Karen is a first-generation MBA from Dallas, South Dakota — population 120. She wants to open a juice bar in her hometown. She has no wealthy connections, no venture capital contacts, and two banks that turned her down. So she posts about her business plan on Facebook, where her group “Juicing for Jesus” has several hundred engaged followers. Some of them want to invest.

She may have just committed a federal securities violation.

Under Regulation D Rule 502(c), issuers of private securities are prohibited from engaging in “general solicitation” — which the SEC defines to include public websites and broadly disseminated communications. The rule was promulgated in 1982 to clarify the distinction between public and private offerings. In an analog age, the line was intuitive: a letter to Grandma was not a general solicitation; an ad in the New York Times was. But how does this rule apply when Facebook is the dominant platform for communication and nearly half the world’s population uses social media?

The SEC has issued almost no guidance on this question. In one enforcement action against Prescient Capital Partners, the SEC found that the company used “mail, email, social media, internet websites, and videos” to generally solicit investors — but never specified what the social media behavior actually was. Issuers have almost no evidence on whether the SEC will declare a social media post to be a general solicitation.

The disparate impact

The general solicitation ban is not neutral in its effects. It systematically advantages established, urban, wealthy, and well-connected entrepreneurs — people who can raise capital through pre-existing relationships with accredited investors. It systematically disadvantages young, rural, poor, and less established entrepreneurs — people who need social media to reach a broader audience because they do not have personal access to angel investors and venture capitalists.

Compare Karen to Blake, a big-city entrepreneur launching a tech startup in San Francisco. Blake graduated from Stanford’s MBA program and has direct access to Sand Hill Road investors, Y Combinator partners, and a network of accredited angels. Blake does not need to post on social media to raise money. The general solicitation ban does not affect Blake at all.

Karen, by contrast, depends on social media. It is her only channel to reach potential investors beyond the two banks in Dallas that already rejected her. The ban on general solicitation is, in practice, a ban on Karen’s ability to raise capital.

Social media has democratized speech. It has the power to democratize entrepreneurship. But the ban on general solicitation prevents social media from creating more equal access to capital markets.

The Facebook friends problem

The SEC has historically treated “pre-existing relationships” as a safe harbor from the general solicitation ban. If you already know the person you are soliciting, it is not a general solicitation. But what counts as a pre-existing relationship on social media?

The average Facebook user in 2016 had 155 friends. Does that constitute a pre-existing relationship with all of them? A nightclub promoter named Justin Tayler reached the 5,000-friend cap on Facebook. Could he solicit all of them for an investment opportunity? Barack Obama had over 121 million Twitter followers. Does he have a pre-existing relationship with all of them?

The impossibility of answering these questions reveals the absurdity of applying a 1982 rule to 2020 technology. The concept of “pre-existing relationship” was designed for a world of handwritten letters and Rolodexes. It has no coherent application to social media networks where the nature, depth, and financial relevance of relationships varies infinitely.

Why the ban should go

The general solicitation ban was designed to prevent fraud. But the new social media investment platforms — angel portals, equity crowdfunding sites, mini-IPO platforms — have built fraud-prevention mechanisms that are in many ways more robust than the general solicitation ban itself. They use identity verification, accreditation checks, financial disclosure requirements, and community-based reputation systems. The ban is no longer the best available tool for investor protection. It is an artifact of a pre-internet regulatory framework that imposes enormous costs — chilled investment, geographic inequality, disparate impact on less-connected entrepreneurs — while providing diminishing anti-fraud benefits.

The general solicitation ban carries the heavy burden of proving that it prevents enough fraud to be worth its cost. It has not met this burden.

Read the full article: Securities Regulation and Social Media, 52 Loyola University Chicago Law Journal (2020).