SEC logoAt an open meeting on October 30, 2015, the Securities and Exchange Commission by a three-to-one vote adopted final rules for equity crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act.   The final rules and forms are effective 180 days after publication in the Federal Register.

Crowdfunding is an evolving method of raising funds online from a large number of people without regard to investor qualification and with each contributing relatively small amounts.[i]   Until now, public crowdfunding has not involved the offer of a share in any Crowdfunding1financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding. Such a profit or revenue-sharing model – sometimes referred to as the “equity model” of crowdfunding – could trigger the application of the federal securities laws because it likely would involve the offer and sale of a security to the public.  Equity crowdfunding has the potential to dramatically alter the landscape of capital markets for startup companies. It has also been the subject of a contentious debate ever since it was included in the JOBS Act, pitting those who want to allow startups to leverage the internet to reach investors and to permit ordinary people to invest small amounts in them against those that view crowdfunding as a recipe for a fraud disaster.

The SEC had issued proposed rules in October 2013 (see my blog post here), and received hundreds of comment letters in response. When the final rules become effective (early May 2016), issuers for the first time will be able to use the internet to offer and sell securities to the public without registration.  Here’s a brief summary of the new crowdfunding exemption rules and where they deviate from the original proposal.

Issuer and Investor Caps

  • Issuers may raise a maximum aggregate amount of $1 million through crowdfunding offerings in any 12-month period.
  • Individual investors, in any 12-month period, may invest in the aggregate across all crowdfunding offerings up to:
    • The greater of $2,000 or 5% of the lesser of annual income or net worth, if either annual income or net worth is less than $100,000, or
    • 10% of the lesser of their annual income or net worth if both their annual income and net worth are equal to or more than $100,000.
  • Aggregate amount an investor may invest in all crowdfunding offerings may not exceed $100,000 in any 12-month period.

Many commenters believed that the proposed $1 million offering limit was too low, but the SEC in the end believed the $1 million cap is consistent with the JOBS Act. The SEC did state in the final rules release, however, that Regulation Crowdfunding is a novel method of raising capital and that it’s concerned about raising the offering limit of the exemption at the outset of the adoption of final rules, suggesting that it would be open to doing so down the road.

As for the individual investment limit, the final rules deviate from the original proposal by clarifying that the limit reflects the aggregate amount an investor may invest in all crowdfunded offerings in a 12-month period across all issuers, and also specifies a “lesser of” approach to the income test.

Financial Disclosure

Financial disclosure requirements are based on the amount offered and sold in reliance on Section 4(a)(6) within the preceding 12-month period, as follows:

  • For issuers offering $100,000 or less: disclosure of total income, taxable income and total tax as reflected in the federal income tax returns certified by the principal executive officer, and financial statements certified by the principal executive officer; but if independently reviewed or audited financial statements are available, must provide those financials instead.
  • Issuers offering more than $100,000 but not more than $500,000: financial statements reviewed by independent public accountant, unless otherwise available.
  • Issuers offering more than $500,000:
    • For issuers offering more than $500,000 but not more than $1 million of securities in reliance on Regulation Crowdfunding for the first time: financial statements reviewed by independent public accountant, unless otherwise available.
    • For issuers that have previously sold securities in reliance on Regulation Crowdfunding: financial statements audited by independent public accountant.

The financial disclosure requirements contain a number of changes from the proposal that hopefully will help reduce the costs and risks associated with preparing the required financials. Instead of mandating that issuers offering $100,000 or less provide copies of their federal income tax returns as proposed, the final rules require an issuer only to disclose total income, taxable income and total tax, or the equivalent line items, from filed federal income tax returns, and to have the principal executive officer certify that those amounts reflect accurately the information in the returns.  This minimizes the risk of disclosure of private information which would exist if tax returns had to be provided.  In addition, reducing the requirement for first time issuers of between $500,000 and $1 million from audited financials (as had been proposed) to reviewed financials is a sensible accommodation inasmuch as the concern about the cost and burden of the audit relative to the size of the offering is even greater for first timers who would need to incur the audit expense before having proceeds from the offering.

