Crowdfunding – Impractical Business Plans

There seems to be an overriding attitude in the crowdfunding industry that it exists solely to provide access to capital to small entrepreneurs who have previously been denied access by the evil barons of Wall Street.  Many people in the industry are amazed when I tell them that under the regulatory scheme in the US, the owner of an equity crowdfunding platform or portal is in the business of selling securities and every sale that they do is highly regulated.

The regulations include provisions that are firmly rooted in the idea of investor protection. The regulators will never accept the idea that investors in the crowd can be left to fend for themselves or that proper disclosures do not have to be made. Equity crowdfunding is not a caveat emptor marketplace.

Small investors are being hyped with the idea that crowdfunding portals are offering opportunities for them to invest in the next Facebook or Amazon that will turn their modest investments into huge profits. Investors are actually being offered shares in breweries, distilleries and a lot of small companies with dubious products and often inexperienced managers.

In the mainstream financial market, virtually all of the brokerage firms are members of FINRA so the rules are uniform one firm to the next. In the crowdfunding marketplace only those Title III portals that sell offerings to small investors under Reg. A or Reg. CF need to apply for FINRA membership.  That was intended to provide an extra level of protection for smaller investors.

Unfortunately, some of the portals do not seem to understand their responsibilities as FINRA members.  Several have no personnel on staff with any experience in any aspect of selling securities, let alone compliance with the regulations.

When FINRA expelled crowdfunding portal UFP (uFundingPortal) late last year, in part for listing companies with “impractical business plans”, I expected to see some articles or at least comments from some members of the crowdfunding community about impractical business plans.  The silence from the industry and industry experts has been deafening.

So what, exactly, does FINRA mean when it is telling crowdfunding portals not to list a company that has an “impractical” business plan? It starts with what the company that is raising money is trying to accomplish and whether or not the business plan has a reasonable chance of getting them there.

Everyone would agree that a company that is raising $100,000 and promising that it will be enough money to build a skyscraper in Manhattan or to develop a drug that will cure all cancers has an impractical business plan.  The same would be true if the skyscraper was not designed by an architect or the drug was intended to be sold without FDA approval.

A business plan that suggests that the company will sell one million units of its product using social media would be impractical if the company did not have some way of backing-up that assertion.  FINRA has a consistent policy that requires that there be a reasonable basis for all sales and revenue projections.

As the regulators move forward they will likely find that a company that intends to market a product that infringes on another company’s patent has an impractical business plan. It is also impractical to raise funds to operate a business that is illegal, like a brothel. But not every case will be as clear cut.

The FINRA regulations governing these portals are in addition to the regulations that stem from the federal securities laws. They require additional work and additional skills. Being able to identify and eliminate impractical business plans is one of those skills.

This will make it more expensive to operate a Title III portal than a Title II platform.  Potentially, it is also far more lucrative to be able to accept investments from a larger group of smaller investors.  If you are operating a FINRA portal but you do not have people on staff or as advisors who have experience working at FINRA firms and a clear understanding of what is expected, then I suspect that FINRA will tell you that it is your business plan is “impractical” and put your portal out of business.

In the mainstream markets, FINRA and the SEC have begun enforcement actions signaling that they intend to hold the compliance directors at the brokerage firms personally liable for unlawful transactions that took place on their watch.  I would wager that at least a few of the compliance directors at the 2 dozen or so crowdfunding portals already have regulatory targets on their backs.

I just completed the paperwork for a client who is making an offering through one of the better crowdfunding firms. The offering documents, risk factors, and advertising materials were all reviewed by the firm and the comments demonstrated to me that the reviewers were knowledgeable, competent and well-versed in the rules and requirements. It is not all that hard to comply with the rules if you know what you are doing.  The portals who follow the rules are generally the ones who hire people with some relevant experience.

At the same time, it is very easy for anyone to find crowdfunding portals that are actively inviting small investors to invest in companies that are, for want of a better word, crap.  A portal that lists even one company that would garner this distinction is not doing its job. To my mind, it makes every other offering listed on the portal suspect.  If you cannot make that distinction, you should not be investing at a crowdfunding portal and you certainly should not be operating one.

Please do not push back and tell me that it does not really matter because most start-ups will fail anyway or that investors in these companies know that they are really gambling.  Even casinos are regulated and are expected to operate correctly and in accordance with the rules.

This issue is not that most start-ups fail. The issue is that any start-up funding on a crowdfunding portal should have at least a legitimate chance of success.  They should know how much money they will need and how they will spend it. There is nothing wrong with raising funds to conduct research and development for a new product as long as there is a demonstrable market for the product and the company has people on staff or on hand to conduct the research.

I realize that insisting on “practical business plans” will eliminate a fair amount of the companies that are currently trying to get funded on the crowdfunding portals. That is exactly the point. The JOBS Act was supposed to help companies that could provide sustainable jobs.  Funding companies that are here today and gone tomorrow was never anyone’s idea of what this legislation was intended to do.

The capital  markets, like all markets, work best when they are efficient.  Funding companies that are not likely to succeed is never efficient.  Efficiency results when the companies that have the best chance of success  get funded and those with little or no chance of success do not.

