Capital Markets Reform

On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 on a vote of 233-186. Congress loves acronyms, and here “CHOICE” stands for Creating Hope and Opportunity for Investors, Consumers and Financial Choice ActEntrepreneurs. Although the thrust of the bill is focused on repeal or modification of significant portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and addresses a number of other financial regulations, it also includes a broad range of important provisions aimed at facilitating capital formation, including:

  • Exemption of private company mergers and acquisitions intermediaries from the broker-dealer registration requirements of the Exchange Act;
  • Expansion of the private resale exemption contained in Section 4(a)(7), which codified the so-called “Section 4(a)(1½)” exemption for resales of restricted securities by persons other than the issuer, by eliminating information requirements and permitting general solicitation, so long as sales are made through a platform available only to accredited investors;
  • Exemption from the auditor attestation requirement under Section 404(b) of Sarbanes-Oxley of companies with average annual gross revenues of less than $50 million;
  • Creation of SEC-registered venture exchanges, a new class of stock exchanges that can provide enhanced liquidity and capital access to smaller issuers;
  • Exemption of small offerings that meet the following requirements: (i) investor has a pre-existing relationship with an officer, director or shareholder with 10 percent or more of the shares of the issuer; (ii) issuer reasonably believes there are no more than 35 purchasers of securities from the issuer that are sold during the 12-month period preceding the transaction; and (iii) aggregate amount of all securities sold by the issuer does not exceed $500,000 over a 12-month period;
  • Exemption from the prohibition in Regulation D against general solicitation for pitch-type events organized by angel groups, venture forums, venture capital associations and trade associations;
  • Streamlining of Form D filing requirements and procedures with the filing of a single notice of sales and prohibiting the SEC from requiring any additional materials;
  • Exemption from the Investment Company Act for any VC fund with no more than $50 million in aggregate capital contributions and uncalled committed capital and having not more than 500 investors;
  • Exempting Title III crowdfunding shareholders from the shareholder number trigger for Exchange Act registration;
  • Amendment of Section 3(b)(2) of the Securities Act (the statutory basis for Regulation A+) to raise the amount of securities that may be offered and sold within a 12-month period from $50 million to $75 million; and
  • Allowing all issuers, not just emerging growth companies, to submit confidential registration statements to the SEC for nonpublic review before an IPO, provided that the registration statement and all amendments are publicly filed not later than 15 days before the first road show.

In the coming weeks, I intend to blog in greater detail about a few of these reform efforts, including the proposed broker-dealer exemption for M&A intermediaries, venture exchanges and crowdfunding fixes.

NYSEThe fate of the Financial CHOICE Act is unclear. A variety of interest groups have expressed strong opposition to the bill, and it appears unlikely the Senate will pass it in its current form. My hunch is that the more controversial aspects of the bill relate to the Dodd-Frank repeal and other financial services reforms. I also believe that there is greater potential for general consensus building around capital markets reform, as was demonstrated in connection with the passage of the JOBS Act five years ago, so that any final version that ultimately gets passed will hopefully include much if not all of the reforms summarized above.

On March 22, the Subcommittee on Capital Markets, Securities, and Investment of the Financial Services Committee conducted a hearing entitled “The JOBS Act at Five: Examining Its Impact and Ensuring the Competitiveness of the U.S. Capital Markets”, focusing on the impact of JOBS Act at 5the JOBS Act on the U.S. capital markets and its effect on capital formation, job creation and economic growth. The archived webcast of the hearing can be found here. Most people won’t have the patience to sit through two hours and 44 minutes of testimony (although the running national debt scoreboard on the right side of the home page showing in real time the national debt increasing by $100,000 every three seconds, and by $1 million every 30 seconds, etc., is eyepopping). At the risk of being accused of having too much time on my hands, but as an act of community service, I watched the hearing (or at least most of it) and will offer some takeaways.

Raymond Keating, Chief Economist of the Small Business & Entrepreneurship Council, testified about some disturbing trends in angel and VC investment. The value and number of angel deals is down from pre-recession levels.  VC investment showed the most life but a decline in raymond keating2016 is troubling. So what’s going on?  Keating believes it’s about reduced levels of entrepreneurship stemming in large part from regulatory burdens that limit entrepreneurs’ access to capital and investors’ freedom to make investments in entrepreneurial ventures. He also testified on the need for further reform, particularly in Regulation Crowdfunding under Title III which allows companies for the first time to raise capital from anyone, not just accredited investors, without filing a registration statement with the SEC, and identified the following reform targets:

  • Issuer Cap. Currently, issuers are capped at $1 million during any rolling twelve-month period. There’s been a push to increase that cap, perhaps to $5 million.
  • Investor Cap. Currently, investors with annual income or net worth of less than $100,000 are limited during a 12-month period to the greater of $2,000 or 5% of the lesser of annual income or net worth, and if both annual income and net worth exceed $100,000, then the limit is 10% of the lesser of income or net worth. The proposal here would be to change the application of the cap from the lower of annual income or net worth to the higher of annual income or net worth.
  • Funding Portal Liability. Currently, funding portals can be held liable for material misstatements and omissions by issuers. That poses tremendous and arguably unfair risk to funding portals and may deter funding portals from getting in the business in the first place. The proposal here would be that a funding portal should not be held liable for material misstatements and omissions by an issuer, unless the portal itself is guilty of fraud or negligence. Such a safe harbor for online platforms would be similar to the protection that traditional broker dealers have enjoyed for decades. A funding platform is just a technology-enabled way for entrepreneurs to connect with investors, and they don’t have the domain expertise of issuers and can’t verify the accuracy of all statements made by issuers.  Part of the role of the crowd in crowdfunding is to scrutinize an issuer, a role that should remain with the investors, not with the platform.
  • Syndicated Investments. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field.
  • $25 Million Asset Registration Trigger.  Under current rules, any Regulation CF funded company that crosses a $25 million asset threshold would be required to register under the Securities Exchange Act and become an SEC reporting company. Seems inconsistent with the spirit of Regulation Crowdfunding, which for the first time allows companies to offer securities to the public without registering with the SEC.

