Volume 108
Issue 1
November '19

Weakness in Numbers: The Risks Investors’ Bounded Rationality and Cognitive Biases Pose to the U.S. Securities Crowdfunding Market

Written By: Tessa Bell

Abstract

Increased communication facilitated by the rise of the Internet has developed the necessary infrastructure to gather a virtual “crowd.” This has permitted crowdfunding, which was previously a method of offering credit to low-income families, to thrive and adapt to new uses. Rewards-based crowdfunding has developed as a method for entrepreneurs to gauge the viability of proposed businesses prior to launching a venture. Under this crowdfunding model, the crowd contributed money to entrepreneurs in return for a “non-monetary reward.” However, when some crowdfunded ventures reaped immense returns through acquisitions by established companies, the crowd was dismayed to be excluded from these rewards. This helped spur a shift in securities law. Although historically only wealthy or experienced “accredited investors” could participate in funding start-up businesses in return for equity, the passage of the Jumpstart Our Business Startups (JOBS) Act in 2012 authorized retail securities crowdfunding and granted “ordinary Americans” the ability to “invest in entrepreneurs they believe in” and to finally reap monetary rewards in return for their support. . . . . 

The goal of this Note is to identify how the SEC’s restrictions on securities crowdfunding fail to address, and potentially hinder, the formation of a wise crowd. Although the SEC’s restrictions are reasonable given the investment risks involved, in practice, they do not adequately account for investors’ bounded rationality and cognitive biases. This Note concludes that further regulatory intervention is necessary to guide the crowd because interested parties in the market are unlikely to invest in correction absent regulatory mandates. Online intermediaries lack sufficient financial and reputational incentives to incur the costs of improving the crowd’s wisdom. Therefore, this Note will address potential regulatory intervention to facilitate formation of a wise crowd. Solutions should target increasing the number of investors conducting research or reducing the interdependence of investor decisionmaking. However, regulators should also consider whether securities crowdfunding is defensible given the inherent obstacles to fostering crowd wisdom, or whether the exemption should be discontinued.

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