Intermediaries

  • Offerings must be conducted exclusively through one platform operated by a registered broker or funding portal.
  • Intermediaries required to provide investors with educational materials, take measures to reduce the risk of fraud, make available information about the issuer and the offering and provide communication channels to permit discussions about offerings on the platform.
  • Funding portals prohibited from offering investment advice, soliciting sales or offers to buy, paying success fees and handling investor funds or securities.
  • Funding portals must register with the SEC by filing new Form Funding Portal, which will be effective January 29, 2016.

The rationale behind the requirement to use only one intermediary is that it helps foster the creation of a “crowd”. Having one meeting place enables a crowd to share information effectively, and minimizes the chances of dilution or dispersement of the crowd. This in turn supports one of the main justifications for equity crowdfunding, which is that having hundreds or thousands of investors sharing information increases the chances that any fraud will be exposed, thus the “wisdom of the crowd”. The one platform requirement also helps to minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering using more than one platform would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit.

One important deviation from the proposed rules is that funding portals will be permitted to curate offerings based on subjective criteria, not just based on perceptions of fraud risk.  A second important deviation is that all intermediaries will be allowed to receive as compensation a financial interest in the issuers conducting offerings on their platforms, which will expand the options available to cash-starved startups.

Preliminary Thoughts

The ink is still wet on the SEC’s 686 page release, but here are some preliminary thoughts. 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 and sell to prospective investors without regard to accredited investor status. The federal securities laws were written over 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 companies and ensure that ample information is spread to interested parties.

As I’ve stated before, however, the SEC’s preoccupation with investor crowdprotection has created a disconnect between the potential of equity crowdfunding and its reality, now expressed in the final rules. To be fair, the framework for most of the rules was predetermined by what Congress enacted in Title III of the JOBS Act and the final rules do contain some welcome relief from the original proposal. Nevertheless, I fear that the burden and expense associated with some of the rules will make Regulation Crowdfunding far less attractive to most companies than traditional offerings under Rule 506 notwithstanding the latter’s pro-accredited investor bias. For example, the requirement to produce audited financial statements for offerings above $500,000 (except for first time Regulation Crowdfunding issuers) 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 governing 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.

In the final analysis, though, Title III equity crowdfunding will finally become law, meaning that issuers will for the first time be allowed to leverage the internet to sell securities to an unlimited number of investors without registration and without regard to accredited investor status, and that is decidedly a treat.

[1] The term “crowdfunding” has also been used more broadly as a somewhat generic term for any campaign to raise funds through an online platform.  These include non-equity crowdfunding (i.e., rewards or pre-order based), “accredited” crowdfunding (in reliance on Rule 506(b) or 506(c)) and registered crowdfunding (in reliance on Regulation A+).  This post will use the term only as it applies to small equity offerings to many investors, each contributing relatively small amounts, and soon to be available under Regulation Crowdfunding.

In my last post, I blogged about online funding platforms. In that post, I described the typical model of indirect investing through a special purpose vehicle (“SPV”) with the platform sponsor taking a carried interest in the SPV’s profits from the portfolio company and no ourcrowdtransaction fee, as a means of avoiding broker-dealer regulation. I also discussed the concept of a pre-screened password protected member-only website as a means of establishing a preexisting fundablerelationship with prospective investors and thus avoiding the use of any act of “general solicitation,” which would otherwise violate the rules of the registration exemption under Rule 506(b).

SEC logoIn a no-action letter dated August 6, 2015 entitled Citizen VC, Inc., the SEC has provided important guidance on the procedures needed for an online funding platform to establish the kind of preexisting relationship needed to avoid being deemed to be engaged in general solicitation. As an aside, the concern over general solicitation and preexisting relationships is relevant to offerings under new Rule 506(b), but not under Rule 506(c).   Despite the creation in 2013 of an exemption under new Rule 506(c) pursuant to the JOBS Act for general solicitation offerings in which sales are made only to accredited investors, most online funding platforms continue to prefer to conduct portfolio company offerings indirectly through SPVs under Rule 506(b), despite the prohibition on general solicitation, primarily because of the additional requirement under Rule 506(c) that issuers use reasonable methods to verify accredited investor status.