As to the continuing challenge for companies to go and remain public, Thomas Quaadman, Vice President of the U.S. Chamber of Commerce, testified that the public markets are in worse shape today than they were five years ago and that we have fewer than half the public companies quaadmantoday than we had in 1996, a number that has decreased in 19 of the last 20 years. Mr. Quaadman blamed this in part on an antiquated disclosure regime that is increasingly used to embarrass companies rather than provide decision useful information to investors. In order to rebalance the system and reverse the negative trend, he suggested a numbere of reform measures the SEC and Congress should undertake. The disclosure effectiveness proposal should be a top priority for the SEC to bring the disclosure regime into the 21st century. We need proxy advisory firm reform that brings transparency, accountability and oversight to proxy advisory firms. Also, there should be recognition that capital formation and corporate governance are inextricably linked and there should be reform of the shareholder proposal process under Rule 14a-8.

2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

On October 26, 2016, the Securities and Exchange Commission adopted final rules intended to make intrastate and regional offerings more viable pathways for smaller raises. The new rules (i) amend Rule 147 to simplify the “doing business” SEC logostandard, (ii) create a new intrastate exemption, Rule 147A, which allows use of the internet and other forms of general solicitation as well as out-of-state incorporation and (iii) increase the 12-month offering cap under Rule 504 from $1 million to $5 million.  This post will address all three of these significant reforms.

Amendments to Rule 147

The statutory exemption for intrastate offerings appears in Section 3(a)(11) of the Securities Act of 1933, which exempts from registration “any security … offered and sold only to persons resident within a single State … where the issuer … [is incorporated] and doing business within … such State …”.  Rule 147 is the safe harbor for Section 3(a)(11), and has not been amended in any significant way since its adoption in 1974.

One of the primary impediments to the use of Rule 147 has been the difficult test that issuers have been required to meet in order to establish sufficient nexus with the state in which the offering is made. To satisfy the doing business test, issuers were required to derive at least 80% of their consolidated gross revenues in-state, have at least 80% of their consolidated assets in-state and use at least 80% of net proceeds from the offering in connection with the operation of an in-state business.  Requiring an issuer to derive most of its revenue, maintain a majority of its assets and invest most of the capital it raises all in one state could create inefficient constraints for many emerging companies to operate and grow.

The final rules modify the current “doing business” in-state requirements in Rule 147 by requiring issuers to satisfy only one of four specified tests. Under amended Rule 147 (and new Rule 147A), in order to be deemed to be “doing business” in a state, an issuer will have to satisfy only one of the following requirements:

  • 80% of consolidated assets located in-state;
  • 80% of consolidated gross revenues derived from operation of a business or of real property located in or from the rendering of services within such state;
  • 80% of net offering proceeds intended to be used, and are in fact used, in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services within such state; or
  • Majority of employees are in such state.

The final rules take a side-by-side approach, adopting amendments to modernize Rule 147 and also establishing a brand new intrastate offering exemption under the Securities Act, designated Rule 147A, which will be similar to amended Rule 147 but with no prohibition on offers to non-residents and allowing issuers to be incorporated out of state. Under the final rules, issuers will be able to choose between utilizing Rule 147 and Rule 147A for intrastate offerings based on their preferences for communicating with investors. The SEC elected to keep and modify Rule 147 as a safe harbor under Section 3(a)(11) to allow issuers to continue to rely on state law exemptions that are conditioned upon compliance with Section 3(a)(11) and Rule 147.

New Rule 147A

In addition to the overly restrictive doing business requirements, two other features have served to dissuade issuers from taking advantage of the intrastate exemption. The first is the requirement that issuers be incorporated in-state, which disqualifies many emerging companies all over the country that choose to incorporate in management friendly confines like Delaware (or are forced to do so by their investors).  Second is the prohibition on making offers to out-of-state residents, even if sales are made only to in-state residents, which effectively eliminates the use of the internet, social media and other methods of general solicitation in conducting the offering.

New Rule 147A corrects these shortcomings. First, there is no requirement that the issuer be incorporated in-state.  So, for example, a company incorporated in Delaware that has its principal place of business in New York may sell to New York Delawareinvestors.  Second, it permits offers to out-of-state residents so long as all sales are limited to in-state residents, and more broadly allows general solicitation and general advertising (including use of unrestricted websites).  When using space-constrained social media like Twitter to solicit, the issuer may use an active hyperlink to the offering disclosure.   Rule 147A does require, however, prominent disclosure in all offering materials that sales will be made only to residents of the same state as the issuer.

Features Common to Amended Rule 147 and New Rule 147A

Both amended Rule 147 and new Rule 147A contain the following common features:

  • Issuer “principal place of business” must be in-state, and issuer must satisfy at least one “doing business” requirement that would demonstrate in-state nature of issuer’s business;
  • New “reasonable belief” standard in determining purchaser’s residence;
  • Issuers must obtain written residency representation from each purchaser;
  • Resales limited to state residents for a six month period;
  • Integration safe harbor that would include prior offers or sales of securities by the issuer, as well as certain post-offering offers or sales; and
  • Legend requirements to offerees and purchasers about resale limits.

