In a massive 585 page release, the Securities Exchange Commission on October 23 issued its long overdue proposed rules on equity crowdfunding to implement the statutory equity crowdfunding exemption set forth in Title III of the JOBS Act. As proposed, Regulation Crowdfunding implements and further clarifies the statutory requirements for equity crowdfunding, and in some instances imposes conditions that exceed those in the JOBS Act. The process is far from over. Given the sheer volume of issues over which the SEC is seeking comment — the release identifies 295 separate issues over which it is inviting specific comment — it’s hard to imagine that final rules will be enacted before the middle of 2014. Equity crowdfunding has the potential to create meaningful new capital raising opportunities for startups and early stage companies, but that potential may be undercut, however, by the disproportionate disclosure and other burdens imposed in the proposed rules on issuers and intermediaries relative to other private offering exemptions.
Crowdfunding is a relatively new and evolving fund raising method used by artists, musicians and not-for-profits who leverage social media, websites and the internet to raise funds from large numbers of individuals. Crowdfunding has even been used successfully by for-profit ventures who often entice contributions by offering some token object of value such as tee shirts, early versions of a product, invites to a screening or back stage passes, in exchange for contributions.
These forms of crowdfunding have not implicated the securities rules and are perfectly legal because there is no expectation of sharing in profits, i.e., the contributors are not issued securities. Any fund raising campaign in which contributors are offered some share of profits would either need to be registered or qualify for an exemption. Registration would be disproportionately expensive and burdensome for the relatively small amounts raised in crowdfunding transactions. On the other hand, limitations under existing exemptions, including restrictions on general solicitation and general advertising and purchaser qualification requirements, have made private placement exemptions generally unavailable for crowdfunding. Moreover, funding portals would, under existing regulations, be required to register with the SEC as broker-dealers which would also be impractical in a crowdfunding context.
Title III of the JOBS Act, enacted in April 2012, fashioned a new exemption in the form of Section 4(a)(6) of the Securities Act for offerings of securities through a funding portal with limits on amounts raised ($1 million during any twelve month period) and invested, and instructed the SEC to promulgate rules to implement the new exemption. The new Section 4(a)(6) exemption will not be available until the SEC approves final rules. Our original post summarizes the JOBS Act, including Title III on crowdfunding.
Limits on Amounts Raised and Invested
As proposed, issuers and investors would be limited by caps on dollars raised and invested in Section 4(a)(6) offerings, as follows:
- An issuer could raise a maximum aggregate amount of $1 million through Section 4(a)(6) offerings in any rolling 12-month period
- Investors, over the course of a 12-month period, would be permitted to invest up to:
- $2,000 or 5% of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000
- 10% of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or greater than $100,000. Investors would not be able to purchase more than $100,000 of crowdfunding securities during any 12-month period
SEC Seeking Comment: Should the $1 million issuer limit be net of fees charged by the intermediary? Should issuers be allowed to exclude any other fees when calculating the amount raised?
Non-Financial Disclosure Requirements
Consistent with Title III of the JOBS Act, the proposed rules would require companies to file certain information with the SEC and provide it to shareholders, the funding portal intermediary and potential investors.
The offering document, Form C, would be required to disclose:
- description of the business and business plan
- price of securities offered, target offering amount, deadline to reach target, and whether company will accept investments in excess of target
- names of 20% or larger shareholders
- information about officers and directors
- related-party transactions
- commitments cancelled if target not met
Companies would be required to amend Form C to disclose material changes (Form C-A) and provide updates on progress toward reaching the target offering amount (Form C-U). Following the offering, crowdfunding issuers would be required to file an annual report with the SEC and provide it to investors.
SEC Seeking Comment: The proposed rules don’t specify the specific disclosures that an issuer must include in the description of the business and the business plan, recognizing that crowdfunding issuers will be at various stages of development. Should there be specific disclosure requirements about the business and the anticipated business plan?
Financial Statement Requirements
Issuers would be required to provide the following financial statements in the offering document, depending on the aggregate amount they offer and sell under Section 4(a)(6) in any rolling 12-month period:
- Offerings of $100,000 or less: U.S. GAAP financial statements for the two most recently completed fiscal years or shorter period during which the issuer has been operating, and income tax return for the most recently completed fiscal year, if any, in both cases certified as true and complete by the issuer’s principal executive officer.
- Offerings of $100,000 – $500,000: U.S. GAAP financial statements reviewed (in accordance with AICPA standards) by a public accountant independent of the issuer and accompanied by the accountant’s review report.
- Offerings above $500,000. U.S. GAAP financial statements audited by an independent auditor, accompanied by the audit report.
SEC Seeking Comment: Should the SEC exempt from the financial statement requirement issuers with no operating history and/or issuers that have been in existence for fewer than 12 months?