In its request for a no-action letter, Citizen VC described itself as an citizen vconline venture capital firm that facilitates indirect investment in portfolio companies (through SPVs) by pre-qualified, accredited and sophisticated “members” in its site. It asserted to have qualification procedures intended to establish substantive relationships with, and to confirm the suitability of, prospective investors that visit the website. Anyone wishing to investigate the password protected sections of the site accessible only to members must first register and be accepted for membership. To apply for membership, prospective investors are required to complete an “accredited investor” questionnaire, followed by a relationship building process in which Citizen VC collects information to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks related to an investment. It does so by contacting the prospective investor by phone to discuss the prospective investor’s investing experience and sophistication, investment goals and strategies, financial suitability, risk awareness, and other topics designed to assist Citizen VC in understanding the investor’s sophistication, utilizing third party credit reporting services to gather additional financial information and credit history information and other methods to foster online and offline interactions with the prospective investor. In the request letter, Citizen VC asserted that the relationship establishment period is not limited by a specific time period, but rather is a process based on specific written policies and procedures created to ensure that the offering is suitable for each prospective investor.

Citizen VC stated in its request letter that prospective investors only become “members” and are given access to offering information in the password protected section of the site after Citizen VC is satisfied that the prospective investor has sufficient knowledge and experience and that it has taken reasonable steps necessary to create a substantive relationship with the prospective investor. Once a sufficient number of qualified members have expressed interest in a particular portfolio company, those members are provided subscription materials for investment in the SPV formed by Citizen VC to aggregate such members’ investments, the sale of interests of such SPV is consummated and the SPV then invests the funds, and becomes a shareholder of, the portfolio company.

In its request letter, after providing the foregoing background, Citizen VC asked the SEC staff to opine that the policies and procedures described in the letter are sufficient to create a substantive, pre-existing relationship with prospective investors such that the offering and sale on the site of interests in an SPV that will invest in a particular portfolio company will not constitute general solicitation.

sec no-actionIn its no-action letter, the SEC staff concluded that Citizen VC’s procedures were sufficient to establish a preexisting relationship and do not constitute general solicitation. It stated that the quality of the relationship between an issuer and an investor is the most important factor in determining whether a “substantive” relationship exists and noted Citizen VC’s representation that its policies and procedures are designed to evaluate the prospective investor’s sophistication, financial circumstances and ability to understand the nature and risks of the securities to be offered. The staff went on to say that there is no specific duration of time or particular short form accreditation questionnaire that can be relied upon solely to create such a relationship, and that whether an issuer has sufficient information to evaluate a prospective offeree’s financial circumstances and sophistication will depend on the facts and circumstances of each case. The staff also based its conclusion on Citizen VC’s representation that an investment opportunity is only presented after the prospective investor becomes a “member” in the site.

An argument could be made that SPV-based online funding platforms represent the future of VC investing. The Citizen VC no-action letter provides valuable guidance relating to the establishment of the kind of substantive relationship with prospective investors needed to enable the online funding platform to conduct Rule 506(b) offerings without being deemed to engage in general solicitation.

Lately I’ve been approached by current and prospective clients about ourcrowdonline funding platforms, either by folks interested in forming and operating them or those interested in raising capital through them. There seems to be a lot of confusion surrounding how they work and what the legal issues are, so here’s my attempt to bring some clarity to this topic.

Quite simply, an online funding platform is any website that seeks to fundableconnect issuers seeking capital with investors willing to invest. Historically, the prohibition on general solicitation in private offerings meant as a practical matter that an issuer was limited to raising capital only from those with whom it had a preexisting relationship. In fact, the prohibition on general solicitation was considered by many to be the most significant obstacle to private capital formation. It’s for this reason that many private issuers seek the services of a placement agent, on whose preexisting relationships an issuer could piggyback. But securing the services of a decent placement agent by a startup looking to make a small offering (e.g., less than $1 million) could be daunting. Commonly referred to as crowdfunding, the phenomenon of online funding platforms is essentially the internet coming to the capital raising industry, which has the potential to transform it the same way the internet disrupted the publishing, retail and transportation industries.

pitchbookOnline funding platforms also have the potential to address another related problem. If you’re a startup located outside of the three major venture hubs – Bay Area, New York Metro and Boston – your chances of raising capital are even slimmer. According to PitchBook’s analysis of second quarter 2015 venture capital activity by region, those three regions accounted for nearly half of total global venture capital invested. Funding platforms have the potential to reach neglected regions of the world.

