Beginning on May 16, issuers for the first time will be able to offer and sell securities online to anyone, not just accredited investors, without 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.
But 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.
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.
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 which 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
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. 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.