Amendment to Rule 504

Rule 504 of Regulation D exempts from registration offers and sales of up to $1,000,000 of securities in any rolling 12-month period. Two of Rule 504’s general requirements, the prohibition on general solicitation and securities sold being deemed “restricted” securities, do not apply if the offer and sale are made:

  • exclusively in one or more states that provide for the registration of the securities, and require the public filing and delivery to investors of a disclosure document before sale;
  • in one or more states that require no registration, filing or delivery of a disclosure document before sale, if the securities have been registered in at least one state that provides for such registration, filing and delivery; or
  • exclusively according to state law exemptions that permit general solicitation so long as sales are made only to “accredited investors”.

Several states have instituted coordinated review programs to streamline the state registration process for issuers seeking to undertake multi-state registrations in reliance upon Rule 504. Because these offerings are typically limited to a few states, review of these offerings is undertaken on a regional basis. These programs establish uniform review standards and are designed to expedite the registration process, thereby potentially saving issuers time and money.

The new rules amend Rule 504 to increase the aggregate amount of securities that may be offered and sold from $1 million to $5 million. The SEC is hoping that the higher offering cap will promote capital formation by increasing the flexibility of state securities regulators to implement coordinated review programs to facilitate regional offerings.

The final rules repeal Rule 505 of Regulation D, which exempts offers and sales of up to $5 million and is now rendered obsolete by amended Rule 504. The rules also apply bad actor disqualifications to Rule 504 offerings, consistent with other rules in Regulation D.

Effective Dates

The foregoing reforms have the following effective dates:

  • Amended Rule  147: 150 days after publication in the Federal Register
  • New Rule 147A:  150 days after publication in the Federal Register
  • Amended Rule 504:  60 days after publication in the Federal Register
  • Repeal of Rule 505:  180 days after publication in the Federal Register

On July 5, the House of Representatives passed a watered down version of the Fix Crowdfunding Act (the “FCA”) that was initially introduced in March.  The bill seeks to amend Title III of the JOBS Act by expressly permitting “crowdfunding vehicles” and broadening the SEC registration exclusion, but leaves out three important reforms that were part of the original version of the FCA introduced in March and about which I blogged about here. The House bill is part of the innovation initiativeInnovation Initiative which was jointly launched by Majority Leader Kevin McCarthy and Chief Deputy Whip Patrick McHenry.  The bill was passed by the House with overwhelming bipartisan support, so it’s likely to be passed quickly by the Senate.  This post summarizes what was left in the bill from the original and what was dropped from it.

What’s In: Special Purpose Vehicles and the Section 12(g) Registration Exclusion

Special Purpose Vehicles

Title III of the JOBS Act excludes from crowdfunding eligibility any issuer that is an “investment company”, as defined in the Investment Company Act, or is exempt from investment company regulation by virtue of being owned by not more than 100 persons. Several accredited investor-only matchmaking portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in which investors invest into a special purpose vehicle (“SPV”), which in turn makes the investment into the issuer as one shareholder. Because Title III did not permit issuers to sell shares through SPVs, many growth-oriented startups may be dissuaded from engaging in Title III crowdfunding offerings if they expect to raise venture capital in the future, as VC funds don’t like congested cap tables.

The FCA would create a new class of permitted crowdfunding issuer called a “crowdfunding vehicle”, which is an entity that satisfies all of the following requirements:

  • purpose (as set forth in its organizational documents) limited to acquiring, holding and disposing crowdfunded securities;
  • issues only one class of securities;
  • no transaction-based compensation received by the entity or any associated person;
  • it and company whose securities it holds are co-issuers;
  • both it and company whose securities it holds are current in ongoing Regulation Crowdfunding disclosure obligations; and
  • advised by investment adviser registered under Investment Advisers Act of 1940

Section 12(g) Registration Exclusion

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) of the Securities Exchange Act that triggers registration with the SEC, which subjects the company to periodic reporting obligations (e.g., 10-Ks, 10-Qs, etc.). It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC provided that shareholders that purchased crowdfunded shares would be excluded from the shareholder calculation under Section 12(g), but conditioned the exclusion on, among other things, the issuer having total assets of no more than $25 million.

The $25 million limit on total assets may have the perverse effect of deterring growth companies from utilizing crowdfunding and/or prompting such companies to issue redeemable shares to avoid the obligation to register with the SEC if they cross the shareholder threshold because of a crowdfunded offering.

The original version of the FCA would have removed from the 12(g) exclusion the condition that an issuer not have $25 million or more in assets.

The version of the FCA passed by the House removes the $25 million asset condition but replaces it with two other conditions: that the issuer have a public float of less than $75 million and annual revenues of less than $50 million as of the most recently completed fiscal year.

What’s Out: Issuer Cap, Intermediary Liability and Testing the Waters

The House version of the FCA unfortunately dropped a few of the reforms that were contained in the original version introduced in March, apparently the price paid for securing votes of opponents of the FCA.

Issuer Cap                                                                                    

Title III limits issuers to raising not more than $1 million in crowdfunding offerings in any rolling 12 month period. By comparison, Regulation A+ allows up to $50 million and Rule 506 of Regulation D has no cap whatsoever.

The original version of the FCA would have increased the issuer cap from $1 million to $5 million in any rolling 12 month period. This was scrapped from the House version.

Portal Liability

Title III imposes liability for misstatements or omissions on an “issuer” (as defined) that is unable to sustain the burden of showing that it could not have known of the untruth or omission even if it had exercised reasonable care. Title III also exposes an intermediary (i.e., funding portal or broker-dealer) to possible liability if an issuer made material inaccuracies or omissions in its disclosures on the crowdfunding site. It is over this very concern over liability that some of the largest non-equity crowdfunding sites that have otherwise signaled interest in equity crowdfunding, including Indiegogo and EarlyShares, have expressed reluctance to get into the Title III intermediary business.