So, if you’re looking to create and operate an online funding platform, there are two legal issues to be concerned about: the prohibition on general solicitation, and broker dealer regulation.

General Solicitation

The earliest online funding platforms were launched in the ‘90s long before the JOBS Act created an exemption for private offerings using general solicitation. So from their inception, funding platforms sought to avoid engaging in any act that could be construed to fall within the prohibition. And even to this day, nearly two years after the accredited investor only exemption under Rule 506(c) which allows general solicitation, most funding platforms still rely on the old exemption under Rule 506(b) which prohibits it.

So how does one use the internet to conduct an offering without engaging in a general solicitation? The answer lies in the concept of the preexisting relationship, which a platform may establish under the right circumstances through a process of pre-screening, password protection and cooling off. The practice was blessed by the SEC in its 1998 Lamp Technologies no-action letter, in which the SEC staff found that the pre-qualification of accredited investors and posting of a notice concerning a private fund on a website administered by Lamp Technologies, Inc. (“LTI”) that is password-protected and accessible only to pre-screened accredited investor subscribers would not involve general solicitation. Subscribers who pre-qualified as accredited investors and paid a subscription fee would receive a password granting them access to the site, and subscribers were then subject to a 30-day cooling off period during which they could not invest. The SEC staff noted that (i) both the invitation to complete the questionnaire and the questionnaire itself would be generic in nature and would not reference any of the investment opportunities on the site, (ii) the password-protected site would be accessible to an investor only after LTI confirmed accredited investor status, and (iii) a potential investor could purchase securities only after the 30-day cooling-off period.

Broker-Dealer Regulation

Funding portals must choose between two alternative but mutually exclusive business models: broker-dealer and venture fund. In the former, investors purchase the securities of, and invest directly in, the operating company; in the latter, the platform organizers form a special purpose vehicle (“SPV”), investors buy shares in the SPV and the operating company closes the round with only one investor (the SPV). Among other things, the choice of business model has enormous consequences for the operating company’s cap table.

Many sponsors of funding platforms structure themselves so as to not be deemed to be a “broker-dealer”, which would mean having to register with the SEC as a broker-dealer and be subject to reporting, disclosure and other burdensome regulations.

Under Section 3(a)(4) of the Securities Exchange Act of 1934, a “broker” is defined as any person that is “engaged in the business of effecting transactions in securities for the account of others.” According to the SEC, a person “effects transactions in securities” if he participates in such transactions “at key points in the chain of distribution”, and that a person is “engaged in the business” if he receives transaction-related compensation and holds himself out as a broker. The determination as to whether an entity is acting as a “broker” requires a facts and circumstances analysis, but the SEC attributes great weight to whether transaction-based compensation is paid.

Some funding platforms are operated by registered broker-dealers, or are owned, operated by or partnered with registered broker-dealers. These platforms facilitate sales of the operating company’s securities directly to accredited investors. The broker-dealer model platforms receive transaction-based compensation, typically consisting of a percentage of the funds raised, generally ranging from one to ten percent, depending on the offering amount and type of deal.

Other funding platform operators avoid broker-dealer regulation like the plague. Before the JOBS Act, the SEC provided some guidance in the form of no-action letters that conditioned relief from broker-dealer regulation on the platform not providing investment advice, receiving transaction-based compensation, participating in negotiations or holding investor funds. Section 201 of the JOBS Act provides an explicit broker-dealer exemption for online platforms to broker capital raising transactions under Rule 506 (even with general solicitation), provide ancillary services other than investment advice and provide standardized deal documents so long as the platform does not receive transaction-based compensation or handle customer funds or securities and is not a “bad actor.”

In 2013, the SEC gave further guidance to investment fund model platforms in the form of two no-action letters, FundersClub and AngelsList.

FundersClub sources start-ups for its affiliated funds or SPVs to invest in and fundersclubthen posts information on its website that is only available to FundersClub members, all of whom are accredited investors. The SPV relies on Rule 506 to conduct an offering in the SPV. FundersClub negotiates the terms of the SPV’s investment in the start-up. FundersClub does not receive any transaction-based compensation other than administrative fees; instead, it receives a carry of 20% or less of the profits of the SPV but never exceeding 30%. In stating that it would not recommend enforcement action under Section 15(a)(1) of the Exchange Act, the Staff noted that FundersClub’s activities appear to comply with Section 201 of the JOBS Act, in part because it receives no compensation in connection with the purchase or sale of securities.

