This article provides a detailed overview of the final rules, Regulation Crowdfunding, which will be applicable to crowdfunding offerings conducted in reliance on Section 4(a)(6) of the Securities Act of 1933 as amended (the “Securities Act”), which was added by Title III of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”), as well as to those intermediaries participating in such offerings. We do not address the proposed FINRA framework applicable to funding portals, which will be covered in a separate alert. All rule references, unless otherwise noted, refer to rules under Regulation Crowdfunding.

We will supplement this alert with a more detailed practical analysis comparing the various new offering exemptions available to issuers as a result of the JOBS Act.

PART ONE: GENERAL REQUIREMENTS

Limit on Capital Raised

Consistent with the statutory limitations, Rule 100(a) provides that an issuer may sell up to $1 million in any 12-month period to investors in an offering made pursuant to the exemption. Of course, an issuer may consider conducting other exempt offerings in close proximity with its crowdfunded offering.  In calculating the amounts sold for purposes of the threshold, amounts sold by a predecessor or by an entity under common control with the issuer will be aggregated with the amounts sold by the issuer.

Individual Investment Limits

In the final rules, the Securities and Exchange Commission (the “SEC”) has modified the investor limits from those included in its proposed rules. The final rules make clear that the individual investor limit is an aggregate limit, which applies to all investments made by the individual over a 12-month period in crowdfunded offerings and not to a specific offering.

An investor will be limited to investing:

  1. The greater of: $2,000 or 5% of the lesser of the investor’s annual income or net worth if either annual income or net worth is less than $100,000; or
  2. 10% of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more.

As we discuss below, the issuer can rely on the intermediary’s calculation of the investment limit; provided that the issuer does not have knowledge that the investor has exceeded, or would exceed, the investment limits as a result of participating in the issuer’s offering.

Offering through an Intermediary

An issuer would only be able to engage in an offering through a registered broker-dealer or through a funding portal, and an issuer can only use one intermediary for a particular offering or concurrent offerings made in reliance on the exemption.

The offering must be conducted online only through the intermediary’s platform, so that the “crowd” has access to information and there is a forum for an exchange of information among potential offering participants.

A “platform” is defined as “a program or application accessible via the Internet or other similar electronic communication medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6) of the Securities Act.”

Eligible Issuers

The ability to engage in crowdfunding is not available to all issuers. By statute, the following issuers cannot rely on crowdfunding transactions under Section 4(a)(6):

  • issuers not organized under the laws of a state or territory of the United States or the District of Columbia;
  • issuers already subject to Securities Exchange Act of 1934, as amended (the “Exchange Act”) reporting requirements;
  • investment companies as defined in the Investment Company Act of 1940 (the “Investment Company Act”) or companies that are excluded from the definition of “investment company” under Section 3(b) or 3(c) of the Investment Company Act; and
  • any issuer that the Commission, by rule or regulation, determines appropriate.

The final rules also exclude:

  • issuers disqualified from relying on Section 4(a)(6), or “bad actors;” and
  • issuers that have sold securities in reliance on Section 4(a)(6) and have failed, to the extent required, to make required ongoing reports required by Regulation Crowdfunding during the two-year period immediately preceding the filing of the required new offering statement; and
  • any issuer that is a development stage company that has no specific business plan or purpose, or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company or companies.

Continue Reading Following the Wisdom of the Crowd? A Look at the SEC’s Final Crowdfunding Rules

For several months, various legislative proposals that would ease regulatory and financing burdens on smaller companies have been discussed by legislators, business leaders and commentators. These proposals were brought together under the Jumpstart Our Business Startups (JOBS) Act (H.R. 3606). The JOBS Act was passed by Congress on March 27, 2012 and signed into law by President Obama on April 5, 2012. For a comprehensive overview of the JOBS Act, see our Client Alert.

The JOBS Act tackles various issues relating to financing businesses, however, within the realm of social media, “crowdfunding” is a key topic which Congress has chosen to regulate. In this article, we take a close look at the crowdfunding component of the new law.