The original version of the FCA would have clarified that an intermediary will not be considered an issuer for liability purposes unless it knowingly made a material misstatement or omission or knowingly engaged in any fraudulent act. Presumably then, as proposed, a plaintiff would have had the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time. The House version dropped this relief for intermediaries.

Testing the Waters

Securities offerings are expensive and risky with no guaranty that they will generate enough investor interest. Congress and the SEC chose not to allow Title III issuers to “test-the-waters”, i.e., solicit indications of interest from potential investors prior to filing the mandated disclosure document with the SEC, out of concern that unscrupulous companies could prime the market before any disclosure became publicly available.

The original version of the FCA would have allowed Title III issuers to test the waters by permitting them to solicit non-binding indications of interest from potential investors so long as no investor funds are accepted by the issuer during the initial solicitation period and any material change in the information provided in the actual offering from the information provided in the solicitation of interest is highlighted to potential investors in the information filed with the SEC. This too was left out of the version approved by the House.

Although it was disappointing to see the foregoing three reforms dropped from the eventual House bill, half a loaf is better than no loaf. Perhaps the dollar cap, intermediary liability and testing the waters could be revisited at some point down the road.

Ever since the Federal securities laws were enacted in 1933, all offers and sales of securities in the United States had to either be registered with the SEC or satisfy an exemption from registration. The commonly used private offering exemption, however, prohibited any act of general solicitation. The JOBS Act of 2012 JOBS Act signingcreated a new variation to the private offering exemption under Rule 506 of Regulation D that permits online offers and other acts of general solicitation, but issuers selling under this new Rule 506(c) may sell only to accredited investors and must use reasonable methods to verify investor status.

Starting today, companies will be permitted to offer and sell securities online to anyone, not just accredited investors, without SEC registration. This is pursuant to Title III of the JOBS Act and the final crowdfunding rules promulgated by the SEC called Regulation Crowdfunding.  The potential for Title III Crowdfundingequity crowdfunding is enormous and potentially disruptive.  It is believed that approximately 93% of the U.S. population consists of non-accredited investors who have an estimated $30 trillion stashed away in investment accounts.  If only one percent of that amount got redirected to equity crowdfunding, the resulting $300 billion dollars invested would be ten times larger than the VC industry.  Hence the potential.

The reality, however, is not as encouraging. In the interest of investor protection, Congress in JOBS Act Title III and the SEC in Regulation Crowdfunding created a heavily regulated and expensive regime that many fear will severely limit the prospects of equity crowdfunding.  The rules include a $1 million issuer cap, strict dollar limits on investors, disclosure requirements and funding portal liability, registration and gatekeeper obligations.

wefunderSEC registration for funding portals began on January 29. But as of last week, only five portals had completed the registration process: Wefunder Portal LLC, SI Portal LLC dba Seedinvest.com, CFS LLC dba seedinvestCrowdFundingSTAR.com, NextSeed US LLC and StartEngine Capital LLC.  Over 30 others are apparently awaiting approval.  Of the two best known and most successful non-equity crowdfunding portals, only Indiegogo has declared an intention to get in the Title III funding portal business; Kickstarter has so far declined.

The likely reason for the apparent lackluster funding portal activity so far is the restrictive regulatory regime referred to above, the burden of which falls disproportionately on funding portals. None of this should be a surprise.  Several key aspects of the crowdfunding rules were contentiously debated at the Congressional level and later during SEC rulemaking.  Opponents asserted that retail equity crowdfunding is an invitation for massive fraud against those who can least afford it and so believe Title III is a mistake.  Proponents advocated against several of the more restrictive rules but conceded on these points in order to get Title III passed.  And because the legislation itself was so prescriptive and granular, there was only room for marginal improvement in the final SEC rules relative to those proposed in the initial release.

Regrettably, there’s painful precedent for securities exemptions so restrictive that no one used them.  Regulation A allowed for a mini-public offering through a streamlined filing with the SEC.  But issuers were capped at $5 million and were forced to go through merit review in each state where they offered the securities.  The result:  hardly anyone used Reg A.  In recognition of this, Title IV of the JOBS Act reformed Reg A by increasing the cap to $50 million and, more importantly, preempting state blue sky review for so-called Tier II offerings which must satisfy investor protection requirements.

In an effort to prevent Title III from a fate similar to pre-reform Reg A, legislation has been introduced in Congress to increase the issuer cap, allow for special purpose vehicles, remove the $25 million asset cap on the exemption from the 500 shareholder SEC registration trigger and allow issuers to test the waters. See my previous blog post here on the proposed Fix Crowdfunding Act.

It may seem somewhat premature to advocate for reform when the rules have barely gone live. But given the time necessary for the legislative process to run its course, and inasmuch as the indications are already fairly clear that both issuers and funding portals remain skeptical about Title III crowdfunding, it makes sense to begin the process now of introducing necessary common sense reform of Title III.

Beginning on May 16, issuers for the first time will be able to offer and sell securities online to anyone, not just accredited investors, withoutTitle III Crowdfunding registering with the SEC. The potential here is breathtaking.  Some $30 trillion dollars are said to be stashed away in long-term investment accounts of non-accredited investors; if only 1% of that gets allocated to crowdfunding, the resulting $300 billion would be ten times bigger than the VC industry.   But the onerous rules baked into JOBS Act Title III and the SEC’s Regulation Crowdfunding (the statutory and regulatory basis, respectively, for public equity crowdfunding), leave many wondering if Title III crowdfunding will prove to be an unattractive alternative to other existing exemptions and become a largely underutilized capital raising pathway – a giant missed opportunity.