In AngelList, the SEC staff noted AngelList’s platform must be “exclusively available” to accredited investors and that AngelList may not receive any transaction-based compensation or solicit investors outside of the website itself. In AngelList, a “lead angel” would source the start-ups and structure terms in exchange for a back-end carried interest that would be shared between an AngelList-affiliated investment adviser and the lead angel. The significance of this letter appears to be in not treating back-end carried interest as transaction-based compensation.

The Regulation A amendments adopted by the Securities Exchange Commission on March 25 are Federal Registerbeing published tomorrow, April 20, in the Federal Register.  That means the final rules and form amendments will officially become effective on June 19, 2015 (by rule, 60 days after such publication).

The new Regulation A, referred to widely as Regulation A+, increases the offering cap from $5 million to $50 million with reasonable investor protection safeguards.  I previously summarized the regulation here.  The main reform features of the new regs are blue sky preemption for Tier II offerings, broader “testing the waters”, scaled disclosure and modified reporting.

Reg A+In theory, Reg A+ has the potential to provide growth companies with a viable alternative to a traditional S-1 IPO, albeit with a more cost effective runway and scaled disclosure than even the streamlined emerging growth company pathway under JOBS Act Title I.  It remains to be seen whether a sufficiently robust small public company ecosystem will develop to support companies that go public through Reg A+.

Importantly, new Reg A+ also reforms the resale rules in a significant respect by eliminating the requirement under old Reg A that issuers must have had net income from continuing operations in at least one of its last two fiscal years for affiliate resales to be permitted.  This is a sensible reform inasmuch as many emerging companies experience net losses for several years due to high research and development costs.  Absence of net income, by itself, is not a sufficient indicator of enhanced risk, and increasing selling stockholder access to avenues for liquidity will encourage investment in emerging companies.

 

My partner Steve Melore and I braved the latest New York snow storm to attend the Small Business Investor Alliance’s Northeast Private Equity Conference on January 22, of which Farrell Fritz was a sponsor.  The SBIA is the leading professional organization for lower middle-market investment funds and the LPs that invest in them.

The Conference kicked off with a presentation on SBA goals and priorities for 2014 by Javier Saade, the new Associate Administrator for the SBA’s Office of Investment and Innovation, the division that runs an alphabet soup of programs to provide capital to private investment funds to invest in small businesses (SBIC) and Federal research grant dollars to technology companies (SBIR and STTR).  Mr. Saade announced that the SBA intends to expand the SBIC program’s annual budget from $3 billion to $4 billion.  He stated that another priority for the SBA in 2014 will be the promotion of equity crowdfunding, and in answer to a question posed during the Q&A from your humble blogger about how the SBA might lean on the SEC to finally pass reasonable crowdfunding rules, Mr. Saade said that he believes the SBA could play a constructive informational role in this regard.

Next up was Doug Farren, Associate Director of the National Center for the Middle Market, who deftly filled in for his boss in presenting the results of the Center’s quarterly business  performance and outlook survey.  The report was based on a survey of 1,000 C-suite executives of middle market companies – those with annual revenues between $10 million and $1 billion — on key indicators of past and future performance.  Among other key results, the survey revealed that revenue for these companies increased during the fourth quarter of 2013 and that 57% continue to expect improvement in 2014.  A majority of middle market companies, however, said that “uncertainty” regarding government policies (perhaps a euphemism for an increase or expected increase in burdensome regulation) is hampering their ability to grow and their willingness to hire and invest.  In particular, healthcare legislation continues to be the largest concern.

Brett Palmer, the energetic President of SBIA, delivered an insightful analysis of this year’s midterm elections and an update on key legislative and regulatory initiatives affecting private equity.

The final speaker was the least connected to private equity, but the most talked about during the post-conference networking session.  J.J. French, the founder, lead guitarist and manager of heavy metal band Twisted Sister, was clever and comedic as he regaled the audience with tales of the band’s battles with Murphy’s Law during the 70’s and 80’s in its quest to secure a record contract.

