Effect of Technology on Regulation of Capital Markets

-- By AlexeySokolin - 27 Nov 2011

Online tools challenge financial regulation of private offerings and capital markets. Surprisingly, securities regulation is bending to technology and accepting the new paradigm.

Traditional Regulation Framework

Companies raise money for many reasons: to finance operations, build products, or experiment with business models. Raising money implies that someone is investing in the company, whether in the form of debt or equity, and corresponds to a certain level of risk. To appropriately communicate that risk to investors, firms are regulated under the Securities Act of 1933 and must disclose relevant information in offering documents. For billion dollar market capitalization companies, the cost of compliance is onerous but manageable. Younger, smaller companies can be dissuaded from public capital raising altogether by the associated costs.

Regulation D provides an exemption that allows capital to be raised privately when certain threshold are met. For example, the number of offerees and purchasers is limited, general promotion is prohibited, the purchase is made without a view to resale, and investors contract directly with the issuer. The investors must be accredited, with an income greater than $200,000 or over $1 million in investable assets. In principle, the rule strips regulatory protection from people that can protect themselves, with wealth being a proxy for ability to understand risk.

Private Securities and Technology Innovation

In the age of Facebook, everyone is an entrepreneur. The web has enabled explosive growth in technology start-ups and their funding. It is also easier than ever to find a company in which to invest. Thus the corollary: in the age of AngelList, everyone is an investor. Several companies have emerged to facilitate next-generation financing, and challenge how private placements have been done in the past.

Kickstarter is one of the most successful crowd-funding websites. It allows regular, unsophisticated, unaccredited people to contribute capital for projects. The transaction is structured as follows: a project owner sets some minimum amount that they are raising, and then associates certain contribution levels with certain rewards. For example, a $25 contribution may be a pre-order of the product when it is made; a $500 contribution may be an autographed copy of the product, along with special commentary and extra personalized goods. If the minimum tipping point is reached, the project is funded and the author commits to carrying it out. Most projects are creative, in music and visual arts, and cost below $1,000, but some are as large as $200,000 and have more than 6,000 backers. The contributions are unlike equity or fixed income investments since contributors have no claim on the company, other than the products. This cooperative form of finance allows customer demand to support projects they care about before a product is finished.

AngelList is a social network for angels--individuals that are likely accredited investors, and qualify for the Regulation D exemption. Driven primarily by reputation and references, this network quickly accelerates traditional fundraising timelines. Instead of going door-to-door with a presentation, entrepreneurs can take advantage of network effects and access a large number of people simultaneously. This is convenient. As an entrepreneur, you want to put your materials in front of every single person that could potentially invest, which would run afoul of the rule against promotion of securities. AngelList? deals with this by facilitating personal introductions and warning against solicitation. Warned or not, the entrepreneur is one click away from tweeting an investment update to thousands of strangers. A competitor site, Gust, serves a similar function for investor networks. Stronger restrictions on mass communication make it less convenient to spam your investment materials to venture firms, but not less feasible.

Another innovation in marketing private equity is represented by secondary market exchanges. After an initial public offering, public stock is traded on secondary markets like NYSE and NASDAQ. As stressed before, financial regulation mandates compliance using accounting and disclosure standards so that risks about the security are known. When those securities are private, compliance is far less rigorous; the stock must not be widely traded and is restricted to institutional and accredited investors. However, recent years have seen low IPO activity and high demand for private company stock (e.g., Facebook). Companies like Second Market and Share Post built online exchanges for restricted share, creating prices and convenient trading platforms. Although members are limited to legally appropriate categories, the line is being blurred and the SEC had launched investigations into trading members.

Emerging Legal Foundation

It is no surprise then that these companies consider existing regulation outdated and are lobbying to change the rules. Combined with the pressure of a stagnant economy, tight lending, and politically appealing “small business” demographic, it may be working. The House passed several bills to make private investment easier: increasing the number of maximum shareholders for closely held banks by 1,500 and growing the exemption from SEC registration from $5 million to $50 million. Other proposals on the table would allow broad soliciting and advertising, replace the accredited investor rule with a 10% of income rule, and empower online services to offer equity. The failure of traditional finance recover from the current recession is building the legal foundation to support future creativity.

Emerging Financial Organisms

Technology trends such as web-enabled cash micro-transactions, social networking with access control, and real time private company information will disrupt the opaqueness of the traditional finance industry. The power of the crowd can perfectly match demand and bring to life previously "unfundable" projects. Capital flows can bypass the broker-dealer all together, making financial power less concentrated in the hands of existing firms. Furthermore, the increasing automation of financial advisory services (see Axial Markets, Betterment, Credit Sesame), when combined with Big Data and free information, will transform the existing financial industry into a paradigm that better empowers people as creative individuals. Still, compliance and regulation are a huge barrier to innovation in the industry, and it is encouraging to see progress, however incremental.