Patrick_McHenry_OfficialBut help may be on the way. Congressman Patrick McHenry recently introduced new legislation to address certain defects in Title III.  The Fix Crowdfunding Act (H.R. 4855)  would seek to improve the utility of Title III crowdfunding by raising the issuer dollar limit, simplifying the Section 12(g)(6) exemption, clarifying portal liability, permitting special purpose entities to engage in Title III offerings and allowing issuers to “test the waters”.  The House Financial Services Committee’s Subcommittee on Capital Markets recently held hearings on the Fix Crowdfunding Act labeled “The JOBS Act at Four: Examining Its Impact and Proposals to Further Enhance Capital Formation”, with witnesses such as Kevin Laws (Chief Operating Officer of AngelList) and The Honorable Paul S. Atkins (Chief Executive Officer of Patomak Global Partners) testifying.  Congress should pass this proposed legislation, and the sooner the better.

Here’s a summary of the proposed legislation, identifying the defect in the original Title III and the proposed fix.

Issuer Cap                                                                                     

Title III limits issuers to raising not more than $1 million in crowdfunding offerings in any rolling 12 month period. By comparison, Regulation A+ allows up to $50 million and Rule 506 of Regulation D has no cap whatsoever.

The new legislation would increase the issuer cap from $1 million to $5 million in any rolling 12 month period.

Portal Liability

Title III imposes liability for misstatements or omissions on an “issuer” (as defined) that is unable to sustain the burden of showing that it could not have known of the untruth or omission even if it had exercised reasonable care. By comparison, a plaintiff in a Rule 506 offering must allege not just a material misstatement or omission but that the issuer either knew or should have known if it made a reasonable inquiry.  Title III defines “issuer” to include “any person who offers or sells the security in such offering.”  In its final rules release, the SEC considered but refused to clarify that intermediaries were not issuers for purposes of the liability provision.  As it currently stands, Title III exposes intermediaries (i.e., funding portals and broker-dealer platforms) to possible liability if issuers commit material inaccuracies or omissions in their disclosures on crowdfunding sites.  It is over this very concern over liability that some of the largest non-equity crowdfunding sites that have otherwise signaled interest in equity crowdfunding, including Indiegogo and EarlyShares, have expressed reluctance to get into the Title III intermediary business.

The Fix Crowdfunding Act would make clear that an intermediary will not be considered an issuer for liability purposes unless it knowingly makes any material misstatements or omissions or knowingly engages in any fraudulent act. Presumably then, as proposed, a plaintiff would have the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time.

Section 12(g) Registration Exemption

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) that triggers Exchange Act registration. It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC exempted crowdfunded shares from the shareholder calculation under Section 12(g), but conditioned the exemption on, among other things, the issuer having total assets of no more than $25 million.  The $25 million limit on total assets may have the perverse effect of deterring growth companies from utilizing crowdfunding and/or prompting such companies to issue redeemable shares to avoid the obligation to register with the SEC if they cross the shareholder threshold because of a crowdfunded offering.

The new legislation would remove from the 12(g) exemption the condition that an issuer not have $25 million or more in assets.

Special Purpose Vehicles

Several portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in SPVwhich investors invest into an SPV which in turn makes the investment into the company as one shareholder. Because of the SPV exclusion, many growth-oriented startups might avoid Title III crowdfunding if they expect to raise venture capital in the future, as VC firms don’t like congested cap tables.

The proposed legislation would make “any issuer that holds, for the purpose of making an offering pursuant to [Title III], the securities of not more than one issuer eligible to offer securities pursuant to [Title III]” eligible for Title III offerings.

Testing the Waters

testing the watersSecurities offerings are expensive and risky with no guaranty that they will generate enough investor interest. Congress and the SEC chose not to allow Title III issuers to “test-the-waters”, i.e., solicit indications of interest from potential investors prior to filing the mandated disclosure document with the SEC.  The concern is that allowing issuers to do so would enable unscrupulous companies to prime the market before any disclosure became publicly available. Without the protection of public disclosure, issuers may be able to use selective disclosures or overly enthusiastic language to generate investor interest.

The Fix Crowdfunding Act would specifically allow Title III issuers to test the waters by permitting them to solicit non-binding indications of interest from potential investors so long as no investor funds are accepted by the issuer during the initial solicitation period and any material change in the information provided in the actual offering from the information provided in the solicitation of interest are highlighted to potential investors in the information filed with the SEC.

One of the key investor protections of Regulation Crowdfunding under JOBS Act Title III is theyou've got funding requirement that offerings must be conducted exclusively through a single platform operated by a registered broker-dealer or a new type of SEC registrant, a funding portal. Although SEC registration for funding portals began January 29, 2016, intermediaries (funding portals and broker-dealers) may not engage in crowdfunding activities until May 16, 2016, the date that Regulation Crowdfunding goes live. It remains to be seen how popular Title III crowdfunding will prove to be given its burdensome rules relative to other available exemptions, but the potential is enormous both for issuers and for the brand new type of financial intermediary it created, the funding portal.

SEC logoThe SEC spent three years trying to reconcile the enormous capital markets potential of the “crowd” with the investor protection concerns voiced by equity crowdfunding’s critics. The SEC believes that requiring an issuer to use only one intermediary to conduct an offering helps foster the creation of a crowd, by facilitating information sharing and avoiding dilution or dispersement of the crowd, and helps minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering usingcrowd 2 more than one intermediary would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit. But to mitigate fraud risk concerns, the SEC has also imposed a heavy gatekeeping burden on intermediaries, particularly funding portals.