Decidedly a worthwhile conference, and I was particularly impressed with how Brett and his staff were able to control the mix of attendees, tactfully ensuring an overwhelmingly large percentage of fund managers and investors and keeping guys like me to a minimum.  

On January 2, 2014, the Financial Industry Regulatory Authority (“FINRA”) published its annual priorities letter for 2014, chief among which will be IPOs, general solicitation in private offerings, crowdfunding portals and microcap fraud.

IPOs

In the area of IPOs, FINRA intends to focus on “spinning,” a practice in which an underwriter allocates “hot” IPO shares to directors and/or executives of potential investment banking clients in exchange for investment banking business.  An IPO is considered to be a “hot” offering when investor demand significantly exceeds the supply of securities in the offering.  Spinning became the subject of regulatory scrutiny during the dot com driven IPO boom of the late 1990s, and is a prohibited practice under FINRA Rule 5131.  FINRA is also concerned about bad actors being drawn to the IPO market, which often occurs during a robust market.  Finally, FINRA intends to focus on compliance with rules governing the sale and allocation of IPO securities, including whether firms are incenting associated persons to sell cold offerings to obtain client allocations of hot offerings.  Shares in hot offerings often trade at substantial premiums to the offering price.  An IPO is considered to be a “cold” offering when there is weak investor interest in the IPO shares.

General Solicitation in Private Offerings

Private placement abuses by placement agents has long been a primary focus of FINRA. The recent amendments to Rule 506 of Regulation D, which became effective September 23, 2013, remove the prohibition on general solicitation and advertising provided that all purchasers are accredited investors and the issuer takes reasonable steps to ensure they are such. FINRA believes that general solicitation, which before the amendments had been permitted only in connection with public offerings registered with the SEC, provides new challenges for securities firms to ensure that advertisements and other marketing materials are based on principles of fair dealing and good faith, are fair and balanced and provide a sound basis to evaluate the facts about securities acquired in a private placement.

Crowdfunding Portals

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 funding portals 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.  On October 23, the SEC issued its proposed rules on equity crowdfunding, and on the same day FINRA issued its proposed rules on crowdfunding portals.  The new equity crowdfunding exemption will not be available until the SEC approves final rules. The objective of FINRA’s proposed rules is to ensure that the capital raising objectives of the JOBS Act are advanced in a manner consistent with investor protection.  Under the proposed rules, a private company raising capital under the crowdfunding exemption will be required to use an intermediary that is either a registered broker-dealer or a newly-created category of intermediary, a funding portal, which must register with the SEC and FINRA. If the intermediary is a funding portal, its activities will be more limited than those permitted for broker-dealers. For example, a funding portal may not solicit purchases, sales or offers to buy the securities offered or displayed on its website or portal; compensate promoters, finders or lead generators for providing information on individual  investors; hold, manage or accept customers’ funds or securities; or offer investment advice or recommendations.  FINRA’s proposed rules attempt to streamline the registration and oversight of funding portals to reflect their limited scope of permitted activity. The proposed rules address a number of topics, including the membership application process, and fraud and manipulation. The proposed rules also contain provisions to ensure that bad actors do not enter the system. In its priorities letter, FINRA indicated that as the rules become effective, and funding portals become FINRA members, it will implement a regulatory program designed to protect investors while recognizing the distinctions between funding portals and broker-dealers.

Microcap Fraud

Offerings of microcap and speculative low-priced over-the-counter securities continue to be an area of significant ongoing concern for FINRA. FINRA is urging securities firms to review their policies and procedures to ensure that activities at the firm related to microcap and low-priced OTC securities are compliant.  FINRA believes that firms should carefully supervise employees who conduct direct or indirect outside business activities associated with microcap and OTC companies, traders involved in trading microcap and low-priced OTC securities and firm activities where an affiliate of the firm is the transfer agent for the microcap or low-priced OTC securities. Finally, FINRA is encouraging firms to monitor customer accounts liquidating microcap and low-priced OTC securities to ensure, among other things, that the firm is not facilitating, enabling or participating in an unregistered distribution.

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.

Background

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?

Disqualification

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?

Resale Restrictions

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?

Crowdfunding Intermediaries

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

Concluding Thoughts

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.

Comment Process

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.