People in the crowdfunding industry tell me that the problem is that the industry is new and just finding its way.  They want to be excused from regulatory compliance until they figure out what to do.

Except that what the crowdfunding portals are doing is not new. People have been selling securities to investors for a long time. The only reason some of the portals are not following the rules is that they do not want to spend the money to do it right.  If they do not believe me, they can explain it to FINRA and the SEC, who are not likely to give them the fair warning that I keep trying to offer.


The Artificially Intelligent Lawyer

In the last few months I have read several articles that suggested that artificial intelligence will soon transform the practice of law. The general spin of the articles was that artificial intelligence would eventually take over many if not most of the tasks currently performed by lawyers and perform those tasks much better than we mere mortals.

Forgive me if I question the validity of this idea. It is not that I am anti-tech or just too old to appreciate what technology can do.  To the contrary I have been a user of technology all my professional life and I fully appreciate that it has exponentially increased my productivity and reduced my costs.

When I started my career as a lawyer, I dictated to a secretary who took my words down in shorthand and typed them up. She made copies using carbon paper. My first personal computer was an Apple II and later the first Macintosh.  Over the years, using ever better personal computers, my personal productivity has greatly increased and the quality of the work that I put out has gotten better and better.

So I certainly appreciate that technology can be a tool that helps lawyers perform better. But the idea that tech will replace lawyers or do some of the tasks that lawyers do, makes me pause.

I certainly am not the best lawyer who ever wrote a contract or legal brief.  I fully acknowledge that over time, I got better at both by working with and often against lawyers who were better than I was. Lawyers learn from each other.  So I question the idea that machines can learn how to be better lawyers much faster than human beings and that they will quite easily surpass the best of us, if they do not interact with lawyers.

I acknowledge that a computer can research the universe of case law on any subject far better and much faster than I can. I will admit that a computer can assemble those cases into a brief that will be more on point than anything that I can write.  But the best brief is not always the one that carries the day.

Years ago, in the days before personal computers, I had dinner with a single practitioner who had a rural, small town practice.  He was fresh off a victory against the largest law firm in his state in a contested land use matter.  He was complimenting the brief that the other firm had filed, noting that it was extremely well researched and had included myriad footnotes citing cases and authorities from all 50 states. He told me that he thought that the brief was good enough to be published as a law review article.

His own brief had cited a single legal treatise and the cases in it. He was successful because the nearest law library was two hours away and in that small town that treatise was “all the judge had and all the judge used.”

If an intelligent computer is writing a brief, then it is fair to assume that eventually it will put out the same brief on the same points of law for all for cases with similar facts and issues.  It is fair to say that the computer should make the “best” argument every time.

As long as we are still arguing cases in front of judges who are not computers, knowing the arguments to which a particular judge might be receptive can be at least as important as knowing the best arguments that could be made. Trial judges are not perfect and not uniform in their interpretation of the law.  I cannot imagine how a computer will input information about a particular judge’s preferences, prejudices or idiosyncrasies.

I spent a lot of years doing arbitrations at FINRA over investments that went bad. Both the plaintiff’s bar and the defense bar practicing in these forums is pretty small and I would see the same firms and often the same lawyers on the opposite side of a lot of cases.

A lot of defense firms have a playbook. They know what arguments they are going to make to the arbitrators and what questions they are going to ask witnesses in every case with a similar fact pattern. After a while, I got to know the playbook used by different defense firms.  Knowing what a specific defense lawyer was likely to ask helped me to prepare witnesses.

Knowing what these lawyers were likely to argue in rebuttal of the arguments I was making caused me to change the emphasis of my arguments, case to case.  I would sometimes try two or more cases involving the same investment differently, just to keep the opposing lawyer a little off base.

Seeing the same experts used again and again helped me to understand where they were strong and where they were weak.  Will an artificially intelligent computer ever get intelligent enough to understand how an individual firm is likely to defend a case or how an individual expert is likely to respond to cross-examination?

When I write a contract I do not just put boilerplate together. I try to understand what the client needs and expects from the underlying transaction.  Part of it is trying to predict the future; understanding what might precipitate a breach by either party or how a court might interpret the language that I am putting into the contract should the need arise.

The law is dynamic; it evolves. Will a computer actually be able to see trends in the law and to predict how it is likely to evolve?  Will a computer be able to disregard decisions from another era when attitudes, statutes or procedures were different?

Juries are often hard to predict even after the trial. If you do not believe me, ask any lawyer who has spent time pacing the courthouse hallways waiting for a jury to deliberate. If you’ve done it enough, you have certainly been surprised by a jury’s verdict, probably more than once.

More importantly, will a computer be able to explain to a client the emotional side of writing a will, getting a divorce or  filing a lawsuit against a  family member?  Having those conversations is part of the practice of law and it takes some amount of “emotional” intelligence to do them well.

Nothing that I have read about artificial intelligence indicates to me that this type of “artificial   emotional intelligence” is in the offing. Rather, artificial intelligence is the ability of a machine to analyze and assimilate data and to draw logical and rational conclusions from that data. That may help some, but it does not replace the very human interactions that clients have with their lawyers. If clients were always logical and rational they would not need lawyers in the first place.