This blog post will focus on the rules governing funding portals, and will summarize the permitted “safe harbor” activities and compliance rules unique to funding portals, as well as certain requirements common to both types of Regulation Crowdfunding intermediaries (broker-dealers and funding portals).

Unique Funding Portal Requirements

Registration. Funding portals are required to register with the SEC on Form Funding Portal, a stripped-down version of Form BD, the registration form for broker-dealers.  For example, unlike broker-dealer registration, funding portals will not be required to post a fidelity bond to register as a funding portal.  As required under the JOBS Act, SEC registered funding portals are exempt from broker-dealer registration.  The text of the Form currently appears only in the final rules release on pages 623-664 (inclusive of Schedules A-D and general instructions).[i]

All registered funding portals are also required to become members of the Financial Industry Regulatory Authority, or FINRA.  FINRA funding portal registration information can be found here.

A funding portal’s SEC registration becomes effective on the later of: (1) 30 calendar days after the date that the registration is filed with the SEC; or (2) the date the funding portal is approved for FINRA membership.

Form Funding Portal must be filed electronically on EDGAR, although as of this writing the Form has not startenginebeen assigned a submission type or even been listed on the EDGAR forms index. To gain access to EDGAR for the electronic filing of Form Funding Portal, a funding portal will first need to obtain an EDGAR access code and a central index key, or CIK, by submitting a Form ID with the SEC. When a funding portal’s registration becomes effective, the information on Form Funding Portal becomes publicly available except for certain personally identifiable information.  As of this writing, there are no Form Funding Portals shown to have been filed on EDGAR, although at least one portal, StartEngine Capital LLC, put out a press release that it did so on January 29.

Permitted Activities – Safe Harbor. Unlike registered broker-dealers, funding portals are prohibited from giving investment advice, soliciting offers, paying success fees to persons for solicitations or handling investor funds or securities.  To help funding portals navigate these prohibitions while trying to function as effective intermediaries, the rules provide a safe harbor for the following activities:

  • Curating Offerings. A funding portal may use broad discretion to determine whether and under what circumstances to allow an issuer to offer and sell securities through its platform, subject to the prohibition on providing investment advice or recommendations and provided it complies with all other provisions of Regulation Crowdfunding. The SEC believes this kind of discretion is important for the protection of investors, as well as to the viability of the funding portal industry and the crowdfunding market.
  • Highlighting Issuers and Offerings. A funding portal is permitted to highlight particular issuers or offerings on its platform based on objective criteria where the criteria are reasonably designed to highlight a broad selection of issuers offering securities through the platform, are applied consistently to all issuers and offerings and are clearly displayed on the platform. The permissible criteria include type of securities offered (e.g., common stock, preferred stock or debt securities), geographic location of the issuer, industry or business segment of the issuer, number or amount of investment commitments made, progress in meeting the target offering amount and minimum or maximum investment amount.
  • Providing Search Functions. A funding portal may provide search functions on its platform that investors could use to search, sort or categorize available offerings according to objective criteria, and that would allow investors to sort through offerings based on a combination of different criteria, such as by the percentage of the target offering amount that has been met, geographic proximity to the investor and number of days remaining before the closing date of an offering. However, search criteria may not include the advisability of investing in the issuer or its offering, or an assessment of any characteristic of the issuer, its business plan, its management or risks associated with an investment.
  • Providing Communication Channels. A funding portal may provide communication channels by which investors can communicate with one another and with representatives of the issuer through the funding portal’s platform about offerings conducted through the platform, but neither the funding portal nor its associated persons or employees may participate in these communications, other than to establish guidelines about communications and to remove abusive or potentially fraudulent communications. The communication channels must be made available to the general public and must restrict the posting of comments to those who have accounts on the funding portal’s platform. The funding portal must require each person posting comments to disclose clearly with each posting whether he is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or will receive any compensation for promoting an issuer.
  • Advising Issuers. A funding portal may advise an issuer about the structure or content of the issuer’s offering, including preparing offering documentation. For example, a funding portal may provide pre-drafted templates or forms for an issuer to use in its offering, and advice about the types of securities the issuer can offer, the terms of those securities and the procedures and regulations associated with crowdfunding.  Without these services, the SEC believes that crowdfunding as a method to raise capital might not be viable.
  • Paying for Referrals. A funding portal may compensate a third party for referring a person to the funding portal if the third party does not provide the funding portal with personally identifiable information about any investor, and the compensation, other than that paid to a registered broker-dealer, is not a transaction based success fee. The SEC believes the prohibition on success fees will help to minimize the incentive for high-pressure sales tactics and other abusive practices in this area.
  • Compensation Arrangements with Registered Broker-Dealers. A funding portal may pay compensation to a registered broker-dealer for services, including for referring a person to the funding portal, in connection with the offer or sale of securities, provided that the services are provided pursuant to a written agreement between the funding portal and the registered broker-dealer, the compensation is permitted under Regulation Crowdfunding and the compensation complies with FINRA rules.
  • Advertising. A funding portal may advertise its existence and identify one or more issuers or offerings available on its portal on the basis of objective criteria, so long as the criteria are reasonably designed to identify a broad selection of issuers offering securities through the platform and are applied consistently to all potential issuers and offerings, and the funding portal does not receive special or additional compensation for identifying the issuer or offering in this manner. However, a funding portal may not base its decision as to which issuers to include in its advertisements on whether it has a financial interest in the issuer, and any advertising may not directly or indirectly favor issuers in which the funding portal has invested or will invest.
  • Denying Access to Platform. A funding portal may deny access to its platform to an issuer if the funding portal has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.
  • Accepting Investor Commitments.  A funding portal may, on behalf of an issuer, accept investment commitments from investors but may not actually handle the funds.
  • Directing Transmission of Funds. A funding portal may direct investors where to transmit funds and may direct a qualified third party to release proceeds of an offering to the issuer upon completion of the offering or to return investor proceeds when an investment commitment or offering is cancelled. Interestingly, the SEC chose not to impose requirements that would prohibit variations of a contingency offering, such as minimum-maximum offerings, that would establish a fixed deadline for transmission of funds as compared to the proposed requirement to transmit funds “promptly” or that would require funding portals to maintain a certain amount of net capital.