The following issuers would not be eligible for equity crowdfunding under Section 4(a)(6):
- foreign issuers, SEC reporting companies and investment companies
- issuers that failed to make any required Form C filings in the two years before a crowdfunding offering
- issuers with no business plan or with only a plan to merge with an unidentified operating company
Further, an issuer would be ineligible if any of the following “covered persons” was involved in a “disqualifying event”:
- the issuer, its predecessors and certain affiliates
- the issuer’s directors, officers, general partners or managing members
- 20% beneficial owners of the issuer (calculated by voting power)
- compensated solicitors for the offering
- any director, officer, general partner or managing member of a compensated solicitor for the offering
The “disqualifying events” would include certain securities-law related injunctions and restraining orders entered in the last five years and certain regulatory orders entered in the last ten years, with exceptions for events the issuer did not know of and, in the exercise of reasonable care, could not have known of. This would require the issuer to make a factual inquiry into whether any disqualifications existed, the nature and scope of which would vary based on the circumstances of the issuer and the other offering participants.
SEC Seeking Comment: Should the SEC include additional guidance on what types of factual inquiries should be undertaken under the reasonable care standard and should there be a cut-off date?
Securities acquired in a crowdfunding transaction would not be allowed to be resold for a period of one year, unless they are sold to a member of the family of the purchaser, to a trust controlled by the purchaser, to a trust created for the benefit of a member of the family of the purchaser or in connection with the death or divorce of the purchaser.
Exemption from Section 12(g) Cap
Section 12(g) of the Securities Exchange Act of 1934 now requires that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons or 500 persons who are not accredited investors register that class of securities with the SEC and subject itself to the SEC’s periodic reporting regime.
The proposed rules provide that securities issued in a crowdfunding transaction under Section 4(a)(6) would be permanently exempted from the record holder tabulation under Section 12(g). An issuer seeking to exclude a person from the record holder tabulation for Section 12(g) purposes would have the responsibility for demonstrating that the securities held by the person were initially issued in a Section 4(a)(6) offering.
SEC Seeking Comment: Should the Section 12(g) exemption for securities issued in a Section 4(a)(6) offering be permanent or only when held of record by the original purchaser, an affiliate of the original purchaser, a member of the original purchaser’s family or a trust for the benefit of the original purchaser or the original purchaser’s family?
The proposal requires that equity crowdfunding offerings be conducted only through a broker or funding portal (and only one), in each case that complies with Section 4A(a) of the Securities Act. The SEC believes that this facilitates the ability of members of the crowd to share information and evaluate the idea or business. Section 4A(a) places certain requirements on these crowdfunding intermediaries, including that they:
- be registered with the SEC either as a broker or as a funding portal by filing Form Funding Portal, as well as other substantive requirements such as the requirement to have a fidelity bond in place
- prohibit their directors, officers and partners from having any financial interest in an issuer using their services
- provide investors with educational materials
- have a reasonable basis to believe the issuer is in compliance with regulations and has set up a means to keep accurate records of its shareholders, and must deny access to any issuer the intermediary believes presents a potential risk of fraud by conducting certain background checks.
- make available information about the issuer and the offering no later than 21 days before the first day securities are sold to any investor.
- ensure no investor exceeds the investment limits (intermediary allowed to rely on an investor’s representations about its income and net worth and total crowdfunding investments made in the last 12 months)
- Allow investors to cancel their investment commitments until 48 hours before the deadline identified in the issuer’s offering materials
Equity crowdfunding has the potential to create new capital raising opportunities for many startups and early stage companies by removing antiquated regulatory barriers and allowing companies to leverage the internet and social media to reach prospective investors. The federal securities laws were written 80 years ago when investors had no access to information about issuers. In the internet age, prospective investors have many sources of information at their fingertips and the “wisdom of the crowd” can both steer dollars to the most promising ideas and ensure that ample information is spread to interested parties.
But the preoccupation of the SEC with investor protection has created a disconnect between the potential of equity crowdfunding and its reality in the form of the proposed crowdfunding rules. To be fair, the framework for most of the rules was predetermined by what Congress enacted in Title III of the JOBS Act. Nevertheless, I fear that the burden and expense associated with many of the proposed rules will, if passed substantially unchanged from its current form, prove to be far less attractive to most companies than traditional private placements. For example, the requirement to produce audited financial statements for offerings above $500,000 will seem prohibitively expensive when compared with accredited investor-only Rule 506 offerings where no financials are mandated at all. It’s also unclear how the burdensome rules proposed to govern intermediaries will attract established investment banks, or even boutiques, and will likely leave the field open primarily to persons with scant resources and experience. Lastly, even in the context of a successful crowdfunded offering, companies will also need to consider carefully the negative consequences associated with a shareholder base consisting of potentially thousands of individual investors. Those consequences include the expense associated with keeping them informed, the difficulties of securing quorums and votes and the inevitable misgivings VCs will have of investing in a crowdfunded startup.
The SEC is seeking comment generally on its proposed rules during a 90-day comment period, and the release identifies 295 separate issues over which it is inviting specific comment. The deadline for comments is February 3, 2014 and could be submitted here.