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Crowdfunding: Trends and Developments Impacting Entertainment Entrepreneurs

By Ronald Barabas

In 1913, a young man named Oscar Micheaux financed the printing of his autobiographical first novel with door-to-door advance sales of the still-unpublished work to his neighbors. He pitched them with a sample chapter and his considerable sales skills. Successful in this and a subsequent literary effort, Micheaux, a self-made African-American entrepreneur born to freed slaves, sought to produce the first feature length motion picture featuring African-American milieu and actors. Hollywood film studios would not undertake anything like this for many years to come. In order to accomplish this unprecedented, expensive adaptation of his first novel, Micheaux formed a corporation for film productions and sold shares of stock directly to the public. He drafted an investment brochure himself and personally solicited investments in company shares. Micheaux's initial capital-raise helped lead to some of the most groundbreaking cultural contributions in American history.

Micheaux was a pioneer of what we now call "crowdfunding". Yet if someone today were to solicit investments as he had, that person would likely be stopped by and face sanctions from the Securities and Exchange Commission.

Efforts to ease restrictions that limit artists' abilities to finance creative projects by raising small amounts of money from everyday investors online seem to be reaching a critical mass of support that could very likely lead to consequential near-term changes in securities law. At the present moment, three competing bills that address crowdfunding are in Congress (one of which, H.R. 2930 (http://thomas.loc.gov/cgi-bin/bdquery/z?d112:H.R.2930:@@@L), has passed the House). The SEC and the White House have also expressed their support.

Crowdfunding can be defined as a collective effort to pool money, popular today through the Internet, to support a project, cause or organization. It has become an increasingly common and effective way for entrepreneurs and artists to finance business and creative endeavors, making it easy to solicit financing from anyone with Internet access and available capital. Current US securities laws, however, limit the full possibilities of crowdfunding.

A security is an investment of money in a common enterprise with an expectation of profits arising from the efforts of others. When a security is offered to the public over the Internet or other means, the offering party is required to meet registration and ongoing disclosure requirements with the SEC. While this helps guard against potential fraud, the expense and time it takes make public offerings impractical for almost all start-ups and small businesses. There are several exemptions to the public registration requirement, but none that would apply to a crowdfunding equity model where a financial stake in a small business or project is promoted online to the general investing public.

Internet crowdfunding initiatives have thrived despite the prohibition of offerings in unregistered investment opportunities. Artists, entrepreneurs and non-profits successfully use four non-equity Internet crowdfunding models that circumvent securities regulation. They are: (1) the rewards model; (2) the pre-payment model; (3) the donation model; and (4) the loan model (see Bradford, C. Steven, Crowdfunding and the Federal Securities Laws (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1916184)).

The first three crowdfunding models can best be explained with a simple example. A musician wants to raise funds to finance the recording of an album. She sets up an account on a popular crowdfunding website like Kickstarter ((http://www.kickstarter.com/) and offers to send a copy of the finished album to anyone that has paid, in advance, $10 or more. This is the pre-payment model. In the same listing, she offers to write a song about anyone who pledges $500 or more (the rewards model) and also accepts donations in any amount (the donation model, where there is no expected return, is more commonly used for charitable causes). None of these is a situation in which the financial backer has an expectation of profit, and therefore no securities registration is needed.

The loan model has two importantly different variations. On sites like Kiva (http://www.kiva.org/about), lenders select a project to help finance and their loans are repaid to them without interest when the borrower makes repayments. Like the other non-equity models, offering individuals the opportunity to provide an interest-free loan does not trigger registration requirements since the lender has no expectation of profit. The SEC has, however, indicated that registration would be required for interest-bearing crowdfunding notes and loans, the other variety of the loan model (http://www.sec.gov/litigation/admin/2008/33-8984.pdf).

At a time when agreement between the major political parties is rare, a convincing group of economic factors have led policymakers to the popular consensus that action needs to be taken to open up the equity crowdfunding model. Among these is the increased difficulty of financing for seed-stage start-ups. Banks have altered their approaches to small business lending over the last five years and sophisticated investors are investing in later-stage emerging companies with greater regularity. Entrepreneurs need alternatives to traditional capital markets to fund their growth, and the weak job market needs the boost from small business hiring that access to new sources of capital could provide. This, combined with the proven success of other crowdfunding models, has helped this issue pick up steam.

The challenge for Congress and the SEC is to create a regulatory framework that unlocks the possibility of crowdfunding while mitigating the risk of fraud that comes with easing restrictions on the public solicitation of investment opportunities online. The current legislative proposals (H.R. 2930 (http://thomas.loc.gov/cgi-bin/bdquery/z?d112:H.R.2930:@@@L), S.1791 (http://thomas.loc.gov/cgi-bin/bdquery/z?d112:s.1791:), and S.1970 (http://thomas.loc.gov/cgi-bin/bdquery/z?d112:s.01970:)) each address this with some key common features, including:

• a cap on the amount of the offering;
• a cap on the amount each investor can contribute; and
• limited disclosure and ongoing reporting requirements.

Important differences in these bills include the amount of the offering and investor contribution cap and whether crowdfunding websites that act as intermediaries between a company and investors will be regulated as a broker-dealer or subject to other compliance guidelines.

Several outstanding issues will need to be considered as rulemaking progresses. When can an offering be grounds for a fraud claim if disclosure requirements are limited? If individual investments are limited to small amounts, will fraud victims have an incentive to seek legal redress? How can disparate small investors replicate the leverage and sophistication that enables an "angel investor" to receive offering terms that merit their capital risk?

While most politicians and commentators have focused on the expected increase in small business hiring that opening a crowdfunding exemption to the securities laws would have, it will have a particularly profound impact on the arts. Crowdfunding already has a special role in the creative community. Part of this is because first-time filmmakers and other less-established artists typically have even fewer financing options than other entrepreneurs. Angel investors and banks will rarely finance a creative project helmed by a novice. Friends, family, savings and credit cards are often the only way to fund such an independent endeavor.

Moreover, crowdfunded ideas get the unique benefit of public feedback before production begins. They go forward when enough people use their money to express interest and belief in a project, in contrast to hierarchical decision-making. Independent investors are also free from public relations and corporate conflict concerns that can hinder unorthodox works. Perhaps even more importantly, individuals that participate in funding a project are likely to be consumers of that project and promote it to others.

A crowdfunding exemption to the securities laws could have broad implications on the arts and development of artists. As Oscar Micheaux proved almost 100 years ago, crowdfunding can lead to great things.

Ronald Barabas is a Corporate and Entertainment Attorney at Di Santo LLP. He can be contacted at rbarabas@disantolaw.com.

An expanded version of this article will appear in the Spring 2012 issue of The Entertainment, Arts and Sports Law Journal.

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