            Compliance.  A funding portal must have written policies and procedures reasonably designed to achieve compliance with the federal securities laws and regulations relating to its business as a funding portal.  In addition, funding portals must follow the same privacy rules as those applicable to brokers.  Finally, funding portals are required to preserve certain records for five years, with the records retained in a readily accessible place for at least the first two years.

Rules Governing Crowdfunding Intermediaries Generally

The following rules apply to all Regulation Crowdfunding intermediaries, i.e., funding portals and broker-dealers:

  • Receiving Financial Interests in Issuers. The intermediary entity (but not its directors, officers or partners) is permitted to receive a financial interest in an issuer using its services, provided that the financial interest is compensation for the services provided to the issuer in connection with the offering and the financial interest consists of the same security as being offered to investors in the offering. This was as an accommodation in the final rules that will better enable issuers to pay intermediary upfront fees (through stock) and also have the added benefit of aligning the interests of issuer, intermediary and investors.
  • Measures to Reduce Risk of Fraud. There are several measures that intermediaries are required to take that are designed to reduce the risk of fraud in crowdfunding transactions. An intermediary is required to have a reasonable basis for believing that the issuers on its platform comply with Regulation Crowdfunding and have established means to keep accurate records of the holders of the securities, and may reasonably rely on representations of the issuer unless the intermediary has reason to question the reliability of those representations.   An intermediary must deny access if it has a reasonable basis for believing that an issuer, or any of its officers, directors or any 20% owner is subject to a disqualification under Regulation Crowdfunding.
  • Accounts and Electronic Delivery. Intermediaries may not accept an investment commitment unless the investor has opened an account with the intermediary and the intermediary has obtained from the investor consent to electronic delivery of materials.
  • Educational Materials. Intermediaries must deliver certain educational materials to investors, including information on process for purchase of securities, types of securities that may be offered on the intermediary’s platform, risks associated with each type of security, restrictions on resale, types of information that an issuer is required to provide in annual reports, frequency of the delivery of that information, limits on amounts investors may invest and limitations on an investor’s right to cancel an investment commitment.
  • Promoters. Intermediaries must inform investors, at the time of account opening, that promoters must clearly disclose in all communications on the platform the receipt of promotion compensation and the fact that he is engaging in promotional activities on behalf of the issuer.
  • Compensation Disclosure. At the time of opening an account, intermediaries must clearly disclose the manner in which they will be compensated in connection with Regulation Crowdfunding offerings.
  • Issuer Information. Intermediaries must make available to the SEC and investors, not later than 21 days prior to the first day on which securities are sold to any investor, any information provided by the issuer pursuant to Regulation Crowdfunding, and that such information be publicly available on the platform for a minimum of 21 days before any securities are sold in the offering, during which time the intermediary may accept investment commitments, and remain publicly available on the platform until the offering is completed or cancelled.
  • Investor Qualification. Before accepting an investment commitment, an intermediary must have a reasonable basis for believing that the investor satisfies the investment limits under Regulation Crowdfunding. An intermediary may rely on an investor’s representations concerning annual income, net worth and the amount of the investor’s other investments in Regulation Crowdfunding offerings through other intermediaries unless the intermediary has a reasonable basis to question the reliability of the representation. Intermediaries must also confirm that an investor has reviewed the intermediary’s educational materials, understands that the entire amount of his investment may be lost and is in a financial condition to bear the loss of the investment and has completed a questionnaire demonstrating an understanding of the risks of any potential investment.
  • Communication Channels. Intermediaries must provide on their platforms channels through which investors can communicate with one another and with representatives of the issuer about offerings, to make the channels publicly available, permit only those persons who have opened accounts to post comments and require any person posting a comment in the channels to disclose whether he is a founder or employee of an issuer engaging in promotional activities on behalf of the issuer or otherwise compensated to promote the issuer’s offering. Funding portals are prohibited from participating in communications in these channels.
  • Transaction Confirmations. At or before the completion of a transaction, an intermediary must send to each investor a notification disclosing date of transaction, type of security, identity, price and number of securities purchased by the investor, certain specified terms of the security and source, form and amount of any remuneration to be received by the intermediary in connection with the transaction.
  • Completion of Offerings, Cancellations and Reconfirmations. Intermediaries must give investors the right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. If an issuer reaches the target prior to deadline, it could close the offering provided the offering has been open for a minimum of 21 days, the intermediary provided notice about the new offering deadline at least five business days prior to the new offering deadline and investors are given the opportunity to reconsider and cancel their investment commitment until 48 hours prior to the new offering deadline. Finally, if there was a material change to the offering terms or to the information provided by the issuer, the intermediary would be required to give or send to any investors who have made investment commitments notice of the material change, stating that the investor’s investment commitment will be cancelled unless the investor reconfirms his or her commitment within five business days of receipt of the notice.

[i] Although funding portal registration went live on January 29, 2016, Form Funding Portal does not yet appear on the SEC’s website and a Google search came up empty.

