The SEC should trust the wisdom of crowds

The Securities and Exchange Commission dipped a toe into the social media waters this week. The agency said it will allow publicly traded companies to announce market-moving news on Facebook, Twitter and other online messaging tools.

This is a welcome development. But if the SEC really wants to make the most of social media, it should find a way to allow startup companies to use intermediaries, called crowd-funding portals, to attract small amounts of capital from large numbers of people.

Congress allowed this capital-raising shift in the JOBS (Jumpstart Our Business Startups) Act, which President Barack Obama signed a year ago, but the SEC has yet to write the rules to make the act effective. Until it does, projects financed through crowd-funding portals can’t offer shares in return for money.

What’s the hang-up? The regulator has legitimate concerns about fake entrepreneurs and mythical companies taking advantage of unsophisticated investors. By no means are we suggesting that the SEC curtail its investor-protection role. Still, we believe the agency, after a year of study, should get on with it; the rules were supposed to be ready by Jan. 1.

Crowd-funding portals have shown they can work in other realms. In 2011, they raised about $1.5 billion. New York-based Kickstarter has had phenomenal success: About 3.7 million people have used it to raise $550 million to back various creative projects.

Some of the SEC’s hesitancy is encouraged by Wall Street. The JOBS Act overturns 70 years of securities laws and traditional practice, including Wall Street’s dominance of initial public offerings. But Wall Street long ago decided to stop focusing on the startup entrepreneur, preferring to raise large amounts of money from a manageable number of pension funds and mutual funds for companies with proven track records.

Crowd funding does the opposite, raising very small amounts from large numbers of people. Though it’s true that some of these investors may not understand the risks, fears of swindles are overblown. One reason is that the JOBS Act limits companies to raising $1 million over a 12-month period. As well, an individual whose annual income is below $100,000 could invest no more than $2,000 a year. Those with incomes above $100,000 could invest up to $10,000.

The act has other protections. Crowd-funding portals, for example, must register with the SEC, which in turn will make sure the sites vet both the entrepreneurs issuing securities and the investors buying them. Issuers must make financial statements, business plans, tax returns and the like available online.

Most important, portals can’t hire salespeople to round up investors, beyond directing people to the site. Once online, potential investors will be required to document income and net worth, and take a mini-course on investor education. What’s more, an issuer’s officers, directors and partners can be sued for misstatements and omissions.

Beyond those safeguards, the SEC could require portals to use digital footprint technology that can tell if potential investors have actually read the section on “risk factors” and bar them from sending money until they do. The SEC could require links to its online list of approved portals, reducing the chances that fake portals would exist for long. The regulator could also create an account that holds, say, 0.025 percent of all offerings, to compensate fraud victims.

The challenge is to not saddle startups with so many onerous rules as to neuter the crowd-funding advantage. It was less than a decade ago that the SEC worried about allowing companies to distribute shareholder information via the Internet (techno-phobes would be at a disadvantage). Those concerns did not come to pass. Today, social networking is similarly on the rise. The SEC would do well to allow the wisdom of crowds to go to work on capital-raising.