of rules on advertising, in combination with the crowdfunding elements, will mean that “investors need to prepare themselves to be bombarded with all manner of offerings and sales pitches. Congress has just released every huckster, scam artist, and small business owner and salesman onto the Internet.” Writing in Forbes, John Wasik argues that “although it seems to be a decentralized way of creating wealth — perhaps bypassing Wall Street — the vampire squid financiers who brought us 2008 will still find a way to game the system.”
So why won’t all that bad stuff happen? Crowdfunding advocates offer two related defenses. First, times are much different than they were in the 1930s, when the original securities regulations were written, and second: the “wisdom of the crowd” will step in to identify frauds and cheats, while promoting those who actually do deserve support.
Times are certainly different, As Amy Cortese, author of “Locavesting: The Revolution in Local Investing,” explained to me, back in the day, it was much harder to investigate a scamster’s background.
“It was usually some fast-talking huckster from the East Coast going out to the farmers and widows in Kansas and selling them shares in some can’t miss speculative deal,” said Cortese, “a mine somewhere or some land deal, and it was always far away and they had no way of vetting it. Now it is just a completely different environment on the Internet. People know other people, there are social relationships — I think there is just a greater level of scrutiny with a lot of eyes.”
“The best way for an individual investor to reduce the risk of fraud,” added Cortese, “is to keep it local where there are social bonds and relationships and knowledge of the market.”
Mike Norman, co-founder of the prospective crowdfunding portal WeFunder, believes that identity verification through social media and the collective intelligence of the communities that cohere around crowdfunding sites will cut through the flim-flam.
“That’s where the wisdom of the crowd really plays a mitigating effect,” said Norman. “If you are able to get a couple of hundred people to comment on a specific company and say for example ‘look I know something about zoning in Boston and this business is never going to get off the ground because the state is never going to allow this particular facility here’, and enough other people endorse that comment then you are able to use the Internet to crowdsource expertise, I think part of what is going to differentiate good portals from bad portals is their ability to actually make sure that the good information is rising to the top, rather than bad information, and a big piece of that is the ability to thumbs up and thumbs down, to endorse a certain comment or not.”
Not everyone is so sanguine. James Kwak, a blogger at The Baseline Scenario, dismissed the notion that social media could provide sophisticated consumer protection as absurd.
“Social networks and online communities tend to generate activity around things that are interesting, not things that are boring,” explained Kwak in an email. “So maybe if someone is selling equity in his project to mine gold from asteroids, then a lot of people would ask hard questions. But there is also enormous opportunity for boring fraud: Just imagine some legitimate, boring business idea, tell people you’re going to pursue that idea, and pocket their money. Given that only a small fraction of all the capital-raising ventures out there will get any serious attention, counting on the crowd seems optimistic to me.”
Maybe the skeptics will be proved right, and instead of using our smartphones to direct our capital to the local urban farming startup, we’ll end up getting an endless amount of spam on our phones trying to convince us to invest in the latest iteration of Florida swampland. But maybe this time we shouldn’t let our skepticism win out over optimism. As economist Robert Schiller explained in an op-ed piece in the New York Times on Monday, not all financial innovation is bad. And if doesn’t work out quite as planned the first time round, then fix it!
[Crowdfunding] might be as well received as Wikipedia, which is constantly being updated and improved by a vast army of users. There may well be disappointments at first, but the concept can be tinkered with, like other democratizing financial innovations that have eventually delivered much good to society… Finance is substantially about controlling risk. If risk management is suitably democratized, and if its sophisticated tools are better dispersed throughout society, it could help reduce social inequality.
So don’t throw the crowdfunding baby out with all the rest of the venture-capital-and-Wall-Street-friendly JOBS Act bathwater. Give it a chance.