Background on Crowdfunding

“Crowdfunding” or “crowdsourced funding” is a new outgrowth of social media that provides an emerging source of funding for ventures. Crowdfunding works based on the ability to pool money from individuals who have a common interest and are willing to provide small contributions toward the venture. Crowdfunding can be used to accomplish a variety of goals (e.g., raising money for a charity or other causes of interest to the participants), but when the goal is commercial in nature and there is an opportunity for crowdfunding participants to share in the venture’s profits, federal and state securities laws will likely apply. Absent an exemption from SEC registration (or actually registering the offering with the SEC), crowdfunding efforts that involve sales of securities are in all likelihood illegal. In addition to SEC requirements, those seeking capital through crowdfunding have had to be cognizant of state securities laws, which include varying requirements and exemptions. By crowdfunding through the Internet, a person or venture can be exposed to potential liability at the federal level, in all 50 states, and potentially in foreign jurisdictions. Existing exemptions present some problems for persons seeking to raise capital through crowdfunding. For example, Regulation A requires a filing with the SEC and disclosure in the form of an offering circular, which would make conducting a crowdfunding offering difficult. The Regulation D exemptions generally would prove too cumbersome, and a private offering approach or the intrastate offering exemption is inconsistent with widespread use of the Internet. Section 25102(n) of the California Corporations Code might provide a possible exemption for some California issuers, given that it permits general announcement of an offering without qualification in California (with a corresponding exemption from registration at the federal level provided by SEC Rule 1001, the California limited general solicitation exemption). Crowdfunding advocates have called on the SEC to consider implementing a new exemption from registration under the federal securities laws for crowdfunding. For more on crowdfunding, see also our prior Client Alert here.

When H.R. 3606 was adopted in the House of Representatives, the bill included Title III, titled “Entrepreneur Access to Capital.” This Title provided an exemption from registration under the Securities Act for offerings of up to $1 million, or $2 million in certain cases when investors were provided with audited financial statements, provided that individual investments were limited to $10,000 or 10 percent of the investor’s annual income. The exemption was conditioned on issuers and intermediaries meeting a number of specific requirements, including notice to the SEC about the offering and the parties involved with the offering, which would be shared with state regulatory authorities. The measure would have permitted an unlimited number of investors in the crowdfunding offering, and would have preempted state securities regulation of these types of offerings (except that states would be permitted to address fraudulent offerings through their existing enforcement mechanisms).

The House measure also contemplated that the issuer must state a target offering amount and a third-party custodian would withhold the proceeds of the offering until the issuer has raised 60 percent of the target offering amount. The provision also contemplated certain disclosures and questions for investors, and provided for an exemption from broker-dealer registration for intermediaries involved in an exempt crowdfunding offering.

After it was adopted, the House crowdfunding measure drew a significant amount of criticism, with much of that criticism focused on a perceived lack of investor protections. In a letter to the Senate leadership, SEC Chairman Mary Schapiro noted that “an important safeguard that could be considered to better protect investors in crowdfunding offerings would be to provide for oversight of industry professionals that intermediate and facilitate these offerings,” and also noted that additional information about companies seeking to raise capital through crowdfunding offerings would benefit investors.

In the Senate, an amendment to H.R. 3606 submitted by Senator Merkley and incorporated in the final JOBS Act provides additional investor protections in crowdfunding offerings. Title III, titled “Crowdfunding,” amends Section 4 of the Securities Act to add a new paragraph (6) that provides a crowdfunding exemption from registration under the Securities Act. The conditions of the exemption are that:

  • The aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction, is not more than $1,000,000;
  • The aggregate amount sold to any investor by the issuer, including any amount sold in reliance on the crowdfunding exemption during the 12-month period preceding the date of the transaction, does not exceed:
    • the greater of $2,000 or 5 percent of the annual income or net worth of the investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; or
    • 10 percent of the annual income or net worth of an investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;
  • The transaction is conducted through a broker or funding portal that complies with the requirements of the exemption; and
  • The issuer complies with the requirements of the exemption.