Buried in the recently enacted Highway Bill, officially the Fixing America’s Fast ActSurface Transportation Act or FAST Act, is a new exemption for the resale of securities.  The new resale exemption appears in the form of a new Section 4(a)(7) of the Securities Act of 1933 and essentially codifies the so-exit strategy 2called 4(a)(1-1/2) exemption.  New Section 4(a)(7) will provide securityholders seeking to resell their securities without registration greater certainty and another viable alternative exit pathway, particularly from privately held companies.   Inasmuch as no Securities and Exchange Commission rulemaking is required, the new exemption is effective right now.

Background

The requirement that each sale of securities be either registered with the Securities and Exchange Commission or satisfy an exemption from registration applies as well to any resale of securities by security holders. Rule 144 is a common exemption for the resale of restricted securities (and of any securities by holders who are affiliates of the issuer, i.e., control securities).  Another exemption used by reselling shareholders is the so-called 4(a)(1-1/2) exemption, an unofficial, unwritten exemption conceived by securities lawyers which over time has become accepted practice.  It’s called the 4(a)(1-1/2) exemption because it contains elements of both Section 4(a)(1) of the Securities Act, which exempts from registration transactions by any person other than an issuer, underwriter or dealer, and Section 4(a)(2) of the Securities Act, which exempts transactions by an issuer not involving any public offering.

The New Section 4(a)(7) Resale Exemption

New Section 4(a)(7) essentially codifies “Section 4(a)(1-1/2)” by exempting from the registration requirements of Section 5 of the Securities Act resales of restricted securities that satisfy the following requirements:

  • securities sold only to accredited investors
  • no general solicitation
  • if the issuer is not a reporting company, the seller and prospective buyer are able to obtain from the issuer certain reasonably current information about the issuer, including the number of shares outstanding, information about the officers and directors, any persons registered as a broker, dealer or agent that will receive any commission for the transaction; recent balance sheet and profit and loss statements; and if the seller is a control person of the issuer, a statement regarding the nature of the affiliation and a certification by the seller that it has no reasonable grounds to believe that the issuer is in violation of the securities laws
  • seller is not a direct or indirect subsidiary of the issuer
  • neither the seller nor any person being paid in connection with the sale is a bad actor, as described in Regulation D
  • the issuer is not a blank check, blind pool or shell company; and
  • the class of securities has been outstanding for at least 90 days prior to the transaction.

New Section 4(a)(7) will provide greater legal certainty to shareholders seeking to resell shares than currently provided in the so-called Section 4(a)(1-1/2) exemption, which was never formally legislated or codified through SEC rulemaking.

New Section 4(a)(7) will also present a viable alternative to Rule 144, the traditional safe harbor for the resale of restricted and control securities, in relation to which Section 4(a)(7) has both advantages and disadvantages.

As to the advantages, sellers under Section 4(a)(7) may sell an unlimited number of shares, unlike affiliates in Rule 144 transactions who are capped in any rolling three month period to the greater of one percent of the outstanding shares or the average weekly trading volume over the preceding four week period. Section 4(a)(7) sellers need not satisfy any holding period, unlike Rule 144 sellers who must hold the shares for either six months in the case of reporting issuers or one year in the case of non-reporting issuers.  A Section 4(a)(7) exemption need not be reported in an SEC filing, unlike Rule 144 sales by affiliates.  Finally, the FAST Act made explicitly clear that shares sold in a Section 4(a)(7) transaction are deemed “covered securities” for purposes of the National Securities Markets Improvement Act of 1996, meaning that state regulation is preempted and these transactions are not subject to state review.

On the other hand, there are certain disadvantages relative to Rule 144. Shares sold in a Section 4(a)(7) transaction are deemed to be restricted securities in the hands of the purchaser, who would then need to find his own exemption on a subsequent resale, as opposed to shares sold under Rule 144 which become unrestricted.  Furthermore, Section 4(a)(7) shares may only be sold to accredited investors, whereas shares sold under Rule 144 may be sold to anyone.

Finally, it will be interesting to see what practices emerge with respect to the information that must be obtained from a non-reporting issuer, including whether issuers will insist on signed confidentiality agreements as a condition to disclosing the required information.

It’s official: the new Regulation Crowdfunding rules will become effective on May 16, 2016.  The SEC’s crowdfunding-keyboardfinal rules release of October 31, 2015 provided that, with certain exceptions, the new rules will go into effect 180 days after they are published in the Federal Register.  We just learned that the rules were published in the Federal Register on November 16, and that, accordingly, they will become effective on May 16, 2016.

So mark your calendars.  May 16, 2016 will be the first day that companies will be able to file Form C, the offering statement mandated by the SEC for Regulation Crowdfunding offerings.  But because of the requirement that disclosure be made publicly available on the intermediary’s platform for a minimum of 21 days before any securities are sold in an offering, however, the first Regulation Crowdfunding closings will not take place until at least June 6, 2016.

An important exception to the May 16, 2016 effective date relates to registration of funding portals, the relevant effective date for which remains January 29, 2016.  That means that funding portals, one of the two types of intermediaries (the other being registered broker-dealers) that will be permitted to operate funding portalsonline platforms for securities transactions under Regulation Crowdfunding, could begin filing their registration form, called Form Funding Portal, on January 29, 2016.  The reason for the staggered effective dates is to provide a level playing field between broker-dealers, who would already be registered and possess built-in infrastructure, and “funding portals”, the newly designated category of intermediary that will need to register with the SEC as funding portals and develop infrastructure.  I’ll be blogging about what the new Regulation Crowdfunding means for funding portals in my next post.

You can find my initial reaction to the new Regulation Crowdfunding rules here.