Among the requirements for exempt crowdfunding offerings would be that an intermediary:

  • Registers with the SEC as a broker or a “funding portal,” as such term is defined in the amendment;
  • Registers with any applicable self-regulatory authority;
  • Provides disclosures to investors, as well as questionnaires, regarding the level of risk involved with the offerings;
  • Takes measures, including obtaining background checks and other actions that the SEC can specify, of officers, directors, and significant shareholders;
  • Ensures that all offering proceeds are only provided to issuers when the amount equals or exceeds the target offering amount, and allows for cancellation of commitments to purchase in the offering;
  • Ensures that no investor in a 12-month period has invested in excess of the limit described above in all issuers conducting exempt crowdfunding offerings;
  • Takes steps to protect privacy of information;
  • Does not compensate promoters, finders, or lead generators for providing personal identifying information of personal investors;
  • Prohibits insiders from having any financial interest in an issuer using that intermediary’s services; and
  • Meets any other requirements that the SEC may prescribe.

Issuers also must meet specific conditions in order to rely on the exemption, including that an issuer file with the SEC and provide to investors and intermediaries information about the issuer (including financial statements, which would be reviewed or audited depending on the size of the target offering amount), its officers, directors, and greater than 20 percent shareholders, and risks relating to the issuer and the offering, as well specific offering information such as the use of proceeds for the offering, the target amount for the offering, the deadline to reach the target offering amount, and regular updates regarding progress in reaching the target.

The provision would prohibit issuers from advertising the terms of the exempt offering, other than to provide notices directing investors to the funding portal or broker, and would require disclosure of amounts paid to compensate solicitors promoting the offering through the channels of the broker or funding portal.

Issuers relying on the exemption would need to file with the SEC and provide to investors, no less than annually, reports of the results of operations and financial statements of the issuers as the SEC may determine is appropriate. The SEC may also impose any other requirements that it determines appropriate.

A purchaser in a crowdfunding offering could bring an action against an issuer for rescission in accordance with Section 12(b) and Section 13 of the Securities Act, as if liability were created under Section 12(a)(2) of the Securities Act, in the event that there are material misstatements or omissions in connection with the offering.

Securities sold on an exempt basis under this provision would not be transferrable by the purchaser for a one-year period beginning on the date of purchase, except in certain limited circumstances. The crowdfunding exemption would only be available for domestic issuers that are not reporting companies under the Exchange Act and that are not investment companies, or as the SEC otherwise determines is appropriate. Bad actor disqualification provisions similar to those required under Regulation A would also be required for exempt crowdfunding offerings.

Funding portals would not be subject to registration as a broker-dealer, but would be subject to an alternative regulatory regime, subject to SEC and SRO authority, to be determined by rulemaking. A funding portal is defined as an intermediary for exempt crowdfunding offerings that does not: (1) offer investment advice or recommendations; (2) solicit purchases, sales, or offers to buy securities offered or displayed on its website or portal; (3) compensate employees, agents, or other persons for such solicitation or based on the sale securities displayed or referenced on its website or portal; (4) hold, manage, possess, or otherwise handle investor funds or securities; or (5) engage in other activities as the SEC may determine by rulemaking.

The provision would preempt state securities laws by making exempt crowdfunding securities “covered securities,” however, some state enforcement authority and notice filing requirements would be retained. State regulation of funding portals would also be preempted, subject to limited enforcement and examination authority.

The SEC must issue rules to carry out these measures not later than 270 days following enactment. The dollar thresholds applicable under the exemption are subject to adjustment by the SEC at least once every five years.

The provisions of this title of the JOBS Act are not self-effectuating, as indicated above.

Practical Considerations

Issuers: For those issuers who are seeking to raise small amounts of capital from a broad group of investors, the crowdfunding exemption may ultimately provide a viable alternative to current offering exemptions, given the potential that raising capital through crowdfunding over the Internet may be less costly and may provide more sources of funding. At the same time, issuers will need to weigh the ongoing costs that will arise with crowdfunding offerings, in particular the annual reporting requirement that is contemplated by the legislation. Moreover, it is not yet known how much intermediaries such as brokers and funding portals will charge issuers once SEC and SRO regulations apply to their ongoing crowdfunding operations.

Intermediaries: Brokers and potential funding portals will need to consider how their processes can be revamped to comply with regulations applicable to exempt crowdfunding offerings, in particular given the level of information that will need to be provided in connection with crowdfunding offerings and the critical role that intermediaries will play in terms of “self-regulating” these offerings.